Modern Applications of Austrian Thought

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MODERN APPLICATIONS OF AUSTRIAN THOUGHT Edited by Jürgen G. Backhaus

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Modern Applications of Austrian Thought

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Modern Applications of Austrian Thought

Austrian economics is often criticized as being hostile to empirical research and seen purely as an ideology. On the contrary, the purpose of this book is to show that Austrian economics provides an interesting approach to most conceivable subjects in economics. The book includes Austrian analysis of health economics, labour economics, taxation, business cycle theory and property rights. The authors include Roger Koppl, Laurence S. Moss, Bart Nooteboom and Gerrit Meijer. This book will prove invaluable to students studying economics and prove to be interesting reading for the applied economist in any area of application. Jürgen G. Backhaus holds the Krupp Foundation Chair of Public Finance and Fiscal Sociology at the University of Erfurt in Germany. He is also the founding editor of the European Journal of Law and Economics.

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Modern Applications of Austrian Thought

Edited by Jürgen G. Backhaus

First published 2005 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Ave, New York, NY 10016 Routledge is an imprint of the Taylor & Francis Group © 2005 editorial matters and selection, Jürgen G. Backhaus; individual chapters, the contributors Typeset in Baskerville by Wearset Ltd, Boldon, Tyne and Wear Printed and bound in Great Britain by MPG Books Ltd, Bodmin All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data A catalog record for this book has been requested ISBN 0-415-36542-2

Contents

List of illustrations List of contributors Preface

xii xiii xv

A

General economics and teaching 1 The applied economics of the modern Austrian school

1 3

LAURENCE S. MOSS

B

Schools of economic thought and methodology 2 F.A. Hayek’s methodological U-turn reconsidered in light of his concept of social facts

21 23

G.M. HUUSSEN

D

Microeconomics 3 The consumer in Austrian economics and the Austrian perspective on consumer policy

39 41

AUKE R. LEEN

E

Macroeconomics and monetary economics 4 Austrian cycle theory and the prospect of a coordinationist macroeconomics RICHARD E. WAGNER

75 77

x Contents G

Financial economics 5 Big Players and money demand

93 95

CATHERINE BECKETT GILANSHAH AND ROGER KOPPL

H

Public economics 6 Taxation: an Austrian approach

113 115

JÜRGEN G. BACKHAUS

7 Some aspects of the relationship between the Freiburg school and the Austrian school

139

GERRIT MEIJER

I

Health, education, and welfare 8 A model of the dynamic welfare state: Friedrich von Hayek revisited

151 153

MANFRED PRISCHING

9 Austrian aspects to health economics

175

URSULA BACKHAUS

J

Labor and demographic economics

195

10 Austrian theory in the area of labor economics

197

DON BELLANTE

L

Industrial organization

207

11 Neo-Austrian, industrial and Ordo-Austrian competition policy

209

J.A. HANS MAKS

M

Business administration and business economics; marketing; accounting

223

12 Discovery, competence and services

225

BART NOOTEBOOM

Contents

xi

N

Economic history

241

13 Werner Sombart’s views on profit, capital, credit, and the Austrian school of economics

243

GÜNTHER CHALOUPEK

O

Economic development, technological change, and growth

251

14 Austrian economics and ‘The Other Canon’

253

ERIK S. REINERT

P

Economic systems

299

15 The property rights basis of von Mises’s critique of socialism and its relevance for the privatization of state enterprises in Eastern Europe

301

WILLEM KEIZER

16 Comparative economic systems

327

STEVEN HORWITZ

Q

Agricultural and natural resource economics; environmental and ecological economics

345

17 Austrian views on environmental protection

347

ANDRIES NENTJES

Index

371

Illustrations

Figures 6.1 Relationship between tax base and public services 14.1 The Renaissance world-view 14.2 Reality economics: the knowledge- and production-based other canon of economics

123 258 262

Tables 5.1 The Hurst coefficient for the initial and the final period 14.1 The two canons of economics

108 263–264

Contributors

Jürgen G. Backhaus, Krupp Chair in Public Finance and Fiscal Sociology, University of Erfurt, Nordhäuser Str. 63, 99089 Erfurt, Germany Ursula Backhaus, Magdeburger Allee 55, D-99086 Erfurt, Germany Catherine Beckett Gilanshah, Department of Economics, George Mason University, Fairfax, VA 22030, USA Don Bellante, Department of Economics, University of South Florida, 4202 East Fowler Avenue, BSN 3403, Tampa, FL 33620-5524 Günther Chaloupek, Prinz Eugen Str. 20, A-1041 Vienna, Austria Steven Horwitz, Department of Economics, St Lawrence University, Canton, NY 13617, USA G.M. Huussen, Heemraadsingel 12, 3641 JH Mijdrecht, The Netherlands Willem Keizer, Joh. Vermeerplein 16 II, 1071 DV Amsterdam, The Netherlands Roger Koppl, Department of Economics and Finance, Fairleight Dickinson University, Madison, NJ 07940, USA Auke R. Leen, Department of Tax Law and Economics, Faculty of Law, Leiden University, Steenschuur 25, PO Box 9520, 2300 RA Leiden, The Netherlands J.A. Hans Maks, EURECOM, Maastricht University, PO Box 616, 6200 MD Maastricht, The Netherlands Gerrit Meijer, Department of Economics, Maastricht University, PO Box 616, 6200 MD Maastricht, The Netherlands Laurence S. Moss, Babson College, Babson Park, MA 02157, USA Andries Nentjes, Vakgroep Belastingrecht, Economie en Openbare Financien, Faculteit de Rechtsgeleerdheid, Postbus 716, 9700 AS Groningen, The Netherlands

xiv

Contributors

Bart Nooteboom, Adelheidstraat 82, 2595 EE The Hague, The Netherlands Manfred Prisching, Karl Franzens University Graz, Universitätsstraße 15, A-8010 Graz, Austria Erik S. Reinert, Centre for Development and the Environment, University of Oslo and Norsk Investforum, Oslo, Norway Richard E. Wagner, George Mason University, St Georges Hall, 4400 University Drive, Fairfax, VA 22030, USA

Preface

Austrian economics is often conceived as an ideology. People are thought to stir in the older mud of unintelligible writings, and henceforth disagree among another. It is also often said that Austrian economics is not empirical. With this book, I try to dispel all three of these notions. I believe that Austrian economics is a sensible way of approaching current economic issues, it is not backward-looking and it can make sense when mainstream economics does not. Austrian economics may be clustered by economists who emphasize ideologies. These ideologies actually differ, but their study is not the purpose of this book. Austrian economics is also often criticized as being hostile to empirical research. The studies in this book prove the contrary. The purpose of this book is to show that Austrian economics provides an interesting approach to most any conceivable subject in economics, and this is demonstrated by the table of contents. We have, using the index of the Journal of Economic Literature, tried to cover each sub-discipline of economics that is currently taught at most Western universities. This provides for an impressive compendium that is meant to be a reference source for researchers who may have a particular research project in mind, but cannot readily deal with mainstream theories in their effort to understand a particular programme. These graduate students or researchers may find a framework for their own research design in their own studies. 1

Ideology, by and in itself, as Schumpeter (1949) has pointed out, is not only a vice, but can also be a virtue. If it drives particular research programmes, a free market of ideas should ultimately divide the grain from the chaff. We are interested in harvesting the corn. It is true, and it cannot be contested, that a lot of what passes for Austrian economics is published on the fringe. This is true for any economic approach one can think of. Even the current mainstream of economics is tainted in this way (Stigler 1980). This problem can only be resolved once the free competition of ideas leads to a better refinement of propositions, models and solid conclusions. It is even

xvi

2

3

Preface conceivable that a Marxian-Austrian perspective could lead to particulars that cannot be otherwise captured. We do not have an AustrianMarxist contribution in this collection, but I would never have hesitated to include one, had I received one. As regards method, in textbook renditions it is often said that the Austrian approach stood for the deductivist method, while its conceived counterpart, the so-called historical school, stood for inductivist methods. Nothing could be further from the truth. Menger, although he started from observing financial markets as a journalist, was not empirically minded. Hayek, on a Ford Foundation grant, observed empirical facts in order to determine business cycles. The difficulty, in my mind, does not lie in the method. The approach, since it is based on individual judgement, required case studies showing individuals’ decisions. This can only be done on the basis of very careful case research. In this sense, there is little disagreement between the Austrian school and the mainstream. As for the third issue, the contributors to this volume have no problem with empirical work, and hence the case can be laid to rest. Prof. Dr. Jürgen Backhaus Lic. jur. March 2004

References Schumpeter, J.A. (1949) “Science and Ideology”, American Economic Review 39 (March): 345–359. Stigler, George J. (1980) “The Economist as Preacher”, George J. Stigler Center for the Study of the Economy and the State Working Papers Series.

A

General economics and teaching

1

The applied economics of the modern Austrian school Laurence S. Moss

Introduction One criterion for assessing the significance of a school of thought in economics is to ask, “What problems can it solve with the tools that it has developed?” This question has long haunted the proponents of the modern Austrian school. During the 1970s and 1980s, Israel Kirzner, Ludwig Lachmann, and their students offered their readers (1) lengthy discussions about the subjectivist underpinnings of market behavior, and (2) exhaustive discussions of what it means to claim that markets “coordinate” the economic behavior of private individuals and the behavior of the associations to which they belong (Kirzner 1973, 1976, 1985a, 1986, 1992; Lachmann 1973, 1976, 1977). In the eyes of the rest of the economics profession it appeared that modern Austrians were unable and perhaps entirely unwilling to provide any specific analytic tools that might help predict and control the outcome of the market process.1 This may explain why modern Austrians have earned a reputation as “methodologists” and have received little recognition for their practice of normal science. Modern Austrians do indeed attach greater importance to a cultivated and sophisticated understanding and appreciation of the market process than they do to “mere” prediction and control (see Dolan 1976; Vaughn 1994). This, however, is a matter of personal preference and not one of logical necessity. Indeed, there is an applied side to the teachings of the modern Austrian school that sometimes is unnoticed. I shall emphasize this aspect of the Austrian contribution here. At the outset, I readily admit that Austrian writers have not been kind to those in the profession who claim to have derived models that can predict the future course of market activity in such detail that profits can be made. Modern Austrians consider such claims mostly ill-conceived, or, even worse, fraudulent (see Skousen 1988). The Austrian school is a “humbling school,” one that cautions other economists not to pretend that they can make marvelous forecasts about future market conditions. Austrians have most consistently ridiculed the pretensions of statistical economists and econometricians who, whether for private gain or for

4 Laurence S. Moss media reputation, declare that they can estimate some specific market rate, such as short-term interest rates, with enough accuracy to guide business decision-making or (in some circumstances) orchestrate national economic planning (Hayek 1978: 23–24; Mises 1949: 352; cf. Vaughn 1994). This war against arrogance and pseudo-science constitutes perhaps the greatest of all the practical achievements of the modern Austrian school. Unfortunately, it has contributed to the reputation of modern Austrians as mavericks in the economics profession. This verdict is particularly harsh, and in this chapter I shall offer a more balanced view. The first section takes a careful look at statistical economic research and offers evidence that Austrian theorizing has not emerged in a historical vacuum. Indeed, Austrian economics can be appreciated as a defensive reaction to the long struggle against ferocious price inflation, first in Central Europe and later, in a less virulent form, among all major industrialized nations. The second section returns to the problem of hawking economic research for business consulting purposes and highlights an inner tension that exists within modern Austrian economics over precisely this problem, the practical significance of economic knowledge. The third section outlines the varieties of modern policy analysis and at the same time distinguishes the intentionally limited focus of the Austrian school from the wider interests that mainstream economics offers. In the final section, I offer some concluding remarks.

Statistical economic research Modern Austrians stubbornly refuse to join the legions of professional economists who search for (stable) empirical economic relationships among the truckloads of economic data that are now available to researchers. Most agree with Mises’s verdict that there are no “constant relations” in economics, as there are in the natural sciences (Mises 1949: 354). Economists who pretend these constants exist and apply for funding to try to hunt for them are committing an elementary blunder. In his Nobel lecture, Hayek (1978) criticized those in economics who try to mimic the natural scientists by employing methods that are quite inappropriate to the study of complex social phenomena. Elsewhere, however, Hayek (1967a) admitted that it is appropriate when studying complex social phenomena to recognize that certain patterns or sequences of events tend to occur in similar situations. The modern Austrians Gerald O’Driscoll and Mario Rizzo (1985: 27) have expanded on Hayek’s insights here. They admit that economists can predict certain patterns of market activity and anticipate certain broad sequences of events. If they can do this, then of course the Austrians can go one step further, and provide some analysis and discussion of the linkages between statistical regularities and the underlying market processes at work. While Austrians make much of their differences with the econometri-

The modern Austrian school 5 cians, there is nothing about the Austrian brand of methodological discussion that rules out the possibility that a major discovery in statistical research will help improve our understanding of the market process and aid us in a search for new statistical patterns. This statement requires some clariffication. The place to start is with Mises himself. Early in his career, Mises flatly denied that there was any sense in trying to express the relationship between money and prices in the form of a simple deterministic equation.2 Mises was reacting in part to Irving Fisher’s classic book Theory of the Purchasing Power of Money, published in 1911, which provided an important quantitative statement of the quantity theory (Fisher [1911] 1971; cf. Mises [1924] 1953: 136). Still, Mises agreed with Fisher that money and prices were connected in some systematic way, with changes in the money supply causing prices to change. Mises, in his Theory of Money and Credit, offered a “market process” account of the popular quantity theory of the purchasing power of money ([1924] 1953: 97–186). Mises’s account was intentionally qualitative and not quantitative, and, perhaps as a consequence, he was able to offer a more insightful interpretation of the existing statistical record regarding the empirical connections between money and prices. Observing that individuals hold cash balances as part of their daily routine, Mises ([1924] 1953: 139–140) offered a subjectivist account of how private efforts to adjust cash balances at a time when nominal balances are increasing throughout the relevant currency area lead to price rises. On the basis of this analysis, Mises agreed with the older “currency school group” that insisted that the cause of a sustained rise in prices was an overly rapid growth of the money supply (ibid.: 219–231). Mises assumed that most responsible political leaders found inflation to be quite unacceptable. Using a broader definition of the money supply that included bank deposits subject to check, Mises evaluated the large variety of institutional reforms to identify those that would make it difficult for the money supply to rise and inflation to follow.3 After World War II, Mises came to realize that instructing politicians about what they should do when they consistently lack the political will to do it will not produce useful results. This realization led Mises to a prescient analysis (1978b – written in 1946) of the connections between political parties, politicians, credit-financed booms and the subsequent economic crises that follow. Others, including Hayek and Murray Rothbard, expanded on Mises’s teachings. It was generally agreed in Austrian circles during the 1950s and 1960s that adherence to the “trade cycle theory” was the hallmark of the Austrian school. For this reason, the Austrian theory of the credit trade cycle held pride of place among Mises’s contributions to the modern Austrian school.4 It is sufficient for our purposes here to credit Mises with an early and persuasive version of the political theory of the business cycle and with a keen understanding of the phenomenon now dubbed “rent seeking” in the economic literature (Tullock [1962] 1993).5

6 Laurence S. Moss The consistency between statistical research and Austrian school theorizing is nicely brought out by one important episode in Mises’s career: the experience of the Central European economies during the early 1920s. The historical record in Central Europe, seemed to contradict the alleged connection between money and prices. Many of Mises’s contemporaries, especially those working for the central bank, delighted in querying why if it is true that the rapid growth of the money supply causes high prices, the majority of market participants – despite rising prices – complained of a “shortage” of money (Mises [1924] 1953)?6 Mises answered this question with novel tools of analysis. He pointed to the critical role expectations play in markets. According to Mises, when an episode of inflation has proceeded for some time, people make commitments to pay prices according to the criterion of what future prices will turn out to be. They believe that they will have enough cash on hand to meet those extra cash obligations because they expect their private cash balances to rise along with the higher prices.7 If the money-issuing authorities were to retrench and try to stop the inflation by slowing down the rate of growth of the money supply, people would experience a veritable “shortage” of money. Indeed, they would complain of a shortage even if the money supply’s rate of growth were to remain constant. To state this another way, the community’s real balances decline while at the same time their nominal balances increase because the increase in the nominal balances is smaller than they had expected. This explains political lobbying to keep the inflation going, so that many can meet their contractual commitments and avoid financial embarrassment. Mises went on to suggest that a statistical time-series plot of the ratio of some index of the quantity of money to prices would show a downward trend during prolonged inflationary periods.8 This statistical record mirrors the disappointed price expectations. My efforts here to link the evolution of Mises’s pioneering contributions to monetary economics to some of the stylized findings of statistical economics will not satisfy many of Mises’s strongest critics. Milton Friedman, in an informal interview that took place in 1988, was uncharacteristically harsh in his assessment of Mises’s credentials as an applied economist (see Hammond 1992). According to Friedman, Mises claimed that the more prolonged the inflationary boom, the more severe the subsequent business crisis. Friedman claimed that the opposite relationship is in fact true, as he himself demonstrated in earlier published work.9 Friedman faulted the Austrian school in general and Mises in particular for showing a wanton disregard of the statistical record. Surprisingly, Friedman did not comment on the many other parts of Mises’s monetary economics, such as his theory of price expectations, which was developed to help rationalize the actual statistical series. Nor did Friedman offer any opinion on the role Mises played in promoting sta-

The modern Austrian school 7 tistical research in Austria by his association with the Austrian Institute for Trade Cycle Research. It is quite obvious that any correct overall assessment of Mises’s contribution to statistical economics would have to balance a number of contributions, rather than single out one episode while ignoring others, as Friedman appears to have done. Suffice it to say that the evidence, while mixed, certainly provides no basis for the claim that modern Austrian school members are opposed, as a matter of methodological principle, to careful statistical analysis. Let me conclude this section on an even more constructive note. A statistical pattern has come to light that may offer fertile ground for Austrian research. William J. Baumol, Richard R. Nelson and Edward N. Wolff (economists not associated with the Austrian school) have pointed to a surprising statistical regularity. Apparently, there is a tendency among the industrialized nations of the world to grow increasingly homogeneous with regard to technology, productivity, and per capita income. This is the “convergence of productivity phenomenon” (Baumol et al. 1994). It seems to me that the Austrian theorists now have a dramatic statistical illustration of how quickly and effectively the market system encourages its participants to utilize information and apply it in valuable ways (Hayek 1945; Thomsen 1992). This is what now happens with accelerating speed among the industrialized nations. It is proving increasingly difficult for one trading nation to maintain a significant productivity lead over the others. The development of new institutions in communications and transportation is what has probably hastened the diffusion of scientific as well as what Hayek has termed “circumstantially relevant” business information (1945: 80). This rapid utilization of knowledge has now become a veritable global phenomenon. To the best of my knowledge, modern Austrians have not as yet taken up this topic for research and analysis. Austrians can explain what institutions serve to promote this development and its probable impact on material progress. When they do this work – and there is no reason why they should neglect such international developments – they will be following the precedent set by Ludwig von Mises in his monetary debates during the interwar period. Again we see statistical economics and Austrian economic theory developing side by side in mutually supportive ways. It was the historical situation in Central Europe that prompted Mises to develop the subjectivist foundations for the so-called quantity theory, and it may indeed be the important “convergence of productivity phenomenon” that will inspire additional useful research about the production and diffusion of information in years ahead.

Practical advice sold to business We have seen that modern Austrians do not (and should not) rule out the possibility that broad statistical relationships both exist to suggest

8 Laurence S. Moss conceptual innovations and can themselves can be explained in terms of market processes. Austrians remain skeptical if not contemptuous of those who pretend to have the power to discover lucrative arbitrage opportunities in the market and then try to sell this information to others.10 In a market setting, anyone may discover a veritable “rule to make it rich.” Some may go the next step and exploit their rule to their personal advantage (Mises 1949). Such discoveries are usually the province of entrepreneurs, and it is not likely that standard statistical research can produce any information about where economic profits can be found. Statistical categorization necessarily strips economic information of its distinctive or local aspects and therefore of much of its relevance to making money. In addition, by the time the statistical series have been published, individual actors in the chain of production will have had an opportunity to exploit these patterns and thereby destroy whatever market value the information might originally have had. Both the “rational expectations” school and the modern Austrians agree that anyone who claims to have a “rule to riches” is more likely than not a huckster and mountebank (Malkiel 1992). This is because as an empirical matter there are an ample number of “soldiers of fortune” in the market to exploit differences in prices and promote economic coordination. Mises (1949: 252–255) and later Kirzner (1976) analyzed the type of mental and conceptual activity involved when the entrepreneurial function is exercised in market settings. Entrepreneurs are alert to opportunities and are lured to make commitments toward the exploitation of these opportunities by the prospect of what Kirzner (1985b) called “open-ended” profits. Interestingly, the problem of the self-destructing nature of rules to riches has also come to haunt the Austrian school for its claims to have “explained” the precise series of economic events that lead up to a business crash. From a logical point of view, if the modern Austrian theorist were to foresee this series of events, the possibility exists that entrepreneurs who take up the study of economics can themselves profit from this knowledge (cf. Mises 1949: 871–872). And if they were to profit from this knowledge, wouldn’t their actions substantially alter the economic sequence? Consider one important example. Throughout his career, Hayek insisted that the “Ricardo effect” lay hidden within any boom phase of the business cycle (see Moss and Vaughn 1986). Furthermore, the Ricardo effect provided the ultimate explanation as to why government attempts to prolong the boom phase of the cycle indefinitely must end in failure. According to Hayek, if the credit expansion boom does not come to an end sooner for some other reason, it must come to an end when consumer product prices advance ahead of wage and resource prices. The Ricardo effect lowers real wages and encourages a shift toward labor-intensive methods of production. A lowering of the real wage of labor makes

The modern Austrian school 9 short-term (labor-intensive) projects appear to be more profitable than long-term (capital-intensive) methods of production. The Ricardo effect may account for the sudden wave of bankruptcies among the large fixedinvestment projects that occurred toward the end of many nineteenthcentury business cycles.11 If, however, Hayek’s Ricardo effect were publicized among investors, the investors would speculate by purchasing the stock (or stock options) of those firms primarily involved in the management of short-term investment projects. The resulting rise in the capitalized value of the business organizations would bring an earlier end to the boom itself. By 1943, Mises began to admit that this consequence was possible (Mises 1943). The action of self-fulfilling prophecies may indeed unravel each and every one of the so-called laws of the market. In short, the Austrian emphasis on “entrepreneurial alertness” may provide a logical reason why certain historical patterns of market activity tend to reverse themselves and disappear over time. Some students of Austrian economics claim that the credit expansion business cycle has itself become a phenomenon of the past. In the end, the only pattern prediction that endures is one that claims that pattern predictions themselves tend to vanish!

Policy advice to policymakers Austrians are not shy about offering practical advice on matters of public concern. Surely the growth of the modern bureaucratic state has been viewed with alarm by those fearing the threats to liberty posed by state power more than they fear threats posed by unchecked market power in the hands of cabals, or cartels or by the general machinations of business (Rothbard 1977; cf. Mises 1944). I shall restrict myself here to the strictly twentieth-century concern of the Austrian school: that the unprecedented growth of national governments may have a negative effect on the development of those economic institutions that themselves contribute to rising living standards. Economists who criticize others Austrians are upset by economists who pretend that their special training in economics contributes to a heightened awareness of what some might call the “aesthetics” of economic justice. These critics delight in proving that such policy analysis is simply one economist’s private subjective value judgments carefully packaged in the rhetoric of economic reasoning. Such a juxtaposition of norms and science is, in short, an awful fraud of the public trust. Indeed, in his celebrated critique of John Kenneth Galbraith’s Affluent Society, Hayek (1967b) pointed to the author’s repeated practice of substituting his own preferences for those of the people he studied (see also Mises 1944). As we shall see, Austrian economists insist

10 Laurence S. Moss that where something cannot be scientifically proven to be true, the economist is forbidden to speak. Among modern economists this normative position, which acts as a self-imposed gag order on what the Austrians can contribute to public debates, is seen as quite eccentric. Instrumental critiques Consider a law that promises to increase the supply of housing by holding down rents. Modern Austrians delight in showing how laws such as these are “wrong-headed.” Rent controls, usury laws, and minimum wage laws are all wrong-headed. They are wrong-headed because they lead to results that are precisely the opposite of those originally intended. This type of policy analysis, one that passes judgment on the suitability of certain means to stated ends, is the crux of much modern Austrian policy analysis. Such critiques of government policy are persuasive if not exciting, and at seminars and public engagements modern Austrians tend to focus on analyses of “wrong-headed” government intervention (Mises 1929). Unfortunately, not all governmental laws and regulations can be criticized in this way. Efficiency critiques Some government interventions do actually achieve their intended results. For example, command and control clean-up requirements at industrial water dump sites do actually make the areas better for recreational lake users (Frederick 1982). Also, some recipients of government welfare actually do use the funding to provide for the care and comfort of dependent children (Murray 1984). Only a madman would deny that sometimes legislation does achieve its stated mandates. This does not mean that government laws and their implementation are unassailable on other grounds. Indeed, Austrians point out and describe alternative methods of intervention that have been used in the past to achieve similar objectives. The comparative study of different institutional reforms allows a comparison of the pros and cons of the different methods. Finally, modern Austrians spell out in shocking detail the political consequences of some interventions, such as those that propose to replace the market with national planning (Hayek 1944). Other interventions, such as direct controls to overvalue a local currency, sometimes lead to borderline body searches and household raids that cause lovers of individual liberty to recoil in disgust (cf. Yeager 1976). All of this and more constitutes a contribution to policy assessment, but none of it allows efficiency comparisons. Efficiency comparisons are what mainstream economists do best: a dollar comparison of one intervention to another in order to determine which achieves the policy objectives at the smallest opportunity cost. Much of the clamor for government intervention in the twentieth

The modern Austrian school 11 century stemmed from one individual or small group of individuals trying to extract subsidies from other individuals. Redistribution politics fuels the well-known phenomenon of “rent seeking” (Tullock [1962] 1993; Robbins 1962). The modern Austrian may secretly agree with the mainstream economist that what the subsidy receivers receive is only a tiny part of what the losers lose but will, ironically, refuse to conclude that this sort of legislation is “inefficient.” To say an intervention is not wrong-headed but “inefficient” is to imply that the losers lose more utility than the winners win. Unfortunately, according to the modern Austrian school, such a comparison of psychological states is invalid because interpersonal comparisons of utility are impossible to make (Rothbard 1956; Pasour 1987). Even if one feels in both body and soul that the losers lose more than the winners win, “feeling something” is not proving it to be true. Unlike modern Austrians, mainstream economists are eager to use market prices as simple “indices of worth” and thereby compare levels of gain against levels of loss. After World War II the scientific economic journals filled with articles of this sort and the field of welfare economics grew in stature (Mishan 1983). Generally speaking, modern Austrians have not contributed to this literature. Austrians insist that it makes no sense to compare governmental interventions and deduce which program is “least harmful” to the economy. Suppose the problem is to compare a government-run rent subsidy program with another program involving the construction and provision of public housing by the government. Generally, an economist would propose a measure of utility gained and resources consumed and then go on to recommend the program that promised the greatest benefit–cost ratio. Such constructions rely on dollar prices as measures of utility and perform a variety of heroic arithmetical operations in which interpersonal comparisons of utility are made with something approximating complete abandon (Mills 1986). Modern Austrian theorists recoil at the thought of making such efficiency comparison, and some will go so far as to say they insist on remaining “pure” (Hoppe 1994). This stubbornness is an example of “scientific purity” in a world in which most economists keep busy by providing the public with what it enjoys most of all: that is, the scientific measurement of waste. By refusing to compromise about the legitimacy of “efficiency” calculations, the modern Austrians rule out the possibility of a measured criticism of those government policies that may not be wrong-headed (that is, they do achieve their intended outcome) but “succeed” only at a large and in some cases an enormous economic cost. Unable to offer an efficiency critique, modern Austrians choose to remain outside the major policy debates that fascinate many mainstream economists.

12 Laurence S. Moss A scientific welfare economics According to one line of analysis that has taken root among adherents of the Rothbardian branch of the Austrian school, no government intervention can ever be scientifically demonstrated to have raised social welfare (Rothbard 1956).12 The reason is that all government intervention relies on the initiation of either direct coercion or the threat of coercion, and therefore at least one person’s utility level has been lowered. Those who derive benefits from the government intervention will naturally find their utility levels raised. Unfortunately, interpersonal comparisons of utility cannot be made on any precise quantitative basis and so (therefore) no act of government intervention can be said with any degree of scientific precision to have raised social welfare (ibid.: 255n). It is argued that the opposite conclusion can be reached when it comes to voluntary market trade. Market exchange would not occur unless both parties expected to gain utility. Since market activity is mostly based on mutually advantageous trading, only market activity can be said with any degree of scientific precision to raise social welfare. This sweeping conclusion does not involve any interpersonal comparison of utility and therefore, according to its proponents, it is not an efficiency critique and hence passes scientific muster. The first version of this argument appeared in a remarkable essay by Murray N. Rothbard (1956). Two decades later, I pointed out that from a logical point of view one could not reach the implied conclusion that the removal of some forms of government intervention would invariably make everyone better off (Moss 1974). The reason was that the absence of a coercive intervention does not automatically lead to a world of voluntary trading. In the absence of government hegemony in the marketplace, gangs competing for merchant contributions may emerge in the vacuum created by the destruction of the central taxing authority. Indeed, the extent of felonious behavior in the former Soviet Union may be a dramatic example of this phenomenon.13 As Thomas Schelling (1984) reminded us, the substitution of “disorganized” for “organized crime” can make everyone worse off (1984: esp. 172 passim). I insist that any thinking and feeling person can reach such a conclusion even if interpersonal comparisons of utility are impossible. As David L. Prychitko has pointed out, Rothbard’s scientific proof that only the market system can be said to raise social welfare has been deduced from “a questionable view of science [namely, that] we only scientifically ‘know’ that which can be deduced from ‘absolutely true’ axioms” (1993: 525). Surely we can also “know” other things as well, such as the tremendous extent of suffering that accompanies national sovereignty movements when they eliminate ethnic minorities and so on. Reasonable thinkers can conclude that the suffering of the many outweighs the joys of a few even if a precise scientific measure of net utility gain cannot be made. In Prychitko’s words, “The immeasura-

The modern Austrian school 13 bility of utility gains and losses in no way entails their complete inaccessibility to analysis” (ibid.: 583). Comparative institutional analysis Modern Austrians have excelled at the careful analysis and evaluation of contemporary institutions. By “institutions” I mean all those decisionmaking procedures and routines both within and between organizations that affect the performance of the market system.14 Institutions of great interest to the Austrians are those that (1) connect the national treasuries and the central banks; (2) link special interest groups, such as unions and manufacturers’ lobbies; (3) guide political parties and the competition among them to obtain votes from special interest groups; (4) emerge when governments try to reshape international payments mechanisms; (5) arise out of central planning agencies trying to plan the economy; and (6) connect government policies to third-world business investment. The list of institutions evaluated by modern Austrians is thus quite long (see Mises 1951; Hayek 1971, [1933] 1979, 1988; Rothbard 1962). If there were a single political attitude that permeates Austrian policy analysis, it would be this: Austrians distrust broadly popular democratic processes because they fear that the voters are doomed to place their short-run private interests above the policies that are needed to sustain the market system. Although Mises implored men and women to trust their “rightly understood long-run interests” as the surest safeguard against the abuses of demagogues and popular democracy, he and especially Hayek advocated speciffic constitutional reforms in case human diligence failed (cf. Yeager 1976). Constitutional reform is designed to limit the excesses of popular democracy by restraining popular emotions from voting out the basic framework and legal structures needed to support a market system. A survey of all this important work is beyond the scope of this chapter, but it will be suffficient to summarize the policy component of this work as follows: Modern Austrians have been and remain keenly interested in the problem of how incentives come to be (or fail to be) aligned within and between these large institutions. Through the judgments they have made about this phenomenon, they have provided rich insight into our understanding of contemporary economic history. Under the nineteenth-century international gold exchange system, local political leaders were given a powerful excuse for not capitulating to the infflationary fi f nancing of government programs. Politicians could blame the international community for preventing them from catering to the interests of local political parties that wanted to redistribute income by effecting artifficially contrived changes in the quantity of money. The Austrians explained how large budget defficits fi f nanced by money-supply creation would diminish gold reserves in the banking system and threaten fi f nancial default and currency devaluation. Mises and Hayek predicted that once the reigns of the gold-exchange

14 Laurence S. Moss standard were loosened, especially as happened after World War II, national governments would end up under the control of leaders who would fi f nd infflationary ffinance irresistible (see, for example, Hayek 1972). It has been over a half-century since the end of the war and the installation of the International Monetary Fund. It has been more than a quarter of a century since the U.S. government removed the last links between the dollar and gold in 1971. The feared hyperinfflation has not yet arrived, but neither have clusters of prices moved in any other way than steadily upward in the United States and also among other industrialized nations (Yeager 1976). The problem national governments face is not whether to accept a mild infflation but rather how much infflation is politically feasible because, whatever its conceptual merits, defflation has become politically unacceptable. The proponents of the Austrian school have been the veritable chroniclers of and astonished witnesses to this development.15 If there is one common theme to the policy writings of the modern Austrian school, that theme is how to discipline and constrain the appetites of vote-gathering politicians for issuing money. It is well known how Hayek labored to compare the consequences of monetary nationalism (i.e., separate currencies and fflexible exchange rates) with the outcomes of alternative institutional arrangements such as the gold exchange standard (Yeager 1976). In his later years Hayek endorsed “private competing money” as the best institutional device to avoid sustained infflation (1976). Here Hayek departed from Mises, who rested his hope in a return to full-bodied gold coins.16 While a speciffic topical index to the modern Austrian school would fi f ll many volumes, what all these writings have in common is the attention paid to the broad problem of aligning incentives and responsibilities within alternative institutional structures so that the basis for material economic progress is not destroyed or diminished. The wisdom that modern Austrians have brought to these questions is quite literally unsurpassed in the policy literature and constitutes another important contribution of the school to practical problem solving.

Conclusion The conclusion I reach is quite defensible and I hope entirely persuasive. It is clear that characterizing the modern Austrian school as being entirely embroiled in methodological discussions and having little to contribute to the leading policy problems of the day overlooks the historical record. It is somewhat misleading to claim that the modern Austrian school asks interesting questions but (by implication) lacks adequate tools to provide proper answers to these questions (Vaughn 1994). As I have demonstrated here, important questions have been raised, and important answers have been offered. This is not to deny that by refusing to use money as the “measuring rod” of utility, modern Austrians have excluded themselves from the enormous policy literature that calculates benefit–cost ratios and makes

The modern Austrian school 15 efficiency comparisons of different forms of government intervention. Remaining “conceptually pure” has (apparently) led the Rothbardian variant of Austrian economics into the uncomfortable corner of arguing that only deductive logic matters in policy analysis. This position gives no place at all to historical understanding and common sense, which are also pertinent to our understanding of the linkages between government intervention and private economic welfare. Finally, by excelling at comparative institutional analysis, Austrians have pioneered the analysis of rules and institutions well in advance of other contemporary schools of thought, such as the “public choice school” and the “Coaseian property rights school.”17 I offer this chapter as a modest contribution toward correcting the historical record by pointing to these Austrian contributions.

Notes 1 Milton Friedman plainly speaks his mind as follows: “the so-called Austrians, or von Misesians [champion a] philosophy which admits no role whatsoever for empirical evidence – it’s entirely introspective – [and] leads to an attitude of human intolerance. . . . The scientific work [on the modern Austrians] is from my point of view useless” (quoted in Hammond 1992). See also Ernesto Screpanti and Stefano Zamagni, who remark that Austrians “refuse to reduce economics to a discipline that seeks observed regularities or mechanical laws from which quantitative predictions can be derived” (1993: 389). 2 Mises characterized the mechanical version of the quantity theory as the “erroneous transference of static law to the dynamic sphere” ([1924] 1953: 152). 3 In preparation for the 1953 edition, Mises added a section to his Theory of Money and Credit entitled “Monetary Reconstruction,” in which he stated, “The eminence of the gold standard consists in the fact that it makes the determination of the monetary unit’s purchasing power independent of the measures of governments. It wrests from the hands of the ‘economic tsars’ their most redoubtable instrument. It makes it difficult for them to inflate. This is why the gold standard is furiously attacked by all those who expect that they will be benefited by bounties from the seemingly inexhaustible government purse” (p. 438). 4 According to Rothbard, Mises’s cycle theory was the “only such theory integrated with general micro-economics and built on the foundations of the analysis of individual action” (1988). 5 On the political business cycle, see Mueller (1989: 277–306). 6 On the German Reichsbank’s stubborn refusal to believe that “printing money in favour of businessmen . . . could have any inflationary effect,” see Yeager (1976). 7 In Mises’s words, there is a “maladjustment between depreciation and circulation” ([1924] 1953: 229). Unfortunately, Mises makes no mention of this controversy in his short autobiography (1978a). Mises credits himself and his colleague Wilhelm Rosenberg with preventing the collapse of the Austrian crown in 1922 (ibid.: 78). 8 Mises must have added this discussion in the 1924 second edition of his Theory of Money and Credit ([1924] 1953: 228). Mises’s formulation was essentially the inverse of the one described in the text. Mises objected to the use of prices indexes (ibid.: 187–190) and preferred to use a single price. The price he used was the price of gold – expressed in local currency – the price established in

16 Laurence S. Moss

9

10

11 12 13 14

15

16 17

the international market. Mises stated that the behavior of the ratio of the money stock to its gold price had “often been shown by simple statistical investigations” to have fallen during the course of the inflation, suggesting that the commodity (gold) value of the stock of money had shrunk. This shrinking is what creates the impression that there is a “shortage” of money rather than an overabundance (ibid.). According to Friedman, “I looked at the relationship between the amplitude of a recession and the amplitude of expansions and amplitude of the succeeding recessions. There’s zero correlation. On the other hand, there’s a very high correlation between the amplitude of the succeeding expansion. That’s utterly inconsistent with the von Mises theory. It seems to me that that one little bit of evidence is decisive refutation of von Mises” (1969: 271–275). “Entrepreneurs . . . would never venture to take their economic life into their hands because an expert advised them to do so. Those ignorant people who operate on the stock and commodity exchange according to tips are destined to lose their money” (Mises 1949: 871–872). Also see Skousen (1988). On the importance of this “empirical fact” in the applicability of the Austrian cycle theory (see Rothbard 1963). On the statistical evidence and its relationship to the Ricardo effect, see Tsiang (1947). On the “Rothbardian wing” of the modern Austrian school and other personal reflections on the sociology of the school of thought, see Vaughn (1994: 99–100). A fuller analysis of this problem remains to be written; see Specter (1994). “U.S. Business and the Russian Mob,” New York Times (July 8, 1994). According to Richard N. Langlois, there are spontaneously generated institutions such as money and others that are constructed, such as the “outer framework” of society: that is, its laws and rules. Langlois explained that what “unifies both types of institutions, and what makes the same methods of analysis more or less applicable to both, is that both are in large measure regularities of behavior understandable in terms of rules, norms and routines” (1986: 19). Modern Austrians favor neither inflation nor deflation. They prefer whatever the ordinary market process happens to bring. Hayek stubbornly refused to allow the authorities to depart from the market situation in his Prices and Production (1935). Mises pointed out that a “metallic currency is not subject to government manipulation” (1949: 786). Compare Rothbard (1965). See Moss and MacDonald (1981: 98–109). On the “public choice” school, see Mueller (1989). On the “property rights” approach, see Coase (1988).

References Baumol, William J., Nelson, Richard R. and Wolff, Edward N. (1994), Convergence of Productivity: Cross-national Studies and Historical Experience, Oxford University Press, Oxford. Coase, R.H. (1988), The Firm, the Market and the Law, University of Chicago Press, Chicago. Dolan, E.G. (ed.) (1976), The Foundations of Modern Austrian Economics, Sheed & Ward, Kansas City. Fisher, Irving ([1911] 1971), Theory of the Purchasing Power of Money: Its Determination and Relation to Credit, Interest and Crises, Augustus M. Kelley, New York.

The modern Austrian school 17 Frederick, K.D. (1982), “Water Supplies,” in P.R. Portney (ed.) Current Issues in Natural Resource Policy, Resources for the Future, Washington, DC. Friedman, M. (1969), “The Monetary Studies of the National Bureau,” in “The Optimal Quantity of Money” and Other Essays, Aldine, Chicago, pp. 271–275. Hammond, D. (1992), “An Interview with Milton Friedman on Methodology,” in W. Samuels and J. Biddle (eds) Research in the History of Economic Thought and Methodology, vol. 10, Greenwich, CT: JAI Press. Hayek, F.A. (ed.) ([1933] 1975), Collectivist Economic Planning, Augustus M. Kelley, New York. Hayek, F.A. ([1933] 1979), Law, Legislation and Liberty, University of Chicago Press, Chicago. Hayek, F.A. (1935), Prices and Production, 2nd edn, Routledge & Kegan Paul, London. Hayek, F.A. (1944), The Road to Serfdom, University of Chicago Press, Chicago. Hayek, F.A. (1945), “The Use of Knowledge in Society,” American Economic Review 35: 519–530; reprinted in Hayek, F.A. (1949), Individualism and Economic Order, Routledge & Kegan Paul, London, pp. 77–91. Hayek, F.A. (1967a), “Degrees of Explanation,” in Studies in Philosophy, Politics and Economics, University of Chicago Press, pp. 3–21. Hayek, F.A. (1967b), “The Non Sequitur of the ‘Dependence Effect’,” in Studies in Philosophy, Politics and Economics, University of Chicago Press, Chicago. Hayek, F.A. (1971), “Monetary Nationalism and International Stability,” in The Collected Works of F.A. Hayek, ed. W.W. Hartley III, University of Chicago Press, Chicago. Hayek, F.A. (1972), A Tiger by the Tail: A 40-Year Running Commentary on Keynesianism, ed. Sudha R. Shenoy, Institute of Economic Affairs, London. Hayek, F.A. (1976), Denationalization of Money: The Argument Refined, Institute of Economic Affairs, London. Hayek, F.A. (1978), “The Pretence of Knowledge,” in New Studies in Philosophy, Politics, Economics and the History of Ideas, University of Chicago Press, Chicago, pp. 23–34. Hayek, F.A. (1988), Fatal Conceit: The Errors of Socialism, vol. 1 of The Collected Works of F.A. Hayek, ed. W.W. Bartley III, University of Chicago Press, Chicago. Hoppe, C. Hans Hermann (1994), “F.A. Hayek on Government and Social Evolution: A Critique,” in Murray A. Rothbard (ed.) The Review of Austrian Economics, Lexington Heath, Lexington, MA, pp. 67–93. Kirzner, Israel M. (1973), Competition and Entrepreneurship, University of Chicago Press, Chicago. Kirzner, Israel M. (1976), Perception, Opportunity and Profit, University of Chicago Press, Chicago. Kirzner, Israel M. (1985a), Discovery and the Capitalist Process, University of Chicago Press, Chicago. Kirzner, Israel M. (1985b), “Taxes and Discovery: An Entrepreneurial Perspective,” in Discovery and the Capitalist Process, University of Chicago Press, Chicago, pp. 93–118. Kirzner, Israel M. (1986), Subjectivism, Intelligibility and Economic Understanding, New York University Press, New York. Kirzner, Israel M. (1992), The Meaning of the Market Process: Essays in the Development of Modern Austrian Economics, Routledge, London.

18 Laurence S. Moss Lachmann, Ludwig M. (1973), Macroeconomic Theory and the Market Economy, Institute of Economic Affairs, London. Lachmann, Ludwig M. (1976), “From Mises to Shackle: An Essay,” Journal of Economic Literature 14 (1): 54–62. Lachmann, Ludwig M. (1977), Capital Expectations and the Market Process, ed. Walter E. Grinder, Sheed Andrews & McMeel, Mission, KS. Langlois, Richard N. (1986), Economics as a Process: Essays in the New Institutional Economics, Cambridge University Press, Cambridge. Malkiel, Burton G. (1992), “Efficient Market Hypothesis,” in The New Palgrave Dictionary of Money and Finance, ed. P. Newman, M. Milgate and J. Eatwell, Macmillan, London, pp. 739–744. Mills, Edwin S. (1986), The Burden of Government, Hoover Institution Press, Stanford, CA. Mises, Ludwig von (1924), Theory of Money and Credit, 2nd edn, Yale University Press, New Haven, CT. Mises, Ludwig von (1929), A Critique of Interventionism, New Rochelle, NY. Mises, Ludwig von (1943), “ ‘Elastic Expectations’ and the Austrian Theory of the Trade Cycle,” Economica 10 (39): 251–252. Mises, Ludwig von (1944), Bureaucracy, Yale University Press, New Haven, CT. Mises, Ludwig von (1949), Human Action, Yale University Press, New Haven, CT. Mises, Ludwig von (1951), Socialism: An Economic and Sociological Analysis, trans. J. Kahane, Yale University Press, New Haven, CT. Mises, Ludwig von (1978a) Notes and Recollections, Libertarian Press, South Holland, IL. Mises, Ludwig von (1978b) “The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money,” in Percy L. Greaves (ed.) On the Manipulation of Money and Credit, Free Market Books, New York. Mishan, E.J. (1983) Cost–Benefit Analysis, George Allen & Unwin, London. Moss, Laurence S. (1974), “Private Property Anarchism: An American Variant,” in G. Tullock (ed.) Further Explorations in the Theory of Anarchy, University Publications, Blacksburg, VA, pp. 1–31. Moss, Laurence S. and MacDonald, Stephen (1981), “An Economical or a Social Currency? Ludwig von Mises and the Defense of the Gold Standard,” Wirtschaftspolitische Blätter, pp. 98–109. Moss, Laurence S. and Vaughn, Karen I. (1986), “Hayek’s Ricardo Effect: A Second Look,” History of Political Economy 18 (Winter): 545–565. Mueller, Dennis C. (1989), Public Choice II, Cambridge University Press, Cambridge. Murray, Charles (1984) Losing Ground: American Social Policy, 1950–1980, Basic Books, New York. O’Driscoll, Gerald P., Jr. and Rizzo, Mario (1985), The Economics of Time and Ignorance, Blackwell, Cambridge, p. 27. Pasour, E.C., Jr. (1987), “Rent Seeking: Some Conceptual Problems and Implications,” in Murray N. Rothbard (ed.) The Review of Austrian Economics, Lexington Books, Lexington, MA, pp. 123–143. Prychitko, David L. (1993), “Welfare Economics and Austrian Economics,” Critical Review 7: 567–592. Robbins, L. (1962), An Essay on the Nature and Significance of Economic Science, Macmillan, London.

The modern Austrian school 19 Rothbard, Murray N. (1956), “Toward a Reconstruction of Utility and Welfare Economics,” in M. Senholz (ed.) On Freedom and Free Enterprise, Van Nostrand, New York, pp. 224–262. Rothbard, Murray N. (1962), Man, Economy and States, 2 vols., Van Nostrand, New York. Rothbard, Murray N. (1963), America’s Great Depression, Van Nostrand, Princeton, NJ. Rothbard, Murray N. (1965), What Has Government Done to Our Money?, Studies in Human Action, Pine Tree Press, Colorado Springs, CO. Rothbard, Murray N. (1977), Power and Market: Government and the Economy, Sheed Andrews & McMeel, Kansas City. Rothbard, Murray N. (1988), Ludwig von Mises: Scholar, Creator, Hero, Ludwig von Mises Institute, Auburn, AL. Schelling, Thomas C. (1984), Choice and Consequences: Perspectives of an Errant Economist, Harvard University Press, Cambridge, MA. Screpanti, Ernesto and Zamagni, Stefano (1993), An Outline in the History of Economic Thought, Clarendon Press, Oxford. Skousen, Mark (1988), “Murray Rothbard as Investment Advisor,” in Walter Block and Llewellyn H. Rockwell, Jr. (eds) Man, Economy and Liberty: Essays in Honor of Murray N. Rothbard, Auburn University, Auburn, AL. Specter, Michael (1994), “U.S. Business and the Russian Mob,” New York Times, July 8. Thomsen, Esteban F. (1992), Prices and Knowledge: A Market Process Perspective, Routledge, London. Tsiang, Sho-chieh (1947), The Variation of Real Wages and Profit Margins in Relation to the Trade Cycle, Pitman, London. Tullock, G. ([1962] 1993), “Rent Seeking,” Shaftesbury Papers, Elgar Publishing, Brookfield, VT. Vaughn, Karen I. (1994), Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge. Yeager, Leland (1976), International Money Relations: The History and Policy, Harper & Row, New York.

B

Schools of economic thought and methodology

2

F.A. Hayek’s methodological U-turn reconsidered in light of his concept of social facts G.M. Huussen

The thesis of the U-turn does not do justice to the development of Hayek’s thought The purpose of this chapter is to disprove the thesis of the U-turn. I shall show that even right at the start of his career, Hayek had different methodological ideas from those of his mentor Mises. This argumentation is sufficient for my objective, but it is rather unsatisfactory if we want to gain a better understanding of the development of Hayek’s thought. I will defend the thesis that he derived his ideas on the philosophy of science from Mach and the logical positivists. In my opinion, this more elaborate argumentation is preferable – not because I subscribe to Hayek’s ideas, but because any attempt to take up a critical position should be based on a correct understanding of his own intentions. Hayek wrote only one work, The Sensory Order (1952), that was devoted exclusively to the theory of knowledge, although it was to give a basis to theoretical psychology. For the rest we have to manage with his casual remarks and allusions, particularly in his early work. However, the core of his interest for the philosophy of science is in his criticism of ‘scientism’, already found in a series of articles in Economica (1941–1944) and later collected under the title The Counter-revolution of Science ([1952] 1955). Hayek was full of admiration for the ‘hard’ sciences, but was hesitant regarding the slavish imitation of their methods in the fields of the social sciences. This hesitancy was born out of concern for the empirical basis of economics – that is, the facts of the social sciences in general – rather than the wish to achieve an indisputable aprioristic foundation.

The thesis of the U-turn examined Hutchison (1981: 210) suggests that Hayek initially was profoundly influenced by his mentor Mises, but increasingly shifted towards Popper’s direction later on. In order to make this plausible, he distinguishes various

24 G.M. Huussen phases in the development of Hayek’s thought. He states that in the first phase Hayek based his monetary theory of the trade cycle not only on Mises’s monetary theory ([1912] 1924), but also – and this is the crucial point here – on his eccentric methodological views. With biting irony, Hutchison dates the change in Hayek’s views to 1937, when in his opinion Hayek broke with the assumption of perfect knowledge (Alwissenheit) in his famous article ‘Economics and Knowledge’. In this article, Hayek introduced the distinction between what one now would call objective, scientific knowledge and the subjective or private knowledge of economic subjects – such as their knowledge of their own preferences and local situations. In ‘Economics and Knowledge’, Hayek briefly refers for the first time to Popper’s falsificationism. According to Hutchison (1981: 215), this article marks ‘a vital turning-point, or even a U-turn in Hayek’s methodological ideas’. In his opinion the second phase in Hayek’s development starts here: from now on, Hayek would gradually depart from Mises’s ideas and finally take sides with Popper openly in his Nobel Prize Lecture (1974). Against this background the thesis of the U-turn seems very plausible. Nevertheless, the relationship between mentor and pupil proves nothing concerning the specific contents of the thesis: that is, their methodological descent. This still will have to be proved from Hayek’s early and later work. In this respect I am inclined to protect Hayek against his critics. As will be shown, Hutchison does not provide convincing proof to support his thesis.

Two interpretations of the early Hayek Hutchison states that the methodological ideas that Hayek had before and after 1937 were ‘quite incompatible’. However, Hayek’s work can also be viewed as a unity, but then as a unity in a process of development. The theme of freedom was unfolded ever more consequently – first in the economic field and later in studies in philosophy, politics and the history of ideas. This also applies to Hayek’s ideas in the field of the theory of knowledge and the philosophy of science. Barry (1979: 41), for instance, speaks of ‘a basic continuity in Hayek’s writings on methodology’. But he considers that continuity as a strained relationship full of tension between Mises’s ‘praxeology and empirical science’. For his thesis, Hutchison (1981: 219) gratefully exploits Barry’s ill-founded hint. The neo-Austrians Kirzner (1976) and Rothbard (1976) even go a step further. They consider Hayek to be an exponent of Mises’s praxeology. I will not further elaborate on these one-sided interpretations, because, together with Hutchison’s thesis, they will be refuted, provided that I can prove that Hayek did not follow Mises, but Mach. Without a doubt, Hayek was challenged by his mentor Mises and made sensitive to problems that kept him occupied. In his festive speech in

F.A. Hayek’s methodological U-turn 25 honour of the seventy-fifth birthday of Mises he mentions that most members of the Mises circle had socialist ideals: ‘Professor Mises’s theory seemed to deny everything that we were taught to believe until now’ (M. von Mises [1976] 1981: 284). After Mises had published his anti-socialist book Die Gemeinwirtschaft (1922), Hayek continues, ‘we were left almost with nothing else than dark, brooding doubts’. Apparently Hayek only gradually became a supporter of the liberal ideas of Mises. However, it can be questioned for two reasons whether Hayek also adopted the methodological ideas of his mentor. At that time the methodological ideas of Mises were not crystallised out in the least. Furthermore, Hayek came from a totally different, more scientific intellectual climate. The shock experience of the collapse of the Danube monarchy induced him, as he stated in an interview for Video Arts Television (1985), to focus his scientific interest not on physical or biological questions but, contrary to the family tradition, on political and economic issues. This means that for the interpretation of Hayek’s early period we have the choice between two competitive hypotheses: the ‘Misesian’ hypothesis of Hutchison and the ‘scientific’ hypothesis of Hayek himself. About this second hypothesis, Hayek wrote in ‘The Facts of the Social Sciences’ (1943, para. 1): I had, perhaps, better explain that I myself originally approached my subject thoroughly imbued with a belief in the universal validity of the methods of the natural sciences. Not only was my first technical training largely scientific in the narrow sense of the word, but also what little training I had in philosophy or scientific method was entirely in the school of Ernst Mach and later of the logical positivists. Thus, the second, ‘scientific’ hypothesis fits in with Hayek’s own account. In addition, this hypothesis corresponds with his critical stance against scientism, because, he continues: Yet all this had the effect only of creating the awareness, which became more and more definite as time went on, that, certainly in economics, all the people who are universally regarded as talking sense are constantly infringing the accepted canons of scientific method evolved from the practice of the natural sciences. These quotations from Hayek’s later work show that his criticism of the slavish imitation of the methods of the natural sciences in the fields of social sciences (or scientism, as he prefers to call it) can be considered as a self-criticism, as a matter which he advocates in his own thinking. In other words, he gradually became aware of the ‘devastating effects’ that a ‘scientistic’ approach has on our views concerning social issues.

26 G.M. Huussen When one assumes that Hayek was ‘nurtured in the Viennese school of Ernst Mach and the logical positivists’, as Klant rather ironically does (1984: 79), and one bears in mind that he was challenged by Mises, the fight against scientism is placed in a different perspective. There seems to be a gradual rapprochement with Mises rather than a farewell. Should one therefore not speak of a convergence rather than a U-turn?

More Mach than Mises The methodological ideas of the early Hayek were discussed by Hutchison on the basis of Hayek’s ‘Habilitationsvortrag’ ([1929] 1976) and essays entitled ‘Socialist Calculation’ (1935). Hutchison’s critique of ‘Habilitationsvortrag’ focuses in particular on two aspects. In his opinion Hayek wanted to save static equilibrium theory and to maintain the assumption of Alwissenheit. This would reveal the influence of Menger and maybe of Mises, although Hutchison (1981: 213) thinks that he can only definitely catch Hayek on a Misesian apriorism in ‘Socialist Calculation’. We will first discuss the points of criticism concerning Hayek’s ‘Habilitationsvortrag’. These points refer to theoretical rather than methodological issues, and they are incorrect on theoretical grounds. The fact is that Alwissenheit and statics are contrary to the essence of Hayek’s monetary theory of the trade cycle. According to this theory, the use of money is the necessary condition to moderate the rigorous exchange equilibrium which the static equilibrium theory still assumes on the basis of Say’s law. Subsequently, an elastic money supply forms the sufficient condition for the trade cycle phenomenon. As a result of these new circumstances, market prices, to which the actors must take recourse because of their limited knowledge, provide ‘false’ information. Thus, the actors are not omniscient. In whatever way this theory is further assessed, it assumes neither Alwissenheit nor a static approach; it has an intent contrary to the one Hutchison imputes to it. This will be shown more extensively with quotations. We will first examine the methodological aspects, which Hutchison almost completely ignores. ‘Habilitationsvortrag’ comprises the first three chapters of Geldtheorie und Konjunkturforschung (1929; GK for short), to which two papers for Verein für Sozialpolitik from the same period and some concluding observations have been added. Hayek’s methodological ideas, stated in his ‘Habilitationsvortrag’, can be summarised in the following five theses: 1

2

All theoretical social sciences, including economics, are predictive sciences (GK: 7n1). Economists have to do with the equilibrium theory; they have no better alternative. Statistical investigations are not theoretical, but descriptive. Scientific predictions are conditional; they say what will necessarily

F.A. Hayek’s methodological U-turn 27

3

4

5

happen if certain conditions occur and no interventions are undertaken. This is why statistical extrapolations, for example of economic trends, are scientifically inadequate. They lack a theoretical explanation based on necessary interconnections. ‘Empirically established relations between various economic phenomena continue to present a problem to theory until the necessity for their interconnections can be demonstrated independently of any statistical evidence’ (Monetary Theory and the Trade Cycle, Hayek [1933] 1975: 31; MT for short). However, this independent demonstration or ‘obviousness’ (GK: 4) is not something that is based on intuition or intellectual contemplation, because: For a theory ‘there are only two criteria of correctness’ (MT: 32). A theory can be incorrect owing to a logical deficiency or because under the given conditions it explains something different from what we observe. At most a theory can be found to be logically sound and empirically not untrue. After all, verification is only possible in a negative sense. An unexplained residue proves that a theory is inadequate, but ‘It cannot be expected [however] to confirm [a] theory in a positive sense’ (GK: 6; MT: 34). A correspondence with the observed facts (or ‘corroboration’, as the English translation of 1933 has it; MT: 35) still does not prove that the theory is empirically true (GK: 4). After all, in what way could a necessary interconnection be substantiated on contingent grounds? Conditional predictions mainly have a practical meaning. They allow us to intervene so as to affect the conditions in a purposeful way. Collective forecasts in the socio-economic field, for example on tradecycle movements, are usually ‘too unconditional in forms’, therefore without a practical meaning and of a doubtful scientific standard (GK: 7n; MT: 36n).

Whoever reads these propositions will be struck by their similarity with the present hypothetico-deductive model of science. The explicitly mentioned logical and empirical ‘criteria of correctness’ reveal a logical positivist intent, which is hardly compatible with a Misesian apriorism. Furthermore, it is significant that the method of verification is treated with a caution that reminds us of Popper rather than of logical positivism. But Popper’s Logik der Forschung appeared only at the end of 1934! Did Hayek anticipate the ideas of Popper? This may seem to be the case, but the simplest explanation for their methodological resemblance is that both base themselves on Mach.

A comparison with Mach’s philosophy of science When we, following Hayek’s hint, draw a parallel with Mach, it is in particular his philosophy of scientific discovery that is relevant here. Later,

28 G.M. Huussen the epistemological principles of this philosophy will be discussed in so far as they are relevant concerning Hayek’s view regarding the task of the social sciences. In his compellingly written Knowledge and Error ([1905] (1976; KE for short), Mach argues that errors are no regrettable aberrations of scientific research, but a source of discoveries and thus of the growth of knowledge. Errors are connected with our ignorance, with the incongruence between theory and experience. According to Mach, the development of scientific theories shows a smooth transition with our daily experience. The patterns of expectation that we form on the basis of experience are improved by the concepts and theories of the natural sciences. A law of nature forbids certain expectations. It is not a prescription for nature, as Kant wrongly thought, but rather a restriction on our expectations with respect to the course of natural events (KE: 352ff.). The aim of science is to try to organise our thoughts as economically as possible, both mutually and in relation to the facts. The first aspect is a matter of logic and mathematics; the second is a matter of concept and theory development. Theories consist of conditional, functional relations: they have a hypothetical ‘if–then’ character. The essential function of a hypothesis is that it ‘leads to new observations and experiments, which confirm, refute or modify our surmises and so widen our experience’ (KE: 176).Because of the logical problem with induction, a confirmation can never remove the ‘self-destroying’ function of a hypothesis (KE: 176, 181, 228). The error or refutation, the finding that a general hypothesis suddenly does not apply to the usual conditions, ‘makes us look for so far unknown complementary conditions’ (KE: 354). We should not accept the incongruence between theory and experience, but regard it as an opportunity to make new discoveries. These ideas on the method of science appear to have inspired not only Hayek, but also Popper. Because Popper developed his philosophy of science as a move away from the ‘received view’ of the Vienna Circle, more attention is usually paid to their mutual differences than to their common backgrounds. Mach is undoubtedly also part of these common roots. The dynamic, open-ended model of science outlined by Popper in The Logic of Scientific Discovery ([1935] 1959/74) appears to be very similar to that of Mach, but is placed under a different sign. The difference of opinion with Mach, which is mainly fought out by Popper in footnotes, focuses on the question of whether theories are merely instruments of thought, which can predict adequately or inadequately, or descriptions that can be true or false. Against Mach’s instrumentalism Popper puts his realistic interpretation of theories. Theories are descriptive, universal hypotheses; they can be true or false (although we can never establish their truth with certainty).

F.A. Hayek’s methodological U-turn 29 Hayek shares this realism with Popper, in contrast with his liberal kindred spirit Friedman. An instrumentalist is not concerned about the question whether his or her assumptions are realistic and whether they are able to explain the observed phenomena. Hayek states this as a requirement: the theory has to be able to explain the empirically observed phenomena even without a residue.

Contra Hutchison: no ‘omniscience’ and no ‘instrumentalism’ The problem that Hayek tries to solve in his ‘Habilitationsvortrag’ ([1929] 1976) is that addressed by Mach: the incongruence between theory and experience. General equilibrium theory (GET) offers no explanation for the phenomenon of the trade cycle, although it claims to cover the entire range of economic phenomena (GK: 2). While rejecting various alternatives, Hayek claims that the trade cycle theory has as a task to ‘broaden’ the ‘explanatory scheme’ of GET in such a manner that the trade-cycle phenomena can be deduced in a purely deductive manner from its premises (GK: 13ff.). The problem is how a theory of a general disturbance can possibly be derived from ‘presuppositions, according to which such a disturbance is rendered impossible by the regulatory mechanism of the economic system’. This is, according to Heimann (1945: 220), like squaring the circle. In agreement with Mach’s indications, according to Hayek (GK: 46–48), the theory will have to be extended with a so far unknown complementary condition. For this additional assumption he consults the monetary theory of Mises, though not without criticism. Say’s law, which is fundamental for equilibrium theory, assumes barter. This does not fit in with the reality of the modern monetary and credit system. The monetary system is the absent assumption that will have to be built in the static theory in order to be able to deduce the trade-cycle phenomena from it. In his criticism, Hutchison (1981: 213) suggests that Hayek sticks to the ‘static assumptions’ of equilibrium theory in his trade-cycle-theory, which in his opinion includes perfect expectations or ‘omniscience’, besides assuming perfect competition. In its purport this criticism is incorrect, because – as we saw – Hayek aims at broadening the empirical range of the theory by enriching its premises with certain explanatory principles: ‘no one has yet undertaken the decisive step which creates a complete theory by using one of these principles to incorporate all the known phenomena into the existing system in a satisfactory way’ (MT: 40). For the same reason, Hayek (MT: 93) does not want to save the equilibrium theory, as Lowe does in an instrumentalist sense, by reconciling himself to the discrepancy between the closed theoretical system and the supposed openness, elasticity or indefiniteness of the economic system.

30 G.M. Huussen The endorsement of the incongruence between theory and experience boils down to a sacrificium intellectus (cf. MT: 96). It is this passage that Hutchison completely erroneously explains as an allusion to the definiteness of the system as a result of a supposed ‘omniscience’ of the actors. Hayek does not defend ‘omniscience’ here; he is fighting instrumentalism. The suggestion that Hayek considers ‘omniscience’ a necessary condition for a vigorous deductive theoretical system is unfounded. Hayek (MT: 84) does not base himself on ‘omniscience’, but on ‘imperfect knowledge’. He argues expressis verbis that imperfect knowledge does play a role, but is not a sufficient condition to explain the trade-cycle phenomena, because even in a barter economy that obeys Say’s law, ‘production is governed by prices, independently of any knowledge of the whole process on the part of individual producers’ (ibid.). The decisive point is that ‘ “wrong” prices . . . which lead to “wrong” dispositions, cannot in turn be explained by a mistake’ (MT: 85). The unknown sufficient condition, which creates as it were a wrong inclination of the ‘market compass’, is not part of the psychological sphere, but part of the modern monetary system. Hutchison (1981: 213) concludes rather cautiously that ‘in the context of the problem of the trade cycle Hayek seems to have expressing a somewhat similar fundamental methodological aperçu to that of J.S. Mill and F.Y. Edgeworth’. He suspects that in this respect it is not so much a Misesian apriorism, but a ‘Millian’ or ‘empirical apriorism’, as Klant ([1979] 1984) calls it – a surmise based on the putative ‘omniscient’ economic subjects. However, this empirical apriorism is definitely no apriorism in the neoKantian sense of the word, as found with Mises (Huussen 1989). By ‘knowledge a priori’, Mill ([1836] 1984: 56) does not mean knowledge preceding experience, but empirical knowledge of a psychological nature which precedes economic theories and their testing. In my opinion the label ‘psychological reductionism’ instead of ‘empirical apriorism’ would be more apt (Huussen 1988: 117). Precisely these ‘psychological theories’ are criticised by Hayek because of their logical inadequacies in the paragraph quoted by Hutchison. Thus, hitherto the thesis of the U-turn seems to be based on a confusion of Misesian apriorism with ‘empirical apriorism’ and an alleged ‘psychological reductionism’ with Hayek.

The so-called apriorism in ‘Socialist Calculation’ Hayek’s article ‘Socialist Calculation I’ ([1935] 1947: 1–40) appears to be more in line with Mill. He reasons: physicists can experimentally test inductively established hypotheses on causal relations. Economists cannot. However, they have something better: ‘The essential basic facts which we need for the explanation of social phenomena are part of common experience, part of the stuff of our thinking’ (ibid.: para. 3). This quotation appears to be an allusion to Mill’s method of introspec-

F.A. Hayek’s methodological U-turn 31 tion to lay down the fundamental postulates of the human behaviour in the pursuit of wealth: ‘The material of this knowledge every-one can principally collect within himself’ ([1836] 1984: 60). However, such a psychological reductionism cannot be compatible with Hayek’s previous objections raised against a psychological foundation of economic theories. Hutchison argues that Mill’s ‘empirical apriorism’ is at least open to correction through empirical data, while Hayek excludes this possibility when he continues, ‘In the social sciences it is the elements of the complex phenomena which are known beyond the possibility of dispute. In the natural sciences they can only be at best surmised’ (1981: 213; my italics). In this claim to justified knowledge, Hutchison definitely senses the influence of Misesian apriorism. However, there is still a third possibility: the empiriocriticism of Mach. This third interpretation is worth a serious consideration, as Hayek subsequently calls the explanatory factors, or ‘elements’, ‘the truly empirical factor in the social sciences’ ([1935] 1947). Mises would not come up with this. In his view the ‘logic of action’ is a priori – that is to say, non-empirical, ‘prior to experience’, like mathematics ([1933] 1960/81: 17ff.). Instead of rashly classifying the early Hayek now with Mill’s apriorism and now with the apriorism of Mises, it would be more worthwhile to analyse the tenor of Hayek’s ‘empiricism’. Besides the typical concept of ‘elements’ (or ‘empiricism’), empiriocriticism is also a serious option for the Hayek interpretation for a different reason. It concerns the methodological unity or plurality of the social and natural sciences. According to Hutchison (1981: 210), Hayek initially followed Mises in his support of a methodological dualism, but later acknowledged Popper’s unified vision on the method of science. However, it is striking that Hayek already establishes a methodological similarity in the paragraph in which Hutchison thinks he can catch him on a Misesian apriorism and methodological dualism. Here Hayek characterises the social and physical sciences as ‘empirically deductive sciences’ ([1935] 1947). The difference is their ‘empirical basis’. The concept of ‘experience’ is ambiguous here.

Hayek’s concepts of ‘experience’ and ‘social facts’ We will return to Mach for Hayek’s concept of experience. In his theory of knowledge Mach continued Kant’s criticism under the influence of the late nineteenth-century ‘back-to-Kant’ movement, which aimed at purifying mathematics and physics from metaphysics. In a criticism of pure experience, the so-called empirio-criticism, Mach removes the last metaphysical residues. He drops the Kantian ‘things in themselves’ and related essentialistic concepts in physics, such as causality, atom, force (cf. Passmore [1957] 1972: 321). For the same reason, the concept ‘I’ is removed from psychology.

32 G.M. Huussen In addition, scientific language becomes more pre-eminent. It should be able to dissolve all our scientific judgements about material matters or a spiritual ‘I’ in series of perceptions or ‘elements’. Empirio-criticism leads to this radical conclusion: the elements, or most simple perception data, are the only concrete phenomena in the world. They are neither mental nor physical, but have a neutral character. Therefore, it is called ‘neutral monism’ (see Passmore [1957] 1972). According to the theory of neutral monism, the same elements can be grouped in two different ways. They show a physical order (as it were, ‘outside’ us) and at the same time a mental or biographical connection (as it were, ‘inside’ us). Thus, the same elements can be viewed in a physical or a psychological context. Considered in this way, the so-called external and internal world with their material and mental contents are nothing else than theoretical constructions from the same elements or data. Hayek wrote in The Sensory Order (1952: vi) that he can vividly remember how he read Mach when he was a student: ‘I suddenly realized how a consistent development of Mach’s analysis of perceptual organization made his own concept of sensory elements superfluous and otiose, an idle construction in conflict with most of his acute psychological analysis.’ The student Hayek attempted to solve this inconsistency, but only succeeded in doing so thirty years later. In design and purpose The Sensory Order is a criticism of a tacit assumption by Mach: the assumption that a ‘simple one-toone correspondence’ exists (Hayek 1952: 3) between the elements of the physical and mental order. Therefore, it is significant that the name of Mach is conspicuous by its absence in Barry’s work on ‘Hayek’s philosophy’ (1979). The most important points in Hayek’s argument are the following. Similar stimuli can bring about dissimilar perceptions. This fact indicates that our perceptions are already loaded with classifying concepts. Physics solves enigmas in our perceptual field by reconceptualising these often unintentional classification systems. This allows us to explain regularities in the course of nature more adequately, but does not solve the psychological issue of our daily experience. Even if we can explain that the broken appearance of the stick in the water is based on optical deception, the question remains: why is it that we still see the stick in a broken state? This theme of the double, physical and mental, order forms the pattern in which the pieces of Hayek’s methodology can be combined in an unconstrained manner. An allusion to this double order in our experience can be found in Hayek’s trade-cycle theory, in which he speaks of the Eigenart der Erkenntnismittel of economic theory and statistics (GK: 2; the English translation gives ‘the means of perception’, MT: 28). These typical means of perception now prove to be the classification systems of the physical and mental order. More Kantian than Mach, Hayek resumes with the theme of the con-

F.A. Hayek’s methodological U-turn 33 ceptual frameworks, and less Kantian than Kant, he considers these frameworks to be open to reconstruction under guidance of higher regulatory systems. In this respect he acknowledges affinity with the group theory of Piaget (Hayek 1952: 48). The distinction made by Hayek in 1943 between physical and social facts fits into the same pattern. Social sciences are based on social facts: that is to say, ‘the things are what people think they are’ (Individualism and Economic Order, Hayek 1949: 60; for short IEO). Economists cannot deduct from a physical object whether it is a means of production or consumption and what its value is. They do not work with physical concepts, but with teleological concepts: that is to say, with perception frameworks that can be reconceptualised, but that nevertheless continue to play a role in the actions of the economic subjects. The fight against scientism also fits into the pattern. Scientism reduces the development of scientific concepts to the physical order; it does not consider teleological concepts, although they are fundamental to the economic actions that it wants to study. Better than Hutchison, Popper understood that the struggle against scientism refers not so much to scientific method, as to physical reductionism: the monopoly of the physicalist concept of experience. Falsificationism can put right the logical inadequacies in that method. The physicalistically reduced concept of experience is a different matter. In contrast with Hutchison, Popper ([1972] 1975: 106) advocates no physical reductionism, but an interactionism between the world of the physical and mental phenomena, to which he adds a world of language. In this respect, Popper repeatedly supports Hayek’s warning (1943: 65) against behaviourism: ‘there is nothing wrong . . . in thinking anthropomorphically about man’ (Popper [1963] 1974: 81n; Popper and Eccles 1977: 105n2). There is nothing wrong in assuming that the economic subjects use teleological concepts when a social scientist is theoretically explaining their actions. The problem is whether these concepts may also occur in the ‘empirical basis’ that is the touchstone for the theory. This problem leads to the question whether introspection is a reliable observation method.

Introspection and ‘other minds’ Physical reductionism limits the language of science to physical statements. Statements about certain ‘inner’ experiences, which we do have, are not allowed. ‘The pin pricks the finger’ is allowed, but not ‘the prick gives me pain’. This last statement has to be translated into terms of overt behaviour for the sake of intersubjective testability. This is why logical positivism requires a physicalist unified language, while Mach still kept room for psychological language. The problem is: can everything that is said in a psychological sense also be translated into physical terms? In

34 G.M. Huussen principle it can, because physical reductionism is a direct consequence of the ‘one-to-one correspondence’ that Mach assumed between the physical and the mental order. Illustrative of this language problem is the issue of the knowledge of ‘other minds’. Mach reasons that we cannot tell from someone’s behaviour what he or she experiences internally, but can imagine it through our own experience in analogous cases. In essence this is the method of introspection. Thus, knowledge of ‘other minds’ is based on an argument by analogy. But this logically risky indirect manner to obtain knowledge of ‘other minds’ is strictly speaking superfluous if there is a ‘one-to-one correspondence’ between the physical and the mental order. This is indeed what radical behaviourists argue. As we saw, like the logical positivists, Hayek links up with Mach, but immediately rejects the thesis of the ‘one-to-one correspondence’ and thus physical reductionism. On this point he parts the ways with logical positivism, and this is where Hayek’s criticism of the slavish imitation of the methods of natural sciences in the fields of the social sciences (like behaviourism and historicism) starts. Hayek assumes a double order without postulating a ‘one-to-one correspondence’. This is why first of all the knowledge of ‘other minds’ is problematical. There is a discrepancy between the overt behaviour of the economic actors and their subjective experience. This discrepancy is exactly what the transition of the classical to the subjective theory of value is about. Value is no ‘illusory substance’, but a relation. This concept expresses an ordering of preferences that subjects apply to goods, which implies: so many men, so many scales (Hayek [1935] 1947 I: para. 8). Therefore, the subjective theory of value is based on an argument by analogy with respect to ‘other minds’. The argument by analogy is logically inadequate, but according to Hayek it is indispensable and reliable enough for us to understand the rational behaviour of others ([1943] 1949: 66). ‘Understanding’ refers to the mental order, to elements in a psychological context. Social facts are elements placed in subjective concepts by the actors. So, establishing social facts would be a task for social psychologists. But Hayek did not draw this conclusion. In the ‘turning-point’ article ‘Economics and Knowledge’, Hayek argues that it is possible to distil from ‘the facts of economic life those parts which are truly a priori’ (1937: 35). Understanding implies that something can be placed in a meaningful scheme. According to the subjective theory of value, these schemes are, in the context of economic action, rational choice schemes. If one abstracts from the contents of a choice, a purely formal logic of choice is conceivable, which is comparable with mathematics. In the same part of Hayek’s work we find for the first time an explicit reference to the apriorism of Mises (1937: 36n). Thus, the turning point is

F.A. Hayek’s methodological U-turn 35 not a turning away from Mises, but a turning away from Mach and rapprochement with Mises. The double order with its two ‘means of perception’ which the early Hayek referred to has become two worlds. The mental order has become a mental world, which does not coincide with the psychological context any more. A formal ‘choice-logic’ component can be separated, which is not psychological. Apparently this occurs under the influence of Mises, whose ideas had matured in the meantime. Understanding is something different from explanation. Understanding concerns the knowledge of ‘other minds’; the explanation concerns social interaction. What Hayek calls the purely formal components of social facts are now the elements from which a theory has to be constructed in order to explain the phenomenon of social interaction. This is illustrated by a distinction Hayek had made in 1937 between the ‘individual’ equilibrium concept of the logic of choice of Mises and the concept of an interpersonal equilibrium. A few years later he specified this distinction in terms of the ‘taxonomic’ and ‘explanatory’ task of economics. Explaining means the ‘construction of hypothetical models’ from the taxonomic elements in order to reproduce social relationship patterns ([1943] 1949: 68). If one wishes to statistically test economic theories, for instance the trade-cycle theory, the empty boxes of the ‘aprioristic’ classification system will have to be filled with data. In economics these ‘data’ are ‘economic facts’: that is to say, the result of subjective valuations. Knowledge of these valuations is dispersed among many persons and there is no ‘master brain’ who can directly survey all these data (Hayek [1952] 1955: 52). Although introspection is not possible, statistical measuring is possible provided that there is a communication system in which these ‘data’ can be expressed – that is, the system of free market prices. I mention these well-known theses of Hayek to indicate the relation with his methodological ideas. This shows that the later Hayek increasingly considered the specific nature of ‘social facts’ to be a central element of his philosophy of the social sciences, so that also in this respect there is more a rapprochement with his mentor than alienation.

Conclusions According to the U-turn thesis, Hayek switched over from Mises to Popper around 1937. On closer examination this thesis turns out to be untenable. The hypothesis that Hayek developed his ideas from the empirio-criticism of Mach offers more perspective. This hypothesis is preferable for five reasons. It corresponds with Hayek’s own justification and the model of science in his trade-cycle theory; furthermore, it is essential for the interpretation of Hayek’s concept of experience and his struggle against scientism. Finally, it has become possible now to explain why Hayek explicitly refers to the

36 G.M. Huussen apriorism of Mises only at a later stage and, even then, only between quotation marks.

References Barry, N.P. (1979), Hayek’s Social and Economic Philosophy, Macmillan, London. Hayek, F.A. ([1929] 1976), Geldtheorie und Konjunkturforschung (GK), W. Neugebauer, Salzburg. Hayek, F.A. ([1933] 1975), Monetary Theory and the Trade Cycle (MT), Augustus M. Kelley, Clifton. Hayek, F.A. ([1935] 1947), ‘Socialist Calculation I & II’, in F.A. Hayek (ed.) Collectivist Economic Planning, G. Routledge, London (also in IEO 1949, pp. 119–180). Hayek, F.A. (1937), ‘Economics and Knowledge’, Economica 4: 33–54 (also in IEO 1949, pp. 33–56). Hayek, F.A. (1943), ‘The Facts of the Social Sciences’, Ethics 54: 1–13 (quoted from IEO 1949, pp. 57–76). Hayek, F.A. (1949), Individualism and Economic Order (IEO), Routledge & Kegan Paul, London. Hayek, F.A. (1952), The Sensory Order, Routledge & Kegan Paul, London. Hayek, F.A. ([1952] 1955), The Counter-revolution of Science, Free Press, Glencoe, IL. Hayek, F.A. (1974), ‘The Pretence of Knowledge’, in New Studies in Philosophy, Politics, Economics and the History of Ideas, Routledge & Kegan Paul, London, pp. 23–35. Heimann, E. (1945), History of Economic Doctrines, New York. Hutchison, T.W. (1981), The Politics and Philosophy of Economics, Basil Blackwell, Oxford. Huussen, G.M. (1988), De keerzijde van de munt, Amsterdam. Huussen, G.M. (1989), ‘Mises and the praxeological point of view’, Journal of Economic Studies 15: 121–133. Kirzner, I.M. ([1976] 1979), ‘On the Method of Austrian Economics’, in E.G. Dolan (ed.) The Foundations of Austrian Economics, Steed & Ward, Kansas City, pp. 40–52. Klant, J.J. (1979), Spelregels voor economen (1972), Stenfert Kroese, Leiden; English transl., The Rules of the Game, Cambridge University Press, Cambridge, 1984. Mach, E. (1905), Erkenntnis und Irrtum; English transl., Knowledge and Error, Reidel, Dordrecht, 1976. Mill, J.S. (1836), ‘On the Definition of Political Economy and the Method of Investigation Proper to It’, in D.M. Hausman (ed.) The Philosophy of Economics, Cambridge University Press, Cambridge, 1984, pp. 52–70. Mises, L. von ([1912] 1924), Theorie des Geldes und der Umlaufsmittel, Munich. Mises, L. von (1922), Die Gemeinwirtschaft, Gustav Fischer, Jena. Mises, L. von (1933), Grundprobleme der Nationaloekonomie; Eng. transl., Epistemological Problems of Economics, New York, 1960/81. Mises, M. von (1976), My Years with Ludwig von Mises; German transl., Ludwig von Mises. Der Mensch und sein Werk, Philosophia Verlag, Munich, 1981. Passmore, J. ([1952] 1972), A Hundred Years of Philosophy, Penguin Books, Harmondsworth, UK. Popper, K.R. (1935), Logik der Forschung; English transl., The Logic of Scientific Discovery, Hutchinson, London, 1959/74.

F.A. Hayek’s methodological U-turn 37 Popper, K.R. ([1963] 1974), Conjectures and Refutations, Routledge & Kegan Paul, London. Popper, K.R. ([1972] 1975), Objective Knowledge, Clarendon Press, Oxford. Popper, K.R. and Eccles, J.C. (1977), The Self and Its Brain, Springer, Berlin. Rothbard, M.N. ([1976] 1979), ‘Praxeology: The Methodology of Austrian Economics’, in E.G. Dolan (ed.) The Foundations of Austrian Economics, Steed & Ward, Kansas City, pp. 19–39. Video Arts Television (1985), ‘Hayek – His Life and Thought’, interviewer John O’Sullivan, London.

D

Microeconomics

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The consumer in Austrian economics and the Austrian perspective on consumer policy Auke R. Leen

The consumer in Austrian economics Austrian economics: what’s in a name? In the 1880s, German professors attached the epithet ‘Austrian’ to the economic theories of Menger, Böhm-Bawerk and Wieser. It was a pejorative epithet bestowed by disdainful German economists. Why was it pejorative, and what was the reason for their disdain? As far as the epithet ‘Austrian’ relates to a geographical area, it is justified because of the historic fact that it was founded and first elaborated by three Austrians, holding chairs at the universities of Vienna, Innsbruck and Prague. In 1871, Carl Menger published his Grundsätze der Volkswirtschaftslehre (Principles of Economics), an event usually recognized as the birth of the Austrian school of economics. Until the end of the 1870s, however, there was no Austrian school: there was only Menger. Later on he was joined by two younger economists, brothers-in-law, Eugen von Böhm-Bawerk and Friedrich Wieser. They became enthusiastic supporters of Menger’s new ideas. The pejorative overtone of the word ‘Austrian’ was the result of another historic fact: never before had any new mode of thinking originated in Austria. For people who were not familiar with economics, the predicate ‘Austrian’ as applied to a doctrine carried strong overtones of the darkdays of the Counter-Reformation and of Metternich. To an Austrian intellectual, nothing could appear more disastrous than a relapse of his country into the spiritual inanity of the good old days. (Mises 1969: 14) The German economists attached the smear to Menger and his followers because for them Austrian economics meant backwardness. Both the Germans and the Austrians attacked classical economics. The Germans were appealing for an allegedly modern historical approach. Menger, on

42 Auke R. Leen the contrary, retained the abstract, theoretical character of economics. The clash over methods is known as the Methodenstreit. In the end, the clash over methods seemed one of precedence and relative importance of historical research versus analytic tools. Later commentaries interpreted the whole quarrel as one ‘of wasted energies, which could have been put to better use . . . [to be] settled by allowing every type of work to find the place to which its weight entitled it’ (Schumpeter 1954: 814). For Ludwig von Mises, the founder of modern Austrianism, on the other hand, [i]t is a complete misunderstanding of the meaning of the debates concerning the essence, scope, and logical character of economics to dismiss them as the scholastic quibbling of pedantic professors. The real issue was the epistemological foundations of the science of human action and its logical legitimacy. (1966: 4) At stake was the value and usefulness of economic theory. The real motivation of the ‘Prussian Historical School, the self-styled “intellectual bodyguard of the House of Hohenzollern” ’ (Mises 1966: 4), Mises says, was to make coercive government intervention in the free market respectable. The historical school could not demolish, by means of the classicals’ own abstract methodology, the classical school’s conclusions regarding laissezfaire. It had to take recourse to another, empirical methodology to sustain its toleration of government intervention. Because for the historical school there are no economic laws transcending mere description of the circumstances of individual time and place, there are no inconvenient economic laws for government to violate. Subjectivism Menger’s theory turned the value theory of the classicals upside down. The classical Ricardian theory held that the normal value of consumption goods was determined by their cost of production. Menger’s theory, on the contrary, held that the cost of production itself is ultimately determined by the value of consumption goods. Labour is not the source of value, but is a means to value. Value was no longer to be seen as governed by past resource costs but as expressing judgements concerning future usefulness in meeting consumer wants (Kirzner 1987: 146). Menger’s theory came to be known as the subjective theory of value. The classical objective value theory was a second-best solution to the problem of how prices are determined. Classical economists ‘were fully aware of the fact that prices are not a product of the activities of a special group of people, but the result of an interplay of all members of the

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market society’ (Mises 1966: 62), but because of the problems encountered in the famous value paradox they considered the activities of the producer only. The puzzle of the value paradox was that, in exchange, diamonds are more highly valued than water, although the latter is more useful than the former. Because the classical economist could not solve the puzzle, rather than its use value the exchange value of a good became the kernel of their labour theory of value. Utility, and so the consumer, was left aside. The Austrians solved the value paradox by stating that no individual on the market is ever faced with the choice between water as a class and diamonds as a class. Prices arise in connection with definite amounts of goods, and the greater the quantity of a good that anyone possesses, the less that person will value any given unit (the law of diminishing marginal utility). Value has nothing to do with broad classes, either of human beings or of products. Consequently, the reason that water is so much cheaper than diamonds is that the number of litres of water is enormously greater than the number of carats of diamonds. The value and the price of a litre of water will be far less than the value and price of a carat of diamonds. And if one were in the impossible position of having the choice between all water and all diamonds, one would rate water first and diamonds second. What disproves the existence of the paradox of value. By offering a more satisfactory theory of demand, the subjective or marginal theory of value was more comprehensive than the classical theory. Value is in the mind of the one who chooses and maximizes, for whatever reason, his or her profit or utility. From the interaction of the valuations of the consumers flows the market demand. The market supply of the producers is determined by expected demand. The interaction of demand and supply determines the market price. Israel Kirzner (1986: 134, 152) describes modern Austrianism as an authentic extension of Menger’s older static subjectivism: a consequent dynamic subjectivism. In modern Austrianism, the post-World War II continuation of the Austrian tradition, the two central figures are Mises and Friedrich Hayek. Both authors focus in their theories on market adjustment processes. For Kirzner, building his theory along the lines of Mises and Hayek, one of the greatest failures of neoclassical equilibrium analysis is that it takes it for granted that equilibrium is actually achieved. For instance, in a disequilibrium, would-be buyers who have returned home empty-handed should learn that it is necessary to outbid other buyers, and buyers who have paid high prices should discover that they could have obtained the same goods at lower prices (Kirzner 1973: 14). The real problem for modern Austrians is to describe the possible realization of an equilibrium as the result of ‘the systematic way in which plan revisions are made as a consequence of the disappointment of earlier plans’ (Kirzner 1962: 381). Neoclassical equilibrium theory cannot describe endogenous changes in the end–means framework; its maximization scheme is not fit for the

44 Auke R. Leen task of generating systematic modifications of choices. The allocation model suffers from a discontinuity in the succession of decisions. Only an exogenous change in the data – for example, in tastes, in technology, or in information – can generate a new decision, a decision unexplainable in terms of the original framework. Without exogenous changes there is no ‘choice-theoretic’ explanation as to why yesterday’s plans are replaced by today’s. Mises and Hayek made it possible to describe the adjustment process as a systematic sequence of decisions. Mises’s extension of subjectivism was to describe the individual decision unit not only as maximizing but also as finding out the relevant ends–means relationship. This opens the way for incorporating learning into the understanding of market processes. Hayek’s extension of subjectivism was to describe the market process as one of learning by discovery (Kirzner 1986: 147; cf. Kirzner 1985: 26). Endogenous change in the ends–means relationship is possible with the entrepreneurial element in each individual market participant: alertness (Kirzner 1967: 793–794; 1973: 70–72). Alertness is the propensity of knowing where to look for information (ibid.: 68), ‘the propensity . . . toward fresh goals and the discovery of hitherto unknown resources’ (ibid.: 34). A disequilibrium situation points to a situation of market ignorance. From the ignorance emerge profitable opportunities that entrepreneurial alertness exploits (Kirzner 1979: 30). Alertness gives a more realistic image of human action and makes possible the description of the market as a unified discovery process. [The] ‘alertness’ view of the entrepreneurial role rejects the thesis that if we attribute genuine novelty to the entrepreneur, we must necessarily treat entrepreneurially generated market events as not related to earlier market events in any systematic way. The genuine novelty . . . attribute[d] to the entrepreneur consists in his spontaneous discovery of the opportunities marked out by earlier market conditions (or by future market conditions as they would be in the absence of his own actions) . . . [These] entrepreneurial discoveries are the steps through which any possible tendency toward market equilibrium must proceed. (Kirzner 1985: 11–12) The missing consumer: the socialist calculation debate The consumer was central to Menger (cf. Menger 1923), but the consumer is not for modern Austrian economics. Somewhere in the traject between Menger’s contribution – the way in which all value in economics derives from the final valuation of the consumer – and the modern Austrian contribution – the process through which consumer valuations are being translated in production decisions – the consumer got lost.

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From their early start onwards, Austrian economists have been polemical in their writings. Menger fought the historical school, Böhm-Bawerk fought the Marxists, and Mises and Hayek had their own clash with the socialists. And, in these days, modern Austrians are fulminating against the mixed economy. No wonder that it is claimed that the ‘debate over economic calculation under socialism . . . [was] a catalyst in the development and articulation of the modern Austrian view of the market’ (Kirzner 1988: 1; cf. Rothbard 1980: 27). The socialist calculation debate in the interwar period started with Mises’s denial of the possibility of allocating factors of production efficiently in a socialist economy. For most economists the debate ended with the answer of Lange and Lerner, namely to ‘play at’ markets and market prices: centrally promulgated given prices. The debate brought to the fore two modern Austrian insights (Taylor 1980: 23). First, because there are no market-determined monetary prices, in a centralized economy rational calculation is impossible. Subjectivism entails the contention that one does not and cannot calculate or measure values directly. One can only calculate with the results of individual valuations: money prices. Money prices do not measure value; value is merely expressed in money prices. There is a need of a market for the means of production. Second, because there are no market-determined monetary prices, a centralized economy lacks ability to promote a discovery process. ‘The most impressive aspect of the market system is the tendency for . . . opportunities to be discovered’ (Kirzner 1985: 30). Monetary prices show price discrepancies and stimulate, by the possibility of monetary profits, the discovery of valuable information. I shall not discuss the question of whether one of (or both) the insights was the crucial point in the calculation debate. Rothbard (1988: 37) and Salerno (1990: 45) represent the calculation insight; Kirzner, (1985: 129; 1989b: 66) and Lavoie (1985) represent the discovery insight. Though both insights are theoretically compatible, they differ in their consequences for the possibility of a socialistic system. The calculation insight states that socialistic calculation is fundamentally impossible. In a socialistic system there are no markets, hence there are no market prices to base the calculation upon (Rothbard 1988: 37). The discovery insight, on the other hand, states that socialistic calculation is fundamentally flawed. The scope for entrepreneurial decisions is available only for the central planner. In a market economy with its decentralized decision making, however, there is widespread scope for entrepreneurial decision making (Kirzner 1989: 94; cf. Rothbard 1988: 78n28). As a direct consequence of the focus on the central planner in the socialist calculation debate, modern Austrian economics discusses the two insights from the producers’ side. The first is discussed explicitly as a problem of the calculation of the means of production (Salerno 1990: 39). How can a central planner rationally calculate costs or allocate factors

46 Auke R. Leen of production efficiently? The second one is discussed by way of the methodological makeshift of an entrepreneurial producer and a nonentrepreneurial consumer (Mises 1966: 253; Kirzner 1973: 41). Though alertness is in principle present in every action, in their elaborations the modern Austrians ascribe it to the producer (cf. Rothbard 1985: 282; Ekelund and Saurman 1988: xx; Pasour 1989: 95). Consumers are passive, non-alert, Robbinsian maximizers. For instance, one of the functions of advertising is ‘getting the Robbinsians [the potential consumers] to see the availability of . . . opportunities’ (Kirzner 1973: 148). Advertising differs from changing the consumers’ taste or providing information (non-entrepreneurial knowledge) to them. Advertising (an entrepreneurial device) makes consumers aware of available opportunities, regardless of the level of alertness. As Mises did before him (1966: 251–256), Kirzner motivates the identification of alertness with the role of the producer in the market process as ‘purely for simplicity for analysis’ (Kirzner 1967: 797; 1973: 18, 41). In addition, there is some sense in the identification if we consider the ‘nearinevitability of an entrepreneurial role’s, being filled by the producer’ (Kirzner 1973: 72). Whether the identification makes the analysis less complicated I leave out of consideration for the moment. Yet why is there ‘some sense’ in situating the entrepreneurial element with the producer? To answer the question, Kirzner looks at the roles of the different market participants. He distinguishes consumers, resource owners and producers. Producers, converting resources into commodities, are alert to price discrepancies between the total price paid for each unit of a product on the resource markets and the price to be obtained on the final product markets. This alertness, however, is a form of entrepreneurial behaviour. We can distinguish ‘a built-in group of entrepreneurs’ in society (Kirzner 1973: 18). In other words, the essential difference between consumers and resource owners on the one hand and producers on the other is that producers do not have to possess means. The pure producer can gain profit by being alert to price discrepancies. We can think of all consumers and resource owners as pure Robbinsian allocators, which is unthinkable for all producers. For a pure producer, alertness is a conditio sine qua non (Kirzner 1973: 39). In the modern Austrian discussions about calculation and entrepreneurship, the consumer as the personification of the ends fades into the background. But what about the consumer? Is there no relevant distinction between the calculations of the producer and those of the consumer? Also, perhaps the methodological makeshift of a Misesian entrepreneur and a Robbinsian consumer is spun out too far.

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The consumer: entrepreneurial and calculative Menger The end of the preceding section showed us that the socialist calculation debate brought to the fore two modern Austrian tenets. In their opposition towards the possibility of central planning the modern Austrians state that (1) a centralized economy is fundamentally flawed in its discovery process, and (2) rational calculations of production decisions are impossible in a socialistic commonwealth. As a direct consequence of the context of discovery, both tenets are discussed for the case of rational, purposeful production only. Therefore, I look first at the discovery element in the act of consumption, and later at the possibility of calculation in the act of consumption. It is necessary to take a consequent look at the consumer’s subjectivism. What aspects does the consumer, the consumption aspect of action, add to calculation and entrepreneurship? For [t]he conduct of the consumer – i.e., of everybody – is no less a topic of economic studies than that of anybody else. The businessman is, in his capacity as a businessman, not more closely related to or involved in the process that produces market phenomena than anybody else [i.e., the consumer]. (Mises 1962: 77) We know from Mises that ‘every actor is always an entrepreneur’ (1949: 253) and from Kirzner what entrepreneurship entails for the producer. For Mises (1949: 255), ‘entrepreneur means acting man in regard to the changes occurring in the data of the market’. For Kirzner (1988: 4), entrepreneurship is the ‘alertness to and the discovery of as yet unknown information’ (both in regard to existing opportunities for potential gains from trade with existing techniques and in regard to possibilities for innovative processes of production). What, however, are the explicit repercussions for the consumer – that is, the act of consumption – of the modern Austrian emphasis on adjustment processes instead of the more usual neoclassical market equilibria? Producers are always calculating in monetary prices between two markets, their input and their output market. The producer ‘should buy in the cheapest market and sell in the dearest market. In buying and selling [he or she] should know no other goal than the greatest monetary profit’ (Mises 1960: 176). Consumers, on the other hand, are always only spending their money on one market. They try to bring their immeasurable utility in a motivated, efficient way into their monetary calculation process. Consumers places utility at the centre of their calculations. Utility and marginal utility

48 Auke R. Leen are present in the calculations of the consumer only (Schönfeld-Illy 1924: 13–14; 1948: 1). Let me start at the beginning: the choices of the consumer – that is, consumer demand. For [t]he demand for goods with the expected utility and marginal utility which it recalls, is the first and last link, the alpha and the omega, in the chain of the origin in price, it is the driving and decisive force, the dynamics of it all. (Schönfeld-Illy 1948: 231; cf. Abbott 1955: 24) The demand of the consumer, however, is not the present desire of consumers for a hypothetical product not yet produced. ‘[T]he demand that is expressed in the demand curve for a product means the quantities of it that consumers will be prepared to buy, at given prices, when offered the opportunity of doing so’ (Kirzner 1973: 178). The sovereignty of the consumer, production patterns dictated by the pattern of consumer demand, means that ‘production decisions are determined by entrepreneurial anticipation of the patterns of demand that will be evoked by alternative production plans’ (Kirzner 1973: 176). Opportunities are placed before the eyes of consumers after the production decisions have taken place. So, the consumer’s alertness must be part of the answer to the question: what makes for a consumer of an already existing thing a consumer’s good? This is a question the modern Austrians lost sight of when giving predominance to the producer. As Böhm-Bawerk said, ‘How frequently, for instance, in a society which engages extensively in “utilization by way of exchange” [i.e. production] do we find there is a watering down in the subjective requirements that makes of a thing a consumer’s good?’ ([1881] 1962: 101). The goods question brings us, says Menger, to the heart of economics. For one of the first questions encountered in economics is: what makes a thing a good (Menger [1871] 1950: 48)? The answer from a subjectivistic point of view reads like this. ‘[G]oods-character is nothing inherent in goods . . . but merely a relationship between certain things and men’ (ibid.: 52). In his magnum opus, Grundsätze der Volkswirtschaftslehre ([1871] 1950), Menger gave four essential characteristics of a good (need, useful properties, knowledge, and power of disposal). In this way he was trying to define the essence of a good. Ten years later, Böhm-Bawerk, in his Habilitationsschrift, Rechte und Verhältnisse vom Standpunkte der volkswirtschaftlichen Güterlehre ([1881] 1962), added as a fifth characteristic the condition that individuals must possess knowledge of how to utilize the thing (Gebrauchskunst). In the history of economic thought the difference between Menger’s and Böhm-Bawerk’s characterizations has almost been forgotten. In most cases the difference is not even noticed (e.g. Amonn 1911: 266). If men-

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tioned, the addition of a fifth characteristic is characterized as a sign of Böhm-Bawerk’s objectivism (Endres 1987: 294). Compare an often quoted remark made by Menger, that the error of objectivism was made inside the Austrian camp in the works of Böhm-Bawerk (Schumpeter 1954: 847n8). But according to Mises, in Böhm-Bawerk’s case this was probably only a matter of stylistic habit, inherited from Böhm-Bawerk’s own ‘objectivistic’ economic childhood – stylistic faults to which even Menger sometimes fell prey (Mises [1928] 1960: 167, 171). So – again according to Mises – it is better to turn to the more clearly stated views of the epigones (Mises [1928] 1960: 174, 178). One of the results of this chapter is to prove exactly the opposite: that there is still something to be learned from one of the founding fathers of Austrianism: Böhm-Bawerk. He, however, in a remark characteristic of his general attitude towards Menger, said that he supplemented Menger’s findings ‘only in one minor respect’ (BöhmBawerk [1881] 1962: 41). In his magnum opus, Kapital und Kapitalzins, of 1884, he dropped his fifth characteristic. Is, however, Böhm-Bawerk’s own and other people’s negative verdict on this fifth goods-characteristic correct? Or have I come across a hint of the entrepreneurial appraisal of a consumer good? The question will be: what light does Böhm-Bawerk’s subjectivistic goods-concept shed on the untouched subject of the entrepreneurial behaviour of the consumer? What are the formal characteristics of this alertness concept? What are the implications for the theoretical underpinnings of the idea of competition: that which keeps the market process in motion? Competition (‘entrepreneurial activities that . . . are . . . creative acts of discovery’; Kirzner 1985: x) is in the modern Austrian vision not only a process of rivalry between producers for the money of the consumer, but above all things a two-sided discovery process between producer and consumer (Kirzner 1963: 110). Competition is a process that takes place between producer and consumers and at the same time within each of these groups. Still, when it comes to the point, the modern Austrians impute, as we saw, the entrepreneurial role in the competitive process to the producer (Kirzner 1973: 72). This is in spite of the fact that the ultimate king in market processes is without doubt the consumer (cf. Mises 1966: 269–270). But if the consumer king rules, he must occupy a place in the market process. Böhm-Bawerk In his Principles, Menger gave four characteristics of goods. He described them by stating the standard ends–means relationship. People have needs. The only way in which needs can be satisfied is by means of a causal process. What things, to be called useful things (Nützlichkeiten), can satisfy the needs in such a causal process? Two conditions must be fulfilled: (1) a human need must exist, and (2) the thing must have useful properties to satisfy the need. If the causal process is recognized and if there is control

50 Auke R. Leen over the useful things, the thing is not only useful but also a good. This leads to two further conditions: (3) knowledge of the causal relationship, and (4) the power of disposal over the thing (Verfügungsmacht) (Menger [1871] 1950: 52). The four characteristics were the culmination and more or less also the end of a lively discussion about goods-characteristics. Alter (1982) gives an explanation why the four characteristics are the ‘end’ of economic thought on goods-characteristics for the Austrians in general and for Menger in particular. He refers to the Aristotelian character of the foundations of Menger’s economic theory, a statement that can be extended to older Austrianism in general (Smith 1986: 9). The four necessary and jointly sufficient conditions to make a thing into a good are ‘nothing else but Aristotle’s four causes operating in the realm of immaterial objects [psychological states]. They are the material [need], the efficient [useful properties], the formal [power of disposal], and the final cause [knowledge]’ (Alter 1982: 152–153). In his Rechte, Böhm-Bawerk stated five goods-characteristics. To Menger’s four he added a fifth characteristic: individuals should know how to utilize a useful thing (Gebrauchskunst; Böhm-Bawerk [1881] 1962: 42). He must have had good reasons to add this fifth condition. Austrian thinking is usually not very light-hearted about essences. Goods-characteristics are part and parcel of the Austrians’ essentialism. Böhm-Bawerk himself played down his divergence from Menger, stating his reasons only in a footnote in which he said that the knowing-how condition cannot be included in the fourth condition on the command over the thing. He gave two reasons for this: (1) the knowing-how condition is too subjective; and (2) it would stretch language usage too much to include knowing-how as a part of the condition on the command over the thing (ibid.: 42n2). First I classify Böhm-Bawerk’s fifth (knowing how to use) characteristic by differentiating it from the other four characteristics. To start with, I will differentiate it explicitly from the common characteristic, stated by both Menger and Böhm-Bawerk, that there must exist a knowledge of the causal relationship between the means and the end. I use the second reason (that it would stretch language usage too much) – or, actually, hint – in Böhm-Bawerk’s explicative footnote. The first reason (that it is too subjective) I shall discuss later. Subsequently I use the stated classification for analysing Menger’s implicit concept of knowing how to utilize a useful thing. I call Menger’s knowing-how condition ‘implicit’ because in the posthumously published (second) edition of his Principles there is a remark that the knowledge of how to utilize a thing should be classified under the power of disposal (command) condition (Menger 1923: 17). It comes down to the question: how must Menger’s fourth characteristic be interpreted to include the whole or part of Böhm-Bawerk’s fifth characteristic? Both Menger and Böhm-Bawerk put forward the condition that one must have knowledge of the causal connection between a useful thing and

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a need; one must have the knowledge that such a situation exists. The knowledge, on the other hand, of how to use a thing – Böhm-Bawerk’s fifth characteristic – refers to a form of knowing-how. The knowing-how aspect states what it is for someone to have the know-how to be able to perform certain tasks. It refers to the possession of certain skills. There is a difference between a theoretical knowing that something is the case and a practical knowing how to do things. The consumer’s knowing-how concept I have in mind is directly combined with utility. It is particularly revealed in consuming the subjective images of services. Classical music, for example, has no value for someone who only loves pop music: that person does not know how to use it. He or she cannot do a thing with it. This is an instance of the general fact that ‘[p]eople want products because they want the experience-bringing services [psychological states, immaterial objects] which they hope the products will render’ (Abbott 1955: 40). Here, knowing-how clearly does not have the ‘objective’ connotation of, say, knowing how to use a can-opener. In Austrian thinking the difference between knowing-how and knowingthat is widely known and considered of fundamental importance (Hayek 1967: 44; Lavoie 1985: 62; O’Driscoll and Rizzo 1985: 104). It functioned as an argument of the Austrians against the efficiency of a central planning system. Knowing-how cannot be communicated to and therefore used by a central authority. What I want to do is to look at the concept of knowinghow and see how it relates to Kirzner’s concept of entrepreneurship. At this point I refer to the famous elucidation of the concepts by the British language philosopher Gilbert Ryle (Ryle 1945, 1949). This in contrast to the more usual Austrian explication of it based on Michael Polanyi. Given their appropriate logical uses, knowing-how and knowingthat ought to be clearly distinguished. If this is not done, a category mistake is made – a mistake comparable to the one somebody makes when he asks where the university is after a tour of the grounds of the university in which he has been shown a number of colleges, libraries, playing fields and museums. ‘He was [by asking the question] mistakenly allocating the University to the same category as that to which the other institutions belong’ (Ryle 1949: 18). Why are the logical uses of the concepts so different? Knowing-how refers to an observable regularity in the behaviour of a person. The concept does not refer to a possession of knowledge-that, neither does it signal the occurrence of special (theoretical) internal acts of thought. Knowing-how has the character of a disposition, not that of an occurrence. ‘Just as the habit of talking loudly is not itself loud or quiet, since it is not the sort of term of which “loud” and “quiet” can be predicated’ (Ryle 1949: 33). Neither do we have to know-that before we know-how. The crucial objection to the [what Ryle called] intellectualist legend [which means trying to reassimilate knowing-how to knowing-that] is

52 Auke R. Leen this. The consideration of propositions is itself an operation the execution of which can be more or less intelligent, less or more stupid. But if, for any operation to be intelligently executed, a prior theoretical operation had first to be performed and performed intelligently, it would be a logical impossibility for anyone ever to break into the circle. (Ryle 1949: 31) For the intelligence of an act is given by another, preceding intelligent act and so on ad infinitum. If we confront the Misesian (entrepreneurial) producer and the Robbinsian (non-entrepreneurial) consumer with each other, we find two irreducible concepts. There is on the one hand the dynamic market concept, seen as the disposition to perform a certain activity (a knowing-how) and on the other hand the static market concept, seen as the possession of a certain knowledge (a knowing-that). The market may be seen as a capacity to perform certain tasks, to sort something out, or as a theory, a stock of cognitive knowledge. The two descriptions have parallels and differences. It is possible to speak of learning an activity, as well as learning knowledge, although learning-how differs from learning-that (cf. Kirzner 1979: 29). ‘We can be instructed in truths, we can only be disciplined in methods’ (Ryle 1945: 14). We can ask for the reasons why someone accepts a proposition, but we cannot ask this if someone’s skill is at stake. So, a distinction is made between the market conceived as a disposition and as a stock of knowing-that. Knowing-how is made clear through actions, not through internal or external dicta (which is knowing-that). To conjoin or disjoin them is a category mistake. Compare the conjunction ‘She came home in a flood of tears and a sedan-chair’ with the disjunction ‘She came home either in a flood of tears or else in a sedan-chair’ (Ryle 1949: 23). The distinction Ryle made in the use of the different kinds of categorical concepts is of interest in expanding on Böhm-Bawerk’s concern that it would stretch language too much if one included knowing-how as part of the condition that requires command of the thing. Böhm-Bawerk’s fifth characteristic of knowing-how, in the light of Ryle’s classification, cannot logically be put under the condition that states factual command over the thing. In language we make a distinction between a state of things and a mental disposition. The condition of command as used by Menger refers to an entity at our disposal. Likewise, Menger’s discussion of the other characteristics clearly reveals the need of their actual occurrence (Menger [1871] 1950: 52–53). The question can be asked as to how the five characteristics of BöhmBawerk fit into Alter’s explanation of Menger’s four goods characteristics in terms of Aristotle’s four causes. The question disappears as soon as it is realized that knowing-how is a dispositional concept and not the description of another cause.

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The sense in which we ‘explain’ . . . is not that we infer to occult causes, but that we subsume under hypothetical . . . propositions. . . . The explanation is not of the type ‘the glass broke because a stone hit it’; but more nearly of the different type ‘the glass broke when the stone hit it, because it was brittle’. (Ryle 1949: 49, 113; cf. O’Driscoll and Rizzo 1985: 26) In the second edition of his Principles, Menger said that knowing-how can be classified under the command of a thing. This begs the question as to how to interpret the command condition to make this happen. For Menger the command of a thing appeared in the description that he gave of the production process of goods – that is, the process of converting higher- into lower-order goods. Menger’s first law on goods-character concerned the causal connection between goods: ‘The goods-character of goods of higher order is dependent on command of corresponding complementary goods’ (Menger [1871] 1950: 58). If the command condition was to ‘include’ a form of knowing-how, then, for Menger, it had to be that aspect of knowing how which stated a capacity or skill of the producer. The producer could bring off certain things: he or she could actually produce the goods. He or she had control over the necessary complementary goods. For Böhm-Bawerk, on the other hand, to illustrate the explicit condition of knowing-how in the context of a production process would be completely out of the question. For him, the possibility of multiple uses of higher-order goods, and especially the existence of barter in our society, both change the order of a good: the place a good occupies in the causal nexus of goods. Like the conditions of need and knowing-how, the prerequisites for a thing to become a good show themselves precisely in these situations in a very watered-down version. The strange phenomenon of ‘utilization by way of exchange’ simply reveals here a feature which is apparent in many other aspects of the nature of goods, the vexatious power of causing supposedly welldefined characteristics to fade and become obliterated – a power which has so often caused economists in general to surrender to what Robinson calls ‘the role of the inevitable supernumerary’. (Böhm-Bawerk [1881] 1962: 101n2) So, the object of this chapter can also be characterized as sketching out, from a consequent subjectivistic point of view, the difference between first-order (consumer) and higher-order (producer) goods. For the causal nexus between goods, just like goods-character itself, is not a property inherent in the goods themselves but a relationship between man and goods (Menger [1871] 1950: 58). The conclusions up to this point are that (1) Böhm-Bawerk’s added

54 Auke R. Leen fifth goods characteristic is different from the other four goods characteristics; (2) in Ryle’s terminology the difference is parallel to the difference between knowing-that and knowing-how, or, more generally, between episodes (occurrences) and dispositions; and (3) if knowing-how is to be included – as Menger is inclined to do – in the goods-characteristic of command over a good, then that characteristic seems to designate the capacity aspect of the role of the producer in the market process. The entrepreneurial consumer Kirzner describes alertness as ‘ “knowing where to look for knowledge” rather than knowledge of substantive market information’ (1973: 68). ‘He [the entrepreneur] has not “deployed” his hunch for a specific purpose; rather, his hunch has propelled him to make his entrepreneurial purchase and sale’ (Kirzner 1985: 22). Entrepreneurial alertness is not an ingredient to be deployed in decision-making; it is rather something in which the decision itself is embedded and without which it would be unthinkable. (Kirzner 1985: 22; cf. Kirzner 1989: 23–24) . . . No matter how calculative a man’s behaviour may be, it seems impossible to avoid having accepted, without calculation, some framework within which to self-consciously engage in cost–benefit comparisons. (Kirzner 1985: 22, 48; cf. Kirzner 1989b: 23–24) The descriptions of alertness are analogous to the ones given by Ryle of the knowing-how concept. For Ryle, too, ‘the explanation is not of the type “the glass broke because a stone hit it”; but more nearly of the different type “the glass broke when the stone hit it, because it was brittle” ’. (1949: 49). And we do not have to know-that before we know-how (ibid.: 29). Alertness, ‘the elusive analytical category’, then clearly becomes a form of knowing-how, a mental quality. It is a disposition that expresses itself in practice for the producer as the capacity or skill to bring about certain things. Alertness and the capacity aspect of the command condition are two sides of the same coin. They bring about or create the producer’s ends–means relationship as far as it depends on the category of knowing-how. Böhm-Bawerk’s explicit concept of knowing-how as shaped implicitly in Menger’s concept of the power of disposal has found its counterpart in the modern Austrian theory about market processes. It refers to the producer’s propensity of alertness. The core role in the market is for the producer and not for the consumer. This is a rather startling conclusion. For

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it puts things back – as we saw – in the same position as described by Mises over sixty years ago. Even more astonishing, it was precisely this position that the Austrians tried to get rid of with their subjectivism. To solve this riddle I return to Böhm-Bawerk and expand on his other, first reason for adding the fifth goods-characteristic. What is so subjective about knowing-how that it can neither be part of the command condition nor coincide with the above-mentioned ‘implicit’ (producer’s) capacity aspect of the command condition? To answer the question I look at someone who simulates the disposition of alertness (knowing-how). How can such acts be qualified? ‘We use abusive names like “charlatan” and “quack” for the frauds who pretend to be able to bring things off, while we use the word “hypocrite” for the frauds who affect motives and habits’ (Ryle 1949: 128). With the disqualifications of both forms of reproachable behaviour, I differentiate between two forms of alertness: a tendency to act or react in a certain manner, and a capacity to get something right. Compare the difference between proneness and competence. ‘ “Tends to” implies “can”, but is not implied by it’ (Ryle 1949: 126). A tendency concerns a proneness, in which the source is of interest, in contrast to a capacity, a skill, in which the method is of interest. This difference coincides with the different roles that can be ascribed to consumption and production in the market process. The consumer is asked why he or she believes something, whereas the producer is asked how he or she knows something and what his or her method has been. The fraudulent behaviour of the hypocrite, for instance, is often a problem in market research when the consumer who is interviewed wants to give a socially acceptable answer. Ask the consumer the wrong question (alertness being understood as a capacity aspect, which the modern Austrians are inclined to do), and the possible silence following that question does not signal a lack of alertness. It signifies different forms of alertness by producer and consumer. I interpret Böhm-Bawerk’s concept of knowing-how as being broader than the implicit capacity aspect of the producer, which is part of Menger’s command condition. Böhm-Bawerk’s explicit concept includes the subjective aspect of a tendency, the liability to a certain tendency which is pre-eminently applicable to the entrepreneurial role of the consumer in the market process. To describe a market process, both forms of alertness – alertness towards monetary profit (producer goods) and alertness towards utility gains (consumer goods) – are formally necessary. The pejorative terms in which Mises describes the consumers do not contradict but reinforce my interpretation of the alertness concept. Mises speaks of ‘[t]he hosts of inferior people’, ‘[t]he inferiority of the multitude’, and ‘[t]hese dull beneficiaries’ (1962: 112–113). It is exactly the quality of verbs expressing a tendency, which imply that a person tends to act or react in certain manners and which do not imply that anything is brought off, that they can be qualified by such adjectives as ‘fanatical’, ‘stupid’ and ‘childlike’. On the other hand, none of the qualifications are

56 Auke R. Leen applicable to capacity verbs, which express that a person is equipped to bring things off, or to get things right (Ryle 1949: 128–129). Therefore, probably the best attitude for an economist to take towards these pejorative terms has already been given by Mises himself: There is little sense in distinguishing between economic and other motives [error, ignorance, incapacity, laziness, neglectfulness] . . . if one starts with the action of the marginal consumer and not with that of the businessman. . . . One can see how ridiculous such scholastic distinctions are. The maxims of the businessman cannot be applied to the action of the consumers, which, in the last analysis, governs all business. ([1928] 1981: 176) In this way I gave a theoretical answer to the unexploited subject of the entrepreneurial behaviour of the consumer. I have stated the logical domain of the categories to be used, with what other propositions they are consistent and inconsistent, what propositions follow from them and from what propositions they follow. Moreover, the idea of competition has changed. The alertness concept referred to earlier in the chapter focused on the relaxation of the postulate of full knowledge in the traditional neoclassical market model. The alertness concept as shaped in the consumer’s goods concept, on the contrary, focuses on the relaxation of the postulate of homogeneous goods. At the centre of the analysis is the goods quality as a means of satisfaction. Competition for a consumer, the entrepreneurial appraisal of a consumer good, does not only give rise to price competition, price behaviour, but also to goods competition, goods behaviour. [T]he study of competitive exchange, in order to be significant, must concern itself with the quos as well as the quids of an economy’s quid pro quo transactions – that is, not only with the prices paid but with the things for which the payments have been made. (Abbott 1955: 24) Goods – that is, quality-competition, however, is not always an inverted form of price competition. Of course, a different-quality good for the same price is often equivalent to a different price for the same good. For example, a restaurant that wishes to raise the price of its cup of coffee without actually altering the price on the menu can either serve the coffee in smaller cups or use a cheaper grade of coffee. The first is a change in size, the second a change of quality. But both have the same end in view as a price increase: to give less for the money. (Abbott 1955: 126)

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But in some matters of quality there is no clear-cut agreement. Different people will rank qualities in a different order – for example, according to aesthetic considerations (the cut of a woman’s dress) or matters of convenience (the arrangement of the shelves in a refrigerator). What attracts some buyers may repel others. ‘It will be useful to label such differences as horizontal differences – as opposed to vertical differences, which may properly be thought of in terms of “higher” or “lower” ’ (Abbott 1955: 127). For modern Austrianism, with its emphasis on the producer and higher-order goods, quality competition is connected with vertical quality. Henceforth, competition can be reduced to price competition. For the consumer, on the other hand, this is not a viable option. There is horizontal quality differentiation at the level of consumer goods. The entrepreneurship of the consumer is directed not only at prices, but also at goods. The consumer discovers new, unexpected ends, new forms of utility, to (old) means (cf. Kirzner 1989: 107). Consequently, it is not always the case that the role of the producer ‘consists in relieving the consumer of the necessity to be his own entrepreneur’ (Kirzner 1973: 136). The situation can also be the other way around. The producer hires his or her trendwatcher: someone who looks out for what a trendy consumer discovers. Rosenstein-Rodan In this and the following section I examine whether there is an equally important role for market-determined monetary prices in consumption as there is for them in production. In what sense are market prices a relief for consumption? In older Austrian economics, marginalism not only is the solution to a problem, but also gives rise to a new problem. Marginalism, the solution to the value paradox, poses the problem of finding an overall goods allocation, with its astonishing number of individual comparisons. Comparisons are necessary in order to determine the values of the different goods and thereby the optimal goods allocation. In the classical objective value theory this problem was not as intimately connected with the core of economics and could for that reason be relegated by the theoretical economists. With subjective use value this changed. Value was no longer given from outside, but had to be calculated by human beings themselves. The problem was further aggravated with the transition from a cardinal to an ordinal utility concept, because now the calculation problem changed from a quantitative to a much more difficult to handle qualitative one. The solution to this problem was so important that Paul RosensteinRodan in his summarizing article on marginal utility said, ‘[T]he essential function of marginal utility is to abbreviate economic calculation’ ([1927] 1960: 94). For Mises, too, economics is first and foremost concerned with the question how calculable action is possible (1940: 186). ‘No other

58 Auke R. Leen distinction is of greater significance . . . than that between calculable action and incalculable action’ (Mises 1966: 199). The infinity of the calculation process arises as we go from simple consumer decisions regarding first-order goods to complicated producer decisions concerning higherorder goods (Mises [1922] 1981: 98). ‘Here [in a production context] the processes of production are so many and so long, the conditions necessary to the success of the undertaking so multitudinous’ (ibid.: 98). In other words, for Mises the calculation problem arises if we change the analyses from an isolated individual to an individual in a full-grown exchange economy ([1912] 1971: 48). For Mises, the solution to the calculation problem is given with the possibility of monetary calculations in an exchange economy: ‘No individual could so discriminate between the infinite number of alternative methods of production that he could make direct judgments of their relative value without auxiliary calculations’ ([1922] 1981: 101). Money makes it possible to come to grips with ‘the confusing multiplicity of the exchange ratios’ (Mises [1912] 1971: 48). The division of labour in an exchange economy, with money as its collateral, ‘effects a kind of mental division of labour, without which neither economy nor systematic production would be possible’ (Mises [1922] 1981: 101). It is not only that it would cost the consumer too much time and trouble to make all the necessary calculations. It is also the case, claims the older Austrian Leo Schönfeld-Illy, that not all utilities can be stated and henceforth compared. It is, for example, almost impossible for someone to state with certainty whether a good that protects against death by starvation has a higher value than a second good that protects from freezing, or a third good that protects from being choked to death. These utilities cannot be compared or grasped at all (Schönfeld-Illy 1924: 21). But if this is the situation, how can our theory be useful if it has to be in accordance with the rightly named practical facts of life? Do we have to admit that, at least partially, subjective value cannot explain economic calculation? For we do buy goods in certain quantities without which we cannot survive (Schönfeld-Illy 1924: 21). Modern Austrians, with their emphasis on the producer’s point of view, do not worry about these problems. Indifference is not a concept of action. It lies outside economics, a science of human action (Rothbard 1962: 265). Moreover, if utility cannot be grasped, it simply lies outside the field of economic calculation (Mises 1966: 215). The question arises, what relief does money give the consumer? Money is the sine qua non for rational production save for primitive production and consumption. What is the role of money for the consumer in a fullgrown market economy in respect of the multiplicity of all the necessary calculations and the impossibility of stating all the necessary utilities? There are questions that take us to the core of modern subjectivism: ‘the analysis of the mental processes performed by acting man in applying

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quantitative distinctions when planning conduct’ (Mises 1966: 210). Subjectivism ‘systematically recomposes market phenomena in terms of typical structural components of everyday decision making’ (O’Driscoll and Rizzo 1986: 252). In his ‘Grundzüge der Theorie des wirtschaftlichen Güterwerts’ (1886), Böhm-Bawerk discusses the calculation problem. From a purely theoretical point of view, calculation has to be very labour- and timeconsuming. To compute the marginal utilities we have to state again and again the needs that goods of the first order can satisfy, and so on for all the units of the goods we have at our disposition. The problem even grows in complexity with goods of higher order, for then we have to state the needs to be fulfilled not only by the goods themselves, but also by their intermediate products (Böhm-Bawerk 1886: 74). But, he continues, we know from our experience that calculations do not give us much trouble. First, we do have a lot of practice. We are great virtuosi in our value calculations – calculations, after all, that from a cost–benefit point of view do not have to be scrupulously careful. We do not have to be more exact than is worthwhile. This reason is analogous to the one given by Kirzner. For him, ‘[t]he essence of the problem facing the consumer . . . consists in choosing one out of an immense number of alternative assortments of goods’ (1963: 64). The solution to this problem, however, so far as it concerns the ‘immense number’, does not need special attention inside theoretical economics. ‘[I]ncome allocation can be made as precise as the consumer wishes; that is, as precise as the consumer feels worthwhile in view of the difficulty of choosing carefully between a number of closely similar alternatives’ (ibid.: 65). Second, we have all sorts of short cuts and rules of thumb – our own recollections of earlier, similar decisions, what we have learned from other people – and we follow routines. All these reliefs can be used as long as our situation does not drastically change, which in practice is the case for most of us. Third, there is a reason that is particularly relevant for the increased calculation problem for goods of higher order. Nearly all stages of production are taken care of by separate industries: the familiar phenomenon of the division of labour. Consequently, further stages of production lie outside the economic calculation problem of the individual producer. The producer only asks him- or herself: what are these goods worth on my next market? Rosenstein-Rodan made the solution of this calculation problem the central function of marginal utility. He specifies the condition that permits abbreviation: ‘Observation shows that during an economic period the majority of the needs . . . usually remain constant’ (Rosenstein-Rodan [1927] 1960: 84), and the same holds for the supply of productive resources. The complementarity of utilities seems to pose a problem. It suggests the necessity of a complete revision of the whole economic plan,

60 Auke R. Leen even with a relatively small change in the data. This, however, is not the case. For the layers of goods allocation under discussion are the marginal ones. Here complementarity is always the lowest and the utilities the smallest. For these reasons, complementarity has no great repercussions elsewhere in the system. But how do we find the initial situation, the one that holds in the first place, and that is of relevance if nothing changes? The situation is the result of a process of historical development. We cannot create it instantaneously, it is the result of a historical process of trial and error. If we are in this situation, the attained marginal utilities fulfil their function as a short cut without which there simply can be no rational economic conduct. The utilities of the new uses which are contemplated are compared with past marginal utilities in these uses; if they are larger, the new uses are expedient, if smaller, the new uses are not expedient. The marginal utility in different need classes (kinds of uses) thus fulfills a watch-dog function with respect to consumption. (Rosenstein-Rodan [1927] 1960: 85) Schönfeld-Illy In two of his books (1924, 1948), Schönfeld-Illy extensively investigates the abbreviation procedure of consumer calculations. For him, the use of marginal utility as an instrument of abbreviation changes the situation from one of equilibrium to one of disequilibrium. The phenomena to be explained are no longer associated with marginal changes in an equilibrium allocation, but with abrupt, great changes in means and ends. His favourite examples of budget allocation are students who receive their first income after graduation, people who get married, or emigrants upon arrival in a foreign country (Schönfeld-Illy 1948: 125–126, 321). A theory able to describe small changes in equilibrium only, and not the origination of this equilibrium itself, would be just as unsatisfying to him as a theory that could explain only price changes and not their origination. We cannot take as given the results that our theory intends to explain. What is noteworthy is that with this change comes not only a different definition and function of the marginal utility concept, but also a change in the character of the proof of the abbreviation procedure. Schönfeld-Illy introduces his version of marginal utility with the following question: How can the transition process come about to deduce from the data, which include Gossen’s first law of diminishing marginal utility, the result formulated as Gossen’s second law of equi-marginality? This is a question overlooked because of the mathematical mould of economics (Schönfeld-Illy 1924: 204–205; 1948: 3–4). To explain the function of marginal utility he states the principles that can substitute for an actual numerical calculation process, since utility is immeasurable (Schönfeld-

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Illy 1924: 40, 56). He distinguishes three principles. All three are necessary and sufficient. The first principle is the principle of the separate utility of a good (Prinzip des Einzelnutzens) (Schönfeld-Illy 1924: 49). Though the consumers’ aim is to reach the greatest total utility, they do not and cannot calculate total utility as such, but only changes in total utility, changes brought about by adding goods to the ones already used. These changes give the utility of each good separately. To determine the utility of each good separately, in the sense of its own abstract utility, is impossible. The utilities of goods influence each other simultaneously and depend on the actual situation. (ibid.: 3). The second principle is the principle of quid pro quo (Prinzip des Vergleichens von Leistung und Gegenleistung) (ibid.: 44, 50). Changes in total utility do not give consumers numbers in which they can calculate. What they can do is compare the changes with other changes. Given scarcity, a change in total utility can always be compared with another change in total utility, a comparison that must be made if the calculation is to have any economic significance. In discussing the principle, Schönfeld-Illy clarifies the object of Gossen’s first law: the pivotal fact behind the third principle (ibid.: 198n1). In conformity with modern Austrianism (Kirzner 1963: 50, 56; Mises 1966: 126), the object of Gossen’s law is not the image of a subsequent consumption of goods (Schönfeld-Illy 1924: 92), but a contemplated variation in goods quantities. The interpretation of marginal utility as a subjective demand price gives us the third principle of economic relevance (Prinzip der ökonomischen Relevanz) (Schönfeld-Illy 1924: 48). It states the economic relevance of a margin for the whole. The price relevant for the marginal part of a divisible amount of goods has an economic relevance for all other units of that amount of goods, a fortiori: for the utility of the other units is higher than the utility of the marginal unit and therefore the price paid for the other units certainly must be justified (ibid.: 59–60). The cumulative validity of marginal utility makes it possible to abbreviate the calculation process and to solve problems of goods of which the utilities cannot be stated or compared. With the three principles, not only utility in general and the two problems in particular are brought into the calculation process, but marginal utility fulfils a special role, too. It no longer functions pre-eminently as a watchdog that precludes all utility under it and sustains all utility above it. But its function becomes its economic relevance: the relevance of the economic use at a margin for a whole. For Schönfeld-Illy, this interpretation of marginal utility dissolves an inconsistency in the thinking of Wieser. Wieser takes the description of marginal utility from the situation in which the calculation is already completed. ‘The measure of marginal utility is got from the least useful of the

62 Auke R. Leen most important uses . . . conditional on the highest use of the supply and the most careful inquiry of the needs’ (Schönfeld-Illy 1924: 75). On the other hand, Wieser draws the description of the function of marginal utility inside calculation from the situation whereby action starts. ‘All uses, which stand below, are forbidden . . . all uses which stand above or are equal, are permitted’ (ibid.: 75). Schönfeld-Illy wonders whether the last stage of calculation contains all those things that have been used during the actual economic action and, consequently, are contained in a conceptional description grafted onto this final stage. The correct definition of marginal utility consistent with the function it performs, reads: For a particular consumer, the marginal utility of a certain amount of goods is the utility of the smallest part of a stock of goods relevant from an economic point of view. The economically smallest part is the part that lies at the circumstantial margin of use of the stock of goods and is of relevance for the whole stock of goods considering the plans one has for using it. Marginal utility is an instrument in a process of trial and error (SchönfeldIlly 1948: 67, 126). As a result, Schönfeld-Illy and Rosenstein-Rodan give a different interpretation of Wieser’s statement that the entire surplus utility (Übernutzen) can be neglected. For Rosenstein-Rodan the surplus utilities are the utilities above the equilibrium marginal utilities ([1927] 1960: 85). For Schönfeld-Illy they are the utilities above the marginal utilities of certain quantities of goods in a disequilibrium situation (1948: 65). What about the change in character of the proof of the abbreviation procedure? For Böhm-Bawerk and Rosenstein-Rodan the possibility of abbreviation procedures is a direct consequence of certain empirical, psychological characterizations: an unchanging world around and within us. For Schönfeld-Illy, on the other hand, abbreviation is a direct consequence of Gossen’s first law. Schönfeld-Illy gives a, in a modern Austrian terminology, praxeological proof. The calculating consumer What is the subjective demand price in which each consumer calculates (Schönfeld-Illy 1948: 194)? The answer is the price that functions as an intermediary (die Vorgestalt des Preises) between the price that prevails on the market and the incalculable marginal utility (Schönfeld-Illy 1948: 40–41). The subjective demand price is an expected price. (Schönfeld-Illy 1924: 6, 62). The combined actions of consumers and other factors lead to the actual price on the market (Schönfeld-Illy 1924: 6, 62; 1948: 238). There are for the consumer no unchangeable, unambiguous data (Schönfeld-Illy 1948: 210, 237). Consumers live and learn (ibid.: 210, 237) from their experiences and adapt their behaviour (ibid.: 222–223, 264). Schönfeld-Illy also characterizes this price as a dynamic price. While determining the price, the consumer focuses on the existing state of the

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market. The price with which the consumer operates on the market is not the maximum subjective price he or she is willing to pay for a good. The consumer might not even be aware of the highest price, a price that would not allow him or her any ‘profit’ (ibid.: 241) Just as the producer bases his or her price on the prices presently charged by competitors and the probable changes thereto (ibid.: 229), consumers base their price on the circumstances of the marginal buyer on the market (ibid.: 244). The rich buyer pays after the measuring-rod of the poor buyer (ibid.: 245, 289). Schönfeld-Illy’s view about the dynamic, expected demand price is analogous to Kirzner’s alertness and related price concept. Kirzner endorses Mises’s thesis that ‘there is nothing automatic or mechanical in the operation of the market’ (Mises 1966: 335). ‘The idea of a price that does not reflect and express entrepreneurial judgment and hunch is virtually a contradiction in terms’ (Kirzner 1988: 6). The dynamic, expected demand price has not only internal aspects for the economic calculations of the consumer, but also external aspects of interest to the market as a whole. On the market level the expected price solves the problem of the so-called economic determination circle: the mutual, reciprocal dependence of the variables in the functional equilibrium theories (Preisveränderungstheorie). The circular reasoning occurs because on the one hand market prices follow from the value estimations of the economic subjects, but on the other hand these value estimations presuppose the existence of given prices. The utility of a good depends on the amount of other goods one consumes. The consumption of these goods in its turn depends on the prices of these goods (Schönfeld-Illy 1948: 184). In other words, in the special theory about consumer behaviour prices are given; in the general price theory (of which the special theory forms a part) the prices are the unknowns of the system (ibid.: 187). This Gordian knot is due to a confusion between the expected and the actual price (ibid.: 214). The market is a causal-genetic process (Preisbildungstheorie). On the bases of actual prices, producers and consumers are calculating with dynamic, expected prices ibid.: 215, 229, 245). To start with a world without prices is completely unreal. ‘The aim, which is actually realized only later, is placed in the form of its subjective expectation causally in the economic thinking and action of the actor’ (ibid.: 213). Both parties learn from their market experiences (for example, the good cannot be bought by the consumer at the expected price; the producer cannot sell all the goods that he or she wants to sell) and revise their conduct (ibid.: 222). This leads to a process in time that is similar to ‘the modern Austrian view of the market as a competitive-entrepreneurial process of discovery’ (Kirzner 1988: 1). To conclude, the dynamic, expected demand price of the consumer gets around two consumer calculation problems: (1) the multiplicity of all the necessary calculations, and (2) the impossibility of stating all the

64 Auke R. Leen necessary utilities. These are problems situated within a given ends relationship (in a certain sense). This dynamic, expected demand price is the result of entrepreneurship: the process of conceiving the ends–means relationship. The consumer is alert towards monetary profits and utility gains.

The Austrian perspective on consumer policy Consumer policy Opposition towards a free market for consumer goods is manifold. It ranges from radical critics of capitalism to people who though in general appreciate the role of the market system in the efficient allocation of resources, because of chronic market failures admit the necessity of government intervention. It has been said that the theory of market failure is ‘now more suitable as a story line for texts in the history of economic thought than for texts in economic theory’ (Wagner 1991: 295). Yet consumer policy seems to be one of the strongholds of the theory of market failure. Hardly any measures to protect consumers’ interests are ever revoked. Rather, new justifications for consumer policy are given. Of course the critics know that government regulation produces its own undesirable distortions in market outcomes. Therefore, it is a necessary but not a sufficient condition for intervention when one of the conditions fails for the (Pareto) optimal operation of a competitive market as described in the static neoclassical equilibrium model. To show sufficiency, one has to make an assessment of the costs and benefits of government intervention in each particular case. Next to the already stated undesirable distortions in market outcomes, it is another well-known drawback of consumer policy that it is often undertaken to further the well-being of special interests instead of the interest of the public at large. William Stanley Jevons said that ‘the great lesson which we can learn, and it is an impressive one, is that legislation with regard to labour [in which Jevons included laws to protect the consumer] has always been class-legislation’ (1882: 33–34). The so-called sumptuary laws in the Middle Ages, which defined what to wear and to eat, ‘were mere class laws, intended to support the pride of an aristocracy by restraining the tastes of the lower class’ (ibid.: 40). More recently, Tibor Scitovsky suggested more or less the opposite for modern capitalism: In the modern economy, therefore, wherever economies of scale lead to important reductions in cost, plutocracy [each consumer’s influence on what gets produced depends on how much he or she spends] is combined with mob rule: the crowd’s ability to get those things on whose desirability its members agree. (1976: 9)

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And if it is not unequivocally the aristocracy or the lower classes that fix consumer policy, then, as Beat Bürgenmeier concludes for the Swiss consumer protection laws, there is always the possibility that ‘[t]his codification will reflect more closely the relative strength of different political pressure groups than considerations based on economic theory’ (1985: 45). But what are, quite apart from such already well-known difficulties, the harmful effects, according to the Austrians, of government intervention on the entrepreneurial processes of producers and consumers? For the most basic of the market’s virtues in the Austrian vision is the ability of the spontaneous discovery process of the market to generate equilibrating tendencies. Ever since the early beginnings of economic science the welfare of the consumer has taken a central position. Economic processes start and end with consumers. Consumption is, according to Adam Smith, the sole end of all production. The interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer. Policies to strengthen the functioning of the market, however, concern the consumer only indirectly or, if directly, on an ad hoc, temporary basis. We may think of price policies (e.g. rationing devices in situations of extreme scarcity) or the prescription of certain product qualities in the case of dangerous products (e.g. food quality). From the 1960s onwards, however, the aim of consumer policy has been a systematic and direct improvement of the position of the consumer on the market. The traditional motivation for consumer policy goes as follows. First, consumer sovereignty is absent in present-day society. The will of the consumers is no longer fundamental for production decisions. Second, in choosing, consumers are confronted with a highly complicated, untransparent market. The consumer faces a situation of information shortage as well as one of information overload (Imkamp 1986: 235; cf. Thorelli and Thorelli 1977: 23). I take a closer look at both reasons. The first reason goes along the following lines. Full sovereignty of the consumer implies a complete servitude of the producer to the consumer. The consumer ‘king’, however, is capricious and unpredictable in his consumer behaviour. To secure their capital investments, producers try to plan production and distribution. Through all kinds of sales effort the producer tries to secure its existence. Consumers feel their impotence. They feel themselves played upon by the producer. Consumer sovereignty becomes an empty word. The second reason emphasizes that consumers also feel a certain discomfort in choosing from all the available, constantly growing and changing products and services. Present-day consumers are confronted with a rich but, because of its magnitude and variation, untransparent assortment of goods. Product information is mainly given by the producers and is, consequently, one-sided. In choosing, the consumer is stifled by

66 Auke R. Leen information dependence. The market for consumer goods is highly untransparent. Consumer policy tries to answer these feelings of impotence and discomfort. The first reason, lack of consumer sovereignty, gives rise to a top to bottom motivation of consumer policy. Aims are deduced from certain basic values or needs of the consumer (Kuhlmann 1990: 60). Consumer policy becomes the protection of individual rights in the economic context. Deriving from President Kennedy’s presidential address of 1962, these rights are (1) the right to safety; (2) the right to be informed; (3) the right to choose; and (4) the right to be heard. The implementation of the rights must restore the equality in the producer–consumer relationship. The second reason, consumer feelings of discomfort, gives rise to a bottom to top motivation of consumer policy. Inductive methods show consumer complaints; in aggregated form they build up the aims of consumer policy. The purpose of the inductively formed aims is, for example, to restore the market transparency of the consumers. Consumer policy tries to ensure that all consumers obtain what they would really want, were they fully informed, subject to the limitation of their income (Maynes 1979: 97). What measures are proposed to strengthen the position of the consumer on the market? Some are primarily aimed at changing the behaviour of the producers, others at changing the behaviour of the consumers. In both fields they try to protect or inform the consumers. The overall aim is to ensure that no unreasonable physical and economic risks fall on the consumer. For physical safety, protection means bans on certain dangerous products and, for other, less dangerous products, technical standards specifying acceptable safety standards. For economic safety, protection means, for example, regulation of the information content of advertising, and one-sided producer-formulated standard contracts are regulated. Furthermore, there are subsidies for comparative testing, mandatory informative labelling, and quality certification (Thorelli and Thorelli 1974: 2), all aimed at better consumer information. The measures try to increase the market transparency for the consumer. From an Austrian perspective the common denominator of all the measures is that the ends–means relationship is supposed to be already known to consumers and government officials. The essence of consumer policy is, first, to increase the efficiency of the known (household) production process, and second, in cases of conflict between certain ends, from an individual or social perspective, consumer policy also tries to influence the ends of the consumer household. But given a socially accepted hierarchy of ends, these latter policies are in a certain sense also only trying to ensure the efficiency of the household production process (Kuhlmann 1990: 5–6). The government claims to know which products are unequivocably

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dangerous and ought to be banned and what the minimally acceptable safety standards are. The government also claims to know the standard price, standard quality, standard contract terms, the relevant product characteristics in comparative testing, and the relevant product characteristics for the product labels. To sum up, consumer policy tries to reduce the known transaction costs of a consumer transaction in terms of physical risk, economic risk and search costs. The theoretical motivation behind consumer policy is taken from the neoclassical market model. The consumer is a maximizer: action follows from an optimal choice in a given and known ends–means relationship which includes situations of measurable uncertainty that can be reduced with search. Because, in reality, the consumer is confronted with an information gap as well as, just the opposite, an information overload, the essence of consumer policy is to direct or restrict the choices of the consumers. Prices per standard quantity and comparative testing, for instance, increase the market transparency for the consumer and direct consumers’ choices. Laws putting limits on interests rates or prescribing standard rules, on the other hand, restrict the choices of consumers. Consumer policy and the competitive-entrepreneurial market process For Austrians, however, the consumer and producer are more than mere calculators: they are venturing, innovating, exploring, and searching for new means and new ends. Contrary to the neoclassical market model, consumer problems are not to be attributed to inadequate resources or to a faulty institutional structure. There is also the possibility of sheer error: opportunities costlessly available are overlooked. The question becomes, what is the impact of consumer policy upon the perception by consumers and producers of the available array of opportunities? Consumer policy ‘may affect what it is that decision makers discover to be the situation in which they act’ (Kirzner 1985: 94). These consequences are to be taken account of, in terms of costs, in each assessment of the likely consequences of consumer policy (cf. Kirzner 1985: 137). A consumer problem by itself does not necessarily point to the necessity of government intervention. The market is a discovery process: genuine inefficiencies can be relied upon in the future to generate market processes for their own correction. But inefficiencies are not solved the very instant they emerge. The systematic tendency for imperfect knowledge to be spontaneously improved upon is not an instantaneous one. In Austrian economics, time is not the problem but part of the solution. What are, for instance, the market responses in the case of consumer services to the noted information asymmetry between producers and consumers? Of course sellers, as specialized producers, know more about their services than buyers who are not specialists possibly can. Also, sellers, by knowing more about the quality of their service than consumers, are

68 Auke R. Leen able to manipulate consumers. This led Akerlof to his prediction that in equilibrium, only ‘lemons’ will be offered for sale (Akerlof 1970: 490). Governments’ answer to this problem often takes the form of occupational licences or governmental organizations of certification to protect the public health or safety. But there are also many free-market responses to this alleged market failure. Producers supply guarantees, private information services, producer-provided quality screening services, and all forms of non-governmental organization of certification. Besides, there are many information surrogates that keep consumers adequately informed – for instance, by repeatedly purchasing certain services, by drawing on the experience of friends, relatives and neighbours, or by inferences drawn from the length of life of firms offering services. In conclusion: (1) ‘if consumers are able to check the veracity of suppliers in any manner, laissez-faire market equilibrium can support [contrary to Akerlof’s assertion] high quality’ (Young 1987: 18); and (2) consumers who prefer lower-priced, lower-quality service will be worse off with licensing, because such suppliers will not be permitted to practise, and in this way the poor subsidize the lower information search costs of the rich (ibid.: 21). It is significant to notice that even in an untransparent market, such as the market for heroin, institutions arise that lower the transaction costs of both producer and consumer. Producer and consumer both face high transaction costs. For consumers there are high search costs and high costs in the form of uncertainty over the quality of the goods, and in cases of fraud there is no law to protect them. If caught, a producer faces high costs in terms of imprisonment. In this disequilibrium case it is to be expected that some entrepreneurial people will try to make some profit as middlemen. They try to reduce the high costs for both producer and consumer in offering information that the consumer of heroin needs and the heroin supplier likes to be spread (Kunz 1985: 93–103). The middleman separates the market of heroin supply from that of heroin selling. He creates an information market that lowers the transaction (selling) costs of the supplier in the form of imprisonment costs. The middleman himself does not face these costs. At the same time, he lowers the search costs for the consumer. Both supplier and consumer value the middleman, because for both the transaction costs are lowered. Both have an interest, too, in maintaining such an information market. The question can be asked: How do government officials know what prices to set or qualities to require? Given the absence of the pure profit incentive, market opportunities that present themselves in the form of potential profit opportunities are not likely to be discovered by the regulators. It is doubtful in the extreme if ideals such as benevolence or patriotism can be relied upon, in general, to enable a potential discoverer

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to identify his own personal interest with that of the discovery of an opportunity for a reallocation of resources desirable for society. (Kirzner 1985: 33) The discovery process of the market cannot be simulated by regulatory activity. Because in consumption consumers always capture the profit themselves, at first sight it looks as though for consumers their alertness is stimulated irrespective of the market form. The relevant information will always be of benefit to the potential discoverer. In a regulated market, however, things are a bit more complicated. Regulators and consumers in a regulated economy are focusing on the efficiency of the household production process for which traditional incentives, such as lowering the search costs, are of help. Consumers in a non-regulated economy, however, are next to the efficiency of the transformation process and alert to the discovery of genuine errors: they expect the unexpected. Government regulation of producer decisions, however, takes possible surprises out of the open-ended surroundings of the consumer. It is to be expected that consumers in a regulated market will be less alert to new ends and means than consumers in an unregulated market are. Profit-inspired diversity in consumer goods and services stimulates consumers. Consumers’ alertness is switched on by the fact that there may be something lurking around the corner – something hopeful or something to be fearful of. Government regulation – for example, price and quality restraints – tends to bar entry by potential new competitors. A quality or price restraint does not merely block the upper reaches of a given supply curve, but also may inhibit the discovery of as yet unsuspected sources of supply. As well as the miscoordination generated by imposed prices and qualities in markets for existing goods, there is the effect that such ceilings may inhibit the discovery of as yet wholly unknown new products (Kirzner 1985: 143). To stick to my earlier example of the drugs market, think of such ‘undiscovered’ uses of marijuana as a valuable source of such products as paper, fuel, building materials, clothing, animal food and a protein source for humans. The Austrian methodological makeshift of a Misesian entrepreneurial producer and a Robbinsian non-entrepreneurial consumer, used for the elucidation of the market process, is at this point of no help and leads to wrong policy conclusions. If the methodological makeshift is not removed, then the Austrians do not have valid arguments against, for example, those forms of consumer policy that try to increase the market transparency of the consumer. For then there are no valid arguments against passing on to the consumer comparable and relevant product characteristics for the existing supply of products. Consequently, when the methodological makeshift is not removed, it is possible from an Austrian

70 Auke R. Leen perspective to make a plea for quality certification, as a form of collective (public) good (Hayek 1982, III: 44). It is also possible to defend the subsidization by the government of comparative testing by consumer organizations (Kaufmann 1985: 24). From the Austrian vision concerning the functioning of the market in general, however, these policies can only be rejected. The questions are: What are the relevant product characteristics? How have these characteristics changed over time (cf. Rothbard 1970: 43–47; O’Driscoll and Rizzo 1985: 105, 236). The consumer, too, discovers new, unexpected ends (new forms of utility) to (old) means and new means. For Scitovsky, the mass market, the mob rule, ‘pushes us toward standardization and uniformity, both of which inhibit our ability to exploit the possibilities it creates’ (1976: 11). The fact that the mass market does not stimulate the consumer has serious consequences. ‘The yearning for new things and ideas is the source of all progress, all civilization; to ignore it as a source of satisfaction is surely wrong’ (ibid.: 11). For Austrians, however, capitalism, with its fundamental principle of mass production, stimulates novelty (Mises 1966: 621). To be more specific, the functioning of the market depends on being alert to new and unexpected means and ends. The Austrian idea of the role of novelty in capitalism is in direct opposition to the one of Scitovsky. Measures taken by government officials to protect consumers are likely to open up new avenues for entrepreneurial gain. It is likely that government measures introduce a different disequilibrium situation. This new disequilibrium situation, however, will generate its own discovery process with its own wholly unexpected and even undesired final outcomes – for example, enterprising bribery and corruption of the regulators.

Conclusion From the Austrian perspective, consumer policy stifles the profit or utility incentive that converts a socially desirable opportunity (an opportunity that transcends an existing framework of perceived opportunities) into a personally gainful one. These ‘conversions’ are the steps of the discovery process through which any possible tendency towards market equilibrium must proceed. So, consumer policy ends up with just about the opposite of what it intends. For is not its ultimate aim to better the possibilities of satisfying needs by means of consumption? The Austrian understanding of the market economy provides a novel angle for a critique of the regulated consumer. Regulatory restrictions interfere with the spontaneous discovery process that the unregulated market generates. In order to give a full appreciation of the market as a competitive-entrepreneurial discovery process it was necessary to emphasize the entrepreneurial role of the consumer.

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References Abbott, L. (1955), Quality and Competition, Columbia University Press, New York. Akerlof, G.A. (1970), ‘The Market for “Lemons”: Qualitative Uncertainty and the Market Mechanism’, Quarterly Journal of Economics 84: 488–500. Alter, M. (1982), ‘Carl Menger and Homo Oeconomicus: Some Thoughts on Austrian Theory and Methodology’, Journal of Economic Issues 16 (1): 149–160. Amonn, A. (1911), Object und Grundbegriffe der theoretischen Nationalökonomie, Franz Deuticke, Vienna. Böhm-Bawerk, E. von ([1881] 1962), Rechte und Verhältnisse vom Standpunkte der volkswirtschaftlichen Güterlehre, Verlag der Wagner’schen Universitäts-Buchhandlung, Innsbruck; translated by G.D. Huncke as Whether Legal Rights and Relations Are Economic Goods, in Shorter Classics of Eugen von Böhm-Bawerk, vol. 1, Libertarian Press, South Holland, IL. Böhm-Bawerk, E. von (1884), Kapital und Kapitalzins, Gustav Fischer, Jena. Böhm-Bawerk, E. von (1886), ‘Grundzüge der Theorie des wirtschaftlichen Güterwerts’, Jahrbücher für Nationalökonomie und Statistik NS 13: 1–82. Bürgenmeier, B. (1985), ‘Consumer Protection in Switzerland: Strengthening Countervailing Power or Competition?’, Journal of Consumer Policy 8: 45–52. Ekelund, R.B. and Saurman, D.S. (1988), Advertising and the Market Process, Pacific Research Institute for Public Policy, San Francisco. Endres, A.M. (1987), ‘The Origins of Böhm-Bawerk’s “Greatest Error”: Theoretical Points of Separation from Menger’, Journal of Institutional and Theoretical Economics 143: 291–309. Hayek, F.A. (1967), Studies in Philosophy, Politics and Economics, Routledge, London. Hayek, F.A. (1982), Law, Legislation and Liberty, Routledge & Kegan Paul, London. Imkamp, H. (1986), ‘Zur Operationalisierung des individuellen Informationsdefizits von Verbrauchern’, Hauswirtschaftliche Wissenschaft 34: 232–235. Jevons, W.S. (1882), The State in Relation to Labour, Macmillan, London. Kaufmann, P.J. (1985), ‘Passing Off and Misappropriation in the Law of Unfair Competition’, PhD thesis, Utrecht. Kirzner, I.M. (1962), Market Theory and the Price System, Van Nostrand, Princeton, NJ. Kirzner, I.M. (1967), ‘Methodological Individualism, Market Equilibrium and Market Process’, Il Politico 32: 787–798. Kirzner, I.M. (1973), Competition and Entrepreneurship, University of Chicago Press, Chicago. Kirzner, I.M. (1979), Perception, Opportunity, and Profit: Studies in the Theory of Entrepreneurship, University of Chicago Press, Chicago. Kirzner, I.M. (1985), Discovery and the Capitalist Process, University of Chicago Press, Chicago. Kirzner, I.M. (1986), ‘Ludwig von Mises and Friedrich von Hayek: The modern Extension of Austrian Subjectivism’, in N. Leser (ed.) Die Wiener Schule der Nationalökonomie, Böhlau, Vienna. Kirzner, I.M. (1987), ‘Austrian Economics’, in The New Palgrave: A Dictionary of Economics, ed. J. Eatwell, M. Milgate and P. Newman, Macmillan, London. Kirzner, I.M. (1988), ‘The Economic Calculation Debate: Lessons for Austrians’, Review of Austrian Economics 2: 1–18. Kirzner, I.M. (1989), Discovery, Capitalism, and Distributive Justice, Basil Blackwell, Oxford.

72 Auke R. Leen Kuhlmann, E. (1990), Verbraucherpolitik: Grundzüge ihrer Theorie und Praxis, Franz Vahlen, Munich. Kunz, H. (1985), Marktsystem und Information, Mohr, Tübingen. Lavoie, D. (1985), Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered, Cambridge University Press, New York. Maynes, S.E. (1979), ‘Consumer Protection: The Issues’, Journal of Consumer Policy 3: 97–109. Menger, C. ([1871] 1950), Grundsätze der Volkswirtschaftslehre, Wilhelm Braumüller, Vienna; translated by J. Dingwall and B.F. Hoselitz as Principles of Economics, Free Press, Glencoe, IL. Menger, C., (1923), Grundsätze der Volkswirtschaftslehre, 2nd edn, Hölder-PichlerTempsky, Vienna. Mises, L. von ([1912] 1971), The Theory of Money and Credit, Foundation for Economic Education, Irvington-on-Hudson, NY. Mises, L. von ([1922] 1981), Socialism, Liberty Classics, Indianapolis. Mises, L. von (1940), Nationalökonomie. Theorie des Handelns und Wirtschaftens, Genf; reprinted (1980), Philosophia Verlag, Munich. Mises, L. von (1949), Human Action, Contemporary Books, Chicago. Mises, L. von ([1928] 1960), Epistemological Problems of Economics, Van Nostrand, Princeton, NJ. Mises, L. von (1962), The Ultimate Foundation of Economic Science, Van Nostrand, New York. Mises, L. von (1966), Human Action, 3rd edn, Contemporary Books, Chicago. Mises, L. von (1969), The Historical Setting of the Austrian School of Economics, Arlington House, New Rochelle, NY. O’Driscoll, G.P. and Rizzo, M.J. (1985), The Economics of Time and Ignorance, Basil Blackwell, Oxford. O’Driscoll, G.P. and Rizzo, M.J. (1986), ‘Subjectivism, Uncertainty, and Rules’, in I.M. Kirzner (ed.) Subjectivism, Intelligibility and Economic Understanding, Macmillan, London. Pasour, E.C. (1989), ‘The Efficient-Markets Hypothesis and Entrepreneurship’, Review of Austrian Economics 3: 95–107. Rosenstein-Rodan, P. ([1927] 1960), ‘Marginal Utility’, International Economic Papers no. 10. London and New York. Rothbard, M.N. (1962), Man, Economy and State, Van Nostrand, Princeton, NJ. Rothbard, M.N. (1970), Power and Market, Sheed Andrews & McMeel, Kansas. Rothbard, M.N. (1980), The Essential Ludwig von Mises, Ludwig Mises Institute, Auburn, AL. Rothbard, M.N. (1985), ‘Professor Hébert on Entrepreneurship’, Journal of Libertarian Studies 7 (2): 281–286. Rothbard, M.N. (1988), Ludwig von Mises: Scholar, Creator, Hero, Ludwig von Mises Institute, Auburn, AL. Ryle, G. (1945), ‘Knowing How and Knowing That’, Proceedings of the Aristotelian Society NS 46: 1–16. Ryle, G. (1949), The Concept of Mind, Hutchinson, London. Salerno, J.T. (1990), ‘Ludwig von Mises as a Social Rationalist’, Review of Austrian Economics 4: 26–54. Schönfeld-Illy, L. (1924), Grenznutzen und Wirtschaftsrechnung, Vienna; reprinted in 1982 with a introduction by Kurt R. Leube, Philosophia Verlag, Munich and Vienna.

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Schönfeld-Illy, L. (1948), Das Gesetz des Grenznutzes: Untersuchung über die Wirtschaftsrechnung des Konsumenten, Springer-Verlag, Vienna. Schumpeter, J.A. (1954), History of Economic Analysis, Oxford University Press, New York. Scitovsky, T. (1976), The Joyless Economy, Oxford University Press, Oxford. Smith, B. (1986), ‘Austrian Economics and Austrian Philosophy’, in W. Grassl and B. Smith (eds) Austrian Economics, Croom Helm, London. Taylor, T.C. (1980), The Fundamentals of Austrian Economics, Adam Smith Institute, London. Thorelli, H.B. and Thorelli, S.V. (1974), Consumer Information Handbook: Europe and North America, Praeger, New York. Thorelli, H.B. and Thorelli, S.V. (1977), Consumer Information Systems and Consumer Policy, Ballinger, Cambridge, MA. Wagner, R.E. (1991), Review of T. Cowen (ed.) ‘The Theory of Market Failure: A Critical Examination’, Public Choice, Jan. 295–297. Young, S.D. (1987), The Rule of Experts, Cato Institute, Washington, DC.

E

Macroeconomics and monetary economics

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Austrian cycle theory and the prospect of a coordinationist macroeconomics1 Richard E. Wagner

Introduction Someone who surveyed the literature on business cycles in the early 1930s, and who then jumped ahead just twenty years to survey the literature in the early 1950s, would surely be astonished by the stark contrast in the treatment accorded to Austrian formulations. In the 1930s, Austrian cycle theory held a prominent position in the efforts of economists to understand and explain business cycles. This can be seen readily by perusing such treatises as those of Alec Macfie (1934) and Gottfried Haberler (1964; first edition 1937). Twenty years later the standing of Austrian cycle theory had collapsed dramatically. Robert Gordon (1961; first edition 1952), for instance, gave only a couple of pages of dismissive references to Austrian cycle theory in a treatise of some 700 pages. The bulk of the contemporary textbook literature does not mention Austrian contributions at all. Most of those texts portray a menu of options for macro theory that include classical, Keynesian, monetarist, new classical, and new Keynesian, but which mention an Austrian contribution hardly at all. There are a number of possible explanations that might be advanced for the evanescence of interest in Austrian cycle theory. One possibility is that Austrian cycle theory was not readily assimilable to the growing demand for mathematical and econometric modeling that was entering economics around the same time. Another is that Austrian cycle theory clashed with the increasingly collectivist temper of the times that emerged in the 1930s and started to recede only in the 1960s. With a present recession attributed to a past inflation, an Austrian remedy of market-based liquidation had no chance against any remedy that called for yet more state-sponsored inflation. Yet a third possibility, one that I think can be dismissed readily, is that Austrian cycle theory fared quite poorly compared with other options when those various theories were assessed against the world of experience. Whatever the explanation, Austrian cycle theory did disappear from the analytical radar screen of the economics profession within a short period of time, and has yet to make any significant reappearance. At the same

78 Richard E. Wagner time, however, there has been a growing interest in a coordinationist approach to macroeconomics, an approach that differs severely from the single or representative agent approaches that have been so dominant in recent times. Austrian cycle theory is also a form of coordinationist macroeconomics, and it is plausible that a program of coordinationist macroeconomics could be advanced by some insights from a suitably renovated Austrian cycle theory. This chapter starts by presenting a stylized portrait of Austrian cycle theory at its apogee in the 1930s. The remainder of the chapter explores some of the contours of a coordinationist macroeconomics and notes some of the ways that considerations from Austrian cycle theory might advance a program of coordinationist macroeconomics. The central theme of the chapter is that the central ideas of Austrian cycle theory still have merit, but only within the framework of a coordinationist approach to macroeconomics. At the same time, however, a coordinationist macroeconomics involves much more than restatements of Austrian cycle theory circa 1935.

Austrian cycle theory: a quick review When people refer to Austrian cycle theory, they are referring primarily to an analytical framework initially articulated by Ludwig von Mises ([1912] 1934) and refined by Friedrich Hayek (1935). This Mises–Hayek theory of the business cycle was in turn erected principally upon foundations laid by Eugen von Böhm-Bawerk ([1884–1889] 1959) and Knut Wicksell ([1898] 1936). Central to Austrian cycle theory is a particular capital-theoretic formulation of the capitalist production process, where the relationship between production processes that require different amounts of time is governed by the rate of interest. Most economists characterize production as taking place instantaneously, as illustrated by a production function that describes current production as a function of the amount of inputs currently applied. This common formulation yields the conventional circular flow of income that appears in nearly all the texts these days. In sharp contrast, Böhm-Bawerk described production as possessing a time structure. Inputs that were applied today would contribute to output only sometime in the future. When in the future this might occur would depend on where in the structure of production those inputs were applied. For instance, someone who constructed a plant to freeze-dry vegetables would contribute to an increased consumption of food more quickly than would someone who constructed a laboratory to do research on plant genetics, although the laboratory might eventually contribute more to food consumption than the freeze-drying plant. An economy would be described as a river, where the volume of consumer goods that flow through the terminus depends on the amounts of water that enter from the various tributaries, and where those inflows do

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not reach the terminus without some passing of time. The rate of interest connects and renders consistent the prices of all goods within the structure of production. Böhm-Bawerk recognized that the rate of interest governed the structure of production within a society. If the rate of interest is, say, 5 percent, the structure of production will include some relative investment in plants to freeze-dry vegetables and laboratories to pursue research on plant genetics. Should that rate of interest be, say, 8 percent instead, the structure of production will entail less capital invested in laboratories and more in freezers. Wicksell subsequently distinguished two kinds of interest rate, a real rate and a loan rate. The real rate was a theoretical construct. It was the rate of interest that was consistent with equilibrium in the structure of production, as illustrated above. The loan rate was the rate of interest that was available on the market. If the loan rate diverged from the natural rate, a process of adjustment would be set in motion. This adjustment would continue until equality was restored between the two rates. For instance, suppose the loan rate were lower than the real rate. In the presence of this divergence, people would bid up the prices of capital goods and associated inputs. These increased demands would generate increases in money incomes, which in turn would lead to increased demands for consumer goods. The economic structure of production in the society would change, by becoming more roundabout in Böhm-Bawerk’s unnecessary terminology.2 It is but a short distance from the formulations of Böhm-Bawerk and Wicksell to the Austrian theory of the cycle articulated by Mises and Hayek. In its inception, Austrian cycle theory looks like a standard monetarist explanation of expansion or contraction. In both cases a monetary expansion quickens the pace of economic activity, while a monetary contraction slows it. What gives a different character to Austrian cycle theory is that the monetary disturbance affects the entire structure of production. For instance, an expansion of bank credit that drives the loan rate of interest below the real rate will upset the entire structure of price relationships within the economy. This change in the structure of price relationships will affect calculations of anticipated profitability throughout the economy, with relatively more roundabout projects becoming relatively more profitable. Both a plant to freeze-dry vegetables and a laboratory for research on plant genetics may appear more profitable after the loan rate falls below the natural rate, but the increase in profitability will be relatively stronger for the laboratory. The initial impact of an expansion in bank credit, in the canonical Austrian formulations of the 1930s, is to lengthen the structure of production. This lengthening results because the decline in the loan rate of interest affects the entire structure of price relationships within the economy, by increasing relatively more strongly the anticipated profitability of projects whose eventual contribution to consumption is further removed in time.

80 Richard E. Wagner What happens next depends on the source of the expansion in bank credit. One possible source of credit expansion is a genuine reduction in time preferences among a significant set of people within the society. This increased desire to save would enable banks to expand their offerings of credit. The structure of production within the economy would lengthen as the economy moved to a more capital-intensive structure of production, and this new structure of production could be maintained so long as there were no further changes in time preference. The alternative source of credit expansion is one that does not stem from an increase in saving. Even if there is no change in time preferences and desires to save, a central bank may pursue a program of credit expansion. The initial effect of this credit expansion is identical to the expansion that results from an increase in desires to save: the structure of production lengthens, owing to the increased relative profitability of more roundabout projects. This increased profitability, however, is not genuine, but only temporary. Time preferences are unchanged, so there has been no decreased desire for consumer goods. The lengthening in the structure of production reduces the relative supply of consumer goods. Without a decreased demand for consumer goods that would have accompanied a fall in time preferences, the prices of consumer goods will rise. This leads to revisions in entrepreneurial calculations of profitability, as the production of consumer goods now appears more attractive than it would have done had time preferences truly fallen. The structure of production thus shortens. If the original lengthening in the structure of production corresponds to the expansion phase in a business cycle, the subsequent shortening corresponds to the contraction phase. Both the initial expansion and the subsequent contraction are set in motion by the initial monetary expansion.

Austrian cycle theory: continuing verities and particularistic obsolescence Austrian cycle theory pretty much reached canonical status in the mid1930s, and subsequent expositions have been largely restatements.3 As was mentioned earlier, it had pretty much disappeared from economics by the 1950s. While there has been some resurgence of interest in Austrian economics over the past twenty years or so, that resurgence does not seem to have extended to Austrian cycle theory.4 While there are a number of explanations that might be advanced for the evanescence of Austrian cycle theory, I have no desire to pursue any effort at historical explanation here. My interest is rather to make some effort to distinguish between those aspects of Austrian cycle theory that are still valuable for macroeconomics today and those that are not. Perhaps the two places where obsolescence most strongly dates the canonical formulations of Austrian cycle theory are the treatment of

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expectations and the process through which credit expansion generates economic expansion. As for expectations, even Wicksell wondered about the impact of expectations on the cumulative process. In these days of continual, large-scale financial observation and reporting, expectations must be incorporated into any theoretical enterprise. If the fate of an entrepreneurial undertaking were to depend on making an accurate distinction between credit creation by a central bank and an increase in saving, it would surely be unreasonable to use a theoretical construction that ignored that distinction. If one element of rationality in expectation involves an effort to distinguish between the two different processes of credit expansion, people would treat the lower interest rate due to credit expansion as transitory, and would treat as permanent only the lower interest rate due to increased saving. Austrian cycle theory must incorporate some requirement of rationality in expectation, in conjunction with a recognition that aggregate data are widely and readily reported. For a profession whose members almost universally embrace a belief in rationality, it is difficult to do anything but embrace rational expectations. To be sure, there is quite a bit of experimental work on such things as preference reversals that might seem to challenge rationality, but theories are rarely abandoned simply because of contrary evidence. What is the alternative to rational expectations? It certainly cannot be adaptive expectations. Indeed, adaptive expectations violates thoroughly the entire corpus of Austrian scholarship. More than any other set of economists, Austrians have stressed the forward-looking character of economic action. It is this feature that makes entrepreneurship so central to Austrian economics. It is in acts of entrepreneurship that the future is made. The Lange–Lerner scheme of socialist planning illustrated a version of adaptive expectations, in that it looked backward to what was already known and in existence. There is no way that such a planner could announce prices for what had not yet come into existence. The other source of particularistic obsolescence for the canonical version of Austrian cycle theory is the portrayal of how a credit expansion generates a general lengthening of the structure of production. Even setting aside questions of expectation and their formation, the canonical story of credit expansion leading to increased roundaboutness is highly particular and neither general nor necessary. In the presence of the small governments and institutional arrangements that existed in the early part of the twentieth century, the canonical Austrian formulation had great plausibility. At that time, currency was freely convertible into gold, governments were small, and credit transactions and markets operated and were organized almost wholly within the sphere of private ordering. The world is now ruled by wholly fiat standards. Governments are gigantic. Public ordering is ubiquitous. These modern developments have opened many channels for credit to operate besides the purely private calculus of commercial profitability that was incorporated into the canonical Austrian

82 Richard E. Wagner formulation. To mention just two plausible instances, credit expansion might take the form of booms in real estate markets or securities markets, as against a general lengthening in the structure of production.5 What is of continuing value in Austrian cycle theory is its foundational orientation toward a coordinationist style of macroeconomics. In sharp contrast, conventional macroeconomics is choice-theoretic and not coordinationist. Macro variables are treated as direct objects of choice, whereas within a coordinationist perspective macro variables are simply phenomena that emerge through interaction among people, but which are not chosen directly by anyone. Central to the entire corpus of Austrian economics is the claim that macro variables are not direct objects of choice but are built up through the interactions among participants within the economic process. In recent years there has been a growing interest in bringing issues of coordination back into macroeconomics. Much of this has doubtlessly been spurred by a slowly growing recognition of the inadequacies of macro modeling based on single agents or representative individuals.6 This growing interest in restoring coordination to a place of prominence in macroeconomic theory surely provides an opportunity for a redeployment of Austrian insights. However, such redeployment would have to involve more than restatement. We are a long way removed from the 1930s, and in a way that would lend a good deal of obsolescence to any effort at restatement, as I have already noted. Moreover, Austrian cycle theory is actually a blend of two distinct conceptual frameworks that clash with each other. One is the coordinationist framework, where aggregate economic patterns are emergent phenomena. The task of economic analysis within this framework is to explain how orderly patterns of economic activity emerge out of interactions among people. This framework of emergent order is truly central to the Austrian orientation toward the economic process. It was conveyed, however, with the use of a contradictory framework of postulated order.7 In this alternative framework, order is not an emergent tendency or property, but rather is a postulate to which the theoretical exercise must conform. This framework of postulated general equilibrium renders impotent any formulation that treats aggregate variables as emergent phenomena and not direct objects of choice. The challenge for Austrian cycle theory is the same as that for coordinationist macroeconomics generally, which is to explain macro phenomena as emergent features of interaction and not as direct objects of choice. The canonical Austrian formulation of a lengthening in the structure of production is simply one particular way of locating coordination and emergence at the core of the macro enterprise. There may be numerous ways that a credit expansion influences macro phenomena, depending on historical and institutional details. In all such instances, however, the Austrian orientation holds that the course of macro variables is to be

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built up out of interactions among those who participate within the economic process.

Reason, expectation, and coordination How might elementary requirements of rationality in the formation of expectations operate within the purview of an Austrian-type orientation toward a coordinationist approach to macro phenomena? The use of the faculty of reason to form expectations would surely have to occupy a prominent position in any analytical effort. That expectations are products of reason and imagination is surely noncontroversial at the level of general principle. It is a different matter, however, when it comes to particular methods for implementing that principle. Consider, for instance, the simple expectation-augmented Phillips relationship Yt  Y¯  (t  et) (where   0) that dominates contemporary macro formulations. In this expression, Yt is actual growth in output during period t and Y¯ is the natural rate of growth in the economy. The remainder of the equation shows that deviations of the actual from the natural rate of growth depend on the direction and size of the deviation of actual from expected inflation. Save for deviations of actual from expected inflation, the rate of growth would be steady at its natural rate. Variability in growth rates through time thus depends on inaccuracies in forecasting inflation. Indeed, forecast inflation is the only variable of relevance for the explanation of why macro variables do not follow some steady-state path. A de-trended flat line is the norm, with variability due either to exogenous shocks to the natural rate of growth or to error in forecasted inflation. Nowhere in this formulation is there any room for macro variability to result from processes of interaction among people. There is simply no room for coordination to proceed with some variable degree of smoothness that, in turn, influences observed macro outcomes. Yet growth is surely an emergent property of an economic system, and it is hardly sensible to treat it as a exogenous shock to that system. Further, the only object of future interest to market participants is a forecast of future inflation. Yet entrepreneurs who made their choices based only on information about probable inflation would be acting foolishly in the extreme. In most instances a rate of inflation has but limited relevance for economic conduct. It might be of strong concern to bond traders and other dealers in financial paper, but these activities comprise only a small part of the universe of economic activities. For most entrepreneurial activities a forecast about some average level of future prices is surely of secondary importance. Of much greater importance would be forecasts that pertain to the particular markets in which the entrepreneur is engaged.

84 Richard E. Wagner There would be different particular objects of expectation, depending on the particular activity about which expectations are being formed. If the course of the economy is built up out of dispersed individual decisions, and with a rate of inflation rarely being a consideration in those decisions, how do expectations about inflation come to command such interest in the macro literature? It comes back to the presumption of postulated order. It may be granted that people form expectations over particular variables that are of particular interest in light of their commercial niches. So long as a consistent array of general equilibrium prices is assumed to exist, individual expectations must be consistent with one another, and with all being consistent with some aggregate price level. The postulated order framework thus presumes a consistency and sustainability among plans and prices that makes it plausible to resort to aggregate measures in place of individually relevant variables. From a framework of postulated order, Austrian cycle theory would seem to violate elementary requirements of rationality in expectation, because it seems to presume that people cannot distinguish changes in saving from changes in central bank holdings of government debt. A framework of postulated order neuters the economic significance of any distinction between ex ante and ex post, by relegating the distinction to a simple error term. Within a framework of emergent order, by contrast, the distinction between people’s ex ante beliefs or expectations and the ex post observations that are revealed as the economic process proceeds is central to many features of the economic process, as is a dissimilarity and divergence among expectations. An economy will be characterized by a plethora of objects of expectation. It would not possess some common object of expectation. What is the appropriate conceptualization of the macroeconomy? One thing I would say about a good macro theory is that it should be consistent and conformable with the central features of the microeconomy. At first glance, this might seem simply to represent a show of support for the literature on micro foundations.8 At the level of principle this is correct, but it is not correct with respect to actual practice. I make this distinction between principle and practice out of recognition that there are two different ways that a principle of micro foundations can be put into practice. The existing literature seeks to postulate choice-theoretic foundations for macroeconomics. The maximization of utility by Robinson Crusoe is the paradigmatic model that guides the search for micro foundations. Macro phenomena are simply micro phenomena spoken of more loudly. For instance, individual firms are thought of as moving along supply and marginal product schedules, and it is the same for the aggregate economy. The alternative to a choice-theoretic foundation for macroeconomics is a coordinationist foundation.9 While a choice-theoretic foundation might be workable for a small reclusive tribe here or there, for modern complex societies only exchange and its various extensions can provide a suitable

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framework for approaching microfoundations. Only in this way can there be an order of movement from simple to complex that corresponds with the distinction between micro and macro. The economy is a dense network of transactions that no one can control or apprehend in its entirety in any great detail. Central planning is impossible, though participants can achieve a generally coordinated pattern of activity with the help of various institutions and conventions that they develop. If macroeconomics rested on adequate micro foundations, it would involve analytical constructs that were consistent with spontaneous order and related notions. To hold that the microeconomy is created through the development of networks of transactions and then to treat the macroeconomy in simple choice-theoretic terms is clearly a backwards movement, from more to less complex phenomena. The standard variables of macroeconomics – rates of growth, levels of employment, and rates of inflation – are not objects of choice for anyone, but rather are emergent outcomes of complex economic processes. Governments may do things that might influence the subsequent measures that are assigned to those variables, but this is a very different thing from choosing values for those variables. Macro and micro would thus both be concerned centrally with the coordination of economic activities, and within an analytical framework where economic outcomes are not objects of policy choice, but emerge through interactions among participants within the economic process. False trading wreaks havoc with the calm facade of postulated order. Yet it is surely a ubiquitous feature of reality that could never be excluded from a framework of emergent order. The distinction between postulated order and emergent order, along with its relevance for macro theory, can be illustrated by comparing the movement of troops on a military parade ground with the movement of people leaving a stadium after an athletic event. The postulated order framework is suitable to explain the movement of troops, for the march has been coordinated in advance. There is no scope for any endogenous source of surprise. Any surprise must be exogenous to the march. A tank might throw a track. A horse might throw its rider. A soldier might faint or die. Observed discoordination can only be exogenous to the coordinator’s intentions and plans. It is wholly different for the spectators leaving an athletic event. The order that results in this case emerges through some process of spontaneous ordering. There is no informative value in stating that the exodus proceeds “as if” it were organized by a coordinator. To do this is simply to clothe ignorance with a fictional garment. There is no coordinator, and the order that results must be explained by other means. Some of these surely involve such conventions as walking on the right, along with some elementary principles of courtesy. Traffic lights and police barricades also help the exodus. These rules and institutions provide a framework that allows a generally orderly exodus to be generated on the spot. Among

86 Richard E. Wagner other things, this exodus will generate some volume of false trades as an endogenous part of the process. In some cases there will be sufficient pushing and shoving to cause some people to be injured and require first aid, thereby causing them to be late in arriving at their next appointment. Capital gains and losses are endogenous and anticipatable elements of the emergent order. Suppose a central bank increases its holding of government debt. It is, of course, a strong empirical regularity that increases in money growth are accompanied by increases in real output in the short run. There are several ways to account for this regularity within the postulated-order context of an expectations-augmented Phillips curve. These mostly involve informational asymmetries and price rigidities of some type. For instance, it might be claimed that entrepreneurs initially interpret price increases incorrectly as signifying increased demands for their particular products. To maintain a crisp focus on the distinction between postulated and emergent order as it pertains to macro theory, however, I will assume that price rigidities are absent and that there is full knowledge of the monetary expansion. Within the framework of postulated order there has been no change in real variables, and the monetary expansion will have no effect on the real economy. In standard macro terms the situation just described is one of a vertical Phillips curve, in the short run as well as in the long run. The postulated increase in central bank holdings of government debt presents no opportunities for a profitable credit expansion because nothing has changed in real terms, in the aggregate. In this instance the credit expansion will inject no errors into the economy, entrepreneurial or otherwise. The same result does not follow, however, from a framework of emergent order. For a theory of emergent order, it is not sufficient to compare presumed equilibrium conditions before and after the credit expansion, declare them to be identical, and to conclude from this that the credit expansion had no macro effect. Macro variables are built up or emerge out of interactions among people, and from the perspective of postulated order it is necessary to ask whether a credit expansion, even under the austere conditions postulated above, might lead to changes in the conduct of individual entrepreneurs. If so, macro consequences can arise in the aggregate. A credit expansion will take place if lenders and potential borrowers recognize opportunities for profitable trade, even if there are no such opportunities in the aggregate. Consider a simple illustration of a model economy where each of 100 lenders has initially extended 100 units of credit. Suppose the central bank’s increased holdings of government debt expand potential aggregate lending ability by 10 percent. Under the aforementioned situation of postulated order, no opportunities for profitable lending would exist. In this situation the lenders would put their increased reserves into such things as treasury bills. There would be no

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change in the aggregate volume of loans. This, however, is to derive aggregate outcomes in terms of postulated equilibrium values, and not to derive them through aggregation from market interaction. There would seem to be a number of avenues by which the central bank purchase of government debt might exert aggregate effects even under the postulated conditions. What matters most of all is whether there are individual contractual opportunities that appear profitable in light of the loosened reserve position of banks. A claim that there are no profit opportunities in the aggregate is irrelevant. The aggregate conditions do not determine the content of individual acts of exchange, for those aggregate conditions are rather the reflections of those individual exchanges. A claim that in the aggregate lenders cannot increase their volume of profitable loans does not mean that no loans will be made. To be sure, this claim involves a presumption of possessing knowledge that is available to no one. But even if that claim is granted purely for the sake of pursuing the argument, the aggregate condition does not guarantee that no new loans will be made. Even if we might grant that the ex post volume of profitable loans might be unchanged, it does not follow that the ex ante plans will start from that resting point. This situation is sensible only in terms of a framework of postulated order, where the economy is presumed to move down unchanging marginal productivity schedules. The most profitable credit contracts are executed first, and the resulting equilibrium pattern of contracts is not changed by the central bank’s increased holdings of government debt. This proposition from comparative statics is, however, a proposition of the logic of postulated relations, and is not adequate for an examination of emergent order where history moves sequentially and unidirectionally. There is plenty of reason to think that ex ante commercial judgments among commercial participants will lead to some credit expansion. Credit contracts are created in a historical sequence, and all of them are thought by the participants to be ex ante profitable. At any subsequent moment, however, some of those contracts will remain profitable while others will seem inferior to new possibilities. In this situation a credit expansion will allow lenders to exploit new credit opportunities.10 Moreover, a claim that on average new profit opportunities do not exist does not bring the matter to a close. Few participants in any field of endeavor think of themselves as merely average. The mere making of a claim that there is no change in the total volume of loans that will be profitable does not imply that all lenders will refrain from seeking new business. There is no external selection procedure that selects and matches opportunities with lenders. Rather, the selection and matching occurs through an openly competitive process in which most competitors think of themselves as above average. In this situation it is surely plausible that some aggregation of ex ante commercial calculations will both lead to an

88 Richard E. Wagner expansion in the volume of loans and bring about a situation that will prove incompatible with the ex post observations that will eventually materialize. To make this latter statement is simply to assert that capital gains and losses are an endogenous part of the economic process, and are not exogenous shocks to some otherwise pre-coordinated process.

Two types of cycles and the problem of policy Traditional Austrian cycle theory treats cycles as undesirable deviations from normally stable conditions. The blame for this instability is generally placed on fractional reserve banking, particularly as supported by central banking, and with central banks often acting to support governmental fiscal policies. The remedies that have appeared in the Austrian literature seek to address these sources of instability in one fashion or another. Currency competition and free banking are at the forefront of most Austrian proposals for a program for economic stability.11 Other suggestions can be found in the Austrian literature as well, and there is also some controversy about whether fractional reserve banking should be permitted or should be replaced with a requirement of 100 percent reserves. It is not my interest here either to support or to dispute Austrian claims about central banking and economic disruption. Rather, what I want to do in closing is to point to some difficulties in the conventional use of aggregate economic variables to judge economic performance. I would like to do this by advancing two claims: (1) variability in economic time series is not a necessarily sign of poor economic performance; and (2) constancy in economic time series is not necessarily a sign of good economic performance. The original point of departure for Austrian cycle theory was a postulated state of general equilibrium. The normal economy was a flat-line economy, at least after the incorporation of seasonal adjustments. Within this analytical framework, observed variability was a sign of economic miscoordination. The booms and busts characterized by Austrian cycle theory describe an inferior state of affairs relative to the postulated flat-line economy of general equilibrium. By contrast, within a framework of emergent order, variability in observed time series can also be a sign of progress in an interdependent world with capital complementarity. There would thus be two types of cycles, one that was consistent with the orderly coordination of economic activities in a complex environment and another that emanated from disruptions to the processes of orderly coordination. The second claim means that the mere observation of stability in aggregate variables does not mean that coordinative processes are working as well as they might. Consider a simple micro-level illustration of the point I have in mind. An artist who makes pen-and-ink sketches can make 100 pieces ready for sale by working full time, if everything goes well.

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Suppose a time comes when not everything goes well. While making the frames and mounting the sketches, some of the frames fracture, causing her to divert time from sketching to making more frames. During this period she is able to produce only 80 finished sketches. We would not, however, say she experienced an unemployment rate of 20 percent, even though her output of finished product would show such a drop. Rather, we would say that her pattern of output shifted, as she made more frames than in previous periods. Suppose we analogize the artist’s situation to standard macro formulations of shocks to the economy. The first instance is one of full employment equilibrium. In the second instance her studio is hit with negative shocks that she had not anticipated. Yet full employment continues to exist, only with a different pattern of activities in the face of disruptions than when those disruptions are absent. At the macro level this second situation would be characterized as involving miscoordination, at least as regarded from a posture of omniscience. A rise in the volume of miscoordination means that there will be some shift of human activity away from executing original plans into activities that revise or reorient plans that have proven unsatisfactory.12 An economy can be represented by a network of human activity, some of which is engaged in executing original plans and some of which is engaged in rectifying plans judged to have been unsatisfactory. This distinction between types of activity is, of course, an analytical and not an empirical distinction. There is no way, at least so far as I know, that a census could be taken to determine how many people are employed in executing plans and how many are employed in revising plans that have been judged unsuccessful. Yet this analytical distinction follows from the claim that the degree of coordination is a variable that can be influenced, for good or for bad, depending on a variety of institutional arrangements and policy measures. An increase in the volume of miscoordination in a society will shift the pattern of activity in a society, but it need not alter the total volume of activity. In traditional Austrian cycle theory, micro disruption in the pattern of prices leads to boom followed by bust. Both the boom and the bust result from the reactions of market participants to nonsustainable price signals. There is no need to consider rationality in anticipations again at this point. Still, it does not follow that nonsustainable price signals must show up as variations in aggregate series through time. It is conceivable that miscoordination could increase without any impact on aggregate time series. Miscoordination induces revisions in plans. Labor is shifted from the execution of plans to the revision of plans. It is conceivable that this shift of labor can be accommodated within an unchanged aggregate volume of employment. Using normative language, cyclical variability may be either good or bad. It depends on the source of the cyclicity. In like manner the absence

90 Richard E. Wagner of cyclical variability can be either a good thing or a bad thing. It depends on the degree of coordination that is present. A benevolent policy maker would seem to face an insoluble problem of knowledge. It would be necessary to be able to distinguish good cycles from bad, a task rendered even more difficult by a recognition that both features may be present at the same moment. It would also be necessary to know when aggregate stability is a sign of a smooth coordination of plans and when it rather means merely a unitary elasticity of movement between the execution of plans and the revision or reassembly of plans. The active promotion of stability in aggregate time series is neither per se desirable nor is it possible. Aggregate outcomes are emergent outcomes and not direct objects of choice. There is no sense to a policy aimed to prevent cycles, any more than it would be sensible to prevent traffic delays. What is sensible is to seek to preclude unnecessary cycles or disturbances to the coordination of economic activity. Policy for a coordinationist macroeconomics would be of the same genre as policy generally, and would be concerned with providing and maintaining a framework within which people can order their activities. The pursuit of a truly activist stabilization policy will be both impossible and mischievous. Appropriate macro policy cannot aim to achieve particular values for macro variables, for these variables are not objects of choice. Appropriate macro policy is indistinct from appropriate micro policy, and both involve the creation and maintenance of a constitutive framework within which people can generate orderly patterns of economic activity.

Notes 1 An earlier version of this chapter was presented as a paper given at a workshop on “New Perspectives on Austrian Economics,” held at the Max Planck Institute in Jena, 7–8 August 1998. I am particularly grateful to Nicolai Foss, Sylvie Geisendorf, Ulrich Witt, and Michael Wohlgemuth for their comments and suggestions at that time. A revised version of that paper was published as Wagner (1999), and this chapter addresses similar themes in a somewhat different manner. 2 It is possible to argue that the period of production has some useful heuristic properties even if it must also be acknowledged that there is no way of developing a coherent measure of the period of production. 3 See, for instance, Gerald O’Driscoll (1977) and Roger Garrison (1989, 1991). 4 For sharply contrasting assessments of that resurgence, compare Nicolai Foss (1995) and Karen Vaughn (1994). 5 For an effort to reconcile some of the Austrian insights with real estate booms, see Fred Foldvary (1997). 6 For a splendid, pithy examination of the dead ends to which a non-coordinationist macroeconomics leads, see Alan Kirman (1992). 7 This point is developed crisply by Ulrich Witt (1997). 8 For a lucid and penetrating survey of this literature, see Maarten Janssen (1993). 9 See, for instance, Axel Leijonhufvud (1981) and John Bryant (1994).

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10 To be sure, the emergence of secondary markets, whereby an original lender sells a note to someone else, operates in a somewhat similar manner. Indeed, the emergence of such secondary market arrangements is itself an endogenous market phenomenon that is best treated in light of a theory of spontaneous order applied to institutional development, a nice survey of which is presented by Thráinn Eggertsson (1990). 11 See, for instance, F.A. Hayek (1976), George Selgin (1988), and Lawrence White (1989). 12 Such miscoordination can be categorized as wasteful, as explained by W.H. Hutt (1943).

References Böhm-Bawerk, Eugen von ([1884–1889] 1959), Capital and Interest, 3 vols., Libertarian Press, South Holland, IL. Bryant, John (1994), “Coordination Theory, the Stag Hunt, and Macroeconomics,” in J.W. Friedman (ed.) Problems of Coordination in Economic Theory, Kluwer Academic Publishers, Boston, pp. 207–225. Eggertsson, Thráinn (1990), Economic Behavior and Institutions, Cambridge University Press, Cambridge. Foldvary, Fred (1997), “The Business Cycle: A Georgist–Austrian Synthesis,” American Journal of Economics and Sociology 56: 521–541. Foss, Nicolai (1995), The Austrian School and Modern Economics, Munksgaard, Copenhagen. Garrison, Roger W. (1989), “The Austrian Theory of the Business Cycle in Light of Modern Macroeconomics,” Review of Austrian Economics 3: 3–29. Garrison, Roger W. (1991), “New Classical and Old Austrian Economics: Equilibrium Business Cycle Theory in Perspective,” Review of Austrian Economics 5: 91–103. Gordon, Robert Aaron (1961), Business Fluctuations, 2nd edn, Harper & Row, New York. Haberler, Gottfried (1964), Prosperity and Depression, 5th edn, Allen & Unwin, London. Hayek, Friedrich A. (1935), Prices and Production, 2nd edn, Routledge & Kegan Paul, London. Hayek, Friedrich A. (1976), Denationalisation of Money, Institute of Economic Affairs, London. Hutt, William H. (1943), “The Concept of Waste,” South African Journal of Economics 11: 1–10. Janssen, Maarten C.W. (1993), Microfoundations: A Critical Inquiry, Routledge, London. Kirman, Alan P. (1992), “Whom or What Does the Representative Individual Represent?,” Journal of Economic Perspectives 6: 117–136. Leijonhufvud, Axel (1981), Information and Coordination, Oxford University Press, New York. Macfie, Alec (1934), Theories of the Trade Cycle, Macmillan, London. Mises, Ludwig von ([1912] 1934), The Theory of Money and Credit, Jonathan Cape, London. O’Driscoll, Gerald P., Jr. (1977), Economics as a Coordination Problem, Sheed Andrews, Kansas City.

92 Richard E. Wagner Selgin, George A. (1988), The Theory of Free Banking, Rowman & Littlefield, Totowa, NJ. Vaughn, Karen I. (1994), Austrian Economics in America, Cambridge University Press, New York. Wagner, Richard E. (1999), “Austrian Cycle Theory: Saving the Wheat while Discarding the Chaff,” Review of Austrian Economics 12: 65–80. White, Lawrence H. (1989), Competition and Currency, New York University Press, New York. Wicksell, Knut ([1898] 1936), Interest and Prices, Macmillan, London. Witt, Ulrich (1997), “The Hayekian Puzzle: Spontaneous Order and the Business Cycle,” Scottish Journal of Political Economy 44 (February): 44–58.

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Financial economics

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Big Players and money demand Catherine Beckett Gilanshah and Roger Koppl

Introduction In this chapter we build on Hayek and Lachmann to further develop Austrian ideas about knowledge and institutions. We apply the theory of Big Players (Butos and Koppl 1993, 1999; Koppl and Yeager 1996) to the problem of the stability of money demand. We find that discretionary monetary policy produces instability of money demand. The difficulty of predicting a discretionary monetary policy reduces money holders’ knowledge of the future. This ignorance of the future induces a kind of herding (explained on p. 99), which creates instability of money demand. The institutions governing money supply influence the stability of money demand by way of their influence on the knowledge and expectations of economic actors. Our Austrian interest in knowledge and institutions has its origins in the work of Carl Menger. Ludwig von Mises ([1920] 1935) greatly expanded the Austrian understanding of knowledge and institutions. The position he and Hayek defended during the socialist calculation debate clarified the Austrian “knowledge problem” upon which Hayek and Lachmann both worked. Hayek’s work has given rise to the theory of expectations proposed by Butos and Koppl (1993, 1997). Lachmann’s work refined our understanding of the role and importance of institutions. Our results build on Butos and Koppl’s Hayekian theory of expectations. They illustrate important themes of Lachmann’s work, especially as expressed in his essay The Legacy of Max Weber (1971). The second section discusses money demand in the context of the theory of Big Players. The section after that reviews the history of monetary policy in the United States from 1950 through the 1980s. We argue that it became more discretionary after 1970. The fourth section explains our statistical methods and results. Our numerical evidence supports our theoretical claim that discretionary monetary policy creates instability of money demand. The fifth section, the conclusion, contains some comments on the implications of our study for future work in the theoretical and empirical study of money demand. If the results of our preliminary

96 Catherine B. Gilanshah and Roger Koppl study hold up in other studies, the theory of money demand will require amendment.

Money demand and the theory of Big Players The demand for money has potentially profound effects on economic activity. In the absence of offsetting factors, an unstable demand for money translates into instabilities in prices, employment, and output. Despite its significance, however, the demand for money is a variable whose behavior perplexes economists. Most monetary economists have been in search of a well-specified model that will allow them to track accurately the demand for money and predict its future movements. By the early 1970s a consensus had emerged among economists as to the functional form of money demand, which seemed to exhibit a high degree of empirical stability in the period after World War II (see Laidler 1993: 171, Goldfeld 1973). At about the same time, the Fed began a long series of changes in its policies and procedures. As we shall argue, these changes produced greater activism and discretion on the part of the Federal Reserve System. Shortly thereafter, money demand estimates became unstable, and the emerging data began to expose shortcomings in the accepted models. Most economists came to believe these problems with tracking money demand were a product of mis-specification of the models. Thus, since the 1970s the game has been one of discovering which measure of income or wealth to use, which measure of risk, and which measure of liquidity, as well as some way to account for advances in payment technologies and institutional change. Yet no model to date has proved to be robust over a satisfactorily long period. Was it merely a coincidence that the shortcomings of money demand specifications became obvious at roughly the same time that the Fed adopted much more activist and discretionary policies? The theory of the Big Players would suggest that it was not. A Big Player is an important actor such as the Federal Reserve that is insensitive to profit and loss and acts on discretion rather than according to a known rule. We review the theory of Big Players and briefly discuss its theoretical origins. We then apply it to U.S. money demand from 1950s to 1980s. We find that after 1970, Fed policy grew more discretionary and that this increase in Big Player influence at least contributed to greater instability in money demand. The facts are as follows: (1) the Fed began to undertake more discretionary policy actions beginning in 1970; (2) shortly thereafter, the estimates generated by the standard money demand specifications began to show sizable prediction errors; (3) despite considerable effort, no new and improved specification of money demand has emerged that can satisfactorily account for its seemingly aberrant behavior during the 1970s and 1980s. The puzzle is that if the prediction errors were purely a product of

Big Players and money demand 97 mis-specification, why, despite the enormous resources devoted to this task, have economists been unable to produce a better model for money demand? Though we do not deny that financial innovation, changes in definition of money, wage and price controls, and other factors might have contributed to instabilities in money demand during the period in question, we take a different approach in attempting to solve the money demand puzzles of the 1970s and 1980s. If the theory of the Big Players is correct, then the sort of instabilities generated by the discretionary actions of Fed policy makers cannot be explained by the addition of new variables. Instead, we will contrast the behavior of money demand estimates over two periods, the 1950s–1960s and the 1970s–1980s. Using rescaledrange analysis, we will test whether the more discretionary and interventionist monetary policies of the latter period were indeed a factor in the observed instabilities of money demand estimates. We find evidence that Fed activism did induce instability in money demand. If the result holds under scrutiny, it has important implications for monetary policy. The implication is that the Fed should not abandon money supply targets, but should pursue them according to a fixed rule. This implication contradicts one common inference drawn from the literature on instability of money demand. Mishkin’s undergraduate text is representative of this common view. Mishkin argues that “because the money demand function has become unstable, velocity is now harder to predict, and setting rigid money supply targets in order to control aggregate spending in the economy may not be an effective way to conduct monetary policy” (1995: 572). But if this instability of money demand is a product of Fed activism, Mishkin’s conclusion does not follow. If discretion produces instability, we have an argument for less of it, not more. The debate over rules versus discretion in monetary policy is one part of the larger issue of flexibility versus coherence of a society’s institutional order. Ludwig Lachmann has argued that an “institution provides means of orientation to a large number of actors.” They can “co-ordinate their actions by means of orientation to a common signpost.” But a signpost must not be moved too often. “If institutions are to serve us as firm points of orientation their position in the social firmament must be fixed.” But, of course, “it is hardly possible to imagine” that any institution could be “totally exempt from change.” A change known in advance “need not interfere with the plans of users.” But some changes will be surprises. “What happens then?” In situations of unexpected change, could “institutions mislead rather than guide planned action?” (1971: 49–51). Lachmann argued that regular and predictable changes pose no fundamental problem, but “irregular” change does. “Not movement as such, but irregular movement that disqualifies an institution from serving as a point of orientation. The crucial requirement is for actors to be able to take their bearings by existing institutions, to be able to ‘steer by them’ ” (ibid.: 79). The theory of the Big Player fits well with Lachmann’s theoretical work

98 Catherine B. Gilanshah and Roger Koppl on institutions. In fact, the Big Player’s discretion can be viewed as creating the irregular movement Lachmann warned of. As defined by Koppl and Yeager (1996) and Butos and Koppl (1993, 1997), a Big Player must satisfy three criteria: 1 2 3

He must be big in the sense that his actions influence the course of economic events. He must be relatively insensitive to profit and loss. He must use discretion in his exercise of market power.

Koppl and Yeager (1996) and Butos and Koppl (1993, 1995) argue that when a Big Player is present, not only will his actions directly affect economic variables, but also they will lower the informational content of many market signals, including prices and interest rates. That is, the signposts will shift. This has several implications. First, “small players” will have increased difficulty extracting useful knowledge about economic fundamentals, thereby reducing the reliability and usefulness of their expectations. Second, success now becomes more closely tied to anticipating the behavior of the Big Player, resulting in a reallocation of entrepreneurial alertness toward this task and away from fundamentals. Finally, discretionary policies on the part of the Big Player will create “Keynesian Beauty Contests” (Butos and Koppl 1999). That is, the decisions of policy makers will be based on their expectations of how private actors will behave, while the decisions of private actors will be based on their expectations of how policy makers will behave. This, at least in part, divorces the process of expectations formation from underlying economic fundamentals. The theory maintains, then, that the Big Player’s discretionary policies increase the uncertainty of the market, and contribute to greater volatility or market instabilities.1 According to the theory, an independent central bank may easily become the quintessential Big Player. First, the policy actions of the Federal Reserve System clearly affect the course of economic events. Second, the System’s policy-making committee may exercise any desired degree of discretion in setting and pursuing various targets; it may choose either rules or discretion. Third, the Federal Reserve System is free of profit and loss constraints with respect to its policy actions. All three characteristics of a Big Player are present potentially. The central bank’s choice between rules and discretion decides the case. If the Fed chooses rules, it is not a Big Player, and may indeed act as Lachmann’s “signpost” for guiding and coordinating the money management decisions of many. If it chooses discretion, it becomes a Big Player. In the case at hand, one of the many variables that may be affected by the discretionary actions of Federal Reserve policy makers is the demand for money. Since Federal Reserve policies directly affect the opportunity cost of holding money, they also affect the quantity of it demanded.

Big Players and money demand 99 Past work on the theory has argued that Big Players induce “herding” or “bandwagon effects” in asset markets such as the stock market and the foreign exchange market. The evidence so far collected supports this claim (Koppl and Yeager 1996; Ahmed et al. 1997; Koppl and Mramor 2003; Koppl and Nardone 2001). We argue that Big Players also induce herding in the demand for money. Our argument is similar to that of Koppl and Yeager, who build on Scharfstein and Stein (1990). Bandwagon effects enter money demand through the role of cash managers. A substantial portion of money demand is, of course, demand on the part of business enterprises. The decision of how much money to hold is often made by a professional cash manager. Scharfstein and Stein (1990) have noted the importance of reputation for portfolio managers. We note that the same holds for cash managers. As with the portfolio manager, the cash manager’s job prospects depend mostly on his or her reputation. It is hard for a cash manager’s supervisors and potential employers to measure the quality of his or her decisions. One criterion they will employ is the cash manager’s conformity to industry practice. This is a global criterion. Supervisors who use this global criterion will ask, for example, if their cash manager reduced money holdings when trade journals warned of the dangers of excess liquidity in the current macroeconomic climate. They will also want to know, however, if the cash manager’s decisions were appropriate to the unique circumstances of their business situation. This is a local criterion. Because the cash manager is judged partly on global criteria, he or she has an incentive to act as other cash managers act. If you act as others do and things go well, your reputation is ensured. If you act as others do and things go badly, you can share the blame with others. It is dangerous to act on one’s own judgment. If you defy common wisdom and things go badly, your reputation is shot and your job prospects diminished. Scharfstein and Stein (who considered only portfolio managers) call this incentive to imitate the “sharing-the-blame effect” (1990: 466). Cash managers are not judged on global criteria only. They are also judged on local criteria. A cash manager who can consistently make good decisions in defiance of common wisdom will earn a strongly favorable reputation and enjoy improved job prospects. There is therefore a counter-incentive discouraging bandwagon effects. Money demand is influenced by the sharing-the-blame effect, which creates herding and the incentive to ignore local information. At any one time we can expect some herding to occur without imagining cash managers to be perfect sheep. Some will herd, others will not. Big Player activism increases the fraction who herd. A Big Player monetary authority weakens the counter-incentives to sharing the blame and thus encourages herding. The Big Player’s discretionary actions influence the opportunity cost of holding money. It is thus important for cash managers to pay attention to the actions and prospective

100 Catherine B. Gilanshah and Roger Koppl actions of the Big Player. Fed watching is necessitated by discretionary monetary policy. Fed watching, however, diverts attention from local factors. Moreover, a Big Player Fed is difficult to fathom. Almost by definition, the actions of a discretionary agent cannot be predicted (see Koppl and Yeager 1996; Koppl 1996). Thus, cash managers’ attention is diverted from what is relatively easy to predict to what is relatively hard to predict. In this greater state of ignorance, the cash manager has a stronger incentive to share the blame. Each cash manager has a stronger incentive to act as other cash managers do. The advice promulgated in trade journals will be more universally adhered to, less frequently ignored. There will be more herding in money demand. Fed policy went from one of little Big Player discretion in the 1950s and 1960s to one of greater Big Player discretion in the 1970s and 1980s. We chronicle this change and provide evidence that it induced increased herding in money demand.

The Federal Reserve as Big Player In the 1950s and 1960s the primary operational guide for Federal Reserve policy makers was free reserves (excess reserves less borrowed reserves), with bank credit (commercial loans and investments) serving as an intermediate guide (Meulendyke 1989: 34). Free reserve targets did not constitute a strict and binding rule; nonetheless, throughout this period the Federal Reserve would respond to changes in the level of free reserves in a predictable manner. Equally importantly, throughout this period the assumptions underlying monetary policy procedures were relatively stable. This meant that private actors could form reasonably certain expectations of what the Federal Reserve was going to do or how it was going to react to a given change. In other words, the element of discretion in Federal Reserve policy making was relatively low. As a number of studies showed, money demand behaved in a predictable manner over this period such that by 1970 there was general agreement among economists over its longterm functional form – which seemed to exhibit stability over time. The basic model utilized in studies such as those of Laidler (1977) and Goldfeld (1973) took the following form: ln (Mt /Pt)  0  1 ln Yt  2 ln R st  3 ln R mt  4 ln (Mt1/Pt1)

(1)

where Yt  some measure of wealth or income, such as GNP; R st  interest rate on savings deposits; R mt  some market interest rate, such as the rate on T-bills; and Mt1/Pt1  real money balances, lagged one period. The inflationary pressure of the late 1960s prompted many economists to question the assumed relationships underlying current monetary policy (Meulendyke 1989: 38). This led to a number of policy initiatives in the early 1970s that resulted in much more discretionary and activist policies.

Big Players and money demand 101 Indeed, 1970 marked the beginning of a new era in Federal Reserve policy in which there would be greater discretion not only as to the appropriate range for a given Federal Reserve target, but as to which targets were appropriate. In other words, what had previously been a system of relatively modest discretion within the rules now turned into a series of discretionary and unpredictable changes in the rules themselves. The Federal Reserve had truly become a Big Player. We will argue in this section that there were three identifiable regime shifts in the 1970s and 1980s: 1970–1972, 1979, and 1983. Following each shift to a new regime, there was a significant period of experimentation and modification on the part of the Federal Reserve policy makers as they sought the best way to implement their new objectives. During these periods the market was characterized by greater uncertainty, as small players could not clearly distinguish signals reflecting discretionary interventions from those reflecting shifts in underlying economic fundamentals. Furthermore, following a shift the market would reward entrepreneurs who could correctly anticipate the actions of the Big Player, resulting in a reallocation of resources toward “Fed watching” (see Meulendyke 1989: 197–198; Jones 1989; Melton 1985). At the same time, the Federal Reserve, uncertain of how its new technique would affect the market, responded to every jitter and jump, basing each move on how it expected the market to react. Likewise, the market expectations of “private actors” would now have to be based not only on their theories of what the market would do in the absence of intervention, but also on their theories of what the Fed would do. Meulendyke (1989: 188) describes the market’s response to the changes in the following way: Decisions about the management of money and credit were influenced by estimates of how rapidly the monetary authorities would raise or lower the funds rate; the judgement often depended as much on assessing policymakers’ willingness to allow interest rates to change as on observing the behavior of money growth and the economy. Most forecasting focused on the factors believed to affect the timing and magnitude of funds rate changes. The result, as the Big Players theory suggests, was a separation of expectations formation from underlying economic fundamentals; the Federal Reserve had created a “Keynesian beauty contest.” Discretion becomes the rule: the 1970s 2 In an attempt to bring down inflation, the Federal Reserve formally adopted monetary targets in 1970.3 The new operational guides required new techniques, however, for setting targets and pursuing monetary policy, and this process involved much experimentation and modification

102 Catherine B. Gilanshah and Roger Koppl during the early years of the decade. At various stages, the Fed attempted to control money through the demand side, at others, through the supply side, and at others still, by manipulating both. For instance, in 1972 the Federal Reserve briefly experimented with targeting reserves on private deposits (RPD). Fearing unacceptable volatility in interest rates, however, it also attempted to constrain the federal funds rate. The Federal Open Market Committee (FOMC) was always reluctant to change the federal funds rate by more than incremental steps, even when larger movements were deemed necessary to hit monetary targets. Thus, despite the stated policy of RPD targeting, the narrow range set for the federal funds rate was typically the binding constraint, and the reserve targets were frequently missed. The result, of course, was inflation. By 1973 the targets on RPD were already widely perceived to be unachievable, and they were downgraded to an intermediate target4 (see Meulendyke 1989: 38–43). By the mid-1970s the federal funds rate had essentially become the de facto operational target (Roley 1990: 39–40). Once this shift had taken place, the FOMC’s desk became increasingly reluctant to permit the federal funds rate to deviate from its target. Thus, by the late 1970s the desk was promptly and predictably responding “to even small wiggles in the federal funds rate” (Meulendyke 1989: 43). This again created an environment in which private actors could form expectations of Federal Reserve behavior with some degree of certainty; however, the inability of this regime to contain the runaway inflation indicated that a new technique or target was just around the corner. The Volcker experiment: 1979–1982 The federal funds targeting regime clearly had not brought inflation under control. Many critics of the federal funds regime, influenced by the monetarists, argued that what was needed was a rule-based operating technique in which the Federal Reserve would control money from the supply side. Driven by pressures on all sides, in October 1979 Paul Volcker, the new chairman of the Board of Governors, implemented sweeping changes in the Federal Reserve’s operating technique. Although the new regime appeared to be rule based, it was actually a convoluted scheme of multiple targets and derived estimates. As described by Meulendyke (1989: 43–44), operationally the FOMC would choose a desired quarterly growth rate for one of the monetary aggregates. The Federal Reserve staff would then estimate a level of total reserves consistent with that growth rate, as well as deposit and currency mixes to derive average reserve ratios and currency deposit ratios. Finally, the desk would derive a target for nonborrowed reserves, which at the same time would determine the level of borrowed reserves, given the FOMC’s total reserve target. Thus, what was called M1 targeting was based on an estimation technique that involved the analyst’s discretion at nearly every one of the four steps.

Big Players and money demand 103 Even under this “supply-side” regime the federal funds rate was not ignored. It was recognized that this key rate, along with all other interest rates, would be both higher and more volatile; yet its level was considered, and could result in the acceleration or delay of an operation necessary for a reserve adjustment (Meulendyke 1989: 45). In addition, it was occasionally deemed that the adjustment implied by the FOMC’s orders was proceeding at either too slow or too fast a pace, in which case, discretion entered the equation again as the desk was granted permission to make alterations in the borrowing objective between official meetings. Under this regime, nonborrowed reserve growth targets were derived for inter-meeting average periods. As Meulendyke (1989: 44–45) describes it, this technique meant that if a reserve target were missed in the early part of the period, as it often was, it had to be offset by large swings in borrowing at the end of the period. Thus, “informal adjustments” were sometimes implemented to smooth temporary spikes and drops that were deemed inconsistent with the longer term patterns. Although [these] adjustments were considered necessary to avoid severe short-term swings in reserve availability and interest rates, they gave the appearance of “fiddling” and caused considerable confusion for outside observers.5 Only three years after its introduction, in late 1982, the Federal Reserve abandoned M1 targeting. New data indicated that the relationship between M1 and economic activity was not a stable one – a prerequisite for monetary targeting. The FOMC briefly experimented with M2 targeting in the final quarter of 1982, but the introduction of money-market deposit accounts in December of that year strongly affected the demand for M2, and this scheme, too, proved unsuccessful (Meulendyke 1989: 46). The Volcker years, while successful in moderating inflation, generated further unpredictable swings in money demand. In 1980–1982 the demand for M1 rose sharply in a way that no model predicted. Though the theory of the Big Player does not speak to the direction of changes in key variables, it does suggest that the unpredictable movements in money demand were, at least in part, a consequence of the unpredictable and discretionary actions of the Federal Reserve. The guise of borrowed reserve targeting: 1983–1987 Beginning in the last weeks of 1982, the Federal Reserve shifted its focus from the indirect method of nonborrowed reserve targeting to targeting borrowed reserves directly. This, however, was essentially a move back toward targeting interest rates. The FOMC would choose the desired level of borrowed reserves, but the way to attain that level was through the interest rate. Then, if interest rates threatened to rise, the Fed would

104 Catherine B. Gilanshah and Roger Koppl supply nonborrowed reserves to the market to bring the interest rate back down. Operationally, in addition to weighing economic activity and inflation, the FOMC would consider a number of “supplemental indicators” such as foreign exchange movements and financial market conditions in formulating its policy decisions. In essence, the FOMC considered whatever variables it deemed important at that time, and often even gave the desk further discretionary powers within the targeted ranges (Meulendyke 1989: 47). The borrowed reserve targeting regime was no different than the previous regimes in that it relied heavily on the discretion of a few individuals. “Fed watchers” tried, as they had in previous monetary regimes, to estimate reaction functions for the Big Player. Yet policies that rely on the discretion of individuals are by their nature impervious to such quantification. Thus, small players had to form expectations of both what the market would do, and how the Federal Reserve would react. Meulendyke (1989: 189) describes the process in the following way: In observing the behavior of the funds rate, market participants had to decide whether a move in the rate occurred for policy or for other reasons. Since the Federal Reserve was basing its borrowed reserve objectives on a variety of indicators, including the outlook for economic activity and inflation as well as the behavior of the monetary aggregates, participants [had to] forecast those variables in order to estimate the next move in the policy stance. But often the Fed did not even know how it would react; it was frequently uncertain of how its policies would affect the market, and thus had to react to every jump and jitter, even if those volatilities were in response to its own prior actions. The uncertainty associated with the FOMC’s reactions only increased as the policy makers expanded the number of “supplemental indicators” during this 1983–1987 regime. As predicted by the theory of the Big Player, money demand estimates throughout this period continued to behave in an unpredictable and volatile manner.

Statistical methods and results We have blamed Big Players for much of the instability of U.S. money demand since the early 1970s. If our explanation is about right, there should be more herding in money demand after 1970 than before. In that case, after 1970 there should be more “persistent dependence” in the residuals of standard money demand equations. The statistical concept of persistent dependence is explained below. Together with the use of rescaled-range analysis as a test, it was developed by the great hydrologist H.E. Hurst, known as “the Father of the Nile” (Hurst et al. 1965), by Benoit Mandelbrot (1971, 1972), Mandelbrot and Wallis (1968, 1969a, b),

Big Players and money demand 105 and by Wallis and Matalas (1970). (Lo 1991 developed a version of R/S analysis. We do not use Lo’s techniques, however, for reasons given by Ahmed et al. (1997: 30–31).) Persistent dependence in time-series data creates “aperiodic cycles,” irregular ups and downs in the data that cannot be attributed to “short-period” autocorrelation. Persistent dependence The concept of persistent dependence and tests for its existence were developed originally by Hurst et al. (1965; see Mandelbrot 1972: 282). Persistent dependence has been found in foreign exchange markets (Booth et al. 1981, 1982; Diebold et al. 1991; Koppl and Yeager 1996), the New York Stock Exchange (Greene and Fielitz 1977; Peters 1989), closed-end country funds (Ahmed et al. 1997), commodity futures (Helms et al. 1984), gold and silver spot markets (Booth and Kaen 1979), Treasury-bond returns (Peters 1989), aggregate output (Diebold and Rudebusch 1989), and even in sports scores (Hurst et al. 1965). Persistent dependence or memory in a stationary time series is simply the failure of the autocorrelations to die off quickly: that is, at least exponentially. The influence of each innovation “persists” indefinitely. Such a time series is not ergodic. When a time series has a long memory, it will swing up and down about its long-term expected value in irregular waves or “aperiodic cycles.” If a positive (negative) innovation in any one period tends to produce positive (negative) innovations in latter periods, there is “positive persistence.” In this case the waves will be longer, on average, than the pseudo-cycles of a white-noise process. Graphs of the time series will undulate too much to have been generated by white noise. If there is “negative persistence,” the aperiodic cycles will be shorter on average than the pseudo-cycles of a white-noise process. In this case the graph of the time series will be too spiky to have been generated by white noise. The aperiodic cycles created by persistent dependence are just these tooundulant or too-spiky pseudo-cycles in the graph of the time series. Hurst performed an experiment with playing cards that nicely illustrates the nature of positive persistence – the case of interest to us. He relabeled the fifty-two cards with the numbers 1, 1, 3, -3, 5, 5, 7, and 7 in proportions designed to approximate a normal distribution. He then shuffled the deck and picked a card at random by cutting the deck. After writing down the number of the card turned over, 5 for example, he shuffled the deck again and dealt out two hands of twenty-six cards each. He then biased one of the hands by replacing some of its cards according to the number written down earlier. In our example the number was 5, so Hurst would have created the biased hand by removing the five lowest cards and replacing them with the five highest cards of the other hand. The final step in preparing the biased hand was adding a joker. Hurst would repeatedly shuffle the biased hand, cut it, and record

106 Catherine B. Gilanshah and Roger Koppl the number of the card turned over. This shuffling and cutting would go on until the joker came up, at which point a new biased hand would be created and the process repeated. The sequence of values generated through this experiment was characterized by persistent dependence and aperiodic cycles. R/S analysis as a test for persistent dependence Today’s most popular techniques of times-series analysis assume that the series under study has a “short memory.” They assume that for the indexed random variable in question, X, the autocorrelation between Xt and Xtk, (k), declines rapidly as k goes to infinity. The decline in the covariance is rapid when |(k)|  Crk

(2)

where C is positive and r is between 0 and 1. When this condition fails, the series is characterized by “memory,” “persistence,” “persistent dependence,” or, as Mandelbrot and Wallis put it, the Joseph effect. (“Behold, there come seven years of great plenty. . . . And there shall arise after them seven years of famine”; Genesis 41: 29–30.) The presence of persistence is consistent with both short-term autocorrelation and its absence. We do not assume any particular functional form for (k). Rescaled-range analysis tests for persistence assuming the series is “stationary” in the sense that the expected value of any function of {Xt} is the same for {Xtk}. Let us consider such a series {Xt} for which we have a sample of size T. The cumulative sum of the series, X*(t), is just the sum of the values up to t: t

X*(t)   Xu

(3)

u1

where t  1. For t  0 we define X*(t)  0. For any interval of length s beginning at t, the range of the interval is given by R(t,s)  max {X*(t  u) X*(t)  (u/s)[X*(t  s)  X*(t)]} 0us min {X*(t  u) X*(t)  (u/s)[X*(t  s)  X*(t)]} 0us

(4)

(5)

To rescale the range, divide through by the sample standard deviation of the original series {Xt} over that interval, S(t,s). The rescaled range, R/S, is just the ratio R(t,s)/S(t,s). The expected value of the rescaled range is independent of t because the series {Xt} is sta-

Big Players and money demand 107 tionary. It is not, however, independent of s. The rescaled range can only grow with the length of the sample. (This will be more obvious when we turn to the graphical representation of R/S analysis.) Its asymptotic rate of growth, moreover, is a measure of the degree of persistent dependence. If {Xt} has no long-run dependence, i.e., if |(k)|  Crk, for all values of k beyond some point, then h  0.5. Mandelbrot and Wallis (1969a, 1969b) report that R/S is asymptotically proportional to a fractional power of interval length. That is, R(t,s)/S(t,s)  Csh

(6)

where C 0 and 0 h 1. The Hurst coefficient, h, is a measure of persistence. If h  0.5, there is no persistence. If h 0.5 there is positive persistence and if h 0.5, there is negative persistence. Taking the natural logarithm of each side of equation (6) yields ln (R/S)  ln (C)  h* ln (s).

(7)

The coefficients of this equation can be estimated by ordinary leastsquares regression. The Hurst coefficient, h, measures the rate at which the rescaled range of the cumulative series grows with interval length. If the original series is white noise, this growth rate is 0.5. Even if there is autocorrelation, the asymptotic rate of growth is still 0.5 as long as the correlellogram dies off “quickly.” If there is positive persistence, then deviations from trend tend to persist. In this case, the rate at which the rescaled range grows with interval length will exceed the rate given by chance: h 0.5. Similarly, if there is negative persistence, then deviations from trend tend to be reversed more promptly than rate chance alone would have produced. In this case the rescaled range of the cumulative series will grow more slowly than the rate given by chance: h 0.5. Statistical results If money demand is subject to increased herding because of increased discretion in Fed policy, there should be increased persistence in the residuals of money demand equations. Herding among cash managers will create a tendency of money demand to swing up and down in irregular pseudo-cycles about its trend line. If the regression line from a money demand equation is a reasonable measure of that trend, the residuals from it will swing up and down in irregular pseudo-cycles about zero. Moreover, these pseudo-cycles will be greater after 1970 than before. Increased Big Player influence will cause an increase in persistent dependence after 1970 in the residuals from money demand equations. This prediction is consistent with the statistical analysis reported below.

108 Catherine B. Gilanshah and Roger Koppl We ran six versions of a standard money demand equation. In each case M1 was the dependent variable. Our quarterly data cover the period from 1960 to 1987. In each case the equation was of the following form. ln (Mt/Pt)  0  1 ln Yt  2 ln Rts  3 ln Rtm  4 ln (Mt1/Pt1)

(8)

where Yt  some measure of wealth or income, such as GNP; Rts  interest rate on savings deposits; Rtm  some market interest rate, such as the rate on T-bills; and Mt1/Pt1  real money balances, lagged one period. What differed from one equation to the next was the choice of variables used to measure the various right-hand-side items. We took the residuals from these six money-demand equations and applied R/S analysis to them. We divided the residuals into an initial period running through 1969 and a final period beginning in 1971. We omitted 1970 as a transition year. For each equation and each period we calculated the Hurst coefficient, h. Our results are presented in Table 5.1. While these results should be viewed as preliminary, they are surprisingly consistent. In each case our measure of persistent dependence grows for the period after 1970. In all but one case the difference is statistically significant. Thus, our evidence supports (though it does not “prove”) the following claims: Table 5.1 The Hurst coefficient for the initial and the final period Equation

Hurst coefficient for initial period

Hurst coefficient for final period

1

0.865 (0.028)

0.898 (0.013)

2

0.361 (0.027)

0.722 (0.021)

3

0.784 (0.025)

0.926 (0.011)

4

0.186 (0.019)

0.619 (0.015)

5

0.540 (0.025)

0.647 (0.017)

6

0.168 (0.018)

0.686 (0.029)

Note The column labeled “Hurst coefficient for initial period” reports the Hurst coefficient for the period up to and including the fourth quarter of 1969. The column labeled “Hurst coefficient for final period” reports the Hurst coefficient for the period beginning the first quarter of 1971. Standard errors are reported in parentheses.

Big Players and money demand 109 1 2 3

There was less stability of money demand after 1970 than before. This reduction in stability was caused by increased Big Player influence. Increased Big Player influence reduced the stability of money demand by inducing herding in the behavior of cash managers.

Discussion and conclusion Lachmann (1971: 79) posed the question, “How much [flexibility] can we concede before the institutional structure is impaired?” While it is beyond the scope of this chapter to draw out specific guidelines as they relate to the conduct of monetary policy, our analysis here does permit us to draw some conclusions. If our analysis is about right, there is something missing from standard money-demand regressions, namely, the degree of Big Player influence. This influence cannot be accounted for, however, by adding in one or more new regressors. To have such a regressor (or group of regressors), we would need a measurable variable that rises when cash managers herd in one direction and falls when they herd in the opposite direction. This variable would have to track the microeconomic dynamics of cash managers’ environment. The relevant events it would have to track, however, occur below our threshold of observation. No macroeconomic variable tracks the underlying dynamics, nor does any measurable microeconomic variable. One might say, if one wished, that we have identified a missing variable causing mis-specification of money-demand equations. The misspecification, however, cannot be put right by adding in any measurable variable. In his famous restatement of the quantity theory, Milton Friedman (1956) seems to be reacting to critics of the quantity theory from the 1930s. According to these critics, Friedman explained, “[t]he demand for money . . . is a will-o’-the wisp, shifting erratically and unpredictably with every rumor and expectation; one cannot, it was asserted, reliably specify a limited number of variables on which it depends” (p. 16). Chicago’s oral tradition, by contrast, “accepts the empirical hypothesis that the demand for money is highly stable.” Indeed, it is a stable function of a few known variables. “For to expand the number of variables regarded as significant is to empty the hypothesis of its empirical content” (p. 16). This view of things, however, neglects the possibility that the stability of money demand may itself be a function of institutional particulars. Old and new monetarists alike have neglected the possibility of identifying empirical circumstances governing the stability of money demand. We need not choose between “stability always” and “stability never.” We have “stability sometimes.” Moreover, we can identify the conditions that increase stability and those that reduce it. “Stability sometimes” is thus an empirically viable program. In this chapter, we have identified one empirical factor that

110 Catherine B. Gilanshah and Roger Koppl seems to influence the stability of money demand, namely, Big Player influence. We hope for further work of a similar nature.

Notes For useful comments on earlier drafts of this chapter we thank George Selgin, Tyler Cowan, David Laidler, and Burton Zwick. Much of this chapter has appeared in Koppl (2002). 1 Koppl (1998) relates the Big Players theory to its Austrian inspiration in the writings of Lachmann ([1943] 1977), Hayek (1948, 1952, 1967, 1973), Machlup ([1936] 1978), and Schutz ([1932] 1967). 2 The historical account of monetary policy regimes in the following sections draws heavily from Meulendyke (1989). 3 Also of significance were the events surrounding Nixon’s closing of the gold window in 1971. 4 Further modifications of monetary targeting practices were implemented in 1975 and 1978 in response to congressional legislation. 5 To further confuse the already dizzying system, the Federal Reserve redefined monetary aggregates in 1980 and introduced “shift aggregates” in 1981 in an attempt to account for new liquid assets and other financial innovations.

References Ahmed, Ehasn, Koppl, Roger, J., Rosser, Barkley, and White, Mark V. (1997), “Complex Bubble Persistence in Closed-End Country Funds,” Journal of Economic Behavior and Organization 32 (1): 19–37. Booth, G. Geoffrey and Kaen, Fred R. (1979), “Gold and Silver Spot Prices and Market Information Efficiency,” Financial Review 14: 21–26. Booth, G. Geoffrey, Kaen, Fred R., and Koveos, Peter F. (1981), “Foreign Exchange Market Behavior: 1975–1978,” Rivista Internazionale di Scienze Economiche e Commerciali April: 311–325. Booth, G. Geoffrey, Kaen, Fred R., and Koveos, Peter F. (1982), “R/S Analysis of Foreign Exchange Rates under Two International Monetary Regimes,” Journal of Monetary Economics 10: 407–415. Butos, William and Koppl, Roger (1993), “Hayekian Expectations: Theory and Empirical Applications,” Constitutional Political Economy 4 (3): 303–329. Butos, William and Koppl, Roger (1997), “The Varieties of Subjectivism: Keynes and Hayek on Expectations,” History of Political Economy 29 (2): 327–359. Butos, William and Koppl, Roger (1999), “Hayek and Kirzner at the Keynesian Beauty Contest,” Journal des Économistes et des Études Humaines 9 (2/3): 257–275. Diebold, Francis X. and Rudebusch, Glenn D. (1989), “Long Memory and Persistence in Aggregate Output,” Journal of Monetary Economics 24: 189–209. Diebold, Francis X., Husted, Steven, and Rush, Mark (1991), “Real Exchange Rates Under the Gold Standard,” Journal of Political Economy 99 (6): 1252–1271. Friedman, Milton (1956), “The Quantity Theory of Money: A Restatement,” in Milton Friedman (ed.) Studies in the Quantity Theory of Money, University of Chicago Press, Chicago. Goldfeld, S.M. (1973), “The Demand for Money Revisited,” Brookings Papers on Economic Activity no. 3: 577–638.

Big Players and money demand 111 Greene, Myron T. and Fielitz, Bruce (1977), “Long-Term Dependence in Common Stock Returns,” Journal of Financial Economics 4: 339–349. Hayek, F.A. (1948), Individualism and Economic Order, University of Chicago Press, Chicago. Hayek, F.A. (1952), The Sensory Order, University of Chicago Press, Chicago. Hayek, F.A. (1967), Studies in Philosophy, Politics and Economics, University of Chicago Press, Chicago. Hayek, F.A. (1973), Law, Legislation and Liberty, vol. 1, Rules and Order, University of Chicago Press, Chicago. Helms, Billy P., Kaen, Fred R., and Rosenman, Robert E. (1984), “Memory in Commodity Futures Contracts,” Journal of Futures Markets 4: 559–567. Hurst, H.E., Black, R., and Simaika, Y.M. (1965), Long-Term Storage: An Experimental Study, Constable, London. Jones, David M. (1989), Fed Watching and Interest Rate Projections: A Practical Guide, New York Institute of Finance, Simon & Schuster, New York. Koppl, Roger (1996), “It Is High Time We Take Our Ignorance More Seriously,” International Review of Financial Analysis 5 (3): 259–272. Koppl, Roger (1998), “Lachmann on the Subjectivism of Active Minds,” in Roger Koppl and Gary Mongiovi (eds) Subjectivism and Economic Analysis: Essays in Memory of Ludwig Lachmann, Routledge, London. Koppl, Roger (2002), Big Players and the Economic Theory of Expectations, Palgrave Macmillan, London and New York. Koppl, Roger and Miramor, Dusan (2003), “Big Players in Slovenia,” Reviewer of Austrian Economics 16(2/3): 253–269. Koppl, Roger and Nardone, Carlo (2001), “The Angular Distribution of Asset Returns in Delay Space,” Discrete Dynamics in Nature and Society 6 (2): 101–120. Koppl, Roger and Yeager, Leland (1996), “Big Players and Herding in Asset Markets: The Case of the Russian Ruble,” Explorations in Economic History 33: 367–383. Lachmann, Ludwig ([1943] 1977), “The Role of Expectations in Economics as a Social Science,” in Capital, Expectations, and the Market Process, ed. Walter E. Grinder, Sheed Andrews & McMeel, Kansas City, MO, pp. 149–165. Lachmann, Ludwig (1971), The Legacy of Max Weber, Glendessary Press, Berkeley, CA. Laidler, D.E.W. (1977), The Demand for Money: Theories and Evidence, DunDonnelley, New York. Laidler, D.E.W. (1993), The Demand for Money: Theories and Evidence, 4th edn, HarperCollins, New York. Lo, A. (1991), “Long-Term Memory in Stock Market Prices,” Econometrica 59: 1279–1313. Machlup, Fritz ([1936] 1978), “Why Bother with Methodology?” in Methodology of Economics and Other Social Sciences, Academic Press, New York. Mandelbrot, Benoit (1971), “When Can Price Be Arbitraged Efficiently? A Limit to the Validity of the Random Walk and Martingale Models,” Review of Economics and Statistics 53 (3): 225–236. Mandelbrot, Benoit (1972), “Statistical Methodology for Nonperiodic Cycles: From the Covariance to R/S Analysis,” Annals of Economic and Social Measurement 1 (3): 259–290. Mandelbrot, Benoit and Wallis, J.R. (1968), “Noah, Joseph, and Operational Hydrology,” Water Resources Research 4: 909–917.

112 Catherine B. Gilanshah and Roger Koppl Mandelbrot, Benoit and Wallis, J.R. (1969a), “Some Long-Run Properties of Geophysical Records,” Water Resources Research 5: 321–340. Mandelbrot, Benoit and Wallis, J.R. (1969b), “Robustness of the Rescaled Range R/S in the Measurement of Noncyclic Long Run Statistical Dependence,” Water Resources Research 5 (5): 967–988. Melton, William W. (1985), Inside the Fed: Making Monetary Policy, Dow Jones-Irwin, Homewood, IL. Meulendyke, Ann-Marie (1989), U.S. Monetary Policy and Financial Markets, Federal Reserve Bank of New York. Mises, L. von ([1920] 1935), “Economic Calculation in the Socialist Commonwealth,” in F.A. Hayek (ed.) Collectivist Economic Planning, Routledge, London. Mishkin, Frederic S. (1995), The Economics of Money, Banking, and Financial Markets, 4th edn, HarperCollins, New York. Peters, Edgar E. (1989), “Fractal Structure in the Capital Markets,” Financial Analysts Journal, July–August: 32–37. Roley, Vance (1990), “Market Perceptions of U.S. Policy since 1982,” in Thomas Davis (ed.) Financial Market Volatility and the Economy, Federal Reserve Bank of Kansas. Scharfstein, David S. and Stein, Jeremy C. (1990), “Herd Behavior and Investment,” American Economic Review 80 (3): 465–479. Schutz, Alfred ([1932] 1967), The Phenomenology of the Social World, trans. George Walsh and Frederick Lehnert, Northwestern University Press, Evanston, IL. Wallis, James R. and Matalas, Nicholas C. (1970), “Small Sample Properties of H and K-Estimators of the Hurst Coefficient h,” Water Resources Research 6 (6): 1583–1594.

H

Public economics

6

Taxation: an Austrian approach Jürgen G. Backhaus

Introduction Austrian economics is often conceived of as a normative approach to economics in general and economic policy in particular. “Austrian” economists are said to favour private over state economic activity, to emphasize entrepreneurship over public rule making, and not only to insist on individualism as a method of inquiry (with the individual as the central unit of analysis), but likewise to propose individualism as a precept for economic policy. Such a programme would reveal more trust in private organization than public policy and institution building. The purpose of this chapter is to cast doubt on some of the aforementioned perceptions in so far as they relate to public finance. The essay offers a reconsideration of some Austrian work in public finance analysis that is based on a positive theory of the state and its relationship with the market economy. These (mostly early) contributions are not merely of an antiquarian interest. The purpose is not to propagate these neglected approaches, rather to offer an introductory account of the contributions of some prominent Austrian economists and how they relate to contemporary thinking in public finance. There is, after all, an explicit contention that these theories bear on questions of relevance today. The chapter first and very briefly introduces some major protagonists on the Austrian scene. It covers aspects of the works of Friedrich von Wieser (1851–1926) and Emil Sax (1845–1927), whose effort to build a theory of the public economy on Austrian marginalism met with surprise when it appeared about a hundred years ago. Not unlike Wieser, Philippovich (1858–1917), without neglecting theory development, nevertheless found a way to merge the competing research programmes of the Austrian and the historical school respectively. A generation later, Schumpeter (1886–1950) and Goldscheid (1870–1931) presented a series of path-breaking studies that, although in very different ways, both revolutionized the way we look at the public economy. Finally, Martha Stephanie Brown’s theory of economic policy, one of

116 Jürgen G. Backhaus the first of its kind when it appeared in 1929, is discussed in terms of its public policy contributions. The central paradigm in public finance is the tax state, and one of the central paradigms in Austrian economics is entrepreneurship. Therefore, the second and longer part explores by way of example how these two central paradigms relate to each other in Austrian scholarship on public finance.

Some major protagonists on the Austrian stage Scholars and their contributions Textbook discussions of Austrian economics will generally focus on three major protagonists: Karl Menger, Eugen Böhm von Bawerk and Friedrich Freiherr von Wieser. In addition, Friedrich von Hayek and, above all, Ludwig von Mises tend to be mentioned as students of the former three. Yet from the public finance point of view, the cast seems seriously understaffed. Important contributors are simply missing. This would be true for Emil Sax and Eugen Freiherr Philippovich von Philippsberg. Emil Sax pioneered Austrian marginal utility theory in public finance analysis. Equally, Eugen Freiherr Philippovich started out as a professor of economics and public finance at the University of Freiburg, and his work shows a preoccupation with the role of the state. This is important, because it has methodological consequences. An economist who wants to apply his or her scientific tools to an analysis not only of market processes but also of the state economy will necessarily find that task methodologically challenging. The challenge can be met with different methodological postures. Philippovich characteristically opted for a particular solution, methodological pluralism. In his inaugural lecture (1886: 6) he strictly argued for methodological coexistence in economics: Nichts hat bisher eine klare Erkenntnis des Wesens unserer Wissenschaft so sehr verhindert, wie die verbreitete Meinung, die politische Ökonomie oder Nationalökonomie in jenem weiteren Sinne des Wortes, in welchem sie die ganze wirtschaftswissenschaftliche Forschung umfaßt, habe es entsprechend dem einheitlichen Begriffe auch nur mit einer Aufgabe und einer Methode zu tun.1 A very different conclusion was reached by Eugen Böhm von Bawerk, whose professional life, similarly, was deeply involved with public finance. Indeed, he spent most of his active professional life as a practitioner of public finance. He entered the ministry in 1872 and stayed there till 1880, became a counsellor there in 1889 and was Austrian finance minister in 1895, 1897–1898 and 1900–1904. In his case the extensive practical experience cannot be readily recognized in his published work. However,

Taxation: an Austrian approach 117 he devoted his most conspicuous single piece of academic work, his inaugural lecture, to the subject with a very specific proposition. One of the most productive thinkers in public finance analysis during the first half of the twentieth century was undoubtedly Joseph Schumpeter, who held the public finance chair at both Graz and Bonn. He was strongly influenced by Friedrich Freiherr von Wieser, as Warren Samuels (1982) pointed out in his presidential address to the History of Economics Society. Wieser had already struck a rather anti-capitalist chord and had considered the protection of the people (Volk) against the preponderance of capital the major purpose of economic policy (Schutzfunktion der Volkswirtschaftspolitik). This view was undoubtedly refined by Joseph Schumpeter, who, although critical of socialism (in the sense of a system in which societal decisions override market decisions), was equally convinced that it was an inevitable political economic outcome. The reality of Europe today has largely proved him correct. While often labelled a socialist and thereby ignored, Rudolf Goldscheid is more aptly described as a most innovative thinker in public finance, a man who wanted to merge public finance and sociological theory in order to overcome the rigidities of purely market-based marginal analysis. In this sense he shared the predispositions of Wieser, Schumpeter and Sax. He strictly differed from Böhm von Bawerk, however. Another pioneering work in Austrian economics was Martha Steffie Braun’s theory of economic policy. The German title, Theorie der staatlichen Wirtschaftspolitik, translates as “theory of state economic policy”, which to the contemporary reader would sound almost superfluous. Braun was a student of Mises, however, and it was her purpose to apply standard microeconomic analysis to all those instances where some state agency is intervening into the market. In so doing, Braun found herself in the tradition of both Wieser and Mises, overcoming the limitations of both Wieser’s anti-capitalism and Mises’s anti-statism. In fact she was dissuaded from presenting her book to the Vienna Faculty as a habilitation thesis. The state as a central concern That the state emerges as a central concern of many leading Austrian economists is almost self-evident after this first overview. Philippovich, the author of the most successful textbook in the entire German-speaking area at the time, developed economic theory and the theory of economic policy side by side. The state is at the centre of his concerns. Friedrich von Wieser put society (das Volk) before the economy (die Volkswirtschaft), and most of Schumpeter’s contributions during the 1910s and 1920s are devoted to public finance, fiscal sociology and the theory of economic policy. The case of Emil Sax is self-evident. Equally so that of Braun, and also Mises, whose monumental Die Gemeinwirtschaft after all was devoted to a problem of social economics, not of economic theory. Friedrich von

118 Jürgen G. Backhaus Hayek has re-established this rich tradition of political economy, beginning with his Road to Serfdom and leading on to the trilogy Law, Legislation, and Liberty. A different and strikingly modern position is taken by Eugen Böhm von Bawerk in his Macht oder ökonomisches Gesetz?. In order to overcome the methodological pluralism that for instance Philippovich was arguing for, he pleaded for use of marginal utility analysis to be extended to cases where power relationships were to be analysed. In citing Schumpeter’s (!) support, he proclaims that the influence of economic power on the distribution of wealth can only be understood by invoking the categories of marginal utility and subjective value: Daß die ökonomische Macht auf die Verteilungsverhältnisse nicht anders als durch das Medium der Kategorien vom “Grenznutzen” und “subjektiven Wert” hindurch wirken kann, ist eigentlich eine gar nicht fernab liegende Erkenntnis.2 (1975: 15) Here we clearly recognize the attempt, now being followed through by the “new institutional economists”, to explain the emergence and persistence of economic institutions with the extensive use of price theory. The specifically “Austrian” aspects Whether a particular author is counted among the Austrians or not often depends more on his or her political views than his or her economic contributions. Philippovich, who is numbered among the most successful of the Austrians in his time, tends not to be included because of his close cooperation with Schmoller’s group and his concerns for social policy. Goldscheid is hardly ever mentioned among the Austrians, although in his time his work was systematically noticed by them and built upon. Schumpeter is often considered only partly an Austrian, although in fact he is the archetypal Austrian. Braun’s work, along with that of Bresciani Turroni, made a pioneering contribution to the then underdeveloped field of the theory of economic policy. Yet it was apparently Mises himself who refused to suggest, as was his right, his student for the habilitation at the University of Vienna (the reasons he gave did not include anything referring to her qualification). Schumpeter, as the archetypal Austrian, combines these characteristics in his work: 1 2

a systematic use of modern theory, and notably marginal utility theory, in a variety of problems; an involvement and interaction with the central figures in the Austrian mainstream and their work;

Taxation: an Austrian approach 119 3 4

a systematic reliance on the history of economic thought; and a willingness to go beyond the confines of economics, as it happens to be defined at a particular time.

The choice of constitutions: Austrian economics today In this sense, Austrian economics and modern public choice analysis converge. Yet there are some issues where both traditions can more fruitfully meet than at others. Typical for public choice analysis is the concern with structures in the economy and the polity as they predetermine individual actions, and as those actions translate into social outcomes. This is germane to the view of Böhm Bawerk, who wanted to specify the constraints as precisely as possible in order to fruitfully invoke marginal utility analysis and thus predict individual and societal outcomes (1975: 17). Yet Austrian economics can also contribute a broader interdisciplinary and historical perspective, two perspectives that are not alien to each other, but tend to be less emphasized in public choice analysis; and finally, Austrian theory contributes the notion of entrepreneurship in both economics and politics. All these aspects pertain to discussions about the tax constitution of a particular state. It is for this reason that I try to show what Austrian economics can contribute to the modern discussions involving a tax constitution for Leviathan.

A tax constitution for Leviathan Tax constitutions Since “the budget is the skeleton of the state stripped of all misleading ideologies”,3 discussions concerning the practice of public finance and budgetary choice as well as the theory of public finance politics,4 although on the surface being simply concerned with “technical” decisions on budgetary planning and balancing, basically aim at nothing less than defining the role of the state in the economy. This definition and delineation can be rather an inconspicuous continuous process embedded in the normal course of day-to-day politics. Sometimes, however, the underlying issues are brought out succinctly into the flashlight of public debate. In the United States, during the 1970s Proposition 13, the quest for balanced budgets (see, for example, Buchanan and Wagner (1977), and the call for a constitutional convention to solve the problem of ever-growing debts come to mind as characteristic elements of the debate; while in the European context, the demand to “privatize” public services5 or to reintroduce the benefit principle6 stem from a similar basic attitude towards principles of the fiscal constitution. Also, the introduction of a common European currency has been used as a lever for fiscal reform.

120 Jürgen G. Backhaus Along the same lines, a fundamental reorientation of public finance theory cum politics was proposed two decades ago by Professors James Buchanan and Geoffrey Brennan in a couple of seminar articles7 and two books in which the state is modelled as a bureaucratic Leviathan,8 and the task of the public finance theorist is to design a tax constitution for Leviathan in order to have a restless and never satiated bureaucratic state organization entrenched again by long-standing principles of “sound” fiscal behaviour. This is by no means the first time in the history of public finance theory that eminent scholars have sought to design a new tax constitution for a state that they, in consonance with at least parts of public opinion, felt had developed beyond the limits of its natural prerogatives and arrived at a critical stage where instead of therapeutic reforms a new structure (or constitution) was badly needed.9 By the end of World War I, two Austrian economists of differing political persuasion, Rudolf Goldscheid (1870–1931) and Joseph A. Schumpeter (1883–1950), engaged in an academic dispute centring around the question of how the (tax) state could cope with the accumulated burden of the war debt. Goldscheid, who saw an inevitable correspondence between the fiscal constitution of a state and its political activities (including warfare), on the basis of an extensive historical analysis carried out in the framework of his general theory of public finance (Finanzsoziologie), proposed expropriation of profitable industries by the state in order to repay the debt out of the profits earned with those industries. Thus, he pointed out, there would be no allocative distortion, which otherwise levying a heavy tax would generate by necessity. The proposal was made in the interest of a dual objective: on the one hand to restore the power of the state, and on the other to make sure these powers were used more responsibly in the interests of the citizenry. Such an outcome was conceivable since after the reforms the state would be referred to profits instead of taxes, public debts or money creation for meeting its financial demands. Schumpeter, who was later appointed the Austrian minister of finance, although sympathizing with most of Goldscheid’s concerns, favoured a solution by taxation, more specifically by capital levy. Unlike Goldscheid, although on the basis of a similar historical analysis, he could not conceive of a state fiscal constitution the backbone of which would no longer be some system of taxation. He proposed a property tax of expropriative nature, to be levied only once, and high enough to pay back the bulk of the war debt. The rest of this debt was to be serviced later out of normal tax revenues. Underlying this dispute is a problem much more profound than the question of how to design a technical solution to a politically intricate issue, in turn posed by an economy in a state of crisis. At issue in 1919 (quite similar to the situation in 1979 and 1999 referred to earlier) was the definition of the role of the state vis-à-vis the economy. While Goldscheid wanted to transfer profitable property to the state in order to achieve a proper balance between taxation and income out of

Taxation: an Austrian approach 121 profits, the industrial property serving as a base for (and ceiling to the extent of) public debt, Schumpeter did not see the necessity of abandoning the concept of the tax state, which he identified with the concept of the state itself. He wished the state to abstain from profitable entrepreneurial economic activity, wishing it to be distinct as well as distant from the economy. Although the contemporary situation is certainly not identical to the fiscal crisis of Austria in 1919, there appear to be quite a few parallels in both emphasis and perspective of the basic problems at issue. Therefore, a historical analysis of the issue “The tax state versus the entrepreneurial state” should help us to clarify some considerations that in present debates tend to be overlooked.10 Taming Leviathan Recent proposals for fiscal reform stem from two different though related sets of preconceptions. According to one line of argument (see especially Buchanan and Wagner 1976), Keynesian macro-economic policies of stabilization have, when carried out by democratic governments, eroded received fiscal principles. This happens because in a democracy, governments are rewarded for a partial application of Keynesian principles only; while deficits may be incurred during recessions, democratic governments are unlikely to run the offsetting budgetary surplus in period of a booming economy. Starting from this theoretical politico-economic background, a case is then made for a fiscal constitution to fulfil these criteria (see Buchanan and Wagner 1976: ctr. 12): first, being straightforward and its logic understood by the public; second, offering clear criteria for adherence or violation; and third, expressing values held by the citizenry. The principle of balanced budgets, to be relaxed only under a state of acknowledged national emergency, is proposed as a constitutional amendment fulfilling these three criteria. The principles laid down in the Treaty of Maastricht come remarkably close to this approach. Another line of argument, however, starts from a much more radical conception of the underlying politico-economic structure. This is a Manichean view of the politico-economic system, where the state, which emerged as the result of consensus among free human beings deciding behind the veil of ignorance at a pre-constitutional stage, soon turns into a revenue-seeking Leviathan, where [t]he citizenry has no effective or operational control over government, once established, beyond the constraints that are imposed at the constitutional level; in-period or post-constitutional fiscal decisions are made entirely by the budget-maximizing or revenuemaximizing politician-bureaucrat. (Buchanan and Brennan 1977: sect. 2)

122 Jürgen G. Backhaus In a later paper, the language is even more explicit. In it we have a utilitymaximizing “king” vis-à-vis the citizenry. Since – and here the argument is not unlike arguments in the European constitutionalist tradition – in a Leviathan model “individual voter-taxpayers exert control over the fiscal system only at the constitutional stage’’ (Buchanan and Brennan 1978: sect. 2), while being “essentially powerless to effectively control the government’s fiscal activities in post-constitutional political settings” (ibid.), the task is set to design a fiscal constitution, which hypothetically could have been agreed upon at a pre-constitutional stage and which effectively restricts Leviathan in its fiscal activities. There are two problems involved. On the one hand, purely concerning the revenue side, a tax constitution is designed that limits Leviathan’s access to the citizens’ property. Among the various principles underlying a tax constitution such as problems of equity or the minimization of “excess burdens”, in the context of the Leviathan model of post-constitutional political process maximum revenue potential is thought to be the predominant issue in the selection of tax institutions (Buchanan and Brennan 1977: sect. 4). An argument is then made for the limitation of the tax base,11 and the further requirement is set that the tax levied on this somewhat restricted tax base should be uniform (in order to prevent discrimination among citizens as a device of monopolistic revenue maximization). A further restriction imposed on Leviathan’s total revenue by the tax rate structure is the principle of progressive taxation. An essential feature of this Leviathan approach to public finance theory is the attempt to design a tax constitution that is self-enforcing by the logic of politico-economic interaction, which it constitutes. This is brought out more clearly in a second paper by the same authors, where, more realistically, Leviathan not only is revenue seeking, but at least in principle also provides some valuable services. Leviathan, personified as a king, is an income maximizer, spending part of these revenues on valuable government output, and keeping the rest for itself.12 Starting from a simple relationship such as Yk  R  Gs  (1  a)R the problem to be solved by the public finance theorist giving advice to his or her society is almost identical to the task that the cameralist public finance theorists and advisers faced in continental Europe after the Thirty Years War: how to convince a prince or sovereign that it may be wise to spend part of his revenues (Yk) on public services (Gs), keeping the expenses for himself or his court (R) to certain limits. While the cameralists advanced a theory that positively related a and Yk in the long run, where Gs was to be regarded as an investment in the tax base to be developed (and later exploited), the Leviathan approach sets out to design a tax constitution establishing similar relationships for the bureaucratic welfare state.

Taxation: an Austrian approach 123 B Q 45°

E

T

C

a  DC/ DE Q

D

G

Figure 6.1 Relationship between tax base and public services.

The fiscal principle derived from this analysis amounts to postulating for each class of public expenditures a tax base B such that there is a strong complementary relationship between G and B (QQ in Figure 6.1). In the graphical example given, the king, in maximizing his revenues, will provide expenditures up to point D on the abscissa, at a cost DC and a net revenue of CE.13 The entrepreneurial state Where partisans of the Leviathan approach to public finance seek to design elements of a self-enforcing tax constitution, the underlying conception of the interaction of the citizenry and the state is invariably rather predetermined. This is also characteristic of the basic design of the fiscal constitution, which mainly consists in postulating a technical relationship such as between tax base and tax revenue, or tax base, tax revenues and outlay of public services. These technical relationships later serve as a basic rationale for the fiscal constitution, in the institutions of which Leviathan, appropriately entrenched, can put its inherent vigour to some socially useful purpose. Quite obviously, such technical relationships as those postulated by Professors Buchanan and Brennan as well as by others do indeed exist. The cameralist insight into the interdependence between (productive) public spending and the richness of revenue sources is an example. (In order to avoid further repetition, I shall denote this as the “cameralist relationship”.

124 Jürgen G. Backhaus T1

YkT  f

 G  t0 t

s

t  (1, . . ., T)

The insight into the exhaustibility of tax bases, implying an optimal rate of exploitation, gave rise to the famous excise tax dispute (Akzisenstreit) in the seventeenth century. (As tax policies have gone beyond the optimal point, rate reductions can increase revenue; this feature was part of Schumpeter’s argument (1954b), and the graphical representation of the relationship has since come to be known as the “Laffer curve”.) These relationships, however, would hold true irrespective of the constitution and raison d’être of particular states, even over time, whereas the difference in fiscal organization – that is, the scope for creative constitutional design – should be expected not to be determined by “technical” interdependencies. The roots of contractarian or constitutional reasoning are to be found in the tradition of liberalism. The doctrines of liberalism, in so far as they are quite different from the present Leviathan approaches, centred around two related sets of civil rights for which constitutional guarantees were sought as a means of protection against the discretion of the king or sovereign: this is because as far as the absolute ruler is concerned, property and the domain of individual liberties are substitutes; in principle, for each infringement on individual liberties imposed by a ruler to further some of his or her interests, there is a functional tax equivalent with which these interests can be equally served, and vice versa. This broader view is also taken into account by Goldscheid, who accordingly advanced an evolutionary theory of the state in which, initially, the state as personified by the prince could seek either revenues or services in kind. Goldscheid’s theory systematically relies on this dualism, upon which a second dichotomy is constructed. There are two classes of citizens in the population: the owners of labour and the owners of capital. While the state is able to tax the former and, beyond the point of optimal tax extraction, demand services in kind, capital, which in his model is more flexible and powerful, is only borrowed, and the state incurs the public debt. Where the first group actually contributes to the state’s expenses through taxes or (mostly military) services, the second receives a claim in return, a claim that has to be satisfied later out of the general tax revenues or by services in kind. These services, in particular the draft, play a crucial role in Goldscheid’s politico-economic analysis, which is also designed to explain the extraordinary duration of World War I. Both Goldscheid (1919: 77) and Schumpeter (1954: 28–29; 1976: 358) agreed that some state activities, such as the war, could never have been carried out had the enormous cost immediately and visibly been shifted to an identifiable public through expropriative taxes. Schumpeter argued more technically in terms of the maximum exhaustibility of the tax base, whereas Goldscheid put forward

Taxation: an Austrian approach 125 his interest group perspective, whereby the creditors to the public (capital owners) had no interest in ending the war, never expecting to be required to foot the bill – rather, receiving reliable promises that they would be repaid. In either case, the war debt contributed to fiscal illusion in that it covered up the destruction of real resources and property and so helped carry out policies that, had their true costs been obvious to the citizens, would never have been accepted. When honouring the war debt, in Goldscheid’s model, the labour class would end up with the entire bill as the creditors to the public demanded their interest and repayment out of the national dividend. It is here that Goldscheid’s peculiar approach to the notion of human capital (Menschenökonomie) becomes relevant. Whereas the contributions of the labour class to the expenses of the state represent real goods and services, either taxes (which represent part of the national product), services in kind or other infringements on individual liberty, the capital class contributes only credits, which are to be repaid. Thus, even when real capital, human and material, is used up or destroyed, only the owners of material capital continue to present claims. These claims constitute political leverage, which, still according to Goldscheid, the creditors use to have the state governed in their own interest. Whereas this model was obviously constructed under the impression of politico-economic interaction during World War I in Austria and Germany, Goldscheid’s proposal for fiscal reform was based more broadly on his unorthodox interpretation of the fiscal history of the state, from the Middle Ages to his time. This story begins with a strong state, independent and relatively rich, relying on large property holdings. Only after the Thirty Years War, however, did the rising demands of the budget exercised by war finance and the desolation of the country give rise to a new approach to economic policy: cameralism, in which the state, gradually transforming itself into the tax state, follows policies of economic development in order to strengthen the tax base, notwithstanding engagement in traditional and new forms of public entrepreneurship – both types of policies aiming at long-run revenue maximization. This dual policy is constrained by the two relationships governing fiscal technology as discussed earlier: first, the cameralist relationship as the interdependence between public spending and the productivity of the tax base; and second, the experience of rising marginal costs of tax extraction, which leads to the definition of a point of optimal extraction (Laffer curve). In this state of affairs the absolutist state acted as a residual claimer in both its roles as the tax state and as an entrepreneurial state, the fiscal and economic constitution being such that a conflict of interest between economy and polity did not arise; the absolutist state (Leviathan) was restrained by its own interests. This is certainly an example of a self-enforcing fiscal constitution.

126 Jürgen G. Backhaus Whereas this part of the story, although perhaps little known, is hardly disputed, Goldscheid’s special twist enters where the absolute state was transformed into a democracy. Under democratic institutions, not only was taxation strongly resented, but also voters could make this resentment effective, while claims on the democratic government as put forward by interest groups certainly did not decrease. This led the government to have more and more recourse to public debt as a means of financing activities, activities that came to be increasingly less in the interests of the majority of the citizens. Whereas the autocratic state had been rich and strong, the democratic state became weak and poor, being dependent on its creditors and carrying out their policies. After this, Goldscheid’s proposal will hardly come as a surprise. He demanded a restitution of the entrepreneurial state, effected through a levy on real capital, not just titles, to be transferred to the state as collateral for the outstanding public debt. From then on, the capital value of the state’s productive properties would constitute the ceiling to public debt. State entrepreneurship, alongside private entrepreneurship, which Goldscheid wanted to spare as much as possible by avoiding excessive taxation, would promote economic efficiency and growth, assisted by state policies no longer subservient to debtors’ interest, but informed by the state’s experience as an entrepreneur in the marketplace, and being carried out in the public interest. The tax state This fiscal constitution, the underlying ideas of which, in post-war Austria, became quite influential, was described by Schumpeter as a non-necessity. In retrospect it is surprising how Schumpeter, who never earned a reputation for being highly reluctant to use explicit language, did not take issue with the central points of Goldscheid’s argument despite the obvious flaws of the latter’s analysis, such as the dichotomous formulation of his model of politico-economic interaction, which leaves some problems of incidence and shifting patently unanswered,14 or the fuzziness of his human capital approach (Neumark 1977: 437). To be sure, Schumpeter was in dispute with Goldscheid on neither method of analysis nor – with minor exceptions – facts. But he interpreted these facts – what was – quite differently. Schumpeter’s somewhat pale hypothesis that reforming the tax state to become an entrepreneurial state was a non-necessity (not disputing the potential desirability of such a move), and the obvious parallels between Schumpeter’s and Goldscheid’s evolutionary analyses of the tax state (Schumpeter’s hypothesis seems to have been devised more in order to take issue with Schmoller15 than to refute Goldscheid’s analysis), have led me to the conclusion that Schumpeter actually might have favoured Goldscheid’s proposal, but feared that in the course of political development

Taxation: an Austrian approach 127 something quite different from Goldscheid’s vision would become reality. Where Goldscheid stresses the necessity of entrepreneurial discretion and scope for initiative and decision taking, of means to promote economic efficiency and pursue policies to foster economic growth, drawing a picture of administered state socialism that clearly matches any description of Leviathan (Goldscheid 1919: 201), Schumpeter seems to have feared that precisely this form of administrative state socialism, which Goldscheid attacked, as later Mises did, would be the imminent consequence of a reform along the lines of Goldscheid’s proposal (Schumpeter 1954: 34; 1976: 365). Tracing the history of fiscal organization back to the feudal state, Schumpeter insisted that the feudal lord did not represent the idea of the state at all, the entire feudal empire having been a system of quasi-private loyalties. Only when the common task of fighting the long wars against the Turkish invaders in the fifteenth and sixteenth centuries in consonance with a few similar objectives became imperative, did the principle of the common cause or public purpose win recognition, jointly with the principle of taxation. The rise of the state as a form of social organization was closely related to the development of a system of more intensive and efficient taxation, and the development of a state bureaucracy. As for the necessity to agree on a new fiscal constitution, Schumpeter was particularly reluctant. To recall, his position was this: technically, the tax state need not collapse; whatever may be the difficulties in implementing the solution to the fiscal crisis within the framework of the institutions of the tax state, these can only be political difficulties, not technical impossibilities. Therefore, they do not really relate to the structure of the tax state. This somewhat aloof treatment of the problem, of course, is a rather surprising one, in particular when Schumpeter’s general analytical approach is taken into account, which tended to be pragmatic as well as realistic, since Schumpeter emphasized the integrated analysis of political and economic developments in many of his other writings.16 Schumpeter’s entire proposal, capable of being outlined in a few sentences, was put forward under the somewhat disillusioning condition “[w]hatever may be politically feasible . . .”, implying that not even Schumpeter thought he was discussing realistic policy alternatives (Schumpeter 1954: 33; 1976: 363; original italics). The major fiscal operation that was needed, accordingly, was merely described as being predominantly a technical matter. In real terms, the expenses on the war had long been affected. It was “only” the outstanding bonds and titles that caused Schumpeter, the later Austrian minister of finance, some headache. Therefore, he proposed a capital levy payable in bonds, not in real property: The operation ends in the furnace, in which all cash and titles, which fall into the hands of the state, must be burnt. In the case of stock

128 Jürgen G. Backhaus certificates, the state would, of course, not burn them, but exchange them against cash or war bonds. (Schumpeter 1954: 33; 1976: 364) Was there no need to try to prevent a catastrophe of the sort that had struck Austria as a consequence of the war, from happening again? Why should Goldscheid’s proposal, which was designed to prevent such catastrophes from happening by imposing fiscal constraints, not be followed? And why should the state not be infiltrated with the spirit of efficient and enterprising management? Would this not prevent the state from continuing to take easy recourse to public indebtedness again and again? Schumpeter had essentially three answers to these questions. While he went a long way towards subscribing to Goldscheid’s proposal, the sociologist in him gained the upper hand over the economist when assessing the realism of what Goldscheid had proposed. First, he doubted that an entrepreneurial state can generate more revenues than a tax state can levy on private entrepreneurship by using a rigorous approach to taxation (herauspressen). This is what he says: Das entscheidende Kriterium ist, ob er [der Staat] noch – abgesehen von einer Monopolstellung, die er sich sichern mag – in einem Milieu von freier Wirtschaft arbeitet, dessen Daten und Methoden er auch für seine Betriebe hinnehmen muß oder nicht. Ist das der Fall, arbeitet er also vor allem in kapitalistischem Geist auf tunlichst hohen Geldbetrag hin, so ist das, was er dabei gewinnen kann, durch die ökonomischen Gesetze des kapitalistischen Produktionsgewinns umgrenzt. Und diese Grenzen sind enger als der Laie glaubt. Da der Staat natürlich mit einem Geldkapital arbeiten muß, wie jeder andre Unternehmer und sich dieses Kapital nur durch Leihe beschaffen kann, so wird das was ihm bleibt – auch bei äußerster fiskalischer Ausnützung einer eventuellen Monopolstellung und auch wenn wir ganz absehen von der tatsächlich so geringen Unternehmertüchtigkeit des Staates – sich kaum wesentlich über den Betrag stellen, den er aus derselben Industrie durch direkte und indirekte Besteuerung – die der Einkommen aus dieser Industrie eingeschlossen – herauspressen kann.17 We should observe at this point that Schumpeter argues in a Walrasian context. There are no innovative (state) entrepreneurs who can reap extra rents. This is at variance with Goldscheid’s vision, who anticipated that innovation would come from state entrepreneurship. The second of Schumpeter’s arguments against Goldscheid’s rests on political feasibility. Pushing the programme through would require a politician with superb skills and authority, a person Schumpeter obviously believed was nowhere to be seen:

Taxation: an Austrian approach 129 Wirkliches politisches und finanztechnisches Können braucht der Mann, der diese Aufgabe lösen soll – und jenen Glanz des Wollens und des Wortes, dem die Völker vertrauen. Außerdem hat die bisherige Behandlung der Fragen unserer Finanzpolitik eine fachgemäße Lösung beinahe schon präjudiziert.18 The last argument is again of a sociological nature. It actually shows that Schumpeter and Mises were travelling in parallel, though at some distance from each other. Schumpeter feared that Goldscheid’s proposals, despite their author’s intentions, would turn themselves into a bureaucratic nightmare, that “a bureaucracy would succeed in piling up mountains of red tape between us and the raw materials needed” (Schumpeter 1917: 57). A second look at Leviathan: what have we learnt? The flat assertion contained in Schumpeter’s first argument, however, is strikingly at variance with the contemporary property rights literature. The principle of the optimal exhaustibility of the tax base (Laffer curve) can certainly not be interpreted as implying that whatever the fiscal constitution may be, the state’s share can be regarded as predetermined and invariable. If this were true, reflections on the design of fiscal constitutions would not only be pointless; such a view would also imply a rather mechanistic, even deterministic perception of politico-economic interdependence. In terms of the structure of the argument, the situation here is not unlike the debate on the Coase theorem19 or the Modigliani–Miller theorem,20 stating that irrespective of the legal structure in a situation involving spillovers (the financial structure of a firm), the allocative result will be invariant. In the same way as in either of these cases, the institutional structure has an overall effect on the production possibility frontier of an economy, because under this analytical perspective, transactions costs have to be taken into account. Neither the relative positions of the state vis-à-vis the economy nor the societal production possibility frontier will remain unchanged when the fiscal constitution, which governs the interdependence of polity and economy, is restructured or amended. Starting from the proposition that the choice of the fiscal constitution is not irrelevant to the welfare potential of society, in the light of the preceding discussions, three problem areas deserve particular attention: 1 2 3

What is the politico-economic relevance of the public debt? How can self-enforcing constitutions be designed and implemented? How does a Leviathan state react to restrictions imposed by a fiscal constitution?

130 Jürgen G. Backhaus Public debt Economic theories of the public debt have traditionally neglected the politico-economic framework and conditions leading to the creation and specific incidence of the public debt. It was not until Buchanan (1958) challenged what he termed three fallacies21 of the received doctrine that the dimension of political interest was explicitly included in the analysis. Buchanan’s view that, to the lenders, taxes are fundamentally different from titles of public debt since the latter are voluntarily purchased while the former are not voluntarily paid, and that the burden of the debt falls on those taxpayers who have to finance the interests to be paid on the outstanding debt, is by no means unlike the view of Goldscheid, who also insisted on the difference between taxation (including services in kind) and subscription to the state’s debt. This similarity is not exploited by Professors Buchanan and Wagner, who focus on the pitfalls of Keynesian politics. Their argument in favour of strictly balanced budgets needs to be seen in the context of Lernerian functional finance. Buchanan and Wagner are mainly concerned with inflationary consequences of the public debt, disregarding the possible influence of the public debt on the formulation of particular policies. This effect, however, was precisely what Goldscheid had in mind. He went much further than Buchanan with his observation that political activities of economic agents are determined by the “portfolio” of their wealth. Public creditors are likely to favour policies different from those favoured by citizens to whom the state owes nothing, but whose earnings and earning capacities are subject to taxation and regulatory infringements, in particular when a public debt incurred earlier is served and honoured at the present time. This basic proposition, which firmly rests on Goldscheid’s politico-economic approach to public finance (Finanzsoziologie), adds significantly to an analysis of tax contributions. Goldscheid’s approach can also be used in order to derive testable hypotheses. Suppose that a new research programme is opened, focusing on new questions that relate to the problem of how to design an “optimal” fiscal constitution. In the context of advocating balanced budgets and largely excluding deficit financing, following Goldscheid’s approach, one has to ask: What will be the effect on the shape and contents of policy making? What are the policies usually favoured by public creditors? Which policies are usually financed by deficit spending? And which policies tend not to be affected by the mode of their financing? Likewise, within the broader framework of politico-economic interaction, it may be possible to relinquish the somewhat troublesome concept of fiscal illusion, to which recourse has to be taken if one wishes, within the framework of traditional analysis, to explain why some policies are unacceptable when financed by means of taxation, while they can be carried out if deficit financed.22

Taxation: an Austrian approach 131 Self-enforcing constitutions Constitutions can be said to be self-enforcing when they create an order or environment in which agents, in pursuing their own interests, achieve the “common good” as defined by the designers of the constitution (hypothetically in some pre-constitutional state of limited knowledge). In the case of fiscal constitutions, the problem is rendered intricate because there are two potentially conflicting orders, which have to be synchronized in terms of their reward systems: the economy and the polity. The present Leviathan approach to public finance seems to start from the assumption of an inherent conflict of interests among the dominant actors of the political sector (Leviathan) and those agents whose interests are decisive in the economy (taxpayer-consumers). The basic approach to the design of a new fiscal constitution for the Leviathan state is to restrict Leviathan, take away policy options and limit the scope of activity. At present there is no systematic attempt to synchronize interests that, under the present constitution, are at odds. Schumpeter, who in his time saw no need for a new fiscal constitution, nevertheless started from assumptions about the difficulties caused in the political sector in implementing policies following the logic of economic policies oriented at overall welfare considerations similar to the Leviathan assumptions. Goldscheid, however, designed a proposal that, despite its obvious shortcomings, is basically different from the Leviathan approach in so far as it constitutes a systematic attempt at synchronizing the interests of political and economic decision makers, and in so doing refers back to the cameralist tradition, which puts his approach squarely into the mainstream of continental public finance. The entrepreneurial state, in its own interest, pursues policies that are not at variance with optimal economic interaction. Restricting Leviathan When, in contrast, the restricting approach towards a tax constitution for Leviathan is followed, this immediately begs the question of how Leviathan is going to react. In order to be consistent, the Leviathan assumptions have to be made for any line of activity that could potentially be followed by a state authority.23 This problem only occurs when the designed constitution is not strictly self-enforcing. Further and further regulations have to be imposed, and the question of who is going to control the regulators arises by necessity. In this respect, approaches along the lines of Goldscheid’s analysis could prove to be productive in two ways: on the one hand, the integrated politico-economic analysis systematically explores all those areas where restrictions on Leviathan can be evaded by substituted political action. And second, attempts to synchronize political and economic actions by means of constitutional design can (and necessarily have to) improve our understanding of the underlying motivations and restrictions in both the polity and the economy.

132 Jürgen G. Backhaus

Concluding observations The purpose of this chapter is to show what Austrian economics can contribute to modern public finance analysis. While evaluating the marginal value product of this contribution has to be left to the reader, I feel that the following can be claimed. The systematic use of price theory in analysing public finance systems leads, first, to insights that systematically differ from standard public finance textbooks in the tradition of Musgrave. This is particularly so when, second, the key notion of Austrian thinking, the concept of entrepreneurship, is invoked and used to describe as well as prescribe state activity. Third, a careful historical overview over both theory and history, an exercise befitting an Austrian contribution, as we have seen, sheds new light on what to expect from state institutions and how to set up a constitutional order. And finally, pursuing an Austrian approach necessarily leads to trespassing beyond the standard confines of what economists are expected to do.

Notes 1 “There is a widely held opinion that political economy or economics, in the sense that covers all economic research, has only one single name, one single purpose and one single method. There is no bigger obstacle to understanding what economics really is about than this widely held opinion.” 2 “It is really not such a far-fetched insight that marginal utility and subjective value determine the distribution of economic power and wealth.” 3 Schumpeter (1954: 6) paraphrasing Goldscheid (1917: XIV, passim; [1965] 1976: 41). 4 This refers to a distinction to be made between the pure theory of public finance (in the Lindahl-Samuelson tradition) and an integrated economic theory of public finance politics in the Wicksell–public choice tradition. This approach is sometimes referred to as “fiscal sociology” – such as by Musgrave (1978) as well as in his and Stolper’s literal translation of Schumpeter (1954: 6, passim). This term refers to the otherwise unfamiliar notion of a generalized sociology as being an integrated economic theory of social interaction, as in Pareto’s Trattato di sociologia generale (1916). The appropriate term in contemporary German is Finanzpolitik. It has no apparent English equivalent and refers to a politico-economic theory of public finance. 5 This type of argument is embedded into a stream of thought referring back to Adam Smith; see Recktenwald (1978: sect. 5) with further references. 6 This is also referred to as the “benefit principle”. One of its strongest advocates is Wittmann (1970–1973, II, ctr. 6B, passim), see also Haselbekke (1987). 7 In particular, Buchanan and Brennan (1977, 1978). 8 The normative foundations of this approach were formulated earlier by Buchanan (1975) 9 Following Schumpeter, “crisis” should refer to a state of affairs where a system collapses for reasons following from its inner logic, where remedies cannot be found within the system, and where the causes of the collapse are not accidental, exogoneous (Schumpeter [1954b: 13] 1976: 337). 10 Incidentally, this approach suggests a Schumpeterian view on the usefulness of analysing the history of thought on economics (Schumpeter 1954c: 4–6).

Taxation: an Austrian approach 133 11 Apart from the assumptions on the dynamics of state organizations (Leviathan approach), the justification for this argument is somewhat weak: “Since it is inconceivable that anyone could ever anticipate an ‘efficient’ public–private sector mix that would require all potential income above subsistence for government purposes, it seems clear that a potential taxpayer-beneficiary would not select the comprehensive tax base at the constitutional level if he predicts post-constitutional governmental behaviour of the type that we have postulated” (Buchanan and Brennan 1977: 262). There are two classes of possible counter-arguments. On the one hand, it may be shown that there are different ways of restricting Leviathan; then the superiority of tax-base limitations would have to be established in response. Second, a partial analysis cannot really be expected to be sufficient, since, given Leviathan’s vigorous nature and zeal, limitations of one kind would predictably lead to Leviathan’s excesses where limitations are weak or absent. 12 To give an idea of how the authors think of this approach to relate to reality, the following quotation may be helpful: “Once given the taxing power, what is to prevent Leviathan from utilizing revenue to further its own particular purposes (a lavish court at one period in history; high salaries, perks, and congenial working conditions for politicians-bureaucrats as a class at another)? (Buchanan and Brennan 1978: 302–303). 13 The list of practical examples given by Buchanan and Brennan (1978: sect. 6) is by no means exhaustive, since there is no systematic exploration of the relationships between Gs and B. They rather refer to possibilities of conceptually individualizing collective goods – for example, when broadcasting is financed by taxes on receivers or, following Earl Thompson’s argument (1974), when defence expenditures are financed by taxes levied on capital on the grounds that capital accumulation increases the threat of external aggression. 14 For a critical evaluation, see Musgrave (1978: 11, passim), who also offers a criticism of O’Connor’s (1973) model, which builds on Goldscheid’s. 15 This becomes a little more obvious in Schumpeter (1926) and (1954: esp. IV ctr. 4). 16 See in particular Schumpeter (1985). 17 “The relevant criterion is whether the state – apart from its position as a natural monopolist – can still employ, in a free economic environment, the data and methods it can use for its own enterprises. If it can do so, the state operates in a capitalist spirit and with a view to maximizing profits. These profits are more narrowly circumscribed than is generally believed. The costs of capital the state is faced with – even if it exerts its strong position on the capital market – are hardly lower than those facing the competition. In addition, the state lacks entrepreneurial experience. Hence, the revenues the state can earn from a particular industry will hardly exceed the direct taxes, if they are moderate, that it can squeeze from the same industrial operations.” 18 “The man supposed to solve this problem needs not only political and fiscal technical skills, but also the will to solve it, and the people must have trust in what he says. On the other hand, our previous more technical treatment from the point of view of fiscal policy has rather pointed to the only, and very narrow, possible set of feasible solutions.” 19 This theorem was initially proposed in an article by Coase (1960). 20 See Modigliani and Miller (1958), as well as a compilation of the discussion edited by Archer and D’Ambrosio (1967). 21 The three fallacies challenged by Buchanan are (1) the assertion that the primary burden of the public debt cannot be shifted forward in time; (2) the view that internal public debt is fundamentally different from external public

134 Jürgen G. Backhaus debt; and (3) relatedly the assertion that international public debt is not similar to private debt. For a further discussion of received theories of public debt vis-à-vis Buchanan’s theory and a suggested new approach, see Gould and Jensen (1977). 22 Illusions, including “fiscal illusion”, do not necessarily escape economic analysis. Randall Bartlett’s (1973) treatment might be quoted as an example of an economic analysis of illusion creation. 23 Without any further consequence for their analysis, this is also acknowledged by Professors Buchanan and Brennan in a footnote: “Of course, restrictions on non-tax means of securing credit surplus (use of laws, commandeering without compensation, etc.) would be required, both in the case of tax liability and in our discussion to insure that the constitutional constraints are operative” (1977: 275).

References and further reading Archer, S.H. and D’Ambrosio, C.A. (eds) (1967), The Theory of Business Finance: A Book of Readings, Macmillan, New York. Bartlett, Randall (1973), Economic Foundations of Political Power, Collier Macmillan, London. Böhm-Bawerk, E. von ([1896] 1926), “Zum Abschluss des Marxschen Systems”, in O. Von Boenigk (ed.) Staatswissenschaftliche Arbeiten, Festgaben für Karl Knies, Verlag O. Häring, Berlin, pp. 85–205; reprinted, F.-X. Weiss (ed.) Gesammelte Schriften, vol. 2, Hölder-Pichler-Tempsky, Vienna and Leipzig, pp. 321–435. Böhm-Bawerk, E. von (1975), Macht oder ökonomisches Gesetz?, Wissenschaftliche Buchgesellschaft, Darmstadt. Bös, D. (1982a), “Crisis of the Tax State”, Public Choice 38: 225–241. Bös, D. (1982b), “Krise des Steuerstaates”, in G. Bombach, B. Gahlen and A.E. Ott (eds) Möglichkeiten und Grenzen der Staatstätigkeit, Schriftenreihe des Wirtschaftswissenschaftlichen Seminars Ottobeuren, vol. 11, J.C.B. Mohr/Paul Siebeck, Tübingen, pp. 354–393. Braun, Martha-Stephanie (1929), Theorie der staatlichen Wirtschaftspolitik, Franz Deuticke, Leipzig and Vienna. Buchanan, James M. (1958), Public Principles of Public Debt, Irwin, Homewood, IL. Buchanan, James M. (1975), The Limits of Liberty: Between Anarchy and Leviathan, University of Chicago Press, Chicago. Buchanan, James M. and Brennan, Geoffrey (1977), “Towards a Tax Constitution for Leviathan”, Journal of Public Economics 8: 255–273. Buchanan, James M. and Brennan, Geoffrey (1978), “Tax Instruments as Constraints on the Disposition of Public Revenues”, Journal of Public Economics 2: 301–318. Buchanan, James M. and Lee, D.R. (1982), “Politics, Time and the Laffer Curve”, Journal of Political Economy 90: 816–819. Buchanan, James M. and Wagner, Richard E. (1977), Democracy in Deficit: The Political Legacy of Lord Keynes, Academic Press, New York. Coase, Ronald H. (1960), “The Problem of Social Cost”, Journal of Law and Economics 3: 1–44. Coats, A.W. (1969), “Research Priorities in the History of Economics”, History of Political Economy 1 (1): 9–18.

Taxation: an Austrian approach 135 Corry, Bernard A. (1975), “Should Economists Abandon HOPE?”, History of Political Economy 7 (2): 252–260. Dietzel, Heinrich (1912), “Kriegssteuer oder Kriegsanleihe”, J.C.B. Mohr/Paul Siebeck, Tübingen. Dietzel, Heinrich (1919), Die Nationalisierung der Kriegsmilliarden. Eine Behandlung des von der Breslauer Fakultät der Rechts- und Staatswissenschaften gestellten Themas: “Wahres und Falsches an der derzeit viel gebrauchten Redewendung: ‘Das Geld bleibt im Lande’ ”, J.C.B. Mohr/Paul Siebeck, Tübingen. Goldscheid, Rudolf (1917), Staatssozialismus oder Staatskapitalismus. Ein finanzsoziologischer Beitrag zur Lösung des Staatsschuldenproblems, Anzengruber Verlag: Brüder Suschitzky, Vienna and Leipzig. Goldscheid, Rudolf (1919a), Grundfragen des Menschenschicksals: Gesammelte Aufsätze, E.P. Tal, Leipzig and Vienna. Goldscheid, Rudolf (1919b), Sozialisierung der Wirtschaft oder Staatsbankrott: Ein Sanierungsprogramm, Anzengruber Verlag: Brüder Suschitzky, Leipzig and Vienna. Goldscheid, Rudolf (1926), “Staat, öffentlicher Haushalt und Gesellschaft: Wesen und Aufgabe der Finanzwissenschaft vom Standpunkte der Soziologie”, in Handbuch der Finanzwissenschaft, vol. 1, ed. Wilhelm Gerloff and Franz Meisel, J.C.B. Mohr/Paul Siebeck, Tübingen, pp. 146–184. Goldscheid, Rudolf (1928), “Steuerverwendung und Interessenpolitik”, in Finanzwissenschaftliche Gutachten, ed. Walter Lotz, Teil I, Duncker & Humblot, Munich and Leipzig, pp. 8–46. Goldscheid, Rudolf (1958), “A Sociological Approach to Problems of Public Finance”, in Richard A. Musgrave and Alan T. Peacock (eds) Classics in the Theory of Public Finance, Macmillan, London, pp. 202–213. Goldscheid, Rudolf ([1965] 1976), “Joseph Schumpeter, Die Finanzkrise des Steuerstaats: Beiträge zur Politischen Ökonomie der Staatsfinanzen”, ed. Rudolf Hickel, Suhrkamp, Frankfurt am Main, 1976. Gordon, Donald, “The Role of the History of Economic Thought in the Understanding of Modern Theory”, American Economic Review 55: 110–127. Gould, J.P. and Jensen, Michael C. (1977), “Towards a Positive Theory of Public Debt”, manuscript, Rochester, May. Haselbekke, A.G.J. (1987), Profijtbeginsel en politieke besluitvorming, Stenfert Kroese, Leiden. Modigliani, Franco and Miller, M.H. (1958), “The Cost of Capital, Corporation Finance and the Theory of Investment”, American Economic Review 48: 261. Musgrave, Richard A. (1978), “Notes On Fiscal Sociology”, Harvard Institute of Economic Research, Discussion Paper 642, August. Musgrave, Richard A. (1980), “Leviathan Cometh – or Does He?”, Harvard Institute of Economic Research, Discussion Paper 744, February. Neumark, Fritz (1965), Grundsätze der Besteuerung in der Vergangenheit und Gegenwart, Wiesbaden. Neumark, Fritz (1977), “Die Finanzkrise des Steuerstaats (Review)”, Finanzarchiv, 536–538. O’Connor, James (1973), The Fiscal Crisis of the State, St. Martin’s, New York. Pareto, V. (1916), Trattato di sociologia generale, 2 vols, Barbera, Florence. Philippovich von Philippsberg, E. Freiherr (1893), Grundriss der politischen Ökonomie, I (19 1926), II 1 1899 (15 1923), II 2 1907 (11 1923).

136 Jürgen G. Backhaus Philippovich von Philippsberg, E. Freiherr (1886), Über Aufgabe und Methode der politischen Ökonomie, Freiburg. Philippovich von Philippsberg, E. Freiherr (1891), “The Verein für Socialpolitik”, Quarterly Journal of Economics 5: pp. 220ff. Recktenwald, Horst Claus (1978), “An Adam Smith Renaissance Anno 1976: The Bicentennary Output, A Reappraisal of His Scholarship”, Journal of Economic Literature 16: 56–83. Rogin, Leo (1956), The Meaning end Validity of Economic Theory: A Historical Approach, New York. Samuels, Warren J. (1974), “The History of Economic Thought as Intellectual History”, History of Political Economy 6: 304–333. Samuels, Warren J. (1982), “The Influence of Friedrich von Wieser on Joseph A. Schumpeter”, Presidential Address, History of Economics Society, May, History of Economics Society Bulletin 4 (2): 5–19. Sax, E. (1884), Das Wesen und die Aufgaben der Ökonomie, Vienna. Sax, E. (1887), Grundlegung der theoretischer Staatswirtschaft, Vienna. Sax, E. (1889), Die neusten Fortschritte der nationalökonomischen Theorie, Leipzig. Sax, E. (1892), “Die Progressivsteuer”, Zeitschrift für Volkswirtschaft, Sozialpolitik und Verwaltung, Vienna. Sax, E. (1924), “Die Vertragstheorie der Steuer”, Zeitschrift für Volkswirtschaft und Sozialpolitik, NS 4. Sax, E. (1930), “Bedürfnis, Wert und Vorzug”, Zeitschrift für Nationalökonomie. Schultz, Bruno (1960), “Die Geschichte der Volkswirtschaftslehre im Lehrbetrieb deutscher Universitäten und einiges zur Problematik”, in Otto Stammer and Karl C. Thalheim (eds) Festgabe für Friedrich Bülow, Duncker & Humblot, Berlin, pp. 301–318. Schumpeter, Joseph Alois (1913), “Eine ‘dynamische’ Theorie des Kapitalzinses, Eine Entgegung”, Zeitschrift für Volkswirtschaft, Sozialpolitik und Verwaltung 22: 599–639. Schumpeter, Joseph Alois (1913), “Zinsfuss und Geldverfassung”, Jahrbuch der Gesellschaft Österreichischer Volkswirte, Manzsche k.u.k. Hof-Verlags- und Universitätsbuchhandlung, Vienna, pp. 38–63; reprinted as pp. 1–28 of J.A. Schumpeter (1952), Aufsätze zur ökonomische Theorie, J.C.B. Mohr/Paul Siebeck, Tübingen. Schumpeter, Joseph Alois (1914–1915), “Die Wellenbewegung des Wirtschaftslebens”, Archiv für Sozialwissenschaft und Sozialpolitik 39: 1–32. Schumpeter, Joseph Alois (1917–1918), “Das Sozialprodukt und die Rechenpfennige: Glossen und Beiträge zur Geldtheorie von heute”, Archiv für Sozialwissenschaft und Sozialpolitik 44: 495–502. Schumpeter, Joseph Alois (1918), “Die Krise des Steuerstaats”, Leuschner & Lubinsky, Graz and Leipzig. Schumpeter, Joseph Alois ([1918], 1953), Die Krise des Steuerstaates, Leuschner & Lubensky, Graz and Leipzig; reprinted as pp. 1–71 in J.A. Schumpeter (1953), Aufsätze zur Soziologie, J.C.B. Mohr/Paul Siebeck, Tübingen; English translation by W.F. Stolper and R.A. Musgrave (1954), in International Economic Papers, vol. 4, Macmillan, London. Schumpeter, Joseph Alois (1919a), “Zur Soziologie der Imperialismen”, Archiv für Sozialwissenschaft und Sozialpolitik 46: 1–39, 275–310; reprinted as pp. 72–146 of J.A. Schumpeter (1953), Aufsätze zur Soziologie, J.C.B. Mohr/Paul Siebeck, Tübingen.

Taxation: an Austrian approach 137 Schumpeter, Joseph Alois (1919b), Grundlinien der Finanzpolitik für jetzt und die nächsten drei Jahre, Deutschösterreichische Staatsdruckerei, Vienna. Schumpeter, Joseph Alois (1920–1921), “Sozialistische Möglichkeiten von heute”, Archiv für Sozialwissenschaft und Sozialpolitik 48: 305–360; reprinted as pp. 455–510 in J.A. Schumpeter (1952), Aufsätze zur ökonomischen Theorie, J.C.B. Mohr/Paul Siebeck, Tübingen. Schumpeter, Joseph Alois (1925), “Kreditkontrolle”, Archiv für Sozialwissenschaft und Sozialpolitik 54: 289–328; reprinted as pp. 118–157 of J.A. Schumpeter (1952), Aufsätze zur ökonomischen Theorie, J.C.B. Mohr, Tübingen. Schumpeter, Joseph Alois (1925), “Eugen von Böhm-Bawerk”, pp. 63–80 of Neue Österreichische Biographie ab 1815, Grosse Österreicher, vol. 2, Amalthea, Vienna, Munich and Zürich; reprinted as pp. 82–99 of J.A. Schumpeter (1954), Dogmenhistorische und biographische Aufsätze, J.C.B. Mohr/Paul Siebeck, Tübingen. Schumpeter, Joseph Alois (1926), Gustav von Schmoller und die Probleme von heute, Schmollers Jarhbuch 50 (1): 337–388. Schumpeter, Joseph Alois (1926–1927), “Finanzpolitik”, Der deutsche Volkswirt 1: 827–830. Schumpeter, Joseph Alois (1927), “The Explanation of the Business Cycle”, Economica 7: 286–311. Schumpeter, Joseph Alois (1927), “Unternehmerfunktion und Arbeiterinteresse”, Der Arbeitgeber 17 (8): 166–170. Schumpeter, Joseph Alois (1927), “Die goldene Bremse an der Kreditmaschine (Die Goldwährung und der Bankkredit)”, pp. 80–106 of Kölner Vorträge, vol. 1, Die Kreditwissenschaft, part 1; reprinted as pp. 158–186 of J.A. Schumpeter (1952), Aufsätze zur ökonomische Theorie, J.C.B. Mohr/Paul Siebeck, Tübingen. Schumpeter, Joseph Alois (1951), Essays, ed. Richard V. Clemence, Addison Wesley, Cambridge. Schumpeter, Joseph Alois (1952), Aufsätze zur ökonomische Theorie, J.C.B. Mohr/Paul Siebeck, Tübingen. Schumpeter, Joseph Alois (1953), Aufsätze zur Soziologie, J.C.B. Mohr/Paul Siebeck, Tübingen. Schumpeter, Joseph Alois (1954a), Dogmenhistorische und biographische Aufsätze, J.C.B. Mohr/Paul Siebeck, Tübingen. Schumpeter, Joseph Alois (1954b), “The Crisis of the Tax State”, International Economic Papers 4: 5–38. Schumpeter, Joseph Alois (1954c), History of Economic Analysis, Oxford University Press, New York/London. Schumpeter, Joseph Alois (1970), Das Wesen des Geldes, Vandenhoeck & Ruprecht, Göttingen. Schumpeter, Joseph Alois (1975), “The Future of Private Enterprise in the Face of Modern Socialistic Tendencies”, History of Political Economy 7: 294–308. Schumpeter, Joseph Alois (1976), “Capitalism, Socialism and Democracy”, 5th edn, Unwin University Books, London. Schumpeter, Joseph Alois (1985), Aufsätze zur Wirtschaftspolitik, J.C.B. Mohr/Paul Siebeck, Tübingen. Seidl, Ch. (1982), “Joseph Alois Schumpeter in Graz”, Research Memorandum 8201, Nationalökonomisches Institut der Universität Graz. Seidl, Ch. (ed.) (1984a), Lectures on Schumpeterian Economics:. Schumpeter Centenary Memorial Lectures, Graz, 1983, Springer-Verlag, Berlin.

138 Jürgen G. Backhaus Spengler, Joseph J. (1968), “Economics: Its History, Aims, Approaches”, Journal of Economic Issues 2: 5–30. Spiethoff, A. (1949–1950), “Joseph Alois Schumpeter in memoriam”, Kyklos 3: 289–293. Stigler, George J. (1969), “Does Economics Have a Useful Past?”, History of Political Economy 1 (2): 217–230. Stolper, W.F. (1984), “Schumpeter: der politische Ökonom für die Neunziger Jahre?”, in D. Bös and H.-D. Stolper (eds) Schumpeter oder Keynes? Zur Wirtschaftspolitik der neunziger Jahre, Springer-Verlag, Berlin, pp. 1–44. Thompson, Earl (1974), “Taxation and National Defense”, Journal of Political Economy 82: 755–782. Weber, Max (1904), “Die Objektivität sozialwissenschaftlicher und sozialpolitischer Erkenntnis”, Archiv für Socialwissenschaften und Socialpolitik, 22–87. Wicksell, Knut (1896), Finanztheoretische Untersuchungen, Gustav Fischer, Jena. Wieser, F. von (1914), “Theorie der gesellschaftlichen Wirtschaft”, in Grundriss der Sozialökonomik, Sect. 1, Wirtschaft und Wirtschaftswissenschaft, J.C.B. Mohr/Paul Siebeck, Tübingen, pp. 125–144. Winterberger, G. (1983), Über Schumpeters Geschichtsdeterminismus, J.C.B. Mohr/Paul Siebeck, Tübingen. Wittmann, Walter (1970–1973), Einführung in die Finanzwissenschaft I–IV, Fischer, Stuttgart.

7

Some aspects of the relationship between the Freiburg school and the Austrian school Gerrit Meijer

Introduction This chapter identifies relationships between the Freiburg school and the Austrian school, specifically in the fields of economic theory and economic policy. No attention will be paid to the similarities and differences in the field of social philosophy and methodology. For the Freiburg school the chapter concentrates on W. Eucken, F.A. Hayek and W. Röpke; for the Austrian school it concentrates on L. von Mises and F.A. Hayek. Schumpeter is also discussed. Contrast with Schumpeter illustrates what the fundamental interrelationships between the Freiburg school and the Austrian school actually are.

Eucken and the Austrian school Eucken and the Freiburg school It is important to begin with a brief introduction of Walter Eucken and the Freiburg school. Walter Eucken (1891–1950) was professor of economics in Freiburg, Germany. The Ordo school, of which he may be regarded as the founder or head, originated in Freiburg in the 1930s. The term “Ordo school” was coined by Hero Moeller to refer to the ideas of the contributors to ORDO (Jahrbuch für die Ordnung von Wirtschaft und Gesellschaft, founded by the lawyer Franz Böhm and Eucken in 1948). (For a fuller treatment, see Meijer 1987a, b, 1988a, 1994.) It is important for the argument of this chapter to note that F.A. Hayek and W. Röpke contributed regularly to ORDO. Although Hayek and Röpke did not belong to the Freiburg school in a strict geographical sense, there was mutual influence among Eucken, Hayek and Röpke. ORDO also published many articles on problems of international economic order, written in the Austrian tradition by authors such as Haberler and Machlup. But those ideas had been formulated in the 1930s, long before the founding of ORDO. In the work of Eucken (1990, Viertes Buch; first edition 1952) one

140 Gerrit Meijer explicitly finds six constitutive and four regulative principles on which a competitive order (Wettbewerbsordnung) is founded. According to Eucken, these six constitutive principles are: (1) stability of the monetary system; (2) open market, i.e. free entry; (3) private property, including private ownership of means of production; (4) freedom of contract, so long as it is not destructive of competition; (5) complete liability for economic actions; and (6) constancy of government policy regarding the economy. Eucken believed all six conditions were required, and needed to be realized simultaneously in order to have a well-functioning competitive economy. Apart from these constitutive principles, Eucken distinguishes the regulative principles that are directed towards keeping the competitive order intact. There are four of these principles: (1) a policy to attack monopolies (Antimonopol-politik); (2) a policy aimed at changing the distribution of incomes; (3) the fixing of minimum wages; and (4) a policy to equalize individual and social costs. Eucken and Mises Looking at points of influence of Mises on Eucken reveals important interrelationships between the Freiburg school and the Austrian school. The most important direct influence concerns the theory of the centrally administered economy. Eucken (1959, p. 255) thinks that Mises ([1920] 1922) is correct in his analysis of pricing for the completely centrally administered economy. This type of centrally administered economy has no exchange and therefore lacks pricing. According to Eucken, exact economic calculation is then impossible. For that reason, centrally administered economies encounter great difficulties in the long run. In practice, the centrally administered economy is never present in its pure form, but always exists in connection with a free exchange economy. In this mixed form, pricing can take place. To the extent that the exchange economy is more dominant, the above-mentioned difficulties are less pronounced. Eucken builds on Mises but his own theory is based on historical reality; in particular, experiences with the centrally administered economies in the Soviet Union and Nazi Germany. Eucken ([1952] 1990: 1939) refers in this connection to two post-war works of Mises: Planned Chaos (1947) and Human Action (1949). Besides this directly traceable influence, Mises also had an indirect influence on Eucken via his pupils Haberler, Hayek and Machlup. This primarily concerns monetary theory and business cycle theory. Their work on monetary overinvestment theory (in which monetary theory and capital and interest theory were brought together) was incorporated as a basic element in Eucken’s thinking on the business cycle. This theory originated in the Austrian school through work of Böhm-Bawerk, Mises

The Freiburg school and the Austrian school 141 (1924; first edition 1912), and also Wicksell, who had great influence. Eucken himself contributed to the development of these theories from the 1920s onwards in his own way (see Folz 1970; Yeager 1994). Another example of Austrian influence can be found in work on international economic relations. This is an indirect influence of Mises through his pupils Haberler and Machlup. These theories of Austrian economists have become generally accepted. In the Freiburg school these ideas were elaborated by Eucken, Gestrich, Lutz, Maier and Meyer. Eucken’s theory of market structures and price theory were not influenced by the Austrian school (see Eucken 1959; Meijer 1987b, 1988a). In this, Eucken has affinities with Chamberlin, Robinson and Stackelberg. He integrated and corrected their work by examining the historical record concerning variation in market structures. This is very important for his ideas on competition policy. Here there is distance between Mises and Eucken; and also between Eucken on one side and Hayek and Röpke on the other. It concerns a difference in opinion on the norm for competition policy: complete (not perfect) competition versus some kind of workable competition (Röpke 1962). Mises also disagreed with Eucken on competition policy (Röpke 1961: 10, 11). The constitutive and regulative principles are important for the national as well as the international economic order. Eucken explicitly worked out his constitutive principles for the international order (especially with regard to the monetary system, for which he was in favour of the commodity reserve standard and 100 per cent money). In the case of regulative principles, Eucken is also clear, although somewhat less explicit. These topics were not as important at that time as they are nowadays (the environment, multinationals), so he does not focus on them very much. In an article in ORDO titled Staatliche Souveränität und die Ordnung der Weltwirtschaft, Hans Willgerodt (1989) reviews the central ideas of the Freiburg or Ordo school on international order, especially the work of Eucken, Hayek, Lutz and Röpke. Willgerodt also asks whether regulative principles have to be enforced at the international level or whether it is sufficient that all nations follow them. He thinks international action may be necessary, for example, in the case of multinationals and the environment (i.e. with regard to border-crossing problems). In the same article Willgerodt shows the importance for the international economic order of all the six constitutive principles of Eucken. Eucken and Hayek In 1960 Hayek gave an inaugural lecture at the University of Freiburg, in which he acknowledged his affinity to Eucken and the Freiburg school. In his lecture, called ‘Wirtschaft, Wissenschaft und Politik’ (Economy, Science and Politics), he notes:

142 Gerrit Meijer Besonders musz ich aber der persönlichen Beziehungen zu Freiburger Kollegen gedenken, die mich schon seit Jahrzehnten mit dieser Universität verbinden. . . . Weitaus am wichtigsten für mich war aber meine langjährige Freundschaft, gegründet auf völlige Ubereinstimmung in theoretischen und politischen Fragen, mit dem unvergeszlichen Walter Eucken.1 (Hayek 1969: 1–2) Eucken tried to find out which orders (e.g. market and money) have existed and how they worked in practice and to understand them theoretically. He defends the competitive order and clearly points out that spontaneous orders have to be made to conform to this system (Eucken 1990: 179). Hayek’s position was that by studying the evolution of human society it would be possible to find out where the existing order had made developments that had to be corrected (e.g. money) and in what way, and that it would be possible to foresee where it would go wrong (e.g. his critique of Lange). But he warned against the hubris of reason and the possibility of destruction of freedom by the omnipotent totalitarian state. Therefore, he prefers selective intervention by the state – that is, planning for competition. Hayek advises limiting government regulation to the enforcement of rules that are necessary for the formation of a spontaneous order. Although a spontaneous order is thinkable without force, as a rule, (en)force(ment) is necessary. This is the task of government (Hayek 1973, 1976, 1979). In this respect, Eucken and Hayek were in full agreement. There is no fundamental disagreement between the two. Eucken and Schumpeter There are several important disagreements between Eucken and Schumpeter. Three of these should at least be mentioned here. They are interesting because they suggest important interrelationships between the Freiburg school and the Austrian school. With regard to centrally administered economies, Schumpeter (1961, III; first edition 1942) thought that there were no differences in principle between a free exchange economy and a centrally administered economy. Eucken (1948, 1990), however, developed a special theory for the centrally administered economy based not on abstract theory but on historical reality. With regard to the market structures of oligopoly and monopoly, Schumpeter wrote that they have dynamic advantages over perfect competition. Eucken attacks this opinion. He argues that oligopolies and monopolies infringe upon optimal equilibrium by negating consumer sovereignty. Schumpeter denies that there is any such thing as perfect

The Freiburg school and the Austrian school 143 competition. Eucken disagrees, and observes that Schumpeter’s ideas in this respect have no foundation in reality, when perfect competition is redefined as complete competition (for this discussion, see Eucken 1990: 38, 226, 239; Schumpeter 1961: ch. 8). The most important difference is that Schumpeter studied the development of capitalist society. He observed in a positivist way the forces and contra-forces in society. He thought the development from capitalism to socialism to be inevitable because the tendencies in this direction were stronger. Eucken argues that Schumpeter studied theoretical constructs of capitalism and socialism rather than the realities of capitalism and socialism, Schumpeter’s theories on the economic working of socialism and his theory of the cultural indeterminateness of socialism (especially that it could be combined with democracy) are not founded in reality. They are also theoretically untenable. Historically, this kind of socialism has never existed and will never become reality. The same can be said of the combination of socialism and democracy, which Schumpeter thinks is possible. Eucken, on the other hand, looked for theoretically grounded yet practical avenues for creating and maintaining a well-functioning humane economy (ORDO), and he recognized that a competitive order would be at the heart of a functioning humane economy (Ordnung); for this discussion, see Eucken 1948, 1990; Schumpeter 1961).

Röpke and the Austrians Röpke’s life and work Wilhelm Röpke was born in Germany in 1899 and lectured at the universities of Jena, Graz and Marburg. In 1933 he was dismissed by the Nazis, who had just come into power, because of his anti-national socialist behaviour. He left for Turkey (the University of Istanbul). In 1937 he became a professor at the Institut des Hautes Études Internationales in Geneva, where he remained until his death in 1966. After World War I, in which he had to serve, Röpke studied political sciences (Staatswissenschaften, political economy). In the 1920s and early 1930s he devoted himself mainly to the study of economics. In his contribution to the compilation of articles published on the occasion of Röpke’s sixtieth birthday, Hayek (in Röpke 1959: 25–28) tells us that he and Röpke came into contact because they were both working on monetary and business cycle theory and problems of international economic relations. Röpke made important contributions to all these subjects and also to public finance. In this respect he worked in the Austrian tradition. Besides these “Austrian” influences, Röpke was influenced by the sociologist A. Rüstow (1885–1963), who, like Röpke, became a professor at the University of Istanbul and did not return to Germany before 1949. In 1950

144 Gerrit Meijer Rüstow was appointed to succeed Alfred Weber at Heidelberg (Meijer 1988b: 77–80). Röpke and Rüstow extended the renewal of liberalism in a sociological direction, just as Müller-Armack did. But Rüstow’s influence is already apparent in the English translation of Röpke’s book on business cycles (1936; an extended version of the German book of 1932), in his textbook on economics (1954; first published in 1937) and in Rüstow’s appendix to Röpke’s book of 1942 on international economic disintegration. From this time onwards his publications are mainly on international economic and political relations and on the political and sociological problems of Western society. In this respect there is also a close parallel between Röpke and Hayek. The concern of both changed more and more from theoretical economics to political problems. During and just after the war, Röpke published his trilogy Die Gesellschaftskrise der Gegenwart (The Social Crisis of Our Time, 1943), Civitas Humana (1946) and Internationale Ordnung (1945), in which he elaborated his ideas on economic and social policy at the national level as well as from the international perspective. In these books the influences mentioned earlier are clearly recognizable, especially the influence of Rüstow, who published his trilogy Ortsbestimmung der Gegenwart between 1950 and 1957. The programme of social and economic policy that Röpke advocates includes four supplementary groups of measures. First, there must be measures to create and maintain the institutions of an economic order based on competition (Wettbewerbsordnung). This is the policy of economic order (Rahmenpolitik), and it includes a policy directed against monopolies. Second, he wants to interfere in the economic process. This he calls the policy of the economic process (Marktpolitik). He looks for policy criteria to guide this interference. In the footsteps of Rüstow, he is in favour of adjustment interventions. Changes in the data of the economic process often bring painful adjustments for the economic subjects involved. Then only those interventions that do not resist the dynamic working of the formation of prices are acceptable. Intervention should speed up the adjustment process and make it less painful. The second criterion is that of compatible and non-compatible (conforming and non-conforming) interferences. With each measure one has to ask oneself whether the instrument used is compatible with the market economy. According to Röpke, interventions that are not market compatible will lead to collectivism. This position is in agreement with that of Mises ([1926] 1929) and Hayek (see Hayek 1976, II: 128–129, 188). Third, measures are needed that together form economic–social structure policy. They aim at changing the income and property distribution, the size distribution of firms, the distribution of the population between city and countryside, and relative support for agriculture and industry. They concern the sociological conditions of the market economy. Röpke favoured fostering medium-sized and small firms and property formation, in order to fight proletarianization and massification. Such policies

The Freiburg school and the Austrian school 145 encourage dispersion of industry and deconcentration in industry. In this context he speaks of economic humanism. Finally, Röpke argued for a policy fostering societal conditions in which the market economy can prosper. According to Röpke and Rüstow, policies of this kind (the so-called Gesellschaftspolitik) had been almost entirely neglected by the liberals of the previous century. Fighting against massification and proletarianization, and fostering of agriculture, handicraft and dispersion of industry are absolutely necessary, in the view of Röpke and Rüstow. From this time on, Röpke’s influence – including international influence – grew very fast. His works were translated into many languages. He propagated his ideas wherever he could to influence public opinion. Röpke’s endeavours to institutionalize international contacts between scientists should also be pointed out. Together with Rüstow, he attended the Colloque Lippmann in Paris in 1938. This colloquium was held at the initiative of Louis Rougier, and named after the American publicist Walter Lippmann. Lippmann’s book The Good Society (published 1937) was the subject of discussion. After World War II a meeting, made possible by the endeavours of Röpke, was held in Vevey in Switzerland. Here, in April 1947, the Mont Pèlerin Society was born. Röpke became its second president in the 1960s, after Hayek (Hartwell 1995). During and after the war, Röpke immediately tried to influence the Allies, and wrote on the German problem (1947). His ideas became the background of German economic policy in 1948. They were accepted by Erhard and Müller-Armack. When Erhard’s economic reforms were fiercely attacked by American Keynesians, the Adenauer cabinet asked Röpke to write a report on German economic policy (1950a). The title of this report was Ist die deutsche Wirtschaftspolitik richtig?. In it Röpke defended German post-war economic policy and persuaded the US government to support the German approach to recovery. However, he was critical of Germany’s social market. This appears clearly in his study ‘Ein Jahrzehnt Soziale Marktwirtschaft und seine Lehren’ (1958a), and also his last book, Jenseits von Angebot und Nachfrage (1958b). Of special importance are his contributions to the meetings of the Aktionsgemeinschaft Soziale Marktwirtschaft (ASM) (whose first president was A. Rüstow). In these studies Röpke notes a general improvement in the situation since the publication of his trilogy. However, the economic-social structure policy and the Gesellschaftspolitik had been neglected. Röpke attacks the welfare state, especially as envisioned by Beveridge and Keynes. Röpke also complains about the fact that his criteria for sound economic policy are often neglected. Röpke and Mises Röpke himself recognizes that he has been deeply influenced by Mises. In this respect he mentions three books by Mises: Die Gemeinwirtschaft ([1920]

146 Gerrit Meijer 1922), Nation, Staat und Wirtschaft (1919) and Theorie des Geldes und der Umlaufsmittel (1924; first edition 1912). Röpke and Mises use the same broad approach (common in continental Europe in that time) to the study of society. In this connection I want to pay attention to Röpke’s ideas on the international economic order. He was strongly opposed to centralization in Europe and feared Fortress Europe. He was in favour of free migration (1950b: 607–645). Röpke’s experience in the two world wars and with red and brown totalitarianism during the 1930s and the 1940s was decisive in this regard. An important source of these ideas was, according to Röpke, Ludwig von Mises in his much-neglected book Nation, Staat und Wirtschaft (1919). A central idea in that book is the distinction between two categories of nationalism: liberal or non-aggressive nationalism (liberale oder pazifistische Nationalismus) and imperialistic or aggressive nationalism (militante oder imperialistische Nationalismus). The first is compatible with international peace, welfare and justice. This kind of nationalism is no barrier to international economic relations. This idea is also central to the thinking of Röpke. Similar ideas can be found in the work of Lionel Robbins (1937), who was also strongly influenced by the Austrians, especially in the 1930s. Another source of influence was in his case (and to some extent also in the case of Hayek) the English economist E. Cannan. In 1942 Röpke published a book titled International Economic Disintegration, which explores the causes and consequences of disintegration of the world economy in the twentieth century. According to Röpke, following in the footsteps of Mises, economic nationalism was the cause of disintegration. To overcome this situation he propagates denationalization of economic life, and especially denationalization of people (Denationalisiering des Menschen). Nevertheless, he thinks this is the second-best solution. Röpke thinks a better solution lies in the following direction, and in this he goes (like Robbins (1937) and Hayek ([1944] 1961)) a step further than Mises. The existence side by side of sovereign states endangers the peace, which is a prerequisite for a well-functioning world economy. The liberals in the nineteenth century (and Mises) were not sufficiently aware of this. They argued that free trade is advantageous for everybody and war is senseless and harmful. They thought that when all states conducted a liberal policy internally as well as internationally, international conflicts would be seen as senseless and would be avoided. This was a serious misunderstanding, according to Hayek, Robbins and Röpke. In order for a global economic order to function for the benefit of all, states have to surrender their right to conduct war (their sovereignty) to a federation. States should not be allowed to hamper free trade. Decisions about this rest upon the federal government. A federated government also needs to look after uniformity in legal orders to make the market order as effective as possible. World federalism has to be realized in stages if possible.

The Freiburg school and the Austrian school 147 After World War II the problem of European economic integration was under discussion. Röpke was rather sceptical with regard to the European Community. He expected Europe to split into two blocks, namely the European Community and the European Free Trade Area. He feared that cooperation within NATO would be disturbed, impeding realization of the Atlantic Community. Röpke and Hayek Röpke is sometimes considered a conservative; certainly when compared with Hayek. However, in his Constitution of Liberty (1960) Hayek never attacks Röpke and cites him only in a favourable way. In the postscript to this book, Hayek explains why he himself should not be considered a conservative. In his contribution to Gegen die Brandung (Against the Tide), Hayek mentions the civil courage of Röpke for discussing cherished ideas such as equality and full employment, etc. Of course, like Hayek, Röpke was looking for allies in his intellectual and political battles. Many of his allies were conservatives. But Röpke, although quoting Burke as an epigraph for his last book, was not a conservative. Even less so was Burke, also according to Hayek. Many conservatives, especially Russell Kirk, do hold Röpke in high esteem. Röpke’s ideas were, however, founded firmly in Austrian economics. Both Hayek and Röpke have to be given their full due for their work. Ever since the beginning of the industrial revolution there have been discussions on the development of society. We may mention St Simon, Marx, Mill, Schumpeter, Sombart and Rüstow. Röpke and Hayek shared their concern with the development of society. There were optimists and pessimists. There were those who thought society ought to be wholly restructured and that this could be done by using a combination of state power and reason (science). Hayek (1973, 1976, 1979) prefers selective intervention by the state, in the form of planning for competition. The spontaneous order may be improved by rules of reason. It is the government that has the task of doing this. For that reason, identifying necessary and sufficient conditions for the creation and preservation of the spontaneous order has always been at the centre of Hayek’s research programme. Therefore, Hayek (see also 1960) wrote extensively on problems of economic policy, to find out which policy ought to be conducted in order not to destroy, and if possible to improve, the spontaneous order. This is exactly the same attitude as we find in Röpke. Röpke and Schumpeter There are important parallels between the thought of Röpke and that of Schumpeter (Röpke 1959: 354–362; Schumpeter 1961). Their analyses of capitalism are similar, and they were both concerned with what they saw as

148 Gerrit Meijer the erosion of the foundations of capitalism. However, they fully disagree on the possibility and desirability of having a centrally administered economy – economically as well as politically. The difference may stem from intellectual style. Whereas Schumpeter constrained himself to studying theoretical constructs and observing with crossed arms, Röpke was searching for a third way and fought against the totalitarian centrally administered systems (collectivism) and capitalism.

Closing remarks A few remarks may be made at the end of this chapter. Considering main threads in the work of Eucken, Hayek, Mises, Röpke and Schumpeter helps us to better understand the relationships between the Freiburg and Austrian schools, and to appreciate the different positions of those schools on economic theory and economic policy. Schumpeter and Mises belong to the same generation of the Austrian school. Schumpeter studied the relations between socialism, capitalism and democracy but abstained from formulating ideas about policy. Mises staunchly defended liberalism and argued against centrally administered economy and interventionism. He (Mises 1959: 591–603) questioned whether the renewal of liberalism (the foundations of which were laid by Cannan, Knight and himself) would avoid interventionism. He (Mises [1926] 1929) distinguished Preistaxen (maximum and minimum prices) and Ordnungstaxen (prices fixed at the level of equilibruim market prices). Preistaxen had to be avoided. His critique on Eucken’s ideas on competition policy originates from this source. He thinks that Eucken’s policy approach would rely not only on Ordnungstaxen but also on Preistaxen. Eucken, Hayek and Röpke also sought concrete policy avenues for influencing the economy. In principle, the disagreement between the fundamental position of Mises and that of this triumvirate may be described as follows. In contrast to Mises, they thought that their diagnosis of the crisis of society had to be accompanied by policy recommendations showing a way out of that crisis. The crisis of the times was, according to them, so deep and severe that they felt obliged to do their utmost to turn the tide. They thought active policies were necessary. But in contrast to Schumpeter, they sought to avoid the kind of centrally administered economies and the kind of interventionism that Mises had warned against, using arguments they found convincing.

Note 1 “In particular, however, I should like to mention my personal relationships with colleagues in Freiburg, which have for decades now connected me with this university. . . . The most important association for me was my many years’ friendship with the unforgettable Walter Eucken, a friendship based on complete agreement in theoretical as well as political questions.”

The Freiburg school and the Austrian school 149

References and further reading Eucken, W. (1948), “On the Theory of the Centrally Administered Economy: An Analysis of the German Experiment”, Economica NS 15 (May and August): 79–100, 173–193. Eucken, W. (1959), Die Grundlagen der Nationalökonomie, 7th edn, Springer-Verlag, Berlin. Eucken, W. (1990), Grundsätze der Wirtschaftspolitik, 6th edn, J.C.B. Mohr/Paul Siebeck, Tübingen. Folz, W.J. (1970), Das geldtheoretische und geldpolitische Werk Walter Euckens, Duncker & Humblot, Berlin. Hartwell, R.M. (1995), A History of the Mont Pelerin Society, Liberty Fund, Indianapolis. Hayek, F.A. ([1944] 1961), The Road to Serfdom, University of Chicago Press, Chicago. Hayek, F.A. (1960), The Constitution of Liberty, University of Chicago Press, Chicago. Hayek, F.A. (1969), Freiburger Studien, J.C.B. Mohr/Paul Siebeck, Tübingen. Hayek, F.A. (1973, 1976, 1979), Law, Legislation and Liberty, 3 vols, University of Chicago Press, Chicago. Lippmann, W. (1937), The Good Society, Allen & Unwin, London. Meijer, G. (1987a), “The History of Neoliberalism: A General View and Developments in Several Countries”, Rivista Internazionale di Scienza Economiche e Commerciali 34: 577–591. Meijer, G. (1987b), “The History of Neoliberalism: Affinity to Some Developments in Germany”, Festschrift in Honour of Anghel N. Rugina, Part II, International Journal of Social Economics 14 (7/8/9): 142–155. Meijer, G. (1988a), Het neoliberalisme. Neoliberalen over economische orde en economische theorie, Van Gorcum, Assen and Maastricht. Meijer, G. (1988b), “Alexander Rüstow Commemorated”, HES Bulletin 10 (1): 77–80. Meijer, G. (ed.) (1994), “The Institutional Basis of Market Economies: Walter Eucken’s Contribution to Economics”, special issue of Journal of Economic Studies, vol. 21, no. 4. Mises, L. (1919), Nation, Staat und Wirtschaft, Manzsche Verlags- und UniversitätsBuchhandlung, Vienna and Leipzig; trans. L. Yeager (1983), Nation, State and Economy, New York University Press, New York. Mises, L. ([1920] 1922), Die Gemeinwirtschaft, G. Fischer, Jena; English translation, Socialism, Liberty Press, Indianapolis, 1981. Mises, L. (1924), Theorie des Geldes und der Umlaufsmittel, 2nd edn, Duncker & Humblot, Munich and Leipzig; English translation, The Theory of Money and Credit, Liberty Press, Indianapolis, 1981. Mises, L. ([1926] 1929), Kritik des Interventionismus, G. Fischer, Jena. Mises, L. (1927), Liberalismus, G. Fischer, Jena. Mises, L. (1947), Planned Chaos, Foundation for Economic Education, Irvingtonon-Hudson, N.Y. Mises, L. (1949), Human Action, Yale University Press, New Haven, CT. Mises, L. (1959), “Liberalismus”, Handwörterbuch der Sozialwissenschaften, vol. 6, Göttingen, pp. 591–603 (together with F.A. Hayek). Robbins, L. (1937), International Order and Economic Planning, Macmillan, London.

150 Gerrit Meijer Röpke, W. (1932), Krise und Konjunktur, Quelle & Meyer, Leipzig. Röpke, W. (1936), Crises and Cycles, W. Hodge, London. Röpke, W. (1942), International Economic Disintegration, Macmillan, London. With an appendix by A. Rüstow: “The General Sociological Causes of the Economic Disintegration and Possibilities of Reconstruction”. Röpke, W. (1943), Die Gesellschaftskrise der Gegenwart, vol. 4, E. Rentsch, Erlenbach and Zürich. Röpke, W. (1945), Internationale Ordnung, E. Rentsch, Erlenbach and Zürich. Röpke, W. (1946), Civitas Humana, 2nd edn, E. Rentsch, Erlenbach and Zürich. Röpke, W. (1947), The Solution of the German Problem, G.P. Putnam’s Sons, New York. Röpke, W. (1950a), Ist die deutsche Wirtschaftspolitik richtig? Analyse und Kritik, W. Kohlhammer, Stuttgart and Cologne. Röpke, W. (1950b), Barriers to Immigration, in Twentieth Century Economic Thought, Glenn Hoover (ed.) The Philosophical Library, New York, pp. 607–645. Röpke, W. (1954), Die Lehre von der Wirtschaft, 7th edn, E. Rentsch, ErlenbachZürich. Röpke, W. (1958a), Ein Jahrzehnt soziale Marktwirtschaft in Deutschland und seine Lehren, Schriftenreihe der ASM, Part 1, Verlag für Politik und Wirtschaft, Cologne. Röpke, W. (1958b), Jenseits von Angebot und Nachfrage, E. Rentsch-Verlag, Erlenbach, Zürich and Stuttgart. Röpke, W. (1959), Gegen die Brandung. Zeugnisse eines Gelehrtenlebens unserer Zeit, Gesammelt und herausgegeben von A. Hunold, E. Rentsch-Verlag, Erlenbach and Zürich. Röpke, W. (1961), “Blätter der Erinnerung an Walter Eucken”, ORDO 12. Röpke, W. (1962), Wettbewerb II, in Handwörterbuch der Sozialwissenschaften, vol. 12, Göttingen. Rüstow, A. (1950, 2), Das Versagen des Wirtschaftsliberalismus als religionsgeschichtliches Problem, H. Küpper, Zürich and Godesberg. Rüstow, A. (1950, 1952, 1957), Ortsbestimmung der Gegenwart, E. Rentsch, Erlenbach-Zürich and Stuttgart. Schumpeter, J.A. (1961), Capitalism, Socialism and Democracy, 4th edn, Allen & Unwin, London. Willgerodt, H. (1989), “Staatliche Souveränität und die Ordnung der Weltwirtschaft”, ORDO 41. Yeager, L.B. (1994), “Eucken on Capital and Interest”, in G. Meijer (ed.) “The Institutional Basis of Market Economies: Walter Eucken’s Contribution to Economics”, special issue of Journal of Economic Studies, vol. 21, no. 4, pp. 61–75.

I

Health, education, and welfare

8

A model of the dynamic welfare state Friedrich von Hayek revisited Manfred Prisching

Introduction The last sentence of this chapter was written the day Hayek died. I dedicate the chapter to his memory. During the past hundred years, Western democracies have developed a model of the welfare state that is considered appropriate to reconciling the principles of ‘democracy’ and ‘market society’. Thus, economic dynamics and social justice are combined. However, criticism concerning the sclerotic consequences of expansionist welfare programmes, which impede economic growth, and criticism concerning the patronizing attitudes of authorities, which threaten individual freedom, is receiving more and more attention. Since the 1970s, liberal ideas attempting to restrict government activities and to promote the free economic action of individuals have gained some force in capitalist countries. Moreover, after the decline of the planned economic systems in Eastern Europe, the Western paradigm, which is depicted as a model of pronounced economic and political liberalism, is being recommended to the post-socialist countries as an institutional opportunity to attain the income level of the most developed industrialized nations within a short period of time. Friedrich von Hayek has always been one of the proponents of the favourable system of Western capitalism, combined with the English-born model of liberal democracy (Hayek 1960; Butler 1983), and he has always emphasized the necessary connection of freedom in the economic and freedom in the political sphere (Hayek 1944). Therefore, he is one of the most famous critics of social policy in the welfare state, which he considers a dangerous phenomenon threatening the persistence of liberties in a free society (Hayek 1982). Some students of long-term economic developments ascribe the fact that the economic policy of Western industrialized countries has become much more liberal-minded since the mid-1970s not least to his increasing intellectual influence. This chapter deals with the relationship between Hayek’s theory of society and the limits of the welfare state. In the first section we will start

154 Manfred Prisching with the well-known story of welfare developments and expansionary state budgets. In the second section some fundamentals of Hayek’s theory of society are sketched, and in the third section the application of Hayek’s model to modern social policy is analysed. In the fourth section we will consider empirical findings concerning the Hayek model as deployed so far. In the fifth section a reformulation of Hayek’s model is provided, and the revision of the model leads us, in the sixth section, to a second application to social policy: to a model that retains Hayek’s aims concerning the stabilization of an innovative and dynamic society, but derives different conclusions – a more favourable assessment of welfare policy.

The expansion of the welfare state: a well-known story Concerns about the rising expenditures of state budgets started in the second half of the 19th century; Adolph Wagner (1879) tried to establish a ‘law’ describing the expansion of government activities. There may be lags in this process (Timm 1961) or displacement effects (Peacock and Wiseman 1967), and some empirical analyses display stages or non-linear developments (e.g. Borcherding 1977; Recktenwald 1977, 1978) – but the expansionary process obviously exists through time. At the beginning of the twentieth century, economists estimated that taxes could rise to 10 per cent of GDP before the economic process would be seriously impeded, while after World War II they increased their estimation of the dangerous level to up to 30 or 40 per cent. Since then, taxation in some countries has exceeded the remarkable figure of 50 per cent of GDP. The rise of budgets was paralleled by the increasing number of studies that analysed the reasons for the steady expansion of state budgets. Looking back over the past decades, we find that the most expansionist element in the process of budget growth was social expenditures (OECD 1985). Around the turn of the twentieth century, the social budget was about 1 per cent of GDP; in the 1980s, the OECD average was about a quarter of GDP, with some countries almost reaching a level of 40 per cent. The share of the domestic product that is used for pensions, health, family allowances, unemployment compensation and related purposes is rising permanently. There are severe difficulties in determining the factors that drive this expansionary development, even by carefully analysing the historical path of development. First, there are socio-economic theories. Wilensky (1975), for example, emphasizes that the most important variables that shape the path of social expansion are the level of economic development, the age of the social security system, and the demographic structure of a country. Similar findings are provided by Zöllner (1963), Cutwright (1964–1965), Aaron (1967), Pryor (1968) and other researchers. Second, there are neo-Marxist theories that explain welfare programmes by the deteriorating conditions for the process of production, which must be regulated by the state in order to safeguard the interests of the capitalists (Gough 1979;

A model of the dynamic welfare state 155 Offe 1985). These models, however, are unable to explain the differences in the levels as well as the rate of further expansion of social budgets between different industrialized countries. Third, there are functionalist theories in the Durkheimian tradition regarding anomic social tendencies (as operationalized, say, by divorce rates) as developments that demand additional money for social programmes; eroding social relations demand more security, but, considering the growing weakness of intermediary structures, the ‘private sector’ is becoming less and less able to meet these demands. However, these models also have difficulties in explaining differences between developed countries. Fourth, there are political theories, such as the models of Flora et al. (1977), Flora and Heidenheimer (1981), Alber (1983) and Castles (1982). They acknowledge the state as being a powerful institution that is able to shape historical and political evolution to a considerable degree (Skocpol 1979). They find that the degree of political mobilization of the working class, the domination of leftist governments, the weakness of right-wing parties and the type of constitutional order (monarchy or democracy) are relevant variables in the historical process. However, after World War II, ideological influences of this kind seem to decline; all governments take part in the process of rapid expansion of social policy. In the 1960s and 1970s some differences resulting from political ideologies could still be found, but the picture becomes even more complex from the 1970s to the 1980s: forces tending towards further expansion are intermingled with attempts at saving, but there is no clear pattern of an ideological justification of state expenditures (Schmidt 1982, 1986, 1988). The fact that the absolute and relative expansion of social expenditures generally continues, in spite of opposing ideologies and political programmes, has led to concerns about the ‘crisis of the welfare state’ (Prisching 1986; Pulkingham 1989). For liberal observers, the expanding welfare state is not only a problem for financial experts who have to cover the expenses, but also a danger for market society. Paradigmatic for the consequences of the decision against market society in favour of public welfare and expansion of state power is what Nevil Johnson calls the ‘British disease’ (1977). Governments are not able to keep societies on the path towards long-term aims without threatening the motivation of the citizens and the viability of the economy – this was, according to Johnson, the fundamental error of Keynes and Beveridge. Following the advice of these economists, the triumph of public welfare has been considered morally better than the pursuit of private economic interests. Keynes and his epigones optimistically believed that liberal collectivism was possible, as well as totalitarian collectivism. According to Johnson, they did not realize that liberal collectivism is necessarily unstable, that it enhances tendencies towards centralism and power, and, in the end, results in totalitarianism. It is a world of dreams that they propagated, one in which nobody is aware of the powers of tyranny (ibid.: 14–20). Hayek would fully agree with this condemnation of Keynesian policies.

156 Manfred Prisching

Hayek’s theory of society: evolution and adaptation According to Hayek, a German philosophy of history and a French rationalism of the Cartesian type aggravated the fundamental intellectual error that human beings, who have been able to create manifold social institutions, must equally be able to design or change their ‘social environment’ at will (Hayek 1937, 1945, 1960, 1970, 1982; Radnitzky 1984; Gray 1986; Vanberg 1986). Hayek’s central hypotheses may be summarized as follows: 1

2

3

It is erroneous intellectualism to think that we consciously choose institutions because of the expected advantages that they will deliver to us. In fact, institutions grow because of the advantages they actually provide. They come into being as a result of trial and error, and they stand evolutionary pressure because they are useful. Man learns to do things without fully comprehending them. In this perspective, Hayek’s theory is a modified social Darwinist approach (Gray 1986: 140ff.). Social order emerges out of human behaviour, which is guided by rules: Rules are behavioural patterns (in a descriptive sense), but they are also norms and values (in a normative sense). Most relevant institutions are ordered and structured, but essentially they are unplanned phenomena: elements of a spontaneous order. This means that they are patterns of human behaviour, but not the results of human design – like language, which cannot be supposed to have been constructed by conscious human will, or like customs, money, law and morality. Evolutionary success is the only proof of superiority. While this is true even for primitive societies, in the difficult realm of modern societies the complexity of relations and networks exceeds by far our capacity to plan and control. We have to rely on the decentralized mechanism of individual adjustment processes in order to coordinate human behaviour. There are only small parts of the whole system in which the conscious design of ‘organizations’ that are installed to attain concrete purposes may prove successful. Constructivist illusions about the viability and planning of the whole society fail because of the impermeable complexity of the world. We have but the chance to use the accumulated knowledge and experience of the generations before us. A spontaneous order is the unintended outcome of evolution.

This model goes back to the ideas of participants in the Scottish Enlightenment, such as Adam Ferguson’s History of Civil Society (1767) and Adam Smith’s Wealth of Nations (1776), and it is also based on the research of early members of the Austrian school, namely Carl Menger’s Investigations (1883). Menger applied the evolutionary perspective to several phenomena, including the state. He considered to be erroneous theories that tried to deduce the existence of the state from a consensus among founding

A model of the dynamic welfare state 157 members, because the state was the unintended result of the uncoordinated pursuit of individual interests (ibid.: 179f.). The coordination of economic behaviour by division of labour and by multilateral exchange must be understood in the same way: the market is the fullest deployment of the principle of the ‘invisible hand’.1 There are three important features of the model that must be emphasized if we want to apply the theory to social policy problems. First, Hayek relies on the historical process, which will secure the selection and persistence of efficient institutions. Groups that produce a superior system for regulating social and economic life, and that are able to institutionalize an appropriate way of transferring their cultural rules to their descendants, will be more successful in their process of reproduction. They will have a growing population, which allows improved specialization and division of labour, thereby increasing their lead. Other groups that develop more inefficient rules and institutions will shrink or will be destroyed. Group selection is the process that shapes human history. Ideas are part of the process of adaptation: groups that are unable to avoid constructivist illusions, and that, by wrongly applying interventionist policy, lower their level of efficiency are in danger of being eliminated. The attempt to intervene in a spontaneous order by direct commands will produce worse results compared to the decentralized procedure of coordination, or even wholly destroy the social order. Attempts to improve the unsatisfactory situation by special interventions will fail because of unintended side effects. Second, modern society is especially impossible to plan and control. Hayek’s belief that planning becomes more and more difficult turns on its head the socialist idea that a liberal order might be viable in a system of less developed economic relations, whereas modern society, with its complex structure, shaped by a process of rationalization thoroughly interpenetrating all realms of life, needs state management. It is precisely the growing complexity of modern society that does not allow increasing regulation, and renders political regulation more and more inefficient. The only way to come to terms with this situation is a withdrawal of government and a stronger reliance on decentralized market information through economic actors (Pullen 1989). Third, the self-stabilization of a spontaneous order needs freedom. Society needs adaptation to social change, and there must be leeway for the individuals’ permanent revision of ideas to secure progress for the future. There must be freedom to strengthen individual behaviour that produces unexpected (innovative) results in order to survive the evolutionary process of selection among competing rules, institutions and goals. A high level of conformity, which is the result of ‘planned progress’, lowers the chance for survival. Hayek is a libertarian who does not base his demand for freedom on moral grounds, or deduce his liberal values from a philosophy of natural rights, like Nozick (1974). Political liberty, economic

158 Manfred Prisching freedom and free speech are beneficial for society because they are more efficient than other types of social order.

Hayek’s application of the evolutionary model to the modern welfare state: the need for a liberal society Hayek’s struggle against the totalitarian consequences of social policy dates from his Road to Serfdom (1944) in which, faced with fascist and communist regimes, he tried to show that state interventionism would eventually result in a planned economic system: Interventionism that is based on the idea of the ‘benevolent despot’ leads to a totalitarian order, including a system of economic planning. But totalitarianism prevents adaptation and innovation so that, in the long run, the unfree society will not survive. Hayek, who is a classic liberal maintaining the ideas of the eighteenth century, seems to be an evolutionary optimist; but in considering the welfare state, he has no other feeling than deep pessimism. The application of his model of social change to the problems of social policy includes the following considerations: 1

It is irrational to deal with concepts such as ‘social justice’. In the introduction to the second volume of his Law, Legislation and Liberty (1982), Hayek confesses that he thinks the greatest service he could render to his fellow human beings would be to make them ashamed of ever again using that ‘hollow incantation’ social justice. He cannot detect any meaning in these words. The results of the market cannot be unjust, because nobody can control them and nobody can be blamed for the outcome. Life may treat people well or badly, but we cannot say that it is ‘unjust’ to become sick. Market society is neither just nor unjust – even if we avow that it does not reward individuals according to their efforts or give to them according to their needs. The market is beyond good and evil. We can describe events as being just or unjust only if people are guided by specific commands (as in the army or in a centrally directed system) and not by rules of ‘just’ individual conduct (as under the rule of law). It is like a parlour game: we make the rules, under which the outcome is unpredictable, and afterwards, when there are losers and winners, it is unreasonable to consider the results as ‘unjust’ – results that come about partly by skill and partly by chance. In the case of the market process, we have the same situation: ‘And while, as in a game, we are right in insisting that it be fair and that nobody cheat, it would be nonsensical to demand that the results for the different players be just’ (Hayek 1982: II, 71). Therefore, the problem of misery is eliminated by no longer conceding a semantic opportunity to speak about it (Dorschel 1988). The opportunity to change the rules is taken away too; for we are not able to forecast which rules would produce the desired distribution.

A model of the dynamic welfare state 159

2

The criterion by which to determine the ‘Good Society’ is one ‘which we would choose if we knew that our initial position in it would be decided purely by chance’ – similar to John Rawls’s ‘veil of ignorance’ or James Buchanan’s ‘unanimity criterion’ (Rawls 1971; Buchanan 1975, 1986). But while Buchanan, for example, allows for recontracting procedures as time goes by, Hayek does not concede bargaining opportunities for changing the rules. Individuals have nothing to do but maintain an attitude of humility towards the superindividual forces of evolution. Even moderate interventionism is too dangerous; a ‘third way’ for the economic system is impossible. The fall of man takes place when government is viewed no longer as an instrument for protecting property rights, but as an institution for redistributing wealth. In interpreting Hayek, contributors to a collection of essays want to show that, given the institutional arrangements of the mixed economy, the unequivocal outcome is that individuals in positions of authority will enact policies which are detrimental to society. Furthermore, such policies will be encouraged by individual members of society. We shall show that the mixed economy is synonymous with the rentseeking society. (Brough and Naka 1984: 84) According to Hayek, a welfare state that redistributes income and is anxious to realize ‘social justice’ will gradually transform its structures to socialism and finally use the violent measures that are characteristic of a socialist system. Therefore, Hayek tries to destroy any hopes for a ‘mixed system’ – a way between ‘planned scleroticism’ and ‘capitalist jungle life’, such as was proposed as a synthesis in the post-war models of soziale Marktwirtschaft. For Hayek, the spontaneous order of market society is no jungle; it has obviously produced general welfare at a historically unprecedented scale for all inhabitants of capitalist systems. In such a perspective, poverty is no problem: ‘Much effort goes into enumerating the presumed “causes” of poverty’, Thomas Sowell complains. You might think that wealth was something spontaneously appearing in nature – and automatically growing – so that its absence in an individual or a nation could only be explained by some malign intervention. You would never guess that what we call ‘poverty’ in contemporary America has been the fate of 99 percent of the human beings who have ever lived on this planet. Yet those who seek the ‘causes’ of poverty treat the other one percent as the norm – and look for mysterious or sinister reasons why everyone does not reach that norm. (Sowell 1984: 140)

160 Manfred Prisching

3

4

5

It follows that a liberal has to be concerned with how to limit the coercive power of government, not how to bring liberty or wealth down to the people (Brough and Naka 1984: 86). The modern understanding of democracy – the validity of majority rule – threatens individual freedom. The majoritarian principles of modern democracy enhance the departure from classical liberalism; the ‘doctrinaire democrat’ bases his or her intentions on popular sovereignty. But if we acknowledge that the majority of representatives in parliament may decide whatever they want, – that is, that majority rule is unlimited and unlimitable – the idea of democracy becomes the justification for arbitrary power. Constitutionalism means the limitation of all power, and not merely the condition that it is bound to certain procedures. The majority of the representative assembly is forced to do what it can to buy the support of several interests by granting them special benefits (Hayek 1982: 3). In spite of the system’s history of success, citizens of the industrialized countries reveal a dangerous deficit of understanding the complex mechanisms of the market order. The opposition against the market society is either rational (a social order will be accepted only if it is the result of conscious human planning) or irrational (it is demanded to revive deeply rooted values and altruistic sentiments that stem from the long history of human life in small groups). Both attitudes create a disposition that is favourable towards collective action – that is, for applauding any social policy programmes. Hayek argues that the sentiments that were developed in hunting and gathering societies are no longer appropriate in the ‘Great Society’. They must be substituted by reasonable selfcontrol – by the subordination of human action under abstract rules and formal procedures. The spontaneous order that is the only mechanism for coordinating individuals in modern life is endangered by expanding demands for collective programmes, especially in the realm of social policy. There is no conflict with the rule of law when the state provides minimal social security at the subsistence level. Hayek wants to push the state towards the periphery of social and economic activities, but he does not aim at a nightwatchman state. He concedes a minimal social net: There is no reason why in a free society government should not assure to all protection against severe deprivation in the form of an assured minimum income, or a floor below which nobody needs to descend. To enter into such an insurance against extreme misfortune may well be in the interest of all; or it may be felt to be a clear moral duty of all to assist, within the organized community, those who cannot help themselves. So long as such a uniform minimum income is provided outside the market to all those who, for any reason, are unable to earn in the market an

A model of the dynamic welfare state 161 adequate maintenance, this need not lead to a restriction of freedom, or conflict with the Rule of Law. (Hayek 1982: II, 87; cf. also III, 54f.)

6

But public subsidies have to be strictly limited to the minimal level: there must not be any protection against an unmerited descent from previous material positions; there must not be a redistribution of different social burdens, such as family allowances; government should withdraw from many tasks, conceding private schools, a private post office, private money supply; there is no need for local monopolies on communication, transport and energy supply to be in the hand of state authorities. Hayek even refuses such weak measures of redistribution as a progressive income tax. His arguments are as follows. The progressive tax means that the majority expropriates the rich minority. Thus, the tax does not represent a general rule because it applies only to a minority; the principle of the rule of law that all rules apply to all people is contravened.2 Interventionism suffers from an inherent dynamics of expansionism. There are two processes enhancing political interventions. First, the belief in ‘social justice’ renders a self-accelerating tendency to government measures: the more dependent the position of the individuals or groups is seen to become on the actions of government, the more they will insist that the governments aim at some recognizable scheme of distributive justice; and the more governments try to realize some preconceived pattern of desirable distribution, the more they must subject the position of the different individuals and groups to their control. So long as the belief in ‘social justice’ governs political action, this process must progressively approach nearer and nearer to a totalitarian system. (Hayek 1982, II: 68)

7

Second, according to societal complexity, interventionism fails, at least partially. Therefore, the adherents of social policy demand the expansion of government programmes to additional realms of social ‘needs’ to compensate for the failures. Paradoxically, failure does not lead to the elimination of interventionist measures, as a result of the experience that they do not work, but to an expansion of programmes. Therefore, every social project provides a new impulse towards growing state control. Inequality has its positive functionality. The elimination of prosperous classes threatens future economic growth. Selection is an essentially anti-egalitarian process. There are the following detrimental consequences of equalization. First, wealthy people are an example that

162 Manfred Prisching

8

stimulates other people to strive for higher income. Second, rich citizens ‘test’ products that are expensive during the first phases of production, but that are produced cheaply when mass demand comes into effect. Third, the rich are able to take risks and expand the frontiers of production. Fourth, wealthy people promote art, education and research, and they disseminate new ideas in policy, morality and so on. Fifth, because of their wealth, they are – if necessary – able to resist repressive measures of government. Creeping welfare interventionism spoils the mind of the people. Social policy destroys the consciousness of what principles that are fundamental for a free and dynamic society mean. First: any redistribution (such as a progressive income tax) demands that people should be treated unequally, so the principle that the same rules are to be applied to all people is shattered. Second: redistributional measures are not based on rules enacted with unanimous consent, so government decisions are arbitrary and not foreseeable. Third: general irreverence towards general rules grows. Fourth: every social group tries to profit from public programmes, so that ultimately distribution merely depends on the political power of different groups. The result is that the political sphere becomes a battleground where everybody tries to obtain a better place at the public trough. Love for freedom diminishes, and liberal society transforms into an assembly of happy slaves.

Some empirical findings: politics and growth Hayek’s arguments against illusions about ‘social justice’ rest on the assumption that fatal consequences must be expected for the political as well as the economic system if politicians attempt to realize them. As we are able to survey more than a century of welfare policy since Bismarck’s remarkable starting point of social security development, we should be able to find some empirical justification for the unfavourable effects of domesticated markets. First, countries with well-developed social security systems should be more endangered by authoritarian or totalitarian features than late-comers in social policy. Second, welfare-prone countries should exhibit poorer economic performance than ‘liberal’ states. There are no serious assertions that twentieth-century history might be probative for the political hypothesis of threatening totalitarianism. But social scientists have again and again examined the economic hypothesis: if the expanding welfare state causes economic sclerosis and lowers the dynamic development of national economies, a relation between the level of state expenditures and the growth rate (or other economic performance indicators) should be found in samples of industrialized countries. However, the findings are meagre. David Smith (1975), for example, found a weak and questionable association between public-sector levels and growth rates, but his sample was shaped by the special case of Japan.

A model of the dynamic welfare state 163 Kwang Choi (1983) found no relation between the role of government and the rate of economic growth. Samuel Brittan (1978) could not find an explanation for the poor performance of the British economy by considering the economic role of the state or the extent of redistribution to lowincome classes. Olson (1989) was not able to observe any relation between income growth per capita and the average percentages of GDP used for government expenditures plus transfers. Similar studies could be added. There are three ways to overcome this situation. The first option is to keep the model without any change and go on looking for appropriate figures. The second option is to analyse other possible reasons for unsatisfactory economic performance, and a wide array of possibilities is provided; let us only consider one example. Olson (1982) has supplied a model of growing distributional coalitions in stable political systems from which one can derive the supposition that the age of democracy explains institutional sclerosis with reduced economic growth rates. Weede (1991) supports such an explanation by contending that rent-seeking practices in democracies lead to price distortions and dysfunctional inequality – so ageing democracies transform themselves from systems with less inequality into systems with more inequality. In these models it is not the mere share of state budgets or welfare expenditures or the disincentives for individual motivation resulting from the well-developed social insurance system that explains unsatisfactory economic performance, but the intermediary factor of sclerotizing group privileges (Weede 1984). In this chapter I shall explore the third option: to modify Hayek’s model. I shall seek to interpret it in a way that maintains its central ideas but allows the welfare state to be considered in a friendlier perspective.

A reinterpretation of the Hayekian problem: limited knowledge, learning and constrained selection Hayek’s model can be preserved when it is detached from liberalist ideologies that are sometimes glued to it without necessarily being an element of the theory. I will develop four principles that modify Hayek’s model for our purposes. The first is the principle of limited knowledge – an attempt to balance Hayek’s despair concerning practical politics. It is the merit of Hayek’s theory that it shows the fundamental unpredictability of social development. It is uncertain how society actually develops and how interventionist measures work. It is also uncertain how the future preferences of people develop. Actually, the era of ‘fine-tuning’ and ‘golden age’ growth paths is over; the crises of the 1970s destroyed the self-consciousness of interventionists who had really expected to tune the economic process precisely according to their plans by using bigger and faster computers. They had to realize that complex systems provide surprising disturbances, turbulences, paradigm shifts, unintended side effects, even ‘revolutions’. The

164 Manfred Prisching experiences demonstrate the extent of ignorance; Alexander Cairncross (1976: 119) concludes: We know very little about the forces governing the rate of growth and still less about how to make them operate more powerfully. There is no simple or certain way of establishing the maximum growth rate of which a country is capable or finding out what rate or rates would be socially acceptable. We cannot be sure that the efforts of the state to accelerate growth will have a significant effect or that they will necessarily be beneficial in the long run. So we are in an area of almost total uncertainty in which economists have expressed themselves for thirty years with unbecoming assurance and have had to unsay in one decade a large proportion of what they said in the previous one. The second problem – the future of human preferences – is also part of a history of trouble: trouble for the social sciences. It is difficult to recognize reliable patterns that represent the expectations and values of individuals. There are theories of a general decline of values, of values converging between social classes, of strengthened pluralism and of equalizing mass culture, of rationalization and of the hedonization of life, of post-materialism and postmodernism, of shifting involvements, and many other theories are supplied, partly based on empirical research. Plans and projects that are based on ‘given’ preferences – that is, on unchanged psychological households of individuals, and on well-known ‘given’ circumstances of acting – must fail. It is reasonable to take uncertainty into account: the uncertainty of technocratic interventions as well as the uncertainty of future preferences. The new technocratic modesty should not, however, become a coquettish gesture of theoretical despair – and therefore shift towards political irrationalism. General uncertainty means: total paralysis of action. There is nothing more to be done. Long-term policy is unreasonable. Democracy is superfluous, because in a situation of perfect ignorance any decision is equally sensible. We may even dispose of democracy. If liberty has nothing to do with one’s choice and with the shaping of one’s life and personality; if liberty is limited to the fact that we are so blind that we cannot foresee what is going to happen; in a word, if liberty is basically our miscalculation, why should we care so much about it? (Galeotti 1987: 167) On the other hand, the unlimited belief in market forces is a secularized version of the belief in natural harmony of God’s world order; nature and culture melt into one another, and the myth of encompassing market

A model of the dynamic welfare state 165 rationality rises (Ulrich 1987: 96). Humankind is totally ignorant, and the natural-cultural process includes all historical wisdom. It is true that human knowledge is much too poor to get the historical process under control. But exaggeration of technocratic ignorance, to which some neo-Austrian writers are inclined, comes to the same result as exaggeration of technocratic capacities. If we did not know anything about tomorrow, we would permanently live in a situation of anomie and anarchy. In fact, human action is based on continuity – on the fact that society essentially is the same today as yesterday, and that most circumstances of the world in which we live will be the same tomorrow. It is not a situation of total uncertainty in which we have to decide; our basis is, rather, restricted knowledge. The same deliberation applies to the design of social institutions and to social policy programmes. The second is the principle of human learning and conscious action. Cultural evolution follows, as Hayek states, a Lamarckian rather than a Darwinian model. Rules that are modified by experience are transferred to the next generation; human beings may create new rules (Witt 1989). Why should it only be a ‘blind process’ of trial and error in which the rules are changed, and a ‘blind process’ of socialization in which they are transferred? Why should we subscribe to social-cybernetic reverence, acknowledging the superhuman regulation capacity of the ‘natural order’ – a giant machinery that is untouchable because the reproach of showing technocratic behaviour is directed towards people who want to give a turn to a screw of the machine. Actually, even markets were not the ‘natural order’ of economic relations; in early capitalism they were politically construed, and not only bourgeois merchants but enlightened kings and princes, supported by their deploying bureaucracy, were busy providing the preconditions for capitalist entrepreneurship. The state was an important actor in consciously creating the institutions that provided the framework for the modern economy. In fact, it was a process of trial and error – but a well-considered and often rationally planned process of institution building (see, for example, Sombart [1916–1927] 1987). The fact that intelligent problem-solving behaviour is hidden behind established rules and institutions is not excluded. These rules and institutions may have been improved by scientific advice or intelligent deliberation, and it may be possible to improve them further. Not every reform falls under the verdict of constructivist illusions or the arrogance of knowledge. Therefore, it is surely illusionary to reconstruct the whole of society; but this is not the problem of welfare policy. In general, social policy is not trying to build up a new society: it aims at the relief of special risks and needs in the existing one. The third is the principle of rule design. Hayek is used to confronting two social models: the spontaneous model, which represents a free market society in which government is a faraway legal machinery providing courts and streets, policemen and necessary administrative functions; and the

166 Manfred Prisching constructive model, in which the government continually attempts to decide concrete problems: by discretion, by commands or by individual instructions. The confrontation of these two paradigms not only ignores the importance of the state for institutionalizing and controlling markets, but also draws an inaccurate picture of social policy endeavours. Hayek’s perspective is restricted to the alternative: justice and redistribution plus commands and totalitarianism; or market outcome without any interventions. For example, by discussing social justice, Hayek deplores the misleading use of the term ‘distribution’, ‘which inevitably suggests a personal distributing agent whose will or choice determines the relative position of the different persons and groups’ (1982: II, 72). In another context he contends, ‘If “social justice” is to be brought about, the individuals must be required to obey not merely general rules but specific demands directed to them only’ (1982, II: 85). The reality of welfare policy is different. After a process of legalization, social programmes obviously consist of general legal rules. Modern interventionism tries to modify the framework of markets, the rules of the game, to improve the results according to majority values. We do not deal with the problem that impersonal market results which are the outcome of unanimous rules are considered ‘unjust’; the issue at stake is the modification of the rules of the market game, which in some cases produce undesirable results. The welfare state is not a system of caritas; we speak of a welfare state when legal obligations exist to which individual rights correspond. The idea of security and freedom stems from the epoch of Enlightenment, when individual rights had to be secured against feudal rights and absolute discretionary powers; in the nineteenth century security and freedom had also to be secured against the uncertainties and risks of the market process – by the same instruments as had been successful in limiting state power and securing the constitutional state, namely the enactment of general rules that are obligatory for citizens, politicians and bureaucrats. There is no reason why the welfare state should be a Hobbesian and not a Lockian state (Preuß 1990). There is an additional argument. It is just the legal institutionalization of rights which – against Hayek’s contention – makes the question of ‘justice’ in the single case superfluous: if the legal order acknowledges certain interests, there is no further demand for considering special circumstances or justifications, personal kindness, social position or political power. Modern security is no longer guaranteed by controlling all sources of uncertainty (as in the absolutist state) but by opening opportunities for action within a framework of rules that mark the limits of individual risk-taking. Hayek explicitly denies the possibility of implementing redistribution by guarding the Rechtsstaat, the rule of law: Such beliefs, however, overlook the fact that no specific pattern of distribution can be achieved by making the individuals obey rules of

A model of the dynamic welfare state 167 conduct, but that the achievement of such particular pre-determined results requires deliberate co-ordination of all the different activities in accordance with the concrete circumstances of time and place. (1982, II: 86) But suppose that the rules of criminal law allow suspects to be put on the rack to obtain confessions, or murderers to be publicly executed. If those rules are considered ‘unjust’, then we might modify them. If free contracts in the labour market result in pauperization and the ruin of labourers’ health, we are able to put constraints on those contracts. If families with many children fall below the material level of human living that we consider appropriate for a rich society, we are free to pass ‘general’ redistributional rules that compensate for a part of the burden. Therefore, Hayek’s attacks against the demand for ‘social justice’ do not meet the problem. Social policy is not necessarily a problem of individual commands by authorities, but it is a problem of framework modification. This strategy does not dismiss the principle that the remuneration people can expect to get for their work corresponds to the value their services have to their fellows, and that these values will often have no relation to their individual merits or needs (Hayek 1982: II, 72). The fourth is the principle of uncertain selection. Even selection does not work perfectly. Selection might work in the wrong direction, or might not work at all. The first problem may be illustrated by some old questions. What about market failures – that is, situations in which the spontaneous order as it develops from uncoordinated rational behaviour by many individuals lowers the opportunities for survival, because society gets caught in situations that are inefficient compared to situations that would be obtainable by well-designed collective institutions? What about externalities and public goods, phenomena that comprise more and more of the central problems in industrialized countries? What about wrong selection because of power relations? It seems too apathetic for people not to be able to do anything in all these situations. The second problem appears if we consider the possibility that a high level of inefficiency might be tolerated without the extinction of groups. Selective pressure for the human population seems to be weak nowadays, and survival depends on no more than some medical care and the supply of minimal food. How realistic is a process of group selection working by the growth or decline of populations when we compare, in today’s world, the most efficient market societies (with their decreasing population) and the underdeveloped nations (with their exploding numbers of people) (Witt 1989)? One might argue that successful societies are sustainable with low birth rates, which are desired by most people, while less developed societies have to develop preferences for more children. But if we suppose that evolutionary pressure works in spite of these empirical findings, we have to explain what essentially the indicator is that allows us to decide the

168 Manfred Prisching ‘survival fitness’ of a social order. If, on the other hand, evolutionary pressure is weakened, so that even less efficient societies survive, the richest countries might be able to produce a luxury good that we call ‘social justice’ – for it is no longer the threat of elimination that does not allow them to realize their preferences concerning social distribution or ideas of appropriate life for all group members. At the least, there is more leeway to provide social policy.

A second application of Hayek’s model to the modern welfare state: the economic and political value of social policy A dynamic society needs innovations, and it is obvious that the institutional framework may promote or prevent them. We may agree with Hayek’s hypothesis that it is only a free society that can provide the opportunity for social change. But what is a free society? According to Hayek, the focus of social freedom is the market. There are no other concepts of freedom that are taken into account. Cultural changes, which could produce human beings with attitudes that would generate a sufficient rate of innovations among other circumstances, are not considered; and it seems reasonable to neglect the possibility that human beings could become more ‘moral’ and less ‘egoistic’. We may, however, stay within the sphere of rational economic human beings, and we may ask which distribution of options and risks they may choose so that a high rate of innovation is obtained. First, for most individuals, competition is attractive only if certain risks are eliminated. The rate of innovation may not be high in circumstances when the lucky winner gets high premiums, but the very survival of the unlucky loser is threatened. An extremely liberal model may produce deficits of innovation, because risks are too high and the individuals optimize their welfare by staying at modest but secure income levels. A higher rate of innovation may be obtained when the loser is penalized, but only by falling to a lower level that nevertheless allows him or her to live decently, while the winner does not get the whole amount, but sufficiently high rewards for his or her risk. Many people start experiments if there is a social net. They dare to try more innovations if an error is not wholly disastrous for them. In this perspective, social policy is an instrument for optimizing the rate of innovation. It is not only an element of economic costs: money that could be used for better purposes (Bartel 1991). It is an investment good. Social policy has economic value. Second, the principles of the market order are agreed upon by the majority of people when certain risks – the risks of pauperization – are excluded by public programmes. The performance principle delegitimizes the social order if it confronts all members with the risk of pauperization; but if there are programmes that provide a certain acceptable standard of living, a situation

A model of the dynamic welfare state 169 that people call ‘social justice’, they are content with the inequalities of the system (Heidorn 1982). Public contentment is a public good; and there is nothing like a free public good. Social policy secures the consensus of the people and stabilizes the system of freedom. A peaceful society, on the other hand, is the fundamental precondition for economic stability, growth and innovation. Third, social policy has direct economic value. The facts are obvious, but Hayek is inclined to ignore them. It may be an efficient solution to pay unemployment compensation above the minimum level of existence, in order to maintain human capital that would be spoiled too quickly. It may be an efficient solution to provide a public school system for most of the population in order to enhance the abilities of the people who contribute to a dynamic and creative society. It may be an efficient solution to provide a sufficient level of old-age security that minimizes social conflicts and secures satisfying expectations for employees. It is possible to institutionalize these programmes in such a manner or to provide them at such a level that inefficient results are produced; but there is no justification for assuming that it is, in every case, the minimum level that produces optimal dynamics and efficiency. Fourth, it is possible that there is not enough social policy as well as too much social policy. Joseph A. Schumpeter, some decades ago, warned of transcending the limits of the tax burden that is compatible with a market society: if the will of citizens demands more and more public expenditures, so that increasing amounts of money are used for purposes for which the private person has not created them, if more and more power backs this development, and if private property and bourgeois life are considered in a new perspective – then the tax state comes to its end, and society depends on other incentives for economic activity, rather than individual egoism. There is a limit for the tax state, and it is possible for the system to come crashing down (Schumpeter [1918] 1976: 351f.). Nothing is wrong with this statement, and also Hayek’s warning concerning a rent-seeking society is wholly correct: redistribution is not only a matter of noble endeavours, but also a chance for egoistic profit opportunities (Buchanan et al. 1981). The rent seekers are supplemented by the ‘political entrepreneur’, a sort of dynamic personality who is not constrained to activities in the economic sphere. Political entrepreneurs discover more efficient and rational ways of meeting certain demands, of improving their own situation, of minimizing risks and transaction costs. There may be favourable as well as detrimental consequences of their activities. If they are politicians or bureaucrats, they share the goal of stabilizing their own position; they have an ‘interest in themselves’ (Vobruba 1983). If they can improve their standing by putting up social programmes, they will try to do so, even against the wishes of other groups. The central point of our discussion, however, is that the highest rate of innovation is not necessarily obtained when markets dominate all areas of life, only

170 Manfred Prisching slightly constrained by programmes securing subsistence levels; but that the highest rate of innovation will be obtained by an appropriate level and structure of social programmes which, according to the specific psychological dispositions of individuals, supplies a portfolio of opportunities with a ‘just’ distribution of risks and chances. Social policy may be justified by ideologies and values that are proposed to balance economic targets. But it is not the only possible perspective to consider welfare programmes as expenses that rich societies should afford for reasons of altruism and esteem of a decent life for all citizens. Hayek’s evolutionary theory of society provides some interesting arguments that can be used to show that modern welfare states may maximize their rate of innovation and guarantee their dynamics by implementing appropriate social policy. Social policy is not a mere aberration from the pure ideal of the optimal laissez-faire society, but the harbour of innovative power and dynamics that is demanded for coming to terms with the problems of the future. Fifth, the welfare state is the best example of a trial-and-error process in which social institutions are built. Social policy institutions have been developed in a heterogeneous way, by putting up rules and abolishing them, by translating institutions into reality and reforming them, by adding more and more bricks to a remarkable social building. The system of social security was not invented at a stroke. The mechanisms of the welfare state had to be designed and planned step by step, by persons or groups that wanted to realize their ideas or interests. Therefore, the welfare state is the result of a trial-and-error process – exactly the kind of processes that Hayek favours because they encompass the experience of decades or centuries and harbour the knowledge of past generations. If the historically transmitted institutions embody the wisdom of historical selection, the welfare state is the best example of it, and if we take Hayek’s advice seriously, we should not touch its structure. But if we consider Hayek’s model in a reasonable way we are able to acknowledge that, on the one hand, the welfare state is a favourable social innovation and the product of a balancing of experiences with the advantages of different principles of societal design; and that, on the other hand, the welfare state of the industrialized countries urgently needs a reform of some of its programmes – so that the welfare state remains an innovative system.

Conclusions The model of the innovative welfare state competes with other models of welfare development. There is no reason to assume that these models do not emphasize important variables that are responsible for welfare expansion. However, the innovation model might add a relevant perspective: the welfare state as the result of a trial-and-error process that incrementally

A model of the dynamic welfare state 171 built up a balanced structure of leeway for individual action and framework for social security. The model of the innovative welfare state is not a constructivist, but a constructive model. Not only is government driven by functional failures of the system and the need to compensate for them, but the ‘social market system’ is a social structure that is suitable for optimizing the rate of sustaining innovation. The argument runs against Hayek’s own application of his theory, as well as against a narrow-minded application of liberal ideology to the process of the market society. But its reinterpretation shows that Austrian theory may be used to describe a theoretical basis for the European market societies (Bryant 1991) that are presently in the process of adapting the framework of free markets. They have already proved the success of adding social aims to the structure of market efficiency, and a further adaption will include ecological aims. There is no reason why this enrichment of the framework of the market society should not be possible.

Notes 1 There are some problems connected with this evolutionary model: how to combine the individualistic approach with the model of group selection – because for Hayek it is competition between groups that produces social progress (Vanberg 1986)? How does the mechanism work which implements the transfer of rules to the next generation? Aren’t there many problems of public goods in modern societies where favourable solutions can only be reached by collective, consensual measures, and not by uncoordinated selfish behaviour? And there are more problems. 2 This is a strange argument. Why should a rule that applies to certain groups with certain characteristics not be ‘general’? First, most rules apply to ‘minorities’ – to bakers, car drivers, mothers or teachers. Second, if liberal society offers all individuals chances to get rich, one has to realize that the rule ‘potentially’ applies to all citizens.

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172 Manfred Prisching Bryant, G.A. (1991), ‘Europe and the European Community 1992’, Sociology 25: 189–207. Buchanan, J.M. (1975), Limits of Liberty, Chicago. Buchanan, J.M. (1986), Liberty, Market, and State: Political Economy in the 1980s, Brighton. Buchanan, J.M., Tollison, R. and Tullock, G. (eds) (1980), Towards a Theory of the Rent-Seeking Society, College Station, TX. Butler, E. (1983), Hayek: His Contribution to the Political and Economic Thought of Our Time, London. Cairncross, A. (1976), ‘The Market and the State’, in T. Wilson and A.S. Skinner (eds) The Market and the State: Essays in Honour of Adam Smith, Oxford, pp. 113–134. Castles, F.G. (ed.) (1982), The Impact of Parties: Politics and Policies in Democratic Capitalist States, London and Beverly Hills, CA. Choi, K. (1983), Theories of Comparative Economic Growth, Ames, IA. Cutwright, Ph. (1964–1965), ‘Political Structure, Economic Development, and National Social Security Programs’, American Journal of Sociology 70: 537–550. Dorschel, A. (1988), ‘Ist “soziale Gerechtigkeit” ein “sinnloser” Begriff?’, Österreichische Zeitschrift für Soziologie 13: 4–13. Flora, P. and Heidenheimer, A.J. (eds) (1981), The Development of Welfare States in Europe and America, New Brunswick, NJ, London. Flora, P., Alber, J. and Kohl, J. (1977), ‘Zur Entwicklung der westeuropäischen Wohlfahrtsstaaten’, Politische Vierteljahresschrift 18: 707–772. Galeotti, A.E. (1987), ‘Individualism, Social Rules, Tradition: The Case of Friedrich A. Hayek’, Political Theory 15: 163–181. Gough, I. (1979), The Political Economy of the Welfare State, London. Gray, J. (1986), Hayek on Liberty, 2nd edn, New York. Hayek, F.A. von (1937), ‘Economics and Knowledge’, Economica 4: 33–54. Hayek, F.A. von (1944), The Road to Serfdom, New York. Hayek, F.A. (1945), ‘The Use of Knowledge in Society’, American Economic Review 35: 519–530. Hayek, F.A. von (1960), The Constitution of Liberty, London. Hayek, F.A. von (1970), Die Irrtümer des Konstruktivismus und die Grundlagen legitimer Kritik gesellschaftlicher Gebilde, Munich and Salzburg. Hayek, F.A. von (1982), Law, Legislation and Liberty: A New Statement of the Liberal Principles of Justice and Political Economy, 3 vols, London, Melbourne and Henley, 1973–1979; first publ. in one vol. 1982. Heidorn, J. (1982), Legitimität und Regierbarkeit. Studien zu den Legitimitätstheorien von Max Weber, Niklas Luhmann, Jürgen Habermas und der Unregierbarkeitsforschung, Berlin. Johnson, N. (1977), Die englische Krankheit. Wie kann Großbritannien seine politische Krise überwinden, Stuttgart. Menger, C. (1883), Untersuchungen über die Methode der Sozialwissenschaften und der Politischen Ökonomie insbesondere; reprinted in Gesammelte Werke, vol. 2, 2nd edn, Tübingen, 1969; English trans., Investigations into the Method of the Social Sciences with Special Reference to Economics, ed. L. Schneider, New York, 1985. Nozick, R. (1974), Anarchy, State and Utopia, Oxford. OECD (ed.) (1985), Social Expenditure 1960–1990. Problems of Growth and Control, Paris.

A model of the dynamic welfare state 173 Offe, C. (1985), Disorganised Capitalism, Oxford. Olson, M. (1982), The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities, New Haven, CT, and London. Olson, M. (1989), ‘How Ideas Affect Societies: Is Britain the Wave of the Future?’, in Ideas, Interests and Consequences, Institute of Economic Affairs, London, pp. 23–51. Peacock, A.T. and Wiseman, J. (1967), The Growth of Public Expenditure in the United Kingdom 1890–1955, London. Preuß, U.K. (1990), ‘Verfassungstheoretische Überlegungen zur normativen Begründung des Wohlfahrtsstaates’, in Ch. Sachße and H.T. Engelhardt (eds) Sicherheit und Freiheit. Zur Ethik der Wohlfahrtstaates, Frankfurt am Main, pp. 106–132. Prisching, M. (1986), Krisen. Eine soziologische Analyse, Vienna, Cologne and Graz. Pryor, F.L. (1968), Public Expenditures in Communist and Capitalist Nations, Homewood, IL. Pulkingham, J. (1989), ‘From Public Provision to Privatisation: The Crisis in Welfare Re-assessed’, Sociology 23: 387–407. Pullen, G.R. (1989), ‘Liberty and Spontaneous Order in the Thought of Friedrich A. von Hayek’, Wirtschaftspolitische Blätter 36: 149–157. Radnitzky, G. (1984), ‘Die ungeplante Gesellschaft: Friedrich von Hayeks Theorie der Evolution spontaner Ordnungen und selbstorganisierender Systeme’, Hamburger Jahrbuch für Wirtschafts- und Gesellschaftspolitik 29: 9–33. Rawls, J. (1971), A Theory of Justice, Cambridge, MA. Recktenwald, H.C. (1977), ‘Umgang und Struktur der öffentlichen Ausgaben in säkularer Entwicklung’, in Handbuch der Finanzwissenschaft, ed. F. Neumark, vol. I, Tübingen, pp. 713–752. Recktenwald, H.C. (ed.) (1978), Tendances à long terme du secteur public (Secular Trends of the Public Sector), Paris. Schmidt, M.G. (1982), Wohlfahrtsstaatliche Politik unter bürgerlichen und sozialdemokratischen Regierungen. Ein internationaler Vergleich, Frankfurt and New York. Schmidt, M.G. (1986), ‘Politische Bedingungen erfolgreicher Wirtschaftspolitik. Eine vergleichende Analyse westlicher Industrieländer’, Journal für Sozialforschung 26: 251–273. Schmidt, M.G. (1988), Sozialpolitik. Historische Entwicklung und internationaler Vergleich, Opladen. Schumpeter, J.A. ([1918] 1976), ‘Die Krise des Steuerstaates’, in R. Hickel (ed.) Rudolf Goldscheid, Joseph Schumpeter. Die Finanzkrise des Steuerstaats. Beiträge zur politischen Ökonomie der Staatsfinanzen, Frankfurt am Main, pp. 329–379. Skocpol, T. (1979), States and Social Revolutions, Cambridge. Smith, D. (1975), ‘Public Consumption and Economic Performance’, National Westminster Bank Review. Sombart, W. ([1916–1927] 1987), Der moderne Kapitalismus, 3 vols, Munich, reprint of the 2nd edn. Sowell, Th. (1984), ‘The Road back to Serfdom’, in K.R. Leube and A.H. Zlabinger (eds) The Political Economy of Freedom: Essays in Honor of F.A. Hayek, Munich and Vienna, pp. 137–142. Timm, H. (1961), ‘Das Gesetz der wachsenden Staatsausgaben’, Finanzarchiv 21: 201–247.

174 Manfred Prisching Ulrich, P. (1987), Transformation der ökonomischen Vernunft. Fortschrittsperspektiven der modernen Industriegesellschaft, Berne and Stuttgart. Vanberg, V. (1986), ‘Spontaneous Market Order and Social Rules: A Critical Examination of F.A. von Hayek’s Theory of Cultural Evolution’, Economics and Philosophy 2: 75–100. Vobruba, G. (1983), Politik mit dem Wohlfahrtsstaat, Frankfurt am Main. Wagner, A. (1879) Allgemeine oder theoretische Volkswirtschaftslehre, part 1, Grundlagen, 2nd edn, Leipzig. Weede, E. (1984), ‘Democracy, Creeping Socialism, and Ideological Socialism in Rent-Seeking Societies’, Public Choice 44: 349–366. Weede, E. (1991), ‘Functionality, Rent Seeking, and Government as Determinants of Inequality’, Rationality and Society 3: 423–436. Wilensky, H.L. (1975), The Welfare State and Equality: Structural and Ideological Roots of Public Expenditure, Berkeley, CA, Los Angeles and London. Witt, U. (1989), ‘Bemerkungen zu Hayeks Theorie sozioökonomischer Evolution’, Wirtschaftspolitische Blätter 36: 140–148. Zöllner, D. (1963), Öffentliche Sozialleistungen und wirtschaftliche Entwicklung. Ein zeitlicher und internationaler Vergleich, Berlin.

9

Austrian aspects to health economics Ursula Backhaus

Introduction Health economics is considered a new science and is traced back to Arrow’s seminal contribution of 1963, in which he set the research agenda for this field. By concentrating on the current institutional setting, health economists typically have given little or no attention to approaches based in the history of economic thought, thereby possibly overlooking useful tenets. In this study I should like to explore what we can learn in health economics from the Austrian approach. Time plays an important role in Austrian economic thought. Carl Menger (1840–1921), who founded Austrian economics with his Grundsätze der Volkswirtschaftslehre (Principles of Economics) ([1871] 1968), states that planning for the future is what leads to the development of a nation. The further ahead individuals plan for the future, the higher will be the state of development that a nation will reach. He thus builds on the old cameralist tradition (see also Backhaus forthcoming).1 Hence, public policy was among other things directed to maintaining public health standards. Menger’s students and proponents of the Austrian School, Eugen von Böhm-Bawerk (1851–1914) and Friedrich von Wieser (1851–1926), further develop his work. Böhm-Bawerk (1921a–c) develops Menger’s work of capital and analyzes the effects of the interest rate on the economy, especially on the formation of physical capital and money. He builds on Menger’s observation ([1871] 1968: 122) that satisfaction of future needs generally is valued less by people than satisfaction of current needs. Friedrich von Wieser’s Vorwerttheorie is developed on the basis of Menger’s analysis of the conditions determining the distribution of scarce goods among competing uses and of the way in which different goods competed or cooperated to the satisfaction of different needs – in short, what has been called above the “means–ends structure.” (Hayek 1968: 459)

176 Ursula Backhaus Wieser (1889) interprets costs as sacrificed utility, which later became known as the concept of opportunity costs. Menger has a broad view of the concept of capital and recognizes the role of the subjective discount rate as a factor for development. Sometimes he implicitly applies the subjective discount rate to human capital. In the next section I will give an overview of health-related aspects in his work and focus on the time aspect, which is also emphasized by BöhmBawerk. In health economics today the role of the subjective discount rate is typically analyzed in the context of a human capital model in order to explain choices that people make with respect to lifestyle. Those persons with a low subjective discount rate (the individual subjective discount rate measures the valuation of the future in relation to the present) are more concerned about their future health than persons with a high subjective discount rate. Therefore, we can expect that people with a low subjective discount rate will be willing to incur higher costs for their present and future health in the form of direct health care-related payments or better eating habits, etc. and will stay healthier as they get older, on average, and live longer than those with a high subjective discount rate. People’s subjective discount rate does not have to be constant during their lifetime; it is likely to vary over the life cycle. Posner2 notes that the elderly tend to be more pessimistic and that their lives are more driven by habits and routines than those of young people, so that less happens to interrupt the flow of time. Therefore, the future seems to get closer to the present, which means that we can expect a decline in the discount rate when aging. An explanation is that the elderly typically have low opportunity costs of time and might face restrictions in their movement so that they have a much smaller set of activities to choose from. The young tend to have much higher opportunity costs and they have more alternatives to fill their time than do elderly persons. The experience that time passes more quickly for the elderly can be due to somatic and nonsomatic changes taking place, as well as a decline in their subjective discount rate, caused by aging. The role of time preferences for individual decisions and in public health policy will be discussed in the third section of the chapter.

Health-economic aspects in Austrian thought In this section I investigate the health economic aspects in the writings of the Austrians. With their focus on individual decision taking and an emphasis of the concept of time, we can find health economic applications in their writings. A substantial part of Menger’s library at the Hitotsubashi University consists of medical books, which shows his interest in the medical field. As a nation becomes more developed, people become more knowledgable and make fewer errors about the character of goods. An example

Austrian aspects to health economics 177 of human error is given at the beginning of Menger’s Principles, when he refers to imaginary goods with medicine as an example. As a nation develops, those imaginary goods tend to disappear. The context is as follows: Development of a nation takes time and requires cause and effect (Menger [1871] 1968: 21). The law of causality has been inspired by the natural sciences3 and cannot be separated from the idea of time: When therefore we move from the state of desire into that of the satisfied need, there have to be sufficient causes to bring this about. This means either that forces acting within ourselves remove our distracted state, or that things from outside of ourselves have an influence on us, things that by their nature are able to bring about that state we refer to as satisfaction of our needs.4 ([1871] 1968: 1) A special case applies if a causal relationship does not exist, but people treat things as goods nevertheless. Menger defines as goods those things that can be used to satisfy needs ([1871] 1968: 2). Four requirements are needed in order that a thing can become a good (ibid.: 3): 1 2 3 4

A human need must be present. The causal relationship must be given in the sense that the thing must possess qualities that enable it to satisfy the human need. A person has to be aware of the causal relationship between satisfaction of the need and the good. A person has to be able to dispose of the good in such a way as to satisfy the need.

If at least one of these four requirements is not met, then a thing cannot become a good. Menger thinks that medicine often does not have a goods’ character. He distinguishes between the following two cases: A special relationship can be observed in those cases when things that do not stand in a causal relationship with the satisfaction of human needs are treated as goods. This happens if things are falsely thought to have properties that in reality they do not have, or if human needs are falsely assumed which in reality do not exist. . . . To the things of the first kind belong most cosmetic goods, amulets, the majority of medicines, which are given to sick people in a nonadvanced culture, and, in the case of extant primitive peoples, divining rods, love potions, etc., because all of these things are in reality unable to satisfy those human needs that they are supposed to satisfy. To the things of the second kind belongs medicine supposed to cure illnesses, which in reality does not exist.5 ([1871] 1968: 4)

178 Ursula Backhaus The special case applies when people think that some things have qualities and effects that in reality they do not have, and if human needs are wrongly assumed as given, but in reality do not exist (ibid.: 4). Menger’s examples for both cases include medicine. In the first case, he states that if the cultural level of a society is low, medicine is often ineffective. In the second case, medicine is prescribed for pretended illnesses. As knowledge and welfare of a people grow, there will be fewer imaginary (eingebildete) goods (ibid.: 5) in the economy. A good can according to Menger consist in an activity not undertaken. Menger speaks of relations, which can be on a voluntary basis or legally enforced. Relations are far-reaching and include friendships or religious communities. He gives the following example to illustrate relations: If someone buys from me, or uses my services as a lawyer, he or she certainly does not do so because of my work effort, but it is an act that is nevertheless very beneficial for me. And if a rich physician living in a small country town with only one other physician should stop practicing, that is even less a work effort on the part of the former, but for the latter, who thereby becomes a monopolist, it is a very useful act of omission.6 ([1871] 1968: 6) Menger considers the market structure, but he does not discuss the problems associated with a local monopoly in health care.7 Böhm-Bawerk ([1914] 1975: 26, 27) further develops Menger’s thought. He thinks that to monopolists the fear of outsider competition is perhaps the most effective remedy against unscrupulous exploitation of their monopoly position.8 Over time, people’s preferences can change. Menger gives the example of a sudden stop in the use of tobacco, which would lead to a wealth of adjustment processes, making the stock of tobacco leaves and seeds obsolete and requiring a different use of land, farmhands working in the tobacco fields, and machines.9 The production process takes time and is connected to consumption. By distinguishing between goods of higher and lower order, Menger tries to integrate the production and consumption process. Goods of lower order are able to satisfy a need immediately – for instance, tobacco, which is a good of first order. Other goods, for instance tobacco leaves and tobacco seeds, are necessary to make the tobacco and are called goods of second order. Tools, human labor, or the tobacco plot are even further away from immediately satisfying a need and are considered goods of third and fourth order. In this example, tobacco leaves and dry air are complementary goods. They are necessary in order to make tobacco. In a highly developed economy, complementary goods will be provided through the market.10 In case of a disturbance such as war or a sudden preference change, shortages or surpluses of complementary goods can occur and temporarily lead to unemployment. The longer the production process, the more time it takes to transform

Austrian aspects to health economics 179 goods of higher order into goods of lower order, and the higher will be the degree of uncertainty with respect to quantity and quality of the good produced, but for the further development of a nation it is important that people employ goods of higher order. In a culturally high-standing nation Menger considers planning for a lifetime and beyond as not unusual. We enjoy the fruits of the provisions for the future of the past (Menger [1871] 1968: 33) when we have to use the services of a lawyer or physician, as it would be too late to acquire these skills at the moment we need them. Individuals will plan ahead for expected developments and to a certain degree make provisions for unforeseen needs in the future.11 Goods have value because they can satisfy our needs (Menger [1871] 1968: 75, 85). Satisfaction of individual needs has a subjective component, as individuals maximize marginal utilities when consuming or producing different goods and services, and an objective component, as consumption depends on the means someone has to spend and the availability of certain goods or services. Marginal utility typically decreases with a higher consumption of a certain good, as illustrated by Menger (ibid.: 91) with the example of food consumption in relation to individual health: The satisfaction of the need for food up to the point at which the subsistence level is reached has for each person the entire meaning of maintaining that person’s life; consumption above that level (as observation teaches us) has for that person only the meaning of a progressively decreasing satisfaction, until consumption reaches a level at which the need for food is fully satisfied, so that every additional intake of food neither contributes to maintaining life itself, nor makes a positive contribution to health, nor leads to additional satisfaction to the consumer, but starts not to matter to him or her any longer, and eventual further consumption will become painful, a jeopardy to health, and finally a threat to life itself.12 Menger thinks that people do not always act in an enlightened way,13 and even if they are not stupid and try to make rational decisions, they might make errors in evaluating future needs: In particular, people are easily misled when they value the satisfaction of needs that improve their well-being in an intense but transient way more highly than the satisfaction of needs that are less intense, but occur over longer periods of time. This means that it is not unusual for people to value passing intense pleasures more highly than their permanent welfare, sometimes even more highly than their own life.14 (ibid.: 22) The decision to value present satisfaction more highly than future satisfaction even if it has negative effects on health and other aspects of life is

180 Ursula Backhaus interpreted by Menger as bad judgment on the part of a person. He thinks that human insights and errors inevitably go along with each other. He also observes that “as experience teaches us, a current satisfaction or satisfaction in the near future seems to be more important to people than a satisfaction of the same intensity at a more distant point in time” (ibid.: 128).15 Menger recognizes in this observation an obstacle to planning and provision for future needs, which are important for the development of a nation. People should use goods of higher order, build up long production processes, accumulate knowledge and plan for further knowledge accumulation – for example, by setting up institutions for the education of highly specialized professionals. Building up capital is crucial in this development process, and Menger makes his understanding of capital clear in a long footnote in the Principles ([1871] 1968: 130–131n).16 He thinks that the productivity that derives from land or buildings is different from the productivity resulting from that part of “capital” that is often represented by sums of money. Menger wants the two parts of capital to be treated separately. In his terminology, human labor is a part of capital and a good of higher order. In his early work Lectures of Economics, Böhm-Bawerk states as the highest principle of economics that people should strive to reach the highest possible utility in their personal lives with as few sacrifices as possible (see Tomo 1998: 43). Utility and sacrifices can be direct or indirect. A direct sacrifice, according to Böhm-Bawerk, occurs if someone gives up his or her health. According to this view, health is part of the production function and is consequently discussed by Böhm-Bawerk in his lecture on production. Under division of labor, it is possible for an employee to face one-sided requirements that can have negative effects on his or her physical and mental health. Division of labor is also a reason for occupational diseases. When losing his position, a worker can be economically disadvantaged and be helpless to improve his situation because his skills are limited owing to the one-sidedness of requirements. Böhm-Bawerk thinks that loss of employment is likely under a far-reaching system of division of labor, which requires an organization for coordination. The organization can easily be disturbed, especially through war, political unrest, and if the division of labor is on an international level (Tomo 1998: 137). As remedies for the disadvantages of division of labor, Böhm-Bawerk proposes continuing general education, shorter working hours, time for leisure and cultural activities, support for employees who become unemployed, and economically and technically skilled employers and supervisors responsible for the coordination of work. Böhm-Bawerk not only stresses the importance of investment in human capital by proposing to invest in general human capital of employees and specific human capital of employers and supervisors, but also suggests that labor has to be supported by as much physical capital as possible (Tomo

Austrian aspects to health economics 181 1998: 138). He strives for a form of development in which productivity of labor is high, so that much output can be produced using minimal labor. Three factors are listed that lead to progress: first, growing knowledge of nature; second, widespread education; and third, a larger concern for the future, which leads to an increase of national saving and national capital (ibid.: 308). These factors pertain to investments in human capital and suggest a low discount rate of people, leading to high levels of education and the choice of a healthy lifestyle. According to Hayek (1968: IV, 460), Böhm-Bawerk’s most important original contribution was his Theory of Capital and Interest, but it was not accepted by all members of the Austrian school, which shows that the Austrian school of economics was not a monolithic body of thought. Wieser, former classmate and later brother-in-law of Böhm-Bawerk, as well as editor of the fourth edition of Theory of Capital and Interest (Böhm-Bawerk 1921a), states in the preface (p. vi) that he disagrees with Böhm-Bawerk’s theory of interest. In the first volume, History and Criticism of Theories of Interest, BöhmBawerk gives an overview of theories on interest. In the volume as a whole he is concerned with valuation of goods and services and strictly opposed to the idea that the amount of labor as input for goods and services determines their value. He argues that the existence of the phenomenon of interest shows that there must be another determinant to value, apart from labor: One does not receive interest from capital because of some kind of labor performed, but simply because one can dispose of capital through ownership; interest from capital is not a labor income, but an income due to ownership of capital goods.17 (1921a: 268) This insight leads Böhm-Bawerk into sharp contrast with Marx, but also with John Stuart Mill, Smith and Riccardo, who assume labor to be an important if not the main source of value. He proposes to look for the value of goods to the future and not into the past. Böhm-Bawerk looks for the influence of time as an explanation for the evaluation of goods.18 Böhm-Bawerk shows in the second volume, Positive Theory of Capital (1921b: 454), that all forms of interest are based in a difference in value between future and present goods, and that the value difference itself is caused psychologically, as well as by reasons of production technology. This is a subjectively based interest rate; everyone can take his or her own situation into account.19 Böhm-Bawerk bases himself on Menger when he shows that farmhands, without possessions of their own, in comparison to capitalists “always” more strongly prefer present goods to future goods than do the latter (1921b: 458n2).

182 Ursula Backhaus

The subjective discount rate in a human capital model Menger and Böhm-Bawerk described the role of the subjective discount rate for development of a nation. This relates to building up human capital. Today we can refer to a vast body of literature on human capital economics for a discussion of health-related phenomena. An example is the empirical study by Victor Fuchs (1982), who explores the role of time in relation to individual behavior and health status. He provides empirical evidence that people who have a low discount rate invest more in their long-term health than others do. They incur higher costs in the present in return for potentially better health in the future by smoking fewer or no cigarettes, eating less fatty food, sticking to a diet, drinking less alcohol, exercising more, etc. than people with a high discount rate. By enriching a conventional human capital model, additional health-related applications are possible. In this section I first describe lifestyle choices, then briefly summarize a basic human capital model and the lifestyle choices it can explain. I then present Fuchs’s empirical results on time preferences and health status, and finally discuss the role of the subjective discount rate in public health policy. Lifestyle choices Choices of lifestyle often involve a comparison between the benefits of current consumption and possible negative health effects in the future. The adverse health consequences of a particular behavior do not afflict individuals with absolute certainty. Smokers are affected by a certain statistical chance of suffering various smoking-related diseases (Adams and Brock 1999: 54). Because of negative external effects, this chance might affect nonsmokers suffering from secondhand smoke as well. People who overeat face a similar dilemma: skinny people have a lower lifetime risk of negative health effects and can expect to live longer than people who overeat. Excess drinking is associated with a higher risk of accidents, personal deterioration, neglect of family responsibilities, and early death. The question is whether giving up smoking, losing extra weight and keeping it off, or stopping drinking excessively is worth the present effort and forgone pleasure of current consumption for an uncertain future health gain. The picture is a broader one20 and concerns basic values.21 People are faced with multiple, conflicting, and often irreconcilable choices, when they make their lifestyle decisions. The choice of obesity, smoking, and alcohol (ab)use does not exhaust the set of lifestyle alternatives. They pick from a larger set, including behaviour associated with obstructive stupidity, cruelty, extreme materialism, drug abuse (coke, heroine, crack), and other conditions such as driving tractors, lorries, certain sports that

Austrian aspects to health economics 183 require constant painkillers, or being a workaholic, to name but a few examples. Individual time and risk preferences are important for a person’s choice. Some people value current satisfaction much more highly than future satisfaction, and accept a higher risk of the chance of suffering from a future lifestyle-related disease than others. Human decisions are not made with respect to medically relevant single aspects of one’s health. People grow into or else opt for a particular lifestyle, a concept that in the Austrian tradition is called Lebenslage. It became extremely important when Otto Neurath proposed a planned economy for post-World War I German-speaking countries (Backhaus 1979: 51). Planning was to be done not in terms of planning prices, production, or physical goals, but in terms of physical lifestyles to be attained for and by the democratically constituted people. The policy makers, then, had to choose among alternative lifestyles (Lebenslagen). Conceivably, one of the most important contributions of the Austrian School, namely, Ludwig van Mises’s Socialism ([1922] 1981),22 was written in order to disprove the feasibility of this Austro-Marxist concept (Blum 1985). This again shows of how important it is to look at all the different Austrian contributions. Mainstream economists today assume that individuals act rationally in their choice of lifestyle. Given individual restrictions, they will consume those goods and services that provide them the greatest marginal utility relative to the price they must pay. Negative adverse health consequences will raise the price of that particular activity and a person will engage in it if the benefits outweigh the price. The salient question remains whether a person is free in choosing a certain lifestyle. In the case of addiction, we cannot speak of a rational and voluntary individual choice. However, as Becker and Murphy have shown, in the long run even addiction is a rational choice (Adams and Brock 1999: 55, referring to Becker and Murphy 1988). Lifestyle is no choice when it is required as necessary behavior in a group – for example, professional behavior – or when it is required in order to belong to a certain group. We can, however, consider a person’s decision to belong to that particular group a free and rational choice. Health effects in a basic human capital model In a basic human capital model, economists explain with reference to differences in investment in human capital a variety of phenomena, including differences in earnings among individuals and over the lifetime of a single individual, but also differences in the lifestyle of persons that lead to differences in their health status. The term “human capital” is used, strictly by analogy with physical capital, as an asset that yields earnings over time rather than immediately. Earnings can be pecuniary or nonpecuniary. An example of nonpecuniary earnings is when human capital investments improve the health of a company’s employees, leading to

184 Ursula Backhaus higher productivity for that company. This could occur directly, by the encouraging of a healthy lifestyle, or indirectly, by the company providing on-the-job training. As employees become more knowledgeable, they are likely to become more productive and face less stress in their work. Human capital can be created by activities such as formal education or on-the-job training, but also by forming networks with other people. A person investing in human capital cannot engage in other activities at the same time and might therefore lose wage or other benefits, which means that part of the investment in human capital is indirect, even when schooling is free. The direct cost of acquiring human capital might consist in accepting a lower wage from an employer who provides on-the-job training. If the on-the-job training consists in experience, an employee will not have to pay for it.23 Employees will be reluctant to pay for human capital if it is only applicable in the specific work environment provided by the employer, as they cannot transfer specific human capital and translate it into a wage advantage when leaving the position. Similarly, the employer will be reluctant to pay for the creation of general human capital that employees can take elsewhere, possibly in return for a higher wage.24 An assumption in the basic human capital model is that people act rationally. Employees incur the costs of the creation of human capital only if they will gain higher earnings in return, and employers are willing to invest in human capital only if they can expect higher productivity by employees in the future. As with investment in physical capital, investments in human capital require that the investment will be repaid with interest, and this will be compared with the earnings deriving from alternative investments of similar risk. The higher the investment in human capital, the greater must be the present value of the anticipated earnings or productivity gain with interest in order to make the investment worthwhile as compared to alternative projects. In a basic human capital model, depreciation of human capital is not assumed,25 only truncation of the time horizon, which could consist in proximity to death or retirement, in leaving a family, a company, or a country, etc. Truncation of the horizon shortens the payback period and causes disinvestment in human capital. Posner gives the example of a young or middle-aged person newly infected with HIV, who has at least ten more years to live before his health deteriorates. He reports that disinvestment in human capital can be observed, as well as a high rate of suicides, even before HIV-infected persons develop AIDS.26 Sometimes, people do not cut off investment in human capital even when approaching a horizon such as death. Some people who are about to die still try to finish an autobiography. It can be astonishing how much very sick people can still accomplish, a fact that is not usually discussed in the health economics literature, but that can be explained in a human capital context. Posner (1995: 58) explains the phenomenon that people still invest in human capital despite approaching a horizon such as death,

Austrian aspects to health economics 185 and despite diminished health, in terms of posthumous utility. If a person is altruistic towards family and friends, that person might want them to benefit from his or her work; if the person is more selfishly oriented, he or she might want to cement in place a good reputation for him- or herself, a reputation that would also be a family asset. When people are very close to a horizon, human capital economists speak of the last-period problem. Then, rewards and punishment as incentives for good behavior become irrelevant. An example is the drugaddicted HIV infected criminal who threatens to infect people with AIDS. The period for punishment is too short to be a disincentive for his behavior. For religious people there might not be a last period, as they may believe in an afterlife where their current behavior will be judged. Human capital, like physical capital, depreciates, for instance through a change in the environment, in the work environment or as a result of a change of political system (Posner 1995: 53). A change in the work environment typically requires new knowledge and skills and reduces the value of the existing knowledge and experience. Human capital can also depreciate as a result of bad health or aging. Aging often goes along with somatic and nonsomatic changes leading to a loss of memory, reduced dexterity, a lack of flexibility, and a slower rate of learning and applying new skills. Posner asks whether people will replace human capital lost by depreciation and, if so, to what extent. If people did not change physically, they would consider the cost of the new human capital investment and compare the minimum payback period with the real payback period, which is the time they have left to work before they retire, or until they plan to leave the company, or some other horizon. They would not undertake human capital investment to replace human capital if the real payback period would be longer than the minimum payback period. If the employer were to pay for the human capital investment, he or she would also take the truncated horizon into account. If the assumption is dropped that people do not change physically by becoming less healthy, people might not be able to replace the knowledge lost, or not as easily as they used to, which increases the cost of acquiring human capital. They might find it more difficult to apply new knowledge, and perhaps be confronted with a longer real payback period than the minimum payback period, decide not to replace losses of human capital due to depreciation, which might lead to net depreciation. If the net depreciation of human capital causes a fall in real earnings, the employee has fewer incentives to remain employed. This explains how people decide when to retire, provided that the retirement age is flexible and for the employee to decide. There are two effects on the formation of human capital (Posner 1995: 55). The trend towards increased longevity is well established in the United States, and Americans can be expected to continue to live longer, partly because of a better medical system and partly owing to a general rise in the standard of living. Posner expects that additional healthy years

186 Ursula Backhaus will be added to the prime years, which will enable people to be active for longer before their health diminishes. A rise in the amount of human capital investment due to the longer payback period (retirement age is more flexible in the United States than in Europe) can be expected. At the same time, it can be expected that because of diminished health in old age, these people eventually will need caretakers, but caretaking generally is a low-skilled job, and so there will be a fall in the investment of human capital. Some caretaking, of course, requires high medical skills, and therefore partly offsets the first effect. I should like to add from a political-economic perspective that as many elderly people are well-off financially, they can afford to pay for private caretaking, and entry to this market, which is partly a healthcare market, should not be regulated by the state. (Minimum standards have to be ensured to prevent neglect or criminal activity.) Human capital is formed not only through formal schooling and onthe-job training, but also by personal relationships, which require the investment of time to develop into mutually beneficial relationships. In health economics, personal relationships are very important as sick people receive help from family, friends, or neighbors, etc. Posner investigates the relational human capital formation of elderly persons. He notes that people who reach old age are not a random section of the population and finds that they have fewer friends than an average younger old person. They are typically of better health than average, more intelligent, more affluent, and better educated. Empirical studies show that health, age, income, and education are correlated with each other. A possible explanation for these correlation patterns lies in differences in subjective discount rates among people. Empirical results on the relationship between time preference, individual behavior, and health status Victor Fuchs (1982) explores the interrelationship between time preference, individual behavior, and people’s health status. His empirical study is based on Becker’s theory of human capital investment (1993; first edition 1964), and on Grossman’s empirical application of this theory to the relationship of health and education (1972). Grossman shows a statistically significant effect of schooling on health, which remains after controlling for income and other variables. Additional schooling has a further positive effect on health. This seems to be in contrast to the income variable, where the correlation to health status is strong at low levels but tends to become weaker with a higher income. The association of schooling and health status is, according to Fuchs (1982: 94), so strong that it appears in cross-sectional as well as longitudinal studies, and in objective measurement of health status as well as self-reported data. When one controls for income, the relation between health and schooling remains strong. In

Austrian aspects to health economics 187 Grossman’s interpretation, a person is the more efficient in producing health – that is, in choosing a healthy lifestyle – the better educated he or she is. Empirical evidence is provided by epidemiological studies that show the importance of lifestyle variables as determinants of health status and mortality. Fuchs tries to explain different choices of lifestyle with differences in the time preference of individuals, who might have a different willingness or ability to undertake an investment (1982: 95).27 His first hypothesis is that time preferences are formed early in life and influence both investments in education and investments in long-term health. People with a low discount rate can be expected to invest in high levels of schooling and to choose more health-enhancing activities than people with a high discount rate, who prefer a minimum of education and a not-so-healthy lifestyle. Fuchs’s second hypothesis, not mutually exclusive with the first one, is that education affects time preferences: the more highly educated a person, the lower becomes his or her discount rate. Although Fuchs cannot empirically distinguish between the two hypotheses, he shows that people with low discount rates will choose a more healthy lifestyle and therefore make higher investments in their long-term health than people with high discount rates. Posner uses a basic human capital model as the starting point to explain the behavior of the elderly and subsequently suggests ways of enriching the basic human capital model, for example by dropping the assumption generally made in the human-capital literature that an individual does not experience physical changes during his lifetime (1995: 58). Over a person’s life cycle, time preferences tend to be different. Posner notes a difference in the experience of time between young and old people. As young people tend to be hopeful, and therefore impatient, and can choose from a large set of alternatives to fill their time with, time for them passes slowly. The elderly are typically more pessimistic and routinized, and because of poorer health can often only choose from a very limited set of alternative activities. As the elderly do not interrupt the flow of time with as many activities as the young, time seems to pass rapidly. Posner suggests that the discount rate declines over the life cycle (ibid.: 70–73). We can expect the young to have a higher discount rate than the old. Another argument for why we observe low discount rates among the very old is a selection bias argument, under the assumption that the discount rate does not change during the life cycle. Only those people who have a low discount rate reach old age, as they have made more investments in their long-term health than people with a high discount rate. There might be an increase in discount rates during the last period, when there is little time left to live, but how strong the increase will be depends on the strength of the bequest motive of the very old. After having discussed the role of subjective discount rates in the

188 Ursula Backhaus context of a human capital model, I should like to turn to public health policy, as healthcare involves not only individual choices, but also public choices. Through public health policy, the state undertakes health-related investments. To evaluate alternative public healthcare investments, cost–benefit or cost-effectiveness studies have to be performed. As benefits and costs are not always incurred at the same time, a discount rate has to be determined. For preventive public health policy measures or for illnesses with long latency periods, the choice of an appropriate discount rate is important, because benefits are expected in the future and costs have to be incurred in the present (Russell 1986: 115). Public health policy can be directed towards encouraging people to adopt a better lifestyle. Louise Russell (1987: 4) reports the results of a workshop on the question of how preventive public health policy measures might affect people’s health and ability to work, especially later in life. The studies apply cost-effectiveness analysis in order to compare the effects of a proposed change with the costs necessary to achieve that change. Costs include the costs of the intervention and the costs of treating possible side effects. Health effects are calculated by estimating the years of life added by the intervention, as well as improvements in health during the years lived without the intervention, minus deterioration in health due to side effects of the intervention. In a third step, the health effects have to be translated into capacity to work. Areas of prevention discussed by Russell are vaccinations for smallpox and measles, screening for high blood pressure in order to avoid hypertension, improving lifestyle by exercising, refraining from smoking, taking exercise, taking dietary calcium supplements, alcohol use, and avoiding obesity (1986, 1987). In order to make the studies comparable, a discount rate of 5 percent is suggested (Russell 1987: 73). A cost-effectiveness study should be performed under the social perspective, so that all costs are accounted for, no matter who pays them, as well as all health effects, no matter who experiences them.

Public health policy Public health policies involve a variety of different time horizons.28 Vaccination for an expected flu epidemic is a short-term matter, reducing mortality especially among the elderly. Encouraging people to a better lifestyle is, from the “nation” point of view, extremely long term, but affects many short-term preferences. Adopting healthy eating habits, moderate alcohol consumption, and regular exercise can reduce the probability of heart disease over the entire remaining lifespan. Fabian (1994: 131) reports the results of a model in which individual health choices are placed in a lifecycle decision-making framework. The model is applied to life-threatening illnesses with long latency periods.

Austrian aspects to health economics 189 A strong result, both theoretical and empirical, is that people discount future health problems. Young people in particular heavily discount health problems that are postulated to occur late in life. Time preference is involved, and more research is needed on the problem. The discount rate of 5 percent, as suggested by Russell, is an arbitrary measure. In 1988, Moore and Viscusi studied time preference of workers whose job involved a high risk of injury, and observed discount rates of 10–12 percent. As reported in the study cited earlier, Fuchs (1982) obtains values for time preference by asking people for interest rates, but a money-related measure might not reflect people’s choices with respect to health-related activities. Fabian suggests the direct measuring of health behavior involving intertemporal choices, either by developing alternative life-cycle scenarios and letting people choose a certain scenario (but then the discount rate might remain implicit) or by contingent market experiments, which would reveal the discount rate in a procedure such as the following: One way of doing this would be to derive qualy estimates for several health conditions that explicitly pertain to the present. The second step is to arrange these health states in various plausible life-path scenarios. The sum of the qualys is a quality-adjusted life for each scenario. The implicit discount rate is zero. The next step is to present these scenarios to respondents with the time dimensions clearly stated. The disability time paths would differ considerably among scenarios. The respondent would compare them with each other and with a base-case scenario in which none of the disabilities appeared. Respondents would first rank the scenarios according to their preferences. They would then evaluate the scenarios in qualy terms. . . . The implicit discount rate would be obtained by comparing the qualityadjusted lives with the life path constructed by adding together the timeless qualys into corresponding life paths. The discount rate that emerged could be used to evaluate qualys in the traditional way. This work could of course be carried out in willingness to pay terms as well as qualys. (1994: 32) On normative grounds, Fabian suggests that there might be a reason to use a discount rate of zero. This is suggested under the egalitarian assumption that later years are of the same value as current years and using a discount rate of zero might be empirically justified when people regret the health choices they made in the past. One has to note that a discount rate of zero is not egalitarian, but favors public health measures that benefit the elderly. After having discussed choices of lifestyle in a human capital model and

190 Ursula Backhaus the role of subjective discount rates in public health policy, I turn to the conclusions. What does the Austrian approach add to current healthrelated applications in a human capital framework?

Conclusions The Austrian approach with respect to health economics is not fully developed, but a typical health-economic study leading to health policy conclusions could gain from employing the Austrian approach. Health policy conclusions could be made more realistic if health economists integrated different subjective discount rates into cost–benefit analyses. We could better forecast the effects of various cost-containment measures in healthcare if we assumed that individuals have different subjective discount rates. Finally, when listening to the Austrians, we would know that lifestyle choices are a matter not of providing information, but of the concept of Lebenslagen.

Notes This chapter was presented as a paper at the Workshop of the Max Planck Institute for Research into Economic Systems “New Perspectives in Austrian Economics” in Jena, August 7–8, 1998. I should like to thank Mrs. Silke R. Stahl for her useful detailed critiques, the editor for much worthwhile advice, and the other workshop participants for their valuable suggestions, which helped to improve the chapter. Any remaining errors are my own. 1 The Cameralist tradition held the state of health of the people to be an important part of the wealth of the nation. 2 Somatic and nonsomatic changes of aging can go along with a change in the subjective discount rate. On somatic changes while aging, see the discussion by Posner (1995: ch. 2, pp. 31–50); for references and discussion with respect to nonsomatic changes of aging and subjective time and discount rate, see Posner (1995: ch. 4, esp. pp. 70–72). 3 “Cause and effect” cannot be applied only to phenomena in the natural sciences; it applies to social activities of people as well. Menger shares this view with Albert Schäffle, who had held a chair at Vienna University since 1868 (Ikeda 1997: 70). 4 “Wenn demnach unsere Person aus dem Zustande des Bedürfens in jenen des befriedigten Bedürfnisses treten soll, so müssen ausreichende Ursachen hierfür vorhanden sein, das ist, es müssen entweder die in unserem Organismus waltenden Kräfte unseren gestörten Zustand beseitigen, oder aber äussere Dinge auf uns einwirken, welche ihrer Natur nach geeignet sind, jenen Zustand herbeizuführen, welchen wir die Befriedigung unserer Bedürfnisse nennen.” 5 “Ein eigentümliches Verhältnis ist überall dort zu beobachten, wo Dinge, die in keinerlei ursächlichem Zusammenhange mit der Befriedigung menschlicher Bedürfnisse gesetzt werden können, von den Menschen nichts destoweniger als Güter behandelt werden. Dieser Erfolg tritt ein, wenn Dingen irrthümlicherweise Eigenschaften, und somit Wirkungen zugeschrieben werden, die ihnen in Wahrheit nicht zukommen, oder aber menschliche

Austrian aspects to health economics 191

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8 9

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Bedürfnisse irrthümlicherweise vorausgesetzt werden, die in Wahrheit nicht vorhanden sind. In beiden Fällen liegen demnach unserer Beurtheilung Dinge vor, die zwar nicht in der Wirklichkeit, wohl aber in der Meinung der Menschen in jenem eben dargelegten Verhältnisse stehen, wodurch die Güterqualität der Dinge begründet wird. Zu den Dingen der ersteren Art gehören die meisten Schönheitsmittel, die Amulette, die Mehrzahl der Medicamente, welche den Kranken bei tief stehender Cultur, bei rohen Völkern auch noch in der Gegenwart gereicht werden, Wünschelruthen, Liebestränke u. dgl. m., denn alle diese Dinge sind untauglich, diejenigen menschlichen Bedürfnisse, welchen durch dieselben genügt werden soll, in der Wirklichkeit zu befriedigen. Zu den Dingen der zweiten Art gehören Medicamente für Krankheiten, die in Wahrheit garnicht bestehen.” “Der Umstand, dass Jemand bei mir seine Waaren einkauft, oder meine Dienste als Advocat in Anspruch nimmt, ist sicherlich keine Arbeitsleistung desselben, aber eine mir nützliche Handlung, und der Umstand, dass ein wohlhabender Arzt, der in einem kleinen Landstädtchen wohnt, wo sich ausser ihm nur noch ein anderer Arzt befindet, die Praxis auszuüben unterlässt, ist noch viel weniger eine Arbeitsleistung des Ersteren zu nennen aber jedenfalls eine für den Letzteren, der hierdurch zum Monopolisten wird, sehr nützliche Unterlassung.” The existence of a monopoly in health care has already been a problem to Paracelsus and to the cameralists, who fear that the provision of health care to the population is insufficient and possibly of low quality. The cameralists want to ensure minimum quality standards of health care through supervisory committees. To Menger, market structure does not seem to be the central argument. In Macht oder ökonomisches Gesetz? (Böhm-Bawerk [1914] 1975), Böhm-Bawerk’s main thesis is that markets should be regulated not in opposition to what market participants want, but in line with what they want to achieve. How little did he know about the tobacco plant. Because of its many health-relevant ingredients, a new tobacco boom can be expected as a consequence of anti-smoking legislation and adjudication. From a social welfare point of view, smoking tobacco is a waste and luxury, since the plant has so many other useful applications. Menger refers to “Verkehr” ([1871] 1968: 16). In a similar way, communities will act and anticipate the increased future need when planning public buildings such as schools and hospitals, roads, parks, water facilities, etc. ([1871] 1968: 39). This is central to Wagner’s law, which Menger seems to be aware of. “Die Befriedigung des Nahrungsbedürfnisses bis zu jenem Puncte, wo hiedurch das Leben gesichert ist, hat für jeden Menschen die volle Bedeutung der Erhaltung seines Lebens, die darüber hinausgehende Consumtion hat für dieselben lediglich die Bedeutung eines – wie die Beobachtung lehrt – noch überdiess sich immer mehr abschwächenden Genusses, bis die Consumtion endlich an eine gewisse Grenze gelangt, wo die Befriedigung des Nahrungsbedürfnisses bereits eine so vollständige ist, dass jede weitere Aufnahme von Nahrungsmitteln weder zur Erhaltung des Lebens, noch zu jener der Gesundheit beiträgt, noch auch dem Consumenten einen Genuss gewährt, sondern ihm gleichgiltig zu werden beginnt, um bei der etwaigen Fortsetzung derselben zur Pein zu werden, die Gesundheit und schliesslich das Leben zu gefährden.” He shows a paternalistic attitude, a characteristic of much of modern health economics too. “Insbesondere lassen sich die Menschen leicht verleiten, die Bedeutung von Bedürfnissbefriedigungen, welche in intensiver, wenn gleich auch nur rasch

192 Ursula Backhaus

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vorübergehender Weise ihr Wohlbefinden fördern, höher anzuschlagen, als solche Bedürfnissbefriedigungen, von welchen ein zwar minder intensives, aber über lange Zeitperioden sich erstreckendes Wohlbefinden abhängig ist, das ist, sie pflegen nicht selten vorübergehende intensive Genüsse höher zu achten, als ihre dauernde Wohlfahrt, ja bisweilen höher sogar als ihr Leben.” “Ein Genuss pflegt den Menschen, wie alle Erfahrung lehrt, in der Gegenwart, oder in einer nähern Zukunft wichtiger zu erscheinen, als ein solcher von gleicher Intensität in einem entfernteren Zeitpuncte.” “Der häufigste Fehler, welcher nicht nur bei der Eintheilung, sondern auch bei der Begriffsbestimung des Capitals begangen wird, ist, dass der technische, statt des wirthschaftlichen Standpunktes betont wird. . . . Die Eintheilung der Güter in Productiv- und Genussmittel, (Güter höherer und erster Ordnung,) ist eine wissenschaftlich berechtigte, fällt aber mit der Eintheilung des Vermögens in Capital und Nichtcapital durchaus nicht zusammen. Ebenso unhaltbar scheint mir die Meinung derjenigen zu sein, welche jeden Vermögensbestandtheil, welcher dauernd Einkommen gewährt, ‘Capital’ nennen. Die consequente Ausbildung dieser Lehre führt (wofern der Begriff des Vermögens auch auf die Arbeitskraft und jener des Einkommens auch auf die Nutzungen von Gebrauchsgütern Seitens ihrer Besitzer ausgedehnt wird; vid. Herrmann . . . Schmoller . . .) dazu, dass sowohl die Arbeitskraft . . ., als auch Grundstücke . . . endlich auch alle Gebrauchsgüter von einiger Dauer . . . Capitalien genannt werden müssten. . . . Der wichtigste Unterschied zwischen einzelnen Vermögensobjecten, welche Einkommen gewähren (Grundstücke, Gebäude, etc.) und Capitalien besteht darin, dass die erstern concrete, dauerhafte Güter sind, deren Nutzungen selbst wieder Güterqualität und ökonomischen Charakter aufweisen, die letztern aber, sei es nun mittelbar oder unmittelbar, Gesammtheiten von ökonomischen Gütern höherer Ordnung (complementäre Quantitäten von solchen) darstellen, deren Nutzung zwar gleichfalls den ökonomischen Character hat und desshalb Einkommen gewährt, deren Productivität indess wesentlich anderer Natur ist, als jene der obigen Vermögensobjecte.” “Man bekommt den Kapitalzins eben nicht dafür, daß man dabei eine Arbeit leistet, sondern einfach, weil man Eigentümer ist; der Kapitalzins ist kein Arbeits-, sondern ein Besitzeinkommen.” Time is an objective measure. As we shall see in the next part on human capital theory, if no horizon is defined, time cannot be used as an explanation. This is different from the view for instance, of Wicksell, who tries to arrive at an objective measure of an interest rate. He calculates the interest rates according to investment possibilities. Also pertinent to the area of lifestyle choices are industrial and legal issues, and policies related to public health. An example is taxes on alcohol and tobacco. An illustration of far-reaching consequences in the case of tobacco is given by Adams and Brock (1999). The cameralists considered the lack of chastity to be a reason for the spread of diseases and tried to promote this value. Hayek writes in the foreword of the translation that “the crucial section on economic calculation under socialism was in fact provoked by a book by Otto Neurath published in 1919, from which Mises quotes” (p. xxi). This is different in the case of an apprenticeship, which will lead to a high qualification for the employee. This is also a selection mechanism whereby employers can find those people who have a low discount rate and whom they expect to be more productive than others.

Austrian aspects to health economics 193 25 See Posner (1995: 56), who refers to Becker’s treatise Human Capital (1993: 86–87, 92). Becker notes that his model does not incorporate so-called lifecycle effects, which include health effects. 26 Risk preferences have been assumed to be the same. Time and risk preferences are not independent, for instance in the case of combat troops with high-risk components. They are highly trained but their chances of surviving combat are very low. 27 The empirical study of 1979 is based on a response of 508 men and women aged between 25 and 64. Lifestyle variables used are cigarette smoking, dental visits, exercise, weight, and seat-belt usage. Health status is reflected by three sets of indicators: first, self-reported health; second, a checklist of symptoms and diagnoses, hospital stays, visits to physicians, and use of drugs; and third, whether the respondent was able to walk or jog a mile. These measures are correlated among each other. Time preference is measured by asking the respondent questions on whether they prefer money now, or a higher amount of money in the future. Fuchs shows that for a measure of “excellent health” as dependent variable, the effect for time preference is stronger and the effect for schooling relatively weaker. 28 This is an application of game theory. Risk and time preferences are both important, because there is only a chance that someone will become ill in the case of a disease with a long latency period.

References Adams, Walter and Brock, James (1999), The Tobacco Wars, South-Western College Publishing, Cincinnati, Ohio. Arrow, Kenneth (1963), “Uncertainty and the Welfare Economics of Medical Care,” American Economic Review 53 (5): 941–973. Backhaus, Jürgen (1979), Ökonomik der partizipativen Unternehmung, J.C.B. Mohr/Paul Siebeck, Tübingen. Backhaus, Ursula (forthcoming), “Health Economics in Cameralism,” in The Economic Consequences of the Peace: The Treaties of 1648 Reconsidered, Metropolis, Marburg. Becker, Gary S. (1993), Human Capital: A Theoretical and Empirical Analysis, with Special Reference to Education, 3rd edn, Columbia University Press, New York. Becker, Gary S. and Murphy, Kevin M. (1988), “A Theory of Rational Addiction,” Journal of Political Economy 96: 675–700. Blum, Mark E. (1985), The Austro-Marxists, 1890–1918: A Psychobiographical Study, Lexington: University Press of Kentucky. Böhm-Bawerk, Eugen von ([1914] 1975), Macht oder ökonomisches Gesetz?, Wissenschaftliche Buchgesellschaft, Darmstadt; reprint of (1914), Zeitschrift für Volkswirtschaft, Sozialpolitik und Verwaltung 23 (3, 4): 205–271. Böhm-Bawerk, Eugen von (1921a), Kapital und Kapitalzins. I. Geschichte und Kritik der Kapitalzinstheorien (Capital and Interest. I. History and Criticism of Theories of Interest), 4th edn, Gustav Fischer, Jena. Böhm-Bawerk, Eugen von (1921b), Kapital und Kapitalzins. II. Positive Theorie des Kapitales (Capital and Interest. II. Positive Theory of Capital) 4th edn, vol. 1, Gustav Fischer, Jena. Böhm-Bawerk, Eugen von (1921c), Kapital und Kapitalzins. II. Positive Theorie des Kapitales (Capital and Interest. II. Positive Theory of Capital) 4th edn, vol. 2, Gustav Fischer, Jena.

194 Ursula Backhaus Fabian, Robert (1974), “The Qualy Approach,” in George Tolley, Donald Kenkel and Robert Fabian (eds) Valuing Health for Policy: An Economic Approach, University of Chicago Press, Chicago, pp. 119–136. Fuchs, Victor R. (1982), “Time Preference and Health: An Exploratory Study,” in Victor R. Fuchs (ed.) Economic Aspects of Health, University of Chicago Press, Chicago, pp. 93–120. Grossman, Michael (1972), The Demand for Health: A Theoretical and Empirical Investigation, Columbia University Press for the National Bureau of Economic Research, New York. Hayek, Friedrich A. (1968), “The Austrian School,” in International Encyclopedia of the Social Sciences, vol. 4, pp. 458–462. Ikeda, Yukihiro (1997), Die Entstehungsgeschichte der “Grundsätze” Carl Mengers, Scripta Mercaturae Verlag, St. Katharinen, Germany. Menger, Carl ([1871] 1968), Grundsätze der Volkswirtschaftslehre, 4 vols, ed. F.A. Hayek, J.C.B. Mohr/Paul Siebeck, Tübingen. Mises, Ludwig von ([1922] 1981), Socialism, Liberty Classics, Indianapolis. Moore, M.J. and Viscusi, W.K. (1988), “The Quantity-Adjusted Value of Life,” Economic Inquiry 26: 369–388. Posner, Richard A. (1995), Aging and Old Age, University of Chicago Press, Chicago. Russell, Louise B. (1986), Is Prevention Better Than Cure?, Brookings Institution, Washington, DC. Russell, Louise B. (1987), Evaluating Preventive Care: Report on a Workshop, Brookings Institution, Washington, DC. Tomo, Shigeki (ed.) (1998), Eugen von Böhm-Bawerk. Innsbrucker Vorlesungen über Nationalökonomie. Wiedergabe aufgrund zweier Mitschriften, Metropolis, Marburg. Wieser, Friedrich von (1889), Der natürliche Wert, Hölder, Vienna.

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Labor and demographic economics

10 Austrian theory in the area of labor economics Don Bellante1

Introduction Economists working within the Austrian methodological tradition have only occasionally devoted their energies to the analysis of issues in labor economics. This lack of attention is at once both puzzling and promising. It is puzzling because there are strong elements of subjectivism in any meaningful analysis of human behavior in labor markets, almost regardless of the methodological school from which such analysis proceeds. The clearest example is the analysis of labor supply in mainstream economic analysis. The classic exposition of labor supply as an effort–leisure tradeoff is the only part of the neoclassical model in which final utility in consumption is employed to explain the cost schedule of a factor of production. The concept of the role of final utility in supply is of course one of the hallmarks of Austrian economics that distinguishes it from the Marshallian conception of supply–demand interaction. There are as well a number of other elements of subjectivism in neoclassical labor economics that arise simply because the supply of labor cannot be separated from the person supplying it. These subjective determinants all fit under the general heading of “equalizing differences in wages.” Given the acceptance of some elements of subjectivism in neoclassical labor economics, the methodological distance between Austrian and mainstream economists is comparatively short. But this short distance suggests that there are heretofore unexploited, low-cost opportunities for modern Austrian economists to explain real-world phenomena in a more satisfactory fashion. Also promising is the possibility of critiquing along Austrian lines the multitude of labor market policies extant in Western economies. This chapter is devoted to the following matters: (1) the characteristics of the Austrian approach that are most appropriate to the understanding of the workings of labor markets; (2) the potential for the Austrian approach to policy analysis in the area of labor market interventions; (3) the extension of Austrian conceptions of capital structure and trade cycle theory to the labor market; and (4) a critique of macroeconomic policy in light of Austrian insights into labor market processes.

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Austrian economics and the market for labor The key elements of Austrian economics are subjective value and methodological individualism; the decentralized nature of information; disequilibrium as the continual state of markets; the central role of entrepreneurship; and competition as a market process rather than a market state. In the Austrian approach, value is seen to reside in the subject of economic activity (i.e., the human actor) rather than in the object (i.e., goods and services) of activity. The value of an object or exchange is inseparable from the purposes that the human actor intends. Further, these valuations differ not only across individuals, but over time. The conduct of a value-free social science requires the analyst to separate his or her own values and goals from those of his or her analytical subject. Accordingly, the subjective nature of value limits the power of valid economic analysis to a narrower range than is recognized by other schools of economics: If motives and values reside in the subject of analysis, it is impermissible for the economist to pass judgment on the optimality of an individual’s chosen course of action in the presence of given objective conditions. Consequently, it also is impermissible for the economist to pretend to have aggregated individuals’ utilities, by means of a social welfare function, in order to evaluate the efficiency of alternative social choices or in order to judge the efficiency of social institutions. Simply put, it is not scientifically possible to judge the desirability of trading off the gains of some individuals against the losses of others in the evaluation of any nonvoluntary action. The importance of the subjective nature of value is most easily demonstrated in the workings of the labor market. Because the supplier of labor cannot separate him- or herself from the factor he or she supplies, the compensation that a worker receives is not measured solely by pecuniary payments. All of the conditions of employment affect the attractiveness of a particular employment situation and the costs borne by the employer. Subject to legal constraints, almost all of these conditions or job characteristics can be altered by the employer. Desirable characteristics (e.g., fringe benefits of all sorts) can be increased, undesirable conditions (e.g., the risk of an accident, or the variability of income) can be reduced, but all such marginal adjustments involve costs that presumably rise at the margin. These costs are likely to vary substantially across occupations and industries, and across firms within these occupations and industries. When an employer in effect offers a package of pecuniary and nonpecuniary compensations, that employer is operating on a large number of margins. An employer is willing to incur additional cost along one margin if there are offsetting cost reductions realizable at other margins. Again, the valuations by employees of these various job characteristics are subjective: these workers’ values will differ not only from the costs of employers but from one another’s. The employer-entrepreneur profits to the extent that he or

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she is able to coordinate the disparate subjective values (pertaining to the multitude of job characteristics) of actual and potential employees with his or her objective of securing the services of labor. His or her return to this coordinating activity is the cost saving realized by altering the package of job characteristics offered to employees. On both the buyer’s and the seller’s side of the market for labor, highly imperfect information prevails and the entrepreneur has no explicit “market prices” for the individual elements in an employment package to guide his or her decisions. In the market for labor it is the entrepreneur’s alertness to unexploited opportunities, and the process of trial and error, that drive the market in the direction of coordination. This discovery process, which is at the heart of so much of the writings of Israel Kirzner (1979, 1989), is particularly relevant to the labor market because of the absence of explicit markets for individual job characteristics. But the imperfect information that characterizes the labor market at a point in time is even more relevant to an understanding of the dynamic functioning of the labor market and the entrepreneur’s role in it. Under conditions of changing tastes, preferences and technological possibilities, disequilibrium is the continual state of affairs in all markets, but especially in labor markets. True, it is entrepreneurial activity in the competitive market process that provides an equilibrating force, but neither the labor market nor any other ever attained a state of complete equilibrium. It is the disequilibrium that exists in markets that give rise to the discrepancies that provide opportunities for pure entrepreneurial profit in the first place. In the labor market these are, among others, the discrepancies between input prices and output prices, between the prices of labor and those of other inputs relative to their respective productivities, among input prices in various locations, among input prices in various uses, etc. Most pertinent to the discussion above is the discrepancy between the worker’s subjective values attached to a change in any nonwage component of the employment package (which should in time affect the price at which any quantity and quality of labor can be attracted and maintained), and the employer’s change in cost associated with the marginal change in the nonwage component. Hence, the degree of diversity of those situations that can be objectively observed in labor markets (e.g., wage dispersions within an industry) may more readily be understood not as an indication of market inefficiency or misallocation, but as a consequence of the working out of the discovery process under conditions of a diverse, complex subjectivity of values and circumstances, many of which do not have an objectively observable counterpart value.

The critique of labor market policy It is a fair question to ask whether recognition of the diversity of circumstances and the subjectivity of values confronting the labor market

200 Don Bellante provides any useful insights aside from the recognition that the labor market has more dimensions than usually are provided in simple neoclassical models of the labor market. One could point out the simple insight that governmentally imposed uniformity across society in the package of offered job characteristics is not welfare enhancing, given the variety of values and circumstances. But one could counter that a restatement to the effect that “individual welfare is potentially greatest when the range of choices is greatest” is a well-recognized deduction of the neoclassical welfare theory that Austrian economists reject. Indeed, there are many policy conclusions arrived at by Austrian economists that are identical to those deduced by other free-market economists using the criteria of Paretian welfare economics. So, it also is fair to further ask whether or not an Austrian critique of public policies in general, and labor market policies in particular, yields any distinct perspectives and conclusions. At first glance, it might appear that the subjectivist approach can have little to say about policy. After all, subjectivists reject even the concept of a social welfare function, let alone the possibility of measuring one. In fact, the Austrian approach rejects the entire Paretian framework, save the axiom that voluntary exchange is mutually beneficial, and therefore welfare enhancing, from the perspective of the parties to that voluntary exchange. Certainly, the characteristics of an Austrian welfare economics are an unresolved matter among self-identified Austrian economists (see Cowen 1994). But it does seem that the emphasis placed by subjectivists on coordination, discovery, and innovation suggests several criteria with which to judge social and legal institutions.2 The efficiency of any institution should be judged by whether that institution advances or impedes the market processes of economic coordination, discovery, and innovation – not in some imagined static world, but in the one in which human actors reside with imperfect information about the present and future. One good illustration is in the analysis of workplace safety regulation. The specific example chosen here is the Occupational Safety and Health Act of 1970, which legislates safety standards in the United States.3 The commission that administers the Act originally established over 4,000 regulations pertaining to the safety of working environments. The Act was motivated by a belief that firms lack incentives to provide the optimal degree of safety, and that workers lack sufficient information about the risk and safety associated with their employments to take such safety considerations into account. Similarly to what is done in so many policy contexts, the correct assumption that workers and firms lack perfect information leads to the incorrect assumption that a centralized authority can have the ability to better possess and process this widely dispersed information peculiar to time and place – a miniaturized version of the socialist calculation problem. Indeed, the idea that employers lack incentives has easily been shown to be false by mainstream economists, and they have also shown that workers’ information is not all that inaccurate – cer-

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tainly not systematically biased.4 Further, they have shown that the Act did not have a noticeable impact on industrial accident rates.5 One could explain this lack of apparent effect along conventional lines in terms of bureaucratic and lag-in-adjustment problems, but the approach of Austrian economics produces further insights. Such an approach leads to the expectation not merely that the Act will fail to improve safety over time, but, given enough time, that its effect will be negative. Like all other aspects of the operation of the firm, workplace safety is subject to the potential for technological improvement through entrepreneurial alertness to opportunities. But the establishment of myriad detailed legal prescriptions changes the incentives facing entrepreneurs. Such rules tend to freeze into place the existing level of safety technology and reduce the incentive to discover new safety technologies and new ways to employ existing ones. Assume for the moment that the administrators of the Occupational Safety and Health Act initially knew what they most certainly couldn’t have known: namely, the entire range of technological safety possibilities available at that time, as well as the subjective values pertinent to them possessed by the relevant individuals, as well as the objective costs associated with the assortment of then available safety technologies. If this were true (and only if it were true), it is then conceivable that the regulations put forth would be efficient, so long as there were no distortions in the incentives facing the bureaucrats themselves. But such regulations could only be efficient in the most static sense, and are almost certain to be dynamically inefficient. Innovations in safety would require bureaucratic approval. The rigid imposition of national standards of safety would retard the process of discovery of and competition from new safety technologies precisely because of the writing of standards into stone. This is not to argue that the standards cannot be changed, but those closest to the problem have reduced incentives to seek their change, for two reasons. First, the nationalization of standards changes a private good into what is essentially a public good: any entrepreneur seeking to obtain a change in a national standard has by definition no means or, at the least, dramatically reduced means of profiting from such a change. Inasmuch as neoclassical economists see a public good as a market failure, it is ironic that a perceived lack of perfect information produces an intervention that transforms a private good (in this case safety) into a public good. Second, in addition to whatever costs are associated with the discovery and installation of and adaptation of production processes to technological improvements in safety, there is a substantial additional cost when standards are codified. Specifically, the entrepreneur must undertake the costs of lobbying the appropriate legislature or administrative bureaucracy (or the costs of persuading a trade association to do so) for a change for which, as argued above, the benefits cannot be privately captured. And the responsiveness of the relevant legislators and bureaucrats is likely to be more closely associated with political considerations than actual safety

202 Don Bellante consequences. Of course, it can be argued that the substitution of political for market mechanisms is often the worst substitution of all.

The structure of production and the labor market To the extent that Austrian economists have been concerned with labor issues, it has been primarily with regard to macroeconomic considerations. The sharpest distinction between Austrian and other non-Keynesian approaches to the macroeconomics of the labor market concerns the socalled neoclassical dichotomy. The neoclassical model begins with a production function that aggregates over all categories of capital and labor. In other words, there is no structure to capital. To an Austrian economist, this aggregation as if all parts of the capital structure were homogenous (perfectly substitutable) would make heuristic sense only if the capital structure were always perfectly coordinated. In any event, this aggregate production function of neoclassical economics determines a national economy’s potential supply and, given perfectly flexible prices, its actual level of output and income. The common belief is that prices are sufficiently flexible in the long run to bring this macroeconomic equilibrium about. The level of the money supply is argued by means of the quantity theory to determine the price level, but not the structure of relative prices. All that is required for equilibrium is that the aggregate amount of investment be equal to national saving, irrespective of how well coordinated are the various types of investment expenditure. In the short-run response to an unanticipated change in the money supply, the price of labor and other inputs may be changed relative to output prices (owing to greater short-run inflexibility of wages compared to output prices), but this is the only systematic and material respect in which a monetary injection is seen to affect relative prices.6 Alternatively, the Austrian perspective focuses on the consequences of a monetary injection for the intertemporal structure of production, arguing that the structure of capital is distorted by such credit expansion in a manner that cannot be sustained through time. Specifically, the fall in the interest rate associated with bank credit expansion results in an increased entrepreneurial incentive to reallocate capital toward earlier stages of production and to create more roundabout production processes than are justified by presumably unchanged internal rates of time preference. The problem is not overinvestment or underinvestment, but malinvestment. Hence, a complete business cycle is generated through a credit expansion. Output and employment may initially increase in response to the typical monetary injection, but must inevitably decrease when the altered structure of production proves in time to be inappropriate. In virtually all treatments of the business cycle from Mises and Hayek to the present, labor is heuristically treated as a homogeneous and perfectly mobile input, in order to focus on the importance of the intertemporal structure of capital.

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Nonetheless, labor too is heterogeneous, and human capital may be as specific to a particular point in the production process as the capital that it complements. That labor, like capital, is ex ante putty-like but ex post claylike suggests that an Austrian-inspired view of human capital may produce additional insights into the unfolding and playing out of macroeconomic disturbances as they affect the labor market. Unless Austrians accept various Keynesian notions of wage inflexibility as sufficient by themselves, it is difficult to see how, without some degree of heterogeneity and specificity of human skills, the Austrian theory of the business cycle can explain the cycles in employment that accompany the cycles in output that many proponents believe are well explained by the theory.7

Macro-policy consequences of the specificity of human capital Given that human capital is at least partly specific to a certain production process, every change in the production process requires a concomitant change in the structure of human skills employed. Since the structure of production is always changing, owing to changes in tastes and technology, there is always present some degree of unemployment associated with such structural change. In the neoclassical literature this source of unemployment is recognized and labeled as “structural unemployment.” However, this neoclassical conception of structural unemployment has nothing to do with the business cycle: it, along with frictional unemployment, makes up the natural rate of unemployment that is seen to persist regardless of the state of the business cycle. Hence, the terms “structural unemployment” and “cyclical unemployment” are mutually exclusive terms in the vocabulary of mainstream economics. In what follows, this type of structural unemployment will be labeled “neoclassical-structural” unemployment. But when a cycle is produced by a bank credit expansion, the cycle itself will induce structural unemployment which, for simplicity, will be referred to as “Austrian-structural” unemployment. This phenomenon is probably not of much consequence for minor cycles of short duration, but for more protracted cycles the consequences may be substantial. As employers are led because of the creation of bank credit to shift toward more roundabout means of production, the skills required to complement the more roundabout capital stock are not instantaneously produced. Rather, specific human capital investment is required. As the structure of capital eventually proves inappropriate, so does the structure of human skills. The consequences of neoclassical and Austrian types of structural unemployment are not the same. The changes in tastes, preferences, and technology that give rise to neoclassical-structural unemployment tend to be cumulative and evolutionary – they are not necessarily self-reversing. Except under extreme change, attrition from and new

204 Don Bellante entrants to the labor force can accommodate most of the restructuring of skills required by a cumulatively changing structure of production. Because the required restructuring is not self-reversing, there is no systematic malinvestment in human capital – that is, no systematic intertemporal inconsistency in the structure of skills. In the case of a monetary policyinduced cycle the malinvestment in physical capital is accompanied by corresponding malinvestment in human capital. Whereas the changes in the required structure of human capital are self-reversing, the costs associated with accommodating the reversal add substantially to the human costs generally recognized as accompanying cyclical unemployment. There is no practical way to measure this cost, but it is in addition to the more generally recognized costs associated with lost output, and it likely persists well after the return of the appearance of full employment. Socalled full employment is eventually restored, but with so much human capital inappropriate to the corrected structure of production, real standards of living are reduced because time and other resources were used up in the production of human capital that was only temporarily in demand. By emphasizing the malinvestment in human capital, the Austrian analysis strengthens the argument made by monetarists against the use of inappropriate monetary policy to reduce unemployment, an argument based mainly on the misperceptions of workers regarding their real wages. The Austrian perspective on the structure of production also suggests an additional criticism of fiscal policy efforts aimed at shortening the duration of recessions. One standard Keynesian policy prescription calls for expanded government expenditure in time of recession. In such a view, what is aimed at is an expansion of aggregate demand achieved by temporary increases in government spending. Presumably, it does not matter where the expansion takes place, or what effect it has on the structure of production. But to understand the significance of a temporary fiscal stimulus on the structure of production, assume for simplicity that the coordinated structures of production that will be observed both before and after the recession are the same. If, for example, a massive road-building program is undertaken, it is likely that not all of the labor drawn into that program will be unemployed workers who have the requisite human capital. But if human capital specific to the make-work projects is developed, it is not transferable to the post-recession coordinated structure of production. When the fiscal stimulus ends, there is further adjustment that must be made to the structure of human capital. In the Austrian view the recession was a manifestation of previous malinvestment in the process of being corrected. The fiscal stimulus not only delays the restructuring of human as well as physical capital, but by inducing investment in specific human capital that is not coordinated with the post-recession structure of production, the fiscal stimulus further adds to the amount of human capital restructuring that must be done. The losses associated with such malinvestment would be even greater if instead of a

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road-building project the fiscal stimulus involved, for example, the expansion of mental health facilities and personnel. This expansion would generate more human capital investment since it is less likely that a pool would exist of unemployed individuals with the requisite skills. Further, human capital investment of a much more roundabout nature would take place, and those skills are likely to prove less transferable in a postrecession labor force. That the fiscal stimulus induces investment in specific human capital that is only temporarily in demand (if the Keynesian prescription is strictly followed) partly explains why there is typically so much political pressure to continue such programs rather than adhere to the prescription of cutting off the project once the appearance of full employment is restored.

Conclusion It has been argued herein that the Austrian approach to issues of labor economics, though potentially fruitful, has been underdeveloped. Nonetheless, there is a small modern literature that has developed in this area. Some of the applications not mentioned above include general critiques of labor economics and labor market policies (Bellante 1983, 1990, 1994a), and labor market discrimination issues (Walker 1994). Issues dealing with macroeconomic aspects of labor markets have been discussed by Gallaway and Vedder (1987, 1991) and Bellante (1994b). Hopefully, Austrian approaches to the area of labor markets will be more abundant in the future.

Notes 1 The author wrote this chapter with the assistance of a grant from the John M. Olin Institute for Employment Practice and Policy. 2 For example, in the United States, objectivists have suggested a process called job evaluation as a means of rectifying gender differences in pay in ostensibly similar jobs. This “comparable worth” practice, which recognizes the complexity but not the subjectivity of the employment relationship, has been criticized along the subjectivist lines suggested here by Walker (1984). 3 The discussion that follows is adapted from a more elaborate treatment of workplace legislation presented by Bellante and Porter (1990). 4 See Smith (1976) and Viscusi (1983). 5 In this regard, see McCaffrey (1983). Evidence indicates that accident rates have gone down since passage of the Act, but they already had been going down for decades. Passage of the Act did not seem to accelerate this trend. Among other reasons that could be given for this secularly downward trend is the likelihood that safety is a normal good. With secularly rising income, workers will willingly pay more for any degree of safety, thus giving employers a greater incentive to provide it. 6 There are at least two versions of the neoclassical model to be considered in this context. For a detailed comparison of Austrian and monetarist versions of the effect of bank credit expansion, see Bellante and Garrison (1988). For a similar comparison to the new classical version, see Garrison (1991).

206 Don Bellante 7 Despite the universality among modern Austrians in the acceptance of the concept of the structure of capital, not all are enamored with the business cycle theory that flows from it. See Lewin (1994).

References Bellante, Don (1983), “A Subjectivist Essay on Modern Labor Economics,” Managerial and Decision Economics 4 (4): 234–243. Bellante, Don (1990), “Labor Markets and the Welfare State,” in K. Groenveld, J.A.H. Maks and J. Muysken (eds) Economic Policy and the Market Process: Austrian and Mainstream Economics, North-Holland, pp. 151–164. Bellante, Don (1994a), “Labor Economics,” in Peter J. Boettke (ed.) The Elgar Companion to Austrian Economics, Edward Elgar, pp. 258–263. Bellante, Don (1994b), “Sticky Wages, Efficiency Wages, and Market Process,” Review of Austrian Economics 8 (1): 21–33. Bellante, Don and Roger W. Garrison (1988), “Phillips Curves and Hayekian Triangles: Two Perspectives on Monetary Dynamics,” History of Political Economy 20 (2) (Summer): 207–234. Bellante, Don and Philip K. Porter (1990), “A Subjectivist Economic Analysis of Goverment-Mandated Employee Benefits,” Harvard Journal of Law and Public Policy 13 (2): 657–687. Cowen, Tyler (1994), “Austrian Welfare Economics,” in Peter J. Boettke (ed.) The Elgar Companion to Austrian Economics, Edward Elgar, pp. 304–308. Gallaway, Lowell and Richard K. Vedder (1987), “Wages, Prices and Employment: Von Mises and the Progressives,” Review of Austrian Economics 1: 33–80. Gallaway, Lowell and Richard K. Vedder (1991), “The Great Depression of 1946,” Review of Austrian Economics 5 (2): 3–31. Garrison, Roger W. (1991), “New Classical and Old Austrian Economics: Equilibrium Business Cycle Theory in Perspective,” Review of Austrian Economics 5 (1): 91–103. Kirzner, Israel M. (1979), Perception, Opportunity and Profit: Studies in the Theory of Entrepreneurship, University of Chicago Press. Kirzner, Israel M. (1989), Discovery, Capitalism and Distributive Justice, Basil Blackwell. Lewin, Peter (1994), “Capital Theory,” in Peter J. Boettke (ed.) The Elgar Companion to Austrian Economics, Edward Elgar, pp. 209–215. McCaffrey, David P. (1983), “An Assessment of OSHA’s Recent Effects on Injury Rates,” Journal of Human Resources 18 (1): 131–146. Smith, Robert S. (1976), The Occupational Safety and Health Act: Its Goals and Its Achievements, American Enterprise Institute for Public Policy Research. Viscusi, W. Kip (1983), Risk by Choice: Regulating Health and Safety in the Workplace, Harvard University Press. Walker, Deborah (1984), “Value and Opportunity: The Issue of Comparable Pay for Comparable Worth,” Cato Institute Policy Analysis 38. Walker, Deborah (1994), “Economics of Gender and Race,” in Peter J. Boettke (ed.) The Elgar Companion to Austrian Economics, Edward Elgar, pp. 362–371.

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Industrial organization

11 Neo-Austrian, industrial and Ordo-Austrian competition policy J.A. Hans Maks

Introduction Competition policy is attracting more and more attention, sometimes to the surprise even of professional economists. A subject that for many years almost remained unnoticed is nowadays a regular news item. So, it might be a good moment to review various contributions economic science has made to competition policy recommendations. The first two sections of this chapter will review the neo-Austrian position towards regulation and competition policy. The neo-Austrian critical attitude is partly based on and refers to the ‘perfect competition and Pareto-optimality’ benchmark of traditional microeconomics. Also, modern industrial economics cannot be identified with this benchmark. The third section summarizes and characterizes the development of industrial economics. There then follows a brief impression of European competition policy. Finally, Ordo-Austrians aim at a ‘competitive order’, but they too do not identify such order with the perfect competitive Pareto-optimal benchmark. Modern third-best welfare economics may offer a solid competition policy basis to further and maintain a socially beneficial competitive order. In the fifth section I review these developments. Finally, I compare the various positions discussed and then evaluate strong and weak points of the three approaches in the concluding section.

Neo-Austrian discovery economics and regulation In the eyes of the neo-Austrian economist, competition policy is a specimen of government regulation of the market process. So, it might be useful to first, very briefly, summarize the neo-Austrian insights on the functioning of the market process (see, for example, Kirzner 1973, 1985) and then review the neo-Austrian evaluation of government regulation (see, for example, Kirzner 1985, 1990). Entrepreneurship plays an essential role in the market process. Starting from utter ignorance, entrepreneurs discover opportunities. They expect

210 J.A. Hans Maks that these opportunities will be profitable. The profit opportunities alert them and give them incentives to participate in the market. If an entrepreneur decides to offer an item of a certain quality at a certain price, he or she will learn that this offer leads to a certain volume of sales. Perhaps the volume is disappointing, because competitors are offering the item on terms that are better in the eyes of the buyers. The entrepreneur may respond by improving his or her offer: a better quality or a lower price. Or perhaps the volume surpasses the entrepreneur’s expectations: the entrepreneur may raise his or her price and increase his or her profits. This higher price, however, stimulates competition: other entrepreneurs try to offer the item on better terms (lower prices or better quality) so as to divert the profits in their direction. The market process not only reveals information about the scarcities but also satisfies them as well as this can be done. Entrepreneurship and the competition caused by entrepreneurship are the driving forces of the market process. Since profitable opportunities indicate mismatches or disequilibria, the functioning of the market, in discovering and attempting to remove them, tends towards a moving, temporary equilibrium. The equilibrium will never be reached. There will always remain disequilibrium states to discover, because, for example, preferences and technology change. So, the market process communicates information on disequilibria and at the same time moves towards a better coordination of demand and supply. The ownership of capital goods is not a prerequisite for entrepreneurial action. But it might be profitable to be the sole owner of a necessary resource. Entry by other entrepreneurs is then blocked, so one is able to monopolize the particular productive activity. The benefits of this sole ownership must be distinguished in cause: entrepreneurial profit versus monopoly rent. If a producer establishes a monopoly position by buying up all of a necessary resource, the benefits are entrepreneurial profits. The monopoly may also be a consequence of a ‘given’ distribution of resource ownership. In this case the benefit is a rent. To capture such a rent, the owner needs only to sell his or her resource to an entrepreneur. The monopoly benefits will usually be only temporary, because they will attract competition from production techniques not using the monopolized resource. So, neo-Austrians emphasize the discovery function of the market process. However, they agree with the more traditional arguments raised by Chicago economists concerning the dangers of government regulation. These arguments generally cover the following points: (1) government regulation may entail substitution of the preferences of legislators or officials, inspired by personal interests, in place of the wishes of the public; (2) there may be unanticipated side effects of the intervention that render it undesirable. The neo-Austrian, however, identifies an additional argument. This addition has to do with the propensity of government regula-

Competition policy 211 tion to hamper discovery. Regulation may influence the incentives upon which the market process depends for its functioning. A harmful influence occurs where regulation restricts or prevents the exploitation of opportunities for entrepreneurial profits. Such regulation may be a barrier to entry to a market. Freedom of entry is essential to potential competitors for them to discover profit opportunities. An example illustrates this point. Mainstream microeconomics frequently draws attention to the harmful consequences of fixing non-equilibrium prices. This government price regulation generates artificial shortages or surpluses. But price constraints may also prevent the discovery of new opportunities. In the mainstream analysis the price ceiling erases the upper portion of the supply curve. In addition, the neo-Austrians argue that the ceiling slows down the process through which unimagined sources of supply may be discovered. Such discovery may shift the supply curve to the right, or may create supply curves for new products. The basic insight that emerges from the foregoing concerns the assumption underlying the mainstream treatment of regulation. That assumption is that economic policy can be conducted against a background of given information. Neo-Austrians drop this assumption and emphasize that economic efficiency depends on continual alertness to unknown information. The main ways in which governmental regulation may hamper the discovery process are: • •

•

Undiscovered discovery. Regulation may frustrate (limit or prevent) the discoveries that otherwise might have emerged in the market process. Stifled Discovery. Since regulation often takes the form of inhibiting entry by potential new competitors, such regulation discourages discovery of existing disequilibria. Superfluous Discovery. Regulation itself opens new opportunities for entrepreneurial gain. This may not be socially beneficial. Zoning regulations, for example, channel entrepreneurial ingenuity into grasping profit generated (unintended) by the regulations.

Neo-Austrian discovery economics and competition policy In this section we will discuss neo-Austrian antitrust insights in relation with the neo-Austrian critique on Pareto-optimal allocation and standard welfare economics. A typical quotation may illustrate the topic of this section: Consumer fear of monopoly power does not depend on the dominance of the model of perfectly competitive equilibrium. But modern anti-trust policy draws upon that model for much of its intellectual ammunition. If one begins from the premise that complete allocative efficiency depends upon the attainment of the conditions necessary

212 J.A. Hans Maks for perfect competition, any departure from those conditions appears as a threat, not merely to consumers who might be subjected to ‘higher’ monopoly prices but also to the allocative efficiency properties of the entire market system. (Kirzner 1997: 58) Earlier it was explained that in the neo-Austrian theory of entrepreneurial discovery, the relevant notion of dynamic competition depends on only one condition: freedom of entrepreneurial entry. This social advantage of competition does not consist in optimal allocation. It consists of, as Kirzner puts it: a systematic process of discovering and correcting entrepreneurial errors, especially errors which have left open opportunities for as yet unexploited mutual gain through trade among market participants. Consequently, departures from the optimality conditions of perfectly competitive equilibrium are not a threat to any relevant notion of economic efficiency. (ibid.: 59) Freedom of entry is the only requirement. In most instances of blocked entry, the source is governmental privilege or governmental obstacles to entry. The only government policy needed to bring about the dynamically competitive character of the market process is to remove all such government-created obstacles. Hence, competition policy introduced to create or maintain competition is no less harmful to the entrepreneurial discovery process than are other forms of entry-limiting regulation.

Industrial economics One of the important roots of traditional industrial economics is the Harvard School.1 Whereas Chicago economics was based on maximization and microeconomic theory, traditional industrial economics was until the early 1960s characterized by case studies and a loose, often incoherent, use, if any, of theoretic tools. There are two essential concepts: the structure–conduct–performance (SCP) paradigm and the workable competition concept. In the SCP paradigm, market structure (mainly, the number of sellers and the distribution of market shares) determines conduct (mainly, price, research and development, investment, cooperation among sellers) and conduct generates performance (mainly, efficiency, ratio of price to marginal cost, profits, innovation rate). The paradigm entails a basically oneway causation scheme, but conduct and performance may alter structure. According to the SCP paradigm, a highly concentrated market structure may lead to cooperation between the sellers and thus to monopoly-like

Competition policy 213 conduct: this conduct leads to high profits and a high price to marginal cost ratio. This is basically the well-known concentration doctrine. The workable competition concept poses norms for structure (e.g. an appreciable numbers of traders, at least as many as economies of scale permit, with none dominant), conduct (e.g. there should be no unfair, exclusionary, predatory or coercive tactics) and performance (profits should be at levels that reward investment and induce innovation). The number of norms suggested varies from about six to thirteen per paradigm aspect. It is assumed that the norms can be aggregated to a rating: thus, a market may be judged to be, say, ‘almost workable’ or ‘optimum’. The workable competition concept provoked criticism. It was not operational, not consistent and it lacked a solid theoretical foundation. The results of empirical research intended to support the concentration doctrine came under attack. Research from the Chicago school and elsewhere indicated that despite high concentrations, profits fade away over time and should be seen as a consequence of efficiency and entrepreneurial skill (see, for example, Styler 1963; Brozen 1971; Phlips 1971; Demsetz 1973; Pagoulatos and Sorensen 1976). Moreover, the lack of theory, or the loose use of it in empirical research, was more and more seen as a weak point. So, one might say that all this criticism around the mid-1960s and early 1970s was the basis for a reformation leading to the new industrial economics (Scherer and Ross 1990; Tirole 1988; Schmalensee and Willig 1989). This approach is characterized by the criticism of the concentration doctrine mentioned above and an important increase in the use of the formal economic theory of imperfect competition. Moreover, attention focuses on the dynamics of the market structure. Theoretical analysis concentrates on oligopolistic interaction (game theory) and entry barriers. New models of entry deterrence have been developed. The contestable market emerges. Attention is also given to imperfect information, product differentiation and innovation. Econometric research is able to include many more variables and thus can be adapted to the specific characteristic of particular markets. The results show that higher profits require not only high concentration but also barriers to entry (see, for example, Scherer 1984). But it is still a matter of debate what kinds of barriers offer this profit protection and for how long. So far as innovation is concerned, the findings suggest that the rate of innovation is higher with market forms between pure competition and monopoly. A market in which there is hardly any room for technological innovation (the standard example is brick making) should contain relatively few competitors, whereas a market with ample innovation potential (the standard example is computer hardware and software) should have more competitors (see, for example, Scherer and Ross 1990: ch. 17). Of course, this finding too is not generally accepted and is still under discussion. The limit price scenario, with roots in traditional industrial economics (especially in the ideas of Bain (1949, 1951) has been criticized (see, for

214 J.A. Hans Maks example, Schmalensee 1988: 883), for game-theoretic reasons. The approach tries to explain, with the help of entry barriers, the phenomenon that real-world prices appear to be somewhere between monopoly and perfectly competitive levels. The idea that prices can be set such that entry is prevented by potential competitors survives, however. It can be modelled in game-theoretic settings in cases with asymmetric information (see, for example, Milgrom and Roberts 1982, 1987). Credible threats of post-entry competition, signalled through the manipulation of information (in the form of commitments, prices, announcements), are entry-deterring devices. The contestable market approach clarifies how entry barriers such as increasing returns to scale fail to have an impact on prices. With potential competition and in the absence of sunk costs, Ramsey welfare optimality can be obtained. Of course, the contestability approach has been criticized (see, for example, Shepherd 1984). The approach assumes total entry with Bertrand–Nash price setting2 without any timely response from the expelled firm. As was indicated earlier, in the new industrial economics simple conclusions that meet general acceptance are scarce. Policy implications are deduced case by case. In each specific case one explicitly analyses the welfare effects of market performance; the commonly used concepts are consumers’ surplus and producers’ surplus. These instruments are applied in partial analyses of the market(s) under consideration.

Modern European competition policy In this section I shall give a very short impression of the essentials of modern competition and especially antitrust policy. In European competition policy the Treaty of Rome (in particular, articles 85, 86 and 90) is seminal.3 Cases with effects on the trade between member states are dealt with by the European Commission on this legal base. Moreover, Europe has a substantial impact on the legal systems of member states, and/or their policy implementation (Maks 1998). Article 85 prohibits horizontal and vertical cartel arrangements, article 86 prohibits the abuse of dominant market positions and article 90 prohibits state aid. Since 1990 this system has been supplemented by a regulation concerning mergers. Although a prohibition system can be clearly observed, individual and generic exemptions are numerous. The implementation system allowing these exemptions is basically determined in line with section 3 of article 85. This section formulates the conditions that must be fulfilled to obtain an exemption. The arrangement (and to a certain extent this also holds true for mergers and state aid) should improve production, leading to higher quality or lower costs, or it should lead to an improvement in the distribution, and the customer must obtain a fair share of the fruits of the arrangement. Second, the arrangement must be necessary to obtain the goals. Finally, there must remain sufficient (potential)

Competition policy 215 competition in the market. If one analyses policy practice and the individual end generic exemptions granted, one cannot escape the impression that the principles of article 85 section 3 have been very influential. From these considerations we conclude that (mainstream microeconomic) perfect competition and Pareto optimality considerations may still play a role in the back of the minds of the relevant politicians and civil servants. But in addition, case-by-case analysis of the welfare benefits of competition restricting arrangements, in the spirit of modern industrial economics, has a growing policy impact.

Ordo-Austrian economics The Freiburg School, its seminal authors being W. Eucken and W. Röpke, clearly has established roots in the Austrian tradition (Meijer 1999). A competition order (Wettbewerbsordnung) should have as its constituting principles stable money, private property, freedom of contract, complete liability, steady and reliable government policy, and open markets. The regulating principles needed to maintain the competitive order are minimum wages, an acceptable income distribution, equalization of social and private costs, and the constraining of monopoly power to keep markets open (Grossekettler 1994). Because the emphasis is on the establishment of and maintaining the competitive ‘order’, members of the Freiburg school are denoted ‘ordo-liberals’.4 Since they also have roots in the Austrian tradition, I shall refer to the school as ‘Ordo-Austrian’. The ideal of the Ordo-Austrians is a competitive order with ‘vollständige Konkurrenz’ (i.e. complete competition; see Eucken [1950] 1992). One should not confuse ‘perfect competition’ with ‘complete competition’ (Meijer 1988: 153–160). An essential insight is that complete competition does not necessarily imply a great number of suppliers and does not include homogeneity of the product, as is normally assumed in the context of perfect competition. What is fundamental for vollständige Konkurrenz seems to be the absence of the persistent possibility of abuse of a monopoly position. In modern terms this implies that a contestable market with one supplier and a Bertrand oligopoly may be completely competitive, but price cartels are in general not. It is also acknowledged that monopoly situations cannot always be avoided. But on this point there are divergent views. The disputes relate to the level of the socially desired price and the policy to be applied to obtain these desired prices. A possible solution in this debate may be offered by modern third-best welfare economics. Ordo-Austrian competition policy and third-best welfare economics Along with twentieth-century microeconomic theory, there developed modern welfare economics. The analysis of the impact of economic policy upon society’s welfare has always been an important issue in economics.

216 J.A. Hans Maks Pareto optimality of general equilibrium is a cornerstone of the science. But since Clark (1940), Samuelson (1947) and especially Lipsey and Lancaster (1956), we know that partial corrections of the market process designed to eliminate specific disturbing factors, so-called piecemeal policies, are very hard to formulate and to execute if a complete picture of all disturbing factors, as well as the market mechanism itself, is lacking. The received extensions of general equilibrium theory relate to time, space, state and risk. If an economy with n commodities exists for a given number of periods, say t, and is partitioned into a given number of regions, say s, the general equilibrium model remains applicable. Only the commodity space is enlarged (from n to n  t  s), and so the number of excess demand equations and equilibrium prices increases. If all agents have perfect foresight of all equilibrium prices, spot markets may exist in all periods and all regions for each commodity. Risk may be brought in by expressing the probabilities of a finite number of ‘states of the world’ in each period and each region. A state may be characterized by, for example, its particular technologies, preferences and climate. Each state, in each period, has a chance to prevail. If such an economy is equipped with a complete system of future (insurance) markets, trade can be allowed at the beginning of this economy against equilibrium insurance premiums. Then again we may obtain a general intertemporal equilibrium. Such models also have in each period a temporary equilibrium. In fact, we can see the intertemporal equilibrium over several periods as a sequence of temporary equilibria in each of the consecutive periods. These extensions of the general equilibrium theory make it clear that one really needs to be omniscient to know the general equilibrium. They also demonstrate the need for a welfare economics based on incomplete information, the so-called third-best welfare economics. Third-best welfare economics is an offspring of second-best welfare economics. The founding fathers of second-best welfare economics are Lipsey and Lancaster (1956). They clearly proved that if in some parts of the economy we do not have first-best optimum conditions (price  marginal costs, etc.), a partial realization of a first-best condition in a particular market does not necessarily improve social welfare. What is socially optimal for this particular market can be calculated in principle if we have precise information on the situations in all the other (including future) markets. Since the real-world market economy is not equipped with a complete (including future) market system, third-best welfare economics may offer a way out. Third-best welfare economics starts from imperfect information. The version that is discussed here has been developed by Ng (1975, 1983), who distinguishes between informational poverty and informational scarcity. Informational poverty is defined as a situation in which we know nothing about the differences between prices and marginal costs (or

Competition policy 217 about any of the other first-best optimality rules). We can proceed if we make a very simple assumption. If one assumes that the chance of a given positive deviation of the welfare function equals the chance of an equal negative deviation and that the welfare function is symmetrical around its maximum, the expected value of the welfare is maximized by a partial realization of ‘first-best’ optimum conditions. Informational scarcity denotes a situation in which one does have some information, say an estimation of the likelihood of a given positive and negative deviation of the welfare function on a market for good i and a guesstimate of its form. Whether the likely optimum lies to the right or the left of ‘first best’ may, according to Ng (1983: 237), be more generally guesstimated as follows. Second-best welfare maximization demonstrates that, under certain conditions, it is not too far from optimal to equate the price to marginal cost ratio to the average in the economy. The conditions required are that the commodity under consideration should not be highly complementary to or substitutable by goods offered under highly monopolized market conditions. Ng considers this the beginning of an operational third-best piecemeal approach, based on informational scarcity. Note that maximum welfare in this approach is related not to perfect competition, but to the average imperfect market in the economy. One may see this result as a welfare-theoretical basis of the social desirability of the Ordo-Austrian ‘competitive order’, which is now related to average market imperfectness and not to the perfectly competitive general equilibrium benchmark. In characterizing this third-best theory, Ng states (1983: 228) that it is a ‘quite different approach’ if compared with, for example, that of Green (1961) and Hatta (1977). In developing the policy recommendations given above, he refers again to Green (1961), Mishan (1964) and Ng (1975). However, no explicit explanation or proof is offered by Ng (1975, 1977, 1979, 1983). What Green (1961) and especially Hatta (1977) were able to prove is that if we (piecemeal) decrease the highest distortion ( persistent high monopoly profit) in the economy, the social welfare increases until we meet the next highest distortion. Then, if we also lower this next higher distortion level until it reaches the following highest level, we are sure that social welfare will increase, and so on. Such a succession of steps decreasing the highest distortions) has a natural end if all distortions are equal. Hatta’s approach moreover shows that lowering of a distortion on a market has a positive influence on social welfare if there are not too many markets with higher distortions in the economy and if the commodities on the markets with higher distortions are either close substitutes or have low marginal costs. Hatta’s results can be used to specify Ng’s policy recommendations. Let us assume that the distortions in an economy are distributed such that they can be described with some density function. Suppose that they are log-normally distributed. It is clear from the considerations put

218 J.A. Hans Maks forward earlier that the more to the right of the maximum of the density of this distribution we start a decrease in a distortion, the likelier it is that we will generate an increase in social welfare. It is also obvious that a piecemeal policy of successive changes of the distortions towards the (mean) distortion value corresponding with the maximum of the distribution density diminishes the standard deviation and diminishes the number of markets in the tail of the distribution. Hence, if a consequent piecemeal policy of changing distortions towards a mean value is maintained, this will diminish the standard deviation of the distribution. The number of markets in the tails of the distribution diminishes, hence the likelihood rises of increasing the social welfare by a partial change of a distortion towards the mean value. Hence, a piecemeal repetition of such a distortion policy enhances the likelihood of a positive effect on the social welfare of a partial distortion policy. We may again conceive this as a policy that promotes and maintains the socially desirable Ordo-Austrian ‘competitive order’. We are now in a position to further specify Ng’s policy recommendations with Hatta’s insights. His statement ‘it is not far from optimal’ is not sharply defined. From the observations given here, one might see as a benchmark the ‘mean of the (log-normal) distribution of ‘price/MC ratios in the economy’. Diminishing a distortion in a monopolized market equal to this mean ratio is ‘not far from optimal’ if the standard deviation of the log-normal distributed distortions is relatively small, because then we are less likely to be troubled by wrongly signed welfare effects of markets with lower distortions. It is to be emphasized that a recurrent piecemeal successful application of such a distortion policy makes the condition ‘not far from optimal’ more likely. However, if we have reasons to believe that in an economy the standard deviation (of a log-normal distribution of distortions) is relatively high, we might adapt Ng’s policy recommendation. First, one should guesstimate where the distortion is situated in the distribution: how many markets with higher distortions are situated in the right-hand tail of the distribution. If we find that the distortion is sufficiently far from the ‘mean’, one might decrease the distortion towards ‘mean’ of the distribution of the distortions. Doing so will probably enhance social welfare if the markets showing greater distortion have low marginal costs, or if no close substitutes are traded on those markets. Finally, it is to be emphasized that one should decrease the most severe distortions first.

Comparison of the policy insights In the eyes of the neo-Austrian economist, competition policy is a specimen of government regulation of the market process. Government regulation may entail substitution of the preferences of legislators or officials, inspired by personal interests, in place of the wishes of the public. More-

Competition policy 219 over, there may be unanticipated side effects of the intervention that render it undesirable. Finally, regulation may hamper the discovery process and influence the incentives upon which the market process depends for its functioning. Neo-Austrians reject the assumption that economic policy can be conducted against a background of given information. Departures from the optimality conditions of perfectly competitive equilibrium are not a threat to any relevant notion of economic efficiency. Freedom of entry is the only requirement. In most instances of blocked entry, the source is governmental privilege or governmental obstacles to entry. The only government policy needed to obtain the dynamically competitive character of the market process is to remove all such government-created obstacles. Hence, competition policy introduced to create or maintain competition is no less harmful to the entrepreneurial discovery process than are other forms of entry-limiting regulation. Industrial economics offers scope for imperfect information and departs from the optimality conditions of a perfectly competitive equilibrium. Nevertheless, the competition policy insights differ from those of the neo-Austrians. In partial, case-by-case analyses, driven by consumer and producer surpluses, their policy recommendations may vary considerably. Cartel arrangements or mergers may under certain conditions be approved, in others cases rejected. Cost reductions, quality and distribution improvements are important considerations. This case-by-case analysis is playing an increasing role in the practical implementation of European competition policy. The Ordo-Austrian ideal is a competitive order with vollständige Konkurrenz (i.e. complete competition). Fundamental for vollständige Konkurrenz is the absence of the persistent possibility of abuse of a monopoly position. It is acknowledged that monopoly situations cannot always be avoided. Here, however, divergent views can be observed. The disputes relate to the level of the socially desired price and the policy by which one may obtain these desired prices. A possible solution in this debate may be offered by modern third-best welfare economics. Third-best welfare economics is able to cope with imperfect information and also departs from the optimality conditions of a perfectly competitive equilibrium. Nevertheless, the competition policy insights again differ from those of neo-Austrian and industrial economics. If one (piecemeal) decreases the highest distortion in the economy, the social welfare increases until we meet the next highest distortion. Then if one also lowers this next higher distortion level, until the following highest level, social welfare will increase, and so on. Moreover, lowering of a distortion on a market probably has a positive influence on social welfare if there are not too many markets with higher distortions in the economy and if the commodities on the markets with higher distortions are either close substitutes or have low marginal costs.

220 J.A. Hans Maks

Conclusion and evaluation This chapter reviews three approaches to competition policy, based, respectively, on neo-Austrian, industrial and Ordo-Austrian economics. Each approach offers scope for imperfect information and they have the rejection of the ‘perfect competitive Pareto-optimal general equilibrium benchmark’ in common. Yet their policy insights differ substantially. NeoAustrian economists advise the abolition of legal barriers to entry. Dynamic competition driven by entrepreneurial discovery will then best serve society’s economic well-being by the identification of opportunities for mutual gain through trade. Policy recommendations of the new industrial economists may vary considerably on a case-by-case basis, driven by partial welfare analyses of consumer and producer surpluses. The OrdoAustrian ‘competitive order’ may be best served by a third-best welfare economics policy. This approach proposes to diminish the greatest monopoly distortions or advises that a given distortion in the mean level in the economy should be decreased under certain conditions. Each school has its own weak and strong points. Neo-Austrian economic advice has the advantage of being simple and straightforward. However, a thorough welfare-analytic explanation of why dynamic competition always serves society’s economic well-being best is lacking. The conclusions of the analysis of an industrial economist are very much determined by the starting assumptions. A small change in these assumptions often leads to quite different and even the reverse conclusions. The difficulty lies in the choice of the relevant assumptions to solve a given case. Some reviewers would argue that any conclusion is derivable in an industrial economic analysis. The strength of the approach is often its analytical rigour. An Ordo-Austrian approach based on third-best welfare economics would call the partial welfare calculations of industrial economists misleading, because it is not certain that society’s welfare will be increased by a welfare increase in a given market. An industrial economist might argue that the third-best approach is too complicated for practical policy implementation. The choice between these three schools is for the economist largely a matter of (political) taste, and de gustibus non est disputandum. The fact that a dispute does not take place at all is highly regrettable. If the choice between these schools is a matter of taste, a scientific evaluation of economic policy advice is out of our reach.

Notes 1 Leading names: J.M. Clark, E.S. Mason and J. Bain. 2 Price setting with the conjecture that other firms will keep their prices fixed. 3 In the Treaty establishing the European Community (published in the Official Journal C 325 of 24 December 2002) the numbers of these articles are respectively 81, 82 and 87.

Competition policy 221 4 The name ‘Ordo-liberals’ can be traced back to the homonymic ORDO yearbook: Jahrbuch für die Ordnung von Wirtschaft und Gesellschaft.

References and further reading Bain, J. (1949), ‘A Note on Pricing in Monopoly and Oligopoly’, American Economic Review 40: 448–464. Bain, J. (1951), ‘Workable Competition in Oligopoly,’ American Economic Review 41: 35–47. Bain, J. (1956), Barriers to New Competition, Harvard University Press, Cambridge, MA. Brozen, Y. (1971), ‘Concentration and structural and market disequilibria’, Antitrust Bulletin 16: 241–248. Clark, J.M. (1940), ‘Towards a concept of workable competition’, American Economic Review 30: 241–256. Demsetz, H. (1973), ‘Industry structure, market rivalry and public policy’, Journal of Law and Economics 16: 1–10. Eucken, W. ([1950] 1992), The Foundations of Economics, Berlin. Green, H.A.J. (1961), ‘The Social Optimum in the Presence of Monopoly and Taxation’, Review of Economic Studies 29: 66–77. Groenveld, K., Maks, J.A.H. and Muysken, J. (1990), Economic Policy and the Market Process: Austrian and Mainstream Economics, North-Holland: Amsterdam. Grossekettler, H.G. (1994), ‘On Designing an Institutional Infrastructure for Economies: The Freiburg Legacy after 50 Years’, Journal of Economic Studies 21 (4): 9–24. Hatta, T. (1977), ‘A Theory of Piecemeal Policy Recommendations’, Review of Economic Studies 21 (4): 9–24. Kirzner, I.M. (1973), Competition and Entrepreneurship, University of Chicago Press, Chicago. Kirzner, I.M. (1985), Discovery and the Capitalist Process, University of Chicago Press, Chicago. Kirzner, I.M. (1990), ‘The Market Process: An Austrian View’, in K. Groenveld, J.A.H. Maks and J. Muysken (eds) Economic Policy and the Market Process: Austrian and Mainstream Economics, North-Holland, Amsterdam, pp. 23–39. Kirzner, I.M. (1997), ‘How Markets Work: Disequilibrium, Entrepreneurship and Discovery’, Hobart Paper 133, Institute of Economic Affairs, London. Lipsey, R.G. and Lancaster, K. (1956), ‘The General Theory of Second Best’, Review of Economic Studies 24 (1): 11–32. Maks, J.A.H. (1998), ‘Post-war Anti-trust Policy in Germany and the Netherlands in a European Perspective’, Papers and Proceedings, 4th ISINI Congress, Maastricht. Mason, E.S. (1957), Economic Concentration and the Monopoly Problem, Harvard University Press, Cambridge, MA. Meijer, G. (1988), Het Neoliberalisme, Van Goreum, Assen/Maastricht Meijer, G. (1999), ‘Some Aspects of the Relationship between the Freiburg and the Austrian School’, Journal des Économistes et des Études Humaines 8 (June/September). Milgrom, P. and Roberts, J. (1982), ‘Predation, Reputation and Entry Deterrence’, Journal of Economic Theory 27: 280–312.

222 J.A. Hans Maks Milgrom, P. and Roberts, J. (1987), ‘Informational Asymmetries, Strategic Behaviour and Industrial Organization’, American Economic Review 77: 184–193. Mishan, E.J. (1964), Welfare Economies: Five Introductory Essays, Random House, New York. Ng, Yew-Kwang (1975), ‘Non-economic Activities, Indirect Externalities, and Third-Best Policies’, Kyklos 29: 507–525. Ng, Yew-Kwang (1977), ‘Towards a Theory of Third Best’, Public Finance 32: 1–15. Ng, Yew-Kwang (1979, 1983), Welfare Economics, London. Pagoulatos, E. and Sorensen, R. (1976), ‘Foreign trade, concentration and profitability in open economics’, European Economic Review 8: 255–267. Phlips, L. with M. Biart et al. (1971), Effects of Industrial Concentration: A Cross-section Analysis for the Common Market, North-Holland, Amsterdam. Samuelson, P. (1947), Foundations of Economic Analysis, Harvard University Press, Cambridge, MA. Scherer, F.M. and Ross, D. (1990), Industrial Market Structure and Economic Performance, 3rd edn, Houghton Mifflin, Boston. Scherer, F.M. (1984), ‘On the Current State of Knowledge in Industrial Economics’, Discussion Paper IIM/IP 84-24, Wissenschaftszentrum Berlin. Schmalensee, R. (1988), ‘Industrial Economics: An Overview’, Economic Journal 98: 643–681. Schmalensee, R. and Willig, R.D. (eds) (1989), Handbook of Industrial Organization, North-Holland, Amsterdam. Shepherd, W.G. (1984), ‘Contestability vs. Competition’, American Economic Review 74: 572–587. Stigler, G.J. (1958), ‘The Economics of Scale’, Journal of Law and Economics 1: 54–71. Stigler, G. (1963), Capital and Rates of Return in Manufacturing Industries, Princeton University Press, Princeton, NJ. Tirole, J. (1988), The Theory of Industrial Organization, MIT Press, Cambridge, MA.

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Business administration and business economics; marketing; accounting

12 Discovery, competence and services Bart Nooteboom

Introduction We expect analysis of markets from an Austrian perspective of discovery to yield a better understanding, because it alerts us to the question of how producers and consumers behave in discovering needs and ways to satisfy them. Conversely, the attempt to make Austrian theory work may contribute to further development of that theory. For example, we need to consider not only competition as a discovery process, as Hayek proposed, but consumption as well. We pay particular attention to services, because they serve as a magnifying glass for seeing neglected aspects of the market process. As I shall show, in services consumers are active not only in consumption, but also in production, and thereby take part in the discovery process in competition. Once we are alerted to this, we see more clearly how consumers also play an active role in the production of goods. In this way, services are of theoretical importance, but they are also of great practical importance since services have grown enormously as a proportion of employment and national product, whereas the older Austrians, like most economists of the past, focused on goods. If we accept the Austrian subjectivist assumption that knowledge is dispersed, and “different minds think different things” (Lachmann 1978), then the market process requires discovery by interaction between the carriers of that dispersed knowledge. Producers and consumers have to identify opportunities, recognize them as relevant, and match them with preferences, technological feasibilities and competencies. Different people have not only different preferences, but also different perceptions, interpretations and understandings of utilities and feasibilities, and different competencies in both production and consumption. If subjectivism is taken to imply consumer sovereignty, this is mistaken. A deep reason for this is given in Wittgenstein’s argument against the possibility of a private language: without intersubjective discourse there is no basis for truth.1 A similar view was expressed by, among others, Levinas and G.H. Mead: a subject needs interaction with other subjects to develop

226 Bart Nooteboom his or her own identity. In the present context, in both the formation and satisfaction of preferences, consumers are subject to external influence: effects of communication, demonstration, snobbery and bandwagon effects, advertising and the like. Without such interaction, economic agents could not learn and there would be insuperable problems of incentive alignment. Accepting this, one might now think that, ultimately, interaction between economic agents would yield an equilibrium of common understanding and shared competency. But interaction produces new perceptions, interpretations, meanings, and technical possibilities. Products are adapted to a variety of tastes, and preferences are adapted to newly perceived consumption opportunities. There is hardly a point at which equilibrium can ever arise. In this perspective, competition does not take the form of producers employing equal competencies and pushing prices to marginal costs. The drive behind competition is that entrepreneurs try to distinguish themselves from competitors, and thereby push profits above marginal costs. They do this by replacing products and practices by new ones that are more efficient, or satisfy preferences more closely, or generate novel perspectives for production or consumption, and thereby shift preferences. They try to do this on the basis of distinctive competencies that are not easily imitable. “In the long run”, knowledge will spill over, and in that sense there may be a tendency towards equilibrium, but entrepreneurs strive to develop novel opportunities and competencies before that happens, and stay ahead of the game. Here I take the “resource” or “competency” view of the firm, which goes back to the work of Edith Penrose (1959; for a survey, see Foss and Knudsen (1996)). This fits with Austrian subjectivism, applied to the firm. Not only consumers, but also different firms “think different things” – have different cognitive and other capabilities. These are firm specific, and not easily subject to spillover to the extent that knowledge is tacit, or embodied in organizational structure, process and culture. Even if competitors can observe what a firm does, what it does may be “causally ambiguous” (Lippman and Rumelt 1982): they may not understand it or be able to implement it in their own organization. In other words, they may not have “absorptive capacity” for it, to use another piece of modern parlance (Cohen and Levinthal 1990). What precisely, then, is involved in producers finding out about consumer needs and offerings by competitors, and in consumers finding out about needs that can be satisfied and opportunities to satisfy them? These processes are far from trivial or simple. A whole discipline exists to study this: the discipline of marketing. There is hardly any Austrian theory of the firm that analyses what precisely firms do in the market process, and how they do it. Auke Leen, in this volume, finds that how consumers go about consumption has also

Discovery, competence and services 227 been neglected by Austrian theory. In both production and consumption, capabilities are neglected. Menger (1934: 78) defined value as follows: “the significance which concrete goods or quantities of goods obtain for us from the fact that we are aware that the satisfaction of our wants is dependent upon our disposing of these goods”. Thus, as indicated in the chapter by Leen, Menger identified as conditions for consumption that consumers need to have knowledge of the causal connection between a useful thing and a need, and need to have command over the thing. Böhm-Bawerk proposed that apart from “knowing that” a thing works to satisfy a need, one will also need to have “know-how” in using the thing to that effect. Although attempts were made to subsume this under the “command” of the thing, Leen argues that this does not work, and know-how remains as a separate category in consumption. More generally, Austrians do not specify the causal processes by which valuation, production and consumption, including preference formation, take place. This point will be taken up further in the present chapter. Both producer and consumer competency, and the relation between them, will be modelled in terms of scripts.

Consumer capital As proposed by Lancaster (1966), products (goods and services) entail bundles of characteristics: utility has multiple dimensions. How are these evaluated by consumers? Multiplicity of characteristics can yield problems of choice between two products if the one is better in some characteristics and the other in other characteristics, and the different characteristics are not commensurable. This can yield violation of the axiom of transitivity.2 But more fundamentally, it has been recognized that for consumption, consumers need “consumer capital”, not unlike the “human capital” that is needed in production (Stigler and Becker 1977; Woo 1992). Woo (1992) proposes six aspects of this capital: information and experience from the past, skills and interest in consumption, propensity to try novelties, knowledge and skill in bargaining and decision making, ability to protect their interests as consumers, and availability of aids needed in the process of consumption. This partly corresponds with the features that Leen (this volume) derived from Menger and Böhm-Bawerk, as indicated earlier in the chapter, but it does explicitly include skills in the consumption process. The notion of consumer capital is closely related to the notion of competency used in this chapter: competency in the process of consumption is part of the wider notion of consumer capital. It is also related to the notion of “absorptive capacity” (Cohen and Levinthal 1990), which is usually applied to firms but can equally well be applied to consumers: to what extent are consumers able to absorb a product in their consumptive repertoire? In part, consumer capital serves to reduce transaction costs. These are costs of contact, contract and control. They arise in the search to achieve

228 Bart Nooteboom contact between producers and consumers: producers seeking out the nature, price and location of consumer demand and competitive supply, consumers seeking out nature, price and location of supply. They arise in contract: evaluating quality and reliability, bargaining and preparation of a contract or some other form of explicit or implicit agreement to transact. While Williamson defined a transaction as a “transfer across a technologically separable interface”, it seems better to define it as a transfer of property rights (either in the sense of decision rights, which leaves room for transactions within a firm, or in the sense of claims to residual profit, or both). They arise in control, including monitoring, “haggling”, renegotiation. They also arise in mutual adaptation of competencies or other resources, particularly when these entail transaction-specific investments, which yield problems of “hold-up”, as argued in standard transaction cost economics (TCE; see Williamson 1985). There is a well-known distinction between “search”, “experience” and “credence” products,3 according to whether quality can be judged by consumers prior to consumption, during consumption or not even after consumption. Transaction costs are greater, ceteris paribus, to the extent that quality is harder to judge, since that increases the cost of search as well as costs of contracting and monitoring. We should thus expect transaction costs, and the resulting need for consumer capital, to be highest for credence products and lowest for search products, and intermediate for experience products. However, consumers do not stand alone in the reduction of transaction costs. Often, third parties of many types act as intermediaries, to reduce transaction costs. And we would expect the roles they play to be more intricate and developed to the extent that transaction costs are higher: most for credence products, and intermediate for experience products.

Are consumers entrepreneurs? Casson (1998) characterized entrepreneurship as reducing transaction costs. This keeps the notion of entrepreneurship close to the long tradition of seeing the entrepreneur as someone who “makes markets work”, by arbitrage or, when we recognize the importance of transaction costs, the reduction of transaction costs. A reduction of transaction costs allows for more market and less “hierarchy”, according to TCE. If we accept this view and also grant that consumers develop capital to reduce transaction costs, as argued above, then it follows that consumers are entrepreneurs. But this characterization of entrepreneurship would turn all kinds of intermediaries into entrepreneurs – not just retailers, brokers, insurance middlemen, estate agents, notaries, art dealers and advertising agencies, but also trade fairs, government information services, lawyers, sports journalists, art critics, museums and scientists. If we were to allow not only the reduction of transaction costs but also

Discovery, competence and services 229 their avoidance, by integrating activities in the firm and thereby bringing them under “hierarchy”, as TCE proposes, then all kinds of managers also would be entrepreneurs. Though perhaps unusual, that suggestion is not new: Marshall, for example, recognized managers as entrepreneurs. But soon we would approach a viewpoint that goes even beyond Mises: not only does everyone have the potential to be an entrepreneur, but most people are actual entrepreneurs in taking actions that reduce transaction costs. From a Schumpeterian perspective, entrepreneurship by yielding novelty increases rather than decreases transaction costs: new producer and consumer capital, or absorptive capacity have to be developed to utilize the innovation. However, such building of absorptive capacity might also be seen as innovation. In the innovation literature a distinction is usually made between innovations new to the world, new to the industry and new to the firm. If different people (and firms) think different things, and knowledge is dispersed, then the adoption of some innovation might require quite an adjustment. Adopting an innovation in a firm will in general require organizational adjustments to enable its absorption, and this entails the ability to achieve an adaptation and alignment of the mental frameworks and competencies of people in the firm. This should probably be counted as entrepreneurial (Nooteboom 1992), even if for other firms the novelty has become routine. Now, if a consumer builds consumer capital and develops his or her absorptive capacity, would that count as entrepreneurship? If not, what if in the process he or she takes others along, such as family members or friends, by pioneering and demonstrating new consumption? In the literature on the diffusion of innovations, “early adopters”, at the beginning of the “product life cycle”, are in fact also called “innovators”. Diffusion curves are modelled on the assumption that their consumption spills over by “contagion”, on the basis of demonstration or communication.4 In this way, consumers can assume the role of agents in diffusion and thereby become like entrepreneurs. But we will see that consumers can be seen to participate in innovation for much more fundamental reasons.

Cognition To proceed, we need to unpack the notions of “competency” and “absorptive capacity”, and for this we need to consider how cognition works. We cannot afford the Austrian disregard for this out of the mistaken idea that subjectivity entails sovereignty and that therefore consumers should remain black boxes. We do not need to delve deeply into psychology and sociology, and thereby subject the fundamental basis of economic behaviour to the vicissitudes of those disciplines. We can build upon a few basic and simple principles of mental economy, as argued for a long time by Herbert

230 Bart Nooteboom Simon in many of his works, and others (e.g. Woo 1992). Given that cognitive capacity is limited, it is rational to have a mind that works on the basis of two principles: routinization and a “chunking” or modularity of knowledge. Routinization allows us to focus our capacity of rational evaluation on what is new and urgent, and to conduct other activities on the basis of subconscious or semi-conscious routines that have survived as successful from previous experience. To organize knowledge as a combination and recombination of different component routines is efficient for the same reason that it is efficient to construct organizations from subsidiaries or divisions and computer programs from modules. If component activities appear repeatedly in different configurations, it is wasteful and slow to construct them from scratch each time they are needed in different contexts. Thus, “chunking” yields efficiency and speed. Of course, we do pay a price for this. Subconscious routines are vulnerable to failure under change and to outside manipulation. While routine has a rational basis in successful past practice, it fails when conditions change and invalidate that practice, and because routines are largely tacit, it can be difficult to become aware of such inadequacy. And rhetoric and imagery in advertising and corporate culture can insinuate themselves in the tacit routines that underlie cognition. In corporate culture this helps entrepreneurs to align incentives and perceptions of the people in it (Nooteboom 1992), but indoctrination also has its darker sides.

The scripture of know-how What more, then, can we say about routines or “mental maps”? Here I employ the notion of a script, taken from cognitive science (Abelson 1976; Shank and Abelson 1977) and applied to organizations by Gioia and Poole (1984) and Barley (1985). It is a simple concept, and one that is not quite adequate without extensions, but is nevertheless worthwhile. A script represents an activity as an ordered sequence, or network, of “nodes”, which represent constituent activities. It is arguably the simplest way to model the notion of “chunking”. Such “chunking” is an important concept in cognitive science to explain cognitive functioning, and its function has already been indicated. On the organizational level a script models what March and Simon (1958) called “performance programs” and others have called an organizational “routine” (Cyert and March 1963; Nelson and Winter 1986; Levitt and March 1988). It is perhaps the simplest device with which to model coordination of activities. It allows us to do two important things: first, to distinguish lower-level innovation (novel nodes) and higher-level innovation (novel “architecture”; cf. Henderson and Clark 1990); and second, to yield a framework for a multi-level theory of people, organizations and markets/industries. People employ scripts in their cognition, people substitute activities into nodes of organizational scripts of production, firms substitute their activities into nodes of

Discovery, competence and services 231 industrial scripts (such as “supply chains”). The notion has been used in this way in a theory of innovation and learning (Nooteboom 2000). This implies recursiveness: scripts have superscripts and subscripts; when we apply a looking glass to a node, we see subscripts. Scripts impose constraints on activities substituted into nodes, to ensure that conditions of outputs from preceding nodes and inputs in succeeding nodes are satisfied. A practice or technology is more “systemic” (as opposed to “standalone”) to the extent that such conditions are narrow (Teece 1986, 1988; Chesbrough and Teece 1996). We need a wider, more flexible structure that allows for variation of a script in different conditions. For example, in a service restaurant script (Shank and Abelson 1977) people select their food after they are seated and they pay after eating, but in the innovation of a self-service restaurant, selection and paying precede seating. With different probabilities of selection attached to different variants of a script, we allow for genetic-type algorithms, where probabilities of selection vary according to success experienced in similar conditions. In cognitive science the script has been criticized for being insufficiently flexible: it does not deal with events that are atypical for the context (Holland et al. 1989: 13). This was admitted by Shank and Abelson (1995). What happens if a dog enters a restaurant? If it belongs to a customer, some restaurants will allow it, but then the dog does not participate in the seating and the eating (although some people sneak food to the dog under the table, and in some countries it is acceptable to ask for a doggy bag for taking home the remains). What happens when a goat enters? Something will be done, but there is no prescription for it in the script. Holland et al. (ibid.) conclude that the script might still be of some use, but in combination with other knowledge structures. One might use multiple scripts plus processes of script selection, integration and coordination. This indeterminateness of scripts is crucial. It is related to the impossibility to reduce tacit knowledge to documented knowledge without any residual. This applies at least to knowledge in the form of know-how. Perhaps knowing-that can be documented without residual, such as a mathematical theorem. But even there, at some level the elements of discourse have to be taken for granted. In any case, know-how in organizations is embedded in “communities of practice” (Brown and Duguid 1991), where prescribed procedures are supplemented with tacit knowledge that requires socialization to acquire. The irreducibility of tacit knowledge explains how “working to rule” – that is, conformance to what is prescribed in a script – can amount to sabotage. But know-how in consumption is embedded in social contexts as well. The proposition now is that both production and consumption entail scripts (or some more sophisticated generalization of that notion). The consumer’s script constitutes his or her know-how in consumption. So,

232 Bart Nooteboom here building social capital is rendered as developing scripts. A producer who offers a product to a consumer offers either something to be substituted into one or more nodes in an existing consumer script or a novel script. Products are substitutes when they can replace each other as substitutions into a node, and are complementary when they are substitutions into different nodes of the same script. A substitution might not fit – that is, the consumer has no absorptive capacity for it, and would have to adjust his or her script (“know-how”). Such adjustment can be local to a particular node, or architectural, requiring a rearrangement of nodes. The need to make architectural changes appears sooner to the extent that the practice is systemic – that is, the restrictions on substitutions are narrow. To the extent that a new product requires a change of users’ scripts, it will have difficulty in penetrating the market. Learning can entail an increase of efficiency in operating existing scripts, or the development of novel scripts. This may align with the distinction between “incremental” as against “radical”, innovation, and with the literature on organizational learning which distinguishes between “first” and “second-order” learning (Bateson 1972; Fiol and Lyles 1985) or “single-” and “double-loop” learning (Argyris and Schön 1978). First-order learning may be identified with finding the most efficient substitution into nodes and shedding redundant nodes, or splitting up nodes for specialization, or merging nodes from different positions in the script to a single position to increase volume for economy of scale. But this already suggests that in this way first-order learning can shift into architectural, second-order learning. However, it goes beyond the purpose of this chapter to develop a full theory of learning (for such a theory, see Nooteboom 2000). The social embedding of consumption can entail learning in the form that people copy substitutions into scripts from each other – that is, learn to use new products by imitation. Consumers can be innovative in pioneering novel scripts of consumption. But for reasons of social prestige, people might purchase products that do not fit in their scripts, to signal that they do have the appropriate script, without the intention to actually develop it. An example is people buying computers without intending to utilize their potential.

The discovery of services The characteristics of a service recognized in the marketing literature are that a service is intangible, disembodied, is often a process, cannot be stored and entails a coupling of production and consumption in time and place. In the script model we reconstruct services as turning around the relation between producer and consumer: the consumer contributes an activity to one or more nodes in a producer script. For example, he or she enters a restaurant, shop, doctor’s surgery, classroom or concert hall to take part in a process.

Discovery, competence and services 233 However, the distinction between goods and services is not as strict as is suggested here. Services contain tangible elements, such as food in a restaurant, or the plane and catering in air transport. Consumers contribute their activities in only part of the productive process: in the “front office” as opposed to the “back office”. Goods include services added to the physical product, such as installation, training, maintenance and repair. While many goods can be seen as substitutions into consumer scripts, some goods provide a script into which a consumer substitutes his or her activities. A car, for example, has to fit into consumers’ travel scripts (the garage, family size, style of driving), but within that script the consumer has to fit actions into the subscript of driving, which is to a large extent determined by the car’s design. As a result of the development of information and communication technology (ICT), the characteristic features of services are subject to erosion. ICT enables information and even know-how to become embodied in databases or software (including so-called expert systems, which incorporate heuristics derived from professional actions), so that they can be stored to be used by the user at other times and places, meaning that the coupling in time and place of production and consumption is broken. Increasingly, the consumer can determine time and place: in “telebanking”, applications for finance or insurance, claims processing in insurance, ordering and paying via the Internet. In terms of our script model, there is a shift from producer to consumer scripts. Conversely, the service aspects of manufacturing are expanding. Its core activity is the artificial transformation of material inputs into material outputs.5 But in addition, there are many peripheral, connecting and supporting activities with service characteristics: R&D, design, internal transport and stocking, quality assurance, administration, marketing, management, personnel services, finance and control, and the information processing involved in these activities and their coordination. These aspects are expanding as a result of the increased importance of product design, product differentiation and speed of introducing new products. Manufacturing and services are becoming not only more alike, but also more intertwined. This process is associated with novel concepts of “lean production” and “supply chain management”. These entail a closer coordination of different parts of the chain of production and distribution. This serves to improve quality, reduce losses and costly errors, and to speed up processes of delivery and development. This increased coordination entails an increase of service components in manufacturing, and a closer integration of manufacturing and services. In terms of the script model, service nodes are increasingly added to industrial scripts. This entails a greater involvement of users in producer scripts in manufacturing too. To sum up: in both services and manufacturing there is a shift towards the involvement of users.

234 Bart Nooteboom

Innovation and the role of the consumer Schumpeterian entrepreneurship in general can now be associated with changes of script, by providing either novel substitutions into nodes of existing scripts or novel architectures of scripts. Because of the recursiveness of scripts, this is a matter of level rather than principle: a novel substitution into a node entails a novel architecture in a corresponding subscript. Consumers, then, are also entrepreneurs to the extent that they contribute to changes of script. These may be consumer or producer scripts. Especially in services, consumers participate in producer scripts, and can thus be crucial for their innovation. For example, an innovation in retailing was the shift from service to self-service. In the logic of scripts this constituted a reversal of flow from products to consumers: rather than consumers standing in front of a counter and goods being collected by an attendant, in self-service the goods are static on their shelves, and consumers move through the store. In that sense there was a shift from a producer to a consumer script: store design had to be adapted to consumers’ capabilities and preferences in perception and the handling of goods. To the extent that in services there is a shift to consumer scripts, and services play a greater role also in manufacturing, users will to a greater extent participate in production, and by extension play a role in their innovation. To sum up: consumers are of importance for innovation, by adapting consumer scripts, but also by contributing to the change of producer scripts in services, which are playing an increasing role also in manufacturing.

Intermediaries It was noted earlier that intermediaries between producers and consumers are needed to the extent that there are transaction costs, and that this need is greater to the extent that product quality is difficult to judge. I have already mentioned brokers, insurance middlemen, trade fairs, estate agents, notaries, attorneys, sports journalists, art dealers, museums and art critics. Retailers provide a utility of time (opening hours), place (distance) and assortment (range of goods offered). They used also to provide a utility of information, both to the consumer and about the consumer to the producer. Increasingly, the need for this has declined as a result of increased knowledge, confidence and experience on the part of consumers, and computer-assisted gathering of consumer data (accelerated by the development of the bar code and scanner checkouts). But in markets where product quality is difficult to judge, and where product use entails important tacit knowledge, the importance of intermediaries in the informational role remains. In policy debates there is the

Discovery, competence and services 235 expectation of “dis-intermediation” as a result of the emergence of the “electronic highway”: intermediaries will be eliminated as supply and demand meet there. And for some intermediaries this effect is doubtless emerging. It is, for example, a threat for insurance middlemen, who might be eliminated by “direct writing”, for at least a number of insurance products. But for others it does not apply. Examples are intermediation in the labour market, recreation and arts. Roles of intermediaries go far beyond any simple “provision of information”. Nooteboom (1999) identified seven roles for a go-between: trilateral governance (arbitration or mediation), keeping of hostages, revelation of value, spillover control, acting as a sieve and amplifier in a reputation mechanism, trust building and build-up, maintenance and ending of relations. Trilateral governance derives directly from standard TCE. As prescribed by Williamson (1985), when investments in a transaction relation are moderately “specific” (sunk in the relation), and transactions are insufficiently frequent to warrant the cost of extensive “bilateral governance” to control risks of “hold-up”, then a third party might solve the problem: it acts as an arbitrator when conflicts arise. According to TCE, “hostages” form an instrument of governance, in the form of an exchange of staff, information concerning a firm’s “core competency”, or equity participation. But a complication is that the keeper of a hostage may be tempted not to return it even if the partner honours the agreement for which the hostage was given as a safeguard. This risk can be reduced if the hostage is kept by an outside third party who has no interest other than maintaining the trust of the people for whom he or she intermediates. The revelation problem derives from Arrow’s paradox of information: a potential buyer of information would want to first see it to assess its worth, but once the potential buyer sees it, he or she has it and will no longer be prepared to pay. This also can be solved by a competent and trusted third party to whom the judgement of value is delegated, without the information itself reaching the potential buyer. Associated with this, in the exchange of sensitive information a third party might monitor information streams to prevent spillover to outsiders. The point that drives the logic of this is that the partners themselves could not conduct such monitoring of each other because that would lead to more information being exchanged, which would further increase the risk of spillover. The go-between would constitute less of a threat, because he or she could make no use of the information for him- or herself, and the go-between’s overriding aim is to maintain a reputation of competence and fairness in that capacity. Go-betweens are often needed in reputation mechanisms, to separate true allegations of untrustworthiness from malicious gossip, and as an amplifier to broadcast evidence to potential partners of the culprit.

236 Bart Nooteboom Finally, a go-between can facilitate the building of trust, which would reduce transaction costs without expensive governance (Nooteboom 1999). He or she can do so primarily by eliminating misunderstandings from accidental mishaps that might be interpreted as opportunism, which might trigger a vicious circle of mistrust. Especially at the beginning of a relationship, when something goes wrong it is difficult for a partner to decide whether it is due to mishap or opportunistic intent, because it is in the interest of the partner to profess the former when it is the latter. Closer investigation to decide the issue may be blocked for fear of the threat of spillover of knowledge gathered in the process. The go-between by assumption presents less of a threat in this. Clearly, this relates to the other roles of the gobetween: the roles of revelation and spillover control. The go-between can also help in ending and untangling relationships with a minimum of conflict.

Absorption We reconstructed absorption as a substitution into nodes of a script. On the level of people, scripts include mental categories (or “maps” or “frameworks”) that are largely tacit. Clever advertising helps to achieve the fitting in. If there is no absorption due to lack of fit, the script will need to be adapted, but when it is tacit, the person may need to go through a possibly lengthy process of cognitive development. It may be possible to make tacit knowledge explicit by some process of Socratic “midwifery” by which tacit presuppositions are made explicit in dialogue. Or one may try to penetrate into tacit knowledge by ingenious symbolism that entails “sense making” rather than “explanation”. This is among the things that advertising tries to do, in ways that often seem to make little rational sense: rationality would require prior transformation of tacit into explicit knowledge, for which in competition there is often no time and no money. Symbolism in sight and sound is used to smuggle in new nodes or trigger the formation of novel scripts. So, apart from the fact that the discovery process entails not only the transfer of knowledge, but also issues of governance, spillover control and trust building, as discussed in the previous section, the “transfer of information” itself, particularly the transfer of knowledge in the sense of altering a script, is a highly complicated, sophisticated and partly non-rational affair, which includes apparently non-informative and nonsensical advertising.

Discussion With the use of the Austrian notion of the market as a discovery process, an attempt was made to apply it by considering what problems of information and knowledge arise in markets, and how they might be overcome. In investigating this, the modern concept of transaction costs was incorporated, and also the notion of a script.

Discovery, competence and services 237 An attempt was also made to clarify the notion of entrepreneurship. One reason for this was to further contribute to debate on the issue, raised by Auke Leen in Chapter 3, of whether consumers too can be seen as entrepreneurs. In the analysis, entrepreneurship was first seen in terms of “making markets work”, and this was interpreted as reducing transaction costs. This definition of entrepreneurship was found to be too wide, hardly excluding anything. We next concentrated on competencies of production and consumption, where the latter is associated with the notion of “consumer capital”. Competencies were reconstructed in terms of the notion of a “script”, taken from cognitive science. This serves to model a hierarchy of activities in processes of production and consumption – an architecture of nodes that represent “chunks” of activity. In organizational scripts, people substitute their actions into such nodes, but those actions in turn have the form of “sub-scripts”. Consumers also operate on the basis of scripts. A basic characteristic of goods is that they are substituted into nodes in consumer scripts. A basic characteristic of services is that users substitute actions into producer scripts. But in a hierarchy of scripts mixes increasingly occur, in the “industrialization of services” and in services playing a greater role in manufacturing. Because of ICT, there is a pervasive shift to a greater involvement of consumers. Entrepreneurship was then defined as the changing of scripts. This allows for different levels of innovation: by contributing one or more novel substitutions into one or more nodes, or by offering a novel “architecture” of a script. The notion of “absorption capacity” was rendered as the ability to substitute into a node of a script. This allows for entrepreneurial consumers who innovate scripts of consumption. But in services, users contribute actions to producer scripts, and can thereby contribute to their innovation as well. And since manufacturing tends to include increasingly more service activities, users can contribute to innovation there also. Summing up, users contribute to innovation and entrepreneurship in the following ways: •

• •

For goods, users set the scripts within which goods have to fit, and often producers do well to involve users in finding out the conditions of fit. Users develop novel user scripts. In services, users participate in producer scripts and their change.

A further analysis of transaction costs yielded an extension and a deepening of roles for intermediaries in markets. These roles go far beyond the “transmission of information”. They include support in governance and monitoring, revelation of the value of information, hostage keeping, spillover control, reputation mechanisms, trust building and relationship development. But more fundamental than that is the fact that in the

238 Bart Nooteboom market process the “transfer” of knowledge is highly non-trivial and can entail “sense making” rather than rational explanation. That too is part of entrepreneurship, in its role of changing scripts: with respect to consumers in advertising and with respect to workers in the firm, on the basis of symbolic manipulation that is often called “appeal” or “charisma”. In conclusion: the Austrian notion of the market as a discovery process has prompted us to develop a deeper understanding of how markets work regarding the utilization and development of knowledge and competence. Conversely, by utilizing novel concepts, such as transaction costs and scripts, I hope to have contributed to Austrian theories of market process and entrepreneurship.

Notes 1 In his later work: the Philosophical investigations. 2 It can yield the equivalent of Arrow’s paradox of majority voting in interpersonal comparison of utility; cf. Nooteboom (1984). 3 Usually the term used is “goods”, not “products”. But we should also consider services, and the term “products”, denoting anything with added value, includes both goods and services. 4 Yielding the well-known “logistic” diffusion curve. 5 The qualifier “artificial” is added to distinguish manufacturing from agriculture, which constitutes a “natural” transformation of material inputs into material outputs.

References Abelson, R.P. (1976), “Script processing in attitude formation and decision making”, in J.S. Carroll and J.W. Payne (eds) Cognition and Social Behavior, Erlbaum, Hillsdale, NJ, pp. 33–45. Argyris, C. and Schön, D. (1978), Organizational Learning, Addison-Wesley, Reading, MA. Barley, S.R. (1986), “Technology as an Occasion for Structuring: Evidence from Observation of CT Scanners and the Social Order of Radiology Departments”, Administrative Science Quarterly, March: 78–108. Bateson, G. (1972), Steps to an Ecology of Mind, University of Chicago Press, Chicago. Brown, J.S. and Duguid, P. (1991), “Organizational Learning and Communities of Practice”, Organization Science 2 (1); reprinted in M.D. Cohen and L.S. Sproull (eds) (1996), Organizational Learning, Sage, London, pp. 58–82. Casson, M. (1998), “An Entrepreneurial Theory of the Firm”, paper presented at the DRUID conference, Bornholm, 9–11 June. Chesbrough, H.W. and Teece, D.J. (1996), “When is Virtue Virtuous? Organizing for Innovation”, Harvard Business Review, Jan.–Feb.: 65–73. Cohen, W.M. and Levinthal, D.A. (1990), “ Absorptive Capacity: A New Perspective on Learning and Innovation”, Administrative Science Quarterly 35: 128–152. Cyert, R.M. and March, J.G. (1963), A Behavioral Theory of the Firm, Prentice Hall, Englewood Cliffs, NJ.

Discovery, competence and services 239 Fiol, C.M. and Lyles, M.A. (1985), “Organizational Learning”, Academy of Management Review 10 (4): 803–813. Foss, N.J. and Knudsen, C. (eds) (1996), Towards a Competence Theory of the Firm, Routledge, London. Gioia, D.A. and Poole, P.P. (1984), “Scripts in Organizational Behaviour”, Academy of Management Review 9 (3): 449–459. Henderson, R.M. and Clark, K.B. (1990), “Architectural Innovation: The Reconstruction of Existing Product Technologies and the Failure of Established Firms”, Administrative Science Quarterly 35: 9–30. Holland, J.H., Holyoak, K.J., Nisbett, R.E. and Thogard, P.R. (1989), Induction: Processes of Inference, Learning, and Discovery, MIT Press, Cambridge, MA. Lachmann, L. (1978), “An Austrian Stocktaking: Unsettled Questions and Tentative Answers”, in L. Spadaro (ed.) New Directions in Austrian Economics, Sheed, Andrews & McMeel, Kansas City, MD, pp. 1–18. Lancaster, K.J. (1966), “A New Approach to Consumer Theory”, Journal of Political Economy 74: 132–157. Levitt, B. and March, J.G. (1988), “Organizational Learning”, in W.R. Scott (ed.) Annual Review of Sociology, Annual Reviews, Palo Alto, CA. Lippman, S. and Rumelt, R.P. (1982), “Uncertain Imitability: An Analysis of Interfirm Differences in Efficiency under Competition”, Bell Journal of Economics 13: 418–438. March, J. and Simon, H.A. (1958), Organizations, Wiley, New York. Menger, C. (1934), Collected Works, vol. 1, Grundsatze der Volkswirtschaftslehre. Nelson, R. and Winter, S. (1982), An Evolutionary Theory of Economic Change, Cambridge University Press, Cambridge. Nooteboom, B. (1984), “Intransitive Preferences in Retailing”, Service Industries Journal 4: 82–92. Nooteboom, B. (1992), “Towards a Dynamic Theory of Transactions”, Journal of Evolutionary Economics 2: 281–299. Nooteboom, B. (1999), Interfirm Alliances: Analysis and Design, Routledge, London. Nooteboom, B. (2000), Learning and Innovation in Organizations and Economies, Oxford University Press, Oxford. Penrose, E. (1959), The Theory of the Growth of the Firm, Wiley, New York. Shank, R. and Abelson, R. (1977), Scripts, Plans, Goals and Understanding, Lawrence Erlbaum, Hillsdale, NJ. Shank, R. and Abelson, R. (1995), “Knowledge and Meaning: The Real Story”, in R.S. Wyer Jr (ed.) Advances in Social Cognition, Laurence Erlbaum, Hillsdale, NJ, pp. 5–81. Stigler, G.J. and Becker, G.S. (1977), “De Gustibus Non Est Disputandum”, American Economic Review, March: 76–90. Teece, D.J. (1986), “Profiting from Technological Innovation: Implications for Integration, Collaboration, Licensing and Public Policy”, Research Policy 15: 285–305. Teece, D.J. (1988), “Technological Change and the Nature of the Firm”, in G. Dosi, C. Freeman, R. Nelson, G. Silverberg and L. Soete (eds) Technical Change and Economic Theory, Pinter, London, pp. 256–281. Williamson, O.E. (1985), The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting, Free Press, New York. Woo, H.K.H. (1992), Cognition, Value and Price: A General Theory of Value, University of Michigan Press, Ann Arbor.

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Economic history

13 Werner Sombart’s views on profit, capital, credit, and the Austrian school of economics Günther Chaloupek

Introduction Werner Sombart is generally considered an antagonist of the Austrian school. In his early writings he had avowedly been a sympathizer towards Karl Marx’s theories as well as of the social democratic movement, although these sympathies had always been ambiguous and mixed with serious criticism of various aspects of Marxism and socialism.1 In discussing Sombart’s later anti-socialist book Der proletarische Sozialismus, Ludwig von Mises stated that Sombart could not be considered an opponent of Marxist theory. Sombart’s teachings were – even if subconsciously – built on Marxist ground (Mises [1929] 1976: 117), although his Marxist concepts were not of the naive materialistic kind of the founders but “of a more refined form which he [Sombart] and his like-minded have given to the doctrine” (ibid.: 118). In judging Sombart’s relationship to the Austrian school, one has also take into account that Sombart was very sceptical about contemporary theoretical economic analysis. In his otherwise very positive review of Sombart’s Moderner Kapitalismus, Schumpeter had criticized his tendency to neglect all the previous sixty years’ achievements in economic theory “with the healthy scorn of the creative thinker who disregards everything that is uncongenial to his thought” (Schumpeter 1927: 204). Yet if Austrian economic thought is taken in a wider sense, to include Schumpeter’s writings, it can be shown that Sombart incorporated several elements of Austrian economics in his analysis of capitalism.

Value theory: profit and “surplus value” If Sombart was an advocate of a labour theory of value in a rather strict sense in his early writings,2 his frequent use of the term “surplus value” (Mehrwert) for “profit” does not imply that his theory of profit is Marxist. In a very general sense Sombart follows the view that “all economic goods are – under given natural conditions – the product of human labour and only of human labour” (Sombart 1927: 141). But Sombart explicitly

244 Günther Chaloupek rejects any attempt to explain profit by exploitation: that the working class receives less “than the value it has produced . . . is nonsense because as a separately identifiable quantity the latter does not exist. In a capitalist economy, total revenue is the result of all factors contributing to production” (ibid.: 139). For Sombart, surplus value – i.e. profit – is simply the consequence of certain features of the capitalist economic system such as the advanced degree of overall productivity, which allows for a differentiation between dispositive functions and manual labour, the social division between owners of capital and a propertyless working class, and the market as the mechanism of coordination between economic units. Given these conditions, “surplus value appears spontaneously (ungezwungen) as an expression of the relationship of economic power . . . between the working class and the capitalist class under free market exchange” (ibid.: 140–141). Sombart did not bother with the question of how profit is possible in a fully competitive economy. Implicitly, in this respect his basic idea was essentially the same as Schumpeter’s. In Sombart’s concept of the capitalist system the entrepreneur plays a central role, and it is the entrepreneur’s drive for extra profit from which the system derives its energy for unlimited expansion. Because every entrepreneur hopes to gain an edge and thus an extra profit over his competitor through improvements of the production process or of the organization of production, his efforts and endeavours are directed towards permanent innovation, with his entrepreneurial spirits always under utmost possible tension. In this drive for extra profit . . . the innermost secret of the utmost dynamic orientation of “high capitalism” is embedded. (ibid.: 35) The idea of extra profit figures, of course, quite prominently in Marx’s writings too, which obviously were Sombart’s primary source. But unlike Marx, Sombart did not consider profits to be a consequence of some intrinsic value of labour that was lower than labour’s productive capacity. The surplus that the use of labour produces in capitalist enterprise in his view was the result of several factors, among which the appearance of differential profit rates was the most important. With respect to possible tendencies of the rate of profit to rise or to fall, Sombart put great emphasis on the necessity for a clear distinction between the theoretical and the empirical side of the question. He denied that any factual assertions could be derived from merely theoretical reasoning. The persuasive power of even the greatest masters’ systems, those of Ricardo and Marx, is diminished by their “recurrent painful confusing of theoretical and empirical approaches” (ibid.: 144).

Werner Sombart’s views 245

“Capital” The meaning of “capital” was the subject of an intensive controversy among economists during most of the nineteenth and also the first decades of the twentieth century.3 When Sombart wrote his summary of this debate, the importance of the issue had already begun to fade. Nonetheless, in a theory of “modern capitalism” the meaning of capital as a central concept needed clarification. As with profits and surplus value, Sombart follows the Marxian line of argument only in a very general sense, and he owes a great deal more to modern theories than he himself seems to be aware of. He accepts the “drive for self-realization of capital” as the “innermost core of the capitalist system” (Sombart 1927: 7) as a context of mutual reference (Sinnzusammenhang) of actors, not, however, as a driving force of its own – thereby emphasizing the importance of the human factor, which he had elaborated with great care in Der Bourgeois (1913). More specifically, his concept of capital follows essentially Carl Menger’s understanding of the term (Menger 1888). Sombart defines capital as “the sum of exchange value which is the material base of a capitalist enterprise” (1919: 324; 1927: 129). Explicitly, he advocates the same understanding as is used in everyday economic life and in the world of commercial enterprise – which is exactly what Menger had argued for in his famous article of 1888. Total national (“social”) capital is nothing but the sum of all commercial capitals. When Sombart differentiates his understanding of the concept from that of other writers, his affinity to Menger becomes even more intimate. Without quoting or even mentioning him, Sombart repeats Menger’s criticism of the practice, initiated by Adam Smith, of treating all real means of production such as buildings, machines, raw materials, inventories, and goods used for the consumption of workers as capital in a direct sense instead of their monetary equivalent (Sombart 1927: 132ff.). In this sense, only assets intended to earn income are capital. In Sombart’s view it is a grave misunderstanding if this category is applied where no such intention exists.4 Sombart’s concept of capital is clearly different from that of Marx, for whom capital consists of fixed capital and the wage fund by which surplus-producing labour is employed (and exploited). It is also different from Schumpeter’s, because in Sombart’s view it is not merely entrepreneurs in the narrow Schumpeterian sense who employ capital: “The traditional joint stock company also has a ‘capital’, doesn’t it?” (ibid.: 131). From Sombart’s views of capital and of the production process it is a logical consequence that the creation of surplus value through entrepreneurial activity is the dominant aspect of his investigations into the monetary sphere, where he is mainly interested in credit and capital markets.

246 Günther Chaloupek

Credit If both Sombart and Schumpeter followed Menger’s (1888) concept of capital (Schumpeter narrowed it down to conform to his definition of entrepreneur), it follows that in essence their views on the function of credit in a capitalist system are the same. Credit has made the expansion of the capitalist economy possible “by unfettering the forces that have caused the expansion”. It was credit that “infused the dynamics into the economic process and drove for ever greater acceleration of circulation. . . . It is the economic counterpart to modern technology: infinite in its goals, revolutionary and revolving in its means” (Sombart 1927: 219f.). In rather metaphorical language, this amounts to the same as Schumpeter’s central thesis that the process of credit-financed innovations is the driving force of a capitalist economy. Sombart also explicitly rejects the traditional concept of credit, which gave the decision to save priority among the forces that determine the process of capital formation.5 Credit is instrumental to transform “potential “ into “actual” capital – that is, the investing of money in capitalist enterprise (Sombart 1927: 168). Transfer of purchasing power, important as it is, is only one form of credit (Übertragungskredit), whereas it is the creation of purchasing power out of nothing through “assignment credit” (Anweisungskredit) that makes possible the accelerated expansion of production that characterizes a capitalist economy (ibid.: 177ff., 182). Sombart also mentions extra profits due to technical innovations as a principal source of capital accumulation (ibid.: 160f.). As a historian and theoretician of the secular development of the capitalist system, Sombart was interested in the evolution of the credit and banking system that had made possible the modern and revolutionary forms of financing capitalist enterprise. Originally, the relationship between creditor and debtor had been strictly personal. The separation of obligations from personal relationships was a sine qua non condition for the modern financial system. This and other types of institutional changes were elaborated by Sombart not only for the final stage of capitalism, but also during its earlier stages.6 On the other hand, Sombart took little interest in the interplay of the various processes that determine the rate of interest for credit and the rate of return on real capital investment during the business cycle. In his chapter on the business cycle, the main emphasis is on disproportions within the sphere of real production, not between monetary and real spheres. He also points to the limits of monetary and credit expansion due to the gold base of the monetary system without further elaborating on this aspect.7

Increasing roundaboutness of production processes In the section on capital, Sombart expresses his unease with the Austrian school’s style of theorizing when he mentions Böhm-Bawerk’s “Positive

Werner Sombart’s views 247 Theorie des Kapitalzinses” as an example of economic reasoning that “lies beyond the area of what I consider fruitful economic theory” (Sombart 1927: 128). Despite this rather harsh verdict, in his section on the perfection of internal organization of capitalist enterprise (Ausbau der Betriebe) which Schumpeter (1927) considered one of the most convincing parts, Sombart discusses at length Böhm-Bawerk’s thesis of increasing roundaboutness of production processes. Sombart refers to the controversy between Böhm-Bawerk and the German economist Wilhelm Lexis, who had challenged Böhm-Bawerk’s thesis. Lexis contended that from the beginning of the development of civilization, technological progress had displayed a tendency to reduce the number of workers employed by a given amount of capital and, at the same time, also a tendency towards shortening the production period (Böhm-Bawerk 1921, II/2: 42). In his reply, Böhm-Bawerk admitted that the issue could not be decided by a priori reasoning because of the possibility of technical inventions shortening the production period. However, he emphasized that it was beyond any doubt that a lengthening of the production period had occurred “since the beginning of civilization . . . when men lived from hand to mouth” (ibid.: 43). If there had been in fact timesaving inventions such as the railway, increased requirements for fixed capital had also to be taken into account. Moreover, after each truly timesaving innovation, additional, successive applications of the invention would re-establish the tendency towards increasing roundaboutness (ibid.: 47ff.). In reviewing the controversy, Sombart stated that in a sense both Böhm-Bawerk and Lexis were right. Lexis was right to emphasize the drive inherent in capitalist enterprise to reduce the production period by increasing the rate of turnover of circulating and also fixed capital. But according to Sombart, Böhm-Bawerk is also right when he maintains that from increasing amounts of fixed capital per worker there resulted a tendency towards a lengthening of the production period. Such a tendency was well in accordance with a central socio-philosophical argument of Sombart: “the growing domination of the real-objective [sachlich] over the personal factor of production in the economic process” (1927: 947). At the same time, Sombart held that due appreciation had to be given to labour- and hence time-saving effects of technical progress, which in his view had to be seen as a reaction to the tendency towards increasing roundaboutness.

Concluding remarks From the examples of Werner Sombart’s use of instruments of contemporary economic theory discussed above, it seems evident that Mises’s characterization of Sombart as a Marxist is untenable. The concepts of value, capital and profit, and the theory of credit on which

248 Günther Chaloupek Sombart based his theory of capitalist development, are taken from or bear significant similarities to Austrian economic thought. Sombart’s attitude towards analytical theory can perhaps best be characterized as “eclectic”, with an ostensible unwillingness to attach himself to a particular theoretical school. As regards Joseph Schumpeter, Schumpeter certainly had a rather profound and direct influence on Sombart, even though this is often not explicitly acknowledged.8 On the other hand, differences remain important. If Sombart more or less neglected microeconomic theory, consequently he did not pay much attention to the functioning of the allocation mechanism as an aspect of the economic process. His treatment of the market process and of consumer demand were inadequate by “Austrian” standards. If Sombart, on the one hand, was one of the foremost representatives of the third and last generation of the German historical school, on the other hand he promoted the return of economic science in Germany to the international mainstream of economic thinking by his eclectic approach to matters of theoretical analysis, which allowed him to make use of a variety of analytical concepts. Starting from Sombart’s fundamental question of what constitutes an “economic system”9 and exploiting the findings of “Austrian” as well as Anglo-American market theory, microeconomics and business-cycle theory, Alfred Müller-Armack (1932), Walther Eucken (1939) and other German economists developed the theory of the “social market economy”, which has come to be the basis of economic policy in Germany and elsewhere in the second half of the twentieth century and at the start of the twenty-first.

Notes 1 For Sombart’s basically sympathetic attitudes towards the labour movement and towards Marxism, see Sombart (1896). 2 In his review of the third volume of Das Kapital (Sombart 1894), Sombart accepted Marx’s theory of value and profit, although at the same time emphasizing that the Marxian “law of value” was to be understood as a theoretical construct through which to understand reality, not a part of reality itself. 3 For a comprehensive summary of the debate on capital, see Passow (1927). 4 Sombart criticizes Böhm-Bawerk, who mentions the example of a girl gathering berries with a basket as a case of capitalist method of production (Sombart 1927: 134). 5 Explicitly referring to Schumpeter’s Theorie der wirtschaftlichen Entwicklung (1912), Sombart notes that the dynamic theory of credit has finally superseded the older static theory, for which he quotes Komorzynski (1903) as an example. 6 See Sombart (1911: 60–135; 1927: 147–224). 7 Backhaus (1989: 88). Backhaus (1989: 91) points to a parallel between Sombart and Schumpeter in their views of the function of the depression phase in eliminating inefficient producers. On Sombart’s Konjunkturtheorie, see also Hagemann and Landesmann (1996: 184ff.). 8 Likewise, it appears quite evident that Sombart’s influence on Schumpeter’s book Capitalism, Socialism and Democracy (1942) was significant – even if one does

Werner Sombart’s views 249 not have to go as far as Michael Appel, who holds that Schumpeter took over major parts of Sombart’s analysis without giving him due credit (1992: 259ff.). For a systematic comparison of Sombart’s and Schumpeter’s long-term perspectives of economic development, see Chaloupek (1995). 9 Sombart’s concept and theory of economic systems is developed in Sombart (1925) and Sombart (1927: 950ff.).

References Appel, Michael (1992), Werner Sombart, Metropolis-Verlag, Marburg. Backhaus, Jürgen (1989), “Werner Sombarts Konjunkturtheorie”, in Bertram Schefold (ed.) Schriften des Vereins für Socialpolitik, NS vol. 115/VII, Dunckar & Humblot, Berlin, pp. 77–98. Böhm-Bawerk, Eugen von (1921), Positive Theorie des Kapitals, vol. 2 (Exkurse), Gustav Fischer, Jena. Chaloupek, Günther (1995), “Long-Term Economic Perspectives Compared: Joseph Schumpeter and Werner Sombart”, European Journal of the History of Economic Thought 2: 127–149. Eucken, Walther (1939), Die Grundlagen der Nationalökonomie, Gustav Fischer, Jena. Hagemann, Harald and Landesmann, Michael (1996), “Sombart on Economic Dynamics”, in Jürgen Backhaus (ed.) Werner Sombart (1863–1941), Social Scientist, vol. 2, Metropolis-Verlag, Marburg, pp. 179–204. Komorzynski, Josef von (1903), Die nationalökonomische Lehre vom Kredit, Wagnersche Universitätbuchhandlung, Innsbruck. Menger, Carl (1888), “Zur Theorie des Kapitals”, in, Jahrbücher für Nationalökonomie und Statistik, vol. 17; reprinted in Gesammelte Werke, ed. F.A. Hayek, vol. 3, J.C.B. Mohr, Tübingen, pp. 133–183. Mises, Ludwig von ([1929] 1976), Kritik des Interventionismus, ed. F.A. Hayek, Wissenschafliche Buchgesellschaft, Darmstadt. Müller-Armack, Alfred (1932), Entwicklungsgesetze des Kapitalismus, Junker & Dünnhaupt, Berlin. Passow, Richard (1927), Kapitalismus, Verlag Gustav Fischer, Jena. Schumpeter, Joseph A. (1912), Theorie der wirtschaftlichen Entwicklung, Duncker & Humblot, Leipzig. Schumpeter, Joseph A. (1927), “Sombart’s Dritter Band”, in Bernhard vom Brocke (ed.) Sombarts “Moderner Kapitalismus”, Deutscher Taschenbuch-Verlag, Munich, pp. 196–217. Schumpeter, Joseph A. (1942), Capitalism, Socialism and Democracy, Harper & Row, New York. Sombart, Werner (1894), “Zur Kritik des ökonomischen Systems von Karl Marx”, Archiv für Sozialwissenschaften und Sozialpolitik 7: 555–594. Sombart, Werner (1896), Sozialismus und soziale Bewegung im neunzehnten Jahrhundert, Gustav Fischer, Jena; English translation (1898), Socialism and the Social Movement in the 19th Century, G.P. Putnam’s Sons, New York. Sombart, Werner (1911), Die Juden und das Wirtschaftsleben, Duncker & Humblot, Leipzig; English translation (1913), The Jews and Modern Capitalism, T.F. Unwin, London. Sombart, Werner (1913), Der Bourgeois, Duncker & Humblot, Munich and Leipzig; English translation (1915), The Quintessence of Capitalism, New York.

250 Günther Chaloupek Sombart, Werner (1919), Der moderne Kapitalismus, vol. I–1/2, Duncker & Humblot, Munich and Leipzig. Sombart, Werner (1924), Der proletarische Sozialismus, 2 vols, Gustav Fischer-Verlag, Jena. Sombart, Werner (1925), Die Ordnung des Wirtschaftslebens, Verlag Julius Springer, Berlin. Sombart, Werner (1927), Der moderne Kapitalismus, vol. III–1/2, Das Wirtschaftsleben im Zeitalter des Hochkapitalismus, Duncker & Humblot, Munich and Leipzig, 1927.

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Economic development, technological change, and growth

14 Austrian economics and ‘The Other Canon’ Erik S. Reinert

Typologies of economic theory and the two canons We have recently argued that when focusing on very long-term longitudinal trends in economics, two ideal types of economic theory appear to have coexisted in parallel over an extended period of time (Reinert and Daastøl 2004). These ideal types can be seen as constituting two separate filiations1 – to use Schumpeter’s term – and they come into occasional methodological clashes. Werner Sombart (1928: 919) fittingly calls the first tradition activistic-idealistic, a tradition born with the Renaissance. The second type of economic theory he calls passivistic-materialistic, a tradition having its origins with Mandeville and Adam Smith and solidifying as the ‘a priori method’ with David Ricardo. The purpose of this chapter is to outline the characteristics of the two traditions – the tradition behind today’s mainstream and ‘The Other Canon’ – and to discuss the position of Austrian economics in this context. In most sciences, periodic radical gestalt switches terminate old theoretical trajectories and initiate new ones. In a Kuhnian paradigm shift, the scientific world moves from a situation in which everybody knows that the world is flat, to a new understanding in which everybody knows that the world is round. This happens in a relatively short time. Lakatos’s idea of ‘degenerating scientific research programmes’ that gradually shift to ‘progressive’ ones conveys a similar idea. In this respect economics is different. In economics the theory that the world is flat has been living together with the theory that the world is round for centuries. We describe this apparent lack of paradigm shifts in economics by acknowledging the coexistence of these two long-term parallel filiations, where weight and influence periodically tilt back and forth between two alternative Weltanschauungen. Today, evolutionary economics – based on a tradition founded by the Austrian Joseph Alois Schumpeter – represents the most important challenge to the mainstream. However, evolutionary economics has, in my view, so far had an unnecessarily limited scope. This tradition now focuses relatively narrowly on innovations, failing to include Schumpeter’s own interest in financial matters, and not addressing to any extent the broader

254 Erik S. Reinert issues of uneven economic growth and employment on a world level, which are, in their origin, intimately tied to Schumpeterian mechanisms. And, by bringing simple ‘Schumpeterian’ variables into mainstream equilibrium models, his message is being domesticated and made innocuous. As in the case of Keynes, the mainstream again shows a great ability to usurp, absorb and subdue threatening alternative theories. As already indicated, the two different canons are based on fundamentally different Weltanschauungen. The lines of the two canons can be traced back to the period when the term ‘economics’ was first used, to ancient Greece (Reinert and Daastøl 2004). While today’s standard economics is based on a mechanistic and barter-centred tradition, Renaissance economics – The Other Canon – is dynamic, activistic-idealistic and production centred. The first tradition belongs to what Werner Sombart calls ordnende Nationalökonomie, which is concerned about organising the economic sphere. The second tradition is what Sombart (1930) calls verstehende Nationalökonomie or what Nelson and Winter (1982) refer to as appreciative economics. The first tradition typically explains man’s economic activities in terms of physics (of dead matter), the second in terms of biology (of living matter and of man’s wit and will). The first tradition is represented by Malthus’s dismal science, the second by Christopher Freeman’s Economics of Hope (1992) – by the never-ending frontier of human knowledge. Present mainstream economic theory places itself solidly in a canonical sequence descending from the physiocrats, via Adam Smith and Ricardo, to the neoclassical tradition beginning with Jevons and Marshall. The sequence has been made clear to generations of economists as the ‘Family Tree of Economics’ featured on the inside back cover of many editions of Paul Samuelson’s Economics. The alternative canon in economic theory runs parallel in time with the tradition of Samuelson’s ‘Family Tree’. I have named this alternative type of theory The Other Canon or Renaissance Economics – the latter because never before or since have the values that this canon represents dominated the world picture as they did during the Renaissance. The mainstream canon is clearly a product of the next philosophical period – the Enlightenment – which was in opposition to Renaissance values and outlook on important matters. Rationality and individuality during the Renaissance were based on an image of man as a spiritual being: creative and productive. The Enlightenment had a more materialistic understanding of human rationality and individuality: mechanical and consuming. Today the Renaissance canon – The Other Canon – tends to disappear in the history of economic thought, as this branch of economics more and more concentrates on the predecessors of neoclassical economics. In nineteenth-century United States, The Other Canon dominated economic policy and the land-grant universities, while the standard canon dominated at the Ivy League universities. Typically, Cornell University, as

Austrian economics and ‘The Other Canon’ 255 the only university that was both land-grant and Ivy League, for a while taught two kinds of economics: the British system and the American system. In all presently wealthy nations, an economic policy based on The Other Canon has served as a mandatory passage point in the history of economic policy. I would claim that the absence of the history of economic policy as a branch of economics to some extent explains why The Other Canon has been brought into virtual oblivion. As already mentioned, Renaissance economics is optimistic: the neverending frontier of knowledge stands in sharp contrast with Malthus’s dismal science and with the production theory of mainstream economics, the foundation of which is still today fundamentally a formalisation of Ricardo’s static corn economy. Here the main agents of change – new knowledge and the entrepreneur – are both absent. In the middle of the Cold War, in 1955, Nicholas Kaldor made the extremely important point that ‘the Marxian theory is really only a simplified version of Ricardo, clothed in a different garb’ ([1955–1956] 1960: 211). It was not at all obvious to most people at the time that the two political extremes were based on what were really only nuances of the same basic Ricardian economic theory. Only long after the fall of the Berlin Wall, in the late 1990s, did arguments stressing the similarities of the two political extremes again surface, in books by Stiglitz (1994) and Hodgson (1999). The cold war between what were in effect two versions of Ricardian economics led to the present crisis of The Other Canon. As it now is, the healthy Galbraithian balance of countervailing powers between the standard Anglo-Saxon theory and The Other Canon no longer exists. A hundred years ago the need for a balance between induction and deduction was generally recognised in all schools.2 On this matter the neoclassical founder Alfred Marshall (1961: 29) approvingly quotes the historicist Gustav Schmoller as saying that ‘Induction and deduction are both needed for scientific thought as the right foot and left foot are both needed for walking.’ Induction has to a very large extent been lost, making mainstream economics tilt very heavily towards the left side of the brain. The essentially mechanical neoclassical economics now dominates the field, and – as we shall see – the prominent ‘Other Canon’ aspects of both Alfred Marshall’s early neoclassical economics and Carl Menger’s early Austrian economics have largely been lost. Several observers have in fact pointed to the similarities between the economics of Alfred Marshall and of Carl Menger.3 In this chapter I argue that the theories that these two economists founded – neoclassical and Austrian – suffered a gradual and parallel loss of their Other Canon aspects over the course of the twentieth century. The main characteristics of Other Canon economics are as follows. First, the fundamental cause of economic welfare is man’s productive creativity and morality – the immaterial production factors. In order for these ideas to materialise, capital is needed. Capital per se is in this tradition

256 Erik S. Reinert sterile. The Renaissance tradition can be contrasted with the mainstream using Schumpeter’s description of the economics of John Rae, a nineteenth-century US economist of the Renaissance canon: ‘The essential thing is the conception of the economic process, which soars above the pedestrian view that it is the accumulation of capital per se that propels the capitalist engine’ (Schumpeter 1954: 468). Whereas classical economics focused on barter, exchange and the accumulation of material capital, the Renaissance tradition focuses on production based on human creativity. For this reason, Renaissance economics emphasises education, science, incentives, and entrepreneurship. Mainstream economics defines its origins in the French school of physiocracy4 (i.e. ‘the rule of nature’), where value is created by nature and harvested by man. In Renaissance economics, value originates through man’s wit and will (i.e. ‘ideocracy’ – ‘the rule of ideas’). During the mechanisation of the world picture, which took place during the materialistically oriented Enlightenment, the defenders of the Renaissance tradition were the anti-physiocrats.5 The Renaissance tradition is holistic and idealistic – not atomistic and materialistic. Nevertheless, at the core of the system is the individual, set in a complex web of synergetic interrelations. The beneficial effects of these interrelations first became evident in Renaissance towns, giving birth to the Renaissance expression of the common weal (il bene comune, das Gemeinwohl) – a synergetic understanding of society as being more than the sum of its parts.6 The growth of towns and cities brought these synergies into evidence. Towns permitted communication that unleashed individual freedom, creativity, diversification and synergies that together created unprecedented wealth. This was the fundamental observation of one of the earliest bestselling books in economics, Delle cause della grandezza delle città, written by Giovanni Botero (1543–1617) and published in 1890. (The English translation, published in London in 1606, is entitled The Cause of the Greatnesse of Cities.) This argument was to be discussed at great length by Antonio Serra in 1613. Later nation building in this tradition tried consciously to reproduce the synergetic benefits of towns on a larger, national scale.7 In order to achieve this, the sciences of law and administration had to be consciously cultivated and promoted. Renaissance economics emphasises the crucial role of nation-states and the duties of ‘the ruler’ – i.e. government. Not only had ‘the ruler’ to regulate in order to provide incentives for the creation of welfare (in the old tradition of law and economics), but also it was his duty to initiate projects that created a demand for knowledge-based production. Thus, Renaissance economics has a strong emphasis on institutions. After all, the key enabling institutions of capitalism – such as patents, banks and standards – were products of Renaissance Italy. At the core of the Renaissance Other Canon is the observation that some economic activities produce greater welfare than others, a static and non-systemic observation of welfare being activity specific. (As if today: lawyers

Austrian economics and ‘The Other Canon’ 257 make more money than people who pick lettuce; therefore, a nation of lettuce pickers will be poorer than a nation of lawyers.) Very soon – before 1500 – this argument became extended into one of synergies: some economic activities are seen as being at the core of systemic synergies that produce and spread welfare locally or nationwide (‘where there are many people working with machines, also the shopkeepers are wealthier than in other places, where machines are not used’). There are degrees of understanding how these systemic synergies develop into positive feedback systems, but the top performance is that of Antonio Serra in 1613, who has a description of Venice as a true autocatalytic system, where increasing returns and diversity – the latter expressed as the number of different professions in a nation (i.e. degree of division of labour) – are identified as being at the core of virtuous circles that generate wealth.8 Naples is the example of the opposite effect in Serra’s system, because the production of raw materials is not subject to increasing returns. We also find Adam Smith in The Wealth of Nations ([1776] 1976) asking himself why there is so little division of labour in agriculture. On the other hand, agriculture is to him the only ‘natural’ activity. Smith fails, however, to make the connection that the ‘unnatural’ imperfect competition is a product of a sophisticated division of labour. Today these synergy-based arguments are found in the works on increasing return by authors such as Paul David, W. Brian Arthur (1994) and James Buchanan (Buchanan and Yoon 1994). An integral part of the nation-building strategy was the notion that a national market had to be created – that such a market did not appear spontaneously. For this reason, communication and state-initiated investments in large-scale infrastructure projects hold a very strong position in the Renaissance tradition, from the dams and irrigation canals of the Sumerian kingdoms via Colbert’s canals to Kennedy’s interstate road projects. Using modern terms, we could say that the strategy of Renaissance economics was to create perfect competition within national borders and dynamic imperfect competition in the export trade. Contrary to the common preconceptions of economics before Adam Smith, ‘Competition was often artificially fostered (nationally) . . . in order to organise markets with automatic regulation of supply and demand’ (Eli Hecksher quoted in Polanyi [1944] 1957: 278). It was commonly agreed that a national competitive advantage had to be created in knowledge-intensive activities before free trade could be established with the most advanced nations. This new world-view of the Renaissance released enormous creativity in all the sciences and arts; the new intellectual freedom gave us Leonardo da Vinci, Michelangelo, Raphael, Kepler and Copernicus. In all the arts and sciences the people of the Renaissance still stand out in a heroic light in history – all except the statesmen and economists of the Renaissance. These economists of the Renaissance, who made the modern world possible, still today come across as the gold-loving caricature that Adam Smith created of his mercantilist predecessors. These economists, however, are

258 Erik S. Reinert

The Bible: A new interpretation of the role of man in the creation

Leibniz (1646–1716)

Christian Wolff (1697–1754)

Neo-Platonism to Italy via Constantinople (Plethon 1360–1452) The Renaissance

A new interpretation of Aristotle

Francis Bacon (1561–1626) ‘An essay on innovations’

Figure 14.1 The Renaissance world-view.

the true founders of evolutionary economics. In the spirit of the Renaissance, Francis Bacon – Queen Elizabeth’s Lord High Chancellor – wrote, around 1605, ‘An Essay of Innovations’. Bacon became the ‘scientific leader of the new industrialists’ (Crowther 1960: 97) urging the use of science to produce manufactured goods and profits. Up until and including James Steuart’s 1767 Inquiry into the Principles of Political Economy, the term ‘innovation’ is frequently used, only to disappear with Adam Smith. Bacon’s spirit has often been evoked in order to argue against the mechanical world-view of post-Ricardian economics. Richard Jones, the founder of the English historical school (see Rashid 1979), and John Rae (1834) were two economists who – as a reaction to the Ricardian system – consciously attempted to ‘Baconise’ economics again. Also, Carl Menger quotes Francis Bacon against what we would today call ‘physics envy’ when he criticises ‘the attempts to carry over the peculiarities of the naturalscientific method of investigation uncritically into economics’.9 Bacon’s emphasis on scientific knowledge was very similar to that of Friedrich List more than two hundred years later: Industry is the mother and father of science, literature, the art, enlightenment, useful institutions and national power. . . . The greater the advance in scientific knowledge, the more numerous will be the new inventions which save labour and raw materials and lead to new products and processes. (List [1841] 1904: 66–67) In this sense there is a continuity of argument from the Renaissance,

Austrian economics and ‘The Other Canon’ 259 through Francis Bacon and Friedrich List to today’s evolutionary economics, which emphasises the role of research and development and of innovations for economic welfare. As to natural resources, List says that ‘industrialisation will greatly increase the value of a country’s natural resources’ (ibid.: 79). This thinking was the basis for economic policy in the resource-rich nations that have achieved general welfare: Canada, Australia and New Zealand. A manufacturing sector – although one that was not seen as being competitive with that of England – was needed in order to transform the natural resources of a nation into national wealth. The two types of economics that I have outlined should be seen as ‘ideal types’ in the Weberian sense. Through time there are several distinguishing features that clearly separate the two canons. A basic one is their different conceptions of the origin of wealth: 1

2

In the mainstream canon, wealth originates from material sources: from nature – that is, land, physical labour and capital. The accumulation of these assets takes place through trade and war. This accumulation is static – that is, more of the same. In the Renaissance Other Canon, wealth originates from immaterial sources: from culture – that is, man’s creativity and morality. The accumulation of assets takes place through innovations, cumulatively changing humans’ stock of knowledge and his tools (technology). This accumulation is dynamic – that is, more of something new and qualitatively different.10

A second major distinguishing feature between the two canons is the following: 3 4

In the mainstream canon the focus of analysis is barter, consumption and accumulation (‘man the trader and consumer’). In The Other Canon the focus of analysis is on production and innovation – productivity being the pineal gland bringing together mind and matter (‘man the creative producer’).

There is a third and fundamental difference between the canons: 5

6

The mainstream canon – since the Aristotelian idea of the complete independence of politics from all other aspects of social life – has been fundamentally atomistic and mechanical in its analytical approach. The unit of analysis is the atomistic unit (in economics: the individual). The Other Canon – since Plato’s Republic – has been fundamentally holistic, organic and synthetical (from synthesis) in its approach (die Ganzheit). The units of analysis include both individuals and their institutions in time and space.

260 Erik S. Reinert At a very fundamental level, the two canons of economics are founded on two different views of how man differs from other animals. We shall let Adam Smith represent the material and barter-based canon, and Abraham Lincoln represent Renaissance economics – the immaterial and production-based canon. According to Adam Smith ([1776] 1976: 17): The division of labour arises from a propensity in human nature to . . . truck, barter and exchange one thing for another . . . It is common to all men, and to be found in no other race of animals, which seem to know neither this nor any other species of contracts. . . . Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. And Abraham Lincoln: Beavers build houses; but they build them in nowise differently, or better, now than they did five thousand years ago. . . . Man is not the only animal who labours; but he is the only one who improves his workmanship. These improvements he effects by Discoveries and Inventions. (Speech during the 1860 presidential campaign) We also see a consistent pattern of application of the two canons in a catching-up framework. No nation-state11 has ever gone through a transition from poverty to affluence without practising a long period of the immaterial and production-based canon as the fundamental guide for economic policy. This is true in France (where a modern starting point for policy could be Louis XI (1461); and Montchrétien, Jean Bodin and Sully for theory), England (where a logical starting point for policy is the reign of Henry VII, in 1485), in Germany, the United States (Benjamin Franklin, Alexander Hamilton, Daniel Raymond, Henry Clay, Mathew and Henry Carey, E. Peshine Smith) and Japan (the Meiji Restoration). Today we see the production-based economic strategy at work in East Asia. The Third World is essentially an area that has experienced neither a Renaissancetype creative awakening nor any production- and knowledge-based economic canon. Figure 14.2 shows the family tree of The Other Canon. On the practical policy level the two canons produce conflicting recommendations. This is due to the fact that whereas in the Renaissance theory different economic activities offer different potentials for achieving national welfare, in the barter-centred theory all economic activities become qualitatively ‘alike’. If anything, in the standard canon superiority is traditionally awarded to agriculture, which is more ‘natural’, first, because it delivers Nature’s produce, and second, because competition here is more ‘natural’; atomistic and ‘perfect’. It is really only since 1960 that the economic policies of Smith and Ricardo have completely won the day in economic policy. The economists

Austrian economics and ‘The Other Canon’ 261 of alternative traditions who were crucial to the economic policy are almost completely left out of today’s history of economic thought. The last history of economics to give a good coverage of the theories behind the nineteenth-century economic policy was Ottmar Spann’s Die Haupttheorien der Volkswirtschaftslehre, which first appeared in 1911. By 1936 this book had reached twenty-four editions, and a total of 120,000 copies were printed in German. There were translations into several languages, and, interestingly, the UK edition was published under the title Types of Economic Theory, flagging Spann’s awareness of diversity: that there are, indeed, different types of economics, not only one monolithic canon.12 Of course, I am not implying that the world is a binary one in which all economists belong either to one tradition or the other. On the contrary, a key characteristic of several important economists is their at times schizophrenic allegiance to both sets of theory. One example of this is the conflict between the Marshall whose ‘Mecca of the economist’ lay in economic biology (1890: iv) and the Marshall of the appendices to his Principles, which were deeply steeped in ‘physics-envy’. In order to create the equilibrium that characterises today’s physics-based standard economic theory, Marshall paradoxically had to resort to a biological metaphor. Increasing returns had been an important argument for industrial policy ever since Antonio Serra in 1613, all through the nineteenth century. In order to reconcile the existence of increasing returns with equilibrium, Marshall uses a lengthy metaphor of firms growing and dying like trees in the forests (1890: 315–316). This evolutionary growth process supposedly counteracts the tendency towards uneven accumulation caused by increasing returns to scale.13 The argument that killed all future biological analogies in neoclassical economics was a biological analogy. This biological analogy was important in making economics into what it is today, a profession in which a physics-inspired equilibrium is the central gestalt. Seen from this point of view, Marx too was caught between two paradigms that at one level are mutually exclusive. In terms of his emphasis on technology and economic dynamics, Marx – like Schumpeter – is a clear member of the Renaissance production-based canon. Marx’s and Schumpeter’s visions have a common basis in the German economic tradition. In Anglo-Saxon economics these two economists come across as extremely original; seen from the German side, they are both firmly rooted in that alternative canon. The one aspect of Marx’s theory that decidedly belongs to the Anglo-Saxon canon is his use of Ricardo’s labour theory of value. The labour theory of value is out of place in the German tradition, where entrepreneurship, ideas, knowledge, leadership and management necessarily contribute importantly to the value added created by physical labour.

Figure 14.2 Reality economics: the knowledge- and production-based other canon of economics.

Austrian economics and ‘The Other Canon’ 263

The two canons contrasted as ideal types14 Table 14.1 The two canons of economics Starting point for the standard canon

Starting point for ‘The Other Canon’

Equilibrium under perfect information and perfect foresight

Learning and decision making under uncertainty (Schumpeter, Keynes, Shackle) Level of abstraction chosen according to problem to be resolved Moving force: Geist- und Willenskapital: Man’s wit and will, entrepreneurship Novelty as a central moving force

High level of abstraction Man’s wit and will absent Not able to handle novelty as an endogenous phenomenon Moving force: ‘capital per se propels the capitalist engine’ Metaphors from the realm of physics Mode of understanding: mechanistic (‘begreifen’) Matter Focused on Man the Consumer: A. Smith: ‘Men are animals which have learned to barter’ Focused on static/comparative static Not cumulative/history absent

Increasing returns to scale and its absence a non-essential feature Very precise (‘would rather be accurately wrong than approximately correct’) ‘Perfect competition’ (commodity competition/price competition) as an ideal situation  a goal for society The market as a mechanism for setting prices

Moving force: new knowledge which creates a demand for capital to be provided from the financial sector Metaphors (carefully) from the realm of biology Mode of understanding: Qualitative (‘verstehen’), a type of understanding irreducible only to numbers and symbols Geist precedes matter Focused on Man the Innovator and Producer: A. Lincoln: ‘Men are animals which not only work, but innovate’ Focused on change Cumulative causations/‘history matters’/backwash effects (Myrdal, Kaldor, Schumpeter, German Historical School) Increasing returns and its absence essential to explaining differences in income between firms, regions and nations (Kaldor) Aiming at relevance over precision, recognises the trade-off between relevance and precision as a core issue in the profession Innovation – and knowledge-driven Schumpeterian competition as both engine of progress and ideal situation. With perfect competition, with equilibrium and no innovation, capital becomes worthless (Schumpeter, Hayek) The market also as an arena for rivalry and as a mechanism selecting between different products and different solutions (Schumpeter, Nelson, and Winter)

264 Erik S. Reinert Table 14.1 continued Starting point for the standard canon

Starting point for ‘The Other Canon’

Equality Assumption I: no diversity Equality Assumption II: all economic activities are alike and of equal quality as carriers of economic growth and welfare

Diversity as a key factor (Schumpeter, Shackle) Growth and welfare are activity specific – different economic activities present widely different potentials for absorbing new knowledge Both theory and policy recommendations highly context dependent

Both theory and policy recommendations tend to be independent of context (‘one medicine cures all’) The economy largely independent from society Technology as a free good, as ‘manna from heaven’

Equilibrating forces at the core of the system and of the theory Economics as Harmonielehre : the economy as a self-regulating system seeking equilibrium and harmony Postulates the representative firm Static optimum. Perfect rationality No distinction made between real economy and financial economy Saving caused by refraining from consumption and a cause of growth

The economy as firmly embedded in society Knowledge and technology are produced, have cost, and are protected. This production is based on incentives of the system, including law, institutions, and policies Cumulative forces are more important than equilibrating ones, and should therefore be at the core of the system Economics as an inherently unstable and conflict-rich discipline. Achieving stability is based on man’s policy measures (Carey, Polanyi, Weber, Keynes) No ‘representative firm’. All firms are unique (Penrose) Dynamic optimisation under uncertainty. Bounded rationality Conflicts between real economy and financial economy are normal and must be regulated (Minsky, Keynes) Saving largely results from profits (Schumpeter) and saving per se is not useful or desirable for growth (Keynes)

Canonical battles: the head-on confrontations Occasionally the two canons meet head-on in what I have labelled canonical Methodenstreite. In what follows, I describe five of these Methodenstreite: Canonical Methodenstreit 1: Misselden versus Malynes, 1622–1623 The theoretical conflict between the forefathers of today’s mainstream canon and the Renaissance canon has existed at least since the ‘English’

Austrian economics and ‘The Other Canon’ 265 debate between Gerard de Malynes (1622, 1623) and Edward Misselden (1622, 1623), in which Malynes represented a static theory rooted in barter and Misselden represented a theory centred around learning and production. Both Misselden and Malynes were Dutchmen from Antwerp working in London. In the history of economic thought, their debate is interpreted as being about exchange controls and the balance of trade.15 The controversy between the two was an ‘acrimonious, even abusive’ one, in which ‘ink was shed like water’ (Buck 1942: 23). However, by going back to the sources, one finds that the main line of attack by Misselden against Malynes is his ‘mechanical’ view of man – Malynes has left out man’s ‘art’ and ‘soul’. Misselden quotes at length a paragraph from Malynes, where Malynes reduces trade to three elements, ‘namely, Commodities, Money, and Exchange’ (Misselden 1623: 8). Objecting to this definition, Misselden says, ‘It is against Art to dispute with a man that denyeth the Principles of Art.’ Misselden scorns Malynes for not seeing the difference between a heap of stones and logs and a house – because man’s productive powers and his soul, which produce the house, have been left out. A similar criticism can of course be made of neoclassical economics. Typically, after the Renaissance, the wealth of a nation was seen as lying in its capacity to produce, its ‘productive powers’. Misselden represents the acute Renaissance awareness of the enormous territory to be covered between humankind’s present poverty and ignorance, and the enormous potentials. This released enthusiasm and energy. The situation recalls Keynes’s frustration with the suboptimal situation of the world under the Great Depression. Both the Renaissance philosophereconomists and Keynes were searching for the formula needed to liberate society from its obviously suboptimal position at the time. This is what Keynes called ‘Salvation through Knowledge’ (quoting Misselden 1623: 102). This attitude is very different from seeing man as the passive victim of ‘two sovereign masters, pain and pleasure’ (Bentham 1780: ch. 1), which is the philosophical foundation of English classical economics. Canonical Methodenstreit 2: anti-physiocracy versus physiocracy and Adam Smith (c. 1770–1830) The second Methodenstreit between the knowledge-based Renaissance school and the predecessor of today’s standard (neoclassical-based) economic theory starts in the 1770s with the rise of the physiocratic school in France. It may be said that the physiocratic school in some sense was a reaction to the perversion of Colbertism into a policy of indiscriminate taxation. It was also clearly a reaction of the landowners against Colbert’s policy of systematically diverting resources from agriculture to manufacturing. The physiocrats had an animalistic view of humankind that was compatible with the philosophical foundations of English classical economics:

266 Erik S. Reinert ‘sometimes [the physiocrats] regard man as a browsing animal, concerned only with his nourishment, the maximum production of the fruit of the earth as his social ideal’ (Higgs 1897). The anti-physiocratic movement has received little attention in the history of economic thought. These authors, however, represented the true continuation of Renaissance economics. Interestingly, two of the main opponents of physiocracy in France were clergymen: Abbé Mably and Abbé Galiani, the Neapolitan envoy to the court of Paris.16 Galiani was to take a position that in many ways foreshadowed the position of the historical school in the late nineteenth-century Methodenstreit: Abstract principles are no good for commercial policy. Corn laws which are good in one time or place may be bad in another. . . . The statesman who admired Colbert should not imitate him, but ask himself, ‘What would Colbert do if he were here now?’ (Higgs 1897: 117) Abbé Galiani’s criticism of a very abstract and context-free theory is very similar to the reaction of the Reverend Jones against the writings of Ricardo in 1820. Richard Jones was the father of the English historical school of economics, which became very influential during the latter half of the nineteenth century. The insistence that economic theory and policy must be context specific is a sure hallmark of Other Canon economics through the ages. One of the main opponents of the physiocratic school17 in France was Forbonnais, who refused to admit that trade and industry are sterile. Also, to Forbonnais the main agent creating wealth is humankind – not nature itself: without human agency, the land itself is doomed to absolute or relative stability. Other contemporary French opponents of physiocracy were Accarias de Serrionne, Graslin, Necker and Linguet. Perhaps the most ardent anti-physiocrats were found in Germany. Under the heading ‘Antiphysiokraten’, Humpert’s bibliography of the German cameralist school lists twenty-five works published between 1771 and 1832 (1937: 1031–1032). The best known of these works is Johann Friedrich von Pfeiffer’s Der Antiphysiokrat (1780). Pfeiffer was also the author of the most influential economic work in Germany at the time. Other strong Continental opponents of physiocracy were Johann Jakob von Moser, Dohm and Sonnenfels. Canonical Methodenstreit 3: the American system versus the British system (nineteenth-century United States) The US opposition to English classical economic theory started with Benjamin Franklin and continued with Alexander Hamilton’s 1791 ‘Report on the Manufactures’. This Methodenstreit on the policy level lasted all

Austrian economics and ‘The Other Canon’ 267 through the 1930s, although on the theoretical level English classical economics was to be increasingly taught at the Ivy League universities during the late nineteenth-century. Important economists in this US tradition were Daniel Raymond, Mathew and Henry Carey, John Rae, E. Peshine Smith and many others. The last great economists of this tradition were Richard Ely and Simon Patten, who – like most US economists who studied abroad in the nineteenth century – studied in Germany. After Thorstein Veblen, this economic tradition continued under the label of institutional economics. Both the general stance against Ricardian economics and the mental affiliation with German-type economics continued much as in the nineteenth-century tradition. On the policy level, the nations industrialising in the nineteenth century were to take up the example that had been set by England – and later abandoned by her when she had reached world hegemony. Economic thought and policy of all great industrial nations in their pre-takeoff period share a core theme of the activity-specific nature of growth. Economic growth could only be achieved by including activities with fast technological change and a rapid growth in output in the nation’s portfolio of industrial activities. This theme can be followed in economic writings from the early sixteenth century in Italy and England and France, a little later in the German cameralists. It was introduced to the United States through Alexander Hamilton and his favourite economist, the English mercantilist Malachy Postlethwayt.18 Two path-breaking volumes in this school were published in 1820 by Daniel Raymond and Mathew Carey (in the latter’s pamphlet An Address to the Farmers of the United States). Heavily influenced by Daniel Raymond, Friedrich List’s involuntary exile in the United States reinforces this already traditional way of thinking in the Germany of the Zollverein. In Meiji Japan the doitsugaku school – favouring the German model – came to be the most influential for the building of society, at least until 1945 (Yagi 1989: 29). In Japan, after 1883, ‘a stream of German teachers of political economy and related disciplines continually flowed in’ (Sugiyama and Mizuta 1988: 32). A common thread of successful long-distance catching up through the centuries is a shared distrust of generalised free trade until the nation is firmly established in what were seen to be the right economic activities – the specific activities that increased the nation’s ‘productive powers’. Through the dynamic imperfect competition (i.e. Schumpeter’s ‘historical increasing returns’) in these specific activities, real wages could be raised – first in the ‘engine’ industry and subsequently spreading through the whole national labour market. In the US tradition, by adding skill to the labourer, his price or value ( wage) was increased. This tradition survived in the United States up until and including the economists who were taught by Ely’s and Patten’s generation. In a letter to the author dated 16 August 1996, Moses Abramowitz comments, ‘I agree in particular that the “residual” and growth in general are industry-specific. That has seemed

268 Erik S. Reinert clear to me since I was a graduate student in the Thirties and read the Kuznets and Burns books.’ This certainly points to a ‘filiation’ between the old American school and present-day ‘economics of catching up’. Canonical Methodenstreit 4: the historical school versus marginalism, 1883–1908 The resounding success of Ricardian economics and its extreme laissezfaire policies during the 1840s provoked a theoretical counter-movement following the political events of 1848. The international depression in 1873 further increased the opposition against the classical economic tradition all over Europe. The stronghold of the opposition was in Germany, where the older historical school, founded by Bruno Hildebrand – whose book was published in 1848 – Karl Knies and Wilhelm Roscher, increasingly challenged both the theoretical foundations and the practical conclusions of Ricardian economics. Later, a new generation of historical economists led by Gustav Schmoller – the younger historical school – for a long time completely dominated German academic and practical economics. Carl Menger, the founder of the Austrian marginalist school, in 1883 published his book Untersuchungen über die Methode der Sozialwissenschaften und der politischen Ökonomie insbesondere. Menger had dedicated his first book to Wilhelm Roscher, the prominent German economist of the historical school. Menger closed the preface by praising recent German economics and hoping that his book would ‘be regarded . . . as a friendly greeting from a collaborator in Austria’. The reply from Germany to his books was not friendly. Schmoller reviewed the Untersuchungen unfavourably in his Jahrbuch, and Menger replied in a small book entitled Die Irrtümer des Historismus (Errors of Historicism) in 1884.19 Of all the Methodenstreite, this – the most famous one – is paradoxically the least fundamental of them all. Menger and Schmoller essentially shared the same critical attitude towards the mechanical and barter-based English theory. Their personalities and pride clashed, but compared to Ricardian economics the two are next of kin. This Methodenstreit created a debilitating civil war inside The Other Canon. Schmoller wanted theory to be empirically founded, in opposition to the English classical tradition, which founded theory on introspective assumptions, and deduced far-reaching practical conclusions from these abstract structures. This practice was what Schumpeter labelled ‘the Ricardian vice’. Today’s standard explanation of the Methodenstreit generally fails to point out how similar Schmoller’s and Menger’s criticisms of Ricardian economics were. The New Palgrave describes the Methodenstreit as follows: [Schmoller] rejected Menger’s deductive method for three chief reasons: its assumptions were unrealistic, its high degree of abstrac-

Austrian economics and ‘The Other Canon’ 269 tion made it largely irrelevant to the real-world economy, and it was devoid of empirical content. The theory was therefore useless in studying the chief questions of importance to economists; how have the economic institutions of the modern world developed to their present state, and what are the laws and regularities that govern them? The proper method was induction of general principles from historicalempirical studies. (Fusfeld 1987) However, reading through Menger’s Errors of Historicism with the perspective of what economics had become by 2000, it becomes clear how ‘Other Canon’ both Schmoller and Menger in fact were. I shall return to this argument later. The historical school was deeply steeped in the German tradition of embracing die Ganzheit – the whole. This search for die Ganzheit forced the historical school to cross the boundaries into what in the English tradition were other – and to them unrelated – academic disciplines. In the German historical tradition it would be complete nonsense to exclude any information relevant to the question asked – be it from the realm of climatology, pedagogy or any other branch of human knowledge. In the German tradition, economics was a science that integrated all the others. However, it is not at all clear that Menger disagreed with this. Menger drew up a picture – a model – of the economic forces at work, but, like Schumpeter later, he insisted that history was an ‘indispensable’ tool for the profession. To Menger, the problem of the historical school was that its adherents suffered from a kind of ‘case-study syndrome’: they collected raw materials for a theory, but never got around to establishing a proper theory. This criticism is similar to that of Thorstein Veblen, but it is more appropriate to some members of the historical school than to others. It is indeed crucial to define what is meant by ‘theory’. The marginalist tradition came to seek ‘pure theory’, a formalist kind of theory that excluded from economics all the forces that in the Renaissance tradition were the driving forces of history. However, of all the marginalists, Menger was clearly the closest to the historical school; as we shall discuss later, he both ‘invented’ marginalism and, at the same time, went far beyond it. The criticism of the marginalists from the historical school was that the very source of wealth – man’s wit and will – had disappeared. This had led to an Entgeistung der Volkswirtschaftslehre; the role of Man’s wit and will had been left out of the science. The German ethical historical school – with its US followers such as Richard Ely and Simon Patten – followed the Renaissance tradition of seeing economics as a normative science, setting out to transform society for the benefit of the common weal. Morality was, to them, rational, and part of the Ganzheit of the economics profession. In contrast, to British empiricist philosophy and classical economics, morality

270 Erik S. Reinert was irrational and based on sympathy (feeling) in the tradition of Hume and Smith. Accordingly, to the English school, morality was totally separated from economics. Canonical Methodenstreit 5: the US institutional versus the neoclassical school (twentieth century) Institutional economics presents a continuation of the US and German nineteenth-century economics tradition. Institutionalism – a term originally coined only to describe the work of the Norwegian-American economist Thorstein Veblen (1857–1929) – continued the radical trend of the ‘American System’ in opposing the abstract structures of English theory. The institutionalists were very critical of the established economic doctrine, but most of them did not seek to throw it out completely. Since their theory was praxisnah – empirical and close to reality – the institutionalists attracted the attention of policy makers. Academically and in terms of influence, US institutionalism peaked in the troubled 1930s, and it may be argued that institutional policy makers in the early 1930s anticipated the Keynesian policy prescription without Keynes’s elaborate theoretical framework. Although institutionalism declined rapidly after World War II – really, during the years of McCarthyism – its influence on economic policy making in Washington lingers on. Two informative and fairly recent books trace the demise of institutional economics in the United States: Yuval Yonay’s The Struggle over the Soul of Economics (1998) and a collection of papers: From Interwar Pluralism to Postwar Neoclassicism (Morgan and Rutherford 1998). Today, Paul Krugman complains that ‘It is not just that economists have lost control of the discourse; the kinds of ideas that are offered in a standard economics textbook do not enter into that discourse at all’ (quoted in Reder 1999: 6). If we ask ourselves to whom the economists have lost control, Krugman lists an alliance of ‘policy makers, business leaders and influential intellectuals’ (ibid.: 6). These are the groups that today defend the common sense and pragmatism of institutional economics against the unmitigated rule of standard textbook economics. To the ‘Ricardian vice’ labelled by Schumpeter we may add the ‘Krugmanian vice’: the vice of possessing more relevant economic theories – such as a new trade theory – but refusing to employ these principles in real-world economic policy. Thus, although neoclassicism won the day in academia and in Western economic policy towards the Second and Third Worlds, the eclectic pragmatism of the institutional school lives on in policy making both in the United States and in Western Europe. In academia the proponents of this school are today mostly scattered in business schools, government departments and departments of international affairs. As a result of the virtual

Austrian economics and ‘The Other Canon’ 271 eradication of Other Canon economists from departments of economics, the poor countries of the world are still treated to undiluted neoclassical economics as administered by the Washington institutions.

The Austrians and The Other Canon Austrian economics in many ways bridges the two canons. If the theory of economics is seen from the angle outlined in the first part of this chapter, the founder of Austrian economics, Carl Menger, his pupil Richard Schüller, and Joseph Alois Schumpeter all stand out as economists whose fundamental attitudes make them Other Canon economists. In the other end of the historical spectrum – in a process clearly also influenced by the political agenda created by the Cold War – the modern US/Austrian school has, for most practical purposes, strongly approached what we here refer to as the standard canon of economics. The central idea of Menger’s Grundsätze (1871, 1923) is to present a dynamic theory of economic development, which he presents in the fifth paragraph as ‘The Causes of Progress in Human Welfare’. In this section I shall attempt to illustrate the similarities between Menger’s approach and that of nineteenth-century Other Canon theorists in the United States, people like John Rae and E. Peshine Smith. Like Menger, these were economists writing in strong opposition to the English classical school. When one reads Menger, it soon becomes clear that this man went far beyond the marginalism he is noted for. As Erich Streissler says, ‘Menger is unique because he surpassed marginalism at the same time that he created it. . . . To him, his ideas beyond marginalism were the most precious’ (1972: 430). A re-reading of Menger makes it clear that Streissler is right when he explains: Menger . . . is to a large extent now forgotten precisely because in the reign of his successors in Vienna, the co-reign of Wieser (1903–1924) and Böhm-Bawerk (1904–1914) – the latter pre-dominating during his life-time – much of what was genuinely Menger’s tradition got lost. I shall argue that both neoclassical economics and Austrian economics have followed similar paths away from the visions of their founders, Marshall and Menger, parallel paths away from a focus on production and methodological diversity towards a theory where barter/exchange and lack of diversity dominate. In my terminology, very important ‘Other Canon’ elements were lost both in neoclassical and in Austrian economics during the twentieth century. Menger lived long enough to see that his successors were sliding back into ‘old errors’ of economic science. Menger told Schumpeter that ‘The time will come when people will realize that Böhm-Bawerk’s theory is one of the gravest errors ever committed’ (Schumpeter 1954: 847). Menger

272 Erik S. Reinert also charged Böhm-Bawerk directly in his obituary with relapsing into old doctrines. Schumpeter identifies these doctrines as the ‘Ricardian roots’ of Böhm-Bawerk’s theories (ibid.: 846). With Menger’s first successor in the genealogy of Austrian economics, in 1903, Austrian theory was already taking a decisive bend towards the English-based mainstream tradition. One recent book discusses this under the fitting heading of ‘The progressive neglect of Menger’s originality’ (Gloria-Palermo 1999: 37–75). Typically, today’s standard economic theory is what Lionel Robbins (1952: 22–29) termed a Harmonielehre, a system in which the resulting economic harmony is built into the very assumptions of the theoretical structure. There are two types of entrepreneurs in Austrian theory, who have opposite impacts in this respect: 1 2

the Hayekian/Kirznerian entrepreneur, who produces equilibrium and economic harmony; the Schumpeterian entrepreneur, who produces disequilibrium and disharmony in the form of uneven economic development.

Of these two types of entrepreneurs, the Hayekian version is fundamentally a harmony-producing element of the standard economic canon, whereas the Schumpeterian entrepreneur is the destroyer of equilibrium, the element introducing the novelty and new knowledge that standard theory is essentially unable to handle. As we shall see, the young Schumpeter – as opposed to most other Austrians – also fundamentally disagreed with the notion of equilibrium. Today the fundamental difference between modern US/Austrian and neoclassical economics seems to be that while neoclassical economics has a mechanical view of equilibrium, the Austrians focus on the process of reaching equilibrium, and the need for an entrepreneur to get there.20 This may indeed have been a crucially important distinction in the debate between central planning and capitalism, but in a post-Cold War world the differences in policy recommendations that can be derived from the two theories seem less important. Although the intellectual effort underpinning Hayek’s laissez-faire towers above the mechanics of basic neoclassicism, the outcome on the policy level does not differ significantly.21 Nicolai Foss pinpoints the problem: ‘It is not only that modern Austrian economics asks different questions and gives different answers, it is perhaps more fundamentally a matter of modern Austrian economics being unable to ask a number of interesting questions’ (1994: 194). Foss then lists the questions about which Austrian economics is silent: ‘the process of technological change, its organization and economic consequences, strategic interaction between duopolists, oligopolists, etc., the firm, its organization and activities’. One could also add: diversity of all kinds, including the issue of world poverty, and novelty. The lists of questions that are outside the reach of the modern Austrian and of the neo-

Austrian economics and ‘The Other Canon’ 273 classical paradigms overlap to a large degree, although most of these questions were discussed both by Menger and Marshall. This is one reason I here refer to the parallel loss of Other Canon issues in both sets of theories. One fundamental element causing this convergence between Austrian and neoclassical economics seems to lie in the loss of the factor time in both theories.22 Focusing on exchange rather than on production, and having accepted Walras’s virtually instant equilibrium – the one-minute tâtonnement – modern Austrians and modern neoclassicals are both Harmonielehren. Here they stand in sharp contrast to Menger and Schumpeter. Menger’s tâtonnement takes a century (see Streissler 1972: 440), and in a system with constant innovations, equilibrium will hardly ever be reached. Here we find a most important difference between Menger on the one hand and the later Austrians and the neoclassical school on the other. To Menger, the theoretical structure was a map of the forces at work, but the final outcome of these forces could neither be fully described, nor quantified. Nor would the final result necessarily be harmonious. Menger thus opens up for an economic theory that analyses the world as it is, and whose development is potentially an uneven process. Menger’s pupil Richard Schüller wrote his two main works while Menger’s influence dominated at the University of Vienna, before the ‘backsliding’23 of Wieser and Böhm-Bawerk was much felt. Schüller dedicated both his works to his teacher Menger: Die klassische Nationalökonomie und ihre Gegner (Berlin, 1895) and Schutzzoll und Freihandel. Die Voraussetzung und Grenzen ihrer Berechtigung (Vienna, 1905). There are reasons to believe that Schüller was one of the students who were closest to Menger. This is indicated when – much later, in 1923 – Menger’s son, Karl Menger, asked Schüller to write the foreword to the second edition of his father’s Grundsätze. This edition was published two years after Menger’s death at the age of 81, marking the fiftieth anniversary of the first edition. In his introduction, written just five months after Menger passed away, Karl Menger thanks ‘his father’s dear friend, Prof. Dr. Richard Schüller’, for his ‘many valuable suggestions’ and for agreeing to write the foreword to the book. In Schüller, a Mengerian unpolluted by the ‘backsliding’ Austrians of the next generation, we find a typical Other Canon economist. When discussing the perennial question of free trade versus protectionism, Schüller starts with a discussion of how costs develop as a nation specialises in a certain type of activity (1905: 9ff.). This discussion goes right to the core of the trade debate of The Other Canon from Serra’s first description of increasing returns in 1613, limited to manufacturing, and all through the nineteenth-century debates in the United States and Germany. Schüller’s focus on production rather than on barter, and on increasing returns, makes him a typical Other Canon economist, whose system is one of uneven benefits from trade caused by the different development in costs

274 Erik S. Reinert structures according to a nation’s ‘choice’ of specialisation. Schüller’s increasing returns are found not only in production, but also in finance, advertising and in ‘travelling salesmen’ (ibid.: 15). Increasing and diminishing returns are, to Schüller, factors that cause uneven economic growth, and are among many factors that need to be evaluated before deciding whether a nation should protect its manufacturing industry or not. As in Schumpeter’s world, economic development is an uneven process. To Schumpeter, ‘the upper strata of society are like hotels which are . . . always full of people, but people who are forever changing’ (1934: 156).24 In chapter 7 of the first edition of his Theorie der wirtschaftlichen Entwicklung (1912), Schumpeter makes the following statement on economic equilibrium: It lies in the very foundation of our way of thinking that there is no such thing as a dynamic equilibrium. Economic development is in its very nature a disturbance of the existing static equilibrium, without any tendency whatsoever for the system to move back either to the original point of equilibrium, or to any other point of equilibrium. (1912: 489) By the time the second edition of this work appears, in 1926, the whole chapter containing this paragraph – ‘Das Gesamtbild der Volkswirtschaft’ – is gone. This ‘case of the missing chapter’ contains some interesting elements. In his new foreword to the second edition, Schumpeter informs the reader that chapter 7 has been omitted. Then, later on in the same foreword, he comments on the changes that have been made to chapter 7 – a chapter that is not in the book at all. The same mistake – referring to a chapter that is not there – is repeated in the otherwise carefully edited French translation of 1935. In his foreword, Schumpeter comments as follows on chapter 7, which he must have decided at the last minute not to publish: ‘as I reworked it, I agreed with [my] most severe critics, and excused others who did not understand the argument’(1926: xiii). Like the other Austrians who came after Menger, here Schumpeter moves towards a rapprochement with the standard canon. This rapprochement is also on an issue of almost religious significance: is there such a thing as equilibrium or not? Or rather, what kind of questions can be usefully answered by the metaphor ‘equilibrium’? In my view the postulate of an equilibrium severely reduces the scope of economic theory, leaving issues of great practical importance outside the paradigm. We can only speculate how much the different factors weighed in Schumpeter’s decision to abandon his most fiercely anti-equilibrium stance: the weight of the criticisms, his admiration for Walras’s system, or – and this is pure speculation – perhaps the fact that he wanted his work to appeal more to the AngloSaxon economic world, where he was to spend the final two decades of his

Austrian economics and ‘The Other Canon’ 275 career. I must agree with Streissler that, in general, it is ‘because he admired Walras so much that Schumpeter is such a bad guide to the real Austrian achievement, which has always been in complete contrast to Walras’ (1972: 430). With a perspective of more than a hundred years, we see that the ties and similarities between the economics of Carl Menger and traditional German economics are many. This is particularly true when the development of mainstream economics since the Methodenstreit is taken into consideration. In commenting on the Methodenstreit, Carl Brinkmann wrote in the Encyclopaedia of the Social Sciences that both Schmoller’s and Menger’s economics were parts of ‘the great reaction that had set in against the one-sidedly deductive methods of orthodox utilitarianism’. ‘In fact,’ Brinkmann says, ‘there is the same craving for realism, after an age of self-satisfied “pure” reasoning, in the opening pages of Menger’s Principles as there is in Schmoller’s contemporaneous work on the small crafts in Germany’ (Seligman [1930] 1953: 167). The fact that Menger dedicated his first work to Wilhelm Roscher now seems a natural choice, whereas the Methodenstreit appears as a fight between two factions that had more elements in common against the English neoclassical school than elements that divided them. Hence, one would have thought that once the personal animosity between Schmoller and Menger had disappeared, the two schools would have found each other again. If Austrian economics had followed the path embarked upon by Menger, the Methodenstreit would most likely have come down differently in history, appearing less methodologically acute and more of a personal quibble between insiders of the anti-classical movement. The opposite seems to have happened. The more the second- and third-generation Austrians moved away from Menger, the more relentless became their criticism of the historical school. I suggest that the reason why the Methodenstreit worsened considerably over time – the most vitriolic attack ever on historicism being that of Mises’ in 1959 – is that both Austrian economics and neoclassical economics, in a parallel fashion, moved away from all the Other Canon aspects that Menger and Schmoller shared. This will be discussed more in detail later in the chapter. The rest of this chapter is dedicated to the discussion of concrete theoretical points where Menger and Schmoller were both on the Other Canon side, against what developed into the English–Walrasian theoretical mainstream. In the foreword to the second edition of Carl Menger’s Grundsätze, his son Karl Menger emphasises his father’s belief that ‘the starting point of all inquiry into theoretical economics is the needs of human nature’ (1923: ix). This is the classical starting point of German economics since the times of Leibniz and Christian Wolff: the profession is ‘anthropocentric’ – that is, centred on ‘man and his needs’. The Germans always saw this as a sharp contrast to the English classical tradition, which is centred

276 Erik S. Reinert on barter, and where – in the end – humankind is just a ‘factor of production’. Menger’s roots in German cameralism are discussed by Paul Silverman (1990). Menger makes the very Other Canon statement that ‘the quantity of consumption goods at human disposal is limited by the extent of human knowledge’,25 evoking the ‘never-ending frontier of knowledge’, which is so typical of the activistic-idealistic and optimistic alternative canon. Menger here appears to be inspired by the spirit of the US economist Erasmus Peshine Smith,26 whose work was translated into German only in 1878. To Peshine Smith there were two factors of production: nature; and man’s wit and will. This is similar to Menger’s view that production in primitive societies depends solely on nature: ‘it takes place independent of the wishes and needs of Mankind, and hence, so far as they are concerned, accidental’ (1923: 28). When human beings leave primitive society and explore and research the causal mechanisms which produce consumption goods and take control over these processes, the production of consumption goods takes place as before, but their production is no longer coincidental to the wishes and needs of Man. Instead this is a process where Man is in charge and which is organised around Man’s needs and purposes within the limits of nature’s laws. (ibid.: 28–29) Like John Rae in his 1834 book, Carl Menger sees the division of labour as being a necessary consequence of human innovations and inventiveness,27 not – like Adam Smith – the other way around. Menger uses a whole section of his Grundsätze to refute Adam Smith on this point. This again is the ‘anti-English/anti-barter’ stance that is typical of The Other Canon. Menger also represents the ‘economics of time and uncertainty’, which in many ways is the antithesis of neoclassical economics. However, with the passage of time, Austrian economics and neoclassical economics – particularly in their policy prescriptions – have converged on something that for all practical purposes is indistinguishable from that of the neoclassical synthesis. Hayek was, of course, sharply critical of any attempt to convert economics into a discipline similar to the natural sciences (1952). Yet in a post-Cold War world, Austrian economics came to seem like neoclassical economics in words rather than in mathematics. Menger’s great map of the forces at work, which would hardly ever even come close to their resting position, became a map that was considered accurate enough to reach the same policy conclusions as mainstream neoclassicism. One important criticism of The Other Canon tradition against neoclassical economics has traditionally been its emphasis on monetary aspects and the limited role of the real economy of goods and services (what

Austrian economics and ‘The Other Canon’ 277 Schumpeter and others called the Güterwelt). In 1936, just after Menger’s works had been reprinted in German at the London School of Economics, one author saw this as the key issue separating neoclassical and Austrian economics. The author, Franz Wien-Claudi of the University of Prague, published a book that was an early attempt to introduce Austrian economics to an English-speaking public. Wien-Claudi claims at that point that ‘Hayek’s main objection to the modern English School of Economics was that these authors have overestimated the significance of monetary phenomena and undervalued the importance of the events in the world of goods.’ (1936: 7). However, this point is not listed as one of Fritz Machlup’s six ideas that separated Austrian economics from neoclassical economics before World War II (see Kirzner 1987: 148). Again, what was a typical ‘Other Canon’ feature of early Austrian economics seems to have been lost. As the tradition was ‘backsliding’ into Ricardian and Walrasian economics, Austrian economics became increasingly ‘schizophrenic’, torn between a verstehende and a mechanistic/ordnende paradigm. Schumpeter emanated from the Renaissance tradition of the German historical school and spent his life on the hopeless task of formalising the creative essence of Renaissance economics – of entrepreneurship, novelty and creative destruction – into the framework of dead equilibrium that is at the core of neoclassical economics. Schumpeter was indeed ‘a living, breathing contradiction’, as Mirowski (1994: 5) puts it. I would claim that this contradiction is an inevitable result of attempting to reconcile two paradigms that are irreducible to any common language (Reinert 2003). John Maurice Clark points to this ‘schizophrenia’ when he discusses Hayek’s Individualism and Economic Order. The factors that create disequilibrium and, consequently, those that create the need for economic policy and government intervention are still there in the Hayek of 1949. However, these factors are being pushed more and more into the background as Austrian economics comes of age, ‘slides back’, and increasingly focuses on addressing the threat from communist central planning: Hayek’s position on economic policy is baffling: stressing the function of the free market and the dangers of expanding public controls, admitting the necessity of a considerable measure of control, but avoiding adequate definition of the line between the controls he opposes and those he would approve. The present volume contributes little to clarification of this vagueness. This is partly because the volume is a collection of short essays and addresses, in which Hayek repeatedly excuses himself from systematic and specific elaboration on grounds of space; but it seems to be fundamentally a matter of Hayek’s method of attacking the analysis of these problems. He starts with a principle, which he emphasizes as of dominant importance. He then admits that an opposing principle has validity and

278 Erik S. Reinert some proper scope; but never comes to grips with the question how far the opposing principle may be properly carried, and how it may be kept down to sound methods and limits. This is a fairly common theoretical method of analysis; and amounts to throwing the pragmatic emphasis, which generally accompanies the inevitable oversimplification of theory, in one direction or the other. If this direction is that in which the next step need to be taken, this pragmatic effect may be useful, as far as it goes and so long as only those steps are in consideration. If the emphasis is thrown in the opposite direction, as Hayek’s is, its usefulness is limited to sounding a very general warning against possible excesses of wrong methods, but without yielding much useful guidance to those who are earnestly seeking it, aware of dangers but aware also of things that must be done. In general, Hayek seems to underrate amazingly the seriousness of the problem of assured employment, and the extent of the public intervention it makes inevitable. He pitches the argument on a mechanistic economic level, and seems intolerant of attitudes that do not fit that scheme, rather than recognising their existence and seeking a viable adjustment with them. On this basis, he seems doomed to the role of Cassandra.28 (J.M. Clark quoted in Hickman 1975: 69–70; my italics)

The twentieth-century closing of the economic mind In 1987 Richard Bloom’s book The Closing of the American Mind became an unlikely bestseller in the United States. The aim of the book was to prevent American education – and the United States itself – from degenerating further into what the author perceived as an increasingly low and narrow mental horizon. Bloom describes American society’s loss of the foundations in the humanities that were once synonymous with civilisation itself. He holds up the Europeans as being better off than the Americans – whom he at one point refers to as ‘big babies’ – in this respect. However, the twentieth century as ‘the American century’ has meant that US values and attitudes have diffused within Europe too. One important aspect of this development has been thoroughly analysed in the early 1960s in Richard Hofstadter’s Anti-intellectualism in American Life (1963). Although the roots of this anti-intellectualism can be traced back to the Pilgrim Fathers, Hofstadter focuses on the 1950s, on McCarthyism, as being the decisive period for the growth of antiintellectualism. McCarthyism and the Cold War created a demand for a kind of economics that the mechanical versions of neoclassical economics and Austrian economics could both provide. The neoclassical utopia of a market creating harmony and factor price equalisation was an important counterweight to the communist utopia and its omnipotent state that promised to wither away.

Austrian economics and ‘The Other Canon’ 279 In this context the ‘intellectuals’ became a nuisance. The ‘intellectuals’ had historical and political qualifications and modifications to the clear message of an absolute superiority of the unmollified market economy. American pragmatism under the pressures of the Cold War degenerated into expediency and anti-intellectualism. History – including US history – cluttered the message of the near-‘evilness’ of state interventions under all circumstances and in all contexts. Removing economics’ previously solid foundation in the humanities pried open the way for the rule and dominance of the mechanical models: clear conclusions, but conclusions that in their pure and undiluted form are only valid in a world void of diversity, of friction, of scale effects and of time and ignorance. The onehanded economist was created, freeing the profession from the nuisance of qualifications – ‘on the other hand’ – created by the inclusion of historical context and perspective. This new economist was created at the cost of severely limiting the use of experience-based cognition, intuition and Fingerspitzgefühl – of qualities that are normally associated with the right half of the brain. The one-armed economist is to some extent also the ‘left brain only’ economist. The pure neoclassical techniques in which economic harmony is already solidly built into the basic assumptions – providing results like Samuelson’s factor-price equalisation – were the kind of theory that was ideologically and politically in demand. I am not suggesting that this kind of theory was created for political purposes. The theories had been there essentially since Ricardo, but the demand for this kind of theorising rose considerable during the Cold War, sharpening its focus and message, but conveniently leaving aside the mitigating counter-arguments of history. John Bates Clark’s criticism of Hayek’s failure to come to grips with ‘the opposing principles’ is a case in point. In this way the ‘technicians’ crowded out the ‘intellectuals’ of the economics profession. Still today, when Paul Krugman complains that ‘economists have lost control of the discourse’, his villains are an alliance of ‘policy makers, business leaders and influential intellectuals’ (quoted in Reder 1999: 6). Some of Hofstadter’s anti-intellectualism is still around when a technical economist like Krugman perceives the ‘intellectuals’ as being his enemies. Both neoclassical economics and the Austrian economics of Hayek and Mises provided extremely useful defence mechanisms against what indeed was a communist threat. The question is what to do now, when this battle is won, and the problems of the world are essentially new, while the Cold War versions of neoclassical and Austrian economics are still the only games in town. I suggest that the need to re-establish the countervailing ‘Other Canon’ is urgent. Both neoclassical and Austrian economics came to lose the kind of historical knowledge and experience that is required for the Fingerspitzgefühl necessary for difficult policy decisions. In this respect it is interesting to note that also typical neoclassical economists of the pre-World War II

280 Erik S. Reinert kind complained about the loss of historical knowledge. In pre-World War II neoclassicism, both theory and history were used as a matter of course. Jacob Viner is one example of this. Viner was largely responsible for eliminating increasing returns from international trade theory on the account that it was not compatible with equilibrium (1937: 475–482), thus sacrificing the real world in order to keep the ‘purity’ of the model. It was indeed a paradox that this happened in the middle of the ‘Fordist’ paradigm, in which increasing returns were at the very core of the wealth-creating economy of the industrialised world. This severed the understanding of the relationship between manufacturing/industry and progress, which had been at the core of European and North American economic policy for about five hundred years. This is very different from the attitude of the founder of neoclassical economics, Alfred Marshall, who in the early editions of his celebrated Principles of Economics (1890: 452) clearly recognised that a nation could improve its position by subsidising economic activities subject to increasing returns, and tax those subject to diminishing returns (e.g. agriculture). Just like Austrian economics, neoclassical economics was backsliding away from its founder into Ricardian and Walrasian models even before World War II. Yet the very same Jacob Viner wrote a most interesting book (1972) on the problem of economic man as a passive being in the hands of ‘Providence’ – of the invisible hand being a metaphor for Providence, thus bringing laissez-faire and ‘passivity as strategy’ close to a primitive belief in faith and providence. The same Viner who threw out increasing returns also, years later, complains that ‘economists have succeeded in being as ahistorical as an educated man can perhaps possibly be’ (1991). This shows the dualism so typical of economists of both the Austrian and the neoclassical school before World War II: the real world was kept as a frame of reference that was to be continuously confronted with the theoretical map of ‘the forces at work’. What has been lost is primarily this important skill of going back and forth between the theoretical models and the real world, between theory and experience. The loss of this skill, and a general lack of historical knowledge, contribute to what Veblen calls the contamination of instincts. Today’s standard education in economics too often fails to communicate with what to practical people is ‘common sense’. In this vein, a distinguished committee of the American Economic Association pointed in 1991 to the danger that ‘graduate programs [in economics] may be turning out a generation of too many idiots savants, skilled in technique but innocent in real economic issues’.29 An Austrian parallel to Jacob Viner – very orthodox but still insisting on the role of history and of the real world – is Fritz Machlup. One of the founders, with Hayek, of the ideologically important Mont Pelerin Society, Machlup received his Ph.D. in Vienna in 1923 and moved to the United States in 1933. In spite of his orthodoxy, Machlup wrote extensively on

Austrian economics and ‘The Other Canon’ 281 ‘Schumpeterian’ subjects like ‘The Supply of Inventors and Invention’ (1960) and The Production and Distribution of Knowledge in the United States (1962). Machlup was also the supervisor for Edith Penrose’s research for her Ph.D. thesis, research that eventually led to the Theory of the Growth of the Firm (1959). This book is important as a key foundation for the microeconomics of The Other Canon. A recent publication on work of Edith Penrose comments that it is ‘a fascinating paradox how Machlup, a doyen of neo-classical economics, should have been partially responsible for a work so far removed from the mainstream’ (Penrose and Pitelis 1999: 5). I would suggest that this was much less of a paradox forty or fifty years ago than it is now. This is yet another example of the loss of diversity of scope and tools in the profession.30 The economics of Edith Penrose was sharply at odds with textbook theory, but she would not engage in a Methodenstreit: ‘Would anyone . . . try to reconcile a football game with a cricket match just because they are both ball games?’ (Penrose and Pitelis 1999: 5). Whereas the early Austrians and early neoclassicals were able to play both ‘football’ and ‘cricket’, this ability was gradually lost, together with the multitudes of tools and approaches previously used. In spite of what we today may perceive as a position against the use of history in economics in his Irrtümer des Historismus, Carl Menger really goes out of his way to emphasise the important role of history in economics (1884: 22, 26, 31, 35, etc.): ‘A highly developed theory of economic phenomena is inconceivable without the study of economic history’ (ibid.: 22); ‘No reasonable person conceals the importance of historical studies for research in the field of political economy’ (ibid.: 26); and history is ‘indispensable’ for theoretical economics (ibid.: 36). Schmoller and Menger agree that both induction and deduction must be on board, and the Methodenstreit is seemingly about who is to be in the driver’s seat – which of the two is going to be the ‘main science’ and which should be the ‘auxiliary science’. Menger’s main objective seems to be to relegate history to the position as a Hilfswissenschaft (auxiliary science), a term to which he returns again and again. The contestants of the Methodenstreit discuss whether history – which they both see as indispensable to economics – should be an Überbau (superstructure – Schmoller) or an Unterbau (foundation – Menger). From this methodological angle the Methodenstreit seems to fit the definition of a quibble: an unsubstantial argument based on playing with words. As has been said by many commentators, this particular Methodenstreit seems like a waste of scholarly energy. Seen from today’s perspective, Schmoller and Menger were very close in the role they saw for economics, and both were far from today’s mainstream. In his first book – of which there is still no English translation – Schumpeter (1908) denounced such doctrinal wranglings as the Methodenstreit as a waste of time. Each method had its concrete areas of application, and it is useless to struggle for

282 Erik S. Reinert universal validity. According to the young Schumpeter, one should enter the theoretical edifice at a level of abstraction where one is likely to find answers to the questions posed. In this spirit we might say that the neoclassical structure is not ‘wrong’ in its assumptions. It becomes wrong only when – unmitigated by historical observations – it is applied to the real world, where entirely different assumptions are appropriate. The cases when economists were able both to keep their theoretical models and to refer back to the many dimensions and complexities of the real world became increasingly rare. Economics came to suffer from what Philip Mirowski calls ‘physics-envy’ (1989) (see also De Marchi 1993). Also, the Austrians ‘suffered to some degree from the effects of an intellectual world that expected all science to emulate the rigour of physics’, as Allen Oakley puts it in his book on the Austrians (1997: 2). John M. Clark’s 1949 accusation, quoted earlier, that Hayek ‘pitches the argument on a mechanistic economic level, and seems intolerant of attitudes that do not fit that scheme’, is indicative of the same development. I shall let the development of Ludwig von Mises’s treatment of historicism – comparing his 1933 treatment and his 1957 treatment of the same subject – serve as a final illustration of the development of Austrian economics over time. Mises’s treatment of the Methodenstreit went from being a purely academic disagreement in 1933 to being an important ideological and political issue in Austrian economics after World War II. In Mises’s 1933 Grundprobleme der Nationalökonomie the Methodenstreit is still very much alive, even in the introduction to the book. Mises here presents and caricatures historicism in its ‘pure’ form. When Sombart is quoted as admitting that ‘general economic concepts, which are valid for all economies’ do exist, Mises does not take this as an invitation towards a compromise (ibid.: 6). All through the book, Mises introduces a Methodenstreit type of debate that seems to allow few concessions. For example, on pp. 56–59 Mises argues that ‘[Gunnar] Myrdal knows neither the contemporary situation nor the history of our science, and is therefore fighting against windmills’. On pp. 129–134 he polemicises again against Werner Sombart. However, the whole debate is apolitical and – though caustic – purely confined to academic economics. When Mises again picks up historicism in his Theory and History ([1957] 1985), the basic criticism is the same, but the treatment very different. (It may be noted that in his 1933 book the author was ‘Ludwig Mises’, but in the United States he is Ludwig von Mises). Mises comes to the treatment of historicism from a section called ‘planning history’, which ends as follows: It is possible that in a few years all nations will have adopted the system of all-round planning and totalitarian regimentation. The number of opponents is very small, and their direct political influence almost nil. But even a victory of planning will not mean the end of

Austrian economics and ‘The Other Canon’ 283 history. Atrocious wars among the candidates for the supreme office will break out. Totalitarianism may wipe out civilization, even the whole of the human race. Then, of course, history will have to come to its end too. ([1957] 1985: 197) I shall quote extensively from chapter 10, ‘Historicism’, which in a sense represents the last act to be performed in the Methodenstreit (italics are mine): 1. The Meaning of Historicism Historicism developed from the end of the eighteenth Century on as a reaction against the social philosophy of rationalism. To the reforms and policies advocated by various authors of the Enlightenment it opposed a programme of preservation of existing institutions and, sometimes, even a return to extinct institutions. Against the postulates of reason it appealed to the authority of tradition and the wisdom of ages gone by. The main target of its critique was the ideas that had inspired the American and the French Revolutions and kindred movements in other countries. Its champions proudly called themselves antirevolutionary and emphasized their rigid conservatism. But in later years the political orientation of historicism changed. It began to regard capitalism and free trade – both domestic and international – as the foremost evil, and joined hands with the ‘radical’ and ‘leftist’ foes of the market economy, aggressive nationalism on the one hand and revolutionary socialism on the other. As far as historicism still has actual political importance, it is ancillary to socialism and nationalism. Its conservatism has almost withered away . . . If the historicists had been consistent, they would have substituted economic history for the – in their opinion counterfeit – science of economics. . . . But this would not have served their political plans. What they wanted was to propagandise for their interventionist and socialist programs. The wholesale rejection of economics was only one item in their strategy. It relieved them from the embarrassment created by their inability to explode the economists’ devastating critique of socialism and interventionism. But it did not in itself demonstrate the soundness of prosocialist or interventionist policy. In order to justify their ‘unorthodox’ leanings, the historicists developed a rather self-contradictory discipline to which various names were given such as realistic or institutional or ethical economics, or the economic aspects of political science (wirtschaftliche Staatswissenschaften). The line of reasoning against historicism – most of it is not quoted here – is very much like Mises’s 1933 treatment of the same subject. But in the 1957 book the academic antagonism has yielded to what, in the eyes of

284 Erik S. Reinert this writer, comes very close to being McCarthyist political propaganda. Historicism is vilified as being the root of most evils of history – not only of socialism. All reactionaries, enemies of ‘reason’, and also the enemies of the American Revolution, are by definition ‘historicists’. Note that the institutional school is, according to Mises, just another name for these ‘reactionaries’. Again this contrasts sharply with Menger, who – as Streissler (1972: 433) points out – on many points ‘was very close to the Institutionalists’. This piece of Cold War Americana would not be complete without a brief account of the alleged ‘ideological conflict’ between Yale University Press – which originally published the book – and Mises. The disagreement between Mises and his publishers seems to have originated in quality problems in the production of Mises’s Human Action. The press has apologised, and admitted that it was not up to standard.31 This printing problem is interpreted by the Mises as an ‘ideological conflict between Ludwig von Mises and Yale University Press’. ‘Who was it that wanted to harm my husband by producing a bad print, and in that way obstruct the reader?’ ‘Why did Lu’s [Ludwig von Mises’s] lawyers, who had such a clear case in their hand, decide not to go to court, although Ludwig von Mises so obviously had the right on his side?’ Not only does Mises insist that historicism is the incarnation of all evil across history from the ‘conservative’ opponents of the American Revolution to ‘revolutionary socialism’, but Yale University Press is seen as waging an ideological war against Mises. It is easy to understand an author who sees his press as not doing a proper job. However, these kinds of interpretations are understandable only in the context of McCarthyism. Austrian economics had indeed come a long way from Carl Menger. In many ways the twentieth century witnessed a slow closing of the minds of the economics profession. More than before, economists became the ‘eggheads’ they were traditionally accused of being in the United States: ‘people who do not understand everything they know’. Probably the most dramatic event in this development is that the economics profession lost its base and points of reference in the humanities. The early Austrian and neoclassical economists used the theoretical structure as an inaccurate map that was constantly held up and evaluated against realworld history, and its philosophy and values were firmly embedded in the humanities. This approach created and allowed methodological diversity and pluralism, a diversity that was lost when the ties between economics and the humanities were slowly severed. I have already mentioned two recent volumes that trace this development in economics, and their titles are descriptive: The Struggle over the Soul of Economics (Yonay 1998), and From Interwar Pluralism to Postwar Neoclassicism (Morgan and Rutherford 1998). The founders of both the neoclassical school and the Austrian school, Alfred Marshall and Carl Menger respectively, took great care to empha-

Austrian economics and ‘The Other Canon’ 285 size the importance of history in economics. In his preface to the Principles of Economics, Marshall spells out the chief influences common to all modern schools of economic thought as biology and history, whereas mathematics is seen as influencing the form of the theory (1890: ix–x). ‘It is the business of economics . . . to collect facts, to arrange and interpret them, and to draw inferences from them’, Marshall says,32 laying the foundation for economics as an Erfahrungswissenschaft (a science of practice), rather than the Ricardian science of a priori assumptions with categories established once and for all. Later, as mentioned earlier in this chapter, Marshall approvingly quotes Schmoller as saying that ‘Induction and deduction are both needed for scientific thought as the right foot and left foot are both needed for walking’ (1961: 29). Both neoclassical economics in general and modern Austrian economics in the United States seem to have taken on many of the characteristics that Bloom (The Closing of the American Mind) and Hofstadter (Anti-intellectualism in American Life) associate with intellectual life in the United States, and spread this attitude to the rest of the world. In terms of economic policy and of belief in ‘spontaneous order’, Austrian and neoclassical economics seem, for all practical purposes, to be of one mind. The main difference between the two schools seems today to lie in the absence or presence of an equilibrium-making entrepreneur. The foundations of the theory in the humanities are difficult to locate in today’s structures, and this economic theory – void of context and of institutions beyond that of the market – indirectly also becomes curiously ethnocentric. If institutions are assumed away in a theory void of time and history, this implicitly assumes that the institutions ruling in one’s own country can be taken for granted and can be expected to arise spontaneously and instantly anywhere and in any context. The co-evolution of economic activities and their accompanying institutions is lost. The collective memory of the tremendous effort it took to build the institutions of civilisation was lost from the neoclassical and also to a large extent from the neo-Austrian schools. As a German economist put it in 1840: As the grown man has long since forgotten the pains it cost him to learn to speak, so have the peoples, in the days of their mature growth of the State, forgotten what was required in order to free them from their primitive brutal savagery.33 The policy implications of this loss of memory proved devastating to economic welfare in the former communist world and in Africa. A reintroduction of brutal savagery has, in some cases, been the result. US pragmatism in its best sense is related to praxisnähe in German social sciences. What is wanted is not theory for its own sake, but a practical theory in which action is intimately tied to analysis. The same US

286 Erik S. Reinert pragmatism, however, may deteriorate into ‘expediency’, into going ahead without proper analysis of alternatives and of consequences. After World War II, Western Europe was given a period of fifteen to twenty years to adjust to free convertibility of currency and free trade. Comparing the economic policy applied in Western Europe after World War II with the ‘shock therapy’ applied to the former communist world after 1990 provides a good example of how the praxis of economics degenerated from the first definition of pragmatism (operating with a ‘practical’ theory reflecting the real situation) to the second (going ahead without a proper analysis).

Understanding human cognition: Carl Menger and the king who wanted to make the perfect map In the previous section we looked at Menger’s Irrtümer des Historismus (1884) compared to mainstream economics during the latter half of the twentieth century. From this vantage point the Methodenstreit between Menger and Schmoller seems like two ‘Other Canon’ economists involved in a relatively minor quarrel. They both agreed on the fundamental importance of history as an indispensable building block for any economic theory. This point was later strongly emphasised also by Schumpeter. From this point of view, Marshall, Menger, Schmoller and Schumpeter all represent a theoretical tradition that was virtually dead by 2000. Only in one aspect does there seem to be a fundamental disagreement between Menger and Schmoller. This disagreement is about the use of past experience in human cognition. In his disagreement with Schmoller, Menger here takes a position that finds its parallel in a short story by the Argentine author Jorge Luis Borges about the king who wanted to make the perfect map. The perfect map was seen as one holding all conceivable details, and – obviously – the larger the map, the better. Borges tells the story through a fictitious seventeenth-century book, Viajes de varones prudentes: In that Empire, the Art of Cartography achieved such perfection that the Map of one single Province occupied the whole of a City, and the Map of the Empire, the whole of a Province. In time those disproportionate maps failed to satisfy, and the Schools of Cartography sketched a Map of the Empire which was of the size of the Empire and coincided at every point with it. (Borges and Casares 1970) The Norwegian author Tor Åge Bringsværd (1974) has a similar story about a man who wants to write world history and starts with 11 September of one particular year. He found that so many things had happened in

Austrian economics and ‘The Other Canon’ 287 the world on that particular date that his history of the world never advanced as far as 12 September of the same year. Menger criticises the Kleinmalerei or Mikrographie of the German historical school, the ‘small paintings’ they produce of apparently insignificant historical events. Schmoller’s publications on cloth production in Strasbourg are attacked by Menger as such a useless micrography. Menger quotes his colleague Emil Sax and considers him optimistic when he claims that the historical research needed to create a sufficient basis for economics will take ‘generations’. Says Menger: Should economic history be completed, in the spirit of Schmoller’s micrography, before it could go on with theoretical economics, only aeons would suffice. Just think of the meat prices in Elberfeldt! In Pforzheim! In Mühlheim! In Hildesheim! In Germersheim! In Zwickau! And so on. As astronomers had to introduce the concept of light years in their science to measure enormous distances, we economists would at least have to start using the living spans of solar systems as time units, in order only to achieve an approximate idea of the amount of time needed to achieve a complete historical and statistical foundation for scientific research in Schmoller’s meaning of the word. (1884: 38–39) Hopefully, the parallel between Menger’s idea of historicism, Mr Borges’s mapmaking and Mr Bringsværd’s writing of history will now be clear. Menger creates the picture of a map at a scale of 1 to 1, a complete historical record of every price in every village in Germany (and presumably the rest of the world), which will have to be faithfully drawn in order to create the necessary theoretical foundations for a historical economics. The quotation from Menger also gives a flair of the aggressive and personal, even insulting, style on both sides of the Methodenstreit. In continuation of the meat price argument, Menger accuses Schmoller of being ‘naïve’ and a ‘dilettante’, and – closing the book – claims that ‘in the future only children and idiots will pay any attention to [Schmoller’s] odd theoretical gestures’ (1884: 87). This tone was not particularly unusual among academic economists in Germany at the time. Eugen Dühring’s debates with his opponents were possibly even more vitriolic. The debate over the use of history in economics is fundamentally a debate on human cognition. Schmoller and the German historical school come from a long tradition in which history was the raw material for human decision-making. Economics was, like conducting a business, an Erfahrungswissenschaft – a science of practice and experience. As we shall see, Schmoller directly inspired the man who created the Harvard Business School, a place where management is still today successfully taught as an Erfahrungswissenschaft using the case method of the German historical school.

288 Erik S. Reinert This view of the role of history contrasts with the philosophical foundations of Adam Smith’s economics, which lie in the philosophy of John Locke. In this philosophical tradition the human mind is a passive ‘blank slate’. The philosophers behind The Other Canon – Gottfried Wilhelm von Leibniz and Christian Wolff – were in extreme opposition to John Locke’s view of the mind as a ‘blank slate’ passively receiving impressions. To Other Canon philosophers the mind is fundamentally active, not passive. The mind perceives the world by incessant observations, continuously formulating and reformulating hypotheses based on pre-existing patterns, or schemata, of thought. Feedback mechanisms in this system – important parts of which are clearly subconscious – include intuition, vision and ‘gut feelings’. Memorising series of numbers in large statistical databases, as Menger suggests, is not a part of this system. In this tradition the mind produces ‘clues’. In economics, Keynes’s biographers call it his ‘intuition’, while Schumpeter speaks about ‘vision’. These theories of the mind are based on a mode of inference called abduction, or phronesis, Aristotle’s third form of knowledge. The tradition was revived by the Italian philosopher and historian Giambattista Vico (1668–1744), and continued in the eighteenth century in German philosophy, and in the nineteenth century in both German and US philosophy. To the US philosopher C.J. Pierce, [Induction] can never originate any idea whatever. No more can deduction. All the ideas of science come to it by way of Abduction. Abduction consists of studying facts and devising a theory to explain them. Its only justification is that if we are ever to understand things at all, it must be in this way. Pierce here continues the role played by the formation of hypothesis in the Neoplatonic tradition of Leibniz and Christian Wolff.34 The Anglo-Dutch economist Edward Misselden expressed the view that abduction anticipates ‘science’ in 1623: ‘Wee felt it before by sense, but now wee know it by science.’ W. Brian Arthur of the Santa Fe Institute is today working on economics and human cognition. Based on work in psychology, a scientific foundation for what was the ‘sense’ of the historical school is again being established. In an article in the Harvard Business Review, but without reference to economics, Arthur describes how the study of history builds qualitative verstehen: What counts to some degree [in hi-tech business] – but only to some degree – is technical expertise, deep pockets, will, and courage. Above all, the rewards go to the players who are first to make sense of the new games looming out of the technological fog, to see their shape, to cognize them. Bill Gates is not so much a wizard of technology as a wizard of precognition, of discerning the shape of the next game. (1996)

Austrian economics and ‘The Other Canon’ 289 This is a description of the abductive, qualitative understanding (verstehen) that has been lost in economics. US pragmatism at its best is also ‘abductive’, and nowhere are the principles of the German historical school being put so consciously to work as at the Harvard Business School (HBS). Reading and discussing several cases from real business every day for two years, forcing people to make decisions from real-life cases, produces an ‘artificial experience’ that develops and fine-tunes the underlying and subconscious system of production and constant and continuous modification of hypotheses. The cases are full of figures, but thinking – as Menger did – that the training for decision-making in real life consists in memorising these numbers is completely missing the point. There is a consistent discrepancy between how the HBS is rated by the deans of other business schools (‘not that brilliant’) and what HBS graduates are paid (considerably more than the graduates of any other business school). The market is willing to pay a large premium for the systematic and focused artificial honing of abductive reasoning that is unique to this school. HBS students know that they are trained in ‘management by gut feeling’; there are T-shirts sporting a mock Latin translation of this slogan and the school’s coat of arms. The link from Schmoller’s historicism to the HBS is direct. The man who created the case method was a student of Schmoller, Edwin F. Gay (1867–1946). Gay is representative of a whole generation of US students who came back imbued with the attitudes and values of the German historical school, and whose careers formed the economic policy of the United States up until World War II. We shall therefore look at Gay’s career in some detail, as a typical representative of those great American scholars who brought home both their scientific methods and their social consciousness from Germany. After taking an MA in Michigan, Gay spent more than twelve years studying in Europe, mainly in Berlin, Zürich and Leipzig. He studied under Schmoller and Adolf Wagner, receiving his Ph.D. in economic history in Berlin in 1902. Studying under Wagner, Gay found himself losing the ‘kind of fear of the encroaching action of the state’ that he had carried with him from America. ‘It was Schmoller, however, who really fired Gay’s attentive interest and enthusiasm,’ says his biographer (Heaton 1952: 38). Gay joined the Harvard Faculty in 1902. He was a brilliant organiser and motivator of people, so when Harvard decided to set up a Business School in 1908, Gay was called upon to be its first dean, a job he kept for ten years. All through his life he was frequently hand-picked to launch new ventures, and was constantly called upon for his advice. In spite of his vast knowledge of economic history, he therefore published very little. Although he was very proud of the achievements of the Business School, Gay later regretted giving up so much research and writing time in order to launch the HBS. However, among his students of economic history at

290 Erik S. Reinert Harvard were Julius Klein and Earl Hamilton, who were to become the foremost economic historians of Spain in the United States. Gay held the job of dean of HBS until 1918, but spent the war years in Washington organising US foreign trade, minimising international trade (maximising autarky!) in order to free as much tonnage as possible of ocean freighters for the war effort. It was here that Gay met Herbert Hoover. From 1919 to 1923 Gay worked as the editor of the New York Evening Post, and started what became the Saturday Review of Literature. From 1923 to 1933 Gay shared the direction of the National Bureau of Economic Research with Wesley Claire Mitchell. He was the first secretarytreasurer of the Council of Foreign Relations and was the ‘moving spirit’ in launching Foreign Affairs in 1922. Gay was also elected president of the American Economic Association. Today it is of course absolutely unthinkable that a former dean of the HBS should be elected president of the American Economic Association. This again goes to show how extremely different and more praxisnah mainstream US economics was before World War II, and how much more intimately the leading economists were integrated into the practical life of the nation. Gay was very active in promoting better labour legislation and a new Factory Act. His colleagues emphasised that he always saw the ‘altogetherness of everything’ – the Faustian Ganzheit – and one comments that ‘He is an exceedingly important part of the bridge between the social sciences and the humanities.’ As a keen observer of economic history, Gay also saw successive waves of industrialisation: a sequence of techno-economic paradigms. Under the heading ‘Swings of the Pendulum’, a history of the HBS states the following about its first dean: [H]e developed a dynamic vision of economic history: it was, he concluded, a record of swings of the pendulum between periods when social controls dominated, and periods dominated by the actions of aggressive individuals. The former periods were static, characterized by security and stability. The latter periods, ushered in by the introduction of new tools, weapons, or other forces, were controlled by the powerful individuals who introduced these forces. (Cruikshank 1987: 29) These dynamic periods, Gay felt, were crucial to economic development. The industrial revolution, for all its unwelcome side effects, had made possible new levels of productivity and prosperity. The role of the economic historian, as Gay perceived, was to study and comprehend these cycles, and to suggest ways of restraining their excesses. In the famous and voluminous Hoover Report – so optimistic before the 1929 crash – Gay’s is the only paper that senses that something is not right in the economy. At the root of the present problem of economics is the loss of the edu-

Austrian economics and ‘The Other Canon’ 291 cational tradition that produced people like Gay. The practice lives on, as in the case method that Gay introduced at the HBS – which is a tool right out of Schmoller’s historical school of economics – and in the ‘businessmen, politicians and intellectuals’ who, as Krugman complains, do not listen to textbook economic theory. US history holds a treasure of ‘Other Canon’ personalities such as Gay; they just become fewer and fewer in economics as the mechanical world-view increasingly takes over economics after World War II, contaminating the healthy instincts of abductive reasoning in the profession. All founders of the American Economic Association had studied in Germany, and most of US economics essentially belonged to The Other Canon until just after World War II.

Relevance lost: the parallel paths of Austrian and neoclassical economics Neoclassical economics travelled a long way from Alfred Marshall’s Wanderjahre in English industry to Paul Samuelson’s factor price equalisation – from a production-based understanding of what creates differences in income, to a barter-based Harmonielehre. The young Marshall took pride in being able to estimate, with remarkable accuracy, any wage in the industries he visited by observing the skill required for the job (Pigou 1925: 358–359). The path travelled by Austrian economics from Menger’s insistence that ‘the quantities of consumption goods at human disposal are limited only by the extent of human knowledge’ (Streissler 1972: 431) to the modern Austrian economics of the US South is equally long and changing. The trajectories of the two schools of economics are in many ways parallel. Both founders – Marshall and Menger – built theoretical structures as maps of the forces at work. Menger in particular insisted that his map was extremely inaccurate; he consistently refused attempts to derive ‘high degrees of exactness’ from a structure that was, by its very nature, sketchy.35 Over time, their respective maps of forces became rigid structures in which time, diversity, friction and complexity disappeared in an increasingly mechanical exercise. Both schools – Austrian and neoclassical – came to focus on barter/market rather than on production. In short, they lost the Other Canon features of economics that make the structure praxisnah (close to the real world) and able to explain such important features as uneven economic growth. The rising threat from communism and the planned economy influenced both schools. The political element, we could even call it the propaganda elements, in the writings of Hayek and Mises is unmistakable. In many ways, Samuelson’s factor price equalisation is more insidious as a tool of propaganda, because the political elements are better hidden under a mathematical garb than in prose. Communism promised that everyone should receive according to his or her needs; Samuelson ‘proved’ that

292 Erik S. Reinert under a market economy all wage earners would be equally rich! Samuelson here ‘reinvents’ and widens the scope of the Gesetz des Preisausgleiches (law of the equalisation of prices) from the ‘second-generation’ Austrian economist Friedrich von Wieser, who – in sharp contrast to Menger – believed in ‘perfect markets’. In both cases it seems to me that the conclusion – factor price equalisation – automatically results from the assumptions. Samuelson’s journal articles on this matter were published during the height of the Berlin blockade. Both neoclassical and Austrian economics lost their embeddedness in real economic life and in society in general. Both drifted away from production into barter and, each in its own way, became fascinated with Walrasian instant equilibrium. In the case of neoclassical economics the system worked without an entrepreneur. In case of the Austrians the system needs a Hayekian equilibrium-making entrepreneur. But both theories became static and mechanical, as John Maurice Clark pointed out in relation to Hayek. Both types of theory came to produce automatic economic harmony, and both became useful propaganda tools in the Cold War. The Cowles Commission, for neoclassical economics, and the Mont Pelerin Society, for Austrian economics, each in their own way contributed to the development of harmonious economic utopias that were effectively pitched against the communist utopia. In this battle of utopias the praxisnah Other Canon became almost extinct. Both the neoclassical and the Austrian theories lost their ties to a different, and lower, level of abstraction. The praxisnah (‘near to reality’) Other Canon traditionally scorns what German economists Karl Bücher called ‘die verschimmelte Schulweisheiten’ – the mouldy school-truths – of theoretical economics (1919: 197). When these mouldy school-truths are driven through in economic policy unmitigated by any reference to history or to context – as in the case of the World Bank and the IMF during the 1990s – they may cause considerable harm. Menger’s economics was also disequilibrium economics, one of uncertainty and of increasing complexity over time. Menger introduces monopoly theory as the general theory. However, both neoclassical and Austrian economics became over time more simplistic and focused on frictionless perfect competition. Economics increasingly became catallectics – a science of exchange. Both traditions became more static and void of diversity; they became Harmonielehren. During the twentieth century, theory stopped being only a starting point for analysis in both neoclassical and Austrian economics, a starting point that was continuously to be compared with historical reality. Theory was increasingly treated as if it were a description of reality itself. Menger’s original Austrian vision was a world of dynamic imperfect competition in a world pushing forward with ‘the never-ending frontier of knowledge’ as the engine of growth. If Menger was the prototype Austrian economist, Schumpeter was surely the most ‘Austrian’ of both the second-

Austrian economics and ‘The Other Canon’ 293 and the third-generation Austrians. In my view the task of economics is now to reconstruct an appreciative economic theory based on the visions of Menger and Schumpeter, to resurrect an economics profession in which ‘subjective’ theory finds an arena where it meets ‘objective’ facts. In this chapter I have attempted to outline the characteristics of this type of theory, and how it contrasts with today’s mainstream. The Austrian economics of Carl Menger and Joseph Schumpeter are valuable building blocks in this project. Like other Erfahrungswissenschaften, Menger’s theory produced neither accuracy nor any positive theorems. Just as in The Other Canon and in the historical school, ‘truth’ – and economic policy – will always be highly context dependent. Menger, the original Austrian economist, was clearly an Other Canon economist. Echoing Other Canon criticism of mainstream economics since the publication of Ricardo’s Principles in 1817, Menger chided Böhm-Bawerk – his successor in the chair of Economics at Vienna – both for ‘the obvious artificiality of his theoretical constructions’ and for ‘the contradictions between Böhm’s fundamental ideas and the real world’ (Streissler 1972: 433).

Notes 1 ‘The relation of one thing to another from which it may be said to be descended or derived; position in a genealogical classification’, Oxford English Dictionary, vol. 4, Oxford, 1933, p. 212. 2 At the time, most economists stressed the importance of having access to different theories at different levels of abstraction. See, for example, Aschehoug (1903–1908). This was also one of Schumpeter’s most important comments to the Methodenstreit in Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie (1908). 3 For example, Foss (1998). Erich Streissler (1990) looks at the common roots of Menger and Marshall. 4 Of which Schumpeter says, ‘Its analytical merit is negligible, but all the greater was its success’ (1954: 175). 5 In Germany the main anti-physiocrat was Johann Friedrich von Pfeiffer, in France Abbé Mably, Accarias de Serrionne, Necker, Forbonnais, Jean Graslin, Abbé Galiani – a Neapolitan envoy at the Court of Paris – and, most critical of them all, Simon-Nicolas-Henry Linguet. For a list of works by German antiphysiocrats, see Humpert (1937: 1031–1032). 6 The description of these synergetic effects is clear in Giovanni Botero (1590) and even more so in Antonio Serra (1613). To Serra, these ‘virtuous circles’ have their origins in the increasing returns found in the manufacturing sector, which are absent in agriculture. Machiavelli is also clear on this point: ‘Il bene comune è quello che fa grandi le città.’ 7 For a discussion of this, see Reinert (1994). 8 For a discussion of this, see Reinert (1999). 9 In the foreword to the Grundsätze (Menger 1871). In the 1950 English edition of the work, Menger’s Latin quotation from Bacon is translated as ‘similitudes and sympathies of things that have no reality, . . . they describe and sometimes invent with great vanity and folly’ (p. 47).

294 Erik S. Reinert 10 11 12 13 14 15

16 17 18

19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35

For a discussion of this, see Reinert and Daastøl (1997). With the possible exception of small city-states, like Hong Kong or San Marino. The US edition is The History of Economics (Spann [1911] 1930). This problem is discussed by Hart (1990). I am grateful to the co-authors of this set of ideal types: Leonardo Burlamaqui, Ha-Joon Chang, Peter Evans and Jan Kregel. Schumpeter discusses the controversy between the two men in his History of Economic Analysis (1954: 344–345). See also their respective entries in The New Palgrave. In all cases these references are purely to the mechanics of money and exchange. A good description of Galiani and his unique standing in French society at the time is given by Pecchio (1849: 80–86). The anti-physiocrats are discussed by Weulersee (1910) and Higgs (1897: 102–122). It has been shown that Hamilton knew his Adam Smith, but rejected particularly the free trade conclusion. Excerpts from Postlethwayt’s Universal Dictionary of Trade and Commerce were scattered through Hamilton’s army pay book; see Morris (1957: 285). Hamilton’s view on the English classical economists was similar to that taken eighty years later by the Japanese; see Morris-Suzuki (1989). See also Ritzel (1950). This is the main argument of Machovec (1995). For an evaluation of Hayek and economic policy, see Streit (1997). With some exceptions in the Austrian tradition. This is the term Streissler uses in describing Menger’s successors. This part was not present in the first German edition (Schumpeter 1912). Streissler’s translation (Streissler 1972: 431). The first of many US editions was Smith (1853). See paragraph 5, ‘Über die Ursachen der fortschreitenden Wohlfahrt der Menschen’ in Menger (1871: 26–29). In Greek mythology, Cassandra is the woman to whom Apollo granted the gift of prophecy, but – when she refused to return his love – made the gift useless by decreeing that no one would believe her predictions. ‘Report of the Commission on Graduate Education in Economics’, Journal of Economic Literature, September 1991, pp. 1044–1045. For a discussion of the loss of tools, see again Morgan and Rutherford (1998). This account is found in Mises (1981: 155–163). This phrase marks the start of chapter 3, ‘Economic Generalizations or Laws’, in the ninth edition of Principles of Economics (Marshall 1961: 29). J.G. Hoffmann, introduction to Lehre von den Steuern, quoted in Cohn (1895: 60). For a discussion of this, with references to Pierce, Leibniz and Wolff, see Reinert and Daastøl (1997). For a discussion of this, see Streissler (1972: 439).

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Economic systems

15 The property rights basis of von Mises’s critique of socialism and its relevance for the privatization of state enterprises in Eastern Europe Willem Keizer

Introduction The past three decades have witnessed renewed academic interest in the arguments of the Austrian economists Ludwig von Mises and Friedrich Hayek during the so-called socialist calculation debate. This debate started in 1920 with a pioneering article by von Mises, in which he stated that under socialism rational economic calculation was impossible. In the 1930s a number of “neoclassical” socialist economists, such as H.D. Dickinson, O. Lange and A.P. Lerner, provided theoretical responses to the Austrian critique. By 1940 it was commonly believed that the socialists had won the debate. Rational economic calculation under socialism was generally held to be both theoretically possible (as proved by the general equilibrium models of Barone, Cassel and Bilimovich) and practically feasible (as solved in principle by Lange’s model of market socialism or some other decentralized model). Thus, the debate was relegated to textbooks on the history of economic thought. This opinion changed in the mid-1970s. Recognition of the importance of knowledge and uncertainty in economics, and the development of neoinstitutionalist theories of property rights, led to renewed academic interest in the arguments of von Mises and Hayek against the solutions of the neoclassical socialists. These critiques can be roughly divided into two categories: first, institutional arguments stressing the motivation and control functions of private property rights in the means of production, as propounded by von Mises; and second, epistemological arguments in favour of the free market mechanism, as formulated by Hayek. Only von Mises argued the importance of private property rights in the means of production. Hayek’s arguments from 1937 onwards dealt with a new aspect of market allocation: the discovery and use of dispersed subjective knowledge. I have argued that the critiques of socialism by von Mises and Hayek are different but complementary (Keizer 1994: 212–213). Von Mises argues the need for private property rights (and therefore for

302 Willem Keizer markets to exchange them), and Hayek the need for the market (and hence private property rights in the goods traded). Together they offer the theoretical rationale for the two basic sets of institutions of capitalism: the free market and private property rights. Von Mises’s original critique of 1920 does not distinguish clearly between the two sets of arguments, which makes him partly responsible for the confusion of the issues later in the debate. In his first contribution he follows several lines of attack against economic calculation under socialism: now he argues that socialism is irrational because it dispenses with money, then because it abolishes free markets, and then again because it abolishes private property in the means of production. He does not show the interrelations between these institutions of capitalism. His confusion can be explained by the fact that he was attacking at least three different contemporary socialist proposals simultaneously: • •

•

contemporary pleas for a moneyless economy (Naturalwirtschaft), as proposed by Otto Neurath in the aftermath of World War I; orthodox Marxist proposals for the abolition of the market (and scarcity pricing) and its substitution by central planning in physical or value terms; all socialist proposals for abolishing private property rights in, and markets for, the means of production.

To each of these contemporary currents of socialist thought he responded with different arguments, with the result that his critique of socialism appears muddled. His polemical style of writing must also be mentioned as a possible explanation for this, as well as the early date (1920) of his first contribution. Kirzner has shown that the specific “Austrian” conception of the calculation problem crystallized only gradually in the course of the debate (1988: 1). Whatever the reason, the fact that von Mises mixed his arguments was partly to blame for the result that his opponents confused them and responded only to some aspects of his critique, ignoring the others. The Lange–Lerner model of “market socialism” can be interpreted as their admission that the Austrian arguments in favour of the free market as an allocation mechanism were correct. The “neoclassical” socialists introduced money, free markets for labour, consumer and intermediate goods, marginal scarcity prices, etc. into their models of a rational socialist economy. Their admission of the indispensability of these “bourgeois” economic institutions meant an ideological retreat from the original Marxist conception of a socialist economy (Keizer 1989: 69). Of the original socialist ideal, Lange retained only the state ownership of the means of production. Implicitly the socialists admitted that all the other economic institutions of capitalism were necessary for rational economic calculation. The two rules for the managers in Lange’s model cannot be

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called “socialist”, and the same holds for his “trial-and-error” process for determining market-clearing prices. This is ostensibly done by the Central Planning Bureau, but in reality by the autonomous forces of the market. Lange’s model is not Marxist socialism, but “a kind of simulacrum of the capitalist economy” (Dickinson 1939). It is not a refutation of von Mises’s critique, but “a vindication of the market mechanism” (Roberts 1971: 568, 575). It is remarkable that Lange and the other proponents of “market socialism” disregarded von Mises’s arguments in favour of private property rights. They admit the necessity only of such “system-neutral” institutions as money, scarcity prices and interest. As socialists they obviously had to reject private ownership of the means of production as a prerequisite for rational calculation. Not to do so would mean abandoning all belief in a “socialist” economy differing in any major institutional respect from capitalism. Yet their responses to von Mises’s claims for private property rights are remarkably few. They hardly discuss his institutional and motivational arguments. Lange relegates them to the field of sociology and dispenses with any treatment whatsoever ([1938] 1964: 109). The neoclassical socialists implicitly assumed that under “market socialism” the markets for raw materials, intermediate and consumer goods would function as efficiently under state ownership as they did under a private property regime. In their view, the rational allocation of the means of production depended on control, on the right of usage only. In modern corporations this right is exercised by managers, who are merely salaried employees. It is assumed that they perform as well (or even better) for the socialist state as they had done for the private shareholders. In the socialist view the other two property rights, those of usufruct and alienation, do not perform any necessary economic functions, so they can be altered or abolished without any repercussions on enterprise performance. In order to bring about a socialist property regime the government merely has to take over the economically irrelevant usufruct and alienation rights from the “mere rentier” class of owners.1 The implicit slogan of von Mises’s socialist opponents was that “property doesn’t matter”. This is what von Mises had explicitly denied, but his institutional arguments on this point were ignored in a subsequent debate over the practical solvability of the “millions of equations” of general equilibrium models and Lange’s decentralized solution to that problem. Von Mises’s arguments about the importance of private property rights were disregarded in Hayek’s unfortunate sidetracking of the real issue in the debate (Keizer 1994: 212–213). I shall show that von Mises’s critique of socialist calculation is based upon property rights arguments, and indeed is a property rights theory avant la lettre. I shall reconstruct his critique as really saying that without private property rights in the means of production, there can be no real markets, no real scarcity prices and hence no rational allocation.2 The importance of property rights for von Mises and his

304 Willem Keizer critique of socialism is shown by the fact that he explicitly defines both “socialism” and “capitalism” by their property rights structures: as, respectively, state and private ownership of the means of production.3 In order to preclude a common misunderstanding, it is necessary to explain what kind of socialism von Mises’s critique is aimed at. He stressed that it was directed at a socialist economy characterized by total state ownership of the means of production. He defines “socialism” as an economic system in which the community, as represented by the state, is the sole legal owner of all the means of production and in which state officials exercise the ownership functions. He does not define socialism in the conventional way as “state ownership of the means of production plus central planning of the allocation process”, but solely in terms of its state property rights structure. The allocation process can be performed either by a central planning bureau or by some quasi-market mechanism such as Lange proposed. His critique applies to both, as it was aimed at the socialist property regime and its allocative consequences. His critique was explicitly not directed at some variety of what he called “worker capitalism” or “syndicalism”, in which independent syndicates of employees in a particular enterprise or sector exclusively exercise the ownership rights over the means of production used in it, and therefore act as its private owners. This is a kind of private “group ownership”, like an extended capitalist partnership (von Mises [1920] 1935: 105). He stressed the property rights difference between syndicalism and socialism. His critique is only aimed at socialism properly so called, with exclusively “communal” (i.e. state) ownership of the means of production.

Von Mises’s concept of property rights Von Mises’s concept of property implicitly encompasses all three specific property rights distinguished in modern property rights literature: • • •

the right of usage or control (control right, ius utendi); the right of usufruct (cash flow right, ius fruendi); the right of disposal (alienation right, ius abutendi).

Writing in 1920, he did not refer to them in the terms we now employ, but it is clear from his arguments that he sees “full” private property as comprising all three specific rights together. He explicitly defines the first and third rights (usage and alienation) as the essence of property: “Eigentum ist Verfügungsrecht” (von Mises 1924: 491). and “we will henceforth use the words ‘ownership of the means of production’ in the generally accepted sense, i.e. to signify the immediate power of disposal” (von Mises [1936] 1951: 42). In the latter quotation the right of disposal covers both usage (to dispose over) and alienation (to dispose of). To von Mises these rights are the essence of property. They include the right to dispose of

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both in whichever way the owner sees fit: to give them away, or to sell or destroy them. He also says that the owners must also have the right of usufruct in order to motivate them to maximize profits and thus the welfare of the consumers (von Mises [1936] 1951: 138). In sum, he sees the bundle of all three property rights as constituting “full” property. The essence of socialism is that the state is the sole owner of all the means of production. As there can be no other owners, they cannot change ownership. In his well-known phrase: under socialism, producer goods are res extra commercium. Capitalism is characterized by full or unattenuated private property rights in the means of production. Private property rights presuppose the existence of free markets, and vice versa. The unattenuated right of alienation cannot be exercised without a free market for the property in question. The concepts of “full private property rights” and “free markets” presuppose each other. In various (re)statements of his critique, von Mises stresses this point: without private property rights there can be no real markets (von Mises [1920] 1935: 112; 1949: 706). He additionally assumes that the private property rights are dispersed over many owners, and are not concentrated in the hands of a single person or a few persons. To von Mises, private property means dispersed property rights. There must be many owners, so that there can be different subjective valuations of their respective property rights. This makes trade appear profitable, causing a market for property rights. Differences in intersubjective valuations and the resulting potentials for private gain create rivalry between the owners in trading their rights, which leads to their most-valued allocation. This idea is complementary to Hayek’s later (1937/1945) argument about the dispersal and use of human knowledge in general (see Keizer 1994: 214–216).4

Property rights and the principal–agent problem in capitalist corporations and in socialist state enterprises The motivating function of private profits In section IV of his 1920 article, von Mises faced the socialist argument that salaried managers (with only the right of usage, and no usufruct and alienation rights) run modern capitalist corporations very efficiently. His opponents refer to what later became known as the “managerial revolution”: the separation between decision making, done by salaried managers; and risk bearing, done by the shareholders. In property rights terms the managers have been delegated the right of usage, while the shareholders retain the rights of usufruct and alienation. The managerial revolution posed a serious threat to von Mises’s property rights-based argument. The socialists argued that if the state took over the usufruct and alienation rights from the rentier shareholders, nothing would change in the operation of the firms and in the efficiency of the markets and the economy.

306 Willem Keizer Professional managers would work no less efficiently for society at large than they had previously done for the shareholders (Lange [1938] 1964: 109). Von Mises acknowledged that in modern corporations only the large shareholders (blockholders) exercise their usage right by serving on the board of directors. They have the same profit interest as the owners of unincorporated firms. However, most shareholders are absentee owners and are not involved in the daily operations of their firms. Von Mises does not explain how they can control its management when they are not directors themselves. He does say that modern corporative managers either hold shares in their companies themselves, or hope to do so. Being (or hoping to become) shareholders themselves, their interests coincide with those of the outside shareholders. For this reason they will pursue profit maximization. Apart from the higher dividends, this also raises the value of their shares. Conversely, enterprise losses lower share values and cause wealth losses to the owners, including the shareholding managers. Potential capital gains and losses motivate the owners to maximize profits and the net discounted worth of a company when they run it themselves; and to exercise strict control over the salaried managers who run it for them when they do not. This makes corporate managers have the same motivation and behaviour as the shareholders (von Mises [1920] 1935: 118–119). Modern property rights theory shows that rentier shareholders exercise their usage right indirectly, by the latent threat of dismissal for malfunctioning managers (see p. 315). But von Mises did state explicitly that even salaried managers find it to their long-run advantage to maximize the profit interests of the shareholders ([1920] 1935: 117–118). In Human Action (1949) he deals more explicitly with the problem the managerial revolution poses for his property rights arguments against socialism. Here he does so by downplaying the role and importance of the “mere” managers of other people’s capital, as contrasted with that of the real “entrepreneurs” left under corporate capitalism: the investors, speculators and financiers on the capital market. He views most corporate managers as “subaltern clerks” who loyally carry out the tasks entrusted to them by their bosses, the shareholders. Their activities form only a minor segment of the total market. The role that the loyal corporate manager plays in the conduct of business is much more modest. . . . His is only a managerial function, a subsidiary assistance granted to the entrepreneurs and capitalists, which refers only to subordinate tasks. It can never become a substitute for the entrepreneurial function. (von Mises 1949: 704) In modern corporate capitalism the real entrepreneurs are the investors, financiers, stock promotors and speculators, who determine the structure of the share, commodity and money markets.

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This particular argument is both wrong and right. It is wrong in stating that the average corporate manager plays only a minor decision-making role. But even if the manager’s role is a major one, von Mises’s argument can still be upheld if it can be shown that the managers’ activities are directed by the profit-oriented control of the equity owners. Jensen and Meckling (1976: 354) provide support for his claim concerning the importance of the capital market agents referred to above. They find that managerial behaviour is channelled towards the discounted net value maximizing interests of the shareholders by the monitoring activities of the security analysts employed by the private and institutional investors and stockbrokers. They are the contemporary version of von Mises’s “speculators, investors and financiers”, whom he saw as the decisive entrepreneurs of corporate capitalism. His argumentation is on steadier ground when he makes his oftquoted contrast between the private corporation manager and the state firm manager (von Mises [1920] 1935: 120ff.). He says that the motive force behind corporate managers disappears with the elimination of private property. The dynamic entrepreneur is then transformed into a state bureaucrat, like any other public-service employee. Von Mises stresses that the entrepreneur is characterized not by any inborn personal qualities, training or knowledge, but by his characteristic position in the economic process. Not the person himself, but his institutional position makes the salaried manager’s personal interests coincide with those of the owner and makes him behave like a private owner striving to maximize his profit (von Mises [1920] 1935: 120). Thus, the socio-economic and legal institutions of capitalism make “entrepreneurs” out of propertyless managers, not any inborn or acquired skills. Without private ownership of the means of production and its supportive institutions, all the personal capabilities of a manager cannot make an entrepreneur out of him. If the institutional parameters provided by private property are abolished, the entrepreneurial manager of corporate capitalism is turned into a state bureaucrat. As early as 1920, von Mises was rejecting the counter-argument that any loss of entrepreneurial initiative under socialism was merely caused by organizational failures. It was inherent in the nature of this kind of enterprise, meaning its state ownership (von Mises [1920] 1935: 121). According to Von Mises, it was common opinion by 1920 that the lack of private initiative and individual responsibility was the greatest threat to socialism ([1920] 1935: 116). It was generally agreed by then that communal firms did not innovate and improve production and did not adapt flexibly to changes in demand (ibid.: 118). This point was admitted by most of his socialist opponents (see Lange [1938] 1964: 109). However, they offered no structural (i.e. institutional) remedies. In his model of market socialism, Lange evaded the issue of the relative efficiencies of state officials versus private entrepreneurs or corporate managers by

308 Willem Keizer saying that the subject belonged to the field of sociology, rather than to economic theory. For him, this sufficed as a reason to refrain from discussing it. However, he did not deny its great importance: “It seems to us, indeed, that the real danger of socialism is that of bureaucratization of economic life” (Lange [1938] 1964: 109). But he comforted himself by believing that the same or even greater danger existed under “monopolistic capitalism” and by thinking that “Officials subject to democratic control seem preferable to private corporation executives who are practically responsible to nobody” (ibid.: 110). This quotation shows Lange’s total misapprehension of von Mises’s argument. Whereas the latter had referred to economic control over the managers by private owners, Lange sidesteps the issue by referring to political control over them by state officials and ultimately by the citizens. This is an entirely different matter, and irrelevant to von Mises’s point. Von Mises rejected the obvious solution of motivating state managers to maximize profits by offering them a share in the enterprise. Modern property rights theory supports this view. Under any profit-sharing scheme a manager has only a partial right to the usufruct. He (or she) bears the full costs of his extra exertions, but receives only a part of the resulting extra profits. On the other hand, the non-pecuniary benefits of maximizing his personal utility function by not exerting himself beyond duty accrue wholly to himself. In contrast to his partial profit share, he has full usufruct rights to his personal non-pecuniary benefits. The postulate of rational behaviour dictates that it will be more profitable for him to maximize a variable to which he has full usufruct rights, than one to which he has only a limited right (Meyer 1983: 25–26). For this reason, monotonic profit-sharing schemes do not elicit managerial profit-maximizing behaviour. The motivating function of losses Von Mises follows a different line, by stressing the motivational effects of negative profits, i.e. losses. Private owners are also motivated to maximize profits in order to minimize potential losses, which they have to compensate out of their private wealth. Loss minimization is the inverse of profit maximization and it may even have the stronger motivating effect. Under capitalism, private owners have full usufruct rights to both profits and losses. Their motivation function is symmetrical. This symmetrical pecuniary motivation system cannot be applied to propertyless state managers. Under profit-sharing schemes they can be given a share in the profits, but they can hardly be made accountable for losses (von Mises [1920] 1935: 122). Their salaries are small compared to the potential losses their enterprises can incur, so that they cannot be penalized by negative bonuses. A 10 per cent share in profits cannot be matched by a similar share in potential losses, as this could easily result in

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a negative total income for the managers. They are not assumed to own private wealth from which they can cover heavy losses. State managers function under an asymmetrical incentive system: they can be made to share in the profits, but not in the losses of their firms. They can be penalized by lump-sum fines, but, again, their possible size cannot stand in any meaningful and predetermined relationship to the losses incurred. For gross personal failures they can also be penalized with demotion or even imprisonment, but such non-pecuniary negative incentives are very crude compared to pecuniary ones. Furthermore, they can normally be applied only once. They are so repressive that they will stifle all initiative and force the manager into unquestioning compliance with his superiors’ orders. Hence von Mises believes that socialist state managers can only be held morally responsible for any losses their enterprises may suffer. This exposes them to the moral hazard of taking undue risks with the state capital entrusted to them.5 On this point he holds the opposite opinion to Hayek, who believed that socialist state managers would behave like risk-averse bureaucrats and shun innovations (1935: 234–235; [1940] (1949): 199). The difference between their views may lie in the nature of the negative incentives they envisaged. Von Mises (writing in 1920) foresaw no severe non-pecuniary penalties for managerial failure in the normal course of duty, and hence believed them to be risk prone. Hayek on the other hand (probably having Stalin’s USSR of the mid-1930s in mind) foresaw severe penalties for failing managers, and thus believed them to be risk averse. Both authors may be right: the issue depends on the actual system of negative incentives imposed by the political authorities. Von Mises’s case appears to fit the Hungarian experience with the “New Economic Mechanism” after the 1968 reform. Kornai (1980: 152, 155) has shown that in socialist Hungary the responsibility for investment decisions was dispersed over many officials, none of whom was personally responsible. In the case of malinvestments each official could shift (part of) the blame on others, with the result that no one was held personally responsible and penalized. Kornai states that this diffusion (and hence evaporation) of personal responsibility led Hungarian state managers to take undue risks, and to continue doing so after repeated failures. His argument was in fact a veiled plea for the restoration of private property rights and the personal responsibility of decision makers. In his famous paper on the “soft budget constraint”, Kornai (1986: 12) shows that the absence of risk to the private wealth of the decision makers, coupled with their expectation that failing firms will be bailed out by the government, led to a lack of restraint in investment decisions. Not only were overly risky investments undertaken, but the excessive demand for investment funds generated by this asymmetrical incentive system caused the notorious “investment hunger” of the socialist economies and gave rise to a specifically socialist form of business cycle.

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Property rights and the pseudo-markets of market socialism Long before the formulation of Lange’s model, von Mises had already scorned the idea of “quasi-markets”, on which the managers of the state enterprises trade state-owned goods with each other. His critique of this solution is twofold. In the first place he argues that it is not (Marxian) socialism, a point also made by orthodox Marxists such as Dobb and Sweezy. A real socialist economy is tradeless (verkehrslos), because it is directed by an imperative central plan drawn up by the central planning office. The planning officials, and not the enterprise managers, have autonomous decision-making power. As the managers do not possess usage and usufruct rights over the state goods, they have no property rights to trade. They merely transfer their custody over the goods to each other, according to the instructions of the central plan. If the managers do have the rights of usage and disposal assumed by the market socialist model, then we are dealing with some kind of “syndicalism”, not with Marxian socialism. Thus, von Mises’ first criticism of “market socialism” is that it is not socialism, as he (and in his opinion all socialists; see von Mises [1936] (1951): 20) defines it. Proposals for “market socialism” a priori relinquish the attempt to create a rational socialist economy. His second point of criticism is based on the motivational consequences of state property rights on managerial behaviour. Even if we accept that “market socialism” is a kind of socialism, Von Mises rejected it as merely creating “pseudo-markets” with “pseudo-competition”. These cannot generate real market prices and thus lead to rational calculation. The managers will not really compete with each other to secure maximum gain for themselves when they trade goods. The selling state manager will not really strive to get the highest possible price, and the buying manager to get the lowest possible, as they do not have the right of usufruct. It would cause them extra effort (i.e. non-pecuniary costs), for which they would not be compensated by appropriable profits, or would be compensated insufficiently. The interchange of subjective valuations between two state managers on a socialist “market” will not create “real” competition or rivalry, with each of them doing his (or her) best to obtain the most advantageous terms for himself. As non-owners they can only “play” at the rivalry existing between private owners, who exchange their property rights for their personal advantage (von Mises 1949: 703). Hence, what looks like “buying” and “selling” on socialist “markets” is by its nature something very different from the trading between private owners on real markets (von Mises 1924: 493). If the state managers do not engage in competition as real rivals, the prices generated by their negotiations will not reflect the real subjective scarcities of the goods either. It is in this sense that von Mises says that the pseudo-markets of market socialism will not generate the “real” market

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prices necessary for rational economic calculation. To von Mises, “prices” meant capitalist prices, established through real rivalry between the full owners of the goods traded, i.e. on the basis of private property rights (Lavoie 1985: 49, 59; Keizer 1989: 67). Von Mises did not regard prices as “system-neutral economic categories”, as the general equilibrium theorists and Lange did (Lange [1938] 1964: 60).6 Prices depend on the institutional framework within which they are derived. Lange was right to call prices mere “terms on which alternatives are offered”, but these terms will differ, depending on whether they are generated through real rivalry between private owners, or by an ordained “pseudo-competition” between state managers lacking property rights. Real market prices are established through the rivalrous negotiation between owners striving to maximize their personal wealth. The exchange terms agreed upon in the negotiations between state managers do not reflect the same motivation, and hence subjective valuations and scarcities. The exchange of the exactly the same goods will occur at different prices under capitalism and market socialism. It is according to this concept of prices that von Mises states that socialism cannot generate (rational) prices. “Nur dieser Wettbewerb der Unternehmer, die sich sachliche Produktionsmittel und Arbeitskräfte gegenseitig zu entwinden suchen, bildet Preise” (Only this competition between entrepreneurs, who reciprocally seek to wrest means of production and labour away from each other, forms prices) (von Mises 1924: 494). This is not the tautology it seems to be: “capitalist market prices equals rational prices”. Von Mises does not say that capitalist prices are (always) rational and he mentions cases in which capitalist market calculation falls short of perfect rationality ([1920] 1935: 98–100; 1949: 215–218, 701). But, given the limitations of monetary calculation and uncertainty about the future, capitalist market prices reflect the scarcities based on the subjective evaluations of the private owners as well as is possible. The same argument holds for his concept of “money”. The nature of money again depends on the property rights structure. It is not a neutral economic category. Under socialism, “money” does not encompass prices for the means of production, so that “socialist money” cannot play a role in rational economic calculation (von Mises [1920] 1935: 108). For similar reasons he criticizes the Austrian socialist Otto Bauer’s proposal for the nationalization of the banks. Their fusion into a single state bank will transform their nature. The name “bank” may be retained, “[b]ut it is no longer a bank, it fulfills none of those functions which a bank fulfills in an economic system resting on the private ownership of the means of production” (ibid.: 124). Again, socialist institutions function differently from capitalist ones, even when they have the same names. The economic functions of the abolished capitalist institutions cannot be performed under socialism by merely giving the old names to different institutions.

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Functions of usufruct and alienation rights in capital allocation Von Mises says that the private property rights of usufruct and disposal are necessary to allocate capital according to consumer preferences. By this he does not mean neoclassical static optimization, but the dynamic process of continuously shifting capital from one venue to another. This is not a matter for the managers of joint stock companies, it is essentially a matter for the capitalists – the capitalists who buy and sell stocks and shares, who make loans and recover them. . . . It is not possible to eliminate from such markets the influence of the supply of capital by the capitalists and the demand for capital by entrepreneurs, without destroying the mechanism itself. ([1936] 1951: 139, 140) This dynamic capital allocation function is so important that it should be entrusted to the most successful investors, who have to be motivated to exercise it to the best of their ability. Capitalism provides property institutions for both selecting the most successful investors and for motivating them to direct social capital to its most profitable uses. The most important one is the right of usufruct, the private appropriability of profits and the private responsibility for losses. [T]he function which capitalists and speculators perform under Capitalism, namely directing the use of capital goods into that direction which best serves the demands of the consumer, is only performed because they are under the incentive to preserve their property and to make profits. (ibid.: 141)7 This function cannot be performed by propertyless managers, be they capitalist or socialist. Only the private owners of capital can strike an optimal balance between the desire for profit and the fear of loss, for they are risking their personal wealth. Large or continuous losses will drive unsuccessful investors out of the capital market, for they either will have no more personal wealth to invest, or will no longer be able to persuade others to entrust their wealth to them. In this way the process of capitalist rivalry will automatically select only the successful investors for allocating social capital. Under socialism this rivalry between capitalists is abolished. Their capital allocation task is taken over by a state authority that is not motivated by personal gains or losses. In order to perform this dynamic capital allocation function, the persons doing it must have the right of alienation. They must have the right to transfer their usage and usufruct rights to other ventures if these

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appear more profitable to them. In rebutting an early proposal for a kind of market socialism by Eduard Heimann, von Mises remarks that the managers of the socialist production “departments” do not have the right of alienation. They cannot transfer their property rights to whatever venture seems most advantageous to them. Competition exists only when everybody produces what appears to be most profitable for himself. These conditions exist only under private property (von Mises 1924: 495).8

Property rights and enterprise governance: controlling managers under corporate capitalism and state socialism Property rights theories of the capitalist corporation and the socialist state firm support von Mises’s arguments against the socialist assumption that salaried managers will function as well under socialism as they do under corporate capitalism. This concerns the principal–agent relationship between the owners of the means of production (the risk bearers) and the managers to whom they delegate the right of usage (the decision makers). Under corporate capitalism the principals are the shareholders, who retain the rights of usufruct and alienation, while the salaried managers are their agents. Under socialism the state is the sole owner and principal, with the state officials and enterprise managers as its agents. It may be assumed that under both capitalism and socialism the goal functions of the respective principals and agents differ. The owners pursue the maximization of their wealth, the present value of the expected future net income stream from their property. This motivates them to maximize profits. Propertyless agents are also assumed to pursue their utility function, which in their case also comprises non-pecuniary benefits, such as “leisure on the job” or shirking, and various managerial perquisites such as luxurious offices, expense accounts and excessive staffs. All these managerial benefits increase costs and/or lower earnings, thus reducing the profits of the firm and the net income stream of its owners. Thus, they lower the present value of their principals’ property. The latter’s property rights are “attenuated”, because part of their usufruct right is appropriated by their agents. The principals will monitor their agents’ performance to detect and prevent such behaviour. This involves increasing monitoring costs, which will be incurred until the marginal returns of the additional profits/wealth equal the marginal monitoring costs. The optimal monitoring point will be reached before all potential profits have been recovered. Positive monitoring costs give the agents discretionary power to pursue their personal utility functions and appropriate part of the potential profits in the form of non-pecuniary benefits (Furubotn and Pejovich 1972: 1149). The value of these benefits is less than the potential profits sacrificed to obtain them. According to Pejovich (1976: 11), managerial usurpation of the owners’ usufruct rights is a negative sum game: the

314 Willem Keizer owners’ loss exceeds the managers’ gain, so that there is a residual loss to society. Total agency costs to society consist of the owners’ monitoring costs plus this residual loss (Jensen and Meckling 1976: 308). The principal–agent problem and agency costs exist in all economic systems, which must all devise institutional means for monitoring and controlling managerial behaviour. Under capitalism, corporate managers must be made to maximize profits and the present value of the assets they manage for the incomes and wealth of the shareholders. Under socialism they must do so for the income and wealth of the state, as the representative of all citizens. Property rights solutions to the principal–agent problem in capitalist corporations Capitalism solves the principal–agent problem by means of institutions such as specified organizational contracts, the capital structure of firms and the operation of the stock market. The private firm can be seen as a legal fiction for a set of specific contractual relationships between joint inputs (Alchian and Demsetz 1972: 794; Jensen and Meckling 1976: 310–311). The “classic” capitalist firm consists of a set of contracts between several owners of joint inputs engaging in team production. The entrepreneur or “capitalist” is the one party common to all contracts. He or she specifies the contractual obligations and can renegotiate or terminate any other party’s contract. It means that the entrepreneur has the rights of usage and of “hiring and firing”. To motivate him or her to monitor the inputs’ performance optimally and so prevent shirking by the other inputs and by him- or herself, the entrepreneur must have claim to the residual income. It means that he or she must have the right of usufruct. To enable the entrepreneur to transfer his or her talents to other ventures that appear more profitable, he or she must also have the right of alienation. The classic “capitalist” is characterized by the possession of all three ownership rights of usage, usufruct and alienation (Furubotn and Pejovich 1972: 1148). Under capitalism, the corporate managers’ discretionary power is constrained by a number of institutions that have evolved over time to control their performance. Furubotn and Pejovich (1972: 1150) list the following constraints on managerial discretion: • • • • • •

managerial rewards, including profit shares; competition among managers (the market for managers); shareholders’ meetings; blockholdership and proxy voting; market valuation of corporate stock (“stock market signalling”); the threat of unfriendly takeovers (the market for corporate control).

The first two constraints can also exist under socialism, but the last four are specific to capitalism, as they require private shareholdership and a

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stock market. With widely dispersed share ownership, the individual small shareholder can ostensibly exercise no control over management. Yet even here, dissatisfied shareholders can express their disapproval by selling their shares. By exercising their alienation right, they in effect “fire” that management from further managing their property (Alchian and Demsetz 1972: 788). If there is general dissatisfaction with the performance of a management team and many small owners sell their shares, the shares’ value on the stock market falls. This is a warning to the managers, indicating danger to their position. Non-selling shareholders see their wealth diminished and will demand improvement at the shareholders’ meeting. In the extreme case they can fire the directors for failing to maintain their share values. Moreover, low share prices indicate that the firm is undervalued on the stock market, compared to its potential net worth if it were efficiently run by a non-shirking management. At such low prices, specialized entrepreneurs (corporate raiders) may buy a sufficient number of shares to acquire a controlling interest in the firm. They can call a shareholders’ meeting, fire the existing management and replace them by a more efficient body (Leipold 1981: 44–49). Thus, the stock market is also a market for control over firms and their management teams. In this view the wave of “unfriendly” corporate takeovers in the 1980s was in effect a shake-out of inefficient corporate management teams who pursued their own goals at the expense of the shareholders’ profits and wealth. This led to “leaner and meaner” managements, which raised profitability and share values in the 1990s. Pejovich (1976: 15–16) concludes that The stockholders’ freedom to sell shares in a market that reflects the capitalized value of correct managerial decisions reduces the power of managers to pursue their own objectives at the expense of profits. . . . (Stock)market forces reduce the stockholders’ costs of detecting and policing managerial decisions. . . . They reduce the conflict between the manager and the stockholders as well as between the modern corporation and the interests of society. Leipold (1981: 43) speaks of the “disciplining function” of the stock market. Under capitalism, the right of usufruct motivates private owners to control managerial decision making by means of their right of alienation over their shares on the stock market. Contrary to the belief of the neoclassical socialists of the 1930s, property rights theory proves that private property rights do matter: they ensure managerial and enterprise efficiency, and hence overall economic rationality. The property rights analysis of the socialist state firm Under a state property rights structure the institutional constraints that private property rights exert on managerial behaviour are absent.9 There

316 Willem Keizer are no private owners possessing property rights over enterprise assets. The theoretical owner is the population, as represented by the de jure owner, the state. The citizens have delegated their rights of usage and alienation to the governing politicians. They only retain their right of usufruct, in the form of the right to a “social dividend” or lower taxes. Under socialism there has also been a managerial revolution, with the politicians and planners delegating their right of use to professional managers. Despite the imperative nature of the central plans, the managers of state firms also possess discretionary power to appropriate pecuniary and non-pecuniary benefits for themselves (Furubotn and Pejovich 1972: 1154–1155). Each of the four parties mentioned has its own utility function, which it seeks to maximize. Under socialism, we have three successive principal–agent relationships: 1 2 3

between the citizens and the government (primary principal–agent relationship); between the government and the central planners (secondary principal–agent relationship); between the central planners and the enterprise managers (tertiary principal–agent relationship).

This multiple devolution of property rights creates a three-tiered principal–agent structure, in which the agent of a higher level is the principal of a lower one. The control of the primary principal (the citizens) over the final agent (the managers) is much weakened by the length of the chain of control and the discretionary power of the two intermediate links in it. The ultimate owners of the productive assets can control the managers only at two removes. This indirect control is weakened further by the fact that under socialism the primary principal is the entire population, a collective entity that cannot act as an individual and enforce its rights itself. The only opportunity it could have for doing so is at general elections, when (like small shareholders at annual shareholders’ meetings under capitalism) it can vote against the governing party if it mismanages the national assets. However, democratic political control by the voters over the government, and via the planning officials over the state enterprise managers, is less effective than the purely economic control of private shareholders over corporate managers. Moreover, this periodic control by means of general elections did not exist in socialist states, as in practice all of them were dictatorships. This denied the citizens the right of “voice” in choosing or firing the political managers of their property. In socialist states, legal emigration was usually forbidden, which also denied citizens the right of exit (“voting with their feet”). In property rights terms they also lacked the right of alienation of their property rights in a specific country’s national wealth by leaving it.

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Under real-life socialism the primary principal had no institutional means of control over its primary agent. As there is no effective residual owner under socialism, there is no motivation to maximize profits and the net income stream from the national assets. The three parties with usage rights over the assets are mere agents, with none of the residual owners’ interest in its usufruct, except in so far as they can appropriate part of it for themselves. Not having a legal right to the pecuniary usufruct, they appropriate it in the form of excessive salaries and numerous perquisites attached to their functions. As self-interested beings, they will maximize their pecuniary and non-pecuniary benefits at the expense of the residual income of the population. The absence of owner control over the nationalized assets explains the perquisites of the nomenklatura who ruled the socialist states, as well as its inefficient production and the low income of its population. It also explains the nomenklatura’s determination to retain political power. Leipold (1981: 51ff.) has analysed the bureaucratic nature of the principal–agent problem under socialism. Under state ownership, managerial monitoring becomes a matter of bureaucratic control by state officials. Political control over the managers furthers the expansion of bureaucratic authority and leads to output maximization instead of profit maximization by both the control organs (the economic ministries) and the managers. This causes neglect of efficiency considerations and promotes X-inefficiency. It leads to the waste of scarce resources and a lack of technological innovation (ibid.: 56). In a later study, Leipold (1983: 210ff.) discusses the Misesian issue of the compatibility of socialist property rights and (market) competition. Under exclusive state property, private entrepreneurs are precluded from founding new enterprises. There is no free entry, so that existing firms are not restrained by the threat of potential competition from newcomers. Therefore, investment in existing firms will primarily serve to expand output, not to increase profits.10 Capital allocated according to bureaucratic preferences will not increase market competition, but favour the restriction of competitive behaviour (ibid.: 212). Leipold concludes that East European attempts to introduce competitive pricing systems have confirmed von Mises’s thesis of the incompatibility between a state property structure and a competitive economic order (ibid.: 217). Property rights theory thus lends theoretical support to von Mises’s institutional arguments against socialism. Under a state property regime, production costs are higher and national income, the rate of technological progress and the rate of innovation lower than under a private property regime. State officials (including the managers) enjoy more perquisites, which reduces the welfare of the population more than it increases theirs. This suboptimal situation could be improved by reinstating private property rights. Pejovich (1976: 4) concludes that “nonattenuated private property rights are a powerful, and possibly necessary,

318 Willem Keizer condition for the efficient allocation and use of scarce resources”. This is exactly what von Mises had argued in 1920, and his socialist opponents of the 1930s had denied.

Von Mises’s property rights critique and privatization in Eastern Europe After the political collapse of the communist regimes in 1989–1991, all the socialist countries in Eastern Europe started a transition process to capitalism by reintroducing the market mechanism and private property rights. The market was reintroduced by abolishing central planning and fixed prices. Private property rights were reinstated by privatizing the state enterprises and state farms. On the issue of privatization the economic aims of the reformers were fully consistent with the property rights arguments of von Mises, although they did not refer to them explicitly. Through privatization the reformers hoped to achieve the following economic goals (Mroz 1991: 331; Dallago 1991: 137): • • • • • •

to depoliticize the economy by abolishing political control over, and interference with, enterprises; to abolish the soft budget restraint; to promote the pursuit of profit maximization by the managers; to increase competition by de-monopolizing the economy and increasing the number of small and medium-sized firms; to increase allocative and productive efficiency, especially of capital; to stimulate innovation and technical progress.

Many of these positive effects of private property rights had already been brought forward by von Mises. What conclusions and lessons for the privatization process in the former socialist countries in Eastern Europe can be drawn from his property rights arguments against state socialism? The basic conclusion that can be drawn is that the fundamental cause of the economic collapse of socialism in Eastern Europe in the late 1980s was its inefficient property rights structure. The primary cause for the failure of real-life socialism was not the Hayekian reason of the inadequacy of central planning, but the Misesian reason of an inefficient property rights structure. The exclusively state property regime gave rise to a particular motivation system that made rational economic subjects behave in ways that were detrimental to the national economy. Von Mises’s thesis was that if the socialist authorities abolished private property rights, there would no longer be real markets to allocate goods rationally, both statically and dynamically. Thus, inefficient property rights are the root cause of the economic failure of socialism: the deficiencies of the central planning system stem from it. Von Mises and not Hayek exposed the Achilles heel of socialist economics: the adverse motivational effects of the abolition of private property rights.

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From this conclusion the first lesson for the economic reformers in East Europe is that free markets will not function effectively unless they are complemented by an efficient structure of private property rights in the means of production and all its complementary institutions. The “socialist market economy”, which some reformers again advocated in the early 1990s, is a chimera. Von Mises’s arguments against Lange’s market socialist model still hold today: exclusive state property rights and real market competition are incompatible. Competitive and efficient markets require private property rights. This was acknowledged by the East European reformers when they proposed the mass privatization of state enterprises. Of the privatization programmes in Hungary and Poland, Dallago (1991: 137) says that “Privatization . . . is generally seen to be a prerequisite for the success of the transition to a market economy.” The inverse also holds: if privatization fails, then the market reforms will fail as well. It takes us too far afield to discuss the success or failure of the privatizations in Russia, but we can conclude that the problems of the transition to capitalism are due more to the failures of privatization (and especially the lack of concomitant legal institutions) than to the failures of the market mechanism. The first lesson from von Mises’s property rights critique of socialism is “Get your property institutions right!” Another lesson for the reformers is that financial discipline (or a “hard” budget restriction) for managers and enterprises can best be achieved under private ownership (Kornai 1998: 12). Only private usufruct rights to both profits and losses, and hence personal risk-bearing, will impose financial discipline on enterprises. Kornai (1986, 1998) saw the traditional “soft budget constraint” as the prime cause of the inefficiency of socialist enterprises. As long as governments are unwilling to let state enterprises go bankrupt, their managers operate under moral hazard to pursue their personal utility at the cost of potential profits. Private owners must compensate, out of their private wealth, the resulting losses; but politicians and officials can do so out of public funds. This lowers their resistance to demands for enterprise subsidies and relieves them of the difficult task of controlling the managers more effectively, which encourages the latter to continue their loss-making practices. After the Kosygin reforms of 1965, Soviet leaders and economists unsuccessfully urged the state enterprise managers to “apply the principle of khozraschyet”. It meant that they should cover their costs out of earnings and avoid losses. For the next twenty-five years no authoritarian threat or economic reform could induce Soviet managers to do so, as long as their firms remained state property. Privatization is necessary to institutionalize a hard budget constraint, and with it the financial discipline to induce real competitive and entrepreneurial behaviour. Since 1991 nearly all former socialist countries in Eastern Europe have undertaken mass privatization programmes in which a large part of the state industry sector was privatized. This was usually done by transforming

320 Willem Keizer the state enterprises into limited liability companies, of which the shares were sold or distributed in one way or another to private persons. Privatization meant that a new property regime had to be chosen out of a limited number of alternative structures, each of which has its own motivational and economic consequences. Some of the most important choices were those between: • • • •

personal versus institutional shareholding; dispersed versus concentrated shareholding; outsider versus insider shareholding; manager versus worker shareholding.

Each country made a different choices, resulting in differing property regimes. A new field of theoretical and empirical research in the economics of transition relates the ownership structure of enterprises to their performance in terms of sales growth, employment, cost reduction and profitability. The multifaceted issues in this field could not have been foreseen in von Mises’s time, so there will not be any explicit references to them in his writings. Yet we can see the originality and correctness of his property rights arguments by considering them in the light of some of the present-day problems of the East European privatizations. Personal versus institutional shareholding Should the shares mainly be held by natural persons or by legal persons such as banks or investment and pension funds? Von Mises argued that only natural persons can be motivated by usufruct rights to maximize profits and thus the discounted value of their property. To this end they will personally exercise optimal control over their agents and continuously reallocate their wealth to the most profitable venues. The salaried employees of institutional shareholders have no usufruct right and occupy the same position as the managers they should control: they are both agents. Such employees will be less motivated than private shareholders to manage their asset portfolios actively and successfully. Here von Mises’s argument against state managers who turn into bureaucrats is relevant. Considering the stress he laid on motivational factors and the dynamics of capital allocation, he would have advised that natural persons and not institutions should become the major shareholders. This has not happened in the Russian privatization, where banks are the chief outside shareholders. Dispersed versus concentrated shareholding Should the shares be distributed widely over the population, or should they be concentrated in the hands of relatively few people? Socialist ideo-

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logy and considerations of justice favour a wide distribution of shares. Insiders such as the managers and employees of enterprises also prefer this, as it dilutes the power of the shareholders and hence their control over the managers and workers. Numerous small shareholders will probably have a weaker profit-maximizing motive and less voting power than a small number of very large shareholders. On the other hand, good corporate governance demands continuous monitoring and effective control by parties with a large stake in the residual income, i.e. the large shareholders (blockholders). This is especially important if the stock exchange functions poorly, as is the case in most East European countries. Then the stock market cannot perform its signalling task well, that of letting a relative fall in share values indicate shareholder dissatisfaction with managerial performance. When this is the case, only major shareholders can exercise enough power to discipline malfunctioning management teams with the threat of dismissal. Thus, despite his belief in dispersed share ownership, von Mises would probably have advised the sale of shares to large shareholders only. Outsider versus insider shareholding Should the shares be owned by persons acting solely as risk bearers, without any other interest in the enterprise; or by persons who hold some other stake(s) in the enterprise as well, such as the employees? Should the shares go to outside shareholders or to inside stakeholders? Only shareholders are exclusively interested in maximizing profits and thus the contribution of their assets to national income and consumer welfare. Insiders such as workers and managers have another stake in the enterprise, one that conflicts with profit maximization. As employees they also enjoy other (often non-pecuniary) benefits attached to their position. Therefore, they can opt for “leisure on the job” and diverse perquisites at the expense of profits. An equilibrium will be found between their interests as consumers of leisure-atwork and perquisites on the one hand, and as receivers of the residual income on the other. Their demand for leisure and perks is positive, so that this equilibrium will be reached at a lower level of profits than in the case of outside shareholders. Both von Mises’ arguments and modern property rights theory conclude that outsider ownership is to be preferred to insider ownership. However, owing to their political influence and to corruption, the privatization process in Russia brought a major part of the shares into the hands of incumbent managers. Theoretically, this insider control should have a negative effect on enterprise performance. Manager versus worker shareholding If insiders are to have the ownership rights, should these primarily be given or sold to the managers or to the workers? The latter have socialist

322 Willem Keizer ideology on their side: they are “the people” and as such already were the legal owners under socialism. Giving them the shares would be ideologically correct, would mobilize popular support for privatization and would aid acceptance of any restructuring measures. On the other hand, the workers will be more inclined to pursue leisure, non-pecuniary benefits and high employment at the expense of potential profits than the managers (Jones 1998: 76, 93). Being a smaller group, the latter would have a more substantial individual share in the profits. Again, a Misesian standpoint would be that the group with the greater interest in profit maximization (i.e. the managers) should obtain the shares. The present managerial control of many privatized enterprises in Russia and some other former socialist states would then appear to be the lesser of the two evils. Inviolability versus revocability of property rights The question of inviolability versus revocability of property rights is a separate point, but important for the success of a private property regime. To a large extent, the privatization in Eastern Europe was the appropriation of a common resource, the national stock of productive assets, by the possessors of power and influence under the old system (the old communist nomenklatura, including the managers of large enterprises) and a new domestic mafia. From an economic point of view the main thing is that the new owners should exercise their property rights in ways that maximize their contribution to national income. For this purpose their rights should be inviolable and sanctioned by the state. Only when the new capitalists are sure their property will not be taken away from them again by a more honest or communistic government will they strive to maximize their wealth by investing it in domestic productive assets, instead of smuggling it abroad to financial safe havens at high transaction costs. According to Hayek’s knowledge argument, East European capitalists seeking to maximize their profits and wealth should invest in their own countries, where they have specialized local knowledge of potential profit opportunities. However, we have seen that the new plutocracy in Russia (and some other ex-socialist states) often behave like a kleptocracy, “stripping” the assets of their dubiously gotten enterprises in various ways and smuggling their value out of the country. This does not necessarily mean that the new capitalist elite in these countries consisted of crooks and thieves (as a moral or Marxist view of the matter would have it); but rather that the new structure of property rights (including the political stability of the government) in these countries was such that the new owners were insecure regarding their permanency. Under these circumstances it was rational for them to transform their insecure property rights in Russian enterprises into secure property rights in Western assets, hence they smuggled asset values out of the country and invested them in Western capital ventures. There, however, they lacked the specific knowledge of local

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profit possibilities, and it may be safely assumed that a great deal of their gains were misinvested and hence lost. The insecurity of their property rights led to a negative-sum outcome: the loss to Russia and other exsocialist countries was greater than the West’s gain. From a purely economic point of view the first requisite for any privatization programme (or any other major redistribution of property rights) is that the new owners should feel that their newly gotten rights are secure and inviolable.11 In the past few years, stock markets have been re-established in all former socialist countries. One of their main functions should be to align managerial behaviour with the profit- and wealth-maximizing interests of the shareholders. To make this possible, certain particular property institutions must be established, such as an unequal distribution of shareholdings, majority shareholding, proxy voting at shareholders’ meetings, and various other institutions of good corporate governance. Shareholders must have the unattenuated right of disposal over their shares, to enable the stock market to fulfil its signalling function. Alchian and Demsetz (1972: 788) state that “The unrestricted salability of stock and the transfer of proxies enhances the probability of decisive action in the event current stockholders or any outsider believes that management is not doing a good job.” The present dispersed or insider-held share ownership in many East European countries is unable or unwilling to control managements effectively, but in due course specialized institutions and agents to perform this monitoring and controlling function will arise. In his famous 1908 article on the socialist economy, Enrico Barone wrote that “If the Ministry of Production proposes to obtain the collective maximum . . . all the economic categories of the old regime must reappear” (quoted in Hayek 1935: 289). This return of the old capitalist institutions also holds for the financiers, stockbrokers, speculators and company raiders, those “Promoters und Faiseure” whom von Mises in 1920 had already called the ultimate entrepreneurs of corporate capitalism. To eliminate them had been (and is) one of the supreme goals of socialism, but both von Mises’s theoretical critique and historical experience have shown that no economy can function efficiently without them.

Notes 1 A measure considered relatively easy by Schumpeter, who, surprisingly, shared this view of the irrelevance of property rights. See Schumpeter ([1942] 1950: ch. 12.III) and Keizer (1997: 86). 2 “Every step that takes us away from private ownership of the means of production . . . also takes us away from rational economics” (von Mises [1920] 1935: 104). 3 “My own definition of Socialism [is] a society in which the means of production are socialised” (von Mises [1936] 1951: 20). “Under socialism all the means of production are the property of the community” (von Mises [1920] 1935: 89). “Production goods in a socialist commonwealth are exclusively com-

324 Willem Keizer

4

5

6

7

8

9

10

munal; they are an inalienable property of the community, and thus res extra commercium” (ibid.: 91). Conversely, capitalism is defined as “the economic system of private ownership of the means of production” (von Mises [1920] 1935: 107). “[T]he mind of one man alone . . . is too weak to grasp the importance of any single one among the countlessly many goods of a higher order. . . . The distribution among a number of individuals of administrative control over economic goods . . . and who are economically interested in them, entails a kind of intellectual division of labour, which would not be possible without some system of calculating production and without economy” (von Mises [1920] 1935: 102). The English translation is less clear than the German original: “Doch der Geist eines Menschen allein – und sei es auch der genialste – ist zu schwach, um die Wichtigkeit eines jeden einzelnen von unendlich vielen Gütern höherer Ordnung zu erfassen. Kein Einzelner kann die unendliche Fülle verschiedener Produktionsmöglichkeiten dermaßen beherrschen. . . . Die Verteilung der Verfügungsgewalt über die wirtschaftlichen Güter . . . auf vielen Individuen bewirkt eine Art geistiger Arbeitsteilung, ohne die Produktionsrechnung und Wirtschaft nicht möglich wären” (von Mises, “Die Wirtschaftsrechnung im sozialistischen Gemeinwesen”, 1920: 97–98). “. . . for in practice the propertyless manager can only be held morally responsible for losses incurred. And so ethical losses are juxtaposed with opportunities for material gain” (von Mises [1920] 1935: 122). “All those who bid for these [communal] funds . . . are not restrained by any financial dangers they themselves run. . . . All the hazards of this insecurity would fall upon society, the exclusive owner of all resources available. . . . [It] would simply put a premium upon audacity, carelessness, and unreasonable optimism” (von Mises 1949: 705). “Moreover, just because no production good will ever become the object of exchange, it will be impossible to determine its monetary value” (von Mises [1920] 1935). Again the German original is more explicit: “Da kein Produktivgut im Tauschverkehr umgesetzt wird, wird es unmöglich, Geldpreise der Produktivgüter zu erkennen” (von Mises 1920: 90). “Stünden sie (d.h. die Güter höherer Ordnung) nicht im Tauschverkehr, dann würde es nicht zur Bildung Austauschverhältnissen kommen” (ibid.: 97). Only the exchange of property rights in goods creates prices. Pejovich (1976: 9) states that “the owners must seek the maximum profit in order to survive. The objective of profit maximisation is then not a choice objective. It is an externally-imposed survival trait on the firm’s owner. The decision-maker must allocate his assets to their highest valued uses in order to earn survival income (opportunity income)”. “Departements des gemeinschaftlichen Gesamtkörpers, denen je ein abgegrenztes Gebiet der Produktion zur ausschließlichen Besorgung zugewiesen ist. Wenn die auf dem ‘Markte’ der Beschaffungsgüter einkaufen, dann ist das kein Wettbewerb. . . . Wettbewerb besteht nur dann, wenn jeder das produziert, was ihm die günstigsten Rentabilität in Aussicht zu stellen scheint. Ich habe zu zeigen versucht, daß diesen Bedingungen nur das Sondereigentum an den Produktivgütern entspricht” (von Mises 1924: 495). “Beim Staatseigentum als dominierender Eigentumsform entfällt somit der Kapitalmarkt als Informations- und Kontrollinstitution. Die Kontrolle des Managerverhaltens durch die staatlichen Eigentümerorgane hat daher überwiegend in direkter Form zu erfolgen” (Leipold 1981: 53). Crane (1991: 75) shows that under the New Economic Mechanism both the Hungarian government and the managers used investments for expanding output, rather than for increasing efficiency. As a result, investments were misallocated.

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11 Bethell (1998: 246–247, 253–256) has argued that the insecurity of the English landlords’ property rights regarding their newly gotten Irish estates in the eighteenth century caused them to exploit them in a “predatory” way, which in the long run led to the impoverishment of Irish agricultural land and the famines of the 1840s.

References and further reading Alchian, A.A. and Demsetz, H. (1972), “Production, Information Costs, and Economic Organization”, American Economic Review 62: 777–795. Bethell, T. (1998), “The Noblest Triumph: Property and Prosperity through the Ages”, St Martin’s Press, New York. Crane, K. (1991), “Property Rights Reform: Hungarian Country Study”, in H. Blommestein and M. Marrese (eds) Transformation of Planned Economies: Property Rights Reform and Macro-economic Stability, OECD, Paris. Dallago, B. (1991), “Hungary and Poland: The Non-socialized Sector and Privatization”, Osteuropa: Wirtschaft 36 (2): 130–153. Dickinson, H.D. (1939), The Economics of Socialism, Oxford University Press, London. Eggertson, T. (1990) Economic Behavior and Institutions, Cambridge University Press, Cambridge. Furubotn, E.G. and Pejovich, S. (1972) “Property Rights and Economic Literature: A Survey of Recent Literature”, Journal of Economic Literature 10: 1137–1162. Hayek, F.A. (1935) “The Present State of the Debate”, in F.A. Hayek (ed.) Collectivist Economic Planning, George Routledge, London. Hayek, F.A. ([1940] 1949), “Socialist Calculation III: The Competitive Solution”, in F.A. Hayek, Individualism and Economic Order, Routledge & Kegan Paul, London. Jensen, M.C. and Meckling, W.H. (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”, Journal of Financial Economics (3): 305–360. Jones, D.C. (1998), “The Economic Effects of Privatization: Evidence from a Russian Panel”, Comparative Economic Studies 40 (2): 75–102. Keizer, W. (1989), “Recent Reinterpretations of the Socialist Calculation Debate”, in J.J. Krabbe, A. Nentjes and H. Visser (eds) Austrian Economics: Roots and Ramifications Reconsidered, MCB University Press, Bradford. Keizer, W. (1994), “Hayek’s Critique of Socialism”, in J. Birner and R. van Zijp (eds) Hayek, Co-ordination and Evolution, Routledge, London, pp. 207–231. Keizer, W. (1997), “Schumpeter’s Walrasian Stand in the Socialist Calculation Debate”, in W. Keizer, L.A.W. Tieben and R. van Zijp (eds) Austrian Economics in Debate, Routledge, London, pp. 75–94. Kirzner, I.M. (1988), “The Economic Calculation Debate: Lessons for Austrians”, Review of Austrian Economics, 2: 1–18. Kornai, J. (1980), “The Dilemmas of a Socialist Economy: The Hungarian Experience”, Cambridge Journal of Economics 4: 147–157. Kornai, J. (1986), “The Soft Budget Constraint”, Kyklos 39 (1): 3–30. Kornai, J. (1998), “The Place of the Soft Budget Constraint Syndrome in Economic Theory”, Journal of Comparative Economics 26: 11–18. Lange, O. ([1938] 1964), “On the Economic Theory of Socialism”, in B.E. Lippincott (ed.) On the Economic Theory of Socialism, McGraw-Hill, New York.

326 Willem Keizer Lavoie, D. (1985), Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered, Cambridge University Press, Cambridge. Leipold, H. (1981), “Eigentümerkontrolle und Managerverhalten”, in G. Hedtkamp (ed.) Anreiz- und Kontzrollmechanismen in Wirtschaftssystemen, Duncker & Humblot, Berlin. Leipold, H. (1983), “Der Einfluss von Property Rights auf hierarchische und marktliche Transaktionen in sozialistischen Wirtschaftssystemen”, in A. Schüller (ed.) Property Rights und ökonomische Theorie, Franz Vahlen, Munich. Meyer, W. (1983), “Entwicklung und Bedeutung des Property Rights-Ansatzes in der Nationalökonomie”, in A. Schüller (ed.) Property Rights und Ökonomische Theorie, Franz Vahlen, Munich. Mises, L. von ([1920] 1935), “Economic Calculation in the Socialist Commonwealth”, in F.A. Hayek (ed.) Collectivist Economic Planning, George Routledge, London. Mises, L. von (1924), “Neue Beiträge zum Problem der sozialistischen Wirtschaftsrechnung”, Archiv für Sozialwissenschaft und Sozialpolitik 51: 488–500. Mises, L. von ([1936] 1951), Socialism, Jonathan Cape, London. (This is the English translation of the second edition of Die Gemeinwirtschaft, the first German edition of which appeared in 1922.) Mises, L. von (1949), Human Action, William Hodge, London. Mroz, B. (1991), “Poland’s Economy in Transition to Private Ownership”, Soviet Studies 43 (4): 677–688. Pejovich, S. (1976), “The Capitalist Corporation and the Socialist Firm: a Study of Comparative Efficiency”, Schweizerisches Zeitschrift für Volkswirtschaft und Statistik 112 (1). Roberts, P.C. (1971), “Oskar Lange’s Theory of Socialist Planning”, Journal of Political Economy, 19 (3): 564–577. Schumpeter, J.A. ([1942] 1950), Capitalism, Socialism and Democracy, Harper & Row, New York.

16 Comparative economic systems Steven Horwitz

Introduction Assessing the contribution of modern Austrian economics to the field of comparative economic systems is a complex task, owing to the immense influence of the socialist calculation debate on the subsequent development of Austrian thought. In some sense, Austrian economics as a mode of analysis is always concerned with the questions that motivate the subdiscipline of comparative economic systems. The Austrian understanding of the microeconomic market process derives from a broader understanding of the market’s advantages versus other forms of social and economic coordination. Contributions to the more specific area of comparative economic systems have generally been extensions and applications of this broad argument to (1) new attempts to defend nonmarket forms of economic coordination; (2) historical episodes of socialist construction; and (3) ongoing issues of privatization, de-monopolization, and economic reform in the former Soviet-style economies. In this survey I will briefly review the Austrian contribution to the socialist calculation debate and then proceed to give a critical overview of the contributions to the comparative economic systems literature by the postrevival (i.e., post-1974) generation of Austrian economists.

Hayek, socialism, and modern Austrian economics The claim that modern Austrian economics emerged out of the socialist calculation debate of the interwar era is not a new one. Various interpretations of the development of Hayek’s work (Caldwell 1988) and Austrian economics more broadly (Vaughn 1994) have pointed to the importance of Hayek’s articles on knowledge in the late 1930s and 1940s for the subsequent development of the Hayekian/Austrian tradition. Both authors noted above recognize that Hayek’s work on the epistemological underpinnings of economic theory was motivated by his participation in the socialist calculation debate and the difficulties he faced in making his position understood to his neoclassical audience.1 In his attempt to clarify

328 Steven Horwitz his understanding of the debate over the feasibility of socialism, Hayek was forced to retreat to first principles and delineate what he believed was the proper task of economics and the best means to carry out that task.2 It is those attempts, most of which are collected in Hayek (1948), that gave birth to modern Austrian economics. The central issues that Hayek faced during the interwar period were those dealing with knowledge and equilibrium. Mises’s 1920 article that launched the calculation debate argued that without private property in the means of production, there could be no exchange and thus no market for capital goods. Without such a market, capital goods would not have money prices attached to them, and in the absence of such prices, planners would be unable to determine whether they were using resources efficiently. In other words, by eliminating private property in the means of production, socialism would eliminate the possibility of rational economic calculation, undermining its claim to be more rational and more efficient than the “anarchy of production” under capitalism. It is important to note that Mises’s argument was rooted in his understanding of capitalist economies in general, particularly his earlier work on money ([1912] 1980). The issue of economic calculation was linked with the use (or nonuse) of money. One of the defining characteristics of market economies was the use of money prices for economic calculation. In his book on money, Mises clearly lays out the relationship between money, calculation, and uncertainty.3 Much of the discussion previews the themes of the 1920 article. Even before Hayek’s work in the 1930s and 1940s, the Austrian perspective on economic systems derived very directly from the school’s theoretical tools for analyzing economic activity in general. Hayek’s particular criticisms of the market socialist models of the 1930s provided the defining lines of inquiry for the next generation of Austrian economists. In response to Mises’s original argument claiming that socialist planning was impossible, neoclassical economists of the 1920s and 1930s set out to use the latest techniques of economic theory to establish the feasibility of planning. The work of Fred Taylor, Abba Lerner, H.D. Dickinson, and, especially, Oscar Lange all converged around a common theme: that public ownership of the means of production did not preclude an economy from reaching general equilibrium. In fact (this argument proceeded), having some sort of planning agency setting the prices of capital goods might do the job better and faster than would a competitive market. What made the Lange-type arguments so powerful was that they relied on the very tools that neoclassical theory had developed to explain the operation of the market to explain why markets might not be superior to planning. To the extent that the economics profession between the wars accepted the validity of those tools, they would be hardpressed to reject the conclusion that the so-called market socialists drew from using them.

Comparative economic systems 329 What the Lange-type models proposed was to have capital goods prices set by a Central Planning Board (CPB) rather than through exchanges of private property in a competitive market. In Lange’s model he argued that producers in such a system would be in the same effective position as they are in the perfect competition models of general equilibrium theory. That is, producers would be directed to produce at minimum average total cost and produce that quantity where their price equals marginal cost (Lange 1936: 72ff.). This directive can only work, Lange points out, if prices are treated as parameters. In other words, producers must act “as if prices were independent of the decisions taken” (ibid.: 81). If they do so, then production can proceed using those parametric prices, as can consumption, because consumers will also treat prices as parametric and proceed to maximize utility in the standard way based on those prices. As people on each side of the market perform their respective maximization operations, they will produce specific quantities supplied and demanded. The task of the CPB is to compare those quantities and, where they are not equal, adjust prices in the equilibrating direction. Eventually, Lange argued, the planning board will find the vector of prices that clears each and every market, just as competition is said to do in general equilibrium theories of the market. In Lange’s model it is only after the equilibrium prices are found that any trading actually takes place. Thus, in Lange’s view, “The Central Planning Board performs the function of the market” (1936: 82–83). Hayek’s response to Lange laid out both the general research program of Austrian economics and its application to issues of economic systems. His main point was that Lange’s fixation with establishing equilibrium prices was misplaced: [I]t is difficult to suppress the suspicion that this particular proposal has been born out of an excessive preoccupation with problems of the pure theory of stationary equilibrium. . . . The practical problem is not whether a particular method would eventually lead to a hypothetical equilibrium, but which method will secure the more rapid and complete adjustment to the daily changing conditions in different places and different industries. (Hayek 1940: 188) The heart of Hayek’s response was that Lange was confusing the operation of the model of perfect competition with the operation of real-world competitive markets.4 Although economic theory was consumed by the search for equilibrium solutions, this was not the issue facing real-world markets and planners. In particular, Hayek was concerned with the way in which the knowledge assumptions associated with general equilibrium models were uncritically transferred to real-world actors and institutions. For example, Lange assumes that producers know their average and

330 Steven Horwitz marginal cost curves, as they are assumed to in textbook models. However, Hayek’s point was that what is true of such models need not be true of real-world actors. He argues that the various costs curves are not “objectively given facts,” and that, instead, they are “a thing which has to be discovered, and to be discovered anew, sometimes almost from day to day, by the entrepreneur” (1940: 196). For Hayek the question was under what sorts of political and economic institutions would producers be most likely to discover knowledge that they did not now possess. The problem of efficient resource allocation was not about achieving equilibria but about the epistemological properties of alternative institutional frameworks. Thus, in analyzing economic systems, these institutional concerns should come to the forefront. As a result of Hayek’s position in the debate, modern Austrian economics has become increasingly concerned with issues of knowledge, equilibrium, institutions, and evolution. To the degree that Hayek’s critique of Lange showed the difficulties inherent in those type of market socialist proposals, it also revealed the ways in which the Austrian tradition in economic theory was becoming increasingly differentiated from the mainstream of neoclassical theory, despite both having emerged from the same marginalist revolution. Hayek’s response to Lange could easily be recast as a critique of the emerging domination of general equilibrium theory in neoclassical economics.5 Modern Austrian economic theory takes many of its cues from the Hayek essays of the 1930s and 1940s as well as Israel Kirzner’s (1973) Competition and Entrepreneurship, which very carefully laid out the points of difference between Austrians and the mainstream. In particular, Kirzner’s emphasis on the knowledge assumptions of general equilibrium theory, and the corresponding absence of the entrepreneur, set the stage for many of the directions Austrians have pursued since. Combined with Hayek’s later work on spontaneous order and the evolution of institutions, modern Austrian economics is in the process of developing an alternative theoretical framework for trying to understand both human action and the emergence of social and economic order. In what follows, we shall examine the ways in which this framework has been deployed to understand socialist economies and the problems faced in reform and transition.

Modern extensions of the calculation argument Modern Austrians have not let the calculation debate rest where it ended in the 1940s. In fact, one important catalyst in the revival of Austrian economics has been a rethinking of that debate and what it implied about both economic systems and economic theory. Shortly after the awarding of the Nobel Prize to Hayek in 1974, a few articles began to appear that questioned the generally accepted verdict that Lange had won the debate (e.g., Vaughn 1980; Lavoie 1981; Murrell 1983). In all three cases the

Comparative economic systems 331 authors argued that the participants in the debate had fundamentally talked past each other, precisely because neither side was aware of the theoretical divide that separated them. Lange assumed that, in his original contribution, Mises was talking in the same theoretical language as were Anglo-American economists, and Hayek’s response to Lange is best understood as Hayek slowly coming to the realization that he and Lange did not share a theoretical language. In other words, if the terms of the debate were those of Anglo-American general equilibrium theory, then Mises’s and Hayek’s arguments probably looked weak by comparison. However, if one saw their argument in its Austrian context, and as a broader critique of the whole orientation of Anglo-American economics of the period, then their points look different. These extensions of the debate in the early 1980s began to hint a more radical reading of the Austrian position. This reinterpretation of the debate was completed by Don Lavoie’s (1985a) Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered. Lavoie’s careful scholarship revealed the ways in which the original debate reflected a clash of paradigms between the Austrians and the “general equilibrium market socialists.” More specifically, that clash centered around the concepts of competition and equilibrium: At the heart of the debate is a confusion between two fundamentally divergent views of “competition”: (1) the rivalrous competitive process of the Austrians (similar to the classical notion), and (2) the neoclassical notion of a nonrivalrous, static, competitive equilibrium. (Lavoie 1985a: 22) Lavoie (ibid.: 24) continues: Models of static competitive equilibrium banish economic rivalry from the scene and employ the construct of a (centralized) Walrasian auctioneer to adjust the prices that the actual participants passively accept as “parametric.” Within this essentially static framework it seems quite plausible to imagine a central planning bureau fulfilling the auctioneer’s duties. . . . [However,] many of the same criticisms that presentday Austrian economists are leveling against this model can be leveled with equal force against modern central planning theory. The running theme of Lavoie’s book was that the Austrians had an understanding of competition fundamentally different from that of the neoclassical market socialists. In particular, the Austrian notion of competition as rivalry was intrinsically linked with the structure of property rights and the ownership of the means of production. Where the means of production were socially owned, competition in the Austrian sense was absent by definition, no matter how closely a planning agency could induce the economy to behave like the perfectly competitive model.

332 Steven Horwitz Lavoie also advanced Hayek’s work on knowledge and competition, which increasingly was defining Austrian economics. What made rivalrous competition, and hence private property, indispensable for economic calculation was that only the pushes and pulls of market competition could generate the knowledge necessary for rational economic calculation. When Mises had said in 1920 that without private property there could be no market, and without a market there could be no prices, and therefore no rational economic calculation, he was implying what Hayek and Lavoie would say more explicitly: competitive markets are epistemological ecosystems. The role of market prices is to serve as knowledge surrogates in order to inform market actors as to the preferences of others, their own opportunity costs, and the possibilities available in the market. The notion that competitively determined market prices were usable knowledge that would be unavailable to planners was a fundamental criticism of Langetype models that abolished true competition in capital goods and attempted to find equilibrium prices through nonmarket mechanisms.6 Lavoie’s book has spurred several attempts to further elucidate aspects of his argument. Lavoie’s own contributions (1985b, 1986) expanded on the epistemological perspective that underpinned his argument. In response to the counterargument that computers or other forms of communication could overcome the knowledge problem, Lavoie picked up on a theme Hayek introduced in his 1945 article “The Use of Knowledge in Society.” There Hayek distinguished between scientific (or articulatable) knowledge and the knowledge of the circumstances of time and place (1945: 80). Lavoie updated that distinction by linking it to Michael Polanyi’s (1958) work on “tacit knowledge.” As Polanyi and other philosophers argue, not all of what we know do we know in a form that we can linguistically report to others. In the distinction made by Gilbert Ryle, it is the difference between knowing “how” and knowing “that.” Lavoie’s 1986 paper argued that the irreplaceable function of competitively determined market prices was that they conveyed this tacit knowledge that otherwise would not be socially usable. Because planning by necessity relied on forms of knowledge that could be put into words or statistics, it would be unable to have access to this entire other form of knowledge. In some ways, Lavoie’s work on tacit knowledge and economic systems was also the logical progression of the more general subjectivism of Austrian economics. Beyond Lavoie’s own extensions, other modern Austrians have attempted to explore aspects of the calculation argument.7 Boettke (1990: 130) expanded on the prices-as-knowledge-signals argument by proposing three separate ways in which prices convey knowledge in market economies. Prices have an “ex ante,” “ex post,” and “discovery” role. The first of these refers to the way in which prices are used to calculate the potential costs and revenues from future possible lines of production. The ex ante function of prices is forward-looking. The ex post function is, by

Comparative economic systems 333 contrast, backward-looking. Here prices tell producers, through profitand-loss accounting, how well or how poorly their just completed projects performed. These prices, in turn, become ex ante inputs into the next round of production decisions. The discovery role of prices, most clearly emphasized by Kirzner, is the way in which existing price discrepancies alert producers to possible production projects that they might have otherwise overlooked. Where the ex ante and ex post role of prices are connected up with the appropriateness of means to given ends, the discovery role is to suggest alternative ends that might be pursued. This schema has been helpful in clarifying more precisely the epistemic function of the price system. Another extension of the prices and knowledge theme is the work of Esteban Thomsen (1992). Thomsen uses the Austrian perspective on prices and knowledge that emerged out of the calculation debate to show the differences between the Austrian approach and that of Grossman and Stiglitz. Grossman and Stiglitz have tried to show that prices are not sufficient statistics to produce Pareto-optimal equilibria, implying that the Hayekian claim about prices conveying knowledge need not lead one to dismiss all sorts of government intervention. In the Grossman and Stiglitz model, informational asymmetries might provide scope for government planners to improve on the price system’s performance. Thomsen’s response is that Grossman and Stiglitz have misinterpreted Hayek’s argument as being about the informational properties of equilibrium prices. Instead, Hayek’s argument can be understood as a claim about the way prices in disequilibrium enable entrepreneurs to calculate and behave rationally. The crucial function of prices is not that they are sufficient statistics to reach equilibrium, but that they provide knowledge signals in disequilibrium that would be distorted by government intervention or absent under more comprehensive forms of planning.8 This argument can fruitfully be applied to various sorts of market socialist and interventionist proposals. A further extension of the prices and tacit knowledge argument can be found in Horwitz (1992a, 1996). Horwitz (1992a) analogizes money to language and argues that monetary exchange enables us to communicate the tacit forms of knowledge that language cannot. This argument extends both Hayek’s 1945 paper and Lavoie’s 1986 paper by exploring in more detail the communicative role of money and monetary exchange and the ways in which the system of money prices functions like an extension of language. That perspective is applied to the calculation debate in Horwitz (1996). Here, the communicative role of monetary exchange is linked to Mises’s 1920 calculation article by illustrating how Mises himself saw the relationship between money prices and economic calculation. The moneyas-language view is then used as a vantage point from which to revisit the calculation debate and the Lange-type proposals more specifically. In addition, Horwitz (1996) uses the Austrian argument to critically

334 Steven Horwitz assess the market socialist proposal of Cottrell and Cockshott (1993). They argue that labor time can be used as a way to measure value across different goods and that advances in computational technology and artificial intelligence give us the ability to use computers to compute rational resource use based on those labor-time indicators. Cottrell and Cockshott explicitly argue that these technological innovations neutralize the Austrian argument. However, they confuse two important issues. The Austrian argument, as indicated earlier in this chapter, was never about the limits of computational technology, but rather about the epistemic barriers to acquiring the information that such computers would have to work with. The Cottrell and Cockshott scheme completely overlooks this central aspect of the Austrian critique of planning, and also ignores the way in which that critique is complementary to public-choice analyses of the limits of the political process. To the extent that such schemes continue to be developed, there will likely be further extensions of the Austrian calculation argument.

Explaining really existing socialism Modern Austrian economists have not been content with simply arguing for the theoretical difficulties faced by noncapitalist economic systems; they have also tried to use that argument to explain the origins, evolution, and collapse of the really existing socialism of the twentieth century. One of the first problems faced by Austrians embarking on this endeavor is how to explain what appears to be a contradiction between the claim that “socialism is impossible” and the historical evidence that nominally socialist economies have survived for decades. As Prychitko (1994: 228) puts it, “To claim today that the collapse of the Soviet economy represents a collapse of socialism (and a final vindication of the Austrian position) may simply prolong . . . misunderstanding.” The path around this apparent contradiction is the recognition that the so-called socialist economies were in fact not socialist in any meaningful sense of the term. Even by Marx’s own classificatory scheme, these economies were commodity-producing systems and would therefore fall in the same category as capitalism. However, once Austrians make this claim, they face a further problem. If those economies were not socialist (and were arguably just capitalist economies with a large amount of arbitrary intervention), why did they collapse and how is that collapse related, if at all, to the issues raised in the socialist calculation debate? It might well work to the advantage of a defender of socialism to argue that the Soviet Union was not a socialist economy, as that claim leaves open the possibility that a “true” socialist economy might work. These dilemmas demand some careful empirical/historical work to sort them out. The most important Austrian attempt to do so is Peter Boettke’s (1990) examination of the first ten years of the Soviet Union. Building on earlier work by Paul Craig Roberts (1971) and others, Boettke attempted

Comparative economic systems 335 to use the Austrian calculation argument to explain the problems of the War Communism period (1917–1921), the move to the New Economic Policy (NEP) (1921–1928), and the factors that led to the rise of Stalin. The historical evidence on the collapse of the Russian economy during War Communism is unambiguous, but the explanation for that collapse has been highly contested. The standard view among Sovietologists is that the centralization and decommodification of that period were due to the ongoing civil war that required such measures for a Bolshevik victory. So, argues this view, the economic collapse was brought on by the necessity of fighting the war, and was not due to any problems inherent in Bolshevik ideas. Once the war was won, the Bolsheviks began to establish socialism as they saw it, which was the set of less draconian policies of the NEP. Boettke’s interpretation is different. Using primary source material, he argues that the policies of War Communism reflected the Bolshevik interpretation of Marxian socialism. Although the war may have affected certain policy choices on the margin, the attempts to eliminate the market and substitute a centrally coordinated plan were ideologically motivated and reflected a genuine attempt to put socialism into practice. On this view the economic collapse that ensued is an empirical confirmation of the Austrian argument against the possibility of rational economic calculation outside of the market. The move to let some of the market back in under the NEP was not “real” socialism, but a necessary retreat to capitalism in the face of the utter failure of the prior attempts to abolish the market. As Boettke (1990: 7) summarizes his argument: I strive to demonstrate that the first three years of the Bolshevik regime (1918–1921) constitute an attempt to carry out the Marxian ideal of comprehensive central planning, and that the disastrous results, which all commentators agree occurred, were the inevitable outcome of this Marxian ideal coming into conflict with the economic reality of the coordination problem that all economic systems face. Much of Boettke’s book is devoted to clarifying the Austrian argument and exploring the historical evidence that backs up this claim. On this view the rest of the Soviet experience can be understood a bit differently. After the move to the NEP in April 1921, the Soviet economy never again attempted to abolish the market and commodity production. Even under the worst excesses of Stalinism, goods still had prices and traded in markets. From 1921 to the present, the Russian/Soviet economy was capitalist in its essence. Explaining its survival and eventual collapse requires both an understanding of the Austrian calculation argument and some insight into the operation of political intervention processes. Anderson and Boettke (1993, 1996) have begun that project. What their work does is to treat the Soviet economy as an instance of mercantilism. Given the party’s inability to plan centrally, the ideological project

336 Steven Horwitz collapsed into a system of interlocking interest groups and de facto contractual arrangements. By combining the Austrian critique of planning with public choice insights about the nature of the political process, the logic of concentrated benefits and dispersed costs, rent seeking, and the importance of credible commitments, the picture of the mature Soviet-style economy as a species of socialism is overturned. This insight explains the system’s ability to survive for many decades as well as clarifying exactly what kind of system is being reformed. If reformers assume that they are moving from some sort of truly socialist economy to a market economy, they will be led to make crucial errors. If, instead, the Soviet-style economy is seen as an example of neomercantilism, the nature and direction of reform look different, and reform will require something like the kinds of changes Western economies underwent in the late eighteenth century. It is worth repeating that seeing the Soviet-style economy as neomercantilist rests on the Austrian view that true central planning is impossible and therefore not descriptive of the Soviet economy after 1921, or of any other Soviet-style economy ever. Austrians have also explored the histories of other noncapitalist economies. Prychitko (1990, 1991) examined the so-called cooperative economy of the former Yugoslavia. As with the Soviet-style economy, defenders of socialism might point to Yugoslavia as the “true” socialist model because it avoids the centralization of Stalinism. Some interpreters of Marx have argued that his vision of the planned economy was one planned using the full cooperation of the workers, rather than by a centralized planning board. Prychitko (1991) makes the case for this “praxis” interpretation of Marx and uses it to examine the way Yugoslavia attempted to implement a cooperative economy. Central to Prychitko’s analysis is the distinction between workers’ selfmanagement as a way to internally organize a firm and workers’ selfmanagement as a way to coordinate an economy across different producers. What Prychitko argues is that the Austrian critique of planning suggests significant problems with the latter, but not necessarily with the former. To the extent that the Yugoslavian economy was still intent upon abolishing the market but substituting a network of workers’ cooperatives for a central planning agency (such as Gosplan), it would face the same problems in calculating rationally that the Russians did under War Communism. Although the process might be more participatory, and thus take advantage of the perspectives of a larger number of economic actors, the nature of bureaucratic processes precludes the transmission of the knowledge necessary to make rational economic decisions. If a network of workers’ cooperatives were to substitute for markets and market prices, “How will [they] evaluate the many, inevitably conflicting uses of a single resource?” (Prychitko 1991: 87). In a world of heterogeneous capital and the uncertainty that pervades the firm’s production function and the value of the factors of production, there is no alternative to market prices, no matter how decentralized and democratic such an alternative might be.

Comparative economic systems 337 In fact, just as the Austrian argument implied that an economy could not be centrally planned in any meaningful sense, so does it suggest that more decentralized forms of planning would not be possible. Thus, the Yugoslavian model could not be doing what it claimed to be, and Prychitko (1991: 93) recognizes this: “Neither appropriately decentralized nor fully and comprehensively planned, the Yugoslav system nevertheless preserves the worst elements of these two contradictory extremes.” In the end, as the network of workers’ groups and councils failed to provide the necessary economic coordination, the Yugoslavian Communist Party became the ultimate decision maker, and those decisions were either highly politicized or made using economic data from the rest of the world. In a later paper (1995), Prychitko argues that there is no distinctly Austrian critique of the worker-owned firm (operating in a market economy). Rather, Austrians have borrowed many of their criticisms from neoclassical arguments. He goes on to claim that aspects of Austrian economics suggest that worker self-management might have some advantages over the traditional firm. For example, to the extent that knowledge within the firm is tacit and that workers’ skills are more about creativity than about mechanical movement, the traditional notion of centralized management and oversight might fail in comparison to methods that give workers more voice in management decisions by relying on decentralized knowledgetransmission processes. An implication is that what might have been “right” about the Yugoslavian experiment was the emphasis on worker ownership, while what was wrong about it was the attempt to substitute a network of worker-owners for the market among firms.

Austrian economics and the political economy of transition With the collapse of the nominally socialist economies, Austrians have turned their attention more toward the problems faced during transition and reform. The inescapably political elements of such analyses have led most Austrians to combine insights from Austrian economics with public choice theory’s understanding of the dynamics of the political process. As noted earlier, had really existing socialism really tried to abolish the market, it would not have survived. The market lived on in Eastern Europe and the former Soviet Union, and so-called central planners were no different from Western politicians who used their power to please various constituents. Once socialist politics was unable to fulfill its ideological mission, it could be understood as a self-interested process of exchange. This latter point is crucial to understanding the problems of transition and reform. First, the transition is not from a “centrally planned” economy to a market economy, but from a market economy with vast and arbitrary intervention to a market economy with much less intervention. Paul Craig Roberts (1971: 84) saw this point over three decades ago: “Economic reforms are not, as is generally believed, a matter

338 Steven Horwitz of radical organizational change but a matter of replacing signals that are less rational with signals that are more rational from the standpoint of economic efficiency.” Second, the central problem of reform is how one gets those who possess power to give it up. The reform process apparently needs to have some political value for those in power, or why else would they be willing to go along with it? And if they are not, how is reform to come about if not by those at the top walking away from what they have? Boettke’s (1993) analysis of Gorbachev’s “perestroika” program is the most complete attempt to use Austrian economics to explore issues of reform and transition. He argues that an Austrian understanding of the problems faced by planning implies the need for an immediate and complete turn to the market economy. Gorbachev’s attempt to finesse radical reform with piecemeal and gradual changes failed miserably precisely because it did not create the credible institutional framework that is necessary for the discovery process of the market to unfold. Those who are holding power will be reluctant to give it up, and without a clear commitment by those in power to shackle their own hands, actors in the “private” sector will be unwilling to make the long-term commitments of capital and labor needed for economic growth. The constant “zigging and zagging” that characterized the Gorbachev era meant that actors could not know whether Gorbachev the reformer or Gorbachev the conservative was the real thing. As a result, economic growth never took off and the eventual collapse of the system was hastened. Boettke (2001) collects a number of essays that extend these themes. Horwitz (1992b) makes some parallel arguments with respect to the reform process in Poland. Focusing on the issue of price reform, he argues that the logic of the political process suggests that genuine price reform will be difficult. If government grows because the benefits of its programs are concentrated, obvious, and short-run, while the costs are dispersed, subtle, and long-run, then the opposite would be true of shrinking government. Price reform bears this out. The costs of price reform fall on current producers and consumers who benefit from state-set prices. If prices are liberalized, these groups know they will lose, and that those losses will be obvious and short run. By contrast, the benefits of liberalization are longer-term, subtle, and much more dispersed. The promise of price liberalization is generalized economic growth. This point is most obvious when combined with the Austrian view of competition as a discovery process. On that view, the specific beneficiaries of price reform necessarily cannot realize their positions ex ante, because the whole justification for liberalizing prices is to discover what prices “should” be and, therefore, who would benefit from them. As a result, there is unlikely to be an effective political coalition in favor of price reform. The impetus for reform must come from somewhere else. In his examination of reform in China, Prychitko (1987) also raises the issue of the relationship between economic reform and the political

Comparative economic systems 339 process. Although China, at the time, had started down the road of decentralizing its economic system, the political process remained in the hands of a centralized bureaucracy. That group of leaders was unlikely to relinquish control in any meaningful way despite increasingly powerful pressure to do so in the face of modernization and the influence of its own economic reforms and world economic trends. In the absence of serious reform of the political process, Prychitko (1987: 39) remains skeptical: “those who dare to predict China’s economic future suggest that although the country will probably never return to its dim past; its reforms may nevertheless get stuck in a quagmire of regulations and corruption.” He goes on to cite agriculture as a prime example of this problem. As Austrian economics has done from its first analyses of economic systems, understanding reform requires that we take into account both economic and political factors, and the ways in which they are interdependent. One explanation for where reform might arise is from the spontaneous evolution of social institutions outside of the traditional political process. In a paper that builds on Austrian analyses of the evolution of other social institutions, Boettke (1994) argues that any reform program must recognize, and grant some priority to, emerging indigenous cultural practices and institutions. For example, to the extent that the Russian government has failed to provide the legal/political infrastructure necessary for economic growth, private market actors have had to evolve their own ways of settling disputes and clarifying contracts. Boettke’s claim is that these practices and institutions are beginning to emerge “underground” in former Soviet-style economies, and that they can serve as the basis for reform. In other words, the reform process may largely involve finding ways to legitimate ongoing actual practices. It is those practices that create the law, and the most the state can do is to recognize and formalize those practices.9 Austrian economists have also applied these kinds of arguments to the reform of Third World economies as well. Chamlee (1993) argues, like Boettke, that indigenous institutions are important for understanding the operation and reform of African economies. Chamlee’s central claim is that many indigenous practices are already oriented toward the market even if they do not exactly resemble Western-style institutions. In trying to move Third World economies away from socialist models, it is neither necessary nor wise to simply import exact replicas of Western institutions. Instead, one needs to build on market institutions that are already in place and create the political infrastructure that will allow them to grow and evolve in correspondence to the practices and preferences of the persons who use them. The work of Boettke and Chamlee on these issues suggests a way for Austrians to provide a unique perspective on reform and economic development emerging from the Hayekian emphasis on spontaneous order. This Austrian contribution is crucial, as so much of the current literature on reform and transition is filled with formal models that often pay little attention to cultural and institutional factors in the countries being

340 Steven Horwitz modeled. Austrian economics provides both a methodological justification for asking such questions and a set of theoretical tools for examining them. It may turn out that Austrians find it difficult to convince their colleagues in economics that such issues are worth exploring, but they will surely find a receptive audience in other areas of social science. Indeed, such disciplinary trespassing could give Austrians a wonderful opportunity to, as it were, “speak for” economics in those discussions in political science or history. These cultural and institutional issues will likely be the crucial questions facing reformers, and Austrians are in a very effective position to speak to them.

Conclusion That Austrian economics should have a distinct perspective on economic systems and reform ought to come as no surprise given that the modern version of the school’s unique set of ideas emerged out of the socialist calculation debate of the interwar period. In the postrevival era, Austrians have begun to return to these defining issues and deploy their now sharper theoretical insights toward issues of socialism, planning, and the transition to the market economy. The work discussed in this chapter has made important advances in both Austrian theory and comparative economic systems, and modern Austrians have cause to feel vindicated for the dismissal of their predecessors. However, much remains to be done. With their distinct emphasis on process, knowledge, and spontaneous order, Austrians are well positioned to be influential players in the field of comparative economic systems well into the twenty-first century.

Notes 1 Foss (1995), however, argues that Hayek’s original motivation for considering the interrelationship between knowledge and equilibrium theory was his work in macroeconomics, particularly his 1928 paper on intertemporal equilibrium and his 1933 paper on expectations. 2 He also was led to reconsider the methodology of the social sciences (Hayek 1952a) and its foundations in theoretical psychology (Hayek 1952b). In his introduction to the latter, Hayek says explicitly that “In the end it was concern with the logical character of social theory which forced me to re-examine systematically my ideas on theoretical psychology” (1952b: v). 3 See Horwitz (1998) for development of this argument. 4 To be consistent with his own use of the conditions of perfect competition, Lange should have claimed that the CPB performs the function of the auctioneer, not “the market.” In perfect competition theory, prices can only be changed by the hypothetical auctioneer. In real-world competition this is not an issue, because prices are not taken as parametric by producers. For a detailed and perceptive overview of the changing understanding of competition in neoclassical theory, see Machovec (1995). 5 There is a substantial literature addressing the relationship between Austrian economics and the neoclassical mainstream. The following is a good sampling: on the

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7

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various strands of the marginalist revolution, see Streissler (1972) and Jaffe (1976); on the interwar years, see Kirzner (1994); on the postrevival years, and Hayek’s role in that revival, see Boettke et al. (1986), Caldwell (1988), and Vaughn (1994). Lavoie (1985b) extended his argument in a second book that explored more deeply the epistemological underpinnings of his discussion of the calculation debate. It is that book that is generally credited with coining the phrase “the knowledge problem” to summarize the Austrian critique of planning. General discussions of the calculation debate that offer new twists and interpretations can be found in Boettke (1990: ch. 2), Prychitko (1991, ch. 3), Kirzner (1985, 1992), and Vaughn (1994, ch. 3). In addition, there is an alternative Austrian interpretation of the calculation debate associated with the late Murray Rothbard and several of his followers. This view tries to drive a wedge between the views of Mises and Hayek, arguing that the former’s emphasis on calculation is the more correct view and that the Hayekian emphasis on the knowledge problem is misguided. As my argument in the text suggests, I do not accept this view, and it is still in the very clear minority among Austrians. For more on the Rothbardian position, see Rothbard (1991) and Salerno (1990a, 1990b, 1993). For responses suggesting the unity of Mises and Hayek, see Kirzner (1996), Yeager (1994, 1996), Horwitz (1998), and Boettke (1998). Although Thomsen raises some valid and important criticisms of his approach, Thomas Sowell’s (1980) book Knowledge and Decisions should also be mentioned as an extension of the Hayekian knowledge arguments. This is, of course, is not a radical idea. Boettke builds explicitly on Menger’s and Mises’s work on the origin of money, particularly the Misesian “Regression Theorem.” Bruce Benson’s account (1990) of the evolution of Western law suggests that it emerged precisely in this way. What both bodies of work conclude is that the state’s role in the evolution of money and law is far less important than is usually claimed. For more on this, see Horwitz (1993).

References Anderson, Gary and Boettke, Peter J. (1993), “Perestroika and Public Choice: The Economics of Autocratic Succession in a Rent-Seeking Society,” Public Choice 75 (2): 101–118. Anderson, Gary and Boettke, Peter J. (1996), “Soviet Venality: The USSR as a Mercantilist State,” Public Choice 93: 37–53. Benson, Bruce (1990), The Enterprise of Law, Pacific Research Institute for Public Policy, San Francisco. Boettke, Peter J. (1990), The Political Economy of Soviet Socialism: The Formative Years, 1918–1928, Kluwer Academic Press, Boston. Boettke, Peter J. (1993), Why Perestroika Failed, Routledge, New York. Boettke, Peter J. (1994), “The Reform Trap in Politics and Economics in the Former Communist Economies,” Journal des Économistes et des Études Humaines 5 (2/3): 267–293. Boettke, Peter J. (1998), “Economic Calculation: The Austrian Contribution to Political Economy,” Advances in Austrian Economics 5: 131–158. Boettke, Peter J. (2001), Calculation and Coordination: Essays on Socialism and transitional Political Economy, Routledge, New York. Boettke, Peter, Horwitz, Steven and Prychitko, David L. (1986), “Beyond Equilibrium Economics: Reflections on the Uniqueness of the Austrian Tradition,”

342 Steven Horwitz reprinted in Peter J. Boettke and David L. Prychitko (eds) The Market Process: Essays in Contemporary Austrian Economics, Edward Elgar, Aldershot, UK, 1994. Caldwell, Bruce (1988), “Hayek’s Transformation,” History of Political Economy 20 (4): 513–541. Chamlee, Emily, (1993), “Indigenous African Institutions and Economic Development,” Cato Journal 13 (1): 79–99. Cottrell, Allin and Cockshott, W. Paul (1993), “Calculation, Complexity, and Planning: The Socialist Calculation Debate Once Again,” Review of Political Economy 5 (1): 73–112. Foss, Nicolai (1995), “More on ‘Hayek’s Transformation’,” History of Political Economy, 27 (2): 345–364. Hayek, F.A. (1940), “The Competitive Solution,” in F.A. Hayek, Individualism and Economic Order, University of Chicago Press, Chicago, 1948. Hayek, F.A. (1945), “The Use of Knowledge in Society,” in F.A. Hayek, Individualism and Economic Order, University of Chicago Press, Chicago, 1948. Hayek, F.A. (1948), Individualism and Economic Order, University of Chicago Press, Chicago. Hayek, F.A. (1952a), The Sensory Order, University of Chicago Press, Chicago. Hayek, F.A. (1952b), The Counter-revolution of Science, Liberty Press, Indianapolis. Horwitz, Steven (1992a), “Monetary Exchange as an Extra-linguistic Social Communication Process,” Review of Social Economy 50 (2): 193–214. Horwitz, Steven (1992b), “Poland and the Political Economy of Price Reform,” in Robert McGee (ed.) The Market Solution to Economic Development in Eastern Europe, Edwin Mellen, Lewiston, NY. Horwitz, Steven (1993), “Spontaneity and Design in the Evolution of Institutions: The Similarities of Money and Law,” Journal des Économistes et des Études Humaines 4 (4): 571–587. Horwitz, Steven (1996), “Money, Money Prices, and the Socialist Calculation Debate,” Advances in Austrian Economics, vol. 3, JAI Press, Greenwich, CT, pp. 59–77. Horwitz, Steven (1998), “Monetary Calculation and Mises’s Critique of Planning,” History of Political Economy 30 (3): 427–450. Jaffe, William (1976), “Menger, Jevons, and Walras De-homogenized,” Economic Inquiry 14: 511–524. Kirzner, Israel (1973), Competition and Entrepreneurship, University of Chicago Press, Chicago. Kirzner, Israel (1985), “The Perils of Regulation: A Market-Process Approach,” in Discovery and the Capitalist Process, University of Chicago Press, Chicago. Kirzner, Israel (1992), “Economic Planning and the Knowledge Problem,” in The Meaning of Market Process, Routledge, New York. Kirzner, Israel (1996), “Reflections on the Misesian Legacy in Economics,” Review of Austrian Economics 9 (2): 143–154. Lange, Oscar (1936), “On the Economic Theory of Socialism,” in Benjamin Lippincott (ed.) On the Economic Theory of Socialism, McGraw-Hill, New York, 1964. Lavoie, Donald C. (1981), “A Critique of the Standard Account of the Socialist Calculation Debate,” Journal of Libertarian Studies 5 (1): 41–87. Lavoie, Donald C. (1985a), Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered, Cambridge University Press, Cambridge. Lavoie, Donald C. (1985b), National Economic Planning: What Is Left?, Ballinger, Cambridge, MA.

Comparative economic systems 343 Lavoie, Donald C. (1986), “The Market as a Procedure for the Discovery and Conveyance of Inarticulate Knowledge,” Comparative Economic Studies 28 (1): 1–19. Machovec, Frank M. (1995), Perfect Competition and the Transformation of Economics, Routledge, New York. Mises, Ludwig von ([1912] 1980), The Theory of Money and Credit, Liberty Press, Indianapolis. Mises, Ludwig von (1920), “Economic Calculation in the Socialist Commonwealth,” in F.A. Hayek (ed.) Collectivist Economic Planning, Augustus M. Kelley, Clifton, NJ, 1935. Murrell, Peter (1983), “Did the Theory of Market Socialism Answer the Challenge of Ludwig von Mises?” History of Political Economy 15 (1): 92–105. Polanyi, Michael (1958), Personal Knowledge: Towards a Post-critical Philosophy, University of Chicago Press, Chicago. Prychitko, David (1987), “Modernizing Markets in Post-Mao China,” Journal of Economic Growth 2 (3): 31–42. Prychitko, David (1990), “Perestroika in Yugoslavia: Lessons from Four Decades of Self-Management,” Global Economic Policy 2 (2): 25–37. Prychitko, David (1991), Marxism and Workers’ Self-Management, Greenwood, Westport, CT. Prychitko, David (1994), “Comparative Economic Systems,” in Peter J. Boettke (ed.) The Elgar Companion to Austrian Economics, Edward Elgar, Aldershot, UK. Prychitko, David (1995), “The Critique of Workers’ Self-Management: Considerations from Austrian Theory,” presented at the History of Economics Society meetings, June 1995. Roberts, Paul Craig (1971), Alienation and the Soviet Economy, University of New Mexico Press, Albuquerque. Rothbard, Murray N. (1991), “The End of Socialism and the Calculation Debate Revisited,” Review of Austrian Economics 5 (2): 51–76. Salerno, Joseph (1990a), “Postscript: Why a Socialist Economy is ‘Impossible’,” in Economic Calculation in the Socialist Commonwealth, Ludwig von Mises Institute, Auburn, AL. Salerno, Joseph (1990b), “Ludwig von Mises as a Social Rationalist,” Review of Austrian Economics 4: 26–54. Salerno, Joseph (1993), “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6 (2): 113–146. Sowell, Thomas (1980), Knowledge and Decisions, Basic Books, New York. Streissler, Erich (1972), “To What Extent Was the Austrian School Marginalist?” History of Political Economy 4 (2): 426–441. Thomsen, Esteban (1992), Prices and Knowledge: A Market-Process Perspective, Routledge, New York. Vaughn, Karen (1980), “Economic Calculation under Socialism: The Austrian Contribution,” Economic Inquiry 18 (20): 535–554. Vaughn, Karen (1994), Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, New York. Yeager, Leland B. (1994), “Mises and Hayek on Calculation and Knowledge,” Review of Austrian Economics 7 (2): 93–109. Yeager, Leland B. (1996), “Rejoinder: Salerno on Calculation, Knowledge, and Appraisement,” Review of Austrian Economics 9 (1): 137–139.

Q

Agricultural and natural resource economics; environmental and ecological economics

17 Austrian views on environmental protection Andries Nentjes

Introduction At first sight an investigation into what the Austrian school has to say about environmental issues does not look like a really exciting enterprise. Neo-Austrians such as von Mises, von Hayek, Rothbart and Kirzner are well-known proponents of the minimal state: that is, a government that focuses on the core business of providing law and order and a few other essential public goods. Does protection of the environment belong to this category in the Austrian view and has the Austrian doctrine anything noteworthy to say on environmental degradation? The answer to these questions given in this contribution is in the affirmative. In the first section I present the views of the neo-Austrians Mises, Hayek and Rothard on environmental policy. The second section takes a step of more than a hundred years back in time to search for Karl von Menger’s ‘old-Austrian’ vision on environmental problems. It turns out that a discrepancy exists between the ideas of Karl Menger and those of later authors in the Austrian tradition. These relate to the scope for public versus private action in coping with environmental scarcity. In the final section we shall discuss a solution to bridge the discrepancy between private law and public law as instruments for solving conflicting environmental interests of parties. This is what I shall call the post-Austrian view on environmental policy.

The neo-Austrians Since the writings of Pigou (1912) and in particular Mishan (1967), mainstream economic thinking accepts that environmental problems are the consequence of negative external diseconomies or spillovers. Government intervention is accepted as the appropriate way to internalize such external effects in decision making. The representative textbook on environmental economics presents the Pigovian tax as the first-best solution and direct regulation, such as emission standards, as the second-best instrument to be handled by the government. However, the neo-Austrians are

348 Andries Nentjes no mainstream thinkers. They are proponents of the minimal state, who first look for the scope for private action before requiring public intervention. In Human Action (1966: 658; first edition published 1949) Ludwig von Mises calls the question of external effects a pseudo-economic problem. Rothbart in Man, Economy and the State (1962) is of the same view. In their neo-Austrian vision of the world, the origins and existence of social costs have to be traced to insufficient articulation of property rights and in deficiencies in the ways and means to enforce private property rights. Consequently, the solution should be sought in the identification and clarification of property rights; for example: do I have an unqualified right to quiet in my home, or has the neighbour the unqualified right to use noisy devices at any time of the day or night; or should a compromise be made between the two extremes? It is up to the court to decide on how the law applies here. If necessary, new legislation can be enacted. Through jurisprudence and within the boundaries of private law, the external effects are internalized and the pseudo-economic problem signalled by von Mises has been transformed into a legal dispute between private parties. The legal disputes in such cases of environmental nuisance would have to be settled in the context of tort law. My reasonable guess is that the neo-Austrians mentioned can be classified as supporters of a scheme of strict or no-fault liability. Liability law gives the victim of environmental damage the opportunity to claim compensation from the party causing the damage. The question in court is whether there is a causal link between the defendant’s action and the claimant’s damage, and, if so, how great the damage is. Whether the damage could have been avoided is not an issue in strict liability cases. The perspective of having to pay for damage inflicted on others is an incentive to adjust one’s activities to reduce the nuisance they cause, thus lowering the compensations to be paid to reduce such activities or even to stop them. Adequate design of liability or nuisance law enables citizens to regulate the nature and extent of activities causing environmental damage through private contracts. Once court cases have set the precedents clarifying where compensation begins and ends, parties can settle directly out of court. Government intervention by way of public law statutes can and should be avoided according to the neo-Austrian view on how to protect the public against environmental degradation. An illustration An illuminating early example of an environmental nuisance court case in England is Waterton v. Simpson, 1847–1850.1 Charles Waterton, a ‘traveller and conservationist’, was one of those eccentric country gentleman of which nineteenth-century England seems to have the patent. After his travels through the wilderness of British Guyana he withdrew to Wake-

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field, his country estate in Yorkshire. The park around the house was recreated as a nature reserve. With his great expertise concerning wildlife, Waterton created the habitats and niches for a great variety of birds and other animals. Until well into his old age he would climb a tree and set himself on a branch next to a bird’s nest without any sign of anxiety from the birds. However, paradise was under terrible threat. In 1840 Mr Simpson managed to establish the Walton Soap Works on a meadow next to the Waterton estate and nature reserve. The production of soap basically involves boiling a fat with an alkali and a salt. The Walton Soap Works produced their own alkali from salt and sulphuric acid. The list of pollutants to air and to the water of the brook which passed through Waterton’s estate included sulphuric acid, hydrochloric acid, soda ash and caustic soda. Public regulation did not exist. Waterton gives the following accounts of the effects on his estate: [T]he neighbourhood of Wakefield was chosen for the scene of devastation among gardens, fair meadows and richly wooded property . . . ancient trees, inestimable for their beauty and historical associations, as well as valuable for their timber, were scorched, dried up and killed. (Blackburn 1990: 150) The opponent Simpson retorted: Mr. Waterton, a lover of natural objects, allows trees to stand which on all other estates would have been taken out half a century ago; he sees these, and the tall chimneys, and he imagines the one produces the other. (ibid.: 511) Early in 1847 Waterton takes Simpson to court. By the end of 1847 the judge refers the case to arbitration. In October 1848 the arbitrator finds Simpson guilty of negligence and awards Waterton the sum of £1,100 as compensation; but net it is considerably less, since the arbitrator also orders Simpson to pay a share of the legal cost. The polluting activities at Walton Soap Works go on uninterrupted and Waterton starts a second court case. In August 1849 the verdict is that Waterton is not entitled to financial redress and Simpson is encouraged to maintain his high standard of safety. Waterton now prepares his third action with a shrewd manoeuvre. He has learnt that Simpson is trying to obtain more land in order to expand his factory. Waterton offers him for a very reasonable price an alternative site: an abandoned dye factory ten kilometres from Wakefield and situated on a different river. The arbitrator orders Simpson to move and pay the legal cost. In April 1850 a contract between the two parties is signed. Simpson promises to dismantle the old works and tear

350 Andries Nentjes down the tall chimneys. Waterton has to make the promise that neither he nor his heirs will manufacture soap in the empty buildings at Walton. Julia Blackburn comments that Waterton after four years of persistent legislation told himself that he had won his case, but the victory was only relative. He had lost hedgerows and trees, birds, animals and fish as well as a good deal of time and money; his water had been badly contaminated, his health and the health of his family had been affected and he had made a number of new enemies. (1989: 147) Moreover, pollution had not been eliminated but simply moved to a different environment. Did tort law work in this case as assumed by the neo-Austrians? Looking at the ultimate result, the answer is yes. Waterton claimed his right to clean air and clean water, and conquered and not in the weak form of receiving compensation for infringements on his rights, but by repelling the intruder. However, the transaction costs had been quite high. The compensation for the subjective damage suffered by Waterton had been far from complete. One can object that high transaction costs are the unavoidable price of establishing precedents in jurisprudence. That compensation was not provided in full may have been due to liability being based on negligence. Tort law is the traditional approach to legal liability issues and still in full swing in England halfway through the nineteenth century. The tort feasor has to pay damage, or to take remedies only in so far as he could have avoided the action that causes nuisance. Unavoidable damage is for the account of the victim. In the European Union there is today a clear move in progress from no-fault (tort) liability for environmental damage to fault (risk) liability, which means that all damage that has been inflicted has to be restored, irrespective of whether it could have been avoided or not. From a neo-Austrian perspective that should be welcomed. It allows a more transparent confrontation of values of the parties involved in the conflict of interest, since the (possibly mistaken) judgment of the court on what can and cannot be avoided is no longer required. A second important trend is the growing scope for group actions in lawsuits and for court action to protect so-called immaterial interests. Victims of one and the same polluting source can lower their transaction costs by joining forces in a group action. In an action for immaterial interests one can even try to protect nature without having a title to property. The recent developments will lead to more conflicts being resolved in court and a more refined jurisprudence specifying the property rights of those parties that cause environmental damage on the one hand and, on the other hand, the entitlements of the parties suffering from the degradation of their environment.

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The short survey of legal developments since Charles Waterton’s case again Simpson lends support to the neo-Austrian idea of how to tackle environmental issues. Over time, a commensurate scheme of environmental liability might evolve. However, direct government intervention would frustrate such an evolution, for example because it raises the question whether liability action under private law and regulation under public law are of equal rank. Before going more deeply into that issue we need to discuss the views of the founder of the Austrian school: Karl von Menger.

Karl von Menger on the environment Karl von Menger (1842–1921) held the chair of economic theory at Vienna University from 1873 until his retirement in 1903. In Europe those last decades of the nineteenth century were the episode of ‘the social question’. The Danube double monarchy was no exception. In the depression year 1870 Emperor Franz Joseph even went so far as to plead for ‘Arbeit für brave Hände’ (Work for honest hands) in an assembly of the Reichsrat (Streissler 1990: 113). To see this in perspective it should be remembered that traditionally, and certainly from the Metternich era on, Austria-Hungary had a highly paternalistic and interventionist state (ibid.: 111). The high tide of economic liberalism was over; on the European continent and in Austria-Hungary it had never attained full maturity. What was Menger’s political-economic position? It appears that he never took part in public discussion on policy issues (ibid.: 108). However, in a few places he gave his view on what he considered to be the legitimate tasks of the government. They have led to apparently contradictory assessments of his position, summarized by Kirzner as follows: ‘He was a champion of laisser faire; he favoured substantial state interventions; he had no clearly defined political position at all’ (1990: 93). We shall return to this riddle later on and for a start try to unravel Menger’s views on environmental issues. In Grundsätze der Volkswirtschaftslehre (1871) Menger points out that economic goods do not come into being unless there is scarcity. Those things that are not scarce presently and are expected not to become scarce in the future (the non-economic goods) will be used non-economically: ‘Z.B. beim Hölze durch Ausrodung oder Devastierung von Wäldern wie sie bei gewissen Kulturentwicklung eigentümlich ist’ (for example, in case of wood through eradication or devastation of forests as is practised in certain stages of cultural development) (ibid.: 63). I want to add here that in such circumstances of environmental abundance no environmental problem in the economic sense exists. However, when scarcity emerges – the available quantity falling below the quantity needed for full satisfaction of wants – the objects will be used economically. The mechanism at work is the incentive to seize scarce goods (including resources) and bring

352 Andries Nentjes them into ownership – Besitzergreifung, as Menger calls it. He identifies here private property as an institution born out of economic necessity; it is not a historical accident. From Menger’s work it is clear that in his view property and the possibility to exchange property are the foundation of the market economy. Illustrations are given for natural resources such as land, water (quantity and quality) and forests. Economic development can change non-economic resources into economic resources. The switch is brought about by dwindling supply due to inconsiderate use in the times when there was no scarcity and future scarcity was not foreseen. On the demand side, population growth and development of new wants are of significance as well as discovery of causal relationships between objects and the welfare they create, opening up new uses for goods. The observations would fit quite well into a modern account of how environmental problems emerge. Menger reminds his readers that Germany, although it was once richly endowed with forests, had seen these being transformed into economic goods in the process of economic development. What strikes the present-day reader is that the type of environmental degradation known as unpriced scarcity cannot occur. Wherever there is a threat of environmental scarcity, the resources under threat will be taken into ownership and be drawn into the domain of economic calculation and, one step further, a market price will be attached to them. In this perspective the neo-Austrian reflections on environmental issues can be seen as amendments to the old Austrian notions. The neoAustrians recognized that deficiencies in the established system of property rights and gaps can emerge which require new arrangements under private law. In a developing world, new scarcities appear and the process of Besitzergreifung these set in motion proceeds according to established legal procedures geared to refining and redefining the existing structure and bundles of private property rights. Yet this is not the full Menger. In the late 1980s the notes Crown Prince Rudolf made of the personal lectures given to him by Menger in 1876 were discovered in the Austrian State Archives. The lectures are basically a course in public economics. The lecture notes were taken and written out by the prince and corrected by the lecturer. Here we get a clear, genuine view of what, in Menger’s opinion, an emperor-to-be ought to know about the economics of the public sector. Streissler (1990: 110) gives a synopsis of the prince’s lecture notes and concludes that as a teacher Menger appears here as ‘a classical liberal of the purest water with a much smaller agenda for the state in mind than even Adam Smith’. Menger makes no mention of tasks for the government in the domain of distribution or stabilization and restricts the discussion to allocation issues, remaining within narrowly drawn boundaries.2 However, within these limits Menger refines and elaborates Adam Smith’s guidelines by expanding a broader principle of what nowadays is called externalities or spillover (ibid.: 113).3 Economic intervention by the state is reserved for abnormal circum-

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stances when, in the absence of such action, disastrous developments threaten. To turn off the negative externalities special laws are required, then. The following examples are given by Menger to illustrate the principle. One such example is measures to prevent and contain contagious diseases among cattle and plants. The individual farmer cannot defend himself, but the state can take adequate measures, such as quarantine or prohibition of imports. Negotiating and signing commercial treaties is also a government task, giving the individual access to foreign countries for his or her goods. Another is the prevention of abuse in the domain of working hours. The government forbade factories to have a working day of more than fifteen hours (!) because a longer period would sap the physical strength and health of labourers. Child labour should be forbidden as well, for the same reason and because it interferes with regular school attendance. ‘The vital interest of a whole class of the population’ is at stake here and should be protected ‘since the existence of industry rests on its shoulders too’ (Streissler 1990; 117). One can read this as a warning concerning the negative long-run externalities caused by profit-maximizing factory owners. The last example of a case where government intervention is necessary is by far the most interesting one for our subject. The crown prince has noted here: Quite often a forest-owner in the mountains who is temporarily short of money will want to clear out his high-lying forests. This can easily cause irreparable damage since the rainfall will then run off in torrents and wash out the humus layer. Floods in springtime, droughts in summer, and other kinds of damage in agriculture in the plains result from such deforestation of the mountainsides and tend to worsen over time. The Southern Tyrol, Istria, Dalmatia are sad object lessons of the blind greed of individuals and the thoughtless negligence of former governments. Protecting forests is among the major duties of the state that, by virtue of their importance, justify interference with individual economic activity. (ibid.; 118) Apparently Menger here provides the economic argument for an existing practice of regulation. He refers to a case of what in present-day terminology are negative external effects. What makes the case even more interesting is that the externalities cannot be dealt by bilaterally; they have the characteristics of a public bad. The activities of one or more forest owners inflict capital losses and other types of damage on thousands or tens of thousands of farmers and other inhabitants of the plains simultaneously. The negative externality has the feature that no one in the plains can exclude him- or herself from the consequences. Aggregate costs for the population can easily accumulate to many times the benefits for the forest

354 Andries Nentjes owners. Yet the individual victim in the plains whose damage is only a tiny fraction of total losses is locked in, unable to break out of his or her state by way of tort litigation. The judicial costs of such court action exceed the compensation the individual can expect. Uncertainty about the court’s ruling depresses the expected value; but even with the full certainty that full compensation for damage will be granted, litigation does not pay off. Suppose that an individual party were to start such a court action and be successful in stopping wood cutting in high mountains: then the whole population in the plains would benefit. This illustrates the property of non-rivalry of the externality. The only way to break out of the impasse is by having a procedure that bundles and represents the interests of the whole population of the plain, or at least a considerable proportion of the victims. One can see Menger’s intervening state as such a representative, using its public authority to force a breakout of the lock-in situation by pomulgating a public regulation and enforcing compliance with it. If the type of externality is such that emerging environmental scarcity does not instigate the process of private property taking, the state has to intervene. Although Menger’s own argumentation does not go that deep, it does legitimize the state’s use of public law in the domain of environmental problems, next to the category of environmental issues that can be decided by the courts in the regime of private law. Menger’s view is highly relevant today. The largest environmental problems turn out to be extremely public in character. Acidification and eutrophication are a truly European problem due to transboundary emissions involving more than thirty European states. Climate change and deterioration of the ozone layer even have a global scale: hundreds of millions of emitters as well as entities suffering damage are involved. It is unthinkable that court action by private plaintiffs could successfully hold the multitude of tort feasors liable for damage and retract compensation or reduction of emissions. The neo-Austrians have a blind spot for the public good characteristics of modern environmental pollution, which thwarts solutions through private law. As far as their publications from the 1960s are concerned (Rothbart 1962; Mises 1966; Hayek 1960), there is the excuse that at that time the new phenomenon of large-scale pollution had not yet been perceived as a social and political problem. One also has to recognize that the authors mentioned focus on natural resource issues, where internalization of spillovers through demarcation of property rights is much more feasible because of spatial concentration than in the case of environmental spillovers, which tend to diffuse widely through air and water. The tragedy here is that although the space to emit pollutants has become scarce in a physical sense – and even though the knowledge of the causal relationships between humankind, the economy and the environment has grown immensely – emission space is not ‘naturally’ transformed into an economic good, because it cannot be seized and taken into possession. Possession means being capable of excluding other would-be users

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from using that which is owned. But how could this be done? Suppose a single ‘entrepreneur’ were to try the experiment: demarcate an airshed above the land he owns and get the support of the highest court in his claim on private property of the airshed. To enforce his right as owner to exclude others from trespassing on his property he would have to identify all emitters at short and long distances from his property, prove that they were trespassing and stop them through the courts if necessary. The costs of enforcing his property right and thus creating the base for selling the use of his airshed would be immense, even if he restricted his actions to nearby firms and households. On the other hand, each single emitter has to negotiate with as many owners of airsheds as make themselves known to him, to buy access to their airsheds. This thought experiment brings out the ‘public bad’ character of emissions and the like: when emissions are produced, they affect many, and not merely a single party or a few parties. One might refer to Coase’s theorem and recall that this is a case where emitters have actually seized the property right by emitting and actually using the environment as a sink. If, then, this harms other functions and makes them scarce, and thereby changes them into economic goods, why do those who are harmed not turn up to buy their quantities by paying for reduction of emissions? Again the public bad features of pollution and the public good character of reducing it are the barriers to a market solution. Parties cannot be excluded from the benefits of lower emissions bought by one party. Potential buyers will free-ride and a market will not develop.

Post-Austrian environmental policy Our quest through the Austrian school for guidance on the question how to tackle environmental problems has delivered arguments for privatizing human use of the environment in all its functions (the neo-Austrians) on the one hand and on the other hand a plea for direct government intervention by way of public law (the old-Austrian Menger). Could it be possible to bring these two seemingly opposing views together in a synthesis? I shall try to do so in what one might call a post-Austrian synthesis on environmental policy. To make a start, I shall present a short history of environmental policy. Although the case focuses on the Netherlands, it is illustrative of how public intervention has developed in industrialized countries facing increasingly serious environmental problems. We shall see how environmental policy has run into a deadlock and how post-Austrian environmental policy offers a way out. The Dutch nuisance law and its aftermath Local environmental policies in towns have a history dating back centuries, but national environmental policy in the Netherlands started as late as 1875 with the Nuisance Law. The law introduces a licensing system for

356 Andries Nentjes activities by firms which might cause a nuisance and harm to the neighbourhood. Installations are allowed to operate only if the firm has applied for and obtained the required Nuisance Law licence from the local government. The licence enumerates the measures to be taken by the firm in order to limit the nuisance for other households and firms in the neighbourhood. It is not coincidental that the law came into force at the dawn of the industrial revolution, which came relatively late in the Netherlands. Industrial works were built in quarters where people lived, polluting and harming their immediate environment through smell, bad air, noise and polluted waters – the experience Waterton had lived through thirty years earlier. Problems manifested themselves at the spatial scale of district or town, were limited in numbers and involved relatively simple technologies. Understandably, public law intervention took the form of a type of direct regulation commanding the use of specific, known pollution-control technologies. After decades of high economic growth the environmental problem reemerged on the political agenda from the late 1960s on. But now, pollution by industry, transport and agriculture was manifest on a much larger spatial scale: not local, but regional, national and, in the case of water, even international. New environmental legislation was drafted; basically it was a copy of the system and procedures of the old Nuisance Law, but now with a focus on regional and national decision making instead of decision making on the local level. The requirement that firms have to apply for and get a licence specifying the measures to be taken at the source to achieve maximum protection of the environment, if not too expensive, was also applicable to the big polluter, which usually had to address the regional or national environmental authority. For our historical account the feature to be remarked on is the continuation, spread and scaling up of the command and control approach, focused on the micro level of plant and, within the plant, even each single source or installation. It should be clear that if such a policy course is taken, total reduction of emissions and the residual total of regional and national pollution is the unplanned and uncontrolled outcome of all decisions per plant or installation. Total national and even total regional emissions are irrelevant as long as environmental harm is a neighbourhood or local phenomenon caused by concentrations of polluting activities in a further relatively clean space. Things are different if emissions of all national (Dutch) sources together, or even all European sources, or all emission sources in the world in aggregate are the cause of the environmental problem. If one looks back over the past forty years, one of the most striking trends is the increase in spatial scale of environmental problems. In contrast, and despite all efforts undertaken in the past twenty years to improve and streamline the licence system, the myopic, source-oriented legal command and control approach has been maintained. What has been said here about environmental policy in the Netherlands also pertains to the European Union’s environmental policy. The

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hard core of European environmental policy is a licence system for major polluting plants and installations. Since 1972 the European Union has issued directives ordaining minimum requirements for emission standards. A central office in Seville makes inventories of Best Available Technologies Not Exceeding Excessive Cost (BATNEEC) which should be prescribed by governments of member states for specific installations (see van der Laan 2002 for a survey). Only since the late 1990s has the stance of European environmental policy been changing. Nowadays, uniform minimum environmental quality norms are the primary aim and it seems to be understood that on a national level this will require emission standards that may differ considerably between member states. Yet although more differentiation in emission standards between member states is accepted, commands on the micro level of firm, plant and source are still the habitual legal procedure employed to solve European-wide environmental problems. A somewhat rhetorical assessment of EU and Dutch environmental policy would conclude that the centrally planned economy collapsed in Eastern Europe around 1990, but that it is still in full service in the European Union in the domain of environmental policy. To be fair, in the Netherlands ever since the early 1980s the Ministry of (then) Health and Environment has perceived that its policy is in need of improvement. A major step forward was the efforts to calculate the quantities of pollution the environment can bear and decide on a time path for maximum total national emissions, as a compromise between what is necessary for the environment on the one hand and what is technically feasible and economically acceptable for business on the other. The consequence of this focus on national emission targets has been that the authority to decide upon minimum emission standards for sources had to be taken away from local and regional authorities and to be transferred to the national (The Hague) and EU (Brussels) levels. What we see is that the commands and controls regarding what firms should do and not do has gradually and unnoticed shifted to higher and higher levels of centralization. In that sense, the centrally planned economy of environmental policy has become more and more centralized. From an Austrian perspective as well as a mainstream neoclassical economic perspective the observer will be pessimistic about the effectiveness and efficiency of such a command and control economy. And indeed costs are running up and targets are not achieved. In search of a way out of the impasse, the environmental authority (Ministry) in the Netherlands has tried since the early 1990s to combine the command policy with the consensus policy. Such an approach, of making a deal between public authority and major interest groups, had been developed during the past fifty years, in particular in labour relations: for example, labour unions restricting their claims for higher wages in exchange for improvement in social security arrangements. The environmental covenant was the consensus approach in its newest appearance and

358 Andries Nentjes it has been highly praised by the parties involved; but it has become apparent that in many covenants organized polluters do not deliver what has been promised. The failure is particularly apparent in industries with many and heterogeneous firms. In such cases there are difficulties in distributing the burden of pollution control among group members, and additionally, trade organizations that have negotiated the covenant have no effective means of enforcing compliance by individual group members. So, the group has an internal free-rider problem. Negotiations between officials of the Ministry of the Environment and representatives of the chemical industry about nitrogen oxide (Nox) emissions have been going on for many years and illustrate the major bottlenecks. Tradable permits Is there a workable alternative and, if so, could it be Austrian in spirit? We turn to Hayek. He may be renowned for his view of the market as a highly complex mechanism collecting and disseminating information on the scarcities of economic goods, but there is more than that in Hayek. In The Road to Serfdom (1944: 28, 29) he had already made it clear that the market can never be the exclusive mechanism of economic coordination; as he writes: There are, finally, undoubted fields where no legal arrangements can create the main condition on which the usefulness of the system of competition and private property depends: namely, that the owner benefits from all the useful services rendered by his property and suffers for all the damages caused to others by its use . . . there is divergence between the items which enter into private calculation and those which affect social welfare; and whenever this divergence becomes important some method other than competition may have to be found to supply the services in question. . . . Nor can certain harmful effects of deforestation, or of some methods of farming, or of the smoke and noise of factories, be confined to the owner of the property in question or to those who are willing to submit to the damage for an agreed compensation. In such instances we must find some substitute for the regulation by the price mechanisms . . . we have to resort to direct regulation by authority. The quotation refers implicitly to Menger (‘certain harmful effects of deforestation’) and anticipates critically the later liability proposals of von Mises and Rothbart (‘Nor can certain harmful effects . . . be confined to those willing to submit to the damage for agreed compensation’). In The Road to Serfdom and elsewhere in his work, Hayek does not pay much attention to the question of what form this required ‘direct regulation by authority’ should take. However, in The Constitution of Liberty (1960: 370) he gives a hint that is highly relevant for our interpretation of Austrian

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thought on direct regulation. In the context of an exposition on natural resources Hayek writes: It cannot be denied that there are some facts concerning probable future developments which the government is more likely to know than most of the individual owners [of the natural sources] . . . it is equally true that the government will be ignorant of relevant facts known to some others. We can bring together all the knowledge that is relevant to particular problems only by dispersing downward all the generic knowledge available to the government; not by centralizing all the special knowledge possessed by individuals. It is evident that with regard to environmental problems, and once a problem has become an item on the political agenda, the public authority is the organization with superior knowledge of national environmental impacts of pollution. The government is the appropriate organization to carry out and finance environmental research on quantity of emissions, their expected growth, their diffusion and the ultimate impacts of the pollutants. The government is also the organization to weight the environmental benefits of lower pollution loads against the estimated costs of emission control. It is, then, the government that must decide how much of the public good pollution control should be provided. The key decision is how many kilotonnes of sulphur dioxide, volatile organic compounds in air, etc. per year can be accepted for the next ten or twenty years. Deciding upon and announcing a time path of annual emission caps is, then, the first step in ‘dispersing downward all the generic knowledge available to the government’. A similar action would be involved in the restriction of wood cutting in mountain areas, as defended by Menger. By setting national and, if necessary, regional emission caps for a number of successive years, the government creates the scarcity of space for emissions that is necessary for the containment of public bads. The next step is to change emission space into an economic good, which can be done by making the allowance to emit one kilogramme or tonne of a specific pollutant in year X the unit that can be owned and used or transferred. Keizer (1984) has pointed out that Ludwig von Mises in his writings on the impossibility of socialist calculation in the 1920s had forcefully brought forward the fact that well-functioning markets will only develop if property rights are allowed to concrete, existing organizations (Mises 1924). The essence of ‘property is the right of use’ (ibid.: 791, cited from Keizer 1984). The allowance to emit is a specific form of property. A market can develop only if the right of use can be transferred to others. The same holds for emission permits: they should be tradable, without restriction on who can own the permits. If the government, following Hayek’s advice, does what it can do best it will determine the cap on total emissions and on that basis also the total

360 Andries Nentjes number ( supply) of emission permits to be issued. It has to be decided who shall be owners and how the permits are to be made available. Basically, the three options for allocation are similar to those of governmentowned goods that are to be privatized. The first option is to consider the government as the true owner of emission space and auction the permits. The alternative is to distribute emission permits for free among the population, similar to vouchers in case of privatization in some Eastern European countries (for this option for tradable CO2 permits, see Nentjes et al. 2002: 6–9). The third possibility is allocation of emission permits for free to emitting firms. Whatever the initial allocation of permits may be, in all cases a market will develop between private parties owning the permits. Tradable emission permits are of the same class as tradable quota (such as for milk production, fish catch, etc.) Experience teaches that free allocation to former users, more or less in proportion to their historical use, is the politically most feasible and most practised option. The rules for allocation should be clear and should leave no doubts about exactly what the permit entitles its owner to do. This is the first pillar of a scheme of tradable permits. The second pillar is accurate registration of permit ownership and its transfer. The third indispensable element is precise measurement of actual emissions. At the end of the adminstrative year the account is made up: actual emissions are compared with permit ownership. In case of non-compliance – that is, a permit deficit – a considerable penalty should be paid. Public monitoring and enforcement of compliance is indispensable for creating and maintaining property rights and markets based on scarcity created by public law. The difference with property of private goods – such as owning a house or a share in a limited liability company – is that ownership of an emission permit is a right vis-à-vis a public authority. It is a kind of entrance ticket that has value only if entrants are checked out and have to hand over their tickets. Allocating emission permits and preventing the use of emission space without legal title are all that government should do. By taking these actions it has sown the seeds from which the system will evolve that disperses the generic knowledge available to the government downward to individuals. Property rights and a legal order to protect their proper use are sufficient conditions for seeing markets spring up, as experience teaches. Middlemen (brokers) will enter the market and intermediate between buyers and sellers (Klaassen and Nentjes 1997). The big difference from the traditional command and control method of regulating the use of environmental space is that instead of there being a rigid command from the top to the bottom level on how much to emit maximally, the firms have flexibility to make their own choice on how much to emit and on how to control or prevent emissions, taking into account all the relevant circumstances and preferences at the micro level – things about which the government will be ignorant. The market translates and disseminates all the information in the scarcity signal of environmental

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space: the permit market price (the spot price as well as the forward prices). On the other hand, the market price is also the compass for the individual firm (and household), guiding its decisions. Neoclassical theory as presented in the economic textbooks gives a peaceful picture of a permit market equilibrium, where all market participants have adjusted to the prevailing market price. Polluters with high marginal control costs relative to permit price will prefer to buy extra permits to cover emissions and thus save on abatement cost. Firms with low marginal control costs will intensify abatement until their higher abatement costs are equal to permit price and will then sell their surplus of permits. Through this mechanism, pollution control will concentrate at those places where its costs are lowest. Economic growth will shift the demand for emission permits upwards and, given the available stock of permits, the market price will go up, thus inducing increased pollution control to ‘absorb’ the increase of potential (unabated) emissions. A higher permit price will also be an incentive to step up investments in research and development of cleaner technology, which in the long run will depress the demand for emission permits, and therefore their price. In my view the neoclassical blueprint of markets for tradable permits captures fundamentals of how permits work and coordinate individuals’ decisions. In many respects the blueprint is also very old-Austrian in pointing out that the market price signals scarcity and that scarcity depends on several distinct factors. Yet it cannot be denied that the focus on market equilibria makes the analysis incomplete and the picture too rosy. NeoAustrians detest the Idealtypen of neoclassical economics and accentuate the rough-and-tumble of market prices, their incessant being on the move, reacting to ever-changing circumstances. Yet they stick to the view that market price transmits information. The market price is the result of all individuals’ demand, including own demand, given the available present and future stocks of permits. The market price reflects all available information individuals have about emission control technologies and their expected improvements. It also reflects plans to increase output capacity and the consequential increase of potential emissions. The price will also reflect beliefs and uncertainties of market parties about future environmental policy. The permit price evolves on the market, where individuals face an unknown future and have to make guesstimates about what that future will bring. Their uncertainties and changes in beliefs will be reflected in the volatility of the market price. Experience with the US market for tradable sulphur allowances illustrates the above dynamic view of the market process very aptly. When the scheme of tradable sulphur allowances was designed in the late 1980s, the experts expected that marginal control cost and consequently the market price would be around $1,500 per ton of sulphur. Based on that expectation, the penalty for having too few permits to cover emissions was fixed at $1,500 per ton of excess sulphur emissions. When the first transactions were made in 1992,

362 Andries Nentjes anticipating the start of the scheme in January 1995, the price was between $180 and $270 (Klaassen and Nentjes 1997). The spot price subsequently fell to $130 in 1995 and went down to no more than $70 in 1996. Since then it has fluctuated. What these figures bring out in the first place is that marginal control cost and permit price have turned out to be much lower than expected in the late 1980s: by more than 80 per cent. But it is also evident that the price has been very volatile, probably reflecting big changes in expectation about the future. Ex post, one can find plausible explanations for the ups and downs of the sulphur allowance price; the important thing to note here is that no one predicted or expected these wild swings in price. In the projections that have been made to calculate cost savings deriving from this economic instrument, the rosy picture of a gradually increasing permit price is usual. The neoAustrians, if consulted, might have warned those involved to be more cautious and would have underlined that the market is necessary just because we do not know the future; neither the market parties nor the government know it. The experience with tradable sulphur allowances also illustrates that the government should be modest in its pretence of being capable to foresee and direct the development and introduction of improved environmental technology. It may have demonstrated its capability of doing so in its traditional approach of mandatory emission standards. But here it rests on the effectiveness of the command and control method to suppress innovative creativity. Until recently one had to look to the United States for policy initiatives introducing schemes of tradable permits of the cap and trade type. However, the European Commission, with the support of the Council of Ministers, has developed the idea of a cap and trade scheme for CO2 emissions of energy-intensive industry in the European Union. The latest proposals, discussed in the European Parliament in October 2002 and approved with a huge majority, set 1 January 2004 as the date for starting the programme. This is an unexpected turn of the tide, and the promise of a real breakthrough. To assess its qualities we have to wait for its design and see whether basic errors – such as adequate monitoring, sloppy mechanisms for enforcement of compliance, restrictions on trade in allowances, insufficient protection of emission allowances against unpredictable political interventions – can be avoided when designing the scheme. Tradable emission reduction credits In the Netherlands in recent years the understanding has been growing that for pollutants such as Nox emissions and also CO2 emissions from large combustion installations, the traditional approach of emission standards and covenants does not function adequately. Policy makers, in particular members of the environmental civil service, recognize that

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some form of exchange between sources would increase their flexibility and help to achieve the industry’s emission targets at lower costs. For Nox emissions a scheme of tradable emission reduction credits has been worked out. The intention was to start the programme in autumn 2004. Leaving aside the details, the scheme boils down to uniform Nox emission standards with flexibility through transfer between sources of non-mandatory emission reductions. The emissions allowed to a firm over a year are equal to the firm’s energy consumption multiplied by specified Nox emissions allowed per unit of energy use. If the firm actually emits less emissions than allowed, calculated according to the formula, then it earns emission reduction credits (ERC) which it can sell to firms with actual emissions that exceed the emissions allowed by emission standard and output. Is this the market for use of environmental space that meets our postAustrian criteria and transmits information available to the government down to the firm level in an adequate way? The answer is no: the heart of the problem is that the property rights specifying the right to emit are inadequately defined. The ERC scheme works in such a way that a firm becomes smaller (and thereby reduces its energy input) or shuts down also curtails its allowed emissions; therefore, such adjustments do not create ERCs. On the other hand, entrants that start up, and firms that expand their operations, get (additional) allowed emissions proportional to their energy use, for free. The method may look sympathetic at first sight, or even fair, because firms receive allowed emissions according to their needs. There are even people calling themselves economists who maintain that it is the appropriate approach by which to avoid barriers to entry for new firms. However, on further reflection it should be crystal clear that the ERC scheme is no good, even though it is preferable to mandatory emission standards without credit trade. In a true market based on the property rights of participants, the entrant usually receives its property rights through purchase from someone who is leaving the market. This is how the emission permit system works. With tradable emission reduction credits it is different. In periods of economic growth, new credits drop like manna from heaven for entrants and expanding firms. More new emissions are allowed than are withdrawn through exit and shrinkage of firms. This clearly is bad for the environment, but, less obviously, it is also bad for the economy. Take the example of Nox emissions. One type of technical option to reduce Nox emissions is to install control equipment or make improvements to the combustion process. Other options are to save on energy consumption by reducing output or changing its composition. But the Dutch Nox ERC scheme discourages the last two options since reduction of fuel use, either through energy saving or lower output, is ‘rewarded’ by the reducing of allowed emissions; consequently, this type of reduction of Nox emissions does not yield emission reduction credits. If firms decide to increase Nox emissions by expanding

364 Andries Nentjes their output or by using more energy per unit of output, this is for free as long as the firm does not exceed its emission standard. Credit trading clearly is an instrument with an in-built distortion of incentives, leading to an inefficient allocation in emission reduction activities. In contrast, in a scheme of tradable emission permits, energy conservation and shutting down firms with low profitability do yield revenue since the emission permits can be sold, while entrants have to buy in themselves to get entry to emission space. In the Netherlands the dominant view of policy makers seems to be a type of post-Keynesianism that looks upon every case of closing or downsizing of firms, even if they are really at the margin of profitability, as a loss of employment, output and welfare. In times of a booming economy this is simply a misconception. In years of economic low tide it is a very narrow and short-sighted view of the economic process. We have to confront it with the neo-Austrian view, in particular in its Schumpeterian appearance. Shutting down a marginal energy-intensive firm is a deed of creative destruction: the most efficient way of reducing Nox emissions, creating emission space, and setting capital and labour free for new innovative firms with high added value per unit of Nox emissions. A scheme of tradable permits with genuine property rights in emission space creates the appropriate conditions and incentives for such creatively destructive adjustments. We conclude that the scheme of tradable Nox emission credits that has been planned for the Netherlands and will start by the end of 2004 is far from conforming with the market and is bound to fail to achieve the planned reduction of Nox emission unless it gets the support of an unusually deep economic slump. The plan for reducing CO2 emissions for energy-intensive industry, worked out by the Vogtländer Committee, was based on the Nox ERC model and shows the same weaknesses. The probability that it will be implemented seems very small now that the European Union is heading towards a system of tradable CO2 permits with an absolute cap to total industry emissions and no ways to allow free entry to emission space. The Dutch treat will not be accepted and dismissed as a distortion of competition in the common market. Evolution of environmental policy instruments If one looks at the development of the instruments of environmental policy in Western European countries from a long-run perspective and focuses on the Netherlands as a paradigmatic case, the conclusion must be that one can see the contours of slow but gradual progress. It goes from source- and location-oriented technical regulations at the beginning of the 1970s towards centrally decided emission standards at the national European Union level, and also includes simplification and standardization of the procedure for acquiring an environmental licence in the 1980s. In the 1990s we observe the rise of the more flexible and faster

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environmental covenant. Looking forward, one can foresee the first decade of this century bringing the first experience with uniform national emission standards made flexible through trade. Yet despite all progress, a fully market-conforming environmental policy has not been achieved: cap and trade programmes are not on the political agenda in the Netherlands. In a short survey of developments in member states of the European Union, Woerdman (2002) finds only a few and rather weak national initiatives. As was mentioned, a European Union directive for a cap and trade programme for CO2 emission of large combustion plants is in the making. For the moment this is the most hopeful sign of a turnaround from command and control methods in environmental policy towards marketconforming approaches. One may wonder what forces other than time and ignorance are inhibiting progress in government policy in Europe. A possible barrier might be the obstruction of powerful interest groups which block a policy that is in the general interest because it would undermine their specific interests. But which interest group is the culprit here? Dijkstra (1999) has shown that a cap and trade scheme with free distribution of permits to incumbent firms suits the interests of shareholders better than any other instrument does. If managers of joint stock companies seek the maximum shareholders’ value possible, they should support cap and trade programmes. Casual observation of Dutch experience reveals that they prefer emission standards with tradable reduction credits. An ad hoc explanation for such behaviour could be that managers are really more interested in keeping up sales and employment, which do perform better under a tradable credit scheme than under cap and trade. Perhaps it is not too far-fetched to associate the differences in penetration of tradable permits schemes between the United States and the European Union with the more ‘capitalist’ firm model in the United States, strongly geared to the shareholders’ interest, versus the continental European ‘Rhineland model’, with its broader spectrum of firm objectives among which stable employment for the firm’s personnel is certainly not the least. To put it more bluntly: it is the divide between a culture that accepts and even admires creative destruction versus a culture that emphasizes, above all, stability in economic and social conditions. The above search for forces thwarting a market-conforming environmental policy does not exclude another line of investigation and explanation. One of the main lines in Hayek’s work is the idea of evolution of human society, in particular the evolution of its economic organization. It is encapsulated in his vision that the market economy is the result of human action, not of human design. If one takes the Hayekian perspective on development of government policies in a market economy, the last thing to be expected is that the rise of new scarcities with strong public good characteristics – environmental scarcity – will be solved by one brilliant strike of human design: the cap and trade scheme. Much more in

366 Andries Nentjes agreement with the Hayekian ‘vision’ (in the sense of Schumpeter 1954) is the kind of muddling through in shaping and implementing environmental policy instruments that we have seen during the past thirty to forty years. In various respects that episode of evolving environmental policy reflects the ideas and developments that shaped the political-economic history of Europe during the twentieth century. It was the age of large-scale experiments with the communist, corporatist, national socialist and welfare state models as ideal types for organizing the economy, and these were very much political reactions to the type of market economy that had developed during the nineteenth century. Most of those human designs turned out to be dead-end alleys in the process of societal evolution. Communist economic organization managed for many decades to impress scores of observers who considered themselves to be experts, but in the end the Soviet empire was brought down. In fact, it failed economically for precisely the reasons indicated by von Mises as early as 1924 and politically for reasons indicated by Hayek from 1944 on. In short, the communist system was unable to create a level of economic welfare and human well-being that could compete with the more market-oriented organization of economic life in the West. Although it would be an over-simplification to explain the transformation of economic systems over the past century exclusively in terms of between competition systems and survival of the economically fittest – that is, most efficient – systems, this dimension certainly has been of influence, among other forces. Acceptance of that approach to interpreting the great transformations in economic society can also be helpful for discerning the goings-on in sections of society and policy. Governmental policy to cope with new and changing environmental scarcity bears the marks of societal ideals and views that affect the routes chosen to try to escape emerging impasses. It is no accident that in Dutch society, with its surviving strong corporatist element, in particular the search for consensus between major interest groups, the environmental covenant has been invented and hailed as the almost perfect instrument. Yet just as in society at large, on the sector level too there are economic forces at work as well as ideology and tradition. In an internationally open society, as we have in many respects in the West, policy competition could function as the mechanism for selecting out the fittest policies and eliminating the evidently unfit policy variants. In a future of continued economic growth in an environmentally finite world, the tendency in developed countries will be towards an increasingly stringent pollution control policy, which will also tend to absorb an increasing share of the national product. The costs of controlling pollution will become an increasingly important component of costs of production. Assume that in such a world national schemes with floating emissions ceilings and credit trade exist next to cap and trade schemes with fixed emission ceilings. If my predictions about the superior efficiency of cap and trade systems are correct, the schemes chosen will be among the components distinguishing

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economies with good overall performance from economies with poor performance. In so far as the factors explaining differences in economic growth are identified, internal pressure in poorly performing countries might develop for economic reform, including a more market-conforming environmental policy that does not rely on the pseudo-market of credit trading but instead creates the conditions for a real market with a price that genuinely reflects environmental scarcity and internalizes it in firms’ decision making. The above scenario may look over-optimistic. But let me give an example to illustrate my evolutionary view of instrument change in environmental policy. It has already been mentioned that the European Parliament has adopted with an overwhelming majority the proposed directive for a cap and trade scheme for CO2 emissions from large combustion plants to start as early as 1 January 2005. The Parliament has even understood that in order to get sufficient support from industry, the majority of permits have to be handed out for free. The Parliament now accepts that no more than 15 per cent of permits will be auctioned. As I said, this is a surprising U-turn in EU environmental policy, which up to now has basically been a scheme of mandatory minimum emission standards for sources. The story of how this change of mind on the part of policy makers came about still has to be written, but it is difficult to imagine that it could have occurred without the recent experience in the United States with well-designed cap and trade schemes, in particular sulphur allowance trading for electricity producers and the positive assessment of that experience in research reports. That experience has contributed immensely to reducing uncertainty among practically minded politicians and civil servants who distrust blueprints for schemes not yet in existence put forward by economists. If no insurmountable obstacles arise that block the introduction of tradable CO2 permits in Europe, and no fundamental errors are made in elaborating its design and implementation, the actual experience with tradable permits in the European Union will provide information on its functioning that can be compared with the performance of traditional command and control approaches in other areas of environmental policy. The results of such assessment could become the motive for the start of further environmental policy reforms. Basically, one sees here the selection mechanism at work, through which the fittest environmental policy survives in an ever-changing world.

Conclusion This chapter has presented a selection of what old-Austrians and neoAustrians have said and written on the question of how to deal with environmental problems when they become manifest in a market economy. It turned out that their insights provide the theoretical foundations for a modern ‘post-Austrian’ environmental policy.

368 Andries Nentjes One thread in neo-Austrian thinking is the view that what is needed in the first place is a further development and refinement of private law. Tort law should support citizens who suffer from environmental harm in demarcating the rights of polluters and pollutees, thus stopping excessive pollution. One can see this strand of thinking as elaboration of a line of thought in Karl von Menger, the founding father of Austrian economics, who had predicted that emerging uncontrolled resource scarcity would be redressed by individuals seizing resource ownership. Improvements in tort law imply a restructuring of property rights, and they channel the process of Besitzergreifung within an orderly legal bedding. I have dismissed this view as being too narrow and unsuitable where pollution control has the characteristics of a public good. Surprisingly, it was the same Karl von Menger who recognized the problem and made a pledge for government intervention through the public law method of direct regulation. A concise history of environmental policy in the Netherlands since the industrial revolution serves to illustrate that direct regulation and not tort law has been the dominant approach. But in the face of increasing environmental scarcity on an ever-extending spatial scale, the traditional method of licensing and instructing the licensed firm on what measures it should take was confronted with ever bigger bottlenecks that could not be removed sufficiently by improving the quality of the commands and controls. However, between the Scylla of self-help only and the Charybdis of a government taking charge and commanding everyone, I traced a third way, one that combines old and new Austrian insights. The government intervenes only where and in so far as necessary and creates legal conditions that enable the markets to coordinate individuals’ environmental use decisions. The government seizes the ownership of the public good emission space, thus making it an economic good, and allocates private user rights to private entities. The government also applies criminal law to repress theft of emission space. By these government actions, public emissions space is privatized and the legal framework creates the conditions for a well-functioning market in private user rights. Participants transfer their information through the market price, which in turn coordinates their economic decisions as users. The visible hand of government command and control to guide decisions can be transferred to the invisible hand of the market. Privatization of emission space should be radical. Solutions such as emission standards with credit trade fail to create the conditions for a true market. Because the public authority unduly discriminates between the ways private parties reduce their use of emission space, the credit market is a pseudo-market with a misleading price signal of true environmental scarcity. Correct and complete privatization appears to be politically a hard job – in the West no less than in the East.

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Notes 1 The case is presented in greater detail in Julia Blackburn’s entertaining biography of Charles Waterton (1990). 2 Kirzner (1990) referring to Boehm (1985), has pointed out that in 1884 in Die Irrtümer des Historismus in der deutschen Nationalökonomie Menger does include just distribution of income, together with improvement of the situation of the working class and encouragement of individual ability, thrift and entrepreneurial activity, in his list of five legitimate tasks of the state. Kirzner speculates, but quite convincingly, that as a liberal in the Austrian tradition of ‘Josephenismus’ Menger may have had the personal feeling that a different, less feudal, more equal distribution of property had to be preferred and would not be in conflict with the ideal-typical market economy of his theoretical works. In my view one can understand very well why Menger would not and could not discuss such issues in his lectures for Crown Prince Rudolf. 3 Streissler detects here elaboration on the work of Rau (1826-1837) and Heiman (1832) of Adam Smith’s observations on ‘public works which it can never be for the interest of any individual, or small numbers of individuals, to erect or maintain’ (book 4, ch. 4.51).

References and further reading Blackburn, J. (1989), Charles Waterton, 1782–1865: Traveler and Conservationist, The Bodley Head, London. Boehm, S. (1985), ‘The Political Economy of the Austrian school’, in Piero Roggi (ed.) Gli economisti et la politica economico, Edizione Scientifiche Italiane, Naples. Dijkstra, B.R. (1999), The Political Economy of Environmental Policy: A Public Choice Approach to Market Instruments, Edward Elgar, Cheltenham, UK. Hayek, F.A. (1944), The Road to Serfdom, Routledge, London. Hayek, F.A. ([1960] 1972) The Constitution of Liberty, Henry Regnery, Chicago. Houmanides, L.Th. and Leen, A.R. (2001), A Great Revolution in Economics: Vienna 1871 and After, Cerealis Foundation, Wageningen. Keizer, W. (1984), Further Contributions by L. von Mises to the Central European Debate on Socialist Calculation, Research memorandum 1984 – 16, VU, Economische Faculteit, Amsterdam. Kirzner, J. (1990), ‘Menger, Classical Liberalism and the Austrian School of Economics’, in B.J. Caldwell (ed.) Carl Menger and His Legacy in Economics, Duke University Press, Durham, NC. Klaassen, G. and Nentjes, A. (1997), ‘Sulphur trading under the 1990 AAA in the US: An Assessment of First Experiences’, Journal of Institutional and Theoretical Economics 2: 384–410. Menger, C. (1871), Grundsätze der Volkswirtschaftslehre, Braumüller, Vienna. Mises, L. von (1924), ‘Neue Beiträge zum Problem der sozialistischen Wirtschaftsrechnung’, Archiv für Socialwissenschaft und Socialpolitik, vol. 51. Mises, L. von (1966), Human Action: A Treatise on Economics, 3rd edn, Contemporai Books, Chicago. Mishan, E.J. (1967), The Costs of Economic Growth, Staples Press, London. Nentjes, A. et al. (2002), National and International Emissions Trading for Greenhouse Gases, Dutch National Research Programme on Global Air Pollution and Climate Change, Report no. 410200093, Groningen University, Groningen.

370 Andries Nentjes Pigou, A.C. (1912), Wealth and Welfare, Macmillan, London Rau, K.H. (1826–1837), Lehrbuch der politischen Ökonomie, vol. 1, Grundsätze der Volkswirtschaft, Heidelberg 1828; vol. 3, Grundsätze der Finzanzwirtschaft, Heidelberg 1832, 1837. Rothbart, M.N. (1962), Man, Economy and the State, Van Nostrand, Princeton, NJ. Schumpeter, J.A. (1954), History of Economic Analysis, Oxford University Press, New York; George Allen & Unwin, London. Shand, A.H. (1990), Free Market Morality: The Political Economy of the Austrian School, Routledge, London. Streissler, E.W. (1990), ‘Carl Menger on Economic Policy: The Lectures to Crown Prince Rudolf’, in B.J. Caldwell (ed.) Carl Menger and His Legacy in Economics, Duke University Press, NC, pp. 107–133. van der Laan, R. (2002), ‘The European Environmental Policy with Respect to Stationary Sources: Harmonization versus Differentiation’, Ph.D. thesis, Groningen University, Groningen. Woerdman, E. (2002), ‘Implementing the Kyoto Mechanism: Political Barriers and Path Dependence’, Ph.D. thesis, Groningen University, Groningen.

Index

absorptive capacity 227, 229–30, 236, 237 Affluent Society 9 ageing 185–6 alienation rights 312–13 American Economic Association 280, 290, 291 An Essay of Innovations 258 Anglo-Saxon economics 261 Anti-intellectualism in American Life 278 anti-intellectualism 278–86 anti-trust policy 211–12, 214 arbitrage opportunities 8 Aristotle 50, 52, 259 Arthur, W. Brian 288 Austrian Institute for Trade Cycle Research 7 Bacon, Francis 258, 259 Barone, Enrico 323 Bauer, Otto 311 Bechte 50 Becker, Gary 186 behaviour 186–8, 189–90 Bertrand–Nash price setting 214 Best Available Technologies Not Exceeding Excessive Cost (BATNEEC) 357 Big Players’ theory 96–100 Bloom, Richard 278 Boettke, Peter 334–6, 338, 339 Böhm-Bawerk, Eugen von: economic theories 41, 271, 273; knowledge theory 227; production theory 78, 79; public choice analysis 116–17, 119; socialist calculation 49–53, 54–5, 59, 62; theory of capital and interest 175, 178, 180–1 borrowed reserve targeting 103–4 Botero, Giovanni 256 Braun, Martha Stephanie 115–16, 117, 118 Brennan, Geoffrey 120, 123 Bresciani Turroni, Constantino 118 British economic theory 266–8 Buchanan, James 120, 123, 159 bureaucratisation 307–8

calculating consumer 62–4 cameralism 122, 123, 125, 266, 276 capital: allocation 312–13; concept 245; goods 210; structure 202–3 cartels 214–15 cash managers 99–101, 107 causality 177 Cause of the Greatness of Cities, The 256 central banking 88–90, 98 centrally administered economy theory 140, 142 Chicago tradition 109, 212, 213 China, economic reform 338–9 Civitas Humana 144 Closing of the American Mind, The 278 Coase theorem 129, 355 Cockshott, W. Paul 334 coercion 12–13 cognition 229–30, 286–91 Cold War 278–9 command and control regulation 357–8, 360–1 communist economic organization 366 comparative institutional analysis 13–14 competency 229–30 competition 226; creation 257; policy 141–2, 211–14, 215–19; and risk 168 Competition and Entrepreneurship 330 competitive order 142, 143, 217 competitive-entrepreneurial market process 67–70 concentrated shareholding 320–1 conscious action 165 consensus policy 357–8 Constitution of Liberty, The 147, 358–9 constrained selection 163–8 consumer: calculation 60–4; capital 227–8, 237; policy 64–70 consumers: Austrian economics 41–6; as entrepreneurs 228–9, 237; role in innovation 234 contestable market approach 214 coordinated processes 88–9

372 Index coordinationist macroeconomics 82, 83–8 corporate managers: role and importance 306–7, 314–15 Cottrell, Allin 334 Counter-revolution of Science, The 23 Cowles Commission 292 credit: concept 246; expansion 79–80, 81–3, 86–7, 202–3; theory 247–8 Crown Prince Rudolf 352 cycle theory 5, 6–9, 26, 29, 30, 32, 78–83, 140–1, 203 de-forestation 353–4 decommodification 335 demand: price 62–4; theory 43, 48 denationalisation 146 Der Antiphysiokrat 266 Der Bourgeois 245 Der proletarische Sozializmus 243 Die Gemeinwirtschaft 117, 145–6 Die Gesellschaftskrise der Gegenwart 25, 144 Die Haupttheorien der Volkswirtschaftslehre 261 discovery: economics 209–12, 219; of services 232–3; process 45, 201, 225–7 discretionary monetary policy 95, 96–8, 101–2 disequilibrium 199 dispersed: knowledge 225, 229; shareholding 320 doitsugaku school 267 Eastern Europe see privatization; transitional economies economic development, dynamic theory of 272–8 economic theories, typologies 253–64 economic value of social policy 168–70 economic: biology 261; determination circle 63; goals 318; goods 351–2, 359; growth 83–4, 162–3; integration 146–7; intervention 353–4; order 146; policies 144–5, 260–1; reform 337–40; research 4–7 Economica 23 Economics 254 Economics and Knowledge 24, 34 Economics of Hope 254 economy, description of 78–9 Edgeworth, F.Y. 30 efficiency critiques 10–11 elderly people 185–6, 187 Ely, Richard 267, 269 emergent order 82, 84–6, 87, 88–9 emission permits 358–62 emission reduction credits (ERC) 362–4 Emperor Franz Joseph 351 energy-intensive firms 364 Enlightenment 254, 256 entrepreneurial: alertness 44, 46, 54–5; consumer 54–7; state 123–6; types 272

entrepreneurship 209–10, 228–9, 237 environment, Menger’s theories on 351–5 environmental: policy 355–67; protection 237–51 equilibrium theory 43–4, 272–5 Errors of Historicism 268, 269 Euchen, Walter 139–43 European competition policy 214–15; economic integration 147 European Union: environmental policy 356–7, 362, 364–5, 367 evolution of human society theory 365–6 evolutionary economics 253–64, 271–8; of the state 124–5 expansionism 161 expectations theory 6, 80–8, 95, 98–9 experience 31–3 externalities 352–3 Facts of Social Sciences, The 25 false trading 85, 86 Ferguson, Adam 156 feudal state 127 firm, theories of 226–7 fiscal reform 121–3 Fisher, Irving 5 Fordism 280 Foss, Nicolai 272 free exchange economies 142 Freeman, Christopher 254 Freiburg School 139–48, 215 Friedman, Milton 6–7, 109 Fuchs, Victor 182, 186–7 Galbraith, John Kenneth 9 game theory 213–14 Gay, Edwin F. 289–91 Gegen die Brandung 147 Geldtheorie und Konjunkturforschung 26 general equilibrium theory 29, 216, 327–30, 331 German historical school 268–70, 276 gold exchange standard 13–14 Goldscheid, Rudolf 115, 117, 118, 120–31 Good Society, The 145 goods: behaviour 56–7; characteristics 49–50, 53–4, 176–81; services elements 233 Gordon, Robert 63, 77 Gossen’s laws 60 Grossman, Michael 186–7, 333 Grundprobleme der Nationalökonomie 282 Grundsätze der Volkswirtschaftslehre 41, 48, 176, 177, 271, 273, 275–6, 351–2 Grundzüge der Theorie des wirtschaftlichen Güterwerts 59 Haberler, Gottfried 77, 140–1

Index 373 Habilitationsschrift Rechte und Verhältnisse vom Standpunkte der volkswirtschaftlichen Güterlehre 48 Habilitationsvortrag 26–7, 29 Hamilton, Alexander 212, 266, 267 Harvard Business School 287–91 Hatta, T. 217–18 Hayek, Friedrich von: cycle theory 78, 79; economic theories 43–4, 277–8; Freiburg School 139, 140–2, 147; knowledge and institutions theory 96; methodological Uturn thesis 23–36; research method 4–7; socialist calculation 301–2, 327–34; theory of society 154–5, 156–62, 163–8, 365–6, 367 health: behavior 186–8, 189–90; economics 176–81; effects in human capital model 183–6 ‘herding effects’ 99–101, 107 heroin market 68 higher order goods 178–9 historicism 279–87 History and Criticism of Theories of Interest 181 History of Civil Society 156 Hofstadter, Richard 278 homogeneity 7 Human Action 140, 284, 306, 348 human capital 125–6, 176, 180–1; investment theory 186; specificity of 203–5; subjective discount rate 182–8 Humpert, Magdalene 266 Hungary, privatisation 319 Hurst, H.E. 104–8 Hutchinson, T.W. 29–30 imperfect information 199, 200–1, 210, 216–17 Individualism and Economic Order 277 industrial economics 212–14, 219, 220 inequality, positive functionality of 161–2 inflation forecasting 83–4 information streams 235 informational: asymmetries 333; intermediaries 234–6 innovation 229; rates 169–70; role of consumers 234 Inquiry into the Principles of Political Economy 258 insider shareholding 321 institutional: economics 270–1; order of society 97–8; shareholding 320 institutions, evaluation of 13–14 interest: rates 79–80; theories 181 International Economic Disintegration 146 International Monetary Fund 14 international order 141–2 Internationale Ordnung 144 interventionism 159–60, 161, 162 Investigations 156–7

Ist die deutsche Wirtschaftspolitik richtig? 145 Jenseits von Angebot und Nachfrage 145 Johnson, Nevil 155 Jones, Richard 258, 266 judicial costs 354 Kaldor, Nicholas 255 Kant, Immanuel 28, 30, 31, 32–3 Kapital und Kapitalzins 49 Keynes/Keynesianism 98, 101, 121, 203, 204–5, 265, 288 Kirzner, Israel 8, 44, 54, 302, 330 know-how 50–6, 230–2 knowledge 7, 31–2, 33–5, 163–8, 327–30; spillovers 226 Knowledge and Error 28 Krugman, Paul 170, 270 labor: division of 180, 266, 276; market 198–9; theory of value 243–4 labor market policy, critique of 199–202 Lachmann, Ludwig 96, 97–8, 109 Lange, Oscar 328–9, 330–1 Lange–Lerner model of market socialism 302–4 Lavoie, Donald 331–3 Law, Legislation and Liberty 118, 158 law, rule of 166–7 learning 163–8, 232 Lectures of Economics 180 Legacy of Max Weber, The 95 Leviathan model of the state 119–31 Lexis, Wilhelm 247 liability law 348–51 liberalism 124 lifestyle choices 182–3 Lincoln, Abraham 260 Lippmann, Walter 145 List, Friedrich 258, 259, 267 Locke, John 288 Logic der Forschung 27 Logik of Scientific Discovery, The 28 longevity 185–6 losses, motivation function of 308–9 lower order goods 178–9 McCarthyism 278 Mach, Ernst 25, 26–9, 31, 32–4, 35 Machlup 140–1, 277, 280–1 Macht oder ökonomishes Gesetz? 118 macroeconomics, approaches to 82, 84–9 majority rule 160 de Malynes, Gerard 264–5 Man, Economy and the State 348 manager shareholding 321–2 manufacturing, service aspects 233 marginal utility 57–62, 179 marginalist school 268–70

374 Index market: activity 3–4; distortions 217–18, 219; entry 211–14; price and scarcity 361–2; order 160; prices 11, 67–70, 310–11, 332; process 67–70, 209–11; system and social welfare 12–13 market socialism 302–4; efficiencies of state officials 307–8; pseudo-markets of 310–11 market structures theory 141 Marshall, Alfred 255, 261, 284–5, 291–2 Marx/Marxism 243, 244, 245, 255, 261, 302, 334, 335, 336 medicine 177 Menger, Carl: capital theory 175–81, 245, 246; cognition 268–91; dynamic theory of economic development 271–6; environmental theory 351–5; historicism 284–5; knowledge and institutions theory 96, 227; monopoly theory 292–3; resource scarcity theory 351–2, 361–2, 365–6, 368; socialist calculation 47–9, 50–1 mercantilism 335–6 methodologists 3 Mill, J.S. 30–1 Ministry of the Environment, Netherlands 357, 358 Mises, Ludwig von: consumer calculation 55–6, 57–8; critique of socialism 301–4, 318–23; cycle theory 78, 79; economic theories 42, 43–4; and Euchen 140–1; knowledge and institutions theory 96; methodology 23–36; property rights theory 304–5, 359; research method 4–7; and Röpke 145–7 Misselden, Edward 264–5, 288 Moderner Kapitalismus 243 Modigliani–Miller theorem 129 monetary: calculation 58–9; economics 6–7; investment theory 140–1; phenomena 276–7 money demand: Big Players’ theory 96–100; statistical methods and results 104–10; US Federal Reserve 100–4 money: under socialism 311; theory 32 monopolies 142–3, 178, 210, 215 Mont Pèlerin Society 145, 280, 292 motivation function: losses 308–9; private profits 305–8 Nation, Staat und Wirtschaft 146 national markets 257 nationalism 146 needs 177, 179–80 neo-Austrian: discovery economics 209–12, 219; environmental protection 237–51 neoclassical school 270–1, 291–3 Netherlands, environmental policy 355–8, 362–4, 368 Neurath, Otto 183, 302

New Economic Police (NEP), Soviet Union 335 Ng, Yew-Kwang 217–18 nuisance law 355–8 Nuisance Law (1875), Netherlands 355–6 O’Driscoll, Gerald 4 objective costs 198–9, 201 oligopolies 142–3, 213, 215 opportunity costs 176 ORDO 139–40 ‘Ordo school’ 139–40, 215–18, 219, 220 Ortsbestimmung der Gegenwart 144 outsider shareholding 321 Pareto optimality 64, 211, 215, 216, 220, 333 particularist obsolescence 80–3 Patten, Simon 267, 269 Pejovich, S. 314–15 Penrose, Edith 281 ‘perestroika’ program 338 perfect competition 220 persistent dependence, money demand 104–7 personal shareholding 320 Pfeiffer, Friedrich von 266 Philippovich von Philippsberg, Eugen Freiherr 115, 117, 118 Phillips curve 83, 86 physical reductionism 33–4 physiocracy 256, 265–6 Pigovian tax 347 Planned Chaos 140 Poland: economic reform 338; privatisation 319 policy: advice 9–14; critiques 10 political value of social policy 168–70 politics 162–3 pollution 354–67 Polyani, Michael 51, 332 Popper, K.R. 23, 24, 27, 28, 29, 31, 33, 35 Positive Theory of Capital 118, 181, 246–7 Posner, Richard 176, 184–5, 187 post-Austrian environmental policy 355–67 postulated order 82, 84–7, 88 pragmatism 284–6 preferences 164, 167–8 preventative health policies 188 price: relationships structure 79–80; theory 5–6, 141 prices-as-knowledge 332–3 principal–agent problem 313–17 Principles 49–50, 53, 177, 180, 275, 293 Principles of Economics 280, 285 private profits, motivating function of 305–8 privatization: Eastern Europe 318–23; human use of environment 355–67 production: factors 45–6, 276; processes 246–7; structure 79–83

Index 375 property rights: analysis of socialist state firm 315–18; enforcement of 348; inviolability v. revocability 322–3; as means of production 301–4; and pseudo-markets 310–11; and principal–agent problem 305–9; right to emit 363–4; solutions to principal–agent problem 314–15 property tax 120–1 Prussian Historical School 42 Prychitko, David L. 12–13, 334, 336, 337, 338–9 public: debt 130; good 201, 354–5; finance 115–20; health policy 188–90; ownership of means of production 328–30 quantity theory 5, 109 quid pro quo 61 Rae John 256 rational expectations 81, 83–8 Rawls, John 159 recession 204–5 Renaissance theory see evolutionary theory rent-seeking 5, 11, 163, 169 Report on the Manufactures 266–7 Republic 259 reserves on private deposits (RPD) 102 resource scarcity 351–2, 361–2, 365–6, 368 resource theory of the firm 226 Ricardian theory 8–9, 42, 254–5, 261, 270, 277, 280, 285 rights, legal institutionalisation 166–7 risk 168–9, 309 Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered 331–2 Rizzo, Mario 4 Road to Serfdom, The 118, 158, 358–9 Robbins, Lionel 146, 272 Röpke, Wilhelm 139, 141, 143–8 Rosenstein-Rodan, Paul 57–60, 62 Rothbard, Murray 5, 12 routinization 230–2 rule design 165–6 Russell, Louise 188, 189 Rüstow, A. 143–4 Ryle, Gilbert 51–2, 53, 54, 55–6 Samuelson, Paul 254, 291–2 Sax, Emil 115, 116, 117, 287 Say’s law 26, 29, 30 Schmoller, Gustav 255, 268–9, 275, 281, 286 scholars 116–19 Schönfeld-Illy, L. 58, 60–3 schooling, effect on health 186–7 Schüller, Richard 271, 273–4 Schumpeter, Joseph A.: capitalist development 243, 244, 245, 246, 247, 248; entrepreneurship 229; and Eucken 142–3; evolutionary economics 253–4, 271–5,

277, 281–3; public finance theories 115–19; and Röpke 147–8 scientific welfare economics 12–13 scientism 23, 24, 25, 27–9, 33–6 Scitovsky, Tibor 64, 70 Scottish Enlightenment 156 selective: intervention 142, 147; pressure 167–8 self-enforcing constitutions 131 Sensory Order, The 23, 32 Serra, Antonio 256, 257, 261, 273 services 225; discovery of 232–3 shareholders 306, 312, 313, 314–15, 316 shareholding 320–2 Smith, Adam 65, 156, 245, 257–8, 260–1, 265–6, 276, 352–3 Smith, Erasmus Peshine 276 social: adaptation/change 156–8; expenditure 154–5; facts 31–3; institutions 339; justice 158–9, 162; models 165–6; order 168–9; policy 145, 157, 166, 168–70; security 160–1, 162; welfare 12–13 Socialism 183 socialism: collapse of 318; critiques of 301–4; economic working of 143 Socialist Calculation 26, 30–1 socialist: calculation debate 44–6, 327–30, 330–4; economies 334–7 socialist state enterprises 305–9; property rights analysis of 315–18; society, theory of 154–5, 156–8, 365–6, 367 Sombart, Werner 243–8, 282 sovereignty, surrender of 146 Soviet Union: economy 334–6; privatisation 319 Sowell, Thomas 159 Spann, Ottmar 261 spontaneous order 142, 147, 157–8 Staatliche Souveränität und die Ordnung der Weltwirtschaft 141 state: intervention 10–11, 355–67; managers 307–9, 310–11; minimum intervention 352–5; regulation 209–11 statistical economic research 4–7 stock markets 314–15 structure–conduct–performance (SCP) paradigm 212–13 Stuart, James 258 subjective discount rate, human capital model 182–8, 189 subjective values 198–200, 201 subjectivism 42–4, 225–6 sumptuary laws 64 tacit knowledge 236, 332, 333 tax: constitutions 119–31; state 126–9 taxation, limits of 169 Theorie der staatlichen Wirtschaftspolitik 117

376 Index Theorie des Geldes und der Umlaufsmittel 146 Theory and History 282 Theory of Capital and Interest 181 Theory of Money and Credit 5 Theory of the Growth of the Firm 281 Theory of the Purchasing Power of Money 5 Third World, economic reform 339 third-best welfare economics 215–18, 219 time: factor 273; horizons 184–5; preferences 186–8, 189; series 6, 105–9; and uncertainty 276 totalitarianism 162–3 transaction costs 227–9, 234–5, 237; court actions 350, 354 transitional economies 337–40 trilateral governance 235 trust 236 uncertain selection principle 167 uncertainty 276 unemployment 203–4 Untersuchungen über die Methode der Sozialwissenschaften und der politischen Ökonomie insbesondere 268 US: economic theory 254–5, 266–8, 270–1; environmental policy 365; Federal Open Market Committee 102; Federal Reserve 96–104; institutional economics 270–1; values 278–86 usufruct, property rights of 312–13, 316 utility 11, 12–13, 47–8, 179, 180

value: calculations 59–60; revelation of 235; theory 34, 42–3, 45, 57, 243–4 Veblen, Thorstein 267, 269, 270 Vienna Circle 28 Viertes Buch 139–40 Viner, Jacob 280 Volcker experiment, US Federal Reserve 102–3 Walrasian economics 274–5, 280 war debt, Austria 120, 125, 128 Waterton v. Simpson 348–51 Wealth of Nations 156, 257 Weiser, Friedrich von 41, 61–2, 115–17, 175, 181, 273 welfare: as activity specific 256–7 welfare economics 215–18, 219 welfare state: evolutionary model 158–62; expansion of 154–5; as a trial-and-error process 170 West, economic organization 366–7 Wicksell, Knut 79–80, 140–1 Wien-Claudi, Franz 277 Willgerodt, Hans 141 Wirtschaft, Wissenschaft und Politik 141–2 workable competition concept 212–13 worker shareholding 321–2 workers’ cooperatives 336–7 workplace safety regulation 200–1 Yugoslavia, economy 336–7