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Table of contents :
cover
Series
The Oxford Handbook of Austrian Economics
Copyright
Contents
List of Figures and Tables
List of Contributors
1. Introduction: Austrian Economics as a Progressive Research Program in the Social Sciences
Part I Methodology
2. Austrian Methodology: A Review and Synthesis
Part II Microeconomics
3. The Knowledge Problem
4. Market Theory and the Price System
5. Austrians versus Market Socialists
6. Spontaneous Order
Part III Macroeconomics and Monetary Economics
7. The Capital-Using Economy
8. Capital-Based Macroeconomics: Austrians, Keynes, and Keynesians
9. Austrian Business Cycle Theory: A Modern Appraisal
10. Free Banking
Part IV Institutions and Organizations
11. Social Economy as an Extension of the Austrian Research Program
12. Organizations and Markets
13. The Evolution of Property Rights Systems
14. On the Origins of Stock Markets
Part V Public Policy and Interventionism
15. The Rule of Experts
16. The Problem of Rationality: Austrian Economics between Classical Behaviorism and Behavioral Economics
17. Dynamics of Interventionism
Part VI Political Economy
18. Ordoliberalism and the Austrian School
19. The Tax State as Source of Perpetual Crisis
20. Constitutional Political Economy and Austrian Economics
21. Public Choice and Austrian Economics
22. The Market Process Theory Perspective on Capitalism: Normative Facets and Implications
Part VII Austrian Connections and Extensions
23. On the Economy-Wide Implications of Kirznerian Alertness
24. Contemporary Austrian Economics and the New Economic Sociology
25. The Austrian Theory of Finance: Is It a Unique Contribution to the Field?
26. Austrian Economics and the Evolutionary Paradigm
27. Complexity and Austrian Economics
28. The Sensory Order, Neuroeconomics, and Austrian Economics
Part VIII Development, Transition, and Social Change
29. What Have We Learned from the Collapse of Communism?
30. The Political Economy of Foreign Intervention
31. From Subsistence to Advanced Material Production: Austrian Development Economics
32. On Your Mark, Get Set, Develop! Leadership and Economic Development
Part IX Applications: The 2008 Financial Crisis
33. The Financial Crisis in the United States
34. The Financial Crisis in the United Kingdom: Uncertainty, Calculation, and Error
Index
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T h e Ox f o r d H a n d b o o k o f

AU ST R IA N E C ON OM IC S

C ON SU LT I NG E DI TOR S Michael Szenberg Lubin School of Business, Pace University Lall Ramrattan University of California, Berkeley Extension

The Oxford Handbook of

AUSTRIAN ECONOMICS Edited by

PETER J. BOETTKE and

CHRISTOPHER J. COYNE

1

3 Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford New York Auckland  Cape Town  Dar es Salaam  Hong Kong  Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Oxford is a registered trademark of Oxford University Press in the UK and certain other countries. Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016

© Oxford University Press 2015 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by license, or under terms agreed with the appropriate reproduction rights organization. Inquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above. You must not circulate this work in any other form and you must impose this same condition on any acquirer. Library of Congress Cataloging-in-Publication Data The Oxford handbook of Austrian economics / edited by Peter Boettke and Christopher Coyne. pages cm Includes bibliographical references and index. ISBN 978–0–19–981176–2 (alk. paper) 1.  Austrian school of economics.  2.  Microeconomics.  3.  Macroeconomics.  I.  Boettke, Peter J.  II.  Coyne, Christopher J. HB98.O94 2015 330.15′7—dc23 2015014991

1 3 5 7 9 8 6 4 2 Printed in the United States of America on acid-free paper

Contents

List of Figures and Tables  List of Contributors  1. Introduction: Austrian Economics as a Progressive Research Program in the Social Sciences  Peter J. Boettke and Christopher J. Coyne

ix xi 1

PA RT I   M E T HOD OL O G Y 2. Austrian Methodology: A Review and Synthesis  Adam Martin

13

PA RT I I   M IC ROE C ON OM IC S  3. The Knowledge Problem  Lynne Kiesling

45

4. Market Theory and the Price System  Frederic Sautet

65

5. Austrians versus Market Socialists  Jesús Huerta de Soto

94

6. Spontaneous Order  Daniel J. D’Amico

115

PA RT I I I   M AC ROE C ON OM IC S A N D  M ON E TA RY  E C ON OM IC S 7. The Capital-Using Economy  Peter Lewin and Howard Baetjer Jr. 8. Capital-Based Macroeconomics: Austrians, Keynes, and Keynesians  John P. Cochran

145

164

vi   Contents

9. Austrian Business Cycle Theory: A Modern Appraisal  Andrew T. Young

186

10. Free Banking  Kevin Dowd

213

PA RT I V   I N ST I T U T ION S A N D ORG A N I Z AT ION S 11. Social Economy as an Extension of the Austrian Research Program  Emily Chamlee-Wright and Virgil Henry Storr

247

12. Organizations and Markets  Nicolai J. Foss, Peter G. Klein, and Stefan Linder

272

13. The Evolution of Property Rights Systems  Bruce L. Benson

296

14. On the Origins of Stock Markets  Edward Peter Stringham and Nicholas A. Curott

324

PA RT V   P U B L IC P OL IC Y A N D  I N T E RV E N T ION I SM 15. The Rule of Experts  Roger Koppl 16. The Problem of Rationality: Austrian Economics between Classical Behaviorism and Behavioral Economics  Mario J. Rizzo 17. Dynamics of Interventionism  Sanford Ikeda

343

364 393

PA RT V I   P OL I T IC A L E C ON OM Y 18. Ordoliberalism and the Austrian School  Stefan Kolev

419

19. The Tax State as Source of Perpetual Crisis  Richard E. Wagner

445

Contents   vii

20. Constitutional Political Economy and Austrian Economics  Mark Pennington

464

21. Public Choice and Austrian Economics  Randall G. Holcombe

491

22. The Market Process Theory Perspective on Capitalism: Normative Facets and Implications  Paul Dragos Aligica

508

PA RT V I I   AU ST R IA N C ON N E C T ION S A N D  E X T E N SION S 23. On the Economy-Wide Implications of Kirznerian Alertness  Maria Minniti

529

24. Contemporary Austrian Economics and the New Economic Sociology  Ryan Langrill and Virgil Henry Storr

547

25. The Austrian Theory of Finance: Is It a Unique Contribution to the Field?  Gregory M. Dempster

563

26. Austrian Economics and the Evolutionary Paradigm  Ulrich Witt and Naomi Beck

576

27. Complexity and Austrian Economics  J. Barkley Rosser, Jr.

594

28. The Sensory Order, Neuroeconomics, and Austrian Economics  William N. Butos and Thomas J. McQuade

612

PA RT V I I I   DE V E L OP M E N T, T R A N SI T ION , A N D  S O C IA L C HA N G E 29. What Have We Learned from the Collapse of Communism?  Peter J. Boettke and Olga Nicoara

643

30. The Political Economy of Foreign Intervention  Thomas K. Duncan and Christopher J. Coyne

678

viii   Contents

31. From Subsistence to Advanced Material Production: Austrian Development Economics  G. P. Manish and Benjamin Powell

698

32. On Your Mark, Get Set, Develop! Leadership and Economic Development  Scott A. Beaulier and Daniel J. Smith

713

PA RT I X   A P P L IC AT ION S : T H E  2 008  F I NA N C IA L  C R I SI S 33. The Financial Crisis in the United States  Steven Horwitz

729

34. The Financial Crisis in the United Kingdom: Uncertainty, Calculation, and Error  Anthony J. Evans

749

Index 

781

List of Figures and Tables

Figures 2.1. The overlap between Austrian and Walrasian economics 

31

2.2. A general schema for social processes 

32

2.3. Austrian market process theory 

33

2.4. A taxonomy of Austrian methods 

35

6.1. Spontaneous relative to emergent orders 

122

6.2. Classifications of order 

124

9.1. Thirty-year conventional mortgage rates and Aaa corporate bond yields, 1990–2011  194 9.2. GSE activities 

196

9.3. The Garrison (2001) framework 

199

9.4. The Garrison (2001) framework: A decrease in time preferences 

200

9.5. Incorporating a time structure of consumption and a risk structure 

202

9.6. A policy-induced “forced” decrease in time preferences 

204

9.7. The recent boom-bust cycle 

207

11.1. Research program on social economy 

250

15.1. Monopoly expertise 

351

15.2. Competing experts 

352

15.3. Some elements of the ecology of expertise 

354

25.1. Financial flow of funds from an Austrian perspective 

569

29.1. The barstool analogy 

657

29.2. Rule of law, 1996–2011 

665

29.3. Rule of law, groups, 1996–2011 

666

29.4. Judicial framework and independence in Russia and the FSRs and satellite states, 2003–2013 

666

x    List of Figures and Tables 29.5. Freedom of the press, 2002–2013 

667

29.6. Rule of law versus income in C&EE and FSRs, 2011 

667

34.1. Private investment YoY % change 

761

34.2. Net quarterly private investment 

762

Tables 2.1. Boettke and Wagner on defining Austrian economics 

27

4.1. Kirzner’s elements of human action 

80

10.1. Central banking versus free banking 

231

29.1. Income groups, World Bank country classification (gross national income per capita, 2012) 

664

29.2. Estimates of net foreign direct investments (% GDP) 

668

29.3. Change in entrepreneurial intention and perception of entrepreneurship as a desirable career choice in C&EE and FSU societies, 2002–2012 

669

Contributors

Paul Dragos Aligica, Senior Research Fellow, F. A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University Howard Baetjer Jr., Lecturer, Department of Economics, Towson University Scott A. Beaulier, Executive Director, Center for the Study of Economic Liberty, Arizona State University Naomi Beck, Researcher, Max Planck Institute for the History of Science, Berlin Bruce L. Benson, Department of Economics, DeVoe L. Moore Professor and Distinguished Research Professor in Economics, Florida State University Peter J.  Boettke, University Professor of Economics and Philosophy, George Mason University William N. Butos, Professor of Economics, Trinity College Emily Chamlee-Wright, Provost and Dean of the College, Washington College John P. Cochran, Emeritus Dean School of Business, Emeritus Professor of Economics, Metropolitan State University of Denver Christopher J. Coyne, F. A. Harper Professor of Economics, George Mason University Nicholas A. Curott, Assitant Pofessor of Economics, Ball State University Daniel J. D’Amico, The Political Theory Project at Brown University Gregory M. Dempster, Elliott Professor of Economics and Business, Hampden-Sydney College Kevin Dowd, Professor of Finance and Economics, Durham University Business School Thomas K. Duncan, Assistant Professor of Economics, Radford University Anthony J. Evans, Associate Professor of Economics, ESCP Europe Business School Nicolai J. Foss, Professor, Copenhagen Business School, and Professor, Norwegian School of Economics Randall G. Holcombe, DeVoe Moore Professor of Economics, Florida State University

xii   Contributors Steven Horwitz, Charles A. Dana Professor and Chair, Department of Economics, St. Lawrence University Jesús Huerta de Soto, Professor of Applied Economics, King Juan Carlos University Sanford Ikeda, Professor of Economics, Purchase College, State University of New York Lynne Kiesling, Associate Professor of Instruction, Economics, Northwestern University Peter G. Klein, Professor, University of Missouri, and Professor, Norwegian School of Economics Stefan Kolev, Professor of Economics, West Saxon University of Applied Sciences Zwickau and Deputy Director, Wilhelm Röpke Institute Erfurt Roger Koppl, Professor of Finance, Syracuse University Ryan Langrill, Evaluator, Idaho Legislature’s Office of Performance Evaluations Peter Lewin, Clinical Professor, Finance and Managerial Economics, School of Management, University of Texas at Dallas Stefan Linder, Assistant Professor, ESSEC Business School G. P.  Manish, Assistant Professor of Economics, Sorrell College of Business, Troy University Adam Martin, Assistant Professor, Agricultural and Applied Economics, Texas Tech University and Political Economy Research Fellow at the Free Market Institute Thomas J. McQuade, Independent Scholar Maria Minniti, Luis Bantle Chair of Entrepreneurship and Public Policy, Syracuse University Olga Nicoara, Visiting Assistant Professor of Economics, Denison University Mark Pennington, Professor of Public Policy and Political Economy, King’s College London Benjamin Powell, Professor of Economics, Rawls College of Business and Director, Free Market Institute, Texas Tech University Mario J. Rizzo, Associate Professor of Economics, New York University J. Barkley Rosser, Jr., Professor of Economics, James Madison University Frederic Sautet, Visiting Associate Professor of Economics, The Catholic University of America Daniel J. Smith, Associate Professor of Economics, Troy University

Contributors   xiii Virgil Henry Storr, Research Associate Professor of Economics, George Mason University Edward Peter Stringham, Davis Professor of Economic Organizations and Innovation, Trinity College, Hartford, Connecticut Richard E. Wagner, Harris Professor of Economics, George Mason University Ulrich Witt, Professor of Economics, Max Planck Institute Jena and Griffith Business School, Griffith University, Gold Coast, QL, Australia Andrew T. Young, Associate Professor of Economics, West Virginia University

T h e Ox f o r d H a n d b o o k o f

AU ST R IA N E C ON OM IC S

Chapter 1

I n t roduc tion Austrian Economics as a Progressive Research Program in the Social Sciences Peter J. Boettke and Christopher J. Coyne

Origins The Oxford Handbook of Austrian Economics was designed to give an overview of the main methodological, analytical, and practical implications of the Austrian school of economics. This intellectual tradition in economics and political economy has a long history that dates back to Carl Menger in the late nineteenth century. Menger is recognized as one of the three codiscoverers of marginal utility analysis, which became the cornerstone of early neoclassical economics. But Menger’s analysis from the beginning offered something different from either the analysis of Léon Walras or that of William Stanley Jevons. Menger stressed the subjective nature of value in the individual decision calculus. Individual choices are indeed made on the margin, but the evaluations of rank ordering of ends sought in the act of choice are subjective to the individual chooser. For Menger, the economic calculus was about scarce means being deployed to pursue an individual’s highest-valued ends. The act of choice is guided by subjective assessments of the individual and is open-ended as the individual is constantly discovering what ends to pursue and learning the most effective way to use the means available to satisfy those ends. The early Austrian economists were among the first thinkers to reason about opportunity costs, to view time as an economic factor that must be reckoned with, to discuss expectations and knowledge, to explore the implications of human errors in judgment for economic theory, and ultimately to define the economic problem as one of the coordination of economic activities through time. The contributions of Menger, and then Eugen von Böhm-Bawerk and Friedrich von Wieser represent the founding period of the Austrian school of economics (1870s–1920s). For our purposes, the next major

2   Introduction thinkers of the Austrian school include Joseph Schumpeter, Hans Mayer, and Ludwig von Mises and the circle of economists that formed around Mises in Vienna: F. A. Hayek, Fritz Machlup, Oskar Morgenstern, and Gottfried Haberler (1910s–1920s). In the 1930s, all of these economists, except Mayer, left Austria and established their careers in Geneva, London, and the United States. During the 1930s and 1940s, at least in the English-speaking world, Schumpeter would build a separate identity as an economic thinker, and Hayek and his circle at the London School of Economics (LSE) (including Lionel Robbins) would emerge as the leading representatives of the Austrian school and its methodological, analytical, and practical policy positions. Eventually, Mises’s work, in no small part through the initiative of Hayek and Robbins, would be translated into English and also influence the economic conversation, most notably as the spark in the controversy over socialist economic planning.

The Postwar Period In 1940, Mises migrated to New York, and in 1950, Hayek moved to Chicago. During the 1950s, the Austrian school of economics no longer existed in Vienna, but its leading practitioners were on the faculties at Harvard, Princeton, Chicago, Johns Hopkins, and New York University (NYU). The economics profession during this time had decidedly moved in a direction away from the methodological and analytical position that had been developed by the Austrian school. And it is important to note that the practical implications of economic analysis also shifted. From an Austrian perspective, economics as practiced in the 1950s was too aggregative in perspective, too formalistic in presentation, too positivistic in scientific purpose, and too interventionist in practical importance. Scientism and statism had formed an unholy alliance, and the embodiment was the modern neoclassical synthesis of Keynesian macroeconomics combined with market failure microeconomics. This transformation of economics might have been initiated by the charismatic John Maynard Keynes and his The General Theory of Employment, Interest, and Money (1936), but it was accomplished by Paul Samuelson and his successful move to corner both the market in the teaching of basic economics with his Economics (1948) and the market for advanced training in economics with his Foundations of Economic Analysis (1947). Both these books were published in the late 1940s and set the agenda for economic education and research for at least the next forty years, if not beyond that. At roughly the same time, both Mises and Hayek published systemic works that reflected an alternative path in economic education and research. Mises’s Human Action was published in 1949, and Hayek’s Individualism and Economic Order was published in 1948. These books would have a hidden but profound influence in the counterrevolution in economics that arose in the 1950s and 1960s to challenge the hegemony of the neoclassical synthesis. Property rights economics, public choice economics, law and economics, and market-process economics are all developments that can find their roots in these two

Introduction   3 books. When traditional histories of the counterrevolution against Keynesian hegemony are written, the focus is typically placed on Milton Friedman and the development of monetarism. This is not entirely inaccurate, as Friedman had a powerful mind and not only contributed to basic research, but also had the ability to communicate effectively with wide audiences about the power of the market and the potential tyranny of politics. But Friedman’s own monetarist framework was itself an imminent challenge to the Keynesian system, not a fundamental rejection of the Keynesian apparatus. Moreover, Friedman was largely responsible for the spread of positivism as the reigning philosophy of science within the economics profession. Friedman in his professional work reinforced the emphasis on economic aggregates and scientism, but his broader public appeal was in challenging statism as the practical implication of economic analysis. Friedman, an old classmate of Samuelson, was in fact not too different from his main professional adversary in methodology and method of analysis. But both represented quite a break from their teacher Frank Knight. Mises and Hayek were closer to Knight, despite some obvious fundamental differences, in terms of methodology and analytical method. By the time Knight delivered his presidential address to the American Economic Association, his ideas were decidedly out of fashion. This is the ironic intellectual context within which the modern “Austrian” school was born—not in Vienna but in London (Hayek) and New York (Mises). At the LSE, Hayek mentored and influenced many young economists who would make their mark in the economics profession: Hicks, Kaldor, Coase, Shackle, and Lachmann, to name a few. Shackle and Lachmann, in particular, would stress subjectivism, expectations, and process in their subsequent work. Moreover, Lachmann contributed directly to the advancement of the Austrian tradition methodologically and analytically with works such as, Capital and Its Structure (1956), and The Legacy of Max Weber (1971), and in various articles in professional journals (see the collection of his papers Capital, Expectations, and the Market Process, edited by Walter Grinder and published in 1977). In New York, Mises would also influence a new generation of economic thinkers. Many of these individuals would focus on basic economics and the promotion of free-market public policies to counter the interventionist hegemony. Hans Sennholz stood out among this crowd with his many books and popular articles, but the entire staff at the Foundation for Economic Education (FEE) was influenced by Mises. Henry Hazlitt, an economic journalist, translated Mises’s ideas for the general public with his writings at the New York Times and then Newsweek and, of course, in his best-selling book, Economics in One Lesson (1946). But in terms of the methodology and methods of analysis for economic science, Mises’s legacy was carried forward by Murray Rothbard and Israel Kirzner. Rothbard, who was a few years older than Kirzner, was a Ph.D. student at Columbia when Mises’s Human Action was published in 1949. Rothbard was advised to read the book by free-market friends he had met through FEE. He quickly became a major advocate within professional journals for what he understood as Misesian economics and its emphasis on deductive logic and verbal reasoning. Rothbard also provided an uncompromising defense of the unhampered market economy and a thorough

4   Introduction indictment of the interventionist policies that were being advocated in the neoclassical synthesis. In 1962, Rothbard published the two-volume, Man, Economy, and State, which represented his own systematic statement of the principles of economics. In 1963, he published America’s Great Depression, which sought to counter both the Keynesian and the monetarist explanations for the depression and present the Mises-Hayek theory of the business cycle as the most compelling framework for studying the problem of economic crises. Among Mises’s direct Ph.D. students at NYU, Kirzner quickly emerged as the one most focused on contributing to the professional scholarly conversation. His doctoral thesis, The Economic Point of View, published in 1960, was a history of the way the discipline of economics was understood by its practitioners from the classical thinkers to those of modern times. Kirzner’s work throughout his career was similarly directed at his scientific peers and advanced economics students. Among his many contributions written for these audiences were Market Theory and the Price System (1963), An Essay on Capital (1966), and Competition and Entrepreneurship (1973). Where Rothbard, after Man, Economy, and State and America’s Great Depression, would mostly focus his intellectual efforts on creating a broader intellectual movement—libertarianism (see, for example, For a New Liberty [1973]),—Kirzner would continue to focus his efforts on representing the modern Austrian school in methodology and method of analysis within the economics profession. Throughout his body of scholarly work, methodological individualism, methodological subjectivism, and market-process analysis were Kirzner’s main points of emphasis. The Austrian school during this time was decidedly out of favor professionally and out of step in the realm of practical affairs. As a result, both Rothbard and Kirzner were quasi-isolated thinkers. They had each other (although they were other-directed), and they had a few sympathetic fellow travelers among economists in the United States and the United Kingdom coming into professional maturity in the post–World War II period, notably Armen Alchian, P. T. Bauer, Yale Brozen, James Buchanan, Ronald Coase, G. Warren Nutter, Gordon Tullock, and Leland Yeager. And while the Austrian school was out of fashion, professional recognition was not denied to either Mises or Hayek. Further, members of their old scientific circle from Vienna were well placed and well regarded within the profession. However, the members of that old Viennese circle thought that the Austrian school was a thing of the past, and they never did appreciate the unique contributions that were embodied in Human Action (Mises 1949) and Individualism and Economic Order (Hayek 1948). For Machlup, Haberler, and Morgenstern, these books were merely summaries of positions long held by their former mentors and friends. Mises was too strident and Hayek too scholastic to offer any sort of guidance for the rethinking of the modern scientific project of economics. This is in no way meant to downplay the successful careers of Mises and Hayek as judged by professional standards. Mises was named a Distinguished Fellow of the American Economic Association in 1969, and Hayek was awarded the Nobel Prize for Economic Science in 1974, to provide but two illustrations.

Introduction   5 Despite these recognitions, it is not an exaggeration to say that circa 1970, only Rothbard, Kirzner, and Lachmann thought of the Austrian school as a progressive research program in the social sciences. To friend and foe alike, the school of thought was a relic of a pre–World War II economics and had either been soundly defeated in the Keynesian avalanche or fully incorporated into the teachings of modern neoclassical economics. As mentioned, Rothbard had directed much intellectual energy to laying the groundwork for a broader libertarian movement, Lachmann’s career had taken him from London to South Africa and into university administration, so only Kirzner was left in a situation where he could train Ph.D. students and pursue scientific and scholarly research in economics. Through the activities of the Institute for Humane Studies (IHS), an organized effort was made to introduce a new generation to the teachings of the Austrian school of economics and to encourage them to view the tradition as a living body of economic thought. Classic works were made available, conferences were held, and new publications were produced.

The Austrian Revival Most narratives date the resurgence of interest in the Austrian school of economics to the IHS-sponsored conference in South Royalton, Vermont, and the subsequent volume edited by Edwin Dolan, The Foundations of Modern Austrian Economics (1976). This conference took place in the summer of 1974. Mises had passed away the previous October, and Hayek would win the Nobel Prize the following October. So the timing was fortuitous to maximize interest. Further strengthening this interest was the breakdown of the Keynesian consensus in public policy as the United States and the United Kingdom struggled with stagnation, in particular the simultaneous experience of high inflation and high unemployment during the mid- to late 1970s. Fellowships were made available for graduate students to pursue their doctorates at NYU under Kirzner’s direction, and Kirzner was joined there by Lachmann as a regular visiting professor each spring from the mid-1970s until the late 1980s. In addition, junior faculty—Mario Rizzo, Gerald O’Driscoll, Lawrence White, and Peter J. Boettke—were hired to further support Kirzner’s efforts. And along with a vibrant group of Ph.D. students, postdoctoral fellowships were available, as were visiting scholars programs. From the 1970s through the 1990s, the NYU Austrian program, while a minority within the economics department, had a very active research and graduate teaching presence. The list of alumni would include, among others, Don Lavoie and George Selgin. Postdoc fellows included Bruce Caldwell and Richard Langlois, while visiting scholars included Roger Garrison and Uskali Maki, among others. Each of these individuals has made significant contributions to economic research and graduate education. Lavoie, in particular, became a very influential graduate student mentor when the Ph.D. program at George Mason University (GMU) was established. He was a faculty member at the Center for the Study of Market Processes at GMU, working with Richard

6   Introduction Fink, Jack High, and Karen Vaughn. Through Vaughn’s initiative, the new Ph.D. program at GMU received a major boost when James Buchanan and Gordon Tullock were persuaded to join the GMU faculty and relocate the Center for Study of Public Choice to GMU. GMU was also fortunate that Henry Manne became the dean of the law school and moved the Law and Economics Center to GMU, with its array of research and educational programs. A few years later, the IHS also relocated to GMU. Since that time, hundreds of graduate students have been educated in law, economics, and public policy with strong and direct influence from the modern Austrian school of economics. The Ludwig von Mises Institute at Auburn University and the Center for the Study of Market Processes at GMU were both established in the early 1980s and offered graduate student fellowships and various other educational and research opportunities. Roger Garrison was the main mentor at Auburn for Austrian students, but Leland Yeager retired from the University of Virginia and joined Garrison as the Ludwig von Mises Professor. Again, through Auburn and more generally the Mises Institute, multitudes of students have been exposed to the modern Austrian school of economics. However, it might be important to stress that the Mises Institute is more directly influenced by Rothbard; the character of its programs reflects his broader interests in the libertarian movement and popular outreach than in economic scholarship strictly speaking. On the more academic side, Austrian influence at the graduate level has also been evident at the University of Connecticut with Richard Langlois, and at Florida State University with the work of Bruce Benson and Randall Holcombe. These professors have taught students who have tried to make a mark within the economics profession as researchers and graduate teachers. New programs that have a modern Austrian influence to varying degrees include: King’s College (London), West Virginia University, and Texas Tech University. Each of these programs has a core research group of faculty, dedicated graduate student fellowships, and educational opportunities for the formal study of Austrian-related ideas. The Austrian school is not only represented in colleges and universities in the United States and the United Kingdom, but also has important research and educational centers throughout Europe and Latin America. Particularly strong groups can be found in Argentina, the Czech Republic, France, Guatemala, Germany, Spain, and Romania. As one indication of the intellectual growth of interest in the Austrian school, Boettke has served on Ph.D. dissertation committees at schools such as the Stockholm School of Economics, the University of Paris I, Guelph University in Canada, and Erasmus University in Holland, where the topic and mode of analysis were decidedly influenced by the modern Austrian school. This worldwide interest in the contributions of the modern Austrian school is embodied in the thought of Mises, Hayek, Kirzner, Rothbard, and Lachmann. It is also evident in the scholarship of subsequent generations—for example, Dominick Armentano’s Antitrust and Monopoly (1982), Lawrence White’s Free Banking in Britain (1984), Don Lavoie’s Rivalry and Central Planning (1985), Gerald O’Driscoll and Mario Rizzo’s The Economics of Time and Ignorance (1985), Peter Lewin’s Capital in Disequilibrium (1999), and Roger Garrison’s Time and Money (2001)—which has resulted in the evolution of

Introduction   7 the Austrian tradition in new and novel directions. The contemporary Austrian school of economics is varied and vibrant, and its practitioners are contributing to the living body of economic thought and practical application in the realm of public policy. In The Elgar Companion to Austrian Economics (1994), Boettke, who served as the editor, chose to emphasize not biographies but the main ideas in the tradition from the perspective of methodology, method of analysis, and practical political economy. This emphasized the distinction among pure theory, applied theory, and empirical analysis. Many critics of the Austrian school and in particular of Mises, interpreted him as claiming that all of economic knowledge was derived from a priori true propositions and thus that the logical deductions would be known with apodictic certainty. Economic theory was not falsifiable by empirical testing. The nuance involved in understanding the philosophical issues at stake, let alone Mises’s precise formulation, is beyond our present scope. But we hope that the distinction among pure theory, applied theory, and empirical examination will suffice. Translating Mises into traditional critical-reasoning language results in restating his position as claiming that in pure theory, economics is derived from the proposition that humans act purposively to better their condition. When we enter the realm of applied theory, however, the theorist must understand the institutionally contingent nature of the claims. Economic analysis at this stage focuses not merely on the pure logic of choice but on the exchange relations that emerge from the interaction of individuals and the institutions within which those exchange relationships are played out. Pure theory and applied theory are combined to forge a framework for the interpretation of the empirical world either historically contemplated (economic history) or in more contemporary contexts (public policy). From this perspective, economic theory is tested in terms of its logic and its relevance. The relevant criterion in empirical analysis is the applicability or nonapplicability of a theory, not its falsifiability. In The Elgar Companion to Austrian Economics, short essays were arranged to make this subtle point about the nature of economic theory and historical analysis. Further, the volume demonstrated the growing body of literature in Austrian economics and its connection to other traditions within the social sciences. In the Handbook on Contemporary Austrian Economics (2010), also edited by Boettke, the purpose was different. In the introduction, Boettke summarizes the Austrian school in ten propositions as it relates to the science of economics, microeconomics, and macroeconomics. The selection of authors was biased toward scholars in the first decade of their professional academic careers. Again, however, the propositions were of a methodological, method, and practical nature. The modern Austrian school of economics has indeed resulted in the emergence of a distinct contemporary school of thought reflecting a mix of influences in micro and macro theory and practical policy questions for this age, such as the collapse of communism, the failure of development planning, the antiglobalization movement, and the global financial crisis. Not only is there a growing number of scholars in disciplines such as philosophy, politics, economics, the history of ideas, and applied fields such as entrepreneurship and public policy, but these scholars are engaging in professional journals,

8   Introduction publishing with top university presses, and tackling pressing issues in public policy. It is not an exaggeration to say that there are more economists and social scientists working within the Austrian tradition today than at any time in the history of the tradition and that more of them are publishing in the main outlets of professional and popular opinion than ever before. The catalogs of Cambridge University Press, Chicago University Press, Oxford University Press, Princeton University Press, and Stanford University Press carry recent books by scholars within the contemporary school of Austrian economics. These same individuals have been successful in publishing papers in the top journals in their fields of study. As the Austrian school moved from its intellectual roots in continental Europe, and even more in the historical context of fin-de-siècle Vienna, the stream of influences became more varied, and many things (large and small) were lost in translation. But perhaps we can regain focus if we go back to Kirzner’s three major points of emphasis: methodological individualism, methodological subjectivism, and market-process analysis. The contributions of the contemporary Austrian school are decidedly methodologically individualistic and radically so in rejecting even representative agent models. The contributions also take subjectivism of not only value but also knowledge (and expectations) seriously. And the focus of analysis is on the dynamic adjustment to changing circumstances, rather than on the equilibrium properties of any given situation. At a minimum, contemporary Austrian economists see equilibrium economics as the background, while the processes of adjustment are in the foreground of analysis. This is why entrepreneurs, and other such change agents, play such a critical role in the Austrian theory of social order.

Contemporary Austrian Economics and an Overview of the Handbook The contemporary Austrian school sees conciliation, not conflict, among the various microeconomic developments that challenged the Keynesian hegemony: property-rights economics, law and economics, public choice economics, constitutional political economy, new institutional economics, and market process economics. Menger said that man was the alpha and the omega of economic theory, and this remains true in the contemporary Austrian school. But the subjectivism in the Austrian tradition prevents its practitioners from reducing the dilemma of human choice to a mechanical exercise in decision science. The process orientation in the Austrian tradition prevents its practitioners from adopting the caricature of the market as depicted in the textbook model of perfect competition. People are caught between alluring hopes and haunting fears, and choice is seen as a very human act filled with contingency and irony but always guided by the purposes and plans of the choosing actor. From the Austrian perspective, the competitive market process is one of constant change and

Introduction   9 adjustment driven by the entrepreneurial action of individuals striving to exploit profit opportunities. The various contributions in this volume reflect this “tension” of an orthodox argumentative structure (rational choice and invisible hand) to address heterodox problem situations (uncertainty, differential knowledge, ceaseless change). The Austrian economists, from the founders to today, seek to derive the invisible hand theorem from the rational choice postulate via institutional analysis. The economics produced is not that of perfect agents interacting in perfect markets, but instead one that stresses very imperfect actors stumbling about in a very imperfect world but grasping on to various institutions that ameliorate social tensions, transform situations of potential conflict into opportunities for cooperation, and enable the coordination of economic activities through time in such a way that the gains from trade and the gains from innovation are realized. In sum, the contributions to the this volume embrace rational choice as if the choosers are human, institutional analysis as if history mattered, and economic development as the byproduct of realizing social cooperation under the division of labor. In organizing The Oxford Handbook of Austrian Economics, we draw from a wide variety of practitioners, old and young, who have established international reputations within the scholarly community for their work in the categories their respective chapters represent. In short, the reader will get to sample the work of the leading practitioners of the contemporary Austrian school of economics in their respective areas of expertise. The purpose of the Handbook is to investigate and analyze some of the central aspects of the Austrian school as they have been historically understood and are currently interpreted. We had two goals in organizing this Handbook. The first was to introduce readers to some of the main theories and insights of the Austrian school. The second aim was to demonstrate how Austrian economics provides a set of tools for making original and novel scholarly contributions to the broader economics discipline. We hope that by providing insight into the central Austrian theories, the volume will be valuable to those who are unfamiliar with Austrian economics. At the same time, given its emphasis on Austrian economics as a live and progressive research program in the social sciences, it will be appealing to those already familiar with the Austrian school of thought.

References Armentano, Dominick T. 1982. Antitrust and Monopoly:  Anatomy of a Policy Failure. New York: John Wiley and Sons. Boettke, Peter J., ed. 1994. The Elgar Companion to Austrian Economics. Northampton, MA: Edward Elgar. Boettke, Peter J., ed. 2010. Handbook on Contemporary Austrian Economics. Northampton, MA: Edward Elgar. Dolan, Edwin, ed. 1976. The Foundations of Modern Austrian Economics. Kansas City, MO: Sheed and Ward.

10   Introduction Garrison, Roger W. 2001. Time and Money:  The Macroeconomics of Capital Structure. New York: Routledge. Hayek, F. A. 1948. Individualism and Economic Order. Chicago: University of Chicago Press. Hazlitt, Henry. 1946. Economics in One Lesson. New York: Harper Brothers. Keynes, John M. 1936. The General Theory of Employment, Interest, and Money. London: Macmillan. Kirzner, Israel M. 1960. The Economic Point of View:  An Essay in the History of Economic Thought. Princeton, NJ: Van Nostrand. Kirzner, Israel M. 1963. Market Theory and the Price System. Princeton, NJ: Van Nostrand. Kirzner, Israel M. 1966. An Essay on Capital. New York: August M. Kelley. Kirzner, Israel M. 1973. Competition and Entrepreneurship. Chicago:  University of Chicago Press. Lachmann, Ludwig M. 1956. Capital and Its Structure. London: Bell and Sons. Lachmann, Ludwig M. 1971. The Legacy of Max Weber:  Three Essays. Berkeley, CA: Glendessary Press. Lachmann, Ludwig M. 1977. Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy. Edited by Walter E. Grinder. Kansas City, MO: Sheed, Andrews and McMeel. Lavoie, Don. 1985. Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered. New York: Cambridge University Press. Lewin, Peter. 1999. Capital in Disequilibrium:  An Examination of the Role of Capital in a Changing World. New York: Routledge. Mises, Ludwig von. 1949. Human Action:  A  Treatise on Economics. New Haven, CT:  Yale University Press. O’Driscoll, Gerald P., and Mario J.  Rizzo. 1985. The Economics of Time and Ignorance. New York: Basil Blackwell. Rothbard, Murray. 1962. Man, Economy and State. Princeton, NJ: Van Nostrand. Rothbard, Murray. 1963. America’s Great Depression. Princeton, NJ: Van Nostrand. Rothbard, Murray. 1973. For a New Liberty: The Libertarian Manifesto. New York: Macmillan. Samuelson, Paul A. 1947. Foundations of Economic Analysis. Cambridge, MA:  Harvard University Press, 1947. Samuelson, Paul A. 1948. Economics. New York: McGraw-Hill. White, Lawrence H. 1984. Free Banking in Britain: Theory, Experience, and Debate, 1800–1845. New York: Cambridge University Press.

Pa rt  I

M E T HOD OL O G Y

Chapter 2

Austrian M eth od ol o g y A Review and Synthesis Adam Martin

Why So Serious (about Methodology)? Austrian economists have a reputation for intensive—some would say excessive— ruminations on the methodology of economics. The Austrian moniker itself originates in the Methodenstreit between the early Austrians and the German historical school (Bostaph 1994; Caldwell 2004, chap. 3; Mises [1969] 1996). The Austrians argued that abstract economic theory has a central role to play in understanding economic phenomena, while the historical school insisted that economists require a large body of evidence about particular historical circumstances before making theoretical pronouncements. Despite its vitriol, this debate had no real impact outside the German academy, where Carl Menger’s approach was more in step with the international economics community’s move toward marginalism and increasingly abstract theory. By the time of Ludwig von Mises and Friedrich Hayek, Austrian was a term of historical significance only which referred to the first generation of Menger’s followers (Mises [1969] 1996). Mises and Hayek saw themselves simply as economists. But the socialist calculation debate revealed some fundamental theoretical cleavages between Mises and Hayek on the one hand and the neoclassical approach on the other (Lavoie 1985; Kirzner 1988). Baffled as to how other marginalist economists could side with the claims of the market socialists, both Mises and Hayek produced a large volume of methodological musings in the middle decades of the twentieth century. In order to explain why they had lost the debate, each put forward a case about where modern economics had gone wrong. Alongside their theoretical work, these writings provided the foundations for the Austrian “revival” of the 1960s and 1970s (Vaughn 1994, chap. 5). Younger economists appropriated the Austrian label to distinguish themselves from the then-dominant Samuelsonian paradigm in the economics profession. The Austrian emphasis on methodology continued among this generation. In fact, until the past decade or so, one would

14   Methodology have been hard pressed to find a self-identified Austrian economist who had not written on methodology at some point. But despite this common interest in the topic, Austrians vary wildly in their professed methodological beliefs. Common themes exist, but so do areas of intense internal debate. It is easy to locate a set of shared complaints about the methodology and methods of mainstream economics. But while there is a great deal of agreement on what not to do, there is a broader range of perspectives on how to actually undertake social-scientific inquiry. In this chapter, I offer a constructive approach to Austrian methodology that avoids conflating the distinctive methods proposed by Austrians and instead aims at synthesizing those distinct methods. My purpose is both descriptive and prescriptive. Descriptively, I hope to capture the central shared concerns that distinguish Austrian economics from other social-science approaches. Prescriptively, I argue that a synthesized Austrian methodology can make important contributions to twenty-first-century social science. Three caveats are in order. First, because of space constraints, I can only offer the preliminary sketch of a synthesis of Austrian methods. It is simple and abstract but cohesive. Second, I  do not directly address extant methodological controversies among Austrians or between Austrians and non-Austrians. Delving into this voluminous literature would bog down the prospect of offering a synthesis of Austrian methodological insights. Third, this chapter focuses on the methodology of Austrian economic theory and does not delve into any discussion of the appropriate methods for empirical research. This is not because empirical methods do not deserve consideration but because Austrians—while they might offer a unique perspective on the limitations and implications of different empirical methods—do not propose a completely different empirical tool kit from those of other social scientists. Throughout the chapter, I focus on what makes Austrians unique rather than what they share with other economists. The body of this chapter contains four sections. The first reviews the major methodological contributions of Austrian economists, focusing on their (professed) epistemological foundations. I argue that epistemological beliefs fail to provide any common grounding for Austrian methodology. The second section argues that the hard core of the Austrian research program is better characterized by shared ontological commitments (about the nature of social phenomena) rather than by epistemological foundations. The third section synthesizes various methods proposed by Austrian economists by constructing a general schema of the ontological characteristics of social processes. And the final section offers reflections on the distinctiveness of Austrian methodology in contemporary economics.

Epistemological Problems of Austrian Economists Since virtually all Austrians have dipped their toes into methodological water at some point, some selection criterion for discussion is necessary. In order to draw out

Austrian Methodology   15 important methodological differences, this section focuses on Austrians who posit distinctive epistemological foundations for economics. This has the advantage of including the three most influential Austrians: Menger the realist, Mises the rationalist, and Hayek the empiricist. These thinkers, I show, are more complex than these labels and their professed sympathies indicate. To these three I add a composite consideration of Ludwig Lachmann and Donald Lavoie, giving space for concerns associated with hermeneutics and postmodernism. I mention other influential work in Austrian methodology insofar as it sharpens or clarifies particular points.

Carl Menger “All things are subject to the law of cause and effect” (Menger [1871] 1994, 51). So reads the first sentence of Carl Menger’s Principles of Economics, which—though not primarily a treatise on methodology—elaborates an economic theory whose distinctiveness still embodies the unique elements of Austrian economics. As its opening line indicates, Menger’s treatise exhibits ample readiness to engage in more abstract questions concerning the nature of economic phenomena and the best way to understand them. Principles can be usefully read as a response to two distinctive literatures within nineteenth-century economics. On one hand, Menger seeks to reformulate the classical theory of economic value that runs from Adam Smith through David Ricardo, Karl Marx, and John Stuart Mill. Alongside William S. Jevons and Léon Walras, Menger is rightly credited as a codiscoverer of the marginalist theory that supplanted the labor theory of value. On the other hand, Menger hoped to demonstrate the value of abstract economic theory to the German historical school then dominant in his own corner of the world. The book is dedicated to Wilhelm Roscher, a prominent member of the “older” historical school. It is only after its poor reception by the “younger” historical school that Menger’s ideas become seen as the foundation of a new school of thought (see Mises [1969] 1996; Caldwell 2004, chap. 3). Throughout much of the twentieth century, Menger’s work was interpreted simply as an imprecise, verbal version of early neoclassical economics (see Vaughn 1994, 12–19). This view is simply untenable. Menger does formulate (though not name) a principle of diminishing marginal utility and explains the logic of partial equilibrium market clearing. But these insights are embedded in an overarching theoretical framework very different from most other marginalist economics. Streissler (1972) interprets Principles as descending from Smith’s work on economic development and evolution rather than other classical economics concerned with stationary states. One of the central ideas of Principles is that the “goods character” of commodities depends on the knowledge of their ability to satisfy human needs, a knowledge that is subject to historical revision and growth (Menger [1871] 1994, 51). Jaffe (1974) likewise draws attention to the differences between Menger on the one hand and Jevons and Walras on the other, arguing that Menger’s approach is deliberately distinctive in both presentation and content. Menger eschewed mathematical formulations not because he was ignorant of math but

16   Methodology because he thought it was a poor tool for analyzing the questions he sought to answer (Menger 1973). Principles recognizes a definite role for abstract theory, but that theory’s purpose is to help explain a complex and evolving social world (Vaughn 1994, 19–27). The best example of this approach is Menger’s theory of the origins of money (Menger [1871] 1994, 257–260). Rather than simply explaining why individuals would want to use money if it already exists, Menger uses economic reasoning to explaining the piecemeal evolution of exchange activity from a barter system, through various stages of indirect exchange, to a money-using economy. He advances a methodological approach to examining these “organic” institutions in Investigations into the Methods of the Social Sciences. He asks, “how can it be that institutions which serve the common welfare and are extremely significant for its development come into being without a common will toward establishing them?” (Menger [1883] 1996, 124; emphasis in original) The value of abstract, individualist economic theory is precisely in explaining these episodes of complex institutional evolution. Investigations is Menger’s primary salvo in the Methodenstreit (see Bostaph 1994) and defends in depth the sort of theorizing found in Principles. Menger distinguishes between history (including statistics) and theory (Menger [1883] 1996, 7–16), which he further breaks down into realistic-empirical theory and exact theory (22–35). Both forms of theory examine typical forms of phenomena; research only qualifies as theory to the extent that it applies beyond individual historical cases to broader classes of phenomena. Theory breaks down concrete phenomena into typical elements and investigates the relationships between those elements (17–21). Realistic-empirical theory does so on the basis of empirical evidence but is limited to generalizations rather than strict causal inferences (24–27). Exact theory, on the other hand, is based on the laws of cognition: typical phenomena stand in relationships to one another that, given identical conditions, cannot be otherwise (28–32). Exact theory can furnish causal laws, but these laws describe types of phenomena that are never encountered in pure form in the real world; such laws are thus of necessity unempirical. Both forms of theory investigate types of phenomena that are real, based on typical forms found in concrete historical phenomena (Menger [1883] 1996, 19). And both forms of theory are valuable for understanding those concrete phenomena. For example, Menger argues that there is an exact theory of price based on the nature of economic goods and their relationship to human knowledge and wants (42–44). That theory states that under strict conditions, an increase in demand of a certain amount will lead to a certain increase in price. But this theory can be neither confirmed nor falsified by experience, because the strict conditions may not be met. On the other hand, there is also the empirical regularity that actual increases in demand tend to correspond to increases in price. These historical price increases will not be precisely predictable but will manifest to the extent that conditions in the real world approximate those of exact theory. Jointly, the two forms of theory provide an account of concrete price increases that is both causal and empirically relevant.

Austrian Methodology   17 In steering a middle course between formalism and historicism, Menger is drawing on a broadly Aristotelian epistemology. The reason both exact theory and realistic-empirical theory can illuminate the real world is that the abstract types of phenomena they study can correspond to the forms that constitute real entities. While many have noted this Aristotelian and realist strain in Menger (Kauder 1957; Maki 1990), he is not a straightforward Aristotelian. Smith (1996, chap. 10) situates Menger’s approach within the broader intellectual currents in Austrian philosophy that run through the work of Franz Brentano, which puts a unique and more modern spin on Aristotelian ideas. To explain social phenomena is to explain how abstract types relate to one another to constitute the empirical world. Combined with his emphasis on the evolution of social phenomena such as money and markets, Menger’s orientation has been aptly described as a “genetic-causal” approach to economic theory (see Mayer [1932] 1994; Cowan and Rizzo 1996). In his own notes, he refers to this approach as “compositive,” a term that Hayek takes up (Hayek [1942–1944] 2010, 102).

Ludwig von Mises Ludwig von Mises is probably both the most influential and the most controversial thinker for postrevival Austrian economics. Both his theoretical economics and his methodology are central to the Austrian identity. But while the former commands virtually unanimous acceptance among Austrians, the latter has been the subject of decades of continuous debate. A case can be made that, like Menger, Mises took up methodology in response to the reception of his theoretical work, in particular the socialist calculation debate. Unlike Hayek, Mises—participating primarily in the German-language round of the debate—had to contend both with the faith in scientific planning and with the historicist and Marxian dismissal of “bourgeois” economic theory as wholly inapplicable to a socialist society (Caldwell 2004, chap.  5). Mises’s methodology can be understood as part of a broader argument that economic theory is applicable to any form of social order, but at the same time, economic calculation exists only in the context of a capitalist private-property order. Economics thus rests on universally valid propositions whose applicability is a question of historical and institutional contingency. Mises situates the traditional subject matter of economics—markets, exchange, money, and so on—within a broader science of human action. In his first major methodological work, a collection of essays translated into English as Epistemological Problems of Economics ([1933] 2003), Mises refers to this broader science as “sociology” (chap. 2). But in his later, more comprehensive treatise Human Action ([1949] 1996), he adopts the term praxeology (the “logic of action”) to refer to the study of the universal characteristics of human action (chap. 1). Praxeology overlaps substantially with what most social scientists refer to as rational choice theory, but Mises’s approach differs in two important, substantive ways from the more orthodox approach.

18   Methodology First, praxeology takes for granted a radical subjectivism not only of the value attached to different objects of choice but also to the very nature of those objects. Preference scales do not exist independently of choices, making acting counterpreferentially impossible (Mises [1949] 1996, 94–96). The relevant options for explaining individual behavior are the options the choosing individual imagines them to be. Mises makes this move explicitly to strip all psychological content from his theory of action; it does not presuppose selfishness or epistemic rationality but only that individuals act purposively, utilizing means to achieve ends (13–22; Mises [1933] 2003, chap. 4). Praxeology strips action down to its barest formal structure. Second, action presupposes the flow of real time and thus changes in the knowledge of choosing agents (Mises [1949] 1996, chaps. 5–6). Action is the projection of the mind “into the world of becoming and change” (36). In emphasizing time, Mises draws on the work of Henri Bergson (100–101), arguing that time is not just a dimension or factor of production but that it entails the possibility of real, radical change and thus the possibility of surprise (Rizzo 1979). The flow of time thus matters crucially for how the economist understands the knowledge of individuals. Any account of action that omits the flow of time by ignoring the necessity of coping with an uncertain future and changing conditions is a theory of automata ill suited to explaining human behavior. Mises seeks to establish a universally valid foundation for economics by stripping the concept of action down to a bare minimum: agents act purposively by choosing means and ends. This aspect of Mises’s approach commands wide assent among Austrians. Intensive debate centers on how one learns about the basic characteristics of action and what follows from knowledge of those characteristics (Vaughn 1994, 70–78). Mises argues that the propositions of praxeology are derived from a priori understanding of the basic categories of action without reference to sense data (Mises [1949] 1996, 32–36). Concepts such as choice are a priori categories that precede sensory experience but are sufficient to derive further insights such as the law of diminishing marginal utility. Concepts such as choice cannot be derived from experience but are instead used to understand sense data. Mises explicitly adopts a Kantian epistemology, placing praxeological reasoning on the same level as logic or mathematics. Because praxeological propositions are derived a priori, they can be neither confirmed nor falsified by experience. This, of course, confronts the same problem as Menger’s exact theory: how do we know that praxeological categories are helpful for elucidating real-world phenomena if they are not subject to empirical testing? A priori deductions may be logically valid but simply irrelevant. For Mises, the key to solving this problem is that praxeologists themselves are human agents. “Action and reason are congeneric and homogeneous; they may even be called two different aspects of the same thing. That reason has the power to make clear through pure ratiocination the essential features of action is a consequence of the fact that action is an offshoot of reason” (Mises [1949] 1996, 39). Economists are the types of agents they study, and so they have a firm basis for asserting the relevance of praxeological propositions. This solution underscores Mises’s methodological dualism, whereby he insists that there are methods appropriate to the social sciences that do

Austrian Methodology   19 not conform to the methods of the natural sciences. Because of human volition, Mises rejects both behaviorism and the idea that social science can rely on the sort of regularities that make empirical testing possible for the natural sciences: The experience with which the sciences of human action have to deal is always an experience of complex phenomena. No laboratory experiments can be performed with regard to human action. We are never in a position to observe the change in one element only, all other conditions of the event remaining unchanged. Historical experience as an experience of complex phenomena does not provide us with facts in the sense in which the natural sciences employ this term to signify isolated events tested in experiments. (31)

Rather than wade through the controversies surrounding these views—and without implying acceptance of every one of his arguments—it is more constructive to elaborate on three key distinctions Mises makes that illuminate the nuances of his position. The first distinction is between praxeology and catallactics. Praxeology provides the foundation for all social sciences. Catallactics—the science of exchange—is economics proper, the branch of praxeology that studies markets, prices, and so on (Mises [1949] 1996, chap. 14). Unlike praxeology, catallactics relies on subsidiary empirical assumptions such as the disutility of labor (611–623) and the existence of money; it takes social cooperation under the division of labor as its very starting point, the phenomenon that it seeks to explain. Praxeological propositions drive the analysis of that phenomenon and establish what counts as a satisfactory explanation for catallactic theory. Satisfactory explanations of social cooperation are those that make sense in light of the fundamental concepts of human action (such as choice and cost) and the implications of those concepts. The distinctiveness of praxeology as a theory of rational action leads to a distinctive understanding of markets. For instance, Mises’s emphasis on time and knowledge leads him to develop a theory of markets as an entrepreneurially driven competitive process rather than in terms of the properties of a static equilibrium (chaps. 14–16). This approach likewise underwrites Mises’s skepticism about formal mathematical modeling—both as a tool of planning and as a representation of markets—since modeling omits both genuine uncertainty and the flow of (real, Bergsonian) time (350–357). The second key distinction is between praxeology and history, which Mises considers the two ur-sciences of human action (Mises [1949] 1996, 30–32); praxeology studies the theoretical and necessary characteristics of action, while history studies its contingent characteristics and manifestations. In Theory and History, Mises develops this argument further, identifying individuality as the ultimate given of history (Mises 1957, chap. 9). Mises is keen to draw a sharp distinction between these two disciplines without denying that they are intimately linked and equally vital. History can neither confirm nor falsify praxeological propositions. Theories are illustrated by historical evidence rather than being tested by them. Indeed, Mises goes so far as to argue that pure history is impossible; theory is the lens through which history is always interpreted. “Historical facts need to be interpreted on the ground of previously available theorems. They do

20   Methodology not comment upon themselves” (208). Even a seemingly atheoretical, historical account imposes some selection criterion to determine what facts are worth reporting (Mises [1949] 1996, 47–51). Historical research can only determine the applicability of given propositions. But just as history cannot judge theory, theory can make no independent claim to applicability. Historical work is necessary to show whether certain propositions help explain any given phenomenon (66). Theory and History also introduces a distinction between praxeology and thymology (Mises 1957, chap. 12). Praxeology treats the characteristics of action qua action, while thymology studies the substantive content of action (ideas, values, etc.). Mises coins the term thymology as a substitute for psychology because he does not want to associate his theory with any particular theory of psychology. Rather, thymology is essentially historical and contingent. The ultimate given in historical research is the beliefs and values of individuals; thymology is cognition of those beliefs. Indeed, Mises offers scant detail regarding what correct or even reasonable thymology entails, both because it is focused on understanding individual motivations and because it is a mundane capacity. He identifies it with the understanding of others’ motivations that we use in day-to-day life: “It is practiced by children in the nursery and kindergarten, by businessmen in trade, by politicians and statesmen in affairs of state. All are eager to get information about other people’s valuations and plans and to appraise them correctly” (265). So defining thymology reinforces the radical subjectivism of Mises’s praxeology by making the analysis of preferences and beliefs a matter of sheer historical contingency. When pressed on concrete questions, Mises’s economics does appear consistent with this method. For example, in defending his business cycle theory, Mises admits that it is based on empirical assumptions about how entrepreneurs form expectations (Mises 1943). Mises fits the profile of a neo-Kantian with a strong belief in the power of a priori reasoning. However, the above three distinctions make clear that (a) the scope of what counts as purely a priori for Mises is strongly limited, and (b) his views are a long way from any sort of claim that empirical work is irrelevant for economics. Despite some rhetorical embellishments, his ideas sport more nuance than is often recognized by either his critics or his followers.

Friedrich Hayek As with Mises, Friedrich Hayek’s interest in methodology is partly an outgrowth of the socialist calculation debate. But whereas the bulk of Mises’s methodology is aimed at Marxists and historicists, Hayek’s intellectual opponents believe wholeheartedly in the power of economic theory not only as a mode of explanation but also as a tool of social control.1 Hayek directs his methodological arguments against the “pretense of knowledge” that economics can provide either precise predictions or effective control 1 

Where Hayek does criticize historicism, his arguments essentially rehash those of Menger and Mises (Hayek [1942–1944] 2010, chap. 7).

Austrian Methodology   21 of market forces (Hayek 1974). The language with which Hayek levels his critiques shifts throughout his career as he engages the literature in a variety of scientific disciplines, but his thoughts on the methodology of the social sciences remain largely consistent throughout.2 “Economics and Knowledge” (Hayek [1937] 1948) is the pivotal piece for tracing the evolution of Hayek’s signature ideas, both in theory and in methodology (Caldwell 2004, 209). Market socialists argued that the tools of general equilibrium theory could be used as a substitute for actual markets in goods and services. Hayek argues that this is an invalid use of abstract economic theory. He distinguishes between individual equilibrium, in which an individual has no desire to change his or her plans (Hayek [1937] 1948, 35–37), and interpersonal equilibrium, in which the plans of different individuals are consistent with one another (41–43). Interpersonal equilibrium obtains when individuals correctly anticipate how their plans interact with the plans of others. The problem with understanding markets in terms of general equilibrium is that it skirts the crucial question of how individuals come to form correct expectations (44–48). Abstract economic theory—the “pure logic of choice”—can describe the properties of a state of affairs in which individuals’ plans are already in alignment but not how they come into alignment. Correct expectations require knowledge—or a substitute for the knowledge—of potential trading partners’ beliefs and values, which is dispersed throughout society and whose acquisition is an empirical matter. Economic theory is no substitute for the process of knowledge acquisition. Hayek famously draws out the implications of dispersed and tacit knowledge to critique market-socialist proposals (Hayek 1945), but the same argument also undergirds much of his methodology. Hayek again picks up on the importance of individual beliefs in “The Facts of the Social Sciences” (1943) and “Scientism and the Study of Society” ([1942–1944] 2010). The facts of the social sciences are individual beliefs: “in the social sciences things are what people think they are” (1943, 3). Hayek distinguishes between speculative and constitutive beliefs about social phenomena3 ([1942–1944] 2010, 99–101). Speculative beliefs concern the nature of social structures and “collective wholes,” including both social-scientific and folk theories about how economies and other social systems operate. These are the beliefs that social scientists challenge or elaborate. Constitutive beliefs, on the other hand, are beliefs that guide individuals’ actions and thus play a role in constituting social phenomena (92–98). Money, for instance, is money just because individuals commonly 2 

Because of space constraints, I omit any reference to the literature that sees sharp distinctions between phases of Hayek’s thought; Caldwell’s (2004) comprehensive examination highlights with sufficient force the continuity (at least of trajectory) in Hayek’s thinking. The best case for a turning point in his thinking is “Economics and Knowledge” ([1937] 1948), but since all of Hayek’s methodological writings postdate that article, I treat them as a continuous stream of argument. This is not to say there are no tensions, but they are both overstated and largely beside the point for my argument. 3  It would be a mistake to read much into the word phenomena, as Hayek certainly did not believe that the objects of social-scientific study were visible in the relevant sense. I follow Hayek in using the term as it seems the most neutral, although one could substitute social entities or objects of social-scientific inquiry.

22   Methodology accept it as a medium of exchange. Rules, organizations, and even goods and services only exist in terms of the beliefs of individuals. These beliefs are the data from which social-scientific explanation begins (103). In order to explain a market for snake oil, the economist appeals not to objective physical properties but to individuals’ beliefs about the ends it might serve. Hayek draws out two main arguments from this starting point. First, economics explains social phenomena through the compositive method (Hayek [1942–1944] 2010, 101–104). The “individualist or compositive method” begins from the beliefs of individuals and explains how complex patterns of social order emerge from interaction predicated on those beliefs. Economics uses constitutive beliefs to formulate new speculative beliefs. The social scientist cannot observe “collective” entities or “wholes” such as “the economy,” “the polity,” or “capitalism.” Rather, such broader phenomena are “reconstructed” from more directly known facts about individual beliefs. Later in his career, Hayek associates this method not just with social structures but with any “complex phenomena,” such as the human mind or languages (Hayek [1964] 1967). Complex phenomena are those whose properties are the result of interactions among large numbers of constituent elements. Scientific understanding of complex phenomena cannot generate precise estimates of given variables of interest but only “explanations of the principle” (Hayek 1952, 182–184) by which the phenomena are constituted that result in very rough “pattern predictions” (Hayek [1964] 1967, 27–28). This argument tilts against the leap from social science to social engineering. Second, because social phenomena emerge from interactions predicated on individual beliefs, Hayek argues that it is unscientific to excise concepts such as meaning and purpose from social science ([1942–1944] 2010, 82). He directs much of his criticism against “scientism,” the uncritical application of the methods of the natural sciences to the social-scientific questions (80). Since the very objects of social-scientific inquiry cannot be conceptualized without reference to individual beliefs, it makes no sense to reduce social science to relationships between observable magnitudes. Subjective phenomena play an indispensable role in social-scientific explanation. The Sensory Order (1952), Hayek’s treatise on theoretical psychology, bolsters this second argument. Hayek argues that mental phenomena of consciousness emerge from the firings of neural networks whose structure is determined by past stimuli (Hayek 1952, 52–54). The mind emerges from brain activity. Subjective mental phenomena have emergent properties that are irreducible to their physical constituents. So behaviorist approaches to social science, which try to excise meaning and other subjective referents, can omit the very constituent causes of social phenomena (Caldwell 2004, 270–272). And even if the mind is ultimately a determinate system, Hayek argues, we would still need to make reference to subjective phenomena to explain human behavior. In order to exhaustively model a complex phenomenon such as the mind—and thus deduce mental states from physical states—we would need to be able to build a map of neural networks more complex than that system (Hayek 1952, chap. 8). In other words, Hayek defends

Austrian Methodology   23 methodological subjectivism on grounds similar to his critique of socialist planning, which requires similar predictive capacities to those of behaviorism (Caldwell 2004, 275–277). Hayek strongly critiques the French “rationalist” strain of individualism and defends the English “anti-rationalist” strain (Hayek 1946, 56–57). Yet Hayek shows no qualms about defending what looks like an a priori “pure logic of choice” as an indispensable part of economic inquiry (Hayek [1937] 1948; Caldwell 2004, 220–223). The Sensory Order also helps clarify his epistemological position. Hayek believes that knowledge derives from experience but maintains that sensory experience is itself the product of classification. He deems this the “primacy of the abstract” (Hayek [1969] 1978). The mind constitutes sensations in a certain way because external stimuli provoke neural responses similar to previous responses. These responses gradually build up neural connections that modify how we classify stimuli (Hayek 1952, chap. 3). Experiences thus build up the system of classification that constitutes sensation, but any individual experience is “pre-interpreted” according to the existing system. Hayek's epistemology is thus empiricist with regard to the abstract categories of thought through which the world is interpreted (Hayek 1952, 106; Caldwell 2004, 273–275) but not too far removed from a Kantian interpretation of the relationship between those abstract categories and concrete observations.

Ludwig Lachmann and Donald Lavoie Ludwig Lachmann is associated with a turn toward interpretive questions in Austrian methodology. As with Menger, Mises, and Hayek, Lachmann’s methodological views plausibly relate to his more substantive interests in macroeconomic fluctuations and capital theory. Unlike his predecessors, Lachmann builds more explicitly on the methodological work of earlier Austrians. He echoes the recurring distinction between theory and history and explicitly takes on praxeology from Mises (Lachmann 1951) and the compositive method from Hayek (Lachmann [1969] 1977). To avoid repetition, then, I focus here on the most distinctive elements of Lachmann’s thought and how those elements were developed in the work of Donald Lavoie. Lachmann’s focus on interpretation stems from the controversies surrounding expectations in the macroeconomic debates of the 1930s. Picking up on John Hicks’s work on the “elasticity of expectations,” Lachmann (1943) argues that all theories of macroeconomic fluctuations ultimately rest on some (often implicit) presuppositions about expectations. Adequately conceptualizing those expectations requires understanding how market participants interpret changing conditions. For example, an increase in the price of a commodity could be interpreted as a temporary surge in demand, soon to dissipate, or as heralding a new long-term trend. Such interpretations vary, so economists err when trying to treat expectations as mechanical or fixed. Instead, a key part of

24   Methodology successful economic explanation is rendering intelligible individuals’ interpretations of the world or the meanings they assign to observable phenomena. Lachmann pushes this point to the conclusion that “the Social World consists not of facts but of our interpretations of the facts” (Lachmann 1943, 14). The Legacy of Max Weber most fully develops Lachmann’s thoughts on meaning and interpretation by situating the Austrian paradigm—especially the work of Menger and Mises—in the tradition of Weberian Verstehen social science. Social-scientific explanation entails tracing phenomena back to individuals pursuing plans (Lachmann 1971, 20). But individuals interpret the world differently and so form divergent expectations about the future. This problem of divergent expectations is especially acute in large societies, in which the success of individuals’ plans depends on coordination with thousands or millions of other individuals (49). The scale of mass societies makes it impossible for either individuals in everyday life or social scientists studying such societies to depend on concrete knowledge of particular individuals; both analysis and action thus depend on “institutions.” It is true that in explaining recurrent patterns of action, the essential subject-matter of all social sciences, we cannot provide such explanation in terms of purposes, as elements of plans, because the purposes pursued by millions of people are of course numbered in millions. But often we are none-the-less able to provide explanations in terms of the elements common to all these plans, such as norms, institutions, and sometimes institutionalized behaviour, the maximization of profits, or the avoidance of the risk of insolvency. As long as we are able to account for the recurrence of patterns of action in terms of such elements of plans, we are successfully employing the classical method of interpretation. (22)

Actors orient their plans toward institutions rather than trying to discern the plans of countless others. For the social scientist, institutions enable broad if abstract access to what individuals believe and think and thus constitute an essential element of social-scientific explanation. In “Austrian Economics:  A  Hermeneutic Approach,” Lachmann later reaffirms the relevance of interpretation for understanding not only individual action but also institutions: “an institution is a network of constantly renewable meaningful relations between persons and groups of persons who may not all ascribe the same meaning to the same set of relations. The task of the student of institutions is to distil such meanings from his observations and to interpret them to his audience” (Lachmann 1991, 137).4 Lachmann thus associates good social science with a hermeneutic approach to institutions and sees this approach as fundamentally congruent with Austrian economics. Indeed, Lachmann uses essentially the same definition of hermeneutics as he does of Verstehen: the classic method of interpreting texts 4  As both of these essays predate the new institutional revolution in economics, Lachmann includes not only rules but also organizations such as firms in this definition, so they more closely correspond to the broader category of “social structures” (Lawson 1997; Hayek 1943).

Austrian Methodology   25 (Lachmann 1971, 10; Lachmann 1991, 135). Verstehen is the mirror of the compositive method; it reads meaning out of institutions rather than reconstructing how they come to be (Lachmann [1969] 1977, 153–155). But it would be a mistake to read any deeper epistemological commitments out of Lachmann in this regard. He consistently refers to hermeneutics as a “style of thought” that is helpful for social science and rarely makes reference to any broader epistemological concerns. Donald Lavoie embraces hermeneutics more wholeheartedly. Lavoie advocates hermeneutics both as a helpful input into social-scientific methodology and as a broader philosophical movement. He draws on the work of Lachmann and Alfred Schutz to build on the Austrian tradition. Schutz was a sociologist who studied Max Weber under Mises’s influence and subsequently influenced the development of modern phenomenological sociology (see Schutz [1932] 1967; Berger and Luckmann 1966). Schutz argues that individual action takes place within a “life-world” that is constituted by shared intersubjective meanings. The idea, as with Lachmann’s theory of institutions, is that meaning exists not only in individual minds but also in social phenomena such as language, texts, norms, rules, and so on. These meanings give the social scientist a foothold for grasping at “the facts of the social sciences.” Recall that Mises took a radically individualist and common-sense approach to thymology and empirical understanding of human action. Hayek, while asserting the empirical nature of such questions, offered little guidance in how they were to be answered (Caldwell 2004, 209). The Lachmann-Lavoie project can be seen as an attempt to make such empirical investigation more rigorous by identifying methods for getting at contingent, historical meanings that are made intelligible but not predictable by praxeology. Lavoie hoped that by taking on a more developed version of the interpretive historical method that Mises drew on, Austrians could turn toward more applied work. Mises (1957, 312) approvingly cites Wilhelm Dilthey’s approach to history, so Lavoie seeks out later writers in the tradition of phenomenology and hermeneutics to try to bring Austrian empirical work “up to date” in a way that maintains Austrian distinctiveness. The usefulness of the technical apparatus of modern hermeneutics for social science has been questioned by many Austrians with varying degrees of sympathy and is now less widely discussed (see Rothbard 1989; Vaughn 1994, 127–133). However, the body of applied historical work that this move helped initiate is still growing and is at least correlated with the most successful period in the school’s modern (postrevival) history. But Lavoie also goes further than this, embracing hermeneutics as a method for understanding scientific inquiry more generally. He affirms the antifoundationalism of thinkers such as Richard Rorty and can reasonably be called a postmodernist but not of any nihilistic sort. Following Richard Bernstein (Lavoie 2011, 94), he argues that proper philosophy of science steers a middle course between relativism and objectivism. Relativism errs in asserting that there is no way to ascertain which scientific judgments are valid. Objectivism—which he associates with the positivism that most Austrians are critical of—wrongly asserts that validity can be established by adherence

26   Methodology to some given procedure, usually involving supposedly unambiguous tests of hypotheses. Lavoie argues that we can assess the merits of theories but that this is accomplished through the discursive social practices of science (99–104). The process of scientific engagement—debating and discussing both theoretical frameworks and particular applications—is what establishes the validity of economic propositions and theories. Because this process is constituted by language, hermeneutics offers broad norms which help establish whether ideas and evidence have been correctly interpreted and analyzed (109–110).

Taking Stock The preceding discussion not only introduces the key methodological insights of the Austrian tradition but also illustrates that epistemological differences fail to result in methodological differences. Without denying their distinctiveness, the methodological writings of the five authors evince far more continuity and complementarity than discontinuity or discord. They are all antihistoricist: while they do not agree on the “ultimate” epistemological justification of economic theory, they all agree that theoretical propositions are logically prior to empirical observations. They are all antipositivist: none believes that empirical tests can directly confirm or disconfirm a sufficiently abstract theory, and all are skeptical of precise prediction. And they are all antibehaviorist: they affirm the relevance of categories of subjective mental thought for social-scientific explanation and refuse to reduce explanation to prediction. Austrians have spilled a great deal of ink considering the epistemological foundations of economic science, but, in practical terms, they agree on the relationship between theory and history and the role of empirical work in economics. Menger posits exact laws, Mises defends a priori reasoning,5 Hayek rests knowledge on preexperiential mental classification, and Lavoie argues that any scientific paradigm relies on shared understandings between scientific practitioners. Moreover, their general perspective—that theory is a lens for viewing history that cannot be directly confirmed or disconfirmed—is well supported in the philosophy literature on scientific research programs (see Rizzo 1982; Lavoie 2011). Rather than retreading questions about the ultimate grounding of economic theory, the remainder of this chapter sketches out a synthesis of the above methods proposed by Austrian economists. In order to do so, it is helpful to pinpoint exactly what is unique about the Austrian approach.

5  Murray Rothbard (1956) criticizes Fritz Machlup (1955; 1956) for defending a priori theory with insufficient vigor, but this is a dispute about how to defend Mises’s position rather than about whether it is correct (Zanotti and Cachanosky 2015).

Austrian Methodology   27

Getting Real about Austrian Distinctiveness Methodology should not be a mere abstract exercise to give confidence to individual belief but must speak to the nature of scholarly inquiry and the object if its study if it is to be accurate or fruitful (Menger [1883] 1996, xii). Despite some fundamental epistemological cleavages, there is a shared core of “Austrian” intellectual concerns—methodological, theoretical, and applied—that sustains a wide range of scholarly activities. Table 2.1 presents two lists of the core propositions of the Austrian school according to Boettke (2010) and Wagner (2010, 15). Wagner builds his list as a parallel to Weintraub’s (1993) discussion of the hard core of a Walrasian research program. Boettke’s list is likewise presented as a set of guiding propositions for applied research. In fact, it serves as an organizing set of chapter titles for a book written by ten younger Austrian researchers, most of whom (not incidentally) typically focus on applied work. While the two lists are distinct, they share some family resemblance. What is missing from both lists is any particular claim about the epistemological basis for these propositions. This is to say not that their epistemological warrant is Table 2.1  Boettke and Wagner on defining Austrian economics. Boettke’s Ten Austrian Propositions

Wagner’s Neo-Mengerian Hard Core

1 . Only individuals choose. 2. The study of the market order is fundamentally about exchange behavior and the institutions within which exchanges take place. 3. The “facts” of the social sciences are what people think and believe. 4. Utility and costs are subjective. 5. The price system economizes on the information that people need to process in making their decisions. 6. Private property in the means of production is a necessary condition for rational economic calculation. 7. The competitive market is a process of entrepreneurial discovery. 8. Money is nonneutral. 9. The capital structure consists of heterogeneous goods that have multispecific uses that must be aligned. 10. Social institutions often are the result of human action but not of human design.

1. Relevant reality contains both economic agents and social structure. 2. Agent preferences have social as well as genetic sources. 3. Agents choose ends in addition to economizing on means. 4. Markets are interrelated and modeled as networks. 5. Agent knowledge is incomplete and distributed among agents. 6. Observations are reflections of plans in progress.

28   Methodology philosophically unimportant but that such considerations fail to define the boundaries of a uniquely Austrian paradigm. Epistemology is neither necessary nor sufficient. Non-Austrians utilize a priori reasoning, and some Austrians—while accepting that it is impossible to test them directly—argue that knowledge of praxeological propositions is ultimately empirical (see Rothbard 1976, 24–27). It is the content of these propositions, the concrete methods for investigating them, and their relationship to one another that situate research within the Austrian paradigm. But while these core ideas do not come with any strict epistemological baggage, they do carry certain ontological presuppositions. Austrian economics ascribes certain abstract characteristics to social phenomena such as exchange, money, and markets, as well as to the nature of individual action that generates social phenomena in the first place. Both lists in table 2.1 fit this description, including propositions about the nature of the social world. This is not to say that Austrians are necessarily realists or essentialists but rather that they believe that characterizing social phenomena in a certain manner is, at a minimum, a helpful intellectual exercise. Even if an individual defends core Austrian propositions for purely pragmatic purposes, he or she still takes for granted claims about the ontological characteristics of the social world. Social ontology is a burgeoning field in both philosophy and the social sciences (see Searle 1995; Lawson 1997). It examines the fundamental features of social reality and asks about both the methodological and theoretical implications of those features. There already exists a stream of research connecting social ontology with Austrian economics (Beaulier and Boettke 2004; Lewis 2005; Lewis and Runde 2007; Runde 2001; Martin 2009). A key idea of the social ontology literature is that there is a link between the nature of an object of study and the methods that can illuminate various aspects of that object. The most basic features (ontology) that are ascribed to an entity or event have a powerful influence on the methods that seem appropriate to studying it. One does not study an ecosystem the same way one studies the works of Shakespeare. Ontological propositions about the nature of the social world better account both for the uniqueness and for the appropriateness of Austrian methods than do epistemological beliefs. That ontology underwrites methodology should make intuitive sense to Austrians who find Hayek’s discussion of the compositive method compelling. We never directly encounter social wholes but rather mentally reconstruct them. Austrians are distinctive precisely because they conceptualize the object they study differently from adherents of other schools of thought. They adopt methods meant to understand and analyze a different set of phenomena from those studied by other social scientists, because the phenomena themselves are mental constructs. “Until we have definite questions to ask we cannot employ our intellect; and questions presuppose that we have formed some provisional hypothesis or theory about the events” (Hayek [1964] 1967, 22). But Austrians also make distinctive claims about “microfoundations”—such as radical subjectivism, discovery, and uncertainty—that lead to distinctive mental models about social wholes. Before offering a synthesis of Austrian methods grounded in social

Austrian Methodology   29 ontology, it is worth sketching out some of the abstract differences between Austrian and mainstream rational choice theory here. Rather than produce a third list of definite propositions, I focus on three central themes common to all Austrian work: subjectivism, time and ignorance, and spontaneous order. Subjectivism. Hayek, in “Scientism and the Study of Society,” argues that “every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism” (Hayek [1942–1944] 2010, 94). While virtually all marginalist economics embraces some form of subjectivism, Austrian economics takes it to the extreme. For instance, Austrians typically reject Alfred Marshall’s metaphor of subjective utility and objective cost-of-production as the two blades of a pair of scissors jointly influencing prices (Kauder 1957, 418). Instead, production costs themselves are the subjective evaluations of entrepreneurs based on imputations of value from consumer goods. Austrians are apt to be suspicious of arguments about “social cost” disembodied from individual action. Buchanan (1969) aptly characterizes the Austrian approach to cost as part of a more radically subjectivist line of thinking. For Mises, hard-core subjectivism is what gives praxeology its claim to universal applicability: “it is in this subjectivism that the objectivity of our science lies” (Mises [1949] 1996, 22). But subjectivism also helps define the very role of economic science for Austrians. Economic theory rests on subjective concepts of purpose and meaning. Kirzner (1976) relates the parable of the Martian observer. An alien scientist with no knowledge of human subjective states, observing Grand Central Station, would be able to note human bodies entering and exiting metal boxes. The alien could even predict regular intervals of increased activity. But without access to human meanings, he would not have a complete description of the phenomenon, namely, that individuals are utilizing a mass-transit system to go to work and return home. Meanings are irreducible to the observation of event conjunctions. Lachmann’s work situating Austrian economics in the Verstehen tradition of sociology likewise reaffirms the centrality of subjectivism. White (1977) identifies it as the central methodological tenet of Austrian economics, and Lavoie (1991, 470) goes so far as to claim that “ ‘subjectivism’ … stands for the school itself.” Time and ignorance. “The economics of time and ignorance” is a phrase from John Maynard Keynes’s General Theory, but it serves also as the title of Gerald O’Driscoll and Mario Rizzo’s (1985) restatement of the Austrian paradigm. These two interrelated concepts have always been central to Austrian theory. Menger addresses time and uncertainty in the first chapter of Principles ([1871] 1994, 67–71) and is primarily interested in explaining the process of economic development wherein knowledge grows through time (71–74). Austrians typically accept Frank Knight’s distinction between risk and uncertainty (Langlois 1994). Mises makes time and uncertainty central to his understanding of action itself, while Hayek argues that competition is valuable precisely to the extent that we are ignorant of the best ways of accomplishing our ends (Hayek [1968] 1978). Kirzner (1960, chap 7) identifies Mises’s dyadic “logic of action”—“Action is to make choices and cope with an uncertain future” (Mises [1949] 1996, 248)—as

30   Methodology an importance advance over the more narrow “Robbinsian maximizer.” He goes on to place entrepreneurial discovery—the response to “sheer” ignorance—at the center of his own contributions to market-process theory (Kirzner 1997). He goes to great pains to distinguish sheer ignorance and discovery from “known” ignorance and search theory (Kirzner 1978). And Lachmann sees radical ignorance as an extension of radical subjectivism, embracing G. L. S. Shackle’s work on uncertainty (Lachmann 1976; Shackle 1972). Spontaneous order. Hayek does not use the phrase “spontaneous order” until his later work in political theory (Hayek 1973, chap. 1), but the central idea—that social structures and processes are often “the results of human action but not of human design”— goes back to the beginning of the Austrian tradition. Menger distinguishes between social institutions of pragmatic origin, which are designed for a purpose, and social institutions of organic origin, which arise spontaneously from the decentralized actions of individuals (Menger [1883] 1996, 124). The spontaneous-order approach stems from the emphasis on time and ignorance and takes seriously the epistemic problem of how actions come to be coordinated. Mises and Kirzner, for instance, argue that the market should be understood as a process (Mises [1949] 1996, chap. 15; Kirzner 1997). Hayek argues that if social wholes were only of human design, there would never have been an explanatory task for social science, and economics would never have developed (Hayek [1942–1944] 2010, 103). O’Driscoll (1977) characterizes Hayek’s writings in economic theory with the phrase “economics as a coordination problem.” Both Hayek in his last years and Lachmann come to question the value of equilibrium constructs entirely, with Hayek ([1981] 2012) preferring the metaphor of a series of rivers and streams (“The Flow of Goods and Services”) and Lachmann (1976) describing social order as constantly realigning itself a “kaleidic” fashion. Figure 2.1 depicts the relationship between Austrian economics and mainstream (Walrasian) economic theory. It is a Venn diagram that indicates both the overlap and the divergence between the two paradigms. Models of individual behavior occupy the top portion, with models of progressively larger-scale social phenomena as one moves farther down. Both approaches are methodologically individualist, so the arrows indicate the typical order of logical derivation, but there are differences in their microfoundations. Austrians emphasize subjective choice under uncertainty, while the Walrasian approach models human behavior as constrained optimization of a given utility function. The difference between these two approaches can be subtle. Different microfoundations make little or no difference to how Austrians would analyze partial equilibrium situations or the sorts of topics covered in an introductory economics class. But they diverge substantially in how they characterize broader-scale social phenomena. The differences between the two paradigms on this level of analysis are large and are rooted in the smaller differences in their microfoundations. Considerations at the bottom of the diagram would include the “big questions” of political economy: Why are some nations rich and others poor? What caused the Great Depression? How should we compare capitalism and socialism? These are precisely the sorts of substantive questions on which Austrians have diverged from their Walrasian colleagues.

Austrian Methodology   31 Choice under Uncertainty

Constrained Optimization Incentives

as alr General Equilibrium

ian

W

str Au

ian

Supply & Demand

Spontaneous Order

Figure 2.1  The overlap between Austrian and Walrasian economics.

The Methods of Austrian Economics No single orientation of research encompasses all research problems. Rather, advancing cognition of the real world and its processes and increasing claims on theoretical and practical knowledge ceaselessly bring to light new orientations of the desire for knowledge. Justified in itself, the single orientation of research still seems inadequate in view of the totality of the problems which science has to solve. This is especially true of the theory of a science. Its perfection can only be found in the satisfactory development of all justified orientations of theoretical research and in order of its results into one theoretical scheme, or into a system. (Menger [1883] 1996, xvii)

Austrian economists have proposed a number of methods for analyzing social phenomena. How can those interested in applying these insights organize their thinking about which methods are appropriate for which lines of analysis? This question admits of multiple (pragmatic) answers. Figure 2.2 offers one.6 It depicts, in extremely simplified form, the constituent element of a social process as understood in Austrian theory. Each of the three nodes in the figure refers to a distinct type of causal component of social processes, while the arrows refer to the relationships between those components. The arrows are labeled both for the source of causal influence they exert (choice, emergence, or supervention) and the possible ways those sources of influence can affect 6 

The figure is an adaptation of the one in Martin (2011), summarizing Wagner (2010).

32   Methodology

,o e: enc uce erg rod Em , Rep ent e lem ng alle Supp Ch

Su Kn perve ow nti Inc ledge on: ent a ive nd s

Social Structure

r

Individual Action

Interaction Choice between Plans: Conflict or Coordination

Figure 2.2  A general schema for social processes.

the next node. The dashed arrows indicate simultaneity, in the sense of the “real” or “praxeological” present in which an individual pursues a given plan (Mises [1949] 1996, 100–101). The solid arrow indicates the flow of time, defining a new present or “period.” In each period: 1. Individual action. The fundamental driver of any social process; individuals imagine possible plans and choose among them. Those plans either dovetail or conflict with the plans of others. 2. Interaction. How individuals’ several plans and expectations interact with one another can generate emergent social structures. This can entail reproducing, challenging, or supplementing existing social structures (i.e., generating new structures). 3. Social structures. Social structures—possessed of causal properties that emerge from the ways in which individuals interact—supervene on individual minds. As configurations of interaction, social structures can only exert influence on future activity, meaning that they operate in an “inherently tensed” (Lewis 2005, 92) manner, affecting the expectations of the costs and benefits of future actions. This then marks the start of a new present or period. The language of “social structures” is not common in Austrian economics, but the idea is.7 Social structures constitute and influence the forms that cooperation takes and thus are the primary determinants of the extent of social coordination. They include formal rules, informal norms, specific contracts, organizations, and other social institutions such as language and money. Social structures exert causal influence on social processes by affecting individuals’ perceptions of the costs and benefits of various plans they might pursue. Interactions either reproduce existing social structures, challenge (and 7 

This usage follows Lawson (1997) and roughly corresponds to the way Lachmann (1971) describes institutions.

Austrian Methodology   33

Entrepreneurship & Economizing

, or e: enc uce erg rod Em , Rep ent e lem ng alle Supp Ch

Su Kn perve ow nti Inc ledge on: ent a ive nd s

Relative Prices

Choice between Plans: Conflict or Coordination

Accept or Reject offers

Figure 2.3  Austrian market process theory.

sometimes alter) existing structures, or supplement them by generating new structures. An individual interaction may reproduce some structures while challenging or supplementing others. For example, an exchange may reproduce existing property-rights institutions while altering the going market price of a commodity. Social structures do not exist apart from the interactions that constitute them. And of course, interactions themselves can be decomposed into different individuals acting. This is why the schema defines a praxeological present in terms of action, interaction, and emergence of social structures. But since existing social structures are ultimately patterns of activity that affect expectations, they only affect future actions.8 The schema flexibly operates at different time scales and different levels of abstraction. The present may involve activities as direct as buying a horse (Menger [1871] 1994, chap. 5) or as extended and complex as establishing and running a new enterprise (Wagner 2010, chap. 6). Similarly, it can address particular historical episodes or the typical features of social processes. Figure 2.3 presents a stylized representation of Austrian market-process theory utilizing the schema. Entrepreneurs imagine profit opportunities that involve buying and selling various bundles of goods and services. Prospective trading partners either accept or decline those offers based on their expected costs and benefits and also the offers they perceive (or imagine they will receive) from rivalrous competitors. Trades may reproduce previous money prices or alter them. Relative prices enable economic calculation, affecting the expectations of entrepreneurs concerning future profit opportunities and the incentive for seizing them, in addition to rewarding previous trades. Each of the three nodes “makes a difference.” Money prices enable individuals to better coordinate their plans. Relative prices emerge spontaneously from individuals pursuing several ends. And entrepreneurial discoveries drive the changes to the system. 8  This is not to deny that individuals act upon anticipated changes in the social structures (such as changes in relative prices or regulatory rules). Social structures are not the only influence on expectations, but outside influences on expectations will be mediated by existing social structures.

34   Methodology Other signature Austrian theories likewise fit this general pattern. Menger theorizes the origin of money as a chain of entrepreneurial discoveries that increase the indirect exchange value of a commodity, each effecting marginal modifications to its emergent capacity to coordinate exchange activity. Fungibility, divisibility, ease of transport, and durability do not come all at once but rather in successive steps, each rendered intelligible by the logic of action, interaction, and social structure. Menger’s framework allows Mises to develop the regression theorem, which dissolves a puzzle about the circularity of the demand for money and its purchasing power by recognizing the flow of time between the emergence of social structures and individual actions predicated on those structures. Mises’s dynamics-of-intervention story follows a similar logic, with changes in government regulation (social structures) initiating a series of back-and-forth responses by market and political entrepreneurs alike. Austrian business cycle theory also relies on the entrepreneurial response to a monetary shock and the series of successive adjustments it triggers. Since the schema can highlight distinctively Austrian contributions, it can likewise identify theories and methods that run afoul of the Austrian approach (Martin 2011).9 The diagram helps identify theories that Austrians would consider in error by contradicting their ontological commitments about social phenomena. Atomism denies the causal power of social structures. Austrians believe that the institutions constituting a market system have causal import in enabling economic coordination. Holism, conversely, ignores the causal efficacy of individual action. Austrians emphasize entrepreneurs as agents of change and thus resist theories that treat social institutions as determining individual action. Austrians have consistently argued that methodological individualism is the best way of understanding social wholes (Menger [1883] 1996, 67). Constructivism ignores the causal import of interactions. This runs afoul of the Austrian emphasis on exchange and the division of knowledge. As a result, constructivism treats social structures as (isomorphic to or actually) objects of design rather than spontaneous in origin, reducing problems of social order to problems of organization. For example, the neoclassical take on market socialism ignores the importance of rivalrous competition as a discovery procedure. These causal forces are necessary components of social processes as understood by Austrians, not sufficient components. The figure contains, for instance, no reference to the physical environment in which action takes place. This is not because Austrians ignore such considerations but because there is no distinctively Austrian approach to taking account of them. Theories that fit the basic structure of the diagram may also fall outside of Austrian economics for substantive reasons. For instance, a behavioristic account of individual action that denies the applicability of subjectivism and sheer ignorance to explaining human behavior may otherwise fit this schema but would not be an Austrian approach. 9  This is not to say that every Austrian argument or line of inquiry explicitly makes (or should make) reference to all three, because which nodes are prominent will depend on the question asked. A Crusoe thought experiment, for instance, would have room for neither interaction nor social structures.

Austrian Methodology   35 The schema can also depict the relationships among the different methods espoused by Austrians, effectively synthesizing them into a coherent system. Since each node corresponds to a type of causal relationship constituting the social world, each node likewise corresponds to a set of methods appropriate to analyzing that type of relationship. Each node asks a different question and calls for a different type of answer. Figure 2.4 depicts how different methods map onto understanding different components of a social phenomenon. As a modification of fi ­ gure 2.2, it replaces the types of causality constituting social processes with the ways of studying them that Austrians have proposed. 1. Individual action. How do individuals behave? This node is the most straightforward; Austrians analyze how individuals act by appeal to praxeological categories and to thymological understanding. Action is understood as choice under uncertainty. Choosing individuals seek to economize on the means necessary to accomplish their ends. But agents also confront uncertainty, meaning they must imagine possible plans—which connect present means to future ends—before they can act upon them. The plans they imagine may dovetail or conflict with the plans of others. Thymology seeks to understand the concrete beliefs and values that shape action. It could be expansively interpreted to include common psychological generalities, such as the disutility of labor, along with propositions concerning knowledge such as entrepreneurial alertness. 2. Interaction. What are the possible emergent effects of the types of actions individuals engage in? This node corresponds to Menger and Hayek’s compositive method, sometimes expressed in terms of the causal genetic approach or an explanation of the principle. Kirzner (1976) points to an underlying tension in Austrian economics: on the one hand, Austrians emphasize meaning and purpose, but on the other hand, they preach unintended consequences and spontaneous order. The scheme helps explain why these two points of view are compatible. Individuals act purposively but cannot control how their plans will interact with those of others. They may be coordinated explicitly, as Social Structure

He Phe rmen e n Ver omen utics ste olo hen gy de

od eth ach e M pro ciple tiv Ap osi tic e Prin mp ne Co l-Ge of th usa on Ca anati l Exp

Individual Action

Interaction Praxeology Thymology Verstehende

Figure 2.4  A taxonomy of Austrian methods.

36   Methodology in an organization, but there is no added social-scientific puzzle there. It is only when order is spontaneous that this causal node requires a distinctive mode of explanation. 3. Social structure. What are the knowledge and incentives generated by emergent social structures? Social structures, following Lachmann and Lavoie, have embedded meanings. These meanings are in principle distinct from the individual meanings of question 1. Individuals usually draw their beliefs and values from social structures, but they can also challenge those meanings. Social structures do not determine knowledge or incentives, but they do influence them, both by providing incentives and by generating knowledge. When a social scientist wishes to understand a social process, he or she needs to “read” or interpret the social structures that shape the actions that constitute that process (Storr 2010). This method does not entail a deeper commitment to philosophical hermeneutics—and one may legitimately question whether any scientific or philosophical apparatus will improve such interpretations beyond common sense—but there is an element of Verstehen involved in understanding how individuals experience social structures. How best to answer this last question is the least-developed branch of Austrian methodology. Schutz, Lachmann, and Lavoie recognized more than other Austrians that question 3 is truly distinct from questions 1 and 2. But they often tacked back and forth from discussing the role of subjectivity and meaning to both individual action and social structure, so their critics read them as attacking the Austrian answers to question 1. Their proposed method remains the most controversial of the methods discussed here, but they are not the only social scientists to make the connection between the properties of language and the properties of social structures. Both Vincent Ostrom and Elinor Ostrom place language at the center of their understanding of institutions. Vincent Ostrom (1993) argues that the capacity for language is what enables any sort of genuinely social interaction to get off the ground, while Elinor Ostrom (Crawford and Ostrom 1995) traces out the syntactical properties of institutions. Institutions prohibit, prescribe, or permit different types of actions, and so they always carry some message that individuals need to grasp.

Conclusion: Austrian Distinctiveness in the Twenty-First Century Austrians have historically defended a distinct and largely consistent methodological position that recognizes both the need for an abstract, universal theory of human behavior and the importance of historically contingent and evolving social structures within which that behavior is situated. Consequently, Austrians have typically stood with one foot in mainstream economics, emphasizing rational choice and price theory, and the other in heterodox institutionalism. But the mainstream itself has both fragmented and moved in an Austrian direction on many margins. The importance of institutions—a

Austrian Methodology   37 sticking point in the socialist calculation debate—is now widely acknowledged. Assumptions of full and complete information and unbounded cognition are no longer taken for granted. Economic development and innovation are live research areas. None of this was true in the middle decades of the twentieth century, but it is now. What, if anything, is still distinctive and potentially valuable about the Austrian approach? This chapter has emphasized elements of the Austrian tradition that are still unique: radical subjectivism, uncertainty, the importance of time, and a spontaneous-order approach to understanding broader-scale social phenomena. While mainstream economics includes subjectivist elements, it is less committed to this principle than is Austrian economics. This is especially true when it comes to the nature of economic explanations. Austrians describe the role of economic theory as rendering social phenomena intelligible in terms of plans, purposes, and meanings rather than as a predictive science. Models of incomplete information or behavioral biases still fall short of genuine Knightian uncertainty. Equilibrium modeling is still the dominant approach to understanding social phenomena. And spontaneous social formations are still frequently modeled as if they were designed by “elites” or chosen by a “representative agent.” Keeping these methodological divergences in mind, there are several areas of research in which Austrians have a great deal to offer: 1. Economic development. Austrian market process theory has traditionally addressed itself to mainstream price theory, but in the past twenty years, economic development has once again emerged as a live topic in academic economics. As noted by Streissler (1972) and Vaughn (1994), Austrian economics since Menger has an intellectual framework built precisely for explaining the process of development through time. Austrians are in a position to explore development processes as driven by entrepreneurship and divided knowledge as a complement or substitute for the dominant approach that leans heavily on technological innovation. 2. Entrepreneurship in nonmarket contexts. Over the past fifty years, economists have broadened their field of study to include politics, law, culture, and any other sphere of social interaction. Austrians can import the epistemic dimension of praxeology into these domains of rational choice social science, illuminating the effects of uncertainty and entrepreneurship in public choice, law and economics, and so on. 3. Social epistemics. Economists, modeling individual action as constrained optimization, typically emphasize the incentive-generating effects of institutions, organizational arrangements, and policies. Austrians can supplement these discussions by investigating the missing epistemic dimension (McCloskey 2010, chap.  33). What are the knowledge-generating properties of institutions? What is the relationship between entrepreneurship and various organizational forms? How do different policies take account or run afoul of the problem of dispersed knowledge? 4. Institutional evolution. Institutions are a tricky topic for rational choice theory, since they are both the results of behavior (the equilibrium of a game) and a

38   Methodology constraint on behavior (the rules of the game). On the one hand, we cannot understand institutions as fixed, since they spring from human action. On the other hand, there is overwhelming evidence that institutions are not merely epiphenomenal patterns of activity but actually influence the course of history. Institutional change and development is one of the trickiest subjects in economics. Austrian economics, with its emphasis on time, can help both to resolve the theoretical tensions in this literature and to shed light on historical cases of gradual institutional evolution (see Boettke, Coyne, and Lesson 2008). 5. “Social” or heterodox economics. A  variety of social-scientific perspectives— economic sociology, behavioral economics, various forms of heterodox economics, and so on—have leveled critiques of rational choice theory for being inattentive to various dimensions of human behavior and social life. Economists, it is said, ignore social embeddedness, language and talk, power relations, altruism, intrinsic motivation, behavioral biases and heuristics, and so on. Calls for economic pluralism are increasingly common but could threaten to erode the identity of the discipline. Key Austrian ideas such as radical subjectivism, meaning, uncertainty, and the division of knowledge can help bridge the gap between these concerns and a sensible core of microeconomic analysis. 6. Philosophy and economics. The interdisciplinary dialogue between economics and philosophy is probably stronger in recent years than it has been since at least the nineteenth century. Moral and political philosophers increasingly appeal to economic theory in addressing philosophical questions (e.g., Bicchieri 2005), while economists are increasingly interested in the foundations of social cooperation (e.g., Fehr and Gachter 2000). Austrians should eagerly chime in on these discussions, highlighting the positive and normative implications of concepts such as uncertainty, discovery, and spontaneous order. 7. Qualitative research. The use of qualitative evidence has become increasingly accepted in contemporary political economy, especially with the rise of the “analytic narrative” approach to empirical work (Bates et al. 1998). The Austrian emphasis on meaning and intelligibility fits neatly into this growing body of work, where distinctively Austrian concerns can get a fair hearing as long as they are shown to be applicable (Storr 2010; Chamlee-Wright 2011). The economics profession today is much more “Austrian-friendly” than it was in the latter half of the twentieth century, but by no means are all the insights of the Austrian approach incorporated into the standard tool kit of economic analysis. With a diminished language barrier and with the benefit of prior methodological reflection, contemporary Austrians have the best prospects for engaging the substantive issues in the professional economics conversation since the Great Depression. Methodology itself will not win recognition for unique Austrian contributions, but an unreflective and undefended methodology would silence them prematurely.

Austrian Methodology   39

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Pa rt  I I

M IC ROE C ON OM IC S

Chapter 3

The Knowled g e Probl e m Lynne Kiesling

Introduction We typically associate the knowledge problem concept with F. A. Hayek’s seminal article “The Use of Knowledge in Society” (1945). Hayek argues that the fundamental economic problem societies face is not the allocation of a given set of resources based on a given set of preferences and technical capabilities; instead, the coordination of decisions and actions among interacting individual agents with diffuse private knowledge and plans forms the basis of economic activity. The diffuse and private nature of knowledge hampers such plan coordination, but out of human interaction, institutions emerge that enable decentralized coordination. Prices and market processes compose an institution for coordination in the face of the knowledge problem. Moreover, Hayek argued, knowledge transcends “scientific” information, there is no given and uniform set or distribution of data, and such information fails to capture all knowledge relevant to both static and dynamic decision-making and coordination. Hayek’s substantial insight in this work, one that has become largely incorporated into mainstream economics, is that the price system operating through market processes is an effective, parsimonious (but not perfect) means of generating, signaling, and aggregating such knowledge. Prices cannot convey all individual knowledge pertinent to a particular economic decision, but they do serve as knowledge surrogates by communicating some private knowledge (Horwitz 2004). Coordination of individual actions and plans emerges as a beneficial consequence of the price system; thus, the price system and market processes enable emergent, or unplanned, order. While this argument captures much of the substance of the knowledge problem as both a coordination problem and an epistemological issue, Hayek and other scholars developed the concept more deeply, including the idea that knowledge may be contextual and

I am grateful to Chris Coyne and Steve Horwitz for helpful comments and suggestions.

46   Microeconomics may not even exist outside of the economic process. Private knowledge includes knowledge of “time and place,” which is difficult to articulate, communicate, and aggregate. Its highly contextual nature can make private knowledge fleeting and ephemeral. Thus, the knowledge problem has two main components (Thomsen 1992, 16–17): • Complexity knowledge problem. The difficulty of coordinating individual plans and choices in the ubiquitous and unavoidable presence of dispersed, private, subjective knowledge. • Contextual knowledge problem. The epistemic fact that some knowledge relevant to such coordination does not exist outside of the market context; such knowledge is either created in the process of market interaction, tacit knowledge that is not consciously known (Polanyi [1966] 2009), or inarticulate knowledge that is difficult to express or aggregate. The distinction between knowledge and information has been important for twentieth-century economic thought, although it is a distinction that modern information theory has blurred (Thomsen 1992). Information can be acquired, although at a cost, but not all decision-relevant knowledge is consciously knowable or can be acquired explicitly. Boettke (2002, 166–167) illustrates this distinction with an example of an engineering student looking for a model to solve a problem. Treating this as an information and search cost problem, she will search the library for a model and search as long as the expected marginal benefit is at least as large as marginal cost. However, treating the problem as an information problem ignores her development and creation of new knowledge in the process of her problem solving, such as her creation of new models; consider also the variety of dispersed engineering students coming up with different new knowledge in the process of their activity. The provenance of the knowledge problem idea is older and is more broadly applicable than the aggregation and transmission of diffuse private knowledge through prices. In fact, the knowledge problem is a deep epistemological challenge, one with which several scholars in the Austrian tradition have grappled. This chapter provides an overview of the development of the knowledge problem as a concept that has both complexity and epistemic dimensions, its relation to and differences from modern game theory and mechanism design, and its implications for institutional design and political economy.

History of the Idea: The Complexity Knowledge Problem Ludwig von Mises’s reading group in Vienna provided an interdisciplinary, intellectual focal point for the development of many ideas related to the knowledge problem. Meeting between 1922 and 1934, this group included Hayek, Alfred Schutz, Oskar

The Knowledge Problem    47 Morgenstern, Fritz Machlup, and other economists, sociologists, and psychologists working and studying in Vienna in the 1920s. Schutz’s ([1932] 1967) analysis of meaning and how we create intersubjective knowledge provided an early and significant foundation for the role of the knowledge problem in Austrian economics. Schutz worked primarily to extend and clarify Max Weber’s methodology of the social sciences and his “ideal type” concept.1 In The Phenomenology of the Social World, Schutz explored how knowledge helps individuals coordinate their actions and plans, framing this exploration in the quest for intersubjective understanding. Shared meaning across individuals plays an important role in this understanding. Schutz contended that humans use ideal types daily and that those ideal types contain our conscious and unconscious knowledge, past and current. This knowledge combines with our perceptions to enable us to form expectations about the motives, plans, and actions of others (Knudsen 2004, 48). This understanding of the separate existence and perception of “the other” led Schutz to argue that meaning is subjective and therefore differs for each individual ([1932] 1967, 138). Furthermore, Schutz argued that individual perception of the surrounding environment and of events and actions, not to mention perception of the motives of other agents, is fragmentary and incomplete. Subjective meaning and fragmentary perception combine to create private local knowledge. During the same period as Schutz’s investigation of subjective and fragmentary knowledge, Hayek and Mises were embroiled in the socialist calculation debate. Hayek tended to emphasize more the ideas associated with the knowledge problem, building implicitly on Schutz’s work, while Mises took a more computational approach that was still focused on the information available to agents to enable them to perform economic calculation. More than a mathematical exercise, economic calculation encompasses an evaluation of the subjective perceptions and trade-offs of current and future decisions made in a dynamic, complex, nondeterministic environment. Economic calculation enables the connection of means and ends and the assessment of value in purposeful human action. Mises tended to characterize the problem with socialism as an economic calculation problem, while Hayek tended to view the main problem underlying socialist calculation as being that of aggregating and acting on dispersed private knowledge, but these arguments complement each other through their shared emphasis on the irreplaceable role of decentralized money prices and market processes in a large, complex system. Mises described money prices as “aids to the mind” that facilitate economic decision-making in a complex economy ([1920] 1990, 12), while also arguing that a complex economy is characterized in part by a division of knowledge ([1922] 1981, 101). The absence of prices in a socialist system would mean the absence of the information contained in prices enabling agents to make choices and coordinate plans (Yeager 1994; see also Horwitz 2004 and Ebeling 2008). Economic calculation plays a coordinating role in dynamic social systems, and decentralized decisions facilitated by prices are indispensable in enabling that coordination to occur by providing a way to access dispersed, private knowledge.

1 

For an analysis of the use of ideal type methodology in economics, see Koppl (1994).

48   Microeconomics Thus, we can distinguish between the knowledge problem and the computation problem as different but related aspects of the critique of centralized economic planning (Lavoie 1986, 5). The knowledge problem argument that Hayek developed in the socialist calculation debate was primarily the complexity knowledge problem, focusing on the impossibility of accessing and aggregating dispersed private knowledge in the absence of prices and market processes. In the debate, however, Hayek was already formulating the contextual knowledge problem argument by arguing that much of the knowledge relevant to decision-making is inarticulate (Hayek 1935, 210). Hayek’s essay “Economics and Knowledge” (1937) explores some of the same problems of coordination in the presence of dispersed and local knowledge that Schutz explored and complements the arguments against central economic planning that Mises laid out in the socialist calculation debate. He does so in the context of examining the information assumptions associated with the economic concept of equilibrium. Information (or data), knowledge, and foresight undergird the equilibrium state, a state in which agents have coordinated, mutually compatible plans from which no agent deviates. What knowledge is necessary for achieving equilibrium, and how do agents acquire it? Analyzing the epistemic conditions for equilibrium, Hayek starts to connect the ideas of Schutz, Mises, and others with his own to develop the knowledge problem critique of neoclassical economic theory. Hayek begins this argument by characterizing data, or a stock of information, as observable and knowable facts given to an individual. Neoclassical equilibrium models assume full availability of such data, but how is that possible when the actions of one person provide the data for other people and any change in the relevant data will disrupt equilibrium because others will change their plans, which changes the data for others, and so on (Hayek 1937, 36–38)? Moreover, equilibrium is time-dependent because agents will adjust their expectations of the actions of others, in addition to adjusting their own actions, as they observe and learn from experience. The plans, actions, and expectations of agents are interdependent, and changes in those variables for one agent can lead to a change in information and expectations in others; this interdependence is one hallmark of a complex system. Thus, a defining characteristic of equilibrium is that agents have perfect foresight—their expectations are all realized, contributing to their lack of deviation from their plans—but we should not make perfect foresight assumptions in models because perfect foresight is unlikely to exist in disequilibrium (42). His critique continues with the “common knowledge” assumption that even if agents are not omniscient, they possess the knowledge relevant to their individual and joint economic decision-making. Theory that relies on this assumption does not create any understanding of where and how agents acquire or communicate the relevant knowledge that enables them to achieve equilibrium (Hayek 1937, 46).2 Through this critique, Hayek begins to distinguish between information and knowledge. 2  Morgenstern was also making related critiques of the common knowledge and perfect foresight assumptions underlying models of perfect competition; his critiques provided a foundation for the development of game theory in economic analysis.

The Knowledge Problem    49 In the standard full-information assumptions underlying the neoclassical equilibrium model, the form that necessary knowledge takes is straightforward: an individual agent knows his or her preferences or cost of production and also full common knowledge across agents about market prices. Hayek’s counter to this argument is twofold. First, the knowledge relevant to decision-making goes beyond market prices; it also includes knowledge such as individual skills and alertness to or awareness of profit opportunities. Second, the knowledge relevant to decision-making is dispersed among agents in the economy (he credits Mises with the “division of knowledge” concept), and yet a market economy enables the “spontaneous interaction” of these agents with diffuse private knowledge to bring about an outcome “in which prices correspond to costs” (Hayek 1937, 50–51). Analyzing the importance of the dispersion of knowledge marked the beginning of Hayek’s extensive work on the knowledge problem. “Economics and Knowledge” enabled Hayek to explore the crucial role of learning processes in the concept of equilibrium itself (Knudsen 2004, 62). This background creates a context for the seminal arguments in “The Use of Knowledge in Society” (Hayek 1945), which refined the ideas developed in “Economics and Knowledge” (Hayek 1937) and the socialist calculation debate to address the fundamental role that the price system plays in aggregating and communicating dispersed private knowledge among the autonomous individual agents who interact, usually anonymously, through market processes. Here Hayek departs from the equilibrium framework of “Economics and Knowledge” and develops the role of prices as knowledge surrogates (Horwitz 2004, 314). This departure from the equilibrium framework marks a significant turn in Hayek’s work in general, including his analysis of knowledge (Thomsen 1992). Hayek characterized the fundamental economic problem not as the static allocation of scarce resources among uses by omniscient agents but rather as the coordination of actions and plans among dispersed agents with diffuse private knowledge. In his statement that “the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess” (Hayek 1945, 519), Hayek draws on the earlier arguments of the socialist calculation debate and of his (1937) work. The “man on the spot” (1945, 524) has subjective, private knowledge of “the particular circumstances of time and place” (522), and that knowledge is among the decision-relevant data that cannot be aggregated except through a decentralized system of prices and a market process of exchange to determine those prices. Prices economize on the communication and interpretation of knowledge among dispersed agents. How do individuals learn the plans of others? How do they learn when they are wrong and take action accordingly? Prices and market processes provide feedback channels. Feedback loops, learning, adaptation to a changing environment and changing actions and plans of others, interdependence of agents and their actions in a complex system, and how prices and markets serve as feedback loops making a complex system adaptive are all important implications of Hayek’s argument. Prices provide profit opportunities and realized profits, and those realized profits serve as feedback that can spur

50   Microeconomics the discovery of new products, services, business models, or other ways to create value through economic activity. Alert entrepreneurs see these opportunities, learn from observed and realized feedback, and adapt their plans accordingly. Prices enable “error detection and correction within the market” (Boettke 1998, 135). Markets are processes for social learning and provide feedback channels for entrepreneurial alertness. Note that Hayek’s argument here emphasizes the complexity knowledge problem. Knowledge is dispersed, subjective, and private, and capturing that knowledge to enable plan coordination requires a decentralized system of prices generated in a market process. However, as Horwitz (2004) noted (and as cited above), prices cannot convey full knowledge among individuals but instead communicate the consequences of the realized actions and interactions of many agents. For that reason, we should think of prices not as containing full knowledge but as knowledge surrogates that aggregate the knowledge reflected in individual actions. Full knowledge is unrealistic and not achievable by any person or group of people. These ideas converge in Hayek’s The Sensory Order (1952), which provides a theoretical psychological framework for analyzing the context in which individuals actually make decisions. Hayek constructed a theory of mind in which the consciousness that we use to process, understand, and interact with the world around us is itself an emergent or unplanned abstract classification system. The mind creates distinctions and evolved because classifications that do not connect action to physical reality well enough for an individual to thrive will not survive (Horwitz 2000, 25). Individuals make decisions based on perception, which can be distinct and subjective because of the particulars of individual experience but which also has consistency across people because of the evolutionary process.3 Furthermore, the human mind has cognitive limitations, because in its entirety, the human mind cannot be comprehended fully by the human mind; an individual cannot grasp all of the relevant factual, institutional, and cognitive knowledge for decision-making because of the inescapable embeddedness of the human mind in the system. Hayek reaches this conclusion because he conceives of the mind as a self-organizing, emergent order; through evolutionary processes involving both the brain’s physical structure and the cultural and empirical experiences of individuals, the mind’s capacity to classify and distinguish emerges, beyond the conscious control of any one person. This theory of mind has significant implications for the definition of knowledge and the use of knowledge: “What this amounts to is that all the ‘knowledge’ of the external world which such an organism possesses consists in the action patterns which the stimuli tend to evoke, or, with special reference to the human mind, that what we call knowledge is primarily a system of rules of action assisted and modified by rules indicating equivalences or differences or various combinations of stimuli” (Hayek 1969, 41). The mind

3  These questions of perception and knowledge have their roots in David Hume, to the extent that Hayek’s theory of mind relies on the evolution of the mind and its distinctions via the interaction of biology and experience.

The Knowledge Problem    51 categorizes information and inputs (stimuli) and uses perception in the process, resulting in knowledge. This theory of the mind as an emergent classification system complements the subjectivist approach to both value and knowledge and thus provides a scientific underpinning of the phenomenon of dispersed, private, subjective knowledge. It also resonates with the subjectivity and perception themes that Schutz had raised two decades earlier. Hayek’s epistemological theory in The Sensory Order reinforces the argument that knowledge is different from data/facts, is not given, is not objective, and includes not just preference- and cost-related knowledge but also institutional knowledge—the rules by which we interact and exchange in society. These rules, both informal and formal, are grounded in custom as the transmitter of rules that have proven effective, or robust, over time.

Information and Knowledge in Modern Economics During the twentieth century, many economists conflated knowledge and information, although knowledge and information are not the same thing. While paying attention to and approaching the problems of the complexity knowledge problem in their models of decentralized mechanisms, the game theory and mechanism design literatures ignore the contextual knowledge problem (Boettke 1998, 150). Theorists typically make strong assumptions regarding information, starting with the assumption that information incompleteness is a stochastic problem and that information has a known underlying probability distribution. While the distinction between risk and uncertainty is typically associated with Frank Knight, Austrian economists have used this distinction to point at a significant difference between this definition of information and knowledge, over which there can be no known probability distribution ex ante, in either the complexity sense or the contextual sense of knowledge. Moreover, these models often rely on the assumption that complete information is available but at a cost: “complete information is available, but agents are imperfectly informed and have to engage in a deliberate process of gathering the information that is relevant to their decision-making” (Boettke 2002, 265). The related literature on search theory relies on similar assumptions and characterizes agents as Bayesian updaters of their priors as they acquire more information. This treatment of information is consistent with the complexity/coordination knowledge problem analyzed in Hayek (1945), but it inaccurately treats information aggregation mechanistically, in addition to ignoring or assuming away the contextual knowledge problem.4 4  For example, Stigler (1961) wrote one of the first papers in the information literature, and his mechanistic treatment of information falls prey to this criticism. While a seminal work in the development of information economics, it does not engage or address any of the knowledge problem arguments that Hayek had raised in the preceding twenty-five years.

52   Microeconomics Despite such developments, modern information theory (encompassing game theory and mechanism design) has Austrian roots in Oskar Morgenstern (Foss 2000). Morgenstern was a key member of the reading group that Mises held in Vienna between 1922 and 1934, through which he developed and shared ideas with Hayek, Schutz, and others. A critic of the simplistic information assumptions of neoclassical economic theory, Morgenstern brought a process approach to understanding the interdependence and strategic interaction of agents in a social system, including their beliefs about one another that enabled them to form expectations. Through his pioneering collaboration with John von Neumann to develop game theory and apply it to economic questions, Morgenstern challenged the fundamental assumptions about information and knowledge in economic theory and contributed to a fundamental change in the assumptions and the methodology of economic theory. Morgenstern ([1935] 1976) analyzed the perfect foresight assumptions of equilibrium economic theory when applied across several agents in an economy and how they might simultaneously all have perfect foresight. In a result that would be important later in game theory, Morgenstern argued that the strategic interaction of multiple agents made it difficult to justify the assumption of perfect foresight for all agents. The self-reference problem meant that the simultaneous perfect foresight assumption made equilibrium a degenerate outcome of the model (Knudsen 2004, 63). He also argued that this problem would make the theory of perfect competition conceptually problematic; Hayek would reach the same conclusion two years later in “Economics and Knowledge.” Both Hayek and Morgenstern argued that maximization is only a well-defined concept in equilibrium, and when agents are not in equilibrium, the model could not say anything about how they make choices or about the process by which they could converge to an equilibrium. One consequence of this exploration of the conceptual problems of knowledge and foresight in perfect competition was that both Hayek and Morgenstern contributed to Morgenstern’s subsequent development with Neumann of strategic interaction, game theory, and individual-choice-interdependent, strategic environments. Schotter (1992) and Shubik (1992) both recognize Morgenstern’s original contribution to game theory arising from his focus on the paradox of perfect foresight in equilibrium theory (Knudsen 2004, 65). Herbert Simon’s (1982) work on bounded rationality reflects the influence of both Hayek’s knowledge problem ideas and modern information theory. Simon bridged economics, decision science, information theory, complex systems, and psychology in developing his theory of bounded rationality. He took the inescapable incompleteness of knowledge at both a mechanical and an epistemic level and concluded that individuals generally make the best decisions they can, given the physical and cognitive limitations people possess. The shared influence of Hayek’s work on the knowledge problem, modern information theory, and Simon’s bounded rationality synthesis also shows up in Vernon Smith’s (2009) concept of ecological rationality. A related area of inquiry that builds on these different strands is psychologist Gerd Gigerenzer’s (1999) analyses of the “fast and furious” heuristics and rules of thumb that individuals use to filter, categorize, and act on their simultaneous flood of information

The Knowledge Problem    53 and lack of knowledge (see also Gigerenzer and Goldstein 1996). These heuristics are grounded in bounded rationality and, whether consciously or unconsciously, develop and are transmitted over time and are context-dependent. This idea reinforces Hayek’s later arguments for emergent social institutions, often based on informal norms and customs, as a historical information repository that “made institutions” cannot replicate; institutions serve as a sort of social heuristic for the intertemporal transmission of social knowledge.

The Contextual Knowledge Problem Thus, as the complexity knowledge problem filtered into Austrian economics, information theory, and ultimately the neoclassical economics synthesis, the contextual argument continued to develop that not all relevant knowledge is conscious, articulate, or given. Here I  define contextual knowledge as including tacit knowledge (knowledge relevant in specific contexts that we do not know consciously that we know or how we acquired the knowledge), inarticulate knowledge (unexpressed or unspoken knowledge underlying an action or decision), and emergent knowledge that only exists in the specific context of a purposeful action or interaction. Hayek elaborates on the contextual knowledge problem in “Competition as a Discovery Procedure” ([1968] 1978), although traces of it show up notably in “The Competitive ‘Solution’ ” ([1940] 1948), “The Use of Knowledge in Society” (1945), and The Sensory Order (1952), among other works. Hayek’s earlier work on diffuse private knowledge and critiques of the full information assumptions of neoclassical equilibrium models set the stage for extending the analysis to include contextual knowledge in decision-making and economic calculation. The Sensory Order provided a theoretical framework for the psychological and cognitive foundations of contextual knowledge. The contextual knowledge problem incorporates the idea of knowledge generation within the market process and thus presents a substantial challenge to rationalist neoclassical treatments of information. Some of the knowledge relevant to decision-making and economic calculation does not exist independent of the market context. Knowledge is, therefore, in part a function of individual perception, again reflecting the earlier concepts of Schutz and the psychological framework from The Sensory Order. Boettke (1998) summarizes the argument that some knowledge needed for economic calculation exists only within the actual market context: [T]‌he benefits of competitive markets are tied to the existence of markets and cannot be obtained independent of that context. … The knowledge argument is a contextual argument. Hayek’s argument is not limited to the complexity issue of how various scattered bits and pieces of information held privately can be summarized in a form which is objectively useful for others so that economic actors can coordinate their plans. … In addition to the complexity argument that most scholars read in Hayek,

54   Microeconomics there is an argument—as we have seen—that the knowledge required for economic calculation is available only within the market process itself. Outside of that context this knowledge does not exist. And, it is precisely this contextual knowledge of the market which enables economic actors to select out from among the numerous array of technologically feasible production projects those which are economically viable—in other words to engage in rational economic calculation. (145; emphasis in original)

Thus, such knowledge is itself emergent and is endogenously created within the market process; this is the primary sense in which the market is a discovery procedure. The contextual nature of knowledge also contributes to understanding feedback effects in social systems. For example, contextual knowledge means that individuals and the patterns that emerge from their aggregate interactions in social systems are prone to amplification through positive feedback, such as riots, bubbles, and bank panics (and more innocuous effects, such as doing the wave at sporting events or participating in a standing ovation). But contextual knowledge also helps us understand the dampening, or equilibrating, negative feedback effects in markets that take the form of entrepreneurial alertness (Kirzner 1997). Exploring the intersection of the Austrian concept of contextual knowledge and models of feedback effects in complex systems is a fruitful area for future research in a variety of applications. Later scholars have also synthesized and further developed both the complexity and contextual knowledge problems. In Knowledge and Decisions ([1980]1996), Thomas Sowell develops these ideas and uses them to analyze the social processes and institutions to aggregate fragmentary knowledge, coordinate decisions across individuals possessing this fragmentary knowledge, and generate beneficial outcomes and enable a complex society to emerge and function. The unifying theme of Knowledge and Decisions is that the specific mechanics of decision-making processes and institutions determine what kinds of knowledge can be brought to bear and with what effectiveness. In a world where people are preoccupied with arguing about what decisions should be made on a sweeping range of issues, this book argues that the most fundamental question is not what decision to make but who is to make it—through what processes and under what incentives and constraints, and with what feedback mechanisms to correct the decision if it proves to be wrong. (Sowell [1980] 1996, xxii)

Sowell uses the reality of the knowledge problem as a starting point to analyze the institutions humans use to make collective decisions. He emphasizes the evolutionary nature of complex social systems, in which much of the rationality guiding individual decisions is embedded in the inarticulate knowledge contained in such social processes. Don Lavoie (1986) provides one of the seminal works in the development of the knowledge problem with his thorough analysis of the inarticulate nature of knowledge. Not only does he give the knowledge problem its name in this work (1986, 6), but he also expands the contextual knowledge problem argument in particular by

The Knowledge Problem    55 analyzing the pervasiveness of inarticulate knowledge and its implications. Consider, as Lavoie does, the problem of riding a bicycle: most people ride bicycles even without knowing the physics underlying how to maintain balance on a bicycle, without solving the equations for the bicycling equilibrium. Knowing how to ride a bike is an example of inarticulate knowledge, the difference between “knowing that” if I pedal fast enough the wheels will turn to maintain balance and “knowing how” the physics works (1). Similarly, inarticulate knowledge informs economic decision-making, and that knowledge emerges from our actions and interactions in the process of exchange. An important implication of the pervasiveness of inarticulate knowledge is that an ex ante, nonmarket, decentralized mechanism cannot replicate either the efficiency or the knowledge-creating or knowledge-revealing effects of prices and market processes. Decentralized market processes and price mechanisms can elicit and make use of inarticulate knowledge where other institutions cannot. Lavoie also includes in inarticulate knowledge the inarticulate meaning attached to prices, concluding that this inarticulate, subjective, personal meaning is impossible to create otherwise or, therefore, to aggregate through some other nonmarket means (16). No one knows the meaning that a person attaches to an item, a concept, or an action other than that individual; that said, though, that person may not even be able to articulate that meaning or why it exists in a way that is comprehensible to someone else. Yet that person can still act purposefully on that inarticulate meaning in a market context. This insight incorporates a Schutzian theme: meaning itself, with subjectivity and with fragmentary personal perception, is also a part of knowledge. Interpretation and judgment create knowledge (Boettke 2002).

Implications for Institutional Design The knowledge problem is particularly relevant in political economy, or the comparative analysis of economic and social institutions and their performance. Some of the most important implications of the knowledge problem arise in the area of institutional design. Economics is the study of human action and decisions, and all such activity takes place within an institutional context; the informal and formal institutions that structure individual incentives do shape decisions and thus ultimately affect outcomes. Consider a general model of human action and decision-making, in which the important determinants of an individual’s actions and interactions are his or her preferences, the environment, and the institutional framework. Institutions interact with preferences and the environment to determine individual actions and interactions with others. Thus, economists can evaluate the relationship of institutions to outcomes, taking into account the incentives they generate and the features of the environment in which the institutions operate. Furthermore, using the Austrian conception that the fundamental economic problem is the coordination of actions and plans among heterogeneous agents with dispersed, private, contextual knowledge, we can frame the institutional question as one of

56   Microeconomics evaluating the emergence and the deliberate design of institutions that maximize social cooperation (Horwitz 2000). Institutions often emerge out of history, experience, and trial-and-error experimentation, and in fact, formal legal institutions have often been codifications of informal norms and emergent informal legal systems, some of which had existed for centuries. In this sense, we can think of, for example, the English common law as an emergent legal order, or an organic, grown legal order grounded in basic principles of property rights, commutative justice to defend negatively defined rights, rights of contract, and consent (Hayek 1960). The long evolution of precedent and the roles of judges in interpreting the common law provide feedback channels that enable this legal institution to change over time, to adapt to changes in the economic, social, and physical environment and changes in preferences. The experiences and information flows that inform this evolution feed into the legal system in a bottom-up manner, through individual interactions and experimentation. The knowledge problem is a fundamental reason for the robustness and longevity of the English common law, in the sense that robust institutions “generate prosperity in less than ideal conditions” (Leeson and Subrick 2006, 107). The common law’s emphasis on enforcing basic, universal principles of physical liberty, property rights, contract, and consent has worked to promote prosperity even in the presence of other limitations and obstacles to economic growth, and its feedback channels for incremental modification in a changing environment enable trial-and-error experimentation in economic activity. This legal institution is compatible with both the complexity and the contextual aspects of the knowledge problem. The common law does not require aggregation of diffuse private knowledge in order for a community to meet and enforce its principles, and its grounding in these basic principles enables individuals to prosper from the exercise of their division of knowledge through mutually beneficial exchange. It also does not restrict the ability of individuals to act on their contextual knowledge, as long as those actions do not harm the rights of others with respect to life, property, contract, and consent. In the course of creating and exploiting such opportunities, these individuals actually create a more complex economic and social order as they innovate and take entrepreneurial actions to create new value propositions; our modern society is an example of this general pattern in economic history. Contrast this concept of emergent institutions and the example of the English common law with the idea of “made” institutions (here the contrast is between made and grown). Such deliberately designed institutions typically are created through legislative and administrative procedures and are imposed in a top-down fashion to achieve a specific objective. Economic regulation frequently takes this form, whether at the local level (e.g., zoning regulations) or at the national level (e.g., regulations on the business activity of the financial industry). These made institutions do not always facilitate outcomes consistent with taking into account the knowledge problem and thus also do not necessarily maximize social cooperation. They often limit the ways in which individuals could create mutual benefit by making use of diffuse private knowledge. A concrete example of this problem is the

The Knowledge Problem    57 regulation of retail electricity prices, which for most customers for more than a century in the United States have been fixed to reflect the average cost per unit (Kiesling 2008). This unvarying regulated price (and the operation of the retail provider as a government-granted monopoly) precludes any different pricing over time to appeal to consumers whose preferences vary over the course of the day, week, month, or season. Such dynamic pricing could benefit both producer and consumer and could enable signaling of the relative value of electricity in that hour as a knowledge surrogate for those interested in consuming electricity in that hour. The top-down imposition of this price control stifles the exercise of private knowledge and the creation of contextual knowledge, resulting in an inferior outcome to the extent that consumer preferences deviate from the average-cost-based regulated price, and the regulated monopoly status means that the firm never faces a market test of its pricing decisions. Any instance of price controls falls prey to this knowledge problem critique, because price controls truncate both the communication of dispersed knowledge and the creation of contextual knowledge. Seeing the negative consequences of failing to allow for the knowledge problem can be problematic, though, because it requires comparing the actual outcome of the made institution with the next feasible institutional alternative that would allow for more decentralized coordination. This comparison is often counterfactual, unless, for example, another state or country has this institutional alternative and data available for a comparative institutional analysis. Other research methodologies can illuminate this problem, such as experimental economics and agent-based modeling. Both of these approaches require simplification and paring down of the environment and the institution to their most salient features (and have other characteristics, good and bad, that go beyond the scope of this chapter), but they can be used effectively for an institutional analysis that incorporates the knowledge problem. The institutional and political economy implications of the knowledge problem are significant, because the knowledge problem strikes at the core of some of the most essential assumptions underlying government action and regulation. At some level, arguments for government intervention and the associated theoretical models and institutional designs all rely on the presumption of the existence, knowability, and stability of an optimal outcome. The complexity knowledge problem suggests that optimal outcomes are not knowable ex ante, while the contextual knowledge problem means the stability of the optimality of an outcome is very context-dependent and that if such an outcome does exist, its existence may be fleeting and ephemeral. As Boettke et al. (2005) observed in their discussion of the relevance of the knowledge problem to comparative institutional analysis: The principles of optimality within a market economy are the outcome of a competitive process, not merely a formal mathematical rule that is an assumption going into that process. Firms seek to maximize profits and in competition with other firms stumble to marginal cost pricing and producing at the level that minimizes average costs. Pricing equal to marginal cost does mean that the full opportunity cost of

58   Microeconomics resource use is being taken into account and minimizing average costs does translate into the deployment of all least cost technologies, but the important point Mises and Hayek were attempting to make is that these optimality conditions emerge out of the competitive market process. (285)

The institutional context will affect the knowledge and the actions available to individuals who are trying to coordinate their actions for mutual gain. Thus, a regulatory plan or institutional design based on theoretical models that ignore the knowledge problem is grounded in unrealistic assumptions and is therefore prone to unintended consequences and an inability to achieve the desired, postulated optimal outcome. Neoclassical public utility regulation provides a stark example of this phenomenon. The underlying theoretical model stipulates a static cost function with economies of scale over the relevant range of (static) demand and proposes an institutional design in which regulators control the rate of return the regulated firm earns on its assets such that on average, the regulated retail price equals average cost and the regulated firm earns zero economic profit. While several scholars in industrial organization have formulated models incorporating the information asymmetry with respect to the firm’s costs (see, for example, the literature reviewed in Laffont and Tirole 1993), these models continue to embody the assumptions of static, knowable demand and costs. These assumptions increase the tractability of a formal model, at a cost of forgoing any understanding of the effects of the knowledge problem on the actual outcomes of particular institutional designs based on such formal models. Boettke et al. (2005) provide a thorough discussion of development economics as another policy example prone to these criticisms. Examples like these illustrate the importance of the knowledge problem both as an unavoidable trait of humans and social systems and as a performance metric in the field of robust political economy. As mentioned above, robustness is a measure of how well an institution performs in enabling prosperity even in the least favorable situations: “For instance, it is not so obvious that in an economy of less than perfectly rational, perfectly informed individuals where prices are sticky and informational asymmetries persist that markets will prove efficient and general equilibrium will obtain. The hard case is hard because in order to demonstrate the desirability of a particular system under worst-case scenarios, the system must be robust” (Boettke and Leeson 2004, 100). Robust social institutions take into account the cognitive, psychological, and strategic realities of being human and trying to live together in civil society, rather than being based on some mythical, hypothetical agents who are either entirely Cartesian-rational, entirely Hobbesian-rapacious, or possessing full foresight. Robust political economy uses two main criteria to evaluate institutions: simply put, the absence of both omniscience and benevolence. Robust political economy uses the knowledge problem as an essential component of defining robustness and evaluating different institutional designs and their performance. Such an analysis requires moving away from the restrictive, unrealistic assumptions underlying formal theoretical models and toward an analytical framework that recognizes the knowledge problem, takes into

The Knowledge Problem    59 account human imperfection and bounded rationality, and acknowledges the range of motives facing individuals as economic actors and bureaucrats. Part of this framework includes individual beliefs and the extent of shared meaning, because without understanding social meaning, it is difficult to understand incentives and how people act on them (Boettke et al. 2005, 290). In this sense, robust political economy and its treatment of knowledge tie directly back to the Schutzian questions of perception and social meaning in the early twentieth century. Benevolence captures the set of ideas, incentives, and models arising from public choice theory. If we relax the assumption that individuals are benevolent and well intentioned in their roles as policy makers and bureaucrats and instead assume that they will make institutional decisions based on their own self-interest, how well does the institution made in that process perform in facilitating prosperity? More realistically, humans have diverse motivations, ranging from material self-interest to benevolence and individual disinterestedness, and a robust political economy analysis examines how an institution performs under the worst-case assumption of policy makers and bureaucrats having material self-interest motivations. Following Hume and James Buchanan, we could call this the “men as knaves” criterion for evaluating institutions (Pennington 2011, 5). Omniscience (or the lack thereof) reflects the role of the knowledge problem in institutional analysis. Taking into account the knowledge problem, what are institutional traits that enable heterogeneous self-interested individuals, for whom self-interest usually takes many different forms, to live together and to thrive in civil society? The knowledge problem means that the ultimate, specific individual consequences of a particular institution, along with the wider social or system-level consequences, will be unknown. Both complexity and context point to the inability to predict the specific consequences of an institution, and indeed the creation of new contextual knowledge is part of the reason for the complexity of social systems and the nondeterministic nature of social system outcomes. Thus, “[r]‌obust institutions should therefore allow people to adapt to circumstances and conditions of which they are not directly aware, and under conditions of ‘bounded rationality’ must enable them to learn from mistakes and to improve the quality of their decisions over time” (Pennington 2011, 3). Robust social institutions are those that fare better in conditions of imperfect and incomplete knowledge and that allow the processes of experimentation, adaptation, and evolution to occur that are essential for error correction. These processes and the resulting error correction are crucial foundations for facilitating and aligning individual and social prosperity. One substantial insight of robust political economy is that given the inescapable reality of the knowledge problem, institutions that enable adaptation by individuals, that allow for experimentation, and that can themselves adapt to unknown and changing conditions are more likely to be robust and generate superior outcomes (Pennington 2011, 4–5). In dynamic, complex social systems, change is ubiquitous and pervasive; agents within these systems change their behavior in response to changes in their own perceptions of preferences and opportunity costs, to changes in the actions of others,

60   Microeconomics and changes in the rules that structure these interactions and shape their incentives and behavior. Because social systems are complex, the outcomes of these interactions are nondeterministic, so designing rules ex ante that will enable perfect plan coordination and avoid processes such as rent dissipation or contract renegotiation is difficult, if not impossible. Indeed, North (2005) contends that the nonergodic nature of dynamic, complex social systems means that designed rules (made institutions) are almost always out of date, because they are designed to address issues and incentives at a particular time and context. The constantly changing world changes that context and at the margin changes the relative importance of different issues and the relative weight of incentives in shaping behavior. Experimentation enables social learning in these complex social systems in which both economic outcomes and how specific institutions will function are unknown (Kiesling 2010). Only by experimenting with different institutions or by testing institutions in economic experiments that capture the salient features of the real-world environment can we learn the effects of rules on behavior, resource allocation, and other social phenomena (such as social cohesion). The rules embedded in different institutions change the interactions of individuals in complex social systems, thereby changing outcomes, often in unpredictable and nondeterministic ways. The knowledge problem’s centrality in robust political economy points to another dimension to explore in institutional analysis: complexity science and its application in economics and the analysis of social systems. Complexity economics draws on the extensive, interdisciplinary literature on complex adaptive systems and frames economic questions explicitly in terms of the dynamics of human action and interaction, over space and time.5 As Tesfatsion (2001) observes: Decentralized market economies are complex adaptive systems, consisting of large numbers of buyers and sellers involved in massively parallel local interactions. These local interactions give rise to macroeconomic regularities such as shared market protocols and behavioral norms that in turn feed back into the determination of local interactions. The result is a complicated dynamic system of recurrent causal chains connecting individual behaviors, interaction networks, and social welfare outcomes. (1)

Markets are complex adaptive systems that involve large numbers of distributed actors and rules, or institutions, governing their interactions. A complex adaptive system has a large number of interacting heterogeneous agents. These agents react to the actions of other agents and to changes in the environment, and they are autonomous, so control and decision-making are decentralized and distributed in a complex adaptive system. Through their interactions, the agents in the system adapt to the changes that they themselves help to bring about through their independent decisions, and the

5 

This discussion draws on the more extensive treatment in Kiesling (2008), chap. 3.

The Knowledge Problem    61 effects these decentralized decisions have on individual and system-level outcomes provide feedback channels for learning, adaptation, and evolution.6 This distributed learning and decision-making process leads to potentially unanticipated changes in the environment, but a principal defining characteristic of a complex adaptive system is that it is self-organizing, and that self-organization, or order, emerges from the interaction (i.e., is an emergent property). Complex systems are defined by their dynamic properties and the extent to which the interactions of agents are nondeterministic and are thus emergent phenomena (Metcalfe 2010). Complex systems have the superficially contradictory combination of unpredictable specific outcomes with system-level patterns of self-organization and emergent order; this combination also features prominently in Austrian economics. In the presence of knowledge constraints and cognitive limitations, such as sheer ignorance (Kirzner 1997) or bounded rationality (Simon 1982), market processes enable these agents to achieve their plans mutually. In the process of doing so, market processes generate and aggregate information that reduces uncertainty and ignorance; this information also enables agents to adapt by revising their plans and actions. In this analysis, we take diffuse, private, and tacit knowledge as given and focus on the role of economic, legal, and social institutions in aggregating that diffuse knowledge and enabling decentralized agents to coordinate their plans and actions. Decentralized coordination occurs in market processes through prices. Prices allow for the decentralized coordination of plans among distributed, heterogeneous agents with private knowledge. Price signals act as feedback and coordination mechanisms in two distinct ways. First, in a market in equilibrium, the equilibrium price signals to individual agents what their decisions should be. In particular, price signals communicate to lower-value consumers and higher-cost producers that they are low-value and high-cost, respectively. Second, in a market in disequilibrium, price signals communicate information that results in agents making systematic changes to their bids and offers; these changes themselves enhance the degree of coordination via feedback mechanisms. Price signals are an information flow that may lead agents to revise their decisions, resulting in a higher degree of plan coordination. More generally, the knowledge problem forms the basis for the existence of complexity in social systems, for the evolution of complex adaptive social systems, and for the discovery and design of rules and institutions that exploit that complexity to get better outcomes (and enable us to use our imperfections to our advantage). Markets and prices are the most obvious and pervasive example, but there are multitudes of others, many awaiting deeper examination using the ideas and tools described here.

6  For a thorough discussion of complexity economics, a critique of neoclassical economics, and an application of complexity economics to analyzing economic growth and business strategy, see Beinhocker (2006); see also Rosser (2009) and Holt, Colander, and Rosser (2010). For a primer on complexity science and complex adaptive systems, see Miller and Page (2007) and Mitchell (2009).

62   Microeconomics

Conclusion The development of the knowledge problem and its implications over the past century has enriched our understanding of the challenges of coordination and also of why systems for decentralized coordination tend to perform better in an environment with imperfect and incomplete knowledge. This research has also indicated the epistemic nature of the knowledge problem, beyond the mechanical search for information that is reflected in modern information theory. A research agenda incorporating the knowledge problem and synthesizing Austrian economics, robust political economy, and complexity science, using tools including experimental economics and agent-based modeling, will generate a deeper understanding of the processes and institutions through which human societies achieve coordination and social cooperation. Knowledge is inherently imperfect, because it is dispersed, private, local, often tacit, frequently inarticulate, sometimes ephemeral, and usually contextual. Economic models based on assumptions of perfect knowledge thus do a poor job of capturing the informational and epistemological factors that are most relevant to both static and dynamic decision-making and economic calculation. Economic and social institutions designed deliberately based on those models are unlikely to perform well at generating prosperity, as research in robust political economy indicates and as Hayek (1974) suggested in his Nobel address: If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants. … The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society—a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

References Beinhocker, Eric. 2006. The Origin of Wealth. Cambridge, MA: Harvard Business Press. Boettke, Peter J. 1998. “Economic Calculation:  The Austrian Contribution to Political Economy.” Advances in Austrian Economics 5: 131–158. Boettke, Peter J. 2002. “Information and Knowledge:  Austrian Economics in Search of Its Uniqueness.” Review of Austrian Economics 15, no. 4: 263–274.

The Knowledge Problem    63 Boettke, Peter J., Christopher J. Coyne, Peter Leeson, and Frederic Sautet. 2005. “The New Comparative Political Economy.” Review of Austrian Economics 18: 281–304. Boettke, Peter J., and Peter Leeson. (2004) “Liberalism, Socialism, and Robust Political Economy.” Journal of Markets and Morality 7(1): 99–111. Ebeling, Richard. 2008. “The Life and Works of Ludwig von Mises.” Independent Review 13, no. 1: 99–109. Foss, Nicolai. (2000) “Austrian Economics and Game Theory:  A  Stocktaking and an Evaluation.” Review of Austrian Economics 13: 41–58. Gigerenzer, Gerd. 1999. Simple Heuristics That Make Us Smart. Oxford: Oxford University Press. Gigerenzer, Gerd, and Daniel Goldstein. 1996. “Reasoning the Fast and Frugal Way: Models of Bounded Rationality.” Psychological Review 103, no. 4: 650–669. Hayek, F. A., ed., 1935. “The Present State of the Debate.” In Collectivist Economic Planning, 201–244. London: Routledge. Hayek, F. A. (1937) 1948. “Economics and Knowledge.” In Individualism and Economic Order, 33–56. Chicago: University of Chicago Press. Hayek, F. A. (1940) 1948. “The Competitive ‘Solution.’ ” In Individualism and Economic Order, 181–208. Chicago: University of Chicago Press. Hayek, F. A. 1945. “The Use of Knowledge in Society.” American Economic Review 35: 519–530. Hayek, F. A. 1952. The Sensory Order. Chicago: University of Chicago Press. Hayek, F. A. 1960. The Constitution of Liberty. Chicago: University of Chicago Press. Hayek, F. A. (1968) 1978. “Competition as a Discovery Procedure.” In New Studies in Philosophy, Politics, Economics, and the History of Ideas, 179–190. Chicago: University of Chicago Press. Hayek, F. A. (1969) 1978. “The Primacy of the Abstract.” In New Studies in Philosophy, Politics, Economics, and the History of Ideas, 35–49. Chicago: University of Chicago Press. Hayek, F. A. 1974. “The Pretence of Knowledge.” Nobel Prize lecture. Available at http://nobelprize.org/nobel_prizes/economics/laureates/1974/hayek-lecture.html. Accessed February 25, 2011. Holt, Richard, David Colander, and Barkley Rosser. 2010. “The Complexity Era in Economics.” Middlebury College Discussion Paper 10–01, Middlebury, VT. Available at sandcat.middlebury.edu/econ/repec/mdl/ancoec/1001.pdf. Accessed December 29, 2011. Horwitz, Steven. 2000. “From The Sensory Order to the Liberal Order: Hayek’s Non-rationalist Liberalism.” Review of Austrian Economics 13: 23–40. Horwitz, Steven. 2004. “Monetary Calculation and the Unintended Extended Order:  The Misesian Microfoundations of the Hayekian Great Society.” Review of Austrian Economics 17, no. 4: 307–321. Kiesling, Lynne. 2008. Deregulation, Innovation and Market Liberalization:  Electricity Regulation in a Continually Evolving Environment. London: Routledge. Kiesling, Lynne. 2010. “The Knowledge Problem, Learning, and Regulation: How Regulation Affects Technological Change in the Electric Power Industry.” Studies in Emergent Order 3: 149–171. Kirzner, Israel. 1997. “Entrepreneurial Discovery and the Competitive Market Process:  An Austrian Approach.” Journal of Economic Literature 35: 60–85. Knudsen, Christian. 2004. “Alfred Schutz, Austrian Economists and the Knowledge Problem.” Rationality and Society 16: 45–89. Koppl, Roger. 1994. “Ideal Type Methodology in Economics.” In The Elgar Companion to Austrian Economics, edited by Peter J. Boettke, 72–76. Aldershot, UK: Edward Elgar.

64   Microeconomics Laffont, Jean-Jacques, and Jean Tirole. 1993. A Theory of Incentives in Procurement and Regulation. Cambridge, MA: MIT Press. Lavoie, Don. 1986. “The Market as a Procedure for Discovery and Conveyance of Inarticulate Knowledge.” Comparative Economic Studies 28, no. 1: 1–19. Leeson, Peter, and Robert Subrick. 2006. “Robust Political Economy.” Review of Austrian Economics 19: 107–111. Metcalfe, J. Stanley. 2010. “Complexity and Emergence in Economics: The Road from Smith to Hayek (via Marshall and Schumpeter).” History of Economic Ideas 18, no. 2: 45–75. Miller, John, and Scott Page. 2007. Complex Adaptive Systems. Princeton, NJ:  Princeton University Press. Mises, Ludwig von. (1920) 1990. Economic Calculation in the Socialist Commonwealth. Auburn, AL: Ludwig von Mises Institute. Mises, Ludwig von. (1922) 1981. Socialism. Indianapolis: Liberty Press. Mitchell, Melanie. 2009. Complexity: A Guided Tour. Oxford: Oxford University Press. Morgenstern, Oskar. (1935) 1976. “Perfect Foresight and Economic Equilibrium.” In Selected Economic Writings of Oskar Morgenstern, edited by Andrew Schotter, translated by F. Knight, 169–183. New York: New York University Press. North, Douglass. 2005. Understanding the Process of Economic Change. Princeton, NJ: Princeton University Press. Pennington, Mark. 2011. Robust Political Economy. Cheltenham, UK: Edward Elgar. Polanyi, Michael. (1966) 2009. The Tacit Dimension. Chicago: University of Chicago Press. Rosser, Barkley, ed. 2009. Handbook on Research in Complexity. Aldershot, UK: Edward Elgar. Schotter, Andrew. 1992. “Oskar Morgenstern’s Contribution to the Development of the Theory of Games.” In Toward a History of Game Theory. Annual supplement to Vol. 24, History of Political Economy, edited by Roy Weintraub, 95–112. Durham, NC: Duke University Press. Schutz, Alfred. (1932) 1967. The Phenomenology of the Social World. Evanston, IL: Northwestern University Press. Shubik, Martin. 1992. “Game Theory at Princeton, 1949–1955:  A  Personal Reminiscence.” In Toward a History of Game Theory. Annual supplement to Vol. 24, History of Political Economy, edited by Roy Weintraub, 151–164. Durham, NC: Duke University Press. Simon, Herbert. 1982. Models of Bounded Rationality, Vols. 1–2. Cambridge, MA: MIT Press. Smith, Vernon. 2009. Rationality in Economics:  Constructivist and Ecological Forms. Cambridge: Cambridge University Press. Sowell, Thomas. (1980) 1996. Knowledge and Decisions. New York: Basic Books. Stigler, George. 1961. “The Economics of Information.” Journal of Political Economy 69, no. 3: 213–225. Tesfatsion, Leigh. 2001. “Economic Agents and Markets as Emergent Phenomena.” Proceedings of the National Academies of Science 99, supp. 3: 1–2. Thomsen, Esteban. 1992. Prices and Knowledge:  A  Market Process Perspective. London: Routledge. Yeager, Leland. 1994. “Mises and Hayek on Calculation and Knowledge.” Review of Austrian Economics 7, no. 2: 93–109.

Chapter 4

M arket Th e ory an d the Pric e  Syst e m Frederic Sautet

Introduction This chapter seeks to produce a coherent narrative about the evolution of market theory from its early days in the eighteenth century to the recent debates in market-process analysis. It presents a detailed explanation of the historical evidence in order to show that current developments in market-process theory rest on an important intellectual evolution. Examining precursors and connecting current thoughts to past achievements, however, can be a dangerous affair, as looking back from the present can distort the past (Weintraub 1983, 1). History doesn’t unfold in a linear way. But identifying major lines of influence and of intellectual lineage may help shade a new light on present controversies. The chapter discusses two approaches to market theory: the genetic-causal and the instrumental-causal traditions. By and large, contenders in both traditions have identified Adam Smith as their forefather. The Smithian project has given birth to many interpretations, some of which seem hard to reconcile with Smith’s economics. A turning point in market theory had been brewing since at least the days of Augustin Cournot, but it was around 1920, when economists started considering prices as parameters in their models, that it became clearly established. This break with past analysis cast a new light on the way market processes were understood. Parametric prices became the core concept differentiating the truly dynamic approach from the static view. It propelled economics in a direction that precluded many important theoretical developments such as establishing the discovery function of competitive markets. It is primarily through the works of Ludwig von Mises and Friedrich Hayek that modern Austrian market theory found its identity. They laid a solid foundation on which others would build. Among those, the work of Israel Kirzner stands out. Born under the domination of the instrumental-causal tradition, Competition and Entrepreneurship

66   Microeconomics ([1973] 2013), Kirzner’s major contribution to economic science, has become the point of reference against which ideas in Austrian market-process theory are compared. Supporters and detractors have been arguing over the meaning of its core ideas for more than forty years. This chapter aims to demonstrate that Kirzner’s oeuvre is arguably the most accomplished approach in market theory in the genetic-causal tradition to date. The chapter is organized as follows. The first three sections below set the historical stage, presenting the most relevant ideas in the evolution of market theory. After that comes a section discussing the two strains of market theory and a section presenting the main critiques of the dominant approach. The last two sections offer a detailed presentation and defense of Kirznerian market process.

From Turgot to Marshall: Classical Thoughts on Market Theory The classical economists’ view of the market as a process was widely shared from the eighteenth century up to Alfred Marshall. With the exception of a few prominent thinkers—such as David Ricardo and William S. Jevons in England; Augustin Cournot, Jules Dupuit, and the engineering school in France; and Johann Heinrich von Thünen in Germany—most classical economists conceived of the market as a social process of continuous price adjustments under the division of labor. Even Karl Marx saw the capitalist economy as a dynamic process driven by competition. As early as 1766, A. R. J. Turgot discusses the benefits of specialization under the division of labor. While this is not as clearly articulated as in Adam Smith’s work, Turgot states in his “Reflections,” “Everyone profited by this arrangement, for each, by devoting himself to a single kind of labor, succeeded much better in it.” And specialization led to greater gains from trade: “The shoemaker, by making shoes for the husbandman, secured for himself a portion of the latter’s harvest” (Turgot [1766] 1977, 7). Smith reinforces and develops Turgot’s view.1 In The Wealth of Nations (Smith [1776] 1904), the market is a process governed by profit-seeking individuals leading to social cooperation under the division of labor. Smith tackles the hard question of demonstrating how market arrangements lead not to chaos but to order. In the market system, we must rely on others whom we do not know in order to live and flourish. We are dependent on one another. It is within the system of “natural liberty” (the common-law rules of property, voluntary transfer, and tort) that self-love generates social benefits. Smith was well aware that the effects of self-interest are not always socially beneficial. It all depends on the rules that constrain it. This is, in fact, the subject of both The Theory of Moral Sentiments ([1759] 2009) and The Wealth of Nations ([1776] 1904). And contrary to what is generally accepted, the former displays a much more favorable account 1 

On the influence of Turgot on Smith, see Groenewegen (1968).

Market Theory and the Price System    67 of self-love than the latter (Paganelli 2008, 372–373). Self-interest not only is the force at the foundation of commerce, but it is also the root of virtues and social ills, depending on whether it is kept in check. In his 1776 book, Smith argues that the natural constraints on self-interest (virtues) can break down because of the role of government, which perverts people by offering incentives to gain at the expense of others.2 Within this rich institutional story, Smith elaborates a theory of market competition based on the freedom of entry and the incentives that competitors face. His discussion of the incentives in teaching illuminates that point ([1776] 1904, book V, chap. III, 249). The most exceptional teachers will be found where the incentives to provide valuable instruction are present (in Glasgow). John M. Clark labeled Smith the “prophet of competition” (McNulty 1968, 646), even though the analysis of pure market process is rather scarce in Smith’s work. In a rare comment, Smith speaks of “the competition of producers who, in order to undersell one another, have recourse to new divisions of labour, and new improvements of art, which might never otherwise have been thought of ” (Smith [1776] 1904, book V, chap. III, 239). Generally speaking, the question of allocation in classical economics is not disconnected from that of the market process. The Smithian market process is also a process of Smithian growth.3 Jean-Baptiste Say, an admirer and follower of Smith, offers a market theory based on the entrepreneurial function. Most classical economists had a dynamic concept of competition, but the entrepreneur was not always present. Many, especially in England, failed to identify the entrepreneurial role separately from that of the capitalist. Smith mentions the “undertaker” and the “projector,” but the entrepreneur’s role is more elaborated in the French tradition, starting with Richard Cantillon ([1755] 1959), where it is often seen as a risk bearer (Schumpeter 1954, 222, 555; Kirzner 1979a, 42). Joseph Schumpeter (1954, 556) criticized David Ricardo, Nassau William Senior, and Karl Marx for their poor analysis of production as if it were an “automatic” process not calling for active decision-making. In fact, classical economists in England did not have a clear-cut theory of profit that would distinguish the uncertain proceeds of the entrepreneurs from the payment of already deployed resources (Machovec 1995, 98). In addition to his view of the entrepreneurial role, Say deserves a special mention for his law of markets. While some see it as controversial, Say’s law has an important place in the history of market theory. It can be “understood as an analytical proposition about the functioning of the market” (Horwitz 2003, 82). This proposition means that everyone must first be a producer, as only production provides the means to trade. Say’s law is a complement of Smith’s division of labor principle (Young 1928, 533). A growing population leads to an expanding market and more demand for all products. But this demand can only come from having more means to trade with, that is, from production. So the 2 

As Paganelli (2008) states: “With the introduction of government protection and the change in incentives they cause, self-interest can hopelessly deviate from a source of virtue and social well-being into a cause of mean rapacity and social impoverishment” (377). 3  Note that Nicholas Kaldor views Smith as the precursor of the allocative efficiency approach. See the next section.

68   Microeconomics more production takes place, the more the demand for the goods and services produced increases. Two other classical economists who saw the market as a dynamic system were Carl Menger and Alfred Marshall. Although Menger is widely recognized for being the father of the Austrian school of economics, his main work, Grundsätze der Volkswirthschaftslehre (Principles of Economics), does not contain much analysis of the entrepreneurial role (Kirzner 1979b). At best, Menger sees that role as a special kind of labor service. Yet Menger’s market theory depicts an open dynamic economy in which the possibility of error is present. He is aware that some prices may be “uneconomic,” that is, in disequilibrium, while clearing the market. He emphasizes product variation, the qualitative dimension of competition, and, of course, subjective value, but paradoxically his price theory is not entrepreneurial (Kirzner 1979b, 64). Marshall’s work is a turning point in market theory, and yet his theory of the market is mostly classical. “His treatment of competition was much closer to Adam Smith’s than to that of his contemporaries [and was] almost as informal and unsystematic” (Stigler 1957, 9–10). Paul McNulty echoes this interpretation, explaining that Marshall “took a quite realistic view of competition” (McNulty 1968, 648), although his approach to the subject in Industry and Trade (Marshall 1919) can be read as a pre-Chamberlin exposition of monopolistic competition (Peterson 1957, 73). Recent research on Marshall (Simpson 2013; Tubaro 2008) highlights his treatment of uncertainty and his dynamic view of the market based on the organic metaphor. But while the entrepreneurial function is present in Principles of Economics (Marshall 1920), it closely resembles that of the manager. And according to Mirowski (1984), he helped import the methods of physics into economics. In that sense, Marshall is a bridge between the classical and the neoclassical schools.

From Cournot to Stigler: Market Theory as Precise and Elegant There is no doubt that most of classical market theory depicts a genuinely dynamic view of the economic system. Competition is akin to gravitation under the constant influence of the entrepreneur. It is a price-determining force (McNulty 1968, 644). Yet in parallel to the classical view depicted above, another line of thought develops in the nineteenth century. In continental Europe, it starts with Augustin Cournot, Jules Dupuit, and Johann Heinrich von Thünen and continues with Léon Walras. In the English-speaking world, it can be traced back to David Ricardo, William S. Jevons, and Francis Edgeworth. This brand of market theory uses mathematics to define relationships between identified variables. The conceptual difference between the classical market theory of the first group identified above and that of the second one is the idea of price as a parameter, which

Market Theory and the Price System    69 appears in the works of Cournot ([1838] 1897) and his successors (McNulty 1967, 397). This analytical change is not a simple footnote; it represents a sharp discontinuity in the development of market theory. Indeed, the two notions of price are “incompatible in a fundamental sense” (McNulty 1968, 649). Machovec talks of “a mutation” (1995, 1) and a “sharp break in continuity” (10). Mirowski also sees a “fundamental break” (1984, 362), which he explains is the seed of the neoclassical school. This change is already visible in Ricardo’s work, which presents a narrow treatment of the market and focuses on comparative statics (Machovec 1995, 97). But it is only with the work of Cournot that the idea gains a strong defender. Although he remained unknown in the English-speaking world for some time, his influence over subsequent developments, especially Walras’s work, is without question (Jaffé 1976, 514). As George Stigler puts it, the idea of competition in Cournot’s work was “enormously more precise and elegant than Smith’s” (Stigler 1957, 5). While Jevons had not read Cournot’s Researches at the time of the publication of his major work, he later explicitly hailed him as a predecessor. Jevons’s work anticipates the concept of perfect competition. The conditions necessary for the operation of his fundamental propositions of exchange are those of a perfect market (Jaffé 1976, 517). Moreover, Jevons explicitly invokes physics as the source of his inspiration (Mirowski 1984, 363), and he promotes the use of mathematical language in the description of economic relationships. This brand of market theory is deeply at odds with that of the first group of classical economists. The puzzle is to understand the source of such divergence. Four concomitant influences may have driven this fundamental analytical difference. 1. The starting point may be an interpretation of Smith’s statement about businessmen getting together to raise prices ([1776] 1904, book I, chap. X, part II, 130). Smith warned against the power to raise prices, arguing that in specific cases, it was detrimental to the public. More important, Nicholas Kaldor contends that it was the shift of focus from the creative function of the market to its allocative function that paved the way for the economists’ obsession with equilibrium (and parametric prices) (Kaldor 1972, 1240–1241). According to Kaldor, this shift had already happened in The Wealth of Nations (book I, chap. IV). 2. Another influence is the idea of “natural price.” The natural price is determined solely by the costs of production in Smith’s and Ricardo’s works. This labor theory of value may also have driven the development of the idea of price as a parameter (i.e., the marginal conditions).4 3. A third source is the rise of positivism in the nineteenth century, with Auguste Comte, who saw the triumph of science, especially the sciences of measurable 4  In his discussion of the just price in the economics of the school of Salamanca, Norman Barry (1982) states that the schoolmen were reluctant to embrace a cost-of-production theory rather than a subjectivist theory because it would give merchants an excuse to raise prices above their market-clearing level.

70   Microeconomics phenomena such as physics, medicine, biology, chemistry, and so on. Science would solve all human problems. This view influenced social sciences, and the “new discipline of economics wanted to be recognized as a predictive science” (Machovec 1995, 268). Cournot epitomized this trend, as he defined market situations in formal terms, not in verbal logic. He held a doctorate in mathematics and mechanics and imported the “rigor” of classical mechanics into economics. 4. Finally, an important change in commercial practice took place in the mid-nineteenth century, with the introduction of “displayed fixed prices” (Chambolle and Allain 2003, 23). The great Parisian entrepreneur Aristide Boucicaut bought Le Bon Marché in 1852 and launched what became one of the first department stores in the world. The introduction of clearly displayed fixed prices next to the merchandise for sale was an innovation in commercial distribution at the time. Until then, customers in shops and boutiques would haggle over the prices of the goods on offer, the way it was also done at bazaars and fairs. It may be tenuous to argue that the introduction of fixed prices had an influence on the development of market theory, but classical economists could not have failed to notice the evolution of commercial practices. Fixed prices were a major difference between the world of Smith and that of Walras. By the time Boucicaut died in 1877, customers in Paris were seen as “price takers.” But without a theory of the entrepreneurial role, one would only notice what was seen: prices as parameters. Besides Walras (whose influence is analyzed below), it took two more heavyweight scholars to move the pendulum toward static market theory. The first one was John B. Clark, who, in The Distribution of Wealth ([1899] 1908), developed the concept of a stationary economy in order to analyze the effect of competition on resource allocation. As McNulty states, “it was Clark’s static analysis of perfect competition, and not his observations on economic change, or on the dynamic aspects of competition, which had a permanent effect on the development of economic theory” (1968, 648). The other scholar was Frank Knight, who perfected the notions of competition and equilibrium in Risk, Uncertainty, and Profit ([1921] 1964). In order to isolate the role of uncertainty in economic life, he first defined the nature of an economy with complete information, thereby establishing the assumptions (e.g., rationality, mobility of resources, costless information) necessary to perfect competition. Convinced by Knight that a world under true radical uncertainty could not be studied scientifically, the profession followed his lead by adopting perfect competition as the benchmark for market-process analysis. Defining prices as parameters had many implications, most notably that “supernormal profits” came to be seen in terms of defect. Parametric prices drove the entire corpus of hypotheses of perfect competition, starting with the assumption of having a large number of buyers and sellers such that it would exclude any joint action that could influence prices (Stigler 1957, 12). The same became true of knowledge: perfectly informed individuals could not fall prey to a manipulation of prices and would have sufficient

Market Theory and the Price System    71 knowledge to eliminate all fear of joint action. For all these reasons, competition came to be defined through its structure rather than its process, and resource allocation was dissociated from change and growth. This is another sharp discontinuity with the classical view. Economists started using equilibrium as a critical standard against which they could indict reality (Boettke 1997); hence the development of market-failure theory under Arthur Pigou. The old view of social efficiency crumbled. The interwar period saw more evolution toward the condemnation of actual market arrangements. Any model allowing price modification became immediately suspect. Reasoning in static terms, Piero Sraffa attacked perfect competition theory as too lenient, because he saw market economies as essentially made of monopolistic elements. Sraffa helped discredit Marshall’s view of the positive role of external economies and decreasing long-run costs of production, accusing them of being a monopoly-generating element. This opened the door to Edward Chamberlin’s monopolistic competition theory. With the rejection of long-run effects and the analysis focusing essentially on static equilibrium, classical economics was further discarded (Machovec 1995, 272–273). Chamberlin took the next step in The Theory of Monopolistic Competition ([1933] 1962), arguing that product differentiation was a source of monopoly power. As soon as goods cease to be perfectly substitutable, some power of price determination exists. The genuine competitor is transformed into a monopolist, and his or her presence “reduces rather than enhances consumer welfare” (Machovec 1995, 183). By the mid-1930s, economics was light years away from the classical understanding of dynamic competition, in which entrepreneurs submit their production decisions to the judgment of consumers. Instead, in the stationary economy of the perfectly competitive market, entrepreneurs “are essentially brokers between resource owners and consumers” (Stigler 1957, 12); they have lost all genuine risk-taking function and are reduced to mere middlemen. This entire approach was most cemented in Lionel Robbins’s second edition of An Essay on the Nature and Significance of Economic Science (1935), which fundamentally established economics as a problem of constrained optimization. Economists even argued, on the basis of some spurious perfect information assumption, that market economies produced too many varieties of goods and that advertising was a threat to competition. The indictment of reality was complete. The door was now open to accept policy prescriptions based on government central planning. The refinements of the model in the decades following World War II, with Stigler’s work on information economics, were the logical extension of perfect competition to all aspects of human life. It solidified the view of equilibrium as a description of reality. As Melvin Reder explains in his discussion of Chicago economics: “in applied work, adherents of [tight prior equilibrium] have a strong tendency to assume that, in the absence of sufficient evidence to the contrary, one may treat observed prices and quantities as good approximations to their long-run competitive equilibrium values. Call this the ‘good approximation assumption’ ” (1982, 12). After Stigler, the assumption is that markets are always in equilibrium, for if we include the relevant costs in the analysis, an efficient-always situation obtains.

72   Microeconomics

From Walras to Debreu: General Equilibrium as an Abstract Answer to an Abstract Question Schumpeter considered Walras a genius for having described the optimal allocation of resources for a system of interdependent markets. Inspired by Cournot’s partial equilibrium analysis, Walras developed a theory of general equilibrium that he first published in Elements of Pure Economics ([1874] 1954). He explored the problem of the interdependence of markets (i.e., whether equilibrium in one market is necessarily consistent with equilibrium in another one), which eventually led to the issue of general equilibrium (i.e., whether a vector of prices can be found that would enable consumers’ buying decisions and producers’ selling activities to mesh perfectly, such that the right quantities are being produced in every market, including factors markets for all industries). Determining the existence of a general equilibrium is analogous to finding a unique solution set for a set of simultaneous equations. The Walrasian system is highly imperfect, but it possesses a unique solution under some strict assumptions (Blaug 1985, 570–577). According to Mark Blaug, the effects of Walras’s research on subsequent neoclassical economics are not to be underestimated: “All of modern micro- and macroeconomics can be viewed as different ways of giving operational relevance to general equilibrium analysis” (Blaug 1985, 585). Stigler argues that Marshall’s towering prestige delayed the adoption of abstract formalism (Machovec 1995, 266), but the field continued to advance with the works of Gustav Cassel and Karl Schlesinger in the early part of the twentieth century and that of Abraham Wald, who came under the influence of Karl Menger and Oskar Morgenstern in Vienna in the 1930s (Weintraub 1983). It was John von Neumann’s arrival at Princeton in 1930, however, that started the quest to define modern general equilibrium theory. In a paper originally published in German in 1937, Neumann (1945–46) solved the problem of establishing an equilibrium in a uniformly expanding economy. John Hicks revived Walrasian analysis with Value and Capital (1939) and presented general equilibrium theory, including the properties of stability and determinacy, to an English-speaking audience. But he avoided dealing with the serious difficulties in the mathematical-logical analysis of economic systems. The existence of a solution to the equations of general equilibrium was still an open question as the war broke out (Walras offered a solution, but his model was too simple). It was Neumann’s and Morgenstern’s work on game theory, along with the development of activity analysis and programming, that would lead to the solution devised by a few mathematician-economists, most notably Lionel McKenzie, Gérard Debreu, and Kenneth Arrow. Arrow and Debreu published their solution proving the existence and uniqueness of a general equilibrium in 1954 in Econometrica.

Market Theory and the Price System    73 The work on general equilibrium is mostly a mathematical exercise. It consists in establishing existence theorems. Frank Hahn’s remark on this point is instructive: “General Equilibrium Theory is an abstract answer to an abstract question: Can a decentralized economy relying on price signals for market information be orderly? The answer of General Equilibrium Theory is clear and definitive: One can describe such an economy with these properties. But this of course does not mean that any actual economy has been described” (1981, 126). Kaldor notes that general equilibrium is “not put forward as an explanation of how the actual prices of commodities are determined” (1972, 1237). Weintraub states the same idea: “The ‘equilibrium’ story is one in which empirical work, ideas of facts and falsification, played no role at all” (1983, 37). As Blaug remarks, however, if one is to use general equilibrium modeling, one must be sure that a solution exists (1985, 577).

The Knight-Stigler Thesis and the Two Strains of Market Theory In Risk, Uncertainty, and Profit, Knight argues that the “historic body of economic theory rests upon the assumption of perfect competition, but … the precise character of this assumption has been partially implicit and never adequately formulated” ([1921] 1964, 51). Stigler echoes Knight in his 1957 article, as he explains that the premises of perfect competition can be found in The Wealth of Nations. Stigler lists five conditions of competition found in Smith that resemble more “modern” treatments of competition. Paul Samuelson adopts the same position, stating that Smith’s “pluralistic supply-and-demand analysis in terms of all three components of wages, rents, and profits is a valid and valuable anticipation of general equilibrium modeling” (1977, 42). In other words, classical market theory gave birth to the modern neoclassical view. In a Whigian understanding of history, the Knight-Stigler thesis basically states that the difference between the classical view of the market and the modern view is one of degree, not one of nature. Several economists, starting with John M. Clark and his paper on workable competition (1940), have challenged this view. Shorey Peterson (1957) examines the difficulty of applying static analysis to actual cases of antitrust and how economists use substitute theories based on the old notion of competition. As McNulty argues in his note on competition (1967), Smith viewed competition as rivalry, not as a structure or a situation. The modern concept of competition abstracts from behavioral issues. For Smith, the market is a process, whereas for Cournot, it is a state. Blaug explains that the classical model is not “a species of general equilibrium theory except in the innocuous sense of an awareness that ‘everything depends on everything else’ ” (1987, 443). Frank Machovec states that “the classical conception of competition, with few exceptions, was moulded

74   Microeconomics by a sense of the market as a process of discovery, not by some embryonic form of modern-day equilibrium theory” (1995, 136). Following McNulty (1967), we see two important strains of market theory in the history of economics. The first runs from Cantillon, Turgot, James Steuart, Smith, Say, and Carl Menger, to Mises, Hayek, James Buchanan, and Kirzner. Following Hans Mayer ([1932] 1994, 57), Robin Cowan and Mario Rizzo (1996) call it the “genetic-causal” tradition, and Peter J. Boettke describes it in terms of the “mainline” of economic thinking (2007, 8). The other strain starts with Achille Nicholas Isnard, Ricardo, Cournot, Thünen, Dupuit, Jevons, Walras, and Edgeworth and continues into the twentieth century, with John B. Clark, Knight, Chamberlin, Joan Robinson, Sraffa, and the modern view of perfect competition, general equilibrium theory, and the development of macroeconomics in general. This is the mainstream of economic thinking. This line of market theory fits the “instrumental-causal” tradition.5 The genetic-causal tradition rests on the idea that economic phenomena are the results of chains of causes and effects that can be traced back to individual purposes and choices (even when the effects are unintended). There is an asymmetry in the sense that a cause has an effect; it is not a concomitant variation (Cowan and Rizzo 1996, 275). The genetic-causal tradition is rooted in action and causality in the Thomist sense. Individuals form plans and choose means to attain ends: they are efficient causes. By contrast, the instrumental-causal tradition seeks to determine explanations of economic phenomena that rest on functional relationships among variables. It is the mutual determination of equilibrium values. In the genetic-causal tradition, semantic precision is necessary to describe economic phenomena. The instrumental-causal view, on the other hand, seeks syntactic precision. The human element is purged from the analysis (Boettke, Coyne, and Leeson 2003). The genetic-causal approach aims to explain “how prices come into being,” whereas the instrumental-causal tradition exhibits “what system of prices will secure equilibrium”6 (prices are parametric). General equilibrium theory is a prime target in this respect. “Walras’s system of general equilibrium reveals the interconnectedness of economic phenomena without needing to specify the means by which a particular interconnected state is reached” (Cowan and Rizzo 1996, 274). Mutual determination cannot explain what makes general equilibrium exist. Walras did not see that his system of simultaneous equations could not establish the cause of value other than in an instrumental sense (Jaffé 1976, 522). While analytically distinct, the two strains have at times fed each other (Jaffé, 1976, 522). But with syntactic precision (and elegance) came semantic superficiality (Boettke 1997, 50). The essence of Smithian market theory was lost by trying to fit human action into the Cournot-Walras mathematical box. 5  Jaffé uses the terms “generative causality” and “logical causality” (1976, 521). Buchanan and Vanberg, in a similar discussion, refer to “nonteleological” and “teleological” perspectives (1991, 173). 6  The words quoted are from Kaldor (1972). See Cowan and Rizzo (1996, 279). See also Mayer ([1932] 1994), who argues that Carl Menger’s theory is one of price “formation,” not price “determination.”

Market Theory and the Price System    75

The Hayekian Knowledge Problem and Other Difficulties Critics of the Knight-Stigler position echoed those who rejected the instrumental-causal tradition, and they were numerous, starting with Carl Menger. In a debate with Walras, Menger “declared his objection in principle to the use of mathematics as a method of advancing economic knowledge” (Jaffé 1976, 521). Instead, he explained, economics should aim at unearthing the essence of social phenomena, tracing them back to human action. An early critique of Walras’s theory is Philip Wicksteed (Machovec 1995, 176), who in 1910 argued the impossibility of attaining equilibrium prices because of the problem of out-of-equilibrium exchanges and bilateral trades, which alter agents’ biddings and have impact on the final equilibrium. Walras recognized this point but dismissed it as intractable. He knew he needed to show that the relative prices that emerge from the process of free competition must be identical to the roots of his system of equations in which the unknowns are the equilibrium prices and quantities exchanged (Blaug 1985, 578). The way he could achieve this result in his model was by assuming tâtonnement (groping), which is a random process of price determination. It shows the immense difficulty theorists encountered in trying to establish a market theory based on general equilibrium, which led them to ignore the actual behavior of an exchange system based on genuine uncertainty and disequilibrium trades. In spite of his role in the development of neoclassical market theory, John B. Clark was well aware of its limitations: “a static state … is imaginary. All natural societies are dynamic; and those which we have principally to study are highly so” ([1899] 1908, 29). Many economists voiced their concerns in the 1930s, even, surprisingly, Abba Lerner, Edgeworth, and Allyn Young, who are not known for their antineoclassical stance (Machovec 1995, 287–293). In spite of his interest in mathematic psychics, Edgeworth criticized Walras’s model, explaining that instead, we should recognize the complexities of the world. Marshall witnessed the rejection of his “high theme of economic progress” (the secular reduction in production costs) and was dissatisfied with the static analysis of monopolistic competition. John M. Clark persevered all his life in trying to establish that a truly dynamic theory of the market is superior to a static view, but he never realized the commonalities of his thinking with that of Hayek (Endres 1995, 1). Young (1928) pointed out the incompatibility of general equilibrium theory and the notion of increasing returns, a point that Kaldor (1972) also makes. It was Hayek’s belief, as stated in his inaugural lecture at the London School of Economics in 1933, that historicism would put the final nail in the coffin of laissez-faire. But it turned out to be economics itself, in its neoclassical variety, that did so. Oskar Lange and the defenders of socialism captured neoclassical thinking during the interwar period and argued, contra Hayek and Mises, that one could mimic the market’s results without having actual market processes. The profession was convinced, because it failed to see that the limitations of knowledge and the presence of radical uncertainty rendered equilibrium market theory inadequate.

76   Microeconomics Stemming from the debate on the feasibility of socialist planning, it was Hayek’s fundamental contribution to remind the profession of the issue at stake. In a series of famed papers between 1937 and 1948, Hayek examined the economic problem and its implications in terms of the market theory that economists should adopt. Starting with “Economics and Knowledge” (1937), Hayek examines the assumptions used in modern market theory and their implications for economic analysis. Equilibrium implies a level of coordination of individuals’ plans that can only be reached under the assumption of perfect knowledge. But equilibrium analysis does not explain how that knowledge comes to exist; it merely assumes it—this is the Hayekian knowledge problem. In other words, “if we want to make the assertion that, under certain conditions, people will approach [the equilibrium state], we must explain by what process they will acquire the necessary knowledge” (Hayek 1937, 45). At the end of the day, it was the way economists perceived the economic problem that was the issue.7 As Hayek states: The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources—if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality. (1945, 519–520)

One key to finding a solution to the knowledge problem is to analyze knowledge in all its facets. What matters according to Hayek is not scientific knowledge but the “knowledge of the particular circumstances of time and place.” That relevant knowledge is communicated to others through the price system, which reflects the changes in relative scarcities of goods. Because it conveys knowledge that is not given to anyone in its totality, the price system is a communication system that cannot be superseded. Hence, market theory should describe the economic system the way classical economics does it, that is, as a dynamic process (Hayek 1948). Hayek’s critique of the instrumental-causal tradition of market theory is devastating if one understands the aim of economics as explaining the process by which the market order evolves. The assumption of perfect knowledge (even in stochastic terms) ultimately supports the theory of price-taking behavior and the conundrum it creates: price theory does not explain how prices come into being. As Arrow himself puts it, “what individual has chosen prices? In the formal theory, at least, no one” (1994, 4).8 In the instrumental-causal view, there is no endogenous agent of change. Even neoclassical 7  As Boettke and Prychitko state it, “the way economists explain the workings of the market economy depends, in good measure, upon our understanding of the basic economic problem” (1998, ix). 8  Other neoclassical scholars have made the same point. See Koopmans (1957).

Market Theory and the Price System    77 models of disequilibrium build on an equilibrium theory of individual competitive behavior in which prices are taken as given (Fisher 1983, 12). Neoclassical disequilibrium analysis attempts to show the path to equilibrium (i.e., stability) by showing how perceived opportunities lead to out-of-equilibrium trades, which drive the economy toward equilibrium (i.e., convergence). But even in such a setting, agents optimize their plans according to the specifications of the model (including when transaction costs and stochastic uncertainty are introduced). What is being studied is “moving equilibria” rather than disequilibrium in a context of radical uncertainty. In the final analysis, there is a “market theory problem” in modern market theory (Sautet 2000, 10), that is, a misuse of equilibrium analysis in the understanding of the competitive process. The market theory problem is the inconsistency involved in trying to answer questions that would not exist in an equilibrium-always world. An instance is Francis Bator’s “The Anatomy of Market Failure,” which was published more than twenty years after Hayek had started formulating his critique. It dealt exclusively with “the statical efficiency of price-directed allocation in more or less idealized market situations” (Bator 1958, 377). Bator summarizes the accepted theories of market failure without making any reference to the critiques of Hayek or John M. Clark. In the quasi-institution-free world of neoclassical equilibrium, Bator assumes away uncertainty, dispersed information, and time. Endogenous growth theory (Romer 1994) is another instance of the market theory problem. It tries to force the Smithian division of labor and Say’s law of markets (two main sources of increasing returns) into the equilibrium framework. With Hayek, the economic problem becomes “How does the market discover and utilize the dispersed knowledge in the economy?” It is not about the allocative properties of the market system; it is about the market as a process of social creation. Yet the profession did not heed Hayek’s critique. “To most members of the new generation of young pioneers, whose analytical habits of thought were a product of their weaning on full-information models that yield concrete equilibrium prices and quantities, Hayek’s vision was simply unintelligible. … Contending with the Hayekian perspective required the unwanted exhumation of an unscientific (i.e. non-equilibrium) corpus of non-theory” (Machovec 1995, 278).

Israel Kirzner and the Entrepreneurial Market Process It was in the context of the continuous development of the instrumental-causal approach in economics that Kirzner took on the task to elaborate a market theory that would tackle the limitations of the equilibrium-always view by building on Mises’s insights into the entrepreneurial function and Hayek’s analysis of the knowledge problem. Hayek never fully explained how that problem comes to be solved. Kirzner’s research program

78   Microeconomics demonstrates how entrepreneurship marshals and generates the knowledge needed for the coordination of individuals’ plans and the emergence of the social order. Mises saw the mathematical description of various states of equilibrium as mere play. Equilibrium is not a description of the world but a foil against which one can understand change. The main goal of theory is the market process (Mises [1949] 1998, 353); it consists in explaining how the decisions of individuals to alter and adjust their plans generate the forces that compel changes in prices, quantities, qualities, and types of goods and services on offer. Neoclassical economics does not provide a satisfying explanation. As Kirzner states, “there is nothing in the formulation of the economizing view of the decision that tells us how, in the absence of unexplained exogenous changes, one pattern of relevant ends-means comes to be replaced by another” ([1973] 2013, 29). Disequilibrium, argues Kirzner in Competition and Entrepreneurship ([1973] 2013), is a situation of widespread market ignorance, in which multiple opportunities to gain from trade exist but are unexploited. In disequilibrium, opportunities present themselves as price discrepancies. Entrepreneurship consists primarily in the noticing or discovery of these price discrepancies, that is, the discovery of new means-ends frameworks that were hitherto not part of the agent’s optimization set. For Mises, entrepreneurs “discover discrepancies between the height of the prices of the complementary factors of production and the anticipated future prices of the products, and they are intent upon taking advantage of such discrepancies” ([1949] 1998, 326). Opportunities tend to be discovered because individuals possess a propensity to discover what is useful to them. This is the idea of alertness to opportunities. While alertness is a human capacity, it is not a resource; that is, it is not something that can be deployed in order to discover opportunities. It is the result of one’s own history, prior knowledge, and other traits. To a large extent, it lies outside the purview of one’s own control. Alertness is Kirzner’s main contribution to the theory of the entrepreneurial function. It goes beyond the analytical contributions of Schumpeter and Mises. It is akin to Smith’s human propensity to truck, barter, and trade and the fundamental and universal desire for bettering our condition. Alertness is the motor of the entrepreneurial function. As Kirzner puts it, “We have no assurance that a man walking down the street will, after his walk, have absorbed knowledge of all the facts to which he has been exposed; we do, in talking of human action, assume at least a tendency for man to notice those that constitute possible opportunities for gainful action on his part” (1979c, 29). While people may err, they also tend to sniff out opportunities lurking around the corner that are useful to them. This insight assures us that price discrepancies in the market set a process in motion whereby these opportunities tend to be noticed and exploited. Alertness cannot be captured in the instrumental-causal approach, and without it, one cannot explain the emergence of sheer novelty (primarily in terms of new means-ends frameworks) in the economic system.9 9  Novelty is purely exogenous in the instrumental-causal tradition. Even endogenous growth theory does not theorize novelty as endogenous. It simply assumes that specific inputs create positive externalities, which generate increasing returns. Growth is not a phenomenon of the mind in neoclassical economics; it is sheer mechanical computation (Boettke, Coyne, and Leeson 2003).

Market Theory and the Price System    79 The other side of the alertness coin is the costlessness of entrepreneurial discoveries. Since discoveries are not the result of search (otherwise they would already be known), resources cannot be deployed to discover a specific opportunity.10 Therefore, there is no cost associated with noticing an opportunity. As in the case of alertness, the costlessness of discoveries cannot be captured in the instrumental-causal approach, which is built entirely in a closed framework where every opportunity is already recognized. People possess different knowledge (as knowledge is dispersed and often tacit) and interpret the world differently (the perception of information is subjective). These two tenets combined with idiosyncratic life experiences mean that some entrepreneurs will know about particular market characteristics or will see the importance of some services to customers when others will not.11 Moreover, discoveries take place in a cultural milieu, which acts as an interpretative framework through which entrepreneurs filter the world around them (Lavoie 1991). The process of entrepreneurial opportunity discovery is serendipitous. Opportunities may or may not be noticed. It is also a process of learning, as individuals acquire and accumulate knowledge from experience. Hayek sees knowledge acquisition as an empirical proposition in economics, whereas Kirzner considers this as part of the notion of purposeful action (Kirzner 1979c, 23–25). This learning process extends to the social level, as prices gradually reflect the knowledge that individuals acquire. Kirzner’s theory explicates a systematic process linking today’s relative prices directly to those that prevailed yesterday. As soon as the entrepreneurial function is introduced into the framework of human action, the fundamental point of the instrumental-causal theory of the market—namely, parametric prices—can only be rejected. Indeed, prices change because individuals realize they can seize new gains from trade by offering or asking prices different from those hitherto prevailing. In the entrepreneurial approach, prices cannot be parameters; they become an object of human action. There is a misalignment of prices both in space (two or more prices for the same good can coexist) and in time (current prices of resources can be seen as too low or too high with respect to future states of the market). Mises talks of “false prices.”12 Moreover, price discrepancies in the market reflect the misalignment of the relationship between underlying variables (tastes, technology, and available resources) and induced variables (prices, profit-and-loss accounting).13 These discrepancies and relationships are 10 

Even in cases where the discovery of an opportunity seems to result from the deployment of resources (such as in the case of a firm’s research and development), the actual discovery took place earlier, when the idea to pursue some specific R&D investment was found and implemented. See the discussion in Kirzner ([1973] 2013, 49). 11  As Mises explains: “Economists must never disregard in their reasoning the fact that the innate and acquired inequality of men differentiates their adjustment to the conditions of their environment” ([1949] 1998, 325). 12  Mises explains that “it is the competition of profit-seeking entrepreneurs that does not tolerate the preservation of false prices of the factors of production” ([1949] 1998, 335). 13  See Kirzner (1992, chap. 2).

80   Microeconomics Table 4.1  Kirzner’s elements of human action. Robbinsian maximizer (RM)

Misesian homo agens (RM and PE)

Pure entrepreneur (PE)

Means and ends

Given. Cannot identify any other.

Some already recognized, others discoverable.

Not given and not known.

Change

Purely exogenous because of data shift/shocks. No change as a result of learning.

Exogenous and endogenous. Learning. Creativity. Seeing around the corner.

Purely endogenous. Identifies new means-ends framework even if no change in external data. Uncertainty.

Allocation

Of known means to given ends. Pure allocation. Equilibrium.

Allocation and discovery. Purposeful action.

No allocation, just pure alertness and pure discovery of net gains. Disequilibrium.

not determined, but entrepreneurial alertness to profit opportunities will tend to move the induced variables of the market in a direction that reflects the underlying values. The market system is a self-correcting process. Since the underlying variables are ever changing, they will permanently reset the direction of change for the induced variables. In Kirzner’s framework, human beings can be modeled, on the one hand, as “Robbinsian maximizers”; that is, they are able to pursue known goals with means that are clearly defined and identified. On the other hand, they are also “pure entrepreneurs”; they can discover new means-ends frameworks.14 Simply put, it is the Robbinsian maximizer who generates order, and it is the pure entrepreneur who delivers creativity. Through this analytical lens, Kirzner provides a precise content to Mises’s notion of homo agens and shows the richness of the Misesian approach to human action. Homo agens integrates the two functions: Robbinsian maximizing and the pure entrepreneur (see table 4.1).15 The focus of the instrumental-causal tradition is on the first column of table 4.1: the Robbinsian maximizer and the allocative efficiency of the market. The genetic-causal tradition is concerned with a wider sense of human action. Its focus therefore is on homo agens. In the Kirznerian entrepreneurial market, competition is a rivalrous process, a permanent discovery procedure of the knowledge contained in the underlying variables. The understanding of competition and monopoly (and the field known as “industrial 14 

The pure entrepreneurial function rests entirely on the concept of alertness: “We can now introduce into the analysis the device of the pure entrepreneur, that is, a decision-maker whose entire role arises out of his alertness to hitherto unnoticed opportunities” (Kirzner [1973] 2013, 31). And the individual’s “decisions as pure entrepreneur display no trace at all of Robbinsian economizing; there is nothing at all to be allocated. As pure entrepreneur he is seen displaying nothing but alertness to the existence of price differences between inputs and outputs” (37). 15  As Mises states, “in any real and living economy every actor is always an entrepreneur and speculator” ([1949] 1998, 253).

Market Theory and the Price System    81 organization”) is one of the topics where the divergence between the instrumental-causal and the genetic-causal views is most acute. Blaug’s statement is interesting in this respect:  I contend that perfect competition is a grossly misleading concept whose only value is to generate an endless series of examination questions. Economics would be a better subject if we discarded it once and for all. Having expunged perfect competition, we ought to follow it by also discarding Walrasian existence proofs and the Invisible Hand Theorem of welfare economics. … [T]‌here is never any doubt that competition is an active process, of discovery, of knowledge formation, of “creative destruction.” I call this “the Austrian view of competition” because it is most firmly enshrined in the writings of such Austrian economists as Hayek, Schumpeter and, more recently, Kirzner. (Blaug 1996, 594–595)

The discovery approach demonstrates how the market can reconcile (however imperfectly) the infinite multitude of independent ends that individuals pursue at a given time in an economy based on the division of labor and knowledge. In part, this is because there is no divorce between the allocative properties of the market and its creative properties. Individuals’ lure of profit in a disequilibrium market constitutes the recipe for allocation and change. The Kirznerian theory of the market process is also a theory of growth. And because entrepreneurs make plans that include the use of heterogeneous capital goods, market-process theory extends into capital theory to explain the evolution of the structure of capital. In contemporary economic theory, the Austrian school of economics is the main promoter of the genetic-causal tradition, that is, the mainline of economics. Kirzner stands as its chief representative.

Kirznerian Market Process Theory and Its Critics Just as Hayek’s vision was unintelligible to most economists in his generation, Kirzner’s view has failed to convince the majority of mainstream economists that (a) a fundamental element is missing from the instrumental-causal tradition, and (b)  Kirzner’s entrepreneurial function defined as alertness to hitherto unknown possibilities represents a good alternative theory. Benjamin Klein’s scathing critique of Competition and Entrepreneurship is illustrative. Klein explained that “because of its peculiar methodology and language, [Competition and Entrepreneurship] is unlikely to have a large impact on the profession” (Klein 1975, 1308). While Klein agreed, at some level at least, with Kirzner’s research agenda, he clearly stated that Kirzner fell short of providing an alternative model to microeconomic theory as it stood then. The lack of formalization and the focus on the elusive idea of entrepreneurship made it difficult for economists trained

82   Microeconomics in traditional industrial organization and market theory to understand Kirzner’s new approach. But the way Kirzner’s work was received is not surprising if one considers that he aims at reversing the sharp break in continuity that occurred in market theory around 1920. As he puts it, “our position will call for reconsidering very substantial portions of the theory of price” so that “a reconstructed theory of the market may be built” (Kirzner [1973] 2013, 2). Other economists have objected that (Kirznerian) entrepreneurship has no place in economics (Demsetz 1983) or that all that Austrian economics has to say has already been incorporated into neoclassical economics (Rosen 1997)  or can be incorporated in it (Yates 2000). But Kirzner’s theoretical framework has mostly been criticized from within Austrian economics. Several authors, including Peter Klein, Murray Rothbard, and Joseph Salerno have expressed their disagreement. We focus here on three main lines of criticism. A first line of criticism regards market theory and the equilibrium concept. In the introduction to the scholar’s edition of Mises’s Human Action, Jeffrey Herbener, Hans-Hermann Hoppe, and Joseph Salerno make the following point: “[F]‌atal for the theoretical core of the Austrian School, was the displacement of its theory of price, as originated by Carl Menger. … Another strain had begun to develop along the lines spelled out by … Friedrich von Wieser, who followed the Walrasian path of developing price theory within the framework of general equilibrium” (in Mises [1949] 1998, vi). Peter Klein echoes this view, arguing that Austrian price theory is about value and exchange and not about knowledge, expectations, and disequilibrium (2010, 130–133). A change of analysis came with Friedrich von Wieser, Hayek, and later Kirzner. There are, in essence, two strains within Austrian market theory, Klein explains. The first one (to which Mises belongs) is centered on value and exchange and does “mundane price theory,” and the other one, which emerged after 1974, is centered on uncertainty, knowledge, and disequilibrium. It is true that some economists within the Austrian tradition, such as Wieser and Schumpeter, had a theoretical interest in Walras’s general equilibrium theory. This was not the case for Menger. Jaffé (1976, 520) opposes Menger’s market theory to that of Walras and Jevons. A close look at Carl Menger’s Grundsätze ([1871] 1976), however, reveals a more complex picture: “An examination of Menger’s fifth chapter on the theory of price provides no hint of any time-consuming market process (entrepreneurial or otherwise) through which prices are systematically formed. On the contrary, Menger explicitly assumed the absence of all error, an assumption guaranteeing instantaneous equilibrium and one that starts out by giving entrepreneurs little to do” (Kirzner 1979b, 64). While Menger focused on exchange, his price theory was not, contrary to the claims of the economists cited above, an entrepreneurially driven, disequilibrium theory. Kirzner’s theory builds on the Mengerian tradition with its focus on exchange, on consumer-driven valuations of production factors, on product variation, on spontaneous market processes, and on the implicit rejection of the general equilibrium framework. Like Schumpeter and Mises before him, Kirzner adds to the theory of markets the entrepreneurial function, which was not explicit in Menger’s Principles. Moreover, Kirzner’s

Market Theory and the Price System    83 theory adheres to the idea that prices are not parametric and instead are the object of entrepreneurial action. Therefore, Kirzner’s theory belongs entirely to the genetic-causal tradition of market theory. Klein seems to be saying that market theory went astray by focusing on uncertainty, knowledge, and disequilibrium (Klein 2010, 133). But how could that be? All of these concepts are present in Mises’s Human Action and form the substrate of a truly dynamic theory of the market. It is precisely because of uncertainty and disequilibrium (and the corresponding rejection of parametric prices) that Kirznerian market process theory does not belong to the instrumental-causal tradition. While it is true that different definitions of equilibrium have circulated in the modern Austrian economics literature (Klein 2010, 140), the idea of mutual compatibility of plans or of a state in which each decision perfectly anticipates all other decisions (plans perfectly dovetail with one another) can be taken as a basic definition. What matters most, however, is that Kirzner ([1973] 2013, 10), following Mises ([1949] 1998, 247–251, 354, 697), uses equilibrium as a foil against which he can assess market changes. Using equilibrium as a reference point helps, for instance, establish the existence of price discrepancies in the market. Kirzner’s goal, which is the same as Mises’s, is to explicate the mechanisms by which the market generates forces that compel changes in prices, quantities, qualities, and types of goods and services on offer. It is an explanation of the forces that produce the spontaneous organization of the market. It seems that a return to a “more mundane” view of price theory would impoverish our explanation of the market process without much corresponding gain. This leads us to a second line of criticism on the nature and existence of the equilibrating process. The issue revolves around the presence or absence of a tendency toward equilibrium. Kirzner contends that his analysis of market theory argues in favor of the existence of equilibrating tendencies. Ludwig Lachmann (1986) takes the opposite stance. In Lachmann’s terms, the market is not clockwork; it’s “kaleidic.” Individuals form subjective expectations about market data. As the market process unfolds, knowledge changes (learning takes place), and expectations also change. But individual expectations may evolve in a variety of ways, since they are subjective perceptions of market data. As a result, and because there are no objective market data, no tendency toward equilibrium can be asserted. According to Lachmann, the market moves from one situation of discoordination to another one. Entrepreneurial activity itself generates endogenous changes that preclude any certainty of equilibration. Kirzner disagrees and argues that his own theory shows how market forces induce plan coordination, even if equilibrium is never achieved. Out-of-equilibrium trades lead to learning and expectation revisions, which enable entrepreneurs (and this is the difference with Lachmann’s view) to know whether they were right or wrong (through profit-and-loss accounting). Each step in the market process aims to realign the induced market variables with the underlying economic realities. Lachmann contends that once the subjectivity of expectations is acknowledged, no underlying realities of any kind can be established to exist objectively, let alone to guide market adjustments. Kirzner asserts, on the other hand, that it is the change in the underlying values that preclude the economy

84   Microeconomics from ever reaching equilibrium, not the subjectivity of expectations about them. At the end of the day, it is a question of emphasis on the role of subjectivity. Lachmann emphasizes subjectivity in expectation to the exclusion of almost anything else. Kirzner argues that market signals (prices, profit-and-loss accounting) reveal the underlying reality, which, even if it is fleeting, remains sufficiently present to guide entrepreneurial activity over some period. Expectations are subjective, but some entrepreneurs identify the underlying economic reality better than others and are rewarded for doing so.16 Kirzner accepts the classical economics idea that the market tends to create order out of chaos. The sum total of individual activities does not amount to random anarchy but to a harmonious order. This is the orderliness of markets, the great lesson of nineteenth-century economics. Here again, Kirzner’s theory finds its place in the mainline of economics. He sees Austrian market theory as the middle ground between “equilibrium always” and “equilibrium never” approaches (Garrison 1982). A third line of criticism has to do with the nature of the entrepreneurial function. We will focus here on three issues: (1) alertness versus judgment, (2) discovery versus creation or imagination, and (3) whether the entrepreneurial function implies some form of ownership of the factors of production. Rothbard (1985) argues that “alertness” is incompatible with the Misesian understanding of entrepreneurship. Klein states that “Kirzner’s concept of alertness can … be seen as an addendum to the neoclassical understanding of market equilibrium” (2010, 148). The notion of entrepreneurship according to Klein, is “judgmental decision making under conditions of uncertainty” (69).17 It was argued above that the concept of alertness is the essential component of Kirzner’s entrepreneurial market theory. The question is not whether judgment is exercised, as there is no doubt that judgment takes place in uncertainty. The question concerns the object of the judgment under consideration. Kirzner considers that the object of judgment must first be noticed before any judgment can take place (judgment is judgment of something). As High states it, “judgment is the mental process of assigning relevance to those things we already know” (1982, 167). This relates to Schumpeter’s notion of “pre-scientific hunch” (scientists always start from some seminal idea). This is why the human propensity to sniff out opportunities lurking around the corner is the engine of the entrepreneurial function. It is on par with Smith’s propensity to barter and trade, as it sets a process in motion whereby opportunities tend to be noticed and exploited. The essence of entrepreneurship must be located at its point of origin. And that point is the moment where a new means-ends framework comes to be noticed, even if the details of the opportunity are clouded in uncertainty; it is not judgment. This discussion relates to the second point on discovery versus creation or imagination. Critics often quote the passage in Competition and Entrepreneurship in which Kirzner describes entrepreneurship as a responding agency: “I view the entrepreneur not 16  See Rizzo (1992) for a discussion of equilibrium in Austrian economics and in the radical subjectivist approach. 17  See also High (1982), who makes a similar point on the role of judgment.

Market Theory and the Price System    85 as a source of innovative ideas ex nihilo, but as being alert to the opportunities that exist already and are waiting to be noticed” ([1973] 2013, 59). It seems that Kirzner’s critics may have a point. They see in this passage a description of entrepreneurship as a mere reaction to existing opportunities rather than as a creation of new opportunities. One may offer two responses in defense of Kirzner’s position. First, it was Kirzner’s goal in Competition and Entrepreneurship to present a theory of the market process, which would solve the Hayekian knowledge problem. Entrepreneurship is seen as the driving force that marshals knowledge and sets the market process in motion. The passage quoted above is part of a discussion of Schumpeter’s view of the entrepreneurial role. Because of the entrepreneur’s innovative activity, Schumpeter sees the entrepreneur as a disequilibrating force, whereas Kirzner theorizes it primarily as an equilibrating tendency. Kirzner’s primary but not sole concern in his 1973 book is to explain the allocative properties of the market. It is only in subsequent writings that he develops the view of the entrepreneur as a creative and innovative force responsible not only for the equilibrative tendencies in the present market but also for its growth through the intertemporal coordination of present and future actions under uncertainty (Kirzner 1982a; 1982b; 1985; 2000; 2008).18 A second line of response rests on the idea that Kirzner is concerned with what is possible within the world, as the entrepreneur perceives it.19 For instance, Robinson Crusoe on his island can imagine all sorts of ways to go fishing (including using dynamite), but he is constrained by reality and his perception of the world. The opportunities to go fishing are bounded by reality. Therefore, alertness is the propensity to introduce new information in the world (i.e., being creative) while being constrained by the state of reality (vines, and not dynamite, are available on the island). Entrepreneurial creation is constrained by the present state of the world but is not limited in the way one can apply one’s own imagination to the future. Kirzner is concerned with discovery of what is possible and not with just sheer invention or imagination unrelated to the state of reality. The concept of alertness grounds entrepreneurial discovery within the possible and the actual (i.e., the current reality of the world) and, at the same time, enables human imagination (considering the present state of the world) to create the future. This is especially crucial in the context of market transactions, where human creativity is bound by factor prices on the one hand and by individual preferences on the other. As in the debate between Kirzner and Lachmann, it is a matter of emphasis on the role of subjectivity. In Kirzner’s work, while perceptions are subjective, entrepreneurs tend to discover what the objective reality is about (e.g., in Crusoe’s world, nets are made with vines). In the social context, that objective reality is made of other individuals’ perceptions of the world (individuals’ preferences), and Kirzner considers this framework as part of the constraints that entrepreneurs face. It is only within this theoretical framework that theory can explain the self-correcting properties of the market system. 18  Note that in Competition and Entrepreneurship, Kirzner also states that the entrepreneurial element is “responsible for our understanding of human action as active, creative, and human rather than passive, automatic, and mechanical” ([1973] 2013, 27–28). 19  See Sautet (2010, 95–96) for a discussion of the subject.

86   Microeconomics Klein suggests that “opportunities are best characterized neither as discovered nor created, but imagined. … [T]‌he concept of opportunity imagination emphasizes that gains (and losses) do not come into being objectively until entrepreneurial action is complete” (2010, 105). Klein is correct to emphasize the uncertainty that exists until profits and losses have been fully accounted for. His theory, however, rests on a radical subjectivist approach to opportunities à la Lachmann: opportunities are imagined, and there is no objective market data.20 Buchanan and Vanberg make a similar point: “Entrepreneurial activity … is not to be modeled as discovery of that which is ‘out there’ ” (1991, 178). But then one may ask whether there is any correspondence between reality and entrepreneurial action. In such a setting, there is no feedback mechanism to speak of. What profit or loss has been made in a world where opportunities are imagined and have no correspondence to reality? Buchanan and Vanberg retort that the creativity of human choice poses a problem to economics because it is genuinely unpredictable, as individuals “have no idea in advance concerning the ideas that their own imaginations will yield” (184). But Klein and Buchanan and Vanberg fail to understand the nature of alertness as the propensity to see around the corner what is in one’s own interest to know. The “creative market” that these authors describe possesses no property of social coordination. The radical subjectivist approach has no explanation for the adaptiveness and coordinative properties of the market system. It is a kaleidic market but probably not an orderly one. An alternative to the radical subjectivist view of expectations is Weberian and Schutzian ideal typification (Ebeling 1995; 1999). Mises (1957), following Alfred Schutz’s work, argues that ideal types are the primary tool that entrepreneurs use in anticipating the possible demands of consumers. Individuals are guided in their decisions by the mental constructs they create through their past experiences with others. They vary in their degrees of anonymity and intimacy in various settings. Typifications constitute structures of intersubjective orientation (Ebeling 1999, 126–129). Lavoie (1991) also argues that culture constitutes a shared interpretative framework that enables entrepreneurs to see what others may want. 21 The third point relates to whether the entrepreneurial function implies some form of ownership of the factors of production. Kirzner ([1973] 2013, 32, 38, 79) introduces the “pure entrepreneur” as a function, which is unrelated to (tangible and intangible) asset ownership. Salerno (2008) reminds us that Rothbard, among others, disputed this approach. Rothbard sees Kirzner’s conception as “un-Austrian,” because it represents a departure from “the basic Austrian insight that the entrepreneur and the capitalist are one and the same.”22 While Rothbard correctly emphasizes the importance of the capitalist in real-world entrepreneurship, he chooses to ignore the role that the analytical separation of the capitalist and the entrepreneurial functions played in the development of market 20 

Klein states: “Opportunities do not exist objectively, ex ante, but are created, ex nihilo, as entrepreneurs act based on their subjective beliefs” (2010, 107). 21  See also Koppl (2002) for an analysis of alertness as a propensity to problematize open possibilities. 22  Quoted in Salerno (2008, 191). Rothbard’s (1995, 395–396) point stems from the notion of the “capitalist-entrepreneur” that he identifies in Turgot’s work.

Market Theory and the Price System    87 theory (Schumpeter 1954, 222). Kirzner’s approach is part of that lineage, which sees great analytical value in the separation of the entrepreneurial function from the other elements in the market (capitalist and laborer).23 John B. Clark proceeds similarly in The Distribution of Wealth ([1899] 1908). Mises also considers the construct of the pure entrepreneur in his analysis of uncertainty and functional distribution ([1949] 1998, 253–254). The difficulty comes in when one realizes that only property owners can bear the burden of uncertainty. Losses must fall on someone who can bear them and therefore cannot fall on a propertyless entrepreneur (High 1982, 166). This is true. The response to this conundrum can be found in Mises’s Human Action, in which he makes the distinction between the “pure entrepreneur” (the analytical function) and the “promoter” (the entrepreneur in the living economy) ([1949] 1998], 256.24 The pure entrepreneurial function cannot exist in the real world without asset; it is always mixed with an asset-ownership function of some sort (including one’s own reputation and human capital) such that a real-world entrepreneur (a “capitalist-entrepreneur” to use Rothbard’s terminology) invests capital and shoulders uncertainty. The pure entrepreneur (the entrepreneurial function) realizes neither profits nor losses. It is only a pure theoretical construct (Mises [1949] 1998, 253–254). Unfortunately Kirzner pays scant attention to this issue in his work, although he remarks that “the important point is that analytically the purely entrepreneurial role does not overlap that of the capitalist, even though, in a world in which almost all production processes are more or less time-consuming, entrepreneurial profit opportunities typically require capital.” ([1973] 2013, 40). Some critics, such as Jack High (1982), have said that Kirzner gives only cursory attention to uncertainty and accounting losses. Yet unless one distinguishes the entrepreneurial function from the other elements in the market, it is impossible to separate analytically pure entrepreneurial profits from pure interest (and also from other types of rents). These categories of functional distribution must be clearly established if one is to understand the market forces responsible for resource allocation and growth. This was the task Kirzner accomplished in Competition and Entrepreneurship.

Conclusion Two ways of theorizing the market exist in economics. Mainstream contemporary theories use an instrumental-causal approach, which is characterized by a complete reliance on some form of equilibrium. In spite of the effort to introduce stochastic elements to mimic dynamism, this vision of the economic system is largely static.

23 

Kirzner also carefully distinguishes the entrepreneur from the producer ([1973] 2013, 36). Salerno finds the use of the term “promoter” confusing because of its modern meaning (2008, 193). See also Sautet (2000, 74). 24 

88   Microeconomics The market system can also be understood as a complex adaptive system embedded in institutions and time. This view has been at the core of the genetic-causal tradition in economics since the eighteenth century. In his “Letter to l’Abbé Terray”, Turgot discusses the impossibility of guiding commerce, for “it would be necessary to know [all the changes in the needs, the interests, and the industry] in such detail as would be physically impossible to obtain” ([1773] 1977, 256). Smith gives the example of the woolen coat and the idea that one cannot compute the number of exchanges necessary to make it ([1776] 1904, book I, 13). Menger offers a sophisticated analysis of the market system as a spontaneous order by means of which money can be selected. Marshall saw the economic system fundamentally as a dynamic organism evolving in historical time. Hayek starts incorporating complexity into his analysis of social systems as early as 1955, with the publication of “Degrees of Explanation.” Complex orders and institutions then become a recurrent theme in his work. At the same time, the neoinstitutional economics of Douglass North brought institutions back into the picture of neoclassical economics. The rise of institutional analysis in modern thinking is largely a result of the influence of the genetic-causal approach. Evolutionary economics revived the biological metaphor along with institutional change (Hodgson 1998). Contemporary Austrian thinkers such as Boettke have developed the idea that alternative institutional arrangements affect the type of knowledge that is generated by the system through the level of learning of economic participants (Boettke 1997, 36). Boettke (2014) has also started using Kirzner’s analysis to explain the emergence of institutions—a domain that, in Kirzner’s view, remains outside the boundaries of economics. Rizzo (2000) has applied Henri Bergson’s analysis of time to economic analysis, showing how a fully consistent theory of market change must take place in real time. It is our contention that Kirzner’s theory of the market represents the most accomplished analysis of its kind in the contemporary genetic-causal tradition. It aims at explaining the microforces that compel changes in prices, quantities, and qualities of goods on offer, thereby generating the spontaneous dynamic process of the market. Surprisingly, perhaps, one can argue that there is room for the two strains of market theory. Comparative static and also game theory can deliver powerful analysis, especially when it comes to specific applied problems. But it is a question of knowing the limits. The genetic-causal tradition provides a much richer analysis of the world and helps put constraints on the claims of the mainstream (for instance, regarding the notion of competition and the importance of market failure). As Jevons explained ([1871] 1957, 5), it was inevitable that economics would come to use mathematics, since it deals with marginal effects, prices, and quantities. In the final analysis, the differences between the two strains of economic thinking rest on the anthropological vision (man as a robot versus man as creative being), the understanding of the basic economic problem, and the importance of subjectivism (rightly understood) in the way economics deals with the phenomena of the mind.

Market Theory and the Price System    89

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Chapter 5

Austrian s v e rsu s Market So c ia l i sts Jesús Huerta de Soto

Introduction: Entrepreneurship and Socialism To define socialism, we must first understand the concept of entrepreneurship. Austrian economic theorists define entrepreneurship as an innate human ability to discover, create, or recognize profit opportunities that emerge in one’s environment and to act to take advantage of them (Kirzner 1973). Indeed, etymologically speaking, the word entrepreneur brings to mind the discoverer, someone who perceives something and grasps it. Every entrepreneurial act sets off a chain of three events. The first is the creation of information: when an entrepreneur discovers or creates a new idea, the entrepreneur produces in his or her mind information that did not exist before. Then, in one way or another, that information is transmitted in consecutive waves, which is the second event. Here I see a cheap resource being put to poor use, and there I discover an urgent need for the same resource. I buy low and sell high. I transmit the information. Finally, economic agents who act in a discoordinated manner learn or discover that they should save the resource because someone needs it. Those are the three events in the chain: the creation of information, the transmission of information, and, most important, coordination or adjustment. From morning till night, we discipline our behavior according to the needs of others, people we never even meet, and we do this motu proprio, because we realize that when we act in our own best entrepreneurial interest, we come out ahead. Socialism should be defined as “any system of institutional aggression against the free exercise of entrepreneurship” (Huerta de Soto 2010, 49). Socialism acts via systematic, institutional coercion, and this is its primary characteristic. This is a very significant point, because, without fail, socialists wish to hide their coercive side, the essential characteristic of their system. Coercion involves the use of violence to compel someone to

Austrians versus Market Socialists    95 do something. On the one hand, there is the coercion of a criminal who mugs people in the street; on the other hand, there is state coercion, the sort that typifies socialism. In the case of the asystematic coercion of the criminal, the market has mechanisms to define property rights as far as possible and to defend against crime. However, in the case of systematic, institutional coercion from the state, which holds the reins of power, chances of avoiding this power or defending against it are very slim. Therefore, we have gone beyond the classic definition of socialism, which centered on whether the means of production are publicly or privately owned. The fundamental nature of socialism is institutional state coercion (Hoppe 1989), by which a governing body is supposed to carry out the tasks necessary to coordinate society. Responsibility is transferred from common people at the helm of their entrepreneurship, who seek their own ends and try to create the best conditions for attaining them, to a governing body, which, from above, attempts to forcibly impose its own objectives or vision of the world on all areas of life in society.

The Theorem of the Impossibility of Socialism Socialism is an intellectual error, because it is impossible for the governing body responsible for exercising coercion to acquire the information it would need to make its commands truly coordinating. This is the problem with socialism, its central paradox. A governing body needs information, knowledge, and data to achieve the coercive impact it seeks: the organization of society. Indeed, neoclassical economists thought socialism was possible because they presumed that all the information necessary to develop and solve their system of equations, the embodiment of their equilibrium model, was given. This assumption blinded them to what was happening in the real world, to what should have been the object of their research. Austrian theorists subscribed to a different paradigm. They never presumed that information was given. On the contrary, they believed the economic process to be fueled by entrepreneurs who constantly changed and uncovered new information. For this reason, it was Austrians alone who saw that socialism was an intellectual error. They advanced four arguments, two static and two dynamic, as a basis for their analysis. First, for reasons of volume, it is impossible for the governing body to acquire the information it would need to truly coordinate with its commands. Humans work with a huge volume of information, and what seven billion people have in their heads simply cannot be administered. Neoclassical theorists might grasp this argument, but it is the least powerful and the least important. At any rate, nowadays, computers are potent enough to enable us to deal with enormous volumes of information. The second argument is weightier and more compelling. The information handled in the market is not objective; that is, it is unlike the information printed in a phone

96   Microeconomics book, for instance. Entrepreneurial information is of a profoundly different nature. It is subjective and practical, not objective. It is tacit; that is to say, we know something, know how, but we do not know all the specifics, know that. In other words, it is like the information a person gains when he or she learns how to ride a bicycle. The knowledge one needs to ride a bike is acquired through a “learning process” in which there are mishaps but which permits us to develop our “sense of balance” (Polanyi 1959). Tacit information cannot be manifested in a formalized, objective way, nor can it be transferred to anyone, especially not to a governing body. Most of the information that determines the success of our lives is not objective; it is not like the information we find in the phone book but, instead, is subjective, tacit, practical, and dispersed. These two static arguments—that information is of an enormous volume and tacit in nature—combine with two more dynamic ones to demonstrate the theorem of the impossibility of socialism. Humans are innately creative. We are always discovering new things, new objectives, and new means for reaching them. Entrepreneurs cannot transmit to a governing body information or knowledge they have not yet created. In a socialist system, the governing body is bent on instituting social nirvana via coercion and the official gazette. To do this, it has to know what will happen tomorrow, but what happens tomorrow depends on entrepreneurial information not yet created and thus not transmittable today to allow our leaders to coordinate us well tomorrow. And that is not all. There is a fourth, definitive argument. The coerciveness of socialism, which reflects its very essence, obstructs, impedes, or prevents the entrepreneurial creation of precisely that information authorities would need to truly coordinate society with their commands. Furthermore, this obstruction occurs wherever socialism has an impact on society and to the extent of its impact. Not even the kindest person on earth, with the best of intentions and the greatest of knowledge, could organize society based on the coercive socialist framework. He or she would make life hell, since, given the creative, entrepreneurial nature of human beings, the socialist ideal or objective is impossible to achieve.

Market Socialism: Definition and Types One characteristic common to all the different versions of market socialism is that, to a greater or lesser extent, they introduce a sort of “competitive solution” or “quasi-market” (to use Mises’s terminology, [1922] 1981), in which the different economic agents behave in a manner as similar as possible to how they would behave in a capitalist system. Such proposals are typically ambiguous and contradictory, and to the extent that the imagined systems are to remain socialist, in other words, to methodically and coercively limit

Austrians versus Market Socialists    97 the free exercise of entrepreneurship, they fail to address the problem Ludwig von Mises and Friedrich Hayek initially posed regarding the impossibility of economic calculation wherever the necessary information is not freely generated. Within the market socialism tradition, there are two broad types of “competitive solution” to the economic problem posed by socialism. The first is envisioned as just a subsidiary solution to permit in practice the algebraic calculation of the equilibrium prices that would have to be known in order to coordinate the system. The second is envisioned as an entirely independent solution designed to bring about the best of both worlds, socialism and capitalism, and give rise to a synthesis in the shape of a market socialism that in its weakest form would be hard to tell apart from modern social democracy and in its most radical form would attempt nothing more and nothing less than the squaring of the circle, the solving of society’s problems. Market socialism theorists usually devote considerable effort to convincing their fellow socialists on the one hand and the general public on the other that “the market” is an institution that “has nothing to do with” capitalism and that it can be used successfully as a mere tool by the socialist system (Lange 1987; Le Grand and Estrin 1989). Or, as Anthony de Jasay indicates in his description of the position of market socialists, they believe that apologists for capitalism usurp the market, appropriating it as if the market—an efficient institution—depended for its functioning on capitalism—a repugnant and alienating system. However, the suggestion that market and capitalism go together is but “a sleight of hand.” Traditional socialists fall for this trick, and think they dislike and mistrust markets when in fact it is capitalism they reject. This is a confusion, a failure to see that the market can be trained to serve socialist goals just as it now serves capitalist ones. Indeed, though the authors do not say so, they tacitly treat the market as a neutral tool in the hands of its political master who can use it in fashioning the kind of society he wants. (de Jasay 1990)

Historical Forerunners of Market Socialism Prior to the refined proposals of Oskar Lange, Evan Durbin, Henry Dickinson, and Abba Lerner for a competitive solution, such ideas were already being developed, though in embryonic form, in both German and English. In German, the first theoretical developments in this area emerged in the 1920s as a reaction against Mises’s landmark article ([1920] 1963) and mainly from the pens of Eduard Heimann and Karl Polanyi. They both advocated a solution founded on a certain amount of competition between a set of monopolies or trusts, which, under union or government control, would lie at the core of the economic organization of socialism.

98   Microeconomics So, for example, Heimann understands that prices and the market are vitally important, yet he desires the establishment of a socialist system at any cost. He attempts to solve this clear dilemma with the proposal of what he terms “peaceful or friendly competition” (freundlichen Wettbewerb). This competition would be orderly and supervised and would exist among the managers of the various corporate and sectoral bodies into which the economic system would be divided (Heimann 1922). Heimann claims that if the managers of the different sectoral monopolies had varying goals, ideals, and interests, then their activity would yield results as competitive as those continually achieved in a real market economy. Thus, he holds that there would be no problems of economic calculation and that most of the benefits of the competitive system would be preserved, even if private ownership of the means of production were prohibited and an egalitarian distribution of income were forced. Furthermore, Heimann advocates doing away with rent, interest, and dividends, which would go straight to the central coercion bureau. Moreover, managers of the sectoral monopolies would be ordered to fix their prices at the level of costs incurred and to avoid using the monopolistic power given to them by their situation. For his part, Polanyi (1922) expressly states that economic calculation is impossible in a centrally planned system, but then he puts forward a proposal for “guild socialism,” in which he suggests that “ownership” of the means of production corresponds to a central planning body and that the right to use production and consumer goods and services corresponds to production guilds. Polanyi’s solution is an ambiguous one resembling Heimann’s, and it also does not specify who would have the final say in decision-making, whether that be the central coercion bureau or the guilds. On the one hand, if the central planning agency gets the last word, then we are once again faced with the question of how to obtain dispersed knowledge, a problem that impedes economic calculation in centralized systems. On the other hand, if it is ultimately the unions that systematically coerce their members and make decisions, then we are faced with a guild socialism fraught with insurmountable problems of intra- and intersectoral coordination (Mises 1924). Among scientists in the English-speaking world, prior to the contributions of Lange, Durbin, Dickinson, and Lerner and not counting W. C. Roper’s (1931) brief remarks on the subject, hardly anything had been written in English on market socialism and the competitive solution. However, at least in academic seminars, a doctrine had already been sufficiently developed for both Mises and Hayek to theoretically refute it.

Mises’s and Hayek’s Anticipatory Criticism of Market Socialism The earliest critical remarks on the competitive solution were made by Mises in his book Socialism ([1922] 1981), in a section devoted to the “artificial market.” Mises identifies the market as the “focal point,” the very essence, of the capitalist system. He asserts that

Austrians versus Market Socialists    99 the market can thrive only under capitalism and that it is therefore impossible to artificially simulate the market and competition in a socialist system. The reasons Mises gives to back up this conclusion are in perfect accordance with entrepreneurship’s creative, coordinating nature, which was explained at the beginning of this chapter. Mises expressly states that it is the entrepreneur who generates the practical information that economic calculation requires: “It is the speculative capitalists [i.e., the entrepreneurs] who create the data to which he has to adjust his business and which therefore gives direction to his trading operations” (Mises [1922] 1981, 121). Nevertheless, information is only created, discovered, or seen when the entrepreneur is working toward a goal that provides him with an incentive to obtain this information. The incentive is the aim or profit the entrepreneur seeks to realize with his action, but if he is unable to attain his aim, profit, or end because property rights are not recognized, then he will fail even to create the information economic calculation requires, and the whole creative, coordinating process typical of a market economy will never be set in motion. “Without the striving of the entrepreneurs for profit … the successful functioning of the whole mechanism is not to be thought of. … The motive force of the whole process which gives rise to market process for the factors of production is the ceaseless search on the part of the capitalists and the entrepreneurs to maximize their profits” (119). Therefore, we cannot separate the market and its typical functions—with respect to the constant formation of prices and the creative, coordinating capacity of the individual acts of its participants—from the institution of private ownership of the factors of production. In short, as soon as private ownership of the means of production is abolished, it becomes pointless to order company managers to act as if they were entrepreneurs, since they are cut out of the loop when the possibility is taken from them of obtaining what they subjectively consider their potential profits. Moreover, Mises indicates that it makes no sense for a hypothetical “state bank” to auction its funds to those managers who provide the chance of attaining a higher “rate of profit”: “Such a state of affairs would simply mean that those managers who were less cautious and more optimistic would receive capital to enlarge their undertakings, while more cautious and more skeptical managers would go away empty-handed. Under capitalism, the capitalist decides to whom he will entrust his own capital” (Mises [1922] 1981, 121). Thus, the process rests not on presenting the maximum rate of profit but on the practical information perpetually created ex novo in a capitalist market when entrepreneurs act on their speculations and are impelled by the psychological tension they experience between their wish to earn profits and their subjective estimate of their chances of suffering losses. The manager working in circumstances other than those of an entrepreneur in a free market will never have access to the same practical information as the entrepreneur. Hence, in a socialist system, the final entrepreneurial decision will ultimately be made by the central planning agency in charge of deciding who will receive the corresponding funds and resources, and this central agency will never succeed in acquiring the practical information it would need to avoid acting arbitrarily. Mises concludes that “the alternative is still either socialism or a market economy” but that the possibility of market socialism as a middle ground is inconceivable (142).

100   Microeconomics Hayek, in “The State of the Debate” (1935) under the heading “Pseudo-Competition,” also criticizes the models that had been developed in German by Heimann and Polanyi and the other proposals for market socialism that the most active young socialist economists were formulating orally in London’s economic circles. Hayek’s critical comments about this second group of competitive socialism proposals, in which competition is meant to extend to the broadest sphere compatible with public ownership of the means of production and in which the central planning body only intervenes to appropriate profits and distribute the corresponding investment funds, are of a certain interest mainly because of their implications as a precedent for the modern economic theory of property rights and for the analysis of the public choice school concerning the behavior of bureaucrats and civil servants. Nonetheless, they do not incorporate the essential theoretical arguments Mises had already voiced. Indeed, Hayek points out that even if competition is permitted at all levels, if there is no private ownership of the means of production, it will be necessary to develop or discover an alternative system for confirming that the corresponding managers are acting correctly. Hayek lists and analyzes a series of possible systems that could be devised as alternatives to the private ownership of the means of production. The past successes or failures of future managers are worthless as criteria, since it is not the past that is of interest but the future behavior of the corresponding manager. Furthermore, it is not possible to discern objectively whether a manager is acting foolishly when he appears to be incurring losses, because he may actually be investing properly from a longer-term perspective, with the expectation that in the future those losses will turn into large profits. The establishment of a system of bonuses or monetary incentives in favor of managers would present the same difficulty: the distribution of the bonuses would require prior, objective, and unequivocal knowledge of whether a course of action had succeeded or failed, and this is not possible, given the dispersed and inarticulable quality of the information involved in the process and the uncertain nature of all future events. Moreover, a system of bonuses would only provoke excessively optimistic and reckless behavior if these were not counterbalanced by negative bonuses in the case of losses or errors. However, the establishment of monetary or other penalties depending on the seriousness of the losses entails the risk of making entrepreneurial behavior too conservative. Hayek concludes that there is no alternative system that would make it possible to reproduce or simulate, in a socialist system, the typically competitive behaviors that derive from private ownership of the means of production. None of the above possible solutions, nor any of the related criticisms, penetrates the heart of the problem, which does not arise solely from a lack of the incentives necessary for the system to function just as market processes function in a capitalist system. Indeed, the problem is also one of dispersed, ever-changing knowledge, and it cannot be eradicated, as we have been following Mises to explain. In fact, if production goods are publicly owned and the community, through the central coercion agency, appropriates the corresponding profits, dividends, and interest, it is clear that no individual agent can acquire those same profits, since this would contradict the proposed model of socialism and would mean the reintroduction of the capitalist system and of private ownership of

Austrians versus Market Socialists    101 the means of production. If each economic agent is forcibly prevented from pursuing his own goal or profit, he will not discover the large quantity of practical information crucial to economic calculation and to the coordination of social processes. Moreover, even if the economic agent deceives himself and believes his situation is identical to what it would be in a capitalist society, and even if he believes he has his goal or profit in view (because he does not mind that once he has obtained it, he will have to hand it over to the community, or simply because of chance or any other reason), it is obvious that to pursue that goal and undertake the corresponding course of action, given that by definition he does not possess his own resources, he will have to resort to requesting them from the central planning agency, which represents the community. It will inevitably be this planning agency that will ultimately decide whether or not to provide the corresponding resources, yet, as we know, this agency lacks the vital, practical (and essentially subjective and tacit) information dispersed in the minds of economic agents, and therefore, the state agency will invariably tend to act in an arbitrary, rather than a coordinating, manner. In other words, in the absence of private ownership of production goods (that is, if one is not free to enjoy the profits or fruits of one’s own creativity, to build a capital base, and to draw from it the resources necessary to pursue new actions), a forced dislocation occurs between the individual agents who potentially possess dispersed knowledge (“potentially” because knowledge is not creatively generated when individual agents are prevented from acquiring the profits they earn) and the central planning bureau. Despite any good intentions, this agency will never be able to access the dispersed knowledge that citizens could potentially generate under other circumstances (free enterprise and private property), and it will have no choice but to decide in an arbitrary, and not a coordinating, manner to whom it will supply the resources at its disposal.

The Contribution of Oskar Lange In the scientific life of Oskar Ryszard Lange (1904–1965), it is possible to identify four very distinct stages in terms of his conception of the socialist system. The first stage was characterized by his defense of a socialist model that was very influenced, in general, by the Austrian Marxists and, in particular, by Heimann and Polanyi. In the second stage, Lange developed his classic model, which was firmly rooted in neoclassical welfare theory, in the trial-and-error solution, and in the introduction of decentralized mechanisms of competition in order to find the corresponding equilibrium solutions. The third stage was an ambiguous one in which Lange reached the highest level of liberalism in his proposals, although he never explicitly and satisfactorily reconciled them with his socialist ideal. The fourth and last stage, which began with his entry into the Polish Communist Party and ended with his death, was characterized by a frank withdrawal from his earlier proposals, in the sense that he ended up explicitly praising the theory and practice of the Stalinist system, and he even eventually recanted his competitive

102   Microeconomics solutions and proposed a rigid, Stalinist sort of central planning system in which, given dramatic advances in computer science, he believed no competitive solution was necessary. Because of its importance, we will only consider in detail Lange’s classic model (Lange 1936; 1937).

Lange’s Classic Model Lange’s big dream was that it would be possible to imitate the final state toward which the market process and competitive economics tend but without a capitalist market, that is, without private ownership of the means of production or the free exercise of entrepreneurship. This hope was based on the belief that it would be possible to arrive at a list of parametric prices, which, although not determined in a free market, would nevertheless permit rational economic calculation by incorporating the vital information essential for it and would thus enable society’s different economic agents to act in a coordinated manner. Lange views the neoclassical theory of prices and “perfect competition” as the ideal theoretical foundation for the socialist system, and he begins his proposal with a detailed review of the typical elements of economic equilibrium theory as textbooks usually explain them. According to the neoclassical paradigm, in the model of perfect competition, equilibrium is reached whenever the three following conditions are met: first, subjectively speaking, all individuals who participate in the economic system must achieve their maximum at market prices; second, objectively speaking, the supply and demand for each good and service must be identical at equilibrium prices; and third, the income of all consumers must be equal to the income derived from the services of their productive factors. According to Lange, the first condition, which we have labeled subjective, would be met in the case of consumers by permitting them to maximize their utility in a fully competitive market of consumer goods and services. Nevertheless, producers would no longer be allowed to act to maximize profits, but instead, they would be subject to two rules; the central planning bureau would coercively impose these rules and monitor producers’ compliance with them. The two rules are designed to simulate the results of producers’ maximizing behavior in the market, and thus, they involve replacing the principle of profit maximization with each of the results this principle yields within the perfect competition model. The first rule requires producers to choose the combination of factors that minimizes the average costs of production. The second rule, which also applies to the managers of the different factories, requires them to produce the volume at which marginal costs equal prices. Overall production at the sectoral level would also be determined by the second rule, but instead of the managers of each company, it would be the managers of each sector who would be required to comply and thus to increase or decrease the overall production of each industry accordingly. Therefore, Lange asserts, compliance

Austrians versus Market Socialists    103 with the second rule at the level of each sector would perform the same function that the principle of free entry and exit performs in a competitive market. In Lange’s model, both the prices of consumer goods or services and wages are determined by the market, and the central planning agency sets only the prices of the factors of production. In this sense, all the central planning agency needs to do initially is to establish some prices for the factors of production, and it can choose these prices intuitively or arbitrarily. Company and sector managers, in addition to consumers and workers, make all of their decisions passively; that is, they key them to the above prices and apply the above rules, and in this way, the quantity of each good and service to be demanded and supplied is determined. If, with respect to some production goods, the quantities demanded and supplied do not coincide, the central planning agency has to review and modify the prices by a process of trial and error which comes to a halt at the moment the final equilibrium price is reached, in other words, when supply and demand have been equalized. Hence, the prices the central planning bureau establishes for productive factors are of a merely parametric nature: they determine the passive behavior of economic agents, who must simply adapt to the data, and they objectively generate certain indicators (product surpluses or shortages), which unequivocally lead the central coercion agency to modify prices to the extent and in the direction necessary to achieve equilibrium. In short, the central planning agency takes the place of the market with respect to the allocation of capital goods, and the socialist system can formally reach the equilibrium of the perfect competition model via the same trial-and-error procedure Walras devised for the competitive system, the procedure Taylor (1929) had already proposed as a solution for the socialist system eight years earlier.

Critical Analysis of the Broadest Interpretation of Lange’s Model Lange’s contribution incorporates and combines a series of elements (the trial-and-error method, the setting of prices in terms of marginal costs, instructions from the central planning bureau to managers, etc.), almost all of which, as we have seen, socialist theorists had already proposed, though in an isolated manner. Thus, Lange’s main innovation was simply to have linked them more logically with the neoclassical Walrasian model as the common denominator. All of the comments and critical observations already made could be repeated here concerning the various components of the different solutions to the problem of socialist economic calculation. Nonetheless, it is important to make some critical comments that are particularly significant in light of Lange’s model.

The Impossibility of Assembling the List of Capital Goods How can the central planning agency parametrically set prices for capital goods, the type, number, quantity, quality, and characteristics of which are unknown to the very agents involved in the process of production? A capital good is any intermediate stage

104   Microeconomics in a process of production, as subjectively viewed by the actor involved. In other words, anything the actor deems useful for achieving a goal is a capital good. That is, what constitutes a capital good will be recognizable only to the actor involved in the process, who will discover this information gradually and entrepreneurially, and thus, its subjective, practical, dispersed, and inarticulable nature will render it impossible for the central planning agency to possess. Furthermore, let it not be said that experience—that is, whatever appears to have constituted a capital good in the past—will assist one in assembling the corresponding lists. For the concept of capital good is subjective and also strictly prospective; that is, the actor determines it depending on how he or she believes events will unfold in the future. Hence, the fact that something seems to have worked in the past does not guarantee that it will accomplish the same goal in the future. On the contrary, only those goods that the actor subjectively considers potentially useful, in light of their specific features (their particular level of quality, their availability at a proper time and in a suitable location, etc.), for achieving a certain end or completing a certain project will be capital goods. However, the issue is not simply that the central coercion agency cannot possibly acquire the dispersed, ever-changing information necessary to identify potential and existing capital goods. It is also that this information will not even be effectively discovered, generated, or created, to the extent that ordinary economic agents themselves are unable to freely exercise their entrepreneurship. Indeed, if economic agents cannot act entrepreneurially—that is, if they cannot think up new ends, pursue new profit opportunities, and make the most of them, then profit will not act as an incentive, and consequently, vital practical information about ends and means, information that would emerge in a free market economy, will not even be created (Hayek 1940).

The Complete Arbitrariness of the Time Period for Which Parametric Prices Are Fixed Not only will the parametric prices established and the list of capital goods drawn up be arbitrary, but the time period during which the planning agency considers that prices should remain constant will also be totally arbitrary. This is one of the points on which Lange’s ambiguity is most evident, since in one place, he states that price readjustment will always take place “at the end of the accounting period,” and in another place, he indicates in passing that prices will be readjusted “constantly.” In both cases, the period will be totally arbitrary, because the planning bureau will lack the information entrepreneurs possess in a real free-market economy, information that permits them to modify prices at the juncture and for the period that they consider most appropriate and conducive to the achievement of their ends.

The Lack of a True Market for Labor and Consumer Goods and Services Even though Lange states that a completely free and competitive market would necessarily exist for consumer goods and services, and also for labor, one is left with the impression that this market would only be nominally free and competitive. Indeed, a

Austrians versus Market Socialists    105 truly competitive market for consumer goods and services requires, not only on the side of demand but also on that of supply, the totally unfettered presence of true entrepreneurs or free actors. If coercion crops up on either side, the market ceases to be competitive. Thus, one cannot fathom how the managers of the socialist system—who are not true entrepreneurs, since they cannot freely seek the profit or benefit (defined in subjective terms) they deem most fitting—could generate the information that is constantly created in a capitalist system concerning the continual launching of new consumer goods and services; the improvement of existing goods; changes in quality, in commercial distribution, and in physical location; advertising systems and so on.

The Inanity of the Rules Lange Proposes Lange’s rules of adopting the combination of factors that minimizes average costs and producing the volume at which prices equal marginal costs are impossible to apply. It is clear that if costs are not given but instead are subjectively estimated through constant trial and error in each course of action, then industry managers can hardly be instructed to comply with the above rules, and still less can the central planning bureau objectively monitor such compliance. Lange’s proposal simply reveals that in practice, neoclassical cost theory has failed to incorporate the subjectivist revolution, except in purely rhetorical terms, and in fact continues to be rooted in the old, outdated objectivism of David Ricardo and Alfred Marshall. Therefore, it should not surprise us that James Buchanan (1969) has asserted that the entire controversy surrounding the possibility of economic calculation in socialist economies stems from a lack of understanding on the part of socialist theorists regarding the true, subjective nature of costs. Therefore, it is of very little use to instruct the managers of the corresponding factories and companies to employ that combination of factors for which average costs are lowest. Given the subjective nature of costs, this rule is devoid of content and is tantamount to ordering managers to do the best they can but without allowing them to simultaneously perform those entrepreneurial actions that alone can guarantee the desired result of reducing costs. In fact, in a market economy in which entrepreneurship can be freely exercised, entrepreneurs constantly get new ideas, intuitions, and so on, regarding the creation of new combinations of capital goods and new, cheaper, and more efficient characteristics that can be entrepreneurially tested and, if successful, give rise to the corresponding entrepreneurial profits and the gradual elimination of competitors. If they want to survive, these competitors are forced to introduce the improvements and innovations that have already been discovered and successfully tested. In the system Lange proposes, this entire process is absent: there is no possibility of freely exercising entrepreneurship, and thus, information on procedures for reducing the costs of capital goods is not even generated. Moreover, even if it were generated by accident, it would be irrelevant, since the central planning bureau establishes parametric prices for these goods beforehand, and the only potential solution available to a manager who, by a fluke, had an entrepreneurial idea would be to attempt to convince the central planning authorities that the good in question could be produced more economically and

106   Microeconomics effectively in another way and that its price should be lowered. Naturally, this would be an impossible task, not only because of the difficulties involved in transmitting practical, dispersed, subjective, and inarticulable knowledge but also because, by definition and according to Lange’s model, the central planning agency only reduces prices when it has become clear, a posteriori, that excess production exists but not when a more or less bright or original manager believes it would be better to do things differently in the future. All of these arguments also apply to Lange’s second rule. Recall that the marginal cost rule is pointless, because it is not costs that determine prices but, in any case, prices that determine costs. Therefore, the rule is ambiguous, as is all circular reasoning. Furthermore, one of the most important components of cost is the rate of depreciation on a capital good, so to calculate cost, one must know the future replacement value of the capital good. It would be impossible to obtain this information in the system Lange proposes, since this value would depend on either the arbitrarily chosen parametric price to be established in the future or the future result of the arbitrary process of adjustment based on the trial-and-error method Lange suggests.

The Theoretical Impossibility of the Trial-and-Error Method Lange places so much importance in his model on the application of the trial-and-error method that it must be stressed that the rule of observing the state of inventories or stock to identify any surplus or shortage and to modify prices accordingly is deceptively simplistic, because there is no objective reference point to guide such an observation, nor is it possible to generate or transmit the information that would be necessary to modify prices in the appropriate direction. This criticism can also be applied to all the recent literature on planometrics (Lavoie 1982). In fact, neither a shortage nor a surplus of a product can be objectively discerned by merely consulting certain statistical figures concerning stock. Instead, regardless of the calculation or figure reflected by statistics, a shortage or surplus exists when, depending on the specific circumstances of a case, the actor subjectively judges that one exists. A product surplus may not be such if one subjectively considers a longer time period or expects an increase in demand to occur during that period. Under these circumstances, it would be a grave error for the central planning agency to reduce parametric prices with the idea that doing so would bring them closer to the hypothetical equilibrium prices that would form in the market. Likewise, an apparent shortage may not be such if one anticipates a drop in demand or, even if mistaken, one believes it advisable to cope by focusing on innovation or the use of substitutes, rather than by increasing the price (Huerta de Soto 2010, 206–208). As the concepts of surplus and shortage are purely subjective, they can only emerge within the context of an entrepreneurial action that is freely performed, and they constitute a bit of subjective, practical, dispersed, and inarticulable information that therefore cannot be transmitted to the central planning agency. Furthermore, if managers are unable to exercise their entrepreneurship with complete freedom, the information crucial to rational economic calculation will not even be generated at their level. Hence, the decisions of

Austrians versus Market Socialists    107 the central planning board to raise prices when product shortages are observed and to lower prices when product surpluses are perceived are purely arbitrary and in no way permit rational economic calculation. Moreover, in the equipment or capital-goods sector, Lange’s proposed method is, in many cases, theoretically inapplicable at its root, as is invariably true for the typical equipment good, which is specially contracted for and produced in small quantities, as opposed to a standardized capital good produced on a massive scale.

The Arbitrary Fixing of the Interest Rate It is important to note that the fixing of the interest rate (understood as the price of present goods with respect to future goods, or the ratio between the value given to present consumption and that attached to future consumption) in Lange’s socialist model will be purely arbitrary. Savers or suppliers of present goods will be prevented from making a rational economic decision about the allocation of their resources between present and future consumption, because of both the restricted menu of present goods that the system offers them and the impossibility of having at their future disposal consumer goods and services as plentiful and diverse as those generated by a system in which entrepreneurship can be freely exercised to discover and satisfy an increasing number of needs. Moreover, we are assuming that the central coercion agency does not insist on implementing forced saving policies, as it usually does, to the widespread detriment of current consumers.

Ignorance of the Typical Behavior of Bureaucratic Agencies Finally, Lange’s model cannot work because it does not allow for the real future behavior of the different economic agents, especially of the managers of the nationalized companies and of the bureaucrats in charge of the central planning body, within the institutional framework established in the model itself. With this in mind, we should take into account the following criticism Buchanan leveled against Lange for not having examined one of the most important facets of the problem, that is, how economic agents would behave within the institutional framework he had designed:  By the third decade of this century, economic theory had shifted to a discipline of applied mathematics, not catallaxy. Even markets came to be viewed as “computing devices” and “mechanisms,” that may or may not secure idealized allocative results. Markets were not, at base, viewed as exchange institutions, out of which results emerge from complex exchange interaction. Only in this modern paradigm of economic theory could the total absurdity of the idealized socialist structure of Lange-Lerner have been taken at all seriously, as indeed it was (and, sadly, still is) by practicing economists. We may well ask why economists did not stop to ask the questions about why socialist managers would behave in terms of the idealized rules. Where are the economic eunuchs to be found to operate the system? (Buchanan 1986, 25).

See also Kornai’s (1986) keen observations on the issue.

108   Microeconomics

Other Market Socialism Theorists Generally speaking, Lange’s proposals are the most commonly cited and considered by the secondary sources that, thus far nearly always in a biased, erroneous manner, have described and commented on the controversy over socialist economic calculation. At the same time, the other market socialism theorists very often simply repeat Lange’s original arguments, though they modify the details slightly. From this group, we will consider Durbin, Dickinson, and Lerner in some depth.

Evan Durbin Evan Frank Mottram Durbin’s contribution appears mainly in the 1936 article “Economic Calculus in a Planned Economy.” Durbin claims to be “almost certain” that the problem of economic calculation in a socialist economy could be resolved if the central planning board were to order the different production units to act in accordance with two rules: first, to calculate the marginal productivity of all movable factors of production, and second, to allocate productive factors for those uses for which marginal productivity is highest. Companies would be instructed to produce the highest volume compatible with “normal” profits (“average cost rule”). To minimize the possibilities of error involved in calculations of marginal productivity, Durbin deems it necessary to calculate the corresponding demand curves. Furthermore, he maintains that the interest rate should be established by the “free” new capital market, yet at no point does he clarify how such a market would function in a system in which private ownership of the means of production is prohibited. Finally, Durbin believes the economy should be organized in terms of large sectors, trusts, or monopolies, which would be ordered to compete with one another. We have already offered arguments concerning the proposal of competitive trusts (originally defended by Heimann and Polanyi) and the possibilities of organizing a true capital market, based on the services of a monopolistic state bank, where there is no private ownership of the means of production. Durbin’s proposal contains exactly the same error Lange and others had committed before: the presumption of a context of equilibrium in which no changes occur and all information necessary to calculate the marginal productivity of productive factors is given and easily attainable. In fact, in a competitive market, there are no supply, demand, or other sorts of curves or functions. The information necessary to draw or describe them does not exist, and therefore, it is not available anywhere (not to a company or industry manager, much less to a scientist or central planning agency), not only because the information that would make up the demand curve is dispersed but also because this information is not even forming constantly in the minds of the individual participants in the market. In other words, supply and demand curves can never be discovered in the market, simply because they do not exist. At most, they have a merely heuristic or interpretative value

Austrians versus Market Socialists    109 within economics, and any person, whether an expert in economics or not, who, almost without realizing it, begins to think of such functions or curves as real will commit serious errors. This is because information about the quantities that will be bought or sold at each price is not abstractly considered by each economic agent, nor is it stored in each person’s memory for all future circumstances. On the contrary, such information is strictly subjective and dispersed and only emerges at the specific moment an economic agent decides to make a purchase or a sale, as a result of the entrepreneurial process itself, along with numerous particular influences and circumstances that the agent involved in the transaction subjectively perceives. Hence, this information is created ex novo at that moment; it did not exist before, and it will never be replicated. Therefore, at most, entrepreneurs in a real market economy try to estimate what could be viewed as certain isolated points along hypothetical future supply and demand curves. Still, this approach is not necessary for the formulation of price theory, nor do we find it appropriate, since it could somehow imply a recognition that such curves or functions exist or could exist in the future.

Henry Dickinson The role that, according to Henry Douglas Dickinson, both “uncertainty” and “the entrepreneurial function” would necessarily play in a socialist system is very original. In fact, Dickinson believes that one of the advantages of the socialist system would be to reduce the uncertainty that typically emerges in the capitalist system as a result of the interaction between many separate decision-making entities. This supposed reduction in uncertainty would be achieved through the intervention of the central planning agency, which, by imposing a series of conscious, direct production ratios via commands, would necessarily reduce the high levels of uncertainty normally present in the market. Dickinson refers to the “glass walls” metaphor, which would be represented in a socialist system, as opposed to the typical behavior of companies in a capitalist system, which he asserts is characterized by excessive “secrecy” and a lack of “information transparency” (Dickinson 1939). In making these assertions, it is clear that Dickinson implicitly considers the central planning bureau capable of accessing information that would permit it to coordinate society from above and thus to reduce the degree of uncertainty and the errors entrepreneurs normally commit. However, Dickinson never explains how this would be possible, especially in light of the fact that the information the planning agency needs to lessen uncertainty is not generated from above but from below, at the level of the economic agents themselves. Also, as we know, such information is subjective, practical, dispersed, and inarticulable, and therefore, it cannot possibly be transmitted to a central planning body, or even created, in the absence of complete freedom for the exercise of entrepreneurship. Furthermore, when Dickinson advocates total “information transparency” and the publicizing of all the “commercial secrets” that are guarded in the capitalist system, he is implicitly assuming that the information is objective

110   Microeconomics and that once all the data and “secrets” of the different economic agents were spread throughout the social framework, the level of uncertainty would drop significantly. However, we must consider that any economic agent can literally flood his competitors or colleagues with all the information concerning his plans without necessarily reducing the level of uncertainty. This is because it is only possible to flood others with information that can be articulated or transmitted in a formalized manner. Moreover, the data must be interpreted; all interpretations are subjective; and in countless situations, the economic agents and their competitors may not subjectively interpret the same data in exactly the same way, and thus, the data could not take on the same subjective meaning conveyed to the entrepreneur who originally issued the information. The limit could conceivably lie in a set of circumstances in which the entrepreneur would not only transmit the information but also indicate how, in his subjective opinion, future events would unfold and what the best course of action would be. If economic agents decided to follow the intuitions of the issuer, they would simply be giving up the opportunity to interpret the data themselves and thus to personally exercise their entrepreneurship, and they would be limiting themselves to merely following the entrepreneurial leadership of another. The socialist system can only eliminate uncertainty via the ostrich method; that is, people must bury their heads in the sand and refuse to see uncertainty or recognize that it is not a problem but a social reality that is inherent in human nature and that man constantly faces through the exercise of his entrepreneurship.

Abba Lerner According to Abba Ptachya Lerner, it is not so important to find a practical rule as to directly pursue the final objective of the socialist system, which can only be done by ensuring that no factor or resource is used to produce a good or service while the production of others more highly valued is neglected (Lerner 1936, 74). The only way to ensure this is to order managers to make prices equal to marginal costs in all cases (MC = P), a principle that, although it coincides with Lange’s second rule, must be followed exclusively and without the obsession Lerner believes Lange had with simulating the functioning of a competitive market. According to Lerner, it is unnecessary to insist, as Durbin does, that managers obtain normal profits, since such profits are simply a sign of static equilibrium, and what the socialist system really needs is a guide for the allocation of productive resources in a dynamic world. Therefore, we see that Lerner’s dynamic analysis is limited to an attempt to find a rule applicable, in his opinion, to all of the circumstances that arise on a daily basis in a socialist economy. Paradoxically, Lerner’s solution is as static as those proposed by Lange, Durbin, and Dickinson, and we could repeat here all of the detailed criticism expressed earlier concerning the rule of establishing prices based on marginal costs. At this point, it is enough to repeat that marginal costs are not objective in the sense that they are given and can be unequivocally observed by a third party. On the contrary, they are a typical example of entrepreneurial

Austrians versus Market Socialists    111 information, that is, information gradually generated in a subjective, dispersed, tacit, practical, and inarticulable manner in the minds of those who freely exercise their human action or entrepreneurship, and therefore, it cannot be supposed that information about costs is created or discovered by managers who cannot freely exercise their entrepreneurship, because of the elimination of private ownership of the means of production. It is even more absurd to assume that such information can be transmitted to the central planning body and that this body is somehow capable of monitoring the compliance of the different industry mangers with the rule (MC = P). Furthermore, curiously, Lerner himself realizes that the relevant prices that must be taken into account in his rule (MC = P) are not present prices (which have already emerged in the market, even in the recent past) but future prices as economic agents foresee them (expected future prices). Therefore, Lerner’s fundamental rule must be established in such a way that each manager equates prices to marginal costs according to his own expectations. Nonetheless, not only is it impossible for these expectations to arise if managers cannot freely exercise their entrepreneurship (because of the absence of private ownership of the means of production), but it is also theoretically impossible for a bureaucratic inspector and member of the central planning bureau to objectively monitor whether the rule is being followed (that is, whether each manager is acting correctly in accordance with his own expectations). Lerner intuits an idea that is basically correct, but he fails to realize that it demolishes his entire proposal and reduces it to nonsense.

The Impossible Squaring of the Circle In view of our analysis of the proposals of Lange and the rest of the market socialists of his school, we can conclude that theoretically and practically, only two alternatives exist: either people enjoy complete freedom to exercise entrepreneurship (in a context in which private ownership of the means of production is recognized and defended, and there are no restrictions beyond the minimum of traditional rules of criminal and private law necessary to avoid both the asystematic assault on human action and breaches of contract), or there is systematic, widespread coercion of entrepreneurship in more or less broad areas of the market and society and, specifically, private ownership of the means of production is prevented. In the latter case, it is impossible to freely exercise entrepreneurship in the affected social areas, particularly that of the means of production, and the inexorable result is that the rational economic calculation described here in detail becomes unachievable in any of them. The second type of system renders impossible both social coordination and economic calculation, both of which can only take place in a system of complete freedom for the exercise of human action. What market socialists have attempted, with phantasmagorical results, is to formulate a theoretical synthesis in which a socialist system is established (one characterized by systematic aggression against human action and by public ownership of the means of production),

112   Microeconomics yet the existence of a market is maintained. For ideological, romantic, ethical, or political reasons, they stubbornly refuse to abandon socialism, and because Mises’s and Hayek’s criticisms have made a strong impact on them, they seek to reintroduce the market into their models, in the vain hope of attaining the best of both worlds and of making their ideal more popular and attractive. We have devoted considerable space here to studying the classic contributions market socialists made during the first half of the twentieth century, for, despite appearances and the claims of their authors, later contributions add little or nothing new to the debate. For instance, this is true of the proposals of John Roemer and others; they merely offer a potpourri of ideas market socialists have developed, beginning with the contributions of Heimann and Polanyi in German in the 1920s (Roemer 1994). Scott Arnold, Michael Wohlgemuth, and others have extensively refuted Roemer’s arguments and revealed their lack of originality (Arnold 1994; Wohlgemuth 1997). Something very similar is happening with respect to the Hayekian version of self-management socialism, which is intended to abolish the employment contract and was formulated by Theodore A. Burczak in his work Socialism after Hayek (2006). The ambiguities and difficulties of coordination involved were analyzed in a recent symposium organized by the Review of Austrian Economics (22, no. 3, September 2009, 281–300). What socialists do not wish to understand is that the mere, violent restriction of free human action in any social area, especially that of the factors or means of production, is enough to keep the market, which is the social institution par excellence, from functioning in a coordinated manner and from generating the practical information necessary for economic calculation. In short, market socialists fail to comprehend that systematic violence cannot be employed with impunity against the very essence of our humanness: our capacity to act freely in any particular set of circumstances, at any time and in any place. At least, many former market socialists have not comprehended this until recently. For example, Wlodzimierz Brus and Kazimierz Laski (who have described themselves as “ex-naive reformers” and who for many years defended market socialism), (Brus and Laski 1989), have ended up endorsing these words written by Mises:  What these neosocialists suggest is really paradoxical. They want to abolish private control of the means of production, market exchange, market prices and competition. But at the same time they want to organize the socialist utopia in such a way that people could act as if these things were still present. They want people to play market as children play war, railroad, or school. They do not comprehend how such childish play differs from the real thing it tries to imitate. … A socialist system with a market and market prices is as self-contradictory as is the notion of a triangular square. (Mises 1966, 705–710).

More recently, following Mises’s example, de Jasay has even more graphically concluded that market socialism is “an open contradiction in terms, much like hot snow, wanton virgin, fat skeleton, round square” (de Jasay 1990, 35).

Austrians versus Market Socialists    113

References Arnold, N. Scott. 1994. The Philosophy and Economics of Market Socialism: A Critical Study. New York: Oxford University Press. Brus, W., and K. Laski. 1989. From Marx to the Market: Socialism in Search of an Economic System. Oxford: Clarendon Press. Buchanan, J. M. 1969. Cost and Choice. Chicago: Markham. Buchanan, J. M. 1986. “The Public Choice Perspective.” In Liberty, Market and State. Sussex, UK: Harvester Press. Burczak, T. A. 2006. Socialism after Hayek. Ann Arbor: University of Michigan Press. De Jasay, A. 1990. Market Socialism:  A  Scrutiny. This Square Circle. London:  Institute of Economic Affairs. Dickinson, H. D. 1939. Economics of Socialism. Oxford: Oxford University Press. Durbin, E. F. M. 1936. “Economic Calculus in a Planned Economy.” Economic Journal 46, no. 184 (December): 676–690. Hayek, F.  A. 1935. “The Present State of the Debate.” In Collectivist Economic Planning. London: Routledge. Hayek, F. A. 1940. “Socialist Calculation : The Competitive ‘Solution.’ ” Economica 7, no. 26 (May): 125–149. Heimann, E. 1922. Mehrwert und Gemeinwirtschaft: Kritische und positive Beiträge zur Theorie des Sozialismus. Berlin: Robert Engelmann. Hoppe, H. H. 1989. A Theory of Socialism and Capitalism. Amsterdam and London: Kluwer Academic. Huerta de Soto, J. 2010. Socialism, Economic Calculation and Entrepreneurship. Cheltenham, UK, and Northampton, MA: Edward Elgar. Kirzner, I. M. 1973. Competition and Entrepreneurship. Chicago: University of Chicago Press. Kornai, J. 1986. “The Hungarian Reform Process.” Journal of Economic Literature 24, no. 4 (December): 1687–1737. Lange, O. 1936. “On the Economic Theory of Socialism: Part I.” Review of Economic Studies 4, no. 1 (October): 53–71. Lange, O. 1937. “On the Economic Theory of Socialism: Part II.” Review of Economic Studies 4, no. 2 (February): 123–142. Lange, O. 1987. “The Economic Operation of a Socialist Society: I and II.” Contributions to Political Economy 6: 7–13. Lavoie, D. 1982. The Market as a Procedure for Discovery and Conveyance of Inarticulate Knowledge. Working Paper, Department of Economics, George Mason University, Fairfax, VA. Le Grand, J., and Estrin, S., eds. 1989. Market Socialism. Oxford: Clarendon Press. Lerner, A.  P. 1937. “A Note on Socialist Economics.” Review of Economic Studies 4 (October): 72–76. Mises, L.  von. (1920) 1963. “Economic Calculation in the Socialist Commonwealth In Collectivist Economic Planning, edited by F. A. Hayek, translated by S. Adler, 87–130. London: Routledge. Mises, L. von. (1922) 1981. Socialism: An Economic and Sociological Analysis, 3rd ed., translated by J. Kahane. Indianapolis: Liberty Press. Mises, L. von. 1924. “Neue Beiträge zum Problem der sozialistischen Wirtschaftsrechnung.” Archiv für Sozialwissenschaft und Sozialpolitik 51: 488–500.

114   Microeconomics Mises, L. von. 1966. Human Action: A Treatise on Economics, 3rd rev. ed. Chicago: Henry Regnery. Polanyi, K. 1922. “Sozialistische Rechnungslegung.” Archiv für Sozialwissenschaft und Sozialpolitik 49: 377–420. Polanyi, M. 1959. The Study of Man. Chicago: University of Chicago Press. Roemer, J. E. 1994. A Future for Socialism. Cambridge, MA: Harvard University Press. Roper, W.  C. 1931. The Problem of Pricing in a Socialist State. Cambridge, MA:  Harvard University Press. Taylor, F.  M. 1929. “The Guidance of Production in a Socialist State.” American Economic Review 19, no. 1 (March): 1–8. Wohlgemuth, M. 1997. “Has John Roemer Resurrected Market Socialism?” Independent Review 2, no. 2 (Autumn): 201–224.

Chapter 6

Sp ontaneous  Orde r Daniel J. D’Amico

Introduction: What Is and What Is Not a Spontaneous Order? Merriam-Webster’s dictionary defines the word spontaneous as, “1. proceeding from natural feeling or native tendency without external constraint, 2. arising from a momentary impulse, 3. controlled and directed internally, 4. produced without being planted or without human labor, 5. developing or occurring without apparent external influence, force, cause, or treatment and 6. not apparently contrived or manipulated.” Dictionary definitions and/or encyclopedic treatments of the fuller term spontaneous order are more rare, as it is a more complicated and nuanced idea. It is also less widely used in common parlance beyond the professional fields of social science and economics. One well-researched and thorough survey,1 “The Tradition of Spontaneous Order,” by political philosopher Norman Barry (1982), alludes to the apparent tension between formal definitions, on the one hand, and the more detailed meanings implied throughout the history of thought behind the longer terminology, on the other: The simplest way of expressing the major thesis of the theory of spontaneous order is to say that it is concerned with those regularities in society, or orders of events, which are neither (1) the product of deliberate human contrivance (such as a statutory code of law or a dirigiste economic plan) nor (2) akin to purely natural phenomena (such as the weather, which exists quite independently of human intervention). While the words conventional and natural refer, respectively, to these two regularities, the “third realm,” that of social regularities, consists of those institutions and practices which are the result of human action but not the result of some specific human intention. (7–8)2 1 

See also Hamowy (1987). Barry (1982, n. 2) cites Hayek (1967) and Ullman-Margalit (1978) as additional high-quality survey sources on the history of thought surrounding spontaneous order theory. See also Barry (2008). 2 

116   Microeconomics Nobel laureate and Austrian economist F. A. Hayek is most often credited with coining the particular phrasing spontaneous order, because much of his research program was focused on elaborating and applying the idea.3 Drawing from Hungarian philosopher Michael Polanyi’s idea of “polycentric order” (1951), Hayek’s earliest usage of the fuller terminology is found amid his legal and political theories elaborated within The Constitution of Liberty (1960). He writes: “When order is achieved among human beings by allowing them to interact with each other on their own initiative—subject only to the laws which uniformly apply to all of them—we have a system of spontaneous order in society” (160). Here Hayek is not offering a full operational definition per se, but the essence of the meaning of the term is fully intact, namely, that the functional and desirable aspects of the systemwide patterns governing different individuals cannot be attributed back to the preferences, interests, or intentions of any of those particular individuals. The functional and orderly qualities of society develop and persist spontaneously and distinctively from any of the interests that so happen to constitute it. In later work,4 Hayek (1973) gives a more detailed exposition and definition of the concept. First, he defines order more generally: “a state of affairs in which a multiplicity of elements of various kinds are so related to each other that we may learn from our acquaintance with some spatial or temporal part of the whole to form correct expectations concerning the rest, or at least expectations which have a good chance of proving correct” (36). He goes on to differentiate “made” or “designed orders,” which he terms taxis, in contrast to cosmos, “unplanned” and or “grown” orders: [A]‌spontaneous order or kosmos . . . [i]ts degree of complexity is not limited to what a human mind can master. Its existence need not manifest itself to our senses but may be based on purely abstract relations which we can only mentally reconstruct. And not having been made it cannot legitimately be said to have a particular purpose, although our awareness of its existence may be extremely important for our successful pursuit of a great variety of different purposes. (38)

Herein Hayek reemphasizes the defining features of spontaneous orders. The patterned nature of the order, in a way, helps the various actors within the system better fulfill their separate goals, because it offers them some reliable predictability from which to inform their plans. Though beneficial and, for some, even aesthetically preferable (Klein and Osborn 2009), this orderliness was not historically intended or designed by any of the individual actors that nonetheless constitute and contribute to it. Furthermore, no individual could have possibly designed the orderly outcome, neither within the system nor apart from the system. First, this is because the nature of the knowledge required to successfully navigate and comprehend even partial facets of the system requires a 3 

Boettke (1990), Petsoulas (2001), and Hunt and McNamara (2007) trace the inspirations, development, applications, and criticisms of spontaneous order throughout Hayek’s work and beyond. 4  Jacobs (1997, n. 7) comments on Hayek’s stated motivations for drafting his later work Law, Legislation and Liberty; he sought to complete and correct the substantive content of his earlier expositions because he saw them as inadequate.

Spontaneous Order   117 direct participation within the system, which is often referred to as tacit5 and/or local6 knowledge (Hayek 1945). Second, the system’s degree of complexity simply surpasses that which any individual mind could feasibly foresee. Jacobs (1997; 1999; 2000) suggests that Polanyi’s (1941; 1951) use and understanding of the term spontaneous preceded and arguably inspired Hayek’s, although Polanyi’s influential role in the coinage or resurgence of spontaneous order theory is less appreciated.7 Jacobs (1997, 18) notes that Polanyi (1951) first makes explicit use of the full phrasing spontaneous order and highlighted the phenomenon’s operation throughout a variety of social contexts prior to Hayek’s (1960) use and later definitional treatments. Bladel (2005, 23) counters Jacobs and emphasizes theoretical differences between Polanyi and Hayek. He notes that Ropke (1937, 4–5), a colleague of Hayek’s, described the market economy explicitly as a spontaneous order even before Polanyi’s use. Much of Jacobs’s case rests on Polanyi’s uses of spontaneous apart from the fuller phrase spontaneous order, and his apparent appreciation for the fuller meaning of the theory prior to the explicit coinage of the complete phrase.8 Such a case can also be made for Hayek’s understanding and use because his prior economic writings (1936; 1945; 1949a) arguably convey a full understanding of the concept despite lacking the explicit terminological label.9 Such is similarly the case throughout the intellectual history of spontaneous order theory more generally. Various thinkers, working on different subject matters, in different contexts, nonetheless identified and attempted to explain the origins and operational features of social orderings as unplanned and inherently complex phenomena.10

5  Polanyi (1958) first discusses and explains the relevance of tacit knowledge in social processes; see Polanyi (1966). Lam (2000) and Collins (2010) are recent contributions explaining the role of tacit knowledge in the production and maintenance of effective social institutions. On the meaning and significance of tacit knowledge in Hayek’s work, see Oguz (2010). 6  Local knowledge is most often highlighted as a tool of effective managerial decision-making. Lavoie (1985) first coined the term knowledge problem when referring to national economic decision-making lacking tacit knowledge garnered through local-level perspectives and experiences. Ostrom (1990) and Ostrom (2007) similarly emphasize knowledge problems endemic to centralized management schemes. 7  Polanyi applied spontaneous and cognates to one of these modes, writing variously of “spontaneous ordering,” “spontaneously arising order,” “spontaneously attained order,” and “spontaneous mutual adjustment” (1941, 432, 435). In this particular essay, however, he never used “spontaneous order” as such, preferring “dynamic order,” “dynamic system,” and “dynamic forms of organization” (435). Polanyi represented “dynamic order” as grounded on freedom and spontaneously emerging from mutual adjustment of free actions (Jacobs 1997, 15). 8  Polanyi (1962; 1975) explicitly used the full term spontaneous order (Jacobs 1997, n. 6). Gray (1986) and Cronk (1988) describe Polanyi’s treatment of spontaneous orders confined to the process of science. Jacobs (1997, n. 11) disagrees. Hayek biographer Caldwell (2004, 294) remains agnostic on the debate surrounding first use of the term. 9  Jacobs (1997, 1, nn. 1–3) cites Ross (1987), who traces Hayek’s use of the term spontaneous throughout his early economic writings (Hayek 1936; 1945; 1949a). Barry (1982; 2008) also attributes the coinage to Hayek. Jacobs (1997, 1, n. 4) cites Roche (1976), O’Brien (1994), Letwin (1977), Moldofsky (1989), and Cubeddu (1993) as also attributing the term’s origin to Hayek. 10  Barry (2008, 485) notes that similar ideas of self-organization can be found in the writings of ancient Chinese philosopher Chuang Tzu and sixteenth-century Jesuit priests from the school of Salamanca. See also Smith (2006).

118   Microeconomics Regardless of the term’s specific historical origins, three things are commonly and rightly agreed on about the intellectual history of spontaneous order theory. First, the substantive theoretical concepts implied by the term are now relatively well defined and better understood than in previous decades. Namely, the functional features of society are as such not because of the planned intentions of particular individuals, authoritative decision makers, or any individual designers’ intentions. Rather, most social outcomes, particularly functional and orderly processes, are more often and better understood as the unplanned by-products of decentralized human interactions. The definition of spontaneous orders is often well captured by the succinct but accurate description of social institutions being “the result of human actions but not necessarily the product of any particular human design.”11 Second, spontaneous order theory traces its origins throughout a long and rich intellectual tradition. Most notably, the first renditions of spontaneous order theory were forged amid the Scottish Enlightenment, the intellectual tradition surrounding the political philosophy of liberalism, and the classical school of economics.12 Last, in the wake of Hayek’s research and professional success, scientific interest and appreciation for spontaneous order theory have revived and multiplied. These latter points of agreement are not coincidental. It is not surprising that the historical context of the Scottish Enlightenment happened to be the spawning ground of spontaneous order theory. Nor is it serendipitous that the discipline of economic science and the particular methodological tradition surrounding Hayek, the Austrian school of economics, has been most responsible for harboring the greatest appreciation for spontaneous order theory. Contemporary Austrian scholars continually perform applied research to expand the relevant cases of observed spontaneous orders. This will be more fully explained throughout this chapter. With renewed attention to spontaneous order theory have also come new debates, disagreement, and occasional obfuscation. Some are made explicitly uncomfortable by the common use of the term spontaneous order. While it well differentiates from intentionally designed social systems such as clubs (Buchanan 1965) or formal business firms (Coase 1937), anxiety remains concerning the connotations of randomness that the term spontaneous seems to imply, as if the functional features of a spontaneous order occur through sheer luck or by happenstance. Again, refer to the definitions from Merriam-Webster’s: “arising from a momentary impulse … developing or occurring without apparent … cause.” Similar implications admittedly occur throughout the term’s historic usage. For one example, the fuller quotation of Ferguson’s earliest description reads: “Every step and every movement of the multitude, even in what are termed enlightened ages, are made with equal blindness to the future; and nations stumble upon

11  Hayek (1967) adopted Enlightenment era political philosopher Adam Ferguson’s ([1767] 2001, 119) original description of social processes in this way by titling one of his own essays “The Results of Human Action but Not of Human Design.” 12  Hayek (1967), Ullman-Margalit (1978), Barry (1982; 2008), Hamowy (1987), Otteson (2008), Petsoulas (2001), and Smith (2006) trace spontaneous order theory throughout the Scottish Enlightenment and especially in the works of Adam Smith.

Spontaneous Order   119 establishments, which are indeed the result of human action, but not the execution of any human design” ([1767] 2001, 119; emphasis added). It is not unreasonable for writers and thinkers to be dissatisfied with these connotations, just as describing evolutionary processes as random or chaotic is a disservice and obfuscation to the procedural realities of natural selection, adaptation, and genetic mutation that occur within biological and other natural processes. For some writers, the term emergent order is sometimes synonymously and at other times preferably used for spontaneous order.13 Within its definition of emergence, Merriam-Webster’s reprints material from the concise encyclopedia Britannica: In the theory of evolution, the rise of a system that cannot be predicted or explained from antecedent conditions. The British philosopher of science G.  H. Lewes (1817–78) distinguished between resultants and emergents—phenomena that are predictable from their constituent parts (e.g., a physical mixture of sand and talcum powder) and those that are not (e.g., a chemical compound such as salt, which looks nothing like sodium or chlorine). The evolutionary account of life is a continuous history marked by stages at which fundamentally new forms have appeared. Each new mode of life, though grounded in the conditions of the previous stage, is intelligible only in terms of its own ordering principle. These are thus cases of emergence. In the philosophy of mind, the primary candidates for the status of emergent properties are mental states and events.

An emergent phenomenon is the result of some complex causal procedure, meaning that the outcome of said process cannot be inferred as a simple summation of its constituent parts. Hence, emergence successfully refers to the unplanned but structurally patterned characteristics of complex processes, and the term does so perhaps without invoking connotations of serendipity or randomness, as the word spontaneous inappropriately does. It is therefore not surprising that some writers opt to use emergent over spontaneous, although such equivocation, especially regarding the topic of specifically human-social processes, has significant analytical consequences. 13 

In the plenary essay of the aptly titled journal Studies in Emergent Order, DiZerega (2008) writes, “Hayek encapsulated the process he described by his term ‘spontaneous order.’ Today other terms describing the same basic dynamics are in more common use, particularly ‘complex adaptive systems’ and ‘emergent orders’ ” (1; emphasis added). The paper proceeds to use the terms interchangeably, as do most authors in the journal. Martin and Storr (2008) initially use the terms interchangeably but resolve upon emergent over spontaneous. Lewis (2011, 171) cites Wagner (2010) as falsely conflating spontaneous and emergent orders and neglecting to offer definitions. Wagner (2011) concedes this point. The term stigmergy (Grasse 1982–1986; Beckers et al. 1994; Bonabeau 1999; Elliott 2006; Heylighen 2007; Marsh and Onof 2007; Christensen 2007 and 2008) has been coined to refer to features of certain logistical traits of some social species and computer software platforms that allow various users to simultaneously but separately contribute to products and outcomes distinctively more functional and complex than any of the individuals’ particular actions. Ants secrete pheromones assisting them to follow one another’s trail to and from food sources. Similarly, open-source software platforms such as Wikipedia provide a logistical medium particularly convenient for complex collaboration among dispersed individuals and groups without conscious or concerted collective action or agreement.

120   Microeconomics First, spontaneous orders are not the inevitable result of chaotic or random processes. Active substitution away from the term spontaneous in favor of emergence in part promotes this confusion. Second, passive and or inadvertent equivocation blurs a more nuanced and accurate distinction between these two concepts. The intellectual tradition of spontaneous order theory possesses a unique connotation that is not necessarily endemic in today’s parlance surrounding the use of the term emergence within the dedicated fields of study on complexity, agent-based modeling, self-organizing processes, or stigmergy.14 Conflating terms without attention to the distinct facets of those processes that are rightly and uniquely spontaneous orders risks modeling such complex human social phenomena inaccurately. Finally, the distinctive use of spontaneous puts unique emphasis on the human features of spontaneous orders relative to how the term emergence is more broadly used. Following Hayek’s (1973) defining descriptions of spontaneous relative to planned orders, he writes: Most important, however, is the relation of a spontaneous order to the conception of purpose. Since such an order has not been created by an outside agency, the order as such also can have no purpose, although its existence may be very serviceable to the individuals which move within such order. But in a different sense it may well be said that the order rests on purposive action of its elements, when “purpose” would, of course, mean nothing more than that their actions tend to secure the preservation or restoration of that order. The use of “purposive” in this sense as a sort of “teleological shorthand,” as it has been called by biologists, is unobjectionable so long as we do not imply an awareness of purpose of the part of the elements, but mean merely that the elements have acquired regularities of conduct conducive to the maintenance of the order—presumable because those who did act in certain ways had within the resulting order a better chance of survival than those who did not. In general, however, it is preferable to avoid in this connection the term “purpose” and to speak instead of “function.” (39)15

In short, the harmonization processes that occur amid interacting human agents are distinct from those that occur between other types of agents, specifically because of the greater range of subjective purposes sought by humans relative to nonhuman actors. Again, spontaneous orders are identified by the distinction between the intentions of

14 

DiZerega (2008) explains that various research fields attuned to emergent orders, such as self-organizing systems and agent-based modeling, have arisen independently of the Smith-Hayek tradition. Key examples of these parallel research streams include, but are not necessarily limited to, Ross (1947) and Holland (1992). See also Harper and Lewis (2012) and the various research surveyed therein. See also the comments and citations on stigmergy in note 13 above. 15  In reflecting on Barry’s survey, Buchanan (1982) affirms the a-purposivity of complex social processes. “[T]‌he ‘order’ of the market emerges only from the process of voluntary exchanges among the participating individuals. The ‘order’ is, itself, defined as the outcome of the process that generates it. The ‘it,’ the allocation-distribution result, does not, and cannot, exist independently of the trading process. Absent this process, there is and can be no ‘order’ ” (7).

Spontaneous Order   121 the agents within the system and the seemingly functional but unintentional aspects of the system writ large. In the course of acting to pursue personal interests, individuals contribute to a general condition of social order. While the general conditions of the social order complement various individual interests, such functionality occurs irrespective of those interests. This gap of intentionality is precisely the reference point of the spontaneous terminology. Such interactive purposivity cannot be said to occur amid nonhuman orders.16 Insofar as emergence can also refer to complex outcomes of nonhuman processes, equating spontaneous orders with emergence diminishes the focused need for unique methodological considerations when investigating human social phenomena relative to other natural-science subject matters. Natural sciences afford a larger and more appropriate role of mathematical formalism and precise statistical forecasting. Such techniques are more prone to error and misspecification when applied to human social processes, because the potential diversity and conflict of subjective intentions is exponentially greater.17 When spontaneous human social orders are treated as if they are no different from nonhuman emergent orders, through applied public policies or strategic initiatives for social change, significant unintended consequences may ensue and are in many ways inevitable. Hayek ([1941] 1980) argues so boldly as to suggest that the historic course of real contemporary social problems in the twentieth century were largely the result of methodological failures within the professional social sciences to account for the operational features of human society as they accord to spontaneous order theory.18 It is most appropriate for a handbook on Austrian economics to include a chapter dedicated to spontaneous order, as the theory has played both a significant and an essential role throughout the school’s intellectual history. One should also recognize inversely, that were it a dedicated volume to the theory of spontaneous orders, there would need to be a dedicated chapter, or several, on the Austrian tradition because of its emphasis on the methodological challenges inherent in the investigation of human actions and complex social processes.19 Once the idea of spontaneous social orders had been recognized and somewhat fleshed out, society could be better seen to conform to some degree of orderly pattern, wherein a variety of systematic relationships could be seen to hold and therefore could also be scientifically investigated and objectively understood. This is to say that spontaneous order theory was groundbreaking in that it provided a method to 16  Hamowy (1987, 40) summarizes Merton (1936) and Forbes (1954) as similarly conflating spontaneous orders with the law of unintended consequences. Schneider (1967) recognizes the similarity of spontaneous orders as exemplary of unintentionality but highlights their uniquely social functionality and coordinative effects as essential to spontaneity’s meaning. 17  Hayek (1967, 25, n. 8) surveys Nagel (1961), von Neumann (1951), and von Bertalanffy (1952), estimating the degree of complexity found in interactive biological processes relative to basic physionatural operations to be many degrees of magnitude larger. In addition to a substantive difference of type, Hayek explains that social processes still also possess exponentially larger degrees of complexity. 18  See also Boettke (1997), Mirowski (2002), and Beinhocker (2007), who trace the practical consequences of methodological failures in professional economics. Huemer (2012) infers such social complexity to support passivity over activist preferences and strategies for social change. 19  See Menger ([1883] 1985) and Mises ([1933] 1978) as classic examples.

122   Microeconomics investigate human behaviors and social processes through objective science in a way that was untenable before then. One could argue that with spontaneous order theory, the Scottish Enlightenment in effect invented social science as a positive research program. This chapter is a defense and explicit support for the terminology of spontaneous order, properly understood. Although it is not a rejection of the term emergence in all of its own uses. In other words, emergent and spontaneous have similar meanings, but they are differentiable. They are neither totally exclusive nor oppositional ideas. They have unique definitions with overlapping applications, but they still have separable and nonsynonymous meanings. Simply put, “emergence refers to a broader domain of phenomena than does spontaneous” (Wagner 2011, 217). In this vein, all spontaneous orders possess emergent qualities, but not all emergent processes are necessarily spontaneous orders. Figure 6.1 portrays a simplistic Venn diagram to visualize this distinction. A subset area representing distinctive spontaneous orders is nested fully within a larger set of emergent orders. Spontaneous orders possess a unique feature relative to nonspontaneous emergent orders, namely, the presence of multiple and likely conflicting human intentions that are shaped subjectively by the unique preferences and choices of individuals. Spontaneous orders proceed in ways that promote and contribute to human social coordination and cooperation. The institutions that develop as a consequence of and facilitator to human coordination and cooperation require unique methodological considerations to understand their developmental and operational processes relative to the coordination mechanisms that occur in nonhuman emergent orders. How do social scientists retain positivity while describing and analyzing the behaviors of agents and groups who possess normative preferences? The next section specifies the definitional differences between emergent and spontaneous orders by offering a conceptual framework to distinguish between the scientific nature of the agent types of an orderly system and the degree of complexity derived from those agents’ interactive behaviors. Examples are offered for each category. The

Humane Social Orders

Organizations (Taxis)

Spontaneous Orders (Cosmos)

Non-human Biological, Physical, or Chemical Orders

Non-human Social Orders Emergent Orders

Figure 6.1  Spontaneous relative to emergent orders.

Spontaneous Order   123 necessary features for each type of social order to prove sustainable are identified. The presence of purposeful human intention contributes to the development of distinctive institutions in the human social realm unparalleled in complexity and coordinative potential by any other subject matter throughout the natural sciences. Animals and certainly inanimate objects do not communicate with languages as detailed or abstract as those of humans. They do not truck, barter, and/or exchange goods and services and hence possess no monetary currencies or market price exchange ratios. Many species often do conform their behavioral patterns to social standards akin to moral norms or even rules of law, although nonhuman actors do not reflect back on the desirability or optimality of their orders, whereas humans do. And herein lie the determining factors of society’s progression through coordination and cooperation or its destabilization through discord and strife. The following section surveys the intellectual history surrounding spontaneous order theory in an attempt to complement and justify the framework laid out in the previous section. Smith’s and Hayek’s research programs have been particularly influential in shaping spontaneous order theory. As social scientists, both sought to develop consistent models to account for processes of social change across varied institutional realms—language, morality, legal and political norms, and economic development. Both saw the phenomena of economic production as uniquely human and obviously complex beyond the potential of human design. Both sought unique methodological frameworks to cope with the distinct challenges of this subject matter; thus, they are most recognized for significantly shaping the theoretical tradition. While economic science provided the most ideal theoretical techniques for identifying and explaining the operational features of spontaneous orders, several writers throughout the spontaneous order tradition have noted the fate of harmonious social operation to rest on the interplay between spontaneous processes of material prosperity with moral social and cultural perceptions regarding the causes and consequences of prosperity and its associated social changes.

Different Categories of Order There is a need for a separable terminology when referring to complex human social processes relative to similar orders found amid nonhuman agents and groups. This is simply because the conditional factors of individual human choices are distinct from those facing nonhuman conscious agents, comparable to how processes of nonhuman conscious agents are significantly distinct in complexity from nonconscious objects. In other words, the predictability of the order that develops amid a community of human people is significantly more complex than that found amid a flock of birds or a school of fish, in much the same way as the degree of complexity amid a flock of birds is significantly greater than the patterns of operation amid balls on a billiard table. Billiard balls do not act but are acted upon. Birds act but do not make distinctive plans and intentions

124   Microeconomics apart from their biologically shaped instincts and needs for survival. While the difference in agent type may be a matter of degree rather than type, the social experience of humans is of a significant difference in type relative to nonhuman social contexts. By interacting in an environment made up of intelligent and intentional interacting agents, human social systems emerge and require institutional regularities, informational signals, and enforcement mechanisms to help promote coordination and cooperation. In all such cases, order can and does emerge, although the human condition allows for the development of social institutions that are of both a greater degree of complexity than and a distinctive type of complexity from those forms of coordination mechanisms common amid nonhuman processes. In particular, human languages, legal and political rules, commonly accepted moral norms of conduct, and decentralized economic decision-making through the advanced division of labor and market price signals are all uniquely human institutions considerably more complex than any of the behavioral patterns found in nonhuman systems. This section provides a framework to categorize different types of complex orderly processes. Figure 6.1 first clarifies the degree of complexity demonstrated within different types of orders by listing the relative number of conscious agents within an orderly system. Separate rows are included for zero agents, one or few agents in relative harmony to one another, and many competing agents. Second, a distinction is made regarding the nature of the agents within the supposedly orderly phenomena. Biophysical processes or nonhuman systems are differentiated from human ones. Each cell within the body of the figure is labeled with its own letter, A through F, and will be explained below. Processes within cells A, B, C, and F exhibit sufficient characteristics to warrant the title of emergent orders, while only processes within cell F ought to be considered spontaneous orders. Cells D and E are planned orders or examples of designed taxis, as Hayek (1973) used the term.

Subject Type Bio-physical Number of Conscious Agents

Zero

One or few in harmony to one another Many potentially competing against one another

Figure 6.2  Classifications of order.

Humane

A: sunflower seeds, D: a garden, architecture, honeycomb, snail shells, interior design flower pedals B: schools of fish, flocks E: sports teams, of birds, ant colonies, business firms, formal beehives organizations or clubs C: ecosystems, species F: market prices, commodity evolution, planetary currencies, the division orbits of labor, private property rights, the common law

Spontaneous Order   125 Beginning in the upper left corner, cell A lists various examples of complex patterns observed in the natural world. Such patterns conform to the basic definitional characteristics of complex orders. The individual components of the orderly system have particular features. A sunflower seed is a particular shape and size, as are the hexagons of a honeycomb, the spirals of a snail shell, and the petals of a flower. When fitted together, these noncomplicated parts generate a pattern with its own size, shape, and proportioned characteristics distinctive from those features of its constituent parts. If one were to view the individual components of the order apart from the order itself, it would be difficult to foresee or predict the complex pattern. Cell B is similarly focused on nonhuman complex orders, just as in cell A, but cell B includes examples of processes that possess a greater degree of complexity than those in cell A. This greater complexity is a function of the fact that the agents in the system, while not human, are somewhat autonomous. They engage in their own unique behavioral actions based on their own individual perceptions, influences, and stimuli. In other words, there is a similar emergence of order amid the patterns of seeds on the face of a sunflower and the orderly flow of ants within a colony’s mound, but there is a significant difference between the two. Ants walk about in accordance to their own individual actions. In the context of interacting with other ants, any individual ant faces a degree of variability in the potential outcomes of its behavior unparalleled by the distribution of seeds on the face of a sunflower.20 Orders within cell C demonstrate yet another level of complexity beyond those found within cells A or B. Not only are the agents within cell C autonomous relative to one another, but they are of various different species from one another, and as such they are most often in conditions of conflict and or competition with one another regarding food, territory, sexual mates, or all of the above. While planets and terrestrial objects would not seem autonomous, their distinct properties of movement relative to one another and interactive effects on others suffice to be included in cell C. Interspecies competition is most common. Species exist as innate predators and/or prey to one another. Interspecies coordination is also common but only as a function of optimized interspecies competition. Different species contribute to the functioning of a vibrant ecosystem in harmonic symbiosis with one another, but the health and vitality of any nonhuman ecosystem depends on the relative success of some species 20  There remain different meaningful types of order found with cell B characteristics. First, lower organisms such as slime molds and some social insects such as ant colonies and beehives perform coordinated behaviors amid such large groups; some have inferred the collective unit itself as the more relevant organism. Different types of agents, drones versus worker bees, for one example, operate more akin to organs with specialized functions rather than independent agents themselves. Tullock (1994) and Resnick (1994) describe the emergent qualities of social species. Seabright (2004) notices that social species share much higher rates of genetic homogeneity relative to others. Equipped with biological adaptations such as bio-determined divisions of labor and stigmergic mechanisms (see note 13 above), lower organisms can form groups of hundreds of thousands of agents, whereas more intelligent species maintain smaller group sizes. De Waal (1990) describes the proto-legal and moral norms evolved and required to resolve conflict amid various ape species. Differences across social norms are primarily shaped by biological factors such as gendered differences and sexual reproductive habits.

126   Microeconomics and/or populations over others (Forsyth and Miyata 1987). Foxes and rabbits have yet to discover an institutional arrangement wherein both species may thrive without the episodic predation of rabbits by foxes. Interspecies cooperation or symbiosis is not impossible but is more rare and typically the result of unique evolutionary conditions. Cell D is the first type of order listed within the human category and is also the first nonemergent type of order surveyed thus far. Examples such as gardens, architecture, and interior design are orderly insofar as they promote particular functions and purposes. Good gardens are usually both aesthetic and conducive to the healthy growing of the plants therein. But such orders are the result of direct planning insofar as they are intelligently designed and constructed by a gardener; hence, they are not fully emergent. Walking through a forest and stumbling upon a well-groomed garden, while the observer could remark on the well-ordered nature of the garden, he would obviously not infer that the garden had developed naturally without some intelligent designer. That being said, a successful garden must operate within the natural parameters beyond the gardener’s design or control. The gardener may desire to optimize the growing and cultivation of a particular plant or crop, but his ability to do so will be determined in part by his ability to identify, tap into, and harness the unplanned natural conditions of his environment and the interactive conditions of the fauna he chooses to plant. Cell E is another nonemergent form of order, but it does express a degree of complexity beyond those orders found within cell D. While cell D orders result from the application of human intelligence imposed on nonhuman entities, cell E results from a singular or unified human intention being imposed on and accepted by other human agents. Firms, organizations, clubs, and formal governments are all orders with cell E characteristics.21 Here again, the success or failure of the particular intention chosen by the order’s designer will hinge on his ability to identify, tap into, and harness the unplanned and/or emergent conditions operating within the population of individuals he has selected to work with. Now, fully within the realm of human social interaction, one could make a distinction within cell E of voluntary versus coercive arrangements akin to Smith’s ([1776] 1904) distinction of “raping, pillaging and plundering” relative to “trucking, bartering and exchanging.”22 The coercive arrangements like those conflicting interests across species in cell D orders are zero sum, meaning that one agent gains at the others’ expense. But unlike cell D orders, human agents have a significantly greater capacity to counterreact, be it through foresight, evasion, and/or cooperative retaliation. Smith’s ([1759] 1790) comments on the personality types of “men of systems” bear relevance here: The man of system, on the contrary, is apt to be very wise in his own conceit; and is often so enamoured with the supposed beauty of his own ideal plan of government, 21  For thorough investigations of decision-making within the firm and formal organizational settings, see Coase (1937) and Williamson (1981; 2002). 22  See also Oppenheimer ([1908] 2012).

Spontaneous Order   127 that he cannot suffer the smallest deviation from any part of it. He goes on to establish it completely and in all its parts, without any regard either to the great interests, or to the strong prejudices which may oppose it. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it. If those two principles coincide and act in the same direction, the game of human society will go on easily and harmoniously, and is very likely to be happy and successful. If they are opposite or different, the game will go on miserably, and the society must be at all times in the highest degree of disorder. (233–234).

Sustainable coercive relationships such as slavery or conscription required unique enforcement technologies and costs. Over time, such balances of power endure gales of creative destruction as changes in the conditional factors affecting the costs and benefits of coercion alter its equilibrium conditions (Acemoglu and Robinson 2012). For one example, the invention of the cotton gin radically increased the value of a marginal slave worker but lowered the net demand for the quantity of slaves writ large. In contrast, voluntary cooperation mechanisms are a uniquely human institutional arrangement wherein multiple parties may benefit despite alternative, competing, and/ or conflicting interests. Private property rights, contracts, rules of law, arbitration, and dispute resolution are all mechanisms to aid and facilitate the harmonization of the individual designers’ intention with the surrounding conditions of environmental resources and the ulterior motives of other human agents. Hence, again, we see that the relative success of an individual plan is at least in part determined by its ability to nest compatibly amid a broader condition of unplanned interactions (Koch 2007). Last, cell F is reserved for spontaneous orders properly understood. Rather than individual human actors within a system comporting their behaviors to a particularly designed intention, each of the members of a spontaneous order pursues intentions of his or her own accord. Here it is perhaps important to emphasize that all such behaviors are not necessarily harmonious or without conflict. In fact, systemic disorder and instability can be and often are stable outcomes for a variety of social contexts (Martin and Storr 2008). Although the contributing conditional factors of such disorderly states are similar to those that accommodate spontaneous order outcomes, the results of such processes do not conform to Hayek’s proffered definition of order as providing predictable reliability. Such disorderly states are also possible under cell B and cell C conditions. Seabright (2004) and Boettke, Caceras, and Martin (2013) suggest in comparison that the potentials and realities of conflicting disorderly states far surpass orderly alternatives; hence, ordered outcomes are all the more demanding of account and explanation. Although the potential for disorder is great and arguably surpasses that for order, it has been theoretically (Demsetz 1967), historically (Ellickson 1991; Anderson and Hill 2004), and even experimentally demonstrated (Kimbrough, Smith, and Wilson

128   Microeconomics 2010) that human agents are inclined to conform their behaviors to not conflict with other human agents to the extent that conflict is costly and or uncertain. Given humans’ greater capacity to impose costs amid conflict, this provides a greater incentive and greater potential for coordination in cell F than in other cells. To the extent that agents can recognize that their own plans may be better fulfilled under conditions of nonconflict coordination, individuals will prefer conditions of peaceful coexistence relative to conflict. Hence, cooperation and coordination in human societies without formal state enforcement mechanisms are feasible in relatively smaller and homogeneous groups (Landa 1994; Zerbe and Anderson 2001; Greif 2002; Dixit 2004; North, Wallis, and Weingast 2009) but rarely observed in large-scale heterogeneous social orders.23 Agents may intentionally conform their behaviors to rules of conduct and/or institutional patterns that explicitly signal nonthreatening intentions to others and accurately communicate information regarding interpersonal behaviors so that individuals within the system are best informed regarding how they may navigate action without conflict. Such institutional participation inadvertently contributes to a social environment more conducive to and accommodating for the fulfillment of ever greater and more diversely selected plans and agents. Institutional mechanisms such as language, property rights, contracts, rules of law, moral norms, market pricing mechanisms, and an advanced division of labor, though not designed by any individual actor, crucially aid and assist the plans of the participants within them because they funnel and churn knowledge more systematically and effectively amid the members of the system.

The History of the Spontaneous Order Tradition Equivocation between emergent and spontaneous orders obfuscates the meaning that theorists intended to convey throughout spontaneous order’s history of thought. Although common parlance of spontaneity implies that the subject matter develops as

23 

Samuelson (1964), McKenzie and Tullock ([1975] 2006), Landes and Posner (1975), and Cowen (1992) all highlight public-good dilemmas surrounding the provisions of law, security, and punitive enforcement. The positive externality conditions and high potential for free riding surrounding law-enforcement services are presumably inherent and logistical, thus limiting the potential for spontaneous order to sufficiently support large-scale heterogeneous networks of anonymous exchange. In contrast, Friedman (1979) argues that multiple equilibriums are possible in alternative societies. Benson (1992), D’Amico (2010), and Allen and Barzel (2011) trace criminal institutional changes and consequences through legal history. Gambetta (1993), Kaminski (2004), Leeson (2008a), Leeson and Skarbek (2010), and Skarbek (2010; 2011; 2012) explain functional punitive enforcements in criminal networks wherein group interests are conveniently aligned against formal state enforcement by the nature of their illicit intentions. Hoebel (1954) shows similarly for remote tribes. Leeson (2008b; 2009; 2014) and Benson (1989a; 1989b; 1990) argue that self-enforcing exchange is more durable than is commonly recognized and at least possible in some larger heterogeneous cases.

Spontaneous Order   129 if from nowhere and/or operates through random happenstance, spontaneous orders, as described by their most noted contributors, are decidedly not the inevitable result of chaotic interactions and/or serendipity. Spontaneous orders are instead the unintended result of certain structural features inherent to the processes of human decision-making and human interaction. Although they are unplanned, such phenomena are not random. The history of thought specifically surrounding spontaneous order theory, stemming most notably from Smith amid the Scottish Enlightenment, academically resurrected by the research program of Hayek, and continued by the contemporary scholarship associated with the modern Austrian school of economics highlights the unique methodological considerations necessary for investigating and accurately understanding human behaviors and complex social processes relative to subject matters more common throughout other natural sciences. The tradition of scholarship most responsible for developing the idea and terminology of spontaneous order theory has continuously been an effort to conduct objective positive social science, given the realization that human beings and human societies are more complicated subject matters and require unique methodological considerations compared with other natural subjects. In short, the process of coordinating human intentions contributes to the formation of institutions and societal outcome patterns that require uniquely gauged methods in order to accurately identify, understand, and/or compare objectively without systemic error or unintended consequences. Each of the theorists surveyed in this section highlights a particular facet of the spontaneous ordering of economic production and material prosperity. The increased population, density, and diversity afforded by material abundance often inspire subsequent cultural, moral, and ideological change. This feeds back on the stability of economic prosperity. The processes of individual perception, collective coordination, and reactive cooperation of such sociological processes are a distinctively human process in need of uniquely human, socially scientific, methodological considerations to accurately understand and objectively assess. Contemporary research and parlance surrounding the more general term emergence are less uniquely focused on distinctively human social processes. The idea of spontaneous social order was at first an inferred conclusion regarding the essential causes of the conspicuous social changes surrounding Enlightenment writers nested within the early stages of the industrial revolution. Spontaneous social ordering through processes of interindividual interaction was, in effect, a basic alternative hypothesis to the previous dominant theories that associated prosperity with the superior foresight and/or divine rights of ruling authority. Having endured similar political arrangements for relatively long periods of previous history, ruling intentions were simply insufficient explanations for the distinct levels of prosperity, human population, and social diversity all found more systematically throughout the developed world amid industrialization than ever before. One could simply not proclaim to be a philosopher dedicated to investigating and understanding human behavior and human society without devoting significant attention to those unique features of the human social world distinctive from all other times, places, and sectors of the natural world.

130   Microeconomics Though not a researched piece of formal social theory or political philosophy per se, Bernard Mandeville’s lyrical fable The Grumbling Hive: or Knaves Turned Honest (1705) was nonetheless one of the earliest presentations of the spontaneous order theory and arguably was most responsible for first popularizing the idea throughout the eighteenth century. The poem was quickly republished with additional commentary under the modified title The Fable of the Bees: or Private Vices, Public Benefits ([1714] 1992). Both publications gave rise to heated debate and provided significant theoretical inspiration for subsequent theorists and classical liberals throughout the Enlightenment period. Mandeville’s poem remarkably conveyed a relatively complete essence of spontaneous order theory as a hypothesis for explaining the causes and operations of complex social order, namely, that the prosperous, functional, and generally peaceful welfare of human society rests more on the unplanned processes of interacting human individuals than they stem from the plans of ruling authorities or moral theorists. Mandeville’s poem was even so bold as to allude to and explicate a nuanced model of socioinstitutional interaction, in other words, how economic prosperity relates to society’s moral and cultural qualities and vice versa. Just as prosperity is not the planned result of authority, neither is the virtuous or depraved character of society, or the general moral patterns of people within it, the product of conscience philosophical reflection or explicitly planned moral campaigns. In short, moral norms are themselves spontaneous orders, and individual moral beliefs are developed within this context. Mandeville’s narrative implied, first, that private vices did not necessarily contribute to broader moral depravity, let alone any sort of material consequences, as many at the time and arguably still today tend to presume. Such is evidenced merely by the simultaneity of prosperity, increased opportunities for vice, and peaceable social functioning. If self-interest, competition, consumption, and vice are so socially problematic, then why amid the observed periods of the greatest increased opportunities and expressions of these behaviors has society undoubtedly progressed materially, culturally, and peaceably? Thus every Part was full of vice, Yet the whole Mass a Paradise; Flatter’d in Peace and fear’d in Wars, They were th’ Esteem of Foreigners, And lavish of their Wealth and Lives, The Balance of all other Hives. (Mandeville [1714] 1992, 24)

Second, the subtitle of the second publication refers to “Private Vices, Public Benefits”; insofar as self-interested and competitive behaviors are contributors to social order, supposed vice and vanity may be inevitable correlates to prosperity. The freedom required to afford producers and innovators the environment to make and trade goods and services will also provide the requisite freedom to accommodate and afford

Spontaneous Order   131 a broader variety of civic behaviors, many of which will inevitably strike against previously held moral sensibilities. Finally, Mandeville implies a specific theory of culturally and ideologically driven social change, hence the descriptor “grumbling” in his original title. Concerted moral campaigns cannot refine their efforts solely to eliminate supposedly harmful vices without also casting aspersion on the general behaviors of self-interested consumption, profit seeking, and competition. Thus, they tend to throw the material progress baby out with the unvirtuous bath water or kill the ornery goose that happens to lay golden eggs. Here, Mandeville is significantly ahead of his time in recognizing that the maturing process of cultural and moral evolution occurs in stride and is related to a society’s material prosperity. Given Puritanism’s popularity and political influence at the time, it is not surprising that Mandeville’s essay provoked such contention. In contrast to the social harms invoked by moral crusades, regulators, and prohibitionists, vice appears marginally welfare-productive.24 After Mandeville, Ferguson ([1767] 2001) is often credited with having first recognized the concept of spontaneity when describing the functionality of legal and political systems. His turn of phrase is frequently echoed to convey a succinct but essentially accurate definition for spontaneous order theory: Men in general, are sufficiently disposed to occupy themselves in forming projects and schemes: But he who would scheme and project for others, will find an opponent in every person who is disposed to scheme for himself. Like the winds that come we know not whence, and blow whithersoever they list, the forms of society are derived from an obscure and distant origin; they arise, long before the date of philosophy, from the instincts, not from the speculations of men. The crowd of mankind, are directed in their establishments and measures, by the circumstances in which they are placed; and seldom are turned from their way, to follow the plan of any single projector. Every step and every movement of the multitude, even in what are termed enlightened ages, are made with equal blindness to the future; and nations stumble upon establishments, which are indeed the result of human action, but not the execution of any human design. (119; emphasis added)

As Hamowy (1968, 257–258) explains, Ferguson, like Mandeville, also recognized the correlation between material prosperity and the moral attitudes of society: Many mechanical arts, indeed, require no capacity; they succeed best under a total suppression of sentiment and reason; and ignorance is the mother of industry as well as of superstition. Reflection and fancy are subject to err; but a habit of moving the hand, or the foot, where the mind is least consulted, and where the workshop may, without any great effort of imagination, be considered as an engine, the parts of which are men. (Ferguson [1767] 2001, 182–183) 24 

Such was coincidentally the similar intellectual setup and public reaction to Block (1976).

132   Microeconomics Ferguson also parallels Mandeville in his recognition that economic prosperity may invoke cultural processes that are potentially self-defeating to prosperity. Specialized populations in the division of labor may not afford the time or energy to comprehend the operational features of the social system they live within, contribute to, and benefit from. But if many parts in the practice of every art, and in the detail of every department, require no abilities, or actually tend to contract and to limit the views of the mind, there are others which lead to general reflections, and to enlargement of thought. Even in manufacture, the genius of the master, perhaps, is cultivated, while that of the inferior workman lies waste. The statesman may have a wide comprehension of human affairs, while the tools he employs are ignorant of the system in which they are themselves combined. The general officer may be a great proficient in the knowledge of war, while the soldier is confined to a few motions of the hand and the foot. … The practitioner of every art and profession may afford matter of general speculation to the man of science; and thinking itself, in this age of separations, may become a peculiar craft. … [T]‌he labourer, who toils that he may eat; the mechanic, whose art requires no exertion of genius, are degraded by the object they pursue, and by the means they employ to attain it. Professions requiring more knowledge and study; proceeding on the exercise of fancy, and the love of perfection; leading to applause as well as to profit, place the artist in a superior class, and bring him nearer to that station in which men are supposed to be highest; because in it they are bound to no task; because they are left to follow the disposition of the mind, and to take that part in society, to which they are led by the sentiments of the heart, or by the calls of the public…. We look for elevation of sentiment, and liberality of mind, among those orders of citizens, who, by their condition, and their fortunes, are relieved from sordid cares and attentions. … [Thus,] in every commercial state, notwithstanding any pretensions to equal rights, the exaltation of a few must depress the many. (183–186).

Perhaps not coincidentally, just as Jacobs (1997; 1999; 2000) has inspired dispute regarding whether Hayek or Polanyi originated the term spontaneous order, Hamowy (1968) surveys Rae (1895), Carlyle (1910), and Oncken (1909), suggesting that the innovative origins surrounding the idea of the division of labor was a point of personal conflict and made accusations of quasi-plagiarism between Ferguson and Smith. Smith’s ([1776] 1904) opening sentences in the first chapter of his economic treatise define the division of labor and cite it as the primary source for the greatest influence upon material growth: The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour. The effects of the division of labour, in the general business of society, will be more easily understood, by considering in what manner it operates in some particular

Spontaneous Order   133 manufactures. It is commonly supposed to be carried furthest in some very trifling ones. (13)

Smith proceeds with applied descriptions of the specialized division of labor within a pin factory, the decentralized production of a common woolen coat, and eventually the inventory processes of corn houses as they operated in conjunction with various tax codes under the corn laws.25 In all such cases, Smith highlights the self-regulating and equilibrating results of profit-seeking market decision-making. Herein Smith’s initial outlines of the classical model of the economy first took form. Hamowy (1968, 259) suggests that Smith’s insights regarding the division of labor are more limited to the economic sphere, compared with Ferguson’s more sociological, cultural, and political applications. Smith ([1776] 1904) does address the cultural consequences of expansions in the division of labor and the material progress it engenders: In the progress of the division of labour, the employment of the far greater part of those who live by labour, that is, of the great body of the people, comes to be confined to a few very simple operations, frequently to one or two. But the understandings of the greater part of men are necessarily formed by their ordinary employments. The man whose whole life is spent in performing a few simple operations; of which the effects too are, perhaps, always the same, or very nearly the same, has no occasion to exert his understandings, or to exercise his invention in finding out expedients for removing difficulties which never occur. He naturally loses, therefore, the habit of such exertions, and generally becomes as stupid and ignorant as it is possible for a human creature to become. The torpor of his mind renders him, not only incapable of relishing or bearing a part in any rational conversation, but of conceiving any generous, noble, or tender sentiment, and consequently of forming any just judgment concerning many even of the ordinary duties of private life. (book V, chap. 1, part 3, article 2)

While it is textually accurate to say that Smith’s observations regarding the causes and consequences of the division of labor were relatively limited to the economic sphere of human society, a wider review of his broader sample of writings demonstrates an attempt to fully survey the totality of human social interaction by means of a unified theory of human behavior and socioinstitutional operation. Spontaneous order was in essence the mechanism of operation found throughout various social arenas, from language to morality, economic production, and legal policies. In all applications, there is an inevitable interplay between individual human actions via rational decision-making on the one hand and the existence of structural institutional rules and incentives on the other. Again, Smith’s coining of the phrase “invisible hand,” when referring to the self-organizing properties of buyers and sellers in the market economy, is commonly inferred as synonymous with spontaneous order (Nozick 1974, 18–22; Ullman-Margalit 25 

Leonard Read’s I, Pencil (1958) adopted this same pedagogical technique to great popular success.

134   Microeconomics 1978)  and most often referred to its centrally found location (Klein and Lucas 2011) within his most economically oriented work: But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it. (Smith [1776] 1904, 455–456)

However, as Hamowy (1986, 78) notes, Smith’s ([1759] 1790) earlier work on moral theory also used the “invisible hand” phrase and generally comported to the same idea, that the functional and harmonizing facets of cultural mores and social norms are more the product of unplanned interindividual human behaviors than they are the direct result of conscientious philosophical reflection: They consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose from the labours of all the thousands whom they employ, be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species. (184–185).

Hamowy (1986, 78)  also refers to Macfie (1971) rightly noting that Smith’s ([1795] 1982) first mention of “invisible hand” is found in his “History of Astronomy,” probably written but not published prior to Theory of Moral Sentiments: For it may be observed, that in all Polytheistic religions, among savages, as well as in the early ages of Heathen antiquity, it is the irregular events of nature only that are ascribed to the agency and power of their gods. Fire burns, and water refreshes; heavy bodies descend, and lighter substances fly upwards, by the necessity of their own nature; nor was the invisible hand of Jupiter ever apprehended to the employed

Spontaneous Order   135 in those matters. But thunder and lightning, storms and sunshine, those more irregular events, were ascribed to his favour or his anger. Man, the only designing power with which they were acquainted, never acts but either to stop, or to alter the course, which natural events would take, if left to themselves. (vol. 3, section 3).

This chapter lacks the forum or expertise to definitively resolve such matters of historical usage and/or creative authenticity among authors, although the context of Smith’s initial use of “invisible hand” within his dedicated material on specifically nonhuman subjects and scientific methodology does seem pertinent. In other words, viewing the range of Smith’s applied subject matters, one sees an attempt to develop a theory of human decision-making universally applicable in all variety of social realms: political-legal, cultural-moral, and economic. Smith’s forays into nonhuman natural sciences also appear to be explicit attempts to forge methodological techniques capable of identifying and comprehending the operations of complex systems. With both a theory of individual decision-making and a method for understanding complex interaction in hand, Smith’s economic analysis hosted his most systematic contributions to spontaneous order theory. The quantifiable nature of market prices and material production provided analytical traction of spontaneous order processes within the economic sectors more so than in other institutional arenas despite their uniquely human identity, such as language, moral norms, or legal processes. It is not coincidental or unwarranted that Smith is given prominent attention for most early and systematically identifying and developing the theory of spontaneous orders.26 It is arguably his particular attention and dedicated analysis of economic processes that afforded him this vantage. Hence, it is within the tradition of economic science, and the Austrian tradition’s unique attention to methodology therein, that the most significant attention and insight regarding spontaneous order theory have stemmed from in the wake of Smith. Most notably, Carl Menger’s (1892) account of the spontaneous origins of monetary currency from amid the incentives and procedural behaviors of agents within a barter economy subsequently inspired the research programs of Austrian figureheads Ludwig von Mises and Hayek. Mises’s ([1912] 1953) initial goal was to incorporate a theory of money consistently into the broader model of individual decision-making and economic production. Hayek (1945) in turn traced the communicative and epistemic value conveyed by monetary prices in an exchange economy to promote material production and social harmony. Hayek’s initial definitions and applications of spontaneous order theory have been sufficiently summarized above, although it is worth pointing out how significantly his latter insights regarding social morality paralleled other enlightenment thinkers.

26  Hamowy (1986, 65) cites Kettler (1965), who notes that “Hume found Ferguson’s style both unsystematic and inexact.”

136   Microeconomics Hayek (1941) lays out a detailed model of social change wherein social harmony and/ or systemic problems hinge critically on the presence of accurate methodologies within the professional social sciences. His shorter essay, “Intellectuals and Socialism” (1949b), proffers an account of the apparent animosity toward market processes popular among professional intellectuals. In his final work, Hayek (1988) explicitly refers to Mandeville’s insights regarding the sociological effects of prosperity. He outlines how tensions arise among instinctive moral beliefs, designed moral beliefs, and evolved moral beliefs. Throughout the long and active history of thought surrounding spontaneous order theory, a variety of key contextual factors were critical in shaping its substantive content and applications. First, the historical conditions and knowledge of comparative social environments provided thinkers in the tradition with the common vantage to recognize the complex nature of material prosperity and social progress. All began from the basic premise that advanced material production and social harmony conformed to a sufficient degree of patterned operation so as to be investigated and understood scientifically. In turn, these contributors shared a deep appreciation for gauging scientific methodology to suit the needs of human social science.

Conclusion In a way, spontaneous order theory is both the alpha and omega of a shared research project in positive social science. With its discovery and elucidation, thinkers could utilize the spontaneous order framework as a baseline for comparative institutional analysis. Given the incentive structures of interacting individuals, their diverse interests, and the resource constraints of a particular social context, theorists were left to ask what moral, legal, political, and economic institutions are likely to evolve. How do they compare with those real institutional attempts to manage social welfare by design? Spontaneous order provides the ability to identify and diagnose natural social problems apart from those social problems stemming from unintended consequences of failed plans. Spontaneous order is the omega of social science insofar as it became for many of its key theorists the critical subject matter to continuously identify and comprehend its procedural operation in all walks of human association. To understand human action and human association essentially requires a keen recognition of spontaneous orders in society and a thorough comprehension of how they operate. Hence, the intellectual tradition stemming from Smith to Hayek and beyond has been keenly focused on both tracking the institutional histories and operations of spontaneous orders throughout social contexts and methodologically reflecting on how best to identify and comprehend social meaning in a complex world of human individuals.

Spontaneous Order   137

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Pa rt  I I I

M AC ROE C ON OM IC S A N D M ON E TA RY E C ON OM IC S

Chapter 7

T he Capita l - U si ng Ec onomy Peter Lewin and Howard Baetjer Jr.

Introduction It is no exaggeration to say that capital theory is fundamental to everything else in Austrian economics. It lies at its core, implicit in discussions of monetary policy, the business cycle, the entrepreneur, and the subjectivity of value and expectations. Prior to the Keynesian revolution, it was capital theory for which the Austrian school was most known among mainstream economists. With the advent of Keynesian macroeconomics, interest in capital theory all but disappeared, but it has recently been the subject of increasing attention. After a brief overview of the main ideas in Austrian capital theory (ACT) from its origins and extensions through the middle of the last century, this chapter will note this rekindled interest and survey recent applications.

The Austrian Theory of Capital Production refers to the process of transforming physical resources into more useful forms. This is how value is created. A series of activities must occur in a specific context and sequence in order for the production project to be successful. Carl Menger ([1871] 1976)  spoke of higher-order (intermediate) goods used in the service of producing first-order (consumer) goods. Eugen von Böhm-Bawerk (1959) has a similar image of concentric circles, the outermost being most remote from the final product. Friedrich Hayek (1935) used the image of a production triangle, with the base indicating time and the height indicating value added. All of these visions see production as a process in time involving sequential, related activities. (For a survey of the history of ACT, see Lewin [1999] 2011 and Lewin 2005.)

146    Macroeconomics and Monetary Economics The Austrian economists emphasize that production takes time, and, other things constant, the longer the (linear) supply chain, the more “time” it takes. Thus, modern production is much more “roundabout” (Böhm-Bawerk’s term) than older, more rudimentary production processes. Rather than picking the fruit in our backyard and eating it, most of us today get our fruit from farms using complex picking, sorting, and packing machinery and specialists to process carefully engineered fruit products. Consider the amount of “time” (for example, in people-hours) involved in setting up and assembling all the pieces of this complex production process from scratch—from before the manufacture of the machines and so on—to appreciate what is meant by production methods that are “roundabout.” Doing things in a more complicated, specialized way is more difficult—loosely speaking, it takes more “time” because it is more roundabout, more indirect—it involves the construction of more intermediate products (or services) before moving to the next step in the process. The scare quotes for “time” in the previous paragraph are used because, even for simple linear processes, there is no perfectly rigorous way to define the length of a production process in purely physical terms. This essential fact is at the heart of the three capital controversies that have occurred over the last one hundred years: the first in the late nineteenth and early twentieth century involving Böhm-Bawerk and his critics (notably J. B. Clark [1888] 1988; 1893), the second in the 1930s and 1940s involving Hayek and his critics (notably Frank Knight 1936), and the last from the 1970s onward, lingering until today, known as the Cambridge-Cambridge debate, involving, respectively, protagonists from Cambridge, England, and Cambridge, Massachusetts (for a summary, see Blaug 1974). ACT was explicit in the first two controversies and implicit in the third. All concerned the essential nature of production in a capital-using economy. Böhm-Bawerk was tackled because of his use of a simplifying, inconsistent theoretical construct: the “average period of production.” It can be easily shown that any attempt to calculate such a magnitude is fraught with insurmountable difficulties except in the simplest of cases—and even there, the calculation is impossible if we consider, as we should, the interest rate implicit in the formula to be compound interest (see the appendix to this chapter for a formal discussion). Böhm-Bawerk’s lengthy, intuitive discussion of the nature of capitalist production as an increasing reliance on produced means of production in specialized production processes became associated with this rather specific and limited formula. Though actually a small part of his work as a whole and arguably an aberration in his breadth of vision, it became the focus for the prolonged and energetic debate in capital theory. A similar story was repeated in the later debate between Hayek (1936) and Knight (1936). Hayek (1935) had tried to use a very stylized version of ACT in his debate with Keynes over the business cycle—Hayek’s famous triangles. Subsequently, Hayek tried to flesh out ACT for an English-speaking audience in a way that avoided Böhm-Bawerk’s errors. This project was both incomplete and unsuccessful (Hayek 1941). By this stage, interest in capital theory was passing. It revived briefly with the Cambridge-Cambridge debate. This did not explicitly involve ACT; it pitted the English (and Italian) neo-Ricardians against the American

The Capital-Using Economy    147 neoclassicals. It was overtly ideological in tone, with the former group trying to stake out a respectable theoretical position for a Marxist view of production and the latter trying—rather lamely—to defend against it using the postwar neoclassical framework. The neo-Ricardians won the theoretical debate in showing that the neoclassical concept of capital as a factor of production contained irresolvable contradictions. Capital as an input whose price is the rate of interest is an idea whose coherence cannot withstand logical scrutiny. As Ludwig Lachmann (1973) and Israel Kirzner (1993) have shown, however, this is a matter of no relevance to ACT. From an Austrian perspective, interest is not the price of capital, and capital as an input is not quantifiable in physical terms, whether using time or any other physical measure. In the disequilibrium of the real-world market process, capital is a much more complex phenomenon. Both Cambridges were wrong in their understanding of the essential nature of capitalist production. The difficulties faced by the Austrian capital theorists through to Hayek were the result of a focus on discovering a way to characterize in some quantitative fashion the total capital endowment of an economy. It was Lachmann who realized that this was both impossible and unnecessary. His realization that in a dynamic, innovative economy, the (functional) heterogeneity of capital goods precluded the adding up of capital goods into a single aggregate capital stock motivated his work in extending the ACT (1947; [1956] 1978). According to him, although the capital stock is heterogeneous, it is not amorphous. The various components of the capital stock stand in sensible relationship to one another because they perform specific functions together—they constitute a structure of complex interrelationships. That is to say, capital goods are used in various capital combinations. If we understand the logic of capital combinations, we give meaning to the capital structure. Understanding capital combinations entails understanding the concepts of complementarity and substitutability. Capital goods are complements if they contribute together to a given production plan. A production plan is defined by the pursuit of a given set of ends to which the production goods are the means. As long as the plan is being successfully fulfilled, all of the production goods stand in complementary relationship to one another. They are part of the same plan. The complementarity relationships within the plan may be quite intricate and involve different stages of production and distribution. Substitution occurs when a production plan fails (in whole or in part). When some element of the plan fails, a contingency adjustment must be sought. Thus, some resources must be substituted for others. This is the role, for example, of spare parts or excess inventory or alternative suppliers of the same input. Thus, complementarity and substitutability are properties of different states of the world. The same good can be a complement in one situation and a substitute in another. Lachmann uses the example of a delivery company (1947, 199; [1956] 1978, 56). The company possesses a number of delivery vans. Each one is a complement to the others in that they cooperate to fulfill an overall production plan. That plan encompasses the routine completion of a number of different delivery routes. As long as the plan is being fulfilled, this relationship prevails, but if one of the vans should break down, one or more of the others may be

148    Macroeconomics and Monetary Economics diverted in order to compensate for the unexpected loss of the use of one of the productive resources. To that extent and in that situation, they are substitutes. Substitutability can only be gauged to the extent that a certain set of contingent events can be imagined. There may be some events, such as those caused by significant technological changes, that, not having been predictable, render some production plans valueless. The resources associated with them will have to be incorporated into some other production plan or else scrapped; they will have been rendered unemployable. This is a natural result of economic progress, which is driven primarily by the trial-and-error discovery of new and superior outputs and techniques of production. What determines the fate of any capital good or supplier in the face of change is the extent to which it can be fitted into any other capital combination and thereby retain value. Capital goods are regrouped. Those that lose their value completely are scrapped. That is, capital goods, though heterogeneous and diverse, are often capable of performing a number of different economic functions. By the mid-twentieth century, then, ACT had been extended and reoriented along a track that made it both more accessible and more relevant. With the turn toward extreme formalization in mainstream economics, however, this revitalized theory could garner no interest outside of Austrian circles. It has become a focus of interest again because of its relevance in macroeconomics and in management studies. This revitalized theory stresses the complexity of real-world production processes and networks. Real-world production processes are much more complicated than the simple, linear pictures suggested by Menger and Böhm-Bawerk and, in his earlier work, by Hayek. Rather, they are nonlinear and complex, involving multiple, and multilevel, interactions. Some product types may be both inputs and outputs (such as sugar), and some may be inputs at multiple parts of the supply chain; some firms are substitute providers, and some are complementary to others. Rather than straight-line processes, modern capital structures are more like meandering spiderwebs, with multidirectional connections (multidimensional, with feedback and feedforward loops). It is this realization that led Lachmann to his work on capital theory and, arguably, led Hayek to his work on complex phenomena (Lewin 2013).

Capital Structure and the Growing Complexity of Production Lachmann points to the increasing number of production stages as an indication of the growing complexity of the capital structure. Considering the importance of complementarity (a form of interaction between elements) at multiple levels (capital combinations, plans, firms), complexity in this context implies an increasingly complicated network of production linkages, a progressively expanding network of complex, multilevel mutual dependencies between increasingly specialized elements. Lachmann

The Capital-Using Economy    149 suggests dispensing with any notion of quantifiable production time and replacing it with the notion of “degree of complexity.” “The richer a society the smaller will be the proportion of capital resources used in the ‘later stages of production’, the stages nearest to the consumption end, and vice versa” (Lachmann [1956] 1978, 82). The increased number of stages is indicative of increased complexity, which, in turn, is indicative of increased productivity. Increased complexity implies “an ever more complex pattern of capital complementarity” (85). Ludwig von Mises points this out in a particularly graphic way. An increase in the number of stages of production, that is, an increase in specialization, necessarily implies an increase in complexity, in that those stages closer to final products are more complex than those stages farther from them. Complexity is related to specificity: the construction of artifacts for specialized purposes implies more internal structure and more linkages between the stages. “Iron is less specific in character than iron tubes, and iron tubes less so than iron machine parts. The conversion of a process of production [to another purpose, in response to unexpected change] becomes as a rule more difficult, the farther it has been pursued and the nearer it has come to its termination, the turning out of consumers’ goods” (Mises [1949] 1998, 500). Both Lachmann and Hayek made the connection between the complexity of the capital structure and the role of expectations (Lewin 2013). The more complex the system, the more complex the disparate expectations of the agents that operate within it and the more difficult managed coordination becomes. Disparate expectations imply error and uncertainty. Thus, capital complexity is related to (unexpectable) change. It is not change itself that is revolutionary and potentially problematic, it is the speed with which it is occurring. The pace of change in the modern world is not only quicker, it is accelerating. Lachmann’s considerations suggest, however, that our ability to absorb and adjust to change has dramatically increased—it must have, or else we would not be able to observe these changes occurring as they do within a well-ordered social framework, a framework that remains intact in spite of the ubiquity and rapidity of change. So an interesting question arises regarding how exactly we are able to cope with this increasing complexity. How have changes in organization and management technology allowed us to absorb and benefit from the ever-growing specialization of function that has produced this complexification of the production process? We return to this below. The increasing complexity of the capital structure can be understood in broader terms, especially if we include human capital (as we should). In some respects, this is only the latest in a line of similar revolutions such as the original emergence of language and the development of writing, accounting, and printing. The latest, and to date most profound, in this line of developments is electronic communication, of which the telephone, the computer, the video and audio recorder-transmitter, and, of course, the Internet are all part. Electronic communication by all of these means is responsible for the developments of global markets, desktop publishing, fuel injectors for automobiles, computer-aided design of everything from microchips to airplanes, and so on; and of course, it has revolutionized the entire supply process in all of its diverse aspects, from

150    Macroeconomics and Monetary Economics containers to custom design. Thus, to understand the phenomenon of accelerating structural change occurring together with our enhanced abilities to adapt to change, we must realize that the scope and pace of technological change itself is governed by our ability to generate and process relevant information. If technological change is seen as the result of many trial-and-error selections (of production processes, product types, modes of distribution, etc.), then the ability to generate and perceive more possibilities will result in a greater number of successes. It will, of course, also result in a greater number of failures. Lachmann’s proposition that capital accumulation, proceeding as it does hand-in-hand with technological change, necessarily brings with it capital regrouping as a result of failed production plans appears in this perspective to be particularly pertinent: “economic progress … is a process which involves trial and error. In its course new knowledge is acquired gradually, often painfully, and always at some cost to somebody” (Lachmann [1956] 1978, 18). Today new knowledge acquisition is not so gradual.

The Capital-Based View of the Firm Firms, Capital Goods, and the Entrepreneur Recently, this vision of capital has been applied to problems in the literature on the theory of the firm. It sheds light on such questions as the determinants of the boundaries of the firm, product design, internal organization, and so on (this section draws from Lewin and Baetjer 2011, outlining a capital-based view [CBV] of the firm). Capital assets derive their value from the value of the products their services help to produce, in the absence of which they would have no value. Capital value is, thus, the result of forward-looking processes undertaken by the entrepreneurs who plan them. There must be a production plan if the activities of these resources are to have any meaning to anyone. These production plans reflect the knowledge and expectations of the planners and of the human resources employed by the planners. Knowledge is thus an important dimension of every production plan. The knowledge dimension is always there. Further, capital accumulation, adding value to the capital structure, involves learning—it involves change—as the knowledge base of workers and planners is enhanced. Time and knowledge are inextricably connected. One cannot conceive of the lapse of time in real-world situations without a change in knowledge (Lachmann [1956] 1978), although, of course, some changes have more economic significance than others. Changes in knowledge often become incorporated in additions to the capital structure. As mentioned earlier, capital accumulation and technological change are thus intertwined (Menger [1871] 1976; Böhm-Bawerk 1959; Lachmann [1956] 1978; Lewin [1999] 2011; Baetjer 1998; 2000). This view contrasts with economic approaches that imagine a world in which additions to capital occur without

The Capital-Using Economy    151 changes in technology, such as standard neoclassical growth models deriving from Solow (1956). Each capital good may be said to possess a set of attributes that are (potentially) useful in the production process (Barzel 1997). These attributes determine the services the capital good can yield. Sometimes capital goods are deliberately constructed with these attributes in mind. Other times, these attributes may be fully revealed only after being used in combination with other resources. In either event, the entire set of valuable attributes of capital goods, and especially combinations of capital goods, is not likely to be obvious to every observer. Different evaluators see them differently. Capital-goods combinations have to be subjectively appraised according to the value of the product they are expected to yield, that is, according to the revenue streams they are expected to generate in changing circumstances. Account must be taken of the future actions of both competitors and producers of complementary products (Richardson [1960] 1997), as these will affect the value of the product produced. Different appraisers will thus have different expectations. Their cognitive models will be heterogeneous (Klein 2008). In forming specific capital combinations, it is the role of the entrepreneur to bring to the production process his or her particular appraisal, his or her vision (Penrose [1959] 1995; Lachmann [1956] 1978). It is unavoidable, therefore, that in many spheres of human action, notably in the sphere of economic competition, expectations will be mutually inconsistent. Rival economic models are the essence of the competitive process—for example, in predicting standards, fashions, brand appeal, price/quality trade-offs, and so on. And where expectations are mutually inconsistent, at most one person can be right (Lachmann [1956] 1978). Disparate expectations mean inevitable errors. They are a normal part of the experimental nature of the market process. Entrepreneurs pit their judgments against one another. Such judgment is necessary in a world where product values are uncertain. The more successful the judgment, the appraisal, the more surplus value will be earned by the entrepreneur—revenue minus the payments (or opportunity costs, implicit prices) of the services of the employed resources. In a world of uncertainly, of heterogeneous capital resources and heterogeneous cognitive models, profit (and competitive advantage) is not difficult to explain (Knight 1921; Mathews 2006, 102; 2010, 225–226). For entrepreneurial judgment to be effective, it must be exercised within a framework in which the entrepreneur has property rights (use and residual claimant rights) to the capital goods necessary to fulfill his or her vision (Barzel 1997). In this sense, entrepreneurship implies ownership (Foss and Klein 2011; Foss et al. 2007). It is the entrepreneur’s judgment that is implemented by him or her or by his or her delegates (in which case, the judgment of the delegate is “derived” from that of the entrepreneur). In sum, production occurs through the formation of capital structures in which heterogeneous capital goods are combined in real time by ambitious entrepreneurs in an uncertain world in the hope of earning a profit as a result of the superior judgment of the value of those combinations—or equivalently the value of the produced product.

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Knowledge about the Knowledge in Capital The above discussion provides the basis for a closer examination of the nature of capital and capital goods and the role of knowledge. What kinds of things qualify as capital goods? Should we consider knowledge to be a capital good? And what exactly is the role of knowledge in the production process? In order to use capital goods, we have to know what they can do. The attributes that a capital good possesses can be thought of as useful (productive) knowledge. Different capital goods “know” how to do different things. Capital heterogeneity (of economic function) is a reflection of the division of labor—we might say it is a “division of capital” (Lachmann [1956] 1978). This division of labor, whereby different parts of the production structure are devoted to specialized activities, is an organizing principle (Loasby 2007) based on what Hayek called a “division of knowledge” (Hayek 1948). In order to understand this principle, one needs to take account of the various ways in which knowledge enters the production process. This is the knowledge dimension of production. There is a fundamental relationship between knowledge and capital. Indeed, capital goods are useful because they embody knowledge about productive processes and how they may be carried out (see Baetjer 1998; 2000 for a fuller exposition). Much of our knowledge is to be “found” not in our heads but in the capital goods we employ. In particular, capital equipment (tools) embodies knowledge of how to accomplish some purpose or function, as explained above. It is also true that much of our knowledge of the causal relationships between things, and of how to achieve the changes we desire, is tacit knowledge. Adam Smith speaks of the “skill, dexterity, and judgment” of workers (Smith [1776], 7); these attributes are a kind of knowledge, a kinesthetic knowledge located in the hands rather than in the head. The improvements these skilled workers make in their tools are embodiments of that knowledge. The very design of the tool passes on to a less skilled or less dexterous worker the ability to accomplish good results. Consider how the safety razor enables those of us unskilled in the barber’s craft to shave with the blade always at the correct angle, rarely nicking ourselves. The skilled barber’s dexterity has been passed on to us, as it were, embodied in the design of the safety razor. To emphasize, the knowledge aspect of capital goods is the fundamental aspect. Any physical aspect is incidental. A hammer, for instance, is physical wood (the handle) and minerals (the head). But a piece of oak and a chunk of iron do not make a hammer. The hammer is those raw materials infused with the knowledge embodied in the precise shape of the head and the handle, the curvature of the striking surface, the proportion of head weight to handle length, and so on. (We leave aside, for now, all the additional knowledge required to shape the oak into a handle and the iron into a steel head.) Even with a tool as bluntly physical as a hammer, the knowledge component is of overwhelming importance. With precision tools such as microscopes and calibration instruments, the knowledge aspect of the tool becomes more dominant still. We might say, imprecisely but helpfully, that there is a greater proportion of knowledge to physical stuff in a microscope than in a hammer.

The Capital-Using Economy    153 The case of computer software provides both a compelling analogy for general understanding and a particular case of the nature of capital. Software is less tied to any physical medium than most tools. Because we may with equal comfort think of a given program as a program, whether it is printed out on paper, stored on a hard drive, or loaded into the circuits of a computer, we have no difficulty distinguishing the knowledge aspect from the physical aspect with a software tool. Of course, to function as a tool, the software must be loaded and running in the physical medium of the computer, and there are definite physical limits to computation. Nevertheless, it is in the nature of computers and software to separate clearly the knowledge of how to accomplish a certain function from the physical embodiment of that knowledge. (More accurately, the software is a symbolic representation of the knowledge; in this way, it embodies the knowledge. When loaded into a computer, the computer then embodies the software that embodies the knowledge.) Because the knowledge aspect of software tools is so clearly distinguishable from their physical embodiment, in investigating software capital we may distinguish clearly the knowledge aspects of capital in general. While software may seem very different from other capital goods in this respect, we find no fundamental difference between software tools and conventional tools. What is true of software is true of capital goods in general. What a person actually uses is not software alone but software loaded into a physical system—a computer with a monitor, or printer, or plotter, or space shuttle, or whatever. The computer is the multipurpose, tangible complement to the special-purpose, intangible knowledge that is software. When the word processor or computer-assisted design package is loaded in, the whole system becomes a dedicated writing or drawing tool. But there is no important difference in this respect between a word processor and, say, a hammer. The oaken dowel and molten steel are the multipurpose, tangible complements to the special-purpose, intangible knowledge of what a hammer is. When that knowledge is imprinted on the oak in the shape of a smooth, well-proportioned handle and on the steel in the shape, weight, and hardness of a hammer head, and when the two are joined together properly, then the whole system—raw oak, raw steel, and knowledge—becomes a dedicated nail-driving tool. All tools are thus a combination of knowledge and matter. They are knowledge imprinted on or embodied in matter. The value of our tools is not in their weight of substances, however finely alloyed or refined. It is in the quality and quantity of knowledge imprinted on them. Menger notes: Increasing understanding of the causal connections between things and human welfare, and increasing control of the less proximate conditions responsible for human welfare, have led mankind, therefore, from a state of barbarism and the deepest misery to its present stage of civilization and well-being. Nothing is more certain than that the degree of economic progress of mankind will still, in future epochs, be commensurate with the degree of progress of human knowledge. ([1871] 1976, 74)

In sum, a significant proportion of the knowledge we use in production is not in any person or even any group but in the tools we use. We who use a hammer know nothing

154    Macroeconomics and Monetary Economics of ergonomics and have not the slightest idea what the correct ratio of head weight to handle length is. Nevertheless, when we drive a nail, we can tell if the hammer feels right. Thus, we use that knowledge. The knowledge is “built into” the hammer. Capital goods, then, are embodied knowledge of how to accomplish productive purposes.

The Social Character of the Valuable Knowledge in Capital The knowledge of many people is combined in capital goods; product development is a process of social interaction, not a matter of individuals working autonomously. Most individual capital goods are manifestations of a far-flung division of knowledge, an incomprehensibly extensive sharing of the knowledge and talents of thousands of people across time and space. The ever-changing pattern of relationships among these capital goods—the capital structure as a whole—is an essential aspect of what Hayek called “the extended order of human cooperation” (1973). Capital goods and the capital structure at any time result from a tremendously rich social interaction through which the knowledge of many has been combined. One type of social interaction occurs in the social construct that we refer to as the firm (and the teams within and between firms that work on particular projects). The division of labor is best understood as the whole pattern of cooperation in production, direct and indirect. The indirect contributions—in the form of tools and processes developed elsewhere—are, in an advanced economy, the most significant. The crucial labor is the creative effort of learning how to do things and the embodying of that learning in the design of a tool that can be used by others, who themselves lack the knowledge in any other form. Through the embodiment of knowledge in an extending capital structure, each of us is able to take advantage of the specialized knowledge of untold others who have contributed to that structure. Thus, this structure becomes increasingly complex over time, as the pattern of complementary relationships extends. In modern, capital-intensive production processes, the division of knowledge, capital, and labor is to be found not in the large number of people at work in a particular production process but in the tools (including scripted techniques and instructions) used by a relatively few people who carry out that process. The knowledge contribution of multitudes is embodied in those tools, which give remarkable productive powers to the individual workers on the spot, though, as explained above, these productive powers have to be organized by the discerning judgment of the entrepreneur. In a fundamental sense, all economies are “knowledge economies,” and all firms are “knowledge-based,” and this is because they are “capital-based.” To be perfectly clear, when we say that a capital good “knows” how to accomplish a certain set of activities, what we mean is that when used by someone who knows what he or she is doing, these activities can be successfully accomplished, because at some earlier time, someone else knew how to design this capital good to perform the way it does when used properly. The latter knowledge is obviously more comprehensive, in

The Capital-Using Economy    155 that the designer of the equipment, in addition to possessing the knowledge of how to use it, also has an understanding, at a more fundamental level, of the workings of the designed equipment. This deeper knowledge has to be retained by someone if such expertise in design is to be retained in the economy at all and if progress in design is to occur, but it can be dramatically economized on to the extent that it is unnecessary for the routine operation of the capital good. Most of the users do not have and do not need to have that knowledge. Furthermore, and this is important, the design process itself is subject to knowledge and time-saving design, in that the various design components, or modules, are highly specialized (Baldwin and Clark 2000). This obviates the need for very costly and time-consuming iteration when setting design parameters of different components of the capital good. In fact, in modern production processes in the current information age, the line between production and design is often blurred. Products evolve rapidly through various versions as specialized producers implement incremental improvements. The rapidly growing literature on the science of product design (see Baldwin and Clark 2000 for an extensive treatment) unconsciously echoes in a very concrete way the more abstract ACT with its examination of what Austrians would call the inseparable connections between capital accumulation and technological change (Lachmann [1956] 1978; Lewin [1999] 2011) and the phenomenon of the enhanced productivity of wisely chosen roundabout methods of production (Böhm-Bawerk 1959) or, more recently, the increasing complexity of the capital structure (Lachmann [1956] 1978). These enhancements and complementarities offer opportunities for further research along these lines. In summary, we have established that underlying the physical form of machine and human, there lies an intricate structure of knowledge embodied in capital goods and complemented by the knowledge of how to use such goods in the minds of workers. The development of capital goods brings to bear increasing amounts of knowledge in the productive process over time. Economic growth and development entail the increasing complexity of knowledge, one aspect of which is the increasing ratio of knowledge to “stuff ” embodied in capital structures. We may refer to this as the complexification of production. It is this complexification that has given rise to the challenges of managing in the capital-using economy, including the familiar firm-boundary, agency, and hold-up problems (Lewin and Baetjer 2011).

The Organization of Production The ingredients of any production project are the (human and physical) capital assets in capital combinations, characterized by their economic heterogeneity and complementarity and also by their substitutability/specificity/adaptability in the face of change. The capital goods of an economy compose a structure within which exist a multitude of substructures. At each level, these structures are the result of planning and exogenous change. At the level of the economy, the capital structure is a result of the spontaneous workings of the market and interfirm contracts. Firm-level structures have to be

156    Macroeconomics and Monetary Economics carefully planned and maintained, although their adaptive mutations are governed by unpredictable, emergent knowledge phenomena. As discussed earlier, heterogeneity of capital resources is a reflection of the division of labor and knowledge, of the specialization of knowledge and function. As emphasized, different capital goods “know” how to do different and complementary things. Thus, the greater the degree of specialization, the more heterogeneous the capital structure. Furthermore, heterogeneous capital implies heterogeneous knowledge. And since the extent of the market and of economic growth is crucially related to the degree of specialization, heterogeneity will increase with economic growth and development, as will complexity. The greater the heterogeneity of resources, the greater the complexity of the organizational task. Organization of heterogeneous knowledge assets into productive combinations requires organizing ability and an organizational structure. The organizational structure of the firm can be thought of as an aspect of the firm’s general capital structure. The firm has “social capital” in the useful (knowledge-economizing) rules, customs, norms, and so on, that it develops. The value of its leadership lies in the ability of the leaders to organize complementary activities “through the creation of belief conditions that (at least) approximate common [homogeneous] knowledge” (Foss 2001, 357). So homogenization of the knowledge of both the “rules of the game” and the “aim of the game” is necessary for the efficient coordination of heterogeneous production knowledge. This homogenization provides the “constitution” within which the complex activities of the firm are carried out (Vanberg 1994). The organizational efficiency of the firm thus depends crucially on the functionality of this constitution, and the value of its leadership depends on the extent to which such a constitution can be successfully developed and accepted.

Modularity as Structure As knowledge becomes more complex (heterogeneous), advanced knowledgemanagement strategies can be expected to develop. Successful business ventures, involving more complex knowledge, can only occur if the complexities can be successfully handled. So the observation of such successes is a clear indication of the development of practical, advanced knowledge-management strategies. One of the most ubiquitous development strategies is increased modularization (Garud, Kumaraswamy, and Langlois 2003; Langlois 2002). Resource management requires structure. A structure can be described by a list of items that stand in a certain orientation to one another. Complex structures are composed of many items with many orientations and interactions. A structure, as opposed to a simple list of the structure’s elements, is distinguished by the fact that one can infer properties about the whole list from a description or observation of just a few component (or typical) parts together with an articulation of the principles of interaction—in other words, by abstraction (Tulloh and Miller 2006). Abstraction is an important strategy for economizing on knowledge about knowledge. Modules are

The Capital-Using Economy    157 self-contained substructures whose inner workings are hidden from the high-level observer (manager). Organizations (and their design and production activities) must be organized by deciding what managers need to know and need not know. They do need some knowledge of the knowledge of others. But what do we really know when we have knowledge about knowledge? We move to successive levels of abstraction (modularization) in order to economize on what we need to know. Yet the nature of knowledge as a phenomenon makes this very difficult. Knowledge of what we need to know about the knowledge of others is most complete when we share their knowledge, but this is precisely what we wish to avoid having to do. Successful management thus depends on finding the right level of abstraction—that is, knowing enough to make correct judgments about the deployment of assets (human and physical) that know more (about their specialized activities) than the managers do but not seeking to know so much as to tie up managers’ time and energies in the process of learning and understanding. The managers’ “big picture” must be accurate yet not too detailed. Easier said than done, yet this is a key element of successful organizational design.

Modularity and Outsourcing Another aspect of modularity is outsourcing, the delegation of a group of tasks culminating in a particular input product or service to a separate firm, thus adding an element to the supply network. This simplifies management and adaptation by raising it to a higher level (abstracting), managing by the emergent result and obviating the need to know about and deal with multiple production details and interactions. It also facilitates adaptation to change, by allowing a manager to plug firms in and out of the supply network—within the constraints of existing contracts—instead of having to reconfigure complex, often durable production processes. (Using “core suppliers” is perhaps an example of this.) This tendency to outsource, thereby creating additional supply firms, militates against the common tendency to simplify the supply network by reducing the number of suppliers that need to be managed directly or indirectly (Choi, Dooley, and Rungtusanatham 2001). It seems that both tendencies exist. The heterogeneity of supply firms may provide an explanation. Outsourcing may be particularly profitable in relation to complementary inputs, whereas reducing the number of suppliers may apply more to competitive supplier-firms. Information-age supply-chain management technology allows for less redundancy in supply-network relationships. As the production process becomes more complex, more complementary components are involved. Modularization by outsourcing is a natural way to reduce the complexity of management. But it is not always possible. As Richard Langlois has argued, when markets are thin and market-supporting institutions are weak, technological change, especially systemic change, leads to increased vertical integration, since in such an environment, centralized ownership and control may be necessary to ensure the integrity of the supply chain (e.g., Henry Ford); but when markets are thick (technology is diffused) and market-supporting institutions are well developed, technological

158    Macroeconomics and Monetary Economics change leads to vertical disintegration, since in that environment, the benefits of specialization and the division of labor outweigh the (now relatively smaller) transaction costs of contracting (Langlois 2012). This attention to market context explains the increasing trend toward vertical disintegration, an increasing complexity of the production structure and evolution of the institutional structure to handle it.

Macroeconomic Policy With the resurgence of Keynesian economic policy as a response to recent financial crises, echoes of past debates are being heard, in particular the debate from the 1930s between John Maynard Keynes and Hayek. Keynes talked about the “capital stock” of the economy. He argued that by stimulating spending on outputs (consumption goods and services), one can increase productive investment (adding to the capital stock) to meet that spending, thus adding to the capital stock and increasing employment. Hayek accused Keynes of insufficient attention to the nature of capital in production. Hayek pointed out that capital investment does not simply add to production in a general way but, rather, is embodied in concrete capital items. The productive capital of the economy is not simply an amorphous “stock” of generalized production power; rather, it is a very intricate production structure of interrelated complementary specific production items, as explained above. Stimulating spending and investment amounts to stimulating specific sections and components of this intricate structure. The “shape” of production gets changed by stimulatory spending. And given that productive resources are not free, this change comes at the expense of productive effort elsewhere. When “stimulus” spending is not guided by profit and loss feedback that signals how well a particular investment fits into the evolving capital structure, the pattern of production gets out of sync with the pattern of consumption, and eventually this discoordination must lead to a collapse. Productive sectors, such as telecom start-ups or residential housing, become “overbought” (while other sectors develop less), and eventually a “correction” must occur. Add this “distortionary” effect to the fact that the original stimulus must somehow eventually be paid for, and we have a predictable bust. The Austrian vision of capital, as described above, enters crucially into this story. The complex and intricate capital structure of the economy is partially organized, partially spontaneous (organic). Every production process is the result of some multiperiod production plan. Entrepreneurs envision the possibility of providing (new, improved, cheaper) products to consumers whose expenditure on them will be more than sufficient to cover the cost of producing them. In pursuit of this vision, the entrepreneur plans to assemble the necessary capital items in a synergistic combination. These capital combinations are structurally composed modules that are the ingredients of the industry- or economy-wide capital structure. The latter is the result, then, of the dynamic interaction of multiple entrepreneurial plans in the marketplace; it is what constitutes the market process. Some plans will prove more successful than others, some

The Capital-Using Economy    159 will have to be modified to some degree, and some will fail. What emerges is a structure that is not planned by anyone in its totality but is the result of many individual actions in the pursuit of profit; it is an unplanned structure that has a logic, a coherence, to it. It was not designed, and it could not have been designed, by any human mind or committee of minds. Thinking that it is possible to design such a structure or even to micromanage it with macroeconomic policy is a fatal conceit. As we have seen, the division of labor reflected in the capital structure is based on a division of knowledge. Within and across firms, specialized tasks are accomplished by those who know best how to accomplish them. Such localized, often unconscious knowledge could not be communicated to or collected by centralized decision-makers. The market process is responsible for discovering not only who should do what and how but also how to organize it so that those best able to make decisions are motivated to do so. In other words, incentives and knowledge considerations tend to get balanced spontaneously in a way that could not be planned on a grand scale. The boundaries of firms expand and contract, and new forms of organization evolve. This, too, is part of the capital structure broadly understood. For Austrians, there is no “capital stock.” Any attempt to aggregate the multitude of diverse capital items involved in production into a single aggregate number is bound to result in a meaningless outcome, a number devoid of significance. Similarly, the total of investment spending does not reflect in any accurate way the addition to value that can be produced by this capital stock. The value of capital goods and of capital combinations or of the businesses in which they are employed is determined only as the market process unfolds over time. It is based on the expectations of the entrepreneurs who employ them (the capital goods and workers and the combinations thereof), and these expectations are diverse and often inconsistent. Not all of them will prove correct—indeed, most will be, at least to some degree, proven false. Basing macroeconomic policy on an aggregate of values for assembled capital items as recorded or estimated at one point of time is foolish. What do the policy makers know that the entrepreneurs involved in the micro aspects of production do not? The folly is compounded by connecting capital and investment aggregates to total employment, under the assumption that stimulating the former will stimulate the latter. Such an assumption ignores the heterogeneity and structural nature of both capital and labor (human capital). Simply boosting expenditure on any kind of production will not guarantee adding to the employment of people without jobs. The current economy is characterized by both sizable unemployment numbers and job vacancies. Their coexistence is a result, in part, of a structural mismatch: the skills of the unemployed workers do not match those required to work with the currently unemployed specific capital items. This mismatch is often seen by Austrian economists to be the result of a credit-induced cycle, the Austrian business cycle. The solution, from this perspective, is to remove the distortions, to allow the market process to “restructure” production. This would mean a sustained period of consolidation in the distorted markets, not a policy that

160    Macroeconomics and Monetary Economics attempts to revive them. But then, policy makers seldom have the beneficial guidance of knowing ACT.

Conclusion Capitalist economies use capital in a fundamental way. But this is more than the simple mechanization of physical tasks. The accumulation of (physical and human) capital involves the generation and encapsulation of ever more specialized and complex production knowledge. Knowledge is the glue that holds the capital structure together. This has implications for an understanding of economic growth and development, economic organization, and macroeconomic policy. The connection between capital and knowledge opens up diverse areas of potential research. In the area of management studies, the recent interest in the role of the entrepreneur may be aided by a perspective that sees the entrepreneur as a capital organizer par excellence. This would likely lead to insights in strategic management, firm boundaries, economic organization, and related fields. And notably, the bourgeoning field of supply-chain networks bears a strong affinity to the view of a supply chain as a capital structure. The applications of Austrian ideas on capital to macroeconomic policy are numerous to the point of being repetitious. However, work always remains to investigate this at the empirical-historical level. Furthermore, variations on the theme of distortions in the capital structure, with greater institutional and historical detail, remain interesting.

Appendix: The Average Period of Production The average period of production may be succinctly expressed as follows: n



T = ∑ (n - t )lt t =1

n

∑l t =1

t

  n = n −  ∑ tlt N    t=1

where T is the average period of production for a production process lasting n calendar periods; t, going from 1 to n, is an index of each subperiod; lt is the amount of labor n

expended in subperiod t; and N = ∑ lt is the unweighted labor sum (the total amount of t =1

labor time expended). Thus, T is a weighted average that measures the time on average that a unit of labor l is “locked up” in the production process. The weights (n–t) are the distances from final output. T depends positively on n, the calendar length of the project, and on the relation of the time pattern of labor applied (the points in time t at which labor inputs occur) to the total amount of labor invested N. Since this formula is in units of time, it may be added across various processes to yield an overall measure of

The Capital-Using Economy    161 “roundaboutness.” In this way, Böhm-Bawerk hoped to have solved the problem of measuring roundaboutness. It should be clear that this formula does not allow for a unique or monotonic expression of roundaboutness. In other words, (a) this measure may yield a number that is consistent with an infinite number of input patterns, different amounts of labor time occurring sooner or later in the process; and (b) when considerations involving interest are included, this measure may not rise or fall uniformly in any ranking of roundaboutness as we add labor-time units at various points; it may change direction (in its ranking) at some points under certain conditions if we change the inputs at various points in the production process. These types of considerations played an important role in later criticisms of any attempt to measure capital in physical terms in the Cambridge-Cambridge debate. In the special case where there is an even flow of inputs so that the same amount of labor time l0 is applied in each period,

n

∑ (n − t ) l t =1

t

= 1 2 n (n + 1) l0 and

n

∑l t =1

t

= nl0 , and

therefore T = n/2 + 1/2 or simply n/2 (when n is large enough so that the 1/2 can be ignored or when T is expressed in continuous time where it is absent). So, when inputs occur at the same rate over time, each unit is “locked up” on average for half the length of the production period. The effect of compound interest can be seen as follows. If l units of productive inputs are applied in the first and second periods and if only simple interest is considered, then we may use the equation 21 (1 + Tr) = l (1 + 2r) + l (1 + r) where r is the rate of interest to solve for the unknown average period of production T. This gives 1.5 units, which is the same value as yielded by Böhm-Bawerk’s formula, (l + 2l) / 2l. Using compound interest, however, the equation changes to 21 (1 + r) T = l (1 + r) 2 + l (1 + r). If we solve this for T, we get T = (ln (2 + 3r + r2) − ln2) / ln (1 + r), which contains the rate of interest r, implying that no purely physical measure can be obtained (Lutz 1967, 20–21). Besides this problem, numerous others exist, such as the problem of measuring different qualities of labor inputs and the problem of accounting for the input of land (Lewin [1999] 2011, chap. 3). All in all, the notion of a viable quantitative time-based measure of the capital stock is a chimera, one that diverted attention from Böhm-Bawerk’s many valuable insights. Finally, the connection between capital theory and complexity studies remains largely unexplored.

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Chapter 8

Capital - Base d M acroec onomi c s Austrians, Keynes, and Keynesians John P. Cochran

Introduction The worldwide financial crisis accompanied by the recession that began in 2007 and the follow-up period of lingering stagnation which in the United States and Europe continues into 2015 have triggered a renewed interest in the economic analysis of John Maynard Keynes and the Austrian economists, most notably Ludwig von Mises, Friedrich A.  Hayek, and Murray N.  Rothbard. Previous clashes of these contrasting visions of control of the commanding heights of the economy and economic policy have, like this renewal of interest, coincided with major economic disturbances. While the first major skirmish was the Hayek-Keynes debate (Tieben 1997; Cochran and Glahe 1999; Steele 2001a; Wapshott 2011), the first English-language intellectual interaction between Keynes and the Austrians was Keynes’s short (three paragraphs) review (1914, 417) of Mises’s Theorie des Geldes und der Umlaufsmittel (1912). A second, 1924 edition of this work by Mises was eventually published in an English translation in 1934 with the title The Theory of Money and Credit. This is where Mises introduced Austrian business cycle theory (ABCT), which Hayek later developed. It was, in fact, Hayek’s introduction of ABCT to an English audience, his London School of Economics lectures subsequently published as Prices and Production ([1931] 2008), that was the target of Keynes’s (1931) attack on Hayek in a rebuttal of Hayek’s (1931a) review of the A Treatise on Money (Keynes [1930] 1971). The negative, almost dismissive tone of the review of Mises was a forerunner of much of Keynes’s later formal exchanges with The author wishes to thank Roger Garrison and David Sanz Bas for helpful comments and suggestions for improvement. The usual caveats apply.

Capital-Based Macroeconomics   165 Hayek. Compare Keynes’s comments on Mises and his biting summary of Hayek’s book. Concerning Mises, Keynes writes, “Dr. Mises strikes an outside reader as being the very highly educated pupil of a school once of great eminence, but now losing its vitality” (1914, 417; emphasis added). And: “One closes the book, therefore, with a feeling of disappointment that an author so intelligent, so candid, and so widely read should, after all, help one so little to a clear and constructive understanding of the fundamentals of his subject.” Relative to Hayek’s book, Keynes argues that it is “one of the most frightful muddles,” with “scarcely a sound proposition in it,” and “an extraordinary example of how, starting from a mistake, a remorseless logician can end in bedlam” (1931). How much of the above criticism of Mises would have been justified on a careful reading of the work and comprehension of the arguments one will never know, because the review is “superficial” (Laidler 1999, 137, n. 8) and contains no detailed discussion or specific critique, only generalities. A clue to why may be in a footnote to a passage in the Treatise where Keynes recognizes Knut Wicksell’s contributions and the development of a “neo-Wicksell” school in Germany and Austria, which includes works by Mises and Hayek. While crediting the approach as having a theory of the credit cycle fairly close to the theory of the Treatise, Keynes admitted that his limited knowledge of the German language was such that “in German I can only clearly understand what I know already!—so that new ideas are apt to be veiled from me by the difficulties of language” ([1930] 1971, 178, n. 2). The debate between Hayek and Keynes was viewed then and now (Wapshott 2011) as a major clash of ideas. While the actual debate focused mainly on contributions by Hayek that were available in English and Keynes’s Treatise, the debate is the foundation of much of the literature contrasting Austrian economics and the economics of Keynes as developed in The General Theory of Employment, Interest, and Money ([1936] 1973). To the extent that the IS-LM model captures key components of Keynesian thought, the contrast is stark. According to Laidler (1999, 49), “It would be difficult, in the whole history of economic thought, to find two bodies of doctrine which so grossly contradict one another.” Laidler’s contrast (1999, 49): (1) Keynesianism represented by IS-LM is static, while the passage of time is critical in Austrian analysis. (2) In IS-LM, “inadequate level of aggregate demand” (emphasis in original) is the source of depression, while for the Austrians it is an “inappropriate composition of the supply of output” (emphasis in original). (3) For the Keynesians, either monetary or fiscal policy can effectively relieve unemployment. Austrian theory, which does not dispute that policy, particularly monetary policy that includes public works financed by money creation, may temporarily reduce unemployment, argues that in the long run, either policy will only make matters worse by making employment even more unstable, more dependent on continuation of inflation (money creation), and unemployment will be potentially even higher in the long run (Ravier 2011; Hayek 1979, 11–14; Hayek 1978a, 192–196, 205, 211–212; Steele 2005, 10). And (4) The Keynesian framework suggests that without policy, the economy “is likely to remain in depression.” In contrast, the Austrian view is that inaction is the best path to recovery. The road to recovery is to “avoid government interference with the depression, and thereby to allow the depression-adjustment process to complete

166    Macroeconomics and Monetary Economics itself as rapidly as possible, and thus restore a healthy and prosperous economic system” (Rothbard [1963] 2000, xxix). Hayek (1978a, 210–212; 1979, 15–17) offered caveats that, in some circumstances, authority must be given discretion to prevent a secondary deflation, and in extreme situations, low-wage public-works projects may be justified; however, market adjustments ultimately provide the best assurance of eventual recovery. The main exchanges of the original debate were Keynes (1931; [1931] 1973), Hayek (1931a; 1931b; 1932a; 1932b), and Sraffa (1932a; 1932b). In addition to the formal exchanges, Hayek and Keynes engaged in a personal correspondence, much of it now available in The Collected Writings of John Maynard Keynes (Vol. 13, 257–266). The debate, at least the direct engagement between the main protagonists, effectively ended with Keynes’s letter of March 29, 1932, in which Keynes writes, “I doubt if I shall return to the charge in Economica. I  am trying to re-shape and improve my central position, and that is probably a better way to spend one’s time than in controversy.” Hayek perhaps felt the same way (Caldwell 1998, 563–564). However, traces of the debate lingered in the later writings of both main participants, with Hayek ([1941] 1975, chaps. 25–27, especially 369–380) and Keynes ([1936] 1973, 182–184, 192–193, 320–324, 328–329, 376) the most representative. After the publication of the General Theory, which Hayek never formally reviewed (Caldwell 1998; Wapshott 2011), and the apparent triumph of Keynesianism, Hayek’s The Pure Theory of Capital ([1941] 1975) was virtually ignored. The Pure Theory was an attempt by Hayek to provide theoretical foundation for an eventual fully developed theory of a money-production economy to compete with Keynes’s “general” theory. Sadly, the whole debate became a mostly forgotten side note in the history of economic thought (Hicks 1967). What was lost? Backhouse and Laidler (2004, 46) sum it up nicely: “With the eclipse of Austrian Economics in the 1930s, a key perspective on the importance of the economy’s supply side in economic fluctuations was lost.” By ignoring that current investment has an impact on not just the size but also the composition of the future capital stock, Keynes and IS-LM Keynesians, to an even greater degree, lost sight of key insights developed most fully by the Austrians but also by Keynes’s English contemporaries, such as Robertson (Blackhouse and Laidler 2004; Laidler 1999), that “mistaken investment decisions made in the present had a capacity to disrupt future equilibria between supply and demand” in either the economy as a whole or in key sectors. As the formal debate ended, Hayek’s influence waned considerably even before the release of the Pure Theory. While this decline was partly a result of his apparent inability to effectively respond to Sraffa (1932a and 1932b), the unfamiliarity of the English world with Austrian capital theory, and the buzz around the development of the General Theory and its ultimate publication, as suggested by Coase (1982, 11) and Laidler (1999, 50), the key factor for the decline in influence was the above-mentioned policy pessimism. The Austrian model, if correct, left little room beyond possible monetary policy actions to avoid a secondary deflation for those “in charge” to actively and effectively do something to manage an economy in depression in beneficial ways. Hayek’s productivity did not decline in this period. The first edition of Prices and Production (1931) was followed by a second expanded edition in 1935. Monetary Theory

Capital-Based Macroeconomics   167 and the Trade Cycle, an English translation of Hayek’s earlier foundational work in German (1929), probably commissioned in response to Keynes’s footnote in the Treatise about his inability to understand arguments in German, was released in 1933. Hayek not only worked on the Pure Theory, but he continued to develop, in both English and German, his exposition of ABCT, expanded his debate with Sraffa on capital theory to an exchange with Frank Knight, engaged the English-speaking world in the socialist calculation debate, and begin developing what is often referred to as Hayek II (Hutchison 1981; Milgate 1982), his work on knowledge and society. Hayek II and his work on calculation developed from his attempts to make ABCT more accessible to an audience not familiar with Austrian-Wicksell capital theory. Despite this enormous output, many have questioned why Hayek didn’t review the General Theory (Caldwell 1998; Wapshott 2011). There are two more important questions related to the topic of this chapter. First, did Hayek take the changes in Keynes’s approach to money and macroeconomics into account in his later relevant cycle writings? The answer appears to be yes, if one carefully reviews Hayek’s writings during the 1930s. Many of the cycle-related works were collected in Profits, Interest, and Investment ([1939] 1975). Often, these works were, rather than systematic developments, piecemeal responses to critics and/or attempts to deal with issues raised by Keynes. David Sanz Bas recently made this point in very strong terms: “there is a criticism by Hayek of the General Theory that is scattered throughout his work after 1936, that, to a certain extent, has remained unnoticed. This criticism is very consistent and addresses Keynes’ theory from different angles. Indeed, in my opinion, Hayek presented very strong arguments against the principles on which the crowning work of Keynes rests” (2011, 307). These works by Hayek are now more easily accessed in Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard (2008); The Collected Works of F. A. Hayek, Vol. 9, Contra Keynes and Cambridge Essays and Correspondence (1995); and The Collected Works of F. A. Hayek, Vols. 5–6, Good Money parts I and II (1999). Hayek’s last formal attempts, prior to the 1970s, to deal with the more technical aspects of ABCT were part IV of The Pure Theory of Capital ([1941] 1975) and “The Ricardo Effect” ([1942] 1948). Both, like Profits, Interest, and Investment ([1939] 1975), included direct responses to issues raised by Keynes in the General Theory. While not reviewing the General Theory may be viewed in hindsight as a lost opportunity, given Hayek’s high volume of output during this period, it was possibly seen at the time as a low-value, high-cost opportunity. Hence, the project was most likely not undertaken, as suggested by Bronfenbrenner, Emmett, and Marcuzzo but discounted by Caldwell (1998, 558, n. 11), because “no one asked.” This would be certainly consistent with today’s academic culture. Book reviews can be time-consuming, generally with limited impact and reward. Time in controversy is much better spent doing exactly what Hayek did, writing books, book chapters, and journal articles. The relevant second question is whether it would have made any difference if Hayek had reviewed the General Theory or devoted more time to complete an explicitly anti-General Theory book. Given how little impact Hayek’s cycle writing did have (and the long-run importance of some of what he did contribute instead, such as “Economics and Knowledge” [1937]

168    Macroeconomics and Monetary Economics 1948) during this time, the answer is most likely no. The intellectual tide was clearly in favor of policy activism. Many leading economists provided negative reviews of the General Theory, such as Viner and Knight (Hazlitt [1960] 1995), with little impact. Soon thereafter, Hayek further lost influence as a professional economist with the publication of The Road to Serfdom ([1944] 1996). Keynes’s reading of the book resulted in a letter to Hayek (Keynes 1980, 385–388) that Wapshott (2011) says revealed strong sympathy and philosophical agreement but to Rothbard (2010, 57) was nothing more than a comment in “a polite note to a causal friend” followed by detailed criticism. Keynes wrote: “In my opinion it is a grand book. We all have the greatest reason to be grateful to you for saying so well what needs so much to be said. You will not expect me to accept quite all the economic dicta in it. But morally and philosophically I find myself in agreement with virtually the whole of it; not only in agreement with it but deeply moved agreement” (1980, 385). The letter also clearly exposed a major difference relative to how far Keynes would expand coercive control of the economy relative to Hayek (Rothbard 2010, 57), and even more so relative to many modern Austrians (Block 1996), to “save” capitalism and remnants of classical liberalism (Wapshott 2011, 189–206). After stating that what was needed was not a change in economic policy but an enlargement of them, Keynes writes: “Dangerous acts can be done safely in a community which thinks rightly and feels rightly, which would be the way to hell if they were executed by those who think and fell wrongly” (1980, 387–388). Knowledge and calculation problems pose no serious barrier to right-thinking, pragmatic actions, especially actions including a low-interest-rate monetary policy to continue a quasi-boom and more direct measures to maintain investment spending at right levels ranging from deficit-financed public works during a lack-of-confidence-induced cyclical downturn to outright socialization of investment to reduce involuntary unemployment.

Keynes G. R.  Steele, in a summary of his book on Hayek and Keynes (2001), asks:  “In the recent history of economics:  Who are the most significant economists? What are the most significant events? Which are the biggest theoretical and policy issues?” He answers: “Prime candidates are: John Maynard Keynes and Friedrich Hayek, The New York Stock Exchange crash and the Great Depression, capital theory and problems of the money economy.” In his view, “Keynes and Hayek inspired the economic controversy of the twentieth century: the role of the state, and of money and interest rates in an advanced capitalist industrial economy.” Steele contrasts Keynes and Hayek and by extension the Austrians as: Keynes points to high interest rates, low asset values and a negative wealth effect as the principle causes of a slump. By contrast, Hayek points to a system extended

Capital-Based Macroeconomics   169 beyond its full-capacity by low interest rates and high investment yields. Where Keynes argues that under used capacity is symptomatic of deficient aggregate demand, Hayek viewed under used capacity as symptomatic of inappropriate investments and of a demand for consumption goods that is too pressing to allow the completion of investments in current gestation. (Steele 2001b)

A subtheme of Cochran and Glahe (1999) is that a common feature of Austrian capital-structure-based macroeconomics and the economics of Keynes is that both were attempting to model a modern monetary production economy where major disruptions were possible in such economies because of issues related to time and money. The Austrian framework, like Keynes’s model, was a clear alternative to Keynes’s caricature of the “classical model” and the modern macroeconomic variants of the new classical economics including equilibrium business cycle models, real business cycle models, and the new Keynesian models. Keynes, especially in the Treatise, appears to be linked to the Austrians by a “Wicksell connection” (Leijonhufvud 1981, 131–202; Cochran and Glahe 1999, 21–30). In monetary theory, the common connection was that money changes, whether endogenous or exogenous, work first through the banking system, affecting credit availability, interest rates, the saving-investment balance, and intertemporal economic activity. Laidler (1999) demonstrates, however, that there were developments in monetary theory in England during the 1920s, notably by Arthur Cecil Pigou, Dennis Robertson, Frederick Lavington, and Keynes, that had much in common with the analysis of Wicksell and the Austrians but most likely developed independently and absent the capital theory foundation. This “Wicksell connection,” which emphasized time-related coordination failures, is readily apparent in the Treatise, is less so in the General Theory, and becomes irrelevant in IS-LM-based Keynesianism. While Leijonhufvud (1981, 169–73) argues the Wicksell connection is not totally abandoned by Keynes in the General Theory and is, in fact, important for understanding the key ways in which Keynes departed from quantity-theory-based analysis of a money-using economy, Backhouse and Laidler (2004, 48, n. 23) argue that “the General Theory, along with IS-LM, is an important contributor to the suppression of these ideas about time.” Garrison notes that it is Leijonhufvud’s (1981) “makeover of Keynesian theory” that “preserved the critical insights into interest-rate dynamics that Keynes once borrowed from Knut Wicksell (but later returned)” (cited in Cochran and Glahe 1999, vi), not the General Theory. Keynes in the General Theory reinforces Backhouse and Laidler and Garrison: I am now, no longer of the opinion that the concept of a “natural rate” of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is just the rate which will preserve the status quo; and in general, we have no predominant interest in the status quo as such. If there is any such rate of interest which is unique and significant, it must be the rate which we might term the neutral rate of interest, namely the natural rate in

170    Macroeconomics and Monetary Economics the above sense which is consistent with full employment, given parameters of the system; though this rate might be better described, perhaps, as the optimum rate. (Keynes [1936] 1973, 243)

While Keynes’s verbal analysis in the General Theory continued to emphasize the role of investment, interest, and money in determining output and employment, his abandonment of the natural rate concept masked the intertemporal coordination issues at the heart of fundamental economic problem, made it easier to ignore the important capital theory issues involved in the original Hayek-Keynes debate, and facilitated the morphing of the economics of Keynes into the IS-LM single macroeconomic output aggregate Keynesianism. Relative to most quantity theorists, old or new, and most modern macroeconomists who model the economy with a single-aggregate production measure, Keynes, even in the General Theory, continued to stress the importance of the distribution of production and resources between present uses, or consumption, and the future-oriented uses, or investment. The single-aggregate approach makes it nearly impossible even to recognize intertemporal coordination problems. Keynes does recognize potential problems. But a major factor differentiating Keynes from the Austrians is Keynes’s lack of any well-defined capital theory compared with the Austrian use of structure of production capital theory, a capital-structure-based macroeconomics (Cochran and Glahe 1999, 103–118; Horwitz 2011). Hence, “In the judgment of the Austrians, Keynes disaggregated enough to reveal potential problems in the macro economy but not enough to allow for the identification of the nature and source of the problems and the prescription of suitable remedies” (Garrison 2001, 226). Accordingly, Leijonhufvud (1981, 173)  argues that Keynes’s wording ([1936] 1973, 243)  where he dismisses the concept of a natural rate in the General Theory is of current interest to macroeconomist “because it reinforces the impression one gets from his controversy with Hayek, namely, that he had given very little thoughts to the problem of capital and growth theory.” The hardest part of comparing or contrasting Keynes and other competing models of the economy, whether Austrian, Keynesian, monetarist, or new classical, is determining exactly what Keynes’s message was. Much of this analysis will rely on Garrison (2005 and ­chapters 7, 8, and 9 of 2001) for an interpretation of Keynes. This interpretation will be used to contrast with an Austrian or capital-structure-based macroeconomics. Keynes’s critique of capitalism is multipronged. His broad concern was with factors that could reduce employment, especially by creating involuntary unemployment (Keynes [1936] 1973, 15–17). The factors that most impede the expansion of employment to its maximum level are related to time, interest, and money. What follows is Garrison’s (2001, 186–187) three-part summary of Keynes’s critique of capitalism. Keynes’s critique is a “comprehensive account of the involuntary unemployment associated with the capitalist system.” First, “Capitalism has a lower level of employment than socialism,” with socialism “meaning simply capitalism minus its faults.”

Capital-Based Macroeconomics   171 According to Garrison, this employment gap is the “most fundamental component of Keynes’s involuntary unemployment.” This level of employment would only be reached if policies could be enacted that would have the effect of a euthanasia of the rentier (Keynes [1936] 1973, 374–377). At the next level, a fetish for liquidity in the absence of a real-cash balance effect, which in Keynes’s opinion often (always?) plagues a capitalist economy, has “a lower level of employment than capitalism-atits-best.” For Keynes, without proper policy, this capitalism-at-its-best outcome would happen only by chance and only if investor expectations were correct and the interest rate was at the natural rate, defined as the rate consistent with equilibrium growth (Leijonhufvud 1981, 173). Finally, there is a cycle-related component. In a capitalistic economy, periodic collapses in confidence and hence in investment demand reduce the demand for labor, which may partially be “mitigated by bidding down the wage rate” and is the “least fundamental component of involuntary unemployment” (Garrison 2001, 186–187). Keynes’s framework is clearly set out in the title of his magnum opus. The level of employment in a money-production economy is what is to be explained. Employment is determined by interest rates through their influence on investment spending. Interest rates, through a fetish for liquidity, are determined by money. Keynes’s diagnosis of capitalism’s chronic problem is that “Employment is low because Interest is kept high because Money is the object of a fetish” (Garrison 2001, 171; emphasis in original). Market mechanisms for dealing with the dark forces of time and uncertainty operate such that markets, instead of having a tendency to track a high-employment equilibrium, reach high or full employment only by accident. Market mechanisms are modeled as mechanical responses of broad aggregates to external shocks, not as price and quantity adjusting to interactions between acting human beings. Setting aside for a moment the Keynes ideal of full employment in a socialist economy, a complete absence of involuntary unemployment, employment levels associated with capitalism at its best would occur only if (1) business expectations about expected future returns on investment in plant, equipment, and inventories were “correct”; (2) the investor or rentier class had absolutely no fetish for liquidity, so that the market interest rate equaled Keynes’s neutral rate or optimum rate ([1936] 1973, 242) or the “natural rate” defined as the rate that would equate savings and investment at level of income consistent with high employment; and (3) the real wage was correct. Why full employment by accident? Assume that an economy at a capitalism-atits-best employment level is disturbed by a fetish for liquidity. The market rate of interest will increase so that the market rate exceeds the neutral rate. Investment would decline, even with correct expectations, to a level below that necessary to ensure high employment. Quantity and income adjust so that saving declines until saving equals investment at a lower level of income. Employment falls, and involuntary unemployment increases. The real (and, given the price level, the money wage) wage rate is correct, but involuntary unemployment has increased beyond capitalism-at-its-best levels. Reductions in the money wage might increase employment somewhat, but without a return of the

172    Macroeconomics and Monetary Economics money interest rate to the neutral rate, employment will remain persistently below the previous level (Leijonhufvud 1981; Garrison 2001). Markets subject to a fetish for liquidity are thus likely to suffer persistent, secular involuntary unemployment, unemployment not caused by a real wage that is too high. The problem could be masked or magnified by cyclical elements. Fluctuations in employment occur around this too low secular trend. Since the future is essentially unknowable, long-term expectations and hence expected returns on investment fluctuate with swings in “animal spirits.” Expectations underlying the marginal efficiency of capital schedule are not likely to be correct. Keynes’s trade cycle (Keynes [1936] 1973, 313–320; Garrison 2005, 509–513) is driven by swings in the marginal efficiency of capital schedule. Downturns result from undue pessimism, which reduces planned investment at the given interest rate. Lower investment reduces income and employment. Downturns may be prolonged and have higher levels of unemployment than warranted by the depressed investment-demand schedule, as the same factors that induce pessimism may also increase the desire for liquidity. Investment demand may be further retarded by an interest rate even farther above the “natural rate” or neutral rate (Garrison 2005, 512). Booms, in this scenario, occur when expectations of returns are optimistic. More investment is deemed worthwhile at any given market rate of interest. Higher investment leads to higher income and a higher demand for labor with increased employment. During periods of exuberance, employment might even increase beyond capitalism-at-its-best levels. “A boom is a situation in which over-optimism triumphs over a rate of interest which, in cooler light would be seen to be excessive” (Keynes [1936] 1973, 322). Economic activity fluctuates not around a norm of full employment but around the lower levels of employment associated with the secular unemployment consistent with an underlying fetish for liquidity. Booms temporarily mask the underlying problem of secular involuntary unemployment. For Keynes ([1936] 1973, 322), “The remedy for the boom is not a higher rate of interest but a lower rate of interest. For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.” Keynes ([1937] 1973, 121)  himself summarized his theory of why “output and employment are so liable to fluctuation” in very similar terms: “given the psychology of the public, the level of output and employment as a whole depends on the amount of investment.” His more detailed list of factors determining employment: (1) “the propensity to hoard”; (2) “the policy of the monetary authority as it affects the quantity of money”; (3)  expectations on the yield of capital assets; (4) “the propensity to spend”; and (5) “social factors” influencing the money wage. However, it is investment that is most likely to be volatile, because the factors that determine investment are “influenced by our views of the future about which we know so little.”

Capital-Based Macroeconomics   173

Austrian Monetary Theory and Capital-Structure-Based Macroeconomics The foundation of the Austrian boom-bust cycle theory is a general principle of monetary theory known as Cantillon effects (Thornton 2006). Monetary changes/shocks alter spending patterns, including both real spending and spending on classes of assets. These temporary spending-pattern changes affect relative prices and hence the pattern of use of productive resources. Monetary changes thus temporarily misdirect production and create a potential future economic crisis. When the monetary shock ends or fails to accelerate, the misdirection of production and the accompanying “existence of discrepancies between the distribution of the demand among the different goods and services and the allocation of labor and other resources among the production of those outputs” (Hayek 1979, 25) will be discovered, and resources will have to be reallocated to uses more consistent with underlying real factors. With Cantillon effects, the allocation of resources and the valuation of assets (bubbles) are shaped by nonneutral monetary changes. Two empirical generalizations contributed to the Austrian emphasis on the importance of the capital-structure approach in analyzing the macroeconomy. In a fractional reserve banking system, especially one supported by a central bank, money creation can be accompanied by credit creation. Credit may be made available in excess of available savings as banks extend loans to entrepreneurs. The money and credit creation process reduces interest rates relative to equilibrium rates (Garrison 2006b). The new pattern of money expenditure directs resources into more labor-saving and “roundabout” methods of production. In addition, a market rate below the natural rate may provide an incentive for reduced saving (higher consumption). The lower interest rate used as a discount factor combined with an inflation-induced illusion of higher expected profits creates a “wealth” or “net worth” effect which artificially increases consumption expenditures during the money-induced boom (Salerno 2012). Modern Austrian capital-structure-based macroeconomics, while derived from Mises, Hayek, and Rothbard, is most completely developed in the work of Roger W. Garrison. Garrison’s Time and Money (2001) is in many ways the book Hayek should have written in response to Keynes and other critics of ABCT. Garrison not only provides a clear explanation of business cycle phenomena, but his work extends the analysis beyond the traditional focus of the cycle. He shows how a capital-based macroeconomic model can be a useful tool to analyze other important macroeconomic topics such as budget deficits and financing of public-sector expenditures, tax reform, risk and bubbles, and the boom-and-bust cycle in developing nations. As discussed earlier, Garrison presents an Austrian interpretation of Keynes. He also provides a useful framework for comparing other competing and/or complementary macroeconomic theories

174    Macroeconomics and Monetary Economics such as Milton Friedman’s plucking model or real business cycle models. Like the Hicks-Hansen development of the economics of Keynes into IS-LM, Garrison’s graphics provide a pedagogy that is useful from a basic principles to a graduate level of instruction. The capital-based approach is unique in macroeconomic modeling, as it is a seamless macroeconomics of the short run, the medium run, and the long run, particularly when compared with current mainstream analysis, which lacks a medium run and has long-run and short-run models that are often in conflict (Garrison 2001, 3–5; Sechrest 2001; Cochran 2001). Unlike Hayek, who, in response to critics of Prices and Production, attempted to develop a comprehensive theory of capital ([1941] 1975) which he hoped would be a foundation for further investigations into the dynamics of a money-production economy, Garrison (2005, 489–498; 2001, 33–56) argues that if combined with two other simple but useful models of economic activity, a production-possibility frontier and a loanable-funds theory of the interest rate, Hayek’s earlier simpler Austrian model of an intertemporal structure of production is more than up to the task of leading us to a better understanding of how markets can work, the “marvel of the macro economy” (Garrison 2006a), and to an understanding of why and how markets get out of whack. This structure of production approach (Lewin 1999; Hayek [1931] 2008, 242; Garrison 2001, 45–49) emphasizes important but too often overlooked features of a capital-goods-using economy. These features are keys to understanding why prices are so fundamental to any endeavor by acting humans to solve the economic problem properly understood. Markets, prices, and calculation are the fundamental tools by which individual planning can most effectively overcome the unknowable future. Individual planning operates best in the “ ‘real present,’ that never ending sequence of ‘given situations’ which is created by purposive entrepreneurial evaluation of past experience and forecasting of the future and in which all action is initiated and all human life is lived” (Salerno 1993, 119). Individual planning, not central planning, best takes advantage of the knowledge of time and place. The key features are: 1. “Means are employed to achieve ends and those means are temporally prior to the corresponding ends” (Garrison 2005, 476). 2. The important relative price for intertemporal coordination is the “value differential that separates stages of production” (Garrison 2005, 477). For Austrians, this rate of return is the “natural rate” to which the market or loan rate must ultimately adjust (Rothbard [1960, 1970] 2004, 1003–1004, n. 112). 3. The Austrian analysis operates at a “lower level of aggregation” than Keynes’s model. Both Austrian and Keynes’s analyses are at a lower level of aggregation than IS-LM, monetarist, and “classical” models using a single production aggregate (Garrison 2005, 485). 5. Both the magnitude and the direction of investment spending matter for macroeconomic activity and coordination. Two important influences affect the magnitude and direction of investment at the margin: derived demand, which is the main element in Keynesian analysis, and the time discount factor. Derived demand has

Capital-Based Macroeconomics   175 more impact on late stages of investment demand, while the time-discount factor dominates early-stage development (Garrison 2005, 486–489; Garrison 2001, 61–67; Hayek [1939] 1975). 6. Capital goods must continuously be replaced. 7. The Austrian perspective as represented by a structure of production indicates that future-oriented spending is a much larger portion of current economic activity than represented by national income and product accounts (Cochran and Glahe 1999, 107–117). Investment, as measured by product and income accounts, greatly understates the role of capital or future-oriented expenditures in the economy. Hayek ( [1931] 2008, 156) raised the point in his criticism of the writings of Foster and Catchings (1923, 277; 1925; 1926; 1927, cited in Hayek 2008, 136, nn. 1–4). Expenditures on “raw materials, semi-finished products and other means of production” greatly exceed “the value of consumption goods that are simultaneously offered in the markets for consumption goods” (emphasis added). Hayek ([1929] 2008, 155–156), in support of his argument, cites work by M. W. Holtrop, based on data developed by I. Fisher and the NBER, showing that for 1912, the sum of money payments was “more than twelve times larger than the sum of all money incomes” (Hayek ([1929] 2008, 156, n. 43). Mark Skousen ( [1990] 2007, xi–xxxix) provides an excellent summary. Sudha Shenoy (2007) provides historical examples of these complex investment chains. 8. Not explicit in the model but of extreme importance, market processes are the result of actions by planning individuals, and all economic phenomena must be explainable in terms of such actions/adjustments on the margin. The focus should be microeconomics, not macroeconomics. Macroeconomics, analysis based on causal relationships in terms of broad aggregates, is inappropriate and misleading (Hayek [1966] 1978, 284, 285, 289; Cochran and Glahe 1999, 10, n. 8). Capital-based business cycle theory is a boom-bust framework and traces the cause of a bust back to the boom. The theory is best interpreted as a theory of the upper turning point and origin of the crisis. The downturn is the ultimate consequence of malinvestment and overconsumption, which develops as a direct result of credit creation and market interest rates artificially below the natural rate generated by central bank policy (Garrison 2004; Cochran 2010; Salerno 2012). The crisis following a created-credit-induced boom is often a consequence of saving generated sustainable growth and unsustainable growth spawned by credit creation (Garrison 2009). Central bank policy prevents the interest rate brake from more efficiently allocating resource use across time (Hayek [1933] 2008, 47; Cochran and Glahe 1999, 185; Garrison 2006a). Whereas Keynes ([1936] 1973, 322) argued that the key to sustaining economic growth and avoiding the trade cycle is active demand-management policies to keep “us permanently in a quasi-boom,” in a capital-based macroeconomics framework, sustainable growth is market-driven growth. Investment exceeds depreciation and is financed by saving (Garrison 2001, chap. 3). The growth is sustainable because it is consistent with tastes and preferences and resource availability. Regardless of its actual rate, such growth

176    Macroeconomics and Monetary Economics should be of no concern to policy makers in general (Garrison 2005, 482), particularly monetary policy makers concerned with growth as a trigger of inflation. Sustainable growth in a sound money environment or under a monetary policy regime following a productivity norm should be accompanied by declining prices (Selgin 1997; Salerno 2003; Steele 2005). Growth becomes unsustainable when it is not consistent with underlying tastes and preferences and resource availability; that is, it is policy-induced growth. Unsustainable growth develops when the mix of output shifts toward investment relative to consumption without a corresponding change in time preference. Capital-based macroeconomics emphasizes how interactions among money, credit, and investment set up conditions for unsustainable growth and explains why conditions of unsustainable growth generate cycles in economic activity. The model can explain a long-run growth trend (and changes in the trend), fluctuations around the trend (cycle phenomena), and the associated greater variability in investment relative to total output and consumption that is consistently picked up in economic data series. In addition, the capital-based approach of the Austrian theory can explain why an expansionary demand-side policy shock, even during periods of recession and recovery, can be destabilizing (Ravier 2011; Mises 1998, 576, 792; Hayek [1939] 1975). Vedder and Gallaway (2000) provide empirical evidence that historically, countercyclical policy has in fact been destabilizing. The change in the spending pattern caused by a monetary policy that lowers the market rate relative to the natural rate should lead to a change in the pattern of resource use (Garrison 2001, 64–67; Garrison 1996; Bellante and Garrison 1988; Sechrest 2006). Resources are switched from production for the immediate future to production for the more remote future. Both the level and the type of investment change. Because of the time-discount effect, investment projects on the margin are started that will when complete be both more roundabout and more productive. Disposable income for resource owners, however, increases as entrepreneurs bid resources away from alternative uses and/or draw resources from idleness and leisure where available. Factor owners with more disposable income have not only no reduced demand for consumption goods but most likely a more intense demand for consumer goods (Salerno 2012). Full employment (and possibly overemployment) may exist, but equilibrium does not (Garrison 1996). The boom phase of the cycle and the crisis or bust are marked by dueling structures of production or dueling triangles, which clearly illustrate the misdirection of production generated by the monetary shock (Cochran 2001, 19; Garrison 2001, 67–77; Garrison 2005, 503–509). Malinvestment develops in the lengthening of the structure of production because of the time-discount factor (increased early-stage investment) at the same time as overconsumption and overinvestment occur in later stages because of wealth and derived demand effects. The crisis or bust occurs in the intermediate run. The new pattern of investment is not consistent with a more immediate delivery of consumption goods. A relative undersupply of consumption goods will be made evident as resource constraints and bottlenecks become apparent. The developing new time structure of production cannot be completed and maintained without an increase in savings (reduced time preference). In the absence of increased saving, relative prices must

Capital-Based Macroeconomics   177 change to reflect the underlying real factors and tastes and preference. Entrepreneurs were attempting to do more than the available resources will allow. In the process, capital may actually be consumed rather than created (Ravier 2011, 369; Salerno 2012, 30–36). The onset of the crisis may or may not be accompanied by a higher market rate of interest. In the absence of an increase in market rates of interest, adjustments will be driven by the Ricardo effect (Hayek {1939] 1975, 10; Hayek [1942] 1948; Hayek [1969] 1978; Moss and Vaughn 1986). It is more likely that the rate of interest and credit availability will play a significant role in ending the boom and precipitating a crisis: “investment cycles typically end in a credit crunch, with a comparatively sudden and simultaneous financial ‘crisis’ for numerous firms” (O’Driscoll and Rizzo 1985, 210). As the boom progresses, entrepreneurs will need progressively larger increases in the supply of money credit to continue the process of building the new structure of production in the face of increasing relative demands for consumer goods and increased competition for available resources. The increased demand for credit needed to maintain the new proportions, the less liquid positions of banks, and/or a tighter monetary policy by a central bank fearful of the effects of inflation should cause the market rate of interest to increase. Both the form and the quantity of investment will change again. The time-discount effect or Ricardo effect and direct-demand effect will lead to investment patterns shifting toward shorter processes, in less durable goods and in less labor-saving capital goods. Demand for inputs in these “shorter” processes will intensify, but at the same time, demands for inputs in longer, more durable, or more labor-saving processes will decline. The net demand for inputs in investment industries will decrease (Hayek [1941] 1975, 387; Garrison 2001, 67–77). Layoffs and idle capacity will develop in these industries. Thus, market adjustments and/or a credit crisis will eventually reverse the initial effects of the artificial expansion of credit and money. As explained by Mises (1998, 40), “But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a ‘crack-up boom’ and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis.” The downturn follows in either instance. The crisis can be complicated by a “secondary deflation,” which should be viewed as not the “original cause of a decline in business activity” (Hayek 1978a, 206) but as a consequence of possible reactions to the unfolding crisis. The secondary deflation could develop in several ways, including a solvency cum money and debt deflation problem (Bordo and Lane 2010), which would negatively affect the money supply and money-spending stream, a money demand/liquidity problem reducing the money-spending stream through velocity changes, including monetary aggregate changes from a buildup of reserves held by financial institutions (Bordo and Lane 2010; Salerno 2012, 37–38). A Keynesian income-constrained reduction in aggregate demand and spending is also a possible secondary consequence of the initial crisis complicating policy responses (Hayek 1978a, 210; Garrison 2003; O’Driscoll and Rizzo 1985). Here Austrians policy views differ. To

178    Macroeconomics and Monetary Economics one group, Mises (1998), Salerno (2003; 2012), Rothbard ([1963] 2000), or Hayek of the 1930s, a secondary deflation is a necessary part of the correction process. As explained by Mises, (1998, 568–569) and summarized by Salerno (2012), the “secondary deflation” is categorically distinct from a monetary deflation, for it is not the cause of a protracted recession-adjustment period but its essential consequence and cure. But the later Hayek (1978a, 206 or 210)  and many modern Austrian monetary disequilibrium theorists (Horwitz and Luther 2011) see a secondary deflation as something that must be prevented to keep a minor bust from turning into a prolonged crisis and depression. The recession is the corrective phase of the cycle; market forces have begun to reassert themselves. Once a crisis has begun, policy makers must walk a fine line. If market processes are not interfered with by price rigidities and/or other government interferences, the recession that follows the crisis should be a procedure that eliminates and corrects the past errors and malinvestments (Rothbard [1963] 2000, xxix; Cochran 2010). Vedder and Gallaway (1993; 1997) and Anderson (1949) provide arguments and evidence that the 1920–1921 crisis fits the recovery-without-interference model, while Kuehn (2011) provides a Keynesian perspective. The Great Depression is interpreted by Austrians as a crisis followed by significant interference in the pricing system accompanied by monetary policy mistakes contributing to a secondary deflation (Rothbard [1963] 2000). More recently, Cole and Ohanian (1999) and Prescott (1999) have looked at the Great Depression from the perspective of neoclassical growth theory and come to similar conclusions: employment remained low because “labor market institutions and industrial policies changed in a way that lowered normal employment” (Prescott 1999, 29) While conceding that measures may have to be taken to prevent a deflation or decline in the money-spending stream, responses are complicated, because expansionary policies in the recession and early recovery phase of the cycle may be counterproductive in the long run (Ravier 2011; Hayek 1978; Hayek 1979; Steele 2005). The measures may succeed in the short run but only by setting up conditions that generate even more instability by creating more and more employment whose continuation depends on further monetary or fiscal stimulus (Hayek 1978a, 192–194). Despite disagreement on what might be the best policy after a crisis has developed and in clear contrast to Keynes’s analysis, the more disaggregated capital-based model implies unambiguously that the time to prevent a crisis is during the boom (Cochran 2010). Extensive malinvestment and overconsumption needs to be prevented if persistently high unemployment is to be prevented. The way to avoid extensive malinvestment and overconsumption is to avoid money and credit creation.

Conclusion The common ground between Austrian capital-based macroeconomics analysis and the economics of Keynes is the presumption in common to all “Wicksell connection” theorists, “the notion that the ‘Dark Forces of Time and Ignorance’ as Keynes put it,

Capital-Based Macroeconomics   179 will make intertemporal economic activities the most difficult to coordinate and that the saving-investment problem, therefore, was the most likely place to start looking for the key to macroeconomic instability” (Leijonhufvud 1981, 201). However, as observed by Hicks (1967, 204), Wicksell plus Keynes said one thing, Wicksell plus Hayek quite another. With his newfound emphasis on quantity adjustments and effective demand as drivers of employment, Keynes abandoned any connection to Wicksell and, with it, any role for savings in determining the rate of interest. No market mechanism was left to facilitate intertemporal coordination. However, Keynes did maintain the focus on investment and the difficulties associated with intertemporal coordination as the place to look to explain economic instability. It was unfortunately a short step from Keynes of the General Theory to the adoption of a single production aggregate IS-LM by Keynes’s followers. With a single production aggregate, intertemporal coordination quickly disappears from the stage. Following the 2007–2008 financial crisis, there has been a renewed interest in the Austrian approach, because both the dot-com boom/bust and the housing market bubble and crash preceded by a period in 2003–2004 where the Fed kept interest rates too low for too long and thus led to a “boom and an inevitable bust” (Taylor 2008) appear to fit Austrian explanations of boom and bust. A renewed interest in Keynes was triggered by the thoroughly Keynesian policy response to the same events (Wapshott 2011, 293). Even though the effectiveness of the policy response is an open question (Cogan and Taylor 2011), Wapshott (2011, 295) uses the policy response not only to inappropriately and prematurely declare Keynes the clear winner but also to credit Keynes and Keynesianism with saving capitalism from itself and the ideas of the Austrians “twice in eighty years.” A  more balanced new look at the Hayek-Austrian-Keynes dynamic relative to understanding the continuing intellectual and political battle over the virtues of a free market and government intervention is provided by John Papola and economist Russell Roberts. They have recently popularized the differing views on the virtues of markets and individual planning versus government intervention and more centralized planning as crucial for understanding the current economic stagnation and policy debate in two excellent and entertaining music videos: “Fear the Boom and the Bust” (http://econstories.tv/2010/06/22/fear-the-boom-and-bust/) and “Fight of the Century” (http://EconStories.tv). The contrast is relatively clear. Keynes is macroeconomics. Key causal relationships between broad aggregates can be discovered and exploited for policy purposes. Demand is emphasized as the driver of economic activity, and supply-side considerations are neglected, if not totally ignored. An economics of scarcity is replaced by an economics of abundance. Keynes argues that the market system, under institutions of modern finance, is unable, except by accident, to effectively coordinate intertemporal economic activity. The problem is both secular and cyclical. With the failure to coordinate intertemporal activity, a market economy unaided by policy will fail to generate consistently high levels of employment. This failure could lead to the collapse of capitalism and the associated liberal order. Active policy and management of the economy, including some selective elements of central planning by right-thinking people, is a necessary

180    Macroeconomics and Monetary Economics prerequisite for saving capitalism from itself. Monetary authorities must be freed from past institutional constraints. Effective monetary policy would operate to keep interest rates in normal times sufficiently low to overcome a fetish for liquidity. In periods of business pessimism, rates might be pushed even lower by the monetary authority and private investment supplemented by public works. Some socialization of investment would be desirable. Tax policy could be used if overheating became a problem to control inflationary pressures. Davidson (2009) provides a blueprint for modern interpretation of a Keynesian path to prosperity. For Austrians, the analysis should be in terms of microeconomics. An economy is populated by acting human beings. There are no causal relationships between broad aggregates. The level and direction of economic activity depends on and is ultimately coordinated as individuals adjust plans in response to changing market prices and changing expectations about the future. In general, such planning does generate the “marvel of the macroeconomy.” The interest rate, if not distorted by central bank activity, facilitates coordinating intertemporal economic activity. Sustainable economic growth can and does occur. Economic fluctuations can and do occur as shocks affect the economy à la real business cycle activity. Such adjustments are a normal part of economic activity. However, the norm is often sustainable growth accompanied by unsustainable growth, because money is the loose joint. Money and credit creation cause boom-bust patterns in economic activity and are thus a source of economic instability. The best way to create greater economic stability is to prevent boom-bust cycles and associated secondary deflation-related problems. Monetary institutions should create a monetary environment that facilitates the flow of saving into investment without interest-rate distortions. Given a central bank and fiat money, policy should aim for constancy or stabilization of the money-spending stream (White 2008). While not entirely adequate, because the spending stream associated with the structure of production is much broader than nominal gross domestic product, a nominal GDP-targeting policy may be the best available practical alternative. Such a policy may be better but less than ideal. Selgin, Lastrapes, and White (2012) question whether the Fed has been an effective institution. A monetary institution framework sans a central bank such as a gold-based free-banking system may be even more effective in eliminating boom-bust patterns in economic activity (White 2011). Horwitz and Luther (2011), Garrison (2009), and Cochran (2011) provide Austrian views of the causes of the recent Great Recession, which include elements of ABCT and capital-based macroeconomic policy and reform suggestions. Wapshott sees Keynes and his policy recommendations as ultimately conservative, aimed at saving the system from revolution, socialism, and totalitarianism. Wapshott (2011, 296) quotes Galbraith: “Keynes was exceedingly comfortable with the economic system he so brilliantly explored. So the broad thrust of his efforts … was conservative; it was to help ensure that the system would survive.” The thrust of much of Hayek’s work and of work by the Austrians was to argue that Keynes’s analysis was flawed and his policy, rather than ensuring the survival of the system, would be mostly unnecessary and, if applied consistently, would destabilize, not stabilize, the system. Keynes’s comment in the preface to the German edition of the General Theory—“Nevertheless,

Capital-Based Macroeconomics   181 the theory of output as a whole which is what the following book purports to provide, is much more easily adaptable to conditions of a totalitarian state”—should give pause to any liberal considering adoption of the “social philosophy [and policies] towards which the general theory might lead” as a way to save a classical liberal order and market system from itself. Robert Skidelsky (quoted in Wapshott 2011, 285), one of Keynes’s biographers, observed, “Hayek was defeated by Keynes in the economic debates of the 1930s, not, I think, because Keynes ‘proved’ his points, but because, once the economy had collapsed, no one was very interested in the question of exactly what had caused it.” Maybe this time around, the interest will rightly turn not only to after-the-fact policy actions but also to cause and prevention. Here Austrian analysis has much to offer.

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Chapter 9

Austrian Bu si ne s s Cycle Th e ory A Modern Appraisal Andrew T. Young

Introduction According to the National Bureau of Economic Research (NBER), the fourth quarter of 2007 witnessed the end of nearly seven years of economic expansion in the United States and the beginning of what is now known as the Great Recession. The economy was rocked by financial crisis in 2008. By the NBER’s reckoning, economic activity contracted for a year and a half. The unemployment rate reached a high of 10.6 percent and, as of this writing, remains at 8.2 percent.1 Furthermore, if discouraged workers and part-time workers who would prefer to have full-time jobs are taken into account, US unemployment stands at about 15.6 percent. While the NBER dates the beginning of an expansion to the third quarter of 2009, real GDP growth has proceeded at an annualized rate of less than 0.9 percent in 2011.2 Federal Reserve chairman Ben Bernanke felt confident in June 2010 that a “double dip” would not occur: “My best guess is that we’ll have a continued recovery [though] it won’t feel terrific.” However, by October 2011, he was testifying to Congress that “the recovery is close to faltering.”3 I thank Chris Coyne, Peter J. Boettke, and Steve Horwitz for helpful comments on a previous draft. Errors are inevitable and invariably my own. 1  According to the Bureau of Labor Statistics for June 2012: http://www.bls.gov/news.release/empsit. nr0.htm. 2  This statement is based on initial real GDP numbers published by the Bureau of Economic Analysis on September 29, 2011. These number, of course, will be subject to (what may be economically significant) revision as time passes. 3  “Bernanke: No Double-Dip Recession” (http://www.nytimes.com/2010/06/08/business/08fed. html?_r=0); “Bernanke Urges Obama and Congress to Do More for Economy” (http://www.nytimes. com/2011/10/05/business/economy/fed-chief-raises-doubts-on-recovery.html?ref=bensbernanke).

Austrian Business Cycle Theory    187 The anemic nature of the recovery—if one can even call it that—comes as no surprise to students of the Austrian business cycle theory (ABCT). In light of the exceedingly loose monetary policy beginning in 2002 (Taylor 2009) and the massive expansion of the mortgage market by Fannie Mae and Freddie Mac, their intuitions suggest that a policy-induced expansion of credit resulted in a misallocation of resources across economic structures. Such a situation can be rectified only through a reallocation of resources into sustainable structures via markets. For students of ABCT, it is no wonder that the Fed’s new discounting facilities have failed to reflate the economy. The ineffectiveness of the Troubled Asset Relief Program (TARP) and the separate $168 billion and $787 billion congressional stimulus packages also come as no shock.4 However, while Austrian insights apply generally to business cycles, ABCT’s most prolific modern expositor, Roger W. Garrison (1994; 2001, chap. 6), argues that different variants of the theory are appropriate to specific business cycle episodes. For example, while what I  will refer to as the canonical variant of ABCT—developed by Ludwig von Mises (1934; 1963) and Friedrich A. Hayek (1933; 1935)—focuses on policy-induced changes in the intertemporal structure of production, Garrison argues that changes in the risk structure of production were more relevant to the 1990–1991 US recession: Like the time-consuming production processes that were out of line with time preferences, speculative loan portfolios that were out of line with risk preferences generated an artificial boom in the 1980s that belonged to the same general class as that of the 1920s. However, the distinction between economic activities that are excessively speculative—together with some institutional considerations—allows us to see systematic differences between the 1930s and 1990s. (Garrison 1994, 15)

While the canonical variant of ABCT was developed to account for the unsustainable boom of the 1920s and the subsequent Great Depression, for the business cycle experiences of the 1980s and 1990s, “Parallels can be found not in the strict sense of a replay but in the broader sense of variations on a theme” (Garrison 1994, 8).5 The purpose of this chapter is twofold. First, I argue that the US experience from roughly 2002 through the present is, in a general sense, an Austrian boom-bust cycle but that Austrian economists have largely cast the episode in terms of the anachronistic canonical model. Second, I articulate a specific variation on the ABCT theme that more closely accounts for recent events in the United States. This variant incorporates two key elements absent from the canonical variant: (1) the risk externalization of debt issued by 4  It is easy to forget just how many new Fed facilities came into existence in the aftermath of the crisis: Term Auction Facility (2007); Term Asset-Backed Securities Loan, Primary Dealer Credit, Commercial Paper Funding, and Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facilities (2008); Money Market Investor Funding Facility (2009). 5  Compare Garrison’s analyses with those of Hughes (1997), and Cwik’s (1998) comment on that paper, and Cochran and Yetter (2004). Cochran and Yetter explicitly evoke Garrison’s (2001) analytical framework but only to the extent that it exposits the canonical ABCT. Empirical studies based on data that cover the 1980s and 1990s also largely motivate their analyses in terms of the canonical ABCT (e.g., Young 2005; Keeler 2001; Mulligan 2002; 2006).

188    Macroeconomics and Monetary Economics the government-sponsored entities (GSEs), Fannie Mae and Freddie Mac; and (2) the continuous input–continuous output nature of the housing market. The externalization of GSE debt casts the Federal Reserve in a supporting (indirect) role in fostering the boom.6 The continuous input–continuous output nature of housing implies that the cycle features symmetric distortions of the risk and time structures of both production and consumption. I set about my task as follows. First, I briefly describe the canonical variant of ABCT against which what follows can be juxtaposed. Next, I argue that a correct accounting of the recent US business cycle must incorporate the role of the GSE mortgage giants in reallocating resources to the housing market. In particular, I highlight the continuous input–continuous output nature of the housing market and the Treasury’s and the Fed’s supporting roles in externalizing the risk associated with GSE debt. I then develop a variant of ABCT that expands on Garrison’s (2001) graphical framework, followed by a brief concluding discussion.

ABCT: The Canonical Variant ABCT provides a coherent story of a boom-bust cycle that is a consequence of credit inflation by a central bank (Mises 1934; 1963; Hayek 1933; 1935). The theory starts from a hypothetical equilibrium in the time structure of production and then derives the predictable results of a central bank disrupting that equilibrium.7 The canonical ABCT came to prominence when Mises’s Theory of Money and Credit was translated into English in 1934, and it was refined and presented to English-speaking audiences by Hayek (1933; 1935) upon his arrival at the London School of Economics. Hayek’s refinement and exposition of Mises’s theory were tailored to account for the Great Depression and the preceding boom in the 1920s. Prominent economists such as Gottfried Haberler (1932; 1937) and Lionel Robbins (1934), who adopted much of the 6 

Garrison (1994; 2001, chap. 6) stresses the risk externalization associated with federal debt finance as the direct cause of the 1980s boom; the Federal Reserve plays the supporting role by making default risk on treasuries effectively zero via its ability to monetize the debt. In the variant of ABCT developed below, both the US Treasury and the Fed play supporting roles in externalizing the risk associated with GSE debt. 7  Wagner (1999, 66) argues that “the Austrian cycle theory has no place within the confines of a general equilibrium theory.” He advocates a through recasting of the theory in the “corpus of coordinationist macro theory,” with its focus on the emergence of “spontaneous order.” I am sympathetic to this criticism but ultimately feel that equilibrium theory is a convenient way to summarize the tendencies resulting from individuals’ actions in the business cycle context. The variant of ABCT elaborated on below will be a general equilibrium analysis. Block (2001) criticizes Wagner’s “attack” (64) on ABCT. However, a close reading of Block reveals that he focuses on what Wagner claims are implications of ABCT conditional on taking general equilibrium analysis too seriously. In other words, while Wagner’s article aims at “saving the wheat while discarding the chaff ” of ABCT, Block replies that “we have no chaff ” (63) and then proceeds to criticize precisely the chaff.

Austrian Business Cycle Theory    189 Austrian perspective, further entrenched the discussion, unsurprisingly, in the context of the Great Depression. When these authors looked at the events preceding the Great Depression—and in particular, the policy environment under which the events unfolded—what exactly did they see? As Garrison (1994, 9) comments, “the 1920s were characterized by (relatively) tight fiscal policy and loose monetary policy”; furthermore, “the money growth rate peaked near the end of the decade as the Federal Reserve attempted with increasing resolve to keep the boom going” (7). It is little wonder, then, that the canonical ABCT focuses on the (1) time structure of production, (2) the potential for credit inflation to disrupt the relative prices of current versus future goods, and (3) a misallocation of resources across more versus less time-consuming production processes. Any discussion of the original Mises-Hayek ABCT begins with the observation that the production of goods and services is time-consuming. Resources will pass from firm to firm as they are fashioned from raw materials into intermediate goods and then finished goods. (Even if only a single firm is involved, internal production is still time-consuming.) The finished goods themselves may be consumption goods or capital goods. If they are capital goods, they will be used in the production of yet other goods, and that will also take time as well. Production is always time-consuming. Whether it is more or less so will depend on available technologies and the preferences of consumers for various goods and services. Concerning technologies, Eugen von Böhm-Bawerk ([1888] 1959, Vol. 2, 12)  built Austrian capital theory on the “proposition that the adoption of roundabout methods of production leads to greater returns from the production process.” He considered this one of the “most important and fundamental tenets of the whole theory of production”:  more roundabout (i.e., time-consuming) production methods tend to be more productive.8 To use a well-trodden example from economics (Rothbard 1962, 50), Robinson Crusoe can catch fish using only his hands. He will be more productive if he uses a net. However, he must take time to fashion a net from nature-given resources before he can use it. While more roundabout production methods tend to be more productive, it is also true that people value time; they discount the future. 9 Implied, then, are trade-offs for consumers between more goods later (that are ceteris paribus less valuable) versus 8  See Buechner 1989 for an argument that Böhm-Bawerk did not equate roundaboutness and time-consuming in his analysis. I am unaware of much modern debate among Austrian economists on this point. However, for my purposes, I only contend that Mises, Hayek, and their followers proceeded as if he did equate the two. 9  Rather than assuming that more roundaboutness processes “tend to be” more productive, as a technological fact, Rothbard provides the following reasonable interpretation that is a sufficient foundation for what follows: “The first processes to be used will be those most productive … and the shortest. … No one has maintained that all long processes are more productive than all short processes. The point is, however, that all short and ultraproductive processes will be the first ones to be invested in and established” (1962, 537–538). It follows, then, that any more roundabout production processes that are actually invested in and employed will be more productive than the less roundabout processes in use. This is precisely because people discount the future (which is a fact of human action).

190    Macroeconomics and Monetary Economics fewer goods sooner (that are valued more). This creates profit opportunities for certain individuals—entrepreneurs—who are particularly savvy in ascertaining and acting on consumers’ perceptions of these trade-offs. Entrepreneurs are successful, in general, when they demonstrate “alertness to hitherto undiscovered opportunities” (Kirzner 1973, 31). In doing so, of course, market prices are indispensable. When dealing with intertemporal trade-offs, market interest rates embody the relative prices of goods sooner versus those only available later. Entrepreneurs “discover discrepancies between the present prices of the complementary factors of production and the anticipated prices of the products minus the rate of interest” (Mises 1963, 547). On a given market for finance, a higher (lower) interest rate signals a higher (lower) price for current goods relative to those for future goods and a higher (lower) time preference on the part of the marginal consumer.10 Interest rates are determined on markets where entrepreneurs recognize the potential for higher productivity via more roundabout methods. They must obtain funds from savers who prefer goods today to goods in the future. Since individuals’ saving decisions imply their consumption decisions, the market interest rates will tend toward expressing the trade-off between the productivity gains from waiting and consumers’ time preferences. But as in any other market, if prices are regulated or otherwise manipulated by policy to not accurately express relevant trade-offs, surpluses and shortages will develop. Funds will be allocated in ways that are inconsistent with consumers’ time preferences and the available technologies. Consider what happens when a central bank increases the growth rate of an economy’s money supply, inflating credit and lowering interest rates below their free-market, natural rates (Wicksell [1898] 1936). To entrepreneurs, this is a signal that the supply of savings has increased; consumers have become more willing to exchange goods today for goods in the future. Entrepreneurs respond by undertaking more roundabout ventures—those to produce future goods, the demand for which entrepreneurs expect to manifest in the future. (Entrepreneurs are led to believe that people are saving more now so that they can increase their demand for goods later.) This represents the boom phase of the ABC. The boom creates discrepancies between the investment plans of entrepreneurs and the plans of consumers. In particular, planned investments outstrip planned savings. Of course, at any given time, more resources cannot be invested than are available. However, planned investments are projects that are pursued and completed over time. They involve both higher-order and lower-order goods, terms that Austrian economists use in reference to, respectively, goods applied during earlier and later stages of production (Menger [1871] 2007). The fact that the higher-order goods associated with an 10 

The time preference component of interest rates is stressed in the canonical version of ABCT. This is what Mises (1963, 526) refers to as “originary interest”: “the ratio of the value assigned to wanting satisfaction in the immediate future and the value assigned to wanting satisfaction in the immediate future.” The risk premium component of interest rates is given attention in the account of the 1990–1991 recession and preceding boom offered by Garrison (1994; 2001, chap. 6).

Austrian Business Cycle Theory    191 investment are available today does not necessarily imply that the lower-order goods needed to complete the investment will be available tomorrow. During the boom. entrepreneurs reallocate resources toward more roundabout production processes with more stages of production. As the planned investments begin, the credit inflation places cheap money into the hands of entrepreneurs. The lowered interest rates signal to entrepreneurs that consumers are more future-oriented, that they are willing to forgo enough resources to complete investments in more roundabout production processes. Since the new money enters the economy specifically through the entrepreneurs’ purchases of higher-order goods, the prices of those goods rise relative to the prices of lower-order goods (both consumption and investment goods).11 This supports entrepreneurs’ interpretation of the lower interest rates. There are neither indications that consumers’ time preferences have not fallen nor indications that the planned investments cannot be affordably completed. However, a bust is inevitable as entrepreneurs continue to pursue roundabout production processes to produce future goods for which no demand exists. As investments continue, this generates income for the producers of higher-order goods. Of course, their time preferences have not really changed, and they express their demand for consumption (lower-order) goods. This leads to increases in the prices of those lower-order goods, and this effect is exacerbated by other entrepreneurs stepping forward to meet that demand, increasing their own demand for lower-order investment goods. Suddenly, the indications that consumers’ time preferences have not actually fallen and that the completion of roundabout production methods will not actually be affordable rear their heads.12 The turn from boom to bust finds entrepreneurs who had initiated investments in more roundabout production methods in a “tug-of-war” with consumers (Garrison 2005, 32). Entrepreneurs are attempting to call upon resources to complete roundabout processes aimed at the production of future goods; consumers are calling for more resources to be devoted to satisfying their demands for current goods. Cochran (2001, 19) refers to this conundrum as one of “dueling production structures.” Ultimately, entrepreneurs cannot profit by acting contrary to consumer preferences.13 Resources must be reallocated toward less roundabout production processes. As the prices of lower-order goods rise, the completions of investments begun during the boom are realized to be unprofitable. Those incomplete investments are 11  When the effect of new money on the economy is a function of the specific individuals, firms, industries, and so on, that are the initial recipients, this is referred to as a Cantillon effect, after the eighteenth-century economist Richard Cantillon. Recently, Thornton (2006) has argued that Cantillon is the intellectual forefather of ABCT. 12  This development could, in principle, be put off by an acceleration of the credit inflation by the central bank. However, Austrians hold (quite reasonably) that if ever-accelerating inflation is needed to maintain the boom, the well-known ills associated with hyperinflation will manifest and put an end to the efforts of even the most determined central bank. 13  Regarding a market economy, no one makes this point more forcefully and consistently than Mises ([1958] 2009, 23–24): “economic power is ultimately vested in the hands of the buying public of which the employees themselves form the immense majority.”

192    Macroeconomics and Monetary Economics abandoned (along with the jobs that had been associated with them). The reallocation of resources to a sustainable time structure is painful (i.e., there is a great deal of real value lost), because that structure is complex, with capital components that are heterogeneous and largely particular-process-specific (Lachmann [1956] 1978). The higher-order capital goods put in place during the boom are not straightforwardly placed in less roundabout production processes. Costly liquidation is an inevitable part of the bust.

The Need for a New Variant on the ABCT Theme The canonical variant of ABCT was developed in a particular historical context. That it can be, without modification, applied in other contexts is a heroic assumption.14 Applying an ABCT to a given business cycle episode may involve adding additional elements to the canonical model, such as Hayek’s ([1970] 1996 explicit discussion of labor market institutions. Alternatively, it may call for a more fundamental change in perspective, such as Garrison’s (1994; 2006, chap. 6) shifting of focus from the time structure of production to its risk structure. While several authors have provided Austrian analyses of the recent US business cycle, they have attempted, to too great an extent, to fit that cycle into the mold of the canonical ABCT. Unfortunately, the fit is not entirely flattering. The boom of the early and mid-2000s was particularly (and dramatically) pronounced in the housing/mortgage market. I will argue that two important aspects of this housing-centered boom and subsequent bust have not been adequately addressed in the ABCT literature: (1) that the risk associated with the secondary mortgage market was externalized by the GSEs with the support of the US Treasury and the Federal Reserve; (2) that housing, relative to other goods, is associated with a high degree of roundaboutness in consumption. The risk externalization associated with the mortgage market has not been adequately addressed in the Austrian literature. This has led, in my view, to an unacceptably monolithic focus on Fed-based inflation of the monetary base that while appropriate for the 1920s and 1930s, seems out of place in the context of the 2000s. Also, the ABCT literature has not adequately bridged the gap between the changes in the time structure of production stressed by the canonical variant and the changes in the risk structure that seem more relevant to the Great Recession. 14  This is not to say that the statements of the canonical ABCT are not “true” statements derived from the axiom of human action. (I am not claiming that they all are, either. For an example, see Hülsmann 1998 for a criticism of, and attempted rectification of, the Mises (1934) ABCT as being founded on a lack of “prudent attitude” toward credit inflation on the part of entrepreneurs, which is not a universal of human action.) Rather, certain true statements about human action my undoubtedly not be particularly important for understanding a given episode.

Austrian Business Cycle Theory    193 While risk externalization has not been adequately addressed, the high degree of consumption roundaboutness in housing has been, to my knowledge, entirely ignored. I argue that a key to understanding the severity of the Great Recession lies in the recognition that distortions in both the time and risk structures of production were accompanied by symmetric distortions in the time and risk structures of consumption. Below, I consider just a couple of examples of Austrian analyses of the recent US business cycle.15 Both are important and insightful pieces, but they are also representative of how more needs to be done to elaborate a specific ABCT appropriate to the recent cycle.16 Prychitko (2010, 200) claims that “the Austrian theory of the cycle is already fit to explain” the onset of the crisis.17 The usual suspect of “an injection of credit” (212) is rounded up, but as for why this credit found its way disproportionately into the housing market, Prychitko offers only: “The housing bubble developed between 2001 and 2006 when the Fed lowered the federal funds rate and government agencies (through the Community Reinvestment Act and other devices) encouraged and targeted credit towards the housing industry in particular” (215). Prychitko does not elaborate on how credit was targeted. There is no mention of the externalization of risk generally or in that specific sector of the economy. The canonical variant stresses that credit inflation ends up, broadly, in the hands of entrepreneurs and that given lower-than-natural interest rates, they pursue more roundabout production methods. There are two problems with fitting this canonical story to the recent episode. First, during the boom, mortgage rates were not actually low relative to rates in other financial markets. Figure 9.1 plots thirty-year conventional mortgage rates and Aaa corporate bond yields from 1990 through 2001. During the boom, these two rates tracked each other closely; if anything, starting in 2004, the mortgage rate rose relative to the corporate yield and remained high until the crisis began to unfold. If a greater supply of credit was simply “targeted” to a particular sector, then, all else equal, rates would have been relatively low in that sector. Furthermore, is there any reason to think that housing production is particularly roundabout relative to, say, a given manufacturing industry? In Young (2012), I attempt to use data from the Bureau of Economic Analysis (BEA) input-output (IO) tables to classify US industries (during the 1998–2009 time period) in terms of their roundaboutness. I argue that the value of total industry outputs used by a given industry, taken as a fraction of that given industry’s value added, will be proportional to its stages of 15  To avoid awkward and wordy phrasing, whenever an author offers a discussion of the recent business cycle propounding ABCT as an (accurate) explanation, I refer to the author as “Austrian.” I do so with apologies to any such authors who do not brand themselves as such. 16  Other Austrian analyses of the recent cycle include White 2009; Boettke and Luther 2010; Callahan and Horwitz 2010; and Horwitz 2011. 17  Prychitko is primarily concerned with evaluating Hyman Minsky’s financial instability hypothesis versus ABCT as interpretive models for a bust—a “Minsky moment.” Prychitko’s discussion of the competing hypotheses is compelling, his conclusion convincing: financial crises are more fruitfully viewed through an Austrian, rather than a Minskyan, lens.

194    Macroeconomics and Monetary Economics 12.00

10.00

8.00

6.00 MORTG AAA

4.00

2010-09-01

2008-07-01

2009-08-01

2007-06-01

2006-05-01

2005-04-01

2004-03-01

2002-01-01

2003-02-01

2000-12-01

1998-10-01

1997-09-01

1995-07-01

1996-08-01

1994-06-01

1993-05-01

1991-03-01

1992-04-01

1990-02-01

0.00

1999-11-01

2.00

Figure 9.1  Thirty-year conventional mortgage rates and Aaa corporate bond yields, 1990–2011. Note: Data are from the Federal Reserve Board of Governors. Bond yields are Moody’s seasoned Aaa corporate bonds.

production.18 Construction does not rank among the most roundabout industries; real estate ranks among the least roundabout (Young 2012, table 3). In this way, the canonical variant of ABCT seems an awkward fit to the recent cycle. Horwitz (2010) provides another Austrian analysis of the recent cycle. He begins his discussion by acknowledging that “although theoretical propositions are universally valid, they provide only the framework of a full historical explanation. In applying theory to specific historical episodes, Austrians recognize that the particular details of each episode may vary in important ways, even as the outlines of the episode conform to the pattern identified by the theory” (2010, 101). Horwitz then correctly highlights the importance of the GSEs and the “implicit promise of government support” that allowed the “market for mortgage-backed securities … to tolerate a level of risk that truly free markets would not” (103). The “marginal effects of the Community Investment Act” (104) are also alluded to. While Horwitz (2010, 102) provides details concerning the “set of policies that artificially reduced the costs and risks of home ownership,” he does not elaborate on the links 18 

The intuition is that relative to value added, the counting up of gross outputs used en route to that value added involves double counting. (Think of the expenditures approach versus the value-added approach to counting up GDP that we teach in principles of macroeconomics classes.) Assuming that rates of return tend toward equalization across sectors, more stages of production will, all else equal, be associated with more double counting while summing up gross outputs used.

Austrian Business Cycle Theory    195 between the Fed and the Treasury that gave the “implicit promise” bite and allowed for risk to be externalized across taxpayers broadly.19 As I argue below, the Fed’s explicit ability to monetize Fannie and Freddie debt, along with the Treasury’s mandate to purchase that same debt, was fundamental to distortions in the risk structure of both US production and consumption. Regarding the latter, Horwitz also does not consider the importance of consumption roundaboutness in the housing market. In a notable paper on the recent US cycle, Salerno (2012, 3)  does “extend the [ABCT] analysis of the effects of the central bank’s manipulation of interest rates … to household choice among intertemporal consumption patterns.” This is a welcome contribution, especially in light of criticisms that ABCT is unable to account for the positive co-movement between consumption and investment spending during the cycle (e.g., Krugman 1998, Cowen 2008, and DeLong 2008). However, Salerno (2012, 16) focuses on how a depressed interest rate “misleads households into a falsely optimistic appraisal of their real income and net worth that stimulates consumption and depresses saving.” These wealth effects are complementary to but also different from the effects of policy on the time structure of consumption that I am emphasizing.

The GSEs and the Housing Market My call for a new variant of ABCT rests on the institutional, policy, and market particulars associated with the historical context of the recent US cycle. Here I  briefly document these particulars, drawing heavily on my recent writing on the GSEs’ role in precipitating the housing boom, the financial markets crisis, and the Great Recession (Young 2010) The Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Corporation (Freddie Mac) factored critically into the housing boom and subsequent bust. These GSEs were chartered by the US Congress, separately, to provide liquidity in the mortgage market by creating a secondary market for those loans. They became dominant participants in the US secondary mortgage market during the quarter-century leading up to the Great Recession. By that time, they had about $5.5 trillion in obligations (bonds and credit guarantees), accounting for about half of US residential mortgage debt (Frame 2008, 127). To put this in historical perspective, in 1980, Fannie and Freddie accounted for only about 7 percent of mortgage debt (Frame and White 2005, 162).20 19  In a separate paper, Horwitz and Luther (2011, p. 77) appear to be more dismissive of the importance of risk externalization vis-à-vis the canonical story of credit inflation: “The underlying reason for these errors, regardless of where they would turn up, was too-easy monetary policy.” 20  Frame and White (2005) and Frame (2008) both provide excellent reviews of the histories, activities, and institutional characteristics of Fannie and Freddie, and I draw extensively from those sources below.

196    Macroeconomics and Monetary Economics Source of Funding

Bonds

Investors

Money

Swap Programs

Raise funds to Securitize; purchase mortgages provide credit and MBSs guarantee

Mortgages

Originators MBSs

Fannie and Freddie Secondary Market Institutions

Mortgages

MBSs Money

Cash Programs

Hold MBSs and mortgages as assets

Originators Money

Cash Programs

Figure 9.2  GSE activities.

Operating on the secondary market, Fannie and Freddie do not—nor legally can they—originate mortgages. Rather, the GSEs deal in selling, buying, and securitizing mortgages. Mortgages are mostly originated by depository institutions such as commercial banks and savings and loans, and also by mortgage companies. The activities of the GSEs can be broken down into swap programs and cash programs. (Figure 9.2 provides an illustrative flow chart for what follows.) The former of these involves an originator, which provides a GSE with a pool of mortgages in exchange for a marketable mortgage-backed security (MBS). The MBS is based on the same promised future payments represented by the pool of mortgages. However, the GSE guarantees the payments for a fee, about twenty basis points on the principle of the mortgage pool (Frame and White 2005, 160). The originators retain the MBSs on their portfolios, while a GSE carries the default (credit) risk of the underlying loans. In 2008, the GSEs’ combined net credit guarantees on these swaps amounted to about $3.7 trillion. The GSEs also purchase mortgages and private-issue MBSs for their own portfolios. The sources of mortgages and MBSs for cash program outright purchases are originators and investment banks. In the case of the latter, private financial institutions purchase mortgage pools from originators and securitize them. The resulting MBSs are what the GSEs subsequently purchase. The GSEs can subsequently sell out of that portfolio to other private market participants. Similar to private financial institutions, Fannie and Freddie have two basic sources of funds with which to make their mortgage and MBS purchases: debt and equity. The GSEs have traditionally been highly leveraged; in 2008, their book equity was less than 4 percent of their total assets (Frame 2008, 126). Fannie and Freddie’s primary source of funds is the issue of debt for purchase by investors. The activities of the GSEs involve considerable risk, as one would expect given their involvement with long-term loans to finance long-term real assets. This risk stems from the one sector of the economy in which the GSEs operate: the housing/mortgage market.

Austrian Business Cycle Theory    197 However, this risk was (and continues to be) externalized across taxpayers generally. While Fannie and Freddie’s debt obligations were not explicitly backed by the federal government during the boom, market participants believed that they were implicitly backed. This perception was founded on what the Federal Reserve and the Treasury were explicitly authorized to do in regard to the GSEs. The Treasury had the authority to purchase up to $2.25 billion of their securities. This authority amounted to a line of credit from the federal government—a line that existed previous to the GSEs being taken into conservatorship in September 2008 and formally bailed out. The GSEs’ debt was also classified as US government securities. In addition to being “stamped” as if they were Treasury securities, this also meant that they were eligible for purchase by the Fed during its open market operations. Simply put, the Fed could monetize the GSEs’ debt if it so chose. That this resulted in market participants not bearing the risk associated with the housing market was evidenced by the twenty-five to thirty basis point advantage that Fannie and Freddie enjoyed on their debt issues (Ambrose and Warga 2002; Nothaft, Oearce, and Stevanovic 2002). The risk associated with the financial and underlying real assets did not just disappear during the boom. It became implicit in the liabilities of the Treasury and the Fed; it became the burden of the US taxpayer. Interest rates in the mortgage market and the quantities of mortgages and real estate and housing did not reflect that risk. Likewise, taxpayers took on the risk not as a result of their individual choices based on their individual risk tolerances but rather based on policy. This policy was encouraged by a series of legislative and oversight-based innovation from 1992 through 2004. These included the 1992 (ironically named) Federal Housing Enterprises Financial Safety and Soundness Act, which established targets for credit to “low- to moderate-income” and “special affordable” households and “underserved areas.” Also, the Clinton administration requested in 1995 that the Department of Housing and Urban Development (HUD) begin enforcing the GSA’s efforts toward these goals.21 In 2004, HUD issued its controversial GSE “final rule” (HUD 2008). This rule established home purchase “subgoals for GSE acquisitions of goal-qualifying home purchase mortgages on owner-occupied properties in each of the three overall goal categories” (HUD 2008).22 The real assets underlying mortgages (i.e., housing), while not necessarily particularly roundabout in terms of the production processes that resulted in them, were exceptionally roundabout in terms of the services they produced. Housing is clearly best described in terms of a continuous input–continuous output process. There is a time-consuming process that leads to the completion of a structure and also a time-consuming process over which the services of that structure are enjoyed. If policy distorts price signals in the housing market, this can lead to distortions in not only the time structure of production 21  HUD was requested to do this under the auspices of the previously toothless Community Reinvestment Act of 1977. HUD’s involvement led to Fannie and Freddie’s first forays into the subprime mortgage market starting in 2000 (DiVenti 2009). 22  These subgoals excluded refinance mortgages and were especially targeted toward first-time homebuyers (HUD 2008). Included in the “final rule” were explicit and implicit exceptions to previous GSE standards aimed at moving the GSEs further into the subprime market.

198    Macroeconomics and Monetary Economics but also the time structure of consumption. The distortions in construction and consumption will be symmetric, misallocations of resources that amplify rather than offset one another. Young, Wiseman, and Hogan (2014) report evidence consistent with the idea that policy distorted the time structure of consumption in the housing market. We find that starting in the 1990s, the market prices of the mortgages and MBSs held by commercial banks indicate that they had become effectively shorter-term. As these loans primarily financed the purchases of completed structures, this change in perceptions would have been associated with consumers taking on longer-lived real assets despite their actual time preferences not having changed. Intuitively, low mortgages rates and rising house prices convinced consumers that (1) they could afford to finance a home over a long period of interest payments, and/or (2) they could “flip” the house in the near term. In the latter case, consumers were (incorrectly) convinced that their desire to sell before the stated time to maturity of their mortgage was consistent with the desires of others wishing to buy at the elevated prices.23

A Garrisonian Exposition Garrison (2001) provides a graphical exposition of the canonical ABCT that is helpful for both organizing the fundamentals of the theory in a coherent fashion and introducing new students to the theory. For both these purposes, I introduce the elements of risk externalization and a time-varying consumption structure into that exposition. The result should not only offer a clear presentation of the Austrian features relevant to the recent cycle but also provide students and researchers with framework flexible enough to illustrate alternative variants of the ABCT theme. Figure 9.3 presents the basic set of graphs utilized by Garrison (2001). The top right-hand graph represents production possibilities. The curve assumes constant resources and technology; given these, various combinations of consumption and investment goods are feasible. The bottom right-hand graph represents the loanable funds market, where, in the absence of policy intrusions, the interplay of individuals’ supplies of and demands for funds establishes a (natural) rate of interest. That rate corresponds to an equilibrium bundle of consumption and investment goods that are consistent with production possibilities. The left-hand graph is a Hayekian (1935) triangle, and it provides the uniquely Austrian element: a variable time structure of production.24 Investment goods do not 23  Benítez-Silva et al. (2009) find that from 1992 through 2006, homeowners overestimated their homes’ values by between 5 and 10 percent on average. 24  See Barnett and Block (2006) for a thorough criticism of the use of Hayekian triangles. By thorough, I mean that the use of Hayekian triangles is criticized on quite possibly every dimension imaginable. However, I ultimately disagree with their claim (39) that the use of triangles as expository devices is “highly problematic, if not fatally flawed.”

Value

Consumption

Austrian Business Cycle Theory    199

Investment

Production time

Rate of interest

S

D

Saving (S) Investment (D)

Figure 9.3  The Garrison (2001) framework.

simply become part of a homogenous stock of capital. Rather, investments contribute to a complex capital structure, one dimension of which (roundaboutness) is represented by the triangle. The horizontal axis measures time consumed during production. The vertical axis measures value. The hypotenuse of the triangle, then, records goods thus far produced at each instant of time during the process, each stage of production. Holding the vertical right arm of the triangle in place, if the triangle expands leftward, then the structure of production is lengthening; if it contracts rightward, then the structure of production is shortening. As a quick example of how this unified set of graphs operates, assume that the time preferences of individuals decrease (uniformly or on average). Figure 9.4 illustrates this scenario in two frames. In the top frame, the decrease in time preferences implies that individuals increase their savings as a portion of their incomes. Given a constant demand for funds, increased savings initially result in a lower interest rate and, given production possibilities, a shift toward more investment and fewer consumption goods. The time structure of production expands as the shift towards investment goods implies that a greater amount of resources is devoted toward future consumption goods production.

Production time

Production time Value

Rate of interest

Value

Consumption

Consumption

Investment

S

D

Saving (S) Investment (D)

Investment

S

D

Saving (S) Investment (D)

S

S

Figure 9.4  The Garrison (2001) framework: A decrease in time preferences.

Rate of interest

Austrian Business Cycle Theory    201 As the new investments are made—the bottom frame of figure 9.4—and lead, eventually, to the completion of new capital structures, the production possibilities expand. This occurs because the lengthened production structures—associated with increased capital intensity—lead to a greater value flow of both consumption goods and investment goods. This occurs although, by assumption, no increase in natural resources or technology has occurred. Rather, the economic growth is entirely capital-based.25 The task is now to incorporate two new elements into the framework:  (1)  a time-variant structure of consumption and (2)  a risk-structure of production.26 Figure 9.5 does just that. Straightforwardly, the original Hayekian triangle representing production is joined to another triangle representing consumption. Together, these two triangles represent a continuous input–continuous output structure.27 Starting from the right vertical arm of the production triangle, the area of the right-hand triangle—which represents the value of consumption goods produced—indicates the length of time over which that total value is enjoyed. The hypotenuse of the consumption triangle records the remaining value not yet enjoyed at each instant of consumption time.28 Consistent with the above modification, the production possibilities axes are now relabeled from consumption and investment to, respectively, present consumption and future consumption. When resources are allocated toward more future consumption, this may either take the form of forgoing present consumption to accumulate capital goods or forgoing present consumption by producing noncapital goods that are durable, the consumption services of which are largely enjoyed later rather than sooner.29 In either case, there are forward-looking resource allocations being made at the expense of current enjoyment. Garrison (2001, 47–49) claims that while incorporating a time structure of consumption is straightforward, doing so adds “complexity while clouding the fundamental relationships that are captured by the simpler structure[;]‌there is little to be gained analytically.” Barnett and Block (2006, 55) disagree: “both the time-structure of 25 

Garrison (2001, chaps. 3–4) claims that long-run, sustainable economic growth can continue via this process. I argue (Young 2009a) that Garrison is mistaken in this case. Rather, assuming that there are diminishing returns to capital accumulation (and increased roundaboutness), there must be some source of technical change, broadly understood, for growth to be sustainable. I offer nonrivalrous intangible capital and the associated positive externalities as a solution. Engelhardt (2009) claims that I am in error; Young (2009b) is my response. 26  Arguably—and especially since I am introducing an independent time structure of consumption to go along with that of production—I should introduce, separately, risk structures to both production and consumption. However, since introduction of a risk structure period involves an additional axis to the Hayekian triangle, I believe that separating that element into production and risk components would be prohibitively costly in terms of dimensions. 27  The traditional Hayekian triangle represents a continuous input–point output structure. 28  As in the case of the production triangle, the linear nature of the consumption process over time is for simplicity of exposition and is not assumed to be particularly realistic. 29  Alternatively, a third dimension could be added to the production possibilities. I believe, however, that doing so would be slipping off balance from Occam’s razor. The Austrian insights and implications, which I seek to highlight, are largely to be seen in changes in the Hayekian triangles. Therefore, I reserve the third dimension for that graphical component.

Value

Present consumption

202    Macroeconomics and Monetary Economics

Risk

Future consumption

Consumption time

S Rate of interest

Production time

D

Saving (S) Investment (D)

Figure 9.5  Incorporating a time structure of consumption and a risk structure.

production … and the time-structure of consumption … are affected by changes in interest rates … and thus both should be part of the ABCT.”30 I, of course, agree with Barnett and Block on this point. Furthermore, since I argue above that risk externalization in the housing sector channeled funds into relatively roundabout consumption (rather than production) structures, the representation in figure 9.5 does not cloud the fundamental relationships relevant to the recent cycle but, rather, highlights them. The importance of risk externalization leads also to the representation of an additional economic structure: the risk structure. Austrians insist that capital in an economy is a complex structure. That complexity goes well beyond the single dimension of time. The canonical ABCT merely stresses that one dimension of the structure. I am here claiming that for the recent episode, additional dimensions of that complex structure 30  Barnett and Block (2006, 55) also note that the representation in ­figure 9.5 may conflate production structures that, once in place, yield flows of goods throughout time and, on the other hand, goods that are consumed over time: “Consistency and clarity warrant that the figure be labeled ‘continuous-input/ continuous (or point)-output/continuous-consumption.’ ” This point is duly noted; what I am referring to by continuous output in this chapter is the continuous flow of value through the consumption of goods already produced.

Austrian Business Cycle Theory    203 need to be made explicit.31 Figure 9.5 now includes an axis projecting in a third dimension that represents risk involved in both the (time-intensive) production and consumption of value. The vertical arm shared by all three triangles is now best interpreted as the expected value of consumption goods arising from production and to be enjoyed over time. The horizontal axis of this third triangle is labeled risk. Thus, the triangle can expand or contract as more or less risk is being incurred during either the planned process of production or that of consumption. However, a caveat: unlike with the other two triangles, the interpretation of the hypotenuse and the triangle’s area is, unfortunately, not straightforward. Distortionary policies can cause changes in the shape of the risk triangle. These changes can only be loosely interpreted as discrepancies between the risk structure created by the policies and that which would be consistent with the preferences and decisions of both consumers and entrepreneurs in the absence of such policies. This is an admitted weakness of the framework, and refinements in representing and interpreting the risk structure are certainly desirable. All three dimensions (i.e., both of the time structures and the risk structure) cannot be viewed as independent. In particular, as the time involved in production and/or consumption increases, the risk involved will, all else equal, tend to increase. As the time contemplated increases, so do the possibilities for unanticipated outcomes along with the number of probabilistic outcomes.32 For the sake of examining each structure clearly and independently, I assume for the moment that the more or less roundaboutness of production or consumption does not imply changes in risk, all else equal. This assumption can easily be abandoned without damaging any of my claims below.33 Figure 9.6 uses the framework, first, to examine a canonical ABC save for the fact that the time structure of consumption is allowed to vary. The boom-bust episode represented is not essentially changed, but one can now see how changes in the time structure of consumption amplify the policy-induced distortions. In the top frame, a boom is initiated by a policy-induced increase in the supply of funds, represented by a shift to the right of the savings curve. This shift (by assumption) is based not on changes in 31 

That economic structure is multidimensional is a characteristic belief of Austrians. However, the canonical ABCT focuses on a single dimension of that structure: the time structure. Lachmann ([1956] 1978, 54) presents the broader view of capital theory in terms of “the consistency … of plans within the economic system as a whole, i.e., the plan structure of the economy.” Note that Lachmann explicitly limits his discussion to capital theory—“production plans are the primary object of the theory of capital”—but his description of the plan structure is easily grafted onto a description of consumption plans. Also, Carilli, Coyne, and Leeson (2008) provide a characteristically Austrian analysis of the bridging-versus-bonding structure of social capital and how it can be distorted by government interventions. 32  This statement conflates the concepts of risk and uncertainty, which should be made distinct in many contexts. However, in the context of this specific illustration of ABCT, it is not important. Knight (1921), of course, is the classic source of distinction between risk and uncertainty. 33  Distortions in either time structure will result in misallocations of resources, and the same will be true for distortions in the risk structure, if roundaboutness and riskiness are inherently, positively related. The two types of misallocations are not, except by complete serendipity, offsetting of each other.

Production time

Risk

Production time

Risk

Consumption time

Consumption time

Future consumption

S

D

S

S

(s) Saving (S) (d) Investment (D)

Future consumption

S

D

Saving (S) (s) Investment (D) (d)

Figure 9.6  A policy-induced “forced” decrease in time preferences.

Present consumption Rate of interest Present consumption Rate of interest

Value Value

Austrian Business Cycle Theory    205 individuals’ time preferences but, rather, on a central bank credit inflation. The interest rate falls, and production shifts toward more future consumption relative to present consumption. The cheaper funds allow entrepreneurs to plan on the completion of more roundabout production processes. For consumers’ part, the lower interest rate entices them to plan on financing purchases of longer-lived consumption goods. Both time structures on the graph expand according to these plans. However, the sustainability of these more roundabout time structures—the completion of these production and consumption plans—depends on an increased amount of loanable funds being available not only today but also in the future at the depressed interest rate. Unfortunately, time preferences have not actually fallen; individuals do not actually wish to save more. Indeed, the bottom frame of figure 9.6 traces the depressed interest rate over to the actual (and still unchanged) savings schedule, demonstrating that individuals are actually postponing the consumption of a smaller amount of resources. Tracing up to production possibilities, individuals desire more present consumption than they had previous to the credit inflation. At the depressed interest rate, a comparison of the (contracted, bottom frame) time structure triangles to the (expanded, top frame) triangles indicates the discoordination between production and consumption plans and the actual amount of voluntary saving. In the case of production plans, the planned investments are revealed to be malinvestments. In the case of consumption plans, at first blush, it may seem nonsensical that individuals’ consumption plans are inconsistent with their savings plans. This would certainly be true if we were dealing with a rational (in the Lucas 1976 sense) representative agent. However, individuals make consumption plans based in part on financing made available by other individuals’ savings. Given the cheap funds made available by an inflation of credit, it is completely plausible that all (or many) individuals make consumption plans that assume future savings that will never materialize. At the time of the bust, the shaded areas in the bottom frame of figure 9.6 embody inconsistencies between production and consumption plans that are distorted toward more roundabout structures and savings plans that are distorted toward being more present-oriented.34 The inconsistencies mean that planned capital structures must be abandoned (e.g., half-built factories are left incomplete) and also that roundabout consumption plans must be aborted (e.g., mortgages are defaulted on, homes are foreclosed on).35 34 

Note that what is being highlighted is the inconsistencies that manifest during the bust. They are not inconsistencies relative to what plans would have been in the absence of the credit inflation. However, this is not a welfare analysis; I am not claiming that these are deadweight loss triangles (or something of that sort). The shaded areas are meant to indicate plan inconsistencies created by policy and given the policy. These are the points of crisis that manifest with the onset of bust. 35  There is also an inconsistency of plans visible in the risk structure. This does not indicate a positive relationship between risk and roundaboutness (which I have assumed away; see above). Rather, in lieu of such a relationship, all else equal, risk is proportional to the value of present consumer goods. Given this simplification, the inconsistency is between plans for less present consumption (less risk) and plans for more present consumption (more risk).

206    Macroeconomics and Monetary Economics The variation of the consumption time structure could be ignored in figure 9.6 (by deleting the right-hand triangle, assuming just a continuous input–point output scenario) while changing nothing else about the exposition. However, when that variation is introduced, the distortions in the time structure of consumption complement those in the time structure of production. The boom-bust cycle is amplified. Furthermore, which of those two distortions is more empirically relevant will depend on the specific Cantillon effects corresponding to a particular historical business cycle. For example, if credit were to be injected only in the form of mortgage loans to consumers, the time structure of consumption would expand, while producers, without access to those funds, would not necessarily undertake more roundabout production structures.36 Moving away from the canonical ABCT, the narrative from the last section above is played out in figure 9.7. Initially (top frame), the channeling of funds into the housing market comes about through the GSEs’ secondary market purchases. These are funded through an increased supply of savings (purchases of Fannie and Freddie’s debt), which is encouraged by externalizing the risk associated with mortgages. The GSEs’ debt is implicitly guaranteed by taxpayers broadly, and individuals who purchase it do not bear all of the risk associated with the activities being funded. At the same time, by loosening their standards in terms of which mortgages they buy, the GSEs open borrowing opportunities to individuals who, by those previous standards, would have been deemed not creditworthy. Mortgage originators are essentially given incentives to ignore adverse selection problems. As these individuals gain access to the mortgage market, the effective demand for funds increases. Again, the risk associated with these new market participants is externalized to the taxpayers generally. Since both supply and demand are increased in the loanable funds market, the effect on the interest rate is ambiguous. In the reality of the recent cycle, the Federal Reserve was maintaining loose monetary policy during the years following the 2001 recession. Interest rates, in response, were generally low. However, note that the ambiguous effect on the interest rate makes intelligible the boom in the housing market specifically while mortgage rates were not particularly low relative to other US interest rates. (See figure 9.1.) For simplicity, figure 9.7 is drawn such that the net effect on the interest rate is nil. The bottom panel of figure 9.7 highlights unsustainable economic distortions that become apparent during the bust. The inconsistencies between the planned time structure of consumption and savings plans are shaded. Also shaded are the discrepancies between the triangles drawn in third dimension. These discrepancies are between production and consumption plans initiated during the boom and alternative plans that are consistent with choices made assuming that the relevant risks are internalized. 36  Of course, they might. Specifically, if the construction of homes called for production structures that were more roundabout than the typical production structure in the economy, then the shift toward home construction would entail a lengthening of the aggregate time structure of production. However, there is no a priori reason to believe that this is the case. (See above and Young 2012.)

Production time

Risk

Production time

Risk

Consumption time

Consumption time

Future consumption

SS

D D

S

D

D

S

(s) Saving (S) (d) Investment (D)

Future consumption

SS

D D

(s) Saving (S) (d) Investment (D)

Figure 9.7  The recent boom-bust cycle.

Present consumption Rate of interest Present consumption Rate of interest

Value Value

208    Macroeconomics and Monetary Economics The above exposition is admittedly crude. There are some particulars that I am not entirely comfortable with. As I comment above, for example, the interpretation of the risk structure triangle’s hypotenuse and area is, unfortunately, not straightforward. Increasing the complexity of the framework can go a long way toward smoothing out these rough points. However, in experimenting with more complex alternatives, I faced the danger that the exposition was becoming muddled and unwieldy. I therefore leave further refinements to future research.

Conclusion Some theories of the business cycle are identified with a particular source of the cycle, such as real business cycle theory. Real business cycle is the particular hypothesis that a large part of macroeconomic fluctuations is caused by exogenous productivity (or technology) shocks. Compare this with new Keynesian theory, which is a body of hypotheses that emphasize certain aspects of the economy—price and wage rigidities, preference shocks (animal spirits), imperfect competition, and so on. A new Keynesian theory incorporates at least some of these elements—but not necessarily all of them—in an attempt to explain or account for the business cycle. I view ABCT as akin to the latter in this regard. Austrians emphasize capital as a complex structure and the essentiality of the price system for conveying information and coordinating individuals’ savings and investment plans, the monetary calculations of entrepreneurs, and so on. An ABCT is an account of the business cycle—or a particular cycle—that attributes importance to some combination of these elements. As Garrison states, Austrian explanations for the cycle are variations on a theme. The canonical ABCT, developed by Mises and Hayek to account for a Great Depression world, is one such variation. But it is only one variation. I have argued here that too many authors have been content to cram the recent business cycle and financial markets crisis into the contours of the canonical theory. The fit has not necessarily been flattering. Specifically, I argue that two elements essential for an account of the recent episode have been largely neglected: (1) the risk externalization in the housing/mortgage market arising as a direct result of the GSEs (and indirectly as a result of the Federal Reserve) and (2) the time structure of consumption and the particularly roundabout nature of housing services. To rectify this neglect, I  articulate an ABCT that emphasizes both elements. This theory, along with the empirical facts, makes intelligible a boom that was centered in the housing/mortgage market despite mortgage rates that were not relatively low in the United States. The theory is illustrated as an extension of Garrison’s (2001) diagrammatical framework. In addition to accounting for the recent cycle, the extended framework can be used to illustrate various ABCTs that are consistent with various particular historical contexts. Policy-based distortions to the workings of the price system can

Austrian Business Cycle Theory    209 be analyzed in terms of the time structure of production (consistent with the canonical ABCT) but also the time structure of consumption and the risk structure of the economy. It is hoped that the present theory and exposition can guide empirical investigations of the recent US cycle. Essentially, all econometric studies of ABCT have been guided by the canonical theory, their testable implications being based on the time structure of production (e.g., Le Roux and Levin 1998; Keeler 2001; Mulligan 2002; 2005; 2006; Young 2005; Bismans and Mougeot 2009; Sechrest 2004). Future work should exploit the opportunities to estimate, document, and examine Austrian-type patterns in the risk and consumption time structures. The same can be advised for cliometric studies. Historical data can be sought and gathered in reference to risk and consumption time structures.

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Austrian Business Cycle Theory    211 hangover_theory.html).Lachmann, L. M. (1956) 1978. Capital and Its Structure. Kansas City, MO: Sheed, Andrews and McMeel. Le Roux, P., and M. Levin. 1998. “The Capital Structure and the Business Cycle: Some Tests of the Validity of the Austrian Business Cycle in South Africa.” Journal for Studies in Economics and Econometrics 22, no. 3: 91–109. Lucas, R. E. 1976. “Econometric Policy Evaluation: A Critique.” Carnegie-Rochester Conference Series on Public Policy 1, no. 1: 19–46. Menger, C. (1871) 2007. Principles of Economics. Auburn, AL: Ludwig von Mises Institute. Mises, L. von. 1934. The Theory of Money and Credit. New Haven, CT: Yale University Press. Mises, L. von. (1958) 2009. Liberty and Property. Auburn, AL: Ludwig von Mises Institute. Mises, L. von. 1963. Human Action: A Treatise on Economics, 3rd ed. New Haven, CT: Yale University Press. Mulligan, R. F. 2002. “A Hayekian Analysis of the Term Structure of Production.” Quarterly Journal of Austrian Economics 5, no. 2: 17–33. Mulligan, R. F. 2005. “The Austrian Business Cycle: A Vector Error-Correction Model with Commercial and Industrial Loans.” Journal of Private Enterprise 22, no. 1: 51–91. Mulligan, R. F. 2006. “An Empirical Examination of Austrian Business Cycle Theory.” Quarterly Journal of Austrian Economics 9, no. 2: 69–93. Nothaft, F. E., J. E. Oearce, and S. Stevanovic. 2002. “Debt Spreads between GSEs and Other Corporations.” Journal of Real Estate Finance and Economics 25, nos. 2–3: 151–172. Prychitko, D. L. 2010. “Competing Explanations of the Minsky Moment: The Financial Stability Hypothesis in Light of Austrian Theory.” Review of Austrian Economics 23: 199–221. Robbins, L. 1934. The Great Depression. London: Macmillan. Rothbard, M. N. 1962. Man, Economy, and State: A Treatise on Economic Principles. Princeton, NJ: D. Van Nostrand. Salerno, J. T. 2012. “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis.” Quarterly Journal of Austrian Economics 15, no. 1: 3–44. Sechrest, L. 2004. “Evidence Regarding the Structure of Production: An Approach to Austrian Business Cycle Theory.” Unpublished Manuscript. (https://mh19870410.files.wordpress. com/2013/02/evidence-regarding-the-structure-of-production-sechrest-2004.pdf). Taylor, J.  B. 2009. Getting off Track:  How Government Actions and Intereventions Caused, Prolonged, and Worsened the Financial Crisis. Stanford, CA: Hoover Institution Press. Thornton, M. 2006. “Cantillon on the Cause of the Business Cycle.” Quarterly Journal of Austrian Economics 9, no. 3: 45–60. Wagner, R. E. 1999. “Austrian Cycle Theory: Saving the Wheat while Discarding the Chaff.” Review of Austrian Economics 12: 65–80. White, L.  H. 2009. “Federal Reserve Policy and the Housing Bubble.” Cato Journal 29 (Winter): 115–125. Wicksell, K. (1898) 1936. Interest and Prices, translated by R. F. Kahn. London: Macmillan. Young, A.  T. 2005. “Reallocating Labor to Initiate Changes in Capital Structures:  Hayek Revisited.” Economics Letters 89, no. 3: 275–282. Young, A. T. 2009a. “A Capital-Based Theory of Secular Growth.” Quarterly Journal of Austrian Economics 12, no. 1: 36–51. Young, A.  T. 2009b. “A Capital-Based Theory of Secular Growth:  Reply to Engelhardt.” Quarterly Journal of Austrian Economics 12, no. 2: 63–67. Young, A. T. 2010. “A Government-Sponsored Crisis: How Fannie and Freddie Caused the Recession.” Collegiate Journal of Economics 1, no. 1: article 1.

212    Macroeconomics and Monetary Economics Young, A.  T. 2012. “The Time Structure of Production in the US, 2002–2009.” Review of Austrian Economics 25, no. 2: 77–92. Young, A. T., T. Wiseman, T. L. Hogan. 2014 “Changing Perceptions of Maturity Mismatch in the US Banking System: Evidence from Equity Markets. Southern Economic Journal 81, no. 1: 193–210.

Chapter 10

Free Ban k i ng Kevin Dowd

Introduction The subject of private money must be the most misunderstood in the whole of political economy. Throughout its history, it was repeatedly discovered, forgotten, and then rediscovered. It has also been the subject of a remarkable degree of ignorance and bad thinking among professional economists, even among some sympathetic to free-market ideas. A good starting point is Carl Menger’s 1892 account of the origin of money; this story showed how we could regard the emergence of money as the outcome of a spontaneous as opposed to a planned social order.1 Menger stopped his story at the point where gold had emerged as a generally accepted commodity money, but we can imagine it continuing through at least two further stages, both of which are of great interest to students of private monetary systems. The first is the development of coinage. Lumps of gold might circulate as money, but there are transaction costs in assessing their weight and fineness. So specialists arise to attest to their weight and fineness by stamping them with seals, which they do for a fee. 1 

A striking real-world example of this evolutionary process is the World War II POW camp described by Radford: Starting with simple direct barter, such as a non-smoker giving a smoker friend his cigarette issue in exchange for a chocolate ration, more complex exchanges soon became an accepted custom. … Within a week or two, as the volume of trade grew, rough scales of exchange values came into existence. … By the end of a month, when we reached our permanent camp, there was a lively trade in all commodities and their relative values were well-known, and expressed not in terms of one another—one didn’t quote bully in terms of sugar—but in terms of cigarettes. The cigarette became the standard of value. … [Everyone,] including non-smokers, was willing to sell for cigarettes, using them to buy at another time and place. Cigarettes became the normal currency. (1945, 191) It is interesting to note that the Radford system of unregulated currency worked well until senior officers started to control it; their meddling then led to its collapse.

214    Macroeconomics and Monetary Economics They also start to melt the gold units into shapes that are convenient and attest to their not having been subsequently tampered with, and these stamped lumps of gold become accepted at face value. We now have private coinage, with each coin bearing the recognizable design of the mint that produced it. At the same time, there are economies from standardizing the units in which the coins are minted, and we have the emergence of monetary units of account such as the pound (originally a pound of silver) and the dollar. Typically, there will be one dominant unit of account across the economy, consisting of a given amount of gold of a specified fineness. There will also be coins of different metals circulating side by side, with gold coins used for high-value transactions, copper for very low-value transactions, and silver for intermediate-value transactions. The second stage is the emergence of paper money along the lines of the textbook story of the goldsmiths. Goldsmiths always have strongrooms to store their gold, and people start to ask them to store their gold for them. The goldsmiths are ready to oblige for a fee; they accept deposits of gold and issue receipts against them, and these receipts are easier to store and carry around than coins. Over time, merchants find that it is easier to conduct transactions using the receipts themselves. The receipts also become standardized; instead of saying “I promise to pay X the sum of one and a quarter gold dollars,” they become anonymized and issued in standardized dollar amounts—“I promise to pay the bearer the sum of 1 gold dollar” (or just “1 dollar,” with the adjective “gold” being understood)—which makes it easier for them to circulate as a medium of exchange. By this point, the goldsmiths have become bankers and their receipts banknotes, and this banking system operates free of government interference. This sets the stage for our central theme: unregulated or free banking. This chapter provides an introductory overview of the issues raised by free banking.2 A central objective is to set out the core theory of free banking, draw out its predictions, and then compare those predictions against the abundant historical evidence from the many free (or relatively free) banking systems of the past. As we shall see, the evidence is largely supportive of the predictions of free banking theory and, in particular, of its claim that an unregulated banking system would be stable. The evidence also supports the predictions made by free banking theory that government intervention weakens the financial system—often in profound and misunderstood ways—and causes many of the problems it is ostensibly meant to cure. The chapter is organized as follows. The first section below provides an overview of the theory of free banking and explains how a free banking system works. It is important to appreciate that free banking is a very tightly constrained system with a number of mutually reinforcing checks and balances that combine to create an exceptionally stable system. The section after that examines what happens if the government intervenes in a previously free banking system. We can think of these interventions as kicking aside key 2  Inevitably, this overview is subjective, and space precludes any attempt at being comprehensive. However, there are already overviews by other authors (in particular, Brown 1978; Selgin and White 1994), and a considerable number of books on the subject, some of which are cited in the references list.

Free Banking   215 stabilizing mechanisms in the free banking system, in the process unleashing a variety of moral hazards that the free banking system had previously kept under control, so creating a highly unstable system. The following section examines the historical experience of free banking systems. The next section after that addresses misconceptions about free banking by prominent economists and offers some thoughts on why these misconceptions are still so common; the driving factors boil down to the power and influence of vested interests, including economists whose personal professional capital is threatened by free banking, and central banks and financial regulators, whose existence is redundant under free banking. A final section offers some advice for students interested in exploring the subject further.

The Theory of Free Banking Definition of Free Banking Free banking can be defined as a banking system that operates in an environment free of any government intervention. There is no central bank, no central bank lender of last resort, no government deposit insurance, and no government regulation of the financial system as such. Let us therefore assume that the legal system is a liberal one that provides for the enforcement of any contract between freely consenting parties. We can also describe such a regime as one of financial laissez-faire.

How Free Banking Works: Classical Free Banking on a Gold Standard The classical case is a free banking system operating on a gold standard. By this point, the economy will be operating with a unit of account consisting of a specified amount of gold. For example, under the US Gold Standard Act of 1900, the dollar was defined as 25.8 grains of gold of 90-percent purity, which was equivalent to 23.22 grains of pure gold; this implied that banks were willing to buy and sell gold at just more than $20.67 per Troy ounce. The economy will also be operating with a medium of exchange consisting primarily of bank money—banknotes and bank deposits—along with a supplementary coinage whose main function is to provide for small transactions. In this system, bank notes and deposits are receipts against gold. Banks would be free to issue as many of them as they wished, subject to the legal requirement that they redeem them on demand.3 Failure to redeem on demand would constitute a legal default. 3  It is possible that banks might issue some notes or deposits with provisions to allow for deferred redemption. Notes might have an option clause that allows them to defer redemption for a certain period in exchange for specified compensation, and banks might issue term deposits that require advance notice

216    Macroeconomics and Monetary Economics The structure of the banking industry would consist of a small number of nationwide branch banks that offer a full range of services combined with a larger number of specialist banks that cater to niche markets, and market forces would make the industry competitive. The big players would be large enough to exploit the empirically well-established existence of economies of scale and scope, but there is no evidence that these are large enough to make the industry a natural monopoly. An important feature of this system is the existence of a note-clearing system.4 Initially, banks refuse to accept payments on other banks’ notes, but such refusal limits the public acceptability of all banks’ notes. We can then imagine pairs of banks entering into bilateral arrangements by which they agree to accept each other’s notes as payment; this increases the public acceptability of both banks’ notes. At the end of each day, their agents meet to exchange each other’s notes and settle any difference in gold. These bilateral clearing arrangements spread, and soon the banks form a central clearinghouse club; all members of the club accept one another’s notes in payment, and at the end of each day, they meet in a central location to settle up. The notes of all member banks are now generally accepted among the public. The banks would make their profit by lending out the gold (or notes or checks) deposited with them, and we can imagine the managers operating under a tight governance structure accountable to their shareholders.5 This would give managers a strong incentive to manage their risks—to lend to good credit risks and develop good systems to monitor loan progress and manage borrowers who get into difficulties. Bankers also need to manage their reserve ratios. In doing so, they have to strike a balance: the more they lend out, other things being equal, the greater their expected profit but the lower their reserves. If their reserves are too low, however, they run the risk of being unable to redeem when required to. Experience over time would teach them the best practices to manage this trade-off. These would involve some combination of keeping gold reserves on hand, holding assets that can be liquidated quickly into gold, and maintaining lines of credit with other institutions on which they might of withdrawal. Option clauses have been controversial, but these are useful protections against note duels (in which a rival bank gathers up a large number of a bank’s notes and then presents them unexpectedly for redemption in an attempt to force it out of business), and under free banking, no bank would be able to compel the public to accept option-clause notes instead of notes giving the right to demand without notice. For more on the note option clause, see, e.g., Meulen 1934, chap. 8; Dowd 1988. 4  For more on the development of the note-clearing system, see, e.g., White 1984, chap. 2; Selgin 1988, chap. 2. There would also be an equivalent check-clearing system that would discipline the overissue of bank deposits, but in the interests of brevity, we focus here on the note-clearing system. 5  In our conjectural history, we would also imagine that bank shareholders would operate under unlimited or, at the very least, extended liability and that senior bank executives would operate under similar constraints. A common misconception, even among free-marketeers, is that limited liability, also known as the joint stock form, was somehow the “natural” market outcome, but it was not. In fact, the limited-liability statutes were a clear legislative intervention into the free market in the mid-nineteenth century and were bitterly opposed by the free-marketeers of the time. They argued, rightly, that limited liability created major incentives to take excessive risks. Adam Smith himself had famously condemned the joint stock form for this reason. For more on this important subject, see White 1984, 41; Campbell and Griffin 2006.

Free Banking   217 draw in the event that they have difficulty meeting demands for withdrawal of their gold reserves. Experience indicates that banks tend to adopt fairly low reserve ratios—often just a few percent or even less. This is largely because of the operation of the law of averages: most of the time, ingoings and outgoings are fairly independent and hence tend to balance out, and in such circumstances, fairly low reserves are generally adequate, provided that the bank has other means of obtaining reserves in an emergency if the need should arise.

Stability of a Free Banking System A free banking system has a number of stabilizing features that mutually reinforce to produce a highly stable system. We can think of these features as falling under three headings: those related to the demand for and supply of currency, those related to interest rates and the loan market, and those related to the threat of bank runs and the ways in which banks deal with that threat. The fact that banks issue notes on demand means that they operate on a perfectly elastic—that is, horizontal—supply schedule: the supply of notes in circulation is determined by the demand to hold them. When demand rises, the supply of notes in circulation will rise, and when demand falls, the supply of notes in circulation will fall. There is, thus, a “law of reflux” that corrects excess issues of notes and ensures that the banks themselves have no control over the note supply. Imagine, then, that a bank consciously sets out to increase its note issue. It issues lots of notes and puts them into circulation somehow; however, these extra notes soon make their way back to the banking system, and the bank concerned finds itself taking them back through the daily note-clearing system. So even if a bank can get its notes into circulation, it can’t keep them there unless there is the demand to hold them. The elasticity of note supply also means that the banking system is well able to respond to sudden increases in the demand for bank currency. This might happen in a crisis, when banks perceived as strong might experience increases in the demand for their currency during a “flight to quality” in which customers switch their holdings from weaker to stronger banks. Pronounced but temporary increases in the demand for currency were common during the crop-moving season in the late nineteenth century. US banks at the time had great difficulty accommodating these, because they were operating subject to the legal restrictions of the national banking legislation that had been adopted toward the end of the Civil War. However, the free Canadian banks north of the border were able to accommodate this extra demand with no difficulty. The extra currency issued was then retired when it was no longer needed. Interest rates are also highly stable under free banking because they are determined by demand and supply in competitive loan markets free of intervention from any leading player with the power to manipulate them. Individual free banks have little ability to engage in any overexpansion of credit. A general overexpansion is hardly possible,

218    Macroeconomics and Monetary Economics because no one bank provides reserves to the rest or has the ability to lead the system. If there is a rise in the demand for loans, the loan interest rate will rise, and the rising interest rate—the “interest rate brake” – will curb any potential overenthusiasm or nascent asset price bubbles: Banks as a whole will not be in a position to expand unless interest rates rise, because without an interest rate rise their deposits and thus their reserves won’t rise. Even then banks will not all expand at a uniform rate. Any banks that expand their loans and liabilities too aggressively will quickly lose reserves, through the interbank clearing and settlement system, to other more conservative banks. The adverse clearing process nips their excess expansion in the bud. (White 2011, 500)

Critics of free banking often strain to produce fanciful scenarios of destabilizing behavior, and one such scenario has free banks colluding to produce a concerted expansion. However, critics overlook the point that free banks cannot sustain a large expansion, because they would run their reserves down and expose themselves to runs. Each bank would then be compelled to reverse any expansion before it had gone too far. Critics also overlook the point that even if free banks were able to collude, they would still have no reason to engineer an expansion. On the contrary, if they could collude, they would want to behave like a monopolist and rig the market by restricting credit rather than expanding it.6 Indeed, critics overlook even the evidence itself; to quote Kurt Schuler in his article on the world history of free banking: “No account of any [historical] free banking system that I am aware of mentions any attempt by free banks to expand credit in concert with one another; each bank was too much concerned with guarding its own reserve” (Schuler, 1992). Another stabilizing feature of free banking is its ability to handle sudden changes in the demand for loans, including demands for emergency loans and lender-of-last-resort assistance. Should a bank find itself distressed, it would seek assistance from other banks, which would consider that request in their own interests. If the distressed institution was regarded as solvent and generally well run, then the other banks would be more inclined to assist it, granting it loans at a penalty rate of interest against prime collateral.

6 

Anticompetitive collusion is not easy to engineer in a free market, because the would-be colluders cannot compel others to cooperate. Although critics of free banking have sometimes argued that free banks operate a cartel, it is difficult to substantiate that claim with hard evidence. The usual evidence cited is the uniformity of interest rates, but such evidence hardly supports their case, as we would expect uniform interest rates to emerge through competition. An example is Checkland (1975, 452), who argued that the Scottish free banks operated a cartel and gave as evidence the uniformity of their interest rates, but even he admitted that interest-rate-setting agreements among the banks never lasted long (391). In short, even though we might expect free banks to try to rig the market, they don’t have the ability to do so over anything but the short run; under a free market, cartels eventually break down. It is curious that such bogus “evils of cartels” arguments are put forward by advocates of central banking, who omit to mention that state intervention via central banking is one big cartel enforced by the power of the state—and the only effective one, too. If they are against cartels, then why do they support them?

Free Banking   219 This would be especially the case if the institution concerned was a respectable member of the “banking club.” On the other hand, if the institution had a bad reputation, they would be much less likely to assist it and might even be inclined to make an example of it. The big banks would also be mindful of the broader effects of their decision and the potential for contagion. So in the first case, the decision to grant assistance would place the resources of the whole banking system behind the institution concerned, which would save it and quell any further panic. In the second case, the decision to refuse assistance would send out a clear signal, throwing it to the wolves, and it would then be run out of business. Either way, assistance is granted or denied where appropriate, and the crisis is resolved. We should also remember that in this system, the bankers operate subject to the threat of a bank run. Holders of banknotes and deposits would be aware that there is no central bank to offer their bank loans of last resort in a crisis, nor is there any system of government deposit insurance to make them whole again if their bank goes bankrupt. For their part, bank managers would understand that their long-term survival depends on their ability to retain their creditors’ confidence. They would therefore pursue conservative lending policies, submit themselves to outside scrutiny, and publish audited accounts. They would also provide reassurance by maintaining adequate capital. The greater a bank’s capitalization, the more losses it can withstand and still be able to pay off depositors in full. If the bank’s capital is large enough, the bank can absorb any plausible losses and still repay depositors, and depositors can be confident that their funds are safe. The precise amount of capital is then determined by market forces. The better capitalized a bank, other things being equal, the safer and more attractive it is to depositors, but capital is also costly, and depositors need to pay shareholders to provide it (e.g., by accepting lower interest on deposits). Competition among banks should ensure that banks converge on whatever degrees of capitalization their customers demand and, by implication, are willing to pay for; banks will be as safe as their customers demand. The conclusion that banks under laissez-faire would maintain high levels of capital is consistent with the empirical evidence. US banks in the antebellum period were subject to virtually no federal regulations and yet had capital ratios in most years of more than 40 percent (see, e.g., Kaufman 1992, 386). US banks were subject to more regulation at the turn of the century, but even then, their capital ratios were close to 20 percent, and capital ratios were still around 15 percent when federal deposit insurance was established in 1934. The evidence is also consistent with the associated prediction that laissez-faire banks face low probabilities of failure. Thus, US banks appear to have been fairly safe in the period before the Fed. Losses to depositors were correspondingly low (Kaufman 1987). Failure rates and losses were also low for other relatively unregulated systems such as those in Canada, Scotland, Switzerland, and so on. Nor is there any reason to expect banking instability arising from the ways in which banks relate to one another, either because of competitive pressures or because of “contagion” from weak banks to strong ones. It is frequently argued that competitive pressures produce instability by forcing “good” banks to go along with the policies of “bad”

220    Macroeconomics and Monetary Economics ones (e.g., Goodhart 1988, 47–49). The argument is that if the bad banks expand rapidly, they can make easy short-term profits, which pressures the managers of good banks also to expand rapidly, with the result that the banking system as a whole cycles excessively from boom to bust and back again. However, as we have already seen, free banks cannot sustain a large expansion, because they would run down their reserves and expose themselves to runs. In any case, even if a free bank could engage in such an expansion, it would have no reason to. A bank can expand rapidly only by allowing the average quality of its loans to deteriorate, and a major deterioration in its loan quality will undermine its long-run financial health. A profit-maximizing bank will not choose to undermine itself this way, even if other banks appear to be doing so. If a bank believes that its competitors are taking excessive risks, the rational course of action is to distance itself from them—indeed, to build up its financial strength further—in anticipation of the time when they start to suffer losses and lose public confidence. When that happens, the good bank is strongly placed to increase its market share at their expense and even drive them out of business. The good bank might have to forgo short-term profits, but it would win out in the long run. There is no reason, then, to suppose that competitive pressures as such would force free banks into excessive cycling.7 Then there is the contagion argument that the difficulties of one bank might induce the public to withdraw funds from other banks and threaten the stability of the financial system. However, this argument ignores the earlier point that good banks have a strong incentive to distance themselves from bad ones. If the good banks felt there was any danger of contagion, they would take appropriate action to help ensure that contagion did not, in fact, occur. Indeed, they would position themselves to offer the customers of weaker banks a safe haven when their banks get into difficulties. A serious danger of contagion is therefore inconsistent with equilibrium. Instead, we would expect the difficulties of a weak bank to trigger a “flight to quality,” and this expectation is borne out by the evidence that runs occur in response to news that a particular bank or group of banks has sustained major losses that call into question its ability to repay its debts. There is also little evidence that such runs are more than locally contagious, if even that (see, e.g., Benston et al. 1986, 53–60).

The Monetary Standard and the Price Level The price level under this system would be determined by demand and supply in the market for gold. Recall that the banks are committed to buy and sell banknotes (or 7  Proponents of the excessive cycling theory sometimes look to examples such as the excessive bank lending to LDCs in the late 1970s and early ’80s or, more latterly, the subprime lending boom as examples of what might happen under free banking. However, episodes like these are not examples of free banking and can hardly be held up as illustrating what would happen under it. These booms were actively encouraged by governmental agencies of the time, and banks could reasonably expect some form of bailout if things went bad. In the circumstances, it was hardly surprising that many of them overreached themselves.

Free Banking   221 other bank money) at the fixed price of just more than $20.57 an ounce. If the market price of gold should differ significantly from this price, there would be arbitrage profits to be made from buying gold from the banks or selling gold to them; consequently, the only equilibrium market price of gold is just more than $20.67 an ounce. Given that the nominal price of gold is thus fixed, the only way in which the gold market can equilibrate is through changes in the relative price of gold—that is, through changes in the purchasing power of gold against goods and services in general—and the only way this can change is through changes in the price level itself. Consider two conceptual experiments: • In the first, there is an increase in the demand for gold for some reason—for example, gold becomes more fashionable as jewelry. The demand curve shifts out, but as the supply of gold is inelastic, the relative price of gold rises, and this outcome is produced through a fall in the price level. • In the second, there is an increase in the supply of gold—because of a gold discovery, say—so the supply curve shifts right, but the demand remains as it was. In this case, the relative price of gold has to fall, and this comes about through the price level rising. In short, under any gold standard—whether the banking system is free or not—the price level is determined by whatever factors equilibrate demand and supply in the gold market. The historical evidence suggests that the price level under the gold standard had a tendency to fluctuate over time—increases in the supply leading to rising prices, periods of strong demand leading to falling prices—showing a high degree of stability over the longer time. The longest-standing gold standard since paper money evolved was that of the United Kingdom from Isaac Newton’s currency reforms of 1717 to 1914; this was de facto one long gold standard interrupted by the 1797–1821 suspension of specie payments during the French wars. Over the whole period except for the suspension, the UK price level never fell below 71 percent of its 1914 value and never rose above 143 percent of that value. We can also picture free banking systems operating under alternative commodity anchors. Instead of a gold anchor, the anchor might consist of some other commodity (e.g., silver, copper, brick, etc.) or basket of commodities (e.g., as in a commodity reserve currency, as proposed by Friedman 1951). In each case, the price level would depend on demand and supply in the market for the relevant anchor commodity or commodities basket. We can also picture a free banking system based on a frozen monetary base, as discussed by Selgin (1994); in this case, the price level would depend on demand and supply in the market for the monetary base, which, in the event of a frozen monetary base, means that the price level would depend on the demand factor only.

222    Macroeconomics and Monetary Economics

Impact of State Intervention in a Free Banking System Perhaps the most important feature of this system is that it cannot be improved by intervention from the government. Instead, such intervention is always damaging, sometimes very much so. Consider some typical interventions, as follows.

The Establishment of a Central Bank with a Note Monopoly The first intervention is the establishment of a note monopoly, which we can think of as a central bank. There is then no longer a note-clearing mechanism to discipline overissue, although the new central bank is still subject to the need to redeem its notes on demand. The main problem, however, is that the central bank now has a lot of discretion and has the power—even on a gold standard—to manipulate interest rates. It then faces the temptation to pull interest rates down to stimulate the economy; we saw this in the late 1920s, when the Federal Reserve held interest rates down for too long and created too much credit, creating the asset price bubble that burst in October 1929. Much the same happened again in the late 1960s, which culminated in the Penn Central burst of 1970. There was also the problem that the Fed was a large, even dominant, player in the gold market itself, well able to manipulate the market and subvert or at least slow down the discipline of the price-specie flow mechanism that would have led to a loss of gold abroad and pressured it to raise interest rates. The root difference is that a central banking system is loosely constrained, and it is this looseness that gives rise to the need for discretion on the part of the central bank. By contrast, a free banking system is always tightly constrained, as all players have to operate under the discipline of the market, and none is big enough to lead the market itself. We see this difference above all in the interest rate, which in the one system is essentially a plaything of the central bank but in the other is determined by the market itself and not by any big player. Eventually, faced with the realization that the United States could only continue to maintain the gold peg by reversing its soft money policies, in August 1971, President Richard Nixon decided to abandon the gold peg as an inconvenient nuisance. The Fed was now free to do whatever it wished, free of even the loosest gold constraint. Even if the central bank is well intended—but one has to bear in mind that it also has its own vested interests and faces a lot of political pressure—it faces the problem that it doesn’t really know what to do; its policy mandate leaves it with a wide room for maneuver. So if it believes that the economy is undergoing a boom, it is all too easy for the central bank to persuade itself that it should feed that boom—it should satisfy “legitimate” business

Free Banking   223 demand for credit—by ensuring that credit is easy and interest rates don’t rise to choke it off. Similarly, if the stock market undergoes a correction, it is all too easy for the central bank to persuade itself that it should give the stock market a helpful dose of stimulus to get it back on its feet. We then get the Greenspan put and a market boom fueled not just by low interest rates but also by the expectation that the central bank will always intervene to correct a market correction. The result is a system with an inbuilt tendency to expand too much—loose money and low interest rates are generally more popular than their opposites—and the US dollar has now lost more than 83 percent of its value since the link to gold was severed in 1971, even according to the government’s own statistics, which underestimate the debasement. There is now no limit to how far it can expand the money supply, but even so, policies of loose money are still unable to engineer a permanent boom, however much the central bank might try. Any credit-fueled investment boom will eventually burst as the structural maladjustments it creates—not to mention underlying real scarcities—eventually assert themselves. We then end up trapped in the ever more destabilizing asset boom-bust cycle we have been experiencing since the mid-1990s. We had low-interest policies stimulating the tech boom of the late 1990s, which bust in 2001; we then had more aggressively low interest rates after that, which produced an even bigger bust in 2007–2008, and then the über-aggressively low interest rates since 2009, which will produce the mother of all busts when they eventually burst.

The Central Bank Lender-of-Last-Resort Function The provision of a lender of last resort (LOLR) is one of the primary functions of a central bank—and, indeed, one of the primary justifications for its existence. The central banking textbooks ignore the point that a free banking system is perfectly capable of providing this function itself. This is error number one. Instead, we set up a central bank, give it the LOLR responsibility, and then worry about how it should exercise that function. The classic answer was suggested by Walter Bagehot in Lombard Street ([1873] 1882). He suggested that the central bank should provide last-resort support to solvent but illiquid institutions at a penalty rate against prime collateral. The penalty rate would discourage such requests (and make them genuinely last resort), and the requirements that the bank be solvent and offer first-class collateral should protect the central bank against possible losses. The textbooks then imagine the central bank responding to occasional regrettable but effectively unavoidable requests for assistance by providing assistance along the lines of the Bagehot rule—after all, bankers do get into difficulty from time to time (as if this had nothing to do with the bankers’ prior decisions), and the central bank seldom has much choice but to assist (really?). Yet the existence of the rule itself (or, more generally, of any willingness by the central bank to rescue institutions in difficulties) creates a major moral hazard: banks then count on that support and behave less responsibly, and so they become more inclined to end up seeking assistance. This gives the central bank a major

224    Macroeconomics and Monetary Economics headache: how to credibly limit central bank support ex ante to discourage such irresponsibility? While a central bank might talk tough before the event about not bailing out badly run banks, how it responds in the heat of a crisis is another matter, when the pressure is on to arrange a hurried rescue, and never mind any promises it previously made to let such banks fail. Ex ante, bankers know this, and they rightly dismiss such threats as lacking credibility. This leads to a game of chicken that is impossible for the central bank to win, because it is trapped by its own discretionary powers. Moreover, the LOLR undermines market stability in another, less obvious way. Recall the good bank/bad bank game discussed earlier. Since an LOLR tries to keep weaker banks open, its very existence reduces the incentives for good banks to adopt the virtuous strategy of building themselves up in anticipation of eventually winning weaker banks’ market share. That strategy depends on the weaker banks being ruined and cannot promise much payoff if the central bank LOLR is going to bail them out. In these circumstances, even the good banks may decide to take greater risks. Ironically, the LOLR can then produce the very instability that proponents of central banking often claim would arise under free banking. In fact, someone who observed this instability might easily attribute it to the market itself and falsely believe that the banking system actually needs the LOLR support that is, in reality, undermining it. A major cause of banking instability—the LOLR—can easily be (and often is) mistaken for its cure. There is no credible solution to these problems short of abolishing the central bank. Even Bagehot himself acknowledged this point:  I know it will be said that in this work I have pointed out a deep malady, and only suggested a superficial remedy. I have tediously insisted that the natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it. I have shown that our system is that of a single bank keeping the whole reserve under no effectual penalty of failure. And yet I propose to retain that system, and only attempt to mend and palliate it. I can only reply that I propose to retain this system because I am quite sure that it is of no manner of use proposing to alter it. A system of credit which has slowly grown up as years went on, which has suited itself to the course of business, which has forced itself on the habits of men, will not be altered because theorists disapprove of it.. . . You might as well, or better, try to alter the English monarchy and substitute a republic, as to alter the present constitution of the English money market, founded on the Bank of England, and substitute for it a system in which each bank shall keep its own reserve. There is no force to be found adequate to so vast a reconstruction, and … therefore it is useless proposing [it]. (Bagehot [1873] 1882, 329–330)

In short, Bagehot himself offered his rule as a second-best solution to a problem that shouldn’t have existed in the first place and could be remedied by abolishing the privileges of the central bank. But that solution—free banking or, as Bagehot put it, the “natural system”—has already been ruled out. In practice, the pressure is then on to expand LOLR support over time, and with each such expansion—one thinks of Continental Illinois (1984), Long-Term Capital

Free Banking   225 Management (1998), and so on—the moral hazard gets worse.8 It then gets out of control, and we end up with the albatross of Too Big to Fail: the big banks especially can then be certain that they will be bailed out. There is, thus, something especially unfortunate about the Bagehot rule. It was well intended, and Bagehot himself was aware of its limitations. Yet it is routinely rolled out as providing the classic justification for the central bank LOLR function. Critics of central bank rescues can then be told that their worries are exaggerated, because the Bagehot rule provides only the most limited and expensive support, conveniently ignoring the point that most rescues are much more generous to the rescued firms. Central bankers then agonize over the moral hazards that they themselves create and retreat into hot air (“Next time, we really are going to let banks fail”) or plain denial, hoping the problem will go away. In doing so, they miss an elementary point: on the one hand, they really do want to discourage requests for assistance, but on the other, they are willing to consider them; that is, they are willing to reward the very behavior they wish to discourage. They then wonder why they can’t get that problem under control. Any schoolteacher could have told them the answer to that one: if you want to discourage a particular behavior, you have to punish it. Bankers who get to the point where they ask for assistance from the central bank should face personal punishment. Critics might respond by saying that banks would then never apply for assistance, but that is exactly the point: we don’t want them to. This is not as good as free banking—the innocent get punished along with the guilty—but it would be a decent second-best. Again, the classroom is a perfect analogy. We hand out homework assignments and have to stipulate rules governing what happens if they are late. The central bank LOLR is akin to saying that we will grant extensions to kids who turn up with a superficially plausible hard-luck story. We are then overwhelmed with requests for extensions from kids with all manner of “dog ate my homework” excuses. If we get soft in granting extensions, the problem gets worse, and no amount of threats of future punishment will offset that. Under genuine free banking, however, each case would be considered on its merits, and in some cases, the assistance would be granted—after all, the dog has sometimes been known to eat the homework—but in some cases, it would not. Under conventional central banking, we then get pressured into granting extensions regardless of their underlying merit, and the problem gets out of control. If we automatically punish everyone who is late, we will certainly get that problem under control again, although we will then 8 

One has to bear in mind that decisions to bail out institutions or let them fail have to be made under a lot of pressure and very quickly. Policy makers then face a very asymmetric decision calculus, nicely set out by then-comptroller of the currency, C. T. Conover, at the time of the Continental Illinois bailout: “had Continental failed and been treated in a way in which depositors and creditors were not made whole, we could very well have seen a national, if not an international, financial crisis, the dimensions of which were difficult to imagine. None of us wanted to find out” (Conover 1984, 288). One can argue that policy makers have a tendency to spook themselves, but one cannot deny that the pressure to agree to a bailout is considerable. This is exactly the problem: banks (and the big banks especially) know that when push comes to shove, the central bank will have great difficulty letting them fail (hence Too Big to Fail).

226    Macroeconomics and Monetary Economics punish the unlucky good along with the deserving bad. But to repeat, we have already ruled the best solution out.

Government Deposit Insurance A third form of government intervention is government deposit insurance. In the United States, federal deposit insurance was established in 1934 under the provisions of the Banking Act of 1933. Its proponents offered an apparently self-evident justification: that it would help the banking system by removing any incentive on the part of depositors to run. Yet federal deposit insurance was bitterly opposed by the bankers themselves. Opponents argued that deposit insurance is bad because it creates major moral hazard problems. Once we introduce deposit insurance, depositors no longer have any incentives to monitor bank management, and managers no longer need to worry about maintaining confidence. A bank’s rational response is then to reduce its capital, since the main point of maintaining capital strength—to maintain depositor confidence—no longer applies. Deposit insurance also encourages more bank risk taking at the margin; if a bank takes more risks and the risks pay off, then it keeps the additional profits, but if the risks do not pay off, part of the cost is passed on to the deposit insurer. Moreover, even if an individual bank did wish to maintain its earlier standards, it would be outcompeted by competitors that cut their capital ratios to reduce their costs, took greater lending risks, and passed some of the benefits to depositors by offering them higher interest rates. The fight for market share would then force the good banks to imitate the bad, in the process subverting the competitive process into another race for the bottom. Critics of federal deposit insurance in the 1930s also pointed out that past experience with similar deposit insurance systems at the state level showed that it didn’t work for these reasons.9 It turned that the critics were right. Banks’ capital ratios fell by more than half in just more than a decade, and regulators were never able to reverse the trend to capital deterioration created by deposit insurance. The adoption of deposit insurance also led over time to major changes in the banking industry itself, which became less conservative and more prone to risk taking. The eventual outcome was the great deposit insurance crisis of the 1980s and early ’90s and the destruction of much of the American thrift industry. Ironically, just as the problems of deposit insurance were becoming evident in the early 1980s, mainstream economists were persuading themselves that we really did need 9 

For more on US experiences with state deposit insurance, see, e.g., Calomiris 1990. The performance of these systems depended, however, on how they were set up: “insurance systems that relied on self-regulation, made credible by mutual liability, were successful, while compulsory state systems were not” (Calomiris 1990, 283). It was therefore unfortunate that federal deposit insurance was set up along the lines of the latter model rather than the former.

Free Banking   227 deposit insurance after all—and never mind the basic rudiments of moral hazard economics or even its track record. The seminal event was the publication of the Diamond-Dybvig (DD) model (Diamond and Dybvig 1983), which offered a justification for deposit insurance based on the (fallacious) premise that the banking system was inherently unstable. This model rapidly gained mainstream acceptance. The reasoning goes as follows. Imagine that we live in a neoclassical economics world, where we make up simplified models to capture the essence of an economic problem—the model is our analytical framework and is intended to guarantee rigor.10 In this model, individuals live for two periods and are given endowments at the start of period 1. They have access to a technology that will yield a return in period 2 but don’t know in which of the two periods they will want to consume; these consumption preferences are only revealed after they have invested. At that point, individuals’ types are revealed: type I individuals, who want to consume in period 1, and type II individuals, who want to consume in period 2. Individuals can always invest in their own backyard—they can live in autarky—and consume whenever they want, but in that case, the type I individuals would never earn any return, because they would have to dig up their investment and consume it before it had had time to produce any yield. Diamond and Dybvig now suggest that everyone could be better off ex ante coming to a mutual insurance arrangement in which they insure one another against the risk of turning out to be type I. They call this arrangement a “bank.” The arrangement works if the proportion of type I is known, but the DD “bank” is then exposed to a run problem if the proportion of type I is not known. Everyone knows that the bank does not have the resources to redeem all its deposits at the promised rate if everyone decides to withdraw in period 1, because the underlying investment has not yet yielded a return, but the bank has committed itself to pay some return to depositors who withdraw in the first period. This leads to the possibility that individuals might get spooked and decide to redeem their deposits, just in case. A bad sunspot count might then create a self-fulfilling fear of a bank run, and the bank would be run out of business. To prevent this from happening, the “government”—whatever that might be in the context of this model—intervenes to offer a deposit guarantee, and the fear of a run goes away; those who wish to consume

10  Austrian economists might object to my use of neoclassical modeling here, but it is important to meet arguments for central banking on their own terms. If the proponent of some form of government intervention sets out to justify intervention using market-failure arguments, then we, too, can use those models to deconstruct such arguments. Typically, proponents of central banking establish (to their satisfaction, at least) the existence of some market failure, assert that some intervention will correct that market failure, and then presume that they have made their case. However, I have never come across a model in which such a case was convincingly made; they always fall down at the point where they propose their favored intervention, which is inconsistent with the model environment they claim to be working under. Such poor logic is remarkably prevalent among neoclassical economists. And we haven’t even mentioned the Coasean critique of such regulatory policy, which says that no convincing case for regulation can be made without first taking account of its costs.

228    Macroeconomics and Monetary Economics early can do so, and, thanks to the guarantee, the others can be confident that their deposits will be safe at the end of period 2. Unfortunately, there are not one but three serpents lurking in this Garden of Eden. The first is that the model involves a deus ex machina—a methodological “no-no,” because it means that the model is logically inconsistent. The problem here is that the deposit insurance mechanism has to be feasible in the context of the assumed model. So how would this mechanism work? Presumably, once the last type II depositor had withdrawn and the proportion of type I versus type II depositors had been revealed, then the “government” would be able to track everyone down and arrange for the transfer payments between them to honor the deposit guarantee. However, the model itself presupposes that individuals cannot be traced once they leave the “bank”—it was exactly the absence of any mechanism to track them down afterward that was used to justify the existence of the “bank” in the first place. In short, Diamond and Dybvig assume that such a mechanism does not exist when they motivate the existence of their “bank,” but they assume that such a mechanism does exist when they propose their solution to the inherent instability to which their “bank” is prone. Well, either the mechanism exists, or it does not. If it does, then the model’s private sector can also use it and create a run-proof and certainly different institutional structure from the one postulated by Diamond and Dybvig. In this case, there is no “need” for deposit insurance. If the mechanism does not exist, then neither the “government” nor anyone else can make use of it, either. In this case, deposit insurance would not be implementable, however much it was “needed”—it would just not be possible. In a nutshell, in this model, properly considered, deposit insurance is either (a) not needed or (b) impossible to implement. Either way, the model can’t be used to justify it.11 Even if we ignore the point that the model is inconsistent, there is a second problem. Let’s suppose for the sake of argument that Diamond and Dybvig are correct that what is needed is a collective guarantee along the lines of their deposit insurance scheme. Since this supposedly gives a welfare-superior outcome, then everyone in their society will agree to it voluntarily, and there is no need for any compulsion by the government. In other words, the market left alone would deliver their preferred outcome; we would have private rather than government deposit insurance. So their own model, taken at face value, gives no justification for any compulsory system such as, for example, federal deposit insurance. The third problem is obvious to any banking professional:  the “bank” in the DD model has no capital. Such an institution is not a bank in any true sense; it is a mutual fund that tries to ape a bank by fixing the values of its liabilities despite having uncertain asset returns and no capital. Although Diamond and Dybvig call this institution a bank, just calling it a bank does not make it one. A (true) bank is a financial institution that issues both debt (deposits) and equity. If Diamond and Dybvig had called their financial institution a mutual fund instead of a bank and had then assumed that their

11 

For a more extended treatment of these issues, see Dowd 1992c; 1996.

Free Banking   229 mutual fund was going to issue fixed-value liabilities, the problem with their financial intermediary would have jumped out: you cannot have a financial intermediary with fixed liabilities, assets that vary in value and no capital, and expect it to be anything but prone to runs. With this point in mind, consider an extension to the DD environment:  suppose we have a type III agent who has an endowment but who differs from the other agents in knowing that he or she will not wish to consume in period 1. This agent can then use his or her endowment to create a financial institution that has the capital to offer credible guarantees to the type I and type II agents. This institution can be described as a bank in a recognizable sense, and the type III agent can be described as the banker. We then have an institutional structure that resembles the banking systems we observe in the real world—in particular, we have deposits, equity capital, depositors, and bankers. And guess what? Assuming that the “banker” has enough equity capital, then the promised returns on early-withdrawal deposits can be credibly met even if everyone runs on the bank, and there is then no reason for any of the type II individuals to panic. In plain English, extend the DD model to allow for bank capital, and the DD problem of a run-prone financial intermediary disappears. Again, there is no justification for deposit insurance. Instead, depositors are reassured by bank capital—provided that the banker has enough of it, but this is just a modeling assumption.12

Bank Capital Adequacy Regulation Another form of government intervention is capital adequacy regulation, rules that impose minimum capital standards on banks. Such systems of rules are among the most distinctive features of modern systems of central banking and financial regulation. The knee-jerk justification given by most financial regulators is that we need such rules to maintain minimum levels of bank safety and soundness, but this is hardly a convincing reason to intervene in a free banking system in which banks have strong incentives to maintain their own financial health. A second, more thoughtful argument—put forward by, for example, Benston and Kaufman (1995)—is that we need such rules to counter the moral hazards created by the regulators themselves, such as those created by the central bank LOLR function or by government deposit insurance, but such an argument implicitly concedes the point that there is no useful scope for capital regulation in a free banking system in which there are no regulatory bodies to create these moral hazards in the first place. However, David Miles (1995) puts forward a third argument for capital regulation that poses a direct challenge to free banking; he argues that an information asymmetry between bank managers and depositors produces a market failure and that this market failure can be solved by capital regulation.

12 

Dowd 2000 provides a worked-out model along these lines.

230    Macroeconomics and Monetary Economics The essence of Miles’s argument—which, again, takes place in the confines of a neoclassical model—is that if depositors cannot assess the soundness of individual banks, then banks will maintain lower than optimal capital ratios, where the optimal ratios in his model are those that banks would have maintained had depositors been able to assess their financial positions properly. The solution to this “market failure” is for a regulator to determine the optimal ratio and then impose that as a minimum capital standard. However, this argument implicitly assumes what it sets out to prove. Let’s suppose that some technology exists that allows the user to determine banks’ true capital positions. Miles assumes that depositors don’t have access to this technology; otherwise, they would use it, and the market failure would disappear. At the same time, he also assumes that the regulator does have access to this technology; otherwise, the regulator would be unable to use it to correct the market failure. This is tantamount to assuming that the regulator has some technical edge over the depositor and effectively assumes what he sets out to prove. If we assume a level playing field, however, then either the technology exists or it does not. If it does, then, presumably, the depositors can use it, too, in which case there is no market failure; and if it does not, then, market failure or no, there is no feasible way for the regulator to correct it—which is to say, there isn’t a correctable market failure at all. In any case, it is relatively easy for depositors of free banks to monitor their banks’ financial conditions. They would be able to read reports in the newspapers, and they would be well aware whether their bank was in good standing or the subject of a run—and they would also have the incentive to keep an eye on their banks, because of what they would stand to lose if their banks failed. There is also abundant evidence that note holders and depositors “cared about the financial conditions of their banks and carefully scrutinized bank balance sheets” in the period before federal deposit insurance was introduced (Kaufman 1987, 15). Of course, depositors of modern banks have no such incentive, so it is hardly surprising that they might be ill informed about their banks, but we can’t extrapolate from ill-informed modern depositors to the note holders and depositors of free banking systems, who have much more at stake. There are also other arguments we could make—such as when do regulators actually practice “optimal” regulation?—but perhaps the strongest argument against capital regulation is simply that it does not work. In the United States, capital regulation persistently failed to stop the long decline in the capital standards of US banks that occurred after the establishment of federal deposit insurance. Instead, regulators indulged banks with looser definitions of bank capital and policies of forbearance for those banks that failed to meet their standards, but these policies merely sanctioned the growing deterioration in capital adequacy without reversing it. … The persistence of regulators’ inability to reverse the trend toward capital inadequacy seems to confirm that capital adequacy in banking deteriorates for fundamental, institutional reasons that no amount of regulation can effectively counter. Central bankers and regulators may pose as the prudent regulators of system capital

Free Banking   231 Table 10.1  Central banking versus free banking. Central Banking Monetary policy Inflation

Interest rates Financial stability

Sustainability of financial system Bank corporate governance Risk taking Constraints on system Accountability of decision makers Systems of financial regulation Cost on taxpayer Track record

Free Banking

Arbitrary, politicized, policy makers unaccountable Prone to inflation, because there is no limit to money issue

No problem, because there is no monetary policy Price level tied to a commodity standard; control against overissue of money; long-term price stability Manipulated, resulting in bubbles Market-determined and stable and misallocated resources Financial system weakened and Financial system highly stable prone to crisis because of many stabilizing mechanisms Not sustainable because of Strong because of long-term focus short-term focus Weak Strong Out of control Reined in; sensible trade-offs Weak Tight Weak to none Strong Costly and ineffective

None: not needed

Incalculable but certainly large Poor

None Very good

adequacy but in fact it is central banking that brings about its deterioration. (Salsman 1990, 57)

The more recent Basel system of bank capital regulation has also been a complete failure. As we saw in the recent crisis, much of the banking system was signed as Basel-compliant, only to collapse soon afterward. Much of this failure can be ascribed to the fact that the regulatory system was captured by the banks it was meant to control, whose main concern was to ensure the lowest possible capital requirements rather than maintain their own long-run financial health.13

Central Banking versus Free Banking: Main Comparative Features I end this section with a brief outline of the comparative features of central banking and free banking systems. These are summarized in table 10.1. 13 

For more on the failure of Basel, see Dowd et al. 2011.

232    Macroeconomics and Monetary Economics The differences between the two systems are striking: • The current central banking system is characterized by arbitrary politicized monetary policy making, a tendency to inflation, manipulated interest rates giving rise to asset price bubbles and major misallocation of resources, a highly unstable (and now insolvent) financial system, poor governance structures, and out-of-control risk taking. It is also loosely constrained, has a short-term focus, has no accountability, has useless and expensive regulatory bodies, inflicts a huge cost on the taxpayer, and has a very poor track record. • The free banking system is characterized by the opposite features: no problematic monetary policy, long-term price stability, control against the overissue of money, stable interest rates, a stable financial system, a long-term focus, strong governance, controlled risk taking and tight constraints overall, good accountability, no useless regulatory bodies, no cost to the taxpayer, and a very good track record. To my way of thinking, the free banking system has all the features we might want—it is, indeed, ideal—whereas the central banking system has, quite simply, none.14

The Historical Experience of Free Banking There have been a considerable number of unregulated or loosely regulated historical banking systems that approximate, at least, the free banking model. In his overview of world free banking, Kurt Schuler (1992) was able to identify no fewer than sixty such 14  Another set of arguments against free banking is offered by Goodhart (1988) and Gorton and Mullineaux (1987). They argue that central-bank-like arrangements would arise spontaneously even under unregulated conditions, that unregulated banks would develop “banking clubs” that would have many of the features of central banking, including, most notably, banking regulation. In response, note the following: (1) Even if one grants their argument at face value, it still fails to explain many of the key features of modern central banking, including the note monopoly, the fiat currency, government control, deposit insurance, and the vast systems of modern financial regulation. (2) I agree that banks would form clubs to deal with issues of mutual interest—such as providing LOLR and note exchange functions—and I agree that these would have rules that one might describe as a form of private financial regulation. However, (3), as we have seen, the LOLR function provided by a free market is very different from that provided by a central bank: the one is highly restrained, and the other is essentially out of control. Finally, (4) any “regulation” under free banking is of a very limited functional kind, and the rule-generation process is constrained, because those who produce it bear its cost; this makes the regulation accountable to those who (choose to) live under it. Moreover, those banks that dislike the rules are free to opt out, and there is no political intervention—that is, compulsion—involved. By comparison, the financial regulations characteristic of central banking are characterized by extensive government intervention, are imposed from above, lack the discipline of competitive private rule-making bodies, not least the freedom to exit, and, last but not least, lack the most elementary accountability mechanisms to keep the rule-generation process under control.

Free Banking   233 cases, and new ones are periodically coming to light. Most were in the nineteenth century, and they were most common in the United States, in Europe, and in territories of the British empire. By and large, we can say that these experiences are largely consistent with the claims of free banking theory: • They tended to be nationwide branch banking systems, and in not a single case was there a tendency toward concentration of the note issue in a single bank. • In the early stages of free banking, banks sometimes attempt to eliminate rivals using note duels, but these rarely worked as intended, and banks that engaged in them risked being subjected to the same treatment themselves. So note duels disappeared, and banks learned to cooperate instead. • Counterfeiting was not a serious problem: free banks had both the means and the incentive to keep this problem under reasonable control. • Attempts by free banks to establish cartels always broke down. • The currency issued by free banks was convertible, and—except for cases where the government intervened to create inconvertibility—there were no cases of free banks themselves issuing inconvertible currency. • Free banking systems did not have formal LOLR arrangements but did evolve market-based ways of making emergency loans and issuing emergency currency. • Free banking systems were generally very stable—indeed, very few experienced any peacetime systemwide crises.15 This said, there is still some controversy. One example is the Australian experience in the early 1890s, when there was a major banking crash and subsequent depression. The conventional interpretation of this episode puts much of the blame on free banking (e.g., Pope 1989; Hickson and Turner 2002), but at least one study traces it to misguided government intervention instead (Dowd 1992b). There is considerable controversy over Scottish free banking. The eighteenth- and early-nineteenth-century controversies are documented in, for example, Meulen (1934), Smith (1936), White (1984, chap. 3), and Rothbard (1988). It is interesting how opponents of Scottish free banking had considerable difficulty explaining its success. In the mid-1820s, Sir Walter Scott noted the contrast between Scotland’s “practical system successful for upwards of a century” and the “opinion of a professor of economics that, in such circumstances she ought not by true principles to have prospered at all” ([1826] 1972, 38–39). John Stuart Mill discussed the success of Scottish free banking but was unable to explain it and in the end dismissed the issue, “with the somewhat curious conclusion, that free note issuing is very good north of the Tweed, but very bad south of it” (quoted in Wesslau 1887, xi). Another leading nineteenth-century thinker, 15  The literature on the experience of free banking is too extensive to list, but the reader might start with the cases studies collected in Dowd (1992a) and especially the world overview by Schuler (1992). Conant ( [1896] 1927) also has a long list of cases. Some other studies (which are, regrettably, just a sample of those available) are listed in the references. See also n. 18 below.

234    Macroeconomics and Monetary Economics William Stanley Jevons, could do little better: “if we were all Scotchmen the unlimited issue of one-pound notes [a key feature of the Scottish system] would be an excellent measure” ([1875] 1907, 319), he said, and then proceeded to explain that the unlimited issue of one-pound notes had worked in Scotland only because of the superior Scottish banking system! In recent years, the controversy over Scottish free banking has centered around whether the Scottish system was a satellite of the English system and therefore dependent on the support of the Bank of England (a point of view argued, e.g., by Goodhart 1988, 52, but disputed by, e.g., Selgin and White 1994) and on the question of whether the Scottish banks really were issuing convertible currency (no, according to Rothbard 1988 and Sechrest 1993, 87; yes, according to Dowd, Selgin, White, and others). There has also been controversy over the failure rates of Scottish free banks, the option clause, the impact of interest rate ceilings and small denomination restrictions, and the privileges of the bigger Scottish banks. Free banking in the United States is more complicated. The focus of interest is the free banking period in the generation following President Andrew Jackson’s veto in 1836 of the renewal of the charter of the then-central bank, the Second Bank of the United States. During this period, the federal government left banking regulation to the individual states. The first point to appreciate here is that to set up a bank required a charter, and these charters were (usually) granted by the local state legislature. However, the charters severely limited banks’ ability to amalgamate. In the north especially, they often limited a bank to operate in one county and often only in one branch; this was the “unit banking system.” The chartering system was often also highly corrupt. By the 1820s, there were proposals in New York State to allow nonchartered banks to operate. It was also proposed that these banks should be required to deposit approved bonds with state authorities to offer protection to their creditors in the event of default. These two features—free entry and the bond-deposit condition—were to become the hallmarks of the subsequent “free banking” laws. However, these free banks were not “free” in the sense of being able to operate under laissez-faire. Meanwhile, the chartering system had become “so shameless and corrupt that it could be endured no longer,”16 and a “free banking act” finally became law in New York in April 1838. This period, 1837–1861, witnessed a wide range of experiments in state banking regulation, ranging from outright prohibition to virtual laissez-faire, with state monopoly banks and various forms of state charter and New York–style free banking systems in between. To summarize:17

16 

These were the words of New York comptroller Millard Fillmore, looking back later in 1848 (quoted in Klebaner 1974, 9). 17  There is a very extensive literature on the US experience of free banking. It includes, among many others, Hammond 1957; Klebaner 1974; Rockoff 1975; Trivoli 1979; Rolnick and Weber 1983; Rolnick and Weber 1984; Rolnik and Weber 1985; Economopoulos 1988; and Dowd 1992e. Space precludes a larger selection or a discussion of where and how the literature disagrees. The discussion in the text is drawn from Dowd.

Free Banking   235 • The New York experiment with free banking was highly successful and widely copied by other states, where it also met with much success. • Where there were problems with these systems, these can be largely attributed to the impact of state intervention or legal restrictions. An example was Michigan, where a state law passed three months after its free banking law authorized a general suspension of specie payments and led to major problems of overissue and subsequent failure. Indeed, it was the Michigan case that was still remembered afterward when the success of free banking elsewhere had been forgotten. In a number of states, free banks also got into difficulties when they took heavy losses from their holdings of state bonds, which fell sharply in value in response to their states’ severe fiscal problems; in such cases, the cause of these difficulties was the states’ fiscal problems combined with the legal requirement that free banks hold those states’ bonds, not some defect in free banking as such. • Experiments with bank prohibition and monopoly state banks were, in general, failures. • Some states had very liberal banking regimes that closely approximate laissez-faire banking, and their performance was even better than that of New York–style free banking systems. In a nutshell, antebellum banking experience strongly suggests that liberal financial regimes were broadly successful and that state intervention largely failed. There was also a tendency to imitate successful systems, and so the more liberal regimes tended to spread over time. By the outbreak of the Civil War, more than the half the states in the Union had adopted New York–style free banking systems, and a number of others had adopted regimes not far short of laissez-faire. The Civil War then broke out, and the federal government intervened once more with the national banking legislation of 1863–1865. This new system was introduced primarily for fiscal reasons and not to correct any well-established dissatisfaction with the existing state systems. It was only meant to be temporary but was left intact after the war and lasted until the Federal Reserve Act of 1913. And so it happened that “The fiscal exigencies of the Civil War checked the process of evolution and fastened upon the country the incubus of a cumbersome and unscientific banking system. But for this check it was highly probable that some such organization as the free banking system of New York … would have spread throughout the entire country” (Holdsworth [1911] 1971, 23).

Misconceptions about Free Banking I observed at the start of this chapter that the subject of free banking has been greatly misunderstood. This tendency to misunderstand free banking is unfortunate both because of the intrinsic importance of the subject and because the case for free banking

236    Macroeconomics and Monetary Economics is very simple, even self-evident. The gist of it is merely an application of the general principle of free trade. If free trade is generally desirable, as most economists agree, then why does the free trade principle not apply to money and banking? Most economists take a patently untenable position on this question. They accept the free trade principle but deny that it applies to money and banking. Yet few of them can give any sort of coherent defense of their position or have even thought much about it. When pushed, they come up with all manner of ad hoc explanations—the usual ones being that free banking “can’t work” or “failed” or that the “banking system needs regulating because it is unstable”—all of which are demonstrably false. By the mid-twentieth century, the earlier experiences of free banking had been mostly forgotten, and textbooks were written by economists who had grown up taking central banking for granted and who could not comprehend any other system. Even in the United States, the broadly successful experiences of free banking during the generation before the Civil War had been transmuted into twisted folk memories of disastrous experiments with “wildcat banking,” entertaining but essentially fiction. A shocking example is Paul Samuelson. In the first edition of his Economics—the most popular economics textbook of all time—in 1948, he wrote that central banking was established in the United States because “the country was fed up once and for all with the anarchy of unstable, private banking.” He went on to elaborate: Certainly, if one reviews the history of private, small scale nineteenth century banking, there is plenty of gloom to be found in it. … All countries have long recognized that banking is one of those activities “affected with a public interest” and in need of government control. They have created central banks … to correct the inherent instability of laissez-faire banking. … How is government action able to bring important change, without which our system of small unit banking would remain perilously unsafe? The government can (and must!) use its boundless emergency monetary powers to avert collapse whenever a real financial crisis should arise. (Samuelson 1948, 322–323) Without government regulation and examination, without the Federal Reserve System, and without guaranteeing of bank deposits by the FDIC, out system of small unit banking would be intolerable. Indeed, a few economists think that a return to a 100 per cent reserve banking system is desirable and necessary, not only for safety, but also to prevent banks from creating bank deposits. (Samuelson 1948, 334)

There is no reason to suppose that Samuelson was intentionally misleading, so one can only assume that he was writing out of ignorance. Leaving aside that the United States never had a serious problem with laissez-faire banking, he conflates laissez-faire with small unit banking and neglects to mention that the unit banking model was itself a product of legal restrictions that limited American banks’ ability to amalgamate and so left them small and vulnerable—or that other countries did not have this problem because their banks were allowed to grow into nationwide branch banking systems. Later editions did not even mention the possibility of systems other than central

Free Banking   237 banking. It is no wonder that generations of students brought up on Samuelson could not understand free banking. Unfortunately, free banking was also misunderstood by prominent pro-market economists. In A Program for Monetary Stability, Milton Friedman poses the question of whether monetary arrangements cannot be left to the market. He answers by saying that he is “by no means certain that the answer is indubitably in the negative” (Friedman 1960, 4), but he goes on to give an uncharacteristically muddled argument for why the government should be involved. He starts by explaining commodity money and the resource costs involved, going on to suggest that these resource costs create incentives to find cheaper ways of providing a medium of exchange, that is, paper promises to pay. He acknowledges that this system might work if promises to pay were always fulfilled or if the community were willing to adhere to extreme caveat emptor, but he doubts that these conditions would be fulfilled. He then raises the issue of counterfeiting and fraud—ignoring the ways in which free banks have their own incentives to address these problems and have done so successfully—and concludes, wrongly, that such paper money will likely be overissued from time to time, making convertibility impossible. He then asserts: “Historically, this is what happened under so-called ‘free banking’ in the United States and under similar circumstances in other countries” (6). But this is simply not true; instead, both free banking theory and the historical evidence indicate that free banks would continue to issue convertible notes indefinitely, even if the occasional bank went under. By this point, however, he has persuaded himself that banks would be competitively issuing inconvertible notes. Since each note has a face value greater than its intrinsic value, which is essentially almost nothing, they would overissue such notes, and the currency “would thus probably tend through increased issue to degenerate into a commodity money—into a literal paper standard—there being no stable equilibrium price level short of that at which the value of currency is no greater than that of the paper it contains.” (8). This latter argument is conditionally true—competitive banks issuing inconvertible notes will overissue them—but, to repeat, it is based on the false premise that free banks would issue inconvertible currency, which they would not. Friedrich Hayek fares no better in his The Constitution of Liberty ([1960] 1978). There he asks the right question: why should we not rely on the market? His answer, however, is patently unconvincing:  “this is not only politically impracticable today but would probably be undesirable if it were possible.” The reason he gives is that “Perhaps, if government had never interfered, a kind of monetary arrangement might have evolved which would not have required deliberate control; in particular, if men had not come extensively to use credit instruments as money or close substitutes for money, we might have been able to rely on some self-regulating mechanism” (324). The first statement begs the issue, and the second implicitly asserts, but does not justify, the (patently false) claim that the free market cannot handle credit instruments. In a footnote, however, Hayek concedes the benefits of competition in money while still asserting the necessity of a central bank.

238    Macroeconomics and Monetary Economics But in the mid-1970s, the wheel started to turn again. In 1976, Hayek produced his famous Institute of Economic Affairs monographs, first on competing currencies and then on the privatization of money, regarding the latter initially only as a bitter joke. However, the idea soon took off. The mid-1970s also saw the publication of Hugh Rockoff ’s (1975) reevaluation of antebellum free banking in the United States—this argued that these episodes had been much misunderstood and were, in fact, more successful than commonly appreciated—and a number of studies on competitive money. Then, in 1984, came Lawrence H. White’s influential revisionist study of the Scottish free banking experience and the debates surrounding it. The subject of free banking was soon undergoing a renaissance; a number of monographs on the subject followed, including Dowd (1988; 1989; 1996), Goodhart (1988), Glasner (1989), Selgin (1988), Salsman (1990), Horwitz (1992), and Sechrest (1993), and hundreds of articles, a few of which are listed in the references. There was also important associated historical research, most notably by Timberlake (1981; 1984) and Horwitz (1990). Free-market think tanks were also heavily involved in free banking research, including most notably the Cato Institute, the Institute of Economic Affairs, and the Mises Institute. In the process, many historical experiences of free banking and their associated controversies were rediscovered and reevaluated, and the underlying theoretical issues were once again worked through.18 For the most part, however, mainstream economists continued either to misrepresent the subject19 or ignore it altogether. The main reason is, one suspects, that mainstream economists have too much invested in belief systems that take the existence of central banking for granted; many careers have been built on the backs of models of monetary policy—especially models of optimal monetary policy—and it is a lot to ask their authors to admit that the best monetary policy might be no monetary policy at all. Many of these scholars would be redundant if there was no central bank. Most academic economic journals are also heavily invested in central banking. So, of course, is the Federal

18  For his part, Friedman conceded later that his arguments for government intervention had been ill founded. His later view was that he was not against free banking in principle, but he felt that advocating free banking was politically unrealistic. 19  An example is Bennett McCallum (1985, 29), who suggested that inconvertible currency somehow spontaneously emerged from previously convertible currency. As he put it, “since it is costly for banks to maintain the requisite commodity reserves and since the convertibility option is very rarely exercised, banks might eventually do away with this guarantee,” as if it served no purpose, and banks could disregard the preferences of their customers for the convertibility guarantee. He goes on to suggest that the abolition of convertibility by the Bank of England in 1797 might be an example of such a process. However, if one examines this episode at all, it is clear that it is a textbook-perfect example of government intervention. For years, the government had been leaning on the Bank of England for loans; these loans severely weakened the bank and made it increasingly difficult for it to maintain specie payments. A point then came when a relatively minor shock set off a run that the bank did not have the resources to meet. The government then intervened to legalize the bank’s bankruptcy—a bankruptcy caused by the government’s own profligate spending—to prohibit it from making any further specie payments. It is difficult to see how the role of the government in this suspension could be any more clear-cut.

Free Banking   239 Reserve itself, which affects research into money and banking in profound ways, highlighted in a study by White (2005): • The Fed employs a large number of economists who work in these areas. In 2002, for instance, the Fed employed 495 full-time staff economists, 27 percent more than the number of money/macro/banking economists hired by the top fifty US academic economics departments put together. The Fed also sponsors large numbers of conferences and is able to influence discussions of monetary policy and banking via large numbers of research papers and a vast number of freely available publications, all of which make it ever so easy for scholars and textbook writers to go along with a Fed-friendly line, even if they are not consciously setting out to do so. • Even economists outside the Fed have an interest in pursuing Fed-friendly research. Federal Reserve officials are very prominent in editing important field journals—as White puts it, “scholars who want to publish in the field of monetary economics must pass through a gateway controlled largely by editors affiliated with the Federal Reserve System” (2005, 341)—and they might aspire to work for or at least visit the Fed themselves at some point. In any case, to paraphrase Friedman, if you wish to advance in monetary research, you would be disinclined to criticize the biggest employer in the field. • There is anecdotal evidence of censorship—in one case, a well-known economist on a visiting scholarship to a Federal Reserve Bank submitted an article to the local Fed’s research journal, only to have the reviewers blue-pencil a passage for removal because it criticized a Fed decision made fifty years earlier. Another example was given by Auerbach (1985, 52), who reported that the practice at his Federal Reserve Bank was to clear research through the Board of Governors and “persuade” offending authors to delete material that the board or bank officials did not like. • Fed research shows a bias toward articles favoring discretion over rules, and White could not find a single Fed-published article calling for the elimination, privatization, or even restructuring of the Fed itself. Research on free banking was limited to a small number of evaluations of the antebellum state banking systems that went by that name, and with one exception only, the notion of free banking as laissez-faire banking was not even mentioned. Above all, it would simply be unreasonable to expect the Fed not to use its formidable influence and resources to steer the subject in ways that suited its own institutional interest. Turkeys rarely vote for Christmas. Nor should we underestimate the role of propaganda. In the Fed’s own accounts of its origins, it consistently misrepresents the pre-Fed period as some kind of wild free-for-all, ignoring how misguided regulations such as barriers to branch banking and restrictions on the note issue contributed to instability in that period. Nor do Fed accounts mention, let alone explain, how Canada avoided these problems without a central bank. Nor do they address the politics and vested interests of the time, which ruled

240    Macroeconomics and Monetary Economics out the natural solution, a return to free banking. Instead, the impression given is that the Fed was the only conceivable solution to the problems of the time. The Fed’s propaganda has been particularly successful on the awkward subject of the depreciation of the currency—the value of the dollar has fallen by more than 96 percent since the Fed was founded in 1914. Even the Fed can’t deny this failure, so it redefines price stability; hence the support, partly from within the Fed, for treating a 2-percent inflation rate as “the new zero,” and there is even support to establish a new-new zero as high as 6 percent, which would enable it to claim that it kept prices broadly stable throughout the postwar period. The Fed also responds to its own inflation failures by retreating into fantasy. To quote George Selgin: When it isn’t claiming, implicitly or otherwise, to have prevented it, the Fed portrays inflation, not as evidence of its own lack of monetary restraint, but as a kind of menace-from-without, while portraying itself as a heroic, if not invisible, inflation fighter. … [A]‌blatant example of this tactic is in the New York Fed’s educational comic book, “The Story of Monetary Policy,” … with its panel showing the Fed, depicted as a superhero complete with blue bodysuit and yellow cape—thrusting an elbow into a Big Red Blob standing for “inflation.” Just where the blob came from is never explained, though readers might just as well assume that, like Superman’s nemesis Jax-Ur, it came from the planet Krypton. (2014, 240)

But perhaps the Fed’s most brilliant public relations feat yet is the way in which it has spun the recent crisis. Leaving aside that Fed easy-money policies did much to create the crisis, which Fed officials were among the last to anticipate, and leaving aside that the Fed’s own blundering and its use of scare tactics did much to destroy confidence and destabilize the financial system, the Fed has managed to create a conventional wisdom that maintains that without the Fed to handle the crisis, the outcome would have been much worse than it was.

Some Advice for Students I end with a few words of advice for students interested in learning more about free banking. To start with, it is useful to have a bibliography, and one is offered in the references list below. This bibliography is necessarily only illustrative, but it opens the door to the literature, and those who wish to investigate particular threads can do so. They should check out the websites of think tanks that have promoted free banking—such as the Cato Institute, the Institute of Economic Affairs, the Mises Institute, the Foundation for Economic Education, and so on—and check out their in-house research journals (e.g., Cato Journal, Review of Austrian Economics, Quarterly Journal of Austrian Economics, etc.). They should also check out think tanks and websites that focus specifically on

Free Banking   241 sound money: the Atlas Sound Money Project, and www.freebanking.org, which offers access to a great deal of material on free banking. For students, the scope of possible research topics is truly vast, and much of it is still unmined. One relatively easy but also very useful option is to look for new—well, hitherto overlooked—cases of private monetary systems, both historical and contemporary. These are being discovered, or rediscovered, all the time. There is also a lot of good history of thought work to be done examining the views of famous scholars on free banking—some obvious candidates for examination are the great nineteenth-century writers such as Mill, Lysander Spooner, Herbert Spencer, and Benjamin Tucker—but there are many more to choose from. There is also a lot of largely forgotten “underground” literature that is very relevant and well worth exploring, much of which deals with free money issues. Some examples of this literature from around a century ago were highlighted by Cowen and Kroszner (1987) and Dowd (1992d), but these barely scratch the surface of the material available. There is also a great deal of material in other languages, especially French, German, and Italian. A good starting point is to look at the huge collection of microfiched material put together by John Zube as part of his Libertarian Microfiche Publishing project, which seeks to make this material available to other researchers interested in exploring it. There is also much to be said for poking around one’s local libraries for archival material. There is an ongoing need for good economists who can deconstruct the models used to justify government intervention into the financial system. These typically boil down to dubious attempts to establish some market failure. I would suggest that a good rule of thumb is to start by regarding any market-failure claims as bogus. It then merely remains to work out where the errors lie, bearing in mind that any solutions to the purported market failure must be consistent with the model itself and not some deus ex machina, as in, for example, DD. This is easier said than done, however, and trying to publish the results of such work is not for the faint-hearted. Going further, there is always a need for good people with the ability to critically examine current policies and institutional arrangements and suggest superior alternatives—and never more so than since the onset of the current financial crisis, where those policies and institutions have failed dismally, and yet the Federal Reserve has been able to establish a conventional wisdom narrative according to which it saved us from an outcome that would have been very much worse.

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244    Macroeconomics and Monetary Economics Samuelson, P. A. 1948. Economics: An Introductory Analysis. New York: McGraw Hill. Schuler, K. 1992. “The World History of Free Banking.” In The Experience of Free Banking, edited by K. Dowd, 7–47. London and New York: Routledge. Scott, W. (1826) 1972. A Third Letter to the Editor of the Edinburgh Weekly Journal, from Malachi Malagrowther, Esq. on the Proposed Change of Currency, and Other Late Alterations, as they Affect, or are Intended to Affect, the Kingdom of Scotland, 38–39. Edinburgh: Ballantyne. Sechrest, L.  J. 1993. Free Banking:  Theory, History, and a Laissez-Faire Model. Westport, CT: Quorum Books. Selgin, G. A. 1988. The Theory of Free Banking: Money Supply under Competitive Note Issue. Totowa, NJ: Rowman & Littlefield. Selgin, G. A. 1994. “Free Banking and Monetary Control.” Economic Journal 104: 1449–1459. Selgin, G. A. 2014. “Operation Twist-the-Truth: How the Federal Reserve Misrepresents Its History and Performance.” Cato Journal 32 (2): 229–263. Selgin, G. A., and L. H. White. 1994. “How Would the Invisible Hand Handle Money?” Journal of Economic Literature 32: 1718–1749. Smith, V. C. 1936. The Rationale of Central Banking. London: P. S. King. Timberlake, R. H. Jr. 1981. “Private Production of Scrip-Money in the Isolated Community.” Journal of Money, Credit, and Banking 19, no. 4: 437–447. Timberlake, R. H. Jr. 1984. “The Central Banking Role of Clearinghouse Associations.” Journal of Money, Credit, and Banking 16, no. 1: 1–15. Trivoli, G. 1979. The Suffolk Bank: A Study of a Free-Enterprise Clearing System. London: Adam Smith Institute. Wesslau, O. E. 1887. Rational Banking versus Bank Monopoly. London: Elliot Stock. White, L.  H. 1984. Free Banking in Britain:  Theory, Experience, and Debate, 1800–1845. Cambridge: Cambridge University Press. White, L.  H. 2005. “The Federal Reserve System’s Influence on Research in Monetary Economics.” Econ Journal Watch 2 (August): 325–354. White, L. H. 2011. “A Gold Standard with Free Banking Would Have Restrained the Boom and Bust.” Cato Journal 31, no. 3: 497–504.

Pa rt  I V

I N ST I T U T ION S AND ORG A N I Z AT ION S

Chapter 11

S o cial Ec onomy as an Exte nsi on of the Au st ria n Research Pro g ra m Emily Chamlee-Wright and Virgil Henry Storr

Introduction Although the origins of the Austrian school are usually tied to Carl Menger, an argument can be made that its genuine origins rest within the writings of the early classical liberal thinkers, particularly Adam Smith. Boettke (2007), for example, argues that although Austrian economics is outside the mainstream of contemporary economic thought, it is squarely within the “mainline” of thinking that begins with Smith and runs through the development of political economy in its various forms to investigations into the economics of social institutions and the study of entrepreneurship. Many of the most prominent themes in the development of Austrian economic thought were present in Smith’s writings. The Austrian emphasis on the market process as a spontaneous self-regulating order, for instance, can certainly be found in Smith’s classic “invisible hand” discussion. Austrian emphasis on the importance of institutions for market discovery finds roots in Smith’s discussions of how property rights shape incentives and how money facilitates economic exchange. Arguably, Smith’s discussion about the productive advantages that come from the division of labor is as much about the division of knowledge, which features prominently in Friedrich Hayek’s critique of socialist economic planning. The political economy that connects the Austrian school to mainline economic thought is thus clear and well recognized. Yet there is another thread that connects the

248   Institutions and Organizations Austrian school to the mainline, and although it is less well recognized, it is similarly robust in terms of its potential to advance the Austrian research program. Just as they developed the nascent political economy, Smith and other classical liberal thinkers were developing what can be called a research program in “social economy.” This program in social economy focuses attention on the connections between noneconomic social interaction and economic patterns and outcomes. Whereas political economy asks foundational questions about why and how specific political and institutional arrangements affect economic processes, social economy asks foundational questions about why and how social processes intersect with, shape, and are shaped by market processes (Chamlee-Wright 2006; Chamlee-Wright 2011; Storr 2013). Although Austrians have tended to emphasize the political economy themes, leaving the social economy themes to political and moral philosophers, they never completely abandoned this social territory. Menger (1976, 116), for instance, emphasized that the value of goods is subjective and discussed how subjective valuations were affected by social circumstances. Similarly, Ludwig von Mises (1957) has stressed the importance of thymological considerations in explaining human action in the real world. Hayek, particularly in The Constitution of Liberty (1978), Law, Legislation and Liberty (1973; 1976), and The Fatal Conceit (1988), focused on cultural transmission as essential to understanding the evolution of the informal norms necessary for the emergence of the extended order. Nonetheless, even in Austrian circles, discussion of how social factors affect economic action was not a principal focus. Beginning in the 1980s, however, Austrians became increasingly interested in the intersections between social factors and economic activity. Lavoie (1991), for example, explored the relationship between culture and entrepreneurship. Following Lavoie, others within the Austrian tradition investigated how culture directs the entrepreneurial gaze, intersects with the institutions that underlie markets, shapes the process of economic development, and establishes limitations and possibilities of self-governance (see Chamlee-Wright 1997; Storr 2004). Austrian investigations into the role of social institutions in market discovery were another way in which Austrian scholarship began working its way into social territory. Lewis (2008), Ikeda (2008), Meadowcroft and Pennington (2008), Chamlee-Wright (2008), Carilli, Coyne, and Leeson (2008), and others have discussed the role of trust and social capital in the market process. Other Austrians have investigated the intersection between market processes and social institutions, such as the family (see Horwitz 2005; 2008; 2010). Further, postcommunist transitions directed the attention of Austrian scholars who puzzled over the question of whether part of the difficulty in making a transition to market-oriented society rested in the cultural shift that would be necessary if institutional change was to bring about the results that economic theory had predicted (see Boettke 2001; Pejovich 2003; Runst 2013). Similarly, Austrians interested in economic development also considered the question of whether social factors are an important consideration in how we understand institutional change, entrepreneurship, and public policy surrounding economic development strategies (see Boettke, Coyne, and Leeson 2008). Moreover, Austrians became increasingly interested in the Bloomington school of social thought in which

Social Economy as an Extension    249 Elinor Ostrom and Vincent Ostrom investigated the political and social prerequisites for self-governance. Thus, at this point, it is appropriate to assert two points regarding the Austrian school’s contribution to social economic research. First, it is clear that a good number of Austrian scholars are deeply interested in social economy. Second, although Austrian scholarship on the intersections between social and market processes is robust and growing, rather than settling on a single approach or adopting a single perspective, contemporary Austrians have pursued a number of different research strategies. As a result, Austrian contributions to our understanding of how social factors affect economic action have yet to be systematized as part of a coherent social economy research program. The aim of this chapter is to fill that gap. Put another way, the aim of this chapter is to depict a program of study on social economy that is as coherent and relevant as the research program on political economy. Further, we will argue that although it is broadly interdisciplinary, a social economy research program is one in which Austrian economics has a particularly important role to play in advancing an economics of meaning in which the plans, purposes, expectations, and framing perspectives of individual actors feature prominently in how we understand broader social and economic outcomes. Arguably, connecting the categories of socially embedded resources discussed below also improves our understanding of the social learning processes that occur within both priced and nonpriced environments. Looking at these socially embedded resources helps us to understand how actors interpret the meaning of price changes in the market. Additionally, focusing on these socially embedded resources helps to explain how it is that individuals negotiate nonpriced environments. Austrians have advanced political economy inquiry by focusing not only on the incentives that political actors face but also on the nature of knowledge within the market and the role that markets play as a social discovery process. Austrians have a similarly important role to play in advancing social economy inquiry.

Systematizing the Social Economy Research Program Drawing on the anthropological, sociological, and economic scholarship that explores the intersection between social and economic processes, this section offers an analytic framework for social economy inquiry. With the framework in place, the particular role that Austrian economics can play in advancing such a program, we argue, becomes clearer.1 1  Ensminger (1996); Denzau and North (1994); Jennings and Waller (1995); and North (1990; 2005) are among the new institutionalists who investigate the connection among culture, shared mental models, and economic outcomes. Landa (1981; 1995) bridges cultural analysis to public choice economics. Among

250   Institutions and Organizations Social Institutions

Structure of Socially Embedded Resources A

B Shared mental models (often expressed as collective narratives)

Generalized norms

C

D

Social networks

Cultural tools

Social Patterns/Outcomes

Figure 11.1  Research program on social economy.

Figure 11.1 attempts to capture visually the basic structure of social economy inquiry. As with political economy inquiry, the structural elements of a social economy research program include the social institutions that govern human interaction. But in addition to the political and legal institutions emphasized in political economy, social economy also focuses on institutions that govern human interaction beyond the market and political spheres. For example, institutional rules relating to family and kinship have tremendous impact on patterns of resource allocation, both in terms of the material resources that can be exchanged in the conventional sense and in terms of nonmaterial resources (e.g., status or social capital) that represent real value to those who have access to them. Because they shape and are shaped by socially embedded resources available to individuals and communities, formal and informal rules that govern property relations, the Austrian economists investigating the link between economic and cultural processes are Boettke (2001); Boettke and Storr (2002); Boettke, Coyne, and Leeson (2008); Chamlee-Wright (1997; 2002; 2005; 2006); Coyne (2007); Evans (2007); Lavoie (1990a; 1990b; 1991; 1994); Lavoie and Chamlee-Wright (2000); Schutz ([1932] 1967); and Storr (2004; 2006; 2008; 2013).

Social Economy as an Extension    251 exchange, contract, dispute resolution, labor and occupational access, and the rights, limitations, and obligations associated with kinship, gender, caste, and ethnic identity are all examples of social institutions relevant to social economic inquiry. The socially embedded resources to which individuals and communities may (or may not) have access constitute further essential elements within a social economy research program. The categories of socially embedded resources discussed below include shared mental models, generalized norms, cultural tools, and the resources embedded within social networks. This list is not intended to be exhaustive but does provide a sense of the diversity and forms that such resources can take. Ultimately, social economy research seeks to understand the connections between institutional rules and/or socially embedded resources that define a given social context and economically relevant outcomes or patterns that emerge from them.

Shared Mental Models Shared mental models, sometimes referred to as “ideological schemes” (Sewell 1992), serve as theoretical frames for understanding cause and effect and the order we observe in the world. Mental models may be highly refined and well articulated (e.g., the Pythagorean theorem), or they may be more general and operate in the background of consciousness (e.g., “patience is rewarded”). They may be drawn from a broader belief structure (e.g., “God will provide”) or the state of scientific inquiry (e.g., the belief that “the celestial bodies we see in the night sky orbit the earth”), or they may be drawn from a community’s shared history (e.g., “our community is particularly self-reliant”). Mental models are often expressed as universal statements about how the world works in general (e.g., Newtonian laws of motion), or they may be expressed as statements about a particular group (e.g., collective narratives about “who we are” as a people). While all mental models have the potential to shape the social economy landscape, because they can be the source of significant variation, social economy inquiry tends to emphasize the mental models that operate within the background of consciousness and/or the mental models that are expressed in the form of collective narratives. Mental models are relevant to social economy inquiry primarily because they frame the way people understand themselves and their circumstances and their ability (or inability) to affect those circumstances through individual action or public policy. Further, because they link cause and effect in the minds of those who hold them, mental models tend to offer particular solutions (which may or may not be correct) for remedying problems. Putting it slightly differently, any particular mental model may render a correct solution either more or less visible. By way of example, consider the mental model that illness is caused by plethora (an overabundance of blood). If plethora is understood to be the cause of ill health, bloodletting will be identified as the obvious solution. Despite the fact that bloodletting was almost always the wrong solution if recovery was the goal, this mental model was particularly “sticky,” persisting from antiquity through much of the nineteenth century. The

252   Institutions and Organizations absence of a robust feedback mechanism helps to explain why the mental model and its associated course of treatment held sway for centuries. If the patient recovered, success was attributed to the bloodletting. If the patient died, the presumption was that nothing could have helped and that it was the original ailment, not the bloodletting, that was the cause of death. Notice that the mental model defines not only a prescribed course of action but also the path of learning that emerges. As a mental model, plethora defined what it meant to engage in careful medical practice; more refined and precise prescriptions for bloodletting were cultivated and practiced. Contrast this with a mental model that links infection to a colony of bacteria. Such a mental model suggests a very different course of action (e.g., cleaning a wound rather than drawing blood, using sterilized instruments, etc.) and sets physicians on a very different path of discovery (one that eventually leads to the discovery and perfected use of antibiotics). Similarly, the mental model of a “just price” will likely lead to formal and informal sanctions against sellers who deviate from the price that was customarily charged. In the context of heightened scarcity, adherence to the customary price will exacerbate the shortage, although the mental model of a just price may be so culturally ingrained that the alternative (flexible prices) is never given serious consideration. The mental model of a just price may direct producers away from discovering ways to increase yield through quality improvements and directs moral and legal authorities to discover more effective means of enforcement. (Alternatively, the mental model may direct learning toward discovering artful ways of circumventing the prohibition.) The mental model that attributes widespread social coordination to flexible prices, on the other hand, shifts what is morally taboo (allowing sellers to charge higher prices) into a solution for resolving the shortage and, correspondingly, shifts the paths of discovery that producers and moral and legal authorities will pursue. New institutional economics has been at the forefront of examining the reciprocal relationship between mental models and institutions. In keeping with the examples above, North (1981; 1990; 2005; see Denzau and North 1994) describes how the mental templates people possess play a significant role in carving out a particular path by which institutional change unfolds. The particular forms that institutions take are, at least in part, the consequence of the mental models people possess about how the world works. Experience and learning may improve our mental models, but there is no guarantee of self-correction. Recalling the persistence of bloodletting through the ages, the absence of a clear alternative and more rigorous standards of scientific experimentation meant that the feedback available to physicians was too weak to reject the ineffective practice. Further, North (1981) points out that groups advantaged by the status quo have an interest in investing in ideologies that support existing mental models. Thus, even if a corrected course (a more accurate mental model) is within view, political interests may make significant financial and ideological investments aimed at maintaining inaccurate mental models. (Imagine an organized guild of early phlebotomists engaged in a public campaign touting the benefits of bloodletting.) Conscious and unconscious investment in existing ideological frames puts further in doubt the notion that the evolutionary

Social Economy as an Extension    253 interplay between shared mental models and social institutions leads inevitably or swiftly to social progress, but it underscores the mutual influence that mental models and social institutions have on one another. Austrians have, similarly, discussed the role of mental models in shaping individual action and the processes through which mental models evolve. Mises (1949, 178), for instance, has argued that ideologies (i.e., shared frameworks of mental models) precede and so guide human action. He also explained that these theories about how the world works are necessarily confronted by reality (181). According to Mises, individuals discover that their plans and projects are perhaps guided by spurious ideologies when they do not yield the results that were expected (180–181). When this occurs, they adopt a new set of theories. Mises demonstrates his theory of ideology using an anecdote about a man who possesses a mental model that the water is safe to drink and so heedlessly drinks the water from the tap but moves to a context where it is no longer safe to drink. “When he moves to a place in which the water is polluted by morbific germs, he will devote the most careful attention to procedures about which he never bothered before. He will watch himself permanently in order not to hurt himself by indulging unthinkingly in his traditional routine and his automatic reactions” (47). Stated another way, he will update his mental model regarding the water. Mental models are shed and updated when they become too costly to maintain. Hayek ([1952] 1967, 145) has similarly argued that individuals update their theories and classificatory systems when they “give rise to expectations which [are] not borne out by events.” Additionally, Storr (2009) has argued that North’s underdeveloped concept of the ideological entrepreneur (i.e., the agent of ideological change) might be improved if it was combined with Austrian theories of entrepreneurship. Austrians conceive of entrepreneurs as the driving force in the market process, as individuals who are driven by profit opportunities and succeed by creating new products or markets. As Storr explains, “a Kirznerian ideological entrepreneur would be alert to opportunities to advance an existing ideology that people in a particular place want but do not yet know about (i.e., to engage in ideological arbitrage). He would be alert to opportunities to sell a new ideology that better explains the world than existing ideologies” (108). Elsewhere, and as we discuss below, Austrians have also written about how the existence of certain mental models can both facilitate and retard entrepreneurial activity.

Generalized Norms Generalized norms, such as norms of trust, reciprocity, authority, and habits of association, are another category of socially embedded resources that have impact on the social economic framework. Contributors to the social capital literature have identified the links between such generalized norms and economic outcomes. In his now-classic essay on the connection between social capital and human capital, for example, Coleman (1988) argues that the investments we make in norms of trust and reciprocity have the potential to generate tangible returns, as exemplified by the lower transaction costs

254   Institutions and Organizations enjoyed among Jewish merchants in the New  York diamond market. Putnam (1993; 2000) also relates economic progress (by virtue of more robust democratic institutions) to Tocquevillian habits of association. Fukuyama (1995) argues that the “radius of trust” explains a good deal of variance in economic performance across societies. Further, he argues that adaptability of social norms to new economic and social conditions is critical to long-term economic health (Fukuyama 1999). Clearly, there exists a symbiotic relationship between norms of expected behavior within a community and other socially embedded resources. For example, as discussed below, investments in specific social networks are often associated with more generalized norms. Similarly, generalized norms and shared mental models can influence each other. Mental models help agents identify a causal link between particular behaviors with particular outcomes and thus generate support for specific social norms. For example, a mental model of “deference to authority brings about order” will tend to support a generalized norm respecting authority. On the other hand, a mental model of “unquestioned authority leads to abuse of power” supports a norm favoring skepticism of those in power. Similarly, a generalized norm of reciprocity is more likely to prevail in a community that holds to the mental model that kindness to a stranger in need generates some positive outcome (e.g., spiritual reward or a more hospitable neighborhood) than in a community that expects strangers, particularly strangers presenting themselves in need, to be swindlers. In the former context, kindness to the stranger in need will be considered the right thing to do; in the latter context, kindness to the stranger in need will be considered foolhardy and a sign of naiveté. In turn, because they render behavior within a community more predictable, generalized norms can either reinforce or erode the mental models that people in that community possess, that is, render them more or less sticky. For example, a generalized norm favoring hard work or self-reliant behavior within an ethnically homogeneous neighborhood can reinforce a mental model of “people in our ethnic group are more resilient than the society at large.” In the face of unexpected hardship, such as a natural disaster that causes physical damage across multiple neighborhoods, the mental model of greater resilience offers a sort of hypothesis, “members of our community will recover faster.” To the extent that the generalized norm of hard work and self-reliant behavior is operative, expectations of greater resilience will be borne out, and the mental model is reinforced. The reverse is also possible. If members of the community do not adhere to the generalized norm—if their behavior is not in keeping with what the mental model of greater resilience would expect—then that mental model may eventually be cast aside if it is no longer helpful in predicting behavior. Or, as North suggests, people within the community may (deliberately or unconsciously) invest more intensively in the mental model of greater resilience. If such investments are successful, the associated norms may be strengthened as a result. The relationship between generalized norms and social institutions is also closely linked. Cultural transmission of moral rules and sentiments that foster trust, honesty, respect, and toleration form a cultural infrastructure that supports institutional rules, such as rights of property and contract, necessary for the extended order to thrive. In

Social Economy as an Extension    255 turn, the institutional framework can either reinforce or erode the norms that make widespread economic coordination possible. For example, whether community members rely on habits of association or they rely on outside assistance to solve local problems is likely to depend on the institutional context that either supports or undermines independent community response. Austrians have discussed the role that generalized norms such as trust play in facilitating market exchange, how norms evolve, and the critical role they can play in nonmarket collective action. Hayek, for instance, has discussed how rules of just conduct, which proscribe certain activities, shape market interaction. These rules, Hayek explains, “enable us … to determine which particular things belong to particular persons … provide information for the decision of individuals, and thus help to reduce uncertainty … they state the conditions under which any person can acquire or give up particular things” (1976, 123). Rules, Hayek writes, makes social life possible (1973, 44).2 Ikeda (2002; 2008) has similarly discussed the critical role that social capital plays in the market process. As Ikeda explains, “social capital makes it easier for agents to rely on strangers in face-to-face encounters (based on trust) and the impersonal market process (based on confidence)” (2008, 176). In a world characterized by radical uncertainty, norms of reciprocity and trust promote entrepreneurial discovery. Indeed, for Ikeda, action in the face of uncertainty presupposes the existence of their generalized norms.

Cultural Tools Cultural tools represent another category of socially embedded resources relevant to social economy research. Cultural sociologist Ann Swidler (1986) has advanced the idea of “culture as tool kit” to draw attention to the causal link between culture and strategies of action. Cultural embeddedness, Swidler argues against those who suggest otherwise, does not render actors passive recipients of culture. Rather, in Swidler’s view, individuals often become skillfully adept at using their culture in toollike fashion. For example, a cultural practitioner might use her exposure to feminist theory to fashion a strategy for exiting an unhappy marriage, negotiating with a supervisor, or developing a new entrepreneurial venture that taps an otherwise untapped market (Swidler 2001). In essence, Swidler marries the economist’s respect for purposeful intention and agency with the sociological concept of embeddedness. Swidler argues further that as circumstances change, actors can become more (or less) aware of the toollike features of the culture they practice. Moments of dramatic political, economic, cultural, or institutional change provide a context in which new models of social organization more openly compete in the minds of cultural practitioners. Under such circumstances, Swidler argues, we are likely to become more focally aware of the 2  Hayek (1988) has also discussed how these social rules evolve through a process of group selection. See also Lavoie (1990b), Caldwell (2000), and Festre and Garrouste (2009) for critical appraisals of Hayek’s writings on social norms and the evolution of those norms.

256   Institutions and Organizations tools at our disposal and better able to articulate our use of cultural tools (to ourselves and to others) as we compose new strategies of action.3 A close relationship exists between the cultural tools that one might read out of his or her context and the shared mental models that operate within that context. The repeated use of particular tools, such as retelling a historical narrative, can reinforce mental models from which they are drawn. A historical narrative that ties members of a community to a particular place, for example, can serve as both mental template and cultural tool. Stories of ancestors who have endured hardship, such as crop failure, flood, earthquake, or some other calamity common to the physical location, can render a new episode of hardship familiar and therefore more navigable than it otherwise might be. In other words, the mental model drawn from the past serves as a guide under present circumstances. At the same time, such narratives can be consciously drawn on and rearticulated in order to affect some particular course of action. For example, a community leader might publicly and repeatedly recall the successes of previous generations or reassert the shared belief that “the good life” can only be found within their particular neighborhood, village, or city, so as to organize a coordinated recovery effort. Note, however, that the relationship between mental models and cultural tools need not be mutually reinforcing. The repeated use of novel tools or cultural tools borrowed from another community can also undermine a dominant collective narrative and can be an important source of social change. For example, younger generations within a community may be particularly likely to adopt cultural tools that favor mobility and adaptation to new environments, rendering a mental model that ties the good life to a particular place less influential. Cultural tools and generalized norms also stand in relation to each other. Generalized norms can become toollike when incorporated into an active strategy. For example, a destitute urban trader might return to his home village, where he is confident that given the norms at work within that community, means of support will likely be offered. The repeated use of such tools can reinforce the generalized norm if the outcome is positive. For example, the trader and others in similar positions receive support, and this experience, in turn, makes them more likely to offer support to others in similar circumstances. On the other hand, if the outcome is negative—for example, too many urban migrants return and the community’s capacity to help is overwhelmed—the repeated use of this particular tool might erode the generalized norm. Austrians have written quite extensively on the role of culture in coloring economic behavior and outcomes. Lavoie (1991, 46), for instance, has argued that culture directs an entrepreneur’s gaze toward certain opportunities and away from others. Moreover, entrepreneurs rely on culture as they identify profit opportunities. Similarly, Chamlee-Wright has argued, “markets are an extension of culture because it is culture that shapes the rules necessary for a market to function” (1997, 41). Her studies of market women in Accra, Ghana (1997), and in Harare, Zimbabwe (2002; 2005), focus on the

3 

See Polanyi (1958) for his distinction between “focal awareness” and “subsidiary awareness.”

Social Economy as an Extension    257 cultural practices in these contexts (e.g., susu rotating credit associations) that facilitate market activities and the cultural mores (e.g., the nature of marital relations) that shape market interactions. Moreover, Lavoie and Chamlee-Wright (2000) have argued that understanding a community’s culture is critical to understanding that community’s development prospects. As they write, “if you want to get a sense of whether a community is apt to grow wealthier, we are suggesting you find out what stories they tell, what myths they believe, what heroes they admire, what metaphors they use. Economic development is, at its heart, a cultural process” (53). Lavoie and Chamlee-Wright (2000, 68–80) have also argued that differences in culture can help to explain why certain formal rules are likely to be effective in some contexts and not in others and why certain industries might succeed in some contexts and not in others. Likewise, Boettke, Coyne, and Leeson (2008) argued that institutions grounded in metis (i.e., culture, norms, conventions, practices, etc.) are more likely to “stick” (i.e., to persist and to be effective). As such, foreign, exogenously introduced institutions are less likely to succeed than institutions that evolve out of the local context. Austrians have also written about how culture can complicate the transition to the market in former communist and colonized countries. Storr (2002), for instance, has written of how several of the cultural attitudes that evolved during slavery and colonialism (e.g., government plays a necessary role in driving the economy) persisted long after West Indian countries achieved independence and explains in part why those countries remained underdeveloped (see also Storr and Butkevich 2002). Boettke (2001) has suggested that the persistence of pretransition cultural attitudes in former Soviet countries explains their struggles with transition (e.g., the high levels of rent seeking). Runst (2013) has argued that the continued gap in economic performance between eastern and western Germany is explained in part by the persistence of pretransition cultural attitudes in eastern Germany, which retard entrepreneurial activity in that region. Additionally, Storr (2013) has pointed to the importance of (Austrian) economists focusing on culture. According to Storr, economists can ignore culture, but they cannot avoid it. As he writes, “the choice before economists is not between employing culture or not employing culture. Instead, it is a choice between implicitly or explicitly employing culture” (31). Although changes in relative prices explain why individuals will economize on the use of some good, for instance, the meanings attributed to price changes are culturally constructed. Storr (2013) recommends that Austrians adopt a Weberian approach to explicitly incorporating cultural considerations into their economic analysis and, so, that they focus on the economic spirits that animate markets. Storr (2004; 2006) employs this approach to examine economic life in the Bahamas.

Social Networks Finally, the resources embedded within social networks of friends, family, and neighborhoods and in civic, religious, and professional associations are also critical to a program of study on social economy. Social network analysis has emphasized, among other

258   Institutions and Organizations effects, the impact that social networks can have in enabling and inhibiting social mobility and economic opportunity. Granovetter’s (1973; 1983; 1995) “strength of weak ties” thesis posits that social mobility is more closely associated with weak ties beyond one’s immediate sphere, as individuals with whom we have weak ties will tend to foster novel connections that others in one’s close networks of friends and family will not share. Following Granovetter, other scholars have investigated how individuals cultivate social capital within and (more important) across social networks (Lin 1999; Lin, Cook, and Burt 2001; Burt 1992). Social networks share a similarly close and sometimes symbiotic relationship with other socially embedded resources. For example, when social exchange becomes routine, habits of reciprocity within close networks tend to spill over into the community at large. Or, in other words, tit-for-tat reciprocity (“I will help you in a time of need, because I expect that you would help me in a time of need”) turns into a pattern of generalized reciprocity (“I will help you in a time of need, because I expect someone would help me in a time of need”). In turn, generalized norms of trust and reciprocity tend, as Coleman (1988) finds, to lower transaction costs of social exchange within networks. Shared mental models and collective narratives help to define what counts as a social network. For example, whether professional acquaintances or membership within a religious congregation count as social networks from which one can draw resources, and what those resources might be, depends in part on the prevailing mental model of these categories of association. It may, for instance, be appropriate to tap a professional network for resources related to career advancement but not for resources needed to deal with a personal crisis. In turn, regular interactions within particular social networks can reinforce or challenge the mental models one holds. For example, if the members of a professional network make a regular practice of providing mutual assistance in times of personal crisis, the mental model of what constitutes a robust professional network may begin to shift. Further, many cultural tools are drawn from and practiced within the context of specific social networks. Tools that leverage an importance placed on authority or reciprocity, for example, may be most effectively leveraged within the context of a faith-based social network that provides ideological support for such tools. In turn, exchange within social networks can either reinforce (if the outcomes are perceived to be positive) or challenge (if the outcomes are perceived to be negative) the wisdom of deploying specific cultural tools. Austrians have discussed how individuals rely on social networks and the resources embedded within social networks as they pursue their ends. Chamlee-Wright (2008) shows that social capital, in the form of social relationships that facilitate economic interactions, is a complex structure made up of heterogeneous and complementary elements. Chamlee-Wright and Storr (2009; 2011) have discussed both the positive and negative aspects of social capital in the form of social networks in postdisaster contexts. Social networks help individuals to overcome the collective action problem that characterizes postdisaster contexts by giving them access to needed resources and information.

Social Economy as an Extension    259 Social networks, however, can also facilitate rent seeking as communities develop organizations that become skilled at lobbying. Additionally, Meadowcroft and Pennington (2008) have argued that market institutions facilitate social cooperation and offer an environment where both strong ties and weak ties can coexist. Similarly, Storr (2008) has argued that the market is a social space that not only depends on social networks but also facilitates social relationships. Carilli, Coyne, and Leeson (2008) have also pointed out that government efforts to create and manipulate social capital can actually retard and damage existing social capital.

Advancing Austrian Economics through Social Economy As the foregoing discussion suggests, the research program on social economy is necessarily an interdisciplinary effort that draws on anthropology, sociology, network theory, and a variety of subdisciplines within economics. But here we wish to emphasize the particular place the Austrian school holds within the social economy research program. As we argue below, Austrian economics stands to benefit from social economy’s emphasis on the interpretive dimension of human decision-making, in that it helps Austrian economics deliver an economic approach that takes human meanings seriously—something that Austrians lament is absent within the dominant economic approach (Lavoie 2011; Lavoie and Chamlee-Wright 2000; Lavoie and Storr 2011). In turn, relative to other schools of economic thought, the Austrian school is particularly relevant to the advancement of the social economy paradigm. The Austrian school’s emphasis on the discovery role of entrepreneurial decision-making in the market also serves as a platform for thinking through discovery in nonmarket social contexts and, as such, helps make the connection between localized discovery in the context of socially embedded resources and broader patterns of social coordination.

Social Economic Inquiry as an Economics of Meaning Understood from an Austrian perspective, economics is a science of meaning. In keeping with the Weberian tradition of Verstehen, Mises insisted that economic behavior must be understood as being fundamentally connected to the purposes and plans of autonomous human beings. As Mises (1949) argues, “we cannot approach our subject if we disregard the meaning which acting man attaches to [his] situation” (26). Also, “the task of the [social sciences] is the comprehension of the meaning and relevance of human action” (51). In contrast to standard economic theory, which Hayek ([1952] 1967) described as being more akin to a “physics” of economic life, an economics of meaning takes the individual’s subjective state of mind as the relevant starting point of

260   Institutions and Organizations analysis. As Hayek later argued ([1952] 1979, 279), the relevant facts of the social sciences are the beliefs and interpretive meanings people possess, not “objective facts” pertaining to the material world. As such, the methods of the natural sciences are a poor fit when the meanings that human beings attach to the world around them are the relevant focus of the investigator. Mises referred to this concern over meaning as the “thymological approach” (1957), characterizing it as a branch of applied social science that investigates the intentions that underlie human action (Lavoie and Storr 2011). Lavoie and Storr (2011) point out that Mises sometimes treated the differences between praxeology (the universal science of human action) and thymology (the study of human meanings, which are context-dependent) as a distinction—that it is appropriate to distinguish between what we do when we engage in theory (praxeology) and what we do when we engage in history (thymology) but that each informs the other. At other times, they argue, Mises treats the differences between praxeology and thymology as a dichotomy, ultimately concluding that history can never inform theory. Lavoie and Storr argue that Mises’s view of theory and history as dichotomous was an unfortunate turn, as it diminished the emphasis on the interpretive dimension of human action and thereby missed an opportunity to drive the discipline closer to an economics of meaning.4 Others, however, sought to strengthen the Austrian school’s commitment to being an economics of meaning by introducing the “interpretive turn” that had shaped much of cultural anthropology and the Verstehen tradition within sociology. For instance, Lavoie and other Austrians advocating the interpretive or hermeneutical perspective in economics argued that the interpretive frame, the intellectual framework that renders systematic thought possible, fundamentally shapes both purposes and plans and therefore the action that follows from these plans. According to this view, the connections between purpose, plan formation, expectation, action, and learning remain beyond the investigator’s intellectual reach without a deliberate introduction of the interpretive dimension. Thus, without including the interpretive dimension in our discipline, we can’t understand questions that are most essential to economics, for example, how it is that people carve out effective strategies of action under conditions of radical uncertainty or how people come to know the economic knowledge that is necessary to fulfilling their productive and consumptive plans. Absent the interpretive dimension, our economics may be able to predict outcomes in the positivist sense, but in order to be good science, our economics not only must enable us to predict behavior under given conditions but also must tell a plausible story—it must render complex phenomena intelligible to the trained mind. Further, an economics of meaning recognizes that the direction of influence between interpretive frame and action is two-way. Once action takes place, expectations are either affirmed or disappointed, and learning inevitably unfolds (O’Driscoll and Rizzo 4  While unfortunate, the dichotomous view was understandable, Lavoie and Storr argue, given Mises’s attempts to discredit historicist concepts such as polylogism, or the notion that different peoples possess different basic logical structures of mind.

Social Economy as an Extension    261 1996). The quality of what is learned will depend a great deal on the social institutions that are in place. Whether the feedback is robust or distorted, the learning that unfolds will, in turn, either reinforce or revise the framework of thought. This two-way discursive relationship between action taken place at the individual level and outcomes that emerge at the social level characterizes a broad set of social phenomena, including language (Gadamer 1975a; 1975b), cultural norms (Geertz 1979), social structures such as race and class (Giddens 1984), and the institutional arrangements that govern the market order (Hayek 1973; 1978). Convinced that the intentions and subjective meanings of individuals operating within particular institutional and cultural contexts ought to feature prominently in our economic investigations, many Austrian researchers have followed this tradition. See, for example, Boettke (1990), Horwitz (1992), Prychitko (1991), Chamlee-Wright (1997), Storr (2004), Evans (2007), Coyne (2007), and Leeson (2009). And it is no coincidence that the contemporary Austrian contributions to social economy research have come from the interpretive branch of the Austrian school. Investigations of entrepreneurship in diverse cultural contexts, for example, begin with the recognition that the cultural context matters in how entrepreneurs direct their gaze to identify opportunities and in how they navigate the resources embedded within the social context in which they operate. A research program on social economy is thus one pathway by which the Austrian call for an economics of meaning can be answered. Social economy goes beyond what McCloskey (2008) describes as the “Max-U” notion of human agency, stripped of any context or identity, as the relevant starting point for analysis and instead begins with human beings situated within a particular historical context and embedded within social structures that define both opportunities and constraints. Social economy is inherently interpretive in that it takes the mental models and collective narratives by which people understand the world and their own circumstances seriously. Further, social economy is inherently interpretive in that it recognizes that the landscape we navigate is not only a material and financial landscape but one in which strategies for effective action must be culled out of nonmaterial socially embedded resources. The discussion of socially embedded resources presented above underscores the point that effective strategies of action are generally nonobvious and, just as in commercial settings, call forth complex interpretation of the context to tease out potential opportunities. In his theory of capital development, Lachmann ([1956] 1978) emphasized the heterogeneity of capital and the multiplicity of uses to which capital could be directed to underscore the creative and interpretive role played by the entrepreneur. Similarly, social economy recognizes the heterogeneity of socially embedded resources and the multiplicity of ways in which the same social resource might be interpreted and used in a variety of contexts and for diverse ends (Chamlee-Wright 2008).5 A  particular 5  Lachmann ([1956] 1978, 22) has similarly pointed out that “people gain knowledge about each other by closely following market prices. But in the world in which we are living change does not follow such a convenient pattern. Here knowledge derived from price messages becomes problematical. It does not

262   Institutions and Organizations community narrative, for example, may serve as both a mental template and a cultural tool, depending on the interpretive stance one takes. Thus, culture can serve both as context, providing the framework of thought that mediates our understanding of the world (Geertz 1973; Rabinow and Sullivan 1979; Lavoie and Chamlee-Wright 2000; Storr 2013), and as an object of our deliberate thought and purposeful action (Chamlee-Wright 1997 and 2002; Storr 2004). Such an interpretive approach provides balance between the undersocialized view of human decision-making that characterizes much of contemporary economics and the oversocialized view that emphasizes social structure to the point that individual agency is all but eliminated (Wrong 1961; Boettke and Storr 2002; Granovetter 1985). Social economy’s emphasis on social intuitions and socially embedded resources emphasizes embeddedness on the one hand, yet individual agency is also taken seriously. The social economy context is one that calls forth creative reinterpretations of the social context as individuals cultivate strategies for effective action within the context of social structures and socially embedded resources. In other words, social economy inquiry recognizes that social structures both limit and enable certain courses of action. Similarly, frameworks for understanding (mental models) and the tools and socially embedded resources that people will deploy in order to fashion and execute an effective strategy of action are the target of creative human agency. Finally, social economy answers the Austrian call for an economics of meaning by connecting the perspectives, intentions, plans, expectations, and learning that sit at the individual level of decision-making and the unintended patterns that emerge at the social level. Similarly, social economy emphasizes the recursive relationship between the social outcomes that emerge out of a given institutional framework and the socially embedded resources to which individuals may or may not have access. Social economy seeks to understand how individuals cultivate effective strategies of action and how these strategies might in turn generate some systematic social outcomes.

Discovery Processes and Social Order A principal claim of the Austrian school is that the market serves as a discovery process. The central point in Mises’s critique of socialist economic planning is that when we eliminating private ownership of the means of production, we also eliminate competitive bidding, which generates market prices. Without meaningful prices, socialist planners are incapable of guiding the economy in any sort of economically rational way, as the cognitive tools necessary to making such decisions—market prices—have been eliminated. While a socialist planning authority could determine (by vote or by fiat) which endeavors it wishes to pursue on society’s behalf, it has no way of discovering how cease to be knowledge, but ‘does not tell the whole story.’ … [Information from prices] therefore requires interpretation (the messages have to be ‘decoded’) in order to be transformed into knowledge, and all such knowledge is bound to be imperfect knowledge.”

Social Economy as an Extension    263 to produce any given set of goods and services that would leave the maximum resources left over for other pursuits. Thus, according to this view, the market process is essential to the social order because it generates the cognitive tools necessary to discovering the best use of resources, that is, the mix of resources that leaves the maximum resources left over for other pursuits. Hayek developed the Austrian school’s emphasis on the discovery role of the market process by emphasizing the nature of economic knowledge. The knowledge relevant to market coordination, Hayek argued, is fundamentally dispersed across countless market participants. The knowledge possessed by any particular individual is always partial, connected to a particular context of time and place, and frequently the sort of knowledge that is difficult or impossible to articulate. Economic knowledge, in other words, is often tacit in nature, as opposed to objective and concrete forms of knowledge, associated with, for example, scientific discourse. The dispersed and tacit nature of economic knowledge, therefore, raises the question of how, given the fact that no one is ever in possession of all the knowledge necessary to widespread social coordination and could never become so, market coordination happens. Like Mises, Hayek emphasized the critical role of market prices that enable individuals to use knowledge they require to make sound economic decisions, even though they do not possess that knowledge directly. A system of market prices serves as a process of discovery by extending our cognitive reach beyond what we can know directly. Kirzner based his theory of entrepreneurship on these insights. As Kirzner (1973, 1979, 1984, and 1985)  argues, it is entrepreneurial alertness to price differences that allows us to explain how prices, quantities, and qualities of inputs and outputs change and how the plans of countless market participants that fail to align in one moment tend to move toward greater coordination over time. Neoclassical presentations of competition tell a story of market perfection in which profits are instantaneously seized and efficient equilibrium obtained. While such depictions of perfect competition are internally consistent, they are irrelevant, Kirzner argues, if what we want to understand is the nature of the market process. Because such models assume away ignorance, they also assume away the need for a discovery process. In contrast to standard economic theory, Kirzner begins his analysis by understanding the world as it is, mired in ignorance. It is this ignorance, Kirzner argues, that triggers the entrepreneurial search for profits. In turn, it is this search for profits that renders entrepreneurship a process of systematic discovery. Market discovery unfolds at the individual level as entrepreneurs notice arbitrage opportunities. But it is in seizing those opportunities that a broader pattern of social coordination emerges. It is the cognitive role of markets at the level of the extended social order that marks the Austrian perspective. The emphasis on the market as a process of discovery leads to another central theme within the Austrian school, and that is the question of how societies achieve a level of complexity, coordination, and social intelligence that far surpasses the individual capacity to design and control such complexity (Hayek 1978; 1988). Or, in other words, how do societies learn, and (in some cases) what allows them to learn so well? In the case of market discovery, prices serve as the cognitive tools that individuals need to communicate

264   Institutions and Organizations relevant bits of knowledge to countless other individuals, separated by geography and time, each unknown to the vast majority of others. So long as the institutional environment conducive to production and exchange is well defined, profit-and-loss signals serve as meaningful guides to action in enabling producers to identify the best combination of resources required for a given task and providing entrepreneurs with the information they require to identify and seize profits and abandon projects that do not generate, on net, added value. By aligning their actions to the meaningful price signals that the market offers, individual decision-making generates overall spontaneous adjustment to changing market conditions and generates widespread social coordination across countless individuals unknown to one another. The existence of a system of meaningful prices also allows us to move beyond face-toface exchange and production to the broader extended order. From this view, then, the market order is more than a system of resource allocation. Instead, it is a complex system of social learning. Price signals allow individuals to systematically make use of knowledge that they do not possess directly. In turn, the specialized knowledge that each individual cultivates within his or her own sphere serves others far removed from their immediate sphere of intentional influence. Thus, in addition to being a complex knowledge system, the market order becomes a system of unintentional beneficence in which each market participant unintentionally benefits and is benefited by unknown others (perhaps) far removed from their immediate sphere of influence. Admittedly, in order for widespread patterns of unintended beneficence to obtain in markets, information signals need, as described above, to convey a great deal of information in a form that is easily interpreted, to have some capacity for self-correction, and also to extend knowledge easily beyond the local sphere. Credit rating systems and other forms of reputational ranking that are easily accessed are among the nonprice signals that do this. Similarly, certain institutional environments are more likely to foster a social economy that is characterized by widespread unintended beneficence. Developed-world contexts, for example, offer greater opportunity for individuals to count on the unintentional cooperation of others far removed from their local sphere than contexts in which individuals are cut off, because of the high transactions costs of such interactions. Despite, for example, the fact that many entrepreneurs in sub-Saharan Africa might enjoy solid reputations in their local contexts, often they cannot effectively signal their creditworthiness to distant unknown others who might provide the financing they require. The existence and effectiveness of nonprice signals to generate widespread unintended benefit to unknown others is, then, an empirical question requiring an Austrian lens. If we extend this reading of social discovery processes beyond the market sphere, an Austrian reading of social economy asks whether, in any particular context or in reference to some set of socially embedded resources, such resources can be the source of a similar process of social learning. While it is true that most socially embedded resources like those discussed above are nonprice resources, the question can still be posed regarding whether there is a discovery process that unfolds within this context that leads to overall social coordination. Can, for example, shared mental models or a

Social Economy as an Extension    265 collective narrative overcome a collective action problem? Do collaborations within and across particular social networks benefit not only those whom the collaborators intend to benefit but also countless unknown others, as we see so regularly within the social learning process of the market? Can the regular use of specific cultural tools generate widespread benefits by aligning expectations or mobilizing a collective effort to accomplish some end? Can the use of socially embedded resources not only benefit the generations who deploy them but also systematically (though unintentionally) benefit future generations? The process by which people navigate socially embedded resources, when situated within the right institutional context, can constitute a process of widespread social learning (Chamlee-Wright 2008; Chamlee-Wright 2010; Chamlee-Wright and Myers 2008; Chamlee-Wright and Storr 2009 Chamlee-Wright and Storr 2010; Chamlee-Wright and Storr 2011). In their effort to negotiate effective strategies of action out of socially embedded resources, individuals generate signals that (1) condense large amounts of information in a form that can be relatively easy to interpret, (2) have the capacity to “self-correct” so that, in general, bad information is weeded out and good information is amplified, and (3) effectively convey relevant knowledge that emerges within a local context to unknown and far-flung outsiders. In this respect, the social economy environment mirrors the political economy and the discovery that unfolds in the market order. Price signals foster social learning because they consolidate vast amounts of information into a relatively simple and easy-to-read metric. In the context of socially embedded resources, signals with somewhat similar characteristics can also emerge. In the context of social networks, for example, the analogs to prices are signals such as reputation, status, and authority. Relative to prices, nonprice signals are, to be sure, far less precise, and nonprice signals cannot in general be relied on to convey unambiguously whether a course of action has, on net, generated value for society. Austrians will be the first to caution that this difference is far from trivial. Recall that it is the absence of market prices and associated profit-and-loss signals, Mises argued, that dooms socialist efforts to replace markets with central economic planning. Yet, as Hayek argued, prices are only meaningful when read in the context of a particular time and place. While much of the economically relevant knowledge is fleeting shifts in local prices, much of the relevant knowledge that renders an economic decision a profitable one is nonprice knowledge of the context. Further, prices are not the only form by which meaningful signals might emerge. Reputational signals, for example, can serve as effective guides to action in that they offer critical information in a form that is “ready at hand” to those reading the particular context. Like prices, such signals extend our “cognitive reach” beyond what we can know through direct experience. The question of whether any particular nonprice signal is robust enough to foster widespread social learning is an empirical question and the target of case study analysis. We can imagine relatively closed and noncompetitive contexts in which such signals will not be subject to challenge. Rigidities within the social structure, such as laws arbitrarily protecting a given person’s or a given group’s social status, can reduce the quality of such signals. Under such circumstances, one’s “good reputation” tells others very

266   Institutions and Organizations little. Yet in a highly competitive environment, in which the barriers to entry are low and feedback is robust, reputation means a great deal precisely because it can be earned and lost. Similarly, if they are to serve as a cognitive tool, nonprice signals must be subject to revision, and there must be reason to believe that bad information tends to get weeded out and good information tends to be amplified. Information diffusion is not the same thing as social learning. For social learning, there must be some mechanism by which self-correction is likely to unfold. Again, the extent to which this may or may not hold in any given case is an empirical question. For example, if an ethnically homogeneous trading group benefits from a reputation for providing high-quality goods and services even in contexts in which it is difficult for clients to detect quality differences directly, such a signal will only remain meaningful if there is some mechanism by which the group is able to police its members and weed out those who would erode that reputation (Chamlee-Wright and Myers 2008). Then there is the question of whether engagement within the social economy context has similar properties to that within the political economy context in terms of its ability to convey relevant knowledge to others beyond the local sphere and across the extended order. Social network analysis has certainly focused on the ability of social network entrepreneurs to seize and use information across specific networks to gain advantage (see Granovetter 1973; 1983). And such maneuvering is the source of considerable variation in achievement in terms of educational attainment, income, and status. Burt (1992; 2005), for instance, argues that it is the way in which a person is situated between two or more otherwise disconnected networks that affords the opportunity to act as a broker, an arbitrageur of information flows. In one respect, these insights run parallel to Kirzner’s (1973; 1979), in that it is the imperfection of information that gives rise to profit opportunities. Further, it is well recognized within the social network literature that network brokering can benefit those within the same networks as the people engaged in the initial exchange. For example, if your coworker taps another network to learn of a lower-cost supplier, you benefit from that brokering, even though you were not a part of the original exchange of information. But what is less well recognized is whether and how such information flows extend beyond the local sphere. Social capital literature, on the other hand, does recognize the far-reaching impact that social norms can have across the extended order—that generalized norms of reciprocity, authority, and trust benefit those who had no part in creating them—but tends to underemphasize the role that individual discovery plays in generating those broader patterns of social coordination (Chamlee-Wright 2008). Similarly, cultural tools analysis offers a clue to how the entrepreneurial use of socially embedded resources can generate broader social patterns. By tapping into public codes, cultural practitioners offer a sort of template for how existing or emergent cultural tools can be used that others can emulate. Austrians have a particularly important role to play in the advancement of social economy research by focusing attention on the ways in which individual action within the social economy context can generate broader patterns of social coordination and change in which people far removed from the sphere of intentional influence are unintentionally (though systematically) benefited.

Social Economy as an Extension    267

Conclusion In an attempt to complement the Austrian school’s already well-developed research program in political economy, contemporary Austrian scholars have attempted to develop a research program in social economy. These efforts have included a focus on mental models, generalized norms of trust and reciprocity, social networks, and culture. We have attempted here to systemize these contributions into a coherent Austrian social economy research program. It is our contention that Austrian contributions to social economy are particularly important given the school’s view of economics as a science of meaning and the school’s focus on the market’s role in social learning and social coordination. There are several open questions that a program in social economy could address. Social economy stands to complement and enhance the Bloomington school’s efforts at understanding systems of self-governance, the efficacy of such systems in managing resources held in common, and the ability of such systems to provide public goods, such as effective monitoring and rules that align interests within self-governing communities. Additionally, although social economy has already shed light on the study of entrepreneurship in diverse cultures, much more work needs to be done, especially as physical distance in global interactions becomes less and less significant a factor in mobilizing resources to capital-poor entrepreneurs and as financial and social networks increasingly grow beyond the local intimate sphere and, in some cases, transcend international and cultural boundaries. Social economy also has a great deal more to contribute to the study of social resilience in the face of economic crisis and natural disaster. Moreover, social economy research can help us to understand why policies aimed at economic development may or may not work within given contexts. While most policy discussions compare the efficacy of alternative policies, social economy can help us understand why the same intervention may work better or worse in a given social economy context. A research program in social economy would seem to be fertile ground.

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270   Institutions and Organizations Kirzner, I. M. 1985. Discovery and the Capitalist Process. Chicago: University of Chicago Press. Lachmann, L. (1956) 1978. Capital and Its Structure. Kansas City, MO: Sheed, Andrews and McMeel. Landa, J.  T. 1981. “A Theory of the Ethnically Homogeneous Middleman Group:  An Institutional Alternative to Contract Law.” Journal of Legal Studies 10, no. 2: 349–362. Landa, J. T. 1995. Trust, Ethnicity, and Identity: Beyond the New Institutionalist Economics of Ethnic Trading Networks, Contract Law and Gift Exchange. Ann Arbor:  University of Michigan Press. Lavoie, D. 1990a. “Hermeneutics, Subjectivity, and the Lester/Machlup Debate:  Towards a More Anthropological Approach to Empirical Economics.” In Economics as Discourse, edited by W. Samuels, 167–184. Boston: Kluwer Academic. Lavoie, D. 1990b. “Introduction to FA Hayek’s Theory of Cultural Evolution:  Market and Cultural Processes as Spontaneous Orders.” Cultural Dynamics 3, no. 1: 1–9. Lavoie, D. 1991. “The Discovery and Interpretation of Profit Opportunities: Culture and the Kirznerian entrepreneur.” In The Culture of Entrepreneurship, edited by B. Berger, 33–51. San Francisco: ICS Press. Lavoie, D. 1994. “Cultural Studies and the Conditions for Entrepreneurship.” In The Cultural Context of Economics and Politics, edited by T. W. Boxx and G. M. Quinlivan, 51–69. Lanham, MD: University Press of America. Lavoie, D. 2011. “The Interpretive Dimension of Economics:  Science, Hermeneutics, and Praxeology.” Review of Austrian Economics 24, no. 2: 91–128. Lavoie, D., and E. Chamlee-Wright. 2000. Culture and Enterprise. London: Routledge. Lavoie, D., and V. H. Storr. 2011. “Distinction or Dichotomy: Rethinking the Line between Thymology and Praxeology.” Review of Austrian Economics 24, no. 2: 213–233. Leeson, P. 2009. The Invisible Hook: The Hidden Economics of Pirates. Princeton, NJ: Princeton University Press. Lewis, P. 2008. “Uncertainty, Power and Trust.” Review of Austrian Economics 21, nos. 2–3: 183–198. Lin, N. 1999. “Social Networks and Status Attainment.” Annual Review of Sociology 25: 467–487. Lin, N., K. Cook, and R. S. Burt, eds. 2001. Social Capital: Theory and Research. New York: Aldine de Gruyter. McCloskey, D. 2008. “Mr. Max and the Substantial Errors of Manly Economics.” Econ Journal Watch 5, no. 2: 199–203. Meadowcroft, J., and M. Pennington. 2008. “Bonding and Bridging:  Social Capital and the Communitarian Critique of Liberal Markets.” Review of Austrian Economics 21, nos. 2–3: 119–133. Menger, C. 1976. Principles of Economics. New York: New York University Press. Mises, L. von. 1949. Human Action. New Haven, CT: Yale University Press. Mises, L. von. 1957. Theory and History, New Haven, CT: Yale University Press. North, D. C. 1981. Structure and Change in Economic History, New York: W. W. Norton. North, D.  C. 1990. Institutions, Institutional Change and Economic Performance. Cambridge: Cambridge University Press. North, D. C. 2005. Understanding the Process of Economic Change. Princeton, NJ: Princeton University Press. O’Driscoll, G.  P., and M. J.  Rizzo. 1996. The Economics of Time and Ignorance. London: Routledge.

Social Economy as an Extension    271 Pejovich, S. 2003. “Understanding the Transaction Costs of Transition: It’s the Culture, Stupid.” Review of Austrian Economics 16: 347–361. Polanyi, M. 1958. Personal Knowledge. Chicago: University of Chicago Press. Prychitko, D. 1991. Marxism and Workers’ Self-Management:  The Essential Tension. New York: Praeger. Putnam, R. 1993. Making Democracy Work:  Civic Traditions in Modern Italy. Princeton, NJ: Princeton University Press. Putnam, R. 2000. Bowling Alone. New York: Simon & Schuster. Rabinow, P., and W. Sullivan, eds. 1979. Interpretive Social Science. Berkeley:  University of California Press. Runst, P. 2013. “Post-Socialist Culture and Entrepreneurship.” American Journal of Economics and Sociology 72, no. 3: 593–626. Schutz, A. (1932) 1967. The Phenomenology of the Social World. Evanston, IL: Northwestern University Press. Sewell, W. 1992. “A Theory of Structure:  Duality, Agency, and Transformation.” American Journal of Sociology 98, no. 1: 1–29. Storr, V. H. 2002. “All We’ve Learnt: Colonial Teachings and Caribbean Underdevelopment.” Journal des économistes et des études humaines 12, no. 4: 589–615. Storr, V. H. 2004. Enterprising Slaves and Master Pirates. New York: Peter Lang. Storr, V. H. 2006. “Weber’s Spirit of Capitalism and the Bahamas’ Junkanoo Ethic.” Review of Austrian Economics 19, no. 4: 289–309. Storr, V.  H. 2008. “The Market as a Social Space:  On the Meaningful Extra-Economic Conversations That Can Occur in Markets.” Review of Austrian Economics 21, nos. 2–3: 135–150. Storr, V. H. 2009. “North’s Underdeveloped Ideological Entrepreneur.” In Annual Proceedings of the Wealth and Well-Being of Nations edited by Emily Chamlee-Wright, Vol. 1, 99–115. Beloit, WI: Beloit College Press. Storr, V. H. 2013. Understanding the Culture of Markets. New York: Routledge. Storr, V. H., and B. Butkevich. 2002. “Subalternity and Entrepreneurship: Tales of Marginalized but Enterprising Characters, Oppressive Settings and Haunting Plots.” International Journal of Entrepreneurship and Innovation 8, no. 4: 251–260. Swidler, A. 1986. “Culture in Action.” American Sociological Review 51: 273–286. Swidler, A. 2001. Talk of Love: How Culture Matters. Chicago: University of Chicago Press. Wrong, D. 1961. “The Oversocialized Conception of Man in Modern Society.” American Sociological Review 26: 183–193.

Chapter 12

Organiz at i ons and M a rk ets Nicolai J. Foss, Peter G. Klein, and Stefan Linder

Introduction Austrian economics deals primarily with markets, focusing on production, exchange, and consumption by individuals interacting in commercial markets characterized by private property, monetary calculation, and the price mechanism—what Mises (1949) called “catallactics.” Of course, Austrians have also dealt with socialism (Mises [1920] 1990; [1928] 1978; Rothbard 1976; Lavoie 1985), interventionism (Mises [1928] 1978; Rothbard 1970; Ikeda 1997), law (Hayek 1960; 1978), and other institutions (Menger [1883] 1985), mainly to enhance our understanding of market exchange. Austrians have devoted less attention to the internal workings of voluntary, private organizations such as families, clubs, and business firms, where resources are allocated by fiat or consensus rather than monetary exchange. Like their neoclassical counterparts, Austrians have, until recently, been reluctant to open up the “black box” of the organization. Austrian theory suggests that organizations, as with the Crusoe economy or cottage production, are inherently disadvantaged relative to market systems in which a complex division of labor is needed, because they lack the alienable property rights and internal price system needed to facilitate monetary calculation (Klein 1996). Moreover, organizations encounter the problem faced by any planned order, namely, that the “organizer must wish the individuals who are to cooperate to make use of knowledge that he himself does not possess” (Hayek 1973, 49). Yet organizations—collectives aimed at achieving specific goals (Parsons 1956)—are ubiquitous parts of market economies, possibly even the dominant features of the economic landscape (Simon 1991). Why, given what Hayek called the “marvel” of market coordination, do organizations large and small emerge and persist? How do they avoid the problem of economic

Organizations and Markets    273 calculation faced by socialist economies? Why do organizations take the shapes they do, why do their characteristics vary over time and across industries, and why do they succeed or fail? Are most organizations stable over time, or do organizations, like markets, adapt and learn? How do entrepreneurs arrange assets and manage individuals within organizations? These and similar questions are key to an understanding of both organizations and markets. Yet while Austrian economists have studied institutions and theorized about the organization of economic activities (Langlois 1992), a stream of literature on a “theory of the firm” building on distinctly Austrian assumptions and insights has emerged only recently. The modern economic theory of the firm is usually traced to Ronald Coase’s seminal 1937 article and the classic contributions in the 1970s from Williamson (1971; 1975; 1979), Alchian and Demsetz (1972), Jensen and Meckling (1976), Klein, Crawford, and Alchian (1978), and others. As we argue below, key insights from this field also appear in the Austrian literature (Foss 1994; Klein 1996; Foss and Klein 2010); in many cases, Austrian insights not only precede (Foss 1994) but also challenge modern organizational economics and provide solid foundations for a distinctly Austrian theory of organizations that overcomes weaknesses in the standard treatments.1 In particular, the Austrian understanding of heterogeneous, subjectively perceived capital resources; Mises’s ([1920] 1990) contribution on the calculation problem of socialist economies; Hayek’s ([1937] 1948; [1945] 1948) work on dispersed knowledge and the problem of coordination; Rothbard’s (1962) generalization of Mises’s insights to the case of large firms; and the long-standing Austrian emphasis on the entrepreneur as a causal agent provide the foundations for a full-fledged theory of organizations in general and firms in particular. Drawing on earlier work such as Foss (1994; 1997), Klein (1996; 1999), and Foss and Klein (2010; 2012), we discuss these key Austrian insights and how they allow building a promising Austrian theory of the firm. We subsequently discuss attempts within Austrian economics to build such a theory and present the judgment-based approach proposed by Foss and Klein (2012). While we focus on firms, the subsequent discussion bears implications for research on organizations more generally; all organizations are challenged by dispersed knowledge and genuine uncertainty, and all of them need to allocate resources in the context of heterogeneous capital assets and partly missing markets. Thus, while we refer to profit-seeking organizations (i.e., firms) in what follows, most of the discussion also applies to nonprofit organizations. 1  By “modern organizational economics” or the “modern theory of the firm,” we mean primarily agency theory, transaction cost economics, mechanism design, incomplete-contracting theory, and other approaches surveyed, for example, in Gibbons and Roberts (2012). In this chapter, we ignore the relationship between Austrian economics and other approaches to the firm that dominate the strategic management literature, such as the resource-based and capabilities approaches. On resources and capabilities, see Foss 1997; Langlois 1992; Foss et al. 2007; and Foss and Ishikawa 2007. Like Austrian economics, resource-based and capabilities approaches stress the heterogeneity of capital assets and the benefits of combining them in complementary bundles that generate competitive advantage.

274   Institutions and Organizations

Thinking about Organizations What is usually termed the “neoclassical” theory of the firm emerged in the 1920s and 1930s in the works of Arthur Pigou, Jacob Viner, and Joan Robinson as a parallel effort to the formalization of consumer theory (Hicks and Allen 1934; Loasby 1976). In many economics textbooks, the “firm” is portrayed as a production function or production possibilities set, a black box that transforms inputs into outputs. The firm is modeled as a single actor, solving a maximization problem completely analogous to the problem facing the utility-maximizing consumer. How production is organized—for example, whether inputs x1, x2, and x3 are combined into output y within a single firm, between partners, across a network of independent contractors, or by some other means—is treated as a secondary, even trivial, issue with little consequence for resource allocation. Coase (1937) introduced a fundamentally different way to think about production and the firm. In the world of neoclassical price theory, he noted, firms have no reason to exist. If firms emerge in a market economy, he reasoned, it must be that there is a “cost to using the price mechanism” (Coase 1937, 390). Market exchange entails certain costs, such as identifying trading partners, negotiating terms, and writing and enforcing contracts. Inside a firm, the entrepreneur may be able to reduce these “transaction costs” by coordinating these activities himself. However, internal organization brings other kinds of transaction costs, namely, problems of information flow, incentives, monitoring, and performance evaluation. The boundary of the firm, then, is determined by the trade-off, at the margin, between the relative transaction costs of external and internal exchange.2 Modern, post-Coaseian theories of the firm, such as transaction cost economics (TCE) (Williamson 1971; 1975; 1985; also Klein, Crawford, and Alchian 1978) and the incomplete-contracting or “property rights” approach (PRT) (Hart 1995), along with the nexus-of-contracts view (Alchian and Demsetz 1972), agency theory (Ross 1973; Jensen and Meckling 1976), and team theory (Marschak and Radner 1972), follow Coase in seeing the firm as a contractual entity whose existence and characteristics are shaped by transaction costs or information costs.3 Of course, each theory asks somewhat different questions and invokes particular kinds of transaction or information costs to give the answers. Principal-agent models and team theory are interested mainly in 2  An earlier tradition approached the distinction between firm and market in terms of the relative intensities of the division of labor, but this tradition was ignored by Coase and largely forgotten after Coaseian insights began to take hold (Bylund 2011). 3  Only transaction cost economics and the incomplete-contracting approach are theories of the firm per se (Hart 1995). Nexus-of-contracts, principal-agent, and team theories deal with productive relationships but do not address asset ownership; that is, they do not talk about the boundaries of the firm. To explain boundaries, one must presuppose that contracts are incomplete, for otherwise, everything can be stipulated contractually, and there is no need for ownership, understood as the “residual right” to make decisions that are not specified by contract. Team theory and principal-agent models assume complete contracts, whereas TCE and PRT work from an incomplete contracting foundation.

Organizations and Markets    275 internal organization and emphasize monitoring costs, while TCE and PRT deal with firm boundaries and highlight costs of writing (complete) contracts or the ex post costs of enforcement and renegotiation. Still, all branches of modern organizational economics reject some or all aspects of the perfectly competitive general equilibrium model, starting with Coase and Williamson and including modern contract theory (Laffont and Martimort 2002).4 Complications such as (genuine) uncertainty (Knight 1921), imperfect foresight or bounded rationality (Coase 1937), small-numbers bargaining (Williamson 1996), haggling costs (Coase 1937), private information (Holmström 1979), cost of processing information (Marschak and Radner 1972), costs of inspecting quality (Barzel 1982; 1997), or imperfect legal enforcement (Hart 1995; Williamson 1996) are all deviations from the full, complete, contingent contracting model of perfectly competitive general equilibrium theory (Debreu 1959). Post-Coaseian theories of the firm have greatly enhanced our understanding of firms as contractual entities whose existence, boundaries, and internal organization can be rendered intelligible in terms of economizing on (various types of) transaction costs. Yet numerous issues have remained unaddressed by modern economics thinking on organizations. Consider the following questions. 1. What is a firm, exactly? Coase (1937) defines the firm in terms of the employment relation. A one-person operation, in this definition, is not a firm, and vertical integration deals with the question of adding producers of intermediate products to the firm’s employment roll. For Knight, Williamson, and Hart, in contrast, the firm is defined not by the employment relationship but by the ownership of alienable assets. In this approach, the question is who owns what, not who is employed by whom.5 Knight, for example, begins with judgment, defined as business decision-making when the range of possible future outcomes, let alone the likelihood of individual outcomes, is generally unknown—what he termed uncertainty (or uninsurable risk), rather than probabilistic (or insurable) risk. To exercise judgment, the entrepreneur must own and control resources, which are then deployed under conditions of uncertainty. The firm is then the entrepreneur plus the assets he owns and controls (Foss and Klein 2012). Of course, even in this approach, to get from the one-person firm to the multiperson firm requires some theory about the relative transaction costs of employment versus independent contracting (we discuss this issue later). Perhaps the better question than “What is a firm?” is “What are the important research questions that can be answered when the firm is defined in a particular way?” 2. Why do firms differ, and why does it matter?6 Despite moving beyond neoclassical notions of the “representative firm,” some branches of modern organization economics 4 

The rejection is clearly spelled out in Knight 1921, although Knight did not develop a systematic theory of the firm. 5  Spulber (2009) offers yet another approach, defining the firm as nexus of transactions with objectives different from those of its owners. 6  Nelson (1991) poses the question in exactly this form.

276   Institutions and Organizations remain committed to explaining equilibrium configurations populated by optimizing agents. And yet most industries are characterized by wide variation in firm performance (e.g., Cool and Schendel 1988; Porter 1979). Why some firms earn superior returns has been the area of key interest among strategic management scholars, yet it received little attention in the established economics thinking on organizations. Interfirm performance differences is the central explanandum of strategic management theory, which relates these differences to heterogeneous resources or differential capabilities of firms (e.g., Winter 1988; Langlois 1992; Jacobides and Winter 2005). Strategy research describes firm-specific knowledge as sticky and tacit and argues that such knowledge develops through path-dependent processes, implying that organizations are necessarily limited in what they know how to do well.7 Such an emphasis on knowledge contrasts sharply with the organizational economics focus on incentives, opportunism, and transaction costs. While much of the modern theory of the firm treats knowledge needed for exchange as costly, it treats the knowledge needed for production as essentially free (Demsetz 1988). The strong emphasis on transaction costs “dims our view of the full picture by implicitly assuming that all firms can produce goods or services equally well” (Demsetz 1988: 147). However, it might be in the interest of a firm to produce its own inputs even if transaction costs were zero and costs of in-house managing were positive, if firms differ in how well they can do production. Low-cost methods of production have to be “discovered anew, sometimes almost from day to day, by the entrepreneur” (Hayek [1940] 1948, 196). The dispersion of knowledge (Hayek [1945] 1948) and the idiosyncratic nature of much of the economically relevant knowledge (Hayek 1935), the distribution of entrepreneurial capabilities (Knight 1921), or the benefits of specialization imply that organizations will differ in how well (or how cost efficiently) they can produce or provide their offerings. Hence, besides transaction costs, the production costs may enter the make-or-buy decision, the question about the boundaries of the firm (Foss 1994). There have been several attempts at integrating transaction cost and capabilities approaches to the firm (surveyed in Argyres et al. 2012). Argyres and Zenger (2012) argue, for example, that transaction costs and property rights govern how capabilities are generated and transmitted. On the whole, however, these branches of literature remain distinct. Austrian economics certainly recognizes performance differences among firms but, rejecting the perfectly competitive model as a market benchmark, 7 

There are important connections between capabilities and knowledge-based views and Austrian ideas about tacit knowledge. Not surprisingly, several Austrian writers have been particularly attracted to the knowledge-based view, as it appears to take seriously the Hayekian notions of tacit, dispersed knowledge and rule-following behavior (Malmgren 1961; O’Driscoll and Rizzo 1985; Loasby 1992; Langlois 1992; 1995; 1998; Foss 1997; Dulbecco and Garrouste 1999). Exploring the Austrian roots of capabilities theory has become a virtual cottage industry in recent years. The connection between Penrose and the Austrian school—both indirect and directly through Penrose’s dissertation advisor, Mises student Fritz Machlup—has also been examined (Connell 2007). However, these explorations have produced few distinctive insights and refutable implications, limited mainly to exploring similarities between the two bodies of thought.

Organizations and Markets    277 does not see deviations from “normal” profits as a particularly interesting or important phenomenon to be explained. Austrians view profit as an amount (revenues less costs), not a rate of return, and Austrian concepts of competition leave no room for a normal rate of profit that firms try to exceed. 3. How do organizational forms emerge, and what determines their survival? A given transaction may be organized in different ways, such as arm’s-length market exchange, internal production, and intermediate forms like franchising agreements and joint ventures. However, the range of possible forms is typically given in modern organizational economics to the decision-maker, there is no uncertainty about them, and there is no room for organizational innovation and entrepreneurship. Williamson, for example, takes as a heuristic starting point that “in the beginning there were markets” (1985, 142). Since markets are given, so are also inputs, outputs, and technology. As it is the case with the nexus-of-contracts approach, the agents that occupy Williamson’s attention are managers of existing transactions, shifting transactions over the boundaries of the firm. He thus does not address questions of innovation and the creation of markets (Williamson 1985). Introduction of new types of governance modes is “outsourced” to an essentially unspecified external mechanism, and equally essentially unspecified selection forces are presumed to select the fittest/most efficient (or fitter/relatively more efficient) of these contracts or organizational forms (Foss 1997). However, a complete theory of organizations should account for the emergence and diffusion of organizational forms (James, Klein, and Sykuta 2011). 4. What explains change in organizational boundaries? Established economics thinking about organizations readily allows firm size to be affected by innovations, such as the telephone or other communication media, that change the relative costs of market versus in-house transactions (Coase 1937). Yet, just as for the emergence of new governance modes, it leaves the source of and drivers behind the innovation in the dark; that is, innovations are exogenous events to which firms simply adapt by shifting their boundaries inward or outward. Modern theories of the firm, in the tradition of Schumpeter (1911), often resort to a deus ex machina that introduces new innovations affecting transaction costs and firm sizes. The highly prosperous cottage industry working on innovative management accounting practices, such as the balanced scorecard, activity-based costing, activity-based budgeting, new enterprise resource planning systems, and so on, suggests that firms engage in (and are willing to spend considerable resources on) developing and introducing innovative practices that facilitate cost allocations, internal calculations of unit and product profitability, and resource allocation processes. Thus, a theory of the firm should at least partially endogenize the development of innovations affecting firm size and scope. 5. Do organizations learn? Firm boundaries change frequently, in ways that are difficult to explain within an equilibrium, comparative-static framework. In other words, firms adjust their behavior even in the absence of changes in technology, institutions, or market conditions. Firms regularly acquire other firms and divest parts of their current business. While part of this merger and acquisition (M&A) activity likely is a response

278   Institutions and Organizations to new governance modes and new innovations that change the relative transaction costs of using the market versus exchanging the service/good internally, a significant part takes place without changes in transaction costs and can be understood as a process of experimentation and learning (Klein and Klein 2001; Lien and Klein 2013). Still, much of the extant literature focuses on equilibrium “optimal” contracts. Agency theory, for example, assumes that the roles of principal and agent are already assigned, that principals know the full set of possible actions that the agent can take, and that all contracting is efficient on an ex ante basis, meaning that all gains from trade have been discovered and no reallocations of property rights during later stages need to occur. In the real world of dispersed knowledge and uncertainty, this kind of optimality cannot be assumed; as Loasby (1992, 140) puts it, “all perceived gains from trade are realized; but there may be gains that are not perceived, simply because the attempts to carry out plans do not bring them to anyone’s attention.” Hence, principals may be surprised, leaving room for Kirznerian discovery (Kirzner 1973) or Knightian judgment (Knight 1921). Transaction cost economics does allow for novelty and genuine surprise, captured by the notion that all real-world contracts are incomplete. Even in this case, however, participants are assumed to have “correct” knowledge about fundamental market conditions, such as the likelihood of potential holdup (Foss 1994). Hence, there is no need to change a firm’s boundaries in the absence of changes in transaction costs—the “right” boundaries were chosen ex ante. Reports about firms’ M&A activities and reasons for divestures, however, suggest that firms in fact commit errors and see a need for ex post adaptation of their boundaries (Klein and Klein 2001). 6. Is entrepreneurship a factor of production? When explaining the returns to factors of production, economists often define wages as the payment to labor, interest as the payment to capital, rent as the payment to land, and profit as the payment to entrepreneurship. Treating entrepreneurship as a factor of production, earning a return that we label profit, poses some challenging problems, however. Does entrepreneurship have a marginal revenue product, corresponding to a firm’s profit? Is there an upward-sloping supply curve for entrepreneurship (more of it is offered to the market when profits rise)? Are there diminishing returns to entrepreneurship? The answer given by the classic contributors to the economic theory of entrepreneurship such as Cantillon, Say, Schumpeter, Knight, Mises, Kirzner, and others is clearly no. They treat entrepreneurship as ubiquitous, an attribute of the market mechanism that can never be absent. This perspective is neatly summarized by Marchal (1951: 550–551; emphasis added): [E]‌ntrepreneurs obtain remuneration for their activity in a very different manner than do laborers or lenders of capital. The latter provide factors of production which they sell to the entrepreneur at prices which they naturally try to make as high as possible. The entrepreneur proceeds quite otherwise; instead of selling something to the enterprise he identifies himself with the enterprise. Some people doubtless will say that he provides the function of enterprise and receives as remuneration a sum

Organizations and Markets    279 which varies according to the results. But this is a tortured way of presenting the thing, inspired by an unhealthy desire to establish arbitrarily a symmetry with the other factors. In reality, the entrepreneur and the firm are one and the same. His function is to negotiate, or to pay people for negotiating under his responsibility and in the name of the firm, with two groups: on the one hand, with those who provide the factors of production, in which case his problem is to pay the lowest prices possible; on the other hand, with the buyers of the finished products, from which it is desirable to obtain as large a total revenue as possible. To say all this in a few words, the entrepreneur, although undeniably providing a factor of production, perhaps the most important one in a capitalist system, is not himself to be defined in those terms.

Entrepreneurship, in this sense, is embodied in the firm; the decision to be “entrepreneurial” is not a marginal decision, in the sense of supplying one more or one fewer unit of entrepreneurial services to the firm.8 Writing of socialism, fascism, and other forms of government intervention in the economy, Mises (1949) describes the struggle of business owners to operate in deteriorating political circumstances. Despite the threat of expropriation and other hazards, entrepreneurs will continue to act: “In the market economy there will always be entrepreneurs. Policies hostile to capitalism may deprive the consumer of the greater part of the benefits they would have reaped from unhampered entrepreneurial activities. But they cannot eliminate the entrepreneurs as such if they do not entirely destroy the market economy” (Mises 1949, 291). As long as there is private ownership, markets, and prices, there is entrepreneurship—regardless of the numbers of start-ups, patents, and the like. Part of the reason economists speak of the supply of entrepreneurship and the marginal return to entrepreneurship is that they conceive of entrepreneurship as an occupational category such as self-employment. An entrepreneur is a person who starts his or her own business, as opposed to an employee who works for someone else. In this sense, it makes sense to talk about entrepreneurship as a factor of production with an upward-sloping supply curve. As profit opportunities increase relative to wages, more individuals will choose self-employment over employment. If one conceives of entrepreneurship as a function such as alertness, cognitive leadership, or judgment, however, it cannot be treated as a factor of production and is exercised, as in the Mises quote above, even in the worst market conditions. 7. How do organizations influence the institutional environment? Established thinking on organizations typically takes the institutional environment—legal rules, political processes, social norms, and the like—as given, asking how firms try to make profits within the constraints established by these rules of the game. Changes in macrolevel institutions are viewed as shocks, or “shift parameters” (Williamson 1996, 326), that affect the efficient boundary between one organizational form and another. But the institutional environment is not fixed, and efforts to influence legal, regulatory, political, 8  Menger’s ([1871] 1976) treatment of the entrepreneur is similar: “The activity of the entrepreneur is recognized by Menger as being unique in that, unlike other goods of higher order, it is not intended for exchange and therefore does not command a price” (Martin 1979, 279–280).

280   Institutions and Organizations and social conditions may be as important to firms as efforts to influence their competitive and technological environments. Firms seek to influence legal, regulatory, and political institutions through lobbying, rent seeking, and other activities. A complete theory of organizations, and of the boundaries between organizations and markets, must take into account the fundamental endogeneity of institutions and the coevolution of organizational and market characteristics. The shortcomings of established economic thought on organizations suggest that we need to look for models that allow us to answer the same fundamental questions while also being able to circumvent or at least minimize the shortcomings identified. As we demonstrate in the following sections, key Austrian insights on production processes and the nature of capital goods, dispersed knowledge, uncertainty, and entrepreneurship provide a promising avenue for such a venture.

Austrian Capital Theory and the Theory of Organizations Austrian production theory starts with the insight that production takes time and, in an advanced industrial economy, typically involves a series of temporally specific, causally linked stages and a complex latticework of inputs and intermediate outputs (Menger [1871] 1976). This has two implications. First, factors of production must be committed in the present for making final goods that will have value only in the future after they are sold (e.g., Hayek 1931). As a consequence, from the time the decision is made to use the factors of production to when the final good has been finished, the entrepreneur’s judgment about market demand and prices for the final good may turn out to be flawed. Entrepreneurs pay today’s certain prices for factors but cannot be sure whether they will realize the expected value of the final goods in the future. Second, as capital goods are used in production, they are transformed from general-purpose materials and components to intermediate products specific to particular final goods. Consequently, these assets cannot be easily redeployed to alternative uses if demands for final goods change (Lachmann [1956] 1978). Metal stamped into part of the chassis of a Ferrari likely cannot be directly redeployed to the chassis of a Freightliner or another brand of heavy truck, or used to make a toaster, or used to thresh wheat. This is particularly true for the capital goods that are in later stages of the production process, because they are typically already more specific to a particular end use and thus more difficult to convert. The claim is not that there is no substitution among capital goods but that the degree of substitution is limited (i.e., capital goods are considered as multispecific). Because capital is heterogeneous, production cannot be adequately described by the stylized production function—a “black box” transforming in one single stage inputs (land, labor, capital) into outputs (consumer goods)—favored by neoclassical economists.

Organizations and Markets    281 This heterogeneity of capital assets stems, as modern Austrian economics points out (e.g., Kirzner 1966), from the entrepreneurs’ subjective, individual production plans—plans that are formulated and continually revised by profit-seeking entrepreneurs. Instead of characterizing capital goods by their physical properties, as earlier Austrian scholars attempted do (e.g., Böhm-Bawerk [1889] 1959), modern Austrian economics proposes to rely on their place in the structure of production as conceived by entrepreneurs. The actual place of any capital good in the time sequence of production is given by the market for capital goods, in which entrepreneurs bid for factors of production in anticipation of future consumer demands. This subjectivist, entrepreneurial approach to capital assets is particularly congenial to theories of the firm that focus on entrepreneurship and the ownership of assets (Foss and Klein 2012). This understanding of capital as a complex structure formed the basis of the Austrian theory of the business cycle (Mises [1912] 1981; Hayek 1931), which highlights the role of malinvestments. The concept of malinvestment is foreign to neoclassical production theory (and to mainstream macroeconomics), which usually considers only the level of investment. Modern production theory focuses on a single stage of production in which “capital,” along with other inputs, is transformed into final goods. As we argue next, this limits the explanatory power of theories, such as modern macroeconomics, that are based on this conception of capital. If capital is a homogeneous substance with one price, then entrepreneurship is reduced to choosing between capital-intensive and labor-intensive production methods (or among types of labor), a problem a central planner could potentially solve. The failure of socialism, in Mises’s ([1920] 1990) formulation, follows precisely from the complexity of the economy’s capital structure and the subsequent need for entrepreneurial appraisal. As Lachmann ([1956] 1978, 16) points out, entrepreneurship consists primarily of choosing among combinations of capital assets: “We are living in a world of unexpected change; hence capital combinations … will be ever changing, will be dissolved and reformed. In this activity, we find the real function of the entrepreneur.” Attributes may also vary over time, even for a particular asset. In a world of “genuine” uncertainty, entrepreneurs are unlikely to know all relevant attributes of all assets when production decisions are made. Nor can the future attributes of an asset, as it is used in production, be forecast with certainty. Future attributes must be discovered over time, as assets are used in production. Therefore, capital heterogeneity has several important implications for economic organization (Foss and Klein 2012). First, capital heterogeneity implies the need for monetary calculation in the formulation of entrepreneurial plans. If each capital good is perfectly specific to just one final good, then the valuation of consumer goods directly allows valuing the capital goods. Yet if capital is heterogeneous but multispecific (Lachmann [1956] 1978)—that is, if some substitution can take place at a certain cost—then we need markets in which these capital goods are traded to have indications of relative scarcity and to be able to evaluate economically alternative plans for using capital goods. In general, the calculation problem highlighted in the socialist calculation debate waged by the Austrians in the

282   Institutions and Organizations 1920s and 1930s (e.g., Mises [1920] 1990; [1936] 1981) is not about socialism per se but the results of the heterogeneous yet multispecific nature of capital assets. Second, because it is difficult, or perhaps even impossible, to specify all relevant attributes of an asset ex ante, ownership rights are assigned to assets, not their attributes. Ownership of an asset gives the owner the rights to exploit attributes unknown at the time ownership rights are conferred. When firms are defined in terms of asset ownership, this entrepreneurial perspective helps explain the boundaries of the firm. Third, because attributes of assets are costly to measure, and often unknown even to their owners, entrepreneurs must often experiment with different combinations of capital goods. Finally, the entrepreneur’s success in experimenting with assets in this manner depends not only on his or her ability to anticipate future prices and market conditions but also on internal and external transaction costs, the entrepreneur’s control over the relevant assets, how much of the expected return from experimental activity he or she can hope to appropriate, and so on. Thus, entrepreneurs who seek to create or discover new attributes of capital assets will want ownership titles to the relevant assets, both for speculative reasons and for reasons of economizing on transaction costs. These implications already suggest some preliminary answers for questions about why firms exist and what determines their boundaries. They thus suggest that the Austrian theory of production may be a fruitful starting point for building a “good” theory of organizations.

An Austrian Theory of Organizations? While until recently, the theory of the firm did not attract much attention in Austrian economics, the last two decades have seen a number of publications emerging that develop elements of a distinctly Austrian theory of the firm (e.g., Dulbecco and Garrouste 1999; Foss 1994; Foss et al. 2007; Foss and Klein 2012; Ioannides 1998; Klein 1996; Lewin and Phelan 2000). The Austrian emphasis on subjective knowledge, skills, beliefs, expectations, and mental models is a central element in these steps toward building an Austrian theory of the firm. Together with the Austrian focus on process analysis, subjectivism and uncertainty open the door to address entrepreneurship—arguably the most neglected Austrian concept within the contemporary theory of the firm—and to build a theory of the firm around it (Dulbecco and Garrouste 1999). While Austrians agree on the central role of entrepreneurship for an Austrian theory of the firm, there is some disagreement about how to characterize entrepreneurship for this purpose. This disagreement has led scholars to pursue different routes for developing elements of an Austrian theory of the firm. The best-known perspective on entrepreneurship is Kirzner’s (1973; 1979; 1992) identification of entrepreneurship with alertness to profit opportunities. The simplest case of alertness is that of the arbitrageur, who discovers a discrepancy in present prices that can be exploited for financial gain. In a more typical case, the entrepreneur is alert to a

Organizations and Markets    283 new product or a superior production process and steps in to fill this market gap before others. Success, in this view, comes not from following a well-specified maximization problem but from having some insight that no one else has, a process that cannot be modeled as an optimization problem. Because Kirzner’s entrepreneurs perform only a discovery function, rather than an investment function, they do not need to own capital; they need only be alert to profit opportunities. They own no assets, they bear no uncertainty, and hence they cannot earn losses—the worst that can happen to an entrepreneur is the failure to discover an existing profit opportunity. Several scholars have worked on developing a theory of the firm based on Kirzner’s conception of entrepreneurship (e.g., Ioannides 1998; Sautet 2010). At the same time, Kirzner’s view on entrepreneurship has been the object of much critical debate. Loasby (1992, 143), for example, claims that “Kirzner has also accepted the neoclassical view of knowledge as ‘information,’ which is not merely inadequate but false. For many simple entrepreneurial perceptions, the falsity of this view does not matter, but for more complex opportunities of arbitrage … it may be important.” Rothbard (1985) and Salerno (1990; 2008), in turn, question Kirzner’s purely alert entrepreneur as neglecting the importance of assets for exploiting entrepreneurial opportunities and thus also criticize him for misreading Mises and Hayek, whose position on entrepreneurship is one about economic calculation and (price) coordination rather than about alertness and discovery and who stress the importance of asset ownership. Even the arbitrageur—to use the simplest examples of the Kirznerian entrepreneur—needs some funds (or at least control over them) to acquire the assets that are undervalued at one location before being able to sell them off at a profit in another location. Without these funds, the arbitrageur may well identify an entrepreneurial opportunity but may not be able to realize it—or, when sharing his ideas with potential not-penniless others, have problems appropriating (a part of) the profit. If the Kirznerian entrepreneur shares his discovery with others in order to persuade them to provide him with their funds for realizing his entrepreneurial opportunity, they may simply go about realizing his idea without him, as the opportunity now is known to them and as the alert but penniless entrepreneur lacks bargaining power. The link between Kirznerian entrepreneurship and other branches of economic analysis, such as industrial organization, innovation, and the theory of the firm, is thus weak. As a consequence, progress toward a full-fledged theory of organizations based on Kirzner’s concept has been slow. Another approach, advanced by Witt (1998; 1999), focuses not on alertness but on coordination via cognitive leadership. Entrepreneurs, Witt argues, require complementary factors of production, which are coordinated within the firm. For the firm to be successful, the entrepreneur must establish a tacit, shared framework of goals—what Casson (2000) calls a “mental model” of reality—which governs the relationships among members of the entrepreneur’s team (Witt 2007). As Langlois (1998) points out, it is often easier (less costly) for individuals to commit to a specific individual, the leader, rather than an abstract set of complex rules governing the firm’s operations. Exercising charismatic authority in an appropriate manner, then, facilitates coordination within

284   Institutions and Organizations organizations (Witt 2003). It allows benefiting from autonomous motivation (also known as intrinsic motivation), which would not be possible using a market setting where extrinsic motivation, and in particular monetary motives, is the sole driver (Witt 2007). Cognitive leadership, thus, provides a rationale for the multiperson firm. Building on self-determination theory from social psychology, Witt (2007), however, is careful to highlight the danger of a potential crowding-out of employees’ autonomous motivation by the entrepreneur’s monitoring and incentivizing practices. The appropriate design of the firm’s internal organization to leave “the employees room for their own initiative and creative problem solving” (Witt 2007, 1137), thereby fostering high effort based on autonomous motivation, hence is a centerpiece for benefiting from the advantage that firms as institutional arrangements can offer to entrepreneurs above what markets can offer. Witt’s cognitive leadership approach to the firm thus combines insights from economics, psychology, and sociology. Leaders coordinate through effective communication, not only of explicit information but also of tacit knowledge—plans, rules, visions, and the like (Witt 2003). The successful entrepreneur excels at communicating such models. In Witt’s proposal for an Austrian theory of the firm, as in Coase (1937), the employment relationship is central to the theory of the firm. The entrepreneur’s primary task is to coordinate the human resources that make up the firm. Consequently, Witt’s approach explains the dynamics among team members but does not necessarily provide an answer to the questions of whether the charismatic leader necessarily needs to own physical capital and why charismatic leadership should be regarded as more “entrepreneurial” than other, comparatively mundane managerial tasks such as structuring incentives, limiting opportunism, administering rewards, and so on. By leaving open the question of how the entrepreneur gets the requisite assets, Witt’s approach runs the risk of being criticized for the same issue as approaches (e.g., Ioannides 1998) that build on Kirzner’s alert but penniless entrepreneur: how does the entrepreneur convince asset owners—given dispersion of knowledge and genuine uncertainty hampering communication and rendering entrepreneurship not a normal factor of production—to provide the capital necessary to implement his or her vision (or perceived business opportunity), or how does the entrepreneur go about implementing those visions or opportunities requiring assets for exploitation and not only ideas or alertness? Exercising judgment in a world of uncertainty is a third Austrian perspective on entrepreneurship that is associated mainly with Knight (1921) and Mises (1949). As noted above, judgment refers primarily to business decision-making when the range of possible future outcomes, let alone the likelihood of individual outcomes, is generally unknown. Decision-making about the future thus relies on a kind of understanding that is subjective and tacit, one that cannot be parameterized in a set of formal, explicit decision rules. Judgment, as described by Knight, is distinct from boldness, innovation, alertness, and leadership. Judgment must be exercised in mundane circumstances, for both ongoing operations and new ventures. Alertness is the ability to react to existing opportunities, while judgment relates to beliefs about new opportunities. Those who specialize in judgmental decision-making may be dynamic, charismatic leaders, but

Organizations and Markets    285 they need not possess these traits. In short, in this view, decision-making under uncertainty is entrepreneurial, whether or not it involves imagination, creativity, leadership, and related factors. In the most general sense, then, all human behavior in the world envisioned by Austrian economics is entrepreneurial. For explaining the emergence of firms, however, it is useful to focus on a narrower conception of entrepreneurship, that of a businessperson who invests financial and physical resources in hopes of earning monetary profits and avoiding monetary losses. As outlined earlier, in the Austrian world, production involves a series of temporally specific, causally linked stages and a complex latticework of inputs and intermediate outputs. The heterogeneous capital goods implied by this view of the world render finding the optimal combination a daunting task (Lachmann [1956] 1978). Contrary to the alertness or the cognitive leadership conception, Mises, Hayek, and Rothbard conceive of the entrepreneurial function as judgmental decision-making under Knightian uncertainty and presupposing the ownership of assets (Salerno 2008). Consequently, they define the firm as the entrepreneur plus the alienable resources the entrepreneur owns (or is able to influence). An important argument for following the Mises-Hayek-Rothbard conception of entrepreneurship lies in the particular nature of judgment. As noted above, Knight (1921) argued that entrepreneurial judgment is not a “normal” factor of production and cannot be bought and sold on a market. While Coase (1937) disagrees, he seems to have overlooked Knight’s key point, namely, that while much can be “imagined,” the “system where all advice or knowledge was bought as required” (Coase 1937, 249) cannot include entrepreneurial judgment—in particular the judgment of whether to follow (or not) the recommendations of the advisers (Foss 1996). Whereas Kirzner’s notion of entrepreneurship as alertness is attractive, as it seems to correspond with the intuitive idea that new opportunities need to be discovered, and Witt’s idea of entrepreneurship as cognitive leadership is appealing to the undoubtedly important question of how the entrepreneur can exploit (new) business opportunities, the notion of entrepreneurship as judgment following Mises and Hayek seems particularly adept for developing a coherent Austrian theory of the firm. First, judgment, as opposed to alertness, cannot be bought and sold on a market. Costs of moral hazard or of trying to communicate entrepreneurial judgments close markets for judgments, for the same reason that judgment is uninsurable (Foss and Klein 2012). Second, starting with entrepreneurship as judgment as the foundation of a theory of the firm as opposed to cognitive leadership does not per se require resorting to building on a combination of insights from economics, psychology, and sociology. It can, as already roughly illustrated (and as we shall demonstrate in more detail below), serve to build a theory of the firm purely relying on insights from economics. In particular, the key foundations of a judgment-based theory of the firm can be grounded within a single theory, namely, in Austrian capital theory. A judgment-based approach, thus, while not necessarily entirely circumventing them, certainly facilitates reducing dangers of potential misfit of insights as compared with approaches that draw on insights generated in different disciplines.

286   Institutions and Organizations

A Judgment-Based Positive Theory Why do firms exist, what determines their boundaries, and how are they organized internally? The judgment-based perspective on entrepreneurship associated with Knight and Mises provides several answers.9

The One-Person Firm Foss and Klein (2012) argue that the one-person firm can be explained by incomplete markets for judgment: First, entrepreneurs know themselves and their project ideas to be “good risks” but may be unable to communicate this to the capital markets. Second, as emphasized by Knight (1921, 311) and Mises (1949, 585), entrepreneurship represents judgment under “genuine” uncertainty that cannot be assessed in terms of its marginal product and that cannot, accordingly, be paid a wage. In other words, there is no market for the judgment that entrepreneurs rely on, and therefore, exercising judgment requires the person with judgment to start a firm. Both reasons imply incomplete markets for judgment and help understand the one-person firm, yet this does not yet explain multiperson firms (Foss and Klein 2012). But it does underscore that entrepreneurs in almost all real-world cases cannot be of the Kirznerian penniless type (Salerno 2008). Exercising judgment implies, as Klein (1999) and Foss and Klein (2012) further explain, asset ownership, for judgmental decision-making is ultimately decision-making about the employment of resources, that is, to arrange or organize the capital goods the entrepreneur owns (or has influence over). Obtaining ownership rights over tangible and intangible assets also strengthens the bargaining position. Ownership rights—as stressed in organizational economics—allow parties to “fill in the blanks” of a contract, including the right to exclude others from accessing or using an asset (Foss and Klein 2012). It thus also ensures that the entrepreneur can appropriate rents from his or her entrepreneurial idea.

The Multiperson Firm Following Lachmann ([1956] 1978), it may be difficult for the entrepreneur to specify all valued dimensions of assets prior to specialization. Many dimensions or attributes of dimensions (valued and nonvalued ones) only become apparent from using, that is, experimenting with the uses of assets and discovering the best uses for them. Given the interdependence that typically exists in a multistate value chain and involving different inputs, the best time and place to use a particular asset depend on the specification of 9 

See also Casson 1982; Rothbard 1985; Salerno 1990; Salerno 2008; Langlois and Cosgel 1993.

Organizations and Markets    287 the uses of all other assets that are needed in value delivery (Hayek 1941). Thus, entrepreneurs need a contractual setup that allows them to experiment at low cost. Foss and Klein (2012) argue (albeit based on mainstream Williamsonian economics rather than on Austrian economics) that relying on a hierarchical relationship within an organization as means of coordination instead of the market can be the least costly way for an entrepreneur to organize the experimental activity. Under market contracting, collaborators can veto changes in the experimental setup, thereby extracting additional quasi-rents from other collaborators in return for their d’accord to a rearranged setup. By possessing the rights to redefine and reallocate decision rights among collaborators (i.e., employees) and to sanction those who do not use their decision rights efficiently, the entrepreneur can conduct experiments without continuously having to renegotiate contracts, thereby saving bargaining and drafting costs. This provides a rationale for the multiperson firm within an entrepreneurial judgment approach.

Efficient Firm Boundaries The entrepreneur’s success in experimenting with assets, however, depends not only on his or her authority to rearrange them but also on his or her ability to anticipate future prices and market conditions in order to make rational decisions and to avoid pure trial-and-error processes. Such judgment however relies on information:  economic calculation that allows forming a rational judgment implies the use of today’s prices and anticipated future prices to compare present costs with expected future revenues (Klein 1999). Since entrepreneurs often face a plethora of options, Mises ([1951] 1980, 110) stressed that “[t]‌he business of the entrepreneur is not merely to experiment with new technological methods, but to select from the multitude of technologically feasible methods those which are best fit to supply the public in the cheapest way with the things they are asking for most urgently.” And it is exactly this need for decision-making under genuine uncertainty that was at the heart of the socialist calculation debate waged by the Austrians in the 1920s and ’30s and that provides important insights into the boundaries of the firm (Foss and Klein 2012; Klein 1996; Montias 1976; Rothbard 1962; Rothbard 1976; Williamson 1991).10 The Austrian argument against (market) socialism was threefold (Boettke 2001): (1) in the absence of private property of the means of production, there will be no market for these means; (2) without such a market, there will be no monetary prices established for the means of production; and (3) without such prices, decision-makers are unable to 10 

Santos and Eisenhardt (2005) propose a number of views on organizational boundaries made up of efficiency, power, competence, and identity perspectives. The Austrian insights from the socialist calculation debate follow efficiency considerations and—in particular in Rothbard’s generalization—focus on the question of organizations versus markets. The other perspectives advanced by Santos and Eisenhardt, in contrast, focus on non-efficiency-oriented questions of conscious versus unconscious organizations, the possession of competences versus their deployment, and ownership versus control and thus are only limitedly related to the “organizations” versus “markets” debate.

288   Institutions and Organizations rationally allocate resources, as they lack information that reflects the relative scarcity of resources. Yet, as Rothbard (1976, 75) already notes, “what the Mises theory focuses on is not simply the numerous inefficiencies of the political as compared to the profit-making process, but the fact that a market for capital goods has disappeared. This means that, just as socialist central planning could not calculate economically, no One Big Firm could own or control the entire economy.” Within the judgment-based approach to the firm, Foss and Klein (2012) suggest applying insights from the calculation debate—in particular, Rothbard’s (1962) generalization to nonsocialist settings—to the discussion about the boundaries of the firm. In any situation, socialist or not, in which no such prices are available, entrepreneurs cannot arrive at rational judgments about the scarcity of the resources and whether an entrepreneurial profit exists (Rothbard 1962; Rothbard 1976; Foss and Klein 2012). Of course, entrepreneurs might try to infer what prices for these resources would be if there were a functioning market through relying on cost-based estimation techniques, yet such “prices” will in all likelihood diverge from the prices an entrepreneur would observe in a market (Rothbard 1962). While the past decades have seen many advances in allocating costs and calculating meaningful transfer prices by scholars in economics and management accounting, all the alternative methods developed share the fundamental problem that any such artificial price contains less information than an actual market price (Rothbard 1962). Therefore, the use of internally traded intermediate goods or services for which no external market reference is available introduces distortions that reduce organizational efficiency. This problem grows as the firm expands and more and more external markets disappear, which means that the “islands of noncalculable chaos swell to proportions of masses and continents” (Rothbard 1962, 548). The Austrian ideas developed in the calculation debate, therefore, suggest that when organizations are large enough to conduct activities that are exclusively internal—so that no reference to the outside market is available—they will face a calculation problem (besides any incentive problems that are linked to the fact that managers lacking ultimate property rights have only limited incentive to engage in high effort) (Foss 2002; Klein 1996; Rothbard 1962; Foss and Klein 2012).

Internal Organization Austrians are quick to point out that the key challenge, besides incentive issues, to internal organization from an Austrian perspective stems from the entrepreneur allocating resources inside the organization typically lacking information or knowledge to make optimal decisions (Mises [1936] 1981; Hayek [1937] 1948; 1973). The fact that firms exist and thrive would seem to indicate that they somehow successfully cope with this dispersed knowledge. Foss et al. (2007) and Foss and Klein (2012) point to Mises (1949) for an answer to this puzzle. He suggests delegation of decision rights to managers—creating what Foss, Foss, and Klein (1997) termed “proxy-entrepreneurs” exercising “derived judgment” as

Organizations and Markets    289 a solution. By delegating decision-making authority to those who “know best,” the firm is able to exploit the locally held knowledge without having to codify it for internal communication or motivating managers to explicitly share their knowledge. Yet Mises (1949) also realized that delegation is a somewhat two-edged sword. Unlike independent players in markets, managers within firms never possess ultimate decision rights, and thus, there are incentive limits to the extent to which market principles can be applied within firms (Foss 2002).11 This gives rise to problems of motivation, that is, moral hazard—to use the organizational economics terminology. Managers and employees may use the delegated decision rights in both productive (i.e., functional or value-enhancing from the owners’ perspective) and destructive (i.e., dysfunctional or value-diminishing) ways (Foss, Foss, and Klein 1997; Foss and Klein 2012). They may pursue new profitable business opportunities or engage in developing new forms of exploiting (quasi-)rents from the firm by creating new forms of holdups and so on. Yet delegation may also imply risks of duplication of effort because of a lack of coordination of activities. The benefits of delegation in terms of better utilizing dispersed knowledge thus need to be balanced against the costs of delegation resulting from problems of interest alignment (what organizational economics would call “agency costs”) and coordination (Foss 2002). Entrepreneurial judgment enters the picture here, as entrepreneurs exercise judgment about other people’s judgment. Entrepreneurs evaluate employees according to their ability to use delegated decision rights properly. While this is an attractive answer, it raises the question about the actual mechanisms for judging others’ judgment (Foss and Klein 2012). Here, existing Austrian literature is not very forthcoming and allows only speculating about the actual mechanisms implied by Mises and Lachmann.

Conclusion Many of the analytical components that are necessary to develop a coherent theory of the firm were already present in Austrian economics long before they attracted interest within modern organizational economics. Like their neoclassical counterparts, Austrians have been reluctant for many years to open up the “black box” of the organization. In recent years, however, a number of scholars have ventured into developing elements of a distinctly Austrian theory of the firm. In fact, more than seventy-five years after the publication of Coase’s (1937) article about the nature of firms and more than fifty years after Rothbard’s (1962) generalization of Mises’s argumentation regarding the

11  Research within the contractual theory of the firm has clarified in the meantime that the problem may be handled if the central (planning) board can credibly commit to a noninterference policy. Committing to a noninterference policy is difficult, though, in practice, as promises not to intervene for bad cause are simply not credible (Williamson 1996).

290   Institutions and Organizations calculation problem of socialist economies to large firms, Austrians have come a long way toward developing a first cast of a distinctly Austrian theory of the firm. While some scholars have taken Kirzner’s notion of entrepreneurship as alertness as a point of departure in their efforts at building an Austrian theory of the firm, entrepreneurship understood in the Knight-Mises conception of judgment under uncertainty seems particularly promising for such a venture. A judgment-based approach to entrepreneurship allows drawing on Austrian production and capital theory—a unique and coherent theory of capital that allows overcoming major shortcomings of existing (contractual) approaches to the theory of the firm in mainstream organizational economics. The multistage nature of production processes gives rise to heterogeneous capital assets, which in turn require entrepreneurs to experiment with capital goods in order to discover their attributes step by step. Asset ownership greatly facilitates such experimentation with assets. Thus, the Austrian conception of production processes allows deriving why entrepreneurs will not be of the penniless type claimed by Kirzner. Moreover, entrepreneurs cannot sell their judgment on a market, as in a world of thoroughgoing subjectivism as assumed by modern Austrian capital theory, costs of moral hazard or of trying to communicate entrepreneurial judgments close markets for judgments, for the same reason that judgment is uninsurable (Foss and Klein 2012). Therefore, entrepreneurs need to found their own firms. Heterogeneity in capital goods, however, also allows for explaining the multiperson firm, as a hierarchical relationship (i.e., employment contracts with collaborators) facilitates rearranging the experimental setup. The Austrian conception of the production process equally allows explaining firm boundaries by the entrepreneurs’ need for indications of relative scarcity of heterogeneous capital goods in order to economically evaluate alternative plans for using capital goods. Finally, the judgment-based approach also allows for shedding light on questions of internal organization; entrepreneurs exercise judgment also about other people’s judgment. However, the judgment approach relies heavily on ideas about the decomposability of processes and asset specificity from more mainstream organizational economics to get from a one-person firm to the multiperson firm. Thus, if one wants to define a firm as in the Coaseian theory of the firm—that is, as an employment relationship—Austrian insights available in literature only go part of the way toward building a theory of the firm. Similarly, the Austrian idea of the entrepreneur judging others’ judgment is still abstract and calls for further refinement. Yet, given the growing proportion of indirect costs in many (though not all) industries, the calculation problem stressed within the judgment approach advocated by Foss and Klein (2012), seems increasingly attractive for empirical and conceptual investigations into organization size. Firms within a particular industry that are better able to allocate indirect costs to the respective subunits within the value chain should be at an advantage in comparison with their peers, and thus be able both to outperform those and to grow larger than them (Klein 1996). Recent advances in cost accounting, such as activity-based costing (Cooper and Kaplan 1988) or activity-based budgeting (Brimson and Antos 1999), may provide more accurate approximations in transfer

Organizations and Markets    291 pricing and thus reduce the misallocations and inefficiencies linked to the disappearance of markets. Yet it is unclear so far whether and how much the introduction of such systems allows a firm to shift outward its limits and how they affect relative performance of firms. Thus, while a judgment-based approach to the theory of the firm based on Austrian capital theory without any doubt still needs further refinement, it addresses major weaknesses in the assumptions underlying the dominant (contractual) theory of the firm in organizational economics. It thus promises to be a fruitful avenue for arriving at a “better” theory of the firm. Austrians might not want to stop there. It also seems time to broaden the study from firms to organizations, that is, to build a first version of a theory of the organization. While all organizations face uncertainty and while it is likely that all organizations plan in one form or the other, and thus the calculation problem might apply to all kinds of private, public, profit, or nonprofit organizations (Klein 1996), more research explicitly targeting not-for-profit organizations seems necessary to establish the generalizability of the insights from firms to all kinds of organizations.

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Chapter 13

The Evolu t i on of Propert y Righ ts Syst e ms Bruce L. Benson

Introduction The institutions of a property rights system—the rules and governance arrangements1 that define and encourage respect for entitlements regarding access to, uses of, and transfer procedures for resources and other assets—evolve as conflicts over the use of scarce resources are resolved by individuals attempting to find ways to achieve their objectives in the face of this scarcity. The evolutionary process is driven by entrepreneurial discovery as individuals attempt to gain control of or avoid losing control of valuable resources. There are two ways for these institutions of property to be developed (Mises 1949, 683), however, and therefore two broad arenas through which entrepreneurs can operate. One is through explicit or implicit bargaining as individuals combine their bilateral and multilateral relationships into communities made up of people with shared values. Members of these communities voluntarily agree to respect one another’s claims to scarce resources that were not previously owned and to cooperate in governance, including mutual protection arrangements and third-party dispute-resolution processes. Oppenheimer (1908) labels this process the “economic” means for pursuing personal goals and objectives. A second method for the creation of rules and governance arrangement is through the use of or threat to use violence as one individual or organized group takes scarce resources or the products of those resources from another individual or group through plunder or conquest and extortion.2 Oppenheimer (1908) 1  These rules and governance arrangements will be referred to as the institutions of property using North’s (1990) definition of institutions as the “rules of the game.” In this context, the rules consist of Hart’s (1961) primary rules of obligation, along with secondary rules of governance processes (e.g., third-party dispute resolution, methods of changing and inducing acceptance of primary rules). 2  A person “becomes an entrepreneur in seizing an opportunity and filling the gap” (Mises 1949, 314). In an unregulated (free) market economy characterized by limited knowledge, such opportunities

The Evolution of Property Rights Systems    297 defines this as the “political” means. Plunder requires military might, after all, and extortion requires coercion.3 A positive analysis of the evolution of the institutions of property must account for the influence both of the rules adopted voluntarily to facilitate cooperation and of those that arise as part of an involuntary transfer process.

Scarcity, Rules, and Property Rights Rules are behavioral patterns that other individuals expect a person to adopt and follow in the context of various interdependent activities and actions. The rules one individual is expected to follow influence the choices made by other individuals; like prices, rules coordinate and motivate interdependent behavior. Rules are generally not necessary if there are no conflicts to avoid or resolve, and, as Hume ([1751] 1957) emphasizes, the primary source of conflict between individuals is scarcity. In this context, Coase (1960) stresses that externalities arise when two or more individuals attempt to use the same asset or resource for conflicting purposes. This would not occur if the asset or resource was abundant, so the existence of an externality implies scarcity. In fact, scarcity often becomes apparent when externalities become evident and conflicts over use arise. Because the allocation and enforcement of property rights determine the distribution of costs and benefits associated with a scarce asset, the affected individuals obviously will have different opinions about how the rights should be assigned and protected. Thus, attempts to create and then protect property rights are costly, as other individuals must either be persuaded or induced to accept obligations to respect claimed rights and associated liabilities that are required to internalize the externality. In this context, Demsetz (1967, 350)  argues that effective can arise through discovery of a new product that will fulfill consumers’ desires more effectively or of a production technique that lowers the costs of providing an existing product, as the neoclassical economist would suggest, but innovation and, even more narrowly, research and development, are not the only entrepreneurial activities. Opportunities can also arise through discovery of an “error” (or a “difference in knowledge”) in a market that creates an opportunity for arbitrage, for entry into a profitable niche in an existing market or into an untapped market for an existing product. And they can arise through discovery of an organizational error that can be taken advantage of to lower transaction costs. Thus, as Kirzner (1997, 62) explains, entrepreneurial discovery of opportunities in a free-market environment gradually and systematically pushes back the boundaries of ignorance, thereby driving down costs (both production and transaction) and prices while increasing both the quantity and quality of output. Note that some economists use the term entrepreneurship in a normative sense by only applying it to the desirable consequences that entrepreneurial activities tend to generate in market processes. The term is used in a positive sense here, however, to describe someone who searches for and takes advantage of opportunities. There can be entrepreneurs who pursue illegal gains in black markets, entrepreneurs who pursue advantages through political and/or bureaucratic arenas, and entrepreneurs who employ violence to plunder or extort. 3  Theft also is an involuntary transfer process, but it generally does involve the imposition of rules and governance arrangements, at least when practiced on a small scale. Large-scale theft can involve governance processes (e.g., see Gambetta 1993; Leeson 2009), but such activities can generally be described as plunder or extortion. Guile may be employed to commit theft rather than violence, of course, and this also can be an important factor in the institutionalized political process, as noted below.

298   Institutions and Organizations property rights are likely to arise when the benefits of creating them exceed the associated costs: “Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization. Increased internalization, in the main, results from changes in economic values, changes which stem from … changes in technology and relative prices.”4 This implies that in a positive sense, property rights are a matter of economic value, not legal definition or moral philosophy. Many things can change the relative values of assets, ranging from a change in demand for a good produced with the resource to a change in the cost of defining or protecting the resource (Demsetz 1967; Anderson and Hill 1975; Libecap 1986, 231; Barzel 1989, 74; North 1990, 48), and this in turn leads to changes in the rights structure. Such changes in conditions need not be exogenous, however. In fact, they are not likely to be. The market discovery process is driven by entrepreneurs’ efforts to fill gaps, perhaps by lowering production costs (e.g., by finding a way to replace a relatively scarce resource with a relatively abundant one) or by offering an improved product or new product that consumers find relatively valuable (e.g., developing a product that can be made using relatively abundant resources, thus increasing their value) or taking advantage of errors that can be arbitraged (e.g., discovering situations where resources can be reallocated to higher-valued uses). Entrepreneurs might also discover lower transaction costs of rights creation, as Anderson and Hill (1975) demonstrate. Thus, the technological advances and other increases in knowledge that alter relative values and result in property rights changes often are endogenous.

Inducing Recognition of Property Rights While scarcity is emphasized as the reason for developing property rights in the Coase-Demsetz view, this line of analysis does not explicitly explain the process or processes through which this evolution actually occurs. Mises (1949, 683)  explains, 4  Some other economists recognized that incomplete property rights are the source of externalities before Coase (1960)—see Mises’s (1949, 658) explanation, for example, that external costs and their consequences are “not the outcome of alleged deficiencies in the system of private ownership of the means of production. It is on the contrary a consequence of loopholes left in this system. It could be removed by a reform of the laws concerning liability for damages inflicted and by rescinding the institutional barriers preventing the full operation of private ownership.” The dominant view in economics, however, focused on a divergence between the private and social costs or benefits: an action by one individual imposes a cost on or provides a benefit captured by another individual, so the decision-maker presumably does not consider the cost or benefit in the decision. In the case of external costs, for instance, the pre-Coaseian analysis started with a charge that A inflicts harm on B, so the policy question was how A should be restrained. But Coase points out that this traditional approach really obscures the nature of the problem: externalities arise as individuals attempt to use a scarce resource for conflicting purposes, so constraining A gives B property rights in the resource, while constraining B gives them to A. Should A have the property rights, or should B?

The Evolution of Property Rights Systems    299 however, that “Virtually every owner is the direct or indirect [e.g., through voluntary purchase] legal successor of people who acquired ownership either by arbitrary appropriation of ownerless things or by violent spoliation of their predecessors.” Clearly, one way to induce recognition of property claims is to use or credibly threaten to use violence. Violence may be produced by individuals or groups of individuals seeking the control of assets (property rights), but it also can be provided by a third party with sufficient coercive power if those seeking control can persuade the third party to act on their behalf. Another way to induce recognition of property rights is through negotiation among cooperative individuals resulting in agreements to recognize one another’s rights to resources that were previously not owned or that were obtained from someone else. It is important, however, that the process through which property rights evolve affects the nature and assignment of rights. The process employed (violence or bargaining) and the resulting rights assignments can also change (evolve) when changes in the costs of using or credibly threatening violence occur (e.g., one entrepreneur develops a new military tactic or new military equipment that lower its cost of warfare; Benson 2006) or when the cost of negotiating is altered (e.g., an entrepreneur offers a system for certification of trustworthiness such as VeriSign’s “trustmark” that makes promises more credible, thereby lowering the cost of bargaining; Benson 2005).5 Therefore, a positive analysis of the evolution of property rights must account for the influence of the rules and institutions that arise through and facilitate cooperation along with those that arise through violence and coercion employed to produce involuntary wealth transfer. Unilateral efforts to claim property rights over scarce resources require sufficiently strong threats of violence to induce others to behave as if they respect the claims. Since several individuals are likely to have similar incentives to capture control of any scarce resource, however, violent competition in an effort to establish claims could consume vast amounts of resources. Is such a Hobbesian “war of all against all” inevitable? No. For instance, individuals with similar capacities for violence (and therefore similarly small expectations of winning the Hobbesian war) might agree to recognize an equal initial distribution of property rights to scarce resources. In fact, essentially all anthropological evidence points to cooperation as the primary means to facilitate order within groups rather than the emergence of intragroup arrangements for coercion (Benson 1989a; Benson 1991a; Ellickson 1993; Ridley 1996). Hobbes’s “war of all against all” at the individual level is rejected, even in the most primitive states of human (and prehuman) existence. Voluntary cooperation requires trust, so rules that encourage ethical behavior tend to evolve in order to encourage participation in such positive-sum games (Benson 2007). One of the important determinants of trust is mutual respect for property rights (Benson 2007). As Hayek (1973, 107) notes: The understanding that “good fences make good neighbors,” that is, that men can use their own knowledge in the pursuit of their own ends without colliding with each other only if clear boundaries can be drawn between their respective domains of free 5 

For example, see Benson (1994b; 1999; 2006) and Anderson and McChesney (1994).

300   Institutions and Organizations action, is the basis on which all known civilization has grown. Property, in the wide sense in which it is used to include not only material things … is the only solution men have yet discovered to the problem of reconciling individual freedom with the absence of conflict.

The incentives to accept the relevant rules of obligation are largely positive: individuals expect to increase personal well-being by focusing in productive activities as a result of reciprocal commitments to accept rules of obligation to respect property claims, rather than in protective or aggressive activities.6 As noted above, however, Oppenheimer (1908) explained that there are two ways for an individual or group to gain access to scarce resources:  (1)  “economic” processes, which consist of voluntary bargaining to establish rules of obligation to respect property rights and other cooperative voluntary interactions, including team production through the division of labor and voluntary exchange; and (2) “political” processes, which take property claimed by and produced by others through the use or threat of force (and/or guile). A Hobbesian war can arise if some parties believe that their relative capacities in the use of force substantially enhance their probabilities of controlling more resources, for instance, whether that force arises through violence or coercion (the threat of violence). As noted above, historical and anthropological evidence suggests that the earliest men lived in groups that were largely cooperative in nature. This is not surprising, since significant differences in the capacity for using force within such groups probably did not exist until some individuals developed such capacity, so mutual deterrence tended to prevent wealth transfers, leaving cooperation as the only effective means of enhancing individual well-being. Violence is not likely to persist even when one party’s capacity for using force is substantially greater than that of other parties. Indeed, if an individual or group has an absolute advantage in violence, others can be coerced into accepting rules that establish slavery, thus concentrating all property rights (including the ownership of other persons’ labor) in the hands of one “authority.” Of course, the authority will also have to maintain a position of dominance in order to ensure continuation of the very uneven distribution of rights. After all, the slave’s incentives to accept the rules are “negative”—subjugation is expected to be better than the alternative very high probability of losing everything, including life. Such rules obviously are not shared values, but, instead, they discriminate in favor of targeted individuals and are imposed on others by 6  As Mises ([1957] 1985, 207) stresses, the idea that economic man is an egoist who pursues only higher income or material wealth is incorrect. He cites Böhm-Bawek, who, in his theory of value, employs the term well-being to refer to “everything that appears to an individual as desirable and worthy of being aimed at.” Mises (1949, 14) makes the point even more forcefully by noting that “the ultimate goal of human action is always the satisfaction of the acting man’s desires. … To establish this fact does not refer in any way to the antitheses of egoism and altruism, of materialism and idealism, of individualism and collectivism, of atheism and religion. There are people whose only aim is to improve the condition of their own ego. There are other people with whom awareness of the troubles of their fellow men causes as much uneasiness as or even more uneasiness than their own wants. There are people who desire nothing else than the satisfaction of their appetites for sexual intercourse, food, drinks, fine homes, and other material things. But other men care more for the satisfactions commonly called ‘higher’ and ‘ideal.’ ”

The Evolution of Property Rights Systems    301 using coercive threats. That is, they are intended to take property rights from the weak and transfer them to the strong. Their design and enforcement typically involve cooperative efforts by those with power, of course, and these cooperative processes are often governed by norms that apply within the group that has power in order to establish sufficient trust to support this cooperation. Between the extremes of voluntary agreements and coercively imposed slavery, many other possible arrangements actually exist. The result is extortion for “protection” from the powerful authority itself with payments of tribute to the extortionist (the authority will want to induce outsiders to respect his claims, of course, so the protection racket can also protect subjects from other threats). Some protection rackets involve large extortion payments, concentrating property rights, while others are characterized by dispersed property rights and modest extortion payments to someone with a comparative advantage in force. Indeed, it may well be that the person choosing to pay the extortion could effectively produce a sufficient counterforce to overthrow the extortionist, but if the payment demanded is not too great, then the opportunity cost of creating this counterforce may be too high to make it worthwhile. In this case, the extortionist clearly is constrained in how much can be extracted (implications of such constraints are discussed below). The designed and coercively imposed rules intended to facilitate transfers are rarely able to completely dictate the targeted behavior, because knowledge is incomplete for the rule makers, and policing is imperfect (e.g., see Mises 1949, 764, 856; Hayek 1973, 51; Kirzner 1985, 145). Norms supporting resistance within the group(s) being dominated will also evolve as they attempt to avoid the transfers (Benson 1999; 2007; Nee 1998). Nonetheless, the designed transfer rules virtually always influence behavior. Deliberate efforts to impose rules to facilitate transfers create incentives to find and exploit uncontrolled margins in order to avoid the full consequences of those rules (e.g., see Cheung 1974; Kirzner 1985; Benson 2002; Benson 2004), and in this context, the search for ways to avoid the rules also can significantly alter the path of the spontaneous evolution of norms among both the group with power and the group(s) subject to the takings (Benson 1999; Benson 2007; Nee 1998). Therefore, as suggested earlier, a positive analysis of the evolution of property rights must account for the influence of the rules and institutions that facilitate cooperation and wealth expansion along with those that arise as part of a wealth transfer process. First, consider a spontaneously evolving voluntary property rights system, however, before turning to the implication of extortion and the evolution of property rights.

Property Rights through Cooperation Voluntarily recognized “trust rules,” to use Vanberg and Buchanan’s (1990) terminology, essentially involve explicit or implicit agreements to adopt predictable behavioral patterns or “norms” in dealings with a limited number of identified individuals.

302   Institutions and Organizations Since the primary source of conflict is scarcity, trust rules focus on property allocation. As Vanberg and Buchanan (1990, 185), explain:  “Because compliance and non-compliance with trust rules are … ‘targeted,’ the possibility exists of forming cooperative clusters.” In this light, imagine an evolutionary process in which individuals recognize the high cost of unilateral violence as a means of establishing property rights. Individuals with similar capacities for violence facing the likelihood of repeated interaction (e.g., neighbors) form relatively tentative bilateral relationships, limiting claims in exchange for explicit or implicit promises to recognize one another’s property boundaries. Suppose, for instance, that the entrepreneurial leader of a nomadic hunter-gatherer clan persuades others in the clan to establish permanent farms in a fertile valley. The various families clear different pieces of land, then plant and successfully harvest a substantial crop. Some of the members of the extended tribe, or perhaps those from the clan that chose not to farm, observe their success and decide to do the same. Since land in the valley is abundant, there is no need to try to take land already controlled by others. Instead, the newcomers implicitly recognize the entitlements of those who arrived first and occupy another area in the valley. Still others follow suit, and more farms are established. Each family recognizes the property rights of all those who came before, essentially establishing a right of first possession. At some point, the number of farms is such that there is not another economically feasible farmstead available. Land is no longer abundant. If another family chooses to enter the valley, its members will have to obtain land currently occupied by someone else—a conflict arises. If they try to take land by force, the previously established landowners may recognize the potential threat that they all may face. In order to protect against such claim jumping, the entire community may choose to participate in a mutual protection arrangement, agreeing to explicitly recognize one another’s property rights and assist one another in the exclusion of outsiders who might attempt to take any of their farmsteads. Whether this hypothetical story is accurate or not, the fact is that, as Mises (1949, 683) explains, “private property is a human device. It is not sacred. It came into being in early ages of history, when people with their own power and by their own authority appropriated to themselves what had previously not been anybody’s property.”7 In all likelihood, the individual families will have established other kinds of mutually beneficial relationships to socialize, celebrate successful harvests, trade, and so on, before the community as a whole comes together. In fact, since the shift from hunting-gathering to agriculture occurred as an already existing community (clan, tribe) led by entrepreneurial example or persuasion, settled in a fertile valley, they will have had established norms of behavior for a variety of interactions, including norms that oblige them to respect one another’s property (e.g., hunting equipment, shelters, 7  While this example is hypothetical, it is actually based on historical examples, including the settlement of Iceland (Friedman 1979; Solvason 1992; Solvason 1993) and the creation of mining camps during the various gold rushes that occurred in North American (Umbeck 1981; Anderson and Hill 1979; Anderson and Hill 2004), where prior relationships did not necessarily even exist.

The Evolution of Property Rights Systems    303 domesticated animals). These individuals previously realized significant benefits from ongoing bilateral relationships, so a violation of a norm could be “corrected” bilaterally through the “tit-for-tat” strategy or multilaterally through social pressures and ostracism threats.8 The threat to withdraw the benefits of community activities can induce the violator to once again recognize the rules and even compensate anyone who was harmed by the violation. Security of each individual’s property claims is increased by accepting an obligation to respect property rights of other individuals who are expected to reciprocate by doing the same. As this occurs, individuals’ time horizons lengthen, they can plan better, and resources can be allocated to maximize the potential for long-run wealth creation. Things are not quite this simple, of course, as disputes may arise over what rule actually applies to a given situation; individuals may be accused of violating a rule, rightly or wrongly, and deny it; new situations may arise that require adjustment of rules and/ or the allocation of newly valuable (scarce) resources; or incentives to respect property might change (e.g., through technological change and/or entrepreneurial discovery or through natural occurrences such as a drought or flood that put some individuals in such dire circumstances that they may feel compelled to steal just to stay alive) that require some change in methods of inducement to respect rights. Dealing with these issues will generally require additional rules that establish means of resolving disputes and adapting rules to new circumstances, that is, rules establishing processes of governance. Indeed, Vanberg and Buchanan (1990, 185–186) explain that once a group is formed based on intermeshing bilateral trust rules, “solidarity rules” (obligations that are expected to be followed by all members of a group because compliance benefits everyone) can develop. Individuals might cooperate unconditionally with anyone known to be trustworthy within their network of relationships, for instance, while refusing to interact with anyone known to have violated a trust rule with anyone in the group. If information spreads quickly and everyone spontaneously responds to a rule violation, the violator is excluded from all interaction with any member of the community. Social ostracism is the result, and it can be a very significant punishment. In fact, an individual’s incentives to exact physical or tit-for-tat punishment are weak when competitive alternatives exist and information is easily spread. Essentially, investments in communication mechanisms substitute for investments in capacity for personal violence. Solidarity rules are things such as “inform your neighbors about individuals who violate trust rules” and “boycott untrustworthy individuals,” and they evolve spontaneously as individuals substitute ostracism for violence. Related rules such as “watch out for your neighbor” and “inform everyone when a rights violation occurs” tend to follow, and multilateral cooperative policing (responding to the “hue and cry”) as a mutual

8 

Other strategies can also offer both punishment for misbehavior and signals of an interest in cooperation (Ridley 1996, 53–84).

304   Institutions and Organizations insurance of property rights ultimately evolves. The empirical fact is that joint products of close-knit groups often include watching to prevent theft and cooperation in pursuit and prosecution when a theft occurs (Benson 1989a; 1991a; 1994a; 1998). Individuals who do not follow solidarity rules (e.g., contribute to cooperative policing) are also ostracized, so free-rider problems are not significant. Threats and sanctions actually are not the primary sources of incentives to recognize rules in an evolving cooperative group, as important positive incentives also evolve. Mutual protection is one, but others include friendships, social and religious organizations, joint production where scale economies exist, and specialization and trade. Similarly, unexpected fires, storms, accidental death of a household head, and other events of this kind can lead to predictable changes in the incentives to accept obligations, so a group may establish mutual insurance arrangements to protect people from occurrences that might force them to steal in order to survive. Rational self-interested individuals will make voluntary transfers to someone in distress in an attempt to create positive incentives to continue respecting their property rights (Johnsen 1986; Ridley 1996, 114–124). Furthermore, there is also a reciprocal assurance that they can receive transfers in the future, without resorting to theft, if they are in distress. Not surprisingly, such “gift exchanges” and “potlatching” are common practices in close-knit communities all over the world (Ridley 1996, 114–124). Other institutional arrangements also evolve. For instance, a dispute may arise over ownership of a previously unclaimed asset that has become scarce as a result of some technological advance that makes it useful in production. Similarly, policing is imperfect, so someone accused of a rule violation may not be guilty and may dispute the charge. Disputes can be resolved by violent “prosecution” and exclusion of the loser, but in a close-knit group, such violence can have significant negative spillover costs, particularly if opinions of individuals in the group are mixed. These costs can be reduced by developing nonviolent means of resolving disagreements and clarifying property rights and by making acceptance of a judgment relatively attractive for the loser. For instance, a mutually acceptable mediator or arbitrator might be chosen from among the most reputable members of the community or from a pool of competitive dispute-resolution specialists. Since this third party must be acceptable to both disputants, “fairness” is embodied in the dispute-resolution process. The loser may also be allowed to buy his way back into the community by paying an appropriate restitution, rather than being subject to physical punishment or exclusion. Given that the chosen arbitrator/mediator convinces individuals in the group that a judgment should be accepted, the ruling can be backed by an ostracism threat, of course, although in general, dispute resolutions are likely to be accepted because even losers recognize that the long-term benefits of behaving in accordance with members’ expectations probably exceed the restitution payment (or the costs of exclusion). Numerous historical and anthropological studies demonstrate that restitution and voluntary third-party dispute resolution are common institutions in close-knit groups’ legal systems (Benson 1989a; Benson 1989b; Benson 1990; Benson 1991a; Benson 1991b; Benson 1999a; Benson 2007; Pospisil 1971).

The Evolution of Property Rights Systems    305 All such institutional developments tend to be spontaneous and unplanned, and the result is a movement toward increasingly secure property rights.9 Indeed, “There is abundant evidence that a … group need not make a conscious decision to establish private property rights. … People who repeatedly interact can generate institutions through communication, monitoring, and sanctioning. … Contrary to Hobbes and Locke, a property system can get going without an initial conclave” (Ellickson 1993, 1366). Thus, no central “authority” with coercive powers is necessary to produce law in such a cooperative social order. Many so-called primitive societies can be at least approximately characterized by the kinds of institutions that are described here, and in this context, Bailey (1992) points out, after a large-scale review of relevant anthropological and historical information, these societies are characterized by “approximately efficient” property rights arrangements.10 An examination of relationships in modern international commerce (Benson 1992), within domestic trade associations (Bernstein 1992; Benson 1995), and between neighbors in stable economic communities (Ellickson 1991; Acheson 1988) reveals that they are ruled by modern versions of the same kinds of institutions that develop in primitive communities.

Entrepreneurship in Close-Knit Communities and Evolving Institutions of Property While the process described above is unplanned, it does not follow that there are no plans or intentional acts.11 The potential benefits of institutional development and of expanding the sizes of groups that voluntarily recognize property rights suggest a significant entrepreneurial role. One or more persons generally emerge as “community leaders,” for instance, not because of an ability to threaten violence but because of an ability 9 

This claim is based on observation, but there are also numerous theoretical models, generally using game theory, that develop mechanisms through which such arrangements evolve, including repeated games, reputation games, and so on (Ellickson 1991; Ridley 1996, 53–84; Greif 2006). 10  While such societies are characterized by widespread private property rights to most valuable resources (Benson 1989a; 1991a; 1990), it does not follow that all rights must be or should be private. First of all, if the costs of creating private rights exceed the benefits, rights are not likely to privatized, as noted above. Furthermore, “communal rights” with access limited to members of a community (in contrast to true free-access common pools) and norms that also limit members’ use of the resource can also be efficient (Ostrom 2010). Such resources may include community-controlled hunting territories, fisheries or pastures, community roads, a community common where social and religious activities occur and where disputes are resolved by selected arbitrators or mediators, and so on. 11  This statement actually describes the situation when an authority designs and imposes rules, as explained below. Indeed, “History is made by men. The conscious and intentional acts of individuals, great and small, determine the course of events insofar as it is the result of interaction of men. But the historical process is not designed by individuals. It is the composite outcome of the intentional actions of individuals” (Mises [1957] 1985, 195–196).

306   Institutions and Organizations to recognize opportunities to gain from cooperation and to persuade others that the benefits of cooperation and recognition of obligations will be beneficial for all of them. As Polanyi (1951, 165) stresses, the evolving spontaneous order in rules and governance institutions often is “based on persuasion.” Such a leader need have no special power or coercive authority to make or enforce rules, however, as his or her maintenance of a network of trust is sufficient for others respect the entrepreneur’s opinion about what the rules are or should be. The capacity to attract followers is likely to depend on a perception that the person is a “wise” man or woman with whom others wish to consult, and a very productive and trustworthy individual with whom others can interact in joint production or trade to expand their own wealth. Indeed, it is likely that only trustworthy and successful individuals will be voluntarily recognized as leaders within small groups. The wealth accumulated by an individual in a close-knit cooperative community almost always depends on that individual’s work effort and skill and his or her ability to cooperate with others, since wealth is most effectively expanded through joint production or division of labor and voluntary exchange. Therefore, anyone who acquires sufficient property to reach the status of leadership is likely to be a mature, skilled individual with considerable physical ability and intellectual experience and, perhaps more important, someone who has a history of cooperative behavior. Such personal capabilities are deserving of respect, and in fact, those who gain wealth in cooperative communities are generally held in very high regard (Benson 1991a; Pospisil 1971). Not all wise and wealthy individuals are likely to achieve respect that attracts substantial numbers of others to regularly rely on them as a “leader”—essentially, an individual who acts as a nexus of the voluntary exchange relationships. Those seeking leadership will have to indicate their willingness to provide wise advice and decisions to the community. Therefore, for instance, when disputes arise, these entrepreneurs have incentives to offer their services as arbitrators or mediators, both in order to gather information and to demonstrate wisdom and trustworthiness. Furthermore, “The way in which capital is acquired and how it is used make a great difference; the [members of a community] favor rich candidates who are generous and honest. These two attributes are greatly valued” (Pospisil 1971, 67). Indeed, long-term leadership requires that shares of the gains from entrepreneurial innovations in rules and institutions (and in production, etc.) be dispersed through the community of individuals who follow the entrepreneurial leader. If the benefits are exclusively captured by the innovator, the individual will be unable to attract followers. Thus, a self-interested entrepreneur’s “greed” must be tempered; an individual with a long time horizon seeking a position of leadership in order to enhance personal wealth accumulation efforts within a close-knit community will rationally choose to pursue innovations that benefit others in the group and generously spread the wealth. Someone with an ability to recognize the gains from innovations in rules and governance institutions that generate dispersed benefits and with entrepreneurial skills in persuasion naturally may accumulate greater wealth as the group evolves, however. The individual is able to personally instigate more joint ventures, wealth-enhancing exchanges, and various social forms of interaction that enhance the individual’s well-being. Furthermore, those who

The Evolution of Property Rights Systems    307 benefit from the entrepreneur’s projects tend to reciprocate when they perceive some wealth-enhancing opportunity, by seeking out the entrepreneur as a partner or investor. Innovations in rules and institutions that may generate disproportionately large returns for the entrepreneur can also be accepted if the entrepreneur generously disperses the benefits in the form of gifts. Indeed, in primitive societies, the honor of being recognized as a leader is often “purchased” through public displays of generosity demonstrated at occasions such as marriages and in connection with disputes, in the form of gifts on behalf of the leader’s followers in order to secure good marriages or buy peace among disputants. By achieving (purchasing) prestige as a wise and generous individual, however, such a leader expects to benefit in the future for reasons suggested above. As Ridley (1996, 138) puts it, such acts “scream out ‘I am an altruist; trust me.’ ” Thus, incentives to build a reputation as a wise, trustworthy, capable, and generous individual are strong. The preceding discussion suggests, as does Mises (1949, 725), that There is no need to enforce cooperation by special orders or prohibitions. Noncooperation penalizes itself. Adjustment of society’s productive effort and the pursuit of the individual’s own concerns are not in conflict. Consequently no agency is required to settle such conflicts. The system can work and accomplish its tasks without the interference of an authority issuing special orders and prohibitions and punishing those who do not comply. Beyond the sphere of private property and the market lies the sphere of compulsion and coercion…. This is the realm of constraint as distinguished from the realm of freedom. Here are rules discriminating between what is legal and what is illegal, what is permitted and what is prohibited. And here is a grim machine of arms, prisons, and gallows and the men operating it, ready to crush those who dare disobey.

Let us now consider how the sphere of compulsion and coercion comes about and what it means for the evolution of a property rights system.12

Extortion and the Evolution of the Institutions of Property No community evolves in complete isolation. Since a key function of cooperative clusters is to establish and secure private (and communal) property rights, and such rights are insecure if outsiders are able to raid or invade and take the property, one joint product of

12  It should be noted that Mises (1949, 725, and elsewhere) contends that the use of coercion and control arises “for the protection of private property and the market against violence, malice and fraud.” It is contended below that this is not the impetus for the “grim machine,” however, and that other arguments by Mises suggest the actual origins of such institutions.

308   Institutions and Organizations a cooperative group is likely to be mutual defense. In this light, another source of prestige for entrepreneurial leaders seeking to enhance their ability to enter joint production and trade agreements within a group is skill and bravery in battles against external enemies, including organizational and strategic skills (Benson 1991a; Ridley 1996, 166). This skill and bravery can be exhibited in community defense or in aggression against enemies, however, and if a significant comparative advantage in violence is achieved, aggression becomes an attractive way to gain control of and benefits from property. One group may rely on hunting, for instance, and while the improvements in technologies for hunting resulting from specialization can enhance wealth in the short run, the long-run effect can be quite different. Many migratory animals were hunted into extinction by primitive groups (Ridley 1996, 227–247) because ownership could not be established until an animal was killed. As a result of such free-access common pool problems, the group’s members might find themselves less well off than members of another group that has settled on relatively fertile land to engage in agriculture. Furthermore, entrepreneurial members of the hunter community also develop new inputs to hunting (e.g., spear throwers, bows and arrows, horses, ships). These inputs to hunting are also tools that enhance the capacity for violence. Therefore, an entrepreneurial leader skilled in combat may expect that an attractive way to gain property rights and wealth is through organized aggression against the agricultural community. He may persuade members of his community to follow him in the joint production of plunder. Not surprisingly, many historical examples of organized plunder involve cooperative communities with established internal trust relationships such as those described above (e.g., tribes that attacked Rome during its decline, Vikings). Indeed, anthropological and historical evidence suggests that intragroup conflict has been an almost ubiquitous characteristic of human history.13

13 

It must be emphasized that cooperative arrangements can and often do evolve between members of different groups. Even in primitive societies, entrepreneurs establish extensive trade networks that cross community boundaries, for instance (Benson 1989a; Benson 1991a; Ridley 1996, 195–211), but as such arrangements evolve, they also have to be accompanied by various institutionalized rules to function effectively (Benson 1989a; 1991a). Groups need not formally “merge” and accept an entirely common set of rules governing all types of interaction, however. Individuals only have to expect one another to recognize a common set of rules pertaining to the types of intergroup interactions (e.g., trade) that evolve. Indeed, a “jurisdictional hierarchy” often arises wherein each group has its own norms for intragroup relationships, with a separate and possibly different set of rules applying for intergroup relations (Pospisil 1971; Benson 1991a; Benson 1994b). Furthermore, to facilitate intergroup interactions, entrepreneurs who expect to benefit often promote the use of internal sanctions to bring community members to justice when they attempt to take advantage of (e.g., attack) members of the other group (Benson 1991a). These entrepreneurial leaders also may serve as arbitrators of disputes arising between members of the different groups (Pospisil 1971), in order to enhance their reputations as fair and cooperative (trustworthy) individuals, but this increases the security of property rights for both groups. Many intragroup norms will be commonly held, of course, and emulation also will occur where differences initially exist but individuals observe and perceive superior arrangements among other groups (Benson 1989b; 1990), so the evolution of common norms recognized and applied in a very extensive web of communities is clearly possible (e.g., Benson 1989b). The transaction costs of such intergroup cooperation are obviously relatively high, however, so intergroup conflict can also be expected.

The Evolution of Property Rights Systems    309 Mises (1949, 804–805) explains:  When the Vikings turned their backs upon a community of autarkic peasants whom they had plundered, the surviving victims began to work, to till the soil, and to build again. When the pirates returned after some years, they again found things to seize. But capitalism cannot stand such reiterated predatory raids. Its capital accumulation and investments are founded upon the expectation that no such expropriation will occur. If this expectation is absent, people will prefer to consume their capital instead of safeguarding it from the expropriators. This is the inherent error of all plans that aim at combing private ownership and reiterated expropriation.

Raiding for plunder may produce relatively large returns in the short term, but over time, they will become smaller. There is an alternative to plunder, however. A protection racket can extort payments over time if productive people are allowed to continue to combine their productive efforts and capital with resources they own in exchange. They may be willing to make continuous payments of “protection money” (tribute, taxes) for a guarantee that the attacks will stop. Therefore, an entrepreneurial leader may advocate invasion and occupation of the territory of another community, intending to tax those who are conquered as they continue to “own” their resources and produce. Ownership is attenuated, of course, since some of the benefits generated through use of the resources are captured by the entrepreneurial extortionist. The most successful examples of protection rackets by modern organized crime typically are kinship or ethnic “communities” run by the extortionist leader which have strong internal trust relationships supported by recognized norms of behavior, for instance,14 although the territories controlled by such efforts are often relatively small (for example, a few blocks of a city, part of the island of Sicily). Protection rackets with control over much larger geographic areas have arisen. Oppenheimer (1908) contends that the origins of the earliest states trace to precisely this situation, for example, as nomadic hunting and/or herding communities from the relatively unfertile mountains, deserts, or sea coasts invaded and subjugated those who had settled in fertile valleys. Many historians and political theorists also characterize the earliest states (for instance, in Egypt, Mesopotamia, and China) in this fashion.15 Those communities that are clearly weaker have incentives to submit and pay tribute rather than fight. Carneiro (1970, 733–738) further notes that successful creation of relatively permanent states of this type occur where exit by those being subjugated was very difficult because of the surrounding hostile environment (for example, deserts, mountains, other hostile communities). A vital institutional objective of an entrepreneurial extortionist must be to erect barriers to exit from the extortionist game (that is, establish a “monopoly in violence” over the subjugated territory): “For the real tyrant, hardly any measure of security is more pressing than to raise barriers, psychological and 14  15 

For example, see Gambetta (1993, 57–58). For example, see Carneiro (1970) and Levi (1988, 11).

310   Institutions and Organizations political, to fence in his realm” (Wesson 1978, 190). Furthermore, an extortionist is likely to develop institutions to lower measurement costs, keep records, reduce collection costs, institutionalize threats, and so on (Benson 1999). This discussion may imply that the reason for establishing a protection racket is material gain, but as noted above, value is subjective, and the goals of individual actions can arise through the desire to achieve many other objectives. An invader might be driven by a desire to impose a religion on another community, altruistically believing that it will make the conquered people better off. Tribute then takes the form of worshiping as the extortionist demands. A strong belief that those who are conquered will be better off with communism, socialism, capitalism, democratic government, or any number of other ideological objectives could be the motivate for imposing rules that would not be voluntarily accepted. Any of these objectives could dominate for those who subjugate others, but the result still is extortion, as those who are subjugated must give up something (their own religion, ideology, etc.) in exchange for protection from the invader. As suggested above, an entrepreneur in extortion generally arises within an established community as other members are persuaded to participate in the transfer process (e.g., strong-arm enforcers, army or police personnel, producers of tools or symbols of violence, or, in some cases, missionaries, educators, etc.). There is likely to be significant competition for control of such a protection racket, however, including other aggressive communities, revolutionaries and resistance movements within the territory, and even members of the entrepreneur’s own community (military coupes are not uncommon, after all). The extortionist must maintain a strong and credible threat against competitors to survive, but he or she also can reduce the incentives for competitive entry by bargaining and agreeing to provide something desired by potentially powerful individuals and groups in exchange for an agreement not to oppose the extortion efforts directed at others. As a result, the protection racket can involve a mix of extortion of those whose property rights are very insecure and protection/privileges for the relatively powerful whose property rights are quite secure as long as the extortionist leader remains in power. Kings in medieval England “granted” powers, privileges, and part of the tax revenues to the barons, for instance, in exchange for their military support, but it was also clear that if the barons as a group became sufficiently dissatisfied, they could revolt and even defeat the king, as they did when they forced the king to sign Magna Carta. Similarly, the kings supported the hierarchy of the church and even mandated that subjects accept the church’s teachings in exchange for church support (e.g., recognition of divine rights to kingship), but this was also because the church had tremendous influence over the population of believers. In order to maintain power, the extortionist also has incentives to redistribute as the relative power of subgroups within his or her jurisdiction changes. The ongoing redistribution involves an effort to obtain the support of the subgroups whose comparative advantage in violence appears to be developing in order to hold on to power. Thus, while mutual insurance arrangements in cooperative systems transfer to the disadvantaged who may have relatively weak incentives to respect property rights, extortion-based systems transfer to those

The Evolution of Property Rights Systems    311 who are becoming wealthy and/or powerful, as they have weaker incentives to respect the extortionist’s claim to sovereignty. As the market towns became cities controlled by wealthy merchants, for instance, kings granted privileges to them in exchange for taxes. Of course, there is a potential danger of the poor (or heathens or other subjugated groups) organizing effectively and revolting, too, so some transfers may flow in their direction if they are perceived as a developing threat. In a relative sense, however, transfers to the wealthy and/ or powerful will actually dominate, and any transfers to the poor will predominantly flow from others who lack power. The incentives for groups to organize in order to enter the transfer-seeking process rise as transfers increase, and more interest groups arise. Thus, the path of institutional development changes dramatically once involuntary transfers become a means of gaining property rights. Those who fail to gain political influence see whatever property rights they might have had becoming increasingly insecure as they are vulnerable to takings at any time. To facilitate this redistribution process, the cost of allocating transfers can also be lowered. Because the resulting transfer process is a negative-sum game, for instance, subgroups have incentives to compete for favorable treatment. The extortionist may encourage such competition, since by keeping subgroups divided into adversarial camps, the possibility of a strong coalition forming to overthrow the extortionist’s rule is reduced. This also makes the property rights of those engaged in such competition less secure, as losers may see their rights reallocated, and the dynamics of the process mean that some groups that are winners at one point in time can be losers at another. Governance institutions should develop through which the competition for transfers can be channeled and observed. By focusing such competition in “advisory councils” or “representative assemblies,” for instance, the cost of gathering information about the relative power of groups is reduced, as is the cost of interacting with various powerful groups.16 Powerful groups also see their interests linked to the interests of a “sovereign” as institutionalized exchanges of support for privileges develop, and therefore, they may be less likely to challenge the extortionist for power.17 This process can backfire, of course, as the assembly also lowers the bargaining costs among the different factions, and at some point, sufficient numbers of these factions might unite and challenge the extortionist for authority. Oppenheimer’s political means is a parasite on the economic host, so at any point in time, an extortionist is constrained regarding how much can be transferred. Indeed, the 16  An effective entrepreneur in extortion might also be able to simultaneously lower the cost of ruling and legitimize his or her claim as the monopoly source of rules and rule interpretation by establishing “adversarial” dispute-resolution forums (e.g., courts or assemblies) backed by threats of violence—adversarial because disputes are generally over distributional issues. 17  Oppenheimer (1908) suggests that this ongoing process of expanding the numbers and types of groups represented ultimately leads to the institutions of representative democracy, assuming that they continue. Mises (1949, 189–190) makes a similar point when he contends that “Though a tyrant may temporarily rule though a minority if this minority is armed and the majority is not, in the long run a minority cannot keep the majority subservience. The oppressed will rise in rebellion and cast off the yoke of the tyrant. … If the victorious conquerors do not succeed in subsequently converting the system of rule by violence into a system of rule by ideological consent on the part of those ruled, they will succumb in new struggles.”

312   Institutions and Organizations extortionist faces a trade-off. Large levels of extortion in the short term reduce productivity, economic growth, and the potential for transfers over the long run. The actual degree of transfers in any period, therefore, depends in part on the extortionist’s time horizon. With any time horizon at all, the extortionist is likely to recognize some property rights and allow some cooperative organizations in order to create incentives for those subject to extortion to continue producing more wealth. Nonetheless, the potential for transfer means that all property is in a common pool open to political competition, at least to a degree, with security of property assignments varying considerably depending on the relative political power of those in the extortionist’s realm. To the degree that the extortionist is successful in legitimizing his or her claims to sovereignty and preventing exit, the result is a perception that there is a single legitimate source of rules in a geographic jurisdiction.18 The sovereign may attempt to design and impose his or her own rules but is also likely to claim to be the source of rules adopted as norms in cooperative groups, because they are low-cost mechanisms for facilitating production that can then be expropriated. The sovereign’s “law” must be “above” the norms generated by such institutions, however, as involuntary reallocations of property rights must be an ongoing option. Thus, for instance, many early codes by kings claiming to be lawgivers were largely codifications of custom but with modifications to dictate distributional issues (Benson 1989b; 1992). The widespread belief that the “state” is the source of all “law” and required for an effective property rights system suggests that many historical claimants to sovereignty have been relatively successful, since most (all?) modern nation states clearly evolved from nonstate extortionist institutions (e.g., tribal war chiefs became kings, and kingdoms became nation states). But the “law” of the state serves many conflicting functions, simultaneously harassing and protecting private interests, extorting and encouraging its production, maintaining the class structure and cutting across classes, integrating parts of society and disintegrating other parts. This dynamic environment opens up numerous opportunities for entrepreneurs, in both the market arena and the political arena.

Economics versus Politics and the Evolution of Property Rights The power of a sovereign never becomes absolute. Furthermore, even in a society with a very strong extortionist ruler, some formal and/or informal cooperative groups always remain. These groups may still be able to enforce some of their own norms, even when doing so violates the extortionist’s “law” (e.g., vigilantism). Indeed, if in its effort to monopolize law, the extortionist prevents some activities (e.g., formal agreements to ostracize, third-party dispute resolution, restitution as 18 

For discussion of legitimization methods, see, for example, Levi (1988) and Benson (1999).

The Evolution of Property Rights Systems    313 an alternative to physical punishment) that voluntary groups would prefer to use, the groups may have to resort to tactics that are more difficult for the state to detect, and a considerable amount of violence (“crime” as defined by the state) may be undertaken to exercise control within nonstate institutions.19 When politics dominate society, it may not be able to emerge very far from the Hobbesian jungle. Some voluntary groups are likely to be strong enough to maintain formal alternatives to the extortionist’s legal system, however. This is most likely where the benefits generated through voluntary interaction are large and/or the relevant group interacts across the jurisdictions of different authorities so that interjurisdictional competition occurs. The international merchant community of medieval western Europe is one such example (Trakman 1983; Benson 1989b). Similarly, modern international commercial law remains a largely voluntarily produced and enforced system of rules, despite many attempts to subjugate it over the centuries (Benson 1992). Many other examples of parallel systems of rules and institutions also exist, wherein a political system is established but alternative systems of norms actually support most behavior, including recognition of and respect for property rights (Hernando de Soto 1989; Ellickson 1991; Bernstein 1992; Acheson 1988; Benson 1995; Benson 2005). Moreover, the market process always continues, perhaps largely in a black market in order to protect property rights by raising the cost of monitoring and measurement by the extortionist and his or her bureaucracy. And entrepreneurial behavior cannot be completely squelched. As European governments attempted to establish control over maritime trade in order to tax it and also granted franchises for numerous trading monopolies between 1500 and 1800, for instance, the “average merchant and seaman” responded with piracy and smuggling, and a substantial part of maritime commerce was carried out in violation of the laws of some nation state (Rosenberg and Birdzell 1986, 92–96). Furthermore, the middle and even the upper classes willingly wore, drank, and ate smuggled goods (Rosenberg and Birdzell 1986, 93). Indeed, many smugglers were highly respected members of the merchant community and also of their geographically localized communities. The multiattribute character of most assets and the transaction costs associated with delineating and enforcing property rights mean that rights to an asset or resource are never perfectly delineated and secured. That is, using Barzel’s (1989) terms, “some valued properties will always remain in the public domain.” Furthermore, the transaction costs of enforcing any property rights assignment, and especially an assignment arising though special-interest-driven actions by the state, mean that enforcement will be imperfect. After all, new top-down rules intended to assign property rights to particular interested parties will tend to place additional value in the public domain. The value that remains in the public domain because of incomplete property rights delineation and enforcement creates incentives for entrepreneurial individuals to take actions to capture that value. Under these circumstances property rights continually evolve, driven

19 

See Hernando de Soto (1989), for instance.

314   Institutions and Organizations by (1) entrepreneurship in an ongoing discovery process, including (2) political and bureaucratic entrepreneurs attempting to influence rules and policies that underlie the allocation and enforcement of property rights through interest group formation, lobbying for legislation, engaging in litigation, and influencing administration, while (3) market entrepreneurs respond to political actions by seeking ways to avoid losses and/ or take advantage of gaps in the rules and/or enforcements that leave value in the public domain, resulting in (4) a continuous path-dependent spontaneous evolution of property rights (as opposed to a static equilibrium). The inherently destabilizing evolutionary process that characterizes political actions to design rules disrupts spontaneous orders, but the result is not an imposed designed order, as Hayek (1973, 51) explains: It is impossible, not only to replace the spontaneous order by organization and at the same time to utilize as much of the dispersed knowledge of all its members as possible, but also to improve or correct this order by interfering in it by direct commands … it can never be advantageous to supplement the rules governing a spontaneous order by isolated and subsidiary commands concerning those activities where the actions are guided by the general rules of conduct … the reason why such isolated commands requiring specific actions by members of the spontaneous order can never improve but must disrupt that order is that they will refer to a part of a system of interdependent actions determined by information and guided by purposes known only to the several acting persons but not to the directing authority. The spontaneous order arises from each element balancing all the various factors operating on it and by adjusting all its various actions to each other, a balance which will be destroyed if some of the actions are determined by another agency on the basis of different knowledge and in the service of different ends.

While balance created by a spontaneous order does tend to be destroyed by efforts to deliberately implement “isolated and subsidiary commands,” these deliberately designed rules are rarely able to completely dictate the targeted behavior, because knowledge is incomplete for the rule maker (Mises 1949, 764, 856; Hayek 1973, 51; Kirzner 1985, 145; Ikeda 1997, 50–52), and because policing is imperfect (Benson 1999; 2002; 2004; 2007). The knowledge problem suggests, among other things, that there are too many uncontrolled margins and unanticipated responses for a rule designer to recognize and anticipate, in part because the changes create a new set of opportunities that have not previously been available. After all, as Kirzner (1985, 135) stresses, In the face of these controls, regulations, and interventions there remains, nonetheless, a genuine market. … Government controls constrain and constrict; they rearrange and repattern the structure of incentives; they redistribute incomes and wealth and sharply modify both the process of production and the composition of consumption. Yet within the limits that such controls impose, buying and selling continue, and the constant effort to capture pure entrepreneurial gain keeps the market in perpetual motion.

The Evolution of Property Rights Systems    315 Top-down designed rules are likely to have a significant impact on the discovery process, however, as they create incentives to find and exploit the uncontrolled margins in order to avoid the full consequences of the rules (Benson 2002; 2004). Thus, the discovery process tends to be redirected along a new path. This means, as Kirzner (1985, 141–144) explains, that discoveries that probably would have been made in the absence of the imposed rules are never made. In addition, a “wholly superfluous” discovery process is created as “entirely new and not necessarily desirable [either from the perspective of the interest groups involved or from an efficiency perspective] opportunities for entrepreneurial discovery” arise (Kirzner 1985, 144). Thus, as Mises (1949, 758–776, and elsewhere), Kirzner (1985, 133–145), Ikeda (1997, 94–99, and elsewhere), and Benson (2002; 2004) stress, an attempt to design rules that reallocate property rights through political action leads to spontaneous responses, many of which are not anticipated by members of the interest groups, the legislature, or the enforcement bureau, which in turn leads to more rules designed to prevent these unanticipated actions (i.e., impose more constraints on the use of property). As a result, the evolution of intentionally created rules is path-dependent; Mises ([1957] 1985, 288) notes, “The description of the present state of politics and of business is inevitably the narration of the events that have brought about the present state.” Since politically determined rules are influenced by what has come before and they in turn influence the market responses that determine more rules, the process is not equilibrating.

Market Entrepreneurship When Politics Influence Property Rights When a market is subject to property rights manipulation through political action, the potential for entrepreneurial discover may actually be enhanced, although it is also redirected (Kirzner 1985, 141–145). Designed rules introduce errors into markets, so by finding ways to circumvent rules or reduce their impact, entrepreneurs capture some of the rents that are suppose to go to members of powerful interest groups. Consider Mises’s (1949, 762–766) and Cheung’s (1974) analyses of the consequences of price ceilings, focusing first on the question of how property rights are allocated to a commodity that is sold at a money price below the market equilibrium.20 The standard neoclassical textbook prediction is that a permanent shortage arises with a price ceiling, but this ignores the potential for rational responses by individuals to the resulting situation. Essentially, the price ceiling puts the value between the price consumers are willing to pay and the 20 

Neither Mises nor Cheung explicitly begins the analysis of price controls with interest groups demanding such regulation, but assume that such a group successfully lobbies a legislature to set prices below the market clearing level in order to transfer wealth to consumers from producers. Rent controls are expected to benefit tenants rather than landlords, for instance, and they arise in communities with large populations of renters who have considerable political influence.

316   Institutions and Organizations legal price into the public domain—that is, creates “gaps between costs and revenues,” as Kirzner (1985, 132) explains—creating incentives for both buyers and sellers to attempt to capture that value. Therefore, buyers and/or sellers can take additional steps to get or to provide another unit at a cost below added gain. For instance, consumers compete for the limited supply by queuing and searching (Mises 1949, 763), but these activities are costly, so the full price consumers pay is much higher than the money price. Demand based on full price implies that the shortage shrinks and, given no other adjustments, ultimately disappears. Some consumers may be better off (e.g., those with low values of time), but others are worse off. Other margins of adjustment also often exist, however, so this “full price” equilibrium is not actually likely to arise, as both entrepreneurial buyers and sellers will “take advantage of disequilibrium conditions” (Kirzner 1985, 129). Barzel’s (1989) discussion of an example, the price ceiling on gasoline during the early 1970s, suggests the kinds of reallocations of resources, à la Mises (1949, 763), and superfluous discoveries, à la Kirzner (1985), that inevitably arise. In this case, sales were in terms of tanks of gasoline, so consumers tended to queue up relatively frequently (not allowing their tanks to get as close to empty as they would if there was a market clearing price), but the resulting high time costs created incentives for some consumers to add gasoline-tank capacity and others to pay people to wait in the queue for them. Entrepreneurial sellers had more margins to adjust on, however. Under the law, they were supposed to maintain pre-price-control money prices, but regulations did not control numerous characteristics of the product. Producers were able to capture part of the value from the public domain by reducing quality (e.g., octane), unbundling products (e.g., removing additives to sell them separately, removing the “services” that had been bundled with gasoline by moving to self-service, reducing the hours of operation and therefore the level of convenience that consumers had previously enjoyed), rebundling products in different ways (e.g., selling gasoline only to consumers who purchased an oil change or a lube job at prices raised to capture the value of the accompanying gasoline), requiring cash payments (refusing credit cards), and so on. Furthermore, enforcement of the price regulation itself was imperfect, so some sellers also gained part of the value in the public domain by illegally selling on the black market at prices much higher than would be necessary to clear the market. The point is that the discovery process continued, apparently at an accelerated pace (although this cannot be determined for sure, because the discoveries that were stifled by the price controls are not known) but with largely superficial discoveries. The full costs of the controls will never be known, however, because the path of market evolution was altered (e.g., self-service remained as full-service practices were generally not reestablished), suggesting that at least some of the discoveries that would have arisen had the controls not been imposed never have arisen. One reason for not returning to the original path is that the initial very profitable (because of the size of the gap between costs and revenues that had been artificially created) entrepreneurial discoveries under the price-control regime tended to sharpen the awareness of other entrepreneurs to such profits, promoting the emergence of a competitive profit-seeking process that quickly evolves along a new path (e.g., see Ikeda 1997, 60), creating a very different market environment for which the post-price-ceiling

The Evolution of Property Rights Systems    317 discovery process proceeds. In addition, the fact that the government had been willing to impose such controls once probably created an expectation that it could do so again, making property rights to value relatively insecure. Therefore, entrepreneurs were probably unwilling to abandon some of the innovations they had discovered that might mitigate future price controls. Another reason is that as superfluous discoveries under price controls spawned additional controls, as Mises predicts (1949, 763–764), and even when the price control was abandoned, some of the other new rules were not, as noted below.

Political Entrepreneurs and the Determination of Property Rights Entrepreneurs may also discover opportunities in the political arena.21 This may involve the identification of an unexploited political opportunity that can be pursued through the organization and leadership of an interest group. Indeed, entrepreneurship of this kind presumably is the source of the initial demands for reallocation of rights. Such entrepreneurship raises the cost of protecting property, as those who lose in transfers to this new group now have incentives to organize and attempt to regain/retain their rights. Politicians have incentives to respond to the demands of new groups by taking from unorganized individuals, in order to avoid causing discontent on the part of organized groups. Some of those unorganized individuals are likely to organize in an effort to regain their rights. Rather than transferring rights back from the previously favored group, however, the politician has incentives to find wealth that can be taken from as yet unorganized individuals, creating more incentives to organize. Furthermore, because a new set of rules places value in the public domain and political entrepreneurs, like market entrepreneurs, have incentives to capture it, entirely new interest groups may emerge.22 The result is a spiraling process of more and more political action and control (Buchanan and Tullock 1962; Benson 1984; Benson 2002; Mises 1949, 763–764; Ikeda 1997, 99–137).23

21  Note that there are important differences between entrepreneurial discovery in markets and entrepreneurial discovery in the political arena (e.g., price signals are not likely to be relevant in nonmarket settings, except through bribery and “contributions,” so barter exchange is generally required), as Ikeda (1997, 77–83) explains, but these differences do not alter the prediction made here. 22  Benson (2002) notes that the Teamsters union became powerful because of the rules created through interstate trucking regulation, for example, and the union members captured many of the benefits of the regulations that were intended to go to the owners of trucking firms. 23  Political entrepreneurs might also pursue political offices where they are in a position to make and/ or enforce rules in ways that will generate personal benefits (for instance, once in office, they may simply have to threaten to reallocate some property rights in order to extract part of the existing benefits for themselves; McChesney 1987).

318   Institutions and Organizations Political entrepreneurs demand rule changes expecting their constituencies to benefit from them, but the benefits are dissipated. The time costs rise for consumers under a price ceiling, for instance, and both market and other political entrepreneurs adjust along numerous margins to capture value that was intended for members of the interest group constituencies. Thus, political entrepreneurs who initiated the original reallocation are likely to demand more rules in an effort to direct the benefits to their constituents (e.g., in the price ceiling case, to reduce time costs by instituting some other rationing mechanism, such the use of rationing coupons or a lottery; see Mises 1949, 763) and in an effort to control the previously uncontrolled margins along which superfluous adjustments are being made (e.g., to prevent reductions in octane levels by firms selling gasoline in the price ceiling case). Bureaucratic enforcement cost will rise as the enforcement apparatus expands to apply these new rules. If these additional rules fail to allocate the rights to the targeted group, more rule changes will be demanded.24 The complex and multidimensional nature of the result can be seen by examining any specific transfer process that exists, such as New York rent controls, land use regulation (Benson 2010), or farm subsidy programs. In every case, the authority has made many changes in addition to the initial transfer rules in an effort to maintain the system. Enforcement and compliance costs rise both to implement the new rules and to control illegal activities. Another avenue for entrepreneurial activity also arises in the political arena. As Mises ([1944] 1983, 80) explains: The bureaucrat is not only a government employee. He is … at the same time a voter and as such a part of the sovereign, his employer. He is in a peculiar position: he is both employer and employee. And his pecuniary interest as an employee towers above his interest as employer, as he gets much more from the public funds than he contributes to them. This double relationship becomes more important as the people on the government’s payroll increase. The bureaucrat as voter is more eager to get a raise than to keep the budget balanced.

In this context, Breton and Wintrobe (1982, 108–131) characterize the bureaucratic institutional process as one dominated by Austrian entrepreneurial competition wherein the discovery process involves individual bureaucrats pursuing their subjective goals by selectively seeking and implementing policy innovations (i.e., altering the allocation of intensity of enforcement of property rights). The multidimensional competition 24 

Ultimately, as the effort fails to produce the anticipated benefits and political support wanes, and as those who discover that they are worse off because of the regulations are organized (probably under the leadership of another political entrepreneur), the rules may actually begin to reallocate rights to move the situation back to what it was initially. Thus, the price controls on gasoline discussed by Barzel (1989) were short-lived, although other rules remain that were instituted at the time (e.g., some states set minimum octane levels for various classifications of gasoline to limit unbundling options). Of course, many rules, including some involving price ceilings, persist by continually evolving in the face of market and political changes.

The Evolution of Property Rights Systems    319 includes the general struggle for budgets, along with that for power and influence. Bureaucratic power and discretion depend on limited knowledge on the part of those who monitor them, and monitoring is very costly because the relationship between monitors (elected officials, political appointees, interest groups) “is not restricted by considerations of profit and loss” (Mises 1949, 310) and value is not measured by price. Therefore, bureaucrats are able to engage in “selective distortion” to enhance their ability to pursue their own objectives. Tactics include “(i) alterations in the flows of information … ; (ii) variations in the quality or quantity of information leaked to the media, to other bureaus in the organization, to special interest groups, and/or to opposition parties and rival suppliers; and (iii) changes in the speed of implementation of policies as these are put into effect” (Breton and Wintrobe 1982, 37–39). How effective are bureaucrats in their efforts to pursue their own objectives? Tullock (1965, 193) suggests that when a bureaucracy is set up to accomplish some political goal, it inevitably fails, and The continuous failures of bureaucracies are met in part by continuing reorganizations, the reasoning being that the failure has resulted from organizational details. In part, the failures are met by concealed shifts in the objectives for the organization. As an experiment, if one examines the original arguments for establishment of almost any government bureau and compares these arguments with those that may be currently offered for the retention of the bureau, one is likely to find that a considerable shift has occurred in the specification of the objectives that the bureau is supposed to attain. The governmental bureau becomes a permanent fixture, with the objective continually changing. Over time the vested interests of the bureaucrats themselves become more and more important in justifying the organization, although this can never be the sole argument in discussions with outsiders.

Bureaucracies fail because of the knowledge problem and the superfluous market and political discovery processes. Once an enforcement bureaucracy is in place, however, it controls property rights and their allocation to a substantial degree. Furthermore, the bureaucrats have incentives to maintain the system whether it accomplishes its objectives or not, so they have incentives to add more rules to enforce, seek new objectives that might be achieved, and so on. Thus, the bureaucracy is a spontaneously evolving institution able to influence property rights allocations and capture some of the benefits from the allocations it directs. A bureaucracy might survive and prosper for a long time in such a dynamic environment, even if it is not achieving the “political” objectives that it was intended to provide.

Conclusion The dynamic instability of property rights in a political regime might be thought of as arising from the constant conflict among market, political, and bureaucratic entrepreneurs. Political entrepreneurs pursue rights allocations that benefit them and their

320   Institutions and Organizations constituencies, but the transaction costs of delineating and enforcing rights mean that market entrepreneurs find margins along which to adjust in order to gain some of the value that political entrepreneurs intended for others. Bureaucratic enforcement efforts expand as new rules are implemented, in an effort to satisfy political demands. The interests of the bureaucrats themselves also come into play, so interest groups rarely get what they expect out of any enforcement process, as bureaucrats manipulate policies in ways that allow them to capture some benefits.

References Acheson, J.  M. 1988. The Lobster Gangs of Maine. Hanover, NH:  University Press of New England. Anderson, T. L., and P. J. Hill. 1975. “The Evolution of Property Rights: A Study of the American West.” Journal of Law and Economics 18: 163–179. Anderson, T. L., and P. J. Hill. 1979. “An American Experiment in Anarcho-Capitalism: The Not So Wild, Wild West.” Journal of Libertarian Studies 3: 9–29. Anderson, T. L., and P. J. Hill. 2004. The Not So Wild, Wild West: Property Rights on the Frontier. Stanford, CA: Stanford Economics and Finance. Anderson, T. L., and F. McChesney. 1994. “Raid or Trade: An Economic Model of Indian-White Relations.” Journal of Law and Economics 37: 39–74. Bailey, M. J. 1992. “Approximate Optimality of Aboriginal Property Rights.” Journal of Law and Economics 35: 183–198. Barzel, Y. 1989. Economic Analysis of Property Rights. Cambridge: Cambridge University Press. Benson, B. L. 1984. “Rent Seeking from a Property Rights Perspective.” Southern Economic Journal 51: 388–400. Benson, B. L. 1989a. “Enforcement of Private Property Rights in Primitive Societies: Law without Government.” Journal of Libertarian Studies 9: 1–26. Benson, B. L. 1989b. “The Spontaneous Evolution of Commercial Law.” Southern Economic Journal 55: 644–661. Benson, B.  L. 1990. The Enterprise of Law:  Justice without the State. San Francisco:  Pacific Research Institute for Public Policy. Benson, B. L. 1991a. “An Evolutionary Contractarian View of Primitive Law: The Institutions and Incentives Arising under Customary American Indian Law.” Review of Austrian Economics 5: 65–89. Benson, B. L. 1991b. “Reciprocal Exchange as the Basis for Recognition of Law: Examples from American History.” Journal of Libertarian Studies 10: 53–82. Benson, B.  L. 1992. “Customary Law as a Social Contract:  International Commercial Law.” Constitutional Political Economy 2 (Winter): 1–27. Benson, B. L. 1994a. “Are Public Goods Really Common Pools: Considerations of the Evolution of Policing and Highways in England.” Economic Inquiry 32: 249–271. Benson, B. L. 1994b. “Emerging from the Hobbesian Jungle: Might Takes and Makes Rights.” Constitutional Political Economy 5: 129–158. Benson, B.  L. 1995. “An Exploration of the Impact of Modern Arbitration Statutes on the Development of Arbitration in the United States.” Journal of Law, Economics, and Organization 11: 479–501.

The Evolution of Property Rights Systems    321 Benson, B. L. 1998. To Serve and Protect: Privatization and Community in Criminal Justice. New York: New York University Press. Benson, B. L. 1999. “An Economic Theory of the Evolution of Governance, and the Emergence of the State.” Review of Austrian Economics 12, 131–160. Benson, B.  L. 2002. “Regulatory Disequilibium and Inefficiency:  The Case of Interstate Trucking.” Review of Austrian Economics 15: 229–255. Benson, B. L. 2004. “Opportunities Forgone: The Unmeasurable Costs of Regulation.” Journal of Private Enterprise 19: 1–25. Benson, B.  L. 2005. “The Spontaneous Evolution of Cyber Law:  Norms, Property Rights, Contracting, Dispute Resolution, and Enforcement without State Involvement.” Journal of Law, Economics and Policy 1: 269–348. Benson, B. L. 2006. “Property Rights and the Buffalo Economy of the Great Plains.” In Self Determination: The Other Path for Native Americans, edited by T. L. Anderson, B. L. Benson, and T. Flanagan, 29–67. Palo Alto, CA: Stanford University Press. Benson, B.  L. 2007. “Beliefs as Institution-Specific Rationalized Self-Interest.” In Ordered Anarchy:  Jasay and His Surroundings, edited by Hardy Bouillon and Hartmut Kliemt, 103–145. Aldershot, UK: Ashgate. Benson, B.  L. 2010. “Instability and Inefficiency Are the Inevitable Results of Government Planning and Regulatory Implementation.” In Property Rights:  Eminent Domain and Regulatory Takings Re-examined, edited by B. L.  Benson, 257–299. New  York:  Palgrave Macmillan. Bernstein, L. 1992. “Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry.” Journal of Legal Studies 21: 115–158. Breton, A., and R. Wintrobe. 1982. The Logic of Bureaucratic Control. Cambridge: Cambridge University Press. Buchanan, J., and G. Tullock. (1962) 1999. The Calculus of Consent:  Logical Foundations of Constitutional Democracy. Indianapolis, IN: Liberty Fund. Carneiro, R. L. 1970. “A Theory of the Origin of the State.” Science 169: 733–738. Cheung, S. N. S. 1974. “A Theory of Price Control.” Journal of Law and Economics 17: 53–72. Coase, R. H. 1960. “The Problem of Social Cost.” Journal of Law and Economics 3: 1–44. Demsetz, H. 1967. “Toward a Theory of Property Rights.” American Economic Review 57: 347–359. Ellickson, R.  C. 1991. Order without Law:  How Neighbors Settle Disputes. Cambridge, MA: Harvard University Press. Ellickson, R. C. 1993. “Property in Land.” Yale Law Journal 102: 1315–1400. Friedman, D. D. 1979. “Private Creation and Enforcement of Law: A Historical Case.” Journal of Legal Studies 8: 399–415. Gambetta, D. 1993. The Sicilian Mafia:  The Business of Private Protection. Cambridge, MA: Harvard University Press. Greif, A. 2006. Institutions and the Path to the Modern Economy: Lessons from Medieval Trade. New York: Cambridge University Press. Hart, H. L. A. 1961. The Concept of Law. Oxford: Clarendon Press. Hayek, F. A. 1973. Law, Legislation and Liberty. Vol. 1: Rules and Order. Chicago: University of Chicago Press. Hernando de Soto, J. 1989. The Other Path:  The Invisible Revolution in the Third World. New York: Perennial Library.

322   Institutions and Organizations Hume, D. (1751) 1957. An Inquiry concerning the Principles of Morals, edited by C. W. Hendel. Indianapolis: Bobbs-Merrill. Ikeda, S. 1997. Dynamics of the Mixed Economy:  Toward a Theory of Interventionism. London: Routledge. Johnsen, D. B. 1986. “The Formation and Protection of Property Rights among the Southern Kwakiutl Indians.” Journal of Legal Studies 15: 41–68. Kirzner, I. M. 1985. Discovery and the Capitalist Process. Chicago: University of Chicago Press. Kirzner, I.  M. 1997. “Entrepreneurial Discovery and the Competitive Market Process:  An Austrian Approach.” Journal of Economic Literature 35: 60–85. Leeson, P.  T. 2009. The Invisible Hook:  The Hidden Economics of Pirates. Princeton, NJ: Princeton University Press. Levi, M. 1988. Of Rule and Revenue. Berkeley: University of California Press. Libecap, G.  D. 1986. “Property Rights in Economic History:  Implications for Research.” Explorations in Economic History 23: 227–252. McChesney, F.  S. 1987. “Rent Extraction and Rent Creation in the Economic Theory of Regulation.” Journal of Legal Studies 16: 101–118. Mises, L. von. (1944) 1983. Bureaucracy. Cedar Falls, IA: Center for Future Studies. Mises, L.  von. 1949. Human Action:  A  Treatise on Economics. New Haven, CT:  Yale University Press. Mises. L.  von. (1957) 1985. Theory and History:  An Interpretation of Social and Economic Evolution. Auburn, AL: Ludwig von Mises Institute. Nee, V. 1998. “Norms and Networks in Economic and Organizational Performance.” American Economic Review Papers and Proceedings 88: 85–89. North, D.  C. 1990. Institutions, Institutional Change and Economic Performance. Cambridge: Cambridge University Press. Oppenheimer, F. (1908) 1914. The State:  Its History and Development Viewed Sociologically, translated by J. M. Gitterman. Indianapolis: Bobbs-Merrill. Ostrom, E. 2010. “Beyond Markets and States: Polycentric Governance of Complex Economic Systems.” American Economic Review 100: 641–672. Polanyi, M. 1951. The Logic of Liberty:  Reflections and Rejoinders. Chicago:  University of Chicago Press. Pospisil, L. 1971. Anthropology of Law: A Comparative Theory. New York: Harper & Row. Ridley, M. 1996. The Origins of Virtue:  Human Instincts and the Evolution of Cooperation. New York: Viking Penguin. Rosenberg, N., and L. E. Birdzell Jr. 1986. How the West Grew Rich: The Economic Transformation of the Industrial World. New York: Basic Books. Solvason (Runolfsson), B. T. 1992. “Ordered Anarchy: Evolution of the Decentralized Legal Order in the Icelandic Commonwealth.” Journal des économistes et des études humaines 3: 333–351. Solvason (Runolfsson), B. T. 1993. “Institutional Evolution in the Icelandic Commonwealth.” Constitutional Political Economy 4: 97–125. Trakman, L. 1983. The Law Merchant: The Evolution of Commercial Law. Littleton, CO: Fred B. Rothman. Tullock, G. 1965. The Politics of Bureaucracy. Washington, DC: Public Affairs Press. Umbeck, J. 1981. A Theory of Property Rights with Applications to the California Gold Rush. Ames: Iowa State University Press.

The Evolution of Property Rights Systems    323 Vanberg, V. J., and J. M. Buchanan. 1990. “Rational Choice and Moral Order.” In From Political Economy to Economics and Back? edited by J. H. Nichols, Jr., and C. Wright, 175–236. San Francisco: Institute for Contemporary Studies. Wesson, R.  G. 1978. State Systems:  International Pluralism, Politics, and Culture. New York: Free Press.

Chapter 14

On the Ori g i ns of Sto ck Ma rkets Edward Peter Stringham and Nicholas A. Curott

Introduction Many of the greatest things man has achieved are not the result of consciously directed thought, and still less the product of a deliberately coordinated effort of many individuals, but of a process in which the individual plays a part which he can never fully understand. (Hayek 1944, 67)

Where did stock markets come from? One of the primary contributions of Austrian economists was to show that something as crucial for markets as money emerged from the market (Menger [1871] 2007; Hayek [1976] 1990; Rothbard [1963] 2005; Selgin and White 1994). Money was not invented by government but instead evolved in an emergent or spontaneous order. The same is true of stock markets and the rules and regulations that make them possible. From the world’s first major stock market in seventeenth-century Amsterdam to the world’s second and third major stock markets in the eighteenth and nineteenth centuries in London and New York, the markets developed over centuries when government officials did not understand them and refused to enforce advanced contracts in them. Officials viewed much of what went on in stock markets as forms of gambling and passed various prohibitions, yet brokers continued trading anyway and developed amazingly sophisticated types of contracts. Forward contracts, short sales, securitization, hypothecation, and options were invented long before government enforced contracts for them. They were all made possible not because of government but from private governance that emerged from the market. In Amsterdam, brokers made their unenforceable contracts in open-air venues such as the Amsterdam Bourse, and in London and New York, brokers congregated in coffeehouses and taverns that they transformed

On the Origins of Stock Markets    325 into private rule-enforcing clubs (Stringham 2002; Stringham 2003; Stringham and Boettke 2004). Even though government officials actively attempted to prohibit trading in these markets, the genie was out of the bottle, and markets in Amsterdam, London, and New York became the most sophisticated the world had ever seen. Stock markets let everyone become involved in world trade and industry, and that in turn helped finance enterprise in the New World and the Industrial Revolution itself. By the time of Henry Hudson, gone were the days that one needed to approach government to finance exploration to the New World; instead, Hudson was financed by the Muscovy Company in London and subsequently the East India Company in Amsterdam. Stock markets in Amsterdam, London, and New York turned their cities into leading financial centers that brought rapid economic development to their nations and the world.1 Modern capitalism owes its existence to these markets and the private rules and regulations that made them possible. Both primary markets (the markets that give firms initial access to capital) and secondary markets (the markets that enable investors to buy and sell shares anytime) evolved over time and did not follow a plan outlined by government or any individual. At each stage, market participants were making conscious choices and often attempting to adjust various aspects of the market, but the planning was private and decentralized and could be continually updated over time. Certain government actions affected what market participants did, but government’s importance for the development of these markets should not be overestimated. The constant trading of shares and the subsequent democratization of finance were certainly not the vision of any government official. Similar to the evolution of money, the stock markets grew out of a series of private choices and can be seen as a quintessential example of spontaneous market order.

Does the Study of Spontaneous Order Apply to Stock Markets? The economic investigation of spontaneous social order traces to the Spanish scholastics and reached more systematic expression in the work of Scottish Enlightenment thinkers such as Bernard Mandeville, Adam Ferguson, David Hume, and Adam Smith (Barry 1982; Hamowy 1987).2 The founder of the Austrian school of economics, 1 

See Levine (2004) for a comprehensive overview of the theoretical and empirical literature on the link between finance and economic development. Many economists believe that by improving financial intermediation, financial deepening precedes and spurs economic growth. Many economic historians, such as Rousseau and Wachtel (1998), Wright (2002), and Rousseau and Sylla (2005), argue that well-functioning capital markets, particularly secondary securities markets, provide an important explanation of where and when economic development and rapid economic progress have occurred. 2  These writers identified how social institutions that arise from unintended consequences of human action can coordinate the diverse plans and preferences of individuals in society. One can characterize

326   Institutions and Organizations Carl Menger, helped create stronger foundations for the analysis of spontaneous social order by introducing subjectivism and marginalism.3 A spontaneous order is a self-regulating system that can be investigated using reason but is not created by any one person’s design (Hayek 1973, 35–54). Spontaneously arising, self-regulating systems are familiar features of the natural world in the realms of physics and biology, but they can also exist where human agency is present. In much the same way that species evolve through genetic variation and selection, firms try out different ideas, and those that are best at satisfying consumer wants tend to survive in the continual tournament of the competitive market process. Klein (2008, 171) writes that “Menger’s concept of spontaneous order is simply the process by which voluntary interaction establishes social regularities such as prices, wages, interest rates, rents, and the like.” Spontaneous order can be found in many important human social structures, including language, social conventions, and markets themselves. Each of these social institutions evolved slowly out of the interactions of many individuals pursuing their own goals, instead of resulting from the planned central direction by one or a few. Although humans use reason and help bring about outcomes (Salerno 1990), the planning is decentralized and often leads to outcomes much more complex than anyone envisioned beforehand. Menger’s analysis of the evolution of money is the most famous example. As Menger explains, in a society without money, individuals gradually move away from barter as they realize the benefits of using marketable commodities as an indirect means of attaining goods that they ultimately wish to consume. Because barter has the major inconvenience of requiring a double coincidence of wants between trading partners, the market has built-in incentives for individuals to acquire marketable commodities as a medium of exchange. Individuals are particularly likely to accept goods that are well suited as a medium of exchange because they are durable, portable, divisible, and uniform and have a stable value. The demand to hold easily salable goods with these characteristics as a medium of exchange increases the overall demand for them and increases their marketability even further.4 The good selected at this final stage is money. At this point, the good being used as money is far more liquid than any other good, and it has taken on the familiar properties of being a unit of account and a store of value. The implication of Menger’s analysis is that no preplanned edict or collective decision is ever required.

Smith’s entire project in The Wealth of Nations ([1776] 1976) as explaining how the extended social order of the market economy is a spontaneous order. 3  One of Menger’s ([1871] 2007) most important achievements was his elucidation of the subjective theory of value and the principle of marginal utility. Menger wrote about marginalism at the same time as William Stanley Jevons and Léon Walras, but Menger’s treatment stands out for looking at price formation as the outcome among market participants pursuing subjective goals, rather than representing prices as mathematical end states and backward-inducting costs and preferences from them. 4  Over time, the number of goods held as media of exchange gets winnowed down as those that are perceived to be the most convenient and liquid are given preference over others. Eventually, this process of selection leads to a situation where traders in an economically integrated region converge upon using one good as a generally accepted medium of exchange.

On the Origins of Stock Markets    327 Instead, money is “the spontaneous outcome, the unpremeditated resultant, of particular, individual efforts of the members of society” (Menger [1892] 2009, 38). Menger ([1883] 1985) expounds on this approach in economics and argues that the appropriate method for studying social institutions is to use abstraction to reconstruct the regularity of social phenomena out of the choices of individuals.5 Menger contrasts what he calls “organic institutions,” such as language, religion, law, and markets, which are the outcomes of natural and spontaneous development, with “pragmatic institutions,” which are the result of deliberate design. In Menger’s ([1883] 1985, 146) view, a primary purpose of the economist is to understand how organic institutions promote mutual well-being:  “How can it be that institutions which serve the common welfare and are extremely significant for its development come into being without a common will directed toward establishing them?” Answering questions such as this has been the hallmark of Austrian economists ever since. Menger’s approach has influenced much of the foundation for Ludwig von Mises’s classic contributions to economics, including his study of money and banking ([1912] 1981) and his critique of socialism ([1920] 1990; 1951), and also Friedrich Hayek’s (1944; 1948; 1973; [1976] 1990; 1979) well-known examination of social and political institutions. Also particularly noteworthy is the research of George Selgin (1988; 2008) and Lawrence White (1984; 1989; 1999), who document how complex banking institutions can evolve in spontaneous fashion.6 How much of this analysis applies to stock markets and the rules and regulations that make them possible? Until recently, little attention has been paid to the study of stock markets from this perspective, but stock markets, too, can be analyzed as spontaneous orders. Stock markets and their enabling institutions such as stock exchanges were not suddenly invented or designed by government. Rather, like other spontaneous order institutions, they evolved slowly and gradually adopted a system of private rules. Stock markets fit perfectly with this point by Griffiths (2004, 212): “Although the spontaneous order develops through individuals pursuing their own interest, the individuals still behave by following commonly held rules rather than by acting in a random fashion, and these rules are themselves the product of evolution.” All of the world’s first three major stock markets, Amsterdam, London, and New York, developed a system of private rules and regulations that enabled them to become far bigger and far more complex than anyone envisioned. 5  In his methodological treatise Investigations into the Method of the Social Sciences with Special Reference to Economics ([1883] 1985), Menger specifies a causal-genetic approach to the study of economics, which he called the “compositive method.” For an explication of the causal-genetic approach, see Rizzo (1996). 6  Selgin and White (1987; 1994) explain the evolution of monetary institutions after the development of commodity money with basic money transfer services developing first, then inside money, and finally clearing institutions. They show that the pursuit of self-interest was sufficient for the development of a mature banking system with all of the conveniences of modern banking, a self-regulating money supply, and clearinghouses capable of performing regulatory tasks.

328   Institutions and Organizations

The Emergence of the World’s First Stock Market in Seventeenth-Century Amsterdam Business ventures with multiple shareholders became popular with commenda contracts in medieval Italy (Greif 2006, 286), and Malmendier (2009) provides evidence that shareholder companies date back to ancient Rome. Yet the title of the world’s first stock market deservedly goes to that of seventeenth-century Amsterdam, where an active secondary market in company shares emerged. The two major companies were the Dutch East India Company and the Dutch West India Company, founded in 1602 and 1621. Other companies existed, but they were not as large and constituted a small portion of the stock market (Israel [1989] 1991, 109–112; Dehing and ’t Hart 1997, 54; de la Vega [1688] 1996, 173).7 The Dutch East India Company was originally set up as a venture for a limited time that would be disbanded at a certain date. The company had shares (but one could own fractions thereof) that entitled owners to their share of the dividends in the short run and a proportion of the proceeds when the venture would be disbanded. The founders of the company never intended for their venture to be enduring or for an active secondary market for shares to emerge, but both outcomes came about. Originally, parties who wanted to transfer shares had to go to the company’s offices and pay a fee to record the change in ownership (Neal 1990a, 195; Israel [1989] 1991; Israel 1995). The arrangement did exactly what it was designed to do, but company officials did not realize that people would want to transfer shares as much as they did, and the lack of capacity ended up causing many delays. In response, intermediaries emerged to eliminate the step of going to the company’s offices for each transaction. At the time, Amsterdam had brokers specializing in all sorts of commodities, so it was not much of a step for some to begin dealing in stocks. Going through these intermediaries had many benefits, but it also posed certain risks. In modern times, simple stock trades are settled within three days, and not much can go wrong in the interim. Yet in this first stock market, the contracts would be settled at quarterly settlement dates (making these essentially forward contracts). If brokers kept a ledger of who traded what and when, they could save a lot of time settling everything at once. Come settlement date, one could settle in two ways: by transferring actual shares for money or by engaging in a different contract where one party paid the difference between the agreed-upon sale price and market value at settlement time. For example, if Ed agrees to buy a share from Nick for 3,000 guilders and at settlement time the market price for a share is 3,300 guilders, we could settle by having Nick deliver an actual share 7 

This and the next section summarize or draw from research in Stringham (2002; 2003) and Stringham and Boettke (2004); readers interested in more details are invited to read those works.

On the Origins of Stock Markets    329 worth 3,300 and Ed give 3,000, or we could settle simply by having Nick pay Ed 300. (If the initial agreement price was the same and prices went in the opposite direction to 2,700, a payment-of-difference contract would require Ed to pay Nick 300.) All of these contracts saved trading partners time, but they introduced counterparty risk, which comes about from unintentional default or intentional fraud by the counterparty or his broker. People who have state-centric views of markets would argue that such contracts can only exist when government enforces them. It turns out, however, that from very early on, government looked down on these types of contracts and refused to enforce them, but people engaged in them anyway. Political authorities considered much of the transactions associated with the stock market as wasteful, manipulative, and immoral (de Vries and van der Woude 1997, 150; Garber 2000, 34). Rather than actively supporting markets, government in this instance actively tried to restrict them. Starting in 1610, ordinances were passed against “trading in wind” (Kellenbenz [1957] 1996, 134–135), followed by other restrictions that outlawed all but the most straightforward of transactions (contracts by which shares were transferred within two weeks). Even though their contracts were de jure illegal, brokers were not punished for engaging in these contracts, and people ignored the prohibitions. Not only did market participants engage in these forward contracts in which one party had a long and the other had a short position, but they developed many other advanced contracts, including hypothecation, options, and other derivatives. Hypothecation involved using shares as collateral to secure a loan of up to 80 percent of the value of the shares, option contracts were amazingly advanced and functioned similar to options markets today, and other derivatives included contracts for “ducaton” shares, which were basically fractions of full shares that had become so expensive that few could afford them. All of these contracts were quite complex, and none was enforceable in courts of law. How was it possible for the market to thrive if government was not playing an active role? Rather than relying on law, market participants relied on reciprocity and reputation mechanisms to induce contractual performance (Klein 1997; Smith [1766] 1982). Evidence from a stockbroker writing at the time, Joseph de la Vega ([1688] 1996), indicates the importance of these factors. Anyone could show up to the market, but that did not mean anyone could find trading counterparts. De la Vega ([1688] 1996, 201) describes the consequences of having a bad reputation: “Since the status, the insignificant capital, the low reputation, and the limited trustworthiness of such people are well known, they do not dare attempt to carry on any considerable business.”8 People who were new to the market had to start off small and gradually build up their reputations before they could engage in larger transactions. Those who defaulted would be bad-mouthed and boycotted by others, which created incentives for good behavior (Caplan and Stringham 2003). De la Vega ([1688] 1996, 172) writes: “tremendous business is done by the merchants without the mediation of brokers who could

8 

See also de la Vega ([1688] 1996, 150, 172, 176, 201).

330   Institutions and Organizations serve as witnesses, no confusion occurs and no quarrels take place. … Such honesty, co-operation, and accuracy are admirable and surprising.” The markets expanded so much that by the end of the century, de la Vega (188) writes: “Even children who hardly know the world and at best own a little pocket money agree that each point by which the large shares rise or fall will mean a certain amount of their pocket money for their small shares. … If one were to lead a stranger through the streets of Amsterdam and ask him where he was, he would answer, ‘Among speculators,’ for there is no corner [in the city] where one does not talk shares.” The Dutch East India Company turned out of be wildly profitable and helped make Amsterdam the world’s first major market economy. Over the course of 120 years, dividends on the original capital of the Dutch East India Company ended up averaging 22.5 percent per annum, thereby enriching many people (Neal 1990b, 17). By 1688, the company had more than three hundred ships traveling to the East Indies and more than twenty thousand employees (Israel [1989] 1991, 258; 1995, 942). The Dutch West India Company never ended up being as profitable as the Dutch East India Company, but on the plus side, it founded New Amsterdam, which would become New York City. The founders of these companies and the brokers in these exchanges almost certainly did not foresee what they were creating, but they were participating in a project that ended up being much more important than any of them knew.

The Transformation of Coffeehouses into Stock Exchanges in Eighteenth-Century London The second major stock market in the world appeared in England, and it, too, was made possible because of private mechanisms. Although the first major joint stock companies in London came before those in Amsterdam, the popularity and growth of the market in London came after those of Amsterdam. England’s first major joint stock company was the “Mystery and Company of Merchant Adventurers for the discovery of regions, dominions, islands, and places unknown,” founded in 1551 (later known as the Muscovy Company, chartered in 1555). Other major English companies included the Levant Company, the English East India Company, and the Virginia Company, chartered in 1581, 1600, and 1606, respectively. Many of these companies were given certain monopoly privileges by government, but we must put those privileges in perspective. First, some companies were given monopoly privileges or charters years after they were founded, so having a monopoly or a royal charter then was no more a requirement for listing than it is for companies today. Harris (1997, 677) also reports that even after the government required firms to have royal charters, “many of them were not incorporated by the state, either by royal charter or by special act of parliament.” Moreover, firms that were given privileges held

On the Origins of Stock Markets    331 them in relationship to other English firms, but often this did not affect foreign competition. For example, the Muscovy Company had a “monopoly” of trade with Russia, but it was a relatively small player in the region compared with merchants in the Hanseatic League, which had had trading routes with Russia for centuries. Likewise, in the seventeenth century, the English East India Company faced competition from the Dutch East India Company, the Danish East India Company, the French East India Company, the Portuguese East India Company, and the Swedish East India Company. If we go by the dictionary definition of monopoly as “exclusive supply,” then no monopoly existed. These companies’ monopolies were somewhat like the monopolies of taxis in New York, a market that is certainly not free but still has a fair amount of competition. As in Amsterdam, the government was hardly supportive of the stock market and passed various rules and regulations interfering with it. One of the first major pieces of legislation regarding the stock market was the 1696 act “To Restrain the Number and the Practice of Brokers and Stockjobbers.” Government passed rules effectively banning stockbrokers from trading at the Royal Exchange (which was itself financed and built by Thomas Gresham in 1571). Another major piece of legislation involved the government all but outlawing the formation of new joint stock companies in 1720 with the passing of the Bubble Act.9 In addition, a 1734 bill, “To prevent the infamous Practice of Stock-jobbing,” also banned options, futures, and margin trading, and government animosity toward stock traders persisted for well more than a century (Harris 2000, 225). Yet brokers continued trading anyway and met in their new favorite venues, coffeehouses. Perhaps borrowing from their Dutch counterparts, the stockbrokers had quarterly settlement dates (Dickson [1967] 1993, 491, 507–510), and that posed the same risks of counterparty default. In a handbook first printed in the 1760s, Every Man His Own Broker; Or, a Guide to the Stock Exchange, Thomas Mortimer ([1762] 1801, 53–54) writes that “problems arise if the person making the trade does not have the ability (cash) to settle, for in many cases a broker and his customer had no money.” But here, too, the brokers developed private mechanisms rather than relying on a government that had declared these contracts illegal. The English brokers took bad-mouthing defaulters to a new level and would label defaulters “lame ducks.” In 1761, Mortimer described a lame duck as a “name given in ’Change Alley to those who refuse to fulfil their engagements. … There are some at almost every rescounter” (quoted in Morgan and Thomas [1962] 1969, 61). Although lame ducks posed problems for trustworthy brokers, it paid to investigate the reliability of one’s trading partners and to boycott the untrustworthy. We can see evidence of this in various other sources such as Adam Smith’s Lectures on Jurisprudence ([1766] 1982, 538): “They who do not keep their credit will be turned out, and in the language of Change Alley be called lame duck.” The system of sharing information went beyond 9  The Bubble Act was passed in the midst of a government scheme to convert government debts into shares of the South Sea Company. Shortly thereafter, the price of South Sea Company stock plummeted, and of course, government blamed the market for this bubble.

332   Institutions and Organizations a few brokers gossiping over coffee; eventually, the system advanced to where brokers would write the names of unreliable brokers on a chalkboard in the coffeehouses (Morgan and Thomas [1962] 1969, 61). Jonathan’s Coffeehouse and Garraway’s Coffeehouse were the main places to trade stocks. As the market grew in popularity, it attracted many brokers, including unreliable ones, into the ranks. Calling defaulters lame ducks and writing their names on blackboards functioned to a degree, but brokers eventually decided to create a stricter setup. In 1761, Mortimer wrote: “The gentlemen at this very period of time … have taken it into their heads that some of the fraternity are not so good as themselves … and have entered into an association to exclude them from [Jonathan’s] coffee-house” (quoted in Smith 1929, 215). A committee was formed between the brokers and the owners of the coffeehouse to decide on admission requirements and rules. Excluding unreliable brokers eliminated much of the potential for cheating. Yet the government was unhappy with this proposed arrangement and said that Jonathan’s did not have a right to exclude nonmembers (Morgan and Thomas [1962] 1969, 68; Jenkins 1973, 45). The brokers were persistent, and in the next iteration, they constructed a building of their own and changed its name from New Jonathan’s to the Stock Exchange in 1773. The Stock Exchange had various rules, documented in its first written rulebook in 1812 (Committee for General Purposes of the Stock-Exchange 1812, 10). The rulebook stated that although many disputes could be settled with existing rules, “many others (which, from their nature and extent, preclude the possibility of forming any general laws on the subject, so as to meet every contingency) may also be adjusted by the known custom and practice of the market” (10). There were rules about admissions and membership and what would happen if someone defaulted or got into a dispute. “All disputes between individuals (not affecting the general interests of the Stock-Exchange) shall be referred to arbitration” (20). Defaulters would have their membership suspended, to be renewed only if they made good on their debts and petitioned to have their membership reinstated. By excluding most of the unreliable people to begin with and kicking out anyone else who violated the rules, the London Stock Exchange created a system of privately generated order. Members aptly adopted as their motto “My word is my bond.” The exchange ended up becoming very successful and had one thousand members by the mid-nineteenth century and two thousand by 1878 (London Stock Exchange Commission 1878, 5). Even though it was large enough that widespread cheating could have occurred, the private rules and regulations prevented that from happening. By the time the government ended up repealing the Bubble Act in 1825, thereby legalizing new joint stock companies, the London Stock Exchange was in the important position of helping new firms raise capital. Harris (1997, 681–682 describes the nineteenth-century bankers who saw that “the joint-stock company made possible the development of capital-intensive projects:  canals, docks, and other infrastructures that individuals could not and government should not administer.” The brokers who transformed coffeehouses into rule-enforcing clubs likely did not realize that they would help finance large-scale enterprise and the Industrial Revolution, but they did.

On the Origins of Stock Markets    333

The Evolution of Private Trading and Listing Rules in Nineteenth-Century New York Like their counterparts in Amsterdam and London, stock markets in New York evolved from informal venues into more formal clubs. The New York Stock Exchange can be traced back to the development of a regular market for securities trading in the postconstitutional Federalist era. Before the American Revolution, certain ventures, including “chartered towns, churches, and schools,” were organized as corporations (Werner and Smith 1991, 12), but they did not warrant an active secondary market for trading shares. Occasional transactions transpired as early as 1725, and the exchange of securities grew in significance by the 1790s.10 In 1792, New York papers quoted prices for only three federal bonds and two bank stocks, but they were enough to create a speculative frenzy. In a 1791 letter to Thomas Jefferson, James Madison wrote that “stock jobbing drowns every other subject. The coffee house is an eternal buzz with the gamblers” (Madison [1791] 1900, 55). Increasing volume of transactions prompted specialization in securities trading, with brokers segregating themselves from commodities dealers and meeting on a regular basis. Brokers saw almost immediately that their enterprise would be improved by forming an organization to provide an orderly atmosphere and set expectations for trade conduct. Brokers made several attempts to set up a private club for the benefit of members. The earliest evidence comes from a broadside printed in 1791, which announced that “dealers in the public funds” agreed to the establishment of fourteen rules. Among other things, these rules included sanctions for defrauders, terms for carrying out different futures contracts, stipulations for dealing with public auctioneers, and an agreement to charge a standard commission rate. The extent to which these rules were binding is unclear, but this was not the last time brokers would meet to establish such an agreement (Werner and Smith 1991, 22). A more well-known and significant event occurred in March 1792, when several leading brokers met at Corre’s Hotel to discuss setting up an organization for regulating the field of securities. On May 17, 1792, they drew up and signed the Buttonwood Tree Agreement.11 This document marked the establishment of a club of brokers in New York, 10  Bond and stock trading increased after the Funding Act of 1790 (the acquisition of state debts by the federal government through the issuance of securities) and the creation of the First Bank of the United States in February 1791, so it should be recognized that trading in both government bonds and private stocks were important features of the market in the 1790s. 11  The agreement reads: “We the Subscribers, Brokers for the Purchase and Sale of Public Stock, do hereby solemnly promise and pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever, any kind of Public Stock, at less than one quarter of one per cent Commission on the Specie value and that we will give preference to each other in our Negotiations. In Testimony whereof we have set our hands this 17th day of May at New York, 1792” (Eames [1894] 1968, 43).

334   Institutions and Organizations creating a definite institution that some historians view as a precursor to the New York Stock Exchange.12 Essentially, the brokers attempted to centralize the market by agreeing not to deal with anyone who was not a member. In the winter of 1792, they created a subscription to construct the Tontine Tavern and Coffee House as a base of operations for the newly formed organization. Tontine was devised as a meeting place and club that would be open to the public but with access to trade at the auctions restricted to members (Sobel 1965, 21). The “Constitution and Nominations of the Subscribers to the Tontine Coffee-House” spelled out certain rules. Over time, brokers became more organized and formed the New  York Stock and Exchange Board in 1817. The initial membership was made up of eight firms and nineteen individuals and met in a rented room at 40 Wall Street. The new institution had a much more advanced organizational structure than its predecessors. On February 25, 1817, a full constitution was drawn up, which was subsequently ratified on March 8. The original constitution consisted of nineteen rules. Some were procedural; the first three, for example, provide for the election of officers, including a president and a secretary, and detail their respective duties to call the stocks in order at the specified time and to record the minutes. Other rules provided for the collection and dissemination of information about market participants and for methods of excluding cheaters. Access to the benefits of the board was carefully watched, and potential new members were thoroughly screened for trustworthiness. According to rule 5, election was to be made by a secret ballot of current members, and “three black balls shall exclude”; that is, a negative vote by any three members was sufficient to block admittance. An additional rule was unanimously passed on September 19 requiring that all prospective members must first undergo a two-year apprenticeship to a current member immediately before being admitted. The membership fee was $25 in 1817 and $100 in 1827. The exchange rules required all disputes to be settled by a majority of the board, and defaulters would be held liable. Noncompliance with any of the rules by members was punished by fines or expulsion under a two-thirds majority vote. Nonmember brokers and clients refusing to pay a commission were punished by being barred from any further trade with members. A “Black Book” was created especially for this purpose, and a member caught dealing with anyone on the blacklist was to be immediately expelled from the board. The New York Stock and Exchange Board operated as an exclusive club, screening potential candidates thoroughly and enforcing rules through a system of fines and boycotts. As a result of its reorganization, the New York Stock and Exchange Board was in a position to draw up and enforce rules for its members and to prevent nonmembers from participating in securities auctions on its premises. Why did members of the New York Stock and Exchange Board take all of these steps? They did so because government enforcement was not an option, as New York did not 12 

Although Teweles and Bradley (1998, 109) view the Buttonwood agreement as a direct ancestor of the New York Stock Exchange, Werner and Smith (1991, 23–26) disagree.

On the Origins of Stock Markets    335 enforce whole classes of securities contracts until 1858, and the legislature did not offer any regulatory statutes on how such contracts should be performed. The transactions had had an uncertain legal status ever since a stock market crash in 1792, which had provoked hostility against the purchase and sale of stocks. Officials denounced stock trading as “speculation” that was morally on par with gambling.13 The public antagonism led to legal prohibitions on many transactions. On April 10, 1792, the New York state legislature passed “An Act to Prevent the Pernicious Practice of Stock-Jobbing, and for Regulating Sales at Public Auction.” Section III of this act prohibited the legal enforcement of any contracts in which the agreement to transfer a stock and the settlement of payment were not coincident: all contracts, written or verbal, public or private, made after the passing of this act, for the sale or transfer, and all wagers concerning the prices, present or future, of any certificate or evidence of debt, due by or from the United States, or any separate state, or any share or shares of the stock of the bank of the United States, or any other bank, or any share or shares of the stock of any company established or to be established, by law of the United States or any separate state, shall be, and all such contracts are hereby declared to be absolutely null, void, and of no effect. (cited in Werner and Smith 1991, 199).

Thus, an entire class of common derivative stock transactions, including forward and option contracts, were deemed to be mere wagers and unenforceable in court. This act did not alter prevailing conditions but instead simply codified what was already standard practice, as these stock transactions also had not been enforceable under the common law. The act was modified several times, without any significant substantive alteration, and the unenforceability was kept in effect until the act was finally repealed in 1858. This was crucial, because these sorts of derivatives made up a large fraction of the overall trade in securities in New York. In the period immediately following 1817, they accounted for between a third and a sixth of all trades made on the floor of the New York Stock and Exchange Board. Given the lack of state enforcement for such a large number of contracts, arbitration of disputes and regulation of agreements became fundamental services performed by the board (Banner 1998). Initially, the board’s constitution stipulated that all matters of dispute in the buying and selling of stocks be resolved by a majority of members. As membership grew, this procedure became impractical, and the board began to appoint committees for resolving disputes. This innovation provided the board with a mechanism for overseeing a considerable market and arbitrating disputes between a large number of parties. The board operated as its own miniature legal system, similar in essence to the Law Merchant (Benson 1989; Stringham 13  The public reaction was particularly fervent in New York, where large segments of the populace had gotten in on the investment happening around them. Widows, artisans, and common day laborers were all affected by the sharp fall in the value of stocks, and thus, financial losses were not confined to the concentrated and relatively small group of specialized investors.

336   Institutions and Organizations and Zywicki 2011)  and other earlier spontaneously arising trade-facilitating legal systems. The threat of expulsion gave the board a strong means of punishing dishonest traders within its organization. The board also had the ability to discipline nonmembers by blacklisting them and preventing them from engaging in trades with any of its members. The ability of the board to centralize local knowledge, disseminate reputation information, and punish cheating substituted for the lack of enforceability in the public courts. In this way, the volume of trade was able to expand widely even in the absence of third-party enforcement. The New York Stock and Exchange Board shortened its name to the New York Stock Exchange in 1863 and made membership a property right transferable to other eligible members in 1868. Requiring members to pay a $3,000 initiation fee (no small sum in the 1860s) prevented unreliable members from getting in and made membership the equivalent of a bond that would be forfeited by rule breakers. This can be analyzed as an irrecoverable asset or a hostage to facilitate exchange in Williamson’s (1983) terminology. The New York Stock Exchange also began having basic listing requirements during that time, and those were gradually strengthened. The New  York Stock Exchange always faced competition from nonmembers who could trade on other venues such as the Curb Market, the Open Board of Brokers, or the Consolidated Stock Exchange of New York. The New York Stock Exchange also competed with regional exchanges in Philadelphia and Boston and had to create a set of rules that members, listing firms, and ultimately their investors found attractive. It was quite successful, it moved into its current home in 1903, and by World War I, it had became the most important stock exchange in the world.14 As in Amsterdam and London, the rules and regulations that made the New York Stock Exchange possible emerged spontaneously through market forces, rather than being imposed in top-down fashion by government decree.

Conclusion The beginnings of the three most successful stock markets in history have this important similarity: government officials did not enforce contracts in these markets, yet market participants engaged in tremendously complex contracts. In each case, brokers created a system of private regulation that facilitated trade and helped the market advance to a highly developed form. The brokers who created order in these stock markets likely were only thinking about their own interests, but in the process, they enabled markets that became much more important than they could have imagined. 14  With the Securities Act of 1933 and the Securities Exchange Act of 1934, the government chose to mandate nationwide many rules and regulations that had been privately adopted by the New York Stock Exchange.

On the Origins of Stock Markets    337 Menger’s ([1892] 2009) discussion of the origin of money is a quintessential example of spontaneous order analysis. His achievement is notable because on the surface, it would seem unlikely that such a “public” institution as money could result from individuals pursuing their interests, especially since the use of money requires widespread social acceptance. Yet money did not come about because of some prearranged agreement or government decree, instead emerging with each person considering his or her own interests. As Menger ([1883] 1985, 154) notes, “the economic interest of the economic individuals, therefore, with increased knowledge of their individual interests, without any agreement, without legislative compulsion, even without any consideration of public interest, leads them to turn over their wares for more marketable ones” (emphasis in original). A similar history unfolded in the area of stock markets. Nobody knew that when the original joint stock ventures were created, an active secondary market in their shares would emerge. Nobody knew that brokers who had been specializing in other things would become specialized stockbrokers who would develop tremendously sophisticated contracts, including forward contracts, short sales, and options. Nobody knew that the contracts would be privately regulated through reputation mechanisms and later privately enforced rules. Nobody knew that these secondary markets would attract interest to the stock market and that this would enable many more firms to raise money in the future. Nobody knew that a system of private governance would emerge to regulate stock markets and help finance modern capitalism.

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Pa rt  V

P U B L IC P OL IC Y A N D I N T E RV E N T ION I SM

Chapter 15

The Ru le of E x pe rts Roger Koppl

Introduction Anyone who is paid for his or her opinion is an expert. Experts “fail” when they produce incorrect opinions. Experts may threaten individual autonomy if they have power. A psychologist with the legal authority to commit persons to an institution is an expert with power. The risk of expert failure is greater when experts enjoy an epistemic monopoly and when they choose for others rather than merely advising them. The “rule of experts” exists when experts have an epistemic monopoly and choose for others. Even when the power of experts is limited or compromised, however, they may fail, and they may act in ways tending to reduce the autonomy of others. Many writers have recognized problems with experts, however the term is defined. Some have found problems with psychologists (Szasz 1960), physicians (Berger and Luckmann 1966, 87–88), medical researchers (Berger, Matthews, and Grosch 2008; Ioannidis 2005), economists (Levy and Peart 2006), forensic scientists (Cole 2005; Pyrek 2007), expert witnesses in civil court (Huber 1993), and eugenicists (Peart and Levy 2005). Some have recognized problems with experts in general, such as a link between expertise and power (Foucault 1980) or a tension between expertise and democracy (Merton 1976; Habermas 1987; Turner 2001). It may still be true, however, that experts and expertise enjoy high prestige with most intellectuals and much of the general public. While expertise seems to be a necessary consequence of the division of labor, the existence of experts seems to create a problem of power. The problem of experts is intractable, because the division of labor creates a division of knowledge, which entails specialized knowledge. Typically, though not necessarily, the expert is paid for his or her opinion because the expert has specialized knowledge. Typically, therefore, demand for the expert’s opinion will dissipate if his or her specialized knowledge becomes common knowledge or is no longer valued by others. It seems, then, that we will always have experts and that most experts will receive a rent on their expertise.

344    Public Policy and Interventionism In a competitive market for expertise, the return to the marginal expert’s specialized knowledge will tend toward the ordinary rate of return adjusted for factors such as risk and the pains or pleasures of acquiring and using that knowledge. Entry restrictions will tend to raise the rate of return on the expert’s specialized knowledge and increase the expert’s monopoly power as measured by the elasticity of demand. It seems likely that the danger of expertise is correlated with the expert’s monopoly power so defined. The expert’s rate of return may nevertheless have no necessary or immediate link to the threat the expert poses to the autonomy of others. Market structure (the “ecology of expertise”) matters for the rule of experts, but the expert’s rate of return on his or her specialized knowledge may not always be relevant. As Hayek (1948, 77) emphasized, the knowledge deployed in the division of labor is widely dispersed and may exist in the inarticulate form of habits and judgment (80, 83). Thus, each person in the division of labor has specialized knowledge and is, in this sense, an expert. If we equate the word expert with specialized knowledge, however, everyone in the division of labor would be an expert and the term rule of experts might be too fluid to help in understanding the problem of experts. The economics of experts, which Koppl (2012) calls “information choice theory,” contains a definition of expert as anyone paid to give an opinion. The theory includes an explanation of why there is a problem of experts. (The following section borrows from Koppl 2012.)

Information Choice Theory The economic theory of experts builds on the assumption that experts respond to incentives. It thus exhibits the same methodological symmetry characterizing public choice theory. In particular, it assumes that experts may not be truth seekers and that truth seeking competes at the margin with other goals such as fame and fortune. Because of its similarities to public choice theory, the economics of experts may be called information choice theory. The expert must choose what information to provide to others. Just as public choice theory includes a theory of government failure, information choice theory includes a theory of expert failure. In some institutional contexts, experts are likely to produce relatively unreliable opinions. Information choice theory supports the view that monopoly expertise tends to produce a poorer epistemic performance than competition. It notes, however, that many other variables influence the performance of epistemic systems, including redundancy, degeneracy (defined below), the correlation structure among expert errors, and conditions of expert entry and exit. Information choice theory replaces the naive model of the “objective” expert with models in which the opposed interests of rival experts can be leveraged to enhance epistemic outcomes. In information choice theory, an expert is anyone paid for his or her opinion. Economists, forensic scientists, and statisticians are experts; race-car drivers are not. This definition of expert implies that entrepreneurs and profit-seeking enterprises

The Rule of Experts    345 are not experts. An entrepreneur’s output might, of course, be his or her opinion. Consultants are paid for their opinions. But the entrepreneurial function is not identical to that of the expert, nor is one an aspect or subset of the other. The entrepreneur is paid for his or her output; experts are paid for their opinions themselves. The term information choice suggests that scholars should recognize that experts choose what information to share. This point is recognized in many contexts, including models of asymmetric information, principal-agent models, signaling games, and sender-receiver models. Economists and other scholars do not always apply the insight consistently, however. As Levy (2001) and Peart and Levy (2005) have noted, for example, economists tend to assume that other economists are pure truth seekers. Feigenbaum and Levy (1996) present a canonical model of information choice. They show that fraud may be unnecessary for a biased scientific expert. Performing multiple tests and strategically choosing which results to report create a bias. This bias may allow the expert to report the results of one or two unbiased, but strategically chosen, estimation procedures. Such strategic choice of which results to report supports the expert’s bias. The expert in this model must make a choice about what information to share. He or she must choose which test results to report. Whitman and Koppl (2010) present a rational choice model of a monopoly expert. In their model, a monopoly forensic scientist chooses whether to “match” ambiguous crime-scene evidence to a suspect. (The assumption of binary choice is a simplification. In forensic science practice, the word match is used less often than words such as individualization, association, and consistent with.) Because the evidence is ambiguous, the forensic scientist must choose when to declare a match. The forensic scientist must make a choice about what information to convey. He or she must choose whether to report “match” or “no match.” Whitman and Koppl show that a rational Bayesian will be influenced by the results of the forensic examination but also by his or her prior estimation of the probability of guilt and by the ratio of the disutility of convicting an innocent person to the utility of convicting the guilty. In some cases, priors and utilities may render the results of the forensic examination irrelevant to the expert’s expressed opinion. Whitman and Koppl note the importance of institutional factors in influencing both priors and utilities. Working as an employee of the police department, for example, will likely increase the forensic scientist’s prior belief in the suspect’s guilt and lower the disutility of convicting an innocent person relative to the utility of convicting the guilty. The institutional structure creates a bias even when experts are perfectly “rational” Bayesian decision-makers. This model, suitably adjusted, can be applied to many cases of monopoly expertise. In such models, ambiguity increases the importance of the expert’s preferences and prior judgments. Even in unambiguous situations, dishonest monopoly experts may have the desire and the ability to give opinions that depend on the expert’s preferences and prejudices rather than relatively objective factors. Milgrom and Roberts (1986) provide an early canonical model in information choice theory. They consider a naive recipient of information confronting competitive suppliers of information. “The question at issue,” they write (1986, 25), “is under

346    Public Policy and Interventionism what circumstances competition among providers of information can help to protect unsophisticated and ill-informed decision-makers from the self-interested dissembling of information providers.” If the competitors’ interests are “strongly opposed,” as in a civil trial in a common-law country, even a naive information recipient will come to the full-information decision. Interests are strongly opposed when for every pair, d, d´, of alternative choices the information recipient might make, one of the interested information suppliers prefers d to d´, and the other prefers d´ to d. If the interests of the competing information suppliers are strongly opposed, then one of them always has an incentive to provide additional information. Assume for a moment that the information revealed to the recipient does not induce the full-information choice, d*. Then it leads to some other choice, d0. Because interests are strongly opposed, one of the information suppliers prefers d* to d0 and thus has an incentive to reveal more information. Even though the decision-maker is naive, competition ensures that he or she reaches the full-information decision. The model of Milgrom and Roberts shows that a battle of the experts is not a race to the bottom (Koppl and Cowan 2010). It shows that competition among experts will influence their choices of what information to share. Their result suggests the epistemic value of having opposing interests for competing experts. It suggests the need to leverage the biases of experts, causing one bias to check another. The Milgrom and Roberts model supports the view that competition among experts reduces the danger of experts to others. As Whitman and Koppl (2010, 254) discuss in some detail, monopoly experts may have an incentive to “give oracular pronouncements rather than clear explanations. When they do, they resemble wizards whose power is enhanced by an air of esoteric mystery.” When experts behave like wizards, they are freer to act on preferences and prejudices. In extreme cases, the expert must be obeyed but not understood. Non-experts must trust the expert (obey) or make a more or less arbitrary choice not recommended by the expert. Competition among experts tends to produce a different result if the interests of the competing experts are not fully aligned. The tendency is stronger the more fully opposed are the interests of the experts, as the model of Milgrom and Roberts suggests. In a competitive market for expertise, the individual expert must offer services more attractive than those of competing experts. It may be necessary to give more transparent opinions and to empower the non-expert to make an informed, autonomous choice. In other words, competition increases the value of teaching the non-expert and reduces the value of obscurity. In this sense, as Koppl and Cowan (2010, 254) have said, “Competition turns wizards into teachers.” If experts are paid for their opinions, then they are agents of the payers, their principals. Thus, the subject of expertise has been treated in the economics literature mostly in the context of principal-agent models. It is probably fair, however, to distinguish standard principal-agent models from information choice theory. In the canonical model of Ross (1973), the principal cannot observe the agent’s action; the principal can observe the payoff, which depends on chance and the agent’s actions. This model clearly applies to some situations in which the agent is not an expert. Workers paid on

The Rule of Experts    347 commission or at piece rates, for example, are being paid not for their opinions but for their results. Ross’s assumption that payoffs are observable does not always apply to experts. The doctor tells me I will die tomorrow if I do not take his patent medicine. I take the tonic and live another day. My continued existence does not help me to discriminate between the hypothesis that the doctor is a quack and the hypothesis that the doctor saved my life. There is a difference between standard principal-agent models and information choice models. In Ross (1973), the agent’s actions are distinct from the output created by the interaction of the agent’s actions with chance events. If the agent is an expert, the observable outcome of the expert’s activity is a part of the agent’s action and not separable from it. This lack of separability does not help the principal to monitor the agent if the principal lacks the expertise that the agent was hired to deploy. Thus, it may be difficult for the principal to assess the outcome of the agent’s actions. Getting opinions from other experts may not solve the principal’s monitoring problem if errors and inaccuracies are correlated across experts. The model of Milgrom and Roberts (1986) discussed earlier suggests that competition among experts with opposed interests may help third parties to judge expert opinions. Information choice theory is more sensitive to the fallibility of experts than standard principal-agent models. It makes the somewhat innovative assumption that incentives skew expert errors, including “honest” errors. Information choice theory also gives greater attention to four motives absent from standard principal-agent models: identity, sympathy, approbation, and praiseworthiness. Finally, information choice theory does not presume an isolated principal-agent institutional structure. Instead, the theory recognizes that the larger institutional context may create different degrees and forms of competition among experts. In both its positive and normative aspects, information choice theory explicitly considers the ecology of expertise. Because the analysis of Sah and Stiglitz (1986) neglects the incentives of experts, it is not an example of information choice theory (Koppl 2012). Information choice models will often assume asymmetric knowledge, but information choice and asymmetric information are distinct. A model of asymmetric information might contain no experts, and a model of information choice may contain no asymmetric information. In Akerlof ’s (1970) illustrative model of the market for used cars, the used-car owner has information unavailable to the potential buyer. But the owner is not an expert, because he is paid not for his opinion but for his car. The potential buyer knows the relative frequency of lemons but has no information indicating whether any particular car is a good car or a lemon. Thus, Akerlof ’s basic model has no experts and is not an example of information choice theory. A referee or umpire in a sporting event need not necessarily have asymmetric information, particularly when it is cheap to make a video recording of the event and study an instant replay of close calls. Nevertheless, we pay referees and umpires to give their expert opinions about whether a goal was scored or a foul was made. Arbiters do not always have asymmetric information about the facts of the dispute or the rules governing

348    Public Policy and Interventionism dispute resolution. And yet they are paid as experts to give an opinion that may be binding on the parties. Thus, information choice does not necessarily imply asymmetric information, even though experts in most information choice models will have asymmetric information.

Motivational Assumptions of Information Choice Theory Information choice theory has three key motivational assumptions. First, experts seek to maximize utility; thus, the information-sharing choices of experts are not necessarily truthful. Second, cognition is limited and erring. Third, incentives influence the distribution of expert errors.

Experts Seek to Maximize Utility The assumption of utility maximization should not be given a narrowly selfish meaning. Agents who seek to maximize utility may seek praise or praiseworthiness as well as material goods. Truth may often be an element in the utility function, although it will usually be subject to trade-offs with other values. The assumption of egoistic rationality among experts is clearly exaggerated, but it will sometimes be a serviceable first approximation that helps draw our attention to basic issues and relationships, while pointing to empirical anomalies that can be resolved only by relaxing the assumption. Peart and Levy (2005) have emphasized sympathy, approbation, and praiseworthiness as expert motives. We should recognize, therefore, that the economic perspective of information choice theory does not require us to assume that an expert—or anyone else—is selfish in any substantive sense. We should repudiate both the naive view that experts are always and everywhere truth seekers and the cynical view that truthfulness has no value to any expert ever. Akerlof and Kranton (2000; 2002) introduce identity to the utility function. Akerlof and Kranton (2005; 2008) put identity into the utility function of the agent in an otherwise standard principal-agent model. Following Koppl and Cowan (2010) apply the principal-agent model of Akerlof and Kranton (2005; 2008) to forensic science.

Cognition Is Limited and Erring While bounded rationality is not always assumed in economic analysis today, it is probably uncontroversial to say that the cognition of experts is limited and erring. The

The Rule of Experts    349 assumption that experts seek to maximize utility might create the mistaken impression that information choice theory repudiates bounded rationality. It does not. If experts have bounded rationality, then they may not always be able to maximize their objective functions. Computability theory gives us an approach to bounded rationality that does not depend on empirical claims about human psychology but only on the claim that the agents of our models should not be able to compute mathematically uncomputable functions. A  mathematical function is “computable” if a Turing machine, the mathematicians’ ideal type of a digital computer, can be programmed to solve it. Building on Lewis (1992), Tsuji, da Costa, and Doria (1998) reveal just how pervasive non-computability is. They show that even finite games can be undecidable. A finite game is trivially decidable, of course, if we have a complete and explicit list of strategies and payoffs. But if the game is described in formal language, it may be impossible to solve by “brute force.” In that case, the game may be undecidable. In a deep and important remark, they note, “Formalized theories are about strings of symbols that purport to represent our intuitions about concrete objects” (555). We use general terms to describe the world, only rarely employing detailed listings and the like. Thus, our account of the world is radically incomplete and constantly subject to limits of computability and decidability. Velupillai (2007, 273, 280) shows that “an effective theory of economic policy is impossible” for an economy that can be modeled as “a dynamical system capable of computation universality.” Policy makers would have to compute the uncomputable to know the future consequences of their policies. Velupillai (288) links his important result to Hayek’s “lifelong skepticism on the scope for policy in economies that emerge and form spontaneous orders.” Algorithmic information theory “studies the size in bits of the smallest program to compute something” (Chaitin, da Costa, and Doria 2011, 62). It reveals a sense in which it may be impossible to have a theory of some complex phenomena. To predict, explain, or even merely identify a sufficiently complex system may require a description so lengthy that no simplification of the original system is achieved. The behavior of a sufficiently complex system (one at the top of a Chomsky-Wolfram hierarchy) cannot be predicted ahead of time (Wolfram 1984; Markose 2005). We can do no better than watch it unfold. The computability results reviewed above concern Turing computability, that is, what can be decided by a Turing machine. An analog “hypercomputer” could theoretically compute functions that are not Turing computable (da Costa and Doria 2009, 80). Opinions differ on whether hypercomputation is possible (da Costa and Doria 2009; Cockshott, Mackenzie, and Michaelson 2008). Wolpert (2001) shows that computability problems would arise even in a world with hypercomputers, if they were physically realizable. He shows, for example, that for any pair of physically realizable computers, at least one will be unable to reliably predict the output of the other.

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Incentives Influence the Distribution of Expert Errors There are two aspects to the assumption that incentives skew expert errors. First, experts may cheat or otherwise self-consciously deviate from complete truthfulness. Second, experts may unknowingly err in ways that serve an external master or internal bias. In a standard principal-agent model, expert “errors” are the product of guile. In a standard model, they must be the product of guile because cognition is unerring. In information choice theory, however, experts may make errors that are not fully or even remotely intentional. In this sense, they may make “honest” errors. These honest errors, however, are influenced by incentives. The lower the opportunity cost of making an error of a particular sort, the higher the incidence of such errors, independently of the degree of intention associated with the error. In other words, experts respond to bias. Experts may make honest errors in favor of their clients because they are paid by their clients or because they have sympathy for the client. Sympathy for someone else, perhaps other experts, may encourage an error that hurts the client. In all such cases, incentives skew honest errors. The assumption that incentives skew honest errors is a natural assumption only if we are also assuming fallible cognition. When economists assume strong forms of rationality, the assumption of skewed errors may be unnatural. In that case, one may be led to model expert errors as random draws from a symmetric distribution. Tullock ([1966] 2005), Levy and Peart (2012), Diamond (1988), Wible (1998), and others have made the economic assumption that incentives help shape the opinions of experts. Levy and Peart (2012) suggest that the assumption has not been well understood or widely adopted. In all these versions of the idea, however, the assumption is that scientists or other experts knowingly serve their interests. Some evidence suggests, however, that the same thing can happen without the affected expert knowing it. Some evidence has been discussed in the economics literature with the Allais paradox, preference reversal, and other cases in which people seem to contradict themselves. The literature on observer effects includes further evidence. This literature seems to show that our opinions may serve our interests even when we know it not. Risinger et al. (2002) include a masterful review and summary of the literature on observer effects. We are generally more likely to observe, perhaps mistakenly, what we expect than what we do not expect. Errors of observation tend to be skewed in the direction of our hopes and expectations. Tversky and Kahneman (1974) discuss representativeness bias (1124), availability bias (1127), and adjustment and anchoring bias (1128). These biases have since become familiar to economists. When incentives skew honest error, the erring person knows, presumably, what his or her incentives are. The error may be honest, however, if the person does not know that those consciously known incentives have altered his or her perceptions. The error may also be honest if the person underestimates the effect and therefore fails to fully compensate for it. There are many very different perceptions that may be altered by incentives. The fingerprint examiner may not notice dissimilarities between a known

The Rule of Experts    351 and an unknown print, for example. A research scientist must search for deviations from experimental protocol before accepting the data generated by an experimental trial. That search may be more diligent or thorough when an experimental trial has produced disappointing results. If the scientist is unaware of this asymmetry in his or her search efforts, the results will be biased in spite of a conscious desire to be unbiased.

The Ecology of Expertise Information choice theory assumes that errors are skewed by incentives. But incentives depend on institutions. Thus, information choice theory includes comparative institutional analysis. This institutional connection brings us to a point of distinction between information choice theory and principal-agent models that was noted earlier. Information choice theory studies the ecology of expertise. Recall that information choice theory does not presume an isolated principal-agent institutional structure. Instead, the theory recognizes that the larger institutional context may create different degrees and forms of competition among experts. In both its positive and normative aspects, information choice theory explicitly considers the ecology of expertise. Some simple analytics of epistemic systems (Koppl 2005)  may help us to identify relevant features of the ecology of expertise. Epistemic systems are agent-based processes viewed from the perspective of their tendency to help or frustrate the production of local truth. (This definition generalizes that of Koppl 2005) In this context, “local truth” may mean true beliefs, correct expectations, appropriate behaviors, or something else depending on context. Local truth is “getting it right.” (See Koppl, Minai, and Sayama 2010.) It will sometimes be convenient to model an epistemic system as a game, perhaps a sender-receiver game, specifying a set of senders, a set of receivers, and a set of messages, together with payoffs and rules for their interactions. The senders may have a probability distribution over messages, showing the subjective probability that each message is true. The senders send messages to the receivers, who somehow nominate one message from the message set and declare it “true.” This message is the judgment of the receiver(s). Figure 15.1, adapted from Koppl (2005), illustrates epistemic system with monopoly experts.

message set

Figure 15.1  Monopoly expertise.

sender

receiver

judgment

352    Public Policy and Interventionism In the figure, the oval marked “message set” represents the messages an expert might deliver. A forensic scientist, for example, might declare of two samples “match,” “no match,” or “inconclusive.” (NAS 2009, S-15, discusses the variety of terms used to describe what is commonly thought of as matching.) The dashed arrow represents the expert choosing from the message set. The solid arrows represent the transmission to the receiver, for example, the judge or jury at trial, and the “nomination” of a message by the receiver. The circle marked “judgment” represents the receiver’s judgment. It may represent, for example, the judgment of the jury in a criminal case that a latent print lifted from the crime scene was left by the defendant. When the receiver is able to compare the opinions of multiple experts, we have the sort of situation represented in ­figure 15.2, also adapted from Koppl (2005). Because each receiver gets messages from multiple senders, the experts are in a position of strategic interdependence, which may constrain their choice of message. Figures 15.1 and 15.2 do not represent all of the dimensions relevant to the ecology of expertise. For example, are the competing experts truly independent? If they are, the multiplicity of signals available to each receiver acts like a coding redundancy to reduce the receiver’s rate of error in judgment. If they are highly correlated, however, the appearance of redundancy may reinforce errors in the mind of the receiver, serving only to degrade system performance. Sympathy among experts or identity with an expert’s professional standards and practices may reduce independence among experts and cause expert errors to be correlated. In some applications, it is important to know whether sender messages are independent. A  jury in a criminal trial may be presented a confession, eyewitness testimony, and forensic evidence. It seems plausible that a jury in such a case might imagine that it has three independent and reliable sources of evidence pointing to the defendant’s guilt. Any one of these three forms of evidence would be sufficient for conviction if errors were not possible. When presented with multiple channels of incriminating evidence, a jury that is highly alert to the possibility of error within

message set

Figure 15.2  Competing experts.

senders

receiver

judgment

The Rule of Experts    353 each channel considered individually might nevertheless wrongly convict because errors are correlated across evidence classes. If each of three forms of evidence has a 50-percent chance of falsely suggesting guilt, the chance that three independent forms of evidence would all point in the wrong direction is only one in eight, or 12.5 percent. If each line of evidence has only a 10-percent chance of falsely suggesting guilt, the seeming probability of error falls to just one in a thousand, or 0.1 percent. But in some cases, these seemingly independent sources of evidence may be correlated as suggested by the analysis of Koppl and Sacks (2013). In such cases, the probability of innocence would be underestimated by multiplying the error probabilities for each line of evidence considered individually. Degeneracy may reduce the chance of correlated errors. Edelman and Gally (2001 13763) define degeneracy as “the ability of elements that are structurally different to perform the same function or yield the same output.” They contrast degeneracy with redundancy, “which occurs when the same function is performed by identical elements.” Degeneracy, by contrast, “involves structurally different elements.” It “may yield the same or different functions depending on the context in which it is expressed.” If each expert in a multi-expert system is unique, then the system exhibits degeneracy. A priest, a psychologist, a Buddhist monk, and a bartender may give very different advice on relieving anxiety. When all experts are the same, expert errors may be correlated.

Theory of Expert Failure Information choice theory helps us to understand when reliance on experts is more likely to disappoint expectations and when it is less likely to do so. In this sense, it gives us a theory of expert failure. We have expert failure if an expert produces an analysis that deviates from some normative expectation associated with the decision to rely on that expert. Such failure may take different forms, but bias might be the most salient. The expert may produce a biased analysis when he or she was expected to produce an unbiased analysis. We are unlikely to recognize the causes of expert failure if we do not model both the motives of experts and the ecology of expertise. Forensic science has given us several examples of how flawed institutions may give rise to expert failure. As a rule, monopoly expertise invites expert failure. It may be true that competition among experts is less likely to produce expert failure, but it is not enough to merely multiply experts. The ecology of expertise is vital. Can experts enter freely? What limits entry to the market for a given type of expertise? Do experts in a given area have more sympathy for one another than for their clients? And so on. Thus, it is necessary to model several dimensions of the social processes surrounding experts. Expert failure is more likely when experts have an epistemic monopoly than when they must compete with one another. And expert failure is more likely when experts

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Monopoly expert Expert decides for the nonexpert

Competitive experts

Rule of experts Expert-dependent choice Examples include forensic science Examples include medicine, and state-administered law, and financial advice eugenics programs when patients and clients are Highest chance of expert failure relatively ill informed. Moderate chance of expert error

Nonexpert decides based, Quasi-rule of experts perhaps, on expert advice Examples include religion under a theocratic state and state-enforced religion. Relatively high chance of expert failure

Self-rule or autonomy Examples include periodicals such as Consumer Reports and liberal professionals when clients are relatively well informed. Relatively low chance of expert error

Figure 15.3  Some elements of the ecology of expertise.

choose for their clients than when the clients choose for themselves. These two dimensions of expert power suggest the four-quadrant diagram of ­figure 15.3, which identifies four cases: (1) the rule of experts, (2) the quasi-rule of experts, (3) expert-dependent choice, and (4) self-rule or autonomy. The “market for preferences,” as analyzed by Earl and Potts (2004), informs the case of self-rule in which experts compete to provide advice to relatively autonomous clients.

Epistemic Engineering Information choice, the economic theory of expertise, should inform epistemic engineering. Koppl, Minai, and Sayama (2010) define epistemic engineering as “the study of the design principles of ‘epistemic systems,’ ” where epistemic systems are “agent-based processes viewed from the perspective of their tendency to help or frustrate the production of local truth,” and “local truth” may mean “true beliefs, correct expectations, appropriate behaviors, or something else depending on context.” Local truth is “getting it right.” Epistemic engineering has many different applications extending well beyond social systems with human agents, for example, the stigmergic organization of an anthill, agent-based software systems, and multi-robot systems. But when applied to human systems such as political constitutions and the organization of state crime labs, epistemic engineering should be informed by information choice theory. Good epistemic design will generally not create or permit an epistemic monopoly.

The Rule of Experts    355 Like information choice theory, epistemic engineering is closely related to the veritistic social epistemology of Alvin Goldman (1978; 1999; 2001). It takes a more open-ended view of knowledge, however, which permits agents to achieve local truth with or without human beliefs. Information choice theory applies only to human systems. Nevertheless, some of its concepts and methods might also apply to nonhuman systems.

Applications Information choice (the economic theory of expertise) has many applications.

Priests and Wizards Information choice theory can inform the economic analysis of religion. Iannacone (1998, 1478)  says that Adam Smith’s The Wealth of Nations “laid the foundation for the economic analysis of religion.” Smith noted the dangers of granting an epistemic monopoly to any one religion. Under religious competition, he says, “The teachers of each sect, seeing themselves surrounded on all sides with more adversaries than friends, would be obliged to learn that candour and moderation which is so seldom to be found among the teachers of those great sects whose tenets, being supported by the civil magistrate, are held in veneration by almost all the inhabitants of extensive kingdoms and empires, and who therefore see nothing round them but followers, disciples, and humble admirers” (Smith [1776] 2000, vol. 1, 197). This analysis seems to support the claim noted earlier that “Competition turns wizards into teachers” (Koppl and Cowan 2010, 254). Smith’s analysis is supported by Buddhist texts describing how the Buddha drew followers in a competitive market for gurus: “Instead of mysterious teachings confided almost in secret to a small number, he spoke to large audiences composed of all those who desired to hear him. He spoke in a manner intelligible to all…. He adapted himself to the capacities of his hearers” (Narasu 1912, 19). The Buddha taught religious toleration and emphasized the student’s need to see the truths being taught for himself or herself rather than accepting them on authority. Leeson’s (2012) analysis of the medieval practice of trial by ordeal explains how a priestly elite enjoying an epistemic monopoly was able to leverage the superstitions of a subject population to discriminate, if only weakly, between the guilty and the innocent. Turner (2001, 131) says that “the theologian is an expert with cognitive authority.” Mackay (1852, chap. 4) reviews the history of alchemy, whose practitioners sometimes adopted wizardly airs and invented powers they did not really have. The open and public nature of modern science encourages a less wizardly and mysterious approach to chemical knowledge. In principle, only reproducible results are admitted into the corpus of modern chemistry.

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Political Economy Experts to whom the legislature has delegated authority dominate all areas of policy in modern democracies. Thus, the theory of information choice should be a central feature of political economy. Friedman and Schwartz (1963, 407–419) explain why the “Great Contraction” of 1929–1933 might have been avoided if Benjamin Strong, president of the New York Federal Reserve Bank, had been alive to prevent it. They describe an institution, the Federal Reserve System, whose performance was sensitively dependent on a named individual. Institutions with such sensitive dependence on “Big Players” (Koppl 2002) will generally misbehave at some point, because the relevant individuals lack the knowledge or incentives to prevent system failure. Monetary policy is no less subject to expert failure today than it was in 1929. Appelbaum (2012) reports that Federal Open Market Committee transcripts from 2006 reveal that when the housing market faltered, “top Federal Reserve officials” knew of the problems but “gave little credence to the possibility that the faltering housing market would weigh on the broader economy.” Later, Alan Greenspan would say, “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief ” that bankers seemingly failed to do so (Andrews 2008). Levy and Peart (2008) and Levy (2009) help to explain why monetary authorities and others underestimated the financial risks of the housing crisis. They quote the SEC’s 1994 “concept release” on nationally recognized statistical rating organizations (NSROs) (SEC 1994, 4): Over time, the NRSRO concept has been incorporated into other areas of the federal securities laws and Congress itself employed the term “NRSRO” in the definition of “mortgage related security.” Pursuant to Section 3(a)(41) of the Exchange Act, which was added by the Secondary Mortgage Market Enhancement Act of 1984, a mortgage related security must, among other things, be rated in one of the two highest rating categories by at least one NRSRO. Although Congress did not define what it meant by an NRSRO, its reliance on the term used in Commission rules is significant because it reflects a congressional recognition that the “term has acquired currency as a term of art.”

Note that the quote includes the phrase “by at least one NRSRO.” Levy and Peart (2008) and Levy (2009) point out that this phrase authorizes rate shopping. If one NRSRO does not rate your mortgage-related security in one of the two highest rating categories, go to another for a better rating. This incentive system creates a bias in favor of high ratings. Moreover, the label NRSRO is an official designation bestowed by the SEC and requiring an application to the SEC. There are currently ten NRSROs, of which three—Moody’s, Standard & Poor’s, and Fitch—dominate the market. Presumably, the presence of a few small players encourages the Big Players to conform to their incentives and provide favorable ratings. Regulation may invite expert failure. The theory of regulatory capture (Stigler 1971; Posner 1974; Yandle 1983) explains how experts may fail because they have an incentive

The Rule of Experts    357 to act on relatively narrow interests rather than in the public interest. Velupillai (2007) shows that policy experts, including regulators, are subject to expert failure when success requires them to have knowledge that they cannot have. The modern theory of financial regulation calls for regulators to collect detailed information on bank portfolios and calculate systemic risks from that information (Beale et  al. 2011a; 2011b; Caccioli, Catanach, and Farmer 2011; Gai, Haldane, and Kapadia 2011; Haldane and May 2011; Yellen 2009). Such ambitious tasks may not be epistemically possible. Other forms of social control are also subject to expert failure. Rizzo and Whitman (2009) criticize libertarian paternalism on epistemic grounds. Social workers, judges, psychologists, and forensic scientists are experts who may have power. The design or reform of the systems in which they act should aim in part at reducing the risk of expert failure. Traditional socialism, which requires extensive central planning, may be viewed as an extreme form of the rule of experts. Socialist planners are experts subject to failure for reasons of incentives and epistemics. Progressivism tends to create the rule of experts and a risk of expert failure. One fairly recent definition of progressive shows how hard it is to pin the concept down. Weinstein (2006, 50) says, in part: “a progressive is a person who believes that social reform is achievable over time with the proper mixture of individual participation and government support. He or she … recognizes that there is a universal standard for justice while acknowledging that only by understanding particular contexts and circumstances can the adequacy of the progress be measured.” The gist of Weinstein’s “definition” seems to be the vague notion that a progressive weighs all relevant considerations carefully when making up his or her mind. Nevertheless, it seems fair to look at a foundational text of the progressive tradition for evidence on the relationship between progressivism and the rule of experts, namely, Woodrow Wilson’s “The Study of Administration” (1887). Wilson extols the technical knowledge of the administrator. He makes a sharp distinction between “administration” and “politics,” which seems to be more or less that between means and ends. While cleaving to the principle of democracy, Wilson notes the difficulties it creates for “administration.” He says: “It is harder for democracy to organize administration than for monarchy…. The very fact that we have realized popular rule in its fullness has made the task of organizing that rule just so much the more difficult” (1887, 207). He favorably cites Bluntschli (1876, 467), suggesting that we “separate administration alike from politics and from law” and quotes his description of “administration” as the “province” of “the technical official” (Wilson 1887, 210–211). Wilson says: “It will be necessary to organize democracy by sending up to the competitive examinations for the civil service men definitely prepared for standing liberal tests as to technical knowledge. A technically schooled civil service will presently have become indispensable” (216). Wilson even imagines that this corps of functionaries will be “drilled … into a perfected organization, with appropriate hierarchy and characteristic discipline” (216). Democratically elected representatives of the people will somehow ensure that creating such a “distinct, semi-corporate body” will not simultaneously create “a domineering, illiberal officialism” (216).

358    Public Policy and Interventionism Thus conceived, progressivism creates the rule of experts and the risk of expert failure. The difference between “administration” and “policy” is fluid or nonexistent. Thus, the more completely Wilson’s vision is realized, the weaker is the principle of democracy, and the greater is the rule of experts. The risk of regulatory capture is high under progressivism, and the extensive duties given over to “administration” may easily exceed the epistemic potential of humans and human organizations.

Law and Justice The administration of justice relies on experts. Criminal justice professionals, including police investigators and forensic scientists are experts. Koppl and Sacks (2013) show that police, crime labs, and prosecutors all have strong incentives to convict but no strong incentive to discriminate between the guilty and the innocent. This incentive structure creates a multitask problem (Holmstrom and Milgrom 1991) in criminal justice. Huber (1993) criticized the use of experts in civil court in the United States, saying that the testimony of experts is too often based on “junk science.” Information choice theory can inform the analysis of admissibility standards and judicial procedures, such as the “hot tubbing” (Yarnall 2009) sometimes practiced in Australia. In the United States, the Supreme Court decision in Daubert v. Merrell Dow Pharmaceuticals (509 U.S. 579, 1993) created a set of guidelines for the admissibility of expert testimony in federal courts. This standard has been invoked in most state courts. Some states have the alternative Frye standard, which is often interpreted and applied, however, with language that seems to invoke the Daubert standard. There may be no difference in how the Frye and Daubert standards are applied in practice (Cheng and Yoon 2005). The National Academy of Sciences (NAS 2009, S-8) cites evidence that standards for the admissibility of scientific evidence in the United States are higher in civil courts than in criminal courts.

Medical Research Information choice may be applied to the organization of medical research. Altman (2002, 2765) says: “There is considerable evidence that many published reports of randomized controlled trials (RCTs) are poor or even wrong, despite their clear importance.” He lists seven widespread problems, including “[n]‌ot reporting an adequate method for generating random numbers” and “[i]nadequate information on harmful consequences of interventions” (2766). Berger, Matthews, and Grosch (2007) give three examples in which experimental precautions against observer effects are compromised by “inappropriate yet regimented research methods.” In the most striking of the three examples, “run-in bias” is created by deleting adverse events prior to randomization: “In randomized treatment trials, it is common to pre-treat the patients with the active treatment, evaluate their outcomes, and determine which patients to randomize based upon

The Rule of Experts    359 those outcomes. Bad outcomes (even deaths) prior to randomization do not make it into the analysis and do not count against the active treatment under scrutiny” (234). Ioannidis (2005) explains “why most published research findings are false.” If many researchers are confidant that, say, sunspots cause baldness, we will have many studies examining this relationship. The few studies that generate a positive result by chance will be published. Sincere and honest researchers who get negative results may innocently cast about for reasons to doubt their own findings. Rather than attempting to publish the negative result, they search the space of regression equations, adding and dropping regressors, casting out outliers, and so on. If the search chances upon the right combination to generate a positive result, the researcher will be rewarded with a well-cited publication that strengthens the growing evidence for a link between sunspots and baldness. “The probability that at least one study, among several done on the same question, claims a statistically significant research finding” grows as the number of such studies grows (Ioannidis 2005, 0697). Ioannidis says: “The greater the number … of tested relationships in a scientific field, the less likely the research findings are to be true…. The greater the flexibility in designs, definitions, outcomes, and analytical modes in a scientific field, the less likely the research findings are to be true” (0698).

Other Applications Information choice theory may be fruitfully applied to research science, science policy, and economic science. Levy and Peart (2012) draw our attention to the important analysis of Tullock ([1966] 2005), who asked what science would be like “if the subjects of our discipline could trade with us, offering us things of value to bend our results.” His answer was that “we would have economics, a racket not a science.” Tullock cites Roucek’s (1963) examination of “some academic ‘rackets’ in the social sciences.” Peart and Levy (2012) ask what would happen “if germs could sponsor research.” National food safety systems depend on testing regimes that could be studied from the perspective of information choice theory. Many topics in homeland security should be studied from the perspective of information choice theory. Battlefield forensics may be subject to biases that reduce the value of the information generated (Whitman and Koppl 2010, 83–84). Hierarchically organized intelligence services may have relatively low epistemic diversity. In any social setting in which some people rely on the paid opinion of others, the problem of experts arises, and the tools of information choice theory may be applied.

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The Rule of Experts    363 Szasz, Thomas S. 1960. “The Myth of Mental Illness.” American Psychologist 15, no. 2: 113–118. Tsuji, M., N. C. A. da Costa, and F. A. Doria. 1998. “The Incompleteness of Theories of Games.” Journal of Philosophical Logic 27: 553–564. Tullock, Gordon. (1966) 2005. The Organization of Inquiry. Indianapolis: Liberty Fund. Turner, Stephen. 2001. “What Is the Problem with Experts?” Social Studies of Science 31, no. 1: 123–149. Tversky, A., and D. Kahneman. 1974. “Judgment under Uncertainty: Heuristics and Biases.” Science 185 (September 27): 1124–1131. Velupillai, K. 2007. “The Impossibility of an Effective Theory of Policy in a Complex Economy.” In Complexity Hints for Economic Policy, edited by M. Salzano and D. Colander, 273–290. Berlin: Springer. Weinstein, Jack Russell. 2006. “On the Meaning of the Term Progressive:  A  Philosophical Investigation.” William Mitchell Law Review 33, no. 1: 1–50. Whitman, D. Glen, and Roger Koppl. 2010. “Rational Bias in Forensic Science.” Law, Probability and Risk 9, no. 1: 69–90. Wible, James R. 1998. The Economics of Science: Methodology and Epistemology as if Economics Really Mattered. London and New York: Routledge. Wilson, Woodrow. 1887. “The Study of Administration.” Political Science Quarterly 2, no. 2: 197–222. Wolfram, S. 1984. “Universality and Complexity in Cellular Automata.” Physica 10D: 1–35. Wolpert, David H. 2001. “Computational Capabilities of Physical Systems.” Physical Review E65, 016128: 1–27. Yandle, Bruce. 1983. “Bootleggers and Baptists: The Education of a Regulatory E27conomist.” Regulation 7, no. 3: 12. Yarna-ll, Megan A. 2009. “Dueling Scientific Experts: Is Australia’s Hot Tub Method a Viable Solution for the American Judiciary?” Oregon Law Review 88: 311–340. Yellen, Janet. 2009. “A Minsky Meltdown: Lessons for Central Bankers.” Presentation to the 18th Annual Hyman P. Minsky Conference on the State of the US and World Economies. http://www.frbsf.org/news/speeches/2009/0416.pdf accessed November 11, 2009.

Chapter 16

The Probl e m of Rationa l i t y Austrian Economics between Classical Behaviorism and Behavioral Economics Mario J. Rizzo

Introduction In the discussion of conduct we cannot separate description from teleological interpretation—the “what” from the “why” in this sense—what is done from what is achieved or expected to be achieved. (Knight 1944, 307)

Psychological economics is enjoying a renaissance. We call it behavioral economics. It differs from the older application of psychology to economics insofar as the kind of psychology and psychological methods used are quite different. But the claim that economics is quite closely related to psychology is not new. On the other hand, the story of neoclassical economics over the past century or so has been captured, in important part, as “an escape from psychology” (Giocoli 2003, 41–133). We see this quite clearly, for example, in Joseph Schumpeter’s long-untranslated 1908 book Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie.1 Schumpeter makes it clear that economic theory should begin only from the outward or objectively manifested actions of individuals: prices and quantities and their movements. There is no need to speculate on the psychological origins of economic behavior.2 1 

This has now been translated as The Nature and Essence of Economic Theory (Schumpeter [1908] 2010). 2  It is notable, however, that Schumpeter restricted this view to what he regarded as static theory. The theory of economic development or change involved entrepreneurship, which clearly involved institutions and psychological factors.

The Problem of Rationality    365 It appears that the young Schumpeter was also responding to intellectual trends that affected psychology. Beginning in 1908, John B.  Watson was discussing what would become behaviorism or behaviorist psychology at professional meetings.3 He summarized and systematized his arguments for a psychology without unobservable mental states in an important article in 1913 and also later in influential books (Watson 1919; 1930). The development of standard neoclassical economics proceeded for most of the twentieth century under the influence (sometimes stronger and sometimes weaker) of scientific behaviorism. Behavioral economics can be seen as a reaction against either the complete elimination of mind in economics, as in the original revealed preference project (Samuelson 1938a; 1938b), or the purely instrumental (predictive) role of apparent mental referents such as preferences and beliefs in contemporary standard theory. Behavioralists treat these concepts as if they were psychological constructs and find them wanting as a foundation for economics. Most important, they claim that preferences and beliefs often do not satisfy the most basic criteria for rationality. Thus, people do not actually behave in accordance with rationality postulates of standard theory. Although behavioral economics rejects the positive claims of standard neoclassical economics, it, perhaps surprisingly, accepts neoclassical normative standards. Thus, behavioral economics is itself a hybrid; it is part psychological economics and part neoclassical economics. Furthermore, many behavioral economists accept the methodological stricture that the new experimental or behavioral insights must be incorporated into the fundamental axiomatic structure of contemporary economic theory. In at least two respects, behavioral economics is less revolutionary than it might at first seem. Both the method and the normative view of rationality are neoclassical (Berg and Gigerenzer 2010). With respect to the role of psychology in economic theory, the Austrian tradition is nuanced. It has attempted to steer a difficult middle course between, on the one hand, the behaviorist-inspired abolition of mental or, as Lionel Robbins (1934) put it, “psychical” elements and, on the other hand, the incorporation of detailed insights from experimental psychology in the manner of behavioral economics. Indeed, it is one of the ironies of intellectual history that at the dawn of Austrian economics, even a relatively sympathetic interpreter of the Austrian theory of value should caution that the subjective value approach threatened to convert economics into a branch of psychology (Bonar 1888, 24). The distinction between subjectivism and psychology was not seen as sharp. Indeed, as soon as we begin taking the perspective of the agent, it is not easy to say where subjectivism ends and psychology begins. For Austrians, the issue is not so much whether there should be any psychological insights in economic theory as it is just what they are and what role they should play. We must distinguish the detailed findings of experimental or behavioral psychology from the fundamental mind-dependency of economic theory. Then we must decide where, if anywhere, the specific findings of psychology belong. Do they affect the basis of 3  It is one of the inconveniences of intellectual history that Watson’s opposition to considering mental states in the explanation of human behavior is called behaviorism, while the modern reinstatement of mental states—albeit in a different form—is called behavioralism. The reader must exercise caution.

366    Public Policy and Interventionism economic theory, or do they have a role only at the level of applications? The difference is that the former may require alteration in the semipermanent structure of economics (axioms), while the latter may simply require adjustments to account for particular kinds of phenomena in particular areas.4 These are large issues. To make the task of this chapter manageable, it shall concentrate specifically on the problem of rationality in individual behavior. It ignores such important questions as: To what extent do institutional constraints function as substitutes for the rationality of individual behavior? To what extent is it desirable to incorporate psychological findings, especially about learning, into the analysis of the social transmission of knowledge? We are dealing only with what Hayek (1937) called the “pure logic of choice.” This chapter is made up of two main parts. The first establishes the rationale and substance of the Robbinsian middle ground—the psychical or mind-dependent character of economics. To accomplish this, I explore three post-Wieserian frameworks for Austrian economics: (1) the phenomenological social science of Alfred Schutz, (2) the structure of mind analyzed by Friedrich Hayek in The Sensory Order, and (3) the later Ludwig Wittgenstein’s logical analysis of thought. While there are no doubt differences among these approaches, they form a broadly consistent way of establishing the essential mind-dependency of economics. The second part of the chapter directly examines the basic issues involved in the characterization of human behavior as rational or irrational. Most important in this effort is the ascertainment of the meaning that individuals express in their behavior. I then go on to examine the roles played by criteria of rationality in logic, belief, and preferences. The primary, though not only, reason we are interested in the rationality of human behavior is the normative significance of rationality. For many economists and philosophers, the issue of rationality is connected to the normative status of human behavior. While simply declaring behavior to be rational does not in itself make it normatively compelling, interpreting a person’s behavior as the pursuit of his own well-being as he sees it at the time of the action is an important element of what economists have called normative economics.

The Mind-Dependency of Economics What Do Economists Study? In 1891, Friedrich von Wieser challenged the characterization of the Austrian school of economics as the “abstract school” in contrast to the historical school’s emphasis on 4  Of course, some economists are, for methodological reasons, extremely sensitive to the possibility of ad hoc adjustments because they think the structure of economic theory is complete or should be so. For them, the distinction between theory and applications may not be so clear.

The Problem of Rationality    367 facts and observation ([1891] 1994). He said that both schools seek “their highest laurels on the fields of observation.” Austrians “are wholly set on being experimentalists” (Wieser [1891] 1994, 237). The interpretation often given to statements like these is that Wieser and others were talking about introspective observation or introspective facts. To a certain extent, this is true, but the interpretation is, in terms of today’s philosophies of science, highly misleading. Wieser’s analysis of the contrast between “objective exchange value” (relative prices) and “subjective value” is illustrative. The former is concerned with the relation between commodities, while the latter is concerned with the relation between commodities and human valuation: Theory has to examine both phenomena. I will restrict myself to showing why it may not neglect subjective values. The reason is, that it would thereby leave unexplained all individual decisions in economic matters, e.g. it would not even explain why any one buys. For by objective standards wares and prices have the same value; by objective standards we always give equals for equals, for which there should be no motive. (Wieser [1891] 1994, 247)

Nevertheless, the buyer values, say, the apple more than the two pears that he has, and the seller values the two pears more than the apple that he has. Differences in the subjective values of buyers and sellers are an explanation of exchange at a given price. If we do not admit this, Wieser believed, we would simply be reporting the observation of an exchange. Nevertheless, it is no part of the theoretical structure of economics to specify the reasons for the subjective valuations of each party, but we say that a difference in such valuations provides the motive for each party to engage in exchange. And yet we can say more. What is an exchange, after all? Schumpeter ([1908] 2010, 31–48) wanted to see it as simply the movement of an object from one “possessor” (location) to another. Could we then see the flight of a butterfly as an exchange? What about movements that are rituals or amusing games? Of course, Schumpeter would resist including these, as well he should. It is only after implicitly recognizing that some movements of goods in location are exchanges and others are not that Schumpeter can afford to empty the concept of exchange of its mental content. In fact, the theorist is “helpless” if he can only rely on the simple observation of movement of physical things (Wieser [1911] 1994, 296). If the notion of exchange must have mental content, what is the bare minimum of that content? The movement of commodities must be purposeful or intentional. It must, of course, be differentiated from a ritual of some sort or from gift giving, each of which would be purposeful in its own way. There seems to be no escaping the characterization that an exchange is, first, conditional (“If you give me this, I will give you that”) and, second, motivated by a desire to improve one’s state of affairs. Wieser’s invocation of differences in subjective values is an attempt to explicate or perhaps simply to state this.

368    Public Policy and Interventionism Generalizing from this point in the theory of value, Wieser ([1911] 1994, 288–89) expresses what will turn out to be an essential insight: The assumption of a physical world which differs from my psychological world and the further assumption of another self which differs from mine but nevertheless resembles it belong to the essential prerequisites of sound thinking and communication of thoughts. … The purpose of every scientific discussion is to produce judgments with a scientific and therefore social value. A writer who tries to present his best reasons as proof of his claims thus tacitly admits these best reasons must also be considered as conclusive by the readers whose agreement he is trying to obtain, and that “the judgment processes of others operate in the same way as his” [quoting Ernst Mach]. That which he assumes of the scientific judgment process, he cannot easily deny of the economic judgment process. (emphasis added)

This idea was further developed by Frank Knight (1940, 7), who argued that our knowledge of the external world “presupposes ‘valid’ intercommunication of mental content, in the sense of knowledge, opinion, or suggestion, among the members of a knowing group or intellectual community.”5 This is because immediate observation itself, whether of the ordinary person or of the scientist, must be tested. At the very least, the perceiver must determine if he is deluded by optical illusions, hallucinations, and so forth. To do this, he refers to other trusted observers or, for example, physical instruments produced by others. If he is a scientist, he uses conventional testing procedures, developed by others, and subjects himself to criticism by a community of rational scientists. Thus, “anything that can be properly called knowledge on the part of the subject is unthinkable apart from self-knowledge and valid intercommunication with similar (competent and trustworthy) knowing selves” (Knight 1940, 8). It may seem possible to agree with this but then to claim that we can ignore the intentionality of economic agents, even if we cannot ignore the intentionality of the economist actors. However, as Wieser suggests, this is not the case. Let us step back for a moment to think about economics in a naive way. What words do economists use? Exchange, prices, capital, savings, and interest rates are some of the first that come to mind. It is hard to imagine economics without these concepts. They do not refer to facts in some brute sense; they are all mental constructions of individuals in a social context. The phenomena of economics are mind-dependent. Schumpeter agreed that economics is fundamentally about exchange (and the other phenomena mentioned above), but he believed that the idea of exchange can be separated from mind-object and mind-mind relationships: 5 

Knight’s argument brings to mind a variant of Bertrand Russell’s “unhappy barber” parable. Let us imagine the “unhappy economist” who thinks about only people who do not themselves think and who, whether he thinks or not, cannot help acting contrary to his definition. If the economist thinks, he cannot think about himself and how to present his arguments. If he does not think, he cannot come up with ideas or think about those who do not think. Poor fellow. See Bernardelli (1936, 449, n. 1).

The Problem of Rationality    369 We interpret  all economic acts as an exchange and assume that even where no exchange actually exists, an economy runs as if it did exist. This is not as paradoxical as it looks. One should note that all economic behaviors mean changes in economic quantities. For example, a man who exchanges labor for bread is changing the quantities of two goods in his possession. The same is also true of an isolated man who shoots game, because he diminishes the stock of bullets or labor and increases the stock of foodstuffs. (Schumpeter [1908] 2010, quoted in Shionoya 1997, 131)

And yet “we do not want to look at the acting humans at all but rather only on the amounts of goods they own: We want to describe the changes, or better a certain type of changes, as if they would happen automatically, without looking at the people who are responsible for those changes” (Schumpeter [1908] 2010, 54). Therefore, Wieser’s criticism of Schumpeter, mentioned above, is on the mark. Schumpeter takes phenomena that cannot be identified, in the first instance, without reference to their subjective (or, better, intersubjective) meaning and then attempts to drain them of all mental or psychical content. He seeks to treat them as physical objects as much as possible. In fact, it has been persuasively argued that “Schumpeter seems to have had what today would have been called a naive positivist view that objective facts exist independently of theories” (Shionoya 1997, 108). However, the phenomena that economics claims to study are mind-dependent. They would not exist without human minds. The basic facts of economics are meaning facts. Yet they are not known by an idiosyncratic or personal intuition shielded from objective scrutiny. They are quite public. For example, we can observe (test) whether people treat certain objects as money or certain labels on commodities as prices. This world of subjective meaning is out there, and moreover, it is epistemically what we must grant to observe the kinds of phenomena we claim to be observing.6

The Prestructured Economic World The structure of the world we seek to explain, or at least describe, in the discipline of economics is not, in the first instance, derivative of specific theories or hypotheses 6  “Is it not the ‘behavior of prices’ rather than the behavior of men in the market situation which is studied by the economist …? Does not the economist investigate successfully subject matters such as savings, capital business cycle wages and unemployment, multipliers and monopoly, as if these phenomena were entirely detached from any activity of the economic subjects, and even less without entering into the subjective meaning structure such activities have for them? … Closer investigation, however, reveals that this abstract conceptual scheme is nothing else than a kind of intellectual shorthand and that the underlying subjective elements of human actions involved are either taken for granted or deemed to be irrelevant with respect to the scientific purpose at hand. . . . Correctly understood, the postulate of subjective interpretation as applied to economics as well as to all other social sciences means that we always can—and for certain purposes must—refer to the activities of the subjects within the social world and their interpretation by the actors in terms of systems of projects, available means, motives, relevancies, and so on” (Schutz 1962, 34–35; see also Weber 1978, 64).

370    Public Policy and Interventionism created by economists. It is a prestructured world of “common-sense” observation that is a framework for the existence of the phenomena that economics seeks to engage. On the other hand, recall that Schumpeter believed that we could empty the basic economic concept of exchange of all mental content. We could imagine, for example, a Cartesian coordinate plane in which we place “individual” X1 with his bundle of commodities a1 and X2 with her bundle of commodities a2. If these two exchange a1 for a2 then X1 is paired with a2 and X2 is paired with a1. The a1 and a2 have shifted location. This basic idea is the root of what later became the axiomatization of general equilibrium theory in the Arrow-Debreu construction. Simply by extending the dimensions, commodities in the possession of an individual (location) can become commodities at a point in time, in a state of the world, and in a contingent state of the world, that is, a dimension with a probability attached to it. This getting down to basics drains the economic world of mental content. All the economist needs to do is establish the relationships among the various points, that is, the relations among the external objects that putatively constitute his or her subject matter. The growing tendency toward the de-mentalization of economics was of increasing concern to Austrian economists in the 1920s and ’30s. The discussions in Vienna both in the Ludwig von Mises circle and in the Karl Menger seminar (Giocoli 2003)  often concerned the proper foundations for economic theory. The issue for Austrians was how to preserve the subjectivity of the theory of value, the foundation of economics, and meet the requirement of scientific objectivity in the construction of theories. Closely related to this was the balancing act in which Wieser, Eugen von Böhm-Bawerk, and others had engaged to eschew psychology in one sense and to embrace it in another sense. What follows is a brief discussion of three approaches that Austrians developed or adapted to meet the challenge of preserving the theory of subjective value along with the general mind-dependent character of economics while, at the same time, ensuring the objectivity of the scientific enterprise. Each of them has very different intellectual origins and looks at the issues from a different perspective. Nevertheless, they lead to a similar place for our purposes and, I suggest, are collectively reinforcing.7 The first is the sociological framework of Schutz, which emphasizes the foundations of social science in a common-sense understanding of the social world. The second is Hayek’s effort in The Sensory Order ([1952] 1976) to provide a psychological foundation for the common-sense construction of the social world. The last is an adaptation of the later philosophy of Wittgenstein to show how mental states can be brought outside the confines of a purely inward scientifically unobservable world (Long 2004; 2006), thus satisfying Wieser’s goal of ensuring the scientific status of the theory of subjective valuation.

7 

I am not arguing that they together form a single, consistent intellectual framework. I am agnostic on this question. So the philosophical purist may wish to see them as alternatives.

The Problem of Rationality    371

Schutz’s Phenomenological Social Science The earliest successful effort to meet these challenges was made by philosophersociologist Alfred Schutz. Schutz was a member of the Mises Kreis in Vienna and left Austria for the United States in 1939. During his days in Vienna, he published Der sinnhafte Aufbau der sozialen Welt (1932), which developed a theory of the foundations of the social sciences, including economics.8 The book was heavily influenced by Edmund Husserl’s work on the foundations of science more generally and, to a lesser extent, by the philosophy of Henri Bergson. Schutz’s work was exposed to the English-speaking world in Stonier and Bode’s (1937) article in Economica and in an article by Schutz himself (1943), also in Economica. Schutz argues that the “observational field” of the social scientist is preselected and preinterpreted by the common-sense constructs of the actors in the social world. This is a structured world of purposes, plans, actions, and ultimately social institutions. Maurice Natanson (1962, xxxv) captures Schutz’s analysis succinctly: [M]‌en in their daily life interpret their world from the outset as a meaningful one. … [The acts of others] are … treated as the conduct of a purposeful creature. Motives and goals are as inescapably part of the other’s behavior as they are of our own. When I encounter a man acting in the world, I know I must understand him as a human being, and this means that his actions mean something to him as well as to me. … But this knowledge is itself taken for granted by me as well as by him; its being taken for granted by us is precisely the typification which makes intersubjectivity possible.

From this, we can infer both the mind-dependency of the economic world and the relative anonymity (abstractness) of the mind constructs with which we, as participants and economists, understand this world. First, Schutz tells us that our daily concrete experience is structured as a common world (“life-world”). In our “natural” or practical attitude, we take the life-world’s characteristics as simply given. Individuals engage one another as thinking, planning, and acting beings within a certain unquestioned framework. This is the basis of the possibility of human interaction. Thus, the specific issues with which the economist is concerned have no existence outside of this constructed world. Without purposes, there would be no problems of scarcity, consumer allocation, exchange, inflation, economic growth, business cycles, and so forth. Second, although we understand the motives and purposes of others, we ordinarily know them not in particular detail but in their typical or abstracted forms. We know the postman, the butcher, and the baker as roles; that is, we know what to expect of them, and they know what to expect of us. We know the meaning of social institutions such as 8  This has been translated by George Walsh and Fredrick Lehnert as The Phenomenology of the Social World (Schutz [1932] 1967). However, another, perhaps more transparent, translation would be “The Meaningful Structure of the Social World.” See Wilson (2005, 20).

372    Public Policy and Interventionism money and the marketplace. We know the meaning of a price. We drain these aspects of social life of their individual detail because we must deal with many particular people, various specific exchanges, different prices, and so forth, in ways that do not require knowledge of the full measure of things. In fact, knowledge of particularistic details would be an information overload. We economize on knowledge by engaging our interactors at a fairly high degree of anonymity. Economists also use ideal types in the development of their theories (Machlup 1978, 273–274).The reasons are similar to those actors have for using ideal types. Economics strives for a fairly high degree of generality. We do not wish to develop a separate theory for every concrete action. Therefore, we abstract from much detail about how real-world agents actually behave. We focus on those motivations and beliefs that are relevant to explaining the particular actions under investigation. If the data of the social sciences are thus mind-dependent, it is hard to see how the questions posed by economists can be answered without reference to mind-dependent categories (O’Driscoll and Rizzo 1996, 17–20). Thus, Schutz ([1953] 1962) argued, the theories of social scientists must be higher-order constructs of the actors’ common-sense constructs. In brief, this means mind constructs of an ideal typical or abstract nature. For example, the higher-order construct of a preference ordering is almost an immediate inference from the recognition that we all face scarcity and need to establish priorities. From this, the economist may generate a “law” of behavior: Individuals will choose courses of action so as to satisfy their wants of greater subjective significance before those of lesser significance. Individuals will impute value to a commodity on the basis of the particular want satisfied by the added or lost unit of that commodity (the marginal unit). And so forth. The idea of a structured life-world functions at three levels. First, it is part of our experience, and hence we take the purposefulness of much human behavior as a fact. Second, it is one of the knowledge requirements of successful human interaction. We cannot engage in exchange without either consciously or tacitly accepting the life-world as the epistemic foundation of our economic behavior. We must know that other people act so that we can determine our own actions. Third, it provides the basis of a method of social-scientific analysis. Since the purposefulness of the life-world constitutes the fundamental building block of the phenomena in search of an explanation, our scientific constructs must bear a logical relationship to statements about the common-sense world. In other words, for example, any statement about exchange must logically presuppose a statement about the purposes of the agents or, at least, that they have purposes.9

Hayek and The Sensory Order In the preface to The Sensory Order, Hayek makes a puzzling statement that, if understood, reveals a connection between theoretical psychology and the social sciences that 9 

I am indebted to David Harper for help in distinguishing these levels. See also Natanson (1962, xxxv).

The Problem of Rationality    373 is very different from the one adopted by contemporary behavioral economics. Let us begin with Hayek’s ([1952] 1976, v) statement in which he says he moved from psychology as a student to the social sciences and then, to an extent, back again: But though my work has led me away from psychology, the basic idea then conceived has continued to occupy me: its outlines have gradually developed, and it has often proved helpful in dealing with the problems of the methods of the social sciences. 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. (emphasis added)

The puzzle is, how does understanding the human mind from the perspective of “theoretical psychology” help us understand the logical character of economics? It is important, at the outset, to know that Hayek’s views on theoretical psychology were heavily influenced by the Berlin school of gestalt psychology of the early twentieth century (De Vecchi 2003). According to this school and Hayek, there are no pure or immediate sensations (or observations).10 Whatever we sense is not independent of processing by the mind. Furthermore, external stimuli of all kinds are organized in a way that is highly dependent on context. For physical objects, it is the physical context. For mental objects, Hayek believes, it is both the physical context and the relationship of the object to the perceiver. The key distinction between the physical and the mental (body and mind) is the way in which the mind classifies the objects. In what we call the physical world, the objects are seen—and in some cases defined—by their relations to one another. In the mental world, they are seen and defined by their relation to the perceiver. And yet even in the latter case, the classifications of the mind are not completely independent of the classifications of the physical objects. For example, a gold bar may be treated as money (relationship to the perceivers), but this treatment is related to the physical object’s hardness and its portability. Human beings perceive according to rules of association or connection. These rules are theories that are prior to the specific theories developed by the social sciences. They are the foundation of social-scientific theories. To see this, let us examine the fundamental classifications of the social world. It is necessary to keep in mind that the focus here is on communication, as in Knight’s analysis (1940, 12–13). While Knight emphasized communication in a scientific community specifically to show the uncomfortable position in which behavioristic social scientists found themselves, Hayek (and Schutz above) looked at the phenomenon of communication more generally. There can be no society as we know it without communication among human beings. 10  Positivism “does not realize that perception is more than sensuous apprehension, that it is an intellectual act performed by the mind. In this regard both associationism and Gestalt psychology agree” (Mises [1962] 2006, 64).

374    Public Policy and Interventionism What does effective interpersonal communication presuppose? Certainly, at the epistemic level, it presupposes that the others with whom one comes in contact are usually acting, that is, engaging in purposeful behavior. One takes for granted that their behavior is “caused” by their desires and beliefs.11 However, that their behavior is purposeful is one thing; the content of those purposes is another. For Hayek, the grasping of meaning is the recognition of patterns in the behavior of others and in oneself. This pattern recognition depends on the whole gestalt of attributes of a given action, especially including its context. Thinking about meaning in terms of pattern recognition is the neural analog to Schutz’s idea of “typification.” For example, my mind classifies the various behaviors of another person as a bond trader. This is the result of his whole set of behaviors in its context being classified in a certain way. There is thus the “bond trader” type. Note, however, that types can be constructed at different levels of abstraction. So at a higher level, the person might be simply a trader or an arbitrageur. At a lower level, he may be a trader in municipal bonds and so forth. There is nothing absolute about any of these classifications. They are relative to the agent’s purposes at hand. At a methodological-scientific level, they are relative to the economist’s purposes. The one thing all of these have in common, however, is the perception and classification of the agent as purposeful. In the early decades of the development of Austrian economics, it was not uncommon to claim that the fundamental propositions of economics have an empirical and introspective basis. (Introspection was considered a kind of observation.) This was certainly encouraged by Wieser’s distinction between knowledge from within and knowledge from without (Wieser 1893). In a sense, of course, all knowledge is from within, since knowledge presupposes the classification activity of the mind. But this is not how many people interpreted it. The idea seems to have been that the economist simply thought about his own purposeful behavior and concluded that this was the way everyone else must be. While it is true that in Hayek’s approach, an individual will not be able to recognize patterns in the behavior of others that he cannot recognize in himself (Hayek 1948), this recognition need not be conscious and thus would not be available to introspection in the usual sense of the word. Hayek makes the difference between what he is saying and introspection clear in three fundamental points. First, subjective experience is misleading. It seems to us that we perceive unprocessed concrete particulars. This is false, because “these concrete particulars are the product of abstractions which the mind must possess in order that it should be able to experience particular sensations, perceptions or images” (Hayek 1978, 36–37). Our introspective view deceives us. Second, the basic classifications of our minds are not deliberate constructions. As Hayek puts it, “the formation of abstractions ought to be regarded not as actions of the human mind but rather as something that happens to the

11 

In an important sense, however, this is always a conjecture. One can be convinced that what one thought was purposeful behavior was really a purely automatic response to a stimulus.

The Problem of Rationality    375 mind” (Hayek 1978, 43; emphasis added). The “automaticity” of this is probably responsible for the idea of unprocessed sense impressions or of purely concrete data. Third, the ordering of both our physical and our mental universe is determined by rules so abstract that we are not consciously aware of them: “much [of what] happens in our mind we are not aware, not because it proceeds at too low a level but because it proceeds at too high a level” (Hayek 1978, 45).12 Thus, our social world, the material of our economic questions, is a construction of the human mind in ways that are not always subject to conscious awareness. Nevertheless, these constructions—derived from the purposefulness of our and others’ behavior—form the elements of social interaction. They are not simply heuristic embellishments, as the early Schumpeter erroneously argued ( [1908] 2010, 49–55). Before concluding this section, we must forestall a possible misconception. To say that the economic universe is constructed by abstract patterns is not to create an insulated aprioristic system. The distinction between a priori and empirical, often cited by economists and other scientists, can be, and usually is, highly misleading and confusing. The mind classifies, organizes, and sees patterns in objects in the physical universe. These objects (say, gold) are in the first instance defined in relationship to other physical objects (a kind of gestalt). The gold is hard, yellow, and so forth. But it is also, when it enters the social world, defined in relation to the perceiver, the economic actor (gold as money). This construction is not independent of the physically defined object, since these properties are relevant to its social function. Both the physical and the mental (or social) relations and classifications emanate from the human mind, but they are not phantoms. Classifications are generated by the individual’s context and history. They are also generated by evolutionary processes that have withstood the pressures of selection, at both the biological and the cultural level. These are complex interactions beyond the scope of this chapter.13 But a fundamental point remains. For the point of view of the individual person, at a point in time, his structuring, organizing, and classifying of the social world has an unconscious and aprioristic character. He sees the world as the context and history warrant. Over time, as his circumstances change, patterns of organization will change or be reshuffled to preserve intelligibility. Over the course of cultural history, there will be further changes, as there will be over the course of biological evolution. 12 

Schutz ([1953] 1962, 56) agrees that the perception of the social world as exhibiting purposeful behavior and meaning “has nothing to do with introspection; it is the result of processes of learning or acculturation in the same way as the common-sense experience of the so-called natural world.” 13  “Those primates who had serviceable categories survived, not because, having had the experience that their categories were serviceable, they decided to cling to them. They survived because they did not resort to other categories that would have resulted in their own extirpation” (Mises [1962] 2006, 13). Further, “The human mind is not a tabula rasa on which external events write their own history. It is equipped with a set of tools for grasping reality. Man acquired these tools, i.e., the logical structure of his mind, in the course of his evolution from an amoeba to his present state. But these tools are logically prior to any experience” (Mises 1966, 35).

376    Public Policy and Interventionism To summarize, it important to see Hayek’s psychological theory in the context of the empirical and antiempirical disputes in the early twentieth century. This has been captured by De Vecchi (2003, 152): Indeed, on the one hand he radicalizes the anti-empiricist position of the Berlin (gestalt psychology) school, because he manages to attribute an “abstract” character to sensory qualities. On the other hand, he … can proclaim himself an empiricist, because he explains the structure of relations that at the level of the central nervous system give meaning to sensory experience by referring to the past experience of the species.

It would be helpful, then, to rid ourselves of the introspective and the confusingly aprioristic characterization of the foundations of the Austrian approach to economics.

Wittgenstein’s Constitution of Thought As discussed above, the undoubted fact that society consists in the possibility of communication among human beings is an important starting point in the methodological conceptions of Wieser, Knight, Schutz, and Hayek. Social science should not—actually, cannot—deny this fact. We base our communication on the epistemic ground that other human beings engage in purposeful behavior. This means, at its most general level, that people’s actions are explained by their desires and beliefs. These desires and beliefs must be organized in a certain logical way, however. We call that thought. This is where the influence of Wittgenstein comes in. Wittgenstein is interested in what constitutes thought. What properties must thought have to be thought in contrast to mere psychological impressions? First, let us see why this is an important question. In everyday parlance, the word thought is ambiguous. It refers both to the purely subjective or psychological contents of the human mind and to the objective contents. In the former case, we might say things like “John Smith believes that all men are mortal, Socrates is a man, and therefore Socrates is not mortal.” Wittgenstein would not call this thought. Thought has a certain objective character. It is not a relationship between John Smith and some group of propositions. It is a relationship among propositions or judgments. This is significant because we could not communicate with a person who always “thought” like John Smith, that is, with a person who is was illogical. We cannot even really know what his “syllogism” means. Logic, on the other hand, provides the objective substratum that constitutes the possibility of our communication and hence of the existence of society as we know it. We can deal or interact with a person who thinks, not with a person who merely experiences psychological impressions. It is important to recognize that, especially in the context of the relationship between economics and psychology, Wittgenstein was reacting to a view held by some

The Problem of Rationality    377 philosophers that the rules of logic are just empirical generalizations about how the mind works. But if so, since all empirical generalizations are contingent, that is, open to possible exceptions, we must be prepared to encounter “logical aliens.” These are people for whom the laws of logic do not apply. At most, we could say to them that they should correct themselves and think logically. Yet in order to sustain this descriptive-normative dichotomy, we would have to entertain the possibility of illogical thought. However, we cannot do this. Beyond mouthing the “syllogism” about Socrates mentioned above, we do not have any idea what it means if taken at face value. If thought is the relationship between propositions, what is the relationship here? None. It is nonsense. Wittgenstein’s view is that we must go beyond the descriptive-normative dichotomy to the position that the laws of logic are constitutive of thought. Without logic, there is no thought, and without thought, there is no objective substratum of communication. Suppose, however, we come across people who seem to be thinking illogically. How should we react? Let me give an example that has been widely discussed in the Wittgensteinian literature:  the woodcutters. This example was first discussed by Wittgenstein himself. Recently, philosopher Roderick Long acutely analyzed it in the context of the methodological status of Austrian economics, specifically, of the logic of action. The following are Wittgenstein’s words (1983, sec. 144–150) as edited and quoted by Long (2004, 351): People pile up logs and sell them, the piles are measured with a ruler, the measurements of length, breadth, and height multiplied together, and what comes out is the number of pence which have to be asked and given. They do not know “why” it happens like this; they simply do it like this: that is how it is done. … Very well; but what if they piled the timber in heaps of arbitrary, varying height and then sold it at a price proportionate to the area covered by the piles? And what if they even justified this with the words: “Of course, if you buy more timber, you must pay more”? … How could I shew them that—as I should say—you don’t really buy more wood if you buy a pile covering a bigger area?—I should, for instance, take a pile which was small by their ideas and, by laying the logs around, change it into a “big” one. This might convince them—but perhaps they would say: “Yes, now it’s a lot of wood and costs more”—and that would be the end of the matter.—We should presumably say in this case: they simply do not mean the same by “a lot of wood” and “a little wood” as we do; and they have a quite different system of payment from us.

There are a number of possibilities for explanation of this behavior. The most straightforward ones, and those that come to an economist’s mind most readily, concern simple computational error or peculiar tastes. If the woodcutters are selling their wood but do not know how to calculate its quantity correctly, they can simply be instructed in correct measurement. In that case, they are playing the same game as we are. The structure of their minds is the same. We can communicate with them. They will change their system of pricing. If the woodcutters know that their customers have some special preference for wood laid out horizontally (for example, it looks nicer), then they can charge more for laid-out wood of the same cubic feet as the piled-up wood. If this practice has been going on for

378    Public Policy and Interventionism a short time, disequilibrium is possible. Outside of equilibrium, the price of the laid-out wood might be much higher. We might see arbitrageurs setting their gears in motion. They buy low and sell high, and the excess price differential disappears. Similarly, the wood sellers would be subject to a “money pump.” A clever person—one who calculates correctly—could buy up laid-out wood relatively cheaply and then resell it back to them at a higher price more than covering the cost of reorganization. The deficient calculators would lose money continually and go out of business. However, in equilibrium, the price will be higher only by the cost of taking piled-up wood and spreading it out—and also by the possibly increased costs of storing laid-out wood. If it is a long-standing practice, as Wittgenstein suggests, and if the price does not vary in this way, this preference explanation will fail. At this point, where do we go in our effort to explain their behavior? Perhaps it is not exchange as economists generally conceive of it. They may be using the words exchange and money, but they do not mean what we mean by them. One can see this easily if instead of using these words they used others that have no connotations or denotations to us (Cerbone 2000, 301). In any event, how would we find out if it is exchange? Well, if their behavior operates according to the constitutive rules of exchange, then it is. But, ex hypothesi, it does not. If it does not quack, it is not a duck. So it is something else. Possibly, it is a religious or other kind of ritual or even a kind of gift giving. Still, it would be purposeful behavior or “action” strictly conceived. We might even notice that such behavior changes in response to exogenous shocks in the costs of engaging in rituals or gift giving. The obvious question that may be posed here is this: Why have we seemingly gone to great lengths to avoid saying that the people are illogical and/or irrational? Let’s be precise about what these characterizations mean. If we say that these people are illogical, we are saying that they think in a way very different from us. It is as if in their world, 2 + 2 = 5. Whatever this is (a mental impression?), it is not thought. It does not have the objective character of thought. Their minds operate according to different principles. We cannot recognize it as mind. Recall that exchange, money, and so forth, are (our) mind-dependent concepts. But then, so also are the concepts of ritual and gift giving. Calling their behavior irrational is even trickier. This might be the case when they simultaneously want to maximize their profits (or believe they are doing so), know that their behavior will subject them to a money pump, and yet price their wood according to the strange method. It is possible, perhaps, to accept this action that is inconsistent with the actors’ desires and beliefs as a temporary phenomenon (akin to a disequilibrium), but it cannot be accepted as a long-standing phenomenon emanating from mind as we know it. Hayek (1948, 66) understood the issue clearly and he also saw, in this connection, the limited truth of introspection as an adjunct to scientific method: [I]‌t is not only impossible to recognize, but meaningless to speak of, a mind different from our own. What we mean when we speak of another mind is that we can connect

The Problem of Rationality    379 what we observe because the things we observe fit into the way of our own thinking. But where this possibility of interpreting in terms of analogies from our own mind ceases, where we can no longer “understand”—there is no sense in speaking of mind at all; there are then only physical facts which we can group and classify solely according to the physical properties we observe.

Recall that in the framework of The Sensory Order, the “mental” refers to the relationship of physical objects to the mind, while the “physical” refers to the relationship among physical objects.14 If they do not have a mind, we must treat the behavior of the woodcutters in physical terms of one sort or another. Their story may be the material for physiological, chemical, biochemical, mechanical reflex analysis, and so forth. It is not human action.

Ludwig Wittgenstein and Ludwig Von Mises Although Wittgenstein was an Austrian philosopher, he was not an Austrian economist. And yet it has been extensively and persuasively shown by Long (no date) that Mises was affected by a set of ideas very close to Wittgenstein’s. We shall not attempt to go over the detailed arguments provided by Long in this chapter. However, we can show, in Mises’s own words, the striking connection between his ideas on the foundations of economics and praxeology more generally and those of Wittgenstein on logic and thought: 1. Logic. “The fundamental logical relations are not subject to proof or disproof. Every attempt to prove them must presuppose their validity” (Mises 1966, 34). 2. Logic and thought. “The human mind is utterly incapable of imagining logical categories at variance with them” (Mises 1966, 34). 3. Logic and experience. “They are the indispensable prerequisite of perception, apperception, and experience” (Mises 1966, 34). 4. Logic and communication. “He who addresses fellow men, who wants to inform and convince them, who asks questions and answers other people’s questions, can proceed in this way only because he can appeal to something common in all men—namely the logical structure of human reason” (Mises 1966, 35). 5. Logic and the science of human action. “Human knowledge is conditioned by the structure of the human mind. If it chooses human action as the subject matter of 14 

Some philosophers refer to the distinction Hayek is making as the difference between the intensionality of mental states (such as desires and beliefs) and the extensionality of physical objects. Desires and beliefs are reported by propositions. These are true only under certain descriptions. (This is what is meant by intensionality). Thus, it may be true that “I want to kill fascists” but not true that “I want to kill beings who share my humanity with all its failings,” even though, extensionally, they are exactly the same people. The description expresses the relationship of the physical objects to the mind. This is absent in a world without mind. Such a world is one of pure extensionality or relationships only between physical objects. See, for example, Rosenberg (2012, 60–69) and Schick (2003, 97–116).

380    Public Policy and Interventionism its inquiries, it cannot mean anything else than the categories of action which are proper to the human mind and its projection into the external world of becoming and change” (Mises 1966, 35; emphasis added). The link between logic and action lies in the type of explanation that economics and other social sciences provide. They explain by making the behavior (action) intelligible in terms of the desires and beliefs of the agents. To do this, certain connections between propositions about desires and beliefs held by the actors must be made. The connections must be in accordance with the laws of logic. Thus: 6. “The real thing which is the subject matter of praxeology, human action, stems from the same source as human reasoning. Action and reason are congeneric and homogeneous; they may even be called two different aspects of the same thing. … [A]‌ction is an offshoot of reason” (Mises 1966, 39). How it came to be that Mises and Wittgenstein had largely compatible views on the nature of logic and the rationality of action may perhaps be attributable in part to the somewhat overlapping membership of the Mises circle and the Vienna circle in the 1920s and early ’30s, especially including Schutz and Felix Kaufmann. More important is that similar ideas were in the air through Vienna during this time. The antipsychologism of Gottlob Frege and of the later Husserl was widely discussed. Both Wittgenstein and Mises picked up on Frege-influenced ideas of the universality of logic (Long 2004, 367, n. 1; Long, no date, 5–6). And the connections among logic, thought, and action were evident in the kind of explanations that Austrian economists had been giving about economic activity. The complex of ideas, discussed in the first part of this chapter, initially explored during the early part of the twentieth century, provides new post-Wieserian bases for the Austrian assertion of the importance of mind in understanding the social order. Many of these ideas were developed, in part, as a result of a perceived need to find an alternative to introspection as a basis for the elementary structures of economic theory (Prendergast 1986, 8–14).

The Problem of Rationality Much of the research in behavioral economics is devoted to using the results of behavioral psychology to show that the standard neoclassical criteria of rationality are not descriptively accurate, even if they have normative force. However, in order to understand the relationship between Austrian economics and behavioral economics, we must have a more precise idea of how Austrians see rationality. To do so, we must make a number of important distinctions. First, we must distinguish between the meaning of behavior and criteria for the rationality of behavior. Abstract criteria of rationality cannot be applied without first

The Problem of Rationality    381 understanding what individuals mean by what they do. Getting the meaning wrong may result in inaccurately labeling behavior as irrational. Second, since rationality is a multifaceted concept, we must distinguish three dimensions: logic, the criteria for belief, and the consistency of preferences.

The Importance of Meaning We cannot know whether or how behavior is rational unless we understand its meaning context. What does the actor mean by his behavior? How does the actor see the alternatives and constraints before him? The old-fashioned behaviorist is at a loss here. Suppose, for example, we equate irrationality of choice with the economist’s observation of inconsistency or intransitivity in the agent’s pattern of choices. This requires that the economist know what the choices mean to the agents. To put it another way, the objects of choice are not simply the entities described in purely physical terms or in the terms that the economist personally considers relevant. The identification of a choice (action), as such, is inseparable from knowing the meaning of the choice as the agent sees it. Consider an individual who chooses the medium-sized piece of cake when both a big and a small piece are also available (Sen 1993). Why he chose this piece is strictly irrelevant to the revealed preference approach. We simply observe that he chose the medium-sized piece. Now suppose the individual is faced with a contracted choice set. He can have either the medium-sized piece or the small piece. He chooses the small piece. Why he has done so is again none of our concern. He has violated the consistency axiom. The elimination of an irrelevant alternative—the big piece—should not make a difference to his ultimate choice.15 The problem (if there is one) is not with the agent but with the economist. He has tried to apply an abstract criterion of rationality in the absence of any idea of what the agent is trying to do or what the options mean to the agent. In the first case, the economist may have informally surmised that the agent wanted to balance the pleasure of cake with the costs of high caloric intake and so he chose the medium piece. But in fact, let us suppose, the options did not (simply) mean or represent pleasure-calorie composites. They may have represented pleasure-politeness composites. If the agent believed that taking the biggest piece was impolite, he was really balancing eating pleasure with politeness costs.16 In that case, the medium-sized piece becomes, in a sense, the largest piece in the second choice situation. The contraction inconsistency vanishes.

15  This is the idea of contraction consistency. It is related to the principle of the independence of irrelevant alternatives. 16  He may have also been concerned about too many calories. In that case, his preferences will have to be defined over three characteristics.

382    Public Policy and Interventionism The general difficulty to which this example points is that in the absence of knowing the agent’s criteria of choice (mental preferences) and his beliefs about the consequences of choosing particular objects, we shall be at a loss to ascertain whether choices are consistent. The agent is not choosing the pieces of cake for their own sake, pure and simple.17 He intends something. We need to know what. This is the first step in the analysis of rationality.

Logic and the Logic of Action Adherence to the rules of logic is fundamental to rationality. The dispute over psychologism in the early part of the twentieth century was a dispute about the status of logic. This had great importance in the development of Austrian economics and its independence from the discipline of psychology (Long 2004, 346–349). Are the laws of logic and mathematics simply empirical generalizations about how the human mind works? If so, then logic and mathematics are properly subjects for psychology. On the other hand, are these laws universally valid, even if no one thinks them? Most logicians and mathematicians implicitly subscribe to the latter view. They are attempting to find out what is true or, at least, what valid inferences are—and not what most people suppose they are. This is important for economics insofar as it attempts to explain human behavior as action, that is, as rendered intelligible by statements about desires (preferences) and beliefs. An illogical transition from the set of desires-beliefs and the associated action will not do: Consider the question “Why are you going upstairs?” answered by “To get my camera.” And yet isn’t it a future state of affairs which is going to be brought about my going upstairs? … On the other hand, if someone says “But your camera is in the cellar,” and I say “I know, but I am still going upstairs to get it” my saying so becomes mysterious; at least there is a gap to fill up. Perhaps we think of a lift which I can work from the top of the house to bring the camera up from the bottom. But if I say: “No, I quite agree, there is no way for a person at the top of the house to get the camera; but I am still going upstairs to get it” I begin to be unintelligible. (Anscombe 1963, 35–36)

The last sentence does not explain the behavior of going up the stairs. It is nonsense. It is not even thought, properly speaking. We can mouth these words, but we cannot think this as a practical syllogism. If we believe that the individual saying these things is not trying to deceive us, then the behavior here described is not rational. Perhaps it is some sort of compulsion best explained by physiology or what-not. 17  Once we identify the objects of choice as pieces of cake rather than in some equivalent physical or chemical terms, we are implying that the objects of choice are simply food. But if the agent’s purposes and beliefs are as outlined above, this is an incorrect description or, at least, an incomplete description.

The Problem of Rationality    383 We could, for certain purposes, confine our treatment of rationality to behavior based on the logical connections between desire-belief complexes and actions. We could treat any and all errors or “crazy stuff ” as exogenous. Consider two examples. It has never been disputed that man does not always act correctly from the objective point of view; that is, that either from ignorance of causal relations or because of an erroneous judgment of the given situation, in order to realize his ends he acts differently from the way in which he would act if he had correct information. In 1833 the method of healing wounds was different from that used in 1933, and in 2033 still another way will presumably be thought suitable. … The causes of action and the goals toward which it strives are data for the theory of action: upon their concrete configuration depends the course of action taken in the individual case, but the nature of action as such is not thereby affected. (Mises [1960] 2003, 34, 36; emphasis added)

The doctors in 1833 and 1933 did their best. Obviously, they were not irrational. On the other hand, even rash emotions need not render behavior irrational: He who acts under an emotional impulse also acts. What distinguishes an emotional action from other actions is the valuation of input and output. Emotions disarrange valuations. Inflamed with passion, man sees the goal as more desirable and the price he has to pay for it as less burdensome than he would in cool deliberation. Men have never doubted that even in the state of emotion means and ends are pondered and that it is possible to influence the outcome of this deliberation by rendering more costly the yielding to the passionate impulse. (Mises 1966, 16)

Notice how Mises treats emotion. He does not treat it as compromising the means-ends rationality of an action. In other words, he does not treat it as a force making for illogical conclusions or one that transforms action into mere behavior. The individual is not thinking as Anscombe’s camera seeker. Mises’s individual makes sense. He says, in effect, “I know that when I am not sitting right in front of this delicious cake, I will abstain in the interests of good health. But here I am—inflamed by my desire. The cake seems more delicious than before, and the cost in good health seems less important.” How is this irrational? Given the valuations, the action is perfectly intelligible. But suppose people believe really stupid things. Should we characterize these people as behaving irrationally? Not in the sense of illogic. Given that I believe a magic ritual will effect a given end—make it rain—I behave rationally in performing it if I desire to stop the rain. Therefore, in general, we separate the truth of the agent’s beliefs and the reasonableness of holding them, on the one hand, from the logic of the action, on the other. Furthermore, it is important to recognize that “we” do this not only in the role of social scientist but, more fundamentally, in our roles as participants in the life-world. We can only understand others, and thus communicate with them, if we separate beliefs (and desires) that we may not share from their implications for action. Given that people

384    Public Policy and Interventionism desire x and believe y, what do they do? This is how we understand and predict in everyday life. This is the basis for the social scientists’ constructs of constructs.

Rationality of Belief This separation is by no means peculiar to Misesian economics or even to Austrian economics; it is characteristic of standard price theory. Kaufmann (1944, 220) provides a convenient illustration: The economist, or rather the interpreter of economic theory, places himself in the situation of the economic subject—in our example a monopolist—who is confronted with the problem: How shall I fix the price and level of output in order to obtain maximum profit? He may err in three respects, namely: (a) in his estimate of the demand function, (b) in his estimate of the cost function, and (c) in his calculation of the maximum profit in terms of these functions. In this sense, (c) is coordinated with (a) and (b). But this should not prevent us from realizing that (c) has a logical status different from that of (a) and (b). (emphasis added)

Given (a) and (b) and the agent’s desire to maximize profit, he will compute or try to compute (c). This is a matter of logic or mathematics; (c) is derivable from the content of his beliefs. The content of (c) is to tell him what his price and output should be. Given all of this, it would be illogical for him to do anything else. Here is where we must be careful. The action referred to in the example is an instance of logical rationality. It is what makes the behavior in this case an action. But there is a further dimension of rationality, that is, the rationality of the estimates.18 “While it (the proposition that a particular price in combination with a particular level of output yields maximum profit) thus presupposes the ‘givenness’ of these two functions, it does not presuppose the correctness of the procedure leading to their establishment” (Kaufmann 1944, 220). What does it mean to talk of the “correctness of the procedure leading to” an estimate or, more generally, to a belief about the present or future state of the world? From the perspective of fundamental rationality, there can be no unique meaning to the rationality of belief or any unique method of arriving at the correctness of estimates. It is true that particular economic models may specify criteria for holding beliefs or certain rational methods of learning. But these cannot have any claim to universal normativity or even general empirical adequacy. There is simply a large element of scientific conventionality involved in these models. The evidence for this is the wide variety of plausible beliefs about the logic of scientific discovery that even a brief perusal of articles in the field will reveal (Curd and Cover 1998). 18  Kaufmann distinguishes between logical rationality and “empirical rationality.” He says, in traditional positivist fashion, that the former is analytic and the latter synthetic. I do not find this characterization helpful, as it implies that logic has nothing to do with reality or that it is a pure convention.

The Problem of Rationality    385 Nevertheless, it will be useful to review two of the normative criteria for rational belief that are held by behavioral and neoclassical economists alike: descriptive invariance and Bayesian learning. Descriptive invariance is an attempt, consistent with the more behavioristic tendencies in neoclassical economics, to evade the psychical or mind-dependent element in the theory of individual choice. For standard economics, it is both a positive and a normative principle; for behavioral economics, it is a normative principle only. Most frequently, this issue is referred to as the framing problem. According to Tversky and Kahneman (1986, S253), “An essential condition for a theory of choice that claims normative status is the principle of invariance: Different representations of the same choice problem should yield the same preference [choice]. That is, the preference between options should be independent of their description.” What can they possibly mean by “the same choice problem” that is “independent of [its] description”? These words seem to mean that there is an objectively characterizable array of options facing the individual independent of his interpretation. Tversky and Kahneman are claiming that the individual sometimes gets “confused” by the particular description of these objects of choice made in the real world or in an experimental situation. Then the individual may inconsistently (irrationally) make different decisions depending on mere descriptive variations. However, a choice problem is nothing else but a problem under a certain description (Rosenberg 2012; Schick 2003). In any variant of desire and belief in explanation of human behavior, the desires and beliefs are reported as propositions or judgments. In other words, we say that the agents believe such and such. But to say this is to describe it in a certain way. There is no escaping that. A description is a way of construing the facts of a problem. An agent may agree that the facts of the situation have not changed but that his understanding of those facts has. This is what may persuade him to change his decision. Frederic Schick (2003, 108–110) provides a compelling illustration of George Orwell in the Spanish Civil War. Is the person Orwell may shoot a “fascist” or a “fellow human being”? The known facts are the same in each description, but their construal is different. The particular construal makes the difference between deciding to shoot and deciding not to shoot. Orwell is admittedly conflicted. He wants to shoot a fascist but not a fellow human being. Tversky and Kahneman will say that making a different decision on the basis of a different description of the same facts is a violation of the principle of invariance. And so it is. But it is not therefore irrational except by a stipulated definition designed to exhibit the prejudices of the old behavioristic epistemology; that is, facts speak for themselves, and interpretation is unnecessary. On the other hand, it may seem that the invariance principle is sometimes dictated by mathematics or logic. Is it not true, one may ask, that if there are two mutually exclusive and exhaustive outcomes of an action—call them X and Y—a p probability of X is equivalent to a (1 - p) probability of Y? Shouldn’t a rational actor make the same decision regardless of how the outcome is framed? If the doctor says that a drug has a p probability of a cure (Y) or, alternatively, a (1 - p) probability of death (X), it should not

386    Public Policy and Interventionism matter to me. The two statements are “informationally equivalent descriptions” (Burkett 2006, 140). However, abstract logical criteria are not sufficient to understand behavior either descriptively or normatively. In general, logically equivalent statements used outside of logic classes or logic textbooks may not have the same semantic content. There can be “information leakage” from the selection of the particular frame, which, in turn, can be received by those who interpret the frame (Sher and McKenzie 2006). The act of selecting or interpreting a frame is part of the premaximization process. It selects or receives information that can be relevant to the decision at hand. Consider the earlier descriptions of a medical treatment. Are they informationally equivalent? In normal everyday contexts, it appears that they are not. McKenzie and Nelson (2003) show that people select and interpret the different logically equivalent formulations when they are implicitly comparing the result relative with a norm or expected result. The p-description is more likely when the framer is conveying that the survival data are better than might be expected, that they may be better still if certain structural features in the world have changed, or if there is reason to believe that in the case at hand, the doctor’s degree of belief in a successful result is greater than the statistical frequency.19 The selection of frame is an information message. The study of human action and choice is not simply an exercise in applying abstract logical relations. Before the logic of choice can enter the picture, both actors and analysts must attend to the meaning attached to decision, to the objects of choice, to the ways in which choice is conceived or presented. Framing is preeminently part of the process of rationality, that is, part of the process by which agents set up a decision problem in the first place. At that point, and only relative to that point, we can assess the rationality of their behavior. Let us assume, merely for purposes of argument here, that the Bayesian approach is the best way to model learning or the acquisition of beliefs. What are the implications for the rationality of choice? Remarkably little changes from the treatment of beliefs in Mises’s analysis above. Given strange beliefs, strange actions will follow. In the first instance, Bayesian learning provides a normative standard not of which beliefs to hold but of the appropriate (rational) degree of confidence to have in beliefs, that is, the rational degree of belief. Since for most Bayesians there are no constraints on initial or prior degrees of beliefs except coherence, Bayesian learning does not preclude any degree of belief in a statement of hypothesis. Therefore, the rationality of belief consists in the rationality of updating one’s initial degrees of belief. If people begin with different priors, there is no reason in principle that these people will converge on the same ultimate degrees of belief. Thus, Bayesian rationality cannot require convergence. The Bayesian principle of conditionalization is an attempt to “extend the justification of the laws of deductive logic to include a justification for the laws of inductive logic” (Talbott 2011, sec. 1). Although rationality has a clear meaning in the sense of logical 19 

On the last point, Gigerenzer (1994; 1996) has emphasized the inappropriateness of simply applying relative frequencies to single case.

The Problem of Rationality    387 thought, it does not have so obvious a meaning in terms of the search for empirical knowledge. Bayesian learning is about carving out the deductive aspects of inductive inference. Consider that once the prior degrees of belief are somehow established, the conditional probabilities are ipso facto determined. Conditionalization is simply bringing out what was implicit in the initial degrees of belief as we partition the initial set of possibilities (Albert 2009). When events occur, they reduce the set of possibilities and thereby in a systematic way cause reallocation of the remaining unchanged probabilities. Thus, this approach is an extension of the idea of deductive thoroughness or omniscience in the realm of degrees of belief. If you have certain priors, then you must also have certain conditional probabilities. Then, as events unfold, the consequent posteriors will ensure that even the most absurd decisions can be optimal.20

Consistency of Preferences It is important to understand that preferences in themselves are neither rational nor irrational. Economics does not prescribe the ends toward which agents aim. This is generally accepted by both the Austrian and neoclassical traditions. Nevertheless, the point has been obscured by, for example, the identification of rationality with expected utility theory. While standard neoclassical economics says, for example, that people are motivated by expected levels of wealth (or expected levels of utility) in risky or gambling situations, behavioral economists say that in many cases, they are motivated by relative changes in wealth (losses or gains relative to some baseline). So in this view, rationality is tied to a specific preference or carrier of value. To the extent that it is shown that real people have preferences relative to a baseline—perhaps difficult to identify precisely—they violate a standard model of rational behavior under risk. But that is really the long and short of it: the standard model fails; rationality does not. In general, however, the issue of the rationality of preferences has arisen in the context of sets of preferences that may be internally inconsistent. Amartya Sen (1993) has adequately disposed of the behaviorist (revealed preference) notion of inconsistency and intransitivity by showing, as discussed above, that one cannot identify inconsistency without knowing the goals (carriers of utility) of the agents. Yet the problem is deeper than this. Action takes place in time, and thus, we cannot observe choices synchronically (Mises 1966, 103). Strictly speaking, the transitivity of preferences, as a logical criterion of rationality, does not involve a series of binary choices but a supergame that includes all of the options (Anand 1993). For example, a series of choices over time may be c ≺ b, b ≺ a, and a ≺ c. Is this an intransitive preference 20  To establish even this limited sense of belief rationality requires, in my view, heroic assumptions about betting analogies. The issue of belief is reduced to the special case of betting odds even where individuals have no intention of betting and are in no danger of Dutch book exploitation. Then there is the problem of the rigidity of conditional probabilities. See Talbott (2011) and Glymour ([1981] 1998).

388    Public Policy and Interventionism system? No. On the other hand, suppose an individual were willing at a point in time to accept the outcome of paying dollars to another person in accordance with the above preference relation. He starts out with c and gives up c plus a dollar for b, then gives up b plus a dollar for a, and finally gives up a plus a dollar for c. So he has decided to give up three dollars and with c still in his possession. In fact, in the spirit of the synchronicity of transitivity, he simply pays someone now three dollars for nothing. This behavior could be irrational (that is, a nonaction). But this is not what revealed preference transitivity is usually about. It usually conflates transitivity with constancy by saying that we assume constant tastes (or, more exactly, the economist has decided to model the series of binary choices as if it were, or should be, a single utility function). This example makes two general points. First, transitivity as a logical criterion does not apply to actions over a period of time. Second, if we are to find irrationality in synchronically intransitive behavior, we must not look to the internal structure of the behaviors themselves. The irrationality of behavior must be relative to consequences. The elements of a behavior complex, such as those in the three-step exchange above, are for the sake of some outcome. Therefore, the only criterion can be: Is the behavior self-defeating?21 If so, then it is not plausibly an action. Some other discipline, certainly not economics, must be involved in its explanation.

Conclusion We have attempted to develop the rationale and substance of the middle ground between a psychology-dominated economics and a largely de-mentalized or mindless economics. This middle ground, I think, is largely what Lionel Robbins meant by the “psychical” element in economics. Let us conclude by pulling together the various strands of our analysis in eleven points: 1. Economics does not study phenomena constituted in terms of the relationship to one another. The phenomena of economics are constituted in terms of their relationship to the mind. 2. The standard neoclassical “escape from psychology” went too far. It became an unsuccessful attempt to escape from mind altogether. It could not be consistently implemented. 3. Explanation in economics, especially microeconomics, generally proceeds in terms of exhibiting the rationality of the individual’s behavior. When we ask why an individual or group of individuals did something, we invoke desires (preferences), beliefs, and the manner of problem construal. 21 

Mises (1966, 104) suggests that the actor may be (mischievously?) trying to refute the assertion that his actions are rational—in which case, they are.

The Problem of Rationality    389 4. Especially when faced with odd behavior or beliefs, the economist tries to enter into the problem situation as faced by the agent. To understand how the agent sees things is the first step toward rationalizing his behavior. 5. The rationality of action is, at its most fundamental level, the logical structure of thought. In other words, the desires, beliefs, and problem construals are organized in a logical framework akin to a practical syllogism. 6. This is not only a scientific way to understand what is going on, but it is also a way we can understand and interact with people who may have very different desires, beliefs, and construals from ours. 7. This technique may require that we exogenize more than preferences but also beliefs and construals. 8. Exogenization does not mean that for descriptive or positive analysis we do not ever care to learn about how certain beliefs may be formed. In those cases, the learning processes may be endogenized. It also may rest on psychological findings. But as long as we are dealing with purposeful behavior, the psychological insights do not weaken the case for rationality. 9. The logic of action is a limited form of rationality. For example, it does not address questions about how much individuals should take as given in their system of beliefs. It does not tell us how an individual should construe a problem situation. (Is the man on the battlefield a fellow human being or a fascist?) It does not tell us what tastes a person should have. 10. Behavioral economics is often impatient with these constraints. It seeks ways to exceed the traditional boundaries without introducing the value judgments of the economist. It has not succeeded. What it has attempted to do is to challenge the descriptive accuracy of specific formalizations of the rationality principle, such as (diachronic) transitivity of preferences or expected utility theory or Bayesian updating, without challenging the normative significance of these formalizations. 11. When we step back to view the substance of these criticisms, we more often than not see the limitations in the critics’ understanding of the character of economics. The fundamental rationality of human action is unaffected, because logic is still logic. People are still purposeful.

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Chapter 17

Dy nami c s of Intervent i oni sm Sanford Ikeda

Introduction Interventionism is a policy doctrine based on the belief that government authorities can effectively steer a “middle way” between laissez-faire capitalism and collectivist central planning. Supporters of interventionism seek to preserve the wealth-creating and efficiency properties of the private ownership of the means production, while using political means (i.e., legitimized aggression in the sense of Oppenheimer ([1914] 1975) to direct the market process and avoid the putative weaknesses of both laissez-faire capitalism and pure collectivism. Interventionism gives rise to the so-called mixed economy. The economic consequences of an intervention such as price control or fiscal policy have been thoroughly studied. But the unintended consequences of the overall doctrine of interventionism and the logic that links one intervention (or disintervention) to another has not been an area of systematic study in the mainstream. On the other hand, interventionist dynamics, driven by both incentive problems and knowledge problems, have been a central and long-standing feature of Austrian political economy. There are three aspects to the dynamics of interventionism (Ikeda 1997; 2005). The first focuses on the sequence of events that occur within the area of the market system where public choosers—that is, those whose choices influence public policy (e.g., voters, bureaucrats, politicians, interest groups)—initially intervene. Among the negative unintended consequences of drug prohibition, for example, are higher prices for and a lower quality of the banned drug (Thornton 2007), resulting in calls for further interventions to address those perceived problems. These are the internal responses to an intervention. The second aspect focuses on how an intervention impinges on the system external to the initial intervention. For example, drug prohibition not only affects the price and quality of the banned drug, but it may also increase the school dropout

394    Public Policy and Interventionism rate by raising the returns from drug dealing, promote the formation of gangs and the enforcement of illegal drug-market territories through gang violence, and foreclose the opportunities to discover potentially valuable alternative uses of the banned drugs. Again, these spillover effects tend to provoke further interventions. They are the external responses to an intervention. The third aspect of interventionist dynamics concerns the way in which interventions impinge over time on the attitudes, norms, and ideology of public choosers, which in turn tends to influence how public choosers subsequently respond to negative unintended consequences that result from either intervention or disintervention. And although the internal, external, and attitudinal consequences of interventionism are not predictable in their particulars, I will attempt to show that it is possible to make falsifiable predictions about the general patterns of those consequences.

Interventionism as Neither Laissez-Faire Capitalism nor Pure Collectivism The mixed economy, within which the dynamics of interventionism takes place, lies in the vast range of politicoeconomic systems between laissez-faire capitalism and pure collectivism. Interventionism in practice is an amalgam of ad hoc government policies and programs. Richard Wagner (2009, 1) has described the result as entangled political economy, “wherein relations among state-based and market-based enterprises are knotted together in complex ways, with each type of enterprise participating in the activities and domains of the other type.” Laissez-faire capitalism and pure collectivism both have ordering principles that, while radically different from each other, lend them a certain logical coherence. Interventionism lacks a similar ordering principle, making the mixed economy highly unstable and logically incoherent (Ikeda 2005). The market process is a self-sustaining and self-regulating system of social cooperation that emerges from a legal framework that largely respects private property, voluntary exchange, and the rule of law. It is a spontaneous order—that is, the result of human action but not of human design (Hayek 1967). When resources are scarce and knowledge imperfect, alert agents in the market process discover profit opportunities by reconciling discordant plans (Kirzner 1973). To the extent that political means are used under laissez-faire, or the so-called free market, they are limited to maintaining that framework, preserving domestic security, and providing a limited number of public goods (i.e., goods subject to nonexclusivity and nonrivalry) in a way that neither intentionally privileges nor disadvantages any person or group. The free market harnesses self-interest to minimize costs, but, more important, it rewards entrepreneurship and innovation, releasing Schumpeterian “gales of creative destruction.”

Dynamics of Interventionism    395 At the other extreme of the politicoeconomic spectrum is pure collectivism, in which the state controls all means of production. While the organizing principle of the free market is entrepreneurial competition, the organizing principle of collectivism is central planning and rule following. The state rather than the market process allocates resources and distributes wealth, which means that private claims to resources must always defer to the decisions of the planners. The effective abolition of private property means that economic calculation of profit and loss using money prices is impossible, rendering robust and complex economic development also impossible. Unlike laissez-faire capitalism, the collectivist state cannot as a rule permit people to pursue their own plans, because doing so would necessarily create unexpected and costly disruptions to the central plan (Hayek 1944). Interventionist dynamics arise out of the clash between the market process and the governmental process. The governmental process consists of the interactions of public choosers over time in governmental institutions—for example, the bureaucracy and legislature—in response to events in the mixed economy. Whereas the market process, though never perfect, has money prices to help guide profit-seeking entrepreneurs in making decisions, the governmental process lacks those organizing principles and relies much more on bureaucratic rule following and central planning (Mises [1944] 1969). Consequently, the response of public choosers tends to be relatively sluggish, although voting, exit, and voice give some information feedback. The elements of interest in the governmental process from the viewpoint of Austrian political economy are the unintended consequences of actions that then require public choosers to adjust in ways they may not have expected (Ikeda 1995).

Interventions as Varied as the Perceived Market Failures That Motivate Them In order to isolate the knowledge effects from the incentive effects of the interventionist process, Austrian political economy often assumes that public choosers support interventionism because they sincerely believe that it will better promote the general welfare than the free market, not because they simply want to further some special interest. This assumption of beneficence on the part of public choosers underlies the rationales for interventionism in the standard economics of market failure, that is, market equilibria that are in some sense systematically inefficient. There are thus interventions for every putative market failure. In the case of microeconomics, public-spirited people may advocate the use of political means to provide public goods; combat externalities; tax or prohibit undesirable behaviors; subsidize or otherwise support desirable behaviors; lower the price of housing; raise the price of labor; promote workplace safety; mandate the provision

396    Public Policy and Interventionism of healthcare; regulate land use, especially in the form of building, zoning, and design ordinances; provide for sewers, roads, and other community infrastructure; redress or prevent various kinds of discrimination; equalize incomes or wealth; and impose regulations, informed by psychology or behavioral economics, for paternalistic reasons. Macroeconomic interventions include fiscal policy aimed at stimulating or (more rarely) slowing down economic growth by changes in government spending, borrowing, or taxation. Likewise, monetary policy, typically via a central bank, manipulates the supply of money and credit often to address perceived problems of inflation (or deflation) and to boost economic activity. Support for either microeconomic or macroeconomic interventions necessarily assumes that public choosers have both sufficient knowledge and the proper incentives to effectively solve the problems they have identified. As we will see, economists in the tradition of Austrian political economy tend to question both of those assumptions, especially the knowledge assumptions of the neoclassical paradigm.

Milestones in the Austrian Critique of Interventionism It may be useful to view the main contributions to the development of Austrian political economy in terms of eight historical milestones. (1) Ludwig von Mises’s Theory of Money and Credit ([1912] 1971) contains what Don Lavoie (1982) identifies as the genesis of the analysis of the dynamics of interventionism, in a discussion of the effects of price controls. In addition, however, Mises sets out his business cycle theory, which Mises ([1949] 1963) and F. A. Hayek ([1931] 1967; [1933] 1975) later further develop into what is often referred to as Austrian business cycle theory (ABCT). ABCT incorporates what I believe to be the main elements of the interventionist dynamic:  well-intentioned interventions resulting in negative unintended consequences that seem to call for further intervention, an unsustainable cumulative process of frustrated intentions, and a systemic crisis that finally makes plain the choices facing public choosers. A brief outline of that theory will serve here to illustrate these points. ABCT begins with public choosers who believe that macroeconomic performance is below acceptable levels and attempt to stimulate economic growth by increasing the supply of money and credit into an economy. Doing so drives market interest rates below the “natural rate” that would arise from the unhampered interaction of the demand for and supply of loanable funds in accord with actual time preferences. Relying on the interest-rate signal, investors are misled into thinking that the supply of private savings is larger than it really is. As a result, businesses undertake projects that are unsustainable in the long term, in the sense that the future demand that entrepreneurs depend on in order to profitably sell their greater future output never actually materializes

Dynamics of Interventionism    397 because deferred consumption (i.e., saving) earlier in the process never takes place. As a result, production, prices, and private investment threaten to collapse, as consumers’ time preferences reassert themselves and market interest rates rise as they realign with actual time preferences. Entrepreneurs will adjust by curtailing projects and reallocating resources to where the return is more in line with actual preferences. But this correction would entail unemployed labor and resources in the short term. If public choosers do not realize that their policy is fundamentally unsustainable, they may choose at this nodal point to expand credit still further in order to avoid the negative consequences associated with the systemic correction. If they do so, they avoid the problem in the short term, but because people continue to err in their private investments, the misalignment between actual and perceived preferences will only grow worse. Ultimately, the unsustainable process must reach a systemic crisis, at which point public choosers will have to abandon their interventionist policy, in favor of either more comprehensive economic planning or a more laissez-faire approach. In this way, ABCT can serve a paradigm for the dynamics of interventionism in the way it integrates radical ignorance, error, market-process correction, nodal-point decision-making, systemic crisis, and the fundamental instability of the interventionist process. (2) In his seminal article, “Economic Calculation in the Socialist Commonwealth,” Mises ([1920] 1935) argues that rational economic calculation is impossible under pure socialism, owing to the absence of private property rights and the consequent absence of market exchanges that give rise to money prices. Money prices are an indispensable aid for agents to calculate profits and losses that indicate ex ante where investment decisions are likely to be worthwhile and ex post whether those decisions were correct. Hayek ([1945] 1948, 80) later argues that market prices also reflect the relative scarcity of goods and services, without which agents would be unable to utilize “the particular knowledge of time and place” needed to coordinate the plans of countless individuals. Prices then coordinate more poorly insofar as they are not allowed to adjust to changes in tastes, technology, and resources. Mises’s analysis of the central role of property rights and relative prices set the stage for the next important contribution, his Critique of Interventionism ([1929] 1977) and his Interventionism: An Economic Analysis ([1940] 1988). In the Critique, Mises uses a stylized example to explain how price controls set off a series of market consequences and political responses that constitute an interventionist dynamic. The example is a central paradigm in Austrian political economy. Mises begins by supposing that public authorities believe that milk prices are too high. They may do so for narrowly selfish reasons, but Mises (and Hayek after him) tends to assume that they are men and women of goodwill. Given their ideological propensities, however, they choose to use political means to force milk sellers to charge a price lower than the current market price. If that controlled price does not cover the marginal cost of supplying milk, some sellers will withdraw milk from the market, even while additional buyers, attracted by the now lower prices, will demand more milk. The result is a milk shortage, a consequence well understood in the literature.

398    Public Policy and Interventionism At this point, which I will henceforth refer to as a nodal point, the authorities can address the shortage either by removing the price ceiling or by intervening further. Taxing activities in other markets to provide subsidies to milk sellers is one option, in which case similar kinds of distortions will occur in those markets. Mises supposes, however, that the authorities will try to lower milk sellers’ costs by extending price controls to some or all of the input markets that supply milk sellers. Those input markets, however, will eventually also suffer shortages, so that the authorities, with their limited knowledge and ideological propensities, will again have to decide whether to intervene further or to disintervene. If at each nodal point they choose more intervention, the politicoeconomic system will eventually reach a crisis where the market process can no longer function, because the price system will have become so distorted that it no longer effectively transmits information about relative scarcities or enables reasonable calculations of profit and loss. Moreover, interventions may have so discoordinated plans that what Mises terms the “reserve fund” (i.e., exploitable private wealth that can be used to finance interventionist policies) becomes exhausted. At that nodal point, a major systemic crisis, public choosers will have to decide whether to reject interventionism and either pursue more comprehensive collectivist planning or turn radically toward laissez-faire capitalism. In Mises’s exposition, the authorities choose to intervene further by imposing one price control after another. Other kinds of interventions to remove the milk shortage, such as subsidies, would, however, have the same dynamic, market-distorting consequences. (For an analysis of these alternative responses, see Ikeda 1997.) (3) Hayek extends the analysis of collectivism in “The Use of Knowledge in Society” ([1945] 1848), in which he introduces the concept of (though not the term) the knowledge problem. He argues that economic modeling and statistical methods do not make the problem of economic calculation more tractable for the central planner. As Hayek ([1945] 1948, 77) explains, “The reason for this is that the ‘data’ from which the economic calculus starts are never for the whole society ‘given’ to a single mind which could work out the implications and can never be so given.” Rather, the relevant knowledge is contained in the minds of individuals scattered across the economic system. Moreover, the kinds of data most relevant for economic decisions are for the most part not codifiable by those persons or not legible by anyone who is not “on the spot” and therefore cannot be contained in formal models. Instead, they are “knowledge of the particular circumstances of time and place,” that is, local or contextual knowledge. If Lucy offers Linus health insurance, is that an efficient or a wasteful thing to do? If Jack gives Jill a loan, can he trust her to pay him back? Only Lucy, Linus, Jack, and Jill are in a position to have the economic incentive and are practically situated to know. (4) Later, Israel Kirzner (1973) points out that it is not only the case that the central planner does not have the relevant local knowledge, but even people on the spot may not themselves be aware of knowledge relevant for their decision-making or may mistakenly believe that they are aware. It is one thing to know that you don’t know something, quite another to not even know that you don’t know. Economists use the term rational ignorance to refer to the former—ignorance by choice—but radical ignorance

Dynamics of Interventionism    399 is not knowing that you don’t know something. Kirzner goes on to explain that a benefit of the entrepreneurial competitive process, in addition to the ones identified by Mises and Hayek, is that the prospect of gaining entrepreneurial profit from eliminating radical ignorance gives Lucy, Linus, and others the incentive to become aware of previously undiscovered opportunities for improvement or else be displaced by people who are. (5) While Hayek’s The Road to Serfdom (1944) concerns the incompatibility of central planning and democracy, what is most relevant for us is his description of the way in which “extensive government control … produces a psychological change, an alteration in the character of the people” (xi), in which “the political ideals of a people and its attitude toward authority are as much the effect as the cause of the political institutions under which it lives” (xii). I have elsewhere (Ikeda 1997; 2005) identified three ways in which such “ideological” change might take place and termed them the gradual-acceptance thesis, the self-fulfillment thesis, and the dynamic trade-off thesis. Ideological change either reinforces or offsets the dynamics of both interventionism and disinterventionism. Briefly, if we assume that people under laissez-faire capitalism are initially reluctant to use political means, the gradual-acceptance thesis refers to the way in which observing others employ political means to further personal ends lowers one’s own reluctance to do likewise. Next, the self-fulfillment thesis refers to the way in which the abstract idea of social justice (or its equivalent) only becomes coherent once the state gets involved in redistribution. That is, in the absence of intervention, differences in income and wealth inevitably occur as the result of myriad private decisions, the unplanned outcome of impersonal market forces rather than of anyone’s conscious decision. But when public choosers intervene in the market process to achieve a particular result, their decisions single out specific persons or groups for privilege or penalty. At that point, social justice becomes coherent, because it is then possible to trace unequal outcomes back to specific decisions. Finally, the dynamic trade-off thesis refers to more than the trade-off between personal freedom and security. In order to privilege a particular group in society—for example, by protecting large corporations against competition or insuring organized labor against unemployment—it is necessary in some way to restrict the economic freedom of others, such as via taxation or legal barriers to entry. Restricting the freedom of these others entails further constraining how they might adjust to changing socioeconomic conditions, and that in turn increases their insecurity and may stimulate a demand on their part for further interventions for protection. If public choosers then meet those demands, it will be at the expense of the security of still others, and so the demand for intervention spreads from one sector of society to another. In this way, ideological change and changes in the rules, norms, and conventions of social interaction that complement it, are an important part of the interventionist process. If incentive and knowledge problems (which I outline below) fuel the process, then ideological change directs it. (6) Kirzner’s “The Perils of Regulation” (1985) contributes enormously to our understanding of interventionism. Kirzner distinguishes four possible unintended consequences of an intervention.

400    Public Policy and Interventionism The first he terms the undiscovered discovery process, which refers to public choosers’ presumption that the unhampered market process would be unable on its own to solve the various forms of market failure enumerated earlier and that public choosers have the knowledge and ability to intervene so as to correct them. Kirzner follows up with the unsimulated discovery process, which refers to the inability of public choosers even to mimic what the market process would have done. In the absence of an entrepreneurial competitive process, “How will government officials know if their earlier decisions were in error and in what direction to make corrections … how will government officials discover those opportunities for improving the allocation of resources, which one cannot assume to be automatically known to them at the outset of a regulatory endeavor?” (Kirzner 1985, 139–140; emphasis in original). The third unintended consequence is the familiar stifled discovery process. Interventions can interfere with prices, property rights, and even social rules, norms, and conventions that promote interpersonal coordination over time. That makes it harder for people to detect entrepreneurial profit opportunities (especially the ones owing to overpessimism), which freely adjusting prices, dependable property rights, and the proper social institutions enable us to see (Kirzner 1985, 141–144). Finally, there’s the wholly superfluous discovery process, which channels entrepreneurship into areas where the market process would not otherwise have gone. In some cases, this may be relatively innocuous, such as peanut butter instead of almond butter. But if the redirection is indeed wholly superfluous, the results may be undesirable even from the point of view of the supporters of interventionism, who might abhor bribery and corruption in addition to the regulatory thickets that grow as clever people innovate around interventions and public choosers respond with interventionist “solutions.” All part and parcel of the dynamics of interventionism. (7) The contributions of Mises, Hayek, and Kirzner provide the theoretical core of interventionist dynamics. I  mention in passing several other contributions that are important in the development of the analysis of interventionism. One of the first to attempt to explicitly extend Mises’s critique is that of Walter Grinder and John Hagel (1977, 67), who emphasize the role of political elites in wielding political means to protect and stabilize their interests against the relentless forces of the market process. Murray Rothbard’s Power and Market ([1970] 1977) offers a wide-ranging economic analysis of various forms of interventionism and provides a means of classifying interventions as autistic, binary, and tertiary. Robert Higgs (1989) highlights the role of ideology in the expansion of state power. And Lavoie (1982) points out a number of gaps in Mises’s analysis, including his handling of nationalization. (8) Among more recent contributions to the study of interventionist dynamics, and Austrian political economy more generally, the following deserve special mention: Peter J. Boettke and Edward Lopez (2002) on the relation between Austrian and public choice approaches to political economy (along with Ikeda 2003 on the same topic); Robert Bradley (1995) on the dynamics of oil and gas regulation; Higgs’s (2005) critique and development of Ikeda (1997; 2005); and Mark Thornton’s (2007) extensive analysis of the (Austrian) economics of prohibition.

Dynamics of Interventionism    401

The Misesian Paradox Mises ([1929] 1977, 25)  characterized interventionism as illogical, unsuitable, and unworkable:  “In this sense it may be said that limited intervention is illogical and unsuitable, that the economic system that works through such interventions is unworkable and unsuitable, and that it contradicts economic logic.” Essentially, he argued that while the free market has an internally consistent organizing principle, that is, competition in a regime of private property and money prices, interventionism has none. Interventionism attempts to preserve enough of the private property order to retain capitalism’s innovativeness and dynamic efficiency. At the same time, it tries to address problems associated with the free market. But what these problems are and how far intervention goes before it transforms into one of the various forms of collectivism (e.g., socialism, communism, fascism) is arbitrary. As we have seen, these can range from the provision of national defense, to education, to urban planning, to income equality, to environmental sustainability, to antiracism, and so on. There is, however, no principled stopping point. Where action takes place in the presence of radical ignorance, the consequences of any given intervention and public choosers’ responses to them will be impossible to predict. Political expediency conflicts with economic principles. And it is the clash of interventionist intentions, whether benevolent or opportunistic, with the market process in which myriad private choosers attempt to form and execute their own plans, that gives interventionism its incoherent character. But Mises’s assertion raises the question of why such an inherently problematic nonsystem dominates the economies of the modern world. That is the Misesian paradox. It has a fairly straightforward resolution: instability does not imply transience. If we imagine a scale of politicoeconomic systems ranging from anarcho-capitalism at one extreme and pure collectivism at the other, the mixed economy and the dynamics of interventionism occupy the bulk of the territory in between. So even if the mixed economy is never stable, moving constantly between collectivism and the free market, the systemic space in which it can do so is sufficiently vast to contain all of the world’s politicoeconomic systems.

Opportunism Motivating Interventionism As we have seen, Austrian political economy traditionally assumes that public choosers seek to promote the general welfare, that they are motivated by beneficence. While often, though not always, empirically false, the assumption serves to isolate the knowledge problem from the problem of perverse political incentives. Among

402    Public Policy and Interventionism some contemporary Austrian political economists, however, it seems to be more common to assume with Wagner (1989, 56) that “Policy failure has often been attributed to mistakes and ignorance, but it might rather be the result of the rational pursuit of interest and not really a failure from the perspective of those whose interests are controlling the choice at hand.” Interventionism in which public choosers are motivated mainly by opportunism, that is, taking advantage of someone’s vulnerability and gaining at his or her expense, has been called political capitalism or crony capitalism, in which special interests use political means as a shield against the creative destruction of the market process. Tariffs, quotas, exclusive franchises, raising rivals’ costs—interventions that are typically cloaked in socially progressive language—are forms of rent seeking, that is, the use of resources to acquire government privilege for economic advantage. Whether you emphasize opportunism or knowledge problems depends largely on the perceived source of government failure. This raises the question of what government failure is.

Two Concepts of Government Failure Political economists associated with Austrian political economy use the term government failure to refer to interventions that systematically make things worse than they were before, where the cure is somehow worse than the disease. But there are at least two meanings of government failure, depending on how one determines whether things are worse than before. Two quotations illustrate the point. The first is from an introductory economics textbook by Heyne, Boettke, and Prychitko (2006, 331): (1) [T]‌he demonstration by modern political economists of the tendency within democratic governments to concentrate benefits and disperse costs within policy-making has been one of the most important contributions to our intellectual understanding of why good politics is not necessarily good economics.

For example, implementing a government project where the total cost to a community is $3 million but only provides a total benefit of $1 million (resulting in a deadweight loss of $2 million) would be grossly inefficient. Despite this, if authorities forced everyone in a community of one million to pay an equal share of the cost while at the same time limited the benefit of the project to one thousand people, it may well be enacted. That is because the losers would pay no more than $3 each, while beneficiaries would each receive $1,000, and the gainers would presumably have a greater incentive to pass the project than the losers would have to fight it. Compare with this, Hayek’s The Road to Serfdom (1944, 71):

Dynamics of Interventionism    403 (2) Against the innumerable interests which could show that particular measures would confer immediate and obvious benefits on some, while the harm they caused was much more indirect and difficult to see, nothing short of some hard-and-fast rule would have been effective.

The kinds of measures Hayek has in mind are things such as minimum-wage laws that appear to benefit workers at the bottom of the wage scale but, as is well established in the economics literature (Gorman 2008), actually price lower-skilled workers out of the market over time. Employers will avoid hiring a person whose marginal product is worth less than the legal minimum wage, as is likely the case if he or she is young and unskilled. At first glance, statements (1) and (2) appear to be saying more or less the same thing. Both identify a source of systematic government failure: in the first, concentrated benefits versus dispersed costs; in the second, immediate and obvious benefits versus harm that is indirect and difficult to see. Both identify interventions that benefit only some while their consequences fall elsewhere or elsewhen. And both imply that the outcome of interventions will tend to be undesirable to someone. Note, however, that statement (1) is in terms of “benefits” and “costs,” while statement (2) speaks of “benefits” and “harm.” Perhaps one could interpret harm as the cost that is dispersed in the first statement, although harm has a more general meaning that may not be easily quantifiable, such as undermining the norm of preserving the free market. More specifically, statement (1)  focuses on concentrated benefits, while statement (2)  focuses on the immediate and obvious benefits. Beneficiaries of the government project get $1,000 each, while only some under the minimum-wage regulation (i.e., those who are still employed ex post) benefit at all. Now, beneficiaries in both cases can see immediately what they are getting, but those proposing the minimum-wage law in the Hayek case mistakenly believe that it will benefit everyone, or at least all workers, not just a few, while the people in the Heyne, Boettke, and Prychitko concentrated-benefits approach are fully aware that only a few will benefit from the intervention. The “costs” in statement (1) are dispersed, while the “harm” in statement (2) is indirect and difficult to see. In the Heyne, Boettke, and Prychitko case, the $3-per-person cost of the government project is certainly not indirect or difficult to see; rather, all, both gainers and losers, do see it, but it’s too small an amount for most to bother with. The economic problem is that few have an incentive to do anything about it. However, the harm in the Hayek case of the minimum-wage law is indirect and difficult to see, so that acquiring that knowledge is hard. Moreover, time is not necessarily an element in statement (1), but it is an important element in statement (2). It’s because some time has to pass before you can see the full consequences of an intervention that makes them difficult to see. Finally, the nature of government failure in statement (1) is defined in terms of inefficiency and deadweight loss:  the total social costs exceed the total social benefits. Government failure in statement (2), on the other hand, is based on misperception or

404    Public Policy and Interventionism error; actual outcomes deviate from intentions. Statement (1) implies that inefficiency is systematic because the political rules of the game make people follow perverse incentives, while statement (2) implies that error is systematic because interventions hamper learning. And statement (1) suggests that people can manipulate the system with full knowledge of all the consequences so that they can effectively concentrate benefits on themselves or their cronies and disperse the costs among taxpayers—announced intentions differ from actual intentions—while statement (2) suggests that the harm that a policy causes is largely unintentional and the result of (radical) ignorance—actual outcomes differ from intended outcomes. Hayek (1944, 134–152) does argue, however, that under collectivism, perverse incentives and self-selection mean that “the worst get on top.” In short, the Heyne, Boettke, and Prychitko approach emphasizes incentive problems, whereas the Hayek approach emphasizes knowledge problems. Both approaches certainly correspond to and can explain the causes and consequences of interventions, sometimes the same intervention, although there are occasions when one or the other might be more appropriate. For example, some political economists argue that labor unions say they favor raising the minimum wage to express solidarity with their nonunion brethren but that they really support it because it insulates their members from competition from unskilled workers. Wagner (1989, 47)  has even characterized the approach to political economy that emphasizes “concentrated benefits, dispersed costs” as “a proposition about inferring intentions from outcomes,” which implies that public choosers unerringly connect intentions to outcomes. Attributing such perfect information to public choosers, however, rules out the possibility of knowledge problems and genuine error. As we have seen, Mises’s formulation at least implicitly assumes radical ignorance in contrast to the more common rational ignorance. Public choosers genuinely err when they fail to consider the negative unintended consequences of an intervention. Mises also assumes that public choosers are men and women of goodwill and that they are genuinely trying to better the situation of their constituency and not themselves. This serves, among other things, to separate the Heyne, Boettke, and Prychitko incentive problems from the Hayek knowledge problem. So we can distinguish two mutually exclusive assumptions about the knowledge that public choosers have, either perfect knowledge or radical ignorance, and two mutually exclusive assumptions about their incentives, either opportunistic or beneficent. This gives us four possible approaches to political economy:

(a) (b) (c) (d)

Perfect knowledge with beneficence Perfect knowledge with opportunism Radical ignorance with beneficence Radical ignorance with opportunism

I identify approach (a) with the public interest approach to political economy, which is the approach taken by most advocates of interventionism. Approach (b) is characteristic

Dynamics of Interventionism    405 of much of public choice, as reflected in Wagner’s statement about “inferring intentions from outcomes.” Such inference is only possible if we assume that the chooser has perfect knowledge. Approaches (c) and (d) embody radical ignorance and are thus the ones most consistent with Austrian political economy. We can identify approach (c) with the critique of interventionism in the tradition of Mises and Hayek, while approach (d) is the one suggested by Boettke and Lopez (2002) and Ikeda (2003) for the further development of Austrian political economy. We now explore more carefully the implications of the incentive-cum-ignorance approach to political economy.

A Closer Look at the Dynamics of Interventionism The static consequences of particular interventions are well known and rigorously analyzed in neoclassical economic theory. In positive analysis, the familiar microeconomic tools—demand and supply, utility and production functions—make it fairly easy for the trained economist to trace out the effects on price, cost, quantity, and quality of various forms of intervention, such as barriers to competitive entry, taxes and subsidies, the costs and benefits for producers and consumers of various regulations. And neoclassical macroeconomic models—aggregate demand and aggregate supply, the labor market, investment savings and money demand-and-supply equilibria—are also well known. On the normative side, particularly with respect to microeconomics, interventions—legal barriers to entry, taxes and subsidies, regulation of production and consumption—have been shown to generate deadweight losses in which social costs exceed social benefits, or to create Pareto-suboptimal outcomes. Of course, the existence of deadweight losses or suboptimality does not necessarily rule out the desirability of an intervention, because public choosers may agree that, say, reducing income inequality by X is itself worth incurring inefficiencies amounting to Y. The normative standard in Austrian political economy does not rest on equilibrium standards or on the concepts of optimality or efficiency: “Consequently we do not ask whether interventionism is good or bad, moral or immoral, to be commended or condemned. We merely ask from the standpoint of those who want to put it into operation whether it serves or frustrates their intentions. In other words, does its application attain the ends sought?” (Mises [1940] 1988, 2). In both positive and normative terms, however, the dynamics of interventionism, that is, the logic of the entire interventionist process (internal and external effects plus ideological change), have not been the subject of analysis outside Austrian circles, at least in a non-Marxian context. Using the interventionist dynamics spelled out so far, I will now examine some of the main kinds of intervention to illustrate how those dynamics operate.

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Price Control First, we have already seen how price control contributes to interventionist dynamics. The positive effects go far beyond the surpluses or shortages that occur within the target area of an intervention during the early stages of the process. Interventionist dynamics encompass the subsequent decisions that public choosers make at nodal points external to the target area on the basis of relative price effects (i.e., the surpluses or shortages) and ideology, which together determine whether the process broadens the scope of government authority and moves the social order further along toward collectivism or reduces intervention toward the free market. As negative unintended consequences accumulate, as the price system becomes more distorted and the underlying property rights progressively undermined, the social order will eventually reach a major macrocrisis, at which point the interventionist roots of systemic failure become easier to see. At that nodal point, public choosers will have to decide whether to push radically toward collectivism or back toward the free market, because interventionism will have become delegitimized. Note that the failures of an intervention that are most easily perceived, which we will call errors of overoptimism, induce choosers imbued with an interventionist ideology to intervene further into the market process. Second, according to standard microeconomics, price controls create inefficiencies, but given perfect knowledge, people instantaneously adjust to them. Consequently, the reduced output and consumption are actually optimal given a price ceiling. From the Austrian viewpoint, however, not only are people not immediately aware of surpluses and shortages (owing to radical ignorance), but the unintended external effects of price controls involve distortions in relative prices, prices that are themselves typically not in equilibrium. For Kirzner (1973), relative prices are an indispensible guide to decision-making outside of equilibrium, where entrepreneurs profit from discovering disequilibrium arbitrage opportunities. And so when price controls distort prices, those arbitrage opportunities become harder to see, and individual plans are more likely to remain discoordinated. Less reliable price signals mean poorer judgments on the part of entrepreneurs, more passed-up opportunities, and error.

Impact on Property Rights The socialist calculation debate highlighted the role of private property rights in the market process. In the case of pure collectivism, we have seen how the absence of private property means no market trade and thus no money prices to guide profit seeking or loss avoidance or to signal the relative scarcity of resources. This result is robust in the sense that as interventionism brings the social order closer to pure collectivism, and the more it compromises the underlying property rights, entrepreneurs will find prices less and less reliable. Thus, interventions that undermine or delegitimize private claims to property, such as income redistribution or constraints on the use and disposal

Dynamics of Interventionism    407 of property, will over time reduce the ability of the price system to help entrepreneurs discover genuine instances of plan discoordination.

Nonprice Regulation In the standard economics, the effect of nonprice regulation is typically to raise cost and, like price control, to generate inefficiencies or deadweight losses. As with price controls, however, the Austrian view looks at the impact these regulations have on relative prices outside of equilibrium and their impact on the property rights to the relevant resources. Distortions in relative prices hamper the entrepreneurial competitive process in the same way price controls do. The usual distinction between price and nonprice regulation, then, is thus much less important in Austrian political economy than in standard microeconomic analysis.

The New Paternalism Economics research has been growing in the area of behavioral economics. Rizzo and Whitman (2009) critique the application of some aspects of behavioral economics to public policy, especially so-called new paternalism. While not directly related to the dynamics of interventionism, their critique does fit squarely into Austrian political economy. Behavioral economics is based on research into how individuals may not always act in their own best interests: “People are not fully ‘rational,’ as economists understand that term, because their choices are adversely affected by various cognitive biases, insufficient willpower, and difficulties of information processing” (Rizzo and Whitman 2009, 103). New paternalism draws on some of this research to justify interventionist sin taxes, default enrollments in savings plans, cooling-off periods, risk narratives, and so on. New paternalism emphasizes the possibility of making individuals “better off ” according to their own preferences (Rizzo and Whitman 2009, 106), which purportedly is what differentiates it from “old paternalism.” But Rizzo and Whitman argue that the new paternalism not only ignores the incentive problems that face the people who enact and enforce new-paternalist interventions, but more fundamentally, it ignores the Hayek-Kirzner knowledge problem: If well-meaning policymakers possess all the relevant information about individuals’ true preferences, their cognitive biases, and the choice contexts in which they manifest themselves, then policymakers could potentially implement paternalist policies that improve the welfare of individuals by their own standards. But lacking such information, we cannot conclude that actual paternalism will make their decisions better; under a wide range of circumstances, it will even make them worse. New

408    Public Policy and Interventionism paternalists have not taken the knowledge problems that are evident from the underlying behavioral and economic research seriously enough. (Rizzo and Whitman 2009, 105–106)

An issue related to both the knowledge problem and behavioral economic considerations is whether the same kinds of behavioral maladies that afflict private choosers, which purportedly justify intervention, might not also afflict public choosers. While there seems to be no good reason they shouldn’t, Berggren (2012, 216)  finds that in top-flight economics journals between 2000 and 2009, “only two of the 67 articles in behavioral economics with a policy recommendation contain an assumption or analysis of the policymakers of the same kind as that applied to economic decision-makers.” This seems to be a potentially very important, but so far largely neglected, area of research, one that could cast even more skepticism on the workability of interventionism.

Two Kinds of Interventionist Dynamics Whether internal or external, the effects of an intervention follow the general interventionist pattern. But there are nevertheless important differences between the interventionist dynamics that are driven primarily by regulation and those driven by redistribution.

Regulatory Dynamics If regulation rather than redistribution is the dominant form of intervention in the mixed economy, regulatory dynamics will drive the interventionist process. I  have termed the resulting politicoeconomic order regulatory-state capitalism. In Market Theory and the Price System, Kirzner ([1963] 2011, 122–123) identifies two classes of errors that people commit in the market process. The first are errors of overoptimism. Wilma values her car at $10,000 and overoptimistically thinks she can sell it for $20,000, which is more than anyone will actually pay. That entails deliberately passing up opportunities to sell at lower prices, some of them above $10,000. Or Fred, who would pay as much as $15,000 for a car, overoptimistically thinks he can buy one for $12,000, which is lower than anyone will actually sell. As a result, he deliberately passes up opportunities to buy at higher prices, some of them below $15,000. At the end of the day, Wilma and Fred will wind up disappointed, realize they’ve made a mistake, and regret having done so. The second kind of market-process errors are errors of overpessimism. Barney thinks the most he can charge for his house is $100,000, when Betty would be willing to pay up

Dynamics of Interventionism    409 to $150,000; while Betty thinks she has to pay a minimum of $175,000 for a house, when Barney would be willing to accept as little as $125,000. The result is a lost opportunity to gain from trade. At the end of the day, neither Barney nor Betty need realize he or she had made a mistake at all, because their pessimism has kept them from acting. For them, there is, in a sense, nothing to regret. Of course, if they discover the opportunities to buy and sell, they will do so, but for Barney and Betty, that discovery does not have the same inevitability as it does for Wilma and Fred. Errors of overpessimism are thus harder to detect than errors of overoptimism. Errors of overpessimism are the sorts of errors that generate dynamic inefficiencies in consumption and production—overlooked costs or benefits over time—as in the case of Barney and Betty, which require a more dynamic form of entrepreneurial alertness to discover. Fred and Wilma, however, are almost bound to discover their errors of overoptimism when they see a surplus or a shortage at the end of the day. These are the kinds of shortages and surpluses that public choosers respond to at nodal points and that propel the interventionist process forward. Regulatory-state capitalism is driven by such regulatory dynamics.

Transfer Dynamics If income (and wealth) redistribution rather than regulation is the dominant form of intervention, then transfer dynamics drive the interventionist process. I have termed the resulting order welfare-state capitalism. Redistribution entails tax and subsidy on a large scale. If the redistribution benevolently seeks to address income inequality, the government may tax people who earn more in order to subsidize those who earn less (or nothing at all). Such a policy has well-understood disincentive effects: both those taxed and those subsidized will have less of an incentive to earn taxable income. In addition, however, to the extent that redistribution undermines private property rights, it will also indirectly distort relative prices. But outside of labor markets, redistribution distorts relative prices less severely than regulatory capitalism, while price controls and nonprice regulations impinge much more on prices and profit-and-loss calculations. Thus, pure welfare-state capitalism will tend to be more stable, though still subject to interventionist dynamics, than pure regulatory-state capitalism. Consequently, a pure welfare state may be longer-lived, because errors of overpessimism, owing to the hidden discoordination and inefficiencies more typical of the pure welfare state, are harder to detect than errors of overoptimism more typical of the pure regulatory state (subject to the qualification I make with respect to credit expansion). Ideology and ideological change may also play a greater role in transfer dynamics, because while considerations of efficiency and market failure are the focus of interventions in the regulatory state, considerations of fairness and justice often motivate (benevolent) redistributionist policies. Ideology may thus be both a driving and a steering force in the welfare state.

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Credit Expansion as a Complicating Factor Monetary and credit expansion can facilitate either regulatory-state capitalism or welfare-state capitalism, especially when the political cost of direct taxation of fiscal measures is high. But using credit expansion to offset the booms and busts associated with macroeconomic growth have effects that are especially relevant to the study of interventionism. As explained earlier, from the Austrian perspective, ABCT incorporates the main elements of the interventionist dynamic: well-intentioned interventions resulting in negative unintended consequences, an unsustainable cumulative process of government failure, and a systemic crisis that reveals the stark choices that public choosers must face. Monetary manipulation can exacerbate the problems associated with regulatory and transfer dynamics. In particular, if credit expansion finances a significant part of welfare-state capitalism, that may decrease its stability compared with regulatory-state capitalism and hasten the onset of a major systemic crisis.

The Role of Changes in Ideology and Norms in the Interventionist Process Ideologies, like preferences, are generally considered to be outside the purview of economic theory. But in Austrian political economy, the unintended consequences of interventions themselves can endogenously alter the ideological preferences of public choosers. That is the role of Hayek’s gradual-acceptance thesis, self-fulfillment thesis, and dynamic trade-off thesis discussed earlier. Ideology is not entirely endogenous, however. In the interventionist process, public choosers can change their minds and can choose at nodal points to reverse the collectivist momentum of the process or to allow the momentum to continue. Ideology and people’s ability to perceive the negative consequences of their policies (see Ikeda 1997, 110–112) are particularly important during major, systemic crises. The cumulative effect of negative unintended consequences generates the nodal points at which the inner contradictions of interventionism and the unworkability and incoherence of the mixed economy become manifest. It is at these moments when public choosers are most likely to reject interventionism. Their choices can push the social order toward laissez-faire or toward collectivism. Interventionism also has unintended consequences for rules, norms, and conventions. While the market process may be possible without, for example, rules of fair play and reciprocity, norms and beliefs that enforce those rules, and conventional understandings of what constitutes a contract, and so on, their absence would severely constrain the opportunities for risk taking, long-term investment, and innovation. In turn, the market process itself promotes these “sociological factors” by enabling weak ties (Granovetter 1973) to form among people who are socially distant from one another, and

Dynamics of Interventionism    411 there is evidence that the market process is a major factor in fostering trust in diverse communities around the world (Heinrich et al. 2010).

Disinterventionist Dynamics as Part of the Interventionist Process In a certain sense, the progressive movement of the politicoeconomic system toward collectivism entails the shifting of private investment away from more controlled areas of the system, where returns have fallen owing to burdensome regulatory or redistributive interventions, toward those areas that are relatively free of interventionist entanglements, where returns tend to be higher. We have seen, however, that with each shift, public choosers respond to negative unintended consequences by intervening further. We might view the contractionary phase of the process, in which public choosers have chosen to disintervene by reducing regulatory and redistributionist policies, in a similar way. At the point at which the system reaches a macrocrisis, there are likely to be few attractive investment opportunities. At that point, of course, public choosers may decide to jettison interventionism in favor of greater collectivism and central planning. But, as I have argued, the ideology prevailing among the relevant public choosers is only partly endogenous. Contractionary disintervention is still possible. Disintervention would imply shrinking the scope of government authority so that growing areas of the system would become freer of superfluous or stifled discovery processes and become places where private investment could earn higher returns than in more controlled sectors. Interventionist dynamics then reverse themselves, and the ideological momentum turns back toward freer markets, releasing entrepreneurial competitive forces and reestablishing market-promoting social norms and institutions. If the interventionist process does reverse direction, the reversal is likely to be sudden and dramatic. That is because at the point of macrocrisis, systemic problems would be much like those that follow from errors of overoptimism: their source will have become so apparent that public choosers are almost bound to realize that piecemeal intervention is inherently unworkable and so reject interventionism as a policy doctrine. One advantage of such a widespread rejection and large-scale disintervention is that otherwise, bottlenecks may occur in vital supply chains that would prevent a higher degree of plan coordination and inefficiency reduction than might otherwise have been possible, frustrating the intentions of radical reformers. If that frustration quells enthusiasm for reform, those bottlenecks could jeopardize disintervention by weakening public choosers’ ideological commitment to freer markets. The result would likely be recidivism. Thus, the more radical and far-reaching the rejection of interventionism is, the fewer and less significant such bottlenecks will be, and the more promising will be the prospects for reform.

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The Possibly Unstable Minimal State For Mises, interventionism entails the use of political means beyond the minimum needed to provide those services deemed necessary for the effective functioning of the market process and that cannot be provided by profit-seeking enterprise. Such services must then be provided bureaucratically (Mises [1944] 1969, 441). Or as Mises ([1949] 1963, 722) put it, “the only purpose of the laws and the social apparatus of coercion and compulsion is to safeguard the smooth functioning of social cooperation.” According to Mises, there is no intervention in minimal-state, laissez-faire capitalism. While a social order that was protected by a minimal state would be less subject to the kinds of conflicts between the market process and the governmental process, between bureaucratic and profit management, than a more interventionist mixed economy faces, it would not be completely immune to them. Taxing, spending, and regulation in a minimal state would still, under imperfect knowledge, generate negative unintended consequences of the kind, though perhaps not of the magnitude, typical of the mixed economy. It is probably only a matter of time then before those dynamics—incentive problems, knowledge problems, and ideological propensities—take hold.

Examples Systemic Crises Leading to the Rejection of Interventionism For examples from the twentieth century of systemic crises that result in the rejection of intervention in favor of collectivism, see tsarist Russia and Weimar Germany earlier in the century; and for examples of mixed-economy regimes that rejected extreme interventionism in favor or freer markets, see the Soviet Union, the People’s Republic of China, and New Zealand later in the century.

The Panic of 2008 and Its Aftermath The events surrounding the “Great Recession” also follow this pattern. Many subscribe to some version of Hyman Minsky’s (1986) thesis that speculative financial bubbles are inherent in laissez-faire capitalism. The American economy, however, especially its financial markets circa 2007, were hardly laissez-faire. Indeed, the decisions and events culminating in the panic of 2008 and its aftermath follow very closely the narrative of interventionism. In brief, from 1998 to 2006, the United States experienced a housing boom in which median prices rose from just less than $60,000 to more than $90,000 (in 1983 dollars),

Dynamics of Interventionism    413 owing in large part to the “flexible” lending policies of the Federal Reserve System. The “federal funds rate,” which the Fed targets via open-market operations, dropped from near 6 percent in January 2001 to 1 percent in January 2004 (in nominal terms). Much of this was in response to the recession that accompanied the events of September 11, 2001, and also in support of the federal government’s decades-long commitment to expanding single-home ownership. In any case, as ABCT would predict, the US economy experienced a short-term boom in the form of a bubble in the housing and financial sectors. In the third quarter of 2006, loan defaults and foreclosures began their sudden climb (Liebowitz 2009). By 2008, investment banks and other financial institutions that, after years of encouragement from the government and government-sponsored enterprises such as Fannie Mae and Freddie Mac, held a significant part of their assets in mortgage-backed securities (MBSs) with defaulting loans. Large financial concerns such as Bear Stearns, Lehman, and AIG saw their asset values plummet. Panic raced across the rest of Wall Street, and the Dow Jones crashed again and again. In the midst of the panic, the government intervened and nationalized a significant and ever-growing percentage of the financial market. In short: (1) Government legislated and the Fed helped to implement flexible standards in the mortgage industry. (2) Throughout the 1990s and early 2000s, government pressured Fannie Mae and Freddie Mac to purchase an increasing proportion of MBSs and subprime loans (based on flexible standards), while at the same time (perhaps unintentionally), loosened traditional lending standards across the board. (3) From 2001 to 2004, the Federal Reserve deliberately drove interest rates down (as much as 5 percentage points) in order to stimulate the economy. (4) This all fueled a speculative housing boom beginning in 1998, financial innovations on Wall Street based on MBSs and other derivatives in the early 2000s, and a housing bust in 2006. (5) This in turn precipitated an historic financial collapse and equally historic bailout in September 2008. Horwitz and Boettke (2009) tell essentially the same story. Greed and overly exuberant speculation were clearly part of it—they are as constant as gravity in any politicoeconomic system. Given the breadth and depth of involvement by government institutions and policies, however, blaming the Great Recession solely on the free market is nonsense. It is rather almost a textbook example of the dynamics of interventionism.

Conclusion: Implications and Pattern Predictions Prediction is a matter of degree. At one extreme are point predictions that predict an event precisely, with little or no margin of error: “The Consumer Price Index on January 31, 2025, will be exactly 30 percent higher than on January 31, 2015.” At the other extreme are pattern predictions about the behavior of an entire class of phenomena rather than a specific event within that class: “Prices will rise between 2015 and 2025.” Reasoning,

414    Public Policy and Interventionism then, from the aspects of interventionist dynamics discussed here, it is possible to derive the following pattern predictions, taken from Ikeda (2005, 45). Ikeda (1997, 213–232) provides a detailed derivation and interpretation of these propositions and discusses their empirical implications at greater length. 1. At any given time, nearly all economic systems will be mixed economies. 2. Nearly all existing systems will be in flux, cycling somewhere between the extremes of laissez-faire capitalism and complete collectivism. Of these, the majority will tend to be moving secularly toward collectivism. 3. A mixed economy in the expansionary phase will be characterized by a series of micro- and lower-level macrocrises that ultimately culminate in a major macrocrisis encompassing the entire politicoeconomic system. 4. If there is a turning point at which public choosers reject the interventionist ideology and take radical steps toward either pure collectivism or the minimal state, it will occur at a systemic macrocrisis. 5. Turning points will occur on the politicoeconomic spectrum closer to pure collectivism than to laissez-faire capitalism. 6. State expansion will tend to take place more continuously than state contraction or disinterventionism, which, especially in its initial stages, will display change of a more rapid, radical, and sweeping nature. 7. The pure welfare state (absent monetary manipulation) will be less prone to severe macrocrises and endure longer than the pure regulatory state, although it is still subject to the same underlying instability and tendency toward systemic failure. 8. The more strongly committed public choosers are to the principles of the minimal state, the less likely it will be that changes in endogenous ideological preferences, in response to governmental error, will generate the critical mass among the public that is needed to initiate the dynamics of interventionism.

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Dynamics of Interventionism    415 Grinder, Walter E., and John Hagel III. (1977). “Toward a Theory of State Capitalism: Ultimate Decision-Making and Class Structure.” Journal of Libertarian Studies 1, no. 1: 59–79. Hayek, F. A. (1931) 1967. Prices and Production. Clifton, NJ: Augustus M. Kelley. Hayek, F. A. (1933) 1975. Monetary Theory and the Trade Cycle. Clifton, NJ: Augustus M. Kelley. Hayek, F. A. 1944. The Road to Serfdom. Chicago: University of Chicago Press. Hayek, F. A. (1945) 1948. “The Use of Knowledge in Society.” In Individualism and Economics Order, 77–91. Chicago: Regnery. Hayek, F. A. 1967. “The Results of Human Action but Not of Human Design.” In Studies in Philosophy, Politics and Economics, 96–105. Chicago: University of Chicago Press. Heinrich, J., et al. 2010. “Markets, Religion, Community Size, and the Evolution of Fairness and Punishment.” Science 327, no. 5927: 1480–1484. Heyne, Paul, Peter J. Boettke, and David L. Prychitko. 2006. The Economic Way of Thinking, 11th ed. Upper Saddle River, NJ: Pearson/Prentice Hall. Higgs, Robert. 1989. Crisis and Leviathan:  Critical Episodes in the Growth of American Government. New York: Oxford University Press. Higgs, Robert. 2005. “The Ongoing Growth of Government in the Economically Advanced Countries.” Advances in Austrian Economics 8: 279–300. Horwitz, Steven, and Peter J. Boettke. 2009. “The House That Uncle Sam Built.” Foundation for Economic Education. http://www.fee.org/library/detail/the-house-that-uncle-sam-built#a xzz2nvc1A3f6. Ikeda, Sanford. 1995. “The Use of Knowledge in Government and Market.” Advances in Austrian Economics 2A: 211–240. Ikeda, Sanford. 1997. Dynamics of the Mixed Economy: Toward a Theory of Interventionism. New York: Routledge. Ikeda, Sanford. 2003. “How Compatible Are Public Choice and Austrian Political Economy?” Review of Austrian Economics 16, no. 1: 63–75. Ikeda, Sanford. 2005. “Dynamics of Interventionism.” Advances in Austrian Economics8: 21–57. Kirzner, Israel M. (1963) 2011. Market Theory and the Price System. Indianapolis: Liberty Fund. Kirzner, Israel M. 1973. Competition and Entrepreneurship. Chicago:  University of Chicago Press. Kirzner, Israel M. 1985. Discovery and the Capitalist Process. Chicago:  University of Chicago Press. Lavoie, Don C. 1982. “The Development of the Misesian Theory of Interventionism,” in Method, Process, and Austrian Economics: Essays in Honor of Ludwig von Mises, edited by Israel M. Kirzner, 169–183. Lexington, MA: Lexington Books. Liebowitz, Stan J. 2009. “Anatomy of a Train Wreck: Causes of the Mortgage Meltdown.” In Housing America: Building out of a Crisis, edited by Benjamin Powell and Randall Holcomb. http://ssrn.com/abstract=1211822. Minsky, Hyman. 1986. Stabilizing an Unstable Economy. New York: McGraw-Hill. Mises, Ludwig von. (1912) 1971. The Theory of Money and Credit, translated by H. E. Batson. Irvington-on-Hudson, NY: Foundation for Economic Education. Mises, Ludwig von. (1920) 1935. “Economic Calculation in the Socialist Commonwealth.” In Collectivist Economic Planning, edited by F. A.  Hayek, 87–130. Clifton, NJ:  Augustus M. Kelley. Mises, Ludwig von. (1929) 1977. Critique of Interventionism, translated by Hans F. Sennholz. New Rochelle, NY: Arlington House.

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Pa rt  V I

P OL I T IC A L E C ON OM Y

Chapter 18

Ord olibera l i sm and the Austria n S c h o ol Stefan Kolev

Introduction As it is widely known, the Austrian School of economics came into existence out of the clash of its founder, Carl Menger, with German economists of the Younger Historical School around Gustav von Schmoller. The Methodenstreit that started in the 1880s was a truly multifaceted debate centered on the role of theory in social sciences, the famous induction-versus-deduction issue being one of several battlefields (Koslowski 1995; Louzek 2011). In the ensuing decades, animosity perpetuated itself as the two schools followed diametrically divergent paths. While the second Viennese generation around Eugen von Böhm-Bawerk and Friedrich von Wieser spent its intellectual energy to creatively apply Menger’s marginalist approach to fields such as capital theory or imputation theory, in Germany, the historicist paradigm exhausted itself intellectually, came under attack by younger scientists such as Max Weber, and proved unable to explain the economic disturbances during and after World War I (Köster 2011, 41–60). After World War II, the situation was completely different. Suddenly, the discourse between representatives of Austrian and German economics—some in exile abroad, others in “half-exile,” as their inner emigration was characterized (Johnson 1989, 40)— was not only vivid, but it was characterized by a common spirit, shared values, and, at least partially, proximate ideas on how economics was to be conducted and applied to economic reality. The reasons for this shift in the intellectual relations were manifold but can be depicted with one symbolic transformation: German economics’ intellectual center had meanwhile shifted, away from the Friedrich-Wilhelms-Universität in Berlin, with its former leading figures Schmoller, Adolph Wagner, and Werner Sombart, to the Albert-Ludwigs-Universität in Freiburg im Breisgau, where a new group of economists and lawyers had formed during the 1930s. In the years after 1945, this Freiburg School, along with a group of German émigrés, became famous under the

420   Political Economy caption ordoliberalism—both in the field of economic theory and in the field of practical economic policy (Goldschmidt and Wohlgemuth 2008a). This German type of the incipient neoliberal varieties was seminal for the upcoming Social Market Economy, being the predominant economic theory pillar of this doctrine (Goldschmidt and Wohlgemuth 2008b), and West Germany’s outperforming its neighbors in the postwar period is very often attributed to the explicitly ordoliberal economic policies during the first twenty years of the Federal Republic’s development. Until today, ordoliberalism has had a significant impact on German economic policy debates, also with regard to the current financial crisis and the country’s reactions to it within the European context (White 2010; Dullien and Guérot 2012; Kundnani 2012; Wren-Lewis 2012). Rule-based economic policy has always been controversial, as can be prominently observed in an earlier aggressive critique by Paul Krugman focusing on its lack of flexibility and pragmatism, deficiencies which he traces back to Immanuel Kant (Krugman 1999). The aim of this chapter is to shed light on the specific approach of ordoliberalism to economics and to set it into relation with corresponding phenomena within the Austrian School. What are the theoretical commonalities and differences between the ordoliberal and the Austrian approaches to economics and, more broadly speaking, to political economy? What caused the aforementioned drastic shift from aggression and neglect to fruitful discourse in the first half of the twentieth century? What caused the revival of the interest in ordoliberalism in the Anglo-Saxon world amid the current first global crisis of the twenty-first century? And, above all, can knowledge of the ordoliberal paradigm help to better understand some specificities within Austrian economics, especially with respect to Friedrich Hayek’s oeuvre and its evolution? Answering these overarching questions is by far not just of historical interest; instead, such a comparative analysis might be an inspiration to today’s representatives of both schools in terms of how their future research agendas can creatively profit from a discourse based on the commonalities and on impulses that can result from debating the differences.

Intellectual History of Ordoliberalism’s Formative Years In order to understand the emergence of ordoliberal thinking and the evolution of its formative representatives in the initial generation, a brief look at the Weimar Republic is necessary. For young economists in the Weimar period, socialization was problematic at least in two respects. First, the academic landscape in economics in Germany was still dominated by the remnants of historicism and the “Youngest” Historical School (Rieter [1994] 2002, 154–162; Goldschmidt 2013, 127–129), despite the revitalization of economic theory at some faculties (Janssen [1998] 2009, 48–86). Second, the economic policy of the Weimar governments is best characterized as an interventionist chaos, which to a significant degree can be attributed to the inability of historicist economists to come

Ordoliberalism and the Austrian School    421 up with adequate solutions for the grave policy problems of the time, especially with respect to the hyperinflation in 1923 and the Great Depression (Köster 2011, 258–268). Thus, the formative ordoliberal generation grew up in an academic and political environment in which the discipline was seriously challenged in scientific terms and its relevance as a guide for political action was very earnestly put into question (Nicholls [1994] 2000, 15–31). Economics failed when it was most urgently needed, and the German electorate—including its middle class, impoverished by the hyperinflation and the Depression—fell prey to the propaganda of the National Socialists. This narrative of the ordoliberal origins will be centered on two principal figures: Walter Eucken (1891–1950) and Wilhelm Röpke (1899–1966). A focus on their personalities, intellectual transformations, and political impact entails three benefits. First, this procedure enables identifying the substantive core of the ordoliberal program with the commonalities and differences between Eucken’s and Röpke’s approaches. Second, it allows introducing other thinkers of this and later generations who were affiliated with Eucken and/or Röpke without overloading the chapter with too many biographical details. Third, it is Eucken and Röpke whose sets of ideas and personal relationships are the most important ones when it comes to the nexus of ordoliberalism and the Austrian School. The year 1933 marked the beginning of a highly problematic period for both Eucken and Röpke, with the former as professor of economics in Freiburg and the latter in Marburg. Their intellectual incompatibility with the National Socialists then in power manifested itself in Röpke’s immediate emigration to Atatürk’s Turkey (Hennecke 2005, 99–114) and in the immediate harsh clashes of Eucken at the University Senate with the newly elected Rector Martin Heidegger in the months around his infamous Rektoratsrede of May 1933 in Freiburg (Klinckowstroem 2000, 85–88). Both Eucken and Röpke were academically raised in the historicist tradition (Goldschmidt 2002, 139–189; Zweynert 2013), with the notable difference that Röpke—who was younger and only began his studies after the war—emancipated himself faster and became a leading business cycle theoretician in Germany at the time of the Great Depression (Haberler [1979] 2000). The Verein für Socialpolitik (German Economic Association) served with its annual meetings as an important platform of exchange, which allowed Eucken and Röpke to get acquainted both intellectually and personally with other eminent German-speaking economists of the period: Ludwig von Mises, who authoritatively claimed at the Verein’s meeting in Zurich in 1928 that his business cycle theory was dominating the German-language discourse on cycles (Mises [1928] 1929, 326), and also Friedrich Hayek, Gottfried Haberler, and Fritz Machlup, age peers of Eucken and Röpke. For this generation, both the Great Depression and the rise of totalitarianisms were formative experiences. What distinguished Eucken and Röpke from Hayek during the years of the Depression was that, whereas Eucken and Röpke perceived it very early through the prism of political economy, Hayek remained much longer committed to his purely theoretical perspective as the best legitimate solution tool kit. Even though they were initially adherents of the Austrian Business Cycle Theory, Eucken and Röpke soon recognized the enormous dynamite-like effects of deflationary processes on the

422   Political Economy stability of the political order. That was why they stressed early, both in public and in closed politicoscientific circles (Borchardt and Schötz 1991; Allgoewer [2009] 2010), the necessity for expansive impulses once deflation reached its “secondary phase” (Röpke’s terminology), that is, when the malinvestments of the boom were already purified (and thus the primary phase was completed), so deflation was of no use anymore in terms of economics but of great danger in terms of destabilizing the political system (Röpke 1932; 1936, 119–134). As Hayek would remember decades later, Röpke realized “early, probably earlier than most of our contemporaries, that an economist who is only an economist cannot be a good economist” (Hayek 1959, 26). At the same time, Eucken’s programmatic article of 1932 can be seen as a direct precursor of Public Choice Theory, since he describes the chaotic deficiencies of economic policy before and during the Depression as the result of willingness of the state to distribute all types of privileges and rents. These provide strong incentives for special-interest groups to capture this same state and to manipulate it into their particular direction. The ensuing “economic state” is an enmeshed entity of the state and of special-interest groups, and according to Eucken, the only possibility for (re-)establishing impartiality is a “strong state” that abstains from granting privileges and rents and is thus not any more attractive for private capturing attempts (Eucken 1932). So the specific political economy of ordoliberalism started taking shape already in the early 1930s, but it would take many more elements before it became a coherent body, both as a scientific paradigm and as a policy advice instruments set. The roads taken by Eucken and Röpke after 1933 were different, in various ways. Apart from the emigrate-versus-persevere decision, the most obvious difference was that Eucken was highly successful in surrounding himself with a large number of scholars, economists and lawyers, of his own generation—the most important being law professor Franz Böhm (1895–1977)—and also younger ones. The formation of this Freiburg group around a well-defined and quite homogenous research program soon made the term school legitimate when applied to them (Blumenthal 2007, 25–33). The Freiburg School was interdisciplinary from its beginning, with a focus on the interface between economics and law but also with strong ties to epistemology and political philosophy. Eucken’s research program shifted away from technical economics and generated the Ordnungstheorie approach, which was given its full-fledged formulation in his The Foundations of Economics (Eucken [1940] 1989) regarding its methodological and epistemological elements.1 For him and his students, this was a time of active participation in various intellectual opposition circles in Freiburg, their lives being seriously endangered by Gestapo interrogations and imprisonments in 1944 and 1945 (Ott 2005). After the end of the war, the network of Freiburg School representatives was increasingly important in shaping the public spirit in the occupied Western zones and the evolving new political elite. Immediately in 1945, the prewar relationship between Eucken and Hayek was revitalized and became extremely important in the course of the founding of 1 Eucken’s Foundations was translated into English upon Hayek’s intermediation by T. W. Hutchison

and published 1950 in London and and 1951 in Chicago.

Ordoliberalism and the Austrian School    423 the Mont Pèlerin Society and its selection of German members (Hartwell 1995, 82–84). Eucken’s Principles of Economic Policy ([1952] 2004), a book with seminal impact for Germany’s postwar economic policy route, was published posthumously.2 As can be shown in great detail, the intellectual exchange between Eucken and Hayek between 1945 and 1950—the year of Eucken’s sudden death when lecturing at the London School of Economics upon Hayek’s invitation—was immensely important not only for constructing the Mont Pèlerin Society as an institution but also for the specific spirit of the Society in its early years (Kolev, Goldschmidt, and Hesse 2014). The term ordoliberalism itself was coined in 1950, shortly after Eucken’s death, also an indication of the increasing popularity of the ORDO Yearbook, which Eucken and Böhm founded in 1948 (Moeller 1950). Röpke’s path followed a different direction; his emigration brought him to Istanbul in 1933 and to Geneva in 1937. It was his stay there until his death in 1966 that gave him a unique degree of freedom compared with his German compatriots in the dark age of National Socialism. Röpke, unlike Eucken, did not form a school himself; his closest associate and scientific friend was a German fellow émigré in Turkey, Alexander Rüstow (1885–1963), with whom Röpke shared fundamental assumptions in social philosophy and anthropology. Though not a founder of a school of his own, Röpke was extremely active in networking, and he played, together with Rüstow, a central role at the Colloque Walter Lippmann 1938, the birthplace of neoliberalism. It was Röpke and Rüstow who proposed the term neoliberalism in order to describe the future agenda of twentieth-century liberalism as opposed to the “paleoliberalism” of the nineteenth century (Plickert 2008, 93–103; Gregg 2010, 82–86; Burgin 2012, 67–78; Goodwin 2014, 233–240). Between 1942 and 1945, Röpke published a trilogy on economics and social philosophy ([1942] 1950; [1944] 1948; [1945] 1959), which, even though banned personally by propaganda minister Joseph Goebbels, circulated in Germany and shaped the politicoeconomic views of, among others, Ludwig Erhard (Commun 2004; White 2012, 233–238). Röpke was also an omnipresent public intellectual, publishing on a regular basis in various newspapers and languages, most prominently in the Neue Zürcher Zeitung. He was seminal in founding and developing the Mont Pèlerin Society, although Hayek’s link to Eucken seems stronger than the one to Röpke, judging by the tone of the correspondence collections in the Hayek and Röpke archives.3 After Eucken’s death, Röpke was probably the most authoritative economists in the eyes of Chancellor Konrad Adenauer and, especially, for Erhard, minister of the economy, both on internal economic issues and on questions of the incipient European integration (Zmirak 2001, 149–161; Hennecke 2005, 181–200; Warneke 2013, 168–179). In the late 1950s, the Hunold affair of the Mont Pèlerin Society led to an abrupt disruption of the relationship between Röpke and Hayek, which—apart from personal affects and vanities in the course of the 2 Eucken’s Principles has never been fully translated into English. Both Eucken volumes will be cited according to their current German editions because of the solely antiquarian availability and some semantic imprecisions of the English translations. 3  The systematic exploration of the Eucken archives only started in 2013.

424   Political Economy affair—could also have been based on Röpke’s increasingly conservative stance characteristic of the last decade before his death in 1966 (Burgin 2012, 137–143). Perhaps even Hayek’s famous “Why I Am Not a Conservative” postscript to The Constitution of Liberty might have been directed not only, as commonly assumed, to American conservatives such as Russell Kirk or William Buckley but possibly also to this transformation of Röpke, as very recent findings of rather aggressive correspondence among Röpke, Hayek, and Rüstow in the Röpke archives tentatively suggest. Finally, there is a direct link between ordoliberalism and the concept of the Social Market Economy. Alfred Müller-Armack (1901–1978) coined the term Social Market Economy in 1946 in his now widely known wording of an “irenic formula,” that is, a concept that aims to harmonize the liberty and efficiency of the market with social balance and justice. Ordoliberalism was not the only intellectual source that formed this doctrine, but in terms of economics, Müller-Armack stressed that “neoliberal political economy” had been vital as the economic fundament for the Social Market Economy (Müller-Armack [1959] 1974, 119–120). Because of its conceptual openness, which often—and, in the decades to follow, increasingly—entailed a significant degree of vagueness regarding the precise manner of reconciling the market with the social balance (Goldschmidt and Wohlgemuth 2008b), this coinage can to a certain extent be seen as an illustration of Hayek’s “weasel word” critique of the term social. The following analysis will thus concentrate on ordoliberalism and not on the much broader concept of the Social Market Economy, which in itself—and also in terms of comparative attempts—is far less operational than using the agendas of Eucken and Röpke.

Substantive Core of the Ordoliberal Paradigm Theory of Orders Traditionally, the ordoliberal paradigm is subdivided into two layers:  the theory of orders (Ordnungstheorie) and the policy rules sets to shape reality corresponding to the theory of orders, that is, order-based policy (Ordnungspolitik). On the theoretical level, ordoliberal thinkers delineate their methodological approaches and identify the constitutive elements and concepts they need in order to pose their fundamental questions about the theory-reality relation. On the policy level, they attempt to show in an intersubjective manner the economic policy types and concrete policy measures necessary to establish an economic constitution in line with the criteria developed on the theoretical level, the common denominator of these policies being their rule-based character. The overarching goal is to resolve what Eucken terms “the Great Antinomy,” that is, to bridge the epistemological gap between the theoretical and the historical approaches to economics as debated (at least) since the Methodenstreit.

Ordoliberalism and the Austrian School    425 To begin with, the genesis of the ordoliberal program cannot be understood without taking into account that, above all, it was a decades-long search project, pursued in conditions of harsh opposition to the surrounding world. The profound alienation from the totalitarianisms in Europe experienced by its founders provided the spark of a radical research quest for a social philosophy that would entail an order diametrically opposite to the existing one. The term order, which Eucken introduced in details in his Foundations, has two meanings. As a positive concept of “economic order” (Wirtschaftsordnung), it is an instrument to structure the perception of reality, and as such, it facilitates identifying abstract economic systems in concrete economic reality. As a normative concept—Eucken refers to this “order of the economy” (Ordnung der Wirtschaft) as an “ordo”—it is an entity that has to fulfill defined criteria regarding its economic and anthropologic content (Oliver 1960, 133–140). The result is a compass for steering an economy toward a constellation that conforms to the criteria of ordo. Eucken’s two core criteria require that such an order be productive in economic terms (funktionsfähig) and humane (menschenwürdig) (Eucken [1940] 1989, 239–241). The combination of these two criteria clearly proves that material prosperity is by far not the only focus of the inquiry; instead, it is about identifying forms of economizing and—even more important—of coexistence that are best compatible with human nature. As will be shown below in detail for both authors, the question of whether an order is compatible with human nature is centrally related to the issues of power and of centralization and in this way directly related to the value of liberty. Eucken’s generic classification of abstract economic systems is centered on the question of how many plans in an economy are relevant: if one plan is relevant, the system is either a simple centrally directed economy (i.e., a single household) or a centrally administered economy; if a multitude of plans coexist, it is an exchange economy (Eucken 1948b). The analogy to Mises’s systems classification is imperfect, since the ideal exchange economy is defined differently. Whereas for Mises a capitalist economy is one with the highest possible degree of private property of the means of production and hence state interventions are mostly regarded as detrimental and as infringements on private property, for the ordoliberals exchange needs an elaborate foundation for its proper functioning, and an important part of this foundation is to be provided by the state. An economic order is a part of concrete reality combining elements of abstract economic systems, these elements being shaped and ordered by different influences in the concrete historical moment. Identifying economic orders requires analytical penetration of reality, for which Eucken develops an epistemological approach based on elements from Weber’s ideal types method along with Edmund Husserl’s phenomenology (Goldschmidt 2013). As for the types of order, ordoliberalism shares the innovative thesis of the Scottish Enlightenment that existing orders are not only natural and artificial and that not every social order is to be seen as artificial, that is, purposefully designed (Anter [2004] 2007, 129–143). Instead, among the social orders, the distinction between “grown” (gewachsen) and “designed” (gesetzt) orders can be found directly in early ordoliberal texts (Eucken [1952] 2004, 373–374). As a recommendable description for the market economy, the

426   Political Economy term spontaneous order appeared already in the first chapter of the first edition of Röpke’s economics textbook Economics of the Free Society (Röpke [1937] 1963, 4). This can also be taken—as can Hayek’s stress on Röpke’s prescient stance on the political economy of business cycles—as a case in which the ordoliberals are not followers but, instead, trendsetters within the early neoliberal discourse, in terms of substance and/or rhetoric (Johnson 1989, 57). The results of the ordoliberal search process are probably best summarized by philosopher Hans Albert under the Kantian motto of an “order of liberty” (Albert 2005, 414–417). Liberty is discussed by Eucken as a direct nexus to power (Eucken [1952] 2004, 175–179) and by Röpke as a direct nexus to centralization (Röpke [1942] 1950, 9–16). It is through this vital and inseparable link to liberty that the supreme importance of power and centralization in the respective oeuvre becomes evident. Such concepts can be called topoi, a topos being a seminal location in an author’s system of ideas, a recurring leitmotif that characterizes the principal question an author is addressing (Pribram 1953, 243–245; Kolev 2013, 7–9). And indeed, the problems of power and the problems of centralization can be identified as truly fundamental for Eucken and for Röpke, respectively. Both authors choose wide definitions of their topoi, since the topoi include multifaceted threats and dangers to liberty in all its dimensions. Power in Eucken’s perspective can stem from various sources, the state being by far not the only one. He identifies private power on markets, power within the collective (community, society), and power of the state. The acknowledgment of private power as a threat to liberty, which can be just as grave as state power, is one of the central distinctions of ordoliberalism when compared with other strands both of nineteenth-century liberalism and of neoliberalism (Foucault [1979] 2008, 129–158). The economic dimension of private power in a noncompetitive market is just one side of it. What is regarded as even more dangerous is that private power can easily usurp the state and combine private and state power, thus bringing the concentration of power to a maximum, which can virtually annihilate liberty (Eucken [1952] 2004, 173–175). In Röpke’s work, the corresponding idea is that of centralization in all its forms: in markets, in society, within the state, and among states. While he is less worried about market power than Eucken is, he emphasizes just as much the danger resulting from the combinability of the different forms of centralization. Centralization in society is presented by Röpke as the rise of “enmassment” and the growing predominance of collectivist thinking over individualism, which invariably leads to an uprooting of the individual from the humane order (Röpke [1958] 1960, 36–89). Centralization within the state entails the successive undermining of federalism and hence a growing distance between the state and the increasingly unimportant citizen, a development that can be observed both in the national states of the West and in supranational processes among states in the then-incipient European integration (Petersen and Wohlgemuth [2009] 2010; Warneke 2013, 119–140). Disempowering (Eucken) and decentralizing (Röpke) apply to all spheres of human life and all interpersonal relations, not only to the economy. A key concept of the ordoliberals that can elegantly be introduced here is the notion of interdependence. It acknowledges that different societal suborders (i.e., economic, legal, state, and cultural

Ordoliberalism and the Austrian School    427 orders) do follow different internal logics and are not to be perceived as an organic whole. However, an isolated perspective only on the economic or the legal order might also be strongly misleading. Instead, these suborders are to be seen as a system of manifold links and feedback mechanisms, an image that contains the notion of mutual dependencies and patterns of (in)compatibility between them—also in terms of transition processes such as the ones after 1945 or 1989 (Schwarz 1992). The following section concentrates on the issue of how a worldview specifically based on the theory of orders can alter the manner in which policy is to be conducted, that is, how reality can be shaped if a society adopts the aforementioned theoretical structure as practically desirable.

Order-Based Policy Starting from their topoi of power and centralization, both Eucken’s and Röpke’s normative stance can be summarized as “liberty has its prerequisites and preconditions.” Because of the various threats that originate from the power problem and the centralization problem, ordoliberals underscore that liberty cannot exist in a vacuum in terms of absence of an institutional framework; instead, it indispensably needs an economic constitution, and only within such a constitution is it possible for liberty to persist. It is of particular importance that ordoliberalism utilizes the metaphor of the economy as a game. More explicitly than others, ordoliberals stress the differentiability (separability) of the game into two layers: the rules of the game and the moves of the game. Eucken’s early starting point is that the question of how much state is optimal is wrongly posed. He insists that this question cannot be posed in a quantitative manner in the sense of how much; instead, the question should be qualitative in the sense of what kind of. For him, policy measures are not per se harmful, liberty-infringing interventions but can well be liberty-enhancing pillars of the order (Eucken [1952] 2004, 336–337). For these to be differentiated, the level of the economic order, synonymous with the “rules of the game” level, and the level of the economic process, as the “moves of the game,” have to be kept apart. Along with these two levels of the economy, two types of policy are definable: order-based policy (Ordnungspolitik, sometimes also translated with the more general term “rule-based policy”) and process-based policy (Prozesspolitik). While the former establishes by universally applicable rules the pillars for the market to become a productive and humane order and is as such a sine qua non condition, the latter's distribution of privileges is characterized by meddling with the prices of the economic process and is thus to be discarded as harmful interventionism. Order-based policy in this sense can be perceived as a shield against interventionism: the closer the rules of the game are to the ordoliberal ideal, the lower is the likelihood in the well-ordered economy for constant state interference into the moves of the game, as there is less to correct here in terms of material failures and/or inhumane outcomes. In the economic sphere, the order that corresponds to the general criteria productive and humane is called by Eucken and Röpke the competitive order

428   Political Economy (Wettbewerbsordnung), and it represents the ordoliberal benchmark for what economic policy must be aimed at if it pursues the ordoliberal paradigm. Regarding the aforementioned distinction of designed versus grown orders, the competitive order is designed and set by economic policy but simultaneously corresponds to the “spontaneous formations” of human coexistence and only protects these from power concentrations (Eucken [1952] 2004, 373–374). For ordoliberalism and its criteria pair, competition is a an essential feature of the economic process, since it is an indispensable tool to disempower economy and society, as discussed by Böhm as early as 1928 and 1933 (Böhm [1928] 2008, 61–65; [1933] 1964, 24). The ordoliberal ideal of competition takes two shapes: either defined in the market form of complete competition, where individual players have no impact on the price formation, a concept with less restrictive assumptions than neoclassical perfect competition (Renner 2002, 72–77); or in the selection mechanism of performance-based competition (Leistungswettbewerb), where success in the market is to be decided by superior performance of players and not by impediments posed by other players to hinder the success of their superior competitors. Whereas in its first shape the ideal of competition can be characterized as an end state, the second shape is to be perceived as procedural, since, refraining from declaring a particular end state of the economic process, it focuses on the rules of the game within which the process evolves (Vanberg 1997, 718–720; 2001, 46–47). Eucken’s competitive order is based on two sets of principles which can be seen as a compass for designing rules of specific economic policies on the basis of these principles. The first set consists of seven constitutive principles (konstituierende Prinzipien) that are the central pillars of the competitive order. These should not be seen as isolated entities; their essential characteristic is rather an indispensable complementarity, so that it is only their simultaneous coexistence that legitimizes applying the term competitive order to a concrete economic order (Eucken [1952] 2004, 289–291). A functioning price system, defined as a price system that to the largest possible degree is free from power, is called the fundamental principle. As potential sources of power, both the state and private players are identified here. For Eucken, only under the conditions of disempowerment (i.e., when all principles discussed here are fulfilled) are relative prices undistorted indicators of scarcity; otherwise, power can strongly bias or even annihilate their coordination function (254–255). The primacy of currency policy as the next principle expresses the impossibility of constructing an economic order upon a currency whose value varies dramatically. Apart from this theoretical criterion of value stability, and now led by politicoeconomic considerations, Eucken poses a second precondition for a currency’s compatibility with the competitive order: the currency should be as automatic as possible; that is, the possibility of politicians meddling with its mechanism is to be brought to the absolute minimum (255–264). Open markets are the third constitutive principle, being indispensable for tackling the power problem. Closing markets for potential external players facilitates the power accumulation on the individual market, but it also undermines the entire mechanism of general equilibrium, since closed markets, with their distorted prices and possible disequilibria, can

Ordoliberalism and the Austrian School    429 destabilize the entire set of markets in an economy (264–270). Considered self-evident today, the principle of private property was, in the formative years of ordoliberalism, a fervently debated matter in Germany and in many other Western countries, and its automatic predominance should by no means be taken for granted in the postwar economies. Without the delineation of a certain sphere of liberty by the principle of private property, the spontaneous forces of entrepreneurs would be rather unlikely to unfold. An important qualification for Eucken is that private property is legitimate only as long as it does not entail power; otherwise, it can mutilate the character of the competitive order (270–275). The same is true about the principle of freedom of contract, which, though an essential milestone of the exchange process in markets, is nevertheless a subject of an ordoliberal qualification. In this view, there are cases in which the freedom of contract threatens competition, that is, when contracts are targeted at precluding players from participating in the market. Such contracts, typical among others for cartels, limit the freedom of contract of others, so application of this principle is only unproblematic in market forms that are close enough to complete competition and thus sufficiently void of power (275–279). The next principle, liability, makes players within the competitive order develop adequate attitudes toward risk. In case one is not liable and accountable for both the positive and the negative results of his or her action, especially investment decisions will not be taken with the due pricing in of risk; such incentives of limited liability, in its generously granted scope today, can cause serious misallocation of resources, on the level of companies and on the level of individual managers (279–285). The last constitutive principle is the one of constancy of economic policy. If economic policy is erratic and characterized by continuous restlessness in its various fields (taxation, foreign trade, currency policy, etc.), investors will be confronted with high adjustment costs and unnecessary price fluctuations within the market system. Thus, conducting economic policy is to be primarily stabilizing, and its patterns are only to be altered carefully (285–289).4 In addition to the seven constitutive principles, a second set of four regulative principles is formulated, which are necessary to fully ensure the compatibility of the competitive order to the productive and humane criteria pair. They are on a different argumentative level, and in contrast to the constitutive principles, which are pillars of order-based policy, the regulative principles can be seen as attempts by Eucken to justify necessary, genuine interventions of the state into the economic process (Horn 2010, 87). The only regulative principle that is sufficiently documented in the posthumous text is the one on the monopoly problem; the other three are only sketched and not nearly as elaborated as the preceding principles. The principle of tackling the monopoly problem addresses the question of how to handle monopolies that remain despite the constitutive principle of open markets, such as monopolies of public utilities and other technically efficient monopolies. Eucken discusses the options of a regulation authority and of nationalizing the monopoly and opts for the former, since the latter would bring the 4 

The alteration possibilities are not detailed in this posthumously compiled text, but the editor reports a note from Eucken that more details are needed here.

430   Political Economy enmeshment of private and state power, that is, the maximum degree of power concentration. He also discusses additional measures for restraining monopoly such as prohibiting practices of price discrimination. As for oligopolies, he again prefers the regulation authority option instead of nationalization and states that such an authority will have above all a prophylactic role, since oligopolists will now anticipate the punishment of anticompetitive practices and will be less likely to use them (291–299). The last three regulative principles deal with income policy, external effects, and abnormal labor supply situations. In terms of income policy, Eucken sketches the necessity to correct market results with moderately progressive taxation without endangering the economy’s propensity to invest. External effects are to be integrated into the accounting calculations of the player who has caused them. In the special case of labor supply, which increases with falling wages, Eucken sees minimum wages as legitimate, once such an abnormal labor supply becomes persistent (300–304). How “thick” should a framework be so that it guarantees the desirable properties of the market process within the order? In other words, how many layers does the constitution need so that it ensures the stability of the order vis-à-vis possible degenerations along the two criteria? This is the seminal question to be addressed by every proponent of the order-versus-process differentiability thesis as cherished by the ordoliberals. And there are important divergences among the ordoliberals on this issue, as there are between Eucken’s and Röpke’s stances. Eucken sees the ordering of the economy toward a competitive order as the primary goal in shaping reality. Röpke acknowledges this as a necessary condition for establishing a desirable order, but for him, this goal does not suffice; his “full program” aims at reforming both the economy and society (Röpke [1944] 1948, 40). Social reforms are necessary, since he gives the game metaphor and its applicability a different interpretation. While he certainly shares the differentiability thesis of rules and moves, he poses an additional, radical question that metaphorically can be called the (in-)stability thesis. Röpke expresses deep skepticism regarding the properties of the playing field itself: can it be taken for granted that the pillars of the playing field itself, upon which the market game is played, are stable and will remain so? In this context, he underscores that ordoliberalism is to be seen as a decidedly positive program, interpreting it as “anti-Laissez-faire” (40). Apart from being more generous regarding the acceptability of process interventions than Eucken—as long they are conformable with the market mechanism and facilitate structural change instead of blocking it (Röpke 1929)—he stresses the necessity of a decentralization program not only for the economy (as seen in Eucken’s competitive order) but also for society and the single individuals. The triumph of totalitarianisms in Röpke’s reading is not only a result of the power concentration in the economy but is also caused by the individuals’ “losing their roots” from their natural communities and life forms and the resulting “enmassment” in human coexistence (Röpke [1958] 1960, 101). This decentralization program of economy and society leads to his famous depiction of the Swiss village, with its moderate number of inhabitants who are primarily self-employed individuals, as the ideal societal constellation which is an inalienable complement to economic decentralization (Röpke [1944] 1948, 30–32); only with this strict complementarity is

Ordoliberalism and the Austrian School    431 the playing field stable and the free order likely to sustainably persist. In his late writings, especially A Humane Economy ([1958] 1960, 57–65), he underscores also the role of informal preconditions on the level of individual ethics as additional stabilizers for the decentralization program, along with the aforementioned formal order-based policies. Both Eucken’s competitive order and Röpke’s decentralization program certainly evoke the impression that a large scope of action is needed for these ideals to become reality. This is undeniably true, but it is important to note that the state is by far not the only the addressee of this call for action. The state is an important ordering factor; indeed, the political economy of ordoliberalism is very adequately characterized by Chicago economist Henry Simons’s metaphor of a search for the optimal “division of labor between the state and the market” (Simons [1934] 1948, 41–42). However, both Eucken and Röpke involve a number of other important players with tasks in establishing and supporting an order with the depicted desirable qualities. Eucken names science and churches as such additional “ordering forces,” and Röpke gives a long list of institutions called “clerks,” later also named “nobilitas naturalis,” such as the judiciary, the central bank, churches, universities, foundations, media, and the education system (Eucken [1952] 2004, 338–350; Röpke [1944] 1948, 117–126; [1958] 1960, 129–136). These institutions are not to be seen as assistants of the state; rather, they are assigned the task of being its counterweights and correctives. Thus, the division of labor here is not just between the state and the market but among the state, the market, and these players within civil society. The question of whether the ordoliberal conception of civil society is elitist depends on the openness of these lists of relevant players, that is, on whether ordoliberal thinkers set up an exhaustive list of all institutions in question or solely hint at what potential institutions may be involved in the ordering dynamics (Ebeling 2003, 242–243; Hennecke [2009] 2010; Rieter 2010). With this, the presentation of the fundamentals of the theory of orders and of the principles of order-based policy should be sufficiently delineated: the ordoliberal way of thinking is a delicate structure to perceive reality and to seek solutions for shaping it. As for the concrete policy proposals in the fields of business cycle policy, currency policy, competition policy, or social policy, a detailed exposition of these would go beyond the scope of a single chapter, particularly as they are to be seen as historically contingent plans (thus entailing the necessity of explaining their economic history context); in addition, they evolve significantly in the life spans of these formative authors and also in the next generations of ordoliberal scholars.5 Nevertheless, being already sufficiently equipped with the essential knowledge of the ordoliberal paradigm, the second central substantive question of this chapter can now be addressed: what types of relations between Freiburgian and Viennese reasoning can be identified, and in what way can these relations matter for a better understanding of the two research agendas and toward generating impulses for their future development? 5 

A detailed discussion of the four aforementioned fields of economic policy and their evolution in the comparative constellation Eucken-Röpke-Hayek-Mises is contained in Kolev (2013).

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Freiburg and Vienna: Mutual Gains from Trade or “It Is All in Hayek”? Proximities and Divergences in Historical Perspective Especially in this area [creating the conditions for effective competition], already before the war a number of important studies were published in Germany, primarily owing to the impulses of Professor Walter Eucken in Freiburg i.B. and of Professor Franz Böhm, now in Frankfurt. … The problem of the “order of the economy” [“Ordnung der Wirtschaft” in the original] in the sense in which these scholars have addressed it and have attempted to sketch its solution is one of the most important tasks which the human mind can pose itself today, and the solution of which is of immense importance. (Hayek [1947] 2004, 170)

This quotation from Hayek’s presentation at the European Form Alpbach in August 1947 clearly testifies to his pronounced esteem for the ordoliberal program in the immediate postwar years. Was this just a ceremonial politeness or rather an indication of particular intellectual proximity between ordoliberal thought and Hayek’s own research program at that moment? As this section will show in detail, the latter is definitely the answer, and so the following discussion focuses on Hayek’s relationship to—one could even speak of fascination with—the ordoliberals and their scientific agenda in the 1930s and, even more so, in the 1940s. Awareness of this period’s lasting trace on Hayek’s further approach to political economy is helpful in confronting some misinterpretations of his oeuvre, stemming not only from outside the Austrian School but also from within the school itself. As mentioned earlier, the networks within this generation of German-speaking economists started forming already in the 1920s and survived the intricacies of the 1930s. The Colloque Walter Lippmann in 1938 functioned as an important gathering for exchange of arguments about the future of liberalism, but Eucken was not able to attend it. Hayek maintained the relationship to Eucken by visiting him on his travels from London to Vienna (Hayek [1983] 1992, 189–190), and from 1937 onward, Röpke served as the hub of the network for passing news, letters, and books between London, Freiburg, and Geneva. Immediately after the end of the war, the direct communication in this triangle was resumed, and for the next five years, the intensity of exchange was constantly very high (Vanberg 2013; Kolev, Goldschmidt, and Hesse 2014). Hayek’s intellectual biography in that period was also one of special transformations. Apart from the formation of the knowledge problem as a topos in the course of the Socialist Calculation Debates (Boettke 2001, 34–43; Caldwell 2004, 203–231), the late 1930s and early 1940s marked a shift in the focus of his research efforts. While The Pure Theory of Capital (Hayek 1941) is the last major work in technical economics for many years to come, his brochure “Freedom and the Economic System” (Hayek [1939]

Ordoliberalism and the Austrian School    433 1997) contains the first motifs of what are later to become famous theses in The Road to Serfdom (Hayek [1944] 2007). Leaving technical economics for what seem to be more pressing questions—the ones of social philosophy, as expressed later in the introduction to The Constitution of Liberty (Hayek [1960] 2011, 49–50)—was a course taken by many prominent members of this generation, among others Eucken and Röpke (Blümle and Goldschmidt 2006). For readers of these early writings in Hayek’s social philosophy, certain topics and rhetoric devices definitely need specific explanations, since they are likely to be regarded as incompatible with some widespread readings of Hayek today. This complex is concentrated around the issues of laissez-faire, rules, and the competitive order. When embarking on his quest to reformulate liberalism in the context of the twentieth century, Hayek posed the central question of why liberalism in its nineteenth-century formulation had lost its appeal so dramatically in the preceding decades. One of his core insights was that in the course of the nineteenth century, the formula of laissez-faire had become the trademark of liberalism, and in his 1935 edited volume on socialist calculation (Hayek [1935] 1948), in “Freedom and the Economic System” ([1939] 1997), and in The Road to Serfdom ([1944] 2007), he at several places identifies this as a grave mistake. The reason, in Hayek’s eyes, is that the formula of laissez-faire does not bear any meaningful content as far as the role of the state is concerned ([1935] 1948, 134–135; [1939] 1997, 193–200; [1944] 2007, 71–72). Hence, if citizens regard liberalism as the ideology of laissez-faire, they will not perceive it as a helpful tool kit for solving societal problems and will thus prefer other options from the political menu. Hayek acknowledges this seminal weakness and has one overarching substitute proposal: the competitive order. While in The Road to Serfdom, the state’s ensuring the functioning of competition is called “planning for competition” ([1944] 2007, 88–90), at the founding meeting of the Mont Pèlerin Society in April 1947, the very first session bore the title “ ‘Free’ Enterprise and Competitive Order,” and Hayek delivered a paper with a strong explicit emphasis on the desirability of the competitive order ([1947] 1948). Having delineated the ordoliberal paradigm above, the term competitive order becomes a clear sign of intimate intellectual proximity between Hayek and the scholars around Eucken and Röpke at this point in time. Is it a sign of influence of the ordoliberals on Hayek? An analysis of the available correspondence in the Hayek and Röpke archives suggests that the answer is a tentative yes (Kolev, Goldschmidt, and Hesse 2014). Indeed, the theoretical findings of the Freiburg School fascinated Hayek in this period. The personality of Eucken, a liberal scholar who had survived National Socialism without concessions and compromises, was also impressive—not only to Hayek but also to other attendants of the first meeting of the Mont Pèlerin Society, such as Milton Friedman or George Stigler, who experienced Eucken there for the first time (White 2012, 202). Certainly, a claim for an exclusive formative impact of the ordoliberals on Hayek in this respect would be too strong. Both in Walter Lippmann’s The Good Society (Lippmann 1937) and, even more so, in the work of Simons within what has recently been called by James Buchanan (2012) the “Old Chicago School,” one finds terminology and notions close to the ordoliberal type of reasoning regarding the

434   Political Economy competitive order (Van Horn 2009; Köhler and Kolev 2013). Still, correspondence on the eve of the Mont Pèlerin Society’s founding between Hayek and Aaron Director, and also between Hayek and Eucken, shows that Hayek perceived the Chicago and Freiburg research programs as intimately congruent and that Simons’s untimely death in 1946 hindered his intention to institutionalize these ideas at the University of Chicago (Van Horn and Mirowski 2009). Thus, inquiries into a substitute for the laissez-faire type of liberalism at Hayek’s London, Eucken’s Freiburg, Röpke’s Geneva, and Simons’s Chicago seem to be going very much in the same direction. Competitive order instead of laissez-faire is the programmatic aim of the new agenda; this program has to be positive in character (as opposed to the negative essence of criticizing socialism and interventionism), which Hayek underscores in correspondence with Machlup in 1953 at the beginning of the Constitution of Liberty project (Hamowy 2011, 6). Identification of principles for the role of the state as an orientation instead of the “doing nothing” call to the state of late-nineteenth-century liberalism is the operational roadmap to be explored. If metaphors about the role of the state are to be distilled from the respective oeuvre, the ones of Eucken, Röpke, and Hayek do evoke similar associations. For Eucken, the state is to be perceived as an impartial judge/umpire who sets and implements rules with the central aim of disempowering the market game. For Röpke, the state can be depicted as an assistant architect or a structural engineer in charge of controlling the stability of the pillars upon which the playing field of the market is resting. For Hayek, the most adequate metaphor seems to be that of a gardener in charge of an English (as opposed to French) garden, who cultivates the general patterns of the garden but abstains from controlling each individual element in the garden, constantly learning from the garden’s differing evolutionary performance under varying conditions (Kolev 2013, 274–275). The partial disintegration of this transcontinental constellation after the unexpected deaths of Simons in 1946 and Eucken in 1950 has multiple reasons. The most obvious problem is that the principal linking persons were not there anymore to bridge the gaps in the programs. And gaps do exist, also between the ordoliberals and Hayek, since the foundation of the respective searches for a notion of competitive order is based on different topoi. While Eucken and Röpke legitimize the desirability of the competitive order by its capability to disempower and to decentralize economy and society, Hayek is less skeptical about the threats of private power, concentration, and centralization—perhaps owing to Böhm-Bawerk’s preliminary conclusion in his famous 1914 article that power can disrupt economic laws of supply and demand only in the short term, whereas the ordoliberals might be taking up Böhm-Bawerk’s challenge when he states that power has to be better integrated into marginalist economics than is the case at this very early point (Böhm-Bawerk [1914] 1999, 162–165; Streissler [1972] 1973). Instead, it is the epistemological properties of the competitive order that increasingly occupy Hayek’s attention, as he formulates the central function of competition to be a knowledge-discovery procedure. This is visible in terms of rhetoric in his increasing use of the term spontaneous order as a metaphor for the market economy. In addition, after The Constitution of Liberty and especially during the Law, Legislation and Liberty project, Hayek increasingly focuses on the evolutionary processes regarding the rules of human coexistence,

Ordoliberalism and the Austrian School    435 so that the notion of a designable, consciously constructible framework for the market process—which, as shown above, is explicitly present and rather prominent in his works of the 1930s and 1940s—does not fit that well anymore into this evolutionist turn (Buchanan 1992, 134–135). Since the criterion of whether frameworks are consciously constructible is vital for the genesis and the change possibilities of rules sets within a theory of orders, this issue of designability can be utilized as a separation line within Hayek’s own evolution: following his initial focus on business cycles and capital theory until the late 1930s, the 1940s and 1950s can be depicted as the “ordoliberal Hayek II” phase; during his Law, Legislation and Liberty project in the 1970s, the “evolutionist Hayek III” period starts, characterizing his last decades of productive theorizing, including the long Fatal Conceit project (Kolev 2010). Despite these later divergences, Hayek retained a lifelong appreciation of the Freiburg School. His inaugural lecture upon his arrival from Chicago at Freiburg ([1962] 1969) is a vivid testimonial to his lasting high esteem for Eucken and his associates. Numerous activities in the three last decades of his life, spent mostly in Freiburg, showed Hayek’s commitment to the heritage of the Freiburg School and the Walter Eucken Institute, of which he served as director and honorary president until the end of his life (Vanberg 2013). Whereas the relationships between the ordoliberals and Hayek are predominantly harmonious and close, Mises’s nexus to ordoliberalism is more intricate and problematic. The fundamental divergence is the question of the differentiability of the layers of “rules of the game” and “moves of the game” in the notion of the market economy. As depicted above, Hayek shares the ordoliberal commitment to the central role of this differentiability (separability) thesis for establishing a competitive order. Here the primary role of the state is to shape and improve the rules of the game but not to interfere in the moves of the game; that is, the distinction is between desirable order-based policy which constitutes and facilitates the free order, on the one hand, and harmful process-based policy which poses the interventionist threat to liberty, on the other. Mises opposes this stance of Eucken, Röpke, and his student Hayek and insists that any intervention is to be seen as an infringement on liberty, regardless of the level at which it takes place, be it at the level of the rules or at the level of the moves (Vanberg 1999, 219–228). From the very beginning of the founding of the Mont Pèlerin Society, Mises was explicitly critical of Hayek’s plans to reformulate liberalism and of the necessity to rethink the laissez-faire principle of liberalism, as can already be inferred from a memorandum from Mises to Hayek on the eve of the founding (Mises [1946] 2009). Röpke, with whom Mises had worked in Geneva between 1937 and 1940, was in Mises’s eyes an “outright interventionist” (Burgin 2012, 84). Already in 1949, at the second meeting of the Society in Seelisberg, Eucken and Mises clashed on the issue of whether enabling competition by confronting monopolies and cartels was an integral part of liberal economic policy (Plickert 2008, 198–203). Despite these theoretical differences, personal esteem also existed here. In 1966, Mises published a National Review obituary of Röpke in which he called Eucken and Röpke “the intellectual authors of Germany’s economic resurrection” (Mises 1966). On his very last journey from New York to Vienna in 1963, Mises made a stopover in

436   Political Economy Freiburg, where, upon Hayek’s suggestion, he was awarded his only honorary doctorate in economics. Very recent findings from the archives of the University of Freiburg, which will soon be published, show that Mises was particularly grateful to receive the doctorate from this faculty because of its special history. In addition, he held a lecture at the Walter Eucken Institute with the title “Property of the Means of Production in the Market Economy,” in which, judging by the title, he probably touched on the issues of interventionism (the process of identifying a manuscript from the lecture is still ongoing). Thus, an easy discarding of ordoliberalism by Mises as “ordo-interventionism” (Hülsmann 2007, 739, 880) seems an oversimplified reading of this decades-long relationship and calls for further research, especially of archival sources.

Complementarities and Incompatibilities for Today and Tomorrow Explaining ordoliberalism to classical liberals unfamiliar with this tradition is best done by indicating that it is a way of reasoning close to that known from Hayek’s work (Zöller 1995, 84). While the above analysis shows that Hayek’s work indeed bears a high degree of proximity to the ordoliberal paradigm, important differences could be identified within the analyzed generation. What are the consequences for scholars today who show interest in one or both of the two schools? What can be the mutual gains from trade if a higher degree of acquaintance leads to a higher degree of intellectual cooperation? Within the Austrian community, awareness of the specificities within Hayek’s own evolution can be helpful for the relationship of the Austrian paradigm to laissez-faire and the reason of rules. Particular groups within the community have shown strong antipathies to this side of Hayek’s search for a constitution of liberty, calling him a social democrat for the “large” scope of the state that he legitimizes in his political philosophy (Hoppe 1994; Colombatto 2007). As explained above, according to the ordoliberal perspective, the question of how much state is wrongly posed in this quantitative manner. Rather, the focus should be on the qualitative issue of what the prerequisites of liberty are and how they are to be guaranteed, so that an order does not degenerate and thus lose its desirable properties. Seen from this perspective of Freiburg (and “Old Chicago”), Hayek is neither a social democrat nor an interventionist; instead, he can be perceived as a political economist who is aware of the necessity of a constitution or framework for a free order to function persistently. Following this reasoning, today’s Austrian scholars might feel provoked to stop seeing every action by the state a priori as a threat to liberty and instead to differentiate between desirable order-based policy and hampering process-based policy measures, as attempted by Hayek in the third part of The Constitution of Liberty (Streit and Wohlgemuth 2000; Watrin 2000; Vanberg 2003; Wohlgemuth 2013). In this vein, ordoliberals share Hayek’s warning of “pretence of knowledge” (Anmaßung von Wissen) but have been warned from a reading that, in their eyes, misinterprets Hayek’s intention here: it would be wrong to read it as “pretence of not knowing anything” (Anmaßung von Unwissen), whereby liberal

Ordoliberalism and the Austrian School    437 scholars would have to abstain from recommending any kind of policy for epistemic reasons (Willgerodt 2004). While Austrians can receive some useful “statics” support from ordoliberal thinking regarding the necessity of pillars for liberty—in the sense of becoming more sensitive to the prerequisites of a free order, for example, by considering Eucken’s competitive order proposal or Röpke’s decentralization program, the ordoliberal paradigm today can be “dynamized” from Austrian influxes in two dimensions: the market process theory and the evolution of rules. First, ordoliberal market theory is based on market forms and shows some neoclassical properties, a fact that can be attributed to the close theoretical nexus between Eucken and Heinrich von Stackelberg (Eucken 1948a). Market forms fit well to depict the situation of extreme power concentration and undesirably stable equilibria characteristic of the German economy in the formative years of ordoliberalism, but they fail to explain dynamic transitions and disequilibria situations that are typical for a system of open markets as in today’s globalized economy (Bosch, Koslowski, and Veit 1990). Eucken’s topos of power would not lose its importance in such a market theory shift but would need a partial reformulation. The threat of market power per se is not as acute in open markets. However, what remains dangerous is that the market power of players—even if more transient today than in previous decades—is still capable of usurping the state in order to manipulate it in the direction of particular interests, such as closing the market or distributing rents, still very much in line with Eucken’s 1932 diagnosis of the “economic state.” Second, Hayek’s concept of cultural evolution—if applied here not just to processes in economy and society but more specifically to the research process of multiple generations within one school—entails a portion of necessary dynamism and openness for today’s ordoliberals in identifying and redefining sets of the desirable rules and their possible changes by later, nonformative generations. This change can be endogenized through an academic evolutionary process, and thus, the sets of identified and possibly redefined rules—even if the underlying principles and criteria of orders do not change—are in less danger of being seen as static “dogma,” a serious danger for any group of scholars when perceived in that way by scientific peers. Another field of possible complementarity of the two perspectives is the “division of labor” among them regarding different types of politicoeconomic situations to which they are best applied, especially related to the phenomenon of transition. Ordoliberalism’s focus on power and centralization makes it very attractive for use in periods when these topoi are particularly present, as in the transition periods in Germany after 1945 or in the post-Soviet world after 1989, when the issues of disempowerment and decentralization are among the most pressing ones. That is why shaping such moments of sudden breakups of incumbent power constellations in highly centralized states calls for the ordoliberal prism and order-based policy (Schüller 1992). Austrian perspectives seem better applicable to moments of political and societal stability of well-ordered economies, where the open market process itself can perform its endogenous property of precluding power accumulation in the economy more reliably, that is, where the seminal role of competition is indeed Hayek’s discovery procedure for innovative market solutions and not Eucken’s disempowerment procedure. Ordoliberalism

438   Political Economy can in this sense be seen to a greater extent as a theory for moments of urgency and instability, which, of course, are still omnipresent in the non-Western parts of the world today. Awareness that economic power is by far not irrelevant in such specific moments can prove to be an important impulse for Austrian scholars who sometimes ignore this phenomenon in a far too generalized manner (Block 1995; Armentano 2013).

Conclusion James Buchanan, while explaining in his last presentations the seminal role of the “Old Chicago School” for his constitutional approach to political economy, on various occasions underscored the role of the Freiburg School as being paradigmatic in reminding twentieth-century liberalism of the reason of rules (Buchanan 2012). Elinor Ostrom and Vincent Ostrom, in their writings and their visits to the Walter Eucken Institute, have also shown an explicit proximity to the ordoliberal way of thinking (Boettke 2012, 148). During the current crisis, Germany’s relatively positive development and the stance of the German government toward the European partners using the vocabulary of rules and of order-based policy have also brought ordoliberalism some international attention in the economic policy discourse (White 2010; Dullien and Guérot 2012; Kundnani 2012; Wren-Lewis 2012). In the academic world, in contrast, the ordoliberal paradigm has difficulties in convincing the economics profession that it is still a relevant and promising progressive research agenda. The reasons for this crisis are partly methodological and partly related to the perception of what relevant discourses are. The methodological gap between the ordoliberals of previous generations and today’s economics are comparable to the incompatibilities that Austrian scholars might face in today’s academia, related to the unwillingness to use the same formalistic language as that of predominant current paradigms. Concerning the choice of discourses to participate in, some ordoliberal scholars in earlier decades have chosen to primarily be public intellectuals instead of generating genuinely new scientific output; in addition, some have not actively participated in international discourses, preferring a concentration solely on Germany-focused debates. Austrians in recent decades have not committed the mistake of shunning new scientific output, the vibrant academic community in the United States and elsewhere being a clear indication of undiminished proliferation. In recent years, scholars close to the ordoliberal paradigm have undertaken initiatives to revitalize the ordoliberal heritage in academia, combining this tradition with institutions-related approaches such as constitutional political economy, public choice, law and economics and, certainly, with central tenets of Austrian economics (Vanberg 1988; Goldschmidt et al. 2009; Feld and Köhler 2011; Wohlgemuth 2013; Goldschmidt, Kolev, and Zweynert 2015). As in this chapter, the primary aim of these initiatives, which are most recently called “new economics of orders” (Neue Ordnungsökonomik), is to identify the commonalities with ordoliberalism in the different paradigms and, without ignoring the differences, to establish common ground for mutual advance. The current crisis has seriously reignited both public and academic

Ordoliberalism and the Austrian School    439 interest in fundamental economic debates and is doubtless a time of stir and rupture regarding societal rules, including discourses on the prerequisites of the free order. In this line of reasoning, aiming at a joint renaissance of various paradigms that broadly adhere to the motto of “laissez-faire within rules” might prove well timed today.

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Chapter 19

T he Tax State as S ou rc e of Perpetua l  C ri si s Richard E. Wagner

Introduction The sense of crisis that arose once again in 2008 is but the latest in a continuing chain of events that have evoked claims that a crisis has surfaced that calls for extraordinary action on the part of a state, presumably acting in the role of protectorate or guardian of its citizens. For the most part, these claims reflect the presumption that any particular crisis arises from outside the state, with the state subsequently acting to alleviate that crisis. Contrary to this common way of thinking, this chapter explains that tax-based states, particularly of the democratic form, contain imperatives within their modus operandi to create those very situations that subsequently are described as crises. This is not to say that crises are created through intentional state action, although some could well be. It is rather to treat a continuing parade of what are called crises as reflecting the logic of the operation of states that feed on taxation. Tax states attract patterns of activity that create situations that become widely regarded as critical. This heightened sense of crisis leads, in turn, to increases in power and prominence of political officials within society, further intensifying the operation of this crisis-generating logic that Higgs (1987) explores. The logic of how democratic states operate in this fashion, violating in the process a basic democratic ideology that describes states as protective or guardian agencies, is the purpose of this chapter. To say this is not to deny the significance of protective activities to societal flourishing. It is only to note that state activities invariably create Faustian bargains (Ostrom 1996) whereby the good that might be secured through the deployment of force to secure protection is also used to secure the numerous evils

I am grateful to Peter J. Boettke for offering valuable comments and suggestions on an earlier version of this chapter.

446   Political Economy that accompany the use of force and generate the very situations that subsequently are described as crises. The chapter starts with a brief description of the controversy between Rudolf Goldscheid and Joseph Schumpeter, for it was Goldscheid who coined the term tax state to express a particular mode of state operation wherein states operated by taxing market activities in contrast to operating in entrepreneurial fashion with their own capital, as Backhaus (1994) explains. This description is followed by exploring some of the parallels between cities and hotels as a means of examining alternative visions of the capital accounts of states. An understanding of the imperatives for the generation of crises through the activities of tax states starts with recognition that human action is subject to different substantive rationalities depending on the context of action. For purposes of this chapter, the prime difference is between action that takes place within a context of private property and action that takes place within a context of common or state property. Recognition that substantive or practical rationalities can conflict leads to a different treatment of the compound noun political economy. In this different treatment, particular attention is given to credit markets to illustrate how the generation of situations that are commonly described as critical is an intelligible feature of democratic political economy. These alternative treatments subsequently are brought to bear on public debt in light of the distinction between tax states and capitalized states. Perpetual crises are a product of this form of interaction between differently constituted entities, as Ikeda (1997) and O’Connor (1973) explain, with Ikeda focusing on regulation and O’Connor on budgeting. As a logical matter, elimination of perpetual crisis requires establishment of a single institutional framework for governing human action and interaction. As a historical matter, it is doubtful that this is possible, because societies require some admixture of private and common property (Wagner 2007). While singularity may be impossible to attain, there are different architectures of duality that can differ in the intensities of conflict that are likely to emerge inside those architectures, as Jacobs (1992) explains.

Goldscheid, Schumpeter, and the Crisis of the Tax State The term tax state originated in a controversy between two Austrian economists, Rudolf Goldscheid and Joseph Schumpeter, over the treatment of Austria’s public debt in the aftermath of World War I and the dissolution of the Austro-Hungarian empire.1

1  This began with publication of Goldscheid (1917) and continued with Schumpeter (1918). These works, along with additional pieces by Goldscheid, are collected by Hickel (1976) and accompanied by Hickel’s introductory essay. Schumpeter’s piece was made available in English in 1954. Goldscheid is not available in English, except for a 1958 excerpt.

The Tax State as Source of Perpetual Crisis    447 Goldscheid asserted that this debt represented a crisis for a state that relies on taxation and claimed that resolution of the crisis required a transformation of the state into an entity that operated with its own capital. By recapitalizing the state, Goldscheid meant a resumption of some of the aspects of feudal regimes where kings and princes used their assets such as lands and enterprises to generate the revenues for the conduct of kingly or princely activities along the lines common to the cameralist regimes that inhabited the Germanic lands starting in the sixteenth century and continuing into the nineteenth century. In their use of state property as a means of generating revenue for the activities of states, the cameralist regimes differed sharply from the mercantilist empires to their west. Where the mercantilist regimes were predatory on market activities and enterprises, the cameralist regimes operated within the market economy to generate revenues for the provision of services. While the cameralist era had ended early in the nineteenth century, a residuum of cameralist practice persisted late into that century. Public finances in the Germanic lands late in the nineteenth century were still financed significantly more heavily by revenues derived from the operation of state enterprises, as Backhaus and Wagner (1987) discuss and as Wagner (2012a) elaborates, than were the public finances in other lands. Where agricultural enterprises in such noncameralist lands as France, England, Italy, and Russia generated between 2 and 4 percent of state revenues, agricultural enterprises provided more than 17 percent of state revenues in Bavaria and close to that share in Prussia and Württemberg. State enterprises, moreover, provided nearly 60 percent of state revenue in such formerly cameralist lands as Saxony and Prussia. Railroads, post offices, and the like were not objects that drained revenue from state treasuries but rather were significant objects for supplying revenue. Goldscheid argued for a restoration of the cameralist form of state finance by transforming many enterprises into state ownership and subsequently operating those enterprises in revenue-generating fashion. In contrast, Schumpeter expressed doubt that under contemporary conditions state enterprises would be good sources of revenue. It was better for state revenue, he claimed, to have enterprises operated by real entrepreneurs, with states taxing those enterprises, than to try to substitute state entrepreneurship for market entrepreneurship. Instead, Schumpeter argued that Austria’s debt crisis was temporary and could be resolved by a one-time capital levy to buy bonds and then burn them, after which the state could resume its tax-based mode of operation. In short, there was nothing about the debt that jeopardized the existence of the tax state. Significantly different conceptions of the relationship among state, economy, and society are in play in these contrasting formulations. For Schumpeter, economy and state denoted distinct and separate domains of activity within society, with each of the domains acting according to principles unique to it. Hence, entities within the economy acted according to the principles and conventions of private property whereby societal patterns arise through production and exchange among market-based entities. In contrast, entities within the polity acted in parasitical fashion by taxing the fruits of

448   Political Economy market-based interaction. To be sure, such parasitical action was accompanied by ideological support grounded in claims of public good and necessity, but the state acted parasitically on the market economy all the same. Contrary to Schumpeter, Goldscheid sought to locate a uniform mode of operation that would pertain to both polity and economy. In this search, he did not support a refeudalization of society but rather sought to recapitalize the state. In the movement from feudalism to capitalism, taxes replaced capital as the basis for the generation of state revenue. As an idealized representation, a capital-based logic impels all enterprises to act to increase their market value, which they can do only by providing service valued by others. In contrast, a discordant note is injected into society when some entities operate within a tax-based logic. In the presence of taxation, it is no longer necessary for state enterprises actively to seek mutual gain, because they can live off the productive activities of market entities. This debate is now nearly a century behind us, the parties to the debate have long been dead, and the inspiration for the debate—Austria’s public debt after World War I and the collapse of the Austro-Hungarian empire—would seem to hold historical but not contemporary interest. Beneath the particularities of time and place concerning this debate, however, reside some enduring issues regarding relationships among what we recognize as private and public entities within a society. Both types of entity, after all, occupy the same societal space, so the governance of relationships between those different types of entity has great significance for the character of the structured living together through which societies are constituted. It is easy enough to point to particular instances of crisis. All crises contain a common thread, which is an incompatibility among the plans and anticipations of the various members of a society. The standard mode of economic theorizing treats societies as being in equilibrium until disturbed by an exogenous shock, with a new equilibrium eventually resulting. Typical discussions of crisis proceed within this mode of thought by asking how state action might help to restore a new equilibrium. An alternative line of thought, sketched in Wagner (2010), denies that it is meaningful to speak of exogenous shocks when society is the object of analysis, even though individuals experience exogenous shocks all the time. For a society, however, what is described as an exogenous shock is a misidentified conflict among plans of various members of the society. A significant source of that conflict, moreover, arises through the different rationalities that are set in motion when discordant institutional arrangements inhabit the same societal space, as shall be explored more fully below. The present sense of crisis that has spread throughout the West since around 2008 is a readily intelligible feature of a society that contains a large set of enterprises that together make up a tax state. At some future time, the current instance of crisis may appear only in our rearview mirrors, as has happened with all such crises throughout history. Yet we may be certain that as we keep moving forward, we once again find ourselves wrestling with crisis, for crisis is a natural feature of what might be called the societal genetics of the tax state.

The Tax State as Source of Perpetual Crisis    449

Capitalizing the State within the Economy: Cities as Hotels A city is a small-scale exemplification of state activity. Indeed, a city state is an alternative to a nation state as a form of state, as Spruynt (1994) explains in his treatment of city states and nation states. Both cities and nations organize the provision of services within some particular territory, much as did the princes of cameralist times and as do a number of small states today, of which seven European ones are described in Eccardt (2005). So, too, do hotels. A comparison of hotels and cities provides a different analytical window for comparing tax-based states and capital-based states. A recapitalization of the state would thus not require a restoration of feudal arrangements but would rather entail an extension of the hotel template to the organization of collective activities more generally. There is little if any formal difference between cities and hotels, as MacCallum (1970) explains lucidly. Indeed, a continuum can be imagined running from hotels to states. What exists in any particular instance is a geographic arrangement of human interaction and governance that entails both privately and collectively organized activity. The standard distinction between public goods and private goods is misleading, because it has nothing essential to do with a distinction between the domains of collective and market activity, as Wagner (2007) explains. The standard distinction between public goods and private goods is typically thought to entail an essential distinction between collective and market activity, because it is commonly presumed that public goods aren’t suitable for market production. This distinction is typically thought to render taxation the natural way to support state activity, in contrast to prices, which are the means of supporting market activity. This common presumption fails to recognize the numerous instances in which public goods are provided through market transactions, with hotels providing a good illustration of the supply of collectively beneficial activities through private property governance and with Boudreaux and Holcombe (1989) exploring the broad scope for incorporating contractual principles and practices into collective activity. The standard treatment of public goods follows from the conceptualization of the tax state as a complement of the market economy. While this conceptualization is overwhelmingly accepted by economists and other social scientists, there is no necessity to accept this conceptualization, because its acceptance reflects more historical convention than analytical coherence. A large and complex hotel is an excellent illustration of how both private and public activities are organized within a particular geographical territory. A hotel is a territory within which numerous market-type activities are undertaken. Guests stay in rooms they have rented from the hotel, which is no different from tenants who lease apartments within a city. They buy meals from restaurants located within that territory and also visit shops located within that territory. What are recognizably market types of activities are undertaken within the boundaries of a hotel. Within those same boundaries, however,

450   Political Economy numerous collective activities are also undertaken. Security services are provided, just as they are within cities. Hotels provide subways that run vertically, along with providing street lighting and sanitation services. Some larger hotels provide park and recreation services and sponsor art exhibits. In short, cities illustrate how public goods can be supplied through market transactions, as against being financed by taxation. While taxation was the path taken for the supply of state activities after the demise of the feudal system, it is plausible that those activities could have been and still can be organized through the market-based institutions of private property and contractual liberty. To do this would require the Goldscheid approach of recapitalizing the state, thereby replacing the tax state with a form of entrepreneurial state. How this might be done can be adumbrated here, but this is a topic that deserves a fuller treatment, by different people with different insights to bring to bear on the topic. The first thing to be said about hotels is that collective activities are financed through tied sales with market purchases. People who lease rooms in a hotel are paying a charge that generates revenue to support the provision of the collective services that the hotel offers. The owners of a hotel have the problem of selecting the forms and types of public goods to offer to attract business in an environment of free and open competition. As with any commercial activity, there is neither recipe for nor guarantee of success. There is, however, freedom to try to fashion enterprises that will be successful in covering their costs, which includes convincing investors to support the enterprise. The prime difference between cities and hotels resides in the character of their capital accounts and with this difference leading economic calculation in different directions (Boettke 1998; 2001), as will be explored below. For a hotel, all activities are organized within a framework of private and alienable property. At one time, a hotel might be owned by a single person. At some later time, the owner might divide ownership among several partners. At a yet later time, the partners might incorporate by allowing the private sale of ownership shares to replace the pervious requirement that partners could not dispose of their ownership without securing permission of the other partners. Whatever particular ownership form was in operation, the hotel would face the setting of seeking to attract customers in an environment where those customers had options regarding where to stay. Through this openly competitive environment, we find the familiar result of hotels varying widely in the quality of the rooms they offer and in the quality of the public services they supply. While hotel guests typically stay for short periods of time, it would be easy enough to imagine them staying for extended periods. Indeed, condominiums and apartments represent long-stay versions of hotels. It would also be easy enough to imagine a hotel, condominium, or apartment complex being converted into a town or city. To accomplish this would require little more than a change in the character of the capital accounts of the members of the unit. Individual tenants would continue to have transferable ownership over their living spaces, but ownership of all common territories and properties would be transferred to a body denoting the collective entity. Initially, this might be little more than a change on paper. But as time passed, the situation would surely change. The maintenance and operation of common properties would now

The Tax State as Source of Perpetual Crisis    451 require collective action, which would require new organizational arrangements. The hotel would have become a city. There is no principled reason why the reverse direction of movement couldn’t occur, with the city becoming a hotel. In either case, there is a conceptual distinction between people in their capacities as owners of assets and people in their capacities as consumers. With the hotel, people can consume services supplied by the hotel without participating in ownership of the hotel. In contrast, people are both consumers and owners when cities supply public services. Under present institutionalized practices, individual homeownership is a significant source of personal wealth. It would doubtless be different if cities were transformed into hotels. In this transformation, practices would come to resemble much commercial real estate, where businesses are often tenants and not owners.

Capitalization and the Value of Cities Cities contain many businesses and residences that are subject to private ownership and so have market value, because those businesses and residences can be sold. Cities themselves, however, have no market value, because they operate through collective or inalienable property rights. Yet they could acquire market value. All that would be necessary would be for alienable property rights to be established. If so, cities would become genuine corporations as distinct from their current status as municipal corporations, with the adjective municipal denoting that ownership of the corporation is inalienable. If the ownership rights to cities were to become alienable, the distinction between cities and hotels would dissolve, as Foldvary (1994) examines and as Wagner (2011) explores. The city as a form of tax state would be transformed into a hotel as a form of entrepreneurial state. All that would be required would be a change in the conceptualization of ownership and the associated change in the character of the capital account. Like cities, hotels contain territory that holds both private and collective activity. The rooms that people rent in a hotel map directly into the houses and apartments they occupy in cities. Both hotel rooms and apartments are financed through market prices. Hotels and cities differ only in how their collective activities are financed. Hotels finance collective activities through market prices that are tied to or embedded in the prices of rooms. Cities finance collective activities through taxes imposed on the value of market transactions. Those taxes might be expressed as a share of the value of real estate. They can also be expressed as a share of the value of retail transactions, as with sales and excise taxes. Collective activities will be supported in some manner, and the central questions concern in what manner and to what effect. The hotel illustrates the capitalized state, while the city illustrates the tax state. Before turning to the dynamical differences between the hotel and city frameworks, it will be worth exploring a bit more fully some issues regarding the capital accounts of cities in comparison with those of hotels. Hotels face the same problem as cities in choosing what kinds of collective activity to support and to what extent. There is, however, no problem in inducing a registration of

452   Political Economy demand for collective activities. Demand is never expressed in advance of production, contrary to all of the concerns expressed about demand revelation. Production always occurs first, with the value of those entrepreneurial choices revealed subsequently according to how eager people are to buy the services. A hotel is no different in this respect. A hotel will offer a supply of rooms along with a package of collective services. For the hotel, the supply of collective services will be tied to the rental of rooms. The economic challenge facing the hotel is to construct a package of private and collective services that will result in a successful operation, meaning that the hotel is able to generate a return on its investment that induces no desire to liquidate that investment. The same situation is faced by cities. Cities and hotels both provide security services, and both face problems of how to organize that provision. Cities and hotels both provide forms of public transit. In cities, public transit is typically in the form of buses and subways; in hotels, the most common form of public transit is elevators. Cities typically provide parks, and so do hotels. The parks in smaller hotels might be small and simple, such as sitting areas in lobbies. Small cities likewise typically have small and simple parks, in contrast to large cities. But large hotels can likewise be found in which elaborate parks exist and which encompass such attractions as rock climbing, aquariums, aviaries, and art exhibits. There is nothing about the economic organization of hotels that does not mirror the economic organization of cities. Nothing, that is, but the system of property rights under which that economic organization operates and takes its shape. For hotels, ownership rights are universally alienable. But for cities, alienability is incomplete. An owner of a business can sell that business in whole or in part, but ownership in city parks or buses cannot be sold. To be sure, it is possible to imagine institutional arrangements that come close to providing alienability in the ownership of cities. Suppose cities were financed by a flat tax on the value of real estate within city boundaries and that participation in collective action was the exclusive province of the owners of real estate. In this institutional setting, people acquire tied packages of real estate and city assets. In buying and selling real estate, a tied package of real estate and city assets is the object of the transaction. Hence, the market value of real estate includes some implicit value for the ownership of city assets that is tied to the real estate.

Owners, Customers, and Capital Accounts With a hotel, there is a clear distinction between the capacities of being owners and of being customers. While a customer can also hold ownership in the hotel, this jointness is neither necessary nor typical. With a democratically governed city, however, those who use city services are simultaneously owners of the city and of its assets. One cannot live in a tax-financed city without becoming an owner. The acquisition of ownership is a necessary condition of residing in the city, in contrast to the voluntary acquisition of ownership in hotels. With hotels, the capital account specifies the liability of individual

The Tax State as Source of Perpetual Crisis    453 owners: the market valuation of their ownership might fall to zero, but they cannot be forced to supply additional capital. If a majority of shareholders, or even a minority of them, conclude that they would like to increase their investment in the hotel, whether by buying bonds or subscribing to new stock, they can do so. The remaining shareholders do not have to do this. Were the hotel to be converted into a city and governed accordingly, a different setting for governance arises, as a result of the establishment of a different relationship between cost and choice (Buchanan 1969). There are numerous particular ways in which a hotel could be transformed into a city, and likewise for the transformation of a city into a hotel. A simple mental experiment for moving from a hotel to a city would be to eliminate the transferability of ownership shares and adopt some constitutional framework in which governance runs through voting. The possible details by which this might be accomplished are numerous. Simple nationalization without compensation would be one option, as a type of revolutionary act. Alternatively, shareholders could be given city bonds whose face value was equal to the market value of the ownership shares. The central point of this mental experiment is to illustrate possible transformation across institutional arrangements through revisions to the capital account of the enterprise. Where the hotel is governed by private or alienable property rights and private ordering, the city is governed by collective and inalienable property rights with public ordering. Hotel governance occurs through a network of contractually constructed relationships where all participation is voluntary. A hotel that wants to secure a vendor for one of its empty stores must attract that vendor. In contrast, a city can use partial compulsion to attract that vendor. Compulsion is partial because the city cannot conscript the vendor to locate in the city. But the city can offer inducements to potential vendors that would be unlikely to have been offered by the hotel. Those inducements would not be paid for by voluntary contributions from those residents who have special attachment to that particular vendor; they would be paid for by tax extractions paid for to a large extent by residents who lacked such special attachment. Contractual relationships reflect mutual promises (Fried 1981). In contrast, relationships organized through collective property arrangements operate with an admixture of mutuality and compulsion: where some people are willing supporters of particular collective actions, others are forced supporters through taxation. What results from this admixture is a conflict between the distinct rationalities suitable to private and public ordering and with this conflict being the source of perpetual crisis within the tax state.

Conflicting Rationalities within an Entangled Political Economy Economic theory is centered on the presumption that people act rationally in applying means to the pursuit of ends they have chosen. In this presumption, rationality is treated in a purely formal manner, as illustrated by generic models of optimization and

454   Political Economy constrained maximization. If all economic activity took place within the framework of a pure market economy where all economic relationships were governed by private property, this might be fine, because the form of rational conduct would conform to the substantive requirements of such conduct. But political economy denotes interactions and relationships among differently constituted entities. While economic entities are constituted according to the principles and conventions of private property, political entities are constituted according to the different principles and conventions of common or collective property. There are thus different institutional contexts within which economic interaction occurs, and these differing contexts generate differences in the substance of rational human action, as conveyed by the formulations of Bourdieu (1990), Gigerenzer (2008), and MacIntyre (1988). A single formal setting for rational conduct can map into various substantive patterns of rational conduct. The significance of context for the substance of rational action can be illustrated by the harvesting of oysters. As Angello and Donnelley (1975) explain, oysters can be harvested on either privately held or commonly held grounds. Oysters are harvested by dredging the seabed. When this is done, immature oysters are dredged up along with mature oysters. Cultch on which oysters grow is also dredged up. When oyster grounds are held privately, a farmer who takes the time to return the immature oysters and cultch before moving to another location will increase the present value of future harvests. This is not the case when oyster grounds are held in common. With common ownership, someone who stops to return immature oysters will mostly be increasing the value of the oysters that other people harvest at later times. If one hundred people farm oysters on that common ground, the farmer who delays harvesting to return immature oysters and cultch will bear all of the cost of that delay while receiving on average only 1 percent of the increased future yield. The substantive or practical rationality of farming oysters under common property differs from the practical rationality of farming them under private property. At first glance, this difference in contexts might seem to show simply that productivity will be higher when oyster grounds are held privately than when they are held in common. This is so, as Angello and Donnelley showed. So long as these different institutional contexts have separate domains of operation, what results is a simple difference in productivities across institutional arrangements. But what happens if the two domains intersect? This is the setting for political economy, where there is interaction among entities that operate within different institutional contexts. Market-based entities are formed according to the conventions of private property and operate according to those conventions. In contrast, polity-based entities are formed according to conventions of common or collective property and operate according to those conventions. Moreover, there is interaction between those distinct types of entity, which leads to clashes that would not normally be part of the operation of a market economy. For instance, scholars of law and economics have long noted that commercial disputes typically are settled without the disputants going to trial (Miceli 1999). There is a simple economic explanation for this observation, and it is grounded in the logic of private property. The disputants are residual claimants to their legal expenses, so they

The Tax State as Source of Perpetual Crisis    455 can keep whatever expenses they can save by settling the case rather than going to trial. The situation changes if one of the disputants is a public entity. A public entity is not a residual claimant to legal expenses. Whatever legal expenses might be saved by settling a dispute will revert to the budget and will be deployed to other activities. An ambitious attorney general who is interested in seeking higher elected office can, however, convert legal expenses into an investment in seeking that higher office by selecting cases based on their ability to generate favorable publicity for the prosecutor. What results is an instance of a tectonic clash between rationalities, a clash that can be played out many times through interactions between market-based and polity-based entities, resulting in tectonically generated turbulence within society. Credit transactions and credit markets provide a good illustration of such internally generated turbulence. It is conventional to refer to credit market in a generic fashion, just as it is conventional to speak of rationality in a purely formal manner. But just as rationality operates to differing substantive effect under different contexts for human action, so does credit market have widely different meanings and implications under different institutional arrangements. Credit transactions governed by private property will differ in many ways and with significant effect from credit transactions governed by common or collective property relationships. To apply the generic term credit markets across different institutional arrangements surely does more to obscure than to illuminate many credit phenomena. Credit markets are often depicted in terms of the demand and supply of loanable funds. This depiction divides the world between those who desire to receive credit and those who are willing to supply it, with financial institutions serving in an intermediary capacity. A credit contract is a form of rental contract in which a lender gives temporary custody of an asset to a borrower. As with any rental contract, several issues arise regarding the lender’s concern with regaining the asset at the end of the contract, with receiving the asset in proper condition, and with receiving payment as agreed. Such issues are reflected in the various terms of credit contracts. Borrowers have to convince lenders of their reliability, with the means of trying to do so including paying higher rates of interest and accepting provisions for collateral and repossession that are sufficiently favorable to the lender to lead to an agreement between borrower and lender. The aggregate of all such transactions under wholly private property will constitute the market for credit. Within this setting, the terms of credit transactions and the volume of those transactions is a simple aggregate of individual transactions. Whether or not a contract is made after a meeting of a borrower and a lender is a matter that resides only between the parties. If the lender rejects a borrower’s proffer, the borrower is free to try a different lender; however, the borrower has no recourse to a third party to try to force the lender to extend credit. This is how it is with private property and private ordering. This situation is a purely abstract rendition of a pure market economy where all relationships are governed by private property. Probably nowhere do actual credit arrangements operate in this manner, because states intrude into credit markets in numerous ways. One way is through regulation of private contracting. Another way is through direct participation

456   Political Economy as borrower or lender, as illustrated by transactions in public debt and by guarantees of private loans. In all of these cases, the intrusion of public ordering into credit markets brings some qualities of common property into the operation of credit markets. This intrusion intensifies the turbulence that would naturally accompany credit transactions even under private property and private ordering, because of the conflicting rationalities that are set in motion. Under private ordering, credit transactions are dyadic. Each transaction is between willing participants, and the aggregate set of transactions is what is meant by the term credit market. When public ordering intrudes, credit transactions become triadic. A credit transaction is no longer exclusively between a borrower and a lender. Public entities now participate in credit transactions. As one illustration of such participation by public entities, Freddie Mac and Fannie Mae were instructed in 1995 to provide at least 42 percent of mortgages to borrowers with incomes below the median income for that region. This requirement was increased to 52 percent in 2005, with at least 12 percent going to borrowers whose incomes were less than 60 percent of the median income (Moyo 2011). A different pattern of credit transactions results in the presence of public ordering from what would result under purely private ordering. There is no doubt that reasons or justifications can be advanced in support of any such measure, for the supply of such derivations along the lines of Pareto (1935) is doubtless limited only by the quality of one’s imagination. It is equally certain, however, that the resulting set of credit transactions will be more volatile than what would have resulted under purely private ordering. The simple fact of the matter is that public ordering forces lenders to replace some transactions they would have made with transactions they would not have made. With lenders operating under private property, moreover, they bear the value consequences of nonperforming loans. In contrast, collective entities bear no value consequences, because those entities have no enterprise value in the first place. It is a mistake, however, to think of market-based lenders as making up a unified mass and public entities that are involved in credit transactions as another unified mass. Once both sets of entities are recognized to be networks of entities, analytical space is created for lenders to be differentially favored or hindered by the requirements imposed by public ordering. So we find public ordering increasing turbulence within credit markets, which in turn will elicit various offers of guarantees to cover over the increased turbulence that is created. Those guarantees, however, do not come from some sponsor’s capital account, for there is no genuine sponsor who funds the guarantee. The guarantee is left as a general charge on the fiscal commons, contributing to its tragic character (Wagner 2012b). What results is a form of tectonic collision in which the imperatives of private ordering conflict with the imperatives of public ordering, similarly to the institutional incongruity within a society that Lachmann (1971) explores. Under private ordering, all credit transactions conform to Ricardian equivalence; for if they did not, the transaction could be theft, or it might be charity, but most certainly, it would not be commerce. With public ordering, lenders are forced to make transactions that do not conform to Ricardian equivalence.

The Tax State as Source of Perpetual Crisis    457 What thus results is a form of tie-in sale in which lenders make some loans of their choosing while also making loans to conform to the requirements of public ordering. Regulation will thus reduce the expected gain from participating in credit markets, which by itself would shrink the supply of credit. Public ordering can also operate to offset this shrinkage, as by subsidizing those losses in a separate transaction, perhaps as illustrated by doing commercially favorable business with those lenders, with that favorable business doubtless financed to some extent by tax burdens that are higher than they would otherwise have been. Beyond the particular instance of credit markets, the conflicting rationalities generate internal commotion beyond what would be generated within the ordinary ecology of plans that denotes a market economy (Wagner 2012c). In other words, state action cannot improve on the ecology of plans, but it can disorient the operation of that ecology, in contrast to the ideology of supplying protection.

Contrasting Frameworks of Political Economy Schumpeter’s formulation of the tax state entailed denoting states and markets as separate objects, each referring to subsets of activities that interact with one another. With the demise of the feudal system, the state became dependent on market entities for support. The state was no longer an entrepreneur or enterprise, regardless of how good or bad it might have been. Instead, it became parasitically attached to the market economy. This parasitical quality reflects recognition that the state does not have the entrepreneurial tools necessary to generate a self-supporting stream of revenue. There is no transferable ownership for public enterprises, so there can be no market valuation of those enterprises. Without such market valuation, no disinterested test is possible for claims that a particular state action has replaced a less valued with a more valued option. To be sure, state enterprises necessarily engage in economic calculation, for all choices entail appraisal by some choosing agent, but that appraisal remains the private knowledge of the chooser and is not subject to third-party examination, in contrast to the third-party appraisal that is possible when ownership shares are transferable.2 Pantaleoni (1911) conceptualized societies with a tax state as containing two systems of pricing: a market system of pricing and a political system of pricing. The market system can generate prices; the political system cannot and must instead operate parasitically on the market system. This host-parasite relationship gives a different character to political-economic interaction in the presence of a tax state from what would result in the presence of a capitalized state, with that interaction promoting the inconsistencies 2  Closely held firms don’t have an active market in ownership shares, but ownership is transferable all the same, and so such firms have latent market value that is revealed when such firms are sold or otherwise reorganized.

458   Political Economy among entrepreneurial plans that result in a continuing parade of situations that are commonly designated as instances of crisis. The tax state is a form of fiscal commons (Wagner 2012b), with instances of crises reflecting interaction among common property and private property entities. Interaction among such entities is central to the systemic generation of crises. Should those entities operate in separate societal spaces, it would simply mean that private property entities would tend to operate with greater technical efficiency in resource allocation than common property entities. But those entities don’t operate in separate spheres. They are entangled in a system of political economy. It is temptingly convenient to treat the state as an independent entity, as a form of Leviathan (Brennan and Buchanan 1980; de Jasay 1985) that maximizes its revenue or some similar objective function. In this type of formulation, the state is treated as a monocentric entity as a cousin to a private firm. Yet democratic states are characterized by having multiple sources of independent participation, resembling an order much more than an organization, as Ostrom (1997) explains with particular cogency. This recognition that states are polycentric entities leads to an alternative orientation toward the internal generation of crises. Economists typically treat entities as scalable, with the difference between small and large being a simple matter of multiplication. There is good reason to think that the conventions of private property promote scalability. Should a firm that doubles in size encounter organizational difficulties that reduce its ability to compete with smaller entities, we may feel confident that competitive processes will reduce the size of that firm. There is thus good reason to think that the difference between small and large firms is mainly quantitative, with large firms just doing more business than small firms—and with firms of all sizes engaged in the same types of activity all the same. Extended to governments, the principle of scalability would similarly say that there is no significant difference between a town of 10,000 people, a city of 1,000,000 people, and a nation of 100,000,000 people. Each larger unit is 100 times larger than the preceding unit, but governance is scalable and proceeds in the same manner regardless of size. This common presumption, however, is erroneous. Suppose the town is governed by a council of 10 members. Each member of the council will represent 1,000 residents. At this scale, it is reasonable to presume that each member of the council has personal knowledge of the residents he represents. It’s also reasonable to presume that members of the town council have deep knowledge of one another, allow great scope for tacit knowledge to come into play, and conduct much town business in a relatively informal manner even if regularly scheduled meetings are also held. Governance within a city with 1,000,000 is not simply a matter of multiplying town governance by 100. Governance relationships are not scalable.3 The city council could remain at 10 members. If so, each member would now represent 100,000 residents. At this scale, it is impossible for council members to have personal knowledge of more than 3 

See Barabási (2002) for an extended examination of networks that are scalable in comparison with those that are scale free.

The Tax State as Source of Perpetual Crisis    459 the proverbial handful of those they represent. To the extent that residents are known to council members, it typically will be as members of some such aggregated status as campaign contributors or members of some prominent association. The political patterns associated with interest-group processes will come more fully into play. Alternatively, the town council could be enlarged to 1,000 members, thus maintaining the scale of representation at 1,000 residents per council member. An assembly with 1,000 members cannot, however, conduct any business in an open manner and will instead revert to various oligarchic devices that limit significant participation to a handful of members of the council, as Michels (1962) and de Jouvenel (1961) explain. For a nation of 100,000,000 people, the oligarchic tendency of democratic polities intensifies further. Nations will thus undertake activities that would never be undertaken in towns, because of changes in the scale of governance in conjunction with the specialized and divided quality of knowledge. The business of a town council might be conducted under conditions that conform reasonably well to notions of complete knowledge that economists use so often to close their models. But as the scale of government increases, the activities of government become more fragmented and specialized, as does knowledge about the activities of government. Within a town, for instance, business regulation is likely to be general in its application. For a large nation, regulation will be highly discriminatory, extending even to some firms being treated differently from other firms in the same industry. Public debt provides a promising avenue into the analysis of democratic oligarchy within the tax state.

Promise, Contract, and Public Debt: Who Owes What to Whom? The tax state does not finance its activities from the revenues it generates through commercial activities by the enterprises it sponsors. Rather, it generates its revenues from the taxes it imposes on the activities and enterprises of private citizens who act within the market. Rather than imposing taxes to finance an activity, the tax state can issue debt by selling bonds. Doing this is to substitute future taxation for present taxation. It is a linguistic convention to speak of states as being indebted, as illustrated by references to the effect that the public debt of the American federal government is now roughly equal to annual GDP, which in turn can be expressed as being on the order of $50,000 per resident. This convention is misleading, because it treats the state as an acting entity that acquires debt just as a monarch might acquire debt. A monarch can become indebted, and it would be reasonable for a monarch’s creditors to be concerned about being repaid. If we ask who becomes indebted when a democratic state borrows, the question is not easy to answer in any substantive manner. As a purely formal matter, it can be answered by saying that the people become indebted. But this answer isn’t quite right, because it reduces the “people” to a representative agent, in which case borrowing is impossible.

460   Political Economy For a democratic polity, public debt is incurred by a parliamentary assembly. Creditors of the state have agreed to buy government debt. But who has agreed to accept liability to amortize the debt? It is certainly not the members of parliament who approved the debt, for they bear no liability to repay that debt. Liability to service the debt becomes a future charge upon the fiscal commons. But what kind of liability is this, or whom might it obligate? With personal debt established under private ordering, the pattern of obligation for amortization is clear. But it is not similarly clear for public debt. Much in this respect surely depends on the appropriate characterization of the political process through which public debt is created. In this respect, de Viti de Marco (1936) distinguished between two forms of democratic states, which he called cooperative and monopolistic. The cooperative state was similar to Wicksell’s ([1896] 1958) call for unanimity within parliament as a suitable benchmark for beneficial collective action. If collective choices were made under a rule of unanimity, collective activity would expand so long as all in the society thought they gained from such activity. This statement could not be made under other voting arrangements, for unanimity brings scalability in its train, while other arrangements do not. A monopolistic state dominated by interest-group processes, for instance, would be encased in relationships of domination and subordination. Some would gain and some would lose through state activity, which might lead to a distinction between willing debtors and forced debtors with respect to public debt. In this instance, the creation of public debt to finance added expenditure would reflect a coalition among bondholders and citizen advocates of added public spending, with that coalition dominating citizen opponents of added public spending. So long as the dominant coalition remains dominant, rolling over of the debt is likely to continue. A shift in the pattern of coalitional dominance, however, could bring a reversal in support for public debt. Actual polities are doubtless admixtures of cooperative and monopolistic modes of operation, with the monopolistic mode increasing with increases in the size of units of government. In the United States, for instance, nearly half the adult population is exempt from the federal income tax. For people in this position, there is no personal cost of supporting governmental activities financed through the income tax. On the other side of the matter, something like 50 percent of income tax revenues are collected from about 10 percent of the population. This situation can easily map into a distinction between tax providers and tax eaters, which in turn is a form of domination and subordination and not a form of cooperative state. If a population comes increasingly to sense the existence of some such cleavage, questions concerning the legitimacy of a particular regime seem increasingly likely to come into play as a consequence of conflicting rationalities.

Conclusion The tax state represents a particular historical appearance of a particular manner of societal organization to provide for various collective activities. Prior to the tax state, there was the feudal state. Human nature is constituted to provide space in society for

The Tax State as Source of Perpetual Crisis    461 both activities directed at private accomplishment and activities directed at providing for collective wants within the relevant territory. With the demise of the feudal state, states in the persons of princes and kings gave way to parliamentary assemblies, with formerly royal lands largely transformed into private ownership. The tax state arose as a parasitical attachment to the market economy. Where the feudal state generated revenue through its activities, the tax state generates revenue through parasitical attachment to market enterprises and activities. This parasitical attachment generates forms of societal tectonics through the clash of rationalities that accompanies the division of the economic organization of the society into collective and market activity, with collective activity conforming to the imperatives of common property, while market activity conforms to the imperatives of private property. What results is a continuing sequence of societal earthquakes that often are described as instances of crisis, recognizing that crisis is a description that can be used as a tool for generating support for a regime. Whether the continuing parade of crises can be weathered is for the future to determine. It can be asserted, however, that those crises are a product of conflicts and incongruences among the institutional arrangements that operate within the same society, with some of those incongruities noted with special clarity by Lachmann’s (1971) examination of Weber. As presently organized, the democratic state operates with a feudal-proletarian orientation, which conflicts with the bourgeois orientation that characterizes the market economy. There are, however, institutional means of going beyond that conflict by expanding on the notion of hotels as cities, which would lead in the direction of an entrepreneurial state to replace the tax state. Knut Wicksell’s (1896) treatment of unanimity and not majority rule as a benchmark for beneficial collective action is one particular institutional suggestion for dissolving the incongruity of private ordering and public ordering. While Wicksell is mostly cited as an exponent of unanimous consent, his venture into institutional-based public finance had several elements that he thought would work together to bridge the gap between private and public ordering, as Wagner (1988) explains. For one thing, Wicksell presumed that a system of proportional representation could be instituted that would make it reasonable to claim that unanimity within a parliamentary assembly would correspond to unanimity within the society. Under unanimity, moreover, parliamentary activity would resemble commercial transactions. In Wicksell’s formulation, the tax state would have been replaced by a form of entrepreneurial or commercial state. A formulation similar in spirit was set forth by Walter Eucken (1952) in articulating the requirement that state actions should not violate the central operating principles of a market economy, namely, private property, freedom of contract, and liability for the value consequences of one’s actions.4 State actions would thus be restricted to conformability with the operating principles of a market economy. To be sure, one might reasonably wonder how this restriction might be implemented. After all, Primo (2007, 109) notes 4 

For some significant extensions of these ideas, see Vanberg (1988), Streit (1992), and the essays collected in Leipold and Pies (2000).

462   Political Economy that Congress enacted legislation in 1978, known as Bryd-Grassley, which abolished deficits after 1981. Simply to articulate a principle is not by itself to bring that principle to life. There are, however, several strands of thought that come together in illuminating how perpetual crises are a natural operating feature of a tax state, with the supporters of state action typically seeking to use the crisis of the day to strengthen state power still more. The capitalized state is an ideal type that stands in sharp contrast to the tax state. Cities are municipal corporations that could be transformed into genuine corporations, dissolving in the process the institutional incongruity that brings about a continuing parade of crises as a natural product of a tax state inside an otherwise liberal society.

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The Tax State as Source of Perpetual Crisis    463 Jacobs, J. 1992. Systems of Survival. New York: Random House. Lachmann, L.M. 1971. The Legacy of Max Weber. Berkeley, CA: Glendessary Press. Leipold, H., and I. Pies, eds. 2000. Ordnungstheorie und Ordnungspolitik: Konzeptionen und Entwicklungsperspektiven. Stuttgart: Lucius & Lucius. MacCallum, S. H. 1970. The Art of Community. Menlo Park, CA: Institute for Humane Studies. MacIntyre, A. 1988. Whose Justice? Which Rationality? Notre Dame, IN: University of Notre Dame Press. Miceli, T. J. 1999. “Dispute Resolution.” In The Elgar Companion to Law and Economics, edited by Jürgen G. Backhaus, 219–229. Cheltenham, UK: Edward Elgar. Michels, R. 1962. Political Parties: A Sociological Study of the Oligarchical Tendencies of Modern Democracy. New York: Collier Books. Moyo, D. 2011. How the West Was Lost. New York: Farrar Straus and Giroux. O’Connor, J. 1973. The Fiscal Crisis of the State. New York: St. Martin’s Press. Ostrom, V. 1996. “Faustian Bargains.” Constitutional Political Economy 7: 303–308. Ostrom, V. 1997. The Meaning of Democracy and the Vulnerability of Societies: A Response to Tocqueville’s Challenge. Ann Arbor: University of Michigan Press. Pantaleoni, M. 1911. “Considerazioni sulle proprieta di un sistema di prezzi politici.” Giornale degli economisti 42: 9–29, 114–133. Pareto, V. 1935. The Mind and Society: A Treatise on General Sociology. New York: Harcourt Brace. Primo, D. 2007. Rules and Restraint:  Government Spending and the Design of Institutions. Chicago, IL: University of Chicago Press. Schumpeter, J.  A. 1954 [1918 in Hickel (1976)]. “The Crisis of the Tax State.” International Economic Papers 4: 5–38. Spruynt, H. 1994. The Sovereign State and Its Competitors. Princeton, NJ:  Princeton University Press. Streit, M. 1992. “Economic Order, Private Law, and Public Policy:  The Freiberg School of Law and Economics in Perspective.” Journal of Institutional and Theoretical Economics 148: 675–704. Vanberg, V. J. 1988. “Ordnungstheorie as Constitutional Economics: The German Conception of a ‘Social Market Economy.’ ” ORDO 39: 17–31. Wagner, R. E. 1988. “The Calculus of Consent: A Wicksellian Retrospective.” Public Choice 56 (February): 153–166. Wagner, R.  E. 2007. Fiscal Sociology and the Theory of Public Finance. Cheltenham, UK: Edward Elgar. Wagner, R. E. 2010. Mind, Society, and Human Action: Time and Knowledge in a Theory of Social Economy. London: Routledge. Wagner, R.  E. 2011. “Municipal Corporations, Economic Calculation, and Political Pricing: Exploring a Theoretical Antinomy.” Public Choice 149: 151–165. Wagner, R. E. 2012a. “The Cameralists: Fertile Sources for a New Science of Public Finance.” In Handbook for the History of Economic Thought, edited by Jürgen G. Backhaus, 123—135. Dordrecht, Netherlands: Springer. Wagner, R.  E. 2012b. Deficits, Debt, and Democracy:  Wrestling with Tragedy on the Fiscal Commons. Cheltenham, UK: Edward Elgar. Wagner, R. E. 2012c. “A Macro Economy as an Ecology of Plans.” Journal of Economic Behavior and Organization 82: 433–444. Wicksell, K. (1896) 1958. “A New Principle of Just Taxation.” In Classics in the Theory of Public Finance, edited by R. A. Musgrave and A. T. Peacock, 72–118. London: Macmillan.

Chapter 20

C onstitu t i ona l P olitical E c onomy and Au strian E c onomi c s Mark Pennington

Introduction The latter part of the twentieth century witnessed a revival of interest in contractarian approaches to questions of socioeconomic organization. At the heart of what has become known as constitutional political economy is a concern shared with the earlier generation of contractarian thinkers that legitimate political authority must be based on the voluntary consent of the governed and on how one should determine the conditions under which this consent might be forthcoming. John Rawls’s A Theory of Justice was the contribution that reestablished the social contract tradition in contemporary political theory, while the works of James Buchanan inspired the development of a constitutional economics. In their different ways, Rawls, Buchanan, and their followers have sought to combine insights derived from modern social science with some core moral precepts in order to discern the requirements of a just constitution and to build this into various schemes for constitutional design. The emphasis on voluntary agreements in constitutional political economy reflects a shared orientation with the tradition of Austrian economics. Austrians have always rejected the idea that society should be conceived of as an entity separate from its constituent individuals and have focused on how purposeful individual action may contribute to the formation of socially beneficial practices. Yet there are, from an Austrian standpoint, important weaknesses in constitutional political economy that stem from the rationality assumptions underlying its analytical methods. This chapter aims to explore the implications of an Austrian perspective with a particular emphasis on Rawls and Buchanan. Its analysis is presented in four parts. The first sets out the ethical and methodological approaches of the two authors to questions of constitutional choice. The

Constitutional Political Economy    465 second summarizes the Austrian analysis of limited rationality and knowledge problems and their potential implications for constitutional design. The third section draws on Austrian insights while working within the contractarian constitutional principles set by the Rawls-Buchanan perspective. The final section sets out an Austrian-influenced argument for rejecting these principles. The aim of the chapter throughout is not to present a definitive account of what Austrians have to say about matters of constitutional choice but to offer a critique of constitutional political economy that is consistent with core Austrian concepts such as subjectivism, dispersed knowledge, bounded rationality, and the coordinating functions of spontaneous order.1

Rawls, Buchanan, and Constitutional Political Economy Constitutional political economy (CPE) is concerned with the choice of the rules that govern the interactions among members of a particular community. Although there are important differences among CPE scholars, what unites the perspective is the idea that the rules under which people live should be the result of voluntary agreement. Or that the relevant rules should be justifiable to actors who did not actually agree to the specific terms themselves. This requirement need not necessarily apply to rules covering every aspect of social life, but it most certainly should apply to those rules that constitute what Rawls calls the “basic structure” of society (such as rules of property ownership), which must typically be enforced by the coercive apparatus of the state. The centrality of voluntary agreement to CPE stems from a belief that the foundations of legitimate moral and political order should be understood in individualistic terms. According to this view, there is no social agency with moral standing over and above the individual agents who make up the community concerned. A legitimate authority therefore must be justifiable to the individuals who are subject to its coercive powers. In the case of Rawls, the advocacy of a contractarian method for questions of political legitimacy follows from his recognition that utilitarian alternatives fail to reflect the moral significance of the “separateness of persons.” On this Kantian view, the ability to reason and to pursue projects is what constitutes the distinctive moral core of human beings, and this should lead to an emphasis on securing basic individual rights (Rawls 1971). Each person should be recognized as a separate actor with the capacity for autonomous, reasoned action in pursuit of a plan of life. Utilitarian accounts of justice and social order are rejected, because they allow the possibility that individual rights may be overridden if this contributes to the “happiness of the greatest number.” On Rawls’s understanding, it is to place excessive “strains of commitment” on individuals to require 1 

Those Austrians influenced by the rights-based ethics of Murray Rothbard would undoubtedly take issue with the weak form of rule utilitarianism that this chapter reflects.

466   Political Economy that they submit to having their interests and plans sacrificed for the sake of social utility (Rawls 1971, 176–178). In such an order, people would never know if their rights are to be sacrificed and would lack the certainty necessary to formulate and implement a plan of life. By contrast, the just society is one whose institutional rules operate to the mutual benefit of all participants and reflect principles that all actors would willingly support. Buchanan also aims to put the understanding of constitutional order on an individualistic footing, and, like Rawls, this places him firmly in the Kantian tradition, with its emphasis on the autonomous individual as the focus of moral concern (see, for e.g., Buchanan 2001; see also Kliemt 2000). For Buchanan the economist, the individualistic approach is the logical implication of recognizing that economics is a “catallactic perspective” or “science of exchange” (e.g., Buchanan 1979). The science of “economics as exchange” focuses on the complex interactions that take place among many different individual “choosers” (Buchanan 1975b; see also Marciano 2009). When people know what they want and know what means are available to achieve these wants (as is the typical assumption in neoclassical economics), then it makes no sense to speak of choice. In a world of such complete certainty, choice becomes a mathematical problem that could be solved by computers. For Buchanan, by contrast, the proper subject matter of economics is choice that cannot be predetermined and could not possibly be dealt with by machines (Buchanan 1969). The implications that follow from understanding the subject matter of economics in the above regard are, according to Buchanan, twofold. First, politics cannot be seen as a means to achieve social ends, because there is no single fixed scale of value, no social end against which decisions can be evaluated. Second, if exchange lies at the heart of human interactions, then questions of politics revolve around how this exchange should be organized. For Buchanan, there are two fundamental ways in which this may occur. Either people can organize their exchanges on a private basis through market processes, or, where the organization of markets is impractical, they may opt into a collective choice structure, such as that provided by the state. The basic question of politics and of constitutional order, therefore, becomes how individuals agree to a set of rules determining the relative extent of privately organized versus collective action and how changes in these rules might be the subject of consensual agreement between individual actors (Buchanan and Tullock 1962; Buchanan 1975a). If voluntary agreement and Kantian ethics lie at the core of Rawls’s and Buchanan’s constitutionalism, then a further commonality between the authors is an attempt to identify the conditions where people might in fact agree to a set of constitutional rules to govern their interactions. More specifically, the aim is to highlight conditions that would enable individuals to choose rules in an impartial manner acceptable to all parties irrespective of their personal situation and bargaining power. Existing socioeconomic institutions can then be evaluated to see if and to what extent they might be compatible with the requirements of impartial justice. In the case of Rawls, the goal of impartiality results in the theoretical device of the original position (OP). In the OP, people are assumed to be choosing a set of constitutional principles from behind a “veil of ignorance,” where they know nothing about

Constitutional Political Economy    467 their particular position in society, the natural and socioenvironmental advantages/disadvantages they might have, or the ends in life that they wish to pursue (Rawls 1971, 139). The only information that participants are allowed to have in this thought experiment is the realization that they are choosing rules for a “closed society” and access to “general facts of social theory” that can help them to choose between regimes of socioeconomic organization such as private or public property, the market economy, or socialism (e.g., Rawls 1971, 142). The purpose of making these assumptions is to secure a reasoning process that is universal and general rather than one skewed to reflect the personal interests and biases of those involved. Although it is recognized that people in the OP do not consciously aim to achieve impartial results, the conditions behind the veil force even self-interested agents to reason in such a way that they take the interests of others into account when deciding their own personal fate. Deliberations behind the veil occur at the level of “ideal theory,” where it is assumed that conditions of full motivational compliance with the chosen rules will apply once the veil of ignorance is removed (Rawls 1971, 8). In the case of Buchanan, impartial reasoning when thinking about the design of legitimate political authority is secured with a different thought experiment. In The Calculus of Consent (Buchanan and Tullock 1962), actors know more about their current interests than is the case in the Rawlsian model but are assumed to be deciding rules from behind a “veil of uncertainty.” Constitutional choice concerns only general rules rather than specific legislation, so actors in the thought experiment do not know how these rules will affect particular individuals or groups. If a person is tempted to support a general rule that allows for discrimination or favoritism because he or she may benefit from a specific policy bias, that person is unable to predict whether he or she may be a victim of other policies passed under the same constitutional rule. Reasoning under such uncertainty, people will tend to adopt the perspective of the “typical” individual and will have strong incentives to opt for constitutional rules that are nondiscriminatory, positive-sum in character, and equally applicable to all (Buchanan and Tullock 1962, 78). Given their somewhat different ways of idealizing the conditions for an impartial process of constitutional choice, Rawls and Buchanan also differ about the substantive principles that might reflect a process of impartial agreement. For Rawls, choice from behind a veil of ignorance would lead people to prefer a “basic structure” of society characterized by his two principles of justice: the principle of equal liberty and the difference principle. The former, which is held to be “lexically prior” to the latter, states that individuals should have “the most extensive sphere of liberty compatible with a like liberty for all.” The difference principle meanwhile states that “an inequality is allowed only if the institution that allows it works to the greatest advantage of the least advantaged,” (Rawls 1971, 302). It is this second principle, alongside a commitment to “fair equality of opportunity,” that is widely held to justify the existence of an extensive and redistributive welfare state as part of any legitimate constitutional order. The logic behind Rawls’s derivation of the difference principle is that self-interested agents in the original position would opt for a rule of equal shares, but recognizing the scope to expand the social product by offering differential rewards, they would agree to inequalities provided these

468   Political Economy work to the advantage of the least well off. The underlying assumption is that people behind the veil are averse to risks and, not knowing what position they will assume when the veil is removed, will seek to maximize the minimum standard for those who turn out to be least fortunate in the lottery of life. For Buchanan, by contrast, the constitutional rule to emerge from behind a veil of uncertainty would be one reflecting the desire of individuals to minimize the possibility of facing the external costs of others actions (Buchanan and Tullock 1962; Buchanan 1975a). Buchanan conceives of constitutional choice taking place at two levels. The “constitutional stage” involves the assignment of individual rights via a “mutual disarmament” contract, which allows actors in a Hobbesian state of nature to “escape from anarchy” and the inconveniences of having to engage in acts of self-defense. Actors at this stage also bind themselves into a set of rules for decision-making at the subsequent “post-constitutional” stage. These rules will be ones that allow for Pareto-improving bilateral exchanges of property rights via market transactions. Realizing that there may be some collective goods that might not be supplied in markets, people will, however, also contract into a set of rules for collective/political decision-making over the provision of such goods. The ideal rule that would ensure all externalities are internalized during the political process would be one of unanimity, but the costs of achieving unanimous agreement may be too high. People would therefore accord to less than unanimity when deciding about the provision of collective goods, but in order to reduce the possibility of rent seeking and other predatory behavior, they would also agree to limit the actions of the collectivity by specifying constitutional constraints on government power, such as a cost/benefit rule or a requirement that goods produced benefit the general interest rather than particular groups. For Buchanan, then, the constitutional principles commensurate with voluntary consent are those of a limited government confined to the protection of persons and property and the provision of a set of collective/public goods. The differences between the Rawlsian and Buchananite perspectives and their modeling of constitutional choice reflect conflicting views on the significance of equality for voluntary agreement. For Rawls and his followers, meaningful voluntary agreement is only possible in circumstances where inequality has first been removed from the scene, hence the conditions specified in the OP and behind the veil of ignorance. Buchanan, by contrast, aims to discern the type of voluntary arrangements that could be agreed to even by unequal actors. Justice on this view involves people agreeing to a set of mutually beneficial rights in the context of past, present, and future inequalities. Rawlsians and other egalitarians have, as a consequence, criticized Buchanan’s approach for failing to take seriously issues of power and inequality in the determination of social rules. On this view, Buchanan’s derivation of strict limits to the power of the state with regard to matters of income redistribution offers little more than a justification for maintaining the position of those who may be unfairly privileged by the prevailing status quo (e.g., Barry 1965). From Buchanan’s perspective, however, this type of critique misses its mark. Given that the very need for institutions of justice arises from the potential for predation and

Constitutional Political Economy    469 because the state itself is a potentially predatory weapon that is as likely to transfer resources from the poor to the rich as vice versa (or from some subset of poor or rich actors to another subset of poor or rich actors), all people, irrespective of their current social position, have an interest in securing a framework that limits the potential for predation and increases the scope for mutually beneficial exchange (see Meadowcroft 2014). Rawlsian “ideal theory,” with its assumption of full motivational compliance with the principles of justice, assumes away the very conditions that give people at all levels of society good reason to be wary of an overly powerful state.

Austrian Economics and the Limits of Constitutional Construction With its insistence that the choices of individual actors should lie at the center of political analysis, the CPE perspective has much in common with the methodological individualism that is the hallmark of Austrian economics. The specific type of individualism that informs the Austrian approach, however, also exhibits significant differences of emphasis with CPE. By far the most important of these center on the knowledge and rationality attributes of individual actors. Whereas CPE analyzes how rational actors would approach the question of arriving at ideal constitutional rules, the Austrian perspective is concerned with the constraints on institutional design set by the limits of human knowledge and rationality. Hayek (1948), in particular, argues against a “false individualism” that conceives of society as the rational creation of individuals aiming to design optimal or efficient rules, of which contractarian approaches such as those of Rawls and Buchanan might be considered prime examples. For Hayek, even the most intelligent individuals lack the cognitive capacity to comprehend more than a tiny fragment of their society. Although people may act purposefully in their interactions with others, the complex patterns that emerge from this interaction are unintended consequences or “emergent phenomena” and cannot be not fully anticipated by those involved. Moreover, since the human mind must actively perceive the environment in which it is situated, the data on which people base their decisions are necessarily subjective. Different people confronted with the same data about their environment are likely to arrive at different conclusions about the best course to pursue. In essence, Austrian skepticism about designing an ideal constitution is analogous to the arguments against central economic planning developed by Mises and Hayek. In contrast to central planning, private-property-based competitive markets may be best placed to cope with the constraints set by bounded rationality, because they draw on and adapt to the subjectively held knowledge embedded in the multiple decision-making nodes that constitute them. The price signals that emerge unintentionally from the process of market exchange prompt “economizing behavior” and

470   Political Economy act as “knowledge surrogates” for the buying and selling decisions of countless actors, enabling a degree of coordination that would be beyond the cognitive capacity of a central authority (Hayek 1948; 1982). At the same time, the decentralized exchange of property rights allows divergent production and consumption ideas to be tested simultaneously via competitive evolution where both ends and means are subject to a process of intersubjective “discovery” (Hayek 1978). Private property rights and market decentralization facilitate the discovery of ends and means via the account of profit and loss while at the same time reducing the effect of what will be inevitable human errors. Markets cannot eliminate human error, but by decentralizing decision-making authority and allowing rival practices to coexist, they may reduce the likelihood of systemic failure, relative to a regime where decisions are concentrated in a single center of control. On a Hayekian understanding, processes of spontaneous order and competitive evolution also apply to many of the rules that underpin social life. Individuals are rule-following agents who must use the rules they find in their environment (such as those of language) as tools to cope with the limits of their own reason (Hayek 1948; 1982). Just as boundedly rational agents in markets can rely on price signals as surrogates for the economic experiences of many dispersed actors, they can also rely on culturally transmitted rules that have emerged via the trial-and-error interaction of countless people. In a world more complex than can be directly perceived, individuals must follow culturally transmitted rules without always thinking about them in order to navigate their relationships with others. Yet, given the possibility that these rules might be defective, they must remain open to challenge from those wishing to adopt a rival sets of practices. Just as market competition facilitates evolutionary discovery of the best-adapted products and processes, competition may enable the discovery of the best-adapted social rules. Incremental change via competitive testing of alternative practices is likely to produce a richer process of evolution than any attempt to reconstruct social institutions in whole cloth (Hayek 1982). The insights of Austrian economics as set out above have not been lost on CPE scholars. Buchanan, in particular, draws on many Austrian concepts, and his rejection of the mechanistic view of choice depicted in neoclassical models in favor of a catallactic perspective places him squarely within the Austrian camp. Where Buchanan parts company with the Austrian tradition—or, to be more specific, with Hayek—concerns the extent to which conscious design should play a role in the development of social institutions. From Buchanan’s perspective, an emphasis on “pure evolution” results in an unduly panglossian outlook in which everything that currently exists may be seen to have resulted from an evolutionary process and may therefore be assumed to be efficient. Yet, as Buchanan (1977, 31) contends, “the forces of social evolution alone contain within their workings no guarantee that socially efficient results will emerge over time.” The spontaneous order that may emerge in markets can easily transform into a spontaneous disorder in the absence of an appropriate set of rules that structure interactions so as to produce positive- rather than negative-sum results. Whether evolutionary processes produce beneficial rules depends on the type of selection mechanism in

Constitutional Political Economy    471 operation. One might not, for example, want to favor evolution in a context where the ability to use violence is the primary means of securing competitive advantage. From Buchanan’s perspective, the contractarian method provides a set of criteria against which to evaluate potential changes to existing rules (Buchanan 1977, chap. 2). Beneficial reforms are those that might be Pareto-improving and might thus secure unanimous support. Even from a starting point that reflects some prior injustice or inequality, the contractarian ideal of voluntary consent can generate proposals for institutional reform that would be to the benefit of all parties. Rawlsians would replace the unanimity/Pareto-improvement criterion with the difference principle as the relevant benchmark to judge proposals for constitutional change. Either way, however, the CPE perspective suggests that the moral legitimacy of possible institutional changes can be evaluated against the principles that people might favor in an impartial contractarian scenario. The impatience with pure evolutionism reflected in Buchanan’s critique of Hayek is understandable given the seemingly contradictory views Hayek expressed about the possibility of redesigning social institutions. In The Fatal Conceit, Hayek (1988) appears to imply that people do best by leaving their fate to be guided by the accumulated wisdom reflected in spontaneously evolved rules and traditions. On this account, the social rules that frame the context within which spontaneous ordering processes such as markets unfold may themselves arise via a process of evolutionary competition. Attempts to design an optimal set of social rules would be an exercise in “constructivist rationalism” that might block the very competitive processes that may be best placed to cope with the limits of human knowledge. Elsewhere, however, Hayek himself appears to engage in the exercise of constructing an ideal constitutional order. In The Constitution of Liberty and the final chapters of The Road to Serfdom, for example, Hayek (1960; 1944) develops an outline for a liberal “constitution” which involves some very specific attempts to embed a market economy within the framework of a broadly federal political system.2 In Law, Legislation and Liberty, meanwhile, Hayek (1982) is explicit in recognizing that path-dependent processes within spontaneous orders can result in evolutionary “dead ends” and that, in principle, these might need to be “corrected” via deliberate legislation. Examples include changes to the law of contract, landlord and tenant law, the laws governing the conduct of corporations, taxation (Hayek 1982, 88–89) and changes to the structure of property rights to tackle environmental externalities (107–109). Turning to the question of how social and political institutions should be justified, Hayek (1982, 122) notes that political legitimacy resides “in the last resort on the approval of the people at large of certain fundamental principles underlying and limiting all government” and thus seems to approach Buchanan’s notion that the legitimacy of constitutional proposals should be tested against a standard of what might be voluntarily agreed. Hayek’s emphasis on the need for impartial rules that might be chosen “if 2  Hayek is not the only member of the Austrian school to advocate what might be conceived of as constructivist proposals in this sense. Mises, for example, sets out a highly rationalist case for the constitution of little more than a “night-watchman state” (see, e.g., Mises [1929] 2005).

472   Political Economy we knew that our initial position … might be determined by pure chance (such as our being born into a particular family” (132) also sounds strikingly similar to Rawlsian attempts to discern the constitutional principles that might be agreed on behind a veil of ignorance. Vanberg (1994, chaps. 6–7) has sought to reconcile these apparent conflicts in Hayek’s work by emphasizing the Humeian refrain that unites his overall perspective, that of “using reason to understand the limits of reason.” According to this view, all political theories are constructivist insofar as they advocate any kind of positive institutional proposals. What distinguishes good from bad political theories is whether they recognize the limits of this constructivism and appreciate the need to rely on spontaneous ordering processes owing to the prevalence of the knowledge problem. Historically, market practices appear initially to have developed from historical accident, but it was the subsequent recognition by classical liberals such as Hume and Smith of the benefits of these spontaneous orders that led them to argue proactively for a legal framework that would remove obstacles to their growth. On this view, recognizing the benefits of competitive processes is not to deny a role for institutional design but implies the creation of a framework that increases the scope for competitive experimentation and the discovery of beneficial practices. This need not rule out a role for legislation in order to address the supply of those goods that might not be supplied in markets and to provide a mechanism for resolving disputes when inevitable conflicts arise, but it does imply that all such efforts should be constrained by a recognition of the knowledge problem and the likelihood of unintended consequences. Whatever the merits or otherwise of Hayek’s specific constitutional proposals, his overall approach to the question of institutional design appears to be based on creating a constitutional order that may best cope with the problem of ignorance (Vanberg 1994, 196–198). This implies a framework that enables people who differ about both means and ends to coexist in a context that allows for evolutionary learning from those practices that prove most successful. When Hayek speaks of “constructivist rationalism,” by contrast, he is referring to the attitude that suggests that no limits should be placed on deliberate design and that assumes much greater scope for agreement on both means and ends than is possible in a context where people differ in their interpretations of the world around them. Notwithstanding these remarks, ambiguities undoubtedly remain both in terms of the practicality of Hayek’s attitude to institutional design and on the question of ethical evaluation and political legitimacy. With regard to practicalities, it remains unclear from Hayek’s account why any form of legislation will not in fact be subject to the knowledge problem and whether, therefore, it would be better to rely in a still more thoroughgoing manner on competitive mechanisms, including ones at the level of legal/constitutional order (Kukathas 1990). Second, with regard to the question of ethical evaluation and political justification, if the knowledge problem leads people to disagree about the ethical status of different norms and practices to the extent that Hayek suggests, it is unclear why there should be any basis for moral agreement on constitutional principles, even the relatively minimalist ones that Hayek himself advances.

Constitutional Political Economy    473 It is not the aim of this chapter to resolve these tensions in Hayek’s work and thus to offer a definitive Hayekian perspective on CPE. Rather, the intention is to draw on the insights of the broader Austrian tradition to offer a critical assessment of the proposed institutional arrangements and standards of evaluation offered by Rawls and Buchanan. Within this context, two routes of inquiry seem possible. The first would adopt a weaker version of the Hayekian/Austrian position, accepting the contractarian method and the principles of justice advanced by Rawls and Buchanan, but, drawing on an understanding of knowledge problems, would question the specific institutional regimes considered compatible with these standards of evaluation. The second route would adopt a stronger version of the Hayekian/Austrian position, challenging both the principles of justice and the standards of evaluation advanced by Rawls and Buchanan, and would question the viability of contractarianism as an approach to issues of political legitimacy. The next section of this chapter adopts the weaker form of the Austrian argument. The section after that explores the implications of adopting the stronger, more radical position.

The Knowledge Problem, Austrian Economics, and Constitutional Implementation Rawls and Buchanan proceed from the view that it is possible to generate agreement on the principles that govern the basic structure of constitutional order. Rawls argues that actors operating behind a veil of ignorance would opt for a social order that embodies the liberty principle and the difference principle. For Buchanan, meanwhile, actors choosing rules from behind a veil of uncertainty would favor a regime designed to limit the scope for generating externalities. The discussion here proceeds by accepting the potential validity of these principles of justice and the contractarian thought experiments from which they are derived but uses Austrian economic theory to question the specific institutional arrangements that Rawls and Buchanan believe are most likely to realize their particular principles in practice.

Rawlsian Justice and the Knowledge Problem When discussing the institutions most likely to embody his two principles of justice, Rawls (1971, 8) contends that the choice between institutional regimes should be based on “ideal theory,” where actors take on board “general facts of social theory” to consider the possibilities afforded by different regimes and proceed on the basis that there will be full motivational compliance with whatever principles are adopted when the veil of ignorance is removed. This means that the types of considerations that might

474   Political Economy be emphasized by public choice theory—the possibility, for example, that people might act in their self-interest by “gaming” the rules that are chosen—should not enter into an account of what a just and hence legitimate set of rules will look like. Rather, institutions should be evaluated in terms of how people would/should behave and what laws they should support if they are sufficiently committed to realizing an impartial ideal of justice. Drawing on this perspective, Rawls identifies two regime types—liberal socialism/ market socialism and welfare-state capitalism—which he considers compatible with the realization of his two principles of justice. By contrast, authoritarian, nonmarket socialism and laissez-faire capitalism are ruled as illegitimate regimes from the perspective of impartiality. In later work, Rawls (e.g., 2001, 139) makes a distinction between welfare-state capitalism, which he came to view as falling short of the requirements for a just regime, and a more extensive and interventionist welfare regime known as property-owning democracy, which he thought better approximated the necessities of justice. 3 Whether there are in fact significant differences between welfare-state capitalism and property-owning democracy is a matter of some debate. The arguments developed later in this section to question the status of welfare-state capitalism on Austrian grounds would also apply to property-owning democracy, so for the purposes of this chapter, a distinction between these regime types is not drawn. Rawls’s ethical evaluation of different regime types appears to derive from certain assumptions about the possibilities for social coordination afforded by the “general facts of social theory.” He takes these to include the recognition that some form of efficient pricing mechanism is necessary to sustain an advanced economic order and thus to avoid the chronic shortages of goods that would thwart any attempt to implement a just political regime. It is on this basis that authoritarian, nonmarket socialism is ruled out, because it lacks an adequate pricing mechanism in addition to denying people the basic social and political liberties to which they are entitled. For Rawls, however, liberal market socialism, where most property is held in public rather than in private hands, is indeed a viable candidate for a regime type that can realize justice. On this view, 3 

Rawls’s reasoning here is that welfare-state capitalism fails to provide sufficient decision-making autonomy to the worst off, especially in the workplace. Property-owning democracy is a more extensive welfare state that also includes measures designed to disperse capital ownership, to ensure that private enterprises are subject to some sort of worker participation, and also to privilege the place of worker cooperatives. In making these arguments, Rawls seems to have abandoned commitment to a wealth-centered view of the difference principle. Maximizing the position of the least advantaged is no longer viewed in terms of what increases their absolute income but rather is seen in terms of increasing the scope for collective decision-making by workers in the enterprises that employ them, even if this reduces incomes owing to organizational inefficiency. It is not the intention here to develop an argument against property-owning democracy except to note that the knowledge-based arguments developed in criticism of the welfare state would also seem to apply to it. Moreover, the institutionalized privileges granted to worker cooperatives under such a regime seem to cut against the moral basis of Rawls’s own theory; if the aim of the basic structure is to enhance the moral autonomy of individual actors, then should not the decision of whether people wish to trade off more income against greater participation be left to individual workers themselves? (See Tomasi 2012.)

Constitutional Political Economy    475 economic theory—which Rawls conflates with the general equilibrium perspective of postwar neoclassical economics—confirms that the efficient pricing of resources can be achieved as effectively under a system in which a government simulates the operation of a market in order to generate prices as when the free exchange of private property titles generates the relevant signals. Under the conditions of full information assumed in neoclassical theory, the same information that is available to market participants would also be available to public officials. Thus, according to Rawls (1971, 271), “It is evident that there is no essential tie between the use of free markets and private ownership of the instruments of production.” From an Austrian perspective, however, Rawls’s neoclassical economic assumptions are untenable. Assuming that the knowledge necessary for economic coordination is objectively given to decision-makers is to neglect the kind of institutional processes that may be required to generate this very knowledge in the first place. The Austrian analysis suggests that such knowledge cannot be generated as effectively, if at all, by a system of market socialism when compared with a private property regime. At the core of this argument is the comparative institutions claim that private market processes are better placed to cope with a world where the conditions articulated in the neoclassical model are absent (see Boettke 1997; Pennington 2011, chap. 2). Most examples of “really existing” socialism in the twentieth century were not in fact purely “planned economies” (Boettke 2001, chap. 6). Given the impossibility of controlling everything from the center, these examples were forced to adopt an element of decentralization—delegating key decisions down to enterprise managers—and allowing trade and pricing to take place between enterprises to alleviate shortages. In other words, they incorporated significant elements of market socialism. Absent open competition, however, where private entrepreneurs could enter markets challenging the terms offered by incumbents, the informational quality of the price signals generated was massively inferior to that in comparable private enterprise regimes. The knowledge necessary to secure adaptation to shifting resource scarcities and to facilitate innovation cannot be generated when there is a single owner of property (state socialism), and neither can it be secured when the extent of decentralization is determined by a superior public owner (market socialism). In order for a process of entrepreneurial discovery and adjustment to unfold, it is imperative that dispersed entrepreneurs can make production and investment decisions without requiring the permission of an overarching authority, and it is this ability that is enhanced by a private property regime. In a context of limited and dispersed knowledge, civil servants and politicians may not know the optimal number of competing agencies and who the relevant competitors should be—these are some of the very facts that must emerge from a bottom-up environment where a diversity of private investors, personal and institutional, sponsor an array of competing capital projects subject to the entry and exit decisions of consumers. Substantially, private property is, therefore, an essential aspect of any basic structure capable of creating and maintaining the background level of wealth that is a precondition for the realization of Rawlsian justice. One might add to this general fact of social theory that no regime that has sought to eliminate private

476   Political Economy ownership of productive assets has ever protected the basic political liberties that are an essential aspect of the Rawlsian constitutional schema. In view of this fact, Rawls was surely in error to retain the institutions of liberal market socialism as a candidate for a just political regime. It should be emphasized that the case for private ownership set out above does not require any departure from the principles of Rawlsian ideal theory with respect to the motivation of social participants. On the contrary, these arguments depend solely on the inability of any non-private-property system to mobilize the knowledge necessary to sustain the background conditions of wealth and opportunity that are required, irrespective of motivational commitments. It follows that while regimes retaining substantially private ownership of capital assets—such as welfare-state capitalism or property-owning democracy—may satisfy Rawlsian criteria, liberal market socialism cannot do so even in the best-case scenario when one assumes full motivational compliance. Of course, to reject the case for market socialism is not to have provided an argument that would endorse laissez-faire capitalism as a potentially just regime. On the contrary, Rawlsians are likely to insist that while a private-property-based market order may after all be an essential element of the basic structure, a noninterventionist laissez-faire form of capitalism would fail the test of political legitimacy, because it would offer no institutionalized guarantees aimed at maximizing the position of the least-advantaged class. While a commitment to the difference principle does not specify how much, if any, wealth should be redistributed to the poor, Rawls and his followers are of the view that redistributive mechanisms are required to correct the distribution of income emergent from market forces and that the absence of such direct legislative attempts to secure the difference principle is a clear marker of injustice. More specifically, Rawls (1971, 277) suggests the need for a “transfer branch” of government charged with ensuring that all receive the social minimum and, further, that there should be a “distributive branch” to “preserve approximate shares by means of taxation and necessary adjustments to the rights of property.” It is these statements alongside a commitment to “fair equality of opportunity” that are usually held to imply the ethical legitimacy for some kind of welfare-state capitalism/property-owning democracy. From the perspective of Austrian political economy, however, the notion that a regime can provided institutionalized guarantees commensurate with Rawlsian justice is entirely dependent on the assumption that those charged with the delivery of the relevant guarantees have the knowledge to make the right distributive decisions. If the assumption of omniscience is dropped, then it is hard to see how any regime type can claim to guarantee the difference principle. Rawls’s preference for welfare-state capitalism/property-owning democracy on the grounds that it includes a legislative administrative apparatus that intends to maximize the position of the least advantaged over a regime of laissez-faire capitalism where there is no such apparatus is thus questionable. Those working in the agencies of the welfare state may use what knowledge they have to try to realize the difference principle, but in the absence of clear feedback signals and a synoptic overview of how the relevant decision-making dovetails with countless other

Constitutional Political Economy    477 acts of private and government spending, there is no reason to assume that they will succeed. The repeated failure of such a regime to deliver Rawlsian outcomes will in turn act to undermine its moral and political legitimacy in the eyes of those who are subject to its coercive powers. When discussing the issue of distributive justice and legitimacy, Rawlsians often distinguish between micro-level interactions and those that reflect the willingness or otherwise of people at the macro level to uphold a basic structure commensurate with a just distribution (see, e.g., Freeman 2007, 100). On this view, it is not the justice or otherwise of interpersonal exchanges at the micro level that is of central concern but whether the overall distributive consequences of a basic structure accord with the interests of the least well off (Rawls 1996, 262–269). This type of argument is invoked to rebut the charge of Nozick (1974, 160–164) and others that since the liberty to exchange legitimately held property (legitimately held by Rawlsian or other standards) continually “upsets patterns,” attempts to secure distributive justice require ever greater attempts to control the choices that people make. On the Rawlsian view, Nozick’s analysis entirely misses the point. What justice requires is determined not by evaluating and interfering with each and every exchange but by assessing what type of “broad institutional structures” work to the advantage of the least advantaged (Rawls 1996, 262–269; 2001, 51–52). Thus, it is not a social injustice for someone to earn a huge income, but it is a matter of justice whether the person concerned is willing to support the broad system of property law, taxes, and welfare spending needed to sustain the background opportunities and resources required by justice. Laissez-faire capitalism is deemed unjust when compared with welfare-state capitalism/property-owning democracy precisely because it lacks the necessary macro-legislative structures. This identification of legislative public welfare measures as somehow definitive of a just regime leads to some awkward possibilities for the Rawlsian viewpoint. It would imply, for example, that a regime under which the least well off secured a higher standard of living but that lacked an administrative apparatus designed specifically to achieve this goal would be considered unjust and hence illegitimate when compared with a regime that possessed such an apparatus but where the poor were worse off in absolute terms (see Brennan 2007). From the perspective of Austrian political economy, however, there is a more fundamental problem with the Rawlsian view. In order to make a credible claim that a broad institutional structure realizes justice, it is necessary to offer an account of how that structure is able to dovetail all of the various spending and other decisions in society—whether private or public—in a manner reflective of the difference principle. In other words, a credible case for an institutional regime must show that it does not depend for its success on what Hayek describes as the “synoptic delusion,” the assumption that all the facts needed to deliver on the principle at the macro level can be gathered and integrated into a single center of control. If they are to have any chance of success, the relevant macro-level rules must enable individuals to coordinate with one another by adapting to circumstances known only at the micro scale. Instead of simply assuming that the administrative arm of government knows how to maximize the position of the

478   Political Economy worst off, a credible basic structure must facilitate the discovery and communication of who should give what to whom. Is a person best placed to help the disadvantaged by starting a new enterprise and employing poorer sections of the population? Would it be better for someone to take a high-paying job and contribute part of his or her income to a charitable association? Does a person have an aptitude for charitable work? If charitable activity is indeed the best way for a person to help the disadvantaged, should this take the form of monetary contributions or spending time directly with the less well off in order to provide education, advice on healthcare, or the transmission of values conducive to prosperity? These are the types of questions that need to be addressed by a regime that is to claim any credibility for its ability to realize justice. Seen in this light, an unwillingness to support tax-financed income redistribution need not reflect a failure of idealism or a lack of moral commitment to Rawlsian justice but is mere skepticism that the broad structures of a welfare state can generate the knowledge to deliver an appropriate combination of tax and spending decisions. More important, if one retains the motivational assumptions of ideal theory—that people are fully committed to realizing Rawlsian justice but lack the knowledge of how to achieve it, then laissez-faire capitalism appears to be a credible candidate for a potentially just regime, precisely because it offers a broad institutional structure that does not depend for its success on the need for a synoptic overview of resource allocation.4 In conditions of limited knowledge and uncertainty about the effects of distributive decisions, a case can be made that a system that decentralizes these decisions down to individuals and voluntary associations is more likely to facilitate the necessary processes of discovery and adjustment than a regime that centralizes the distribution of funds in the agencies of the state. At the very least, this is a possibility that Rawlsian theory should entertain. There can be no guarantee that the difference principle will be achieved under a laissez-faire regime (or any other), and neither can individuals know whether their own actions have contributed to its fulfillment at the macro scale—a problem compounded by the absence of a clear test of success and failure in catering to the interests of the worst off equivalent to the profit-and-loss system in a context of competitive market exchange. Nonetheless, without a framework that allows for emulative learning and decentralized adjustment, the prospects of maximizing the position of the worst off may be even more remote. Now, it might be argued that the above analysis is unrealistic because individuals acting on their own or in voluntary groupings cannot possibly be expected to address issues of poverty and inequality that occur on a societywide basis—because these are inherently collective goods. Even in Rawlsian ideal theory, people are not expected to be saints, devoting themselves to causes where their action can make no demonstrable impact on outcomes. People may act in full compliance with the law, but their response to everyday incentives at the micro scale (which is allowed under the terms of Rawlsian 4  The term laissez-faire here does not necessarily imply a regime where government intervention is entirely absent save for protections against force, theft, and fraud. It might include, for example, a role for the state in improving the specification of property rights. It would not, however, include an administrative structure charged with controlling the distribution of income.

Constitutional Political Economy    479 ideal theory) may produce results that depart from what justice requires.5 Market failures, therefore, can be expected to occur even under ideal conditions, and in such circumstances, there may be no substitute for the coercive power of government to enforce the necessary contributions (Rawls 1971, 236–237). To make this argument, however, would be to ignore that placing all poverty-alleviation resources into a single pot reduces the capacity for citizens to have any direct control over the manner in which their contribution will be spent and thus creates everyday incentives that may themselves result in collective-goods dynamics. If poverty is conceived of as a national rather than a local or individual problem, then there is no more reason to suppose that people will vote for appropriate welfare measures—even under ideal conditions—than that they would give to voluntary associations. Just as the decision of a single individual or group to offer voluntary assistance to the poor will not have significant impact on the problem of poverty as a whole, so, too, the decision of any one person to vote for particular welfare measures will be irrelevant to the actual type of welfare delivered, since this will be determined by how everyone else votes. Similarly, civil servants charged with delivering welfare services will have minimal scope to affect outcomes by experimenting with new approaches, because all such spending decisions would first require the approval of a superior hierarchy. As a consequence, even if poverty as a whole has collective-goods attributes, there may still be reason to favor a laissez-faire regime, because knowledge of how to address individual instances of the phenomenon is unlikely to be collectively held. On the contrary, it may be widely dispersed across different individuals and groups, each of whom may possess unique information about particular people facing poverty and what measures might be best placed to address their problems. Libertarian critics of Rawls have often argued that the emphasis placed on state-based income redistribution is inconsistent with Rawls’s own claim that liberty should be accorded “lexical priority” in an ideal system of justice (e.g., Lomasky 2005).6 If the argument presented in this section has any merit, however, then far from conflicting with the 5 

This minimal recognition of the role of incentives even under ideal conditions is also why the difference principle allows for inequalities—arising from the need to generate incentives for more production than under strict equality. It is this role given to incentives that led Cohen (1995, 396) to argue that Rawls’s theory was insufficiently “ideal” and failed to allow that people might undergo “the fullest realization of their natures.” Strangely enough, Cohen’s Marxian utopianism with regard to the possibility of fully altruistic motivations, combined with an Austrian account of knowledge problems, would seem to generate a powerful case for laissez-faire. A private-property-based market economy would, owing to the knowledge problem, still be needed to generate a high level of background wealth and opportunity (Cohen has no argument against the Austrian side of the socialist calculation debate, which makes no assumptions about self-interest and the need for incentives), while under conditions where people realize their altruistic nature, there would be no collective-action problems and no requirement for an apparatus of state coercion to ensure that people contribute sufficiently to the needs of others. 6  Lomasky (2005) provides a detailed discussion of Rawls’s definition of the “liberty principle” and its lexically prior status, noting the conspicuous absence of “economic liberties” such as the right to buy, employ, invest, and accumulate capital. As Lomasky (2005, 184) notes, this is a rather odd set of omissions given the historical record, which would appear to suggest that personal and political liberties of various sorts have only ever existed in regimes where there is substantially private ownership of productive assets and the economic freedoms these bring.

480   Political Economy difference principle, liberty—understood as the right of people to dispose freely of property and to exit and enter different jurisdictions, contracts, and gift relationships—may be a necessary though not a sufficient requirement of that very principle. It is not a sufficient condition, because while liberty may be required to allow experimentation in order to increase the chance of catering to the worst off, there is no way the difference principle can be enforced. Rights of property can be enforced (albeit imperfectly), but which uses of these rights benefit the least-advantaged class cannot be known in advance. If, for example, a person chooses not to give his or her income directly to the poor, preferring instead to invest in a business enterprise, there is no way to discern whether the person is acting in the belief that investment is more likely to advance the interests of the least advantaged than redistributive giving or whether the decision is based on moral disregard for the worst off. Attempts to enforce a particular allocation of resources by way of legislation will choke the very process of evolutionary learning and adaptation to changing circumstances that is required if there is to be any chance of the difference principle being achieved. While it has not been its purpose to challenge Rawls’s ethical justification of the difference principle, the above analysis raises an important question for the Rawlsian approach. If a principle of justice depends for its fulfillment on knowledge requirements that cannot be met in any real-world situation, then it is difficult to see why an impartial consideration of legitimate social rules should be expected to favor such a principle.

Buchanan, Collective Goods, and the Knowledge Problem At first glance, Buchanan’s constitutional ideal of a limited government may seem less susceptible to the Austrian critique than Rawls’s favored ideals of welfare-state capitalism/property-owning democracy and liberal market socialism. This is because Buchanan’s scheme does not advocate a patterned principle of justice. Discerning whether people are abiding by the terms of private contracts and supplying a limited range of collective goods requires considerably less in the way of knowledge than the synoptic overview of resource allocations required to guarantee Rawlsian justice. The Austrian analysis is nonetheless of relevance when considering how the supply of the collective goods that Buchanan does believe to be a function of government should in fact be accomplished. The assumption underlying Buchanan’s approach is that when goods have publicness characteristics, people would willingly abandon the principle of unanimity in order to secure them. In Buchanan’s model, people contract into a single constitutional regime charged with producing collective goods. From an Austrian standpoint, however, there is a knowledge problem in discovering which goods fall into the collective category and the manner in which they might be supplied—a problem unlikely to be addressed under a single-supplier regime. With the possible exception of defense protection and certain types of global-level pollution control, most goods with publicness characteristics are not completely

Constitutional Political Economy    481 indivisible in supply. Typically, they are territorial goods—excludable within a particular region or much smaller locality—and need not therefore be supplied by a monopolistic agency. Buchanan himself (1965) has written extensively on the concept of “club goods” and demonstrates how services with a high degree of publicness can be provided on a private contractual basis. Swimming pools, street lighting, golf courses, and public parks are all excludable though nonrivalrous goods (or only nonrivalrous past some congestion threshold) and can be provided privately if suppliers are able to persuade a sufficient number of individuals to share the costs of provision (Leeson 2011). In the recent past, the massive growth of private residential communities illustrates this potential. Such communities now account for the majority of new house-building in the United States and in some East Asian cities (Webster and Lai 2003). These communities are either co-owned by residents in a cooperative or involve a division of property rights between residents and a development corporation that lays down the contractual obligations of those who choose to purchase property in the community concerned. By agreeing to common contractual regulations, for example, on land-use control, and requiring contributions to collective goods such as parks, woodlands, roads, and street lighting, those who enter into such a structure may increase the value of their holdings relative to those who do not. From an Austrian standpoint, the virtue of these arrangements is that they allow for competitive discovery between different packages of collective-goods provision and decision-making rules as people enter and exit a range of different constitutions on an individual basis. If many collective goods can be delivered within a competitive structure, it must also be recognized that the number of goods that can be so supplied is not static. The theory of externalities and collective goods is usually presented in terms of the equilibrium theory central to neoclassical economics, where the circumstances that determine such conditions as nonexcludability are assumed given. For Austrians, however, the ability to internalize externalities is often dependent on acts of institutional entrepreneurship. As technologies evolve that can lower transaction costs and as alert agents discover institutional devices that can limit the extent of free-riding behavior, then many goods that have publicness characteristics may be converted into private or club goods that are in fact excludable (Huerta de Soto 2008, 105). What matters here is that a single-supplier model may limit the scope for entrepreneurs to experiment with new institutional arrangements. This reduction in entrepreneurship will be particularly pronounced where the state assumes sole responsibility for provision by nationalizing assets or subjecting them to a unitary system of regulation. Institutional experimentation may, however, also be reduced if the central state determines how much autonomy more decentralized units may have in experimenting with alternative models of collective-goods delivery. In each of these cases, the scope for the bottom-up emergence of appropriate solutions may be thwarted by the power of an overarching authority. The numerous case studies of common pool management, including fisheries, forests, and irrigation systems, conducted by Ostrom (2006) and her colleagues confirm that institutional diversity is critical to the discovery of solutions

482   Political Economy to collective-goods problems. This diversity may be threatened by any monopolistic regime that mandates contributions from all, even if these mandates are supported by a majority or supermajority of the relevant population. It might be argued that Buchanan’s own theory of constitutional choice allows room for the sort of competitive experimentation implied by the Austrian approach. Buchanan’s constitutional theory involves a multistage process that is likely to involve an agreement to make some political decisions at a lower institutional level, and this opens up room for political federalism and interjurisdictional competition, which would facilitate the type of institutional learning advocated here. In the final analysis, however, unless individuals and voluntary groupings are allowed to secede from Buchanan’s arrangements—that is, unless his constitutional settlement allows for as many subgovernments, each with its own specific contracts to develop, as individuals desire—then his model of federal decentralization is predicated on the suspension of competition from below (Leeson 2011, 305). From an Austrian perspective, it cannot be assumed that the appropriate jurisdictional level at which externalities might best be internalized is given in advance of entrepreneurial experimentation. Rather, sufficient scope must be accorded for individuals and voluntary groupings to craft their own rules in response to the emergent collective-goods problems they face. Ostrom’s (1990; 2006) work, for example, shows that in many cases, even regional and local governments have underestimated the capacity of more decentralized structures to devise systems of rules that can internalize costs. She also suggests that larger-scale collective-action problems are best solved in a context where federated structures emerge from below rather than having these imposed from above. What matters is that these standards are arrived at from the bottom up, and there remains the possibility for dissenters to exit and subscribe to a different set of practices (Kurrild-Klitgaard 2010). If there is a collective good that can only be supplied by government, then the most likely candidate for this may be enforcing a framework that secures individuals the right to exit from any collective-goods arrangements of which they disapprove.

Beyond Contractarianism: An Austrian View The account presented thus far has not taken issue with the constitutional principles set out by Rawls and Buchanan or with the analytical methods and evaluative standards used to derive these principles. Rather, the discussion has focused on the institutional implications of what was earlier described as a weaker Austrian approach to show how those principles might best be achieved in practice. In this section, however, a more radical set of Austrian insights is deployed to question both the methods and the evaluative standards used in the contractarian approach and the specific constitutional ideals of Rawls and Buchanan.

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Against the Rawlsian Contract The thought experiments used to conceptualize the conditions for constitutional agreement in CPE focus on the specification of ideal conditions where rational, impartial agreement between the partners to a constitutional contract might be achieved. Hayek’s writings, by contrast, suggest that the need for social rules and institutions arises from the fact that people do not have the knowledge to agree on what justice requires. In conditions of bounded rationality, there may be no compelling way to generate agreement on a specific set of moral principles. If a condition of permanent conflict is to be avoided, therefore, institutions may need to be structured in such a way as to allow people who exhibit different moral standards to coexist, and this requires that the range of actions that will be subject to coercive decisions is sufficiently thin in character (Gaus 2011; Pennington 2011, chap. 5). Seen in the above light, the Rawlsian method of trying to establish an impartial evaluation of social rules and institutions assumes away the very conditions that require the need for social rules and institutions in the first place. Fully idealized rationality of the sort exhibited by actors behind the veil of ignorance implies that people can see through costlessly and instantaneously all the consequences of their beliefs. The model also assumes that everyone is equally rational, similarly situated, and convinced by the same arguments—the result being that the rules chosen are equivalent to what would be chosen by a single actor. The very idea of using the veil-of-ignorance device to generate evaluative standards is, therefore, conceptually problematic, since the capacity to engage in reasoned action is dependent on personal and social experiences, which are ruled as illegitimate considerations in the OP. For Hayek, reason does not exist independent of personal and social experiences but is in part at least a product of the particular personal and cultural contexts in which people find themselves, and, if allowed to do so, it evolves as people are exposed to and learn from actors with different experiences. It is largely by following moral rules that cannot fully be justified but that have nonetheless proven themselves to work that people are able to engage in rational action and moral reflection in a context where they lack the cognitive capacity to know with certainty the best course to pursue. From a Hayekian perspective, the process of competitive cultural evolution replaces the role of the original position in Rawlsian thought. Among the rules that have survived the process of competitive selection are the basic classical liberal rights emphasizing respect for person and property, contract, and the prevention of force or fraud. Rules of this nature appear to be necessary for any kind of social cooperation to become established. Their virtue is that they enable people who may differ about more substantive distributive ethics to coexist and to avoid a state of permanent conflict. Any attempt to enforce a more substantive principle of justice—such as the Rawlsian difference principle—is likely both to generate resentment from those who reject it and to thwart the broader process of cultural evolution, which requires that rival social norms can coexist in order for a process of social and ethical learning to unfold.

484   Political Economy If the limited nature of rationality highlighted by the Hayekian-Austrian perspective is taken as fundamental to the human condition and there is uncertainty or ignorance over which principles of justice are in fact appropriate, then people must be given sufficient scope to learn from their personal and cultural experiences and from those of others. When people are uncertain of their own interests, let alone how best to achieve them, it is implausible to suggest that they would or should bind themselves into a once-and-for-all set of distributive principles or opt with certainty for any particular distributive rule. The difference principle may well be favored by some people in such an environment, but it would be one among a variety of competing distributive standards on offer. Rawls himself appears aware that allowing for a more limited notion of knowledge and rationality would radically alter the conclusions of his particular contractarian thought experiment. His specification that agents behind the veil of ignorance are identical in terms of knowledge endowments and conceptions of their interests is designed to simplify the choice situation in such a way as to produce unanimity. This assumption “makes possible a unanimous choice of a particular conception of justice. Without these limitations on knowledge the bargaining position in the original position would be hopelessly complicated. Even if theoretically a solution were to exist we would not, at present anyway, be able to determine it” (Rawls 1971, 140). This statement is a fairly candid though often overlooked admission that the constraining assumptions needed to make rationalistic models of justice work are of little use when thinking about how real-world questions of distribution might need to be approached. Just as economic models that assume perfectly rational decision-makers say little about the institutions best suited to allocate resources in a world of imperfect knowledge, so theories of justice that rely on similarly stylized assumptions say little about how justice should be approached when these assumptions are dropped. Instead of implying that people who do not accept the difference principle are morally misguided, it may be better to recognize that people differ in their knowledge endowments and conceptions of their interests and to afford them the moral space to use knowledge derived from their own experiences to craft solutions to the distributive problems they face. More specifically, a better way to address the difficulties arising from the “hopelessly complicated” bargaining problem that Rawls seeks to avoid in designing the original position would be to allow people scope to choose among a variety of social contracts. The possibility that people might choose to live in an open society that allows for competition between distributive norms and provides room for evolutionary learning is ruled out by Rawls, because parties in the OP are told that they are choosing rules for life in a closed society. This proviso would seem to reflect an attempt by Rawls to structure the impartial procedure in such a way as to rule out the very option of institutional pluralism that may be best suited to a world characterized by limited knowledge, bounded rationality, and diverse standards of moral evaluation (see Gaus 2011; Pennington 2011, chap. 5).

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Against Buchanan’s Contract In contrast to Rawls, Buchanan’s case for a constitutionally limited government affords greater latitude for the moral pluralism that recognition of the Austrian knowledge problem would seem to imply. A second advantage of Buchanan’s approach is that it attempts to model people as they are—that is, as potentially unequal actors—rather than the idealized fully equal agents postulated in Rawls’s OP. Even so, at the core of Buchanan’s approach is a somewhat rationalistic homo economicus assumption that actors operating from behind a veil of uncertainty would agree to enter a single disarmament contract in order to secure the protection of their person and property via a government agency that exercises a monopoly of force. Although it is clearly the case that most people have some interest in personal protection, it is not at all clear why people would or should concur on a unitary set of protective arrangements. Some people may be sufficiently willing to take risks with their own security as to prefer not to be part of a protective arrangement and to fend for themselves outside of the law. Others, however, may have a stronger preference for protective services and a higher estimate of their need for such services. Still others may wish to guarantee a far greater range of services than the minimal protective and collective-goods arrangements posited by Buchanan, including perhaps mechanisms for wealth redistribution. More important still, a significant number of actors may simply not know what sort of arrangements would match their interests. Given the likelihood of such disagreement over the desired scope and functions of a protective state, it is questionable whether people would or should opt for a monocentric system of governance. As argued in criticism of the Rawlsian approach, in conditions of genuine uncertainty, a strong case can be made in favor of arrangements that enable people to choose between different contracts, suggesting governance arrangements that offer competing centers of force in society. Such arrangements need not be anarchistic in the sense of providing no basis for social order. Rather, they might be conceived of as a providing overlapping and competing sources of authority (Kukathas 2003). The presence of economies of scale and strong network effects in providing security would mean that most people would need to make compromises and would be unlikely to find the ideal set of governance arrangements that meet their personal requirements as and when these evolve. Nonetheless, there is little reason to believe that scale economies or network effects would be of such magnitude as to result in a single-supplier model. Empirical evidence shows that at levels both above and below those of existing nation states, forms of social order arise in the absence of an agency exercising a monopoly of force. Within nation states, private communities offer a variety of protection services alongside, if not replacing, those supplied by the nation state, while at the international level, commercial contracts and dispute resolution are largely governed by a system of private law in a global context where there is no monopolistic supplier of order (Leeson 2008).

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Beyond Contractarianism The analysis presented above has suggested that there is little reason to suppose that people would or should reach the kind of comprehensive agreement on principles of justice posited by Rawls and Buchanan. If, in fact, there is no way to specify the basis for a moral consensus that can act as an evaluative benchmark for existing societies, then the question arises of how the current sets of institutions that provide the rules within which people live should be judged. An alternative way of thinking about these issues that is compatible with the Austrian emphasis on knowledge problems and bounded rationality is to recognize that the function of social rules and institutions is not to provide justice but to maintain the peace when there may be no basis for agreement on what justice requires (see, e.g., Kukathas 2003). Even when people disagree about justice, they may have a strong interest in maintaining a framework that secures basic norms of interaction—such as stability of possession—because it is adherence to these norms that enables people to live their lives without permanent conflict. Writers in the Humeian tradition have often analyzed the function of political authority in this regard by pointing out that although particular social rules and institutions may not have arisen through voluntary consent, they may prove beneficial insofar as they provide a focal point around which people who differ over matters of justice can coordinate their actions and establish stable expectations (Hardin 1988; 1999). Buchanan himself, in his own writings and in partnership with Brennan moves toward this position (Buchanan 1977; Brennan and Buchanan 1985). Buchanan is careful to note that most existing political institutions have not arisen via a process of voluntary contracting or unanimous agreement, but he maintains nonetheless that the only way to make sense of the commitments people have to governments and political institutions is to treat these relationships as if people had contracted to create them (e.g., Buchanan 1977, 130). The analogy invoked here is with rules of the road. There may be no agreement regarding the desirability of driving on the left- or right-hand side, but it may be better for all concerned that one convention or another is adhered to in order to prevent collisions between social actors, irrespective of how the original convention arose. If sufficient numbers of people are adhering to one such convention, then it may make sense for others who do not themselves agree with the convention to acquiesce, because the alternative would be chaos and disorder (Hardin 1999). To recognize this point, however, is a very different matter from suggesting that the relevant arrangements have the moral force attached to them by contractarian ethics of the sort favored by Buchanan and Rawls. As Hardin (1988) has argued, it is one thing to recognize that some social institutions can be understood as analogous to rules of the road, but it is quite another to suggest that the state can be legitimized as if it emerged contractually or that reforms to social institutions that are potentially beneficial to all can be justified as if a contract had been agreed. The fact that some form of political authority or state may be necessary does not imply that existing centers of authority

Constitutional Political Economy    487 are needed to perform this task. If the choice is between having a governing authority and anarchy, then many people will prefer any form of government—including one that engages in wealth redistribution and activities such as funding of the arts. If, however, the choice is between different kinds of governing authority—some of which redistribute income and fund the arts and others that do not—then it is highly unlikely that there will be a basis for moral agreement (Gaus and Thrasher 2011, 11). If people do not actually contract into, or are prevented from contracting out of, a particular set of arrangements, then we have no way of knowing what they would in fact have agreed to. There may be alternative arrangements that while overcoming coordination problems would allow greater latitude for people to make divergent choices over moral matters but which they are prevented from choosing by the actions of the very state whose legitimacy is at issue. Buchanan’s own Austrian-influenced economic theory is explicit in recognizing that the efficiency of individual trades in a market cannot be judged by an external observer. There is no external standard of what efficiency requires outside of the voluntary exchanges that take place among participating individuals. The determinants of efficiency are endogenous to the market process itself, as people are exposed to different and changing options and as they confront genuine choices, instead of maximizing utility functions assumed to exist independently of the process that generates the relevant choices. On this view, there is no means by which even the most idealized omniscient designer could duplicate the results of voluntary interchange, because the potential participants do not know until they enter the process what their own choices will be (Buchanan 1982). From an Austrian standpoint, a consistent application of this very perspective in the domain of constitutional choice would imply that there is no way for an external observer, however expert in matters of constitutional design, to judge what people have contracted or consented to in the absence of a process in which they are actually able to make such a choice. If contractarianism ultimately fails to provide the evaluative framework that its supporters suggest, then the weak utilitarianism of the Humeian-influenced coordination problem perspective may prove more fruitful. Such an approach would recognize that there is a place for political authority in helping to solve coordination problems, but in view of imperfect knowledge and bounded rationality, it would not seek to offer moral legitimacy for existing patterns of political control. On the contrary, from an Austrian standpoint, it would suggest that the reduction of social conflict may be achieved more successfully in a regime that allows for a polycentric legal order rather than resting all political authority in monopolistic governance structures. It would argue, therefore, that existing political structures might be opened up to institutional competition in order to distinguish the functions required to solve genuine coordination problems from those that are not. The enforcement of private or several property rights is likely to play a fundamental role in such an order, because these are precisely the type of rights that enable people who disagree about matters of justice and morality to coexist. In no way, however, would support for such a framework imply some deontological or prepolitical understanding of private property rights or the notion that such rights are inviolable.

488   Political Economy Although it is radical in its implications, the approach sketched above is far from utopian in character. In view of evidence on the viability of polycentric legal structures both at the international level and even within the boundaries of existing states, it maintains that these structures may have as much chance, if not more, of securing stability and social cooperation in the face of fundamental moral disagreements as more monopolistic legal regimes.

Conclusion This chapter has sought to explore the implications of Austrian economics for constitutional political economy. For those who wish to work within the contractarian tradition, it has argued that the ideals of Rawls and Buchanan are more likely to be achieved within a framework that does not assume that knowledge of how to achieve the relevant ideals can be gathered in a single center of political control. The most likely candidate for such a framework is a classical liberal regime which emphasizes strong protection of private property rights and minimal government intervention. In the final analysis, however, the account offered here has suggested that a consistent application of Austrian insights should lead one to question the value of searching for a contractarian ideal of justice. Institutions such as private property rights should be seen not as a manifestation of justice but as an important element in securing order when there is no agreement on what justice requires. The precise character of these rights cannot be defined in abstract with the necessary precision, but the chance of securing the best-adapted set of rights may be increased in an environment where the sources of legal authority are polycentric in character.

References Barry, B. 1965. Political Argument. London: Routledge. Boettke, P. J. 1997. “Where Did Economics Go Wrong: Equilibrium as a Flight from Reality.” Critical Review 11, no. 1: 11–64. Boettke, P. J. 2001. Calculation and Coordination: Essays on Socialism and Transitional Political Economy. London: Routledge. Brennan, G., and J. Buchanan. 1985. The Reason of Rules. Cambridge: Cambridge University Press. Brennan, J. 2007. “Rawls Paradox.” Constitutional Political Economy 18: 287–299. Buchanan, J. 1965. “An Economic Theory of Clubs.” Economica 32, no. 125: 1–14. Buchanan, J. 1969. Cost and Choice. Chicago: University of Chicago Press. Buchanan, J. 1975a. “A Contractarian Paradigm for Applying Economic Theory.” American Economic Review 65, no. 2: 225–230. Buchanan, J. 1975b. The Limits of Liberty. Chicago: University of Chicago Press. Buchanan, J. 1977. Freedom in Constitutional Contract. College Station:  Texas A&M University Press.

Constitutional Political Economy    489 Buchanan, J. 1979. “Is Economics the Science of Choice?” In What Should Economists Do? Indianapolis: Liberty Press. Buchanan, J. 1982. “Order Defined in the Process of Its Emergence. Literature of Liberty 5, no. 4: 5. Buchanan, J. 2001. Choice, Contract and Constitutions. Indianapolis: Liberty Fund. Buchanan, J., and G. Tullock. 1962. The Calculus of Consent. Ann Arbor:  University of Michigan Press. Cohen, G. 1995. “Incentives, Inequality and Community.” In Equal Freedom: Selected Tanner Lectures on Human Freedom, edited by S. Darwall, 263–329. Ann Arbor:  University of Michigan Press. Freeman, S. 2007. Rawls. New York: Routledge. Gaus, G. 2011. The Order of Public Reason. Cambridge: Cambridge University Press. Gaus, G., and J. Thrasher. 2011. “Contemporary Approaches to the Social Contract.” In Stanford Encyclopedia of Philosophy. Stanford, CA: Stanford University Press. Hardin, R. 1988. “Constitutional Political Economy: Agreement on Rules.” British Journal of Political Science 18, no. 4: 513–530. Hardin, R. 1999. Liberalism, Constitutionalism and Democracy. Oxford:  Oxford University Press. Hayek, F. A. 1944. The Road to Serfdom. Chicago: University of Chicago Press. Hayek, F. A. 1948. Individualism and Economic Order. Chicago: University of Chicago Press. Hayek, F. A. 1960. The Constitution of Liberty. London: Routledge. Hayek, F.  A. 1978. “Competition as a Discovery Procedure.” In New Studies in Philosophy, Politics, Economics and the History of Ideas, edited by F. A. Hayek. London: Routledge. Hayek, F. A. 1982. Law, Legislation and Liberty. London: Routledge. Hayek, F. A. 1988. The Fatal Conceit. London: Routledge. Huerta de Soto, J. 2008. The Austrian School. Cheltenham, UK: Edward Elgar. Kliemt, H. 2000. “Foreword.” In J. Buchanan, The Limits of Liberty, xiii–xiv. Indianapolis: Liberty Fund. Kukathas, C. 1990. Hayek and Modern Liberalism. Oxford: Oxford University Press. Kukathas, C. 2003. The Liberal Archipelago. Oxford: Oxford University Press. Kurrild-Klitgaard, P. 2010. “Exit, Collective Action and Polycentric Political Systems.” Public Choice 143: 339–352. Leeson, P. 2008. “How Important Is State Enforcement for Trade.” American Law and Economics Review 10, no. 1: 61–89. Leeson, P. 2011. “Government, Clubs and Constitutions.” Journal of Economic Behavior and Organization 80: 301–308. Lomasky, L. 2005. “Libertarianism at Twin Harvard.” Social Philosophy and Policy 22, no. 1: 178–199. Marciano, A. 2009. “Buchanan’s Constitutional Political Economy: Exchange versus Choice in Economics and Politics.” Constitutional Political Economy 20: 42–56. Meadowcroft, J. 2014. “Exchange, Unanimity and Consent: A Defense of the Public Choice Account of Power.” Public Choice 158, nos. 1–2: 85–100. Mises, L. von. (1929) 2005. Liberalism. Indianapolis: Liberty Fund. Nozick, R. 1974. Anarchy, State and Utopia. New York: Basic Books. Ostrom, E. 1990. Governing the Commons: The Evolution of Institutions for Collective Action. Cambridge: Cambridge University Press.

490   Political Economy Ostrom, E. 2006. Understanding Institutional Diversity. Princeton, NJ: Princeton University Press. Pennington, M. 2011. Robust Political Economy: Classical Liberalism and the Future of Public Policy. Cheltenham, UK: Edward Elgar. Rawls, J. 1971. A Theory of Justice. Cambridge, MA: Harvard University Press. Rawls, J. 1996. Political Liberalism. New York: Columbia University Press. Rawls, J. 2001. Justice as Fairness: A Restatement. Cambridge, MA: Harvard University Press. Tomasi, J. 2012. Free Market Fairness. Princeton, NJ: Princeton University Press. Vanberg, V. 1994. Rules and Choice in Economics. London: Routledge. Webster, C., and L. Lai. 2003. Property Rights, Planning and Markets. Cheltenham, UK: Edward Elgar.

Chapter 21

Public Choi c e a nd Austrian Ec onomi c s Randall G. Holcombe

Introduction Austrian economics is a school of thought, while public choice is an area of inquiry, so an obvious direction for this chapter is an evaluation of the Austrian school’s approach to the subject matter of public choice, much as one might analyze the Chicago school’s approach to industrial organization or the Marxist approach to labor economics. To do this, one must identify, first, which economists belong to the Austrian school and, second, what constitutes work in the area of public choice. In both cases, one could be more or less inclusive regarding what constitutes the Austrian school and what constitutes public choice. Boettke and Leeson (2004) addressed this issue, taking a relatively inclusive approach. This chapter is deliberately less inclusive than Boettke and Leeson’s analysis, not necessarily because a less inclusive approach provides a better taxonomy but rather because it offers different insights when analyzing public choice within the Austrian school. There is no fine line that divides members of the Austrian school from those outside the school, so the work consistent with Austrian ideas that this chapter discusses sometimes notes that it is written by a member of the school, sometimes notes that it is written by someone not considered a part of the Austrian school, and sometimes leaves some ambiguity on that question. With regard to identifying work that qualifies as public choice, the dividing line used in this chapter is stricter. The substantial body of work both within and outside the Austrian tradition that discusses public-sector resource allocation falls within the broad category of public-sector economics. Public choice is a subset of public-sector economics that analyzes collective decision-making processes. Comparing this chapter with the more inclusive approach taken by Boettke and Leeson (2004), the biggest difference is that they classify some work in public-sector economics that does not analyze collective decision-making processes as public choice, whereas

492   Political Economy this chapter’s stricter definition of public choice would place those works within the area of public-sector economics but not public choice. Specific cases will be mentioned, but it is worth repeating that nothing in this analysis argues that the less inclusive definition used here is the correct one. Rather, this less inclusive approach offers some insights that a more inclusive approach might overlook.

Similarities and Differences The main subject here is the work that Austrian school economists have undertaken in the subdiscipline of public choice, but public choice and Austrian economics share two other connections that add interest to the topic. One is that since the mid-1980s, there has been a concentration of scholars interested in the area of public choice, and a concentration of members of the Austrian school, at George Mason University. Much of what falls under the heading of Austrian school public choice has been produced by scholars who have received their degrees at George Mason or who are on the faculty at George Mason—or both. This cross-fertilization of public choice and Austrian economics at George Mason has been the driving force in public choice analysis within the Austrian school. Second, both public choice and Austrian economics have reputations for drawing conclusions that point toward limiting the scope and power of government. From a policy perspective, members of the Austrian school and scholars working in the area of public choice will often find themselves as allies. With so much in common, one might conjecture that the Austrian school would have a well-developed research program in public choice, but at least through the first decade of the twenty-first century, when one takes a narrow view of what falls within the boundaries of public choice, this does not appear to be true. While one can find many examples of Austrian school economists producing work in public choice, that work rarely uses as its foundation the Austrian school public choice literature that preceded it. Work in Austrian public choice tends to cite non-public choice Austrian work, coupled with public choice work not done in the Austrian tradition. Most Austrian public choice tends to use the general Austrian approach to economics to critically examine mainstream ideas in public choice, rather than building on earlier Austrian public choice literature to develop a distinctive Austrian approach to public choice. Austrian public choice is, in this regard, not a self-sustaining research program. Meanwhile, despite work being done in public choice by members of the Austrian school, Austrian public choice has not had much apparent impact on the more mainstream ideas of public choice. Boettke and Leeson (2004) argue that Austrian economics and public choice share many core ideas, including methodological individualism, the rational choice model of human behavior, and an emphasis on dynamic processes of adjustment rather than equilibrium outcomes. While there is some truth to this, on the first point, methodological individualism is common throughout economics and not unique to the Austrian school.

Public Choice and Austrian Economics    493 This amounts to saying that both the Austrian school and public choice economists take an economic approach to politics. On the second point, Austrian school analysis of government has often slighted the rational choice approach and assumed benevolent behavior on the part of public-sector actors to focus on problems of economic calculation, so the common element here is more tenuous than Boettke and Leeson suggest. On the third point, while the focus on process rather than equilibrium outcomes is true of some public choice scholars, the equilibrium approach is firmly entrenched in much work in public choice. It would be more accurate to say that a subset of public choice work focuses on processes rather than outcomes. The Austrian approach to economic analysis has more in common with constitutional political economy than public choice more broadly considered in this regard. The less inclusive approach taken here does consider work in constitutional political economy to be a part of public choice, but even here, there is not much work done by scholars in the Austrian school that falls under the heading of constitutional political economy. While Boettke and Leeson make some valid points regarding areas of commonality between public choice and Austrian economics, a deeper look reveals that there is less commonality than they suggest. Certainly, the degree of commonality between the Austrian school and public choice analysis is a significant issue in considering whether Austrian public choice is developing into a self-sustaining line of research. But a self-sustaining line of research builds on earlier contributions, and looking at things this way, it would be hard to argue that Austrian school public choice is a self-sustaining subdiscipline within the Austrian school more broadly defined. The lack of a self-sustaining literature in Austrian public choice may partly be a result of the relatively short time that the modern Austrian school has been active. There was very little academic research being done by the Austrian school in the 1950s and 1960s, before a revival of the school in the 1970s. While this is not the place to recount the recent history of the Austrian school—Vaughn (2000) gives a good summary—one might argue that the Austrian research program began a substantial growth in the 1980s and 1990s. In the resurgence of the school, one might expect that the earliest research would be more focused on the core issues of economics, to build a foundation for the ideas that differentiate the Austrian school from other schools of thought, and for that reason subfields such as public choice have only recently been of interest to many in the Austrian school. Does Austrian public choice have the potential to develop into a self-sustaining subdiscipline within the broader Austrian school? One might argue that there is no reason for it to do so and that the most productive way Austrian school economists can contribute to public choice is to react to the work done by others in the area. As noted further below, the general Austrian view on the ineffectiveness of government resource allocation works against pushing scholars to more carefully analyze the public-sector decision-making process. There may be a tension between the way the Austrian school analyzes government and the way the subdiscipline of public choice does. One way to see this is to look at one of the strongest areas of commonality that the subdiscipline of public choice shares with the Austrian school.

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An Area of Commonality: Limiting the Scope and Power of Government The subdiscipline of public choice and the Austrian economics school of thought have a common bond in that in many—but not all—cases in both tend to argue that limiting the scope and power of government will be welfare-enhancing. This common conclusion comes from different sources in public choice and Austrian economics, so the similarity here is more apparent than real, and taking a closer look reveals a significant difference between the Austrian and public choice approaches to analyzing government. The Austrian argument for limiting government starts with the insight, going back to Mises (1951), that rational economic calculation cannot occur outside the market mechanism and without market prices. The decentralized decision-making of the market allocates resources more efficiently than government partly because of the efficiency of the market, as Hayek (1945) notes, but in the Austrian framework, the fact that the rational allocation of resources by government is not possible is the more significant factor. The public choice argument for limiting government comes from an analysis of the problems inherent in collective decision-making institutions. Before the public choice revolution, economists commonly worked out the conditions for policies that would lead to an optimal allocation of resources and then would tacitly assume that government would implement those policies. A market allocation of resources was compared to an ideal—and in the real world unobtainable—allocation of resources, and if the market fell short of this theoretical ideal, the conclusion was that some government policy could improve the allocation of resources. As Buchanan (1975) notes, public choice analysis shows that while in many cases the market allocation of resources will fail to meet some theoretical ideal standard, the same will be true for government allocation of resources. Thus, one must compare public-sector and private-sector resource allocation on an equal footing, using the same methods. Public choice does that, and the common public choice conclusion favoring limits on government is a result of analysis showing that using the same methods that economists use to evaluate private-sector resource allocation, resource allocation through government is likely to produce a result inferior to that of the market. Ultimately, the public choice approach compares government allocation of resources with market allocation of resources by evaluating which is more inefficient in particular circumstances: market failure or government failure. Often, public choice analysis does not make a direct comparison. It simply analyzes a government decision-making mechanism—for example, how bureaucracies allocate resources or how resources would be allocated under majority-rule voting—without comparing how markets might allocate those same resources. Microeconomics does the same thing, for example, by looking at the way monopolies affect resource allocation without directly comparing how government might allocate those same resources. The point is that public choice analysis is the analysis of collective decision-making

Public Choice and Austrian Economics    495 processes and that when public choice analysis compares public and private resource allocation, it compares how a collective decision-making process would allocate resources with how a market would allocate them. In the Austrian school approach, public choice problems are secondary to knowledge problems. Even with the most public-spirited actors, the knowledge problem causes government policies to produce unintended undesirable consequences, and as Ikeda (1997) notes, the undesirable result of one government policy often leads to demands for more government intervention to remedy that undesirable result, which produces more undesirable results and more government intervention. Government expands, becoming increasingly inefficient because of the problems of rational resource allocation outside of markets. This Austrian approach is based solidly on Mises (1951) and Hayek (1944) and explains why, even with the best of intentions, resource allocation through government cannot have a rational basis, why it works against the public interest and yet tends to expand over time. Essentially, the Austrian school says that government interference to try to improve the allocation of resources cannot work, whereas the public choice approach analyzes how government involvement in the allocation of resources actually works. Ikeda (2003) says that the difference between Austrian and public choice approaches to government is that the public choice approach emphasizes a divergence between the announced and actual intentions of political actors, whereas the Austrian approach emphasizes a divergence between intended and actual outcomes. In the public choice approach, interest groups, politicians, and government bureaucrats support particular positions and work to further particular outcomes, claiming that what they are advocating is in the public interest, but in fact, they are promoting policies that further their own interests, typically at the expense of the general public interest. In government, the invisible hand works against, rather than in support of, the public interest. There are incentives inherent in public-sector institutions that lead people, acting in their own self-interest, to act against the general public interest. The Austrian approach assumes that people participating in the political process intend to further certain goals, but because of knowledge problems, their policies produce unintended consequences that prevent them from accomplishing what they had intended. Ikeda (2003, 67) says, “Government failure from the Austrian perspective refers therefore to the failure of an intervention to produce the outcome sought by its proponents” (emphasis in original). Ikeda (2003) goes on to note that while this can apply regardless of the motives of political actors, Austrian analysis has often assumed that those acting in the public sector are people of goodwill who want to further the general welfare, not necessarily because the assumption is true but to emphasize the knowledge problems that exist in trying to allocate resources to produce a particular result through government planning rather than through markets. This Austrian approach to government intervention essentially assumes away the types of problems analyzed by public choice scholars and concludes that even if these public choice problems did not exist, government intervention in a market economy is still undesirable because of the impossibility of government planning to allocate resources rationally.

496   Political Economy The public choice approach assumes self-interested behavior to focus on the incentives that actors face in the public sector. Brennan and Buchanan (1980) argue that even if people in the public sector do not always act in their narrow self-interest, this assumption is desirable when looking at the design of political institutions, so that public choice theory can be used to design political institutions such that they cannot be used opportunistically by unprincipled people. Hayek (1944) argued that “the worst get on top” in government, so the assumption of self-interested behavior seems reasonable from that perspective. If the institutional structure of government allows selfish people to exploit it, self-selection will push the most selfish people into positions of government power. While both the Austrian school and public choice economics tend to support the market  allocation of resources and point toward the desirability of limited government, the Austrian school does so because of the recognition of the knowledge problems associated with allocating resources outside of the market mechanism, whereas public choice does so because of the inefficiencies inherent in the incentive structure of the public sector. The similarity in the two types of critiques is that both tend to argue an efficiency advantage of private-sector over public-sector resource allocation. A big difference, however, is that while one could imagine redesigning public-sector institutions to make individual incentives more compatible with the public interest by taking a public choice approach, the Austrian knowledge problem cannot be overcome, because the market prices required for rational economic calculation cannot exist when the allocation of resources is centrally planned. The Austrian conclusion that government interference with the market’s allocation of resources must be counterproductive stands in the way of moving toward a public choice analysis of how government actually allocates resources. Ikeda (1997) makes this argument most clearly, noting that government interventions have unintended negative consequences, which result in a demand for additional government interventions to mitigate the negative consequences, so a mixed economy inevitably slides toward a larger public sector and an increasingly inefficient allocation of resources. Good intentions produce bad results. This conclusion removes some of the appeal of analyzing how self-interested public-sector actors might work within political institutions to allocate resources. If the outcome is undesirable even with everyone acting with the best of intentions, there is not much point in taking the analysis further. The degree to which one views this Austrian approach to the economic activities of government as standing in the way of a further development of Austrian public choice depends on how broadly one defines public choice. Boettke and Leeson (2004) broadly define it as the economics of politics, and seen this way, the Austrian approach, as described here, would qualify. But the Austrian school tends not to examine the collective decision-making process that goes into producing public-sector outcomes, and the Austrian emphasis on the knowledge problem tends to direct the Austrian school’s analysis of politics in a different direction. If an Austrian analysis of the public sector points to the conclusion that, even with the most well-meaning actors in the public sector, government cannot effectively allocate resources, there is little incentive for the researcher to examine the collective

Public Choice and Austrian Economics    497 decision-making process in more detail. For that reason, there may be limited interest among Austrian school economists to develop a distinct approach to public choice, although they may want to analyze mainstream work in public choice to show why even the government-failure approach to public choice may be overly optimistic. Public choice and Austrian economics tend to be critical of government resource allocation but for different reasons. The reasoning behind the Austrian criticism may serve as a barrier that limits the interest of Austrian school economists in analyzing collective decision-making processes—that is, in analyzing public choice issues.

James Buchanan and the Foundations of Austrian Public Choice Prior to the cross-fertilization of public choice and Austrian economics at George Mason University in the 1980s and 1990s, it is difficult to identify much work that might qualify as Austrian school public choice. One might be tempted to cite Ludwig von Mises’s book Bureaucracy (1944), but Mises focuses on the problems of economic calculation in bureaucracies rather than looking at issues of collective decision-making. The book has a minimal amount of public choice content. One might also consider Friedrich Hayek (1944) and Joseph Schumpeter (1954), as Boettke and Leeson (2004) do, but there are arguments on both sides here, as the next section notes. A narrow definition of public choice would exclude them. Richard Wagner, a student of James M. Buchanan and a faculty member at George Mason, has also done a substantial amount of public choice work in the Austrian tradition and will be considered below. Much earlier, Buchanan started his work in public choice with a distinctly Austrian slant, emphasizing the political process and subjectivism in his work. Buchanan cofounded the Center for Study of Public Choice (hereafter referred to as the Public Choice Center) at Virginia Tech in 1968 and was its general director when he moved with it to George Mason in 1983. Buchanan’s (1969) book Cost and Choice explains the subjective nature of cost and draws out implications from that in a critique of mainstream ideas, including welfare economics and cost-benefit analysis. This book clearly puts Buchanan in the Austrian tradition, although it is not a public choice book. Buchanan and Tullock’s (1962) The Calculus of Consent is perhaps the first book that fits into both the Austrian and public choice camps. It is a work in public choice, beyond a doubt, and one of the seminal works that established public choice as a distinct subdiscipline. Buchanan and Tullock examine the political process, looking at political exchange through logrolling and vote trading, and examining the institutional structure of politics to distinguish constitutional and postconstitutional decision-making. Their emphasis on the political process, rather than on political outcomes, certainly makes the analysis in The Calculus of Consent consistent with Austrian ideas, whether or not one wants to classify this as Austrian public choice.

498   Political Economy Buchanan’s Austrian-oriented work goes back much further than that. Buchanan (1949) argues for an individualistic approach to the analysis of public finance, Buchanan (1954a) compares the process of voting versus market decision-making for choosing outcomes, and Buchanan (1954b) looks at Arrow (1951) from a process-oriented view. From his earliest work in public choice, Buchanan’s ideas are consistent with a process approach to politics, which appears consistent with the market-process approach to markets employed by the Austrian school. Buchanan (1964) argues that economists should focus on the exchange process more than on resource allocation produced by equilibrium outcomes. Sandmo (1990) notes that methodologically, Buchanan falls outside the mainstream, making minimal use of mathematical modeling, never publishing an empirical article, and rarely even citing empirical work. Thus, it is easy to see that Buchanan’s work lays the foundation for the development of an Austrian-oriented analysis of public choice. In addition to his written work, Buchanan brought the Public Choice Center to George Mason, which encouraged the cross-fertilization of public choice with the Austrian school. Buchanan is rarely identified as a member of the Austrian school, but he surely is sympathetic to Austrian ideas. If Austrian public choice predates the coexistence of the Austrian group and the Public Choice Center at George Mason, it would be found in Buchanan’s work and in the work of his student Wagner. Once Buchanan and his Center arrived at George Mason in the early 1980s, the environment was ripe for the cross-fertilization of ideas of the two groups.

Austrian Public Choice before the 1980s Austrian school analysis of public choice might have come from two directions. Scholars interested in public choice could adopt an Austrian approach, or scholars who took an Austrian school approach to economics could extend their interest toward an Austrian analysis of political decision-making. Buchanan’s work might be viewed as coming from the former direction, as he has been a public choice scholar from the beginning and sympathetic to Austrian methods. Indeed, it is possible to categorize much work by scholars not typically associated with the Austrian school as at least consistent with the tenets of Austrian economics, and some examples are discussed later in this chapter. Another approach to identifying work falling into the Austrian public choice framework would be to look at work that analyzes government decision-making done by people generally recognized as belonging to the Austrian school. Looking at both types of work, it is convenient to divide it into work done before 1980 and that done after, in other words, before and after the traditions were cross-fertilized at George Mason. Consider a few early possibilities written by people who might be associated with the Austrian school. Despite the claim of Boettke and Leeson (2004), Hayek’s

Public Choice and Austrian Economics    499 (1944) The Road to Serfdom may not qualify as Austrian public choice, because while it is critical of government intervention, it does little to analyze government decision-making processes. Schumpeter’s Capitalism, Socialism, and Democracy (1954) would come closer to a public choice analysis, in that Schumpeter was concerned that those who received the greatest benefit from capitalism would not protect it from its detractors, so that capitalism faced the threat of being voted away. Even here, there is relatively little analysis of collective decision-making. These books may have been catalysts for an Austrian view of public choice, but taking a narrow view of what constitutes public choice, they do not seem to qualify, themselves, as Austrian public choice. Mises’s Bureaucracy (1951), as noted earlier, emphasizes the knowledge problem and has little public choice content. Among the pre-1980 Austrians, perhaps the work that comes the closest to being Austrian public choice is Hayek’s (1960) The Constitution of Liberty, which can be seen as a precursor to modern constitutional political economy. Mancur Olson’s work seems to fit the mold more closely. Olson (1965) wrote about the organization of interest groups, emphasizing the process by which concentrated interests had an advantage in organization, and Olson (1982) developed a very process-oriented view of the rise and decline of nations, in which young political systems do not have well-organized interest groups, so entrepreneurial individuals engage in productive activity rather than rent seeking. As societies mature and interest groups become more entrenched in the political system, rent seeking displaces profit seeking, which leads to the decline of nations. Nobody would identify Olson as a member of the Austrian school, but his work appears consistent with the Austrian tradition. Similarly, William Baumol (1990; 1993) conjectures that people are entrepreneurial in all societies but that institutional differences push entrepreneurial people in some societies toward productive activities, whereas in other societies, where people get ahead through political favoritism rather than productivity, entrepreneurial individuals engage in destructive activity. Indeed, Baumol has had a long-standing interest in entrepreneurship (see Baumol 1968), like those in the Austrian school and unlike the mainstream economics profession. The bulk of Baumol’s work certainly could not be classified as Austrian, but some of his work on politics, institutions, and entrepreneurship appears very consistent with Austrian public choice. Before 1980, it is difficult to identify work done by individuals who are solidly accepted as members of the Austrian school that would qualify as public choice. Meanwhile, some work in public choice does approach government decision-making from a political-process perspective, analogous to the market-process approach that Austrians use in their analysis. Buchanan and Olson are fairly consistent in this regard, and some of Baumol’s work also fits. Perhaps this work is better viewed as laying the foundation for the development of Austrian public choice, because these scholars are not normally considered part of the Austrian school. Mises (1944), Hayek (1944), and Schumpeter (1954) qualify as Austrians (although Austrians often view Schumpeter as outside the school). But while these works analyze politics, they do not analyze the collective decision-making process in any detail. Taking

500   Political Economy a narrow view, as this chapter does, leaves those works outside the subdiscipline of public choice, even though the broader view of Boettke and Leeson (2004) includes them.

The George Mason Connection The coexistence of a group of Austrian school economists and public choice scholars at George Mason dating back to the early 1980s has played an essential role in the Austrian school’s approach to public choice. Buchanan, along with Gordon Tullock and several other faculty members at the Public Choice Center relocated from Virginia Tech to George Mason and brought the Center with them in 1983. Before that move, the Austrian school had a minimal interest in the subject matter of public choice. The Austrian presence at George Mason predated the arrival of the Public Choice Center by only a few years. Richard Fink moved to George Mason from Rutgers in 1980 and, with Karen Vaughn and Jack High, started the Center for the Study of Market Processes. Don Lavoie joined that group a year later, and while none of the original founders remains with it, the Center (renamed the Mercatus Center in 1999)  and a group of faculty supportive of the Austrian school have been a major presence at George Mason ever since. One reason the Austrian school and public choice have had a connection at George Mason is that some of the key faculty members associated with the Austrian school in 2011 received their doctorates at George Mason, where, as students, they were exposed to both the ideas of public choice and the ideas of the Austrian school. The George Mason Ph.D.s on the George Mason faculty include Peter J. Boettke, Peter Leeson, and Christopher J. Coyne. In addition, Wagner, who moved to George Mason in 1988, is a public choice scholar with strong Austrian leanings. Most graduate students in economics have little or no exposure to the ideas of the Austrian school, so because of the presence of such a substantial contingent of Austrian-oriented faculty at George Mason, which also houses the Public Choice Center, it is not surprising that so much of what could be considered Austrian school public choice has been produced by George Mason Ph.D.s and faculty.

Austrian Public Choice after 1980 One scholar who comfortably fits into both the Austrian and public choice camps is Wagner. Wagner (1966) integrates entrepreneurship and interest-group politics as public choice is beginning to emerge as a separate subdiscipline. Wagner (1977) integrates political incentives into a model of macroeconomic policy, laying an early foundation for the analysis of political business cycles. Gwartney and Wagner (1988) discuss problems that result from the political allocation of resources and consider constitutional remedies. Their institutional approach might be considered consistent with Austrian

Public Choice and Austrian Economics    501 economics, although viewed by itself rather than as a part of Wagner’s research program, the book would appear to be more of a work in public choice than one in Austrian economics. Wagner (1989) clearly combines the Austrian market process approach to economics with a public choice analysis to show that there is a divergence between the stated goals of transfer programs and their results. He explains this with Austrian arguments about the difficulties of economic calculation without market prices and public choice arguments about incentives in public-sector decision-making. Wagner (2006) depicts the public and private sectors as integrated institutions that interact with each other and argues that more decentralized political institutions lead to a more robust, less fragile political economy. Wagner (2007; 2011)  takes a very Austrian approach to the analysis of political decision-making, arguing that political decision-making is more of a spontaneous order than a planned order, as it is often depicted. Those at the top of the political hierarchy do not have complete control over those below them and do not have the knowledge of those below them, because knowledge is decentralized in the public sector as it is in the private sector, so hierarchical models of government decision-making do not depict the actual public-sector decision-making process. Wagner’s Austrian approach to public choice, interesting in its own right, also calls into question the way the Austrian school has depicted government decision-making in the socialist calculation debate and in general. One might view Wagner’s Austrian analysis of public-sector decision-making as support for the argument that earlier Austrian analyses of government do not properly fit under the heading of public choice. In addition to his written work, Wagner’s position as a faculty member at George Mason since 1988 has also influenced the work of the Ph.D. students who have come through that program. One issue that has attracted the attention of some Austrian scholars is the efficiency of government institutions, prompted by Wittman’s (1989; 1995) claim that democratic decision-making allocates resources as efficiently as markets. Sutter (2002) addresses this issue from an Austrian perspective, and while he lists some other critics in his references, they are not Austrian economists, nor do they approach the subject matter in an Austrian framework. Boettke and Lopez (2002, 114) mention Wittman’s work as worth considering within the framework of Austrian school public choice, and Boettke, Coyne, and Leeson (2007) argue that an Austrian approach to public choice is the most productive way to analyze the shortcomings of the arguments that Wittman and others have made about the efficiency of public-sector institutions. The issue is on the radar, so to speak, but it has generated only a small amount of work in Austrian public choice as a response. One distinguishing feature of Austrian economics is the focus on the entrepreneur as a critical actor in markets, so it is natural for Austrian public choice analysis to examine possibilities for political entrepreneurship. Wagner (1966) lays an early foundation, and Baumol (1990) makes an important contribution to the understanding of political entrepreneurship. Lopez (2002) depicts political entrepreneurs as investing in reputational capital and representative capital, where reputational capital establishes a politician’s

502   Political Economy brand name and signals the politician’s reliability in establishing a consistent ideology, and representative capital allows the politician to further policies that enhance the interests of his or her constituents. Holcombe (2002b) builds on Baumol (1990) to note that political entrepreneurs can profit from squeezing efficiencies out of the political system, as Wittman (1989) suggests, but also always have the opportunity to promote policies that transfer resources from some less politically important constituents to other more important constituents, enhancing political support in the process. Austrian economics recognizes the importance of institutions to economic activity, and one can identify Austrian contributions to the analysis of political and legal institutions. Benson (1990) discusses the evolution of legal institutions in a decentralized fashion before they were taken over by the state, and Benson (1999) develops a theory of the evolution of institutions that gave rise to the state. Boudreaux and Holcombe (1989) examine the way individuals contractually form associations that produce governance, and Foldvary (1994; 2002) discusses governance through contractual arrangements, as smaller organizations of people form governance units and those units cooperate with other organizations to provide public goods at a larger scale. Boettke (1993) integrates Austrian insights with public choice analysis to explain the uneven path of the former Soviet Union’s transition from socialism. The impossibility of rational economic planning under socialism lays a foundation for Boettke’s argument, which points him to the conclusion that the old Soviet system was really a rent-seeking society that worked for the benefit of those with political power. The post-Soviet regime in Russia was unable to make a credible commitment to economic liberalization, so the rent-seeking society remained but under a different form. Coyne (2007) also looks at transitioning societies after they are disrupted by war. He notes that in some cases, such as in Germany and Japan after World War II, democratic institutions were successfully imposed by the victors, but in others, such as Haiti and Somalia, political institutions remained poor, and so did those countries. Coyne’s approach is more broadly institutional, rather than narrowly public choice. Stringham (2005) compiles an edited volume that brings together a number of articles dealing with the way market mechanisms can work to replace activities that are normally undertaken by government and to evaluate government versus private-sector activity. While the book mentions public choice in its title, its main subject matter is orderly anarchy and the feasibility of eliminating government entirely. Higgs (1989) gives a process-oriented discussion of the growth of government as a result of the ratcheting up of government expenditures and regulation in response to crises. After a crisis passes, government retrenches some but not to its precrisis level. Holcombe (2002a) offers a process-oriented public choice analysis of the growth of government, showing its path-dependence. Naka (2002) follows up on Olson (1982) by writing about the growth of rent seeking and interest-group politics in postwar Japan. Leeson (2007; 2009) takes an interesting look at governance structures in pirate organizations. This work analyzes institutions and governance in a situation outside of governments, as traditionally understood, so it falls within the bounds of public choice as an analysis of collective decision-making.

Public Choice and Austrian Economics    503 To the degree that there is a contemporary Austrian school literature in public choice, the leading figures are faculty members at George Mason, led by Peter J. Boettke, Christopher J. Coyne, Peter Leeson, and Richard Wagner. This section is intended to give an overview of the type of work done in the past several decades that falls under the heading of Austrian public choice. It is not intended as an exhaustive survey. A complete survey of the Austrian school public choice literature would include many titles by those authors and by their students. One can cite so much work that falls into the category of Austrian public choice, but a question remains of whether Austrian public choice is a self-sustaining research program or whether it is more a reaction of Austrian scholars to developments in the mainstream public choice literature. In June 2002, the Review of Austrian Economics devoted a special issue to “Austrian Economics and Public Choice.” The nine articles in that issue should, almost by definition, be counted as Austrian public choice, and a look through the references of those articles reveals that very few of the references share the qualities of (1) being authored by someone who is associated with the Austrian school and (2) having some kind of economic analysis of government as their subject matter. Austrian public choice does not have the foundation of scholarship that has allowed new developments to be based on earlier work in Austrian public choice.

Conclusion One could view Austrian school public choice in an inclusive way, as Boettke and Leeson (2004) do, or less inclusively, as is done in this chapter. A case could be made for either approach, but by taking the less inclusive approach, this chapter focuses on what the Austrian school would need to do to develop a self-sustaining public choice research program in which new Austrian school research in public choice would build on earlier Austrian public choice work, rather than being more a reaction to developments in mainstream public choice. An argument against such a self-sustaining Austrian public choice is that it might result in Austrian school economists talking among themselves rather than engaging the more mainstream literature; yet much of the current Austrian school public choice research is published in Austrian journals and has had a minimal impact on public choice as a subdiscipline. An argument could be made either way. On the one hand, using the Austrian framework to react to and engage mainstream public choice creates the opportunity to influence the mainstream. On the other hand, the development of a distinct Austrian public choice framework could allow that framework to be readily applied to mainstream ideas, creating a greater opportunity for influence over the long run. As Boettke and Leeson (2004) describe it, there are substantial and long-standing areas of commonality between the Austrian school and public choice analysis. The narrower approach taken here suggests that the Austrian school has not developed its own approach to public choice the way it has, for example, in entrepreneurship,

504   Political Economy the competitive process, the role of knowledge in an economy, or macroeconomic fluctuations. If one defines Austrian public choice as analyses of collective decision-making processes undertaken by scholars recognized as members of the Austrian school, most of that work has taken place in the past few decades and has been done by scholars who are faculty members at George Mason , Ph.D. graduates of the university, or both. The fact that this work is recent is not surprising, because public choice as a recognizable subdiscipline only goes back to the 1960s, and at that time, there were only a few active researchers who could have been categorized as members of the Austrian school. While the Austrian school has produced some interesting and worthwhile work within the subject area of public choice, Austrian public choice does not appear to be a self-sustaining area of research within the Austrian school, at least through the first decade of the twenty-first century. Looking at the work listed in the references of Austrian public choice scholarship reveals that while the work of earlier Austrians is cited, it is extremely rare for any earlier Austrian public choice work to be cited, and the other side of this is that the public choice work that is cited is not work done in the Austrian tradition. As judged by the list of references used by scholars doing Austrian public choice, their work is built on the broader non-public choice work of the Austrian school, combined with non-Austrian public choice work. An argument can be made that the foundations of the Austrian school work against the development of Austrian public choice analysis. The work of the Austrian school builds heavily on the role of market prices acting to coordinate the effective use of all the decentralized knowledge throughout the economy and the fact that without markets and market prices, rational economic calculation is not possible. Because the Austrian school analysis of public-sector resource allocation leans heavily on the problems that occur under even the best of circumstances, scholars working in the Austrian tradition may see a limited usefulness in engaging in an analysis of the public-sector decision-making process—in other words, engaging in public choice analysis. Following this line of reasoning, any analysis of the collective decision-making process is but a minor issue when lined up against the larger conclusion that even under the most favorable collective decision-making procedures, government intervention in the market economy will necessarily fall short of its goals and bring with it a host of negative unintended consequences. The economic calculation argument only goes so far when analyzing the way government allocates resources. Government resource allocation is not completely irrational. People drive on government roads and arrive at their destinations. Countries in which the government produces electricity or telephone service seem to have services roughly equivalent to those in countries that provide these services through the private sector. One can also see that government works better in some countries than in others. So it is worth examining the details of how public-sector decision-making works, to better understand not only what occurs in the public sector itself but also how public-sector activity—production and regulation—affects economic activity in the private sector.

Public Choice and Austrian Economics    505 Surely public choice would offer more insight into these issues if it were to take a more process-oriented approach, if it were to recognize the knowledge problems inherent in collective decision-making, if it were to approach government decision-making as more of a spontaneous order, with unintended consequences, and if it were to depict government decision-making as more of a decentralized order where people at different levels interact with one another, rather than a hierarchical top-down organization. Even in the most hierarchical organization, every individual has some specific knowledge of time and place, and even when trying to faithfully carry out the instructions of those higher in the chain of command, every individual must interpret instructions and make independent judgments. Governments versus markets is much more nuanced than spontaneous versus planned order. There is no planned order in the sense of a central planner whose plan is faithfully implemented by those below. The subdiscipline of public choice would gain a richer understanding of government decision-making and government resource allocation if these factors were taken into account. In other words, the subdiscipline of public choice would benefit from taking more of an Austrian approach. The potential is there, but to date, the Austrian school has barely scratched the surface.

References Arrow, Kenneth J. 1951. Social Choice and Individual Values. New York: John Wiley. Baumol, William J. 1968. “Entrepreneurship in Economic Theory.” American Economic Review 58, no. 2 (May): 64–71. Baumol, William J. 1990. “Entrepreneurship:  Productive, Unproductive, and Destructive.” Journal of Political Economy 98, no. 5, Part 1 (October): 893–921. Baumol, William J. 1993. Entrepreneurship, Management, and the Structure of Payoffs. Cambridge, MA: MIT Press. Benson, Bruce L. 1990. The Enterprise of Law: Justice without the State. San Francisco: Pacific Research Institute. Benson, Bruce L. 1999. “An Economic Theory of the Evolution of Governance and the Emergence of the State.” Review of Austrian Economics 12, no. 2 (November): 131–160. Boettke, Peter J. 1993. Why Perestroika Failed:  The Politics and Economics of Socialist Transformation. New York: Routledge. Boettke, Peter J., Christopher J.  Coyne, and Peter T.  Leeson. 2007. “Saving Government Failure Theory from Itself:  Recasting Political Economy from an Austrian Perspective.” Constitutional Political Economy 18, no. 2: 127–143. Boettke, Peter J., and Peter T. Leeson. 2004. “An Austrian Perspective on Public Choice.” In The Encyclopedia of Public Choice, edited by Charles K. Rowley and Friedrich Schneider, 27–31. Dordrecht, Netherlands: Kluwer Academic. Boettke, Peter J., and Edward J. Lopez. 2002. “Austrian Economics and Public Choice.” Review of Austrian Economics 15, nos. 2–3 (June): 111–119. This chapter was improved by helpful comments from Peter J. Boettke, Christopher J. Coyne, Joshua Hall, and Richard Wagner. All opinions and any remaining shortcomings are the responsibility of the author.

506   Political Economy Boudreaux, Donald J., and Randall G.  Holcombe. 1989. “Government by Contract.” Public Finance Quarterly 17, no. 3 (July): 264–280. Brennan, Geoffrey, and James M. Buchanan. 1980. The Power to Tax: Analytical Foundations of a Fiscal Constitution. London: Cambridge University Press. Buchanan, James M. 1949. “The Pure Theory of Government Finance: A Suggested Approach.” Journal of Political Economy 57, no. 6 (December): 496–505. Buchanan, James M. 1954a. “Individual Choice in Voting and the Market.” Journal of Political Economy 62, no. 4 (August): 334–343. Buchanan, James M. 1954b. “Social Choice, Democracy, and Free Markets.” Journal of Political Economy 62, no. 2 (April): 114–123. Buchanan, James M. 1964. “What Should Economists Do?” Southern Economic Journal 30, no. 3 (January): 213–222. Buchanan, James M. 1969. Cost and Choice: An Inquiry in Economic Theory. Chicago: Markham. Buchanan, James M. 1975. “Public Finance and Public Choice.” National Tax Journal 28 (December): 383–394. Buchanan, James M., and Gordon Tullock. 1962. The Calculus of Consent: Logical Foundations of Constitutional Democracy. Ann Arbor: University of Michigan Press. Coyne, Christopher J. 2007. After War:  The Political Economy of Exporting Democracy. Stanford, CA: Stanford University Press. Foldvary, Fred E. 1994. Public Goods and Private Communities. Aldershot, UK: Edward Elgar Publishing. Foldvary, Fred E. 2002. “Small-Group Multi-Level Democracy:  Implications of Austrian Public Choice for Governance Structure.” Review of Austrian Economics 15 (June): 161–174. Gwartney, James D., and Richard E.  Wagner, eds. 1988. Public Choice and Constitutional Economics. Greenwich, CT: JAI Press. Hayek, Friedrich A. 1944. The Road to Serfdom. Chicago: University of Chicago Press. Hayek, Friedrich A. 1945. “The Use of Knowledge in Society.” American Economic Review 35: 519–530. Hayek, Friedrich A. 1960. The Constitution of Liberty. Chicago: University of Chicago Press. Higgs, Robert. 1989. Crisis and Leviathan:  Critical Episodes in the Growth of American Government. Oxford: Oxford University Press. Holcombe, Randall G. 2002a. From Liberty to Democracy: The Transformation of American Government. Ann Arbor: University of Michigan Press. Holcombe, Randall G. 2002b. “Political Entrepreneurship and the Democratic Allocation of Economic Resources.” Review of Austrian Economics 15, nos. 2–3 (June): 143–159. Ikeda, Sanford. 1997. Dynamics of the Mixed Economy. London: Routledge. Ikeda, Sanford. 2003. “How Compatible Are Public Choice and Austrian Economics?” Review of Austrian Economics 16, no. 1 (March): 63–75. Leeson, Peter T. 2007. “An-arrgh-chy: The Law and Economics of Pirate Organization.” Journal of Political Economy 115, no. 6 (December): 1049–1094. Leeson, Peter T. 2009. The Invisible Hook:  The Hidden Economics of Pirates. Princeton, NJ: Princeton University Press. Lopez, Edward J. 2002. “The Legislator as Political Entrepreneur:  Investment in Political Capital.” Review of Austrian Economics 15, nos. 2–3 (June): 211–228. Mises, Ludwig von. 1944. Bureaucracy. New Haven, CT: Yale University Press,. Mises, Ludwig von. 1951. Socialism:  An Economic and Sociological Analysis. New Haven, CT: Yale University Press.

Public Choice and Austrian Economics    507 Naka, Shigeto. 2002. “The Postwar Japanese Political Economy in an Exchange Perspective.” Review of Austrian Economics 15, nos. 2–3 (June): 175–197. Olson, Mancur. 1965. The Logic of Collective Action: Public Goods and the Theory of Groups. Cambridge, MA: Harvard University Press. Olson, Mancur. 1982. The Rise and Decline of Nations. New Haven, CT: Yale University Press. Sandmo, Agnar. 1990. “Buchanan on Political Economy:  A  Review Article.” Journal of Economic Literature 28, no. 1 (March): 50–65. Schumpeter, Joseph A. 1954. Capitalism, Socialism, and Democracy, 4th ed. London: Allen & Unwin. Stringham, Edward, ed. 2005. Anarchy, State, and Public Choice. Cheltenham, UK: Edward Elgar. Sutter, Daniel. 2002. “The Democratic Efficiency Debate and Definitions of Political Equilibrium.” Review of Austrian Economics 15, nos. 2–3 (June): 199–209. Vaughn, Karen I. 2000. “The Rebirth of Austrian Economics: 1974–1999.” Economic Affairs 20, no. 1: 40–43. Wagner, Richard E. 1966. “Pressure Groups and Political Entrepreneurs: A Review Article.” Papers in Non-Market Decision Making 1: 161–170. Wagner, Richard E. 1977. “Economic Manipulation for Political Profit:  Macroeconomic Consequences and Constitutional Implications.” Kyklos 30, no. 3: 395–410. Wagner, Richard E. 1989. To Promote the General Welfare:  Market Processes vs. Political Transfers. San Francisco: Pacific Research Institute. Wagner, Richard E. 2006. “Retrogressive Regime Drift within a Theory of Emergent Order.” Review of Austrian Economics 19, nos. 2–3 (June): 113–123. Wagner, Richard E. 2007. Fiscal Sociology and the Theory of Public Finance. Cheltenham, UK: Edward Elgar. Wagner, Richard E. 2011. “Municipal Corporations, Economic Calculation, and Political Pricing: Exploring a Theoretical Antinomy.” Public Choice 148, no. 1–2: 151–165. Wittman, Donald. 1989. “Why Democracies Produce Efficient Results.” Journal of Political Economy 97, no. 6 (December): 1395–1424. Wittman, Donald. 1995. The Myth of Democratic Failure. Chicago: University of Chicago Press.

Chapter 22

The Market Pro c e s s T heory Per spe c t i v e on Capita l i sm Normative Facets and Implications Paul Dragos Aligica

Introduction The debates about the new forms and varieties of capitalism and their regulatory and institutional architecture (Braithwaite 2008; Levi-Faur 2005; Bremmer 2009; Hall and Soskice 2001) along with the recent controversies regarding the origins, nature, and solutions of the economic and financial crisis (Cowen 2012; Friedman 2009) have led to the revitalization of several alternative theoretical perspectives challenging the mainstream, neoclassical, synthesis-based interpretation of capitalism. The so-called “market process” theory of capitalism, advanced within the Austrian tradition of economics and social theory, has reemerged as one of the most significant such alternatives. The vision intrinsic to it goes beyond the confines of the Austrian school of economics (Kirzner 1992), as the process approach has been reinforced by developments coming from other sources, such as complexity theory (Arthur 1999; Nelson 2011), philosophy (Rescher 2000; 2012), and institutional theory, both in its evolutionary form (Hodgson 2004; 2006) and its neoinstitutional form (North 2005; Ostrom 2005). The result is the slow and steady emergence of a rather sophisticated process-based view of capitalism and market order, of interdisciplinary ambitions. This is, indeed, a very interesting development, because such a view means a foundational conceptual reframing on a distinctive theoretical basis that is putting in a new light not only the analysis but also an entire set of normative aspects of capitalism. Process theory, as a general theoretical framework applicable to both natural and social order, as Nicholas Rescher (1996; 2000; 2012; ) explains, represents a distinctive

The Market Process Theory Perspective    509 tradition in philosophical and social thinking. The guiding idea “is that natural existence consists and is best understood in terms of processes rather than things, of modes of change rather than fixed stabilities.” In other words, “change of every sort … is the pervasive and predominant feature of the real,” and process philosophy “diametrically opposes the view that denies processes or downgrades them in the order of being or of understanding by subordinating them to substantial things” (Rescher 2012, 1–2). When it comes to the social realm, one needs not to see or theorize society primarily in terms of things. Processes, events, and occurrences offer an alternative or at least complementary perspective. Ultimately, the defining feature of process social theory is that it “stresses the primacy of activity—and the range of associated factors such as time, change, innovation, and so forth” (Rescher 1996, 27). This chapter starts with a brief overview of what the market system looks like when seen through the distinctive set of theoretical lenses shaped by a process view, while noting that using those lenses has important implications for political economy, organizational studies, and social theory in general. Some of these implications are descriptive and methodological, some of them are analytical and explanatory, and some of them are normative. The chapter focuses on the normative aspects, which have been far from fully elaborated or even explored so far by the market process scholars. The key point is that once one adopts a process-based view, the normative dimension (ranging from micro-level business ethics issues to issues of systemic justice) and the institutional framework defining the system’s rules of the game come to be seen in a new light. That doesn’t mean the introduction of novel ethical positions; it simply happens because the change of perspectives brings to light new problems or opens up old problems to new angles and interpretations. As Kirzner (1992, 209) put it, seen from a process theory viewpoint, many structural and normative features of capitalism “become visible—even without any ethical argumentation—in a totally different light.” That is to say, issues regarding the justice of the system or the normative bases of its governance come to be reconsidered “not by articulating novel ethical and philosophical positions but by offering a fresh economic understanding of how the capitalist economic system works.”

Market Process Theory: The Theoretical Core As mentioned, the process perspective on the market economy and capitalism is multifaceted, emerging at the junction of multiple traditions. The oldest and arguably the most elaborated of them is the Austrian theory, relabeled in the second half of the twentieth century by its most important living representative, Israel Kirzner, “market process theory” (Kirzner 1973; Kirzner 1992; Boettke 2012; O’Driscoll 1977; O’Driscoll and Rizzo 1985). The theory advocated by Kirzner (1992) is thus the result of an

510   Political Economy accumulated contribution of an illustrious tradition starting with Carl Menger, one of the leading figures of the neoclassical revolution, and continued via Ludwig von Mises ([1949] 1996)  and Friedrich Hayek (1945; 1978; 1979)  to the current explosive resurgence. Yet market process theory, although originating with a founder of neoclassical economics, is diverging in profound ways from the current neoclassical mainstream. Peter J. Boettke’s (2012) effort summarizes the differences in a very effective way. The pivotal issue, he explains, is the problem of equilibrium. While in neoclassical perspective, the equilibrium situation is the benchmark and the focal point, in the market process perspective, the really interesting things happen in disequilibrium. Competitive equilibrium and maximizing behavior, Boettke (2012) writes, are the hard core of the research program of mainstream economists. Equilibrium is central both for the minority of economists who think that the market economy in real life is approximating somehow the model and for the majority who think that the market economy fails in many respects to approximate it and that government intervention is therefore needed. Equilibrium, Boettke elaborates, emerged, on the one hand, as an indictment of reality in the works of market-failure authors such as Stiglitz and neo-Keynesians. On the other hand, the Chicago economists, such as Friedman, Stigler, Becker, and Lucas, “began to use it as a description of reality.” From their perspective, “real markets come breathtakingly close to approximating the efficiency properties of general competitive equilibrium.” In both cases, Boettke explains, “formalism led to utopianism.” In the minority view, “reality was idealized, so that it approximated the model.” In the majority view, “reality became a dystopia, devoid of dynamic adjustment properties,” while “utopian properties are inadvertently attributed to interventions designed to make reality match the model” (Boettke 2012, 279–289). Market process theory changes the emphasis, and in so doing, it becomes the alternative to both major branches of the mainstream neoclassical synthesis. Three important such changes are noteworthy: from optimal resource-allocation problems and the mechanics of equilibrium to the process of adjustment itself and to the path toward equilibrium and the variety of disequilibria on its way; from the static properties of the mechanics of equilibrium to alertness, change, discovery, invention, and creativity and the processes fueled by them; from a minimal interest in institutions and their role in shaping the market process to a special accent on the role of a variety of institutional environments. All in all, the focal point becomes change, dynamic adjustment, and learning through time—in a word, process. Seen in this light, the market is a matter of dynamic adjustment, in which prices serve as the basis of economic calculation “only in the context of a process of competition brought into being by what formalism assumes away: disequilibrium” (Boettke 2012, 280–281). Capitalism itself is a complex and dynamic social, economic, and institutional process growing out of and pivoting on this dynamic adjustment. On the one hand, there is the tendency to depart from equilibrium. Discovery, error, changes in the environment, or acts of Schumpeterian entrepreneurship fuel it. On the other hand is the

The Market Process Theory Perspective    511 tendency toward equilibrium via the price system. As one may expect, market process theory focuses on this double dynamic: the path toward and from equilibrium and the phenomena taking place in that interval. In “Entrepreneurial Discovery and the Competitive Market Process,” Kirzner (1997, 81) makes very clear that this theory “makes no claim that the market outcomes at any given date are efficient and socially optimal (in any sense in which traditional neoclassical welfare theory would use these terms).” Instead, he argues that the market provides a system of incentives channeling things in the direction of error correcting, and that induces a tendency toward equilibrium: “We appreciate that there are equilibrating forces, but that doesn’t mean that an equilibrating process is at all times in progress.” From that comes a very interesting and important implication: “the social significance of a market system does not reside in the beauty of the allocation pattern under equilibrium conditions.” In fact, “it rests upon the capacity of markets to translate the errors made in the immediate past into opportunities for pure entrepreneurial profit of direct interest to potential entrepreneurs.” It is important to note that this process or, more precisely, its capacities are seen and theorized as a function of the institutional framework. For instance, the institutional environment may help or hinder entrepreneurship by linking “socially significant opportunities” with “the likelihood and security of associated entrepreneurial gain,” thus “improving the chances for entrepreneurial discovery” (Kirzner 1984, 56). It is important to note that Kirzner (1982; 1997) calls this ongoing process of adjustment, alertness, discovery, learning, and error correction the entrepreneurial process. Irrespective of the specific interpretation, whether standard Austrian or Schumpeterian, in process theory, the entrepreneurial spirit, the potential for discovery, arbitrage, and creativity, is always there as the fuel of change waiting to be released. However, to get its release and generate the market process with all its consequences requires an institutional environment that is minimally supportive (Boettke 1992). To sum up, even a brief overview of market process theory identifies two complementary forces, both denoted (in technical and also common language) by using the same label of entrepreneurship. The Mises ([1949] 1996) and Kirzner (1973) line identifies and focuses on the forces and mechanisms pushing toward equilibrium through a dynamic, equilibrating, adjustment process. The Schumpeter (1934; 1942)  line draws attention to the other side: the obliteration of equilibrium via his celebrated notion of “creative destruction.” But it is important to stress, in both cases, that the ultimate focus of interest is the process, the dynamics of disequilibrium and the forces that influence it. All sides agree that the issue of real interest is not the formal properties of equilibrium, as suggested by mainstream neoclassical economics, but an array of phenomena and issues happening in dynamic disequilibrium, such as how the price system works in real-world disequilibrium; how the nonprice competition determines and works in disequilibrium; how alertness, creativity, and innovation are shaped and induced by the institutional, social, and cultural environment of the market; and how all of the above combine to generate a process of great complexity and diversity.

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The Process View of Capitalism We have seen so far how the theoretical core of market process economics diverges from the mainstream neoclassical perspective. It is important to note that the process approach is not limited to the foundational elements outlined above. Around this skeletal conceptual core grows a broader, more substantive, and more elaborated picture of capitalism. The key building blocks defining this second-degree or second-level view emerge naturally, once the notion of process in disequilibrium is on the table: the various facets of the price system as a real-life dynamic; error-correcting device in conditions of disequilibrium; profit and loss as selection and adaptive mechanisms; and the multifaceted notion of entrepreneurship, capturing an entire array of phenomena, from creativity, invention, and discovery to experiment and anticipation in conditions of risk and uncertainty. A mere overview of the list above suggests the measure in which the logic introduced by the core, abstract, and foundational features leads to substantive and significant changes in the ways we depict the nature of the market order and capitalism. A closer look will show how that logic translates from the theoretical basis to the normative implications. To anticipate the further steps of the argument, a notable consequence of putting flesh on the skeleton provided by the theory of disequilibrium and change is that it opens the way for truly grounding in social and economic reality the ethical and normative dimension, for getting naturalized and made endogenous. In fact, probably the most consequential feature of the process perspective in this respect is this social anchoring and naturalization of normativity taking place at several levels. But for now, let us focus on the transition from foundational and abstract market process theory to a more concrete view of the market system, through process theory lenses. In doing so, we prepare the way for a clear identification of the deep normative facets emerging on these foundations. We can illustrate how the logic unfolds by taking as a starting point the core theme of the price system, that is, the most basic level. Both in the mainstream and in the process view, the price system is seen as conveying a large amount of information about the needs, resources, and goods available in society at a certain time and the relationship among them. However, the process view adds a small but consequential twist, by also focusing on profit and loss not as mathematical, formal elements in an equation but as social phenomena embedded in a causal social nexus. The desire for profits may be the most powerful driver of the market. But in the economy as a whole, profits are coexisting with losses at any one moment. The failure or reorganization of an enterprise, economic sector, or industry is not an exceptional event. It is part of the nature of the market itself. The market is propelled by bankruptcy and losses—structural features of the market process—just as much as by profits. The sociology and contextual variety of the conditions, nature, and consequences of bankruptcy become very important for understanding the dynamics of the market. In brief, one may see a shift from price theory to profit

The Market Process Theory Perspective    513 and loss and from there to a view of the market system in which failure and bankruptcy are truly pivotal for its operation, not mere residuals of performance and success. That being said, it is important to keep in mind that the process theory view of capitalism definitely goes beyond the lenses shaped by price theory and its corollaries. It looks at individuals and companies as they try out (with more or less success) new products, new sales techniques, and new methods to organize production, anticipating certain future results or trends. It looks at how each enterprise must adapt not only to consumers’ demands but also to the changes in production or distribution brought in by other economic actors. It looks thus both beyond equilibrium and mere price competition, noting that market practice requires constant alertness, discovery, mutations, and adaptations to a variety of new circumstances. Moreover, as already mentioned, in a process view, competition means not just maximizing or optimizing within given parameters but also having the existing parameters (organizational, technological, economic) constantly challenged and changed. Far from this being a routine, mechanical, maximization-driven, formulaic phenomenon, in their attempt to adapt to consumer preferences and the environment, firms compete in innovation and experiment. Experiment is a natural outcome of creativity confronting uncertainty. As Schumpeter noted, the entire structure of capitalist economy is imbued and modified by that. Innovation and experiment are ongoing activities in capitalism at all levels, from developing new products and services to introducing new management, marketing, and organization formulas. Profit, loss, experiment, and innovation are thus related as faces of the same coin. In brief, the emerging image is one of a process fueled by specific images of the future (including the specters of success or failure) as much as by data and signals from past and present, in which alertness, learning, expectations, innovation, and creativity are pivotal. All in all, this is a dynamic process whose specific composition at any point in time takes forms and directions that are hard to predict. But the major element naturalizing and empirically grounding process theory is the fact that it draws attention to the real-life diversity intrinsic in the market economy. Success and failure take many forms because enterprise takes many shapes and forms. Competition leads to variation:  companies try to be different from others, through their methods and products, in order to gain a competitive advantage. This mechanism, in which change triggers further change, generates a dynamic system, endowed with a spontaneous ability to adapt to a large array of mutations in the natural conditions, social context, or consumer preferences. All of the above are a source and a condition of diversity. The diversity of the market is the key in this story. It is a diversity that feeds itself: new preferences, new attitudes, new projects, new technologies, new worldviews. The intrinsic and multifaceted richness, the variety, is the most striking (and, as we’ll see, the most normatively consequential) feature of the phenomena under discussion. One could see how, out of the abstract formulas of equilibrium and disequilibrium, the image of a real-life process defined by complexity and diversity is starting to emerge and to take shape and content. It is now clearer why looking at the market economy exclusively through equilibrium lenses is far from making sense of major issues such as diversity and complexity, the role

514   Political Economy of the future as an imagined action arena, or the long series of trials, tests, and experiments, some successful, most failed, that all lie at its core. All of these give a more natural and substantive context to the notion of entrepreneurship, sociologically and historically situated, seen as the pivot of a complex and dynamic process. As Kirzner (1973) demonstrated, entrepreneurship has no major place in the neoclassical framework. Yet, either defined as alertness and discovery or defined in a broader way as a process of creation, innovation, and experimentation, it is a central and preeminent feature of capitalism. The process view gives full justice to this reality. Overall, one may see a rather consistent image of the market and capitalism emerging as an unremitting, multifaceted, diverse, lively, noncircular process, historically and sociologically embedded, marked by complex and unpredictable changes, which generate both uncertainty and attempts and means of adapting to it. This is a process in which entrepreneurship matters and which has an identifiable general pattern but which, as a process, remains strongly defined by uncertainty and its consequences. In brief, the emerging view of the market order and capitalism is considerably different from the one framed by the mainstream, neoclassical, synthesis-based, equilibrium-centered perspective.

Basic Normative Implications We have seen so far how the market process perspective brings to the fore a series of issues, phenomena, and themes that were either secondary or not even registered on the radar of the neoclassical mainstream. As one may expect, the shift of accent has nontrivial normative implications. Three such implications are both illustrative and important. First, there is no doubt that the crucial position that error and failure have in the operation of the market process raises very intriguing ethical questions. After all, this seems to be a system that is unavoidably fueled by a huge amount of individual and organizational errors and failures. Error and failure are an intrinsic part of it, because they are part of the learning process; they provide crucial informational and knowledge input for learning to happen. Needless to say, failure brings with it a lot of abhorrent situations, suffering, and ethical dilemmas. Yet all these seem to be necessary in order to keep the system going and bring all its benefits in terms of economic performance. A Faustian bargain seems to lie at its core. How could one be approaching such a system from an ethics standpoint? Second, similar issues are raised by the “creative destruction” angle. Discovery, creativity, and innovation come with a trade-off:  the destruction and replacement of well-established businesses, jobs, and ways of life. One doesn’t even have to take risks, engage in experiments, or make mistakes and errors in order to be hit by the wave of destruction and restructuring. Simply doing your routine thing, the best you can, under the existing rules and parameters, may not be enough to spare you. In fact, most of the time, it isn’t. The process is blind and doesn’t discriminate. There is something deeply

The Market Process Theory Perspective    515 dramatic in all this, a macro-level systemic feature of grand normative clout that seems to escape the standard normative inquiries operating in the mainstream framework. The ethics of creative destruction emerge as both important and intriguing, a normative territory of great significance yet to be explored. Last but not least, the issue of complexity, diversity, and pluralism brings with it a rather sizable normative luggage, also, as we’ll see soon, a rather consequential one. We have established that diversity and pluralism are at the very core of the process view. The heterogeneity of situations and preferences, perspectives, values, and beliefs is the very condition of the existence and operations of the real-life phenomena associated with the market process. Arbitrage is a function of heterogeneity. Creativity is a diversity-generating phenomenon. Discovery is the mere extension of the facts of pluralism and heterogeneity. Entrepreneurship is, in the end, nothing other than an attempt to arbitrate or take advantage of the very fact of asymmetry, heterogeneity, and the ensuing disequilibria. The process view hence reveals a multifaceted, polymorphic, dynamic phenomenon. But this diversity and the associated pluralism of preferences, views, values, and beliefs mean that sooner or later, important ethical and normative tensions may manifest at multiple levels: individual, group, firm, industry, national, and international. Wherever there is diversity, there are competing alternatives, trade-offs, contradictions, and tensions. Solving this challenge requires more than mere individual moral deliberation and decision-making. It requires a set of social and institutional mechanisms. Before dealing extensively with the pivotal issue of the challenge of heterogeneity and its institutional solutions, based on all of the above, one may note that there are in fact three normatively significant dyads emerging. The first is the success versus failure dyad. Both success and failure are part and parcel of the market system and are operating at all its levels. Both involve a strong ethical component. More precisely, they require a threefold ethical framework. The first is for the successful. Success comes with certain responsibilities, with certain normative expectations regarding the attitude and behavior of the successful person or group. The second is for those that failed. But even more, in between the two, or above them, is the problem of the attitude of the rest of the society. A particular mindset should permeate the attitude of the rest in the face of success (or failure) of other members of society. One should have a certain set of expectations regarding how the members of society behave in this respect. As Hayek (1991) and Schoeck (1969) have already demonstrated, the psychological and normative issues surrounding themes such as envy, resentment, and misplaced notions of (social) justice are momentous. The problems of stigma for failure or envy for success have an unmistakable ethical, analytical, and practical significance. Looking at things from a process theory perspective reminds us how little we know or do in this respect. The second dyad is creation/discovery versus destruction. Again, both are intrinsic to the process, and each side comes with a rich normative luggage. The fact that an approach based on the notion of discovery leads, if not to the reconfiguration, at least to the reevaluation of an entire domain of business ethics has been noted and theorized by Kirzner (1992) and further elaborated by authors such as Foss (1997). Less, if at all, has been discussed on the other side. Destruction as a key feature or outcome of human

516   Political Economy entrepreneurial behavior has been largely neglected. Yet it seems obvious that destruction (even if creative) has its own specific ethical luggage. Process theory draws attention to this. The third dyad is the most special and in a sense most profound: pluralism versus monism. Given its nature that in its institutional implications it is of a different magnitude and class from the other dyads, we’ll concentrate attention on it. The argument will show that the next logical step in our efforts to outline the normative dimensions of market process theory goes through it. Its origins are in the very fact that diversity and complexity are always in tension with the simplicity of monism. It is not immediately obvious that the tension between monism and pluralism is so central to the process perspective. But a closer look reveals why that is the case. On the one hand, as already discussed, the market process is undoubtedly a domain of pluralism and diversity. On the other hand, there is the natural tendency of human beings to perceive and interpret situations and the entire normative universe in terms of a unitary normative framework, usually centered on self and its context. In a similar way, moral philosophers have tried most of the time to create and offer consistent and comprehensive ethical systems pivoting around a central value, principle, or worldview. Yet in real life, things are more complicated. Markets thrive on a diversity of views, preferences, and circumstances. They create situations in which trade-offs, negotiations, and reciprocal adjustments (including of the normative frameworks used) are unavoidable. Pluralism is obvious. It is also obvious that the more a phenomenon is defined by heterogeneity and pluralism, the deeper are the ethical cleavages and tensions. The market process perspective challenges this monism by revealing that diversity, divergence, and disagreement are unavoidable and that one should not treat this as an accident or as a transitory deviation from homogeneity-inducing normative equilibrium point. The process of reciprocal adjustment becomes salient, and the fact that its complexity is irreducible to this or that ethical or normative formula becomes even clearer. How diverse people with diverse preferences generate or adjust around such normative equilibrium points in a dynamic environment becomes the key. But even more important, this approach takes a decisive step further in the process of naturalization of normativity, by challenging the idea that the set of normative parameters of a society or community is to be discerned purely through a combination of analytical reason and intuition by the philosopher-king or the economist-king, whose intellect transcends the system. The conclusion is clear: to deal with the complexity and diversity posed by the real-life market process, we should be prepared to resist the monist, rigid approach and try instead to think in contextual and situational terms about a variety of solutions to the variety of problems, identified by a variety of people in a variety of circumstances, sometimes involving profound trade-offs and irreconcilable tensions and sacrifices. The bottom line is that the process view, with its accent on dynamism and diversity, the multiple faces of success and failure, and destruction (and creation and the social reaction to all that), brings to the forefront the fact of heterogeneity and pluralism and its dichotomies. With that it brings to the forefront the theoretical tradition reflecting it and on it. Once

The Market Process Theory Perspective    517 we have managed to recognize this crucial implication, all our attention has to turn to it and what it entails.

Normative Process Theory Descriptive or analytical market process theory leads naturally to the need for a special type of normative theory. But to deal with profoundly unsettling issues such as structural change, uncertainty, ongoing novelty, failure, destruction, and deep heterogeneity of views and preferences and to do it in a context-dependent way able to generate legitimacy in the eyes of real-life social actors and communities on the ground, require indeed a step beyond the standard approaches to normative theory. What this step (rarely if even taken by the market process theorists themselves) entails becomes clearer once we start building on the observation that the moral and normative life of a community or individual is not only about a mere list of values and “moral laws” (more or less backed by some supporting arguments) but is also about a social process of norm selection, interpretation, and application. Indeed, it is always a combination of individual and social factors that determines the shape, dynamics, and results of different cases and situations of normative significance. The social dimension is hence crucial. The emerging operational norms and their interpretation in specific situations by specific groups or communities are ultimately a social fact. In real life ethics and normativity are embedded in (and are part of) a social process. If that is the case, then it seems rather plausible that the best way to deal with all this would be a process-type approach. It is an approach that has to capture how individuals and social groups are able to respond to the challenges of a complex and dynamic process, different views and perceptions, different normative standards, on different themes, at different levels. That means one single thing: that the issue of norms and normative criteria and their application to practice has at its turn to be dealt with as a social process phenomenon, using the conceptual lenses of process theory. The key insight emerging out of this series of observations is that the nature of the normative space, especially when it comes to complex market process situations, is not a matter that could be discerned a priori, by fiat. It is a matter that is emerging within a social process. To paraphrase Gaus (2011, 31–32), for an entire range of normative issues, there is no possibility of a philosopher sitting in the study, abstractly considering what the normative principles or structure of each case or situation should be. This is not about abstract choice of normative solutions “from some impartial Archimedean perspective outside our real social world.” In fact, it is more constructive to assume that “until we actually engage in social interaction with diverse interests,” there is no way to know what the normative solution of the case may be (Gaus 2011, 31). In brief, one is left with a process of interaction and discovery, hopefully institutionalized in ways allowing it to operate at its best. It is a relatively open-ended process that is generating solutions, possible imperfect, and potentially clouded by moral indeterminacy. Ultimately,

518   Political Economy at its core is “a collective choice that arises out of the social nature of individual choices” (Gaus 2011, 31). It is a discussion in itself how the moral boundaries are determined and how total relativism is avoided (some possible solutions will be mentioned below). For now, let’s recapitulate. The argument so far has put us in the position to note that the market process theory invites a special view of the capitalist market system, a view that, at its turn, invites a rich, pluralist, contextual, and dynamic way of dealing with normative issues. That sets the stage for a rather unorthodox approach to normative thinking, an approach in which the emergence and justification of the ethical and governance norms are largely endogenized and in which the very normative foundations are defined more in terms of process than in terms of static norms or states of affairs. If that is the case, then one can see in a new light the challenge of themes such as those brought to the table by the centrality of failure and (creative) destruction in the capitalist system. The focus shifts. It is not so much what the detached philosopher or evaluator thinks but mostly how the living normative framework emerges naturally, on the ground, from the interactions among the relevant individuals. The dynamic interaction between how these norms frame the relevant issues and how the relevant issues are shaping up at their turn the evolution of the normative system becomes critical. Thus, the micro individual judgment and decision-making level comes more and more to be seen as part of a larger social process with a specific architecture of principles and norms at work, which is continually adjusting and readjusting, creating and recreating itself, at the margin. The logic of pluralism is thus leading in the normative realm to a social process perspective in ways that converge and complement the analytical process approach to the market. This should not be a surprise. At a closer look, it seems understandable why it is difficult to have a descriptive and analytical process theory approach, working smoothly with a nonprocess normative framework. Descriptive or analytical process theory requires a normative counterpart of a similar nature. All of the above does not mean that there is no room for genuine philosophical and independent normative engagement from external parties. All it means is that this engagement should be driven by an indirect strategy. As opposed to jumping directly to specific cases and applying to them the favorite normative ethical framework or institutional evaluation criterion, the indirect approach starts with a set of questions. Setting aside the specific cases for now, what would be the normative structure, the governance meta-level framework, for a just and efficient market process, seen as a real-life social system? Given the nature of the market process, what would be the best structural solution to the diversity of endless cases that require contextual treatment and solutions? What would be the optimal approach to thinking about the general normative framework governing such cases and its institutionalization via general governance principles? The crucial fact when thinking about the market process is that its intrinsically dynamic nature requires a framework able to encapsulate and respond dynamically to the ongoing changes (some of them of a radical and unprecedented nature) that are an intrinsic part of it. The issues identified by those questions are of a first-order priority.

The Market Process Theory Perspective    519 The way one solves such systemic, macro-level tasks sets the stage for the way one may deal with other, more specific, normative and ethical problems emerging constantly within the system. The problem of pluralism, diversity, change, and complexity has thus to find solutions that go, at the aggregated, systemic, macro level, before and beyond the individual micro level. In brief, the problem of a general, systemic normative framework and its institutionalization in principles of conduct emerges as the crucial and central problem in the light of the market process perspective. It is noteworthy that although the indirect approach that takes the basic idea of naturalization and endogeneity to the institutional design stage may sound very radical, the fact is that it is far from being an uncharted territory. The truth is that we have been led, by simply following the implication of the market process approach, to a pivotal theme of social theory and political philosophy. As Barry put it, there are two basic traditions competing in political and normative theory: an “end-state” approach and a “process” approach. The first is dominant, and the second is a challenger. The dominant one, the end-state or final-outcome theory, attempts “a description of the features of a society at a specified point in time” while projecting a normative standard on this description. It says that this ideal state is how things should be. For instance, at the macro level, it describes “the features predetermining the society’s distribution of income, wealth, power, prestige, status and the structures of the economic and political systems.” As a normative perspective, “it creates an ideal, a final state or goal, and declares its implementation the final purpose of politics” (Barry 1988, 3–5). The second tradition is process theory. Instead of looking at various fixed points more or less arbitrarily selected on the continuum of social life, it tries to look at the chain of causes and consequences and, even more important, at the rules of the game generating that chain. As a normative perspective, it suggests a “decentralized activity, interaction and co-ordination of social action” trying to stay away as much as possible from the fixation with one specific predetermined state (Barry 1988, 3–5). It is not neglecting the end states that actors or impartial observers may have in their minds, but it goes beyond the end state itself, focusing essentially on the procedural rules. How do we reach a certain state? What are the rules of the process? Have those rules been complied with? Are those rules impartial and just? Obviously, this second tradition is the one of interest in our discussion. The notion that descriptive and analytical market process theory has a corresponding, already rather well-developed normative counterpart finds a robust validation in the literature. Among others, Robert Nozick (1974) worked on what he called “process justice” (judging social and economic systems not on the basis of outcomes but on the basis of the processes that generate those outcomes), offering thus some of the paradigmatic arguments of this literature. In these circumstances, all one has to do is to work out systematically the points of junction between the two forms of process theory, focusing explicitly on the nature of the rules of the game that shape the interactions of the acting and choosing individuals who follow them. Such an approach comes first of all as a corrective. Too many times, we think exclusively in terms of end states and neglect thinking in terms of process. Hence the shift

520   Political Economy from end states to process, or at least to a more balanced take, in which change itself becomes just as important as the particular, static, ideal configuration desired. However, the process-focused normative theory warns that a normative solution doesn’t necessarily mean to change things in a certain way and then simply to lock them into a newly created configuration. Instead, the goal becomes making things flexible enough to reflect and adjust to the diversity of normative conditions and situations, to the evolution of the preferences, values, and beliefs of the individuals on the ground, while maintaining as a focal point a certain set of norms of merit and justice. The key point here is that from the process perspective, the assessment of the justice or fairness of the market should look first at the rules that govern its processes and only then to a particular result. Implicit in this is a comparison between alternative systems, both in terms of their rules and in terms of their results. In this respect, seen through the process theory lenses, the justice of the market system has to stem from the generality and impartiality of its rules of the game and from the nature of the processes engendered by it (Barry 1988; Nozick 1974). The pivotal feature is that the rules of the market only outline the framework of the game and its permitted moves; they do not discriminate in favor of one player or another. If the rules were to favor one group or one player, they would be not rules but agreements on results. There are normative systems that start and end with precisely that—but not the rules of the market system, as seen from the process perspective. The rules do not specify who will win or lose; they simply state what is and what is not allowed. In this respect, one may say that normative process theory has a strong pragmatic element: the observation that it is easier and more ethical to agree about rules than about ; that is, it is much easier to set the rules according to which the winner emerges than to agree about who should win. However, at the same time, normative process theory could also be seen in the light of the concept of fair play, a general respect for the rules, regardless of whether you win or lose. Any game has rules, and we say that someone acts correctly and fairly when he or she plays by the rules. That puts us in the position to illustrate how this approach may deal (at least prima facie) with a theme that we have identified as challenging: the problem of failure. We have seen how the justice principle of the market comes from the character of its ideal-type operating model. It is blind, general, and impartial, and it is intrinsic to the very social process. That means that failures in the market do not necessarily mean that the market system in itself is unfair. We do not say that a sports game is unfair because a team has to lose. The same is true for the market. Some players lose, and others win, but arbitrated markets satisfy a generally accepted criterion for judging fairness, despite their collateral failures and dramas. The criteria of justness of the market system—and by implication of capitalism—stem from the degree in which its operations comply with one of the strongest rules of fairness. But all this becomes clear only when we pay attention to the general rules of the market, rather than its specific results, whether they are successes or failures. That doesn’t mean that one should not pay attention to the specific cases of failure, bankruptcy, or destruction brought about by structural change. It only means that one should approach them in the broader framework of the broader process that they are a part of.

The Market Process Theory Perspective    521 Last but not least, it is important to note that adopting the idea of process implies the acceptance of the irreducible tension between the process view and the end-state view and, with it, the full recognition of what may be called the paradox of process thinking. Whether we like it or not, even when advocating a process view, we explicitly or implicitly operate with an end state in mind; the end state is merely shifted at the meta-level of the rules of the game. It simply becomes the constitutional framework that shapes the process. This observation leads us to the next and final step of our argument. Following the logic of process theory, we have reached a point at which we realize that a discussion of the normative dimension requires a discussion of the institutional-constitutional framework within which the relevant processes are taking place. The central idea emerging from this discussion is that of socially embedded norms and their institutionalization. And the bottom-line idea is that when it comes to the market process, it is almost impossible to see the normative issues independently of the governance systems. One needs to start thinking of embedded systems of rules, checking one another in an embedded set of processes. Normative process theory thus leads us to the notion of an institutional architecture correlated with a multifaceted social process. The theme of constitutions and constitutionalism is the best-known member of the class of themes and discussions defined by this idea.

The Institutional Framework of the Market Process The notion of institutional framework or the meta-constitution of market process emerges as a major element in an analysis that has taken as a starting point market process theory in search of its normative implications. Although the details of the transition from the initial theoretical starting point to these implications have been only sketched, the broad contours are rather clear. We are entering a territory located at the disciplinary boundaries between political science, law, constitutional economics, and ethical and normative theory. This is the domain dealing with the constitutive aspects of the social-normative order. As Vanberg and Buchanan (1996, 55) note, when it comes to this domain, the most important thing to keep in mind is that there is no uniquely perfect institutional design “out there,” no “optimal solution,” no “predetermined future.” Instead, social actors create their future through their choices, step by step through trial and error. For rational actors “who are aware of the fallibility of their constitutional efforts” and “who recognize their embeddedness in an open-ended evolutionary process which is, in part, molded by their own choices,” the fundamental problem is: How can we maintain a desirable constitutional order among ourselves, given that—at any and every point in the continuing process—we cannot know what will

522   Political Economy be known, invented, and created tomorrow, what potential solutions may be available to us, what problems we will face, or even what we will perceive as problems tomorrow? The only reasonable answer to this question is that such rational actors would have an interest in providing for the possibility of continuous learning, for adaptability to changing and unforeseen problem scenarios. In other words, they should have an interest in a metaconstitution for an open society. (Vanberg and Buchanan 1996, 55)

That is to say, the concern for flexibility and adaptability should be manifested not only within the existing framework but also regarding the reformulation and revision of the basic rules that define the overall governance framework. Again, between the lines, one may be able to read the very idea of process. The suggestion is that individuals should be free not only to play the game or have the incentives to self-enforce the rules of the game but also to change those rules in an orderly way. As Ostrom (1999, 60) put it, “if conditions were to change and a particular set of rules failed to evoke an appropriate set of responses, rules could then be altered to evoke appropriate responses.” Or, as Hayek (1979, 65–97) explained, we need to have in mind the “open-endedness of a process in which the complex interactions of human efforts produce an order in a process that over time might approximate a ‘perfect’ constitutional-institutional order.” At this juncture, it is important to note the parallel between the tendency toward equilibrium defined by the market process theory and the tendency of the institutional process mentioned by Hayek. The parallels are not accidental and should not surprise us as they stream from the common family pedigree in process philosophy assumptions.

Conclusion This chapter has charted the basic elements and the conceptual itinerary of a possible elaboration of the normative extension of analytical market process theory. In doing so, it identified the existing relevant themes and theoretical perspectives that should be part of such an enterprise. Once the argument has reached this point, two directions of further development are becoming rather salient. First is the direction defined by the complex and diverse literature that deals from various angles and disciplinary perspectives with the institutional and behavioral facets of the “constitutional” and “meta-constitutional” systems (Hayek 1978; Hayek 1979; Ostrom 1997; Ostrom 1999; Buchanan 1989; Gaus 2011; Elkin and Soltan 1993; Rescher 1993). At minimum, that could reinforce the insights emerging from normative process theory or inspire innovative ways of framing them. Exploring the ways in which a normative market process theory could be further articulated using the approaches and theories of this literature seems to be a rather important item on any further agenda. Second, once the institutionalization and the constitutive dimension are fully taken into account and things are articulated through such general frameworks, the natural

The Market Process Theory Perspective    523 next step leads to a specific subclass of contractarianism. These are approaches that use the idea of a hypothetical social contract whose basic structure allows the emergence with binding force of ethical obligations, through the recognition of existing norms on the ground, in the real social circumstances of groups, organizations, and communities (Dunfee 2006)—in other words, to focus within the broader family of contractarian theories on those perspectives advancing “a communitarian conception of economic morality that defines correct ethical behavior through the device of a hypothetical social contract emphasizing the moral understanding of living members of economic systems and organizations” (Donaldson and Dunfee 1995, 86). In this conception, a hypothetical social contract is integrated with real social contracts. Thus, in this ingenious approach, the notion of contracting “allows both positive and normative applications, and hence assures at least some degree of continuity between the world as we would like it to be and the world as we find it as a matter of fact” (Pursey et al. 2006, 212). Exploring this direction in depth seems to be rather promising. For instance, integrative social contracts theory (ISCT), developed by Thomas Donaldson and Thomas Dunfee (Donaldson and Dunfee 1995; Dunfee and Donaldson 1999), seems to be rather consistent with what we have described up to this point as the process perspective. Even a cursory comparative overview reveals the affinities and complementarities between the two. Moreover, both look at capitalism and its liberal-democratic system of governance with essentially a similar attitude, captured very well by Hartman (2009, 714–715): The current dominance of liberal capitalism suggests that the norms that it supports do solve people’s problems. It also allows for improvements. In a liberal democracy people are encouraged to advocate different norms. Free markets offer alternatives to current products, services, and even lifestyles. People can make stupid choices, but they can learn from experience. That experience might affect not only our choices but also some of our principles. Democratic capitalism is self-correcting in that way.

But there is more than that. For instance, ISCT may be able to offer some solutions to the quandary of relativism that hovers around process theory. ISCT, writes Douglas (2000, 103), attempts “to reconcile particularity and generality through the development of limiting conditions. There are universal moral principles called hypernorms.” Reframing the problem of universalism in terms of hypernorms opens up an entire array of avenues. Most important for the current discussion, such an approach is contextually (socially and culturally) sensitive and flexible. It is also realistic in the sense that it is not an ideal-theory exercise. Instead, it tries to capture the conditions and preferences on the ground with all their variety, having at the same time a level of generality and abstraction that allows it to travel well cross-culturally and internationally (Douglas 2000). It has both a local and a global dimension straddling the normative cleavage of particularism and universalism. And even if, as Hartman (2009, 707–709) puts it, hypernorms and great ethical principles “are of significant but limited use in ethical decision making” because they are rarely directly action guiding, they still are

524   Political Economy of crucial importance. As the same author explains (2009, 707), they have the function of “raising questions and challenges that help us arrive at legitimate local norms and make good ethical decisions.” All in all, the emerging picture is one of a process in which hypernorms are combined with the “attention to the facts, trial and error, and moral imagination to create communities and institutions whose norms offer us useful ways to bring considerations of justice, rights, and welfare to bear in practice” (Hartman 2009, 707). This, in fact, seems to be precisely the logic of meta-constitutionalism evoked by Vanberg and Buchanan (1996, 55) and, as a matter of fact, the core general logic behind the process approach.

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526   Political Economy Schumpeter, J.  A. 1934. Theory of Economic Development. Cambridge, MA:  Harvard University Press. Schumpeter, J. A. 1942. Capitalism, Socialism and Democracy. New York: Harper & Row. Vanberg, V., and J. M. Buchanan. 1996. “Constitutional Choice, Rational Ignorance and the Limits of Reason.” In The Constitution of Good Societies, edited by K. E. Soltan and S. L. Elkin, 39–53. University Park: Pennsylvania State University Press.

Pa rt  V I I

AU ST R IA N C ON N E C T ION S A N D  E X T E N SION S

Chapter 23

On the Ec onomy- Wi de Im plicati ons of  Kirznerian A l e rt ne s s Maria Minniti

Introduction The last twenty years have seen an increasing amount of popular, political, and academic interest in entrepreneurship. In academia, in particular, a specialized field of inquiry has emerged that focuses on entrepreneurship and the identification and exploitation of opportunities. This field has evolved around three distinct albeit complementary levels of analysis: work conducted on the entrepreneurial behavior of individuals, on the entrepreneurial behavior of firms, and on the relationship between entrepreneurship and the economy at the aggregate level. The motivation for this chapter comes from the observation that when the entrepreneurship literature considers system-wide consequences (or implications) of entrepreneurship, it usually cites Joseph Schumpeter on innovation or William Baumol on institutions. While there is no denying the importance of the contributions that those authors have made to entrepreneurship research, I argue that embedding aggregate level studies of entrepreneurship in the context of Israel Kirzner’s framework allows us to move away from a view of entrepreneurship as a special cause of episodic innovations whose direction, productive or unproductive, is a function of existing institutions and toward a view of the market process as entrepreneurial in all its aspects, including its most quotidian operations and adjustments. In fact, focusing on Schumpeter’s and Baumol’s works exposes researchers to the risk of somewhat marginalizing entrepreneurship by viewing it as applicable, at the system I am grateful to the editors of this book for inviting me to contribute this chapter. Many thanks go also to Roger Koppl for his invaluable comments and suggestions. All errors are mine.

530    Austrian Connections and Extensions level, only to two particular phenomena, namely, innovation and how institutions may alter the direction of entrepreneurship toward productive or unproductive activities. In my view, this may falsely reduce the role of entrepreneurship in the economy. If we go with Kirzner, however, we see that entrepreneurship is essential to and at the center of the dynamic market process. Indeed, as Kirzner showed in 1973, even the static economy of the old neoclassical orthodoxy would be impossible without entrepreneurship.1 In general, when we consider the role of entrepreneurship in the market economy, we should not restrict our attention to Schumpeterian “innovation” and Baumol’s allocation of entrepreneurial effort across productive and unproductive activities. We should see that all aspects of the market process, including not only innovation but also growth, allocation of resources, equilibration, and business cycles, are ultimately products of entrepreneurial action. I have argued that entrepreneurship is a human universal, an aspect of all human action (Minniti and Koppl 1999). It follows that all aspects of the dynamic market process are entrepreneurial. The rest of the chapter contains six sections. The first surveys the state of the entrepreneurship field and its levels of analysis and summarizes the challenges and opportunities they provide. The second section reviews recent research on the relationship between entrepreneurship and aggregate economic activity. The third section summarizes recent Austrian contributions on the relationship between entrepreneurship and aggregate economic activity. The fourth section briefly describes Kirzner’s view of entrepreneurship. The fifth section discusses how Kirznerian alertness contributes to our understanding of the relationship between entrepreneurship and aggregate economic activity. The sixth section concludes and suggests opportunities for further research.

The Field of Entrepreneurship Research In academia, the increased interest in entrepreneurship of the last twenty years is illustrated, among other things, by the emergence of an entire field of inquiry focusing on the topic. Begun in the late 1970s, the field of entrepreneurship has blossomed with dedicated journals and high-profile endowed chairs in most major universities. In 2013, for example, the Journal of Business Venturing, the best-known journal dedicated to entrepreneurship research, was considered a tier one tenure publication in more than three hundred research universities worldwide, and it has an impact factor higher than 3, which is superior to that of publications such as the American Economic Review and Management Science. Stanford University, Indiana University, and Syracuse University, among others, have departments dedicated specifically to entrepreneurship along with specific Ph.D. programs, whereas 1 

Young (1928) also gives us a picture of the dynamic market economy that is driven by entrepreneurial alertness.

Kirznerian Alertness   531 several other major research institutions offer Ph.D.s with an entrepreneurship focus in the context of strategy or management programs. At the time this chapter was written, the Entrepreneurship Division of the Academy of Management counted more than three thousand members and was one of the largest and the fastest growing. This trend, of course, has also generated a significant increase in entrepreneurship-related output, with articles appearing, in addition to dedicated journals, in most of the major journals in economics, management, strategy, psychology, sociology, and policy. The legitimacy of a field of inquiry rests, of course, on the distinctiveness of its domain, the soundness of its methods, and the theoretical strength of its core concepts.2 The field of strategy, for example, focuses on issues related to firm performance. While strategy’s core questions overlap significantly with questions in applied economics, economists generally do not concern themselves with organizational problems that are relevant for the creation and sustainability of competitive advantage. In entrepreneurship, although economists have been talking about it for a long time (Cantillon 1755), scholars from a variety of disciplinary backgrounds have embraced the idea that the alertness, identification, and exploitation of opportunities, plus their antecedents and consequences, constitute the distinctive realm of entrepreneurship as a field of inquiry (Alvarez, Barney, and Anderson 2013; Eckhardt and Shane 2003; Shane 2000; Shane and Venkataraman 2000). Sarasvathy et al. (2010), for example, define the concept of entrepreneurial opportunity as (1) new ideas or inventions that may or may not lead to the achievement of one or more economic ends that become possible through those ideas or inventions, (2) beliefs about things favorable to the achievement of those valuable ends, and (3) the actions that generate and implement those ends through the establishment or one or more economic artifacts (economic goods, new firms and markets, or institutions).3 The ramifications of this conceptualization are, of course, very broad, and as a result, so are the resulting streams of research. Nonetheless, regardless of disciplinary background, research in entrepreneurship can be divided roughly into three broad streams, depending on whether the focus is on individual-level analysis, firm-level analysis, or aggregate-level analysis. Within each group, we find both theoretical and empirical pieces. At the individual level of analysis, for example, researchers have studied entrepreneurship as employment choice (Amit, Mueller, and Cockburn 1995; Hamilton 2000) and entrepreneurial cognition, with the latter divided between psychology-focused 2 

Austrian economics and market processes are attracting increasing interest in the field. This provides a receptive and fertile ground for theories of human action that are rooted in economics but not necessarily subject to the constraints of formal modeling and general equilibrium (see, among others, Shane 2003; McMullen and Shepherd 2006; Alvarez and Barney 2007). 3  A lively debate has emerged about whether opportunities are formed by exogenous shocks to preexisting markets that entrepreneurs discover (Shane 2003) or if, instead, opportunities are created by the entrepreneurs themselves (Alvarez and Barney 2007). However, Alvarez, Barney, and Anderson (2013) have suggested that, far from being problematic, these alternative approaches complement each other and shift our attention, appropriately, from opportunity types to the associated entrepreneurial processes.

532    Austrian Connections and Extensions works (Baron 1998)  and behavioral economics (Koellinger, Minniti, and Schade 2007). More recently, significant attention has also been paid to groups of individuals and to the creation of entrepreneurial teams (Harper 2008; Parker 2008). At the firm level of analysis, we find works in corporate entrepreneurship, that is, studies on the degree to which fostering entrepreneurial activity within a firm contributes to determining the firm’s competitive advantage (Stevenson and Jarillo 1990), and works in strategic entrepreneurship where the connections between small and new firm strategic behavior are explored (Companys and McMullen 2007). Finally, as discussed in detail in the next two sections, works on the relationship between entrepreneurship and aggregate economic activity study innovation (Gans, Hsu, and Stern 2002; Tripsas 1997), institutions (Estrin, Korosteleva, and Mickiewitz 2013; Henrekson 2007), and growth (Acemoglu, Aghion, and Zilibotti 2006; Aghion and Howitt 1992). A comprehensive literature review of the field is beyond the scope of this chapter and probably beyond the scope of any single chapter given the size of the emerging literature. However, interested readers can find broad reviews of the literature in Acs and Audretsch (2010) and Agarwal, Alvarez, and Sorenson (2005), and Parker (2009) is a review focused especially on the economics of entrepreneurship. In general, Kirzner’s alertness, Schumpeter’s creative destruction, and Frank Knight’s uncertainty are considered the three classic building blocks of the field. However, unlike Schumpeter (1934; 1942), and although most entrepreneurship researchers would acknowledge the far-reaching implications of their contributions, Kirzner (1973; 1983) and Knight (1921) tend to be cited only in the context of individual-level analysis. As an alternative, I argue that considering Kirzner’s framework as being relevant only at the individual level reduces our ability to appreciate what entrepreneurship is and what it does at the aggregate level. In this chapter, I concentrate on the level of analysis that focuses on the causes and implications of entrepreneurship at the aggregate level. While the individual and firm levels of analysis have seen contributions based on all disciplines mentioned earlier, studies of entrepreneurship at the aggregate level remain largely dominated by economists and an economic view of the world. In the next two sections, I review research in this area and show its systematic link to innovations, institutions, and economic growth.

Recent Research on Entrepreneurship, Innovation, and Aggregate Economic Activity Parker (2009) identifies three main (and somewhat overlapping) approaches to the study of innovation and entrepreneurship at the aggregate level.4 The first approach builds on wealth-based theories. Banerjee and Newman (1993), for example, proposed 4 

Quadrini (2009) also distinguishes contributions to the study of entrepreneurship at the aggregate level in three groups. His grouping, however, differs from Parker’s and identifies contributions that

Kirznerian Alertness   533 a model in which individuals are segregated into three classes based on their occupational status (entrepreneur, wage earner, and self-employed). In their model, the role of entrepreneurship is to create wealth, and as a result, entrepreneurs are the richest group with the lowest borrowing constraints. Banerjee and Newman demonstrate that several alternative development paths can emerge for the economy based on the relative size of the three groups of individuals. Depending on which path emerges, the economy may be trapped in poverty and stagnate. In this view, entrepreneurship is the mechanism that allows the accumulation of wealth and generates development as one of its byproducts, whereas borrowing constraints are the key bottleneck to growth. The second approach builds on technology-based theories. In this view, entrepreneurial action is the response to incentives created by technological change. This view is related to Schumpeter’s, since it is based on the idea that technological change provides entrepreneurial incentives by allowing for the acquisition of temporary monopoly positions and, therefore, economic profits. Within this context, Lazear’s (2005) characterization of entrepreneurs as jacks-of-all-trades suggests that if technological change is complementary with existing entrepreneurial skills, entrepreneurs match themselves with productive projects, and the economy grows, whereas if technological progress requires skills not present among individuals, the number of entrepreneurs decreases, and so does growth. In this view, entrepreneurship is identified primarily with innovation and constitutes the endogenously generated mechanism that allows for sequential waves of technological change, whereas the key bottlenecks are R&D expenditures that support technological advances (Minniti and Levesque 2010) and entrepreneurial skills (Lazear 2005). The third approach builds on knowledge-spillover theories. According to Parker (2009), in this view, entrepreneurs create new ventures to exploit knowledge available in the system even though they did not contribute directly to its production. Already in 1989, Schmitz suggested that an unintended consequence of entrepreneurial searching and investing is to add to the common stock of knowledge. Acs et  al. (2004) argue that entrepreneurship provides the mechanism through which new knowledge (which in itself has no economic value) is commercialized. In the knowledge-spillover theory of entrepreneurship, a clear demarcation exists between invention and commercializable innovation, and the entrepreneur is the actor who bridges the two. In this view, entrepreneurship is also the source of economy-wide positive externalities (Minniti 2005; Minniti and Koppl 1999). One of the main features of the knowledge-spillover approach is its acknowledgment that innovation per se is neither necessary nor sufficient for entrepreneurship to happen. This is in contrast with the technology-based view in which entrepreneurship is synonymous with technological change. deal with the implications of entrepreneurship for savings and investment, the relationship between entrepreneurship and economic growth, and entrepreneurship as an employment choice. While the last is a microeconomic problem, Quadrini’s argument is that occupational decisions at the individual level provide findings that are fundamental for constructing models of aggregate entrepreneurial behavior.

534    Austrian Connections and Extensions In addition to the three approaches just summarized, a fourth approach has emerged recently in which entrepreneurship is viewed as an economic selection mechanism leading to the establishment of alternative institutional settings (Acemoglu 2006). Acemoglu (2008), for example, uses entrepreneurship to develop a model of economic performance under different political regimes. When taxes are high and the distortions caused by entry barriers are low, oligarchy is more efficient than democracy, which tends to result in an oligopoly dominated by the monopoly interests of an economic elite. However, because comparative advantage in entrepreneurship shifts economic profits away from incumbents, the inefficiency created by entry barriers in oligarchy grows over time, tending to make the open competition of democracy more efficient. This story is meant to explain cycles in political economy whereby the system oscillates between oligopoly and democracy. In this view, entrepreneurship is still linked to innovation, although it has both a political and an economic dimension, so that it becomes the mechanism that allows mobility into the elite class. While this stream of research links entrepreneurship to innovation, institutions, and economic growth, its characterization is still that of an innovation that produces short-term monopoly rents and where political power is simply a byproduct of monopoly profits. While partial and brief, this review of the literature illustrates that recent approaches to studying entrepreneurship at the aggregate level, especially when formal modeling is present, tend to link entrepreneurship to innovation and look, rather mechanically, at its implications for institutions and growth. In this sense, while very useful in many ways, these approaches do not really capture many of the distinctive functions that entrepreneurship plays in the economy and, therefore, marginalize its role. Usually, Schumpeter provides the theoretical foundations for these models. Yet he did not really have a theory of the market process. Schumpeter’s importance to entrepreneurial studies is hardly subject to doubt. His theory of innovation is a permanent contribution to the field. However, Schumpeterian entrepreneurs are accounted for in Kirzner’s theory of entrepreneurship and are, in fact, a subset of the more comprehensive group of Kirznerian entrepreneurs (Kirzner 2009). If, as an alternative, we take a Kirznerian approach to entrepreneurship, the latter is viewed as an aspect of human action, which includes but is not limited to the type of technological innovation implied in these models.5 In Kirzner’s case, by its very nature, entrepreneurship is not easily subjected to the assumptions required by general equilibrium analysis.6 The assumptions of general equilibrium modeling constrain the economic role of the entrepreneur to that of a rational optimizing manager. In these models, removing the condition of perfect information allows individuals who have superior knowledge of markets, technologies, or sources of supply to emerge as entrepreneurs. 5  Most formal models of aggregate economic activity, whether including entrepreneurship explicitly or not, identify innovation with technological change requiring R&D expenditure (for a discussion of the implication of this formal requirement, see Minniti and Levesque 2010). 6  This point is developed in Kirzner (1973).

Kirznerian Alertness   535 These entrepreneurs then exploit their superior knowledge through the implementation of productive activities and, in the short run, earn economic profits. Still, neoclassical models tend to emphasize the equilibrium state of the market, while little attention is paid to the process that underlies the movement toward, or away from, such equilibrium. As an alternative, I build on Butos and Koppl (1999), who argue that Kirznerian entrepreneurs should be viewed as Hayekian learners and suggest that some of the most important implications of entrepreneurship at the aggregate level emerge not from innovation per se but from the interdependence of their actions and the unintended consequences of such actions. The consideration of individuals’ interdependence and its unintended consequence brings us organically to discussing the relationship between entrepreneurship and institutions.

Recent Research on Entrepreneurship, Institutions, and Aggregate Economic Activity In addition to innovation, the second-largest stream of entrepreneurship research at the aggregate level focuses on institutions and, again, economic growth. However, whereas in the previous section, innovation was the mediator for economic growth, in this section, institutions (often equated with policies) are the relevant mediator. Institutions refer to the formal and informal rules governing human behavior and can vary across time and space. For most works in this area, Baumol (1990) is a major building block and a “must” citation. Sobel (2008) provides an empirical test supporting Baumol’s thesis that governments, via proper institutions, are more able to influence the distribution of entrepreneurial activity toward alternative types of entrepreneurship than they are to influence its overall quantity. Scholars in the Austrian tradition have recently developed a significant body of work that addresses this important question and also highlights the important causal role played by institutions in entrepreneurship. Boettke and Coyne (2003; 2006; 2009) leverage the Austrian tradition and, in addition to discussing the importance of institutions, provide an analysis of the connection among institutions, the market process, and entrepreneurship.7 Their work explores how various institutional structures influence entrepreneurial behavior and the linkage between the latter and economic growth. The underlying logic of the connection between institutions and entrepreneurial behavior is the realization that institutions provide a framework that guides activity, reduces uncertainty, and makes the actions of others more predictable (Harper 1998). In short, institutions serve to reduce transaction costs and facilitate the coordination of knowledge dispersed throughout society.

7 

Some paragraphs in this section reproduce material originally presented in Koppl and Minniti (2010).

536    Austrian Connections and Extensions Thus, institutional arrangements have major implications for the way we understand economic change. When engaging in productive activities, such as arbitrage, innovation, and other socially beneficial behaviors, entrepreneurs foster economic growth by acting on previously unexploited profit opportunities. In countries with low growth, they argue, it is not that entrepreneurs are absent or inactive but rather that profit opportunities are tied to socially destructive behaviors. Thus, as in Baumol (1990), the adoption of certain institutions precedes (and is a necessary condition for) the existence of productive entrepreneurial behaviors, since it is the institutional framework that enables the right type of entrepreneurship. To get institutions that promote productive market entrepreneurship, Boettke and Coyne argue, it is necessary to understand the conditions and institutions necessary for political entrepreneurs to adopt good policies. In other words, since entrepreneurship is a universal aspect of human action, the entrepreneurial mindset applies not only to the private realm but also to the public arena and to the meta-rules followed by policy makers; thus, appropriate political systems need to be in place.8 As Harper (2003, 125) states, “Societies which bind themselves to the principles of the rule of law, security of property rights, market coordination of resources, free trade and sound money grow faster than societies in which economic freedom is curtailed. Because many of the components of economic freedom are the result of public policy and explicit political decisions, it follows that the choice of institutional framework has immense consequences for economic prosperity and the wealth of nations.” Chamlee-Wright (1997) also takes an Austrian approach and explains how cultural meanings and government policies influence aggregate entrepreneurship. Specifically, she shows that entrepreneurs are cultural figures. On the one hand, their actions reflect the cultural environment in which they act. On the other hand, their actions are an important influence on the culture in which they operate. Of course, much of the work on aggregate-level entrepreneurship and institutions, both inside and outside the Austrian tradition, operationalize institutions with political rules and regulations. Thus, the topic leads organically into the related debate about the relationship between entrepreneurship and policy. Indeed, in the last fifteen years, many governments and international organizations have paid increasing attention to entrepreneurship and have implemented policies aimed at fostering it in various countries. Unfortunately, the results of such policies have been mixed, and, with some exceptions, researchers have been unable to tackle this issue satisfactorily. A broad search of the literature reveals that the fundamental and general question of how, and if, governments are able to positively influence entrepreneurial activity is far from being resolved (Audretsch, Grilo, and Thurik 2007). Koppl (2008) supports the basic institutional perspective of Boettke and Coyne discussed above. He notes that when proposing or supporting entrepreneurship policies, policy makers have expectations regarding the outcome of those policies. Policies that

8 

This argument is consistent with work by Acemoglu cited earlier in the chapter.

Kirznerian Alertness   537 go beyond measures such as institutional transparency to promote relatively concrete ends imply relatively concrete expectations. Such expectations may require policy makers to predict outcomes that are mathematically impossible to predict.9 This impossibility, Koppl explains, is particularly problematic for many entrepreneurship policies, since innovating entrepreneurs are, by definition, individuals who deviate from the norm and act under uncertainty. According to Koppl, governments cannot pick winners. However, they can create a reliable set of rules that entrepreneurs can play by. This is because policies ensuring institutional transparency, predictable taxation, and secure property rights do not require policy makers to compute specific outcomes in order to achieve their intended goal of promoting entrepreneurial ventures. Koppl’s work contributes directly to the debate about the limitations of proactive policies and the claim that only the market can identify value-creating ventures. Along similar lines, Kirzner and Sautet (2006) identify explicitly some of the policy characteristics necessary to encourage productive entrepreneurship. Among other things, they discuss the difficulty faced by governments wishing to implement policies fostering the entrepreneurial process, noting that entrepreneurial activity cannot be directly measured. Policies that enable entrepreneurship to flourish are one step removed from where entrepreneurial activity occurs, as they deal with the institutional and regulatory context. They also stress that particular attention should be paid to well-defined and enforceable property rights, freedom of contract and its enforcement, and the amount of interference from governments with market outcomes, all institutional characteristics whose importance for productive entrepreneurship has also been tested and supported empirically by Sobel (2008). Taking a more regional approach, Desrochers and Sautet (2008) argue that policies enabling entrepreneurs to exploit opportunities in a context of spontaneously evolved industrial diversity are better facilitators of regional development. Following the idea that regional specialization produces external economies of scale, regional policies often emphasize the positive features of industrial environments focusing on concentrated and clustered firms. Desrochers and Sautet, on the other hand, contend that a push toward specialization might leave regional economies more vulnerable to cyclical downturns and less likely to generate innovations such as those made possible by industrial symbiosis and Jacobsian externalities. Noticeably, however, Desrochers and Sautet do not argue against regional specialization. Instead, they provide evidence suggesting that spontaneously developed industrial variety generates an environment very conducive to innovation, as proximity and diversity enable entrepreneurs to build on both explicit and tacit knowledge.

9  Koppl draws on Velupillai (2007), who shows that “an effective theory of economic policy is impossible” for an economy that achieves “computational universality.” Essentially, this means that if the economy is sufficiently complex, there is no way for policy makers to know what the results of any given policy may be. Commenting on his own result, Velupillai (2007, 288) says, “Perhaps this is the reason for Hayek’s lifelong skepticism on the scope for policy in economies that emerge and form spontaneous orders.”

538    Austrian Connections and Extensions

The Kirznerian Approach to Entrepreneurship In neoclassical10 economics, the economy is represented as a system in equilibrium composed of agents who are also in equilibrium. In that model, human action is the allocation of known and scarce resources among known and competing ends. The agent maximizes utility, and the analysis is timeless. In reality, time passes, things happen, and changes occur. For Kirzner, the term entrepreneurship identifies the element in human action that corresponds to the passage of time, makes things happens, and creates change. In Kirzner’s (1973, 31) system, “there is present in all human action an element which, although crucial to economizing, maximizing, or efficiency criteria, cannot itself be analyzed in [those] terms.”11 This entrepreneurial element in human action is the cause of changes at the individual level and distinguishes action from maximizing. Similarly, entrepreneurial action produces change in the market. It “occupies precisely the same logical relationship to the more narrow ‘economizing’ elements in the market that, in individual action, is occupied by the entrepreneurial elements in relation to the efficiency aspects of decision-making” (Kirzner 1973, 32). Without entrepreneurship, Kirzner argues, the market process cannot emerge. Kirzner develops his theory of entrepreneurship with the concepts of alertness and discovery. Kirzner defines alertness as “the ‘knowledge’ of where to find market data” (67). He puts the word knowledge in quotes to warn the reader that the entrepreneur possesses this knowledge only through his capacity to act on it. He cannot write it down and may not know that he possesses it. His knowledge “is a rarefied, abstract type of knowledge—the knowledge of where to obtain information (or other resources) and how to deploy it” (Kirzner 1979, 8). Alertness leads to the “discovery” of opportunities. The entrepreneur did not previously know of the opportunity he acts on, nor does anyone else. If he or someone else had known of it, that opportunity would already have been seized. The exploitation of the opportunity would not, then, constitute a change in any meaningful sense. Thus, the entrepreneur’s alertness leads to something previously unimagined. It leads to the discovery of a new way of doing things. In Kirzner’s theory, market order is produced by entrepreneurship. Without acts of entrepreneurial alertness, our never-changing actions would gradually fall further and further away from consistency with the underlying scarcities. In Kirzner’s vision (1992, 49), the “constant market agitation” caused 10 

The meaning of neoclassical is fluid. While many works in this group entail a sophisticated disequilibrium or process analysis, neoclassical has come traditionally to mean static equilibrium analysis (Machovec 1995). 11  The discussion in this section does not pretend to be a comprehensive treatment of Kirzner’s theory of entrepreneurship. I only review the features of his theory that are relevant to the discussion of aggregate economic activity. Also, some paragraphs in this section reproduce content from Minniti and Koppl (1999).

Kirznerian Alertness   539 by “jostling competitors and innovative entrepreneurial upstarts” is “not chaotic at all.” Rather, it is here, “in this apparently chaotic sequence of market events that the market’s orderliness resides.” The market process is a dynamic process of change driven by alert entrepreneurs who discover new profit opportunities. Throughout the market process, economic incentives exist for people to reallocate resources. People respond to such incentives, but the ability of individuals to recognize incentives and reallocate resources varies. Individuals with superior alertness to changes and to the state of disequilibrium move to exploit opportunities and earn economic profits. Thus, the role of the entrepreneur is to discover and seize market opportunities through the reallocation of productive resources. Butos and Koppl (1999) point out that Kirzner’s theory requires a complementary theory of learning, because entrepreneurs discover things about the world. In their words, they learn. As Butos and Koppl suggest, Kirznerian entrepreneurs should be viewed as Hayekian learners. In Hayek’s cognitive theory, knowledge is the product of an evolutionary process in which mental activity is governed by a hierarchical set of rules (Hayek 1952). The mind’s interaction with the environment generates a series of conjectures. Modifying those conjectures permits improved fit with the environment. The whole process is envisioned as a rule-governed, error-correcting, and dynamic adjustment process. This process is a kind of exchange between conjectures and actions on the one hand and the prevailing but mutable external world on the other. As Minniti and Koppl (1999) argue, Hayek’s cognitive theory from The Sensory Order provides a theory of learning that is highly complementary to Kirzner’s theory of entrepreneurship. Hayek’s discussion of attention fits Kirzner’s notion of alertness quite well. Alertness must be switched on. As noted earlier, Kirzner defines alertness as “the ‘knowledge’ of where to find market data” (1973, 67) or “the knowledge of where to obtain information (or other resources) and how to deploy it” (1979, 8). Thus, if knowledge is structured in more or less the way Hayek suggests, entrepreneurial alertness is a forward-looking structure that is produced by, and in turn influences, the whole economy. Each entrepreneur occupies a different place in the system and is alert, therefore, to different opportunities. Building on the importance of dispersed knowledge for opportunity recognition and exploitation, McMullen and Shepherd (2006) adopt a similar perspective and introduce a distinction between third-person opportunity (an opportunity for a person) and first-person opportunity (an opportunity for the individual under consideration) and argue that entrepreneurial action stems from the possession of applicable (contextual) knowledge (which reduces perceived uncertainty) and the willingness to bear uncertainty. The authors acknowledge that Kirzner’s concept of alertness is first and foremost a system-wide concept that allows the economy to work properly and that the concept gets unduly diluted when applied at the individual level of action. By considering simultaneously both the amount of uncertainty perceived and the willingness to bear uncertainty, McMullen and Shepherd provide a two-stage conceptual model of entrepreneurial action that allows for its examination at the individual level of analysis while remaining consistent with theories of entrepreneurship at the system level.

540    Austrian Connections and Extensions

A Kirznerian Approach to Entrepreneurship and Aggregate Economic Activity The Kirznerian perspective that entrepreneurship is a human universal suggests that entrepreneurship shapes the overall market process more fully and deeply than one might infer from standard interpretations of Schumpeter and Baumol in the entrepreneurship literature. There are at least three aspects to this shaping. First, entrepreneurship is necessary for equilibration and, somewhat more generally, the quotidian operation of the market process. Second, each act of entrepreneurship serves as an example to others and tends, therefore, to produce more entrepreneurship. Third, entrepreneurial innovations create new entrepreneurial opportunities, which in turn propel further entrepreneurial opportunities in a ramified process of economic development.

Quotidian Entrepreneurship Schumpeter’s model of economic development begins in market equilibrium. This equilibrium is disturbed by an innovating entrepreneur whose profits are competed away by imitators until a new zero-profit equilibrium is established. In this story, disequilibrium exists only because of entrepreneurial innovations. The logic of Schumpeter’s story does not require entrepreneurial innovations to be big in any sense. The general tone and spirit of his exposition, however, may suggest that he has in mind only big innovations and remains silent on small innovations. And this interpretation seems to prevail in the entrepreneurship literature, where it is often associated with the fuzzy expression radical innovation. Thus interpreted, however, Schumpeter cannot explain how the rough and ready order of the market is preserved from one day to the next. There are, of course, many causes for disequilibrium that do not qualify as Schumpeterian innovations. Many of them are small, and some are large. The standard Schumpeterian story does not address the consequences of these disturbing causes. In a Kirznerian perspective, however, every cause for disequilibrium corresponds to a profit opportunity. These opportunities switch on entrepreneurial alertness, which tends to discover gaps in the price structure and to close them by entrepreneurial acts of arbitrage. As Kirzner has noted, these acts of “arbitrage” may entail complex intertemporal processes. Indeed, even “the bold, creative, innovative entrepreneur” of Schumpeter’s theory “is at a yet higher level of abstraction also engaged in arbitrage” (Kirzner 2009, 150). Recall that in Kirzner’s theory, market order is produced by entrepreneurship, that the ability of individuals to recognize incentives and reallocate resources varies, and that the role of the entrepreneur is to discover and seize market opportunities through the reallocation of productive resources.

Kirznerian Alertness   541 Market order is where the difference and the complementarity between Kirzner and Schumpeter are revealed. Kirzner provides a theory of equilibration. The entrepreneur coordinates the plans of other economic actors. Schumpeter’s entrepreneur disrupts the plans of other economic actors. This difference is a substantive one. Without the equilibrating entrepreneur, Schumpeter cannot explain the existence of the order disrupted by his disequilibrating entrepreneur. Thus, there is a sense in which Schumpeter has no theory of the market process. (See Kirzner 1999).

Entrepreneurship Breeds More Entrepreneurship Like any human decision, the choice to act on a perceived opportunity is formed and revised given the knowledge available to the individual. Different people have different knowledge, thus different perceptions about the uncertainty and cost associated with exploiting that opportunity. The social circle of the individual, for example, influences perceptions about the likelihood of finding a profitable business opportunity. These perceptions are all aspects of one’s knowledge of “where to obtain information (or other resources) and how to deploy it” (Kirzner 1979, 8). They are thus aspects of Kirznerian alertness. The individual’s social environment thus influences the quality and (what matters here) the quantity of alertness loose in the community.12 The observation of much entrepreneurial activity in one’s proximity tends to make one more alert and therefore more likely to discover an entrepreneurial opportunity (Minniti 2005). Because entrepreneurship creates more entrepreneurship, one cannot predict the aggregate level of entrepreneurial activity toward which the system is moving. It is uncertain and heavily influenced by cultural traits. This means that significant differences in the amount of entrepreneurial activity across different groups may exist in spite of relatively modest differences among their economic and institutional characteristics. If the entrepreneur is a catalyst of further economic activity, then entrepreneurship breeds entrepreneurship, and the aggregate level of entrepreneurial activity within an economy is uncertain and determined by the unfolding of the entrepreneurial process. The level of entrepreneurship is determined through a path-dependent process. Even if individual preferences were known a priori, the equilibrium level of entrepreneurial activity still would not be equal to the sum of many independent decisions but would depend on the dynamic pattern of events in which the interaction among individuals pushes the economy toward its final position. There is a multiplicity of such patterns, and the perfect knowledge of individual preferences, although necessary, is not sufficient to tell us where the economy will end up. The choice will depend on the mix of individual actions, and the aggregate level of entrepreneurial activity is clearly the unintended consequence of such actions. 12 

This section reproduces some paragraphs from Minniti and Koppl (1999).

542    Austrian Connections and Extensions

Entrepreneurship Drives a Ramified Process of Economic Development Entrepreneurial innovations create new entrepreneurial opportunities, which in turn propel further entrepreneurial opportunities in a ramified process of economic development. Young (1928) examined this ramification of opportunities in relative detail. He wrote: “Adam Smith’s dictum amounts to the theorem that the division of labour depends in large part upon the division of labour.” Young (1928, 533) explains: Not only new or adventitious elements, coming in from the outside, but elements which are permanent characteristics of the ways in which goods are produced make continuously for change. Every important advance in the organisation of production, regardless of whether it is based upon anything which, in a narrow or technical sense, would be called a new “invention,” or involves a fresh application of the fruits of scientific progress to industry, alters the conditions of industrial activity and initiates responses elsewhere in the industrial structure which in turn have a further unsettling effect. Thus change becomes progressive and propagates itself in a cumulative way. The apparatus which economists have built up for the analysis of supply and demand in their relations to prices does not seem to be particularly helpful for the purposes of an inquiry in these broader aspects of increasing returns.

In this paragraph, Young notes that the extent of the market is endogenous to the market process and how economic growth can be self-sustaining. The division of labor in such an economy grows increasingly ramified over time. Each change lays the ground for the next. Koppl et al. (2013) suggest that in this view of economic change, each refinement in the division of labor increases wealth, which is an increase in the extent of the market allowing a further refinement in the division of labor. Today we can recognize the role of alert entrepreneurial discovery in the process Young describes. From a Kirznerian perspective, each such response follows from the alert discovery of a profit opportunity. At each step of the ramifying process, there is a set of profit opportunities waiting, as it were, for alert entrepreneurial discovery. Some of these opportunities are discovered, and others are not. And of course, some entrepreneurs err by discovering and acting on opportunities that prove, ex post, to have been false opportunities. Each of these things—entrepreneurial hits, misses, and errors—helps to create in the next step a new set of profit opportunities waiting for alert entrepreneurial discovery. From this deeply Austrian perspective, economic development is endogenous and not, as with Schumpeter, an episodic process driven by exogenous innovations. And at each step, we have more than just the allocation of entrepreneurial effort across productive and unproductive activities, though we certainly also have that. But we also have a process in which entrepreneurial discovery is a principal driver rather than a passive response and in which the number of (productive) entrepreneurial opportunities expands endogenously over time.

Kirznerian Alertness   543 Finally, Holcombe (2003; 2007) provides a complementary contribution by arguing that every time an entrepreneur seizes a new opportunity, the possibility for new markets is created. When an entrepreneur fills a niche in his or her market, resources are mobilized, the possibility of complementary products or services is created, and, as a result, new entrepreneurial opportunities exist. Thus, the entrepreneur is an equilibrator within his or her market and, simultaneously, a catalyst of activity for the economy as a whole.

Conclusion As with many social phenomena, perceptions about the desirability of becoming an entrepreneur are formed and revised given the knowledge available to each agent. Different agents know different things and, as a result, exhibit different perceptions about the uncertainty and cost associated with becoming an entrepreneur (McMullen and Shepherd 2006). In addition to providing a brief outline of the current status of the field of entrepreneurship and reviewing a selected number of contributions on the relationship between entrepreneurship and aggregate economic activity, this chapter argued that embedding aggregate-level studies of entrepreneurship in the context of Kirzner’s framework allows us to move away from viewing entrepreneurship as a special cause of episodic innovations whose direction, productive or unproductive, is a function of existing institutions and toward viewing entrepreneurship as a necessary feature of all aspects of the market process, from the most glamorous to the most mundane. Specifically, I have argued that entrepreneurship is a human universal, an aspect of all human action (Minniti and Koppl 1999). It follows that all aspects of the dynamic market process are entrepreneurial. Within this context, I have suggested that when we consider the role of entrepreneurship in the market economy, we should not restrict our attention to Schumpeterian innovation and Baumol’s allocation of entrepreneurial effort across productive and unproductive activities. Instead, we should see that all aspects of market process, including not only innovation but also growth, allocation of resources, equilibration, and business cycles, are ultimately products of entrepreneurial action. Furthermore, I have argued that much extant research on the relationship between entrepreneurship and aggregate economic activity describes the role played by entrepreneurship as being mediated by innovation or institutions. While there is much value in those approaches, entrepreneurship plays a broader role at the system level of analysis. First, entrepreneurship is necessary for equilibration and, more generally, for the quotidian operation of the market process, an aspect that is not accounted for by Schumpeterian innovation. Second, each act of entrepreneurship provides spillovers in a variety of ways, thereby producing self-reinforcing patterns likely to lead to more entrepreneurship. Third, entrepreneurial innovations create new entrepreneurial

544    Austrian Connections and Extensions opportunities, which in turn generate further entrepreneurial opportunities in a ramified process of economic development. With a few exceptions (e.g., Holcombe 2003; 2007; Minniti 2005), I believe that these features of entrepreneurship have not been taken sufficiently into account when considering its system-wide effects. I also believe that doing so may give us important insights into the workings and impact of aggregate-level entrepreneurship. I hope that thinking about them will encourage new and much-needed research in this direction.

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Kirznerian Alertness   545 Boettke, P. J., and C. J. Coyne. 2009. “Context Matters: Institutions and Entrepreneurship.” Foundations and Trends in Entrepreneurship 5, no. 3: 135–209. Butos, W., and R. Koppl. 1999. “Hayek and Kirzner at the Keynesian Beauty Contest.” Journal des économistes et des études humaines 9, nos. 2–3: 257–275. Cantillon, R. 1755. Essay on the Nature of Commerce. [Republished 1959, London, UK: F. Cass & Co.] Chamlee-Wright, E. 1997. The Cultural Foundations of Economic Development. London and New York: Routledge. Companys, Y., and J. McMullen. 2007. “Strategic Entrepreneurs at Work:  The Nature, Discovery, and Exploitation of Entrepreneurial Opportunities.” Small Business Economics 28, no. 4: 301–322. Desrochers, P., and F. Sautet. 2008. “Entrepreneurial Policy:  The Case of Regional Specialization vs. Spontaneous Industrial Diversity.” Entrepreneurship Theory and Practice 32, no. 5: 813–832. Eckhardt, J.  T., and S. A.  Shane. 2003. “Opportunities and Entrepreneurship.” Journal of Management 29, no. 3: 333–349. Estrin, S., J. Korosteleva, and T. Mickiewitz. 2013. “Which Institutions Encourage Entrepreneurial Growth Aspirations?” Journal of Business Venturing 28: 564–580. Gans J., D. Hsu, and S. Stern. 2002. “When Does Start-Up Innovation Spur the Gale of Creative Destruction?” RAND Journal of Economics 33, no. 4: 571–586. Hamilton, B. H. 2000. “Does Entrepreneurship Pay? An Empirical Analysis of the Returns to Self-Employment.” Journal of Political Economy 108, no.3: 604–631. Harper, D. 1998. “Institutional Conditions for Entrepreneurship.” Advances in Austrian Economics 5: 241–275. Harper, D. 2003. Foundations of Entrepreneurship and Economic Development. London and New York: Routledge. Harper, D. 2008. “Towards a Theory of Entrepreneurial Teams.” Journal of Business Venturing 23, no. 6: 613–626. Hayek, F. A. 1952. The Sensory Order. Chicago: University of Chicago Press. Henrekson, M. 2007. Entrepreneurship and Institutions. IFN Working Paper 707. Research Institute of Industrial Economics. Holcombe, R. 2003. “The Origins of Entrepreneurial Opportunities.” Review of Austrian Economics 16: 25–43. Holcombe, R. G. 2007. Entrepreneurship and Economic Progress. London: Routledge. Kirzner, I. M. 1973. Competition and Entrepreneurship. Chicago: University of Chicago Press. Kirzner, I. M. 1979. Perception, Opportunity, and Profit: Studies in the Theory of Entrepreneurship. Chicago: University of Chicago Press. Kirzner, I.  M. 1983. “Entrepreneurs and the Entrepreneurial Function:  A  Commentary.” In Entrepreneurship, edited by J. Ronen, 281–290. Lexington, MA: Lexington Books. Kirzner, I.  M. 1992. The Meaning of Market Process:  Essays in the Development of Modern Austrian Economics. London: Routledge. Kirzner, I.  M. 1999. “Creativity and/or Alertness:  A  Reconsideration of the Schumpeterian Entrepreneur.” Review of Austrian Economics 11: 5–17. Kirzner, I. M. 2009. “The Alert and Creative Entrepreneur: A Clarification.” Small Business Economics 32: 145–152. Kirzner, I., and F. Sautet. 2006. Mercatus Policy Papers. (http://mercatus.org/publication/ nature-and-role-entrepreneurship-markets-implications-policy).

546    Austrian Connections and Extensions Knight, F. 1921. Risk, Uncertainty, and Profit. Boston: Houghton Mifflin. Koellinger, P., M. Minniti, and C. Schade. 2007. “I Think I Can, I Think I Can … : A Study of Entrepreneurial Behavior.” Journal of Economic Psychology 28: 502–527. Koppl, R. 2008. “Computable Entrepreneurship.” Entrepreneurship Theory and Practice 32, no. 5: 919–926. Koppl, R., T. Felin, S. Kauffman, and G. Longo. 2013. Economics for a Creative World. Manuscript. Koppl, R., and M. Minniti. 2010. “Market Processes and Entrepreneurial Studies.” In Handbook of Entrepreneurship Research, 2nd ed., edited by Z. Acs and D. Audretsch. New York: Springer. Lazear, E. P. 2005. “Entrepreneurship.” Journal of Labor Economics 23: 649–680. Machovec, F. 1995. Perfect Competition and the Transformation of Economics. New York: Routledge. McMullen, J., and D. Shepherd. 2006. “Entrepreneurial Action and the Role of Uncertainty in the Theory of the Entrepreneur.” Academy of Management Review 31, no. 1: 132–152. Minniti, M. 2005. “Entrepreneurship and Network Externalities.” Journal of Economic Behavior and Organizations 57, no. 1: 1–27. Minniti, M., and R. Koppl. 1999. “The Unintended Consequence of Entrepreneurship.” Journal des économists et des études humaines 9, no. 4: 567–586. Minniti, M., and M. Levesque. 2010. “Entrepreneurial Types and Economic Growth.” Journal of Business Venturing 25: 305–314. Parker, S.  C. 2008. “The Economics of Formal Business Networks.” Journal of Business Venturing 23, no. 6: 627–640. Parker, S. C. 2009. The Economics of Entrepreneurship. Cambridge: Cambridge University Press. Quadrini, V. 2009. “Entrepreneurship in Macroeconomics.” Annals of Finance 5: 295–311. Sarasvathy, S.  D., N. Dew, S. Velamuri, and S. Venkataraman. 2010. “Three Views of Entrepreneurial Opportunity.” In Handbook of Entrepreneurship Research, 2nd ed., edited by Z. Acs and D. Audretsch, 77–97. New York: Springer. Schmitz, J. A. 1989. “Imitation, Entrepreneurship and Long-Run Growth.” Journal of Political Economy 97: 721–739. Schumpeter, J. A. 1934. The Theory of Economic Development. Oxford: Oxford University Press. Schumpeter, J. A. 1942. “The Process of Creative Destruction” In Capitalism, Socialism, and Democracy, chap. 9. New York: Harper Brothers. Shane, S. 2000. “Prior Knowledge and the Discovery of Entrepreneurial Opportunities.” Organization Science 11, no. 4: 448–469. Shane, S. 2003. A General Theory of Entrepreneurship:  The Individual-Opportunity Nexus. Aldershot, UK: Edward Elgar. Shane, S., and S. Venkataraman. 2000. “The Promise of Entrepreneurship as a Field of Research.” Academy of Management Review 25, no. 1: 217–226. Sobel, R.  S. 2008. “Testing Baumol:  Institutional Quality and the Productivity of Entrepreneurship.” Journal of Business Venturing 23, no. 6: 641–655. Stevenson, H. H., and J. C. Jarillo. 1990. “A Paradigm of Entrepreneurship: Entrepreneurial Management.” Strategic Management Journal 11, no. 4: 17–27. Tripsas, M. 1997. “Unraveling the Process of Creative Destruction: Complementary Assets and Incumbent Survival in the Typesetter Industry.” Strategic Management Journal 18: 119–142. Velupillai, V. 2007. “The Impossibility of an Effective Theory of Policy in a Complex Economy.” In Complexity Hints for Economic Policy, edited by M. Salzano and D. Colander, 273–290. Milan: Springer. Young, A. A. 1928. “Increasing Returns and Economic Progress.” Economic Journal 38: 527–542.

Chapter 24

C ontem p orary Au st ria n E c onomics and t h e New E c onom ic So c i ol o g y Ryan Langrill and Virgil Henry Storr

Introduction Economic sociology, the study of how economic phenomena affect and are affected by social forces, is a field that arguably dates back to classical economists and social thinkers such as Adam Smith. Arguably, however, Émile Durkheim and Max Weber did the most to systematize and outline the field (see Steiner 2010; Swedberg 2010). Durkheim ([1909] 1978), for instance, described economic sociology as the application of the sociological perspective to economic phenomena. Similarly, Weber (1949, 65) has suggested that the field ought to concern itself with pure economic phenomena along with economically relevant phenomena and economically conditioned phenomena. The new economic sociology, which builds on the writings of these earlier thinkers, begins with the observation that all economic action is embedded within a context of ongoing social relations and seeks to trace out the impact of these social structures on economic behavior and outcomes (Swedberg 1997, 165). As Granovetter (1985, 483–484) explains, while neoclassical economics tends to advance an undersocialized conception of economic actors and traditional sociology tends to advance an oversocialized conception of economic actors, the focus on embeddedness avoids presenting economic actors as social eunuchs or social automatons. The new economic sociology also advances the proposition that economic institutions are socially constructed; that is, they are brought into being through the social action of individuals and are given force as a result of the meanings that individuals come to ascribe to them (Swedberg 1997, 165; Granovetter 1992, 7).1 1 

See Swedberg (1997) for a discussion of the development and the key contributions of the new economic sociology. Describing the origins of the field, Swedberg (1997, 162) writes, “New Economic

548    Austrian Connections and Extensions Contemporary Austrian economics and the new economic sociology have much in common. First, they share intellectual forebears. Second, they offer similar critiques of neoclassical economics. Third, they have complementary conceptions of rational action and the role of social institutions in shaping rational action. Because of these similarities, there has been some effort to bring the two traditions together. Swedberg (2003, 111–112), for instance, briefly mentions the Austrian conception of the market as a process to contrast with the hollow neoclassical conception of the market. Several Austrians have sought to link Austrian economics and economic sociology (see, e.g., Liljenberg 2004; Liljenberg 2005; Lewis and Chamlee-Wright 2008). As Boettke and Storr (2002, 164) write, “in the Austrian school of economics and with Mises and Hayek, the recognized heads of that school, in particular, economic sociologists will not only find a scholarly tradition that shares many of the same intellectual forebears but that is a … comfortable bedfellow.”2 Still, more can be done to bring the new economic sociology and contemporary Austrian economics into conversation with each other. This chapter seeks to tease out the connections between the two schools and discuss possible gains from trade between them.

Sociology is a little more than a decade old and has its roots in some works that appeared in the early 1980s. … If one nonetheless were to choose one single year as the birthdate for New Economic Sociology, it would be 1985 since this was the year when the term ‘New Economic Sociology’ was born and also the year when an article appeared that was soon to become the most popular article of all in contemporary economic sociology. This article, which would galvanize quite a few sociologists into action as well as supply them with intellectual legitimation for venturing onto the economist’s turf, was Mark Granovetter’s brilliant ‘Economic Action and Social Structure: The Problem of Embeddedness,’ which appeared in the November 1985 issue of American Journal of Sociology.” According to Swedberg (164), “The basic thrust of Granovetter’s 1985 article, to recall, was to change the focus of the critique of economics from the assumption of rationality to the use of isolated actors. Embeddedness is then introduced as a counterconcept to atomization. … Although most sociologists are familiar with the centrality of the concept of ‘embeddedness’ to New Economic Sociology, few are aware that there also exists a second, equally important master concept. This is ‘the social construction of the economy.’ … The person who has written the most about its use in economic sociology, however, and who also is one of its major advocates, is—again—Mark Granovetter. The idea of the economy as a social construction does not exist in his 1985 article but appears some time later, more precisely in 1986–87. According to Granovetter, the notion of social construction constitutes—together with the idea of embeddedness—one of the ‘two fundamental sociological propositions’ of his work in economic sociology.” 2  There are, of course, key differences. As Mikl-Horke (2008, 214) writes, “Austrian economics uses interpretive methods to reconstruct the subjective situation of actors. New Economic Sociology in contrast pays relatively little attention to interpretive processes; its main focus is on relations and structures, it can give indications as to the location of actors in networks, but does not look closely at the processes directed at achieving mutual awareness of individuals.” And as Boettke and Storr (2002, 164) have written, “it is our further contention that the Austrians have retained much of value from Weber’s Sozialokonomik that modern economic sociology (‘the new sociology of economic life’) has lost and that forging a closer alliance, that is, encouraging a closer reading of Austrian texts by economic sociologists and vice versa would therefore be a useful effort, particularly since the Austrians also have much of value to say about methodology, markets and money—areas where … a ‘sophisticated sociology’ has yet to evolve.”

New Economic Sociology    549

Shared Intellectual Roots There was little distinction in the late nineteenth and early twentieth centuries between economics and sociology.3 Many foundational figures in the new economic sociology conversed with economists, including the founders of Austrian economics. Eugen von Böhm-Bawerk (1949) wrote an in-depth critique of Karl Marx’s economic system upon the publication of the final volume of Capital. Georg Simmel presented an early version of The Philosophy of Money to the Society of Austrian Economists in 1896, which included Carl Menger, Böhm-Bawerk, and Friedrich von Wieser (Frisby 2004b, xv). Menger (1901, 160–161), while critical of Simmel’s grasp of economic theory, believed The Philosophy of Money to be a “quite brilliantly and stimulatingly written work” that was relevant to economics (Frisby 2004a: lii–liii). Most significantly, Weber was an inspiration to key figures within both Austrian economics and economic sociology. Indeed, Weber is still part of the extended present in both the Austrian and economic sociological traditions. Weber lived from 1864 to 1920 and was the preeminent sociologist of his lifetime. He is most famous for one of his early works, The Protestant Ethic and the Spirit of Capitalism, wherein he argues that capitalism can take on a variety of forms, that each form of capitalism is animated by a particular economic spirit, that the spirit of modern capitalism can be described as a this-worldly asceticism, that the particular ethos of modern capitalism and the attitudes toward work that emerge from Protestantism (particularly Puritanism) are (in many respects) identical, and that the spirit of modern capitalism in Western Europe and the United States found a consistent ethical basis in Protestantism (Storr 2006; 2013). Although his treatment of the subject is not without its critics, The Protestant Ethic remains one of the most influential albeit controversial works in economics and sociology. Weber’s Economy and Society (1978), his writings on social science methodology (e.g., Weber [1915] 1946), and his studies of religion in India and China are also quite well known. Weber was committed to methodological individualism, value freedom, and the interpretive dimension of social science (Swedberg 1998).4 Social phenomena, Weber believed, are the result of individual action. The social scientist should, thus, trace his analysis of social outcomes to the individual choices and behavior that led to those social outcomes. Although it is commonplace to talk about “social collectivities, such as states, associations, business corporations, foundations, as if they were individual 3  Durkheim and the positivist tradition in sociology stemming from Auguste Comte are, arguably, exceptions. These scholars often explicitly contrasted their approach to that of political economy or economics. 4  These are, of course, related. As Ringer (1997, 157) explains, “Weber’s methodological individualism . . . grew directly out of his commitment to the interpretive method. Single individuals and their actions are the ‘atoms’ of sociology … because (and to the extent that) they are the objects of interpretation. For other analytical purposes, human beings may be bundles of chemical and psycho-physical processes; but as the performers of actions and holders of beliefs, they cannot be reduced below the level of the integral individual.”

550    Austrian Connections and Extensions persons,” as Weber (1978, 13)  insists, a commitment to methodological individualism means that “in sociological work these collectivities must be treated as solely the resultants and modes of organization of the particular acts of individual persons, since these alone can be treated as agents in a course of subjectively understandable action.” Weber also believed that social scientists should (as much as possible) be value-free. This is not to pretend that a social scientist’s views will not shape the questions that she asks or the approach that she adopts. But instead, a commitment to value freedom is a commitment to doing positive analysis (i.e., explaining social phenomena) rather than normative analysis (i.e., recommending which ends should be pursued). As Weber (1949, 11) writes, the demand for value freedom “is the intrinsically simple demand that the investigator and teacher should keep unconditionally separate the establishment of empirical facts … and his own practical evaluations, i.e., his evaluation of these facts as satisfactory or unsatisfactory. … These two things are logically different and to deal with them as though they were the same represents a confusion of entirely heterogeneous problems.” Additionally, Weber was methodologically committed to Verstehen, that is, interpretive understanding of the meaning of social actions as a key method of the social sciences. The commitment to Verstehen commits the social scientist to focusing on the meanings that individuals (or ideal types) attach to their actions and their circumstances. As Weber (1978, 4) writes, “ ‘meaning’ may be of two kinds. The term may refer first to the actual existing meaning in the given concrete case of a particular actor, or to the average or approximate meaning attributable to a given plurality of actors; or secondly to the theoretically conceived pure type of subjective meaning attributed to the hypothetical actor or actors in a given type of action.” Contemporary Austrian economics and the new economic sociology have been influenced by and share Weber’s methodological commitments to methodological individualism, value freedom, and the interpretive dimension of social science. Weber’s influence within sociology, in general, and the new economic sociology, specifically, is extensive. As Coser (2005, xxv) remarks, “Weber’s impact on modern social science is similar to that of Lord Keynes on modern economics. Like the work of Keynes, the work of Weber is a landmark. There is a pre-Weberian and a post-Weberian sociology.” Similarly, as Kalberg (2005, 1) writes, “of the three major founders of modern sociology, Max Weber spans the widest horizon.” As Käsler (1988, ix) also describes, “Among sociologists, Weber is recognized as one of the principal ‘founding fathers’ of the discipline.” And “Weber has become regarded throughout the world as an undisputed ‘classic’ of sociology. Every lexicon or ‘history’ of this discipline mentions his name as central and emphasizes his authoritative influence on its development” (Käsler 1988, 211). Additionally, as Smelser and Swedberg (2005, 8) wrote, “among the classics in economic sociology Max Weber occupies a unique place. He proceeded furthest toward developing a distinct economic sociology, laying its theoretical foundation and carrying out empirical studies.” Weber, similarly, has been a key figure in the development of the Austrian school. Ludwig von Mises, in both Epistemological Problems of Economics ([1933] 2003)  and

New Economic Sociology    551 Human Action (1949), for instance, devoted considerable attention to the critical examination of Weber’s methodology. Although Mises disagreed with Weber on the role of ideal types and the scope for instrumentally rational action, he agreed with Weber on methodological individualism, value freedom, and Verstehen.5 To be sure, as Lachmann (1951, 413) states in his review of Mises’s Human Action, “in reading this book we must never forget that it is the work of Max Weber that is being carried on here.” Moreover, in The Legacy of Max Weber (1971), Lachmann attempts to reassess the contributions of Weber, including his explicit discussions of ideal types and his (often) implicit discussions of institutions. As Boettke and Storr (2002, 173) write, “Weber and the Austrians have a deep and symbiotic relationship; they share many of the same intellectual forebears and a commitment to the same methodological approach.” Although much less influential than Weber (in both economics and sociology), Alfred Schutz, along with his students Thomas Luckmann and Peter Berger, is an important link between the new economic sociology and contemporary Austrian economics. Like Weber’s, Schutz’s relationship to the Austrian school was an intimate one. He was an active participant in Mises’s seminar. It was Mises who encouraged Schutz to critically engage the work of Weber and to present it to the group. Schutz also presented an early version of the argument that would later become The Phenomenology of the Social World (1967) (Kurrild-Klitgaard 2003, 48). In addition to the close personal ties, Schutz’s research was also deeply influenced by Austrian economics. Indeed, Schutz’s early philosophical and a handful of economic writings can be seen as an effort to provide a strong philosophical grounding for Mises’s approach to the social sciences (Prendergast 1986). Moreover, several Austrian scholars have focused on the similarities between Austrian economics and Schutzian phenomenology and to explore how Austrian economics can benefit from Schutzian insights (see, e.g., Rothbard 1997). Koppl (1997) and Kurrild-Klitgaard (2001), for instance, have critically engaged Schutz’s discussion of ideal types. Similarly, Boettke (1990), Ebeling (1990), Lavoie (1994), and Storr (2010a) have relied on Schutz to support their calls for a more interpretive economics. Storr (2010b) and others have also applied Berger and Luckmann’s (1967) discussion of the social construction of reality to discussions of the spontaneous ordering of the market. Schutz, Berger, and Luckmann have also influenced a number of key thinkers in the new economic sociology (Swedberg 1997, 165). Granovetter (1992, 4), following Berger and Luckmann, argued that “economic institutions (like all institutions) do not arise automatically in some form made inevitable by external circumstances, but are ‘socially constructed.’ ” See also Zelizer (1979; 1985; 1994); McGuire, Granovetter, and Schwartz (1993); Granovetter (1992); Abolafia and Kilduff (1988); and others on the social 5 

As Mises (1949, 42) writes, “it is meaning which the acting individuals and all those who are touched by their action attribute to an action, that determines its character. It is the meaning that marks one action as the action of an individual and another action as the action of the state or of the municipality. The hangman, not the state, executes the criminal. It is the meaning of those concerned that discerns in the hangman’s action an action of the state.”

552    Austrian Connections and Extensions construction of economic institutions and phenomena such as money, speculative bubbles, firms, and industries. Joseph Schumpeter, an Austrian-born economist, is also an important link between the new economic sociology and contemporary Austrian economics. Schumpeter studied in Vienna under Böhm-Bawerk, and he is most famous for his work on entrepreneurship and its “creative destruction.”6 Schumpeter ([1954] 2006, 19) carved out a role for economic sociology next to economics, writing that “economic analysis deals with the questions how people behave at any time and what the economic effects are they produce by so behaving; economic sociology deals with the question of how they came to behave as they do.”7 This study, Schumpeter ([1954] 2006, 518) believed, includes institutions as a primary area of inquiry. Economic action takes place within social institutions, institutions that Schumpeter (518–522) felt economists have taken for granted for various reasons.8 Richard Swedberg (1992), one of the most prominent modern economic sociologists, wrote a biography of Schumpeter and has done much to bring Schumpeter into the conversation of economic sociology.9 Swedberg argues that Schumpeter is one of the most important figures during economic sociology’s history between Weber’s death and Mark Granovetter’s revival of the discipline. According to Swedberg, who drew on the first edition of Schumpeter’s (1934) Theory of Economic Development, Schumpeter’s entrepreneur is sociological in nature. The entrepreneur, to be successful, must persuade other people of the value of his vision; to study entrepreneurship, then, one must study the social relationships of the entrepreneur (Swedberg 2002; 2006). Smelser and Swedberg (2005, 12) also note that Schumpeter wrote “three studies in sociology,” including one on the concept of social classes, one a theory of imperialism, and one a fiscal sociology of the tax state. Contemporary Austrians and economic sociologists share a number of intellectual influences. Weber was perhaps the most important shared influence, but Schutz and Schumpeter are also important links. There is also important theoretical and empirical common ground between the two fields. 6 

Schumpeter’s relationship to the Austrian school is a complicated one (see Simpson 1983). There are, of course, key differences (e.g., the nature of entrepreneurship) and important substantive agreements (e.g., methodological individualism). 7  Schumpeter, you should recall, has advocated the development of an “economic sociology” as a complement to pure economic theory. As Swedberg (1991, 36) explained, “By [economic sociology] … Schumpeter essentially means an analysis of economics as a social phenomenon as opposed to an exclusively economic phenomenon.” 8  Marx, of course, is an exception. Schumpeter ([1954] 2006, 591) also notes that Jean-Baptiste Say and John Stuart Mill discussed that people can change institutions deliberately to counter what they perceive as the defects of existing capitalist institutions. 9  It is the goal of this chapter to help bring economic sociologists into the conversation in Austrian economics and to bring Mises, Friedrich Hayek, Israel Kirzner, Ludwig Lachmann, and currently active Austrians into the conversation of economic sociology. Swedberg (2007, 1052) calls for the development of a Weberian, interpretive economic sociology and cites the hermeneutical economics of Lachmann and Don Lavoie and the Austrian tradition “from Mises to Boettke” as advances in the direction of a Weberian economics.

New Economic Sociology    553

Theoretical and Empirical Common Ground Contemporary Austrian economics and the new economic sociology agree on a number of key theoretical propositions and empirical approaches, including but not limited to the notions that economic institutions are socially constructed and that actors are neither social automatons nor asocial creatures.10

Economic Institutions Are Socially Constructed Both contemporary Austrian economics and the new economic sociology treat economic institutions as socially constructed (Liljenberg 2004). Although neoclassical economics often portrays firms and other economic institutions as emerging automatically as a result of economic factors, as Granovetter (1992, 7) explains, “economic institutions do not emerge automatically in response to economic needs … they are constructed by individuals whose action is both facilitated and constrained by the structure and resources available in social networks in which they are embedded.” Social networks, for Granovetter, play a critical role in the emergence of institutions. And the form of the institutions that come into being has much to do with the nature and structure of the social networks that were utilized to bring them into existence. Zelizer (2011) has similarly discussed how various economic phenomena, including the purpose of life insurance, the social meaning of money, and the value of children, are socially constructed. For instance, as Zelizer (1978) explains, the life insurance industry in the United States was not successful when it was first developed, because in the first half of the nineteenth century, there was an aversion to treating death as a commercial event. By the second half of the nineteenth century, having life insurance also came to characterize what it meant to die a good death. The change in the social meaning attached to having life insurance allowed the industry to flourish. Similarly, in the twentieth century, children came to be viewed as economically “useless” but emotionally “priceless,” and this change in the social construction of children affected child insurance and adoption markets (Zelizer 1981). Austrians have always viewed the economic institutions as social constructions. For Austrians, for instance, the market is a spontaneous order that is the result of human action. Mises (1949, 312) has stated, “The market is a social body; it is the foremost social

10 

Granovetter and Swedberg have pointed to these two propositions as being critical to the new economic sociology. As Migone (2011) demonstrates, there is much similarity between the spontaneous order theorizing of Austrians and the embeddedness of Polanyi and others. See also Mikl-Horke (2008) for an important discussion of theoretical and empirical common ground between Austrian economics and economic sociology.

554    Austrian Connections and Extensions body. The market phenomena are social phenomena. They are the resultant of each individual’s active contribution.” And “the market is a process, actuated by the interplay of the actions of the various individuals cooperating under the division of labor” (258). It is brought about through the interactions of individuals who are both cooperating with one another in the development and distribution of goods and competing against one another for resources and customers. While stressing that the market is socially constructed, Austrians have tended to stress that most of the time, individuals experience the market as anonymous forces that they cannot affect. “Market phenomena,” Mises (1949, 315) writes, “appear to the individual as something given which he himself cannot alter.” And “the market makes people rich or poor, determines who shall run the big plants and who shall scrub the floors, fixes how many people shall work in the copper mines and how many in the symphony orchestras” (49311). Contemporary Austrians have likewise viewed the market as the product of human action and not design. As Ikeda (1994, 24) summarizes, “the ‘market process’ is a spontaneous order sustained by an institutional framework in which private property and free exchange predominate, and which emerges from the largely independent purposes of individual actors who plan in the face of partial ignorance and unanticipated change.” Similarly, as Sautet (2010, 87) describes, “actual markets … are more than … just a space over which people exchange goods and services. The market is a process driven by entrepreneurial discovery.” This process, driven by individuals acting to satisfy their own (not necessarily selfish) goals, leads spontaneously to an order wherein people coordinate their plans. While sharing the view that the market is a spontaneous order that is brought about through the actions of individuals, some contemporary Austrians have challenged the notion that the market is experienced as an anonymous force. As Storr (2010b, 203) suggests, “although the market is a ‘macro-cosmos’ (to borrow Hayek’s terminology), individuals experience it day-to-day as if it were a ‘micro-cosmos.’ We, simply, do not experience the market process as an anonymous force. … The market is not an unknown thing that we are detached from. It is, if you will, up close and personal.” Moreover, as Storr (2008) suggests, the market is a social space where meaningful social bonds can and do develop. As Storr (2008, 141) writes, “we often portray markets as sterile spaces lacking either souls or sounds. We talk about transactions and prices and profits but seldom mention people (except when we refer to the faceless profit maximizing suppliers and hedonistic utility maximizing demanders). Markets, however, are vibrant, colorful social spaces where real relationships and meaningful contacts are developed and nurtured.” And “meaningful conversations … happen in markets; conversations that express more than bid–ask; conversations that are not just bartering and negotiations; conversations between socially bonded market participants concerned with more than simply making a deal. A variety of meaningful social relationships is buttressed by markets and would not exist if markets did not exist” (137). Individuals, thus, experience the market as microcosmos where relationships become overlaid with social content and social friendships develop. Since market relations do not remain strangers, market relationships have the potential to develop into social friendships.

New Economic Sociology    555

Actors Are Neither Social Automatons nor Asocial Atomized Creatures Granovetter (1985) has argued that neoclassical economics often portrays actors as undersocialized, that is, as atomized figures who narrowly pursue their self-interest. As Granovetter (1985, 485) explains, on this approach, any social relations that individuals may have are at most a “frictional drag” that interferes with their treatments of competitive markets. In contrast, Granovetter has suggested that sociologists often portray economic actors as oversocialized. Individuals respond almost automatically to social factors. As Granovetter (486) writes, “these oversocialized conceptions of how society influences individual behavior are rather mechanical: once we know the individual’s social class or labor market sector, everything else in behavior is automatic, since they are so well socialized.” Each of these approaches, Granovetter argues, offers a problematic picture of economic life. On the undersocialized conception, social factors do not play enough of a role, and their key role in shaping, influencing, and affecting economic behavior and outcomes is ignored. On the oversocialized conception, social factors play too much of a role, and individual choice and agency are assumed away rather than employed and engaged. In contrast, he proposes an alternative approach that avoids both polls: “a fruitful analysis of human action requires us to avoid the atomization implicit in the theoretical extremes of under- and oversocialized conceptions. Actors’ … attempts at purposive action are … embedded in concrete, ongoing systems of social relations” (487). These relations perform a number of key functions in the market especially but not limited to the role they play in engendering trust and reducing malfeasance. Granovetter’s article was the seminal piece in the new economic sociology, and several studies have employed and applied the notion of embeddedness.11 Burt (1992), for instance, has suggested that entrepreneurship involves the linking together of distant parts of individuals and that creativity is likely to occur alongside structural holes. Evans (2004), Platteau (2000), and Evans and Rauch (1999) have also focused on the effect of social institutions or norms on economic development.

11 

The concept of embeddedness that originates within economic sociology is concerned with the social embeddedness of economic action. Economic action and actors are embedded in social relationships, especially in premodern society, Polanyi (1957) argues. Echoing Weber, he sees increasing individualism as a function of modernity. Polanyi (1957, 47–51) formulates a taxonomy of social organization that has been influential in economic sociology: the market society, the redistributive society, and the reciprocal society. Reciprocal societies tend to be the smallest; they are kinship-based tribes based on the sexual division of labor, where the man provides for his wife and she in turn provides children, child care, and household management. Redistributive societies are larger, territorial tribes with a chieftain in charge who distributes resources to those in his territory in a more or less communistic manner, in such a way that increases his power over his tribesmen. Finally, the market economy defines any society based on wage labor. These methods of organization are not mutually exclusive; in a market economy, individual households may still be governed reciprocally, and firms contain both reciprocity and redistribution.

556    Austrian Connections and Extensions Additionally, Lie (1992) has discussed how different markets emerge as a result of different kinds of exchange. According to White (1981), the nature of exchange can be distinguished based on whether it is open to popular participation and whether trade is intraregional or interregional. As White explains, the “macrostructural” framework that makes up each society determines what mode of exchange dominates. While societies that are more egalitarian tend toward open modes, societies with a high degree of social stratification will tend toward closed modes. Additionally, national centralization encourages interregional trade, while decentralization encourages intraregional trade. There is also a large literature on the impact of economic activity on social relationships, particularly within workplaces and between competitors. Abbott (1988) studies the division of knowledge and discusses social reasons that certain sectors of knowledge become professions or occupations with distinct cultural and social networks. Additionally, DiMaggio and Powell (1983) argue that, among other things, normative pressures and mimicry lead organizations in the same “organizational fields” to become very similar to one another. DiMaggio (1982) demonstrates this by looking at the transformation of “high culture” throughout late-nineteenth-century Boston. And Biggart and Guillen (1999) look at the development of auto industries in various developing countries and suggest that the historical experience of each of them primed them for different organizational forms. Austrians have long recognized that social factors affect economic activity. Consider, for instance, Mises’s (1949, 46) discussion of the role of inheritance in shaping individual decision-making:  Inheritance and environment … direct a man’s actions. They suggest to him both the ends and the means. He lives not simply as man in abstracto; he lives as a son of his family, his people, and his age; as a citizen of his country; as a member of a definite social group; as a practitioner of a certain vocation; as a follower of definite religious, metaphysical, philosophical, and political ideas; as a partisan in many feuds and controversies. He does not himself create his ideas and standards of value; he borrows them from other people. His ideology is what his environment enjoins upon him.

Notice here that inheritance “directs” but does not “determine” an individual’s actions. His decisions are framed by his ideology, but his ideology is not necessarily fixed. Contemporary Austrians have also (implicitly or explicitly) employed and applied the notion of embeddedness. Boettke (2001) has, for instance, employed the notion (albeit not by name) of embeddedness in his discussions of the challenges of economic transition in the former socialist countries. As he explains, what matters for the functioning of an economic system are the de facto rules governing economic activity. And the de facto rules have as much, if not more, to do with social factors as it has to do with the formal rules. Economic transition, then, is not as simple as changing the rules governing the economy. In the wake of legal changes (e.g., the privatization of the economy), we should expect to see the persistence of informal relationships (e.g., blat in Russia) and practices (e.g., distrust of legal authorities). Boettke, Coyne, and Leeson (2008) similarly

New Economic Sociology    557 argue that interventionist attempts to promote economic development by imposing growth-enhancing institutions will fail to stick if they do not mirror underlying indigenous institutions. Likewise, Chamlee-Wright (1997) has discussed how market women in Ghana leverage the trust engendered by social relationships as they pursue their market activities. Chamlee-Wright and Storr (2009) have similarly discussed how individuals rely on social relationships in the wake of a disaster. As they explain, social networks are an important source of aid, information, and other forms of support as they attempt to recover and rebuild after a hurricane, earthquake, or flood.

Conclusion The new economic sociology and contemporary Austrian economics are largely compatible research programs. They have common roots. Weber exists as a key figure in both disciplines. Weber’s central place within sociology is well known. His relationship to the Austrian school is well documented. As Boettke (1998, 66) wrote, “Weber’s connection to the Austrians was quite close.” And “the relationship between the Austrians and Weber … was a mutually beneficial one in which both learned from the other and influenced the development of their respective work.” Weber read Menger and Böhm-Bawerk’s writings on methodology and favorably cited Mises’s critique of socialism. Similarly, Mises devoted considerable attention to Weber’s writings on social action and ideal types, and his student Schutz critically engaged Weber’s methodological writings. More recently, Austrians have been calling for a reappreciation of Weberian insights (see, e.g., Storr 2013). The new economic sociology and contemporary Austrian economics also have a shared research agenda. Whereas neoclassical economics has traditionally portrayed individuals as if they were isolated figures, both schools have been critical of economics as the economics of Robinson Crusoe. Both schools also recognize that economic phenomena are socially constructed; that is, they are the result of human action. Both schools also recognize that individuals are embedded within the society, polity, and economy. As Boettke and Storr (2002, 166) write, the Austrians “overcomes the pitfalls of positing either an over- or undersocialized view of the individual by maintaining that his or her behavior is affected by, influenced by, even directed by social structures and relations but not determined by them.” And, as Granovetter (1985, 487) explains, “actors do not behave or decide to behave as atoms outside a social context, nor do they adhere slavishly to a script written for them by the particular intersection of social categories that they happen to occupy.” There are, however, several open questions at the intersection of contemporary Austrian economics and the new economic sociology that ought to be explored. First, as hinted above, there is much to be done to challenge what economic sociologist Viviana Zelizer has characterized as the “hostile worlds” view, that is, the notion that there is a sharp divide between the intimate/social sphere and the market sphere. Ironically,

558    Austrian Connections and Extensions Hayek (1988, 18) seems to be emblematic of this hostile worlds view. Recall his warning that “if we apply the unmodified, uncurbed, rules of the micro-cosmos (i.e. of the small band or troop, or of, say families) to the macro-cosmos (our wider civilization) … we would destroy it. Yet if we were to apply the rules of the extended order to or more intimate groupings, we would crush them.” Weber (1978, 636) has similarly described the “market community” as “the most impersonal relationship of practical life into which humans can enter with one another.” Although Hayek and Weber were right to warn us not to confuse our dealings with strangers in, say, the market and our interactions with intimates in the home, as Zelizer (2005) explains, rather than seeing these worlds as separate, individuals should be conceived of as leading connected lives. Individuals do not leave their intimate connections at home when they enter the market, and market transactions do not necessarily corrupt or distort intimate relations. Recall, as Storr (2008) discusses, in addition to being a sphere where competition and exchange occur, the market is also a social space where meaningful social relationships can and do develop. Individuals can and do occupy two worlds at once and, in fact, often erase the supposed boundaries between those two worlds (without corrupting their market or social dealings). Scholars working at the intersection of these traditions should explore the connections between the microcosmos and the macrocosmos both theoretically and empirically. Another fertile field of study at the intersection of the new economic sociology and contemporary Austrian economics is the area of postcrisis recovery. Understanding how countries recover from disastrous economic policies such as communism or how societies recover from man-made disasters such as war or how communities recover from natural disasters such as hurricanes and earthquakes requires an appreciation of the common features of both traditions. Realizing the errors associated with top-down attempts to reconstruct these spheres would also benefit from an appreciation of the notion that institutions are socially embedded and that actors are neither social automatons nor asocial atomized creatures. See, for instance, Boettke (2001), Coyne (2008) and Chamlee-Wright (2010), who explain that the success of commercial and social entrepreneurs in bringing about recovery and the failure of state actors in promoting recovery occur because the knowledge needed for effective transition and recovery is local and contextualized. Both contemporary Austrian economists and economic sociologists should continue to explore this phenomenon. The culture of markets is a third area of study that should be of interest to scholars at the intersection of the new economic sociology and contemporary Austrian economics. Although markets are ubiquitous, they can look very differently in different places even when governed by the same formal institutions. Nee (1998), for instance, has pointed to the role of norms in shaping economic activity. See also Nee’s (1989) research on informal norms and its effect on economic life in China. Storr (2013) has similarly argued that culture can shape economic behavior and colors economic outcomes. And Boettke and Coyne (2009) have argued effectively that context matters in shaping entrepreneurship. There are opportunities to undertake detailed expositions of how particular markets are shaped by informal institutions and culture.

New Economic Sociology    559 Contemporary Austrian economics and the new economic sociology are disciplines with a common intellectual heritage and shared research interests. It is clear, given the potential gains from trade, that they should not remain apart.

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560    Austrian Connections and Extensions DiMaggio, Paul, and Walter W.  Powell. 1983. “The Iron Cage Revisited:  Institutional Isomorphism and Collective Rationality in Organizational Fields.” American Sociological Review 48, no. 2: 147–160. Durkheim, Emile. (1909) 1978. “Sociology and the Social Sciences.” In On Institutional Analysis, edited by M. Traugott, 71–90. Chicago: University of Chicago Press. Ebeling, Richard M. 1990. “What is a price? Explanation and Understanding.” In Economics and Hermeneutics, edited by D. Lavoie, 174–191. London: Routledge. Evans, Peter. 2004. “Development as Institutional Change:  The Pitfalls of Monocropping and Potentials of Deliberations.” Studies in Comparative International Development 38, no. 4: 30–53. Evans, Peter, and James Rauch. 1999. “Bureaucracy and Growth: A Cross-National Analysis of the Effects of ‘Weberian’ State Structures on Economic Growth.” American Sociological Review 64, no. 5: 748–765. Frisby, David. 2004a. “Preface.” In Georg Simmel, The Philosophy of Money, 2nd ed., xlvi–lxxii. London: Routledge. Frisby, David. 2004b. “Preface.” In Georg Simmel, The Philosophy of Money, 3rd ed., xiv–xlv. London: Routledge. Granovetter, Mark. 1985. “Economic Action and Social Structure:  The Problem of Embeddedness.” American Journal of Sociology 91, no. 3: 481–510. Granovetter, Mark. 1992. “Economic Institutions as Social Constructions: A Framework for Analysis.” Acta Sociologica 35, no. 1: 3–11. Hayek, Friedrich. 1988. The Fatal Conceit:  The Errors of Socialism. Chicago:  University of Chicago Press. Ikeda, Sanford. 1994. “Market Process.” In The Elgar Companion to Austrian Economics, edited by P. J. Boettke, 23–32. Northhampton: Edward Elgar. Kalberg, Stephen. 2005. “Introduction–Max Weber: The Confrontation with Modernity.” Max Weber: Readings and Commentary of Modernity. Malden, MA: Blackwell Publishing. Käsler, Dirk. 1988. Max Weber: An Introduction to His Life and Work. (Philippa Hurd, Trans.). Cambridge, UK: Polity Press. (Original work published 1979.) Koppl, Roger. 1997. “Mises and Schutz on Ideal Types.” Cultural Dynamics 9, no. 1: 63–76. Kurrild-Klitgaard, Peter. 2001. “On Rationality, Ideal Types and Economics: Alfred Schutz and the Austrian School.” The Review of Austrian Economics 14, no. 2: 119–143. Kurrild-Klitgaard, Peter. 2003. “The Viennese Connection:  Alfred Schutz and the Austrian School.” The Quarterly Journal of Austrian Economics 6, no. 2: 35–66. Lachmann, Ludwig M. 1951. “The Science of Human Action.” Economica 18, no. 72: 412–427. Lachmann, Ludwig M. 1971. The Legacy of Max Weber. Berkeley, CA: Glendessary Press. Lavoie, Don. 1994. “The Interpretive Turn.” In The Elgar Companion to Austrian Economics, edited by P. J. Boettke, 54–62. Northampton: Edward Elgar. Lewis, Paul, and Emily Chamlee-Wright. 2008. “Social Embeddedness, Social Capital and the Market Process.” Review of Austrian Economics 21, nos. 2–3: 107–118. Lie, John. 1992. “The Concept of Mode of Exchange.” American Sociological Review 57, no. 4: 508–523. Liljenberg, Anders. 2004. “The Infusion of Relational Market Obligations into the Austrian Agenda—Some Lessons Learned from Economic Sociology.” The Review of Austrian Economics 17, no. 1: 115–133. Liljenberg, Anders. 2005. “A Socio-Dynamic Understanding of Markets.” American Journal of Economics and Sociology 64, no. 4: 999–1023.

New Economic Sociology    561 McGuire, Patrick, Mark Granovetter, and Michael Schwartz. 1993. “Thomas Edison and the Social Construction of the Early Electric Industry in America.” In Explorations in Economic Sociology, edited by R. Swedberg, 213–248. New York: Russell Sage. Menger, Carl. 1901. “Simmel, Georg, Philosophie des Geldes.” Literarische Centralblatt 52, no. 4: 160–161. Migone, Andrea. 2011. “Embedded Markets: A Dialogue between F. A. Hayek and Karl Polanyi.” Review of Austrian Economics 24: 355–381. Mikl-Horke, Gertraude. 2008. “Austrian economics and Economic Sociology: Past Relations and Future Possibilities for a Socio-economic Perspective.” Socio-Economic Review 6, no. 2: 201–226. Mises, Ludwig von. (1933) 2003. Epistemological Problems of Economics. Auburn, AL: Ludwig von Mises Institute. Mises, Ludwig von. 1949. Human Action. New Haven: Yale University Press. Nee, Victor. 1989. “A Theory of Market Transition: From Redistribution to Markets in State Socialism.” American Sociological Review 54, no. 5: 663–681. Nee, Victor. 1998. “Norms and Networks in Economic and Organizational Performance.” American Economic Review 87, no. 4: 85–89. Platteau, Jean-Philippe. 2000. Institutions, Social Norms, and Economic Development. London: Routledge. Polanyi, Karl. 1957. “The Economy as Instituted Process.” In Trade and Market in the Early Empires, edited by K. Polanyi, C. M. Arsenberg, and H. W. Pearson, 243–269. New York: The Free Press. Prendergast, Christopher. 1986. “Alfred Schutz and the Austrian School of Economics.” American Journal of Sociology 92, no. 1: 1–26. Ringer, Fritz. 1997. Max Weber’s Methodology:  The Unification of the Cultural and Social Sciences. Cambridge, MA: Harvard University Press. Rothbard, Murray Newton. 1997. The Logic of Action. Cheltenham, UK:  Edward Elgar Publishing. Sautet, Frederic. 2010. “The Competitive Market is a Process of Entrepreneurial Discovery.” In Handbook on Contemporary Austrian Economics, edited by P. J.  Boettke, 87–108. Cheltenham, UK: Edward Elgar Publishing. Schumpeter, Joseph. 1934. The Theory of Economic Development. Cambridge, MA: Harvard University Press. Schumpeter, Joseph. (1954) 2006. History of Economic Analysis. New York: Taylor & Francis. Schutz, Alfred. 1967. The Phenomenology of the Social World. Evanston, IL:  Northwestern University Press. Simpson, David. 1983. “Joseph Schumpeter and the Austrian School of Economics.” Journal of Economic Studies 10, no. 4: 18–28. Smelser, Neil J., and Richard Swedberg. 2005. “Introducing Economic Sociology.” In The Handbook of Economic Sociology, edited by Richard Swedberg, 3–25. Princeton, NJ: Princeton University Press. Steiner, Philippe. 2010. Durkheim and the Birth of Economic Sociology. Princeton, NJ: Princeton University Press. Storr, Virgil Henry. 2006. “Weber’s Spirit of Capitalism and the Bahamas’ Junkanoo Ethic.” The Review of Austrian Economics 19, no. 4: 289–309. Storr, Virgil Henry. 2008. “The Market as a Social Space: On the Meaningful Extraeconomic Conversations That Can Occur in Markets.” Review of Austrian Economics 21, nos. 2–3: 135–150.

562    Austrian Connections and Extensions Storr, Virgil Henry. 2010a. “Schutz on Meaning and Culture.” Review of Austrian Economics 23, no. 2: 147–163. Storr, Virgil Henry. 2010b. “The Social Construction of the Market.” Society 47, no. 3: 200–206. Storr, Virgil Henry. 2013. Understanding the Culture of Markets. London: Routledge. Swedberg, Richard. 1991. “Major Traditions of Economic Sociology.” Annual Review of Sociology 17, 251–276. Swedberg, Richard. 1992. Schumpeter: A Biography. Princeton, NJ: Princeton University Press. Swedberg, Richard. 1997. “New Economic Sociology: What Has Been Accomplished, What is Ahead?” Acta Sociologica 40, no. 2: 161–182. Swedberg, Richard. 1998. Max Weber and the Idea of Economic Sociology. Princeton, NJ: Princeton University Press. Swedberg, Richard. 2002. “The Economic Sociology of Capitalism: Weber and Schumpeter.” Journal of Classical Sociology 2, no. 3: 227–255. Swedberg, Richard. 2003. Principles of Economic Sociology. Princeton, NJ:  Princeton University Press. Swedberg, Richard. 2006. “Social Entrepreneurship:  The View of a Young Schumpeter.” In Entrepreneurship as Social Change: A Third Movement in Entrepreneurship, edited by Chris Steyaert and Daniel Hjorth, 21–34. Northampton, MA: Edward Elgar. Swedberg, Richard. 2007. “Max Weber’s Interpretive Economic Sociology.” American Behavioral Scientist 50, no. 8: 1035–1055. Swedberg, Richard. 2010. “Thinking and Sociology.” Journal of Classical Sociology 11, no. 1: 1–19. Weber, Max. (1905) 1998. The Protestant Ethic and the Spirit of Capitalism. Los Angeles, CA: Roxbury Pub. Weber, Max. (1915) 1946. “The Social Psychology of World Religions.” In From Max Weber, edited by Hans Gerth and C. Wright Mills, 267–301. New York: Oxford University Press. Weber, Max. 1949. The Methodology of the Social Sciences. Glencoe, IL: Free Press. Weber, Max. 1978. Economy and Society. New York: Bedminster Press. White, Harrison C. 1981. “Where Do Markets Come From?” American Journal of Sociology 87, no. 3: 517–547. Zelizer, Viviana A. 1978. “Human Values and the Market: The Case of Life Insurance and Death in 19th Century America.” American Journal of Sociology 84, no. 3: 591–610. Zelizer, Viviana A. 1979. Morals and Markets: The Development of Life Insurance in the United States. New York: Columbia University Press. Zelizer, Viviana A. 1981. “The Price and Value of Children: The Case of Children’s Insurance in the United States.” American Journal of Sociology 86: 1036–1056. Zelizer, Viviana A. 1985. Pricing the Priceless Child:  The Changing Social Value of Children. New York: Basic Books. Zelizer, Viviana A. 1994. The Social Meaning of Money. New York: Basic Books. Zelizer, Viviana A. 2005. The Purchase of Intimacy. Princeton, NJ: Princeton University Press. Zelizer, Viviana A. 2011. Economic Lives:  How Culture Shapes the Economy. Princeton, NJ: Princeton University Press.

Chapter 25

The Au stria n T h e ory of Fina nc e Is It a Unique Contribution to the Field? Gregory M. Dempster

Introduction The rich intellectual history of the Austrian school has provided contributions to modern economics on a number of fronts, most notably in the areas of knowledge and information, entrepreneurship, rationality and expectations, business cycles, economic method, price theory, and the theory of the firm. Although many of these contributions have been absorbed into mainline (if not mainstream) economic thought, there is a significant sense in which they can be identified as distinctly Austrian on the basis of their underlying premises concerning the subjectivity of means and preferences, bounded rationality in expectations and decision-making, institutions, and evolutionary mechanisms of selection and learning. Applications of Austrian economic thought can also be found in business fields such as finance, accounting, strategy, and business organization. It is not entirely clear, however, whether these contributions represent unique perspectives within those fields or merely amendments of existing paradigms based on critiques from an Austrian viewpoint. In other words, is the Austrian contribution to the business disciplines a purely negative one in the sense of being confined to critique rather than a progressive one from which solid policy prescriptions and managerial actions can be derived? This chapter represents an attempt to answer that question for the business fields concerned with the theory and practice of finance. I deliberately employ the plural based on the argument developed in this chapter that, in fact, the ability of the Austrian approach to integrate various problems in finance with Austrian-influenced research on entrepreneurship, strategy, accounting, and business organization (among, perhaps, other business disciplines) represents its unique contribution. The Austrian approach to finance

564    Austrian Connections and Extensions is unique not only in its critique of certain neoclassical foundations of modern finance but also in its perspective on the interrelationships between finance and other business fields. This constitutes a progressive contribution that can be described as the Austrian theory of finance and that is based in the same unique principles by which we distinguish Austrian economic contributions from both its mainstream and heterodox counterparts. Most important, the seminal research efforts that constitute the field to date already provide an outline of what this theoretical framework entails and point toward future efforts that will continue to define it as a distinct contribution. The remainder of this chapter is organized as follows. First, I attempt to categorize the existing Austrian financial literature using the terminology of modern financial subfields: corporate finance, investments and portfolio theory, financial markets and institutions, international finance, and corporate governance. I discuss the connections and commonalities between these research efforts and how they form the basis for the development of a unique theoretical framework. Next, I discuss Austrian-influenced developments in other business fields and their connection to the problems of finance. Finally, I attempt to outline a comprehensive Austrian theory of finance that incorporates these varied contributions and to draw implications for the direction of theoretical development.

Austrian Contributions to Finance Research Dempster (2011) outlines both the historical evolution of financial theory within the Austrian research program and the recent developments that have guided this evolution toward a more unified theoretical framework. Recent extensions focus on a number of themes that are linked to the underlying premises of subjectivism, choice under uncertainty, expectations formation within bounded rationality, and the evolution of social institutions. Among these themes are the models of big players (Butos and Koppl 1993; Koppl and Yeager 1996; Ahmed et al. 1997; Koppl 2002), asset-price-driven economic volatility (Garrison 1996; Cowen 1997; Mueller 2001; Callahan and Garrison 2003; Bagus 2008; Howden 2010; Prychitko 2010), and market-coordinated monetary organization (Selgin and White 1987; 1994; 1996; 2005; Selgin 1988; 1994; 1997) that have come to virtually define the modern Austrian approach to banking and financial markets. These themes primarily fall into the area of finance classified as financial markets and institutions, and the corresponding number of Austrian-influenced contributions to this area is large.1 However, in addition to the substantial mark made in this area, 1  See also Skousen (1994); Benink and Bossaerts (2001); Carilli and Dempster (2001); Carilli, Dempster, and Rohan (2004); Bagus and Howden (2009); Coyne, Dempster, and Isaacs (2010); Dempster and Isaacs (2011); Zingales (2011).

The Austrian Theory of Finance    565 Austrian researchers have also made important, if less numerous, contributions to other areas such as corporate finance, portfolio theory, international finance, and corporate governance. In the area of corporate finance, for example, Cwik (2008) draws from Machlup (1935) to show how the differential impacts of interest-rate fluctuations on working and fixed capital have implications for the propagation of business cycles. Carilli and Dempster (2003) follow a similar line of reasoning to demonstrate the impact of uncertainty on cost of capital models, such as the capital asset pricing model (CAPM), under situations of financial asset-price inflation (bubbles). In portfolio theory and investments, Skousen (1994) has been particularly active in promoting Austrian concepts, although primarily as a practitioner and writer in the popular press. Koppl and Yeager (1996) produced one of the first applications of the big players model in the context of international financial (currency) markets, and Padilla (2002) shows that insider trading rules have profound implications for agency theory and other issues related to corporate governance. Even with these numerous contributions, however, it may be unclear whether Austrian thought has provided a significant positive contribution to the field of finance, much less a unified framework that one could classify as a theory of finance. Following Sutherland (1975, 9), I define a theory as an “ordered set of assertions about a generic behavior or structure assumed to hold throughout a significantly broad range of specific instances.” Key to this definition are the dual concepts of (1) unified propositions that must relate in some way to each other and (2) general behaviors or structures that define a recognizable domain in which the theory is applicable. Thus, a theory is not merely a set of one or more empirical propositions; it must be unified in such a way as to constitute an explanation of an entire set of generic phenomena. The building blocks of good theory are already well discussed in the literature, and I will not outline those here. Rather, the purpose here is to answer the questions of whether Austrian contributions to finance are, in fact, unified in such a way as to constitute a theory in the sense described above and also to describe what this supposed order might entail. Whetten (1989) describes a legitimate theoretical contribution as one that bears significantly on questions of what, how, why, when, and where a theory relates phenomena to one another. Generally, the what and how questions describe the relationships within a theory, the why questions provide potential explanations for those relationships, and the when and where questions describe the constraints on the domain of the theory. Thus, we examine here the extent to which the Austrian theory of finance not only describes relationships among phenomena and provides explanations for those relationships but also delineates the parameters within which particular relationships do and do not occur. It is this last aspect of theory that bears directly on the nature of finance as a field of inquiry within the broader disciplines of economics and management. An exposition of the role of finance within the Austrian economic framework as applied to entrepreneurship, strategy, corporate governance, and business organization is necessary for a proper understanding of what makes the Austrian approach to finance distinct from alternative approaches.

566    Austrian Connections and Extensions

The Role of Finance in the Austrian Framework Finance addresses the ways in which individuals and organizations raise, allocate, and employ monetary resources over time, taking into account the risks and other opportunity costs associated with funding future consumption out of current savings. It involves both the methods of monetary management and the intertemporal accounting necessary to translate plans for future consumption into present actions. Mises ([1949] 1998, 306–307) underscored the important role of rational financial organization for allocation within a capitalist economic system: The illusion that management is the totality of entrepreneurial activities … disregards entirely the role that the capital and money market, the stock and bond exchange, which a pertinent idiom simply calls the “market,” plays in the direction of corporate business. … In fact, the changes in the prices of common and preferred stock and of corporate bonds are the means applied by the capitalists for the supreme control of the flow of capital. The price structure as determined by the speculations on the capital and money markets and on the big commodity exchanges not only decides how much capital is available for the conduct of each corporation’s business; it creates a state of affairs to which the managers must adjust their operations in detail.

Thus, the role of finance is fundamental in organizing market activity toward the end of matching resources with their most valuable employments. As pointed out by Klein (1999, 19), financial markets provide the means by which “owners of financial capital decide which firms, and which industries, receive resources to make consumer goods,” thus directing current resources on the basis of anticipated risk-adjusted returns to employing those resources for production. Klein suggests that Austrian theory actually recognizes two entrepreneurial perspectives, one of uncertainty-bearing (entrepreneur promoters) and another of ownership (capitalist entrepreneurs) and that the second aspect is distinct in its consideration of money capital as a factor of production, along with real capital, resources, and labor. From this perspective, the “driving force behind the market economy is a particular type of entrepreneur, the capitalist-entrepreneur, who risks his money capital in anticipation of future, uncertain, returns” (21). Within the Austrian framework, therefore, the problems of finance are intimately connected to those of entrepreneurship; indeed, the entrepreneurial problem of what to produce and the financial problem of how to allocate resources are two sides of the same proverbial coin. One of the important questions that emerge from this relationship is how, and to what extent, the financial system provides accurate, timely, and relevant information underlying allocation decisions. In other words, under what conditions will entrepreneur promoters make decisions about allocating real resources, predicated on the procurement

The Austrian Theory of Finance    567 of financial resources from capitalist entrepreneurs, that best match the opportunity costs of those resources to future demands for consumption? Austrian contributions to the business fields have sought to deal explicitly with these conditions, and these contributions tie back to the main themes outlined in Austrian financial literature. Klein (1999) constructs an entrepreneurial theory of the corporation and its governance on the basis of Rothbard’s ([1962] 1993) extension of Mises’s ([1949] 1998) work on economic calculation. Although originally derived as an argument in the socialist calculation debate, the concept of economic calculation is really about the informational aspect of capital markets, that is, the recognition that entrepreneurs “allocate resources based on their expectations about future prices, and the information contained in present prices,” so that “efficient resource allocation in a market economy requires well-functioning asset markets” (Klein 1999, 27). Decision-making about capital allocation, rather than resting directly with firms’ managers—as it does in the traditional production-function approach to the firm—instead rests squarely with the owners of capital, who make their preferences known through the discipline of the market process. Agency issues bear directly on the efficiency of capital market discipline, and mainstream economists have explored in detail the methods of internal monitoring and sanction available to the owners.2 Austrian theory suggests, however, that external market mechanisms may be more important to the smooth functioning of the allocation system. Mises ([1949] 1998)  distinguishes between bureaucratic (internal) and profit (external) management, suggesting that although the day-to-day operations of the firm might be subject mostly to managerial discretion and internal controls, the long-term asset-allocation decisions of modern corporations are subject mostly to decisions of owners expressed in capital markets (Klein 1999, 31). Therefore, any impediment to the functioning of capital markets is an impediment to efficient resource allocation. It is here that the various elements of Austrian research in the business fields come together with Austrian financial theory to form a unified approach. Austrian-influenced researchers have identified a number of factors that appear to have systematic effects on the ability of capital markets to function properly. Insider trading rules and other financial regulations often either impede the flow of relevant information that allows traders to make judgments and forecasts that are as accurate as possible, or they disrupt the process of learning, adjustment, and market discipline that improves outcomes over time (Kroszner 1994; Padilla 2002; Manne 2011). Bankruptcy law, “too big to fail” policies, and other aspects of creditor relations can disrupt the ability of financial systems to efficiently liquidate assets that are dedicated to failing enterprises or mired in declining industries, causing liquidation episodes to turn into widespread crises (Moss 2000; White 2009). The expanding regulatory burden of federal laws such as Dodd-Frank and the ever-growing regulatory reach of the Federal Reserve could have severe unintended consequences that leave the US financial system

2 

See, e.g., Jensen and Meckling (1976) and Fama (1980).

568    Austrian Connections and Extensions even more prone to systematic crisis than before (Peirce and Broughel 2012; Peirce and Greene 2013). Austrian thought has made other important contributions to strategy, accounting, and business organization based on its well-developed conceptions of economic calculation, judgment under uncertainty, and disequilibrium rents. In fact, it is now possible to talk of a unique Austrian theory of the firm based on these fundamental concepts (see, e.g., Foss 1993; 1994; 1997; Lewin and Phelan 1999; Lewin and Phelan 2000; Dulbecco and Garrouste 1999; Langlois 2013; Holcombe 2013). Researchers have employed this perspective to examine Austrian implications for business strategy (Jacobson 1992; Grant 1996), accounting practice (Taylor 2000), and the organization of firms (Klein 1996; 1999; 2010). Agarwal et al. (2009) extended this line of research to examine its implications for financial crisis under the conditions of capital heterogeneity posited in both Austrian and resource-based views of business strategy. In particular, they note the importance of understanding the micro-level lending decisions and associated deterioration of credit underwriting standards in the recent US financial crisis, suggesting that the assumption of capital homogeneity during a period of rapid credit expansion led to systematic policy errors on the part of firms, regulators, and credit-rating agencies. In other words, those policies failed to recognize that, as mentioned earlier in this chapter, the primary purpose of capital markets is to allocate credit on the basis of judgments by individuals and firms, not to determine its aggregate level. Policies that are aimed primarily at the latter, such as unified lending standards and relief packages aimed at addressing system-wide liquidity issues, are likely to fall under the category of impediments to rational resource allocation.

The Austrian Theory of Finance: An Outline The basic principles of an Austrian theory of finance are thus (1) recognition of the entrepreneur capitalist as the primary director of resources toward their most valued ends and (2) the associated role of business enterprises in providing a menu of options by exploring ways in which heterogeneous resources (capital) can be employed for a variety of potential and actual goods and services. As corollaries, two additional elements that arise directly from Austrian theorizing about principles (1) and (2) involve the impacts of (3) legal, social, and political institutions and (4) the actions of big players in financial markets on the processes that translate the decisions of entrepreneur capitalists into business investment decisions concerning the production of goods and services. These four principles make up a set of ordered propositions that unify the various elements of Austrian theorizing into a coherent framework. Key to this framework is a comparative institutional perspective, one that compares the expected

The Austrian Theory of Finance    569 outcomes of financial decision-making under realistic, alternative sets of policy prescriptions, as opposed to unrealistic comparisons with theoretical ideals such as perfect competition. Figure 25.1 provides a representation of this framework using an adaptation of the standard financial flows diagram often found in introductory finance texts. In this version, the saver lenders (surplus-spending units, or SSUs) are explicitly recognized as entrepreneur capitalists, who take on the risks of expending current resources for future production returns by directing capital through the financial markets to business enterprises (deficit-spending units, or DSUs). The latter are entrepreneur promoters who ultimately transform money capital into fixed and working capital for the production of goods and services. The returns to these business capitalists, and ultimately to the financial capitalists who fund them, are determined primarily by the expression of consumer preference in the marketplace for goods and services. However, a number of different institutional and extramarket factors can influence those returns, thereby changing the pattern of business and financial investment based on incentive modifications introduced by extramarket influences. Among the extramarket influences identified and explored by Austrian theorists are big players who affect the process of savings and investment both directly, by acting as surplus or deficit spenders while nonetheless remaining apart from the discipline or profit and loss imposed in financial markets, and indirectly, through manipulation of the legal, social, and political institutions that govern exchange in those markets. A central bank, for example, is a classic example of a big player, in that it provides funds (savings) to financial markets without being subject to the postponement of consumption and risks required of entrepreneur capitalists. Likewise, governments often act as deficit spenders and thus affect levels of business investment and interest rates and also the direction of efforts by entrepreneur promoters in allocating real resources toward future consumption capabilities. The theory of regulatory capture (Levine and Forrence 1990; Laffont and Tirole 1991) provides a good example of the indirect influence of big players on the financial

SSUs

Financial Markets

Legal, Social, and Political Institutions

Impacts from Actions of “Big Players”

Figure 25.1  Financial flow of funds from an Austrian perspective.

DSUs

570    Austrian Connections and Extensions landscape. Central banking, particularly in its dual role as lender of last resort and guarantor of financial stability, also indirectly influences financial markets through institutional channels, by incentivizing behavior on the part of market participants that is different from that solely guided by profit and loss. Of course, it is important to note that not all institutional influences stem from big players, nor are all such influences necessarily impediments to effective coordination in financial markets. Examples of market-augmenting institutional developments abound in the Austrian literature (see, e.g., Stringham 2003; Skarbek 2009). The key finding of these studies is that institutions evolve differently in the presence of big players (such as under government regulation) from how they evolve under the market discipline of profit and loss and that these differences in institutional development have profound consequences for the function and performance of financial markets. Thus, it is often vital to understand the institutional history of financial market development and the historically embedded ways of interacting among market participants, in order to properly ascertain the causes of instability in those markets. Likewise, institutions that develop within the context of market exchange, rather than under the influence of governments and other big players, do sometimes hinder stability and coordination. As pointed out by Taleb (2010) and others, market institutions can evolve in ways that end up being destabilizing in certain circumstances, and any assumption to the contrary is every bit as naive as the “public interest” and “perfect information” assumptions of government intervention. As an example, consider the widespread use of statistical models such as value at risk (VaR) prior to the 2007–2008 economic crash. VaR models assign a dollar value of risk exposure to the firm based on the statistical probability of the entire range of possible positive and negative future outcomes. Of course, this requires accurate information about the probabilities not only of the most likely outcomes that can be imagined but also of very improbable events. In other words, it requires detailed knowledge about the form of the probability distributions that supposedly govern future outcomes. Research on decision-making suggests that human beings are notoriously poor at assigning accurate likelihoods to rare events, especially negative ones, as a result of representativeness and small sample effects (see, e.g., Barron and Erev 2003; Hertwig et al. 2004). Nonetheless, large companies relied heavily on the predictions made by these models—particularly the losses predicted by them—in making investment decisions near the height of the boom, even as evidence of financial instability (and disconfirming of the predictions themselves) began to emerge. More generally, the institutions of exchange in financial markets, much like those in any other market, evolve on the basis of relative costs and benefits in use among heterogeneous actors employing disparate sources of widely dispersed information. This variation in actors, abilities, and sources of information culminates in a selection process for institutions of exchange that is akin to that of selection for genetic traits among biological species. Just as in biological evolution, however, the traits (in this case, decision rules, measurement techniques, and the like) that evolve within one set of conditions may not be ideal, or even beneficial, in other environments.

The Austrian Theory of Finance    571 In particular, there is the danger that if everyone is using the same decision rules, measurement techniques, and informational proxies, there is an institutional source of contagion in financial markets under scenarios where those institutions are noncoordinative. In addition to VaR and other statistical models, this type of contagion has been suggested for the use of accounting techniques (marked-to-market), options-pricing models (Black-Scholes), asset-pricing models, valuation methodologies, technical trading rules, and many other institutions of exchange in financial markets. Regarding the practice of financial management, the Austrian approach emphasizes the inherent uncertainty under which intertemporal decision-making takes place, the embeddedness of social and institutional norms that develop to moderate that uncertainty, the subjectivism of goals and of the means by which agents pursue their goals, and the new spontaneous orders that evolve from repeated exchange and mutual adjustment under these conditions. Thus, just as an Austrian view of business strategy would do (Jacobson 1992), the Austrian theory of finance suggests a focus on disequilibrium, evolution, and change (Dempster 2011). The introduction of new policies and institutions, new players, new products, new financial technologies, and even new ideas and ideologies has a profound impact on practitioners’ attempts to estimate and measure things such as risk exposure, cost of capital, and fundamental value. An Austrian research agenda in financial management will presumably seek to illuminate the processes by which financial orders emerge, are disrupted, and evolve into new forms on the basis of these sorts of factors, without reliance on folk theorems that assign positive or negative values to financial developments outside the context of comparative institutional analysis. Finally, important new work is advancing our understanding of the relationship among institutions, big players, and the nature of financial instability. Mulligan (2013a; 2013b) has provided detailed empirical examinations of the relationship between central-bank-led monetary expansion, as posited by Austrian business cycle theory, and cycles of financial instability as conceived of by Minsky (1982; 1986; 1992). This work builds on the insights of Prychitko (2010) and others linking Minsky’s financial instability hypothesis to behaviors that are incentivized by the impacts of big players (central banks) on financial markets. The key insight here is, again, that the behavior of financial market participants does not evolve over time in a vacuum but is a somewhat predictable (ordered) consequence of institutional constructs and the impacts of big players through those constructs. Thus, Minsky’s view of endogenous cycles in financial activity is transformed into one in which the realities of institutional embeddedness and their consequences are realized and examined.3 3 

This view of social and institutional embeddedness in economic activity is best described in the words of Granovetter (1985, 487): “Actors do not behave or decide as atoms outside a social context, nor do they adhere slavishly to a script written for them by the particular intersection of social categories that they happen to occupy. Their attempts at purposive action are instead embedded in concrete, ongoing systems of social relations.”

572    Austrian Connections and Extensions

Conclusion This chapter has advanced the case for a unique Austrian theory of finance. Beginning from a discussion of what constitutes a unique theoretical contribution and an overview of existing Austrian contributions to the areas of financial markets and institutions, corporate finance, international finance, and corporate governance, I have defined the role of finance within the Austrian framework of economic analysis and shown how that role has been utilized in the Austrian literature on entrepreneurship, strategy, governance, and the theory of the firm. From this foundation, I outlined the basic elements of the Austrian approach to financial theory and practice, one that provides a unique perspective on the role of finance in economic coordination and the various catalysts and impediments to economic coordination that spring from a careful consideration of the impacts of institutions and big players in financial markets. This unique perspective on the coordinative aspects of financial markets is what makes the Austrian approach rich and productive and constitutes a significant contribution to the field of finance that researchers can build on in future efforts.

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574    Austrian Connections and Extensions Laffont, J., and J. Tirole. 1991. “The Politics of Government Decision Making:  A  Theory of Regulatory Capture.” Quarterly Journal of Economics 106, no. 4: 1089–1127. Langlois, R. 2013. “The Austrian Theory of the Firm:  Retrospect and Prospect.” Review of Austrian Economics 26, no. 3: 247–258. Levine, M., and J. Forrence. 1990. “Regulatory Capture, Public Interest, and the Public Agenda: Toward a Synthesis.” Journal of Law, Economics and Organization 6: 167–198. Lewin, P., and S. Phelan. 1999. “Firms, Strategies and Resources: Contributions from Austrian Economics.” Quarterly Journal of Austrian Economics 2, no. 2: 3–18. Lewin, P., and S. Phelan. 2000. “An Austrian Theory of the Firm.” Review of Austrian Economics 13, no. 3: 59–79. Machlup, F. 1935. “The Rate of Interest as Cost Factor and as Capitalization Factor.” American Economic Review 25, no. 3: 459–465. Manne, H. 2011. “Entrepreneurship, Compensation, and the Corporation.” Quarterly Journal of Austrian Economics 14, no. 1: 3–24. Minsky, H.  P. 1982. “The Financial-Instability Hypothesis:  Capitalist Processes and the Behaviour of the Economy.” In Financial Crises, edited by C. P.  Kindleberger and J. P. Laffargue, 13–39. Cambridge: Cambridge University Press. Minsky, H. P. 1986. Stabilizing an Unstable Economy. New Haven, CT: Yale University Press. Minsky, H.  P. 1992. The Financial Instability Hypothesis. Jerome Levy Economics Institute Working Paper 74. http://ssrn.com/abstract=161024. Mises, L. von. (1949) 1998. Human Action. Auburn, AL: Ludwig von Mises Institute. Moss, L. 2000. “Bankruptcy Reform in Russia: The Case for Creditor Rights in Russia.” Review of Austrian Economics 13: 121–146. Mueller, A. 2001. “Financial Cycles, Business Activity, and the Stock Market.” Quarterly Journal of Austrian Economics 4: 3–21. Mulligan, R.  F. 2013a. “New Evidence on the Structure of Production:  Real and Austrian Business Cycle Theory in Light of Minsky’s Financial Instability Hypothesis.” Journal of Economic Behavior and Organization 89: 67–77. Mulligan, R. F. 2013b. “A Sectoral Analysis of the Financial Instability Hypothesis.” Quarterly Review of Economics and Finance 53, no. 4: 450–459. Padilla, Alexandre. 2002. “Can Agency Theory Justify the Regulation of Insider Trading?” Quarterly Journal of Austrian Economics 5: 3–38. Peirce, H., and J. Broughel, eds. 2012. Dodd-Frank: What It Does and Why It’s Flawed. Arlington, VA: Mercatus Center, George Mason University. Peirce, H., and R. Green. 2013. “The Federal Reserve’s Expanding Regulatory Umbrella.” In Mercatus Policy Brief (April). Arlington, VA: George Mason University. Prychitko, David. 2010. “Competing Explanations of the Minsky Moment:  The Financial Instability Hypothesis in Light of Austrian Theory.” Review of Austrian Economics 23: 199–221. Rothbard, Murray. (1962) 1993. Man, Economy, and State. Auburn, AL:  Ludwig von Mises Institute. Selgin, G. 1988. The Theory of Free Banking. Totowa, NJ: Rowman & Littlefield. Selgin, G. 1994. “Free Banking and Monetary Control.” Economic Journal of the Royal Economic Society 104, no. 427: 1449–1459. Selgin, G. 1997. Less Than Zero:  The Case for a Falling Price Level in a Growing Economy. London: Institute of Economic Affairs.

The Austrian Theory of Finance    575 Selgin, G., and L. White. 1987. “The Evaluation of a Free Banking System.” Economic Inquiry 25, no. 3: 439–457. Selgin, G., and L. White. 1994. “How Would the Invisible Hand Handle Money?” Journal of Economic Literature 32: 1718–1749. Selgin, G., and L. White. 1996. “In Defense of Fiduciary Media—or, We Are Not Devo(lutionists), We Are Misesians!” Review of Austrian Economics 9: 83–107. Selgin, G., and L. White. 2005. “Credible Currency:  A  Constitutional Perspective.” Constitutional Political Economy 16: 71–83. Skarbek, D. 2009. “Alertness, Local Knowledge, and Johnny Appleseed.” Review of Austrian Economics 22, no. 4: 415–424. Skousen, M. 1994. “Financial Economics.” In Elgar Companion to Austrian Economics, edited by Peter J. Boettke, 231–243. Brookfield, VT: Edward Elgar. Stringham, E. 2003. “The Extralegal Development of Securities Trading in Seventeenth-Century Amsterdam.” Quarterly Review of Economics and Finance 43, no. 2: 321–344. Sutherland, J. 1975. Systems:  Analysis, Administration, and Architecture. New  York:  Van Nostrand. Taleb, N. 2010. The Black Swan:  The Impact of the Highly Improbable, 2nd ed. New  York: Random House. Taylor, T. C. 2000. “Current Developments in Cost Accounting and the Dynamics of Economic Calculation.” Quarterly Journal of Austrian Economics 3, no. 2: 3–19. Whetten, D. A. 1989. “What Constitutes a Theoretical Contribution?” Academy of Management Review 14, no. 4: 490–495. White, W. 2009. “Modern Macroeconomics Is on the Wrong Track.” Finance and Development (December): 15–18. Zingales, L. 2011. “The Role of Trust in the 2008 Financial Crisis.” Review of Austrian Economics 24, no. 3: 235–249.

Chapter 26

Austrian E c onomi c s and the Evolu t i ona ry Paradi g m Ulrich Witt and Naomi Beck

Introduction The question of the relationship between Austrian economics and evolutionary theory is a rather complex one, primarily because the label Austrian economics does not refer to a homogeneous body of thought. The geographical attribute in the school’s name is misleading since an Austrian school as such no longer exists. Its active branch resides today mainly in the United States and is therefore sometimes referred to as the Austro-American school of economics (see Boettke 1994). However, with respect to the three economists whose “evolutionism” we will discuss here—Carl Menger, Joseph Schumpeter and Friedrich Hayek—the geographic criterion is relevant and historically accurate. The thinking of all three bears the mark of the intellectual environment of the Austro-Hungarian empire, in particular that of Vienna before and after World War I. Furthermore, despite considerable differences among their views, Menger, Schumpeter, and Hayek share what are deemed to be core elements of Austrian economics: a preference for methodological individualism, a skeptical attitude toward static equilibrium economics, and the focus on the role of entrepreneurship and free markets in advancing the economy. The theories proposed by these three thinkers constitute the lion’s share of evolutionary thought in economics up to the present time (leaving aside evolutionary game theory; see Witt 2008b). And the breadth of the topics and phenomena they cover testifies to the great variety of interpretations and potential uses of evolutionary concepts in economics. Indeed, each adopted an idiosyncratic position in terms of method, focus, and general message. Menger, who made no explicit reference to the Darwinian theory of natural selection, advanced an “organic” view of the emergence of social institutions.

The Evolutionary Paradigm    577 Schumpeter overtly rejected the application of the theory of natural selection in economics, which, at the time, was negatively associated with nineteenth-century “social Darwinism.” Instead, he elaborated a theory of industrial development based on the recurrent emergence and dissemination of innovations (note that in German, the same word is used for evolution and development). With Hayek, the evolutionary worldview received prominent expression. Inspired by the biological notion of group selection, Hayek sought to depict the rise of the free market as the result of an evolutionary process that favors groups whose rules of behavior allow for maximum expansion. The present chapter discusses the challenges raised by the inclusion of evolutionary elements in the theories of these three key figures of Austrian economics. The adjective evolutionary is used in a general sense, referring to systematic development over time, without confining it to the theory first expounded by Charles Darwin. This allows us to include Menger and Schumpeter in our analysis although strictly speaking, only Hayek’s theory can be considered to have clear connection with common understanding of evolution. We begin with a review of Menger’s theory of institutional evolution and the particularities of the explanation he advanced in his historical analysis of money. Next, we focus on Schumpeter’s theory of industrial development and contrast it with ulterior views in the neo-Schumpeterian literature. The third section turns to Hayek’s theory of cultural evolution, in which the predominant position devolved to group selection led some to question the strength of Hayek’s adherence to the principle of methodological individualism. The conclusion offers preliminary evaluation of the possible role of evolutionary theorizing in the future development of Austrian economics.

Menger on the Emergence of Social Institutions Carl Menger (1840–1921) gained prominence as founder of the Austrian school of economics through the Methodenstreit (“method dispute”) with the German historical school. It was in this context that Menger’s opponent, Gustav von Schmoller, introduced the designation Austrian economics, to which he attached a pejorative connotation. This is not the place to discuss in detail the Methodenstreit. Suffice to say that it revolved around the issue of whether to assign priority in economics to deductive theorizing, as Menger proclaimed, or to historical and statistical inductions, as Schmoller and his followers advocated. Although Menger weighed in on the theoretical side, giving little room to historical and cultural specificities in economic reasoning, his reflections on the genesis of social institutions involved what might be described as a historical-evolutionary perspective. Menger was interested in the causes and mechanisms that lead to the spontaneous emergence of social institutions. His special focus was on the institution of money (Menger 1892; 1909), yet he claimed that his analysis

578    Austrian Connections and Extensions could be extended to explain the emergence of other social institutions such as customs and manners, the law, the price mechanism, language, and even the formation of states in the course of history (Menger [1883] 1985, book 3). Menger’s study of money had a double objective. On the one hand, he wanted to examine the various advantages of money as a medium of exchange. Among these advantages he counted:, among them the facilitation of trade, the simplification of transfers of purchasing power, the preservation of value, the possibility of wealth accumulation and the easy measurement of exchange ratios. On the other hand, Menger (1892, 241) sought to provide an account of the genesis of money by explaining “how it has come to pass that certain commodities … should be promoted amongst the mass of all other commodities, and accepted as the generally acknowledged media of exchange.” This double-pronged analysis corresponds to the distinction in modern evolutionary biology between proximate and ultimate causes. Proximate causation explains biological function in terms of immediate physiological or environmental factors, while ultimate causation explains biological traits in terms of evolutionary forces, such as natural selection (Mayr 1961; Tinbergen 1963). Menger’s first object of study, the various functions of money, can be viewed as providing a proximate explanation in economics for how and why a monetary medium works. His attempt to offer a causal explanation for the emergence of the social institution of money is tantamount to giving an ultimate explanation not only of the functions of a medium of exchange but also of how these functions mattered for its coming into being. Since ultimate explanations are the core concern of evolutionary theorizing, Menger’s explications of the latter kind are pertinent to our discussion. Menger ([1883] 1985, book 3)  maintained that money is an “organic” institution. This means that it is originally not the result of a deliberate creation by some authority (although authorities my later regularly modify, regulate, and legitimate this medium of exchange). Explaining the origins of money requires, therefore, understanding how a commodity comes to exist in a spontaneous manner as a commonly used medium of exchange. Menger believed the answer lay in the basic problem faced by anyone who wishes to engage in barter: an initial offer rarely meets with an equivalent counteroffer that exactly matches the first party’s desires. If an exchange is to take place in such a situation, a loss (unrealized value) would usually have to be incurred. To avoid such a loss, one can engage in a chain of barters in order to eventually obtain what one wants in return. In such a scenario, Menger argued, it is advantageous to barter for commodities that are traded frequently and qualify as intermediaries because they are easy to measure, compare, store, transport, and—most important—exchange again. In Menger’s (1892, 248) words, “each individual would learn, from his own economic interests, to take good heed that he bartered his less saleable goods for those special commodities which displayed, beside the attraction of being highly saleable in the particular locality, a wide range of saleableness both in time and place.” In a detailed historical examination, Menger (1909) explored the different commodities that have served as money in different geographical conditions. Menger’s explanation of the spontaneous evolution of money thus puts methodological individualism to work. He hypothesized that individual agents take advantage

The Evolutionary Paradigm    579 of the differential “saleableness” of a commodity or, for that matter, its fitness in serving as a medium of exchange for other commodities. If the agents assess this “saleableness” (along with other fitness features) similarly, the “fittest” commodities are likely to eventually be the ones used most frequently in facilitating chains of barter. In a region in which frequent barter takes place, it would then make sense to adopt the commodity most commonly used as the medium of exchange. Accordingly, Menger (1892, 249) emphasized habit as the “highly significant” factor “in the genesis of such generally serviceable means of exchange.” Thus, in a self-perpetuating manner, a social institution such as money can emerge as the most conveniently tradable medium, given the acquired habit to use it and the expectations of future trading partners. Compared with theories of social evolution that reduce all notions of fitness to the biological measure of reproductive success, Menger’s account of the origins of money seems remarkably sophisticated. In his theory, the “adaptive value” of money as an institution is not determined by increased survival and reproduction chances. It is represented instead by efficiency gains that are realized individually in repeated transactions. Naturally, in early stages of human development, realizing such efficiency gains must have had a positive effect on survival and reproduction. But this is not part of Menger’s explanation. Nor can it be claimed to be the reason for which money endured. Its “selection” lies in the properties of money as an institution that allows individual agents to save transaction costs. Since such saving turns out to be the most efficient by adopting a universal medium of exchange, money emerged and prevails. This type of reasoning exemplifies Menger’s method, which seeks to connect the causes of a phenomenon to its origins and manner of development.1 Although historical studies as such are not central in Menger’s oeuvre, they are significant for his methodology (Menger [1883] 1985, book 3). Menger wanted to delve into the ultimate causes of the evolution of social institutions, which he attributed to the specific motivations of individual behavior. This behavior, he argued, led to a collective outcome that was not the deliberate aim of the acting individuals in the first place. Accordingly, Menger juxtaposed “organic” institutions such as money with “pragmatic” institutions, which are deliberately created by some individually or collectively designed plan (Menger [1883] 1985, book 3). However, Menger’s explanation of organic (i.e., spontaneously emerging) institutions rests on a critical assumption. He assumes that the interacting agents make choices that do not involve conflicts of interest between them. While in the case of money this assumption may be justified, it isn’t necessarily warranted in other cases.2 Typical situations in which the condition is not met, and in which Menger’s explanation of spontaneously emerging institutions does not work, are social dilemmas. The question of whether and how they can be circumvented in an organic, bottom-up

1  Menger’s method has come to be dubbed the “causal-genetic explanation” by his academic successors; see Cowan and Rizzo (1996). 2  Indeed, modern attempts to model Menger’s explanation of the emergence of money use convention or coordination games in which no rivalry is present (see Jones 1976; Wärneryd 1989).

580    Austrian Connections and Extensions manner occupies much of the analysis of institutional evolution in recent times (e.g., Ostrom 2014).

Schumpeter’s Theory of Economic Development Unlike Menger, Joseph Schumpeter (1883–1950) is not usually considered a patron saint of Austrian economics. However, as far as Schumpeter’s early works are concerned, there are good reasons not to exclude him from the Austrian school (see Simpson 1983). Schumpeter received his education from, and was strongly influenced by, Menger’s successors Friedrich von Wieser and Eugen von Böhm-Bawerk. He was as much an advocate of methodological individualism as Menger before him, although the subjectivism of individual decision-making—often taken to be another characteristic of Austrian economics (see Boettke 1994, 4)—had minor relevance for Schumpeter’s thought. Note, however, that for Menger, too, subjectivism did not have the same canonical meaning it would later receive in the theories of Ludwig von Mises and his students (see Streissler and Streissler 1994, 9).3 While the methodologies of Menger and Schumpeter can be seen to present some affinities, their political opinions differed significantly.4 If the free-market credo is considered the decisive criterion for membership in Austrian economics (see Rizzo 1992), Schumpeter is likely to be left out. But from an academic point of view, there is a clear link between Schumpeter’s early interest in development—to which the present discussion will be confined—and positions usually associated with Austrian economics. Core concepts of Schumpeter’s ([1912] 1934) theory of development such as entrepreneurship, innovativeness, and the rejection of an equilibrium representation of a market economy, were later shared by almost all proponents of the Austrian school, some interpretative differences of the details notwithstanding. Schumpeter made his first appearance on the Austrian academic scene with a habilitation thesis (Schumpeter 1908), submitted to the University of Vienna and approved by his teachers Wieser and Böhm-Bawerk. It presented a review of contemporary 3  Unlike Schumpeter, Menger took a reductionist approach even with respect to preference subjectivism. He tried to explain in objective terms the motivation to act by recourse to the satisfaction of human needs and wants (see Menger [1871] 1981, chap. 2). As noted below, further doubts about the role of subjectivism and methodological individualism in Austrian economics arise with respect to Hayek’s theory of cultural evolution and his group selection hypothesis. 4  Menger held quite radical minimal-state views regarding economic policy, as the notebooks of his private lectures to the Austrian crown prince reveal (Streissler and Streissler 1994, 17). In contrast, Schumpeter was more critical of free-market capitalism and, particularly in his later publications, not as determined to denounce Marxist ideas as his former classmate Mises. His partly polemic prophecy of the decline of capitalism and the transition to socialism (Schumpeter 1942) is indicative of a development that distanced him further from Austrian economics (see also Schumpeter’s review of Hayek’s Road to Serfdom in Schumpeter 1946).

The Evolutionary Paradigm    581 economic theories, including, among others, those of Irving Fisher, Alfred Marshall, Arthur Pigou, and Léon Walras. These theories, Schumpeter claimed, depict the economy in a state of equilibrium. Such a characterization contrasts with the Marxist tenets of an unstable development of capitalism, which Schumpeter knew well from debates in university seminars and in various student circles in Vienna. His personal experience must have also been at odds with the equilibrium representation. Schumpeter’s father was an entrepreneur during the peak of industrialization of the Austro-Hungarian empire, a time when the actions of single individual promoters were visibly transforming the economy. Schumpeter’s examination convinced him of the need to look for a substitute for the counterfactual equilibrium assumption of contemporary theories. Indeed, two years after the defense of his thesis, he published an article titled “On the Essence of Economic Crises” (Schumpeter 1910), in which he proclaimed that the dynamics of the capitalist engine originate from entrepreneurial activity. This alternative view put forward the hypothesis that incessant innovative change “from within” the economy is the endogenous cause that disrupts an equilibrium when such a stationary state is reached. Schumpeter’s article anticipated the main argument of his pathbreaking Theory of Economic Development ([1912] 1934), according to which capitalist progress is an innovation-driven process with a peculiar cyclical structure (see Witt 2002 and Andersen 2009 for discussion). The growth phase begins when pioneering entrepreneurs accomplish a major innovative breakthrough, which induces a multitude of less innovative entrepreneurs to engage in imitative activities. This causes heavy investments, multiplier effects, and eventually a boom. After the wave of imitations fades out, the overcapacities that were built up result in profit erosion, and the volume of investment breaks down. A period of economic adjustment—a depression—occurs before the economy returns to a state of equilibrium. The difference between the new state of equilibrium and the older one indicates economic progress. The next cycle of growth begins when a new major innovation is introduced. The business cycle framework that Schumpeter chose for his theory of innovation-driven capitalist development was quite popular at the time. It was a new and promising field of research in which other members of the Austrian school, including Mises and Hayek, engaged and gained much of their reputation (Haberler 1937). What was unique in Schumpeter’s contribution was the specific use of the business cycle for attacking the heuristic bias of the equilibrium concept at the heart of mainstream economic theorizing. No other economist in the Austrian school has been more determined to overcome the limitations of the equilibrium heuristic, as is evident in the seventh chapter of the Theory of Economic Development (Schumpeter 2002).5 In 5 

The seventh chapter was omitted from all later editions of the book and also from the English translation. It was translated and published in English only recently (Schumpeter 2002). The reason for the omission is unclear. Some of the material in the chapter, particularly the reflections on how classical economists interpreted capitalism, seems to have been reserved for further development in Schumpeter’s encompassing theory of capitalism (Schumpeter 1942).

582    Austrian Connections and Extensions this chapter—a kind of epilogue—Schumpeter points to the analogy between a market economy in an evenly rotating state and a gravitating physical system such as Newton’s representation of the planetary system. Disturbances of systems of the latter kind can occur only through exogenous forces affecting the gravitational field. In economics, exogenous forces such as natural disasters or military invasions (i.e., forces not usually subject to economic explanations) can, of course, also affect a capitalist system. However, the key to understanding economic development is the endogenous force of entrepreneurial innovativeness. On the basis of this premise, Schumpeter put forward a new method for economic analysis: the developmental method. The developmental method differs from equilibrium analysis and comparative statics in that it focuses on the process of unfolding of the economy. This process is described as an incessant sequence of fundamental economic innovations, which, after their occurrence, disseminate throughout the economy and, in so doing, transform it. Schumpeter (2002, 95)  explicitly states that the developmental method “has neither formal nor material connections with the biological development of any organic body.” Nor was it his intention to evoke “evolutionary analogies or theorems” (107) with reference to Darwin’s biological theory. In fact, Schumpeter considered the Darwinian theory of evolution to be irrelevant for the economic domain and did not rely on it, not even metaphorically. This manner of reasoning may appear alien to the modern reader, given the strong impact of Darwin’s biology on our understanding of evolution. Nowadays, wide use is made of analogies and metaphors borrowed from biology to explain various phenomena in the human and social sciences. The “universal” or “generalized” Darwinism advanced by some (Dawkins 1983; Hull 2001; Hodgson and Knudsen 2010) is the strongest version of the claim that the general principles of evolution apply outside biology.6 But Schumpeter took a different path (see Witt 2003) and offered an original theory of economic evolution/development. The fact that Schumpeter did not appeal to the principle of natural selection in his analysis sets him apart from the neo-Schumpeterian literature (e.g., Hanusch and Pyka 2007) that follows in the footsteps of Nelson and Winter (1982). The theory proposed by Nelson and Winter focuses on the consequences of competitive innovative activities at the level of firms and industries (while completely abandoning Schumpeter’s macroeconomic business cycle framework). Drawing on the notion of bounded rationality (see Simon 1972), Nelson and Winter (1982, chap. 5) argue that firms rely on rules of thumb and organizational routines in their internal interactions. In other words, routines determine activities such as the planning of production, the calculation of costs, setting prices, allocating R&D funds, and so on. These routines form a reservoir of alternative modes of action within an industry in a manner analogous to the different genotypes that exist in the gene pool of a population. The specific decisions resulting from applied routines can be perceived, according to Nelson and Winter, as the equivalent 6  For a critique of this view, and specifically the reduction of evolutionary theory to the three principles enunciated by Campbell (1965)—variation, selection, and retention—see Levit, Hossfeld, and Witt (2011).

The Evolutionary Paradigm    583 of phenotypes. If these phenotypes have a positive effect on the firms’ overall performance, the routines that underlie them will be favored. Thus, the differential growth of firms translates into a corresponding recomposition of the routines in an industry’s routine pool following the principle of natural selection: the more successful routines will become more frequent, the less successful ones less so. In this sense, firms and industries adapt to their competitive environment and evolve. The problem with Nelson and Winter’s assumption of inert organizational routines, which is necessary for obtaining the kind of systematic adaptation or evolution they describe, is that it stretches the concept of bounded rationality so far that human agency seems to have no role. Deliberate change of individual behavior, on which routines are based, is completely negated, as if the agents were mindless and unable to respond to subjectively perceived poor performance of routines. The analogy to natural selection thus induces a systematic heuristic bias. It ignores the agents’ perceptions and inferences. Such a move may be legitimate in evolutionary analysis of behavior that is genetically determined (e.g., studies in behavioral ecology). But when analyzing human decision-making, the role of cognition, subjective deliberation, and learning cannot be disregarded, even though the agents’ perceptions and inferences are far from perfect. Unlike his followers, Schumpeter chose to attribute a decisive role to individual deliberation in his depiction of pioneering innovators and their imitators as the drivers of economic development. As a result, his theory is not subject to the same criticism that can be leveled against neo-Schumpeterians. Schumpeter, however, failed to do full justice to an important aspect of his theory, which figures prominently in the literature affiliated with Austrian economics: the role of novelty (Shackle 1979). In a somewhat artificial manner, Schumpeter distinguished inventions (the emergence of economically relevant novelty) from innovations (the carrying out of existing novel action opportunities not tried before). He assumed that ideas about new action opportunities are abundant, that is, exist independently of any actions performed. An explanation of how novelty is being created, and why, is not part of Schumpeter’s theory. But by making novelty an exogenously given resource, the important sphere of subjective mental processes such as the searching for, the discovery of, and the experimentation with new possibilities is ignored, as is the exploration of the respective individual motivations that drive these activities. Since the emergence of innovations crucially depends on the emergence of new action opportunities in the first place, Schumpeter’s evolutionary mechanism remains incomplete. It lacks a satisfactory account of the emergence of novelty as an enabling factor of economic development. It is true, of course, that the inclusion of the emergence of novelty in the explanatory domain of any theory faces an epistemological constraint or, as Shackle (1983) once put it, “bounds of unknowledge.” Even if the mental processes by which novelty is created or discovered were fully intelligible (which they are not; see Witt 2009), because of the very nature of novelty, the revelation of its meaning would have to be awaited. Neither the meaning of novelty nor its implications can (fully) be anticipated. This situation raises an important question: if searching for, and experimenting with, novelty is an endeavor with unknown outcomes, why do agents engage in such activities?

584    Austrian Connections and Extensions One explanation would be that they act on the basis of subjective expectations that, lacking any experiential basis, amount to prophecy and wishful thinking. An alternative hypothesis refers to individual proclivities such as alertness (Mises [1940] 1949, 252–256; Kirzner 1982) or curiosity, that is, a preference for experiencing the thrill of novel stimuli, which may even be innate. Such a hypothesis can explain not only the motivation to experiment but also individual differences in the search for novelty. Yet another hypothesis, situational rather than personality-related, refers to the motivation to seek novelty under certain conditions, such as intensified competitive pressure, economic crisis, or the general need to look for alternatives when no satisfactory modus operandi is available. It is important to note that the motivation to search for, and experiment with, novelty idles if hard or soft institutional constraints discourage or inhibit the realization of promising novelties as innovations. Conservatism, taboos, religious beliefs, and fear of the new are all discouraging factors. Regulations and political bans can likewise prevent novelty-seeking action. Conversely, in free-market environments, competitive pressure caused by the innovations of rivals can lead to a self-amplifying process. An industry or even a whole economy with intense innovation competition can stimulate the search for novelty and thus encourage further innovative activity. The divergent evolutionary paths that different economic systems have taken in history bear witness to the impact of institutional constraints in situations where the motivational conditions were arguably quite similar. Alas, Schumpeter’s silence on the issue of the emergence of novelty prevented his theory of industrial evolution from accounting for these important institutional contingencies.

Hayek’s Theory of Cultural Group Selection Like Schumpeter, Friedrich A. Hayek (1899–1992) was also a student of Wieser. His real mentor, however, was Mises, whose critique of socialism (Mises [1922] 1936) persuaded Hayek to abandon his youthful Fabian inclinations (Hayek 1992, 127). Mises argued that in the absence of freely adjusting prices in competitive markets, there could be no way to compare the costs of production or to evaluate revenues and detect scarcities. As a result, the data required for economic calculation by a central planning authority (i.e., what to produce, how much to produce, and in what manner) are unavailable. Mises concluded that the feasibility and progressiveness of socialist ideas were therefore an illusion. Although Hayek adhered to Mises’s conclusion, he was critical of the latter’s overreliance on rationalism and a priori principles in the critique of socialism. Indeed, Mises later ([1940] 1949) defined economics as the science of human action or “praxeology,” that is, a science of the “pure logic of choice,” which guides rational individuals in pursuit of their ends. He was not interested in explaining empirically observable, and

The Evolutionary Paradigm    585 potentially fallible, economic behavior. This, Mises held, was a task that should be left to psychology. Hayek was skeptical of Mises’s attempt to explain the market process “through pure ratiocination” (Mises [1940] 1949, 39). To him, an account of the market process based on the choices of market participants necessitated empirical proof and could not be assumed a priori valid (see Kresge and Wenar 1994, 72). If it were indeed possible to reconstruct the actions of all market participants by mere ratiocination, why should a socialist planner not be able to take advantage of this tool for making a central plan? The desire to find a remedy for the problem raised by Mises’s approach induced Hayek to reflect on the role of knowledge in the market process and in economics in general. This question and, more specifically, the various implications of the claim that knowledge is incomplete and fallible are the red threads that run through Hayek’s entire opus, from his seminal paper on “Economics and Knowledge” (1937) to his Nobel Prize lecture, “The Pretense of Knowledge” (1975). Explaining what knowledge consists of and how it is obtained and processed was fundamental, in his eyes, to understanding the conditions under which the free market would provide desirable results. Hayek’s investigation in this domain included a detailed examination of the workings of the mind in The Sensory Order (1952). This psychological study helped Hayek hone his views on evolution and the emergence of spontaneous orders (Kresge and Wenar 1994, 153) and the emergence of spontaneous orders (Kresge and Wenar 1994, 153) and provided an important background for the theory of cultural evolution he would later develop. The gist of Hayek’s theory lies in the claim that the market order emerged as the result of a process of selection of cultural practices that operates on the level of the group rather than the individual. The inspiration for this idea came from the works of zoologists Alexander M. Carr-Saunders and Vero C. Wynne-Edwards (Hayek knew the former personally; the two were colleagues at the London School of Economics). In their writings, Hayek (1967, 70) found the hypothesis that all individuals of a species will behave in a certain manner “because groups of individuals which have thus behaved have displaced those which did not do so.” Carr-Saunders promoted this idea, known as “group selection,” in a book titled The Population Problem (1922). He argued that every human population has an optimal size in which return per capita is maximized. The population problem refers to the necessity of regulating demographic increase so that the optimal size is not exceeded. Carr-Saunders believed this was done through a process of group selection. According to his theory, groups that adopted customs that served to regulate the number of members close to the optimal level have had an advantage over groups with less advantageous customs. His examples for such customs were practices of reproductive restraint such as infanticide, abortion, or sexual abstinence. These practices, which can be observed even outside so-called primitive societies, cannot be explained through a selection that maximizes individual reproductive success and therefore require, according to Carr-Saunders, a group selection explanation. The theory proposed by Carr-Saunders was elaborated further by Wynne-Edwards in his treatise Animal Dispersion in Relation to Social Behaviour (1962). Wynne-Edwards

586    Austrian Connections and Extensions maintained that groups of animals that exhibit the kind of behavior that helps control their population size and density, and thereby avoid overexploitation of resources, were favored by natural selection. His theory was fiercely attacked by George C. Williams (1966) and rejected by most biologists until relatively recently (Sober and Wilson 1998; Borrello 2010). Hayek was aware of the rising criticisms against group selection, which occurred around the time he elaborated the details of his own theory, but was not discouraged by them. He contended that although group selection may not appear as important as it has been considered in biology, there is no doubt that it is of the greatest importance for cultural evolution (Hayek 1979, 202). Moreover, turning Carr-Saunders’s argument on its head, Hayek claimed that cultural group selection actually favors increase in population and wealth rather than limited reproduction. In other words, cultural evolution leads to the selection of groups whose rules of conduct (or “informal institutions” more generally; see Schubert and Wangenheim 2006) lead to prosperity and demographic expansion either through greater reproduction or through the inclusion of immigrants. To back up this hypothesis, Hayek proposed the following scenario. During the longer part of our species’ history—approximately fifty thousand generations—humans lived in small bands of fifteen to forty people (Hayek 1979, 160). This type of social existence was conducive to the development of solidarity and altruism since the members of small bands knew one another, trusted one another, and had shared goals and aims that coordinated their activities. But over the past one hundred to five hundred human generations, living conditions changed dramatically. Modern civilization, which Hayek called the “Great Society,” is founded on an extended order of widely anonymous markets with millions of participants. There is thus a rift between the “natural morality” of solidarity and altruism, which evolved in response to the living conditions of the “face-to-face troop,” and the principles that regulate cooperation in modern society. For this modern society to develop, a new morality had to emerge, one better suited to expansion and to the coordination of largely anonymous interactions of many individuals with different goals and aims. This new morality required de facto repression of the former. Its tenets—for example, the recognition of (private) property, contract compliance, free competition, and the admission of profits and income inequalities—were all “breaches of that ‘solidarity’ which governed the small group” (162). Hayek explained that the feelings of guilt or envy that often accompany material success in modern societies are in fact vestigial, atavistic remnants of a bygone era whose morality disserves the Great Society. He thus portrayed cultural evolution as producing results that do not appeal to our inherent sense of justice. That such a new morality nonetheless evolved, and with it the extended order of the markets, was the consequence of cultural group selection. Morality, Hayek specified, is tied to the rules of conduct and customs that one follows in interactions with other group members. The selection he had in mind operated on these rules and customs, not on individual behavior. Together they formed what Hayek (1979, 153–176) called “tradition,” which he depicted as a layer lying “between instinct and reason.” Rules of conduct are therefore neither inborn nor

The Evolutionary Paradigm    587 the outcome of deliberate design. They are acquired by, and transmitted through, imitation without much cognitive reflection by those who adopt them. Since groups that achieve greater economic success will flourish more than others, their corresponding rules of conduct (morality) will be passed on to a greater number of individuals. On average, the mass of individuals who follow these rules will increase until the rules of conduct that lead to expansion will eventually prevail over all other rules and become the fixtures of the most extended civilization. Because, according to Hayek, the more successful rules and morals were exactly those conducive to the emergence of free markets, his theory illustrated how a process of selection favoring group expansion resulted in this type of social order. Hayek’s theory echoes Menger’s hypothesis concerning the spontaneous emergence of social institutions. Similarly to Menger, Hayek did not see the individual agents as arriving by insight at a collective agreement on a cooperative framework. According to both economists, extended cooperation arose inadvertently, as the side effect of individual striving for economic well-being. But Menger’s description of how the parallel actions of individuals involved in barter lead to the emergence of money did not explain more generally how social institutions emerge. Hayek, for his part, intended to offer such a general explanation by employing the idea of cultural group selection. He postulated that social institutions emerge as the result of a selection favoring the most successful groups in terms of size and wealth. Because groups are defined through the rules and customs they follow, the selection of groups was, at a final instance, the selection of specific rules of conduct. Hayek’s recourse to the notion of group selection led some to question the strength of his commitment to the Austrian principle of methodological individualism (e.g., Vanberg 1986; Boettke 1990; Hodgson 1991; Hodgson 1994; Whitman 1998; Caldwell 2002). It is indeed not obvious who is the agens movens of Hayek’s hypothesized evolutionary process. If groups are the unit of selection, in what sense can individual behavior and subjective intentions still be viewed as the motor of this evolution? While Hayek seems to assume that all individuals strive to improve their economic well-being, it is not clear to what extent he acknowledges that this striving can take the form of conflict and clash of interests so that the collective outcome is not necessarily the increase of economic prosperity. Modern research claims that individual motivation to improve one’s situation is an insufficient agens movens for bringing about the extended order of free markets and the prosperity they are presumed to entail. Besides the development and command of improved technological knowledge (a factor neglected in Hayek’s analysis), institutional constraints that channel potentially conflicting individual ambitions into cooperative forms seem to be the guarantors of prosperity and growth (Birdzell and Rosenberg 1986; North, Wallis, and Weingast 2009). Although the dilemma of conflicting individual interests is not directly addressed in Hayek’s reflections, his theory of group selection could be extended to provide a solution to the institutional problem. One would then need to explain how rules of conduct reducing or preventing conflict emerge and can be preserved within some groups and how selection forces effectively favor groups with such rules. In any case, it is clear that the appeal to group selection in Hayek’s theory

588    Austrian Connections and Extensions transcends the principle of methodological individualism and undermines the reliance on individual reasoned behavior.7 In fact, in Hayek’s most detailed account of this theory (1988), the attack on the “fatal conceit” of those who want to replace the evolved free-market order with the socialist ideal of a rationally designed economy takes an overt antirationalist stance. The advocates of rational design do not comprehend the limits of their cognitive abilities, Hayek warned, nor that what they propose contradicts the mode of development of modern civilization. Their demands for distributive justice may be “instinctually gratifying” since they are “based on primordial emotions” of solidarity. But a realization of their plans would effectively destroy the material foundation of progress, condemning billions to death and the rest to impoverishment (Hayek 1988, 120). This conclusion fits Hayek’s political agenda, but it does not necessarily follow from his evolutionary theory. Indeed, this theory remains the most controversial part of Hayek’s entire opus and continues to draw criticism for leaving many questions open (Gray 1984; Steele 1987; Vlieghere 1994; Witt 2008a; Marciano 2009; Beck 2012; Vanberg 2014).

Conclusion In this chapter, we briefly reviewed the evolutionary elements (broadly conceived) in the contribution of three key figures of the Austrian school: Menger, Schumpeter, and Hayek. Beginning with Menger, we argued that an interest in evolutionary reasoning (though not designated as such) could be gleaned from Menger’s theory of “organic” social institutions. In our examination of Menger’s study of money, we distinguished between, on the one hand, his analysis of the various functions of money and, on the other, his effort to detect the roots of this social institution. We compared this distinction to the difference between proximate and ultimate causation in modern evolutionary biology. With regard to ultimate causation, which refers specifically to evolutionary forces, Menger traced the origins of money to the combined interest of individual agents to save on transaction costs. Key to his explanation was the emphasis on spontaneity and lack of design in the emergence of money. Menger described the mechanism by which money became a common medium of exchange as the result of parallel and similar choices of agents that lead to a special form of unorganized collective action with an unintended outcome. The focus on causes and mechanisms in the evolution of economic phenomena is also a major feature in Schumpeter’s early writings. Similarly to Menger, Schumpeter did not seek to connect his analysis directly to the Darwinian theory of evolution (in fact, he was openly opposed to doing so) and elaborated instead an independent 7  Hayek (1960, 36) was quite explicit: “The ultimate decision about what is good or bad will be made not by individual human wisdom but by the decline of the groups that have adhered to the ‘wrong’ beliefs.” Such a position is irreconcilable with Mises’s praxeology.

The Evolutionary Paradigm    589 theory of development. This theory accounted for the unfolding of industrial capitalism through the principle of recurrent emergence and dissemination of innovations. Schumpeter identified the causes of economic development in the motivation of pioneering entrepreneurs to find new ways of organizing the economy, followed by the profit-seeking imitative activities of less innovative entrepreneurs. We claimed that unlike Schumpeter, posterior neo-Schumpeterian efforts (e.g., Nelson and Winter 1982), which attempt to explain the success of firms through appeal to the natural selection of fitter routines, tackle in unsatisfactory manner the issue of human agency. What role individual reason plays in cultural evolution is also a thorny question in Hayek’s theory. Unlike Menger and Schumpeter, Hayek fully embraced evolutionary arguments in his explanation of the rise of the free market. But he interpreted the concepts he borrowed from biology in his own, heterodox way. Using the notion of group selection, Hayek maintained that cultural evolution favors the groups that expand the most and leads to the selection of the rules of behavior that correspond to the free market. This theory meant to buttress Hayek’s attack on the various attempts to redesign society through rational reforms along the lines of socialist ideals. He proclaimed that such proposals run counter to the development on which the prosperity of modern civilization depends. But Hayek’s evolutionary account left many questions unanswered and drew criticism regarding the tension between the hypothesis of group selection and the principle of methodological individualism. One might wonder what lessons can be learned from the inclusion of evolutionary elements in the Austrian perspectives outlined above. Does such a move hold potential with respect to the future development of Austrian economics? It would be inappropriate to offer, at this point, a definitive evaluation of the highly variegated positions adopted by Menger, Schumpeter, and Hayek. We would like to note, however, a common feature that they share. All three break new ground in directions that transcend the narrower agenda defined for Austrian economics by Mises and his students and followers (see Rizzo 1992; Boettke 1994). Those who limit the label of Austrian economics to the Misesian canon of concepts and political tenets may find it hard to accept as distinctly Austrian many of the extensions and modifications introduced by Schumpeter and Hayek. Other scholars identifying themselves with Austrian economics may be sympathetic with them. Austrian economics thus encounters a dilemma that is characteristic of the development of schools of thought and paradigms in general. Adherents of a school can choose a conservation strategy that sharpens the contours and the identity of their school but also narrows down its ability to break new ground. Or they can vote with their research agenda for a progression strategy, which extends the range of topics, concepts, and methods and allows cross-breeding with other intellectual influences. Such a strategy might help push the creative momentum but it runs the risk of undermining the identity of the school. If one may speak of a lesson to be learned here, it is perhaps this one: in the future, adherents of Austrian economics will have to choose between a conservation strategy and a progression strategy. The evolutionary theories of Menger, Schumpeter,

590    Austrian Connections and Extensions and Hayek offer exciting possibilities for the latter. It can even be argued that the evolutionary agenda is likely to be one of the most promising avenues for expanding and reframing the canon of Austrian economics. Yet it cannot be denied that the variations and extensions involved in such a new canon may challenge and condition received views of Austrian economics even more than Schumpeter’s and Hayek’s theories already did. The open question would then be to what extent and how Austrian economics can maintain its brand identity.

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592    Austrian Connections and Extensions Schumpeter, J. A. 1908. Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie. Leipzig: Duncker & Humblot. Schumpeter, J. A. 1910. “Über das Wesen der Wirtschaftskrisen.” Zeitschrift für Volkswirtschaft, Sozialpolitik und Verwaltung 19: 271–325. Schumpeter, J. A. (1912) 1934. The Theory of Economic Development. Cambridge, MA: Harvard University Press. Schumpeter, J. A. 1942. Capitalism, Socialism and Democracy. New York: Harper Brothers. Schumpeter, J. A. 1946. “Review of The Road to Serfdom by Friedrich A. Hayek.” Economic Journal 54: 269–270. Schumpeter, J.  A. 2002. “The Economy as a Whole” [English translation of the Chapter  7 of Theorie der wirtschaftlichen Entwicklung, 1st Edition,  1912]. Industry and Innovation 9: 93–145. Shackle, G.  L. S. 1979. Imagination and the Nature of Choice. Edinburgh:  Edinburgh University Press. Shackle, G. L. S. 1983. “The Bounds of Unknowledge.” In Beyond Positive Economics, edited by J. Wiseman, 28–37. London: Macmillan. Simon, H. A. 1972. “Theories of Bounded Rationality.” In Decision and Organization, edited by C. B. McGuire and R. Radner, 161–176. Amsterdam: North Holland. Simpson, D. 1983. “Joseph Schumpeter and the Austrian School of Economics.” Journal of Economic Studies 10: 15–28. Sober, E., and D. S.  Wilson. 1998. Unto Others:  The Evolution and Psychology of Unselfish Behavior. Cambridge, MA: Harvard University Press. Steele, D. R. 1987. “Hayek’s Theory of Group Selection.” Journal of Libertarian Studies 3, no. 2: 174–195. Streissler, E., and M. Streissler, eds. 1994. Carl Menger’s Lectures to Crown Prince Rudolph of Austria. Aldershot, UK: Edward Elgar. Tinbergen, N. 1963. “On Aims and Methods in Ethology.” Zeitschrift für Tierpsychologie. 20: 410–433. 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. Vanberg, V. J. 2014. “Darwinian Paradigm, Cultural Evolution and Human Purpose: On F. A. Hayek’s Evolutionary View of the Market.” Journal of Evolutionary Economics 24: 35–57. Vlieghere, M.  de. 1994. “A Reappraisal of Friedrich A.  Hayek’s Cultural Evolutionism.” Economics and Philosophy 10: 285–304. Wärneryd, K. 1989. “Legal Restrictions and the Evolution of Media of Exchange.” Journal of Institutional and Theoretical Economics 145: 613–626. Whitman, D.  G. 1998. “Hayek contra Pangloss on Evolutionary Systems.” Constitutional Political Economy 9: 45–66. Williams, G.  C. 1966. Adaptation and Natural Selection:  A  Critique of Some Current Evolutionary Thought. Princeton, NJ: Princeton University Press. Witt, U. 2002. “How Evolutionary Is Schumpeter’s Theory of Economic Development?” Industry and Innovation 9: 7–22. Witt, U. 2003. “Generic Features of Evolution and Its Continuity:  A  Trans-Disciplinary Perspective. Theoria 18: 273–288. Witt, U. 2008a. “Observational Learning, Group Selection, and Societal Evolution.” Journal of Institutional Economics 4: 1–24.

The Evolutionary Paradigm    593 Witt, U. 2008b. “What Is Specific about Evolutionary Economics?” Journal of Evolutionary Economics 18: 547–575. Witt, U. 2009. Propositions about Novelty.” Journal of Economic Behavior and Organization 70: 311–320. Wynne-Edwards, V.  C. 1962. Animal Dispersion in Relation to Social Behaviour. New  York: Hafner.

Chapter 27

C omplex i t y and Au strian  E c onomi c s J. Barkley Rosser, Jr.

Introduction There is a deep link between complexity economics and Austrian economics, with ideas of complexity foundational in the work of Austrian economics from its generally recognized beginnings with Carl Menger on to the modern day, with Friedrich Hayek (1967) being probably the most important carrier of this theme in the school. While many other Austrian economists have also exhibited ideas from complexity theory, Hayek did so more broadly across varieties of complexity ideas, which are numerous, and of course, he is one of the most important of the Austrian economists.1 More broadly, it would appear that while complexity ideas were important in the founding work of Menger ([1871] 1981), they became less important in the thinking of the next generation of Austrian economists such as Friedrich von Wieser (1884) and Eugen von Böhm-Bawerk ([1888] 1959). However, they have become more important since then, with Mises (1966) exhibiting some interest in these ideas and Hayek becoming increasingly enamored of them as his long career progressed. Today such ideas are quite influential in the work of many Austrian economists (Koppl 2006; 2009), particularly those involving the idea of the emergence of spontaneous order in economic systems. That interest in these ideas among Austrians has waxed and waned over time suggests that there is a conflict over them within Austrian economics. This conflict has not been simply one between such developers of Austrian complexity economics as Menger 1 

There is an ongoing debate over whether Ludwig von Mises or his student Hayek is the most important Austrian economist. This chapter will make no effort to assess this matter. One can note that Hayek is the only Austrian economist so far to win the Swedish Bank Prize in Economic Sciences in Memory of Alfred Nobel, but this does not establish his superiority to Mises, as the latter died fairly shortly after the prize was established.

Complexity and Austrian Economics    595 and Hayek in contrast with those less so inclined such as Böhm-Bawerk but also within the work of individual Austrian economists. We have already noted that Hayek’s views changed over time to become more sympathetic to such views. We shall see that such a conflict exists also within the work of Menger, with him arguably becoming more favorably inclined later in his life, ironically doing so at a time when other Austrian economists, including Hayek, were not so interested in such ideas. Note that an element of this conflict involves the issue of mathematics, with most approaches to complexity being quite mathematical, whereas there is a strong tradition within Austrian economics of being critical of most uses of mathematics in economics.

Varieties of Economic Complexity Obviously, any discussion of the relationship between complexity theory and Austrian economics must entail laying out what the relevant parts of complexity theory are for such a discussion. Up front, we must confront the simple fact that there are many different ideas regarding what complexity is, with physicist Seth Lloyd having come up with more than forty-five definitions of complexity, his list arguably being incomplete.2 Rosser (2009) offers three levels of considering this question:  the meta-complexity level, the dynamic complexity level, and the agent-based complexity level.3 The first considers the question from the perspective of Lloyd, taking into account the full array of approaches to complexity. The second more specifically emphasizes forms of complexity that are defined by the dynamical patterns of phenomena that they are associated with. The final is a more narrowly defined approach that is nevertheless important now in economics that emphasizes local interactions of heterogeneous agents in systems that are often studied using computer simulations given the difficulty of finding analytical solutions for such systems. Most of these complexity approaches involve mathematical definitions or views of some sort or other. In the spirit of building up a higher-order perspective from lower-level ones, these three are considered here in reverse order. While agent-based complexity is usually studied by using computer simulation exercises, the widely accepted beginning of this approach was with Schelling (1971), who used a go board to simulate the dynamic emergence of racial segregation in urban systems out of initial states of integration. His model involved simply local interactions, with agents having only a slight preference to be located next door to those of the same

2  For Lloyd’s list as of the late 1990s, see Horgan (1997, chap. 11). Many of his definitions are variations on one another that can be grouped into a smaller set of groups. 3  Rosser (1999) initially labeled this form of complexity “small tent,” in contrast to “big tent” views that involved other forms of complexity. While that terminology became somewhat widespread, I have since shifted to my current usage, which is more descriptive of what is involved and avoids hints of apparent disapprobation that some found in the earlier terminology.

596    Austrian Connections and Extensions race as themselves. Even a slight such preference was sufficient to lead to the emergence of segregation as agents bought and sold housing and moved over time. Arthur, Durlauf, and Lane (1997) offer a useful set of six characteristics that can be associated with this view of complexity, which also shows up elsewhere. The first is that there is dispersed interaction among heterogeneous agents acting locally in some space. This idea has been very appealing to many Austrian economists. The second is that there is no global controller that can exploit all opportunities or interactions, despite the possibility of some weak global interactions. This also appeals to many Austrian economists, as it harks back to their historically strong position in the socialist calculation debate which argues for the impossibility of any efficient central planning. The third involves cross-cutting hierarchical organization with tangled relations. This theme is less obvious in earlier Austrian work, although it is discernible occasionally, but it has become more important in some recent Austrian work, such as the entangled political economy ideas of Wagner (2010). The fourth is that of continual adaptation and learning by evolving agents. This has been especially important for those emphasizing the importance of the role of entrepreneurs in economic development, ranging from Wieser through Joseph Schumpeter ([1911] 1934)  and Mises to Israel Kirzner (1973, 1985). The fifth emphasizes perpetual novelty as new markets, technologies, behaviors, and institutions create new niches in the ecology of the system. This fits closely with the Austrian approaches to entrepreneurship just mentioned but also brings in more evolutionary views as developed by Menger ([1883] 1985, 1923) and Hayek (1988). The final aspect emphasizes out-of-equilibrium dynamics with either zero or many equilibria and the system unlikely to be near a global optimum, a world of bounded rationality and unexpected events and processes. This one lies at the heart of differences over complexity within Austrian economics, with many accepting equilibrium approaches, even as more recent Austrians have moved more toward accepting disequilibrium ideas. Also, there is more of a tendency to argue that spontaneous market processes produce desirable outcomes, if not necessarily ones that are optimal in the formal sense of Pareto. There are also differences over the degree of rationality involved in economic decision-making, although Koppl (2006) has embraced bounded rationality as the B in his BRICE formulation of complexity Austrian economics.4 The level of dynamic complexity was defined by Day (1994) as involving systems whose dynamic paths fail for endogenous reasons to converge to a point, a limit cycle, or a smooth expansion or contraction. Because of Rosser’s (1999) expansion of this (initially labeled as the “big tent” perspective), Velupillai (2011) called this type of complexity “Day-Rosser complexity.” It is known that such systems involve nonlinearities, although not all nonlinear systems will generate such patterns, with this generally being a matter of the values of parameters within the system. Curiously, this definition is not

4 

In Koppl’s formulation of BRICE, B is bounded rationality, R is rule following, I is institutions, C is cognition, and E is evolution. Rosser (2010) provides a critical discussion of Koppl’s approach.

Complexity and Austrian Economics    597 precisely one of those on Lloyd’s original list, and it has some problems and ambiguities, although it is certainly a very important form of complexity within economics. One ambiguity involves the matter of what counts as endogenous within any system, a long-running point of contention among many economists. In general, in a mathematically defined model, or set of equations, those variables are endogenous that are determined by the model itself, with exogenous ones coming from outside the model to affect it. This might be straightforward in mathematics, but in economics, the model might be viewed as inadequate or incomplete, as failing to describe the real-world system. Such an accusation may be more likely to be made when the observer is one of the Austrian economists, given their history of viewing mathematical models more skeptically than most other economists. However, when such questions are raised by those who take such models seriously, they are often raised with the argument that something being viewed as exogenous is really endogenous when modeled in a way that more accurately reflects reality. Indeed, it is an old saw that “the only truly exogenous factor in the economy is the sun.”5 The other matter of ambiguity involves which dynamic patterns really count as dynamically complex, even if one accepts that a particular model is accurate or relevant. Thus, to those preferring to allow more models or systems to be viewed as dynamically complex, any form of endogenous fluctuation is sufficient to constitute dynamic complexity, whereas for others, only aperiodic fluctuations count. This is in some sense arbitrary. However, many observers clearly view any sort of endogenously generated fluctuation as being problematic for those within the system. On the other hand, it must be recognized that as periods of oscillation grow longer, more observers will find the system to be difficult to understand and somehow more complex. Clearly, in such a view, aperiodic fluctuations constitute a system that is more difficult to understand. In any case, such dynamic complexity has been described by Rosser (1999) as containing within it the “4 Cs” of cybernetics, catastrophe theory, chaos theory, and the agent-based or “small tent” complexity described above. Few Austrian economists have dealt specifically with either of the middle two, Lavoie (1989) being an apparent exception, although he did not develop specific models that generated either pattern. However, the first of these was very much on the mind of Hayek as he developed his own views on a complexity approach, and he personally approached both Ilya Prigogine of the Free University of Brussels and Hermann Haken of the Stuttgart Institute of Theoretical Physics, both of them physicists associated with cybernetic analysis of physical systems along with the other Cs of dynamic complexity.6 He was also influenced by the work of the founder of cybernetics, Norbert Wiener (1948) and that of general 5 

I have heard William A. (“Buz”) Brock make this remark on several occasions, although it is highly likely that it predates him. 6  I learned of Hayek’s approach to the Brussels School from Peter M. Allen, a student of Prigogine’s, and of his approach to Haken, the founder of synergetics theory, from Haken himself, both from personal conversations.

598    Austrian Connections and Extensions systems theorists Ludwig von Bertalanffy (1968) and Warren Weaver (1948). However, it must be noted that Hayek himself did not develop specifically mathematical models that generated such complex dynamics.7 Finally, we come to the broader meta-complexity conceptualization that encompasses the full array of possible complexity approaches that have been used in economics. Besides dynamic complexity, leading alternatives include structural complexity (Pryor 1995), hierarchical complexity (Simon 1962), and especially computational complexity (Albin 1982). Regarding the first of these, it might be argued that it is an example not really of complexity but rather of the closely related concept of complicatedness. Pryor’s argument boils down to arguing that the US economy is complex because an input-output matrix of it shows many links between sectors that one might not readily understand or know about. The US economy is complicated. But this is not what most definitions of complexity involve, which depend on something more happening, some sort of “the whole is greater than the sum of the parts” element, which can be argued to trace back as far as Aristotle.8 Israel (2005) argues that complicatedness is an epistemological concept rather than an ontological one, with the two terms coming from different etymological roots: complexity from the Latin complecti, “grasp, comprehend, or embrace,” and complicatedness from the Latin complicare, “fold, envelop.” Nevertheless, it must be noted that many have used the terms interchangeably, perhaps most important being Neumann (1966).9 Without doubt, the most important rival of dynamic complexity as an approach to economic complexity is computational complexity, and it has many advocates who argue that it is a superior approach because it is more well defined and precisely measurable (Markose 2005; Velupillai 2009). While dynamic complexity may allow one to distinguish the complex from the noncomplex, computational complexity approaches potentially allow one to measure degrees of complexity quantitatively. One problem for those advocating this approach is that there are many different definitions of it; it is the broad category that includes more of the forty-five definitions of Lloyd as candidates than any other broad category of complexity. All of these will not be discussed here, but note that they are covered in Rosser (2009). Many of them entail measures of how long a computer program will take to solve a problem, with the still-unsolved problem of whether or not polynomial computability is the same as exponential or nonpolynomial computability. Dating in economics to work by Albin (1982), hierarchies of computational complexity are invoked citing Wolfram’s (1984) work using linguistic hierarchies 7  While Hayek was only indirectly mathematical himself, Vriend (2002) sees him as a forerunner of modern agent-based computational economics. 8  “The totality is not, as it were, a mere heap, but the whole is something besides the parts.” Aristotle, Metaphysics, book H, 1054a, 8–10. 9  Indeed, it is probably the case that if one pushes the etymological origins further back to proto-Indo-European, the two Latin words will ultimately come from a common origin. Rosser (2004) argues that the epistemological problems associated with mere complicatedness are essentially trivial, simply a matter of figuring out parts and their linkages without any special interactions among these parts that ontologically alter the nature of the system.

Complexity and Austrian Economics    599 first postulated by Chomsky (1959).10 At the highest level of computational complexity are programs of infinite length, in short, ones that never solve the problem. Many of these involve do loops arising from self-referential paradoxes that are associated with the work in logic on incompleteness of Gödel, Church, Turing, and others from the 1930s. While such a mathematically focused view might seem antithetical to most Austrians, Hayek in particular, in fact, latched onto it, even if in a somewhat unrigorous way. He invoked Gödel (1931) in particular in The Sensory Order (Hayek 1952), which was based on his work in psychology from experiences doing medicine during World War I. The key to Gödel’s proof fundamentally involved the so-called diagonal method developed earlier by Georg Cantor (1883), which depends on self-referencing, although Hayek applied it to the idea of a mind knowing itself. Thus, we have Hayek (1952, 188–189) saying: Applying the same general principles to the human brain as an apparatus of classification it would appear to mean that, even though we may understand its modus operandi in general terms, or, in other words, possess an explanation of the principle on which it operates, we shall never, by any means possess an explanation of the principle on which it operates, we shall never, by any means of the same brain, be able to arrive at a detailed explanation of its working in particular circumstances, or be able to predict what the results of its operations will be. To achieve this would be to require a brain of a higher order of complexity, though it might still be built on the same principles. Such a brain might be able to explain what happens in our brain, but it would in turn be unable fully to explain its own operations, and so on.

Koppl (2009) argues that this led to Hayek’s advocacy of using verstehende psychology and ultimately a moderately hermeneutic approach to economics (Koppl and Whitman 2004). Koppl and Rosser (2002) cited Hayek’s invocation of Gödel’s result as providing a deeper entry into the socialist calculation debate by showing the impossibility of a fully knowing central planner. Such a planner would have to know not only the impact of its plans on the economy but also how those impacts would affect its own planning; that is, it would have to have a plan of its own planning in the way that a brain might attempt to understand its own thinking. The only way to overcome this impossibility because of incompleteness would be to have a higher-order planner, which would in turn face the same problem regarding its own planning, with this problem of knowledge being far profounder than those raised by Hayek (1945) in his more famous essay on the problems of knowledge in the economy, which were also relevant to the socialist calculation debate. 10  Note that Velupillai (2000) distinguishes between computational economics and his own neologized computable economics. Whereas the former studies essentially mechanical issues of how to make programs shorter or more efficient to solve given problems, the latter studies such deeper issues as the nature of computability and when problems are solvable at all.

600    Austrian Connections and Extensions This line of argument suggests an element of many forms of complexity that the advocates of computational complexity find problematical, even though it is deeply connected to their approach, particularly in the phenomenon of the highest forms of noncomputability derived from incompleteness:  emergence, something that Hayek (1967) was also deeply aware of and alluded to as a central issue in his essay on complex phenomena, with many other complexity theorists agreeing with him on this matter. However, even though Hayek adopted some of the computational complexity view, more recent advocates of it, such as Markose and Velupillai, argue that emergence is a poorly defined and vague concept and that its vagueness is part of why the more quantitatively precise and rigorous computational approaches are superior to the less well-defined dynamic and other complexity views. In turn, advocates of these other approaches invoke the role of emergence in evolution and other processes to defend its usefulness, and Hayek agrees with this, particularly later in his life (Caldwell 2004).

Austrian Complex Economic Emergence It can be argued that emergence is the central complexity concept in Austrian economics. In particular, the idea of the spontaneous emergence of order out of a decentralized but self-organizing economy is seen as a central theme coming down from the Scottish Enlightenment of David Hume, Adam Ferguson, and Adam Smith. This was indeed a foundational argument for the putative founder of the Austrian school, Menger. We have him declaring ([1883] 1985, 148) that the problem of exact research is to discover “how institutions which serve the common welfare and are extremely significant for its development come into being without a common will directed toward establishing them.” Vaughn (1994, 30) identifies among these “money, law, language, markets, the origin of communities, and of the state itself,” with the most famous example being Menger’s (1892) analysis of the emergence of the use of commodity money for transactions uses in primitive societies, thereby reducing the costs of barter. As we shall see below, this emphasis on such spontaneous emergence of order by Menger would be forgotten or downplayed by many of his immediate successors, but it would reappear in the work of Hayek (1948; 1967), who would increasingly stress it in the later years of his career. That Hayek identified emergence with complexity became clear in his essay on complex phenomena as exemplified by the following statement (Hayek 1967, 26): “The ‘emergence’ of ‘new’ patterns as a result of the increase in the number of elements between which simple relations exist, means that this larger structure as a whole will possess certain general or abstract features which will recur independently of the particular values of the individual data, so long as the general structure (e.g. by an algebraic equation) is preserved.” Hayek furthermore cited the long line of “emergentist” thinking that had been going on in Great Britain since the mid-nineteenth century, even as this thread had

Complexity and Austrian Economics    601 faded after the 1920s. While, as noted above, the roots of such ideas can be traced back as far as Aristotle, Hayek cited John Stuart Mill (1843) as posing it in what he labeled “heteropathic laws.” Mill saw such laws arising when qualitative changes occur in processes that seem to constitute wholes being greater than the sum of their parts.11 His initial example came from chemistry, in particular the  equation that shows how when methane is combined with oxygen, carbon dioxide and water emerge, a distinct transformation of one pair of entities into two quite different ones. Hayek would note that Mill influenced psychologist George Henry Lewes (1875, 412) to coin the term emergence, defining it as happening when “cooperation of unlike kinds” results in something for which “it cannot be reduced to their sum or difference.” Later, such irreducibility would be labeled strong emergence (Broad 1925), with a competing group supporting weak emergence, where the emphasis would be less on such irreducibility and more on the novelty appearing with the newly emergent form (Alexander 1920; Morgan 1923). Indeed, the 1920s would be the high-water mark of this British emergentist movement, with the strong emergentist group focusing more on the emergence of mind and the weak emergentist group, particularly C. Lloyd Morgan, focusing on the evolution of higher-order species over time. The 1930s would see a backlash against such thinking in both areas, as reductionist ideas associated with quantum mechanics and the neo-Darwinian synthesis in evolutionary theory would come to dominate (Rosser 2014). However, Hayek, with his interest in both psychology and evolution, remained strongly influenced by this movement, which was strong in Britain when he first arrived there in the 1920s. There is also a substantial literature in philosophy on the nature of emergence involving much debate over various aspects of it. This debate in recent times extends the earlier one over strong versus weak emergence, which really boils down to the question of the relationship between the higher-order emergent form and the parts from which it emerged, with the term supervention becoming central to the discussion (van Cleve 1990). This term implies both novelty and also the presence of downward causation from the higher emergent order to the lower level. Some are skeptical of this, such as Kim (1999), arguing that causation can only flow upward from the lower-level parts to the higher-level whole. However, Lewis (2012) argues that in his later writings, Hayek saw such downward causation as possible, with the example of the emergence of money as a leading example. Once money emerges in an economy, its presence alters the behavior of the agents and entities operating at the lower micro-levels of the economy. As it is, the harder-line skeptics tend to accept emergence as happening in connection with mind, which, as we know, was a central concern of Hayek’s in The Sensory Order. 11  Lewis (2012) sees Mill’s view as close to that of Hegel (1842), who spoke of quantitative changes bringing about qualitative changes, with the changing of the states of water at different temperatures the canonical example, such changes now being labeled phase transitions in modern chemistry and physics. See also Rosser (2012) for further discussion.

602    Austrian Connections and Extensions

The Struggle over Complex Emergence in Menger’s Work To the extent that the debate over the role of complex emergence is an important issue in Austrian economics, this debate can be found within Menger’s own work, though not posed as a debate. Rather, it is more a matter of him taking one position in one part of his writing and another position in another part of his writing that he himself may not have seen as being in conflict. It may be only by looking back that we see this possible conflict within his work. In any case, his views on this subject played a role in his importance and his work being downplayed and even shoved aside later in his career, as those not so open to this perspective came to dominate the discussions in Austrian economics, with the ultimate manifestation of this being the almost embarrassing decision by Hayek not to reprint the posthumously published second edition of Menger’s Grundsätze der Volkwirtschafslehre (1923), with only the first edition ([1871] 1981) being translated into English as Principles of Economics (so far).12 The irony here is that Hayek himself would follow a somewhat similar path, moving from the more orthodox position that had come to dominate Austrian economics in the 1920s to a position more like Menger’s, arguably even more so eventually. That Menger played an important role in the development of marginalist neoclassical economics cannot be disputed, even if many will argue that this side of him was not the “real” Menger. The standard view is that the “neoclassical revolution,” emphasizing optimizing marginalism within an equilibrium framework, was created in the 1870s by three people—Léon Walras in the French-language tradition, William Stanley Jevons in the English-language tradition, and Menger in the German-language tradition—and there is much truth to this. Indeed, while this diminishes Menger’s role somewhat, Streissler (2001) has argued that Menger represented the culmination of a proto-neoclassical tradition that had been developing for at least thirty years in Germany, as represented by such figures as Karl Heinrich Rau, Wilhelm Roscher, and Hermann Gossen,13 which would be crushed in Germany after the political unification in 1870, following which the German historical school led by Schmoller would come to dominate and contest with the Austrian school led by Menger. Despite this, Streissler agrees with those who view Menger even in that period as being an “incomplete neoclassical,” with a more 12  For discussion of the treatment of Menger’s second edition, see Becchio (2014a; 2014b). She notes that Karl Polanyi (1971) complained about this decision of Hayek’s, charging almost a conspiracy theory to silence Menger’s views, although she argues that Polanyi misinterprets Menger as wanting to embed economics into a broader social-historical perspective that would have gone further than Menger’s view. 13  Rau would be the first to draw supply-and-demand curves in a space with price on the vertical axis, as is done within the English-language tradition following Marshall. Roscher is often viewed as Schmoller’s predecessor in the historical school, but he had a more independent perspective, including personal friendship with Menger. Gossen independently developed the theory of marginal utility in 1854, but apparently Menger was unaware of this work when he developed his own version of it.

Complexity and Austrian Economics    603 complicated and historically oriented view than the more theoretical Walras and Jevons, despite his identification with the theoretical perspective during the Methodenstreit between him and Schmoller in the 1880s and later.14 In any case, Menger certainly had his neoclassical credentials and readily used equilibrium analysis in connection with his development of his version of the theory of marginal utility, which also became the foundation of the later emphasis on supremacy of subjectivism among Austrian economists. Thus, he wrote of prices as “symptoms of an economic equilibrium between the economies of individuals” (Menger [1871] 1981, 191). His emphasis on equilibrium, even in the midst of dynamic historical processes involving technological change and the invention of new products, can be seen in the following (188): The foundations for economic exchanges are constantly changing, and we therefore observe the phenomenon of a perpetual succession of exchange transactions. But even in this chain of transactions we can, by observing closely, find points of rest at particular times, for particular persons, and with particular kinds of goods. At these points of rest, no exchange of goods takes place because an economic limit to exchange had already been reached.

While this fits with many views of equilibrium, it can be contrasted with that of Walras (1874), in that for Menger, transactions and activity actually occur out of equilibrium and come to a halt when equilibrium is reached, whereas for Walras, nothing happens until the auctioneer gets prices to their equilibrium levels (and a general equilibrium at that of all markets) through repeated rounds of tâtonnement. For Menger, the economy is a dynamic process mostly out of equilibrium, whereas for Walras, it is in equilibrium that the most important economic activities occur. In addition to his development of marginal utility theory and his occasional use of the equilibrium concept, Vaughn (1994, 14)  argues that Menger laid the theoretical groundwork for his follower, Wieser (1884), to develop the concept of opportunity cost, one of the most recognized of Austrian contributions to standard neoclassical theory. Furthermore, he is seen as having provided a foundation for determining imputed factor prices. Certainly, Menger deserves his position in the neoclassical pantheon, particularly after his defense of theory in the Methodenstreit. In any case, the conventional history of thought view of Menger exaggerates this side of him while ignoring his non-neoclassical side, the side that influences current Austrian economics. Careful examination of the Methodenstreit shows that Menger was much closer to the German historical school in his views in more ways than has been thought (Vaughn 1994; Caldwell 2004; Becchio 2014a; 2014b). He had dedicated his Principles ([1871] 1981) to his friend Roscher, the founder of the “old German Historical School,” and he viewed his work as providing organizational principles for studying 14 

There was a political element to this conflict as a result of the continuing independence of Austria from Germany, with Schmoller coining the label Austrian school initially as a term of contempt.

604    Austrian Connections and Extensions historical processes. Besides being political after the unification of Germany, the conflict appears to have been intensely personal, with Menger hoping to find the good relations with Schmoller, the successor to Roscher, that he had had with Roscher, only to be disappointed in this, with Menger and Schmoller emphasizing their differences after the conflict exploded in the 1880s. Later followers of Menger such as Hayek would tend to focus on the differences in the conflict rather than the many areas of agreement between Menger and Schmoller. While Menger did indeed emphasize methodological individualism, he also recognized a role for groups in the historical process, with this arising from his subjectivist analysis of needs, which was tied to his advocacy of marginal utility theory. This recognition of the role of groups became stronger as Menger aged and appeared more clearly in the semisuppressed second edition of his Principles. Becchio (2014a) particularly emphasizes how an expanded view of needs led Menger to recognize two different categories beyond strictly individualistic needs. One of these was collective goods (“Gemeinbedüfnisse”), such as transportation infrastructure. Such needs still came from individuals themselves but in the form of adding up individual demands with some scale issue that involves production not by an individual. This was already present in his early work. However, in Menger’s second edition, he extended this by introducing “human associations” that could, as groups, have needs that had to be provided to the association as a whole that could even have an independent life (“ein selbständiges Leben”) with their own personality (“Eigene Persönlichkeit”) following their own purposes (“Eigene Zwecke”) (Menger 1923, 9). These human associations could take the form of “societies, associations, corporations, communities, and the State, of the national or global economy” (“Gesellschaften, Genossenschaften, Korporationen, Gemeinden, Staat, Volks- und Weltwirtschaft”) (7). Furthermore, as argued by Becchio (2014b), in this second edition, Menger introduced evolutionary arguments drawing on both the work of Herbert Spencer (1867–1874) and the emergentist arguments popular in the 1920s, although he tended to go back to Mill’s (1843) formulation in terms of heteropathic laws. Nevertheless, in this final work, Menger posed his view of the spontaneous emergence of order in terms of evolutionary emergence that included the possibility of such processes occurring for social groups or associations along with just individuals. It is not surprising, then, that Hayek in his early career was not eager to publicize such views, even as he arguably moved toward them himself later in his life, in that regard following Menger’s path.

The Debate after Menger While Menger would move more toward a position supporting ideas of evolution of institutions and associations that spontaneously emerge from lower-level structures, the generation of Austrian economists after him tended to move in the opposite direction, toward emphasizing the marginalist neoclassical equilibrium side of the founder of the Austrian

Complexity and Austrian Economics    605 school’s work.15 The leaders of the next wave of Austrians were Wieser and Böhm-Bawerk. Of the two, Wieser adopted more of the dynamic emergent views of Menger than did Böhm-Bawerk. A  part of Menger’s vision was of economic progress manifesting itself through increasing division of labor associated with newer and more complicated products. Wieser picked up on this and highlighted the role of the entrepreneur in this process, an emphasis that was then picked up by two of his most important students, Schumpeter and Mises, and continues to the present as a major theme of Austrian economics. Wieser was also a deep student of evolutionist Herbert Spencer, as was the older Menger. On the other hand, Wieser may have been the most important figure emphasizing and codifying the association between Menger and the neoclassical school in the eyes of most observers. He was the person who coined the term marginal utility (in German, Grenznutzen). He formalized the concept of opportunity cost and also explicitly drew out the imputation of factor values implicit in the analysis of Menger. He identified Menger with the other founders of neoclassical marginalism, Walras and Jevons, also bringing in Gossen, while arguing that Menger’s version of the idea and of equilibrium was superior to theirs because of his developing it verbally rather than mathematically, thus advancing the antimathematical tradition within the Austrian tradition (Menger [1883] 1985). He would also introduce the theme of information and the need for market-determined prices as part of a critique of the possibility of socialist planning (Wieser, [1914] 1927). Indeed, he may have been more responsible than anyone else for establishing Menger’s reputation as an orthodox marginalist neoclassical economist. Wieser’s brother-in-law, Böhm-Bawerk, would become perhaps the most resolutely orthodox of all leading Austrian economists, even causing Menger to complain about some of his ideas, such as his reintroduction of Ricardian elements in his theory of capital and interest (Schumpeter 1954, 847). He developed a theory of essentially homogeneous capital associated with his average period of production measure as a measure of capital (Böhm-Bawerk [1888] 1959), which would lead to Hayek’s (1941) critique of him in The Pure Theory of Capital.16 This argument would form the basis of his critique of the Marxian argument that capital is not an independent source of value (Böhm-Bawerk [1896] 1949), along with a subjectivist emphasis on the importance of marginal utility in the determination of value. He would also assert the neoclassical credentials of Menger, and this observer can find nothing in his work that can be identified with a complexity perspective at all. He was the most neoclassical of all Austrian economists, and his influence would remain strong among the followers of the school for a long time after his death in 1914. The leader of the next generation of Austrians, Mises, would move back toward being somewhere between the conventional equilibrium perspective and the dynamic

15  For a discussion of just how marginalist the early Austrians were, see Streissler (1972), who, perhaps appropriately enough, long held the Carl Menger Chair in Economics at the University of Vienna. 16  In this critique, Hayek noted the problems arising for this measure in a world of heterogeneous capital, with some of these problems foreshadowing the later critiques made during the Cambridge controversies in the theory of capital (Harcourt 1972), with Garrison (2001) following up on these issues within an Austrian framework.

606    Austrian Connections and Extensions complexity view. He would remain under the neoclassical influence of the previous generation of Austrian economists, initially expressed in his Money and Credit ([1912] 1980), but he moved somewhat away from it in later works such as Socialism ([1922] 1981) and Human Action (1966). Two aspects of Mises’s thinking remained more neoclassical. One was his continued adherence to an equilibrium approach, and the other was his adherence to a subjectivist and rationalist apriorism, a point that Hayek would later draw away from when he moved more into an approach of evolutionary emergent complexity. Mises posited three different forms of equilibrium: a “plain state of rest,” essentially very short-run; a “final state of rest,” toward which an economy without shocks would tend to converge in the long run; and the essentially steady-state “evenly rotating economy” (Vaughn 1994, 81–82). However, it must be noted that for Mises, with the possible exception of the first, these were essentially imaginary theoretical constructs that do not occur in the real-world economy. This would be because in the real world, the market process is dominated by the ongoing dynamics induced by entrepreneurs, following on the influence of Wieser and continuing in such followers as Kirzner (1973; 1985). His strongest assertions of the importance of the dynamic market process driven by technologically innovative entrepreneurs arose from his role in the socialist calculation debate. While his initial essay on the topic (Mises [1920] 1935) arguably emphasized static equilibrium arguments in its emphasis on the inability of the central socialist planner to be able to determine efficient equilibrium prices without private markets, his expanded arguments in his book Socialism (Mises [1922] 1981) highlighted this more dynamic issue, emphasizing the technological dynamism of market capitalism driven by entrepreneurs and “speculators” in contrast with a tendency toward stagnation inherent in a centrally planned socialist economy that lacked the profit incentive arising from private ownership of the means of production. As Mises ([1922] 1981, 142) put it: “To assume stationary economic conditions is a theoretical expedient and not an attempt to describe reality.” Nevertheless, in contrast with Hayek and many later Austrian economists, he never stressed such concepts as the spontaneous emergence of order or evolutionary processes, with these implicit in the dynamics of the competitive market process as emphasized by Kirzner.

Hayek’s Journey and the Later Development of Austrian Complexity Views To a substantial degree, we have already laid out the general pattern of Hayek’s trajectory of thought on this matter, as documented definitively by Caldwell (2004), from an early more neoclassical position following the early Mises in such works as Monetary Theory

Complexity and Austrian Economics    607 and the Trade Cycle (Hayek [1933] 1966) through later works that would emphasize the spontaneous emergence of order, such as Individualism and Economic Order (Hayek 1948), to those emphasizing the role of evolution, even at the group level, such his final work, The Fatal Conceit (1988). We have already noted in this regard the irony of Hayek’s having helped suppress the second edition of Menger’s Principles early in his career, only to move toward that view in the later stages of his career. There remains an unresolved debate regarding the extent to which Hayek’s change of views was gradual or constituted a sharp break, with Birner (1994) arguing for the first view and Hutchison (1992) the second. Caldwell (2004) comes down somewhere in between, accepting that there was indeed a “U-turn” in Hayek’s views but that he only gradually developed this over time. Its first appearance was in “Economics and Knowledge” (published only in Hayek 1948), a part of his contribution to the socialist calculation debate, which contained an implicit criticism of the apriorism of Mises. As noted earlier, Hayek’s ideas on emergent complexity gradually emerged from his 1948 book through his 1952 The Sensory Order, reaching a clear explication in his 1967 essay on complexity. His views on evolution, particularly at the group level, developed somewhat more slowly (Hayek 1979). It is thus somewhat curious that one of the last ideas of the old neoclassical orthodoxy that he let go of was that of equilibrium, really only doing so in a little-known essay in 1981. There, we have the following strong statement (Hayek 1981, 8): It is tempting to describe as an “equilibrium” an ideal state of affairs in which the intentions of all participants precisely match and each will find a partner willing to enter into the intended transaction. But for all capitalistic production there must exist a considerable interval of time between the beginning of a process and its various later stages. The achievement of an equilibrium is strictly impossible. Indeed, in a literal sense, a stream can never be in equilibrium, because it is disequilibrium which keeps it flowing and determines its directions. Even an apparent momentary state of balance in which everybody succeeds in selling or buying what he intended, may be inherently unrepeatable, irrespective of any change in the external data, because some of the constituents of the stream will be the results of past conditions which have changed long ago.

Given Hayek’s ultimate prominence in Austrian economics, particularly following his receipt of the Nobel Prize in 1974, his views on these matters have led to an enormous amount of influence on current views among Austrian economists across most of the divides that exist within the school over the role of government, degrees of subjectivism, and apriorism. Even as many continue to emphasize the importance of rationality and equilibrium efficiency—such as Boettke (2012), who emphasizes the continuity he sees in the “mainline” of economics stretching from the Scottish Enlightenment to the modern Austrian school through a considerable number of strongly neoclassical economists in between—others have attempted to construct an economics of complex market processes, even if they do not go along fully with all of the evolutionary ideas that one

608    Austrian Connections and Extensions finds in the later work of Menger and Hayek. Those adopting such a view, at least partly under the influence of Hayek, arguably include Shackle (1972), Loasby (1976), O’Driscoll and Rizzo (1985), Lachmann (1986), Lavoie (1989; 1990), Horwitz (1992), Vaughn (1999), Koppl (2006; 2009), and Wagner (2010). At least to some degree, the idea of complex emergence in some form or other has entered deeply into the corpus of modern Austrian economic thought.

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Complexity and Austrian Economics    611 Rosser, J. Barkley, Jr. 2012. “Emergence and Complexity in Austrian Economics.” Journal of Economic Behavior and Organization 81: 122–128. Rosser, J.  Barkley, Jr. 2014. “Natural Selection versus Emergent Self-Organization in Evolutionary Political Economy.” Advances in Austrian Economics 18: 67–91. Schelling, Thomas C. 1971. “Dynamic Models of Segregation.” Journal of Mathematical Sociology 1: 143–186. Schumpeter, Joseph A. (1911) 1934. The Theory of Economic Development, translated by Redvers Opie. Cambridge, MA: Harvard University Press. Schumpeter, Joseph A. 1954. History of Economic Analysis. New York: Oxford University Press. Shackle, G.  L. S. 1972. Epistemics and Economics:  A  Critique of Economic Doctrines. Cambridge: Cambridge University Press. Simon, Herbert A. 1962. “The Architecture of Complexity.” Proceedings of the American Philosophical Society 106: 467–482. Spencer, Herbert. 1867–1874. Descriptive Sociology: Encyclopedia of Social Facts, Representing the Constitution of Every Type and Grade of Human Society, Past and Present, Stationary and Progressive, Classified and Tabulated for Easy Comparison and Convenient Studies of the Relations of Social Phenomena. London: Williams and Norgate. Streissler, Erich W. 1972. “To What Extent Was the Austrian School Marginalist?” History of Political Economy 4: 426–441. Streissler, Erich W. 2001. “Rau, Hermann and Roscher: Contributions of German Economics around the Middle of the Nineteenth Century.” European Journal of the History of Economic Thought 8: 311–333. Vaughn, Karen I. 1994. Austrian Economics in America:  The Migration of a Tradition. Cambridge: Cambridge University Press. Vaughn, Karen I. 1999. “Hayek’s Thought and Market Order as an Instance of the Theory of Complex Adaptive Systems.” Journal des économistes et des études humaines 9: 241–246. Velupillai, K. V. 2000. Computable Economics. Oxford: Oxford University Press. Velupillai, K. V. 2009. “A Computable Economist’s Perspective on Computational Complexity.” In Handbook of Complexity Research, edited by J. B.  Rosser, Jr., 36–83. Cheltenham, UK: Edward Elgar. Velupillai, K.  V. 2011. “Nonlinear Dynamics, Complexity, and Randomness:  Algorithmic Foundations.” Journal of Economic Surveys 25: 547–568. Vriend, Nicolass J. 2002. “Was Hayek an Ace?” Southern Economic Journal 68: 811–840. Wagner, Richard E. 2010. Mind, Society, and Human Action. New York: Routledge. Walras, Léon. 1874. Élements d’économie pure. Lausanne, Switzerland: L. Corbet. Weaver, Warren. 1948. “Science and Complexity.” American Scientist 36: 536–549. Wiener, Norbert. 1948. Cybernetics:  Or Control and Communication in the Animal and Machine. Cambridge, MA: MIT Press. Wieser, Friedrich von. 1884. Über den Ursprung und die Hauptgestze des Wirtschaftlen Werthes. Vienna: Hölder. Wieser, Friedrich von. (1914) 1927. Social Economics, translated by A. Ford Hinichs. New York: Adelphi. Wolfram, Stephen. 1984. “Universality and Complexity in Cellular Automata.” Physica D 10: 1–35.

Chapter 28

The Sen sory Orde r , Neu roec onomi c s , a nd Austrian E c onomi c s William N. Butos and Thomas J. McQuade

Introduction The distinctive flavor of modern Austrian economics was forged in the debate over the feasibility of socialism.1 An important line of thought that emerged from that interwar argument concerned the character and role of knowledge in social interaction, and this found its culmination in Friedrich Hayek’s characterization of the price system as a vehicle for rendering dispersed and tacit knowledge widely available. Early on, as seen in “Economics and Knowledge”, Hayek ([1937] 1948) understood that an economic system’s ability to function as a milieu in which significant coordination of the plans of individuals is possible hinged, as he put it, on “the nature of the process by which individual knowledge is changed” (45).2 And central to that process, he noted, is the role of the price system in communicating relevant knowledge to economic actors and hence serving as a system-level equilibrating mechanism. These are fertile observations, for it is immediately obvious that individuals are cognitive entities, capable not just of responding to external information, whether in the form of price signals or other events, but of formulating conjectures about future states of the world and adapting their behavior accordingly. Understanding the structure 1 

As Boettke (2002) put it, “it is the epistemic-cognitive turn that the Austrian school took in the wake of the socialist calculation debate that separates the school from other branches of neo-classicism within economic science that constitutes its best case for analytical uniqueness.” Also see Kirzner (1992, chap. 6) on the centrality of the calculation debate in separating Austrians from the direction and content of neoclassical economics. 2 Hayek ([1937] 1948, 45) also highlights “the conditions under which this tendency [toward plan coordination] is supposed to exist.”. See also Kirzner (2000, chap. 10).

The Sensory Order and Neuroeconomics    613 of the entity doing the learning and the process by which that learning takes place becomes a relevant consideration. And Hayek himself provided major steps toward that understanding. Hayek’s The Sensory Order (1952b) proposed a theory of mind that describes in general terms how an individual’s knowledge of its environment can be instantiated in a neuronal network. That he, one of the world’s leading monetary economists and social thinkers, would undertake a monograph in cognitive psychology in his early fifties was not altogether surprising, as it was preceded by a student paper written in 1920 that partly but in important ways anticipated his later work and also by occasional remarks and hints in his “scientism” essays from the 1940s (later published as The Counter-Revolution of Science, Hayek 1952a).3 After the publication of The Sensory Order, Hayek continued to publish various papers based on his cognitive theories, principally geared toward epistemological and methodological questions.4 In Law, Legislation and Liberty (1979), Hayek candidly (and probably correctly) noted that his “colleagues in the social sciences generally find [The Sensory Order] uninteresting and indigestible.” He went on to mention, however, that this work “helped me greatly to clear my mind on so much that is relevant to social theory” and that “my conception of evolution, of a spontaneous order and of the methods and limits of our endeavors to explain complex phenomena have been formed largely in the course of the work on that book” (199, n. 26). Hayek was still citing The Sensory Order in his last book, The Fatal Conceit (1988). Hayek’s work in cognitive theory went unnoticed, although his award of the Nobel Prize in economics in 1974 helped induce a resurgence of interest around the world in his economics and broader social theory. Yet it was cognitive psychologist Walter B. Weimer who should be chiefly credited with bringing Hayek’s theory of mind before a larger audience and making the case for its wider significance for economics and social theory generally.5 Beginning in the mid-1970s, Weimer (1979) started using and developing the ideas in The Sensory Order for his work in cognitive science and the methodology of scientific research. Coming from a background in the philosophy of science, he was especially influenced by W. W. Bartley’s The Retreat to Commitment ([1962] 1984) and Thomas Kuhn’s The Structure of Scientific Revolutions (1970), and he saw Hayek’s work in cognitive science, constraints on knowledge, and spontaneous order as compatible with Bartley’s epistemological stance on “comprehensively critical rationalism” and Kuhn’s evolutionary theory of science. In 1981, Weimer organized a cognitive science conference at Penn State University that featured Hayek as the principal speaker, and Weimer’s (1982) own address to that conference presented the case for the significance of Hayek’s

3 

For example, in Hayek 1952a, 58: “The structure of men’s minds, the common principle on which they classify external events, provides us with the knowledge of the recurrent elements of which different social structures are built up and in terms of which we can alone describe and explain them.” 4  See “Rules, Perception, and Intelligibility,” “Notes on the Evolution of Systems of Rules and Conduct,” and “Kinds of Rationalism,” in Hayek (1967), and “The Primacy of the Abstract,” in Hayek (1978). 5  See Weimer (2011). Agonito (1975) is perhaps the first article-length treatment of The Sensory Order.

614    Austrian Connections and Extensions cognitive psychology for the social sciences. This paper became the preeminent, and for several years the only useful, entry point to The Sensory Order. From the early 1980s to the early 1990s, interest in Hayek’s cognitive theory was generally muted, and among economists it was largely absent. Aside from Weimer’s continued work, several authors drew attention to Hayek’s cognitive theory, including political philosopher John Gray in Hayek on Liberty (1984) and notable neurophysiologists Gerald Edelman (1982; 1985) and Joaquin Fuster (1995; 2011), who connected their work in evolutionary neurophysiology to Hayek. Among economists, Leland Yeager seems to have been the first to seriously apply Hayek’s writings on cognitive psychology to economics. In a short paper, Yeager (1984, 2) sought to establish the proposition that “appreciating Hayek’s work in economics and political science requires knowing of his interest in psychology.” Yeager centered his attention on The Road to Serfdom, connecting the “insights of ‘literary’ psychology” found in The Sensory Order with Hayek’s treatment of “the influence of beliefs and attitudes” in The Road to Serfdom (3). While Yeager’s discussion of The Sensory Order is an excellent introduction—and all the more remarkable given its brevity—the overall cast of the paper set the tone for the subsequent development of the secondary social-science literature spawned by The Sensory Order. The questions asked were: (1) In what ways does Hayek’s cognitive theory fit with his oeuvre and with Austrian economics in general? (2) Do we need The Sensory Order at all to do our social science, and how does it make a difference in providing insight toward understanding the social realm? Following the first line of inquiry, Gray (1984) connected Hayek’s cognitive theory with Hayek’s overall project of the role and character of knowledge in social theory. This theme was also studied by Manfred Streit (1993), who, in a regrettably neglected paper, provided an extended overview of Hayek’s work in epistemology as presented in The Sensory Order. Streit argued that Hayek’s cognitive theory is relevant for understanding Hayek’s economic and social theories, citing the role of cognitively grounded subjectivity, limitations on individual knowledge, and the significance of tacit (or unconscious) knowledge in generating connections between the mental and social orders. He maintained that these elements from Hayek’s cognitive theory provide central ideas with which it is possible to construct a theoretically coherent Hayekian social theory. Streit’s argument received support from Horwitz (2000) in “From The Sensory Order to the Liberal Order,” which developed the implications of constrained knowledge from Hayek’s cognitive theory to argue for constitutional rules in delimiting government intervention into emergent social institutions. A distinct line of thought, but still within the category of squaring Hayek’s psychology with his economics, is represented by Jack Birner (1999), who held that Hayek’s methodology in economics with respect to subjectivism, individualism, compositive method, and pattern prediction could be constructed from his cognitive theory. Birner argued that Hayek’s cognitive theory was decisive for his methodology but played no role in his economics. In fact, Birner (1999, 78) claimed that because Hayek’s cognitive theory is physicalist and reductionist, it actually “undermines his entire system of thought, except, perhaps his economics, which did not

The Sensory Order and Neuroeconomics    615 undergo its influence.”6 Bruce Caldwell (2004) also saw little scope for Hayek’s psychology in economics, arguing that its principal attractions are largely confined to methodological insights regarding “pattern prediction” and “explanation of the principle,” derived from the “limits to knowledge” argument and what Caldwell referred to as his “Abuse of Reason Project.” According to Caldwell (2004, 361–362), the evolution of Hayek’s thinking on methodology led him to reject the Misesian position on methodological dualism that upholds the dichotomy of natural science and social science and to adopt instead a methodological dichotomy between simple and complex phenomena, a claim Koppl (2006b, 289) vigorously disputed on the grounds that complexity theory did not offer Hayek “a path out of methodological dualism and into science, but a scientific defense of methodological dualism.” More recently, Di Iorio (2010) argued that The Sensory Order constituted a defense of methodological individualism, as opposed to methodological holism, by virtue of its nondeterministic theory of decision-making. Since individual action and the meanings the individual treats as knowledge are inseparable, deterministic models of action are untenable and must give way to a subjectivism that treats the mind as a complexly organized system. Unlike Caldwell, Di Iorio held that this very complexity requires an interpretative approach. However, what Di Iorio termed “methodological individualism” would be more true to Hayek if characterized as “methodological interactionism,” thereby explicitly acknowledging the influences of social and institutional factors, as Lewis (2012) points out. The second line of inquiry, one followed by economists who believe that Hayek’s cognitive theory provides insights that extend our understanding of the social realm, has also been given considerable attention. Butos and Koppl (1993) generated a theory of “Hayekian economic expectations” that are coherent, competitive, and self-correcting. They based these expectations on The Sensory Order’s treatment of learning and the individual’s capacity to formulate conjectures and self-corrective routines as adaptations to the external environment. The thrust of this and related subsequent research (see, e.g., Butos and Koppl 1997)  was to demonstrate that a judicious application of insights gleaned from Hayek’s cognitive theory could be useful in addressing questions and issues in economics. Also in this second category is an important line of research that aims to extend social theory by building on Hayek’s cognitive theory, especially with respect to the systemic implications of evolution and self-organization. McQuade (2007, 58), for example, saw The Sensory Order as providing a “prototypical description of an adaptive classifying system” useful for understanding the social arrangements of science and market. The key point of intersection is that both the brain and other adaptive systems, such as science and the market, “implement a classifying process” as an emergent product of the “interactions between their components” that induce “adaptive reactions of the system as a whole” (59). Also, Horwitz (2010) applied Hayek’s theory of learning contained 6  We think that Birner is mistaken on this point. Hayek’s reduction of mental processes to the interaction of neurons does not eliminate the emergent knowledge that is generated, a phenomenon that cannot be reduced to physical terms. See Lewis (2012) on the distinction between explanatory and eliminative reduction.

616    Austrian Connections and Extensions in The Sensory Order to explain how firms adapt via positive and negative feedback to changes in their environment. Although, as we have seen, Hayek’s work was slow to catch on among social scientists, since the 1980s and especially the 1990s, it has generated considerable interest among many scholars and economists. Most Hayek scholars now accept the importance of his cognitive theory as integral to Hayek’s oeuvre. Hayek himself tended to highlight the significance of this work for issues in methodology, a direction that has been enthusiastically picked up by contemporary methodologists, as noted earlier. Hayek, however, was less clear in making an argument that his work in psychology might be germane to nonmethodological questions in social theory. Although various attempts, as noted above, have examined whether his cognitive theory carries in its own right useful applications to economics and social theory, Hayek did not undertake such inquiries directly, except to obliquely note in The Fatal Conceit (1988) that his cognitive work was important for the development of his ideas on evolution and spontaneous order. Hayek’s hesitancy to claim too much might have been a sensibility induced by the long-standing aversion within the Austrian school to psychological explanations for the praxeological science of economics, as articulated by Ludwig von Mises (1966, 11–12; [1957] 1967, chap. 12). In The Counter-Revolution of Science Hayek (1952a, 39) argued that “it is a mistake” for social scientists “to believe that their aim is to explain conscious behavior,” which he saw as “the task of psychology.”7 It may be that once we move beyond methodological issues, an unmistakable tension arises from within Hayek himself regarding the value of his cognitive theories for economic and social theory. The deeper of Yeager’s questions, then, and the one that has generated the most discussion, is this question of the relevance and usefulness of cognitive theory—and of considerations about the structure and functioning of the human mind in general—for economics. We see the following complementary avenues of attack here: • The experimental approach of neuroeconomics, in which brain-scanning techniques are used to investigate the types of mental activity that occur during economic transactions. • Two distinct theoretical approaches, both inspired by the Hayekian model of mind as an adaptive system: a. One focusing on the actions of individuals as adaptive responses to external environments, responses tempered by learning and therefore capable of exhibiting novelty. 7 

The point of Mises’s and Hayek’s antipsychologism was to isolate from economics underlying psychological motivations. We do not disagree with this. At the same time, however, we believe that Hayek’s work in this area goes well beyond such concerns, precisely because it deals with epistemic issues relevant to social theory and a variety of methodological insights that clearly fall within the purview of modern economics. Runde (1988, 107), in an otherwise useful overview of the status of psychology in Austrian economics, surprisingly asserts that “Hayek’s psychological treatise … has little to do with economics,” although he astutely notes that the aversion to psychology by Mises and Hayek is, in fact, directed at behavioristic psychology. Also see Butos (1997) and Butos and Koppl (2007, n. 22).

The Sensory Order and Neuroeconomics    617 b. The other seeing complexes of human interaction as adaptive systems, focused on helping us to understand economic and other social phenomena at the systemic level. In all of these contexts, from the individual to social systems, the central idea from Hayek’s cognitive work is that knowledge is instantiated in a classification that the system in question generates, whether that is reckoned as conjectures and expectations of individuals or as system-level knowledge that transactions between individuals generate in the course of their interactions, including market prices, scientific consensus, social conventions, language, and other emergent system-specific products. It should be clearly understood that conflating economics with psychology is not what the literature in this area calls for or even supports. Rather, by drawing out the ramifications from both Hayek’s work on epistemology and psychology and the ongoing experimental investigations of individual economic behavior, we can point to the possibility of a coherent new view of economic and other social systems in which individuals have realistic capabilities, where emergent effects are recognized as macro-phenomena that supervene on micro-activity rather than being simply reducible to it, and where systemic characteristics such as adaptation and knowledge generation are given their due.

The Sensory Order Social scientists encountering The Sensory Order for the first time may be put off by its seeming obtuseness and may also question its connection to social theory. It is formidable and difficult, attributes that have very likely inhibited it from attaining a broader appeal and may, in part, explain why it has failed to fully penetrate social-science research. During the past several years, however, a large number of Hayek scholars have provided detailed expositions of The Sensory Order that would allow social scientists to easily access and extract the insights germane to social theory that we believe Hayek’s cognitive theory is capable of yielding. In what follows, we shall merely provide an overview of Hayek’s cognitive theory and suggest that readers seeking further expositions consult Hayek’s original work or sources cited below.8 Weimer (1982, 263) argued that throughout Hayek’s oeuvre, a central theme is “how knowledge is manifested in phenomena of organized complexity.” This theme and its application to foundational questions in economics are already evident in Hayek’s early essays during the 1930s, including those specifically penned in the context of the debate on socialist calculation (Hayek 1935). For example, in “The Trend of Economic Thinking” (1933, 129), Hayek held that economics has shown that the “co-ordination of individual efforts in society is not the product of deliberate planning” but that “an immensely 8 

See Weimer (1982), Butos and Koppl (1997; 2007), McQuade and Butos (2005), McQuade (2007), Steele (2007, chap. 2).

618    Austrian Connections and Extensions complicated mechanism existed, worked, and solved problems, frequently by means [which] could not possibly be the result of deliberate regulation because nobody understood them.” Reminiscent of Carl Menger ( [1870] 1950; [1883] 1963, 127–160) and presaging his own later work, Hayek observed that the functions of the economic process “are discharged by spontaneous institutions” (1933, 129) that form part of a “higher organized system” that is best recognized as an “organism and not an organization” (130). A few years later, in “Economics and Knowledge,” he turned his attention to knowledge problems, noting that the tendency toward market equilibrium requires “the expectations of the people and particularly of the entrepreneurs will become more and more correct” ([1937] 1948, 45). Yet he observed that “we are still pretty much in the dark” about two central questions: “the conditions under which this tendency is supposed to exist” and “the nature of the process by which individual knowledge is changed” (45; emphasis in original). Hayek’s interest in epistemic questions, which was to reach its most complete statement in The Sensory Order, was not a new path but a return to questions that he had grappled with since his student days. At the most general level, The Sensory Order provides an account of cognitive processes by which an individual forms an interpretation of reality and makes inferences about reality. The question that led Hayek to write The Sensory Order was the same one he addressed in “Contributions to a Theory of How Consciousness Develops” (1920)9 as a university student: what is mind? In both works, he argued that mental phenomena, including consciousness and emotions, are byproducts of physiological neuronal processes, thus reorienting analysis away from “psychic processes” and toward “a determination of the relationships within which interventions into the organism take place” (Hayek 1920, 1). His central claim is that “the genesis of the qualitatively different sensations can be adduced from experience” (1). Both of these insights—the physiological basis of cognitive activity and the claim that mental phenomena rely on prior experience—formed the basis for his more mature statement in The Sensory Order, where he announced his principal thesis: “we do not first have sensations which are then preserved by memory, but it is the result of physiological memory that the physiological impulses are converted into sensations. The connexions between the physiological elements are thus the primary phenomenon which creates the mental phenomena” (Hayek 1952b, 53). From this starting point, Hayek built a theory that describes the mental realm as a complexly organized system that transforms sensory inputs into an interpretation of reality. It is a theory of a self-organizing system capable of generating knowledge geared toward the adjustment of actions to the environment in which the individual functions or may encounter. This positions Hayek’s theory of cognitive functioning as instantiating an emergent adaptive system (McQuade 2007), which speaks both to the modernity of The Sensory Order and to its possible generalizability to other self-organizing emergent systems within the social realm. 9 

We thank the estate of F. A. Hayek for granting permission to quote from his 1920 paper and Professor Bruce Caldwell for making the manuscript available.

The Sensory Order and Neuroeconomics    619 Hayek’s theory of mind provides an explanation of the way in which two different orders, the objective external environment and the subjective one constructed by the individual’s cognitive functioning, are reconciled or brought into some sort of correspondence by the individual. Yet in Hayek’s theory, the transformation of sensory inputs into knowledge about reality is wholly a function of a classification that the brain performs on sensory impulses; consequently, there is no presumption that this classification refers to any intrinsic properties of the external reality. In short, Hayek understood mind as a process that renders sensory impulses intelligible to the individual by the organization and memory of the mind. As Hayek (1952b, 142) put it: “Perception is thus always an interpretation, the placing of something into one of several classes of objects. … All we can perceive of external events are therefore only such properties of these events as they possess as members of classes which have been formed by past ‘linkages.’ ” What an individual knows, therefore, are “not properties of the object at all, but a set of relations by which our nervous system classifies them” (143). Because the classification produced by the brain is relational and conditioned by “past linkages,” only certain properties of external objects can be perceived. Consequently, not only is our knowledge necessarily an abstraction based on some and not all properties of objects, but it is also necessarily limited. At the same time, those prior linkages are affected by incoming sensory impulses that are capable of forming new classifications against the backdrop of the preexisting taxonomy. This speaks to the constrained novelty or learning that individuals experience and draws attention to the generative cognitive processes implied by Hayek’s theory. The subjective order that an individual constructs, Hayek tells us, is something that happens to the mind and represents a relational structure of perceived events governed by the rules according to which sensory inputs are classified. As Hayek pointed out in “The Primacy of the Abstract” (in Hayek 1978, 41): “all the ‘knowledge’ … an organism possesses consists in action patterns which the stimuli tend to evoke, or … what we call knowledge is primarily a system of rules of action.” Whether innate or learned, such rules are a precondition of classification, so that “the richness of the sensory world in which we live is not the starting point from which the mind derives abstractions, but the product … of abstractions which the mind must possess in order to experience that richness” (44). In Hayek’s theory, the individual’s ability to adapt to the external environment is explained using the metaphors of the map and the model: • The map is the semipermanent network of connections within the central nervous system that determines the pathways that impulses can follow and represents the classification an individual has relied on in the past and found useful. The map is effectively an apparatus of longer-term memory, but it does not indicate “what particular events will be recorded at any moment” (Hayek 1952b, 115). • The current interpretation of the external world is represented by the model, which is constituted by the current flow of impulses coursing their way through the map. In this way, a model of the environment is generated that produces a classification

620    Austrian Connections and Extensions of impulses that is anticipatory, in that certain impulses in the past have been found to be associated with follow-on impulses. In this way, the model embodies expectations of subsequent impulses that the system has learned to associate with the current impulses. The neuronal pathways that constitute the map are not fixed but are subject to change as the system adapts to its environment. As certain pathways fall into disuse, incoming impulses will be classified differently, supporting a different map for such impulses and a corresponding change in the system’s model for that class of impulses. This constitutes what Hayek calls “reclassification” or, more familiarly, learning, as the system adapts to new external conditions. Hayek’s account of cognitive functioning provides a case study of a system that is self-organizing and capable of producing knowledge as an emergent output as it interacts and adapts to its environment. The brain, according to Hayek, is a decentralized system with no central locus of control, yet it is a system that exhibits the capacity to alter its functioning through internal self-regulative adaptation. In what follows, we explore ways in which Hayek’s cognitive theory may carry insights for the economic theory of agency, its generalizability to the theory of adaptive systems, and its relevance for methodology in the social sciences.

The Sensory Order and the Economic Theory of Agency Agency and Individual Behavior The Sensory Order provides a theory of cognitive functioning by which individuals generate adaptive actions based on an interpretation of their environments. This is not limited, however, to simply passive responses to an environment, as might be approximated empirically as highly routinized or habitual activity. It should be obvious that Hayek’s conception of cognitive activity is considerably richer than a simple and fixed stimulus-response mechanism in which the same inputs unfailingly produce the same outputs. Hayek’s theory relies on the individual’s ability to perform ongoing reclassifications that discard less useful classifications and generate more useful ones. The mind is seen as a self-organizing emergent and complex system having the capacity to generate new classifications that constitute knowledge for the individual. There are several relevant implications of this Hayekian view for the theory of agency, and we shall draw attention to just two: rationality and limits on knowledge. From the perspective of Hayekian cognitive theory, rationality is reframed as a process in which the individual maintains an ongoing capacity to learn and adapt. The potential for continuous reshuffling of sensory inputs enables the individual’s brain to

The Sensory Order and Neuroeconomics    621 implement new internal configurations that induce revised conjectures about the external environment, which, it should be noted, is also changing. Feedback loops, both positive and negative, are necessary if the individual is to successfully adapt and gain improved knowledge of the external environment. As such, rationality in this view is processive and is a fully subjective concept that incorporates learning and error correction through time. In addition, Hayek’s theory requires that the higher mental processes are governed by rules of classification that remain tacit (Hayek 1952b, 132–146). So if rationality is processive and tacit, it can never be fully “explicit or instantaneously specified” (Weimer 1980). Hence, the relevance of modeling behavior as optimization recedes as a fundamental component of rationality and refers at best to transient states. From a Hayekian sensory order perspective, the key point is that for any complex emergent system, such as the mind, it is the capacity of the system to engage in error-correcting adaptation that matters. Hayek’s cognitive theory, as already noted, requires that classification is performed in the context of prior memory, which suggests that memory precedes perception. As Hayek (1952b, 166) put it, “every sensation … [is] an interpretation of an event in light of the past experience of the individual.” Thus, not only is the classification that the brain performs not a replication of the attributes of external reality, but it is an interpretation of that reality—and one that is constrained by prior experiences. Koppl (2006a) has used such Hayekian insights to urge social scientists to adopt a conception of bounded rationality, a term originated by Herbert Simon, as a preferred way to model individual behavior. Such conceptions were evident in the calculation debate waged by Mises and Hayek and later were developed more memorably by Hayek in his “knowledge papers” under the guise of the necessary “division of knowledge” (Hayek [1937] 1948; [1945] 1948). The full-information models that once dominated economics, as contained, for example, in the formulation of “pure competition,” have given way to more realistic formulations sensitive to limits on knowledge as a starting point for the theory of agency. While such propositions may seem obvious, Hayek’s work provides a cognitive argument for their adoption. Further developments in the theory of agency inspired by Hayek’s cognitive theory are found in Salvatore Rizzello’s The Economics of the Mind (1999), which is the first full-length study of cognitive economics based explicitly on the neurophysiology of Hayek’s cognitive work.10 In particular, Rizzello (1999, 168) argued that Hayek’s cognitive theory carries important insights for understanding the “economics of complexity, creativity, and uncertainty” and in particular individual rationality and behavior and the economics of path-dependency. Rizzello described cognitive path-dependency as an interaction between the relatively fixed (but still mutable) Hayekian map and the more fluid and anticipatory model. He emphasized the Hayekian conclusion that cognitive activity, though certainly capable of generating novelty, is nonetheless constrained by the prior cognitive history of the individual.

10 

Rizzello also drew deeply on Simon’s bounded rationality in developing his economics of the mind.

622    Austrian Connections and Extensions

Economic Expectations In “Economics and Knowledge,” Hayek introduced the idea of plans and their coordination as central to his theory of equilibrium. He saw the tendency toward equilibrium hinging on the empirical claim that “the expectations of the people and particularly of the entrepreneurs will become more and more correct” (Hayek [1937] 1948, 45), although he added that “we are still pretty much in the dark about (a) the conditions under which this tendency is supposed to exist and (b) the nature of the process by which individual knowledge is changed” (45). But, despite his long-standing interest in the social aspects of production and distribution of knowledge and his work in cognitive science, he never addressed those questions, and he did not develop an explicit treatment of expectations and their formation.11 In an attempt to address Hayek’s questions, Butos and Koppl (1993) turned to Hayek’s cognitive theory and big player theory (see Koppl and Yeager 1996) to investigate, respectively, the process by which individual knowledge changes and factors that underlie equilibrium tendencies. Butos and Koppl found (1) that Hayek’s theory of a map-and-model classificatory apparatus supports a theory of expectations as forward-looking;12 (2) that because the Hayekian classificatory process of cognitive activity is rule-governed, expectations are coherent;13 (3) that expectations are competitive in the sense that cognitive activity for Hayek requires an adaptive process of error correction;14 and (4) that Hayekian expectations are

11 

Hayek’s ( [1945] 1948) insight of the price system as transmitting relevant knowledge obviously speaks to a mechanism that in a general way describes how an individual’s knowledge may change; yet that account assumes that such changes in knowledge as are conveyed in the form of prices are unambiguous in terms of the ways each individual interprets, appraises, and responds to those prices. What is missing, in short, is a theory of economic expectations. Basing such a theory on Hayekian cognitive theory takes seriously the criticism of Boland (1986, chap. 11), who argued that economic theories have been founded on implicit theories of cognition and learning that govern agent behavior and ought to be made explicit. 12  Hayek (1952b, 120) says: “The model of the environment will … constantly tend to run ahead of the actual situation” by providing “representations of the changes to be expected in the environment.” These expectations are not passive thoughts for Hayek; instead, they tell the individual what to do: “knowledge is primarily a system of rules of action,” and it “consists in the action patterns which the stimuli tend to evoke” (Hayek 1978, 41). Expectations, then, are not primarily thoughts but propensities to act in a certain way. 13  It is only because classificatory activity is rule-governed that cognitive activity attains any degree of orderliness. At the same time, even though rules constitute constraints on cognitive functioning, because they are general (or abstract), they allow for cognitive creativity. In short, finite rules permit unlimited particulars in precisely the same sense as a finite alphabet and set of grammatical rules support infinite variety in a language. 14  An individual’s successful adaptation to the external world requires a process that assesses the compatibility of expectations with a complex and changing environment. Expectations (actions) that lead to disappointment will be revised if the individual is to achieve a better fit with reality in the future. Hayek’s theory of learning (what he calls reclassification) results in the retention of actions (expectations) that tend to work and the replacement of those that tend not to. It is through a kind of trial-and-error method of action that an individual’s conjectures or theories about reality are corroborated (or not). The individual’s ability to achieve goals requires successful adaptation and interaction with situations

The Sensory Order and Neuroeconomics    623 endogenous.15 Framing expectations in this manner has also invited comparisons between “Hayekian expectations” and other views, including theories of expectations in new classical theory and in the works of Keynes and Lachmann (Butos and Koppl 1997; Butos 1997; Koppl 2002). For example, recent studies have shown that Hayekian expectations carry testable empirical implications for the coordination of individuals’ activities under different institutional environments. The general framework of Hayekian expectations discussed above presupposes a particular social setting, yet that framework can be used to examine the implications for expectations under different social settings. This result may be particularly relevant, because it opens up an avenue for examining when expectations are likely to be and not to be conducive to orderly or equilibrating or coordinating tendencies. As suggested elsewhere (Butos and Koppl 1993), when the market (or other institutional) environment is itself orderly, (Hayekian) expectations will generate orderly behaviors; however, if the stability of social rules is lost, as in the case of a discretionary or inflationary central bank, expectations tend to become unhooked from underlying fundamentals, thereby tending to further distort market processes. This suggests that we can make explicit use of expectational analysis to understand observed market instabilities. In addition, that same expectational analysis suggests that these instabilities do not inhere in the market process per se but actually reflect the destabilizing effects of discretionary policies. It has also been shown that the theory of Hayekian expectations is useful in understanding the implicit learning and creative processes that entrepreneurial activity involves. This is particularly relevant for Austrian economics given Austrian emphasis on the centrality of the entrepreneurial function. Kirznerian entrepreneurial alertness and Misesian appraisement are crucial aspects of the market process, yet these theories have been posited without a supporting theory of learning and expectation that would give such activities content. For example, Koppl (2002) and Koppl and Yeager (1996) analyze the effect on entrepreneurial activity, in terms of alertness and appraisement, when a big player, an actor (such as a finance minister or central banker who has and wields substantial market power), intervenes in markets. In this case, entrepreneurs have a clear incentive to reorient their attention away from market fundamentals and toward the behavior of the big player. Entrepreneurs face additional epistemic difficulties because profit-and-loss calculations are now tied more closely to appraisement encountered in the course of action. As long as action occurs, success is never absolute; therefore, what matters is the advantage conferred on the individual of one expectation relative to another for achieving ends. In this way, successful adaptation and revision of expectations require expectations to be self-correcting. 15  For Hayek, the individual does not stand alone in a cognitive sense. Hayekian expectations are a byproduct of an interaction between sensory data originating in the external environment and the mind’s classificatory apparatus. The negative feedback mechanism that drives self-correction means that an individual’s actions (expectations) are endogenous to the environment and will change with it. While this does not contend with expectational creativity and novelty, it does carry the particular implication that Hayekian expectations are integral to social processes and cannot be immutable in the face of what the individual perceives about the external environment or what kinds of actions have succeeded or failed.

624    Austrian Connections and Extensions within distorted markets and to anticipations of the actions of the big player. In these situations, market activity becomes more volatile and conducive of “herding,” as is sometimes observed in asset markets. In short, entrepreneurs’ expectations become less reliable guides for action in the presence of big players, and markets become less orderly and come to resemble Keynesian beauty contests.

Neuroeconomics The performance of institutional arrangements is a product both of the rules of interaction and of the behavioral characteristics of the interacting agents. Hence the value of psychological understanding of agent characteristics and of their elucidation in experimental settings. As McCabe (2005, 242) puts it, “to understand the process of social order one must also understand the emergent mental order that is producing it.” This attention to empirical observation has been the focus of recent work in both behavioral economics (e.g., Kahneman 2003; Diamond and Vartiainen 2007)  and experimental economics (e.g., Smith 1982; 1991; 2003) and is particularly evident in the branch of experimental economics called neuroeconomics, in which brain-imaging techniques and experiments with brain-damaged individuals enable the investigation of the neuronal basis for heuristics use and framing in decision-making in studies involving risk preference, intertemporal choice, and strategic behavior. Investigation of the psychology of human social behavior is important simply because both casual observation and careful experiment show clearly that a simple model of a human agent as a rational maximizer of individual utility, while very useful in certain contexts, does not suffice for a satisfactory explanation of economic interaction generally. And even in situations in which the outcomes are in good accord with the predictions of standard maximizing models, these outcomes obtain even under constraints much weaker than those the models call for, indicating incompleteness of the understanding provided by the models. Market outcomes may be predicted using models that impute to agents superhuman abilities to access and computationally process information, and, rather than giving confidence in the assumptions of such models, these results rather point to the effectiveness of certain norms and institutions in constraining and directing behavior. In any case, issues of trust, reciprocity and the influencing power of norms of behavior complicate the simple picture, more in some situations than in others, and experimental economics generally and neuroeconomics in particular offer a means of untangling what Smith (2003) called “the two forms of rationality”: the deliberate and conscious “constructivist rationality” and the subconscious, unarticulated, norm-driven “ecological rationality.” It should be no surprise at all to any student of The Sensory Order or of more modern elaborations of theories of mind16 that both biological and cultural influences have 16 

See, for example, Edelman (1982), Fuster (1995), Cosmides and Tooby (1992), and Churchland (1995).

The Sensory Order and Neuroeconomics    625 combined in the evolution of the human brain and that a facility for conscious reasoning has emerged from such an evolutionary development. Thus, both constructivist and ecological rationality can manifest themselves in interpersonal interactions, and economic understanding could only be enhanced when the possibilities for both and the contexts in which either predominates are better understood. Neuroeconomics offers one window into this task of untangling and understanding. The ability to inspect the neural activity in different regions of the brain of an experimental subject performing a certain task, and to compare the intensity and distribution of this activity with that of the same subject performing a different, “control” task, together with a neuroscientific understanding of the functions of different brain areas, can highlight the involvement of subconscious, preconscious, and conscious processes in particular economic interactions. The most used imaging method is functional magnetic resonance imaging (fMRI), which allows pictures of oxygenated blood flow (and hence of neural activity) to be taken, but scans of electrical activity using electroencephalograms (EEG) are also useful, in that while EEG results are more spatially diffuse than those possible with fMRI, they record events at a finer time scale. Also possible (usually in animal studies but in some instances in humans) is the ability to measure directly, via electrodes, activity in single neurons. Neuroeconomic findings can be incorporated into standard rational choice models, usefully improving the “realism” of such models, as O’Donoghue and Rabin (1999) have done with models of hyperbolic discounting. But in general, the results of neuroeconomics experiments have confirmed that the complexity of human decision-making is not well captured by standard models, and progress has been made in understanding the mental processes involved in economic interactions. Different types of choices are found to involve activity in different brain regions, leading to suspicion of the inadequacy of simple models of utility maximization and of applying economic concepts such as time preference and risk aversion as unvarying attributes of individuals over all choice situations. For example, Sanfey et al. (2003) performed fMRI scans on players in one-shot ultimatum games. In these games, one player offers the other a share of a given amount of money, and if the offer is accepted, both get their respective shares; otherwise, both get nothing. In such games, offers of 50 percent are not uncommon, and low offers (say, below 20 percent) are often rejected. Sanfey et al. found that the rejecting players registered activity in areas of the brain associated with rejection and disgust, with assessment of future reward, and with deciding between conflicting options and that for all second-move players, the experimenter could predict whether a rejection would take place based on the level of activity in the rejection-and-disgust area. The coldly rational moves would be for the first-move player to offer a very small share and for the responder to accept any offer greater than zero, but clearly, some sense of fairness and a propensity to punish unfairness even at cost to the punisher are at play in the context of the experiment. Here the neuroeconomics contribution not only adds credence to earlier behavioral studies but also points to an explanatory basis for such phenomena in neural architecture.

626    Austrian Connections and Extensions McCabe et al. (2001) pursued this task of ferreting out the biological foundations of economic behavior that are the basis for various individual strategies. They investigated the hypothesis that “theory of mind” processing—the ability to infer the mental states of others, which is essential for cooperative behavior—involves the use of prefrontal cortex in integrating such processing with cooperative actions. They employed fMRI scanning during standard two-person “trust and reciprocity” games. With subjects who consistently cooperate when playing with other humans, they found that prefrontal activation is greater when playing a human than when knowingly playing a computer. In contrast, with subjects who are consistent noncooperators, this difference was not found. The conclusion is that the two requirements for cooperation—attention to mutual gains and inhibition of immediate reward gratification—are mediated in those prefrontal regions. As a final example, Camerer, Bhatt, and Hsu (2007) reported on a study of choice under uncertainty involving both fMRI scans and study of patients with brain lesions. They investigated the basis for “ambiguity aversion,” the phenomenon illustrated by the Ellsberg paradox (Ellsberg 1961), in which subjects show a preference for bets on selections of cards from decks of known composition to selections from decks of unknown composition, in situations where this is irrational given the probabilities involved. Explanations of this propensity have been given either in terms of pessimistic expectations of the worst outcomes or as an overgeneralization of the rational response to information asymmetry. In looking for brain areas that were more active under conditions of ambiguity than under conditions of known risk, they pinpointed the amygdalae and the orbitofrontal cortex. The amygdalae are regions in the medial temporal lobes known to process information related to fear and unfamiliarity or lack of information in social situations; the orbitofrontal cortex is thought to integrate expectation of reward or punishment with decision-making. This finding favors the latter of the above explanations, that aversion to making bets in ambiguous situations is strongly related to the natural aversion to competing at an information disadvantage. It is always possible, in the enthusiasm for a new approach, for its practitioners to overhype its potential. Indeed, the potential of experimental economics itself has been seriously questioned, for example, by Levitt and List (2007), who raised concerns about how easily behavior in the laboratory generalizes to behavior in normal economic life. But it is clear that at a minimum, neuroeconomics can contribute to the introduction of more experimentally verified realism into maximizing models and that there is at least the potential for more revolutionary influence on economics generally. Camerer, Loewenstein, and Prelec (2005, 14–15) summarized their view of the possibilities as follows: Neuroscience is sometimes criticized as providing little more than a picture of “where things happen in the brain” or, more cynically, as simply showing that behavior is caused by action in the nervous system (which was never in doubt). … However, the long-run goal of neuroscience is to provide more than a map of the mind. By tracking what parts of the brain are activated by different tasks, and especially by looking for overlap between diverse tasks, neuroscientists are gaining an understanding of

The Sensory Order and Neuroeconomics    627 what different parts of the brain do, how the parts interact in “circuitry” and, hence, how the brain solves different types of problems. … For neuroeconomists, knowing more about functional specialization, and how regions collaborate in different tasks, could substitute familiar distinctions between categories of economic behavior (sometimes established arbitrarily by suggestions which become modeling conventions) with new ones grounded in neural detail.

While the assimilation of some of the findings of experimental economics may present difficulties for mainstream economics, Oprea and Powell (2010) have argued that for Austrian economists, the results of experimental economics in general (and, we add, neuroeconomics in particular) pose no methodological problems. On the contrary, they have served to illustrate that Austrian insights about real economic agents, their behavior under uncertainty, and their inescapable knowledge problems have a firm basis in fact.

Adaptive Systems Theory Overview It is one thing to push forward the understanding of the individual by approaching the theory of agency from a perspective more explicitly grounded in Hayekian cognitive science and by performing explicit empirical investigations. But if the objective is to move beyond the individual to develop a cognitively based social theory, further work is necessary to make precise the connections between individuals and in what way such connections matter. As Hayek argued in “Economics and Knowledge” ([1937] 1948), the social realm is qualitatively different once we move from a single individual to many interacting individuals.17 Connecting these two levels is not a problem of aggregation but one of transformation, which we treat in terms of adaptive systems theory. Hayek’s interest in complex social phenomena and their evolution, which became increasingly evident in his post-1950 writing and thinking (Caldwell 2004), found many outlets that included the market economy, the mind, the law, and social institutions. While the secondary Hayekian-inspired literature that has grown up around these ideas is vast, we confine our attention here to the role of The Sensory Order in providing a theoretical platform capable of dealing with social phenomena from an evolutionary standpoint and showing how salient characteristics of various self-organizing emergent systems found within the social realm derive from a common set of principles. This distinctly Hayekian project sees Hayek’s theory of the individual mind as a 17 

Koppl (2006a) calls for “BRICE” economics, based on Bounded Rationality, Institutions, Complexity, and Evolution. Rizzello (1999) develops his economics of mind explicitly as a platform for studying institutions and market processes in an evolutionary context.

628    Austrian Connections and Extensions prototype that can inform, with suitable modification, our understanding of other and more complex emergent systems, such as the market, science, and cities, and can give insight into how such arrangements function and adapt under different institutional environments. This direction in the application of Hayek’s cognitive theory to economics and social theory has recently been advanced under the rubric of “adaptive systems theory,”18 which in very general terms treats social arrangements as networks of interacting elements, immersed in a dynamic environment to which (at least some of) the elements are sensitive. The interactions between the elements that maintain the network are repetitive and localized but not absolutely constrained, so that while they give the network obvious structure, they can adjust, modifying the structure, as reactions to environmental changes percolate through the system. This work has sought to advance an explicit evolutionary research agenda based in part on The Sensory Order in terms of three principal considerations: first, to provide an account of social phenomena in which the interactions of individuals and the social structures that arise from those interactions are analyzed as adaptive systems; second, to use insights contained in Hayek’s cognitive theory, which is couched in terms of an individual, as a paradigmatic account of an adaptive system having explanatory power for higher-level orders, such as market (or catallactic) systems, science, cities, legal systems, and various suborders, such as monetary and banking systems; and third, to focus on the emergent systemic effects resulting from social interaction in terms of knowledge generation and system adaptation to the environment.

From Neural to Social Orders Generalizing from Hayek’s conception of the neural order to social orders, notwithstanding some obvious differences,19 relocates the significance of The Sensory Order as a prototype for a theory of adaptive social systems. The central features of Hayek’s cognitive theory involve the ongoing interactive activity of a structured network of elements and its ability to generate a semifixed yet mutable “map” and an anticipatory “model” conditioned by the environmental effects currently impinging on the system. The system’s knowledge is the complex of the focal patterns of interactions between elements that the current configuration of the system’s map supports. These particular patterns of activation, the result of map reconfigurations induced by past experiences, are the “attractors” that form the basis of the system’s classifications of future inputs (McQuade

18 

See McQuade and Butos (2005), McQuade (2007), and McQuade and Butos (2009). Thus, we reject the idea that social systems are brains or that they work like an organism with a brain. In addition, individuals exhibit intentionality or purposive behavior, while emergent social systems such as the catallaxy or science do not. This is not to deny, of course, that “spontaneous” social systems can be turned into a constructed order—from a cosmos to a taxis, as described by Hayek (1973, chap. 2). 19 

The Sensory Order and Neuroeconomics    629 2010, 40). In short, knowledge is instantiated as a multilevel classification of phenomena. These features of Hayek’s cognitive theory, as discussed in McQuade and Butos (2009) share characteristics with social systems: • Social systems exhibit structural integrity and mutability in response to environmental factors that establish fundamental and persistent patterns, such as institutions of property and exchange in markets or publication and citation in science. On the other hand, less ingrained, transitory, and more peripheral factors are more easily modified or discarded. Thus, rearrangements in the structural characteristics will tend to be path-dependent (Rizzello 2004). In the face of repeated experience of surprising and unexpected inputs, the system will adapt by internal rearrangements, exhibiting “creative destruction” in markets and “paradigm changes” in science, which are analogs of the “competitive plasticity” observed in brains. Also, even if certain interaction pathways are shut down or immobilized, the system does not necessarily permanently excise responses that would otherwise have been activated; rather, the system may still exhibit functional mutability by creating workarounds that circumvent impediments, as is often seen in “black markets.” • Like cognitive activity, social systems are anticipatory in that their current structure predisposes them to react to possible future events in ways conditioned by past experiences. The operation of speculative and futures markets are examples of market-level functionality geared to the anticipation of future events. • There is a sense in which social systems, like brains, cannot escape the consequences of prior activity or, as noted above, path-dependencies. Individuals cannot somehow negate long-standing structural pathways and simply reinvent themselves de novo. While change is possible, it ordinarily occurs incrementally against the backdrop of our genetic endowment and what has been learned in the course of experience. Nonetheless, the established routines to which individuals cling may result in ex post regret, as seen in addiction. At the level of social systems, examples abound in which actions are enthusiastically undertaken that entail costly consequences. The rapture of “the good fight” gives way to armed conflict and the destruction of property and lives on a mass scale, or the desire of leaders to centrally plan economic systems generates gross inefficiencies and enormous costs to individuals. • In The Sensory Order, a brain responds to its environment in the context of a relatively fixed map and the flows of impulses induced by current stimuli as described by the model. Similarly, the way a social system responds to a particular stimulus depends not only on the prior activation pathways of the system but also on the current state of the system. Thus, for example, contrary to what would be expected from an application of supply-and-demand analysis, a small increase in the legal minimum wage may not induce any measurable change in employment of those so affected, given the available margins that employers may adjust in the current circumstances.

630    Austrian Connections and Extensions Markets, science, and cities are, perhaps to varying extents, grown or spontaneous orders. More to the point, they are complex self-organizing orders that generate emergent characteristics that are unintended byproducts arising from individual interactions and the way the systems function. Such orders have no overall purpose, yet even if the individual interactions are simple or routinized, the system has the capacity to generate system-level outputs that could not have been inferred by any single mind. Because this process is transformative, not additive, a reductionist approach is not adequate for understanding how such systems function. In the case of a market order, for example, the constellation of market prices that the system continuously generates is a distinctive byproduct of the order’s operation, outputs that Boehm (1994, 169) observes “cannot be generated in any other way,” an insight that, by implying that different orders and different environments will produce different outputs, provides a basis for comparative institutional analysis. In applying the concepts of The Sensory Order as a prototypical account of adaptive orders in general, we are entering the realm of complexly organized adaptive systems, which has been an area of intensive study in recent years in a multidisciplinary effort, examples of which include the works of Kaufmann (1993), Holland (1992; 1995; 2006), and Buckley (1998).20 But the insights gained by applying a sensory order perspective can be illustrated by showing in some detail how the systems both of market and of science are arrangements in which adaptation arises through changes in the mutable interactional structures within the system.

The Market Order The structure (or Hayekian map) of a market system is composed of an institutional framework based on rules or conventions regarding property, contract, and money; the habits and routines market participants have used and rely on to implement their plans; and the active components of the system—market participants themselves—whose interactions centering on exchanges of goods and services animate the overall system. The ongoing flow of transactions among market participants constitutes the market’s model of its current environment, given the current structure of the map. These interactions give rise to visible outputs or a classification in the form of market prices and the array of market goods and services. This classification is an emergent phenomenon of the system, which arises from the interactions among the participants. It represents a transformation of the inputs (participants’ preferences and

20  Hayek himself was a forerunner in the realm of complex adaptive systems, arguing in “Notes on the Evolution of Systems of Rules of Conduct” (1967, 74) that “there is no reason why a polycentric order in which each element is guided only by rules and receives no orders from a center should not be capable of bringing about as complex and apparently as ‘purposive’ an adaptation to circumstances as could be produced” in a more hierarchically organized system. For a summary of more recent work in economics, see Kochugovindan and Vriend (1998).

The Sensory Order and Neuroeconomics    631 resource constraints) into a constellation of market prices and goods and services that could not have come about in any way other than the actual process that gives rise to it (Boehm 1994). The market as a system has the capacity to exhibit anticipatory responses to expected environmental changes. Consider some regulatory change that removes prohibitions on offshore oil drilling. While this will have no effect on the current supply of oil, it will most likely trigger a variety of adjustments in speculative and futures contracts that reflect an anticipated future increase in oil output and lower future prices that, in turn, provide an incentive for firms to increase current production and lower prices now before prices fall. Thus, the regulatory change induces an interplay of individual transactions having system-wide effects in the structure of prices and the outputs of goods that reflects both the current state of the system’s environment and its expected future state and also adjustments that mitigate the adverse consequences of the expected future state.

Science and the Scientific Order Science as an emergent social order has been studied from the perspective of adaptive systems theory21 in which its principal output is the generation of scientific knowledge. As McQuade (2010, 52) put it: Individuals and their scientific interactions together form a networked system, and scientific knowledge is an emergent side effect of the activity within that system. To be more specific, scientific knowledge is a classification by the system of science of the environment to which that system is sensitive and to which it adapts—indeed, “knowledge” in general should refer to the classification produced as a side effect of the adaptation to its environment by any adaptive system.

The knowledge produced by the scientific order is of a social character, in that it is the byproduct of interaction of many scientists who directly and, indeed, indirectly may be said to have contributed to what the order itself takes to be warranted scientific knowledge: Scientists use aspects of each other’s work, modifying, adapting, criticizing, reinterpreting, and perhaps (from the point of view of the original author) misinterpreting it as they develop their own work. Repeated applications of this process are observed to tend to converge toward a commonly accepted conception (at least within particular schools, but sometimes in whole disciplines, and especially in those disciplines where empirical reproducibility is considered to be significant), and this convergence, this tacit agreement as to the classification of phenomena in the subject domain (temporary and mutable though it may be) is what we call scientific knowledge. (McQuade 2007, 56) 21 

See McQuade (2007; 2010).

632    Austrian Connections and Extensions Like other grown social systems, modern science, as a self-organizing complex system, has the capacity not only to generate scientific knowledge but also to evolve the various conventions, methodological criteria, and other self-regulative mechanisms that scientists rely on. The enormous creativity of modern science is not because “anything goes” in science but is a consequence of a few simple rules that the scientific order has evolved over time and that scientists have found useful for their activities (see Polanyi 1945; 1962). As an instance of an adaptive system, the scientific order lends itself to a description in terms of The Sensory Order’s map and model. Following McQuade and Butos (2005, 346–347), science’s map is a stable but mutable structure built from the following elements (listed in rough order of increasing mutability): • An institutional framework circumscribing and stabilizing the nexus of interactions between scientists. These include the norms of publication and citation, which, although they appear to have taken their current form as recently as the late 1600s, are the critical institutional structures. • Semifixed routines that individual scientists have learned to rely on to implement their plans. This includes their organization into schools and groups and their patterns in selecting their usual outlets for communication. • Scientists themselves, whose behaviors form overlapping spheres of interactions directly and indirectly as writers, referees, and users of published ideas and whose skills, tastes, and preferences can be changed as a direct result of their experience as scientific researchers. The ongoing flow of interactions among scientists (characterized by publication in various forums and citation when invoking the work of others) constitutes the analogy of the model in The Sensory Order. As with the market, the stimuli that induce these interactions can originate either inside or outside the system. Emergent effects of ongoing scientific interactions include, most important, the reputations of individual scientists and the body of established scientific knowledge, both of which feed back to condition subsequent interactions. Like the neural order, the order of science generates a particular kind of classification that describes aspects of the real world. The particular institutional arrangement that produces scientific knowledge as an emergent effect of its operation reflects classification over a range of inputs that is unique to the circumstances of its generation. The classifications of science and of the individual mind are necessarily different. Also, like the neural order and the catallaxy, science has no central locus of control, in that there is no single element or group that directs the operation of the overall order, although in the social realm, the vulnerability of such orders to constructivist influence makes them susceptible to just that.22 22 

With respect to science, see, e.g., Kealey (1996), Butos and McQuade (2006), Bennett (2010), and Butos and McQuade (2012).

The Sensory Order and Neuroeconomics    633 Finally, note should be made of McQuade’s (2007, 69; 2010, 51) argument concerning Hayek’s widely (and approvingly) cited claim that “capacity of any explaining agent must be limited to objects with a structure possessing a degree of complexity lower than its own” (Hayek 1952b, 185). Hayek’s complexity argument is order-specific, and while it certainly applies to the mind, McQuade holds that it is not correct to assume that the constraints to which an individual’s mind is subject also apply to knowledge-generating orders composed of many individuals, such as science. That is, the interactions of many individuals are capable of producing a kind of knowledge that is not subject to the classificatory constraints that apply to an individual. Thus, for example, we cannot assume that the knowledge produced by the scientific order is in principle circumscribed by what an individual scientist knows. This nonadditive linking of individual interactions to emergent systemic outcomes is a characteristic of a Hayek-inspired approach to social theory.

Cities As noted earlier, generalizing Hayek’s cognitive theory to the social realm must take account of the transformative effects of many interacting individuals in various institutional settings. We have so far highlighted the market economy and science as two particular instances where Hayek’s cognitive work may have useful application as part of an adaptive systems theory of social phenomena. In this section, we highlight from a Hayekian perspective cities as systems, in which their adaptive and emergent properties reflect changing interactional linkages and structures within the systems. Considered as Hayekian emergent orders, cities, like the market and science, have no single locus of control or overriding collective purposes. Cities and the neighborhoods they support are social structures characterized by high-density populations within relatively small geographical areas. As such, they provide many opportunities for interaction, and their capability for rapid innovation is well documented. More things happen faster and to greater numbers of people in cities, and while on the surface this activity may appear disorderly, it is anything but. Since the seminal work of Jane Jacobs (1961), the appearance of cities as chaotic and socially perverse systems cannot be maintained as the dominant view. Cities are better regarded as networks of interacting individuals and the procedures that those individuals use. The speed with which such systems can generate new outputs is symptomatic of rapid-fire adaptation. Following Jacobs’s lead, cities now are being studied by researchers at the Santa Fe Institute and elsewhere as complex adaptive systems whose emergent characteristics empirically support a view of cities as innovative and economically productive, capable of generating and sustaining significant increasing returns, and supporting vast numbers of participants.23

23 

See, for example, Glaeser (2011), Bettencourt et al. (2007), and Batty (2008).

634    Austrian Connections and Extensions From the perspective of this chapter, Hayek’s cognitive theory is amenable and generalizable to this domain of social interaction. For example, Jacobs explains how city neighborhoods endogenously deal with street safety through the emergence of informal networks among residents (a Hayekian map) that provide levels of activity and awareness in support of ongoing commercial activity and social interaction (a Hayekian model). The outputs of this neighborhood subsystem include the richness of urban life and increased quality of life. As Jacobs (1961, 31–320) explains: “the public peace … is kept primarily by an intricate, almost unconscious, network of voluntary controls and standards among the people themselves, and enforced by the people themselves.” Efforts by Austrian researchers, such as Desrochers (2001) and Ikeda (2004), have built on Jacobs’s earlier insights and have identified the relevance of Austrian insights for understanding how cities function. In particular, their work has highlighted the critical role of dispersed and tacit knowledge for cities and the pitfalls associated with interventions that seek to replace the evolved processes of decentralized adaptive systems with top-down bureaucratic controls. Interest in cities from an adaptive systems standpoint has attracted an increasingly large multidisciplinary presence that intersects with Hayekian and other Austrian insights. There are promising opportunities for further work on city networks by Austrians, both in the area of theory development and in the empirical study and analysis of the actual functioning of such networks.

Conclusion One of the distinctive characteristics of Austrian economics is the emphasis on the issues of knowledge. Much of this is because of Hayek, who, building on Mises’s penetrating exposure of the systemic limitations of socialist planning, refocused the argument in terms of the inherent limits of individual knowledge and the possibilities for certain systemic arrangements to generate knowledge that feeds back to individuals. Hayek’s interest in the economic significance of dispersed and tacit knowledge continued to be a central element in the development of his social theory. It is perhaps not surprising, then, that this same Hayek also proposed a theory of mind that describes how an individual’s knowledge of the environment can be instantiated in a neuronal network and that gives a firm basis for the concept of limited individual knowledge enhanced by systemic feedback. This confluence of theoretical interest in questions of knowledge and psychology and their relevance for social theory with experimental interest in both outward and inward manifestations of decision-making has profound consequences for future economic and social research.24 It strongly suggests the need to move beyond models of economic

24 

See Camplin (2011) for a wide-ranging discussion of ongoing work linking evolutionary and cognitive psychology with spontaneous orders and self-organization and network theory.

The Sensory Order and Neuroeconomics    635 behavior that assume unrealistic individual capability, that underplay the mutual feedback between the individual and the social environment, that focus on end states rather than on the understanding of the processes whose continuous interplay makes the very idea of an end state suspect, and that have had an extremely disappointing track record for explaining macroeconomic phenomena. But better understanding of the nature and behavior of economic agents is one thing; integrating this into a real science of society is another. And here the rich tradition of Austrian work on economic institutions and spontaneous order comes into play, and the combination of attention to individual characteristics and to the characteristics of the social environment in which they interact and which is built and continuously modified by their interactions offers real hope for scientific progress. To be more specific, there is a major need for future research in extending the economic way of thinking (as opposed to neoclassical economic theory) to social domains other than markets. It has not worked well to simply assume that other loci of human interaction can be regarded as market exchange institutions with various levels of imperfection, and much can be learned from the empirical observations of Elinor Ostrom, Vincent Ostrom, and their collaborators—see Ostrom (1990) for a good overview—about the characteristics of what are clearly nonmarket institutions that nonetheless serve to further cooperation in areas where common-pool considerations would seem to preclude it. The adaptive systems theory described above and, more generally, the ongoing multidisciplinary research into complex adaptive systems can provide a solid theoretical base for such an enlarged science of society. In addition to the work on science as an adaptive system described above, Horwitz (2008) has used a similar approach to capital and production theory, and Butos (2012) has applied adaptive systems theory to the comparative analysis of different monetary orders. And there is real hope in finding common ground with sociologists such as Elder-Vass (2010), who are developing very compatible ideas on social structures and their emergent characteristics. One major lacuna seems to be the lack of a treatment of government and political systems as adaptive systems, and even authors such as Beinhocker (2006), who promote the wide applicability of a complex systems approach, tend to treat government simply as a device for making and applying (what are hoped to be enlightened) rules. What is not taken into account is that the political system is itself complex and adaptive, with its own characteristic internal transaction repertoire and feedback mechanisms. The incentives inherent in the institutions of government have little to do with the “public good,” and despite the undoubted good intentions on the parts of some individual politicians and bureaucrats, the emergent products of the systemic interactions arise from the interplay of many more locally pressing considerations. Much is already known about the characteristic incentives and feedback mechanisms at play in the political environment, and Wagner’s (2007) and Martin’s (2010) treatments of polities as orders with feedback effects different from markets represent a significant change in perspective from an idealized to a more realistic view of government as a system with emergent characteristics. But fully integrating this into an adaptive systems framework is a task that would seem necessary to finally erase the often unstated but nonetheless pervasive conception of government as a potentially well-intentioned, if flawed, rule maker.

636    Austrian Connections and Extensions

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Pa rt  V I I I

DE V E L OP M E N T, T R A N SI T ION , A N D  S O C IA L  C HA N G E

Chapter 29

What Have We L e a rne d f rom the C ol l a p se of C om muni sm? Peter J. Boettke and Olga Nicoara

Introduction Political economists stress the technical economic principles that one must understand in order to assess alternative arrangements for promoting peaceful cooperation and productive specialization among free men. Yet political economists go further and frankly try to bring out into the open the philosophical issues that necessarily underlie all discussions of the appropriate functions of government and all proposed economic policy measures. (Buchanan 1958)

The Great Depression of the 1930s and the collapse of communism in the late 1980s and early 1990s were probably the two major economic events that caused serious intellectual soul searching among economists. The aftermath of the Great Depression led to the ascendancy of Keynesianism and macroeconomic demand management. The collapse of communism, while similarly seismic to the world of practical economic affairs, did not generate the same professional consensus as was so evident in the aftermath of the Great Depression. There were, though, some general lessons from the collapse of communism that we should not forget. The demise of the communist regimes in central and eastern Europe (1989) and the Soviet Union (1991) seemed to bring an end to the “grand debate,” to definitively declare capitalism as a superior economic system for human flourishing. Ludwig von Mises and Friedrich Hayek argued during the socialist calculation debate (1920–1945) that a private property market economy was able to marshal high-powered incentives, engage in rational economic calculation of alternative investment projects, and utilize the dispersed knowledge within the economic system to achieve a complex coordination through

644    Development, Transition, and Social Change time and, in doing so, realize the gains from social cooperation under the division of labor (see Boettke 2000). On the other hand, collective ownership of the means of production would result in an economic system plagued by the problems of incentive incompatibility, inability to engage in rational economic calculation, and malcoordination of plans that result in systemic waste and inefficiency. It was precisely these problems of collective ownership of the means of production that plagued the communist economies of central and eastern Europe (C&EE) and the former Soviet Union (FSU) during the seventy-year-long experience with socialism. Private property, freedom of entry and contract, and the resulting market price system provide individuals with incentives and information to recognize and realize the gains from cooperation through trade and innovation; collective ownership, bureaucratic economic planning, and administered prices distort incentives, misallocate resources, and thwart productive innovation. By 1989, theory and evidence aligned to such an extent that this basic lesson in economic analysis was finally, if reluctantly, accepted even by many of the previously most ardent critics of the capitalist order (see, e.g., Heilbroner 1990). Just as many Western thinkers were drawn to the Soviet experience in the 1930s in an effort to devise workable models and policies to construct socialism, in the 1990s, leading Western economists were placed in a position to apply the insights of mainstream neoclassical economic theory to the unique social experiment of economic reforms in transition economies. But the question that must be asked is whether the static neoclassical theory can be applied to understand dynamic institutional transformations (see Coase 1992; North 1994). How one answers that meta-theoretical question will determine how one assesses what we have learned from the collapse of communism. In this chapter, we discuss the evolution of thinking in transition studies during the past twenty-five years, survey what the leading thinkers involved in transition studies during that period believe we have learned, present the integrated theory that emerged from that experience with transition, and present cross-nation evidence that illustrates the points raised. We conclude with a discussion of what these lessons of transitional political economy mean for the future of comparative political economy in general.

The Phases of Transition Studies The first phase of transition studies emphasized getting the prices right and pursuing policies of microeconomic efficiency and macroeconomic stabilization. This was the era of the Washington Consensus, where the program was a straightforward application of price liberalization, privatization, macroeconomic stabilization, and trade liberalization.1 It is, however, vitally important to stress that from our point of view, 1  This policy consensus is different from the implementation debate about shock therapy or gradualism, although there is a certain logic that connects the two when discussing questions of policy sequencing.

The Collapse of Communism    645 there is nothing logically wrong with this basic policy prescription, and in fact, rather than criticize the Washington Consensus as an error of commission theoretically, we want to stress the error of omission embedded in this approach which led to the errors in implementation that were often committed. Scholars and advisers pursuing the state-of-the-art Washington Consensus circa 1990 unfortunately overlooked that market institutions require reliable enforcement mechanisms and that the success of the formal enforcement rules are often constrained by the preexisting set of the informal rules (or culture). This error of omission at a theoretical level led to an error of commission at that implementation level. Unfortunately, we argue, this has led to the interpretation that the consensus from basic economic reasoning was a mistaken guide for public policy. On the positive side, the frustration with the initial transition period resulted, among some scholars in economics and political economy, in a deeper understanding of the intricate matrix of institutions that underpin a market economy. Analytically, this led to the next two phases of transition studies, which we characterize as getting the institutions right (1995–2005) and getting the culture right (2005–). As we survey the different arguments, it is important to remember something that often gets blurred in these discussions: no successful development path is possible without paying attention to the issues laid out during the first phase of getting the prices right. All analysis of long-term economic development should begin with the recognition that the only way to increase real income among the population is to increase real productivity, and gains in real productivity are a result of improvements in physical capital, human capital, and the organization of economic activities. The factors that improve real productivity are the proximate causes of economic development. The fundamental cause is the institutions that provide high-powered incentives to invest in these productivity-enhancing endeavors and that provide the information that guides those investment decisions, including the feedback necessary for learning how best to make those investments. The basic mantras of development and transition studies should be incentives matter and information is necessary. Without the institutions established that provide the right incentives and the flow of the required information, the economic system will stagnate, production will be inefficient, and consumers will be frustrated. Economic growth and development follow from the establishment of an economic system with well-defined and enforced property rights, freedom of contract, competitive entry and ease of exit, low inflation, low unemployment, fiscal responsibility, and trade liberalization. In short, a regime of private property, freedom of prices, and profit-and-loss accounting must be established and insulated to a considerable extent from the unscrupulous influence of the politically privileged. Such a regime is part of a nested nature of institutions, an intricate institutional matrix that creates an economic ecology where individuals are free to bet on ideas in their entrepreneurial ventures and find the financing from anonymous others to bring those bets to life in the economic system. Savings, investment, innovation, growth, and development are all byproducts of economic, political, and cultural institutions that encourage long-term economic growth (see Boettke and Candela 2014).

646    Development, Transition, and Social Change After more than twenty-five years of experience, we are today better equipped to answer Peter Murrell’s (1991) challenging question, posed at the beginning of the reforms: “Can neoclassical economics underpin transition in centrally planned economies?” Murrell concludes that standard neoclassical economics, ignorant of institutional insights, is not suited to address the institutional challenges of transition. There is no doubt that the confused understanding of how and why markets work, rooted in the Marxist and Keynesian models that permeated the economic education of those in C&EE and the FSU led the first generation of economic reformers in Hungary, Poland, and Czechoslovakia (1980s) and in the former Soviet Union and then Russia (1960s–1990s) to adopt the idea of transition as a purely technical problem. In the former Soviet context, the effort to provide a technical solution resulted in “the treadmill of Soviet economic reforms” and led to continued frustration with an economic system that could not work as hoped. With the collapse of the system in the late 1980s and early 1990s, the recognition that the problem was with the entire system resulted in more radical thinking about the technical solution. Yet analytical attention was directed away from the necessary and nested nature of the institutional transformation that would be required. The focus was first on getting the economic/financial situation in order, or on getting the prices right, which meant that institutional problems were sidestepped. The neglect of the legal institutions and mechanisms supporting property rights led to surprise discrepancies in economic performance across the C&EE and FSU economies. As we have mentioned, the emphasis for comparative institutional analysis was on fundamental institutions (and not just public policies), such as the rule of law, judicial independence, free media, and so on, and the focus shifted toward getting the institutions right. Since the Western democracies of Europe and the United States seemed to have the “right” institutions, the transition task shifted from a technical task in economic policy to the social engineering task of transplanting “better,” Western-style, legal institutional systems in places where formal pillars of the rule of law and constitutional democracy were weak or absent. This engineering task of institutional transplanting was inevitably daunted by the complexity and dynamics of real-world social systems. The key that was now needed was to focus on getting the culture right or to recognize the set of inherited, informal, indigenous institutions as the most important constraint of economic reforms. The relevant initial conditions for the success of reforms were not economic and financial but cultural and social as constraints on desired legal or political reforms. Countries with a preexisting culture favoring capitalist values or the rule of law and those with liberal-minded leadership in politics and policy outperformed those countries that did not have similar cultural norms and characteristics. The first phase of transition studies proved to be too myopic of an approach to transition reforms, in retrospect, since it led to a neglect of the underlying legal and political institutions that were either strengthening or weakening the validity/legitimacy of liberal economic/financial and political/legal reforms. What was missed in the traditional Washington Consensus formulation of public policy engineering was the subtle lesson of the new comparative political economy: differences in reform outcomes are caused not by differences in the sequencing of reforms and not by the lack of foreign

The Collapse of Communism    647 assistance but by the varying degrees of compatibility or lack of thereof between formal legal rules and the informal, indigenous rules specific to each one of the societies undergoing systemic transformations (Boettke et al. 2005; Boettke, Coyne, and Leeson 2008). The informal constraints and enforcement mechanisms in use are part of a society’s culture, and they include informal rules such as customs, norms, beliefs, civic attitudes, and values. The omission of how culture matters for transition development unraveled in the form of the unexplained differences in economic performance across transition economies submitted to the same type of initial economic/financial reforms. The neoclassical economists took for granted the crucial mechanisms of enforcing property rights, contracts, and the rule of law. Absent these mechanisms, productive and innovative entrepreneurial activity would not take place. In order for the formal/structural reforms to work, they first must be integrated within the underlying indigenous framework of informal institutions and enforcement mechanisms. This is because the underlying framework serves as a basis for legitimization of liberal reform ideas, including respect for private property, freedom of contract and association, rule of law, and sound money. In order for formal structural reforms to be easily adopted by individuals in a reforming society, they must be compatible with the preexisting, informal enforcement mechanisms indigenously in use. Adam Smith ([1755] 1982, 322) remarked in his notebooks that eventually resulted in The Wealth of Nations: “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.” Entrepreneurship, in other words, is natural, but in order to channel entrepreneurial activities toward the most productive and innovative ones, a framework of complementary formal-informal institutions and enforcement mechanisms are needed to guarantee security of individual rights to person and property (secured against the threat of both private and public theft). Only when individuals are released from the constant threat of expropriation will they find it profitable to discover, exploit, and cultivate existing productive gains from trade and innovation. In other words, the economic principles that supported the set of economic and financial reforms in early transition (of stabilization, liberalization, and privatization) hold, but the welfare properties we associate with economic transactions are a function of the institutional framework within which economic life is played out (Boettke 1998, 92). Good policies will be respected, and big bills will tend to be picked up or exploited only under an institutional infrastructure guaranteeing credible commitments on the security of profits as the property of the entrepreneurs who discover them (Kirzner and Sautet 2006; Olson 1996). Clearly defined and enforced property rights were part and parcel of the classical political economists’ and early neoclassical economists’ understanding of the operation of the market economy. Property rights, free pricing, and profit-and-loss accounting were the critical background institutions and commercial practices assumed to be in place in the neoclassical model’s conception of how the market economy operated to realize productive and exchange efficiency and generate economic progress. The post–World War II neoclassical synthesis of Paul Samuelson resulted in taking the

648    Development, Transition, and Social Change ceteris paribus clause regarding the background institutions further to the extreme, becoming institutionally antiseptic and disregarding economic, change, and entrepreneurship. James Buchanan’s efforts to rediscover political economy in the second half of the twentieth century with the development of public choice economics and constitutional political economy must be understood in light of the Samuelsonian revolution in economics the pulled the intellectual attention of economists away from these questions of the institutional infrastructure within which economic activity is played out. As Buchanan (1968, 5) put it: The standard procedure of assuming competitive order when this seems convenient is not acceptable. Appropriately thorough analysis should include an examination of the institutional structure itself in a predictive explanatory sense. The economist should not be content with postulating models and then working within such models. His task includes the derivation of the institutional order itself from the set of elementary behavioral hypotheses with which he commences. In this manner, genuine institutional economics becomes a significant and important part of fundamental economic theory.

And as Rajan (2004) has argued more recently, this is not just a theoretical issue in comparative institutional analysis but also a practical issue of empirical analysis and policy relevance. When the very questions the economists hope to tackle are about the institutional framework itself, assuming its existence is a bad start. In dealing with issues of development or systemic transitions, institutions must become the center of attention. Institutions structure the incentives that actors face in making decisions and determine the quality and flow of information that actors require to guide them in making those decisions and what they learn from the feedback from those decisions on how better to orient their plans in the future. Economists, in short, must never forget that fundamental changes in institutions lead to fundamental changes in economic performance over time. The cross-nation experiences in the aftermath of the collapse of communism demonstrated this basic message of economic reasoning.

Survey of Thoughts on What We Have Learned Today the primacy of legal and political institutions for a successful transition is becoming widely acknowledged (Snowdon 2007). But the popular ideas in the profession have not always been in favor of the primacy of institutions for transition or development and much less on the role of culture in shaping prodevelopment and institutional reform. Despite many breakthroughs in the growing field of institutional economics, the mainstream economics profession continued to treat development and transition economies’ problems as mainly macroeconomic problems requiring monetary and fiscal intervention.

The Collapse of Communism    649 The prime concern for transition economists was about getting the speed or sequencing of economic reforms right rather than with getting the institutions right. The biggest question at the beginning of transition was choosing between a gradual and a radical reform plan (Murrell 1992). The gradualists feared the possible costly social effects of rapid reforms. The shock therapists feared the likely countervailing political effects of gradual reforms. The costs of a radical (“big bang”) transformation were social revolt because of decreases in quality of life and security. Among the most feared cost of gradualism was the high probability of reversibility of reforms by old elites given enough time to resist. The test of time brought into light Russia’s persistent failure to perform relative to its central European stellar counterparts Poland, Hungary, and the Czech Republic. Unlike the C&EE performers, Russia’s economy lagged significantly throughout the 1990s.

Western Economists: Stiglitz, Sachs, Shleifer, and Others Russia’s experience, it should be stressed, did not provide an unambiguous resolution between the two popular camps with regard to implementation strategy. Rather, the alternative interpretations of the meaning of the Russian experience of the 1990s served to heighten the debate among economists and their critics. (see, e.g., Wedel 2001). The main divergences in the camp quickly became (1) differences with respect to the proper pacing of reforms (i.e., shock therapy vs. gradual) and (2) differences on whether reform policies were a result of homegrown initiatives or imported from international development experts from afar (i.e., not enough foreign assistance vs. too much foreign assistance). Promoters of the gradual approach to transition and development reforms, such as Joseph Stiglitz (2002), argued that the problems with Russia’s transition were a result of market failures exacerbated by the shock therapy approach. He denounced the top-down Western intervention in Russia through the International Monetary Fund and the World Bank as faulty and as ideologically driven. Stiglitz saw capital controls, taxation, and sequenced, local, state-led privatization and legal reforms as the proper alternative, as demonstrated by Russia’s economic growth during Vladimir Putin’s administration. Jeffrey Sachs, an architect of the shock therapy approach to reforms, argued that unlike his success in Poland, his efforts in Russia have failed because the type of social and legal/political difficulties in Russia required a significant assistance strategy that has not been provided by the West (Sachs 2012). Both Stiglitz and Sachs, while acknowledging the importance of local institutions for development and a successful transition, favor the approach of manipulating local legal institutions from above. Both are highly critical of the loans-for-shares privatization method of Russia’s most valuable assets and enterprises, which they believe is what caused Russia to become a crony oligarchy. By focusing on the method of privatization and/or on the magnitude or source of assistance with reforms instead of on the cause of weaknesses of the legal framework within which that privatization method took its effects, Stiglitz and Sachs neglect an important distinction in applied political economy

650    Development, Transition, and Social Change between two levels of analysis made by Buchanan: one focused on the rules within rules (such as policies) and one focused on the rules above other rules (such as constitutions), As Buchanan argued since the 1950s, effective reform measures must be conceived of as changes in the rules of the game. As Buchanan (1959, 131) put it, “the scope for political economy is restricted to those social changes that may legitimately be classified as ‘changes in law,’ that is, changes in the structural rules under which individuals make choices.” Limiting analysis to public policies within existing rules is analogous to discussing trades within an Edgeworth box construction as limited to moves within the eye of the respective indifference curves of the parties on the contract curve. In other words, marginal improvements can be agreed on by the respective parties, but no systemic improvement to the overall trading opportunities for mutual benefit can be realized. Without changes in the structural rules of the game, the ordinary politics of the day will persist, and big bills will continue to lie unexploited on the proverbial sidewalk of the transitioning economy. Other practitioners of transition reforms expressed more confidence in capitalism and its positive spontaneous long-run effects on the formal-informal institutional dynamics. Anders Aslund, for example, argued that capitalism can solve the ethical problems of the rise of oligarchies in Russia and eastern Europe. He stated (2005, 15) that we need to “strike a deal with the oligarchs and preach capitalism,” as in the end, more growth and development are achieved by this form of privatization of state assets then by nonprivatization. Establishing a credible commitment to ending state control over vital assets in the economy should take priority over privatizing those assets in the most efficient manner to maximize revenues from their sale for the state. He also supports the idea that the generalized wealth effects created by oligarchs having to compete in relatively open markets will ultimately increase the local demand for improvements in the state of the rule of law, by reforming the legal/judicial system from partial and corrupt to impartial and reliable. Andrei Shleifer (2012) argues that having faith in the long-run effect of liberalized markets and capitalism is one of the lessons from the experience with transition that can be useful to other countries undergoing market reforms. All the problems of transition can be traced back to initial or persisting weaknesses in the former communist countries’ legal and political systems. Legal origins, whether we are talking about differential economic performance among Western economies, less developed economies, or economies in transition, matter. How persistent path-dependencies are in economic development is actually one of the major conceptual and empirical research puzzles that owe their centrality in modern political economy to the experience with postcommunism. The importance of formal rule-oflaw institutions is what contemporary economists in the West and the C&EE countries became aware of during what we termed the second phase of transition studies—getting the institutions right—but, with a few exceptions, the interaction between the formal and the informal indigenous rules or cultural institutions was not emphasized during this period. Again, Buchanan (1993) raised this point relatively early with his discussion of the “tacit presuppositions of political economy.” Daily experience with markets among participants in the socialist economic system is wholly different from the lived

The Collapse of Communism    651 experience with markets that those in Western capitalist societies have on a daily basis. This asymmetrical experience with market exchange matters for the beliefs and attitudes that ordinary citizens have toward commercial society.

C&EE and FSU Economists: Kornai and Others In an interview with Brian Snowdon (2007, 323–324), Harvard economist of Hungarian origin János Kornai expressed that the severity of the 1990s recession can be attributed to “an institutional vacuum” that took economists by surprise. Western-based economist advisers of transition reforms in Russia, in Kornai’s view, paid little attention to reforming or creating credible institutions that guaranteed a secure legal framework2 within which vibrant, productive entrepreneurial activities of all forms and sizes could spontaneously emerge. He argued that Western-based economist advisers of transition needed to look beyond the narrow neoclassical economic theory and the top-down approach of the Washington Consensus in order to provide effective advice. For Kornai (2004, 13–14), the most appropriate conclusion about the experience with transition reforms is not any specific or tangible lesson but a general lesson of the importance of giving priority to getting the legal framework right: Every sphere of the transformation—the political process, the business world, or the arts and sciences—requires an adequate legal or legislative background. Lack of it will only lead to trouble and conflicts, a lesson learned from bitter experience in places where much has already happened on the way to a transition to a market economy. … Whatever non-legal field they are working in, they should not forget to clarify the legislative and judicial branches of government and take account of their complexity when pacing the changes. In Kornai’s (2004, 13) view, the establishment of the rule of law is made possible by creating a state of law [which] entails enacting modern, constitutional civil and penal codes to enforce private contracts. It calls for a range of special laws that regulate business activity in a market-compatible way, along with the provinces, rights, and obligations of various state authorities. Parallel with the legislative activity, an independent judiciary has to be established. There have to be guarantees that the police and law enforcement systems do not abuse their powers. Everyone must be held accountable, and no one—a party or authority or the state itself—can be above the law.

The work of Kornai shows an increasing appreciation for the role of social capital in development and institutional change. Together with Western colleagues, Kornai

2  A reinforcement of Kornai’s earlier position on the primacy of institutions securing property rights to consider in transition reform strategies is “Ten Years after ‘The Road to a Free Economy’ ” (2000, 6), where he states similarly, “Private ownership has to be guaranteed security. Institutions have to be founded that enforce the fulfillment of private contracts.”

652    Development, Transition, and Social Change understands that (a) there exist informal indigenous social systems (such as systems of social trust, trust between individuals, and trust between individual civilians and state representatives) that (b) have a dynamics of their own, such that (c) any successful reform schemes must align the new set of incentives from reformed formal institutions with those of the (pre)existing informal cultural/social institutions (Kornai, Rose-Ackerman, and Rothstein 2004; Kornai, Mátyás, and Roland 2008). Polish economist and minister of finance Leszek Balcerowicz (2002, 53), famous for implementing the first radical set of economic reforms in Central Europe, identified two basic types of reforms that all postcommunist economies needed to undertake at the beginning of transition: “exceptionally comprehensive liberalisation and the vast programme of building or restructuring of institutions conducive to, or required by, free society and a stable and dynamic market economy.” These two distinct yet interdependent kinds of reforms correspond to Balcerowicz’s two main stylized sets of institutional legacies characteristic of all socialist systems (30). The first set, broadly defined as economic institutional legacies, included institutions of economic and individual control or institutions restricting individuals’ economic freedoms, such as laws prohibiting private property; freedom of association, contract, and trade; freedom to a monetary system; and political freedoms. The second set of institutional legacies included the realm of legal and political institutions established to enforce the first (rules about prosecutions and sanctions). Balcerowicz advances a theory of “tacit political pacts” to explain the nonviolent transitions out of communist regimes in the C&EE and FSU republics. The gradual introduction of the ideas of radical political and economic changes through Mikhail Gorbachev’s glasnost and perestroika has provided the context for implicit negotiations between old communist elites and the new democratic regimes in which the latter are promised radical economic and political changes in return for physical safety and freedom of the first:  Peaceful negotiations would never have taken place (or, had they taken place, they would never have borne fruit) had the Soviet threat not been gradually eliminated by Gorbachev’s glasnost and perestroika. These negotiated changes were not always based on an explicit political pact and entailed a large element of surprise for all the main actors. However, they would not have come about if the members of the old elite had felt physically threatened or even if they had not believed that they would be free to seek favorable positions in whatever new system emerged. In this sense one can speak of tacit political pacts. (Balcerowicz 2002, 25; emphasis added)

In this retrospective analysis, Balcerowicz’s focus is on the difference between two types of reforms, economic and political, where the economic reforms are privatization, liberalization, and macroeconomic stabilization, while political reforms are mainly democratization. But discussions of the importance of the rule of law become inevitable as economic changes depend on political and legal changes. Balcerowicz’s (2002, 26)  assessment of legal change comes through changes in political institutions:  “the

The Collapse of Communism    653 efficiency and fairness of the justice system are fundamentally important in terms of limiting the arbitrary power of the state as well as in the enforcement of property rights and contracts, and thus in longer-run economic development.” What seems to still be missing from these analyses of the transition effort is the importance of cultivating an underlying public morality favorable to capitalist values and attitudes in society that may help to alleviate the cultural/social constraints on transition efforts in Russia and the former Soviet republics (FSRs). This is a line of inquiry established recently by Deirdre McCloskey (2006; 2010) as it relates to the economic development of the West, but it has yet to be applied in earnest to the lessons of the transition from socialism in C&EE and FSU.

The Interaction Thesis The conjecture that economic transition and development are not a technical problem but a cultural one has at best only come to be partially appreciated in comparative political economy (Boettke et al. 2005). It is important to note, however, that after about a decade of disappointing results with economic reform strategies, the attention to the interaction between cultural attitudes and beliefs and the formal institutions that provide the infrastructure for economic development became increasingly a topic of research among leading economists. The concepts of trust and reciprocity worked their way into theoretical models, and the World Values Survey was deployed empirically to help explain differential performance by transitioning and developing economies with respect to both economic and political change. This is, as we have dubbed it, the third phase of transition studies: getting the culture right. The interaction thesis builds on many interrelated works on the impact of culture on economic development (Boettke 1996; Boettke, Coyne, and Leeson 2008; Chamlee-Wright 1997; Storr 2012), on culture as the main generator of transaction costs of transition (Pejovich 2003), and on the moral and spiritual components of culture as the underlying drivers of legitimization of reforms (Boettke 2010). In a variety of ways, the interaction thesis derives from an older classical liberal emphasis on the power of ideas in shaping the world of affairs and can be seen in the work of Mises (1949) and Hayek (1960). Both Mises and Hayek made technical arguments about how alternative institutional arrangements affect the ability of the system to realize the benefits of social cooperation under the division of labor, but they also made a deeper philosophic argument about how beliefs and attitudes either legitimize or delegitimize the liberal order. For most of the intellectual history of the Austrian school of economics, the focus was on the methodological and analytical contributions of the school. But the interaction thesis as developed in the context of the serious study of differential performance between transitioning and developing economies brought to the forefront once again these broader arguments about the cultural foundations of economic development.

654    Development, Transition, and Social Change In addition to the underlying cultural beliefs and attitudes, the interaction thesis also brings to the forefront the importance of institutional entrepreneurship or leadership in times of rapid change (Ackerman 1992) in light of the experience with transition. There are pivotal moments when pivotal actors must act decisively, or the opportunity for structural change will disappear. Within a liberal society, the process of democratic decision concerning collective action is ongoing, but even here, the opportunities provided for “constitutional moments” are fleeting. This problem of the window of opportunity closing on chances to get through changes in the structural rules is even more significant when we are talking about the establishment of a liberal democratic order. We argue that differences in indigenous cultures, assumed reform leadership, and the existing/inherited climate of public morality explain the differences in the economic and democratic performance across C&EE and the FSRs under analysis. Unlike Stiglitz and Sachs, we argue that the problems of economic performance in Russia and the FSRs relative to C&EE countries are not the result of a “social shock” of the shock therapy approach to economic/financial reforms (privatization, liberalization, stabilization) or because the international development agencies did not commit enough financial resources at the crucial time but because market reforms in Russia and the FSRs did not coincide with the appropriate transformation and/or establishment of the required institutional framework, and those efforts that were made to change the institutional structure were not compatible with the existing culture, which is the basis for appropriate political and legal reforms. As Milton Friedman admitted, privatization is useless without a functioning rule of law. This was Friedman’s (2002, xvii–xviii) response to the question of what we have learned since the collapse of communism: We have learned about the importance of private property and the rule of law as a basis for economic freedom. Just after the Berlin Wall fell and the Soviet Union collapsed, I used to be asked a lot: “What do these ex-communist states have to do in order to become market economies?” And I used to say: “You can describe that in three words: privatize, privatize, privatize.” But, I was wrong. That wasn’t enough. The example of Russia shows that. Russia privatized but in a way that created private monopolies—private centralized economic controls that replaced government’s centralized controls. It turns out that the rule of law is probably more basic than privatization. Privatization is meaningless if you don’t have the rule of law. What does it mean to privatize if you do not have security of property, if you can’t use your property as you want to?

The change in Friedman’s position is a subtle but profound intellectual shift in our way of thinking about transitional political economy, and it corresponds with the narrative we have constructed about the evolution of thought among political economists as a result of this experience with transitioning economies. The market-preserving function of credible rule-of-law institutions validates the incentives to enterprise and innovation induced by a system of property rights, freedom of contract, and entry. No one today would disagree with the gradualists’

The Collapse of Communism    655 observation that Russia’s path-dependent culture evolved unfavorably toward capitalist values that contributed to the differences in results with transition across postcommunist countries. However, it also must be noted that the attempts to reform the system from within as advocated by gradualists (Stiglitz 2002) have already been tried unsuccessfully in the Soviet Union in the past. In Soviet Russia, Lenin’s new economic policy (NEP), and Gorbachev’s perestroika are two examples of attempted gradual economic reforms (Boettke 1993; 2001). Both failed to spur productivity and entrepreneurship because of inherent economic and political inconsistencies. They failed because the strong entrepreneurial profit incentives under NEP and perestroika were muted, if not completely nullified, by the threat of expropriation by the Soviet state. Russian entrepreneurial actors in both historical time periods had to weigh the profit opportunities they could pursue through commerce with the high risk of public predation by the communist elites of those profits. This phenomenon of confused signals about the rules of the economic game that actors are playing has been termed “regime uncertainty” by economic historian Robert Higgs (1997). Higgs used the concept to discuss the sluggish economic recovery during the Great Depression in the United States, but the concept has wide-scale application. Regime uncertainty results when there is pervasive uncertainty among private investors about the security of their private property rights and thus the security of the returns on their investment decisions from arbitrary confiscation from public predation. Private investment in the above-ground and official economy within such an environment will lag behind what otherwise would be if there was not such pervasive uncertainty about the security of private property rights. Higgs’s concept is particularly relevant to understanding economic development in Soviet and post-Soviet Russia. How else would you explain the empirical ambiguity of simultaneously witnessing a growing “underground economy” at the same time as supposedly market liberalization was occurring, as was the reality during the 1920s and the 1980s and ’90s in Russia. Absent rule of law during the Soviet and post-Soviet eras, as reflected in weak public and political support for the rule of law in today’s Russia, explains reformers’ failure to implement shock therapy reforms at the beginning of the transition as successfully as they were implemented in the Czech Republic. Interestingly, shock therapy may have another argument in its favor: with shock therapy, there is some exposure to liberalization which can start to cultivate the values and beliefs that provide the tacit presuppositions of a liberal, political, and economic order. Shock therapy is not a panacea, but it gets citizens on the right path for learning liberalism and cultivating the virtues of commercial life. Societies can become “civilized” in the spirit of capitalist values (Williamson 2012; Boettke 2010). Moreover, unlike the C&EE reformers, Russia and the FSRs lacked leadership over promotion of free-market ideas in politics and economic policy making. Russia and the FSRs did not have the type of intellectual-political leadership to push economic/financial and legal/political reforms through strong political activism to persuade the public of the welfare benefits of capitalist system and adherence to rule-of-law negotiation with the incumbent elites.

656    Development, Transition, and Social Change

Culture Matters The road to a successful transition from a “shortage economy” to an “innovative economy” is an indigenous one, supported by pivotal people promoting liberal ideas at pivotal times and by a culture and public morality that extends respect and admiration to any one ordinary member driven by productive entrepreneurial innovative ideas in their society. A nation’s economic performance is shaped by the prevailing rules of the game (enforced incentive-generating constraints) within which its citizens act and interact over time (Baumol 1990; Boettke 1996; North 1997; North 2005). Why, then, do we not see poor countries adopting growth-promoting rules of the game? The notions of path-dependence and lock-in tell us only that history matters. Understanding how institutional path-dependence matters should be the focus of reformers preoccupied with finding ways to alter the economic performance of transition economies as quickly and as effectively as possible (North 1997, 16). A country’s experience with historical/political events is imprinted in its culture, which in turn explains the diversity of institutional contexts and therefore the corresponding differences in development and economic performance across countries at any point in time (Boettke 1996; Boettke 2001; Boettke, Coyne, and Leeson 2008). The fuzzy, informal, indigenous institutions (and their enforcement mechanisms) interact with the set of written, formal political and legal institutions to form the institutional infrastructure in a modern society (Boettke 1994). Depending on their degree of compatibility or complementarity, the vector of development/transition and corresponding economic performance resulting from the interaction between the social/cultural, the legal/political, and the economic/financial institutions may point either upward (development and growth) or downward (decline and stagnation). The success of a transition or development process is a function of this interaction between the proposed formal (de jure) and preexisting informal (de facto) rules of the game in society (Boettke 1996; Pejovich 2003; Boettke, Coyne, and Leeson 2008). In figure 29.1, we present a useful analogy of the interaction thesis. On the three-legged barstool, the legs supporting the top represent the three key types of institutions: economic/financial institutions, political/legal institutions, and cultural/social institutions. The top represents a country’s success during transition and its corresponding economic performance (i.e., slow or rapid growth, largely innovative or imitative, with frequent economic crises vs. sustained booming markets). Metis, or the tacit norms and local knowledge embedded in any social system, serves to bond the formal institutions in society. Again, if one attempts to impose formal institutions—even political/legal or cultural/social in nature, rather than merely economic/financial—that are at odds with the underlying metis of that society, frustration will result in the effort at institutional transplantation. A vibrant, dynamic, and healthy, growing economic system is one where the formal and the informal institutions are aligned, in a way that promotes commercial activities and entrepreneurial ventures. This lack of alignment will result in an inability of the reforming system to adopt the necessary “social technologies,” to use Eggertsson’s (2005; 2010) term, that are necessary for the process of economic development.

The Collapse of Communism    657

Economic performance/ transition success

Legal and political institutions

ions nstitu t mic a nd fin ancia li Econ o

s

i /met

is

met

tions

s

stitu

meti

metis

in tural l/cul

Socia

metis

Figure 29.1  The barstool analogy.

The mistake was to ignore the role of culture and its dynamics along with institutional change. In fact, many of the former communist societies have retained their pre-Soviet capitalism-promoting cultural heritage. Unfortunately, for societies dominated by Russian culture, the cultural attitudes and beliefs beneficial for capitalist order have either been lost or consistently discouraged from taking roots in Russia’s history (Pipes 2006; Procaccia 2007). The variety of cultural legacies across the former Soviet republics and satellite states provides one of the key insights into the puzzle of the uneven results with the same transition reforms. One hypothesis we do not explore here but which could be a topic of future research is to examine the postcommunist performance in terms of both politics and economics of countries that retain the dominant use of the Russian language. Another unexplored hypothesis would be simply to measure the postcommunist performance of countries in terms of the distance from the respective capital to London as a proxy for how Western the core value system of that country is and correlate that with capitalist development. Rather than pursue these hypotheses, we will lay out the general themes of the interaction thesis. It is our contention that the costly lessons learned from the collapse of communism and the postcommunist transition for transitional political economy can be traced back to an overemphasis on getting the economic-financial institutions right and an underemphasis on, or ultimately neglect of, the earlier period on getting the legal and cultural institutions right in both our theorizing and practical policy/institutional solutions. The waste of billions in foreign development assistance; missed windows of opportunities

658    Development, Transition, and Social Change for significant political, economic, and social transformation; and a resulting legitimation crisis for liberalism were the consequence of this failed effort at transformation. Ironically, as we stressed at the beginning of this chapter, the worst lesson that could be inferred from that contention is that we do not have to pay attention to getting the prices right, because if you do not get the prices right, nothing else will matter, either. But what should be taken away from the hard experience of the past twenty-five years is the nested nature of these institutions. The barstool analogy is there to show that if any of the legs of the stool are weak, the stool will not be robust against the stress that great transformation places on it. The problem that practitioners of transition reform plans have faced is that when treating the transition as a technical problem akin to an engineering problem, they have focused on what is more tractable and immediate. Similar to the proverbial drunk looking for his lost keys under the lamppost because that is where the light is, rather than where he lost his keys in the first place, transitional reform economists become frustrated in the search. They have focused too much on proposed solutions to economic/financial problems during transition and omitted from the analysis the critical questions of stability and credibility of the economic/financial institutions themselves and how compatible the required formal legal/political institutions are with the inherent social/cultural institutions prevalent in the respective country. Introducing property rights, contract, and rule-of-law institutions in countries where history has wiped out the cultural memory of respect for the rule of law and appreciation for the activity of the productive and innovative class of the society will fail in the short run to induce the spontaneous manifestation of mutually beneficial exchanges. Do not misunderstand; trading behavior is a universal human behavior and will occur even under the most unfavorable of circumstances. But the deepening of exchange relationships and the ability to engage in anonymous transactions, and also to engage in more roundabout methods of production and exchange, will be limited unless the underlying institutions are in place, trusted, and respected. Where formal institutions of the rule of law are weakened or ignored by an unsupportive culture, existing Smithian gains from trade, including Schumpeterian gains from innovation, will tend to not be exploited. This is just another way to restate and rethink Smith’s famous dictum that the division of labor is limited by the extent of the market. Social cooperation under the division of labor requires certain institutions, the absence of which will result in missed opportunities for mutual gains from trade at best and will steer the social order into one of conflict and violence at worst. Exchange does not occur in a vacuum. Economics is a science that studies exchange relationships and the institutions within which exchanges take place. Trust and reciprocity are at the core of economic relationships that form in a commercial society. Economic history research shows that modern societies have flourished under systems of credible property rights institutions, freedom of contract, entry, and competition (North and Thomas 1973; Rosenberg and Birdzell 1986; Acemoglu and Robinson 2012)  and within cultural-moral attitudes of praise and admiration toward the productive and innovative entrepreneurs in society (McCloskey 2006; McCloskey 2010; Mokyr 2009).

The Collapse of Communism    659 Applied to the lessons learned from the collapse of communism, economists’ lack of attention to the legal/political and cultural/social legs of the barstool when theorizing about and designing transition programs has naturally resulted over time in the uneven levels of economic progress across transitioning countries of central Europe, southeastern Europe, Russia, and central Asia. On one side, for a long time, the idea that institutions matter has been neglected in economics for its simplicity. But it is vitally important in the science of economics and in the art of political economy to stress that simple economics is not necessarily simple-minded economics. Ordinary economics, as understood by the classical political economists and early neoclassical economists, might be much more important to stress as the times become even more extraordinary. Ronald Coase remarked that he thought his major contributions in “The Problem of Social Costs” were about “stating the obvious” (Coase 2012). Coase, in fact, stressed that his focus on the costs of exchange and how alternative institutional arrangements affect those costs, was a “novel theory” only if you have not read Smith (Coase 1959, 18) He pointed out that whenever the attempt is made to replace market exchange with political decision-making, the proposed policy will have to deal with the inability to make monetary calculation, the lack of the utilization of local knowledge, and the problems associated with special-interest groups. Smith understood this, and Coase was just invoking the simple and age-old Smithian wisdom to emphasize the importance of institutional analysis in understanding how the self-interest postulate of human behavior is compatible with the invisible hand proposition of the spontaneous order of the market economy. Without the right institutional setting in place, the pursuit of individual self-interest will not be guaranteed to dovetail with the public interest—in fact, it most surely will not. On the other side, the study of institutions has often been neglected in economic analysis because of their complexity. The idea that culture alters the path of transition and development, for example, is still relatively novel, and the implications of path-dependency for the welfare conclusions of economic analysis are still very much a contested conceptual issue. New research on transition economies suggests that the chemistry between the (newly introduced) formal and the (preexisting) informal institutions in transition economies determines the economic success or failure across reforming transition and developing countries. The more compatible are the reforms (the formal) with the local culture (the informal), the greater is the chance of a relatively quick successful transition as translated in economic performance (North 1990; Boettke 1996; Pejovich 2003; Boettke, Coyne, and Leeson 2008). As Pejovich (2003) points out, culture interacts with formal institutions in a way that either increases or decreases the costs associated with transition. These are the transaction costs of transition associated with learning about the local structures of incentives (in order to make adequate adaptations of reforms), understanding how to approach indigenous resistance to reforms, including the effort of negotiating with the existing interest groups, and persuading and informing an electorate with a “Soviet-type mentality” and an acquired “sense of belonging” about the welfare benefits and virtues of the capitalist system and the rule of law. As we mentioned earlier, Buchanan identified that this asymmetry in the lived

660    Development, Transition, and Social Change experience of alternative institutions cannot help but have an impact on the bargaining imagination of public entrepreneurs and the legitimation that ordinary citizens place on the new pattern of political, commercial, and social relations.

Leadership Matters In a lecture at the UN University World Institute for Economic Research in 1997, Douglass North (1997, 16) conceded that our limited understanding of the transition problem was partly a result of a lack of advanced research in constitutional political economy in transition countries at that time: “The interface between economics and politics is still in a primitive state in our theories, but its development is essential if we are to implement policies consistent with intentions.”. Buchanan and Vincent Ostrom promoted the idea of “constitutional craftsmanship” and the role of classical liberal elites in advancing liberal policies and institutions based on the ideas of economic and personal freedom, rule of law, and constitutional democracy. The serial revolutions preceding the retreat of communism in central and eastern Europe and the Soviet Union provided the opportunity for the new elites to craft new constitutional frameworks that would set new directions for future economic, political, and legal policies. Bruce Ackerman (1992, 3) famously advanced the thesis of “constitutional moments,” which he defined as “short windows of opportunity,” in the aftermath of a successful revolution, which “generate a political constellation that allows for mobilization for deep and broad support for a liberal constitution” (Ackerman 1992, 3). Without strong leadership to take advantage of “the opportunity for constitutionalizing liberal revolution,” Ackerman insists, the constitutional moment “may be entirely missed.” For Ackerman, the strategic role of liberal political activists during constitutional moments trumps the role of economic and political reformers, because “constructing a liberal market economy, let alone a civil society, requires decades, perhaps generations, and the project can be easily undermined without the timely adoption of an appropriate constitutional framework.” While agreeing with Ackerman on the primacy of leadership in crafting new constitutional frameworks, we believe that analogous strategic action in the realm of economic policy can set a country on a faster track toward success. It was crucial for the local political and institutional entrepreneurs to recognize and act in a timely manner to grasp the opportunity to advance liberal agendas in politics and in policy making. Leadership of pivotal people at pivotal times (before, during, and after establishment of a liberal constitution) in promoting liberal economic and political reforms in countries undergoing system transformations mattered. Poland is a great example, because its key political and institutional entrepreneurs are well acknowledged in the world and in the literature. The constitutional leadership of Lech Walesa of the liberal Solidarity movement in the aftermath of the Polish revolution was akin to that of George Washington at the time of America’s Constitutional Convention (Ackerman 1992, 48). Regarding postconstitutional reform, consider the leadership of Balcerowicz in Poland’s economic reform programs. As an institutional entrepreneur with economic scholarship and appreciation for classical liberalism and classical liberal thinkers, Balcerowicz recognized the

The Collapse of Communism    661 niche window of opportunity for advancing liberal market reforms in postrevolutionary Poland, which he called a period of “extraordinary politics,” when Polish society was more inclined to accept drastic proposal of system change, and the opposing older elites were not given enough reaction time to organize and plan an opposition (Balcerowicz 1995). The moral and intellectual integrity and reputation of the reform leaders added to the credibility of reforms. These leaders, who were often persuaded by the works of Hayek and Friedman, risked their lives fighting adverse interest groups to promote a set of institutional and policy changes based on ideas they believed would lead to prosperity and a better quality of life. The added credibility of reforms carried forward by leaders in central Europe and the Baltics has increased the chance for the success of other reforms. The pivotal role of the local actors in the advancement of classical liberal (or “neoliberal”) ideas in C&EE countries contributed, for example, to strengthening the credibility of the promised benefits of an economic reform such as the flat tax, which may have led to its widespread adoption (Evans and Aligica 2009). The case of Poland is outstanding but followed in close degrees by the central European and Baltic countries, where leadership over the implementation of shock therapy reforms, both in politics and in the economy, shortened the period and scope of possible institutional frictions. Ultimately, leadership reduced the possible negative effects of a prolonged situation of uncertainty on people’s hopes and expectations about the promised benefits of capitalism for the quality of their lives during the critical first stage of transition. By contrast, countries such as Russia and the FSRs lacked credible and sustained constitutional leadership. Frequent changes in the ruling elites, lack of the rule of law, broken promises, and continued delay in seeing improvements in their quality of life have turned eastern societies against capitalism and in favor of new communist factions and leaders. Path-dependency in Russia’s politics of “broken promises” was caused by the ruling elite’s repeated breaches of promised reforms under Russia’s weak or nonexistent democracy and rule-of-law institutions (Boettke 2001).

Public Morality/Spiritual Capital Matters The prevailing public morality is another important factor that has only recently started to be appreciated in the literature on transition. We believe that a successful transformation toward constitutional democratic governance and a capitalist system is conditioned by the compatibility of the preexisting cultural foundations of a society with sentiments of appreciation for capitalism and the rule of law. The cultural foundations of capitalism and the rule of law form a nation’s social capital, the source of private order based on informal constraints and their enforcement mechanisms supportive of property rights, honest profit making, individualism, and the rule of law. Theorizing about the importance of social capital goes as far back as Smith ([1759] 2009) and includes philosophical and economic analyses of the role of the informal institutions (i.e., the informal rules of the game and their enforcement mechanisms as dictated by the set of indigenous beliefs, customs, moral codes, and attitudes) in economic

662    Development, Transition, and Social Change performance (North 2005; Leeson 2007; Tabellini 2010; Williamson 2009). Elements of social capital such as trust, tolerance, and respect, serve two main functions: (a) to “bond” or strengthen trust and cooperation in personal relationships between socially close groups such as families and friends, and (b) to “bridge” or foster trust and cooperation in impersonal relationships between socially distant groups (Leeson 2005; Boettke 2010). Cultural elements and systems, including language and religion, may serve not only a bonding function promoting greater social cohesion for individuals of a certain group but also a bridging function promoting trust and openness for cooperation and trade with strangers. Some of the most studied informal institutions with cooperative properties are the institutions founded on religious beliefs. Religion is an important source of social capital supportive of capitalist virtues. As research shows, adherence to common religious beliefs signals trustworthiness among socially distant traders, which leads to avoidance of conflict and the exploitation of mutually beneficial transactions (Grief 1997; Leeson 2005; Williamson 2011; Tabellini 2010). By providing the moral foundations for most societies of the world, religion forms the spiritual part of the wider whole of the social capital of a society. Churches or worship houses foster the spiritual capital of a society by deepening trust within existing networks and by extending trust in social interactions with socially distant groups (Putnam 2000; Sacerdote and Glaeser 2001). We are also familiar by now with the idea that some religions are more propitious for capitalism and economic growth than other religions (Weber [1930] 2003). Even among Christian religions, some are based on beliefs more supportive of markets and the rule of law than others. Barro and McCleary’s (2003, 23) empirical analysis supports that “religion affects economic outcomes mainly by fostering religious beliefs that influence traits such as thrift, work ethic, honesty, and openness to strangers” and that church attendance, unlike religiosity, implies a blockage of resources toward unproductive activities (37). They further find that the more diverse and pluralistic a nation is in its religions, the more tolerant and respectful are its members. Mutual tolerance and respect promote trust and cooperation across spiritually distant groups and are therefore two important traits of capitalist societies. By contrast, in nations with monopolized religion markets, or with “state religion,” where there is a codependent relationship between the state and the church powers (e.g., in Russia and other predominantly Eastern Orthodox countries), the spiritual capital is manipulated and averse to openness to strangers (Barro and McCleary 2003). This finding helps us understand the classification of societies, made by North, Wallis, and Weingast (2009), into “open access orders” and “closed access orders.” Spiritual capital is important in the study of processes of transitions to capitalism in C&EE and FSU countries because a constitutional-democratic process relies on ideas favored by the general public. The set of favored ideas in society matters, because they legitimize the public capital or the constitutional and policy frameworks within which social interaction takes place (Boettke et al. 2005). The informal, spiritual capital may enhance the “civilizing effect” of a capitalist system (Williamson 2011) and contribute to a “modern growth effect” when the spiritual capital extends entrepreneurial liberties and confers dignity to ordinary people (McCloskey 2010).

The Collapse of Communism    663

Examples of How Legs of the Barstool Work Studies on the differences between the historical and political paths of the postcommunist countries (Pop-Eleches 2007)  support the interaction thesis of transition in C&EE and the FSU. Successful transition economies benefited from their preexisting culture, dominated by capitalist values and attitudes including individualism, self-determination, strong work ethic, honesty, and respect for religious pluralism/ tolerance (Gorodnichenko and Roland 2011; Pejovich 2003). Eastern European scholars and practitioners of transition reform plans acknowledge that leadership in politics and policy at the beginning of transition also mattered (Balcerowicz 2002; Klaus 2013). By contrast, lack of cultural support of a liberal leadership along with a system of anticapitalist beliefs persisted in the transition laggards: Russia and many of the FSRs today.

Success Stories: Poland, Hungary, Czech Republic, Baltic States The central European and Baltic countries are well-known success stories of the ongoing experience with postcommunist transition reforms. Poland, Hungary, the Czech Republic, and the Baltic states have excelled at reestablishing their market economies and the functioning of the rule of law. One of the initial contributing factors in their success was their geographical and cultural proximity to western Europe, with which they shared common procapitalist cultural characteristics advantageous for their transition. In fact, Western economic advisers (who were called to advise the new governments in charge of reforming their countries’ economic systems) motivated their approach with the “top-down Western-style” economic reforms based on the Western origins of the pre-Soviet institutions of central Europe and the Baltic countries. In Poland in particular, what legitimized the shock therapy market reforms of the Polish proindependence revolution was the slogan “A Return to Europe” (Sachs 1994). The societies in these central European and Baltic countries have preserved the memory of their pre-Soviet cultures favorable to property-rights institutions and the rule of law. As a result, they all benefited from a greater compatibility between the formal economic and intuitional reforms and their preexisting cultural, informal norms. The favorable interaction between their preexisting procapitalist cultural institutional base and the economic, legal, and political reforms resulted in their superior economic performance. The preserved memory of the pre-Soviet, capitalist culture contributed to the manifestation of political and policy leadership of neoliberal ideas in politics and served as fertile ground for further cultivation of classical liberal beliefs, market values, and entrepreneurship-promoting attitudes and virtues.

664    Development, Transition, and Social Change

Failures: Russia and the “Normal Country” Thesis In the earlier years of the 2000s, Shleifer and Treisman’s (2005) analysis of economic data on post-Soviet transition led them to pronounce Russia “a typical middle-income capitalist democracy,” or “a normal country,” unlike most of the nonreforming countries of eastern and central Asia, part of the enduring Community of Independent States (CIS) today. It is important to read the “normal country” thesis closely. The claim is not that Russia has become a well-functioning modern democratic capitalist economy. Schleifer and Treisman argue that middle-income countries historically and at present are characterized by corruption and politically favored private monopolies. The same problems that are so often discussed in nineteenth-century US history classes concerning the era of the robber barons are said to be evident in the middle-income countries today, and we should not expect anything different. We must compare a country’s performance politically and economically at the right cross-section if we want to make an appropriate comparison. More recently, however, the economic data on Russia seems to paint a more optimistic picture. According to the World Bank’s Country Classification of 2013, Russia is more than a middle-income economy; it is a “high-income economy” in line with enduring Western developed, capitalist economies such as the United States and the United Kingdom and the performing countries of the former communist space, the central European and Baltic countries (table 29.1). A look at Russia’s economic-entrepreneurial environment reveals flaws in the above optimistic research findings about the country. As Leeson and Trumbull (2006) show in contrast to Shleifer and Treisman, the relevant group of countries with which to compare Russia’s performance over the last decades is not the entire world but the other former socialist countries embarked on a transition to capitalism at the beginning of the twenty-first century. First, if we look at the progression of Table 29.1  Income groups, World Bank country classification (gross national income per capita, 2012). Developing Economies

Developed Economies

Low income ($1,035 or less)

Lower middle income ($1,036–$4,085)

Upper middle income ($4,086–$12,615)

High income ($12,616 or more)

Kyrgyz Republic Tajikistan

Armenia Georgia Moldova Ukraine Uzbekistan

Azerbaijan Belarus Bulgaria Hungary Kazakhstan Romania Turkmenistan

Czech Republic Estonia Latvia Lithuania Poland Russian Federation Slovak Republic

Source: The World Bank Country Classification 2013.

The Collapse of Communism    665 purchasing-power-parity-adjusted measures of gross domestic product per capita over time, Russia’s economy belongs with the group of average reformers of the C&EE countries, Romania and Bulgaria, and below the performance of worldwide average economies, such as Mexico or Argentina. Russia performs significantly lower relative to the group of the top reformers in central Europe and the Baltic region (table 29.1). Also, when comparing the progress with democracy and governance reforms across the former communist countries in the same group, by indicators of judicial framework and independence, rule of law, and freedom of the press, the Russian Federation ranks as a nonreformer among other FSRs (figures 29.2–29.6). Finally, Russia persistently ranked at the bottom of the Heritage Foundation’s Indexes of Economic Freedom for the past two decades (1992–2012), as a “repressed” environment in terms of investment freedom. Similarly, survey data gathered by the Global Entrepreneurship Monitor (GEM) show that the intention of the Russian people to start a business in the last ten years (2002–2012) has been extremely low relative to that expressed in other countries. Only 2.2 percent of Russians intended to enterprise in their own home country in 2012, and by World Bank and OECD estimates, Russia has not been an attractive destination for foreign entrepreneurs, either, as the net inflows of foreign direct investments in Russia have decreased steadily between 2008 and 2012 (see table 29.2), from 4.5 percent to 2.5 percent of GDP. At the same time, the GEM reports also show that the majority of Russians do perceive entrepreneurship as a desirable career choice, and there being very little variation in this GEM index internationally (table 29.3) suggests that despite the limited freedom to start an enterprise, significant positive attitudes toward 1.5 1 0.5 0 1996

1998

2000

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

–0.5 –1 –1.5 Former Soviet republics

Central European countries

Russian Federation

Romania and Bulgaria

Baltic countries

Figure 29.2  Rule of law, 1996–2011. (Score ranges from -2.5 to 2.5) Source: Worldwide Governance Indicators (WGI) 1996–2013.

666    Development, Transition, and Social Change 1.5

1

0.5

0

–0.5

Former Soviet republics

Central European countries

Baltic countries

Russian Federation

Romania and Bulgaria

–1

–1.5 1996

2011

Figure 29.3  Rule of law, groups, 1996–2011. (Score ranges from -2.5 to 2.5) Source: Worldwide Governance Indicators 1996–2013.

2003

2013

7 6 5 4 3 2 1 0 Former Soviet republics

Central European countries

Baltic countries

Russian Federation

Romania and Bulgaria

Figure 29.4  Judicial framework and independence in Russia and the FSRs and satellite states, 2003–2013. (0 = most reformed, 7 = least reformed) Source: Freedom House, Nations in Transit.

entrepreneurship have prevailed among Russians after the collapse, even more than in many of the developed societies today, including the United States, the United Kingdom, Sweden, and the stars of transition, the C&EE and Baltic countries (table 29.3). Russians are “normal” people as they respond to the incentives of their perceived entrepreneurial profits abundant under capitalism, but the threat of future expropriation under the institutional environment within which the exploitation of their discovered profits must take place is a stopper and leads to an underperformance of the economy. The thesis of this chapter suggests that understanding cross-nation transitional paths requires

70 60 50 40 30 20 10 0 2002

2003

2004

2005

2006

2007

Former Soviet republics

Central European countries

Romania and Bulgaria

Russian Federation

2008

2009

2010

Baltic countries

Figure 29.5  Freedom of the press, 2002–2013. (0 = free, 100 = oppressed) Source: Reporters without Borders for Press Freedom, https://agidata.org/site/SourceProfile. aspx?id=4.

GDP per capita, PPP (constant international 2005 $)

25000

Czech Republic Slovak Republic

20000

Poland Hungary Lithuania 15000

Russian Federation

Latvia

Belarus Kazakhstan 10000 Turkmenistan

Ukraine

Armenia Georgia Moldova

Uzbekistan Tajikistan Kyrgyz Republic 1

Bulgaria Romania

Azerbaijan

5000

0

Estonia

2

3

4

Figure 29.6  Rule of law versus income in C&EE and FSRs, 2011. (0 = lowest, 5 = highest) Source: World Bank Development Indicators and Worldwide Governance Indicators 2012.

668    Development, Transition, and Social Change Table 29.2  Estimates of net foreign direct investments (% GDP).

Armenia Azerbaijan Bulgaria Belarus China Czech Republic Spain Estonia Georgia Kyrgyz Republic Moldova Poland Romania Russian Federation Slovak Republic Tajikistan Turkey Turkmenistan Ukraine Uzbekistan

2008

2009

2010

2011

2012

8.0 8.2 19.9 3.6 3.8 2.9 4.9 7.9 12.4 7.3 12.0 2.8 6.8 4.5 4.2 7.3 2.7 6.6 5.9 2.5

9.0 6.5 8.0 3.8 2.6 1.5 1.3 9.6 6.1 4.0 2.5 3.3 3.0 3.0 1.8 0.3 1.4 22.5 4.1 2.6

6.2 6.3 3.9 2.5 4.1 3.1 3.3 10.9 7.5 9.1 3.5 3.6 1.9 2.8 2.4 -0.3 1.2 16.4 4.7 4.1

6.5 6.8 4.0 6.2 3.8 1.0 2.2 2.3 7.5 11.2 3.9 3.4 1.3 2.9 3.8 1.0 2.1 11.6 4.4 3.2

4.9 7.9 4.1 2.3 3.1 5.4 2.7 7.4 5.3 5.7 2.5 1.4 1.1 2.5 1.7 2.8 1.6 9.0 4.4 2.1

Source: World Bank and OECD http://data.worldbank.org/indicator/BX.KLT.DINV.WD.GD.ZS.

understanding differences in culture and how cultural institutions interact with legal, political, and economic-financial reforms. The main argument is that variations in institutional path-dependence, or the specificity of cultural paths, determine the differences in economic performance across the target former communist countries. Russia’s relative economic underdevelopment is a result of its anticapitalist and weak rule-of-law cultural legacy as reflected in the prevailing post-Soviet informal institutions largely averse to capitalist attitudes, values, and virtues. The prolonged exposure to Soviet authoritarianism and the highly hierarchical political system has damaged the “good,” pre-Soviet, market-promoting informal institutional system of respect for private property and rule of law that started to take roots at the beginning of the nineteenth century. Could Russia’s institutional, and therefore economic, “nonnormalcy” today be a result of its “backward” culture inherited from its past? Chirot (1991), Pipes (1999; 2006), Obolonsky (2003), and Procaccia (2007) discuss how history and politics have modeled Russia’s informal institutions into a “system against individuality” as manifested in its culture and morality altered by centuries of Soviet-style authoritarianism and the monopolized-politicized market of religion brought about by the marriage between the Russian Orthodox church and government. Political morality replaced market morality, collectivist mentality replaced individualism, and preference for an authoritarian political regime is stronger than preference for a rule-of-law regime. Instead of personal

The Collapse of Communism    669 Table 29.3  Change in entrepreneurial intention and perception of entrepreneurship as a desirable career choice in C&EE and FSU societies, 2002–2012. Intention to start a business within the next Positive attitudes toward entrepreneurship as a three years (%) career choice (%)

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Chile Romania Latvia Poland China Mexico Lithuania France Estonia Slovenia Hungary Israel USA Slovak Republic Sweden UK Denmark Germany Japan Russia

2002

2008

2012

34.2 — — 2.2 27.5 23.2 — 3 — 9 5.9 14.4 9.2 — 12.5 4.2 6.2 4.5 0.9 2.5

29.5 8.5 6.6 — — 25.6 — 12.7 — 7.3 6.2 14.2 6.9 — — 5.3 5.5 4.2 3.8 3.1

43.1 27 21.9 21.6 20.4 18.4 18 17.3 16.4 13.2 13 12.8 12.5 11.8 11 9.5 6.6 6 2.5 2.2

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Japan Hungary Germany Slovak Republic UK Slovenia Estonia Mexico Israel Latvia Russia Lithuania USA France Poland Chile Romania China Denmark Sweden

2002

2008

2012

34 — 55 — 51 59 — — — — — — 63 46 — 85 — 73 51 52

26 48 56 — 52 58 — 66 56 75 60 — 63 63 — 80 — — 57 —

30 41 49 50 50 53 55 56 59 60 60 63 — 65 68 70 71 72 — —

(Percentages of population ages 18–64) Source: Global Entrepreneurship Monitor 2002–2012.

responsibility, individualism, strong work ethic, and dignity for the entrepreneurial class, Russia’s culture encourages shirking, collectivism, poor work ethic, and dignity for the politically and militarily powerful class (the bureaucrats). Russia’s political history has put a negative imprint on its cultural institutions (rules, norms, beliefs, morals, traditions). The “conservative mentality” of the Russian people (as expressed through prevailing attitudes, beliefs, and values) can be traced back to their repeated experiences with authoritarian political regimes (Pipes 2006), with the Soviet regime being the most oppressive and damaging to Russians’ cultural consciousness of all (Obolonsky 2003). The rule of law has been persistently undermined in Russia’s history by succeeding authoritarian regimes. Russian law, politics, and culture are especially hard to disentangle; it is “by long tradition” that “the Russian society is authoritarian and hierarchical” (Procaccia 2007, 96). Unlike in innovative societies, where dignity is conferred to any ordinary people who join entrepreneurial-innovative value-creating class, in Russian society, dignity has traditionally been perceived as conferred by rank. Unlike

670    Development, Transition, and Social Change in constitutional democracies, where authority emanates from the supremacy of common general norms, in Russia, authority emanates from the supremacy of men (107). The Western ideas of a constitutional order and the rule of law had no match in Russian history. Soviet slogans are perpetuated in Russia today, and they signal attitudes, norms, ethics, morals, and beliefs that are ultimately detrimental to capitalism. Russia lacks the basic procapitalist cultural, personal, moral, and ethical pillars found in Western developed societies. The notorious slogan, dating back to Alexander Solzhenitsyn’s The Gulag Archipelago, that “everybody can be replaced” and the Marxist-Leninist distributive justice norm of “from each according to his ability, to each according to his need” combined to give Russians clear incentives to hide and/or debase their true abilities, to shirk, and to lie about their true opinions and governance preferences (Kuran 1997) because of fear and lack of competitive reward for their productive and value-creating efforts. The Soviet police state and communist economic system have discouraged Russians from pursuing and expressing their own individuality, creativity, entrepreneurial initiative, and talents. Under severe political, economic, and cultural oppression, the Soviet people have lived a lie, hiding their preexisting culture and their true beliefs and pretending to adhere to the propagandistically forced Soviet culture and false system of beliefs. There was little room for development of a work ethic, appreciation for a system of private property, and freedom to enterprise. And despite the weak legal system in post-Soviet Russia, as revealed in world development and transition reports, there is still a chance for a culture of market-friendly values and beliefs to evolve and develop even in the present day. This chance is severely stifled by Russia’s authoritarian political regime, which manipulates Russian individuals’ access to worldwide information on differences in the quality of institutions and cultures across nations. By manipulating the local media (including media and press censorship), the Russian government maintains its power at the societal cost of evolution toward learning and adoption of superior market-supporting culture and civilization. The difficult task of (re)designing the complex, path-dependent systems of the former communist societies in transition to capitalism has been captured in varied creative metaphors such as “rebuilding the ship at sea” (Elster, Offe, and Preuss 1998) or “changing the engines of a plane in motion” (Roland 2012). Interpreted along the lines we have suggested, these metaphors tells us that (a)  there exist informal institutional indigenous systems that (b) have a dynamics of their own, such that (c) any reform schemes must align their incentives with those of the preexisting and informal cultural norms and mores. There is a knowledge problem in the planning of economic and institutional change sustainable and compatible with the preexisting local incentives. The knowledge of the already existing cultural/social technologies, on the one hand, and the knowledge problem in devising a new/formal set of technologies to match or be compatible with the preexisting one, on the other hand, and also with beneficial outcomes of the dynamics of the cultural/informal and the new/formal social technologies over time (Eggertsson 2005; 2010).

The Collapse of Communism    671 The implications of the interaction thesis for the political economy of transition are first and foremost humbling to the pretentions of economists as architects of systemic transformation. The problem is not an engineering one with a pure technological solution. No doubt, there are some very basic economic principles that must be followed dealing with questions of incentives and information and institutional change. The problem is trying to orchestrate that institutional transformation from above and especially from afar through the political power of international development agencies. The switch from focusing on policy reforms to proposed structural changes in the rules of the game indicates that instead of orchestrating economic transformation, it may be better to create an environment conducive to learning liberalism and allowing for the emergence of a vibrant commercial culture. This switch may be ironic and subtle, but it is also a profound change in the task of the political economist. We have stressed throughout this chapter the importance of exposure to democratic ways of relating to one another and to market forces—both domestic and foreign—in cultivating the beliefs and attitudes conducive to the institutional transformations that lower the costs of implementing sound economic policy. One of the most significant institutions besides trade and commerce is the exposure to an open media within the reforming economy (see Coyne and Leeson 2009).

Conclusion Adam Smith's insight that as long as basic institutions of property rights and rule of law are in place that productive specialization and peaceful cooperation will be “brought about by the natural course of things” is still relevant for any analysis of transitioning and developing economies. But in pursuing the relevance of Smith's ideas, a lot of the details on what institutional structures make possible in a regime of peace, easy taxes, and a tolerable administration of justice must be worked out and placed within specific historical and cultural contexts. Smith is part of the extended conversation in political economy that connects us with our classical predecessors, but the problem situation where his ideas must be put to use has changed drastically from the beginning of the Industrial Revolution in the eighteenth century to the puzzle of the transition economies. The “great economic transformation” (Kornai 2006) of the former socialist economies depended crucially on institutional change focused on strengthening or building market-preserving institutions (e.g., rule-of-law institutions, impartial courts, liberal constitutions, federalism within the larger EU space). A strong rule of law fosters the incentives for productive entrepreneurship and innovation. In weak postsocialist democracies, the new political elites thrived through campaigns of instigation of the public against prominent entrepreneurs, thus eroding public support for capitalist

672    Development, Transition, and Social Change institutions and policies. But establishing the institutions of the rule of law anew is a cultural challenge, not a technical issue of transplanting formal legal institutions. Transition from a “shortage economy” to an “innovative economy” is an indigenous one supported by a liberal public morality, and pivotal people with pivotal liberal ideas, at moments of constitutional redefinition. The fact that radical plans of free-market reforms have succeeded in Poland and other C&EE countries that are geographically and culturally closer to western Europe is not a demonstration that economics can be put into the service of humanity in a mechanistic way. The scholarly consensus on the problems of transition and development is increasingly appreciative of the complexity and specificity of institutions that should from now on inform the transition reform community of the need to change its approach from top-down and foreign-led to bottom-up and locally/indigenously informed. To stress the importance of understanding informal institutions, Douglass North often makes the point that diligent advisers of economic reforms in developing nations must “soak themselves in” the indigenous culture for at least six months in order to be able to give informed advice that takes account of the informal institutions guiding behavior that might conflict with his theory, acquiring the local knowledge of norms, and even then, our success as external planners is not guaranteed. The pretense of knowledge that has dominated the attitude of economists since World War II carried on in postcommunists’ modeling of transition, and that was detrimental to the economies of eastern European in planning intuitional and economic transitions. In this survey of lessons learned from the collapse of communism, we find: 1. The problems encountered in the post-socialist transition can be imputed to a neglect of the role of political/legal institutions and cultural/social institutions that provide the underlying environment within which these institutions take root. 2. The neglect of culture was caused by an overemphasis on the technical approach, emphasizing microeconomic efficiency and macroeconomic stabilization, and then the transplanting of the formal institutions of functioning Western democracies over the informal, cultural institutions as the basis of a nation’s social capital, legitimizing the public capital and the direction of the formal legal/political institutions, and the economic/financial policies. 3. The roles of leadership and liberal ideas are underappreciated. We hope to have shown that the biggest lesson learned is one of humility about the extent to which the standard body of neoclassical economics can directly guide the transition path of reforming countries and the adequate policies and institutions that best promote markets, productive entrepreneurship, and growth. We find that insights from the classical political economists, the Austrian school of economics, public choice and constitutional political economy, law and economics, and new institutional economics filled in the analytical gap in neoclassical economics and revealed three main insights into what contributes to a successful transition:  (1)  leadership matters, as do (2)  the

The Collapse of Communism    673 underlying culture and (3) the moral fabric specific to each society undergoing institutional and economic transformations. The lesson from the collapse of communism is that flourishing markets—where individuals are able to recognize and bet on small and grand entrepreneurial ideas—depend on a formal-informal institutional environment that not only minimizes threats of arbitrary predation but also morally praises individuals for their productive and creative-innovative entrepreneurial contributions to society. Positive societal attitudes and sentiments toward entrepreneurship and innovation matter. A preexisting moral-cultural context of informal norms, attitudes, and beliefs favorable for the innovating class also contributed to success. Access to information through freedom of media, freedom of trade, and competition can help “civilize” society to adopt informal institutions favorable to a capitalist system.

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Chapter 30

T he P olitica l E c onomy of  Foreign In t e rv e nt i on Thomas K. Duncan and Christopher J. Coyne

Introduction Since the turn of the millennium, the United States has been involved in two major military occupations in Iraq and Afghanistan and numerous other military foreign interventions around the globe. In response to the heightened sense of vulnerability following the September 11, 2001, terrorist attack, the United States began the opening salvos of what would eventually become known as the War on Terror. Under the auspices of this open-ended, global war on the perpetrators of terrorism, the US military has found itself embroiled in conflict amid the Middle Eastern and North African regions for more than a decade. While Afghanistan (2001–present) and Iraq (2003–2011) were longer in duration and greater in extent, as measured by troops on the ground, than other interventions, the United States and its allies have conducted military operations of varying levels of intensity in Yemen (2002, 2011–present), the Philippines (2002), Côte d’Ivoire (2002), Liberia (2003), Georgia (2003, 2008), Djibouti (2003), Haiti (2004), Ethiopia (2004), Kenya (2004), Eritrea (2004), Pakistan (2004–present), Lebanon (2006), Somalia (2007, 2011–present), Libya (2011), Uganda (2011), Jordan (2012), Turkey (2012), Chad (2012), and Mali (2013). The major wars in Iraq and Afghanistan were both declared and widely publicized, but many of these other engagements have been largely covert, “fought mainly with air power and increasingly with drones rather than ground troops” (Bilmes and Intriligator 2013, 8). In essence, the United States has set itself on the path of permanent war (Bacevich 2010; Duncan and Coyne 2013a; 2013b) where even appeals to end the continual warfare have fallen to the wayside in the discourse of American politics (Dudziak 2012). Although each of these actions had differing reasons and levels of commitment, the hoped-for end result was much the same for all. In each intervention, those intervening

The Political Economy of Foreign Intervention    679 planned for the stated end of increased peace and stability. In some cases, the stated ends went even further and involved an accompanying shift from an oppressive and dictatorial regime to a free and open democratic system. The results have varied in degrees of success, but to call any one of these interventions successful would be a severe stretch of the definition. Neither the war in Afghanistan nor the war in Iraq has produced a stable, democratic society under which the civilian population is substantively better off than it was previously (Coyne 2008; 2013). Even the less intensive operations do not necessarily produce good results. For example, the 2011 Libyan intervention, limited though it was,1 has not only produced results that have increased instability inside Libya (Mezran, Pack, and Cook 2013) but has also destabilized other nations in North Africa, as mercenary troops previously held in Libya and employed by Mu’ammer Gaddafi have migrated into Mali in order to revisit a previous civil war there (Douthat 2012). That Gaddafi, ruthless and dictatorial as he was, may have been performing a stabilizing function for the region was a concept that the interveners in 2011 either downplayed or did not foresee. The issue of foresight brings us to the central question of this chapter: what role does the Austrian perspective play in our understanding of foreign intervention? The answer lies in the fuller understanding of the epistemological and motivational challenges that interveners face when they decide to engage in an actual intervention, military or otherwise. It is the military interventions that most often capture the headlines, but the challenges that are faced in nonmilitary actions are often as difficult to surmount as those of their military counterparts. In the broadest sense, foreign intervention is the use of the discretionary power of a government in one society to address the perceived problems in foreign societies. Those working in the Austrian tradition have a long history of focusing on the limits of human reason in its ability to improve the world along the margins of economic planning, legal planning, and social planning more generally (Mises [1920] 1990; Hayek 1945; Sowell 1980; Lavoie 1985a; Lavoie 1985b; Boettke 1993; Boettke 2002; Ikeda 1997; Coyne 2008; Coyne 2013). In particular, this tradition has placed a strong emphasis on the epistemic limitations faced by those who would attempt to rationally construct a better world. When it comes to foreign military intervention, the Austrian perspective provides a way of looking at the details, one that grasps the idea that societies are a constantly evolving social order that stems from the actions of many individuals. These individuals pursue their own ends and must coordinate their activities with one another based on a multitude of ever-changing signals and scenarios in such a way that results in a spontaneous order—one of human action but not of human design (Hayek 1978, 96–105; 1988, 6). It is this perspective that grants the Austrian position a fuller accounting of the merits of foreign intervention, with those merits weighted against the known and potential costs of intervening. If the desired goal, from the perspective of the intervener,2 is one of 1  The 2011 Libyan intervention was largely limited to international air strikes and the imposition of a no-fly zone enforced against the Gaddafi regime by the United States and the NATO coalition. 2  To clarify, the desired goals to be analyzed throughout this chapter are those as stated by the intervener. The authors take as given that the intervener is honest in stating a desire and a plan to correct perceived problems in the foreign society.

680    Development, Transition, and Social Change peace and stability, of democracy, or of increased economic growth for the nation being intervened upon, then it is important to take note of what is necessary to achieve any one or all of these goals. There must also be recognition of the differing strategies that one can potentially employ to achieve those desired goals. In order to change individual behavior within the intervened-upon nation, a change of the context within which the individual operates is required. This change in context may arise at varying levels of intensity. The intervener has, in essence, a choice to make about whether the intervention will seek to change the entire political, economic, and legal structure of the society in question, perhaps via a complete reconstruction, as was attempted in Iraq (Coyne 2008), or seek to change behavior within the context of the existing structure of society, perhaps via offering humanitarian aid, as has been attempted in many nations around the globe (Easterly 2002; Easterly 2006; Coyne 2013).3 In essence, the decision becomes one of focusing on changes to the overarching meta-rules of society or focusing only on marginal changes to the incentive structure within the current meta-rules. Either course of action will involve its own unique set of epistemological challenges and, given the limits on human reason, create distinctive unforeseen and unintended consequences. With either approach, the intervener must: 1. Have a broad conception of what is necessary in order to achieve these end goals. 2. Have the context-specific knowledge to move from the general conception to the actual implementation within the nation of interest. 3. Be cognizant of, and able to adapt to, the unintended consequences that may arise in both the foreign nation of interest and domestically within the intervening nation as a result of the continued interaction. In an effort to explore these nuances more fully, this chapter explores foreign intervention from the Austrian perspective. The next section offers an expanded definition of foreign intervention with an emphasis on the process aspect of intervening abroad. The section after that provides a more detailed analysis of the epistemic challenges faced when interventions attempt to create meta-rule changes. Next comes a discussion of the challenges faced when the focus is on changing incentives within the current institutional structure. Then the chapter explores the potential for unintended consequences that arise from the method of intervention within both the intervened-upon nation and the intervening nation. The section after that deliberates the spillover effects of a foreign intervention. A concluding section follows. 3 

Of course, the intervener might also choose a mix of these two strategies, attempting to foster broader institutional change while simultaneously offering short-term aid and assistance. The key point here is that the intervener must make a decision about the desired end goals and that those decisions will influence the scope of required reforms in the occupied nation.

The Political Economy of Foreign Intervention    681

Foreign Intervention as a Process Good intentions do not necessarily lead to good outcomes. The disparity between the intentions of the intervener and the result of the intervention is the crux of the problem that economics can help to understand. The economic way of thinking can be used to analyze why this disparity has historically existed and why one should expect that gap to persist into the future. Much of the disconnection between intentions and results comes from the oversimplification of what it means to actually intervene in a foreign society. Foreign intervention is the use of the discretionary power of a government in one society to address the perceived problems in foreign societies. Typically, the use of this discretionary power is an attempt to construct a preferable state of the world for the population of the intervened-upon nation. The overarching concept is that the intervener will, either through indirect or direct measures, be able to increase the well-being of the recipient nation. Regardless of this intention, the preferable state has not often been achieved (Payne 2007; Coyne 2008; Coyne 2009). While there is an array of potential issues that may contribute to these failures, the focus of the Austrian tradition has been on the knowledge constraint facing the designers of interventions and reforms (see Mises [1920] 1990; Hayek 1945; Sowell 1980; Lavoie 1985a; Lavoie 1985b; Boettke 1993; Boettke 2002; Ikeda 1997; Coyne 2008; Coyne 2013). At its heart, foreign interventionism is a form of rational constructivism, subject to the same or similar challenges inherent in central planning and constructivism. It is a top-down approach to shaping the nature of the world. It is important to note that an intervention is intended to create a state of the world that is preferable from the standpoint of those intervening. The intended new world is designed by the intervener and implemented in the foreign nation through a variety of methods. The challenge of central planning, or the “knowledge problem,” emphasizes that planners lack the context-specific knowledge to effectively achieve their ends through rational planning. The intervener faces the epistemic constraint of discovering and using knowledge that is not only dispersed throughout society (Hayek 1945) but is also changing and adapting in unforeseen ways even as the plans are implemented (Hayek 1988). The extent to which intervention faces these challenges of central planning is a function of how complex and detailed the strategy is to achieve a desired outcome. Foreign intervention can be viewed as lying along a continuum of different methods and strategies. … At one end of the continuum are ”softer” interventions such as the control and dissemination of information and cultural products. As one moves along the continuum, interventions become “harder” and may involve mediation, public denunciation, travel bans, the freezing of assets, embargos, sanctions, and peacekeeping and military activities, among other activities. (Coyne and Mathers 2010, 228).

682    Development, Transition, and Social Change As the interventions become larger and more complex, they come to rely more heavily on rational constructivism. The greater the amount of desired change and the more intrusive the method used to bring about change, the more the intervener must account for, and the more the intervener must design in terms of strategies and contingencies. As a clarifying example, “consider that releasing or controlling certain information (an intervention toward the softer end of the continuum) relies less on constructivism as compared to the military occupation and the construction of a country’s economic, legal, political, and social institutions (an intervention toward the harder end of the continuum)” (Coyne and Mathers 2010, 229). Likewise, the US and NATO intervention in Libya required a less intricately designed plan than the complete reconstruction of Iraq in the postwar period, even though the Libya intervention may still have been on the harder side of the available options for intervening. The same logic that applies to postwar reconstruction can be scaled to match an intervention’s particular location along the continuum. Even softer interventions, such as the release and control of information, face a number of challenges that must be taken into account. Interventions of greater complexity and lengthened duration add to the necessary level of rational constructivism that must exist and hence increase the level of context-specific knowledge that a planner must collect and utilize effectively. Thinking in terms of this continuum, one should expect that softer interventions may be more likely to succeed than harder interventions, as the burden upon the planner is lessened in the former. It may also imply that there is an upper limit to what foreign intervention can reasonably achieve, an upper bound established by the limits of what can be rationally constructed and implemented. An appreciation of these limits, which are not always evident or concrete, will allow decision-makers and analysts to be more realistic when weighing the expected benefits against the potential costs of engaging in an intervention, especially if the expected benefits rely on a state of the world that may not be in the feasible possibility set.

Epistemic Challenges of a Meta-Level Intervention In order to gain further understanding of what it means for a planner to face the knowledge problem, it is useful to consider such challenges in the case of a relatively hard intervention. Specifically, consider an instance where those who engage in military intervention do so with the end of promoting a foreign nation’s shift toward a peaceful liberal democracy. Achieving this goal requires interveners to design and implement wholesale changes to the overarching institutional rules that govern a society. In this context, the knowledge problem manifests itself through the limited knowledge available to outside planners who wish to design effective—that is, self-sustaining and functioning—meta-rules that constrain government (Coyne 2008). To the extent that

The Political Economy of Foreign Intervention    683 policy makers are honest about their intentions to use foreign intervention to construct a liberal democracy, they should be judged in regard to whether that outcome is likely to be the result. To properly assess the ability of an intervening power to change the foreign society in beneficial ways, it is worthwhile first to understand how societies arise and function prior to the intervention. As Hayek (1988, 76) notes:  Adaptation to the unknown is the key in all evolution, and the totality of events to which the modern market order constantly adapts itself is indeed unknown to anybody … the whole structure of activities tends to adapt, through these partial and fragmentary signals, to conditions foreseen by and known to no individual. . . . There can be no deliberately planned substitutes for such a self-ordering process of adaptation to the unknown. (emphasis in original)

Although Hayek speaks of the market order, his analysis is equally true of social order, a point he was cognizant of when he argued that in order to “understand our civilization, one must appreciate that the extended order resulted not from human design or intention but spontaneously: it arose from unintentionally conforming to certain traditional and largely moral practices … whose significance they [people] usually fail to understand, whose validity they cannot prove” (1988, 6). Societies are the outcome of individual actors responding and adapting to a variety of signals received from other individual actors that have created, in essence, a spontaneous order under which these disparate actors either thrive or do not. Of course, order is not entirely spontaneous. Even as he emphasized the importance of emergent orders, Hayek (1988, 37) also recognized that there is an important role for designed organizations: “among the rules of conduct that make it possible for extensive spontaneous orders to be formed, some will also facilitate deliberate organizations suited to operate within the larger system.” In a functioning society, there exist both spontaneous and designed orders that are simultaneously separate and connected (North 2005; Boettke, Coyne, and Leeson 2008; Williamson 2009; Wagner 2010). For interveners to be successful at creating a new and functioning society, they must be cognizant of the changes necessary to not only the designed orders but also the nondesigned ones. To clarify this point, one can think of the institutional structure of a society as the rules of the game. These rules, both formal and informal, are the determinants of economic, political, and social outcomes (North 1990). The informal rules refer to the underlying norms, beliefs, and attitudes held by people, often formed spontaneously through interactions with one another. These informal rules are often context-specific and evolve to coordinate behavior only within that context. They are the result of a historical evolution that may not even be understood by those who still abide by them. In this way, they can be seen as cultural in nature. The formal rules are those that are written, either codified from existing behaviors or designed for new circumstances. However, if these formal rules are to be successful in guiding society toward the desired path, they must operate

684    Development, Transition, and Social Change within the context of the informal rules (North 1990; North 2005; Boettke, Coyne, and Leeson 2008). As there are multiple levels of institutions, with each level providing its own portion of the rules by which individuals in society coordinate, the less conflict that exists between the rules, the better will be the coordinating effect. An understanding of these layers is important when considering the feasibility of foreign intervention, especially a hard one such as nation building, as the intent of the intervention is to generate self-sustaining changes in formal institutions. The introduction of the intervening force, with its own view of the proper rules of the game, adds to the level of complex interactions between levels institutions, and “[c]‌onstructed, large-scale attempts at social change which are not rooted in the de facto norms of existence of the current order are destined to disrupt social order and retard—rather than promote—social betterment” (Boettke 2001, 257). The society where intervention is being considered is not a tabula rasa but rather is characterized by its own unique array of formal and informal rules, which will often be at odds with what foreign interventionists would like to ideally implement. Although formal rules may de jure be removed and implemented through the rewriting of the codes, the underlying informal rules and norms are much more difficult to identify and shape according to the plan. These informal rules will operate as a constraint on what formal rules will peaceably be instituted. The peaceable stability of the society will be a function of how well the implemented formal rules mesh with the informal rules, which are slower to adapt and whose methods of adaptation are far more difficult to predict. In order to highlight this relationship and better understand how conflict between the rules can be minimized or enlarged, one can consider the enforcement costs associated with the continuation of formal rules once implemented. If the formal rules perfectly align with the underlying norms and beliefs, then these rules will be self-enforcing, meaning that the individual actors will voluntarily comply with them absent any external coercive pressure. In such a case, the costs associated with enforcement will be zero or minimal. However, the more incompatible the formal rules are with the underlying norms, the more external coercive pressure must be exerted. This increased pressure necessarily leads to greater enforcement costs. If the individuals in the society do not voluntarily comply with the implemented formal rules, the increased conflict will manifest itself in terms of both greater levels of resources necessary to maintain order and increased levels of coercion necessary to force people to acquiesce to the dictates specified by the formal rules. Thus, failure to coordinate the formal rules with informal ones will lead to both a more costly intervention and the instituting of greater coercion, which will undermine the very liberal democracy that the intervention intended to create. If interveners desire to create a peaceful and prosperous society, they will “have to find a way to understand the ideas, beliefs, habits that are indigenous to an area, and then see how the political, legal, and economic institutions that are correlated with economic development fit into the social ecology” (Boettke 2001, 259). Considered in terms of the epistemic problem of foreign intervention, this reality means that the interveners, in order to plan the institutional structure

The Political Economy of Foreign Intervention    685 that leads to their desired preferable state, must have an understanding not only of the formal rules that they would like to institute but also of the informal, cultural rules that already exist. Of course, gaining this knowledge of the informal rules is not a simple task. Firstly, as previously stated, the actual effects of these informal rules may not be completely understood by those who follow them. As informal rules are emergent in nature, the indigenous population may have a tacit understanding of their interactions, whereby they engage in customs and norms that continue to produce coordinating outcomes but that they cannot coherently explain to one outside the context in which the interactions take place. Second, and related to the first, the informal rules are context-specific. Not only might the context-specificity lead to a tacit knowledge on the part of the intervened-upon population, but if the informal rules require a specific context in which to operate, then a change in the context will lead to a disjointing between the underlying informal rules and the new context. Interactions that were previously coordinating in nature may no longer coordinate when operating within the context of the newly implemented formal rules. The outcomes of the interactions may be dramatically changed. The new context may also create incentives that begin the process of changing the norms and culture. As the original context created a specific emergent order, the new context may also produce its own specific order that emerges over time. Yet the dynamics of spontaneous order formation is a process that neither social scientists nor policy makers fully understand. Should these orderings emerge in ways that are positive, such that the informal rules adapt (slowly) in the direction of the desired goals, then the intervener may find more long-term success from the intervention. However, orders may emerge in unpredictable ways, leaving no guarantee that the society will move toward liberal democracy rather than farther away from it. Thus, the intervener will need a working knowledge not only of the cultural rules but also of how those rules will adapt to the presence of the intervening force as it attempts to create social change.

Epistemic Challenges of Rules-Constrained Intervention Of course, not every intervention is intended to be as sweeping a change as the attempt to export democracy. Rather than seeking to reconstruct a nation at the level of its meta-rules, a foreign intervention may also attempt to change behaviors while operating within the existing framework. Humanitarian action has often employed strategies of this type (Easterly 2002; Easterly 2006; Coyne and Boettke 2006; Coyne 2013). Humanitarian action, much like foreign intervention implies a range of possible activities in which an intervener may engage. This range of activities can also be thought of as a continuum between soft and hard actions, ranging from

686    Development, Transition, and Social Change the distribution of foreign aid to military peacekeeping efforts. Rather than seeking wholesale institutional change, these interventions attempt to make changes at the margin. These actions vary along a spectrum that includes activities such as giving food to people (soft) to giving government funds and advice on how to reform its institutions (harder). Yet even the harder cases are not as hard as attempting complete institutional change via occupation. Although humanitarian actions may be theoretically less complex than a complete societal reconstruction, one should not infer that they are simple. Engaging in state-led humanitarian efforts, with the goal of increasing economic growth in the intervened-upon nation, also relies ultimately on the ability (or failure) to centrally plan. Across the continuum of soft to hard humanitarian interventions, the stated end goal is to “alleviate potential or existing human suffering and to improve the human condition” (Coyne 2013, 18). Operating within the context of a specific national regime, the humanitarian efforts are an attempt to produce a more beneficial allocation of resources, planned and implemented by the intervening state. In general, the state-led humanitarian “mentality holds that human suffering can be removed or prevented, that human welfare can be improved as desired, provided that the right people are in charge with the right level of resources and the right amount of will power … , that improving the human condition is a purely technological problem” (Coyne 2013, 16). Even though the complexity is lessened, and despite the claims of the humanitarian mentality, these efforts do not fully escape the knowledge problem. Resource allocation is also in part an outcome of spontaneous ordering. The determination of value for resources is achieved through the process of market activity (Mises [1920] 1990; Mises [1922] 1981; Hayek 1945; Kirzner 1973; Mises [1949] 2007). It is within the context of market competition, within the “higgling and bargaining of the market” (Smith [1776] 1991, 37), that individual preferences are revealed and resource values are discovered. The knowledge of these preferences and valuations is “not given to anyone in its totality” (Hayek 1945, 520). Within the context of the market setting, goods and services are exchanged via the actions of voluntary buying and selling. The activities of individual producers and consumers are coordinated through the feedback mechanisms of monetary prices and profit and loss. It is these mechanisms that allow economic actors to engage in economic calculation. The exchange ratios, or prices, generated through the voluntary exchange process provide a common denominator with which individuals can calculate the relative values of alternative goods and services. The system of profit and loss, in conjunction with prices, provides feedback regarding whether resources are being channeled to their most socially valued use. When an output generates profit, this provides the producer with a signal that the current use of the resources is valuable. Should the output generate losses, then the producer has a signal that what has been created is not as valuable as the alternative uses toward which the resources could have been put. It is the constant feedback of this profit-and-loss system that enables the outcome whereby

The Political Economy of Foreign Intervention    687 the diverse plans of disparate economic actors are coordinated into socially desirable outcomes. The knowledge of the optimal use of scarce resources is not given ex ante but instead must be discovered through the process of individual choice (Mises [1920] 1990; Mises [1922] 1981; Mises [1949] 2007; Hayek 1945; Thomsen 1992; Duncan and Coyne 2013b). Given that they are executed through a variety of government agencies, state-led humanitarian efforts circumvent the market process and must rely on a nonmarket method of allocation, which becomes allocation by administrative preference (see Hoff 1949; Huerta de Soto 2010). Administrative determinations, based on the intervener’s preference for resource distribution, take precedence over the determinations of those who consume the resources. The central planner asserts his plan over the disparate plans of the individuals within the intervened-upon society, a plan that is based on a predetermined end of his own and without regard or recourse to the emergent discovery and coordination processes that take place in market transactions. The power of markets is that they allow for the spontaneous coordination of individuals who are able to act upon context-specific knowledge of time and place (Hayek 1945). This allows economic actors to continually adjust their plans and actions in response to the rapidly and continuously changing signals of the market. However, in the context of state-led humanitarian action, which takes place outside of markets, the central planner must anticipate these unknown changes and attempt to simulate the coordinating properties through trial and error. Yet with no feedback mechanisms from which to determine failure or success—that is, prices and profit and loss—there is no way for the planner to be sure that he is allocating resources to their highest-valued use. Without the sanctioning force of economic loss, the central planner is without a method for recognizing and correcting his errors (Coyne 2013). This inability to engage in economic calculation matters for two key reasons. First, the state-led humanitarian efforts are unable to achieve economic growth, which ultimately requires continuous allocation of resources to their highest-valued uses (see Coyne 2013). Second, even in instances where humanitarian action does not seek to achieve economic growth but rather seeks more humble ends such as the delivery of relief resources, effective feedback is still lacking. Such feedback, however, is crucial for securing the largest return for humanitarian investments. Wasting scarce humanitarian resources or allocating them to areas where they are less needed undermines the broader goal of alleviating the most suffering possible. To clarify these dynamics, consider a case where humanitarian action has not produced the stated goal: the Helmand Valley Project in Afghanistan. Coyne (2013, 1–7) provides a detailed case study of this failed project, which was meant to produce sustained growth for the region. The interveners, in this endeavor the United States and its NATO allies, determined to “increase the standards of living of the poor through the development of farms, infrastructure for electricity, and protection against flooding” (Coyne 2013, 2). However, the plans of the interveners were unable to account for the context-specific knowledge that had determined the previous uses, or nonuses, of the area.

688    Development, Transition, and Social Change The project was an effort that combined building a massive dam and resettling members of the Afghan population into the newly irrigated lands. While the dam did provide the increase in water flow, the Afghans who had been farming the dry region for centuries had no concept of how to deal with the increased water. It had not previously been an issue with which they had to cope. Rather than provide the planned-for boon, the farmland suffered “numerous instances of flooding of fields, resulting in a substantial decrease in agricultural output—up to 50 percent in some area” (Coyne 2013, 3). Likewise, during the resettlement phase of the project, the interveners did not account for the fact that the land distributed to new settlers was unsuitable for farming, which is why the land was previously unsettled. In these endeavors, the intervening authority assumed a valuation of both the water and the land that was not reflective of the underlying valuation of the individuals meant to farm (or not) the Helmand Valley. Yet because of the missing system of profit and loss, the penalties for misallocating the resources are not available. In the market context, the misallocated resources would result in an economic loss leading to a subsequent exit from the market. Without this sorting mechanism, the failed attempts at humanitarian action get continuously repeated. Now consider an example of the second scenario, an instance where humanitarians seek not to foster economic progress but rather to supply medical assistance to those in need. It is important to note that this is purely a technological issue, in that the governments of developed countries possess the know-how and resources to develop or purchase medical devices and aid. From this standpoint, the issue is a purely technological one of delivering the goods from point A to point B (to those in need) and making sure they have the resources to use the goods. In other words, in theory, this is a much easier task than “creating” development. However, without true economic feedback mechanisms, even this seemingly simpler task becomes an exercise in frustration. This frustration is reflected in the humanitarian attempts to send medical devices to the Mulago National Referral Hospital and the Bwindi Community Hospital in Uganda (Miesen 2013). Both hospitals have received generous donations, including incubators for Mulago’s neonatal intensive care unit and an anesthesia machine for Bwindi. Yet in both cases, the medical devices have become more of a burden on the local hospitals than a boon. While both hospitals were able to receive the devices—that is, the technological problem seemed to be solved—the absence of the market feedback does not allow for the planners to account for the details of the array of complementary goods necessary to allow these devices to function properly. Although Mulago received twenty incubators, thirteen were broken, and one had instructions delivered that were in Dutch, a language not spoken in the region. The anesthesia machine in Bwindi served for one patient before it stopped working. Inside a market context, the feedback mechanisms would signal a demand for staff, technicians, repair people, spare parts, and so on, but under the administrative context, these complements and adjustments to changing circumstances must be recognized and accounted for within the plan. While it is seemingly simple to craft a plan to send the initial devices, crafting a plan that allows for the continuous operation and replacement of the machines becomes far more complex. As it is, the medical

The Political Economy of Foreign Intervention    689 devices now litter wings in both hospitals, taking up space rather than providing actual humanitarian benefits.

Unintended Consequences of Administrative Determination The inability to determine valuations within the administrative decision-making process has further unintended consequences beyond creating an inability to account for context-specific market information. Or, rather, it would be more accurate to say that this inability leads to secondary effects. When operating without the definitive feedback mechanisms of profit and loss, political knowledge is forced to replace market knowledge. Without the rewards and penalties of profit and loss to sanction behavior, political activity will become the norm (Higgs 2007; Coyne 2013; Duncan and Coyne 2013a; Duncan and Coyne 2013b). The political process that replaces the market process generates a set of incentives and a new arena for windfall political profits that differ from those in the market setting. A system of competition for these profits still exists, driven not by consumer demands but by the desires of government agents and those with political ties operating within the context of the bureaucratic system. Political competition in the realm of foreign intervention can manifest itself in a number of ways. First, any benefits that may accrue to the intervened-upon society will be vigorously sought by those within that society. Consider again the humanitarian action aspect of intervention. The availability of funds from donor countries will incentivize political competition within the recipient governments. Current and potential leaders of the intervened-upon society will see the profit opportunity of capturing the influx of humanitarian funds, and the existence of this opportunity will exacerbate infighting and rent seeking at the governmental level. This additional infighting and rent seeking may further erode the institutions of the society in terms of “weakened accountability of political actors, more rent seeking and corruption, greater chances of conflict resulting from efforts to secure and control assistance, and a lessening of the incentive to reform inefficient institutions and policies” (Coyne 2013, 95). Second, competition will arise among the organizations that are employed to oversee the components of the intervention. Nongovernmental organizations (NGOs) that operate in the context of interventions, in demesne of postwar reconstruction (Coyne 2008), humanitarian action (Coyne 2013), or otherwise, stand to benefit from the availability of funds throughout the process of the intervention. Even when operating with the most noble of intentions, the limited nature of government funding available will lead the NGOs to engage in the political process via rent seeking in order to capture as much funding as quickly as possible (Cooley and Ron 2002; Coyne 2013, 96–98). The incentive structure established as a result of relying on the planner’s favor through the

690    Development, Transition, and Social Change political process rather than the signals of valuation in the now-circumvented market process leads to the perverse necessity for NGOs to spend both time and resources on securing new contracts rather than working to actually produce the desired outcomes within the intervened-upon society. Without funding, there can be no resources put toward increasing the society well-being in the intervened-upon society, but without political favor in terms of the planner’s preference, there can be no access to the funding. The incentive, then, is for the NGO to trade off the well-being at the margin in return for continued favor and continued existence of the NGO. The preceding concerns with regard to the political competition that arises in the absence of a market setting consider what unintended changes may arise within the intervened-upon society and with the organizations attempting to aid that society through intervention. Yet the consequences of the political context are not limited to only changing the nature of the foreign society. Similar to the changing nature of the NGO activities, there will also be changes wrought within the administrative agencies and their industrial partners within the intervening nation. Since the administrative decision-making procedure does not provide the same heavy-handed correction as the market’s economic loss function, political competition will become “intensified among the various government bureaus that seek to control as many resources as possible with the aim of securing the power and influence over policy associated with greater resources control” (Coyne 2013, 96). Much like the NGOs, these bureaus, whose budgets depend on the attention paid to their specific issue, must compete for the favor of the planner. Thus, the very organization of the intervening nation’s government will be affected from the changing incentives created by the intervention. New bureaus are created, or existing ones take on new roles, and their budgets or budget increases become tied to their new activities. As each bureau attempts to justify its own existence, each must compete politically for the continuation of its own unique role, leading to “a conflict of visions as each bureau pursues its own agenda, even though all are supposed to be working toward a common goal of helping those in need” (Coyne 2013, 96). Of course, the agencies are not the only beneficiaries of the missing economic profit-and-loss system. As the implementation of foreign intervention moves into the planner’s realm, shifting into administrative decision-making and away from price determination via the market process, the political profits change the incentives of the industrial base of the intervening nation, too. With the influx of funding that is not bounded by the penalties of economic loss, there are gains to be captured via the industries that supply goods for interventions. Higgs (2007, 308) uses similar logic when analyzing the post–World War II national defense system in the United States, arguing that “deals came to turn not on price, but on technical and scientific capabilities, size, experience, and established reputations as a military supplier—vaguer attributes that are easier to fudge for one’s friends.” Foreign interventions are not necessarily militaristic in nature (though postwar reconstructions and many humanitarian interventions are), but the idea that actors respond to changing incentive structures is not applicable only to defense. As the intervention sector increases in influence, because

The Political Economy of Foreign Intervention    691 of the monetary availability that is not subject to the profit-and-loss mechanism, the pseudo-profits available draw actors to seek them. These actors, once engaged within the system of intervention, become another component of the political competition. Those who create the relationships necessary to secure funds will also be those who have the relationships necessary to keep that funding geared toward their specific production, creating vested interests (Friedman and Friedman 1984). These special interests, engaging in political competition, will seek to influence interventionist policy through lobbying. The creation of political profits, unsanctioned by market losses, will engender changes across the intervening nation’s economy in terms of resource use. One effect will be the transfer of wealth and dead-weight loss associated with rent seeking in general. Although there are political profits to be had, there will be a limited number of “winners” that can be selected on the basis of political favor. Thus, as the competition takes place, many resources will be shifted from productive activity into less productive or unproductive areas for lobbying purposes. Many of these resources, in terms of those spent by the political “losers,” will be entirely wasted, creating a greater amount of dead-weight loss in economic activity (Tullock 2005, 148–159). This will occur globally in terms of competing recipient governments and competing NGOs, but it will also occur within the intervening nation’s economy in terms of domestic NGOs, government agencies, and the foreign intervention-specific industries. However, the economic losses and distortion internal to the intervening nation will be greater than even this dead-weight loss might suggest. Once the decision process is removed from the process of market feedback and the price system, the decisions are moved from the realm of economic efficiency and into that of perceived need in the context of a bureaucratic structure. The economic nature of bureaucracy is that of budget allotment. As the system of profit and loss is no longer employed as a benchmark for necessary resource allocation, this allocation becomes determined by spending levels. If the bureau spends less than its complete budget, the additional funds are considered unnecessary during the next term’s budget decisions. This process of resource determination establishes the incentive that a bureau should always spend its complete budget to ensure that it maintains its level of resources over time. Spending the entirety of the budget may also increase the following term’s budget, as it may indicate that the previous resource allocation was too low. The incentive during the foreign intervention, then, is to spend the budget regardless of whether or not spending the entire budget is what is required to generate the outcomes sought during the intervention. To sustain the bureau, or agency, especially in the climate of political competition, is to continuously spend and continuously seek to increase the agencies’ access to funding. In terms of foreign intervention, the agencies involved will seek to create demand for their activities through public relations and lobbying campaigns, they will seek to take on more and more complex projects during the intervention through the process of mission creep, and throughout the intervention they will disregard or neglect cost-saving approaches to the projects they undertake (Coyne 2013, 110–115).

692    Development, Transition, and Social Change The lack of an effective loss signal allows the bureau to expand its range of activities and push up its limit of resource allocation over time. This process is systematically true of the NGO, the government agency, and the industry that supplies the goods and services to the intervention efforts. The incentive structure of the bureaucratic allocation, then, eventually leads to an overinvestment of resources in the area of foreign intervention. Two effects, each related to the other, will result from this incentive structure created by overinvestment. First, as the gains to participation in the intervention increase, more bureaus, agencies, and industries will begin to see expected payouts from rent-seeking activities. Over time, more players will attempt to curry political favor via lobbying, which will lead to greater dead-weight loss in the intervening nation’s economy. This increasing loss will necessarily have an effect on the intervening nation’s long-term economic growth prospects. Second, the unsanctioned overinvestment will lead to profit opportunities in the intervention sector of the economy that otherwise would not have existed, drawing even more resources from other areas of the economy. This effect will cause greater distortions within the market process of economic activity not directly linked to that of intervention as resources are allocated away from more efficient uses (Duncan and Coyne 2013b). This distortion will also increase over time. The lure of profit available in this sector, abnormally high profit resulting from the lack of economic loss, will draw talented entrepreneurs from the nonintervention economy and into discovery activities more oriented toward supplying goods and services to the intervention. As Holcombe (1998, 46–47) argues, “Entrepreneurial ideas arise when an entrepreneur sees that the ideas developed by earlier entrepreneurs can be combined to produce a new process or output,” and “acts of entrepreneurship create an environment within which innovations build on themselves.” In other words, with each new entrepreneurial discovery comes an array of future profit opportunities (see also Kirzner 1985). While this multiplier effect of entrepreneurial activity is a positive force for economic growth and improved well-being in a market setting because of efficiency-enhancing innovation, in the political competitions of the administrative setting, there is no guarantee that the same entrepreneurial activity will yield benefits from an efficiency standpoint (see Coyne, Sobel, and Dove 2010). Should the discovery process begin with a distorted profit opportunity, additional connected discoveries can lead to greater resource misallocations, both in terms of NGO, agency, and industry lobbying and in terms of misdirected production in the intervention sector, which persist for prolonged periods of time with no mechanism for correction. Even if we assume that the initial intervention activity is value-added or matches the intervening population’s demand for humanitarian action, which is a large assumption absent economic calculation as a feedback mechanism, that initial activity will generate future profit opportunities, which may very well fail to be value-added as future entrepreneurs seek to capture the windfall profits through the political, as compared with the market, process. The resulting outcome for the intervening nation is that its economic activity will shift away from that which will increase the well-being of its own population and toward that which will be used in intervention efforts that

The Political Economy of Foreign Intervention    693 ultimately fail, because it also suffers from the knowledge problem on the recipient nation’s end.

Further Unintended Consequences Foreign interventions also do not operate in a vacuum whereby experiments in intervention affect only the two nations directly involved in the attempt. A potential intervener must also consider the effects on the international community when designing an intervention. All action takes place within the international community, meaning that the intervention often has spillover effects into third or more parties. As in the preceding discussion of the limits of constructivism, we must now note the complexity of the global system in which the intervener will seek to operate. Each nation individually has a long history, complete with its own cultural interactions. However, this reality is not limited to only the internal history of a nation. Regions of the world and collections of nations (or at least the individuals who make up these regions and nations) also have a mix of both formal and informal interactions that define their relationships. Relative to the complexity of these layered interactions, an intervention must necessarily be simplistic. Even a major intervention, such as the reconstruction of Iraq, seeks only to change a small section of the much larger region of the Middle East, and as difficult a challenge as reconstructing Iraq may seem independently, that difficulty is dwarfed when considered in the context of reconstructing Iraq without affecting the stability of the surrounding region. As Coyne (2008, 170) notes, “a central negative unintended consequence of the occupation of Afghanistan and Iraq is that these actions may actually contribute to creating the next generation of terrorists.” Those who were a part of the insurgency in Iraq are likely to return to their homelands better trained with their battlefield experience, generating greater conflict in the surrounding region (National Intelligence Council 2004; Coyne 2008, 170). Even interventions on the softer side of the scale can lead to an increase in international instability. For example, one can think of the Libyan intervention with which this chapter began. At the outset of the intervention, it was not fully considered that military aid from the United States and its allies would have consequences on the nation of Mali (Douthat 2012; Mezran, Pack, and Cook 2013). However, what the designers of that intervention failed to recognize was that Gadaffi’s troops were composed of mercenary forces from the surrounding region. Once his regime ceased to pay for their presence, the troops, better trained and better equipped than when they arrived, returned to their homelands. In the case of Mali, this led to the reintroduction of the Tuareg population, who would reengage the nation in a civil war that had been halted during their employ in Gadaffi’s Libya (Nossiter 2012). The conflict in Mali, in part a result of the fall of Libya, would ravage the nation into early 2013. Obviously, if the goal of the intervention is peace and stability, considerations of

694    Development, Transition, and Social Change these consequences of action are of vital importance. Yet, given the above discussion of the difficulty inherent in determining the effects of an intervention on the indigenous population and the effects that will be imparted to the intervening nation, it is unlikely that a planner would be able to foresee the consequences that an intervention may have on the global community. Foreseeing these consequences is necessary. As has been discussed, once the planner has determined to engage in an intervention, where the method is one of administrative decision-making and bureaucratic management, the ability to respond to unforeseen occurrences as they emerge is very limited. Absent the individual adjustment processes that are enabled by the continuous feedback of prices and profit and loss, it will take a greater length of time for problems to be noted and passed up the chain of command in order for an administrative correction to be made. The information-gathering process has been truncated by the absence of feedback, so errors persist over time. This is true both locally and globally when issues arise. In addition to the slower speed of updating information regarding the intervention, the solutions to the problem may be difficult or impossible to determine given the lack of tacit knowledge of the situation. With the inability to engage in economic planning, the difficulty of solving economic problems may become insurmountable as the complexity of the global system is realized. Additionally, given the perverse incentives inherent in political competition and budgetary allocation, the agencies may be slow to implement resolutions even if they are known. Given the combination of the lack of information and the lack of accountability within the administrative decision-making process, adaptation to emerging unintended consequences will be necessarily slow, if that adaptation happens at all.

Conclusion To return to the central question of this chapter, what role does the Austrian perspective play in our understanding of foreign intervention? The Austrian perspective brings a cautionary note to those who wish to engage in intervention. As Hayek (1988, 76) noted, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” In that tradition, it is important for would-be interveners to take a full accounting of the daunting task before them, preferably prior to engaging in the intervention. Yet this should be read as a note of caution, not helplessness. The above discussion is not intended to prove that nothing can be done to improve the world but rather to suggest that those who seek improvement are constrained in their ability to achieve whatever state of the world they may envision. Rather than seeking to achieve specific end states through well-designed interventions, efforts aimed at improving the world may find more success if they are oriented toward unleashing the cooperative and productive nature of humankind. Efforts should be viewed as “unblocking” the discovery process and allowing humans’ natural tendency

The Political Economy of Foreign Intervention    695 of self-improvement to come to the fore. Instead of seeking to “create” the society that he or she wants, one who wishes social betterment may find that end by helping to remove barriers to discovery. This removal of barriers is less taxing in terms of human reason, as it seeks not to plan the structure of society but to allow individuals within it to work more efficiently toward their own goals of success. In other words, the Austrian perspective attempts to interject humility into the area of foreign intervention, emphasizing that “[w]‌hile the assumption of sufficient knowledge of the concrete facts generally produces a sort of intellectual hubris which deludes itself that reason can judge all values, the insight into the impossibility of such full knowledge induces an attitude of humility and reverence towards the experiences of mankind as a whole that has been precipitated in the values and institutions of existing society” (Hayek 1967, 39).

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696    Development, Transition, and Social Change Dudziak, Mary. 2012. “Peace Talks:  How War Disappeared from American Campaign Rhetoric.” Foreign Policy, November 6.  http://www.foreignpolicy.com/articles/2012/11/06/ peace_talks Duncan, Thomas K., and Christopher J. Coyne. 2013a. “The Origins of the Permanent War Economy.” Independent Review 18, no. 2: 219–240. Duncan, Thomas K., and Christopher J.  Coyne. 2013b. “The Overlooked Costs of the Permanent War Economy: A Market Process Approach.” Review of Austrian Economics 26, no. 4: 413–431. Easterly, William. 2002. The Elusive Quest for Growth:  Economists’ Adventures and Misadventures in the Tropics. Cambridge, MA: MIT Press. Easterly, William. 2006. The White Man’s Burden: Why the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good. New York: Penguin. Friedman, Milton, and Rose Friedman. 1984. Tyranny of the Status Quo. New York: Harcourt Brace Jovanovich. Hayek, Friedrich A. 1945. “The Use of Knowledge in Society.” American Economic Review 35, no. 4: 519–530. Hayek, Friedrich A. 1967. Studies in Philosophy, Politics, and Economics. Chicago: University of Chicago Press. Hayek, Friedrich A. 1978. New Studies in Philosophy, Politics, Economics and the History of Ideas. Chicago: University of Chicago Press. Hayek, Friedrich A. 1988. The Fatal Conceit: The Errors of Socialism. Chicago: University of Chicago Press. Higgs, Robert. 2007. “Military-Economic Fascism: How Business Corrupts Government, and Vice Versa.” Independent Review 12, no. 2: 299–316. Hoff, Trygve J. B. 1949. Economic Calculation in the Socialist Society. London: William Hodge. Holcombe, Randall G. 1998. “Entrepreneurship and Economic Growth.” Quarterly Journal of Austrian Economics 1, no. 2: 45–62. Huerta de Soto, Jesús. 2010. Socialism, Economic Calculation, and Entrepreneurship:  New Thinking in Political Economy. Cheltenham, UK: Edward Elgar. Ikeda, Sanford. 1997. Dynamics of the Mixed Economy: Toward a Theory of Interventionism. New York: Routledge. Kirzner, Israel M. 1973. Competition and Entrepreneurship. Chicago:  University of Chicago Press. Kirzner, Israel M. 1985. Discovery and the Capitalist Process. Chicago: University of Chicago Press. Lavoie, Donald. 1985a. National Economic Planning: What Is Left? Cambridge, MA: Ballinger. Lavoie, Donald. 1985b. Rivalry and Central Planning:  The Socialist Calculation Debate Reconsidered. New York: Cambridge University Press. Mezran, Karim, Jason Pack, and Haley Cook. 2013. “Libya’s Lessons on Syria.” Foreign Policy, September 4. http://mideast.foreignpolicy.com/posts/2013/09/04/libyas_lessons_on_syria Miesen, Mike. 2013. “The Inadequacy of Donating Medical Devices to Africa.” The Atlantic, September 20. http://www.theatlantic.com/international/print/2013/09/ the-inadequacy-of-donating-medical-devices-to-africa/279855/. Mises, Ludwig von. (1920) 1990. Economic Calculation in the Socialist Commonwealth. Auburn, AL: Ludwig von Mises Institute. Mises, Ludwig von. (1922) 1981. Socialism: An Economic and Sociological Analysis. Indianapolis: Liberty Fund.

The Political Economy of Foreign Intervention    697 Mises, Ludwig von. (1949) 2007. Human Action:  A  Treatise on Economics. Indianapolis: Liberty Fund. National Intelligence Council. 2004. Mapping the Global Future:  Report of the National Intelligence Council’s 2020 Project. http://www.dni.gov/files/documents/Global%20Trends_ Mapping%20the%20Global%20Future%202020%20Project.pdf North, Douglass C. 1990. Institutions, Institutional Change and Economic Performance. New York: Cambridge University Press. North, Douglass C. 2005. Understanding the Process of Economic Change. Princeton, NJ: Princeton University Press. Nossiter, Adam. 2012. “Qaddafi’s Weapons, Taken by Old Allies, Reinvigorate an Insurgent Army in Mali.” New York Times, February 5. http://www.nytimes.com/2012/02/06/world/ africa/tuaregs-use-qaddafis-arms-for-rebellion-in-mali.html Payne, James L. 2007. “Does Nation Building Work?” In Opposing the Crusader State:  Alternatives to Global Interventionism, edited by Robert Higgs and Carl P.  Close, 139–152. Oakland, CA: Independent Institute. Smith, Adam. (1776) 1991. Wealth of Nations. New York: Prometheus Books. Sowell, Thomas. 1980. Knowledge and Decisions. New York: Basic Books. Thomsen, Esteban. 1992. Prices and Knowledge. New York: Routledge. Tullock, Gordon. 2005. “Rents and Rent-Seeking.” In The Rent Seeking Society:  The Selected Works of Gordon Tullock, edited by Charles K.  Rowley, Vol. 5, 148–159. Indianapolis: Liberty Fund. Wagner, Richard E. 2010. Mind, Society and Human Action: Time and Knowledge in a Theory of Social Economy. New York: Routledge. Williamson, Claudia R. 2009. “Informal Institutions Rule:  Institutional Arrangements and Economic Performance.” Public Choice 139, no. 3: 371–387.

Chapter 31

F rom Subsi st e nc e to A dvanced Mat e ria l Produ c t i on Austrian Development Economics G. P. Manish and Benjamin Powell

Introduction The question of why some nations prosper while others remain impoverished is certainly among the most important topics in economics and has been a central focus of the discipline at least since Adam Smith wrote An Inquiry into the Nature and Causes of the Wealth of Nations. More recently, Robert Lucas (1988, 5) said: “Once you start thinking about economic growth, it is hard to think about anything else.” The Austrian school of economics has unique insights regarding this question that help to better explain the causes of prosperity. Taken at face value, it might seem odd that the Austrian school of thought has much to say about development, since the subjectivism at the core of Austrian economics doesn’t allow an outside observer to pronounce one society to be better off than another as long as each achieved its situation through voluntary interactions. Given that utility is subjective and therefore ordinal, there is no unit for measuring utility and no possibility for adding up the utility of different individuals. As a result, concepts such as social utility, social welfare, and the well-being of a nation lose all meaning.1 A low-income society with much leisure could be as well off as a high-income society. Yet, despite the Austrian school’s subjectivism, it has much to say about economic development as long as development is properly understood. We can observe a society 1 

See Stringham (2010), where he criticizes Mises for utilizing such ambiguous concepts in his defense of the free market.

From Subsistence to Advanced Material Production    699 capable of producing a greater array of consumer goods and explain why that society is able to do so while others, even if they desired to, cannot. This can be done independently of any value judgment of one society being “better off ” than another. Even with this in mind, however, we find that those societies capable of the greatest material production tend also to do better at providing other measures of well-being that would lead most reasonable people to judge a society to be better off when it has greater material levels of production. This chapter focuses on Austrian insights by first outlining how differing rates of time preference lead to different levels of material production. We then consider the roles played by capital heterogeneity and economic calculation.2 Finally, we incorporate these insights into an understanding of development economics and contrast how Austrian views differ from other views on economic development.

Means, Ends, and Time Preference Almost all the elements in man’s environment that are capable of satisfying his ends are scarce and thus are insufficient to satisfy all the ends that could be satisfied with their aid. These scarce elements, also called means or goods, must therefore be allocated among competing ends. Their utilization necessarily involves a choice of which ends to satisfy and which to renounce. Means in general can be subdivided into two broad classes based on their causal connection to the satisfaction of wants. On the one hand, there exist direct means or consumer goods that are used to satisfy wants and that possess a direct relation to want satisfaction. Indirect means or producer goods, on the other hand, are utilized in the production of consumer goods and so possess an indirect relationship to want satisfaction. They also differ in their degree of indirectness to want satisfaction. Thus, the flour that is utilized in the production of bread bears a relationship to want satisfaction that is less indirect than the grain that is used to produce the flour. This complex causal relationship that different goods share with the satisfaction of wants can be captured by dividing the world of goods into different orders. Consumer goods are defined as goods of the first order, whereas producer goods can be classified as higher-order goods. Consider, for instance, the simple process of producing apples by using a stick to shake them off the tree. The apple is a good of the first order, whereas the stick, the apples on the tree, and labor are the higher-order goods. To be more precise, the latter are second-order goods, producer goods used directly in the production of a consumer good. The labor and wood that were spent on fashioning the stick are goods of the third order, utilized not directly in the production of a consumer good but instead in the production of a lower-order producer good that in turn is used to produce

2 

These sections draw on Powell (2010).

700    Development, Transition, and Social Change a consumer good. Thus, the production of a consumer good can also be said to be punctuated by stages, with each stage involving the production of a good. The production of the apples involved two stages, the first stage being the production of the stick and the second being the production of the apples themselves. More complex production processes will involve goods of many higher orders and thus many more stages.3 All means, be they direct or indirect, are allocated not only among ends that can be satisfied at a given point in time but also among ends that can only be satisfied at different points in time. The choice of which ends to satisfy and which to renounce, therefore, is inherently intertemporal in nature; it involves choosing between present consumption, that is, the satisfaction of wants in the present or nearer future, and future consumption, that is, the satisfaction of wants in the remoter future. Thus, an egg can be used to make an omelet today or an omelet tomorrow. Similarly, a given stock of a producer good such as labor can be allocated to a production process that will yield a consumer good today or to a process that will bear fruit only three days from now. In choosing between present and future consumption, individuals exhibit time preference; they place a discount on future consumption vis-à-vis present consumption. In other words, they do not have an infinite time horizon regarding their want satisfaction and see a disutility in waiting. Thus, “the satisfaction of a want in the nearer future is, other things being equal, preferred to that in the farther distant future” (Mises 1998, 480–481).” The existence of time preference follows inexorably from man’s mortality. Since every individual has a finite length of time on this earth, time is a scarce means that must be economized. But as Mises (1998, 101) points out: The economization of time has a peculiar character because of the uniqueness and irreversibility of the temporal order. Time for man is not a homogeneous substance of which only length counts. It is not a more or a less in dimension. It is an irreversible flux the fractions of which appear in different perspective according to whether they are nearer to or remoter from the instant of valuation and decision.

It follows, therefore, that if time is to play any role at all in human choice and valuation, “there cannot be any question of equal valuation of nearer and remoter periods of the same length (Mises 1998, 480).” Man, in making his choices, must be guided by the categories of sooner and later and must prefer a given satisfaction sooner rather than later. While all individuals place a discount on future consumption, the extent of this discount, or the rate of an individual’s time preference, is subjective in nature. A given individual’s rate of time preference is context- or situation-specific; it can vary over time. He or she may go from being a person with a high rate of time preference, one who places a very big discount on future consumption vis-à-vis present consumption, to one who places a significantly smaller discount and thereby has a low rate of time preference. 3 

For more on the categorization of goods into various orders and the concept of stages of production, see Menger (2007, 52–77), Böhm-Bawerk (1959b, 169), and Rothbard (2009, 8–10).

From Subsistence to Advanced Material Production    701 Similarly, at any given moment in time, two different individuals can have vastly different rates of time preference.

From Time Preference to Economic Growth In order to understand some of the implications of the existence of time preference, consider the fictional Robinson Crusoe, stranded on an island with no consumption goods at his disposal. Assume that labor is the only scarce indirect means at his disposal and that he is willing to forgo ten hours of leisure every day to produce consumer goods. To begin with, Robinson decides to devote his entire working day to the production of fish. The production process he adopts is the most rudimentary one: he wades into the sea and tries to catch fish with his bare hands. He obtains one fish per hour worked and thus ten fish in one working day. But Robinson could catch fish with a net, and doing so would be significantly more productive, yielding five fish per hour worked. However, in order to adopt this more productive process, Robinson would have to produce a net, which in turn will take ten hours, or a full working day. The net, being an indirect means, will not directly satisfy any of Robinson’s wants. But fishing with the aid of the net will yield him a greater number of fish per unit labor time. Thus, producing fish with a net involves a longer period of production—that is, it involves a longer waiting time between the input of labor at the highest stage of production and the yielding of the final product—than producing fish with one’s bare hands. At any given moment in time, the first production process provides Robinson with ten fish in ten hours, whereas the second process would provide him with a larger catch of a hundred fish but at the end of two working days. What are the costs and benefits of adopting the longer, more productive production process? The benefit is the ability to satisfy more wants. With a net, Robison’s catch of fish per unit labor time would double. This would enable him to enjoy a larger consumption bundle, a larger combination of fish and leisure. Thus, for instance, instead of enjoying ten fish and fourteen hours of leisure in a day, he could enjoy a hundred fish and fourteen hours of leisure. But in order to build the net, Robinson must allocate labor away from fishing with his hands and invest it in the longer production process, thereby giving up consumption in the nearer future. The fact that he must save, that is, reduce his present consumption below its maximum, is the cost of adopting the longer, more productive production process.4 Thus, 4  To be more precise, he must increase his savings. This follows from the fact that all production requires a reduction of present consumption below its maximum. Even the shortest, most rudimentary production processes, such as catching fish with one’s bare hands, require a sacrifice of leisure. This saving can take many forms. Thus, Robinson need not stay hungry while he produces the net. Instead, he can put away some fish every day while still fishing with his hands and then consume this saved fish while he is working on the net (see Rothbard 2009, 47–57). But whatever may be the form in which

702    Development, Transition, and Social Change in making a decision between these two ways of fishing, Robinson is engaging in intertemporal choice, a choice between present and future consumption. If Robinson had no time preference and did not discriminate between present and future consumption, he would choose to adopt the longer production process without any hesitation. Given that this process yields a larger catch of fish per hour worked, Robinson would, without any hesitation, give up the smaller combination of fish and leisure in exchange for the larger one. As Mises (1998, 479–480) explains If acting men were not to pay heed to the length of waiting time, they would never say that a goal is temporally so distant that one cannot consider aiming at it. Faced with the alternative of choosing between two processes of production which render different output with the same input, they would always prefer that process which renders the greater quantity of the same products … even if the result could be attained only by lengthening the period of production.

But given the existence of time preference, Robinson will adopt the longer, more productive process only if the increased satisfaction provided by the larger yield of fish per hour worked in the future were great enough to overcome the inherent discount that he places on future consumption. Whether he ultimately does so will depend on his rate of time preference. If his discount on future consumption is high enough, he will continue to fish with his hands. On the other hand, if he is a man with a low enough rate of time preference, the increased consumption possibilities in the future will entice him to adopt the more productive process. It is important to note that the above analysis would hold true even if the increased productivity of the longer process consisted not only in the increased amount of output per unit input for a good previously produced, as in the case above, but also in the production of a new, more highly valued good that could not be produced by a shorter process. Thus, Robinson might be choosing between fishing with his bare hands and building a hut for himself, the latter being a much longer production process than the former. In the absence of time preference, Robinson would choose the longer process without hesitation if he valued a hut more than fish. But in the presence of time preference, even if he otherwise values a hut more than fish, the increased future satisfaction per hour worked provided by the hut might not be enough for him to overcome his time preference and engage in the saving and investment necessary to build the hut. Thus, the existence of time preference, in the words of Murray Rothbard, “acts as a brake on the use of more productive but longer processes (of production)” (Rothbard 2009, 539). It limits and restricts the amount of saving and investment. It is only because of time preference that less productive and shorter processes of production are chosen he saves, it is inevitable that he must reduce his present consumption below its maximum when he allocates his labor from a shorter to a longer process of production. As Böhm-Bawerk (1959b, 103) notes, “The essential point is, that the current endowment of productive forces be not devoted entirely to the enjoyment of the ‘moment’—the present period—so that a portion of them may be reserved for the service of a future period.”

From Subsistence to Advanced Material Production    703 when longer, more productive ones are there for the taking. The former are chosen over the latter solely on account of the shorter period of production that they require. Furthermore, the rate of time preference determines the amount of saving at any moment in time and therefore the extent to which longer, more productive production processes can be undertaken. Consider now the situation when Robinson’s technological knowledge includes numerous production processes and not just two or three processes. Robinson not only knows how to catch fish and how to build a hut but also how to obtain berries and coconuts, how to hunt for meat, how to grow grain, and so on. And he knows multiple ways to produce each good. This array of production processes can be classified on the basis of both length and productivity. There will, in general, be a direct relationship between the length of a process and its physical productivity.5 The lower Robinson’s rate of time preference, the greater his savings and the greater his ability to take advantage of longer, more productive processes. Thus, a Robison with a low rate of time preference would be hard at work producing a net and building a hut, whereas a Robinson with a high rate of time preference would still be fishing with his bare hands and sleeping under the stars. In the former case, Robinson would be devoting all or the bulk of his working day to production processes that will bear fruit in the remoter future, whereas in the latter case, all of Robinson’s labor time would be allocated to production processes that bear fruit almost immediately or in the nearer future. In other words, the lower the rate of Robinson’s time preference, the greater the aggregate length of the production structure that can be sustained at any given point of time. Similarly, a Robinson who in the past had a low rate of time preference and engaged in a large amount of saving and investment will today have a larger supply of consumer goods and a higher standard of living than a Robinson who did not engage in much saving and investment in the past. The former will be able to fish with a net, kill prey with a bow and arrow, and sleep in a hut. The latter will, on the other hand, be using his bare hands to catch fish and would still be sleeping under the stars. All these implications of time preference hold true not only in the world of Robinson Crusoe but also in a complex, market-based economy characterized by the existence of specialization and exchange.6 As in the case of Robinson, the technological data known by the participants in a market economy at any point in time consist of an array of production processes of different lengths. The scarce producer goods available for allocation 5 

The fact that longer processes of production are more productive than shorter processes of production (the greater productivity manifesting itself in one of the two ways outlined above) is an empirical law (see Böhm-Bawerk 1959b, 10–15). This is not to say that all longer production processes will be more productive than all shorter production processes. Stated differently, while “not every extended process is better (more productive); among the longer processes there are some which are also better (Böhm-Bawerk 1959a, 2).” 6  All the implications of time preference delineated in this section also hold true for a socialist, centrally planned economy. Such an economy, however, suffers from the problem of the impossibility of economic calculation and the rational allocation of indirect means among competing ends. For more on this, see below.

704    Development, Transition, and Social Change among these processes, however, no longer consist of just the stock of labor but also include the stocks of land and capital goods.7 The period of production of a good is no longer the time that elapses between the application of labor at the first stage of production and the yielding of the consumer good. Instead, it refers to the time that must elapse between the application of the existing labor, land, and capital goods at the first stage of production and the yielding of the consumer good.8 In the array of known production processes, the empirical or technological law of a direct relationship between the length of the process and its productivity will still manifest itself. On the market, the prevailing rate of interest reflects the social rate of time preference, that is, the rates of time preference of the market participants.9 Given the existence of time preference and the discount placed on future consumption, individuals will only part with present money for a greater sum of money in the future, thereby guaranteeing a positive interest rate. Time preference, just as in the case of Robinson, restricts the amount of savings. For in its absence, individuals would be willing to part with present money expecting no return whatsoever. The pool of available savings would therefore be much larger. In fact, nothing would stop an individual from saving all of his income. The market interest rate also fluctuates with changes in the underlying rates of time preference of the market participants. A drop in the rate of time preference leads to an increase in the supply of savings. This in turn drives down the rate of interest. The opposite occurs when there is a rise in the rates of time preference. The existence of a positive interest rate limits the ability of entrepreneurs in a market economy to adopt longer, more productive production processes. Stated differently, there exist at any moment in time longer and more productive processes that would be profitable but for the presence of a positive interest rate. Given the prevailing array of prices we can, following Böhm-Bawerk, distinguish between “two zero points” for the profitableness of longer production processes—a “relative zero point so that an investment merely yields the prevailing (interest) rate and nothing more,” that is, it just breaks even, and an “absolute zero point,” a point at which the longer production process fails to yield any increase of output per unit input. As Böhm-Bawerk (1959a, 6) explains, “between the two points there lies an extraordinarily wide zone in which a lengthening of the production process brings about an increase in production, but an increase that is smaller than the market rate of interest.”

7  Following Rothbard (2009, 483–488, 496–500) and Hayek (1941, 50–65), we can define land as consisting of all the nature-given, material indirect means along with the previously produced indirect means that are physically permanent and need no maintenance or replacement. Capital goods, on the other hand, consist of the previously produced, physically impermanent indirect means. They need maintenance and eventual replacement. Stated differently, they eventually wear out. 8  The period of production, it must be stressed, is a concept prospective in nature. The time expended in the past in the production of the land and capital elements available for utilization today is irrelevant and not included in estimating the period of production of a consumer good. For more on this, see Mises (1998, 477, 491). 9  For a comprehensive introduction to the pure time preference theory of interest, see Herbener (2011).

From Subsistence to Advanced Material Production    705 While these longer processes are physically more productive, they cannot be undertaken because of the presence of a positive interest rate. In the absence of it, they would all be undertaken without hesitation by any profit-seeking entrepreneur. It also follows that a higher (lower) interest rate, reflecting a higher (lower) social rate of time preference, would lead to there being more (fewer) longer, physically more productive but unprofitable production processes.

The Importance of Capital Heterogeneity A tractor is not a hammer. Both are capital goods; that is, they are produced factors of production that are valued because of their ability to produce other goods that are the ultimate object for consumption. Yet they usually serve different purposes and can both be used to accomplish more than one goal. A tractor can be used to plow a field, pull a trailer, or any number of other tasks. A hammer could be used by a carpenter to build a house or by an automobile mechanic to fix a car. Thus, their differing physical properties are not the only features that make a hammer and a tractor heterogeneous. They are also heterogeneous because of the different plans they will satisfy for a particular human actor. Furthermore, they also exhibit multiple specificity; that is, each of them is capable of fitting into more than one single production plan for one consumer good (Lachmann 1978). Because capital goods are heterogeneous and yet have multispecific uses, we must coordinate economic activity to best align the structure of capital goods to most efficiently produce consumer goods without leaving any higher-valued consumption wants unsatisfied. The coordination of consumption plans with the billions of ways the capital structure could be combined to satisfy those consumption plans is one of the major tasks any economy must accomplish. Yet the Solow (1956) growth model and most neoclassical economists typically sum the monetary value of these heterogeneous capital goods and reduce them to a single homogenous stock, K. In doing so, they often forget that underlying this homogeneous stock is a vast array of goods—everything from beer barrels to blast furnaces and trucks to yards of telephone wire—and thus assume away one of the greatest coordination tasks an economy has to solve. Austrian capital theorists emphasize that capital goods are both heterogeneous and multispecific and as a result focus on how these individual units of capital fit together.10 In other words, Austrian economists study the capital structure, not a homogeneous blob denoted by a capital K. In doing so, they are forced to grapple with the issues of capital complementarity and capital substitutability. 10 

See Lewin (1999) for a recent treatment of Austrian capital theory.

706    Development, Transition, and Social Change Capital complementarity stems from the fact that it most often requires more than a single capital good to produce the final consumption good. Few cars will be produced if only the physical building for the assembly line is constructed but the individual assembly machines are not included in the structure. The assembly machines and physical building complement each other and make greater production of cars possible. One of the tasks of entrepreneurs in the market economy is not just to invest and create new capital but to invest in creating the right capital that will best complement the existing capital. That means creating capital that fits into and complements other production plans. Furthermore, given that all investment decisions are made ex ante and the world is uncertain, some plans will have to be altered as market conditions evolve. This raises the issue of capital substitutability. If all capital were perfectly homogeneous, substitutability would not raise any problems. Each capital good would be a perfect substitute for every capital good, and changing plans would not involve any losses. If each capital good were perfectly specific (capable of fulfilling only a single function in a single plan), then substitutability would be impossible, and when plans needed to change, existing capital would be useless. Because capital is both heterogeneous and multispecific, capital substitutability becomes an issue.

From Capital Heterogeneity to Economic Calculation The debate sparked by Mises’s ([1920] 1990)  Economic Calculation in the Socialist Commonwealth is one of the most important occurring in the economics profession in the twentieth century. In many ways, the debate illustrated how the evolving neoclassical paradigm differed from the Austrian school. In fact, Boettke (2001, 30) argues that economic calculation is the contribution of Austrian economics to political economy in the twentieth century; “all the unique contributions of the Austrian school of economics to substantive economics can be traced back to the central importance of economic calculation for human cooperation” (emphasis in original). Mises ([1920] 1990) adopts the definition of socialism as collective ownership of the means of production. A postcard version of his argument reads:

• Socialism is the collective ownership of the means of production (MOP). • Without private property in the MOP, there is no market for the MOP. • Without a market for the MOP, there are no prices for the MOP. • Without prices for the MOP, there are no relative scarcity indicators for the MOP. • Without relative scarcity indicators, economic calculation is impossible; that is, you have no way of knowing which capital goods to combine in which proportions to produce the final consumer goods most economically.

From Subsistence to Advanced Material Production    707 Because socialism is defined as the collective ownership of the MOP, whether capital goods are homogeneous or heterogeneous is crucial, because the economic calculation problem stems from the fact that we have no relative scarcity indicators for these capital goods. If capital goods are all perfectly specific, then no problem arises when you have no relative scarcity indicator for them. Each is only suitable to one task. An economy need only know the final consumer goods it wants, and then the planner can choose to accumulate the capital necessary to make those goods. Similarly, if all capital goods are perfectly homogeneous, their relative scarcities do not matter. Each can be perfectly substituted for every other. A planner, again, only needs to know the desired type and quantity of consumer goods. Any structure of capital goods used to produce those consumer goods is equally efficient. With perfect capital specificity or perfect homogeneity, the economic calculation problem collapses into a technical production problem. Schumpeter (1942, 175) argued that an economy could have economic calculation for factors of production without private property for the MOP, because “consumers in evaluating (‘demanding’) consumers’ goods ipso facto also evaluate the means of production which enter into the production of these goods.” However, the ipso facto does not hold, precisely because capital is heterogeneous. If each capital good could only produce one consumption good then the valuation of consumer goods would suffice to value the capital good. But because capital goods are multispecific, we need to know the relative scarcity of the capital good in its alternative uses in order to have economic efficiency. Hayek (1945) pointed out that Schumpeter’s ipso facto only holds if all the facts are given to one mind. Alternatively, it is also accurate to say that with dispersed knowledge, the ipso facto would hold only if all capital was perfectly specific or all capital was homogeneous. The economic calculation problem only exists because capital is heterogeneous and multispecific.

Implications for Austrian Development Economics According to the Austrian theory of capital and growth described above, the sine qua non of economic growth is the availability of savings. The existence of time preference and the limits that it places on the desire to save limits the ability to lengthen the production structure and thus limits the extent of economic growth. Thus, the lower the prevailing social rate of time preference and the market rate of interest, the greater the available pool of savings and the greater the ability to undertake longer, more productive production processes. It follows that for the Austrian economists, an extremely important underlying cause that explains the differences in the standard of living that prevail in the developed vis-àvis the underdeveloped world is the amount of savings and investment undertaken in

708    Development, Transition, and Social Change the past.11 As seen above, the thrifty Robinson had at his disposal a greater supply of capital goods and thus could enjoy a greater supply and variety of consumer goods. The prodigal Robinson, on the other hand, was living hand to mouth, engaged in short production processes without the aid of capital goods. He thus had at his disposal fewer consumer goods to enjoy. Similarly, a developed country, wherein most goods are produced with the aid of capital goods and processes of production are long and complex, have a great supply and variety of consumer goods available to them because they have saved and invested more over the years. The poorer nations, on the other hand, suffer from a comparative scarcity of capital goods. Manual labor plays a much greater role in the production processes, and labor-saving machines play a relatively minor role. This results in a relative dearth of consumer goods. Thus, as noted by Shenoy (2007), the abundance, variety, and quality of consumer goods in late-twentieth-century Mali compared rather unfavorably with those of early-modern England, the direct result of the dearth of available capital goods in the former region. This Austrian recipe for economic growth, however, clashes with that provided by modern neoclassical economics, which gives pride of place to the state of the arts, or the prevailing technological knowledge, as the engine of economic growth. However, as Rothbard (2009, 542) points out: while knowledge is a limit, capital (the available amount of savings) is a narrower limit. It is logically obvious that while capital cannot engage in production beyond the limits of existing available knowledge, knowledge can and does exist without the capital necessary to put it to use. Technology and its improvements, therefore, play no direct role in the investment and production process; technology, while important, must always work through an investment of capital.

Rothbard’s point is obvious when one studies the economic conditions of poorer countries. Consider, for instance, Mises’s description of the obstacles that lay in the path of Romania’s economic development circa 1860. As Mises (1998, 493) notes, “what was lacking was not technological knowledge.” Entrepreneurs in Romania did not lack knowledge of the more advanced technological methods employed in the developed nations. Instead, these methods “were described in innumerable books and taught at many schools … the elite of Rumanian youth had received full information about them at the technological universities of Austria, Switzerland and France.” What was lacking, however, “was the capital goods needed for a transformation of the backward Rumanian apparatus of production, transportation and communication according to Western patterns.” The provision of these capital goods required savings, a reduction in present consumption in order to free up labor, land, and the previously produced durable capital

11  As explained in more detail below, this is conditional on the existence of market institutions in both the developed and underdeveloped economies being compared. The existence of central planning and socialism causes the existing fund of savings to be misallocated because of the impossibility of economic calculation.

From Subsistence to Advanced Material Production    709 goods for the production, operation, and maintenance of modern plants with state-ofthe-art machinery, mines, railroads, and so on. To take a more contemporary example, consider the case of the marketing of agricultural produce in India. Estimates indicate that India wastes as much as 30 percent of fruit and vegetables produced in transit between the farm and the market (Mukherji and Pattanayak 2011). This wastage is largely a result of the lack of refrigeration and cold storage facilities. Why don’t these facilities exist? Is it because entrepreneurs in India lack the required technological knowledge to produce refrigerators and air conditioners? Certainly not, for refrigerators and air conditioners are currently being manufactured by Indian companies and have been for a number of years. What is lacking is the available supply of savings required to lengthen and extend the structure of production, to produce the refrigerators and air conditioners that will be used not only in homes and in shops but also to store fruit and vegetables as they make their way from the farm to the marketplace. Thus, once again, we see that it is not the lack of technical know-how but the scarcity of available capital goods and the savings that would be necessary to produce them that is the chief obstacle in the path of economic development. The focus on capital as the primary driver in differences in standards of living does not imply that the Solow (1956) model is wrong on its own terms. It implies that Solow’s model misses fundamental factors that cause differences in economic performance in the real world. The main factors it misses are capital heterogeneity and the role of institutions. The driving force of the Solow growth model is diminishing returns to capital with a constant rate of depreciation that eventually leads to a steady-state level of income where growth is only increased by technology. Implicit in applications of the Solow model to the real world is the assumption that countries are somewhere near that steady state. But once we realize that capital is heterogeneous and can be complimentary, then why assume diminishing returns within the relevant range? We can live in a range of increasing returns. In the limit, the Solow model must be right, since it holds one factor fixed (capital per worker). If a neutron bomb destroyed all but one human on earth, that one human would not be able to make use of the entire existing capital stock. But we are not in that situation. For the real world, the Austrian focus on capital as the fundamental cause of observed growth is appropriate. The other reason the Solow growth model fails to explain real-world economic growth is that it lacks any role for institutions. The amount of savings limits the length and productivity of production processes and thus serves to limit the extent of economic growth and development. But given that economic calculation and a rational allocation of resources is impossible in a centrally planned economy, the prosperity of a society does not depend only on how much savings and capital it has or is in the process of creating but also on how rationally those savings are channeled into heterogeneous capital goods. Without the existence of private property and exchange, the existing pool of savings will be misallocated and will not lead to an increased supply of goods in line with consumer preferences. This fact is, however, often overlooked by popular models in the development literature. Take, for instance, the World Bank’s financing gap model, which very well may

710    Development, Transition, and Social Change be the most implemented growth model during the last sixty years. The idea behind the financing gap model is that poor countries are in a low-growth equilibrium where they do not have enough savings to finance capital accumulation, so aid for investment should be used to create capital accumulation. The financing gap model fails to fully appreciate the importance of capital heterogeneity and economic calculation. Poor countries do not simply need investment. They need investment in capital that complements the existing structure of production. Investments need to be made on the basis of expected profit and loss. Private investment accomplishes this. Aid for investment often takes the form of infrastructure investment or other projects that are not bought and sold on the market. Therefore, much of the investment financed by the financing gap model has been outside of the sphere of economic calculation. The impact of poor incentives created by aid for investment programs has been well documented (Easterly 2001). The epistemic problems associated with using aid to finance the right heterogeneous capital have been less emphasized but are no less real. National economic development planning is another area where an appreciation of capital heterogeneity has led Austrians to conclusions different from the mainstream. Advocates of state development planning do not assume that capital is homogeneous. In fact, their rational for planning is that capital is heterogeneous but that they can select the capital better than the market. But by selectively promoting some industries, they enable those industries to bid capital away from other industries, interfering with the very process that reveals the relative scarcity of the heterogeneous capital goods. Lavoie (1985, 95) summarizes the problem: The same lack of knowledge on the part of any single person or organization which makes it impossible for comprehensive planning to replace the market also makes it irrational for a non-comprehensive planning agency to try merely to “guide” the market. If the guiding agency is less knowledgeable than the system it is trying to guide—and even worse, if its actions necessarily result in further undesired consequences in the working of that system—then what is going on is not planning at all but, rather, blind interference by some agents with the plans of others.

When the state actively plans development, it forces heterogeneous capital goods to particular industries. The decision-makers in the government planning bureau have no method to evaluate the opportunity cost of another industry’s potential use of those capital goods. The opportunity cost is the subjective loss suffered by the person who would have received resources if the government had not interfered with the market process. Since the planning bureau has no way of evaluating this loss, it cannot determine if the loss in output from other industries caused by promoting one industry is greater or less than the benefit produced. The planning agency has no way to know if it is promoting development or retarding it. Because capital is heterogeneous and multispecific, whenever competitive market forces are not allowed to dictate the capital structure, an economy will not generate the level of prosperity that it is capable of.

From Subsistence to Advanced Material Production    711 Finally, while the socialist calculation debate illustrates the importance of markets for determining the capital structure, much of the world doesn’t face a stark choice between pure capitalism and pure socialism. The more freely capital prices are formed on the market, the more rational economic calculation will be and the more productive society will become. All governments interfere with this process to varying degrees. The Economic Freedom of the World Annual Report (Gwartney, Lawson, and Hall 2011) provides an approximate measure of how free the various economies of the world are. The overwhelming conclusion of the vast literature on economic freedom is that freer countries are not just wealthier and do not just grow faster than less free countries, but they outperform them on most other margins (literacy, life expectancy, etc.) that people care about.12 That literature also shows that freer countries attract higher levels of investment. Important and consistent with the Austrian theory described above, they also find that a given level of investment increases growth more in a freer country than in a less free country. Thus, as prices are less tampered with by the government, economic calculation is more accurate, leading to the right heterogeneous capital to be created that is most productive. Most of the traditional accounts of growth by Austrian economists focused on capital as the cause of productivity and high living standards. More recently, Austrians have focused much more on how institutions influence growth. Both approaches are compatible. Capital is the proximate cause of growth for reasons described by Mises and Rothbard. But institutions are the fundamental cause of growth, because good institutions generate more investment and support freely formed prices that allow economic calculation to create the most productive heterogeneous capital possible.

Conclusion The Austrian school of thought emphasizes capital as the main proximate cause of economic growth, in contrast with other schools of thought that focus on technological knowledge. The reason for this difference is twofold. First, the Austrians believe that saving is the sine qua non for engaging in longer, more productive production processes and thereby achieving a higher standard of living. Second, the Austrian school takes the role of capital heterogeneity seriously. Capital heterogeneity is what gives rise to the economic calculation problem. That problem is only solved by freely formed market prices. In a world bereft of market prices, the available pool of savings would necessarily be misallocated. This has led Austrians to view institutions that support private property and freely formed prices as the fundamental cause of growth. The Austrians’ focus on institutions is consistent with much of the new institutional economics literature. However, as this chapter has outlined, the unique aspect of the Austrian view is that 12 

See Berggren (2003) for a somewhat dated survey of this literature and www.freetheworld.com for many of the more recent papers using the index.

712    Development, Transition, and Social Change the role of institutions is built up from microeconomic foundations of individual savings and investment decisions and how they manifest themselves in a complex heterogeneous capital structure.

References Berggren, N. 2003. “The Benefits of Economic Freedom.” Independent Review 8, no. 2: 193–211. Boettke, P. J. 2001. Calculation and Coordination. New Brunswick, NJ: Routledge. Böhm-Bawerk, E.  von. 1959a. Further Essays on Capital and Interest. South Holland, IL: Libertarian Press. Böhm-Bawerk, E. von. 1959b. Positive Theory of Capital. South Holland, IL: Libertarian Press. Easterly, W. 2001. The Elusive Quest for Growth, Cambridge, MA: MIT Press. Gwartney, J., R. Lawson, and J. Hall. 2011. Economic Freedom of the World Annual Report. Vancouver: Fraser Institute. Hayek, F. A. 1941. The Pure Theory of Capital. Chicago: University of Chicago Press. Hayek, F.  A. 1945. “The Use of Knowledge in Society.” American Economic Review 35, no. 4: 519–530. Herbener, J., ed. 2011. The Pure Time Preference Theory of Interest. Auburn, AL: Ludwig von Mises Institute. Lachmann, L. 1978. Capital and Its Structure. Kansas City, MO: Sheed, Andrews and McMeel. Lavoie, D. 1985. National Economic Planning: What Is Left? Cambridge, MA: Ballinger. Lewin, P. 1999. Capital in Disequilibrium:  The Role of Capital in a Changing World. New York: Routledge. Lucas, Robert. 1988. “On the Mechanics of Economic Development.” Journal of Monetary Economics 22: 3–42. Menger, C. 2007. Principles of Economics. Auburn, AL: Ludwig von Mises Institute. Mises, L.  von. (1920) 1990. Economic Calculation in the Socialist Commonwealth. Auburn, AL: Ludwig von Mises Institute. Mises, L. von. 1998. Human Action: A Treatise on Economics. Auburn, AL: Ludwig von Mises Institute. Mukherji, B., and B. Pattanayak. 2011. “New Delhi Starts Drive to Root Out Hunger.” Wall Street Journal, June 8. http://online.wsj.com/article/SB1000142405270230425930457637281301033 6844.html Powell, B. 2010. “Some Implications of Capital Heterogeneity.” In Handbook on Contemporary Austrian Economics, edited by P. J. Boettke, 124–135. Cheltenham, UK: Edward Elgar. Rothbard, M. N. 2009. Man, Economy and State, Auburn, IL: Ludwig von Mises Institute. Schumpeter, J. A. 1942. Capitalism, Socialism and Democracy. New York, Harper & Row. Shenoy, S.  R. 2007. “Investment Chains through History or an Historian’s Outline of Development.” Indian Journal of Economics and Business 7, no. 3: 185–215. Solow, R. M. 1956. “A Contribution to the Theory of Economic Growth.” Quarterly Journal of Economics 70, no. 1: 65–94. Stringham, E.  P. 2010. “Economic Value and Costs Are Subjective.” In Handbook on Contemporary Austrian Economics, edited by P. J. Boettke, 43–66. Cheltenham, UK: Edward Elgar.

Chapter 32

On Your Ma rk, G et Set,  Dev e l op ! Leadership and Economic Development Scott A. Beaulier and Daniel J. Smith

Introduction Unless philosophers become kings in our cities, or unless those who now are kings and rulers become true philosophers, so that political power and philosophic intelligence converge, and unless those lesser natures who run after one without the other are excluded from governing, I believe there can be no end to troubles, my dear Glaucon, in our cities or for all mankind. Only then will our theory of the state spring to life and see the light of day, at least to the degree possible. (Plato 1985, 165) [T]‌he main point about which there can be little doubt is that [Adam] Smith’s chief concern was not so much with what man might occasionally achieve when he was at his best but that he should have as little opportunity as possible to do harm when he was at his worst. It would scarcely be too much to claim that the main merit of the individualism which he and his contemporaries advocated is that it is a system under which bad men can do least harm. It is a social system which does not depend for its functioning on our finding good men for running it, or on all men becoming better than they now are, but which makes use of men in all their given variety and complexity, sometimes good and sometimes bad, sometimes intelligent and more often stupid. (Hayek 1948, 11–12)

Adam Smith’s ([1776] 1976)  An Inquiry into the Nature and Causes of the Wealth of Nations is, first and foremost, an attempt to explain why some countries are rich and others are poor. According to Smith:  “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a

714    Development, Transition, and Social Change tolerable administration of justice: all the rest being brought about by the natural course of things.”1 As evidenced by the title of a recent book by two leading development economists, Why Nations Fail (Acemoglu and Robinson 2012), economists are still trying to figure out why some nations embrace the growth-enhancing policies of peace, easy taxes, and a tolerable administration of justice, while others fail to do so. One of the explanations for the vast differences in economic performance across nations involves national leaders and changes in leadership within a nation. The question of whether leaders can promote economic development has a long history in economics and political philosophy. At one extreme sits Marx and disciples of Marx, who view social change as a function of grand economic and historical forces, rather than coming through the work of individuals and leaders (Tucker 1978). At the other extreme are a number of historians and sociologists who posit “great man” theories of history (Kissinger 1968; Ionescu 1991) and emphasize the role that “charismatic leadership” can play in promoting social change (Weber 1947, 358–363). As we will see in the next section, economists have also explored the relationship between leaders and social change; their ideas, which have built on and sought to fill in the details of the grand social theorists, have helped to advance our understanding of how economic growth and stagnation relate to the polity and national leaders. Of particular interest to economists working in the Smithian tradition is the extent to which leaders can influence the adoption of growth-enhancing institutions. According to economists, state-led development planning has, time and again, failed to promote growth (Boettke 1993; Boettke 1994; Easterly 2009). Institutions conducive to economic freedom—private property, the rule of law, and free trade—promote growth (Acemoglu, Johnson, and Robinson 2001; Acemoglu, Johnson, and Robinson 2002; Djankov et al. 2002; Frye and Shleifer 1997). To a large extent, the growth discussion has shifted to a question of how to make the transition from “here” (i.e., current economic environment) to “there” (i.e., more economically free environment). Some economists think we might have to wait hundreds of years for cultural and institutional change (Williamson 2000); others think institutional reforms can be implemented more rapidly through a dose of “shock therapy” or military intervention (Sachs 1994). Once discussions of how to transition are entered, an understanding of leadership and the role that national leaders play in promoting growth is needed. If good leaders, whom we define as leaders who promote growth-conducive policies, can somehow help a nation embrace economic freedom, then maybe growth depends on nothing more than getting the right person at the top. If good leadership is a primary determinant of economic growth, then fostering sound leadership—leaders committed to economic freedom and sound economic policy—may be the most efficient and humane path toward economic growth. On the other hand, if leadership does not matter for economic

1 

This quote is attributed to Smith by Dugald Stewart ([1793] 1829, 64).

On Your Mark, Get Set, Develop!    715 growth, then development economists can refocus their scholarly efforts and policy prescriptions away from figuring out how to get the right people into power. This chapter establishes a middle ground between two prominent views of leadership: (1) leaders matter and can contribute positively to economic growth, or (2) leaders seldom have positive effects and, at best, can avoid doing a great deal of harm. Good leadership can, indeed, have a positive effect on economic growth but only during the initial moment when economic reform is up for grabs. Once the opportunity to implement sweeping reform has passed, interests become entrenched, and the opportunity for growth-enhancing reform passes. Bad leaders, on the other hand, can hamper economic growth in periods well beyond the ideal reform moment. Thus, betting on institutions meant to potentiate strong leadership for development poses significant downside risk but very little upside benefit. Rather than seek to design institutions and lead the development process, economists should focus on how institutions can prevent bad leaders from doing great harm. As Milton Friedman ([1962] 2002, 50) wrote, “Any system which gives so much power and so much discretion to a few men that mistakes—excusable or not—can have such far-reaching effects is a bad system.” Thus, our argument is that leadership can have important positive effects at the reform moment, when the rules are established for subsequent periods, but that the opportunity for a leader to play a positive role in the reform moment is only through constraining future leaders. In the next section, we review the literature on leadership in economic development. The section after that compares leadership-led development with more gradual and spontaneous development processes. Then we argue that leaders matters but in a slight and subtle way. And the final section offers conclusions.

Leaders in the Development Literature In recent years, economists have turned their attention to the role that leaders play in promoting growth. Throughout history, especially in feudal times, leaders played a prominent role in recorded histories (Burns 2003). The idea that leaders play a crucial role in promoting social change remains alive and well in the fields of history, politics, and sociology. For example, Klineberg (1950, 212) writes that “the impact on recent world events of individuals like Churchill, Stalin, Gandhi, Hitler, and Roosevelt make it abundantly clear that the influence of the ‘great man,’ for good or evil, must not be underestimated.” Furthermore, Klineberg says, history’s great men are people researchers should try to understand. What characteristics do history’s great men share? What conditions lead them to becoming great leaders? These are the questions Klineberg thinks we should be asking. Edinger (1964a; 1964b) argues that the political science profession failed to recognize the importance of leadership in political history and calls for more political biographies.

716    Development, Transition, and Social Change While noting the difficulty of studying leaders currently in power, Klineberg (1950, 212) argues, “There is probably no more important problem in this whole field than understanding of the role played by the leader in helping to direct his nation toward peace or war.” More modernly, Thomas Friedman (2009) writes: “One-party autocracy certainly has its drawbacks. But when it is led by a reasonably enlightened group of people, as China is today, it can also have great advantages. That one party can just impose the politically difficult but critically important policies needed to move a society forward in the 21st century.” Long before twentieth-century writers weighed in on the issue of leadership, Karl Marx offered up a theory of historical determinism that placed minimal weight on the role of leaders (Tucker 1978). For Marx, leaders had agency but were largely servants to broader economic forces. Searing (1969) interprets Hegel, Spencer, and Marx as all adhering to the philosophy that a leader can indeed act as a catalyst for change but that these changes would have eventually occurred even without the leader. When we move away from historical arguments about leadership and narrow our focus to contemporary discussions in economics, we see that Acemoglu and Robinson (2006; 2008)  have a dismal view of leaders. For Acemoglu, Johnson, and Robinson, institutions that protect property and restrict the political power of leaders are more important than leaders for transitioning from low economic growth to high economic growth. The colonial origins faced by different countries at the time of settlement also have a first-order effect on economic performance (Acemoglu, Johnson, and Robinson 2001; 2002). Williamson (2009), while not specifically addressing the leadership debate, finds that informal institutions, such as trust, respect, individual self-determinism, and obedience, matter more for economic growth than formal institutions, including a country’s leadership. Turning to empirical work to resolve the leadership debate poses many difficulties. Since each country faces its own unique cultural characteristics, vested interests, historical factors, and geographical features, separating out the effect of a particular leader is a difficult econometric exercise, and endogeneity problems are a constant concern. For instance, Searing (1969, 10) asks, “Do leaders lead, or do they follow?” His question highlights the tricky empirical problem of determining causality when leaders could, quite possibly, be responsible for leading change or, alternatively, take credit for changes already underway that they had no direct involvement in bringing about. In part because of the empirical difficulties inherent in measuring the impact of leaders, most studies involve sui generis case studies, anthropologies, and biographies that often do not lend themselves to statistical analysis (Edinger 1964a, 431). Further biases exist because our knowledge of leaders is limited to the records they leave us. These limitations make historical accounts of social change more state-centric and thus more leader-centric than may be justified by actual circumstances (Hayek 1988, 44; Scott 2009). This leadership-centric bias, by ascribing too much power to leadership in history, can carry over into the policy prescriptions prepared by development economists for developing nations.

On Your Mark, Get Set, Develop!    717 Despite the many econometric challenges that confront leadership research, some scholars have found creative ways to attempt to measure the importance of leadership. Jones and Olken (2005) examine the role that the death of a national leader played in economic development for a cross-section of countries after World War II. Their results suggest that leaders play a crucial role in economic development, especially in autocratic regimes where leaders have few limitations. Similarly, Besley, Montalvo, and Reynal-Querol (2011) use the deaths of national leaders to find that leadership played a significant role in economic performance across countries from 1875 to 2004. One of the primary ways leadership can foster or hamper economic growth is through the selection of institutions. Glaeser et al. (2004) argue against the view that democracy and constraints on government are good for growth, instead arguing that “good-for-growth dictators” have been the source of many successful East Asian reforms, including China’s boom. Glaeser et al. (2004, 298) conclude, “Countries that emerge from poverty accumulate human and physical capital under dictatorships, and then, once they become richer, are increasingly likely to improve their institutions.” The notion that dictators might need to be the driving force of development surely strikes some as dangerous. Any leader with the power to promote growth also has the power to do a great deal of harm. The prevalence of underperforming nations, to a large extent, may have little to do with the constraints placed on a leader and more to do with leaders intentionally maintaining institutions detrimental to economic growth to maintain the current balance of power (Acemoglu and Robinson 2006; 2008). Easterly (2011) criticizes the view of the “benevolent autocrat.” He finds little empirical evidence to support the benevolent autocrat hypothesis, arguing that the proponents of this view cherry-pick examples and that when taken as a whole, autocratic regimes have experienced a higher variance of economic growth but not a higher growth rate. Easterly (2011) also thinks that many economists are asking the wrong questions. Rather than focus on the number of autocratic countries among the fastest growers in the world, he suggests that economists instead focus on the entire universe of autocratic regimes. Once we do so, we should then ask ourselves how many autocratic regimes are enjoying rapid growth. Easterly identifies several biases that result when development economists draw the mistaken, and potentially harmful, conclusion that benevolent autocrats can promote development. The variance in growth performance is not the only thing to worry about for those who embrace benevolent autocrats. Strong, autocratic leaders have been responsible for killing hundreds of millions of their own people through democides outside of warfare. The potential human costs of strong leadership illustrate the risks involved in a full embrace of “good-for-growth” dictators. Rummel (1997) provides a comprehensive overview of the many democides committed by autocrats, and he concludes that while strong leadership may sometimes promote economic growth, there is a far greater tendency for strong leadership to be abused. Easterly, Rummel, and other skeptics of autocratic-led development are echoing an insight made by Hayek ([1944] 2007, chap. 10) about autocratic regimes. For Hayek, the costs of autocracy are large. In addition to these costs, though, the autocratic structure

718    Development, Transition, and Social Change consistently encourages the worst and most ruthless to rise to the top as national leaders. Democratic institutions, by contrast, check excessive discretion on the part of their leaders and promote secure property rights because they encourage government forbearance (Merrill and Smith 2010; Olson 2000).

Institutional Imposition versus Evolution? The debate about the role of leadership in economic development, highlighted above, centers on the following question: do institutions conducive to economic growth need to be grafted onto struggling nations through imposition, or do growth-enhancing institutions need to emerge indigenously through a spontaneous evolution? If the institutions of economic freedom can be imposed, then strong leadership could be a key ingredient in the reform process. On the other hand, if successful institutions need to emerge organically, rather than be imposed, then leadership has a much more modest role to play. At the core of this debate is the degree to which institutions are path-dependent. North (1990) made one of the first attempts at applying the concepts of path-dependency to institutions and institutional change. Path-dependency, in the context of technology, describes a situation where a technology is established as a result of historical adoption. Even if a given technology turns out to be inferior to another technology, the inferior technology may continue to be employed because of the historical embeddedness of the inferior technology. In the context of institutions and institutional change, path-dependency, North argues, is when institutions, even inferior institutions, are locked in because of historical embeddedness. While recognizing the role of culture and embedded informal institutions in economic development, path-dependency implies a larger role for leadership in reshaping indigenous institutions. As North (2005, 164) writes: In a country without a heritage of formal and informal consensual political institutions, the road to an effective political system requires either an authoritarian ruler with an understanding, desire, and ability to put in place the necessary economic rules and enforce them, or the much more lengthy process of piece meal development through non-governmental organizations (NGOs) and effective foreign aid in which educational, health, judicial, or other assistance is effectively designed and delivered with the objective of transferring the essential knowledge and skills to the resident population.

In the 1990s, economists came to settle on the idea that sound economic policies—policies that ensured a fair playing field, predictable taxes, and free trade—were the key to economic growth, a consensus that became known as the

On Your Mark, Get Set, Develop!    719 Washington Consensus (Williamson 1990). With the list of reforms in hand, many development economists started advocating “shock therapy,” which seeks to implement rapid economic reforms on economies in transition (Sachs 1994). Some Austrian economists, such as Peter J. Boettke and Murray Rothbard, became persuaded by the logic of shock therapy reforms and the concomitant strong national leadership needed to ignite these reforms. Boettke (1993, 85–86) argues that exogenous shocks, such as ideological revolutions and economic collapses, introduce a reform opportunity. At that moment, a strong leader—what Boettke terms an “intellectual entrepreneur” (86)—must sweep in and override the dominant interest groups intent on blocking reform and preserving the status quo. Like Boettke, Rothbard (1992, 76) argued for rapid reform—a reform program that, in fact, could be fully completed in “one day.” His reforms, of course, rested on the idea of a strong leader, someone with the power to overcome special interests and the ideology to “push the button of liberty” and desocialize an economy in one fell swoop. While Rothbard and Boettke were arguing for shock therapy in the context of post-Soviet transition, Beaulier (2003) concluded that the same combination of strong leadership and market-based reforms were needed to put African countries on the path to prosperity. Despite the theoretical logic of shock therapy, many think it has failed in practice. Murrell (1993) examined the shock therapy experiments in Poland and Russia and concluded that an evolutionary approach would have performed better. North (1999, 4–5) raised Hayekian concerns about shock therapy when he wrote: “But, essentially, it is an endless story of our having very poor understanding of an enormously complex process in which the uncertainty, again, is in all three dimensions. We do not know enough; we are dealing with a world of continuous change; and we do not have any dynamic theory to guide us when we attempt to get from one point to the next.” For North, there is an arrogance involved when policy makers and Western advisers attempt to impose their economic and governmental systems on diverse and complex cultures. Similarly, Easterly (2006, 66) critiques shock therapy, arguing, “The attempted changes at the top are out of touch with the complexity at the bottom.” Rodrik (2006) criticizes the Washington Consensus model but says it must be tweaked rather than abandoned. After comparing shock therapy to gradual reform experiments, Easterly (2009) argues that the case for transformational approaches, such as shock therapy, has been grossly exaggerated. Despite these severe shortcomings, shock therapy has reinvented itself in the postcommunist period in the form of military interventions and reconstruction efforts that entail broad institutional changes. Examining the record of US military interventions aimed at exporting democracy, Coyne (2008) finds that the majority of these interventions failed to meet the goals of the planners. Despite the US military’s tremendous resource capabilities and long history of experience, the reconstruction efforts of the US military were more likely to result in failure than success. The evidence piling up against shock therapy has led development economists to reconsider their reform options. Many are shifting away from attempts to understand the right mixture of formal and informal institutions; instead, they seek to understand how path-dependencies manifest themselves in historical institutions and vested

720    Development, Transition, and Social Change interest groups (Easterly 2009; Olson 2000, chap. 9; Popov 2007). Williamson (2009) measures the relative impact of formal and informal institutions across forty-five countries and finds that the success of formal institutions depends largely on how well they mesh with the informal. Williamson encourages development economists to study the conditions under which quality informal institutions emerge and rejects the view that formal institutions should be transplanted. Boettke’s later work (Boettke et al. 2005; Boettke, Coyne, and Leeson 2008) focuses less on the role of leadership and emphasizes the role that indigenous institutions play in a nation finding its way to prosperity. For Boettke, Coyne, and Leeson (2008), successful reforms of formal institutions must necessarily be built off of informal institutions and culture. In the absence of change at the informal level, formal institutions will not be effective. In fact, Coyne and Boettke (2006) call for dialing back the hubris of development economists and encourage more professional humility. A more humble development economics means accepting that reform is complex and should be informed by the indigenous institutions and culture of the transitioning economy. Rather than having the economist play the role of savior, they call for the economist to become a student of the economy. The approach being taken by the new comparative political economists (e.g., Boettke, Coyne, Leeson, and Williamson) recognizes the need to use liberal means to obtain liberal ends (Coyne 2008, chap. 8). Since economists have not been successful at imposing institutions, they need to focus instead on how good institutions emerge. Free trade and nonintervention, Coyne (2008) argues, play an essential role in the emergence of good institutions. Trade disrupts the traditional balance of power and allows entrepreneurs and other beneficiaries of trade to pressure political elites into a more equitable distribution of political power (Acemoglu and Robinson 2006; 2008). A humbler political economy is consistent with and, to a large extent, informed by Mises and Hayek. Hayek (1945; 1948, chaps. 7–9) stressed the knowledge problems inherent in economic planning and said that they would seriously cripple any attempts by leaders to manage the economy. Whether the planning’s end goal is liberal or nonliberal, the complexity and informational problems facing the planner make for an insurmountable problem. Hayek (1948, 11) stressed the importance of Smith’s inquiry that sought to design institutions robust do deviations away from idealized conditions. Indeed, indigenous institutions, which emerge from the bottom up, rather than top-down institutions, encourage the development of culture, responsibility, and civil society (Tocqueville [1835] 2010; Ostrom 1997; Otteson 2015, 100). As Tocqueville ([1835] 2010, 148–149) put it: “one of the greatest misfortunes of despotism is that it creates in the soul of the men submitted to it a kind of depraved taste for tranquility and obedience, a sort of self-contempt, that ends by making them indifferent to their interests and enemies of their own rights.” In fact, Tocqueville (149), goes on to criticize the notion that a strong leader can be used to transition a country to liberal institutions: Nearly all the passionate and ambitious men who talk about centralization lack a real desire to destroy it. What happened to the praetorians happens to them; they

On Your Mark, Get Set, Develop!    721 willingly suffer the tyranny of the emperor in the hopes of gaining the empire. So decentralization, like liberty, is something that the leaders of the people promise, but that they never deliver. In order to gain and keep it, nations can count only on their own efforts; and if they themselves do not have a taste for it, the evil is without remedy.

Tocqueville and Hayek had the answers about leadership and development long before us. What the new comparative political economy is, in part, aiming to do is to bring us full circle back to a focus on the organic and informal over the designed and formal.

Leaders Matter … at the Margin Rather than thinking about leadership as an expedient to economic development, historical experience, economic logic, and data suggest that we should instead be quite skeptical of the role that leaders play in development. For most of history, leaders have sought to erect formidable barriers to economic development and control their people. The idea of a “good for growth” leader is fleeting at best and perhaps a myth. To the extent that leaders can be a force for good in economic development, their role is largely symbolic and concentrated in the very early days of reform. That seems to be the main idea to take away when we look closely at the “good for growth” autocrats. The autocrats had a moment—in some cases, only a moment—to spark reforms. Once interest groups had a chance to form or realign, the reform moment was over. During that reform moment, their success was not the result of splendid planning or tremendous autonomy but, rather, resulted from their decision to be liberty leaders. As liberty leaders, they chose to get out of the way and sought to embrace free exchange, the informal sector, and the rule of law. Thus, leaders can have a positive effect on growth if, at the right moment, they set up institutions that curtail future leaders. While the alignment of conditions necessary to spark reforms during a reform moment is rare, there are examples of leaders achieving this. One would be hard-pressed to find a better example of leadership mattering than the case of Botswana (Beaulier 2003). Botswana’s first postcolonial president, Seretse Khama, came to power in 1965 and sought to reform Botswana in ways that were largely proliberty. He did not go about designing institutions from scratch but, rather, embraced the informal, traditional institutions. Even the system in which knowledge was gathered throughout the country—the kgotla system—was preserved. Khama has been praised for being a charismatic leader who helped to launch Botswana’s growth miracle, but he did little in the way of actively advancing policy and focused mainly on serving as the face of Botswana externally, while emphasizing free exchange and tolerance internally. Khama did what any good business leader would do: he delegated and embraced an antiplanning plan. To the extent that he was wise enough to plan for a market, we can say that his leadership mattered.

722    Development, Transition, and Social Change Liberty leaders such as Khama have the potential to ignite reforms. But their potential is far more limited than what the shock therapy writers in development economics imply. They have the potential to set the tone for their country, control the narrative, and block bad ideas. But there is no such thing as a blank slate in the reform moment, and the good ones have an ability to recognize this. In other words, developing nations need to adopt the philosophy that Tocqueville ([1835] 2010, 302) witnessed in America: “The inhabitant of the United States learns from birth that he must depend on himself in the struggle against the ills and difficulties of life; he looks upon social authority only with a defiant and uneasy eye, and calls upon its power only when he cannot do without it.” Other examples of leadership taking advantage of a window of opportunity to successfully institute reform is in post–World War II Germany. While the main task was largely building back infrastructure; rather than designing new social institutions, leadership put in place in both countries made important decisions that allowed the war-stricken nations to recover. In West Germany, Ludwig Erhard, who was elected the director of economics of the Office of Economic Opportunity in 1948, eliminated a wide array of price controls that had been imposed during the war (Coyne 2008, 132). When planners implement antiplanning measures at opportune times, they can drastically change the trajectory of growth for their nation. This is especially true when they respect local culture and institutions. For example, in West Germany, great care was also taken to preserve existing institutions through the placement of native Germans in positions of leadership in order to preserve informal institutions necessary for a successful recovery (Boettke, Coyne, and Leeson 2008, 346–348). Similarly, post–World War II Japan offers an example of leadership successfully ensuring that indigenous culture and institutions were not greatly disrupted. General Douglas MacArthur, who served as the supreme commander of the Allied Powers for the Occupation and Control of Japan, had realized early on that any reforms would be in vain if they tried to impose foreign institutions (Manchester 1989, 390). Rather, MacArthur insisted on largely keeping Japanese institutions intact, especially through the retention of Japanese leadership, and accepting the majority of the constitutional elements that were proposed by Japanese advisers (Boettke, Coyne, and Leeson 2008, 346; Coyne 2008, 124). A few other examples of liberty advancing leadership are noted by Easterly (2006, chap.  10). According to Easterly, the cases of successful reform in Turkey, Hong Kong, India, and Chile all had a lot more to do with leaders just getting out of the way, rather than carefully planning development. The leaders mattered in that they signaled the introduction of a “new boss” into the reform process, but once the signal of a new regime was sent, they largely stepped to the side and let the process of development work. To be successful, leaders must be able to commit to stepping aside credibly (Boettke 2009; Coyne and Boettke 2009; Rodrik 1989). Rotberg (2012) provides several case studies highlighting countries that were positively affected by what he refers to as transformative political leaders, including Nelson Mandela in South

On Your Mark, Get Set, Develop!    723 Africa, Lee Kuan Yew of Singapore, Kemal Ataturk of Turkey, and Seretse Khama of Botswana.2

Conclusion While Smith boiled down the causes of economic growth to peace, easy taxes, and a tolerable administration of justice, the process of getting institutions to support peace, easy taxes, and a tolerable administration of justice is quite complicated and messy in the real world. While strong leadership has seen some successes, promoting autocracy as the path to economic development is premature and has the potential to be extremely harmful. While strong leaders can and have orchestrated success, this misses out on the long history of cacophonic disasters brought about by dictatorial regimes. However, our concerns about leader-led development do not push us all the way to the other extreme of thinking that national leaders can never matter. The examples of a few successful leaders in the real world suggest that there is still a possibility that the appropriate reformer can come onto the scene and transform a nation through his or her embrace of the informal. Botswana’s first president, Seretse Khama, is one of a few examples of a leader who ignited development and left the rest of the process alone. Rather than promoting institutions that will enable the best men to do the greatest amount of good, formal institutions should be sharply circumscribed to protect against the wide variance of behavioral tendencies typical in political institutions. In other words, institutions should be designed so that the worst, who can and do achieve positions of power, can do the least harm. In a reform moment, a good leader can credibly set up such institutions that curtail future leaders. Future research should explore what types of institutional regimes best credibly curtail bad leaders from doing harm and what conditions allow for their emergence and implementation. Rather than focusing on giving the right leader a prefabricated development plan, future research and policy prescriptions should focus more on understanding the ideological and social conditions necessary to restrain harmful leaders.

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Also see a review of Rotberg by McBride (2012).

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On Your Mark, Get Set, Develop!    725 Hayek, F.  A. 1945. “The Use of Knowledge in Society.” American Economic Review 35, no. 4: 519–530. Hayek, F. A. 1948. Individualism and Economic Order. Chicago: University of Chicago Press. Hayek, F.  A. 1988. The Fatal Conceit:  The Errors of Socialism. Chicago:  University of Chicago Press. Ionescu, Ghita. 1991. Leadership in an Interdependent World: The Statesmanship of Adenauer, De Gaulle, Thatcher, Reagan and Gorbachev. Boulder, CO: Westview. Jones, Benjamin F., and Benjamin A. Olken. 2005. “Do Leaders Matter? National Leadership and Growth since World War II.” Quarterly Journal of Economics 120, no. 3: 835–864. Kissinger, Henry. 1968. “The White Revolutionary: Reflections on Bismarck.” Daedalus 97, no. 3: 888–924. Klineberg, Otto. 1950. Tensions Affecting International Understanding: A Survey of Research. New York: Social Science Research Council. Manchester, William. 1989. American Caesar:  Douglas MacArthur 1880–1964, Pleasantville, NY: Reader’s Digest. McBride, Michael. 2012. “Review of Robert I.  Rotberg:  Transformative Political Leadership: Making a Difference in the Developing World.” Public Choice 153, nos. 3–4: 503–505. Merrill, Thomas W., and Henry E. Smith. 2010. The Oxford Introductions to U.S. Law: Property. New York: Oxford University Press. Murrell, Peter. 1993. “What is Shock Therapy? What Did It Do in Poland and Russia?” Post-Soviet Affairs 9, no. 2: 111–140. North, Douglass C. 1990. Institutions, Institutional Change, and Economic Performance. New York: Cambridge University Press. North, Douglass C. 1999. “Dealing with a Non-Ergodic World:  Institutional Economics, Property Rights, and the Global Environment.” Duke Environmental Law and Policy Forum 10, no. 1: 1–12. North, Douglass C. 2005. Understanding the Process of Economic Change. Princeton, NJ: Princeton University Press. Olson, Mancur. 2000. Power and Prosperity:  Outgrowing Communist and Capitalist Dictatorships. New York: Basic Books. Ostrom, Vincent. 1997. The Meaning of Democracy and the Vulnerability of Democracies: A Response to Tocqueville’s Challenge. Ann Arbor: University of Michigan Press. Otteson, James R. 2014. The End of Socialism. New York: Cambridge University Press. Plato. 1985. The Republic, translated by Richard W. Sterling and William C. Scott. New York: W. W. Norton. Popov, Vladimir. 2007. “Shock Therapy versus Gradualism Reconsidered:  Lessons from Transition Economies after 15 Years of Reforms.” Comparative Economic Studies 49, no. 1: 1–31. Rodrik, Dani. 1989. “Promises, Promises:  Credible Policy Reform via Signaling.” Economic Journal 99, no. 397: 756–772. Rodrik, Dani. 2006. “Goodbye Washington Consensus, Hello Washington Confusion? A Review of the World Bank’s Economic Growth in the 1990s: Learning from a Decade of Reform.” Journal of Economic Literature 44, no. 4: 973–987. Rotberg, Robert I. 2012. Transformative Political Leadership:  Making a Difference in the Developing World. Chicago and London: University of Chicago Press. Rothbard, Murray. 1992. “How and How Not to Desocialize.” Review of Austrian Economics 6, no. 1: 65–77.

726    Development, Transition, and Social Change Rummel, P. J. 1994. Death by Government. New Brunswick, NJ: Transaction. Sachs, Jeffrey. 1994. Understanding Shock Therapy. London: Social Market Foundation. Scott, J. 2009. The Art of Not Being Governed: An Anarchist History of Upland Southeast Asia. New Haven, CT: Yale University Press. Searing, Donald D. 1969. “Models and Images of Man in Society and Leadership Theory.” Journal of Politics 31, no. 1: 3–31. Smith, Adam (1776) 1976. An Inquiry into the Nature and Causes of the Wealth of Nations. Indianapolis: Liberty Fund. Stewart, Dugald. (1793) 1829. The Works of Dugald Stewart, Vol. 7. Cambridge, UK: Hilliard and Brown. Tocqueville, Alexis de. (1835) 2010. Democracy in America. Indianapolis: Liberty Fund. Tucker, Robert C., ed. 1978. The Marx-Engels Reader, 2nd ed. New York: W. W. Norton. Weber, Max. 1947. The Theory of Social and Economic Organization, translated by A. M. Henderson and Talcott Parsons. New York: Free Press. Williamson, Claudia. 2009. “Informal Institutions Rule:  Institutional Arrangements and Economic Performance.” Public Choice 139, no. 3: 371–387. Williamson, John. 1990. Latin American Adjustment: How Much Has Happened? Washington, DC: Institute for International Economics. Williamson, Oliver. 2000. “The New Institutional Economics: Taking Stock, Looking Ahead.” Journal of Economic Literature 38, no. 3: 596–613.

Pa rt  I X

A P P L IC AT ION S : T H E 2 008 F I NA N C IA L  C R I SI S

Chapter 33

T he Financia l C ri si s i n the U nited  Stat e s Steven Horwitz

Introduction The housing boom and resulting recession and financial crisis have posed challenges for every school of thought in economics, as their complexity defies easy explanations. As the major schools of thought have struggled to explain a crisis that caught most economists by surprise, particularly in the wake of much self-congratulation during the so-called Great Moderation of the preceding decades, the search for alternative macroeconomic frameworks brought increased attention to the Austrian theory of the business cycle. Given the clear signs that the housing market had diverted from fundamentals, and its eventual crash which led to a recession, it was understandable that the Austrian theory, with its account of an artificial and unsustainable boom that inevitably turns to bust, would attract the attention of academics, intellectuals, and even the media. The Austrian theory offers a very powerful starting point to examine the causes and consequences of the 2008 financial crisis. Many of the features of this particular boom and bust can be rendered intelligible by the conceptual framework they provide. However, the Austrian theory alone cannot explain all of the features of this cycle. The theory operates at a fairly high level of abstraction that requires additional empirical and institutional assumptions in order to be able to explain particular cycles. In the discussion to follow, the Austrian theory serves as the starting point for the analysis but is supplemented with insights from Virginia political economy and other scholarship on the recovery process in order to understand the boom, the bust, and the ongoing slow recovery. Although it is not sufficient to explain the entire process, the Austrian theory of the business cycle is necessary to understand the intertemporal discoordination that is at the heart of the unsustainable booms that characterize business cycles such as the one leading up to the financial crisis of 2008.

730   Applications: The 2008 Financial Crisis

The Austrian Theory of the Business Cycle The underlying analytical vision of Austrian economics is one of humans trying to discern their ends and how best to make use of their means to achieve them in a world characterized by structural uncertainty and actors whose knowledge is fragmentary and often inarticulate. In such a world, all human action is fundamentally speculative and entrepreneurial, in that genuine error and regret are possible and any notion of optimality is highly suspect. This vision contrasts with a neoclassical one in which people are assumed to make the best possible decisions given the information at hand and where meaningful regret is absent. The primary way in which actors attempt to improve their well-being is by giving up lower-valued means for higher-valued ones via exchange. Historically, exchange gave rise to money (Menger 1892), which enabled each good or service to have a price reckoned in terms of a single other good. Prices expressed in terms of money thereby made possible comparisons of value and the broader process of economic calculation that is central to how people determine the most effective use of resources in both consumption and production (Mises [1920] 1935). Actors can also achieve their desired ends by creating value through production. They can bring together resources, including time, and create something new with them, whether as simple as a hammer or as complex as an automobile. Such “roundabout” processes of production direct our attention to the ways in which economic activity is coordinated through time. Carl Menger ([1871] 1981), the founder of the Austrian school, recognized the importance of intertemporal production by distinguishing between goods of the “first order,” or direct consumption goods, and goods of the “higher orders,” or capital goods that contribute to the production of first-order goods. Roundabout production processes make it possible for us to increase our future consumption by consuming less now and using some of those resources to finance multiple-stage production processes that will provide more output in the future. It is our willingness to save by sacrificing current consumption that makes it possible for us to wait for the larger future output. Savings, in the Austrian view, is crucial for long-run growth, as it makes possible these more roundabout, and more productive, processes. Producers make their decisions about what to produce and how to produce it based on current prices and their judgments about what will be wanted in the future. These entrepreneurs purchase raw materials, machinery, or other higher-order goods, along with labor, and combine them to produce output that they believe can be sold at a price that exceeds the cost of the inputs plus an implicit interest rate that accounts for the necessary passage of time. Because production processes take time, the interest rate plays a key role as the central price guiding intertemporal production. At lower market interest rates, which reflect more saving, and therefore more patience, on the part of consumers, production processes with more stages of production (i.e., those with more steps between raw materials and the final output) will be relatively more worthwhile, while

The Financial Crisis in the United States    731 higher interest rates and consumer impatience will make shorter processes relatively more desirable. Entrepreneurs are attempting to produce an array of goods that reflects intertemporal coordination, or the degree to which the roundaboutness of their production plans is coordinated with the time preferences of consumers. This explanation of the production process is linked to the way Austrians think about capital, which is central to the school’s business cycle theory. In neoclassical analyses, capital is normally treated as a homogeneous aggregate; it is K in various models. By contrast, Austrians see capital as always embodied in specific goods, so it cannot be treated as an undifferentiated mass. Entrepreneurs purchase inputs or build machines that are designed for specific purposes. They cannot be costlessly redeployed to an infinite number of other uses the way that treating capital as a homogeneous mass might suggest. Austrians see capital as heterogeneous and having a limited number of specific uses (Lachmann [1956] 1978; Kirzner 1966). The same is true of labor (Lewin 1999). Workers also have skills and training that cannot costlessly be redeployed across production processes; thus, their human capital can be conceived of as heterogeneous and specific to a limited number of uses. Seeing capital this way opens up the possibility of short-run errors by entrepreneurs and workers becoming embedded in physical and human capital in ways that cannot be costlessly corrected. It is in these ways that the Austrian approach to macroeconomics is fundamentally microeconomic. What matters for growth is the degree to which microeconomic intertemporal coordination is achieved by producers using price signals, especially the interest rate, to coordinate their production plans with the preferences of consumers (Hayek [1928] 1984). Because the processes of exchange that underlie both production and consumption take place using money, money holds the possibility of being a source of systematic disruption in the intertemporal coordination process. If the supply of money is not right, the fact that it is half of every exchange will lead to system-wide problems that are rightly characterized as macroeconomic. More specifically, excesses or deficiencies in the money supply will be linked to changes in market rates of interest that disconnect them from the underlying preferences of savers and investors. Monetary disequilibria lead to false interest-rate signals, which in turn lead to intertemporal discoordination as the signals that entrepreneurs are acting on for their production decisions are inconsistent with what consumer/savers are trying to tell them. This is the essence of the Austrian theory of the business cycle.1 According to the Austrian theory, the boom phase of the business cycle is initiated when the money supply is kept at a level greater than the public wishes to hold at the current price level. As these excess supplies of money make their way into the banking system, lenders find themselves able to provide more loans even though they have seen no increase in saving from the public. It does not matter to individual banks whether new reserves come in the form of deposits transferred from other banks or as the result of new funds 1  Key contributions to Austrian business cycle and macroeconomic theory include Hayek ( [1933] 1966; [1935] 1967; [1939] 1975), Mises (1966, chap. 20), Horwitz (2000), and Garrison (2001). The following discussion draws heavily on Horwitz (2010).

732   Applications: The 2008 Financial Crisis created by open market operations. In either case, they see their reserves expand and will lower interest rates to entice marginal borrowers. These lower market rates of interest appear to signal to firms that the public is now more patient and more willing to wait for consumption goods. Had the expansion of loanable funds been financed by genuine savings, the lower interest rate would be sending an accurate signal about the public’s wishes. However, when the expansion is caused by an excess supply of money rather than a shift in the public’s time preferences, the tight relationship between market rates of interest and underlying time preferences is broken. The lower interest rate signals to producers that the public is more willing to wait; they therefore will find projects with a longer process of production to now be worthwhile. Longer processes are more productive, which is why they are desirable to producers, and the lower interest rate makes it economically rational to stretch out production in this way. Capital goods are created or purchased and refit to engage in these longer processes, and labor is bid away from the stages of production closer to final goods and toward markets in the earlier stages of production. For example, labor is more heavily demanded in research and development than in wholesaling or retailing. Prices and wages are bid up, and as Garrison (2001) argues, the economy can, at least temporarily, exceed its sustainable production possibilities frontier. During this boom phase of the cycle, resources, including labor, are malinvested such that the projects being started in the early stages cannot be consummated with the available amount of resources. In Mises’s (1966, 560) famous analogy, it is like building a house and using so many bricks on the foundation that you do not have enough to finish all the other floors. Even as resources are being pulled to the early stages of production by the influx of central-bank-created loanable funds and the corresponding lower interest rate, households have not changed their time preferences, and their demand curves for consumption goods and savings have not changed. Producers are expecting declining consumption and rising savings because of the lower interest rate, but that rate no longer reflects underlying demands. In addition, the falling rate exacerbates the situation by actually reducing the quantity saved and leading households to consume more than they were previously. The result, argues Garrison (2004), is a combination of malinvestment and overconsumption. Firms are pulling resources toward the early stages of production (malinvestment), while consumers increase their demands on the final stages (overconsumption). The structure of production is tugged at both ends in a way that cannot be sustained. The plans of entrepreneurs are inconsistent with the plans of households, and this intertemporal discoordination must eventually reveal itself. This tug of war manifests itself as attempts by some producers to purchase inputs for longer production processes, while others continue to bid up input prices for goods closer to consumers. This is unsustainable, as both groups cannot be successful given the realities of the resources available. Eventually, the longer processes of production are found to be unprofitable as the cost of inputs gets bid up too high and it becomes clear that the public does not want to wait for more output. The unprofitable longer-term processes are abandoned, and the resources used in them are put up for sale, resulting in falling asset prices (both capital goods and financial assets such as stock prices)

The Financial Crisis in the United States    733 and unemployed labor in those sectors in the earlier stages of production. So begins the bust phase of the cycle. In addition to the decline in stock and other asset prices, overall economic activity slows, and unemployment rises. The problem during the bust is the specificity of capital and labor, as abandoned capital goods associated with the longer production processes cannot be instantaneously and costlessly converted over to new uses in the consumption-goods sectors. The same is true of labor: unemployed workers must find their way into the particular sectors closer to final consumption where labor is needed, and they will likely take a loss in income in the process and may even require a different set of human capital to be successful. This refitting and reshuffling of capital and labor during the bust is the process that eliminates the mistakes made during the boom. Within the framework of the Austrian theory of the business cycle, the boom is when the mistakes are made, and it is during the bust that those mistakes are corrected. The false interest-rate signal induces malinvestment that is not sustainable, leading to a bust in which the malinvested capital and labor cannot costlessly be moved to new uses. The result is some degree of idled capital and unemployed labor until the corrective processes unfold. One important difference between the Austrian approach and standard macroeconomics is worth noting. At the center of the Austrian theory is the idea that consumption and investment are substitutes rather than being additive, as we see in typical conceptions of GDP = C + I + G. The Austrian stages-of-production approach disaggregates investment in a way that opens up the possibility of intertemporal discoordination. It allows the interest rate to affect not just the volume of investment but also the allocation of investment across the various stages of production. Once we talk of different kinds of investment, we can speak of malinvestment rather than just too much or too little. Models that do not understand investment decisions, and the capital goods they lead to, as the outcome of a whole series of entrepreneurial decisions at the microeconomic level will be unable to comprehend fully the distortive effects of artificially low interest rates. Hayek ([1931] 1995, 128) recognized this as early as his review of Keynes’s Treatise on Money, when he wrote, “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.” That observation is still at the core of how Austrians look at the business cycle and how their theory differentiates itself from the standard approaches to macroeconomics since Keynes.

Austrian Business Cycle Theory Is Necessary but Not Sufficient The core of Austrian business cycle theory is its emphasis on intertemporal discoordination. Although the theory usually points to the central bank as causing distortions in interest rates that discoordinate the plans of savers and investors, the central bank need not be the culprit. Butos (1993) argues that the brief recession of 1990–1991 was an

734   Applications: The 2008 Financial Crisis example of intertemporal discoordination brought on by regulatory and fiscal policies that led to distorted interest rates. It is the notion that false interest-rate signals can lead to patterns of unsustainable economic growth, which endogenously turn into a bust, that is the essence of the Austrian theory. Whether central banks or other factors are the ultimate cause is contingent. The same can be said of which industries are most affected by the unsustainable boom. The early versions of the Austrian theory argued that the loans made with the excess supplies of money would find their way into the hands of manufacturers as they engaged in more roundabout processes of production. As argued above, this would put more resources into areas such as research and development or perhaps raw materials. However, that claim, while based on empirical observations of nineteenth- and early-twentieth-century cycles, is also a contingent one. The particular path that excess supplies of money take will depend on the policies and institutions that exist at the start of any boom. The mere existence of artificially low interest rates tells us that the areas most affected will be interest-sensitive, but whether those effects are widespread or concentrated in some smaller number of industries will depend on historical circumstances. If policies or institutions subsidize or otherwise provide incentives for resources to be directed into some subset of interest-sensitive production processes, then those areas will be disproportionately affected by the boom. In this way, the Austrian theory is potentially consistent with a variety of particular patterns of boom and bust, including a number of different asset bubbles (Horwitz and Callahan 2010). When we apply the Austrian theory to any particular set of historical events, we have to first ascertain whether intertemporal discoordination is the problem. Not all economic crises result from intertemporal discoordination or take the form of a boom-and-bust cycle. If the crisis does take that form, Austrian economists believe that their business cycle theory is a necessary component of any explanation of what happened and why. However, the theory is not by itself sufficient to offer a complete explanation. If we want to explain any particular cycle, we are going to have to make use of particular contingent facts about policies and institutions along with other theoretical tools that enable us to integrate those facts into a larger narrative. In the case of the 2008 financial crisis, the Austrian theory needs to be supplemented by explanations for why the boom took the form of a housing bubble, why the bust included a financial crisis, and why recovery from the bust has been so slow.

Monetary Policy, Regulatory Policy, and the Housing Boom In the decade or two prior to the financial crisis of 2008, a variety of policies and institutions interacted with the Fed’s expansionary policy in the wake of the events of September 11, 2001 (9/11), to create an asset bubble in the housing market, driving up

The Financial Crisis in the United States    735 real estate prices and serving as the basis for a set of ill-conceived financial instruments. The eventual bursting of that bubble dragged down the other financial instruments premised on those rising prices, leading to the financial crisis and worsening the ensuing recession. A look at various measures of the money supply and related interest rates indicates the US Federal Reserve System’s expansionary policy and how it drove down interest rates.2 The Greenspan-era Fed had adopted expansionary policy as part of its attempt to pull the US economy out of the small post-9/11 recession. It created enough new reserves so that the federal funds rate fell to the 1 percent range for a period, and it stayed well below recent historic norms for much of the period prior to 2007. For around two years of that period, the real federal funds rate (the nominal rate minus the rate of inflation) was actually below zero, implying that people were being paid to borrow. All of these rates were well below what the Taylor rule suggested the low end of the noninflationary interest rate range would be. Looking at market interest rates alone is not enough to provide the necessary evidence of an Austrian-style boom. The key is that those market rates must be below the rate consistent with the public’s time preferences, known as the natural rate of interest. The natural rate of interest is not directly observable, making it hard to determine whether any particular market rate of interest is evidence of expansionary monetary policy (Taylor 2009, 2). However, we can find some corroborating evidence. Seasonally adjusted growth in M2, the widely accepted monetary aggregate in the United States, was on the order of 32.5 percent between 2002 and 2006. If monetary expansion under Alan Greenspan was not excessive, changes in the stock of money would have merely offset changes in velocity, and according to the equation of exchange, nominal spending would have been stable. Using the growth rate for final sales of domestic goods, White (2012) shows that nominal spending increased rapidly from a compounded rate per annum of 3.6 percent between 2001 and 2003 to 7.1 percent between 2004 and 2006. Beckworth (2012) explains this expansion as a mishandling of the productivity boom of the period, as the Fed “fought off ” a benign deflation caused by rising productivity by overexpanding the money supply to maintain a stable price level. With both the money supply expanding and interest rates being plausibly under their natural levels, the evidence for an Austrian-style boom is strong. For these inflationary funds to fuel a housing bubble and financial-sector-driven boom more generally, government policy had to play an additional role. The US government has wanted to expand the affordability of housing for several decades, and doing so was a priority of several recent presidents. At least since the Clinton administration, the federal government has expanded affordable-housing initiatives for lower- and middle-income groups and various minorities. In understanding the financial crisis, the role of the government-sponsored enterprises (GSEs) within the mortgage market was central. The Federal National Mortgage Association (Fannie Mae) and the Federal

2 

The following discussion borrows heavily from Horwitz and Luther (2011).

736   Applications: The 2008 Financial Crisis Home Loan Mortgage Corporation (Freddie Mac) did not originate many of the risky mortgage that characterized the housing boom, but they did develop a number of the exotic mortgages that emerged in this period, including those that involved very low or nonexistent down payments. Their more important role was in the secondary mortgage market as purchasers of mortgages originated by others and driving the market in mortgage-backed securities that were at the center of the various new financial instruments that also emerged in this period. Both GSEs were technically private firms during the housing boom, but both were chartered by the federal government, and both had a number of government privileges, including special access to the Treasury Department and lines of credit. In addition, both carried an implicit promise of government help if their portfolios should collapse. In many ways, the GSEs were the first institutions that were “too big to fail.” Although that promise was never explicitly encoded into law or policy, it was generally understood that they would be bailed out or bought out if their solvency was threatened. The events of 2008 showed that understanding to be correct, as both were quickly taken over in the aftermath of the crisis in the fall of that year. Fannie Mae and Freddie Mac’s privileges and their implicit “too big to fail” status enabled them to accept a level of riskiness in their investments that institutions truly subject to profit and loss would not. Even though the actual loans that failed were mostly generated by financial institutions other than the GSEs, their presence as “big players” (Koppl 2001) in the mortgage market dramatically distorted the incentives facing those truly private actors. By buying up mortgages originated by others without having to be as concerned about their profitability, the GSEs reduced the cost of mortgage originators making risky loans, as they knew they could package them up and sell them off to Fannie Mae, Freddie Mac, and others. Their relative immunity from genuine market profit and loss as big players had distorting effects on the rest of the housing industry, which then became the focal point for the excess supplies of loanable funds from the Fed, leading to the creation of any number of mortgages that never should have existed. The GSEs’ big player status was not the only outside factor directing the loanable funds toward the housing market. The US Congress had put serious pressure on Fannie Mae and Freddie Mac, and also other government agencies such as the Department of Housing and Urban Development, to make access to homeownership increasingly affordable (while at the same time promoting instruments such as mortgage-backed securities whose profitability depended on the constantly rising housing prices) for historically underserved minority groups. Many of the aforementioned no-/low-down-payment mortgages (especially those associated with Countrywide Mortgage) were designed in response to that congressional pressure as a way to enable groups well below the median household income to become homeowners. Throw in the marginal effects of the Community Investment Act, which required lenders to serve those underserved groups, and zoning and land-use laws (Mills 2009) that pushed housing into limited space in the suburbs and exurbs and drove up prices in the process, and you can explain how government policies and institutions

The Financial Crisis in the United States    737 guided the credit expansion into the housing market, leading to the bubble. Unlike past booms, where the excess of loanable funds ended up as credit to producers, this set of unique events that accompanied this boom was responsible for channeling those funds into housing. One last set of distorted incentives came from the “Greenspan put.” When he was chair of the Federal Reserve Board, Greenspan made clear to financial markets that he believed that the central bank could do nothing to prevent the development of asset bubbles, because they were so hard to identify, but that it could cushion the effects when such bubbles burst. Throughout his time as chair, and even when he spoke specifically to the role of the Fed in dealing with the bursting of bubbles, Greenspan seemed ignorant of the role that the Fed might play in causing such bubbles and the moral hazard that the Greenspan put created for investors, who now knew that they would be, at least partially, saved from any losses they might suffer because of a collapsing bubble. In later reflections, Greenspan (2013) never even acknowledges that the Fed might have played a role in generating the housing bubble. The moral hazard problem generated by the Greenspan put surely had a role in making financial market actors believe there was little downside risk to the housing-related instruments developed during the boom. The Greenspan put also compounded the misleading interest-rate signal generated by monetary policy by artificially reducing the riskiness of particular financial instruments and thereby enabling interest rates to be lower than they would have been otherwise. In addition to the Fed’s direct monetary role in causing artificially low rates that led to intertemporal discoordination, it played an indirect role through the Greenspan put being an implicit subsidy for risk taking. The put alone might not have been enough to trigger a significant amount of unsustainable investment, but it certainly enhanced the distortions coming from expansionary monetary policy and the various policies and institutions promoting affordable housing. The boom in the housing market drove home prices to unprecedented levels. The belief in constantly rising prices explains the development of the minimal-down-payment mortgages. Such borrowers would eventually get to the benchmark of 20 percent equity when the value of the house rose sufficiently to make the original loan less than 80 percent of the home’s new value. Even with a zero-down-payment loan, a homeowner could get to 20 percent in a few short years if prices rose enough. The belief that housing prices were in a permanent upward trend also led financial markets to recognize the opportunity to create new instruments that took the mortgage payments of borrowers as a flow of income that could be parceled out among investors. Mortgage-backed securities would also, in theory, have the advantage of being lower-risk given that there was a diversity of specific kinds of mortgage loans in each one. The mortgage-backed securities became the basis for even fancier instruments, such as collateral debt obligations and other forms of cross-insurance. Built on top of the mortgage-backed securities, they were also premised on ever-increasing housing prices. Those prices were, in turn, driven by the combination of fuel from the Fed and an engine in the form of the GSEs and housing policy.

738   Applications: The 2008 Financial Crisis Understanding where the whole regulatory framework pushing for affordable housing came from requires going beyond the Austrian theory of the business cycle, as monetary policy alone was necessary but not sufficient to explain what unfolded. One way to understand what was happening in housing policy is through Virginia political economy. Brennan and Buchanan (1985) and others in that tradition distinguish between constitutional and postconstitutional political economy, where the former refers to the analysis of the rules of the political and economic game, and the latter refers to the analysis of how the game is played given a set of rules (the constitution). Where the rules of the game give political actors a great deal of discretion about the policies they can enact, and particularly ones that distribute wealth or privileges that can be used to acquire wealth, people will expend resources to divert those resources in their own direction. This rent-seeking behavior represents the attempts by private actors to profit from obtaining government-granted privileges or influencing regulations in ways that would benefit them or harm their competition. Many of the US financial institutions that were deeply involved in housing policy engaged in this kind of behavior and profited greatly for many years from their involvement before it all fell apart. The banks were happy to help create a structure that enabled them to originate mortgages and sell them off to others who took on the direct risk. Banks such as Countrywide grew substantially as they became the lead players in implementing the directives to expand minority homeownership. Those same institutions had tight relationships with the agencies responsible for overseeing these policies, and the revolving door among bankers, lobbyists, and employees of the GSEs produced numerous opportunities to seek rents in this market. In addition to those groups, various community-level organizations that might serve as intermediaries between banks and borrowers stood to benefit from this legislation. All of this was equally true of the GSE leadership, who were happy to tell politicians that the work being done by Fannie Mae and Freddie Mac was essential for expanding homeownership. The privileges that both organizations had were also a result of their lobbying efforts. Their status in between public and private not only undermined the signal and incentive effects of profit and loss, but it also enabled them to engage in some questionable accounting that made their balance sheets look more healthy than they were. The concentrated benefits and dispersed costs that characterize political exchange were on full display as the GSEs, banks, community groups, and lobbyists all gained much from these policies, while the costs were distributed widely across homeowners underwater, failed financial institutions and their employees, those unemployed by the ensuing recession, the decline in the value of the retirement plans of millions, and the enormous present and future cost of the policies adopted in the wake of the crisis. The Austrian theory of the business cycle is not a complete theory of the political economy of recessions and financial crises. It is, however, a necessary component if one wishes to understand the unsustainability of inflationary booms and the intertemporal discoordination that characterizes them. A full account of such booms will normally require additional tools.

The Financial Crisis in the United States    739

The Political Economy of the Bust One of the features of the Austrian theory is that it cannot precisely predict the turning point where boom turns into bust. The theory can show that the boom must inevitably come to an end, because the decisions made during the boom lead to a reallocation of resources toward the earlier stages of production that is not sustainable given the underlying real variables. The theory also shows that those longer-term processes of production eventually will be revealed to be unprofitable as the prices of their inputs get bid up and the demand expected to be there when they are completed does not materialize. Which inputs will get too expensive and when, however, is beyond our ability to predict, other than to know that it will come in some form eventually. Given the Austrian explanation of the boom, what can it say about the bust? Recall that the core of the Austrian story is how inflation drives interest rates artificially low, leading to the misallocation of both capital and labor among the various sectors, with capital in particular being malinvested in the earlier stages of long-term production processes. The Austrian theory is often wrongly termed an overinvestment theory. There is some overinvestment for a short period of time, but the real problem is that resources are being used in the wrong places. It is in the bust that this distinction between overinvestment and malinvestment becomes particularly important. During the boom, traditional aggregates may not show any change in the total level of investment, even as resources are misallocated between the earlier stages of production such as research and development and later stages such as retail. During the bust, just looking at the total level of investment is not enough. We must be aware of the need to undo the mistakes of the boom and get resources reallocated, no matter what happens to the total level of investment. The downturn in economic activity that we associate with the recession (or bust) is, on the Austrian view, the economy attempting to shed capital and labor from where it is no longer profitable. The fallible nature of humans and the imperfect discovery process of the market mean that it will take time for actors to figure out where those resources now need to be. The declining profitability of longer-term production processes means that capital and labor associated with the early stages of production will be idled, and entrepreneurs at the later stages will now have to consider whether to purchase new capital or hire new labor. The prices of capital goods and the wages of labor will likely have to fall in order to make such purchases profitable, and capital goods may require refitting and labor retraining so that they are a better fit for the postbust economy. Again, it is a matter not of there being too much or too little capital or labor but of whether specific capital goods or labor are suitable for a particular stage of production in a particular production process. That the Austrian theory of capital treats it not as an undifferentiated aggregate but as specific, heterogeneous capital goods means that capital cannot be

740   Applications: The 2008 Financial Crisis costlessly and instantly reallocated from the early stages to the later. Mainstream aggregative treatments of capital obscure this point. The same is true of labor. The question then becomes what conditions will make it most likely that this reallocation process can take place most quickly and effectively. Other than avoiding the creation of another boom through inflation, the Austrian theory of the business cycle itself tells us little. Other elements of Austrian economics, along with insights from other related approaches to economics, can provide us with some guidance. Specifically, two general conditions are necessary for this corrective process to unfold. First, entrepreneurs must be allowed to sort out the misallocation of resources with the most reliable market price signals possible. Those price signals will prospectively guide their decision-making. They must also have reliable profit-and-loss signals to help them discern whether the decisions they have made were good ones. It was distortions of interest-rate signals that caused the misallocations during the boom, and further distortions of prices, profits, and losses will only worsen those problems. Second, the central bank should not be inflating, as noted earlier, but it also has to be careful to avoid deflation. Ensuring that the supply of money is aligned with the demand to hold it is also necessary to make sure that the reallocation process of the bust proceeds as quickly and as effectively as it can. The immediate chain of events that triggered the bust began when the economy hit a key turning point in 2006. Housing prices began to fall that year and raised concerns about the viability of the entire financial structure that had been built on the secondary mortgage market. The decline in the housing market was a reflection of the unsustainability of the preceding boom. If housing prices continued to fall across the board, the instruments premised on the flow of funds from mortgage payers would be threatened, as falling prices would potentially put owners of low-down-payment mortgages into negative equity (underwater), perhaps leading to foreclosure and a dramatic increase in nonperforming loans. If the mortgage-backed securities failed, the various institutions holding them and insuring them (along with the GSEs) would be facing a nightmare scenario. Worries about a deep US recession grew as Bear Stearns faced bankruptcy in March 2008 and was bought out at a dramatically reduced price by JP Morgan Chase in a deal coordinated by the federal government. The later collapse of Lehman Brothers and the forbearance of policy makers sent mixed signals to an already troubled market. By September, the financial system was dealing with the failure of numerous large institutions, and government was busy trying to orchestrate any number of buyouts, mergers, and bailouts. Later that fall, it was clear that the US economy was in a recession, and a potentially deep one, as the Dow Jones fell from an October 2007 high of more than 14,000 to a March 2009 low of less than 7,000. Rising unemployment and falling GDP put increasing pressure on governments to respond. Unfortunately, the policy response to the 2008 financial crisis worked at cross-purposes with the two conditions that Austrians see as necessary to minimize the length and severity of the bust, leading to a deeper recession and slower recovery than was necessary.

The Financial Crisis in the United States    741

Policy and the Real Adjustment Process In the wake of the 2008 financial crisis, the calls immediately arose for significant government intervention to address the problems in financial markets. The immediate response was the Troubled Asset Relief Program (TARP), which eventually evolved into a complex series of purchases of toxic mortgage-backed securities by the Fed, along with other government-orchestrated bailouts and buyouts of technically bankrupt banks and investment houses. By early 2009, when it was clear that the US economy was falling into a deep recession, further calls for intervention arose, as Keynesian arguments for boosting lagging aggregate demand dominated the discourse. The simplest version of the argument for a stimulus was that private investment had collapsed in the wake of the financial crisis, leading to the decline in GDP and the increase in unemployment. In the basic Keynesian model, the decline in investment can be offset by an increase in government spending, which will activate the idled resources and increase aggregate demand. In February 2009, the US Congress passed the American Recovery and Reinvestment Act of 2009, which was an approximately $800 billion combination of spending increases and tax cuts designed to stimulate the economy. From an Austrian perspective, this attempt was doomed to fail for a variety of reasons. Keeping in mind that the problem of recovery for Austrians is one of reallocation of resources across the structure of production, the stimulus plan was attacking the wrong problem. The Keynesian model underlying the stimulus is couched in terms of macroeconomic aggregates, while the Austrian theory is ultimately a microeconomic one. What is needed is not just an increase in any investment or spending in the aggregate but a microeconomic adjustment based on changing relative prices of inputs and outputs across that intertemporal structure of production. The problem is that the collapse of macroeconomic aggregates such as employment, investment, and GDP is a manifestation of the misallocation of resources among various markets resulting from the distortion in interest rates and other prices associated with the boom. Correcting them requires figuring out where resources should be, given real costs and preferences now, which is obscured, as Hayek noted in the 1930s, by the use of macroeconomic aggregates. Trying to substitute government spending for private investment overlooks both the shifts in specific capital and labor that recovery requires and the comparative inefficiency of government versus private expenditures. The capital structure of an advanced economy is much like a jigsaw puzzle whose eventual picture is not known in advance and where the pieces are made up of specific capital and labor resources. As the Austrian theory points out, each of those pieces has a limited number of other pieces it can fit with to form a recognizable pattern. It is the price system that helps resource owners learn which pieces fit with which. Stimulus programs, especially those premised on the existence of idle resources that just need to be activated, implicitly assume that those puzzle

742   Applications: The 2008 Financial Crisis pieces are (nearly) perfectly substitutable, so it does not matter which ones are activated. What is overlooked is whether the capital and labor that are idle are the resources best suited to those projects, not to mention whether consumers and citizens even want those outputs in the first place. Activating any old resources for the purpose of changing economic aggregates will simply create a new and different but equally unsustainable structure of production. You cannot just jam any old pieces together to form a recognizable pattern when completing a jigsaw puzzle. For example, projects that seem to be “shovel-ready” may need engineers and others to engage in the planning process. If the labor resources idled are predominantly construction workers and financial managers, finding engineers at wages that will make such projects profitable will be difficult, and unemployment will not be reduced. The complementarity of resources is key to forming a capital structure that generates a sustainable recovery, and only those located in the context of the market have the knowledge and the feedback processes to make the decisions that will reallocate and activate resources in a way that does so. We need entrepreneurs in the decentralized decision-making and learning processes of the market to undertake the millions of corrections that have to take place in myriad individual microeconomic markets. Governments lack the detailed knowledge necessary to know the appropriate adjustments.3 We have seen this play out in the US labor market, as unemployment continued to run at or above 7 percent almost for more than four years after the official end of the recession in 2009. That period has also been characterized by a historically unusual amount of long-duration unemployment and an ongoing decline in the overall labor-force participation rate. Labor appears to be having a difficult time in moving to where it is now in demand. When one considers all the ways in which policy has tried to maintain the distribution of resources that characterized the boom by continued subsidization of the housing market, and the ways in which things like the extension of unemployment benefits to ninety-nine weeks have prevented the needed reallocation of labor, it is not surprising that the necessary adjustments have not taken place. Given the time that has elapsed, it is difficult to blame a shortage in aggregate demand for these problems, as six years is plenty of time for price and wage adjustments to take place through the market process and find a new nominal values. There would appear to be real factors preventing the needed adjustment. An Austrian analysis would look at the ways in which the policies noted above, including stimulus spending, have given the errors of the boom a politically supported inertia that has prevented them from being corrected in both labor and capital markets. Those policies do not recognize the microeconomic nature of the problem, and policy makers do not have the knowledge necessary to know what the needed adjustments would be, even if they were conscious of the need to make them. Virginia political economy gives us a second set of reasons to doubt that stimulus spending will be successful. Part of the problem is the structural incentives of the political process. Even if there were some number of things government might do to help 3 

The arguments raised by Austrians in the context of the debate over the possibility of economic calculation under socialism apply here, too. See Mises ([1920] 1935), Hayek (1940), and Lavoie (1985).

The Financial Crisis in the United States    743 the situation and it had knowledge of what those were, we cannot ignore the question of whether political actors have the incentives to do those things, and only those things, once we concede their role in the recovery. Once given the power to intervene, how can we be sure that power will not be expanded beyond what is believed to be necessary? The history of various stimulus and recovery programs clearly indicates that governments will not limit themselves to just those policies that mainstream economic theory, assuming that it is even correct on this point, suggests will help. Once given the power and intellectual rationale to intervene, politicians will gladly make that an excuse to propose and pass a whole variety of items, regardless of whether they fit the economist’s model of a pump-priming stimulus. They will also tend to engage in expansionary fiscal policy even when it is not needed, leading to the cycle of spending, deficits, and debt that has characterized the post–World War II Western market economies (Buchanan and Wagner 2000 [1977]). The debate over the Obama administration’s stimulus package in the United States revealed just this sort of concern, as did the ensuing debate over its proposed budget in early 2009. In both cases, the claim was made that these expenditures were necessary for economic recovery, yet the budget’s significant resources pledged to healthcare, education, and the environment have no known relationship to economic models of recovery. It should not be surprising that these attempts at speeding up recovery were ineffective, as both the knowledge and incentive problems caused a misalignment of where government spending was going and where the actual malinvestments had been made. One final problem with the fiscal policy response to the financial crisis was the degree to which it created what economic historian Robert Higgs (2006) has termed “regime uncertainty.” First developed by Higgs in the context of the Roosevelt administration’s response to the Great Depression, regime uncertainty refers to the ways in which government intervention, particularly when it is does not follow any clear guiding principle, makes the rules of the economic game increasingly unclear. Higgs showed that the very slow recovery of net private investment during the Great Depression could be significantly attributed to the expansion of government that characterized the New Deal. Private investors saw these changes both as threats to the market system in general and as creating uncertainty about the future of the particular industries facing a larger government role. Those investors reported that those uncertainties were causing them to hesitate about long-term investment, which was corroborated by the expanding gap between short- and long-run bond yields. The general expansion of government embodied in the healthcare and financial reform acts passed since the crisis has also created a great deal of uncertainty about both the short-run effects of those laws and the long-run effects of a much larger regulatory role for the state. Both sets of regulations also contain much that is not explicit in the law, giving the implementing agencies a great deal of discretion in interpreting and applying their provisions. That discretion is yet a further source of uncertainty. Faced with not just uncertainty at the prospect of two new major sets of regulations but also uncertainty about their implementation and the basic relationship between the private and public sector, it is not surprising that net private investment has recovered very slowly after

744   Applications: The 2008 Financial Crisis the financial crisis. In particular, the employee-related costs of healthcare reform have slowed down the recovery in employment, as firms have been reluctant to hire until the full scope of the new regulations become more clear. From an Austrian perspective, Higgs’s concept of regime uncertainty can help to underscore the costs of not allowing entrepreneurs the freedom to make use of genuine market prices and profit-and-loss signals to guide the reallocation process that characterizes true recovery. Intervening in the entrepreneurial discovery process will cause the mistakes of the boom to linger longer than necessary, preventing a robust recovery.

Monetary Policy and Economic Recovery The second condition necessary for the market process to produce a sustainable recovery is that monetary policy be nondistortionary. There is much debate among Austrian school economists over exactly what that entails in this situation. For many years, the dominant Austrian position was that the central bank should simply do nothing, including allowing a supposedly “necessary” deflation to take place during the bust (Rothbard 1963). Since the mid-1980s and the research on free banking systems done by White (1996) and Selgin (1988), the dominant Austrian view has changed to one emphasizing the importance of maintaining monetary equilibrium, or ensuring that the supply of money matches the demand to hold it at the existing price level. The monetary equilibrium approach has mostly been developed in the context of what a competitive banking system absent a central bank would do (Horwitz 2000), but it can also be used as a guiding principle for analyzing what sorts of nonideal central bank choices would be better or worse. The theory argues that by supplying that quantity of money that the public wishes to hold, the monetary system avoids both inflation and deflation and allows prices to be determined by real underlying forces of supply and demand. Excess supplies of money lead to prices higher than they would otherwise be, as people spend away the excess of their actual money holdings compared with what they desire. Deficient supplies of money lead to a reductions in demand and excess supplies of goods, because prices cannot fall smoothly and immediately when actors restrict their consumption in attempting to bring their actual money holdings up to what they desire. Although in both cases, the change in the price level will eventually reequilibrate real demands and supplies for money, it will not be without significant economic costs, in either the distortions of inflation (and potentially an Austrian-style cycle) or a deflation-induced recession. As Selgin (1997) argues, maintaining monetary equilibrium also means that the price level will move inversely to productivity, so a growing economy will see falling prices. This supply-side deflation is not only not harmful, but trying to offset it with expansionary monetary policy would be positively harmful by preventing prices from reflecting those productivity gains.

The Financial Crisis in the United States    745 The monetary equilibrium benchmark can be used as the basis for analyzing real-world monetary policy actions such as those during and after the 2008 financial crisis. That benchmark can also be combined with our earlier political economy considerations to offer a perspective on the larger question of monetary institutions. There is little disagreement among Austrians that expansionary monetary policy post-9/11 played a key role in generating the housing boom and bust. What monetary policy’s role should have been in the aftermath is more contested. There are those who continue to maintain that the Fed should simply have done nothing in the face of the immediate crisis in the fall of 2008 and the years that followed. The larger number of Austrians try to distinguish between the immediate crisis of the fall of 2008 and the policies of the subsequent years. The starting point of that analysis is that Austrians are generally skeptical of central banking’s ability to maintain monetary equilibrium. The same concerns raised about the ability of fiscal policy makers to obtain the knowledge necessary to enact appropriate policy, and about whether they have the proper incentives to do so, apply to monetary policy makers. Central banks suffer from a somewhat smaller version of the same problems faced by other forms of centralized direction of economic resources. Central banking, as we saw in the Austrian business cycle theory, is also particularly pernicious, in that its errors are not isolated to a particular sector but are transmitted economy-wide through monetary exchange. In a world of central banks, determining what they should do at any given time is an exercise in second-best thinking. Even in the world of the second-best, however, some choices may be better than others. Austrian monetary theorists have argued that what the Fed should have done in September 2008 was to follow the standard advice laid out by Walter Bagehot (1873) more than a century ago for central banks facing a crisis: lend plentifully to sound banks at penalty rates. Because central banks have taken on the role of lender of last resort, banks have abandoned many of the various institutional arrangements that they used to have to help one another out in crises. Faced with a crisis, the central bank is really the only institution capable of acting, hence Bagehot’s advice. Unfortunately, the Fed did almost the exact opposite, lending plentifully to troubled banks at cheap rates. Bagehot’s rule is intended to make sure that sound banks are not brought down by spillover effects from unsound banks, while also allowing the unsound banks to fail of their own accord. TARP and the Fed’s facilitation of various buyouts and mergers kept pumping funds into unsound banks without those banks paying any real price for the assistance. The result was to set a precedent that extended the Greenspan put in a much broader way and created a whole new class of “too big to fail” institutions. The moral hazard created by the Fed will continue to be a significant concern in the future. Had the Fed instead only provided sound banks with the liquidity they needed to provide their liability holders with the security they needed, we could have allowed the troubled banks to go through the normal bankruptcy process (perhaps in an expedited way) and avoided the bailouts and prolonging of “too big to fail.” The Austrians who have been more skeptical about the Fed doing much of anything, even during the crisis itself, have pointed out that this result should not surprise us, given

746   Applications: The 2008 Financial Crisis what we know about the incentives facing political actors. If we do not expect fiscal policy actors to be able to make the required adjustments without bowing to the pressures of political self-interest, why should we expect a different result from monetary policy makers? Even if our best theoretical arguments indicate a clear best choice for the central bank, we cannot ignore the question of whether executing it is incentive-compatible. The question is whether the costs of imperfect central bank action are greater or less than the costs of inaction. What both sides of this Austrian debate do agree on is that the longer-term expansion of the monetary base that came after the immediate crisis in the form of quantitative easing and other related programs was a mistake. Once the immediate crisis was over, the Fed’s job as a lender of last resort was done, and from that point forward, its only role should have been to use its standard tools to try to maintain monetary equilibrium. The shift in the types of assets the Fed was buying, and its role in getting bad loans off of bank balance sheets, were stretching its role and powers beyond anything necessary. The more than tripling of the monetary base since the fall of 2008 and the dramatic expansion of the Fed’s monetary and regulatory powers are good examples of the crisis-driven growth in government that is documented by Higgs (1987). As Higgs argues, even if the crisis passes, the powers claimed during the crisis will never fully recede, leaving the size of government permanently larger. In the case of the Fed, those powers were acquired without much debate, and the expansion of the monetary base continues to pose a threat of long-run inflation. All of these actions by the Fed amount to creating further misallocations of resources, along with significant uncertainty about the future value of money. All of these contradict the second condition that Austrians believe is necessary for a sustainable recovery, which is nondistortionary monetary policy. The expansion of the monetary base has done little to speed up recovery and does not come without costs, including the interest now being paid on those reserves. Whatever the merits of the Fed providing liquidity to healthy banks in the throes of the crisis, its subsequent actions have been detrimental to what Austrians see as the needed market adjustment processes.

Conclusion The Austrian theory of the business cycle, together with other insights from the Austrian tradition, Virginia political economy, and the work of Austrian-influenced economic historians such as Higgs, enable us to construct a narrative of the housing boom and bust, the financial crisis, and the subsequent slow recovery. That narrative differs from the ones offered by the mainstream in economics by emphasizing the role of monetary policy in generating microeconomic intertemporal discoordination in the form of an unsustainable boom. It can also explain why that boom manifested itself in the housing market and why the recovery has been so slow, by using political economy to indicate

The Financial Crisis in the United States    747 ways in which postcrisis policy has prevented market discovery processes from reallocating resources to their new highest-valued uses. Understanding the microeconomic distortions that characterize the monetarily induced boom enables Austrians to examine the ways in which policies prevent those same microeconomic processes from doing their jobs during the bust and recovery. In turn, that provides a more complete and consistent account of the causes and consequences of the financial crisis of 2008.

References Bagehot, Walter. 1873. Lombard Street: A Description of the Money Market. London: Henry S. King. Beckworth, David. 2012. “Bungling Booms: How the Fed’s Mishandling of the Productivity Boom Helped Pave the Way for the Housing Boom.” In Boom and Bust Banking:  The Causes and Cures of the Great Recession, edited by David Beckworth, 27–53. Oakland, CA: Independent Institute. Brennan, Geoffrey, and James M. Buchanan. 1985. The Reason of Rules: Constitutional Political Economy. Cambridge: Cambridge University Press. Buchanan, James M., and Richard E. Wagner. (1977) 2000. Democracy in Deficit: The Political Legacy of Lord Keynes. Indianapolis: Liberty Fund. Butos, William. 1993. “The Recession and Austrian Business Cycle Theory:  An Empirical Perspective.” Critical Review 7: 277–306. Garrison, Roger. 2001. Time and Money: The Macroeconomics of Capital Structure. New York: Routledge. Garrison, Roger. 2004. “Overconsumption and Forced Saving in the Mises-Hayek Theory of the Business Cycle.” History of Political Economy 36: 323–349. Greenspan, Alan. 2013. The Map and the Territory:  Risk, Human Nature, and the Future of Forecasting. New York: Penguin. Hayek, F. A. (1928) 1984. “Intertemporal Price Equilibrium and Movements in the Value of Money.” In Money, Capital and Fluctuations: Early Essays, edited by Roy McCloughry, 71–117. Chicago: University of Chicago Press. Hayek, F. A. (1931) 1995. “Reflections on the Pure Theory of Money of Mr. J. M. Keynes.” In The Collected Works of F. A. Hayek. Vol. 9, Contra Keynes and Cambridge, edited by Bruce Caldwell, 121–146. Chicago: University of Chicago Press. Hayek, F. A. (1933) 1966. Monetary Theory and the Trade Cycle. New York: Augustus M. Kelley. Hayek, F. A. (1935) 1967. Prices and Production, 2nd rev. ed. New York: Augustus M. Kelley. Hayek, F. A. (1939) 1975. Profits, Interest, and Investment. Clifton, NJ: Augustus M. Kelley. Hayek, F. A. 1940. “The Competitive Solution.” In Individualism and Economic Order, 181–208. Chicago: University of Chicago Press. Higgs, Robert. 1987. Crisis and Leviathan:  Critical Episodes in the Growth of American Government. New York: Oxford University Press. Higgs, Robert. 2006. “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War.” In Depression, War, and Cold War:  Studies in Political Economy, 3–29. Oakland, CA: Independent Institute. Horwitz, Steven. 2000. Microfoundations and Macroeconomics:  An Austrian Perspective. New York: Routledge.

748   Applications: The 2008 Financial Crisis Horwitz, Steven. 2010. “The Microeconomic Foundations of Macroeconomic Disorder: An Austrian Perspective on the Great Recession of 2008.” Macroeconomic Theory and Its Failings: Alternative Perspectives on the Global Financial Crisis, edited by Steven Kates, 96–111. Cheltenham, UK: Edward Elgar. Horwitz, Steven, and Gene Callahan. 2010. “The Role of Ideal Types in Austrian Business Cycle Theory.” In Advances in Austrian Economics. Vol. 14, What’s So Austrian about Austrian Economics? edited by Roger Koppl, Steven Horwitz, and Pierre Desrochers, 205–224. Bingley, UK: Emerald Group. Horwitz, Steven, and William Luther. 2011. “The Great Recession and Its Aftermath from a Monetary Equilibrium Theory Perspective.” In The Global Financial Crisis: What Have We Learnt? edited by Steven Kates, 75–92. Aldershot, UK: Edward Elgar. Kirzner, Israel. 1966. An Essay on Capital. New York: Augustus M. Kelley. Koppl, Roger. 2001. Big Players and the Economic Theory of Expectations. New York: Palgrave Macmillan. Lachmann, Ludwig. (1956) 1978. Capital and Its Structure. Kansas City, MO: Sheed, Andrews and McMeel. Lavoie, Donald. 1985. Rivalry and Central Planning. Cambridge: Cambridge University Press. Lewin, Peter. 1999. Capital in Disequilibrium. New York: Routledge. Menger, Carl. (1871) 1981. Principles of Economics. New York: New York University Press. Menger, Carl. 1892. “On the Origin of Money.” Economic Journal 2: 239–255. Mills, Edwin S. 2009. “Urban Land-Use Controls and the Subprime Mortgage Crisis.” Independent Review 13: 559–565. Mises, Ludwig von. (1920) 1935. “Economic Calculation in the Socialist Commonwealth.” In Collectivist Economic Planning, edited by F. A.  Hayek, 87–130. Clifton, NJ:  Augustus M. Kelley. Mises, Ludwig von. 1966. Human Action: A Treatise on Economics. Chicago: Henry Regnery. Rothbard, Murray. 1963. America’s Great Depression. New York: Richardson and Snyder. Selgin, George. 1988. The Theory of Free Banking: Money Supply under Competitive Note Issue. Totowa, NJ: Rowman & Littlefield. Selgin, George. 1997. Less than Zero: The Case for a Falling Price Level in a Growing Economy. London: Institute of Economic Affairs. Taylor, John B. 2009. Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis. Stanford, CA: Hoover Institution. White, Lawrence. 1996. Free Banking in Britain, 2nd ed. New York: Routledge. White, Lawrence. 2012. “Monetary Policy and the Financial Crisis.” In Boom and Bust Banking: The Causes and Cures of the Great Recession, edited by David Beckworth, 13–26. Oakland, CA: Independent Institute.

Chapter 34

T he Financia l C ri si s i n the United K i ng d om Uncertainty, Calculation, and Error Anthony J. Evans

Introduction The British bank Northern Rock played a starring role in the unfolding drama of the financial crisis (Shin 2009). In September 2007, news that Northern Rock had used emergency liquidity support from the Bank of England led to the first high street bank run in the United Kingdom since Overend, Gurney and Co. in 1866. Following unsuccessful attempts at finding a private-sector buyer, Northern Rock was nationalized in February 2008, a policy outcome that would have struck many people as unthinkable just a few months before. Indeed, the speed at which “the Rock” had gone from being the darling of the city to a symbol of the meltdown was breathtaking. Following its listing on the FTSE 100 in 2000, the share price had been steadily increasing, and the company posted profits of more than £440 million in 2006. Around 5 percent of annual profit was being paid into the Northern Rock Foundation, which grew to be one of the United Kingdom’s largest corporation foundations (giving grants of more than £27 million in 2006),1 and the company had emerged as a beacon of North East economic renewal through its sponsorship of local sports teams and the planned development of new headquarters. If loyal customers were surprised at the speed of the bank’s downfall, they weren’t alone.

I wish to thank Philip Booth, Christopher J. Coyne, Jeffrey Friedman, Jeffrey Rogers Hummel, Lydia Ortega, and Robert Thorpe for helpful comments. The usual disclaimer applies. 1  See “Top 10 Corporation Foundations,” Guardian, June 13, 2007 [http://www.guardian.co.uk/ society/2007/jun/13/societyguardian.societyguardian3, accessed March 15, 2015].

750   Applications: The 2008 Financial Crisis The main problem with Northern Rock’s business model was that its rapid expansion entailed two things:  (1)  allowing mortgage products to constitute a high proportion of its assets (about 75 percent) and (2) funding this through wholesale markets (see Blundell-Wignall, Atkinson, and Lee 2008, 9).2 In hindsight, the errors seem obvious, but the board was so oblivious that it planned a 30-percent increase in dividends as late as July 2007.3 And yet just two months after making a voluntary choice to reduce capital, it required emergency liquidity provisions. When questioned about this decision, Adam Applegarth (then CEO) pointed out that it wasn’t only the board that failed to anticipate the problem; the company had been focused on compliance with the Basel II international standards, working alongside the Financial Services Authority (FSA).4 Indeed, regulators deserve blame for two elements of this. First, the regulations themselves encouraged aspects of the problem: “Mortgage products had been made so attractive by IRB [internal-ratings-based] adherence to Basel II, that there was an incentive to grow them more quickly than could be funded by depositors” (Blundell-Wignall, Atkinson, and Lee 2008, 9). There is little reason to think that stoking a housing bubble was an aim of Basel II, suggesting that it was an unintended consequence, that the Basel committee was simply ignorant of the activity that it was encouraging. The second failure of regulators was in not identifying the problems after they had begun to emerge. In June 2007, the FSA had approved the approach taken by Northern Rock to satisfy Basel II, partly because “they had Tier 1 capital of a ‘healthy’ 11.3 per cent of RAW [risk-weighted assets]” (Blundell-Wignall, Atkinson, and Lee 2008, 9). Despite retrospective protestations, the FSA was hardly trying to rein in a reckless company.5 On the contrary, there is virtually no evidence that Northern Rock executives knew what they were getting themselves involved in. As one former employee says, “the fact that we, as employees, were blissfully unaware of the dangers the sub-prime situation could cause our business, suggests to me that the same was felt by the top brass at Northern Rock, who were clearly of the opinion that the company was well insulated against the potential risks being run” (Walters 2008, 47).6 2 

Note that unlike the situation facing many US banks, it wasn’t an increase in defaults on mortgage payments that got Northern Rock into trouble but the freezing up of funding. 3  In June 2007, the board did issue a profit warning because of strains in funding, but this wasn’t deemed serious enough to repair their balance sheet. See Sean Farrell, “Northern Rock Scraps Dividend Because of Takeover Talks,” Independent, September 26, 2007 [http://www.independent.co.uk/news/ business/news/northern-rock-scraps-dividend-because-of-takeover-talks-403569.html, accessed March 15, 2015]. 4  House of Commons Treasury Committee, cited in Blundell-Wignall, Atkinson, and Lee (2008, 9). 5  Indeed, in its investigation into the Royal Bank of Scotland (RBS), the FSA concludes that “these bad decisions were not the result of a lack of integrity by any individual and we did not identify any instances of fraud or dishonest activity by RBS senior individuals or a failure of governance on the part of the board,” and this includes an investigation into the decision to engage in one of the banking industry’s biggest-ever takeovers with the purchase of ABM Amro in 2007. See “FSA Probe Clears RBS Chiefs,” Wall Street Journal, December 2, 2010 [http://www.wsj.com/articles/SB10001424052748703377504575650 202922703576, accessed March 15, 2015]. 6  It is true that Applegarth sold £2.6 million worth of shares in the buildup to the collapse, but “the timing of the share sales were such that he clearly did not sell at a time when he knew the company was in trouble” (Walters 2008, 98).

The Financial Crisis in the United Kingdom    751 This chapter follows Friedman’s (2011) and Friedman and Kraus’s (2011) focus on the role of ignorance rather than incentive explanations (such as moral hazard) to explain the financial crisis. Despite widespread condemnation by politicians and media, evidence suggests that (as far as we can generalize) (1) bankers did not knowingly cause the crisis, and that (2) they were penalized for their role. By studying some of the most controversial cases—such as Northern Rock—this chapter challenges the notion that executives willingly “bet the company” for their own gain, suggesting an alternative claim that they simply made errors. Conspiracy theories can be intuitively appealing but should not preclude the fact that pervasive human ignorance plays a role. Rather than blame malevolence, this chapter has taken the approach that the motivations are largely irrelevant; what matters are the institutions through which we try to solve the knowledge problem. Focusing on problems of knowledge rather than problems of motivation is a typically Austrian approach, and this chapter also contributes to the mechanisms by which epistemic factors influence economic activity. Particular emphasis is given to the role of regime uncertainty and so-called big players, along with how faulty behavioral foundations and price fetishism misunderstand economic calculation and recalculation. The first section outlines what is distinctive about an Austrian approach to understanding financial crises. This involves a methodological discussion and justification for why this chapter will focus on the second stage of an Austrian cycle, the credit crunch moment.7 The second section looks in more detail at the differences between incentive and knowledge explanations, making the case that epistemic factors should take primacy over motivational ones. The third section utilizes two concepts that are synonymous with Austrian explanations of crises—regime uncertainty and big players—applying them to the UK experience. The fourth section focuses on the calculation problems that characterize a slowdown in economic activity, placing emphasis on recalculation, price naiveté, trading strategies, and corporate governance. The chapter concludes by way of several core implications for policy, including the importance of a stable investment climate, competition through failure, and respect for the price system.

The Moment of Crisis We can split the Austrian-style crisis into four phases: the inflationary boom, the credit crunch, the recession, and the recovery (Skousen 1988). These are analytical tools and should not be taken as literal depictions or a chronological sequence. For example, some would argue that important elements of a recession constitute the recovery, since it’s the reallocation of resources that takes place in a recession that provides the platform for future economic growth. And given that much policy effort is taken to prevent recessions 7 

This moment took place in the summer of 2008, and this chapter is focused on the events of 2007–2011. Data are accurate up to Q2 2011.

752   Applications: The 2008 Financial Crisis from manifesting themselves, it is arguable whether the recovery phase ever occurs or if indeed one recession merely feeds straight into the next inflationary boom. So the four phases should not be viewed as distinct stages that proceed one after the other. In particular, the credit crunch phase is best viewed as a moment rather than an actual period of time (see Ruccio and Amariglio 2003 for a discussion on moments), and it is this phase of the crisis that constitutes the focus of this chapter. The inflationary boom receives perhaps the most attention, and one of the triumphs of the Austrian theory is the extent to which it has become part of the widely accepted narrative. Most economists will allude to artificially low interest rates in the years preceding the crisis as causing asset price booms that are costly to correct (Taylor 2011). The part of the crisis that generates the most controversy is the recession, since this has a direct and timely policy relevance, ensuring widespread public interest. The financial crisis that began in earnest with the run on Northern Rock in September 2007 and reached a new level of panic with the collapse of Lehman Brothers one year later led to a recession in the United Kingdom spanning 2008–2009 and then sustained low growth through 2011. Following a story similar to that in the United States, unemployment has been above 7.5 percent through 2009–2011, with the Bank of England seeing fit to keep interest rates at a historic low of 0.5 percent, plus £200 billion worth of quantitative easing, to prevent deflation. From boom to bust. However, this chapter does not intend to further understanding of the causes or the consequences of the Austrian cycle (Mises [1912] 1953; Hayek [1931] 2008; Garrison 2001). Rather, it concentrates on the credit crunch moment, when the unsustainable nature of the inflationary boom is realized and market participants begin the process of altering their entrepreneurial plans. Indeed, to some extent, the policy responses that occur in the recession can be traced back to the unintended consequences of actions taken during the crisis moment.8 When talking about moments, there is a direct methodological implication. Rather than applying a full explanatory theory, the aim is to use economics as a narrative art. There is a difference between doing so and casual (or naive) empiricism, and the line can appear blurred. In short, the aim is not to attribute cause and effect, for example, by arguing that event X led to an observed change in a macroeconomic indicator. In this regard, causality is not as important as if we were testing a hypothesis. Instead, the crisis is used as an ideal type to establish evidence of multiple conditions at play. A reliance on archival sources of information is crucial, not just to understand public statements but also to gain insights into the thought processes of those involved. For 8  Much more work could be done in tracing through the actual sequence of policy adoption and the unintended consequences that they generate; “among the types of dialectic that such research might uncover, the simplest would be where an initial regulation ‘fails’ in the sense of producing an unintended negative consequence, leading—out of sheer ignorance of the fact that today’s problem is the result of yesterday’s regulatory failure—to the addition of a new regulation, which may, in turn, create new (real or perceived) problems that require still newer regulations” (Friedman 2011, 64). Another consequence is that the additional powers created for the new regulation could be captured and used in ways that were never intended. For example, US car manufacturers were successful in their attempts to lobby for TARP money that was originally intended solely for banks (see Paulson 2010, 420).

The Financial Crisis in the United Kingdom    753 example, following the collapse of so many banks, regulators have an incentive to overstate their warnings, and executives have an incentive to exaggerate their compliance. But, as shall be argued, inside accounts help to reveal this as largely myth, suggesting that there was more ignorance than actors are wont to admit with hindsight.

The Primacy of Epistemic Factors The observation of perceived errors, such as those made at Northern Rock, can be explained in one of two ways. The first, and most obvious, is to believe that it results from human ignorance (i.e., a mistake). The second explanation is to claim that what seem like errors are really illusions, that the agents intended for it to happen because this was, in fact, beneficial to them. This second approach might be more compelling for economists, because economic models of rationality tend to build (overtly or otherwise) on an assumption of omniscience (Evans and Friedman 2011). If agents are omniscient, then it is very difficult to explain why they would make mistakes; the solution is to declare that they must have somehow been incentivized to act that way, and therefore the issue isn’t ignorance but incentive compatibility.9 This explanation is more consistent with the rational self-interest assumption, but it comes at the cost of simply assuming away the possibility of genuine error. The standard neoclassical view is that people made the best decision based on all the available information, but ultimately, this implies that there are no errors, just instances of imperfect information. The subjectivist issue is whether people interpreted the information they had in the right way, and it is conceivable that they did not. In a neoclassical framework, neither surprise nor regret is possible. In an Austrian framework, they are the focus. Indeed, it seems that economists fear that by granting scope for ignorance, this challenges the notion that agents are rational, which would then imply that they are irrational (see Evans and Friedman 2011). But this shouldn’t necessarily follow, because it is possible to be neither rational (as used by neoclassicists) nor irrational. Perhaps a unique contribution of Austrian epistemology is to occupy the middle ground between omniscience and stupidity (Garrison 1982). Evans and Baxendale (2008) downplay arguments citing moral hazard (the claim that a change in incentives leads to a change in behavior in a bad direction) and point to the role of adverse selection in the Austrian theory of the trade cycle. This allows us to focus more on the institutional factors that produce systemic failures, without recourse to issues of motivation.10

9  As Friedman (2011, 33) explains, “those who ended up making bad bets must have known that they were bad bets with the same clarity that we know in hindsight. But why would anyone knowingly make a bad bet? They must (according to economists) have had an incentive to do so.” 10  As an example of how subjectivism casts doubt on moral hazard explanations, note how solutions to moral hazard problems rely on aligning incentives. But what constitutes an incentive isn’t knowable to policy makers. This is why epistemic factors are anterior to motivational ones.

754   Applications: The 2008 Financial Crisis Despite the fact that they are the bread and butter of economic analysis, there are several reasons moral hazard arguments might be overblown. Friedman and Kraus (2011) point to two different examples that are typically invoked. The first is executive compensation, regarding which it is claimed that the key actors in the financial crisis were financially incentivized to take on excessive risks. The second is the too-big-to-fail argument, which implies that the anticipation of bailouts led to the socialization of losses and socially harmful behavior.11 The important point here is that these are empirical claims. Building on Ikeda (2003), Evans (2014, 41) argues that rather than being able to view knowledge problems and incentive problems as two sides of the same coin, (1) the former are more fundamental, and (2)  they can generate competing (not necessarily complementary) hypotheses: “Whether we posit that public officials are deceptive opportunists or merely make honest errors creates two alternative lenses through which to conduct analysis. As soon as we wish to apply this framework, choices (and contradictions) emerge.” While this chapter is an applied study of the UK economy, due attention will be given to the US experience. This is because both the theories being applied and the financial crisis itself originated there. It therefore serves on several margins as a suitable point of comparison and a driver of the events being discussed here. When looking at both countries’ experiences of the financial crisis, a divergence seems to exist between the conventional wisdom and the empirical evidence. Friedman and Kraus (2011) claim that there is no evidence to support either the executive compensation or the too-big-to-fail explanation. Friedman (2011) points to the “red herring” of leverage, maintaining that by itself, leverage does not imply “greed.” Reducing one’s capital ratio merely amplifies the possibility of gains or losses, and while this might increase risk exposure, it does not necessarily increase the expected value (i.e., the return). The idea that bankers thought leverage was good in and of itself rests on an assumption that they were not concerned about losing money, demonstrating that leverage isn’t really the issue: “the problem was that they leveraged up to make what turned out to be a bad bet” (Friedman 2011, 33). The only way to reconcile this is to maintain that bankers felt that they would ride the upside of any gains but be immune to any losses (in other words, that their risk exposure was asymmetric). So why didn’t they 11 

It is true that the socialization of losses creates a divergence between private costs and social costs, and thus standard economic theory would suggest that rational agents would engage in more of the activity than they otherwise would. But Austrians tend to be suspicious of these types of externality claims when the private costs are sufficiently large. For example, it is true that there is a social benefit to education, but because so much of the private benefit can be captured, the positive externality argument does not necessitate subsidizations. Similarly, even if bankers anticipate that taxpayers will pick up the tab for errors, as long as there is a high private cost (and this will be argued later), the externality becomes less relevant. Consider also the distinction being drawn between externalities that are inside and outside the boundaries of the firm. There is a socialization of losses for all poor business decisions, since very rarely would employees personally bear the full costs of a mistake. Unless there is evidence of illegal behavior, companies tend to bail out their employees rather than pursue restitution. Those who place emphasis on externality issues need to explain why there is any real difference between the externalities that exist within a firm and those outside the boundary of the firm.

The Financial Crisis in the United Kingdom    755 load up on risk even more? Friedman (2011) and Friedman and Kraus (2011) point out that banks voluntarily took on less leverage than they were legally able to. For example, “in 2007 … the twenty largest U.S. commercial banks’ regulatory capital ratio averaged … nearly 20 percent above the 10 percent required of well-capitalized banks” (Friedman 2011, 35). According to Blundell-Wignall and Atkinson (2008), Barclays, HBOS, Lloyds TSB, and RBS all had a greater proportion of Tier 1 capital supporting their total assets than Deutsche Bank, Credit Agricole, BNP Paribas, UBS, or Societe Generale. Leverage helps explain how purchases are being funded, but what about the assets being bought? According to conventional wisdom, banks were buying up highly risky assets, but the evidence shows that banks purchased more of the relatively safe (i.e., AAA-rated) securities than the ones with higher risk/return profiles (such as AA) (see Friedman 2011). In short, if the executive compensation theory was true, we might expect banks to be leveraging themselves to the limit in order to purchase high-risk/ high-return assets. But this wasn’t the case; executives were not acting as though they were deliberately taking on leverage and risk. The executive compensation theory therefore fails to explain the bankers’ approach to gains, but the too-big-to-fail theory serves no better as an explanation for their attitude toward losses. The common view that they were immune to losses because they would get bailed out doesn’t stand up to scrutiny. The classic examples of bailouts were Continental Illinois in 1984 and Long-Term Capital Management in 1998, but it’s important not to confuse bailing out the organizations with bailing out management. In both cases, the executives were fired and suffered financially (Friedman 2011, 37). As Hank Paulson said to Barack Obama, “it wasn’t a bailout in any real sense. Common and preferred shareholders alike were being wiped out, and we had replaced the CEOs” (Paulson 2010, 14). When Fannie Mae and Freddie Mac were taken over, “common shareholders had lost nearly everything” (Paulson 2010, 170), and the CEOs were fired without any golden parachutes (Paulson 2010, 306). In the United Kingdom, the chairman of Northern Rock resigned barely a month after the bank run that brought its collapse (Brummer 2009, 86), with the chief executive following soon after. Even before the Northern Rock bank run, HSBC had fired its head of North American operations (Brummer 2009, 191). If these are self-interested and duplicitous people, it is hard to see why the survival of the company is more important to them than the protection of their own jobs and ongoing rewards. The simpler explanation is that these actions were examples of error, that bank executives simply made mistakes. Indeed, this seems to be the conventional view among those in the profession: “why did the very bankers who created the toxic mortgages that undermined the financial system get hurt most by them?” (Zuckerman 2009, 3). Ultimately, there are only two explanations: either they didn’t fully understand them (ignorance), or they weren’t actually hurt. The facts suggest the former. It’s possible to find evidence for conspiracy theories, but it’s also important to push them to their logical conclusion. If bankers were really trying to game the system, why didn’t they do a better job of it? The chief executive of Bear Stearns famously sold $289 million of stock

756   Applications: The 2008 Financial Crisis from 2000 to 2008, but he kept hold of $1 billion (Friedman 2011, 35).12 Kenneth Griffin, the founder of the hedge fund Citadel, spent $500 million of his own money to cover losses, and “the 55 percent tumble by his hedge fund … hurt no one more than Griffin” (Patterson 2010). While it’s true that there were winners and losers, the notion that all of Wall Street benefited from the crisis is pure fantasy. The dissenters won, but the conventional firms were stung. The generalized case was losses.13 The Deutsche Bank broker who helped to short the housing market, Greg Lippmann, received a lot of attention for continuing to inflate the market and writing disparaging emails about investors he was dealing with. However, “when the trading of CDS on subprime mortgage-backed securities began, Lippmann’s first move was to sell protection on about $400 million of subprime mortgages to a hedge fund. He was oblivious to the looming problems for housing” (Zuckerman 2009, 87). An alternative to the conspiracy theory line is that Lippmann felt the need to exaggerate his conviction in order to persuade his bank to engage in a $5-billion short (one that ultimately turned out to be correct). Arguments citing moral hazard imply that bankers bet right, since the claim is that they benefited from their actions. Notwithstanding the fact that there were heterogeneous outcomes, the alternative view is that they bet wrong. And evidence shows that they bet wrong. The causal explanation is neither greed nor recklessness but merely the fact that they were not omniscient and thus made errors. One possible reason for this divergence between rhetoric and facts is an antimarket bias (Caplan 2007). Public antipathy to bankers might be grounded not so much in a detached assessment of the evidence of their conduct but in a general distrust of market exchange and hostility to the wealth it can generate. When policy makers were still looking for buyers for Northern Rock (i.e., a private-sector solution to the liquidity crisis), one of the most serious offers was made by Virgin Money, led by famed entrepreneur Richard Branson. When Branson made his bid public through a series of high-profile newspaper adverts, this private-sector action did more to produce calm than many of the political responses—according to Brummer (2009, 167), “it did help stabilise the situation … the outflow of deposits went from a torrent to a trickle in a matter of days.” The real reason this bid failed is not in the public domain; however, a number of sources point to the fact that policy makers felt Branson would be receiving too good a deal. Chancellor Alistair Darling was conscious of the fact that barely a few months earlier, Northern Rock was worth around £5 billion, and yet Branson was valuing it at just more than £1 billion (see Brummer 2009, 171). Never mind the fact that the run had revealed that earlier valuation to have been wrong; if the resistance was on the grounds 12 

That doesn’t sound like someone who knew the crisis was coming and was trying to cash in. Also, Angelo Mozilo, CEO of Countrywide, sold $400 million of shares from 2004 to 2007 (Zuckerman 2009, 116) but has since been charged with insider trading. It’s interesting to note the legislative factors that encourage executive compensation to be made through share options rather than cash. In part because of a 1993 tax law that meant that salaries of more than $1 million were nondeductible, selling shares wasn’t primarily a verdict on the company but an attempt to obtain compensation. Indeed, the practice of CEOs being incentivized to raise the share price was what the law intended. 13  To be sure, these losses would have been higher if the banks were allowed to fail.

The Financial Crisis in the United Kingdom    757 that Branson was getting too good a deal, why wasn’t anyone else offering more? Darling’s advisers, Goldman Sachs, said that “all the initial bids received had been ‘below current market value’ ” (Brummer 2009, 175), but if they thought it was worth more, why didn’t they put in a bid? As Publilius Syrus is supposed to have said in the first century bc, “a thing is worth whatever a buyer will pay for it”; prices can only come through exchange. Brummer (2009, 182) concludes, “there was a risk that Branson, already in receipt of government largesse for his rail franchise, would be gifted billions of pounds, and, in the process, create a huge embarrassment for the government.” So a deal that would have avoided the nationalization of a bank, exposing taxpayers to all of its liabilities and prompting a wave of bailouts in other institutions, was avoided because it might have made the savior even wealthier. It was almost as if banks weren’t allowed to be run for profit. One of the key players in the UK banking sector was the chief executive of the RBS, Sir Fred Goodwin. The popular story is that he not only helped “cause” the crisis but also then received a golden parachute and full pension. In other words, rather than being seen as a man guilty of making an error, he was rewarded for failure and thus incentivized to fail. But this is an odd notion of reward. Being fired is usually deemed to be an example of punishment, so the controversy seems to rest on whether he should have been punished further, either by having to pay back some of the compensation he had received previously or by forgoing his future entitlements. But this is an argument about contracts and the rule of law. The reason he still received his pension was that he was legally entitled to do so. Should politicians really be granted the discretionary power to overrule such agreements when public sentiment dictates?14 Note that corporate governance is a completely separate argument—a discussion about whether chief executives should be compensated with stock options and the conditions under which they can be exercised is separate from whether or not Goodwin should be allowed to collect what was determined in his contract.15 The bottom line is that Goodwin (and indeed the chairman of RBS, Tom McKillop) “agreed to depart without compensation” (Brummer 2009, 241).16 Note also that it wasn’t only bank executives who made “errors” but also regulators and politicians. Few of these have lost their jobs, and there seems very little public 14 

Consider, for example, that in December 2011, Lloyds TSB (around 40 percent of which is owned by the state) attempted to begin “clawing back” bonuses that had been awarded to senior executives. See “Lloyds Bank ‘May Claw Back Former Boss’s £1.4m Bonus,’ ” BBC News, December 3, 2011. 15  Indeed, this may simply shift the focus of blame from the chief executives themselves to the boards that agreed on their compensation packages. This is still perfectly consistent with an error-based explanation but suggests that the focus should be on shareholders and other owners rather than managers. It is interesting to consider whether shareholders and customers of banks should share in the culpability, for failing to effectively monitor the activities of the organization. If the argument is that this is what the chief executive had been paid to take care of, note that (1) it relies on an assumption of omniscience, and (2) it suggests that chief executives are even more important than previously thought, perhaps deserving of even more compensation. 16  I am grateful to Philip Booth for pointing out that limited liability laws provide a put option for executives with large shareholdings, and thus, if bondholders are bailed out, this removes a major method of discipline. This demonstrates that there are incentive alignment problems, even if I shall argue that knowledge problems should take primacy.

758   Applications: The 2008 Financial Crisis demand for them to pay back their salaries or forgo their future pensions. It seems more likely that the furor directed at Goodwin stems mostly from the fact that he is a wealthy banker and that this is unpopular. But there is a difference between already being wealthy and being rewarded for failure. The simple fact is that he is significantly less wealthy than he would have been had he steered RBS better. The point of comparison when judging the executive compensation theory should be what would have happened if they didn’t make errors, not whether they remain wealthy compared with the ordinary person. Consider Robert Peston’s (2008, 25) verdict on investment bankers: “Many of them are now paying a price for failing to understand the risks they were taking on. But it is often a small price, in the form of reduced future remuneration. Don’t weep for them. They have already extracted fortunes.” There are two points to make here. The first is that even Peston acknowledges that the investment bankers have been penalized. We can quibble about whether the price is large or small (and indeed point to methodological problems with attempting to make such interpersonal comparisons), but when push comes to shove, no one denies that they suffered losses. But second, there is a peculiar behavioral assumption that past rewards cancel out and sterilize present losses. In 2011, Manchester United lost the Champions League football final to Barcelona. Did anybody believe that the team’s pain of losing was mitigated (or indeed canceled out) by the fact that the same team of players (by and large) had won the Champions League in 2008? Introspection suggests that recent events would carry more emotional weight than past ones. Brummer (2009, 53) writes that Morgan Stanley chief executive John Mack “waived his bonus for 2007, but this was hardly a self-sacrifice since he collected a $40 million payout in 2006.” Again, it is a sacrifice, and the fact that Mack is a wealthy man does not change the fact that he was made poorer than he otherwise would have been.17 And surely there must be evidence of illegal behavior to justify the confiscation of previous wealth. Focusing on Northern Rock, according to Brummer (2009, 92), chief executive Applegarth “is said to have left with a ‘broken heart’—though the immense wealth he had accumulated no doubt made the transition easier,” which implies that rich people are somehow immune to the emotions that encumber the rest of us. He also says that Applegarth “would suffer virtually no financial hardship at all. Rock employees would pay with their jobs, but Applegarth received his full £760,000 salary for 2007” (186). But he did lose his job in December 2007 and didn’t find a new one for a full year. And “this amount was said to be considerably less than the package that would have been available to him had he left the company under normal circumstances” (Walters 2008, 105). If Applegarth accrued it illegally, that’s one thing and can be established in the court of law, but the notion that he should no longer be entitled to his contractually agreed pension is mere populist vengeance. Especially since Brummer (2009) goes on to list the personal tragedies that Applegarth has suffered since leaving his position. Someone like Goodwin appears to be an ambitious businessman; indeed, many critics point to 17 

In 2008, Mack received just more than $1.2 million in total compensation, which possibly causes more “pain” for someone with a lifestyle and expenses accustomed to ten times that amount.

The Financial Crisis in the United Kingdom    759 this ambition as a source of his undoing. But surely his legacy is important to him. Do people believe that he wants to be a public hate figure, with a damaged reputation, held in contempt by most of the media? Such figures suffer financially and in terms of reputation, and the idea that “it doesn’t matter because they’re wealthy” is an antimarket bias masquerading as a moral hazard explanation. An ignorance-based explanation merely suggests that the vast majority of the key actors within the major banks regret some of their actions and would have preferred events to turn out differently. Some people point to Goldman Sachs for simultaneously selling their own holdings of assets that it was actively touting to customers. This does not seem compatible with methodological individualism, since it assumes that the company as a whole has a single mindset. It is possible that different parts of the same company were behaving differently, and what is seen as a contradiction is just a result of organizational complexity. Some companies did indeed refuse to participate in these deals. Scott Eichel, a trader at Bear Stearns, said that shorting subprime “didn’t pass our ethics standards; it was a reputation issue, and it didn’t pass our moral compass. We didn’t think we should sell deals that someone was shorting on the other side” (Zuckerman 2009, 181). For the conspiracy theory to be tenable, there needs to be evidence that it is the same people making these contradictory trades. But even if this is the case (and we should expect to see evidence of fraud in many situations, especially during an inflationary boom), the claim of fraud seems to be a separate issue that should be dealt with by the courts. After all, the idea that those who caused the crisis got away with it is untrue. Some people have been found guilty of illegal behavior, such as Bernie Madoff, who is serving a 150-year prison sentence. When it comes to the heads of investment banks and other institutions, the issue isn’t why they got away with it but what they’re supposed to be guilty of.18 However, an antimarket bias doesn’t explain the focus on incentive explanations by the economics profession, and indeed even those sympathetic to Austrian economics (Roberts 2010). One of the main contributing factors to the credit crunch phase of the business cycle was a major strengthening of the calculation problem, that is, regime uncertainty. And it is these epistemic causes, as opposed to motivational ones, that fit better with the evidence.

Regime Uncertainty Robert Higgs’s (1997) seminal account of regime uncertainty focused on the Great Depression, and it would be an exaggeration to apply the concept to the recent financial crisis and expect the same scale of evidence. We can view the Great Depression as 18  Madoff provides an excellent example for why we might expect fraud to rise during an inflationary boom. Much of his returns were being driven by underlying inflation rather than entrepreneurial judgment (a form of money illusion), and he resorted to embellishing records to keep up with the expectations of his investors and the pace of asset inflation.

760   Applications: The 2008 Financial Crisis an extreme (possibly ideal) case of regime uncertainty, so given that the 2008–2009 recession was less severe than the Great Depression, we should expect regime uncertainty to be less prevalent. Another reason to be cautious about the explanatory power of regime uncertainty is that during the Great Depression, both causes and consequences were predominantly contained within the United States. By contrast, the investment climate of the United Kingdom depends on more than just UK policies, placing a limit on how much can be explained by focusing on UK policy. Indeed, the most common estimate of market volatility is the VIX, but this does not have a UK equivalent. So much of the cause and effect will not be contained within the United Kingdom. With those caveats in mind, we can uncover the role of regime uncertainty in the United Kingdom. Higgs (1997, 563) argues that a main reason for the decline in private investment in the United States from 1935 to 1940 was “a pervasive uncertainty among investors about the security of their property rights in their capital and their prospective returns.” Indeed, the “regime” he draws attention to is the property rights regime, “what private owners can reliably expect the government to do in its actions that affect private owners’ ability to control the use of their property.”19 Higgs talks about “the character of the federal government” (564), singling out the rhetoric of Franklin D. Roosevelt for undermining the investment climate. This might range from a tax increase that would lower the returns on investment to the confiscation of assets. As Higgs himself admits, the notion of regime uncertainty is related to “business confidence,” and this ought to give pause for thought. Economists are wont to use “confidence” as a catch-all concept, and it is worth bearing this in mind from former chair of the Council of Economic Advisors Greg Mankiw: “The sad truth is that we economists don’t know very much about what drives the animal spirits of economic participants. Until we figure it out, it is best to be suspicious of any policy whose benefits are supposed to work through the amorphous channel of “confidence.”20 While regime uncertainty makes this channel less amorphous, it is tempting to use it to attribute too much. After all, as Warren Buffett said, “if I didn’t think the government was going to act, I would not be doing anything this week.”21 19 

In Robert Higgs, “Regime Uncertainty in 1937 and 2008,” Beacon Blog, December 6, 2008, he also has defined regime uncertainty as the “widespread inability to form confident expectations about future private property rights in all of their dimensions. Private property rights specify the property owner’s rights to decide how property will be used, to accrue income from its uses, and to transfer these rights to others in various voluntary arrangements” [http://blog.independent.org/2008/12/06/ regime-uncertainty-in-1937-and-2008/, accessed March 15, 2017]; see also Robert Higgs, “Regime Uncertainty: Pirrong Debunks the Keynesian Debunking,” Beacon Blog, September 5, 2011 [http://blog. independent.org/2011/09/05/regime-uncertainty-pirrong-debunks-the-keynesian-debunking/, accessed March 15, 2017]. 20  From “Shiller on Animal Spirits,” Greg Mankiw’s Blog, January 27, 2009 [http://gregmankiw. blogspot.co.uk/2009/01/shiller-on-animal-spirits.html, accessed March 15, 2015]. 21  Quoted in Paulson (2010, 284).

The Financial Crisis in the United Kingdom    761 Private investment YoY % change 15% 10% 5% 0% –5%

2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

–10% –15% –20% –25%

Figure 34.1  Private investment YoY % change. Source: Office for National Statistics, author’s calculations.

Following Higgs, we can focus on private investment, and the investment component of GDP accounting is total gross fixed capital formation (GFCF). If we strip out government and public spending, we can see private investment from 2007 to 2011.22 As figure 34.1 indicates, in early 2007, private investment was growing at 10.98 percent relative to the same quarter of the previous year. However, this plunged such that it began contracting in early 2008, reaching a trough with a growth rate of -19.6 percent in early 2009. Figure 34.2 shows the month-to-month change in private investment from 2006 through mid-2011. But to what extent can this downturn in private investment be attributed to regime uncertainty? An obvious starting point is to look at the criteria originally set forth by Higgs (1997) and see if they apply to the United Kingdom during the period under study. Higgs (1997) identified five key possibilities. The first is whether business leaders believed that the basic system of capitalism would be replaced with socialism, fascism, or another form of economic nationalism. For the period of the Great Depression Higgs (1997, 569) provides convincing arguments for why such an extreme change of regimes was “not only possible but likely,” and economists such as Andrew Lilico have 22 

For more on this measure, see “Kaleidic Economics Publishes New Indicator on Private Investment,” Kaleidic Economics, December 29, 2011 [http://www.kaleidic.org/news/2011/12/20/ kaleidic-economics-publishes-new-indicator-on-private-invest.html, accessed March 15, 2015].

762   Applications: The 2008 Financial Crisis 4,000

Net quarterly private investment

3,000 2,000 1,000 0

2006 2006 2006 2006 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

–1,000 –2,000 –3,000 –4,000 –5,000

Figure 34.2  Net quarterly private investment. Source: Office for National Statistics, author’s calculations.

labeled the nationalization of much of the United Kingdom’s banking sector in 2008 as “the end of private capitalism” (Lilico 2009, 1). But it is also important to point out that such claims rest on the links between the financial system and the economy as a whole, as opposed to government’s direct efforts to alter regimes. According to Alan Greenspan (2011, 173), “few envisioned a major corporation (beside Fannie Mae and Freddie Mac) being ‘too big to fail.’ … The American government, in response to the Lehman crisis, did what to most had been unthinkable previously.” But he is still talking about the scale and scope of interventions within a particular sector, as opposed to across-the-board nationalism. Indeed, there’s also a danger that highlighting the policy interventions downplays the role of the state in the banking system prior to the crisis. In a monetary regime with a monopoly on base money and the setting of interest rates as a policy tool, we must be careful to highlight marginal changes while still being able to see the broader picture. The second indicator is whether the wealthy were punished. Higgs (1997) points to the 1935 Wealth Tax as an example of Roosevelt’s vendetta against the rich. In this regard, consider the income tax hike that was announced by the Labour government in April 2009. As of April 2010, the top rate of income tax rose to a psychologically important 50 percent on income more than £150,000, a rate so punitive that the consensus view seemed to be that it would actually result in lower tax revenues (Baron 2010; Young and Saltiel 2011). However, it sent out a strong signal that the government was increasing

The Financial Crisis in the United Kingdom    763 burdens on the wealthy, supported by plans to “get tough” on what the deputy prime minister considered “excessive” boardroom pay.23 A third issue raised by Higgs (1997) is whether constitutional changes were being made that lifted restraints on political powers. In this regard, the changes to the Supreme Court and the scale and scope of regulatory institutions adopted by Roosevelt are unique. While efforts to reduce the power of the House of Lords are of long standing, the government was not seeking to bolster its economic policies with constitutional reform. A fourth indicator is whether trade union membership was rising, with Higgs (1997) pointing to their increasing power within Democratic politics. In the United Kingdom, trade unions have been declining over time; density fell from 32.4 percent in 1995 to 28 percent in 2007, and the recession saw this trend continue to hit 26.6 percent in 2010. In terms of absolute numbers, this constitutes a fall of almost 200,000 members from 2009 to 2010.24 The final issue relates to the personality of the leader. Gordon Brown’s reputation as prime minister was closely related to his actions as chancellor. As part of the rebranding and modernization of Britain’s left-of-center party, Tony Blair and Brown understood the importance of developing a reputation for economic competence. This was why the removal of clause four from the Labour Party constitution in 1995 was such an important issue in terms of electability.25 But despite Labour’s ability to ingratiate itself with the City of London, its basic support base was trade unions and anticapitalists. While Higgs (1997, 580) points to Roosevelt’s “hostility bordering on hatred for investors as a class,” Brown might be said to have opted for a marriage of convenience. Two conclusions can be drawn. Either the evidence for regime uncertainty in the United Kingdom is weak (in comparison with the case of the Great Depression), or the criteria around which we should judge it have changed in the meantime.26 The so-called congressional effect finds that “more than 90% of the capital gains over the life of the DJIA have come on days when Congress is out of session” (Ferguson and Witte 2006), providing a nice example of how regime uncertainty is supposed to work. Changing the rules of the game creates uncertainty. Entrepreneurs hold off on investment, because they aren’t sure what interventions will occur and require a more stable investment climate. It can sometimes be unclear, when regime uncertainty is invoked, whether scholars are pointing to a lack of investment or a more bearish approach to investment. When looking for indicators, focus tends to fall on three important areas: gold (since it is a hedge against inflation), hoarding cash (a desire for liquidity), and the yield curve (reflecting an uncertainty about the future state of the economy). 23 

See “We Will ‘Get Tough’ on Excessive Boardroom Pay—Clegg,” BBC News, December 4, 2011 [http://www.bbc.co.uk/news/uk-politics-16022162, accessed March 15, 2015]. 24  See “Trade Union Membership 2010,” Department for Business Innovation and Skills and the Office of National Statistics [http://stats.bis.gov.uk/UKSA/tu/TUM2010.pdf, accessed May 30, 2011]. 25  This called for the common ownership of the means of production and represented the socialist core of the Labour movement. By removing this section of the constitution, Labour was seen to become a more moderate, social democratic party. 26  I credit Lydia Ortega for emphasizing this latter point.

764   Applications: The 2008 Financial Crisis But methodology is important here, and Higgs (1997, 576) augments a reliance on indicators with opinion polls and other textual evidence that attempt to get at the interpretations and expectations of market participants, or what he calls “direct access.” There is also an a priori reason to identify uncertainty with financial panics. The precautionary demand for money is highly dependent on uncertainty, and therefore a straightforward explanation for the corporate stockpiling of liquid assets (in the United States, for example, by September 2010, total liquid assets were the highest share of total assets that they had been for half a century; Greenspan 2011, 167), is an increase in particular forms of uncertainty.27 In terms of the US “Great Recession” of 2007–2009, there is evidence that changes in the investment climate contributed to the economic downturn, but we should be careful about distinguishing between traditional regime uncertainty and more mundane policy uncertainty. There are two possible ways to view their relation. One is that there is a categorical difference and that while policy uncertainty relates to changes in the rules of the game, regime uncertainty involves a change in the actual game being played. In this sense, it implies some form of constitutional-level changes. Alternatively, regime uncertainty can be viewed as simply an extreme form of policy uncertainty. The difficulty with the latter is knowing where to draw the line and losing the unique contribution made by Higgs’s (1997) account of the Great Depression. In a Wall Street Journal op-ed piece, Allan Meltzer talk about the harmful impact of White House–generated uncertainty: The most important restriction on investment today is not tight monetary policy, but uncertainty about administration policy. Businesses cannot know what their taxes, health-care, energy and regulatory costs will be, so they cannot know what return to expect on any new investment. They wait, hoping for a better day and an end to antibusiness pronouncements from the White House. President Obama could do more for the economy by declaring a three-year moratorium on new taxes and new regulation.28

James Sherk points to evidence that net private sector US job creation was rising by almost 70,000 jobs per month until April 2010 but then stalls to less than 7,000 over the subsequent year.29 He identifies Obama’s healthcare legislation as being the event causing this discontinuity. According to Chinese investor Lou Jiwei, “Right now we do not have the courage to invest in financial institutions because we do not know what 27  This suggests that firms have not been credit-constrained during the financial crisis, which would be misleading. There is plenty of evidence that small and medium-sized enterprises (SMEs) are facing tough funding situations. Indeed, if some firms are sitting on cash while others are complaining of access to finance, this suggests a breakdown in financial intermediation. 28  “The Fed Compounds Its Mistakes,” Wall Street Journal, October 11, 2010 [http://www.wsj.com/ articles/SB10001424052748704696304575538532260290528, accessed March 15, 2015]. 29  See James Sherk, “Recovery Stalled after Obamacare Passed.” Heritage Foundation. Web memo 3316, July 19, 2011 [http://www.heritage.org/research/reports/2011/07/economic-recovery-stalled-af ter-obamacare-passed, accessed March 15, 2015].

The Financial Crisis in the United Kingdom    765 problems they may have. … If [regulation] is changing every week, how can you expect me to have confidence?”30 In addition, Greenspan (2011, 165) has attributed 50 to 75 percent of the decline in corporate illiquid long-term fixed asset investment to “the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by business since the collapse of Lehman Brothers, deriving from the surge in government activism.” Scott Baker, Nicholas Bloom, and Stewart Davis have created a “policy uncertainty index” to measure the scale.31 Higgs acknowledges that this is not on the same scale as the regime uncertainty that characterized the 1930s, but he presents it as evidence that investors would be placing high-risk premiums on medium- or long-term investments.32 But note that the uncertainty being shown here is related to future regulations (policy uncertainty). It’s not traditional regime uncertainty. This is not to say that policy uncertainty isn’t important, and the Bank of England’s Monetary Policy Committee’s minutes provide an example of it at play in the United Kingdom:  “the Government’s announcement in mid-January of a five-point plan to tackle the problems in the UK banking system had initially had little impact on market sentiment. That also possibly reflected the fact that financial market participants were waiting for more detail on the plan.”33 But this is only a mild form of regime uncertainty, at best. A robust analysis of the concept of regime uncertainty should also look for examples that would suggest a decline in investor certainty and see if they did indeed have a discernible impact. In May 2010, a general election failed to produce a majority government. After about a week of negotiating, it was announced that the Conservatives and the Liberal Democrats intended to govern as a full coalition. It is hard to think of a better example of potential political uncertainty, but the markets barely budged. This was probably because a Conservative government had already been priced into the market, and the economy was already emerging from recession. It can therefore be easy to overstate the impact of policy trivialities on the market as a whole. Indeed, this is the power of Higgs’s argument (i.e., the very real threat of regime change in the United States during the Great Depression), but it’s also why economists need to be cautious about invoking it in less extreme situations. We cannot claim that a change in what we might label as regime uncertainty leads to an observable and identifiable change in private investment or indeed total GDP. 30 

Keith Bradsher, “China Shuns Investments in West’s Finance Sector,” New York Times, December 3, 2008 [http://www.nytimes.com/2008/12/04/business/worldbusiness/04yuan.html?_r=0, accessed March 15, 2015]. 31  Scott Baker, Nicholas Bloom, and Stewart Davis, “Business Class: Policy Uncertainty Is Choking Recovery.” Bloomberg, October 5, 2011 [http://www.bloomberg.com/news/articles/2011-10-06/ policy-uncertainty-is-choking-recovery-baker-bloom-and-davis, accessed March 15, 2015]. 32  Robert Higgs, “Regime Uncertainty in 1937 and 2008,” Beacon Blog, December 6, 2008 [http://blog. independent.org/2008/12/06/regime-uncertainty-in-1937-and-2008/ accessed March 15, 2015]. 33  Bank of England, Minutes of the Monetary Policy Committee Meeting, February 4–5, 2009, February 18, 2009.

766   Applications: The 2008 Financial Crisis If regime uncertainty refers to the signals that policy makers make about the durability of property rights, a related concept is that of big players (Koppl 2002). They are defined as “anyone who habitually exercises discretionary power to influence the market whilst himself remaining wholly or largely immune from the discipline of profit and loss” (Koppl and Yeager 1996, 368; see also Prychitko 2010) and have the benefit of drawing the private sector into the analysis. While we might expect big players to be political leaders, central bankers, and regulators (Higgs’s big player was Roosevelt), they can equally be found as corporate opinion leaders and in the media. Bankers in particular are in some part protected monopolists: “a Big Player may be any actor who combines three things: namely, the power to influence some market, a degree of immunity from competition, and use of discretion in the exercise of his power” (Koppl 2002, 17).34 Big players help put the skin on the bones of the regime uncertainty approach, providing a mechanism by which expectations are managed (and indeed hindered). Consider how US Treasury secretary Hank Paulson (2010, 63) seized the opportunity to coordinate efforts and act as a focal point for the policy response: “throughout the crisis … I would keep in constant touch with Wall Street CEOs.” This is likely to have a homogenizing effect on the behavior of those he was talking to, and Paulson seems unable to properly consider whether he was responding to panic or helping to propagate it. As Koppl (2002, 17) says, “Big Players divert each trader’s attention from underlying conditions of supply and demand towards the personality of the Big Player”; precious (and scarce) cognitive attention to reappraising the new, postmoment economic reality is instead employed in trying to predict the thoughts and actions of Paulson, Ben Bernanke, Darling, and Mervyn King. An industry of Fed watchers and Bank of England spies crops up, and even if investors are savvy enough to know that politicians have little impact on how markets react, they also know that other traders will be trading as if they do. By definition, big players cannot be ignored. In terms of Paulson, he acted as middleman during Barclays’ attempts to buy Lehman prior to it being bankrupt and admits to making a mistake when he failed to interpret Chancellor Darling’s warning about the British government’s willingness to allow Barclays to make such a deal (Paulson 2010, 211). This isn’t to say that such a deal would have been more likely if it wasn’t for Paulson, but there are both costs and benefits involved in centralizing crisis management and placing an impossible epistemic burden on one individual.35 34 

I do not think this contradicts the earlier discussion of the losses inflicted on bankers. It acknowledges that bankers are not as exposed to the profit-and-loss system as they would be under a genuinely free market in banking, but this doesn’t make them impervious to it. 35  Another point worth making is that when judging the merits of large-scale policy responses, the probability of failure should not be ignored. In terms of a cost-benefit test, it’s the expected value of a policy that is relevant, not the impact if it is successful. For example, stocks fell after TARP was announced, and if this is our criterion of success, then doing nothing would have been a better option than making a mistake. Too often, commentators compare the best-case policy outcome with the status quo. In reality, it should be the expected value of the policy outcome (and compared not with the status quo but with the expected value of the next-best alternative policy).

The Financial Crisis in the United Kingdom    767 There are two types of regime uncertainty. The most traditional one is that policy makers provide a credible signal that vast and arbitrary intervention will occur but uncertainty about the scale and scope of such intervention. An alternative version (as the quote above by Buffett shows) is that policy makers fail to provide a clear enough position on policy response. In other words, there is a danger that they say too much and force investors to wait and see and also a danger that they say too little and signal that a collapse in aggregate demand will be tolerated. Risks to confidence lie in both directions.36 Consider examples of both of these in the United Kingdom. On January 1, 2011, Chancellor George Osborne announced a bank levy imposed on the value of certain debts. Initially set at 7 percent, it was expected to raise £2 billion, and a month later, it was made permanent and the rate raised to take in £2.5 billion. At the time, the opposition party was arguing for its own idea of taxes on bonuses, demonstrating a widespread political vendetta against profitable banking. As an example of regime uncertainty, the levy demonstrated the fragility of the investment climate, and the threat of arbitrary, large-scale, and ongoing intervention seemed to harm confidence.37 The announcement came in the middle of Project Merlin, a negotiation between the government and the major banks aimed at agreeing on reforming the compensation of the banking industry. The fact that the bank levy was announced separately from this clearly caused surprise: “We have been negotiating with the Treasury in good faith, on the assumption that the Chancellor would not spring nasty surprises like this on us. … We had no idea this was coming and quite frankly some of us are livid.”38 But if the bank levy provides evidence for how arbitrary interventions can damage confidence, attention must also be given to the risks of saying too little. The fact that leaders of central banks are big players helps to rectify a common myth that the role of central banks in a crisis is to restore confidence. On the contrary, the big player theory actually suggests that if central bankers suffer from the same euphoria as other market participants (and there’s no reason to suggest they don’t), this could amplify and spread panic. According to Walter Bagehot (1873): In common opinion there is always great uncertainty as to the conduct of the Bank: the Bank has never laid down any clear and sound policy on the subject. … The public is never sure what policy will be adopted at the most important moment: it is not sure what amount of advance will be made, or on what security it will be made. The best palliative to a panic is a confidence in the adequate amount of the Bank 36 

Those who point to regime uncertainty might be accused of defining any policy response as being disruptive. It would be asymmetric to look only at how regime uncertainty might stem from too strong government, rather than too weak. The implication is that desirable policy response would be to make a clear and credible commitment to the existing regime, neither stoking fear nor signaling neglect. 37  It’s important to make a distinction between stability and predictability; it’s possible to have changing regulations, but provided these are anticipated and well communicated, we would not expect them to have a negative effect on the investment climate. 38  An anonymous banker quoted by Robert Peston, “Bank Bosses Furious about Additional Levy,” Peston’s Picks, BBC News, February 8, 2011 [http://www.bbc.co.uk/blogs/thereporters/ robertpeston/2011/02/bank_bosses_furious_about_addi.html].

768   Applications: The 2008 Financial Crisis reserve, and in the efficient use of that reserve. And until we have on this point a clear understanding with the Bank of England, both our liability to crises and our terror at crises will always be greater than they would otherwise be.39

On September 13, 2007, BBC journalist Robert Peston revealed that the Northern Rock bank was seeking a liquidity support facility from the Bank of England, prompting the first high street bank run since 1866. In direct contrast to the high-octane manner in which Paulson and Bernanke would come to respond to US liquidity issues, the chancellor of the Exchequer and the governor of the Bank of England didn’t even meet in person and allowed three full days to pass before making a public statement (see Walters 2008, 64). During the Northern Rock crisis, it is believed that governor Mervyn King favored the Bagehot policy:  “instead of the Bank pumping cash into the inter-bank markets, any bank in London that was short of cash had to lodge bids for extra reserves, for which it would pay a penalty charge of one point above the official bank rate” (Brummer 2009, 66). The unintended consequence of this was that it stigmatized those banks that sought to use it. With regard to Northern Rock, King wanted “to have acted covertly as a lender of last resort” (Brummer 2009, 68)  and favored a secret rescue. However, his understanding of EU regulations (in particular the 2005 Market Abuses Act) meant that this approach was dismissed as impossible, and it would have to be done in the public sphere.40 This plan was leaked to BBC business editor Robert Peston, who reported it publicly, at 8:30 that night, and the bank run swiftly followed.41 Images of depositors queuing to withdraw their money spread internationally, exacerbating the situation, spooking the markets, and tainting all UK banks.42 Before the provision of emergency liquidity assistance by the Bank of England could be announced formally, the outlines of the operation were reported by the BBC … the general view is that the leak was instrumental in precipitating the run on Northern Rock because it created a panic amongst investors and savers. Indeed, no 39 

Cited in George Selgin, “Bagehot Was Right,” Pittsburgh Tribune, October 19, 2008. Another example of King’s “dithering” was that he was unwilling to publicly guarantee deposits prior to knowing for sure that this policy would be adopted (Peston 2008, 170). It is easy to see why this might be understandable in theory but catastrophic in practice. 41  Some blame Peston’s elocution for making the situation seem more dangerous than it was: “the release of the information turned out to be a disaster for all those involved. Peston’s delivery, oddly drawling and breathless at the same time, gave rise to panic” (Brummer 2009, 81). This was partly because even though he attempted to make assurances to depositors, it was common knowledge that there were insufficient deposit guarantees in place to reassure the public. 42  According to Peston (2008, 171), “The Chairman of one of the UK’s biggest banks told me that those brainy young business-school graduates who control billions of cash from their offices on Wall Street and Dubai and Singapore were spooked by the TV images of anxious Rock savers desperately trying to get their money out of branches. So, for no other reason than that the world is their oyster when it comes to deploying their cash, in the febrile conditions of mid-September they boycotted the UK.” Note, though, that the chairman of a UK bank has a vested interest in placing the blame on “irrational contagion.” 40 

The Financial Crisis in the United Kingdom    769 matter what the subsequent formal announcement might say, the damage had been done at that stage. (Walters 2008, 70)

In terms of interest-rate policy, the Bank of England waited a full quarter before cutting the official bank rate in December 2007 (from 5.75 percent to 5.5 percent), and it remained at 5 percent until October 2008. By March 2009, it was at 0.5 percent, where it stayed through 2010.43 During this time, the growth of the broad money supply M4 consistently fell, from around 16 percent at the beginning of 2009 to less than 2 percent at the end of 2010.44 As with the United States, there is evidence to suggest that around the summer of 2008 (if not before), monetary policy became excessively tight, contributing to the “secondary” recession. Perhaps more important, perceived failures generated uncertainty about the future path of monetary policy. In terms of the increasing role of central banks as big players and as propagators of regime uncertainty, consider White (2010) and, as follows, Hummel (2011, 512): Even before Bernanke, the Fed’s increasingly conspicuous targeting of interest rates had major economic players sitting on the edge of their chairs, waiting to hear the Open Market Committee’s latest pronouncement, rationally oblivious to the fact that the Fed is basically a noise trader in the market for loanable funds and cannot ultimately control real interest rates.

This claim does not translate perfectly for the United Kingdom, since the policy rate is not an interbank one. However, one can still argue that it receives more attention than it deserves (as demonstrated by how the transmission mechanism almost broke down during the crisis), and that the market tends to price in interest-rate decisions, thus reducing the impact of decisions that aren’t a surprise. Moreover, the increased prominence of Bank of England decisions (such that it has become common for them to be on front pages of newspapers or headline news) has made the governor an even bigger player. And if the surprise is incompetence, then the destabilizing effects can be large. This all implies that even a perfect understanding of economic theory is not enough to predict future movements in the economy. You also need to factor in the regime uncertainty. If there is a subprime crisis, it’s not clear how the government will respond. If they decide to cut interest rates and bail out mortgage holders, then why bother trying to short the market? When Paulson announced a government program to help homeowners who were financially at risk (called HOPE Now), it added another level of uncertainty: “If the government project was a success, and more aggressive steps were taken to help borrowers, it might help to stabilize the housing market and limit losses from pools

43 

The trough of the FTSE 100 also occurred in March 2009, at 3,500. During this time, an adjusted M4x became popular, since it excluded the effects of certain financial instruments such as securitizations. This showed an even more dramatic decline than the traditional M4 measure, becoming negative in the middle of 2010 (Janssen 2009). 44 

770   Applications: The 2008 Financial Crisis of subprime mortgages” (Zuckerman 2009, 219). Policy intervention shifts the problem from one of economic theory to a combined one of economic theory and political science.

The Calculation and Recalculation Problems Share indices such as the FTSE 100 do not constitute real wealth but are, in fact, claims on real wealth. The claims can multiply and shrink, but often this is an accounting effect. All share prices provide are a market estimate of the present value of the future income streams of a company. They are fundamentally a matter of entrepreneurial calculation, since they involve an estimate of the future state of the economy. The financial crisis was in no small part a realization that our expectations about the future income of the economy were faulty. We had systematically overestimated the profitability of various production plans, and the crisis moment was the realization that we were not as rich as we had thought. Thus, it is at this moment that the cluster of entrepreneurial errors becomes apparent and there is a subsequent cluster of recalculation (Garrison 2001). While regime uncertainty imposes additional forms of uncertainty on market participants, it’s important to recognize that economic uncertainty will also increase during a recession or other extraordinary times. The Duke University and CFO Magazine Global Business Outlook survey asked CFOs if they had pushed back hiring decisions, and of those that did, reasons included US economic uncertainty (54 percent), global economic uncertainty (20 percent), and regulatory environment (18 percent).45 It’s hard to interpret these through the lens of regime uncertainty, because the first two relate to economic uncertainty and the latter to policy uncertainty. The reason it’s difficult for Austrians to attribute any strong causal factor to “uncertainty” is that it is taken as given.

Recalculation We can define recalculation as follows: “to calculate again, either to correct previous errors or to incorporate new economic conditions,”46 and it is an integral component of the crisis moment. Prior to goods being allocated to new production plans, entrepreneurs must embark on a recalculation process, because expectations must precede action. Therefore, it is precisely the period in which you need a stable investment climate, since entrepreneurs need to reevaluate the profitability of their plans.47 Hence, large-scale and arbitrary policy 45 See http://www.cfosurvey.org. 46 

The term has been popularized by Arnold Kling, who uses it in a slightly different but largely complementary way. See Arnold Kling, “The Recalculation Model, Simplified,” EconLog, September 6, 2009. http://econlog.econlib.org/archives/2009/09/the_recalculati.html, accessed June 9, 2011. 47  Of course, in reality, entrepreneurs are constantly reevaluating their plans; however, it seems reasonable to assume that a cluster of errors would be followed by a cluster of reevaluation.

The Financial Crisis in the United Kingdom    771 changes disrupt the calculation process and have the potential to make the recession longer and more painful. As one example, consider the labor market during a recession and how the recession generates unemployment. As Bob Murphy says, “they need to be reallocated, and that takes time in a complex, modern economy.”48 But before they can be reallocated, they need to be recalculated. The job-search process is an attempt to match specific human capital with an entrepreneur’s anticipation of future consumer demand in the postrecession economy; after all, “hiring is an investment decision” (Spence 1973, 356). It’s not that some workers are idle or unproductive, it’s that we don’t yet know which industries/ companies will lead the recovery and need to reemploy labor. It is about the discovery of capital complementarities: how do specific units of heterogeneous human capital fit in with units of other capital goods within the production plans of entrepreneurs?49 And if this wasn’t hard enough, entrepreneurs must estimate the future value of the employee with the cost of employment, and this is a function of the changing regulatory environment (as one businessman highlights, “How can I hire new workers today, when I don’t know how much they will cost me tomorrow?”).50 As seen above, not only do entrepreneurs have to reappraise their investment plans in light of the new situation, but they must also factor in the regime uncertainty generated by policy makers. There is the real chance that what only requires a mild reappraisal is compounded by policy error and turned into a secondary depression, or a “cumulative rot” (Horwitz 2000).

Price Naiveté At a theoretical level, the role of prices for economic calculation is crucial, but economists have a tendency to conflate this textbook approach with real-world ones. Equilibrium prices are merely “the daily balance of expectations” (Lachmann 1976, 60), and we can point to two forms of price naiveté. The first results from an overconfidence in our ability to estimate market prices, and the second is an overconfidence in our ability to interpret them. Consider the role that accounting standards played in the financial crisis. The traditional way of treating costs is a historic method that records the actual monetary

48  See Robert P. Murphy, “My Reply to Krugman on Austrian Business-Cycle Theory,” Mises Daily, January 24, 2011 [http://mises.org/library/my-reply-krugman-austrian-business-cycle-theory, accessed March 15, 2015]. 49  In terms of policy relevance, it seems reasonable to expect that markets will do this recalculation more quickly and more accurately than bureaucrats. Critics characterize Austrians for saying “let the market adjust,” but Austrians almost uniquely take the concept of time—the notion that the market is a dynamic process—seriously. If your theory is built on an assumption of equilibrium, it’s no surprise that you don’t require a painful adjustment. But that doesn’t make it applicable to the real world. 50  Quoted in S. L. Carter, “Economic Stagnation Explained, at 30,000 Feet,” Bloomberg, May 26, 2011 [http://www.bloomberg.com/news/articles/2011-05-26/carter-economic-stagnation-explained-at30-000-feet, accessed March 15, 2015].

772   Applications: The 2008 Financial Crisis amount paid for a particular good. It is clear why this approach has limitations. If a company bought £100,000 of land in 1983, it might be expected to have risen in value to something like £800,000 by 2003. Not only is the historic cost economically irrelevant (it’s a sunk cost), but it paints an inaccurate estimate of the value of assets held by the company. If the company wanted to borrow against the value of its assets, then it would make more sense to record the current market price. Fair value accounting (FVA; also known as mark-tomarket) allows companies to record an estimate of the current market price, rather than the historic cost. It should be obvious why it is in a bank’s interest to do this during an inflationary boom, since it encourages money illusion and marks false profits as real ones. However, in the same way that FVA amplifies the boom, it also amplifies a bust. As many banks found out, when asset prices are falling, this creates a vicious circle whereby falling prices create write-downs, which cause fire sales, depressing prices still further. In theory, FVA seems to bring accounting techniques closer to economic reality, but it is a form of price fetishism that fundamentally misunderstands price formation. Prices can only come through exchange; therefore, the idea that one can estimate the market price without actually selling the asset is dangerous; it relies on an assumption that assets are reasonably homogeneous and that there are stable demand and supply curves. However, it is quite possible that if a bank needs to liquidate an asset, it is because of factors also affecting its competitors. In that case, the models break down when they’re needed the most.51 Another form of price naiveté is the conviction that they are easily interpreted. Just because we know that price changes are caused by shifts in demand or supply, that does not mean that we can identify those changes with any real certainty. Expecting all traders to hang on every word a politician utters or to respond to every policy decision underestimates the efficiency of markets. In the grand scheme of things, we should expect most policy changes to have little impact on markets, and those that do are even more likely to be anticipated (after all, markets are forward-looking, and factors that will have a large effect will generate more attention). Even if economists feel they can point to the impact of regime uncertainty, it is impossible to identify the causes of price movements, since this is the emergent outcome of subjective and possibly tacit expectations. Indeed, it’s possible that event studies seeking to explain price movements suffer from a form of attribution bias, whereby they overestimate an identified cause. Taylor (2011) provides an event study to show that the dramatic increase in the LIBOR-OIS spread occurred not after the Lehman bankruptcy (September 15, 2008) but after the Bernanke-Paulson testimony on TARP (September 23). This seems an ideal example of regime uncertainty. It was the policy maker’s attempts to scare the public into accepting the scale of government intervention being proposed that caused the crisis, not the events that they were purporting to be responding to.52 However, we need to be 51 

I credit Peter J. Boettke for pointing out the irony that if the pricing models being used on Wall Street could accurately estimate the market price of untraded assets, then socialism would be possible. The doyens of capitalism fell for the folly of Oskar Lange. 52  In keeping with the general notion that it was knowledge problems that were the main issue and not the motivations of the actors involved, Paulson was aware of the dangers involved. He warned Chris

The Financial Crisis in the United Kingdom    773 cautious about presenting such cause and effect. The simple truth is that we can only make informed guesses at what causes price movements. In the United Kingdom, CDS spreads peaked in February 2009, but I am not aware of anyone who believes they know why this occurred around five months after the Lehman collapse. Indeed, thinking otherwise suffers from a price attribution bias, fetishizing their informational content (and our ability to decipher it) and oversimplifying the way prices function. A too narrow focus on event studies can oversimplify economic history53 and be difficult to reconcile with notions of heterogeneous agents and subjectivism: “Even in a placid external environment, the bubble could burst when a small number of key traders decide that now is the time to pull out … those quiet events are never tracked in event studies, but they might explain why bubbles burst” (Epstein 2003, 254). The attribution bias “occurs when people attribute their success to skills, and their failures to randomness” (Taleb 2001), and the fact that TARP failed before it passed provides an interesting example. According to Brummer (2009, 237), “the rejection [on September 29] provoked a crash on the stock market,” but when it passed on October 3 at the second attempt, “Even the TARP bailout … provided little respite. Share prices around the world continued to tumble” (238).54 But note the behavioral anomaly: when the stock market fell in September, it was supposedly because TARP was rejected. When the stock market fell in October, it was despite TARP being passed. The assumption that ceteris paribus TARP would have a positive impact is driving the interpretation of the stock market response. The possibility that the market reacted negatively to the passing of TARP seems dismissed out of hand, as indeed is the possibility that TARP had little effect either way. This brings us to the myopic attention to market reactions. When Paulson became Treasury secretary, he set up a “markets room” to monitor price information, and it’s revealing that throughout his book, he relies on market data to continually measure the success of his actions.55 Many accounts of the crisis discuss policy responses that seemed to boost markets in the short term but merely made the underlying problem more severe; as Paulson (2010, 142) noted, “each time, the market steadied for a while then resumed its downward tilt.” Perhaps the measures were providing short-term Dodd that “all we’ll do is spook the markets” (Paulson 2010, 150) and seemed genuinely torn between his belief that drastic intervention was required to avoid a meltdown and his concerns that revealing this would become self-fulfilling: “I knew I had to choose my words carefully. We faced a real dilemma: to get Congress to act we needed to make dire predictions about what would happen to the economy if we didn’t get the authorities we wanted. But doing so could backfire. Frightened consumers might stop spending and start saving, which was the last thing we needed right then. Investors could lose the final shred of the confidence that was keeping the markets from crashing” (281–282). 53  As Henry Watson and Walters (1997, 25) say, “There is a different story behind every recession and every boom, and each story is usually complex and ambiguous and highly dependent on people’s expectations—which, of course, cannot be directly observed.” 54  This is similar to Paulson’s (2010, 328) interpretation: “TARP’s passage failed to console the market: the Dow dropped 157 points.” 55  And yet when he points to his successes, he lists policies (not their results), for example, “securing TARP’s passage to the money market guarantee” (Paulson 2010, 405).

774   Applications: The 2008 Financial Crisis respite, but alternatively, it could have been the initiatives themselves that were exacerbating the problem; “our intervention with AIG didn’t calm the markets—if anything, it aggravated the situation” (242). The concept of big players also helps here: “Big Players also encourage ‘contra-herding’ … the tendency for one day’s movement in an asset price to be reversed the next day” (Koppl 2002, 18). This is because it can be difficult to interpret the big players behavior (bulls and bears can interpret the same action differently). The big player creates an additional source of complexity in the market, and this is an additional potential for new trends and new corrections. Alternatively, it is possible that prices were being driven by other factors, ones that Paulson (and others) are unable to identify.

Trading Strategies This price naiveté can also carry over into the issue of trading strategies. Let’s assume that you are such a good economist that you knew that housing was a bubble, investment banks were overexposed to subprime securities, and there would be a credit crunch and subsequent recession.56 There are (at least) two factors that need to be addressed in order for this knowledge to be actionable. The first is that it needs to be converted into a tradable strategy. It’s not at all obvious (and indeed, this is the source of the profits made by traders) how to act on this belief. There are important differences between the real and financial sectors in terms of betting against other participants. For example, “the real sector deals with capital investment that isn’t liquid, and cannot be sold short: if a company alters its structure of production their rival cannot trade against this” (Evans and Baxendale 2008, 87). Similarly, according to Epstein (2003, 253), “there is no hedge for the entire market itself.” So how do you bet against a housing bubble? At a very simple level, you might sell your house, but there are very real costs involved in moving into rented accommodation or buying in a less frothy market. House prices would have to fall by a lot to justify uprooting a family, and if there’s a 10-percent fall across the board, this increases the relative values of many homes.57 There is no real futures market in housing. Shorting construction companies seems like an indirect way to proceed. As Zuckerman (2009, 52) says: some bears favored a … credit-default swap … that serves as insurance protection for the debt of companies in the sub-prime lending business. But these companies didn’t always suffer when housing fell, because some of them benefited from a weak market by grabbing business from rivals or by selling out to larger companies. Besides, there

56 

It’s important that we don’t ignore the scores of private individuals who did indeed have this belief. The belief in a housing bubble in 2004–2006 was widespread. 57  For example, if you own a three-bedroom home worth $300,000 and want to move to a four-bedroom home that is worth $350,000, a 10-percent fall in house prices mean that you only receive $270,000, but your new house only costs $315,000. The extra room costs $5,000 less.

The Financial Crisis in the United Kingdom    775 wasn’t that many of these corporate bonds in the market; it was difficult to create CDS contracts to protect bonds that didn’t exist.

Indeed, Zuckerman (2009) provides an account of John Paulson’s “greatest trade ever,” which reveals that the difficulty lay in creating the types of financial product and market that needed to exist in order to trade on the belief that subprime would collapse. If bulls refuse to lend out mortgage-backed securities, it is impossible to short them. Zuckerman (2009, 53) suggests that because it was so hard to bet against housing, there was no incentive to have an opinion on whether the housing market would turn: “most analysts didn’t even have basic data about things like the level of foreclosures around the country, and how home-price appreciation differed.” The lack of knowledge measures was entirely rational. The second factor is timing. If you act too early, not only do you forgo the profits that might be generated by participating in the boom, but you could also run out of funds before the market even turns. The challenge is to create a trading strategy, create the products required to enact that strategy, keep it quiet, and strike at the right moment. It’s not as easy as hindsight might suggest.58 Plus, hindsight bias can equate mere permabears with savvy investors. There is no value in predicting a housing crash for each of the last forty years, even if you eventually get it right. One of the most famous people to call the housing bubble was Peter Schiff, and his timing was highly prescient. However, his trading strategy failed to capitalize; he shifted investments from housing into foreign currencies and emerging markets. According to Zuckerman (2009, 119), “some clients lost half of their money that year, underscoring the fact that an awareness of an investment bubble is only valuable when you know how to profit from it.”

Corporate Governance In addition to the recalculation, price naiveté, and trading strategies arguments, attention should also be directed at knowledge processes within companies and how this relates to stock market efficiency. Evans (2008) links the suppression of dissent to the internal knowledge problem that firms attempt to deal with. The main argument is that whistle-blowing is the result of inadequate internal communication channels. Consider the example of Applegarth, chief executive of Northern Rock. As an ambitious leader, he has been accused of creating a culture of deference. His chairman was the relatively ineffectual Matt Ridley (who had no prior experience in the banking industry and was referred to as the “invisible man”), and “none of the executive directors appeared strong enough to challenge him” (Brummer 2009, 87). In a telling indictment of the way information was handled at the top level of management, consider the account of one

58 

If it were, perhaps we’d be traders, not academics.

776   Applications: The 2008 Financial Crisis insider: Applegarth “had an iron grip on the company. There was no feedback. He surrounded himself with ‘yes men’ who worked their way up the company and who were dependent on him. Northern Rock ended up with people in senior positions who were not fit for purpose” (Brummer 2009, 91). The “proper” channel for dealing with dissent is escalation of the issue to those in a position of authority, and when that requires crossing the boundary of the firm, it implies alerting the regulators. However, these types of procedures are notoriously flawed (for example, the SEC had received numerous complaints about Madoff). The problem is that an alternative mechanism to register protest is curtailed. It is plausible that if employees of banks were able to register their concerns by selling their own shareholdings, this might have alerted the wider public (and indeed regulators) to the problems sooner (Manne 2005). However, it becomes clear how far insider trading is from being seen as a useful source of market efficiency, when one considers the fact that short selling was banned during the credit crunch.59 This further demonstrated the widespread misunderstanding of how markets operate and the fact that the interpretive dimension of pricing plays as important a role as the incentives they help to provide.

Conclusion It is almost universally acknowledged that the banking system was riddled with bad incentives that enticed executives to take on too much risk, failing to punish them when the mistakes were revealed. However, this has been theoretically and empirically challenged with an alternative narrative, that a cluster of entrepreneurial errors (especially in the banking sector)—caused by an inflationary boom—led to a recalculation and reallocation process that was curtailed by regime uncertainty and pervasive knowledge problems. This is not to say that incentives don’t matter, and there can be no doubt that factors such as deposit insurance, the Greenspan put, the Bernanke bailouts, and so on, played large roles in causing the financial crisis.60 But this can be taken too far. There is far more evidence to suggest that it was ignorance and error that caused the crisis and that theoretical issues such as regime uncertainty, big players, recalculation, price naiveté, trading strategies, and corporate governance deserve closer attention. At least three key implications for policy jump out. First, the policy environment needs to be stable. While it is true that big players can spread panic if market participants lose confidence in their abilities, there is also a risk of being too active, and 59 

It was adopted in September 2008 and applied to twenty-nine financial stocks. Trying to ban one side of the market is akin to shooting the messenger for bringing bad news. 60  Note how Prychitko (2010, 219) uses these as examples of knowledge problems, in a manner that this chapter is attempting to share. These “perverse” incentives are really consequences of the forces of time and ignorance.

The Financial Crisis in the United Kingdom    777 destabilizing the investment climate. In many ways, a firm and credible commitment to existing legislation can be more beneficial than a well-intentioned promise of new legislation. Second, the main way markets help to mitigate the knowledge problem is through the competition of alternative interpretations. To give scope for ignorance requires institutions that deal with mistakes, and this is what the profit-and-loss system provides. While many entrepreneurs embark on a process of recalculation, policy makers are wont to try to freeze market activity and prevent such adjustments from occurring. Rather than reappraise past investments and try to establish the correct value of a bank’s balance sheet, there has been a concerted effort to retain the status quo. But reappraisal can only be done internally, and the idea that regulators can do this is nonsense. As an investment banker warns, “good luck to any supervisors who want to find out what is going on inside businesses—that is difficult for insiders to know fully and impossible for outsiders” (see Blundell-Wignall and Atkinson 2008, 79). Allowing insider trading (to improve market efficiency) and reducing barriers to entry and exit (so that foreign banks can provide additional competition) help to thaw the economy and to solve the knowledge problem. Finally, a general respect for the price mechanism is a crucial means to mitigate our state of ignorance. As the best guess of the most informed, prices provide a crucial informational surrogate but must always be interpreted subjectively. Reliance on the price mechanism for coordination entails reverence for how they are formed and the signal they provide. The crisis wasn’t caused by greedy bankers, complicit politicians, or capitalism itself. It was simply a sobering reminder that the economic problem of calculation is always with us, that the communication system of market exchange can be destabilized, and that ignorance, not omniscience, is the norm.

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Index

Abbott, Andrew, 556 Abolafia, Mitchel, 551 Absolute zero point, 704 Abstractions, 21, 156, 157, 374, 386, 523 Academy of Management, 531 Acemoglu, Daron, 534, 716 Ackerman, Bruce, 660 Acs, Z. J., 532, 533 Activity-based costing, 290 Adaptive systems theory, 627–634 Adaptive value of money, 579 Adenauer, Konrad, 423 Adjustment bias, 350 Admissibility of scientific evidence, 358 Adverse selection, 206, 753 Affordable-housing programs, 735, 738 Afghanistan, 678, 679, 693 Agarwal, R., 532, 568 Agency theory, 261, 274, 278, 347, 565, 583, 617–624 Aggregation, 174, 627 Agriculture, 447 AIG, 774 Akerlof, George A., 347, 348 Albert, Hans, 426 Albert-Ludwigs-Universität, 419 Albin, Peter S., 598 Alchemy, 355 Alchian, Armen A., 4, 273 Alertness, 529–546. See also Entrepreneurship economic development and, 542–543 entrepreneurship research and, 530–532 innovation and, 532–535 institutional framework and, 535–537 judgment vs., 84 market order and, 540–541 as motor of entrepreneurial function, 78 to profit opportunities, 282

Algorithmic information theory, 349 Aligica, Paul Dragos, 508 Allocation of resources, 686, 687 Alternative commodity anchors, 221 Altruism, 38, 586 Alvarez, S. A., 532 Ambiguity aversion, 626 American Economic Association, 3 American Economic Review and Management Science, 530 American Recovery and Reinvestment Act of 2009, 741 Amsterdam stock market, 324, 325, 327, 328–330 "The Anatomy of Market Failure" (Bator), 77 Anchoring bias, 350 Anderson, Benjamin A., 178 Anderson, T. L., 298 Angello, R. J., 454 Animal Dispersion in Relation to Social Behaviour (Wynne-Edwards), 585 Anonymity, 86 Antibehaviorism, 26 Anticompetitive collusion, 218n6 Antifoundationalism, 25 Antiglobalization movement, 7 Antihistoricism, 26 Antimarket bias, 756, 759 Antitrust and Monopoly (Armentano), 6 Appelbaum, Binyamin, 356 Applegarth, Adam, 750, 758, 775, 776 Appraisement, 623 Arbitrage, 221, 282, 283, 374, 378, 515, 536, 540 Arbitration, 127, 335 Argentina, 665 Argyres, Nicholas, 276 Aristotle, 17, 601 Armentano, Dominick, 6

782   Index Arnold, Scott, 112 Arrow, Kenneth, 72, 76, 370, 498 Arthur, W. Brian, 596 Aslund, Anders, 650 Asset ownership, 286, 290 Asset-price-driven economic volatility, 564 Asset-pricing models, 571 Assumption of omniscience, 753 Asymmetric knowledge, 347 Ataturk, Kemal, 723 Atkinson, P. E., 755 Atlas Sound Money Project, 241 Atomism, 34 Attention, 539 Attitudes, 683 Attribution bias, 773 Auburn University, 6 Audretsch, D. B., 532 Auerbach, R. D., 239 Australia, 233, 358 Austria, 447, 708 Austrian business cycle theory (ABCT), 164, 186–212, 396 canonical variant, 187, 188–192, 208 financial crisis (2007–2009) and, 730–734 Garrison on, 198–208 GSEs and, 195–198 housing market and, 195–198 need for new variant of, 192–195 Austrian capital theory (ACT), 145–163. See also Capital theory Austrian economics, 186–212 capital-based macroeconomics, 164–185 capital theory, 145–163 complexity and, 594–611 constitutional political economy and, 464–490 contemporary, 8–9 distinctiveness of, 27–30 economic development and, 698–726 economic sociology and, 547–562 evolutionary paradigm and, 576–593 experts and, 343–363 finance theory, 563–575 interventionism and, 393–416 knowledge problem and, 45–64 market process theory, 508–526

market socialists vs., 94–114 market theory, 65–93 methodology of, 13–42 monetary theory, 173–178 neuroeconomics and, 612–640 ordoliberalism, 419–444 organizations and, 272–295 origins of, 1–2 political economy, 417–526 in postwar period, 2–5 property rights systems, 296–323 public choice and, 491–507 rationality and, 364–392 revival of, 5–8 social economy, 247–271 spontaneous order, 115–142 stock markets and, 324–340 tax state and, 445–463 "Austrian Economics: A Hermeneutic Approach" (Lachmann), 24 Authoritarianism, 474, 668 Authority, 253 Autocracy, 717, 721 Automaticity, 375 Autonomous motivation, 284 Availability bias, 350 Average cost rule, 108 Average period of production, 146, 160–161 Backhaus, J. G., 446, 447 Backhouse, Roger E., 166, 169 Baetjer, Howard, 145 Bagehot, Walter, 223, 224, 225, 745, 767 Bailey, M. J., 305 Bailouts, 754, 755, 757, 776 Baker, Scott, 765 Balance of power, 720 Balcerowicz, Leszek, 652, 660 Banerjee, A. V., 532, 533 Banking Act of 1933, 226 Bank of England, 234, 749, 752, 765, 768, 769 Bankruptcy law, 567 Banks and banking, 219, 227, 235. See also Central banks; specific banks commercial banks, 755 Barclays, 755 Barnett, W., 201, 202, 202n30

Index   783 Barriers to competitive entry, 405 Barro, Robert J., 662 Barry, Norman, 69n4, 115, 117n10, 519 Barter, 326 Bartley, W. W., 613 Barzel, Yoram, 313, 316 Bas, David Sanz, 167 Basel II international standards, 231, 750 Bator, Francis, 77 Bauer, P. T., 4 Baumol, William, 499, 501, 502, 529, 530, 535, 536, 540, 543 Baxendale, T., 753 Bayesian approach, 386, 387 Bear Stearns, 740, 755, 759 Beaulier, Scott A., 713, 719 Becchio, Giandomenica, 604 Beck, Naomi, 576 Becker, Gary S., 510 Beckworth, David, 735 Behavioral bias, 38 Behavioral economics, 364, 365, 389, 532, 624 Behaviorism, 19 Beinhocker, Eric, 635 Beliefs, 384–387, 683 constitutive, 21 Benevolence, 59 Benson, Bruce L., 6, 296, 315, 502 Benston, G. J., 229 Berger, Peter, 551 Berger, Vance, 358 Berggren, Niclas, 408 Bergson, Henri, 18, 88, 371 Bernanke, Ben, 186, 766, 772, 776 Bernstein, Richard, 25 Bertalanffy, Ludwig von, 598 Besley, Timothy J., 717 Bhatt, Meghana, 626 Bias, 345, 356, 716, 717 adjustment bias, 350 anchoring bias, 350 antimarket bias, 756, 759 attribution bias, 773 availability bias, 350 behavioral bias, 38 hindsight bias, 775 leadership-centric bias, 716

price attribution bias, 773 representativeness bias, 350 run-in bias, 358 systematic heuristic bias, 583 Biggart, Nicole, 556 Big player theory, 569, 572, 622, 624, 766, 767, 774, 776 Bilateral clearing arrangements, 216 Bilateral trades, 75 Biology, 70 Birner, Jack, 607, 614 Bladel, John, 117 Blair, Tony, 763 Blaug, Mark, 72, 73, 81 Block, W., 188n7, 201, 202, 202n30 Bloom, Nicholas, 765 Bloomington school of social thought, 248 Blundell-Wignall, A., 755 Bluntschli, Johann Caspar, 357 BNP Paribas, 755 Bode, Karl, 371 Boehm, Stephan, 630 Boettke, Peter J., 1, 5, 27, 46, 53, 57, 74, 76n7, 88, 127, 247, 257, 261, 400, 402, 403, 404, 405, 413, 491, 492, 493, 496, 497, 498, 500, 501, 502, 503, 510, 535, 536, 551, 556, 557, 558, 607, 643, 706, 719, 720 Böhm, Franz, 422 Böhm-Bawerk, Eugen von, 1, 145, 146, 148, 161, 189, 370, 419, 434, 549, 552, 557, 580, 594, 595, 605, 704 Boom-bust cycle, 175, 180, 191, 192, 203, 206, 223, 729, 731, 734 Botswana, 721 Bottlenecks, 176 Boucicaut, Aristide, 70 Boudreaux, D. J., 449, 502 Bounded rationality, 52, 53, 59, 61, 275, 349, 469, 484, 487, 563, 564, 582, 583, 596, 621 Bourdieu, P., 454 Bradley, Robert, 400 Branson, Richard, 756, 757 Brennan, H. G., 486, 496, 738 Brentano, Franz, 17 Breton, A., 318 BRICE formulation of complexity, 596 Brown, Gordon, 763

784   Index Brozen, Yale, 4 Brummer, A., 756, 757, 758, 773 Brus, Wlodzimierz, 112 Bubble Act of 1720 (UK), 331, 332 Buchanan, James M., 4, 6, 29, 59, 74, 86, 105, 120n15, 301, 302, 303, 433, 438, 521, 524, 648, 650, 660, 738 on constitutional political economy, 464, 465–469, 470, 471, 473, 480–482, 485, 486, 487 on public choice, 494, 496, 497–498 Buckley, Walter F., 630 Buckley, William, 424 Buddha, 355 Budgeting, 446, 691 Buffett, Warren, 760 Building ordinances, 396 Bulgaria, 665 Burczak, Theodore A., 112 Bureaucracy, 318, 319, 320, 395, 691, 692 Bureaucracy (Mises), 497, 499 Bureau of Economic Analysis (BEA), 193 Burt, Ronald S., 555 Business cycle, 208, 421, 563, 581. See also Austrian business cycle theory (ABCT) Busts, 191, 733, 734. See also Boom-bust cycle Butos, William N., 535, 539, 612, 615, 622, 629, 632, 635, 733 Buttonwood Tree Agreement, 333 Caceras, Zachary, 127 The Calculus of Consent (Buchanan & Tullock), 467, 497 Caldwell, Bruce, 5, 21n2, 167, 606, 607, 615 Cambridge-Cambridge debate, 146, 161 Cambridge University Press, 8 Cameralist regimes, 447 Camerer, Colin F., 626 Canada, 219, 239 Canonical ABCT, 187, 208 Cantillon, Richard, 67, 74, 278 Cantillon effects, 173, 206 Cantor, Georg, 599 Capital, Expectations, and the Market Process (Grinder ed.), 3 Capital accounts, 452–453 Capital accumulation, 150, 155, 710

Capital and Its Structure (Lachmann), 3 Capital asset pricing model (CAPM), 565 Capital assets, 150 Capital-based business cycle theory, 175 Capital-based macroeconomics, 164–185 Keynes and, 168–172 Capital-based view of firm, 150–158 Capital combinations, 147, 151 Capital complementarity, 705, 706 Capital goods, 151, 152, 154, 732, 733, 739 Capital heterogeneity, 152, 281, 568, 705–706, 711 Capital in Disequilibrium (Lewin), 6 Capital-intensive production, 281 Capitalism, 179, 448, 549 creative destruction in, 518 economies, 160, 425 market process view of, 512–514 Capitalism, Socialism, and Democracy (Schumpeter), 499 Capitalization of state, 446 Capital ratios, 219, 226 Capital regulation, 230 Capital specificity, 707 Capital stock, 147, 158, 159 Capital substitutability, 705, 706 Capital theory, 145–163 capital-based view of firm, 150–158 capital goods, 150–151 entrepreneurs and, 150–151 knowledge and, 152–155 macroeconomic policy and, 158–160 modularity and, 156–158 outsourcing and, 157–158 production complexity and, 148–150 production organization and, 155–156 Carilli, Coyne, and Leeson, 248, 259 Carlyle, Alexander, 132 Carneiro, R. L., 309 Carr-Saunders, Alexander M., 585, 586 Cassel, Gustav, 72 Casson, Mark C., 283 Catallactic perspective, 19, 272, 466, 628 Catastrophe theory, 597 Cato Institute, 238, 240 Cato Journal, 240 CDOs (collateral debt obligations), 737

Index   785 Censorship, 239 Center for Study of Public Choice at GMU, 6, 497, 498, 500 Center for the Study of Market Processes at GMU, 5, 6, 500 Central banks, 225, 569, 570, 734, 745 Centralization, 426, 427, 437, 556 CFO Magazine Global Business Outlook, 770 Chad, 678 Chamberlin, Edward, 71, 74 Chamlee-Wright, Emily, 247, 248, 256, 257, 258, 261, 536, 557, 558 Chaos theory, 597 Charismatic leadership, 714 Charity, 478 Checkland, S. G., 218n6 Chemistry, 70, 601 Cheung, S. N. S., 315 Chicago School, 2, 433, 491 Chicago University Press, 8 Chile, 722 China, 309, 412 Chirot, Daniel, 668 Chomsky, Noam, 599 Chuang Tzu, 117n10 Churchill, Winston, 715 CIS (Community of Independent States), 664 Citadel (hedge fund), 756 Cities as tax state, 451–452 Civic attitudes, 647 Civil service, 357, 479 Civil society, 720 Clark, John B., 70, 74, 75, 87, 146 Clark, John M., 67, 73, 75, 77 Classical economics, 118 Classical liberalism, 168, 488 Classifications, 375 Closed access orders, 662 Closed society, 467 Club goods, 481 Coase, Ronald, 4, 166, 273, 274, 275, 284, 285, 289, 297, 659 Cochran, John P., 164, 169, 180 Coercion, 94, 95, 96, 126, 127, 301, 305, 684 Cognitive leadership, 283, 284 Cognitive limitations, 61 Cognitive psychology, 614

Cognitive theory, 539, 613, 614 Coinage, 213, 214 Cole, Harold L., 178 Coleman, J. S., 253, 258 Collaborations, 265. See also Coordination Collateral debt obligations (CDOs), 737 The Collected Works of F. A. Hayek (Hayek), 167 The Collected Writings of John Maynard Keynes (Keynes), 166 Collective action, 255, 265, 451, 460, 461 Collective decision-making, 491, 499, 504 Collective goods, 468, 479, 604 Collective narrative, 265 Collective ownership, 454, 644, 706, 707 Collective services, 452 Collectivism, 398, 401, 406, 411, 412, 414, 669 Collins, Harry, 117n5 Collusion, 218n6 Commercial banks, 755 Commodities, 221, 237 Common law, 56 Common pool problems, 308 Common will, 16 Communication, 373, 379 Communism, collapse of, 643–677 case studies, 663–671 culture's impact on transition, 656–660 interaction thesis, 653–662 Kornai on, 651–653 leadership's impact on transition, 660–661 lessons learned, 648–662 "normal country" thesis, 664–671 spiritual capital's impact on transition, 661–662 transition studies, 644–648 Western economists and, 649–651 Community of Independent States (CIS), 664 Community Reinvestment Act of 1977 (US), 193, 194, 736 Comparative institutional analysis, 57, 568 Compatibility, 656 Competition by banks, 219 bidding, 262 classical conception of, 73 entry barriers, 645

786   Index expertise, 344, 346 by information providers, 346 macroeconomics and, 151 market process theory and, 513 market theory and, 68, 71, 80 in money, 237 ordoliberalism and, 428, 433, 434 spontaneous order and, 130, 131 Competition and Entrepreneurship (Kirzner), 4, 65, 78, 81, 84, 85, 85n18, 87 "Competition as a Discovery Procedure" (Hayek), 53 Competitive equilibrium, 510 Competitive order, 428, 437 "The Competitive 'Solution'" (Hayek), 53 Complementarity, 147, 656 Complexity, 594–611 agent-based complexity level, 595, 597 BRICE formulation of, 596 computational, 598, 599, 600 degree of, 149 dynamic, 595, 597, 598 of economic emergence, 600–606 Hayek on, 606–608 hierarchical, 598 knowledge problem and, 46, 50, 51, 59, 155 market process theory and, 515, 519 market theory and, 88 Menger on, 602–604 neuroeconomics and, 615 organizational, 759 "small tent" complexity, 597 of systems, 61 theory of, 508 varieties of, 595–600 Complex orders, 125 Compositive method, 22, 25, 35, 614 Computability theory, 349 Computational complexity, 598, 599, 600 Computer software, 153 Comte, Auguste, 69 Concentrated-benefits approach, 403 Conditionalization, 387 Congressional effect, 763 Conover, C. T., 220n7 Consciousness, 251 Conscription, 127

Conservatism, 584 Consolidated Stock Exchange of New York, 336 Constancy, 429 Constitutional choice theory, 482 Constitutionalism, 466 Constitutional political economy, 8, 464–490 Buchanan on, 465–469, 480–482, 485 contractarianism and, 482–488 knowledge problem and, 473–482 limits of, 469–473 Rawls on, 465–469, 473–480, 483–484 The Constitution of Liberty (Hayek), 116, 237, 248, 424, 433, 434, 436, 471, 499 Constitutive beliefs, 21 Constrained maximization, 454 Constructivism, 34, 471, 472, 624, 682 Consumer goods, 145, 699 Consumption goods, 130, 176, 199, 206, 705 Contagion, 220, 571 Contextual knowledge, 46, 51, 53, 54, 55 Continental Illinois, 224, 755 Contractarianism, 465, 471, 482–488 Contractionary disintervention, 411 Contractual arrangements, 127, 128, 502 Contra-herding, 774 "Contributions to a Theory of How Consciousness Develops" (Hayek), 618 Convertible currency, 234 Cooperation evolutionary paradigm, 586, 587 interspecies, 126 macroeconomics and, 154 in policing, 303 in post-Soviet transitions, 662 property rights and, 299, 300 property rights secured through, 301–305 social, 62, 94 Coordination decentralized, 57, 61 of economic activity, 705 of individual actions, 45, 76 intertemporal, 179, 702, 730, 731, 738 of knowledge, 535 neuroeconomics and, 623 by organizations, 273, 283, 287, 289 price, 283

Index   787 of prices, 777 problem of, 48, 487 of social action, 519 social cooperation and, 62, 94 spontaneous, 687 Corporate entrepreneurship, 532 Corporate finance, 565 Corporate governance, 565, 572, 757, 775–776 Coser, Lewis, 550 Cost accounting, 290 Cost and Choice (Buchanan), 497 Côte d'Ivoire, 678 Counterparty risk, 329, 331 The Counter-Revolution of Science (Hayek), 613, 616 Countrywide Mortgage, 736, 738 Cournot, Augustin, 65, 66, 68, 69, 73, 74 Cowan, E. James, 346, 348 Cowan, Robin, 74 Cowen, T., 241 Coyne, Christopher J., 1, 257, 261, 500, 501, 502, 503, 535, 536, 556, 558, 678, 687, 693, 719, 720 Crawford, Robert G., 273 Creative destruction, 394, 511, 514, 515, 518, 532, 552, 629 Creativity, 94, 96, 285, 513, 515, 623 Credit availability, 177 crunch, 751, 752 expansion, 410, 737 inflation, 193, 205 markets, 455, 456 overexpansion of, 217 transactions, 455, 456 Credit Agricole, 755 Credit-fueled investment boom, 223 Credit risk, 196 Critical rationalism, 613 Critique of Interventionism (Mises), 397 Cross-insurance, 737 Cultural group selection, 584–588 Culture attitudes, 257 capitalism and, 661 cultural tools analysis, 255–257, 266 economic development and, 720

entrepreneurship and, 256 evolution in, 437, 589 institutional change and, 714 norms, 261 in post-Communism transitions, 656–660 post-Soviet transitions and, 673 social economics and, 267 social institutions, 672 transmission of, 248, 254 Curb Market, 336 Curott, Nicholas A., 324 Currency markets, 565 Cwik, P., 565 Cybernetics, 597 Czechoslovakia/Czech Republic, 646, 649, 663 Da Costa, N. C. A., 349 D'Amico, Daniel J., 115 Danish East India Company, 331 Darling, Alistair, 756, 757, 766 Darwin, Charles, 577, 582, 588 Daubert v. Merrell Dow Pharmaceuticals (1993), 358 Davidson, Paul, 180 Davis, Stewart, 765 Day, Richard H., 596 Day-Rosser complexity, 596 Dead-weight loss, 691 Debreu, Gérard, 72, 370 Decentralization, 57, 61, 426, 431, 475, 482, 556 Decentralized adaptive systems, 634 Decentralized decision-making, 494 Decentralized knowledge, 504 Decentralized market processes, 55 Decision-making, 284, 285, 287, 289, 494, 567 Default risk, 196, 413 Deficit-spending units (DSUs), 569 Deflation, 177, 178, 422, 735, 744 Degeneracy, 344, 353 De Jasay, Anthony, 97, 112 De Jouvenel, B., 459 De la Vega, Joseph, 329, 330 Demand, 179 De-mentalization of economics, 370 Democracy, 357, 665, 679, 719 Dempster, Gregory M, 563, 564, 565 Demsetz, Harold, 273, 297

788   Index Department of Housing and Urban Development (HUD), 197, 736 Deposit insurance, 226–229 Depreciation, 240, 709 Derivative stock transactions, 335 Derived demand, 174 Derived judgment, 288 Desrochers, Pierre, 537, 634 Destruction, 516. See also Creative destruction Deutsche Bank, 755, 756 De Vecchi, Nicolò, 376 Development. See Economic development De Viti de Marco, A., 460 De Waal, Frans, 125n20 Diagonal method, 599 Diamond, D. W., 228, 350 Diamond-Dybvig (DD) model, 227 Dickinson, Henry Douglas, 97, 98, 109–110 Difference principle, 467, 484 Differentiability (separability) thesis, 435 Di Iorio, Francesco, 615 Dilthey, Wilhelm, 25 DiMaggio, Paul, 556 Diminishing returns, 709 Direct-demand effect, 177 Direct means, 699 Director, Aaron, 434 Discoordination, 83 Discount on future consumption, 700 Discovery costlessness of, 79 creation vs., 84 entrepreneurship and, 538, 542 function, 283 market process theory and, 514, 515 methodology and, 28 process, 81, 314, 315, 319, 694 social economy and, 262–266 Discretionary power of a government, 681 Discrimination, 396 Disempowerment, 426, 437 Disequilibrium theory, 77, 78, 82, 378, 510, 511, 512, 513, 540, 568, 571 Disincentive effects, 409 Dispersed knowledge, 273, 276, 280 Displayed fixed prices, 70 Dispute resolution, 127

Distorted incentives, 203, 737 Distributed learning, 61 The Distribution of Wealth (Clark), 70, 87 Distributive justice, 588, 670 Diversity, 515, 516, 519 Divisibility, 34 Division of knowledge, 49, 152, 159, 621 Division of labor, 67, 128, 132, 133, 152, 154, 159, 247, 343, 437, 542, 554, 644, 658 DiZerega, Gus, 119n13, 120n14 Djibouti, 678 Dolan, Edwin, 5 Domestic trade associations, 305 Donaldson, Thomas, 523 Donnelley, L. P., 454 Doria, F. A., 349 Douglas, M., 523 Dowd, Kevin, 213, 238, 241 Drug prohibition, 393 DSUs (deficit-spending units), 569 Ducaton shares, 329 Duke University, 770 Duncan, Thomas K., 678 Dunfee, Thomas, 523 Dupuit, Jules, 66, 68, 74 Durability, 34 Durbin, Evan, 97, 98, 108–109, 110 Durkheim, Émile, 547 Durlauf, Steven N., 596 Dutch East India Company, 328, 330, 331 Dutch West India Company, 328, 330 Dybvig, P. H., 228 Dynamic adjustment processes, 492 Dynamic complexity, 595, 597, 598 Dynamic trade-off thesis, 399, 410 Dynamism, 516 Earl, Peter E., 354 Easterly, William, 717, 719, 722 East India Company, 325 Ebeling, Richard M., 551 Eccardt, T., 449 Ecological rationality, 624 Econometrica (Arrow & Debreu), 72 Economic calculation, 706–707, 770–776 Economic Calculation in the Socialist Commonwealth (Mises), 397, 706

Index   789 "Economic Calculus in a Planned Economy" (Durbin), 108 Economic development, 37, 698–726 capital heterogeneity and, 705–706 economic calculation and, 706–707 entrepreneurship and, 542–543 implications for, 707–711 industrial development, 577 institutional framework for, 718–721 leadership and, 715–718, 721–723 time preferences and, 699–705 Economic emergence, 600–606 Economic expectations, 622–624 Economic Freedom of the World Annual Report (Gwartney, Lawson, & Hall), 711 Economic growth, 155, 534, 536, 687. See also Economic development Economic knowledge, 263 The Economic Point of View (Kirzner), 4 "Economics and Knowledge" (Hayek), 21, 21n2, 48, 49, 52, 76, 585, 607, 612, 618, 622, 627 Economics in One Lesson (Hazlitt), 3 Economic sociology, 547–562 individualism in, 555–557 institutional framework and, 553–554 intellectual roots of, 549–552 Economics of the Free Society (Röpke), 426 The Economics of the Mind (Rizzello), 621 The Economics of Time and Ignorance (O'Driscoll & Rizzo), 6 Economic transitions, 556. See also Post-Soviet transitions Economies of scale, 216, 485 Economizing behavior, 469 Economy and Society (Weber), 549 Edelman, Gerald, 353, 614 Edgeworth, Francis, 68, 74, 75 Edinger, Lewis J., 715 Education, 401 EEGs (electroencephalograms), 625 Eggertsson, Thráinn, 656 Egoistic rationality, 348 Egypt, 309 Eichel, Scott, 759 Elasticity of expectations, 23

of money supply, 217 Elder-Vass, Dave, 635 Electroencephalograms (EEGs), 625 Elements of Pure Economics (Walras), 72 The Elgar Companion to Austrian Economics (Boettke), 7 Ellsberg paradox, 626 Embeddedness, 556, 571 Emergence, 119, 122, 129, 588, 600–606, 632 Emergency loans, 218 Emotions, 383 Employment gap, 171 Endogenous growth theory, 77 End-state approach, 519 Enforcement mechanisms, 645, 647, 684 England. See United Kingdom English East India Company, 330, 331 Enlightenment, 118, 129, 325, 425, 600, 607 "Entrepreneurial Discovery and the Competitive Market Process" (Kirzner), 511 Entrepreneurship business cycle theory and, 190, 191 capitalism and, 568, 569 competitive process, 399 costlessness of discoveries, 79 creation by, 85 discovery process, 296, 744 economic development and, 542–543, 720 as employment choice, 531 entrepreneurial calculation, 770 entrepreneurial cognition, 531 evolutionary paradigm and, 576, 580 experts and, 344 extortion entrepreneurs, 310 finance and, 563, 565, 566 financial crisis and, 730, 731, 771 foreign interventions and, 692 function, 84, 109, 285 information, 96 innovation and, 532–535 institutional framework for, 535–537 interventionism and, 394, 397 judgment, 151 judgment-based approach, 290 Kirzner on, 538–543 market, 315–317

790   Index Entrepreneurship (Cont.) market order and, 540–541 market process theory and, 511, 512, 514, 515 market socialism and, 94–95, 105 market theory and, 85 multiplier effects and, 692 neuroeconomics and, 623 in nonmarket contexts, 37 organizations and, 279, 280, 283 ownership implied by, 151 political, 317–319 post-Soviet transitions and, 647, 654, 671 process, 109 as production factor, 278 promoters, 569 property rights and, 298, 305–307, 314, 315–319, 317 public choice and, 501, 503 as research field, 530–532 in Romania, 708 social economics and, 263 teams, 532 Entry barriers, 344, 534 Environmental sustainability, 401 Envy, 515 Epistemological Problems of Economics (Mises), 17, 550 Epstein, R. A., 774 Equal liberty principle, 467 Equilibration, 83, 221, 543 Equilibration theory, 541 Equilibrium approach, 8, 48, 52, 71, 75, 76, 78, 87, 102, 173, 481, 493, 513, 535, 538, 580, 581, 582, 603, 607, 771 Erasmus University (Holland), 6 Erhard, Ludwig, 423, 722 Eritrea, 678 An Essay on Capital (Kirzner), 4 An Essay on the Nature and Significance of Economic Science (Robbins), 71 Ethics, 517, 523. See also Morality Ethiopia, 678 Eucken, Walter, 421, 422, 424, 425, 426, 427, 428, 429, 430, 431, 432, 433, 434, 435, 437, 461 Eugenicists, 343 Europe, 164, 233, 768. See also specific countries

Evans, Anthony J., 261, 749, 753 Evans, Peter, 555, 754, 775 Every Man His Own Broker; Or, a Guide to the Stock Exchange (Mortimer), 331 Evolutionary paradigm, 571, 576–593 cultural group selection and, 584–588 economic development and, 580–584 emergent complexity and, 606 Hayek on, 584–588 learning and, 484 Menger on, 577–580 neurophysiology and, 614 Schumpeter on, 580–584 social institutions and, 577–580 Evolutionary theory, 582, 588, 601, 613 Excessive cycling theory, 220n7 Exchange, 368, 378, 686 Executive compensation, 754, 755, 758 Exogenization, 389 Exogenous forces, 582 Expectational analysis, 623 Expectations, 149, 151, 282, 563, 623 elasticity of, 23 neuroeconomics and, 622–624 subjectivity of, 84 of utility, 387, 389 Experience, 379 Experimental economics, 624 Experimentation, 513, 514, 584 Expert failure, 356 Experts, 343–363 applications, 355–359 cognition limitations of, 348–349 defined, 344 democracy and, 343 ecology of, 351–353 epistemic engineering and, 354–355 failure theory, 344, 353–354 fallibility of, 347 incentives skew errors of, 350–351 information choice theory and, 344–351 power linked to expertise, 343 testimony of, 343, 358 utility maximization by, 348 Exponential computability, 598 Externalities, 297, 395 Extortion, 307–312

Index   791 The Fable of the Bees: or Private Vices, Public Benefits (Mandeville), 130 "The Facts of the Social Sciences" (Hayek), 21 Fairness, 520 Fair value accounting, 772 False individualism, 469 False prices, 79 Fannie Mae. See Federal National Mortgage Association Farm subsidy programs, 318 The Fatal Conceit (Hayek), 248, 471, 607, 613, 616 Federal deposit insurance, 219 Federal funds rate, 413, 735 Federal Home Mortgage Corporation (Freddie Mac), 187, 188, 195, 196, 197, 206, 413, 456, 736, 738, 755 Federal Housing Enterprises Financial Safety and Soundness Act, 197 Federal National Mortgage Association (Fannie Mae), 187, 188, 195, 196, 197, 206, 413, 456, 735, 736, 738, 755 Federal Reserve, 188, 189, 192, 195, 197, 206, 222, 239, 240, 241, 356, 413, 567, 734, 735, 737, 746 Federal Reserve Act of 1913, 235 Feedback mechanisms, 148, 252, 476, 621, 635, 686, 687, 688, 694 Feigenbaum, Susan, 345 Ferguson, Adam, 118n11, 131, 132, 325, 600 Feudalism, 448 Final-outcome theory, 519 Finance, 563–575 Austrian theory of, 568–571 as research field, 564–566 role of, 566–568 Financial asset-price inflation (bubbles), 565 Financial crisis (2007–2009), 164, 179, 186, 241, 727–779. See also Great Recession Austrian business cycle theory and, 730–734 calculation problems, 770–776 corporate governance and, 775–776 housing boom and, 734–738 monetary policy and, 734–738, 744–746 policy responses to, 741–744 political economy of, 739–740 price naiveté and, 771–774

regime uncertainty and, 759–770 regulatory policy and, 734–738 trading strategies for, 774–775 in United Kingdom, 749–779 in United States, 729–748 Financial Services Authority (FSA), 750 Financing gap model, 709, 710 Fink, Richard, 6, 500 First-order (consumer) goods, 145 First-person opportunity, 539 Fiscal commons, 458, 460 Fiscal policy, 396 Fiscal responsibility, 645 Fisher, Irving, 175, 581 Fixed asset investment, 765 Fixed prices, 70 Fixed-value liabilities, 229 Flat tax, 661 Flight to quality, 217, 220 Florida State University, 6 fMRI scanning, 625, 626 Foldvary, Fred E., 451, 502 Food safety systems, 359 Forbes, Duncan, 121n16 Foreclosures, 413, 740 Foreign aid, 657, 686 Foreign intervention, 678–697 meta-level interventions, 682–685 as process, 681–682 rules-constrained interventions, 685–689 unintended consequences, 689–694 Forensic science, 343, 345 Formal institutions, 720 Formalism, 17 Formal rules, 683, 684, 685 Forward contracts, 324, 335 Foss, Nicolai J., 272, 273, 286, 287, 288, 290, 515 Foundation for Economic Education (FEE), 3, 240 Foundations of Economic Analysis (Samuelson), 2 The Foundations of Economics (Eucken), 422 The Foundations of Modern Austrian Economics (Dolan ed.), 5 Fractional reserve banking system, 173 Framing, 386

792   Index France, 447, 708 Freddie Mac. See Federal Home Mortgage Corporation Free Banking in Britain (White), 6 Free banking theory, 213–244 bank capital adequacy regulations, 229–231 central banking vs., 222–226, 231–232 classical case, 215–217 defined, 215 on gold standard, 215–217 government deposit insurance and, 226–229 historical experience of, 232–235 lender-of-last-resort function of central bank, 223–226 misconceptions about, 235–240 monetary standard and price level, 220–221 stability of, 217–220 state intervention's impact on, 222–232 in United States, 234 "Freedom and the Economic System" (Hayek), 432, 433 Freedom of association, 647, 652 Freedom of contract, 429, 645, 647 Freedom of the press, 646, 665 Free-rider problem, 304, 481 Free trade, 236, 714, 718, 720 Frege, Gottlob, 380 Freiburg School, 419, 422, 435, 436, 438 French East India Company, 331 Friedman, J., 751, 754, 755 Friedman, Milton, 3, 174, 356, 433, 510, 654, 661, 715 Friedman, Thomas, 716 Friedrich-Wilhelms-Universität, 419 Frye standard, 358 Fukuyama, Francis, 254 Full employment, 176 Full-information models, 621 Full price equilibrium, 316 Functional magnetic resonance imaging (fMRI), 625, 626 Fundamental rationality, 384 Fungibility, 34 Fuster, Joaquin, 614 Future consumption, 201 Future-oriented spending, 175

Gaddafi, Mu'ammar, 679, 693 Galbraith, John Kenneth, 180 Gallaway, Lowell E., 176, 178 Gally, Joseph A., 353 Game theory, 52, 72 Gandhi, 715 Garraway's Coffeehouse, 332 Garrison, Roger W., 5, 6, 169, 170, 171, 173, 174, 180, 187, 188, 188n6, 189, 192, 198, 201, 208, 732 Gaus, G., 517 General equilibrium theory, 21, 72, 73, 74, 370, 475, 534 market theory and, 72–73 Generalized norms, 253–255, 267 The General Theory of Employment, Interest, and Money (Keynes), 2, 165, 169, 170, 179 Generative causality, 74n5 Genetic-causal approach, 17, 74, 81, 83, 88 George Mason University, 5, 492, 498, 500, 504. See also Center for Study of Public Choice at GMU Georgia, 678 Germany, 502 Gestalt psychology, 373, 376 GFCF (Gross fixed capital formation), 761 Gigerenzer, Gerd, 52, 454 Glaeser, Edward L., 717 Glahe, Fred R., 169, 180 Glasner, D., 238 Glasnost, 652 "Glass walls" metaphor, 109 Global Entrepreneurship Monitor (GEM), 665 Global financial crisis. See Financial crisis (2007–2009) Gödel, Kurt, 599 Goebbels, Joseph, 423 Gold and gold standard, 215–217, 222 as inflation hedge, 763 nominal price of, 221 Goldman, Alvin, 355 Goldman Sachs, 757, 759 Goldscheid, Rudolf, 446–448 Gold Standard Act of 1900 (US), 215 Goodhart, C. A. E., 232n14, 238 The Good Society (Lippmann), 433 Goodwill, 397, 495

Index   793 Goodwin, Fred, 757, 758 Gorbachev, Mikhail, 652, 655 Gorton, G., 232n14 Gossen, Hermann, 602, 605 Governance, 278, 453, 458, 502, 665 Government-failure approach, 497 Government-sponsored enterprises (GSEs), 188, 192, 194, 195–198, 206, 208, 735, 737 Gradual-acceptance thesis, 399 Granovetter, Mark, 258, 547, 551, 552, 553, 555, 557 Gray, John, 614 Great Depression, 4, 178, 187–189, 208, 421, 643, 655, 743, 759, 760, 761 "Great man" theories of history, 714, 715 Great Moderation, 729 Great Recession of 2007–2009, 186, 193, 412, 413, 764. See also Financial crisis (2007–2009) Greenspan, Alan, 223, 356, 735, 737, 762, 765, 776 Gresham, Thomas, 331 Griffin, Kenneth, 756 Griffiths, Brian, 327 Grinder, Walter, 3, 400 Groping (tâtonnement), 75 Grosch, Eric N., 358 Gross fixed capital formation (GFCF), 761 Group selection, 585, 586, 589. See also Cultural group selection The Grumbling Hive: or Knaves Turned Honest (Mandeville), 130 Grundsätze (Menger), 82 GSEs. See Government-sponsored enterprises Guelph University, 6 Guild socialism, 98 Guillen, Mauro, 556 The Gulag Archipelago (Solzhenitsyn), 670 Gwartney, James D., 500 Haberler, Gottfried, 2, 188, 421 Habits of association, 253 Hagel, John, 400 Haggling costs, 275 Hahn, Frank, 73 Haiti, 502, 678 Haken, Hermann, 597

Hamowy, Ronald, 121n16, 131, 132, 133, 134 Handbook on Contemporary Austrian Economics (Boettke ed.), 7 Hanseatic League, 331 Hardin, R., 486 Harmonization, 120, 127 Harper, D., 536 Harris, Ron, 330, 332 Hart, Oliver, 275 Hartman, E. M., 523, 524 Harvard University, 2 Hayek, Friedrich A. on business cycle theory, 187, 188, 192, 208 cognitive theory, 617, 629 on complexity, 594–596, 598–602, 604, 605, 606–608, 633 on cultural group selection, 584–588 on economic development, 707, 717, 720, 721 on economic sociology, 548, 558 on entrepreneurship, 539 on evolutionary paradigm, 576, 577, 581, 588, 589 on experts, 344 on foreign interventions, 683, 694 on free banking, 237 gradual-acceptance thesis, 410 influence of, 2, 3 information and knowledge distinguished, 48 Institute of Economic Affairs monographs, 238 on interventionism, 396, 398, 400, 403, 404, 405 on Keynes, 164, 166, 170, 173, 178, 179 on knowledge acquisition, 79 on knowledge problem, 45, 46, 47, 49, 50, 52, 53, 62 on macroeconomics, 145, 146, 148, 149, 154, 158 on market process theory, 510, 515, 522 on market socialism, 97, 98–101, 112 on market theory, 65, 74, 75, 76, 82, 88 methodology of, 13, 20–23, 26, 30, 35 on neuroeconomics, 612, 617–624, 634 Nobel Prize won by, 5, 613 on ordoliberalism, 421, 422, 432–438 on organizations, 272, 273, 283, 285

794   Index Hayek, Friedrich A.  (Cont.) on political economy, 469, 470, 472, 477, 483 on post-Soviet transitions, 643, 653, 661 on property rights, 299, 314 psychological theory, 376 on public choice, 494, 495, 496, 497, 498, 499 on rationality, 366, 373, 376, 378 on social economics, 247, 253, 255, 259, 260, 263, 265 on spontaneous order, 116, 120, 123, 127, 129, 132, 135, 136 on stock markets, 327 theory of learning, 615 theory of mind, 619 triangle of, 198, 201 Hayek on Liberty (Gray), 614 Hazlitt, Henry, 3 HBOS, 755 Healthcare reform, 396, 743, 764 Hegel, Georg Wilhelm Friedrich, 716 Heidegger, Martin, 421 Heimann, Eduard, 97, 98, 100, 101, 108, 112 Helmand Valley Project (Afghanistan), 687, 688 Herbener, Jeffrey, 82 Heritage Foundation, 665 Hermeneutics, 25 Heterogeneity, 515, 516 of capital, 156, 261, 281, 290 of knowledge, 156 of supply, 157 Heteropathic laws, 601 Heuristics, 38 Heyne, Paul, 402, 403, 404 Hicks, John, 23, 72, 179 Hierarchical complexity, 598 Higgs, Robert, 400, 445, 502, 655, 690, 743, 744, 746, 759, 760, 761, 762, 763, 764 High, Jack, 6, 87, 500 Higher-order goods, 145, 190, 699, 730 Hill, P. J., 298 Hindsight bias, 775 Historical determinism, 716 Historicism, 17, 75 "History of Astronomy" (Smith), 134 Hitler, Adolf, 715

Hoarding cash, 763 Hobbes, Thomas, 299, 300, 305 Hogan, T. L., 198 Holcombe, Randall, 6, 449, 491, 502, 543, 692 Holism, 34 Holland, 630 Holtrop, M. W ., 175 Home ownership. See also Housing market affordable-housing programs, 735, 738 costs and risks of, 194 by minorities, 738 Homogenization of knowledge, 156 Homogenous stock of capital, 199 Honesty, 254, 330, 663 Hong Kong, 722 Hoppe, Hans-Hermann, 82 Horwitz, Steven, 50, 180, 194, 195, 195n19, 238, 261, 413, 608, 614, 615, 635, 729 Hostile worlds view, 558 Host-parasite relationship, 457 Hot tubbing, 358 Housing and Urban Development Department (HUD), 197, 736 Housing market, 192, 193, 195–198, 395, 412 boom/bubble in, 729, 734–738, 740, 750 crisis in, 356 HSBC, 755 Hsu, Ming, 626 Huber, Peter W., 358 HUD (Department of Housing and Urban Development), 197, 736 Hudson, Henry, 325 Huemer, Michael, 121n18 Huerta de Soto, Jesús, 94 Human Action (Mises), 2, 3, 4, 17, 82, 83, 87, 551, 606 Human agency, 583. See also Agency theory Human associations, 604 Human capital, 149 A Humane Economy (Röpke), 431 Humanitarian interventions, 680, 685, 686, 687, 689, 692 Hume, David, 50n3, 59, 297, 325, 472, 600 Hummel, J. R., 769 Hungary, 646, 649, 663 Husserl, Edmund, 371, 380, 425 Hutchison, Terence W., 607

Index   795 Hyperbolic discounting, 625 Hyperinflation, 421 Hypernorms, 523 Hypothecation, 324, 329 Ideal theory, 476 Ideal-type operating model, 520 Ideal typification, 86 Idle capacity, 177 Ignorance, 751, 753, 759 Ikeda, Sanford, 248, 255, 315, 393, 400, 405, 414, 446, 495, 496, 554, 634, 754 Imagination, 285 IMF (International Monetary Fund), 649 Impartiality, 466, 467 Imperfect knowledge, 487 Implicit learning, 623 Inarticulate knowledge, 53, 55 Incentives, 276, 304, 358, 478, 495, 539, 635, 644, 645, 690, 691, 692, 710, 736, 754, 759 Income equality, 401 Income policy, 430 Income redistribution, 406 Income tax, 460, 762 Incompleteness, 600 Indexes of Economic Freedom, 665 India, 709, 722 Indiana University, 530 Indigenous institutions, 720 Indirect means, 699 Individual action, 32, 35, 617–621 Individualism, 23, 555–557, 614, 663, 668, 716. See also Methodological individualism Individualism and Economic Order (Hayek), 2, 4, 607 Inductive inferences, 387 Industrial development, 577 Industry and Trade (Marshall), 68 Inflation, 191, 205, 240, 645, 735, 738, 744, 751, 752, 763 Informal constraints, 647 Informal institutions, 668, 720 Informal networks, 634 Informal rules, 683–685 Information, 104, 563 asymmetry, 229 defined, 51

diffusion, 266 entrepreneurship and, 99 gathering process, 694 leakage of, 386 necessity of, 645 processing costs, 275 signals, 264 subjective nature of, 95 transmission of, 94 transparency, 109 Information choice theory, 344–351 applications, 355–359 epistemic engineering and, 354–355 expert failure theory and, 353–354 in law and justice, 358 in medical research, 358–359 motivational assumptions of, 348–351 in political economy, 356–358 in religion, 355 utility maximization by experts, 348 Infrastructure, 396, 604, 710, 722 Inheritance, 556 Innovation entrepreneurship and, 529, 530, 532–535, 536, 543 evolutionary paradigm and, 580, 583 market process theory and, 513, 514 organizations and, 284 in post-Soviet transitions, 645, 658, 671 in rules and institutions, 307 Insider trading, 565, 567, 776, 777 Institute for Humane Studies (IHS), 5 Institute of Economic Affairs, 238, 240 Institutional analysis, 9, 88 Institutional diversity, 481 Institutional framework coercion and, 94 competition and, 487 for economic development, 718–721 economic development and, 720, 722 economic sociology and, 553–554 for entrepreneurship, 535–537 entrepreneurship and, 529, 535, 536 evolution of, 37, 570, 577–580 experimentation in, 481 experts and, 345 finance and, 563

796   Index Institutional framework  (Cont.) foreign interventions and, 684, 689 formal institutions, 720 government in, 635 indigenous institutions, 720 informal institutions, 668, 720 infrastructure of, 656 knowledge problem's implications for, 55–61 legal institutions, 250, 672 for market process theory, 521–522 market socialism and, 107 neuroeconomics and, 632 organizational influence on, 279 political institutions, 250, 672 in post-Soviet transitions, 647 pragmatic institutions, 327 property rights and, 304 social construction of, 553–554 social economics and, 255 transparency in, 537 Institutionalism, 36, 522 Institutional learning, 482 Institutional mechanisms, 128 Institutional theory, 508 Instrumental-causal approach, 74, 76, 79, 81, 87 Integrative social contracts theory (ISCT), 523 Intellectual entrepreneurs, 719 "Intellectuals and Socialism" (Hayek), 136 Intentionality, 121 Interaction, 32, 35, 653–662 Interactive purposivity, 121 Interest groups, 147, 278, 311, 313, 317, 422, 459, 460, 502, 661, 720, 721 Interest rates, 173, 180, 190, 191, 197, 202, 205, 217, 222, 234, 396, 565, 704, 705, 730, 731, 732, 734, 735, 737, 739, 752, 769 Internal-ratings-based (IRB), 750 International commerce, 305, 313 International Monetary Fund (IMF), 649 Interpersonal communication, 374 Interpersonal equilibrium, 21 Interregional trade, 556 Interspecies competition, 125 Interspecies cooperation, 126 Intersubjective orientation, 86

Intertemporal coordination, 179, 702, 730, 731, 738 Intertemporal discoordination, 731, 734 Interventionism, 393–416 Austrian critiques of, 396–400 credit expansion and, 410 disinterventionist dynamics and, 411 dynamics of, 405–410 for global financial crisis, 412–413 government failure and, 402–405 ideological changes and, 410–411 Mises on, 401 in mixed economy, 394–395 motivations for, 395–396, 401–402 as new paternalism, 407–408 norms and, 410–411 opportunism as motivation for, 401–402 organizations and, 272 price controls, 406 property rights and, 406–407 regulatory dynamics of, 408–409 regulatory environment and, 407 transfer dynamics of, 409 unstable minimal state and, 412 Interventionism: An Economic Analysis (Mises), 397 Intimacy, 86 Intraregional trade, 556 Intrinsic motivation, 38, 284 Introspection, 374 Invariance principle, 385 Invention, 533. See also Creativity; Innovation Investigations into the Methods of the Social Sciences (Menger), 16 Investment, 175, 645, 702, 706 Investment bankers, 758 Investment climate, 760, 764 Investment goods, 198 Investment savings, 405 Investment spending, 174 Invisible-hand theorem, 9, 133, 134, 135, 247 Involuntary unemployment, 171 Ioannidis, John P. A., 359 Iraq, 678, 679, 680, 682, 693 IRB (internal-ratings-based), 750 Irrationality of choice, 381 Irreducibility, 601

Index   797 ISCT (integrative social contracts theory), 523 IS-LM, 165, 166, 169, 170, 174 Isnard, Achille Nicholas, 74 Israel, Jonathan, 598 Italy, 447 Jackson, Andrew, 234 Jacobs, Jane, 446, 633, 634 Jacobs, Struan, 117, 132 Jaffé, William, 15, 74n5, 82 Japan, 502, 722 Jefferson, Thomas, 333 Jensen, Michael, 273 Jevons, William Stanley, 1, 15, 66, 68, 69, 74, 88, 234, 602, 603, 605 Jiwei, Lou, 764 Johns Hopkins University, 2 Johnson, Simon, 716 Joint ventures, 306 Jonathan's Coffeehouse, 332 Jones, Benjamin F., 717 Jordan, 678 Journal of Business Venturing, 530 JP Morgan Chase, 740 Judgment, 284, 285, 286, 289, 568 Judgment-based approach, 290, 291 Judicial framework, 665 Judicial independence, 646 Justice administration of, 723 distributive, 588, 670 information choice theory in, 358 political economy and, 474, 486 principle of, 520 social justice, 515 Just price mental model, 252 Kahneman, Daniel, 350, 385 Kalberg, Stephen, 550 Kaldor, Nicholas, 67n3, 69, 73, 75 Kaleidic market, 86 Kant, Immanuel, 18, 23, 420, 465, 466 Käsler, Dirk, 550 Kaufman, G. G., 229 Kaufmann, Felix, 380, 384, 630 Kenya, 678 Keynes, John Maynard

on business cycle theory, 208 capital-based macroeconomics and, 168–172 critique of capitalism, 170, 171 on economic sociology, 550 on full employment, 171 influence of, 2 on macroeconomics, 158, 164, 165, 166, 175, 179 methodology of, 29 on neuroeconomics, 623 on post-Soviet transitions, 643 on trade cycle, 172 Khama, Seretse, 721, 722, 723 Kiesling, Lynne, 45 Kilduff, Martin, 551 Kim, J., 601 King, Mervyn, 766, 768 King's College (London), 6 Kirk, Russell, 424 Kirzner, Israel on alertness, 529–546 on complexity, 596, 606 on entrepreneurship, 529, 538–543 influence of, 3, 4, 5 on interventionism, 398, 399, 400, 406 on macroeconomics, 147 on market process theory, 509, 511, 514, 515 on market theory, 65, 66, 77–87 methodology of, 29, 30, 35 on neuroeconomics, 623 on organizations, 278, 282, 283, 285, 290 on property rights, 314, 315, 316 on social economics, 263, 266 Klein, Benjamin, 81, 273 Klein, Peter G., 82, 84, 86, 272, 273, 286, 287, 288, 290, 326, 566, 567 Klineberg, Otto, 716 Knight, Frank, 3, 29, 51, 70, 74, 146, 167, 275, 278, 284, 285, 286, 368, 373, 376, 532 Knowledge. See also Knowledge problem acquisition of, 150 business cycle theory and, 730 complexity and, 599 constraints on, 61 decentralized, 504 defined, 51

798   Index Knowledge (Cont.) division of labor and, 344 economic, 263 entrepreneurship and, 538, 539 finance and, 563 homogenization of, 156 imperfect, 487 inarticulate, 53, 55 incentive problems and, 743 as information, 283 macroeconomics and, 150 market socialism and, 95 methodology and, 20 neuroeconomics and, 634 rationality and, 374 software tools and, 153 surrogates, 470 Knowledge and Decisions (Sowell), 54 Knowledge economies, 154 Knowledge problem, 45–64 constitutional political economy and, 473–482 contextual, 53–55 economic development and, 720 financial crisis and, 751, 754, 777 foreign interventions and, 681, 682 history of idea, 46–51 institutional design implications of, 55–61 interventionism and, 407, 432 market theory and, 75–77 in modern economics, 51–53 neuroeconomics and, 618 political economy and, 472, 473, 485 post-Soviet transitions and, 670 property rights and, 314, 319 public choice and, 495 Knowledge-spillover theories, 533 Kolev, Stefan, 419 Koppl, Roger, 343, 344, 345, 346, 348, 351, 352, 353, 354, 358, 535, 536, 537, 539, 542, 551, 565, 596, 599, 608, 615, 621, 622, 623, 766 Kornai, János, 107, 651 Kranton, Rachel E., 348 Kraus, W., 751, 754, 755 Kroszner, R., 241 Krugman, Paul, 420 Kuehn, Daniel, 178

Kuhn, Thomas, 613 Kurrild-Klitgaard, Peter, 551 Labor, 15, 69, 192, 395, 430, 731, 732, 742. See also Division of labor Labor-intensive production, 281 Labor unions, 404 Labour Party (UK), 763 Lachmann, Ludwig, 3, 5, 23–26, 24n4, 29, 30, 36, 83, 84, 85, 147–149, 203n31, 261, 281, 286, 456, 461, 551, 608, 623 Laidler, David, 165, 166, 169 Laissez-faire capitalism, 215, 219, 235, 236, 414, 433, 474, 476, 477 Lam, Alice, 117n5 Lame ducks, 331, 332 Landlord and tenant law, 471 Land use, 318, 396 Lane, David A., 596 Lange, Oskar Ryszard, 75, 97, 98, 101–107, 110 Langlois, Richard, 5, 6, 157, 283 Langrill, Ryan, 547 Language, 128, 261, 327, 598 Laski, Kazimierz, 112 Lastrapes, W. D., 180 Lavington, Frederick, 169 Lavoie, Don, 5, 23–26, 29, 36, 54, 55, 86, 117n6, 248, 256, 257, 260, 396, 400, 500, 551, 597, 608, 710 Law, Legislation and Liberty (Hayek), 248, 434, 435, 471, 613 Law and Economics Center at GMU, 6 Law of contract, 471 Law of reflux, 217 Layoffs, 177 Lazear, E. P., 533 Leadership charismatic, 714 cognitive, 283, 284 economic development and, 715–718, 721–723 organizations and, 285 in post-Communism transitions, 660–661 Leadership-centric bias, 716 Lebanon, 678 Lectures on Jurisprudence (Smith), 331 Lee Kuan Yew, 723

Index   799 Leeson, Peter, 257, 261, 355, 491, 492, 493, 496, 497, 498, 500, 501, 502, 503, 556, 664, 720 The Legacy of Max Weber (Lachmann), 3, 24, 551 Legal institutions, 275, 280, 304, 358, 646, 651 Legitimacy, 465, 471, 476 Lehman Brothers, 740, 752, 765 Leijonhufvud, Axel, 169, 170 Lender-of-last-resort (LOLR), 218, 223, 224, 229, 570, 745 Lenin, Vladimir, 655 Lerner, Abba, 75, 97, 98, 110–111 "Letter to l'Abbé Terray" (Turgot), 88 Levant Company, 330 Leverage, 754, 755 Levitt, Steven D., 626 Levy, David M., 345, 348, 350, 356, 359 Lewes, George Henry, 601 Lewin, Peter, 6, 145 Lewis, Alain A., 349 Lewis, Paul, 248, 601, 615 Liberalism, 118, 168, 433, 488 Liberalization, 652, 654 Liberal market socialism, 476 Liberia, 678 Libertarianism, 4 Libertarian Microfiche Publishing project, 241 Libertarian paternalism, 357 Liberty, 426, 467 Libya, 678, 679, 682, 693 Lie, John, 556 Lilico, Andrew, 761 Linder, Stefan, 272 Linguistic hierarchies, 598 Lippmann, Greg, 756 Lippmann, Walter, 423, 432, 433 Liquidity, 171, 172, 180, 763 List, John A., 626 Lloyd, Seth, 595, 598 Lloyds TSB, 755 Loasby, Brian, 278, 608 Local knowledge, 117n6, 398 Local truth, 351, 354 Locke, John, 305 Loewenstein, George, 626 Logic, 376, 377, 379, 382–384, 385, 389, 599 Logical causality, 74n5

Lombard Street (Bagehot), 223 London School of Economics (LSE), 2, 3, 164 London Stock Exchange, 324, 325, 327, 330–332 Long, Roderick, 377, 379 Long-Term Capital Management, 224, 755 Lopez, Edward J., 400, 405, 501 Loss signals, 692 Lower-order goods, 190 Lucas, Robert, 510, 698 Luckmann, Thomas, 551 Ludwig von Mises Institute at Auburn University, 6 Luther, William, 180, 195n19 MacArthur, Douglas, 722 MacCallum, S. H., 449 Macfie, Alec, 134 Machlup, Fritz, 2, 26n5, 47, 421, 434, 565 Machovec, Frank M., 69, 73 MacIntyre, A., 454 Mack, John, 758 Mackay, Charles, 355 Macroeconomics. See also Keynes, John Maynard; Mises, Ludwig von Austrian business cycle theory (ABCT), 186–212 capital-based, 164–185 capital theory, 145–163 free banking theory, 213–244 interventions, 396 stabilization, 644, 652 Madison, James, 333 Madoff, Bernie, 759 Majority-rule voting, 494 Maki, Uskali, 5 Mali, 678, 693, 708 Malinvestment, 176, 281, 422, 732, 733, 743 Malmendier, Ulrike, 328 Man, Economy and State (Rothbard), 4 Mandela, Nelson, 722 Mandeville, Bernard, 130, 131, 132, 325 Manish, G. P., 698 Mankiw, Greg, 760 Manne, Henry, 6 Manual labor, 708 Marchal, Jean, 278 Marginal cost rule, 106

800   Index Marginal costs, 110 Marginalist theory, 15 Marginal productivity, 108 Marginal utility, 604, 605 Maritime commerce, 313 Marked-to-market, 571, 772 Market-based entities, 454 Market-coordinated monetary organization, 564 Market order entrepreneurship and, 540–541 neuroeconomics and, 630–631 Market process theory, 508–526 analysis of, 2, 8, 408, 501 on capitalism, 512–514 implications, 514–517 institutional framework for, 521–522 normative process theory, 517–521 theoretical core, 509–511 Markets coordination in, 272 currency, 565 decentralization of, 470 as discovery process, 74, 298 equilibrium in, 540 exchange, 272 failure, 71, 230 pricing mechanisms, 128, 262, 263, 457, 504 as social phenomena, 554 volatility in, 760 Market socialism, 21, 94–114 defined, 96–97 Dickinson on, 109–110 Durbin on, 108–109 entrepreneurship and, 94–95 Hayek's critique of, 98–101 historical forerunners of, 97–98 impossibility theorem, 95–96, 111–112 institutional framework and, 107 Lange's contribution, 101–107 Lerner on, 109–110 Mises's critique of, 98–101 Market theory, 65–93. See also Market process theory classical approach, 66–68 entrepreneurial process and, 77–81 general equilibrium theory and, 72–73

Kirznerian, 77–87 Knight-Stigler thesis, 73–75 knowledge problem and, 75–77 price system and, 68–71 Market Theory and the Price System (Kirzner), 4, 408 Markose, Sheri M., 600 Marshall, Alfred, 29, 66, 68, 75, 88, 105, 581 Martin, Adam, 13, 119n 13, 127, 635 Marx, Karl, 15, 66, 67, 549, 714, 716 Marxism, 101, 147, 491 Mathematical formalism, 121 Matthews, J. Rosser, 358 Maximization, 52, 274, 349, 510 "Max-U" notion of human agency, 261 Mayer, Hans, 2, 74 MBSs. See Mortgage-backed securities McCabe, Kevin A., 624, 626 McCallum, Bennett, 238n 19 McCleary, Rachel M., 662 McCloskey, Deirdre, 261, 653 McGuire, Patrick, 551 McKenzie, Craig R. M., 386 McKenzie, Lionel, 72 McKillop, Tom, 757 McMullen, J., 539 McNulty, Paul J., 68, 70, 73, 74 McQuade, Thomas J., 612, 615, 629, 631, 632, 633 Meadowcroft, J., 248, 259 Meckling, William H., 273 Medical assistance, 688 Medical research, 343, 358–359 Medium of exchange, 237 Meltzer, Allan, 764 "Men as knaves" criterion for evaluating institutions, 59 Menger, Carl on business cycle theory, 730 on complexity, 594, 595, 596, 600, 602–604, 605 on economic sociology, 549, 557 on evolutionary paradigm, 576, 577–580, 587–589 on free banking, 213 influence of, 1, 8 on macroeconomics, 145, 148, 153

Index   801 on market process theory, 510 on market theory, 68, 72, 74, 75, 82 methodology of, 13, 15–17, 26, 30, 34, 35 on money, 16 on neuroeconomics, 618 on ordoliberalism, 419 on rationality, 370 on social economics, 248 on spontaneous order, 135 on stock markets, 326, 327, 337 Mental models, 251, 252, 253, 267, 282, 283 Mercantilist regimes, 447 Mercatus Center, 500 Merger and acquisition (M&A) activity, 277 Merton, Robert, 121n 16 Mesopotamia, 309 Meta-complexity level, 595 Meta-constitutionalism, 522, 524 Meta-level interventions, 682–685 Meta-rules, 680, 685 Methodenstreit, 16, 419, 577, 603 Methodological dualism, 615 Methodological individualism, 4, 8, 492, 551, 577, 587, 604, 615, 759 Methodological interactionism, 615 Methodological subjectivism, 4, 8, 23 Methodology, 13–42 Austrian focus on, 13–14 epistemological problems, 14–26 of Hayek, 20–23 of Lachmann, 23–26 of Lavoie, 23–26 of Menger, 15–17 of Mises, 17–20 Meulen, Henry, 233 Mexico, 665 Michels, R., 459 Michigan, 235 Microeconomics, 43–142 knowledge problem and, 45–64 market socialism, 94–114 market theory, 65–93 spontaneous order, 115–142 Microfoundations, 28, 30 Miles, David, 229, 230 Milgrom, Paul, 345, 346, 347 Military aid, 693

Military peacekeeping efforts, 686 Mill, John Stuart, 15, 233, 241, 601, 604 Minai, Ali A., 354 Mind-dependence, 372, 378 Minimum wage, 403, 404, 430 Minniti, Maria, 529, 539 Minority homeownership, 738 Minsky, Hyman, 193n 17, 412, 571 Mirowski, Philip, 68, 69 Mises, Ludwig von on agency, 80 on business cycle theory, 187, 208 on complexity, 594, 596, 605, 606 on economic development, 700, 702, 706, 708, 711, 720 on economic sociology, 548, 551, 553, 554, 556, 557 on evolutionary paradigm, 580, 581, 584 on finance, 566, 567 influence of, 2, 7 on interventionism, 398, 400, 405, 412 on knowledge problem, 46, 47, 49 on macroeconomics, 149, 164, 165, 173, 177, 178 on market process theory, 510, 511 on market socialism, 97, 98–101, 112 on market theory, 65, 74, 78, 79, 82, 86, 87 methodology of, 13, 17–20, 25, 26, 29, 30, 34 on neuroeconomics, 616, 623, 634 on ordoliberalism, 421, 425, 435 on organizations, 272, 273, 278, 279, 281, 283, 284, 285, 286, 287, 288, 289 on post-Soviet transitions, 643, 653 on property rights, 298, 302, 307, 309, 315, 317, 318 on public choice, 494, 495, 499 on rationality, 370, 383 on social economics, 248, 253, 259, 260, 262, 265 on spontaneous order, 135 on stock markets, 327 Mises Institute, 238, 240 Mission creep, 691 Mixed economy, 393, 412, 414 Monetarism, 3 Monetary policy credit expansion, 410

802   Index Monetary policy  (Cont.) deflation, 178 equilibrium, 744, 745 expertise and, 356 financial crisis (2007–2009) and, 734–738, 744–746, 769 interventionism and, 396 macroeconomics and, 180 Monetary prices, 316, 686 Monetary theory, 169, 606 Monetary Theory and the Trade Cycle (Hayek), 607 Money, 378, 730 adaptive value of, 579 credit creation and, 173, 180 as "organic" institution, 578 origin of, 34, 213, 337 Money and Credit (Mises), 606 Money supply, 731, 732 Monism, 516 Monopolistic competition theory, 71 Monopolistic state, 460 Monopoly, 80, 235, 309, 331, 353, 429 Montalvo, Jose G., 717 Mont Pèlerin Society, 423, 433, 434, 435 Moral hazard, 215, 225, 227, 285, 289, 290, 737, 745, 753, 756 Moral indeterminacy, 517 Morality, 128, 131, 518, 586, 587, 661–662, 668, 673 Moral pluralism, 485 Moral theory, 134 Morgan, C. Lloyd, 601 Morgenstern, Oskar, 2, 47, 48n 2, 52, 72 Mortgage-backed securities (MBSs), 196, 413, 737, 740, 775 Mortgages, 736, 750 Mortimer, Thomas, 331, 332 Motivation, 289 Müller-Armack, Alfred, 424 Mulligan, R. F., 571 Mullineaux, D. J., 232n 14 Multiplier effects, 581, 692 Mundane price theory, 82 Murphy, Bob, 771 Murphy, Gardner, 715 Murrell, Peter, 646, 719

Muscovy Company, 325, 330, 331 Mutability, 629 Mutual determination, 74 Mutual funds, 228 Mutual insurance arrangements, 310 Mutual protection, 302, 304 Mutual tolerance, 662 Naka, Shigeto, 502 Natanson, Maurice, 371 National Academy of Sciences, 358 National Bureau of Economic Research (NBER), 186 National defense, 401, 690 Nationalization, 762 Nationally recognized statistical rating organizations (NSROs), 356 Nation building, 684 Nationwide branch banking sys-tems, 236 NATO (North Atlantic Treaty Organization), 682, 687 Natural morality, 586 Natural price, 69 Natural sciences, 135, 615 Natural selection, 576, 577, 582, 583, 586 The Nature and Essence of Economic Theory (Schumpeter), 364 NBER (National Bureau of Economic Research), 186 Nee, Victor, 558 Negative equity (underwater), 740 Nelson, John D., 386 Nelson, R. R., 582, 583 Neoclassical economics behavioralism and, 365 competition in, 263 complexity and, 602, 603, 604, 606 disequilibrium analysis, 77 economic development and, 705 economic sociology and, 547, 548, 553, 555, 557 entrepreneurship and, 538 equilibrium models, 53 financial crisis and, 730, 731, 753 foundations, 102, 564 growth models, 151, 178 influence of, 13

Index   803 knowledge problem and, 48 on macroeconomics, 147 marginalism, 605 market process theory and, 510, 512, 514 market theory and, 78, 88 models, 535 political economy and, 475, 481 post-Soviet transitions and, 646, 647, 672 price theory, 274 public utility regulation, 58 Neoliberalism, 423 Neo-Ricardians, 147 Network effects, 485 Neumann, John von, 52, 72, 598 Neuroeconomics, 612–640 adaptive systems theory, 627–634 agency and, 617–624 economic expectations and, 622–624 Hayek on, 617–624 individual behavior and, 617–621 market order and, 630–631 scientific order and, 631–633 social order and, 628–630 Neutral rate, 171 New Deal, 743 New institutional economics, 8 Newman, A. F., 532, 533 New paternalism, 407–408 Newton, Isaac, 221 New York (state), 234 New York City, 235, 318, 324, 325, 327, 330, 333–336 New York Stock Exchange, 333–336 New York University (NYU), 2 New Zealand, 412 Nexus-of-contracts approach, 274, 277 NGOs. See Nongovernmental organizations Nicoara, Olga, 643 Nixon, Richard, 222 Nobel Prize, 5, 613 Nominal price, 221 Noncomputability, 600 Nongovernmental organizations (NGOs), 689, 690, 692 Nonintervention, 720 Nonperforming loans, 740 Nonpolynomial computability, 598

Nonprice signals, 265, 266 "Normal country" thesis, 664–671 Normative process theory, 517–521 Normative significance of rationality, 366 Norms, 301, 517, 523, 647, 683 North, Douglass, 60, 88, 252, 253, 254, 660, 662, 672, 718, 719 North Atlantic Treaty Organization (NATO), 682, 687 Northern Rock, 749, 750, 752, 753, 755, 756, 768, 776 Note-clearing system, 216, 222 Novelty, 78n 9, 278, 583 Novelty-seeking action, 584 Nozick, Robert, 477, 519 NSROs (Nationally recognized statistical rating organizations), 356 Nutter, G. Warren, 4 NYU Austrian program, 5 Obedience, 716 Objective exchange value, 367 Objectivism, 25, 105 Obolonsky, Alexander V., 668 O'Connor, J., 446 O'Donoghue, Ted, 625 O'Driscoll, Gerald, 5, 6, 29, 30, 608 Ohanian, Lee E., 178 Oligarchy, 534 Oligopolies, 430 Olken, Benjamin A., 717 Olson, Mancur, 499, 502 Omniscience, 59, 753 Oncken, August, 132 "On the Essence of Economic Crises" (Schumpeter), 581 OP. See Original position Open access orders, 662 Open Board of Brokers, 336 Open markets, 428 Operational norms, 517 Opinion polls, 764 Oppenheimer, Franz, 296, 300, 309, 311, 393 Opportunism, 276 Opportunity cost, 59, 350, 603, 605, 710 Oprea, Ryan, 627 Optimal resource-allocation problems, 510

804   Index Optimization models, 453 Optimum rate, 171 Option contracts, 324, 329, 335 Options-pricing models (Black-Scholes), 571 Order-based policy, 424, 427–431, 435 Ordnungstheorie approach, 422 Ordoliberalism, 419–444 Hayek on, 432–438 history of, 420–424 order-based policy, 427–431 theory of orders, 424–427 ORDO Yearbook, 423 Organic institutions, 327 Organizational boundaries, 277 Organizational complexity, 759 Organizations, 272–295 efficient firm boundaries, 287–288 institutional framework influenced by, 279 internal organization of, 288–289 judgment-based positive theory of, 286–289 multiperson firms, 286–287 one-person firms, 286 theories of, 274–285 Original position (OP), 466, 468, 483, 484 Orwell, George, 385 Osborne, George, 767 Ostrom, Elinor, 36, 249, 438, 481, 482, 635 Ostrom, Vincent, 36, 249, 438, 458, 522, 635, 660 Out-of-equilibrium exchanges, 75, 77, 83 Overconsumption, 732 Overemployment, 176 Overexpansion of credit, 217 Overinvestment, 692 Overoptimism errors, 409 Overpessimism errors, 409 Ownership of means of production, 84, 98 Ownership rights, 282, 566. See also Property rights Oxford University Press, 8 Padilla, Alexandre, 565 Paganelli, Maria Pia, 67n 2 Pakistan, 678 Paleoliberalism, 423 Pantaleoni, M., 457 Paper money, 214

Papola, John, 179 Parametric prices, 65, 70, 79, 104 Pareto, V., 456 Parker, S. C., 532, 533 Paternalism, 396 Path-dependency, 621, 629, 650, 655, 656, 661, 718, 719 Pattern prediction, 374, 413, 614, 615 Paulson, Hank, 755, 766, 769, 773 Paulson, John, 772, 775 Peart, Sandra J., 345, 348, 350, 356, 359 Pejovich, Svetozar, 659 Pennington, Mark, 248, 259, 464 Perception, 619 Perestroika, 652, 655 Perfect competition, 70, 102 Perfect knowledge, 76 "The Perils of Regulation" (Kirzner), 399 Perverse political incentives, 401 Peston, Robert, 758, 768 Peterson, Shorey, 73 Phenomenology, 551 The Phenomenology of the Social World (Schutz), 47, 551 Phenotypes, 583 Philippines, 678 Philosophy, 38 The Philosophy of Money (Simmel), 549 Physicians, 343 Physics, 70 Pigou, Arthur Cecil, 71, 169, 274, 581 Pipes, Richard, 668 Piracy, 313 Planned investments, 190 Planometrics, 106 Platteau, Jean-Philippe, 555 Pluralism, 515, 516, 518, 519 Poland, 646, 649, 660, 661, 663, 672, 719 Polanyi, Karl, 97, 98, 100, 101, 108, 112 Polanyi, Michael, 116, 117, 117n 5, 117nn7–8, 132, 306 Policy activism, 168 Policy-based distortions, 208 Policy uncertainty index, 765 Political competition, 690, 691 Political economy, 247, 404, 417–526, 746 constitutional, 464–490

Index   805 of financial crisis (2007–2009), 739–740 of foreign intervention, 678–697 information choice theory in, 356–358 knowledge problem implications for, 57 market process theory and, 508–526 ordoliberalism, 419–444 pricing mechanisms in, 457 processes of, 300 public choice and, 491–507 tax state and, 445–463 Political entrepreneurship, 317–319, 502 Political favoritism, 499 Political legitimacy, 471, 476 Political profits, 691 Polity-based entities, 454 Pollution control, 480 Polycentric order, 116 Polynomial computability, 598 The Population Problem (Carr-Saunders), 585 Portfolio theory, 565 Portuguese East India Company, 331 Positivism, 25, 69 Postcrisis recovery, 558. See also Financial crisis (2007–2009) Post-Soviet transitions, 643–677, 719. See also specific countries case studies, 663–671 culture's impact on transition, 656–660 interaction thesis, 653–662 Kornai on, 651–653 leadership's impact on transition, 660–661 lessons learned, 648–662 "normal country" thesis, 664–671 spiritual capital's impact on transition, 661–662 transition studies, 644–648 Western economists and, 649–651 Potts, Jason, 354 Poverty, 479 Powell, Benjamin, 627, 698 Powell, Walter W., 556 Power and Market (Rothbard), 400 Power relations, 38, 426, 427, 437 Pragmatic institutions, 327 Praxeology, 17, 18, 19, 20, 29 Preference consistency, 387–388

market process theory and, 515, 516 ordering, 372 time preference, 191, 699–705, 707 transitivity, 388 Prelec, Drazen, 626 Pre-scientific hunch, 84 Prescott, Edward C., 178 Present consumption, 201 "The Pretense of Knowledge" (Hayek), 585 Price attribution bias, 773 consumer goods, 103 controls, 315, 318, 406, 722 coordination, 777 discrimination, 57, 430 fetishism, 772 of labor, 395 liberalization, 644 naiveté, 771–774 regulation, 316 signals, 61, 264, 265, 469, 475, 731, 740 stability, 240 system, 612 theory, 36, 563 volatility driven by, 564 Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard (Hayek), 164, 166, 167 Prigogine, Ilya, 597 "The Primacy of the Abstract" (Hayek), 619 Primo, D., 461 Princeton University, 2 Princeton University Press, 8 Principal-agent models, 274, 346, 348, 350, 351 Principles of Economic Policy (Eucken), 423 Principles of Economics (Marshall), 68 Principles of Economics (Menger), 15, 68, 602, 607 Prior activation pathways, 629 Private goods, 449 Private investment, 655, 710, 743, 760, 761 Private knowledge, 46, 56, 275 Private money, 213 Private ordering, 456 Private property, 100, 101, 111, 127, 262, 287, 395, 425, 429, 454, 455, 470, 475, 476, 487, 643, 714

806   Index Private residential communities, 481 Privatization, 644, 649, 652, 654 Probabilistic risk, 275 "The Problem of Social Costs" (Coase), 659 Procaccia, Uriel, 668 Process-based policy, 427 Process justice, 519 Process social theory, 509 Process theory, 508 Producer goods, 699 Product development, 154 Production, 145, 189, 281, 635 Production triangle, 145 Productivity, 499 Profit-and-loss accounting, 264, 512, 647, 690, 691 Profit-maximizing bank, 220 Profits, Interest, and Investment (Hayek), 167 Profit-seeking, 131, 133, 273 A Program for Monetary Stability (Friedman), 237 Progressivism, 357, 411 Project Merlin, 767 Propaganda, 239 Property rights, 2, 8, 33, 100, 128, 151, 274, 276, 278, 296–323, 397, 400, 452, 645, 646, 658, 661, 718, 766 in close-knit communities, 305–307 cooperation as route to, 301–305 economics vs. politics in, 312–315 entrepreneurship and, 305–307 extortion and, 307–312 interventionism and, 406–407 market entrepreneurship and, 315–317 political entrepreneurship and, 317–319 recognition of, 298–301 rule of law and, 297–298 scarcity and, 297–298 Proportional representation, 461 Protection racket, 309, 310 The Protestant Ethic and the Spirit of Capitalism (Weber), 549 Protestantism, 549 Proxy-entrepreneurs, 288 Prychitko, David L., 76n 7, 193, 193n 17, 261, 402, 403, 404, 571 Pryor, Frederic L., 598

Psychic processes, 618 Psychological economics, 364 Psychology, 20, 343, 624 Public Choice Center. See Center for Study of Public Choice at GMU Public choice economics, 2, 8, 491–507 Buchanan on, 497–498 George Mason University and, 500 government scope and power limitation, 494–497 history of, 498–503 theory, 344, 422 Public debt, 459–460 Public domain, 313, 317 Public goods, 395, 449, 450, 635 Public ordering, 456, 457 Public-sector decision-making, 491, 501 Public transit, 452 Publilius Syrus, 757 Pure competition, 621 Pure entrepreneurs, 80, 86 Pure logic of choice, 366 The Pure Theory of Capital (Hayek), 166, 167, 432, 605 Puritanism, 131, 549 Putin, Vladimir, 649 Putnam, Robert D., 254 Qualitative research, 38 Quarterly Journal of Austrian Economics, 240 Rabin, Matthew, 625 Radical innovation, 540 Radical subjectivism, 28 Radius of trust, 254 Rae, John, 132 Raiding for plunder, 309 Rajan, Raghuram, 648 Randomized controlled trials (RCTs), 358 Rate of interest. See Interest rates Rate of return, 174 Rate shopping, 356 Rational choice model, 17, 36, 37, 345, 492, 493, 548 Rational constructivism, 681, 682 Rational economic calculation, 397, 494 Rational ignorance, 398

Index   807 Rationalism constructivist, 471, 472, 624 critical, 613 Rationality, 364–392, 455, 563, 607, 620, 621, 624, 753 abstract criteria of, 380, 381 of belief, 384–387 ecological, 624 egoistic, 348 of estimates, 384 fundamental, 384 Hayek on, 372–376 of human behavior, 366 logic and, 382–384 meaning and, 381–382 mind-dependency of economics, 366–380 Mises on, 379–380 normative significance of, 366 preference consistency and, 387–388 Schutz on, 371–372 in tax state, 453–457 Wittgenstein on, 376–380 Rational optimization, 534 Rau, Karl Heinrich, 602 Rauch, James, 555 Rawls, John, 464, 465–469, 473–480, 483–484 RBS, 755, 757, 758 RCTs (randomized controlled trials), 358 Realism, 17 Realistic-empirical theory, 16 Reallocation of resources, 739 Real productivity, 645 Recession, 739, 751, 752 Reciprocal adjustment, 516 Reciprocity, 253, 254, 258, 329, 653, 658 Recovery, 751, 752. See also Stimulus and recovery programs Reder, Melvin, 71 Redistribution, 311, 409 Redundancy, 344 Regime uncertainty, 743, 744, 759–770 Regional specialization, 537 Regression theorem, 34 Regulatory capital ratio, 755 Regulatory capture, 231, 356, 569 Regulatory framework burden of federal laws, 567

capital regulation, 230 expert failure and, 356 financial crisis (2007–2009) and, 734–738 institutions for, 763 interventionism and, 407 knowledge problem and, 58 taxation and, 457 Regulatory-state capitalism, 409, 410 Relative costs, 277, 570 Relative prices, 33, 173, 176, 221, 406, 407 Relative zero point, 704 Relativism, 25, 518 Religion, 327, 355, 663 Rent controls, 318 Rent seeking, 257, 280, 502, 689, 691 Representativeness bias, 350 Reputation, 265, 266, 329, 501 Rescher, Nicholas, 508 Research and development, 732 Resentment, 515 Reserve funds, 398 Reserve ratios, 217 Resnick, Mitchel, 125n 20 Resource allocation, 156, 250, 495, 504 Resource constraints, 176 Resource costs, 237 Respect, 254, 662, 716 Responsibility, 720 Restitution, 312 The Retreat to Commitment (Bartley), 613 Review of Austrian Economics, 240, 503 Reynal-Querol, Marta, 717 Ricardo, David, 15, 66, 67, 68, 69, 74, 105 "The Ricardo Effect" (Hayek), 167, 177 Ridley, Matt, 307, 775 Right of first possession, 302 Risinger, Michael, 350 Risk, Uncertainty, and Profit (Knight), 70, 73 Risk externalization, 187, 192, 193, 202, 208 Rivalry and Central Planning (Lavoie), 6 Rizzello, Salvatore, 621 Rizzo, Mario, 5, 6, 29, 74, 88, 357, 364, 407, 608 The Road to Serfdom (Hayek), 168, 399, 402, 433, 471, 499, 614 Robbins, Lionel, 2, 71, 188, 365, 388 Robbinsian maximizer, 30, 80 Roberts, J., 345, 346, 347

808   Index Roberts, Russell, 179 Robertson, Dennis, 166, 169 Robinson, James A., 716 Robinson, Joan, 74, 274 Robust political economy, 58 Rockoff, Hugh, 238 Rodrik, Dani, 719 Roemer, John, 112 Romania, 665 Roosevelt, Franklin D., 715, 760, 762, 763 Roper, W. C., 98 Röpke, Wilhelm, 117, 421, 422, 423, 424, 426, 427, 430, 431, 432, 433, 434, 435, 437 Rorty, Richard, 25 Roscher, Wilhelm, 15, 602, 603, 604 Ross, Stephen A., 346, 347 Rosser, J. Barkley, Jr., 594, 595, 596, 597, 598, 599 Rotberg, Robert I., 722 Rothbard, Murray N., 3, 5, 26n 5, 82, 84, 86, 86n 22, 164, 168, 173, 178, 189n 9, 233, 273, 283, 285, 288, 289, 567, 702, 708, 711, 719 Roucek, Joseph S., 359 Roundaboutness, 161, 189, 191, 192, 193, 194, 195, 199, 205, 730, 731 Rule-based policies, 427 Rule of law, 297–298, 646, 647, 654, 655, 658, 659, 661, 665, 669, 671, 672, 714 Rules-constrained interventions, 685–689 Rules of conduct, 586, 587 Rummel, P. J., 717 Run-in bias, 358 Runst, P., 257 Russia, 447, 646, 649, 651, 655, 657, 661, 665, 669, 719 Russian Orthodox church, 668 Rüstow, Alexander, 423 Sachs, Jeffrey, 649, 654 Sacks, Meghan, 353, 358 Sah, Raaj Kuma, 347 Saleableness, 579 Salerno, Joseph, 82, 86, 178, 195, 283 Salsman, R., 238 Same choice problem, 385 Samuelson, Paul, 2, 3, 73, 236, 647 Sanctions, 304 Sandmo, Agnar, 498

Sanfey, Alan G., 625 Santa Fe Institute, 633 Sarasvathy, S. D., 531 Sautet, Frederic, 65, 537, 554 Saver lenders, 569 Savings, 702, 704, 707, 708, 710 Say, Jean-Baptiste, 67, 74, 278 Sayama, Hiroki, 354 Scalability, 458 Scarcity, 297–298 Schelling, Thomas C., 595 Schick, Frederic, 385 Schiff, Peter, 775 Schlesinger, Karl, 72 Schmitz, J. A., 533 Schmoller, Gustav von, 419, 602, 603, 604 Schoeck, H., 515 Schotter, Andrew, 52 Schuler, Kurt, 232 Schumpeter, Joseph on complexity, 596 on economic development, 707 on economic sociology, 552 on entrepreneurship, 529, 530, 532, 533, 540, 541, 543 on evolutionary paradigm, 576, 577, 580–584, 588, 589 influence of, 2 on market process theory, 511, 513 on market theory, 67, 72, 82, 84, 85 on organizations, 277, 278 on public choice, 497, 499 on rationality, 364, 367, 368, 369, 370, 375 on tax state, 446–448, 457 Schutz, Alfred, 25, 36, 46, 47, 48, 51, 52, 53, 86, 366, 372, 374, 376, 380, 551, 557 Schwartz, Anna J., 356 Schwartz, Michael, 551 Sciences, 70, 379, 631 Scientific order, 631–633 Scientism, 22 "Scientism and the Study of Society" (Hayek), 21, 29 Scotland, 219 Scott, Walter, 233 Scottish Enlightenment, 118, 129, 325, 425, 600, 607

Index   809 Scottish free banking, 233, 234 Seabright, Paul, 125n 20, 127 Searing, Donald D., 716 Sechrest, Larry J., 238 Secondary deflation, 178 Secondary mortgage market, 192, 195 Second Bank of the United States, 234 Second-order goods, 699 Securities Exchange Commission (SEC), 356 Securitization, 324 Selective distortion, 319 Self-correction, 266 Self-determination, 284, 663 Self-fulfillment thesis, 399, 410 Self-governance, 249 Self-interest, 59, 67, 130, 131, 306, 356, 467, 474, 496, 659 Self-management socialism, 112 Self-regulating system, 326 Selgin, George, 5, 180, 221, 238, 240, 327, 744 Sen, Amartya, 387 Senior, Nassau William, 67 Sennholz, Hans, 3 The Sensory Order (Hayek), 22, 23, 50, 51, 53, 366, 370, 372–376, 379, 539, 585, 599, 601, 607, 612–640 Separability thesis, 435 Separateness of persons, 465 Shackle, G. L. S., 3, 30, 583, 608 Shared mental models, 251–253, 264 Shenoy, Sudha, 175, 708 Shepherd, D., 539 Sherk, James, 764 Shleifer, Andrei, 650, 664 Shock therapy approach, 649, 654, 661, 719, 722 Short sales, 324 "Shovel-ready" projects, 742 Shubik, Martin, 52 Simmel, Georg, 549 Simon, Herbert, 52, 621 Simons, Henry, 431, 434 Der sinnhafte Aufbau der sozialen Welt (Schutz), 371 Skidelsky, Robert, 181 Skousen, Mark, 175, 565 Slavery, 127, 300, 301

Small-numbers bargaining, 275 "Small tent" complexity, 597 Smelser, Neil J., 550, 552 Smith, Adam, 15, 65, 67, 69, 73, 74, 88, 123, 126, 129, 132, 133, 134, 152, 247, 248, 325, 472, 547, 600, 647, 661, 671, 723 Smith, Barry, 17 Smith, Daniel J., 713 Smith, V. C., 233 Smith, Vernon L., 52, 624 Smuggling, 313 Snowdon, Brian, 651 Sobel, Russell S., 535, 537 Social capital, 248, 266, 661, 662 Social cooperation, 19, 658 Social coordination, 111 Social Darwinism, 577 Social economy, 247–271 cultural tools for, 255–257 discovery process and, 262–266 economics of meaning and, 259–262 generalized norms and, 253–255 shared mental models and, 251–253 social networks and, 257–259 social order and, 262–266 systematizing research program for, 249–259 Social embeddedness, 38 Social epistemics, 37 Social epistemology, 355 Social evolution, 579 Social institutions, 486, 548, 576, 577–580 Socialism, 94, 170, 171, 272, 397, 584, 612, 706, 707. See also Market socialism calculation debate, 47, 287, 432, 643, 711 Socialism (Mises), 98, 606 Socialism after Hayek (Burczak), 112 Socialization of investment, 180 Social justice, 515 Social learning, 60, 265, 266 Socially embedded resources, 251, 254, 262, 265, 521 Social Market Economy, 420, 424 Social networks, 257–259, 266, 267, 553, 557 Social norms, 266, 521 Social ontology, 28

810   Index Social order, 262–266, 465, 628–630, 683 "Social" or heterodox economics, 38 Social phenomena, 549 Social sciences, 70, 129, 136, 372, 376, 615, 617 Social-scientific explanation, 24 Social structures, 32, 33, 33n 8, 36, 261 Social systems, 629 Social utility, 698 Social welfare, 698 Societe Generale, 755 Sociology. See Economic sociology Software, 153 Solidarity, 303, 304, 586, 588 Solidarity movement (Poland), 660 Solow, R. M., 151, 705, 709 Solzhenitsyn, Alexander, 670 Somalia, 502, 678 Sombart, Werner, 419 Sorenson, O., 532 Sound money environment, 176 Soviet Union, 412, 643, 646 Sowell, Thomas, 54 Special-interest groups. See Interest groups Specialization, 156, 343, 344, 537 Specificity, 149, 733 Speculative beliefs, 21 Spencer, Herbert, 241, 604, 605, 716 Spending-pattern changes, 173 Spillover effects, 394, 680, 693, 745 Spiritual capital, 661–662 Spontaneity, 128, 588 Spontaneous coordination, 687 Spontaneous order, 30, 115–142, 326, 337, 426, 434, 470, 554, 635, 679, 685, 686 categories of order, 123–128 defined, 115–123, 117nn7–8 history of, 128–136 stock markets and, 325–327 Spooner, Lysander, 241 Spruynt, H., 449 Sraffa, Piero, 71, 74, 166 Stability of possession, 486 Stabilization, 215, 654 Stackelberg, Heinrich von, 437 Stages-of-production approach, 733 Stalin, Josef, 715 Standards of moral evaluation, 484

Stanford University, 530 Stanford University Press, 8 State coercion, 95 State-led development planning, 714 "The State of the Debate" (Hayek), 100 Stationary economy, 70 Steele, G. R., 168 Steuart, James, 74 Stifled discovery process, 400 Stigler, George, 51n 4, 69, 71, 73, 433, 510 Stiglitz, Joseph, 347, 510, 649, 654 Stigmergy, 119n 13 Stimulus and recovery programs, 158, 741, 742, 743 Stochastic problem, 51 Stockholm School of Economics, 6 Stock markets, 324–340 in Amsterdam, 328–330 in London, 330–332 in New York, 333–336 spontaneous order and, 325–327 Stonier, Alfred, 371 Storr, Virgil Henry, 119n 13, 247, 253, 257, 258, 259, 260, 261, 547, 548, 551, 554, 557, 558 Strategic entrepreneurship, 532 Streissler, Erich W., 15, 37, 602 Streit, Manfred, 614 Stringham, Edward Peter, 324, 502 Strong, Benjamin, 356 Strong emergence, 601 Structural incentives, 742 Structural integrity, 629 The Structure of Scientific Revolutions (Kuhn), 613 "The Study of Administration" (Wilson), 357 Subjectivity, 8, 20, 34, 36, 37, 84, 96, 102, 109, 564, 614, 615, 698, 700, 753. See also Methodological subjectivism of choice, 30 of individual decision-making, 580 knowledge and, 282 meanings of individuals, 261 of means and preferences, 563 mental phenomena, 22 nature of costs, 105 opportunities and, 86 probability, 351

Index   811 utility, 29 of value and expectations, 145 value approach, 365, 367, 370 Subsidies, 398, 405, 409 Substitutability, 147, 148 Supervention, 601 Supply-chain management, 157 Surplus-spending units (SSUs), 569 Sustainable growth, 176 Sutherland, J., 565 Sutter, Daniel, 501 Swedberg, Richard, 548, 550, 552 Sweden, 666 Swedish East India Company, 331 Swidler, Ann, 255 Switzerland, 219, 708 Symbiosis, 125, 126 Sympathy, 350, 352 Synoptic delusion, 477 Syracuse University, 530 Systematic heuristic bias, 583 System of sharing information, 331 Taboos, 584 Tacit knowledge, 53, 96, 263, 537, 612 Taleb, N., 570 TARP. See Troubled Asset Relief Program Tâtonnement (groping), 75 Taxation, 180, 309, 395, 398, 405, 409, 471, 534, 537, 649, 718, 723 flat tax, 661 income redistribution via, 478 income tax, 460, 762 Tax state, 445–463 capital accounts in, 452–453 capitalization of state, 449–451 conflicting rationalities in, 453–457 Goldscheid on, 446–448 owners vs. customers in, 452–453 political economy of, 457–459 public debt and, 459–460 Schumpeter on, 446–448 valuation of state, 451–452 Taylor, F. M., 103 Taylor, John B., 772 Team theory, 274 Technical trading rules, 571

Technological change, 150, 155, 533 Technological knowledge, 703 Tesfatsion, Leigh, 60 Texas Tech University, 6 Theoretical psychology, 372 Theorie des Geldes und der Umlaufsmittel (Mises), 164 Theory and History (Mises), 19 Theory of Economic Development (Schumpeter), 552, 581 A Theory of Justice (Rawls), 464 Theory of mind, 613, 626, 634 The Theory of Money and Credit (Mises), 164, 188, 396 The Theory of Monopolistic Competition (Chamberlin), 71 The Theory of Moral Sentiments (Smith), 66, 134 Third-party dispute resolution, 312 Third-person opportunity, 539 Thornton, Mark, 400 Thought, 376, 379 Threats, 304 Thünen, Johann Heinrich von, 66, 68, 74 Thymological approach, 20, 260 Tier 1 capital, 755 Timberlake, R. H., Jr., 238 Time and Money (Garrison), 6, 173 Time costs, 316, 318 Time-discount effect, 176, 177 Time preferences, 191, 699–705, 707 Time-structure of consumption, 201, 202 Tocqueville, Alexis de, 720, 721, 722 Tolerance, 662 Toleration, 254 Tontine Tavern and Coffee House, 334 "Too big to fail" policies, 225, 567, 736, 745, 754, 755 Totalitarianism, 430 Trade, 75, 644, 645, 720 Trade union membership, 763 "The Tradition of Spontaneous Order" (Barry), 115 Transaction cost economics (TCE), 274, 278 Transaction costs, 253, 258, 275, 276, 278, 320, 535, 653, 659 Transferability of ownership shares, 453

812   Index Transfer-seeking process, 311 Transfers of purchasing power, 578 Transitional political economy, 657 Transitivity of preferences, 387, 389 Treasury Department (US), 195, 197, 736 A Treatise on Money (Keynes), 164, 733 Treisman, Daniel, 664 "The Trend of Economic Thinking" (Hayek), 617 Trial-and-error method, 106, 150 Trial by ordeal, 355 Tribute, 309, 310 Troubled Asset Relief Program (TARP), 187, 741, 745, 772, 773 Trumbull, William N., 664 Trust, 248, 253, 254, 255, 299, 653, 658, 662, 716 "Trust and reciprocity" games, 626 Trust rules, 301, 303 Trustworthiness, 299, 306 Truthfulness, 350 Tsuji, M., 349 Tucker, Benjamin, 241 Tullock, Gordon, 4, 6, 125n 20, 319, 350, 359, 500 Turgot, A. R. J., 66, 74 Turing, Alan, 599 Turing computability, 349 Turkey, 678, 722 Turner, Stephen, 355 Tversky, Amos, 350, 385 Typification, 86, 374 UBS, 755 Uganda, 678, 688 Unanimity, 461, 468 Uncertainty, 28, 30, 35, 109, 110, 275, 280, 284, 285, 286, 484, 485, 512, 513, 532, 539, 564, 626, 655, 730, 743, 764, 767 Underwater mortgages, 740 Undiscovered discovery process, 400 Unemployment, 171, 172, 186, 645, 733, 740, 742, 752 Uninsurable risk, 275. See also Uncertainty Unintended consequences, 495, 567, 680, 689–694 United Kingdom, 221, 233, 447, 666, 762 financial crisis (2007–2009) in, 749–779

United States capital regulation in, 230 entrepreneurship in, 666 expert testimony in, 358 financial crisis (2007–2009) in, 164, 412, 598, 729–748, 760 foreign interventions by, 678, 682, 687, 719 free banking in, 233, 236 job creation in, 764 private residential communities in, 481 taxation in, 460 Treasury Department, 192 Universalism, 523 University of Chicago, 434 University of Connecticut, 6 University of Freiburg, 436 University of Paris, 6 Unregulated or free banking, 214. See also Free banking theory Unsimulated discovery process, 400 Urban planning, 401 "The Use of Knowledge in Society" (Hayek), 45, 49, 53, 398 Utilitarian accounts of justice, 465 Utility maximization of, 348, 554 subjective nature of, 698 Valuation methodologies, 571 Value and Capital (Hicks), 72 Value at risk (VaR), 570, 571 Value freedom, 550, 551 Vanberg, V. J., 86, 301, 302, 303, 472, 521, 524 Variable time structure of production, 198 Vaughn, Karen, 6, 37, 493, 500, 600, 603, 608 Vedder, Richard K., 176, 178 Veil of ignorance, 466, 467, 468, 483, 484 Veil of uncertainty, 485 Velupillai, K. V., 349, 357, 596, 600 Verstehen, 25, 29, 36, 259, 260, 550, 551 Verstehende psychology, 599 Vertical disintegration, 158 Vice, 130 Vikings, 309 Viner, Jacob, 274 Virginia Company, 330 Virginia Tech, 497

Index   813 Virgin Money, 756 Volatility, 564 Voting versus market decision-making, 498 Wages, 278, 732, 739 Wagner, Adolph, 419 Wagner, Richard E., 27, 188n 7, 394, 402, 404, 445, 447, 448, 449, 451, 461, 497, 500, 501, 503, 596, 608, 635 Walesa, Lech, 660 Wallis, John Joseph, 662 Walras, Léon, 1, 15, 30, 68, 70, 72, 74, 103, 581, 602, 603, 605 Walter Eucken Institute, 435, 436, 438 Want satisfaction, 700 Wapshott, Nicholas, 168, 179, 180 Washington, George, 660 Washington Consensus, 644, 645, 646, 651, 719 Watson, John B., 365 Weak emergence, 601 The Wealth of Nations (Smith), 66, 73, 355, 647, 698, 713 Wealth redistribution, 311, 409, 485, 487 Wealth Tax of 1935 (UK), 762 Weaver, Warren, 598 Weber, Max, 25, 47, 419, 461, 547, 550, 551, 557, 558 Weimar Germany, 412 Weimer, Walter B., 613, 617 Weingast, Barry R., 662 Weinstein, Jack Russell, 357 Weintraub, Roy, 27, 73 Welfare-state capitalism, 409, 410, 474, 476, 477 West Germany, 722 West Virginia University, 6 Whetten, D. A., 565 White, Harrison C., 556 White, Lawrence H., 5, 6, 29, 180, 233, 238, 239, 327, 735, 744, 769 Whitman, D. Glen, 345, 346, 357, 407

Why Nations Fail (Acemoglu & Robinson), 714 Wible, James R., 350 Wicksell, Knut, 165, 169, 178, 179, 460, 461 Wicksteed, Philip, 75 Wiener, Norbert, 597 Wieser, Friedrich von, 1, 82, 366, 367, 368, 369, 370, 374, 376, 419, 549, 580, 584, 594, 596, 603, 605, 606 Wildcat banking, 236 Williams, George C., 586 Williamson, Claudia, 716, 720 Williamson, Oliver E., 273, 275, 277, 336 Wilson, Woodrow, 357 Winter, S. G., 582, 583 Wintrobe, R., 318 Wiseman, T., 198 Witt, Ulrich, 283, 284, 576 Wittgenstein, Ludwig, 366 Wittman, Donald, 501, 502 Wohlgemuth, Michael, 112 Wolfram, Stephen, 598 Wolpert, David H., 349 Workplace safety, 395 World Bank, 649, 664, 665, 709 World Values Survey, 653 Worldwide financial crisis. See Financial crisis (2007–2009) Wynne-Edwards, Vero C., 585 Yeager, Leland, 4, 6, 565, 614, 616, 623 Yemen, 678 Yield curve, 763 Young, Allyn A., 75, 542 Young, Andrew T., 186, 198 Younger Historical School, 419 Zelizer, Viviana, 551, 553, 557, 558 Zenger, Todd, 276 Zoning ordinances, 396 Zube, John, 241 Zuckerman, G., 774, 775