Austrian Economics

Question 1

Carl Menger

Answer 1

put forward marginal utility theory in his principles of economics at the same time as Jevons and Walras

Question 2

Ludwig Von Mises

Answer 2

• Human action (1949)
• based economics on praoeology
• economics consists of the deductive consequences of purposeful individual action
  ie individual must be the unit of analysis hence scepticism towards macroeconomics, especially Keynesian version
• Theory of money and credit postulated a business cycle driven by over-expansion of credit by banks

Question 3

Friedrich von Hayek

Answer 3

The Road to Serfdom argued that too much government control of the economy led to total control, ‘serfdom’

‘Constitution of Liberty’ defined the fundamental principles of liberty & argued its necessity for civilisation, wealth and justice

Question 4

Principle 1

Answer 4

Competition is a process not a state

• neoclassical economics with its equilibria and zero normal profits leaves out everything of importance
• you’re never in equilibrium
  a) by the time you get there the equilibrium will have changed
  b) an equilibrium is everyone is satisfied with their plans and don’t want to change their behaviour
• but everyone has different information - can’t be aggregated so as to produce an equilibrium
• individuals have knowledge no one else can have

Question 5

Principle 2

Answer 5

In particular individuales have tacit knowledge

a) can’t ride a bike by listening to an explanation
b) CEO’s well paid because of their tacit knowledge - if it didn’t exist new MBAs would be the best CEO’s
- and individuals information can’t be aggregated so as to produce an equilibrium because peoples economic actions reveal their information for the first time

Question 6

Principle 3 - The Market

Answer 6

a) a market is a co-ordination mechanism for people with different knowledge
b) is a process of discovery - you don’t know in advance if A or B is more profitable and have to find out through market transactions
c) every entrepreneurial decision closes off another one so you never find out if you were maximising profits
d) because no one person has enough information, no one can plan the economy

Question 7

Principle 4 - The Monopoly

Answer 7

It’s not a bad thing

• firms seek opportunities to differentiate themselves and earn monopoly profits until competitors catch up
• monopoly good so far as it gives firms an incentive to innovate and usually doesn’t last very long

Question 8

Principle 5 - Down with Maths and the State

Answer 8

Hostility to maths in economics:

• maths focused on equilibrium
• maths focused on individuals maximising utility and firms maximising profits
• entrepreneurship and tacit knowledge left out
• hostile to state intervention

Question 9

Principle 6 - Down with Macro

Answer 9

• Macrovariable (Y, P etc) are illegitimate and pointless aggregations of individual transactions

and Hong Kong decided…

Sir John Cowperthwaite, Financial secretary 1961-1971 to stop publishing GDP figures

Question 10

Hayek and Spontaneous order - ‘order without design’

Answer 10

How did markets and institutions that make markets work begin?

Hayek said not because someone thought them up and planned them

• they evolved because they worked which is equally true of norms, standards of behaviour and ethics
• people adjust to each others behaviour and repeat their own and others practices until there is a system of accepted behaviour

ie morality = adjustment to other peoples circumstances and will thus change when circumstances change

This is how the economy works to Hayek in Eamonn Butler: “a free economy and a free society, though unplanned, are highly organised, the evolutionary product of our constant adaptation to each others values and actions

Question 11

The Socialist Calculation debate

Answer 11

Started by Mises

• Market economy works because it uses the knowledge dispersed within it
• socialist economy: planner has much less knowledge
• in particular there’s no market for means of production (owned by the state) which therefore have no prices
• but prices direct resources to their best use (ie whoever will pay most for them)
• planner doesn’t have this information, thus no basis for pursuing one project rather than another

Question 12

Lange argument against SCD

Answer 12

• you cant plan everything
• but you can still have a socialist economy that works:

State-owned plants must have:

1. Produce at point where average costs are lowest
2. Set price equal to marginal cost (neoclassical economics)

Question 13

Hayek’s response to Lange

Answer 13

This would work in a static world in permanent equilibrium BUT: worlds not like that

• Lange as bad as the neoclassical: no room for learning, entrepreneurship or innovation
• Planners (who have to look at the whole economy) need more knowledge than entrepreneurs but have less
• even if same prices can be introduced into a planned economy, planners have no hope of keeping up with them as they change
• nor can entrepreneurs but they don’t need to - they only need to see the prices that concern them

Question 14

Hayek’s example against Lange

Answer 14

someones discovers new use for tin

• demand up and thus price

1. Mining companies produce more tin
2. Users look for substitutes

so demand for substitutes foes up and so does price

so more substitutes produced etc

• prices have transmitted info about scarcity across the economy - businesses knew exactly as much as they needed to know

and this is before youve even got to the entrepreneurs role:

• spotting gaps in the market
• studying consumers before trying out new products

Question 15

Modern socialist counterattack on Hayek

Answer 15

1. Price signals aren’t always helpful or stabilising
   - what if Hayek’s rise in tin prices caused a speculative bubble?

ie as price rises, supplies fall as people hoard tin in hope for further price rises

2. Hayek’s target no longer exists (USSR broke up in 1991, Mae Tse-Tung died in 1976)

Question 16

Communism wasn’t Hayek’s only target

Answer 16

‘The Road to serfdom’ warning: even part-socialist Economies are on the way to complete state control

• when people outside the state plans act in ways inconsistent with it, state will extend its control to deal with them
• this prediction largely falsified as plenty of social democratic goats have broken down
• taken their countries in direction of free markets

Question 17

Supporting argument for Lange, not Hayek

Answer 17

Modern computing

• a planner would now have enough information
• and hear quickly enough about changes
• and process them at thousands of times the speed of the old central planners

Question 18

Counter attack to modern computing argument

Answer 18

• fall back on original arguments to planning
• tacit knowledge of entrepreneurs
• lack of prices to guide the planner

Question 19

Austrian Business cycle theory

Answer 19

Unsustainable Boom when central bank holds interest rates down

what happens then?

• Eugen Von Bohm-Baverk: Theory of Capital:

Capital introduces greater ‘roundaboutness’ into production

so you can produce more output but it takes longer to produce

• when interest rates fall so does opportunity cost of ploughing your profits into your business (instead of lending it at interest)

ie roundabout production costs you less and so the more capital you install

• Problem now is that businesses may over-invest in capital and in capital which is too roundabout: ‘Malinvestment’

Question 20

When do you get this malinvestment

Answer 20

• depends what caused low interest rate which caused the investment

Question 21

why low interest rates?

Answer 21

1. Plenty of saving
2. Held artificially low by central bank

it its 2 then there aren’t enough savings to sustain the investment and in fact savings will fall so savers take their money out the bank and spend it

• Thus banks are now short of cash and…

1. Recall loans
2. Refuse to roll loans over
3. Raise their lending rates to choke off the demand for credit

Leads to a credit crunch

• falling demand and unemployment especially severe in capital goods industries (where the overinvestment took place)
• But aggregate demand and asset prices fall across the economy

Question 22

Austrian Methodological point

Answer 22

theory first their distrust of macroeconomics (ie dealing in national aggregate variables)

• 1930’s slump blamed on low investment (Keynes)
• fall in quantity of money (Friedman)
• Hayek: slump happened not because of too much/little investment but because of malinvestment (in capital that was too ‘roundabout’
• producing goods that people no longer wanted or could afford

and if the problem is wrong kind of goods, pushing aggregate demand up or down won’t help

Question 23

Austrians since the 2008 Banking crisis

Answer 23

say events have confirmed their view and in particular that setting interest rates with regard only to inflation (price of goods) targets was mistake

1. Largely follow Hayek’s remedies for 1930’s depression
   - trouble caused by overinvestment and unsustainable bubble in asset prices
   - therefore don’t start it all up by again by propping up asset prices with cheap money or fiscal deficits
   - slump has to be worked through: best remedy is not to repeat the mistakes of the last boom
2. Follow Hayek: abolish central banks and have private issued money

Hayek says they wouldn’t over issue money as they don’t know that if their money loses its value, they lose their depositors

Question 24

1st Criticism of Austrian Economics

Answer 24

Malinvestment theory an unnecessary complication and there’s no evidence for it

• why not just say that artificially low interest rates lead to too much investment and not enough saving
• with inevitable credit crunch at the end

Question 25

2nd criticism of Austrian economics

Answer 25

you can’t blame all of the crisis and recession on governments and central banks

• if business can be swept away by overoptimism and invest when they shouldn’t why won’t they do this is Hayek’s laissez-faire economy with free banking?

Question 26

Austrian reply to second criticism

Answer 26

Murray Rothard: yes, with free banking entrepreneurs will make mistakes

but they wouldn’t all make same mistake at the same time - some entrepreneurs would mis-price goods but others would take advantage of their mistakes

• free banking would rule out government insurance of bank deposits
• Hence end of reckless banking decisions because depositors feel safe

Question 27

3rd criticism to austrian economics

Answer 27

If private agents (without distortions caused by the central bank) are as clever as Hayek implies, aren’t they clever enough to see distortions for what they are and this hold back from unsustainable investments

Question 28

Austrian reply to 3rd criticism

Answer 28

1. Businesses may be forced to copy each other or lose market share
2. Central bank doesn’t just set the wrong interest rate but obscures what is the right interest rate (the one the market would find for itself)