Sunday, July 6, 2014

Five common misconceptions about Austrian economics



These five misconceptions were recently publicized in a piece published by Bloomberg View, and there have been some great responses to that piece. I'll take a slightly different route and try to explain why poor interpreters of Austrian thought have these misconceptions about Austrian economics. Note that there are poor interpreters of Austrian thought among Austrian enthusiasts as well. And it seems that the Bloomberg piece itself focuses only on these misguided Austrian enthusiasts. This is unfortunate because it creates the impression in the general public that the 150-year history of serious intellectual work in the Austrian tradition can be reduced to a number of ridiculously shallow propositions. I'll trace these misinterpretations back to the likely original Austrian ideas that have been misunderstood or lost in translation.

Misinterpretation 1: Austrians believe that the Federal Reserve money-printing is a government plot to boost big banks.

Original Austrian idea: The fact that many Austrian economists warn about the consequences of the expansionary monetary policy pursued by the Federal Reserve does not, by any means, imply that Austrian economists believe this policy is a "plot." Austrian economics is not a conspiracy theory, but, more importantly, it is not a mere exercise in historical forensics. Austrians simply point out the fact that, if the Federal Reserve "prints money" to save banks that have made unwise business decisions in the past, we can expect more of the same problem in the future as the same banks keep making unwise business decisions. At the core of this position is the idea that profit is a signal that a firm is making good business decisions, while loss is a signal that a firm needs to change something in order to stay in the market. Without these signals, we wouldn't know who is performing well within the market and who is not. Profit is like a mark that a student gets on a test. Marks tell us which students can pass the course and which students need to either improve or try changing their occupation. Bailing out banks that operate with a loss is like giving passing marks to bad students. Whether giving passing marks to bad students in the banking industry is a plot or not is a matter of historical inquiry into the facts of the actual situation. But, even labeling this situation as a plot does not change the economic consequences of subsidizing bad performers in the banking sector.

Misinterpretation 2: Austrians believe that prices are rising much faster than anyone thinks.

Original Austrian idea: Austrian economists put a lot of emphasis on prices because they recognize that prices are signals of otherwise unavailable information about people's desires and availability of resources. This information is necessary for the coordination of millions of individuals within the market. One of the important features of the Austrian theory is that it stresses that an increase in the money supply generally affects prices of different commodities differently. Some prices rise sooner, while others rise later. Some don't rise at all, while some may even fall. A potential problem with this arises if an increase in the money supply changes relative prices in a way that gives misleading signals to market participants. If this happens, then market participants make decisions based on prices that are poor indicators of the underlying plans made by other market participants. This leads to a lack of coordination within the economy and can ultimately lead to a recession. So, when you hear an Austrian warning that prices of some commodities are rising much faster than the official overall inflation figures would suggest, they are not necessarily claiming that the official inflation rate is a bad indicator of the overall increase in the price level of all commodities. They are warning about these price increases because they might be caused by an increase in the money supply, not by a change people's desire for this commodity or by a change in its availability. This would be a false signal to market participants that they should consume less and produce more of that commodity, which would lead to excess supply in the future. A common term for such excess supply is a bubble. The bubble bursts once people realize that the price signal they were receiving was false. Most of us are familiar with the recent housing market bubble.

Misconception 3: Austrians believe that real “inflation” means money-printing, not an increase in prices.

Original Austrian idea: This is partly a definitional issue, but the core of it is about understanding the origin and consequences of increases in prices. If all prices were rising at the same rate all the time, then we would have little to worry about because people's expectations and plans would always be adjusted to these increases. However, Austrians stress that increases in prices that can happen as a consequence of money printing (physical or electronic) are neither uniform across commodities nor are they predictable over time. This is why an increase in some prices may happen soon after a large quantity of money has entered the market while others may happen years later. In fact, depending on people's (and banks') desire to hold money balances (not to spend or invest money), an increase in the money supply might not affect prices at all for as long as people want to keep their money in idle accounts. This is why we don't get much understanding of the underlying economic process by just looking at prices. But, if we keep track of the money supply, then we may realize that, even if prices are not rising, they may start rising as soon as people decide to spend or invest the money that has been printed and given to them. This is why Austrians stress the importance of increases in the money supply in understanding inflation.

Misconception 4: Austrians believe that printing money can never boost the economy.

Original Austrian idea: It would be unwise to claim that anything can never happen. So, I would be surprised if any conscientious social or natural scientist would claim that an event can never happen. What many Austrian economists will tell you, though, is that money printing tends to temporarily boost some sectors, and not the whole economy. In Misconception 2 above we said that this "boost" can, in fact, be a consequence of false price information created by a sharp increase in the money supply. If this is the case, an Austrian would tell you that we can expect a bust of the "boosted" sector in the future, once people realize that the "boost" was simply a case of excess supply in this particular sector.

Misconception 5: Austrians believe that academic economics is a plot to use mathematical mumbo-jumbo to cover up government giveaways to big banks.

Original Austrian idea: Austrian economists often warn against uncritical application of mathematical formalism, but this does not mean that Austrians are opposed to any use of mathematics in economics. If you open Mises's Human Action, one of the most important treatises in Austrian economics, you will find that he sometimes uses numerical and algebraic examples to illustrate a point. This is math, although relatively simple math. What Austrians warn about is not the use of math in general but its uncritical use that blurs the fundamental features of the economic problems we wish to study. Austrians are not the only economists that warned about this. Ronald Coase, a Nobel laureate in economics was not an Austrian, but he was a fierce critic of uncritical mathematical formalism.

Another important point we should understand before we turn to analyzing the claim that the use of math is a "cover-up" for government giveaways is that not all academic economics contains math. In fact, there are prominent academic economists who are Austrians and who may or may not use math to illustrate their points. Thus, it is possible to be an academic economist without using "mathematical mumbo-jumbo" and it is possible to be an academic Austrian economist.

Is the use of mathematical formalism a cover up for government giveaways? Just like the question in Misconception 1 about a potential plot between the Federal Reserve and big banks, this is not a question of particular interest for an economic theorist. It might be an interesting research question for historians of economic thought, which is just a small segment of the economic discipline.

However, a more profound problem that Austrians point out is that the use of mathematical formalism creates an illusion of knowledge where actual knowledge does not exist. This gives us an impression that we can design policies with predictable outcomes when in fact the model on which we base these policies does not capture the key features of reality we want to predict. For example, this was the central idea of Friedrich Hayek's 1945 paper on prices as sources of otherwise unavailable information, information that is generally assumed to be known in mathematical models of the market. Assuming that unknown information is known removes the need for markets as means of economic coordination, Hayek stressed. All economic planning in such a world could be performed by the government. However, claiming that mathematical formalism creates incentives to turn over the economy to the government is not the same as claiming that the use of mathematics is a plot by anyone. And, even if this was a plot, this fact would be of little importance for Austrian theory.  

Conclusion

Austrian economics is a complex, multilayered approach to economic thought with a long history. It requires careful analysis and consistent application of critical thinking to get a full appreciation of the implications of some of the Austrian insights. This applies both to the critics and to Austrian enthusiasts. Let us not insult the serious scholars in the Austrian tradition with shallow interpretations of their work.


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