Friday, July 16, 2010

Schools of Thought and a Crisis of Conscience Part I

This was a difficult post to write, because I’m really in the process of exploring my basic beliefs of how economics and economic agents interact and operate – you could say this is an examination of my faith. So what will follow is a series of posts on schools of economic thought, from orthodox to heterodox, and I’m going to see where it takes me.

For starters I’ve been listening to a series of audiobooks, partly in an effort to expand my horizons, and partly because as Sun Tzu said:

Hence the saying: If you know the enemy and know yourself, you need not fear the result of a hundred battles.

If you know yourself but not the enemy, for every victory gained you will also suffer a defeat.

If you know neither the enemy nor yourself, you will succumb in every battle.

In this case, I am trying to find answers to the question (about economics): What do I believe? And why is that belief better, or worse, than what others believe? There are a number of distinct schools of thought in economics, with more or less highly divided views on how economies are organised and function, and in what the role should be of various institutions such as government and money.

In my first two excursions into the great unknown, I’ve listened to these two short (<3 hrs) audiobooks:

  1. “The Austrian Case for the Free Market Process: Ludwig von Mises and Friedrich Hayek”
  2. "Struggle Over the Keynesian Heritage: Neoclassical Synthesists vs. the Post Keynesians"

I’ll deal with the Austrian case first, because my thoughts on that are much clearer (the next post will cover the Keynesian book).

Mises and Hayek were two of the leading lights in the early 20th century school of Austrian economics, so-called because it sprang from the University of Vienna. Austrian economics stresses subjective, historical narrative as against the highly mathematical basis of modern economics (which they think isn’t useful). In that sense, it’s related to the German school, but comes to completely different conclusions to how economies should be organised. Austrians largely subscribe to a free market view of economies, taking classical laissez-faire economics to its logical conclusion – as the free market is more effective and efficient in producing social welfare (in their view), than government involvement in the economy should be kept to its bare minimum.

Now that doesn’t differ much from the economic orthodoxy or to classical thought, except Austrians take it to the extreme, up to and including recommending the abolishment of the government monopoly over the issuance of currency. They contrast the efficiency of the market-driven economy with planned economies of socialist thought, which they consider to be prone to failure.

Their other contribution to economic thought is in analysis of the boom-bust business cycle, which in their view is considered to be the result of successive waves of too much credit, and then too little credit, from government attempts at smoothening real economic activity. Hence, Austrian policy prescriptions largely devolve down to abolishment of central banks and fiat money, and a return to hard currencies (i.e. the gold standard).

Most economists have a bit of a libertarian streak in their genes – unless you deliberately go out of your way to pursue Marxist, socialist or other heterodox theories, it’s really hard not to be. You’re exposed to the idea of the price mechanism delivering the “best” outcomes (as in no deadweight social loss, and Pareto efficient) almost right from the start. I started off with classical theory at ‘A’ Levels, and moved on to neo-classical and neo-Keynesian constructs at undergraduate level. You don’t really get into market failures and the nuances involved in economic orthodoxy until you get into graduate studies.

If all I’d had was an undergraduate economics education, I might have found Austrian thought attractive – they appeal to the market-friendly instincts of most conventionally trained economists, and they appear to have a narrative that ties in with what occurs in business cycles, and especially with the underlying causes of the present financial crisis.

But I now feel that the Austrian complete faith in the market is misplaced – you have to believe that markets are perfectly self-regulating and self-correcting, which to my mind isn’t always true. The business world is defined by imperfect competition, not perfect competition – monopolistic and oligopolistic pricing power is more common than price-taking. The standard business unit is not the entrepreneur, but the firm. Markets don’t necessarily exhibit single equilibrium points where demand equals supply, but multiple equilibria with different levels of social welfare i.e. there might not be a mechanism that takes economies to the classical ideal of full employment and no inflation.

Austrian economic thought is in my mind more a philosophy than a concrete theory of how economies behave. That’s all good as far is it goes, except Austrian thought simply can’t encompass what I think of as crisis economics – Mises’ (I think) response to the stagflation problems of the 1970s was along the lines of “if they hadn’t listened to him before, there’s nothing he can offer now.” In other words the best policy in all circumstances is to have no policy at all. Having said that, there’s a kernel of truth in the belief that money helps drive business cycle fluctuations.

As an aside here, I have to put Mises and Hayek’s thoughts in historical perspective, especially for those of you who have less than a passing familiarity with 20th century history. The Austrian stance in favour of a fully market-driven economy, and staunch opposition against any socialist leanings (including any involvement of government in the economy), should be interpreted in light of European history.

Both Mises and Hayek experienced first hand the depression and hyper inflation that hit the losers of WWI – Germany and the Austro-Hungarian Empire – and their subsequent descent into fascism (a totalitarian state with a “strongman” as leader). There was also the rising threat of communism in the East, which appeared far more threatening during the post-WWII era then it does to our modern eyes.

Socialism in their terminology doesn’t quite equate to our current usage of the term, and both condemned the “third way” social democracy route that most of Europe took after the war, as a descent down the slippery slope – the argument is that a little bit of government intervention provides those in power with the incentive to grab more power, in time resulting in the extremes of communism and fascism. I think that’s a straw man argument – I don’t think economies and societies fall too easily into purely binary configurations, no matter the historical process.

Technical Notes:

  1. Quote from Chapter 3, Sun Tzu on the Art of War, Translated from the Chinese By LIONEL GILES, M.A. (1910)
  2. Peterson, William, “The Austrian Case for the Free Market Process: Ludwig von Mises and Friedrich Hayek”, Narrated by Louis Rukeyser, Blackstone Audio, Inc., 2006
  3. Davidson, Paul, "Struggle Over the Keynesian Heritage: Neoclassical Synthesists vs. the Post Keynesians", Narrated by Louis Rukeyser, Blackstone Audio, Inc., 2006


  1. Thank you! Looking forward to the next episodes....

  2. This is interesting. Hope the series continue along with current issues. Obviously, I am hishamh junkie :-)

  3. There's a book entitled Modern macroeconomics: its origins, development and current state by Brian Snowdon and Howard R. Vane. Probably a good read before writing about Keynesian synthesis.

    Reading it made me realize how some professors that I have met changed the world of macro. I used to think they were just, well, some professors.

  4. Okay, that comment on professors is about a different book. Still, Snowdon and Vane's is a good book about the history of macro.

  5. Thanks for the tip, I've found it. Looks like a must-read.

    Regarding professors, I know what you mean. Would you believe James Durbin was one of my undergraduate advisors (as in Durbin-Watson)? I hadn't a clue who he was until years later.

  6. I must admit I didn't take advantage of my time there as I should have - I was too immature and callow. Live and learn I guess.