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Vol I» NO Z

| Austrian Economics Newsletter

Viewpoints on the ‘“New”’
Austrian Monetary Economics

by
Peter Lewin

Dramatis Personae

| pathizer

| DICK: a graduate student in economics, basically a (mod-

| ern) Keynesian

| HARRY: a graduate student in economics, a believer in an
obscure set of doctrines known an “Austrian” or “Subjec-
tivist” economics,

im-economics, a Monetarist sym-

{ The action takes place on the campus of a respected Mid-

western university. |

Nummary of the Main Ideas

Scenei — Prologue

Scene ii — Methodology

Scene iii — Summary of the Main Ideas 3 )

Scene iv — Point-Counterpoint Student editors Sven Thommesen and Mark Thornton laok over the
Scene v — Criticisms and Extensions shoulder of Professor Leland B. Yeager.

Scene vi — Epilogue RT .
Scenei — Prologue. implicit contracts that appear eX post to be inconsistent

with RE do exist.
ench on the laym in fromof | {Harry approaches from the library steps]

the library. The date is early

ab

TOM: Here’s Harry. Let’s see what he thinks.
TOM: Well, Dick are you getting the hang of this Rational DICK: Tom, you know that Harry is a little weird. He

a
0.

Expectations (RE) theory? thinks all chis stuff is fundamentally flawed. Before you
: DICK: Yes, I think so. I must say some of the ideas are very know it we'll be into some deep philosophical debate about

compelling and the techniques used are quite impressive. | methodology.

still believe though that RE is consistent with a case for HARRY: Hi guys! I just received a copy of this great new

discretionary policy. Differences in information and insti- book by O'Driscoll and Rizzo (O-R).!

tutional rigidities—like implicit contracts—suggest that TOM and DICK: Who?

the government can still help avoid the social costs of HARRY: They're two young economists who write on

unemployment. modern Austrian economics and they've produced this

TOM: Really Dick! I don’t know how you can say that. really interesting book; I think you should both read it. It is

Haven't you read Barro’s empirical work or his work on a fundamental challenge to most of mainstream economics.
, contract formation under RE? DICK: Come on Harry! How are you every going to get
Nae?) [CK: Sure, but his and all of the other empirical evidence your Ph.D.? You need to be concentrating on the impor-

presented in favor of the invariance postulate is highly tant stuff. Tom and I were just discussing RE.

ambiguous to say the least. And whether we like it or not, HARRY: Don’t worry Dick, I'll get my degree. Actually in



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chapter 9 of this book O-R discuss aspects of RE. economists don’t really take the falsification criterion seri-

DICK: I can imagine. ously. Their rhetoric is different from their practice. The 13
HARRY: You've dismissed their arguments even before practice is to decide between theories or models on the 3
you know what they are. Talk about keeping an open basis of their intuitive appeal and mathematical cleganceqgy
mind! If you read the Mises chapter 1 put on the reading list, ®] [|
TOM: OK, OK, let’s not get excited. What do they say, you know that, for Austrians, the soundness of a theory is  §
Harry? not an “empirical” matter, but rather a matter of logic. 3
HARRY: Well, its very difficult for me to explain unless TOM: Yes, I did eventually understand the notion that 3
you are willing to let me fill in some background on Aus- theory and history yield different types of knowledge and :
trian economics. That could take awhile. that knowledge in social science theory is 'a priori’ in na-
DICK: Here we go. - ture—although apparently not all Austrians agree com- g
TOM: Look, I've got a proposition to make. We have a pletely on this, [ also understand that praxeology implies $
mid-term break coming up in a couple of weeks. Why both subjectivism and methodological individualism. But
don’t you prepare a reading list for Dick and me on Aus- having come this far it seems to me we have reached an §
trian economics and we'll try to acquire some of the neces- impasse. Mainstream economists simply do not feel bound :
sary background? by the principles that Austrians consider inviolable.’

DICK: Come on Tom. Do you really think that’ $ an of Rather as you know they consider the realism of the as-

cient use of our time? -sumptions—including | suppose assumptions: SEN Sn
TOM: It may provide a fresh perspective on things Dick. quisition of knowledge or the formation of expectations —

And Harry's right. We do need to keep an open mind. to be beside the point. What matters is whether or not the

Now, if that's agreed we'll meet after the mid-term break theory “works” in providing useful predictions.

for a discussion. HARRY: Yes, but how are we to know if the theory
HARRY: Great idea! Let me suggest that to keep it fo- “works” when, as I've said already, most (if not all) hypoth-

cused, we concentrate on chapter 9 of O-R. You can bor- = eses are effectively insulated from refutation.*

row my copy (though I really recommend you buy your DICK: It is clear by the amount of space that they devote
own). I think you should read the whole book, but since ro methodological issues, that O-R are sensitive to these

you're both interested in monetary economics let's focus questions. After exploring at length the meaning and im-

on that. Agreed? plications of subjectivism they attempt, I think, to go

TOM: Agreed. yond their mentors and offer (in chapter 2 section If enti-

DICK: Oh all right. Co tled the Dimensions of Subjectivism) an explicit criterion

for deciding between theories. It is worth quoting’
The covering-law model, therefore, does not provide an
adequate form of explanation for dynamically subjectivist

Scene ii — Methodology
[Later that term, in a study room in the basement of the

library. | theories. An essential feature of these theories is that logi-

TOM: If I'd known what I was getting into, I doubt that I'd cal deducibility of the statement of the relevant decision or

have suggested it Harry. That Austrian stuff is rough go- phenomenon is no longer possible. This, of course, does ;
ing, especially at first before you catch on to the spirit of it. not mean that explanation is no longer possible but merely

It really is quite different from what I'm used to. Fm not that one variety of explanation has been excluded. “Not A
sure I know what to think. IEE - deducibility but intelligibility constitutes the BESET }
DICK: Actually I was very sleasandy surprised. 1 found of the logic" of explanation.” . .. One clear and useful

much of the discussion very refreshing, especially the em- meaning we can attach to the intelligibility relationship is i
phasis on the importance of expectations—that's very that the choice-theoretic explanatory schema must render [4
Keynesian. [ didn't like the policy implications though. the given phenomenon more likely than if the particular \
Those seem very Monetarist. model had not been presented. *
TOM: Yes, perhaps that’s why I'm confused. This intrigued me. Intelligibility itself is surely a subjective ] ;
HARRY: I really think it would help if we spent a little category whose content differs across individuals particu-

time discussing methodology. larly as they appraise real-world situations corresponding

DICK: Uh oh. to proffered theories— business cycles for example. So, in
HARRY: You have to understand that from the Austrian the final analysis what makes a theory “work” or which
perspective mainstream economic methodology is based = theory “works” best is itself a subjective decision. In that

on a view of the world that is very naive. In reality the sense we surely have reached an impasse. i
hypotheses that emerge from theorizing in economics are But, since my interest is now aroused, and [ am anxiouggh
seldom well formed or capable of decisive refutation. And, to discuss O-R’s monetary economics 1 suggest we bear

of course, as was recently pointed out by McCloskey’, their intelligibility criterion in mind and press on. Later we



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can decide whether we agree or not that their theory maxi- TOM: Why do you say this is the mote important? At

mizes intelligibility, times | was at a loss as to its relevance.
TOM: Good idea. But before we leave this there is one HARRY: It has very important implications and it contains
4 other methodological point that’s worth noting. For O-R some ideas that challenge the very heart of neoclassical
| A bjecciviom implies methodological dualism, that is, that monetary economics.
. the social and natural sciences must be treated differently, TOM: You'd better explain.
found this unconvincing. The analysis of cyclical phenom- HARRY: Firstly, there is the basic idea that money, as a
ena, for example, would appear to be amenable to math- social institution, was not designed by anyone. Like lan-
ematical techniques developed in the natural sciences. guage it simply evolved. But, more important, like lan-
HARRY: I don’t think so Tom. My own view of the matter guage it could not have been designed. The analogy with
is as follows. It is not subjectivism per se that leads to language is compelling. {page 13}. The use of a language
methodological dualism. It is rather that subjectivism in presumes that others understand it. The use of a money
human affairs implies disparate expectations. Obviously, instrument presumes that others value it. Money cannot be
all (scientific) investigation leads to results that must be legislated. This should give pause to all those who dabble
subjectively perceived and interpreted. In what we call the in theories about the optimum money supply or the most
hard or natural sciences there is a high probability of efficient monetary rule. Furthermore, money, like lan-
| obtaining a consensus on the meaning’ of those individual ~~ guage, is universal. People invariably tend to use them.
Ce HATE This 15 DEMREthe connection berween the That is a pattern prediction. The precise form that both
individual experience of the “data” and the mental con- take (and we might also include the institution of law) is
structs used to organize them for analysis and prediction not predictable.
vary little, if at all, across individuals. Thus, there is unani- So, [ think these ideas are important. But actually O-R’s
mous agreement that the atomic weight of hydrogen will treatment is both less and more than Menger’s.® They
continue to be what it was (acknowledged by all to be) touch rather lightly on the details of the process by which
historically. Predictions based upon this belief can be =~ money evolves. Menger’s own treatment is replete with
made. Expectations converge. There is a shared experience historical examples. Also, when explaining the benefits
of the world and of ideas that is absent in the case of from money that accrue to society, they did not explain as
individuals experiencing business cycles for example. clearly as they might have that money facilitates both
Ww. Similar considerations apply to objections about the use exchange and production. {See Lewin (1984)]. It does so by
of mathematics in economics. These objections should not economizing on information and reducing risk. The latter,
be to the use of symbolic representations per se, but rather in particular, is important in facilitating production. Thus,
to the interpretation of the symbols as constants—per- when money malfunctions, both production and consump-
ceived to be so by all the economic agents. These symbols, tion activities are affected. This provides a link between
if they are anything, are necessarily expressions of the the origins of money and the topic of economic fluctua-
subjective (disparate) notions in people's minds as to how tions. Of course, this is all there is between the lines, and,
the world works or will work. perhaps, that is where it should be given that both Menger
[ think this will be important in our later discussion, and and Mises had treated the subject quite fully.
I am very 7 gad you both feel that we should continue. DICK: Well, then what is new about O-R’s treatment?
wiliskaellshavinseanms. dhisdar why: not? Lsuggest you... HARRY: To some.extent it is a matter of emphasis-but I
summarize e the n main ideas i in O-R amr 9 Harry. think there are some new things here. One which I think
HARRY: Ok, but why don’t we do this over a beer? It's may be overstated is the idea that the “subjective percep-
getting late. tions and market characteristics of goods not their physical

attributes” [page 8] are important in determining the
course of monetary evolution. I understand this as an at-
tempt to strike a blow for subjectivism, but my reading of

Scene iii — Summary of the Main Ideas
[Later that evening in a favorite student meeting place}

HARRY: Well, as O-R tell us, this chapter is organized Menger suggests a close connection between the physical
around two major topics: Menger’s theory of the origins of attributes of commodities and the value that people place
money and the Mises-Hayek theory of economic fluctua- on them as money qua money. Obviously, these attributes
tions. Of the two | think the former is the less well known have no absolute or intrinsic value, but when coupled with
but, perhaps, the more important. O-R use it to illustrate place and circumstance they combine to suggest that some
the subjectivist approach to analysis and at the same time things make better money than others. I'm thinking of
they illuminate two recurring themes—the distinction be- things like durability, divisibility, transportability, ease of
cen typical and unique events and the development and identification etc. When put like this, O-R’s point may
role of institutions. Also, at the end of the chapter this appear less controversial. What comes to be used as money

topic is tied to the question of monetary regimes. is indeed “partly an accident of history” [page 8} but (again



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reading Menger) there are striking similarities in the type avoided by the Austrians.

of monetary evolution that different societies at the same =~ DICK: So what’s new about O-R’s treatment?
stage of development undergo—and this is true even for HARRY: Once again there are new points of emphasis. But
societies that develop in isolation of one another. O-R also use a mode of expression that is more contempo
Another idea, which is new more in its emphasis than in rary than Mises, Hayek, Rothbard, and others and vod
its content, is that all other kinds of social evolution de- may help make it more accessible. [ am thinking of the use
pend crucially on monetary evolution [page 9}. This is a of [ and S schedules, present-value formulae and terminol-
very important idea that makes nonsense of any attempt to ogy like real interest rates, interest elasticity and so on. This
calculate the value to society of money in terms of some allows them to make some graphic points {no pun in-
notion of consumer surplus. It illustrates quite clearly that tended) that illustrate differences from received theory.
one cannot think about money productively in terms of DICK: For example? |
comparative statics. Monetary developments are part of a: HARRY: For example:
truly dynamic process. (1) that in any realistic account of fluctuations the nu-
TOM: What about the second topic—the theory of fluc- merator of the PV. formula {page 27} will change as a
tuations? result of other changes (like changes in r)
HARRY: I find this much more difficult to characterize (2) that sunk costs make “bad” projects appear profit- :
because I find myself more critical of their treatment than able {page32} :
of the first topic. - I 6) d <T:1 cles will include fluctuations. in. seal integest-d. }
DICK: Why don’t you save your. general criticisms s until  rates.:
later and concentrate on outlining the main ideas now? The lase-mentioned is particularly compelling in the
You may assume that Tom and I are familiar with the light of the economic environment of the last few years i
Mises-Hayek theory. with record high interest rates and persistently low levels of } :
HARRY: OK, that sounds reasonable. Perhaps the most price inflation. §
important is the idea that fluctuations are manifestations TOM: What did you make of the section on empirical EB
of error. People make mistakes and when enough of them evidence? 4
do so in a similar way we get a cycle. Cycles thus generate HARRY: I found it provocative, but wondered if O-R were :
economic losses and opportunities. People make errors be- attempting to claim more for the empirical “tests” than is
cause information is decentralized and they get the consistent with their position. For example, the statemeng
“wrong” messages; for example, that the supply of loanable “Rothbard’s thesis has since been justified . . .”” {page 36}.
funds has increased when actually it has not. Thus, as a However, in general [ welcome this type of approach if
result of “incorrect” investments the capital stock is inap- carefully done, if only for strategic reasons. i
propriate to produce the consumption goods that people TOM: What do you mean?! +
want to consume at prevailing prices. An important insight HARRY: Austrian economics for the most part has been 3
is that production is a complex structure that depends in a thoroughly ignored for the past thirty years or so. I believe 1
crucial way on the intertemporal complementarity of dif- the degree of neglect it has experienced is out of all propor- i
ferent production activities. So, when one set of activities is tion to the contribution the Austrians have made to the
disrupted or shifted the reverberating effects are felt over foundations of modern economics including monetary eco-
time. Also, production instruments are often durable and, nomics. But [ think the reasons for this neglect are ® wider
‘most important, depreciable: only over. time. This.means standable. First; much of Awmstrian literatureappearesvery- be
that investment errors become embodied in specific capital long on destructive criticism and very short on alternatives,
goods. The capital structure at any point in time reflects Second, it is couched in terms unappealing to modern
not only prospective production capabilities, but also technically sophisticated student like you and Dick.
retrospective production decisions and errors. Econometric investigations of Austrian themes may be a
O-R adopt a simplified I-S framework of exposition. But way to get your attention, especially if they perform no }
it is clear that their theory does include the rich complex- ~~ worse then the alternatives. i
ity that I just mentioned. As such it is a fundamental I think O-R have tried to address both these factors by
challenge to prevailing cycle theory. In particular, it is a providing alternative theoretical specifications where they
disequilibrium theory. could and not just criticizing the conventional wisdom and
TOM: It seems to me it is also a Monetary theory not that by addressing the “evidence” in modern terms. To this
different from some of the RE models. extent, [ feel somewhat inhibited in criticizing their efforts.
| HARRY: Actually I think it is more accurate to say that it DICK: You will do it though, won't you!
"| is a money-capital theory. The capital part of it does make HARRY: Yes, but perhaps we should first stop and discus 4
it quite different from all mainstream models. In particu- the ideas | have summarized so far.
lar, the use of broad aggregates in the latter is carefully TOM: OK, but not tonight. Let’s meet again in the library



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next Wednesday.

Scene iv — Point-Counterpoint
[The following Wednesday in the library]

OM. I've been thinking about what you said, Harry—
that Austrian business cycle theory is a disequilibrium
theory. Surely this is a semantic issue, one that may not be
very important. After all, any disequilibrium situation can
be recast as an equilibrium situation simply by respecifying
the constraints to include the time and information avail-
able to agents. Use of the notion of equilibrium simply
reflects the conviction that people do the best they can
given the circumstances and that, therefore, their actions
can be modelled and understood. What is gained by insist-
ing on the disequilibrium character of fluctuations?
DICK: 1 disagree, Tom. One think I liked about O-R’s
book is their emphasis 0 on the difference between individ-

1 ~ual‘and: general edititibe his
most important points. The economic system may find
itself at any time in a situation which from the vantage
point of the ideal observer is a disequilibrium. I agree he
confused matters by characterizing it as a less than full
employment equilibrium. He really was dealing with what
we should recognize as a disequilibrium.

HARRY: think more than semantics is involved here. Iti is
not just that there is a difference between individual and
general equilibrium. It is that if the latter has any meaning

» all, it is a very restricted meaning. | refer to Hayek's

reatment of equilibrium in terms of the coordination of
individual plans. So when we say that economic fluctua-
tions are disequilibrium phenomena we should understand
this to mean that they are the consequences of plan
discoordination—that is of the disappointment or surprise
to individual plans. To define disequilibrium away, in the
manner you suggested, Tom, may be to sacrifice any under-
standing of how this discoordination can occur.

TOM: I see the point, but I don’t think you are entirely

of vents (which may be part of an economic cycle) can be
understood as a succession of individual equilibria. Every
individual is in equilibrium at each point of time (or short
period of time) relative to the circumstances, including
knowledge, at that time. When something changes he or
she moves to a new equilibrium.

HARRY: That's precisely the problem. You can’t explain
how the individual gets from one equilibrium to another—
he or she must be in disequilibrium in the transition or else
action becomes meaningless.

But notice that we have moved from macro to individ-
ual equilibrium. I think that’s important. I have serious
doubts about the applicability of the equilibrium concept
gt the macro level or at any level above the individual.
TOM: I have another point. On page 25 O-R characterize a
typical sequence of the first part of a cycle. It occurs to me

is-surely one of Keynes's ©

dividual plans, any actual series.

hr mi

that a RE invariance property can be derived from this
setup. If the economic agents understand this sequence
then surely they will immediately attempt to buy consumer
goods. If they do, the prices of these goods will rise and the
cycle will be avoided.
HARRY: If you read this chapter carefully you see that O-
R anticipated this point, which has been made before of
the Mises-Hayek theory. They make two points in reply:
(1) While it may be true that agents understand the general
pattern of cycles, they lack the ability to predict magni-
tudes and turning points. Thus, mistakes are still made. “In
a decentralized economy, the kind of information acquired
by agents is not sufficient to insulate them completely from
the effects of monetary shocks.” {page 29}. (2) Even if
expectations in general were correct, cycles may exist. Re-
member the discussion about making Mr. Garrison a
‘wealthy man, =~ |
Buthaving said this Fates chicede that ft does Taise
an important point about the feasibility of cycle theory
(any cycle theory). I hope I'll get a chance later to give you
my own view.
DICK: Perhaps just one final point before you do. The
Austrians seem to have much in common with both the
Keynesians and Monetarists. To oversimplify, they share
many of the Keynesian criticisms of the Monetarists (and
the New Classicals) vet they end up with the same policy
prescriptions.
HARRY: O-R touch on this though they don’t expand on
it. Austrians like the subjectivist elements of Keynes's anal-
ysis and in the hands of O-R can integrate his multiplier
process into theirs, From a policy perspective, however,
they reject both Monetarist and Keynesian approaches as
being constructivist in approach. Thus, paradoxically they
believe that the dark forces of time and ignorance lead in
exactly the opposite direction from what the Keynesians

think they do.

Scene v— Criticisms and Extensions |

“TOM: What w were you “going to say a moment t ago “about
cycle theory!
HARRY: I'm afraid that since this is a major point I may be
a little long winded.

Though [ am in basic sympathy with it, I believe that
Austrian cycle theory may be laboring under an inconsis-
tency in the way in which it treats capital. To understand
you have to remember that one of the earliest and most
well known Austrian contributions was that of Bohm-
Bawerk. Although aspects of his general approach were
repudiated by the Austrian consensus, the spirit of his
approach has been honored. Austrians writing in cycle
theory, continue to cast capital concepts in terms of
“longer” and “shorter” production periods. O-R are no
exception, though they do so in very general terms. Still, I
wonder if this approach is necessary or helpful.



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Bohm-Bawerk, of course, was looking for a method of quences—relation-ships between inputs and outputs over

measuring capital. He zeroed in on “time” as being the time. To the extent that these plans are successfully com-
most important element in capital theory. Production pleted they must be consistent with one another. If they are
takes time. Some production processes take more time inconsistent there will be shortages, surpluses, delays etc
than others. Since people are impatient for the results they Thus, insofar as inconsistency of plans is not a dominan
will only adopt longer processes if they yield more valuable fact of production life, there will be some shared notions of
results. Thus, to say that a society is more highly capital- some production activities having to occur before and after
ized is really to say that its production processes are others. In that restricted sense one may identify “stages” of
“longer” or more roundabout. There is a basic common- production. This also leads to the realization that there is g
sense appeal to this line of reasoning, especially when we an implicit intertemporal structure to the capital stock at 3
look at the real world with its highly complex, specialized any point of time. However, this intertemporal logic, like 3
activities, : the hypothetical core of perfectly consistent plans, is never 3
However, when one tries to formulate it, as Bohm- actually wholly perceived by anyone. No one is actually
Bawerk and others have done, one gets into problems. motivated by it. Individuals, at best, catch glimpses of it. 1
Basically, he tried to use time as a measuring device and What exists in individuals’ minds, the plans they make, i
came up with the concept “average period of production” may bear a closer or more distant relationship to the ideal
as a measure of the size of a capital stock. Now, | need not structure. :
repeat here the difficulties of sustaining this concept. The. ~~ TOM: Where is all this leading, Harry? ne ooo :
extensive literature to which it gave rise bears adequate HARRY: I can understand your ropatience, ., but this is a
testimony. I need say merely that in any actual economy tough subject.
where multiple outputs are continuously produced with TOM: OK, see if you can short circuit it though.
multiple inputs it is impossible to calculate it. In fact any ~~ HARRY: What I'm getting to is that when O-R construct a
measure that attempts to compare processes in terms of the cycle that starts with a fall in the interest rate that causes
“time they take” is bound to fail. When inputs and outputs investors to shift away from “shorter” into “longer” pro-
are heterogeneous they can only be compared using money duction processes, they cannot be talking about anything
prices as a yardstick. But these prices are the result of that corresponds to readily identifiable objects. The whole
production (and consumption) decisions. “Longer” and apparatus is misleading and unnecessary. It is true that
“shorter” are not independent of the decisions they are individual producers may be induced into investing ig J
supposed to determine. So we are in the curious situation what they see as “longer” processes, but even the meanin
of using concepts that rely on general equilibrium for their of this is in doubt. And what if they are so induced? As
very meaning in order to enunciate a disequilibrium theory long as there exists no perfect correspondence between
of the cycle. In fact, in disequilibrium “longer” and these individual-mind constructs and the real world, we do
“shorter” don't have any clear meaning, not have a theory of a cycle-in-process in terms of a shift
Actually, my criticism is more essential than this. O-R- from one class of activities to another. That's it really. The
Garrison attempt to salvage some use for “period or stage defining characteristics of the proposed classes—longer,
of production” by asserting that this concept is really a shorter—have no objective existence.
subjective one: Let me give and example. One page 31 O-R try to ex-
A common misunderstanding can be avoided, and the plain why a monetary cycle is unlikely to be quickly self
element of subjectivism can be reemphasized by correcting; One of the two reasons (the lessér-one)-that |
pointing out that the notion of a “stage of produc- they give is that the government will exacerbate the prob]
tion” is itself a subjective concept. That is, it has’ lem by investing in “capital —goods (i.e. smokestack in-
meaning only in terms of the relationship (as per- dustries’)’. The implication is that it is these industries
ceived by the producers) between capital goods that that are (type-1) “longer” period industries. But, it is by no
make up a stage of production and the future con- means clear that these are the industries that will appear
sumption goods ... The difficulty of concretizing profitable to private investors when the interest-rate falls. j
the notion of stages of production does not render the An industry that appears to embody large amounts of
notion meaningless or unhelpful. It only reminds us physical capital —any may be appealing to the government
that there is coordination. Conceiving of the produc- for political reasons—may not require large amounts of
tion process in terms of (subjectively defined) stages of financial capital investment in order to increase output. If
production does help to identify the specific nature of most of the fixed (specific) resources are already in place
the coordination problem and it points the way to a and production could be increased with a relatively small |
satisfactory solution to that problem: {Chapter 8, increase in the application of variable (general) resourcelygf) b
page 12}. (labor working overtime), then it is not necessarily these
Now, obviously it is true that different producers have industries that will initially appear to increase the most in

production plans. These plans involve temporal se- profitability. There appears to be fallacy of composition



===== PAGE 7 =====

here. what we call a cycle in modern economics may be in large

DICK: I am having some difficulty following this, Harry. part a statistical artifact. In a retrospective sense a cycle is
Perhaps it is because I am used to thinking in terms of RV, an ex post identification of coherence among a set of aggre-
formulae. Can you relate it to that for me? gate time series. The composition (and meaning of the
Nt ARTY, Yes, actually this bears some resemblance to the elements) of the set and the demarcation of the cycles can
réswitching problem.” PV, formulae are similar to period- and do differ across analysts. The “cycle” that is relevant to
of-production formulae in that they attempt to reduce the individual economic agent may be something com-
multi-dimensional production processes to one dimen- pletely different. Looked at prospectively, the cycle doesn’t
sion —present value. (They apply to flow and point output exist. It is in the process of being created by individual
configurations rather than only to point output configura- decisions and its realization will have unique aspects.
tions. But the basic idea is the same.) Remember what I Second, cycles occur because of politics, money and un-
said the other day about subjectivism and the use of sym- certainty. In our modern political systems politicians buy
bois. The point is that when O-R use that formula—admit- votes with inflation {Lewin (1982), pages 639-40}. Inflation
tedly only as a simplification device—they must know that brings resource reallocation because it is the result of gov-
the symbols refer to individual mental images and not to ernment expenditure on specific vote-raising projects.
objectively verifiable phenomena. I'm glad you brought Those who receive the proceeds directly and, to some
this up. Let's lock at t the EV. formula more closely: extent, indirectly perceive a gain. Those who experience
TT - 3g S, 3 Tg the price Inflation perceive a 1085. The gains are more
PV. = —L. 4 _2_ 4 rr immediate and concentrated than the losses and are more
(I+r) (14x) (141) (1+) likel b d » di
ikely to be seen as connected to specific expenditures.
Note that it involves three essential symbols or ideas, Hence, there is a well documented inflationary bias in our
namely, S, r and n. Each of these (not particularly n, i.e. the budgetary system. Everyone would like to see inflation
length of the project) is subjective and will differ across stopped but no-one wants their pet project cut. However,
individuals. There are an infinite number of ways to char- cuts do occur for two reasons. One, in an inflation the real
acterize any investment, especially when it involves a multi- value of a government subsidy erodes with time and pres-
| plicity of complementary processes. Certainly there is no sure builds up to accelerate the subsidy beyond tolerance
| sense in which they can be unambiguously divided into limits. Second, and related, subsidies tend to occur in ailing
fg ect or shorter even at the individual level. As the dis- =~ or nonviable industries. Often these get worse over time or
count rate falls, some projects will gain in relative attrac- at least no better. The subsidy is, in fact, implicitly de-
tiveness and some will fall. But this is not monotonic and it signed to prevent painful resource reallocation or to estab-
may switch and reswitch. It depends on the configuration lish a pattern of resource allocation out of line with private
that the individual has in his or her mind. There is another consumption and production decisions. That is why they
problem. When individuals appraise alternative invest occur through the political process rather than through
ments they may look at more than just the present value. the market process. Thus, unless they are to accelerate
(In technical terms their utility functions may not be addi- without limit, these subsidies eventually get cur (or they
tively separable over time). increase at lower nominal rates). By this time they have
I guess I'm just reacting to what I perceive as an excessive substantial resources committed to them—some of which

.._)_formalism in_this CONEEXE pre oe eo — e heen elsewhe x : 1

~ DICK: Gee, Harry, you were e critical of the Austrians for but for the continuing subsidy. The relative cutback now
destructive criticism. Where does your view leave their causes a large reallocation. This implies unemployment
theory? and an income-constrained process.

‘ HARRY: Actually, I do have a tentative alternative, a half- Third, you see from this that errors will be made, the
formed theory of fluctuations. But its not really very con- indirect effects of the inflation, the subsidy and the subse-
crete and I don’t want to bore you. quent cutbacks are diffuse and uncertain. And the errors
DICK: Go on bore me Harry. Tom wants to hear. will be clustered in time and economic space (i.e. connected
TOM: Sure why not? to each other by type of economic activity). Basically, this
HARRY: As [ see it, there are four basic ideas that must go is because some resources are both durable and comple-
into a cycle or fluctuations theory: mentary to each other. There i is a shared fate that is spread

(1) The identification and characterization of the cycle over time.
as subjective Finally, although fluctuations may appear as general cy-
(2) Cycles are political phenomena cles when, as is bound to happen, the politically exacer-
(3) Cycles involve clusters of errors bated ups and downs in specific industries coincide, these
(4) Cycles are not generalizable at the level of move- cycles are not generalizable in terms of movements of eco-
ments of interest rates, prices, output or any general series. nomic aggregates. Interest rates do not necessarily play a
I will try and elaborate briefly on each in turn. First, pivotal initiating role. The monetary effects may work



===== PAGE 8 =====

directly on consumer goods industries. All that one can say,

[ believe, is that the pattern of production gets out of line Special Price for Theory and

with the more immovable pattern of consumption and History
oscillates around it. {cf. Hayek (1980) pages 20-21}.

Scene vi - Epilogue

TOM: That’s very interesting Harry. | think we'd better get
back to studying the convergence properties of differential nd HESOFY
equation systems for the econometrics exam though. Thee?
HARRY: What did you think about my ideas and the nape £5 1
issues raised in this book? Will economics ever be the same? "
TOM: You know, in the final analysis, it comes down to
choice between methodologies. That's where we started
and that’s where we were bound to end up. Methodologi-
cal assertions really revolve around criteria of “proof” and,
therefore, cannot be proved. (This is a case of Godel’s
theorem). = i
HARRY: What do you think Dick? Ny
TOM: Dick's fallen asleep, Harry. ~~~ | “Luduig von Mises published many books and
| - ‘articles in his long and productive life,” notes Profes-
sor Murray N. Rothbard in his new preface to Theory
and History “each of them making important con-
tributions to the theory and application of economic

Peter Lewin is visiting assistant professor of economics at the University
of Texas at Arlington.

Footnotes science. . . .

| “But Mises’ . . . last great work, Theory and History :

*With apologies to Maddock and Carter (1982). In order not to impede (1957), has made remarkably little impact. [t remains
the flow of action references have been kept to a minimum. by far the most neglected masterwork. And yet it
1. Gerald P. O'Driscoll, Jr. and Mario J. Rizzo, The Economics of Time and provides the philos ophical backstop [to] Human Ac- ) !
2 Ni (1983), See Klamer (1983). tion. It is Mises’ great methodological work, explain. \gabi ;
3. See Lewin (1982). ing the basis of his approach to economics, and pro-
4. See for example Blaug (1976). viding scintillating critiques of such fallacious |
5. O-R page 15 references omitted, emphases added. alternatives as historicism,. scientism, and Marxian
6. Menger (1981), see also White (1984) chapter 2 and Lewin (1984) dialectical materialism. ... J
chapter 2. :

“Austrian economics will never enjoy a genuine |

renaissance until economists read and absorb the vital
References lessons of this unfortunately neglected work.” !
The Ludwig von Mises Institute has reprinted this
masterwork with a new preface by Murray N. Roth- [
bard, and copies sell for $20 00 (hardback) and | .
<i

7. See Samuelson (1966).

 Blaug, Mark. “The Empirical Status of Human Capital Theory”. Journal
of Economic Literature, XIV (3). September 1976.
Hayek, EA. 1980s Unemployment and the Unions: The Distortion of Relative

Prices by Monopoly in the Labor Market. (London: The Institute of $10.00 (quality paperback), not including postage and

Economic Affairs), 1980. handling. i
Klamer, Arjo. Conversations with Economists. (New Jersey: Rowman and However, AEN readers may order copies at a spe- |

Allanheld). 1583, cial discount price of $10.00 (hardback) or $5.00 {pa-

Lewin, Peter. “Perspectives on the Costs of Inflation.” Southern Journal of

Economics, January 1982, perback) with no additional charge for postage and

— — — —. Monopoly in Money: The Enduring Myth. 1984. handling.

McCloskey, Donald. “The Rhetoric of Economics”. Journal of Economic If you would like to order a copy, write Theory
Literature, XX1(2). June 1983. (hb) or Theory (p) in the upper right-hand corner of {

Maddock, Rodney and Michael Carter. “A Child's Guide to Rational your return card, and enclose your check for $10.00

Expectations”. Journal of Economic Literature, XX(1). March 1982, ] es
Menger, Carl. Principles of Economics, translated by J. Dingwall and B.E ot $5.00, plus any tax-deductible contribution for the ;

Hoselitz. (New York: New York University Press). 1981 [1871]. Institute's work, in the enclosed postage-paid enve- i

Samuelson, Paul A. “A Summing Up". Quarterly Journal of Economics, lope. :
80. 1966. - x |