Was Hayek really saying that Free Markets create genius consumers?

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It’s interesting how often the most memorable and thought-provoking parts of a given discussion are to be found in the tangents away from it.

Yesterday I was in a seminar on the history of economic thought in which we were supposed to be discussing Thorstein Veblen and the American Institutionalists, but toward the end of the session we got side-tracked into a discussion of the modern economy’s use of big data and the way companies gather information to provide targeted advertising. The lecturer somehow tied this into Hayek’s famous explanation of how a free price system efficiently conveys information to economic actors, dispersed and local information which could not possibly all be known to an economic central planner, and hence allows for those resources to be economised in a way that more rationally reflects their supply and demand.

Our lecturer, however, seemed to misunderstand the nature of Hayek’s argument and the sort of information to which he was referring. The lecturer sarcastically remarked something to the effect of “Do you think consumers are really well informed about the products they consume, thanks to the free market?” Surely, he seemed to be implying, the fact that most real-world consumers don’t have a full and deep intellectual understanding of every product they consume and where they come from – especially compared to the nefarious producers of those products – proves that Hayek was wrong. Thank goodness our modern understanding of asymmetrical information has superseded Hayek’s naive fantasy of consumers who are automatically kept fully informed by the magic of the market!

This is not only a misinterpretation of Hayek’s conclusions, but a misinterpretation which highlights an incorrect way of even approaching Hayek’s argument to begin with. Therefore I feel it might be worthwhile to briefly clarify what kind of information Hayek was actually talking about, in case anyone else reading this may have fallen prey to the same misunderstanding.

It is certainly true to say that consumers in a relatively free market tend to lack some information about the products they consume. Standing before the bread aisle in a supermarket, most consumers would not be able to tell you off the top of their heads the differences between the different brands of loaves, their ingredients, the companies which made them, and so forth. The same would be true for this sort of information for almost any other product and any other consumer; none of us are omniscient, and Hayek never claimed that a free price system would make us so.

However, this is not the sort of information Hayek was claiming the price system transmits. What the price system does, according to Hayek, is convey the relevant information about the supply and demand for different goods on the market, in a way that allows people to economise those goods as if they did have a conscious, intellectual understanding of those factors, even if they don’t.

To use Hayek’s own famous example, suppose that a major tin mine collapses, making the supply of tin in a given economy even more restricted than it had been before. This information will be reflected by a rise in the price of tin, and this price change will in turn affect the distribution of tin between the different producers who require it. For the producers whose tin-based products are more highly valued by consumers, those consumers will consequently be willing to pay enough for those products that the producers will still be able to sell them at a profit, despite the increased price of the tin the producer needs to buy. For other companies which make tin-based products less highly valued by consumers, those consumers will consequently be less likely to continue buying those products at the increased price, leading those companies to restrict their production of those less highly valued products, hence freeing up tin to be used by the producers of more highly valued products. In this way, the price system has conveyed ‘information’ (the fact that the tin mine has collapsed) to all relevant parties, forcing producers to economise the increasingly scarce tin in a way that sees it being channeled toward the production of the goods most highly valued by consumers.

The critic of Hayek’s theory might object that the price system hasn’t really made anyone more informed about anything, as the above-mentioned consumers and producers wouldn’t necessarily even have to know why the price of tin had risen. But that’s the whole point and the whole beauty of the system! (Indeed, in Hayek’s original argument this was what led him to the conclusion that free markets and free prices would always lead to a more preferable (from the perspective of consumers) distribution of resources than a central planner ever could, as a central planner would have to consciously know such information in order to distribute resources appropriately, whereas economic actors in a free price system are automatically encouraged to do so even without having to consciously grasp why.)

I suppose therefore it is possible, in a certain sense, to criticise Hayek’s preferred system because it does allow consumers to get by despite potentially being ignorant of certain information about the products they consume. An opponent of Adam Smith could likewise lament that, thanks to Smith’s beloved division of labour, many people today are ignorant of how to make bread, a skill which would have been indispensable for survival in previous times. However, rather than sneering at this as evidence of how the division of labour creates consumers who are too stupid to even bake bread, the correct response is to celebrate the fact that many people are now able to enjoy the delicious boon of bread as much as if they did know how to bake it, even if they don’t.

Just as with Smith’s division of labour, so too with Hayek’s division of knowledge. Far from deriding Hayek’s preferred system of free prices because not every consumer under it is perfectly informed about every product they consume, the system should be celebrated for allowing scarce resources to be distributed as if everyone knew all the information concerning their supply and demand, even if they don’t.

 

Some readers might wonder why I even bothered clarifying such an elementary point about what Hayek was saying. Indeed, as a writer, my own instincts usually tell me to focus on more specific, technical, and arcane points, as my own personal inclination is usually to assume that all of the simple, broad, and sweepingly important things that could be said about economics or libertarianism must already have been said by writers more intelligent and eloquent than I could ever hope to be. However, elementary errors sometimes require elementary responses, and if a lecturer in one of the top economics faculties in the world was capable of misunderstanding what Hayek was saying in this way, hopefully my writing this will have helped clarify the thinking of at least some reader on this topic.

And even if not, I’m still going to publish this post anyway; I have to write about something on this cursed blog, after all.

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Why Austrian Economics?

The other day someone sent me a question over on my Tumblr blog: “Why Austrian economist? I thought you were English. Aren’t you a British national?”

The question highlights the fact that, despite its resurgence and speedy growth in recent years, the “Austrian School” of economics is still seen by many as part of what Keynes would have called the economic “underground”. Indeed, the Austrian tradition lies so firmly outside the mainstream of economic thought that, for the inaugural post on this blog, perhaps I should repeat here a somewhat expanded version of the answer I gave to that confused Tumblr follower. What is “Austrian” economics? Why is it unique? And why is it so vital that it’s message be understood in these troubled economic times?

As I highlighted in the “About” page of this blog, I’m still a relative newcomer to Austrian ideas, and my hope is that the level of understanding displayed on this blog will increase as time goes on. So the reader should temper their expectations somewhat for this very first post, as it likely won’t be the most exhaustive or masterful exposition of Austrianism ever. Nevertheless, it should still serve to single out some of the most fundamental ideas in the Austrian tradition, as well as those which strike me as most important to the state of economics today.

So first thing’s first, forget about the “Austrian” part. Austrian economics doesn’t refer to supply and demand in Vienna, or inflation in Salzberg, and too many people get confused thinking it must have something to do with the actual country of Austria itself. In fact, most “Austrian” economists today live and work in North America and, as the great economist Murray Rothbard quipped, “there are very few ‘Austrians’ left in Austria.”  Austrian Economics is rather a school of thought, a body of ideas and theories, which were first explored by Carl Menger in the 1860s.

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Carl Menger (1840-1921)

During his time as a financial journalist in central-Europe, Menger noticed that the received wisdom of Classical Economics did not match-up with how he observed prices being formed on real-world markets. This prompted him to write his Principles of Economics (1871) which demolished the archaic “labour theory of value” favoured by Adam Smith, David Ricardo, and Karl Marx, and ushered in the “Marginal Revolution” of the 1870s. (Incidentally, its genesis in Menger’s 1871 work makes Austrian Economics the oldest continuously-existing school of economic thought in the world.) For about a decade after the publication of the Principles, there was no “Austrian school”, there was only Menger. However, in the mid-1880s Menger came under attack by the dominant school of economic thought in the area at that time, the so-called “German Historical school”. The Germans disdained Menger’s abstract theorising, instead favouring pragmatism and reference to historical knowledge as the correct approach to the economy. At this point in history, Germany was considered the cultural and intellectual centre of Europe, and so adherents to the German Historical school began referring to Menger and his ideas as mere “Austrian economics”, in an attempt to brush them aside as unrefined and parochial. Despite being intended as an insult, the name stuck and, as Menger’s ideas gained an increasing following throughout the 1880s, including brothers-in-law Eugen von Böhm-Bawerk (1851-1914) and Friedrich von Wieser (1851-1926), the “Austrian school” of economics was born.

From that time until this the Austrian school, despite its ostracism from most of academia, has nevertheless developed a host of key economic ideas, some of which have even been accepted into the corpus of acceptable mainstream opinion. These include Menger’s subjective marginal utility theory of value, Böhm-Bawerk’s positive time-preference theory of interest, and Wieser’s concept of opportunity cost. Other adherents to the Austrian tradition, whose names might be more familiar to the lay reader, include: the extremely eminent economist Friedrich von Hayek (1899-1992), whose political writings, such as the famous Road to Serfdom, influenced British Prime Minister Margaret Thatcher; Murray Rothbard (1926-1995), economist and founding father of the political ideology now known as anarcho-capitalism; and three-time US Presidential candidate Ron Paul (1935- ).

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Ludwig von Mises (1881 – 1973)

However, I’m many ways, the central figure to the modern Austrian tradition was the brilliant economist Ludwig von Mises (1881-1973). Although he made extraordinarily important and extensive contributions to the theories of money and credit, the problem of economic calculation in planned economies, and our understanding of the business cycle, perhaps Mises’s most important contribution to economic thought was in the rarely-traversed field of methodology. Mises devoted a large part of his career to explicating and systematising the method which had been implicitly used by previous Austrian economists, as well as by proto-Austrian figures such as J.B. Say and A.R.J. Turgot.

Looking at the academic world around him in the early- to mid-20th century, Mises became increasingly concerned by what he saw as the grave methodological bankruptcy of modern economics. Ever greater numbers of economists, particularly those in the penumbra of the logical positivist movement, were beginning to believe that the best way to gain insights into the economy was simply by  measuring and gathering its empirical data, and then discerning the mathematical relations between the various variables. While this is undoubtedly a fruitful way to approach the natural sciences, such as Physics, Mises believed that its use in the distinctly human science of economics introduced an unacceptable element of error, in particular due to its inability to account for two factors which he called “finality” and “ideas”.

What he means by “finality” is the understanding that human action, unlike the movement of atoms or the reaction of chemicals, takes place in the pursuit of individually chosen goals. Because people chose the outcomes they would like to achieve, this means the range of different behaviours they exhibit in the face of external forces is much wider and less predictable. Not only are the goals people aim at as numerous and varied as the human race itself, but any person or number of people in the economy could change the goals they’re aiming at at any time, in any way, and any number of times, and could do so for reasons completely unknown to anyone but themselves, least of all to the economist and his calculator. This peccadillo of human nature and (apparent) free will, leads to a potentially infinite number and variety of future changes in the economic system, which severely restricts the predictive power of mere data-gathering and mathematical methods.

What he means by “ideas” is the fact that different people have very different ways of looking at the world, which cannot be empirically measured or modelled for. These different world-views, beliefs, and constellations of abstract concepts which exist within each individual mind, cause different people to react in unforeseeably different ways when confronted with the same external circumstances.

Mises argued that the failure of (what is now) the mainstream economic method to account for these two human factors, finality and ideas, as well as the impossibility of truly controlled experiments in economics, renders the empirical/mathematical method useful only as tools of economic history, able to blandly state what happened in the past, but little more. For the purposes of devising economic theories, on the other hand, to actually explain the past and predict the results of future changes, Mises had to create an entirely new field of study: Praxeology.

Praxeology is the value-free, objective science of human action, of which Economics is the most well-developed branch. In order to overcome the extreme variety and unpredictability of human action, Mises sought a few core statements about it which are undeniably true under all circumstances: axioms. The most important praxeological axiom is the Action Axiom: the statement that human beings select particular outcomes which they would like to achieve, and then pursue those outcomes by chosen means. In a word, humans “act.” This is axiomatically true, because any attempt to disprove it would be to select a preferred outcome, and then to pursue it by chosen means. That might seem banal, but because these axioms are undeniably true under all circumstances, that must mean that any statement that can be correctly deduced from them logically must also be true under all circumstances. Any economic statement correctly deduced in this way, would therefore also be universally true, and hence would have overcome the obstacles of finality, ideas, and the sheer complexity of the economy.

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Six key “Austrian” Economists, and some of their notable ideas and works.

Therefore, Mises argued that a priori logical deduction from axioms about human action was the only method by which undeniable economic truths could be discovered. Misesian Austrians argue that this method equips the economist with the ability to make a narrower range of predictions, but to do so with absolute certainty. An Austrian economist doesn’t believe they can predict what the price of crude oil will be in a year, or by how much a certain tax hike will raise government revenue. Rather they believe their system allows the economist to make absolutely certain statements, like “Other things being equal, people will always value acquiring the ‘n’-th unit of a good, more than they value the ‘n+1′-th unit of the same good”,  or “Other things being equal, a rise in the price of a particular good will always cause people to prefer buying a smaller amount of that good than they otherwise would have.”

Mises further understood that, if an economic law really is true under all circumstances, as a result of having been correctly deduced from praxeological axioms, that law would therefore be invulnerable to supposed empirical evidence against it. Indeed, if economic laws can be deduced aprioristically in this way, asking to prove or disprove them with empirical evidence wouldn’t even make sense; to compare economics to another purely aprioristic science, it would be like asking a mathematician to go out into the real world and gather empirical evidence to prove that the 2 is never the same number as 7. Naturally, their complete rejection of supposed empirical evidence, as well as their increasingly unfashionable lack of interest in mathematical analysis, has made the Austrians extremely unpopular in academic circles, and they have consequently been relegated to well outside the mainstream since at least the Keynesian devolution of 1936 onward.

However, there has been a somewhat increasing level of interest in the Austrian school in recent decades, and certainly since the Great Recession. It didn’t go unnoticed that a disproportionate number of the people who accurately predicted the 2008 financial crash in advance were Austrians, and this has led to growing interest in perhaps the most important Austrian theory for our times: the Austrian Theory of the Business Cycle.

I’m conscious that this post is already so long that it could easily be mistaken for the average modern-day cinematic release, and with a roughly equivalent proportion of the audience proffering unanswered pleas to God for mercy at this point. Furthermore, I’m sure I’ll have many other chances to relay this elegant theory in future posts, so I won’t go into it in any great depth here. But basically, the absolute bare bones of the Austrian business cycle theory, which was first outlined by Mises and then fleshed out by Hayek, is the idea that interest rates coordinate production across time. If the interest rate is high, it will be more expensive to borrow money for a long time, so businesses will tend to invest more in enterprises which will yield profits quickly, i.e. consumers’ goods. Conversely, if the rate is low, it will appear more profitable for businesses to invest in producers’ goods and other projects which won’t yield profits for a long time. On a free market, the rate is determined by supply and demand of credit, i.e. how much people are saving. This coordinates things beautifully, because banks will offer high rates (and hence stimulate investment in consumers’ goods) when people are saving least (and hence demonstrating their desire to consume now), and banks will offer low rates (and hence stimulate long-run investment) precisely when people are saving most (and hence demonstrating their preference for spending in the future.) However, the Austrian theory shows that the business cycle is kicked-off when the interest rate is pushed artificially low, usually by a government central bank. The artificially low rate incentivises consumers to save less and spend more in the present, while at the same time incentivising businesses to produce less in the present and invest more in long-term projects. This disco-ordination leads to lots of spending, lots of construction, lots of investment, and outwardly that all looks great, but under the hood it’s merely the boom or “bubble” that precedes the crash. When the government eventually has to raise interest rates again, to avoid severe inflation, all these long-term projects which had the illusion of profitability at the artificially low rate, will be revealed to have actually been unprofitable all along. Therefore all the resources businesses sunk into such projects are shown to have been wasted, resulting in economy-wide losses, the bursting of the bubble, and the resulting inevitable crash.

I understand that that’s an extremely oversimplified version of the Austrian theory, which is actually quite a lot more complex and nuanced than most other explanations of the business cycle, but hopefully I’ll be able to do it a little more justice in future posts.

Anyway, I should probably finish this utter behemoth of a first post here. Hopefully though that will have given pretty good outline of why I think the Austrian school stands so far apart from the crowd, and why I consider its method and business cycle theory so important to the current state of economics today. If you’d like to learn more, I’d heartily encourage you to check out the absolute wealth of educational materials that the Mises Institute puts out, both on their website and on YouTube. They, in their extraordinary generosity, have made practically every major work of Austrian economics available as free PDFs, and sometimes even as free audiobooks, alongside all sorts of other goodies they offer on their website, so you’ll do yourself an immense favour by checking them out. In general though, if you want to learn more I hope you’ll continue to follow the output on this blog in the future, as I certainly look forward to writing more on this fascinating subject, as well as on libertarianism and current events in general.