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The Implications of an Imperfect World

Mises Daily: Tuesday, July 19, 2011 by

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Something of a stain on the post-1970s monetarist counterrevolution is its continued dependence on perfect-market models — notorious for their reliance on various assumptions, including perfect knowledge and perfect competition. Similar schools of thought, such as the economics of rational expectations, are also based on this notion of "perfection," whether it is some form of macro optimality or the supposition of flawless individual decision making.

While it is questionable whether individual economists really believe in perfect markets, the point is that modern macroeconomic modeling and theory is all too often based on the existence of perfect markets. This has led dissenting economists to suspect the accuracy and general usefulness of such models, and it has given the Keynesian revival fodder for their offensive against free-market economics.

When surveyed from a broad perspective, mainstream economics has developed in such a way that two clear stances have emerged. Either you believe that markets are perfect, therefore rendering government intervention unnecessary, or you believe that markets are imperfect, and because of this suggest government intervention as a policy prescription to restore market optimality or something close to it. Based on this dichotomy, it is easy to sympathize with the Keynesian dissenters.

Much of the last few decades' development in macroeconomics has represented retrogression. Time-independent, perfect-market models have replaced a much more exact tradition of free-market economics.[1] The dichotomy between the Keynesians and the these perfect-markets economists is a false one. The belief in perfect markets and flawless rationality (in the sense of utility maximization) is not a prerequisite for belief in the superiority of free-markets over regulated markets.

But there is a superior free-market tradition, unfortunately discarded during the rise of Marshallian economics in England and the United States. This tradition viewed the study of economics, not as the analysis of some supposed perfection, but rather as an examination of real phenomena. Instead of focusing on modeling an economy at a specific moment in time, the focus was on the market process and what tendencies characterize this process. For the sake of simplicity, we can categorize this perspective as "coordination economics."

The idea of the market process is not completely unique to any particular school of thought. It could very well be argued that John Maynard Keynes, for example, was a practitioner of "coordination economics." In fact, this has been argued by George Shackle and Ludwig Lachmann — "radical subjectivists" heavily influenced by Keynes's application of subjectivity to expectations (whereas Austrians had formerly focused on the subjectivity of preferences). Shackle and Lachmann argued that Keynes's economics focused on particular and specific forces of discoordination. Shackle, in particular, developed the concept of the "kaleidic society," where change is bound to upset the existing market status quo.[2]

Several modern economists have also interpreted Keynes's General Theory as a work on the market process. This includes Axel Leijonhufvud[3] (influenced by Hayek) and Roger Garrison[4] (his interpretation of Keynes, admittedly, being heavily influenced by Leijonhufvud's), who see Keynes's work on business-cycle theory as a study of market discoordination. Specifically, they interpret Keynes's theory of liquidity preference as one that recognizes potential for discoordination between savings and investment. Neither would Keynes necessarily disagree with some of the more general concepts of macroeconomic coordination during times of full employment. Keynes's concerns primarily dealt with periods marked by a dramatic fall in effective demand and characterized by massive unemployment.

The concept of macroeconomic coordination also began to play an important role in the economics of the London School of Economics (LSE) during the 1930s. Some of the more well-known economists of this tradition include Frank H. Knight, Arnold Plant, and Plant's student Ronald Coase. The list also includes Friedrich Hayek.[5] It was Hayek, along with his mentor Ludwig von Mises — who was not of the LSE ilk — and their successors (such as Murray Rothbard and Israel Kirzner), who developed the theory of the market process most completely.

The Market Process through an Austrian Lens

The Austrian market, much like Shackle's "kaleidic society," is an economy outside of equilibrium. Reaching equilibrium is deemed impossible, because an economy in equilibrium is one that is no longer experiencing any form of change. The forces of discoordination that cause this change are the constant modification of individual preferences.

To illustrate the point, imagine a supply-and-demand graph, where equilibrium is represented by the point at which the demand and supply curves meet. If the demand and supply curves are constantly shifting, so is the point of equilibrium. In the case of the real-world economy, imagine constantly shifting supply and demand curves for thousands of products. That the market experiences shifting points of equilibria is important, because it is this change that allows for the market process.

With economic discoordination and change in mind, Austrians recognize that the economy enjoys macroeconomic tendencies — coordination forces — toward some theoretical equilibrium or point. The leading market agent in economic coordination is the entrepreneur, whose purpose is to predict and respond to changes in consumer preferences. What incentivizes the entrepreneur to do so is the ability to profit from better satisfying consumer preferences before other entrepreneurs follow suit. Macroeconomics and the entrepreneur aside, the basis of all coordination (and, indeed, all economic theory) is to be found in the attempts of the individual to achieve desired ends by the means available. A very early and basic example of coordination outside of the macroeconomic tendencies we witness in our modern, advanced economy is the development of property rights.

"Markets are imperfect. Humankind is fallible. Perfection is either inaccessible or nonexistent."

The fundamental microfoundation of economics, which leads us to our conclusions on macro coordination and discoordination, is that of rational man. Rational, though, is not a reference to perfection or any one type of decision-making process. Rather, rational in the Misesian sense refers only to the process of economization, or human action. All human action is the purposeful choosing of ends and the subsequent choosing and allotment of means toward any given end. Human action, or economization, is not a choice — there is no alternative in a world beset by scarcity.

Austrian coordination does not represent a destructive struggle between entrepreneur and consumer. Instead, it is a theory of progress. The market represents a process where each individual can successively achieve whatever ends he desires, thereby successively achieving states of greater satisfaction. Progress should not be confused with growth, because if individuals preferred squalor to luxury then surely the market process would tend in that direction. It just happens to be that humankind has been inclined to prefer material growth, and thus we have seen during the past millennia of human history a steady progression toward greater material wealth.

The Allure of Perfection

That the notion of the market process, or of economic progress, has been replaced by an economic theory that has placed a premium on the concept of "perfection" is unfortunate. While economists who practice equilibrium and perfect-market theories may not necessarily disagree with the idea of a market process (and they will claim that they never pretended to replace any "coordination-economics" tradition), they nevertheless remain unaware of the fact that their theories are simply incompatible with the view that stresses a market process driven by individual economization. This is because any economic model that focuses on equilibrium, or market perfection, is necessarily timeless — it is changeless. How can a model reflect on a process if what the model is illustrating is independent of time? What use, for instance, is an equilibrium model if in the real world that equilibrium will be forever changing?

For the interventionist, these models serve an important purpose, which is to illustrate where an economy should be at a specific moment in time. If the economy should be at point A, but is currently at point B, the interventionist will use this model as justification for an interventionist program with the intention of achieving perfection (or maximizing utility, or whatever other language the interventionist prefers to use). In other words, these models allegedly provide the economist an idea of what is "optimal," and from there the economist can use other tools to achieve this optimality.

Why did the monetarist counterrevolution put so much emphasis on perfect markets and optimality? After the publication of Keynes's General Theory there was a macroeconomic revolution, propelled by Paul Samuelson's and John Hicks's (among others') neoclassical-Keynesian syntheses. The monetarist counterrevolution, although a reaction to the revealed weaknesses of Keynesian theory, was built on the foundations of this macroeconomic transformation. It adopted an altered way of perceiving the economy and the tools and language that came with this new perspective — including equilibrium modeling and the concept of perfect markets (i.e., "perfect competition").[6]

Also, one cannot help but place partial blame on the emergence of the false dichotomy between perfection and imperfection. If imperfection justifies policy tools to bring the economy toward the state of perfection, then the free-market alternative can only explain how markets are already perfect. Thus, the post-Keynesian free-market schools stressed perfect rationality. Rationality here, however, is not used in the Misesian sense. Rather, rationality is used as a synonym for "infallible decision making." Macroeconomic problems are no longer considered issues of man-made discoordination (whether by the individual in the market or the individual outside of the market — that is, government), but instead are caused by uncontrollable exogenous factors. With exceptions, the counterrevolution was an exercise in absurdity.

If the choice is between unrealistic perfection and the reality of imperfection, where the former is assumed by free-market economists and the latter by the Keynesian School, it is unsurprising that many have found the monetarist counterrevolution to be lacking. So the Keynesians have a clear theoretical advantage over their opponents — their theories are slightly more based on reality than those of their academic adversaries.

But one does not need to believe in perfection in order to dismiss the Keynesian argument. The theory of coordination and the market process provides enough of a foundation to provide an alternative attack against the Keynesian case. For example, from the perspective of market process, tackling the issue of the benefits of government spending as a means of returning to "optimal output" is an issue, not of achieving perfection, but of whether or not government spending can actually help the market process coordinate resources. The market process represents progress in some direction, where the direction is dictated by the individuals who make up society; and the relevance of government now becomes a question of whether or not government can benefit this process, in other words, stimulate greater progress. Since we know that government does not economize, and in fact acts outside of the market process, the answer is clearly "no" — how can something that avoids the market process benefit it?

The Kaleidic Society

That markets are imperfect and humans are fallible does not make the free-market position untenable, nor does it give any special theoretical advantage to the interventionists. That market perfection is a meaningless concept only condemns those who base their beliefs on the concept of perfection and maximization — monetarists, neoclassicists, Keynesians, et al.

The economics of the Austrian School is fully grounded in the reality of discoordination and coordination. It attempts to explain the market process within the context of these coordinative forces, or how individuals in the market react to changes (discoordination) and thereby unintentionally create recognizable macroeconomic tendencies. That there are few economists who still study economics within the context of coordination, discoordination, and process is unfortunate. This is a sign of the decadence of modern mainstream economic theory.

Mises Academy: Robert Murphy teaches Production and the Market Process

One could go as far as to argue that perfection plays absolutely no role in Austrian economics. First, how does one know where equilibrium lies? To be able to recognize equilibrium, an economist would have to have all available information relevant to that point, including knowledge that is subjective to the individuals in the market. Without all available knowledge, determining where an equilibrium point lies is impossible. Second, because man's demand is essentially limitless (i.e., in no point in time does man stop desiring greater satisfaction), and therefore human action is perpetual, there is no such thing as perfection. Perfection becomes a concept similar to infinity, because there is always room for progress.

Markets are imperfect. Humankind is fallible. Perfection is either inaccessible or nonexistent. Contrary to the mainstream "consensus," these facts bury interventionism and support the free market.

Notes

[1] While this bad turn has been in the making since the beginning of the Marshallian hegemony in economics, in some senses extended by the Keynesian revolution of the 1940s and 1950s, it was the "freshwater" counter-revolution which committed the most damage. With various exceptions, it is in the present that we can see the widest disconnect between "economic theory" and reality.

[2] Ludwig M. Lachmann, "From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society," Journal of Economic Literature 14, no. 1 (1976). It is not uncommon to read suggestions of Lachmann's apparent partial endorsement of Keynesianism, largely due to his adherence to the idea of "radical subjectivism" and his agreement with G.L.S. Shackle over the concept of the "kaleidic society." However, neither radical subjectivism nor the kaleidic society is mutually exclusive in relation to the Austrian School, and in fact Shackle's development of the "kaleidic society" has oftentimes led scholars to link Shackle to the Austrians. It is also worth remembering that Lachmann considered Ludwig von Mises a "radical subjectivist," as he says as much in his review of Human Action; Ludwig M. Lachmann, "Human Action — Treatise on Economics, by Ludwig von Mises," The South African Journal of Economics 19, no. 1 (1951).

[3] Axel Leijonhufvud, "Keynes and the Keynesians: A Suggested Interpretation," The American Economic Review 57, no. 2 (1967); Robert Clower and Axel Leijonhufvud, "The Coordination of Economic Activities: A Keynesian Perspective," The American Economic Review 65, no. 2 (1975). It is of little surprise that, apart from Friedrich Hayek, Leijonhufvud was also influenced by G.L.S. Shackle and Ludwig Lachmann. Leijonhufvud was also somewhat sympathetic to John Hicks's later work on capital and time, which itself was heavily influenced by Friedrich Hayek's early work on capital theory.

[4] Roger W. Garrison, Time and Money: The Macroeconomics of Capital Structure (New York City: Routledge, 2001).

[5] Daniel B. Klein and Jason Briggeman, "Israel Kirzner on Coordination and Discovery," The Journal of Private Enterprise 25, no. 2 (2010), p. 8.

[6] Roger W. Garrison, "Is Milton Friedman a Keynesian?"; Garrison 2001.