Mises Daily Articles
An Austrian in Grad School: Confronting the Mainstream
Because of their minority status, most budding Austrian economists must endure graduate training in the mainstream orthodoxy before earning their Ph.D.s. As a recent graduate of New York University, I thought it might be useful to highlight some of the major differences I perceived between Austrian economics and the neoclassical, New Keynesian paradigm. The following list is by no means exhaustive, nor do I claim that it represents the essential tenets of Austrian theory. However, I hope my discussion will encourage current graduate students to keep their spirits up and finish their dissertations.
The most obvious difference between the Austrians and the mainstream is the choice of method. The Austrians start from the fact that human beings act purposively to achieve their subjectively chosen ends. From this "action axiom" the Austrians (in the tradition of Ludwig von Mises) derive as many implications as possible. So long as the deductive chains of reasoning are free from error, the conclusions reached are a priori true, containing as much validity as a proof in Euclidean geometry.
The mainstream, in contrast, practices economics by the construction of simplified models of the world. From the outset, unrealistic assumptions are made when establishing the "laws" governing behavior in the artificial world being studied. Typical models contain either one or a continuum ("uncountably infinite" number) of agents, who usually live forever and have the selfish preferences mocked by critics of the homo economicus view of man. Macro models will very often have only one or two goods in the entire economy.
The justification for such admittedly unrealistic assumptions is a pragmatic one; because the mainstream economist is concerned primarily with the determination of equilibrium states in the model, the equations describing such states cannot be too difficult to solve. Appeal is often made to the natural sciences, and above all else to physics, where simpler models are sought which best "approximate" the results of Nature. On this point, all I will say is that the Austrians have certainly devoted more careful thought than the mainstream to the methodological problems involved. The Austrians have argued that economics is an entirely new branch of science, whose problems are not at all suitable for the approach of physicists.
II. Individual Choice
If you study Austrian economics, you will learn that a central tenet of the school is methodological individualism. This means that for an Austrian, an "explanation" of an economic phenomenon must ultimately start from the choices of individual actors. This doesn't mean that Austrians only focus on "micro" phenomena; indeed, many of the most important Austrian insights involve macro problems such as unemployment and inflation. Nonetheless, even here the Austrian always couches his analysis in terms of the incentives and behavior of the typical individual, in order to understand the aggregate effects that require explanation.
On a formal level, the neoclassical mainstream too involves the individual and his subjective preferences. An equilibrium state (in a market setting) is defined as a set of prices and behaviors for each agent such that every agent maximizes his utility, given his budget and the (exogenous) prices. However, notice that even at this stage there is a problem: If everyone acts as a "price taker," i.e. if everyone takes market prices as data to which behavior must be adjusted, then how do these prices get established in the first place?1,2
On this point, another difference between the Austrians and the mainstream is the latter's focus on indifference. In an equilibrium state, an agent in a neoclassical model is indifferent to any small change in his consumption decisions; an extra penny spent on any available good (so long as the agent has purchased at least some of the good in question) will yield the same increment in utility. The Austrians, in contrast, stress that human action involves the choice of a over b, where alternative a must be strictly preferred (as demonstrated by the choice itself).
Beyond this, however, there is another sense in which the mainstream focuses on indifference. This occurs when, because of the assumptions going into the model, the analyst wants to ensure that no trading takes place. In these cases, the goal of the analyst is to find the prices necessary to ensure that the individual agent (who doesn't care about the economy-wide constraints) doesn't want to trade.
For example, I had a macro exam question in which there was only a single, perishable consumption good; in this world, physical saving was impossible. Moreover, all agents were identical, and so there was no room for intertemporal exchange at all. The question asked, "What is the equilibrium interest rate in this economy?" The answer was to find the interest rate at which every (identical) agent would be happy to consume his endowments every period, rather than altering his consumption path through exchange (which was impossible by stipulation).
In another exam question, I was told that a single agent owned a tree, which would periodically yield fruit (the consumption good). The question asked the equilibrium price of a share to the tree. Inasmuch as there were no other agents who could buy the tree, this seemed an odd question. But again, the point was to find the price of a share such that the agent would be indifferent between selling ownership of the tree (to a nonexistent second party) versus retaining ownership and consuming the flow of fruit dividends.
If I could pick just one area of economic theory in which the mainstream is weakest, it would be money. Simply put, there is no role for money whatsoever in the typical mainstream model. In a hyper-rich general equilibrium model, there are markets for every conceivable good, in every period of time, in every possible state of the world, and agents have either perfect foresight or rational expectations (in which there is no systematic bias in predictions). In this setting, there is no need for a unit of account or medium of exchange, because all future actions can be specified (perhaps contingent on random events) in the initial period. On the other hand, grossly simplified macro models contain only one or two goods, and hence render a medium of exchange superfluous.
Naturally, the mainstream models (especially macro ones) do contain money; there is simply no other way to deal with issues such as inflation and Federal Reserve policy. But in order to get the agents of the model to hold money, all sorts of ad hoc assumptions are employed. For example, the desire for liquidity might be built right into an agent's utility function, so that cash itself gives satisfaction the same way owning a Picasso might. Another approach is to assume "cash-in-advance constraints," in which the agent needs a certain amount of money in order to complete transactions.
The problem with these remedies, of course, is that in the world of the neoclassical model, there is generally no reason for an agent to gain utility from money, or for firms to insist on cash-in-advance. This problem casts doubt on the use of the models themselves; how do we know that "optimal" Fed policy in the model will translate into the real world, when the true function of money is absent in the model?
In contrast to the ad hoc approach of the mainstream, the Austrians have a solid grasp of the place of monetary theory in economics. Indeed, even an unbiased historian of economic thought would acknowledge that Ludwig von Mises was one of the earliest and strongest proponents of a unified theory of exchange, in which marginal utility analysis explained not only the valuation of consumption goods, but of units of money as well.
Another huge difference between the Austrians and the mainstream is the former's emphasis on time. Although the mainstream has improved considerably on this issue—most notably in the work of Sir John Hicks—nonetheless the Austrians have a superior grasp of the time structure of production. Austrian theory does not avoid the heterogeneity of capital goods, and the tremendous problems this heterogeneity poses for long-term coordination of production and consumption plans.
The typical mainstream macro model, in contrast, still assumes that there is a single good, serving as both capital and consumption,3 and that the entire body of produced means of production in an economy can be summarized by a single number indicating the "capital stock." Moreover, it is typical to "solve" macro models not merely by calculating the equilibrium state, but the equilibrium steady state, i.e. a position in which all actions repeat themselves, every period, forever. It is quite rare indeed for the mainstream economist to consider the convergence path to such steady states (or to consider the adverse consequences of various government policies during the adjustment period).
Because of the Austrians' more modest view of the capabilities of human computation and foresight, there is a far greater role for institutional analysis in the Austrian paradigm. Earlier I explained that the institution of money itself cannot be easily analyzed from a neoclassical point of view. The issue, however, is not merely technical. Failure to understand the role of money can have profound political implications.
The best example is Ludwig von Mises's famous critique of socialism. Mises argued that without market prices for the means of production, socialist planners—even if they were truly benevolent and wished only to help their subjects—could not rationally allocate resources. Mainstream economists eventually conceded that some system of "prices" would be necessary in a socialist State, but felt that the government could still retain formal ownership of all capital goods. Hayek and others argued that the proposals of "market socialism" would still fail, and with the demise of the Soviet Union many academics began to take the Austrians seriously.
In my own experience, I realized the mainstream's failure to understand institutional differences during a lecture from a mathematical economist. He was explaining a puzzle that had arisen with the use of a certain type of production function. If I recall correctly, the problem was that the relationships between interest rates, capital per worker, and GDP were not consistent between the United States and the Soviet Union.
One possible explanation was that the U.S. had better technology, but this wasn't satisfactory because Soviet plant managers could obviously attend American engineering schools. What struck me was that it never even occurred to the professor, or to the students who offered suggestions, that the fact that one system was capitalist and the other communist might have some relevance. Instead, they sought a purely technical solution to the apparent paradox.
VI. Business cycle
Finally, the last area of comparative advantage for the Austrians I wish to highlight is the business cycle. Relying on (in my opinion) their superior understanding of the complexity of the capital structure, and of the vital role money prices play in the coordination of intertemporal plans, only the Austrian economists can hope to offer a satisfactory explanation of the widespread errors that characterize a recession.
The Austrians argue that recessions are the inevitable outcome of prior booms, in which entrepreneurs—goaded by artificial government reductions in the interest rate—make overly optimistic guesses as to the profitability of their projects. In consequence, the entrepreneurs hire labor and buy capital goods for which there are insufficient real savings. When the entrepreneurs realize their errors, they attempt to scale back their plans, and the widespread occurrence of this adjustment is what we know as a recession.
The mainstream, in contrast, offers Keynesian models in which the economy becomes trapped in a state of insufficient demand, or real-business-cycle models in which "technology shocks" cause recessions. Aside from the inherent problems with these models, there remains the empirical failure of the mainstream advisors to prevent recessions with their "scientific" management of the economy.
The above points focus on some of the major differences between Austrian and neoclassical economics. I have been harsh with my treatment of the mainstream, but I believe my criticism has been fair. It is true that there are many areas (e.g. game theory) in which the formal rigor of the mainstream allows for precision that the verbal approach of the Austrians cannot provide. However, when it comes to the central and crucial areas of economic theory, I still believe that the Austrian school offers the best foundation for a young economist.
- 1. This is not merely an Austrian quibble; even noted theorist Frank Kahn has recognized the logical problems involved. See his "General Equilibrium Theory," in The Crisis in Economic Theory, Daniel Bell and Irving Kristol, eds., New York: Basic Books, Inc., 1981.
- 2. In a previous article, I have shown the difficulties of the mainstream approach to modeling stock market prices.
- 3. I explain some of the problems with this procedure in a previous article.