New Directions in Austrian Economics

New Directionsin Austrian Economics

Other titles in Studies in Economic TheoryLaurence S. Moss, Series ConsultantAmerica's Great Depression, Murray N. Rothbard _1975)The Economic Point of View, Israel M. Kirzner (1976)The Economics of Ludwig von Mises: Toward a Critical Reappraisal,ed. Laurence S. Moss (1976)The Foundations of Modern Austrian Economics,ed. Edwin G. Dolan(1976)Capital, Interest, and Rent: Essays in the Theory of Distribuffon, byFrank A. Fetter; ed. Murray N. Rothbard (1977)Economics asa Coordination Problem: The Contributions of FriedrichA. Hayek, Gerald P. O'Dñscoll, Jr. (1977)Capital, Expectations, and the Market Process:Essays on the Theory ofthe Market Economy, by Ludwig M. Lachmann; ed. Walter E.Grinder (1977)The UltimateFoundation of Economic Science:Ah Essay onMethod, byLudwig von Mises, Foreword to Second Edition by Israel M.Kirzner (1978)

New Directionsin Austrian EconomicsEdited by Louis M. SpadaroSHEED ANDREWS AND MCMEEL, INC.Subsidiary of Universal Press Syndi¢ateKansas City

This edition is published in cooperation with the programsof the Institute for Humane Studies, Inc.,Menlo Park, California; and Cato Institute, San Francisco,California.New Directions in dustrian EconomicsCopyñght © 1978 by the Institute for Humane Smdies.Jacket and cover design copyright © 1978 Cato Institute,San Francisco, California.AH rights reserved. Printed in the United States ofAmerica. No part of this book may be used or reproducedin any manner whatsoever without writtenpermission except in the case of reprints in the contextof reviews. For information write Sheed Andrews andMcMeel, Inc., Subsidiary of Universal Press Syndicate,6700 Squibb Road, Mission, Kansas 66202.Library of Congress Cataloging in Publication DataMain entry under rifle:New directions in Austrian economics.(Studies in economic theory)Includes bibliographical references.Papers sponsored by the Instimte for -Humane Studiesand presented ata symposium held at Windsor CastleSept. 1976.1. Austrian school of economists--Congresses.I. Spadaro, Louis M. II. Institute for HumaneSmdies. III. Series.HB98.N48 880.15'7 77-28611ISBN 0-8362-5104-0ISB,N 0-8362-5103-2 pbk.

CONTENTSEDITOR'SPREFACEvi]An Austrian Stocktaking: Unsettled Questionsand Tentative Answers 1Ludwig M. LachmannThe Austrian Method 19John B. EggerPraxeology and Econometrics: A Cñtiqueof Positivist Economics 40Mario J. Riz_Economics and Error 57Israel M. KirznerThe Problem of Social Cost 77S. C. LittlechildA Critique of Neoclassical and AustrianMonopoly Theory 94D. T. ArmentanoSpontaneous Order and the Coordinationof Economic AcÜvities 111Gerald P. O'DriscoU,Jr.Austñan Def'mitions of the Supply of Money 143Murray N. Rothbard

The Emergence of Interest in a PureExchange Economy: Notes on a TheoremAttributed to Ludwig ron Mises 157Laurence S. MossAustrian Macroeconomics:A Diagrammatical Exposition 167Roger W. GarrisonToward a Program of Research and Developmentfor Austrian Economics 205Louis M. SpadaroIndex 229

EDITOR'SPREFACEBecause the approach of the bicentennial of both the AmeñcanRevolution and the publication of Adam Smith's famousWealthofNations tended to overshadow another mílestone--thepassing of a hundred years since the occurrence of the "marginalist"revoluon in economic theorymthe observance of thelatter has been left mostly to economísts.Even among this relatively small company, whatever celebrationthere wastended to be further subdivided owing to the factthat the economic revoluon of the 1870sarose independentlyin three different places and took implicitly different forms.Two of themwthe English and the French variants--soonmerged either with pre-existing analysis or with subsequentformulaons and so have lost some of their specificity and identy.The thirdwthe Austrian_branch not only represented, fromthe outset, a more daring departure from received doctñne, butremained, in the intervening century, more independent anddistimxivein its essenUal imights, its analytical method, and itsimplicationsfor economic and sodal policy.Thus it was thatearly in September of 1976, a small group ofAustrianeconomists (mostofthem returningfrom a sentimentaljoumey to Smith's birthplace) met for a few days in historicWindsor Castle to celebrate their own special anniversary. Anumber of papers prepared for the occasion were presentedthere and arehere offered to a wider audience. The partidpantsat the Symposium also engaged in a great deal of formal andinform__!discussion of the papers, which it was not possible toindude in the present volume.The arrangement of the artides here follows the order andpurpose of their presentaUon at the symposium. The first andvii

viiiEditor's Prefacelast are, respectively, a retrospective anda prospectíve for Austrianeconomic theory; the test deal in their various wayswith anumber of significant points at the leading edge of Austriananalysis, where it interfaces or takes issue with contemporaryeconomic thinking.Thus, ProfessorLachmann's paper is a thoughfful assessmentof the present state of Austrian theory anda lucid statement ofits essential disnnguishing features. This provides the basisforaprovocative criUcalexamination of some of the implications ofthat theory and fora number of imaginaáve suggestions for itsfuture extension.Professor Egger attempts to locate and explain some of thecritical points on which Austrian theory differs significanflyfrom currenfly received doctrines. His discussion of these "differentia"offers a valuable bridging serviceto a potenfially wideaudience who would otherwise find it difficult to perceive andevaluate important Austrian insights on substance and method.The methodological divergence between currently prevailingeconomic analysis and Austrianism is explored in depth in thepaper by Mario Rizzo. By juxtaposing econometric andpraxeological approaches, Dr. Rizzo provides a usefulframework for critical examinaon of the claims and validity ofthe positivism that implicitly pervades so much contemporarytheorizing.The contribution by Kirzner complements and extends thedistinctively Austrian insight into the role of information in theeconomic process to which Hayek called attention in a wellknownarticle some forty years algo.In the present article, ProfessorKirzner analyzes the function of error in economicdecision-making as well as its relaonship to information and tothe nature of entrepreneurship.ProfessorLittlechild addresses himself to the problem of socíalcost--a concept that not only pervades much of moderowelfare economics, but also constitutes a major point of contentionbetween Austñans and conventional theorists. Littlechñdexamines the validity of the concept itself as well as some attemptsto deal with social cost from a subjectivist perspective.

Editor'sPrefaceixStillanother focus ofdisagreement between Austrians and theprevailing orthodoxy is monopoly theory and the concept ofcompetition on which it rests, whether explicitly or not. ProfessorArmentano's paper is a critical examination of the conventionalapproach as well as of several variants of the Austrianview.The essay byProfessor O'Driscolltakes upa question that hasdivided economists for a verylong time: whether there exists in amarket economy an ordernot externally imposed upon it. In thecourse of his analysis, O'Driscollargues that a number of problemsin economic analysis that appear to be separate from thisquestion as well as from one another are ultimately reducible toit.ProfessorRothbard examines the conventional definitions ofthe money supply and argues that the consistent application ofan Austrian approach requires expansion of the meaning of thesupply of money to indude a number of important componentscurrently excluded. Rothbard points out, moreover, that differentcomponents of the money-supply may have very differentbusiness cycle effects--a source of error that is systematicaUyoverlooked by the usual aggregative treatments of the subject.Professor Moss caUsinto question the claim made by someAustñan economists that the subjective concept of time preferenceas developed by Misesimplies that a positive rate of'pureinterest would necessarily appear even in a pure exchangeeconomy (i.e., one with no productioñ). Moss attempts a pureexchange model in which the emergence of such interest wouldnecessarily depend on the presence of certaín objective conditions.Professor Garrisonundertakes the considerabletaskof dep_ctingmacro-economic relationships diagrammatically and in amanner consistent with the Austrian insistence that valíd explanationsof economic relationships must ultimately refer to individualchoices rather than rest on the facile assumption thataggregates interact directly. His graphics are applied to production,exchange, and other relationships in an attempt to establisha better and wider appreciation of Austñan analysis.

xEditor's PrefaceThe last paper, by this writer, attempts to discern, in the lightof the successes and failures of the past and present, somegeneral guidelines for the future development of Austrianeconomícs. It tentatively concludes that suela development willmost probably need to involve a much wider range of methods,disciplines, and professions.FinaUy, ir is the editor's pleasant duty to express a few acknowledgementson behalf of all the participants. We ate gratefulto Professor Arthur Shenfield for agreeing to actas chairmanfor the conference meetings and for his patience and wit in thedischarge of a sometimes diffícult task. The presence of ProlessorFriedrich von Hayek at the meetings was impiring to thescholars participating, and bis contributions to the discussionsadded insight and wísdom. Sincere thanks ate also due AdmiralD. H. Mason and the staffof St. George's House, Windsor Casfle,for all their hospitality and help. Lasfly, a very special word ofthanks is extended to the Uníversity College at Buckingham andto the Institute for Humane Studies for sponsoring theSymposium_and to Koch Industñes, Inc. without whose moraland material support neither the conference nor this bookwould have been possible.Louis M. SpadaroFord_m Universityjuly, 1977

2 New Directions in Austrian Economicstal2 was largely, if not solely, prompted by the latter's disregardof all those economica]ly relevant aspects of time that do not fallunder the headings "Üme preference" and "period of producnon."To Menger, time was, in the first place, the dimension inwhich the complex network of interindividual relations presentsitself to us. Austrian economics has retained and cultivated thisMengerian perspective. Time is the dimension ofall change. Irisimpossible for time to elapse without the constellation of knowledgechanging. But knowledge shapes actíon, and acUon shapesthe observable human world. Hence ir is impossible for us topredict any future state of this world.The third feature ofAustrian economics, a coroUary ofsubjec-Üvism and awareness of the protean character of time, is adistrust of all those formalizaUons of economic expeñence thatdo not llave an identifiable source in the mind of an economicactor. Such distrust naturally engenders skepticism about macroeconomicaggregates. To Austrians, MIeconomic thought isthought within the context of means and ends implying choice.Austrían economics is certainly more than "a pure logic ofchoice." At some stage, we have to introduce"subsidiary assumptions."Expectaons area good example, the granting of credit isanother. But Austrians wiU not accept formalizations ofeconomic experience that altogether defy the category "meansand ends," concepts that ale nothing but formalizations of recordsof statistical observations in which the events recordedappear devoid of their histoñcal character and meaning.In what follows, the impfications of these three feamres will beexplored by applying them to a number of problems with whichAustrian economists have good reason to concern themselves.But, quite apart from the three features, the Austrians, beingsuch stout defenders of the market economy, are namrídly involvedin every attack on ir. An argument currently in fashionamong the would-be sopbísticated says that the existence of sofew forward markets in the real world proves that the effectivenessof the market process in coordinating economic plans andactíon is gravely hampered. In the climate of our time, theímplication that here is a promising f'_.ld of government inter-

4 New Directionsin Austrian Economics(e.g., in the markets for agricultural products and for fashiongoods), expectations play a prominent part. But it ís of somesignificance that whatever scope there is for the expression ofexpectations in suda markets is in general commensurate withwhat scope there isfor the holding and variability of comrnoditystocks. In a pure flow market, in which no stocks can be held,expectations can find little expression, except in consumers'decisions to defer purchases. In product markets in general, inwhich boda flowsand stocksare traded, the influence ofexpectafionsis proportionate to the share of stock transactions in totaltransactíons.It isthus by no means surprising that in asset markets, suciaasthe Stock Exchange, beíng pure "stock markets," expectationsate paramount. Without divergent expectations, vdthout"buUs"and "bears,"such markets evidently could not exist. It is importantto understand that the notorious volatility of Stock Exchangeprices is, in the first place, due to the ease with which in apure stock market it is possible to more from one side of themarket to the other, to be a buyer in the morning anda seller inthe afternoon, or vice versa ir one holds stock. In the potatomarket, by contrast, most participants are firmlywedded to oneside, being either producers or consumers, while only the merchants,holding stocks, are able to change sides.In the second place, short-run stability of the potato markethas to be sustained by "a given taste for potatoes" on the onehand and stability of agricultura1 technology, area of acreage,and wage rates on the other, while the markets for securitiesatesustained byno suda forcessince there isno cost ofproduction orconsumer demand for them. Here stabilityis not inconceivable.But it is impossible for expectations about a certain evént at afuture date to remain constant while this date is moving nearer.The daily flow of the news wiUaffect some of the divergentexpectations. Some bulls wiUturn bears of vice versa. This, asProfessor Shaclde has shown with suda vigour, is the majorreason for the wen-known volatility of asset markets.Austrian economists, face to face with these facts, llave to askwhat they imply. Their first implication, in our view, is that we

6 New Directiom in ,dustrian Economicsmarket economy, mean capital gains and losses to asset holdersand cause a daily redistribution of wealth. In fact, it is hardly anexaggeration to say that the mode of distribution of wealth in amarket economy is largely, though not solely, the cumulaáveeffect of the capital gains made and losses suffered in the past.This should be a sobeñng thought to aU those who contemplateother forms of the redistribution of wealth, e.g., by taxation, andin particular to those who ate ready "to accept the marketeconomy but only after a redistñbution of the existing wealth."As long as asset markets ate open, the process of redistribuonofwealth must continue. Ifthe govemment redistñbutes wealthat the end of September, the mode ofits distribution in Octoberwill not last. By November, the market wíll have modified it, byDecember even more so. This process is a prominent feature ofthe market economy, an inevitable concomitant of the marketprocess, and ultimately a consequence of the divergence of expectations.IIITo acting man time is no continuum. The future is uncertain,the past alone known, or at least knowable. "We cannot haveexpeñence ofactuality at two distinct'moments'. The moment ofactuality, the moment in being, 'the present', is solitary. Extendedtime, beyond the moment, appears in th_is light, asafigment, a product of thought. "8As time is continuously flowingacross the threshold of the present, itis undergoing a change ofquality. With regard to our knowledge, then, time isheterogeneous, compñsing the unknowable and the knowable.Hence Amtrian economists, compened by their commitment tosubjectivism to view aU problems in the perspective of the actor,cannot but look askance at aUtheoñes employing the mathematicalnoÜon of time asa continuum and will cast a suspicious eyeon expressions such as dY/dL To acfing man, time mear___s somethingdifferent.All our knowledge belongs to the past. It is therefore, inprínciple, possible to dassify all items of knowl¢dge by a time

dn Austrian Stocktaking 7index of their acquisiÜon, and this, of course, is what historiansof science are doing. But the relaÜonships among various itemsof knowledge ma), assume vañous forros, and mete dating maytell us little about what we want to know.To simple minds, all knowledge presently acquired is additíveto prior knowledge. Mankind is piling up an ever-growing storeof knowledge, a veritable treasure house of the mind from which= not a single ítem is ever removed. Austrían economists, put ontheir guard by their experience in the theory of capital, knowthat ir may not be so: some old knowledge is rendered obsoleteby new knowledge. The intertemporal relationship betweenítems of knowledge may be subsÚtutive, not addiÚve. Of ir maybe complementary, where the new knowledge enhances thecompass of the old and opens new fields for the combinedapplication of both.In our "kaleidic" society, the obsolescence of old knowledge isa fact of fundamental importance. Its consequences are ubiquitous.Even where technical progress is slow, our knowledge ofthe market, i.e., other actors, is soon out of date. Time cannotelapse without changes in the constellaUon of knowledge accompaniedby capital gains and losses.Austrian economists, laying stress on the coordinating functionof the market, face a problem here: If the market coordinatesexistíng knowledge, what happens when knowledgechanges while the process is taking place, when people acquireknowledge of which it is possible that tomorrow it may havebecome obsolete? Leaving this question open, we must now tumto looking at the problem of time and knowledge in a differentperspective.Similarly, as is the case with B6hm-Bawerk's structure of production,we may look at the relationship between various itemsof kJmwledge either diachronically or synchronically. The firstwe llave already done, and conduded that the intertemporalrelation between items of knowledge ma), be additive, substitutire,or complementary. But the same, of course, applies synchronically.In a market economy, the plans of competing firms may be

8 New Directiom in Austrian Economicsinconsistent. The sarne applíes to the innovations introduced toserve the implementation of the plans. Where these are additive,however, timas will soon learn them from each other. Wherethey ate complementary, profitable arrangements for theirjointexploitaUon will be made in the usual way. But where they aresubstimdve, the plato of competing timas derive additionaldoses of inconsistency from this very fact. The market as thefinal arbiter wiU determine which of these innovatiom survíveand become part of the social body of technical knowledge.From the Austrian point of view, the 6me aspect as well as therelevance of consumers' wants to the economíc significance ofnew lmowledge need emphasis. Not aUtechnical change is technicalprogress. At the moment at which new knowledge becomt_available, nobody can tell ex ante which of the itetm of which it bcomposed will expost make for economic success. Only years ofexperience in the workshops and in the market can tea that. Wemust not treat as social fact what, at the moment at which therelevant decisions llave to be taken, carmot be more than subjectireopinion.The relevance of all this to current discussions on the "socialtate of return to investment in informafion," alleged to be inexcess of the "private tate," is obvious enough. We might addthat our argument wiUalso cast new iight on "product differenation,"so often described asa monopolistic device ptacUsed bywily producers on ah unmspecting public. Can anybody imaginehow the ah-planes, gtamophones, or fountain pero of 60 yearsago could have evolved hato their present-day tdaapes withoutcontinuom product differenUation? Time has more aspects ofeconomic relevance than ate dreamt of in neoda_ical theory./VThe last SOyears saw the ascent of macroeconomics and atempotary ecpse of Austrian though¿ What attitude shouldAustrian economists adopt toda), towards macroecono_m_i_¢aggregates? We spoke above of skeptiásm engendered by a

An Austrian Stoclrtaking 9distrust of aUformalizations of economic experience which donot havean identifiable source in the mínd of aneconomic actor.] But a more positive attitude is called for. Austrian economistsmust attempt, wherever possible, to impart a measure of subjectivismto the products of macroeconomic thought.We may note that Austrian aversion does not pertain to theseaggregates as such. Austrian economists, after aH,di'ddiscussthebalance of payments of the Habsburg Empire. It pertains to theconstruction of an economic model in which these aggregatesmove, undergo change, and influence each other in accordancewith lawswhich are devoid of any visiblereference to individualchoice. Like the bodies of a planetary system, each aggregate isaffected bychanges in other aggregates, but never, itappears, bychanges taking place within itself. It is this conception of themode of relationships among aggregates, rather than the existenceof the aggregates themselves, which defies subjectivism.At fa'st sight it seems futile to attempt to change this state ofaffairs by splitting large aggregates into smaHeraggregates. Butwhere it ispossible to show that movements of the smaHeraggregatesare responsive to changes which constitute effects of individualchoices, while the movements of the larger aggregate atenot, such ah attempt might be promising.In PricesandProduction, ProfessorHayek rejects the Fisheriannotion of the pñce level and substimtes the pñce levels of capitalgoods and consumption goods for it. One might thinkthatone isas macroeconomic as the other. But the whole point of theoperation comists in the fact that the two price levels are tied tothe saving-comumption decisions of income eamers, while theFisherian price level is not.Such an evolution towards subjectivismby means of the disaggregadonof macroaggregates has actually taken place in thetheory of money over the last 60 years.It cannot surprise us thatthe textbook industry has ignored it. It is perhaps moreremarkablethat economic thinkers, even some who took a prominentpart in it, appear to be unaware of it. But it is surprising indeedthat Austrian economists, of aU people, should llave taken nonotice of"this further step in the consistent applicaáon of subjectivism."

10 Neto Directions in Amtrian EconomicsAs late as in 1911, in Fisher's Purchasing Power of Money, theframework of monetary relations presented in the famousQuantity Equaáon consisted entirely of macroeconomic entities,either aggregates like M and T or averages of aggregates like VandP. Within this context, the Quantity Theory proper asserteda relationship between M and P.The following year, Mises took the first step in the direction ofsubjectivism by stressing the important tole of individual cashbalances. In Cambñdge, Pigou tried to subjeaivize the rigors ofthe Quantity Equation by means of the "Cambridge k.''4 Thediscovery of the variabilíty of bank credit played its part. Whilecommodity money "exists" in a physical form, the creation andmaintenance of a volume of credit requires acts of choice. Ajaelement of subjectivism entered into the supply of money.In 1930 Keynes, in the Treatise,_ introduced the dístinctionbetween the industrial and the financial circulation, later calledactive and idle money. We have here a alear case of a dissolutionof a macroaggregate (M) into smaller aggregates amenable tochoice, the choice between money to use and money to hold. Andin 1934, for a fleeting moment, a few economists even becameaware of what was happening, viz. that night in November 1934when young Dr. Hicks read his paper, "A Suggestion forSímplifying the Theory of Money, ''s with its emphasis on subjecfivism,to a baffled London Economic Club most of whose membersfelt that something important had been said, but could notquite make out what.Even in the ranks of the Quantity theorists, subjectivism toda),makes its influence felt. We find Professor Friedman, whomnobody wou]d regard asa subjectivist, telling us that while theold Quantity Theory emphasized the supply of money, the newQuanfity Theory (domicíle: Chicago) prefers to put its emphasison the demand for it. Tlfis demand, as has been noted by many,has a remarkably Keynesian flavor. In the theory of moneysubjectivism appears triumphant.In the theory of capital I made ah attempt to more in thedirection of subjectivism in my book, Cap/ta/and Its Structure(London, 1956)..There I tried to dissolve the capital structure

An Austrian Stocktaking 11into the capital combinations of the various firms and to showhow these are amenable to, indeed the expression of, individualplans. Perhaps the attempt was premature.How lar attempts to infuse subjectivism into other fields ofmacroeconomics will succeed, only the future can show. It seemsfairly obvious, however, that the time for some steps in this: direction has come. Austrian economists should bf best able totake sucia steps.VFuturesmarkets?The), can reconcile,just conceivably,our PRES-ENT ideas, basedon our PRESENTknowledge. Whatof tomorrow'snew knowledge destroying the old or rendeñng ir obsolete, what oftomorrow'schoices and decisions, tomorrow'sdiscoveries,tomorrow'sinventions,work of imaginaon?...We are not omniscient, assured masters of known circumstance viareason, but the prisoners of time.G. L. S. ShackleJournal of EconomicLiteratureJune 1973, p. 519.The market economy has never been _without its cñtics andenemies. Those who feel threatened by the market; those who,however unwisely, feel they could do better without it;economists with little imagination; those, fike the devotees ofPareto optima, with only too much of ir; those who find mostentrepreneurs disgusting characters; those attracted by theromantic charm ofa feudal order in which they never had to live;social thinkers offended by the raucous tone of modern advertising;and social thirtkers who know only too weU how to exploitenvy and greed in the service of anticapitalisc movements--allthese make a formidable array of opponents.On the other hand, the m_arketeconomy has been able to drawsupport from a 200-year-old tradition of economic thought.Here Austrian econom_¢ts, side by side with non-Austñans, havetaken a pmminent part in supporting it. In t_hiscenmry, out-

12 New Directions in Auarian Economicsstanding thinkers like Cassel, Hayek, Mises, and Pareto havedefended the market economy against many misunderstandingsand fallacies.But of late the wind appears to have turned, and the heirs ofCassel and Pareto have changed sides. Leading thinkers of theneoclassical school have launched an attack on the mai'keteconomy, charging it with inadequacy in a field in which, manyof us would have thought, some of its most impressive achievementsare to be found: in the provision of facílities for intertemporaltradíng.To our knowledge, Professor Koopmam first launched theattack in 1957, criticising what he caUed "the overextended beliefof the liberalist school of economic thought in tl_e efficiency ofcompeddve markets asa meam ofallocating resources in a worldfuUof uncertainty." He confinued, "To my knowledge no formalmodel of resource allocafion through competitive markets hasbeen developed, which recognizes ignorante about aH decisionmakers' future actions, preferences, or states of technologicalinformation as the main source of uncertainty confronting eachindividual decision maker, and which at the same time acknowledgesthe fact that forward markets on which anticipatiom andintentions couM be tested and adjusted do not exist in sufficientvariety and with a sufficient span of foresight to make presenflydeveloped theoty regarding the efficiency of competitive marketsapplicable .... In particular, the economics profession is notready to speak with anything approaching scientific authority onthe economic aspects of the issue of individual versus coUectiveenterprise which divides manldnd in our time."*In a similar vein Professor #a'mw, in a recent PresidenfialAddress to the A.E.A., told his listeners, "Even asa graduatestudent I was somewhat surprised at the emphasis on staticaUocative effidency by __rket socialists, when the nonexistenceof markets for future goods under capitalism seemed to me amuch more obvious targeL"sIn February1973,ProfessorHahn, inbisweU-known IrmuguralLecture in Cambridge, ° employed the _me argument toshow that general equilibrium theory has its pracfical uses in

Illl IllllIIn Austrian Stocktaking 13providing a sophisticated critique of the market economy. "The= argument will here turn on the absence of futures markets andcontingent futures markets and on the inadequate treatment oftime and uncertainty." He continued, "Pracfical men and iUtrainedtheorists everywhere in the world do not understandwhat they are claiming to be the case when they claim a beneficentand coherent tole for the invisible hand" (p. 14).This critique of the market economy caUsfor an answer. In thefirst place, it is perhaps obvious that no existing st.ateof affairscan be effectively criticised by compañng ir with a purely imaginaryone, such as the general equilibrium model in its mostup-to-date and sophisticated forro. The critics rail to teU us how awofld with peffect intertemporal markets for everything is to bebrought into existence. Nor ate we given any hint as to how asocialist economy would of could provide a substitute for it.Second, the critics appear to share ah altogether exaggeratednotion of what forward markets can achieve. The), can provide"cover" against some contingencies, they coordinate expectafions,"buUish" and "bearish." But they cannot make the uncertainfumre certain, they carmot prevent plans from being upsetby events nobody could have foreseen, they cannot eliminate thedifference between exante and expost. Shaclde has expressed thisso well in the quotation at the top of this section that no furthercomment seems called for.Third, this entire argument rests upon a confusion betweenactua/and potent/zd markets. No practical conclusions can bedrawn from the mere fact that certain transactions which arepossible do not actually take place. There are toda), no marketsfor ostrich feathers or top hats, but there probably would be iffashion were to mm.Our inability to observe certain transactions does not permitus to infer that they are impossible. The), ma), not be profitablein given circumsta.rtces. In a society full of risk-averters, riskcapitalmay be so u_rce that ir can be provided for only a fewmarkets. Many potentiai markets never become actual becausetransaction cos_ are too higlt, and all transaction costs are,certainly to Austrian$, oppormnity costs. I-Laveour critics ever

14 New Directions in .dustrian Economicsconsidered what immense precautionary (and variable) moneybalances would have to be carried agaimt forward commitmentsin the world they are envisaging?Arrow actually goes into "the causes for the absence of marketsfor future goods" (p. 7). "It seems to me there are two basiccausal factors. One is that contracts are not enforceable withoutcost and forward contracts are more cosfly to enforce than contemporaneouscontracts; the other is that because of the manyuncertainties about the fumre, neither buyers nor sellers arewiUing to make commitments which completely define theirfumre actiom" (p. 8).It is doubtful whether either of these can provide a genera/reason. The cost of enforcing contracts is low in law-abidingsocieties, high in others. Moreover, as Arrow admits, the marketma), provide its own sanction by exduding defaulters fromfurther trading. The second reason should lead to a generaldiscussion of the limits of forward markets in the spirit ofShackle's remarks, but it does not. We are told instead, "As Hicksshowed a long time ago, complementarity and substimon canoccur over time as well as simultaneously. If... uncertainty cantend to destroy m_rkets, then we can condude that the absenceofsome markets for future goods may cause others to fañ" (p. 9).As far as one can judge, this means that we are facing an"extemality" here, according to modero welfare economics asource of "market failure." If so, the answer is that externaleconomies invite joint exploitation by potential, beneñciaries.The second reason seems no better than the first.FinaUy, and for us most important, this criticism of the marketeconomy inuminates the limitations of the neoclassical mindrather than the shortcomings of the market. This mind, incapableof conceiving of "the market" otherwise than in terms of asystem of markets in general equilibrium, is helpless when confrontedwith a real world in which not aHpotential markets areactually in operaon. Not knowing that those whose view of themarket the), criticise conceive of irin terms ver), dífferent fromtheir own, our critics tacifly assume that everybody, like theirwell-trained disciples, identifies the market economy with their

Ah Austrian Stocktaking 15general equilibrium model. To Austrians, by contrast, the market,as Hayek taught, is a process rather than a state of affairs, aprocess which comes to an end when equilibrium is reached.During the course of this process it happens aH the time thatsome potential markets become actual and some actual marketspotential, though nobody, of course, could say for how long.Some economists who are critics of the market appear to sufferfrom a lack of imagination.Needless to say, the circumstances in which intertemporalmarkets come into existence provide an important subject forempirical study, a most significant aspect of the market process.It is to be hoped that Austrian economists will take their fullshare in its pursuit. It is not obvious why a model in which aUobstacles to the birth ofintertemporal markets are assumed awayshould be of much help to us in pursuing such a study.V/In the recent development of economics, there is much Austrianeconomists cannot but disapprove of. We already mentionedmacroaggregates and what might be done with them. Butwhat positive contñbutions do they have to offer for the futureof economic science?FoUowing what was said above, we have to distinguish betweenthe unknowable future and the knowable past. In neodassicalthought this problem does not añse, since one is ostensiblyengaged in finding "laws" applying as muda to the one as to theother. But there are the welbknown puzzles among which theproblem of ceterispar/has, our inability to specify all the conditionsunder which the laws ale to hold, takes prominence. Austrianssimply have to face the fact that the autonomy of the mindprecludes determinism: If knowledge shapes action and actionshapes the human world, the fumre is unpredictable. "But iftheory pretends only to gire an account of particular, peculiarand speci'a! moments (sucia as may be scarcely ever attained infact) and repudiates any hope of connecUng them by any intelli-

16 " New Directions in Austrian Economicsgible, permanent mechanism allowing prognosis, then thetheory ought explicitly to be a dassificatory one, putting situationsin this box of that according to what can happen asa sequelto it. Theories which tell us what will happen ate c!aiming toomuch."10In other words, insolar as the future is concerned, economicswill have to become far more a descriptive díscipline than it is atpresent, giving an intelligible account of a number of futurepossibilities inherent in present situations, unable to rely on thestrict necessity of determinism or even of numerical probability.Economists will have to acquire new skills, the skills required fordescriptíon and comparison of large numbers of possible simations.Remembering how much time and effort have of late beeninvested in mathematical skilLs,the skills of symbolic precisionreflecting necessity and determinism, we cannot but feel uneasyabout the concomitant circumstances of such a change ofparadigm.What promise does the knowable past hold f_r the fumre ofeconomics? Here we encounter the problem of the relationshipsbetween economics and history. According to a view widely heldtoday, it is the task of the analytical social sciences to produce"covering laws" which the historians wiUthen apply to concretecases. But the economist can offer the historian only laws validceterisparibus, unlikely to be of much use to the latter withoutspecification.Yet it remains true that the past is the great storehouse of facts,offering us a vast stock of material for empiñcal generalizations,interesting in themselves provided we do not pretend that theyate universal laws. Here we ate able to compare ex ante with expost since we know, or in principle are able to know, what happenedto plans. We might find out how muda capital was'malinvestedin a certain decade. We can ascertain economic growthpatterns of the past without having to rely on "steady state"models. We might even trace the multiple source$ from whichtechnical progress flowed in the past. The fact that mostgeneralizations we might draw from this material wiUbe limitedin time need not, after aUwe said, discourage us. Nor need we be

Ah Austrian Stocktaking 17afraid lest we trespass on the field of: the historians who maywelcome such help as we ate able to offer. Whenever a complexof relationships persista for a period of time, it constitutes bothan analytical and a historical subject. The finances of theHabsburg Empire under B6hm-Bawerk or the political structureof the Republic of Venice are obvious examples. They atehistorical and analytical subjects.Above all, Austrian economista will want to trace market processesof the past. To identify economic history with the evolutionof the market economy is a bold idea at the application ofwhich Sir John Hicks tried his hand a few years ago.lt A gooddeal might be done within this framework.As the heirs of Menger, Austrian economists will take a particularinterest in how the market evolves those "organic institutions"it needs? 2 But the degeneration of these institutions is asubject that no less deserves our attention. It míght be worth ourwhile to attempt to find out when exactly, and in what circumstances,the downward inflexibility of money wage ratesbecame the prominent feature of the Western world it todayunfortunately is. It would be even more interesting to link it tothe evolution of the imtitutions of coUective bargaining. Historyoffers many instances of instimtions which, created for onepurpose, carne to serve another. The parallel with malinvestmentis obvious.Statistical time series are records of the past. Impossible as it isto derive empirical laws by correlating them, such correlationsmay nevertheless cast some light on the events of the time oftheir origin. How much information these time series will disclosedepends on our ability to ask meaningful questions ofthem. Subjectivism asserts itself here in that different socialscientists wiUask different questions. How large the proportionof persons in "tertiary occupations" was in a given society duringa certain period may be of interest to one social scientist. Austrianeconomists, by contrast, might prefer to know how many ofthem were independent agents, active middlemen and dealers,since the operation of imperfect markets depends so largely on

18 New Directions in Austrian Economicsagents of this type. Asking meaningful questions is a skill that has !to be acquired. ]It is to be hoped that economic science will in the future, as ithas done in the past, though not in the recent past, offer scopefor many diverse skiHs and talents. At the moment, this mustseem a sanguine hope. Austrian economists are perhaps in abetter position than anybody else to make a contñbudon towardsthis end.REFERENCES1. F.A. Hayek, The Counter-Revolution ofScience (Glencoe, 1952), p.31.2. J. A. Schumpeter, History of Economic dna/ys/s (1954), p. 847,footnote 8.3. G. L. S. ShacHe, Ep/stem/cs andEconomics (Cambridge, 1972), p.245.4. A. C. Pigou, "The Value of Money," Quarterly Journal ofEconomics (November 1917), pp. 42-43.5. J. M. Keynes, A Treatise onMoney (1930), Volume I, Chapter 15.6. John Hicks, Crá/ca/Essays inMonetar) Theory (Oxford, 1967), pp.61-82.7. Tjalling C. Koopmans, Three Essayson theState ofEconomic Science(McGraw-Hill, 1957), pp. 146--47.8. K. J. Arrow, "Limited Knowledge and Economic Analysis,"American Economic Review (March 1974), pp. 1-10.9. F.H. Hahn, On theNotion ofEquilibrium inEconomics (Cambridge,1973).10. Shackle, op. c/t., p. 72.li. John Hicks, A Theorj ofEconomicHistory (Oxford, 1969).12. Carl Menger, Problems ofEconomics and Sociology(Urbana, 1963),pp. 151-59.

The AustrianMethodJohn B. EggerGoucherCollegeThere has been a renewal of interest in the Austrian School ofeconomics in recent years. Good public relations deserve part ofthe credit: the 1974 Nobel award to F. A. Hayek and the series ofseminars sponsored by the Institute for Humane Studies havehad some effect. But beneath these lies the substance:economists are learning that information has a great deal to dowith human behavior--and they are learning that the AustrianSchool long has focused on the broad and narrow behavioralimplications of fragmented information.RecognízingthattheAustrianSchoolisdifferentornoveloreven better is easier than recognizing exacfly what makes itdifferent. Sometimes the span between the recognition and theidentification of the difference is long and difficult. Making itshorter and easier is the goal of this paper. It does not particularlyadvance the frontiers of Austrian methodology, but airas atpresenting the basic differences between the Austrian Schooland the neoclassical orthodoxy _ in terms likely to be clear tostudents of the latter. The paper's target reader is perhaps thegraduate smdent who studies to the point of memorizing statementslike "The Austrian School studies purposive human action"and yet is sfill unable to see how this relates to what he findsin bis microtheory course, zDOES A PRIORISM DIFFERENTIATE AUSTRIANISM?Murray Rothbard and Ludwig von Mises, two of the great19

20 New Directions in Austrian EconomicsAustrian School economists, strongly defend the propositionthat economics is apr/or/, s The primary question for my thesis is:does this position differentiate the Austrian writers from othereconomists? While arguing that the laws of economics are independentof the specifics of human experience, Mises stood opposedto historical and institutional approaches which held eventhe very theory of economics valid only in particular historical orinstitutional settings. Of course a theory whose most basic principleschange over time is no theory at all; Mises was thus defendingthe very possibility of a science of economics.But it was never bis intent, in Iris statements ofa pr/0r/sm, todifferentiate his and his followers' method from that of theneoclassical economists. Their "constrained maximization"technique is every bit as independent of historical circumstanceas is the technique of spinning out implications from the "actionaxJom."4 Because a pr/or/sm does not differentiate the AustrianSchool, ir is nota defining characteristic of the School.EQUILIBRIA, STATIC AND DYNAMICOne of the avenues by which the nature of the "Austriandifferentia" can be approached is an examinaUon of two meaningsof"equilibrium. ''sIn the convenonal sense (which I te,m "static'), "equilibrium"refers simply to a state in which prices of the various goodsresult in zero excess demand for each of them. The term "static"is often taken to mean "tirneless" and is inclicated by the absehceof time parameters in the supply and demand functions, but theessenUally static nature of this conception of equiUbrium is notviolat_l even if some of the goods among which the individualschoose are "future goods."Consideras a typical example the interaaions among threeindividuals, each with ah endowment of goods and a specificutility function. Under certain reasonable assumptions about theforros of these utility functions, some set of relative prices amongthese goods wiU be consistent with the preferences and initial

The Austrian Method 21endowment_ of the three individuals. The market's, and eachindividual's, excess demand for each good will be zero at this setof relative prices. The nature of this equilibrium is not at aHchanged if some of the goods are promises of future delivery ofother_---based upon knowledge, let us say, of a regular Sundaynight manna delivery. Each individual independently considershis present and future preferences, and the individuals' interactiondetei c,_ines a mumally consistent (present and future) pricevector.This is certainly ah equilibrium. In the context of the particularmoment's valuations and expectations, any further changesin any of the prices would cause some net excess demands tobecome nonzero. But ir is as¿at/c equilibrium in this sense: ir doesnot differentiate between future expectations which ate consistentamong the individuals and those which ate inconsistent, sEven though a unique price vector of "future goods" is determined,we have no assurance that the plans on which the individualsbased their future valuations ate consistent. In thesimplest case--that of divergent expectations about physicaldata---an equilibrium relative price between beach umbrellasand rain umbrellas may be determined under circumstances inwhich one individual thinks it wñl rain tomorrow while the othertwo believe ir will be a pleasant day for swimming. But even ifexpectations about physical data coincide, expectations abouteach other's action plans may be contradictory: each individualmay base his demand for, say, "tomorrow's automobile services"on the expectadon that he alone platas +to drive on a certainnarrow, dusty mountain road. In either of these cases, a uniquestatic equilibrium price vector may be determined, but the passageof time wiU reveal the inconsistency of the individuals'expectations and hence require the determination of a new pricevector. This equilibrium is static because it is built upon inconsistenciesof which the individuals wiU learn in attempting to followtheir plans. Only a dynamic equilibrium incorporates consistentfumre plans, and hence is not disturbed "endogenously"--bythe very act of following one's plans.The Hayekian dynamic equilibñum, 7 in short, consists of a

22 New Directions in Austrian Economicsmarket-clearing price rector based upon interpersonally consistentexpectations; the stafic equifibrium discussed above consistsof a rector of market-clearing prices based upon plans which theindividuals mayor may not be able to carry out.Two quite different perspectives on the economic problem areimplied by these two viewpoints on the nature of"equilibrium." Iclaimed at the start of this section that these perspectives williUuminate the distinction between the Austrian School and theneoclassical microapproach. There is just a bit more igroundwork.The analysis characterized above as static concentrates uponthe existence of a price rector consistent with the momentaryrelative valuations of the índividuals. The conditions of the1world expected by these individuals--which include the actionsof other índividuals--remain in the shadows; the only relevantissue is the subjective rate of substitution among the commodities,and there is no way tojudge whether or not the subjectirerates of substituáon determined by the different individualsare based upon contradictory future expectations. Static analysisbegins at a point at which expectations and marginal utilities (orpreference orderings) have already been formed and allows usto determine the existence and uniqueness of a price rector(which may include future goods) consistent with these preferences.Whether the preferences themselves are based upon consistentexpectations is simply beyond the pale of this approach. Ihave thus come to believe that ir is not quite accurate to arguethat the (static) analysis of equilibrium conditions "assumesaway" the problem of inconsistent expectations: s it simply hasñothing to say on that issue.Such an approach may be considered "timeless," in a sense,whether or not there are "future goods" in the commodity bundles.For the passage of time would reveal whether the individuals'expectations were interpersonally consistent or not, and thiswould transform the problem into something quite differentfrom that with which static analysis deals. It would, to be specific,shift us into the realm of the dynamic equilibrium or disequilibriumnature of the stafic conditions we have derived.

The ,4ustrian Method 23The difference between a market-clearing price vector correspondingto a static and one relating to a dynamic equilibriumis that the latter necessarily incorporates interpersonally consistentexpectations. The process of deñving, by logical deduction,the distribution of goods and relative pñces under th/s sort ofequilibñum presupposes that the premises on which the deducdonis based--the preferences andplans of the individuals--are,themselves, logically consistent. Thus the application of ourstatic tools to dynamic questions requires a great deal more in theway of assumption: that each individual foresee exactly thoseactions which the others plan to take3 This interpersonal consistencyof expectatíons must be presupposed before the specificpattern of prices and distribution can be logically deduced.THE "/IUSTRI,4N DIFFERENTIA"In his seminal "Economics and Knowledge" Hayek made astatement which for some time I found puzzling:... sinceequilibriumis a relationship between acfions, and since theactions ofone per-.anmust necessañly take place successivelyin time,itis obvious that the passage of time is essential to gire the concept ofequilibrium any meaning. This deserves mention, since manyeconomists appear to have been unable to find a place for time inequilibriumanalysis and consequenfly have suggested that equilibriummust be conceived as timeless. This seems to-me m be a meaninglessstatement,leWhy could.not this great economist understand what I knew:that all we had to do was leave t out of our equations?The answer is provided in the above section. Whether or notthere are "fumre goods" (or t's in the demand functions), 11thesearch for a logically consistent set of preferences (i.e., amarket-dearing pñce rector) does not necessañly present uswith a logically consistent set of p/ans, n Although the pñcevector determination completes the job of the auctioneer, thematter of interest to the individuals participating in the mar-

24 New Directions in Austrian Economicsketplace is whether of not their actions wiUachieve the expectedresults---which most assuredly will not be the case if their expectationsare logically inconsistent.Questiom concerning the existente, uniquene_, and stabilityofa price vector which is mutually consistent with thepreferencesof many different individuals ate, in short, ofan entirely differentcharacter from the questions and problen_ which arise whenone invesgates the existence, uniqueness, and stabiñty of the setof expectafions or p/ans which is interpersonally comistent.Concentration upon this latter set of issues constutes theAustrian differentia. The disnction cannot be appreciated froma simple statement removed from the context of the above remarks,but it appears correct to argue that: whereas most contemporarymicrotheory focuses upon the abstract logic of preferences,the Austrian Sc.hool focuses upon act/on._sM/IN, THE ENTREPRENEURThe above comments may help to clarify some of the ¢lnimsmade by the Austrian School writers: 14although the "abstractlogic of preferences" can employ the technique of mutual determinaÜonvía the soluÜon ofsets ofsimultaneous equaom, ananalysis of the plans underlying these preferences and how plansare modified must incorporate the concepts of purpose andlearning. "Purpose" in this sense cannot refer simply to the apr/or/st/c universal goal of "utUity maximization"; ir refers tosome 5pecific goal the individual wishes to achieve and consequentlyto how bis actions and plans are Ukely to be modifiedwhen he learns that the economic environment is going to bedifferent from that which he anticipated when he developed bisinitial plans. Simuhaneous determination ma), govern the logicalanalysis of preferences, but the "older concept of causeoandeffect"_5is the only technique appropríate to the smdy of learningand the modificaon of inconsistent plans. The "cause," ofcourse, is the individual's subjective perception of an opportunityto improve bis simation, and the "effect" is a change in hisway of acting, of in bis plans.

The Austrian Method 25This process of the revision of inconsistent plans requires thatthe individual be able to recognize those feamres of his originalplans which caused the inconsistency and that he recognize alsothe changes in his plato which tend to eliminate that inconsistency.Such abilities constitute at least part of what economistscall "entrepreneurship." (The popular notion of"creating a newproductor service" is simply a special case in which abusinessman thinks he perceives the desirability of a change inhis own plans and hopes that the resulting plan inconsistency [heplans to get rich but potential customers have yet to leam of hisnew product, so they don't plan to buy any] will be resolved by asubsequent revision ofhis potential customers' plans rather thanof his own.) It is precisely the relation among entrepreneurship,plan revision, and action which explains the irrelevance of entrepreneurshipto neoclassical microeconomic theory whichtakes preferences as axiomatic and does not concern itself withthe possibility of carrying out their underlying plans.Professor Kirzner's important work refers to the "alertness toinformation" as entrepreneurship, ls But the importance of theAustrian viewpoint is more clear if we realize that this ability isprecisely what differentiates man from other living beings, that"entrepreneurship" in general is indisnguishable from use ofthe raonal faculty, from the ability to concepmalize, fromthinking. 17Concept formation requires differentiation and integration:differentiaon among the infinite variety of attributes of certainitems of situations, isolation ofa specific attribute common to theitems, and integration of the different items or situations into aconcept according to whether or not the), possess the chosencommon attribute. The process is one of grouping into dasses,or dassif'maUon, and is common to all thought. A dedsion is adassificaon, and decision is the goal of all thought.How is this process of dassification related to action? Anindividuars action hinges upon the comparison: "What wiHthings be like if I don't act," versus "What will they be like if Ido?" To make sucia a decision the individual must constructhypothefical states of the future, one conditional on the indi-

26 NetoDirections inAustrian Economicsviduars act and the other on its absence. Once the concretes ofthe situation are perceived, the process of conceptualizationconsists of the isolaUonof certain characteristicscommon to thisand to other situations. These other situations may be historicalinstances the individual remembers oran imaginary case inwhich he envisions himself in the role of another person andconsiders how he would behave in that role. In either case thefunction of the isolation of certain features is to eliminate unessentialdutter: specific details of the scene which are not thoughtto be "important." It is the ability to isolate correctly therelevant--causal---aspects of a simation oran ongoing process,and hence to accuratelypredict its fumre in both the absence andpresence of one's own action, which constitutes successful entrepreneurship.And it is the attempt to do so which constimtesentrepreneurship, successful or not.But aUthought isexactlyof this forro.Whether one is trying tothink through the causal forcesbehind the IndustrialRevolutionor to analyze a Frost poem, the technique is to hypothesizealtemaves and to isolate particular causal elements, characteristicswhich appear to make the crucial difference betweenwhat/s and what might have been. The only difference betweensuch contemplative thought and the popular view of entrepreneurshipis that the historian or poet has at his command thedata needed to test his hypothesis, while the fledglingbusinessman must wait and see whether customers come. Butduring the interval of time between the development of thecounterfactual hypothesis and its test (e.g., "perhaps X causedthe Industrial Revolution... but that would imply a certainpattem of relative prices which did not, in fact, occur," or "whydidn't Frostwrite 'The woods are owned by MayorJones, whosewife sells pickled cabbage at the fair' instead of 'whose woodsthese are I think I know'?.., but that would eliminate the degreeof generality Frost is trying to convey in the rest of thepoem .... "), the test liesas much in the future as that facing thebusinessman.To be able to speak of'entrepreneurship" and "thought" asdifferent concepts is useful, to be sure. But this analDis suggests

The/iustrian Method 27that the entrepreneur is anyone acting in accordance with hisspecifically human nature. A school ofeconomics which, becauseof its focus and method, can accord a central role to the entrepreneuris simply respecting the nature of man. Surely this is animportant aspect of the Austrian differentia.METHOD: M/ITHEMATICS /IS /IN AN/ILYTIC/IL TOOLIN ECONOMICSIfwe are to analyze the function of mathematical terminologyin economics, we must analyze it at its best. The difficultiesassociated with the use of differential and integral calculus arewell-known (e.g., the requirements that products and factors beinfinitely divisible, that individuals consider infinitesimalchanges relevant, that all preference orderings be representableby a total utility function and production relations by a totalproduct funcUon), so analyses using differentiable and integrableobjective functions are no longer at the frontiers ofmathematical economics, except perhaps in the smdy of uncertainty.The more general approach of set theory has been developedlargely since Debreu (1959), ls and it is a real and significantimprovement over differentia! calculus in economics.Those who wish to criticize mathematical economics must takeon its best.Bertrand Russell contends that"pure mathematics is the dassof all propositions of the forro í_ implies q:...,,ls The daim ofequivalence between pure logic and pure mathematics is sometimesattributed to Russell and Whitehead's PrincipiaMathemat/ca (1910-13), but the same idea is presented forcefullyin the first few pages of Russelrs 1903 work. Russell was led tothis condusion by the discovery that numbers are sets, t° thatordinary algebra is therefore aja application of set theory, andthat any statement of implication can be rewñtten in settheoreticterms: e.g., "p implies q" is identical to "q is a subset ofp." Venta diagrams even give us pictures. 11Jevom felt that economics was by nature mathematical be-

28 New Directionsin Austrian Economicscause it deals with numbers. 2"Modern mathematicians prefer toidentify the roots of their subject with the theory of sets. Aset is acollection of undefined "elements," which may represent anyproperty we wish to attribute to them, and the theory of setsconsists of the logical relaUons among them. Because of thecompletely general nature of these sets and elements, we canembrace a much wider view of the namre of mathematics thancan those who restrict themselves to, say, functional notation;James R. Newman's cursory sampling of a few modernmathematicians' viewsof their own subject indeed suggests thatthe boundary between Iogic and mathematics is becoming increasinglyblurred."Furthermore, either logical relations or mathematics--whatever the distinction may be---is capable of expression ineither verbal of abstract symbofic temas. Jevons was correct inthis regard: one cannot identífy the basically mathematical ornonmathemadcal nature of a discipline according to whether or_ot it is expressed verbally.24From this viewpoint it appears as ir Austrian School writers'criticisms of mathematics in general--rather than of crudemathematics, or of symbolicmathematic_ _-are,in essence, criticismsofpure logic, which is not always(sometimes, perhaps, butnot always)what they intend. The real issue is: are there advantagesto be gained from the substituon of symbo/sfox"wordsineconomics?"The advantages claimed for this substitution includeeconomy, precision, and rigor." The economy arises simplyfrom the fact that a symbol (e.g., x) is more bñef than the set ofwords it denotes (e.g., "the number of oranges he buys perweek"). The precision and ñgor follow from the abstract natureof symbols: once a set of symbols is appropriately defined (i.e.,related verbally to the problem of interest) the entire corpus ofthe formal theory of relations among these symbols becomesapplicable to one's problem. The ability to draw on the pure,abstract theory of logic (or mathematics) provides the rigor, andthe exactness required in the defmition of symbols forces thepre_.Lsion.

The Austrian Method 29It is clear enough that representati0n with symbols is alwayspossible: by definingf0 and x approprhtely we can represent"absence makes the heart grow fonder" by '_(x)>0. ''2_ Thequestion is, why bother? What advantages might such symbolismoffer? There will be advantages---economy, precision, rigormonly if the symbols wiUbe used repeatedly in the course of somelogical analysis.The economy is achieved by omitting repeated verbal identificationof the symbols. The forro in which this generally occurs is:verbal definifion of symbols, a (perhaps long) process of deductionfrom the initial posmlates with a symbofic conclusion, andastatement in words of the meaning of the conclusion (obtainedby reference to the symbols' initial definitions). Mathemaficalsymbolism is indeed economical in this case, ir only the finaldeduced proposition is held to be important. If the problemwere analyzed in verbal temas, muela unnecessary and redundantrestatement of the symbols' definions would occur. Manyacademicjournal articles are precisely of this lo, cc_:a few wordsat the beginning and end, pages of symbolic mathemacs in themiddle.To evaluate the process of symbolic analysis outlined above,we must consider the epistemological significance of language.Words are concrete audiovisual representations of the abstraconscalled concepts, in which form al1knowledge is retained, ssAsa consequence, any mathematicaUy derived symbolic proposbtions which are to be meaningful must be translated into words.(If they are merely translatable then they are merely potentiaUymeaningful.) Thus, the long sequence of intermediate steps in alogical deñvaon must be expressed verbally if it is to be relatedto human experience. But without subsidiary hypotheses abouthow people learn, these intermediate steps ate not meaningful asguides to the comprehension of behavior and cannot be relateddirectly to human experience. Only the conclusion can, in thesense that it describes an "equilibrium" state toward which actionsare headed. Equilibrium theorists who make extensive useof mathematical symbolism ate, in fact, saving a great deal ofpaper and time. The fact that causality is lost is irrelevant to one

30 New Directions in Austrian Economicsconcerned only with descriptions of equilibria.Those who perceive economic theory asa set of propositionswhich are logically implied by initially hypothesized preferencesets and production possibifities understandably find symboliclogic and mathematics a powerful tool: economical, precise,rigorous. But the analysis of the condiUons specific to an equilibriumpresupposes that the conditions necessary for equilibñumexist. This is hardly much to ask if one restricts his viewpoint tostat/c conditions, in the sense discussed earlier in this paper_thatis, to search for a price rector logically consistent with the individuals'preferences at a spedfic moment. Ifone sees the centralpurpose of economics as the analysis of action, however, therelevant equilibrium is the dynam/c one, and its preconditions--interpersonally consistent future plans or expectation: eannotbe merely hypothesized. One must attempt to examine the waysin which this interpersonal consistency of expectations can bebrought about. This requires the introduction into one's analysisof empiñcal (nondeduced) statements about what reacfions individualsare likely to have when confronted with unexpecteddevelopments, zs If these reactions were implícit in the inifia!propositions and therefore could be logically derived from themusing their symbolism, they would not be reactions to unexpecteddevelopments at aU: they would simply be preprogrammedbehavioral changes in accordance with perfectly foreseenchanges in data and would be empty of learning.The introduction amidstream of unexpected developmentsthus requires the use of words. Symbolism is economical onlywhen one can draw on it for a long time. Process analysis,however, by requiring the continual specification of nondeducedempirical hypotheses about learning and expectationrevisíon, and hence about causality, can make little use of thiseconomy.Of course, if one looks upon the process of plan revision andmovement toward a dynamic equilibrium_ as a series of discretejumps, one can associate a static equilibrium price vector witheach discrete set of preferences as they emerge throughwat theprocess. This would seem to enhance the role of pure logical

The Austrian Method 31deduction and symbolic technique, ratfier than to minimize it.But the meaning of these sets of price vectors is not clear. Theyare still unrelated to the consistency of the expectations on whichthe preferences supporting them are based.Those who are firmly wedded to the symbolic analysis characteristicof so much of modero economics may pref_r to contendthat their work alone is theory, that the introduction of nondeducedhypotheses about reactions to unexpected changesconverts one's study into applied work. But I should point outthat logic is common to all fields of study, and ir is only theintroduction of specific empirical characteristics that makes anengineer's analysis of a nonlinear control system at all differentfrom an economist's study of business cycles. The logic used byphysicists is the same as that used by biologists and byeconomists. What differentiates physics from biology fromeconomics is the namre of the empifical links between the objectsstudied and the abstract logical rules the analyst employs.UNCERTAINTY AND MATHEMATICSIN ECONOMIC ANALYSISI cannot undertake here a systematic examination of recenttrends in "the economics of uncertainty." It deserves mention,however, because it may seem to reconcile the "imperfect information"of the dynamic disequilibrium and the use of mathematicalsymbolism. In what sense does "uncertainty economics" incorporateimperfect information and learning?The relative-frequency concept of probability3ois not applicableto human action with its unique events, u For discussion I willsimply assume here something which I am by no meam convincedis legitimate: that there is ah appropriate subjective probabilityconcept according to which fumre states can be orderedby cardi_nal degrees of belief.Modern analyses using this approach are, like their deterrninisticcou_nterparts, inevitably stat/¢. Even the most sophisticatedof the techniques, th_t of"stochastic dominance," which

32 " New Directionsin AustrianEconomicspermits the entire subjective distribuUon (rather than only itsmean and vañance) to be considered,8snecessarilyinvolves thereduction oran akernativeto a"certainty equivalent,"anordinalwhich can be value ranked against other alternatives. Essentially,a hypothetical and certain alternative is manufactured--one ]which has the same valueas the uncertain state---and preferences _are constructed on the basis of this hypothetical alternative. Forexample, aman may be indifferent to the choice between $40and a 50-50 chance at $100 or nothing. In determining preferenceshe willactas if $40 were actually the alternaUve; marketpñces of lottery tickets, for example, willbe determined in thismarmer.When we consider the individu_!'splans, rather than bis preferences,we see at once that the state of winning $40 with ce::tainty cannot have been expected and planned for. It is simplynot one of the possible outcomes. Asa consequence, the uncertaintymodels are by their nature static: perfectly sufficient forthe analysis of market-dearing prices, but no'more capable ofincorporating learning and the removal of plan inconsistencythan the deterministic static analyses. When the individual discoversthathe has--or has not--won the $100, he no longer actsand plans as ii"he were certain to receive$40. Static uncertaintyanalysis has contributed to our understanding of pñce detei __inationunder uncertainty, but it does not permit us to analyze aprocess of action and learning.THE AUSTRIAN METHODWhat implications do the foregoing comments have formethodology? How are propositions about economics to be developed?The formal study of patterns of consistentpreferences--which I have called the "abstract logic ofpreference_---may employ the techniques of formal logic andmathematics, particularly set theory. The study of consistentplans, and how inconsistencies in interpersonal expectatiom areeliminated through learning, requires atechnique (ifit may be so

The Amtrian Method 33called) different from the abstract syml_lism of mathemaÚcs. Itrequires that specific nondeduced hypotheses be advancedabout how an individual's plans and preferences change whenhe ís confronted with unexpected events. The fact that theseproposions about learning cannot be logically derived fromother accepted statements may make the analysis appear unscientific,because of course it renders the conclusions dependentupon the accuracy of the empirical hypotheses. But if one acceptsPopper's terminology, ss the possibility of falsification isprecisely that which makes a proposition scientific rather thanunscientific.In fact, it may not be the empiri¢al elements themselves whichgire Austrian work an "unsdentific" appearance, but instead theway in which they ate introduced. Rather than being simplyempirical assertions presented as part of the statement of aproblem from which logical implications ate then deduced (e.g.,"such-and-such ah elastidty is greater than one"), these propositionsabout learning must be introduced in the middle of theanalytical process. One is not allowed to follow through with hislogic: the smooth workings of the logical deñvation ate interruptedby the discovery and revision of inconsistent plans.But this introducdon of nondeduced hypotheses does notimply that "anything goes"; the nature of these hypotheses isgoverned by the introspecÜve and experiential evidence thatpeople learn from experience; that when confronted with planínconsistencies they tend to revise their plans in the direcfion ofconsistency, s4 The development of an "A.ustrian processanalysis" consists largely of ah examination of how individualsare likely to interpret market or nonmarket changes as evidencethat their own expectations must be revised. If different inconsistendesare brought to light when they proceed to act on theserevised expectations, some further changes in plans (perhaps,this time, the plans of the other people) will be required. It isalways possible to advance some reasonable hypothesis about thenature of the plan changes.The role of symbolic mathematical analysis consists of thedetermination of the spedfi_: condidons which would exist

34 New Directions in Au_trian Economicsunder plan consistency. Whether there "really are" such consistentplans implicit in current expectaons but somehow unrecognized,deep below the level of awareness, 3s or whether (as isfar more likely) current expectations are fundamentally inconsistentso that some hypothesis must be invented about what planswould be like if they were consistent, this state of plan consistencyis the benchmark, the goal providing a general direction toentrepreneurial activity. But the process by which it is approachedmust be analyzed with unfaifing sensivity to what theacting individual finds in the course of his actions and how he islikely to revise his expectations when he learns these things.As an example of what difference all this makes, we couldconsider literally any process in time, especially a process wecould consider evolutionary. The monetary theor/of Mengerand Mises 3e provides an excellent example because Mises'conclusion--the regression theorem provides the solution tothe so-caUed monetary-value theory dichotomy stiU challengingtoday's monetary theorists.Starting with a set of preferences based upon use values alone(although of course it is irrelevant to the mathematics what theyare based upon), we can logically derive a consistent static set ofrelative prices. Now suppose one individual learns or guessesthat he can use a certain good asa trading medium and therebyacquire goods he could not otherwíse have obtained. His preferencefor this "trading good" rises above its pure use value. Onceagain we can logically derive a new static price rector, based t_histime on his higher valuation (the cause of which, once again, isirrelevant). Now we can hypothesize that others observe thisintermediate trading, or get the same idea independently, orobservethat our inial individualis nowmorewil_lingto acceptthe trade good than before, so their valuations of it rise for thisreason. Once again, we can deñve a new static price rector, thisone revealing again the higher relative price of the traded good.As the leaming process proceeds, the good becomes m0a_. Itsrelative pñce ("the price level') is tied by the gradual process oflearning to the barter relative price of the good from which itdeveloped.

The/lustrian Method 35The whole approach, which provides such fruitful insight intomonetary evolution, is rooted in the question: why do individualspay more for a good than its use value? The answer is: theyhave learned, through observation and experience, of its acceptabilityin trade. However rigorous symbolic logical deductionmay be, it can tell us very little about such everyday evolutionaryprocesses.CONCLUSIONSThe differentia of the Austrian School is its focus upon theplans the action-relevant plans--of the individual rather thanupon his preferences. Preferences can be treated in an abstractfashion, as the preponderance of contemporary economictheory demonstrates, and such analyses make correct and beneficialuse of mathematical symbolism. But the study of plans andhow they are brought into interpersonal consistency requires amuch more sensitive reading of the nature of human thoughtand action. Hypotheses about learning and changes in expectationscan be based only upon such introspective philosophizingas the attributing of one's own thought processes to others andguessing, again based upon one's own personal experiences andhypothetical behavior in similar circumstances, about thespecific purpose of the other's behavior) 7What of the big issues on which the School seems to offerspecial insight? It ís tempting, at first, to try to "define" theSchool by simply listing them: time preference, opportunitycost, business-cycle theory, monetary theory, imperfect information,entrepreneurship, capital theory, the role of time,analysis without symbolic mathematics. Time preferencé andopportunity cost are now part of conventional economics? s Butthe others are still special to Austñans, and the particular Austrianoutlook arise: in each of these cases from the approachI have outlined here: emphasis upon action (not preferences),recognition that action takes time and that because plans may beinconsistent the results of acfions are uncertain, and willingness

36 _ New Directions in ,4ustrian Economicsto adopt a method appropriate to this ouflook.A pnce is paid for all of these insights, and that pric.e is thepurely deductive method. This technique, the approach of today'smathematical economists, is superbly suited to analysis ofthe conditions under which known, given preferences ateconsistent--my static equilibriummbut only to that. Since Austriansare not willing to restrict their viewpoint to the abstractlogic of preferences, they must be willing to admit nondeducedhypotheses about plan revision into their analyses.So which is better--neoclassical and mathematical economictheory, or Austrianism? It is simply not true that all of theadvantages ate on one side: mathematical symbolism offers decidedadvantages when the problem is one of pure and complexlogical deduction, but the Austrian approach must be used whenthe problems are not of thís sort. And the), never are, in any realapplication J business cycles, planning, monetary policy, theyare aU dynamic issues, swept under a rug ir_ contemporaryeconomics by a methodological bias íor pure deduction andagainst any hypotheses having to do with thinldng.Hayek pinpointed the differences in 1942 when he noted that:... the most markedtendencyof the development ofscientifu: thoughtin modern times.... has been correctlydescribed as one toward theprogressiveeliminaUonof aU"anthropomorphic" explanations fromthe physicalsciences.Does this reallymean that we must refraín fromtreating man "anthropomorphically"--or is it not rather obvious, assoon as we put itin this way,that such ah extrapolationof past tendendesis absurd?ssThe differencebetweenphysicaland socialsciencesis not thattheformeris"inducve" andthe latter"declucve." Ir ístl_t thephysicalsciencescanuse pure deductionbecausetheir objectscannot plan and learn. Neoclassical and mathematicaleconomistsuse the samemethodbyrestrictingtheiranalysesto"men"whocannotplanor learnanymorethancanafriconlessplane, whereas the Austrian School builds its enfire _stem andmethod around thesedistincvely human potential: :hinking,planning, learning. Which is better? Each of us must answer. But

The Austr/an Method 37we must answer first: to what extent is economics a smdy ofman?NOTES1. By "neoclassical orthodoxy," I refer to the approach taken inC. E. Ferguson, The Neodassical Theory of Production and Dtribuñon(London: Cambñdge University Press, 1969) and dozens of intermediatemicroeconomic theory texthooks.2. Works taken to represent the Austrian School include especially:F. A. Hayek, lnd/v/dua//sm andEconomic Order (Chicago: Univ. ofChicago Press, 1948); Ludwig von Mises, HumanAction (Chicago: Regnery,1966); Israel M. Kirzner, Competition and Entrepreneurship(Chicago: Univ. of Chicago Press, 1973); Ludwig M.Lachmann, capitaland Its Structurt (London: LSE, 1956); Murray N. Rothbard, Man,Economy, and Stat¢ (Los Angeles: Nash, 1962).3. Mises, op. c/t., pp. 32-36; Rothbard, op. ctt., pp. 63-66; also,Mises, Epistemological Probl¢msofEconomics (Princeton: Van Nostrand,1962), pp. 12-13.4. Rothbard, op. c/t., pp. 1, 63.5. On the many ways in which this word has been used, see FritzMachlup, "Equilibrium and Disequilibrium: Misplaced Concretenessand Disguised Polidcs," in Essays in Economic Sonantics (New York:Norton, 1967).6. On this issue, see F. A. Hayek, "Economics and Knowledge,"reprinted in Individualista and Economic Order, p. 40, pa.u/m.7. "The state of equilibrium as here understood is a state of completecompatibility of exante plans..." (F. A. Hayek, The Purs TluoU ofCapital [Chicago: Univ. of Chicago Press, 1941], p. 23).8. I do not know if this has ever been saidof my stadc conception,but ir certainly (and rightly) has been said of the dynamic equilibrium.It is important that we appreciate the distinction.9. F. A. Hayek, "Economics and Knowledge," p. 45; also bis "TheUse of Knowledge in Society," in lndividualim and Economic Order, p.91.10. "Economics and Knowledge," pp. 36-7.11. _The introduction of time parameters into the equations is nosolufion" 12. In a(Mises, comment Human on an .,la/on, earlierp. draft 356). of this paper, Professor Israe1M.Kirzner observed that the very clearing of a market implies that theparticipants'short-run plans are brought into consistency even while theoutcome permits mconsistencies in/ong-run plans (which I simply call

38 New Directions in dustrian Economics"plans') to remain. I accept Kirzner's point, but it does not seem toinvalidate what follows.13. My phrase "abstract logic of preference" is obviously modeUedafter Hayek's "Pure Logic of Ghoice," but fits my purpose better.14. See especially: Mises, Human Action, pp. 350-57; Rothbard,Man, Economy, and State, pp. 277--80.15. George Stigler, Production and Distri_aztionTheories (New York:Macmillan, 1946), p. 181.16. Kirzner, Competition and Entrepreneurship, p. 68.17. Some of the following is based upon Ayn Rand, "Introducfion toObjectivist Epistemology," which appeared in various issues of TheObjectivist between July 1966 and February 1967.18. Gerard Debreu, Theory of Va/ue (New York: Wiley, 1959).19. Bertrand Russell, Principles ofMathemati_ (New York: Norton,n.c.d.), p. 3. Originally published in 1903.20. Morris R. Cohen, A Preface to Logic (New York: Holt, 1944), pp.9-11.21. I have been informed both by a philosopher and by amathematician that Russell failed in his lifelong attempt to prove theidentity between logic and mathematics.22. W. Stanley Jevons, The Theory ofPoli_al Ecoñomy, 5th ed. (NewYork: Kelley & Millman, Inc., 1957), p. 3.23. James R. Newman, The Wor/d ofMathemat/cs, 4 vols. (New York:Simon and Schuster, 1956), III, p. 1830.24. Jevons, op. c/t., pp. 4-5.25. Several critics of this paper have pointed out that words aresyrnbols which represent concepts. Of course I accept this, and urgethat my "symbols" in the following be interpreted as "second-ordersymbols," standing for words.26. One of more of these advantages have been daimed by manyeconomists. For one example, see Josef Hadar, Mathematical Theoo ofEconomi¢ Behavior (Reading, Mass.: Addison-Wesley, 1971), pp. 5-7.27. Mr. Roger Garrison points out that the verbal phrase expressescausality whil¢ the symbolic expression does not. His observation isabsolutely correct, and ir strengthens all of my subsequent points aboutthe relatíve natures of mathematical and verbal analyses.28. Rand,op.di., pass/_.29. Hayek, "Economics and Knowledge," p. 33, pasdm.30. Richard von Mises, Probab///q 8tat/st/cs and Tr'_h (London:George Allen and Unwin Ltd., 1961), fwst published in 1928.31. See Mises, Human dct/on, op. dg., pp. 105-18; also, G. L. S.Shackle, Expectat/on/n Economics (Cambridge: University Presa, 1952),pp. 5, 109-27.32. See, for example, J. Hadar and W. IL Russell, URulesfor Order-

The Austrian Method 39ing Uncertain Prospects," American EconomicRev/ew, LIX, No. 1(1969),pp. 25--34.33. Karl Popper, The Logic ofScientific Discovery(New York: Harperand Row, 1968), p. 40.34. Hayek, "Economics and Knowledge," p. 44, pass/m.35. It seems to me as ir those who argue that entrepreneurship isalways moving toward and never away from an equilibrium must adoptthis viewpoint.36. Carl Menger, Principles ofEconomics (Glencoe: The Free Press,1950), pp. 25%71; Ludwig ron Mises, The Theory ofMoney and Credit(Irvington-on-Hudson, NY: Foundation for Economic Education,1971), pp. 97-123. See also Philip H. Wicksteed, The Common Sense ofPoli_al Economy, 2 vols. (London: Routledge & Kegan Paul, 1967), I,pp. 136-37.37. See F. A. Hayek, "The Facts of the Social Sciences," in lnd/-vidualism and Economic Order, p. 66.38. It has been pointed out to me that although these temas are nowin common use, the}' are often not applied in the consistently subjectivistAustrian manner.39. Hayek, "The Facts of the Social Sciences," pp. 64-65.

Praxeologyand Econometñcs:A Critiqueof Positivist EconomicsMario J. RizzoNew York UniversityThe ultimategoalofa positivescienceisthedevelopmentof a"theory"or "hypothesis" that yields valid and meaningful (i.e., not truisc)predicfionsabout phenomena not yet observed._Although written a quarter of a cenmry ago, Milton Friedman's"The Methodology of Positive Economics" remains theimmediate philosophical justification for much of the contemporaryapproach to economics research. Nevertheless, the genera1pointsraised in that essay were not new even at the time, butwere an ingenious adaptation of some of the positivist argumentsof the 1930s, and the somewhat revisionist work of SirK,_I Popper. 2 Today, thoroughgoing positivism is clearly inretreat, ir not already defeated, in philosophical cirdes, but avariant of it remains quite vibrant in many of the social sciences,particularly economics. It is the task of this essay to presentacritique of"positive economics" and, at least, some indications ofa viable alternative.40

Praxeology and Econometrics: A Critique of Positivist Economics 41L PREDICTIONAS THE GOALFrom the posivist epistemological viewpoint, is the openingquotaUon to be taken as ah a pr/or/of ah empirical statement?Ira pr/or/, then it is a statement about how we shall use the terna"posive science" and is merely a linguisUc stipulaUon. As such,one might equally weUchoose to stipulate some other mearñng.Ir empirical (/.e., a statement about what people have in factconsidered positive science), then, of course, it does not express anecessary truth and c0u/d be otherwise. But then for a long timethe Darwinian theory of evolution yielded no predicons and yetwas considered scientifically acceptable, sFurthermore, Friedman makes no attempt to survey what hasbeen considered economic science to find out whether "predicon"has indeed been the defining characteristic. In fact, thereare many theoretical frameworks which generate no testablepredictions but are, nonetheless, considered part of economics.For example, it is frequenfly unclear what (predictive) relevancediscussions on the existence and stability of equilibrium undermany special assumpons (the empirical significance of which isunknown) have fora world which is never actually in equilibrium.Of course, one might claim that this is bad economics, andso the demarcaon is really between "good" and "bad" science.There is, however, no escape here, for it merely leaves unansweredthe queson: Why is nonpredictive economics badscience?Another possible escape might be to cláim that, while nonpredictivetheories ma}, be scienfific, they do not qualify as positivescience. To this we ate justified in merely replying: "So what?"What advantage is being claimed for positive science except thatits ultimate goal is prediction? In that case, we are back where westarted: Why must prediction be our goal?The goal of prediction might well obscure what has in factbeen considered a worthwhile airo of science: the explicaon andapprehension of necessary connections. Purely predictive"theory" is little more than a mnemonic device designed to relate

42 New Directions in dus_an Economicsx to y. But the narre of that relafion may be unknown. TheBabylonian astronomical forecasting techniques, which weremerely trial-and-error arithmetic calculations, are an example ofthis kind of"black box" framework. 4 The principle of explanationremains unknown in the sense that the connection betweenthe inifial and marginal conditions (x_,x2, xs, etc.) and the consequence_) is not apprehended as necessary. The relation ischaracterized by an arbitrary givenness.But while it may be true that predíction cannot be considered asuffwient attribute for "scientific" theory, it still might be a necessaryone. However, we have already implicifly refuted this assertionby showíng that within a positivist epistemologicalframework such necessity can be derived ordy from an essentiallyarbitrary prior stipulation.II. FdLSIFIABILITY AS THE CRITERION OF MEANING iThe emphasis on prediction asthe airo ofscience has its roots ina positivist criterion for the meaningfulness of a statement. Tobe meaningful, it has been said, a statement must be in a forrosuch that ir is in principle falsifiable by any observer. 5For example, let us take "the hypothesis that a substantialincrease in the quantíty of money within a relatively short periodis accompanied by a substantial increase in prices. ''eAside fromproblems concerning data availability and the skills of the particularinvestigator, is this hypothesis falsifiable? For now, let us.my it is. Hence, the positivist would claim that this is a genuinelysdentific statement. In fact, the meaning ofa hypothesis is idenfiedwith the relevant test ofits veracity. As Moritz Schlick tellsus, "the meaning of a statement can be given only by indicatingthe way in which the truth of the statement is to be tested. "7 Ofcourse, thís cannot be literally true. If meaning is idenfied withthe test, then what is being tested? But, ir there is a meaningindependent of the test, then the posivist criterion falls in onitself, and unfals[fiable statements can be meaningful. If we arenot to take Schlíck's statement literally, then it seems difficult to

Praxeolog3 and Econometrics:A Critique of Positivist Economics 43find any coherent interpretation of ir.But, of course, the whole concept of a unitary criterion formeaning is somewhat strange when viewed from within apositivist framework. Once again: Is the proposition a pr/or/orempirical? A stipulated definition of "meaning" to include falsifiabilityis not in itself impressive: One could have stipulatedotherwise. Viewed empirically, the criterion is immediately refutedby two thousand years of Western philosophy which claimsthat metaphysics and ontology are meaningful pursuits.Aside from these issues, the falsifiability criterion loses muchof its initial plausibility when the contradictory of a falsifiablestatement is examined. 8 If we admitas falsifiable that aHinflationsare caused by increases in the money supply, then thecontradictory, 9some inflations are not caused by increases in themoney supply, is not falsifiable. If the latter hypothesis is meantto apply to the future aswell as to the past, one could alwaysclaimthat the inflation not caused by money supply increases willappear if youjust search long and hard enough. No example ofmoney-supply-induced inflation refutes the proposition, andwith a future, as well asa past, time horizon one has an infinitepool of inflations within which to search for the complete absenceof nonmonetary inflations.Consequently, the falsifiability criterion involves a majortransformation in our system of logic: Although a given statementmay be meaningful (or scientific), the negation of thatstatement is meaningless (or unscientific). 10A possible route of escape from this argment might appear tobe the claim that while, stricfly speaking, the statement that someinflations are not caused by increases in the money supply is notfalsifiable, evidence could be accumulated which would render irmore or less "probable." Alas, this is no escape either. The truthor falsity ofany statement is nota random variable like tosses of acoin, and hence a frequential interpretation of the "probability"concept is impossible here. So the meaning of the term "probable"canonly involve asubjective degree of belief. This amounts toa radical transformation of the whole positivist framework. Thecñteñon now becomes: Any statement which could be rendered

44 New Directions in Austrian Economicsmore or less "probable" by reference to empirical evidence is ameaningful statement. But then this is a psychological--ratherthan a logical--cñterion. Any proposition for which our subjectiredegree of belief could be increased or decreased by _evidence"is meaningful. Worse still, what kinds of statements doesthis criterion exclude? Probably none. It would seem that humanbeings are not imaginative enough to conceive of propositionsthat have no relafionship at aU to the world. Hence, for anynontautologous (in the narrowest sense) statement, it is possibleto find empirical "evidence" that has s0me bearing on its truth orfalsity. Hence, aU statements are meaningful. If this is so, thenthe original intent of the positivist criterion crumbles.Any statement of degree-of-belief probability does not fitcomfortably within the positivist framework. Statements such as"that some inflations are not monetarily induced is 'probable'"are, of course, neither verifiable nor falsifiable in principle.More importantly, they do not carry with them any element ofintersubjective testability (which was such an important goal). Astipulation that certaln kinds of evidence wiU be interpreted asmaking a statement "probable" is no real solu6on. This makesthe criterion of meaningfulness (or the demarcafion betweenscience and non-science) purely conventional.III. CRITIQUE OF ECONOMETRICS 11Ceteris paribus predicfion is prediction of "stylized facts": xleads toy/f other factors are held constant. But since, in general,they aren't, we are not predicting a "real-world" event. Rather,we are predicting a hypothetical consequence.To subject the hypothesis to potential falsification, we mustcontrol for the other relevant variables. Suppose we try to do thisby using multiple regression analysis. Then:1. How do we know when we have adequately controlled forextra-economic factors? (There is no a pr/or/assurance thateconomic factors are the only ones that matter in a givensimation.) This would require a theory of the interaction

Praxeology and Econometrics: A Critique oOf Positivist Economics 45between economic and non-economic variables. How dowe go about subjecting this to falsifying tests?2. How do we test the theory which enables us to determinethe other economic factors that must be held constant inorder to isolate the effect of x?From the positivist framework the problem is crucial. Howcould we ever know that the (auxiliary) hypothesis, i.e., all otherrelevant factors have been held constant, has been falsified? Weobviously cannot claim that it has been refuted ifx does not resultin y because it is that very relationship which is undergoingtesUng in the first place. It is clear that, unless we have additionalhypotheses about the effects of each of the to-be-held-constantvafiables on y, we shall not be able to subject the crucial ceterisparibus clause to refutation. Furthermore, these auxiliaryhypotheses (or perhaps a single hypothesis since it is their totaleffect with which we are concerned) must be independent of thecentral one in the sense that the falsification of the former mustbe independent of the falsification of the latter. Now, ifwe claimthat we really don't care if the ceteris paribus clause is "true"because all that counts is the predictive ability of the centralhypothesis, then we have gotten ourselves into a new quagmire.First, why have ceterisparibus clauses at all? Second, what are wefalsifying if, in fact, x does not result in y? Certainly not thehypothesis as stated. Suppose the "evidence" fails to refute ourhypothesis; then what have we corroborated? Again, not theoñginal hypothesis because the apparent-consistency of the datawith the framework may be illusory, being entirely due to the"proper" variation of the factors which were supposed to beconstant. Third, this whole viewpoint reinstates the "black box"approach to science and hence vitiates the airo of rational explanation.Ir is quite possible to claim that, although the centralhypothesis must be falsif'mble in order to be meaningful orscienUfic, the ceterisparibus dause need not be. All that is neededin the latter case--it might be asserted--is a kind of educatedjudgment or verstehen. While this might be permissible withinother epistemological frameworks, ir will not be adequate to

46 New Directions in Austrian Economicssupport the daims of positivism. If we can say that "all otherrelevant factors have been held constant" without falsifiabilityand still can be making a meaningful empirical statement, whycan't we do the same in the case of "x causes y," the centralhypothesis? If we can (which seems likely given the initial admission),then once again the criterion of positive science crumbles.IV. MAXIMIZATIONUnder the influence of the "marginalist revolution,"economics has become a discipline devoted in major part to thef'mding of functional maxima and minima. The individual consumeror producer is assumed to maximize or minimize somethingand, from this postulated behavior, testable implicationsare drawn. It is important to keep in mind that the maximizationbehavior itself is not subject to falsification, because it serves notasa substantive hypothesis but as a superstructure which givesrational coherence to the falsifiable implications.Any particular instance of concrete behavior may be"explained" or rationalized in terms of maximization (orminimization) of some appropriate quantity (e.g., utility, wealth,etc.). Since maximization is fundamentaUy a characteristic ofintention (this the positivists won't admit), any concrete behaviormay be viewed as/f it were the maximization of something. Thishas serious implications.Suppose we wish to test not the applicability of a spedficeconomic hypothesis to a given area of human behavior (say,marriage), but, rather, the validity of viewing this kind of behavioras an instance of economic or maximizing acfivityperse. Inother words, we don't care whether a particular maximizingmodel is appropriate, but we ask whether this is an example ofmaximizing behavior at all.It might be claimed that this formulation of the problemmakes no sense. After all, we are never testing economics ormaximizing behavior as sucia, but only specific hypotheses ofwhatever kind. This, of course, misses the crucial point of the

Praxeology and Econometrics:A Critique of Pos_ivist Economics 47need to decide upon a research framework in advance of specific_5.Is the statement "this is ah example or instance of maximizingbehavior" a meaningful and scientific one? Clearly not. Since theset of possible falsifiers is empty, any behavior can be"explained" in terms of maximizing something. TM But thehypothesis, "this is an instance of maximizing sales," can berefuted by appropriate behavior, and so is a meaningful statement.This produces a curious paradox. The more generalstatement about maximization is meaningless (or unscientific),but the more particularized ver$ion of it constitutes a positivescienfic hypothesis.Some authors have tried to escape t.his problem by claimingthat the (maximizing) framework can be refuted by compañsonto an empirically richer and more general alternativeframework. Indeed, Lakatos has gone so lar as to say, "There isno falsificafion before the emergence of a better theory. ''13Thismeans, in effect, that if two hypothese: one maximizing andthe other non-maximizing--both equaHy weH "explain" a particularcase of economic behavior, then the one which is part of amore general approach, the specific applications of which havebeen corroborated in other cases, is to be preferred. This, however,introduces a subtle and important change in the falsifiabilitycriterion. No longer is a statement meaningful or scientific byvirtue ofás empirical content but, rather, by the overall corroboratedempirical content ofother statements to which it is in somesense related. It is hard to recognize this as an epistemologicalcriterion rather than as an aesthetic one. 14Nevertheless, by someinexplicable train of thought, a statement becomes meaningfulbecause ofits relation to other similar statements which, havingbeen corroborated, are themselves meaningful by virtue of theirrelation to, say, the former hypothesis. (Apparently, there issome kind of "simultaneous determination of meaning" argumentunderlying all of this.)Let us look at this problem in a slightly different manner. Themaximhing framework "proves" its worth, we might say, bypredicting everytlfing that the alternative framework does, plus

48 New Directions in Austrian Economi¢s ia little more. 15Hence, ir acts, in a sense, asa falsifier of the Jahernative perspective.This formulation does not seem very convincing. Ineconomics, at least, it would be surprising ir, my, the maximizingframework predicted literaUy all of the facts predicted by thealternative. Normally, I suspect, the "better" framework wouldpredict some of these facts, and some addional ones. Furthermore,competing frameworks frequently do not even ask thesame questions. Why, then, should they be judged on whetherthey gire the same amwers (plus a little more)?AU this aside, ir is hard to see why, from a purely positivistepistemological perspective, consideraons of the framework'ssuccess in other particular instances should affect the meaningfulnessor scientific chamcter of a hypothesis in any givenspecific case.!IV. EVIDENCEUntil this point, we llave implidtly considered as self-evidentthe answer to the quesáon: "What shall count as evidence for andagainst a hypothesis?" How do we recognize a falsifying or corroboratingresult? The answer is, indeed, far from self-evident.In fact, this issue poses some crucial problems for the posiUvistapproach, which, we shall contend, it is incapable of handng.A hypothesis relates a vañable x to a vañabley, cet¢risparibus.Let us assume that the ceterispa_us dause has been corrob_rated adequately; then what would amount to falsification of thehypothesis? To be more specific, hypothesize "that a substantialincrease in the quanty of money.., is accompanied by a substantialincrease in prices. "ls In order to test this statement, wemust have some cñteria by which we can relate the theoreticalterms "money" and "prices" with their empiñcal counterparts.This is the crux of the problem, t7Something must point the way from theory to the relevant"facts"; we need what shall be called "referennal statements." In

Praxeology and Econometrics:A Critique of Positivist Economics 49our iUustration, examples of referential statements might be:"The empiñcal counterpart of theoretical 'money' isM¿'; or, "by'prices' is rneant the consumer pñce index." The need for referentia!statements in applied economics is not restricted to theposivist variant of the science. What is peculiar to posifivisteconomics, however, is a problem arising out of the epistemologicalstatus ofsuch statements. Ifthey ale to be considered apr/or/,then (from a posivist viewpoint) we are merely talking abouthow we use words, and no link between the theoretical constructsand "empiñcal reality" is established. Then it must be establishedvia falsifiable hypotheses. Yet this is ah impossibility. (Referenalstatements make no predictions; they do not say, for exampie,that an increase in x results in ah increase in y. Hence nopredictions can be falsified.)Now it is possible to recast the referential statements in such away that the), will be refutable: "If the criteria of applying thetheoretical construct'money' are, in fact, applied, thenM_ will befound to be the appropriate empirical counterpart." Clearly, thiswon't work because ir requires that we know the criteriapr/0r tothe testing procedure which was to establish (orat least corroborate)these criteria in the first place.Testing the referential statements is impossible unless we alreadyknow the criteria of applying the theoretical terms. If wealready know these (in any meaningful way), then testing isurmecessary. But, from a positivist perspective, it is clearly impossibleto have any meaningful knowledge about the real wofldwhich is given a pr/on.One might attempt to obviate these difficulties by choosingempirical variables so as to present the particular hypothesis inits best light. (Choosing a definition of the money supply so as tobest predict GNP ís an example of this.) Unless one is attempngto insulate a hypothesis from refutation, there seems to be nodear reason for doing this. If empiñcal variables were chosen soas to present the hypothesis in its worst light, and ir stiUremainedunrefuted, would we not then have more fuUy corroborated it?In any event, the outcome of a potential test should not be thedetermining factor in whether ir is performed.

50 - New Directions in dustrian EconomicsVI. THE LOGICAL CHAtL,ICTER OF PR/IXEOLOGYThe epistemological status of praxeology (which is identical toeconomics very broadly conceived) is a subject of considerablemisunderstanding and confusion. Within a positivist frameworkthe d airns of praxeology make no sense. Knowledge is either apr/or/and certain but not pertaining to "reality," or it is empiricaland uncertain but dearly embedded in the "real" world. Anexamination of the logical character of praxeology reveals thesecategories to be totally inappropriate. Praxeology daims to presentknowledge which is at once both absolutely certain andempifical. This is the paradox which we shall have to explain.Praxeological theorems or deduaions are based upon thefundamental self-evident axiom, i.e., man acts or, what is thesame, engages in purposeful behavior. The question at issue,then, is: In what precise sense is this axiom "self-evident," andwhat does it say about the world?The aaion axiom is empirical in the sense fhat it is derivedfrom inner experience or immediate introspeaion. It is sc/ent/ficallyempirical because it passes the intersubjectivity test: Theexperience is universal and hence, in principle, can be assentedto by the observers and the observed alike. Hence, the fact thatthe axiom is based on introspection cannot open the praxeologistto the charge that bis deduaions are of a purely personal andunscientific character. We are dealing here with"universal innerexperience. "18An attempt to deny the action axiom involves us in blatantself-contradicfion. Denial consists of the use of means (argu-• ments) to achieve ends (condusiom) and, hence, purposefulbehavior. In addition, the assumption that men act is a necessaryprerequisite for the e,,Astence of a scientífic community. Arguments,attempts to convince other researchers of a differentview, etc., are all fundamem_!!y based on a conception of scientiststhemselves as engaging in purpmeful behavior. To separateout the scientists, and say that while the observers engage inacfion and the observed do not, would seem to be an arti_ficialityfor whic_ no supportcould be adduced.

Praxeology and Econometrics:A Critique of Positivist Economics 51While the action axiom is empirical and self-evident, it is, in asense, also a pr/o_ 19 That man acts is logically pñor to anyconcrete manifestation of action. In fact, one must have a conceptof action before one can even recognize action in the so-calledreal world. The action axiom is derived from absolutely certaininner experience but is a pr/or/to historical phenomena. History,asa complex of human behavior, is analyzed and interpreted byuse of praxeological theorems which are, in tum, derived fromrelatively simple expeñence.Praxeology concems theforro of acon qua acUon.Just becauseit is not about this specific action or that specific action does notmean that it concerns itself only with words. The category ofaction is about every action that has and wiUtake place empti_dof its specific means-ends content. As sucia, it is no less about"reality" than any generally recognized empiñcal statement. Al1statements about the wofld involve some degree of abstraction,so itis not the abstraction of praxeological deductions which is atíssue. What may be of concern is that they are incapable offalsification. In principle the statement "man acts" cannot befalsified since we cannot conceive of the contrary. This is notbecause we are simply deafing with an arbitrary stipulated definitionof "man" as an acting being. Rather, it is because ouracquaintance with empirical manas acting is both so intimateanŒnecessary that a purely reacting being would not be humanin the only sense we can conceive. The concepts of purposefulbehavior and man are linked so tighfly not because of arbitrar),definition, but because they are necessariIy linked in empiñcalreality. Our language reflects something real, yet necessary.Praxeology as applied to history (broadly viewed as to indudecurrent history) does not depend merely on deductions from theaction axiom. It requires subsidiary assumptíons deñved empiricallyin order to delimit the scope of a praxeological system. 2oFor e___mple, we do not want to develop monetary theory in aworld without money. Now, the subsidiary empirical assumptionsate not seff-evident or necessañly true like the actionaxiom. These assumptiom could conceivably be otherwise, althoughthey may be virtually certain (e.g., the existence of indi-

52 " New Directions in Austrian Economicsrect exchange). Insolar as they are uncertain, so too is theapplicabRity of the praxeological _tatements we can make usingthem.To increase the quantitative definiteness of relationships inapplied praxeology (economic history), we require increasingspedfidty of the subsidiary assumpáons: These assumptionsmust become both more numerous and more precise. This, ofcolarse, results in condusions which ate no 1onge_"apodicticaUycertain. In our terminology, we refer to applied praxeologicaltheory as hypotheses (to indicate their tentative nature). Hence,while economíc theory is immutable and necessary, economichypothesesate changeable and could be otherwise. The view thateconomic theoryis a body of tentative statements about the world(subject to refutation) is implicitly the position that knowledge ofsocial reality is confined solely to historical knowledge."VIL THE ROLE OF ECONOMETRICSWhile ir might appear as if econometrics has no role in theadvancement of economic theory (defined as deductiom fromthe action axiom), this is not quite accurate (although ir mayserve asa tolerable first approximaUon of the truth). StatisUcalregulariUes can be the starting point for a purely theoreticalinvestigation, insolar as they raise questions to which thepraxeologist addresses himself. But the connecfion here is moresuggestivethan logical.The central tole of econometrics is in the application ofeconomic theory to the complex phenomena of history (currentor pasO. There ate two quesons on which econometric workcan shed light:1. To what extent is a given (historical) instance of humanbehavior explicable by reference to purposeful activity, i.e.,how much does a praxeological hypothesis explain?2. What is the magnitude of the effect of x on the wholecomplexphenomenon,y, at somespecificpoint in time?

Praxeologyand Econometrics:.4 Critiqueof PositivistEconomics 53With regard to the first question, it isimportant to understandthat while man necessarily acts, it does not follow that he alwaysacts,i.e.,that he neverengages in automatic response to stímuli orsome other ldnd of nonpurposive behavior. To what extent is agiven histoñcaJ phenomenon the restflt of some blind emotionaiming at nothing? The answer to this cannot be givenapr/or/.__On the second quesfion, it is important to keep in mind thatpraxeological reasoning per se cannot reveal quantave relaons(or even qualitative ones, when many conflicting forcesateoperave) in economic history. Forthis, stastical investigaonsare our only recourse. However, it is important not to interpreteconometrically derived relations as great constants applicableto aUsituaons at all times. These relaons are not theoreticalbut merely historicaL To extrapolate the latter to the formerrequires ah inductíve leap that we ate not prepared to take.In answering both of these questions, econometric evidencecannot, of course, gire us the same certainty as praxeologicalreasoning. Answers in economic history must always be uncertain.Nevertheless, this is not the uncertainty of economictheory; rather, it is the uncertainty inherent in the application ofa structure (involving the forra of action) upon historicotemporalactionswith specific content. The application of theoryto history is not ah exercise in deduction; it necessitates the use ofjudgment or understanding (verstehen)in defining the relevantvariables and the appropriate means of measuring them.A carearis, however, in order. Econometrics ought to be onlyone tool in the apprehension of historical phenomena. Clearly,not all issues of interest are quantifiable. If we try to explaincomplex phenomena only by reference to quantifiable variables,then we are likely to be throwing away some information that wedo, indeed, have. Another danger is that we shall begin to identifyrealitywith statistical data when, in fact, it isjust one aspect ofreality, a particular transformation of more elementary experience.There is no reason whatever why a specific wayof víewinghistory ought to be identified with history itself or, what isworse,with the whole of soc_h]reality.

54 New Directions in Austrían EconomicsVIIL CONCLUSIONS __ND UNRESOLVED QUESTIONSThe purpose of thís paper is primarily to presenta criticalanalysis of"positive economics" and only secondarily to examinethe praxeologíc alternative. It is in the latter area that a great dealof work needs to be done. At this point, however, a number ofconduding observatíons might be made:1. A thoroughgoing positivist approach to economics cannotbe consistently pursued. The positivist framework createscertain problems that ate insoluble from within thatframework.2. Although praxeology is concerned with action qua action,/.e., ahistorical and emptied of specific means-ends content,it is still about reality. The forro of action is no less real thanany of the other abstractions necessary in making generallyrecognized empirical judgments.3. A crucial problem in praxeology is the epistemologicalnature of applied praxeology (economic history). How isthe transition from theoretical constructs to empiricalcounterparts to be made? Verstehen is too vague an answer.4. Does a praxeologist do economic history differently from aposiUve economíst? If so, in what way?In discussing some of the more philosophical issues ofeconomics, it has been our intention to show that the day-to-dayissues of explanation, hypothesizing, and testir_g do not go on ina philosophical vacuum. We do not have a choice as to whetherwe shall make methodological decisions. Our choice, rather, íswhether we shall make them explicitly, examining the variousimplicaáons and subtleties of meaning, or whether we shallmake themimplicifly, blind to ever'fihing but technique.REFERENCES1. Milton Friedman, "The Methodology of PosiUveEconomics,"Essaysin PositiveEconomics(Chicago, 195S), p. 7.

Praxeology and Econometrics: d Critiq_ of Positivist Economics 552. See especially Karl Popper, Log/k der Forschung (Vienna, 1935).The English translation is Karl Popper, The Logic ofScientific Discovery(London, 1962). Other relevant works ate Rudolf Camap, Philosophyand Logical Syntax (London, 1935) and A. J. Ayer, Language, T_h andLog/c, 2nd edition (London, 1946).3. Stephen Toulmin,Foresight and Understanding: AnEnquiry into theAiras ofScience (Bloomington, 1961), p. 28.4. op._., p.28.5. Some philosophers, such as Popper, make this the criterion ofscience, and not meaningfulness. However, such a shift does not affectthe main argument sínce we then must return to the question ofwhy wedefine "science" the way we do. See section I above.6. Friedman, p. 11.7. Moritz Schlick, GesammelteAufs_tze, 1926-1936 (Vienna, 1938),p. 179 as cited in Brand Blanshard, Reason and Analysis (LaSalle, IIlinois,1964), p. 224.8. Blanshard, p. 229.9. The word "contradictory" is here used in its technical sense.Hence, the statement "no inflations are caused by increases in themoney supply" is not the contradictory of the statement in the text. This,is because if"no inflations are caused by increases in the money supply'isla/se, then e/ther "some inflaUons ate (not) caused .... "is true or "allinflaUons are caused .... "is true. "A and O are mumal contradictories,or negaUom:A is true ifand only ifO ís false." On this see W. V. Quine,Methods ofL0g/c, 3rd edition (New York, 1972), p. 84.10. Blanshard, p. 229.11. The general coneeption of this and the next section is drawnfrom Martin Hollis and Edward Nell, RañonM E¢onomic Man (Carobridge,England, 1975), pass/m. However, in many cases the train ofreasoning is different (the reader should beware of assuming that thesame point is being made), while in others the árgument is expanded.12. In a somewhat different context, Friedman says, "Ifthere is onehypothesis that is consistent with the available evidence, there arealways an infinite number that are." Friedman, p. 9.13. Imre Lakatos, "Falsificadon and the Methodology of S.ci'endficResearch Programmes," Criticism and the C,rowth of Knowledge, ImreLakatos and Alan Musgrave, eds. (Cambridge, England, 1970), p. 119.14. Friedman, pp. 10, 20.15. Lakatos, p. 118.16. Friedman, p. 11.17. Much of what follows in this section is from Hollis and NeU,chapter 4. However, the reader should note that our referent/al statementsare not the "criterial statements" of Hollis and NelL

56 " New Directions in Austrian Economics18. Murray N. Rothbard, "In Defense of 'Extreme Apriorism',"$outhern EconomicJournal (January 1957), p. 318.19. Ludwig ron Mises, Human Act/on, 3rd edition (Chicago, 1966),chapter II.20. Op. cit., pp. 64-66.21. For some ver), preliminary observations on these issues, seeMurray N. Rothbard, "Praxeology: Reply to Mr. Schuller," AmericanEconomic.Review (December 1951), p. 945.

REconomics and ErrorIsrael M. KirznerNew York UniversityThe rifle of this paper, it may correctly be surmised, owessomething to the rifle of the famous 1937 paper of ProfessorHayek, "Economics and Knowledge. ''_ There lies, Hayekacknowledged, ah intentional ambiguity in the title of thatpaper: we are in fact to learn in his paper that the knowledgewhich economic analysís conveys depends crucially upon propositionsabout the knowledge possessed by the different membersof society. The not dissimilar ambiguity in the rifle of thepresent paper may, one ventures to hope, suggest that a gooddeal of erroneous thought in economics has its source in confusionconcerning the nature and role of errorin the actions of thedifferent members of society. It is the purpose of this paper todispel at least some portion of this confusion. If, in the course ofthis attempt, some incidental light can be thrown, as well,on theproblems raised by Hayek in his '37 paper, this will be seen toreflect (once again not accidentally) the symmetrical ambiguitiesembedded in the titles of the two papers.EFFICIENCY, WASTE, AND ERROREconomists have traditionally been concerned with issues relatedto effidency. Ineffident action occurs when one places.oneself in a position which one views as less desirable than anequany available alternative state of affairs. Inefficiency cantherefore not be thought of except as the result of ah error, a57

58 New Directions in Austrian Economicsmistake, an incorrect and wrong move. Much of the work of themodern economist has, in fact, the declared aim of avoidingerrors, of achieving efficiency. At the same time, however, as hedirects his energies toward the obviation of error, the contemporaryeconomist is frequently to be found pursuing his analysison the assumption that men do not, and will not, ever faU intoerror. "Waste," declares Stigler in a recent note, "is error withinthe framework of modern economic analysis, and ir wiU notbecome a useful concept until we have a theory of error."2Modern economic analysis, we are to understand, lacking atheory of error, can and does proceed only by assuming it away:error and waste simply have no place in the world of economictheory. It is this position that we wish to examine cñUcally. Is itreally the case, we must ask, that economic theory requires us toabstract completely from the phenomenon of error? Asa preliminarystep toward the consideration of this question, it isnecessary first to review a number of discussiomto be found inthe economic literature in which the possibility of error has beenseriously canvassed.MISES, MARKSMEN,AND MISTAKESIn a passage in which he is concerned to explain that humanaction is always rational (in the sense of being designed to attaindefinite ends), Mises considers the objection that men makemistakes. This does not, Mises points out, constimte irrationalíty."To make mistakes in pursuing one's ends is a widespreadhuman weakness .... Error, inefficiency, and failure must not beconfused with irrationality. He who shoots wants, asa rule, to hitthe mark. If he misses it, he is not 'irratio, ar; he is a poormarksman. The doctor who chooses the wrong method to treat apatient is not irrational; he may be an incompetent physician....-s The impfication here is that the incompetent physician andthe poor marksman may indeed make mistakes and errors.RaUonal Misesian human actors ate human enough to err. But itis alear that these errors are not incomistent with the positíon

Economicsand Error 59(excludingerrors) cited earlier as taken by SUgler. In fact thereason why these are not errors in the sense relevant to theStigler position, is entirely similar to the reason whythese errorsdo not, for Mises,constitute irrationality. The mistakes made bythe ill-trained medic do not representa failure by hito to attainthat which ir is within his power to attain. His failure símplyreflects lack of the necessary quality of input. An error (in theStigler sense) occursonly _íhen ah input is used in a waythat failsto produce what that input can produce. When a poormathematid_n makes a mistake in añthmetic 4 he is not, therefore,maldng an error; nor is the failure by a poor marksman tohit the markan error. Ir is notan error fora physicallyweak manto be unable to lift a heavy weight. Nor is ir an error, in therelevant sense, when one unschooled in medicine fails to prescribetheproper treatment fora patient, (To be sure, it may bethat the incompetent physicían, indifferent mathematician, andpoor markshaanought not to waste their time [and their patients'lives] by engaging in tasks for which they are so def'mitely illsuited.But of course Mises is concerned with the mistake thephysician makes in the course of the pracfice of medicine, notwith the possible error of his attempting to practice medídnealtogether.)CROCE, TECHNICAL ERROR,/INDECONOMIC ERRORIn the course of Irisfamous correspondence with Paretoat themm of the century (in the Giorna2edegliEconomisti),BenedettoCroce did find a definite place for "economic error." Such aherror, Groce explained, must be sharply distinguished from"technical error." Technical error, for Croce,consists in an errorofknowledge; it occurswhen one is ignorant of the properties ofthe materials with which one deals (such as when one places aheavy iron girder on a delicate waU too weak to support ir).Economic error, on the other hand, occurs for example when,yielding to the temptation of the moment, one pursues a transientf_cy which is not one's true goal; it is, Croce explains, an

60 New Directions in Austrian Economicserror of w//l, "the failure to airo directly at one's own object: towish this and that, i.e. not really to wish either this or that. "sAvoidance ofeconomic error requíres that one aim at one's goal;failure to airo at one's goal constitutes, therefore, a special categoryof error. This error arises out of the incorrectness not of thepattern of acts taken in pursuing one's immediate airo, sincethese are, from the point of view of that airo, entirely appropriate,but of one's immediate airo itself. To pursue this airois--from the perspective of one's "u'ue" goals--an aberration.One places oneself into contradiction with oneself, one aims atthat which one does not, in fact, seek to attain.Croce's concept of economic error has not found favor amongeconomists. The writer has elsewhere 6 reviewed the carefulanalysis which Tagliacozzo many years ago made of Croce'spositionY Briefly the reason why economists have no place forCroce's "economic error" is that it seems impossible, from thepoint of view of pure science, to distinguish betwevn "true"goalsand erroneous, transient ones. Once we have accepted the possibilitythat man can discard yesterday's goals and adopt new onestowards which he wiUdirect today's purposeful actiom we havesurrendered the possibility of labelling the pursuit of any end(no matter how fleeting the "temptation" toward ir may be, andno matter how permanent remorse over having "yielded" to itmay turn out to become) as, on scientific grounds, an erroneousone. Croce's economic error, it then mrns out, emerges only asaresult of invoking (unspechíed) judgments of value in terms ofwhich to classify, from a m_n's own point of view, those goals ofbis which it is "correct" to pursue and those the pursuit of_vhichhe must consider ah error.It seems worthwhile to digress bñefly lo note that Mises--inwl_ose writings one finds no room at aUfor the type of "economicerror" identified by Croce.--seems to have consistent scientificgrounds for bis unwillingness to recognize such error. It is wellknown that Míses denied the independent existence ofa scale ofvalues (actuating human choices) apart from the acta of cho/cethemse/ves ("the scale of values.., manifests itself only in therealit'/of action')Y The notion of a given scale of values, Mises is

Economh:sand Err_ : 61at pains to explain, can therefore not be used to pronounce a realacfion (at variance with that scale) as "irrational." The logicalconsistency which human action necessarily displays, by nomeans entails com'tancyin the ranking of ends3 Mises' insistenceon the possibility of changes in adopted preference rankings isclosely related to his understanding of choice as undetermíned.Man does not choose as area¢tion to given drcumstance_ on thebasis ofa previously adopted scale ofvalues; he chooses freely atthe time he acts, between different ends and different ways ofreaching these ends. It foUows that the notion of economic erroras perceived by Croce has no place in economic scien¢e.ERRONEOUS tICTION AND IMPERFECT KNOWLEDGEThat men frequently act on the basis of imperfect knowledgeis of course not disputed by writers for whom error in economictheory is exduded. In the passage (dted above) where Misesdefends the "rationality" of erroneous actions, he menons anexample which we have not yet cited. '_Fhe farmer who in earlierages tried to increase his crop by resorting to magic rites aaed noless rationally than the modern farmer who applies more fertilizer."1°Men certainly engage in actions which they ma), regretwhen they discover the true facts of the simation. Croce, we haveseen, termed this kind of mistake a te¢hnical error. Erroneousaction aHsing from ignorance is not, however, generally seen asaserious threat to an economics which excludes error. With respectto thepercdved framework of ends and means, error-freedecidon making can still be postulated. The very notion of ahends-means framework, of preferences and constraints, of indifferencecurves and budget fines, enables the economist toconfine his analysis to choice udth/n the given framework. Thesource of error in such choices, being out.ddethat framework, isthus, by the very scope of the analysis, in effect excluded fromconsideration.To be sure ir is precisely this aspect of modern economicsagainst which Professors Lachmann and ShacHe have, among

62 New Directions in Austrian Economicsother matters, so vigorously rebelled. Since aU action is fumreoriented,necessarily involving ah unknown and unknowablefuture, men's acÜons are inevitably attended by what Knightcalled error in the exercise ofjudgment, lI Such error may, ifonechooses, be subsumed under Croce's technical error, but theall-pervasive and inescapable character of such errors in judgmentdoes, in the view of these distinguished critics, seriouslycompromise the usefulness of abstractions depending on given,known, ends-means frameworks. In this paper, we will not pursuefurther the profound consequences with respect to moderneconomics which the Lachmann-Shackle critiques imply. Ourdiscussion proceeds, instead, in the context of modes of discoursewhich do perceive continued relevance in theories ofchoice dependent on supposedly given, known frameworks ofpreferences and constraints.It should be pointed out that a good deal of modero theorizingproceeds along a path on which actions based on mistakenknowledge appear not to be errors, in a sense deeper than that sofar discussed in this paper. Ir is not merely that an action is seenas "correct" within the framework of the percewed---but in factthe quite wrongly perceived---ends-means framework. The act.ionís frequenfly seen as correct also in that the ignorance, onwhich the mistaken perceptions ate to be blamed, may/tself beviewed as having beendeliberately (and quite correctly) cultivated.Economists have long recognized that men must deliberatelychoose what information they wish to acquire at given prices.One who on a deliberate gamble refrains from acquiring a certainpiece ofcosfly knowledge, and who then, in consequence ofbis ignorance, makes a "mistake," may indeed regret bis lack ofgood fortune in having lost as a result of bis gamble, but maynonetheless quite possibly still feel that the chances which heoriginally confronted (when deliberating on whether or not toacquire the cosfly information) rendered bis original decisionthe correct one. The relevant ends-means framework, witbinwhich actions llave been pronounced consistenfly errorles$, hasnow been broadened to embrace the situation within wbich thechoice was made not to buy improved Lrtformafion. If Mises'

Economics and Error ,. 63"incompetent" physician had taken a calculated risk in deliberatelynot studying with sufficient care the treatment of a raredisease, his subsequent errors may indeed be seen as "technicalerrors"; (they may also, as we have seen earlier, be seen simply asthe entirely-to-be-expected shortcoming in output quality consequenton the less-than-perfect quality of medical input). Butthe ignorance responsible for the technical error in medicaltreatment (or, irone prefers, for the less-than-perfect quality ofmedical experfise available for deployment) may itself be theconsistent result of a correct, deliberate, choice. This way ofseeing imperfect knowledge--as the correctly planned limitationon input qualitywpermits one to subsume errors arising outofimperfect knowledge under the general class oferrors treatedabove in the section "Mises, Marksmen, and Mistakes," that is, asnot constituting errors at all (in the sense of somehow failing toachieve an available preferred state of affairs). This way oflooking at things has gained plausibility asa result of the developmentduring the last 15 years by Stigler and others, of theEconomics of Information (in which detailed analysis isundertaken of decisions concerning the optimum degree ofignorance to be preserved under different conditions, and of themarket consequences of such decisions).LEIBENSTEINtlND THE LdCK OF MOTIE4TIONHarvey Leibenstein has written an extensive series of papersdeveloping the concept ofX-inefficiency and exploring the extentto which this type of inefficiency has yet to be incorporatedinto standard economic theory. Iz In this paper we consider onlythose aspects of his work that bear directly on the possibility oferror within the scope of economic analysis. In the presentsection we briefly take note of some of the objections raisedrecentlyby Stigleragainst certain aspectsof Leibensteín'scontribution.For Leibenstein, X-inefficiency (as contrasted with the moreconventíonal aUocative inefficiency) is equivalent to what for

64 New Directions in Austrian Economícsothers is called technical efficiency, TMthe failure of producers toachieve, with the inputs they use, the highest technically possiblelevel of output. Among the sources of this kind of inefficiency, inLeibenstein's view, is inadequacy of movation and of effort."The simple fact is that neither individuals nor firms work ashard, nor do they search for informaon as effectívely, as theycould. TM Sgler has severely cricized Leibenstein on his use oflanguage._5 For the purposes of our discussion of the possibilityof error in economics, Stigler's objections can be stated as follows.It is certainly true that greater output could frequently beachieved by greater effort and stronger movation. But this doesnot indicate error, in the sense of failing to achieve an availablestate of affairs more desirable than that actually achieved. Ifindividuals are not sufficiently movated to work harder, thispresumably reflects, deliberately and "correctly," their preferencefor leisure. If, again, firms have not succeeded in organizingproducon so as to enhance worker motivaon, this constutesthe firm's choice of one "technology" of production, asagainst the possibility of alternativ_" (more productivityconscious)technologies. Choice of one technology, yieldinglower physical output per week than another available technology,does not, without our knowing all the relevant costs, warrantour asserting the presence of error in the choice oftechnologies. Stigler's objections are completely convincing.Leibenstein has not, in his exploraon of motivaonal inefficiency,discovered cases of genuine error, in the sense relevant toour discussion. (We will return later in this paper to considerother aspects of Leibenstein's X-inefficiency as more promisingin this respect.)ECONOMICS WITHOUT ERROR?Let us stand back and observe the position to which we havebeen led. This posiáon might appear to coincide completely withthat in which no place for error exists in economic analysis--ffbyerror one means deliberately placing oneselfin a situation which

Economics and Error ; 65one prefers less than another equally available situation of whichone is aware. We have refused to accept Croce's terminology (inwhich economic error can occur when one has been temporarilyseduced to airo deliberately at a goal which one in fact prefersless than another "true" goal). We have, with Stígler, refused toaccept Leíbenstein's apparent perception of inadequately motivatedpersons, persons not trying as hard as they really could, asones who are in fact placing themselves in less preferred situa-Uons. We have pointed out that errors made by agents whoselack of competence or sldll renders such mistakes inevitable,clearly do not involve failure to achieve any attainable preferredposiUon (since the inadequate quality of available ínputs placessuch preferred posiUons out of reach). And where, asa result ofimperfect knowledge, ah agent achieves a position less preferredthan an equally available alternative position, we have seen thathe too cannot, within the framework of the information hebelieved to be relevant, be convicted of error. Moreover we haveseen that insolar as this agent deliberately refrained from acquiringmore complete or more accurate knowledge, he cannot evenbe descríbed as having placed himself in a less preferred situationat aU (since in his view the cost of acquifing the moreaccurate knowledge made ignorance the preferred risk).It should be observed that our apparent conclusion that errorhas no place in economics does not depend on any artificialassumption, as does, for example, appear to be implied in Stigler.For Stigler, it appears, error is delibei'ately (and artificially)excluded by the economist from his purview, on the groundsthat we lack a theory of error. TMBut for us as Austrians, it shouldbe alear, our conclusions follow strictly from the ínsight that menare purposeful (or "rational," as Mises uses the word). Ir menpursue purposes, it foUows that ofcourse they do not consciouslyact to place themselves in situations that are any but the mostpreferred of those equally available alternatives of which the),are aware. If men turn out to have failed to achieve the mostpreferred situations it must be either that those situations werein fact not available, or that (possibly as a result of deliberate,purposeful earlier decisions) these agents were not aware of the

66 New Directions in Austrian Economicsfull range of altematives. Not only, that is, have we apparendybeen led to Stigler's conclusion that there is no place for error ineconomics, we have been led to this conclusion as implied di.rectly in the ver), assumption of purposefulness from which wetake our point of departure, a7Economics, it thus seems to turn out, is peopled by beingswhose purposefulness ensures that they can never, in retrospect,reproach themselves for having acted in error. They may, inretrospect, indeed wish that they had been more skillful, or hadcommanded more inputs, or had been better informed. But theycan never upbraid themselves for having acted erroneously infailing to command those superior skills or to acquire moreaccurate information. They must, at every stage concede thatthey had, in the past, acted with flawless precision (insofar asthey were able). Any reproaches which they may validly wish todirect at themselves--for example for not having tried hardenough or for having succumbed to temptation:-arise out oflaterjudgments of value (conceming the significance of leisureor of the goal represented by the fleeting temptaon) with whichthey had, at earlier dates, disagreed. Such self-reproach, we nowunderstand, is not for having acted in error, in the seme relevantto the present discussion, t8Indeed the reader might reasonably daLm cause for irritationat the tr/v/a//ty of our condusion. Given the pammountcy accordedto purposefulness, and given a definition of error whichexdudes "wrong" judgments of value as well as failures ascribableto ignorance or inadequacy (whether due to causes beyondthe control of the agent or to Iris past purposeful choices)---surely the conclusion that error is exduded is so obviously implicitin our definidons as to be completely uninteresting.But, as the remaining pages of this paper will attempt to show,the condusiom to which we have apparendy been led by ourdiscussion thus far, are not trivial at alt--in fact they are not eventrue. Not only is there nothing, as we shall see, in the assumptionsand definitions on which economic analysis is built, whichrules out erroruit can be shown that economic analysis canhardly proceed at all without making very important use of the

Economics and Error _, 67concept of error (as well as of the discovery and correctionerror). Let us see how aU this can possibly be maintained.ofIGNORANCEAND ERRORMuch weight was placed, in earlier pages, on our recognitionthat mistakes made as a result of ignorance do not qualify aserrors (in the sense relevant to our discussion). A man who actedwith complete precision, given the knowledge he thought hepossessed, could not, we maintained, be reproached with havingacted in error. (And where the limits to his stock of knowledgehad been deliberately selected, we certainly understood hito tohave acted, at all times, beyond reproach.) That is, the man at notime refrained from exploiting any known opportunity forachieving the most desirable situation possible. Yet surely wemust recognize that, valid though these statements are, withintheir own framework, they may not fully exhaust our interpretationof the situations to which they refer.Aman walks along a street, sees a store with signs offering toser apples for $1 but, perhaps thinking of other things, enters asecond store where he pays $2 for identical apples. He may have"seen" the signs in the first store, but his perception ofthem wasso weak as to mean that, when he paid $2 in the second store hedid not, in fact, "know" that he was rejecting a preferred opportunityfor one less preferred. Within the framework of his"knowledge," the $2 apples were indeed his best opportunity; hemade no error. Yet, surely, in an ímportant sense he will (whenhe realizes bis mistake) reproach himself for having been soabsentminded as to pass by the bargain whichhe saw, for the moreexpensive purchase. In this sense he d/d commit an error, theerror of not acting on the information available to hito, of notperceivíng fully the opportunity before bis very nose. He did(without the excuse of not having the necessary informationavailable to him) consciously place him_lf in a less preferredposition than that available to him. It is true that he was not"aware" of the superior alternative. But, because the necessary

68 New Directionsin Austrian Economicsinformation was available to hito, it was surely an error on hispart to have failedto actupon ir(i.e.,to have remained unawareof the superior opportunity). His "unawareness"cannotbe "excused"(from convictionof error) on the grounds of inadequacyof inputs (since the information inputs were at hand). It cannotbe excused on the grounds of anearlierdecision to refrain fromacquiring information (since no such decision was made). Thisunawarenesscannotbe flatlyexduded asimpossible(becauseofinconsistency with purposeful action) because there/s nothinginpurposefulactionwhichbyitselfguaranteesthateveryavailableopportunitymust be instantaneouslyperceived?9In the discussion in the first portion of this paper knowledgewastreated as something like ah input, a"tool." Someone lacldngthis needed input could not be reproached with error for notsucceeding in achieving that for which this input was needed.(And where this input had deliberately and correctly not beenacquired because of its cost, this exemption fróm reproach becarneeven more justified.) But we now see that ignorance maymean something other than lack of command over a neededtool--it may be sheer failure to utilice a resource available andready at hand. Such failure, moreover, is not inconsistent withpurposefulness, since an available resource ready at hand maynot be noticed; purposefulness is not necessarily incomistentwith tunnel-vision. (Of course one might insist that an agent notblessedwith the alermess needed to notice resourcesavailableathand, simply lacks, through no "fault" of his own, another"resource_[i.e.,"alermess"]necessary to take advantage of the otherresources with which he has been blessed. We cannot set downsuch a use of terms as wrong. We simply point out that whiledecisiom can in principle be madé by a person to acquire aresource which he lacks, we can n0t conceive of one lacking"alermess,"making a decision to acquire it. This is so because,amongother reasons,_obefore a decision to acquireanythingcanbe considered, one must alreadyassume the alermess necessaryfor the perception that such ajaacquisitionis needed and possibleat all. Or, to put it somewhat differently, alermess cannot betreated asa resource with respect to whichdecisiom ate made on

Economicsand Error ; 69how to use it, since, in order to make such a dedsion with respectto a resource, one must alreadyhave been alert to its availabílity."Alertness" thus appears to possess a primordial role in decisionmaking which makes it unhelpful for it to be treated, in theanalysis of decisions, "as any other resource." We claim, therefore,justificationfora terminology which maintains that whereignorance consists, not in lack of available informaon, but ininexplicably failing to see facts stañng one in the face, it representsgenuine error, and genuine inefficiency.)_1IGNOtL4NCE, ERROR, dND ENTREPRENEURIALOPPORTUNITIESWe have shown that genuine error isnot inconsistent with thefundamental postulates of economics. It remains to show thateconomic analysis dependson the presence of this kind of errorfor its most elementary and far-reaching theorems. Let us considerthe theorem whichJevons correctlycalled"a general law ofthe utmost importance in economics," which asserts that"in thesame open market, at any one moment, there cannot be twopñces for the same kind of article.''2_NowJevons presented thisLaw of Indifference as valid only where no imperfection ofknowledge exists. Yet surely economists ever sinceJevons haveunderstood the law as asserting a tendencyat all times for divergentprices ofidencal goods to converge,ceterisparibus, towarda single price. That is, the law asserts a tendency for imperfectknowledge to be replaced bymore perfect knowledge,z3Now theexistence of sucia a tendency requires some explanaon. If theímperfection of knowledge (responsible for the inial multiplicityof prices) reflected the lack of some "resource" (as wheremeam ofcommunication are absent between different parts of amarket), then it isdifficult, without additionaljustification, to seehow we can postulate universally a process of spontaneous discovery.Ir, say, imperfection in knowledge resulted from deliberateunwiilingness to incur the costs of search, itis not alearhowwe can be confident that, in the course of the market process

70 New Directionsin Austrian Economicssuch unwiUingnesswillinvariablydissipate, or that the necessarycosts of search wiUinvariably faU.(Of course one can constructmodels in which these costsmaybe supposed to rail. One type oftheorizing concerning the nature of the market process has,following on the line of the economics of information, in effecttaken this approach.)Surely our justification for asserting the existence of a tendencyfor the pñces of identical articles to converge rests on ourunderstanding that the imperfection of knowledge (on whichone must rely in order to account for the initial multiplicity ofpñces) reflected, at least in part, sheer error. We understand,that is, that the initial imperfection in knowledge is to be attñbuted,not to lack ofsome needed resource,but to failure to noticeopportunitíes ready at hand. The multiplidty of prices representedopportunities for pure entrepreneurial profit; thatsuch multiplicity existed, means that many market partidpants(those who sold at the lower pñces and those who bought at thehigher pñces) simply overlooked these opportunities. Sincethese opportunities were left unexploited, not because of unavailableneeded resources, but because they were simply notnoticed, we understand that, as time passes, the lure of availablepure profits can be counted upon to alert at least some marketparticipants to the existence of these opportunities. The law ofindifference follows from our recognition that error exists, thatit consists in available opportunities being overlooked, and thatthe market process is a process of the systematic discovery andcorrection of true error. The hypothetical state of equilibñum, itemerges, consists not so much in the perfecfion of knowledge(since costs of acquiring knowledge may welljustify an eq,fi!ibriumstate of ignorance) as in the hypothetical absence of error.AIIthis permits us to concur (in general temas,ir not in mattersof detail) with that aspect of Leibenstein's concept ofX-inefficiency which he identifies with the scope for entrepreneurship..4 Scope for entrepreneurship, we have discovered,is present whenever error occurs. Pure profit opportunitiesexist whenever error occurs. Whenever error occurs inthe context of producon, inputs are being used to achieve iess

Economics and Error _ 7 lthan the optimum quantity and quality of outputs; the produceris operating inside the "outer-bound production possibility surfaceconsistent with [bis] resources. ":sX-inefficiency/s possible,it reflects error, and is necessarily reflected in the availabílity ofentrepreneuñal profit opportunities and scope for entrepreneurialdiscovery and improvement. That our conclusionwith respect to this aspect of Leibenstein's contribution apparentlydiffers from that of Stigler (who rejects the notion ofX-inefficiency entirely) is fully consistent with our refusal toaccompany Stigler in his insistence on excluding error fromeconomics.MARSHALL, ROBBINS, .4ND THE REPRESENTATIVE FIRMIn the course of bis critique of Leibenstein, Sgler has valuablyrecalled our attention to an old issue in the economic literature,the ratíonale underlying Marshall's concept of the representavefirm. It was Lionel (now Lord) Robbins who in 19282eexplained Marshall's move in introducing the rather troublesomenoÜon of the representaÚve firm, and who showed, withthe most effective logic, that there is in fact no need for thisawkward construct at aH. Our discussion thus far enables us tomake several comments on the issue.Basing his interpretation on the authoritative opinion of DennisRobertson, RobbLnsexplaíns that Marshall devised the representativefirm "to meet the difficulties occuring in the analysisof supply when there is a disparity of effidency as betweendifferent producers. "j7 This disparity means that part of thetotal supply of each product (the magnitude of which helpsdetermine price) is produced by producen making zero of negatireprofits. Consequendy it would appear that "the magnitudeof net profits is irrelevant to the determination of... price." Forthis rea.son Marshall explained that pñce is to be understood interms of the normal costs (induding gross earnings of management)associated with the representative firm? sRobbim went to great paim to show that, insofar as concerns

72 New Directionsin Austrian Economicsthese disparities of effióency between firms that would not disappearin equilibrium,there is no need at allto invoke the notionof a representative firm. Such dispañties in effidency are to betraced to the presence of entrepreneurs of varying ability. "Justas units of a given supply may be produced on lands of varyingeffidency, so their production may be supervised by businessmen of varying ability.What is normal profit for one willnot benormal profit for another, that is all.''2' As StigIer put it, it isinappropriate to use variations in entrepreneurial ability to accountfor varíations in costs among firms:"... differences in thequality of an input do not lead to differences in outputs fromgiven inputs.... [When] costs of firms differed because ofquality of entrepreneurs (or other inputs), the differences inproducvity would be reflected in differences in profits (orother input prices)."8°In other words, differences in costsof producfionarisingfromdifferences in entrepreneurialabilitymean thatthe equilibrium•pricesfor the vañous entrepreneuñal inputswillbe correspondinglydifferent. When account is taken of the costs of theseentrepreneurial inputs it willbe seen that, in equilibrium,thereexistno costvariatiombetweenentrepreneurs. Stiglerappearstocondude that Robbim'sdiscussionjustifies the neoclassicalpracriceof viewing each producer as always at a production frontier.If asa result of varying quality of entrepreneurial inputs, thereoccursoutput vañaon, this is simply because, asa result of thevariance in entrepreneurial quality, each producer may llave aproduction frontier above or belowthat of others,st There is noroom, in this scheme of things, for Leibenstein's X-ineffidency(which implies the possibility that differences in output are aresult of genuine differences in sheer efficier/cy,not attributableto differences in input quality).For our purposes it is useful to point out that the porfion ofRobbins's crique of Marshallupon which Stigler draws,is confinedexplicitly to the state of equilibrium,u Under condions ofequilibrium we mu_ indeed reject the possibility of genuinedisparities in effider/cy among firms that cannot be traced todifferences in input qualities. In equih'brium such disparities

Economics and Error 73cannot be traced to sheer error. But under condifions of disequilibrium,when scope exists for entrepreneurial activity,there is no reason why genuine disparities ma), not exist amongdifferent producers, traceable (not to differences in inputqualíties--since we do not view alertness as an input_but) todifferences in the degree to which producers have succumbed toerror. Robbins's critique of Marshall does not, therefore, implyah), need to reject Leibemtein's X-inefficiency (insofar, as wellave seen, sucia inefficieno/coincides with the existence of ascope for entrepreneurship).ERROR IN ECONOMIC$:SOME NORM/ITIVE APPLICATIONSOur concern in this pape r to defend the possibility of genuineerror in economics is based on more than our wish to show howpositive economic theory cannot proceed without such possibiliD'.Our concem rests, in addifion, upon important normaUvegrounds. Allocative inefficiency in a society of errorless individualmaximizers must, it appears on reflectio_, be accountedfor only by the existence of prohibitive transaction costs) 3 Improvementin social well-being must, in such a world, appear tobe possible only asa result of unexplained technological breakthroughs.Surely such a picture of the world, a picture in which nogenuine opportunities for improvement are permitted to exist,is wholly unsatisfying. Surely ,,ve are convinced that enormousscope exists at ídl times for genuine economic improvement andthat the world is chock-full of inefficiencies. It is most embarrímingto have to grapple with the grossly inefficient world weknow, with economic tools which assume away the essence of theproblem with which we wish to deal.On the other hand, as soon as we admit genuine error into ourpurview, our embarrassment fades away. Our world/s a grosslyinefficient world. What is ineffícient about the world is surelythat, at each instant, enormous scope for improvements exista, is

74 New Directions in Austrian Economicsin one way or another ready at hand, and is yet simply notnoticed. At each instant, because the market is in a state ofdisequilibrium, genuine allocative inefficiendes remain yet to beremoved simply because entrepreneurs have not yet noticed theprofit opportunities represented by these inefficiencies. At eachinstant available technological improvements (in some sense alreadyready at hand) remain to be exploited; they remain untappedbecause entrepreneurs have not yet noticed the profitopportunities embedded in these possibilities. It is genuine errorto which we can ascribe much of the world's iUs,and ,,veneed aneconomics that can recognize this.Fortunately, Austrian economics, with its emphasis on disequilibriumand on the entrepreneuñal role, is richly suited tofdl our need in this respect. Only an economics which recognizeshow the profit motive (by which we mean the lure of pureentrepreneurial profits) can harness entrepreneurial activitytoward the systematic elimination of error can be of service inpointing the way to those ínstitutional structures necessary forthe steady improvement of the lot of mankind.NOTES1. F.A. Hayek, "Economicsand Knowledge,"Economiza,N.S. Vol.IV, No. 13 (February 1937).2. G.J. Stigler, "The Xistence of X-Efficiency,"Amor/canEconom/cRev/ew, March 1976, p. 216.3. L. Mises,Theoryana[H/story(New Haven: Yale UniversityPress,1957), p. 268.4. See Stigler, op. cá. p. 215.5. B. Croce, "On the Economic Prindple," translated in IntemationalEconami¢Papers,No. 3, p. 177.6. I. M. Kirzner, T_ Econom/cPmnt of V/eu,(Princeton: Van Nostrand,1960), pp. 169-72.7. G. Tagliacozzo, "Croceand the Nature of Economic Science,"QUa_sYJournal ofEconomics,Vol. HX, No. $ (May 1945).• L. Mises,Human Action (New Haven: Yale University Press,1949),p. 95.

Economics and Error ; 759. Ib/d. pp. 102f.10. Ib/d.11. F. H. Knight, Risk, Uncertainty and Profit, (1921), pp. 225--26.12. H. Leibenstein, "Allocafive Efficiency vs. 'X-Efficiency'," Amer/-can Economic Review, Vol. 56 (June 1966); "Entrepreneurship andDevelopment," American Economic Review, Vol. 58 (May 1968); "Competitionand X-Efficiency: Reply,"Journal ofPolitical Economy, Vol. 81,No. 3 (May/June 1973); "Aspects of the X-Efficiency Theory of theFirm," BellJournal ofEconomics, Vol. 6 (Autumn 1975).13. H. Leibenstein, "Competition andX-Efficiency: Reply," p. 766.14. H. Leibenstein, "AUocative Efficiency vs. 'X-Efficiency'," p. 407.15. G.J. Sfigler, op. cit.16. lb/d. p. 216.17. Put differently, our perception of the impossibility of error doesnot depend on any "arbitrary" assumption of utility° or profitmaximizingbehavior. Error is impossible because it is inconsistent withthe postulate of purposeful action.18. The possibility for social "inefficiency" of any kind, in such anerrorless world, would, it must appear, then rest either on the possibilitythat high transaction costs make the "correction" in fact uneconomic,or, on the highly dubious nofion of an omniscient observerfrom whose perspective the errorless (but imperfecfly omniscient)members of society are overlooking valuable opportunifies for improvingtheir positions. On all this see further, I. M. Kirzner, CompetitionandEntrepreneurship (Chicago: University of Chicago Press, 1973), Ch. 6.See also the final secuon of the present paper.19. Although, as argued by the writer elsewhe_, the extent to whichavailable opportunities are perceived is not at all unrelated to theconcept of purposeful acUon.20. The other reasons include the circumstance that, were one todiscover someone whose superior alertness to profitable opportunitiesone wishes to hire, we would expect that other ("alert one") to havealready taken advantage of those opportunitíes (or at least that he willanyway do so very shortly) on bis own account.21. For further discussion of some of the issues raised in this and thefollowing secfions, see the writer's Competition and Entrepreneurship,Chapters 2, 3.22. W. S. Jevons, The Theory ofPoli_alEconomy, 4th Edition, 1911(Pecan Books, 1970), p. 137.23. On all this see Hayek's pioneering contribuon in his 1937paper (see footnote 1). See also the writer's unpublished paper,"Hayek, Knowledge, and Market Processes."24. H. Leibenstein, "Entrepreneurship and Development"; and

76 New Directions in Austrian EconomicsKirzner, Competition and Entrepreneurship, p. 46n.25. H. Leibenstein, "Allocative Efficiency vs. 'X-Efficiency'," p. 413.26. L. Robbins, "The Representave Firrn," EconomicJournal, Volume38 (September 1928).27. Robbins, op. vit. p. 391.28. $ee A. Marshall, Principles ofEconomics (Sth Edition,342f.1920), pp.29. Robbins, p. 393.30. Sgler, "The Xistence ofX-Efficiency", pp. 214f.31. Sgler, p. 215.32. Robbins, pp. 392-396.33. See e.g.G. Calbresi, "Transacfion Costs, Resource Allocaonand Liability Rules: A Comment,"Journa/ofLaw and Economics, Vol. 11(April 1968), p. 68.

The Problem of Social CostS. C. LittlechildThe University of Birmingham (United Kingdom)INTRODUCTIONIt is difficult to overestimate the role which socialcost plays inmodern welfare economics. The ideas of socialcost and productlie behind the surplus-maximisaUon criterion frequently urgedupon public utñities, the consequent computaon and comparisonof sociallates of return on road and rail investments, and thephílosophy of marginal cost pricing. FoUowingPigou, the possibílityofdivergencies between private and social cost or productprovides a basis for peak-hour congestion taxes or prices onroads, airports, and telephone systems; for subsidised entranceinto the telephone network on the grounds that other subscribersthereby benefit; for regional investment and subsidies oftaxes on labour to counter hidden unemployment of socialcostsof urban growth not reflected in the private calculus; for reducedprices of educaonal and health services; for subsidiestoinvention, research and development, and so on.The criticismof Pigou provided in Coase's article, "The Problemof Social Cost," and the reformulation provided there, haveto some extent directed attention away from dívergencies betweenprivate and social cost towards the possibility of solvingsocial problems through the market by means of ah improveddefinition of reaUocationof property rights. Despite this changein approach, the concept of value of socialproduct is retaíned byboth Coase and Pigou, and indeed bythe majority ofpresent-dayeconomists, as the basic críteríon for comparing alternave socialsystems. The purpose of the present paper is to examine77

78 New Directions in Austrian Economicsthese notions of social cost and social product from a "subjectivist"or "Austrian" point of view. Apart from its intrinsic importance,the concept of social cost is of particular interest to subjectivists,for Buchanan has suggested that Coase's own work on thistopic is the major success story of the L.S.E. subjectivist school.Perhaps the most significant L.S.E. impact on modern economics hascome through an indirect application of opportunity-cost theoryrather than through an undermining of basiccost conceptions. "Marginalsocial cost," enthroned by Pigou as a cornerstone of appliedwelfare economics, was successfully challenged by R. H. Coase aquarter-century after his initial work on cost. Hisnow classicpaper onsocialcost, which reflects the same cost theory held earlier, succeededwhere the more straightforward earlier attacks on the marginal-costpricing norm--attacks by Coase himself, by Thirlby and byWiseman---apparently failed (I, pp. 11-12).However, we shall discover in the present paper that ProfessorCoase's work, whatever may be its other substantial merits incorrecting Pigou and in reorienting the economics profession,does not present ah approach to cost which is any more satisfactory,from a subjectivist standpoint, than did Pigou. Indeed,once it ís recognised (a) that social value and social cost aresubjective, rather than objective concepts and (b) that they bearonly a tenuous relationship to the true costs of decision-making,then it becomes questionable whether the notion of social cost isthe most useful way of approaching the problem.We shall begin with summaries of the social cost argument andof the subjectivist approach to economics.THE NOTIONSOF SOCIAL V.4LUE AND SOCI/IL COSTThe concept of social cost is remarkably elusive. Economistsunhesitatingly attñbute the concept to Pigou, as expounded inhisEconomies ofWelfare, but in fact in none of the four ediUons ofthat book, nor in his earlier Weal_ and Wdfare, is there anymention of the term social cost itself. It is perhaps not entirelycoincidental, then, that Coase's own paper, "The Problem of

The Problem of Social Cost " 79Social Cost," contains no mention either of the term social cost.The analyses of both authors ate, in fact, conducted almostentírely in terms of social product. (I have not yet been able todiscover the origin of the term social cost. Knight (VI) used it inhis criticism of Pigou without any suggestion that it was original.A. A. Young (XIV), in reviewing Wealth and Welfare, referred to asocial view ofcost. Perhaps this odd situation lends some supportto Coase's suggestion that the Pigovian doctrine on these matterswas largely the product of an oral tradition.)Pigou admitted that the elements of welfare were ukimatelystates of consciousness, but in order to achieve something practicablehe feh it necessary to limit his subject matter to "thatposition of the field in which the methods of science seem likelyto work at best advantage," namely, "... to that part of socialwelfare that can be brought directly or indirectly into relationwith the measuring-rod of money. This part of welfare ma), becalled economic welfare (VII, p. 11).The "objective counterpart of economic welfare whicheconomists call the national dividend or nafional income" was"composed in the last resort of a number of objecUve services,some of which are embodied in commodities." In order to preservethe measuñng rod of money, Pigou decided to include inthe national dividend only those goods and services acmally soldfor money, and for the same reason he rejected consumersurplus as a measure of a change in the national dividend.Pigou's main ínstrument of analysis was marginal product,defined as follows:The marginal so¢i'a!net product is the total net produa of physicalthings or objectiveservicesdue to the marginalincrement of resourcesin any given use of place, no matter to whom any part of this productmay acabe .... The marginal pñvate net product is that part of thetotal net product.., which accruesin the first instance---ge., prior tosale--to the person responsible for investing resources there .... Thevalue of the marginal socJ'a![and pñvate] net product ofany quantity ofresources employed in any use of place is simply the sum of moneywhich the marginal social net product is worth in the market (VII, pp.

80 New Directions in Austrian EconomicsIf pñvate and social net products coincide, then "the free playof seff-interest, so lar as it is not hampered by ignorance, willtend to bfing about such a distñbution of resources.., as wiUraise the national dividend and, with it, the sum of economicwelfare to a maximum" (VII, p. 143). But if there is a divergentebetween private and social products (i.e., ir there ate externalities),then "specific acts of interference with normaleconomic processes," by means of bounties and taxes, will removethe divergence and increase the dividend (VII, p. 172).We need not be concemed here with Knight's observation thatdivergencies between private and social cost depend uponwhether or not the road (or other means of production) isprivately owned, nor with Coase's suggeson that Pigou wasignorant of the legal posion and in any case failed to take intoaccount the response of the party affected by extemalies.There are, however, two aspects of Coase's analysis which deservemention. First, he observed that Pigou's measurement ofnational dividend in terms of goods and services actua//y s0/d"means that the value of social product has no social significancewhatsoever" (III, p. 40). Coase preferred to value production atits market value regardless of whether payment actually tookplace. Second, he recommended thatWhen ah economist is comparing alternave social arrangements, theproper procedure is to compare the total social product yielded bythese different arrangements. The comparison ofprivate and socialproducts is neither here nor there (III, p. 34).He later compares this to the opportunity cost approach used inthe analysis of the firm. Ir seems .reasonable to infer that thesocial (opportunity) cost of choosing one Social arrangementwould- be def'med as the market value of total product correspondingto the best alternative arrangement not chosen.THE SUBJECTIVISTAPPROACHFor those who are not familiar with the writings of the Aus-

The Problem of Social Cost 81'trian school or the L.S.E. subjectivist school, it will be useful tosummarise the relevant parts of this approach, beginning withHayek's work in the 1930s and 1940s, which Buchanan (I, p. 24)has descríbed as la_ng down the central features of the subjectivistmethodolog 7.In the papers repñnted as Part One of The Counter Revolutionof Science, Hayek emphasised that the "facts" of the social sciencesate human perceptions of the world, beliefs held by people"irrespective of whether they are true or false, and whichmoreover, we cannot directly observe in the minds of the peoplebut which one can recognise from what they do and say merelybecause we have ourselves a mind similar to theirs." The objectsof human acfion are not "objective facts" and cannot be definedin purely physical temas. "So far as human actions are concemed,the things are what the acting people think they are."Moreover, "the knowledge and beliefs of different people, whilepossessing that common structure which makes communicationpossíble, wiU yet be different and often conflicting in manyrespects." The term "subjective" thus reflects the idea that actionsdepend upon perceptions and also the idea that differentpeople wiU generally have different perceptions.For present purposes, two implications of this basic insight areof particular relevance. First, as Kirzner (V) has argued, itis nolonger appropriate to restrict definition of the "economic problem"to that of allocating scarce resources between competingends, in the way that Robbins (VIII) had proposed. It is necessaryto indude the perception of ends and means, rather than totake these as given. Hence we are led to the concept of"entrepreneurship,"or alertness to advantageous changes in means orends, and to Mises' "acting man" rather than to Robbins's"economising man." In mm, the entrepreneurial element inhuman acUon can be identified as that which generates a processof change, and indeed the emphasis of the whole Austrian approachis on the market process rather than upon the state ofequih%rium.Ki__rznerhimself has used this notion of perception in commentingupon Coase's analysis of property rights in the social-

82 New Directions in Austrian Economicscost paper already referred to. Coase had argued that, in theabsence oftransactions costs, market transactions would transferproperty rights and allocate resources so as to maximise thevalue of production, independent of the legal position. Kirzner(V, p. 227) objected that zero transactions costs were neithernecessary nor sufficient to ensure that all participants wouldnot/ce the mutually profitable contracts which could be enteredhato.The second implication of the subjectivist approach is that costmust be thought of asa subjective, rather than objective, concept,because the elements of individual choice evidently dependupon the alternatives imagined and thought worthy of¢onsiderationby the decision-maker, and the choice actually made dependsupon his preferences. Buchanan has argued thateconomists at the L.S.E. (including Coase) have played ah importantrole in developing this subjective theory of cost, and hesummarises the theory as follows:Cost is that which the decision-maker sacrifices of gives up when heselects one alternative rather than another. Cost consists therefore inhisown evaluation of the enjoyment or utilitythat he anticipateshavingto forgo asa result ofchoice itself. There are specificimplications to bedrawn from this choice-bound definition of opportunity cost:1. Cost must be borne exclusively by the person who makes decisions;it is not possible for this cost to be shifted to or imposed onothers.2. Costis subjective;it exists only in the mind of thedecision-makeror chooser.3. Cost is based on anticipations; it is necessañly a forward-lookingor ex ante concept.4. Costcan never be realised becauseof the fact that choice is made;the alternative which is rejected can never itself be enjoyed.5. Cost cannot be measured by someone other than the choosersince there is no way that subjective mental expeñence can bedirectly observed.

The Problem of Social Cost 836. Cost can be dated at the moment of final dedsion or choice.In any general theory of choice ¢ost must be reckoned ín a ulityrather t.hanin a commodity dímension. From this it follows that theopportunity costinvolved inchoice cannotbe observedand objectifiedand, more importantly,it cannot be measuredin such a way asto allowcomparisonsover wholly different ¢hoice settings (I, pp. 14-15).Thirlby (1946, 1960) and Wiseman (1953, 1957) have pointedout some of the difficulties of supervision which now arise.I Suppose a manager is instructed to maximise net revenue. (Wer must not say "revenue less cost," since these two concepts areincommensurate: Revenue is measured in terms of money andcost in terms of utility.) Since it is not possible to know withcertainty the outcomes of all possible courses of action, it is notpossible to make a direct check on the efficiency of the manager.One may make indirect checks by ascertaining which alternativeshe considered (i.e., by examining his "plan"), by assessing theactual outcome (i.e., by examíning his "account"), and by checkingthe accuracy of his forecasting (i.e., by comparing his planwith his account). But it is never possible to know whether therewere better alternatives which should have been considered orwhether the outcomes of alternatives not chosen were correctlyforecast. Moreover, when indirect checks of this kind are used,the manager is led to modify his actions to take account of them,for the simple reason that the cost, to him, of taldng one decisionis necessañly his own evaluation of the alternative outcomeforegone. It is not net revenue itself, but thesignificance to hito ofnet revenue, which determines bis actions.Let us now apply some of these ideas to the concepts of socialvahe and cost.SOCIAL COST AND PRODUCT--ARECONSIDEtMTIONFor both Pígou and Coase, social product and social cost ateevidently objective concepts. Social product is defined asa stockOr flow of spedfied physical services. The question of what

84 New Directionsin Austrian Economicsconstitutes a good or service,i.e.,who perceivesit and how, is notraised. There is no uncertainty about the goods and servicesassociated with each possible decision, hence there are no conflictingexpectations. Finally, the question of whose valuation isto be used isavoided byreference to the "market value."In thesecircumstances, the optimal choice is simplya matter of computationand social (opportunity) cost is objective.Ir might be conceded that, in practice, the likely outcomes ofany particular measure are unsure, as are the likely marketprices, but ir isnecessary to make a "best guess." This element ofsubjectivityof course raises the difficules referred to in the lastsecUon. Whose guess is appropriate for policy purposes, andhow is the efficiency of the guessing procedure to be ascertained?Moreover, there is a crucial difference between thissituation and that of the private firm in that no ulu'mateobjectivecheck on efficiency is available: Ir the decision-making procedureis inefficient, there isno direct feedback comparable to thatof financial loss and bankruptcy.But now suppose that werecognise the full degree of subjecUvityofbeliefsabout simations and no longer assume an objectivelyspecified set of physical products ora market pñce for these. Inthis general case, what becomes of the notion of value of socialproduct? Is it possible to reconcile socialproduct and social costwith the subjecáve theory of cost and choice?Take first the Pigovian approach. A decisíon by one personmay also affect other people. It is conventional to describethis asa collection of changes in utility levels. The value of (marginal)social product is, then, in some sense, the net change in totalutility, but this raises the obvious well-known objections thatutilities are ordinal and cannot be aggregated. One thereforeattempts to derive a cardinal measure byasking what the changein utility is worth in money terms. This isdone byconstructing acoUection of artificial choice simations, one for each personaffected, and askingoneselfwhat this person would be preparedto pay for the decision in question to be taken or not to be taken.The optimal decision depends upon the total sums of moneythereby calculated.

The Problem of Social Cost 85Evidently the sítuation envisaged by Coase does not differsignificantly from this. Attention is not focused on a single individualdedsion°taker, but rather all persons ate aHowed to respondto each social arrangement (say, legal position) underconsideratíon, with corresponding changes in utility levels whichare to be valued in money terms. The optimal choice of socialarrangement then depends upon the sum of money values thusobtained.To what extent is this arfifidal choice interpretafion just describedcompatible with the subjectivist approach? In effect, weare asking whether iris possible to attach a meaning to the notionof damage or benefit as valued by the person damaged or benefitedby the action of another person. Ifthis action had been theresult of a contract between the two persons, then we could, inprinciple, have measured the effect (more precisely, the expectedeffect) with respect to the alternative choices available,i.e., to the cost of the contract. In the case where no contract ismade, we are considering a hypothetical choice and asking howattracfive a hypothetical alternative would need to have been inorder to be preferred (or how unattractive it could have beenand stiU have been preferred).The first point to emphasíse is that the proposed proceduredoes not involve choices, albeit hypothetical, by the person inquestion but rather by an outside observing economist, governmentoffid_!,judge, of politidan. As argued earlier, the costs ofhis choice involve the significance to hito of the differentanswer: for example, whether the answers seem plausible toIris peers and supervisors. The valuation put on damage toanother person is thus nota cost to that person at all. Moreover,even ffthe artificial choice were made by the person in question,his costs would involve the benefits of choosing a higher of lowerfigure in a laboratory situation, and would not measure the costsinvolved in the intended choice situation (cf., IX).Second, since this evaluation is nota choice actually made inthe market, there is room for considerable uncertainty as to whatvalue would be appropriate. To use the standard terminology,one is simply guessing where the relevant indifference curves líe

86 New Directions in Austrian Economics(I, p. 72). Different observers could come up with differentevaluations, norte ofwhich could be proved objective!y correa orincorrect.Third, the intention of the hypothetical choice scheme is toevaluate a person's response to a situation while taking as givenhis perceived opportunities and objectives. But we have mentionedthat, in the subjecvist approach, economics is not simplya matter of known meam and ends, but also involves the perceptionof new possibiliUes, which in general change one's evaluationof previously perceived opportunities. Suppose that thealternative under consideraUon by thé policymaker had notbeen conceived by the person whose evaluation ir is required toesfimate. Then an evaluation can only be obtained by (conceptually)changinghis existing perceptions. This, of course, raises twoproblems: how the new alternative should (again concepmally)be presented to the person, and what bis reacfion would be. Theproblem applies more generally: Even if he is aware of thepossibility of the decision under consideration, he will generallyhave a different impression of its namre, implications, andlikelihood than another person will have. Should the observer/economist take as given his initial, perhaps "incorrea," percel>tionsor should he (concepmally) modify them? What is a "correa"perception of the consequences of any act?Even ifit were possible to specify the initial reactions of peoplem a proposed action, what position should be taken concerningsubsequent changes in their perceptions and plans? Coase isevidently aware of this difficulty. He refers to the use ofbluffinorder to induce the other party to make a larger payment, butcomments "such manoeuvres are preliminaries to an agreementand do not affect the long run equilibrium position" (III, p. 8).Evidently, he takes the view that ir is not the immediate responseto a situaon which is relevant, but the "equilibrium" response,after appropriate information has been acquired. The diff'_-ultywith this position is the precariousness of the notion of equilibriumonceeconomicactivityisviewedasaprocessrather than astate.

The Probleraof Social Cost 87CONCLUSIONLet us attempt to summarise the argument of this paper.It was found that the concept of social cost itself, althoughwidely used, was not used by Pigou and Coase, who preferred towork instead in terms of social product. Despite differences intheir usage of this concept, they essentially proposed to use valueof social product as a cfiterion for choosing between alternativesituations. This notion depended upon "physical product" composedof specified objective goods and services, to which objecdvelydefmed pñces were or could be attached.This approach was shown to lead to certain difficulties.Bñefly,1. The basic assumptions are inconsistent with a subjectivistapproach. Goods and prices are defined objectively, so thatthe optimal choice is simply a matter of computation andcost is objective.2. Ir uncertainty of future quantities and prices is admitted,then there is no objectively "ñght" calculation, there aredifficulties in assessing the efficiency of those required tomaxímise social product, and there is no ultimate test comparableto net revenue in a private firm.3. The attempt to use artificial choice situations in order toobtain a monetary figure of change in utility means thatcosts of choice to the observer are not costs which would beexpeñencedin a real choice situation.4. Some persons may not have perceived the altemativeunder consideration as relevant, so that an answer to thehypothefical question can only be obtained by (conceptually)changing that person's perceptions. More generaHy,since different individuals may view altematives differently,they will not necessarily be appraising the "same"

88 New Directions in Austrian Economicsalternative. How then should the situation be (conceptually)presented?5. If economic activity is viewed, notas ah equilibrium state,but asa process involving changing perceptions and values,then it is not dear at what time, or after what period ofreflection, it is appropriate to calculate the value of product.In this discussion I have tried to show that social cost andproduct are not objective concepts. This does not mean to saythat any particular observer cannot make ah estimate of thedamage or benefits accruing from any action, but rather that thisestimate wiUnecessarily embody elements of bis own evaluationand wiU depend upon his own perceptions and assumptious ofwhat is appropriate. Different individuals wiU,therefore, makedifferent estimates, and no objective check on efficiency is possible.This raises the question ofwhether social product as traditionallyconceived is the best concept for use in govemment decisions.We may, in fact, use Coase's argument agaimt himself.The proper question to ask is not whether _ or that socialarrangement maximises value of social product, but ratherwhether using social product as a criterion is preferable to usingsome other approach. In order to answer this question, it isnecessary to know more about how those who have been urgedor required to use this criteñon have behaved in the past. Herewe might examine the decisions of nation_lised industries inBritain, and government response, to cost-benefit analyses ofroads, railways, and airports. Second, iris necessary to know howeffective other objective controls have been, such as breakevenrequirements or specific constraints on spending or provision ofservices. FinaUy, it is necessary to compare government controlsof any kind with those imposed by the market. A fruifful start onthese problems has been made by Alchian, Stigler, Posner, andothers, and one would expect th_t Coase would r/mpathise withsuch ah approach.

The Problem of Social Cost 89However, it would seem that social product cannot be used asthe final criterion of evaluation, for the reasons given. Whatother criterion is available? I simply menUon here Kirzner'ssuggeson (V, pp. 216 ff.) that alternative insfituons or arrangementscan be evaluated in terms of their success in bringingabout mutually beneficial contracts. The effectiveness ofsucia a criterion remains to be explored.POSTSCRIPTI wish to add a bñefcomment on the definition of social cost inthe literature anda more extensive discussion of social cost as thecriterion £or action by a public organisaon.Coase implicitly defines the cost of any social arrangement asthe market value forgone under an alternative arrangement.This is indeed a cost, in the sense defined by Buchanan, ff wethink of society as an entity choosing alternative arrangementswith the airo of maximising market value (though how thesealternafives are generated and evaluated is not specified). However,not all economists adopt this definion. Stigler, for exampie,discusses a chemical plant which discharges waste into astream, and says that "the sum of costs to eve_one is called thesocial cost of waste disposal" (Theo_ of Price, 1966). Such aconcept is nota cost in Buchanan's sense----indeed, an action byone person cannot impose costs on others. This is not to say thatthe one definition is supeñor to the other, ofcourse, but ratherthat one is (or can more easily be made) consistent with the L.S.E.tradition.Several of the parficipants at the W'mdsor Conference, whilebroadly sympathetic to the argument of the paper, neverthelessfelt uneasy on two counts.(a) Sínce the procedure for calculating social costs and benefitsappears to be similar to that for pñvate costs and benefits,why is the latter legitimate, but the former iUegimate?(b) If public organisations are not required to base decisionson social cost, what other instructions should be given

90 New Directionsin Austrian Economicsthem? In this Postscript I shall attempt to answer these questionsmore directly.Consider first two ideal types: the businessman interested inmaximising net private revenue and the benevolent dictatorinterested in maximising net social benefit. The problems theyhave to face are identical, although the criteria they use aredifferent. In neither case is there any distinction m be madebetween subjectiveand objectiveconcepts, because in both casesthe worldistaken to be as the decision-maker perceives it. Thosegoods are relevant which the decision-maker believes to be relevant;those future prices, future responses, and future valuesare appropriate which the decision-maker believes to be appropriate.In principle, to calculate net social benefit is no moredifficult than to calculate net private revenue.Putting plans into aaion generates new information which inturn makes it appropriate, sooner or later, to revisethe previousplans. Investments or other commitments may have been made,yet other previous commitments may have expired, and newopportunities may have añsen. The pattern of costs and benefits,and hence the optimal actions, will generaHybe differentfrom those planned earlier. Revision of plans in this way isnecessary regardless of whether the objectiveis net private revenueor net social benefit, and there is no reason to suppose it isany easier in the one case than in the other.FinaHy, suppose that the businessman and the benevolentdictator do not carry out all the actions themselves, but ratherinstruct subordinates to maximise the respective objectives ontheir behalf. In each case, it may be assumed that the subordinateshave objecáves and preferences of their own which theywill attempt to saásfy insolar as they are not prevented or discouragedfrom doing so. The problem of control arises: how toemure that the subordinates are carrying out their duties efficienfly?In neither case is it possible to ascertain directlywhat isthe optimal policy, so it is necessary to develop indirect checks byexaminm"g the process of plan preparation, the outcomes of theactions taken, and the accuracy of the forecasfing.

The Problem of Social Cost 91Wherein, then, lies the difference between the objectives ofnet social benefit and net private revenue? It lies, I think, in thedegree of difficulty in assessing the outcomes of any series ofactions. Both concepts are measured in money terms, butwhereas the liquid assets of an organisation at any time can beascertained reasonably easily and objectively, this is not true ofnet social benefit. The whole point of a social cost-benefitanalysis is to impute to people values which they 1:1onot in factexpress in the market. There is no"correct" value, there are onlydifferent views about values, which may be more or less plausibleto others. The problem of control is infinitely more difficultwhen the outcome of any action is not immediately apparent.In order to maximise net social benefit it may, paradoxically,be more efficient not to set this as a direct objective, simplybecause of the difficulty of checking performance. As arguedelsewhere, the market mechanism, the profit moáve, and thepossibility of competition provide incenves to discover andmeet the wishes of consumers, with monetary success for thosewho succeed and replacement for those who rail. It is certainlynot guaranteed that the market mechanism will ensure that the"correct" decisions are always taken, since these cannot beknown, but there are reasons to believe the market is more likely,in the long run, to maximise net social benefit.It may be objected that competition is not always possible and,indeed, that this is a major reason for replacing the marketmechanism with some form of government organisation. Asregards the first point, the work of Hayek, Coase, Kirzner,Alchian, Demsetz, and others has gradually provided a betterunderstanding of the namre of competition and market failure.It is now recognised that the effidency of the market may beenhanced (e.g., by developing property rights) irthere is a will todo so. On the second point, whether market failure is the reasonfor government intervention is debatable. By intervention, thegovernment is, in effect, deliberately isolating an industry frommarket forces and subjecting it, instead, to political forces. It ísexpressing the view that the industry should not maximise netsocial benefit, as expressed in market values, but rather should

92 New Directions in dustrian Economicsgive greater weight to some particular consumers or producers.It is not surprising to find, then, that those government organisaonsresponsible for monitoring the performance of 0thergovernment organisaUons charged with maximising net socialbenefit show little enthusiasm for their task. Unlike net pñvaterevenue, net social benefit is ah artificial concept of direct interestonly to economists.This suggests that operang rules for controlling public organisationsshould sasfy two criteña. First, they should relate toconcepts and enties of direct relevance to the people of organisationsconcerned. Second, the rules should be couched in objectiveoperaonal terms: It should be possible to check whether ornot they have been obeyed.To iUustrate bñefly, it is currenfly Brish policy to rcquirenationalised industñes to assess proposed in_,estments against a"test discount tate." Since in practice it is impossible for anoutsider to teU whether the assumpons and forecasts embodied_n the appraisal are reasonable (of even what they ate!), this ruleprovides no effecUve che& on effidency in investment. It wouldbe preferable to replace ir by, e.g., a realisc charge for borrowingfunds plus a specified tate of return on the borrowing of theindustry asa whole. Requiñng the industry to invest so as tomaximise net social benefit provides not control but only theillusion of control.tBIBLIOGRAPHYI. Buchanan,J. M.Costand Choice.Chicago: MarkhamPublishingCo., 1969.II. Buchanan,J. M., and Thirlby, G. F., eds. L.S£. Es.uz3son Cost.Weidenfeld & Nicholson, 1973.III. Coue, IL H. "The Problem of SocialCost,'Jouma/ofLaw£conm/r.s3 (1960): 1-44.andIV. Hayek,Ir.A.T_ Count,,r-lh,vohaionof $cin_e. Glencoe,In.: TheFree Press, 1952.V. Kirzner, L M. C_ and £ntreprmeursh/p. Chicago andLondon: Universityof Chicago Press, 1973.

The Problem of Social Cost 93VI. Knight, F. H. "Some Fallacies in the Interpretation of SocialCost." QuarterlyJournal of Economics 38 (1924): 582-606.VII. Pigou, A. C. TheEconomics ofWelfare. 4th ed. London: Macmillan,1932.VIII. Robbins, L. Ah Essay on the Nature and Significance of EconomicScience. 2nd ed. London: MacmiUan, 1935.IX. Rothbard, M. N. "Toward a Reconstruction of Utility and WelfareEconomics." On Freedomand FreeEnte_prise. Edited by M.Sennholz. Princeton, N.J.: Van Nostrand, 1956.X. Thirlby, G. F. "The Ruler." South AfricanJournal ofEconomics 14(1946). Reprinted in Buchanan and Thirlby (1973).XI. Thirlby, G. F. "Economists' Cost Rules and EquilibriumTheory." Economica (1960). Reprinted in Buchanan andThirlby (1973).XII. Wisernan, J. "Uncertainty, Costs and Collective EconomicPlanning." Economica (1953). Reprinted in Buchanan andThirlby (1973).XIII. Wiseman, J. "The Theory of Public Utility Price--an EmptyBox." Oxford Economic Papers 9 (1957). Reprinted in Buc.hartanand Thirlby (1973).XIV. Young, A. A. "Pigou's Wealth and Welfare." QuarterlyJournal ofEconomics 27 (1913): 672--86.

A Critiqueof Neoclassical and AustrianMonopolyTheoryD. T. ArmentanoUniversity of HartfordOne of the most controversial areas in Austrian economics,and one where even long-established Austrian theorists differsharply, is monopoly theory. Indeed, as we shall see below, thedifferences are not merely semantic, nor are they confined todetail or some minor theoretical implication. Rather, there aremajor and fundamental disagreements between some of theleading Austrians, and these disagreements are created bywholly different theories concerning the defin/t/on of monopoly,the or/g/ns of monopoly, and the supposed effectsof monopoly onconsumer sovereignty and efficient resource allocaUon.NEOCLASSICAL MONOPOLY THEORYBy way ofcontrast, and in order to place the Austrian theoriesofmonopoly in perspective, it is perhaps necessary to review andcriticize the traditional (neodassícal) theory of monopoly?A monopolist in neoclassical analysis is a tirm that faces theentire demand for the product under consideration. In order toma_ímize its profits, it produces ah output where the marginalrevenue associated with the last unit sold is jmt equal to the94

A Critique of Neoclassicaland Austrian Monopoly Theory 95marginal costs associated with producing and selling that finalunit. But since the demand function facing the monopolist isnecessarily sloped downward (perhaps even steeply downward),the price charged for the output is greater than both marginalrevenue and marginal cost.This situation, it is argued, compares "unfavorably" with priceand output (and cost) under competitive conditions. Undercompetitive conditions, since price and marginal revenue ateequal, price is always identical with marginal cost when profitsare maximized. Further, under competitive equilibrium conditions,price is always driven down to the minimum point of theaverage cost function, so that production tends to take place at itsmost "efficient" point. Therefore, monopoly prices ate higherthan competitive prices, outputs are less, and average costsgreater than under comparable competitive (cost) conditions.But, importantly, how is a firm able to obtain a monopolyposition in the market and, thus, "misallocate" economic resources?In the first place the monopoly could simply be due togovernmental prohibition of competitive entry, and there iscertainly a recognition of this source of monopoly in the neoclassicalliterature. However, more recently it has been popular tostress certain non/ega/"barriers to entry" that, allegedly, preservemonopoly and resource misallocation, s These barriers wouldindude any difficulty or impediment'that a new firm might haveto overcome in order to compete successfully with an existingfirm (monopolist). Thus, scale economies enjoyed by an existingfirm, or commercially successful product differentiationemployed by such a firm, becomes, in the newjargon, a barrier toentry that limits competition and reduces society's "welfare."CONTEMPORARY MONOPOLY THEORY: A CRITIQUEThere are two avenues of criticism that one might take withrespect to neodassical monopoly theory. In the first place, onemight criticize the purely competitive model which is employedasa benchmark andas a basis of comparison with monopolistic

96 New Directions in Austrian Economicssituations. And secondly, one might criticize the whole conceptof nonlegal barriers to entry, arguing, instead, that it iS simplyconsumer preference that "limits competition" and that consequentlyno misallocatíon of resources occurs.Most economists would agree that pure competition is notactually possible. Some would agree, perhaps reluctantly, that itmight not even be desirable of optimal ir it cou/d exist. (Ir theyagree to this, of course, then they must also agree that movingtoward pure competition is not necessarily desirable, either.) Butfew economists have noced of emphasized thefundaraental flawof the purely competitive model, namely, that it is not a descriptionof competition at all.a Pure competition ís a static, equilibriumcondition whose very assumptions ate such that competitiveprocess is ruled out by definition. Or to put the matter morecharitably, while pure competition may describe the final outcomeof a particular compefitive situation, the ultimate endresult, it does not describe the competitiveprocess that produce.dthat particular outcome. The purely competitíve theory is notatheory of competition as such.The neoclassical habit of confusing competitive process with afinal, stac equilibríum condition makes for gross errors ineconomic analysis. For instance, product differentiation, advertising,price competition (including price discrimination), andinnovation ate rather routinely condemned as "monopolistic"and, thus, as resource misallocating and socially undesirable. Thiscondemnation follows "logically" since not one of these activitiesis possible under purely competitive conditions. Hence everythingthat is truly competitive in the real world, truly rivalrous,gets labeled as "monopolistic" and resource misallocating in theAlice-in-Wonderland, purely competitive world. The analyticalcondusions one is forced to come to, employing the purelycompetitive perspectíve, are notjust wrong, notjust unrealistic,but the very opposite of the truth. Far from being able to "predict,"of tell us anything meaningful concerning competitivebehavior, pure competition can only describe what things wouldbe like if the world contained zombie-like conmmers withhomogeneoustastes, atomistically structured firm$ idenfical in

A Critique ofNeodassical and Austrian Monopoly Theory 97every important respect, with no locational advantages, no advertising,no entrepreneurship, and no rivalry whatever. Surelythis is the aajor flaw and absurdity inherent in the purely competitiveperspective. 4BARRIERS TO ENTRY: A CRITIQUEDiscussions about the nonlegal barriers to entry suffer froathe saae difficulUes. The two aost popular and ímportant"barriersto entry" areproduct differentiation and scale economies.Productdifferentiation liaits coapetifion since it aakes coapefiUveentry more cos@. To use a favorite neodassical example, thefact that the aajor autoaobile coapanies change styles everyyear increases the costs of coapeting in this industry. Would-becoapetitors must be willing and able to undergo the same orsimilar procedures, else they siaply cannot coapete. Evenworse, once coapetition is "liaited," the auto coapaniesroutinely pass along the higher costs in the forro ofhigher príces,which contributes, ir is alleged, to a real reduction in consuaerwelfare.On the other hand--indeed, on the opposite handmscaleeconoaies also limit coapetition. The fact that certain timasrealize lower costs per unit because of large volumes gives thesetimas the "power" to exclude smaUer timas, or smaller potentialentrants, froa the market. Ergo, we are supposed to regret thereduced coapetition and consequent resource misanocationsince ineffident timas cannot compete with efficient ones.Actually, of course, the neoclassical theoñsts have gotten theaatter coapletely and predsely backward. It is because, and onlybecause, consuaers find resources satisfactorily allocated thatwould-be coapetitors find entry difficult or impossible. Productdifferentiation, especially differentiaon that does raise prices,can only actas a barñer to entry ir consumersprefer that differentiation,and pay the presuaably higher pñces associated with,sa),, new armual auto styles. Ir consumen do not prefer suchdifferentiation and, instead, reward the fi,,iis that change styles

98 New Directions in Austrian Economics/ess often, or not at all, then product differentiation could hardlyact asa barrier to competitive entry. Indeed, in the case justpostulated, product differentiation would be an open invitationto entry and to competition.To condemn commercially successful product differentiafionasa misallocation of scarce resources, therefore, is to condemnthe very "resource allocations" that consumers apparenfly prefer.It is the neoclassical economist's allegedly "optimar' allocationof resources under purely competitive conditions that productdifferentiation upsets, and not any allocation that can be associatedwith free consumer choice.The same sort of argument can be made---and even moreobviously--with respect to scale economies. Consumers do notregret the economies nor the consequent reduction in competition.Consumers could "increase competifion" arjy time theychoose to by indicating their willingness to pay higher prices tocover the higher costs of the smaller firms. That they do notusually do thís indicates the resources are correctly allocated sofar as they are concerned. Again, it is the economist's vision ofthe purely competitive wonderland that is upset by the large,efficient firm, and not aHocative efficiency from a conmmerperspective.The fmal absurdity in this area is to observe where suchincorrect theories of competition are likely to lead. Ir productdifferentiation limits competition, i.e., limits the number ofcompetitors, then more competition can be obtained by limitingproduct differentiation---by law. If efficient techniques of producáonor scale economies limit competition, i.e., the number ofcompetitors, then more competition can be obtained by raisingeither costs or pñces for the effident companies--6y law. Thus,to take the barriers-to-entry theory señously is to end up proposingas rational public policy--in the name of consumerwelfare--the very procedures that consumers would likely findmost harmful. The only thing sadder than all of this is that mc_ideas have actually been taken seriously in some antitrust drdesand by the courts, and we llave had some real world legal dedsionsthat reflect such theoretical nonseme, s

.4 Critique of Neoclassical and Austrian Monopoly Theory 99As should be quite clear from the above review and criUque,there is much dissatisfacUon with the traditional notions ofmonopoly and competition, and with the simplisfic antitrustpolicies (antimerger policy, for instance) founded on such assumptions.But if the neoclassical approach to monopoly andcompetition is defective, what is the correct approach in thísarea? Indeed,/s there a logical and rational theory of monopolyand, accordingly, an appropriate public policy to complementthat theoretical approach? In the sections below we will turn to acritical examination of Austrian monopoly theory in an attemptto answer these questions. The views of von Mises, Kirzner, andRothbard will be taken as representative of various Austrianpositions concerning monopoly.MISES' MONOPOLYTHEORYMonopoly exists for Ludwig von Mises when "... the wholesupply of the commodity is controlled by a single seller or agroup of sellers acting in concert. "e This condítion puts themonopolist (or cartel) in the position of being able to restfictsupply in order to raise market price without having to"fear thathis plans wiU be frustrated by interference on the part of theother sellers of the same commodity. "vMises holds, however, thatmonopoly pr/ces do not result unless the restricUon in supplyproduces prices that actually increase the monopolist's "total netproceeds." Only if the demand for the product is inelas.tic in theprice range under discussion could "monopoly pfices emerge asdifferentiated from competitive prices." Hence, ir is not"monopoly" as such that is catallactically relevant for ML*es,butonly the "configuration" of the demand function and theemergence of monopoly prices, sImpormntly ff suela monopoly prices do exist, then they are an"infringement of the supremacy of the consumers and thedemocracy of the market."9 Mises even goes further:Monopolypricesare consequentialonly becausethey ate the outcome

100 New Directions in Austrian Economicsof a conduct of business defying the supremacy of the consumers andsubstituting the pñvate interests of the monopolist for those of thepublic. They ate the only instance in the operaUon of a marketeconomy in which the distinction between production for profit andproducfion for use could to some extent be made.... loAnd again:The characteristic feature of monopoly pñces is the monopolist's defianceof the wishes of the consumers? 1Mises also argues that although most monopolies andmonopoly prices ate made possible by government interventionin the free market (tariffs, licenses, etc.), there ate certain instancesin which monopoly (and monopoly prices) arise in theunhampered market. He specifically mentions natural resourcemonopoly, TM geographic monopoly, TM Iimited-spacemonopoly, TMand monopoly that might arise because consumersplace a "special confidence.., on the individual or firm concernedon account of previous experience, "15 as with certaintrademarked drugs.KIRZNER'S MONOPOLY THEORYProfessor Kirzner's theory of monopoly can be derived logicallyfrom bis well-articulated theory of the competitive process._°Kírzner views the market process as one in which marketseUers are conánually attempting to inch ahead of rivals byoffering moreattracUveopportunides to potential buyers. Andhe views this process as inherently competitive since the key ingredientthat makes the process function---entrepreneurship--can never be monopolized. For Kírzner, pure entrepreneurshiprequires no resources whatsoever; hence the freedom to enterthe market is absolute since no obstacles to entry can ever exist ina free market.However, the exercise of entrepreneurship is quite anothermatter. Here the exclusive ownership or control of "a//thecurrent endowment of a certain resouree" is defmed by Kirzner

A Critique ofNeoclassicaI and Austrian Monopoly Theory 101to be monopoly, can indeed block entry into the production ofsome specific good, and can hamper competition and "impedethe course of the market process." A monopoly producer forKirzner is one whose "exclusive input blocks competitive entryinto the production of his products. ''17 To employ Kirzner'sexample, without access to oranges, "producUon of orange juiceis blocked. ''18Kirzner notes that monopoly should not refer to a producerwho--in the absence of resource monopoly--is the singlesupplier ofsome product in the market. That firm, he reasons, isstill fully subject to the market process since entry into competitiveproduction is always possible. On the other hand, when"needed resources" ate restñcted because of monopoly ownershipor control of a certain resource, the very possibility ofcompetition--and the benefits to consumers that ate the consequencesof competition--are eliminated. 19Here, according toKirzner, the monopolist is completely "immune from the competitionof other entrepreneurs who might, in other circumstances,enter bis field of activity. ''2°Kirzner is quick to note, however, that the monopolist is notimmune from the competitive process itself. Although entry intosome specific activity is by definition blockaded, entry intos/m//aractivities is not. Monopoly control over a resource simply divertsthe competitive, entrepreneurial process into other similar activities,employing other resources which create a "turbulence"that surrounds and impinges upon the monopolist's oñginalactivity.Importan@, Kirzner hints that the equilibrium tendency of amarket containing resource monopoly is to produce a higherthan "competitive-equilibrium price" for the resources and alsoa higher"surplus" for the product produced with that resource.This surplus can be accomplished by withdrawing some of thestock from the market and "forcing" up the market price. _1Thus, consumers raight be harmed by such activity since scarcemonopolized resources are not being employed to the "fullestextent compatiblemarket."2zwith the pattern of consumer tastes in the

102 New Directions in dustrian EconomicsROTHBARD'S MONOPOLY THEORYProfessor Rothbard's analysis of monopoly, monopoly pñce,and the welfare implications of such economic conditions differsradically from that of both Mises and Kirzner. Indeed, in hisdiscussion of monopoly, Rothbard is sharply critical not only ofthe neoclassícal monopoly theories, but also implicitly critical(and occasionally explicifly critical) of víews held by his fellowAustrian theorists as well.2aAs far as Rothbard is concerned, there are three possibledefiniUons ofmonopoly: one, the single seller ofany given good;two, a grant of special privilege by the state, reserving a certainarea of production to one particular individual or group; and ithree, "a person who has achieved a monopoly price. "2_ iAlthough Rothbard admits that the first definition (single jseller) is a coherent and even a "legitimate" one, he wjects it asimpractical because it is too broad and all-indusive. The impracti- ical nature of this definition can be iUustrated, Rothbard argues,by noting that any difference (differentiaUon) in any two goodsor resources and, more importanfly, any consumer-percdved differencein any two commodities or resources will make themunique (specific) goods and thus, by definition, "monopoly."Hence, "the single seller of any given good" could always reduceto the notion that everyone is a monopolist since each person in amarket system is presumed to have exdusive ownership of h/sown (unique) property. But a definion that makes everythingmonopoly and everyone a monopolist is barren, "confusing,"and "absurd" according to Rothbard. "sRothbard clearly prefers the second definition ofmonopoly--i.e., a grant of pñvilege from the state restrictingcompetitive production or sale. This is a monopoly since entryinto the privileged actívity is prohibited by the state; logically, nosuch monopoly could ever exist in a free market. This definitionwill be adopted as the "proper" one should the final alternativedefinition prove nonsemical or iUegitimate, uRothbard's criticism of the theory of"monopoly pñce" (as wellas his criticism of the theory of"competitive price") is certainly a

A Critique ofNeoclassical and Austrian Monopoly Theory 103controversial contribution to the literature on monopoly. Forhere he argues that in a free market there is simply no way ofconceptually distinguishing "monopoly price" from a freemarketcompetitive price.On the free market there is no way of distinguishing a "monopolyprice" ora "subcompetitive price" or of establishing any changes asmovements from one to the other. No criteria can be found formaiángsuch distinctions. The concept of monopoly price as distinguishedfrom competitive price is therefore untenable. We can speak only ofthe free market price,z7It has been common, of course, to speak of monopoly price asthat price accomplished when output is restricted under conditionsof inelastic demand, thus increasing the net income of thesupplier. Even Mises, it will be recalled, employed the term inthis manner and drew some fairly dismal welfare implicationsfrom the "restriction."Rothbard argues, however, that there is no objective way todetermine that such a price is a monopoly pñce or that such a"restricon" is antisocial. AII we can know, according toRothbard, is that a//firms attempt to produce a stock of goodsthat maximizes their net income given their estimation of demand.They attempt to price (other things being equal) such thatthe range of demand above the asking pñce is elastic. If theydiscover that they can increase their monetary income by producingless--or even destroying existing stock_in the next seUingperiod, then they do so.Rothbard maintaim that to speak of the initial price as the"competitive" price, and the second-period price as the"monopoly" price makes no objective seme. How, he asks, is it tobe objectively determined that the first price is really the "competitive"price? Gould it, in fact llave been a "subcompetitive"price? Indeed, the entire discussion is absurd for Rothbard sincethere are no independe_ cñteña t,hat would allow either determination.AII that can be lmown for sure, he argues, is that thepñces both before and after the supply change are free-marketprices.

104 New Directions in Austrian EconomicsRothbard also argues that "monopoly" prices cannot be inferredby comparing such prices to prices charged for similarfactors. So long as the factors ate not perfectly idenfical in theeyes of buyers, the differences in price (of profits) ate simplyfree-market determinations of value for different goods. Andany talk of monopoly price of monopoly "gain" when two d/fferentfactors or goods ate being compared is analytically in.COITeCt. _8Finally, the welfare implications concerning alleged monopolyprices would not fo[low even ir such prices could exist. Since theinelasticity of demand for Rothbard is "purely the result ofvo|untary demands" of the consumers, and since the exchange(at the higher prices) is completely "voluntary" anyway, there isno way to conclude that consumers of their"welfare" have beeninjured. 2e Thus, for Rothbard there ís no social "problem" associatedwith monopoly in a free market. Monopoly príces cannotbe defined logically, let alone established in a free market.CRITICAL REVIEW OF dUSTRIAN MONOPOLY THEORYThe views of Kirzner and Mises that monopoly consists ofexclusive control over the whole supply ofsome specific resourcecreates a number of familiar difficulties. In the first place, there iwould appear to be no objective way to define beforehand some I"homogeneous" stock of resources that might be monopolízed.All individua[ly owned stocks of a resource could be differentiatedIat least with respect to location; in addition, the private-property system itself necessarily imparts a "differentiation" toall privately owned stocks. Further, even identical units ofsomegiven stock might be regarded differenfly by potential users, andthere would be no way to determine this beforehand. Hence, thisview of monopoly could reduce logically to the notion that eachand every unit of everyone's property stock is owned "monopolistically."Rothbard, it will be recalled, was critical of this definition ofmonopoly because its all-indusiveness made ir "impractical,"

A Critique ofNeoclassical and Austrian Monopoly Theory 105confusing, and, ultimately, "absurd." But we can be critical of iton different grounds, employing Professor Kirzner's own (correct)view of the competitive market process. It will be recalledthat Kirzner had argued that the key to competition was freedoroof entry and that entry was impossible if potential entrepreneurscould not gain access to monopolized resources, s°Yet,as has been noted above, ifall individual stocks of resources ate,in fact, monopolized, it would seem to follow that Kirzner's definitionof monopoly would completely negate his own views oncompetition and market process. Indeed, it is difficult to understandhow any competition or market process would even bepossible with this definitional approach. How could any competitionoccur if aU resources are monopolized?Even if it were to be assumed for the moment that resourcesare not uniquely specific and are, instead, completelyhomogeneous, additional difficulties remain. Why, for instance,ought monopoly ownership to preclude thepossibility ofcompetitionfrom potentially rivalrous entrepreneurs that purchaseneeded resources? Indeed, Kirzner himself has already statedthat the market process is "always" competitive so long as there isfreedom to buy and sell in the market. 31Even monopoly ownershipdoes not erase the freedom to buy and seu since it is possiblethat access to resources could be obtained, say, through purchase.Yet Kirzner argues that the "voy possibilitíesthemselves" ofcompetition may be eliminated by monopoly ownership of aresource, s*Another difficulty with Professor Kirzner's approach is his useof the qualifying terna, "current endowment of a certain resource.''SsObviously, nothing prevents potentially ñvalrous entrepreneursfrom exploring for and exploiting new supplies of aspecific resource. Indeed, "current endowment" of a resource isan ambiguous phrase since supplies of resources ate normallyclassified as "proved," "probable," and "possible."If Kirzner means to imply that a monopoly over the currentproved endowment of a particular resource precludes thepossibilofcompetitionand allows the resource owner to be "immunefrom entrepreneurial competition, ''_4 he would be arguing a

106 New Directions in Austrian Economicstenuous point at best. Clearly such a "monopoly" allows no suchthing. In this example, future 35 entry is clearly possible andcannot be precluded a pr/or/. And since the enre Austriantradifion in this area is to treat the competifive process as one thatunfolds through t/me anyway, how ate the potential entrepreneurseffectively blocked from "díscovering unexploited opportuniaesfor profit"?Asa final point, monopoly over a resource would appear tomake rational economic calculadon difficult (if not impossible)since no "market" would then exist for the resource, s6Withoutmarkets economic calculaUon is impossible since objective pricescannot be determined. A firm that monopolized "oranges" forinstance, would have no objective way of knowing, subsequendy,whether it was employing its resources efficiently in the productionof"orangejuice," or even whether it ought to be producingorange juice at all. This "definition" of monopol)_, therefore,would appear to be operationally self-destructive. Themonopoly posítion would tend to generate inevitable irrationalitiesin production since entrepreneurs would have noobjective way to calculate "costs."Mises, it will be recaUed, realized the inherent difficulfies ofdefining monopoly, and so he moved on to the catallactíc significanceof monopoly: obtaining the monopoly price and, thus,frustrafing "the wishes of the consumen." Professor Kirzner,although he denies that the elasUdty of the demand funcfion hasany bearing whatever on whether a monopoly exists or not,nonetheless does argue that resource monopoly is likely to resultin a restricted employment of such resources, higher prices, and ilarger surpluses for the producer employing the resource, a7 iImportantly, such ownership (at least in the short run) has!"harmful effects" since it creates an incentive "for not using a ,scarce resource to the fullest extent compatible with the patternof consumer's tastes in the market."seIt is really difficult to see, however, why any of this argumentnecessarily follows. The "pattern ofconsumer tastes in the market"would appear to be, simply, consumer demand. C,omumerdemand is the vañable amount of some homogeneous stock that

A Critique ofNeodassical and Austrian Monopoly Theory 107consumers would be willing and able to purchase at variousprices. The important point to be made here is that in a freemarket such "demand" determinations by consumers are completelyvolunta d on their part, and all price-output combinaonson that hypothetical function faithfuUy reflect that choice andrelate those "wishes" to the producers. Consequently, consumersare at all times in complete control of (fully sovereign over) theirown property at any given pñce-output combination.It appears completely arbitrary to argue that only "low" prices,or "lower" prices induced by "supply increases," or only the"elastic" porfions of a consumer's demand function ate compablewith consumer sovereignty. Why are not consumers fully"sovereign" throughout the entire price-output range of their0wn demand function? After all it is they who determine, incertain instances, that they will trade greater volumes of dollarsfor fewer units of some good. Indeed, to prevent them fromengaging in such exchanges would more accurately infringeupon their "sovereignty." If and when consumers become dissatisfiedwith such combinations, they are perfectly free tochange the "elasticity" oftheir own demand to combinations thatthe), do prefer.Ifthe above analysis is correct, it follows that resource ownersor producers that voluntarily "restrict" their supplies to obtainhigher prices (not "force" them up as Professor Kirzner asserts)39have committed no sociaUy harmful act. Restrictedsupplies and higher prices rdative to what? All suppliers in freemarketsrestrictthdr supplies in the sen_ that theyonly supplyasmuch ofa good or resource as they determine u_ maximize their numetary orphysic income. But, importantly, this is preciselywhat the "monopolist"does. Ifhis acUon is"harmful," then so is the economic activity ofall other suppliers in the market.Alternatively, it cannot be argued that what distinguishes"monopoly" supply from "competitive" supply is the consequenfl),higher prices. In the first place we have already arguedthat the new price-output combination is perfecfly compatiblewith expressed consumer demand and, therefore, with consumersovereignty. Secondly, prices are always "high" relative to

I108 New Directionsin Austrian Economicslower prices that cou/dexist, but do not. Indeed, any price at all is"high," "frustrates" consumers, and reduces their ulñmate utilityfrom consumption. But surely the ability to charge a lowerprice than the prevailing market price, or no pñce at all, canhardly be a correct criterion for judgíng whether a supply iscompetitive or monopolistic. Indeed, since producers are a/s0sovereign under free-market conditions, we must conclude thatany supply is competitive and any price is "compatible" withconsumer sovereignty and consumer satisfaction.ROTHBARD'S MONOPOLY THEORY RECONSIDEREDRothbard it willbe recalled had defined monopoly as "a grantof special privilege from the State reserving a certain area ofproduaion to one particular individual or group." This definitionof monopoly would appear to be immune from the sort ofcriticism employed above against both the neodassical andMises-Kii-znertheories of monopoly. In the first place, wecan beconfident that competition is "lessened" by this sort ofmonopoly, and that resources are nonoptimally allocated so faras consumers ate concerned, since governmental monopoly restrictsby/aw both competitive entry and, consequently, freeconsumer choice.Legal barriersto entry restrict entry bydefmition.Areas of production that are truly"namrall3t' monopolisticwould hardly require governmental entry restrictions. Consequenfly,consumer choice must be distorted, and the subsequentresource allocations mustbe "ineffident," since consumenare prevented by law from making choices that differ fromthose already made for them by the political authoñty. Hence,we condude that governmental monopoly dways restñcts compeUáon,always violates consumer (and producer) sovereignty,and a/ways"injures" consumer welfare.Ir would be tempting to argue that these "restrictiom" and"injuries"are, perhaps, minor in the case of"minor" legal impedimentsto either production or exchange. Yet, there is nosatisfactory way to card/nally measure either "competition" orif_

A Critique ofNeoclassical and Austrian Monopoly Theory 109consumer"utility." Since uUlity is a completely subjecUve noUon,and since interpersonal comparisons of utility are not possible,there is no objective way to determine how severe even "minor"state impediments to entry and competition actually are. It iscompletely possible, for instance, that what rnay appear to be ahextremely inoffensive governmental regulation, i.e., settingmínimum safety standards for sellers, may in fact be harmful inthe extreme with respect to certain potenal businessmen andspecific classes of consumers.We conclude, therefore, that any and o2/state restrictions are"monopolisc," compeon reducing, and destructive of consumersatisfaction vis-ñ-vis alternave free-market situations.We also conclude, in summary, that this particular theory ofmonopoly is the only theory that meets all the standard cfiticalobjections and remains entirely consistent with the general Austrianmethodology.NOTES1. For a review ofthis position see, for instance, EdwinMansfield,M/croe.conom/_,Second Edition (Norton, 1975), Chapters 9 & 10.2. WiUardF. Mueller,A Primeron Monopolyand c0mpet/t/on(RandoroHouse, 1970), Chapter 2.3. hrael M. Kirzner,CompetitionandEntr¿,prenna'ship(UniversityofChicago Press, 1973).4. D. T. Armentano,TheMy0isofAnt/tn_: Econom/cTheoryand Lega/Coses(Arlington house, 1972), Chapter 2.5. Ibig, pp. 212--15, 246, 267-68.6. Ludwig ron Mises,Human Action (YaleUniversityPress, 1963),p. 358.7. Ib/d.8. Ib/d., pp. 358-60.9. Ibid., p. 358.10. lb/d., p 371.11. Ib/d., 1.,1373.12. Ib/d., p. $71.15. Ib/d., p. 373.14. Ib/d., p. $75.

110 New D:'rections in Austrian Economics15. Ib/d., p. 364.16. Kirzner, op. c/t., Chapter I.17. Ib/d., p. 21.18. Ib/d., p. 103.19. Ib/d.20. 1/ñd., p. 105.21. Ibíd., p. 110.22. Ibíd., p. 111.23. Murray N. Rothbard, Man, Economy, and $tate, Volume II (D.Van Nostrand Company, Inc., 1962), pp. 561-66. See alsoJoumal ofEconom_ Lit_ature, September-October, 1974, pp. 902-3.24. Rothbard, op. c/t., pp. 590-93.25. I/r/d., p. 591.26. lb/d., p. 593.27. Ib/d., p. 614.28. Ib/d., pp. 608-9.29. Ib/d., p. 564.30. Kirzner, op. c/t., p. 103.31. Ibid., p. 20. This statement would seem to refute Kirzner's enreposition on monopoly. If markets are a/tttays competitive so long asthere isfreedom to buy and sell, then in a free market there is alwayscompetition and nevtr any monopoly.32. Ib/d., p. 103.33. Ib/d., p. 21.34. lb/d., p. 110.35. And "future" in an entrepreneurial sense can mean the n_moment competitive supply appears or threatens to appear.36. See Rothbard's discussion of similar problems for cartels inMan,Economy, and State.37. Kirzner, op. r/t., p. 110.38. Ib/d., p. 111.39. lb/d., p. 110.

Spontaneous Orderand the Coordinationof Economic Activifies*Gerald P. O'Driscoll, Jr.Iowa State UniversityThis paper is an essay on the coordination of economic activities.It is exploratory and speculative, connecting argumentsthat I have made in several other places. The essay is an attemptto give a coherent picture ofsome of the theoretical and practicalproblems facing economists, as well as society in general. Writtenfor a conference on Austrian economics, this paper deals withquesfions specifically from that disUnctive víewpoint. It is notthat I propose to defend the proposition that economists of thisschool possess a uniquely correct perspective of the issues, butmerely that they have much to say on the particular questionswith which I wiU deal. I trust that my references to economistsnot normally considered to be members of the Austñan SchoolwiUdemonstrate the universality of the problems discussed here.Those economists who view a system of free exchange---AdamSmith's "obvious and simple system of natural liberty"_---as thesolution of the coordination problem in economics face intellecmalchallenges from at least four sources: first, the conánuíngcha_Uengeof the Keynesian legacy; second, the cha_enge fromwhat James Buchanan has termed the "modero Ricardians";*This essay appeared in The Journal of L/herrar/ahStud/es 1 (Spring1977): 137--51.Copyright © 1977 Pergamon Press Ltd.111

112 New Directions in Austrian Economicsthird, the challenge from the new movement for national planning;and finally, the challenge from certain economists in theAustrian School.In previous papers, I have dealt with the Austrian analysis ofmonetary theory (or macroeconomics) as it is concerned with thecoordination of economic activities. Accordingly, I wiU beginwith this general problem.THE KEYNESIANLEGACYIr has become clear in recent years that Keynes's General Theoryis a very confused work, so much that it is virtually ah ink-blot testfor economists: ah economist's perception of its conter, ts tellsmore about the beliefs of the reader than the _ontents of thatbook. s Indeed, Keynes's sympathetic critics are compelled topoint out these confusions in their attempts to argue that hemade a significant contribution to our understanding of theeconomic system. The best example of this is Axel Leijonhufvud'sOn Keynesian Economics and the Economics of Keynes. sLeijonhufvud argues there that Keynes had important insightsinto coordination failures in market systems. Specifically,Leijonhufvud's Keynes argued that banking and fmancial systemscan operate so as to impede rather than to facilitate theadjustment to a change in the equilibrium rate of interest. Secuñesmarkets ate incapable of moving from a higher to alower equilibrium tate of interest, without attendant fluctuaonsin income and employment. This is true whether the assumeddismrbance consists of a downward shift in the marginalefficiency of investment (Keynes's marginal effidency of capital),of an increase in the savíngs schedule (a decreased marginalpropensity to consume out of current income). The existence ofbearish speculators in securies markets impedes smooth adjustmentof those markets. Keynes's bears do this by speculangagainst any rise in the prices of long-lived assets, real or financial.'Keynesian bears speculate on the basis of the historicalpercepon that the), possess of a "normal" long run tate of

Spontaneous Order and the Coordination of Economic Activities 113interest. If this normal long-rate could be taken as summarizingthe real forces determining the equilibrium rate ofinterest, thenit is quite reasonable, from a profit-maximizing viewpoint, forspeculators to treat deviaUons from the rateas temporary fluctuations.5 Indeed, Keynes's speculators behave precisely the waytextbook examples suggest, in that they act so as to basten thereturn to theperceived equilibñum position (though this effect isnot part of their intention, of course). But in this instance,speculaUve activity, following a guide that normally proves reliable,proves to be disequilibraUng in its effects. Speculators aremisled into identifying as but a transitory fluctuation what in factis the consequence of a shift in parameters.In microtheory ir is customary to point out that speculatorswho misidentify an equilibrium position wiUsuffer capital losses,and that, in any case, market forces wiUrestore equilibrium. ButKeynes raised ah important issue: bearish speculators, in exhibitingliquidity preference, can initiate deflaUonary pressures. 6Unless we assume that wage and price changes occur infinitelyfast, then price deflation will be accompanied by quanUtyadjustments.7 In effect, the resulting speculative losses becomesocialized. To puta Keynesian proposition in Hayekian terms,the unintended consequences of a speculative search for liquiditygenerate falling income and general iUiquidity. Ifone adoptsthe posiUonmas do most Austrians--that-the marketprocess is acontinuing search for opportunities, one cannot dismiss out ofhand the possibility that speculation of the .Keynesian varietycould inhibit the equih'braUng market forces. And unless oneadopts the view that prices ate always correct, which no Austrianwould do, then one must confront this Keynesian informationproblem.Several points need to be made here. I have been talking of"Leijonhufvud's Keynes," because of the problematical namreof The General Theory. Yet my paraphrase of Leijonhufvud'sinterpretaUon is a fairly straightforward argument about discoordinatingmarket processes. The obvious question that comesto mind in th_iscontext is why Keynes didn't say all this explicitlyand simply ff this is what he meant? The thesis, as I have pre-

114 New Directions in ,,lustrian Economicssented ít, can obviously be put very succincfly. What makesLeijonhufvud's presentation of ir so difficult is the web ofconfusionwoven by Keynes.In order to show that his interpretation has captured theauthendc Keynes, Lei.jonhufvud not only must ¢ridcize ¢onflictínginterpretations, but he must deal with Keynes's own imprecisionand confusion. The dearest example of these problemsoccurs in Leijonhufvud's discussion of Keynes's views on capitalBefore examining this discussion, however, one must considerthe intellecmal background to the treatment of capital quesdonsin The General Theory.Hayek was quite cñtical of Keynes's earlíer book, the Treati_eon Money, when he reviewed that work. The general tenor of biscridcísm is that Keynes, at the ume he wrote that book, waslargely ignorant of capital theory. Hayek recognized that Keyneshad developed a neo-Wicksellian theory, but without the necessarytheoretícal foundations, s And he observed that:Ir is a pr/or/unlikely that an attempt to utilise the conclusionsdrawnfrom a certain theory without accepdng that theory itself should besu¢cessful. But, in the case of ah author of Mr. Keynes' inteUectualcalibre,the attempt produces results which are truly remarkable,tIn ah amazing piece of candor, Keynes all but admitted thelegitimacy of Hayek's cridsm; after defending himself by observingthat there was no "satisfactory theory" of capital in"completed forro," Keynes stated:Nevertheless, substantiallyI concede Dr. Hayek's point. I agree withhim that a alear accountof the factorsdetermining the naturalrateofinterestought tohave a placein a completed TreatiseonMomy, and thatít is lackingin reine: and I can only plead that I had much to say forwhichsuch a theory isnot requiredand thatmyown ideasaboutitwerestill too much in embryo to deserve publicafion. Later on, I wiUendeavorto make good this defidency? °Did Keynes ever"make good this ddiciency"? I do not believeso, and I offer the foUowing observadora in support of thisjudgment. Much of the confusion surrounding the namre of

Spontaneous Order and the Coordination of EconomicActivities 115Keynes's message can be accounted for if one accepts the thesisthat Keynes remained largely ignorant of capital theory. He haddifficulty, then, in presenting his message because he did notpossess the requisite technical knowledge. Of course, one couldalso infer that Keynes was not sure of the message that he wishedto present. There is evidence for this interpretation in the recentobservafion of one of his close associates at Cambñdge, JoanRobinson, who noted that certain of Keynes's putaUve followers"... had some trouble in getting Maynard to see what the pointof his revolution really was .... -11But I would offer asa finaljudgment of Keynes the observationof his recent interpreter, Axel Leijonhufvud. By far themost difficult chapter of the latter's book is the fourth, "TheGeneral Theory of Liquidity Preference," in which both the stateof capital theory in the thirdes and Keynes's own views on thesubject are presented. Of this complexity, Leijonhufvud remarks:"This chapter will be a lengthy affair, partly beca.use ofthe intrinsic difficulty of capital theory, partly because Keynesdid not work out his ideas on the subject in much detail so that weare left with only what amounts to an unfinished sketch. ''I_ Inshort, Keynes never made up the self-admitted deficiency of theTreatise. Moreover, it is only by having thus demonstratedKeynes's lack of knowledge and clarity that Leijonhufvud canmake it at aU plausible that Keynes hada comparatively simplepoint to make (i.e., stickiness of interest rates), though this pointis not the one commonly attributed to him (i.e., stickiness ofmoney wage rates).There are several approaches that one can take to Keynes'schallenge. Conceptual errors abound in The GeneralThe0ry; and Ihave suggested that in the area of capital theory, Keynes is quiteconfused. One can fairly easily engage in piecemeal criticism ofKeynes's ideas. I do not believe that the Keynesian system canstand up to such a criticism. But I am not sure that this is afruitful approach, though I myself have adopted it on previousoccasions, ls The reasons are several-fold. First, no one, I believe,can get beyond the exegetical problem--I refer the reader againto my ink-blot analogy. No matter which Keynes one criticizes, a

116 New Directions in Austrian Economicsnew Keynes is proffered in its stead. More to the point, one m stconsider the possibility that the most interesting recent interpretationbears scant resemblance to Keynes's ideas. Yeager hasargued, for instance, that Leijonhufvud and Clower both seemprepared to credit Keynes with their own, original contribu-Uons. 14Perhaps, then Keynes is the wrong target of any criticism.Nonetheless, the Keynesian debate does raise importanttheoretical issues that Austrians must confront, regardless ofwho is adjudged the author of particular views. And I believethat there is one unifying theme running through most, ifnot all,versions of Keynesian economics: the self-correcting forces ofthe market economy cannot be relied upon to maintain fullemploymentand reasonable price stability. In its .t most extremeversion, this criticism would even deny the existence of selfcorrectingmarket forces. Itis to the issue of the strength of thesemarket forces that Austrians should address themselves, for-it isnow becoming increasingly accepted that macroeconomics is infact concerned with the coordination of economic activities.Leijonhufvud has stated the problemas foUows:•.. The central issue in macroeconomic theory ís--_nce again--theextent to which the economy, or at least its market sectors, may properlybe regarded as a self-regulating system.... How wellor badly, doits "automaác" mechanisms perform?_=Before continuing,in detail.it would be well to consider this latter issueTHE PRINCIPLE OF SPONTANEOUS ORDERThe principle of spontaneous order--or of "undesigned order,"as it might more properly be called--can be viewed as thefirst prindple of economics. Indeed, James Buchanan has recentlygone so far as to suggest that it is the on/y principle ofeconomics. The prindple is, in any case, a comerstone of moderneconomics, whet.her we trace modern (Le., pog-mercanfilisO

Spontaneous Order and the Coordination of Economic Activities 117economics back to Adam Smith and the other Scottish moralphilosophers, or to the Physiocrats. With this principle, scholarsfor the first time could see economic phenomena as interdependentevents. Indeed, this principle made it possible to reasonsystematically and coherently about economic phenomena.Much of nineteenth century economics can be seen as consistingof developments of this principle (along with minority criticismsof the princíple and the systems of thought deduced therefrom).On the other hand, most of twentieth century economics hasconsisted of reactions against systems in which this principleplays a central role. In this, Keynesian economics is but oneamong a family of theories that deny the existence of a spontaneousor undesigned market order in which plans are coordinated.The reaction has been so complete that what was taken byearlier economists to be an empirical law_the existence of aspontaneous market order--is now frequently viewed as theproduct of ideological bias or prejudice. If anything, moderoeconomic discussiom presuppose the absence of the very orderwhose existence was the cornerstone of much of nineteenthcentury economics. In this sense, modern economics is fundamentallyinconsistent, lsIt is apparent now that the principle was not firmly enoughestablished in economics to withstand the criticisms that werelevied against it. Yet the question of the existence of a spontaneouslygenerated order remains the central question ofeconomics and of social theory generally--even though it isseldom recognized as sucia. Theories of the instability of investment,of saving, and of aggregate demand ate aUvariants of thegeneral proposition that the economy lacks strong forces leadingto an undesigned order. These are not simply disputes of technicaleconomics, narrowly defined, though they too long havebeen treated as such. The question of the necessary amount ofgovernmental stab'flizaon policy wiUnot ge decided by runningyet another money-demand equation through a computer.Nonetheless, it is imperative that the question be addresseddirectly once again? 7As inteUectual descendants of Carl Menger, most Austrian

118 New Directions in duarian Economicseconomists have defended the proposition that spontaneousmarket forces are capable of producing an overall order insociety. Hayek, for one, is well-known for his emphasis on therole of nonpurposive social organizations in this process. TM Indeed,the persistence of members of this school in their views inthe face of the contrary opinion of much of the profession hascontributed to their intellectual isolation. In this sense, and aloneamong the neoclassical schools, the Austrians can today lay claimto being the inheritors of the Smithian system. In this, thebicentenary of the publication of The Wealth ofNations, it wouldbe well for Austrian economists to seize the opportunity to reestablishthe importance of the principle of spontaneousorder_an order that, though designed by no one, emerges fromthe individual and independent planning of market transactors.THE NEW RICMRDIANS I_There is yet another tradition in the history of economics,distinct from both the Austrian and Smithian traditions, andfrom those that are overtly hosUle to these traditions. It is atradition epitomized by David Ricardo's general approach toeconomic questions. In the Ricardian tradition, attenUon is focusedon the long run, in which full adjustment to all disturbanceshas occurred. Peñods of transition are abstracted from. 2oIt would be anachronistic to credit Ricardo with a theory ofperfect information, but he wrote as though the laborers,capitalists, and rentiers of his system had full access to futureevents. The difference between the Smithian and Ricardiantraditions is a subtle, though important one; and it separatestheorists even today.In Smith's world, changes are constantly occurring, and adaptaUonsto these changes are never complete. These changes maybe of comparatively simple variety, such as variations in the comharvest from year to year (with attendant effects on real wagerates),s_ More importantly, Smith was concemed with the continuousprocess of market adaptation to LnvenUon and further

Spontaneous Order and the Coordination of Economic Activities 119extensions of the division of labor. Changes in institutions andthe legal structure are of prime concern. 22It is not, of course,that Smith had nothing to say about the long run. His valuetheory is a long-run theory, though I find it one of the leastdeveloped parts of Iris system. _3 Nonetheless, the emphasis inThe Wealth of Nations is on change. Moreover, Smith's actorssuffer various illusions and misunderstandings about futureevents, and, indeed, about their own seff-interest. None of thiswould make sense in a Rícardian world.Whether ir is a quesUon of monetary economics or of fiscalpolicy, Ricardo generally treats all disturbances as though theywere fully and completely anticipated. 24In the Ricardian world,then, the problem of coordination disappears. It is not thatRicardo denied the principle of spontaneous order. Rather hedid not treat the emergence of coordinated behavior on themarket asa problem. He in effect assumed that economic behaviorwill be coordinated. Most importantly, and unlike Smith,Ricardo generally ignored the question of what institutionalarrangements are necessary for the emergence of that orderupon which the soundness of his arguments depends.The imtitutional setting and the allocation mechanism matterin economics precisely because behavior in a changing world isnot automatically coordinated. Laws and imtitutions have a significantimpact on human behavior precSsely because somefacilitate and some inhibit the flow of info_l_lation that is necessaryfor adaptation in a changing world. This realization isceRdmly contained in The Wealth of Nat/ons--Smith's emphasison the importance of these matters suffuses that work. Not sowith Ricardo's Pr/n__.th'ofessor Lachmann has recently reminded us that the problemof eommm__ coordination is intimately involved with thetwin problems of acquisition and diffusion of knowledge amongtransactors. In dealing with the characterisdc assumption thatthe state of Lnowledge is among the data of the system, hequeries:Do weassume thatall marketactorsknowall thetastesandresourcesin

120 New Directions in dustrian Economicsall markets in which they, actuallyor potentially, do or might operate?But if so, equilibrium should at once be attained in ah markets. If wewere to make this assumption, there could be no disequilibñum, nodealings at "false prices." Walras's "auctioneer" would become superfluous.If, on the other hand, we do not make it, how do we delimit the•extent of each actor's knowledge ateach point of time, and how do wedeal with the flow of knowledge between actor s over ume?" _sDiscussion about the importance of information may seemprosaic to economists at this point. But the radical implicaons ofimperfect knowledge have simply not been generany absorbedin economic theory. For, inter a//a, imperfecon of knowledgemeam that prices do not necessarily coordinate economic behavior,as those prices are influenced by the inconsistent expectaonson the basis of"false" price signals. Tojustify one's faithin the coordinating function of markets, one cannot simplyassume that prices are coordinang, or at their equiñbrium level.Rather, one must be concerned with the imfimtional environmentof economic systems and with the appropriateness of theseinstimfions for the emergence of a spontaneous market order.One must be concemed, then, with specifying the simations inwhich prices will coordinate, and those situaons in which pñceswin not coordinate, economic acvity. By his attention to thelong run, in which, ex hyp0ther/, all such problems disappearbecause full adjustment to ah changes has occurred, Ricardo(and his followers) ignored these difficules.The problem of economic coordinaon is a theoretical andpractical issue not merely because decision-making is decentralized,though this is an important aspect of the problem. Ofeven more importance is the fact that we live in a world ofconstant change. Were there decentralized decision-making, butan unchanging environment, it might be reasonable to supposethat economic acávity could be coordinated under a wide varietyof insu'tuUonal and allocational arrangements. Learning wouldoccur due to the repetítion of events, with adjustments made aspast errors were revealed, s' A price system and appropriatemarket insfitutiom are of praccal signi_ficance precisely becauseof the need to register the effects of continuous changes in the

Spontaneous Order and the Coordination of Economic Activities 121data, changes which ate given to no one in their entirety. On theother hand, it is doubtful whether money, prices, or the marketsystem would exist in the stationary state. Those who ignore thisaspect of imperfect information are caught in the dilemma ofdealing with phenomena, most of which would not exkst in theworld as the), assume that world to exist--a world of perfectlycoordinated plato. 2TRicardo and bis epigones thus obscured the basic quesfions ofsocial order that Smith had raised. They shifted the emphasisaway from these questiom to the theorems and lemmas of valuetheory. Their legacy is still with us today. Walras and theLau_nne _hool introduced the concept of general equilibriuminto economics. But in other respects the Walrasian system isquite similar to the Ricardian: both are perfectly coordinatedsystems. By the sheer logic of these systems, neither is obviouslyconcerned with the coordination of economic activitie: =thiscoordination is implicifly assumed to take place. In such systemslaws and institutions do not matter. Monetary dismrbances canhave no significant effects--for the tramition periods in whichmoney dearly matters are de-emphasized or ignored in theRicardian system, n In such systems, the market would not beviewed asa process in which continual adjustment to continualchange occurs, but a state of affairs in whie.hthis process was atan end.The Ghicago School can be fairly described as the modernRicardians. In Kirzner's terminology, th_ transactors in theChicago world are nothing but Robbinsian maximizers. 2sChicago economists are Ricardian in their approach to questionsof tax and expenditure policy and monetary policy, to cite twoexamples previously mentioned for Ricardo. The Ricardianbent of the Chicago School is important to the Austrian Schoolfor at least two reasons.Fi1_t, the time has passed when members of the ChicagoSchool .werearticulate, but minority members of the profession.Increasingb/, economic discussions and debates are influencedby their approach. Second, on issues involving coordinaUonquestiom, their Ricardian leanings re-enforce the Walrasian ap-

122 New Directionsin AustrianEconomicsproach of the dominant mathematical, general equilibriumtheorists. This is an important point because economists arebeginning to recognize the distinctiveness of the Marshallianapproach (v/s¿ v/s the Walrasianapproach) of Chicago Schooleconomists. And the differences between Chicago Schooleconomists and the rest of the profession are important for awide variety of issues, such as the role of empiñcal research,partial vs. general equilibrium analysis,etc. But as regards thecoordination of economic activities, the new Ricardiansand theneo-Walrasiam are more of one mind. They tend to take forgranted that markets coordinate economic activities. By doingso, they ignore the complex questions of economic coordination,upon the solution of which depends the degree of economiccoordination. This approach is objectionable because of the conclusionsit engenders when markets demonstrably are not coordina6ngeconomic activity. The "market failure" mentality is aneffea of this approach? ° "The market system"is adjudged afailure in such cases, with scant recognition that "the market" is ametaphor fora complex of interrelatiomhips and institutiom,any one of which may be the source of the problem. Thatmembers of the Chicago School are generally more sanguineabout the efficacy of this system hardly mitigates themethodological point being made here.Austrian economists and other adherents to the prindple ofspontaneous order willreceive little support and should generallyexpect overt hostility from the Chicago School on a widerange ofeconomic questions. 81Austrian economists tend to viewmost economic questions as issues involving the pñnciple ofspontaneous order. Accordingly, they take characteristic positiomon these quesons. Two of the areas where disagreementbetween the two schools is particularly intense are monetary andcapital theory. Quite apart from their differences over the determinationof the equ/br/um values of interest rates, the twoschools are sharply divided over the approach to questions ofcapital and interest theory, as weUas those of monetary theory.Being Ricardians, members of the Chicago School naturallykeep questions of monetary theory and capital theory quite

SpontaneousOrderand the Coordinationof EconomicActivities 123disdnct, since these are distinct problems in long-run equilibriumanalysis. As did Ricardo, they treat deviations from theequilibrium rate of interest as temporary fluctuaons. Thetransitional periods in which monetary disturbances influencethe accumulation of capital and the level of rate of interest aretypicaUyignored or at least de-emphasized.On the other hand, many of the twenUeth century membersofthe Austrian School have dealt with the interface betweenmonetary and capital theory. Misesand Hayek weremost persistentin their analysis of the interrelation between monetary andcapital quesons, precisely because of their interest in adjustmentproblems. Hayek, for instance, has been consistent in treatingeconomic fluctuations as manífestaons of economic discoordinaon,brought on by monetary disturbances? 2 ForHayek, monetary disturbances change entrepreneuñal expectaonsand lead to capital accumulation that, expost, is revealedtohave been malinvestment. These malinvestments cause realscarcities,whose existence becomes manifest in subsequent pricechanges. The price changes compel entrepreneurs--because ofthe capital losses that they eventually incur--to revise their investmentplans. It is in this sense that modern Austrians viewcydical expansions brought about by monetary and credit inflaonas self-reversing and inherendy unstable.3"_Hayek and Misesthus dealt with phenomena virtuallyignoredby monetary theorists of the Chicago School--the transitionpeñod between a monetary disturbance and complete adjustmentto its effects,s4To the extent that ProfessorFriedman, forimtance, deals with the transition peñod, it is only in terms ofone, comparatively narrow problem---anticipation of futureprice levels,ss Asa praccal matter, monetarists generally viewinflaUon as synchronized inflation, with all pñces rising par/pa.m_.For Hayek and Mises, synchronized inflation is a fantasy,so long as monetary disturbances impinge at specific points,ssAnd fuUadjustment to inflation would be all but inconceivable,as it would involve each actor's antidpating correctlythe precisechanges in each relative pñce that wiUoccur in each futureperiod, due to the assumed monetary dismrbances.37

124 New Directions in Austrian EconomicsOnce again, the Ricardian approach to monetary questionsblinds its users to the issues considered paramount by the Austrians.In so doing, this approach,inhibits ah understandíng ofimportant issues confronting market economists. For the Ricardian,quantity theory approach is one in which prices contínuetheir coordinating function even in ah inflation. Yet, the point atissue is whether spontaneous market forces operate as usual inan inflation. If monetary disturbances not only generate pureprice inflation, but also interfere with the coordinatingmechanisms in ah economy, then the quantity theory approachignores an important research programme in economic_ thestudy of the monetary framework necessary for pñces to fulfiUtheir coordinating function? s In the words of one expositor ofHayek's ideas:[Hayek] regarded pñces.., as empirical reflectors of spedfic circumstancesand price changes as ah inter-rdated señes of changes inthese "signals," which produced a gradual adaptaon in the entireprice structure (and hence in the outputs of different commodiUesandservices) to the constant, unpredictable changes in the real world.Pricing, in short, is seen asa continuous information-collecting anddisseminaUng process, but it is the insUmtional framework that determinesboth the extem to which and the degree of success with which,f rices are enabled to perform this potential signalling or allocativencUon.89PLANNING4oThat nonpurposive social organizations will namrally evolveand that an undesigned order can be the product of selfregardingacts are radical ideas in Western thought. These ideasrun counter to the dominant approach to social questions andwere in ascendency for only a brief peñod in Western intellec- [mal history. It is not, then, enUrely surprising that in economics !these ideas have not gained complete acceptance; and thatamong the general public, even the so-called educated public,they are scarcely understood at aH. But there is danger that !because of essenfially reactionary developments in social

Spontaneous Order and the Coordination of Economic Activities 125thought, the insights that were the product of the Enlightenmentwill be all but lost in practice. Adam Smith has apflycharacterized the lar older conception of social order:The man of system.... seems to imagine that he can arrange thedifferent members of a great society with as much easeas the handarranges the different pieces upona chess-board;he does not considerthat the pieces upon the chess-board have no other principle of motionbesidesthat which the hand impresses upon them; but that, in the greatchess-board of human society, every single piece has a pñnciple ofmotion of its own, altogether different from that which the legislaturemight choose to impress upon it. If those two principles coincide andact in the same direction, the game of human society will go on easilyand harmoniously, and isverylikelyto be happy and successful. Ir theyareopposite or different, the game willgo on miserably,and the societymust be at al1ames in the highest degree of disorder.41The liberal conception of society of Adam Smith and theclassical economists stands in sharp contrast with this older view.Yet once again in the United States, we see evidence of this olderconception's becoming prominent, under the guise of nationaleconomic planning. Proposals for planning ate embodiments ofthe chess-game conception of social affairs, adapted to the problemof economic allocation. These pro posals implicitly orexplicifly deny that market forces guide decision making, so as toproduce an overall, yet undesigned order; and they virtually_gnore the function and tole of nonpurposive economic organizaUons.It is not that the arguments for national (i.e., central) economicplanning constitute a direct intdlectual challenge to opponents ofsuch planning. As Professor Hayek has recently demonstrated ina devastating rebuttal of these proposals, modern exponents of"planning" possess as naive and ill-thought-out an approach tothe problem as did the Bolsheviks and European socialists in theimmediate post-World War I period. As he notes:The concepon [coUectivisteconomic planning], oñginally developedby some of the orgarAzersof the C,erman wareconomy duñng World-- • " " ' dWar I, was thoroughly discussed by economlsts in the 19,20s an

126 New Directions in Austrian Economics1930's; and aH those familiar with that discussion will agree that itgreaflycontributedto the darificationof concepts and thatone oughttodayto be entifled to assume that no competenteconomist who livedthrough thatdiscussionwouldever againtalkabouttheissues in temasof the vague and confused concepts initiallybandied about.4sIndeed, if this debate were being carried out in the scholarlyarena, I doubt that the proposals put forth by those in favor ofcentral planning would survive Hayek's recent criticisms. Unfortunately,the debate is not being carried forth in learned journals,or, generally, by learned men; rather, the proposals atebeing developed in the pages of the Neto York Times, and arebeing presented by politicians, businessmen, and labor unionleaders. This is an instance in which those who accept the Smithianinsights have won the intellectual battle, but are in danger ofseeing their arguments lose out in practice. This situation surelyrepresents a dilemma for economists. Economists generaUy disodain polemics, but they now face a situation in_which influencingimportant political questions depends on their ability to presenteconomic ideas in a polemical fashion. Certainly thoseeconomists who have chosen, for whatever reasons, 43 to allythemselves with the misleading arguments of the "planners"have not eschewed polemics. 44Hayek has done an admirable job of marshalling the chiefarguments against central planning in his recent arUcle. I do notintend to repeat these arguments here. But it is worth remindingourselves of the central confusion of the early advocates ofcentral planníng, as ir is the central confusion of the currentadvocates. The confusion concems the very concept of"planning."If nothing else developed from the earlier debates overthe question, it was the realization that a market economy ischaracterized by cor_nua/planning and plan-revision, albeit on adecentralized level. 4_As Hayek put it over thirty years ago, andrecenfly repeated:The dispute between the modern plan_nersand their oppon..ents,is,therefore, nota dispute on whether we ought m cl-moseinteUi_,enflybetween the various possibleorganizations ofsociety; ir is nota dispute

Spontaneous Order and the Coordination of Economic Activities 127on whether we ought to employ foresight and systematic thinldng inplanning our common affairs. It is a dispute about what is the best wayof sodoing. The question is whether for this purpose it isbetter that theholder of coercive power should confine himseffin general to creatingconditionsunder whichthe knowledgeand initiativeofindividuals aregiventhe bestscopesothattheycan planmost successfully;or whetherarationalutilizationof our resources requirescentra/direction and organizationof all our activities according to some consciously constructed"bluepñnt."The socialistsof aHpartieshave appropriatedtheterm"planning"for planning of the lattertype, anditis now generallyacceptedinthissense. But though thisis meantto suggestthatthisis theonly raonal wayof handling our affairs, it does not, of course, provethis. It remains the point on which the plannersand the liberalsdisagree.4eThe challenge of"planning" confronts liberal economists withboth the necessity and the opportunity of once again enteringthe popular debate over the trend of society that we will shapefor the fumre. For it must be remembered that in constructingeconomics upon the principle of spontaneous order, earliereconomists were ultimately interested in the problem of socialand political organization. In part, then, I am proposing a returnto an earlier concepUon of our task as engaging in policaleconomy, though we now recognize a specifically scientific partof this field, v/z., economics. If economist_ do not conceive oftheir task thusly, it is doubtful whether there will be any practicalopportunity in the fumre for the sc/ent/fu: pursuit of the implicationsof the prindple of spontaneous order.In order to pursue this goal, however, Austrian economists inparticular must setfle among themselves certain theoretical andseemingly purely scientific issues. I have argued above thatamong the neoclassical economists, the Austrians have mostconsistently adhered to Adam Smith's conception of theeconomic problem. Ironica!!y, recent debates indicate anything.butagreement among living members of this school. The positionsof some could be construed as an implicit attack on the ideathat there is a spontaneous market order in the economy. It isthus that I ana led hato a final section, involving a discussion ofthe Austrian approach to the queson of the operation of spon-

128 New Directions in Austrian Econoraicstaneously generated forces in a market economy.THE AUSTRI/IN SCHOOL /IND SPONTANEOUSORDERING FORCESIn a recent paper, Professor Kirzner speculates about theexact status of the proposion that profitable opportunities havea tendency to be exploited? 7He condudes that the propensity todiscover opportunities is "inseparable from our insight thathuman beings act purposefully. "'s In fact, he even suggests asympathetic reinterpretaon of the perfect knowledge assumptionof neodassical price theory. Though orthodox use of theassumpon is "carefree, ''49 it does reflect a ieal insight: our"instinct" is seen as assuring us that profitable opportunities wiUbe discovered. He then condudes that: "The perfect knowledgeassumption of neo-dassical economics carried this instinctiveassurance to altogether unjustified lengths. In rejecting thisdangerous assumption, we must take care not to expunge theentirely heahhy instinct on which it rested. "soKirzner's approach to the issue of profit exploitation in amarket economy differs markedly from Lachmann's. Nonetheless,this proposition is not easily demonstrated, for two, interrelatedreasons. First, Lachmann to my knowledge nowhereexp//c/t/y asserts the contrary proposition, v/z., that we have nogrounds for believing that market participants will discover andexploit profitable oppormnifies. Second, though the figure ofProfessor Lachmann lurks in the background throughout thesecond hall of Kirzner's paper, the latter never brings thís figureinto the foreground.The best way of eluddating this issue is to turn to Lachmann'sown recent paper. Toward the end of Iris paper, Lachmannnotes that:... Skepticismaboutequilibriumneed not deter us from appraising therelative strengt.hand weaknem of the equilibrating fortes in variomsituatiom. In fach it mug encourage us todo m. To makeconfident me

Spontaneous Order and the Coordination of Economic Activities 129of the notion of equilibrium means to imply that the equilibratingforces willalwaysbe ofsufficient strength to triumph over all obstacles.A skepticmight readily admit that such situations may exist, but he wiUprobably doubt whether they occur with sufficient frequency to warrantor treating them as the norm. The more skepficalwe are aboutgeneral equilibrium as the central notion of economic analysis, themore incumbent on us ir becomes to examine each situation individuallywith respect to the balance of strength of equilibrating and disequilibratingforces? 1Ir must be noted here that Kirzner's position is not that weshould admire neoclassácal price theory for its treatment ofgeneral equilibrium as "the central notion of economic analysis"of as"the norm." Rather, he suggests that we accept the propositionthat equilibrating tendencies are strong. Ifthe propensity todiscover opportunities is "inseparable from our insight thathuman beings act purposefully," then we must likewise acknowledgea tendency toward equilibrium in all markets.Afort/o_, thereexist strong tendencies toward ah overall or general equilibriumat each moment. Individuals are, then, constantly revising theirplans in a way that brings them into greater uniformity. This"latter proposion, when thus phrased in dynamic terms, doesembody the principle of an undesigned order. It remains questionable,however, whether Lachmann wishes to embrace thisprinciple. Thus he argues that:Experience shows that in the real world of disequilibriumdifferentpersonswilltypically hold different expectaons about the same futureevent. Ir so, at best one person's expectanon can be confirmed and aHotherexpectations willbe disappo_ted. Hence the "assumpon that allother expectations are confirmed cannot possiblyhold. Nobody cantake hisequilibriumbearingsir he does not l_aowhow others willact. Insuda a simation, which we llave every reason to regard as normal, hisequilibrium, as Hayek admits, cannot serve asa source of a "feedbackmechanism."TAe&ac.ont)_ had beendesignedto keepentrepreneurs from_,_ be_ d;.,,n.s--_rm makes much of "the autonomyof the humanmind" (as must all Austrians):

130 New Directions in Austrian EconomicsThis source of... new knowledge may wellbe past experience, but thelatter requires interpretation by a discerning mind, and optimists wiUinterpret it differently from pessimists. The human mind is a filter ofexperience, but each individuars filter is different from every otherfflter. Divergent expectations are thus as "natural," a feature of theso,:i_!landscape as are divergent tastes. Changes in the consteUationofknowledge are an inevitable concomitant of the passing of time, andchanges in the constellation of expectations are bound to followthem.s8There is no denying the autonomy of the human mind, butone is reluctant to follow Lachmann in his apparent conclusionthat we can say nothing about the likelihood that individuals willmake consistent and coordinated decisions in the face of newknowledge. Ir anything, he seems to be saying that they wiUnotcoordinate plans. Yet, one always supposed it was an Hayekianinsight that prices facilitate the diffusion ofinformation and thecoordination of plans, s_We are faced here with an important question: Do differentand disparate Lndividuals have a common reacfion to sharedexperience? We certainly would not want to say they always do,or there would be little sense in referring to "individuals." Yet,there are obvious cases in which people do react to sharedexpeñences in the same or similar ways: the perception of a tirein an endosed room win lead to virtually everyone's making foran exit. Each person could forma reasonable expectaon aboutwhat the others wiU do.Moreover, many events are implidt demonstraUons of thedegree to which expectaons do coindde. Changes in clothingfashion might be cited as an example. The "agreement" amongseparate manufacturers of apparel can be amazing, thoughdearly retail customers do not register their preferences for newfashion in a dothing futures market. Apparenfly individual entrepreneurs,experiencing the same signah and trends, willoften form similar expectations.Norte of these considerations is decisive, of course, but theyare suggeuive. Lachmann has dearly done a great service inpointing out forcefuUy the absurdity of an appmach in which

SpontaneousOrderand theCoordinationof EconomicActivities 131expectations alwaysprove consistent. Ir is an essential feature ofmarkets that not everyone reacts equally quickly to the continualchanges in the data? s But it is true of at least some changes thatthey occur only because actors share a unanimous opinion aboutthe future course of events.Having eschewed the approach of assuming consistencyamong expectations at all Umes, one is not j ustified, withoutfurther argument, in arguing that economists can make no assumptionsabout a tendency toward suelauniformity, where thistendency is based on a universally recognized "propensity todiscover opportunities." To do so would involve a non sequitur.Again, to assume that all opportunities are at any moment fullyexploited (and thus do not really existas opportunities) wouldbe, to paraphrase Kirzner, a "carefree" use of concepts. But wemust surely accept the existence of the propensity, or forsake theprincipleof spontaneous order. This point can be elaborated byrecounting an event that happened at a December, 1975, conferenceon Austrian economics.ProfessorLerner argued that without the concept of generalequilibrium,defenders of the marketsystemllave no basisfromwhichto carryon their defense. His criticismwas in responsemLachmann'sapproach to the queson of general equilibñum. Iconfess that I rose to the latter's defense at_e time, bypointingout that we need only assume that there is market-day equilibrium.If pricesclear existing supplies, then markets can operatesuccessfully.'q'hat is all we need." I ananow not sure that i didnot err. Lerner may have been raising ah important issue forAustñans.We must distinguish two functions of markets.The firstconsistssimply in a method of allocating existing su.ppliespeacefully.Wkhoutpricesand free markets, societyreqmresgunsanddictatorship. Examples of the latter type of socialaUocationofresour¢esase numerous. But Iam not sure that defenders of themarket system can be satisfied with demonstrating that freeUade is ma aiterna_ve to the "warof all against all," howeverimportant this imight may be. For ir supplies, of goods areautonomous, if not gramitous, it is dubious in w at sense_tcan

132 New Directions in Austrian Economicsbe said that prices coordinate activity. Indeed, I suspect thatthere is no coordination in the conventional sense in Lachmann'ssystem. For hito apparently, ex ante plans bear no relation to expost reality. There is not even reason to believe that actors willmore in the right direction in correcting past errors.Lachmann does feel that the market "cannot make bulls andbears change their expectations, but it neverthele_ can coordinatethese." He continues:To coordinate bullish and bearish expectations is, as Keynes _owed,the economic function of the Stock Exchange and of asset markets ingeneral. This is achieved because in such markets the price will moreuntil the wholemarket isdivided intoequal halvesof bulBand bears. Inthis way dívergent expectations are cast hato a coherent pattern andameasure of coordination is accomplished,se"Coordination" is being used here in a híghly ambiguoussense. As Lachmann notes subsequently, he is talking not about_x ante consistency, but about a Marsh_lian ex post, market-dayequilibrium, s_This usage ofcoordination is in sharp contrast tothe more conventional one, and the usage that Austrians havetraditionaUy employed, ss "Coordination of plans" in traditionalusage means there is ex ante consistency among transactors'plans. It is certainly scant comfort for one interested in thisproblem to be informed that there w:dlbe "coordinaUon" expoa.Though related, ex ante and expost "coordination" are conceptuallydistinct issues. To conflate the two issues is scarcely to contributeto the solution of either problem, ssIt is certainly not the case that Austrian economista maintainthat there ever exista ex ante consistency among all tro_nmctors'plans. But they have traditionally maintained, as Lachmannhimself notes, that there is a strong tendency toward dLffusion ofknowledge and increased consistency of plans. In other words,Austrian economists have always víewed the problem ofeconomic coordination in dynamic terms. Do plana becomemore consistent over time? Lachmarm apparently sloughs overthe distinctionbetween two verydifferentpropositions:1. Economicaaivities ale coordinated in the sense that all

SpontaneousOrderand theCoordinationof EconomicActivities 133plato are successfully executed ("general equilibrium").2. Economic activities are coordinated in the sense that amechanism exists (i.e., the price system) that facilitatesrational plan revision and leads to greater consistency ofplato over time.Lachmann switches back and forth between discussions of"the relative strength and weakness of the equilibrating forces,"and "general equilibrium as the central notion of economicanalysis" asthough he were talldng about the same problem (seep. 129). Surely, the statement that "the market produces strongequilibrating forces" is fundamentally different than the assertionthat "the market is always in (general) equilibrium." DoesProfessor Lachmann acknowledge the difference? Ir is certainlynot clear that bis arguments agaimt the first class of statementsaretelling against the second. It istrue that elsewhere Lachmannapparenfly acknowledges the existente of a tendency towardequilibrium in some arcas: "A tendency toward the integrationof the [capital] structure does exist.''e°But even there, he seeminglytakes back what he has just granted.6_ I ana afraid hisoccasional concessions to the existence of a tendency to greaterconsistency of plans in markets only confuses matters.What I fmd most disturbing about Lachmann's position is thathe criticizes a stat/c general eq-ilibñum model, but concludesthat the modern Austrian approach to coordinaUon,in a dynara/csense,is thereby called into question. I aro not at aUalearwhat hethinks "the general equilibrium perspective" is. The reader istold that Hayek's"early work was dearly under the influence ofthe general equilibrium model."s2 Elsewhere the reader is remindedthat as early as 1933 (in "Price Expectations, MonetaryDismrbances and Malinvestments") Hayek dealt with expectations.It was in 1936 ("Economics and Knowledge") that Hayeklaunched his attack on the static, general equilibrium models ofmathematical economics. From this, one must condude thatLachmann is critical even of theories espousing a tendency towardoveraUequilibrium (i.e., he denies the pñnciple of spontaneousorder). I can draw no other condusion.It alto _,ems that what Kirzner treats as the "equilibrating

134 New Directionsin AustrianEconomicsmarket process," Lachmann treats asa "disequilibrating" process.At first, I thought there was a mere semantic confusion. Inow believe the apparent semantic confusion ís masking realconceptual differences. Kirznerseesany disturbance as developingequilibraung market forces. Lachmann sees change as disequilibrating,e3 The only reason that I can adduce is thatLachmann does not see market forces as being equilibrating innature. If this is his position for markets asa whole, then he isgeneralizing the position taken by Keynesabout securities marketsto markets asa whole, v/z., that we cannot relyon spontaneousmarket forces to bring us to an equilibrium position after adisturbance. And ir this be the case, then Lachmann's viewsrepresenta radicalchaHengenot only to his fellowAustrians, butto all those who accept the existence of an undesígned marketorder. Forít certainly seems that the only effective answer to thechallenges with which I have been concerned lies in Kirzner'scharacterization of the entrepreneurial role.Asa final note, ifI have misreadLachmann, I hope this sectionwillat least serveto dañfy issues and develop implications of theprinciple ofspontaneous order. Ir the paper succeeded in nothingelse, it would have served its purpose.CONCLUSIONSI would like to remind the reader that my original task was todemonstrate that seemingly diverse and particular problems arereallyinstances of a more general theoretical disagreement. Forit is only by directly addressing this general theoreticaldisagreement--disagreement that I have identified as devolvingaround the existence of an undesigned market order--that afruitful search toward solutions of these individual problems canbe begun. It is in the nature of ah endeavor to demonstrate theinterconnecfions between such seemingly disparate (but reallyconnected) issues that no one of them is ad_uately treated. Irthe reader feels that each section calls for a separate paper on itstopic, the author can only agree and express the hope that more

Spontaneous Order and the Coordination of Economic Activities 135papers on these subjects will be forthcoming, albeit papers informedby the realization of the overall problem being studied.NOTES1. Adam Smith, The Wealth ofNations, ed. by Edwin Cannan (NewYork: The Modern Library, 1937), p. 651.It is frequenfly forgotten that Smith's defense of a relatively unhamperedmarket is partly based on considerations ofjustice. See Smith,.pp. 141,308 and 497. The ethical basis of Smith's system is emphasizedm a paper byJoseph Cropsey,"The Invisible Hand: Moral and PoliticalConsideration," delivered as part of the Harry Girvetz Memorial LectureSeries at the University of Califomia, Santa Barbara. Also seeJames M. Buchanan, "The Jusrice of Natural Liberty," TheJournal ofLegal Studies, V (January, 1976): 1-16.2. My colleague, Roy Adams, first suggested this very apt analogyto me. Also: "... You can find in Keynes, as in Marx, almost an'ything..." F. A. Hayek, "No Escape: Unemployment Must Follow Inflation,"inFullEmpltryment atAnyPrice? (London: Institute of Economic Affairs,1975), p. 43.3. New York: Oxford University Press, 1968; hereafter, Keynes/anEcorunnics. Leijonhufvud's "Keynes and the Classics" (London: Instituteof Economic Affairs, 1969) is also of importance here.4. Leijonhufvud has argued that, contrary to contemporary pracrice,Keynes aggregated assets according to their term to maturity, andnot according to whether they are real or financial. Cf. Leijonhufvud,Keynesian Economics, pp. 130-57.5. SirJohn Hicks has demonstrated the remarkable stability of theretum on British consols in the nineteenth century. If the yield ofconsols can be taken as proxy for the long-rate, then his findings giresome empirical basis to Keynes's hypothesis. See John R. Hicks, "TheYield on Consols," in Critical Essays on Monetary Theory (Oxford: TheClarendon Press, 1967), pp. 83-102.6. It would be well to recall why speculators seek liquidity in thishypothetical situaUon; or, more precisely, why they attempt to shifttheir holdings from lonlz-lived to short-lived assets. If long-rates arefalling, but are expected'_o rise once again, then wealth-holders have adouble incentive to sell long assets and purchase short assets. By sellingat the long end of the yield spectrum, the), can capture capital gains. By"going short" in the interim, they can purchase these assets ba_ atlower prices and higher yields, once interest rates have risen agam.

136 New Directions in Austrian EconomicsAll this assumes, of course, that in the aggregate, transactors seek toavoid capital uncertaínty. On this point, cf. Leijonhufvud, KeynesianEconomics, pp. 45-46; 282-314.7. Cf. ibid., pp. 49-109.8. See F. A. ron Hayek, "Reflections on the Pure Theory of Moneyof Mr. J. M. Keynes, Part I," Economica, XI (August,9. Ibid.1931): 279.10. J. M. Keynes, "The Pure Theory of Money. A Reply to Dr.Hayek," Economica, XI (November, 1931): 394-95. Of course, thequestion of whether the issues with which Keynes dealt could be treatedwithout reference to capital theory was one of the chief points ofdispute.11. Joan Robinson, "What has become of the Keynesian Revolu-Uon?" in Milo Keynes (ed.),Essays onJohn Maynard Keynes (Cambñdge:Cambñdge University Press, 1975), p. 125; quoted in F. A. Hayek, "NoEscape: Unemployment Must Follow Inflation," p. 43.12. Leijonhufvud, Keynesian Econom/cs, p. 43.13. Cf. "Hayek and Keynes: A RetrospecUve Assessment," IowaState University DepartmentIowa: Photocopy, 1975).of Economics Staff Paper No. 20 (Ames,14. See Leland Yeager, "The Keynesian Diversion," WesternEconomicJournal, XI (June, 1973): 150-63.It should be noted that what Clower and Leijonhufvud have done isto present an interpretation of Keynes that rationalizes his doubtsconcerning the strength of the spontaneous forces operating to maintainor restore full employment. This in no way indicates that these twoauthors share these doubts. Nonetheless, it is frequenfly assumed,without any tima basis, that because Leijonhufvud and Clower haveattempted to explicate Keynes's views, they agree with them in theirentiretyl15. Axel Leijonhufvud, "Effective Demand Failures," SwedishJournalofEconomics, 75 (1973): 28. Leijonhufvud continues, noting that thisissue"lies at the heart of two of the most prominent controversies in thefield over the last decade: the Fiscalist vs. Monetarist controversy...and the controversy over the long-run stability of the Phlips-curve.The volume of writings on each of these continues to mount steadilywith no dear-cut resolution in sight--ín large measure becaqse thiscentral issue is not being effecávely addressed."16. Discussions about the energy problem area prime example ofthis. They almost never even consider what spontaneous market forcesht exist tb_t would lead to the discovery of a new, coordinateduon to the aUocation of energy resources. One very probablesolution--perhaps the most probable if market forces were permitted

Spontaneous Order and the Coordinatior_ of Economic Activities 137to operate unfettered--would involve the destruction of the internationaloil cartel, whose existence makes a reallocation of energy resourcesappear necessary. And it is not merely noneconomists who areguilty of ignoring these market forces.On a more sophisticated level, modern welfare economics is virtuallypredicated on the absence of a spontaneous order in society, thoughpart of the problem here is the static quality of welfare analysis.On the general, 20th century reaction against the principle of spontaneousorder, cf. Leijonhufvud, "Effective Demand Failures," 31-82.Though the principle of spontaneous order continues asa cornerstoneof economics---particularly of microeconomics--this only shows theinconsistency of current micro and macro economics---a pointLeijonhufvud develops at length. Ibid., 28-33.17. The reader is referred to footnote 15 and the relevant portion ofthe text footnoted therein.18. As but one example, see F. A. Hayek, The Counter-Revolution of$dence (New York: The Free Press of Glencoe, 1955), pp. 25-35.19. I adopt here James Buchanan's terminology to describe theChicago SchooL Professor Lachmann has proposed the terna "Neo-Ricardian" to refer to the distinct foibles of yet another school oftheorists, the Cambfidge (U.K.) School.20. As one example of this Ricardian tendency, see the discussion ofthe general glut controversy in Thomas Sowell, Classical EconomicsReconsid_ed (Princeton: Princeton University Press, 1974), pp. 46ff.21. See Smith, pp. 35-36.22. On this point, cf. James M. Buchanan, "Public Goods andNatural Liberty" (Blacksburg, Virginia: Photocopy, 1976), especially3--I0.23. Thus, theorists disagree over whether Smith held a labor costtheory of value, an entrepreneurial cost theory, or merely a labormeasure theory. Smith may also have been unwittingly articulating afactor-exhaustion theorem for the long run. Nor could he seeminglydistinguish between quasi-historical observations about the role oflabor in production and theoretical statements of labor's contribution.This latter difficulty reflects Smith's "speculative" or "theoreticar' approachto history. On this, cf. A. Skinner, "Economics and History--The Scottish Enlightenment," $cottishJournal ofPolitical E¢onomy(February,1965): 1-22.24. Ah example of Ricardo s approach is his tr_atment of the effectsof ah increase in the money supply. On this, see Gerald P. O'Driscoll,Jr., Economics as a Coordination Problem: The Contributions of Friedrich A.Hayek (Kansas City: Sheed Andrews and McMeel, Inc., 1977), pp.37--43.

138 New Directions in Austrian EconomicsRicardo is also famous for bis so-called "Equivalence Theorem" fortaxation and public debt. But though this ma), be the most famous caseof the Ricardian vice, it is the one case where Ricardo was not a Ricardian!See The Works and Correspondenceof David Ricardo, Vol. I: On thePrinciples of Political Economy and Taxation, ed. by Piero Sraffa (Cambñdge:Carnbridge University Press, 1951), pp. 247-48; Ibid., Vol. VI:Pamphlet_ and Papers, 1815-1823, pp. 185--87; Sowell, pp. 67-68; andGerald P. O'Driscoll, Jr., The Ricardian Nonequivalence Theorem,JournalofPolitical Economy, 85 (February, 1977): 207-10.25. Ludwig M. Lachmann, "From Mises to Shaclde: An Essay onAustrian Economics and the Kaleidic Society," Journal of EconomicLiterature, XIV (March, 1976): 55. Cf. Hayek, The Counter-Revolution ofScience, pp. 29-30.26. Cf. Hayek, "The Meaning ofCompetition," inlnd/v/dua//sm andEconomic Order (Chicago:97-98.University of Chicago Press, 1948), pp.27. Ah example of this dilemma is the role of money in a generalequilibrium model. On this, see Hayek, The Pure Theory of Capital(Chicago: University of Chicago Press, 1941), p. 31. Also see Ludwigron Mises, Human Action, 3rd ed. (Chicago: Henry Regnery Co., 1966),pp. 416-19.28. Cf. Sowell, pp. 58-59.29. Cf. Israel M. Kirzner, Competition andEntrepreneurship (Chicago:University of Chicago Press, 1973), pp. 32-37.30. Ignoring the factors that govern the emergence of a spontaneousorder is in some sense more objectionable (from the viewpoint ofone who accepts the prindple) than denying its relevante. Fallure to discussthe conditions under which a spontaneous order would emerge inan economic system prejudices the case against unhampered, decentralizeddecision-maldng. Thus, when obvious misallocations and"marketdirectedfailures" develop in ah. economy, su..g_íesti°r_ that. polio/betowardfreer markets will be met wlth mcreduhty.In a letter to me (dated February 2, 1977), Professor RichardWagner argued permasively that in the Principles Marshall was moreaware of these problems than those daiming to be influenced by him,espeáally ir we look to the Marshall of the text rather than of thefootnotes. I _ inclíned to agree with Professor Wagner.On Walras s assumpfion that markets will clear so as to produce anoverall order, cf. O'Driscoll, £conomics _ a C_ Prob/na, pp.18--19 and Note 16 on pp. 30-31.31. The hostility of the Chicago School to the approach of theAustrian Sc.hool is a fact. What _!!s for explanation is the reason, whichinvolves lar more than a "family" squabble. The divisions between thetwo schools antedate each in the history of economic thought.

Spontaneous Order and the Coordination af Economic Activities 139For a recent example of the Chicago attitude toward the Austrianconception ofeconomics, see the Rev/ew ofCompeñtion andEntrepreneurshipby Benjamin Klein, Journal of Political Economy, 83 (December,1975): 1305-09. For an earlier example of similar treatment, see theReview of Capital and lts Structure by MartinJ. Bailey,Journal ofPoliticalEconomy, LXV (]une, 1957): 265--66.32. For instance, see the discussion in Hayek,Monetary Theoryand theTrade Cycle, translated by N. Kaldor and H. M. Croome (New York:Augustus M. Kelley, 1966), pp. 45--45.In what follows, I will draw on my paper, "Friedrich Hayek and theSdence of Choice," Iowa State University Staff Paper in Economics No.24 (Ames, Iowa: Photocopy, 1975).33. Cf. Friedrich A. Hayek, The Pure Theory of Capital, pp. 33-34.34. "Ofcourse, it is one thing to assert that monetary changes are thekey to major movements in money income; iris quite a different thingto know in any detail what is the mechanism that links monetary changeto economic change; how the influence of the one is transmitted to theother; what sectors of the economy will be affected first; what the timePthatternof the impacts will be, and so on. We have great confidence ine first assertion. We have little confidence in our knowledge of thetransmission mechanism, except in such broad and vague terms as toconstitute litfle more than an impressionistic representaUon ratherthan an engineeñng bluepñnt." Milton Friedman and Anna J.Schwartz, "Money and Business Cydes,"inFriedman, The O_t/mumQuant/ty ofMoney (Chicago: Aldine Publishing Co., 1969), p. 222.CommenÜng on Ricardo's inattention to transitional periods,Schumpeter has remarked: %.. In matters of monetary as of generaltheory, Ricardian teaching is a detour and.., it slowed up the advanceof analysis, which would have been much quicker and smoother had[Henry] Thornton's lead been followed---had Ricardo's force not prevailedover Thornton's insight." Joseph A.'Schumpeter, H./st0_ ofEconomicAnalyais (New York: Oxford University Press, 1954), p. 704n.35. Cf. Gerald P. O'Driscoll, Jr. and Sudha R. Shenoy, "Inflation,Recession and Stagflaon," in Edwin G. Dolan, ed., The Founda6ons ofM0dern Austr/an Econom/¢s (Kansas City: Sheed & Ward, 1976), pp.190-93.For recent statements of Friedman's position, see "A TheoreticalFramework for Monetary Analysis," Journal of Poli_al Economy, 78M.a__ April, 1970): 193--238; and _A Monetary Theory of Nationalncome, JoumalofPolilf_E ,79 (March/April, 1971)"323-37. *. •$6. I ana referring here to the problem of distrtbuuonal, orCa__tillon-effects, which have been so long ignored in monetary theory."Pah gap in monetary theory is not accidental, for most theories ofmoney incorporate neutrality assumpons. If money is neutral, then

140 New Directions in Austrian Economicsindeed there are no distribuon effects. Itis not remarkable, then, thatnaonetary economists generally ignore the problem of distributioneffects. What is remarkable is that the almost fantasc assumpon ofneutrality of naoney generally does not gire economists pause. While itwould be beyond the scope of this paper to denaonstrate this proposition,it does seem that an economy in which naoney could be neutral isone in which there would be no demand for money. For, where eLsebutin a world of correct expectations and perfect coordinaon wouldchanges in the supply-demand relaon of money be neutral in theireffects?The issue of the neutrality of naoney and distribution effects isconsidered in Friedrich A. Lutz, "On Neutral Money," in Erich Streissler,Gottfried Haberler, Friedrich A. Lutz and Fritz Machlup, Roads toFreedom (New York: Augustus M. Kelley, 1969), pp. 105-16.37. Cf. O'Driscoll, Economics asa Coordinatm Problem, pp. 106-08.38. I ana quite aware that to some extent Friedman has deah with thegeneral institutional framework necessary for economic stability. And,indeed, I find his earlier work of maoreinterest in this regard. I wouldpoint out that even in that he focused on price/e_e/s, and did notdevelop the problem of coord/natm at length. Cf. Milton Friedman, dProgramfor Monetary Stabili_ (New York: Fordham University Press,1960).39. From the editorial introduction by Sudha R. Shenoy, ed.,d Tig¿,r/'3 the Tai/(London: Instimte of Economic Affairs, 1972), p. 8.40. The argument appearing in the beginning of this section wasstrongly influenced by a talk, "Adam Smith in Theory and Pracce,"delivered by Thomas Sowell in the Harry Girvetz Memorial LecmreSeries at the University of California,Santa Barbara.41. Adam Smith, Theorj of Mora/Snaba¢nts (London: Henry G.Bohn, 1853), pp. 342--43.42. Hayek, The Morgan C,uaranty Suroey (January, 1976): 4.43. For one re&son that might attract economists to this movement,see Hayek, The Morgan Guaranty Survey: 11.44. See Wassily- Leontief, "For a NaÜonal Economic PlanningBoard," The N¿,w York Tim_ (March 14, 1974): 37.45. "The modern Austrians have specifically emphasized this point.The work of Mises, Hayek, Lachmann and Kirzner are notable na thisrespect. For a recent example of a work wñtten in the Aus.trian traditionthat empb.___Testhe role of decentralized planning na a marketeconomy, see Kirzner's C_ and Ent_r¿,pr¿__urs/I/p.46. This quotaUon appears in Chapter III of Hayek, The R.mít mSerfdom (Chicago: Universirt of Chícago Press, 1944), pp. 35--36, it iscited in Hayek, The Morgan Guarant3 Surv_ (January,1976): 5-6.

Spontaneous Order and the Coordinatiow of Economic Activities 141The word "liberar' refers here, of course, to classical Englishliberalism, and not to twentieth century American liberalism.47. Israel M. Kirzner, "Hayek, Knowledge and Market Processes,"Paper Delivered at the Allied Social Science Association MeeUngs inDallas, Texas (New York: Photocopy, 1975); especially 28-29.48. KitTmer, "Hayek, Knowledge and Market Processes," p. 29.49. Kirzner, "Hayek, Knowledge and Market Processes," p. 32.50. Kirzner, "Hayek, Knowledge and Market Processes," p. 33.51. L. M. Lachmann, "Reflections on Hayekian Capital Theory,"Paper Delivered at the Allied Social Science Associaon Meetings inDallas, Texas (New York: Photocopy, 1975): 13.52. Lachmann, "Reflections .... " 8-9. Emphasis added. Also, cf.Lachmann, "From Mises to Shaclde," 59-61.53. Lachmann, "Reflections... ," 9. "The Future is unknowable,though not unimaginable. Future knowledge cannot be had now, but itcan cast its shadow ahead. In each mind, however, the shadow assumesa different shape, hence the divergence of expectations. The formationof expectations is an act of our minds by meam of which we try tocatch a glimpse of the unknown. Each one of us catches a differentglimpse." Lachmann, "From Mises to Shackle .... " 59.54. In his most recent work, Lachmann notes that Mises, Hayek andKirzner have emphasized the diffusion of knowledge in the marketprocess. But he denies that the market can diffuse expectations in thesame way. Cf. Lachmann, "From Mises to Shackle," 59. I believe thedisfinction between knowledge and expectations is a spurious one.55. Cf. Kirzner, 'Hayek, Knowledge and Market Processes," 30-31.56. Lachmann, "From Mises to Shackle," 59.57. Ibid., p. 61.58. Cf. Hayek, "Economics and Knowledge," in lnd/v/dua//sm andEconomic Order, pp. 39-45.59. It is true that one can find recent instánces in which prominenteconomists imply "coordinaÜon" in the ex post sense. For instance, cf.Leijonhufvud, "Effective Demand Failures," 29. But there Leijonhufvudis dealing, inter a//a, with the quesdon of whether markets alear atall. But the general issue with which Lachmann is dealing is surely theproblem of exan_ coordinaÜon. If not, one must ask "why all the fuss?'Generally it is not denied by non-Marxista that at least output marketsclear.60. Ludwig M. Lachmann, "On Austrian Capital Theory," in Dolan,ed., The Foundations of Modern Austrian Economics, p. 149.61. "... Expectations of early change in the present situafion mayimpede the process of adjustment, and even when this does not happen,the forces of adjustment themselves may be overtaken by other

142 New Directms in Austrian Econom_forces." Lachmann, "On Austrian Capital Theory," pp. 149--50.62. Lachmann, "From Mises to Shackle," 60; also see 58n of thatarticle.63. In any event, this is what I make of his public statements on theissue, made at various times. Also, note the last sentence of the firstquotation appearing on p. 20. Lachmann juxtaposes "the forces ofequilibrium" and "the forces of change." Lachmann, "From Mises toShackle," 61.

Austñan DefiniUons of theSupply of MoneyMurray N. RothbardPolytechnic Institute of New YorkL THE DEFINITIONOF THE SUPPLY OF MONEYThe concept of the supply of money plays a vitally importantrole, in differing ways, in both the Austrian and the Chicagoschools of economics. Yet, neither school has defined the conceptin a fuU or satisfactory manner; asa result, we are never sureto which of the numerous alternative definitions of the moneysupply either school is referring.The Chicago School definition is hopeless from the start. For,in a question-begging attempt to reacia the condusion that themoney supply is the major determinant of national income, andto reach it by statistical rather than theoretical means, theChicago School defines the money supply as that entity whichcorrelates most closely with national income. This is one of themost flagrant examples of the Chicagoite desire to avoid essentialistconcepts, and to"test" theory by statistical correlaUon; withthe result that the supply of money is not really defined at all.Furthermore, the approach overlooks the fact that stafisticalcorrelation cannot establish causal connections; this can only bedone by a genuine theory that works with definable and definedconcepts. 1InAustrianeconomics,Ludwig von Mise setforththecssentíalsoftheconceptofthemoney supplyinhisT/_oryofMoneyand143

144 New Directions in Austrian EconomicsCredO, but no Austrian has developed the concept since then,and unsettled quesUons remain (e.g., ate savings deposita properlyto be induded in the money supply?). 2 And since the conceptof the supply of money is vital both for the theory and forapplied historical analysis of sucia consequences as inflaUon andbusiness cycles, it becomes vitally important to try to settle thesequesdons, and to demarcate the supply of money in the modernworld. In The Theory of Money and Credit, Mises set down thecorrect guidelines: money is the general medium of exchange,the thing that aU other goods and services are traded for, the• final Payment for such goods on the market.In contemporary economics, definiUons of the money supplyrange widely from cash + demand deposita (Mt) up to theinclusion of virtually aUliquid assets (a stratospheñcally high M).No contemporary economist exdudes demand deposita from bisdefinition of money. But it is useful to consider e_acfly why thisshould be so. When Mises wrote The Theory ofMoney and Credit in1912, the inclusion of demand deposita in the money supply wasnot yet a settled quesUon in economic thought. Indeed, a controversyover the precise role of demand deposita had ragedthroughout the nineteenth century. And when Irving Fisherwrote his Purchasing Power of Money in 1913, he sfill felt it necessaryto disdnguish between M (the supply of standard c_sh) andM I, the total of demand deposits, s Why then did Mises, thedeveloper of the Austrian theory of money, argue for indudingdemand deposita as Part of the money supply "in the broadersense"? Because, as he pointed out, bank demand deposita werenot other goods and services, other assets exchangeable for cash;they were, instead, redeemable for cash at par on demand. Sincethey were so redeemable, they functioned, notas a good ofservice exchanging for cash, but rather asa warehouse receiptfor cash, redeemable on demand at par as in the case ofany otherwarehouse. Demand deposits were therefore "moneysubstitutes"and functioned as equivalent to money in the market.Instead of exchanging cash fora good, the owner of ademand deposit and the seller of the good would both treat thedepositas _it were cash, a surrogate for money. Hence, receipt

Austrian Definitions of the Supply of MoffL7 145of the demand deposit was accepted by the seller as final paymentfor his product. And so long o3 demand deposita ate acceptedas equivalent to standard money, they will function aspart of the money supply.It is important to recognize that demand deposits are notautomatically part of the money supply by virtue of their veryexistence; they continue as equivalent to money only so long asthe subjective estimates of the sellers of goods on the marketthink that they are so equivalent and accept them as such inexchange. Let us hark back, for example, to the good old daysbefore federal deposit imurance, when banks were liable to bankruns at any time. Suppose that the Jonesville Bank has outstandingdemand deposita of$1 million; that million dollars is then itacontñbution to the aggregate money supply of the country. Butsuppose that suddenly the soundness of the Jonesville Bank isseverely called into question; antl Jonesville demand deposita areaccepted only ata discount, or even not at all. In that case, as arun on the bank develops, ita demand deposita no longer functionas part of the money supply, certainly not at par. So that abank's demand deposit only functions as part of the moneysupply so long as it is treated as an equivalent substitute for cash.4It might weU be objected that since, in the era of fractionalreserve banking, demand deposita are not really redeemable atpar on demand, that then only standard cash (whether gold orfmt paper, depending upon the standard) can be consideredpart of the money supply. This contrasta with 100 percent reservebanking, when demand deposita are genuinely redeemablein cash, and function as genuine, rather than pseudo, warehousereceipts to money. Such an objection would be plausible, butwould overlook the Austrian emphasis on the central importancein the market of subjective estimates of importance andvalue. Deposita are not infact all redeemable in cash in a systemof fractional reserve banking; but so long as individuals on themarket th/nk that the), ate so redeemable, the)' continue to functionas part of the money supply. Indeed, it is precisely theexpansion of bank demand deposita beyond their reserves thataccounta for the phenomena of inflation and business cydes. As

146 New Directions in Austrian Economicsnoted above, demand deposits must be included in the conceptof the money supply so long as the market treats them as equivailent; that is, so long as individuals think that they ale redeemablein cash. In the current era of federal deposit insurance, added tothe existente of a central bank that prints standard money andfunctíons asa lender of last resort, it is doubfful that this confidentein redeemability can ever be shaken.AU economists, of course, include standard money in their¢oncept of the money supply. The justification for íncludingdemand deposits, as we have seen, is that people believe thatthese deposits are redeemable in standard money on demand,and therefore treat them as equivalent, accepting the payment ofdemand deposits asa surrogate for the payment of cash. But ffdemand deposits ate to be induded in the money supply for thís -reason, then it follows that any other enttities that follow the samerules must also be included in the supply of money.Let us consider the case of savings deposits. There are severalcommon arguments for not induding savings deposits in themoney supply: (1) they are not redeemable on demand, the bankbeing legally able to force the deposítors to wait a certain amountof time (usually 30 days) before paying cash; (2) the), cannot beused direcfly for payment. Checks can be drawn on demanddeposits, but savings deposits must first be redeemed in cashupon presentation of a passbook; (3)demand deposíts atepyramided upon a base of total reserves asa multiple of reserves,whereas savings deposits (at least in savings banks and savingsand loan associations) can only pyramid on a one-to-one basis ontop of demand deposits (sínce such deposits will rapidly "leakout" of savings and into demand deposits).Objection (1), however, fails from focusing on the legalitiesrather than on the economic reafities of the simation; in particular,the objection fails to focus on the subject/ve estimates of thesituation on the part of the depositors. In reality, the power toenforce a thirty-day notice on savings depositors is never enforced;hence, the depositor invariably thinks of his savingsaccount as redeemable in cash on demand. Indeed, when, in the1929 depression, banks tñed to enforce this forgotten provision

A_t,_nDefini_o,uoft_ s__zyofMo_ 147in their savings deposits, bank runs promptly ensued. 5Objection (2) fañs as well, when we consider that, even withinthe stock of standard money, some part of one's cash will betraded more actively or directly than others. Thus, supposesomeone holds part of his supply of cash in his wallet, andanother part buñed under the fioorboards. The cash in thewallet will be exchanged and turned over rapidly; the floorboardmoney might not be used for decades. But surely no one woulddeny that the person's floorboard hoard isjust as much part ofhis money stock as the cash in his wanet. So that mere lack ofactivity of part of the money stock in no way negates its indusionas part of his supply of money. Similarly, the fact that passbooksmust'be presented before a savings deposit can be used in exchangeshould not negate its inclusion in the money supply. As Ihave written elsewhere, suppose that for some cultural quirk--say widespread revulsion against the number "5"---no seller willaccept a five-dollar bill in exchange, but only ones or tens. Inorder to use five-dollar bilis, then, their owner would first haveto go to a bank to exchange them for ones or tens, and then usethose ones or tens in exchange. But surely, such a necessitywould not mean that someone's stock of five-donar bilis was notpart of his money supply, eNeither is Objection (3) persuasive. For whñe ir is true thatdemand deposits area mulple pyramíd on reserves, whereassavings bank deposits are only a one-to-one pyramid on demanddeposits, this distinguishes the sources or volatility of differentforros of money, but should not exdude savings deposits fromthe supply of money. For demand deposits, in mm, pyramid ontop of cash, and yet, whíle each of these forros of money isgenerated quite differently, so long as they exist each forros partof the total supply of money in the country. The same shouldthen be true of savings deposits, whether they be deposits incommercial or in savings banks.A fourth objecfion, based on the third, holds that savingsdeposits should not be considered as part of the money supplybecause they are efficiently if indirecfiy controllable by the FederalReserve through its control of commer_al bank total re-

148 New Directionsin AustrianEconomicsserves and reserve requirements for demand deposits. Sudacontrol is indeed a fact, but the argument proves lar too muda;for, after all, demand deposits are themselves and in turn indirectlybut efficiently controllable by the Fed through its controlof total reserves and reserve requirements. In fact, control ofsavings deposits is not nearly as efficient as of demand deposits;ir, for example, savings depositors would keep their money andactivepayments in the savings banks, instead ofinvanably "leaking"back to checking accounts, savings banks w0u/d be able topyramid new savings deposits on top of commercial bank demanddeposits by a large multiple/Not only, then, should savings deposits be induded as part ofthe money supply, but our argument leads to the conclusion thatno valíd distinction can be made between savings deposits incommercial banks (included in M_) and in savings banks ofsavingsand loan associations (alsoincluded in M3).8Once savingsdeposits are conceded to be part of the money supply, _here isnosound reason for balking at the inclusion of deposits of the latterbanks.On the other hand, agenuine time deposit--a bank deposit thatwould indeed only be redeemable at a certain point of time in thefuture, would merit very different treatment. Suciaa time deposit,not being redeemable on demand, would instead be acredit instrument rather than a form of warehouse receipt. Itwould be the result of a credit transaction rather than awarehouse claim on cash; it would therefore not function in themarket as a surrogate for cash.Ludwig von Misesdistinguished carefully between a credáanda da/m transaction: a credit transacfion is ah exchange of apresent good (e.g., money which can be used in exchange at anypresent moment) for a future good (e.g., ah IOU for money thatwill only be available in the future). In this seme, a demanddeposít, while legally designated as credit, is actually a presentgood--a warehouse claim to a present good that is similar to abailment transacñon, in which the warehouse pledges to redeemthe ticket at any time on demand.Thus, Mises mote:

Austrian Definitions of the Supply of Money _ 140It is usual to reckon the acceptance of a deposit which can be drawnupon at any time by means of notes or cheques asa type of credittransaction andjuristically this viewis, ofcourse,justified; but economically,thecaseis not one ofa credittransacUon. Ifcreditin the economicsense means the exchange ofa present good ora present serviceagainsta future good ora future servace,then it is hardlypossibleto indude thetransactions in question under the conception of credit.A depositor ofa sum of money who acquires in exchange for it a claimconvertibleintomoney at any time whichwiUperform exactly the same servicefor himas the sum ir refers to has exchanged no present good fora futuregood. The claím that he has acquired by his deposit is also a presentgood for him. The depositing of the money in no waymeans that he hasrenounced immediate disposal over the utility it commands2It might be, and has been, objected that credit instruments,such as bilis of exchange or Treasury bilis, can often be soldeasily on credit market: either by the rediscounting of bilis orin selling old bonds on the bond market; and that therefore theyshould be considered as money. But many assets are "liquid,"i.e., can easily be sold for money. Blue-chip stocks, for example,can be easily sold for money, yet no one would include suchstocks as part of'the money supply. The operative difference,then, ís not whether an asset is liquid or not (since stocks ate nomore part of the money supply than, say, real estate) but whetherthe asset is redeemable at a fixed rate, at par, in money. Creditinstruments, similarly to the case of shares of stock, are soldformoney on the market at fluctuating rates. The current tendencyof some economists to include assets as money purely because oftheir liquidity must be rejected; after all, in some cases, inventoriesof retail goods might be as liquidas stocks or bonds, andyet surely no one would list these inventories as part of themoney supply. They are other goods sold for money on themarket, loOne of the most noninflationary developments in recentAmeñcan banking has been the emergence ofcertificates ofdeposit(CDs), which are genuine time and credit tra_nsactions. Thepurchaser of the CD, or at least the large-demonination CD,knows that he has loaned money to the bank which the bank isonly bound to repay at a specific date in the future; hence,

150 New Directions in Austrian Economicslarge-scale CDs are properly not included in the M2 and M3def'mitions of the supply ofmoney. The same might be said to betrue of various programs of time deposits which savings banksand commercial banks have been developing in recent years: inwhich the depositor agrees to retain his money in the bank for aspecified peñod of years in exchange for a higher interest return.There are worñsome problems, however, that are attached tothe latter programs, as well as to sma¿¿-denominationCDs; for inthese cases, the deposits ate redeemable before the date of redemptionat fixed rates, but at penalty discounts rather than atpar. Let us assume a hypothetical time deposit, due in five years'time at $10,000, but redeemable at presentat a penalty discountof $9,000. We have seen that such a time deposit should certainlynot be included in the money supply in the amount of $10,000.But should it be included at the f'Lxedthough penalty rate of$9,000, or not be included at all? Unfortunately, tñere is noguidance on this problem in the Austrian literature. Our inclinaonis to indude these imtruments in the money supply at thepenalty level (e.g., $9,000), since the operative distinction, in ourview, is not so much the par redemption as the ever-readypossibility of redemption at some fLxed rate. If this is true, thenwe must also include in the concept of the money supply federalsavings bonds, whích are redeemable at fixed, though penahyrates, until the date of official maturation.Another entity which should be induded in the total moneysupply on our definition is ca_hsurrmuttr valuea of life insurancepolicies; these values represent the investment rather than theinsurance part of life imurance and are redeemable in cash (orrather in bank demand deposits) at any time on demand. (Thereare, ofcourse, no possibilities ofcash surrender in other forros ofimurance, such as term life, tire, accident, or medical.) StatiscaUy,cash surrender values may be gauged by the total of policyreserves less polio/loíms outstanding, since policies on whichmoney has been borrowed from the insurance company by thepolicyholder are not subject to immediate withdrawal. Again,the objection that poficyholders are reluctant to cash in their

Austrian De.finions of the Supply of Money _, 151surrender values does not negate their inclusion in the supply ofmoney; such reluctance simply means that this part of ah individuíd'smoney stock is relatively inactive. 1_One caveat on the indusion of noncommercial bank depositsand other fixed liabilities into the money supply:just as the cashand other reserves of the commercial banks are not induded inthe money supply, since that would be double _ounting oncedemand deposits are induded; in the same way, the demanddeposíts owned by these noncommercial bank creators of themoney supply (savings banks, savings and loan companies, lifeinsurance companíes, etc.) should be deducted from the totaldemand deposits that are induded in the supply of money. Inshort, if a commerdal bank has demand deposit liabilities of $1million, of which $100,000 ate owned by a savings bank as areserve for its outstanding savings deposits of $2 million, thenthe total money supply to be attributed to these two banks wouldbe $2.9 million, deducting the savings bank reserve that is thebase for its own liabilitíes.One anomaly in American monetary statisfics should also bedeared up: for a reason that remains obscure, demand depositsin commerdíd banks or in the Federal Reserve Banks owned bythe Treasury are exduded from the total money supply. If, forexample, the Treasury taxes dtizem by $1 billion, and theirdemand deposits ate shifted from public accounts to the Treasur),account, the total supply of money is considered to havefallen by $1 billion, when what has really háppened is that $1billion worth of money has (temporarily) shifted from private togovemmental hands. Clearly, Treasury deposits should be indudedin the national total of the money supply.Thus, we propose that the money supply should be defmed asall entities which are redeemable on demand in standard cash ata fLxed rate, and that, in the United States at the present time,this criterion tra_nslates into:Mo(a ffiAustrian) ffitotal supply ofcash-cash held in the banks+ total demand dep_its + total savings deposits in commerd_!and savings total banks shares in savings and loan associations

152 New Directions in/lustrian Economicstotal polio/reserves of life insurance companies--policy loansoutstanding--demand deposits owned by savings banks, savingand loan assodations, and life insurance companies + savingsbonds, at current rates of redempÜon.Ma hews to the Austrian theory of money, and, in so doing,broadens the definiÜon of the money supply far beyond thenarrowMt, and yet avoids the path ofthose who would broadenthe definiÜon to the virtual indusion ofaU liquid _ssets, and whothus would obliterate the uniqueness of the money phenonemonas the final means of payment for all other goods and services.II.THE MONEY SUPPLY AND CREDIT E_ANSIONTO BUSINESSIn contrast to the Chicago School, the Austrian economistcannot rest content with arriving at the proper concept of thesupply of money. For while the supply of money (Ma) is thevitany important supply side ofthe"money relation" (the supplyof and demand for money) that determines the array of prices,and is therefore the relevant concept for analyzing price inflation,different parts of the money supply play very differentroles in affecting the business cyde. For the Austrian theory ofthe trade cyde reveals that only the inflationary bank creditexpansion that enters the market through new business Ioans (ofthrough purchase of business bonds) generates the overinvestmentin higher-order capital goods that leads to theboom-bust cyde. Inflafionary bank credit that enters the marketthrough f'mancing government defidts does not generate thebusiness cycle; for, instead of causing overinvestment inhigher-order capital goods, it simply reallocates resources fromthe private to the public sector, and also tends to dñve up price$.Thus, Mises distinguished between "simple inflation," in whichthe banks create more deposits through purchase of governmentbonds, and genuine "credit expansion," which enters thebusiness loan market and generates the business cyde. As Miseswrites:

Austrian Definitions of the SuI_plyof Money 153In dealingwiththe[businesscyde] weassumedthat the totalamountofadditionalfiduciarymedia enters the market system viathe loan marketas advancesto business....There are, however, ínstances in which the legal and technicalmethods of credit expansion are used for a procedure catallacticallyutterly different from genuine credit expansion. Politicaland institutionalconveniencesometimesmakes it expedient fora government totake advantage of the facilities of banking asa substitute for issuinggovernment fiat money. The treasuryborrowsfrom the bank,and thebank provides the funds needed by issuing addifional banknotes orcrediting the government on a deposit account. Legallythe bankbecomesthetreasury'screditor. In fact the whole transactionamounts tofiatmoney inflation. The additionalfiduciary mediaenter the marketby way of the treasuryas payment for vañous items of governmentexpenditure.... They affect the loan market andthe grossmarketrateofinterest, apartfrom the emergence of a positivepricepremium, onlyira partof them reaches the loan market at a time at whichtheir effectsupon ¢ommodity prices and wage rates have not yet been consummated?zMises did not deal with the relatively new post-World War IIphenomenon of large-scale bank loans to consumers, but thesetoo cannot be said to generate a business cyde. Inflationary bankloans to cons_1_ers will arfificially deflect social resources toconsumption rather than investment, as compared to the unhampereddesires and preferences of the consumers. But theywillnot generate a boom-bust cyde, because they will not result in"over" investment, which must be liquidated in a recession. Notenough investments will be made, but at least there wiU be noflood of investments which wiU later have to be liquidated.Hence, the effects of diverting consumptíon investment proportionsaway from consumer time preferences will be asymmetrical,wíth the overinvestment-business cyde effects only resultingfrom inflationary bank loans to business. Indeed, the reason whybank fmancing of government deficits may be called simplerather than cyclical inflation is because government demandsare "consumption" uses as decided by the preferences of theruling government offidals.In addition to Ma, then, Austrian economists should be in-

154 New Directions in .4ustrian Economicsterested in how much of a new supply of bank money enters themarket through new loans to business. We might call the portionof new Ma that is created in the course of business lending, Mb(standing for either business loans or busíness cycle). Ir, forexample, a bank creates $1 million of deposits in a given timeperiod, and $400,000 goes into consumer loans and governmentbonds, while $600,000 goes into business loans and investments,then Mb will have increased by $600,000 in that period.In examining Mb on the American financial scene, we canignore savings banks and savings and loan associations, whoseassets ate almost exclusively invested in residential mortgages.Savings bonds, of course, simply help finance government acdvity.We ate left, then, wíth commercial banks (as well as lifeinsurance investments). Commercial bank assets are comprisedof reserves, government bonds, consumer loans, and businessloans and investments (corporate bonds). Their liabilities consistof demand deposits, time deposits (omitting large CDs), largeCDs, and capital. In trying to discover movements ofMb with anyprecision, we founder on the difficulty that ir is impossible inpractice to decide to what extent any increases of business loansand investments have been financed by an increase of deposits,thus increasing Mó, and how much the), have been financed byincreases of capital and large CDs. Looking at the problemanother way, it is impossible to determine how much of anincrease in deposits (increase in Ma) went to finance businessloans and investments, and how much went: into reserves orconsumer loans. In tryíng to determine increases in Mb for anygiven peñod, then, it is impossible to be scientifically precise, andthe economic historian must actas an "artist" rather than as anapodictic scientíst. In practice, since bank capital is relavelysmall, as are bank investments in corporate bonds, the figure forcommercial bank loans to business can provide a rough estimateof movements in Mb.With the development of the concepts of M,, (total supply ofmoney) and MI, (total new money supply going into businesscrediO, we have attempted to gire more precision to the Austñan

Austrian Definitions of the SuppTy of Money 155theory of money, and to the theoretical as well as historicalAustrian analysis of monetary and business cycle phenomena.NOTES1. In a critique of the Chicago approach, Leland Yeager writes:"But irwould be awkward ifthe definition of money accordingly had tochange from time to time and country to country. Furthermore, even ifmoney defined to indude certain near-moneys does correlate somewhatmore dosely with income than money narrowly defined, that factdoes not necessañly impose the broad definition. Perhaps the amountof these near-moneys depends on the level of money-income and inturn on the amount of medium of exchange .... More generally, it isnot obvious why the magnitude with which some other magnitudecorrelates most closely deserves overriding attention .... The numberof bathers ata beach ma), correlate more dosely with the number ofcars parked there than with either the temperature or the price ofadmission, yet the former correlation may be less interesting or usefulthan either of the latter" (Leland B. Yeager, "Essenñal Properties of theMedium of Exchange," Kyklos [ 1968], reprinted in Monetary Theory,ed.R. W. Clower [London: Penguin Books, 1969], p. 38). Also see, MurrayN. Rothbard, "The Austrian Theory of Money," in E. Dolan, ed., TheFoundations ofModern Austrian E¢onomics (Kansas City, Kansas: Sheed 8:Ward, 1976), pp. 179--82.2. Ludwig von Mises, The Theory ofMoney and Credit, 3rd ed. (NewHaven: Yale University Press, 1953).3. Irving Fisher, The Purchasing Power ofMoney (New York: Macmlan,1913).4. Even now, in the goldén days of federal deposit insurance, ademand deposit is not always equivalent to cash, as anyone who is toldthat it will take 15 banking days to alear a check from California to NewYork can attest.5. On the equivalence ofdemand and savings deposits during theGreat Depression, and on the bank runs resultihg from attempts toenforce the 50-da}, wait for redemption, see Murray N. Rothbard,America's Grm/Deprex6_, 3rd ed. (Kansas City, Kansas: Sheed &Ward,1975), pp. 84, 316. Also see Lin Lin, "Are Time Deposits Money?/lmetic.an E¢onamic Review (March 1937), pp. 76--86..6. Rothbard, "The Austrian Theory ofMoney, p. 181.7. In the Uni_redStates, the latter is beginning to be the case, as

156 New Directions in Austrian Economicssavings banks are increasingly being aUowed "toissue checks on theirsavings deposits. Ir that became the rule, moreover, Objection (2)would then fall on this ground alone.8. Regardless of the legal forro, the "shares" of formal ownershipin savings and loan associations are economically precisely equivalentto the new deposits in savings banks, an equivalence that is universallyacknowledged by economists.9. Mises, Theory of Money and Credit, p. 268.10. For Míses' critique of the view that endorsed bilis ofexchange inearly nineteenth-cenmry Europe were really part of the money supply,see/b/d., pp. 284-86.11. For hints on the possible inclusion oflife insurance cash surrendervalues in the supply of money, see Gordon W. McKinley, "Effectsof Federal Reserve Policy on Nonmonetary Financia] InstimUons," inHerbert V. Prochnow, ed., The Federal Reseroe System (New York:Harper & Bros., 1960), p. 217n; and Arthur F. Burns, Prospe_ withoutInflation (Buffalo: Economica Books, 1958), p. 50.12. Ludwig von Mises, Human A¢tion, 3rd rey. ed. (Chicago: HenryRegnery, 1966), p. 570.

The Emergence of Interestin a Pure Exchange Economy:Notes on a TheoremAttributed to Ludwig von MisesLaurence S. MossBabson College1. Individuals faced with alternatives equally attractive in allrespects except their position in time prefer proximate enjoymentsto those more remote. According to Ludwig von Mises,this preference for earlier rather than later enjoyments is inherentin aUacts of individual choice and is termed "time preference.''1 It has been claimed that Misesian time preferenceguarantees the emergence of a positive rate of interest in a pureexchange economy, that is,where there is no production and theeconomic fumre is known with certainty.2 Furthermore, theinterest rate that "invariably" emerges results entirely from theinteraction of valuing minds and is therefore a subjectivephenomenon, not being dependent on the technology of productionor the productivity of capital. Interest is nota paymentfora monopolized agent of production, nor does it reflect aparticular distribution of the means of production that can bedone away with by reorganizing the social order in a mannerprescribed by Socialist visionañes, sThe dairathat a positive rate ofinterest willemerge in a pureexchange economy seems fundamental to, and consistent with,157

158 New Directions in Austrian EconomicsMises' entire theoretical system. While in bis early economicwritings Mises embraced Eugen von B6hm-Bawerk's theory thatthe height of the interest tate is determined by the technologicalsuperiority of roundabout methods of production, his later writingsrepudiated the productivity theory of interest rate determinationin favor of the pure time-preference theory advanced inthe United States by Frank A. Fetter at the turn of this century. 4As has been claimed by recent Austrian economists, Mises' adoptionof the so-called pure time-preference concept indicates ahabandonment of B6hm-Bawerkian theory and a return to themore thoroughgoing subjectivism characteristic of CarlMenger's thought. 5 In fact, a fundamental theoretical differencebetween Mises and Friedrich A. Hayek may well turn on theissue of the influence the material structure of the world exertson the individual's personal valuation of goods now as opposedto goods later, e To the extent that the payment of interest isnecessitated by the material conditions surrounding the productionand distribution of commodities rather than by man's subjectiveestimate of future enjoyments, then to that extent thecapitalist system (i.e., the market economy) seems less permanentand more dependent on a historical stage in the evolutionof these material conditions. Thus, modern Austrian economistswho view capi_!ism as the only social system compatible with thenature of man attach great importance to their interest theoryand to the theorem I shall discuss in this paperYWhat I offer here is a model ofa pure exchange economy withah analysis of the circumstances under which a positive marketrate of interest will emerge. I shall show that much of the misunderstandingregarding Mises' interest theory has to do with thespecial meaning Mises attached m the term t/me preferenc4. StiU,when Mises' theorem is correctly stated and understood, it will beseen that the emergence of interest is not inevitable but dependsin part on the existence of certain objective conditions thatprevent the individual from "internally financing" an increase inpresent consumption even when he can afford m do so. Andthese objective conditions that make possible the emergence ofinterest ale hardly the sort that can be efiminated by a reorgani-

The Emergence of Interest in a Pute Exchange Economy 159zation of the social order along the lines advocated by antimarketreformers.2. Consider an economy consisting of a number of individualseach facing a time horizon made up of n consumption periods.Also, assume that each individual is guaranteed an endowmentof a single consumption good (apples) and knows how manyunits of this single consumption good will be made available tohito at the beginning of each of the n consumption peñods. Weassume the individual is able to rank this particular time allocationamong all other conceivable time allocations, and we writethe individual's utility funcfion as follows:UT = f (ti, C|, ti .... CD (1)where U represents, for individual I, the uUlity level associatedwith the time pattern of consumpUon offered by his originalendowment, and C represents the number of units of a consumpongood available to the individual at the beginning of the¡thperiod of consumption (where i ranges over the n peñods).It ma)' be useful to think ofa prisoner ofwar camp where eachof the prisoners is told in advance how many apples he will begiven at each ofn successive dates in the future. Each individualis absolutely certain that he will obtain that number of apples onschedule as promised. 8 Now suppose that after this informationis disclosed, each prisoner is given the option of transferringsome of the apples promised in remoter consumption per[ods toperiods more proximate. For example, an individual may requestthat an apple promised in period number 10 be supplied inpeñod number 3. Also, ifwe assume that storage costs are zero,individuals can always move apples from earlier periods to laterperiods simply by holding them in the form of inventory? Insuch a world each individual will redistribute his consumptionstream over time so that he can achieve a preferred level ofsatisfaction over the whole planning period. Let us represent thispreferred allocaUon as foUows:U,_,ffif (C_, C|, C|,... Cea), (2)

160 New Directions in .4ustrian Economicswhere U_ represents thedesired level of satisfaction of individualI and C represents the desired number of apples to be consumedin the ithpeñod. As should be clear from the description of theproblem, the arithmetic sum ofapples consumed over the entireplanning horizon must be equal to the sum of apples promised indie original situation, that is,nnx c_ = X cL (s)i=li=lStated another way, ifwe define net borrowing between any twoperiods asc_ - cL (4)then the sum of net borrowing over the enUre planning horizonmust be zero, ofnXi=1[cid - CTl= 0. (5)3. It is alear that, if the individual chooses to increase his appleconsumption in some periods, he must decrease it in otherperiods by an exact amount. _oThe utility maximizing allocationhas the property that the marginal utility of apple consumptionís roughly equal in each period, or the marginal rate of substitutionbetween apples in any two peñods is equal to unity and is thesan_e for all individuals. __It may at first seem that the marginalutility of an apple scheduled to be received x periods in thefuture must be perceived as being ofsmaller intensity than it willactually turn out to be when that period of comumption isreached. TMIt may be realistic to assume this in actual life situationswhere individuals often fail to provide adequately for theirold age, but in our model the assumptionof perfectlmowledgeassures us that no such shortsighted valuation takes place. Theindividual is equipped with the power to project his feelings (or

The Emergence of Interest _n a Pure Exchange Economy 161value orderings) forward in time and anticipate quite accuratelywhat his future requirements wiUbe.It is apparent that individuals starting out with identical appleendowments will not necessarily arrive at identical consumptionplans. Economists such as Irving Fisher and more recently GaryBecker tried to say something more definite about the relationshipbetween individual tastes and final consumption patterns.For this purpose the), distinguished among positive, negative,and zero (or neutral) time preference. 13 An individual whopossesses positive time preference will, when given an equalendowment of apples in two adjacent peñods, trade more thanone future apple for one present apple. On the other hand theindividual who is willing to give up more than one present applefor a future apple when his endowment of apples is the same inthe two adjacent periods is said to possess negative time preference(though we would not observe such a trade, as I shall arguebelow). Finally, an individual satisfied with an equal number ofapples in each time period is said to display neutral or zero timepreference. Since any one of these three situations is evidencefor what Mises called "time preference," he must have meant bythe terna something different from what has become standardterminology among neoclassical economists.In Mises' víew an individual demonstrates time preference inany period simply by consuming some apples in that periodrather than none at all. If (in temas of our n-period model) anindividual reallocated his apple endowment so that he consumednothing in the first n- 1 periods and everything in the last peñod,we would have a situation close to what Mises described as theabsence of time preference, a4According to Mises, the ver,/act ofconsuming duñng the planning period demonstrates (positive)time preference. In Mises' writings this concept might better betermed t/me allocation than t/me preference.I do not wish to enter into a discussion of which definition oftime preference is best for modern economics. I do wish to pointout, however, that (1) the Misesian notion of time preference(that is, time allocation) does not make use of the notion of"choice at the margin," or at least it is obscure as to what and

162 New Directions in Austrian Economicswhere the notion of the margin might enter into such a def'mition;"and (2) when semantic considerations are put aside, thereis no fundamental issue separating Mises from the remainder ofthe economícs profession. A great deal ofconfusion has resultedfrom Mises' frequent use of the expression t/me preference tomean time allocation without indicatíng that his special use of theterna was different from that of those whom he credited withoriginating the concept? 64. We may now ask whether Mises was correa when he insistedthat time allocation gives rise to a market for claims to futureconsumption (that is, a bond market) with a positive rate ofinterest. Obviously, we would not observe a negative interest ratein our model of a pure exchange economy where storage costsate assumed to be zero. No one would trade a present apple fofaclaim to/ess than 0he future apple when he could obtain a wholefuture apple simply by stoñng the present app]e until that laterdate. li"consumption goods could be transferred not on]y fromthe present to the future but also from the future to the present,no one wou]d find it economical to trade a claim for more thanone unir of future consumpt/on goods for a unit of presentgoods when that same present good could be obtained morecheaply by transferring goods back through time. In a worldwith this type of symmetrícal me transfer, ah indívidual timeallocator would trade onIy with himself, and there would be noeconomic incentive to create a market in which daims on futuregoods are exchanged.It is only when we drop the assumption that apples can betransferred from the future to the present (though presentapples can stíll be held i'or future consumption) that a (bond)market will merge in which claims to future apples ate exchanged.Here individuals who want more than one futureapple fora present apple and ale unable to acquire that applefrom their future endowment induce others by means of ajainterest payment to gire up some of their current stock ofapples.The actual market rate of interest will more to equate the supplyof, and demand for, goods. Furthermore, the equilibñum in-

The Emergence of Interest in a Pffre Exchange Economy 163terest rate can never fall below zero, because individuals canalways hold present goods until a later period at zero cost.The existence of ah organized market in which claims tofuture consumption are traded now makes it possible fora singleindividual's totaln-peñod consumption to be greater or less thanhis total aggregate apple endowment. Whether it will be greateror less depends, of course, on whether over the n periods he wasa net interest payer or receiver. Ir remains true, however, thattotal apple consumption for the entire society must equal totalapple endowment when both totals are summed over all individualsand all periods. That is,nk2 Y_(Ca - Cti) = 0, (6)i=l j=lwhere all symbols are defined as before andj ranges over all kmembers of society. Itis interesting to point out the majordifference between a pure exchange economy and an economywith production and exchange: Production removes the constrainton societal consurnption represented by equation (6).With production it is possible for all members of society simultaneouslyto reduce present consumption and have future consumptionrise by an even greater amount. It was this phenomenonB6hm-Bawerk had in mind when he wrote of the productivityof roundabout methods ofproducfion? _It is not my purposehere to explore any further the interesting dynamics of theproduction economy.5. In conclusion, we say that in a pure exchange economy amarket wiU emerge in which daims to future consumer goodsare sold at posítive pñces. Ir it were technologically possible toorder up future goods ahead of time (and storage costs werezero), then no economizing individual would pay more than oneunit of a present good for a claim to a future good. In such aworld, there would be no economic incentive to create a bondmarket, anda zero rate of interest would prevail. It is only

164 New Directions in Austrian Economicsbecause of the asymmetry in the time market, namely, thatpresent goods can be costlessly transferred to the future butfuture goods cannot be conjured to the present, that we haveevery reason to expect the emergence of a market for daims tofuture goods along with a posiáve interest tate.Thus, interest will emerge in a Socialist economy as ir does in amarket economy because time allocation proceeds in a worldwhere the present graduaUy unfolds into the future rather thanthe other way around. Mises' attempt to presenta purely subjecotire time preference (read "time allocation') theory of interestmust at the very least admit the empirical or broadly technologicalassumption that the transfer of goods through time is indeeda one-way street."" NOTESI. Ludwig von Mises, Human Action: A Treatise on Economic$(Chicago:Henry Regnery Co., 1966), pp. 479-90; idem, "A Cñtique ofB6hm-Bawerk's Reasoning in Support of His Time PreferenceTheory," in Percy L. Greaves, Jr., MisesMade Easier:A Glossa,jforLudwig ronMises'Human Action(New York: Free MarketBooks, 1974),pp. 150-57.2. See Israel M. Kirzner, "Ludwig von Mises and the Theory ofCapital and Interest," in The Economic$of Lu.d.wig ron Mises: TowardaCriticalReappraisal,ed. Laurence S. Moss!KansasCity:Sheed & Ward,1976), pp. 61-65. Kirzner wrote, "Mises views on capital and on interestmaybeconvenientlysummarized as follows.., interest expressesthe universal.., phenomenon of time preference and will thereforeínevitably emerge also in a pure exchange economy without production"(p. 53).Weate trying to explain what Mísescalled"originaryinterest," whichis the market rate of interest less a premíum for uncertainty (or risk)and less the anticipated tate of price inflation.3. Mises,Hu__n Action, pp. 458, 528, 532.4. On Fetters contribution, see the introductionto FrankA. Fetter,Capital,Interest, avalRent: Essaysin the Theoryof _, ed.Murray N. Rothbard (Kansas City: Sheed Andrews and McMeel,1977), pp. 1-24. On Mises' adoption and subsequent dissatis-

The Emergence of Interest in a Pure Exchange Economy 165faction with B6hm-Bawerk's theory_see Ludwig von Mises, The TheoryofMoney and Credit (New Haven: Ya_e University Press, 1959), p. 24;Kirzner, "Mises and the Theory of Capital," p. 52; and Mises, "ACñtique of B6hm-Bawerk's Reasoning in Support of His Time PreferenceTheory," in Pero/L. Greaves, Jr., Mises Made Easier (New York:Free Market Book, 1974), pp. 150-57.5. See Ludwig M. Lachmann, "On Austrian Capital Theory," inThe Foundations ofModern Austrian Economics, ed. Edwin G. Dolan (KansasCity: Sheed & Ward, 1976), pp. 145--51.6. Cf. Friedrich A. Hayek, "Time Preferente and Productivity: AReconsideration," Economiza 12 (February 1945): 22-25.7. Murray N. Rothbard, Man, Economy, and State, 2 vols. (NewYork: D. Van Nostrand, 1962), 1:350-56.8. CL R. A. Radford, "The Economic Organization of a P.O.W.Camp," Economiza 12 (November 1945): 189-201.9. I ana also assuming that the apples do not spoil and thatthere is no possibility of theft or accidental destruction.10. There ate no fraudulent traders in our model economy; accordingly,without production one cannot promise to pay more than one'sassets wiU atlow.11. If the marginal utilky of an apple in period mis significantlygreater than the marginal utility in period n, then the individual woulddo better m reallocate his apples out of period-n consumption and intopeñod-m consumption. By the familiar law of diminishing returns themarginal utity of apples in pefiod m falls and rises in period n. Thiswill continue so long as the marginal utilities in any two periods arelarger than some vídue say _, í.e.,When (MU..-MU.) > _ then apples ate transferredfrom period n to pefiod m.The size of _ depends on the perceived opportunity costs of makingsuch a transfer. This last value will differ among individuals. When 4, issmall and the same for all consumers, then reallocation will continueuntilMUro = MU..Multiplyingyields,both sides of this equality by Ad and dividing by MUnMUm/MUa = AA/AANow the left-hand side is the marginal rate of substitution for any

166 New Directions in Austrian Economicsindividual and the right-hand side the"terms of trade" between periodm and n which is 1 by the assumptions of this model.12. This is ah important point. B6hm-Bawerk and other writerstried to explain interest by postulating a psychological tendency forindividuals to systematically underva/ue their future needs. Besidesbeing bad psychology, in that it disregards at the very least the paranoidmiser who does quite the opposite, such misvaluation is ruled out by myassumption of certainty about future conditions and needs. Cf. Mises,"A Critique of B6hm-Bawerk's Reasoning," pp. 150-55.13. Irving Fisher, The Theory of lnterest as Determin_ byImpa.6erwetoSpend Inco_w and Opportunity to InveJt Ir (New York: Macmillan Co.,1930), pp. 61-68; see also, for example, Gilbert R. Ghez and Gary S.Becker, The AUocation of Time ami Goods over the Life Cycle (New York:National Bureau of Economic Research, 1975), pp. 8-14.14. This is how I interpret the following passage by Mises in thecontext of ah n-peñod model: "Whoever eats and consumes anythingismaking a choice between a satisfaction in the immediate future and onein the more distant future. Ifhe were to decide differenfly, that is, ifhewere not to prefer the earlier to the later satisfacUon, he would never beable to consume at aU. He could not even eat and consume tomorrow,because when tomorrow became today; and the day after tomorrowbecame tomorrow, the dedsion to consume would still call for valuingan earlier satisfaction more than a later satisfaction. Otherwise, consumpUonwould have to be delayed still further" (Mises, "ACritique ofB6hm-Bawerk's Rcasoning," p. 157).15. See Roge r W. Garñson, "Reflections on Misesian Time lh'eference"(paper presented at Seminar in Austrian Economics, Universítyof Virginia, April 1975), pp. 4-5.16. Mises, Human Act/on, p. 489; see also Garrison, "Reflections,"pp.9--13.17. EugenvonB6hm-Bawerk, PositiveTheoryofCapital,'inCap/-talandlnterest, trans. C,eorge D. Hunche and Hans F. Sennhoh (SouthHolland, IU.: Ia'bertarian Press; 1959), pp. 10-12.

AustrianMacroeconomics:A DiagrammaticalExpositionRoger W. GarrisonUniversityof VirginiaINTRODUCTIONThe object of this paper is the development ofa diagrammaticmodel representing the Austrian view of macroeconomic relationships.More explicitly, the model will be designed to faithfullyreflect the macroeconomic relationships found in the wñtingsof Mises,1 Hayek, 2 and Rothbard. s At this stage in its developmentthe model is little more than a skeletal outline. It is aframework that can facilitate a fuUer discussion of the actualadjustment mechanism: ".heprocesses by which the economy ismoved toward ah equilibrium posidon. Because of the brevity ofsuch discussions in this paper, the model may appear to beunfaithful to the Austrian view in one respect: It focuses onaggregates rather than on processes. Hopefully, this unfaithfulnessis only apparent. Although the model is constructed withaggregate quantities and deals with the relationships betweenthese quantities, no attempt is made to "explain" one aggregatein temas of another. It is fully recognized that, ultimately, eachaggregate must be explained or accounted for in terms of theGraphks by Cheryl L Mallory167

168 New Directionsin AustrianEconomicsindividual choicesand actionsof market participants.It isin thissense that the model is consistent with the methodological indi-Vidualista so characterisficof Austrian theory.Before we begin the actual construction of the model, a previewof some ofits prímarycharacteristicsmay be in order. Thepurpose of the preview is twofold. Firstly,it willsuggest that themodel is in factworth developing. Manyof the following characteristicsate desirableones and gire the Austrian modelan edgeover the more orthodox models. Secondly, it should help thosereaders uninitiated in Austrian macroeconomics to follow thedevelopment of the model more easily.1. The capital stock in Austrian theory is made up ofheterogeneous capital. The relationship between the variouspieces of capital can be one of substitutability or complementarity.The individual pieces of capital (both fixed and circulating)are integrated into a "structure of production." (Although thenature of capital is obscured by simplifying assumptions in thefirst section of this paper, it is taken into account more fully insubsequent sections.)2. The size of the capital stock is treated asa variable in themodel. The usual assumption is that even though investment ofsome positive amount is realizedeach peñod, the stock of capitalremains constant. 4 With the Austrian model this assumpon isunnecessary. This has the important consequence ofintegratingmacroeconomic theory, growth theory, and business cyclethe0ry. Explanatiom of both growth and cyclicadactivity atebased on the same macroeconomic modeL$. The Austrian model is not a full-employment model in thesense that it ass,mes full employment. The analysis does begin,however, with an economy that is fully employed: "[W]e have tostart where general economic theory stops; that is to say at acondition of equih'briumwhen no unused resources exist. Theexistence of unused resources is itself a fact which needs expianation."6The model does in fact explain the almorm_11yhigh

Austrian Macroeconomics:A Diagrammatical Exposition 169levels of unemployment that accompany the contraction phaseof the business cyde.4. The Austrian model takes explicit account of the time elementin the production process. It does not simply add "lags" asan afterthought to an otherwise timeless model. It accounts forthe fact that production takes time and that more productiontakes more time.5. Austrian macroeconomic theory is not a theory of real incomedetermination. Ultimately, it is a theory of coordinatione---ofhowthe production process is co-ordinated withthe tastes of individuals (their time and liquidity preferences),and how monetary disturbances affect this co-ordination. Becauseofits focus on the co-ordination problem, there is no sharpdistinction between Austrian macroeconomics and Austñanmicroeconomics.THE STRUCTUREOF PRODUCTIONOne of the most distinctive features of Austrian macroeconomictheory is its use of the concept of a "structure ofproduaion. "7 This concept was formulated to give explicit recognitionto the notion that capital (and the capital structure) hastwo dimensions. It has a value dimension which can be expressedin monetary temas, and it has a time dimension which is anexpression of the time that elapses between the application of the"oñginal means of produaion "a(labor and land) and the eventualemergence of the consumption goods associated with them.The development of the notion of two-dimensional capital hasits roots, of course, in the writings ofJevons, g It can be tracedfrom Jevons to Cassel lg and B6hm-Bawerk 1_ and then toMisa, ls and from Mises to Hayek, ls Rothbard, _4 and othercontemporary Austrian theorists. This view of capital, then, isneither new nor is ir strictly Austrian, yet the notion of two-

170 New Directions in .dustrian Economicsdimensional capital is by no means readily a¢cepted by capitaltheorists in general.A third though not independent dimension of capital can beenvisaged which represents a composite of the two dimensionsdescribed above. Again, Jevons was the first to synthesize thisthird dimension. He made the distinction between the "quantityof capital" and the "length of me duñng which it remainsinvested." He then devised the third dimension of capital by"...multiplying each portion of capital invested at any moment bythe length of time for whích it remains invested. 'q6 The compoundingofinterest was ignored for the sake of simplicíty. Theresulng composite dimension was shown to have the units of"dollar-years." (The units are Americanized here. Jevons, ofcourse, used "pound-yearsY) _sCassel foUowed thirty years later with a similar formulation:"... interest is paid in proportion to the capital lent and inproportion to the duration of the loan, i.e., in proportion to thepr0duct of value and time" (emphasis added). _7Cass;el'sproductand Jevons's composite dimension measure the _me thing.They are indic.ations of the extent to which capital is "tied-up" inthe production process. No chito is made here that this productcan be calculated dírectly, but ff we can conceive of interestincome and of the rate of interest_ then we can conceive of thiscomposite dimension of capital--the amount of "waiting" orpostponement ofconsumption brought about by the payment ofinterest.This compositedimermionwill be referred to as "aggregateproduction time"_sor simply as "production time." For sure,there ate problemsin aggregating(evenconceptually)the productiontime associatedwith different piecesof capitaljustasthere ate problems with all macroec_nomic aggregates. Much_mbiguity will be avoided, however, by using the concept ofag_gat_ produoion time rather than amrage produaion timeor average peñod of produaion. These latter concepts were usedby both Jevom lp and B6hm-Bawerk, n but were rejected byMi,__,sI Hayek, n and Rothbard. n Many of the problems ofl_hm-Bawerk's capit_l theory had their roots in his use of the

Austrian Macroeconomics:Á Diagrammatical Exposition 171average period of production: Because the denominator of hisaverage was the value dimension of the structure of production(value reckoned in labor units), and because changes in thenumerator of his average are typically accompanied by changesin the denominator in the same direction, the direction ofchange in the average period of production is generally ambiguous.Further problems derive from B6hm-Bawerk's incautiousgeneralizations about changes in the average peñod of productionthat were based on the analysis of ah oversimplified model.With a full awareness of the difficulties of working with aggregatesin general and of working with aggregate production timein particular, the structure of production wiUbe defined in termsof the value of the capital at each stage in the producfion processand the aggregate production time associated with the process.The difficulties encountered by B6hm-Bawerk will be avoidedby relying on a somewhat less rigorous interpretation of"changes in aggregate producfion ame," but discussion of thisinterpretation will be deferred to a later section of the paper.The actual modeling can begin with an examination of earliertreatments of the structure of production.The first graphical representation of the structure of productionin the Austrian literamre is found in Prices and Production inthe forro of the famous Hayekian triangles. 24Such a triangle hasbeen reproduced in Figure 1. (The axes have been reversed forconvenience of exposition.).Hayek envisaged a vertically integratedproduction process in which the "... original means ofproduction are expended continuously duñng the whole processof production."25 Again, "original means" refers to thenon-produced (or non-reproducible) means of produaion, i.e.,to labor and land. (In our discussion we will associate the originalmeans with "laborers" and the produced means with"capitalista." The terms laborers and capitalists, of colarse, areused in a functional sense and do not refer to particular individuah.)The produaion process begins at point T in Figure 1and proceeds leftward. At the conclusion of the process consumptiongoods with a dollar value ofOY emerge. At point T nocapital exists. At point D, one of the intermediate stages of

172 New Directions in .dustrian Economicsproduction, there exists capital with a dollar value ofDD'. Thiscapital can be viewed as simply the unfinished consumpdongoods that will be valued at OY when the producon process iscomplete&#Y0 D _ tzt.e TFigure 1iInThe Hayekian triangle has two mutually re-enfordng interpretations."On the one hand, it can depict the flow of capitalin real time from its incepon at point T through the numerousstages of produaion until it emerges as comumption goodsvalued at OF. This is the interpretation adopted in the precedingparagraph. On the other hand, ir the produaion proce, is ineq_ñlibrium, or to be more vivid, ffit is in the state referred to by

Austrian Macroeconomics: ,4 DiagrammaticalExposition 173Mises as the "evenly rotating economy,''27then the triangle representsall of the various stages of production that co-exist ateach and every point in time. At any given point in time, forinstance, consumption goods OY wiUbe emerging from theproduction process, and at the same time the unfinished goodsDD' wiUbe in existence destined to emerge ata later date asconsumption goods.The dollar amount represented by DD' is less than that representedby OY for two reasons. Firstly, addifional quantities ofthe original means (i.e., labor) are yet to be applied to the unfinishedproduct that exists at point D. Secondly, OF and DD'represent consumption goods available at different points intime. If OF is available now, DD' willbe available for consumpfiononly at some future date. DD', then, is discounted withrespect to OF. To separate these two influences on the value ofDD' with respect to OF, the model wiUbe modified. Instead ofconceiving, as Hayek did, of a process in which the originalmeans of production are applied continuously, wewillconceiveof a production process in which the original means are appliedonly at the beginning of the process. The Hayekian triangle isabandoned in favor of a trapezoid. In Figure 2, the productionprocess begins at point T with the application of labor serviceshaving a dollar value ofTF. These original means grow in valueas the), pass through the numerous stages of production, finallyemerging as consumption goods valued at OY doUars.A second modification has been made in Figure 2. The horizontalaxis now represents the aggregate production time (APT)associated with the structure of production. This allows therelaxation of the assumption that the structure is characterizedby complete vertical integration. The slope of line b3", then,represents the rate of increase in value per urt of time per dollarinvested at point T. That is, the slope of line FY is the (simple)rate of interest (profit) when the economy is in equilibrium.Of course, this is a highly stylized representation of the actualstructure of production. The development of the Austrianmodel, however, willbe accompanied by discussionsof the actualprocesses that take place in the real-world structure of produc-

174 Neto Directions in dustrian Economicstion. These discussions will recognize that capital and laborservices are applied in each of the stages of production. Changesin the structure, for instance, will be couched in terms of laborYFO............ APTTFigure 2and capital being moved out of the stages relaÚvely dose to thefinal (consumption) stage and into stages relatively remote fromthe consumpon stage (or v/ce versa) in response to (intertemporal)pñce changes and profit opporturdes. This correspondsto a lengthening (or shortening) of the structure. Changes in theshape of the stylized representation of the structure of productionw_dlbe an indication of the nature of the changes in thereal-world structure.

Austrian Macroeconomics:_ Diagrammatical Exposition 175INTERTEMPORALEXCHANGEIntertemporal exchange is the exchange of present consumptiongoods for future consumption goods and v/ce versa. Thistype of market transaction is generally introduced by first allowingfor pure consumption loans only. Investment loans arebrought into view only after consumption loans have establishedsome initial terms of trade in the intertemporal market. TheAustrian model, though, will account for intertemporal exchangeby initially abstracting from the pure consumption loan.This will allow us to focus on the type of intertemporal exchangethat is inherent in the production process. The intertemporalmarket, then, can be thought of as dealing with direct purchasesof invest_ment goods as well aswith loans made for the purpose ofpurchasing investment goods.In the context of the present model intertemporal exchan'gecan be accounted for in terms of the original means of production,i.e., in terms of the market for labor services. The laborservices represent future consumption goods, which is to say thatthey can be converted into consumpon goods only by allowingthem to pass through the time-consuming production process.Laborers sell their services (future consumption goods) receivingin exchange dollars that can be used to purchase presenflyexisting consumpon goods. The sale of labor services, then,consmtes the demand for present goods (and the supply offuture goods). Looking at the other side of the market forintertemporal exchange, the labor services are purchased by thecapitalists. The capitalists exchange dollars for labor servicesand, ipsofacto, register a demand for future goods. At the sametime they constitute the supply of present goods. (Of coune, thisis an "excess" supply: At the end of the production process thecapitalists own OY of consumption goods. They consume OY-TF and supply the remaining TF to the laborers.)The supply and demand for present goods are representeddiagrammacally in Figure 3. This market for intertemporalexchange is equilibrated by adjustments in the intertemporalpñce ratio-4he rate of interest. The particular shape and posi-

176 New Directions in .dustrian Economicstioning of these curves is determined by the individuals' (laborels'and capitalists') relative evaluations of presentas opposed tofumre goods, i.e., by their time preferences. The technical aspectsof transforming the labor services into consumption goods, asmight be represented by a technical transformation function,ate kept in the background here. The Austñan model focusesnot on the technical considerations per se but rather on thealternafive combinafions of present and future goods that indi-||||O|AFigure 3viduals perceive to be possible. Of course, when the economy isin equilibrium (the Misesianevenly rotatingeconomy),individuals/mozowhat alternatives arepossiblesothatthetransformationsthat are perceived to be possible and the actual trans-

,4ustrian Macroeconomics:,4 Diagrammatical Exposition 177formations are one and the same. When the economy is out ofequilibrium, however, individuals will act on the basis of whatthey perceive the possibilities to be and not on the basis of whatthe possibilities actually ate in some technological sense. This(fundamentally Austrian) distinction is an important one andwill come hato play in understanding the workings of the Austñanmodel under disequilibrium conditions.Rothbard makes use of a diagram essentially identical to theone in Figure 3.28 He points out that the intersection of the twocurves determines the equilibrium tate of interest and theequilibrium amount of (gross) savings. (Net savings are zero.)Given the stylized structure of production of the present model,these (gross) savings manifest themselves as payments for laborservices. When the economy is in equilibñum, the tate of interestis given by OB; the total payment for labor services by OA.OTFigure 4q_q íIt should be noted at this point that OA in Figure 3 measuresthe same payment that is measured by TF in Figure 2. In recognitionof this connection between the market for intertemporalex¢hange and the structure of production, Figure 3 can be• mverted, rotated, and juxtaposed with Figure 2 to yield thesummary diagram shown in Figure 4. There ís a second connec-

178 New Directions in/lustrian Economicstion between the two panels of Figure 4. The rate of interest isrepresented by OB in the ñght-hand panel and by the slope ofthe line FY in the left-hand panel. In equilibrium, of course,these two representations must reflect the same tate ofinterest.It may be helpful at this point to show the relationship betweenthis simple Austrian model and the corresponding Keynesianmodel. The point of commonality is the maguitude OY whichrepresents the equílibñum dollar value of consumption goods.In the simple Keynesian model point Y is the íntersection of theconsumption function and the 45°reference line. OY is thedistance from that intersection to the horizontal (or vertical) axis.Figure 5 shows the two models drawn on vertical planes perpendicularto one another and intersecting along OF. O"his compañsonmay do some violence to the Keynesían model in that aUmagnitudes are expressed in doUar terms rather than realtemas.)r,cl Ị_71__"__.......- ._1,,,,- ..c_¢vI¢E_'/VE'sIAN MODff LFigure 5

lgstrian Macroeconomics:d Diagrammatical Exposition 179INVESTMENTIn order to deal with (net) investment an addionalrelationshipmust be introduced into the model, namely the relationshipbetween the quanty of capital (dollar value) in the structure ofproducon and the production time associated with ir. ("Quantityof capital" here refers to a/l the capital in the structure ofproduction. In Figure 2 it referred to the quanty that exists ateach stage of the structure of production.) Although these twodimensions of the structure of production (quanty of capitaland production time) are defined independently ofone another,there is, according to Austñan theory, a relationship betweenthem. Again, this relatiomhip has its genesis in the wrifings ofJevons: "Capital simply allows us to expend labor in advance. ''z°More capital, Jevons went on to show, allows us to expend laborfurther Unadvance, s°The positive relationship between capital and production timehas suffered several set-backs during its development. B6hm-Bawerk, for instance, couched it in terms of the "average periodof production," inadvertently causing the formulation to be ambiguous.But Mises and the contemporary Aus'tñan theofists(e.g., Hayek and Rothbard) fully recognize the errors in B6hm-Bawerk's formulation, s_ The), stiU accept, however, the basicnotion that there is a positive relatiomhip between the quantityof capital and the production time associated with it. Mises, forinstance, argues that".., every increase in the supply of capitalgoods available results in a lengthening of the period of production,and of waitingtime,..." and conversely that "... [alaincrease in the quantity of capital goods available is a necessarycondition for the adoption of processes in which the peñod ofproduction and therefore waiting time are longer. "3s Similarstatements can be found in Rothbard's formulation: "Any increasein capital goods can serve only to lengthen the structure,i.e., to enable the adopon of longer.., processes. "34Hayek points out the difficules of talking about "changes inthe period of produaion" when the term refers to the actual

180 New Directionsin Austrian Economicsaggregation of investment periods. He goes on, though, to saythat.., sincetheuseoftheexpression"changesinthelengthof theprocess"is a convenientway of describingthe type of changesin the wholeprocesswhere the changes in the investmentperíodsare predominantlyin one direction,there is probablysomething to be said forretainingit, providedthat it is usedcautiously.... ssWith this somewhat less rigorous view "changes in productiontime" is more of a "shorthand" for the type of changes beingmade to the structure of production than a change in a genuineaggregate.The relationship between the quantity of capital and productiontime has been caUed into question in recent years by theso-called "double-switching and capital-reversing debates."s'The possibilityof capital reversing (vhich involves an apparentviolation of the Austrían relationship) has been the source ofmuch controversy in Cambridge capital theory. Although thereis good reason to believe that the problems created by doubleswitching and capital reversíng are confined to the Cambñdgeparadigm itself, the Austñan model wl eventually have to bedefended against the Cambridge charges. But this task willnotbe undertaken here. Rather, our concern with the problem willend with the observation that even those who think that capitalreversing is possible consider it extremely unlikely: "[Capitalreversing] could happen, but it looks like being on the edge ofthings that could happen. "sT(I)The positive relationship between the quantity of capital (d'ollarvídue) and production time isintroduced diagrammaticallyinthe upper panel of Figure 6. The "wavy" shape of the curve issimpl_ a way ofindicating that no cl_imsare made about the rateof change in the slope of the curve. The only figuificant featureof the curve is that its slope is positive. That the curve shouldbegin at the oñgin seems obviom enough: There can be noproduaion time if there is no capital. The origin, then, mayrepresent the hand-to-mouth existence of a Robinson Crusoe,

Austrian Mazroeconomics:A Diagrammatical Exposition 181K.l"K ............................ .Ko/AAPTOINE-APTY K°i Z_APTOTFigure 6_T

182 New Directionsin .4ustrianEconomicsbut for purposes of developing the Austrian model, this is atrivial aspect of the diagram.The "initial" produaion time is OT as indicated in the lowerpanel of Figure 6. This panel, of course, is the now-famil_arstructure of production. (The word "initiar' is used here in anarbitrary sense: It does not refer to the starting point of theproduction process but rather to the starting point of ouranalysis.) The initi_! dollar value of capital corresponding toproduction time OT is represented by OK in the upper panel.Ir the origin in the upper panel is shifted from O to Ko, thenthe portion of the curve extending northeastward from Ko willrepresent the relationship between/nv_tment and changes inproduction time. This is the relevant portion of the curve. Thetei:a_"investment" in the Austrian model is defined in a slighflyunorthodox manner. It is not the tate of increase in the quantityof capital, but rather the addition of a quantity of capital measuredwith respect to the initial quantity Ko. It is measured indollars rather than dollars per year.At this stage in the constructíon of the model, investment cancome about only at the expense of consumption. (Investmentmade possible by the creation of new credit willbe dealt with inthe following section.) The relationship between investment andconsumption can be shown byinverting the northeast portion ofthe upper panel and lowering it until the horizontal axis isaligned with point Y of the struaure of production. Ifan investmentofK,/is made, for instance, it is made at the expense ofconsumption lq'_. In view of the faa that investment is to be ahendogenous variablein the Austrian model, it is probably preferableto state the relationship in another way. If a change in ahexogenous variable brings about an investment of Ko/, it, ipsofacto, brings about a decrease in consumption of Irg,.The diagrammatics developed to this point ate shown in Figure7. This model allows us to determine the changes in thestructure of production that are brought about by shifts in thesupply and demand curves of the intertemporal market. Theseshifts can be thought of as resulting from changes in individuaAs'relative evaluation of pre'_nt as opposed to future goods, i.e.,

.4ustrian Macroeconomics:.4 Diagrarnmatical Exposition 183_¿g: , . i./"i _i I; I| oIsi i 'i ii• 7-

184 New Directions in Austñan Economicschanges in their time preferences. A decrease in the time pret_rencesof laborers, for example, can be represented by a shift inthe demand for present goods from DpgtoD'pg, which intersectsthe original supply-of-present-goods curve at coordinates 0,4'and OB '. (To this point the magnitude 0,4 has been taken torepresent both the amount paid for labor services and the dorarvalue of present goods consumed by laborers. For this equality tohold requires the tacit assumption that laborers are neitherincreasing nor decreasing their cash holdings. However, ff thedemand for present goods shifts without causíng a correspondingshift in the supply of present goods (demand for futuregoods), then there must be a change in the cash holdings oflaborers (from Walras's Law). That is, a shift in just one of thetwo curves, Dpg and Spg, must correspond to a change in bothtime and liquidity preferences. OA, then, represents the dollarvalue ofpresent goods consumed by laborer: which equals theamount paid to laborers minus the change in their cash holdings.(For our immediate purposes, though, this change in cash holdingswiU be kept in the background.)The diagrammatic representation of the structure of produconis uniquely determined by the shift in the demand forpresent goods. The amount of present goods advanced to laborersis now T_F'(=OA _),and the new equilibrium rate ofinterest isOB_(

Austrian Macroeconomics:A Diagrammatical Exposition 185creates profit opportunities that cause the capitalists to bid capitaland labor services away from the stages of production relativelyclose to the final (consumption) stage and into stagesrelavely remote from the consumption stage. They are alsoinduced by the lowering of the interest rate to create additionalstages that had previously been unprofitable. 38Although the dollar expenditure on consumption goods decreasesfrom OY to OY', consumption in real terms decreasesonly temporarily and then rises to a new high once the additionalinvestment comes to fruition. It is this additional quantity ofconsumption goods coming into the market, of course, thatallows the prices of consumption goods to be bid down to a levelconsistent with OY'.The above description of changes in the structure of produconbrought about by a decrease in time preferences is verysimilar to the discussion found in Prices and Production of thechange in the shape of a Hayel6an triangle brought about byvoluntary savings:If wecomparethetwodiagrams[representing the structureof productionbefore and after the change in voluntary savings]we see at oncethat the nature of the change consistsin a stretching [of the structure].... Its[height at the finalstage], whichmeasure,sthe amountof moneyspent during the period of timeon consumers goods.... has permanentlydecreased.... This meansthat the priceof a unitof consumen'goods, the output of whichhasincreasedasa consequenceof themorecapitalistícmethods of production,will fall.... The amount of moneyspent in each of the laterstagesof productionhasalsodecreased,whilethe amount used in the earlierstageshasincreased,and the totalspenton intermediate productshas increasedalso becauseof the additionot•.. new stage[s] of production,sgAlthough the price level and the real level of consumption areaccounted for in the discussion of the workings of the Austrianmodel, they do not appear in the diagrammatical representationin any explicit form. Austrian macroeconomics has never beenconcerned direcdy with the general price level, but has beenconcerned instead with the rdative price of consumpfion goodsas opposed to investment goods---or, in terms of the present

186 New Directions in Austrian Economicsmodel, the relative amounts paid for consumption goods as opposedto labor services. This is a fundamental aspectof Austriantheory that sets it apart from the more orthodox macroeconomictheory. Patinkin, for instance, lumps "consumer commodities"and "investment commodities" into a single aggregate and thentells us that"... [t]he pñces of these two categories ate assumedto change in the same proportion. "_° By disallowing relativeprice changes between these two categories of commodities,Patinkin puts the structure of production in a straightjacket.This throws the entire burden of moving the economy from oneequilibrium position to another on the real cash balance effect? aA shift in the supply of present goods from S_ toSpg" could bethe result oía decrease in the time preferences ofcapitalists. Theeffects of this shift on the structure of production can beanalyzed in the same manner and with similar results. The newequílibrium (associated with Dpg° and Sp_') is shown withdouble-prime notation. The only _ignificant difference is thatthe amount of present goods consumed by laborers has increasedwhen before it decreased. But this difference was to beexpected: A decrease in the time preferences of/aborers meansthat they are willing to consume fewo" present goods now inorder to enjoy greater (real) consumption later; a decrease in thetime preferences of cap/ta//sts means that they are willing toadvance more present goods to laborers now in order to erijo),more (real) consumptíon later.A change in time preferences is not the ordy change in tastesthat can cause a shift in the supply and demand for presentgoods, although it seems to be the one that the Austrian theoristsare most concerned with. But shifts of the curves can also resultfrom changes in the demand for money, e.g., from increases ordecreases in liquidity preferences. (Hayek was aware in his earlywritings of the need to incorporate the analysis of liquiditypreferences into Austrian macroeconomic theory.) ° To accommodatethe analysis of liquidity preferences the structureof-producUondiagram must be interpreted so as to include cashbalances. In other words, OY must indude the quantity of cashbalances "consumed." Where a change in tLrae preferences

Austrian Macroeconoraics:A Diagrammatical Exposition 187(laborers' and capitalists') will cause both curves of the intertemporalmarket to shift either east or west, a change in liquiditypreferences (laborers' and capitalists') will cause both curves toshift either north or south. A neutral change in liquidity preferentewould be one in which both curves shiftedjn such a way asto leave the rate of interest unchanged. The effects of a changein liquidity preferences can be analyzed in temas of the Austrianmodel of Figure 7, but the details will not be described here. Itcan be said, however, that the results of such ah analysis, whetherthe change in liquidity preferences is neutral or non-neutral,confront us with no surprises.cKo_.....,_P 'P_'R_FN_S IAN MODELFigure 8In concluding this section it ma), be helpful to follow up on thecomparison of the Austrian model and the correspondingKeynesian model. The two models are shown in Figure 8 in thesame formar aswas used in Figure 5. There are now two points ofcommonalit 7. In addidon to the common dollar value of consumpfiongoods, the amount of (exogenous) investment in theKeynesian model corresponds in the Austrian model to the

188 New Directions in/lustrian Econoraicsamount of (endogenous) investment brought about by a shift inthe demand for present goods. Again, the problems created byexpressing the Keynesian model in dollar temas rather than realterms ate overlooked.MONETARYDISTURBANCE$To this point it has been implicitly assumed that the economyis free from monemry disturbances. Clmnges in the endogenousvariables were brought about only by actual changes in thepreferences of laborers and capitalists, by shifts in the supplyand demand for present goods reflecting changes in time (orliquidity) preferences. In this section the supply ofmoney will beintroduced as an exogenous variable in the Austrian model, andits effects on the intertemporal market and the structure ofproduction will be analyzed. To fácilitate this analysis the actualtime and liquidity preferences will be assumed to remain unchanged.The supply and demand for present goods as representedin Figure 3 will be fixed in place throughout the remainingdiscussion.In analyzing the effects of monetary dismrbances Austrianmacroeconomics is not concerned with increases in the quantityof money per se, but rather with the process by which the newmoney enters the economy. According to Hayek: "[E]verythingdepends on the point where the additional money is injected intoárculation. ''4sThus, when Hayek begins his investigation of the"... effects of a change in the amount of money in circulation...", he immediately turns bis attention to the" ... case mostfrequently encountered in practice: the case of ah increase ofmoney in the form of credits granted to producers. "44 Theprimary effect of a monetary expansion in the Austñan viewstems from the fact that newly created money (credit) tends tofall disproporÜonately into the hands of producers.By way of contrast the analysis of a monetary expansion inorthodox macroeconomics is generally begun by assuming thatthe new money is injected uniformly throughout the economy. A

Austrian Macroeconomics:A 1)iagrammaticalExposition 189familiar assumption, for instance, is that a helicopter dispensesthe newly created money and that individuals dash out into thestreets gathering up the new money in direct proporUon to theamount the}' already had. 45 In this sort of highly artificialscenatio it can easily be shown that money is neutral. No realmagnimdes ate changedmapart from a temporary increase incash holdings that causes all prices to be bid up. The only consequenceof an increase in the monetary stock, then, is ah equiproportionalincrease in the general pñce level. Consequencesof a nonuniform injection of newly created money, that is, of thefact that some individuals receive a greater share of the newmoney than others, ate categorized as "distribution effects."These effects ate considered to be of second-order (ornth order)importance and ate generally assumed away in order to get atthe "more fundamental" aspects of an increase in the stock ofmoney.4eBut money in the Austrian view should not be assumed to beneutral and cannot be shown to be neutral in any relevant sense."The notion of neutral money," according to Mises, is a contradicUonin terms: "Money without a driving force of its ownwould not, as People assume, be a perfect money; it would not bemoney al_all.''7 The relevant question, then, is not whether amonetary expansion is neutral of non-neutral, but rather howthe non-neutrah'ty manifests itself in a market economy. TheAustrian theorists have focused their attention on this questionand have been critical of other monetary theorists for ignoring it.Ha),ek, for imtance, criticized them for focusing" ... eitherexdusively of predominanfly [on] the superficial phenomenonof changes in the value of money, while failing to pursue the farmore profound and fundamental effects of the process bywhichmoney is introduced into the economic system, as distinct fromits effects on pñces in general. "4sA "neutral" monetary expansion is represented diagrammaticallyin Figure 9. The vertical axis represents the nominal magnitudeof the original stock of money (Mo), i.e., the stock inexistence prior to the monetary expansion. The horizontal axisrepresents the nomirml magnitude of the expanded stock of

190 New Direaiom in Austrian Economicsmoney (M_), i.e., the stock in existence after the expansion hasoccurred. The 45 °líne, representing the equalityM0 -Me, servesas a reference. A neutral expansíon can be shown, then, byrotang a line clockwise from the reference line.But if the expansion is achieved by extending newly createdcredit to producers, ir is not a neutral expansion. In the terminologyof the present model the newly created money f_llsdisproporUonately ínto the hands o£ capitalists (as opposed tolaborers). This can be represented diagrammaticaUy by showingseparately the increase in the quanty of money in the hands ofcapitalists and the increase in the quantity of money in the handsof laborers. In Figure 10 it is assumed for the sake of simplicitythat a//of the newly created money takes the form of creditextended to capitalists. Initi_lly, then, the laborers are completelyunaffected by the monetary expansion. This is representedín Figure 10 by M_r, which is coincident with the 45 °reference líne. Capitalists, on the other hand, experience aninifially amplífied monetary expansion as indicated by M)_. ButMoMoFigure 9 Figure 10as the capitalists purchase addiÜonal quanties of labor services,the new money fdters through the economy such that eventmdlythe expansion experienced by the laborers ís approximately thesame as the expansion experienced by the capitalists. This isindicated by the expansion lineM)_ _ M=L. The arrows indicatethe dynamics of the expansionas irappears to the capit_lkts andto the laborer_This non-neutral monetary expamion manifests itself asa

Austrian Macroeconomics:_ Diagrammatical Exposition 191temporary distortion in the intertemporal market. In terms ofthe Austrian model the expansion experienced by the capitalistsaffects the supplyoof-present-goods curve, while the expansionexperienced by the laborers affects the demand-for-presentgoodscurve. These two asymmetrical effects can be traced out bythe apparams of Figure 11. The upper panels represent thet_c"Mo , _o,I L_'__/ "-_l'"l___ ..............-!-:....;......................I _J'_L__. .: 7o i i!'_'oo. i! _: tI_2..........f' , S ......._o;. ...... í.....o # o ¿Figure 11monetaryexpansionofFigure]0 andtheintertemporal marketof Figure $. The southeast panel is a dummy diagram thatfacilitates the construcfion of the remaining panel. The southwestpanel, then, shows the effect of the monetary expansion onthe supply and demand for present goods. The supply curve,reflecting the behavior of capitalists, initially rotates clockwisefrom$ to $%while the demand curve, reflecting the behavior oflaborers, initially remains in place (D = D'). EventuaUy, though,as the new money becomes more evenly distributed, the supply

192 New Dírections in Austrian Economicscurve retracts to S" and the demandcurve rotates out to D".These final positions of the two curves correspond to the expansionline labeled M ", _ M"L in the northwest panel.Figure 11 illustrates that the rate ofinterest associated with the"real" parameters remains unchanged, i.e., that the supply anddemand curves in the northeast panel remain in place throughoutthe monetary expansion, while the apparent rate ofinterestnthe rate determined by the southwest p_ne! does not.The injection of newly created money causes the apparent rateof interest to fall from i to ir and then to rise back to a levelapproximating the original rate (i" _ i). This effect oran expansionon the rate ofinterest is, ofcourse, neither new nor uniquelyAustrian. The notion that a monetary expausion causes theínterest rate in the loan market to fall temporarily below the"natural" rate is commonly associated with the wrings ofWicksell. 4g(It might be added here that the Austrian model doesnot deny the existence of the Fisher effect. Ah anticipated increasein the price level would cause a price premium to be builtinto the nominal interest rate. But the present model abstractafrom this price premium justas it abstracts from the pfice levelitself. It focuses instead on relative prices. That the Físher effectcould completelyoffset the other movements in the tate ofinterestwould, of course, llave to be denied.)The intertemporal market, together with the monetary expansionmechanísm, can now be reunited with the rest of theAustrian modelas shown in Figure 12. AIIpanels are numberedto facilitate the discussion. The only new one is panel VI whichsimply shows the monetary expansion independent of the processby which the newly created money is injected hato theeconomy. This allows us to express the changes that occur inpanels II and III in temas consistent with the original monetarystock, that is, it allows us to focus on relative rather than absolutechanges.The monetary expansion shown in F'_,ure 12 is a neutralone---at least neutral with respect to capi_"_ts and laborers--asindicated by the single expansion line in panel IV. As might beexpected this neutral expamion has no effect on the structure of

Austrian Macroeconomics:A Diagrammatical Exposition 193!io'O. Q./_,,__

194 New Directions in Austrian Economicsproduction (panel II). Such an "expansion" could be achieved byrenaming the monetary unit: From this day on "one Dollar" willbe known as "ten Burlas." No real changes would result. The onlyconsequence would be the fundamentally uninteresting one (noteven shown in Figure 12) that the price level would increasetenfold. The expansion could be achieved instead by using thenotoñous monetary helicopter. There seems to be no reason tobelieve that the capitalists would gather upa disproportionateshare of the new money. And so, as before, the primary consequencewould be an increase in the price level reflecting theextent of the monetary expansion. Two differences, however, imake this expansiona little less sterile than the previous one. !IFirstly, the price level increases notas a matter of definition butas the result of a market process. Prices are bid up to the new ilevel as individuals attempt to draw down their newly acquired icash holdings3 ° Secondly, distribution effects among capitalists iand among laborers are not ruled out. Thus, the consumption 1goods are valued at OF both before and after the expansion, butthey are likely to be different consumption goods and to be !consumed by different individuals asa result of these distributioneffects. That this is the only change in panel II rests on theheroic assumption that the real-world structure of production isin fact suitable for produdng these different consumptiongoods.Ir the increase in the stock of money is achieved by the expansionof credit, there will be a systematic distribution effect thatcan be accounted for in the Austrían model. The expansion willbe experienced first by the capitalists and only later by thelaborers. This is illustrated in Figure 13. Unlike the monetaryexpansion of Figure 12, credit expansion has real effects on thestructure of production. Diagramma_I_ly, this is shown by theprime and double-prime notation in panel II. As the apparentrate ofinterest falls from i to i', the capitalists begin constructionof a structure of production that is to llave the configuraÜonOIOF'T'. But as the newly created money becomes more evenlydistributed among capitalists and laborers, the rate of interestrises toi" (_). The beginnings of the longer structure are then

Austrian Macroeconomics:A Dia_rammatical Exposition 195ii.............. °.......... . ........ ] ........................_'- 3.. _II

196 New Directionsin Austrian Economicsliquidated or abandoned in favor of the configuration OY"F"T"whichapproximates the originalstructure.The investment (andsubsequent dis-investment) represented in panel III by Ko/' isnot the result ofvoluntary saving(and voluntarydissaving)but is ithe result of the monetary disturbance. This is what Mises itermed mañnvestment51 and what Hayek called forced savings.5_The changes in the real-worldstructureof production can be ,described in temasof the relative profitabilityof short-term andlong-term projects. The economy is assumed to be in equilib- _.rium priorto the monetary expansion sothat allprojects (shorttermand long-term) are equally profitableat the margin. Whenthe interest rate falls, due to the expansion of credit, the long- Lterna projects, which by definifion involve disproportionatelyhigh interest expenditures, appear to become more profitable.Thus, the capitalists in their entrepreneurial roles bid labor andnon-specific capital away from the later stages ofproduction _ndinto the earlier stages and begin construction of whateverspecific capital is needed to take advantage of the (apparent)profitability of these long-term projects. But in the very processof constructing the new structure of production the newlycreated money flows from the capitalists to the laborers, and thedistribution of money comes to approximate the old, preexpansion,distribution. The laborers, whose tastes have remainedunchanged, and who now have their fuU share of thenew money, wiUbid for consumption goods in an amount consistentwith the old, pre-expansion, structure of production. Thatis, the), are unwilling to forgo current consumpon and to waitinstead for the consumption goods associated with the newlong-term projects. Their me preferences have not changed.With their bidding for consumption goods the rate of interestríses back to somewhere near its original level. The long-termprojects that appeared to be profitable during the expansion arerevealed to be unprofitable. The capitalists must act now to cuttheir losses. The minimizing of losses may require that some ofthe new long-term projects be completed. Others, however, wiHhave to be liquidated. The specific capital associated with them

Austrian Macroeconomics: A Diagrammatical Exposition 197will have to be abandoned. The laborers and non-specific capitalcan eventually be reabsorbed in the reconstruction of the originalstructure of production. But the transition back to the oldstructure is bound to involve abnormally high levels of unemployedlabor and capital. 53The two phases of the process that are initiated by a monetaryexpansion (the first phase corresponding to the prime notation;the second phase to the double-prime notation) should be recognizedas the expansion and contraction phases of the businesscycle. The above discussion and the diagrammatics of Figure 13ate faithful to Rothbard's capsulization of the cyclical boom andbust:The "boom"... is actually a period of wasteful misinvestment. Ir is thetime when errors ate made, due to the bank credit's tampering with thefree market. The "crisis" arrives when the consumers come to reestablishtheir desired proportions. The "depression" is actually the pro¢essby which the economy adjusts to the wastes and errors of the boom, andreestablishes efficient service of consumer desires. The adjustmentprocess consista in the.., liquidation of wasteful investments. Some ofthese will be abandoned altogether...; others will be shifted to otheruses ....In sum, the free market tends to satisfy voluntarily-expressed consumerdesires with maximum e£ficíency, and this includes the pub]ic'srelative desire for present and future consumption. The inflationaryboom hobbles this efficiency, and distorts the structure 0£production,which no Ionger serves consumers properly. The crisis signals the endof the inflationary distortion, and the depression is the process bywhich the economy returns to the efficient service of consumers, s4And final]y, it should be menfioned that to the extent that themalinvestment cannot be recovered there has been a net decreasein the economy's wealth. This can cause real changes intime and ]iquidity preferences (capitalists' and ]aborers') resultingin shifts in the supply and demand curves Di"panel I. To thisextent a monetary expansion is not neutral even in the long run.The Austrian model can be summarized in terms of the diagrammaticsof Figure 13. Panels I, II, and fil are the basiccomponents of the model. Panel I describes the tastes that aterelevant to the macroeconomic variab]es, i.e., the time and

198 New Directions in Austrian Economicsliquidity preferences of capitafists and laborers. Panel II depictsthe structure of production that is consistent with the tastesdescribed in panel I. Changes in these tastes will cause thestructure of production to undergo a corresponding changesubject to the relationship between capital and production timeas indicated in panel III. The remaining panels deal with themonetary linkages that translate the individuals' tastes into acorresponding structure of production. In the absence ofmonetary disturbances the structure of production can be expectedto accurately reflect the tastes descríbed in panel I. Thepresence of a monetary disturbance, however, will prevent thesetastes from being accurately reflected in the structure ofproduc- ition. More specifically, an increase in the monetary stock by imeans of credit expansion will mislead the capit_a!istshato makingan (ultimately unsuccessful) attempt to lengthen the structureof production.FURTHERSTUDYFurther development of the Austrian model outlined in thispaper could take any of several directions. The effects of variousinstitutional ñgidities could be analyzed in terms of the model,for instance, or the model could be modified to take explicitaccount of expectations ofone sort or another. Discussion will beconfined here, however, to one particular direction that appearsto be potentially fruifful. At the condusions ofearlier sections ofthis paper the Austrian model was contrasted diagrammaticallywith the Keynesian model, but no sucia contrast has been madesince the introducfion of monetary considerations. The appropriatecomparison, then, is one between Figure 13 and someversion of the 18.¿34 model. A few comments are in order abouthow such a comparison might be made.The key to the comparison of the two models is panel V ofFigure 13. The movements of the curves in this panel are suspiciouslysimilar to the movements of thelS andLM curves. Theaxes in panel V and in the I$-LM ¢Uagram measure the same or

Austrian Macroeconomics:A Diagrammatical Exposition 199similar magnitudes, and the concepmalizationthe two models bears a certain resemblance.of the curves inIn both models the vertical axis measures virtually the samemagnitude: IS-LM is concerned with the interest rate in the loanmarket, while panel V measures the apparent rate of interest,which encompasses the loan rate. Where the IS-LM diagrammeasures (real) total income on the horizontal axis, panel Vmeasures (nominal) income of laborers, that is, it exdudes interestincome. (It is not altogether clear, though, that interestincome is acmaUy induded in the IS-LM diagram in that theKeynesian full-employment income Y is the income ofN workersreckoned in "wage units.")Further, in elementary form-lations of the IS-LM model theIS curve is frequently conceptualized in a manner consistent withthe conceptualization of the corresponding curve in panel V.Dernburg and McDougal, for instance, teU us that "... ,,vemay... interpret the IS schedule as the schedule of aggregate demandfor goods and services with respect to the interest rate. "ssThe rate of interest referred to is clearly the tate in the loanmarket. It is somewhat less clear, though, whether "goods andservices" refers to present (consumption) goods or to all (consumptionand investment) goods. If the former interpretation isadopted, the corresponding curves in the two models are verysimilar indeed. Ir the latter interpretation is adopted, the actualmeaning of the concept-ali_ationis called into question: IfthelScurve is the demand for all goóds, who are the suppliers of aUgoods, and what are they receiving in exchange for the qu.antitysupplied? (I) The less-elementary macroeconomics texts do notclear up the problem. They usually avoid it by abstaining fromany,attempt to concept-ali_e theI$-LM curves. They are viewedinstead as simply an outgrowth of the graphics that describe thereal and monetary sectors of the economy. In a prelude to bisdiscussion of the IS-LM diagram Ackley tells us that _[w]emustnow throw aU these elements into a single pot, stir well, and tastethe resulting stew."ssViewing the supply and demand curves of panel Vas LM and18, respectively, a number of familiar movements of the curves

200 New Directions in Austrian Economicscan be described. A (non-neutral) increase in liquidity preferentes,for instante, can shift the LM curve up and to the left,causing the interest tate to rise; of a (non-neutral) increase in thewfllingness to save (decrease in time preference) can shift thelScurve down and to the left, causing the interest to rail. Changesin taste will cause real and lasting changes ín the IS and LMcurves, but changes in the nominal stock of money wiU not. Amonetary expansion will shift theLM curve to the right, drivingthe rate ofinterest down, but the monetary stimulation will onlyhave a temporary effect because the real sector will soon adjust tothe larger monetary stock. ThelS curve will also shíft rightward, :returning the tate ofinterest to its original level. A change in thenominal monetary stock does not cause a real and lasting changein the tate of interest.This is not to say that the Austrian model and thelS-1.51 modelyield the same or similar conclusions or have the same or similarimplications. Quite to the contrary. Equilibrium conditions cannotbe defined in temas of panel V of the Austrian model. Thispanel shows the movements of the apparent rate ofinterest andof the nominal income to laborers during the period that theeconomy is expeñencing a monetary dismrbance. Equilibriummust be defined in terms of panels I and II, i.e., in terms of therelevant tastes (time and liquidity preferences) and the structureof production corresponding to those tastes. It cannot be defmedin terms of IS.LM stew. Panel V does open the door,however, to a thorough comparison of the two models and theirimplications.NOTES1. Ludwig ron Mises,Human Ac&m:d Treatiseon Economi¢s,Srdrevised ed. (Chicago:Henry Regnery Co., 1966), pp. 538-86. AlsoseeMises, The Theory of Mon_ and Cr_d/t, trans, by H. E. Bat__, (NewHaven: Yale UniversityPress, 1953), pp. 339-66. And Mises, Money,IpílaÜon and the Trade Cycle: Three Theoretical Studies,"trans, byBettina Bien Greaves,ed. by Pero/T. GreavesJr. (Unpublished papers,1923, 1928, and 1931).2. Friedrich A. von Hayek, Pr/_ and Produce/on(New York: AugustusM.Keney,1967).A1soseeHayeL M_Ty _ aad _ Tra_

Austrian Macroeconomics: A Diagrammatical Exposition 201Cycb, tratas,by N. Kaldor and H. M. Croome (New York: Augustus M.KeUey, 1966).3. Murray N. Rothbard, Man, Economy, and State: A Treatise onEconomics, 2 vols. (Los Angeles: Nash Publishing Co., 1970), pp. 273--501, 850-81. Also see Rothbard, America's Great Depression (LosAngeles: Nash Publishing Co., 1972), pp. 11-38.4. See, for instance, Don Patinkin, Money, Interest, and Prices, 2nded. (New York: Harper and Row, Inc., 1965), p. 200.5. Hayek, Prices and Production, p. 34.6. Gerald P. 0 DriscoU,Jr.,Economics asa CoordinationProblem:TheContributions ofFriedri¢h A. Hayek (Kansas City: Sheed Andrews andMcMeel, Inc., 1977).7. Hayek, Prices and Production, p. 38.8. Ib/d., p. 36.9. W. Stanley Jevons, The Theory ofPolitical Economy, ed. by R. D.Collhon Black (Middlesex: Penguin Books, Inc., 1970), pp. 225-53.10. Gustav Cassel, The Nature and NecessityofInterest (London: Mac-Millan and Co., Ltd., 1903), pp. 96-157.11. Eugen ron B6hm-Bawerk, Capital and Interest, trans, by GeorgeD. Huncke and Hans F. Sennholz, 3 vols. (South HoUand, IU.:LibertarianPress, 1959), vol. 2., pp. 10-15 and pass/m.12. Mises, Human Action, pp. 493-503 and passim.13. Hayek, Prices and Production, pp. 36-68. Also, see Hayek, ThePri_ Theoryof Capital (Chicago: University of Chicago Press, 1941), pp.193-201 and pass/m.14. Rothbard, Man, Economy, and State, pp. 486-92 and pass/m.15. Jevons, Theory ofPolitical Economy, pp. 229-30.16. Ib/d., p. 230.17. Cassel, Nature and Necessity of lnterest, p. 54.18. Rothbard refers to this concept using the terna "aggregate productionstructure." Rothbard, Man, Economy, and State, p. 491.19. Jevons, Theory ofPolitical Economy, p. 231.20. B6hm-Bawerk, Capital and Interest, p. 312ff.21. Mises, Human Action, pp. 488--89.22. Hayek, Pure Theory ofCapital, p. 140ff. Hayek rejected the notionof aggregate as well as average production time except as the ternamight be used in a very loose sense. See lb/d., p. 70.23. Rothbard, Man, Economy, and State, p. 412.24. Hayek, Prices and Production, p. 39.25. Ib/d., p. 40.26. Hayek, Pure Theory of Capital, p. 113ff.27. Mies, Human Artrn, p. 244ff.28. Rothbard, Man, Economy, and State, p. 332.29. Jevons, Theor3 of Politi¢al Economy, p. 227.

202 New Directions in Austrian Economics30. lb/., p. 229.31. See footnotes 20 through 23.32. Mises, Human Action, p. 495.33. Ib/d.34. Rothbard, Man, Economy, and State, p. 487.35. Hayek, Pure Theory of Capital, p. 70. !36. G. C. Harcourt and N. F. Laing, eds., Capital and Growth(Middlesex: Penguin Books Ltd., 1971), p. 211. Also see G. C. Harcourt,Some Cambridge Controversiesin the Themy of Capital (Cambridge,England: The Cambridge University Press, 1972), pp. 118-76.I37. John R. Hicks, Capital and Time (Oxford: The Clarendon Preas, !1973), p. 44.38. Hayek, Prices and Production, pp. 49-54.t39. Ibid., p. 53. Also see Rothbard, Man, Economy, and State, pp. !470-79 where similar diagrammatics are used to depict changes in thestructure ofproducfion brought about by changes in time preferences.40. Patinkin, Money, Interest, and Pr/ces, p. 205.41. l/ñd., pp. 17-21 and pass/m.42. Fñedrich A. von Hayek, ProJ'Oa,I_terest and lnvestment (London:George Routledge and Solas, Ltd., 1939), p. 177.43. Hayek, Prices and Production, p. 11. Hayek reaffirmed this positionin hís Nobel lecture. See Hayek, Full Employment al Any Price?(London: Institute for Economic Affairs, 1975), pp. 23ff. and 37.44. Hayek, Pr/ces andProduct/on, p. 54. See also Mises, HumanAc6on,p. 556 and Rotñbard, Man, Econo_, and State, p. 885.45. Milton Friedman, The Optimum Quantity ofMono and OtlJ¿_'Essays(Chicago: Aldine Publishing Co., 1969), p. 4ff.46. Pafinkin, Money, Int¢rest, and Pric_s, p. 200 and pa.uim.47. Mises, Human dct/on, p. 418.48. Hayek, Monetary Theory and the Trade Cycle, p. 46.49. It should be pointed out, however, that the Wicksellian"naturaltate is the rate corresponding to a constant price level, while theAustrian "natural" rate is the rate corresponding to the absence ofmoney creation vía credit expansion. See Hayek, Mosu__ T_ andTrade C_le, pp. 109-16. Also see Rothbard,Man, Ewnowq, and Sta_,p. 940.50. This is the market proceu that captures Patinkin's attenfion.Patinkin, Money, Interest, and Prices, pp. 236-44.51. Mises, Human dct/on, pp. 559-61.52. Hayek, Pr/ces and Product/on, pp. 18-81, and Hayek, Profi,Interest and Inve#ment, pp. 183-97.53. Hayek accounts for this unsuccessful attempt to lengthen thestructure of production in terms of the Ricardo effect. See Hayek,Profita, lntereatandl_a__tt, pp. 8--15. Als0 see Hayek, "The Ricardo

Austrian Macroeconomics: A Diagrammatical Exposition 203Effect," Econm_a, IX, No. 34 (new ser.; Ma), 1942): pp. 127-52 reprintedin Hayek, Individualista and Economic Order (Chicago: HenryRegnery Co., 1972) pp. 220-54, and Hayek,"Three Elucidations of theRicardo Effect,"Journa/ofPoli_alEconoray, 77 (March/Apñ11969): pp.274-85.54. Rothbard,dmer/ca's GreatDepression, p. 19. Also see Lionel Robbins,The GreatDepression (London: The MacMillan Co., Ltd., 1934), pp.30-54.55. Thomas F. Dernburg and Duncan M. McDougal, Macroeconomi¢s(NewYork: McGraw-Hill Book Co., 1968), p. 161.56. Gardner Acidey, Macroeconomic Theory (Toronto: The MacmillanCo., 1969), p. 347.BIBLIOGRAPHYAckley,Gardner.Macroeconomic Theory.Toronto:The MacMillanCo.,1969.B6hm-Bawcrk,Eugen ron.Capital andInterest. TranslatcdbyGeorgcD. Huncke and Hans F.Sennholz.3 vols.SouthHolland,Ill.:Libcrtarian Prcss,1959.Cassel,Gusmv.TheNaturea__lNece£sity ofInt_est. London:MacMillanand Co.,Ltd.,1903.Dcrnburg,Thomas F.and McDougal,Duncan M.Mac_economics. NewYork:McGraw-HiU Book Co.,1968.Fñedman, Milton. The Optimum Quantity of Money and Other Essays.Chicago: Aldine Publishing Co., 1969.Harcourt, G. C. and Laing, N. F., editors. Capital and Growth.Middlesex: Penguin Books Ltd., 1971.Harcourt, G. C. Some Cambridge Controversies in the Theory of Capital.Cambridge, England: The Cambñdge University Press, 1972.Hayek, Friedrich A. von. FuU Employment at Any Price? London: Instituteof Economic Affairs, 1975.Hayek, Fñedrich A. von. Monetary Theory and the Trade Cycle. Translatedby N. Kaldor and H. M. Croome. New York: Augustus M.Kelley, 1966. (First published in 1933.)Hayek, Fñedrich A. von.Prices andProduction. New York: Augustus M.Kelley, 1967. (First published in 1935.)Hayek, Fñedñch A. von. Profas, lnterest and lnvestment. London:George Routledge and Sons, Ltd., 1939.Hayek, Friedrich A. von. The Price Theoryof Capital. Chicago: Universityof Chicago Press, 1941.Hayek, Friedrich A. von. "The Ricardo Effect," Economica, IX, No. 34

204 New Directions in Austrian Economics(new ser.; May, 1942) 127-52 reprinted in Individualista andEconomic Order. Chicago: Henry Regnery Co., 1972.Hayek, Friedrich A. ven. "Three Eluddations of the Ricardo Effect,"Journal of Political Economy, 77 (March/April, 1969): 274-85.Hicks, John R. Capital and Time. The C]arendon Press, 1973.íJevons, w. Stanley. The Theory of Political E¢onomy. Edited by R.D. !Collison Black. Middlesex: Penguin Books, Inc., 1970.IMises, Ludwig von. Human Action:.4 Treatise on Economics, 3rd rey. ed. JChicago: Henry RegneryCo., 1966.Mises, Ludwig von. "Money, Inflation, and the Trade Cyde: ThreeThcoretical Studies." Translated by Betfina Bien Gr_aves, editedby Percy L. Greaves, Jr., unpublished papers, 1923, 1928, and1931.Mises, Ludwig von. The Theory ofMoney and Cred/t. Translated by H. E.Batson. New Haven: Yale Universky Press, 1953. (First publishedin 1911.)O'Dríscoll, Gerald P., Jr. Economi¢s _ a Coordination Problem: TheCont6butions of Friedrich A. Hayek. Kansas City: Sheed Andrewsand McMeel, Inc., 1977.Patinkin, Don. Money, Interest, and Prices. 2nd ed. New York: Harperand Row, Inc., 1965.Robbíns, Lionel. The Great Depression. London: The MacMiUan Co.,Ltd., 1934.Rothbard, Murray N. Anwrica's Great Depression. Los Angeles: NashPublíshing Co., 1972. (First published in 1963.)Rothbard, Murray N. Man, Economy, and Stabe: A Trw_e on EconomicPrinciples. 2 vols. Los Angeles: Nash Publishing Co., 1970. (Firstpublished in 1962.)

Toward a Programof Research and Developmentfor Austrian EconomicsLouis M. SpadaroFordham UniversityI.Now that Austrian economics has entered its second century,it is both natural and useful--as the subject of the present conferenceimplies to look to the future and to tryto discern,aslaras is possible, the most promising directions along which ourdiscipline might develop further. Of course, the anniversarycustomarily also invites review and evaluation of past experience;itis, in fact, as the resultofsome reflection on the latterthatI venmre to make the single underlying suggestíon whích willbeseen to be the point of the present paper.While the centenary we are celebrating will be thought bymany to be that of the start of the "marginalist revolution," thefact is that the truly seminal insight was not the marginalanalysis--valuable as that analytical device admittedly was, andcontinues to be--but, rather, the strangely belated recognitionof the subjective namre of economic value and even of humanaction in general Ir is the special merit of Austrian economicsthat, wh_e it shares the concept of the margin with its simultaneous_co-discovererselsewhere,its distinctiveand characteristiccontribution has been its insistence on the explanatory power ofsubjectivism.For one thing, unlike either of the other branches of mar-2O5

206 New Directions in Austrian Economicsginalísm, the Austrians put forward a complete altemative to thecost-of-production concept ofeconomic value which permeated iclassical analysis (and also íts derivatives, including Marxista) iand not just the second half of a dualistic explanation,iMoreover, it was precisely this role ofsubjectivism that caused !the early, and subsequently widening, divergences in boththeory and policy among the"marginalisms." The failure on thepart of the non-Austrian marginalists to perceive the fullexplanatory power of the subjective theory of value is, I believe,What led them--each in its own way---away from economic realityand into an increasingly vacuous formalism. On the onehand, English marginalism, perhaps because it was unable totum its back on its own Classical heritage, chose to supplementrather than supplant it. The result was a "neo-classical synthesis"2of supply and demand---best illustrated by the Marshallian"scissors" and progressively refin.ed by an almost obsessivepreoccupation with the geometry of intersectiom, which continuesunabatedwin class and textbook--to the present time.The French marginalists, on the other hand, misled by boththe pretensions of the Enlightenment and their own mathematicalprowes.í, and also lacking the corrective force of a fuHysubjectivist view--were led to conceive of the economic processasa general equilibrium system (expressible by the algebra ofsímultaneous equations)--grander, more inclusive (and, alas,more illusory) than the "partíar' equilibrium of the Englisheconomists. Both have spawned a numerous progeny who havelabored mightily, ir single-mindedly, in exploring the theoreticaland policy implications of their respective paradigms; andthough their results have shown more elegance than usefulness,they have given only cursorymand often contemptuous--attention to the Austrian tradition.Austrians, on the contrary, llave spent an inordinately largepart of their talents and resources in efforts to deid with theerrors of others, induding some frivolous and some highly repetiveones, and correspondingly less on the development andextension oftheir special insight. Ir is to this misallocation ofour

Toward a Programof Researchand Development 207resources that my central suggestion is addressed, as we shaUpresently see.Before proceeding, let me hasten to saythat there is,ofcourse,no denying the fact that individual Austrian economists havecontinued to make contñbutions of great power, clañty, anddepth--and this is increasingly recognized outside their ownmembership. But those of us who area little oldermust, I think,also be sadder to realize how much of the efforts of so many ofour people---never a numerous company--has gone into enocounters with an endless seriesofegregious errors,and to speculateon what might have been accomplished had aUthis investmentbeen directed, instead, to refining and extending our ownanalysis.For, we have allowed ourselves, time and again, to becomeembroiled in time-consuming and largely inconclusive controversies:with Marxism, macroeconomícs, mathematicaleconomics, and monetary medicine men--just to name an alliterativefew. And the end is nowhere in sight, since most ofthese exhibit the sort of imperviousness that led the scholasticphilosophers to coin the term "invincible error."Out of many, let us consider briefly two examples, which notonly iUustratethis resource rnisallocation,but also serveas referencepoints later on in our discussion,a The first concerm theimportant Austrian insight that a centrally directed economycannot, of itself, provide the. data necessary for effectivedecision-making (/.e., consistent with the preferences of consumers).Immediately after Mises had caUed attention to thisdefect, socialistsand other interventionists trained their heaviestanalytical artillery on the idea. There ensued a very long andinvoluted discussion of"shadow-pricing" and other devices,includingnota few mathematical models, which would allegedlyenable the ministry of production in a socialist economy to allocateresources eff'_ently.It is fair to say, I believe, that all the strenuous rebutmtqfailedto bhnt the force of the original criticismof d/r/g/steplanning,though they may have served to obfuscate it somewhat in the

208 New Directionsin Austrian Economicsminds of the faithful and of the unwary. But the debate engageda good deal of time and effort by the then relatively few, highlycompetent advocates of the market system--time and effort iwhich doubtless would have been better spent on refining and iextending their own analysis.4In short, instead oftrying to show jthe inadequacies of every surrogate for calculation that the ad- lvocates of central planning saw fit to come up with, our peoplemight have been better advised to stop after one or two of themand devote the time saved to exploring the agencies, channels,and forms through which a market system conveys and utilizesinformation--and thus how it doescalculate. There is reason tobelieve that ir this had been done successfully, some of ourpresent tasks (e.g.,the "rehabilitation" of the entrepreneur as anactive, motive force) could have advanced earlier and further.The second instance is the latest--most certainly not thelast--resurgence of the advocacyofnational economic planning,one of those imperishable errors we mentioned a little earlier.Although Hayek and others had long ago carefuIly and definitivelyshown that the real issue is not planning versus chaos, butrather who is to plan and for whom, the current proposal seemsto be proceeding as ff the earlier correctiveworkhad never beendone at all. Already, Hayek has found it necessary to write inreply,5repeating the distinction, though with a shade less of the"politeness to a fault" noted bySchumpeter and characteristicofthis civilized man.Though it is undoubtedly presumptuous, one cannot resistexpressing the hope that no further time be taken from other,more deserving tasks, in order to beat this recyded dead horse. Ifeel certain that Profenor Hayek would be forgiven--evenapplauded by many--ff he decided to limit himself, on thisquestion, to sending to two senators and to a select group ofacademiefi'_nsand others simply a cardinscribed with the Frenchsaying: "On ne dit pas la Messe deux fois pour les sourds,"together with ah order blank for The R0ad to Serfdom.If there ís a lesson in all this, it ís that we ought to scale downver), sharply the extent to which our future efforts--and especiallythoseof our best young people--are devoted to the refuta-

Toward a Program of Research and Development 209tion of any and every fallacy which others choose to propose.Instead, increased investment should be made in efforts to workout further the implications of subjectivism--the disnctivelyAustñan contribufion--and to increase its impact on contemporarythought and action. It wiUbe the task of much of the restof the present paper to show that a good deal of this work is sllto be done.There is, then, much more than a simple anniversary occasionto counsel the value of pursuing our own analysis. Furthermore,political and economic developments during the last decadehave created a climate in which subjecvist analysis can expect--temporarily, at least--to get a wider and fairer hearing thanbefore. Though one is tempted to think otherwise, the presenttemper, and opportunity, ma), be attributable more to the manifestfailure of policies based on non-Austñan economic reasoningthan to any sudden persuasiveness ofour own. In any event,the increasing number of talented young scholars attracted tothe Austrian approach deserve, and probably prefer, a morechaUenging and productive objective than putting out small andrecurrent brush tires.By now, the central suggestion of this paper--that we concentrateour resources on perfecting and extending subjectivism--hardly needs to be stated explicifly. But its implementation isvery lar from being obvious. Along what lines is further researchin Austrian economics needed? In which of these is there moreurgency? Ale any of these most effectively pursued by enlistingparticipation and contribution from specialists or practitionersin other disciplines or activities? Answers to sucia quesUonsprobably can emerge only from a continuing, frank, and criUcaldiscussion of points of obscurity, difticulty, or controversyamong Austrian economists. The present conference promisesto give significant Lnitial impems in this direction.The contribution of this paper, if any, is the modest one ofsetting out a few of the possibiliUe.- asa tentative frame ofreference---and thus getting the discussion under way. It is expectedthat some (or all) of these wiUbe rejected and that otherswiUbe proposed. These possible "new direcUons" will be listed

iI210 New Directionsin Austrian Economics :and discussed very briefly under two headings: The next sectionwill offer a small sampling of theoretical (i.e., analytical,methodological) questions. The final section presents ah even ,.smaller sample of interaction between Austrian economics andoperations-oriented and other "outside" fields. These two types !are treated separately largely for conveniente and clarity; it wiUbe obvious that they are ultimately interdependent and mutuallyr¢inforcmg./LAs new implications of subjecávism unfold, the conceptualanalytical-methodologicalframework of Austñan theory mayrequire extensiom, and even revisions, for purposes of consistencyand coordination. While the bulk of such changes willalmost certainly be made by Austrian economists themselves,others may properly come from people not now considered to beAustrian economist:, or even economists at all.Inasmuch as attempts at discovery are mere gropings, andtherefore always run high risk of failure, it is perhaps worthpausing to reflect that ¢ven when they fa _xploratiom mayhave useful residue in the fo_m of fresh insights, or in otherways. In the present case, it is highly probable that suciaeffortswill produce--at the very least.--a deeper understanding on thepart of more people as to just what human acfion is (and, especially,what it is not).1. The most obvious and urgent areas needing our attention arethose which are causing some disagreement among competentAustrians themselves or those in which theorists, individually orin consensus, feel t,hereis a need for additional analytical support.Since each of us is doubfless aware of a number of suchproblem areas, a single illustration will suffic.e.Some time ago, notice began to be taken of the fact that stan-,dard economic analysis tended to make, of the entrepreneurialfunction, something bloodles: rigíd, automatic, and unreal.The present writer, for instance, found Rneceuary to deplore

Toward a Program of Research and Development 211the fact while received theory had gradually relieved everyoneelse from the despicable role of "economic man," the technicalrequirements of its own equilibrium paradigm led to imposingprecisely this role on the entrepreneur, eSince then, in one of the more exciting recent developments ofAustrian analysis---notably in work done by KirznerL--the funct.ionof the enterpriser in a market system is being reformulatedand refined in a manner that is both more reali_'tic and moreconsistent with individual freedom of choice than ever before.The present case is also useful in demonstrating how, typically,answering one question raises others that need to be dealtwith next. There is some difference of opinion as to whether--given uncertainty--this new, much more active concept of entrepreneurshipis stabilizing or not. This queson, which wiil beseen as an aspect of the more general problem of convergence 8in a free market system, has already begun to be discussedamong a group of Austrian economists from the New Yorkmetropolitan area who now meet regularly.Once the specificaon of the new entrepreneurial concept hasbeen completed, and its implicaons worked out, there will sllremain the task of getng non-Austrian theorists to take it intoaccount. This will, ofcourse, be difficult; resistance will be all thegreater because, as ,,ve noted earlier, the new formulaon removesan important element in the neatness and automacity oftheir models. But any success at all in this direction may ultimatelylead to wider recognition of the power and potenUal of afree market to operate without outside direcon.Accumulating e-ddence of the failure of recent interventionsmay, in any event, make others a bit more receptive. Samuelson,for example, in a recent piece ° devoted to Adam Smith on theoccasion of the bicentennial of the Weal_ ofNations, after quotingtwo of its hest-known passages (one on the self-interest of"... butcher, the brewer .... "; the other the passage menoningthe "invisible hand"), says, in condusion:To imow the truth-.-and the limitationsl--ofa/_aa Tka/e of econom_ wisdom.these passages is the

212 N.ewDirectionsin Austrian EconomicsThere is reason to hope thatour efforts, together with the forceof events, may eventually persuade hito to reduce the quu]ification.2. Admittedly, the class of further explorations in subjectivisttheory just illustrated have a legitimate first cluirnin any systematicreallocation of our resources. Beyond these, however,there is another group of needs, whose immediacy is less apparent,but whose ultimate contributions to subjective economictheory might prove to be of considerable importance. Asagroup, these are indirect--theoretic goods of"higher order," soto speak--and involve inputs from a wide variety of disciplinesdifferent from, but often bordering on, economic theory itself.• Let us consider, briefly, a small _mple of these possibiliUes.(a) Statisticalinference, in the forra it eventuaUytook andascurrently understood and applied, is fundamentally incongruentwith subjectivity and therefore of little, ff any, use in thetreatment of most of the phenomena with which Austrianeconomics is concerned. The conceptual (even the axiomatic)basisof contemporary statisticaltheory--and, deñvatively, of allof its calcuhom ksadmittedly that of "objective" probability(/.e.,the observed, or observable, frequency ofindependent andrandom events). It is therefore really inapplicable to anyphenomena that are unique, or interactive, of subjective.-andinapplicableafortiori to those that are all three, asis the case withhuman acfion, in the sense understood by Austrian analysis.Imtead of refrainingfrom such phenomena, objectivelyderivedstatistical analysis and irfferenceale applied to them widely.--atavery high cost in both realista and vañdity--on the OargelyimpliciOassumption that such events are somehow amenable tothe same "law of large numbers" applicable to independent,ru_ndomevents.To tl-_ writer's knowledge, there has been virmally no systematiceffort to develop alternative inferential systems moreconsistent with the inescapable subjecfivity of human events,despite the fact that the clear inadequacy of received statistical

Toward a Programof Researchand Development 213theory in this connection has been recognized for some time? °Itis the more puzzling in that the possibility and feasibility--if notthe primacy--of subjective probability were discussed veryearlyu in the development of statistical thought and have continuedto be mentioned, tsDespite these and other insights concerning the essentially$ubjective element in probability statements, _3 the almostirresistibleurge to assign cardinal numbers to degrees of beliefhas led to the arbitraryrestatement (and distortion)of subjectiveprobability in objective terms--to the consequent neglect of theneed to search for a viable alternaUve.What iscurrently referredto as "subjective probability"is thus nothing morethan the usualobjective probability analysis broken down into segments: ahantecedent (of "prior") probability anda consequent ("posterior")onel_--a process for which subjective is a manifest misnomer;it is more properly designated as "conditional" of "sequentiar'probability.Even here, the crudal problem--and the subject of continuingcontroversy--is the assignment ofsome weight to the antecedent(prior) probability segment in the many instances where occurrencesare too few tojustify reliance on the law oflarge numbers,which underlies the usual statistical apparatus. The faciledevicefor skirdng this difficulty--that of arbitrarily assigning equalprobabilities to such events---is disputed, as one might easilyguess. Some alternative approaches, _5involving the concept oflearning by experience, should be of some interest to subjecdvetheorists in a number of respects, including information theory(to be mentioned briefly below) and the analysis of entrepreneurialdecision-making.(b) The advocacy ofa free-market system (as dearly superiorto one run bycentral direction) relies, to an important degree, onthe asserUon that decentralized (i.e., individual) decisions aremade on the basisof much more reañstic and accurate informaflotaavailableat the source ofhuman decisions:individual valuationsand preferences. But in any complex economy, these elemental(e.g.,consumer) choices triggerlong sequences of deriva-

214 New Directions in Austrian Economicstive decisions by producers and by suppliers of attendant services(e.g., financial, distributive, etc.) at every level and stage ofproduction. The capability of the market process to transmithighly reliable informaÚon along networks of such bewilderingcomplexity--and to do so without undue distortion or loss ofinformatiorb-is impressíve anda standing rebuke to the aspirationsof central planners. That the process works is evident; butprecisely how is only dirnly and intuitively understood, thoughthe importance of informaÚon in the economic process is recognized,le More detailed understanding of its operaÜon (e.g., thelocation and role of linkages, the localization [decentralization]of decision-making through subnetworks of information flow,etc.) could help substantially in validaÜng and extending ourtheoríes---and might even cause some rethinking by interventionists.It happens that--in connection with problems different from,but ultimately not unrelated to, economics---the technicalanalysis of information processing has m_adesignhícant stridesin the last quarter century. 17The results of studies in "communicationstheory" (or "information theory') have proven value inthe communicaÜons industry and in business management ingeneral. And it is not unlikely that this field may have contributionsto make to market theory. For one thing, ir may help usunderstand and explain in a much more precise way how thetra_nsmission of information facilitates the convergence of theplans and decisions of large numbers of independent individualsand firms. For another, the basíc concepts of this analyfm--e.g.,the minimum amount of information (a binary unit or "bit")needed to distinguish between two alternatives (binarychoice)--might prove to be as suggesUve for the development ofnew approaches to subjecfive-choice analysis as they were in theearly design of electronic computers? sAgain, it seems unfortunate that no serious attempt has beenmade to invite the attention--and contribution---of thesespecialists in the explication of the market system. Althoughthese are primarily engineers, there is reason to believe thatmore than a fcw of them would respond to the challenge ofí

Toward a Program of Research and Development 215adapting portions of their analysis to the needs of economíctheory. At the very least, some dialogue with them would notleave the field open for advocates of a contrary economicphilosophy to bend communication theory to their purposes. TM(c) One aspect of the above--the concept of entropy--deserves brief, separate mention for at least two reasons. Thefirst is related to the special (technical) use made of this conceptin communication theory. "Entropy" in this adaptation is verydifferent from the concept of entropy as employed in physics(though possibly ultimately reducible to it). Here, the term isused to mean a measure of the amount of information that atheory provides and is understood to vary directly with thedegree of freedom of choice (or "uncertainty") on the part ofrecipients of ínformationS°--again, there may be interestinginsights and implications here for subjective theory.The second point "_that entropy in its more general sense.(i.e.,the one more directly consistent with its traditional use inphysics) seems to offer a viable alternative to the equilibrium•paradigm so pervasive in contemporary economic theory--andone seemingly more adaptive to the analysis of economic activitiesas processes. It also touches conceptually on a number ofquestions which should be of some heuristic interest to ourtheorists. Space here will not permit more than the mere mentionof some of these: purposive activity, order and probability,partial processes, irreversibility, etc. 21 Some investment inexploñng the potentialities, possibly in consultation withspecialists in that field, would appear to be worthwhile.(d) It is apparent that some explorations of the sort touchedupon in this section imply that at least some ofour students have,or acquire, the ability to follow mathematical argument--perhaps even to initiate it. Many of us who have been involved inthe theoretical wars for some time will---quite understandably-.¿eskeptical of any such involvement. For, weare all tofamiliar with mathematical models of high eleganceand small economic content; and with countless instances of the

216 New Directions in Austrian EconomicsProcrustean torturing of economic reality to make it fit themathematical bed. It is, moreover, notoriously true thatmathematical formulation is often made the end, rather than ameans, of economic reasoning; and that (especially graduate)students are coerced into this mode of argument by a laborintensiveroute which tends to render them the locked-in victimsof their over-investment.But all these are, after all, outrageous abuses of ah essentiallyformal disdpfine which, fike logic, cannot be presumed in advanceto be either wrong or useless. Each of the abuses mentionedcan easily be avoided; indeed, all of them are attributableto dilettantes rather t.han to competent mathematácians and iris to the latter that reference is made here.Several considerations deserve attention in this connection.First, the summary rejection of mathematics--root andbranch--acts to exclude aU mathematicians from our company.Yet, it should be possible fora mathematician to be a libertarian,too--and without schizophrenia. Secondly, it is a fact, howeverregrettable, that arguments in symbolic form--even wheninvalid--are held in awe by many. There is no good reason forthose who have something valid to say to cede this advantage totheir opponents. Thirdly, and more important, the scope ofmathematics---as understood by its most able practitioner: kslar broader, more humane, and more flexible than it appears tobe to others. What Boulding sz calls "the puritanism ofmathematics" is likely to be merely in the eye of the casualobserver.This brings us at last to the suggestion of this subsection: thatwe explore the usefulness, for our purposes, of less numericaland more purely relational branches of mathematics, ss One ofthese---topology--which seems to have special applicability todiscontinuous phenomena (and should therefore "have interestedus long ago), is currendy being utilized by a differentgroup, in conjuncfion with so.caUed "catastrophe theory. _4 It isalso interesting to note that this banch of mathemacs, which isrelatively neglect.._l in our general treatis_, is given more spacein the Soviet texts, n

Toward a Program of Research and Development 2173. The final point of this section is a suggestion for the implementationof our central recommendation on the allocationof our resources with respect to controversies like those mentionedearlier as examples of"malinvestment" on our part. It isunrealisticmand perhaps unwise--to expect that we shall be ableto avoid any involvement at all in recurrent and provocativefallacies. But we can--and should--.-determine to deal with themon our terms rather than on those of others.This implies not only setting quantitative limits on our engagementin controversies of high (and increasing) marginalfutilíty, but also on two qualitative ones. The first is that we act toset the conditions and the form of the discourse in which weconsent to participate, for the purpose of eliminating both sheerrepetition and all the small-minded, often demagogic,stratagems and posturings that one would expect, if at all, ofsecondary school debates and not of mature academic discourse.The second is that we insist on a faírly frank and clear specificationof the context (usually a complex of tacit assumptions andesoteric defmitions) of the discussion, since the failure to do sooften artificiaUy restricts the full scope of the discussion orotherwise puts one group of discussants, from the start, underunfair burden. It is only prudent to ensure that the terms ofdiscourse, like the terms of trade, are not always unfavorable tothe same people.Let us try to iIlustrate, briefly, with reference to several of thecontroversial perennials. The issues of economic planning andmathematical economics have already been discussed and will bepassed over here, except to say that we ought to insist at theoutset ofany further discussion of these that (I) it be recognizedthat,,ve ate not opposed to planning, but only to a special form ofir; (2),,ve reject not mathematics per se, but its irrelevant ordistortive application to economic analysis; and (3) we shall notcontinue in any dh_=ussion which does not accept these distinctions.(a) Although discussion of socialism and capitalism as alternatireeconomic systems long ago ran into diminishing retums,

218 New Directions in Austrian Economicsvery litfle has been done about changing the context. From thestart, Marxista restricted itself to a detailed exposition of theinner stresses expected to emerge within capitalist systems,which would eventually bring about theír collapse and replacementby socialist regimes. Now, over a century later, the latterhall of which has seen one major such state in actual operation,together with a number of satellites, expositions of the contradictionsof capitalista continue, :e while those of socialista are eithervery fighfly touched upon or ate allowed to be buried withobfuscation.Despite the fact that many crucial predictions of Marxista havefailed (e.g., the theory of immíserization, the industrial reservearmy, the absorption of the middle class, the withering of thestate, etc.), we ale stiU largely defending (or criticizing) theoperation of capitali.qm only. On a more theoretical level, boththe "transformation problem" and the calculation critique wiUillustrate clearly the obfuscation mentioned above.We should therefore cease acceding to discussions of the problemsof one system only, or those which compare the actualoperation of one with only putative weaknesses in the other.Instead, there ought to be some insistence on the use of somecommon denominator for comparison---preferably a set of performancestandards capable of empirical verification. The designingof such standards admittedly would be difficult--giventhe incommensurabilifies of economic organization and, in par-Ücular, the differing degrees of coyness with which data aremade available---but the task is far from an impossible one withwhich to challenge young scholars.In fme, the burden of proof should shift in part, so thatsocialists, too, would llave to defend their system against thecharge that it is failing. Nor should an ideological "détente" bepermitted to take the place of the rapidly evanescing politicalmilitaryone; their "drift" toward capitalism is not on the sameroad as ours toward socialista---so we may never meet. They arebacking slíghtly away from sociali_t arrangements which did notwork; while in the West we never really got m trying a really freemarket system.

Toward a Program of Research and Development 219(b) In our differences with macroeconomic analysis, we havebeen once again too accommodating in our willingness to acceptits context and definitions. By this context, macroeconomics istaken to be a system of causal and other relationships amongaggregative economic entities and consequently ah alternative tomicroeconomic_ and, indeed, often in sharp conflict with it. Assuch, it has been vigorously resisted and opposed by free-marketeconomists. But suppose this conceptíon of macroeconomics isneither the only---or correct----one?Ir is by now virmally forgotten that it was the intention of thepioneers of national income estimates to set up the equivalent ofa profit-and-loss statement for the whole economywlike its prototype,ex post and evaluative. Indeed, Kuznets (a founder andleading architect of national income statistics) states this factunequivocally: 27... national income is the end product of a country's economicactivity,reflecting the combined play of economic forces and serving to appraisethe prevailing economic organization in terms of its returns.Being thus a summaryand appraisalnotionratherthanan analytical_enS_.,national income demands statistical measurement. [Emphasisaddexl.lIn this case, as before, ,,vecan insist on the recogrñtion of thedistinction between macroeconomics asa set ofexpost data on theoutcomes in the economy andas a distinct explanatory theory--emphasizing that taken in the lo¿roer sense we accept, and evenwelcome, ir asa valuable supplement to any explanatiorj of theworking of the market economy. Ifthis is done, we may be able toavoid becoming enmeshed in a host of wasteful efforts of whichthe following are illustrations.One is the frequenfly-heard wish that some way be sought tocoordinate macro- and micro-models of analysis--presumablyas separate parts oran even grander, more inclusive explanatorymodel. This appears to be at least.improbable, given their mutuallycontradictory explanadons, and would comprise an inexcusablewaste of time and talent ff the correct disposiUon of theconflict turro out to be not the coordination of the two, but the

220 New Directionsin Austrian Economicssubordination of one to the other as serving very different butcomplementary functions,z8Another is the h_teresting--and generom---offer recentlyvoiced by Lachmann:29that we undertake to "subjecfivize"themacro-enfities by some process of disaggregafion unfil they areconsistent with subjectivechoice. One suspects that this arduouseffort willmerely lead us backout of the looking glassand intothe familiarmicro-economicworld. Fortunately, this travailwillprove unnecessary ff the subordination we have menfionedturns out to be the correct relaon between micro- and macroeconomics.III.Ifit is to be taken seriously, any body of theories about the realworld must eventually take its own measure against that reality.To rail to do somay avoid, fora time, the risk of disconfirmaon,but also forgoes the opportunity for potent reinforcement.It is often daimed, in defense of delay, that the particular andaccidental forros in which actual events present themselves aredifferent and incongruent with those of abstract, systemacthought--and this, of course, is true in part. But, while the mostgeneral proposions of a theory may not lend themselves todirect observaon, the deducve working out of their implicaonsshould tend to produce subsidiary statements whose forroand content lend themselves to some forro of comparison Mthempiñcal reality--if not bythe structured methods of posivisc"scietace,"then by informed subjectivejudgment Cverstehen").The need for some sort of outside confirmaon is especiallyimportant for those theoretical systems whích, like Austrianeconomics, make the claim that the), ate axiomatic and apodicUcallytrue--and are therefore open to the facile criticism thatthey ate purely formal (Le., devoid of real content) and alemerely internMly comistent circulañties.When, in addition to all this, the central proposions of atheory have great generality in their frame of reference, they

Toward a Program of Research and Development 291"vector" out to touch hands with other areas of analysis of ofactivity not normally subsumed within the domain of the theoryitself. This certainly appears to be the case with Austrianeconomics on at least two grounds: (1) it purports to deal with allhuman action and notjust one aspect or subset (economic activity);and (2) it insists on the categorical primacy of individualchoice.In tuna, this generality of Austrian theory implies both anobligation and an opportunity; the obligation, on the one hand,to make whatever contributions it can to other areas to whích itsprinciples apply, and, on the other, the opportunity to invite andreceive contributions from people with special competence insuch areas.The "field" for such mutuality of interest extends not only toother theoretical disciplines, but also to "applied" areas. Severalexamples of the former have already been mentioned in anotherconnection (i.e., statistics and mathematics); others will readilyoccur to the reader (consider, for example, the continuing interestin Austrian theory on the part of philosophers, politicaltheorists, legal scholars, et al.) and will not be discussed here.The specific task of the final section of this paper wiU be tooffer illustrations of more practical, operational areas whichbear this sort of interface with Austrian analysis. Spaie--and thepatience of the reader--will permit only a ver), small sampling ofthese; their selection should not be taken to indicate their importancerelative to the many omitted, but merely as an attempt toshow range and diversity.A. Business operations and management should be the mostobviom and easiest---of the applied areas with which to establíshthe sort of two-way communication we are discussing. Yet,the exchange between economists and businessmen continues tobe very disappointing both in extent and quality. (The manyhistorical,imtitutional,and other factorsbehindthis puzzlingand complex state of affairs---and the possibilities for changingit--are clearly beyond the scope of this paper.) s° Nevertheless,the relatively realistic nature of its concept of the economic

!22_ New Direc_rns in duran Economics !process, together wi_ i¿s emphasis on the power of individualaction, gives Austrian economics a special opportunity toexplore some proxima_ and straighfforward possíbili6es for "_mutual comribuons.(1) Business o_fions offer a vast theater for _sfing theadvanmges of reliance on the mofivafion and responsibilit 7 ofindividuals. Indeed, management _eorists s_ have presented acompellíng case for moving away from traditional centralizedand authoñtañan organi_zational designs of decision-making responsibility("Theory X") and toward more reliance on decentralized,individually oriented initiatives ("Theory Y"). Experimentationwith changes along these lines has had to becautious and marginal (since firms must operate within the constraintsof the cost-recouping"imperative'), and the results thuslar have not been uniformly condusive. Detailed and frankanalysis of instances of success and f_ure in such experimentswould appear to offer interesting opportunities for practitionersto confer with theorists, to the benefit of both.(2) Regular consultation with businessmen would not onlyacquaint the latter wíth the often esóteñc language and conceptsof economic theory, ir would also tend to reduce the risks thattheorists run when they depart from realism. To use one of thepoints already familiar to the reader as illustration: It is inconceivablethat the prevailing conception of the enLrepreneurialfuncáon in traditional economic theory would app_ar to actualentrepreneurs as accurate. If this conception is in serious error, avery long sequence of theorizing--as well as costly policies derivingfrom it---could have been averted by the simple process ofidentifying the picture of the entrepreneur which was implicit inthe early analysis and making it explicit so that experiencedpractitioners could evaluate it.Even now, it would be useful to do this. For any revision of therole of the enterpriser wiU involve radical changes in the traditionalmodels of the operation of the economy and wiUthereforenot be embraced immediately or with enthusiasm. The cooperationof businessmen will not only help confirm that the revision isrealistic, but they can help flesh it out further.

Toward a Program of Research and Development 223(3) The subjective view of human action necessarily puts agreat deal of reliance on the concept of"verstehen"---a compositeof experience, intuition, and other qualities not adequatelyconveyed by the word "understanding." The prevailingpositivist temper ofour age is apt to dismiss so subjective a notionas being simply vague (if not worse) unless it is buttressed bypractical and highly realistic examples. These are best and mostinfluentially to be provided by those experienced in a variety ofmanagement decisions in which the "objective" data had to beevaluated and supplemented by human judgment.(4) Finally, this very subjectivity has important implicationsfor the proper tole of present managers in the education ofthose who wiUfollow them. 8_For, ifthe essence ofwhat they do issubjective, ir cannot be conveyed adequately either by rigid setsof rules or by abstract models devised largely without referenceto the realities of actual performance. There is reason to thinkthat just sucia a deficiency now exists and is being dealt with byon-the-job remedial action. The prevalence and extent of managementtraining programs in so many ofour large corporationsma), thus be a tadt_and very cosfly--cñUcism of the adequacyof programs in the formal education of young business managers.B. This bñngs us to the second illustrative area---and one veryclose to home. Quite apart from its content--one aspect ofwhichwe havejust now touched on--the organization of formal educationon the collegiate and even on the graduate level is deeplyinconsistent with subjecfivism. In this respect, we in educationhave lagged far behind industry, where, as we saw a little earlier,there has been at least some attempt to give greater scope toindividual initiative and provision. But where, in our own house,is the application of the same "Theory Y" which we have beenurging on others? The fact is that education remains---as it haslong been essentially patemalistic and authoritarian. Persistingpatterm of sanctions and rewards are hardly conduciveto-.or even tolerant of--the exercise ofindependentjudgmentsand valuations by the individual student. True academic free-

224 Neto Directions in Austrian Economicsdom (that is, in its original meaning and intent) has more theappearance of a class privilege reserved to the faculty than anintellectual right that extends to students--or even to applicantsfor faculty positions.A litfle reflection by anyone who has attended coUege, andesped_lly graduate school, will suggest many examples of thisperverse state of academic affairs--and the point will not bepursued here. But it should be obvious that subjective theoristshave herea special obligatíon to establish a dialogue with educafionaladministrators and others and to seek ways in which smdentscan be encouraged--certainly not discouraged--in theexercise of independent judgment.C. The third and final example, literature, is illustrative of alarge class of pursuits or professiom whose essence and pracácedepend sígnificantly on individual effort and on subjeaive values.The history of literatures from Milton to Solzhenitsynexhibits real concern for individual freedom of expression andof actionS3--often defended courageously and at great personalcost. Moreover, as the case of the Fabian Society illustrates all toowell, it is possible for people of great literary talent to becomeinterested in social and economic issues and to present these tothe reading public with great potency and effect. Here, again,Austrian theorists would seem to have the opportunity and theobligation to establish and maintain communication with aHthosemhowever distant from strict economy theorymwho sharetheir insight on the nature and significance of human action.REFERENCESI. Although itwas pjablishedthree yearsafter the others, the workof Ix,on Walras (E/ímnUsd'í_ono_ po//t/quspuf,, 1874) is now generallyaccepted as independently developed.2. Unforumately, th_lterm is currently being used for things verydifferent from this, its original meaning, resulting in unnecessaryconfuaon. Cf.,e.g., P.A. Samuelson,Ec_: da Introduetorydnalysis,

Toward a Program of Research and Development 2257th ed. (New York, 1967), pp. 351-52; and also, Newsweek, Ma}, 12,1975.3. Were it not for this double purpose and the related need to savespace, maexcellent example would be provided by the extended discussionby so many Marxists and their opponents of the so-called "transformationproblem" since B6hm-Bawerk (Karl Marx and theCloseof HisSystem, London, 1898).4. This may also apply to extended discussions with less antagonisticcriti_. For example, as Ludwig Lachmann observed at a recentconference on Austrian economics (Milwaukee, March 1976), the longdiscussions following Knight's criticism of Austrían capital theory tooktime whida was needed eBewhere.5. F. A. Hayek, "The New Confusion about Planning," MorganGuaranty Survey, January 1976.6. L. M. Spadaro, The Present State of Profa Theory: Asset orLiability?(Philadelphia, 1963).7. I. M. Kirzner, Competition and Entrepreneurship (Chicago, 1973).8. See Gerald O'Driscoll, "Spontaneous Order and the Coordinationof Eeonomic Activities," elsewhere in this volume.9. Newsweek, March 15, 1976.10. Gr., e.g., L. J. Savage, The Foundañons ofStatistics (New York,1954); also, L. M. Spadaro, "Averages and Aggregates in Economics,"in M. Sennholz, ed., On Freedom and Free Enterprise (Princeton, 1956).11. Both Laplace (Théor/e analytique desprobabilités, París, 1814) andDe Morgan (/In Essay on Probability, London, 1838) regarded probabilityas the degree of belief in a proposition andas referring to a state ofmind.12. Cf., e.g., E. Nagel, "The Meaning of Probability," in J. R. Newman,ed., The World ofMathematics (New York, 1956), rol. 2, pp. 1398-1414; F. J. Anscombe and R. J. Aumann, A Definition of SubjectiveProbability," Annals ofMath. Stat., rol. 34 (196B), pp. 199-205. It isinteresting, too, to note that J. M. Keynes, in an early work on thissubject (d Treatise on Probability, London, 1921), treats probability asadirectly íntuitable relation which, while capable of varying in degree, isnot analyzable by the calculus of probability.1£. One of the earliest and most able of tnose interested initially inthe truly subjective aspect of probability, Thomas Bayes, also em.-phasized its relation to degrees of belief (cf., his two memolrs mpidlo_hical Transactions, 1763 and 1764). Nowadays, however, bisname ls almost exclusively associated--because of a theorem of his(Bayes's Theorem)--with conditional probability. . - .14. E._., S. B. Richmond, O/_eratíonsResearchfor Managemem uec_-s/ons (Ne_ York, 1968),pass/m, _spec. pp. 129-33, 148--52,and 541-47.

226 New Directions in Austrian Economics15. Cf., e.g., R. Carnap, "What is Probability," Sc/ent/fg ,4rn¢dcan(September 1953), pp. 128-36.16. Cf. F. A. Hayek, "Economics and Knowledge," in IndividualistaandEconomic Order (Chicago, 1948), pp. 33-56; also, G.J. SÜgler, "TheEconomics of Information,'Jour. Pol. Econ. (June 1961), pp. 213-25.17. The modero resurgence of interest in the analysis of informationbegins with a seminaIpaper by Claude Shannon (C. E. Shannon,"A MathemaÜcal Theory of CommunicaÜon," Bell Syst. Tech. Jour.[1948]. For more general implicafions, see N. Wiener, Cyhernet/cs[NewYork, 1948]).18. For comprehension of various aspects of this atea, see: C.Cherry, On Human Communication, 2nd ed. (Cambñdge, Mass., 1966);J. 1L Pierce, Symbo/s, Signals and Noise: The Nature and Proce.ssof Commun/cat/on(New York, 1961); and espec. H. Theil, Econom/csand InformatmTheor_ (Chicago, 1967).19. One mteresfing example is an attempt to use communícationtheory to buttress what is essentially a variant of many inflationistschemes: S. Bagno, The ,4ngd and the Wheat: Coramunication TheoryandEconomics (New York, 1963). UnfortunateLy, space does not permitanextended analysis of the inflationism involved, but its dedication isrevealing:"Dedicated toClaude Shannon and Norbert WienerWhose Theorems ate the Fcmndationsof a ConsistentEamomic Doctñneand toJohn LawWhose Methods Enabled Us to Learn Our True Potential"20. Cf., e.g., Pierce, op. di., chap. 5.2I. For a detailed exposition, see N. Georgescu-Roegen, TheEntr0pyLaw and the E_onomi¢ Process (Cambridge, Mass., 1971).22. K.E. Boulding, EconomicsAsaSdence (New York, 1970), p. I01.23. The writer had occasion to make this same suggeson some timeago in another context: L. M. Spadaro, "The Heuristic VaIue of Simulationin Business and Economic Research," Pro¢mlings, ,4wwr. Sta_Assoc., 1966, pp. 73-79.24. Newsweei_,January 19, 1976.25. Cf., e.g., A. D. Aleksandrov, A. N. Kolmogorov, and M. A.Lavrent ev, eds., M_: lts Content, Methods, and Mmning, Eng.transL, 2nd ed. (Cambridge, Mass., 1969), espec, vol. 3, chap. 18.26. The most recent example known to the writer is D. P. Bell, TheCultural Contradictionso_ Capitalm (New York, 1975).27. S. S. Kuznets, National Income," Eno)d. Soc. Sd. (1933) andreprinted in Amer. Econ. Asso_, _/n t/_ T/u_ 7 oflncom D/s-

Toward a Program of Research and Development 227tr/but/on (Philadelphia, 1949), pp. 3--43. The quotation here is fromp. 3.28. For discussion of some of the difficulties and errors resultingfrom attempts to establish causal relationships among macro-quantitiesdirectly, cf., H. Theil, "Alternative Approaches to the AggregationProblem," in E. Nagle, P. Suppes, and A. Tarski, eds.,Log/c, Methodology,and Philosophy of $cience (Stanford, 1962).99. Also in Iris remarks at the Milwaukee conference cited in note 4.30. The writer is planning a monograph which is expected to indudea detailed analysis of this situation.31. Cf., e.g., D. McGregor, The Human Side ofEnterprise (New York,1960); A. H. Maslow, Eupsychian Manageraent (Homewood, I11.,1965);and P. F. Drucker, Management: Tasks, Responsibiliti_, Practices (NewYork, 1973).32. For a literate and cogent discussion of this role, cf., H. M. Boet-Unger, "Is Management Really ah Art?" Harvard Bus. Reo., (January-February 1975), pp. 54--63.33. For one suggestive example from literary criUcism, cf., L. Trilling,The L/bera/Imag/nat/on (New York, 1950).

INDEXAckley, Gardner, Macroeconomic Ayer, A.J.,Language, Truth, andLogic,T/m_, 203 n56 55 n2Action: in Austrian theory, 24; axiomof, 50-52; conceptualization and, Bagno, S.,TheAngdandtheWheat,22625--36; erroneous, 61--63; praxeol- n19ogy and, 50, 54; probabity in, Bíáley, Martin J., "Review of Cap/ta/51-32 and Its Structure," 139 n31Alchian, Armen A., 88, 91 Barriers to entry, 97-99; legal, 10"2,Alek$androv, A. D., et al., eds., 108-109; monopoly and, 95, 9fiMath¢ma6_, 226 n25 Bayes, Thomas, 225 n12Alertness, ó8-89Becker, Gary S.: on time preference,Amcombe, F. J., and IL J. Aumann, 161; a/so su Ghez, Gilbert"A Definion of Subjecve Proba- Bell, D. P., The Cu/tura/Contrad/consbility," 225 n12of Capitalista, 226 n26Antitrust approaches, erroneom, 98 Blanshar d, Brand, Reason andApplication of theory, 220--224 Ana/y_, 55 nn7,8A priorí'sm, 19-20, 49-52 Boettinger, H. M., uIs ManagementArmentano, D. T., ix, 94--110; The ReaUy ah Art?" 227 n32MythJ of An6trust, 109 nn4,5 B6hm-Bawerk, Eugen ron: capitalArrow, K. J.: "Limited Knowledge dimensions, 169; Capital and InandEconom_AnalDh," 18nS;on retes¿ 166n17, 201 nnll,19, 202market economy, 12-15 n31; on capital/produaion time,Asset markets, 3--4; volaÚlity of, 4--6 179; capital theory, 1-2; interestAumann, 1LJ.,see Anscombe, F. J. theory, 158;KarlMarxandtl_CloseAustrian differentia, 23--24 of His System, 225 n3; "PositiveAum'ianeconomics, vii-x, 1 etptm/_" Theory of Capital," 166 n17; onfuture development, x, 205-227 production time, 170-171Amwm method, $2-.S5 Bond market, 162-163Austrian School: Chicago School and, Boulding, K. E.,Econom/csasa Sdence,122-124; ¢oordination and, 128- 226 n22155; on equilibrium, 129-.134; Buchanan, James M.: on the Chicagomoney-suppl F definitions, 143-- School, 137 nl9;CostandChoice, 92156; planning in, 127, 128-154; ni; '_'he Justice of Natural Libqxmtanemuorderand,128-154 erty," 135nl; on the London"Autonomy of the human mind," School of Economics, 81-82; "Pub-129-150 lic Goods and Natural Liberty," 137229

230 I___:n222; on social cost, 78, 89; on Clower, Robert W., 116; Monaaryspontaneous order, 116Theor/, 155 nlBuchanan, J. M., and G. F. Thirlby: Coase, R. H.: on competidon andL. S. E. Es.uzyson C_JZ,92 market failure, 91; Pigou and,Burns, ArthurF.,Prospe_withoutln- 77-87; "The Problem of Socialf/at/on, 156 nll Cost," 77-79, 80, 86; on socialBusiness cycle/s, 35-36; monetary ex- cost/pr_iuct, 77-92pansio_ and, 197; money supply Cohen, Morris 11.,.4 Prf_ace to Logic,and, ix, 152-154; Rothbard on, 197 38 n20Businessmen, economists' dialog Communications theory, 213-215with, 221-223 Compeddon, ix, 94-110; incorrecttheories of, 97-99; plato in, 7--8;Calbr__i, G., '_rranmction Costs," 76 pure, 96-97; social cost and, 90-92n33 CompetiÜve condions, monopolyCambridge School, as Neo- vs., 95Ricardiam, 137 ni9 Competive process, monopoly and,Cantillon-effects, 139 n36 101Capital: dimensions of, 169; quantity Concept, prioHty of, 51of, and investment, 179--188 Conceptualization: action and,Capital theory, 1-2, 35,179-180; _b- 25-36; plato and, 25-36jeávism in, 10-11 Consumpdon, investment relation-Capitalism, _ontroveres concerning, ship, 182217-218 Controveres, dcaling with, 217Carnap, Rudolf:P_0sop/tyandL0¿,/ca/ Coordination of economic activiti_Syntax, 55 n2; "What ii Probabil- 111-142; Austrian school and,ity?" 226 n15 128-135, 169; knowledge and,Cartmls, 106 n._ 119-120; Lachmann on, 119-120;Cassel, Gustar: capital dimensions, in macroeconomics, 169169-170; on the market economy, Cmt/s: calculating, 89-92; pñvate vs.12; T_ Nature and Nueu/ty ofln- social, 77, 80; social, viii, 77-93;tereJ¿ 201 nnl0,11 mbjective theory of, 82-83Catastxophe theory, 216 Credit expamion, 192-198; moneyCerficates of depmit (CDs), money supply and, 152-155suppiy and, 149-150 Credit instruments, money supplyChange, in Smithian economics, and, 149I 18-I 19Croce, Benedetto: "On the F.xxmomicCherry, C.,OnHtma_Cotmmmim6o_ Pñndple7 74n5; on error, 59-61,226 n18 61-65, 65ChicagoSchool: Aum'ianSchooland, Cropsey, Joseph, "The Invisible122-124; Marshalliím approach, Hand," 155 ni122; money-mpply definition, 145;as new Rkardiam, 118--124 De Breu, Getmd, 7_y of Va/ue038Choice: error and, 62-63; pure Iosic n18of, 2; _ cmtand,8$-86 Demanddeposita:u money,144-

Index 231146; not money, 151 Error, 57-76; choice and, 62-63; inDe Morgan, Augustus, dn Essay on decision making, viii, 57-76;Probab////y, 225 ni I economic, 59-61, 61-63; econom-Demsetz, Harold, on competitionand ics without, 64-67; in exercise ofmarket failure, 91 judgment, 62; ignorance and,Dernburg, Thomas F., and Duncan 67-69, 69-71; impossibility of,McDougai, Macroe¢onomics, 203 65--67; normative applications of,n55 73-74; technical, 59--61, 61-63;Determinism, 15-18 theory of, 57-58Distñbutional effects, 139 n36 Evidence, 48--49Doctrinal differences, viii, 19-39, Exchange, intertemporal, 175-178118, 122-124 Exchange economy, interest in, ix,Dolan, Edward G., The Foundat/ons of 157-166ModtmA_Economics, 139 n35, Expectations: of speculators, 131-141 n60, 155 nl, 165 n5 132; subjectivism and, 1, 3-óDrucker, P. F., Management, 227 nS1Falsifiability, meaning and, 42--44Econometrics: criUque of, 44-46; Iris- Federal savings bonds, money supplytory and, 52-53, 54; praxeology and, 150and, 40-56; role in economic Ferguson, C. E,, The Neoclassicaltheory, 52-53Theoryof Production and Dtribution,Economic acfivities, coordinaon of, 37 nl111-142, 169 Fetter, Frank A., Capital, Interest, andEconomic man, entrepreneur as, 211 Rtnt, 164 n4Economists, dialog with others, 214- Fisher, Irving: price-level concepts,215, 221-223 9-10; The Purchasing Power ofEducaUon, in subjectivism, 223-224; Money, I0, 144; The Theory of ln-Efficiency/Inefficiency, 57-58, 75 ttrest, 166 n13; on time preference,ni8; Leibemtein on, 63-64, 70-71 161Egger, John B., viii, 19-39 Fisher effect, 192Energy problem, market forre and, Free market system, 218; entre-136 ni6 preneurial funcÜon in, 210-212Engineers, dialog with economists, Friedman, Milton, 55 n12; on214-215 methodology, 40, 41; The Meth0do/-Entrepreneurial __nction, lmsiness- og? of Positive Econoraics, 54 ni,men'sviewson,222;infreemarket 55nn6,12,16; monetary theory,sy=_em,210--212 10; "A Monetary Theory of Na-Entrepreneurship, 24-27, 35; tional Income," 139 nS; The Opmonopolyand, 100-101 _rnum Quanti_ of Mono and OtherEntropy, 215 Essays, 202 n45; A Program forEquilibria, 5; Austrian approach, Monetary Stability, 140 n38; "A21-23, 129-134; dy_namic, Hayek- Theoretical Framework forian, 21-25; neoclassical approach, Monetary Analysis," 139 n3522--25; static, 20-23 Friedman, Milton, and Anna J.

=232 IndexSchwartz,"Moneyand the Business vidualism and the Economic Order,Cycle,"139 n34 37 nn2,6,9,10, 138 n26, 203 n53,Future markets, 11, 13 226 n16; on information, viii; interesttheory, 158; Keynes con-Garrison, Roger W., ix, 166-204; on troversies, 114-116; marketmathemadcs, 38 n27; "Reflections economy and, 12; on mathematics,on Misesian Time Preference," 166 38 n29; '_The Meaning of Competinnl5,16tion," 138 n26; Monetar3 Theor3 andGeorgescu-Roegen, N., The Entropy the Trade Cycle, 129 n32, 200 n2,Law and the Economic Process, 226 202 nn48,49; in The Morgann21 Guaranty Survey, 140 nn42,43,46,Ghez, Gilbert, and Gary S. Becker, 225 nS; "The New ConfusionTheAllocationofTimeandGood._over about Planning," 225 n5; Nobelthe Life Cycle, 166 n13award, 19; in planningcontroversy,Greaves, Percy L.,MisesMadeEasier, 208; "Price Expectations," 133;164 nl, 165 n4 price-level concepts, 9; The Pr/reTheoryof Capital, 201 n13; on pricesHaberler, Gottfried, see Streissler, and price changes, 124; PricesErich, et al. andProduction, 9, 179, 200 n2, 201Hadar, J., and W. R. RusseU, "Rules nn5, 7, 8, 24, 25, 202 nn38, 43,forOrderingUncertainProspects," 44, 52; Prole, Inttrest and Invest-38n32 ment, 202 nn 42, 52, 53; TheHahn, F. H.: on market economy, Pure Theory of Capital, 37 n7,12-13; On the Notion of Equilibrium 138n27, 139n33, 201 nn22,26,in Economics, 18 n9202 n35; "Reflections on the PureHarcourt, G. C., Some Cambridge Con- Theory of Money of Mr. J. M.trovtrsits on the Theoryof Capita¿ 202 Keynes," 136 n8; "The Ricardo Efn36fect," 202-203 n53; The Road toHarcourt, G. C., and N. F. Laing, eds., Strfdom, 140 n46, 208; on scientificCapital and Growth, 202 n36thought, 36; on spontaneous order,Hayek, Friedrich A. ron: capital di- 118; on structure of production,mensions, 169; on capital/ 171-174; subjectivhm, 81; '`Threeproduction time, 179-181; on ElucidationsoftheRicardoEffect,"compefition and market failure, 203 n53; "Time Preference and91;TheCounterRevolutionofScitnce, I_'oductivity: A Reconsideration,"1, 81, 137n18, 158n25; on 165 n6; _I'he Use of Knowledge ineconomic planning, 125-127; Society," 37 n9; at Winchor Casfle"Economics and Knowledge," 21, sympodum, x$7 nng,10, 38 n29, 57, 74nl, Hayekian triangles, 171-174, 18575 n23, 155, 141 n58, 226 n16; on Hicks, John R.: Cat_t_daro/T/tot, 202equilibrium, 21-23; on expecta- n$7; Critical Essays on Moneta,)tions, 133; "The Facts of the Social Theory, 18 n6; on market economy,Sciences,"$9nn$7,$9;Fu//Emp/oy- 17; monetary theory, 10; "Amentat Any Príce? 5, 202 n45; lad/- Suggestion for Simplifying the

Index 233Theory of Money," 10; .4 Theory of Jevons, w. Stanley: capital dimen-Economic History, 18 nl 1; "The sions, 169-170; capitaltheory, 179;Yield on Consols," 135 n5 on mathematics in economics,Historians: "covering laws," 16--18; 27-28; on production time, 170;econometrics and, 52-53, 54 The Theory of Political Economy, 38HoUis, Martin, and Edward Nell, Ra- nn22,24, 75 n22, 201 nn9,15,19,29tional Economic Man, 55 rml 1,17Keynes, John Maynard: economicIgnorance: error and, 67-71 legacy, 112-116; The General TheoryIndifference, Law of, 69 of Employment, lnterest, and Mon 0,Inefficiency, see Efficiency/Inef- 112, 113, 114, 115; Hayek's criUficiencycisms of, 114-116; monetaryInferential systems, 212-213 theory, 10; "The Pure Theory ofInflaÜon, 123-124, 152-155 Money. A Reply to Dr. Hayek,"Information: in the economic pro- 136 nl0;A TreatiseonMoney, 18 n5,cess, viñ, 57-76; in economics, 19; 114-116; .4 Treatise on Probability,imperfect, 35; investment in, 8; 213Lachmann on, 119-120; a/so see Keynes, Milo, ed., Essays of JohnKnowledge Maynard Keynes, 136 nl 1Information theory, 213--215 Kirzner, Israel M., viii, 57-76; on theInstitute for Humane Studies, x; Chicago School, 121; Competitionseminars, 19 and Entrepreneurship, 37 n2, 75Interest: in Austrian macro- nn18,21, 81, 82, 89, 109n3, I10economics, 170; "originary" nn16--22,32-34,37-39, 138n29,(Mises), 164 n2; in a pure exchange 140 n45, 225 n7; on competitioneconomy, ix, 157-166;inasocialist and market failure, 91; Theeconomy, 164; time allocation and, EconomicPoint of View, 74 n6; on the164;Ümepreferenceand, 157, 166 entrepreneurial function, 211;Interest rate: with expansion ofcred- "Hayek, Knowledge and Marketir, 194-195; intertemporal ex- Processes," 75 n23, 141 nn47-change and, 175--176; monetary 50,55; "Ludwig von Mises and thedisturbancesand, 192; in Rothbard Theory of Capital and Interest,"diagram, 177; structure of produc- 164 n2; "Mises and the Theory oftion and, 185Capital," 165 n4; monopoly theory,Intertemporal exchange, 175-178; 100-101, 104-108; on plans, 37-Austrian and Keynelian models, 38 n12; on spontaneous ordering178-179 forces, 128-129Intertemporal markets, 13-13 Klein, Benjamin, "Review of Compea-Inve_nent, 179-188; Austrian and tion and Entrepreneurship," 139 n3Keynesian models, 187; consump- Knight, F. H.: on error, 62; on Pigou,don relationship, 182; in informa- 79; "Some Fallacies," 79, 80don, 8 Knowledge: coordination and, 119-Irrationality, error and, 58-59 120; imperfect, 61-63, 68-69;

234 IndexLachmann on, 119-120;limited, X-Efficiency Theory of theFirm,"12; perfect, 69; time and, 6-8; a/ro 75 n12; "Competition and X-_e Information Efficiency: Reply," 75 nn 12,13;Koch Industries, x "Entrepreneurship and Develop-Kolmogorov, A. N.,_e Aleksandrov, ment," 75 nn12,24; on error,A.D., et al. 64-66; on inefficiency, 63--64,Koopmans, Tjalling C.: Three Essays 70-71on the State of Economic Science, 18 Leijonhufvud, Axeh "Effective Den7;on market economy, 12 mand Failures," 136 nlS, 137 ni6,Kuznets, S., 219; "National Income," 141 n59; in Keynesian controversy,226 n27 112-116; On Keynesian Economcsand the Economic_ofK¿,3nes,112, 136nn6,12Leontief, Wassily, "For a NationalLabor, original means ofproducfion, Economic Planning Board," 140169, 171 n44Lachmann, LudwigM.,viii, 1-18,225 Lerner, Abba P., 131n4; "On Amtrian Capital Theory," Life insurance poficies, __ surren-141 n60, 165 n5; Capital and Its der values, 150-151Structure, 10-11, 37n2; on error, Lin, I_in, "Are Time Deposits61-62; on knowledge, 119-120; on Money?" 155 n5macroeconomics, 220; "From Mises Liquidity, money supply and, 149to Shaclde," 138 n25, 14l nn52-54, Literature, 224142 nn62,63; on Neo-Ricardians, Littlechiki, S. C., viñ, 77-93157 n19; "Reflections on Hayekian London Economic Club, lOCapital Theory," 141 nnS1, 52; on London School of Economics, on sospontaneousordering forces, cial cost, 78, 81, 89128-134 Lutz, Frederick A.: "On NeutralLaing, N. F., see Harcourt, G.C. Money," 140 n36;a/sosee Streissler,Lakatm, Imre, "FahificaÚon and the Eñch, _ o_Methodology ofScientific ResearchProgranm,"55 nn13,15Lakatos, Imre, and Alan Musgrave, McDougal, Duncan M.,see Dernburg,ed$., C_ and CheGrow¢h of Thomas F.Know/_, 55 nl$ McGregor, D., The Human S/de 0fEn-Land, original meam of producfion, terpr/se, 227 n31169, 171 Machlup, Fritz: "Equilibrium andLaplace, Pierre Simon de, Thíor/e Disequilibrium," 37 nS; also see_ da pro_ 225 nll Streissler, Erich, eta/.Lamanne School, 121 McKinley, Gordon W., "F.ffects ofLavrent'ev, M. A., _ Alehandrov, Federal Reserve Polio/," 156 ni IA. D., et al. Macroeconomic relafionships, ix,Leibemtein, H.: "Aliocative Effi- 166-204ciency v$. X-Efficiency," 75 Macroeconomics: aggregates andnnl2,14, 76n25; "Aspects of the Austrian economics, 8-11; Aus-

Index 235trian, 167-204; controversies con- Menger, Carl, 117; capital theory, 1,cerning, 207, 219--220; further 2; on market evolution, 17; monestudyin,198-200;microeconomics tary theory, 34; Principles ofand, 219-220; subjectivism and, Economics, 39 n36; Problems of8--11 Economics and Sociology,18 ni2Malínvestment, 196-198 Methodological divergences, viii,Man, in economics, 36-37 40-56Management, 83; subjecÜvity and, Methodology, 32-35; positivism and,223 40-54Management theory, 222 Microeconomics, 219--220Mansfield, Edwín, Microeconomics, Misallocation of resources, in109 ni monopoly, 95, 96Marginalism, 205--210; varieties of, Mises, Ludwig ron: on acting man,206 81; on action, 51; a priorism,Marginalist revolution, vil, 205 19-20; on capital dimensions, 169;Market economy, 2-3; criÜcsand de- on capital/production time, 179; "Afenders, 11-15; general equilib- Critique of B6hm-Bawerk'srium model, 14-15; in Keynesian Reasoning," 164 n3, 165 n4,economics, 116; planning in, 126; 166 nn12,14; Epistemological Probspontaneousorder in, ix, 111-142 lems of Economics, 37 n3; on errone-Market process, effectiveness in ousactions,61-63;onerror,58-63;coordinaon, 2-3 "evenly rotating economy,"Market system, 218; entrepreneurial 173,176; Human Action, 24-27,functionin,210-212;interventions 37nn2,3,11, 38n31, 56nn19,20,in, 207, 211 74 nS, 109 nn6-14, 110 n15,138Market theory, information and n27, 156 n12, 164 nnl,3, 166communicationsin, 213-215 n16, 200 nl, 201 nn12,21,27,Market value, social cost and, 89 202 nn31,32,33,47,51; on inflationMarshall, Alfred, 71-73; Pr/nc/p/es of with credit expansion, 152-155; in-Economics, 76 n28, 138 n30terest theory, ix, 157-166; marketMarxism, controversies concerning, economy and, 12; on mistakes and207, 217-218 error, 58-59, 60--61; on monetary/Maslow, A. H., Eupsychian Manage- capital questions, 123; monetarymen¿ 227 n31 theory, 10, 34; "Money, Inflation,Mason, D. H., xand the Trade Cycle," 200 nl; onMathematicaleconomics, controversy money supply, 143-144; onover, 207 monopoly price, 103-104;Mathematics: analysis without _/'m- monopoly theory, 99--100, 104-bolic, 35; as an analytical tool, 108; Probab//y StaK¢ks and Truth,27-31; argument via, 215-216; 38n30; on rationality, 61--63, 65;plancomistencyand, 33-34; uncer- on socialist economy, 207-208;tainty ar.d, 81-32Theoff andH£¢0ry, 74 n3; The ThemyMaximizafion, 46-48 of Money and Cred/t, 39 n36, 143--Meaning:._asthecriterion 144, 156nn9,10, 165n4, 200nl;of, 42--44; probability and, 43-44 on time depmits, 148=149; time

2S6I_¿_preference concept, ix, 157-166 National income, 219--220Mistakes, 58--59Nell, Edward, ses Hollis, MarnMonetary disturbances, in Austñan Neocla_cal orthodoxy, 19macroeconomics, 188-198 NeoclasdcaI synthesis, 206Monetary policy, 36 Neo-Ricardians, 137 ni9Monetary theory, I0-II, 34-35; Newman, James R., The World ofChicago S.chool, 123-124, 189; M_, _8 n23, 225 n12quantity, I0-II; subjectivism in, N¢wsweek, 225 nn2,99-11Money: evolution of, 34-38; neutral, O'Driscon, Gera]d P.,Jr., ix, I I 1-142,189--194; quanÜty theory of, 10--11 225 n8; Economics oz a CoordinatianMoney supply, ix, 143-156; in Aus- Problem, 137 n24, 138 n29,trian macroeconomics, 188-198; 140 n37, 201 n6; "Friedrich HayekAustrian definiÜons of, 143-156; and the Economics of Choice,"Chicago deFmiÜon of, 144; compo- 139 n32; "Hayek and Keynes: Anents of, 151-152; Fisher quanÜty Retrospective Assessment,"theory, 10 IS6n13; The Ricardian Nan-Monopoly: compeÜÚve process and, Equivalence Theorem, 138 n24101; entrepreneurship and, 100- O'Drigoll, Gerald P.,Jr., and Sudha101; government intervendon and, R. Shenoy, "InflaÜon, Recesdon,I00, 102, 108-109; Kirzner def'mi- and StagflaÜon," lS9 n35Úon of, 101; neocla_cal def'miUon OpportuniÚes, entrepreneurial,of, 94-95; price and, 101-104, 69-71106-108; Rothbard's defmiÜon of, Opportunity cost, $5102, 108; sourcesof, 100; in un- Order, spontaneous, 111-142hampered markets, 100Monopoly theory, ix, 94-110; Aus- Pareto, Vilfredo, market economytrian, criUcal review of, 104-108; and, 12contemporary, 95-97; Kirzner's, Patinkin, Don, 186100-101, 104-108; Mi__an, 99- Money, lnteres¿andPrir_, 201 n4,202100, 104-108; neodassical, 94-95, nn40,5096-97; Rothbard's, 102-104, 104- Physiocrats, 117109 Pierce, J. 1L, Symbols, $i¿mals, andMou, Laurence S., ix, 157-166; ed., Na/se, 226 nnl8_0The Ec_ of Ludwíg ven M/_, Pigou, A. C.: Coa_ and, 77-87; The164 n2 Ecenamirz of Wdfart, 78, 79, 80;Motivation, lackof, 63--64 monetary theory, 10; on socialMueller, Willard F., ,4 Pr/mer on cost/product, 77-93; '*The Value ofMonopo/y and Compet/t/on, 109 n2 Money," 18 n4; Wmlth and We_an,78, 79Nagel, E., _ MeaningofProbabil- Planning, economic, $6, 124-128,ity," 225 ni2 207-208Nagel. E.. d aL. edL. Log/c. Met_,_do/- Piara: as the Austrian differentia. 2S.ogy. and Phau_ of Sdence, 227 24-87; of compefing fn-ms. 7-8;n28 constencies and market. 23n;

Index 237modífication of, 24-25; prefer- ReferenÜal statements, 48-49ences and, 24-37 Research, future, 205--227Popper, Karh on falsif'uability,55 n5; Ricardians, new, 118-124The Log/c of Sc/en6fic D/scoveTy, 39 Ricardo, David, 118-124; On theP_inn33,55 n2; Log/k der Forschung, 55 dples of Political Economy and Taxn2;on scientific method, 33 at/on, 138 n24; The Works and Cor-Positivist economics, 40-56respondence of, 138 n24Posner, Richard A., 88Richmond, S. B., OperationsResearchPraxeology: action and, 50, 54; forManagementDecisions, 225n14econometñcs and, 40-56; logical Rizzo, Mario J.', vi, 40-5ócharacter of, 50-52Robbins, Lioneh on the economisingPrediction: ceter par/bus, 4_._.5; as man, 8l;AnEssayontheNatureandthe goal of science, 42-43 Significance ofEconomic Science, 81;Preference/s: "abstract logic of," 24; The Great Depression, 203 n54; onplans and, 24-37; $ubjectivism the representative firm, 71-73;and, 1 "The Representative Firm," 76Price/s: monopoly, 99--100; monop- nn26,27_29,32oly and, 101-104, 106-108 Robertson, Dennis, 71Probability: in action, 31-32; Robinson, Joan,"Whathasbecomeofdegree-of-belief, 43-44; meaning the Keynesian RevoluÜon?" 115and, 43-44; subjectivity and, 212- Rothbard, Murray N., ix, 14._-156;213 ,4merica'sGreatDepression,2, 155 nS,Prochnow, Herbert V., ed., The Fed- 201 n3; a priorism, 19-20; _f'heeral Reserve System, 156 ni 1 Austrian Theory of Money," 155Product differentiaon, 8, 97 nnl,6; on the business cyde, 197;Product markets, 3-4on capital dimensions, 169; Capital,ProducÜon:periodof,2;structureof, Interest, and Rent, 164n4; on169-174 capital/production time, 179; onProduction time, 170-174; invest- cartels, I10 n36; "In Defense ofment and, 179-188 'Extreme Apriorism'," 56 n18;PubIicorganisations, 89-92 Man, Economy, and the State,Public utilies, social cost and, 77 37 nn2,3, 38 n14, 110 nn23-29,36,Pure exchange economy, interest in, 165 n7, 201 nn3,14,18,23,28,157-186 202 nn39,49; monopoly theory,102-109; "Praxeology: Reply toQuine, W.V.,Met/w¿ofLo¿,/¢, 55 n19 Mr. Schuller," 56 n21; "Toward aReconstruction of Utility and Wel-Radford, R. A., "The Economic Or- fare Economics," 85ganization ofa P.O.W. Camp, _ 165 Russell, Bertrand: on mathemacs asn8a tool, 27; P_nciples of Mathematics,Rand, Ayn, _Introduction to Objec- 38 ni9tivist Epistemology," 38 nn 17,27 Russell, W. 1L,see Hadar, J.Reality,theoryand,220-224Redistribution of wealth, market as a, St. George's House, WindsorCastle, x6 Samuelson, P. A., Economics, 224 n2

238 IndexSavage, L J., The Foundat/on of Stat- Social product: defmed, 83--84; diftics,225 nl0 ficulties in approach, 87-88; socialSavings, forced, 196 cost and, 83--87Savings banks, checking operations, Social value, 78-80156 n7 Socialism, controversies concerning,Savings deposits, in the money sup- 208, 217-218ply, 146-148 Socialist economy, interest in, 164Savings and loan shares, money sup- Sowell, Thomas: "Adam Smith inply and, 148 Theory and Practice," 140 n40;Scale economies, 97-99 ClassicalEconomics Reconsidered, 137Schlick, Moñtz, on falsifiability, 42; n20, 138 nn24_28Gesamme/_`4ufs_ze, 55 n7 Spadaro, Louis M., x, 205-227; "Av-Schumpeter, Joseph A., 208; Ht0ry erages and Aggregates inof Economic dnalysis, 18 n2, Economics," 225 nl0; "The139 n34; on Ricardo, 139 n34 HeurisÜc Value of Simulation,"Schwartz, Arma J.,see Friedman, Mil- 226 n23; The Present State of ProfitronTheor3, 225 n6Sennholz, M.,ed.,OnFreedomandFree Speculators: expectations, 131-132;Enterpr/se, 93, 225 nl0 in Keynesian orientaÜon, 112-114Shackle, G. L. S.: on determinism, Spontan¿ousorder, ix, 111-142; Aus-15-16;EpistemicsandEconomics, 18 trian School and, 128-134; as esnn3,10;on error, 61-62; Expecta- sential economic principle, 116-fían in Ecanomics, 38n51; on fu- 118tures, 12; on stability, 4 Stability, market, 4Shannon, Claude E., 226 nlg; "A Statiscal inference, misapplication,Mathematical Theory of Com- 212-213municaÜon, n 226 ni8 StatisÜcal time series, 17-18Shenfield, Arthur, xStigler, G.J.: on the economics of in.Shenoy, Sudha IL, ed.,,4 Tiger by t_e formation, 63; on efficiency/Ta//, 140 n39; a/so see O'Driscoll, inefficiency, 58, 59, 63-65, 71-73;Gerald P., Jr. on entrepreneurial ability, 72; onSkinner, A., "Economics and His- error, 58, 59, 63-65, 71; on motivatory--TheScottish Enlighten- tion, 63--64, 65; on social cost, 88,ment," 137 n23 89; Thany of Price, 89; "The Xis-Smith, Adam, 121; The W¢alth of Na- tence of X-Efficiency," 74 n2, 756ans, vil, 111, 118, 119, 211-212; nnlS,16, 76n30Thearj of Mora/St, n6mengs, 125 Streissler, Erich, ¢t al., Roads to Free-Social cost, viii, 77-93; calculating, doro, 140 n3689--92;choiceand,83--86;competi- Structure of production, 169-174;tion and, 90--92; concept of, 78--80; investment and, 178--188difficultie$ in approach, 87--88; Subjectivism/Subjectivity: in Austrianmarket value and, 89; social prod- economics, 1; education in, 223--uct and, 83--87; subjectívist ap- 224; fumre development of, 209;proach to, 80-_, 85-86 management and, 223; in mar-

Index 239ginalism, 205--206; probability and, Unsettle¿i questions, 1-18212-213; social cost and, 80-86;value ímd, 3 Value: classical economic concept, 3;Suppes, P., see Nagel, E., et al. subjectivism and, 3Supply of money, see Money supply Value dimension, of capital, 169-170Value theory, 206Tagliacozzo, G., "Croce and the Na- Venn diagrams, 27ture of Economic Science," 60 Verstehen, 45--46, 54; history and, 53;Tarski, A., see Nagel, E., et o£.in practical evaluation of theory,Theil, H.: "Alternative Approaches to 220, 223the Aggregation Problem," 227n28; Economics and Information Wagner, Richard, 122nTheory, 226 n18Walras, Léon,121,138 n30; É/émentsTheory, economic, application of, d'économiepolitiquepure, 224 nl220--224 Walras's Law, 184Thirlby. G. F.: "Economísts'Cost Waste, 57-58Rules and Equili_Jum Theory," 83; Welfare economics, 77-92; social cmton management, 83; The Ruler, 83; in, 77set Buchanan, J.M.Wicksell, Knut, on interest rate andTime: in Amtrian economics, 1-2; monetary expamion, 192knowledge and, 6-8; role of, 35 Wicksteed, Philip H., The CommonTime allocation, 161-162; interest Sense ofPolitical Economy, 39 n36and, 164Wiener, Norbert, 226 nn17,19Time depmits, money supply and, Windsor Casfle Symposium, v, x, 89148-149 Wiseman, J.: on management, 83;T'maedimendon, ofcapital, 169-170 "The Theory of Public UtilityTime preference, 2, 35; interest and, Price--an Empty Box,"83; "Uncerix,157-166 tainty, Costs, and CollectiveTopology, 216 Economic Planning," 83Toulmin, Stephen, For_gg/g and Un-_g, 55 nn$,4 Yeager, I_land: "Essential Prol2ertiesTñlling, L., The L/óem/Imag/nat/on, of the Medium of Exchange," 155227 n$$ ni; "The Keynesian Diversion,"116, 136 n14Unc_rminty, mathemaÜcsand,$1-32 Young, A. A., "Pigou's Wealth andUniversity College, at Buckingham, x Welfare," 79

Louis M. Spadaro was born in New York City in 1913 and holdsthe A.B. and M.S. degrees from the City University of New York.He received bis doctorate in economics from New York Universityin 1955.A member of the faculty of Fordham University since 1938,Spadaro has also served in various administrative posts, includingDean of the Graduate School of Business Administrationand Chairman of the Department of Economics.He is the author of numerous articles in economics and thetextbook Economics:An Introductory View (New York: Macmillan,1969).Spadaro is Prcsident of the Institutc for Humane Studies. Heis a member of and has held office in both Beta Gamma Sigmaand Omicron Delta Epsilon. His other memberships include theMont Pclerin Society, the American Economic Association, andthe American Statistical Association.

With the expanding influence of Austrian thought in economicdebate, scholarly discussion has p[oduced major insightsinto theoretical questions. New Directions in Austrian Economicscollects contributions by scholars currently exploring, refining,or extending the f'rontiers of economic analysis.Each paper in this volume advances significant points andreveals the creative diversity of Austnan economic thought.In the course of this collection, traditional economic approachesare closely evaluated and often challenged. Among thecontributions are found:• D. T. Armentano's critique of neoclassical and Austrianmonopoly theory• Roger Garrison's integration of macroeconomic relationshipsin capital theory with microeconomic decision-making• Israel Kirzner on the economics of information andentrepreneurship• Steven Littlechild's examination of subjective social cost andwelfare economics• Gerald O'Driscoll evaluating the nature and stability of marketprocesses• Mario Rizzo's reassessment of positivism and praxeologyas economic methodology• Murray Rothbard on conventional and Austrian definitionsof the money stockIn opening and closing New Directions in Austrian Economics,Professors Lachmann and Spadaro provide a retrospectiveand prospective survey for Austrian economic research.This distinguished volume presents invaluable explorations intomany of the most crucial issues facing modern economics.In U.$.A,