Money and Markets: Essays in Honor of Leland B. Yeager

Money and Markets: Essays in Honor of Leland B. Yeager

Money and MarketsIn recent decades, it has often seemed that economists have been more interested inmathematical technique than anything else. In a career spanning more than 50years, Leland B. Yeager has stood against this trend. An eminent team of scholarsexplore the array of topics on which Leland Yeager has written, including monetarytheory and history, public choice, the history, philosophy, and methodology ofeconomic thought, macroeconomics, and business cycles.Contributions include Nobel laureate James Buchanan on the origins of publicchoice, constitutional economics, and the Virginia School of Political Economy,Gordon Tullock on Yeager’s contributions to public choice, James C. Miller on theproblem of monopoly politics in America, Maria Minniti and Lidija Polutnik onstopping inflation in Slovenia, Harry Landreth and David Colander on pluralismand formalism in American economics, Jürgen Backhaus on the ordo-liberal schoolof economic thought, Roger Garrison on capital theory and reswitching, andRandall Holcombe evaluating Yeager’s utilitarian approach to policy espousal.Many readers will be surprised to learn of Yeager’s contributions to the creationof public choice theory as related in the separate contributions of Buchanan andTullock. Steven Horwitz and Garrison point to important Wicksellian themesin both Yeager’s work and Austrian economics. They highlight an interesting“post-Wicksellian macroeconomics” that integrates Austrian themes with Yeager’smonetary-disequilibrium theory of macroeconomic dynamics. William Breit,Kenneth Elzinga, and Thomas D. Willett provide a portrait of Yeager, the man,which is not to be missed for its sheer joy and delight in representing vividly theunique mind and personality of the volume’s honoree.Roger Koppl is a Professor of Economics and Finance in the Silberman Collegeof Business at Fairleigh Dickinson University, USA.

Foundations of the market economyEdited by Mario J. Rizzo, New York University andLawrence H. White, University of Missouri at St. LouisA central theme in this series is the importance of understanding and assessing the marketeconomy from a perspective broader than the static economics of perfect competition andPareto optimality. Such a perspective sees markets as causal processes generated by thepreferences, expectations and beliefs of economic agents. The creative acts of entre preneurshipthat uncover new information about preferences, prices and technology are centralto these processes with respect to their ability to promote the discovery and use of knowledgein society.The market economy consists of a set of institutions that facilitate voluntary cooperationand exchange among individuals. These institutions include the legal and ethical frameworkas well as more narrowly “economic” patterns of social interaction. Thus the law, legalinstitutions and cultural and ethical norms, as well as ordinary business practices andmonetary phenomena, fall within the analytical domain of the economist.Other titles in the seriesThe Meaning of Market ProcessEssays in the development of modernAustrian economicsIsrael M. KirznerPrices and KnowledgeA market-process perspectiveEsteban F. ThomasKeynes’ General Theory of InterestA reconsiderationFiona C. MaclachlanLaissez-faire BankingKevin DowdExpectations and the Meaning ofInstitutionsEssays in economics by LudwigLachmannEdited by Don LavoiePerfect Competition and theTransformation of EconomicsFrank M. MachovecEntrepreneurship and theMarket ProcessAn enquiry into the growth ofknowledgeDavid HarperEconomics of Time and IgnoranceGerald O’Driscoll and Mario J. RizzoDynamics of the Mixed EconomyToward a theory of interventionismSanford IkedaNeoclassical MicroeconomicTheoryThe founding of Austrian visionA. M. Endres

The Cultural Foundations ofEconomic DevelopmentUrban female entrepreneurship in GhanaEmily Chamlee-WrightRisk and Business CyclesNew and old Austrian perspectivesTyler CowenCapital in DisequilibriumThe role of capital in a changing worldPeter LewinThe Driving Force of the MarketEssays in Austrian economicsIsrael KirznerAn Entrepreneurial Theory of theFirmFrédéric SautetTime and MoneyThe macroeconomics of capital structureRoger GarrisonMicrofoundations andMacroeconomicsAn Austrian perspectiveSteven HorwitzMoney and the MarketEssays on free bankingKevin DowdCalculation and CoordinationEssays on socialism and transitionalpolitical economyPeter BoettkeKeynes and HayekThe money economyG. R. SteeleThe Constitution of MarketsEssays in political economyViktor J. VanbergFoundations of Entrepreneurshipand Economic DevelopmentDavid A. HarperMarkets, Information andCommunicationAustrian perspectives on the interneteconomyEdited by Jack Birner and Pierre GarrousteThe Constitution of Liberty in theOpen EconomyLüder GerkenLiberalism against LiberalismJavier AranzadiMoney and MarketsEssays in honor of Leland B. YeagerEdited by Roger Koppl

Money and MarketsEssays in honor of Leland B. YeagerEdited by Roger Koppl

First published 2006by Routledge2 Park Square, Milton Park, Abingdon, Oxon OX14 4RNSimultaneously published in the USA and Canadaby Routledge270 Madison Ave, New York, NY 10016Routledge is an imprint of the Taylor & Francis Group, an informa business© 2006 editorial matter and selection, Roger Koppl; individual chapters,the contributorsThis edition published in the Taylor & Francis e-Library, 2006.“To purchase your own copy of this or any of Taylor & Francis or Routledge’scollection of thousands of eBooks please go to”All rights reserved. No part of this book may be reprinted or reproducedor utilised in any form or by any electronic, mechanical, or other means,now known or hereafter invented, including photocopying and recording,or in any information storage or retrieval system, without permission inwriting from the publishers.British Library Cataloguing in Publication DataA catalogue record for this book is available from the British LibraryLibrary of Congress Cataloging in Publication DataMoney and markets: essays in honor of Leland B. Yeager/editedby Roger Koppl.p. cm.Includes bibliographical references and index.1. Money. 2. Free enterprise. 3. Economics. 4. Yeager, Leland B. I. Koppl,Roger, 1957– II. Yeager, Leland B.HG220.A2M582 2006332.4–dc22 2005025298ISBN10: 0–415–70162–7 (Print Edition)ISBN13: 978–0–415–70162–4

ContentsList of figuresList of contributorsPreface and acknowledgmentsixxixiii1 A zeal for truth 1ROGER KOPPL2 The Yeager mystique: a profile of the scholar as teacher andcolleague 21WILLIAM BREIT, KENNETH ELZINGA, AND THOMAS D. WILLETT3 The Virginia renaissance in political economy: the 1960srevisited 34JAMES M. BUCHANAN4 Leland: a personal appreciation 45GORDON TULLOCK5 Monopoly politics and its unsurprising effects 48JAMES C. MILLER III6 Good ideas and bad regressions: the sad state of empirical workin public choice 66STEVEN B. CAUDILL7 Pluralism, formalism, and American economics 83HARRY LANDRETH AND DAVID C. COLANDER8 Leland’s favorite economists 99JÜRGEN G. BACKHAUS

viiiContents9 The genesis of an idea: Classical economics and the birth ofmonetary disequilibrium theory 126MICHAEL R. MONTGOMERY10 The macroeconomics of money, saving, and investment 143ROBERT L. GREENFIELD11 No-name money 151MARIA MINNITI AND LIDIJA POLUTNIK12 Monetary disequilibrium theory and Austrian macroeconomics:further thoughts on a synthesis 166STEVEN HORWITZ13 Reflections on reswitching and roundaboutness 186ROGER W. GARRISON14 Leland Yeager’s utilitarianism as a guide to public policy 207RANDALL G. HOLCOMBE15 Ethnic conflict and the economics of social cooperation:reflections on a difficult problem 221LAURENCE S. MOSS16 The legacy of Bismarck 242GORDON TULLOCKIndex 251

Figures8.1 The “Genealogical Table” 1018.2 Eucken’s Wheel 1048.3 Leland’s Diagram 12112.1 Intertemporal discoordination due to credit expansion 17712.2 Intertemporal discoordination due to excess demand for money 17813.1 A three-period project 19213.2 Present value (0%–14%) 19313.3 Present value (0%–1000%) 19313.4 Cost advantage (C B /C A ) 195

ContributorsJürgen G. Backhaus is the Krupp-Foundation Chair in Public Finance andFiscal Sociology at the University of Erfurt in Germany.William Breit is Professor Emeritus at Trinity University in Texas. He was theE.M. Stevens Distinguished Professor of Economics at Trinity from 1983 to1999 and the Vernon F. Taylor Distinguished Professor of Economics from1999 until his retirement in May 2002.James M. Buchanan is Advisory General Director of the James BuchananCenter for Political Economy and Holbert L. Harris University Professor atGeorge Mason University. He received the Nobel Memorial Prize for Economicsin 1986.Steven B. Caudill is Regions Bank Professor of Economics at AuburnUniversity.David C. Colander is Christian A. Johnson Distinguished Professor of Economicsat Middlebury College.Kenneth Elzinga is Robert C. Taylor Professor of Economics at the University ofVirginia.Roger W. Garrison is Professor of Economics at Auburn University.Robert L. Greenfield is Professor of Economics and Finance at FairleighDickinson University.Randall G. Holcombe is DeVoe Moore Professor of Economics at Florida StateUniversity.Steven Horwitz is Professor of Economics at St. Lawrence University.Roger Koppl is Professor of Economics and Finance at Fairleigh DickinsonUniversity.Harry Landreth is Ewing T. Boles Professor Emeritus at Centre College.James C. Miller III is Chairman of The CapAnalysis Group, an affiliate of theinternational law firm, Howrey Simon Arnold & White, Distinguished Fellow at

Contributorsthe Center for Study of Public Choice at George Mason University as well as theuniversity’s Mercatus Center, and Senior Fellow (by courtesy) of the HooverInstitution.Maria Minniti is Associate Professor of Economics, Associate Professor of Entrepreneurship,and holder of the Ann Higdon Term Chair at Babson College.Michael R. Montgomery is Associate Professor of Economics at the Universityof Maine.Laurence S. Moss is Professor of Economics at Babson College in Massachusettsand now serves as the editor-in-chief of The American Journal of Economics andSociology. His specialty fields include the History of Economic Thought, AustrianEconomics, and Law and Economics.Lidija Polutnik is Associate Professor of Economics at Babson College.Gordon Tullock is University Professor of Law and Economics at George MasonUniversity. He has been the Karl Eller Professor of Economics and PoliticalScience at the University of Arizona, Holbert R. Harris University Professor atGeorge Mason University, and University Distinguished Professor at VirginiaPolytechnic Institute and State University.Thomas D. Willett is Horton Professor of Economics at the Claremont GraduateSchool and Claremont McKenna College.xii

Preface and acknowledgmentsLeland B. Yeager is Paul Goodloe McIntire Professor Emeritus at the University ofVirginia and Ludwig von Mises Distinguished Professor of Economics Emeritus atAuburn University. He was born in Oak Park, Illinois on 4 October 1924. Hereceived his AB in Economics from Oberlin College in 1948; his MA in Economicsfrom Columbia University in 1949. Yeager wrote his doctoral dissertation, “AnEvalu ation of Freely-Fluctuating Exchange Rates,” under the joint supervision ofthe monetary economist James W. Angell and Ragnar Nurkse, the famed specialistin International Economics and Economic Development. Yeager received his PhDin Economics from Columbia University in 1952. In the same year, Yeager wasappointed an Instructor at the University of Maryland. He was promoted toAssistant Professor in 1955. In 1957 he was elected Assistant Professor at the Universityof Virginia, where he was promoted to Associate Professor in 1959 and toProfessor in 1963. In 1969, Yeager was named Paul Goodloe McIntire Professor atthe University of Virginia, a position he retired from in 1986. In the same yearYeager was named Ludwig von Mises Distinguished Professor of Economics atAuburn University, where he stayed until his retirement in 1995. Yeager hasbeen a Visiting Professor at Auburn University, Southern Methodist University,University of California, Los Angeles, New York University, and George MasonUniversity. Yeager was President of the Southern Economic Association in 1974–75 and of the Atlantic Economic Society in 1994–95; he has been an AdjunctScholar with the American Enterprise Institute and the Cato Institute; a Fellowwith the American Association for the Advancement of Science; a member of theMont Pelerin Society; and Director and President of Interlingua Institute and ofUnion Mundial pro Interlingua. Today he lives in Auburn, Alabama.This Festschrift was prepared to honor Leland B. Yeager on the occasion of his80th birthday. Many of the contributions in this volume were delivered in twosessions of the 2004 meeting of the Southern Economic Association. The participantswere Jürgen G. Backhaus, William Breit, Edgar Browning, Luis Dopico,Kenneth Elzinga, Roger Garrison, Randall Holcombe, Michael Montgomery,Laurence Moss, George Selgin, Gordon Tullock, and Leland Yeager. I thank themfor their participation. The same annual meeting saw a reception in Yeager’shonor, at which time a manuscript version of this book was presented to him. Ithank William Johnson, then president of the Southern Economics Association, for

Preface and acknowledgmentssponsoring the two sessions honoring Yeager. I thank Steve Caudill and RogerGarrison for abundant and energetic help in arranging them and planning theevening reception. The evening reception was entirely the product of their efforts.Steve Caudill arranged for Auburn University, the University of Virginia, andthe Ludwig von Mises Institute to fund the evening reception for Yeager. RogerGarrison edited and printed the manuscript version of this book presented toYeager on that occasion. This job included the burdensome transformation ofthe Word files I sent him into elegantly formatted pdf files. Roger Garrison alsoprovided the photograph of the frontispiece, which he arranged to have takenspecifically for use in this book. Figure 12.1 is reproduced from Roger’s book Timeand Money: The Macroeconomics of Capital Structure (2001, Routledge).I thank the Eastern Economic Association for permission to reprint Chapter 2,which, apart from some minor changes, originally appeared as Breit, William,Kenneth G. Elzinga, and Thomas D. Willett, “The Yeager Mystique: The Polymathas Teacher, Scholar and Colleague,” Eastern Economic Journal, Spring 1996,22(2): 215–29.I thank all the contributors to this volume for comments on my introductoryessay and for their prompt and professional delivery of papers that, in my opinion,are of uniformly high quality. Finally, I owe further thanks to Roger Garrison forproviding encouragement, lots of good advice, and close supervision of my efforts.xiv

1 A zeal for truthRoger KopplIf there is one Great Fact from which all of Leland Yeager’s special qualities derive,it is his zeal for truth. He must seek the truth, learn the truth, know the truth, writethe truth, and speak the truth. An honest scholar is constrained by truth. He mayerr, of course, but he must be truthful. Leland B. Yeager is much more than anhonest scholar; he has a fervent devotion to truth, a zeal for truth. The contributorsto this volume have all experienced this zeal and been inspired by it. The notorietyof the scholars contributing to this volume is a testament to the respect, admiration,and love that Leland Yeager inspires in all his colleagues and students. They haveall experienced the special qualities that make Leland Yeager an exceptionalscholar and an exceptional friend. These exceptional qualities are reflected in theessay by Breit, Elzinga, and Willett, “The Yeager Mystique: A Profile of the Scholaras Teacher and Colleague.” Their paean to Yeager does not exaggerate. He is anextraordinary teacher, an extraordinary scholar, and an extraordinary personality.Breit, Elzinga, and Willett (Chapter 2) comment on Yeager’s teaching “duende,”which is “that mysterious quality that endears great teachers to pupils in the sameway that it endears great performers to their audience.” I remember Yeager oftensaying (crediting Wilhelm Roepke) that you cannot learn any economics until youhave learned all of economics. And he seemed to squeeze all of economics intoevery class.The tribute of Breit, Elzinga, and Willett covers his scholarly publications as wellas his teaching. They begin in 1954, the year of Yeager’s first scholarly publicationsas an economist. In that year Yeager published two journal articles, a monographon free trade, and a reply to a critic. These four publications by a University ofMaryland instructor display in fully developed form many, perhaps all, of thesalient characteristics of Yeager’s scholarship. Free Trade: America’s Opportunity(Yeager 1954a) was an 88 page monograph arguing, of course, for free trade.“Some Questions About Growth Economics” (Yeager 1954b) is a critique ofHarrod-Domar growth models. “Some Questions About Growth Economics:A Reply” (Yeager 1954c) responds to G.M. Meier’s criticism. Finally, “TheMethodology of Henry George and Carl Menger” (Yeager 1954d) is a classicarticle published in the American Journal of Economics and Sociology.All these works display what Breit et al. rightly describe as Yeager’s “passionfor getting the analysis straight.” They display many other characteristic traits,

2 Roger Kopplhowever, including Yeager’s fearlessness in intellectual exchange, his concernwith practical policy advice and the role of values in policy prescription, his deep,but unadorned erudition in economic method, including methodological individualism,his deep immersion in the history of economic thought, his freedomfrom the idolatry of methods and the fetishism of jargon, and his constant attentionto the central role of money in creating or frustrating economic coordination.Yeager’s free trade pamphlet, Free Trade: America’s Opportunity, uses the samedevice he would later exhibit in his books co-authored with David Tuerck (1966,1976), namely, using testimony at Congressional hearings as a foil against which toset the analysis straight. The style is disinterested, but impassioned; non-technical,but intellectually rigorous; scientific, but richly informed by the values of peace,cooperation, and individual autonomy. He says, for example, “Free Trade wouldcontribute not only to the health of democratic government but also to worldpeace” (p. 26). He even considers the prospects of promoting peace through aworld government and asks us to consider whether legal rules defending liberty“might be enforced by a limited world government with no other powers” (p. 27).Free Trade: America’s Opportunity was published by the Robert SchalkenbachFoundation. This foundation, according to its webpage, “was organized in 1925 topromote public awareness of the social philosophy and economic reforms advocatedby Henry George (1839–97), including the ‘single tax on land values.’”Yeager’s pamphlet shows the strong influence of Henry George’s writings onthe topic, but it sticks to the subject and is not an overall Georgist tract. (I thankthe Schalkenbach Foundation for graciously providing me a copy of Yeager’spamphlet.)Yeager has explained to me his relationship to Henry George. When Yeager wasin high school, his history teacher, Miss Conner, suggested that he take the HenryGeorge School’s correspondence course in Progress and Poverty. After finishing thatcourse, he took the course in Protection or Free Trade? Through this course of study,Yeager became a convinced, even passionate, Georgist; and, convinced that healready knew the essentials of economics, he majored in economics at OberlinCollege in Ohio. There, and especially in graduate school at Columbia, he learnedthat there was much more to economics that fascinated him. “I still greatly admireHenry George,” he has informed me, “although I am no longer a single-taxer.”While I share Yeager’s view that the Georgist idea is “economically inexpedient,” itmay be worth pointing out that similar ideas have been expressed by economists asprominent as François Quesnay and Leon Walras.Yeager’s free-trade pamphlet contains an interesting passage (pp. 24–5) brieflytouching on themes such as rent seeking that later characterized Virginia PoliticalEconomy. This Virginia discussion leads into a defense of “Free Trade” on thebasis of democracy.Government should not have to manufacture agreement on matter whose verynature makes a genuine consensus unlikely. Government should confine itself,as far as possible, to policies that the citizens can discuss intelligently. Now, thefree market decentralizes and keeps out of politics a far-reaching and important

A zeal for truth 3kind of decision-making. It is a shame, in my opinion, to sabotage by Protectionistmeasures such a great bulwark of democratic government and human freedomas the free market.(Yeager 1954a: 26)Free Trade: America’s Opportunity displays fully Yeager’s passion for getting theanalysis straight. In a section entitled “The Importance of Not Weaseling,” he says,“Free Traders should speak out bluntly. They should argue not for lower tariffs, notfor reciprocal trade agreements, not for freer trade, but for Free Trade – thecomplete end to government interference with imports and exports” (p. 86). Thenotion that halfway measures are more “practical, reasonable, realistic” is firmlyrejected. “Practicality, reasonableness, realism take the place of thought. True FreeTraders should not care about a cheap reputation for practicality, reasonableness,realism” (p. 87). He quotes Dennis Robertson’s admonition “not to mind whetheror not the ‘temper of the age’ makes some policy ‘politically impossible’: ‘Let us getthe analysis right . . .’” (p. 87).Yeager’s “passion for getting the analysis straight” is also reflected in a stingingremark from “Some Questions” cited by Breit et al.:One can juggle concepts and symbols defined in a question begging or meaninglessway for quite a while with no danger of saying anything contradictable byobservable facts of technology or of human behavior. Metaphorical languagelets the theorist even think he is saying something.(Yeager 1954b: 62)This comes after a careful demonstration that then-standard growth models hidmonetary factors behind non-monetary variables and, in so doing, obscured therelation between the supposed results of the model and “actual human behavior”(p. 61). In his first major statement of monetary disequilibrium theory, “A Cash-Balance Interpretation of Depression,” Yeager is explicit about linking microeconomicsand macroeconomics. The “cash-balance approach achieves” itstheoretical “unity” in part “by tying macro- and micro-economics together”(Yeager 1956: 438). Fifty years on, we could use more of this kind of microfoundationfor macroeconomics.Yeager’s paper on growth stimulated a response from G.M. Meier. Yeager’sreply demonstrates the same fierce pursuit of the plain truth as the earlier article.Deftly disposing of Meier’s mistakes and misinterpretations, Yeager closes bychallenging Meier to address the issues at hand. “If he had felt able to refute myargument that the nightmares of the growth theorists presuppose monetaryinstability . . . Meier might well have taken up the challenge” (1954c: 937). Thisremark is pure Yeager: Let’s get to the real issues and not be sidetracked bymethodological posturing, uncharitable interpretations, or any other distractionfrom the real points at issue.Yeager’s seeming impatience with methodology is really impatience with badmethodology, which includes any “preachments” that would, in Fritz Machlup’s

4 Roger Kopplwords, “proscribe any technique of inquiry deemed useful by an honest and experiencedscholar” (Machlup 1956 as quoted in Yeager 1995: 28). In class Yeagerwould often quote Percy Bridgman’s remark that “the most vital feature of thescientist’s procedure has been merely to do his utmost with his mind, no holdsbarred” (Bridgman 1955 as quoted in Yeager 1995: 27). The trouble with thisadvice is that it strips you of all methodological props and ornaments. It throws younaked into the problem at hand. Yeager taught us by example to go thus naked intoeconomic theory.I suspect that Yeager’s impatience with bad methodology has been buildingsteadily for the past half century. His earliest explicit foray into the topic was in thesignal year of 1954. There, in his classic “The Methodology of Henry George andCarl Menger,” Yeager outlines a very sophisticated view from which, I believe, henever departed. Here we have a straightforward exposition of the good practices oftwo giants of the discipline, Henry George and Carl Menger. Today, when the“Hayek industry” has exploded and “Austrian economics” has been in “revival”for a generation, we are familiar with much of what Yeager said in 1954. But whenwe put his argument in the context of the times, it is startlingly original andpenetrating. And even today, many will be surprised by its demonstration thatHenry George was “a profound and original economist” (1954d: 233). In six scantpages, Yeager outlines Menger’s compositive method, which George arrived atindependently, methodological individualism, a Misesian emphasis on humanaction, a defense ofintrospection” and “armchair theorizing,” the role of “mentalor imaginative experiment,” a recognition of “some limitations of statistics andother methods of historical research in establishing or testing laws of economics,”an exposition of the “‘organic’ conception of society,” a discussion of dispersedknowledge linked to a criticism of socialism, and a recognition of money and “newcommunities” as evolutionary phenomena.Yeager points out an important argument for the practice of methodologicalindividualism. “The methodological individualism of George and Menger stemsfrom a realization that economists’ ‘inside’ knowledge of human motives anddecision-making is a leading source of basic empirical generalizations” (p. 238).Methodological individualism is not a first principle arbitrarily imposed or somesort of ontological idea. The point, rather, is that we cut ourselves off from usefulinformation if we do not make use of our “inside knowledge of human motives.”In class, Yeager would explain methodological individualism as a kind of check.Let’s see what your argument, theory, or model says about “who does what.” If itimputes to real actors actions that are unreasonable or improbable, the argument,theory, or model has probably gone wrong somewhere. If the implied actions ofindividuals are reasonable, the argument, theory, or model has passed an importanttest and might be true.In 1954 Yeager restricted himself to similarities in the methodologies of Georgeand Menger. Later, in “Henry George and Austrian Economics,” he turned hisattention to other similarities. George “independently arrived at several of the mostcharacteristic insights of the ‘Austrian’ School” (2001a: 3). Yeager’s list of similaritiesand affinities is quite long. He finds points of contact in their value theories

A zeal for truth 5and attributes to George some understanding of the Austrian idea of imputation.He notes that George and the Austrians both had invisible-hand explanations ofmoney’s evolution and both compared money and language. The “major points ofagreement” concern political philosophy, methodology, “knowledge, coordination,and unplanned order” (p. 11), and their criticisms of socialism. I willcomment on the last two points.Chapter 6 of George’s (1898) The Science of Political Economy, “Of Knowledge andthe Growth of Knowledge,” contains many striking similarities to Austrian treatmentsof the same theme. Much as Menger had done in his Principles of Economics(1871), George attributes the progress of civilization to the growth of knowledge.His discussion includes a relatively long treatment of “skill” and how skill emergesfrom practice informed by explicit knowledge. He uses as his leading example theskill of riding a bicycle, which is the standard example in discussions of tacit knowledge.In much the way Michael Polanyi discussed the subsidiary and focalawareness, George notes that the person learning the skill of riding a bicycle “canlook neither to right nor to left, nor notice what he passes” (p. 35). But once the“knowledge required” has passed into “subconscious memory,” the learner “mayride easily, indulging in other trains of thought and noticing persons and scenery”(p. 35). Skill “cannot be communicated from one to another, or so communicatedonly in very small degree” (p. 36). George’s “skill” is tacit knowledge in all butname. Yeager remarks that George “and the Austrians agree that a central taskof economics is to explain how specialized human activities may be coordinatedwithout deliberate direction” (p. 12). George deploys “insights later also achievedby F. A. Hayek,” Yeager says, when discussing “the mobilization of knowledge thatis inevitably dispersed and that simply could not be centralized and put to use by asingle mind or a single organization” (p. 13).George’s critique of socialism bears close similarity to Austrian arguments on thetopic. Building on his distinction between “directed or conscious co-operation” and“spontaneous or unconscious co-operation,” George argues for the “Impossibilityof socialism” (p. 301). George invites us to ignore the “inevitable tendency totyranny and oppression” created by power. Imagine economic control is handedover to “the very wisest and best of men.” Considerthe task that would be put upon them in the ordering of the when, where, howand by whom that would be involved in the intelligent direction and supervisionof the almost infinitely complex and constantly changing relations and adjustmentsinvolved in such division of labour as goes on in a civilized community.The task transcends the power of human intelligence at its very highest.(George 1898: 311–12)Some parts of George’s critique of socialism, Yeager says, “remind us of theemphasis of present-day Austrians on the creative role of entrepreneurship” (p. 15).Yeager thinks George’s critique of socialism is better in The Science of Political Economy(1898) than the “earlier and less insightful” (p. 22) comments in Protection or FreeTrade? (1886).

6 Roger KopplLandreth and Colander (Chapter 7) identify the word to describe Yeager’s laissezfaire attitude on method: pluralism. They argue from Yeager’s pluralism to apessimistic conclusion on his methodology and economics. Yeager’s “commitmentto pluralism has played an important role in reducing his work’s influence.” Theirpessimism, however, is not complete. The pendulum, they think, is swinging in asomewhat Yeagerian direction. Landreth and Colander’s metaphorical pendulumrepresents the fashion in economic method. It swings between formalism and antiformalism.Pluralism takes hold only when neither side has preponderate strength.Thus, Yeager’s methodological pluralism is fated to be a passing fancy at best. Buthis rather inductive and non-formal style of theorizing is making a comeback forgood institutional reasons. In the past, the formalism had an institutional advantageover its rival. The formalist had lots of tidy little projects to give his or her graduatestudents and these students could get tenure off the project thus endowed.Formalism of the post-war type “created large numbers of small jobs, enough tokeep an academic neoclassical army of students busy.” Today, however, we havethe personal computer. “Today, instead of writing a general solution to an abstractproblem, it is easier to provide a solution for a specific problem.” We can programcomputers to solve problems with heterogeneous agents and institutional details.Thus, “solid inductive analysis combined with a sharp intuition and a rigor of thesort that characterized Leland Yeager’s work will be making a comeback, albeit ina quite different form.” Students and admirers of Leland Yeager should welcomethis change. They should also, however, recall the defense of “armchair theorizing”that he made in 1954. Let us not cut ourselves off from our “inside” knowledge ofhuman action.Yeager’s now classic essay comparing George and Menger exemplifies Yeager’sability to construct a close methodological argument without slipping into needlessjargon or the worship of either method or the study thereof, methodology. Anothergood example of the same phenomenon is Yeager’s classic “Methodenstreit overDemand Curves” (Yeager 1960). Addressing a literature on the meaning ofdemand, Yeager takes aim at the “methodological precepts set forth in this literature:its insistence on a particular conception of empirical falsifiability and concreteapplicability of theories and its insistence that the theories deal only with actually orconceptually attainable positions of equilibrium” (p. 53). “Methodenstreit” ends witha plea for methodological tolerance. He says, “there is no warrant for exclusive insistenceon particular methods” (p. 60). Klappholz and Agassi were right, Yeagercontinues, to say that methodological rules more specific than the general admonitionto be critical and exposed to criticism are “likely to be futile and possiblyharmful” (Klappholz and Agassi 1959: 74, as cited in Yeager 1960: 60). Here, as inmost of Yeager’s methodological writings, we sense a careful scholar disgruntled athaving been driven into the tedious muck of methodology in order to clear a pathfor our real business, namely, economics. This attitude reaches one of its highestexpressions in Yeager’s 1995 article “Tacit Preachments Are the Worst Kind.”In his contribution to his volume, Steven Caudill (Chapter 6) reveals himself tobe a Yeagerian methodologist. Caudill’s ire, his withering irony, and his straightshootingargument might be attributed to the coincidence that he was born

A zeal for truth 7“30 years to the day after Leland B. Yeager,” or to the influence of Yeager as acolleague, or, most likely, to a zeal for truth equal to that of his friend and colleague,Leland Yeager. Caudill condemns “bad regressions” in economics, especiallypublic choice. We see research “characterized by the following: 1) no structuralmodel is presented and may not exist, 2) many, if not all, of the variables are proxyvariables, 3) the estimation results may be the result of a proxy variable search, and4) more efficient statistical approaches have not been applied.” Caudill offersseveral solutions, including that we should take our role as educators more seriouslyand impress upon econometrics students the importance of doing good, carefulwork. In characteristically Yeagerian tones, Caudill says, “The most importantsuggestion is that we, as a profession, stop publishing papers containing badregressions.”It is only fitting that Caudill’s objections relating to public choice should beincluded in a volume celebrating Leland Yeager. Caudill’s objections are highlyYeagerian and they concern an intellectual tradition, public choice, Yeager helpedto create. Buchanan’s contribution (Chapter 3) and the shorter contribution ofGordon Tullock (Chapter 4) reveal Yeager’s importance in the creation of thePublic Choice. Buchanan takes credit for hiring Yeager away from the Universityof Maryland, crediting Warren Nutter for nabbing future Nobel laureate RonaldCoase. Buchanan mentions something noted with gratitude in Tullock’s essay aswell. Yeager played an important role in bringing Tullock to the University ofVirginia. Buchanan speaks of Yeager’s “strong support for appointing Tullock.”Tullock says of Yeager, “I remain grateful to him for, in a way, getting me started ineconomics.” He attributes to Yeager a “major role in getting public choice started”and insists that his contact with Yeager in Virginia contributed importantly tohis “intellectual development” in the University of Virginia years. Buchanan’scontribution relates further particulars on Yeager’s intellectual and administrativecontributions to Virginia Political Economy, including the contribution of Yeager’sedited volume, In Search of a Monetary Constitution (1962), to constitutional politicaleconomy.When Yeager’s role in the creation of public choice theory is recognized, wehave less cause to feel surprise that James C. Miller (Chapter 5) would describe hisanalysis of monopoly politics as, in part, “an application of some of the basicprinciples of price theory Mr. Yeager taught” him. That description also makessense in light of Yeager’s dictum: You cannot learn any economics until you havelearned all of economics. Miller’s account is built on Virginia Political Economyand personal experience. The upshot is that under representative democracy,political incumbents and insiders have a tendency to erect barriers to entry todemocratic political markets. Elaborate restrictions thwart outsiders from seekingthe suffrages of their fellow citizens. Campaign finance “reform” is a salientexample. Incumbents have an incentive to restrict campaign spending because“they do not like their odds against well-funded challengers and seek to limit theirability to raise such resources and to spend them effectively.” Besides, with suchrestrictions in place, incumbents have the advantage that “they make news, and thushave more access to the media.”

8 Roger KopplBuchanan mentions Yeager’s 1954 growth paper. “I had scarcely put the articledown,” he reports, “before I commenced to search out Yeager’s possible interest ina position on our faculty.” As I indicated above, Yeager’s article drew out thehidden monetary elements in then-popular growth models. This was to be the firstin a very long list of contributions to monetary theory, including “A Rehabilitationof Purchasing-Power Parity” (1958b), International Monetary Relations: Theory, Historyand Policy (1966), “The Essential Properties of the Medium of Exchange” (1968),Experiences with Stopping Inflation (1981), and “A Laissez Faire Approach to MonetaryStability” (Greenfield and Yeager 1983). Readers interested in Yeager’s monetarytheory should consult Yeager (1997) and the introduction by its editor, GeorgeSelgin. Yeager’s achievements in monetary theory are reflected in several contributionsto this volume.Rob Greenfield (Chapter 10) uses metaphors characteristically his own, to giveus a kind of primer on Yeagerian monetary disequilibrium theory and indirectconvertibility. A primer on indirect convertibility seems especially desirable to me.I have long felt that the monetary proposal of Greenfield and Yeager, the “BFHsystem” as they unhappily dubbed it, has been underappreciated and misunderstood.(Their odd name derives from an attempt to honor some of their sources:Black, Fama, and Hall.) Their proposal is simpler and infinitely more practical thanit is sometimes made out to be. Perhaps it would be helpful to some readers if Iexplained a simplified version of BFH.Imagine we have a monetary system with one bank. Bank notes, and only banknotes, circulate as hand-to-hand currency. To keep things really simple, imaginethat there are no checkable deposits in this system. We will call the unit for banknotes the “dollar.” Notes are denominated in silver, with each dollar in notes beingworth, say, 0.8 ounces of silver. Thus, the “dollar” is a unit for counting bank notes,but a dollar should also be worth 0.8 ounces of silver. The notes, after all, aredenominated in silver. But does the silver value of a dollar have operationalmeaning? If I cannot redeem bank notes, the stated silver value may be a fiction. Inour imaginary system, bank notes can be redeemed, but in gold rather than silver.Each dollar can be redeemed for as much gold as happens to equal in value 0.8ounces of silver. This ratio values silver at $1.25 per ounce. Bank notes cannot bedirectly converted into a fixed quantity of silver. They can, however, be convertedinto a variable amount of gold, the amount depending on the price of gold in termsof silver. Such a system has “indirect convertibility.” Let us imagine that the priceof silver is $1.25 per ounce and the price of gold is $20 per ounce. If I have a $10bank note, I can go to the issuer and demand my gold. For each dollar, he must giveme as much gold as is worth 0.8 ounces of silver. He must redeem my note for $10-worth of gold. Given the assumed prices, a $10 note can be redeemed for half anounce of gold.Let’s say the price of silver somehow rises to $1.50 per ounce. Perhaps, the bankhas over-issued. With that 20 percent increase in the price of silver, we mightimagine that we also have a 20 percent increase in the price of gold, bringing it to$25 per ounce. This possibility turns out not to matter, however, for the operationof the system. Thus, we will continue to imagine gold is priced at $20 per ounce. If

A zeal for truth 9I have a $10 bank note, I can go to the issuer and demand my gold. For each dollar,he must give me as much gold as is worth 0.8 ounces of silver. Since silver sells at$1.50 per ounce, each dollar in bank notes gets me $1.2-worth of gold. My $10 notegets me $12-worth of gold. When I redeem my $10 note, the issuing bank gives me0.6 ounces of gold. I can now sell this gold for $12 in bank notes. If the price ofsilver continues at $1.50 per ounce I will repeat the process, making $2 profit foreach $10 I redeem. As long as silver is priced above $1.25 per ounce, banks willexperience a relatively high rate of redemption and notes will be retired from thesystem, putting downward pressure on the price of silver (and everything else).Conversely, if the price of silver fell to $1 per ounce, a bank could issue a $10 note,buy $8-worth of silver to cover the note fully and have $2 left over. More generally,if the price of silver should fall below $1.25 per ounce, banks would expand issueand put upward pressure on the price of silver (and everything else). Thus, thesystem will automatically move to an equilibrium in which silver sells at $1.25 perounce.The system just described is a simplified version of Greenfield and Yeager’s“BFH” system. In the full BFH system, the “medium of account” is not silver, however,but a broad-based bundle of goods. The “medium of redemption” is not gold,but whatever the issuing bank might choose, probably financial assets. Checkabledeposits would, of course, exist and form part of the money supply. Finally, the fullBFH system is a proposal for laissez faire monetary reform: private banks wouldengage in competitive issue of notes and deposits. The point of indirect convertibilityis to allow the medium of account to be defined so broadly that the system willautomatically produce price stability. The point of competition in banking and theissue of notes and deposits is to get government out of the business of regulating themoney supply.Writers such as Schnadt and Whittaker (1993) have worried about circularity inthe system. To get at the problem and its solution, I will revert to our simplifiedsystem in which silver is the medium of account. It seems to Schnadt and Whittakerthat any event raising the price of silver would trigger a downward spiral in goldprices, so that eventually “the bank would be forced to suspend convertibility”(p. 217). We have seen that if silver’s price rises to $1.50 per ounce, then redeeming$10 in bank notes gets you $12-worth of gold. When silver trades above par, thecheap way to get gold is through note redemption. But in this case no one wouldbuy gold at the relatively high market price; they would instead redeem bank notes.Thus, the demand for gold becomes perfectly elastic at the bank’s redemptionratio. But as long as the price of silver stays the same, the bank must offer $12-worthof gold for every $10 in notes redeemed, which implies an even lower bankredemption ratio, leading to an even lower market price of gold, leading to a stilllower redemption ratio, and so on (Schnadt and Whittaker 1993: 215–17).The idea of such a downward spiral depends on the assumption that the demandfor gold is perfectly elastic (at the bank’s redemption ratio) when silver is pricedabove par. But, as Greenfield et al. (1995) point out (though in somewhat differentlanguage), there is one player with a relatively inelastic demand for gold – the verybank whose notes are trading below par. As their gold reserves dwindle, the bank

10 Roger Kopplwill buy gold to replenish its reserves. Unlike other demanders, it is willing to pay aprice for gold that exceeds the redemption ratio. Other considerations might bemarshaled to bolster the point. The price of silver is not likely to be so sticky. Noteredemption entails transaction costs which, for some, will be high enough to inducethem to buy gold on the open market even at prices above the redemption ratio.The deviations from par that we have imagined were set at unreasonably highvalues only to aid exposition; real deviations would be vanishingly small andquickly closed. Like Greenfield et al., I conclude that there is no problem of circularityin the BFH system.Even if we imagine that the circularity problem is real, there are easy fixes. AsBennett McCallum has said, “this difficulty, even if genuine, can be overcome”(2004: 88). He notes that we can lag by one period the market price the bank uses tocalculate its redemption ratio. This period may be an hour, a day, a month, or ayear. Further safeguards, not mentioned by McCallum, could be applied. Forexample, the bank could retain the option of suspending redemption for, say, tenbusiness days. These and similar measures would prevent the sort of downwardspiral imagined by Schnadt and Whittaker, if such a problem could be shown toexist in the first place.The BFH system was conceived largely as an anti-inflation measure. Yeager’sconcern with inflation is reflected in many of his writings including Experiences withStopping Inflation. Typical of his scholarly style, Yeager looked beyond theories andmodels to consider in detail several historical episodes in which inflation was put toa stop. Minniti and Polutnik (Chapter 11) use the framework of Stopping Inflation toexamine an interesting recent case, that of Slovenia. They find that Yeager’sanalysis applies fully to the Slovenian case as well. They show that “the Slovenianmonetary reform was successful because it addressed all three aspects of theinflationary momentum” identified by Yeager, which they list as “1. The credibilitycomponent. 2. The catch up component. 3. The expectations component.” Minnitiand Polutnik say, “in particular, that the newly appointed Slovenian monetaryauthorities were able to leverage popular expectations in favor of stabilization.”The foresight and cunning exhibited by the Slovenian authorities in stoppingdinar inflation was almost a match for that shown in their brief ten-day war ofindependence. One government official has told me how arms were smuggled intoSlovenia shortly before their war of independence. Slovenian political leaderssecretly engaged the leaders of the garbage-workers union to call a strike. Thegarbage piled up. These same Slovenian political leaders then pretended to breakthe strike by calling in foreign garbage collectors from neighboring Austria. Theentering garbage trucks passed easily through checkpoints manned by Yugoslavsoldiers who were, one may guess, happy for the prospect of seeing rotting garbageremoved from Slovenian street corners and alleyways. If the soldiers had lookedinside the trucks, however, they would have discovered great caches of arms, whichwere later distributed to Slovenian soldiers. The fledgling Slovenian army was nowready to fight.The story Minniti and Polutnik tell is not quite as gripping, but it may be oneof the more exciting episodes in recent monetary history. In class and private

A zeal for truth 11conversation, Yeager often cited the line from Oscar Wilde’s “The Importance ofBeing Ernest,” in which the exceedingly correct Miss Prism protects her charge, theyoung Cecily, from the overexcitement of certain lurid episodes of monetaryhistory: “Cecily, you will read your Political Economy in my absence. The chapteron the Fall of the Rupee you may omit. It is somewhat too sensational. Even thesemetallic problems have their melodramatic side.” I would caution persons ofdelicate sensibility, therefore, to skip the more sensational passages of Minniti andPolutnik.The fledgling Slovenian monetary authority was able to “leverage popularexpectations” even though “there were no legal or regulatory barriers” against thenew tolar simply continuing the inflationary pattern of the replaced dinar. “Andyet, because the Slovenian authorities had restored the credibility of the government,the inflationary momentum was interrupted.” The Slovenes had secretlyprinted up currency tokens, Minniti and Polutnik relate, in case the Yugoslavauthorities should cut off the flow of dinars. These no-name tokens were used tolaunch the currency, however, in response to an inflationary expansion of dinarnotes.Minniti and Polutnik relate an episode in monetary history. Yeager’s Experienceswith Stopping Inflation engages several such episodes. Yeager has made other contributionsto monetary history including Yeager (1958a), (1966), (1969), and (1984).Yeager is widely recognized as a monetary theorist of the highest order. As far as Ican tell, however, Yeager’s equal talents as a monetary historian are not widelyappreciated.Koppl and Yeager (1996) reveal an important episode in monetary history. Thehistorical (and by far best) bit of this paper is, of course, entirely Yeager’s achievement.Yeager’s sources were written in English, French, German, and Russian.Our data set, daily exchange rates for the ruble against the German mark from1883 to 1892, was carefully compiled by Yeager from daily reports in Der Aktionärand Frankfurter Zeitung, contemporary German newspapers. Yeager’s full priceseries was considerably longer than the 2700 days we used in our study. Yeagerrecorded prices from two papers, not just one, as a control against errors in reporting.This sort of care in constructing a data series is unusual and highly meritorious.At one point during the early discussions of the paper, which took place in hishome, Yeager went to a closet and pulled out a set of thick books containing noteson monetary history in Russia and Central and Eastern Europe in the nineteenthcentury. These books are a hidden treasure trove yet to be mined for the riches theycontain.The neglect of Yeager’s achievements in monetary history is reflected in thisvolume’s loving tribute by Breit, Elzinga, and Willett. They discuss his monetarytheory, his early paper on growth theory, work on capital theory, internationaltrade, methodology, competitive money, and “philosophical aspects of politicaleconomy,” but nothing about Yeager’s work in monetary history beyond notingthat International Monetary Relations presented international monetary theory in “itsapplication to historical experience.” It is striking that such deeply informed andappreciative scholars as these three should miss this important element of Yeager’s

12 Roger Kopplscholarly profile. I hope this festschrift results in greater attention to Yeager’s workin monetary history.I said that Yeager is widely recognized as a monetary theorist of the highestorder. Steven Horwitz (Chapter 12) is probably right, however, to describe Yeageras possibly “the most underappreciated monetary theorist of the twentieth century.”I think Landreth and Colander have identified one reason for this neglect. Yeagerwas a pluralist and not a committed formalist at a time of formalist hegemony.Yeager relied on sound microeconomic reasoning and an encyclopedic knowledgeof institutions, economic history, and the history of economic thought. Any careeristworth his salt would have relied almost exclusively on fashionable mathematicaltechnique. In Yeager’s hands, monetary disequilibrium theory was historicallygrounded in both senses, that of economic history and that of the history ofeconomic thought.In his contribution to this volume, Michael Montgomery (Chapter 9) also givesus an historical perspective on monetary disequilibrium theory. Like Yeager (1996),Montgomery traces the theory back to David Hume (1752). Montgomery givespride of place to John Stuart Mill, whose “insights” from the Unsettled Questions essay(1844) “represent the start of monetary disequilbrium theory as that theory is conceivedof today.” Montgomery takes aim at facile interpretations of the classicals assimpletons who believed that prices and wages adjust too rapidly for unemploymentto develop in the wake of any shock. Montgomery says, “it is quite possible toargue plausibly that none of these three propositions – Say’s Law, price/wage flexibility,the neutrality of money – accurately characterize Classical macroeconomicthought, at least not in the simplistic forms in which modern parlance assertsthem.” In exploring the origins on monetary disequilibrium theory, Montgomerycomes across an interesting puzzle in the history of economic thought. Why didMill permit only a weakened form of the theory into his Principles of 1848?In his contribution to this volume, Jürgen Backhaus (Chapter 8) raises anotherinteresting question in the history of economic thought. Could Yeager’s favoriteeconomist, Walter Eucken, have been influenced by Friedrich Nietzsche? Thequestion may surprise some readers. Eucken was a free-market liberal and anarchitect of German “Ordo-Liberalismus.” Nietzsche’s philosophy is oftenassociated with illiberal views. On the other hand, Nietzsche has been given manyconflicting interpretations and, as Backhaus shows, the liberal interpretation is atleast a legitimate candidate. And there is an interesting and important point incommon between them. Eucken, like Nietzsche, suffered a crisis “because he couldnot reconcile scripture and evidence.” They “nevertheless came to rather similarconclusions.” The heart of Nietzsche’s liberalism, if Backhaus is right, may be hiscelebration of the “sovereign individual” as “the ripest fruit” on the “tree” ofEuropean culture.The strength in Backhaus’s interpretation of Nietzsche is its basis in economics.How many scholars have examined Nietzsche’s writings from this particularvantage point? The two central points are Nietzsche’s identification of man as the“animal which is able to make promises” while having also the capacity of “forgetfulness.”Backhaus says, “Although Nietzsche does not fully work out the basic institutions of

A zeal for truth 13a market economy, the key notions are present and could readily be furtherdeveloped.” The sort of economics suggested by Backhaus’s interpretation is aconstitutional economics, which fits well with Yeager’s approach to the subject.These scholarly explorations of Nietzsche, Eucken, and constitutional economicswould not make a very fitting tribute to Yeager if they were merely scholarly, if theyhad no bite. But they have considerable bite, as Backhaus shows in his criticism ofprice indices. Armed with his constitutional and Nietzschean perspective, Backhausargues that the real problem with modern price indices lies not in the details ofstatistical technique, but in the wild variability of the unit of account in today’smonetary constitution. “What is happening here is that the unit of account isconstantly being falsified. Hence, competition among agencies, such as foliomanagingagencies, should decide on the best index for price stability.” Thisfalsification of the unit of account is, presumably, a kind of forgetfulness ofthe economic system, a forgetfulness that corrupts money’s promise as a toolof economic calculation.Backhaus explored links connecting Yeager to Eucken and Nietzsche. In hiscontribution to this volume, Steven Horwitz, a self-described Austrian economist,connects Yeager to Hayek and Wicksell. He shows, successfully I think, that“Austrians have much to learn from Yeager and that Yeager’s work is morecompatible with Austrian macroeconomics than he has been often willing toadmit.” In so doing he develops a theme he has explored in the past, especiallyin his Microfoundations and Macroeconomics: An Austrian Perspective (2000). Horwitzdescribes “the capital-interest rate process” as the “[o]ne element that is missingfrom the Yeager monetary disequilibrium story.” Austrian concerns about real andnatural rates of interest, together with a Jevonsian or Hayekian view of the intertemporalstructure of capital, should be added to Yeager’s monetary disequilbriumtheory to produce an even richer and more informative macroeconomics. Doing sohas consequences. For example, “Placing Austrian macroeconomics on thefoundations of monetary disequilibrium theory suggests, in contrast to the olderAustrian position, that there are situations where the expansion of the money supplyare appropriate, independent of any money commodity backing it.”Yeager’s monetary disequilibrium theory builds on “The Wicksellian Process”of adjusting money holdings to equilibrium levels. Austrian trade cycle theorybuilds on a different Wicksellian process of adjusting interest rates to equilibriumlevels. Horwitz calls on macroeconomists to embed Wicksellian interest adjustment,as enriched by Austrian capital theory, within the context of Wicksellian monetaryadjustment, as developed in Yeager’s monetary disequilibrium theory. The result is“post-Wicksellian macroeconomics.”Horwitz’s contribution builds on his own earlier work and on the capital-basedmacroeconomics of Roger Garrison. In his contribution to this volume (Chapter13), Garrison explores Yeager’s contributions to capital theory. With Garrison, aswith Horwitz, Wicksell is an important source. In this case, the relevant insight isthe “price Wicksell effect,” according to which capital values move in the oppositedirection from interest rates. An increase in capital value caused by lower interestrates will lead to “an increase in capital value not reflected in an actual increase in

14 Roger Koppl(physically defined) capital.” Taking the price Wicksell effect seriously helps us tosee why “unlike labor and land, capital cannot be measured summarily, accordingto Wicksell, except in value terms.”Garrison shows that a little care with units analysis leads us to identify the rightunit for measuring capital. I make the same argument, but in a slightly alteredform. We assume that interest is the price of capital and ask in what units we are tomeasure capital. We denote the interest rate r, the quantity of capital is K, the wagerate is w, and the quantity of labor is L. We need a unit for K such that rK will be somany dollars, just as wL is so many dollars. Recall how units analysis tells us that wLis so many dollars. We calculate w in dollars per man-year and we calculate L inman-years. Thus, wL is calculated in units that put the dollars from w in thenumerator and the man-years from w in the denominator, while also putting theman-years from L in the numerator. The two terms for man-years drop out and wehave wL computed simply in dollars. We calculate r in dollars per dollar-year. Forexample, if the interest rate is 5 percent, the debtor must pay in interest $0.05 foreach dollar that is borrowed and repaid one year later. The debtor must pay $0.05for each dollar-year of debt. The units for K are whatever they must be for rK toresolve into simple dollars, which means the units are dollar-years.It matters that capital is measured in dollar-years. As Garrison explains at somelength, Yeager (1976) was able to transform this insight about units into a thoroughgoingcritique of Cambridge capital controversies. Garrison’s “Child’s Guide tothe Capital Paradoxes” shows, as Yeager had in 1976, that the supposed paradoxesof capital evaporate when put under the combined heat of units analysis and thearithmetic of present values. Units analysis reveals “capital’s dimensional, orradical, heterogeneity.” Barges and blast furnaces are different and can have nocommon unit but dollar-years. In my opinion, this is a definitive solution to the supposed“problem” of reswitching. This solution, however, is so alien to CambridgeUK sensibilities that Cohen and Harcourt imagine that it “did not make a meaningfulcontribution to the debate” (2003, as cited in Garrison’s contribution to thisvolume). Apparently, the logic of this dismissal goes something like this: Yeagerdoes not fit neatly within our pre-fabricated box labeled “neoclassical,” nor is heone of us; thus, his contribution does not count or even have meaning. Fortunately,Mr. Yeager has always shown a greater zeal for truth than is here manifested byCohen and Harcourt.Yeager’s zeal for truth allows him to face tough issues. He “has tackled themhead-on,” as Randall Holcombe (Chapter 14) puts it. Laurence Moss (Chapter 15)takes on the “eliminationist politics” of genocide and ethnic cleansing. In hissecond contribution to this volume, Gordon Tullock (Chapter 16) explores onesuch issue, the financial health of the welfare state. Holcombe examines Yeager’sethic framework for thinking about such issues, namely, utilitarianism.Holcombe’s paper includes a skillful summary of Yeager’s indirect utilitarianism,his protests to the contrary notwithstanding. Yeager develops his position atsome length in his 2001 book, Ethics as Social Science. As a type of utilitarianism,Yeager’s position starts with the undefended and “fundamental value judgment,”

A zeal for truth 15of “approval of happiness and disapproval of misery” (Yeager 2001b: 13, as cited inHolcombe’s contribution to this volume).David Hume’s view that it is not possible to derive an “ought” from an “is” hasproved to be an enduring, solid, and widely accepted principle. It seems quitepossible, therefore, that any ethical system now or in the future will have to build onat least one such undefended ethical principle. Even if we should identify some sortof universal ethics upon which, let us imagine, civilization depends, it remains for usto accept or reject them. In any event, Yeager’s system begins with the innocuousbut undefended postulate of beneficence.Yeager cites Hayek in making the case for rules-utilitarianism over actutilitarianism.We cannot reliably calculate the consequences of individual acts,but we can understand the consequences of following or not a given rule or set ofrules. Yeager taught me that we may often prefer to throw away information. Ithink this principle is important in both positive and normative economics. It mayeasily seem to be foolish or irrational to throw out information. Advocates of“rules” over “discretion,” however, want the central authorities to do preciselythat. A rule-following central bank ignores much of the information available to it.In general, rule-following agents throw out information. Yeager alerts us to thedangers of acting on “fragmentary and probably accidentally biased bits of concreteinformation that one may happen to possess” (2001b: 279, as cited in Holcombe).Recent developments in psychology point in the same direction. The “fast andfrugal algorithms” of Gigerenzer et al. (1999) throw out information. Similarly,Cosmides and Tooby (1994) have argued that our seemingly irrational adherenceto certain heuristics can produce results that are “better than rational.” In bothcases, the point is that the heuristic incorporates information about the environmentthat more seemingly rational decision algorithms lack. Long before these relativelyrecent developments in psychology, Herbert Simon defended heuristics onsomewhat similar grounds.Holcombe points out that Yeager goes beyond rules-utilitarianism “andadvocates indirect utilitarianism, which includes aspects relating to individuals’character and attitudes.” I should probably note a further distinction betweenrules-utilitarianism and indirect utilitarianism. Some rules-utilitarians imagine wecan judge rules one by one. Indirect utilitarians recognize that we cannot alwaysjudge individual rules reliably, but only systems of rules. We might compareindividual rules to individual genes. The behavior of the system depends on thetotal complex of rules or genes. These rules or genes may be characterized by arelatively large number of “epistatic interactions,” which means the effect of anyone depends sensitively upon what others may be present or absent. StuartKauffman (1993, 1994) has studied epistatic interactions among genes.Holcombe tells of his discussions with Yeager about contractarianism and utilitarianism.Contractarianism is an ethical doctrine that imagines what peoplewould choose from behind a veil of ignorance. It has therefore a similarity to Rawls’system. Contractarians espouse the constitutional rules they believe would beunanimously supported behind the veil of ignorance. They say the imagined terms

16 Roger Kopplhammered out represent “conceptual agreement” to those principles. Holcomberecounts Yeager’s response to Holcombe’s contractarianism: “You don’t reallybelieve that, do you?” Part of the trouble for Yeager is the idea of conceptual agreement,which he takes to mean “no agreement.” For Holcombe, the force of thiscriticism comes from the insight that contractarianism tends to represent coercivegovernment as a matter of agreement. “The contractarian framework suggeststhat, from a normative perspective, we should abide by government’s rules becausethey are something we have (conceptually) agreed to, but in what sense have weagreed to the coercive power of government? The contractarian frameworkaccords government more legitimacy than it deserves.” Yeager has influencedHolcombe’s thinking, but he has not won him over completely. In particular, heworries that Yeager’s position “does not adequately safeguard individual rights.”Holcombe notes that “Economists often argue that individuals are the bestjudges of their own well-being, but Yeager does not accept this as a universal truth.”I believe Yeager is quite right on this point. Holcombe raises a basic issue in liberaltheory that has, I think, been somewhat miscast by those liberal theorists whodeclare the individual best able to judge his own interests. We are sometimes toldthat in commercial society the individual judges his own interests and his own comparativeadvantage. He decides for himself how to live and work. This statementmay seem to suggest that only one person is judging the best use of my time, namelyme. But in commercial society many decentralized actors have a role in judginghow I should spend my time. I am one of them, but so are my family members, myemployer, potential employers, religious leaders, and so on. Important in thisgroup, I think, are employers and potential employers. One of the functions of theentrepreneur is to judge how to use the labor time of others. If the entrepreneur hasa comparative advantage in making such judgments, he will continue to be in aposition to offer workers a guaranteed wage in exchange for his right to direct theirefforts. In some contexts, employers may insist on standards of good character andreputation, thus guiding individuals toward some commonly accepted ethicalstandards. Outside the workplace, the individual has many sources of adviceon how to behave, including religion. He may also seek, however, the practicaladvice of self-help manuals. The Great Original of this species in America is theauto biography of Benjamin Franklin, which includes Franklin’s “Project of Self-Improvement.” The advantage of individual autonomy is not so much that theindividual chooses his own path. Yeager is right to deny that the individual is alwaysthe best judge of his own well-being. The advantage consists in the increased probability,relative to available alternatives such as central control, that the individualwill be guided, in the different aspects of his life, by persons enjoying a comparativeadvantage in providing such guidance.Laurence Moss shares Holcombe’s concern over human rights. Moss addressesthe “eliminationist politics” of genocide and ethnic cleansing. Moss’s main point isthat mass murder may be perfectly efficient in the economic sense, as long as youare among the killers and not a victim. “Without a strong commitment to humanrights norms, which must dominate any economic efficiency argument no matterhow well constructed, the economist turned policy maker is not likely to have much

A zeal for truth 17to offer about ending the ethnic atrocities of our age.” Moss’s argument is consistentwith Adam Smith’s remarks on the existence of slavery in otherwise freecountries. Slavery persists in spite of its (supposed) economic inefficiency because ofour “love of domination and tyrannizing,” which “will make it impossible for theslaves in a free country ever to recover their liberty” (Smith 1982: 186; LJ[A] iii,114). Smith, a founding member of the British Anti-Slavery Society, was notopposed to slavery for “economic” reasons, but humanitarian reasons. Moss arguesin a fundamentally similar vein that the mass murder of eliminationist politics canbe perfectly efficient in a narrow economic sense. He shows this by constructing amodel in which deceptive behavior is concentrated in the group that becomes theoppressed minority. It is not necessary that the oppressed group really be deceptive,only that it be perceived as such. Thus, the Nazi era saw many absurd depictions ofJews as conspiring parasites. Moss might have pointed out that the oppressingmajority may gain from eliminating the minority even when the oppressed group isrecognized to be cooperative and honest. If “we” drive “them” out, we lose some ofthe benefits of a more refined division of labor, but we get a larger gain by stealingtheir farms and houses. It is easier to perceive a need for eliminationist policiesand easier to pursue them when “the nation-state is defined in terms of commonancestry and ethnic descent rather than an aggregated administrative unit.” Mossconcludes “that the strict logic of economic reasoning has for too long accommodatedthe strict logic of ethnic cleansing, segregation, and forced emigration.The focus on overall economic efficiency and the gains from trade prove to be inadequatein protecting basic human rights.”Tullock addresses a very different kind of problem that may arise from stateaction, namely, the injustices of an unsustainable welfare state. The advantages ofindividual autonomy come with the risk that the autonomous individual will fallupon hard times because of bad judgment or bad luck. In response to this risk, mostsocial thinkers support some form of welfare, be it a minimal safety net or anelaborate system of “cradle to grave” care. Gordon Tullock addresses problemswith the welfare state as it exists in many of the world’s richest countries. The threepillars of the welfare state are “unemployment relief or aid to the poor, old agepensions, and free medical care.” The two that matter for the fiscal health ofgovernments are pensions and health care. Tullock traces the modern welfare stateto Germany’s Prince Bismarck. “The international adoption of the welfare state, ifplotted on a map, would look much like the spread of a contagious disease. It spreadfrom Germany to its neighbors and then to their neighbors.” The United States“was the last major country to adopt the welfare state.” The welfare state createdno fiscal crisis when medicine was relatively primitive and life expectancy wasrelatively low. In Bismarck’s era, the “germ theory of disease was at the time verynew and sanitation tended to be careless.” A stay in the hospital was dangerous toone’s health. “The advance of science has changed all of this and a very sharpincrease in life expectancy has resulted.” These factors combined with recentdemographic changes are creating a crisis for the welfare state. Tullock suggeststhat Western governments may have to repudiate their debts under the welfarestate. He points to two ways to do it, openly or through inflation. “It’s not obvious

18 Roger Kopplwhich is worse,” he concludes, “an inflation or overt repudiation of the promiseswhich have been implicitly given to almost everyone enrolled in the Bismarckianscheme.”All of the contributions to this volume bear an intimate relationship to Yeager’sscholarship. They cover a very broad range of topics from technical issues ofmonetary regimes or economic method, to broad issues of ethics and politicalphilosophy. This is an impressive range of topics reflecting the unusual breadth ofYeager’s scholarship. In this essay I have come far short of a complete survey ofYeager’s scholarly output. I have ignored completely his work as a translator, hisscholarly contributions to the language Interlingua, his organizational contributionsto the Union Mundial pro Interlingua, his popular writings on liberty, and so on. Itis hardly to be wondered at, then, that Yeager’s career would inspire the enthusiasmand admiration of accomplished scholars. Indeed, many contributions reflectgenuine awe in Yeager’s extraordinary career and personality. On the occasion ofhis 80th birthday, we offer these essays to Leland B. Yeager to honor him for all hehas done and all he represents. We honor him for his scholarship, his teaching, hishard work, and his great erudition. We honor him for his zeal for truth. We honorhim knowing that scholars of his caliber – persons of his caliber – are rare and thatwe have been blessed to call him teacher, colleague, mentor, friend.ReferencesBridgman, Percy W. (1955). Reflections of a Physicist. New York: Philosophical Library.Cohen, Avi J. and Geoffrey C. Harcourt (2003). Cambridge Capital Controversies: Responsefrom Avi J. Cohen and G.C. Harcourt. Journal of Economic Perspectives, 17(4): 232–3.Cosmides, Leda and John Tooby (1994). Better than Rational: Evolutionary Psychologyand the Invisible Hand. American Economic Review, Papers and Proceedings, 84: 327–32.George, Henry (1886) [1966]. Protection or Free Trade? An Examination of the Tariff Question, withEspecial Regard for the Interests of Labor. New York: Robert Schalkenbach Foundation.George, Henry (1898) [1932]. The Science of Political Economy, new edition. London: TheHenry George Foundation of Great Britain.Gigerenzer, G., P.M. Todd and the ABC Research Group (1999). Simple Heuristics That MakeUs Smart. New York: Oxford University Press.Greenfield, Robert L. and Leland B. Yeager (1983). A Laissez Faire Approach to MonetaryStability. Journal of Money Credit and Banking, 15: 302–15.Greenfield, Robert L., W. William Woolsey and Leland B. Yeager (1995). Is IndirectConvertibility Impossible? Journal of Money Credit and Banking, 27: 293–7.Horwitz, Steven (2000). Microfoundations and Macroeconomics: An Austrian Perspective. New York:Routledge.Hume, David (1752) [1970]. Money. In Eugene Rotwein (ed.) David Hume: Writings onEconomics. Madison, WI: The University of Wisconsin Press.Kauffman, Stuart A. (1993). The Origins of Order: Self-Organization and Selection in Evolution.Oxford: Oxford University Press.Kauffman, Stuart A. (1994). Whispers from Carnot: The Origins of Order and Principlesof Adaptation in Complex Nonequilibrium Systems. In George A. Cowan, DavidPines and David Meltzer (eds.) Complexity: Metaphors, Models, and Reality. Reading, MA:Addison-Wesley.

A zeal for truth 19Klappholz, K. and J. Agassi (1959). Methodological Prescriptions in Economics. Economica,new series, 26: 60–74.Koppl, Roger and Leland B. Yeager (1996). Big Players and Herding in Asset Markets: TheCase of the Russian Ruble. Explorations in Economic History, 33: 367–83.McCallum, Bennett T. (2004). Monetary Policy in Economies with Little or No Money.Pacific Economic Review, 9(2): 81–92.Machlup, Fritz (1956). The Inferiority Complex of the Social Science. In Mary Sennholz(ed.) Freedom and Free Enterprise. Princeton, NJ: Van Nostrand. Reprinted in Machlup,Fritz (1978). Methodology in Economics and Other Social Sciences. New York: Academic Press.Menger, C. (1871) [1981]. Principles of Economics. Translated by James Dingwell and Bert F.Hoselitz. New York: New York University Press.Mill, John Stuart (1844) [1983]. On the Influence of Consumption on Production. InHazlitt, Henry, The Critics of Keynesian Economics. Lanham, MD: University Press.Originally published in Mill, John Stuart (1844). Essays on Some Unsettled Questions inPolitical Economy.Mill, John Stuart (1848) [1965]. Principles of Political Economy with Some of Their Applications toSocial Philosophy. Toronto: University of Toronto Press.Schnadt, Norbert and John Whittaker (1993). Inflation-proof Currency? The Feasibility ofVariable Commodity Standards. Journal of Money, Credit and Banking, 25(2): 214–21.Smith, Adam (1982). Lectures on Jurisprudence. Indianapolis, IN: Liberty Fund, Inc.Yeager, Leland B. (1954a). Free Trade: America’s Opportunity. New York: SchalkenbachFoundation.Yeager, Leland B. (1954b). Some Questions About Growth Economics. American EconomicReview, 44: 53–63.Yeager, Leland B. (1954c). Some Questions About Growth Economics: A Reply. AmericanEconomic Review, 44: 937.Yeager, Leland B. (1954d). The Methodology of Henry George and Carl Menger. AmericanJournal of Economics and Sociology, 13: 233–8.Yeager, Leland B. (1956). A Cash-Balance Interpretation of Depression. Southern EconomicJournal, 22(4): 438–47.Yeager, Leland B. (1958a). Some Facts about the Canadian Exchange Rate. Current EconomicComment, 20: 39–54.Yeager, Leland B. (1958b). A Rehabilitation of Purchasing-Power Parity. Journal of PoliticalEconomy, 46: 516–30.Yeager, Leland B. (1960). Methodenstreit over Demand Curves. Journal of Political Economy, 63:53–64.Yeager, Leland B. (ed.) (1962). In Search of a Monetary Constitution. Cambridge, MA: HarvardUniversity Press.Yeager, Leland B. (1966). International Monetary Relations: Theory, History and Policy. New York:Harper & Row (2nd edn, 1976).Yeager, Leland B. (1968). The Essential Properties of the Medium of Exchange. Kyklos, 21:45–68. Reprinted in Clower, Robert W. (ed.) (1969). Monetary Theory, Selected Readings,Baltimore: Penguin Books; and Carson, Deane (ed.) (1972). Money and Finance: Readings inTheory, Policy and Institutions, 2nd edn. New York: Wiley.Yeager, Leland B. (1969). Fluctuating Exchange Rates in the Nineteenth Century: TheExperiences of Austria and Russia. In R.A. Mundell and A.K. Swoboda (eds.) MonetaryProblems of the International Economy. Chicago, IL: University of Chicago Press.Yeager, Leland B. (1976). Toward Understanding Some Paradoxes in Capital Theory.Economic Inquiry, 14: 313–46.

20 Roger KopplYeager, Leland B. (1981). Experiences with Stopping Inflation. Washington: American EnterpriseInstitute.Yeager, Leland B. (1984). The Image of the Gold Standard. In M.D. Bordo and A.J.Schwartz (eds.) A Retrospective on the Classical Gold Standard, 1821–1931. Chicago, IL:University of Chicago Press.Yeager, Leland B. (1995). Tacit Preachments Are the Worst Kind. Journal of EconomicMethodology, 2: 1–33.Yeager, Leland B. (1996). The Significance of Monetary Disequilibrium. Cato Journal, 6:369–99.Yeager, Leland B. (1997). The Fluttering Veil: Essays on Monetary Disequilibrium, edited with anintroduction by George Selgin. Indianapolis, IN: Liberty Press.Yeager, Leland B. (2001a). Henry George and Austrian Economics. The American Journal ofEconomics and Sociology, 60: 1–24. (This is a reprint from 1984, History of Political Economy,16: 157–74.)Yeager, Leland B. (2001b). Ethics as Social Science: The Moral Philosophy of Social Cooperation.Northampton: Edward Elgar.Yeager, Leland B. and David G. Tuerck (1966). Trade Policy and the Price System. Scranton, PA:International Textbook Co.Yeager, Leland B. and David G. Tuerck (1976). Foreign Trade and U.S. Policy: The Case for FreeInternational Trade. New York: Praeger.

2 The Yeager mystiqueA profile of the scholar as teacherand colleagueWilliam Breit, Kenneth Elzinga, and Thomas D. Willett *IntroductionLeland B. Yeager is a scholar and teacher of exceptional talent to which is addedthe spice of an eccentric personality. These qualities attracted to him manygenerations of graduate students at the University of Virginia. His lectures werehighly popular, not only for their disciplined presentation and craftsmanship, butfor the contagious excitement Yeager generated by his dedication to his subject. Hehad the ability to make economics seem crucial to the lives of his students. Yeageralso won the admiration and respect of his colleagues because of the thoroughnessof his research and his wide-ranging erudition.Our contribution to this Festschrift is a profile, not an essay. Its focus is on LelandYeager, the teacher and colleague. Its substance is based in part on accounts providedby students who took his courses at different periods of time at the Universityof Virginia, but most of all from those years when the distinctive approach thatcame to be called the “Virginia School” was being formed. We are indebted tothese students, too numerous to acknowledge by name, for their submissions. Theprofile, in addition, is drawn from our own experiences, having been privileged tohave been Yeager’s colleagues during most of his years in Charlottesville.Many of Leland Yeager’s students were requested by us to provide writtendetails of remembered experiences. Some would have to search their memories bygoing back over 20 years in time. We were aware at the outset that there is adistance between observation and expression which could make for unreliablereporting. However, we were reassured by how often these remembrances werecorroborated in almost identical accounts by more than one respondent: paralleltales of Yeager with only slight variations on a theme. Such reports seemed to us tobe trustworthy.Although some responses were sketchy, taken as a whole they assisted us incomposing this thumbnail sketch. A number of these accounts have beenincorporated into the text more or less intact. These remembrances of LelandYeager in his classroom, his office, and at home, allowed us to make immediatewhat time had made remote.In addition to their remembrances, we requested copies of lecture notes thatYeager’s students might have retained and which they would be willing to share

22 William Breit, Kenneth Elzinga, and Thomas D. Willettwith us. The number of excellent and complete sets that were sent to us is indicativeof the coherency with which Yeager presented his classroom lectures and thismaterial’s lasting value.Yeager in the classroomWhen students entered a class taught by Leland Yeager they encountered a man ofconservative dress, customarily attired in a gray suit. His head was long, narrow,and rectangular, topped by sandy colored hair that was closely trimmed on allsides, including the top. Yeager was tall, but not as tall as John Kenneth Galbraith;he was lean, but not as lean as David McCord Wright; his posture was straight,indeed he had an almost military bearing; he was of serious demeanor and had apenetrating gaze.The evidence suggests that Leland Yeager was the best teacher in the economicsgraduate program during his years at Virginia. This is true notwithstanding thepresence of other great scholars who had influence in their own way upon students.After all, they could encounter James M. Buchanan, the future Nobel Laureate,whose courses resulted in more student publications in major journals than those ofanyone else; there was G. Warren Nutter, the controversial Soviet specialist whoquestioned the exaggerated growth rates of communist economies that otherSovietologists had accepted as gospel; Gordon Tullock, who was, with Buchanan,creating a new field of study in economics that came to be called Public Choice; andRonald H. Coase, whose work on social cost published while he was at Virginia waseventually to gain him a Nobel prize. But it seems safe to say that none of these leftso indelible an imprint upon the consciousness of their pupils as did Yeager.Much has been written about the elusive qualities that make a great teacher. Inone very important sense, they are the same as those that make a great athlete. Thegreat teacher and the great athlete both have natural gifts suited for their respectiveendeavors; a person without this natural talent will never be a truly great teacher,no matter how diligent the attempt.In addition to their endowed prowess, great teachers, like great athletes, practicetheir craft, each thinking hard about how to play the game before their respectiveaudiences. The great teacher frets about preparing the structure as well as thecontent of the material for the next class day; the great athlete frets about how bestto train and practice for the next contest.To describe Leland Yeager’s gifts and devotion to the classroom, and to give asense of the excitement he generated in that setting, we can do no better than quotethe words of one who was there:He was meticulously prepared for every class and his presentation was flawless,beginning with a well organized historical lead into the topic, a detailed explanationof the issues followed by current articles, replies, rejoinders, etc. This stuffwas dynamite. Students quickly realized that Yeager had it all and anyone withhalf a brain knew that they had a once in a lifetime chance to wrap up the wholedamn subject – if they could just get every word he uttered written down. So

The Yeager mystique 23students bent their heads to the task, their hands a virtual blur, and attempted todo the impossible – literally to get every word on paper.Graduate students in economics at Virginia uniformly cited the impeccableorganization of Yeager’s lectures. While most economists taught until the end ofthe class period, picking up next time where the prior lecture left off, Yeager’slectures almost always had a beginning, a middle, and a conclusion. Each class wasdesigned to correlate with the syllabus.This precision led to an inevitable corollary. Class time could not be wasted.Every moment counted. Therefore promptness and punctuality on the part of theclass were essential. Yeager could be reduced to hostile silence in the face ofdiscourteous latecomers to his class. He would stare at the offender, with his mouthset in a grimace. Several respondents commented on this aspect of their Yeagerexperience. One of them put it this way: Yeager was “so concentrated on what hewas doing that a student walking in late for class could throw him off. I recall thatone student who was perhaps ten minutes late caused Yeager to start his lectureagain from the beginning.”Yeager’s reading lists were lengthy; this itself was not unusual in graduate school.What was unusual, students soon realized, was that their professor had not only readevery entry on the list, he had read each one of them exhaustively and recently.Yeager’s students, most of them aspiring academics, understood the incentivestructure of modern higher education. One asked: “How could anyone justify to hisown career, much less to his dean, the inordinate amount of preparation that Mr.Yeager was putting into his classes?”One answer given was that “this irrational – by the world’s current standards –allocation of time was entirely consistent with Mr. Yeager’s devotion to scholarlyvalues: honesty, responsibility, diligence, and love of learning.”When Yeager led his students into a book or article, it was not to dabble. Duringone period of Yeager’s time at Virginia, Don Patinkin’s Money, Interest, and Prices hadbecome a minor classic in the field of monetary theory. It was a highly formalizedextension of the quantity theory of money put into a general equilibrium framework.Yeager considered the work important and decided that students in hismoney and income classes should be acquainted with the work. And acquaintedthey became! In the words of one veteran, “Upon my arrival at UVA, Patinkin’sbook acquired an importance that could only be surpassed by some of ThomasJefferson’s greatest achievements. . . . Not only was Patinkin required reading butone had to eat, breathe, ingest, digest, absorb, memorize, verify, quantify, interpret,question every paragraph, every sentence, every word, every nuance of Patinkin’sopera magna.” This account is consistent with the story that when Patinkinlectured at the University of Virginia, he conceded that Yeager knew more aboutMoney, Interest, and Prices than he did.A great athlete can prosper having only natural talent and dedicated practice. Agreat teacher must have more than mastery of the subject and diligence. TheSpanish have a word for it: duende. We are told there is no good English equivalentto this word. Duende is that mysterious quality that endears pupils to a great

24 William Breit, Kenneth Elzinga, and Thomas D. Willettteacher in the same way that it endears great performers to their audience. LelandYeager had duende.For example, like some show people, Yeager instinctively knew how to use aprop. A yardstick was to Leland Yeager what a violin was to Jack Benny and a cigarwas to Groucho Marx. Nearly every student who responded to our inquiry mentionedthe yardstick when describing Yeager’s classroom demeanor.Why this effect?Because in Leland Yeager’s hands, the yardstick was more than a mere straightedge.It was a tool for perfecting, before class began, elaborate three-dimensionaldiagrams that would be referenced in the lectures. The yardstick was the implementYeager used to expand the visual experience of the student beyond the blackboard’slimits. It was not unusual for students to come into class early and find himprecariously standing on a chair or desk, constructing a diagram that needed morespace than the blackboard permitted. Yeager would draw lines and quadrants thatwent outside the boundaries of the chalkboard itself. One student has described hisimpression of this scene:What has kept the image so vividly etched in my mind these many years is notmy surprise at seeing him so engaged, but rather his nonchalance at beingdiscovered. Unlike other professors who sometimes staged such activities foreffect, I am certain that Professor Yeager’s indifference reflected his convictionthat no one would think his actions unusual. After all, the graph needed to becompleted to scale, did it not?This was not the only way that Yeager found his yardstick useful. A characteristic ofYeager’s lectures was his penchant for summarizing the ideas of other scholars.This presented a problem for him. Being scrupulous about attribution, he worriedthat his students might mistakenly give him the credit for the particular position orcontribution of another. The yardstick provided the solution.Whenever he was expositing the position of another’s writings, he would lift theyardstick over his head; he would lower it when his own ideas were being presented.While Yeager’s students today remember the mental image of the raised yardstickwith wry amusement, and while they might not have chosen to adopt the techniquein their own classrooms, the image still serves as a reminder of the importance ofmaintaining high standards of academic integrity.One of the striking characteristics of Leland Yeager as a teacher and scholar wasthat his ideas were developed in reaction to the ideas of others. Some teachers areknown for an ability to get students to track their instructor’s thought processes asthe professor attempts to develop original approaches to a topic. These students arefortunate to see a creative mind at work before them. But they often are left bereftof any knowledge of alternative approaches that exist in the literature or thehistorical background against which the ideas were first generated. Yeager wasknown for his ability to get students to cover every angle of a topic, as that topic hadbeen developed within the discipline. His own assessment was ancillary to thestudents becoming aware of what others had done.

The Yeager mystique 25Yeager’s pedagogical style is reflected in Yeager’s publications. Two of his mostimportant books are Foreign Trade and U.S. Policy (coauthored with David G. Tuerck)and International Monetary Relations. 1 The first volume is a careful enumeration ofevery protectionist argument made against free international trade, with theauthors then stacking up against each one the free trade alternative. The secondvolume is not a presentation of Yeager’s theories on international monetary relationsbut rather it is an encyclopedic presentation of the ideas of literally hundredsof scholars on the subject, each one carefully presented and assessed by Yeager. Inthis sense, Yeager’s writings are mirror images of the teaching methods he broughtto the University of Virginia classroom.A certain type of graduate student likes a certain type of teacher. Those attractedto Yeager tended to be more philosophical and historically minded than were thefollowers of Buchanan and Tullock, for example, who tended to be more creativeand entrepreneurial. In following in their mentor’s footsteps, Yeager’s studentstended to gravitate toward careers in which teaching was valued as much asresearch.Yeager outside the classroomContributing to Leland Yeager’s mystique as a teacher was his persona outside theclassroom. People got the impression that he was a habitual loner, armored againstattempts to invade his privacy. But what they did not realize was the number ofactivities in which Yeager had engaged himself at the highest level of achievement.This made the opportunity cost of small talk – even lunch – very high, in his decisioncalculus.Yeager’s consuming devotion to his research, teaching, and avocational interestsprovided very little time for casual conversation. This helps explain the periodicaloofness in his relationships with his students and his colleagues: for individuals inboth categories encountered Yeager on the same terms. He made no distinctionbased on departmental hierarchy. Students and colleagues alike encountered thesesingularities.A deeply perceptive student of Yeager’s provided a rationale for his reputedshyness and distance: “How could anyone have enough time to write a scholarlyarticle or two every year; publish a book every four or five years; meticulouslyprepare for a full course load of classes; religiously meet his office hours; supervisea disproportionate share of dissertations; advise students; vigorously pursue hishobby of learning languages; enjoy fine wines; and [then also be expected to]engage in a lot of idle chatter?”This helps explain why a visit to Yeager in his office could be a disquietingexperience. There was no chit-chat, at least from Yeager. A student who wasunaware of this, or a colleague who, out of habit, began a conversation withoutgetting to the point, was met by what students ruefully called “the stare.” The starewas Yeager’s way of avoiding small talk: by not reciprocating. Unfortunately, histactic often caused the opposite effect. To get a response, one might try even harderto find a conversational entry point and end up digressing even more from the

26 William Breit, Kenneth Elzinga, and Thomas D. Willettbusiness that had brought the visitor to Yeager’s office in the first place. Thefollowing reminiscence is so descriptive of the experience that it is worth quotingin full:From the moment you entered his office you knew you were in trouble. Yoursimple question like “Will you be offering International Trade in the fall?” wasmet by this stunned look of disbelief and a penetrating look straight into youreyes. Prof. Yeager said nothing – just “the stare.” To fill this aural void, youbegan to elaborate on why you wanted to take International Trade and how itwould advance your progress through the program. This too was met by just“the stare.” The student, now quite off guard, and desperately searching for anyjustification for his or her presence, began to babble on about the wonders ofinternational trade and how it has improved the lives of millions of peoplethroughout history. The now perspiring student then began to relate intimatedetails about their personal lives (anything to stop “the stare”) – how they oncewere a bed wetter or that they had unresolved guilt from childhood aboutsticking pins into butterflies. Finally, realizing the student was on the verge ofsome kind of psychotic break, Prof. Yeager would slowly reach across his deskand hand you a piece of paper containing the fall term schedule. Totallydevastated, the student would stumble out of the office – realizing they had justmade a total fool of themselves in front of the world’s greatest psychoanalyst.This experience was not unusual. Students and colleagues alike shared in thistype of encounter with Yeager. One student who was beginning his doctoral workat Virginia when Yeager was the Director of Graduate Studies related this accountof going to Yeager’s office for the first time:I came in and made a few cheery remarks expecting him to pick up the ball andtell me all about everything in the department. He said little or nothing. I thencontinued to fill in the blanks. For fifteen minutes, I babbled like a fool. Heknew more about me in those fifteen minutes than I had probably revealed tomy wife!But if Yeager was a psychoanalyst, he was a peculiar one in that his note-takingwas not with pad and pencil or tape recorder. His recording device of choice wasthe typewriter. The student who needed a letter of recommendation found himselfundergoing a Yeager-style non-directive interview. Here is how one described it:I sat in a chair across from his desk. He turned away from me toward the typewriteron his right side, typed a few words, and then asked me to tell him aboutmyself. As I talked, he typed, neither saying a word nor showing expression. Idiscussed my interest in economics, courses I had taken, and my dissertationresearch. I then mentioned that I had teaching experience and that it was somethingI particularly enjoyed. Continuing to look at the typewriter, he asked if Ihad any notable skills or innovations that I brought to the classroom. Having

The Yeager mystique 27none, but not wishing to disappoint, I declared that I specialized in talkingeconomics majors out of going to law school. Mr. Yeager lifted his hands off thetypewriter, turned his head and body toward me, leaned across the desk, anddeclared in a firm voice, “AND JUST HOW DO YOU DO THAT?” Ratherstartled, I quickly admitted that I had said it in jest and that I had no such skill.He appeared keenly disappointed.Yeager’s silences during visits to his office did not preclude the accomplishmentof important departmental business. For example, having difficulty completing arequired term paper, a graduate student paid a visit to Yeager’s office to request anincomplete in the course. What ensued illustrates that while Yeager was not atalker, he was an attentive listener.He did not say a word. After a long moment of silence, I stated that I had donemost of the work on the paper, and could complete it within two weeks of theend of the semester. Another long period of silence. I then reiterated that I hadreally done a lot of work on the paper and would be willing to make an oralpresentation in class. Another moment of silence. But this time, Mr. Yeagerturned toward his typewriter, typed for about a minute, pulled out the paper,and handed it to me. It was a short contract, stating that I agreed to make apresentation of my paper in class and hand in my final paper by the first week inJanuary. His first and final words were to ask me if I would sign the paper.I did.It would be misleading to leave the impression that Yeager was inflexible in hisuse of the non-directive interview. If the situation called for it, he could be a goodquestioner as well as a careful listener. These occasions were more likely to occurwith foreign students about whose prior training Yeager, as Director of GraduateStudies, needed clarification. Such students found him a thoughtful interrogator.But even here, there was no room for small talk. One new graduate student, freshlyarrived from India, remembers:As I entered the room, he gave me a thorough look, as if trying to read my mind.He inquired about my work at the University of Delhi, courses I took there,books I read and professors with whom I studied. I noticed that he took notes ofwhat I said. As I left his room after getting my course assignment, I realized thatthis man did not like to make small talk. He did not ask, “how was your trip” or“how did you like Charlottesville,” etc., as most people asked during my firstcouple of days in this country. That, however, suited me well, since I came froma tradition where the student–teacher relationship is more formal.The admiration students at Virginia have for Leland Yeager also is the sum ofmany individual experiences where Yeager’s generosity and concern were manifestedin special ways. Yeager could spot a student carrying a book, notice the title,and invite the student to his office to discuss the book’s contents. More than one

28 William Breit, Kenneth Elzinga, and Thomas D. Willettstudent expressed their surprise, after serving as Yeager’s research assistant on abook manuscript, to see their name listed on the published book’s cover.The most notable characteristic of Yeager’s teaching duties outside the classroomwas his generous participation on dissertation committees, even those he did notdirect. That Yeager would give such careful attention to early drafts of a dissertation,in his role as even third reader, induced graduate students to seek him out for theircommittees. One student relates the windfall he encountered from Yeager beinghis third reader. Having completed a few chapters of his thesis, he sent them to hisfirst reader, Professor Gordon Tullock. Three weeks later he received a packagecontaining his first two chapters, but there was not a word from Tullock andnothing from the second reader. The student recounted:But attached to the first chapter were four yellow pages of single-spaced, typewrittennotes that extended from edge to edge, and covered both the front andback of each page. What these notes contained was a detailed line-by-line roadmap of how to fix my obvious pitiful mess – with specific references to articles toread, possible journals to consult, and useful insights of how all of my stuffrelated to the “big picture.” Egad, I thought, all of this from just the third reader!Nevertheless, I set about making all the necessary repairs suggested by Yeagerand over the months this whole process was repeated several times. SometimesI think Yeager would send me almost as much as I sent him. Still not a wordfrom Tullock or the second reader – and who could blame them with Yeager onthe job.Yeager’s largesse to students in the publishing realm was not limited to his researchassistants and his doctoral students. Sometimes he would invite students to hisresidence in Charlottesville for a weekend where he provided excellent cuisine andwine. A conversation with him on occasions like this could sometimes lead to apublishable manuscript. A fascinating instance is provided by one such lucky houseguest:I happened to ask him some questions on a topic in monetary theory. Well,Leland immediately brought out his tape recorder, and for the next severalhours I proceeded to ask him questions, which we then discussed fully. Every fewminutes he would summarize the discussion on his tape recorder. Very early thenext morning I could hear Leland typing away at his typewriter. When I got up,he presented me with 23 pages of transcript – he had typed up all that we hadrecorded the night before. We eventually converted that transcript into anarticle which was published by a major journal. I don’t think I will ever be ableto duplicate the excitement I felt during that discussion with Leland into the weehours of the night!Leland Yeager was a very different personality at his home than at the Universityof Virginia. On the grounds he appeared always serious, reserved, and diffident. Athome, he was an attentive host, thoughtful and warm. This change in external

The Yeager mystique 29demeanor could surprise those who were recipients of this hospitality. It extendednot only to faculty and students, but to their spouses and children as well. Whenformer students and their families were known to be passing through Charlottesville,Yeager offered the use of his home for overnight accommodation. A superb dinner,lubricated with wine and champagne from his well-stocked cellar, was provided.Anyone able to discern Leland Yeager’s utility function would know that winewould accompany any festive meal at his home. He was a connoisseur whodelighted in wine-tasting parties and who seemed always ready to accept thechallenge of identifying the output of even an obscure vintner. When he hostedsuch occasions, the dining room table would be laden with wine bottles wrapped infoil so as to hide the labels. Platters of cheese and crackers were interspersed amongthe potables. Their purpose was to clear the palate between tastings of the wine.Participants were asked to write their comments on slips of paper provided by theirhost, to rank in descending order of quality the various selections, to commentabout the wine’s taste, and to identify the country of origin, and, if possible, theregion where the winery was located.Within the Department of Economics, Yeager’s skill at making this identificationwas legendary. New faculty, informed of Yeager’s prowess in this regard, tended tothink the story was exaggerated. A visiting professor from Oxford, whose expertisehad placed him in charge of wine purchases for his college, was skeptical of the talescirculating in the department. He decided to test Yeager’s mettle. A wine tastingwas arranged to which the visitor, an Australian by birth, contributed a wine herecently had acquired on a visit home that took him through New Zealand: acountry not generally known for its wine production. All but Yeager had beeninformed of the ploy.The assemblage watched intently as Yeager poured a sample from this particularbottle. He sipped from the glass, tasted the liquid and swallowed a small amount.Then he took another sip. He seemed puzzled at first. Taking longer than normalto make his written entry, he went on to the remaining samples.Later in the evening, as guests were revealing their written evaluations and theirguesses as to the various wines’ origins, it became Yeager’s turn. When he came tothis entry, he said, “Well, this is just a guess. I can’t be sure about it. I haveeliminated Europe and South Africa. The taste does seem a bit familiar. So I’d say,probably, New Zealand.” The applause that followed astonished Yeager. He alsoseemed pleased.Just as knowledge of wine was part of the Yeager mystique at Virginia, so was hisaversion to the telephone. Colleagues and students both soon learned of this trait.He could be called at home, but only through a prearranged appointment – whichserved to eliminate most phone conversations. In his office, he was known to put thetelephone in his desk drawer, to muffle its ring. At home, cushions and pillowswould be piled upon the nuisance so that one could hear only the faintest buzz.At one point in his Charlottesville days, Yeager was domiciled in a small house.When the service representative came to install the telephone, Yeager requestedthat the instrument have no bell. But he was informed that regulations requiredeach phone to have a bell. Moreover, at that time, customers were not allowed to

30 William Breit, Kenneth Elzinga, and Thomas D. Willetttamper with the equipment; these were still the days when the telephone companyowned everything they placed in a customer’s home and the telephone had nomuting device.Yeager, never one to break rules, had a solution. He inquired as to whetheranything was stipulated regarding where the bell had to be located. The servicerepresentative informed him there were no such rules. Yeager directed that the bellfor his phone should be attached to the utility pole outside his house. Everyonecalling Yeager’s residence thereafter provided an externality to any birds perchedon the telephone lines nearby.We would be remiss if we failed to mention Yeager’s contributions to his departmentwhen he served as chairman from 1969 to 1972. As we have seen, Yeagerseemed able to bring off the unexpected. Some thought his shyness, his aversion tointerruptions, and his disdain for busywork would render him unsuccessful for therole of administrator. Here they would be wrong. His initial term as chairman wasso much appreciated by his colleagues that he was asked to continue.What made him so popular was the unobtrusiveness with which he went aboutthese duties. He applied the golden rule to chairing a department: treating his colleaguesas he would have wanted to be treated. This meant that few questionnairesfrom higher levels of the administration came their way, Yeager having disposed ofthem himself. It meant a minimum of departmental meetings or notices requiring aresponse. In short, Yeager smoothed the way for his colleagues to get their work done.Yeager as polymath linguistLeland Yeager was omnilingual. But he rarely spoke of his skills in foreignlanguages. Indeed, he took it for granted that everyone in the academy would beversatile in and knowledgeable about other tongues. His colleagues and studentslearned about Yeager’s remarkable achievements in this area not because Yeagervolunteered such information or through displays of one-upmanship. For somecolleagues, the revelation came through a visit to Yeager’s home, where a casualbrowse through his bookcases revealed volumes printed in an astonishing array oflanguages. For students, the news came through the University’s grapevine ordirectly through an encounter with him.Foreign languages were much more a subject of interest in an economics programduring Yeager’s years at the University of Virginia than they would be today.At one time, a reading knowledge of two foreign languages was required forcompletion of the doctorate. Later this requirement was relaxed to only one.Today, none would be required.Yeager would have found any language requirement an easy hurdle. During histime on the Virginia faculty, he was reputed to know more languages than anyoneelse. The precise number is difficult to verify. However, the officials who administeredthe exams relied upon Yeager’s skills in those linguistic areas where no onein the various language departments felt fluent.Those students who found themselves being examined by Yeager soon realizedthat this economics professor was no cinch. On one occasion a foreign student

The Yeager mystique 31wanted to count his native language towards the PhD requirement. Yeager knewthe language and was asked to administer the test. The student failed. It seems thatYeager had examined him in the more formal dialect of the language, the versionin which scholarly research appeared. Unfortunately, the candidate’s knowledgewas limited to a provincial dialect.Another doctoral student, who was president of the Graduate Economics Club,was working with Yeager (in Yeager’s capacity as Director of Graduate Studies) tobring Maurice Allais to the University of Virginia for a colloquium. Yeager passedon all the correspondence between himself and Allais to the club’s president for aresponse. The correspondence was in French.Nonplussed by what he considered Yeager’s challenge to him, the club’s presidentdecided to retaliate. With the aid of a graduate student in another department,he responded to Yeager with a letter written in Sanskrit. Yeager was oblivious tothe ruse. In Sanskrit, he innocently replied with enthusiasm, saying how pleased hewas that the club’s president knew this language.Just as remarkable as the portfolio of languages Yeager knew was his ear forspeaking them. One graduate student, from France, was asked by Yeager if hewould, for a stipend, converse with him in French once a week. The student reportson his first session with Yeager:We spoke and he told me in French, using the right vocabulary and the rightgrammar, how he had learnt it with cassettes while driving his car. I was amazedthat he had never been in France because he could speak, rather slowly, butcorrectly, making almost no gender mistake (which is exceptional for Englishspeakingpeople) and with very little accent. This was the evidence of histremendous will and strength. How many people have really learnt a languageby themselves? Certainly very few but he was one of them.Another student, at work in Norway on a doctoral dissertation in comparativeeconomic systems, was corresponding with Yeager about his research findings.In reply to one of his letters, as an aside, Yeager requested the student to purchasefor him the works of a Norwegian author in Norwegian. If you guessed it wasRagnar Frisch, you would be wrong. What the omnilingual professor wanted was acomplete set of Henrik Ibsen’s works.The question arises, why did Leland Yeager spend so much of his time learninglanguages? Most of us who feel the desire to go through the arduous process ofbecoming bilingual do so for pragmatic reasons: to meet an academic requirement,to prepare for a visit to a foreign country, to be able to read some body of literaturein the original language. But these reasons do not explain Yeager’s never endinglinguistic quest. Even as a youngster, Yeager was deeply immersed in working withforeign words. During World War II, when he was only 19, Yeager was a Japanesecryptanalytic translator for the US Army; in other words, he was a code breaker.But this does not explain his zeal for expanding his language horizons.The quantity of languages, the variety of languages, and the degree with whichhe mastered them suggests other motives. For not only did Yeager equip himself

32 William Breit, Kenneth Elzinga, and Thomas D. Willettwith knowledge of the major languages of Europe, spoken in places that he mightexpect to visit, but he also devoured more exotic tongues. Even this was not enoughto satisfy him. At some point he turned his attention to languages native to nocountry. We are not here referring to dead languages such as Latin but artificiallanguages, languages created for the purpose of supplanting native tongues. Two ofthe most prominent of these are Esperanto and Interlingua. Yeager made himselfan expert in both of these, even rising to the position of President of the InterlinguaInstitute.Yeager’s lust for languages is uncomplicated. Languages and linguistics appealto him for the same reason that the market economy appeals to him. Just as theexistence of markets brings order to the allocation of resources, knowledge oflanguage can bring order to interpersonal communication. 2 Esperanto and Interlinguawere languages invented in the hopes of bringing a worldwide efficiency topeaceful discourse among diverse groups. This is not far afield from what Yeagerwould have hoped for through a social regime of free international trade.Yeager: four decades in the vineyardsThe portrait of Leland Yeager that emerges from the forgoing pages displays anindividual rich in accomplishment, unique in personality, and extraordinary in hisfacility with words. To his students, he was a rare, exotic father-figure, eccentric butfull of care and nurture. In the entrepreneurial academy of today, it is hard toimagine another Leland Yeager coming on the scene.Economists today increasingly work in collaborative endeavors; graduate educationin economics increasingly is done through specialized workshops; researchresults are sent around preliminarily in working paper form; and it is important toan economist’s career to be engaged in networking: giving papers at the workshopsof other institutions and at specialized conferences. Yeager is too much the loner tobe comfortable in such a milieu; and he would not expose his ideas until they were,in his judgment, in final form. Strategic networking would be a foreign concept tohim. In short, he is an individualist.All of which brings us to his flirtation with Ayn Rand’s Objectivism. It is unlikelythat any scholar of comparable reputation and accomplishment has devoted asmuch attention to this philosophical system usually placed in the extremist category.However, Yeager the individualist found much in Ayn Rand that appealed.He referred to himself not as a disciple but as a fellow traveler. It is clear that hewas deeply interested in her writings. One student, whom Yeager knew to be anadherent to Rand’s ideas, told of being approached by Yeager at a departmentalpicnic when other students and faculty were playing softball. Yeager sat downbeside him and said, “Ridpath, explain to me the objectivist position on free will.”After a brief talk, Yeager strolled off, the student surmising that Yeager had accomplishedhis purpose.In his Southern Economic Association presidential address, Yeager refers toRand as a writer “whom I respect.” But the homage he paid to her was inspired inpart by the rationale she provided for acting with simple decency. 3

The Yeager mystique 33The common idea that Rand espoused a narrow view of the virtue of selfishnesswas, in Yeager’s judgment, superficial. To Yeager, Rand provided a rationale forthe development of personal standards that lead one to behave in a highly ethicalmanner, subordinating narrow interests to one’s more enduring interests. For sheshowed that in the long run one’s ethical behavior was conducive to one’s ownhappiness. Yeager liked the argument that adopting as the behavioral rule “alwaysact in a decent manner” would improve one’s chances of happiness. This made selfinterest consistent with the high moral standards his students and colleaguesassociated with him.Thomas Robert Malthus considered life as a game of chance. If Malthus iscorrect, it is clear that Leland Yeager has been dealt a good hand: a penetratingintellect, a passion for getting things straight, a facility for languages, a sensitivepalate, and (as this Festschrift attests) admiring students and colleagues.Notes* The authors would like to express their indebtedness to many former students of LelandYeager who kindly shared some memoirs of their Virginia days, thereby providinginvaluable help in the preparation of this profile. They are too numerous to name, but afew of them must be singled out for special mention: Peire Brisson, Charles W. Campbell,William F. Campbell, Vladi Catto, James A. Dorn, Umesh C. Gulati, Barry Hirsch,Joseph M. Jadlow, Kelfala M. Kallon, William A. McEachern, John Mullahy, MarvinPhaup, Lawrence B. Pulley, Alan Rabin, and John Ridpath.1 New York: Praeger (1976); New York: Harper & Row (1966), respectively.2 In his Presidential Address to the Southern Economic Association in 1975, Yeagerrelates the market mechanism to languages and ethical codes as being results of humanaction but not of human design. See (1976) Economics and Principles. Southern EconomicJournal, 42(April): 565.3 Ibid., at p. 566.

3 The Virginia renaissance inpolitical economyThe 1960s revisited *James M. BuchananIntroductionFrom a perspective of the early twenty-first century, the faculty roster of theJames Wilson Department of Economics at the University of Virginia in the early1960s merits attention on several counts. 1 But the “powers that were” at Mr.Jefferson’s university did not value that particular faculty highly. Recall that thosewere years heavily laden with ideological baggage, and that faculty was clearlynonconventional. The university, in its wisdom, allowed the 1960s program in“Virginia Political Economy,” despite its external success, to return to orthodoxy asWhinston, Coase, Tullock, Buchanan departed permanently, and Nutter left for anextended period. 2 The negative aspects of the Virginia story have been recounted,at least in part, and I shall not elaborate on these aspects here. 3My aim in this paper is more positive; I shall discuss the origins, the construction,and the operation of the Virginia program, rather than its deliberate destruction bythe university administration. I should add the disclaimer that my discussion isbased on my own remembered history rather than on a documented record.From idea to actualityWarren Nutter and I were fellow graduate students at the University of Chicago inthe years immediately following World War II. I recall a conversation in early 1948during which we expressed our shared conviction that our discipline, economics,seemed to be drifting away from its moorings in classical political economy. Wequite explicitly discussed the need for an institutional–organizational initiative thatmight serve to bring the classical foundations back to center stage. Like manyconversations, that one was filed away, especially since we were relatively immaturegraduate students with no academic standing.The Virginia program, however, had its origins in that particular conversation.In 1956, both Warren Nutter and I were appointed to faculty positions at theUniversity of Virginia, and I was appointed Chairman of the James WilsonDepartment of Economics. Both of us had completed our apprenticeship, so tospeak. I had fulfilled my obligation to return to southern academia with stints atboth the University of Tennessee and Florida State University. Nutter had put insome token years at Yale University. Both of us had published in professional

The Virginia renaissance in political economy 35journals and Nutter had almost completed a major work on Soviet industrialgrowth for the National Bureau of Economic Research. In other words we now hadsome standing in academia, at least enough to give us the confidence necessary tomove readily into an entrepreneurial role. And, by early 1957, we found ourselvesin a position where we could, indeed, act as academic entrepreneurs.The University of Virginia in the 1950s was a good, if not an outstanding,university. And its tradition in economics was fully respectable with an establishedgraduate program. David McCord Wright, a colorful and eccentric but productivescholar, had resigned before our appointment. But Rutledge Vining remained as asource of imaginative inspiration, as well as irritation, to faculty colleagues. RaymondMikesell was the international policy “wonk” who found the Charlottesvilledistance from Washington ideal for his purposes. James Schlesinger had joined thefaculty earlier as a fresh Harvard PhD; he seemed to Nutter and me to be a welleducatedman, interested in much, but not really a Chicago-type economist at all.Tipton R. Snavely, who had served as departmental chairman for more than threedecades, was required to relinquish that position at age 65.We found ourselves with several opportunities to make new faculty appointmentsin 1957. Warren Smith had resigned late in 1956; Clark Hyde, an economichistorian, died in early 1957; Raymond Mikesell resigned to take a special chair atthe University of Oregon. My first task, as chairman, was to fill faculty positions.How to proceed? My criteria were never articulated, then or now, but they haveremained unchanged. I prefer colleagues who exhibit creative, critical intelligenceand who demonstrate a willingness to challenge orthodox or conventional wisdom.It was my good fortune to read Leland Yeager’s paper “Some Questions aboutGrowth Economics” in the American Economic Review (1954). I did not know Yeagerat all; but I had read enough of the growth models that were cropping up everywherein the 1950s to recognize the emptiness that they reflected. Here was aneconomist who fit my requirements – someone who knew enough about suchmodels to challenge them on their own ground and who pulled absolutely nopunches in calling spades by their rightful names. I had scarcely put the articledown before I commenced to search out Yeager’s possible interest in a position onour faculty.I do not now recall any of the particulars of the negotiation, but Yeager agreed toaccept an appointment, and he came to Virginia, bringing with him two graduatestudents from the University of Maryland, Daniel Edwards and José Vergara. Onevery solid appointment had then been made. The construction of the Virginiaprogram was on schedule.Note that in this narrative account I often use the pronoun “we” rather than “I”in discussing the constructive choices made in the Charlottesville setting of the late1950s and early 1960s. I do this advisedly to convey the relevant point that from theoutset I considered that Warren Nutter and I were coequal partners in theentrepreneurial enterprise. My nominal role as faculty chairman did nothing tomitigate the shared responsibility; and, it should be noted, Nutter assumed thechairmanship after I completed a five-year term in 1961. The joint leadership wasimportant since each of us gained confidence from the other. Neither, singly andalone, might have been able to carry forward the remembered Chicago purpose.

36 James M. BuchananNonetheless, some imputation can be tried, and primary responsibility can beassigned for particular choices. The discovery, recruitment, and appointment ofLeland Yeager was my own affair, almost exclusively. But neither Warren Nutternor I could claim sponsorship for Alexandre Kafka, the second major addition tothe new faculty. Kafka was, almost literally, appointed by Gottfried Haberler.Along with Warren Nutter, I felt myself to be little more than an acquiescor in theHaberler campaign to insure that Kafka secure appointment to the Virginiafaculty. We, along with others in the faculty and administration, were bombardedwith telephone calls, letters, and personal chats, both directly from Haberler andothers, seldom if at all from Kafka himself. Kafka’s credentials were passable, andwith Mikesell’s resignation, we did need strength in international economics. And,as it turned out, this essentially “external” appointment was highly productive forour program. Kafka gave us an entree into academic and quasi-academic (forexample, the international agencies) circles that we could never have attained.And, let us now admit that his Central European manners added a bit of charm andgrace to our brash disturbance of the tranquility of Mr. Jefferson’s lawn.Ronald H. Coase was the third major addition to our faculty at Virginia. AndWarren Nutter deserves full credit for the discovery, recruitment, and appointmentof Coase. Warren had participated, perhaps in the summer of 1957, in one of thelong conferences sponsored by the William Volker Fund. Coase was one of thethree main speakers at the conference, convened, I think, at Chapel Hill. WarrenNutter returned to Charlottesville mightily impressed with Coase, and heimmediately commenced to examine the prospects of prying Coase away from theUniversity of Buffalo, which had been his academic home since his migration fromLondon some years before. After lengthy, and sometimes tortuous negotiations, thedeal was made, and, after a full year’s delay, Coase shifted to Charlottesville.With the additions of Yeager, Kafka, and Coase, the senior staff was basically inplace. Junior appointments were made, including, importantly, Andrew Whinston,one of the best colleagues with whom I personally have worked. We also addedJames Ferguson, a protégé and self-appointed Stigler clone, who kept us alert toChicago-style bumptiousness. And a bit later we appointed John Moes, aDutchman with a Berkeley degree, who was more helpful to me, as departmentalchair with necessary chores, than almost anyone on the faculty. Unfortunately,Moes got at cross-purposes with Coase early on, with the result that he was notmoved along a tenure track.To this point in the narrative of the construction process I have not mentionedGordon Tullock, who many will associate directly with the whole Virginia enterprise,and properly so. But Tullock enters the story only with the complementarynarrative to be discussed in the following section.The Thomas Jefferson Center for Studies in PoliticalEconomy and Social PhilosophyAs we had discussed ten years before, both Warren Nutter and I felt that somethingmore than the appointment of good faculty members within an ongoing program

The Virginia renaissance in political economy 37was needed to bring attention to and concentrate renewed interest in the traditionthat found its origins in Adam Smith and the eighteenth-century moral philosophers.“Economics as moral philosophy,” or as Alexander Rosenberg puts it,“economics as contractarian political philosophy” (1992: 251) – this describes ourpurpose, then and now, and the words “and social philosophy” were explicitlyadded to the name of the center we sought to establish. We believed that it wasessential to set up some such center complementary with, but independent of, theregular departmental program.The establishment of the Thomas Jefferson Center was easier than we hadthought possible. At the University of Virginia in 1957 there were only two administratorsthat mattered: William L. Duren, Dean of the Faculties, and ColgateDarden, President of the University. When we proposed such a center, the responsewas immediate and favorable. Full speed ahead, with Darden’s contribution beingthe “Thomas Jefferson” designation, advanced in part in the misguided hope thatthe trustees of the Monticello Foundation might prove a source of financial support.(As it turned out, the trustees did not have the foggiest idea of what we wereabout.)But, once established, the very existence of the Thomas Jefferson Center gave usthe basis for seeking external funds. In this quest, we were very fortunate to securea large (for 1957), five-year grant from the William Volker Fund for the purpose ofbringing to Charlottesville, for periods of a semester each, a series of distinguishedscholars in political economy. The inclusive program became exciting indeed aslectures, seminars, and informal discussions were led by scholars such as FrankKnight, F. A. Hayek, Michael Polanyi, Bruno Leoni, Bertil Ohlin, Maurice Allais,T. W. Hutchison, Duncan Black, and O. H. Taylor.Included in the center’s project were funds for a postdoctoral fellowship, andGordon Tullock was the first recipient. Warren Nutter is responsible for bringingTullock to my attention. Nutter and Tullock had been members of the undergraduatedebating team at the University of Chicago in the early 1940s, and Nutterknew that Tullock had resigned from the US Foreign Service after a nine-year stint.Further, Nutter knew that Tullock had written a massive book reciting his personalexperience in the federal bureaucracy – a book that contained, amid the personalanecdotes, a new theory of bureaucracy. 4 I met Tullock briefly at the meetings inPhiladelphia in December 1957, and I read the massive volume, warts and all.I agreed with Warren Nutter that Tullock was worth encouraging; we awardedGordon the first postdoctoral fellowship at the center.During his research year at the center, Gordon commenced his work on majorityrule, and, a year later, he and I decided that we should write a jointly-authoredbook on the economics of politics, taking a constitutional perspective. The Calculus ofConsent: Logical Foundations of Constitutional Democracy (1962) was the ultimate result.But after his initial fellowship year, Tullock joined the faculty at the University ofSouth Carolina. It was only in 1961, when we had an opening at Virginia, thatTullock was appointed to the faculty in Charlottesville. And this appointment wasalmost solely on my own responsibility. Nutter was perhaps a bit reluctant to bringTullock back as a permanent colleague. Tullock had no PhD in economics; he was

38 James M. Buchananeccentric along many dimensions; and he and I, in our work in politics, weredeparting a bit from the strictly classical foundations that Warren Nutter held dearto heart and mind. But Nutter accepted my arguments; he could scarcely deny thatTullock represented precisely the critical and imaginative qualities that we soughtin colleagues. Leland Yeager’s strong support for appointing Tullock to the facultyshould be mentioned here. With the addition of Gordon Tullock to a facultyposition, the basic construction was complete. The program, both for the JamesWilson Department of Economics and the Thomas Jefferson Center for Studies inPolitical Economy and Social Philosophy, was alive and well.Dividends were not slow in coming. With some fellowship support from theinitial Volker grant and some additional support from other foundations, notablyEarhart and Relm, graduate students of high potential began to be attracted to theprogram. Exciting research commenced to appear; “political economy,” broadlydefined, seemed to experience a genuine rebirth in those heady years in Charlottesville.Later appointments filled in the gaps, and William Breit, Harold Hochman,and Roger Sherman added to the excitement during the end-years of the criticaldecade.The program in operationSeveral elements were needed to put the sort of graduate-research program wewanted in operating order. First, solid instruction in price theory, aimed towardconveying a genuine understanding of the coordinating properties of marketstructures, was essential. Without this grounding, no program worthy of the name“economics” could exist. Second, a comprehensive and critical understanding ofthe post-Keynesian program in macroeconomics was a necessary part of anyprofessional qualifications. Third, basic mathematical competence was neededwhile, at the same time, we sought to insure against undue investment of scarcestudent resources in mathematization per se. Fourth, graduate students neededsome hands-on guidance into analytical writing that involved coherent constructionof arguments. Finally, and perhaps most important of all, graduate students neededdirection, counseling, and supervision in curriculum choices, timing of requirementsand threshold commitments, and in organizing themselves for the rigors of aresearch career. The anarchy that seemed to be so characteristic of many graduateprograms needed to be replaced with order.Warren Nutter assumed the direct and main responsibility for the first of theseelements. His true interest was always in what some called “old-fashioned” pricetheory, and he taught the students well. At the end of their first year, the Virginiagraduate students knew basic Marshallian economics, as amended and modernizedby George Stigler and Milton Friedman and as translated by Warren Nutter.Leland Yeager admirably fulfilled the second role in the Virginia program. Inmy still-held view, Yeager taught the best year-long course in macroeconomics inexistence during those noteworthy years. He guaranteed that the students wereexposed to, and that they learned, the whole range of ideas that then were includedunder the rubric “macroeconomics.” Using Don Patinkin’s book, Money, Interest,

The Virginia renaissance in political economy 39and Prices (1956), as a basis for critical discourse, Yeager led students throughKeynesianism with a balanced evaluation of the classical precursors, while at thesame time presenting them with some understanding of the then-emergingmonetarism just being developed by Milton Friedman. We did not claim that theVirginia program embodied a research concentration in macroeconomics. But wedid guarantee that students who went through the program would recognize thefield when they saw it, and that they possessed the confidence of their own criticalassessment of ongoing research.We were highly fortunate in being able to insure that our students received theminimal training in mathematics without, at the same time, coming to be overawedby techniques. During the early years this feat was accomplished for us by RobertDavis, himself a mathematician rather than an economist, who understood boththe value and the limits of his subject matter. Our students were not put through thetorture of learning mathematics from an economist who, himself, did not reallyknow what the subject was all about.My own role in the operation of the teaching program was largely limited to thefourth element noted above. In my second-year course in public finance theory,which was really political economy, I developed, at Virginia, a teaching methodthat proved highly successful, both for me and, I believe, for the students. I requiredshort weekly-written papers from students – think pieces, not research papers – onanalytical topics that seemed challenging. And I graded these papers carefully onstyle as well as content. Students learned how to organize an argument and topresent it well. The success of this course was measured by the surprisingly largenumber of these short analytical papers, by graduate students, that found their wayultimately into publication in professional journals.As noted previously, perhaps the most important contributing factor to thesuccessful operation of the program at Virginia was organizational. And in thisrespect, Leland Yeager deserves particular commendation. Shortly after he joinedthe faculty, Yeager assumed duties as coordinator of the graduate program in thedepartment, and it was his effort, almost alone, that did indeed bring order into thewhole operation. Graduate students knew where they were, what their challengeswere, and how they measured up to these. There was an organizational coherenceto the graduate program at Virginia that was, and is, perhaps not present in manyuniversities. (My own experience is worth noting. I left Virginia for UCLA in 1968,only to find that, with comparable faculty and graduate students, the UCLA graduateprogram was essentially anarchy, with almost no coherence. Students weremore or less left alone to work out their own program of progress or retrogression.)Neither Ronald Coase, Rutledge Vining, nor Gordon Tullock were importantcontributors in the direct instructional experience of Virginia’s graduate students.Coase’s appointment to a major professorship was justified on the argument thatundergraduate instruction needed attention and, in particular, that an outstandinglecturer might provide a means of shoring up a relatively weak economics major.Coase was, and remains, an outstanding lecturer, but the effort to exploit thesetalents in elementary teaching was a total failure. Coase’s lectures are good becausethey reflect long hours of intense preparation, something that is not possible on a

40 James M. Buchananregularly scheduled basis. In addition, Coase’s mind was (is) simply too imaginativelyunique to allow him to lecture on standard textbook material. RonaldCoase’s influence on the Virginia program was largely exercised through facultycolleagues, although he did administer the written PhD preliminary examinationsfor several semesters.The intellectual climate in the faculty, and among graduate students, waspermeated with opportunity-cost thinking, either objectively (Coase 1938, 1960) orsubjectively (Buchanan 1969). And scholars in political economy were comingincreasingly to accept Wicksell’s unanimity norm as a benchmark for any evaluationof collectively considered options (Wicksell 1896). Given these two elementsof analysis, Coase’s resolution of “the problem of social cost” emerged quitenaturally (1960), and I distinctly recall the shared surprise those of us at Virginia feltwhen we learned that Coase’s seminar presentation at the University of Chicagohad stirred such controversy. Political economy at Virginia was, indeed, quitedifferent from that at Chicago.Rutledge Vining’s graduate course attracted only a few students, in part becausehe refused to adjust either to orthodox subject matter or method. As base, Vining’sideas were difficult to transmit, and, in fact, they were well in advance of his time(Vining 1984). A temporal displacement of four decades, until the years whencomputer simulations could generate stochastic patterns as desired, would haveallowed Vining to present his provocative ideas on economic diagnoses much morestraightforwardly. Nonetheless, Vining’s critical stress on the relevance of rules wasan important and continuing element in the constitutional direction that politicaleconomy was to take, a direction that is further discussed in the next section.Gordon Tullock occupied the role of conversational gadfly, coming off his considerabletalents as at least one-half of a true Renaissance man (the scientific andhistorical, but relative illiteracy in arts and letters), who kept us all on our toes withhis insistence that Homo economicus was alive and kicking almost everywhere.Tullock also provided me, personally, with a feedback of confidence required topush research and analysis toward the “political” part of the two-word subject“political economy,” a thrust that Warren Nutter would never have supportedother than reluctantly. Tullock and I informally organized a new coequal partnership,perhaps somewhat irritating to Nutter, when we sponsored an initial exploratoryconference in 1963, from which the origins of what later became the PublicChoice Society may be traced. For purposes of this narrative, I should emphasize,however, that the strictly defined “public choice” emphasis arrived relatively late inthe Virginia decade.Constitutional political economyModern public choice theory can be subdivided into two distinct research programs.The first includes analyses of particular outcomes that emerge underparticular rules and institutions that are used or may be used for reaching collectivedecisions, along with the analyses of the behavior of the agents who are constrainedto act within these rules. The second research program includes analyses of the

The Virginia renaissance in political economy 41choices that may be made among alternative sets of rules. This program, latterlychristened as “constitutional political economy,” focuses on ultimate constitutionalchoices.The point to be made here is that there is much more intellectual linkage betweenthe initial Virginia emphasis on political economy, as described in the operationsboth of the economics department and the Thomas Jefferson Center, and modernconstitutional political economy than there is with public choice theory in its more“positive” or “scientific” aspects. From the outset, those of us who were instrumentalin putting together the Virginia program understood, even if vaguely andindirectly, that the ultimate objective to be sought in providing students with anexplanatory understanding of how a market order works is “constitutional” ratherthan strictly “scientific.” That is to say, economics is valuable because it enablescitizens to make more informed choices about the basic organizational structure ofsociety. In one sense the whole focus is on “welfare economics,” if broadly enoughdefined, and on the conditions under which markets fail and markets succeed,always by comparison with alternative political insti tutions. From this startingpoint, the emergence of the more positive research program that concentrates on“how politics works” was a natural consequence.Early on in this sort of inquiry into the “political economy,” as it was observed oras it might be, some identification of the necessary elements in the constitutionalframework for the operation of a market order was required. In this process, thecentral role of monetary rules and institutions becomes evident. How is the operationof a market economy affected by the existence of this or that set of monetaryinstitutions? And, perhaps more importantly, what are the comparative workingproperties of alternative sets of rules, alternative monetary constitutions?During his first year on the faculty at Virginia, Leland Yeager and I discussed therelevance and importance of these questions. And Yeager agreed to undertake theorganizational and administrative role in putting together a series of lectures, eachone of which was designed to present the argument for one of the several monetaryconstitutions or to analyze critically particular elements of such constitutions.Funds were raised specifically for this lecture series. And, during 1959, the lectureswere presented. 5 Under Yeager’s editorship, these lectures were published in 1962by Harvard University Press.This lecture series, and the book, were important for a reason that is independentof the precise content of any or all of the lectures themselves. The project signaled ashift of economists’ attention away from discussions concerning the direction andimpact of policy choices made within the existing structure of rules and by agentsduly authorized under such rules toward discussion of the structure itself. In otherwords, the emphasis was specifically constitutional. These lectures marked a return tosome of the earlier discussion in the 1930s by such economists as Irving Fisher andHenry Simons and by such politicians as Wright Patman, discussion that had fortoo long been superseded both by the Keynesian neglect of monetary influencesgenerally and by the implicit presumption that there were no institutional alternativesto Federal Reserve structure, as it existed.Unfortunately, the Virginia effort organized by Leland Yeager had little lasting

42 James M. Buchananimpact. It did not stimulate much direct or immediate interest in monetaryconstitutions, due in part perhaps to the untimely dating of publication, 1962, atthe precise onset of the apogee years of the translation of the “Keynesian wisdom”into practical politics.When, however, attention came again to be focused on monetary institutionsafter the demonstrable failures evidenced by the stagflation-inflation of the 1970sand 1980s, the 1962 book emerged into a new position of current relevance. Laterefforts that introduced a constitutional approach to analyses of monetary arrangementswere, in one sense, based on the Yeager enterprise. (See Brennan andBuchanan 1981; Buchanan 1983.)The Virginia decade in perspectiveWe are four decades removed from the academic history that I have recalled. Ihave, somewhat arbitrarily perhaps, defined the “Virginia decade in politicaleconomy” to include the years 1957 through 1967, the years during which theprogram was initiated, developed, matured, and “died” in its own fashion. Despiteits within-university, beyond-economics evaluation, the program was an externalsuccess, as measured by almost any objective set of criteria.It is easy to speculate about “what might have been” had the university leadershipnot been blinded by its ideological baggage. How might Virginia’s program inpolitical economy have fared if the university had chosen to retain AndrewWhinston and Ronald Coase on its faculty, neither of whom wanted to leave theCharlottesville scene, had not Gordon Tullock’s promotion been thrice denied,had Warren Nutter’s major work on Soviet industrial growth not been “sent toCoventry” by American Sovietologists, with the consequent feedback into our ownuniversity setting?Even with these questions answered differently from the history we livedthrough, perhaps Virginia’s decade would still have stood as a period apart. By theearly 1960s tensions had already developed between Coase and Vining, and I hadbeen personally upset by the cavalier treatment accorded to John Moes. Nutter wasnever wholly sympathetic to the extension of analysis to politics, and had Coaseremained on the faculty, it would surely have been more difficult for Tullock andme to shift research emphasis so strongly in that direction. After 1963, publicchoice, as a research program on its own and distinct from political economy, waswaiting to be born. But I wonder aloud whether such birth could have happened atall in Charlottesville.At least from my own private and quite personal perspective, in the new century,it seems best to discard all speculation about the might have beens and enjoy andappreciate the remembered history of that which was accomplished in a relativelyshort span of years. We were fortunate in the sense that the University of Virginiawas sufficiently prestigious to insure that our program had significant spillovereffects on academia well beyond Mr. Jefferson’s serpentine walls, while at the sametime the university was sufficiently provincial to insure that our efforts would not besmothered immediately by the dominant academic ideology. We simply exploited

The Virginia renaissance in political economy 43a window of opportunity that rarely opens in the academy. I am sure that those ofus involved, whether alive or dead, are quite willing to leave to others who are moredetached in time, place, and value stance any ultimate assessment of the inclusiveenterprise.Notes* Leland Yeager played a critically important role in Virginia’s “decade of the 1960s” inpolitical economy. Rather than examine this role in isolation, I examine the inclusiveresearch program in retrospect; the “Yeager difference” emerges clearly.1 An incomplete listing includes: James Buchanan, Ronald Coase, James Ferguson,Alexandre Kafka, John Moes, Warren Nutter, James Schlesinger, Gordon Tullock,Rutledge Vining, Andrew Whinston, and Leland Yeager.2 James Schlesinger also resigned from the faculty near the end of the decade discussed. I donot include his name here, nor do I refer to him in the narrative account, because,although he was a fully participating member of the institutional and research faculty,he did not consider himself to be a part of the “team” in Virginia political economy. Nordid those of us on the team consider Schlesinger as a participant in the academicexperience.3 See James M. Buchanan (1988, 1992). By necessity, for purposes of narrative continuity,there will be some overlap between the earlier treatments and that in this paper. Foranother perspective, see William Breit (1986).4 A revised and shortened version of this book was published as The Politics of Bureaucracy(1965).5 These included: Clark Warburton on the quantity theory; Murray Rothbard and ArthurKemp on the gold standard; Benjamin Graham on commodity-reserve money; GeorgeTolley on 100 percent banking; Milton Friedman and Jacob Viner on central bankindependence. There were additional lectures by Clarence Philbrook, James Buchanan,Willford King, and Richard Selden.ReferencesBreit, William (1986). Virginia Political Economy Lecture: Creating the “Virginia School”: Charlottesvilleas an Academic Environment in the 1960s. Fairfax, VA: George Mason University,Center for Study of Public Choice monograph.Brennan, Geoffrey and James M. Buchanan (1981). Monopoly in Money and Inflation: The Casefor a Constitution to Discipline Government. Hobart Paper 88. London: Institute of EconomicAffairs.Buchanan, James M. (1969). Cost and Choice: An Inquiry in Economic Theory. Chicago:Markham.Buchanan, James M. (1983). Monetary Research, Monetary Rules, and Monetary Regimes.Cato Journal, 3(Spring): 143–6.Buchanan, James M. (1988). Nutter Memorial Lecture: Political Economy: 1957–82.In Ideas, Their Origins, and Their Consequences: Lectures to Commemorate the Life and Work ofG. Warren Nutter. Washington, DC: American Enterprise Institute, 119–30.Buchanan, James M. (1992). Virginia Political Economy: Some Personal Reflections. InBetter than Plowing: And Other Personal Essays. Chicago, IL: University of Chicago Press,93–107.Buchanan, James M. and Gordon Tullock (1962). The Calculus of Consent: Logical Foundations ofConstitutional Democracy. Ann Arbor, MI: University of Michigan Press.

44 James M. BuchananCoase, Ronald H. (1938). Business Organization and the Accountant. Accountant, 1October–17 December; a series of twelve articles.Coase, Ronald H. (1960). The Problem of Social Cost. Journal of Law and Economics, 3: 1–44.Patinkin, Don (1956). Money, Interest, and Prices: An Integration of Monetary and Value Theory.Evanston, IL: Row, Peterson.Rosenberg, Alexander (1992). Economics – Mathematical Politics or Science of Diminishing Returns?Chicago, IL: University of Chicago Press.Tullock, Gordon (1965). The Politics of Bureaucracy. Washington, DC: Public Affairs Press.Vining, Rutledge (1984). On Appraising the Performance of an Economic System. Cambridge:Cambridge University Press.Wicksell, Knut (1896). Finanztheoretische Untersuchungen. Jena: Gustav Fischer.Yeager, Leland B. (1954). Some Questions about Growth Economics. American EconomicReview, 44(1): 53–63.Yeager, Leland B. (ed.) (1962). In Search of a Monetary Constitution. Cambridge, MA: HarvardUniversity Press.

4 LelandA personal appreciationGordon TullockI first met Leland when I received a postdoctoral fellowship at the University ofVirginia. Seeing as I really didn’t have a doctorate, since a DJ doesn’t count, thiswas very unusual. However, I can claim other unusual points in my appointment.The center had received a large sum of money to establish a distinguished visitingscholar and a visiting post doc. I was the first recipient of the visiting post doc funds.One of my colleagues said that they had a distinguished fellowship and an undistinguishedfellowship. He, unkindly, maintained that although they continued havingdistinguished and undistinguished fellows, I was the most truly undistinguished ofthem all.This was not Leland, of course, and I believe that he had much to do with myreceiving the fellowship. I had written my Politics of Bureaucracy and was havingtrouble getting it published. I arranged to have some preprints made and distributedthem to friends, one of which was my former debate partner at the Universityof Chicago, Warren Nutter. He distributed it around the department and Lelandread it and was much pleased. I believe he then began a campaign to get otherpeople to read it. He never claimed credit for this, so I can’t be sure, but I remaingrateful to him for, in a way, getting me started in economics. Without thisfellowship and the people I met in Virginia I would probably have continued ininternational studies with main emphasis on purely political problems. Since Ibelieve that my approach to the economics of politics was earlier than Buchanan’s,Leland had a major role in getting public choice started even if he himself seldomwrote on it.The period at Virginia was immensely important for my own intellectual developmentand my contact with Leland was an important part of that development.He was not himself deeply interested in public choice but in more conventionaleconomics. In a way it’s incorrect to refer to him as being a conventional economistbecause he was an extremely original thinker. He not only greatly improved myknowledge of economics, but he did the same for many, many other scholars. Hisimpact on his students was greater than most other teachers I have known. Hislectures were so admired that his students actually printed up their very carefulnotes on those lectures. Leland, with characteristic modesty, objected to this, but itsurely meant that the economic influence of Virginia and, in particular, Leland wasmagnified.

46 Gordon TullockIn any event, I gained a great deal from my association with Leland. It should bekept in mind that at the time I met him I had had one course in economics lasting10 weeks. Admittedly it was taught by Henry Simons and it made an immenseimpression on me. From then on I followed the economic journals as a sort ofhobby. I was engaged, firstly as a completely unimportant member of the militaryin Europe, followed by completing my law school training, and then after a veryshort period of legal practice in a downtown office, I joined the diplomatic serviceand went off to China.In China I followed the practice of a junior Foreign Service Officer, whichmeant that I engaged in minor clerical activities and worked on reporting thepolitical side of the local government and society. All this meant that I had very littlein the way of economic training other than my reading of economic journals in theUSS library. At the time I had no idea of leaving the diplomatic service or, inparticular, of becoming an academic of any sort, certainly not as an economist.I wrote my Politics of Bureaucracy as an effort to regularize and improve politicaltheory. I think I did not at that time regard it as an economic work. In a wayLeland’s reading it and recommending it to other people, indirectly, led me tobecome more interested in economics and less in foreign policy. The year that Ispent as a post doc in Virginia finished off a shift in which I continued to beinterested in political science and in foreign policy, but realized that economics wasdeeply relevant to all of that area.Thus Leland, by first attracting attention to my work in Virginia and henceleading to my receiving a post doc, which led to a firm indoctrination in a year atVirginia in economic methods – particularly, of course, Chicagoan economicmethods – in essence revolutionized my own intellectual development. I was, andremain, deeply grateful for his influence.I should say in passing that I also enjoyed my social relations with him when Iwas in Virginia and since I left Virginia when, as occasionally happens, we meet asships that pass in the night. His particular fields of study are different from mine.Further, he has an apparent great ability to learn foreign languages where I have anequally apparent great inability to do so. This means that in whole areas he is ableto do things that I can only admire from a distance. I can, however, recognize hisgreat contributions in these areas.Altogether his influence on me was great, but I suspect that his influence on hisstudents and other colleagues was even greater. We badly need more members ofthe profession that, if they’re not able to meet the high standards that Leland set,can at least provide an approximation, perhaps a poor approximation. Thus hisinfluence is not by any means entirely through his publications, excellent thoughthey are, or directly through his students, but to a large extent through the studentsof his students. We all should be grateful to the improvement in economics thatcomes out of his work.I cannot trace direct influence between his work and the sharp improvement inmonetary economics since his original work. Still, having a first-class mind devotedto these problems cannot have avoided being one of the causes of the greatimprovement in rationality in that area.

Leland, a personal appreciation 47In addition, of course, his teaching and writing have greatly improved therationality of economic policies in many areas, even if we cannot trace the exactchannels of influence. Once again his influence by way of his students and that ofhis students’ students is great. Altogether, we hope you’ll continue his work formany years and also hope that other people will follow in his footsteps both duringthe rest of his life and afterwards.

5 Monopoly politics and itsunsurprising effectsJames C. Miller III 1In 1964, I was studying for an MA in Economics at the University of Georgia when,at the urging of Professors George Horton and Aubrey Drury, both graduates ofthe University of Virginia’s economics PhD program, I applied for and receivedadmission to the same program. Sometime during the spring of 1965 I visited theUniversity and met with the director of (economics) graduate study, one LelandYeager. In contrast with Profs. Horton and Drury, Mr. Yeager was stiff, formal,and very shy. I was sure the meeting hadn’t gone well. And I was taken back aboutone thing. When Mr. Yeager asked what I was planning to do over the summer, Isaid I wanted to finish my MA thesis. He responded, “Why? You’ll be working on aPhD, right? That’s your terminal degree.” So, instead, during the summer I readeconomics and attended some lectures in Charlottesville, including an unforgettableseries by Ronald Coase. It was good advice.During my first semester at Virginia I took Mr. Yeager’s course in price theory.It was rigorous. The lectures were extraordinarily well organized and well delivered– so much so it was apparent that while Mr. Yeager welcomed questions, it painedhim to be knocked off-stride and off-script. The reason is that he had thoughtthrough carefully what needed to be conveyed to us fledgling economists andwanted to make sure we got it all!It was this class that led to my first crisis in graduate school. For some reason, theuniversity schedule for the final exam conflicted with some other important event,and so, at Mr. Yeager’s suggestion, we all agreed to have the exam at an earlierdate. I know I wrote all this down and had it in my mind as well as in my notes. Butsome way, somehow, I forgot – and missed the exam. Hat in hand, and lump inthroat, I went to Mr. Yeager’s office, during his odd office hours, and apologized.He was nonplussed. Rather than giving me a quick make-up written exam, he saidhe would give me an oral make-up exam – at the end of the second semester!Apparently, he thought stewing for a semester would do me good. It did, and Ididn’t miss another exam.Everyone who has had the honor and intellectual rigor of being a student orcolleague of Leland Yeager’s can attest that he is a most serious and honorableintellectual. In my dictionary, under “scholar,” I see a profile of Mr. Yeager.What follows is an application of some of the basic principles of price theory Mr.Yeager taught me, along with some public choice I learned from Mssrs. Buchanan,

Monopoly politics and its unsurprising effects 49Tullock, Tollison, and Crain. Specifically, I address, first, the applicability of economicprinciples to the political marketplace. As I outline in Monopoly Politics, 2campaigns are a manifestation of the market for political representation. Just as incommercial markets, where sellers compete for consumers, in political markets,candidates compete for voters. The propensity of commercial enterprises to limitthe ability of new entrants has its counterpart in political markets, where incumbentshave a propensity to limit the ability of challengers to mount successfulcampaigns.Second, I describe the benefits of incumbency – and the obverse, the obstaclesfaced by challengers. I describe not only the natural advantages such as havinginvested in advertising and other messages to become well known, but also, andmore importantly, the contrived advantages of incumbency (and the obstaclesimposed on challengers). These include the taxpayer-financed advantages of subsidizedcommunications for incumbents (TV and radio studios, franked mail, etc.)and the ways the office is abused to increase the chances of reelection, but, moreimportantly, the ways campaign rules are “rigged” to benefit incumbents andpenalize challengers.Third, I describe in more detail the steps a candidate has to undertake just to runfor Federal office. I show that complying with current Federal election laws and therules promulgated by the Federal Election Commission (FEC) impose a differentiallyheavy burden on challengers. I also show that the new Bipartisan CampaignReform Act (BCRA) of 2002 further increases the advantage enjoyed by incumbentsand heightens the discrimination faced by challengers. Finally, I show thatthe requirements are so burdensome that, in effect, they amount to a candidate’shaving to secure a “license” from the government in order to compete for politicalrepresentation. Such requirements not only increase costs, especially for challengers,but limit candidates’ and their supporters’ freedom to control how they runtheir own campaigns.Fourth, I describe how political markets would perform without the anticompetitiveconstraints presently incorporated in Federal campaign laws and regulations.I conclude that with their removal the market for political representationwould be much more competitive and that voters would be better served, just asconsumers are better served by competition in commercial markets.Campaigns and the market for political representationAlthough most Americans spend little time considering the government’s impacton their daily lives, the importance of decisions made in political markets rivals thatof decisions made in the commercial sector. A quick look at the size of the Federaland state governments clearly indicates the magnitude of political decision-making.For fiscal year 2001, Federal expenditures topped $1,936 billion, while the 50 statesspent nearly $1,293 billion. Combined, these two levels of government accountedfor 32 percent of the nation’s GDP ($10,082 billion).Just how we, through governments, go about deciding what to spend and how tofinance those expenditures has been the subject of intensive study. 3 One key

50 James C. Miller IIIoutcome of the research is a recognition that elected officials respond to incentivesjust as do producers and sellers in commercial markets. Elected officials competefor voters in elections, just as producers and sellers compete for consumers in thecommercial marketplace. Accordingly, the type of analysis economists haveapplied routinely to assess the efficiency and effectiveness of commercial marketscan also be used to assess efficiency and effectiveness of political markets. Thatthis is possible becomes clearer when we recognize that in most relevant wayscommercial and political markets are very much alike.In commercial markets, providers compete for consumers’ dollars. In politicalmarkets, candidates compete for citizens’ votes. In commercial markets, the abilityof providers to step up to the plate, make offerings to the public, and communicatewhat they have to offer is of vital importance in assuring consumers of the mostvalue for their money. In broad terms, markets are said to be efficient (and effectivein serving consumers’ wants) when competition is vigorous and sellers have ampleopportunities to communicate their offerings.In a similar manner, political candidates compete for the attention of citizens,soliciting their votes at the ballot box. Just as with commercial markets, politicalmarkets are efficient (and effective in responding to citizens’ preferences) whencandidates are able to step up to the plate, make offerings to the public, andcommunicate what they have to offer to prospective voters. 4There are differences between commercial markets and political markets, butthey are not particularly material for the analysis at hand. In the latter, the voterschoose a single person to represent their interests. But choosing a representative ina political market is very much like choosing a retailer in a commercial market. 5The retailer serves as the consumer’s “agent” in picking a line of products orservices from which to choose. Consumers typically do not survey all the goods orservices offered for sale, but instead rely on stores such as Wal-Mart, Winn-Dixie,and their local insurance broker to search through the available product andservice offerings and carry a select few. This makes the consumer’s effort to find agood buy much simpler, but in doing so he or she puts a certain amount of trustin the judgment of the retailer chosen. If, however, the consumer finds over timethat the retailer selects poor product or service lines, he or she will pick a better“agent.”In political markets, voters choose an agent to represent them in collectivedecision-making. Rather than survey all of the political issues facing Congress,inquire into the pros and cons of each, form an opinion, and then take part in amassive referendum on each and every one, voters choose representatives whosejob it is to review all of these issues and make informed judgments. Just as incommercial markets, if citizens find that their agent does not serve them well, theywill choose someone else – that is, unless obstacles prevent or otherwise impedetheir ability to select the best person.Political markets have equivalents to franchises in commercial markets. Theyare interest groups and, especially, political parties. In commercial markets consumersnormally frequent those establishments that have earned their trust asagents. They gravitate towards these places because they have learned that a

Monopoly politics and its unsurprising effects 51particular establishment consistently gives good advice, offers low prices, has outstandingservice, or any number of other factors of importance. The reputationearned by establishments from meeting customers’ expectations consistently can beleveraged through franchising. A consumer traveling far from home knows that theMcDonald’s on the road will serve the same menu, with the same quality, to whichthey are accustomed. This reliance on a firm’s reputation to deliver value is theprincipal reason for franchises.In political markets the equivalent to a commercial franchise is a political party,or to a lesser extent interest groups. Individuals faced with limited time andresources may choose to rely upon the label, Democrat or Republican. Or perhapsthe citizen may take note of the opinions offered by the many interest groups suchas the National Rifle Association, Greenpeace, labor unions, or the countless otherorganizations that take positions on political philosophy and/or policy issues.These groups do more than just inform voters: they also pressure the candidates toremain true to the principles they espouse. If a candidate (or elected official)diverges too far, the group may withdraw its support, just as Burger King might pullits franchise from stores that fail to perform. 6Incentives to innovate exist in both markets. Business firms spend considerableresources to develop new products and services – to gain advantage over their competitors.In a similar manner, candidates (and their parties) put a great deal of effortand expense into making them more appealing to voters and gaining an advantageover their opponents. This can take the form of researching an issue, developing aunique solution, and communicating it to prospective voters. It can also take theform of polling in an effort to probe and assess the opinions and wishes of the public.For politicians and businesses alike, the most important development is irrelevant ifnobody knows about it. The popular saying, “Build a better mousetrap and theworld will beat a path to your door,” is not quite accurate, as the world needs to beinformed and sold on the new idea.Would-be agents in both commercial and political markets solicit our support.In commercial markets, it is called advertising; in political markets, it is calledcampaigning. With respect to purpose there is really no difference between the two.In commercial markets producers promote their prices, qualities, and services, andsometimes even point out the inferior features of their competitors’ offerings, whilein political markets, candidates promote their agendas, their character, theirhistories on the issues, and on occasion suggest flaws in their opponents’ characteror the positions they take. In both cases the purpose is to inform about attributesthat are expected to be decisive to the intended recipient.As mentioned earlier, for commercial markets to be efficient and effective, theymust be competitive. That is, providers must be free to make offerings and “compete”for business. That simple notion is what underlies the antitrust laws and theirenforcement. The reason is that, as Adam Smith observed over two centuries ago,People of the same trade seldom meet together, even for merriment anddiversion, but the conversation ends in a conspiracy against the public, or insome contrivance to raise prices. 7

52 James C. Miller IIIJust as the ability to collude and exclude rivals in commercial markets leads tohigher profits, higher prices, lower quality, and less innovation, collusive and exclusionarybehavior in political markets makes life better for elected officials to thedetriment of voters. Elected officials who are able to exclude, or even disadvantage,rivals have more power and influence, can more easily ignore their constituents,and can enjoy an easier lifestyle, facing less pressure to innovate, campaign, andengage in fundraising. The effects on citizens and voters, however, are like theeffects of monopoly on consumers. The range of options is limited, the overallquality of service is diminished, accountability suffers, officials more frequentlyrespond to vested interests rather than the electorate at large, deliberations are lesstransparent, and citizens have less information about the candidates, their qualifications,and their positions. In the same way that a monopolistic commercialmarket is inefficient and ineffective in serving consumers, a monopolistic politicalmarket is inefficient and ineffective in serving the interests of citizens.The methods elected officials use to advantage themselves and to erect obstaclesto challengers is covered in the next section. But it is important to focus on the factthat political agents have the same incentives to restrict competition as do businessenterprises. Their legal liability, however, is far different. To limit anticompetitivepractices in commercial markets, there are Federal and state antitrust laws,enforced by two Federal agencies, the Department of Justice and the Federal TradeCommission, numerous state Attorneys General, and the private antitrust bar.There is no corollary in political markets. Elected officials face no sanctions foranticompetitive activity. To be sure, there are Federal election laws, and the FEC,among other things, is responsible for monitoring campaign contributions and howthey are spent. But as we shall see, these laws and the FEC impose far greater harmby protecting incumbents and disadvantaging challengers, than any good they doin assuring the integrity of the electoral process.Benefits enjoyed by incumbents and obstacles faced bychallengersFor competition in political markets to be vigorous there must be a reasonably levelplaying field – one free of artificial advantages for one or more candidates versusothers. This is not to suggest a need for rules to restrict natural advantages. Indeed,in an ideal system the natural advantages of the candidates would shine through,whether these are a more popular platform, superior organizational or communicationskills, or even name recognition from previous accomplishments. 8 Whatdoes need to be restricted, and what hampers the efficiency and effectiveness ofpolitical markets, are contrived advantages for certain candidates. Without exception,contrived advantages are on the side of, and are orchestrated by, incumbents.Aside from legitimate, natural advantages, there are two types of contrivedadvantages associated with incumbency. The first type is associated with abuse ofthe office for political gainincreasing the probability of reelection. The second ismore pernicious – rigging the campaign rules to advantage incumbents and to

Monopoly politics and its unsurprising effects 53hinder challengers. The first is explained in this section; the second is explained inthe section that follows.Members of Congress provide themselves with a full range of free services thatare not available to their more cash-starved challengers. Members of Congresshave free mail privileges (referred to as the frank), 9 telephone and Internet access, 10and well-designed web pages. 11 Some people may be surprised at the magnitude ofthese free services. For example, in a recent election cycle, of the 20 largest spenderson the frank, 11 Members spent more on this privilege than their challengers spenton their entire campaigns. 12 And benefits such as frank do help. Albert Cover andBruce Brumberg found that a control group receiving franked mail had a higheropinion of the incumbent than those who did not. 13Members of Congress also derive a significant advantage through casework outof their district or state home offices. The increasing flow of indecipherable andambiguous new laws (and ensuing regulations) increase the demand for caseworkservices – which, of course, only incumbents can provide. Evidence of this can befound in the growth of House and Senate staff assigned to Members’ district andstate offices. From 1980 to 1997, the number of House staffers assigned to offices inthe districts increased from 2,534 to 3,209, and for the Senate offices in the states,the number increased from 953 to 1,366. (The proportion of local-office staff vs. totalstaff increased as well: from 34 percent to 44 percent for the House and from 25percent to 31 percent for the Senate.) 14 Academic research shows how beneficialconstituent services are in garnering support and creating a positive image of theincumbent. 15 And it is apparent that this has not gone unnoticed by the incumbentsthemselves. For example, Morris Fiorina found that incumbents respond to closeelections by increasing allocations to casework. 16Some might argue there is nothing wrong with such a response by the incumbent.They might suggest that the incumbent is only seeking to connect moreclosely with the voters, and that such a response is a sign of competition. To someextent this is true. Members of Congress have legitimate reasons to communicatewith constituents and to help them on occasion. There are two problems, however.First, the evidence is stark that the system is abused for political gain. Second, thisactivity is funded by taxpayers, a source not available to challengers. In any event,the widespread abuse of these free services constitutes a contrived advantage thatmakes the playing field less even, the political market less competitive, and citizensless well served.Incumbents also have at their disposal the ability to send district- or state-specificspending back to their constituents. This practice, more commonly known as “porkspending,” can play a large role in protecting incumbents from challenge. This isparticularly true for more senior incumbents, who because of their tenure are moreeffective at bringing money back to their districts or states. Rational voters recognizingthat the flow of pork is an increasing function of tenure will be more apt toreturn their Congressman for another term. 17 Research has found that incumbentsare effective in taking advantage of these contrived advantages. Robert Stein andKenneth Bickers found that vulnerable incumbents aggressively pursue pork

54 James C. Miller IIIspending, 18 and separately that the success of incumbents in bringing back agencygrants influences a potential challenger’s decision to run. 19 According to the organizationCitizens Against Government Waste, this tool, like so many others, hasbeen growing over recent years, doubling from $6.6 billion to more than $13 billionover the five-year period 1993 to 1998.As mentioned in the previous section, voters have an incentive to reelect moresenior Members due to their effectiveness in delivering pork spending. This incentivealso extends to the committee system, whereby Members jockey to obtain keypositions on various committees that have oversight roles in important areas. Gettingassigned to a powerful committee can enable an incumbent to gain additionalcontributions or support from voters who want to keep their representative in aposition of power. For example, Bennett and Loucks found that being appointed tothe House Banking Committee increases a Member’s contributions from financepolitical action committees (PACs). 20 Additionally, Mark Crain and John Sullivanfound that for Members belonging to the majority party, incumbents assigned tocommittees having significant control over industries under their jurisdictionsignificantly increased their vote margins between the 1988 and 1990 elections. 21These empirical results, and the others like them, 22 are not surprising, given thetremendous power exercised by those committees and by the members who serveon them. 23Another contrived advantage is the ability of incumbents to pressure donors forcampaign contributions when there is little evidence of challenge, and to carry overthese resources from election to election, continually growing their reserves inorder to ward off any potential challenge. Janet Box-Steffensmeier found warchests particularly effective in deterring high-quality challengers. 24 This is notsurprising, given that challengers must recognize the enormous resources stackedup against them. This benefit no doubt helps to explain why, for instance, after the1996 election cycle incumbents’ average cash on hand was over $175,000, andthose incumbents who won with more than 60 percent of the vote had cash on handaveraging more than $230,000. 25The role of Federal election laws and FEC rules inlimiting competitionOf even greater importance and effect are the contrived advantages for incumbentscreated by the Federal campaign laws and regulations. It is important to bear inmind the asymmetry between commercial markets and political markets withrespect to monopolization. In commercial markets, there is no organized forum forthe exchange of information and discussion of ways to limit competition. Indeed, ifthere were such a forum, not to mention if the forum succeeded in orchestratingactions to limit competition, the participants would be liable for criminal prosecutionunder the Federal antitrust laws. On the other hand, in political markets,incumbents have the means as well as the incentive to limit competition. They makethe laws. They not only have a legal forum in which to discuss ways of limiting competition,their actions to carry out policies to limit competition do not create for

Monopoly politics and its unsurprising effects 55them legal liability of any sort. Although usually debated in high-sounding, publicinterest rhetoric, these laws (and subsequent enabling regulations) are understoodto have great impact in limiting the ability of challengers to mount seriouscampaigns. 26Ways Federal campaign laws limit competitionThe ways Federal and state election and campaign-finance laws limit competitionare varied. Only some of the major ones are addressed here. 27Perhaps recognizing the threat from third-party challengers, ballot access lawshave been structured to reduce competition. Theodore Lowi concluded that statebans on “fusion tickets” (the nomination of the same candidate by more than onepolitical party) have a simple objective – to eliminate competition. 28 In a similarvein, Hamilton and Ladd found that ballot structure affects turnout (particularlyfor lesser-known candidates), party-line voting, and election results in partisandistricts. 29Additionally, some states allow incumbents to have significant control in theprimary process. For example: in Virginia incumbents can demand a primary ifthey had been nominated that way the previous election cycle; Louisiana’s openseat primary system, which favors incumbents, only saw one incumbent defeated in22 years; and Connecticut requires a candidate for a party’s nomination to receiveat least 15 percent of the votes at the nominating convention to qualify for theprimary. Also, incumbents work with their state legislatures and governors toformulate redistricting plans in such a way as to protect, and possibly improve, theirchances for reelection. David Gopoian and Darrell West found that incumbentswere more likely to gain, rather than lose, from redistricting because legislaturestended to give incumbents of both parties a greater proportion of their party’svoters. 30 Not surprisingly, additional research has found that if there is a bias in theredistricting process it tends to favor the state’s dominant party. 31Passage of FECA in 1974 dramatically changed the landscape in which campaignsare funded and undertaken. The Act created a tax-return check-off forfunding presidential campaigns, placed limits on spending by presidential candidateswho accept matching funds, and limited the amounts individuals couldcontribute to presidential and congressional campaigns. (The Act also limitedspending on congressional campaigns, but the US Supreme Court later held thisprovision unconstitutional.) 32In researching the academic literature in the process of writing Monopoly Politics,I found overwhelming agreement among scholars that the major effect of the Acthas been to help incumbents further fend off challengers. (Although I have notfollowed the literature as intensely since 1999, I am aware of no further researchthat is of a contrary nature.) I also found evidence that the principal motivation forthe Act was self-interest. Peter Aranson and Melvin Hinich showed that the limitson contributions disproportionally constrain challengers more than incumbentsand thereby benefit incumbents. 33 Abrams and Settle found that the Democrats’support of the 1974 bill was based on self-interest – that in the absence of limits

56 James C. Miller IIIGerald Ford would have won the 1976 presidential election. 34 As another example,Bender found that even in the bill-forming stage, when various spending limitswere considered, Members’ votes were highly correlated with forecasts of theeffects such limits would have had on their chances for reelection. 35 And in Buckley,the Supreme Court recognized that:Since an incumbent is subject to these limitations to the same degree as hisopponent, the Act, on its face, appears to be evenhanded. The appearance offairness, however, may not reflect political reality. Although some incumbentsare defeated in every congressional election, it is axiomatic that an incumbentusually begins the race with significant advantages. 36To see how the 1974 Act and subsequent restraints on contributions help incumbents,recall that a common theme in these reforms is that it makes raising moneymore difficult and spending it less effective. Research has shown that constrainingboth incumbent and challenger fundraising/spending harms challengers muchmore than incumbents. A slew of research has shown that the marginal gain invotes per dollar of spending is substantially greater for challengers. 37 That is, adollar spent by a challenger will increase his or her vote (or vote margin) more thana dollar spent by an incumbent will increase his or her vote (or vote margin). Theprincipal reason is that challengers (and their platforms) are typically not as wellknown as the incumbents they are challenging. Also, since they typically spend farless on their campaigns than do incumbents, their expenditures are especiallyproductive in getting name recognition and in communicating information aboutthemselves and their platforms. On the other hand, incumbents usually have extensivename recognition already, and their positions on issues are fairly well known.In addition, they will have taken advantage of free press coverage and the manyother perks of office discussed above. As Jeff Milyo observed:The evidence . . . strongly suggests that marginal spending by incumbents haslittle impact on their electoral success. Even shocks to spending of $100,000 ormore produce no discernible impact on incumbent vote shares. 38In sum, an incumbent knows that additional spending on his or her owncampaign will be of marginal value in increasing votes (or vote margin), but thatspending by an opponent will have a dramatic, threatening effect. Money forchallengers is therefore absolutely essential if a race is to be competitive, and if theinterests of citizens are to be served. Challengers tend to be relatively unknown, andwithout significant resources it is nearly impossible for them to have any chance atsuccess. Thus, it is in the interest of the incumbent to limit fundraising overall andto encumber the effectiveness of spending.One indication of the effectiveness of limits on a challenger’s ability to accumulatethe resources necessary to wage a competitive campaign can be foundin discussions around various proposals to reform the campaign finance laws.

Monopoly politics and its unsurprising effects 57Consider the proposal in one of the early versions of the McCain-Feingold/Shays-Meehan bill to limit spending in House races to $600,000 per election cycle.According to Bradley Smith (now a Member of the FEC), in 1996, every incumbentwho spent less than $500,000 won versus a meager 3 percent of challengerswho spent that little. Yet challengers who spent between $500,000 and $1 millionwon 40 percent of the time, and of the six who spent more than $1 million, five ofthem won. With respect to the proposal’s variable limits for Senate races (from$1.50 million to $8.25 million per election cycle), in 1994 and 1996 every challengerwho met the limit lost and every incumbent won. 39 It is not surprising, then,that incumbents do not like their odds against well-funded challengers and seek tolimit their ability to raise such resources and to spend them effectively.The Act also advantages incumbents in another way not so generally recognized.By placing restrictions on the ability of candidates to communicate what they have tooffer, the Act increases the role and influence of the media, which are expresslyexempted from FECA and BCRA with respect to news stories, commentaries, andeditorials. Incumbents have a considerable advantage here: they have taxpayerpaidpress spokesmen; they make news, and thus have more access to the media; andthey have access to “inside information,” which they use to curry favor with thepress (the implicit bargain being “my insider information in exchange for yourfavorable coverage”). The reporting requirements also accentuate the role of themedia in campaigns (and diminish the role of the candidates): in effect, thisinformation is a subsidy to the media – giving it stories that it otherwise would nothave been able to secure so easily. 40Bipartisan Campaign Reform Act of 2002With the Bipartisan Campaign Reform Act of 2002, Congress had an opportunityto address some of the anticompetitive features of FECA. On the whole, however,it made matters worse.Title I of the BCRA makes it more difficult for political parties to engage in educationalactivities that mention the names of candidates. While it has the laudablegoal of limiting the influence of “special interest money,” it also limits the ability ofparties to support challengers. Again, anything that makes it more difficult forcandidates to get out their messages reduces the competitiveness of the politicalmarketplace. 41Section 213 of the BCRA says that a political party may engage in independentexpenditures on behalf of a candidate or contribute to the candidate’s campaign –but not both. This change further limits the ability of challengers, especially, toacquire the requisite funds to mount a serious campaign.Section 304 of the BCRA says, in effect, that contribution limits are warranted,but when a challenger appears on the horizon who is prepared to augment his orher campaign treasury out of his or her own pocket, the contribution limits arerevised upward – but only for the opposing candidate(s). Furthermore, the candidatewilling to provide full, or even partial, funding for his or her campaign must

58 James C. Miller IIIsay so in advance, thus tipping off the competition to the campaign strategy. Whiletechnically the provisions contained in Section 304 would benefit a challengerfacing a self-financing incumbent, the real import of the provision is to limit theability of challengers to mount successful campaigns, since over the past years selffinancingappears one of the few ways challengers have been successful in creatingcompetitive races. 42Section 305 of the BCRA requires candidates advertising over the electronic(radio, TV) and print media to reserve a portion of the message for a complete identificationof the candidate on whose behalf the advertisement is placed. Althoughthe amount of time/space required may not seem all that intrusive, the restraintconstitutes a significant diminution in the effectiveness of ads, given that they areusually quite short in duration or space. Also, there is the further encumbrance thatthe requirement makes the ads somewhat off-putting and therefore even lesseffective. Again, anything that makes the expenditure of funds (such as on advertisements)less effective gives further advantage to the incumbent.Sections 312 and 314 of the BCRA impose more severe criminal penalties forviolations of Federal election laws and require the US Sentencing Commission toestablish sentencing guidelines for such violations. While not taking issue with thenotion of requiring compliance with bona fide law, it is notable that such increasedpenalties, combined with the lack of familiarity with the Act’s various provisionsfaced by most challengers, makes it even less likely that a challenger would ventureto enter a political contest. 43In a most blatant “everyone is equal, but incumbents are more equal thanothers” provision, Section 403 of the Act gives incumbents, but not challengers, theright to intervene personally before the court in any challenge to the constitutionalityof any and all provisions of the Act. So, if the constitutionality of a particularprovision whose effect is to advantage incumbents and hinder challengers isquestioned, the incumbent will be heard, but the challenger will not. 44The only provision of the BCRA that would seem to address the overwhelmingadvantage enjoyed by incumbents and the obstacles faced by challengers is Section307, which increases the individual contribution limit from $1,000 per electioncycle to $2,000, increases the individual aggregate (Federal-election) limit from$20,000 to $25,000, and indexes both limits for inflation. Two things are notableabout these changes, however. First, the uneven treatment given to other limits iscurious: the PAC contribution limit is neither changed nor indexed, and thecontribution limits for state parties are raised, but are not indexed for inflation.Second, the doubling of the individual contribution limit places it in real termsbelow the limit the Supreme Court found constitutional in Buckley; an adjustmentfor inflation alone (not to mention the higher cost and greater scope of most Federalcampaigns today) would raise the limit to over $3,000. 45 The 25 percent increase inthe aggregate limit doesn’t even begin to adjust for inflation.Thus, by further limiting the ability of contributors to fund campaigns, which inturn makes it more difficult for candidates to acquire requisite resources, the BCRAcomes down even harder on challengers and further increases the monopoly powerfound in the market for (Federal) political representation.

Monopoly politics and its unsurprising effects 59Federal election/campaign laws are equivalent to requiringa licenseDealing with the various Federal election and campaign laws and regulations hasbecome so burdensome that in a real sense a citizen must obtain a license from theFederal government in order to run for public office. Consider that before a citizenmay campaign for Federal office he or she must file certain forms, in certain ways,with the FEC and agree to abide by its rules and regulations. 46The candidate must have his or her campaign file an initial FEC report (directlywith the FEC, in the case of a run for the House of Representatives, and with theSecretary of the Senate in the case of a run for the Senate) and send a copy to therelevant state agency. The candidate must set up a formal campaign committee,recruit a treasurer, and have that person make the filing and all subsequent reportsto the FEC. 47 (The candidate files only FEC Form 2: Statement of Candidacy.)When I served as treasurer of my spouse’s campaign for Congress in 1998, Ireceived, after the initial filing, the following from the FEC: (a) a pamphlet oncommittee treasurers, (b) a copy of the FEC’s latest newsletter, The Record, (c) a copyof FEC Disclosure Form 3: Report of Receipts and Disbursements for anAuthorized Committee, together with instructions, (d) a list of state offices wherecopies of all reports must be filed, (e) a reprint of an article describing how to filedisclosure reports electronically, (f) a copy of the reporting schedule for the year,(g) a notice about the FEC’s fax line, (h) an announcement of upcoming FECconferences (with no indication whether they are optional or compulsory), (i) acompendium of Federal election campaign laws, and ( j) a copy of the latest issue ofthe Code of Federal Regulations dealing with Federal elections. The number of pagestotaled 618, and the package weighed 1 pound, 12.5 ounces. And that’s not theend. Whether responding to often-indecipherable questions from the FEC’s staffabout filings or guessing about appropriate (vs. inappropriate) language to use inanswering their questions or questions on the various FEC forms, the candidate isreminded constantly that in order to run for office he or she has to secure andmaintain a license from the Federal government. 48To see what maintaining this license is all about, consider that a mistake on areport, no matter how immaterial, can result in frustrating and time-consumingdealings with the FEC. As an example, consider the letter of inquiry I receivedfollowing a midyear report submitted more than one full year after I had lost aprimary election for the US Senate. In part it reads:Your report discloses a . . . loan from the candidate on Line 13(a) of the DetailedSummary Page. It appears that this loan was used to finance expenditures madedirectly by the candidate (pertinent portion attached). Please note that expensesadvanced by the candidate or other committee staff members constitute debtsrather than loans; and should be reported in the following manner: the advanceshould be itemized as a contribution on Schedule A and listed as a memo entry.If, however, the advance was paid in the same reporting period in which it wasmade, the filing of a Schedule A is not required. When the repayment is made,

60 James C. Miller IIIthe transaction should be itemized on a Schedule B supporting Line 17. If theultimate payee (vendor) requires itemization, it should be listed on Schedule B asa memo entry directly below the entry itemizing the repayment of the advance.Continuous reporting (on Schedule D) of all outstanding debts is required.Please amend your report, if necessary.What is not clear from the letter is that the problem stemmed from a transcriptionerror in my report to the FEC, indicating that a major deposit to the campaignaccount had been made the day after the campaign had written a major check to avendor.The learning curve and costs involved in dealing with such reporting requirementsare substantial and amount to maintaining a license to run for Federaloffice. 49Political markets in the absence of Federal laws andrules limiting competitionThose who have been most adamant about the need for stricter regulation of Federalelection campaigns no doubt will respond to the criticisms leveled above by suggestingthat the alternative – the elimination of anticompetitive restraints – wouldbe far worse. That is not the case. As outlined briefly below, a regime where currentanticompetitive restrictions were removed would be far more competitive, andelected officials would respond much more efficiently and effectively to citizens’preferences.An important caveat: the regime posited does not contemplate the removal ofany laws and implementing regulations affecting who is allowed to contribute,fraud, and other criminal acts. That is a whole separate issue. What is posited is therepeal of anticompetitive laws and the elimination of anticompetitive regulations.Under this regime, corporations and unions would still not be allowed to contributedirectly, voter fraud would still be a crime, and so would buying votes, bribingelected officials, etc. Although there are variations on what might be characterizedas a regime free (or relatively free) of anticompetitive restraints, the followingdiscussion assumes the repeal of virtually all of FECA and BCRA. It also assumesthe disestablishment of the FEC and the withdrawal of all its rules. 50How would political markets perform under such a regime? Much more efficientlyand effectively than at present – and relatively free of the unsavory practicescritics are likely to propound as the inevitable consequence of any freeing up ofcurrent legal and regulatory requirements.First, three “macro” issues. It will be said that with no limits on contributions,total expenditures on Federal campaigns would be exorbitant. Judged by spendingon the commercial-market analogue – advertising – this is very unlikely. In MonopolyPolitics, I conservatively estimate that spending (of all types) on Federal campaignsper dollar of “sales” is only half of what is spent on advertising (per dollar of sales) inthe commercial sector. 51 Lifting the lid on contributions would not likely result inmore than a doubling of campaign spending. In any event, the greatest increase in

Monopoly politics and its unsurprising effects 61expenditures would be on the part of challengers, and this would make the politicalmarket more efficient and more effective.In addition, it will be argued that without limits on contributions some groups insociety would have “undue influence” on elected officials. The question is one ofdegree. Undoubtedly, some contributors have “undue influence” now. Would thepractice be more widespread in the regime posited? Interests could contributemore, but to some extent their contributions would cancel out, as others, withopposite interests, competed for favors. On the other hand, “interests” and otherswould have alternatives to “purchasing” influence with elected officials – supportingchallengers. As we shall see below, this makes all the difference.It will also be argued that a lack of limits on contributions would lead to generalcorruption in political contests. Yet the evidence on this issue suggests otherwise.The states of Virginia and Texas have no limits on contributions by individuals instatewide elections, and there appears to be no more corruption in these politicalmarkets than in states having strict limits on contributions.Without limits on contributions and limits on the productivity of expenditures(such as the form and content of messages), political markets would be much, muchmore competitive. Challengers would find it much easier to accumulate theresources necessary to mount effective campaigns. (For one thing, in the absence ofdisclosure, a contributor wanting to support a challenger would not have to worrythat the incumbent might find out and seek retribution.) In contrast, to a considerableextent, it really does not matter how much money incumbents acquire, for, asdiscussed above, the marginal product of incumbent spending (in terms of votes orvote share) tends to be inconsequential, whereas it tends to be quite positive forchallengers. The old adage in politics, “It doesn’t matter how much money youropponent raises; what matters is whether you can raise enough to be competitive,”is operative here.The absence of a requirement for candidates to obtain a Federal “license” beforerunning for office (committee, treasurer, initial filing, periodic filings, responding toinquiries, etc.), and the removal of threat of prosecution because of violations oflaws with which few are familiar, would make it possible for more citizens to run forFederal office. Also, with more resources with which to make a run, candidateswould be better able to communicate their agendas and their qualifications.In a more competitive political market, elected officials would be more accountable.Without the assurance of so many contrived advantages in election contests,incumbents would no longer have so much “freedom” to ignore the wishes ofcitizens. They would have less room to maneuver and would be less responsive to“interest groups.”For those who believe transparency with respect to contributions is highly desirable,there would be a “market test” of that proposition. As did Governor GeorgeW. Bush when he ran for president in 2000, those seeking office might voluntarilypublish their contributors (and amounts) on the Internet. This could be a readysource of differentiation between candidates and an important selling point. Acandidate might publish on the Internet contributions not now required to bereported to the FEC. Candidates might also make other strategic decisions, such as

62 James C. Miller IIIrefusing to accept funds from business, or labor, or other “interest” groups, if theythought such tactics would increase their chances for election.The point is, a regime in which anticompetitive campaign laws and regulationswere eliminated would not degenerate into “the law of the jungle.” To the contrary,political markets would be more orderly and far more responsive to the interests ofthe electorate.Notes1 Chairman of The CapAnalysis Group, an affiliate of the international law firm, HowreySimon Arnold & White, Distinguished Fellow at the Center for Study of Public Choiceat George Mason University as well as the university’s Mercatus Center, and SeniorFellow (by courtesy) of the Hoover Institution. This contribution is based on the author’sexpert report submitted to the US Supreme Court in Congressman Ron Paul, et al. v. FederalElection Commission, et al. (2002). Useful comments by William Olson, Parker Normann,and Jeff Eisenach are gratefully acknowledged.2 James C. Miller III (1999). Monopoly Politics. Stanford: Hoover Press.3 Much of this research is in the field of public choice.4 For more on the similarities and differences between commercial markets and politicalmarkets, see Monopoly Politics, Chapters 2–4.5 The following discussion replicates points made in Donald Wittman (1989). WhyDemocracies Produce Efficient Results. Journal of Political Economy, 97(4): 1395–424.6 Political parties withdraw their support of candidates – especially incumbents – veryrarely.7 Adam Smith (1937). An Inquiry into the Nature and Causes of the Wealth of Nations. New York:Modern Library, p. 128.8 The analogy in commercial markets should be evident: more desirable location andestablishments, superior product/service line, more effective advertising, and betterreputation.9 There are modest restrictions on use of the frank. See Monopoly Politics, pp. 77–8.10 There are also modest restrictions on the use of these instruments for political purposes.See Monopoly Politics, p. 76.11 When governments join the “digital revolution,” elected officials typically commandeerfor themselves the up-front cost (web pages, e-mail, etc.). See Cindy Crandall and JeffEisenach (1998). The Digital State. Washington: Progress & Freedom Foundation.12 National Taxpayers Union and Federal Election Commission. The point made aboutthe incumbent’s spending on franked mail versus challengers’ campaign spending wasnoted in Steve Symms (1997). Campaign Finance Reform Gainers. Washington Times,13August, p. A14.13 Albert D. Cover and Bruce S. Brumberg (1982). Baby Books and Ballots: The Impactof Congressional Mail on Constituent Opinion. American Political Science Review, 76(2):347–59.14 Norman S. Ornstein, Thomas E. Mann, and Michael J. Malbin (1998). Vital Statistics onCongress, 1997–1998. Washington, DC: Congressional Quarterly.15 Yiannakis found that constituent service is especially effective in attracting supporters ofthe incumbent’s challenger. See Diana Evans Yiannakis (1981). The Grateful Electorate:Casework and Congressional Elections. American Journal of Political Science, 25(3): 568–80.Serra and Cover found that constituent service creates a positive evaluation of theincumbent and has the most impact on constituents where only a small portion of themidentify with the incumbent’s party. See George Serra and Albert D. Cover (1992). TheElectoral Consequences of Perquisite Use: The Casework Case. Legislative StudiesQuarterly, 17: 233–46.

Monopoly politics and its unsurprising effects 63Serra and Moon found that voters respond to constituent service and implied thatconstituent service might be able to offset policy differences between the incumbent andhis or her constituents. See George Serra and David Moon (1994). Casework, IssuePosition, and Voting in Congressional Elections: A District Analysis. Journal of Politics, 56:200–13.16 Morris Fiorina (1981). Some Problems in Studying the Effects of Resource Allocation onCongressional Elections. American Journal of Political Science, 25: 543–67.17 Gerald W. Scully (1995). Congressional Tenure: Myth and Reality. Public Policy,203–19.18 Robert M. Stein and Kenneth N. Bickers (1994). Congressional Elections and the PorkBarrel. Journal of Politics, 56: 377–99.19 Kenneth N. Bickers and Robert M. Stein (1996). The Electoral Dynamics of the FederalPork Barrel. American Journal of Political Science, 40(4): 1300–26.20 Randall W. Bennett and Christine Loucks (1994). Savings and Loan and FinanceIndustry PAC Contributions to Incumbent Members of the House Banking Committee.Public Choice, 79: 83–104.21 Mark W. Crain and John T. Sullivan (1997). Committee Characteristics and Re-electionMargins: An Empirical Investigation of the U.S. House. Public Choice, 93(3–4): 271–85.22 For example, Loucks found an increase in PAC contributions from appointment to theSenate Banking Committee. Christine Loucks (1996). Finance Industry PAC Contributionsto U.S. Senators, 1983–88. Public Choice, 219–29.Kroszner and Stratmann found that committee members get more money from PACswith an interest in their jurisdictions, and the contributions rise with seniority. RandallS. Kroszner and Thomas Stratmann (1998). Interest Group Competition and theOrganization of Congress: Theory and Evidence from Financial Services PoliticalAction Committees. American Economic Review, 88(5): 1163–87.Anagnoson found that during election years federal agencies speed up their approvalof grants to the constituents of representatives who are on committees with authorityover them. Theodore Anagnoson (1982). Federal Grant Agencies and CongressionalElection Campaigns. American Journal of Political Science, 26: 547–61.23 Roberts found that the death of Senator Scoop Jackson (then a member of the SenateArmed Services Committee) depressed the prices of stocks of companies in Jackson’sstate and raised the prices of stocks in the home state of his successor. Brian E. Roberts(1990). A Dead Senator Tells No Lies: Seniority and the Distribution of Federal Benefits.American Journal of Political Science, 34(1): 31–58.24 Janet Box-Steffensmeier (1996). A Dynamic Analysis of the Role of War Chests inCampaign Strategy. American Journal of Political Science, 352–71.25 Financial activities of house candidates, 1996, FEC ( It is really not necessary to prove motive here. It is the effect of the laws in limitingcompetition, whatever their official or secret rationale.27 For a more thorough examination, see Monopoly Politics, esp. Chapter 5.28 Theodore J. Lowi (1996). A Ticket to Democracy. New York Times, 28 December,p. A27.29 James T. Hamilton and Helen F. Ladd (1996). Biased Ballots?: The Impact of BallotStructure on North Carolina Elections in 1992. Public Choice, 87: 259–80.30 David J. Gopoian and Darrell M. West (1984). Trading Security for Seats: StrategicConsiderations in the Redistricting Process. Journal of Politics, 46: 1080–96.31 Gary King (1989). Representation through Legislative Redistricting: A StochasticModel. American Journal of Political Science, 33(4): 787–824; Janet Campagna and BernardGrofman (1990). Party Control and Partisan Bias in the 1980s CongressionalRedistricting. Journal of Politics, 52(4): 1242–57; and Bruce E. Cain (1985). Assessing thePartisan Effects of Redistricting. American Political Science Review, (79)2: 320–33.32 See Buckley v. Valeo, 424 US 1 (1976).

64 James C. Miller III33 Peter H. Aranson and Melvin J. Hinich (1979). Some Aspects of the Political Economyof Election Campaign Contribution Laws. Public Choice, 34(5): 435–61.34 Burton A. Abrams and Russell F. Settle (1978). The Economic Theory of Regulationand Public Financing of Presidential Elections. Journal of Political Economy, 86(2): 245–57.35 Bruce Bender (1968). An Analysis of Congressional Voting on Legislation LimitingCongressional Expenditures. Journal of Political Economy, 1005–21.36 As quoted in Aranson and Hinich, “Some Aspects,” p. 451.37 See, for example, Aranson and Hinich, “Some Aspects”; Bruce Bender, “An Analysis ofCongressional Voting,” pp. 1005–21; Amihai Glazer (1993). On the Incentives toEstablish and Play Political Rent-Seeking Games. Public Choice, 75(2): 139–48; Gary C.Jacobson (1985). Money and Votes Re-considered: Congressional Elections, 1972–82.Public Choice, 47(1): 7–62 and (1990). The Effects of Campaign Spending in HouseElections: New Evidence for Old Arguments. American Journal of Political Science, 34:334–62; Christopher Kenny and Michael McBurnett (1992). A Dynamic Model of theEffect of Campaign Spending on Congressional Vote Choice. American Journal of PoliticalScience, 36(4): 923–37; John R. Lott (1991). Does Additional Campaign Spending ReallyHurt Incumbents?: The Theoretical Importance of Past Investments in Political BrandName. Public Choice, 87–92; John L. Mikesell (1987). A Note on Senatorial Mass MailingExpenditures and the Quest for Reelection. Public Choice, 53: 257–65; Dennis C. Mueller(1989). Public Choice II. New York: Cambridge University Press, pp. 209–12; K. FilipPalda and Kristian S. Palda (1985). Ceilings on Campaign Spending: Hypothesis andPartial Test with Canadian Data. Public Choice, 45: 313–31; and Thomas J. Scott (1989).Do Incumbent Campaign Expenditures Matter? Journal of Politics, 51: 965–76.38 Jeff Milyo (1998). The Electoral Effects of Campaign Spending in House Elections. Citizens’Research Foundation, University of Southern California, June 1998, p. 27.39 Bradley A. Smith (1997). Why Campaign Finance Reform Never Works. Wall StreetJournal, 19 March, p. A19.40 Under the Act, a newspaper, for example, may make news-story, commentary, andeditorial (in-kind) contributions to a candidate unless the newspaper is owned by thecandidate. However, a supporter of the candidate may purchase a newspaper and runnews-stories, commentaries, and editorials on behalf of the candidate without restraint.41 Section 103 of Title I waives the relevant restraints when the money is to be used toconstruct buildings to house the political parties.42 See, for example, Larry J. Sabato and Glenn R. Simpson (1994). Money Talks, VotersListen. Wall Street Journal, 28 December, p. A12.43 Given the incredible complexity of the campaign laws, challengers justifiably would befearful of even innocent mistakes. Consider, for example, the final regulations and associatedexplanation and justification the FEC promulgated in 9 February 1995 regulatingall expenditures by principal campaign committees designed to prohibit personal use.These regulations run 14 pages, in the Federal Register, are far from clear, and conveythe notion that it is really impossible to write a clear rule, and therefore violations mustbe left to the judgment of the FEC. Given that penalties under the BCRA for knowing orwillful violations involving making, receiving, and reporting contributions or expenditurescan run as high as $25,000 and imprisonment of up to five years, novice would-bechallengers might opt never to run for office.44 Because of my experience in government, I am aware of the deference the courts affordCongress. But the instances with which I am aware go to broad policy issues. In theseinstances, the law is brazen in its uneven treatment of those competing for the privilegeof representing us: one set of rules for incumbents, another (less desirable) set forchallengers.45 See Monopoly Politics, p. 116.46 Various matters trigger the requirement to file as a candidate, such as raising or spendingover $5,000.

Monopoly politics and its unsurprising effects 6547 Moreover, according to the FEC, the treasurer has unlimited personal liability – surelyan impediment, especially for challengers.48 See Monopoly Politics, pp. 96–100.49 It is worth noting that this license requirement gives incumbents another specialadvantage, for it says, in effect, that a challenger must give ample, and formal, notice toan incumbent that “I want your job.”50 These changes, of course, would not remove all forms of contrived advantages. SeeMonopoly Politics, esp. Chapter 6.51 See Monopoly Politics, pp. 117–18.

6 Good ideas and bad regressionsThe sad state of empirical work inpublic choiceSteven B. Caudill *It was the late 1990s. As I walked down the hallway my young colleague, JohnWells, a times-series econometrician, was standing in his office doorway mutteringsomething about an “intervention analysis.” I asked, “John, isn’t an interventionwhen your family and close friends get you into a room and confront you aboutestimating bad regressions?”(S.B. Caudill)ForewordWe face an epidemic of bad empirical work in economics and much of it can befound in the public choice area. My goal is to characterize and criticize a cavalierapproach to empirical work that I first noticed in papers in the areas of publicchoice and the sociology of economics. I include the latter because much of thework in the sociology of economics is an extension of public choice and many of thesame researchers are involved. If my characterization of public choice is “goodideas and bad regressions,” then my characterization of the sociology of economicsis either “worse ideas and bad regressions” or “no ideas and bad regressions.”There are no theories in the sociology of economics. Both public choice and thesociology of economics employ a common approach to empirical research that Ihenceforth refer to as the PC approach.Despite the suggestions of my colleagues, I do not plan to “name names” so that,in the words of my marketing colleague, Herbert Rotfeld, “more people will feelguilty.” The lone exception I make is to examine, in detail, the bad regression in thepaper by Laband and Taylor published in Economic Inquiry in 1992 entitled, “TheImpact of Bad Writing in Economics.” I use this paper and identify the authorsbecause the econometrics therein has previously been criticized in print by McCloskey(1992). I merely echo McCloskey’s criticisms to evaluate my characterization of abad regression.In this Foreword I wish to indicate why I, in particular, am bothered by the PCapproach to empirical work. The explanation is found in my background and trainingas an economist, the general nature of PC empirical work, and my experienceteaching econometrics courses to PhD students at Auburn University.

Good ideas and bad regressions 67I evaluate all empirical research in light of my training as an econometrician.My PhD is from the University of Florida. There, I studied under the prominenteconometrician, G.S. Maddala, a leader in the development of limited-dependentvariable models. The importance of these limited-dependent variable models ineconomics is indicated, in part, by the fact that the Nobel Prize in Economicsfor the year 2000 is shared by James J. Heckman and Daniel L. McFadden for workin this area.As the name suggests, limited-dependent variable means the dependent variableis limited in some way. This differs from the usual ordinary least squares, orOLS, assumption of normality. The normality assumption implies a dependentvariable that is continuous and has unlimited range. Instead, in limited-dependentvariable models, the dependent variable could be dichotomous (such as a yes or novote), ordinal (such as low, medium, or high), or an integer (such as number ofcoauthors). In fact, the dependent variable might consist of any combination of theabove. Estimation of these models by OLS generally leads to estimators that areunbiased but inefficient. That is, there exist more efficient estimators than OLS foruse in the presence of limited-dependent variables. Limited-dependent variablesoccur quite often in PC data, yet the methods for making efficient use of this limitedinformation are almost never applied. By looking only at the dependent variable ina PC regression model one can determine whether a more efficient statisticalprocedure is indicated. These more efficient procedures have been used extensivelyin other areas of economics, but are not widely applied in public choice and thesociology of economics.My concern about the state of PC research stems partly from my role as aneducator. I have trained several of the economists presently estimating “bad regressions”to include in their PC papers. Many of the students attracted to the PhDprogram at Auburn University were interested in Austrian economics and theLudwig von Mises Institute. Most of these students, although obligated to takecourses in econometrics, had little use for the subject. Those students frequentlyquoted von Mises (1966) that statistics was a method of history. In my role as professor,I tried to show these Austrian students the usefulness of econometricmethods. I encouraged, pleaded, and cajoled them into learning some econometrics.Unfortunately, many of these students are today estimating the same “badregressions” I criticize in this paper. By doing so, my former students are demonstratingjust how useless econometrics is. I feel a little guilt about this matter andproperly so. Either I should have been a better teacher or I should have left wellenough alone.IntroductionSome years ago, I attended a meeting of the Southern Economic Association.There I attended one of many public choice sessions. I took my seat and listened toa newly-minted PhD lecture the crowd on the subject of the “size of state government”or “state government growth.” The lecture was going very well and thenthe speaker came to the discussion of his empirical results. The first independent

68 Steven B. Caudillvariable he discussed was the average altitude of the state. The higher the altitude,the more difficult to leave, and difficulty leaving implied more monopoly power, orso we were told. One has visions of people stuck on mountains being taxed to death.An alternative view is that the high altitude would make it easier to leave a state –one could simply coast downhill to lower taxes. My relatives in Eastern Kentuckywould probably agree with this higher altitude–less monopoly power effect, but foran entirely different reason. The terrain in Eastern Kentucky is hilly which, in thepast, has made it difficult and dangerous for “revenuers” to come around.These comments are not meant to suggest that I took this altitude variableseriously. My reactions were surprise and amusement. As I was seated near themiddle of the room, I began looking over my left shoulder, then my right shoulderto see whether the audience or the presenter would snicker and let me in on thejoke. Neither the audience nor the presenter snickered, so I concluded that this wasto be taken as serious economics. I waited and hoped someone would call this jokeoff, but the presenter calmly began discussing the next explanatory variable, “I alsoinclude the diameter of the smallest circle that can be drawn around the state.”This was too much. Is this really empirical research? Sadly, most of the audience satbusily writing the names of two new proxy variables to use in their regressionmodels, just in case their other proxies failed to produce.The empirical research just described is but one example of a “bad regression”which is all too typical of the approach to empirical research found in public choiceand the sociology of economics. Although the empirical research in public choice andthe sociology of economics are similar, these areas differ in how the research papersare constructed. Public choice is a field in economics based on economic theoriesand principles. A typical public choice empirical paper has a theory sectionfollowed by an empirical section. The sociology of economics is the study ofeconomists – how we write, how we work, how we do what we do. Papers in thisarea do not have theory sections, although authors may try to disguise this fact byusing economic language in place of theory. Without theory, empirical work in thesociology of economics is reduced to being descriptive in nature.This paper represents an attempt to characterize the PC approach to empiricalresearch and to show that “bad regressions” are a consequence of this approach.Several solutions to the problem of bad regressions are discussed including: (1)omitting the empirical work from the paper; (2) requiring that data sets used in thepapers be made publicly available; (3) rewarding research work on the constructionof proxy variables and indices; and (4) reminding those in the profession in theirroles as educators and referees to demand improvements in the quality of empiricalwork and to stop publishing papers until the quality is improved.Why empirical research?First, let us establish the uses of empirical research. Econometricians offer thesethoughts on the goals of empirical research:the entire body of economic theory can be regarded as a collection of relations

Good ideas and bad regressions 69among variables. . . . econometrics is concerned with testing the theoreticalpropositions embodied in these relations, and with estimating the parametersinvolved.(Kmenta 1986: 203)Econometrics, the result of a certain outlook on the role of economics, consists ofthe application of mathematical statistics to economic data to lend empiricalsupport to the models constructed by mathematical economics and to obtainnumerical results.(Tintner 1968: 74)The method of econometric research aims, essentially, at a conjunction of economictheory and actual measurements, using theory and technique of statisticalinference as a bridge pier.(Haavelmo 1944: preface)These quotes point to what most would agree are the two main goals of empiricalresearch: measurement and testing. Econometrics can be used to measure conceptslike the elasticity of demand or the MPC, and can be used to test hypotheses derivedfrom theories and econometrics.Holcombe (1989) argues for a third use of empirical methods. In Holcombe’sview, regression methods are a lens with which to view the world, sometimesrevealing relationships that are not otherwise obvious. When used in this way,econometric methods can lead to the development of a new theory. Holcombecites the Phillips curve as an example of a theory developed from empiricalobservation.Although I am sympathetic to this use of econometric methods, I am notcomfortable with the implications of this use for the goal of hypothesis testing. Onecannot snoop around the data for a new theory and then use the same data set fortesting. If a trade-off between unemployment and inflation is suggested by the data,one should test the theory using different data. However, one might use the samedata set for measurement.The empirical research found in papers in the area of public choice, whichusually follows a theory section, is used for hypothesis testing and measurement. 1Empirical research in the area of the sociology of economics, which usually doesnot follow a theory section, is conducted to find a result. This use of empiricalresearch is consistent with Holcombe’s view that regression methods provideanother way to view the world. Unfortunately, the empirical results are not used todevelop a new theory which is later tested on new data. The empirical result is theend of the story. Empirical work in the sociology of economics is a search forcorrelations.As I state earlier, I see no harm in learning about the world through a regressionmodel. The problem with the use of regression methods to find theories is thatauthors rarely, if ever, confess to having done so. Researchers pretend that theEmpirical Results section of the paper is included for the goals of measurement

70 Steven B. Caudilland hypothesis testing. In these data-instigated papers, it is a certainty that the nullhypotheses will be rejected in favor of the alternative. After all, the high t-ratios arewhat spawned the paper in the first place. If researchers wish to use econometrics toreveal or inspire theories, I insist that they confess. For those working in the area ofpublic choice who are unwilling to test the data-instigated theories using differentdata sets, I suggest that the Empirical Results section be moved nearer to the frontof the paper and re-titled “Look What I Found.” Those working in theorychallengedsociology of economics should simply title their papers, “Look What IFound.”The PC approach to empirical researchWhat I have called the PC approach is really a method of conducting empiricalresearch which I associate with those working in the public choice area or havingpublic choice backgrounds, although examples can be found in all areas of economics.I have not scoured the literature for examples of this type of research. Myhope is that once the approach has been characterized, the articles will be easilyrecognized.PC empirical research is characterized by the following: (1) no structural modelis presented and may not exist; (2) many, if not all, of the variables in the model areproxy variables; (3) the estimation results may be the result of a proxy variablesearch; and (4) more efficient statistical approaches that are indicated by the data ormodel are not applied. 2 In fact, the list could probably be shortened to three characteristicsbecause, as I show, the fourth characteristic of the PC approach is largely aconsequence of the first three.1. No structural model. Economists are taught to think about the world in termsof constructs like supply and demand, production functions, and cost functions.Those adopting the PC approach may mention these constructs but they are neverformalized. No structural model is presented and may not exist. Instead, what thereader gets is something like a reduced form model, or what my colleague, RogerGarrison, calls a “pro forma reduced form model.” 3Econometricians tell us that when the reduced form model is derived from astructural model, one can still estimate regression coefficients, but interpreting theresults is nearly impossible. All that can be estimated is some function of the structuralcoefficients. This is the identification problem in econometrics. The situationin PC regressions is even worse because there may be nothing to identify. 4 A “proforma reduced form” is not derived from any structural model, so interpreting theresults is impossible.The absence of a structural model leads the researcher in the direction ofdata mining. This folly occurs because, without a structural model for guidance,researchers are more likely to try a “kitchen sink” approach to empirical research.One cannot appeal to a theory for help in determining the number and kind ofexplanatory variables to include in the regression model, so many variables are

Good ideas and bad regressions 71“tried.” The consequence of data mining is the dilution of reported significancelevels (see Caudill and Holcombe 1999).2. Many proxy variables. A proxy variable is a substitute for the variable we wish toexamine. The inclusion of a single proxy variable leads to biased and inconsistentparameter estimates of all coefficients in the model. In some cases all the variablesin a PC regression models are proxies. The consequences for estimation are, inall likelihood, not good. The problems of bias and inconsistency are not likelyremedied by using more proxy variables.3. Proxy variable searches. Depending on one’s point of view, a trip into the world ofproxy variables presents problems or opportunities. Because one does not haveinformation or data on a particular variable, one might require a proxy. But proxiesmust be acquired or constructed. One can discover, construct, and imagine manydifferent proxies for any variable. If one has any data related to the missing variable,proxies can be constructed by using differences, ratios and other transformations.The problem becomes how to determine which proxy to use. Of course, the proxyvariable chosen is the one that provides the desired empirical result.What has just been described is a proxy variable specification search (see Leamer1978). The consequence of this type of specification search is a further dilution ofthe true, as opposed to reported, statistical significance of the results.4. Absence of advanced econometric methods. Many of the advanced econometricmethods, including those for estimating models with limited-dependent variables,are absent from PC regressions. This absence occurs despite the fact that many ofthe econometric models used in PC regressions have limited-dependent variables.Estimation of these models by OLS leads to unbiased but inefficient estimators,but there are a number of methods available to estimate regression models moreefficiently than by OLS. These econometric methods, based on the principle ofmaximum likelihood, are detailed in textbooks by Greene (2003), Kennedy (1998),and Maddala (1983).What could an approach to empirical research characterized by a “pro formareduced form” model containing proxy variables, a proxy variable search, andinefficient statistical methods be expected to yield? Not much. The absence of astructural model means that the regression parameters are, at best, jumbles ofstructural parameters, if a structural model exists. The use of proxy variables yieldsbiased and inconsistent estimates of the parameter “jumbles.” The proxy variablesearch means that the reported levels of significance on the coefficient “jumbles”are overstated. We end up with a poorly measured estimate of a jumble ofparameters. 5 In short, the result is a bad regression.A bad regression contains no useful information. No information about theprecise measurement of important economic constructs like elasticities is obtained

72 Steven B. Caudilland no information can be gleaned from the hypothesis tests. Given that thePC approach leads to poor estimates of jumbles of parameters, the goal of measurementis lost immediately. The uselessness of the hypothesis tests is more difficult tocharacterize. The information in a hypothesis test should convince the unconvinced,or at least cause the unconvinced to pause. 6 If a regression model providesno useful parameter estimates and “unconvincing” hypothesis test results, it is a badregression.For public choice empirical research the implications of using the PC approachare that the goals of hypothesis testing and measurement cannot possibly beachieved. In the sociology of economics the PC approach is employed to search forcorrelations. 7Why so many bad regressions?Why are there so many bad regressions in the areas of public choice and thesociology of economics? The explanation follows the reasons as to why there are nostructural models, why many proxies are used, and why advanced econometricmethods are shunned. I also explore the merits of suggesting that empirical researchis as poor as the market will bear, using an argument similar to that made byLaband and Taylor (1992). The Laband and Taylor justification is explored anddismissed.In order to explain the low quality of empirical research in public choice, one candraw upon the distinction made by Holcombe (1989) between a theory and amodel. Holcombe defines a theory as “a coherent group of general propositionsused as principles of explanation for a general class of phenomena” (see Holcombe1989: 26). Holcombe states that theories explain nothing about the real world.Holcombe says, “theories may be developed into models by making assumptionsthat link the conditions of the theory to the conditions of the real world.” InHolcombe’s view a model is “a framework for analysis that duplicates somecharacteristics of the phenomena being modeled” (Holcombe 1989: 27). The gapbetween theory and model in PC research is large. Data are what researchers use tobridge the gap, but data in the PC area are not of high quality and usually bear littleresemblance to the phenomenon being studied.Part of the problem with empirical research in public choice is that much of theeconomic activity examined is non-market. The usual economic data on costs,prices, incomes, inputs, and outputs either do not exist or are poorly measured.As economists, we desire to characterize the world using familiar and rigorouslydefinedconcepts like supply and demand curves, cost functions, and productionfunctions. The poor association of available data to costs, prices, incomes, inputs,and outputs in the PC area makes the use of these familiar constructs problematic.The implication of these data problems is that models in the public choice areacannot bear close association to theories. The gap between theory and model in thepublic choice area is much larger than in other areas of economics. The situation iseven worse in the area of the sociology of economics for there are no theories to

Good ideas and bad regressions 73approximate. One cannot expect to find structural models in these papers. Theconsequence is that PC regressions cannot provide useful information abouthypothesis tests of the theories or measurement of key parameters. In the end, badregressions are produced.Why do PC researchers shun the use of advanced econometric methods? Onepossibility is that the PC researchers are unaware of these methods or lack the skillsto apply them to their PC regressions models. This explanation is inadequate fortwo reasons: the widespread availability of LIMDEP software and the possibility ofco-authorship or friendly advice.The LIMDEP software makes the application of the limited-dependent variablemethods very easy. The program is menu-driven so that all one has to do is checkthe appropriate box and then estimate the model. With LIMDEP, estimating anadvanced econometric model is literally as simple as estimating an OLS regression.One simply needs to check a different box on the menu.One reason PC researchers may not effectively use software like LIMDEP isbecause those working in the PC area may not be aware of the appropriate econ o-metric model to apply. The solution to this problem is to acquire a co-author orseek the advice of an econometrician. The co-author or the econometrician may beable to point the PC researcher in the direction of an efficient statistical procedure.With the availability of user-friendly software and econometric advice, why mightPC researchers still shun advanced econometric methods? The econometricianmay decline to become involved for two reasons. First, the project might be sowhimsical that the econometrician might worry about a loss of reputation if theproject is embraced. Second, the econometrician may simply decide that estimatinga “pro forma reduced form” full of proxy variables is not the place for anadvanced econometric method. Advanced econometric methods might not beused because the author decided the audience would not be interested. A readerundisturbed by a “pro forma reduced form” regression model full of proxyvariables would not likely care about the omission of advanced econometrics.The ultimate consequence is a watering down of PC empirical research. Withpoor data there is little point in applying advanced econometric methods. We havebad on top of bad and the end result is a bad regression.One might try to justify the state of empirical research by using an argumentalong the lines presented by Laband and Taylor (1992) to explain the abundance ofbad writing in economics. Laband and Taylor argue that the writing in economicsis as bad as the market will bear. That is, poorly written papers are being citedat roughly the same rate as well-written papers, so the market has spoken.Laband and Taylor argue that the market is not penalizing those for writingpoorly.Can the same be argued for bad regressions? In the reply to Laband and Taylor,McCloskey argues that one of our duties as teachers is to teach students to be betterwriters. We should educate individuals to consume and produce high-qualitywriting. If we, as economists, are charged with educating in the area of writing, wehave an even greater responsibility to educate in the area of econometrics.

74 Steven B. CaudillA bad regressionLet us look in detail at one case McCloskey considers to be a bad regressionincluded in a paper written in the area of sociology of economics. In 1992 in thejournal Economic Inquiry, Laband and Taylor (henceforth LT), in response to anearlier work by McCloskey (1986), use econometrics to determine whether poorlywritten papers are less valuable than well-written papers. As a measure of value, LTuse citations and adjusted citations. As explanatory variables they include thelength of the article and, as a measure of reputation, the number of citations to theauthor’s work. The independent variables of interest in these regression methodsare several indicators of bad writing suggested by McCloskey such as: (1) words persentence; (2) number of footnotes; (3) number of footnotes that interrupt sentences;(4) use of “bad words” such as “like” and “very”; (5) the use of “five-dollar” words;(6) the use of “is”; (7) the use of rhetorical questions; (8) the presence of table ofcontents paragraphs; and (9) excessive introduction and summarizing. Using thesemeasures and their regression models, LT find no difference in “value” or citationcount between poorly-written and well-written articles and conclude that writingquality does not matter.In the reply to Laband and Taylor, McCloskey criticizes every aspect ofthe paper: the motivation, the “theory,” the writing, and the econometrics. 8In McCloskey’s opinion, the Laband and Taylor model is a “bad” regression.McCloskey describes their empirical work as being “firmly in the lower tail ofmodern economics.” I attempt to fit McCloskey’s criticisms of the LT paper intomy four-point characterization of the PC approach to empirical research.McCloskey’s first criticism is not specific to the LT paper but is a criticism ofeconometrics as it is currently applied. McCloskey says, “What’s mainly wrong inthe use of econometrics in our profession is that it is not used for serious inquiry butfor reaffirming what everyone, especially the authors, already know.” McCloskeychides LT for using their econometrics to show that “Economists’ writing variesaccording to the intended audience” (McCloskey 1992: 693).McCloskey criticizes Laband and Taylor for using a very crude measure ofwriting quality. LT use the nine easy-to-quantify indicators given by McCloskey,individually, as proxies for writing quality. McCloskey argues that a single index ofwriting quality is needed. As McCloskey points out, the approach used by LTassumes that writers displaying excellence on one margin would exhibit excellenceon other margins as well. Writers with high scores on some measures of writingquality might have low scores in other areas. This possibility could mean that thesample contains writing of uniformly poor quality even though scores on individualmeasures vary. If the writing is of uniformly poor quality, the finding that all papersare cited about equally is not surprising. The problem, again, is that no singlemeasure of writing quality is used in the empirical research. In McCloskey’s viewthis is the end of the story. The LT instrument for measuring quality is no good, sothe project is useless.McCloskey notes that LT admit to having an omitted variables problem. Theconsequence of omitted variables is inconsistent estimators. McCloskey then statesthat little can be learned from the statistical failure of a misspecified model.

Good ideas and bad regressions 75Let us examine how aspects of the LT regression model fit my characterizationof PC empirical research. We examine LT for the following: (1) absence of astructural model; (2) many proxy variables; (3) a proxy variable search; and (4)absence of advanced econometric methods.1. No structural model. Throughout their paper LT talk about production functionsand markets. These are familiar concepts to us all, but the actual empirical workbears little resemblance to any of these constructs. LT estimate a single equationmodel with citations as the dependent variable and article length, author citations,and several indicators of bad writing as independent variables. There is no connectionto production, supply, or demand. 9 The result is a “pro forma reduced form”model.Using the theory–model distinction discussed by Holcombe, one can see that thegap between production functions, markets, and the LT empirical work is large.Although many economic concepts are discussed in the LT paper, no structuralmodel is presented. This is a characteristic of research in the sociology ofeconomics.2. Proxy variables. All of the variables used in the LT regression model are proxies.Citations is a proxy for quality or value. The following are all proxies for writingquality: words per sentence, number of footnotes, number of footnotes that interruptsentences, use of “bad words” such as “like” and very,” the use of “five-dollar”words, the use of “is,” the use of rhetorical questions, the presence of table ofcontents paragraphs, and excessive introduction and summarizing.3. Proxy variable searches. LT do not appear to spend much time on a proxy variablesearch, probably because they found a publishable result quickly, but their Table 1does indicate two alternative measures of poor writing: Bad Footnotes and Percent BadFootnotes.4. Advanced econometrics. I have stated earlier that advanced econometric methodsare often not used because the problems associated with estimating a pro formareduced form containing proxies and searched over proxies will discourage othersfrom providing advice or assistance. I offer a suggestion about how the LT papermight be improved but also freely admit that I, and I suspect others, can generatelittle enthusiasm for the undertaking. The nature of the dependent variable affordsthe opportunity to apply a limited-dependent variable model. The dependentvariable in the LT paper is the number of citations to a journal article. As this is aninteger, estimation by OLS will lead to unbiased but inefficient estimation. What isoften done in this case is to estimate a limited-dependent variable model known asa Poisson regression (see Maddala 1983: 51). This model is easy to estimate usingthe LIMDEP software.However, the absence of a Poisson regression from the LT paper is not the point.Had this been a paper in labor economics or industrial organization, the referees

76 Steven B. Caudillwould no doubt have insisted that Poisson regression either be used instead of OLSor in addition to OLS. This is an example of the water-down theory. The idea is nottoo important and the data are not of high quality, so the usual standard forempirical work does not apply. In the end, we have no structural model, a “proforma reduced form” model full of proxies, and no advanced econometric methodsused. In short, we have a bad regression. 10Reducing the number of bad regressionsThere is some hope for reducing the number of bad regressions in empiricalresearch. As many of the problems with public choice empirical research stem fromthe gap between theory and model, some effort to close the gap is helpful. Help forthe sociology of economics is another matter because these papers lack a theorysection. A change in culture among economists would help improve the quality ofempirical research. In our roles as teachers, referees, and editors, we can bettereducate young economists to consume, produce, and appreciate sound empiricalwork. As referees and editors we can stop publishing the stuff. I elaborate on thesesuggestions in the following paragraphs.I offer four suggestions that might help reduce the problem of bad regressions inthe PC area: (1) omit the empirical work from the paper; (2) require that data usedin the papers be made publicly available; (3) reward/publish work on proxyvariables; and (4) remind those in the profession in their roles as educators andreferees to demand improvements in the quality of empirical work. I discuss themerits of each of these suggestions in turn.1. Omit the empirical section. An obvious suggestion is to simply omit the regressionsfrom the paper entirely. The data problems make the interpretation of the empiricalresults impossible. The results do not serve the goals of measurement andestimation and should therefore be omitted. This would save author, editor, andreader time.The implications of this suggestion are very different for papers in the areas ofpublic choice and the sociology of economics. Papers in the area of public choicehave a theory section and an empirical section. If the empirical section containingthe bad regressions is eliminated, the paper could possibly survive. Consider thenew PhD student I mentioned in the Introduction. Little would have been lost if hispresentation had not made mention of the “altitude of a state.” Although theempirical section adds nothing, the presence of the theory section gives the papersome chance of survival.The consequences of omitting bad regressions from sociology of economicspapers are fatal. These papers are purely empirical and contain no theory section.Without the empirical section, the paper no longer exists. In light of this indictmentone might suppose that I argue that these papers should not be written. I do not. Myhope is that papers in the sociology of economics will no longer be published inmainstream economics journals.

Good ideas and bad regressions 772. Require data be made publicly available. Another suggestion is to require authors ofaccepted manuscripts to make their data sets publicly available. Although themeasure will do little to close the gap between theory and model, it will providesome checks on specification searches and proxy variable construction. With easilyaccessible data, others can try different proxies and different specifications in orderto determine the fragility of published regressions results. The data are still bad, butpublishing the data may reduce the tendency to report a fragile result.There is little reason today for not requiring all datasets be submitted to journalsalong with accepted papers. We live in the electronic age where journals have theirown websites and many accept electronic submissions. The cost of supportinga data archive must be low and falling but, at present, only the Journal of Businessand Economics Statistics, the Economic Journal, and the Journal of Applied Econometricscurrently support data archives.3. Encourage work on proxies. Another suggestion for improvements in empiricalresearch in the PC area lies in encouraging increased effort in the production andexamination of proxy variables. Bad data beget bad regressions. To have anychance of producing better results, those in the PC area need to begin with betterdata to close the gap between model and theory. Researchers should be encouragedand rewarded for producing good proxy variables. So far, this research hasbeen neglected in public choice and other areas of economics for two reasons:econo mists are not trained to develop proxies and indices and the work of developingproxy variables is not viewed by the profession as “glamorous.”The area of public choice needs more studies of index and proxy variableconstruction. The good news is that several groups are currently involved in theconstruction of indices that might be useful to PC empirical researchers. The badnews is that most of these indices are not being published in economics journals.Perhaps the most popular are the indices constructed to measure economic freedomin a country. Several indices of economic freedom exist: the Fraser Instituteindex of Gwartney et al. (1996), the Freedom House index in the work edited byMessick (1996), and the Heritage Foundation–Wall Street Journal index ofJohnson et al. (1998).Although producing proxies is a worthy goal, the problems with bad regressionswill not disappear with better proxies alone. The PC people, by and large, do notcare about constructing new proxies and, by and large, do not care whether theexisting proxies are any good. Proxies simply represent another empirical opportunity.At present, the proxies that have been produced have been accepteduncritically, gobbled up, and tossed into the same bad regressions. Construction ofthe indices is the beginning of the process, not the end. Indices should be constructed,dissected, and carefully examined (see, for example, Caudill et al. 2000).More and better proxies can help reduce the incidence of bad regressions. Betterproxies will lead to less data mining. Better proxies will, perhaps, lead to thedevelopment of structural models, and better proxies may help get the interest ofthe neighborhood econometrician.

78 Steven B. Caudill4. Education is the best hope. Education will improve the quality of empirical researchin many ways. The best and probably only hope for improvement lies with usas educators, referees, and journal editors. If we educate and enforce standards,the profession will follow along. On this point I echo McCloskey (1992) about thesolution to the problem of poor writing in economics. We all bear some of theresponsibility for the incidence of bad regressions, and as an econometrician, I bearmore than most. We spend so much time in econometrics class studying varioustechniques that we neglect the transition from theoretical model, or theory asHolcombe would call it, to empirical model. In this area we are far behind ourcousins in agricultural economics departments.As educators. We do not spend enough time in econometrics courses teachingstudents about the transition from structural model to empirical model. To use theanalogy of a cook, “We take them in the kitchen and show them how to use all theappliances but we do not show them how to prepare any meals.” We should do abetter job of training in our graduate programs. As econometricians we do imposestandards on students writing empirical papers for our econometrics classes, but,again, we tend to focus on the methods used and tests performed. Graduatestudents write empirical papers in most graduate courses, so a more global solutionis warranted. I suggest that graduate programs adopt a system similar to the oneused at my alma mater, Ohio Wesleyan University, to address, ironically, theproblem of bad writing. At any time during a student’s college career, any termpaper written for any course deemed to be poorly written obligated the student toretake the freshmen English Composition course. In economics, I propose that anyempirical paper written for any course be submitted to the econometricians forreview. An unacceptable mark in econometrics would obligate the student toretake the econometrics sequence. I do not think this would result in many graduatestudents actually retaking the econometrics courses because the threat, alone,would have the desired effect of improving the quality of the empirical research.As referees and editors. As reviewers, we are too soft. When reviewing a paper, I tendto focus more on the method than the data. I have always felt that researchersshould not be held accountable for their data. Data are what they are. We all facedata constraints. My view was, “Do the best with what you have.” After all, baddata are not the fault of the researcher. For this reason I typically try to determinewhether a researcher has done as well as possible with the data they have. If theyhave done so, I recommend accept, if not, I recommend changes.I now realize that my “don’t blame the author for the data” approach to refereeingis wrong. If the data is no good, then the researcher can be held responsible for notchoosing a different topic. If the data is bad, don’t write the paper. Researchersin the PC area do not always follow this approach because we, as educators andreferees, have not always forced them to do so.The problem is that papers containing bad results still get published. If we, as aprofession, want to improve the quality of empirical research, we must not publish

Good ideas and bad regressions 79papers containing bad regressions. For those papers in the public choice area thismeans, with the weak empirical sections tossed aside, the theoretical model must bepublishable on its own merits.On the other hand, papers in the sociology of economics should never be publishedin mainstream economics journals. They are not economics but sociology.If they are to be published, they can be published in sociology journals. Perhapsnew journals will come into existence with titles like, Sociology of Economists or Journalof Rankings.Let us not forget, journal publication is not the only method of providinginformation. Those working in the sociology of economics can post these papers ontheir web pages. Journals could do the same. Without publishing in a mainstreameconomics journal as the reward, McCloskey’s utilitarians would largely abandonthe sociology of economics. If we, as a profession, remain curious about the subjectmatter of the sociology of economics, perhaps the American Economic Associationcould use some of our dues to hire someone whose job is to keep track of all theminutiae in the sociology of economics. This information could be made publiclyavailable, but not by publishing it in the AER.Of all these suggestions, not publishing papers containing bad regressions is thebest solution. If we want to improve the quality of empirical research, we shouldsimply stop publishing papers containing bad regressions. This will prove to be thebest instructional lesson we, as educators, can deliver. Certainly, we should educateour students to appreciate and produce high-quality empirical research. But publishingis a powerful drug. As long as we publish articles containing bad regressions,they will be written.ConclusionsThis paper characterizes and criticizes empirical research in the areas of publicchoice and the sociology of economics. Research in both areas is characterized bythe following: (1) no structural model is presented and may not exist; (2) many, if notall, of the variables are proxy variables; (3) the estimation results may be the resultof a proxy variable search; and (4) more efficient statistical approaches have notbeen applied. The consequence of this approach to research is that many articles inthese areas of economics contain “bad regressions.”Several solutions to the problem of bad regressions are discussed, including: (1)omitting the empirical work from the paper; (2) requiring that data used in thepapers be made publicly available; (3) rewarding work on the construction of proxyvariables; and (4) reminding those in the profession in their roles as educators andreferees to demand improvements in the quality of empirical work and to stoppublishing papers until the quality is improved.The most important suggestion is that we, as a profession, stop publishing paperscontaining bad regressions. This action will lead to an improvement in the qualityof papers in the area of public choice. I also advocate that economics journals ceasepublication of all articles in the area of the sociology of economics, and offersuggestions as to other means of providing information contained therein.

80 Steven B. CaudillClosing thoughtsI end with some observations and speculations about our profession and the futureof empirical research. A look at the McCloskey/Laband–Taylor exchange in 1992is instructive. Laband and Taylor wrote an article about bad writing in economicswhich they were able to publish in the well-respected journal, Economic Inquiry. I say“well-respected,” but, as Leland Yeager has often reminded us, in these cases onedoes not think more of the paper, one thinks less of the journal. Although I amsurprised that Economic Inquiry published the Laband–Taylor paper, I am moresurprised that they published the reply by McCloskey. I do not think a greatercondemnation of a published paper has ever been printed.What was the fallout? Very little. Laband is still writing and publishing similarpapers. Economic Inquiry has published another 10–15 articles in the sociology ofeconomics area. In fact, soon after this paper is published I expect someone willcollect data and prove that papers using only OLS are being cited no less thanpapers using more advanced econometric methods.Notes* Regions Bank Professor, born 30 years to the day after Leland B. Yeager. My ideas onthis subject have been shaped by many long discussions with Leland Yeager, RandyHolcombe, and Roger Garrison. I am grateful to Janice E. Caudill, Roger W. Garrison,Daniel M. Gropper, Valentina Hartarska, Randall G. Holcombe, and Roger Koppl forseveral helpful comments.1 However, Holcombe does tell the tale of a prominent public choice economist whodeveloped a theory which led to a prediction about the direction of an effect. After anexhaustive data-mining adventure, no regression model could be produced containing aresult consistent with the prediction of the theory. This failure led the economist to redothe theory.2 We have probably all, at some time or other, written empirical research containing someof these characteristics. Although doing poor research should never be excused, I amtalking here about the habitual offenders. For some economists the four characteristicsabove define a research methodology. It is all they do.3 The term I use to describe the result is a “feel good” regression which indicates that thebenefits accrue to the author and not to the audience.4 There is at least one instance in empirical research where a model having the appearanceof a “pro forma reduced form” should be estimated. This case is the estimation of amodel of individual choice. In these models the dependent variable is a dummy variablerepresenting a choice – possibly an individual’s vote. If the dependent variable is a vote,an econometric model called a conditional logit model can be estimated (see Maddala1983 or Greene 2003).To estimate a conditional logit model one needs data on the choice an individualmakes and the attributes, in each chooser’s perception, of each of the choices, even those notselected. The conditional logit model has a familiar underlying structure. The regressionfunctions associated with each choice are indirect utility functions. The observed choiceis the one that maximizes an individual’s expected utility. This regression model lookslike what Garrison might call a “pro forma reduced form,” but actually has an underlyingand familiar structure.The estimation of this conditional logit model requires enormous data because onealso needs to know how the chooser feels about the options not chosen. For this reason

Good ideas and bad regressions 81the conditional logit model is not often used in economic research. Ironically, the onearea in economics where data might be sufficient to estimate such a model is in the areaof voting/public choice with some of the large data sets available.Another model of individual choice that is sometimes found in PC research is calledthe logit model. In this model one needs data on the observed choice, only, andcharacteristics of the chooser. With only characteristics of the chooser, the connection toutility maximization is weak and we are led back in the direction of the “pro formareduced form.” There are many other instances of these “pro forma reduced forms” inPC research and I discuss the conditional logit model in detail because that is the onlyplace a “pro forma reduced form” model can be justified.5 One indication of the problems in PC empirical research is that the terms “structuralmodel,” “reduced form,” and “proxy variable,” are often not mentioned in the paper. Inthe absence of a structural model one might not recognize that what is being estimated isthe “pro forma reduced form.” The term, “proxy variable” has been replaced withlanguage like, “As a measure of X, we used Y.” The term, “proxy,” and discussion of theeconometric implications of proxy variables are omitted.6 McCloskey (1994) would argue that this is too strict a condition because no one believesempirical research.7 One indication that this type of work is being done by some economists is the existence ofempirical papers with titles like, “The Determinants of Something.” In economics oneshould know the determinants before estimating the regression model. This titleindicates that a search for correlations is to follow.8 LT use citations as a measure of value. I note that, in the reply, McCloskey does not citethe LT paper.9 In the reply, McCloskey points out that the bad writing issue can be investigated by othermeans. To directly address the research question about writing quality, McCloskeysuggests that LT simply put examples of writing before experts/people to judge.10 On one count I disagree with McCloskey’s assessment of the LT paper. McCloskeyrefers to the LT paper as “economics.” In my opinion, the LT paper is not economics butsociology.ReferencesCaudill, S.B. and R.G. Holcombe (1999). Specification Search and Levels of Significance inEconometric Models. Eastern Economic Journal, 25: 289–300.Caudill, S.B., F. Zanella and F. Mixon (2000). Is Economic Freedom One Dimensional? AFactor Analysis of Some Common Measures of Economic Freedom. Journal of EconomicDevelopment, 75: 27–40.Greene, W.H. (2003). Econometric Analysis, 5th edn. New Jersery: Prentice Hall.Gwartney, J., R. Lawson and W. Block (1996). Economic Freedom of the World: 1975–1995.Vancouver, BC: Fraser Institute.Haavelmo, T. (1944). The Probability Approach in Econometrics. Supplement to Econometrica,12: iii.Holcombe, R.G. (1989). Economic Models and Methodology. New York: Greenwood.Johnson, B., K. Holmes and M. Kirkpatrick (1998). 1998 Index of Economic Freedom.Washington, DC: The Heritage Foundation and Dow Jones & Company, Inc.Kennedy, P. (1998). A Guide to Econometrics, 4th edn. Cambridge, MA: The MIT Press.Kmenta, J. (1986). Elements of Econometrics, 2nd edn. New York: Macmillan.Laband, D.N. and C.N. Taylor (1992). The Impact of Bad Writing in Economics. EconomicInquiry, 30: 673–88.Leamer, E.E. (1978). Specification Searches. New York: John Wiley & Sons.

82 Steven B. CaudillMaddala, G.S. (1983). Limited-dependent Variable Models in Econometrics. Cambridge: CambridgeUniversity Press.McCloskey, D.N. (1986). The Writing of Economics. New York: Macmillan.McCloskey, D.N. (1992). Writing as a Responsibility of Science: A Reply to Laband andTaylor. Economic Inquiry, 30: 689–95.McCloskey, D.N. (1994). Why Don’t Economists Believe Empirical Findings? EasternEconomic Journal, 20(3): 479–81.Messick, R. (ed.) (1996). World Survey of Economic Freedom 1995–1996: A Freedom House Study.New Brunswick, NJ: Transaction.Tintner, G. (1968). Methodology of Mathematical Economics and Econometrics. Chicago, IL: TheUniversity of Chicago Press.von Mises, L. (1966). Human Action, 3rd edn. Chicago, IL: Henry Regnery.

7 Pluralism, formalism, andAmerican economics *Harry Landreth and David C. ColanderEconomics evolves in fits and starts as it struggles to come to an understanding ofthe economy and to provide some guidance for policy. In this evolution there hasbeen an ongoing debate between “formalists,” those economists who believe thatthe study of economics should consist of a highly formal analysis of the economy,and “nonformalists,” who believe that a less formal, process-oriented analysis ofthe economy, including relevant historical and institutional elements, is the moreappropriate model for economic analysis. Although Leland Yeager falls into thenonformalist category, he is unusual in that he also falls into the committed pluralistcategory, and he is always considering and integrating subtle ideas developed fromformalist models into his work. His wide-ranging scholarship has enabled him tointegrate a sense of history and institutions into his analysis, and while he has consistentlyavoided any mathematical presentation of his ideas, the ideas he addressesare those addressed more by formalists than nonformalists.Although Yeager’s analysis is nonformal, it is, nevertheless, highly rigorous; hisviews are always well thought out and supported by impeccable logic. But, exceptamong his ardent admirers, his work has not had the impact that its cogencydeserves. The reason lies in part in the very attributes of his work that give it itsstrengths. It is iconoclastic – logical unto itself but unbending in its dedication to theexposition of the institutional realities of the time. Be it in his interest in Interlingua,his theory of money, his consideration of the role of ethics, or in his consideration ofwhat Austrian economics is all about, one can be sure that Leland’s work will provideenormous insight but also that it likely will be out of step with the mainstreamprofession’s thinking. He could have expressed his ideas in a formalistic manner,but he found that approach a less than optimal way of expressing them, because itwould not allow him to point out the subtleties of the argument that went beyondthe math. Thus, his work was rich in institutional detail that was impossible toinclude within a formalist presentation of those ideas, but at the same time wasconcerned with the ideas that the formalists were concerned with, not the ideas thatthe nonformalists focused on.Recently there have been a number of considerations of formalism, pluralism,and their relationship to the evolution of economic thought over the last 100 years. 1In Morgan and Rutherford there seems to be a sense that formalism is bad and thatnonformalism is inherently pluralistic and good, and that, in an ideal pluralistically

84 Harry Landreth and David C. Colandercommitted world, being out of step with the mainstream should be a strength. In aprofession devoted to a pluralist methodology, researchers would turn to those whoare out of step for applicable solutions, because the insights one might gain fromthem would likely be higher than from other sources. Leland Yeager certainlywould be considered pluralistic and open; in his work he has demonstrated a willingnessto give every view consideration, and he has always dealt seriously withthose that he felt met his standard of insightfulness, regardless of whether theyadvanced an “in” theory or not. He follows a self-described libertine approach tomethodology. 2 His argumentation demands rigor but is almost impervious to ideologicalpositions – he criticizes mainstream, Austrian, and radical economists withequal vigor.Yeager is in a small minority in following this pluralistic approach on either sideof the formalist/nonformalist divide. Commitment to a pluralistic approach is nota characteristic of the profession – and, in our view, his commitment to pluralismhas played an important role in reducing his work’s influence. 3 Our argument isthat a pluralist methodology, such as that practiced by Leland, and that supportedby Morgan and Rutherford, is not a systemically stable methodology. This presentsa problem for researchers committed to a pluralist methodology: How does oneexist in a world that is not committed to pluralism? We see this question as aYeageresque question; for Leland there is no ideal world, there is only the world welive in. And in this world the periods of pluralism that we observe generally have notcome about because researchers have made a commitment to pluralism, butinstead because various opposing methodological groups have found themselves ofroughly equal strength. The reality is that if you fall outside the methodologicalmainstream of your time, your work will get less consideration than it otherwisewould. It follows that, other things being equal, methodological libertines such asYeager will have less success than methodologically committed individuals. Ourargument is not that this situation is good – in this paper we take Yeager’s commitmentto what is, rather than to what should be, seriously, and simply say that this isthe way it is: a commitment to pluralism is not an evolutionarily stable strategy.We raise these issues because they relate to how one might understand thehistory of the profession over the past century. Specifically, Morgan and Rutherford,having considered that history, have described how the formalist revolutionwiped out the pluralism that existed in the early 1900s. In their story what they termneoclassical economics overcame a pluralistic institutionalist approach here in theUS, with the result that modern economics is far less pluralistic than it was earlier. 4They seem to lament both the formalization of economics and the loss of pluralismthat occurred in the interwar period. We find that story unsatisfying. We see thepluralism that existed then as a byproduct of other forces. It was simply a tem porarypart of a dynamic process in which the formalist and nonformalist methodologicalpositions were of somewhat equal strength. None of the players in the interwarperiod was so dominant that others were excluded from academic appointments atimportant graduate programs, from space in the major journals, from representationin the power structure of the American Economics Association, or fromresearch support. As we will show, our approach provides a different view of the

Pluralism, formalism, and American economics 85formalist revolution over the last 100 years from that found in previous studies.Ours is a process-oriented view of the profession in which ideas compete given theinstitutional realities of the profession. Those that succeed are those that meet theinstitutional requirements of survival. The “truth” or “appropriateness” of the ideais only one of many deciding factors of the success of an idea. 5The alternative story we tell is one in which pluralism has occurred by default, asthe profession has swung from a nonformalist to formalist methodology, as one sideor the other gained prominence while holding an unpluralistic methodology.Formalism and nonformalism are both disequilibrium situations which, over thebroad course of the history of economics, have swung like a pendulum from oneside to another and will likely continue to swing indefinitely in the future. Given thispendulistic swing, our argument is that, when viewed in its historical context, thelast 100 years is best seen not as a movement away from pluralism, but simply aspart of the swing of the pendulum.In our “process” view, a pluralist methodology in which individuals are activelycommitted to pluralism has seldom been the nature of the equilibrium; it is simplya state in the evolutionary process in which competing sides are of relatively equalstrength. Thus, in our view the unpluralistic formalism that emerged in the latterhalf of the twentieth century was a temporary state, one that, in our view, is alreadychanging. Today the formalism of that period is combining with the informal workof earlier times, creating a new type of economics that is inductive, highly mathematical,and institutional. 6 This paper, however, is concerned with the ascendancyof pure formalism, not its current demise, although we will briefly discuss thatdemise in our concluding comments.The swinging pendulumThe ongoing debate between formalists and nonformalists can be seen in theapproaches of the major economists of classical economics. Smith was a nonformalist,Ricardo a formalist. Mill moderated Ricardo’s formalism, while post-Millian economists diverged as to which track to take. In the late 1800s the battlebetween the two approaches peaked in the famous Methodenstreit that pittedthe German historical school against the newly emerging marginalists. ThisMethodenstreit set the backdrop for the rise of the American economics profession,and, with that rise, the shift of the center of world economics from Europe to theUnited States.At the beginning of the twentieth century, the debate considered by Morgan andRutherford was between the institutionalist nonformalists and the neoclassical formalistswho incorporated the newly emerging marginalist ideas as the centerpieceof their approach to economics. The initial debate, however, was nowhere near asstark as it might have been, because at the time the primary standard-bearers of theformalist views were, in large part, Marshallians. From a formalist perspective, thisperiod was hardly pluralistic. In fact, as Blaug notes in 1930, “it is doubtful thatthere were more than a half-dozen economists in the world who had ever read Walras,much less understood him” (Blaug 2003: 150).

86 Harry Landreth and David C. ColanderMarshall’s approach to economics was itself a compromise approach, usingformalist techniques but then moderating them with history and institutions atevery point. Marshall’s approach was essentially a straddle between the Germanhistorical school and the marginalist formalists. Thus, contrary to what is implied inthe Morgan and Rutherford volume, from the perspective of a formalist, the 1930swere hardly pluralistic. What would at that time be called the superformalists, suchas Edgeworth and Walras, were in a small minority in the US during the interwarperiod. 7Why this history is importantThe long history of battles between the two sides is important because of the perspectiveit adds to the transformation of economics that has occurred since the1930s. It strongly suggests that whatever pluralism existed in the interwar period wasa tenuous pluralism existing because neither side had eliminated the other, not apluralism grounded in pluralistic methodological foundations. The history of thedevelopment of the economics profession in the US is one that abounds withintrigue, hostility, and warfare between advocates of the different views (Barber1988). Given this lack of a pluralistic methodological foundation, the transfor mationaway from pluralism that occurred in the post World War II era is about as surprisingas the tipping over of a coin standing on its edge. The relevant question is not:Why did the coin tip? It is: Why did the coin land on the side that it did? Specifically,why did superformalism become the center of the American econ omics profession?This question is even more interesting given the starting point of the debatebetween the formalists and nonformalists. True formalists had a minimal presencein the US at the beginning of the interwar period. Thus, to understand the historyof the profession, one must understand how this small group emerged from WorldWar II as the strongest group and how the institutionalists and Marshallians, whichwere strong at the turn of the century, eroded. In our view, two interrelated issuesexplain these events: the failure of the institutionalist’s research and pedagogicalprogram to meet the institutional requirements of an ongoing research programwithin the US institutional environment, and the instability of the Marshallianstraddle. We will argue that the transformation was essentially bipartite. First, itwas a victory of the coalition of formalists and Marshallians over the institutionalists.Second, it was a victory of the formalists over Marshallians.The playersLet us begin by briefly considering who the players were in the early 1900s and inthe interwar period. Those players can be divided into three loose groups thatrepresented divisions similar to those that existed in Europe at the time. The largestgroup was the institutionalists. This group represented the German and Englishhistorical–institutional approach to economics as a discipline and contained anumber of German trained PhDs. However, the principal intellectual force in thisgroup came from American-trained Veblen, Commons, and Mitchell.

Pluralism, formalism, and American economics 87The second group was what we will call formalists. This was the smallest group.Its roots were not in Smith, but rather in Cournot, Jevons, Walras, and Edgeworth.This group was influenced by contemporaries – the English economists, Edgeworth,Bowley, and Wicksteed, and the Swede, Wicksell. Simon Newcomb was amember of the group, but the towering American figure in the early years of thetwentieth century was Irving Fisher.The third group was a swing group between the two. It probably best goes underthe name Marshallian, because its methodology and approach closely followedAlfred Marshall. Marshall had masterfully built an economic engine of analysisthat tried to straddle the institutionalist and pure formalist schools. It argued for atype of pluralism in which no rigid lines were drawn on almost any issue of scope,method, or content, and all were welcome under the big tent. 8In this development a distinct Austrian school did not exist; it was simply part ofthe Marshallianism that characterized the period. By 1900, the beginning of thetime frame we are mostly concerned with, the existing main contributions of thosewho later became called “Austrians,” in the minds of most economists of the time,had already been incorporated into the Marshallian views of the time, views thatcame to be called neoclassical economics. 9The victory of the coalition of formalists andMarshallians over the institutionalistsIn the early part of the twentieth century, institutionalists were the most powerfulgroup. Thus, the first part of the story is their loss of power. That loss was in manyways due to the institutionalists’ failure to meet the institutional requirements of anongoing research program within the economics profession’s institutional structure.To see this we need to look more closely at the three groups of institutionalistswho, though never united in a coherent research program, came to be linked toone another primarily by their opposition to theory, whether it be formalist, orMarshallian. Thus the glue that held institutionalists together was not a positiveglue, but a negative glue.To give you an idea of their opposition to Marshallian neoclassicism, considerVeblen’s mockery of the assumption of rationality in his essay “Why Economics IsNot an Evolutionary Science”:The psychological and anthropological preconceptions of the economists havebeen those that were accepted by the psychological and social sciences somegenerations ago. The hedonistic conception of man is that of a lightning calculatorof pleasure and pains, who oscillates like a homogeneous globule of desireof happiness under the impulse of stimuli that shift him about the area, but leavehim intact. He has neither antecedent nor consequent.(Veblen 1919: 73–4)Wesley Claire Mitchell, in a letter to J.M. Clarke, made even more bitingcomments about the formalists. In explaining why he could not take neoclassical

88 Harry Landreth and David C. Colandertheory seriously, he compares the grand theorist to a great-aunt with whom heargued when he was young. In arguing with that great-aunt, who “was the best ofthe Baptists, and knew exactly how the Lord had planned the world,” he foundwhen he presented her with logical difficulties that her simple scheme could nothandle, she always “slipped back into the logical scheme, and blinked the facts,”just as the grand theorists do. For Mitchell, developing grand theories was child’splay. He states, “Give me premises and I would spin speculations by the yard”(Mitchell as cited in Clarke 1936: 410–11).While all institutionalists agreed on the problems of neoclassical economics, theydid not agree on what should replace it. This meant that institutionalism went inthree disparate directions. The sons and daughters of W.C. Mitchell never becameinstitutionalized in any academy in the sense that there was a graduate educationprogram in economics founded on the research philosophy of Mitchell. TheNational Bureau of Economic Research and other agencies initially pursued hisempirical approach, but with the development of econometrics that supposedlyoffered a way of integrating theory and measurement, Mitchell’s empiricism diedout. The reasons this change from Mitchell’s empiricism to econometrics occurred– and assessments of it are complicated – are only now beginning to be understood.But it is clear that the initial belief that econometrics offered a way of integratingtheory and empirical work that tested theories was an important element of the fallof Mitchell’s brand of institutionalism and in the transition. In this transitionKeynes’ General Theory played a significant role, providing the needed push to boththe collection of macroeconomic data and the building of macroeconomic econometricmodels and thus precipitated the demise of Mitchell’s approach.The Veblenese part of institutionalism was, in large part, unique to Veblen.Mitchell rejected it, and while almost all will agree that Veblen’s approach washighly insightful, it offered little that ordinary students could build upon. Veblen’sapproach was carried on largely in the work of Clarence Ayres and his students. Inretrospect it appears to have been a non-viable research program, with PhDsreceiving training in what was wrong with Marshall and more formal economicsbut with few tools to bring to a positive research agenda. The Ayresians never wereable to gain editorial control of a major economics journal, and they often squabbledwith editors of journals publishing in the historical-institutional tradition.The criticism that the Ayresians had no analytical framework or research programled Ayres to write “The Coordinates of Institutionalism” (1951), which had littleimpact on the profession. Veblenian–Ayresian institutionalism was fading in postWord War II America. 10While there were a few Austin satellites attempted, they never took hold. Oneimportant aspect of understanding the demise of Veblen–Ayres institutionalism isthe recognition that over time a communication barrier developed between theseeconomists and the rest of the profession. They and the emerging formalists did notread each other’s writings, and both were like visitors in a foreign country with nolanguage skills. The same divide existed for Austrian economists as they developedinto a separate group: their basic framework was so different from that of theformalists that they could not communicate with them. 11

Pluralism, formalism, and American economics 89What happened to the Commons-Wisconsin part of the historical-institutionalcamp is complex and subtle. 12 Here was a progressive research program withpossibly an element more important than the tools: a view that government andintellectuals should work together to help solve some of the social problems createdby the industrial society. The union between the state government at Madison andthe academicians produced a long list of social legislation. The depression of the1930s found a cadre of academicians ready to go to Washington DC to apply theWisconsin model of government–academy cooperation. It is not by chance thatone of the foremost advocates of Keynesianism in the United States, Alvin Hansen,was a Wisconsin PhD who brought the Wisconsin model to Harvard in its fiscalpolicy seminar and began a Harvard–Washington DC nexus which remains today.The demise of Wisconsin economics is in large part explained by its failure toproduce professors who would produce more professors. The chain-letter processof the modern mainstream, whereby graduate professors beget students whobecome professors and beget more students ad infinitum, assures continuity andascendancy, at least until major paradigmatic changes occur. But since the WisconsinPhDs went primarily to government, undergraduate education, and business,no major satellites producing PhDs of their philosophy were established. Part of thedemise is explicable by the fact that the ideological position of Wisconsinites aboutthe faults of society and the role of government became accepted, co-opted, andpreempted by other graduate programs. As it played out in the Roosevelt administration,the rest of the economics profession would not go as far as the CommonsWisconsinites in changing the institutional structure, but they were willing to go farenough to create a society in the 1960s very different from that of the 1920s.The institutional cause of institutionalists’ demiseThe link between the demise of the three brands of institutionalism was the failureof each to meet the institutional requirements for survival. Institutionalist economistswere seen as anti-theoretical and anti-mathematical. Neoclassical economistswere seen as theoretical. Mathematical neoclassical economists portrayed economicsas a predictive science that involved specifying a theory and empirically testingthat theory. Such a method created large numbers of small jobs, enough to keep anacademic neoclassical army of students busy. Institutionalism, however, presentedeconomics as a policy-driven combination of the study of institutions and of empiricalfacts about the economy, neither of which required a formal theory or definitive– and labor intensive – empirical testing. Given those choices, it is quite clearwhich view would succeed institutionally – and it was not the institutionalist view.Whether one believes that a grand theory is true in some fundamental sense isirrelevant. Even if you do not believe a theory, it can still be useful in the metaphysicalsense of organizing one’s thinking. Students and, indeed, almost everyonerequires such an organizational scheme. Neoclassical economics offered one, butonly Veblen’s brand of institutional economics offered broadly inclusive theory,and it was highly nonformal and indefinite. One reason such formal theoriesare needed is that, while Mitchell might have been able to twist his great-aunt’s

90 Harry Landreth and David C. Colanderarguments every which way, most students cannot perform these kinds of mentalgymnastics: they need an organizing structure for their study. Most people needa simple structure to organize complex principles in their minds. Neoclassicaleconomics offered such a simple organizing principle; institutional economicsdid not. The lure of neoclassical economics mimics the lure of religion in being arelatively simple way of organizing one’s understanding of an otherwise almosthopeless chaos.This need for a formal organizing theory was strengthened by the structure ofUS higher educational institutions that typically emphasized a broad-based educationalsystem in which large numbers of students were enrolled in economicscourses. In practical terms, that necessitated the use of multiple-choice tests. Theinstitutionalist approach to economics with no accompanying formal theory didnot fit well into that system. There are only so many times that “it depends” can begiven as an answer.In the eyes of the institutionalists, the simple neoclassical models did not comeclose to corresponding to reality. They recoiled at the disparity between the simplemodel and the observed reality. Students who shared an institutionalist sensibilitytypically either abandoned the study of economics or were weeded out, since theywere unable to bring themselves to provide the simplistic answers to the complexquestions the educational system required of them. Those who appreciated thesimplicity of the neoclassical models did well on exams and went on to create morecomplicated versions of them: they became modern economists.What we are arguing is that having a branch of economics working on a formalgrand theory was a requirement of survival in the US educational environment.Lacking a grand theory reducible to simple textbook models, the institutionalists’complex economic worldview was incompatible with the pedagogical institutionsthrough which economic ideas were propagated. Their decision simply to not discussformal theorizing rendered them incapable of competing in the metaphysicalgrand theory realm, whereas the neoclassical worldview succeeded in providing asystem whereby students could organize their thinking about the economy. Oncethe simplicity of that worldview was built in, moreover, it was not questioned, andit soon became the norm by which economists approached their work. Little considerationwas afforded the implications of the institutionalists’ complexity leap offaith, while more and more elaborate theorizing was developed on the simplicityleap of faith.An ongoing research program needs to excite students, and provide dissertationand article topics for them to work on. These dissertations and articles must lead tojobs at other universities, producing future PhDs so that the research program canreplicate itself. All three branches of institutionalists failed to do these things,although for different reasons. Commons’ students went on to government; so in asense it planted no seed corn. Mitchell gave students no organizing principles.While his mind was large enough to spin out millions of theories, and organizeempirical work, most students were not up to the task of following his lead. Theygravitated instead to the clarity of neoclassical theory and econometrics, even if itdid not fit reality. Veblen required students to be as insightful and as good an

Pluralism, formalism, and American economics 91expositor as he; most weren’t. Thus, institutionalism failed institutionally, and itsdemise was sped up by the enormous growth of universities, requiring large numbersof new PhDs during the post World War II era.The victory of formalists over MarshalliansThe above section explains our view of why institutionalism lost the battle withMarshallian economics. Had that been the end of the story, the pluralism ofMarshallian economics would typify post World War II American economics. Butthat was not the case. Instead, soon after World War II, Marshallian economicsbegan to fade, and with it, the methodological pluralism that characterized it. Bythe early 1960s Marshallian economics was totally overwhelmed by a formalisteconomics clothed in a methodological straight jacket.To understand why this second transformation occurred, we need to look morecarefully at Marshallian economics. One can view Marshall’s economics as anattempt to prevent either side of the long-continuing battle between formalists andnonformalists from winning. Marshall argues that what is needed is the broadest ofscopes, methods, and content with some problems and issues more satisfactorilypursued by less rigid, more historical–institutional approaches, and other problemsand issues by more formal abstract analysis. It all depends said Marshall. This “itdepends” answer irritated both of the other groups. Marshall irritated the would-beformalists in his Appendix B of his Principles (Marshall 1961) praising Adam Smithas a model of method; in Appendix C, “The Scope and Method of Economics,”and Appendix D, “The Uses of Abstract Reasoning in Economics,” where he commendedthe methodology of the German historical school; in his widely circulatedletter to Bowley deprecating the role of mathematics and abstract reasoning ineconomics; in his refusal to give precise definitions of economics, factors of production,or the representative firm; and in his Principles in which he preaches that“a man is likely to be a better economist if he trusts to his common sense, and practicalinstincts . . .” (1961: 368). The institutionalists were similarly irritated withMarshall’s attempt to take what he regarded as something from all sides. Theysaw him as essentially accepting neoclassical theory and then slightly modifying itsapplication.Being the pluralist he was, Marshall was extremely hesitant to draw policy conclusionsfrom economic theory. He believed that policy issues required normativeand institutional judgments that had to be added back to any logical–deductivetheoretical model before policy conclusions could be drawn. Policy conclusions didnot follow from theory alone.Marshall’s hesitation to associate policy arguments with economic theory hasbeen noted by Hirsch and De Marchi. They point out that for Marshall the analysisof direct incentive effects was only a starting point of his analysis of taxes (Hirschand De Marchi 1990: 161). Another example they give is Marshall’s considerationof the question of import duties. In that consideration Marshall lists a variety ofspecific questions that need to be answered before one can come to a policy conclusion.They write:

92 Harry Landreth and David C. ColanderMarshall operates not as a theorist who sets up his assumptions and then“reasons out” (to some general conclusions for hypothetical categories of cases),but as one who actually has to give advice, or to make the decision in favor of one tax overanother, or for no tax at all [emphasis supplied]. He cautions frequently againstmaking direct application of the results of simple first-round impact analysis. Aprefatory note in his Memorandum, for example, points out that “the incidenceof import duties is extremely complex” and he adds: “the indirect are oftenmuch more important than the direct effects.”. .. Marshall also warns thatalthough the exposition to follow is concerned chiefly with “proximate causesand their effects” a student should actually be “endeavoring to probe to thecauses of causes.”. ..(Hirsch and De Marchi 1990: 162)Despite the fact that Marshall worked assiduously not to fall into any particularmethodological or policy position, his partial formalization gave a suggestion ofscientific aura to the results of models. Marshall’s concept of consumer surplusseemed to make it possible to draw policy results from analytic models. We can seethis in Pigou’s proposal to subsidize industries, and in the development of costbenefitanalysis, and the enormous focus of the economics profession on efficiencyand waste to the exclusion of other issues such as the inability of government toimplement proposals, or the information transfer role of prices. Thus, when therewas a debate about market socialism, it concerned technical issues, and the subtletyof Hayek’s arguments against socialism was lost until rediscovered in the 1980s.The instability of Marshall’s straddleWhat we are arguing is that, while Marshall’s pluralist methodological approachworked for him, just as it worked for Leland, it was not transferable. In the handsof a less committed pluralist, such as Abba Lerner, or Milton Friedman, theMarshallian approach provoked reactions against it that undermined pluralism inthe post World War II era. Marshall’s strength was his ability to do formal theoryand simultaneously to recognize the limitations of his formal model. But many ofhis followers did not; they drew policy conclusions from the theory, which set up aproblem for other researchers – to show how, analytically, those conclusions didnot necessarily flow from theory, or that they were based on a particular assumption.Thus, Marshall’s partial formalization was unstable; it set in motion a chainof formalizations, each one demonstrating that the previous formalization wasincomplete – and inclusive – with regard to policy.Perhaps the most obvious partial formalization that Marshallian economicsbrought into the profession was the elevation of the partial equilibrium supply–demand diagram to center stage. This elevation created an almost totem-likemodel that shaped students’ vision and understanding of economics. Within thissupply–demand view, economics issues weren’t complex: they were simple, andcould be answered in reference to the supply and demand diagram. Institutionsweren’t important: they were simply frictions that slowed the forces of supply and

Pluralism, formalism, and American economics 93demand. The market existed: it drove the economy to a desirable equilibrium, andany restriction on the market was bad.Marshall’s vision of economics was far more complex than this, but that complexitydid not come through the supply and demand diagrams. As those diagramsbecame institutionalized, Marshall’s broader pluralism was lost. Thus, it wasFriedman who picked up the mantle of Marshallian economics in the US, and heused it to push a laissez-faire policy agenda. 13 In Friedman’s hands, Marshallianeconomics led to laissez-faire policy conclusions, just as in Lerner’s and Pigou’shands it led to activist policy conclusions.In the 1930s the supply–demand diagram was expanded upon and expandedupon. It was in the 1930s that the standard monopoly concepts were created, andmany of the geometric tools that are now standard in introductory and intermediatemicroeconomics were introduced. This geometricization of economicsstarted a shift within Marshallian economics – towards less focus on historical andinstitutional detail and more on formalization.An example of Marshallianism in America is the theory of monopolistic competitionof E.H. Chamberlin. Chamberlin had neither Marshall’s mathematicsaptitudes nor broad interests in historical materials. The theory of monopolisticcompetition is in Marshall, although never formalized. Chamberlin’s formali zationof it used a combination of words and graphs. The result was something of amuddle, but one that could be taught neatly to undergraduates. It was inconclusive,and it was unclear how it related to a theory of oligopoly, which was, observationally,much more prevalent in the economy.The reality was that markets between pure competition and pure monopolyrequired a mathematics that could deal with the mutual interdependence of actors,and that was beyond the mathematics of the time. The Marshallians formalizedthe presentation sufficiently to make nice neat geometric models that providedexcellent teaching tools for students, but in doing so it naturally led to moreformalization. The pedagogical use of these models elevated their policy conclusionsfrom logical games to formal policy arguments.The formalization of economics allowed by geometricization, no matter howcomplicated the diagram, was highly limited – it reduced everything to two, or atmost three, dimensions. This limitation invited mathematically oriented economiststo correct the errors, which led to publications, advancement in the academicprofession, and the propagation of further formalism to clear up the problems ofthe last level of formalization.The limitations of partial equilibrium analysis were recognized early on, and inthe 1930s the work of Abraham Wald and John von Neuman on equilibrium conditionsof static and dynamic models turned the heads of mathematically trainedeconomists towards general equilibrium theory. As Samuelson cogently noted,“To a person of analytical ability, perceptive enough to realize that mathematicalequipment was a powerful sword in economics, the world of economics was his orher oyster in 1935” (Samuelson 1964: 315). Thus, beginning in the 1940s, economicsbegan considering issues in a formal mathematical manner nicely describedby Blaug.

94 Harry Landreth and David C. ColanderThe movement was first toward a calculus formulation of general equilibriumand then toward set theoretic formulation of general equilibrium in which theexistence of equilibrium was a key issue. Our difference with Blaug is that we seethis work developing because of the Marshallian straddle, which led to a combiningof theory and policy that made it look as if results were being pulled from economictheory that, in fact, could not be pulled from them. The formal work in generalequilibrium theory caught on because it showed the limitations of theorizing, not itsstrengths. It showed the enormously strong assumptions that were necessary to drawout any actual information from the theory much more than it showed the power ofthe theory to explain real world events.As often happens when something develops in reaction to something else, it setsin motion a set of forces that swing the pendulum too far in the opposite direction,and that happened in the 1960s and 1970s. Microeconomics became the formalistgame that Rosenberg (1992) has described, moving to higher and higher levels ofabstraction. Initially macroeconomics was immune to this movement; but in the1970s the push to carry out the logic of macroeconomics in the Walrasian uniqueequilibrium led to the new classical revolution.Formal general equilibrium theory, as contrasted to Marshallian partial equilibriumtheory, could not be studied or applied without considerable training inmathematics. When that training was added to the graduate school curriculum, theformalists’ victory began to fall into place. Sometime in the 1950s, the economist’stool box required for holy anointment began changing. The two foreign languagesrequirement was replaced by mathematics–quantitative proficiency, and economichistory and the history of economic thought went the way of the dodo bird. As thathappened, the curricula of graduate economic programs changed, the editors andcontent of the major journals changed, and the types of individuals who werebecoming economists changed. All of these forces finally prevailed in the 1960s, atleast temporarily. By the 1970s, if you wanted to be considered a theorist, you hadto play by formalist’s rules: the formalist pendulum swing was at its peak.Some final comments and some thoughts about thefutureLet us conclude by briefly summarizing our argument. The evolution of the economicsprofession can best be seen as a pendulum swinging between formalism andintuitive approaches. The nature of the swinging pendulum can best be understoodin reference to the institutional structure of the profession and the changinganalytic and computing technologies of the time. Pluralism is highly unlikely toexist at any given time because researchers favoring either an intuitive or a formalapproach have a commitment to pluralism. Hence, when pluralism does exist, itwill be simply as a temporary state in which various sides are at a point whereneither has won out. Thus, in our view, during the 1930s there was no pluralism inthe sense of a profession committed to a pluralist methodology, there was simply atemporary position in the swing of the pendulum in which competing sides were ofrelatively equal strength.

Pluralism, formalism, and American economics 95Formalism started winning out in the 1930s because of the failure of non formalistschools to meet the institutional requirements for survival. It tried to become toopolicy-oriented, and seemed to be arguing that one could draw out policy conclusionsfrom positive economics. Formalist writing delineated the problems with thatposition, but in the process created a set of institutions that kept the pendulumswinging toward formalism. Analytic and computing power also changed duringthis time period, causing applied work to become more technical – and moreuseful. It is important not to confuse the formalism of Hilbertian general equilibriumtheory that Blaug is describing as formalism with the highly technicalapplied mathematics and econometrics that characterize much of the modernapplied work in economics. That work is technical but nonformal. This increase inthe technical nature of economic analysis is not an increase in formalism; it issimply a reflection of a change in technology. Whereas Marshall had to rely onobservations, today we can rely much more on technical data analysis. Vectorautoregression is highly technical, but it is not formal theorizing. Similarly, much ofmodern applied mathematics is nonformal: researchers are not concerned withproofs but rather with pulling information out of data.Turning to the implications of our argument for the future, we see the following:The profession is now in a period of change. The formalism described by Blaug is onthe wane, as developments in computer technology have made analytic theory lessuseful. Today, instead of writing a general solution to an abstract problem, it is easierto provide a solution for a specific problem. As that happens, the profession ismoving from pure mathematics to applied mathematics (Weintraub 2002). Thesame is true in statistical studies. With the development of computers, statis tical patternssuch as those searched for by Mitchell can now be found, and consequentlycointegration and vector autoregression techniques which pull information fromdata with minimal theory are flourishing, and they are replacing the need for theory.Similarly, agent based modeling is allowing economists to analyze models withheterodox agents and incomplete information that previously were beyond consideration.All these methods are mathematical but not formal. They are essen tiallytools of inductive rather than deductive analysis, and they are likely to characterizethe economics of the future. We believe this because each of these new developmentsis article-laden, which will meet the institutional requirements of survival forthe economists who study them. As they become entrenched in decision-makingpositions in the profession, the formalism of the 1950s, such as that found in generalequilibrium analysis, will further fade, and that solid inductive analysis combinedwith a sharp intuition and a rigor of the sort that characterized Leland Yeager’swork will be making a comeback, albeit in a quite different form.Notes* An earlier version of this paper was presented at a History of Political Economyconference at Duke, April, 1997.1 For other views of the reorientation of economics, mostly complementary and compatiblewith ours, see Blaug (1998, 2002, 2003); Niehans (1990); and Samuels (1998). Quitedifferent conclusions are reached by Morgan and Rutherford (1998), and Yonay (1998).

96 Harry Landreth and David C. ColanderWhile this paper focuses on the changes that took place in American economics duringthe twentieth century, the importance of American graduate education in economicsstrongly suggests important ramifications for the development of non-American economicthought.2 As he points out, by this he does not mean that “anything goes, or that whatever onecomes up with is automatically valid.” He is simply saying that one should “let peoplework with whatever method works for them, and fits with their talents and inclinations,”Austrian Economic Newsletter (1988).3 Our argument is not that he was wrong in holding his views; only that holding thoseviews reduced his influence.4 There are many dimensions of pluralism. There can be pluralism in policy proposals,where the profession comes to multiple mainstream positions on policy. We have notseen a significant post World War II decline in policy pluralism. Where we believe therehas been a decline in pluralism is in methodological pluralism. There is less diversity ofapproach today than there was in the 1930s. It is that aspect of pluralism that we focus onin this paper.5 For a further development of this idea, see Colander (1991).6 This view of economics is developed in Colander (forthcoming) and Colander et al.(2005).7 Since this debate between the formalists and the nonformalists plays such a central rolein the transformation of American economics, it needs to be clarified. It is not a debatebetween those who favor mathematics and those who don’t. It is a debate about theworldview that individuals have concerning the complexity of the economy, and theusefulness of formalizing discussions of the economy with the mathematical tools thatexist at the time. Nonformalists believe that the mathematical tools available at the timeare insufficient to capture the complexity of the economy, whereas formalists believe thatthose tools are sufficient.What this means is that as mathematical tools change, people’s view of the usefulnessof a formal approach may change. For example, with the recent developments in mathematicssuch as chaos and catastrophe theory, and with the increase in the ability ofcomputers to handle difficult problems, views of whether formalism is useful can be quitedifferent today than they were in the 1930s when the tools involved relatively simpledifferential calculus, and almost no developed statistical analysis.8 We see Leland’s methodology as similar to Marshall’s. In many ways Leland was theconsummate Marshallian straddler.9 Austrian economics developed as a separate school only later in the 1970s as a group ofeconomists worked hard to organize themselves into a separate school.10 As an example, consider the path of one of the authors. He, together with three otherTexas economics PhD candidates from the University of Texas at Austin, transferred tothe PhD program at Harvard during the middle 1950s.11 This doesn’t mean that their ideas weren’t correct or better than the emerging ideas; itsimply means their ideas no longer were compatible with the institutional structure of theemerging shape of the economics profession’s institutions.12 Lampman’s Economists at Wisconsin 1892–1992 (1993) may trigger research that willproduce clearer insights into what happened to the Wisconsin school.13 See Colander (1995) for further discussion.Bibliography and referencesAustrian Economic Newsletter (1988). A Conversation with Leland B. Yeager. Austrian EconomicNewsletter, 12(3).Ayres, Clarence E. (1951). The Co-ordinates of Institutionalism. American Economic Review,XLI(May): 47–55.

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98 Harry Landreth and David C. ColanderSchumpeter, Joseph A. (1954). History of Economic Analysis. New York: Oxford UniversityPress.Veblen, Thorstein (1919). The Place of Science in Modern Civilization. New York: B.W. Huebsh.Weintraub, E. Roy (2002). How Economics Became a Mathematical Science. Durham, NC: DukeUniversity Press.Yonay, Yuval P. (1998). The Struggle Over the Soul of Economics. Princeton, NJ: PrincetonUniversity Press.

8 Leland’s favorite economists *Jürgen G. BackhausIn a private conversation, when I invited Leland to come to Maastricht and give alecture on Walter Eucken on the occasion of his 100th birthday, Leland agreedimmediately because, as he said, Walter Eucken was his favorite economist. 1Although Walter Eucken (1891–1950) kept a strong influence on post-World WarII German economics literature, this influence was tongue-tied and almost exclusivelyrestricted to the German language area, in both scholarship and policy application.This is despite the fact that some of his work has been available in English(Eucken 1950, 1951). Ten years ago, however, a first book-length appreciationof Eucken’s work appeared in English as a special issue of the Journal of EconomicStudies and, 50 years after his death, at least three books in German have appearedin appreciation of Walter Eucken’s work.This essay essentially makes three contributions. First, the recent literature onWalter Eucken is briefly reviewed. Second, Eucken’s constitutive principles ofmarket economy, a central focus of his work, are discussed from the point of view oftheir philosophical origin. Third, the issue of hedonic price indices is discussedfrom the point of view of maintaining price-stability, Eucken’s central concern.In this sense, I try to respond to some of Leland’s most fundamental concerns inscholarship. These are the origin and meaning of concepts in economics and theprecision of language. Hence, section II emphasizes the origin and meaning, whilesection III focuses on the precision with which economic phenomena are to beexpressed.I Recent appreciation of Eucken’s workThe first of the four publications reviewed here appeared in 1994 in the Journal ofEconomic Studies (21:4) under the guest-editorship of Gerrit Meijer. The title of thisvolume is appropriately: The Intellectual Roots of Market Economies: Walter Eucken’sContribution to Economics. This volume has six essays in addition to the guest editor’sintroduction focusing on the intellectual roots of the market economy notable inWalter Eucken’s work. Heinz Grossekettler has an extremely thorough article “OnDesigning an Institutional Infrastructure for Economies: The Freiburg LegacyAfter 50 Years.” Since the article was presented at a conference in Maastricht in1991, it could still have had an influence on theory construction with respect to all

100 Jürgen G. Backhausthe economies in transition after 1989, notably the East-German one. On page 11,you find a family tree of the Ordo-liberals (in the broader sense) which I reproducein Figure 8.1. It strikes me as an excellent didactical tool.The guest editor himself follows with an article on Walter Eucken’s contributionto economics in an international perspective. Of course, the purpose is to overcomethe “splendid isolation” in which the Ordo school had existed in German academiaand thereby curtailed its international influence. Eucken’s daughter, Irene Oswalt-Eucken, emphasizes neglected aspects of Walter Eucken’s work, notably freedomand economic power. Methodological aspects of Eucken’s work are taken up byCarsten Hermann-Pillath, and finally Leland Yeager has the exposition on capitaland interest mentioned above. There is a bibliography of Walter Eucken’s work,probably the first one in English, compiled from Wendula Gräfin von Klinckowstroem’sbibliography. This volume of just 80 pages is an excellent introductioninto Walter Eucken’s work for an English-language scholar.In 2000, two books on Walter Eucken were prepared in Freiburg, where hetaught from 1927 until his death in 1950 (in London while lecturing there). The firstbook, Walter Eucken and his Œuvre, was published under the auspices of the WalterEucken Institute at the University of Freiburg (Gehrken 2000). This valuable bookhas a somewhat uneven architecture. The bulk of the work, about two-thirds, is athorough intellectual biography of Walter Eucken authored by Wendula Gräfinvon Klinckowstroem. She includes not only an extensive bibliography, but also aseries of pictures. This long, book-length essay is preceded by a tabulated curriculumvitae of Walter Eucken. After an introduction, there is a 50 page article onWalter Eucken’s conception of Ordo theory by Lüder Gehrken and AndreasRenner. From this essay, we get an understanding of Walter Eucken’s method ofgaining scholarly insight. He conceived the scholar as standing outside society and,by necessity, having to ask radical questions. “Asking radical questions is the trademarkof the scholar” (p. 9). The purpose of asking these radical questions, however,is nevertheless the same as it was with the empirically minded scholars who usedhistorical methods. It was Eucken’s belief that he had overcome the historicalschool by accomplishing his concept of an Ordo theory. As Klinckowstroem pointsout, finding an answer to the social question became the purpose of the last 18 yearsof his scholarly life, to wit “how can a modern industrialized economy and societybe given a human and functional order?” (p. 71).The wide array of topics Walter Eucken is still able to inspire has been docu -mented in a Festschrift for Walter Eucken 50 years after his death (Külp andVanberg 2003). The book has four parts with a total of 24 chapters. The first part isentitled “Economic Policy as Policy with Respect to an Economic Order.” GeroldBlümle and Nils Goldschmidt deal with the normative foundations of Ordo-liberalthought. Likewise, Otto Schlecht, who for many years in Germany was responsiblefor translating Ordo-liberal principles into economic policy as state secretary in thefederal ministry of economics, discusses the ethical formations in Eucken’s work.Werner Zohlnhöfer takes an evolutionary view on Ordo-liberalism and the socialmarket economy. Walter Hamm, long-time co-editor of the liberal daily newspaperFrankfurter Allgemeine Zeitung, takes one element of Ordo-liberal principles, the

Figure 8.1 The “Genealogical Table.”

102 Jürgen G. Backhauspredictability of economic policy, and explains what can be deduced from this principleand what can not. In its first two decades before the accession of Britain to theEuropean Union, Ordo-liberal principles played an important role in EuropeanUnion policies. It is therefore important that François Bilger discusses both ideasand interests in the development of the European economic order.Ordo-economic principles tend to evoke the strongest controversies whenapplied to labor market and social policy. This is the topic of Part II of this book.Five quarters of a century ago, German economists started to pose the “socialquestion” in an unmistakenly different way from how other economists in France,Britain, or Italy predominantly did at the same time (Backhaus in press). BernhardKülp turns to Walter Eucken’s position with respect to the social question. UlrichWitt discusses the social market economy, Germany’s specific “answer” to thesocial question, which he is positioning between notions of rent-seeking and socialcontract respectively. Whether, from Eucken’s point of view, there can be marketorder in the labor market is the topic of Volker Rieble’s contribution. A specificexample of German labor market legislation ostensibly trying to provide for alevel playing field concerns the so-called Worker Transfer Act (Arbeitnehmer-Entsendegesetz), which basically subjects workers employed by foreign companiesoperating in Germany, such as a British construction company doing work ona Berlin construction site, to the same conditions that would apply to Germanworkers. Thus, a British electric contractor who has won a bid on a Berlin constructionsite has to subject his electricians to German working and pay conditions, thusrobbing him of an important competitive advantage. Manfred Löwisch takes thisexample and uses Eucken’s approach for a thorough criticism. This example,whether one agrees with the results of the analysis or not, shows how topicalEucken’s work can be and how usefully it can be employed in the context of law andeconomic analysis. The integration of the German health industry, public, not forprofit, and private, into the European market is the topic of an analysis by EckhardKnappe and Hans-Joachim Jubelius, who again take an Ordo-economic approach.Norbert Berthold, who can always be found in the front lines of current politicaldebate holding up the Ordo-economic flag, discusses options for social securityreform.At the heart of Ordo-economic principles is the notion that it is one of theprimary (if not the primary) purposes of a state to provide for and guarantee theinstitutions which the market requires for its proper operation. Any policy initiativeshould withstand the test of whether it is compatible with the principles of a marketeconomy. Hence, Part III of the book is devoted to the issue of the role of the statewith respect to competition. Hans Otto Lenel therefore takes up the central conceptof private economic power. Christian Watrin compares the view of the purposes ofthe state of Walter Eucken on the one hand and Friedrich von Hayek on the other.Erich Streissler deals with free financial markets from Eucken’s point of view. HansWillgerodt wonders whether state systems of control or system of self-control arethe better remedy against currency crises. Bernd Schauenberg takes up corruptionas a problem for economic organizations as such, but the economic order as awhole as well. Here we see how close Eucken’s approach can come to current issues

Leland’s favorite economists 103of governance. Günter Knieps deals with competition in networks, and HelmutGröner and Gerhard Sauer take up the more specific case of municipal electricitysupply in Germany, which they discuss from an Ordo-theoretic point of view.Part IV takes up basic issues of Ordo-economic theory. Manfred Streit andMichael Wohlgemuth again compare Walter Eucken and Friedrich von Hayek.Franz Schober takes up knowledge in economic organizations and in informationtechnology. Peter Oberender and Claudius Christl wonder whether WalterEucken’s Ordo-economic approach can be seen as a precursor of the new institutionaleconomics. Alan Peacock looks at civil justice from an economic andcompetitive point of view. Thomas Gehrig discusses the political economy oftechnical progress, and Victor Vanberg finally returns to the problem of Ordoeconomicsand ethics, with which the volume had started out.The essays collected in this well-produced book of more than 600 pages can byno means be seen as an un-reflected eulogy of Eucken. Despite the basic assumptionthe authors share that Eucken is a towering figure in the history of economics notjust in Germany and needs to be taken seriously, the 50 years that have passed sincehis death have also seen an unprecedented rise of economics as a social science.In their concluding section entitled “What remains?” Gerold Blümle and NilsGoldschmidt draw up a balance sheet as this: Methodologically, Eucken’s approach,based on phenomenology, can no longer be maintained in a modern discourse inthe philosophy of science. The strong bonds to Husserl necessarily wither, sinceHusserl’s philosophy was basically “an ontology rooted in idealism,” and in thisway an “absolutism in transition” (Külp and Vanberg 2003: 39). For the benefit ofthe German-speaking reader, I reproduce the original. 2 Ethics: If the roots ofeconomic theory can no longer be seen in “eternal truths,” economic ethics can nolonger be stated in absolute terms. If we discard the metaphysical legitimacy ofprinciples of economic order, we can no longer take a moral position from an economicpoint of view. 3 And finally: “If we want to formulate an economic theory in thetradition of Eucken, we have to arrive at the distressful but necessary insight alreadyformulated by Schumpeter: ‘Instead of getting sharp contours for disciplines anddifferent approaches, we have to resign ourselves to the insight that everythingblends into each other.’” 4The remarkable dissertation by Nils Goldschmidt (2002) entitled “Developmentand Legacy of Ordo-Liberal Thought” is completely devoted to Walter Eucken,and was published with the new and enterprising LIT publishers in Münster. Thestudy has, in principle, four parts in addition to the Introduction and Conclusion.Part I is devoted to the notion of a cultural economics, which is relevant for thepurposes of this review only in that it puts economic reasoning into a broadercontext (Storch 1823–24). Part II is devoted to Walter Eucken’s methodologicalapproach. Part III discusses the ethical basis and moving force in Walter Eucken’swork. This is going to be relevant in the course of this essay. In particular, Eucken’sdeep roots in Christianity, as they translate into economic reasoning, need to befurther discussed. Part IV discusses essentially the roots of the Ordo-school inSchmoller, Wagner, Dietzel, and Schumacher. One should emphasize that almostone-fifth of the entire book documents the sources covered. This is an extremely

104 Jürgen G. Backhauscareful review of the sources. For the purpose at hand, however, I focus on whereEucken derived his notion of an order in economic life.In principle, one could think that Eucken followed Max Weber and postulatedan ideal type of an economic order. However, as Goldschmidt points out, he was atpains to distance himself from Weber, whose ideal type he considered a Utopia(p. 51). Rather, as Goldschmidt emphasizes in Chapter 4, Eucken sought scholarlyunderstanding through (religious) belief (p. 121). In this, he explicitly refers back tohis father Rudolf Eucken. 5 The economic order Eucken sought had to be, at thesame time, an order in which one could lead one’s life according to ethical principlesand deeply rooted in Christian (Lutheran) belief (p. 121). The Ordo-principles hefound can be represented in what looks like a wheel of the basic principles of marketeconomy (p. 133). I herewith reproduce an English adaptation of the wheel (seeFigure 8.2).The following section is devoted to a further discussion of the wheel and to anattempt to probe its intellectual origins.It strikes me as surprising that the cornerstone of Ordo-liberalism should begrounded in Lutheran-protestant thought. Leland himself, in an arcane footnote,refers to Friedrich Nietzsche but does not underpin my argument by what he writes(Yeager 2001: 229). Is it not really surprising that Leland, the agnostic, shouldsubscribe to an economic theory ladled out of the fountain of Christianity? Perhapswe are not too off the mark. In logic we learn ex falso quod libet. From a false statementanything can be deduced, even truth. We are not talking about explicitly falsestatements though; the problem is rather that we are confronted with the teachingsof an economist who felt that his economic insight had to parallel his religiousbeliefs. Can a Turkish immigrant to the European Union who opens a grocerystore in a metropolitan city conform to these principles, although he has never beentaught these protestant insights? 6Since Eucken’s principles, which make eminent economic sense, have no crediblefoundation in empiric evidence, 7 but since, on the other hand, they make plainEconomicpolicy to ensurepropertyPrimacy of astable currencyRegulationagainstanti-competitivebehaviorPredictabilityof economicpolicyLiabilityPrimary principle:functional price-basedcompetitionOpenmarketsPrivatepropertyReliableeconomicstatisticsFreedomof contractControl ofmonopoliesFigure 8.2 Eucken’s Wheel.

Leland’s favorite economists 105economic sense, the natural question arises of whether they can find reason inother, perhaps philosophers’, reasonings. In a different context, we have found thatFriedrich Nietzsche might have been a source of inspiration. 8 Is it possible or isit conceivable that Friedrich Nietzsche influenced Eucken’s view of the world?The question cannot be readily answered. On the one hand, both Nietzsche andEucken’s father, Rudolf Eucken, were eminent literary figures. Next to everythingthat Nietzsche had published, in particular Morgenröte, must have been householditems at dinner table conversations in Jena (at Eucken’s table). It is therefore not farfetchedto wonder whether we can find the basic ideas of Eucken’s Ordo-notions inNietzsche’s writings. As the reader will soon discover, we can very well find the gistof the ideas in Nietzsche’s works, but Eucken did make a very good attempt to translatethe basic ideas into economic practice, to the extent that he was aware of it. 9As far as I can see, most but not all what Eucken suggests in his wheel is wellcontained in Nietzsche, but I could have done the same for Justi. What is importantis not the original insight of the basic ingredients of a market economy. What isimportant, and that has to do with his religious dedication, is to have understoodwhat such a market economy requires, and that it takes determination to make ithappen. Having witnessed several generations enslaved in state socialism, whowould cast the first stone against a scholar who honestly believes that his economicinsight comes from the scripture?Clearly, Nietzsche is another scholar who fell apart because he could not reconcilescripture and evidence, and nevertheless came to rather similar conclusions.Although the conclusions cannot be tested, since they are basic propositions, theyearn credence if different trains of thought lead to the same basic principles. It is forthis reason that we now turn to Friedrich Nietzsche.II Sources of insightSince we are now somewhat stunned as to where Eucken got his insights from, let uslook at a somewhat unlikely source.Friedrich Nietzsche (1844–1900) is certainly not known as a profound writer ineconomics. Contemporary writings do not quote him as having contributed toeconomics at all. However, a closer look shows that Friedrich Nietzsche had deepinsights into why and how man can be a homo economicus. This part has three basicpieces. The first piece gives essential quotes from his now available work. Thesecond piece gives a sketch of basic institutions of the market economy. The thirdpiece connects the two in showing that Nietzsche, indeed, had profound insightsthat go way beyond other classical thinkers in economics. In this sense, and in thissense only, Nietzsche can be claimed to be an important thinker in the history ofeconomic thought.A)Friedrich Nietzsche (1844–1900) is probably the most important philosopher of thenineteenth century. Since philosophy is the mother of the social sciences, it would

106 Jürgen G. Backhausbe curious indeed if Nietzsche did not have important things to say about economics.Economics, after all, is a social science. However, the consensus in theeconomics profession today is that Nietzsche had little to add to economic analysis.In this sense, Nietzsche is probably silent on economics. He did not contribute toincreasing the availability of tools available to economists today. Yet, at a differentlevel, he had important things to say, and in this essay devoted to Leland Yeager, Itry to show that Nietzsche indeed had important economic insights.B)In his “Gay Science” section 377, Nietzsche all of a sudden brings up the word ofhonor. It is the culmination of this section, 10 inserted into a longer sentence andended with an exclamation mark. In this section, Nietzsche talks about his vision ofa civil society. Its intellectual leaders, those who preferred to live on the mountains,have left their roots behind, have outgrown nationalism and racism, have leftChristianity behind but are not at all without ideals: “in one word we are – andthis shall be our word of honor! – good Europeans, the heirs of Europe, the rich,overburdened, but at the same time manifold bound heirs of millennia of Europeanspirit and as such grown beyond Christianity . .. .” This word of honor to seal thetrue European spirit is needed, because, as he later points out, the quest for aEuropean civil society is based on belief itself.The notion of a word of honor is not incidental. It has actually been a centralidea in his Genealogy of Morals written five years later. 11 Man is defined as that animalwhich can make and keep promises. He sees this as the basic and most importantmoral achievement attained by mankind, an achievement that is even more surprisingin that man also has a strong tendency to forget. This insight is at the heartof the concept of cognitive dissonance. By being able to make believable promises,man is creating a link between the present and the future through a process ofdivision of labor. The promise entails an exchange which is not constrained to takeplace simultaneously and at the same time; this form of barter we can also observein animal societies. Instead, the promise allows for an exchange of goods or servicein the present in return for equivalent goods or services in the future. This is thebasis for such economic activities as saving, investment, credit, and bequest. If anyone of these institutions is lacking, economic progress can hardly take place.Under current conditions of economies undergoing processes of transition,Nietzsche’s insight appears to be particularly powerful. In order to make this clear,let us take a look at the basic institutions characterizing a market economy. Theseare the institutions signaled by Eucken.C)“The division of labour is limited by the extent of the market.” This basic dictumsharply expressed by Adam Smith (1776) focuses our attention on those factorswhich are responsible for limiting the extent of the market, thereby limiting depthand breadth of the division of labor in the economy and, by implication, thecreation of wealth.

Leland’s favorite economists 107One 12 can identify eight basic institutions which must be present and workable inorder for any market economy to function well, irrespective of the specific style ofthat economy. Hence, these institutions must be present in an unfettered freemarket economy, in a socialist market economy, in a cooperative market economy,in a market economy with syndicalist elements or variously in one with strong statemarket participation. All these forms – and many more – are potentially feasible, providedthese basic institutions are firmly in place and can fulfill their functions well.If these institutions are weakened and impaired, such as when property rights arebeing diluted, this market will work with high transaction costs and only to theextent that the gains from market exchange outweigh those transaction costs.Basic rightsFreedom of contractFrom an economic point of view, freedom of contract is an important guaranteebecause it ensures as a necessary condition that all the information available ina society enters economically relevant decisions and all the resources available in asociety will be put to their most efficient use. This implies that every infringement offreedom of contract has to be judged in terms of the losses imposed on society dueto ignorance and wasted resources. From an economic point of view, it is notsufficient to weigh freedom of contract against some other guarantee such as theprinciple of equality as such, without paying attention to the full consequences ofthe trade-off. If, for instance, it is observed that in a certain society members of aminority are not represented in a particular profession according to their numericshare in that society, from an economic point of view it is not justified to pit theobserved end-state inequality against the guarantee of freedom of contract, since arational choice in the interest of all parties concerned may have led to the unequaloutcome. An economic analysis would have to inquire into the reasons for theobserved inequality, and it would lay the foundation for assessing the trade-offbetween the social (opportunity) costs of constraining freedom of contract on theone hand, and the gains in terms of economic equality on the other. Based onthe inquiry into the causes of the observed inequalities, an alternative strategy toimprove the chances of the minority in question can in all likelihood be derived. Itis at this instance that the economic analysis of constitu tional guarantees can haveimplications for constitutional law. Many constitutions require that basic rights canonly be curtailed if less onerous measures are not available. To the extent thateconomic analysis can yield the design of such less onerous measures, it changes theconstitutionality of particular policies.Private propertyThe guarantee of private property is often thought to be the most important withrespect to the means of production. Again, from an economic point of view, theguarantee goes far beyond the protection of people’s possessions of goods andservices. The reason for this wider scope is fairly straightforward. In economics,

108 Jürgen G. Backhausproperty rights define and circumscribe alternatives for meaningful actions. Hence,the mere property title to some commodity, such as land, is meaningless if it doesnot imply discretionary alternatives and options that can be exercised.In particular, the guarantee of private property rights implies the right to exerciseprivate property prerogatives within workable institutions. The guarantee isviolated if, for instance, the contrac tual forms in which a property right can beexercised are unworkable or impractical, thereby destroy ing the value of theproperty right or seriously reducing it. The institutions in which private propertyrights can be exercised have to provide for the possibility that the four standardoptions of economic conduct 13 remain open. These options include:1 exit, the right to end an economic relationship;2 voice, the option to meaningfully improve upon a relations hip by changing itthrough negotiations;3 loyalty, the ability to foster the growth of trust and goodwill in a relationshipeven in the face of serious problems; and4 avoidance, the option to ignore a particular relationship altogether withoutfacing sanctions.This option is extremely important for Nietzsche and those who followed him.Look at the Widerstand literature, and most recently Helge Peukert (2004), whodiscusses the different economic concepts, but also their motivations, based inChristian and other thought.LiabilityThe two basic rights of freedom of contract and private property need to be complementedby the institution of liability in order to be meaningful at all. The faithfulobservance of contractual terms requires the protection of a shield of liability forfailure of living up to contractual terms just as much as the respective privateproperty rights require the need to make the intruder liable. Although this principleis straightforward, from an economic point of view the implications can be farreaching. In particular, liability can only be assigned if the agent to be held liablewas indeed in control of events that led to the liability. If this is not the case, theclaim has to be followed through all the way to those who were either in control orcreated the situation that made control impossible. If, for instance, a patient suffersa serious injury because a doctor did not administer the necessary treatment, whichhe failed to do because, in order to administer the treatment, according to stateregulations he needed the written consent of two colleagues whom he could notreach because they were tied up in meetings, this doctor is not liable for the injuryimposed on the patient; nor is the full damage to remain with the patient; rather,the principle of synchronizing control and liability requires to make those jointlyand severally liable who contributed to passing the regulations causing the problem– tying up doctors in meetings and requiring written consent to engage in professionalactivities – in the first place. 14

Leland’s favorite economists 109Stable legal environmentThe following three basic guarantees are more or less ancillary to the first three, theclassical threesome of economic basic rights. Constancy and predictability of economicpolicy is required in order to be able to enter contracts covering not only thepresent but also the future. The same is true with respect to the exercise of propertyrights with consequences in the future, notably investment decisions. For privateproperty rights, however, the predictability of economic policy is crucial because itaffects the adjustment costs necessarily borne by the private sector and falling ontoproperty, conceivably reducing its value. This requirement does not affect therange and domain of economic policy, but only the time horizon within which itcan be carried out. The more predictable economic policies are, the smaller theadjustment costs. The corollary statement requires that the more drastic a policychange, the longer its implementation has to be delayed and the more carefully theprecise contours of the new policy have to be explained in order to allow for smoothadjustments in the private sector. A policy may be unconstitutional simply becausethe legislature did not take the requisite care in spelling it out in time and providingfor reasonable adjustment periods before implementation.Stable currencyContractual relationships that are entered into for longer periods of time typicallyrequire for some kind of payment to be made by one or the other party. Thebenefits from contractual relationships can be seriously impaired if there is nocommon language in which to express the duties of the different parties. Theproblem is most serious in the case of payments, if there is no stable unit in which toexpress the size of payments to be made and received. The more uncertainty thereis, the smaller can be the gains from trade and consequently the smaller is thepotential for economic progress in that society. This is why, from an economicpoint of view, the guarantee of a stable currency is important as an ancillary right.Again, what is really required is not one particular monetary policy, but rather aninstitutional arrangement which stabilizes the unit of account. It should be notedhere that this requirement does not prescri be any particular monetary policy for acentral bank, such as a European Central Bank, nor does it require only onecurrency to circulate in a particular market. Leading monetary theorists haveshown that a variety of currencies circulating may not only be compatible with theprinciple of keeping the unit of account stable, it may even be in the interest ofenforcing this principle. 15Open marketsFinally, access to markets has to remain open in order to allow for other basichuman rights to be exercised in a meaningful way. This is obvious for the right offreedom of contract, but also extends into such classical basic rights as the freedomof the press, freedom of political expression, freedom of exercising the religion of

110 Jürgen G. Backhausone’s choice, freedom of exercising the profession of one’s choice, the academicprivileges of freedom of instruction and research, etc. The problem is, by the way,most serious if a particular government or some private agents suppress theexistence of a market altogether. The guarantee of freedom of access to marketsobviously includes the guarantee to have such markets established, which does notpredetermine the shape such markets take, as long as they provide for an openforum to communicate and exchange, which is what a market basically is about(Schwartze 1990).Procedural guaranteesBasic rights and procedural guarantees are equally important, since basic rightscan only be exercised if certain procedural guarantees are observed. The importanceof procedural guarantees is not reflected in the amount of space they receivein this essay, due to space limitations. Essentially, there are two types of proceduralguarantees: guarantees regulating the relationship between public bodies andguarantees regulating the relationship between public bodies and citizens.The relationship between public bodiesThe procedural principles regulating the relationships between public bodies consistof at least three groups. They include all those rules regulating the domains ofcompetence of the various public bodies with respect to each other, including theareas of cooperation, mutual consent, or hierarchical control. A second groupconsists of principles of budgeting such as the principles of timeliness, completenessof budgets, etc. A third involves principles of legislation. One is that legislationalways has to be of a general character, and that acts are invalid if they address onecase only. Another economically relevant principle involves the requirement thatlegislation which has turned out to be faulty, unjust, or seriously impractical, andthereby has turned out to be in violation of basic rights, needs to be corrected.The relationships between public bodies and citizensThe second set of procedural rules typically found in constitutions involves thequestion of how the private citizen or other legal entity relates to public bodies. Intothis category fall two sets of rules. One set again governs the separation of thedomains of competence. A typical example is the separation of church and state.But here, again, forms of cooperation, of mutual consent, or of hierarchical orderingsare clearly available. The second set of rules, generally described by theextremely comprehensive term of due process, lays down the rules of the gamebetween public bodies and private citizens or legal entities. These include informationrights, notification rights, and the right to have access to courts and bodiesof appeal in meaningful ways that go beyond merely procedural ceremonies withoutcontent, since the important benchmark is the effectiveness of these proceduresin safeguarding the six basic economic rights outlined above.

Leland’s favorite economists 111A preliminary summaryIn the preceding analysis, we have identified constitutional guarantees with respectto basic rights on the one hand and procedural rules on the other. There are threebasic rights the guarantee of which has to be considered as central from an economicpoint of view. These guarantees protect the right of freedom of contract, theinstitution of liability in the sense that those responsible for actions or a lack thereofcan be held responsible for the effects of their activities or the lack thereof; and theinstitution of private property in the sense that clearly specified and meaningfulalternatives become available for economic agents to dispose with goods andservices. These basic economic rights are supported by three ancillary economicrights, guaranteeing a stable legal environment, a stable currency providing for acommon language of contractual relationships, and open markets which includethe right to establish such markets in areas where they do not exist.Procedural guarantees cover either the relationship between public bodies, orthe relationship between public bodies and private citizens or other legal entities.The principle of due process requires in this context that citizens and legal personshave access to courts and bodies of appeal in meaningful ways, barring purelyceremonial procedures.The economic analysis of constitutional rights can, obviously, not substitute forconstitutional jurisprudence. But economic analysis can substantially enhance thesharpness of jurisprudential analysis by spelling out the consequences of particularconstitutional provisions (or the lack thereof) and the systematic interconnectionsbetween basic legal institutions such as property, contract, and liability, as wellas legal procedures. In this sense, the economic analysis can be integrated intojurisprudential analysis and by being embodied into the interpretation of constitutionalprovisions, economic analysis can become an integral part of constitutionalscholarship.To the inadvertent, since Leland likes to have the precise language beforehand,here is the original:Insertion IFriedrich Nietzsche: Die fröhliche WissenschaftAbschnitt 377Wir Heimatlosen. – Es fehlt unter den Europäern von heute nicht an solchen,die ein Recht haben, sich in einem abhebenden und ehrenden SinneHeimatlose zu nennen, – ihnen gerade sei meine geheime Weisheit und gayascienza ausdrücklich ans Herz gelegt! Denn ihr Los ist hart, ihre Hoffnungungewiß, es ist ein Kunststück, ihnen einen Trost zu erfinden, – aber was hilftes! Wir Kinder der Zukunft, wie vermöchten wir in diesem Heute zu Hausesein! Wir sind allen Idealen abgünstig, auf welche hin einer sich sogar indieser zerbrechlichen, zerbrochenen Übergangszeit noch heimisch fühlen

112 Jürgen G. Backhauskönnte; was aber deren “Realitäten” betrifft, so glauben wir nicht daran, daßsie Dauer haben. Das Eis, das heute noch trägt, ist schon sehr dünn geworden:der Tauwind weht, wir selbst, wir Heimatlosen, sind etwas, das Eis undandere allzudünne “Realitäten” aufbricht . . . Wir “konservieren” nichts, wirwollen auch in keine Vergangenheit zurück, wir sind durchaus nicht“liberal”, wir arbeiten nicht für den “Fortschritt”, wir brauchen unser Ohrnicht erst gegen die Zukunfts-Sirenen des Marktes zu verstopfen – das, wassie singen “gleiche Rechte”, “freie Gesellschaft”, “keine Herren mehr undkeine Knechte”, das lockt uns nicht! – wir halten es schlechterdings nicht fürwünschenswert, daß das Reich der Gerechtigkeit und Eintracht auf Erdengegründet werde (weil es unter allen Umständen das Reich der tiefstenVermittelmäßigung und Chineserei sein würde), wir freuen uns an allen, diegleich uns die Gefahr, den Krieg, das Abenteuer lieben, die sich nichtabfinden, einfangen, versöhnen und verschneiden lassen, wir rechnen unsselbst unter die Eroberer, wir denken über die Notwendigkeit neuerOrdnungen nach, auch einer neuen Sklaverei – denn zu jeder Verstärkungund Erhöhung des Typus “Mensch” gehört auch eine neue Art Versklavunghinzu – nicht wahr? Mit alledem müssen wir schlecht in einem Zeitalter zuHause sein, welches die Ehre in Anspruch zu nehmen liebt, das menschlichste,mildeste, rechtlichste Zeitalter zu heißen, das die Sonne bisher gesehen hat.Schlimm genug, daß wir gerade bei diesen schönen Worten um so häßlichereHintergedanken haben! Daß wir darin nur den Ausdruck – auch dieMaskerade – der tiefen Schwächung, der Ermüdung, des Alters, derabsinkenden Kraft sehen! Was kann uns daran gelegen sein, mit was fürFlittern ein Kranker seine Schwäche aufputzt! Mag er sie als seine Tugend zurSchau tragen – es unterliegt ja keinem Zweifel, daß die Schwäche mild, achso mild, so rechtlich, so unoffensiv, so “menschlich” macht! – Die “Religiondes Mitleidens”, zu der man uns überreden möchte, o wir kennen diehysterischen Männlein und Weiblein genug, welche heute gerade dieseReligion zum Schleier und Aufputz nötig haben! Wir sind keineHumanitarier; wir würden uns nie erlauben wagen, von unserer “Liebe zurMenschheit” zu reden – dazu ist unsereins nicht Schauspieler genug! Odernicht Saint-Simonist genug, nicht Franzose genug! Man muß schon miteinem gallischen Übermaß erotischer Reizbarkeit und verliebter Ungeduldbehaftet sein, um sich in ehrlicher Weise sogar noch der Menschheit mitseiner Brunst zu nähern . . . Der Menschheit! Gab es je noch ein scheußlicheresaltes Weib unter allen alten Weibern? (-es müßte denn etwa “die Wahrheit”sein: eine Frage für Philosophen). Nein, wir lieben die Menschheit nicht;andererseits sind wir aber auch lange nicht “deutsch” genug, wie heute dasWort “deutsch” gang und gäbe ist, um dem Nationalismus und demRassenhaß das Wort zu reden, um an der nationalen Herzenskrätze undBlutvergiftung Freude haben zu können, derenthalben sich jetzt in EuropaVolk gegen Volk wie mit Quarantänen abgrenzt, absperrt. Dazu sind wir zuunbefangen, zu boshaft, zu verwöhnt, auch zu gut unterrichtet, zu “gereist”:wir ziehen es bei weitem vor, auf Bergen zu leben, abseits, “unzeitgemäß”, in

Leland’s favorite economists 113vergangenen oder kommenden Jahrhunderten, nur damit wir uns die stilleWut ersparen, zu der wir uns verurteilt wüßten als Augenzeugen einerPolitik, die den deutschen Geist öde macht, indem sie ihn eitel macht, undkleine Politik außerdem ist: – hat sie nicht nötig, damit ihre eigene Schöpfungnicht sofort wieder auseinander fällt, sie zwischen zwei Todhasse zupflanzen? muß sie nicht die Verewigung der Kleinstaaterei Europas wollen?. . . Wir Heimatlosen, wir sind der Rasse und Abkunft nach zu vielfach undgemischt, als “moderne Menschen”, und folglich wenig versucht, an jenerverlogenen Rassen-Selbstbewunderung und Unzucht teilzunehmen, welchesich heute in Deutschland als Zeichen deutscher Gesinnung zur Schau trägtund die bei dem Volke des “historischen Sinns” zwiefach falsch undunanständig anmutet. Wir sind, mit einem Worte – und es soll unserEhrenwort sein! – gut Europäer, die Erben Europas, die reichen,überhäuften, aber auch überreich verpflichteten Erben von Jahrtausendendes europäischen Geistes: als solche auch dem Christentum entwachsen undabhold, und gerade, weil wir aus ihm gewachsen sind, weil unsere VorfahrenChristen von rücksichtsloser Rechtschaffenheit des Christentums waren, dieihrem Glauben willig Gut und Blut, Stand und Vaterland zum Opfergebracht haben. Wir – tun desgleichen. Wofür doch? Für unserenUnglauben? Für jede Art Unglauben? Nein, das wißt ihr besser, meineFreunde! Das verborgene Ja in euch ist stärker als alle Neins und Vielleichts,an denen ihr mit eurer Zeit krank seid; und wenn ihr aufs Meer müßt, ihrAuswanderer, so zwingt dazu auch euch – ein Glaube!(Nietzsche 1988)We who are homeless – Among Europeans today there is nolack of those who are entitled to call themselves homelessin a distinctive and honorable sense: it is to them that Iespecially commend my secret wisdom and gaya scienza.For their fate is hard, their hopes are uncertain; it is quite afeat to devise some comfort for them – but to what avail?We children of the future, how could we be at home in thistoday? We feel disfavor for all ideals that might lead one tofeel at home even in this fragile, broken time of transition; asfor its “realities,” we do not believe that they will last. The icethat still supports people today has become very thin; thewind that brings the thaw is blowing; we ourselves who arehomeless constitute a force that breaks open ice and otherall too thin “realities.”We “conserve” nothing; neither do we want to return toany past periods; we are not by any means “liberal”; we donot work for “progress”; we do not need to plug up our earsagainst the sirens who in the market place sing of the future:their song about “equal rights,” “a free society,” “no moreThis openingspeaks to hisbasic dislike ofthe economy assuch. But heturns aroundrather quickly.

114 Jürgen G. Backhausmasters and no servants” has no allure for us. We simply donot consider it desirable that a realm of justice and concordshould be established on earth (because it would certainly bethe lighted with all who love), as we do, danger, war, andadventures, who refuse to compromise, to be captured,reconciled, and castrated; we count ourselves among conquerors;we think about the necessity for new orders, also fora new slavery – for every strengthening and enhancement ofthe human type also involves a new kind of enslavement.Is it not clear that with all this we are bound to feel ill at easein an age that likes to claim the distinction of being the mosthumane, the mildest, and the most righteous age that thesun has ever seen? It is bad enough that precisely when wehear these beautiful words we have the ugliest suspicions.What we find in them is merely an expression – and a masquerade– of a profound weakening, of weariness, of old age,of declining energies. What can it matter to us whattinsel the sick may use to cover up their weakness? Let themparade it as their virtue; after all, there is no doubt that weaknessmakes one mild, oh so mild, so righteous, so inoffensive,so “humane!”The “religion of pity” to which one would like to convertus – oh, we know the hysterical little male and females wellenough who today need precisely this religion as a veil andmake-up. We are no humani tarians; we should never dareto permit ourselves to speak of our “love of humanity”; ourkind is not actor enough for that. Or not Saint-Simonistenough, not French enough. One really has to be afflictedwith a Gallic excess of erotic irritability and enamoredimpatience to approach in all honesty the whole of humanitywith one’s lust!Humanity! Has there ever been a more hideous oldwoman among all old women – (unless it were “truth”: aquestion for philosophers)? No, we do not love humanity;but on the other hand we are not nearly “German” enough,in the sense in which the word “German” is constantlybeing used nowadays, to advocate nationalism and racehatred and to be able to take pleasure in the national scabiesof the heart and blood poisoning that now leads the nationsof Europe to delimit and barricade themselves against eachother as if it were a matter of quarantine. For that we are tooopen-minded, too malicious, too spoiled, also too wellinformed, too “traveled”: we far prefer to live on mountains,apart, “untimely,” in past or future centuries, merely inorder to keep ourselves from experiencing the silent rage toHere, Nietzschetakes up centralaspects of freemarketeconomics, stillin a criticalposture,however.When hetalks about“enslavement”,he is at whatnow we callconsumerism.(It is telling thatVance Packard,who promotedthese ideas,never mentionedNietzsche in hisdiatribes.)

Leland’s favorite economists 115which we know we should be condemned as eyewitnesses ofpolitics that are desolating the German spirit by making itvain and that is, moreover, petty politics: to keep its owncreation from immediately falling apart again, is it notfinding it necessary to plant it between two deadly hatreds?must it not desire the eternalization of the European systemof a lot of petty states?We who are homeless are too manifold and mixedracially and in our descent, being “modern men,” and consequentlydo not feel tempted to participate in the men -dacious racial self-admiration and racial indecency thatparades in Germany today as a sign of a German way ofthinking and that is doubly false and obscene among thepeople of the “historical sense.” We are, in one word – andlet this be our word of honor – good Europeans, the heirs ofEurope, the rich, oversupplied, but also overly obligatedheirs of thousands of years of European spirit. As such, wehave also outgrown Christianity and are averse to it –precisely because we have grown out of it, because ourancestors were Christians who in their Christianity wereuncompromisingly upright: for their faith they willinglysacrificed possessions and position, blood and fatherland.We – do the same. For what? For our unbelief? For everykind of unbelief? No, you know better than that, friends!The hidden Yes in you is stronger than all Nos and Maybesthat afflict you and your age like a disease; and when youhave to embark on the sea, you emigrants, you, too, arecompelled to this by – a faith!(Nietzsche 1974)Insertion IIFriedrich Nietzsche: Die Genealogie der MoralZweite Abhandlung1.Ein Tier heranzüchten, das versprechen darf – ist das nicht gerade jene paradoxeAufgabe selbst, welche sich die Natur in Hinsicht auf den Menschen gestellthat, ist es nicht das eigentliche Problem vom Menschen?. . . . Daß dies Problembis zu einem hohen Grad gelöst ist, muß dem um so erstaunlicher erscheinen,der die entgegen wirkende Kraft, die der Vergeßlichkeit, vollauf zu würdigenweiß. Vergeßlichkeit ist keine bloße vis inertiae, wie die Oberflächlichen

116 Jürgen G. Backhausglauben, sie ist vielmehr ein aktives, im strengsten Sinne positivesHemmungsvermögen, dem es zuzuschreiben ist, daß was nur von uns erlebt,erfahren, in uns hineingenommen wird, uns im Zustande der Verdauung(man dürfte ihn “Einverseelung” nennen) ebensowenig ins Bewußtsein tritt,als der ganze tausendfältige Prozeß, mit dem sich unsre leibliche Ernährung,die sogenannte “Einverleibung” abspielt. Die Türen und Fenster desBewußtseins zeitweilig schließen; von dem Lärm und Kampf, mit dem unsreUnterwelt von dienstbaren Organen für-und gegeneinander arbeitet,unbehelligt bleiben; ein wenig Stille, ein wenig tabula rasa des Bewußtseins,damit wieder Platz wird für Neues, vor allem für die vornehmerenFunktionen und Funktionäre, für Regieren, Voraussehn, Vorausbestimmen(denn unser Organismus ist oligarchisch eingerichtet) – das ist der Nutzender, wie gesagt, aktiven Vergeßlichkeit, einer Türwärterin gleichsam,einer Aufrechterhalterin der seelischen Ordnung, der Ruhe, der Etikette:womit sofort abzusehn ist, inwiefern es kein Glück, keine Heiterkeit, keineHoffnung, keinen Stolz keine Gegenwart geben könnte ohne Vergeßlichkeit.Der Mensch, in dem dieser Hemmungsapparat beschädigt wird und aussetzt,ist einem Dyspeptiker zu vergleichen (und nicht nur zu vergleichen) – er wirdmit nichts “fertig” ... Eben dieses notwendig vergeßliche Tier, an dem dasVergessen eine Kraft, eine Form der starken Gesundheit darstellt, hat sichnun ein Gegenvermögen angezüchtet, ein Gedächtnis, mit Hilfe dessen fürgewisse Fälle die Vergeßlichkeit ausgehängt wird, – für die Fälle nämlich,daß versprochen werden soll: somit keineswegs bloß ein passivisches Nichtwieder-los-werden-Könnendes einmal eingeritzten Eindrucks, nicht bloßdie Indigestion an einem einmal verpfändeten Wort, mit dem man nichtwieder fertig wird, sondern ein aktives Nicht-wieder-los-werden-Wollen, einFort-und-fort-Wollen des einmal Gewollten, ein eigentliches Gedächtnis desWillens: so daß zwischen das ursprüngliche “ich will” “ich werde tun” und dieeigentliche Entladung des Willens, seinen Akt, unbedenklich eine Welt vonneuen fremden Dingen, Umständen, selbst Willensakten dazwischengelegtwerden darf, ohne daß diese lange Kette des Willens springt. Was setzt dasaber alles voraus! Wie muß der Mensch, um dermaßen über die Zukunftvoraus zu verfügen, erst gelernt haben, das notwendige vom zufälligenGeschehen scheiden, kausal denken, das Ferne wie gegenwärtig sehn undvorwegnehmen, was Zweck ist, was Mittel dazu ist, mit Sicherheit anzusetzen,überhaupt rechnen, berechnen können, – wie muß dazu der Mensch selbstvorerst berechenbar, regelmäßig, notwendig geworden sein, auch sich selbst fürseine eigene Vorstellung, um endlich dergestalt, wie es ein Versprechendertut, für sich als Zukunft gutsagen zu können!2.Eben das ist die lange Geschichte von der Herkunft der Verantwortlichkeit.Jene Aufgabe, ein Tier heranzuzüchten, das versprechen darf, schließt, wiewir bereits begriffen haben, als Bedingung und Vorbereitung die nähereAufgabe in sich, den Menschen zuerst bis zu einem gewissen Grade

Leland’s favorite economists 117notwendig, einförmig, gleich unter Gleichen, regelmäßig und folglichberechenbar zu machen. Die ungeheure Arbeit dessen, was von mir“Sittlichkeit der Sitte” genannt worden ist (vgl. Morgenröte, S. 13 f., 18, 21)– die eigentliche Arbeit des Menschen an sich selber in der längsten Zeitdauerdes Menschengeschlechts, seine ganze vorhistorische Arbeit hat hierin ihrenSinn, ihre große Rechtfertigung, wieviel ihr auch von Härte, Tyrannei,Stumpfsinn und Idiotismus innewohnt: der Mensch wurde mit Hilfe derSittlichkeit der Sitte und der sozialen Zwangsjacke wirklich berechenbargemacht. Stellen wir uns dagegen ans Ende des ungeheuren Prozesses, dorthin,wo der Baum endlich seine Früchte zeitigt, wo die Sozietät und ihreSittlichkeit der Sitte endlich zutage bringt, wozu sie nur das Mittel war: sofinden wir als reifste Frucht an ihrem Baum das souveräne Individuum, das nursich selbst gleiche, das von der Sittlichkeit der Sitte wieder losgekommene,das autonome übersittliche Individuum (denn “autonom” und “sittlich”schließt sich aus), kurz den Menschen des eignen, unabhängigen, langenWillens, der versprechen darf – und in ihm ein stolzes, in allen Muskelnzuckendes Bewußtsein davon, was da endlich errungen und in ihm leibhaftgeworden ist, ein eigentliches Macht-und Freiheits-Bewußtsein, einVollendungs-Gefühl des Menschen überhaupt. Dieser Freigewordene, derwirklich versprechen darf, dieser Herr des freien Willens, dieser Souverän –wie sollte er es nicht wissen, welche Überlegenheit er damit vor allem voraushat, was nicht versprechen und für sich selbst gutsagen darf, wievielVertrauen, wieviel Furcht, wieviel Ehrfurcht er erweckt – er “verdient” allesDreies-und wie ihm, mit dieser Herrschaft über sich, auch die Herrschaftüber die Umstände, über die Natur und alle willenskürzeren und unzuverlässigerenKreaturen notwendig in die Hand gegeben ist? Der “freie”Mensch, der Inhaber eines langen unzerbrechlichen Willens, hat in diesemBesitz auch sein Wertmaß: von sich aus nach den anderen hinblickend, ehrt eroder verachtet er; und ebenso notwendig als er die ihm Gleichen, die Starkenund Zuverlässigen (die, welche versprechen dürfen) ehrt, – also jedermann,der wie ein Souverän verspricht, schwer, selten, langsam, der mit seinemVertrauen geizt, der auszeichnet, wenn er vertraut, der sein Wort gibt alsetwas, auf das Verlaß ist, weil er sich stark genug weiß, es selbst gegen Unfälle,selbst “gegen das Schicksal” aufrechtzuerhalten-: ebenso notwendig wird erseinen Fußtritt für die schmächtigen Windhunde bereit halten, welcheversprechen, ohne es zu dürfen, und seine Zuchtrute für den Lügner, der seinWort bricht, im Augenblick schon, wo er es im Munde hat. Das stolze Wissenum das außerordentliche Privilegium der Verantwortlichkeit, das Bewußtseindieser seltenen Freiheit, dieser Macht über sich und das Geschick hat sich beiihm bis in seine unterste Tiefe hinabgesenkt und ist zum Instinkt geworden,zum dominierenden Instinkt: – wie wird er ihn heißen, diesen dominierendenInstinkt, gesetzt, daß er ein Wort dafür bei sich nötig hat? Aber es ist keinZweifel: dieser souveräne Mensch heißt ihn sein Gewissen . . .(Nietzsche 1988)

118 Jürgen G. Backhaus1.To breed an animal which is able to make promise – is thatnot precisely the paradoxical task which nature hasset herself with regard to humankind? is it not the realproblem of humankind? . . . The fact that this problemhas been solved to a large degree must seem all themore surprising to the person who can fully appreciatethe opposing force, forgetfulness. Forgetfulness is notjust a vis inertiae, as superficial people believe, but israther an active ability to suppress, positive in thestrongest sense of the word, to which we owe the factthat what we simply live through, experience, take in,no more enters our consciousness during digestion(one could call it spiritual ingestion) than does thethousand-fold process which takes place with ourphysical consumption of food, our so-called ingestion.To shut the doors and windows of consciousness for awhile; not to be bothered by the noise and battle withwhich our underworld of serviceable organs workwith and against each other; a little peace, a littletabula rasa of consciousness to make room forsomething new, above all for the nobler functions andfunctionaries, for ruling, predicting, predetermining(our organism runs along oligarchic lines, you see) –that, as I said, is the benefit of active forgetfulness, likea doorkeeper or guardian of mental order, rest andetiquette: from which we can immediately see howthere could be no happiness, cheerfulness, hope,pride, immediacy, without forgetfulness. The person inwhom this apparatus of suppression is damaged, sothat it stops working, can be compared (and not justcompared) – to a dyspeptic; he cannot “cope” withanything . . . And precisely this necessarily forgetfulanimal, in whom forgetting is a strength, representinga form of robust health, has bred for himself a counterdevice,memory, with the help of which forgetfulnesscan be suspended in certain cases, – namely in thosecases where a promise is to be made: consequently, itis by no means merely a passive inability to be rid ofan impression once it has made its impact, nor is it justindigestion caused by giving your word on someoccasion and finding you cannot cope, instead it is anactive desire not to let go, a desire to keep on desiringwhat has been, on some occasion, desired, really it isthe will’s memory: so that a world of strange new things,Here, we find the criticalissue of concludingcontracts, the basicnotion of a marketeconomy. Yet, this has tohold for the state as well.Nietzsche is concernedhere with the buildingblocks of society.This speaks directly toissues of property takenand contract nonperformance.Currently,in the German transitioneconomy, “forgetfulness”is a big item. Only in thiscontext can policies beplaced which withholdproperty from theirrightful owners andthereby bringunemployment upontheir dependents.The word of honorestablishes the contractand implies liability incase the promise isbroken. Althoughliability is not mentionedas such, Nietzscheexpresses the very ideaas “reliability.”

circumstances and even acts of will may be placedquite safely in between the original “I will”, “I shalldo” and the actual discharge of the will, its act, withoutbreaking this long chain of the will. But what a lot ofpreconditions there are for this! In order to have thatdegree of control over the future, man must first havelearnt to distinguish between what happens by acci -dent and what by design, to think causally, to view thefuture as the present and anticipate it, to grasp withcertainty what is end and what is means, in all, to beable to calculate, compute – and before he can do this,man himself will really have to become reliable, regular,automatic [notwendig], even in his own self-image, sothat he, as someone making a promise is, is answerablefor his own future!Leland’s favorite economists 1192.That is precisely what constitutes the long history ofthe origins of responsibility. That particular task ofbreeding an animal which has the right to make apromise includes, as we have already understood, asprecondition and prepar ation, the more immediatetask of first making man to a certain degree undeviating[notwendig], uniform, a peer amongst peers, orderlyand consequently predictable. The immense amountof labour involved in what I have called the “moralityof custom” (see Daybreak, I, 9; 14; 16), the actuallabour of man on himself during the longest epoch ofthe human race, his whole labour before history, isexplained and justified on a grand scale, in spite of thehardness, tyranny, stupidity and idiocy it also contained,by this fact: with the help of the morality ofcustom and the social straitjacket, man was made trulypredictable. Let us place ourselves, on the other hand,at the end of this immense process where the treeactually bears fruit, where society and its morality ofcustom finally reveal what they were simply the meansto: we then find the sovereign individual as the ripest fruiton its tree, like only to itself, having freed itself fromthe morality of custom, an autonomous, supra-ethicalindividual (because “autonomous” and “ethical” aremutually exclusive), in short, we find a man with hisown, independent, durable will, who has the right tomake a promise – and has a proud consciousness quiveringin every muscle of what he has finally achieved andHere, Nietzscheemphasizes the rule oflaw as a pre-conditionfor human activity ata high level ofdevelopment.

120 Jürgen G. Backhausincorporated, and actual awareness of power andfreedom, a feeling that man in general has reachedcompletion. This man who is now free and who reallydoes have the right to make a promise, this master ofthe free will, this sovereign – how could he remainignorant of this superiority over everybody who doesnot have the right to make a promise or answer forhimself, how much trust, fear and respect he arouses– he “merits” all three – and how could he, with his selfmastery,not realize that he has necessarily been givenmastery over circumstances, over nature and over allcreatures with a less durable and reliable will? The“free” man, the professor of a durable, unbreak ablewill, thus has his own standard of value: in the possessionof such a will, viewing others from his standpoint, herespects or despises; and just as he will necessarilyrespect his peers, the strong and the reliable (thosewith the right to give their word), – that is everyone whomakes promises like a sovereign, ponderously, seldom,slowly, and is sparing with his trust, who confersan honour when he places his trust, who gives his wordas something which can be relied on, because he isstrong enough to remain upright in the face of mishapor even “in the face of fate”-: so he will necessarily beready to kick the febrile whippets who make a promisewhen they have no right to do so, and will save the rodfor the liar who breaks his word in the very moment itpasses his lips. The proud realization of the extraordinaryprivilege of respon sibility, the awareness of thisrare freedom and power over himself and his destiny,has penetrated him to the depths and become aninstinct, his dominant instinct: – what will he call hisdominant instinct, assuming that he needs a word forit? No doubt about the answer: this sovereign mancalls it his conscience . . .(Nietzsche 1994)Nietzsche even comesclose to the concept ofproducer and consumersovereignty.Again, he returns to thecrucial role of liability ineconomic affairs.Even somewhat goingbeyond Eucken, heemphasizes theimportance of trust forefficient marketexchange.Although Nietzsche does not fully work out the basic institutions of a marketeconomy, the key notions are present and could readily be further developed.III The basic institutions of a market economy –reconsidered: price indicesYet, read on. If man is the animal that can make and keep promises, and currencyis the language in which these promises can be kept, how about the state (of all

Leland’s favorite economists 121conceivable agents) to monitor the stability of the currency. Fruitful advances ineconomic theory mesh with questionable public policy. Here is one example.Having now turned to Nietzsche, the question naturally arises: can we get tomuch less disorganized economic discourse? First, we find an eminent scholardeeply immingled in Christian thought trying to derive economics out of Christianinsights. Then we find a deeply troubled philosopher, who comes up with fairly thesame suggestions as the first one. I repeat: ex falso quod libet. Here we now have a casewhich ties back to Leland Yeager’s basic proposition, “in search of a monetaryconstitution” 16 in order to pose the question, where can we search for a truthfulmonetary constitution? It is true that any good that goes for a price has manycharacteristics. It is therefore also true that any good that goes for one economicprice has many characteristics upon which people may disagree. In due course,sensible entrepreneurs will try to disentangle these characteristics, selling theirgoods with some characteristics on one market and other characteristics on othermarkets. In this way, a price-spread would naturally occur.On this hook of Lancaster’s perfectly sound theory 17 ingenious price indexengineers have now mooted the notion of calculating hedonic price indices. Takea simple example. If some good, such as typewriters, decline in their price, othergoods, such as computers, may all of a sudden appear. First, since some people evenuse a computer as a typewriter, one could have attested an increase in the price oftypewriters, but this has never occurred. On the other hand, since computers alsofacilitate many ways of life, it can be said that the same product, originally atypewriter, now a computer, has made many things much easier to do. You couldconceivably say that the computer as opposed to the typewriter has improved ourlife. To measure this would be a sensible proposition for an economist.We can, however, also turn a legitimate theory into something else in order tomeasure the price index. It needs to be understood that the price index is now ahighly political piece of statistics. The price index, for instance, turns the budget onsocial security entitlements. For this reason, it is by no means inconceivable thatpolitical power turns intelligent minds on manipulating the index. This can readilybe done. Kindly look at the graph in Figure 8.3 that Leland himself has drawn.Yopportunities lost butrejected in the first place●opportunities gainedFigure 8.3 Leland’s Diagram.X

122 Jürgen G. BackhausIf one aspect of a good becomes more expensive, yet another aspect of the goodbecomes less expensive, and these may even be different goods, so an opportunityarises to buy more of the now less expensive good aspect, while a dis-opportunityhas also arisen, for closing, under the same budget constraint, the opportunity tobuy more of the now more expensive aspects. It is not difficult to give a practicalexample. We do understand that the black population has an obesity problem.This is readily revealed in health care costs, but also in mortality figures (heart conditions).The traditional diet of the black population contained a lot of naturalingredients; grandmother would cook the big pot of “greens.” As a consequence ofvarious Washington-sponsored government programmes, this family structure haslargely been eroded. We can now find a dramatic discrepancy between life expectancyamong black and white males in the Deep South. I do not want to suggestsimple conclusions. From the point of view of Lancaster’s sensible suggestion,however, we have to keep in mind that the different characteristics of goods do notescape the consumers.If a calculator in Washington wants to measure the consumer price index, hecannot fail to notice that produce is no longer in much demand. In fact, freshproduce may be too difficult a product to market for many, in particular minorityoperatedentrepreneurships. If the turnips do not get sold, you have to throw themaway, and you have to write that clearly as a loss. On the other hand, if you canorder pre-packaged assortments of groceries, perhaps deep-frozen, you do nothave the problem of having to throw away the waste, as long as you can pay thepower company. Hence, the consumer in the supermarket is confronted with prefabricatedready-made deep-frozen vegetable assortments and next to this, duringa time of duration, fresh produce at, however, increased prices. A simple avocadomay go for a dollar, an artichoke even for two. 18 If you now interpret Leland’sgraphic correctly, you can readily see that there is welfare increase possible due tothe better availability of ready-made groceries, but only if you ignore the redux, i.e.the non-availability of fresh groceries due to price liberations. In due course, thefresh grocery department in the supermarket will disappear, and the customizedgrocery industry will prevail. If you look at this graph, this industry change will looklike a welfare increase, from that point of view, and that will then be recalculatedinto the rate of inflation. When, for instance, the price of eggplants has doubled,while on the other hand the price of a product into which eggplants have beenmeshed ready-made might have even declined, the hedonic index-measurer willtake the general welfare in mind and conclude that not withstanding the exorbitantincrease in the price of eggplant, the price index may actually have gone down, andthe general welfare been increased.Instead of eggplants, let us look at college education. In the state of Alabama,where Leland resides, most families have one or two, sometimes more childrenwhom they want to send to college. The cost of tuition is now between $20,000and $30,000 per year and child, and this is certainly an item that does not escapeattention. In Alabama, tuition costs rose at Auburn by 42.8 percent, at Alabamastate by 40.8 percent, at the University of Alabama by 40.6 percent, atAlabama A&M by 38.1 percent, and I could conclude the whole list, with Troy at

Leland’s favorite economists 123Dothan by a mere 26.3 percent. This compares to a consumer price index thathovers under 2 percent.In economics, we picture the economic man (Der Wirt) as the agent who takesprudent decisions. An agent who sees these figures will draw his conclusions. Oneof his conclusions would necessarily be that he has to doubt the national statistics.Not only is the peculiar hedonic price statistic calculation in doubt, in addition wehave all the fees. There are school taxes, garbage taxes that double henceforth,sewer taxes that even triple, many other such instruments, and they do not getreflected in the price index. And yet, prominent economists lend their services toblinding the statistics.In fact, with the weak European economies, the performance of the US dollarsupports my case. The United States of America, as they could never meetthe Maastricht criteria, are currently the ailing brother of the Western world.(The other siblings are not particularly well either.) It is a poor idea to take inprinciple perfectly sensible economic notions in order to whitewash otherwiseawful scenarios.And where can we find a solution?Leland Yeager has given us such a solution in his remarkable article in theAmerican Economic Review (cited above). What is happening here is that the unit ofaccount is constantly being falsified. Hence, competition among agencies, such asfolio-managing agencies, should decide on the best index for price stability. Thecurrent price stability index is all but credible. In fact, it is hard to see why there isnot yet a protest group against all these falsifications. Public choice theory searchesfor an answer. The majority of the winners from this course are still voting, aliveand well. The heirs will visit their graveyards in grief, but also perhaps with secondthoughts.Notes* Contribution to the Southern Economics Annual Meeting. Session No. 65D*: TheHumble Truth. Honoring Leland Yeager II. New Orleans, November 21–23, 2004.1 The lecture was guest-edited by Gerrit Meijer in the Journal of Economic Studies (1994)under the title “Eucken on Capital and Interest” ( Journal of Economic Studies, 21(4):61–75).2 Footnotes have been omitted from translation: “Methodisches: Das Vorgehen Euckens,das auf die ‘phänomenologische[n] Wesenserfassung’ zurückgeht, kann im modernenwissenschaftstheoretischen Diskurs keinen Bestandhaben. Die Rückbindung an Husserl,dessen Philosophie letzliche ‘eine Ontologie auf idealistischer Grundlage’ ist und somiteinen ‘Absolutismus im Übergang’ bedeutet, muß zerfließen: Im Wissen um eineevolutive Naturgeschichte bietet eine transzendentalphilosophische Methodik und ihreRückbindung an eine ‘Erste Philosophie’ keinen Halt mehr in der sozialwissenschaftlichenDebatte – auch wenn eine ähnliche Vorgehensweise die unausgesprochene Grundlagezahlreicher ökonomischer Theorien bildet.”3 Page 37. In German: “Ethisches Wollen: Wurzelt die ökonomische Theorie nicht auf‘ewigen Wahrheiten’, schwindet ihre Möglichkeit, Wirtschaftsethik absolut zubegründen. Entthront man also den metaphysisch legitimierten Ordo, entfällt derAnspruch, von ökonomischer Erkenntnis zu unverrückbaren moralischen Postulatenfortzuschreiten.”

124 Jürgen G. Backhaus4 Page 41. In German: “Somit verbleibt einer ökonomischen Theorie, die sich in derTradition Euckens neu formulieren will, die betrübliche, aber notwendige Einsicht, wiesie bereits von Joseph Schumpeter formuliert wurde: ‘Statt scharfe Konturen fürDisziplinen und Richtungen zu gewinnen, müssen wir uns damit abfinden, daß allesineinander fließt.’”5 Rudolf Eucken (1846–1926) taught philosophy from 1871 in Basel, and from 1874 inJena. He propagated a neo-idealistic philosophy of creative activism and received theNobel Prize for Literature in 1908.6 The issue is not arcane. The accession of Turkey to the European Union is said by someto revolve on Turkish policy being compatible with European Christian values.7 Unfortunately, Eucken turned, to his later chagrin, explicitly against Schmoller’sunresentful quest for empirical evidence.8 This was when we had just completed our conference on Friedrich Nietzsche’s influenceon the social sciences, and Wolfgang Schluchter gave his lecture in Erfurt on MaxWeber, detailing how Friedrich Nietzsche had influenced both Max and Alfred Weber’swork (see Schluchter et al. forthcoming).9 In contrast to his teacher Schumacher, or to Schmoller and Sombart, he seems to havebeen extremely aloof of economic activities, as they actually happen. An internship in abank would probably have pushed his insight extremely, but perhaps he would havethen been lost from the academic community.10 See insertion I.11 See insertion II.12 The source of this identification is the purpose of this essay (see Buchanan 1969).13 For an analysis of the importance of the first three options see Hirschman (1970).14 The legal implications of this rather apodictive statement have to be further explored.15 See for instance for a short statement Leland B. Yeager (1985: 103–7 with furtherreferences).16 Cambridge: Harvard University Press, 1962.17 Journal of Political Economy.18 Own price observation.ReferencesBackhaus, Jürgen (1989). Sombart’s Modern Capitalism. Kyklos, 42(4): 599–611. Reprinted in:Blaug, Mark (ed.) (1992) Pioneers in Economics, Volume 30, Section III. Aldershot: EdwardElgar, pp. 93–105.Backhaus, Jürgen (1999). Land Rents and Ecological Crisis: The Case of the Oder RiverValley. American Journal of Economics and Sociology, 58(2): 249–52.Backhaus, Jürgen (ed.) (in press). The Social Question. Journal of Economic Studies.Backhaus, Jürgen (ed.) with Günter Krause (1997). On Political Economy of Transformation:Country Studies. Metropolis Verlag.Backhaus, Jürgen (ed.) with Plamen Tchipev and Frank Stephen (1998). Mass PrivatisationSchemes in Central and East European Countries. Implications on Corporate Governance. Sofia:GorexPress.Buchanan, James (1969). Cost and Choice. Chicago, IL: Markham.Eucken, Walter (1950). The Foundations of Economics (translated by Terence W. Hutchison).London: W. Hodge.Eucken, Walter (1951). This Unsuccessful Age of the Pains of Economic Progress, with anIntroduction by John Jewkes. London: W. Hodge.Gehrken, Lüder (ed.) (2000). Walter Eucken und sein Werk: Rückblick auf den Vordenker der SozialenMarktwirtschaft (Walter Eucken and his Œuvre: Looking Back at the Intellectual Founderof the Social Market Economy). Tübingen: Mohr Siebeck.

Leland’s favorite economists 125Goldschmidt, Nils (2002). Entstehung und Vermächtnis ordo-liberalen Denkens: Walter Eucken und dieNotwendigkeit einer kulturellen Ökonomik (Emergence and Legacy of Ordo-Liberal Thinking:Walter Eucken and the Necessity of Cultural Economics). Münster: LIT.Hirschman, Albert O. (1970). Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations,and States. Cambridge, MA: Harvard University Press.Külp, Bernhard and Victor Vanberg (eds.) (2003). Freiheit und wettbewerbliche Ordnung(Freedom and Competitive Order). Freiburg: Haufe.Meijer, Gerrit (ed.) (1994). The Intellectual Roots of Market Economies: Walter Eucken’sContribution to Economics. Journal of Economic Studies, 20(4).Nietzsche, Friedrich (1974). The Gay Science – with a Prelude in Rhymes and an Appendix of Songs.Walter Kaufmann (ed.). New York: Vintage Books.Nietzsche, Friedrich (1988). Kritische Studienausgabe, 15 vols. G. Colli and M. Montinari (eds.).München-Berlin/New York: DTV – de Gruyter. Repr. of 2nd edn.Nietzsche, Friedrich (1994). On the Genealogy of Morality. K. Ansell-Pearson (ed.). Cambridge:Cambridge University Press.Peukert, Helge (2004). Der 20. Juli und die wirtschafts-und ordnungspolitischen Konzeptionender Opposition gegen den Nationalsozialismus. Perspektiven der Wirtschaftspolitik,5(4).Schluchter, Wolfgang (forthcoming). Max und Alfred Weber. In Thomas Beschorner andThomas Eger (eds.) Das Ethische in der Ökonomie. Festschrift zum 60. Geburtstag von Hans G.Nutzinger. Marburg: Metropolis.Schwartze, Andreas (1990). LLM-Thesis. Florence: European University Institute, pp. 30–3.Smith, Adam (1776). An Inquiry into the Nature and Causes of the Wealth of Nations.Sombart, Werner (1928). Der moderne Kapitalismus, I–III. Leipzig und München: Duncker &Humblot.Storch, Henri (1823–24). Cours d’économie politique, I–V. Paris: Aillaud.Yeager, Leland (1985). Deregulation and Monetary Reform. American Economic Review,Papers and Proceedings, 75(2): 103–7.Yeager, Leland (1994). Eucken on Capital and Interest. Journal of Economic Studies, 21(4):61–75.Yeager, Leland (2001). Ethics as Social Science. Cheltenham: Elgar.

9 The genesis of an ideaClassical economics and the birth ofmonetary disequilibrium theoryMichael R. MontgomeryIntroductionAs Leland Yeager establishes impressively in The Fluttering Veil (Yeager 1997a), thenotion of monetary disequilibrium is one of the core ideas of macroeconomictheory. That monetary distortions originating on either the supply or demand sideof the “money market” can have important impacts on the price level and on realincome is decisively argued in his volume. That these impacts are likely to bestronger in the event of monetary change than they are for changes in other majormacroeconomic magnitudes is a proposition for which an ample and impressivecase appears in this book. That money has unique status not only as medium ofexchange but also as the sole asset without a “price” of its own, so that consequencesof excess demands for, or supplies of, money must be worked out piecemeal amongthe millions of markets that employ money for transactions purposes, is, properly,the central insight of the volume. That this central insight, which I have not seenemphasized elsewhere in modern macro-theory, substantially simplifies monetarytheory by establishing a uniqueness factor to the monetary asset that the existenceof numerous “near-moneys” cannot overturn is one of the book’s major achievements.That this uniqueness, when considered in combination with the existenceof a complex, interlocking business structure where the fact that costs of somebusinesses are revenues of others, and cost changes for some lag behind pricechanges for others, leads directly to a monetary theory of the business cycle, followsquickly from the analysis. That all this matters crucially for macroeconomic theoryis difficult to deny once one has read the volume.The Fluttering Veil matters not only as a contribution to modern macroeconomictheory. It is also notable in its establishment of numerous links with past thinkersin the monetary disequilibrium tradition. The present paper seeks to make acontribution in this spirit, by exploring the development of the monetarydisequilibrium idea in the hands of the Classical economists. It will be argued belowthat the “Classicals” were considerably more broad-based in their approach tomacroeconomics than is acknowledged by the modern interpretation emphasizingwage/price flexibility, Say’s Law, and the neutrality of money. It was, I will argue,precisely out of this broad-based approach that the monetary disequilibriuminsight emerged – first by Hume, and then, most notably, in the hands of John

The genesis of an idea 127Stuart Mill. I will argue that Mill’s insights represent the start of monetarydisequilibrium theory as that theory is conceived of today.The Classical macroeconomic tradition as popularlyinterpretedThat the genesis of monetary disequilibrium theory can rightly be attributed to theClassical economists – by which I mean Hume, Smith, Say, Ricardo, James andJohn Stuart Mill, and their contemporary like-thinkers on money and macroeconomicissues 1 – will come as a surprise to some. The reputation of the Classicaleconomists has never quite recovered from the tarring delivered by Keynes in TheGeneral Theory (1965 [1936]). In Chapters 2 and 3 of that book, Keynes portrayedthe Classicals (as well as early twentieth-century theorists, whom he also, strangely,labeled “Classical”) as cloddish believers in simplistic versions of Say’s Law, price/wage flexibility and the strict neutrality of money. Despite the qualified rebuke ofKeynes on this point by Robert Skidelsky (arguably the world’s leading authorityon Keynes), 2 modern macroeconomists have, too often, picked up Keynes’ interpretationwholesale.Thus, Snowdon et al. (1994: 52), writing on Say’s Law, state “That the act ofsupply created an equivalent demand seemed obvious to the Classical writers.” TheClassicals allowed for “the possibility that a misallocation of resources can occurand that a glut of certain commodities can develop, but this problem would be temporaryand no such excess supply could occur for goods as a whole” (ibid.). Likewiseechoing Keynes on flexible prices and wages, Abel and Bernanke (2005: 355) maintainthat, “Classical macroeconomists assume that prices and wages adjust quicklyto equate quantities supplied and demanded in each market.” 3 Stiglitz (1993: 680)also emphasizes price and wage flexibility, stating that Classical economics “recognizedthat the economy might have short periods of unemployment, but believedthat market forces would quickly restore the economy to full employment.” 4, 5Regarding the strict neutrality of money, Mankiw (2000: 187) tells us that “inclassical economic theory, changes in the money supply do not influence realvariables.” Snowdon et al. make the link between the neutrality of money and Say’sLaw explicit:In general classical economists, notably Ricardo and Mill, gave support to Say’slaw, which they believed also held true for a monetary exchange economy.Money was nothing more than a convenient medium of exchange which enabledmarket participants to avoid the awkwardness and inconvenience of barter.(Snowdon et al. 1994: 52)The over-emphasis on price flexibility in interpretationsof Classical theoryActually, it is quite possible to argue plausibly that none of these three propositions– Say’s Law, price/wage flexibility, the neutrality of money – accurately

128 Michael R. Montgomerycharacterize Classical macroeconomic thought, at least not in the simplistic formsin which modern parlance asserts them. Take, for example, wage and price flexibility,supposedly at the very heart of eighteenth- and nineteenth-century Classicalmacroeconomic doctrine. If the Classical economists were apostles of a wage/priceflexibility so powerful as to guarantee that deviations from equilibrium output“would be temporary and very short-lived” (Snowdon et al. 1994: 43), then why dowe not read more about such flexibility and its mechanics in the most importantmacroeconomic writings of the leading Classical economists? John Stuart Mill’sfamous chapter in The Principles of Political Economy “Of Excess of Supply” mentionsprice (not wage) flexibility only in passing and only at the start of the chapter, preliminaryto the main argument, in order to establish early on how there can be aglut of an individual commodity (Mill 1965 [1848]: 570) – an argument which hethen invalidates as an argument for general gluts. His earlier essay on the samegeneral topic, “On the Influence of Consumption on Production,” in Essays on SomeUnsettled Questions in Political Economy, is similarly bereft of any focus on flexible wagesor prices (Mill 1983 [1844]). 6 J.B. Say’s chapter “Of the Demand or Market forProducts” in his Traite d’Economie Politique (Treatise on Political Economy) (1983 [1803])discusses price and wage flexibility only briefly and as an aside after the core of hisargument is complete. 7 Ricardo has even less to say about price and wage flexibilityin his macroeconomic musings in the Principles (1951 [1817]: Ch. XXI, “Effectsof Accumulation on Profits and Interest”). He follows Say in arguing for the insatiabilityof “effectual” demand in ways that do not appeal to price, wage, or interestrateflexibility; his occasional references to the latter concepts are very muchby-the-way and, on the face of it, inessential to his argument. 8Naturally it is tempting to argue that the Classical economists did fully endorsethe necessary-and-sufficient role of wage/price flexibility in guaranteeing fullemployment, and that their failure to focus explicitly on how such flexibility providessuch a guarantee is merely additional evidence that such flexibility was somuch part of their thinking that it never occurred to them to actually discuss it indetail. The fact is, however, that the Classical economists did not openly emphasizewage/price flexibility as the core adjustment mechanism guaranteeing macroeconomicstability. What the Classicals did emphasize repeatedly is the notion thatevery act of production is an act of potential-demand creation. Such potentialwould be rapidly and inevitably transformed into spending due to the self-interestof the producer – either by the producer’s direct consumption or by the producer’slending to another who would in turn consume.Just how that actualization would occur was not detailed. Certainly given theClassicals’ microeconomics, one may presume that wage- and price- (and interestrate-)flexibility would play an important role in this actualization. But presumptionsaside, the fact remains that, precisely where one might have expected them to makethe details of their adjustment mechanism explicit, the Framers of moderneconomic theory left an inkblot.Since the Classical economists were not slipshod thinkers, it is worth consideringthe possibility that the inkblot is there because they meant it to be there. In particular,there are those occasional jarring passages where the Classical economists

The genesis of an idea 129suggest that the idea of full-employment equilibrium, and the path to that equilibrium,is longer, more treacherous and more mysterious at the macro-level than atthe micro-level. In these musings, one can infer a certain skepticism that price/wage flexibility would assure rapid convergence to macro-equilibrium. Adam Smith(1937 [1776]: 406) writes about a sometimes general complaint of a “scarcity ofmoney” occurring throughout “whole mercantile towns” due to “over-trading.” Inthe Unsettled Questions, Mill builds on this line of thought, associating such a statewith times when “general delusion is afloat” (1983 [1844]: 40), and even emphasizing,as a cause, the thoroughly modern notion that the “increase in productionreally takes place during the progress of [currency] depreciation, as long as theexistence of depreciation is not suspected” (ibid.). So far all is still much in line withSmith’s “over-trading” story. Next, however, Mill introduces something new,pointing out that:when the delusion vanishes and the truth is disclosed, those whose commoditiesare relatively in excess must diminish their production or be ruined: and if duringthe high prices they have built mills and erected machinery, they will be likely to repent at leisure.(1983 [1844]: 40, italics added)Repent at leisure? How is such a thing to be reconciled with full price flexibility?Will not this unwanted capital see its price fall until it is disposed of to the highestbidder, and will not the economy quickly return to equilibrium? It is a clear-cutimplication of the price flexibility assumption allegedly at the core of Classicalmacro-thought, and yet no such suggestion is forthcoming from Mill at thisjuncture. The same question may be raised of certain passages by Ricardo in his“On Sudden Changes in the Channels of Trade,” in the Principles (Ch. XIX).Ricardo, however, spells out the fixed-capital mechanism more carefully (he haddoubtless had opportunity to contemplate numerous such cases during his career asa stockbroker). Says Ricardo, “A great manufacturing country is peculiarly exposedto temporary reverses . . . produced by the removal of capital from one employmentto another” (1951 [1817]: 263). When there is such a sudden shift in relativedemands for products, 9It changes in a great degree the nature of the employments to which therespective capitals of countries were before devoted; and during the intervalwhile they are settling in the situations which new circumstances have made themost beneficial, much fixed capital is unemployed, perhaps wholly lost, andlabourers are without full employment. The duration of this distress will belonger or shorter according to the strength of that disinclination, which mostmen feel to abandon that employment of their capital to which they have longbeen accustomed.(1951 [1817]: 265)This link between fixed capital and potentially lengthy periods of stress on business– during which time “labourers are without full employment” – poses a challenge

130 Michael R. Montgomeryto those who would portray Classical theory as implying rapid adjustment to fullemployment in response to macroeconomic shocks. The fly in the ointment is thespecter of expensive, illiquid, debt-creating, industry-specific, and often also firmspecific,capital goods. 10 As Ricardo notes, “[i]t is often impossible to divert themachinery which may have been erected for one manufacture, to the purposes ofanother . . . ” (1951 [1817]: 266).It is true that, if pressed, Ricardo and Mill might without contradiction haveclaimed that these were industry-specific problems, tending to cause someindustries to decline while others prospered in precisely inverse proportion, so thatfull employment overall would be maintained. This would almost certainly havebeen Say’s view. 11 However, Ricardo and Mill choose not to proceed in this way.Ricardo does not say how long “temporary” is in his prediction of a temporaryfailing health of the economy given sudden changes in the “channels of trade.”Later in his essay, Mill emphasizes the transitory nature of the commercial crisis hedescribes – but his “repent at leisure” remark (see above) raises concerns likeRicardo’s about the speed of recovery.Neither Mill nor Ricardo denies that the widespread capital losses alluded to willbring on a general decline in economic activity – indeed, Mill affirms it specifically. 12Neither believes the distress should be confused with a secular overproductionproblem like that which, say, Malthus would have suggested (Mill 1983 [1844]:43–5). On the other hand, neither Ricardo nor Mill is prepared to put theirthoughts about the length of the “temporary” period of distress into calendar units.How long, then, will the period of general distress last? Once nonmarketablefixed capital enters the picture, it is not enough for the crisis in confidence to end inorder to guarantee recovery. The large capital losses associated with the overhangof excess capital will continue to hold the economy down for some period of time.Nor did Ricardo and Mill seem prepared to invoke wage/price flexibility as thesolution to the economy’s “wrong-capital” problem. So it is hard to imagine theirperceived adjustment period as failing to be quite a bit more lengthy than, forexample, Snowdon et al.’s brisk characterization of it as “very short-lived” (1994: 52).Based on how Ricardo and Mill raised and addressed these issues, I suggest thatthe Classicals, generally speaking, were aware, in an intuitive sort of way, of thepotential problems such capital-based speculations posed for any argument thatpure wage and price flexibility was enough to guarantee rapid return to fullemployment. 13 On this interpretation, the original Classical Economists, unlikesome working recently in the New Classical and Real Business Cycle schools, didnot see the role played by price flexibility in achieving economy-wide equilibrium tobe simple and clear-cut; for example, as a straightforward blowup of the role playedby price flexibility in a microeconomic problem. It would appear that they saw themacro-version of this problem as considerably more complex.The Classicals had great respect for, and confidence in, the power of prices toalter behavior in socially desirable ways. They had also a general understandingthat the invisible-hand idea depended crucially on such price flexibility. But theydid not rely explicitly on price flexibility as the thing that guaranteed fullemployment in the economy. Nor did they have to understand the subtleties of the

The genesis of an idea 131macroeconomic implications of price flexibility in order to guarantee that “supplyequaled demand” for the economy as a whole. They had something much simplerthat, they thought, got them to the same result without having to venture into theuncharted territory of price flexibility in a macroeconomic context. It was thisalternate strategy that set them on a path that ended, after considerable resistance,in the recognition of the monetary disequilibrium idea.Say’s Law and moneyThe simple idea, of course, was Say’s Law. The very act of production guaranteedthat an equivalent amount of consuming power would be created. In a bartereconomy, supplying was demanding by definition, and one’s purchasing power wasexactly equal to the value of that which one had produced and then supplied tomarket. It was literally inconceivable that supply could exceed demand or viceversa, regardless of whether or not price ratios were flexible or fixed. Somehow supply wouldhave to equal demand. Price flexibility governed how it would happen, not whether itwould happen. This was the great simplification that the Classicals sought to keepas they turned from the barter to the monetary economy.Keeping this simplification, however, required dealing first with the complicationof money. Money offered a way to put one’s wealth into the form of storablegeneral purchasing power. It constituted a clear threat to the transfer of the analysisbuilt around Say’s Law over from a barter to a monetary economy. The vital needto bottle-up money accounts in large part for the emphasis placed in the classicalliterature on the idea that money is used only for transactions purposes. 14 ToHume, money is “none of the wheels of trade: It is the oil which renders the motionof the wheels more smooth and easy” (1970 [1752]: 33). Smith thinks that “[i]twould be too ridiculous to prove, that . . . [money] is valuable only for purchasing”(1937 [1776]: 406). Say claims that money’s “whole utility” consists in facilitatingtransactions, and compares it to “a public vehicle successively transport[ing]objects one after another” (1983 [1803]: 13). To J.S. Mill, money units “are a sortof tickets or orders” usable in purchasing, and money is “a machine for doingquickly and commodiously, what would be done, though less quickly and commodiously,without it” (1965 [1848]: 506).But if Say’s Law was to be smoothly transferable from a barter to a moneyeconomy, it was also essential that money not be a store of value, so that it could notserve as a “sink” in which unspent purchasing power might accumulate. In writingwhat Blaug has called “a hint of Say’s Law” (Blaug 1978: 56), Smith had beenaware that there were crucial assumptions involved regarding the timing ofspending: “What is annually saved is as regularly consumed as what is annuallyspent, and nearly in the same time too; but it is consumed by a different set of people”(1937 [1776]: 321, emphasis added). As Blaug put it, “[t]he operative propositionhidden away in Smith’s phraseology is that saving is tantamount to investmentbecause ‘hoarding,’ the building up of monetary holdings, is regarded as anexceptional occurrence” (1978: 57).Say goes to great lengths in seeking to establish the irrelevance of the hoarding

132 Michael R. Montgomeryissue. He states that the money “you will have received on the sale of your ownproducts, and given in the purchase of those of other people, will the next momentexecute the same between other contracting parties” (1983 [1803]: 13, emphasisadded). It is risky to hold money, since “the value of money is also perishable”(p. 15) – presumably referring, not only to the possibility of physical destruction ofcertain kinds of money, but also, as Mill would later put it, to the notion that “[n]ocommodity is quite free from such fluctuations [in value]” (1965 [1848]: 504).Buried in a footnote, Say recognized that there would be the occasional “miser”(1983 [1803]: 13) who would obtain money “with a view to hoard or bury it” (ibid.).But he considered this to be an isolated case, and in any event “[t]he heir of thelucky finder [would spend it], if the miser do not” (ibid.).With this point established to Say’s satisfaction, the Law that bears his name was,in his eyes, just as applicable to a monetary economy as to a barter one: “a productis no sooner created, than it, from that instant, affords a market for other products tothe full extent of its own value” (p. 15). Ricardo is content with Say’s analysis,writing that “M. Say has, however, most satisfactorily shown that there is noamount of capital which may not be employed in a country, because demand isonly limited by production” (1951 [1817]: 290). In the Principles, he simply states theneeded condition for money and then moves on without comment: “money is onlythe medium by which exchange is effected” (ibid.). In sum, Smith, Say, and Ricardosaw clearly that “[b]y ruling out hoarding, money is indeed reduced to serving as amedium of exchange and no more: in consequence, saving or nonconsumption isnecessarily equal to investment” (Blaug 1978: 57).It is this denial of money’s potential store-of-value function, not the assumptionof a powerful wage and price (and interest rate) flexibility, that was the key plankallowing Classical economists prior to J.S. Mill to aggressively assert Say’s Law. Ifmoney is only a medium-of-exchange, then all worries about wage/price flexibilityare neatly finessed (how would the issue of price flexibility arise in a critical way inan aggregate context if there were nothing but goods to buy, as in a bartereconomy?). And it is the extraordinary importance of this assumption to theirframework that enticed three generations of leading Classical economists (Smith,Say, Ricardo) to stick doggedly to a position that, with the benefit of hindsight, wasindefensible. Indeed, the tenuousness of the ground on which they had built isrevealed by the qualifiers Smith and Say felt obliged to include in their corestatements. Smith’s use of the qualifier nearly (see above), and Say’s recognition thatsome will hoard, already cede the basic principle. The recognition that money couldbe stored and would be stored by some overwhelmed the Classicals’ bald assertionsthat such activities were rare. What if they were not?Mill’s fateful reckoning with the problem of storablemoneyAccordingly, by John Stuart Mill’s day, Mill seemed to have felt compelled toshore-up the Classical macro-framework by seeking to reconcile it with the clearlyobservable fact that money was not just a medium of exchange but also a store of

The genesis of an idea 133value. His attempt to do so was published as “On the Influence of Consumption onProduction,” in his Essays on Some Unsettled Questions in Political Economy, a volumepublished in 1844, but in fact written in 1829–30 (Hazlitt 1983: 23). Mill thought hewas just making some second-order fine-tunings to the Classical framework. Whathe was really doing was inventing monetary disequilibrium theory, and, as a byproductat the same time, modern macroeconomics.Early in his essay, Mill states its purpose as a kind of mopping-up exercise, “ofseeing that no scattered particles of important truth are buried and lost in the ruinsof exploded error” (1983 [1844]: 26–7). Accordingly, later in the essay, immediatelyafter explaining how a “general delusion” can bring about a commercialcrisis, Mill notes that in this case “it is commonly said that there is a general superabundance”(p. 40), and that he will show the difference between a “crisis” andgeneral overproduction. After a standard restatement of Say’s Law (“whoeveroffers a commodity for sale, desires to obtain a commodity in exchange for it, and istherefore a buyer by the mere fact of his being a seller” (p. 41)), Mill makes themomentous concession that earlier Classical writers had sought to avoid:This argument is evidently founded on the supposition of a state of barter; and,on that supposition, it is perfectly incontestable. When two persons perform anact of barter, each . . . cannot sell without buying. . . . If, however, we supposethat money is used, these propositions cease to be exactly true. It must be admittedthat no person desires money for its own sake, (unless some very rare cases ofmisers be an exception,) and that he who sells his commodity, receiving moneyin exchange, does so with the intention of buying with that same money someother commodity. Interchange by means of money is therefore, as has beenoften observed, ultimately nothing but barter. But there is this difference – that in thecase of barter, the selling and the buying are simultaneously confounded in one operation; yousell what you have, and buy what you want, by one indivisible act, and youcannot do the one without doing the other. Now the effect of the employment ofmoney, and even the utility of it, is, that it enables this one act of interchange to bedivided into two separate acts or operations; one of which may be performednow, and the other a year hence, or whenever it shall be most convenient.Although he who sells, really sells only to buy, he needs not buy at the samemoment when he sells; and he does not therefore necessarily add to the immediatedemand for one commodity when he adds to the supply of another. The buyingand selling being now separated, it may very well occur, that there may be, atsome given time, a very general inclination to sell with as little delay as possible,accompanied with an equally general inclination to defer all purchases as longas possible.(1983 [1844]: 41–2, italics added)Therefore, he concludes,In order to render the argument for the impossibility of an excess of allcommodities applicable to the case in which a circulating medium is employed,

134 Michael R. Montgomerymoney must itself be considered as a commodity. It must, undoubtedly, beadmitted that there cannot be an excess of all other commodities, and an excessof money at the same time.(1983 [1844]: 43)However, such a state of affairs should not be confused with a state of “generalsuperabundance” – meaning overproduction of goods in a strictly real sense, notinvolving a role for money. What is actually going on at these times is that:persons in general, at that particular time, from a general expectation of beingcalled upon to meet sudden demands, liked better to possess money than anyother commodity. Money, consequently, was in request, and all other commoditieswere in comparative disrepute. In extreme cases, money is collected inmasses, and hoarded; in the milder cases, people merely defer parting with theirmoney, or coming under any new engagements to part with it. But the result is,that all commodities fall in price, or become unsaleable.(1983 [1844]: 43)So Say’s Law must be qualified. Once money is recognized as a store of value aswell as a medium of exchange, it is possible for the demand for goods-in-general tobe less than (or, though Mill does not consider it, greater than) that which isrequired for full employment. There can be an excess supply of goods-in-general,the mirror-image of which is an excess demand for money. It is true, Mill states, that“this state can only be temporary . . . since those who have sold without buyingwill certainly buy at last” (1983 [1844]: 42). But he does not state – indeed, onemight say that he is careful not to state – how long a calendar period “temporary” islikely to be.Earlier in this paper, it was asserted that the Classical economists easily could beread as rejecting each of the three propositions often claimed to define Classicalmacroeconomic thought by leading macro-theorists like Stiglitz, Mankiw, andothers – the neutrality of money, Say’s Law, and wage/price flexibility. Let us nowsee how we stand with respect to this claim. (1) It is clear that the last great Classicaleconomist, J.S. Mill, saw clearly how money could be profoundly non-neutral dueto its function as a store of value during times of “crisis” (though only in a transitionalphase of indeterminate – not necessarily trivial – duration). And, (2) due to money’snon-neutral role, Say’s Law as understood by all Classical economists before Mill isincorrect unless money itself is considered a commodity – opening up the possibilityof a lack of demand for goods-in-general for considerable, though not indefinite,periods. Finally, as already argued above, (3) wage-price flexibility as the heart ofClassical doctrine is, arguably, a projection of modern beliefs onto the Classicalviewpoint and is, at the very least, an exaggeration of that viewpoint. And, wemight add, (3A): The notion that the Classicals thought economic downturnswould be necessarily short, also, does not survive close inspection.Yeager (1997b) has pointed out that the so-called “New Keynesians” are notKeynesian at all if words mean anything. It appears the same is true of the other

The genesis of an idea 135half of modern macro-theory. “New Classical” economics (including Real BusinessCycle theory) is not very “Classical” either – at least not in the sense that Classicaleconomists would have understood the term.The regrettable projection of Keynesian ideas ontoClassical traditionUpon reflection, it makes sense that this would be so. It is hardly surprising, forexample, to find that the Classicals differ fundamentally with those coming afterKeynes on the question of the proper emphasis to be placed on wage/price flexibilityas the guarantor of full employment. Those coming after Keynes started withthe proposition that Aggregate Demand would, in general, be insufficient to securefull employment. To them, in the absence of activist government stimulus, theentire, massive burden of returning the economy to full employment would fall uponthe wage/price/interest-rate adjustment mechanism. In the absence of governmentaid on the demand side, it was up to wage/price/interest-rate flexibility tocreate the additional demand that would be needed for full employment. TheClassicals, by contrast, started with the idea that there was, by definition, alwaysenough demand already created to assure full employment. Wage/price/interestrateflexibility did not need to create new demand, it only needed to allocate productioninto channels that would call forth into activity the demand that wasalready there.The difference in perspective is far more than just semantics. The problem asconceived by Keynes and his followers is a massive one, while the difficultyperceived by the Classicals is much smaller. The problem of creating new demanddemanded, quite naturally, all the complexities and subtleties of the macroeconomictheories emphasized by Keynes and his followers. The problem of allocating existingdemand, by contrast, was much simpler. It was far more easily conceived as beingsolvable by merely a wave of the Invisible Hand.Mill made the Classical argument more complex, but weaker, by broadening theframework to include routinely storable money. Now the necessity-of-sufficientdemandidea held good as a “long run,” not an immediate, proposition, where the“long run” was the unspecified period of time required for the excess demand formoney to end (in his Unsettled Questions framework, this was the time required forthose spooked by the commercial crisis who have postponed buying for now butwho “must buy at last,” to re-enter the demand side of the market). But even thepost-Mill Classical framework took the return of demand as automatic, so that thesolution to the short-term crisis was not to create new demand, but merely to allowthe pent-up demand stored in money to return to the markets.The invention of monetary disequilibrium theory andmodern macroeconomicsMill’s discovery in the Unsettled Questions of a way in which demand for goods-ingeneralcould for a time be deficient due to the unique role played by money in the

136 Michael R. Montgomeryeconomy marks the beginnings of a transition from the Classical to the modern“macro-view.” It is, in a sense, the start of mainstream macroeconomic theory. Millshowed how demand for goods-in-general could be inadequate to guarantee fullemployment, without a decline in the money supply, and independently of thequestion of whether or not there is in place the correct “proportionality” inproduction. He did this while still maintaining that overproduction in the longterm,Malthusian sense was impossible. 15 In other words, he identified the keyaspect of modern business cycle theory: that deviations from full employment areself-correcting but occur for reasons that, since they occur in truly economy-widefashion, are not essentially microeconomic in nature.This was a new idea. To the extent that the earlier Classicals had a theory ofaggregate economic difficulties, it involved circumstances where problems in individualcommodity markets were large enough to exert a significant aggregateeffect, as in Ricardo’s “sudden changes in the channels of trade” argument (seeabove). The notion that something might occur that would push more or lessuniformly downward on goods-in-general is, to be sure, not entirely missing fromearlier Classical thought, 16 but it is safe to say that it plays little role in Classicalthinking (with the exception of Hume in the specific context of a change in themoney supply). Aggregate economic issues, to the pre-Mill Classicals, were just theaggregate outcome of the issues of all the individual industries, a problem of microeconomicswrit large. There were no “exclusively macro problems” that needed tobe tackled in a manner separate from microeconomics. 17 In the Unsettled Questions,Mill showed otherwise: Monetary disequilibrium, whether originating from thedemand side or the supply side of the “money market,” could generate aggregateeconomic disturbances that were superimposed onto the microeconomic structureof the economy.Mill’s framework was broader than that presented by Hume, whose analysispredicted problems only in the event of a change in money supply. Moreover, Millwas able to explicitly integrate his idea into the guiding macroeconomic principleof his day: Say’s Law. Finally, Mill’s macro-framework implied that the sole causeof aggregate economic problems on the demand side was money – either its supply orits demand. Thus, Mill is also founding Monetarist business-cycle theory at thismoment. This, then, is arguably one of the most fundamental contributions in all ofmacroeconomic theory.What makes it all the more remarkable is that Mill chose to carry over virtuallynone of these insights into his far-more-influential Principles of Political Economy, whichhe published in 1848, four years after the publication of the Unsettled Questions. In“Of Excess of Supply” in the Principles, after referring to a prior discussion ofcommercial crises, he simply announces perfunctorily that “[a]t such times there isreally an excess of all commodities above the money demand: in other words, thereis an under-supply of money” (1965 [1848]: 574). In the crisis, due to “the suddenannihilation of a great mass of credit . . . [a]lmost everybody therefore is a seller, andthere are scarcely any buyers” (ibid.). The analysis linking money’s role as a storeof-valueto the need to amend the interpretation of Say’s Law is omitted from thediscussion. Also notably absent is the careful explanation he had made in the

The genesis of an idea 137Unsettled Questions of how money allows selling now to become buying later and socauses the barter-economy interpretation of Say’s Law to cease to be “exactly true”(1983 [1844]: 41). In the Unsettled Questions the consequences of “an under-supply ofmoney” are clearly broader than those pertaining merely to a “commercial crisis,”while in the Principles Mill seems at pains to closely limit the dangerous idea [?] of anexcess demand for money to the commercial crisis episode only. It is thereforeironic that the actual term, “under-supply of money,” appears nowhere in theUnsettled Questions essay where the concept is so richly and fully treated, but isintroduced instead in the Principles where the idea’s full power seems carefullysuppressed. 18Conclusion: aggregate economic theory on a new pathIn sum, Mill’s identification of how an excess demand for money can occur, andhow it mandates a softening of Say’s Law, is the beginning of macroeconomics inthe modern sense. Of equal significance, however, is that Mill’s identification wasalso the beginning of monetary disequilibrium theory (along with Hume’s essay OfMoney). And like all good theories, his raised additional questions. How general wasthe monetary disequilibrium phenomenon (was it only the feature of a “commercialcrisis,” or something more fundamental)? Through what mechanism(s) could/didan excess demand for money generate real effects? What was the magnitude, andduration, of such effects on the macroeconomy? Such questions would, in the main,be left to future economists like Irving Fisher, Ralph Hawtrey, Harry GunnisonBrown, Clark Warburton, Milton Friedman, and Leland Yeager.Notes1 Thus I exclude Malthus, Sismondi, and similar skeptics of Say’s Law.2 Skidelsky is the author of a three-volume biography of Keynes. In an interview, Snowdenet al. asked Skidelsky whether Keynes gave the Classical economists “a raw deal.” Hereplied “Yes. He set up an Aunt Sally. No classical economist ever believed in the thingsKeynes claimed that classical economics stood for . . . .” However, it is a qualified rebuke,since Skidelsky goes on to say that Keynes was identifying “the things they would need tobelieve to make sense of what they were saying” (Skidelsky 1994: 84). The “they” inthis quote refers to people like Pigou, but it may plausibly be applied to the Classicalsas well.3 On pages 17–18, Abel and Bernanke make it clear that they are referring to trueClassical economists, not just the modern approach called “New Classical.”4 Moreover, Stiglitz actually follows Keynes so far as to carry forward Keynes’ egregiouserror of using the term “Classical” to mean “the dominant group of economists beforethe Great Depression” (ibid.). The notion that early twentieth-century macroeconomistsblithely presumed wage and price flexibility is very decisively rejected by history (seeYeager 1973, 1993, 1997b; see also Warburton 1951).5 Often such portrayals of Classical theory are followed immediately by a triumphantpresentation of the “commonsense, middle-of-the-road” Keynesian position. Forexample, unlike those silly Classicals, “Keynesians usually agree that prices and wageseventually change as needed to clear markets; however, they believe that in the short runprice and wage adjustment is likely to be incomplete” (Abel and Bernanke 2005: 355).

138 Michael R. MontgomeryPresented on the heels of the Classical caricature, the “Keynesians” look pretty good bycomparison. Leland Yeager (1997b) has pointed out that such “Keynesianism” is nothingof the sort: Wage/price stickiness is also a key part of pre-Keynesian macro-theory, anda core working assumption of Monetarist thought. The only people who have disagreedwith this so-called “Keynesian” position are the modern “New Classical” school(including “Real Business Cycle” advocates). “New Classicals” claim to be new-andimprovedversions of Classical thought. Accordingly, it is convenient for exposition if the“old” versions of those labels are packaged to match closely with the “new” ones.Certainly “New Classical Economics” (particularly its Real-Business-Cycle wing)aggressively asserts a simplistic belief in perfect price/wage flexibility, the neutrality ofmoney, and (by implication) Say’s Law. The real Classicals were more sophisticated thantheir self-appointed successors (see discussion below).6 The closest Mill comes is late in the essay when he writes:Nothing can be more chimerical than the fear that the accumulation of capital shouldproduce poverty and not wealth, or that it will ever take place too fast for its own end.Nothing is more true than that it is produce which constitutes the market for produce,and that every increase of production, if distributed without miscalculation among all kinds of producein the proportion which private interest would dictate, creates, or rather constitutes, its own demand.(1983 [1844]: 44, emphasis added)Here one is tempted to presume that such a distribution is created by the “invisiblehand” through wage-, price-, and interest-rate flexibility. Mill himself, however – whoeasily could have emphasized such mechanisms at this juncture – chooses to let thematter of the adjustment process rest. More to the point: To say that “production .. .creates, or rather constitutes . .. its own demand” “if distributed without miscalculation” is not tosay that such miscalculation will not occur. Nor is it to say how long-lasting the resultingdeleterious consequences are likely to be if there is “miscalculation,” or that it is wage/price flexibility that will cure the problem. Mill emphasizes “the return of confidence,”not flexible wages and prices, as the key event that will end the economy’s difficulties. Itshould also be noted that when Mill uses the word “creates” in the context of demand heimmediately corrects himself and substitutes the more apt word “constitutes” (Mill 1983[1844]: 42, 45, emphasis added). Mill’s most well-known passage on the subject is in the“Of Excess of Supply” chapter of the Principles of Political Economy, where he contemplatesan assumed doubling of a country’s productive powers. There Mill states that, shouldthis doubling lead to a “superfluity of certain things,” then “[i]f so, the supply will adoptitself accordingly, and the values of things will continue to accord to their costs ofproduction” (Mill 1965 [1848]: 558). Exactly how this will occur – and how long theprocess will take – is left unaddressed.7 Thus:Having once arrived at the clear conviction, that the general demand for products isbrisk in proportion to the activity of production, we need not trouble ourselves muchto inquire towards what channel of industry production may be most advantageouslydirected. The products created give rise to various degrees of demand, according tothe wants, the manners, the comparative capital, industry, and natural resources ofeach country; the article most in request, owing to the competition of buyers, yieldsthe best interest of money to the capitalist, the largest profits to the adventurer, andthe best wages to the labourer; and the agency of their respective services is naturallyattracted by the advantages towards those particular channels.(Say 1983 [1803]: 21)To Say, the core issue is the demonstration that [Aggregate] Demand cannot beinadequate – having once established that point, price and wage flexibility determine that thedesired types of goods will be produced and in the right quantities. The Adequacy-of-Demand proposition is established prior to, and not because of, wage and price flexibility.

The genesis of an idea 1398 “M. Say has, however, most satisfactorily shown that there is no amount of capital thatmay not be employed in a country, because a demand is only limited by production”(Ricardo 1951 [1817]: 290). In a footnote, Ricardo has a backhanded reference tomarket forces, though not specifically to price- or wage-flexibility. He criticizes AdamSmith for seeming to imply that England’s capital might remain unemployed in theabsence of a foreign market for British products. Ricardo argues that the capital will finduse domestically, and, within this specific context, argues thatIt is, however, always a matter of choice in what way a capital will be employed, andtherefore there can never for any length of time be a surplus of any commodity; for ifthere were, it would fall below its natural price, and capital would be removed tosome more profitable employment. No writer has more ably and satisfactorily shownthan Dr. Smith the tendency of capital to move from employments in which thegoods produced do not repay by their price the whole expenses, including theordinary profits, of producing and bringing them to market.(Ricardo 1951 [1817]: n. 3, 193–4)As is often the case for Ricardo, the question of the speed of the implied adjustment isdeftly finessed (what is “any length of time”? how fast-acting is “a tendency”?). Back inthe text, as part of his argument that demand for luxuries is infinite, he seeks to establishthat the supply of such goods will be readily forthcoming: “The poor, in order to obtainfood, exert themselves to gratify those fancies of the rich; and to obtain it more certainly,they vie with one another in the cheapness and perfection of their work .. . Hence arisesa demand for every sort of material which human invention can employ ... ” (Ricardo1951 [1817]: 197).These isolated passages, however, do not add up to an argument that Ricardo’sprimary macroeconomic focus was on wage and price flexibility. Like Mill and Say, thecrucial point to be established was that demand was unlimited, given the means topurchase. On the other hand, when challenged by Malthus specifically on the questionof wage-flexibility, Ricardo was quick to contest the assertion of wage-stickiness. WhenMalthus claimed that “We know from repeated experience that the money price oflabour never falls till many workmen have been for some time out of work” (Letter ofMalthus to Ricardo, 16 July, 1821), Ricardo denied it vigorously, responding thatI know no such thing, and if wages were previously high, I can see no reason whateverwhy they should not fall before many labourers are thrown out of work. All generalreasoning I apprehend is in favour of my view of this question, for why should someagree to go without any wages while others were most liberally rewarded.(Letter from Ricardo to Malthus, 21 July, 1821)The question however is not whether Ricardo and, presumably, the other Classicalsbelieved in wage/price flexibility, but rather, as discussed in the text, what was its role intheir macroeconomics.9 While Ricardo emphasized transitions from war to peace in his discussion, we can easilyimagine macroeconomic disturbances such as confusion between nominal and realforces (Principles, 297–8) as likely causes of similar events, if we assume they lead to aconsiderable build-up of excess capital stock.10 A glance at recent graduate macro (or micro) textbooks, with their now-standardassumptions of (1) infinitely-divisible (2) homogeneous capital that is (3) exclusivelyacquired in debt-free ways, suggests that the field has yet to seriously confront the thornydifficulties posed by true-to-life capital. For two useful treatments from outside the mainstreamof such difficulties, see Garrison (2001) and Davidson (2002). For a broad,insightful survey on capital’s role in economic theory, see Lewin (1999).11 “It is observable, moreover, that precisely at the same time that one commodity makes aloss, another commodity is making excessive profit” (Say 1983 [1803]: 16).12 “ ... as there may be a temporary excess of any one article considered separately, so may

140 Michael R. Montgomerythere of commodities generally, not in consequence of over-production, but of a want ofcommercial confidence” (Mill 1983 [1844]: 45, the last line of his essay).13 Perhaps – to indulge for a moment in pure speculation – they also sensed other complications,such as the general equilibrium problem at the heart of the macro-adjustmentquestion, with prices of some being incomes of others (see Yeager 1999 for a usefuldiscussion of the advantages of the general equilibrium approach in macroeconomics).14 Another reason for these assertions is that the Classicals were engaged in a contest ofideas with the Mercantilists and their view of “bullion and treasure as the essence ofwealth” (Blaug 1978: 10). However, many of these statements occurred in the midst of adiscussion of Say’s Law, not Mercantilism.15 This paper, with its emphasis on Say’s Law, has somewhat de-emphasized the pathbreakingcontributions of David Hume. Hume perceived, as an empirical observation,that periods of money inflow corresponded to periods where “industry has encreased”(1970 [1752]: 37) and vice versa (p. 40), and he even reached the momentous deductionthat it is only in the interval while prices are adjusting that such monetary change has realeffects (ibid.: 38, 40). Moreover, Hume saw that such effects are symmetric, sincethe alterations in the quantity of money, either on one side or the other, are notimmediately attended with proportionable alterations in the price of commodities.There is always an interval before matters be adjusted to their new situation; and thisinterval is as pernicious to industry, when gold and silver are diminishing, as it isadvantageous when these metals are encreasing.(1970 [1752]: 40)But Hume addressed only cases of change in money supply. Of Mill’s notion thatchanges in money demand might occur and generate analogous effects, we see no sign inhis essay. In fact, Hume’s essay aggressively denies that money is anything but a mediumof-exchangeand a unit-of-account.16 For example, Ricardo, in his Chapter XXI in the Principles on the effects of accumulation,briefly discusses how a substantial change in the money supply can impact the rateof interest during the interval of adjustment, and – though he does not say so – one mayargue this would have an aggregate impact (1951 [1817]: 297–8). Just prior to thesethoughts, Ricardo traces out the bare bones of a money-driven cycle based on confusionof real and nominal effects (ibid.). But Ricardo discusses these within the context of asingle representative merchant, and does not go on to draw out any economy-wideimplications from these insights. Moroever, he places no special emphasis on thesepassages – they are merely ruminations in the midst of other loosely related ruminations.17 In this one sense, the Real Business Cycle school is truly Classical in its orientation.Such was also Wesley Mitchell’s approach in his Business Cycles (Mitchell 1913). But,historically, these movements are exceptions to the rule started by Mill in his UnsettledQuestions essay.18 In the Unsettled Questions, Mill had expressed concerns that the phrase “excess of allcommodities” should, “perhaps,” not be used, since the phrase wrongly suggests “theidea of excessive production” (1983 [1844]: 43). Of course, an “excess of all commodities”is just the “flip-side” of an “under-supply of money.” One is reminded of the ancientPythagoreans, who suppressed knowledge of the square root of two due to their beliefthat all numbers should be derivable from the ratios of other numbers, a trait not sharedby the square root of two (see Sagan 1980: 185). If some Pythagoreanesque desire tosuppress the full implications of his concept did lead Mill to tone down its presentation inthe Principles, it is ironic. It is doubtful that Keynes (1965 [1936]: 18–21) could haveproceeded with his famously distorted interpretation of Mill, based on the chapter “OfExcess of Supply” in the Principles, had Mill included there more of his discussion in theUnsettled Questions.

ReferencesThe genesis of an idea 141Abel, Andrew and Ben S. Bernanke (2005). Macroeconomics, 5th edn. New York: Addison-Wesley.Blaug, Mark (1978). Economic Theory in Retrospect, 3rd edn. Cambridge: Cambridge UniversityPress.Davidson, Paul (2002). Financial Markets, Money and the Real World, Ch. 4. Cheltenham:Edward Elgar.Garrison, Roger (2001). Time and Money: The Macroeconomics of Capital Structure. London andNew York: Routledge.Hazlitt, Henry (1983). The Critics of Keynesian Economics. Lanham, MD: University Press.Hume, David (1970 [1752]). Of Money. In Eugene Rotwein (ed.) David Hume: Writings onEconomics. Madison, WI: The University of Wisconsin Press.Keynes, John Maynard (1965 [1936]). The General Theory of Employment, Interest and Money.New York: Harbinger (Harcourt, Brace).Lewin, Peter (1999). Capital in Disequilibrium: The Role of Capital in a Changing World. Londonand New York: Routledge.Malthus, Thomas (1952 [1821]). Letter of Malthus to Ricardo, 16 July, 1821. In Piero Sraffa(ed.) The Works and Correspondence of David Ricardo, Vol. IX. Cambridge: CambridgeUniversity Press for the Royal Economic Society.Mankiw, Gregory (2000). Macroeconomics, 4th edn. New York: Worth Publishers.Mill, John Stuart (1983 [1844]). On the Influence of Consumption on Production. In HenryHazlitt, The Critics of Keynesian Economics. Lanham, MD: University Press. Originallypublished in Mill, John Stuart (1844). Essays on Some Unsettled Questions in Political Economy.Mill, John Stuart (1965 [1848]). Principles of Political Economy with Some of Their Applications toSocial Philosophy. Toronto: University of Toronto Press.Mitchell, Wesley Clair (1913). Business Cycles. Berkeley, CA: University of California Press.Ricardo, David (1951 [1817]). Effects of Accumulation on Profits and Interest. Ch. XXI, inThe Principles of Political Economy and Taxation. In Piero Sraffa (ed.) The Works and Correspondenceof David Ricardo, Vol. I. Cambridge: Cambridge University Press for the RoyalEconomic Society.Ricardo, David (1952 [1821]). Letter of Ricardo to Thomas Malthus, 21 July, 1821. In PieroSraffa (ed.) The Works and Correspondence of David Ricardo, Vol. IX. Cambridge: CambridgeUniversity Press for the Royal Economic Society.Sagan, Carl (1980). Cosmos. New York: Random House.Say, J.B. (1983 [1803]). Of the Demand or Market for Products. In Henry Hazlitt, The Criticsof Keynesian Economics. Lanham, MD: University Press. Originally published in English inA Treatise on Political Economy, 1832. Originally published in French in 1803 in Traited’Economie Politique.Skidelsky, Robert (1994). [Interview with] Robert Skidelsky. In Brian Snowdon, Howard R.Vane and Peter Wynarczyk (1994). A Modern Guide to Macroeconomics: An Introduction toCompeting Schools of Thought. Aldershot: Edward Elgar, pp. 79–88.Smith, Adam (1937 [1776]). An Inquiry into the Nature and Causes of the Wealth of Nations. Editedwith an introduction and notes by Edwin Cannan. New York: Modern Library.Snowdon, Brian, Howard R.Vane and Peter Wynarczyk (1994). A Modern Guide to Macroeconomics:An Introduction to Competing Schools of Thought. Aldershot: Edward Elgar.Stiglitz, Joseph E. (1993). Economics. New York: W. W. Norton.Warburton, Clark (1951). The Misplaced Emphasis in Contemporary Business-FluctuationTheory. In Depression, Inflation, and Monetary Policy: Selected Papers, 1945–1953. Baltimore,

142 Michael R. MontgomeryMD: The Johns Hopkins Press, pp. 73–102. Reprinted with minor revisions fromReadings in Monetary Theory (Philadelphia: Blakiston, 1951). Originally published in Journalof Business, XIX: 4 (October 1946).Yeager, Leland B. (1973). The Keynesian Diversion. In The Fluttering Veil: Essays on MonetaryDisequilibrium. Indianapolis, IN: Liberty Fund, 1997, pp. 199–216. Originally publishedin the Western Economic Journal, 11(June 1973): 150–63.Yeager, Leland B. (1993). The Keynesian Heritage in Economics. In Walter Allan (ed.) ACritique of Keynesian Economics. London: St. Martin’s Press in association with the Institutefor Economic Affairs.Yeager, Leland B. (1997a). The Fluttering Veil: Essays on Monetary Disequilibrium. Indianapolis,IN: Liberty Fund. Edited and with an Introduction by George Selgin.Yeager, Leland B. (1997b) New Keynesians and Old Monetarists. In The Fluttering Veil: Essayson Monetary Disequilibrium. Indianapolis, IN: Liberty Fund, pp. 281–302.Yeager, Leland B. (1999). Should Austrians Scorn General-Equilibrium Theory? Review ofAustrian Economics, II(1/2): 19–30.

10 The macroeconomics of money,saving, and investmentRobert L. GreenfieldTroubles adjusting to collegeI grew up in a home that stressed saving as an unquestioned virtue. At 18 years old,however, having gone back to college for my sophomore year, I found both mymacroeconomics professor and the textbook that he had assigned saying somethingfar less complimentary about saving than my parents had said about it. Both theprofessor and the textbook said that, if people tried to save more, production andemployment would suffer (not “could suffer,” they said, but “would suffer”). Farfrom seeing saving as a virtue, I should now see it as a vice, public even if notprivate, the cause of economic depressions, including the Great Depression, whichmy parents themselves had lived through. My days as an undergraduate are nowmore than thirty-five years behind me. Yet some economists and textbooks teachthis anti-saving lesson still, and all the more remarkably, I must say, to judge by the1980s and 1990s lament that we Americans save too little, that we concern ourselvestoo little with the future.Depressed economic conditions, of course, do not mean that the public is actuallydoing too much saving. In fact, quite the opposite is true: under depressed economicconditions, the public can’t do as much saving as it would otherwise like to do. In anyevent, we economists don’t want to risk giving even the appearance of handing upa blanket indictment of intended saving as the cause of depressed economicconditions. After all, where would we be if people didn’t save and the world had nocapital whatsoever?The following classroom story aims at showing what, years ago, Leland Yeagerhelped me understand, namely, that what causes economic depressions isn’t thepublic’s wanting to save, but rather a money supply too small to permit the public’sthrifty intentions to bear fruit as real capital. More than anything else, Yeager’sfame as a teacher emboldens me, here in a volume honoring his long and distinguishedcareer in academe, to present my simple, classroom story. The storyincludes a section on indirect convertibility, which Yeager gives serious considerationas a means of keeping the quantity of money adjusted, automatically, to thedemand for money holdings. After finishing the section on indirect convertibility, Ireminisce just a bit about Mr. Yeager.

144 Robert L. GreenfieldA one-classroom economyMy story begins. Here in our one-classroom economy, we five people work hard.We produce chairs – one chair each, let’s say, per month, or 12 chairs per year.Each of the five of us, then, has a 12-chair real income flow per year. If we cared todo so, we could devote our entire 60 chair per year real income to current consumption;we could use the chairs in our dining rooms, on our patios, or wherever.If used now, each chair will last a year and then disappear.It’s always somebody else’s chair, of course, that appeals to us, and getting itrequires trade. Conducting trade on the basis of barter, of course, would beinconvenient for everyone. Luckily, however, each one of us has a checking accountwith the one-room economy’s only bank. I can sell a chair to one person, have thebank add the proceeds to my account, and then, by writing a check myself, buy a chairfrom someone else. We use no money other than the checking accounts issued by this– our one and only – bank. (The bank would issue folding money, too, but becausenobody prefers it to checking account money, has no call to do so.)Now, who knows when I’ll come across the chair of my dreams? It may happenwhen I have no chair to sell or when I just can’t find anyone who wants to buy mychair. To make sure that I don’t find myself in such a circumstance, to make sure thatI can buy a chair on even a moment’s notice, I find it convenient to hold a checkingaccount balance that is roughly the equivalent of two months’ income (i.e., twochairs), as does everyone else. All of my receipts and expenditures flow through mychecking account balance, receipts enlarging that balance and expenditures reducingit. When I deposit someone else’s check, my balance grows and that other person’sbalance falls; and when someone else deposits a check of mine, my balance falls andthat other person’s balance rises. In neither case does the sum of the two balanceschange.Say, then, that there exist 1,000 of these checking account dollars, total. Makingthe 1,000-unit stock of money the equivalent of two months’ flow of income requiresthat the annual flow of income be $6,000. Each of the 60 chairs that we produceannually must therefore have a $100 price tag.The demand for money and the supply of capitalNow our population doubles, from five people to ten. Like each of us old timers,each of the five newcomers can produce one chair per month, 12 per year, and,again like each of us old timers, each newcomer wants to hold a $200 checkingaccountbalance, the equivalent of two months’ income. With the newcomers’arrival, then, potential total real income jumps from 60 chairs per year to 120chairs per year, and the aggregate demand for money balances grows from $1,000to $2,000.To accumulate a $200 checking account balance, each of the five newcomers iswilling to make a one-time sacrifice of two months’ income. The newcomers as agroup, in other words, are willing just to hold the money that selling ten of their firstyear’s 60 chairs brings in, instead of using that money to buy chairs for themselves.

The macroeconomics of money, saving, and investment 145The newcomers’ demand for money holdings, then, is actually a supply of real capital. Byholding money, they relinquish the chairs that they could have bought with thatmoney. Thanks to the newcomers’ thriftiness, those chairs sit poised, ready to becomepart of the economy’s capital stock.Now, at the very moment that our population doubles, you come up with ascheme for transforming an ordinary chair into something better, a chair that willlast two years. To transform ordinary chairs into new, improved chairs, however,you need ordinary chairs to work with – you need capital. Not wanting to devoteyour own chairs to the project or to borrow chairs from someone else directly, yougo to the bank. You ask for a $1,000 loan. The bank consents and credits yourchecking account $1,000. With the newly created money, you buy ten chairs, pluggingthe hole in the spending stream that the five newcomers create by demandingchecking account balances of their own. By demanding money holdings of theirown, then, the newcomers are actually committing ten chairs to the bank’s care,and the bank, by creating new money on loan, transfers the ten chairs to you. Yourintended investment in chairs equals the newcomers’ intended saving of chairs, or,what is the same thing, the total quantity of checking account money just satisfiesthe now enlarged community’s total demand for holdings of checking accountmoney.Forced savingThere is nothing to guarantee, however, that the plans of chair investors and theplans of chair savers will mesh as nicely as they did in this case. After all, the bankerdoesn’t know what portion of their first year’s production the newcomers arewilling to give up as a means of acquiring checking account balances of their own.How could the banker know anything about the demand for holdings of checkingaccount money? How could the banker know how many checks people plan towrite or in what amounts they plan to write them? On a face-to-face basis, thebanker deals with you, the borrower, but never actually speaks with the people whowind up holding the newly created money.Nor would the banker have any reason to speak with them; their not wanting tohold new money can’t block the bank’s creating it on loan for people who areseeking chair capital. Hoping to work on 20 chairs, for example, you might ask forand actually get a $2,000 loan. Now, the community doesn’t want to add $2,000 toits money holdings: the new total quantity of money, $3,000, is the equivalent ofthree months’ income [($3,000/$12,000) × 12 months], not two months’ income.We have no choice, however, other than to accept the new money when it comesour way; refusing the money would mean refusing to make ordinary sales. We’llgladly accept the new money, planning to spend it away ourselves. Next day, whenwe go to the store, however, looking for chairs to buy, what will we find? We’ll findten fewer chairs than we want to buy, 100 chairs instead of 110. The bank, in effect,gives you, its borrower, keys to the chair stores, and with those keys in hand, youbeat the rest of us to the chairs. Instead of those 10 chairs, then, we 9 people getmoney.

146 Robert L. GreenfieldOur increased holdings of money give concrete evidence of the saving that wedo. One-half of our saving, however, we do under duress. As a group, we get stuckwith $1,000 more money than we find it convenient to hold and have ten fewerchairs than we find it desirable to use. We’re forced to save.No trace of the forced saving – or what is the same thing, the excess supply ofchecking account money – shows up on the bank’s balance sheet. On the bank’sbalance sheet, your promissory note appears as an asset and, offsetting it, the community’schecking accounts appear as liabilities. After you spend it, every checkingaccount dollar that the bank creates to buy your promissory note winds up in somebody’saccount. The bank’s balance sheet has to balance.The accounting balance does no more, however, than confirm what everyoneknows about money, namely, that people will always accept money, even if they haveno intention of holding it. They can get rid of money that they don’t want to hold,of course, just by spending it. But their spending money just passes it along tosomeone else. The community as a whole can’t get rid of the money that the bankcreates when it too generously accommodates you, its borrower. The best thecommunity as a whole can do is to keep spending the enlarged money supply aroundand thus make it once again, through the permanently increased spending-andincomeflow, the equivalent of only two months’ income.Now, by the very definition of the balance sheet, the bank’s loan assets also mustbe the equivalent of two months’ income, and this accounting fact may seem tosuggest that the bank cannot transfer to its borrowers any more real capital (again,chairs) than the newcomers entrusted to it voluntarily. Such a conclusion would beincorrect, however, for the bank has transferred to you not just the two months’income (ten chairs) income that the newcomers wanted to relinquish but two moremonths’ income (another ten chairs) besides. 1 In earlier times, when economistswere more given than they are now to using verbal imagery, the teller of this talemight have described the bank’s balance sheet, no different in income-value termshere than in the previous case, as being like the cat sleeping innocently before thekitchen stove, after already having swallowed the canary.Wasted savingIt was with a concern with the opposite case, however, that this tale began: the birdescapes the cat’s clutches, the verbally artistic economist would have said, and thenheads right out the open window, gone forever.The wasted saving case begins as the two preceding cases began: each of our fivenewcomers wants to hold a $200 checking-account balance, the equivalent of twomonths’ income. You come up with a scheme for transforming an ordinary chair,which if used now will last only one year, into something better, a chair that will lasttwo years. Again, you need capital, and again, you go to the bank. This time, however,you’re not quite as confident in your abilities. You ask for and get just a $500 loan –not enough money to enable you to take over all ten of the chairs that the fivenewcomers want to relinquish in favor of money holdings, but only five of thosesacrificial chairs. The excess of the newcomers’ intended chair saving over your chair

The macroeconomics of money, saving, and investment 147investment, or, what is the same thing, the community’s excess demand for holdingsof checking account money, doesn’t show up on the bank’s books; the bank’s loanassets are, as they must always be, of course, exactly equal to its deposit liabilities. Theimbalance shows up again, as it does in the case of forced saving, not at the bank buton the chair market. The excess demand for money holdings has as its other and moreplainly visible side an excess supply of chairs.The visibility of the one-classroom economy’s chair market and the temptation toapply supply-and-demand type thinking to it might suggest that the price of chairswould just fall, thereby bringing the supply of and demand for chairs (and thus supplyof and demand for money balances) back into line with each other. Perhaps the pricewould fall if a chair were really a chair and nothing else. “A chair,” however, is just ametaphor for what in reality, outside the one-classroom economy, are quantities ofdifferent goods and services, and the chair’s “price,” therefore, a metaphor for thegeneral price level.Despite the excess supply of chairs, then, their price won’t fall quickly and easily.It’s hard to get the general price level down because, for a while, anyway, untilpressure builds sufficiently and someone has no choice but to succumb; what Yeager(1997: 225) calls “the who-goes-first problem” blocks the downward adjustment.Lacking assurance that suppliers and competitors will follow suit by cutting their ownprices, no chair producer wants to take the lead in what, when eventually it happens,has to be a piecemeal and decentralized downward adjustment. At a price now toohigh for equilibrium but resisting adjusting downward, therefore, the excess supply ofmetaphorical chairs persists.There the other five chairs just sit, then, gathering dust, going to waste. More likely,because they can’t be sold, those other five chairs won’t even be produced at all. Theresources that would have been used to produce them will wind up unemployed, andfrom there the waste will more than likely spread (though not limitlessly, because asmoney holdings became too large in relation to incomes shrunken any further,spending would resume).The bank, in this case, fails to translate some of the newcomers’ intended chairsaving into real capital. Yeager would warn against our being overly hard on thebank, however, despite its failing to translate intended chair saving into real capital.After all, savers commit chairs to the bank’s care by simply exercising restraint inspending – by writing fewer checks against the bank and writing even those fewerchecks in smaller denominations, too. The bank has no way of gauging the savers’thrifty intentions, however, and therefore doesn’t know that, by creating newmoney on loan, it should transfer to chair investors all of the furniture relinquishedvoluntarily by the savers. 2 No market mechanism, in other words, links the bank’slending and hence the actual quantity of money to savers’ demand for money holdings.Indirect convertibilitySuch a mechanism could be established, however, by requiring that the bank maintainindirect convertibility of the money that it issues. A $1 deposit (or banknote), that is,

148 Robert L. Greenfieldwould be redeemable in and issuable against a designated conversion medium – itmight even be gold – not a predetermined physical quantity of the conversionmedium, however, but whatever physical quantity had the same market value as acomprehensively defined bundle of goods and services. 3 No scope would exist for thecomprehensively defined bundle’s relative price to change; any change in the bundle’scomposite price would be a change in the general price level and thus a sign thatthe quantity of money had become either too big or too small in relation to the public’sdemand for money holdings.Say, then, that either because the public wanted to hold less money than it didbefore or because the bank itself had over expanded, the bundle’s composite pricebegan rising toward $2. In this circumstance, I could do better with a $1 deposit (orbanknote) than just spend it on goods and services. For $1, the bank would give mea quantity of gold that I could sell for $2. Then, I could turn the $2 in for gold worth$4 and start over again. Arbitrage would thus shrink the quantity of money, matchingit to the demand for money holdings and preventing the bundle’s compositeprice from rising in the first place.In the opposite case, either because the public wanted to hold more money than itdid before or because the bank had for some reason scaled back its operations, thebundle’s composite price would start falling, say toward $0.50. Now, for whateverquantity of gold I delivered to it, the bank would give me enough new money to buytwice that quantity of gold. Arbitrage would thus expand the quantity of money, againmatching it to the demand for money holdings and this time preventing the postulatedrise of the bundle’s composite price.As a means of shrinking the money supply and thus of resisting any tendency thebundle’s composite price might show of rising above par, decreased lending wouldsupplement and probably even supercede actual money redemptions. The bankwould have just minimal gold reserves to conduct redemptions with, anyway; holdinggold reserves would give the bank no protection, because the dollar would be redeemablenot in a pre-specified quantity of gold (as under an ordinary gold standard) but,instead, in whatever quantity of gold would permit buying the comprehensivebundle. 4 Say, again, then, that the bundle’s price rose toward $2. Again, in redeeminga dollar, the bank would have to pay out twice as much gold as the dollar would actuallybuy. To avoid arbitrage losses on actual redemptions, the bank would quicklyshrink the quantity of money through decreased lending.In the opposite case, again, the bundle’s price would show signs of falling toward$0.50. The bank would see the arbitrageurs coming, gold in hand and, in exchangefor the gold, entitled to twice as many dollars as they had just paid for it. Preferringinterest bearing assets to non-interest bearing gold, the bank would pre-empt thearbitrageurs by expanding its loans and thereby, too, the quantity of money.Indirect convertibility would appropriately link the bank’s lending and thus theactual quantity of money to the public’s demand for money holdings. Under indirectconvertibility, the bank could not inflict forced saving upon an unwilling public. Norcould the bank fail, however innocently, to transform the public’s intended saving intoreal capital.

Mr. YeagerThe macroeconomics of money, saving, and investment 149So ends the classroom story that I use to pass along an important piece of whatLeland Yeager has taught me about macroeconomics. I close, now, by reminiscingjust a little bit.Sometime back in the early 1980s, when my friendship and collaboration withYeager had just begun, I attended the American Economic Association meetings,held that particular year in Atlanta. Between two of the first morning’s sessions, Istood on the hotel’s mezzanine level, waiting for the elevator. The bell rang toannounce its arrival, and two of the disembarking passengers, graduate students, Ithought, a young man and a young woman, stepped from the elevator to themezzanine’s railing. “Oh look!” the young woman exclaimed, as she looked down tothe crowded lobby; and then she continued, using the time honored title given maleprofessors at the University of Virginia, “There’s Mr. Yeager!” The young mancraned his neck, as with his eyes he tried to follow the woman’s extended arm andpointed index finger to their target. Then, with enthusiasm that matched and perhapseven exceeded hers: “Oh yes,” he answered. “Now I see him!”As I watched the pair hurry off, I remembered one of my boyhood Talmud lessons.“Find a master teacher,” the Talmud says, “so that you will avoid making dubiousdecisions.” They had found a master teacher, indeed; and in the same man, so had I.Notes1 Only with the bank’s intervention can we have forced saving inflicted upon us. Withoutthe bank’s intervention, you would have to use your own chairs as capital, or else, tofinance the chair improvement scheme, approach the rest of us directly and, by offering ahigher interest rate on your promissory notes, persuade us to lend you our chairs.2 If our new savers had wanted to hold promissory notes, or bonds, themselves, not checkingaccount money, then intended saving could not have gone to waste. The increaseddemand for bonds would have driven their interest yields down, encouraging investors totry their hands at the chair improvement scheme (and perhaps even discouraging saversfrom releasing their chairs).3 An even more basic reform (see Greenfield and Yeager 1983; Yeager and Greenfield 1989)would define the value unit not as one unit of money but, instead, as the comprehensivelydefined bundle itself. Private firms would issue deposits (and also notes and coins) denominatedin value units, and competition would require that the notes and deposits be keptworth their face values, something more conveniently done, owing to the bundle’s comprehensivedefinition, through indirect rather than through direct convertibility.4 Because the bank wouldn’t hold a large quantity of gold reserves, the “price” impliedarithmetically by the bank’s redemption calculation would not dominate the marketprice. If it actually had to redeem money, the bank would buy the needed gold, therebyadding as much to the demand for gold as to the supply of gold and thus leaving gold’smarket price unchanged (see Woolsey and Yeager 1994; Greenfield et al. 1995).ReferencesGreenfield, Robert L. and Leland B. Yeager (1983). A Laissez-Faire Approach to MonetaryStability. Journal of Money, Credit, and Banking, 15(August): 302–15. Reprinted in GeorgeSelgin (ed.) (1997). The Fluttering Veil: Essays in Monetary Disequilibrium by Leland B. Yeager.

150 Robert L. GreenfieldIndianapolis: Liberty Fund. With authors’ addendum in Lawrence H. White (ed.) (1993).International Encyclopedia of Macroeconomics and Financial History, v. 11. Cheltenham: EdwardElgar.Greenfield, Robert L. and Leland B. Yeager (1997). A Real-GNP Dollar. In George Selgin(ed.) The Fluttering Veil: Essays in Monetary Disequilibrium by Leland B. Yeager. Indianapolis:Liberty Fund.Greenfield, Robert L., Leland B. Yeager and W. William Woolsey (1995). Is IndirectConvertibility Impossible? Journal of Money, Credit, and Banking, 27(February): 293–7.Woolsey, W. William and Leland B. Yeager (1994). Is There a Paradox of IndirectConvertibility? Southern Economic Journal, 61(July): 85–95.Yeager, Leland B. (1956). A Cash-Balance Interpretation of Depression. Southern EconomicJournal, 22(April): 438–47. Reprinted in George Selgin (ed.) (1997) The Fluttering Veil:Essays in Monetary Disequilibrium by Leland B. Yeager. Indianapolis: Liberty Fund.Yeager, Leland B. (1968). Essential Properties of the Medium of Exchange. Kyklos, 21(1):45–69. Reprinted in George Selgin (ed.) (1997). The Fluttering Veil: Essays in MonetaryDisequilibrium by Leland B. Yeager. Indianapolis: Liberty Fund.Yeager, Leland B. (1997). The Significance of Monetary Disequilibrium. In George Selgin(ed.) The Fluttering Veil: Essays in Monetary Disequilibrium by Leland B. Yeager. Indianapolis:Liberty Fund.Yeager, Leland B. and Robert L. Greenfield (1989). Can Monetary Disequilibrium BeEliminated? Cato Journal, 9(Fall): 405–19. Reprinted in George Selgin (ed.) (1997). TheFluttering Veil: Essays in Monetary Disequilibrium by Leland B. Yeager. Indianapolis: LibertyFund.

11 No-name moneyMaria Minniti and Lidija Polutnik*The expectational aspect of inflationary momentum makes the credibility of ananti-inflationary policy of great importance to how severe the withdrawal pangs willbe . . . How, though, could a resolute policy be made convincing from the start?(Yeager 1997: 67–8)IntroductionOn October 8, 1991, Slovenia introduced its own currency, the Slovene tolar,thereby becoming the first among the new economies in transition to achievemonetary independence. 1 The introduction of the new currency was justified bythe goal of achieving political independence and of isolating the country fromYugoslav inflation. The success of the effort toward independence, however, restedon the achievement of macroeconomic stability, which, in turn, required monetarysoundness. Within this context, Slovenia’s currency conversion and achievementof monetary stability offer an interesting example for the study of inflation and ofsuccessful stabilization programs.Yeager (1981) identifies some general features of inflation whose analysis isfunda mental when investigating ways to reduce its incidence. Among thesefeatures, the importance of the inflationary momentum, that is the ability exhibitedby inflation to perpetuate and deepen itself, is especially emphasized. Specifically,the inflationary momentum is described as having three distinct, though strictlyrelated, elements: (1) the credibility component; (2) the catch up component; and(3) the expectations component. Expectations are at the core of the inflationarymomentum. When prices rise at a brisk rate for a while, people recognize what ishappening and make their own pricing decisions accordingly. In particular, peoplemodify their calculations in order to catch up with what they expect inflation willbe. Thus, any attempt to alter the inflationary momentum has to be credible inorder to have a chance of succeeding. Interventions lacking credibility increaseuncertainty and, as a result, strengthen the catch-up effect and the inflationaryspiral. Of course, the three aspects may overlap and cannot be always clearlydistinguished. This paper supports Yeager’s analysis and shows that the Slovenianmonetary reform was successful because it addressed all three aspects of theinflationary momentum and, in particular, that the newly appointed Slovenian

152 Maria Minniti and Lidija Polutnikmonetary authorities were able to leverage popular expectations in favor ofstabilization.Inflation, of course, is a monetary phenomenon, and the successful trend couldnot have been sustained over time without an appropriate policy of the centralbank capable of modifying the money supply appropriately. Nevertheless, thereforms could not have started if political credibility had been lacking and ifSlovenes had not been willing to accept the new currency even before knowing itsreal purchasing power. 2 In other words, reforms would not have achieved theirobjectives if the demand for the new currency had not adjusted suitably to thechange in monetary conditions.The Slovenian case illustrates the crucial role that people’s expectations play indetermining the successful interruption of the inflationary momentum and in containingthe costs associated with the adjustment process. Also, the credibility of theanti-inflation policy is shown to be of primary importance in influencing suchexpectations since the political element in anti-inflationary policies has the potentialto condition expectations and to turn them around, thereby breaking themomentum of inflation. Finally, the Slovenian experience suggests that, even for avery small country, the benefits of having one’s own currency may outweigh costsbecause of the ability to conduct an independent monetary policy. 3The contribution of our paper is twofold. First, we provide a review of the currencyconversion process in Slovenia and identify the economic circumstances thatmade the Slovenian reform successful. Second, we show how the asymmetricnature of expectations among different groups of dinar holders played a crucialrole in determining the success of the currency conversion, and how the Bankof Slovenia successfully leveraged these expectations to break the inflationarymomentum.Yugoslavian monetary conditions and the inflationarymomentumThe Yugoslav economy of the 1980s was characterized by stagnation and rapidlyincreasing prices. Large companies, banks, and the government all lacked budgetarydiscipline. The National Bank of Yugoslavia allowed systematic and sustainedincreases of the money supply which, eventually, led the federation into hyperinflation.Average output growth declined from 6.4 percent in the late 1970s to lessthan 1 percent in the late 1980s, while inflation began increasing in the early 1980s,and rose to 1,253 percent in 1989. 4 In 1987, in order to stop the hyperinflation,improve financial discipline, and provide new economic incentives, the Yugoslaviangovernment introduced a package of economic reforms. 5 These reformswere intended to eliminate social ownership of non-financial enterprises, restructurelarge enterprises, reform taxation, and create a new credit distribution role forthe National Bank of Yugoslavia.Although the program was initially successful, its overall results were veryuneven. Stabilization reforms were implemented amidst a series of free electionstaking place in different republics. Pressed by the need to receive public support,

No-name money 153many political leaders were successful in gaining popularity by circumventing thestabilization plan. In particular, some politicians created regulatory loopholes,weakened the popular perception of the desirability of the plan, and triggered newinflationary expectations. As a result, fiscal pressure prevented monetary disciplineand, in spite of the temporary improvement, the federal government experienced asharp loss of credibility and the inflationary spiral resumed.After the failure of this attempt, it became evident that the Yugoslavian federalgovernment did not possess the political leverage necessary for a successfultransition from a socialist to a market economy. The situation worsened toward theend of 1990, when exports fell sharply. 6 On December 28, 1990, in an attempt tosupport exports, the federal government of Yugoslavia devalued the currency,from seven to nine dinars per Deutschemark. Because of the combined effect of theincrease in monetary base and of the depreciation, the inflationary spiral gainedfurther strength. In addition, the branch of the central bank located in Serbia issueda large quantity of additional currency without the approval of the main office ofthe Central Bank of Yugoslavia. 7 By the end of 1990, the annual inflation rate inYugoslavia exceeded 500 percent. Crippled by monetary instability, and in light ofthe uncertain nature of the anticipated political restructuring, many of the republicsceased to comply with federal regulations, refused to pay taxes to the federalgovernment, and precipitated the dissolution of the federation.The events in Yugoslavia triggered an inflationary momentum of significantstrength. History shows that hyperinflation may be caused by unsound monetaryand fiscal policies (e.g., the Weimar Republic in the 1920s) sometimes coupled withpolitical disintegration. Yugoslavia in the late 1980s clearly combined both elements.In addition to a change in monetary policy, the elimination of this type ofinflationary momentum requires the establishment of a new political order.Clearly, the Slovenian authorities (e.g., central bank and Ministry of Finance)understood this problem and exhibited remarkable technical competence in tacklingthe issue. From the beginning, the stabilization program was based on isolatingthe Slovenian economy from Yugoslavia by creating an independent central bank,sound monetary policy, and a freely convertible new currency. Nevertheless,although it is important to recognize its technical merit, it is also crucial to understandthe public choice aspects that contributed significantly to the success of thestabilization program.The declaration of independence and the return ofcredibilityAcross the republics, the climate of distrust for the Yugoslavian governmentprovided a fertile ground for politicians to offer independence as an alternative. 8 Inthis climate, the Slovenian Assembly began nurturing the idea of independenceand national sovereignty. Slovenian voters (as well as voters in Croatia) historicallysaw themselves as belonging to the West and were very susceptible to argumentsmade by a number of Slovenian politicians that the Yugoslav government wasresponsible for Slovenia’s lagging behind Western Europe. Since Slovenia was the

154 Maria Minniti and Lidija Polutnikrichest and most developed of the republics of Yugoslavia, arguments regarding“exploitation” by less developed republics and provinces also found fertile ground.As a result, political independence from Yugoslavia became a major part of publicdiscourse and the preferred path for Slovenia to catch up and become part ofWestern Europe.The loose monetary policy in Yugoslavia had caused consumer prices inSlovenia to grow at an annual rate of 1,253 percent between 1988 and 1989, and ata rate of 552 percent between 1989 and 1990. 9 Also, being one of the more exportoriented of the republics, Slovenia’s GDP had declined from $17.4 billion in 1990to $12.7 billion in 1991, a 27 percent decline. 10 Under pressure because of therapidly deteriorating economic situation of the late 1980s, the Slovene Parliamentvoted to hold a referendum on independence. While the economic rationale forindependence was a successful transition to a market system, political and populistarguments focused on Slovenian higher productivity, better work ethics, and on itsmore than fair contribution to the federation. At the referendum, held on December26, 1990, about 90 percent of the population voted in favor of independenceand Slovenia proposed the creation of a loose confederation among all Yugoslavrepublics. The ensuing negotiations, however, did not produce any result. Thus, onJune 25, 1991, the Slovene Parliament declared full sovereignty which ultimatelybecame effective after a three month moratorium on October 8, 1991.The Yugoslavian response was immediate and, on June 27, the Yugoslav armyinvaded Slovenia and took control of the country. Fortunately, the Slovenianpolitical leadership quickly created ties with the West and the intervention ofEuropean Community mediators prevented the invasion from developing into awar. Most of the other Yugoslavian republics had no clear political or ethnic identityand were, therefore, more vulnerable to external attacks or internal struggles. In asituation where the war had begun developing quickly on many fronts, a deeper andprolonged attack against Slovenia could have significantly endangered its existence.On July 7, a decisive agreement between all concerned parties and EC negotiatorswas reached and the war in Slovenia was avoided. Slovenia agreed to stop furtherimplementation of the declaration of independence for three months and theYugoslav side promised to end the hostilities and withdraw its army. Otherrepublics of the former Federation followed a different path and the formalsecession of Slovenia took place while a terrible war began to develop in the restof Yugoslavia. After three additional months of negotiations that yielded nopositive results, and in light of the disintegration of other parts of Yugoslavia,Slovenia resumed its plans and achieved complete independence by the end ofsummer 1991. 11While the independence process was taking place, it had become clear that thecredibility of the new government was a crucial factor for a successful transition toindependence. Such credibility rested on the government’s ability to nurturethe country’s self-confidence, reduce uncertainty, and restore sound marketincentives. Thus, macroeconomic stability was a necessary element for a successfultransition. 12 Macroeconomic stability, in turn, required monetary discipline.Many questions arose about how monetary discipline was to be created, and alter -native monetary arrangements were debated. Against the suggestions of foreign

No-name money 155consultants, who favored a currency board (Pleskovic and Sachs 1993, 1994),Slovenian authorities insisted on creating their own national currency as the onlyway to insure an independent monetary policy and successfully isolate the newcountry from Yugoslavia. Isolation had to be achieved in order to prevent theYugoslavian inflation from spreading to the new currency and to strengthen thecredibility of the new government.Breaking the inflationary catch: the introduction of thenew currencyIn late June 1991, before reaching complete independence, Slovenia adopted theLaw of the Bank of Slovenia, which created and empowered the central bank. TheBank of Slovenia replaced the National Bank of Yugoslavia as the lender of lastresort. Immediately, all bank claims and liabilities were transferred to its balancesheet, new and lower reserve requirements were applied, and the use of the discountfacility was reduced.In the mean time, reports had circulated that the Yugoslavian government wasattempting to undermine the newly independent country by using economicterrorism. Thus, rumors that Yugoslavia was planning to flood Slovenia withdinars in order to destabilize the country accelerated further changes. On October7, 1991, three months after creating the central bank, parliament called for theintroduction of the Slovene tolar. One day later, on October 8, 1991, the Republicof Slovenia passed two additional and very specific laws. The first one, theRepublic of Slovenia Monetary Unit Act, declared the Slovene tolar as the newlegal tender of the country and the adoption of a flexible exchange rate regime. Thesecond law, the Monetary Unit Application Act, provided for the introduction ofcurrency tokens as legal tender until tolar banknotes and coins could be issued.These provisional notes had been printed secretly during the last months of 1990.They were intended for use in case the central bank in Belgrade stopped supplyingSlovenia with dinars but, contrary to initial expectations, instead of preventing ashortage, they were put in circulation to neutralize a possible surplus of Yugoslavcurrency in Slovenia. Because of the initial uncertainty about their use, the noteshad no printed designation and, until the very last night before the currency switchtook place, remained nameless. 13In practice, the conversion process required a well-organized implementationthat would not disrupt daily economic activity. On October 8, 1991, the same dayof the official introduction of the tolar, all banks were closed. In addition, the centralbank instructed all banks, post offices, and Social Accounting Offices regardingthe terms and methods of conversion. The idea was simple: bank accounts, wages,and prices were to be converted automatically from dinars into the new currency,the tolar. Dinars in circulation, instead, were to be physically exchanged during ashort conversion period articulated in a main phase of three days, from October 9to October 11, and a second phase which lasted from October 12 to October 31.Ninety-nine percent of all dinar banknotes were replaced by new currency tokensduring the first phase, with most of the exchanges taking place through routinepurchases, while only a few customers exchanged currency at banks. 14

156 Maria Minniti and Lidija PolutnikIn Slovenia, the catch up component implied simply transferring the inflationaryexpectations associated to the dinar onto the tolar. In practice, there were no regulatoryor legal barriers against this risk. In fact, during the Yugoslavian inflation,dinars had ceased to serve as a reliable store of wealth and people had alreadybecome accustomed to keeping large holdings of foreign exchange. The timerequired for this inflationary transfer was also negligible, since to adjust theirbalances Slovenes did not need to change their consumption patterns nor the formin which they held their wealth. And yet, because the Slovenian authoritieshad restored the credibility of the government, the inflationary momentum wasinterrupted.In the earlier 1990s, the political and monetary disorder of Yugoslavia hadbecome so extreme that it created a general agreement that something needed tobe done. In Slovenia, supported by a strong sense of national pride for the newcountry, this awareness nurtured a rapid change of expectations. As previouslyargued, Slovenes were eager for a clear break with past policies. Thus, the adoptionof the new monetary unit strengthened the perception that policy had entirelychanged. Indeed, the introduction of the Slovenian tolar had not only economiccauses but also rested heavily on political and social grounds. “The politiciansopted for our own money for another reason. [The Slovenes] . .. wanted ourmoney, like a flag, as the symbol of national independence and a fulfillment ofdreams” (Ribnikar 1998: 9).The conversion process and the change in popularexpectationsThe conversion process was executed very smoothly and the newly created CentralBank of Slovenia exhibited remarkable competence. Yet, the asymmetric nature ofthe expectations of different groups of dinars’ holders played a crucial role indetermining the positive outcome. On the one side, given the uncertainty of thefuture of this newly formed country and its new currency, speculative inflows ofdinars from the rest of Yugoslavia were negligible. On the other side, the Slovenes’willingness to accept the unknown tokens in exchange for well-known dinarsenabled the conversion process to proceed smoothly.Without a strong popular support, it is likely that the currency conversion wouldnot have been as successful. Because people’s expectations played such an importantrole, the Slovenian example points out the importance of social conditions forthe successful introduction of a new fiat money. Indeed, people’s expectations inSlovenia were not about “how credible the anti-inflationary program was going tobe.” It is also most unlikely that the population was aware of the necessity or desirabilityof controlling the money supply. Instead, popular expectations were formedon the belief that Slovenia would be better off as an independent state than as a partof Yugoslavia. Because of this belief, the Slovenes trusted, and willingly accepted,the new national currency. In fact, they used in exchange, and held positive balancesof, the nameless tokens even before learning what their real purchasingpower was going to be. 15Conscious of the importance of people’s expectations, the Slovenian central

No-name money 157bank chose the one to one conversion ratio, in part to preserve the goodwill of thepopulation and prevent the re-emergence of old fears caused by negativeexperiences with past currency conversions. The argument that a more favorableexchange ratio would raise confidence in a new currency unit and lower inflationaryexpectations was rejected. So were other, more drastic, arguments involvingdifferent conversion rates depending on the owner, form, and value of the assetconverted. 16In a sense, the process by which the value of the tolar was eventually determinedin the market can be thought of as being analogous to the float of a new companywith very little track record on the stock market. People may be persuaded to buy itsshares initially, just as people were initially persuaded to hold tolars. But how thevalue of the shares will change in the future is anybody’s guess and it depends, to alarge extent, on how the company is managed. Likewise, the value of the tolarstabilized in terms of goods and other currencies as soon as it became clear that itwas managed well by the central bank. This meant that more and more peoplewere willing to hold it, and to hold increasing amounts. As expected, inflationdeclined, the demand for real cash balances in tolars increased, and the inflationarymomentum was interrupted. 17Indeed, in a situation like that of Slovenia in 1991, one cannot emphasize enoughhow important it was for the government strategy to be in tune with a winningcoalition of voters. Since a real possibility existed that inflationary expectationsassociated with the dinar would extend to the tolar, a crucial aspect of the successof the reform was the Slovenian central bank’s ability to successfully leveragethe unstable economic environment and to influence popular expectations,thereby breaking the inflationary momentum. On October 8, 1991, in addition tointroducing the tolar as sole legal tender in Slovenia, the Monetary Unit CurrencyAct also established that the new national currency was to be convertible from thebeginning, and was to trade freely against the dinar and other internationalcurrencies.The importance of the coalition between the Slovenes and their monetaryauthorities is further illustrated by comparing the Slovenian experience in stoppinginflation with the inflationary dynamics within the Croatian economy over theperiod January 1992–December 1999. In Croatia, the reform has not been able tocreate the alignment of incentives between monetary authority and populationwitnessed in Slovenia. In fact, the structural break in the inflationary processcorresponding to the Croatian anti-inflationary stabilization program of October1993 has shown the Croatian inflation to be positively related to wage growth andcurrency depreciation (Payne 2002). Despite almost 10 years of low inflation,Croatia continues to experience high levels of currency substitution. Roughly,three-quarters of bank deposits and currency in circulation are held in foreigncurrency, especially US dollars and euros (Kraft 2003). This significantly limits theability of the Croatian central bank to conduct its own independent monetarypolicy. The country payment system is also affected since banks, in trying to avoidbalance sheet mismatches, are forced to link via indexes all credit transactions tothe exchange rate. Such an environment increases credit risk, reduces the amount

158 Maria Minniti and Lidija Polutnikof lending, and may slow down the development of domestic markets. In addition,the possibility of some unexpected depreciation could lead to further flight from thecurrency. Although moderate in recent years, currency substitution could thenbecome an inflation pass-through. Policy options such as the adoption of the euroas the official currency or the imposition of more strict limits for the dirty floatcurrently applied have all been discussed (Vujic and Wachtel 2003). Nevertheless,unlike Slovenia, Croatia remains vulnerable to the possibility of a new inflationaryspiral.The stabilization period and the virtuous circleA crucial aspect for the introduction of the new currency and, in general, for thesuccess of the stabilization process was the central bank’s choice of an appropriateexchange rate. Several arrangements were possible with respect to the foreignexchange system. Among them was the use of a currency board in which the tolarwould be linked to the Deutschemark through a fixed conversion rate and the issueof tolars would be fully backed by foreign exchange reserves. 18 The currency boardwas ruled out because Slovenia did not have foreign exchange reserves and externalfinancial support could not be secured to allow this arrangement to succeed. 19 Analternative proposal contemplated the introduction of a parallel currency tocirculate alongside the Yugoslav dinar. Under this arrangement, both currencieswould have remained legal tenders. This proposal was strongly opposed from thebeginning because the existence of the new currency alongside the old dinar wouldhave reduced the perception of complete autonomy from the old regime andweakened popular support. This, in turn, would only aggravate the existingcurrency substitution problem while, at the same time, leaving Slovenia exposed toYugoslav inflation and monetary attacks.Although the pegging option, favored by foreign experts, was debated for a fewmonths, the newly created central bank, and the political leadership headed byPrime Minister Lojze Peterle, both stood firmly in favor of a single independentcurrency, of a floating exchange system, and of monetary rigor. Their position,eventually, prevailed. 20 Initially, the Deutschemark was used as the reference currency,and the starting exchange rate for assets and liabilities in foreign currencieswas set to be 32 tolars per Deutschemark. 21 The initial tolar exchange rate was setrather arbitrarily to match the real exchange rate of the dinar. From October 1991to June 1992, the external value of the tolar declined sharply. The depreciation hadseveral causes. First, the new central bank had not yet built its reputation. Second,while popular expectations about the new currency were very optimistic, there wasstill some currency substitution. Third, inflation, although decreasing, was stillsignificant. Throughout 1992 the Bank of Slovenia maintained its commitmentto domestic stability. Thus, monetary policy was aimed at regulating the moneysupply, while the exchange rate was determined endogeneously. 22By April 1992, six months after the creation of the central bank, and less than ayear after independence, the creation of a new independent monetary area and theintroduction of a new stable fiat currency both had been successfully accomplished.

No-name money 159While inflation in the rest of Yugoslavia accelerated very quickly, Slovenianmonthly inflation, after a very short period of two-digit rates, declined consistentlyuntil it slowed down to 1.4 percent in August 1992. The Slovenian monthlyinflation rate in October 1991 had exceeded that of Yugoslavia, by April 1992 ithad declined to 5.1 percent, while Yugoslavia was entering hyperinflation withmonthly rates exceeding 70 percent. The Yugoslav inflation peaked at 102 percentper month in June 1992. In the same time period, Slovenian inflation had decreasedto 2.4 percent per month. 23Under a technical point of view, Slovenia made the “right” anti-inflationarydecisions by triggering a “virtuous circle” (Yeager 1981: 34). Specifically, a virtuouscircle is created by the simultaneous adoption of a restrictive monetary policy and afloating exchange rate regime for the new currency. In Slovenia, the appreciationof the new domestic currency on the foreign exchange market lowered the domesticprices of imported goods and those of import-competing and export goods. Thus,facilitated by the reduced growth of the money supply, the tolar gained additionalstrength on international markets. Of course, the virtuous circle working throughimport and export prices is particularly important for a country as small as Slovenia,whose growth and development rely so heavily on international markets. This is sobecause by enabling the adjustment of internal and external prices to new tradepatterns, the floating exchange rate promoted a quicker adjustment of expectations.In addition, these adjustments helped the country to allocate resources and effortstowards comparatively advantageous sectors. 24Finally, temporary measures including some price controls also proved useful inbreaking the momentum of inflation during the first couple of years after the introductionof the new currency. In fact, the analysis of the catch up component ofthe inflationary momentum leads to the question whether it is better to achievestabi lization gradually or through a shock therapy. Gradualism is favored by argumentsthat hinge on its ability to reduce the friction caused by changes in the allocationof resources. Additionally, gradualism is supported since it takes time toachieve the degree of credibility necessary for avoiding severe side effects andto change expectations. Arguments against gradualism, on the other hand, claimthat gradualism leaves sufficient time for speculation and inflation hedging, andthat gradualism may hide a dramatic policy change and, therefore, fail in turningaround expectations and weakening popular support. The Slovenian stabilizationprocess succeeded in creating the perception of a dramatic policy change. It is thisperception that assured voters’ support while, at the same time, taking a moregradual approach with respect to areas less exposed to popular scrutiny and concern.Specifically, the stabilization program adopted a slow and gradual strategywith respect to the reorganization of the banking industry.At the time of the newly acquired independence and of the ongoing war in therest of Yugoslavia, Slovenian banks found themselves holding a large portion oftheir asset portfolios in the form of non-performing loans, or frozen in repossessedYugoslavian assets. 25 These losses, which were increasing rapidly because ofinflation, were recorded on the balance sheet of the Yugoslavian central bank andwere recognized at the federal level as public debt. The newly created Bank of

160 Maria Minniti and Lidija PolutnikSlovenia, however, did not report those debts into its balance sheet nor recognizedthem as its liability toward commercial banks. To do so would have meant to beinsolvent from inception. Instead, commercial banks were obliged to continuekeeping these losses in their balance sheets as claims against the Yugoslaviancentral bank. Of course, under these conditions, most Slovenian banks becameinsolvent. Thus, to prevent the collapse of the banking system, the new Sloveniangovernment enacted a bank-specific rehabilitation program aiming at supportingbanks and preventing an epidemic of bank failures (Minniti and Polutnik 1999).The Slovenian experience with stopping inflationYeager (1981) identifies some general features of inflation whose analysis is fundamentalwhen investigating ways to reduce its incidence. Among these features, theimportance of the inflationary momentum, that is the ability exhibited by inflationto perpetuate and deepen itself, is especially emphasized. Specifically, the inflationarymomentum is described as having three distinct elements: (1) the credibilitycomponent; (2) the catch up component; (3) the expectations component. Clearly,all three elements are strictly related. The Slovenian case shows how the threeaspects culminated in a change of inflationary expectations. We argue such achange, together with a sound monetary policy, to be a necessary condition for thesuccessful interruption of the inflationary momentum.The formation of expectations may be discussed by considering the length of theadjustment process between change in prices and changes in real cash balances.Desired levels of real cash balances depend on actual changes in prices. In anenvironment characterized by rapidly changing inflation, actual levels of real cashbalances are not equal to desired levels. Once decided on the desired level,individuals can easily adjust their actual balances by spending them or by sellingother assets for cash. At the time of the Yugoslavian regime, Slovenes had done justthat by substituting dinars with foreign currency. Also, in order to choose anappropriate level for their cash balances, individuals look back in time in order toassess the current trend of prices (Cagan 1956). But there was no trend for theSlovenes. Thus, they could have easily continued holding foreign currency. Thisrisk was reinforced by the second element of the inflationary momentum, that is itscatch up component.The expectation component of the inflationary momentum makes the credibilityof an anti-inflation policy very important in determining the overall costs of thestabilization process. Although inflation is always a monetary phenomenon, thefact that it may be stopped with a drastic change in the political situation suggeststhat its creation and sanctioning have also political roots. Interestingly, muchhistorical evidence illustrates the importance of political and social pressure incausing inflationary policies. In the case of Slovenia, however, political and socialcomponents embraced disinflationary policies. With the exceptions of pricecontrols imposed by the Yugoslavian government, long-term contracts hadvirtually ceased to exist. Thus, there were no influential groups lobbying in favor ofmaintaining the status quo. In addition, “the paramount role of price stabilization

No-name money 161was reinforced by the fact that creation of a new currency was the very process ofestablishing the credibility of a new state” (Bole 1996: 234).The temporal dimension of the process leading to the determination of the valueof a new fiat currency is also important. It contributes to the explanation of thepersistence of inflation even after its monetary causes have been removed. In thecase of Slovenia, the inflation rate declined rapidly and settled, within a few months,at levels that compared favorably with most Western European economies. Thishappened because the anti-inflation program was sufficiently credible to overturnexpectations and cause at least a sufficient number of individuals to revise theirexpectations accordingly. If prices, including the prices of labor, rise at a significantrate for a prolonged period of time, individuals learn how to predict those changesand adjust their expectations accordingly. A new restrictive policy has the potentialfor succeeding in stopping inflation only if individuals are willing to respond to it.And individuals react to the policy only if the strength of the signal is such to makethem fear that, by not adjusting their behavior, they will lose competitiveness.Evidently, in Slovenia, a sufficient number of individuals believed that otherswere to have similar perceptions and revised their expectations and behavioraccordingly. Thus, given the restrictive policy implemented, the new actual rate ofinflation emerged as the unintended consequence of adjustments in individualexpectations.Finally, the initial exchange ratio of one tolar for one dinar performed the role ofa “launching vehicle.” 26 But, in fact, the exchange ratio between goods and servicesand the tolar was not yet established. Although the policy switch had changed theequilibrium price level, this new equilibrium was still unknown and, as discussedpreviously, partly dependent on changes in people’s expectations. Since moneydoes not have a specific market, the determination of its “price” has to be reachedthrough adjustments and trials in all markets, and such a process may take a longtime. This is a process with multiple possible equilibria, including a non-monetaryone in which the currency fails to receive acceptance. Indeed, this was certainly apossibility in Slovenia, where people still remembered negative experiences withprevious conversions and where a large portion of the country’s wealth was alreadykept in foreign currency. Interestingly, in the case of Slovenia, the initial exchangerate with the dinar did represent a “launching vehicle,” but the new currencyworked exactly because the initial parity was immediately abandoned. In otherwords, the tolar was accepted and used on the basis of trust, while its real value wasstill unknown.ConclusionShortly after the declaration of its independence, in 1991, Slovenia succeeded inreducing inflation and in establishing a new political system. This success wasaccomplished through a gradual approach that included tight controls over themoney supply and some temporary controls on selected prices. In this paper, weargued that one of the crucial factors that allowed the success of the stabilizationprocess was the introduction of a new, independent and freely floating currency. In

162 Maria Minniti and Lidija Polutnikaddition to enabling the Bank of Slovenia to implement a new course of monetaryaction, the tolar strengthened popular support for the new government andcemented a rapid and significant change in expectations.During periods of hyperinflation, expectations cause the velocity of money toaccelerate as inflation increases, and to decrease as stabilization policies take place.But the change in expectations necessary for this switch to happen requires morethan a change in monetary policy. The Slovenian authorities exhibited remarkabletechnical competence and based the stabilization process on sound monetarypolicy and a freely convertible new currency. Since a real possibility existed thatinflationary expectations associated with the dinar would extend to the tolar, acrucial aspect of the success of the reform was the central bank’s ability tosuccessfully leverage the unstable economic environment and to influence popularexpectations, thereby breaking the inflationary momentum.The Slovenes’ willingness to accept the unknown tokens in exchange for wellknowndinars allowed the success of the conversion process. It is unlikely that thepopulation was aware of the necessity or desirability of controlling the moneysupply. Instead, popular expectations were formed on the belief that Sloveniawould be better off as an independent state than as a part of Yugoslavia. The adoptionof the new monetary unit strengthened the perception that, indeed, policyhad entirely changed. Because of this belief, the Slovenes trusted, and willinglyaccepted, the new nameless tokens even before learning what their real purchasingpower was going to be, thereby determining, endogenously, that real purchasingpower be positive and a relatively stable one. Overall, without influential groupslobbying in favor of maintaining the status quo, Slovenian political and socialcomponents embraced disinflationary policies.In the end, of course, the more appealing aspect of the Slovenian story remainsits ability to illustrate the unavoidable interdependence between social environment,economic conditions, and politics. The Slovenian story shows how the interdependenceof these factors is especially significant in a risky landscape such as thatcreated by hyperinflation. And finally, it shows how their interplay sets the courseof history and, ultimately, can make the difference between war and peace.Notes* We thank Michele Fratianni, Roger Koppl, Ross MacLeod, and Ivan Ribnikar forhelpful comments on earlier drafts of this paper. All errors are ours.1 Pleskovic and Sachs (1994) argue that other economies in transition benefited greatlyfrom the Slovenian experience.2 This claim is consistent with Menger’s view that the emergence of a monetary unit aswell as its value are both evolutionary phenomena (Menger 1976: Ch. VIII).3 Fischer (1982) argues that, under certain conditions, benefits from an independentcurrency go well beyond those of seigniorage. The example of Slovenia suggests that thisis true even for a small economy.4 Bank of Slovenia, Annual Report, 1992.5 These reforms were proposed in 1987 and 1988 by the Mikulic government. At thattime, a monetary system committee was set up and led by Ivan Ribnikar. Two yearslater, Ribnikar, an economist who had always strongly advocated monetary stability and

No-name money 163private ownership, would join Velimir Bole and Jose Mencinger in advising Arhar, thenewly appointed governor of the Bank of Slovenia. In 1991 and 1992, the four men wereto become the architects of the monetary reform in Slovenia.6 The share of exports as a percentage of imports decreased from 105.97 percent in 1989to 87 percent in 1990 (Statistical Yearbook of the Republic of Slovenia 1996: 359).7 Yugoslavia had a decentralized central banking system. Each of the eight republics andautonomous provinces had its central bank. The federal governing body was composedof the governors of all central banks. Within each region, all claims and debts to thecentral banking system were resolved by the local central bank, with currency being theonly exception.8 Specifically, many voters still remembered the Kingdom of Serbs, Croats, and Slovenes,which preceded Yugoslavia, as well as World War II in which different Yugoslavianrepublics had fought on different sides.9 Statistical Yearbook of the Republic of Slovenia (1996).10 The decline of GDP among all Republics averaged 21 percent (Bank of Slovenia 1992,Annual Reports).11 On January 15, 1992, the European Community ratified Slovenia’s independence,thereby making its existence official. Six months later, the United Nations followed andrecognized Slovenia as a sovereign country.12 The complete stabilization program is detailed in a report issued at the end of 1991 bythe Executive Council of the Assembly of the Republic of Slovenia (Assembly of theRepublic of Slovenia 1991).13 The name was chosen by the Parliament among several alternatives including tolar, lipa,krona, klas, karant, and, of course, Slovenian dinar.14 A few restrictions were imposed on the conversion process. Amounts of up to 20,000dinars (approximately twice the average monthly salary) were converted without anyrestrictions. Amounts between 20,000 and 50,000 dinars, instead, were converted intotolars and credited to the bearer’s current or savings accounts. Finally, amounts of over50,000 dinars were converted only at branches of the Social Accounting Service or atspecial counters of the Bank of Slovenia. In all three cases the institutions converting thecash recorded the transaction and the identity of cash bearers. In line with the smoothnessof the conversion, however, the number of cash operations exceeding 20,000 wasnegligible.15 Because of the flexible exchange rate and because of the catch up effect of theYugoslavian hyperinflation, the value of the tolar remained uncertain for the 10 monthsfollowing its introduction.16 During the collapse of the Austro-Hungarian Monarchy at the end of World War I,south Slavs formed the State of Slovenes, Croats, and Serbs and, on December 1, 1918,joined Serbia and Montenegro to form the new Kingdom of Serbs, Croats, and Slovenes.Until 1924, four currencies were in circulation in the Kingdom: crowns in the formerAustro-Hungarian regions, and dinars, levs, and perpers in Serbia and Montenegro.After several attempts at reforms, central authorities introduced an exchange rate of 4crowns per dinar, thereby imposing a significant penalty on crown holders. Slovenes,who at that time populated some of the least developed regions of the monarchy, tradedin crowns and were among the most heavily penalized groups. Similarly, at the end ofWorld War II, the Yugoslav government withdrew from circulation all occupationmonies (Croat kuna, Serbian dinar, Reichsmarks, Italian liras, Hungarian pengos, etc.)and introduced a new Yugoslavian dinar. Each old currency was exchanged at adifferent rate for the new one. In addition, at the exchange, a maximum of 5,000 dinarswere paid in cash, while the rest remained blocked against receipts, which could beexchanged only after three additional months passed (Notel 1986: 508, 547).17 We are thankful to Ross MacLeod for suggesting this useful analogy.18 Specifically, Pleskovic and Sachs (1994) proposed and advocated a currency board alongwith a fixed or pegged exchange rate regime.

164 Maria Minniti and Lidija Polutnik19 At the end of September 1991, the total foreign exchange reserves of the countryamounted to $170.1 million and consisted exclusively of commercial banks’ operatingaccounts (Bank of Slovenia 1995: 42).20 The Slovenian government contracted advisory services from Jeffrey Sachs. Soon, however,substantial differences developed between the views of Sachs and Joze Mencinger,at the time deputy prime minister of the economy (Mencinger 1993a; Pleskovic andSachs 1993). Eventually, in a memorandum issued on October 8, 1991, Western expertsJeffrey Sachs and Boris Pleskovic changed their view in favor of unrestricted floating(Mencinger 1993b: 11).21 Frankfurt cross exchange rates determined other rates.22 This is consistent with Yeager’s concern that “Loosely speaking, the smaller the countryis in relation to the rest of the world, the more the price incentives of adjustment occur athome rather than abroad” (Yeager 1968: 50).23 By 1994, however, the sharp decline of domestic inflation, coupled with some remainingwage controls, produced a significant real wage increase that, in turn, caused a sharpappreciation of the tolar and imports to increase. As a result, the balance of paymentregistered a significant trade deficit. The Bank of Slovenia was forced to intervene to stopthe foreign currency inflows by stabilizing the tolar and its foreign exchange reservesincreased to $770.1 million (Bank of Slovenia 1994: 28). At that time, the central bankadopted a substantive sterilization policy by issuing bonds with warrants in order towithdraw liquidity from the market. This indicates that, at least until that point, thecentral bank maintained its commitment to monetary stability. This episode is analyzedin Koppl and Mramor (2003).24 Ribnikar (1998) argues that the adjustment of trade patterns executed with little to nomonetary distortion was necessary to guarantee that the Slovenian economy was soundand competitive enough to successfully survive its possible entry in the European Unionand the adoption of yet another super-national currency.25 Most non-performing loans had been made to Slovenian companies that had lost theirmarkets in other Yugoslav republics.26 The concept of initial fixed exchange rates as “launching vehicles” for new fiat currencyis discussed in Selgin (1994).ReferencesAssembly of the Republic of Slovenia (1991). Program for Structural Adjustment and EconomicPolicy in 1992. Ljubljana: Executive Council Report.Bank of Slovenia (1991–97). Annual Reports.Bank of Slovenia (1994). Monthly Bulletin, June–July.Bank of Slovenia (1995). Monthly Bulletin, January.Bole, Velimir (1996). Stabilization in Slovenia: From High Inflation to Excessive Inflow ofForeign Capital. In M. Blejer and M. Skreb (eds.) Macroeconomic Stabilization in TransitionEconomies. Cambridge: Cambridge University Press, pp. 234–55.Cagan, Phillip (1956). The Monetary Dynamics of Hyperinflation. In M. Friedman (ed.)Studies in the Quantity Theory of Money. Chicago, IL: University of Chicago Press, pp. 25–117.Fischer, Stanley (1982). Seigniorage and the Case for a National Money. Journal of PoliticalEconomy, 90(2): 295–313.Koppl, Roger and Dusan Mramor (2003). Big Players in Slovenia. Review of AustrianEconomics, 16(2/3): 253–69.Kraft, Evan (2003). Monetary Policy under Dollarisation: The Case of Croatia. ComparativeEconomic Studies, 45(3): 256–77.

No-name money 165Mencinger, Joze (1993a). How to Create a Currency? – The Experience of Slovenia.Weltwirtshaftliches Archiv, 129: 418–31.Mencinger, Joze (1993b). Comment of Slovenia’s Former Deputy Prime Minister. Transition,4(1): 11.Menger, Carl (1976). Principles of Economics. New York: New York University Press.Minniti, Maria and Lidija Polutnik (1999). Financial Development and Small FirmFinancing in Slovenia. Comparative Economics Studies, 41(2/3): 111–33.Notel, Robert (1986). International Finance and Monetary Reforms. In M.C. Kaser andE.A. Radice (eds.) The Economic History of Eastern Europe 1919–1975. Vol. II. Oxford:Clarendon Press.Payne, James E. (2002). Inflationary Dynamics of a Transition Economy: The CroatianExperience. Journal of Policy Modeling, 24(3): 219–30.Pleskovic, Boris and Jeffrey Sachs (1993). Authors’ Response: We Still Take Great Pride.Transition, 4(1): 11–12.Pleskovic, Boris and Jeffrey Sachs (1994). Political Independence and Economic Reform inSlovenia. In O.J. Blanchard, K.A. Froot, and J.D. Sachs (eds.) The Transition in EasternEurope. Chicago, IL: The University of Chicago Press.Ribnikar, Ivan (1998). From Monetary Integration via Independence to Integration Again?The Case of Slovenia. Manuscript. University of Ljubliana.Selgin, George (1994). On Ensuring the Acceptability of a New Fiat Money. Journal of Money,Credit and Banking, 3: 236–58.Statistical Yearbook of the Republic of Slovenia (1996).Vujic, Boris and Paul Wachtel (2003). Editorial, Special Issue on Dubrovnik EconomicsConference on Currency Substitution and Monetary Policy in Emerging MarketEconomies. Comparative Economic Studies, 45(3): 213–14.Yeager, Leland B. (1968). The International Monetary Mechanism. New York: Holt, Rinehartand Winston, Inc.Yeager, Leland B. (1981). Experience with Stopping Inflation. Washington DC: AmericanEnterprise Institute.Yeager, Leland B. (1997). The Fluttering Veil. Indianapolis: Liberty Fund.

12 Monetary disequilibriumtheory and AustrianmacroeconomicsFurther thoughts on a synthesisSteven HorwitzIt is a pleasure to contribute to a volume honoring the work of Leland Yeager. It haslong been my belief that Professor Yeager is, perhaps, the most under-appreciatedmonetary theorist of the twentieth century. 1 He has contributed to our understandingof the role of money in advanced economies and to the macroeconomicprocesses of those economies in ways that reveal profound insights into theoper ation of the market process. His pursuit of “good economics” withoutsignificant regard to the winds of intellectual fashion, whether those fashions bemethodo logical or ideological, along with his refusal to be pigeon-holed into an allencompassingschool of thought by which others could define, and perhaps dismiss,his work, make him an inspiring role model for all who see themselves in similarterms. In the spirit of Yeager’s non-sectarianism, I would like to explore the connectionsbetween Yeager’s work in the monetary disequilibrium theory traditionand recent work in Austrian macroeconomics. What I hope to show is thatAustrians have much to learn from Yeager and that Yeager’s work is morecompatible with Austrian macroeconomics than he has been often willing toadmit. 2 In finding the common ground between these two bodies of work, I hope tocreate a common theoretical language through which might emerge a twenty-firstcentury macroeconomics that takes money, the disequilibrium market process, andmonetary institutions more seriously.This attempt to find a common theoretical language that could include insightsfrom both monetary disequilibrium theory and Austrian macroeconomics is incontrast to the argument in Rabin’s (2004: 203) otherwise excellent book that theAustrian theory is an “alternative” to the monetary disequilibrium approach andthat Occam’s Razor demands that the Austrian approach be jettisoned because it is“unnecessarily specific” and because the monetary disequilibrium approach canexplain the same phenomena more simply. Key to Rabin’s argument is his claimthat the savings–investment nexus is largely a sideshow to the main monetaryissues. I will attempt to argue instead that the two approaches can be combined,rather than one subsumed in the other, and that, if anything, we can make good useof Garrison’s (2001) three quadrant “macroeconomics of capital structure” modelto illustrate important aspects of Yeager’s approach.

Monetary disequilibrium theory and Austrian macroeconomics 167“The essential properties of the medium of exchange”and the market processYeager’s (1968) understanding of the monetary disequilibrium tradition beginswith the fundamental properties of money. The most important of these propertiesis that money is the generally accepted medium of exchange. In an advancedeconomy, money is half of (virtually) every exchange. Although we normally thinkin terms of money holders buying goods and goods holders selling goods, it isfruitful to remember that the money holders are also selling money and the goodsholders are also buying money. The exchange of money for goods between twotraders is also an exchange of money for goods or goods for money in the pockets ofeach trader. Money’s role as half of every exchange points out the way in which suchexchanges cannot even occur if money does not exist, and how potential exchangesthat are of mutual benefit might not take place if the supply of money is insufficient,whatever that might mean. Finally, it is through the monetary exchange processthat goods acquire prices reckoned in money, which enables actors to engage ineconomic calculation and contemplate more effectively the costs and benefits oftheir actions.Two other features of money that Yeager emphasizes are that the demand formoney is a demand to hold real money balances and that our acquisition of moneyhas a “routineness” to it that distinguishes it from other goods. The so-called “cashbalance” approach to the demand for money dates back at least to Mises, but it isemphasized and made effective use of in Yeager’s monetary theory. The demandfor money is understood to be a demand to hold a certain quantity of purchasingpower in one’s wallet, pocket, or bank account. We demand money by allowing itto accumulate in our various money balances. When we spend money, we reduceour demand for it. Another way to look at this is that money is one form in which wemight choose to store our wealth, thus the act of purchasing is, to the buyer, a tradeof a monetary asset for some other kind of asset. The advantage of holding moneyrather than other assets is that money provides the service of being “available” ifone desires to make a purchase. This notion of “availability” is equivalent to“liquidity,” and the liquidity of the medium of exchange is (near) absolute. No otherasset can be costlessly used to make exchanges, thus the advantage that money hasover other assets.Nothing in these first two properties of money would be strange to Austrianmacroeconomists. The first coincides nicely with Menger’s (1892) work on theorigin of money and Mises’s (1980 [1912]) extensions of it in The Theory of Money andCredit. The second reflects a sound Austrian subjectivism, in recognizing that whatmoney does is precisely what every other good or service does – provide a stream ofsubjectively evaluated use-services. The “return” to money held is ultimately thesubjectively evaluated utility that actors expect from those availability services, justas the “return” to an automobile is the subjectively evaluated utility of the various(including but not limited to transportation) services it provides. 3These first two properties combine to provide the distinction between “actual”and “desired” money balances. Much confusion in monetary theory comes fromoverlooking this distinction. Although it is true that at any moment in time, all

168 Steven Horwitzmoney is being held somewhere by someone, that does not mean that the supplyand demand for money are always in equilibrium with respect to each other. 4 Todraw that conclusion is to confuse the “desired” and the “actual,” or in the terms ofthe Swedish economists of the 1930s, it confuses the “ex ante” and the “ex post.”Just as with any other good where the amount purchased has to equal the amountsold, so too with money someone must be holding every dollar. However, that neednot mean people wish to hold those dollars, in the same way that goods markets indisequilibrium can mean frustrated potential buyers and sellers. Differences amongindividuals’ actual and desired holdings of money are proximal causes of themaffecting the level of spending in the macroeconomy, as we shall see below. Whenthe supply of money is too large or too small, i.e., when we have inflation ordeflation, these discrepencies between actual and desired money balances appeareconomy-wide. The results are the various costs and discoordination associatedwith both inflation and deflation. To see those problems more completely, we needto turn to the third property noted above.Yeager’s (1968: 645) third property, the “routineness” of our acquisition ofmoney, is one that has had less attention paid to it by Austrians historically, despiteit being at least as important as the other two for understanding the monetaryeconomy. What Yeager argues is that we will always accept money in exchangeeven if this means temporarily having more of it than we might wish to hold. Weknow we can always trade the excess for goods and services. The importantimplication of this insight is that we have much more control over getting rid ofmoney than we do obtaining it. This point is particularly important when money isin short supply. If one’s money balances are lower than one would wish, one hasonly two basic options: acquire more money, or reduce one’s expenditures. Giventhat money continues to arrive in a routine way, by reducing one’s expenditures,one can allow one’s money balances to replenish. Balances can also be replenishedby increasing one’s income or by selling off assets, but both of those require thecooperation of willing others. Reductions in expenditures are completely in thecontrol of the actor. With excess supplies of money, it certainly makes more sense toeliminate the imbalance by spending it and acquiring non-money assets than itwould to reduce one’s money holdings by reducing one’s income!What becomes clear from Yeager’s approach is that discrepancies between theactual and desired quantity of money will result in changes in expenditures,affecting the traditional macroeconomic aggregates. When actual holdings are lessthan desired holdings, expenditures will fall and recession will ensue in a process tobe explored below. When actual holdings exceed desired holdings, the excesses willbe spent, driving up prices and causing various forms of economic discoordinationthat will also be explored below. The key point for reconciling Yeager’s approachwith that of the Austrians is to recognize that the former case, that of the insufficientsupply, corresponds to the traditional monetary disequilibrium theory explanationof depressions, while the latter case, that of the excess supply, corresponds to theAustrian concern with inflation and the possibility that it could generate a businesscycle and eventual depression. These two theoretical approaches can fruitfully beseen as two elements of the same underlying story.

Monetary disequilibrium theory and Austrian macroeconomics 169Central to that story is the market process that is kicked into motion by eithercase of monetary disequilibrium. Rabin (2004: 71–4) describes this as “TheWicksell Process” (or what both Keynes and Friedman called the “fundamentalproposition in monetary theory”). We start by noting that because the demand formoney is a demand for real purchasing power, we need to distinguish between thenominal and real demand for money. We then combine this point with the earlierargument that the actual/desired imbalance will either increase or decrease spendingdepending on the direction of the imbalance. The result of those changes inspending will be upward (in the case of too much money) or downward (in the caseof too little) pressure on prices. As prices begin to move in the appropriate direction,the nominal demand for money moves in the same direction – as prices begin torise, actors will demand higher nominal money balances, and as prices fall, theirnominal money demand will fall. Eventually, and how long this takes is crucial tounderstanding the problems that monetary disequilibria can cause, the price levelwill change to the extent necessary to drive the nominal demand for money intoalignment with the real quantity in existence. Put differently, the changes in theprice level that occur during this disequilibrium market adjustment process induceactors to be increasingly satisfied with their real money balances. The changes inthe price level cause changes in the real value of actual money balances, leading tochanges in the actor’s nominal demand for money until those changes in nominaldemand are aligned with the real value of actual holdings (cf. Rabin 2004: 77).To see this more clearly, we can explore each of the two disequilibrium casesseparately. In the case of actual balances being less than desired ones, actors willrestrict their expenditures in order to replenish their money balances. As everyoneattempts to do the same thing, there will be downward pressure on prices, asdemand slackens economy-wide. Eventually, sellers will begin to lower prices. Thiswill increase the real value of the people’s actual money balances, pushing themslightly upward toward their desired levels. Prices will continue to fall in the face ofdemand still well below the original starting point, even as expenditures might startto recover from their early trough. Prices will stop falling when the real value of thequantity of money in existence matches the demand for real balances. If actualbalances exceed desired balances, then the resulting increase in expenditures willput upward pressure on prices. As prices begin to climb, the real value of the excessbalances falls, thus reducing the amount that is “excess” and slowly slackening theneed to shed them into the expenditure stream. This adjustment process will stopwhen the price level rises sufficiently to reduce the real value of the quantity ofmoney in existence such that it matches the demand to hold real money balances.To summarize: changes in the quantity of money that induce monetarydisequilibria will put into motion a market process that causes changes in the pricelevel that adjust the real value of that quantity of money (or, equivalently, thenominal demand for money balances) such that it matches the unchanged, exhypothesi,demand for real money balances. Changes in the demand for realbalances in the face of an unchanged quantity of money will also put this adjustmentprocess into motion and will cause the real value of the actual quantity of money tochange such that it matches the new demand for real balances.

170 Steven HorwitzFinally, although our focus has been on the way in which the market process willrestore equilibrium (again, ceteris paribus) through changes in the price level, wecan also point out that equilibrium can be restored through changes in the nominalquantity of money. For example, should the monetary authority mistakenly allowthe money supply to fall such that actual holdings are less than desired holdings, itcan respond with expansionary policy that reflates the nominal quantity such thatactual holdings realign with desired holdings. In the face of changes in the demandfor real money balances, the monetary authority can, in principle, respond quicklywith changes in the nominal supply in the appropriate direction that would changethe actual quantity to match the hypothesized change in demand. In the sections tofollow we will suggest why this strategy should be strongly preferred to allowing theWicksell adjustment process to play itself out.One important point of contact between Yeager’s perspective on monetarydisequilibria and Austrian economics is that it involves a process story of the sortthat Austrians generally favor. Specifically, if one looked only at the comparativestatics of the original equilibrium and the equilibrium after the Wicksell processplays out, and one focused solely on aggregates such as the price level, one might beled to conclude that there was no damage done. All that has happened is thatnominal values have been raised or lowered depending on which disequilibriumprevailed. However, as we shall see below and as the brief analysis above suggests,it is during those very disequilibrium market processes that all of the interestingthings happen, including the microeconomic discoordination that characterizesinflation and depression. Comparative statics will not suffice to elucidate the costsof deflation and inflation; only a theory that explains the underlying processes ofadjustment can do so. 5Excess demands for money and a market process theoryof depressionWhere the Yeagerian and Austrian theoretical frameworks meet is in seeing thedestructiveness of monetary disequilibria as taking place during the transition processthat moves from one point of monetary equilibrium to another. Although thecomparative statics may lead one to believe that it is “just” a matter of the pricelevel adjusting to realign the real value of actual money balances to the desired levelof real balances, the key shared insight is that the price level does not simply “just”change. The price level is in its essence a theoretical construct that reflects millionsof individual prices determined on individual markets across the economy. Whenmonetary disequilibria spill over into the spending stream, the changes in expenditureswill not affect all markets equally. 6 The result is that different prices will not beaffected equally as well. The upward or downward pressure on individual priceswill not be the same across markets. The ability of the price level to adjust to restoreequilibrium will depend upon the degree to which the various individual prices areable to adjust quickly and accurately in the face of monetary disequilibria. If pricesdo not adjust quickly to either excess supplies or demands for money, the economiccosts of those disequilibria will be revealed during the transition process.

Monetary disequilibrium theory and Austrian macroeconomics 171In the case of excess demands for money, the question is how quickly we canexpect prices to fall in the face of slackening expenditures. If it were the case that assoon as excess demands for money appeared, prices fell instantly to a lower levelthat restored the real value of actual money balances to the desired value, thenthose excess demands for money would be, for all intents and purposes, sociallycostless. However, if there are sound reasons to believe prices cannot react instantaneously,then the costs are real. To the extent that producers do not lower pricesin response to slackening demand, we will find pervasive excess supplies of goodsand services matching the excess demands for money. 7 Among the goods andservices in excess supply will be labor. The inability of prices to respond immediatelyleads to the classic signs of depression: unsold goods and unemployed labor.Assuming for the moment that prices are unable to respond quickly, we can seehow the original excess demand for money can spiral into what Yeager has termedthe “Wicksellian cumulative rot” (Yeager 1986: 370–1; cf. Rabin 2004: 74–5).The key additional assumption here is what is often termed the “dual-decision”hypothesis. Actors cannot separate the ability to spend from having earned theincome necessary to do so. That is, spending decisions are not completely separatefrom income decisions. In order to spend, we must have income and it must comefirst. Once spending begins to slow down in response to the desire to accumulatelarger money balances, it will reduce the incomes of those who see spending ontheir goods and services slacking off. As their incomes fall, their spending will fall offas well, which will reduce the incomes of another set of market actors, leading to afurther fall in their spending, and so on. This cumulative unraveling of the flow ofexpenditures is the monetary disequilibrium-induced depression. Without thespending, excess supplies of goods and labor quickly pile up, leading to theunemployment and idle capital that characterizes the downturn.The crucial assumption, however, is that prices cannot fall quickly enough toequilibrate the real supply of money and the demand for real balances withoutactors reducing their spending in order to reach the same result the hard way. Forboth Yeager and the Austrians, the explanation for what many have called the“stickiness” of prices is simply that markets are processes that unfold through time,rather than having the instantaneous auction-market characteristics of generalequilibrium models. 8 In opposition to the general equilibrium model of utility andprofit maximization, where any change in the “data” leads to an instantaneousrecalculation by agents, causing prices and quantities to adjust instantaneously, theAustrian–Yeager position sees actors as continually searching for, but notnecessarily maximizing, better opportunities. Such a behavioral rule might lead tohesitancy to reducing prices in the face of slackening demand if it occurs in a periodof generalized uncertainty, for example. Or, actors might wish to accumulate otherforms of data before choosing to react.In addition, as Shah (1997), Greenfield (1994), and Yeager (1986) have noted,game-theoretic considerations may present themselves. No actor will wish to bethe first to cut output prices without sufficient certainty of a cut in input prices tooffset the probable negative impact on profits. One way to see this problem isthat, as Rabin (2004: 195) argues, “Taking the lead in downward price and wage

172 Steven Horwitzadjustments is in the nature of a public good, and private incentives to supply publicgoods are notoriously inadequate.” The benefits of going first are dispersed, but thepotential costs are concentrated, thus it is difficult to get the process started. 9 Thelength of time over which no actor is willing to “go first” will also explain the degreeof downward stickiness in prices. What all of these possibilities suggest is that actorsmust begin to search for the appropriate response to the change in demand; they willnot automatically know what the optimal response is.Shah (1997: 52–4) provides a further synthesis of the Yeagerian and Austrianapproaches by offering a market discovery process explanation of why priceseventually fall. By integrating Alchian’s (1969) work on the costs of finding outinformation about prices into an Austrian entrepreneurial framework, Shah arguesthat in the face of the slackening demand generated by an excess demand formoney, firms will first have to decide whether the loss of business is a local or morewidespread phenomenon. This local vs. widespread distinction roughly correlateswith the “real vs. nominal” distinction. Given that changes in demand do not comemarked with their cause, and given that sellers’ interpretation of the cause willaffect the benefits of lowering their prices, sellers may well respond first by makingchanges in the non-price variables relevant to their products as a way to purchaseadditional information about the fall in demand. As sellers buy time in this way, thefull prices of goods (the monetary price plus the non-price factors) become morevariable (Shah 1997: 53), and this leads to buyers engaging in more informationacquisition and searching for better options. This puts more downward pressure onmoney prices. Eventually,Sellers find that they are unable to maintain their customers and profits bysimply adjusting non-price variables. In the face of a monetary contraction,delivery lags cannot be shortened or auxiliary services cannot be increasedwithout limits in order to sell more products. Ultimately prices have to belowered.(Shah 1997: 53, emphasis in original)Shah later notes that this process is simply a Hayek–Kirzner entrepreneurialdiscovery process expanded to include non-price factors.This search process will take time and will not happen smoothly across actors.Even after they unstick, prices, therefore, will not immediately fall to the appropriatelevel given the excess demand for money. In addition, the ragged nature of thedecline in prices will involve wealth redistributions among actors. All of this is incontrast to the perfectly competitive model in which prices react quickly andsmoothly to external changes. Modeling human actors realistically leads to adifferent result.One element that is missing from the Yeager monetary disequilibrium story isthe capital–interest rate process. One of Yeager’s significant disagreements withthe Austrians is over these very issues. However, the injection of some Austriancapital-theoretic insights into the process explored above provides some helpfulnew insights. In the next section, we will take a look at the Austrian inflationary

Monetary disequilibrium theory and Austrian macroeconomics 173monetary disequilibrium story, and the role that capital and interest play in it, thenbring those back to deflation.Yeagerian themes in recent Austrian theories ofinflationFor much of the twentieth century, Austrian macroeconomics has consisted of itstheory of the business cycle. However, in the last 20 years, that has begun to change.Starting with Larry White’s (1984) work on “free banking,” and continuing throughrecent books by Garrison (2001) and myself (2000), Austrian macro has branchedout in a variety of ways. What the work of White and of Selgin (1988) did was toelucidate the connections between the work on Austrian cycle theory and othertraditions in monetary theory that had largely been neglected by Austrians. Inparticular, the dominant Austrian position on banking issues in the mid-1980s wasthat a 100 percent gold reserve system was the only theoretically justified regime.That understanding grew largely out of the later Mises, to some extent, and Rothbard’swork in the 1960s and 1970s. However, that line of analysis, and Rothbard’sin particular, ignored theoretical insights from other strands of monetary theorythat undermined the case for 100 percent reserves.The 100 percent reserve theorists’ concern with the need to have bank liabilitiescompletely backed by outside money led them to focus on that relationship ratherthan the relationship between the supply and demand for money. The policyconclusion they came to was that any expansion of the supply of bank liabilitiesbeyond the quantity of the money commodity was, by definition, inflationary andto be avoided. Underlying this conclusion was the belief that fractional reservebanking was not just inflationary but fraudulent. With the moral-legal injunction tofully-back bank liabilities, expansion of the money supply was tied not to thedemand for real balances but to the supply of the money commodity. Deflation wasalmost ruled out a priori; how could the supply of bank liabilities fall below thesupply of the money commodity resting in bank vaults? 10A key implication of this theoretical stance was that the demand for money wasirrelevant in determining what the supply should be. Should the demand for realbalances rise, the banking system cannot create more liabilities to match thatdemand. Conversely, should the demand for real balances fall, there is no way forthe nominal money supply to adjust to that new reality. As discussed in the previoussection, there are only two options here: either the nominal money supply mustchange or the price level will bear the brunt of adjustment in order to restoremonetary equilibrium. By ruling out adjustments to monetary disequilibrium fromthe nominal money supply, the 100 percent reserve theorists must rely on the pricelevel to do the equilibrating.As Selgin and White (1996) point out, the 100 percent reserve Austrians have aninteresting inconsistency in their approach that centers around this issue. Theinjunction against inflation appears to recognize the problems associated with pricelevel adjustment. The traditional Austrian cycle theory’s emphasis on the relativeprice effects of inflation and the malinvestments and redistributions that occur

174 Steven Horwitzduring the process of the price level equilibrating the supply and demand for realbalances fits nicely with the monetary disequilibrium perspective associated withYeager and others. For the 100 percent reserve theorists, the price adjustmentsnecessitated by inflation do not occur smoothly, instantaneously, and costlessly.The wastes associated with the boom and bust of the Mises–Hayek cycle happenbecause the adjustment process is so imperfect.However, should the demand for money rise, the 100 percent reserve Austrianssee no trouble with the price level simply “adjusting” downward to equilibrate thesupply and demand for real balances. 11 The possibility that the market process willnot produce instantaneous and correct downward adjustments does not evenappear to have been considered. As Yeager’s work suggests, there are reasons tobelieve that prices will not fall instantaneously and the Austrians’ very own insightthat markets are discovery processes would suggest that once they come unstuck,they will not fall evenly and “accurately.” Moreover, one could ask what is supposedto happen if the demand for money should fall with the money supply fixedby the supply of the money commodity. As real balances are disgorged into thespending stream, why will the effects not be as pernicious as if the supply of moneywere expanded beyond the supply of the money commodity? Is there a lack ofappropriate parallel treatment here?What is missing from the 100 percent reserve theory analysis is the monetarydisequilibrium theory insight that the supply and demand for bank liabilities areconnected with savings and investment (Brown 1910). The demand to hold moneybalances, at least when they are bank liabilities, is a source of loanable funds in afractional reserve banking system. To the extent that one allows one’s bank balanceto accumulate, one is supplying loanable funds to the bank by not making anyclaims on its reserves. This, of course, is why banks want customers. Conversely, asbanks create additional bank liabilities, they are meeting the demand for loanablefunds by lending those new liabilities into existence. Banks intermediate betweenthose who hold bank liabilities (i.e., those keeping funds in their accounts, whichappear on the right side of the bank’s balance sheet) and those who borrow them inorder to spend them (i.e., those with loan obligations to the bank, which appear onthe left side of the balance sheet). The demand to hold bank liabilities is a form ofsaving that provides the loanable funds for investment by borrowers of bank liabilities.This connection between bank liabilities and the market for loanable fundsenables further connections between monetary disquilibrium theory and moretraditional Austrian macroeconomics.Specifically, we can now bring in the market and natural rate of interestmechanism that has been central to the Austrian cycle theory yet largely absentfrom the monetary disequilibrium approach. Bracketing out other ways in whichthe supply and demand for loanable funds are activated in the market and focusingonly on bank liabilities, we can see that when monetary equilibrium holds, themarket and natural rates of interest are equal. Since Wicksell, the natural rate ofinterest has been understood to be the rate that directly reflects actors’ underlyingtime preferences, i.e., the degree to which they discount the future. The naturalrate is a theoretical construct and unobservable in the market. It can be thought of

Monetary disequilibrium theory and Austrian macroeconomics 175as the direct “price of time.” Because we cannot exchange time directly, financialintermediaries such as banks have evolved to trade time in the form of money. Thesupply and demand for loanable funds correspond, respectively, to a desire to partwith time by pushing consumption to the future and a desire to acquire time bypushing consumption into the present. To the extent that the supply and demandfor loanable funds is constituted only by the voluntary decisions of market actors, itis an accurate reflection of their underlying preferences about time. Therefore, theinterest rate charged on loanable funds transactions (the market rate of interest) willbe an accurate reflection of the natural rate of interest.When monetary disequilibrium occurs, this analysis suggests that intertemporaldiscoordination will follow. Should the money supply expand beyond the demandfor real balances, the funds available for investment (the supply of bank liabilities)will exceed the savings supplied by bank liability holders. The excess supply ofmoney will drive market rates of interest down (ceteris paribus and starting fromequilibrium) in order to pull in new borrowers, but by hypothesis, time preferenceshave not changed. With the market rate below the natural rate, we have the usualAustrian cycle theory story where the false signal transmitted by the market rateleads to malinvestment in the form of too many resources devoted to goods fartherfrom final consumption than is justified by the unchanged time preferences of thepublic. The public is not more willing to part with time, but the artificially lowmarket rates suggest, falsely, that they are. In contrast to the 100 percent reservetheorists, the problem here is not the expansion of the money supply per se, but itbeing in excess of the demand to hold real balances. For the Yeager-infusedAustrian theory, the cycle can conceivably be triggered by a fall in the demand formoney that is not met with a decline in the nominal money supply.In two previous contributions (2000, 2002), I have argued that Austrian macroeconomicsis not only its theory of the business cycle, and that it has more to sayabout inflation than the cycle story. Central to those arguments is the idea that theeffects of inflation are dispersed and uneven precisely because money has nomarket of its own and the excess supplies of money will therefore affect each andevery market that the excess supply comes into contact with. This core insight comesfrom Yeager as does the underlying cash balance approach to the demand formoney. The result of this process is that the entire array of market prices is changedin unpredictable and varying ways by inflation. This creates additional epistemicburdens for entrepreneurs as they must attempt to disentangle the effects of inflationfrom underlying real changes. To the extent they err (and given the complexitiesof the market that will be frequently), resources get misallocated and distortionsresult. Inflation undermines the process of economic calculation that Austrians seeas a partner with entrepreneurship in making economic coordination and growthpossible. Specifically, to the extent economic miscalculation because of inflationleads to increased investment in fairly specific capital, the wastes of inflation may belarge. More generally, this undermining of the price system causes a lack of confidencein markets as institutions, and a preference, on the margin, for increasedintervention. All of these Austrian observations begin with the Yeagerian insightthat money is half of every exchange and that all markets are money markets.

176 Steven HorwitzExcess demands for money and the macroeconomics ofcapital structurePlacing Austrian macroeconomics on the foundations of monetary disequilibriumtheory suggests, in contrast to the older Austrian position, that there are situationswhere the expansion of the money supply is appropriate, independent of anymoney commodity backing it. Should the demand for money rise, we would befacing the sort of Wicksellian cumulative rot discussed earlier. Seen from theAustrian capital-theoretic perspective, we have the reverse of the cycle theory. Thepublic is attempting to supply loanable funds, but the banking system is not producinginvestment in response. The market rate is above the natural rate, signalingfalsely that the public is less willing to part with time than they really are. The resultwill be firms maintaining the length of their capital projects even though the publicis prepared to wait even more, which would justify a longer process of production.Just as the Austrian cycle theory predicts that the abandonment of unsustainablecapital projects will be the manifestation of the intertemporal discoordinationstemming from inflation, the Austrian-infused deflation theory would predict thatunsold inventories on store shelves will be the manifestation of the reverse form ofintertemporal discoordination. Producers continue to produce for a level of consumptionthat is no longer relevant. The attempt to save via money holding hasreduced consumption, thus the ongoing projects of producers should be morefuture oriented than they are. This intertemporal discoordination due to the falseinterest rate signal will lead to inventory accumulation as producers continue theshorter processes of production even though longer ones are justified. Without theexpected consumption expenditure, inventories will accumulate. As we saw above,monetary disequilibrium theory is consistent with the existence of those unsoldinventories: the downward stickiness of prices during the early stages will indeedlead to unsold goods on store shelves.In his 2001 book and in a recent (2004) article, Roger Garrison has put forwarda three-quadrant model that illustrates the interconnections among the market forloanable funds, the economy’s production possibilities frontier as seen in the tradeoffbetween consumption and investment, and the capital structure as seen in thedevice of the Hayekian triangle (see Figure 12.1). In those two contributions,Garrison puts the model through its paces with a variety of scenarios, almost all ofwhich involve expansionary monetary or fiscal policy (as well as the “baseline” ofsavings-induced secular growth). In particular, Garrison uses the Hayekian triangleto illustrate the effects of the boom on the capital structure. During inflation, theartificially lower market rate both encourages the flow of capital resources to theearlier stages of production via its effect on the cost of borrowing, whilesimul taneously encouraging increased consumption and a demand for goods in thevery last stages of production through the induced reduction in savings. As Garrisonnotes, this pits the structure of production against itself by having the hypotenuse ofthe triangle starting with different slopes at each axis, not unlike a train track beingbuilt from opposite directions only to find out that the two pieces are not aligned.Eventually, producers are faced with real shortages of needed capital and cannot

Monetary disequilibrium theory and Austrian macroeconomics 177Coverconsumptionoverconsumption▲BOOMmalinvestment▲BUSTforcedsavingoverinvestmentSTA G E S O F PRO DUC TIONiimplicit late-stage yieldnatural rateSS + ∆M cIartificially low rateDFigure 12.1 Intertemporal discoordination due to credit expansion (Garrison 2001: 69,Figure 4.4).complete the longer-term projects they have begun. The result is the bust phase ofthe business cycle.In this final section, Garrison’s model is used to explore the effects of the excessdemand for money scenario that Yeager’s work addresses. Imagine a downwardshift in the supply of loanable funds curve as the public attempts to save more byattempting to hold larger quantities of bank liabilities. Assume further that thebanking system does not bring forth an additional quantity of such liabilities, whichalso means that they are not creating the additional lending now justified by theincreased desire to save. For whatever reason, the banking system is unable torespond to the increase in the demand for money by providing more of it for thepublic to hold. This increased desire to save causes a decline in the natural rate ofinterest. However, with the banking system not responding appropriately, themarket rate of interest does not fall to match it. Like the Austrian business cycletheory, we have the start of intertemporal discoordination as the market rate issending a false signal about underlying time preferences by, in this case, making itlook like consumers are less future oriented than they really are.We can see this process play out by reworking Garrison’s Figure 4.4 to reflect thecase at hand (see Figure 12.2).The downward shift of the supply of loanable funds curve looks much like theAustrian scenario. However, this shift in the curve is not an artifice of central bankexpansion but a real change in consumer preferences. Given our assumption thatthe banking system does not translate this into additional loanable funds forborrowers, the market interest rate remains at its original level i 0, setting up anexcess supply of loanable funds to the banking system. At i 0the quantity of loanableS, I

178 Steven HorwitzUnrealizedcapitalaccumulationForced investmentshown by bulge inaccumulationApparent“underconsumption”CooC 1 ,I 1C 2 ,I 2ooSTA G ES O F PRODUCTIONiC 1I 1Excessdemandfor moneySIS’market rate= natural rate i 0oonew naturalrateoDI 2 ,S 2I 1 S 1Figure 12.2 Intertemporal discoordination due to excess demand for money.funds demanded by borrowers is less than that supplied by savers. The hollow pointof disequilibrium on the supply curve in the lower right quadrant represents theactual level of savings at i 0, while the hollow point on the demand curve representsthe actual level of investment at i 0. The difference between those two quantitiescorresponds to the excess demand for money. The long side of the market ruleshere, as in Garrison’s case, because there actually is the level of savings at i 0takingplace. 12 The excess quantity of savings can also be decomposed into two effects.The first is the shift in the supply curve that sets the whole process into motion,while the second is the implicit movement along that new curve that results fromthe market rate of interest remaining stuck at i 0.This excess supply of loanable funds/excess demand for money implies a declinein consumption expenditures. The amount of this decline can be determined byfinding the level of consumption that corresponds to the level of actual saving S 1taking place. The right hollow point in the lower right quadrant corresponds toconsumption level C 1on the production possibilities frontier. However, the actualpoint the economy moves to during the excess demand for money is at the level ofconsumption C 1and the level of investment I 1. Recall that the actual amount offunds available to entrepreneurs is I 1not S 1because the banking system is nottranslating savings into investment appropriately. The hollow point thatcorresponds to (C 1, I 1) is inside the production possibilities frontier, reflecting theWicksellian cumulative rot. It is also of note that I 1corresponds to the originalamount of investment that was taking place before the change in savings behaviorby the public. The net result of the banking system failure is a decline in consumptionand no change in investment. Had the banking system operated properly, we

Monetary disequilibrium theory and Austrian macroeconomics 179would have wound up at C 2, I 2. At that point, consumption has indeed declined(due to the increase in saving), but investment is higher as we would have movedalong the PPF and not inside it. As Garrison (2001: 62) depicts it, this is savingsinducedsustainable growth. The longer-run effect would be an expansion of the PPFdue to the increased production made possible by the lengthening of the capitalstructure.The lower level of consumption C 1can be carried over to the stages of productiontriangle in the upper left quadrant. The effect of the excess demand for money istwo-fold. First, the triangle’s intercept along the vertical axis falls as the level ofconsumption falls. Second, the change in savings/time preference implies adifferent, more shallow, slope for the triangle as it descends from the vertical axis.Again, if the banking system were working properly, we would see a rotation in thehypotenuse with the horizontal axis intercept point moving outward to reflect theincreased investment the new savings was making possible. More precisely, withmore savings and lower time preferences, we can allocate more resources to higher,and additional, stages of production further from the consumer. With the bankingsystem not doing the job in the example at hand, the actual slope and intercept ofthe hypotenuse along the horizontal axis remain unchanged from the previousequilibrium. The result is that the two ends of the triangle have incompatibleslopes, reflecting the market rate/natural rate disequilibrium, and intercepts thatcorrespond to an economy inside its production possibilities frontier, reflecting thefall in consumption generated by the excess demand for money.Garrison (2001: 72) describes the effects on the triangle during inflation as it“being pulled at both ends (by cheap credit and strong consumer demand) at theexpense of the middle – a tell-tale sign of the boom’s unsustainability.” Conversely,we might describe the effects of the excess demand for money on the triangle as it“being pushed down at the right end while the left end remains anchored in place,causing a bulge in the middle – a tell-tale sign of the way deflation idles resources andcauses unintended inventory accumulation.” The “forced investment” of the unintendedinventory accumulation is reflected by the implicit middle-stage bulges inthe triangle created by the incompatible slopes of the deflation-ridden triangle.One could also capture the problem by noting that the area labeled “underconsumption”toward the later stages of production is offset by the area labeled“forced investment,” which is the area between the unchanged portion of thetriangle in the earlier stages and where the triangle should have shifted to if the bankingsystem were functional.This use of Garrison’s model allows us to further synthesize the Yeagerian andAustrian perspectives. Austrian cycle theory has long emphasized the “forcedsavings” that comes with inflation. As Garrison (2004) argues, the best interpretationof that term is to describe the reduction in consumption opportunities thatcharacterizes the period just before the bust, when the goods that were in themiddle stages of production as the boom began come to final consumption. Theproblem is that the allocation of resources to the very early and very late stages ofproduction has robbed the middle of resources, leading to an underproduction of

180 Steven Horwitzconsumables by the time they come to maturity. The original “overconsumption”along with the malinvestment in the early stages leads to “forced savings” justbefore the bust as income earners cannot find consumption possibilities and, asGarrison argues, face higher interest rate returns to savings thanks to distress borrowing.Our use of Garrison’s model suggests there should be an analogy duringdeflation.There is, during deflation, a corresponding “forced investment.” This is theunintended inventory accumulation mentioned earlier. Inventories are a form ofinvestment and the false interest rate signal, and reduction in expenditures, thataccompanies an excess demand for money leads to overinvestment in inventories.This is the bulging of the middle. The intermediate stages of production are “toohigh.” The resources funding those excess inventories are coming from theresources taken away from the later stages of production as a consequence of thereduction in consumption engendered by the insufficient money supply. Garrison(2004) notes that the simultaneous extension of the very early and very late stages ofproduction during the boom is financed by the undermaintenance of capital in themiddle. This could take the form of underinvestment in inventories in those stages, butthere is a limit to this decumulation so undermaintenance will also take place. Whatboth share is that they involve resources being taken from the middle stages. Duringdeflation, however, there is no necessary upper limit to overinvestment in the middlestages, and the resources being taken from consumption will continue to find theirway to those middle stages, at least until prices come unstuck.One final way to blend Austrian insights with the excess demand for moneyscenario is to compare each one’s effects on the capital structure. A central elementto the Austrian cycle theory is that the increased investment in early stages ofproduction has the effect of increasing the demand for complementary capital goods.This view of capital as a complementary structure, rather than a more homogenousaggregate, is what distinguishes the Austrian approach. As Garrison (2001: 73)argues, Hayek’s 1937 article titled “Investment that Raises the Demand forCapital” made this argument as a way of cautioning against viewing all capital assubstitutable and thus speaking in terms of “the” demand for investment goods orthe marginal efficiency of “capital” in general. 13 This point explains why the boommust turn into the bust, as the unsustainable projects taken on during the boom areunable to find (at prices that will make them worth using) the complementarycapital goods needed to complete their projects. In addition, to the extent that thecapital goods brought into the production process during the boom are reasonablyspecific, they will be harder to redeploy in other uses come the bust and the losses ofthe cycle will be that much greater for the entrepreneurs who purchased them.Austrian capital theory can add a little bit to the cumulative rot story discussed inthe previous section. Unlike the case of inflation, where the distinction betweeninvestment or capital “in general” and specific production processes and capitalgoods is key to understanding the adjustment process that takes place whenproduction is unsustainable, the idling of resources, including capital goods, thatoccurs during deflation is less dependent upon the particulars of the capital

Monetary disequilibrium theory and Austrian macroeconomics 181structure and more a result of the drying up of the money necessary to facilitateexchange and production. As consumption expenditures fall, resources in the laterstages of production will be idled. With the piling up of inventories in the middlestages, the capital from the later stages will not be demanded there even if it is nonspecificenough to move, and with no change in the interest rate or demand, at leastin the short run, in the earlier stages of production, there will be no use for thecapital there either. If prices do not fall quickly enough, or if there is no increase inthe nominal money supply, the fall in consumption will eventually, through deriveddemand, begin to idle existing active resources in the other stages of production.Furthermore, with excessively large inventories in the middle stages, it is likely thatresources relatively specific to the earlier stages of production will be among the lastto come out of idleness as those stages are unlikely to heat up until inventories in themiddle stages have been reduced. 14Austrian capital theory has other things to say about the recovery process. Forexample, because the excess demand for money scenario involves a reduction inconsumption expenditures, it is often seen as an “under-consumption” crisis. It istempting, therefore, to cure the problem by artificially stimulating consumption ina variety of ways, particularly through fiscal policy. This confuses the symptom(falling consumption) with the disease (an excess demand for money). The cure is toincrease the nominal supply of money to restore monetary equilibrium and bringthe market rate back down. Doing so will enable consumers and producers to betterachieve intertemporal coordination through their various decentralized decisionsthat are guided by the now more accurate market rate of interest and individualprices.Policies that artificially stimulate consumption may well end up distorting thecapital structure toward shorter term production processes that are not justified byunderlying time preferences. Attempting to restore the vertical intercept of thehypotenuse of the Hayekian triangle will not fix the fact that its slope is out ofalignment with the slope of the hypotenuse toward the horizontal axis. In contrastto the unsustainably long projects of the Austrian cycle, where the over-specificityof capital goods can generate losses when the mistakes are revealed, theinappropriately short projects of pro-consumption policies will involve opportunitycosts of bypassing longer, more productive processes that could add significantly toaggregate wealth in the long run. If these pro-consumption policies take the form ofdeficit spending (e.g., increased borrowing to generate transfer payments toindividuals), they may well worsen the situation by driving up interest rates andcrowding out private investment. If so, the effect is to rotate the broken hypotenusecounter-clockwise, which both reduces future growth through the reduction inprivate investment and does nothing to cure its being broken by remedying theunderlying intertemporal discoordination. The costs of artificially stimulatinginvestment during the Austrian boom are explicit losses; the costs of artificiallystimulating consumption during the Yeagerian bust are in the form of the opportunitycosts of an unnecessarily short and simple structure of production. Thelesson is that intertemporal coordination is best achieved when monetaryequilibrium is maintained. 15

182 Steven HorwitzConclusion: toward a post-Wicksellian macroeconomicsBringing the Wicksellian natural rate process, Austrian capital theory, and theHayekian triangle into the Yeager story creates a more integrated approach tomonetary disequilibria and intertemporal coordination. In particular, it suggeststhat all cases of monetary disequilibria involve intertemporal discoordination, inthe form of misleading interest rate signals, and that this discoordination willmanifest itself within the capital structure, particularly in the misalignment of theearly and late stages of production processes. Combining the Wicksellian interestrate mechanism with a process-oriented view of microeconomics further unites theYeagerian and Austrian perspectives. Both emphasize that adjustments tomonetary disequilibria can occur on many margins, that they take time, and thatthey will not happen in even, smooth ways. Both perspectives agree that althoughthere can be macroeconomic disturbances, the results of such disturbances willalways manifest themselves in the microeconomy. An approach that does all of thefollowing shows great promise in being able to diagnose and treat most, if not all,macroeconomic ills:• Sees the microeconomy in terms of discovery processes not equilibrium solutionsand sees prices as knowledge signals not just incentive aligners.• Integrates institutional considerations into macroeconomic analysis.• Understands the unique properties of money as a medium of exchange.• Integrates the relationship between money and the loanable funds market.• Sees the interest rate as a signal for intertemporal coordination and recognizesthe market rate/natural rate distinction.• Views capital as a structure exhibiting complementarity and necessitatingsubstitution in the face of change.It is the argument of this paper that just such an approach can be created bycombining the underlying elements of Yeager’s work on monetary disequilibriumtheory with Austrian approaches to inflation and business cycles.I have tried to argue here that seeing these two approaches as alternatives orcompetitors is mistaken. They are ultimately complementary if one wishes toexplain both inflation and deflation and explain both the boom and bust of theAustrian-type cycle. Moreover, as I have argued elsewhere (Horwitz 2000, 2002),the Austrian analysis of inflation is about more than just the cycle theory, althoughthat has been the focus in this essay. The insights from Yeager and others workingin the monetary disequilibrium tradition (including Rabin’s excellent book) addvalue to the work of Austrians by providing their theory with more secure microeconomicunderpinnings by clarifying the nature of money as a medium ofexchange and its role in the discovery process of the market. They also add value byproviding Austrians with a framework for explaining the secondary depression thatcan occur during the bust, and that did occur in the historical case of the GreatDepression. Any complete explanation of the Great Depression must make use ofboth Austrian and monetary disequilibrium insights. Austrian work can also add

Monetary disequilibrium theory and Austrian macroeconomics 183value to the Yeagerian approach. Austrian interest and capital theory can illuminateaspects of the intertemporal discoordination caused by excess demands formoney, and Austrian microeconomics can provide important insights into thereasons why prices are unable to immediately adjust in the face of monetary disequilibrium.Viewing these approaches as substitutes rather than complements retardsour ability to understand more fully macroeconomic disorder and intertemporaldiscoordination. As the application of Garrison’s model to the excess demand formoney scenario shows, it is possible to explain that scenario using Austrian toolsjust as using Yeagerian tools can illustrate important effects of inflation. Contraryto Rabin’s attempt to excise Austrian theory cited at the start of this paper, I notehere that Occam’s Razor can cut both ways.Given Yeager’s long-time role as a sympathetic but merciless critic of Austrianeconomics, and his long-standing concerns about Austrian business cycle theory inparticular, this last point most likely comes across as a challenge rather than atribute. In light of Yeager’s willingness to challenge Austrians on these issuesboth in his written work and as a teacher and lecturer for the many decades ofhis outstanding career, I would hope that throwing a challenge right back athim and others, such as Rabin, in the monetary disequilibrium tradition is thehighest form of tribute to be offered. Imitation is said to be the sincerest form offlattery, and Leland’s willingness to engage those with whom he disagrees bothvigorously and with the highest standards of scholarship is well worth attemptingto imitate.Notes1 It goes without saying that Professor Yeager has contributed to a number of areas both inand beyond economics, as the other papers in this volume indicate. My contribution,however, will focus on his work on monetary theory.2 Many of the themes below are explored in Horwitz (2000). What follows can be fruitfullyread as an update and expansion on those ideas in light of several contributions that haveemerged since, particularly Garrison (2001) and Rabin (2004).3 For more on the role of subjectivism in the yield on money held, see Hutt (1956), Selgin(1987), and Horwitz (1990).4 Yeager (1982) discusses the “individual and overall viewpoints” in monetary theory tomake this point.5 As Hayek (1995 [1931/1932]: 128) recognized in his critique of Keynes, “Mr. Keynes’saggregates conceal the most fundamental mechanisms of change.”6 The centuries-old insight of Cantillon, Hume, and others applies to both inflation anddeflation, as we shall see below.7 Rabin (2004) has an excellent extended discussion of “Walras’ Law” that clarifies avariety of issues surrounding this point.8 Shah (1997) provides the best overview of the issues raised in this section.9 Productivity-induced downward pressure on prices does not present this problem.Where individual entrepreneurs have increased their productivity, the benefits fromdownward price adjustments are internalized in the form of higher profits, therefore theydo not face the public goods problem when contemplating price reductions driven byincreased productivity.10 Disinflation was another story. Rothbard (1962: 851), for example, argued that the onlypermissible circumstances under which the money supply could shrink was if inflation

184 Steven Horwitzhad occurred and the supply of bank liabilities was being shrunk to return the reserveratio to 1.11 See the discussion in Horwitz (2000: 170–4) and the citations therein.12 The short side rules in goods markets, but the long side rules when it comes to moneyprecisely because of the “routineness” and liquidity of money that Yeager notes. We canalways spend or not spend money. We do not have the equivalent ability with goods.13 This Hayek article can also be read as a continuation of his debates with Knight over thenature of capital. Central to the article’s argument is that capital cannot be viewed asKnightian “Crusonia plant.”14 For instance, automobile workers might not get rehired until well into the recovery asexisting inventories of cars that went unsold during the recession would have to becleared out before assembly lines got back to normal production.15 This paper does not address the question of what sort of monetary regime is most likelyto maintain monetary equilibrium through time. I have argued (Horwitz 1992, 2000)that a free banking system will do so, while Yeager and other monetary disequilibriumtheorists have argued for variations on what Yeager calls the Black–Fama–Hall model.In previous work (Horwitz 2000: chapter 7), I compare and contrast these models with100 percent reserve banking in terms of their ability to maintain monetary equilibrium.ReferencesAlchian, Armen (1969). Information Costs, Pricing, and Resource Unemployment. WesternEconomic Journal, 7: 109–28.Brown, Harry G. (1910). Commercial Banking and the Rate of Interest. Quarterly Journal ofEconomics, 24: 743–9.Garrison, Roger W. (2001). Time and Money: The Macroeconomics of Capital Structure. New York:Routledge.Garrison, Roger W. (2004). Overconsumption and Forced Saving in the Mises–HayekTheory of the Business Cycle. History of Political Economy, 36(Summer).Greenfield, Robert (1994). Monetary Policy and the Depressed Economy. Belmont, CA:Wadsworth.Hayek, F.A. (1937). Investment that Raises the Demand for Capital. The Review of Economicsand Statistics, 19(November).Hayek, F.A. (1995 [1931/1932]). Reflections on the Pure Theory of Money of Mr. J. M.Keynes. Reprinted in The Collected Works of F. A. Hayek, Vol. 9: Contra Keynes and Cambridge,edited by Bruce Caldwell. Chicago, IL: University of Chicago Press.Horwitz, Steven (1990). A Subjectivist Approach to the Demand for Money. Journal desEconomistes et des Etudes Humaines, 1(December): 459–71.Horwitz, Steven (1992). Monetary Evolution, Free Banking, and Economic Order. Boulder, CO:Westview Press.Horwitz, Steven (2000). Microfoundations and Macroeconomics: An Austrian Perspective. New York:Routledge.Horwitz, Steven (2002). The Costs of Inflation Revisited. Review of Austrian Economics,16(March): 77–95.Hutt, William H. (1956). The Yield From Money Held. In Mary Sennholz (ed.) On Freedomand Free Enterprise: Essays in Honor of Ludwig von Mises. Princeton, NJ: Van Nostrand, pp.196–216.Menger, Carl (1892). On the Origin of Money. Economic Journal, 2.Mises, Ludwig von (1980 [1912]). The Theory of Money and Credit. Indianapolis, IN: LibertyPress.

Monetary disequilibrium theory and Austrian macroeconomics 185Rabin, Alan (2004). Monetary Theory. Northampton, MA: Edward Elgar.Rothbard, Murray N. (1962). Man, Economy and State. Los Angeles, CA: Nash Publishing.Selgin, G.A. (1987). The Yield on Money Held Revisited: Lessons for Today. Market Process,5(Spring): 18–24.Selgin, G.A. (1988). The Theory of Free Banking: Money Supply Under Competitive Note Issue.Totowa, NJ: Rowman and Littlefield.Selgin, G.A. and Lawrence H. White (1996). In Defense of Fiduciary Media – or, We are NotDevo(lutionists), We are Misesians! Review of Austrian Economics, 9: 83–107.Shah, Parth (1997). The Theory of Business Fluctuations: New Keynesians, Old Monetarists,and Austrians. Advances in Austrian Economics, 4. Greenwich, CT: JAI Press, pp. 33–62.White, Lawrence H. (1984). Free Banking in Britain. Cambridge: Cambridge UniversityPress.Yeager, Leland B. (1968). Essential Properties of the Medium of Exchange. Kyklos,21(January/March): 45–69.Yeager, Leland B. (1982). Individual and Overall Viewpoints in Monetary Theory. In IsraelM. Kirzner (ed.) Method, Process, and Austrian Economics. Lexington, MA: LexingtonBooks.Yeager, Leland B. (1986). The Significance of Monetary Disequilibrium. Cato Journal,6(Fall): 369–99.

13 Reflections on reswitchingand roundaboutnessRoger W. Garrison*IntroductionControversies about capital and interest never die. But interest in the issues oftechnique reswitching and roundaboutness waxes and wanes – though withoutrhythm and without obvious provocation. Central to these issues, so says oneschool of thought, is the viability of the neoclassical production function and, morebroadly, the viability of neoclassicism itself. Avi J. Cohen and Geoffrey C. Harcourt(2003a) have recently published an illuminating retrospective on the debatebetween Cambridge, UK and Cambridge, MA. Though engaging, their titlequestion–“Whatever Happened to the Cambridge Capital Theory Controversies?”– never quite gets answered. The reader gets the impression, however, that theauthors are actually expressing annoyance if not dismay that their neoclassicaladversaries have never acknowledged the fatal defects of their theory and scrappedtheir aggregate production function. Commenting on Cohen and Harcourt, JesusFelipe and J.S.L. McCombie (2003: 229) ask the question in a more confrontationalway: “So why is the aggregate production function still widely used in neoclassicalmacro economics, even after the legitimacy of the Cambridge, U.K.’s critique wasexplicitly acknowledged by Samuelson (1966a)?”My own interest in these questions stems from several fortuitous circumstances.While a visiting fellow at the London School of Economics in May and June of2003, I had the privilege of sitting in on a seminar conducted by Geoffrey Harcourt.The paper he presented on that occasion was the uncut version of the “WhateverHappened?” article. Extended preliminary remarks were aimed at justifying ameasure of capital that puts this factor of production dimensionally on a par withlabor and land. Harcourt insisted that to be conformable with the other two factors,capital cannot be measured in value terms. Having set the stage with this imperativeconcerning dimensionality, he walked us through the rounds of debate. While theblow-by-blow was presented with humor and charm, the reaction of the listenerswas in the spirit of Felipe and McCombie – indignation that the losers (theneoclassicals) had never admitted defeat and adjusted their research programsaccordingly.In 1966, the year that MIT’s Paul Samuelson published his “Summing Up”confessional, pouring gasoline on the anti-neoclassical fire, I was immersed in acourse in Engineering Economics at the Missouri School of Mines and Metallurgy

Reflections on reswitching and roundaboutness 187(now the University of Missouri at Rolla). Because of the mathematical orientationof that course and its focus on the calculus of present values and internal rates ofreturn, my classmates and I were fully aware of the possibility of multiple internalrates of return. And as a mathematical matter, in turns out, the occurrence of multiplerates emerges out of circumstances similar to those that give rise to techniquereswitching, a phenomenon that lies at the heart of the Cambridge controversies.As engineering students, however, none of us was aware of the broader economicimplications of movements in interest rates, let alone the supposedly threateningimplications for neoclassical production theory of the paradoxical circumstanceknown as technique reswitching: a decline in the rate of interest could lead to theadoption of less roundabout, less capital intensive methods of production.In the late 1970s after a switching of careers (from engineering to economics), Iwas invited to comment on a conference paper by Leland Yeager (1979) titled“Capital Paradoxes and the Concept of Waiting.” Drawing on Gustav Cassel,Yeager dealt specifically with the issue of dimensions. If the interest rate is a price, itis the price of a factor measured in the complex units of dollar-years. As will bedemonstrated in a subsequent section, this Casselian unit (dollar-years) is thestraightforward result of a simple exercise in unit analysis – a procedure I had usedmany times over in engineering applications. Among other insights in Yeager’spaper was a healthy perspective on the Cambridge controversies, making full use ofthe dual dimensionality of Casselian waiting. (I now realize that Harcourt and hisfellow Cantabrigians would be wholly dismissive of Cassel’s and Yeager’s dollaryearon the grounds of its incorporating the verboten value dimension.)My role at the conference was to provide an Austrian perspective on thesetroublesome issues. Dubbing my comment “Waiting in Vienna” (Garrison 1979),I leveraged Yeager’s critical account of the seemingly paradoxical techniquereswitchingexamples by transplanting the logic from the theory of capital to thetheory of evolution. By constructing an analogously paradoxical species-reswitchingexample (in which the survival of the fittest is violated at one of the switch points),I cast doubt on the wisdom of Charles Darwin. I considered the changing formsof life that we might observe as we travel from the North Pole to the South Pole.If switching from polar bears to alligators (somewhere between the Arctic Circleand the Tropic of Cancer) is consistent with Darwinian theory, then switchingback (somewhere between the Tropic of Capricorn and the Antarctic Circle) isinconsistent with Darwinian theory. The intent of my parody on paradox, ofcourse, was to question the meaningfulness of the charges leveled by Cambridge,UK against the Austrian theory of capital and interest.Paradoxes and frameworksIn the hands of Cambridge, UK, the capital controversies thrive on paradox. Iftheoretical framework X entails paradoxical characteristics that seem to undercutthe fundamental relationships on which it is erected, then theoretical framework Xshould be abandoned in favor of theoretical framework Y. The X, of course, isneoclassicism – with due attention to the temporal dimension of production

188 Roger W. Garrisonprocesses. Böhm-Bawerk’s notion of roundaboutness and the related notion ofcapital intensity are central to the paradoxes. The Y – as put forth by Cohen andHarcourt (2003a: 207ff) – is the classical political economy of David Ricardo andPiero Sraffa, where the fundamental unit of analysis is the social class and where theeconomic problem is the distribution of the surplus. Cohen and Harcourt citeWalsh and Gram (1980), a book that dramatizes the discontinuity entailed inclassicism’s giving way to neoclassicism.It is not difficult to imagine substantive answers to the confrontational questionposed by Felipe and McCombie (“Why is the aggregate production function stillwidely used . . . ?”). Three such answers suggest themselves: (1) The allegedparadoxes are not so paradoxical once the particulars of the trumped-up instancesof them are fully understood. (2) The particular temporal profiles of reswitchingpronetechniques are sufficiently quirky as to warrant neglect in setting outfundamental supply-side principles – a mode of argument that has its parallel in theneglect of the Giffen good in setting out fundamental demand-side principles. (3)No actual instances of the paradoxical supply-side phenomena have ever beenidentified by the Cantabrigians – there not being even so much as a suspectedinstance to parallel the suspected upward-sloping demand for Giffenesque potatoesin Ireland during the mid-nineteenth-century famine.Cohen and Harcourt did not address this third-listed answer, except for insistingthat the empirical question is “beside the point: This was [and is] a theoreticaldebate” (p. 209). In commenting on the Cohen–Harcourt article, Felipe andMcCombie (2003: 230) attempt to turn the tables on the neoclassicals by suggestingthat empirically established regularities that seem to lend credence to the neoclassicalproduction function may instead derive from the underlying accountingidentities. Cohen and Harcourt (p. 200) are specifically unreceptive to the secondlistedanswer – the idea that the anomaly fueling the controversy is akin to theGiffen good. In the perspective of Cambridge, UK, the controversy is not a Giffenlike“tempest in a teapot” but rather an identification of some “deep issues” whoselack of a satisfactory resolution call into question the viability of neoclassicism.The first-listed answer – that understanding deflates paradox – is a non-answeras far as Cohen and Harcourt are concerned. They credit Samuelson withproviding the intuition to accompany the arithmetic demonstrations but questionthe meaning of a theoretical construction in which anomalous relationships areeven a possibility. Samuelson’s (1962) “surrogate production function,” whoseconstruction precluded the possibility of the anomalies, is seen as a very specialcase. Cohen and Harcourt (2003a: 210) ask, “What is the meaning of a simplemodel whose clear-cut results are not sustained when restrictive assumptions areloosened?”Though Samuelson offered some intuition about the capital paradoxes, LelandYeager’s “Toward Understanding Some Paradoxes in Capital Theory” (1976)suggested that to understand them is to resolve them. Why should some technicalreckoning of roundaboutness have a claim on our attention when an economicreckoning – with due attention to both value and time – is what counts for the entrepreneurs’choices among techniques? And if the value dimension is itself affected by

Reflections on reswitching and roundaboutness 189changes in the rate of interest, why not acknowledge this aspect of intertemporalallocation forthrightly rather than lament that our measure of the capital input isfundamentally different from our measures of labor and landand rather thaninsist that all measures of inputs must be dimensionally similar despite the inherentdissimilarities of the inputs?Robert Greenfield (2003), who sees a debate-ending resolution in Yeager’sinsights, is puzzled by Cohen and Harcourt’s wholesale neglect of Yeager’s article.In their response to Greenfield, Cohen and Harcourt (2003b: 232) single out thisarticle for an unduly discourteous response. “Unlike [some articles, which constitutea ‘valuable complement’ to their own summary article], Leland Yeager’sarticle was omitted [from discussion] because it misunderstood the issues and didnot make a meaningful contribution to the debate.” Cohen and Harcourt reproducea long paragraph from Knut Wicksell’s Lectures on Political Economy (1934[1911]) to establish that the neoclassicals understood early on about the inherentlimitations in measuring the capital input: unlike labor and land, capital cannot bemeasured summarily, according to Wicksell, except in value terms. Cohen andHarcourt’s point is that the problem of capital measurement is an “internalneoclassical problem” – and (implicit in their dismissive treatment of Yeager) anunresolvable one.And so, just what are the issues that Yeager misunderstood? The live issues, assuggested by the tone of Cohen and Harcourt’s article and response to critics, canonly be those related to the reluctance – or the intransigence – on the part of theneoclassicals in giving up a fatally flawed framework in favor of an alternativeframework that, even on other grounds, is the more appealing. In short, acknowledgingthe possibility of technique reswitching in the neoclassical frameworkshould lead posthaste to framework reswitching. The neoclassicals should return tothe class-analysis-cum-distribution-of-the-surplus brand of classicism. Yeager hadfailed to understand that Cambridge, UK was not looking for a resolution to theparadox but rather was looking to abandon the framework in which the paradoxemerged.To the three possible neoclassical responses to Felipe and McCombie listedabove, there must be added a fourth. Cohen and Harcourt (p. 210) suggest thatneoclassical production theory is “a mistake whose insights must be discarded” andthat the neoclassicals should be “searching for a better explanation in a completelydifferent direction.” It is not clear, however, that neoclassicals would considerclassical political economy to be the next best alternative to neoclassicism, let alonea “better explanation.” In any case, what is called for, if anything, is not frameworkreswitching on the basis of a perceived flaw in one of the frameworks but rather anexercise in comparative analytical frameworks. Are paradoxes, ambiguities, andindeterminacies less of a problem in classical political economy than in neoclassicism?Arguably, the continuing development of the various schools ofthought – classical, neoclassical, and Austrian – collectively constitutes an ongoingcomparative-framework exercise.A more manageable – and potentially more fruitful – question might be: why inthe critical Cantabrigian literature are the neoclassical and Austrian schools

190 Roger W. Garrisonlumped into one? Most modern expositions of neoclassicism include scant mention,if any mention at all, of Böhm-Bawerk or of any of the other Austrians. Do wesuspect that the summary treatment of these two schools serves some polemicaland/or strategic purpose? And can a disjoining of these schools clear the way for amore healthy understanding of reswitching and roundaboutness, possibly defusingthe charges issued by Cohen and Harcourt and pointing the way to a moresatisfactory treatment of the economy’s supply side?Before attempting an answer to this last question, I offer (1) an exposition ofmultiple internal rates of return and technique reswitching in the form of a child’sguide and (2) a discussion of the issue of dimensionality, identifying a problemquite separate from – and more fundamental than – the possibility of techniquereswitching.A child’s guide to the capital paradoxesSome ideas in economics can best be presented in the form of a “Child’s Guide” –not because the ideas are complex or entail great difficulty but because they areso simple. Maddox and Carter (1982) gained attention and made headway withtheir “Child’s Guide to Rational Expectations.” They convincingly demonstratedthat as the basic idea becomes transparent, its relevance to the broader issues ofeconomics becomes questionable. And in the spirit of Cohen and Harcourt’sresponse to critics (2003b: 232), the presentation below of the supposed capitalparadoxes is offered partly for the benefit of “younger readers unaware of the issuesinvolved.”It is commonplace in the literature on the Cambridge capital controversies torefer to Samuelson’s celebrated “Summing Up” for a hypothetical instance ofreswitching. Cohen and Harcourt (2003a: 203) rely heavily on it, making full use ofits round-numbers arithmetic. As indicated above, no one ever refers to an actualinstance of it. The lack of any documented or even suspected instances of thissupposed capital-market anomaly underlies Joan Robinson’s (1975) verdict of“The Unimportance of Reswitching.” Her more fundamental point is thatreswitching is not something that might actually be “going on” at all; rather, the“switches” refer to critical points of comparison in a strictly comparative-staticsexercise. (The significance of my species-reswitching model derives from this samefundamental point.)Though I doubt the phrase was ever used in Engineering Economics,“comparative statics” was the order of the day at Rolla. And in those days, I was notattuned to the distinction between statics and dynamics in any application outsidethe hard sciences. Attention to units of measurement was critical in the field ofengineering, but with a major in electrical engineering, I was focused on kilowattsand kilowatt-hours and not on dollars and dollar-years. The professor ofEngineering Economics, himself an engineer and not an economist, gave shortshrift to the economics of capital and interest. His goal was simply to familiarize thestudents with present-value equations. Given a rate of discount, a present valuecould be calculated for any constellation of revenues and/or outlays. Alternatively,

Reflections on reswitching and roundaboutness 191setting the present value equal to zero would allow for the calculation of the internalrate of return.With little or no grounding in economics, the students could easily see that if apresent-value equation took the form of a polynomial of second-degree (or of somehigher degree), there was the distinct possibility of multiple internal rates of return.Further, it turns out that if a single project whose break-even point (zero presentvalue) corresponds to more than one interest rate, that project’s outlays and revenuescan be decomposed mathematically into two outlay-and-revenue sequences torepresent two projects that exhibit the supposedly troublesome phenomenon ofreswitching.The illustrative examples I offer below differ from Samuelson’s in three respects.(1) I deal first with a single project that entails multiple rates of return. (2) I workwith numbers that constitute plausible interest rates: r = 2 percent and r = 8 percent.(Samuelson worked with 50 percent and 100 percent.) And (3) I start with themultiple rates and work backward to see what temporal characteristics the projectmust have. Then, having identified a temporal sequence of revenues and outlays, Idecompose the sequence into two projects that will exhibit switching and reswitching,the switch points occurring at those same two rates of interest, i.e., r = 2 percentand r = 8 percent.Multiple rates of returnIf a present-value reckoning yields two solutions for the internal rate of return, say r= 2 percent and r = 8 percent, then that reckoning must ultimately resolve itself intothe equation(r – 0.02)(r – 0.08) = 0 (1)or r 2 – 0.10r + 0.0016 = 0 (2)Rewriting to express this equation in terms of the discount factor (1 + r), we get[(1 + r) 2 – 2r – 1] – 0.10r + 0.0016 = 0 (3)(1 + r) 2 – 2.10r – 0.9984 = 0 (4)(1 + r) 2 – [2.10(1 + r) – 2.10] – 0.9984 = 0 (5)(1 + r) 2 – 2.10(1 + r) + 1.1016 = 0 (6)Dividing by the highest power of the discount factor (1 + r) 2 puts the present-valueequation in standard form:1 – 2.10/(1 + r) + 1.1016/(1 + r) 2 = 0 (7)Finally, we can scale equation (7) by 100 so as to avoid fractions of pennies.

192 Roger W. Garrison100 – 210/(1 + r) + 110.16/(1 + r) 2 = 0 (8)In its simplest interpretation (and taking positive and negative terms to indicaterevenues and outlays, respectively), equation (8) represents a three-period projectthat entails some up-front revenue. In the initial period, t 0, a contractually requiredpre-payment in the amount of $100 is received; in the next period, t 1, outlays of$210 are made; and in the last period, t 2, the project’s output is delivered and a finalpayment of $110.16 is received. Figure 13.1 illustrates the project in terms of bothtime and money. By construction, this is a break-even project at interest rates of2 percent and 8 percent.REVENUESt$10001$110.16t 0 t 2$100$200OUTLAYS$210Figure 13.1 A three-period project.At the middling interest rate of 5 percent, the project is in the red by $0.08. Atinterest rates below 2 percent or above 8 percent, the project is in the black – by$0.06 at a 1 percent rate of interest and by $0.07 at a 9 percent rate. The dependenceof present value on the rate on interest over the range of 0 percent to 14 percent isshown in Figure 13.2. Note that at a zero rate of interest, the present value, which issimply the algebraic sum of the undiscounted revenues and outlays, is $0.16.Except in the vicinity of the switch and reswitch points, the relationship ofpresent value to the rate of interest is well behaved. At extremely high rates ofinterest, where the terms containing positive powers of the discount factor becomenegligible, the profitability of this project approaches the initial receipt of $100.Figure 13.3 shows the dependence of present value on the rate of interest forinterest rates up to 1000 percent. Note that the variations of present value in thelow single digits – including the negative present values over the 2–8 percent range– are too small to be discernible in Figure 13.3.A mirror-image interpretation of our multiple-rate equation is produced byreversing all the signs:–100 + 210/(1 + r) – 110.16/(1 + r) 2 = 0 (9)This three-period project requires an initial outlay of $100 and generatesrevenue in the second period of $210. The outlay of $110.16 that occurs in the third

Reflections on reswitching and roundaboutness 193presentvalue$0.40$0.30$0.20$0.10$0interestrate2 4 6 8 10 12 14–$0.10–$0.20Figure 13.2 Present value (0%–14%).presentvalue$100$80$70$60$50$40$30$20$10interest$0rate0 200 400 600 800 1000Figure 13.3 Present value (0%–1000%).period might be clean-up costs or costs of complying with a service contract. Thebreak-even rates of return are still 2 percent and 8 percent. But with incomes andoutlays reversed, the middling interest rate of 5 percent puts the project in the blackby $0.08, and for all rates less than 2 percent or greater than 8 percent, the projectis in the red. The graph of the outlays and revenues of this mirror-image project,along with the graphs of the dependence of present value on the rate of interest, arethe same as Figures 13.1–13.3 – but with the positive and negative segments of thevertical axis reversed.

194 Roger W. GarrisonEquations (8) and (9) can also represent projects where individual termscorrespond to net outlays or net revenues. The term 210/(1 + r), for instance, mightrepresent revenues at t 1of $300, partially offset in that same period by outlays of$90. Similarly, the equations also permit outlays matched by revenues of equalmagnitude in other periods, say, t 3– at which time, say, $50 of revenues just offset$50 of outlays. Essential to the projects represented by equations (8) and (9) is aninterspersing of revenues and outlays. Any project for which all outlays are madebefore any revenues are received cannot have multiple internal rates of return.From multiple rates to technique reswitchingThe three terms in equation (9) are taken to be receipts (+) or outlays (–) thatcharacterize a single project. Suppose, though, that we transpose the positive termto the other side of the equation and interpret the terms, now all of the same sign, asrepresenting outlays – but of two alternative projects, either of which is a means ofproducing a given output in, say, period t 3.–100 – 110.16/(1 + r) 2 = – 210/(1 + r) (10)These two projects differ not by the nature of the inputs but only by the alternative“techniques,” which are defined as particular temporal sequences of inputs. Thesingle term on the right side of equation (10) can represent the outlay associatedwith Technique A; the two terms on the left side can represent the outlays associatedwith Technique B. (The corresponding revenue terms are the same for the twoprojects and so would cancel one another if added to each side of the equation.)Equation (10) suggests that there is some rate (or rates) of interest for which thepresent values of the outlays are the same for both techniques.The solution to equation (10) is, by construction, identical to the solution toequations (8) and (9). That is, the two techniques have the same costs, reckoned asthe present value of outlays, when the cost of borrowing is 2 percent and when it is8 percent. At all other rates, one technique will have a cost advantage over theother. The relative costs of the two techniques, C B/C A, is given by equation (11):100 + 110.16/(1 + r) 2 100(1 + r) 2 + 110.16C B/C A= = (11)210/(1 + r) 210(1 + r)The general characteristics of C B/C Aas it varies with the rate of interest arerevealed by inspection. At a zero rate of interest, C Bis higher than C Aby $0.16,giving a cost advantage to Technique A. (The zero-interest value of C B/C Ais1.000762.) We can note that equation (11) is a continuous function for interest ratesabove r = –1 and that the cost ratio is 1.0000 at interest rates of 2 percent and 8percent. Hence, as shown in Figure 13.4, C B/C Afalls from 1.000762 to unity as theinterest rate rises from 0 to 2 percent, then dips below that level as the interest raterises beyond 2 percent, returning to unity at 8 percent. Our cost ratio then ascendsindefinitely as the interest rate rises beyond 8 percent. The minimum value of

Reflections on reswitching and roundaboutness 195C B/C Ais 0.999592, which corresponds to an interest rate of 5 percent. Samuelson(1966a) presents a similarly shaped relative-cost curve for his two techniques, forwhich the equal-cost points are 50 percent and 100 percent.C B /C A1.0081.0061.0041.0021.0000.998interestrate2 4 6 8 10 12 14 16 18 200.996Figure 13.4 Cost advantage (C B/C A).Now, which of the two technique-defined projects is the more capital intensive,or the more roundabout? Technique B has the earlier input, but the outlayassociated with that input is only $100. The outlay associated with the initial inputof Technique A is $210, but that input can occur one period later. It is precisely thiskind of play off between time and money that precludes a simple answer to thequestion about capital intensity and roundaboutness. However, if one of thetechniques is to be declared more capital intensive, more roundabout, than theother, then one of the two switchings of technique will be at odds with conventionalneoclassical and Austrian wisdom. Suppose we consider Technique B the moreroundabout. Then a decline in the interest rate from, say, 9 percent to 5 percentwill provoke a switching (from Technique A to Technique B) that is consistent withthe wisdom of Böhm-Bawerk: a lower rate of interest favors more roundaboutmethods of production. But a further decline in the interest rate from 5 percent to,say, 1 percent will provoke a reswitching that is contrary to that wisdom. This is theanomaly that, according to the Cantabrigians, undermines the fundamentals ofneoclassicism and Austrianism.It may be worth noting that the hypothetical examples of reswitching invariablyentail either implausibilities or trivialities. Samuelson’s implausibly high interestrates cast doubts on the relevance of his hypothetical example. Clearly, though,Samuelson (p. 571) has little patience with those who would prefer to see thepercentages that actually look like interest rates. He suggests that “The reader canthink of each period as a decade if he wants to pretend to be realistic.” In otherwords, if you don’t want to think of 100 percent interest rates, then think of 30-yearplanning horizons! But even with this way of thinking, the cost advantage of the20-year project is never as much as 15 percent unless the interest rate rises above a

196 Roger W. Garrison200 percent DPR (decadal percentage rate) or falls to 0 percent, and the costadvantage of the 30-year project (at interest rates between 50 percent and 100percent DPR) maxes out at about 1 percent.My own example features interest rates of 2 percent and 8 percent and productionperiods of two or three years. Using such plausible ranges for interest rates andplanning horizons gives us cost advantages that are minuscule. The cost advantageof the three-year project is 0.0763 percent at a zero rate of interest, and the maximumcost advantage of the two-year project (at a 5 percent interest rate) is 0.0408percent. A 15 percent cost difference (of the three-year project over the two-yearproject) doesn’t occur unless the interest rate is nearly 180 percent APR.The greater point in offering my own hypothetical example, which in manyrespects parallels Samuelson’s hypothetical example, is that the framework ofanalysis here is not Cambridge capital theory at all but rather engineering economics.And, as we will see, my framework is heavy on engineering (or rather onpresent-value calculations) and light on economics. The key difference betweenCambridge, UK and Rolla, MO (where I studied engineering) stems, once again,from the issue of the appropriate units for measuring capital.Dimensions of capital: physical, value, and amorphousAdhering to the Cambridge tradition, Samuelson, Cohen, and Harcourt treat thecapital input as dated labor. That is, so many worker-hours expended during aparticular period constitute a capital investment. This capital investment, orseveral similarly defined capital investments, mature in time into consumable output.Neither dollars nor any other measure of value enters the picture. As already indicated,Cohen and Harcourt, taking to heart Wicksell’s discussion of the ambiguitiesthat arise from measuring capital summarily in value terms, insist on physical measuresonly. My engineering economics, then, though perfectly parallel to Samuelson’sarithmetic, would be strictly illegitimate in the Cambridge view – precisely because“capital value” cannot be equated with “capital.” The conflation of the value ofcapital and the quantity of capital is what gets the neoclassical economists in trouble.So, what units do the neoclassicals actually have in mind for the capital in theirproduction function? It is instructive to consult some reputable mainstream textfrom the Samuelson “Summing Up” era. With no additional criteria (except for thesample text’s being within arm’s reach of my writing desk), I choose C.E. Ferguson’sMicroeconomic Theory (1966). Using conventional symbols, we can write: Q = f (K, L).Output is a function of capital and labor inputs. This approach, which omits anyspecific temporal dimension and identifies labor explicitly as a second input,precludes treating capital as dated labor. The capital input must be modeled insome other way. Ferguson (1966: 153) supplies hints about units – and, unavoidably,hints about the problem with units – in his treatment of the total costs as theydepend on the particular quantities of the two variable inputs:Denote the quantity of capital and of labor by K and L, respectively, and their unitprices as r and w. The total costs of using any volume of K and L is C = rK + wL,

Reflections on reswitching and roundaboutness 197the sum of the costs of K units of capital at r per unit and L units of labor at wper unit.We notice that in introducing total factor costs Ferguson uses the amorphous“units” and “per unit” rather than specifying just what those units are. If only onthe basis of his choice of symbols, however, we might guess that the unit prices arethe interest rate and the wage rate. However, the numerical illustration thatimmediately follows the quoted passage reveals our guess to be only half right: hesupposes that “capital costs $1,000 per unit (r = $1,000) and labor receives a wageof $2,500 per man-year (w = $2,500).” So, now we see that labor – not surprisingly– is measured in man-years. (We won’t chastise Ferguson for the gender bias thatwas prevalent in 1966.) But capital is still measured in unidentified “units.” We alsosee that r is reckoned in dollars, which precludes its being the interest rate.Presumably, r is the price (the rental price in the case of durable capital) of somephysically defined unit of capital.Roger Koppl has called to my attention the fact that in a later book Ferguson(1975 [1969]) dealt at some length with the issue of reswitching though not, it turnsout, with the more fundamental issue of units. Ferguson bows to Cambridge, UK:“there is no doubt that the Cambridge Criticism is valid” (p. 269). But he continuesto embrace “simple neoclassical theory” partly on the belief (as bolstered by MurrayBrown 1967) that the applicability of the neoclassical relationships can be establishedon empirical grounds and partly (along with Samuelson) as a matter of faith.Samuelson had reaffirmed his commitment in the same year (and month) his“Summing Up” appeared in print (1966b: 444): “Until the laws of thermodynamicsare repealed, I shall continue to relate outputs to inputs – i.e., to believe inproduction functions.”The amorphous “unit” for capital is a red flag, indicating that there is no particularunit that recommends itself. I remember other such red flags from lectures at theUniversity of Virginia – and from the literature on which those lectures were based.Marginal increases in the capital input were referred to as “hunks” of capital or“doses” of capital. Capital is by its nature heterogeneous – and more radically sothan other inputs. The heterogeneity is reflected in the various physical measures:lumber is measured in board feet, concrete in cubic yards, steel in metric tons,gasoline in gallons, and electricity in kilowatt-hours. “Machine-hours” are unitsthat evoke some imagery of stereotypical capital equipment but hardly serve as acomprehensive unit. And capital in the sense of goods in process renders the issue ofunits hopelessly open-ended. What, then, is Ferguson’s physically defined unitwhose price is $1,000?Heterogeneity as a fundamental aspect of capital is emphasized by LudwigLachmann (1978 [1956]) and more recently by Peter Lewin (1999). The claimmade here that capital is more radically heterogeneous than labor or land is not justa matter of a difference in degree. Different worker-hours of labor are not perfectlysubstitutable for one another. Neither are different acre-years of land. A substantialdegree of heterogeneity, then, characterizes both of these factors of production.But our attempt to construct an analogous claim for capital is telling: different

198 Roger W. Garrison____________ of capital are not perfectly substitutable for one another. Thedifficulty of even filling in the blank derives from capital’s dimensional, or radical,heterogeneity. This is a point that the Cambridge, UK critics of neoclassicismthemselves skirt – no doubt because it is as telling against their own constructions asit is against the neoclassicals. Taking capital to be dated labor, as in the rarifiedconstructions of Samuelson and others, may serve their immediate purposes, but itfails to identify any general-purpose capital metric. There is a temptation here toparaphrase Cohen and Harcourt: “What is the justification for a rarified unit ofcapital (dated labor) whose utilization is unwarranted outside the context of themost abstract models?”Over the years, an immunizing pedagogical technique has emerged in theclassroom to deal with the problem of units. This technique, I suspect, was not at allunique to my Virginia experience. Instead of writing Q = f (K, L), the professorwould write Q = f (A, B), where A and B were defined abstractly as two well-behavedfactors of production whose prices are P Aand P B. I remember catching the eye of aclassmate as we both wondered just what sort of misbehavior was being ruled out.In subsequent lectures it was easy for the professor to shift the focus from A and B toK and L – and to do so without bothering to reconsider the issue of “behavior.” Ilearned only later that Samuelson in his “Summing Up” article used the phrase“well-behaved” to describe aspects of production theory that were not embroiled inthe Cambridge paradoxes.Though preemptively ruled out by Cambridge, UK, the only solution to theproblem of capital heterogeneity is the one recognized by Wicksell – recourse tothat all-purpose common denominator: money. This is the solution that characterizesmy own child’s guide arithmetic and that reflects the methods of engineeringeconomics. To fully capture the essence of capital investments, we must adopt asour common denominator not just money but rather time and money. So manydollars are tied up for so many years. The appropriate units are dollar-years.“Value over time” was the phrase that Yeager used in his lectures to expressthe nature of the capital input. With this solution, however, the price cannot ber = $1,000 or r = any other dollar amount. Rather, straightforward unit analysisdictates that the price, which by definition is measured in dollars per unit, musthave the units of an interest rate.dollars dollars 1price = = = = years –1unit dollar-years yearsThe price of a loan may be 10 percent, that is, $0.10 per dollar per year – or,equivalently, 0.10 years –1 . Similarly, the price of the factor of production that ismeasured in inverse years, generally expressed as an annual percentage rate (APR),is the rate of interest broadly conceived.So conceived, the interest rate is the price of capital – or, as Cassel and Yeagerwould insist, the price of “waiting.” The problem, here, as recognized and emphasizedby Wicksell, stems from those dollars in the denominator. To illustrate withmy Child’s Guide, consider the dollar outlay of $210 associated with Technique A.

Reflections on reswitching and roundaboutness 199Supposedly, funds are borrowed – say, at 10 percent interest – and spent on realcapital input of some kind – let’s say a somewhat specific kind – at time t 1. In equilibrium,the rate of return on this capital would be that same 10 percent. Now,suppose that market conditions (say, increased saving preferences) change suchthat the price of borrowed funds falls to 9 percent. The interest rate has not fallenpast a switch point, so Technique A is still the technique of choice. But the price ofthe (physically defined) capital input will surely be bid up as a consequence of thatsame change in market conditions that lowered the rate of interest. That is, thevalue of the capital input used in period t 1is now less heavily discounted thanbefore. Hence, the higher dollar outlay required in this period is attributable in partto an increase in capital value not reflected in an actual increase in (physicallydefined) capital. This component of the increased outlay is called the Wicksell effect(Uhr 1960: 23–4, 120–2) – and sometimes called the price Wicksell effect so as toprovide a contrast with the real Wicksell effect (Burmeister 1987: 911).The portion of the increase in the outlay attributable to the price Wicksell effectdepends on the extent to which the capital input is stage-specific and on the remotenessin time to the subsequent revenues that the outlay makes possible. Moredefinitively: (1) the greater the stage specificity, the greater portion of the change inoutlay attributable to the price Wicksell effect and (2) the greater the temporaldistance between capital input and consumable output, the stronger the Wickselleffect (both price and quantity). As a summary reckoning, however, Casselian waiting,which has both a value and a time dimension, faithfully measures the factor ofproduction whose price is the interest rate; while Fergusonian capital, whose priceis r = $1,000, remains unmeasurable.Both the Wicksellian problem and the Casselian fix are pre-empted by theCambridge, UK conception of capital. Capital value never comes into play. Withreal capital (somehow) defined strictly in physical terms and with changes in theinterest rate introduced as parametric changes (rather than responses to changedmarket conditions), the only possible “effect” is a change in technique. The rate ofinterest can fall from 800 percent to 8 percent without inducing any change at all inthe economy’s production process. (This dramatic decrease in the interest ratewould affect only the distribution of income between capital and labor.) And if theinterest rate drops below 8 percent, the only change is the wholesale abandonmentof Technique A and the adoption of Technique B. The reverse change occursif the interest rate drops below 2 percent, the low-interest configuration beingidentical in all respects (except for the associated income distribution) to the highinterestconfiguration. This super-antiseptic quality of the reswitching “dynamics”is what identifies the Cambridge, UK constructions as strictly comparative-staticsexercises. There are no dynamics at all; there are only isolated economies in whichTechniques A and B have the same present value at two different interest rates. Ifwe take Joan Robinson’s “Unimportance” article to heart, we must see that anyaccount of the significance of the 2 percent and the 8 percent that employs a wordending ining” is bound to be misleading.The neoclassical production function, however, is often put to use in the study ofdynamics. It underlies growth theory as well as business cycle theory. The rate of

200 Roger W. Garrisoninterest is not itself parametric but rather is an endogenous variable that respondsto parametric changes – in resource availabilities, technology, and saving preferences.Though the possibilities of reswitching may add a special twist to theproblem of measuring capital, the problem remains even in the absence of thetwist. Measuring capital summarily in physical dimensions, value dimensions, oramorphous dimensions each have their failings. As measures of aggregate capital,dollars per machine-hour, dollars per dollar-year, and dollars per dose serve aswarnings about the problems rather than as solutions to them.A satisfactory solution, in my judgment, requires a theory that (1) takes explicitaccount of the time dimension in the production process and (2) takes the interestrate as a market-determined allocator of saving among different, temporallydefined uses.A time-dependent capital reckoningCohen and Harcourt simply reject the neoclassical theory, with its paradox-riddledaggregate production function. They offer as a viable alternative the classicaltheory of Ricardo and Sraffa, with its attention to class and the allocation of thesurplus. In his “Summing Up” article, Samuelson deals with the neoclassical andAustrian views of production, focusing importantly on the time dimension of theproduction process as set out by the Austrians. He refers to Böhm-Bawerk no fewerthan sixteen times and mentions the Austrians more broadly another ten times.If the Austrian-fashioned sequence of inputs exhibits reswitching, then the neoclassicalcapital-to-output ratio (and the aggregate production function) entailsmisbehavior of the (physically defined) capital input. In his concluding section,Samuelson is not inclined to recommend a return to classical modes of thought.Instead, he waxes philosophical about “scholars [not being] born to live an easyexistence” (p. 583).Surely, the relevant contrast is not that between classical theory and neoclassicalcum-Austriantheory. It is rather that between neoclassical theory, in which capitalis aggregated for inclusion in a production function, and Austrian theory, in whichcapital is temporally disaggregated in order to account for movements of capitalwithin a capital structure. Especially in view of the fact that capital – or waiting –has two dimensions (value and time) that can change in different proportionsdepending upon the particulars of the case, it is critical to maintain the distinctionsamong the various temporally defined capital inputs.As Cohen and Harcourt (2003a: 200) recognize, the neoclassical productionfunction continues to be used today – in endogenous growth theories and in realbusiness cycle theory. Tellingly, this particular piece of neoclassicism was introducedinto modern macroeconomic thought as a foil against which to promote theKeynesian mode of thinking. A quarter of a century after the appearance ofthe General Theory, Gardner Ackley (1961) recreated pre-Keynesian thought bycombining the production function with a supply-and-demand-determinedemployment level and a quantity-of-money-determined price level. Employingthe familiar Q = f (K, L), where the capital input (K ) is given, Ackley showed that

Reflections on reswitching and roundaboutness 201labor-market conditions determine employment and hence real output and realincome and that the additional consideration of the quantity of money allows forthe determination of the nominal levels of the output and income magnitudes. TheAckley-based rendition of Keynes versus the classics continues to be served up asstandard textbook fare, while a blending of Keynes and the classics (Keynesianneoclassicalsynthesis) is presented in the form of Keynesian IS–LM analysis with asupply-side (neoclassical) undergirding.Here and in the discussion below, the term “classical” is used as Keynes used it– to refer to the ideas of all economists (except Robert Malthus) from Adam Smithto Cecil Pigou. Accordingly, the loanable-funds market, in which the interest ratebrings into balance the supply of loanable funds (saving) and the demand forloanable funds (to finance investments), is taken to be the centerpiece of “classical”economics. This application of supply-and-demand analysis would have no placein Ricardo’s Principles of Political Economy (1911[1817]) or in Sraffa’s Production ofCommodities by Means of Commodities (1960).Though Ackley’s trumped-up classical model employing the neoclassical productionfunction is now commonplace, the understanding of how this modelactually relates to classical, neoclassical, and Austrian thought has been largely lost.Ackley himself recognized the nature – though, I will argue, not the significance –of the simplifying assumptions needed to transform pre-Keynesian thought into aclassical model. The introduction of his graphical exposition of classical fullemploymentequilibrium, especially his second-listed simplifying assumption, isrevealing:Actually, Classical price theory (as opposed to monetary theory) implies that thevolume of employment and output is determined in the first instance not bythe level but by the structure of prices. . . . We shall simplify this part of theanalysis very greatly by assuming (1) that perfect competition prevails in allindustries; and (2) that each industry is vertically integrated: it hires only laborand produces final output (using a given stock of capital goods and naturalresources); there are no intermediate goods. These assumptions can be removed with nomajor change in results . . . .(Ackley 1961: 124, emphasis altered)Here, Ackley has collapsed the critical time element out of the Austrians’ capitalstructure. The movement of resources among the temporally sequenced stages ofproduction is no part of Ackley’s classical story. Tellingly, the rate of interest, whichin the Austrians’ own theorizing equilibrates the loanable-funds market, broadlyconceived, and hence governs the intertemporal allocation of resources, makes noappearance in his classical model. Ackley presents separately the loanable-fundstheory, never integrating – or reconciling – this staple of pre-Keynesian macroeconomicswith the production function and its “given” capital stock.Despite Ackley’s claim to the contrary, actually allowing for an intertemporalstructure of capital does produce a “major change in results.” It allows for differentialchanges in the value of capital in response to a change in the rate of interest.

202 Roger W. GarrisonThe so-called Wicksell problem, though still a problem for those who insist on apurely physical measure of capital, is actually an important part of the marketmechanism that translates intertemporal consumption preferences into intertemporalproduction activities. For instance, consider an increase in saving, whichdepresses interest rates and shifts consumer buying power into the future. Thelower borrowing costs get translated through present-value reckonings into changesin the relative values of capital in each of the temporarily sequenced stages ofproduction. Engineering Economics tells us that present values all rise – some morethan others. A more thoroughgoing economic understanding allows us to see thatthe increase in the present values of early-stage capital relative to the present values inlate-stage capital results in resources being reallocated in the direction of the earlierstages. And this pattern of capital reallocation is the very one needed to shift theeconomy’s output further into the future and hence to accommodate the change tointertemporal preferences.Increased demands for capital having higher present values will be partly accommodatedby increased allocations and partly choked off by increased prices.We note that it is specifically in this connection that the Austrians have longemphasized that capital is heterogeneous. It is not surprising, then, that nosummary statement can be made – or need be made – as to just how large the realresponse might be relative to the price response. For capital of low specificity, theultimate price response is minimal, though during the adjustment period it isprecisely the increase in prices that attracts the additional capital; for highly specificcapital, the price response may dominate.It may be true that once the market has adapted itself to an increase in saving, theshifted neoclassical production function, [Q = f (K’, L) instead of Q = f (K, L)], is onethat has a greater capital input and hence allows for a greater aggregate output. Butin Ackley’s model, the significance of the capital structure – and the associatedmarket process – is in total eclipse. As Hayek (1941: 147) insisted, “A given stock ofcapital goods does not represent one single stream of potential output of definitesize and time shape; it represents a great number of alternatively possible streams ofdifferent shapes and magnitudes” (p. 147).The absence of any accounting of the intertemporal capital structure and of themarket process that maintains that structure or modifies it in response to preferencechanges is even more telling against Ackley’s timeless classical model when the issueis policy-induced (rather than preference-induced) changes in the rate of interest.Suppose, for instance, that the central bank injects additional sums of moneythrough credit markets, lowering interest rates and eventually raising prices allaround. The inattention to the market process in this case yields profoundly misleadingconclusions. In Ackley’s classical model, long-run results get undueemphasis at the expense of critical short-run aspects of the market process.With the loanable-funds market relegated to side-show status, the focus is on therelationship between the money supply and the overall price level as implied by thequantity theory of money (MV = PQ). The injection of new money through creditmarkets (a greater M) leads ultimately to increased prices of both consumer goodsand investment goods (a higher P). There are no lasting real effects of a monetary

Reflections on reswitching and roundaboutness 203injection. The Q = f (K, L) of the post-injection equilibrium is the same Q = f (K, L)that characterized the pre-injection equilibrium.A very different conclusion emerges if the effects of the increased money supplyare tracked by the loanable-funds theory rather than by the quantity theory. Themonetary injection increases the supply of loanable funds and hence lowers the rateof interest. The amount of investment funds demanded increases, especially in theearly stages of production. But with no change in intertemporal preferences, theamount of saving actually decreases – in response to the lower rate of interest.(Savers move down along an unshifted supply curve.) And less saving, of course,means correspondingly greater demands for current consumption. The marketprocess that allocates resources within the economy’s capital structure is at warwith itself. The changing pattern of resource allocation, which entails an increasedcommitment to serving future demands while also accommodating currentdemands, is inherently unsustainable. The eventual – and inevitable – reversal ofthe capital restructuring in the face of increasingly binding resource constraints isanything but a side show. Given the heterogeneity of capital and the durability andspecificity of some early-stage capital, the policy-induced boom and subsequentbust can leave the economy’s productive capacity well below its pre-injection level.The distorted Q = f (K’, L) does not morph back to the original Q = f (K, L) in a timelyfashion. The long run in which the original structure recreates itself on the basis ofactual intertemporal preferences may be long indeed.Choosing among frameworksAs it turns out, the neoclassical production function is condemned by both Cambridge,UK and the Austrians – but for very different reasons. The Cantabrigianscondemn a blend of neoclassical and Austrian ideas. They insist on a physicallydefined capital input and then argue that potentially anomalous changes in theinterest rate and in the degree of roundaboutness undermine the logic of the neoclassicalproduction function. The Austrians, who insist that the capital input has avalue dimension, hold to the claim that the degree of roundaboutness and the rateof interest are inversely related. They are not moved by counterexamples involvinga physically defined capital input. A reduction in interest rate increases the demandprice for early-stage capital. But quite independent of the potential for techniquereswitching, which F.A. Hayek recognized early on (Hayek 1941: 76–7, 140–5,191–2, and passim), the Austrians are critical of the neoclassicals for compressingthe temporally defined stages of capital into an all-inclusive K and hence concealingthe differential changes in capital values. The charge that Hayek (1931a: 277)leveled against John Maynard Keynes applies equally well to the neoclassicals:“[Their] aggregates conceal the most fundamental mechanisms of change.”Finally, it can be noted that the action item announced boldly by Cohen andHarcourt – a return to Ricardo and Sraffa’s classical way of thinking – comes asno news to the Austrians. Ludwig Lachmann (1986: 227) saw the general thrust ofthe Cohen–Harcourt message in an early article by Sraffa: “With benefit of hindsightwe are now able to understand that Sraffa’s [1932] critique of Hayek’s book

204 Roger W. Garrison[Prices and Production (1931b), in which the intertemporal structure of productionloomed large] marked the start of the neo-Ricardian counter-revolution. . . . Theaim of [this] counter-revolution is to undo the subjectivist revolution in economicthought which took place in the 1870s, led by Jevons, Menger and Walras.” Animportant difference between Sraffa (1932) and Cohen and Harcourt (2003a) isthat Sraffa offered up his critical remarks while disguising his own preference forthe Ricardian way of thinking, which had fallen into disfavor many decades earlier.Lachmann (1986: 228) explains: “The reason for the disguise he chose to wear isobvious. . . . The neo-Ricardian counter-revolution, in the circumstances of 1932,could not be expected to win adherents. . . . For his polemical purpose it was betterthat [his readers] should be puzzled than that they might become suspicious.”If the 1932 Sraffa article can be seen as marking the start of the neo-Ricardianrevolution, we might wonder if in years to come the 2003 Cohen–Harcourt articlewill be seen as marking the end of it. The lack of a substantive answer to the“Whatever Happened?” question and the lack of appeal of the Ricardo–Sraffa wayof thinking may give just such a special significance to 2003.The thrust of the present paper is that the alternative framework that Sraffa hidand that Cohen and Harcourt proudly advertise is a false one. We need not choosebetween Ricardo’s classical framework and some neoclassical-cum-Austrian framework.This overly constrained two-way choice becomes a three-way choice oncewe recognize that each of the three schools here is sufficiently distinct in terms of theperceived nature of the rate of interest and the role of the interest rate in achievinga coordination of consumer preferences and production activities.The neoclassical school allows for a market determination of the interest rate (theloanable-funds theory) but does not allow for changes in the interest rate to haveany significant effect of the intertemporal structure of capital. Ricardian classicismallows for changes in the interest rate to affect the intertemporal structure of capital– though only through a switching of techniques and possibly a subsequentreswitching – but treats the interest rate itself as if it were determined outside theframework of analysis. The Austrian theory allows for a market determination ofthe interest rate and allows for changes in the interest rate to govern the intertemporalallocation of resources within the economy’s capital structure. In fact,these two features are actually two perspectives on a single feature. Intertemporalexchanges in the marketplace – whether directly registered in the market forloanable funds or indirectly registered as a change in the price of early-stagecapital relative to late-stage capital – work to coordinate the production decisionsin the various temporally defined stages with intertemporal consumption preferences.We can reject the idea that writing Q = f (K, L) somehow allows us to ignore thecomposition of the capital structure. Further, with ample support from LelandYeager, we can reject the claim that the intertemporal structure of capital must bespecified in physical terms and not value terms. Technique reswitching, a possibilitythat hinges critically on a physical measure of capital, has little claim on ourattention. And the insight that a change in the degree of roundaboutness, broughtabout by a change in saving and reckoned in value terms as the movements of

Reflections on reswitching and roundaboutness 205resources among the stages of production, cannot be made meaningless by theCambridge polynomials and cannot be marginalized by the neoclassical K.Note* Roger W. Garrison, Professor of Economics at Auburn University in Alabama, is theauthor of Time and Money: The Macroeconomics of Capital Structure (London: Routledge, 2001).Helpful comments on this paper by Roger Koppl, Thomas McQuade, Robert Murphy,Sudha Shenoy, and Sven Thommesen are gratefully acknowledged.ReferencesAckley, Gardner (1961). Macroeconomic Theory. Toronto: Macmillan.Brown, Murray (1967). Substitution-Composition Effects, Capital Intensity Uniqueness andGrowth. Discussion Paper #2. Economic Research Group, State University of NewYork at Buffalo.Burmeister, Edwin (1987). Wicksell Effects. In John Eatwell, Murray Milgate, and PeterNewman (eds.) The New Palgrave Dictionary of Economics, vol. 4. London: Macmillan,pp. 910–12.Cohen, Avi J. and Geoffrey C. Harcourt (2003a). Whatever Happened to the CambridgeCapital Controversies? Journal of Economic Perspectives, 17(1): 199–214.Cohen, Avi J. and Geoffrey C. Harcourt (2003b). Cambridge Capital Controversies:Response from Avi J. Cohen and G. C. Harcourt. Journal of Economic Perspectives, 17(4):232–3.Felipe, Jesus and J.S.L. McCombie (2003). Cambridge Capital Controversies: Comment.Journal of Economic Perspectives, 17(4): 227–8.Ferguson, C.E. (1966). Microeconomic Theory. Homewood, IL: Richard D. Irwin, Inc.Ferguson, C.E. (1975 [1969]). The Neoclassical Theory of Production and Distribution. London:Cambridge University Press.Friedman, M. (1953). The Methodology of Positive Economics. In Essays in PositiveEconomics, Chapter 1. Chicago: University of Chicago Press.Garrison, Roger W. (1979). Waiting in Vienna. In Mario J. Rizzo (ed.) Time, Uncertainty, andDisequilibrium. Lexington, MA: D. C. Heath and Co., pp. 215–26.Greenfield, Robert (2003). Cambridge Capital Controversies: Comment. Journal of EconomicPerspectives, 17(4): 228–9.Hayek, Friedrich A. (1931a). Reflections on the Pure Theory of Money of Mr. J. M. Keynes.Economica, 11(33): 270–95.Hayek, Friedrich A. (1931b). Prices and Production. London: George Routledge and Sons.Hayek, Friedrich A. (1941). The Pure Theory of Capital. Chicago, IL: Chicago UniversityPress.Lachmann, Ludwig M. (1978 [1956]). Capital and its Structure. Kansas City: Sheed, Andrews,and McMeel.Lachmann, Ludwig M. (1986). Austrian Economics Under Fire: The Hayek–Sraffa Duel inRetrospect. In Wolfgang Grassl and Barry Smith (eds.) Austrian Economics: Historical andPhilosophical Background. New York: New York University Press, pp. 225–42.Lewin, Peter (1999). Capital in Disequilibrium: The Role of Capital in a Changing World. London:Routledge.Maddox, Rodney and Michael Carter (1982). A Child’s Guide to Rational Expectations.Journal of Economic Literature, 20(1): 39–51.

206 Roger W. GarrisonRicardo, David (1911 [1817]). On the Principles of Political Economy and Taxation. New York:E. P. Dutton and Co.Robinson, Joan (1975). The Unimportance of Reswitching. Quarterly Journal of Economics,89(1), 32–9.Samuelson, Paul A. (1962). Parable and Realism in Capital Theory: A Surrogate ProductionFunction. Review of Economic Studies, 29(3): 193–206.Samuelson, Paul A. (1966a). A Summing Up. Quarterly Journal of Economics, 80(4): 568–83.Samuelson, Paul A. (1966b). Rejoinder: Agreements, Disagreements, Doubts, and the Caseof Induced Harrod-Neutral Technical Change. Review of Economics and Statistics, 48(4):444.Sraffa, Piero (1932). Dr. Hayek on Money and Capital. Economic Journal, 42(165): 42–3.Sraffa, Piero (1960). Production of Commodities by Means of Commodities. Cambridge: CambridgeUniversity Press.Uhr, Carl G. (1960). Economic Doctrines of Knut Wicksell. Los Angeles, CA: University ofCalifornia Press.Walsh, Vivian and Harvey Gram (1980). Classical and Neoclassical Theories of General Equilibrium:Historical Origins and Mathematical Structure. Oxford: Oxford University Press.Wicksell, Knut (1934 [1911]) Lectures on Political Economy, vol. 1. London: George Routledgeand Sons.Yeager, Leland B. (1976). Toward Understanding Some Paradoxes in Capital Theory.Economic Inquiry, 14(3): 313–46.Yeager, Leland B. (1979). Capital Paradoxes and the Concept of Waiting. In Mario J. Rizzo(ed.) Time, Uncertainty, and Disequilibrium. Lexington, MA: D. C. Heath and Co., pp.187–214.

14 Leland Yeager’s utilitarianismas a guide to public policyRandall G. HolcombeThe economics profession makes a sharp distinction between positive economics,which analyzes the facts, and normative economics, which is based on value judgments.Because positive analysis deals with the facts, it can be scientific, but there isno way to scientifically show that one set of values is any better than another, whichdistances normative economics from economic science, at least as most economistswould see it, and perhaps even relegates it to a matter of opinion. Much to hiscredit, Leland Yeager has not shied away from normative issues in economics: hehas tackled them head-on, and has consistently advocated a utilitarian approach topolicy espousal in economics. This paper offers a critical analysis of Yeager’s clearthinking and insightful analysis on normative issues. Yeager’s brand of utilitarianismhas much to recommend it. Ultimately, Yeager argues, policy decisions shouldbe judged by their effects on people’s well-being, which is his utilitarian criterion foradvocating public policies. Further, Yeager argues, utilitarian arguments underliemany of the alternatives to utilitarianism that others recommend. Perhaps withoutrealizing it, the critics of utilitarianism offer utilitarian arguments to support alternativenormative criteria. Yeager says that after careful analysis, people should notbe reticent about saying that they recommend particular policies because thosepolicies will increase the well-being of those who are affected by them.I am sympathetic with Yeager’s arguments, yet I do not completely accept them,for reasons that will become apparent by the end of this paper. There are inherentdifficulties with normative arguments precisely because there are value judgmentsinvolved, yet normative analysis is important, and ultimately necessary in the publicpolicy arena. I am writing this paper in honor of Leland Yeager, who was mycolleague at Auburn University for several years, so I want to make it clear to readersthat I have the highest respect for Leland as a person and a scholar, and for his ideas.Those who are fortunate enough to know Leland will have to agree with me that heis the epitome of a scholar, and a man of ideas. I have learned much from myconversations with him, and from reading his work. Also, I hope readers will indulgeme when I include some personal reminiscences that go along with the topic of mypaper, because Leland and I did have a number of discussions on this topic.Positive and normative economicsEver since Milton Friedman’s (1953) essay on the methodology of positive economics,the economic analysis that has appeared in the leading academic economics

208 Randall G. Holcombejournals has been couched in an explicitly positive framework. 1 A good descriptionof the positive attitude that characterizes many economists is found in Alchian andAllen’s introductory textbook. They state:Economic theory is “positive” or “non-normative.” It gives no generallyaccepted criteria for determining which consequence or type of behavior oreconomic policy is good . . . Economics can tell only the consequences of certainconditions, policies, or choices. It is no more proper for the economist than forany other person to sit on Mt. Olympus and decree what is desirable, thougheveryone may in fact make such pronouncements.(Alchian and Allen 1972: 6–7)This statement appears at the beginning of Alchian and Allen’s book; later in thebook they analyze many policies and look at their consequences. For example,when discussing rent controls they say:The connection between rent controls and manifestation of greater discriminationby personal characteristics is exemplified in New York City . . . Perhapsno city is so beset with complaints of shortages, racial discrimination, personalfavors, and rundown conditions in rent-controlled apartments and publiclysubsidized housing – all involving rentals at less than exchange-equilibriumrates.(1972: 103–4)The lesson we take from this is that as economists we can only say that rent controlsproduce shortages, discrimination, and rundown housing conditions, but we are inno position as economists to say whether these things are good or bad.I am sympathetic with Alchian and Allen’s reasoning – to a degree. They aresaying that as economists, they can only say that rent controls cause shortages,discrimination, and rundown housing, but economics stops short of saying whetherthese things are good or bad. They may have their personal opinions, but theiropinions are no better than anyone else’s. At the same time, surely Alchian andAllen (the people, not the economists) would agree that the effects of rent controlsthey list are undesirable, so by their positive analysis there is no other conclusion todraw but that rent controls are poor public policy. 2 It is almost disingenuous forthem to assert that, as economists, they can conclude that these are the effects of thispolicy, but they cannot say whether the policy is good or bad. Their positive analysispoints directly to the normative conclusion that rent controls are undesirable,and Yeager’s utilitarian policy espousal would have little difficulty passing a normativejudgment on rent controls based on Alchian and Allen’s positive analysis, asYeager (2001: 11) emphasizes.Normative analysis must lie at the heart of any economic policy espousal.Positive economics is all that is needed to analyze the order created by the marketsystem which is, as Hayek said, the result of human action but not of humandesign. 3 However, a substantial part of economic activity is channeled through

Leland Yeager’s utilitarianism as a guide to public policy 209government, and government is the result of human design. If people are going todesign the public policies that guide government activities, advocates of policiesmust have some method of determining which policies are desirable. While one cananalyze just the effects of public policies, as Alchian and Allen claim to do with rentcontrols, normative analysis of those policies is almost inseparable from the positiveanalysis. Samuelson (1956) derives social indifference curves to answer normativequestions, mathematically weighing the utility of some against the utility of othersto find a social optimum, but this mathematical formulation, while it gives a positiveappearance to normative analysis, does little in the way of actually answering anynormative questions. Yeager’s utilitarianism goes beyond Samuelson’s in a numberof ways, but both offer a utilitarian argument for determining the desirability ofpublic policies.Yeager’s utilitarianismYeager’s utilitarianism is considerably more sophisticated than simply summing upthe utilities of individuals to try to maximize some measure of social welfare. Yeager(2001) offers a detailed discussion and defense of his ideas on utilitarianism, and Icould not hope to give a good summary of his ideas in so limited a space, so thissection merely identifies some features of it that are relevant to the discussion thatfollows. Yeager says,Utilitarianism as I conceive of it is a doctrine whose test of ethical precepts,character traits, legal and economic systems, and other institutions, practices,and policies is conduciveness to the success of individuals as they strive to makegood lives for themselves in their own diverse ways. Its fundamental valuejudgment is approval of happiness and disapproval of misery.(2001: 13)He notes, “The happiness criterion, being a fundamental value judgment, cannotbe proved valid” (2001: 83). Yet Yeager’s value judgment is not unreasonable, andhis utilitarianism begins from this foundation.Yeager advocates rules-utilitarianism over act-utilitarianism, which means thathe does not want to apply utilitarian judgments to specific acts, but rather to thelarger social framework of formal and informal rules. Appealing to argumentsmade by Hayek, Yeager says,In rejecting act-utilitarianism for rules-utilitarianism – but in terms that are nothis – Hayek explains . . . why it may be rational to disregard known particularcircumstances when making decisions. Accidental and partial bits of informationmight not change the probability that if we knew and could process allinformation about the circumstances, the net advantage would lie on the side offollowing the applicable rule. We should not decide each case on the basis of thelimited number of individual facts we happen to know. . . . Rules-utilitarianism. . . perceives the rationality of acting, in certain cases and aspects of life, on

210 Randall G. Holcombegenerally applicable abstract principles instead of on the fragmentary and probablyaccidentally biased bits of concrete information that one may happen topossess.(1985: 279)Yeager wants to go beyond rules-utilitarianism and advocates indirect utilitarianism,which includes aspects relating to individuals’ character and attitudes,but rules-utilitarianism is a subset of indirect utilitarianism, and that subset directlyapplies to issues of policy espousal discussed in the present paper. Yeager notes,Indirect utilitarianism encompasses and transcends a narrow focus on rules. . . .Indirect utilitarianism recommends, then, rules whose application is conditionedby suitable attitudes and inclinations and dispositions. Examples includesympathy (as of Adam Smith’s impartial spectator) and a sense of fairness, adisinclination to grab special privilege and to make arbitrary exceptions in one’sown favor. Having and acting on such dispositions is likely, by and large, to serveboth one’s own happiness and the general happiness . . .(2001: 88)Yeager recognizes the value of freedom, so is reluctant to push his utilitarianismtoward imposing rules on individuals. He says: “A utilitarian can recognize thatletting people make their own mistakes is more conducive to happiness, after all,than letting ‘the man in Whitehall’ direct their lives” (2001: 102). At the same time,he stops short of the contractarian position, noting “the factually dubious suppositionthat individuals are always the best judges of their own interests” (2001: 102),and goes on to note “actual happiness, not preference-satisfaction, remains themore philosophical criterion” (2001: 103). Economists often argue that individualsare the best judges of their own well-being, but Yeager does not accept this as auniversal truth.Yeager emphasizes the need for social cooperation to promote happiness, and,referring to public policy issues, says,the goal of any such tinkering should be to preserve and improve socialcooperation, which is a state of affairs allowing individuals in general . . .favorable opportunities to make good lives for themselves in their own diverseways through trade and other peaceful interactions with their fellows.(2001: 103)Yeager thus argues that social cooperation is the major goal of public policy, saying“social cooperation is only a nearly ultimate criterion” (2001: 82). Human happiness,of course, is his ultimate criterion.Yeager’s emphasis on social cooperation relates directly to his utilitarian policyespousal. He says,Since maximum utility, whether personal or aggregate, is not a goal that anyonecan directly pursue, the question facing ethical philosophers and policymakers

Leland Yeager’s utilitarianism as a guide to public policy 211concerns background conditions instead. What self-consistent and attainableframework of institutions, rules, character traits, dispositions, and attitudesconduces best to mutual noninterference and effective cooperation amongindividuals pursuing their own diverse objectives?(2001: 117)One sees in Yeager a deep respect for individual rights – yet he rejects any type ofnatural rights doctrine – and a recognition of the need for cooperation – yet he hasbeen very critical of the contractarian paradigm. In advocating his brand ofutilitarianism, one of the things that Yeager has done in a number of places is tocompare his utilitarian approach to policy espousal with alternatives. The next twosections look at two of these alternatives that are related to his own utilitarianderivedvalues: contractarianism, and natural rights.ContractarianismI was privileged to be Leland Yeager’s colleague at Auburn University for a numberof years, and shortly after he arrived I gave him a copy of my 1983 book. Onechapter of that book analyzed the contractarian framework, and Leland and I hadseveral discussions about contractarianism after he had looked at my book. Notingthat I had employed a contractarian framework in my analysis, Leland said to meabout contractarianism, “You don’t really believe that, do you?” One of Yeager’sstrongest objections to the contractarian framework is its hypothetical nature. Inresponse to some of what I wrote, Yeager says,The writings of Buchanan and other contractarians (including Holcombe 1983,especially chapter 8) bristle with words like “conceptual” and “conceptually” –“conceptually agree,” “conceptual agreement,” “conceptual social contract,”“conceptual unanimous approval,” and the like. The very use of the wordsindicates that a “conceptual” agreement is not an actual one, that a “conceptually”true proposition is not actually true. It is no mere joke to say that “conceptually”is an adverb stuck into contractarians’ sentences to immunize themfrom challenge on the grounds of their not being true.(1985: 271)Yeager (1985: 272) goes on to criticize Rawls (1971) on the same grounds. Hisdevice of a veil of ignorance is a fiction that disguises “his total reliance on his ownintuitions.”Another of Yeager’s objections to contractarianism is that it is based on thefiction that citizens have agreed to the terms of their government. I recall Lelandsaying to me, “No matter how much I like my government, I have no choice aboutobeying its rules. Government is based on coercion, not agreement.” The sameidea appears in his 1985 article, where he says,the state is there whether I want it or not. My welcoming certain arrangementsdoes not mean that they are not compulsory. I am glad to have seat belts in my

212 Randall G. Holcombecar and would probably have bought them willingly if I had had a free choice,but the fact remains that I did not have a free choice and that the belts wereinstalled under compulsion of law.(1985: 285)Yeager then says,Far from the state’s being a voluntary arrangement, then, its essence iscompulsion. It relies as a last resort on its power to seize goods and persons, toimprison, and to execute. If obedience to government is not compulsory, thenwhat is? . . . To say this is not to glorify the compulsory aspects of government. Iconcede their necessity only with regret. I want to keep them tightly restrained,as the cause of human liberty requires. One serves that cause poorly if onedeludes oneself into thinking that government embodies free exchange and thatcompliance with its orders is voluntary. . . . Society and government are not andcannot be the results of a social contract. 4 (1985: 285)Both of Yeager’s points are well-taken, but the second point (that government isbased on coercion, not agreement) struck me more forcefully than the first (that aconceptual agreement is not an actual agreement). The chapter of my book thatYeager cites was a critique of the social contract theory, and I had written it to concedethe basic assumptions of the contractarian framework, and then proceeded toshow that even under these assumptions, there would be a bias toward big governmentwithin Buchanan’s (1975) contractarian framework. Thus, I was willing togrant the conceptual nature of the theory in order to tease out its logical implications.Furthermore, economists often make unrealistic assumptions in theirmodels, so this by itself does not seem problematic. However, unrealistic assumptionsmay loom larger in frameworks that have heavy normative implications,like the contractarian framework, and I do think that Yeager’s critique of contractarianismon this ground has merit.Leland’s critique that government is based on coercion, not consent, appears tome to be a more serious problem with the contractarian framework, and one that Iconfess I had not fully recognized before Leland stated it to me. If the strong canforce the weak to give up some of their resources, then conceptual agreement as ananalogy to anything in the real world seems to completely vanish. How could asocial theory be based on the idea of unanimous agreement when the strong canforce the weak to go along with their desires whether or not the weak agree? I thinkthat many of the contractarian conclusions remain after taking account of thesecriticisms, as I explain in Holcombe (1994). 5 But Yeager’s insistence that thecontractarian theory is invalid as an analogy to real-world government becausegovernments impose their policies by force certainly strikes at the heart of anyattempt to claim that people have a duty to abide by government mandates becausepeople are party to a social contract.Yeager’s later writing softens his critique of contractarianism when compared tohis work in the 1980s. Yeager says,

Leland Yeager’s utilitarianism as a guide to public policy 213In substance, contractarianism of James Buchanan’s type is similar to the utilitarianismexpounded in this book. ... Contractarianism emphasizes that it isindividuals who reap benefits and costs, satisfactions and frustrations, andhappiness or misery resulting from their interactions with one another. ... Contractarianshave no monopoly, however, in recognizing these facts. Here againutilitarianism and contractarianism intersect. ... Emphasis on social cooperationfurther dissolves tensions between the two doctrines.(2001: 209)But Yeager goes on to support the utilitarian approach to policy espousal, saying,Although both share individualistic values, one might conceivably try to makethis distinction: while utilitarianism derives individualism as a theorem, contractarianismsimply postulates it as an axiom. . . . [I]s consent (along with choice)really a first principle, an ultimate value? We value consent and choice becausewe care about outcomes and deplore the likely consequences of empoweringauthorities to override individual choice and govern people without theirconsent.(2001: 209–10)Yeager (2001) finds much more commonality between utilitarianism thanYeager (1985), but ultimately he argues that the commonality derives from theutilitarian underpinnings of the contractarian framework. Still, Yeager concludes,“The contractarian and utilitarian doctrines differ mostly in their rhetoric andconceivably also in their epistemology” (2001: 210).I am inclined to agree with Yeager part way on this, but to use his own argumentsto highlight an important difference. The hypothetical nature of the social contractand the Rawlsian veil of ignorance never bothered me much, because I felt like itwas saying, “Put yourself in the other guy’s shoes.” Decide what is good policy foreveryone, abstracting from your own interests. Here, the difference is, as Yeagersays, mostly rhetoric. But Yeager also points out that the contractarian frameworkdepicts government as the result of agreement, whereas in fact government implementsits agenda by coercion, and this seems to be a more important normativeissue. The contractarian framework suggests that, from a normative perspective,we should abide by government’s rules because they are something we have(conceptually) agreed to, but in what sense have we agreed to the coercive power ofgovernment? The contractarian framework accords government more legitimacythan it deserves.Natural rightsYeager sums up the rights approach well by saying,Rights theorists reject the approach that would take a stand on each specificpolicy issue, such as deregulation of a particular industry or imposition of wage

214 Randall G. Holcombeand price controls or government credit allocation, according to the apparentmerits of the individual case; they reject narrowly focused cost-benefit calculations.Instead of being framed by case-by-case expediency, policy shouldconform to persons’ rights.(1985: 260)Yeager answers this natural rights approach by saying,Unfortunately, the door is open to interventionist demands anyway. Libertarianscannot keep it closed by issuing methodological pronouncements or byreporting their intuitions about endangered rights. A pure rights position,untainted by utilitarian aspects, might serve for warding off illegitimate orundesirable interventions if it enjoyed general acceptance. Although it might beconvenient if a particular doctrine were true and generally accepted, that conveniencealone is no evidence, unfortunately, that the doctrine is in fact true.(1985: 260)Yeager then accepts “a pro-rights doctrine, provided that propositions aboutrights are recognized not as purely positive propositions of fact and logic but ratheras normative propositions” (1985: 261). Not surprisingly, Yeager then wants tosupport his pro-rights doctr