Economic Liberalism and (Re)Building Europe after WWII.

It is important to understand that economic recovery and growth in Europe after World War II is not as tied to Keynesianism, unfunded welfarism, and corporatism as is sometimes assumed.

The Glorious Thirty Years of European recovery from world war and subsequent growth were not due to ‘Keynesianism’ etc. The Thirty Years ended because the influence of liberal policies had weakened and the costs of other policies had accumulated to create an obviously dysfunctional system. Left-wingers (and communitarian-corporatist conservatives) who think ‘market fundamentalists’ overthrew a well functioning social and economic settlement which was behind all the economic growth and associated institution building (post-war national recovery and European Union construction) are in error. It is a major error to ignore the influence of Austrian School liberals (see the discussion by a leading current practitioner of Austrian economics, Peter Boettke) and the related Ordoliberalismus of the Freiburg School.

My remarks on what the major terms and schools in this paragraph refer to have become uncontrollably long, so they are relegated to the bottom of the post. I hope readers will have the patience to reach them.

The key points are that the German post-war Economic Miracle came from Ordo-liberal policies, while economic growth in France after Charles de Gaulle came to power for the second time in 1958 comes from the policies of Jacques Rueff, a civil servant, judge, and economist who participated in the 1938 Walter Lippmann Colloquium in Paris, a decisive event in the revival of liberal economic thinking attended by Hayek and many other notable liberal thinkers.

Such ideas have had a lot more influence in France than lazy propagators of clichés about statist France and liberal America understand. Of course, if we look at the French and American economies we can see notable ways in which the US economy is more liberal, but that should not obscure the reality that France has had good economic times and that these have come about because liberal economic policies were applied, even where, as under de Gaulle, the political narrative of the government was not liberal. The France of 1958 and after was able to stabilise institutionally after a real danger of the collapse of constitutional democracy and have a good economic period because of neoliberal economic ideas.

Some on the left think the relative revival of market liberalism in the 1970s can be rooted in the Chilean Coup of September 1973, after which economic policy was to some degree influenced by Chilean economists with doctorates from the University of Chicago. This revival of market liberalism is known as neoliberalism, a potentially useful term which came out of the Lippmann Colloquium (see below) that has unfortunately collapsed into an empty term of abuse for any kind of market thinking in government policy, wherein even the most modest accommodation of economic rationality is labelled ‘neoliberal’ and therefore extreme, authoritarian, and based on the narrow greed of the rich. It is sometimes accompanied by attempts to read enlightenment liberals as somehow ‘really’ left-liberal, social democratic, or even socialist.

The reality is that neoliberal ideas were first obviously influential on Continue reading

Human Action, Ch. 1

Well, I finally started reading Human ActionOne connection stood out to me from the first chapter. 

First, there’s much more attention paid to fundamental philosophy than I expect from economic treatises. This is understandable given that Mises felt he had to set the stage — sparring, as he says, with the irrationalists, polylogists, historicists, positivists, behaviorists, and other economists within the youngest science. Every undergrad, cracking open Hobbes’ Leviathan, is startled to find lengthy remarks on human cognition in what they thought was only a work of political philosophy; this was a similar experience. 

There are noticeable allusions between von Mises and pre- and post-Tractatus Wittgenstein. Both Austrians and both Ludwigs, the economist writes that “It is impossible for the human mind to conceive logical relations at variance with the logical structure of our mind. It is impossible for the human mind to conceive a mode of action whose categories would differ from the categories which determine our own actions” (p. 25). Similarly, for the philosopher, the logical structure of thought (and language) was a central theme of Tractatus Logico-Philosophicus; one of the young Wittgenstein’s conclusions was that some (ethical, aesthetic, metaphysical) postulates go beyond the limits of language and, when crunched into such human linguistic straightjackets, create sheer nonsense (leading to such maxims like, “What can be said at all can be said clearly…”) (TLP, §7).

Each Ludwig, of course, limited their inquiry to the human mind, discovering, like Kant, universal conditions of rational beings (or so I garner so far from Mises). 

Another methodological point in common. Ludwig von Mises, in section The Alter Ego, remarks on “the ultimate given,” an idea which, I believe, is unpopular in contemporary epistemology. The empirical sciences must reach final points of inquiry, upon which their tools fail to produce deeper insight. This is so because, to Mises, there are only “two principles available for a mental grasp of reality, namely, those of teleology and causality” (p. 25): teleology belonging to purposeful behavior, and causality to non-purposive objects of study. The former, applied ad infinitum, must stop at the unmoved mover, and the latter can only invoke an infinite regress. This point is important for deploying praxeology as a deductive science.

This doesn’t seem like a new insight, but it’s also one that Wittgenstein touches upon in a different way in Philosophical Investigations, writing in the first segment “Explanations come to an end somewhere.” The use of language in daily life does not imply ultimate, elucidated concepts between speakers; we never ask for these and likewise we do not need them to communicate. Reaching deeper into shared insight also leads to confusion; we talk of objects and ideas as ‘wholes’ and ‘composites,’ but these categories are not unambiguous. Wittgenstein situates the sense of concept-analysis only within a language game: “The question ‘Is what you see composite?’ makes good sense if it is already established what kind of complexity — that is, which particular use of the word — is in question. If it had been laid down that the visual image of a tree was to be called ‘composite’ if one saw not just a single trunk, but also branches, then the question ‘Is the visual image of this tree simple or composite?’, and the question ‘What are its simple component parts?’, would have a clear sense — a clear use.” So therefore, “To the philosophical question: ‘Is the visual image of this tree composite, and what are its component parts?’ the correct answer is: ‘That depends on what you understand by “composite”.’ (And that is of course not an answer but a rejection of the question.)” (PI, §47).

In the future I might post on Mises’ short use of terms like “being,” “change,”and “becoming,” which he uses in a sense reminiscent of Parmenides.

Wittgenstein, Philosophical Investigations. G. E. M. Anscombe trans.

von Mises, Human Action. Scholar’s Edition. Ludwig von Mises Institute.

Military Dictatorship in Brazil: Was it worth it?

The title of this text can already cause controversy since many understand that there was no dictatorship in Brazil, but a series of military governments that could not be classified as dictatorial. But the fact is that, in 1964, Castelo Branco became president in place of João Goulart, being succeeded by Costa e Silva, Medici, Geisel and João Figueiredo. Calling this dictatorship or not, the fact is that João Goulart was deposed and Castelo Branco occupied the presidency to avoid that the country was taken by groups sympathetic to the communism, making Brazil a “Big Cuba”. And it is against this fact that I ask if it was worth it: was it worth having 21 years of military governments to prevent a socialist government from being implanted in Brazil?

A socialist government was implemented in Brazil in 2003 by popular vote. Although political propaganda in 2002 had proclaimed an inclination towards the center of the political spectrum, the fact is that the PT never completely abandoned its socialist inclinations. It could even be said that FHC is worthy of the same comment: although less inclined to the left, the PSDB does not carry “democratic socialism” in the name for nothing. In light of this, I ask if it was worth having 21 years of military governments in Brazil. In 1988, just three years after João Figueiredo left the presidency of the country, a Constitution was promulgated with a strong Progressive character. In 1994, less than 10 years after the last military president stepped down, Brazil elected a “Third Way” president. In 2002 a president with a past of explicit connections with socialism came to power, and in 2011 the country happened to be governed by a former guerrilla warrior. If the objective of placing the military in power has been to avoid the implantation of socialist governments in Brazil, it can be said that this goal was not achieved. It was only postponed for just over 21 years.

What is socialism? Why is it so bad? Even without any empirical research, I am quite sure that most of the Brazilian population would not know how to answer these questions. In a similar vein, I am quite convinced that most of the country’s “literate class” (artists, academics, and intellectuals of all kinds) is sympathetic to socialism. Many of the political parties in Brazil carry “socialism” or “communism” in the name.

What did the military governments offer in exchange for socialism? Although they had varied characteristics, most of the governments between 1964 and 1985 tended to be a modernized version of Positivism. Positivism states that all knowledge (tradition, common sense, religion) will be superseded by positive scientific knowledge. Another way of defining it is to say that only what is empirically proven is true. Positivism, however, presents some problems. First, it is self-defeating, that is, it does not stand up to its own validation criteria: “Only what is empirically proven is true.” Is this empirically proven? Is it empirically proven that “only that which is empirically proven is true”? No. And it could not even be. Another difficulty is to carry out the empirical tests. It is possible, even with constraints, to conduct empirical tests in a controlled environment (in laboratories) to test theories and hypotheses. But it is not possible to declare the universality of the results, even if the tests are performed a very large number of times.

This “problem of induction” (to draw universal conclusions from particular, albeit many, observations) was famously answered by Karl Popper: in Popper’s definition, the aim of science is not to prove universal truths, but to affirm with confidence a set of information. In other words, nothing is “scientifically proven,” but many things are scientifically falsified by the lack of favorable evidence. Ludwig von Mises answered the problem of induction in another way: not everything has to be empirically tested to be considered true. There are truths that are self-evident, even without any empirical test. Despite the differences, both Popper and Mises offered possibilities of non-positivistic sciences (in the sense of systematic knowledge), especially valid for the study of human beings living in society.

Positivism and Marxism are sister doctrines. Both emerged in the 19th century in response to liberalism. The origin of liberalism lies in Christianity, if not in the affirmation of the existence of the Christian God in all the details presented by the Bible, at least in elements such as Natural Law and an anthropology similar to that of Christian teaching. Positivism and Marxism have moved away from Christianity by adopting a materialist view of reality (it only exists, or at least it only matters what we can experience empirically) and by denying the natural limitations of the human being.

Following von Mises, the Austrian School rejects the positivist methodology, and therefore is classified as heterodox. Although we should avoid anachronisms, the tendency of classical economists was the same: from introspection and axioms, rather than from empirical tests. It is not a matter of despising the scientific method altogether, quite the opposite! The scientific method is excellent for taking the man to the moon and discovering the cure of diseases. It just is not fit for a human “science.” To believe so is to fall into a “fatal conceit”. The military that governed Brazil between 1964 and 1985 can be accused of this fatal conceit. They generally believed that they could rule the country as if it were a barracks.

In conclusion: was it worth it? Certainly avoiding Socialism is a great and necessary goal. But combating it with Positivism is not the right path. Two mistakes do not make a hit. Was there the possibility of combating socialism with liberalism? I think not. Brazil didn’t have the liberal tradition necessary to confront socialism and other forms of authoritarianism or totalitarianism (and maybe it still hasn’t). Looking back, we can only regret that the options were so bad. Looking forward, we can try to improve our options by building a true liberalism in Brazil.

Hayekian Environmental Policy

Just as decentralized knowledge implies economic non-intervention, so too it implies environmental non-intervention.

One of the contributions to economics made by the Austrian-school economist Friedrich Hayek is the theory of scattered knowledge. In his famous article, “The use of knowledge in society,” Hayek analyzed how the knowledge needed for economic activity by consumers, producers, legislators, and bureaucrats is dispersed, tacit, and ever-changing. Sellers of goods can conduct surveys to find out what people want, but such data collection reveals only a small fraction of the subjective desires of buyers. The knowledge of how to produce goods is decentralized among the firms, each of which has its own local knowledge of the costs and the demand for its goods.

Much of the knowledge about goods is tacit, not written down. A label can list the ingredients, but it will not tell the buyer about how good it will taste, and does not reveal the full story about the nutritional benefits and harmful effects. A government bureaucrat cannot know all the details about the way a company handles its goods. The biggest and fastest computers cannot be programmed to know everything the economy is doing. The supplies and demands for goods are dynamic, always changing, like the weather, so that even when knowledge is gathered and analyzed, it soon becomes obsolete.

The Hayekian knowledge problem is one reason the Austrian school of economic thought concludes that only a truly free market can effectively apply the relevant knowledge. Government officials who try industrial policy, the promotion of some goods at the expense of others, often fail. For examples, subsidies to energy from the wind end up wasting resources, as a uniform policy cannot be applied to suit local conditions, and the full effects (such as windmills killing birds) are not known in advance, resulting in bad unintended consequences.

The natural environment, everything apart from human action, is too complex for human beings to fully understand it. As with economic knowledge, the data needed to understand human effects on the environment is both global and local. The knowledge of environmental conditions is tacit, and changing. The ecologies of the earth, like the economies, have interconnected elements with feedback loops. Kill the mountain lions, and the deer multiply, eat up the vegetation, and then the rains wash away the soils.

The Hayekian perspective on global climate change as well as local impacts is to admit that we don’t know the full effects of human activity, but we do know that interference with long-established interconnections can be deadly. The policy implication is that we should minimize unnecessary human interference with the natural environment. Any human presence displaces the natural presence, as a farm replaces meadows and forests. But it is excessive to burn down large areas of rain forests in order to have a few years of crops until the soil nutrients are depleted.

The optimal application of the knowledge issue is to understand that we can apply some general knowledge but not specific knowledge. For example, we know that emissions from power plants, factories, and vehicles have bad effects. Costs are ultimately subjective, but some costs, such as lost income and resources, can be quantified. We cannot precisely measure the social cost of pollution, but by comparing places with various amounts of pollution, and the various rates of diseases in those places, we can obtain some estimates of the ill effects. Policy can therefore require a payment for emissions that invade others’ property. To do nothing is to declare a price of zero, which is less accurate than the positive price obtained by statistical means.

The Hayekian policy for emissions is therefore a payment for the estimated damage. A pollution charge requires less knowledge than detailed regulations such as engine requirements, gasoline additives, and smog tests. The emissions charge would not be based on uncertain climate changes, but on the proposition that human interventions into the atmosphere and oceans could be catastrophic. The probabilities are uncertain, but what we do know is that a small probability times a huge cost equals a substantial present value. Because the earth’s environment is a balance of water and air temperatures, cycles of carbon emissions and absorptions, feedback loops, and substances such as the ozone layer, the probability that human interventions are harmful is much greater than the chance that they are beneficial. The mutual relationship of wolves, deer, and vegetation imply that killing off either the wolves or the deer will have bad effects.

The knowledge problem implies that policy has to confront the environmental issue rather than ignore it, because human activity is inherently environmentally interventionist. In some cases, intervention can help the environment, such as with artificial coral reefs. But large interventions such as deliberately dumping iron compounds into the ocean should be avoided.

The Austrian school of economic thought is critical of central planning due to its absence of economic calculation via market prices, and due to the knowledge problem. But the absence of pollution charges itself implies mispricing and the presumption that we know nothing about the effects of emissions. Given today’s highly regulated economy, the implication of Hayek’s thought on knowledge is to replace regulations and emissions trading schemes with the requirement to pay the estimated social costs. Firms (and their customers) can then either pay that cost or else avoid that cost by polluting less. To be most effective, pollution charges would need to be applied globally.

Some free-market economists respond to the pollution issue by stating that property rights are sufficient to solve the problem. But any negotiation or lawsuit to compensate others for negative external effects necessarily requires an objective estimate of the damages. A complete prohibition of an external effect, whether of emissions or noise or visual effects, imposes a cost on the emitter. Tort law, with transferable lawsuits, as well as arbitration and mediation, could replace governmentally enacted pollution levies when the victims can be identified, but there is no avoiding some objective estimate of costs. And where torts are not effective, an international agreement on pollution charges would be warranted.

Slavery and the footnotes

I came across this old essay on slavery by economist Gordon Tullock (h/t Tyler Cowen) and what struck me (aside from an excellent presentation of the economics of slavery) was this footnote on the inevitable dissolution of Marxism (this paper was written in 1967):

It may be that the dissolution is not the first step toward the total elimination of this powerful religion, but merely a breaking away of the talmudic encrustation of the true scribes and pharisees of the Second and Third Internationals. Such a development is not uncommon in the history of other religions. My personal opinion is that the disintegration which we now see is more fundamental, however, and I doubt that Marxism will survive the century as a living faith.

In my own experience in the classrooms of powerful and plebeian universities alike, Marxism has indeed disintegrated into virtually nothing. Marxism has, rather, become a sort of an embarrassing older uncle that professors chuckle about in a manner that is more reminiscing than bitter. They all realize that Marxism led to very bad things, but they are unable to acknowledge that capitalism – Marxism’s Other – has brought about peace and prosperity for untold billions.

It would be wise for us, therefore, to continue to focus on this dead religion. Deep-seated beliefs are hard to let go of, even after these beliefs have been shown – theoretically and empirically – to lead to horrors of the worst kind. “Yes,” the embarrassed former adherents grudgingly admit, “communism has failed miserably, but socialism has not. It has not even been tried, and besides, it is capitalism that is responsible for the world’s ills today.”

This is not obstinance. This is deceit, plain and simple.

So how do we go about combating obvious deceit (rather than the sophisticated theories of 20th century Marxists)?

I think the answer is to just debunk their examples on a case by case basis, in as public as a forum as you can muster. Famines in east and central Africa, for example, have often been attributed to capitalism because of the policies of the World Bank and IMF. Libertarians ought to agree with most of this, and then simply point out that the World Bank and the IMF are central planning agencies designed, created, and supported by governments in the West. Once this fact -which is not quite as simple as it appears – is acknowledged, you can go from there and take a public choice route, an Austrian route, or even a populist libertarian route to explain why capitalism is not responsible for famines.

Wars, genocides, ethnic cleansing campaigns, etc., can all be explained (and eliminated) if libertarians focus on the role of the State in all of these ills rather than on the theoretical or empirical weaknesses of socialist explanations and proposals.

The Problem with Modern Monetary Theory

“Modern Monetary Theory,” a doctrine about fiat money, has captured the attention of some reformers and progressives. This doctrine – a set of propositions contrary to logic and evidence – purports to explain why the US and other economies are ailing, but is beset by contradictions with the historic facts and within the doctrine.

For example, The New Inquiry on 11 April 2014 featured an article by Rebecca Rojer on “The World According to Modern Monetary Theory.” The author regards it as a revelation of MMT that the “rules of money are not immutable laws of nature.” Since the science of economics explains the effects of incentives and decisions, evidently these money “rules” are the outcomes of private and governmental decisions, and since the effects are not immutable laws, people can arbitrarily create whatever outcomes they wish. That would indeed be wonderful, to just print money are thereby eliminate unemployment, depressions, and poverty, all without creating price inflation, because the rules of money creation are not immutable, so we can have whatever outcome we wish!

Science is based on logic and evidence rather than “revelations.” It is possible that there have been revelations, but these create religion rather than science, since if an experience or experiment cannot be duplicated, the revelations are not sufficient for scientific warrants. Various religions have had different revelations, and the members do not believe the revelations of the others.

The author provides an example of the MMT doctrine. Suppose there is an island that has minerals. The owner of the mines hires workers and pays them with fiat money, like the paper and bank-account money we have today, i.e. money created out of nothing. But the owner also imposes a tax on the wages of the miners. So evidently this mine owner is a government, and we are not dealing with private enterprise, but a coercive socialist state. The miners work enough to both pay the wage tax and be able to survive.

But a premise of this MMT island example is that prior to the mining, the people were able to hunt and farm without working too hard. So why would anyone work in the mines? The historical explanation is the “enclosures” movement, in which land that was held by small-scale farmers or by villages was forcibly taken by the aristocracy or by the state or by foreign invaders. This is not a money story, but a land-grab story. Another way to get forced labor, other than chattel slavery, is to require the payment of taxes in money, which forces subsistence farmers to work on plantations at least long enough to pay the taxes. That is more a tax story than a money story, since if the government insists on being paid in coconuts, and a farmer does not grow coconuts, he must work on the coconut plantation, get paid in coconuts, and then pay the tax. Therefore the forced labor is based on the government’s restrictions on alternative employment opportunities.

MMT is correct in stating that one way that the government gets people to accept its fiat money is what economists call the “fiscal theory of money,” that the government reinforces its money as a medium of exchange by requiring the use of that money for paying taxes. However, if the government currency is being hyper-inflated, taxpayers would keep their savings in, say, gold, or a stable foreign currency, and then convert it to the fiat money only when a tax payment is due. The fiscal effect only works if the government is not creating too much inflation.

Therefore MMT is incorrect as stating, as a “core building block,” that forcing people to pay taxes with fiat money “gives it its value.” That was not the case, for example, in Zimbabwe, which suffered hyperinflation. One “immutable” economic law of money is that the creation of money, beyond what is needed for transactions, results in price inflation, and the payment of taxes becomes tied to that inflation, via the nominal rise of prices and wages, rather than preventing inflation.

A related fallacy of MMT is that “sovereigns” in general create money by “spending it into existence.” That can indeed happen, as for example in the Zimbabwe hyperinflation, but in the US and most countries today, government spending comes from taxes and borrowing, not money creation. The central bank, such as the Federal Reserve, does not create money by spending it for goods, but rather by buying bonds and then increasing the banks’ reserves or funds to pay for the bonds.

Since the “core” proposition of MMT, that price inflation can be controlled by government’s taxing and spending, is incorrect, the whole superstructure of the MMT doctrine built on it collapses. Actually, MMT does accept the proposition that monetary inflation creates price inflation, but that true proposition contradicts the core MMT premise that tax-paying gives money its value.

A worse MMT fallacy is that the taxes paid to the government destroys money. MMT tells us that governments create money when they spend, and then the money disappears when taxes are paid. But a tax no more destroys money than the dollars used to buy bread. The seller of bread now has the money, and the government now has the dollars paid in taxes, and they then spend that money.

There have been various theories and doctrines on money and banking in the history of economic thought, and in my judgment, the explanations that best fit the facts are a combination of the monetarist and the Austrian schools of thought. The monetarist core is the equation MV=PT, which explains that the quantity of money (M) multiplied by its annual velocity or turnover (V) equals the price level (P) multiplied by the amount of transactions (T) measured in money. Thus high price inflation, a rise in P, is usually caused by monetary inflation, an on-going increase in M.

The Austrian school explains how excessive monetary inflation not only cause price inflation, but distorts relative prices, such as when house purchase prices rise faster than rentals. Austrian theory shows how governmental central planning fails because the knowledge to do so well is always lacking, and that applies to money as well. Hence the Austrians propose free-market money and banking, so that the market sets interest rates and the money supply.

Indeed the Fed failed to prevent the Great Depression of the 1930s and the Great Recession of 2008, and its policies generated high inflation during the 1970s and the cheap credit that has fueled land-value bubbles. MMT cannot do any better, because, as the Austrian theory explains, the optimal money supply is not only not known, but not knowable. The pure free market provides the optimal money supply just as it provides the optimal amount of bread and the optimal amount of shoes.

Open Access Gary Becker papers, and a couple of thoughtful links on him

Nobel Prize-winning economist Gary Becker died Saturday. For those of you who don’t know about his work, go here. For the rest of you, economist Tyler Cowen has compiled a great list of articles by Becker that you can read:

    1. Irrational Behavior and Economic Theory.”  Can the theorems of economics survive the assumption of irrational behavior? (hint: yes)
    2. Altruism, Egoism, and Genetic Fitness: Economics and Sociobiology.”  The title says it all, from 1976.
    3. A Note on Restaurant Pricing and Other Examples of Social Influence on Price.”  Why don’t successful restaurants just raise the prices for Saturday night seatings?
    4. The Quantity and Quality of Life and the Evolution of World Inequality” (with Philipson and Soares).  The causes and importance of converging lifespans.
    5. Competition and Democracy.“  From 1958, but most people still ignore this basic point about why government very often does not improve on market outcomes.
    6. The Challenge of Immigration: A Radical Solution.”  Auction off the right to enter this country.

Cowen also linked to sociologist Kieran Healy’s fascinating take on Michel Foucault’s thoughts about Gary Becker’s work over at Crooked Timber (and here is a pdf of Becker on Foucault on Becker).

And economist Mario Rizzo shares some short thoughts about Becker’s work in relation to the Austrian School of Economics (Becker is associated with the Chicago School of Economics). Rizzo’s account of the early 1960s debate on rationality between Becker and Kirzner is worth a look.

Update: Here is Gary Becker’s 1992 Nobel Prize lecture (pdf)

Around the Web

  1. Spontaneous Order and Social Justice
  2. Persuading the Scots in regards to secession from the UK
  3. The prospects of Scottish secession from the UK
  4. The waxing and waning schools of economics: Chicago, Vienna and San Francisco
  5. Cooperation Emerging: Institutional diversity and the history of the West

Economic Rationality

[Cross-posted at the Foldvarium]

The concept of rational action is a frontier of economic theory. The new field of behavioral economics combines economics and psychology to analyze actions that seem to be irrational. For example, people value health and long life, yet they smoke and eat unhealthy food. A related field, behavioral finance, examines psychological and emotional traits that prevent people from making wise investments. Perverse psychological biases include anchoring to past prices and facts, the bias of weighing recent events too highly relative to the more distant past, being overly confident in one’s abilities, and following the herd to a cliff.

Neoclassical economics often assumes that people are purely self-interested and always seek financial gain, and that therefore altruism is irrational, whereas as Adam Smith and Henry George wrote, human beings have two motivations: self interest and sympathy for others. Since people get satisfaction from serving others, it is incorrect to label altruism or actions based on subjective views of justice as “irrational.”

The Austrian school of economic thought has a different perspective on rationality. The Austrian economist Ludwig von Mises envisioned human action as inherently rational. A person has unlimited desires and scarce resources. Human beings economize, seeking maximum benefits for a given cost, or minimizing costs for a given benefit. At any moment in time, a person ranks his goals, ranging from most to least important. He chooses the resources to achieve the most important goal at some moment, then the second most, and so on, until his gains from trade have become exhausted. This is the inherent rationality of human action. Continue reading

Credit Booms Gone Wrong

Recent research by economists Moritz Schularick and Alan M. Taylor have confirmed the theory that economic booms are fueled by an excessive growth of credit. They have written a paper titled “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870–2008“, published by the National Bureau of Economic Research.

A major cause of the Great Depression was a credit boom, as analyzed by Barry Eichengreen and Kris Mitchener in their paper, “The Great Depression as a credit boom gone wrong” (BIS Working Paper No. 137). Eichengreen and Mitchener cite Henry George’s Progress and Poverty as providing an early theory of booms and busts based on land speculation. They also credit the Austrian school of economic thought, which in the works of Friedrich Hayek and Ludwig von Mises, had developed a theory of the business cycle in which credit booms play a central role. Henry George’s theory of the business cycle is complementary to the Austrian theory, as George identified the rise in land values as the key role in causing depressions.

An expansion of money and credit reduces interest rates and induces a greater production and purchase of long-duration capital goods and land. The most important investment and speculation affected is real estate. Much of investment consists of buildings and the durable goods that go into buildings as well as the infrastructure that services real estate. Much of the gains from an economic expansion go to higher land rent and land value, so speculators jump in to profit from leveraged speculation. This creates an unsustainable rise in land value that makes real estate too expensive for actual uses, so as interest rates and real estate costs rise, investment slows down and then declines. The subsequent fall in land values and investment reduces total output, generates unemployment, and then crashes the financial system.

We can ask whether this theory is consistent with historical evidence. One strand of evidence is the history of the real estate cycle, which has been investigated by the works of Homer Hoyt, Fred Harrison, and my own writings. Another strand is the history of credit booms, as shown by Schularick and Taylor, who assembled a large data set on money and credit for 12 developed economies 1870 to 2008. They show how credit expansions have been related to money expansions, and how financial innovations have greatly increased credit. Because economic booms are fueled by credit expansion, Schularick and Taylor note that credit booms can be used to forecast the coming downturn.

Followers of Henry George have focused on the real estate aspect of the boom and bust, while the Austrian school has focused on credit, interest rates, and capital goods. A complete explanation requires a synthesis of the theories of both schools, but these recent works on credit booms have not recognized the geo-Austrian synthesis. In order to eliminate the boom-bust cycle, both the real side (real estate) and the financial side (money and credit) need to be confronted.

Current Austrian-school economists such as Larry White and George Selgin have investigated the theory and history of free banking, the truly free-market policy of abolishing the central bank as well as restrictions on banking such as limiting branches and controlling interest rates. In pure free banking, there would be a base of real money such as gold or a fixed amount of government currency. Banks would issue their own private notes convertible into base money at a fixed rate. The convertibility and the competitive banking structure would provide a flexible supply of money along with price stability. The banks would associate to provide one another with loans when a bank faces a temporary need for more base money, or a lender of last resort.

Both the members of the Austrian school and the economists who have studied credit booms have not understood the need to prevent the land-value bubble by taxing most of the value of land. That would stop land speculation and eliminate the demand for credit by land buyers.

But the credit-bubble theorists have not understood that financial regulation and rules for central banks cannot solve the financial side of credit bubbles. Credit booms always go wrong. As the Austrians have pointed out, there is no scientific way to know the correct amount of money or the optimal rates of interest. Only the market can discover the rate of interest that balances savings and borrowing, and only the market can balance money supply with money demand.

Thus the remedy for the boom-bust cycle is both land value taxation and free banking. Land speculation would not be as bad without a credit boom, but will still take place as land values capture economic gains and land speculators suck credit away from productive uses. But also, a credit boom with land-value taxation will still result in excessive construction and the waste of resources in fixed capital goods, reducing the circulating capital need to generate output and employment, as Mason Gaffney has written about.

Economic bliss requires both the public collection of rent and a free market in money.

[Editor’s note: this essay first appeared on Dr. Foldvary’s blog, the Foldvarium, on April 4 2010]

Around the Web: Cato Unbound Edition

The response essays to Dr. Horwitz’s Cato Unbound lead-off essay are now up.

Horwitz, Economy and Empirics by Bryan Caplan, a very good critic of the Austrian School

Free bankers George Selgin asks: How Austrian Is It?

And Antony Davies plays nice by saying “come to the middle!”

My own quick thought: none of these guys are hostile to the Austrian School the way a Keynesian would be. I take this as a sign that Keynesianism is dead intellectually, rather than any sort of selective bias on the part of Cato Unbound’s very good editors.

Austrian Economics and Empirical Research

Economist Steve Horwitz has a great lead-off in this month’s Cato Unbound. It’s all about the Austrian School of economics and its various detractors and factions. Some highlights:

Rather than being anti-empirical, modern Austrian economists are trying to open up the box of what counts as “empirical evidence” to include forms normally dismissed out of hand by the rest of the profession. Arguably, then, modern Austrians might well be more empirical than other economists, at least as judged by their professional work […]

Good economics for Austrians means sound arguments, not just valid ones. Too much of modern economics consists of valid reasoning from false premises about human action. The accuracy of those premises matter greatly for Austrians.

That is one reason why subjectivism is more important than praxeology for understanding Austrian applied research. Economics is radically subjectivist in the sense that human action depends upon the perceptions of the world held by the actor […]

Subjectivism also explains Austrian skepticism about statistical correlation being the privileged form of empirical evidence. It only provides correlation, and to provide causation requires a theoretical explanation. If such explanations must start with actors’ perceptions of the world, then forms of empirical evidence that capture such perceptions would be at least as useful. Austrians therefore frequently turn to primary source material and interview and survey work as well as quantitative data to tell a complete story of how a particular economic phenomenon came to be and functioned. How did actors perceive their options and constraints and what sorts of consequences emerged from their choices?

Dr. Horwitz goes on to give readers a brief list of introductory readings for those who are interested in the academic side of the Austrian School, rather than just the political and popular side. Highly recommended. You read the whole thing here.

Update: Longtime reader (and admin of NOL’s Facebook page) Hank points us to a rebuttal over at the Mises Institute’s blog. I didn’t find it convincing, but it’s still worth a look.

Chicago, Vienna and San Francisco

Co-editor Fred Foldvary has a great essay up on three schools of economic thought that deserves to be read by all.  An excerpt:

The Vienna school emphasizes the dynamics of the economy, while the Chicago method is to apply self-interest and economizing in an equilibrium analysis.  The San Francisco school uses both equilibrium and dynamics.  The dynamic approach of change over time is used to show the advance of rent and lowering of wages as the margin of production moves to less productive land and as land speculation moves the margin out even further.  Equilibrium shows that since market rent is based on the fixed supply of land and the demand to rent space, the tax on land not affecting the rent.

The San Francisco school agrees with the Vienna school that the spontaneous order of the free market best allocates goods to human desires.  But the San Francisco school points out that if the ground rent is not tapped for public revenue, when taxes on other things finance civic works, then there is in effect a subsidy to land owners, which distorts the market.

The San Francisco school has a theory of the business cycle based on land values, which rise during a boom, when speculation carries land prices so high that investment gets choked off, resulting in a recession.  But San Francisco has lacked a consensus on the role of central banking and money.

Check out the rest here.

I tend to pay attention whenever Dr. Foldvary writes, because he is the guy who wrote a book in 2007 accurately predicting the economic collapse of 2008.  You can access the book for free here.