Microfoundations and Macroeconomics

Steven Horwitz

• Publisher: Routledge
• Year: 2000
• ISBN:
  9781134642212
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

In the past, Austrian economics has been seen as almost exclusively focused on microeconomics. Here, Steven Horwitz constructs a systematic presentation of what Austrian macroeconomics would look like. This original and highly accessible work will be of great value and interest to professional economists and students.

Part I
Market process microeconomics

1 Prices, knowledge, and economic order

As briefly surveyed earlier, neoclassical approaches to the issue of microfoundations of macroeconomics usually begin by constructing some sort of utility maximization/equilibrium model (incorporating rational expectations) and then proceed to show how various macroeconomic phenomena can be derived from that microeconomic model. Because of the wide acceptance of general equilibrium theory, most mainstream discussions of microfoundations spend relatively little time exploring exactly what should constitute those foundations; it is assumed that an equilibrium model is the way to do it. By contrast, one of the defining features of late twentieth-century Austrian economics is its rejection of Walrasian equilibrium theory as the proper theoretical framework for understanding the market process. Rather than Walras, modern Austrian economics begins with another of the marginalist revolutionaries, Carl Menger. An Austrian approach to the microfoundations of macroeconomics will be essentially Mengerian in its emphasis on knowledge, process, and subjectivism.¹ This chapter’s task is to lay out these Austrian microfoundations and highlight some of the aspects of the Austrian approach that will be central to providing the microeconomic answers to the macroeconomic questions discussed in the later chapters.

Austrians are not the only group in contemporary economics that questions the microfoundations of mainstream macroeconomics. David Colander (1996:2), in his introduction to Beyond Microfoundations: Post Walrasian Macroeconomics, has rightly characterized much of modern macroeconomics as ‘Walrasian’ in the sense that it uses a ‘comparative static model that assumes the existence of a unique aggregate equilibrium which is unaffected by dynamic adjustment processes’. This approach reached its apex in New Classical economics with its explicit connection to general equilibrium microfoundations. The papers in the aforementioned collection all attempt to outline a vision of macroeconomics that is not wedded to what the authors believe to be traditional Walrasian foundations.

It is worth noting, however, that Colander chose the name ‘Post Walrasian’. In many ways the contributors are still asking Walrasian questions, but simply answering them in more complex and subtle ways. For example, one of the ‘distinguishing characteristics’ of Post Walrasian economics is conjecturing ‘that the solution to a system of simultaneous equations as complex as is necessary to describe our economy has multiple equilibria and complex dynamics’ (1996:2). This is in contrast to the single equilibrium and simple or non-existent dynamics of Walrasian approaches. The Walrasian vision of an economic system described by the concept of equilibrium and simultaneous equations is retained, but Post Walrasians believe that ‘the mathematics used in Walrasian macroeconomics is too simple to correspond to the complex reality’ (1996:4).² The economist is still asking Walrasian questions, but the answers reflect a more sophisticated understanding of economic systems than that suggested by general equilibrium theory.

By contrast, an Austrian approach to microfoundations might most accurately be described as ‘non-Walrasian’ or, more in line with Colander’s terminology, ‘Post Mengerian’. A Mengerian understanding of the market process rejects the claim that an economy can be fruitfully understood through the use of simultaneous equations and equilibrium constructs. The market is a dynamic process of learning and discovery that cannot be spelled out ex ante and evolves and changes as the human actors who populate it learn, grow, and change. The Austrian approach rejects equilibrium theory as a description of actual economic events (although some Austrians would retain it as the never achieved endpoint of economic activity) in favor of other theoretical and metaphorical devices. Austrians are asking different questions than (Post) Walrasians. To understand this alternative perspective, a recapitulation of the development and main ideas of an Austrian vision of the microeconomic process is necessary.

A Mengerian view of the market process

The relationship between Austrian economics and the neoclassical mainstream has always been a tricky one. Neoclassicism finds its origins in the marginalist revolution of the early 1870s, which included the work of Menger and the earliest Austrians, implying that Austrian and neoclassical economics share a common heritage. However, both in the pre-World War I period and in the recent post-1974 revival, Austrians have been at pains to try to delineate their distinct research program from other mainstream approaches. One can categorize the various sub-divisions with Austrian economics by the degree to which they see themselves as distinct from the neoclassical mainstream. The position to be outlined below lies toward the ‘clearly distinct’ end of that continuum.

The tension between Austrians and neoclassicism surely derives from Menger’s work, which both founded the Austrian school and contributed to the beginnings of neoclassicism more generally. The subjectivist line of inquiry that Menger began in 1871 was highly suggestive but also incomplete and ambiguous in places. That incompleteness and ambiguity opened the door for alternative interpretations of Menger’s contribution that began the tension noted above. As Israel Kirzner (1994a:xii) has argued:

Menger (already in 1871) glimpsed a radically subjectivist way of understanding the determination of economic phenomena in market economies…It was a vision, however, which really did differ sharply, in its radical subjectivism…from the broad understandings of the economic process which came to be encapsulated in Marshallian and in Walrasian economics. Menger, however, was not able to articulate the full implications of what he had glimpsed. Nor did his immediate associates fully grasp the complete perspective which their master had, at least in outline, perceived.

As a result, the lines between Austrian economics and other strands of neoclassicism became blurred, with this overlap arguably climaxing in Lionel Robbins’ The Nature and Significance of Economic Science (1932), which fused together aspects of Austrian subjectivism with the growing formalization of utility theory in the Marshallian and Walrasian traditions. Shortly after the publication of Robbins’ book came the Hayek-Keynes debate and the debate over socialist calculation, both of which would define Austrian economics for the rest of the century. Hayek’s work during these two debates began to recapture a number of Mengerian themes (Vaughn 1990:391ff.). The process of rediscovering what Vaughn calls ‘the Mengerian roots of the Austrian revival’ has continued in the past few decades. Kirzner (1994a:xii) makes this point as well:

It is in the contemporary post-Misesian revival of Austrian Economics that the distinctiveness of the Austrian tradition has emerged as a natural extension of—or perhaps more accurately, the explicit unpacking of the ideas implicit in—the theoretical contributions pioneered by Menger in his 1871 Grundsätze.

What precisely are these Mengerian themes and how do they form the core concepts of modern Austrian microeconomics?

The central themes of both of Menger’s books (the Principles and the Investigations) are spontaneous order and subjectivism. Expanding on the central idea of the discipline of economics since at least Adam Smith, Menger was concerned with explaining how desirable and orderly patterns of outcomes could emerge without direct human design intending them.³ Some economists have argued that general equilibrium theory is also attempting to provide an elucidation of Smith’s ‘invisible hand’.⁴ However, the differences between Mengerian and Walrasian approaches are significant and center on the way in which Menger understood the problem situation of the individual actor (i.e., subjectivism) and his understanding of how various social and economic institutions emerged to enable individuals to transcend their own ignorance and uncertainty (i.e, spontaneous order).

The first chapter of Menger’s Principles contains a section on ‘Time and Error’, where he discusses their influence on economic cause and effect. Time plays a central role because all productive processes involve ‘becoming’ and change, and are thus taking place in time. Error enters when we consider that capital goods (goods of a ‘higher order’ in Menger’s terms) are capital only because the owners of such goods believe that they can successfully produce consumer goods that will be valued by economic actors. Those beliefs may be incorrect and such errors will be revealed by market discovery processes. This emphasis on time and error is part and parcel of Menger’s broader subjectivism.

The emphasis on time and error is also linked with the Austrian skepticism about general equilibrium models and the equilibrium orientation of neoclassical economics more broadly. If human actors are accurately described as having less than perfect knowledge and facing the sort of Kirznerian ‘sheer ignorance’ we shall discuss later, then equilibrium approaches premised on assumptions of perfect knowledge will be problematic. In the Mengerian vision, market actors use their fragmentary and often inchoate knowledge to form their divergent expectations of the future and thereby appraise the value of existing goods of various orders in terms of their ability to produce goods that they perceive will be valuable in the future. Market prices are a key element of this process. Because they are also the product of a process that emerges from the divergent expectations, existing market prices are embedded with the erroneous expectations and judgments of the previous set of suppliers and demanders. The same will be true of the prices that emerge from the current round of market activities. As long as people have imperfect and/or different knowledge, the prices that emerge from human choice processes will not be equilibrium prices and therefore cannot be error-free. The modern Austrian emphasis on the disequilibrium nature of market prices finds its roots in Menger’s work on time, error, and knowledge.

What interested Menger was explaining how individual acts of subjective evaluation, which, as he notes, might be the result of previous errors by the valuers (1981 [1871]:145ff.), might lead to market-level phenomena such as prices. Menger’s book builds toward an explanation of prices, rather than beginning with prices and explaining how humans make use of them to maximize utility, suggesting both that prices actually formed in the market will be disequilibrium prices and that the decisions made based on those prices cannot necessarily be characterized as equilibrating because those prices will have the past period’s errors embedded in them. Menger saw prices as the phenomena to be explained, rather than as an independent variable in explaining human choice, as in a more contemporary understanding. Seeing prices as emerging from subjective acts of human choice (rather than solely as parametric to those choices) will be crucial in the discussions to follow because monetary disequilibria affect price formation by disrupting the link between the subjective evaluations of actors on both sides of the market and the emergent market prices. For Austrians, understanding economic behavior means understanding both how economic institutions and phenomena (like prices) emerge as spontaneous orders from subjective human choices, and how they, in turn, serve to guide (albeit imperfectly) future actions.

In addition to the subjectivist thrust of Menger’s contribution, he also began an Austrian focus on the institutional environment in which price formation takes place.⁵ Unlike the perfectly competitive model, which assumes away the existence of institutions, Menger’s theory of price formation describes the nature of the prices that emerge from varying market structures. His discussion begins with what today we would call ‘bilateral monopoly’ or what he calls ‘isolated exchange’ (1981 [1871]:194ff.). From there he begins to increase the participants on each side of the market until he reaches a discussion of ‘bilateral competition’. Part of his argument is that the more competitive the market is, the more narrow the range of possible prices that will emerge. Under bilateral monopoly, there is a larger range of possible prices that the market might produce, whereas with bilateral competition, the competitive process will winnow that range down very substantially. Menger argues that, over time, monopolistic markets tend to evolve into more competitive ones. Monopoly, in the sense of a single seller with no entry barriers, can be seen as an early stage in economic evolution, with bilateral competition being a more advanced stage.⁶ From early on, Austrian economics has been concerned with the particulars of the process by which prices emerge and how learning takes place in disequilibrium rather than the properties of a vector of equilibrium prices.

Which way forward? Austrian microeconomics between the wars

As noted briefly above, the period between World Wars I and II marks a time when the distinctiveness of Austrian economics as a school of thought most likely reached its nadir.⁷ Not surprisingly, it was also a time when the influence on economics generally of ideas with an Austrian lineage may well have been at its zenith. Deep discussion of this period would be a research project by itself, but what I hope to draw out in this section are the two conflicting tendencies that pervaded Austrian economics between the wars. Those two tendencies might best be characterized as (1) the development of a Mengerian research program distinct from the emerging Walrasian-Marshallian equilibrium research program; and (2) the attempt to bring Austrian insights into the mainstream equilibrium project. Obviously these two ongoing aspects of interwar Austrian economics were in tension with each other. Perhaps nowhere are these differing projects and the tensions between them better captured than in two contributions both published in 1932: Lionel Robbins’ Nature and Significance and Hans Mayer’s essay ‘The Cognitive Value of Functional Theories of Price’.

As Kirzner (1994b) argues, it is fruitful to see Robbins’ book as attempting to show how the emerging post-Marshallian equilibrium economics was qualitatively different from classical economics. In Marshall’s own understanding of his project, he was simply refining what his classical predecessors had done. Robbins saw in the Austrian strand of the marginalist revolution the ideas that, when wedded to Marshall’s framework, could define neoclassical economics as a distinct research program. Kirzner (1994b:xi–xii) observes that the Marshallian framework of the time was still more concerned with issues of the generation of material wealth than with the study of human choice. It was in that sense that Marshall could see his own work as but an extension of classicism. What Robbins saw in the Austrians was the centrality of choice, particularly in the subjectivism of Menger and Bohm-Bawerk. Robbins’ book brought to British economics the methodological individualism, the subjectivism of tastes and preferences, and the ordinal utility approach of the Austrians.

All of these insights were easily combined with the ongoing developments of the Marshallian tradition. The first section of Hicks’ (1939) Value and Capital (which laid the foundation for much of the neoclassical microeconomics that would follow) is entitled ‘The Theory of Subjective Value’ and is clearly the fruit of the Robbins-inspired marriage of Austrian insights with Marshallian demand and supply analysis. The preface to the first edition notes that most of Hicks’ ideas were developed at the London School of Economics during the period 1930–35 and indicates his indebtedness to Robbins (and Hayek) for his leadership of the ‘social process’ that helped produce these ideas. The claim made by some that neoclassical economics has incorporated what was important in the Austrian contribution can only make sense if ‘the Austrian contribution’ is seen only as the impact of Robbins on Hicks. If all there was to Austrian economics was what Robbins incorporated into his book, then Hicks’ work could arguably have claimed to have incorporated that into the neoclassical mainstream. If so, then the development of Austrian economics between the wars looks very much like a process of intellectual assimilation. Clearly I wish to argue that the Austrian contribution goes well beyond the set of ideas that Robbins imported, and, therefore, the claim of assimilation is a dubious one.

The Mayer paper, by contrast, shows the ways in which his understanding of the Austrian tradition differentiated it from the growing neoclassical program. Mayer (1994 [1932]:57) contrasts:

Genetic-causal theories which, by precisely explaining the formation of prices, aim to provide an understanding of price correlations through knowledge of the laws of their genesis [and] functional theories which, by precisely determining the conditions of equilibrium, aim to describe the relation of correspondence between already existing prices in the equilibrium situation.

The main distinction he wishes to draw is that functional theories (which are essentially equivalent to equilibrium theories) of price offer no explanation of the process by which prices are formed, which for Menger was the central question. Mayer makes the following very Mengerian (and very modern Austrian) critique of equilibrium price theories:

In essence, there is an immanent, more or less disguised, fiction at the heart of mathematical equilibrium theories, that is, they bind together, in simultaneous equations, non-simultaneous magnitudes operative in genetic-causal sequence as if these existed together at the same time. A state of affairs is synchronized in the ‘static’ approach, whereas in reality we are dealing with a process. But one simply cannot consider a generative process ‘statically’ as a state of rest, without eliminating precisely that which makes it what it is.

(ibid.: 92, emphasis in original)

In Mayer’s view, the Austrian tradition’s distinct contribution was its emphasis on explaining processes rather than equilibrium outcomes.

Compare Mayer’s arguments with the supposed Robbins—Hicks assimilation noted earlier. Hicks’ book lays out the foundations of general equilibrium analysis, and he begins the book with a discussion of what he calls the ‘subjective theory of value’, which is based on Robbins’ importation of Austrian ideas. There are clearly two distinct understandings of what the core of Austrian subjectivism was, and those two understandings diverged like two paths in a wood during the 1930s. Down the Robbins path lay modern equilibrium theory built on a foundation that included the Austrian insights of methodological individualism and subjective tastes and preferences. Down the Mayer path was an alternative conception of the explanatory task of economics. While many other Austrians of the period drifted toward the Robbins path, Mises and Hayek most notably held to the Mayer path. In Mises’ case, he had developed, independently of Mayer, his own critiques of the direction of mainstream economics that explored more deeply the emphasis on process found in Mayer’s paper.⁸ As for Hayek, we shall discuss his contribution on this issue more fully below.

Hayek on prices and knowledge

The major contributions to the modern Austrian approach to the microeconomic process are Hayek’s papers on knowledge of the 1930s and 1940s and Mises’ discussion of monetary calculation, which originally appeared in the 1940 German language predecessor of Human Action.⁹ In this section, we will explore the contributions of Hayek and link them back to Mises’ discussion of monetary calculation in a later section. The central theme of Hayek’s papers in the 1930s and 1940s was the claim that the competitive market process had to be understood in terms of its ability to create, discover, and communicate knowledge. The two key papers in this line of argument are his 1937 paper ‘Economics and Knowledge’, and 1945’s ‘The Use of Knowledge in Society’. I will also briefly mention ‘...