The Foundations of Modern Austrian Economics
In setting up the market process as the central concept of Austrian economics, as opposed to the general-equilibrium approach of the neoclassical school, Austrian economists have a choice of strategies: They might, on the one hand, attempt to show the absurdity of the notion of general equilibrium, the arid formalism of the style of thought that gave rise to it, and its "irrelevance" to many urgent problems. They might, without denying the significance of equilibrating forces, stress the time aspect and show that the equilibrating forces can never do their work in time, that long before general equilibrium is established some change will supervene to render the data obsolete. They would, however, face the objection that the notion of market process requires equilibrating forces to make it work, an objection that, because it is a half-truth, might be hard to refute without drawing a distinction between "equilibrium of the individual" and "equilibrium of the economic system."
In my view, however, Austrian economists should present their case for the market process by offering a fairly comprehensive account of the human forces governing it rather than by engaging in piecemeal discussions of its various interconnected aspects, which must, in the absence of the total picture, remain obscure. The defects of the neoclassical style become obvious if the Austrian economists simply point to facts the neoclassical conceptual tools are unable to explain.
What keeps the market process in perpetual motion? Why does it never end, denoting the final state of equilibrium of our system? If Austrian economists answered by saying, "Something unexpected always happens," they would be accused of vagueness and reminded that only perpetual "changes in data" could have this effect. An attempt to show that continuous autonomous changes in demand or supply do account for the permanent character of the market process would involve a drawn-out discussion of the effects of ever-changing patterns of knowledge on the conduct of consumers and producers, a discussion in which Austrian economists would be at a serious disadvantage without prior elucidation of the term knowledge.
The market process is the outward manifestation of an unending stream of knowledge. This insight is fundamental to Austrian economics. The pattern of knowledge is continuously changing in society, a process hard to describe. Knowledge defies all attempts to treat it as a "datum" or an object identifiable in time and space.
Knowledge may be acquired at a cost, but is not always, as when we witness an accident or "learn by doing" for other than cognitive reasons. Sometimes, knowledge is jealously and expensively guarded; sometimes, it may be broadcast to reach a maximum number of listeners, as in advertising. Now knowledge, whether costly or free, may prove valuable to one and useless to another, owing to the complementarity of new and old knowledge and the diversity of human interests. Hence it is impossible to gauge the range of application of some bit of knowledge until it is obsolete. But we can never be certain that knowledge is obsolete since the future is unknown. All useful knowledge probably tends to be diffused, but in being applied for various purposes it also may change character, hence the difficulty of identifying it.
Knowledge then is an elusive concept wholly refractory to neoclassical methods. It cannot be quantified, has no location in space, and defies insertion into any complex of functional relationships. Though it varies in time, it is no variable, either dependent or independent. As soon as we permit time to elapse, we must permit knowledge to change, and knowledge cannot be regarded as a function of anything else. The state of knowledge of a society cannot be the same at two successive points of time, and time cannot elapse without demand and supply shifting. The stream of knowledge produces ever new disequilibrium situations, and entrepreneurs continually manage to find new price-cost differences to exploit. When one is eliminated by strenuous competition, the stream of knowledge throws up another. Profit is a permanent income from ever-changing sources.
Certain consequences of what has been said seem to concern the modus operandi of the market, but one appears to be significant for the methodology of all social sciences.
In the first place, how do we determine the true origin of any particular bit of knowledge? When and how do ill-founded surmises and half-baked ideas acquire the status of respectable knowledge? We can neither answer nor ignore these questions. Two things we may assert with reasonable confidence. As Karl Popper showed, we cannot have future knowledge in the present.*12 Also, men sometimes act on the basis of what cannot really be called knowledge. Here we encounter the problem of expectations.
Although old knowledge is continually being superseded by new knowledge, though nobody knows which piece will be obsolete tomorrow, men have to act with regard to the future and make plans based on expectations. Experience teaches us that in an uncertain world different men hold different expectations about the same future event. This fact has certain implications for growth theory—in my view important implications—with which I deal in my paper "Toward a Critique of Macroeconomics" (included in this volume). Here we are concerned with the fact that divergent expectations entail incoherent plans. At another place I argued that "what keeps this process in continuous motion is the occurrence of unexpected change as well as the inconsistency of human plans. Both are necessary conditions."*13 Are we entitled, then, to be confident that the market process will in the end eliminate incoherence of plans which would thus prove to be only transient? What is being asked here is a fairly fundamental question about the nature of the market process.
The subject of expectations, a subjective element in human action, is eminently "Austrian." Expectations must be regarded as autonomous, as autonomous as human preferences are. To be sure, they are modified by experience, but we are unable to postulate any particular mode of change. To say that the market gradually produces a consistency among plans is to say that the divergence of expectations, on which the initial incoherence of plans rests, will gradually be turned into convergence. But to reach this conclusion we must deny the autonomous character of expectations. We have to make the (diminishing) degree of divergence of expectations a function of the time sequence of the stages of the market process. If the stream of knowledge is not a function of anything, how can the degree of divergence of expectations, which are but rudimentary forms of incomplete knowledge, be made a function of time?
Unsuccessful plans have to be revised. No doubt planners learn from experience. But what they learn is not known; also different men learn different lessons. We might say that unsuccessful planners make capital losses and thus gradually lose their control over resources and their ability to engage in new enterprises; the successful are able to plan with more confidence and on a much larger scale. Mises used such an argument. But how can we be sure? History shows many examples of men who were "ahead of their times," whose expectations were vindicated when it was too late, who had to give up the struggle for lack of resources when a few more would have brought them triumph instead of defeat. There is no reason why a man who fails three times should not succeed the fourth. Expectations are autonomous. We cannot predict their mode of change as prompted by failure or success.
What we have here is a difference of opinion on the nature of the market process. For one view the market process is propelled by a mechanism of given and known forces of demand and supply. The outcome of the interaction of these forces, namely, equilibrium, is in principle predictable. But outside forces in the form of autonomous changes in demand and supply continually impinge on the system and prevent equilibrium from being reached. The system is ever moving in the direction of an equilibrium, but it never gets there. The competitive action of entrepreneurs tending to wipe out price-cost differences is regarded as "equilibrating"; for in equilibrium no such differences could exist.
The other view, which I happen to hold, regards the distinction between external forces and the internal market mechanism as essentially misleading. Successive stages in the flow of knowledge must be manifest in both. Market action is not independent of expectations, and every expectation is an attempt "to catch a glimpse of future knowledge now." To say that each market moves toward a price that "clears" it has little meaning where speculators are busy piling up and unloading stocks. The relationship between different markets in disequilibrium is infinitely complex. I shall say nothing more about it here, though I deal with some aspects of this complex problem in "Toward a Critique of Macroeconomics" (included in this volume).
Having set out to replace the paradigm of general equilibrium by that of the market process, why should we concentrate on the equilibrating nature of the latter—on showing that but for the perennial impact of external forces general equilibrium would be reached after all? It might be held, however, that every process must have a direction, and unless we are able to show that every stage of the market process "points" in the direction of equilibrium, no satisfactory theory of the market process is possible.
But this is not a convincing view. In the first place, though a process may have a direction at each point of time, it may change direction over time. The direction the process follows need not be the same throughout. Second and more important, two kinds of process have to be distinguished here. The first is a limited process, in the course of which we witness the successive modes of interaction of a set of forces, given initially and limited in number. Such a process may terminate or go on forever; whatever happens depends entirely on the nature of the (given) set of forces. The system may be subjected to random shocks from external sources, which it may take some time to absorb, such absorption interfering with the interaction of the forces. The second variety of process is the very opposite of the first. No initial set of forces delimits the boundaries of events. Any force from anywhere may at any time affect our process, and forces that impinged on it yesterday may suddenly vanish from the scene. There is no end or final point of rest in sight. Need I assert that history is a process of the second, not of the first, variety?
While our market process is not of the first kind, it is not completely unlimited. Two things may be said about it. The notion of general equilibrium is to be abandoned, but that of individual equilibrium is to be retained at all costs. It is simply tantamount to rational action. Without it we should lose our "sense of direction." The market process consists of a sequence of individual interactions, each denoting the encounter (and sometimes collision) of a number of plans, which, while coherent individually and reflecting the individual equilibrium of the actor, are incoherent as a group. The process would not go on otherwise.
Walrasians, in using the same notion of equilibrium on the three levels of analysis—the individual, the market, and the entire system—succumbed to the fallacy of unwarranted generalization: they erroneously believed that the key that unlocks one door will also unlock a number of others. Action controlled by one mind is, as Mises showed, necessarily consistent. The actions of a number of minds in the same market lack such consistency, as the simultaneous presence of bulls and bears shows. Consistency of actions in a number of markets within a system constitutes an even greater presumption.
Finally, the divergence of expectations, apart from being an obstacle to equilibrium, has an important positive function in a market economy. It is an anticipatory device. The more extended the range of expectations, the greater the likelihood that somebody will catch a glimpse of things to come and be "right." Those who take their orientation from the future rather than the present, the "speculators," permit the future to make its impact on the market process earlier than otherwise. They contrive to inject a glimpse of future knowledge into the emergent market pattern. Of course they may make mistakes for which they will pay. Without divergent expectations and incoherent plans, however, it could not happen at all.
Notes for this chapter
Karl R. Popper, The Poverty of Historicism (London: Routledge & Kegan Paul, 1957).
Ludwig M. Lachmann, "Methodological Individualism and the Market Economy," in Roads to Freedom: Essays in Honour of Friedrich A. von Hayek, ed. Erich Streissler et al. (London: Routledge & Kegan Paul, 1969), p.91.
Part 3, Essay 3, The Theory of Capital
End of Notes
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