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.”

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.

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.

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.

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.

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.