Archive for September 2012

Mises’ 131st Birthday

Ludwig von Mises, the most important social philosopher in history, was born 131 years ago today. To learn about this heroic figure, check out Tom Woods’ excellent resource page on Mises.

Austrian and Neoclassical Concepts of Marginal Ulitity

A recent comment by Bryan Caplan provides a good opportunity to discuss differences between Austrian and neoclassical concepts of marginal utility. In response to Steve Horwitz, who claimed that the law of diminishing marginal utility and the downward-sloping demand curve can be known a prior, Bryan asks:

Mainstream micro textbooks often have counterintuitive examples with increasing marginal utility. Are you really saying that the premise of these problems is somehow logically impossible? Or are you using a heterodox conception of marginal utility?

As Chesterton said, heterodoxy is your doxy and orthodoxy is my doxy, but I think I know what he means. Indeed, the modern, neoclassical concept of marginal utility is quite different from the causal-realist version offered by Menger and developed by Menger, Böhm-Bawerk, Fetter, Rothbard, and others.

Both the Austrian and neoclassical approaches to demand begin with an ordinal preference ranking. But the understandings of marginal and total utility are completely different. For Menger, marginal utility applies only to discrete units of a homogenous stock of a good. The fourth apple is allocated to a lower-valued use than the third apple, and so on. The law of demand follows from the fact that additional units of a homogenous good are used to satisfy lower-ranked ends.Note that for the Austrians, the term “marginal” applies to the units, not the utilities. “Marginal utility” is the total utility of the marginal unit, not the marginal utility of a unit. There is no larger concept of “total utility,” of which marginal utility is a little slice. Note also that if an agent possesses a set of unique goods—one apple, a piece of candy, a dollar bill, an iPod, etc.—he can rank them ordinally, but cannot assign marginal utilities to specific goods, since there are no “supplies”—multiple, homogeneous units—of apples, candy, money, and iPods.

The neoclassical approach begins with consumers who rank not discrete units of goods, but n-tuples or “bundles” of all goods in existence. Bundle A represents one apple, one piece of candy, and one iPod. Bundle B represents two apples, one piece of candy, and one iPod. Bundle C includes one apple, two pieces of candy, and one iPod, and so on. For all possible bundles i and j (and the set of feasible bundles depends on assumptions about divisibility) the consumer is assumed to prefer i to j, to prefer j to i, or to prefer neither i nor j. Hence the concept of indifference: if Bundle D is neither preferred nor dis-preferred to Bundle E, then the consumer is indifferent between D and E (and, if we assume a continuous space of bundles, they lie on the same indifference curve).

In this model, prices are expressed as exchange ratios between elements of the bundles. Given an amount of “income,” which when combined with a given ratio of relative prices gives a set of bundles that the consumer can afford, we can identify which bundle or bundles yield the greatest benefit (i.e., no other bundle is both affordable and preferred to the optimal bundle). This notion of ranking bundles is necessary to decompose the effects of relative-price changes into the familiar substitution and income effects. The notion of a substitution effect assumes that relative-prices changes combined with Hicksian income transfers can be represented by a movement along an indifference curve.

Note that if the consumer is ranking bundles, not individual units of goods, and the bundles are heterogeneous, then Menger’s concept of marginal utility does not apply. The consumer attaches a total utility to each ranked good— i.e., to each bundle—but there are no marginal utilities of individual units of goods, because we have no ordinal rankings of individual goods, only bundles. Hicks of course abandoned the concept of marginal utility altogether in favor of the marginal rate of substitution (the rate at which the consumer would substitute i for good j or the slope of the indifference curve). But Mengerian analysis concerns preferences that can be demonstrated in action. Because indifference among ranked goods (bundles) cannot be demonstrated in action, there is no place for a marginal rate of substitution, and no such thing as a substitution effect that can be analyzed independently of an income effect.

In short, in causal-realist analysis we go from an ordinal preference ranking among homogenous goods (gallons of water, bushels of wheat, whatever) to the law of diminishing marginal utility to the individual’s downward-sloping demand curve to the downward-sloping market demand curve to the conclusion that an increase in the supply of a good on the market leads to a reduction in price and an increase in quantity demanded. The neoclassical approach starts with rankings of heterogeneous bundles of goods, leading to an indifference map in which marginal rates of substitution could be increasing, decreasing, constant, or undefined (as with L-shaped indifference curves) and a conditional law of demand in which a decrease in price may or may not lead to an increase in the quantity demanded, depending on the sign of the income effect and the relative magnitudes of the income and substitution effect.

For Mises, the law of diminishing marginal utility is not only knowable a priori but “apodictically certain,” not conjectural, historically contingent, or subject to validation in a clever (freaky?) laboratory experiment.

Mises Store Sale for LvM’s 131st Birthday

Can’t We (Economists) All Just Get Along?

You may find out the answer at a roundtable discussion that I was invited to participate in on ”Why Economists Disagree.” The event takes place at the Helix Center for Interdisciplinary Investigation of the New York Psychoanalytic Society & Institute on Saturday October 13. 2:30-4:30 at 247 E 82nd St., New York, NY 10028.  The  participants are widely arrayed across the political and methodological spectra and include eminent economists Robert Frank of Cornell, Graciela Chichilniskey of Columbia, and Jeffrey Miron of Harvard.  A special thanks goes to Dr. Robert Penzer, M.D., Associate Director of the Helix Center, for arranging this exciting event.

An International Bank? July 19, 1944

“The drive for a $10,000,000,000 International Bank for Reconstruction and Development illustrates once more the fetish of machinery that possesses the minds of the governmental delegates at Bretton Woods. Like the proposed $8,800,000,000 International Monetary Fund, it rests on the assumption that nothing will be done right unless a grandiose formal intergovernmental institution is set up to do it. It assumes that nothing will be run well unless Governments run it. One institution is to be piled upon another, even though their functions duplicate each other. Thus the proposed Fund is clearly a lending institution, by whatever name it may be called; its purpose is to bolster weak currencies by loans of strong currencies.”

–Henry Hazlitt, From Bretton Woods to World Inflation: A Study of Causes and Consequences

Garrison on Keynes, Hayek, and Wicksell

Roger Garrison reviews Tyler Beck Goodspeed’s Rethinking the Keynesian Revolution: Keynes, Hayek, and the Wicksell Connection (Oxford, 2012) for EH.Net. Writes Roger:

The most recent episodes of unsustainable booms (centered on digital technology in the 1990s and housing in the 2000s) have rekindled interest in the clash between Keynes and Hayek. Which one had it straight about business cycles? In Goodspeed’s view, “the Wicksell connection” – a phrase drawn from the title of a 1981 article by Axel Leijonhufvud – turns the Keynes-Hayek dissonance (as perceived during the 1930s by the principals – and by everyone else) into consonance. Owing to the Wicksell connection, there was, in the author’s view, “a fundamental convergence of Keynes’s and Hayek’s respective theories of money, capital, and the business cycle during the course of the 1930s” (emphasis in the original, p. 3). This claim stands in stark contrast to the more common understanding that by the end of that decade, Hayek’s views were buried under the Keynesian Avalanche (McCormick, 1992).

Read the whole thing here. (Bonus: My review of McCormick’s Hayek and the Keynesian Avalanche).

Would you rather be marooned on a desert island with an Austrian or a Keynesian?

(Thanks to Nielsio.)

And check out the rest of Tim Kelly’s awesome (and very libertarian) cartoons.

George Selgin to Paul Krugman: “I Am a Former Austrian and I Do Believe in Fractional Reserve Banking — Honest”

Well, not exactly his words, but this was the gist of George’s bizarre and irrelevant comment on Krugman’s column asking Austrians what their position is on money market mutual funds. In his haste to establish his mainstream bona fides to Krugman, however, George was blind to the fact that Krugman has been forced to recognize and address Austrian arguments precisely by those who George denigrates in his comment as “the anti-fractional reserve crowd among self-styled Austrians, taking its lead from Murray Rothbard.” But it was due to the prodigious efforts of the Rothbardians including and especially Ron Paul that we have begun to see a radical change of opinion among the public, the establishment media, finance professionals, and even some academic economists concerning the alleged beneficence of the Fed and the effectiveness of conventional macroeconomic policies. It was this challenge that worries Krugman and prompted his insipid column. He could care less about George’s support for fractional-reserve banking and would not bat an eye even if he knew that George supported QE1 and (maybe) QE2 and advocates an aggregative nominal income target for Fed monetary policy, albeit at a lower level than most contemporary macroeconomists are comfortable with.

One more point: Both Rothbard and Krugman would have had a good belly laugh together over George’s peculiar notion that, in the absence of a central bank and government deposit insurance, a fractional-reserve banking system would be stable and flourish on a free market.

The Resentment of the Intellectuals

“It is different with people whom special conditions of their occupation or their family affiliation bring into personal contact with the winners of the prizes which–as they believe–by rights should have been given to themselves. With them the feelings of frustrated ambition become especially poignant because they engender hatred of concrete living beings. They loathe capitalism because it has assigned to this other man the position they themselves would like to have. Such is the case with those people who are commonly called the intellectuals. Take for instance the physicians. Daily routine and experience make every doctor cognizant of the fact that there exists a hierarchy in which all medical men are graded according to their merits and achievements. It is the same with many lawyers and teachers, artists and actors, writers and journalists, architects and scientific research workers, engineers and chemists. They, too, feel frustrated because they are vexed by the ascendancy of their more successful colleagues.”

–Ludwig von Mises, The Anti-Capitalistic Mentality

A Question to Krugman — from an Austrian “Renegade” Professor

Paul Krugman’s jejune column querying Austrians on their view of money market mutual funds (MMMFs) — as if they have never thought or written about the subject — has been roundly skewered by Austrians here and here. But I have a question for Krugman: Why, Paul, would you be interested in the least about what Austrians think about anything?

To understand the significance of this question and the momentous implications of Krugman’s answer, we need to go back to Krugman’s typology of economists. This question is significant because, according to Krugman’s view in his book Peddling Prosperity (1994), “there are two different kinds of economists . . . professors and policy entrepreneurs,” and they are ”radically distinct species.”

The “professors” are academic economists. Like “ostriches and penguins” the professors are “slightly ridiculous.” They write papers that are densely packed with indecipherable mathematics and jargon, and “most of these papers are not worth reading.” In fact they are written not to be widely read but merely to impress the author’s colleagues with his cleverness. The ideas advanced in these papers are not original or definitive explanations of how the economy actually works, but rather “ingenious elaboration without fundamental innovation” — “old wine in new bottles, usually with fancier mathematical labels.” All of this Krugman freely concedes. Ah, but if one would only back up far enough and view the proceedings from a distance, he would see that the professors are engaged in an “enterprise that steadily adds to our knowledge.” The truth is that economics is a “primitive science,” akin to medical science at the end of the nineteenth century, when physicians knew basically how the body worked and not much more.  True these primitive medical scientists were able to  advise how to prevent some diseases and what quack procedures and medicines to avoid, but they could not cure very many diseases. So it is with economics professors today who know a lot about how the economy works. They can even definitively advise how to prevent hyperinflation and in most cases how to avoid depressions. But there is much that remains a mystery to these primitive practitioners of the dismal science. In particular, “they don’t know how to make a poor country rich or bring back the magic of economic growth when it seems to have gone away.”

Oh yeah, and one more thing about members of the professoriate: they mainly write for other professors and rarely make appearances on TV. When they do address the lay public they seldom make definitive pronouncements on policy issues. They are nothing if not humble in the face of their acute awareness of the limitations of knowledge imposed by the primitive state of their science.  (By the way this hardly sounds like Krugman the New York Times “Conscience of a Liberal” columnist so beloved of the Democratic left — but that is a story for another day.)

“Policy entrepreneurs,” according to Krugman, are a different breed altogether. They write books mainly for the public and appear on TV.  They strive to influence public opinion and economic policy. While many are journalists, financial pundits, and lawyers, some have PhDs in economics and jobs as economics professors, just not at the right kinds of academic institutions. For example, they may habitate at ”unorthodox environments like Harvard’s Kennedy School.” But the feature that essentially distinguishes a policy entrepreneur from a professor is the language that he speaks and the audience that he mainly addresses. When addressing the public, the former speaks plainly and offers “unambiguos diagnoses” where the latter is “uncertain.” The mind of the policy entrepreneur is unclouded by “existing economic theories,” while that of the professor is teeming with  inhibitions imposed by these theories against expressing anything with certitude. Krugman points to supply-siders Arthur Laffer and Robert Mundell on the right and Lester Thurow, Robert Reich and John Kenneth Galbraith on the left as epitomizing the academic qua “policy entrpreneur.”  He at one point refers to supply-side academics as “renegade professors.”

Now, in Krugman’s aforementioned column, it is clear that he regards Austrian economists as nothing more than the benighted “policy entrepreneurs” orchestrating Ron Paul’s campaign for sound money and a free market banking system. So to reiterate my question to Krugman in a slightly different form: Why would an eminent, Nobel laureate, Ivy League “professor” like youself care one whit about the views of putative “renegade professors” like the Austrians who reject modern macroeconomics root and branch and aggressively seek to disseminate this view to the public as well as to the rest of the economics profession?

However Krugman chooses to answer this question — and I hope that he does — it is clear that the “existing economic theories” that he so vehemently defended in the 1990s have failed abysmally in preventing or explaining the financial crisis. As a result Krugman and the rest of the establishment macroeconomic “professors” have been catapulted back in time to embrace the crude and discredited ultra-Keynesian policy of inflating our way back to prosperity. Indeed we renegade Austrian professors  have the only correct diagnosis and cure for the present economic stagnation — and I am certain of that.