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PART ONE: INTRODUCTION - Ludwig M. Lachmann, Capital, Expectations, and the Market Process 
Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy, ed. with an Introduction by Walter E. Grinder (Kansas City: Sheed Andrews and McMeel, 1977).
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In Pursuit of the Subjective Paradigm
Walter E. Grinder
For more than fifty years Ludwig M. Lachmann has been participating in scholarly debates on the development and application of economic theory; yet he is relatively unknown to professional economists and the intellectual community at large. Most mainstream economists find no comfort in his work because as a member of the Austrian school he opposes the direction taken by modern economic analysis. An intellectual descendant of Carl Menger (1840–1921), the founder of the Austrian school, Ludwig von Mises (1881–1973) and Friedrich A. Hayek (b. 1899), the Austrian school's most important twentieth-century representatives, Lachmann remains an outsider. It is hoped that this selection of his essays will introduce his thought to a wide and receptive audience.
What distinguishes Lachmann from other economists is his total devotion to subjectivism in economics. In fact, the evolution of his understanding and application of subjective concepts over the past four decades is a coordinating theme for these otherwise disparate essays and lectures. Lachmann's position today is that of a radical subjectivist.
According to Lachmann, economic phenomena cannot be explained unless they are related, either directly or indirectly, to subjective states of valuation as manifested either in choice or in expectations about the market. The implication is not that Lachmann opposes macroeconomic concepts per se. On the contrary, he has done some of his most important work in macroeconomics. His argument is that macroconcepts must be traced to their microeconomic roots in the minds of valuing individuals in the market. In this respect, he is within the Austrian tradition as established by Menger, Mises, and Hayek.
Lachmann agreed with Erich Streissler that the importance of the Austrians and the subjective revolution that took place during the 1870s lies not so much in the development of the notion of marginalism as in the subjectivism established by Menger and his followers (“To What Extent Was the Austrian School Marginalist?” History of Political Economy 4 [Fall 1972]: 426–41; see also “The Significance of the Austrian School” [references to articles included in this volume are in abbreviated form]). Lachmann did not deny the historical importance of Menger's contributions to the technical development of marginal economics, although, Léon Walras's concept of “rareté,” and William Stanley Jevons's notion of “final degree of utility” were in the air during the late 1860s and early 1870s. According to both Streissler and Lachmann the Austrian contribution was unique in its insistence on the thoroughly subjective character of utility, on the impossibility of finding an objective measure of utility for comparing or adding together levels of subjective welfare among individuals.
It is the thoroughgoing subjectivism of Menger, Mises, and, interestingly enough, Max Weber that Lachmann identified as the true heritage of the Austrian school (The Legacy of Max Weber [London: Heinemann, 1970]). Whether in defining “cost” in terms of privately perceived forgone opportunities, or in defining the market rate of interest as an expression of the individual time preferences of the members of the community, or—as is most important in Lachmann's work—in emphasizing the importance to the economy of private expectations about market conditions, subjectivism distinguishes the Austrian school.
Subjectivism as understood and articulated by the Austrians never became part of neoclassical economics after the marginal revolution of the 1870s, although several historians of economic thought, including Mises, maintained just the opposite (Joseph A. Schumpeter, History of Economic Analysis [New York: Oxford University Press, 1954], pp. 849–50). Fritz Machlup stated that all essential insights of the early Austrian school had been incorporated into mainstream economics by the 1920s [lecture before the Austrian Club of New York City in 1968]; and Ludwig von Mises wrote that “all the essential ideas of the Austrian School were by and large accepted as an integral part of economic theory” (The Historical Setting of the Austrian School of Economics [New Rochelle, N.Y.: Arlington House, 1969], p. 41). While subjectivism dominated the early work of Jevons and Philip Wicksteed in England (in this regard philosophically more “Austrian” than other British economists), the Austrian emphasis on the subjective character of economics had almost been forgotten by the time Alfred Marshall's Principles of Economics had become the leading textbook among English-speaking economists during the 1890s and well into the first quarter of the twentieth century. English utilitarianism with its impossible program of “adding up” utilities to get a monetary measure of social or individual welfare eventually became the methodological underpinning of neoclassical economics.
The Lausanne school, which included Walras and Vilfredo Pareto, took the mathematical-functionalist rather than the philosophical approach to the discipline of economics (Emil Kauder, “The Intellectual and Political Roots of the Older Austrian School,” Zeitschrift für Nationalökonomie 17 [December 1957]: 411–25). Individuals were viewed, not as actors pursuing ends susceptible to alteration and adjustment, but as pegs on which static indifference curves could be hung. The meaning of acts to the actors was disregarded in the methodology of the Lausanne school. Rather it was the desire to reduce economics to an “exact” science that led Walras and later Pareto to adopt the quantitative and graphical methods of the physical sciences in presenting the basic insights of marginalism. When subjective notions did enter the analysis of the Lausanne school, it was in the form of “tastes” that were regarded as basic and immutable. In fact, according to Lachmann, time and change—essential ingredients of the economic world—were subtly excluded in the Lausanne school's reliance on the technique of general equilibrium analysis. An individual free to change his mind is excluded by the assumptions of the timeless artificial world of general equilibrium.
As the concepts of neoclassical economics were developed, especially in J. R. Hicks's Value and Capital (Oxford: Clarendon Press, 1939), the subtle fusion of the Cambridge and Lausanne schools was completed. The subjective valuations of the individual and his task of choosing among unequal alternatives—notions considered basic discoveries of the early Austrian writers—were supposedly incorporated into neoclassical economics. But the truth is that the Austrian tradition was buried in a plethora of curves, models, and other quantitative abstractions.
The evolution of Lachmann's thought may be divided into three fairly distinct periods, which coincide with his experience in three different countries. First, there is Lachmann the young student, who is introduced to subjective economics in Germany. Second, there is the journeyman Lachmann maturing within the vibrant intellectual atmosphere of the London School of Economics during the 1930s and 1940s. Finally, there is the mature scholar at the University of the Witwatersrand in South Africa during the 1950s and 1960s. Unlike many who become less active as they get older, Lachmann has continued to search out new issues and push his thought in new directions to become one of the most vigorous and resolute advocates of the subjectivist position in the entire discipline of economics.
For a long time, however, Lachmann was unaware of the width of the gulf that separated his position from that of his neoclassical colleagues. For several decades he believed that almost all economists (with the exception of the Marxists) were part of one big, sometime feuding, but ultimately compatible family. In order to understand his failure to appreciate the gulf between his Austrian approach and the neoclassical school, it is necessary to trace his intellectual odyssey. This volume of essays is not only a positive contribution to an understanding of the market but also constitutes a single document about one man's intellectual development. Lachmann's work over almost five decades amounts to a forceful reassertion of the precious Mengerian insight that economic phenomena are essentially subjective.
In 1924 Ludwig Lachmann entered the University of Berlin to study economics. The formal teaching of economics had deteriorated during the Weimar Republic, and there was little interest in theoretical economics in the aftermath of the Methodenstreit (Mises, The Historical Setting). Among the economic historians only Max Weber was held in academic esteem, and he was not a technically trained economic theorist. The one theoretical economist known in Germany was Joseph Schumpeter, and the name of Pareto was beginning to be heard on the fringes of German economic discussion. Only in monetary theory were German economists accomplishing anything amounting to a breakthrough, mainly due to the efforts of Albert Hahn and Siegfried Budge (H. S. Ellis, German Monetary Theory 1905–1933 [Cambridge: Harvard University Press, 1934]).
During the summer of 1926 Lachmann went to the University of Zurich, where Manuel Saitzew (the Russian-born economic historian) provided him with an overview of Ricardian economics and the marginal revolution. That summer in Zurich marked Lachmann's first, if brief, introduction to the subjectivist position in economics. Already he was attracted to the subjectivism of Carl Menger. In a comparison of the marginal and classical schools not only did the marginalists outshine the Ricardians, but in Lachmann's opinion Menger's accomplishment was the most impressive among the three codiscoverers of marginal utility.
After he returned to Berlin, Lachmann studied the then-current monetary theories, which included business cycle analysis, and concentrated on the work of A. L. Hahn, whose ideas paralleled those of R. G. Hawtrey in England. At this time he also had his first encounter with the Wicksell-Mises theory of the trade cycle, which was beginning to attract attention through the writings of both Mises and Hayek (Friedrich A. Hayek, Geldtheorie und Konjunkturtheorie [Vienna; 1929]; English edition, Monetary Theory and the Trade Cycle, trans. N. Kaldor and H. M. Croome [London: Jonathan Cape, 1933]).
A common practice among students at German universities at that time was to hire a tutor for independent study. Lachmann's choice of a tutor was young Emil Kauder—a stroke of good fortune for both of them, for they shared an interest in the Austrian school. Werner Sombart, Lachmann's mentor and dissertation sponsor at Berlin, advised Lachmann to read Schumpeter and Pareto but discouraged him from spending time on the writings of the Austrian school. Here again the prejudices of the lingering Methodenstreit may clearly be seen. Kauder and Lachmann concentrated on the work of Pareto, and although through this study Lachmann mastered Walrasian general equilibrium analysis well enough to earn his doctorate in 1930, both he and Kauder became convinced that the functional analysis of the Lausanne school was unsatisfactory.
As is often true, Lachmann's real economic education—his detailed inquiry into the problems of the discipline—began after he met the requirements for his doctorate. In addition to the study of Pareto he and Kauder began work on Hayek's Monetary Theory and the Trade Cycle (London: Jonathan Cape, 1933) and Prices and Production (London: George Routledge, 1931). During these sessions Kauder stressed the importance of subjectivism, especially subjective opportunity cost as the key concept in economic analysis. Lachmann also returned to the study of genetic-causal economics, the term of Werner Sombart and Hans Mayer (Hans Mayer, Der Erkenntniswert der funktionellen Preistheorien [Vienna: 1932]) for the Austrian method of reducing aggregates to statements about individual choices.
By this time, Lachmann's basic theoretical formulation, with the possible exception of the role of changing expectations in economic life, had been worked out. The foundations of Lachmann's theoretical structure were (1) a firm belief in the subjective theory of value and the related concept that the economic cost of an action always refers to a forgone opportunity; (2) a preference for the genetic-causal method of inquiry in contrast to the mathematical-functional approach of the Lausanne school, (3) a familiarity with the verstehende methode as espoused by Max Weber (an aspect of Lachmann's work that lay dormant for the next twenty years), and (4) an acceptance of the Mises-Hayek theory as a cogent explanation of the trade cycle.
In early 1933 Lachmann left Germany and settled in England, where he discovered the difference in the intellectual climate, especially in the attitude toward economic theory, to be striking. Cambridge University as well as the more cosmopolitan London School of Economics was teeming with sophisticated ideas. These were, indeed, what G.L.S. Shackle termed “the years of high theory” (The Years of High Theory, 1926–1939 [Cambridge: Cambridge University Press, 1967]).
At the London school the neoclassical synthesis reigned supreme. This synthesis included elements of the Walrasian, Austrian, and classical traditions and, owing to Hayek's influence, a major emphasis on the Austrian theory of the trade cycle. At Cambridge University, on the other hand, the heritage in economic theory began with Marshall, and all contact with the Austrian tradition was avoided. When Lachmann arrived at the London School, Hayek was at the peak of his academic influence. The “big four”—John Hicks, Nicholas Kaldor, Abba P. Lerner, and Lionel Robbins—all adhered to the “new view” of production and its structure. This was definitely a period notable for the convergence of economic doctrines, as described by Lachmann in “Austrian Economics in the Present Crisis.” Other important economists of Hayek's persuasion included Gottfried Haberler (Harvard University), Alvin Hansen (Harvard University), Fritz Machlup (Princeton University), Hans Mayer (University of Vienna), Richard von Strigl (University of Vienna), and, of course, Ludwig von Mises (University of Vienna).
During the 1930s the Hayekian view of the business cycle dominated the newly emerging orthodoxy (besides Hayek's writing cited above, see G. Haberler, “Money and the Business Cycle,” in Gold and Monetary Stabilization, ed. Quincey Wright [Chicago: University of Chicago Press, 1932]; and Lionel Robbins, “Consumption and the Trade Cycle,” Economica 12 [November 1932]: 413–30). Moreover, the trade cycle theory of Mises and Hayek suggested explanations for macrophenomena through the use of conceptual devices that in effect reduce them to microeconomic phenomena (Gerald P. O'Driscoll, Economics as a Coordination Problem [Kansas City: Sheed Andrews and McMeel, forthcoming]).
Another theoretical development at the London School that Lachmann found congenial was the notion of “opportunity cost.” Lionel Robbins among others claimed that costs were necessarily subjective and accessible only to the private decision maker (James Buchanan and G. F. Thirlby, L.S.E. Essays on Cost [London: London School of Economics and Political Science, 1973]). Elsewhere the original objective interpretation of opportunity cost prevailed, and eventually the London School accepted the neoclassical practice of grafting a monetary measure of opportunity cost onto the existing body of microeconomic analysis. Subsequently, James Buchanan tried to revive interest in the subjective interpretation of opportunity cost and the early London School tradition (L.S.E. Essays; and Cost and Choice [Chicago: Markham, 1969]).
Unable to secure an academic position in Britain, Lachmann became a student of Hayek, as were Helen Makower and G. L. S. Shackle. During his first year at the London School Lachmann made the acquaintance of Paul Rosenstein-Rodan, who before leaving Austria had assisted Hans Mayer, holder of Menger's chair at the University of Vienna. From Rosenstein-Rodan Lachmann gained insight into the importance of expectations in economic activity and hence in economic theory.
During those early years of the Great Depression, when the theory of the business cycle was of central concern, the Austrian school economists focused on the factor of changing expectations. Ludwig von Mises had examined the influence of price expectations on the demand for money (Theory of Money and Credit [New Haven: Yale University Press, 1959]) and undertook to integrate expectations into the Austrian account of the business cycle. In 1933 Hayek presented his famous Copenhagen lecture, “Price Expectations, Monetary Disturbances, and Malinvestments,” in which he systematically explored the relationship between expectations and the business cycle (Profits, Interest, and Investment [New York: Augustus M. Kelley, 1969], pp. 135–156). Also from this time the role of expectations became a central theme in Lachmann's writings.
Lachmann's first important article in this vein appeared in 1937 (Economica 4 [August 1937]: 295–308) under the title “Uncertainty and Liquidity Preference.” Here Lachmann explored the relationship between price expectations and the demand for money. In 1943 expectations received central attention in “The Role of Expectations in Economics as a Social Science.” Here Lachmann described how changing expectations alter plans of economic agents and upset the alleged tendency toward equilibrium. For Lachmann, the theory of expectations represents the second wave of subjectivist economics after Menger's break-through in the theory of value. According to Lachmann, economic theories that ignore the role of changing expectations are incomplete and misleading.
Hayek's criticism of John Maynard Keynes's Treatise on Money appeared in 1930 and was of a theoretical nature and analytical in form (“Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” Economica 11 [August 1931]: 270–95; 12 [February 1932]: 22–44). Then the magnitude of the “secondary depression” that gripped the Western nations after the fall of the Kredit Anstalt in Vienna in May 1931 caught the Austrians by surprise. In 1936, when Keynes's General Theory of Employment, Interest, and Money appeared with its argument that a deficient aggregate demand accounts for the general collapse in business and employment, the Austrian theory began to lose adherents.
During the winter of 1935–36, Abba Lerner spent a semester at Cambridge and participated in Keynes's seminar where the soon-to-be-published General Theory was discussed at length. Lerner returned to the London School convinced that Keynes was correct and Hayek wrong. During that same year, Lachmann prepared a paper under Hayek's sponsorship in which he examined Keynes's explanation of “secondary depression.” Since the Austrian theory of the business cycle was developed to explain the “primary depressions” typical in the nineteenth century, it needed to be supplemented by a theory of secondary depressions to account for the massive downturn in all sectors of the economy that immobilized the industrialized nations of the world. In Lachmann's view the cause of the primary depression was credit expansion by the banking system leading to malinvestment and later liquidation. But once in the throes of a primary depression, there was something to be said for Keynes's theory as an explanation of the secondary depression. On this point, Lachmann was closer to Gottfried Haberler (“Some Reflections on the Present Situation of Business Cycle Theory,” Review of Economic Statistics 18 [February 1936]: 1–7; and Wilhelm Roepke, Crisis and Cycles [London: W. Hedge & Company, 1937]) than he was to Mises and his disciples. Lionel Robbins defended the Mises-Hayek theory (The Great Depression [New York: The Macmillan Co., 1934]) as did Murray N. Rothbard at a later date (America's Great Depression [Kansas City: Sheed & Ward, 1975]). Thus in 1936 Keynes presented a challenge on which some Austrians find themselves divided.
By 1938 the Hayekian position was ignored in the enthusiasm for the new Keynesian analysis. As has been said, “[The] voices [of the Austrians] were drowned in the fanfare of the Keynesian orchestra” (John Hicks, Capital and Growth [Oxford: Oxford University Press, 1965], p. 185).
In brief the Austrian theory of the business cycle was never refuted or even rejected at the London School, but simply forgotten despite the efforts of Hayek and subsequently Lachmann (as noted below) to improve the theory (Hayek, Profits, Interest, and investment [1939; reprint; New York: Augustus M. Kelley, 1969]). With the Keynesian revolution, macroentities had replaced the action of individuals. Subjectivism and individual causation had been superseded by functional relations among objectified aggregates, which had few if any real world referents in the actions of economizing individuals. A whole tradition transplanted to British soil vanished. When Lachmann had arrived in London during the early 1930s, everybody was a Hayekian, but by the beginning of World War II the only consistent and thoroughgoing Hayekians left were Lachmann and Hayek himself.
Lachmann spent the next decade trying to piece together what had gone wrong. In 1938 he was appointed Leon Fellow of the University of London to examine economic theory on the causes and phenomena of the Great Depression. He traveled extensively in the United States, where he did research at Columbia University, Harvard University, and the University of Chicago. While at Chicago he participated in Frank H. Knight's famous seminar in economics. Knight, though one of the great defenders of subjectivism in economics, had little sympathy with Austrian capital theory and the theory of the business cycle erected on those foundations. Perhaps after being stimulated by Knight's seminar, Lachmann wrote two articles—“On Crisis and Adjustment” and “A Reconsideration of the Austrian Theory of Industrial Fluctuations”—in which he tried to reestablish the validity of the Austrian position. However, as World War II grew in intensity and the economies of the industrialized countries began to mobilize for the war effort, Lachmann's work failed to attract attention. The same was true of Hayek's Profits, Interest, and Investment (1939), another restatement of the Austrian theory. Keynesian theory was better suited to the direction of a command economy mobilizing for war, and perhaps for this reason the Austrian analysis was ignored.
In a final effort to familiarize English readers with Austrian capital theory, Hayek published The Pure Theory of Capital (London: Routledge & Kegan Paul, 1941). This important work systematically developed the main points of his own investigations in neoclassical terminology. Hayek's treatise did not attract the scholarly attention it deserved, and Hayek, somewhat discouraged, turned his attention to political philosophy and the philosophy of science. Hayek's brilliant Counter-Revolution of Science (London: Free Press, 1955) and the essays included in Individualism and Economic Order (London: Routledge & Kegan Paul 1949) largely date from this period and document the gradual shift in his research interests form pure economics toward social philosophy.
Although there were many areas of intellectual agreement between Lachmann and Hayek, Lachmann was not really satisfied with Hayek's Pure Theory of Capital. Hayek based a large part of his 1941 analysis on Böhm-Bawerkian foundations, and Lachmann considered Hayek's work to possess many of the disadvantages of the current macroeconomic approach. Lachmann considered himself a follower of Menger's subjectivism, and he, like Menger, criticized the work of Eugen von Böhm-Bawerk as a deviation from the main line of development of Austrian economics, in that Böhm-Bawerk's analysis lost sight of the individual and built a model of capital accumulation based on the older Ricardian notion that capital was a “subsistence fund.”
In 1941 Lachmann was appointed a lecturer at the University of London and later moved to Aberystwyth, Wales. In 1943 he received an appointment at the University of Hull, where he remained until 1948. In Wales and later at Hull he perfected his subjectivist position. His work on expectations continued (“The Role of Expectations”). In reaction to Hayek's Pure Theory of Capital and also in response to the general character of modern capital theory, he began a project that was to occupy him for the next ten years. He believed that by analyzing defects in capital theory, he could expose misconceptions in other areas of macroeconomic analysis.
Building on the essential insights of Hayek's classic 1935 paper, “The Maintenance of Capital” (Economica 2 [August 1935]: 241–76), Lachmann attacked the assumption that capital is a homogeneous and measurable aggregate in his article “On the Measurement of Capital” (Economica 8 [November 1941]: 361–77). His later paper “Complementarity and Substitution” is a detailed presentation of the view that capital is not a homogeneous aggregate but rather a complex interdependent structure of heterogeneous producer's goods. This line of inquiry culminated in the publication of his book Capital and Its Structure in 1956 (2d ed., Kansas City: Sheed Andrews and McMeel, forthcoming).
Despite his differences with Hayek on certain aspects of capital theory, Lachmann found Hayek's work on methodology both a guide and an inspiration. The key to a proper understanding of the discipline of economics is the realization that there is more to economic analysis than the pure logic of choice. This criticism was implicit in Hayek's methodological writings. Still it was not clear what that something “more” was. Not until after Lachmann became head of the department of economics at the University of the Witwatersrand in Johannesburg did he succeed in settling the problem to his own satisfaction.
In 1947 Paul Samuelson attempted to fuse the ideas of Keynes and general equilibrium analysis into a new neoclassical synthesis. Lachmann read Samuelson's Foundations of Economic Analysis (Cambridge: Harvard University Press, 1947) and, not surprisingly, found the synthesis unconvincing. Although Keynesian economics had some relevance to extreme situations such as the Great Depression and the command economies of World War II, its prescriptions were unsound for an economy functioning under normal conditions.
By the time Lachmann reviewed Ludwig von Mises's Human Action (1949) in 1951 (“The Science of Human Action”) he had become reacquainted with the writings of Max Weber. The combined influence of Mises and Weber prompted Lachmann to censure Samuelson and others for trying to graft new concepts onto old ideas until economic theory had lost all proportion. To Lachmann there were basically two distinct and mutually exclusive ways of analyzing complex economic phenomena. The Samuelson-Keynes synthesis in positing quantitative relationships between fictitious entities represented the failure of modern economics. The Mises-Weber approach, on the other hand, belonged to a tradition that endeavored to understand the essence of economic action. It embodied and introduced the subjective, or interpretive, economic analysis.
In this inaugural lecture at the University of the Witwatersrand (“Economics as a Social Science”) Lachmann presented a synthesis of his views with those of Mises and Weber. In agreement with Mises, he conceived human action to be more than automatic reaction within a given economic environment; therefore any theory professing to interpret economic activity must refer to the purposive actions of individuals. Since choice is an activity of the human mind, it is impossible to divorce choice from the larger notion of purpose. Economics is therefore a discipline that promotes understanding of economic activity, and not a discipline that uses the methodology of the natural sciences to predict the outcome of economic activity.
Lachmann's work during the 1950s may be described as a fusion of (1) his concept of the role of expectations in capital theory, (2) the Misesian view of human action as purposive, and (3) the verstehende sociology of Max Weber. Since thought and action are identical categories, an understanding of thought will also furnish an understanding of action. To understand action is to comprehend the thought that sets that action in motion. Interpretive economics relates complex economic phenomena to the individual plans and purposes that set them in motion, and this analysis requires constant reference to the plans, preferences, values, and expectations of acting individuals.
In assessing the evolution of economic theory during the decades 1933–1953 (“Some Notes on Economic Thought”), Lachmann attached great significance to the use made of expectations in economic analysis. He took issue with the basic premise of Keynesian analysis that the market economy requires constant stimulation by the state to avoid general stagnation. He also criticized microeconomists who view competition as a state of affairs (that is, “when the demand curve facing the firm is perfectly elastic”) rather than as a process In “Ludwig von Mises and the Market Process” Lachmann found the neoclassical view of competition not only defective but totally misleading as a standard for judging the efficacy of real world market conditions. He concluded that both micro and macroeconomics had led contemporary economists down dead-end streets.
In his 1956 article “The Market Economy and the Distribution of Wealth” Lachmann applied the Misesian notion of market process to the distribution of social income. Here he attacked the concept that the distribution of wealth should be taken as a datum rather than a result of the market process. The market economy constantly adapts to changing historical conditions and alterations in the plans of acting individuals. As conditions change, Lachmann pointed out, the mode of distribution of wealth changes also. These views led Lachmann to join with Mises in a critique of neoclassical economists' use of equilibrium analysis as a blueprint for reordering the social world. This point of view is expressed in “Methodological Individualism and the Market Economy.”
In his review of Joan Robinson's Accumulation of Capital (1956) Lachmann sought to place the book within the traditional framework of economics. Because she was interested in long-run equilibrium questions, not the mainstay of early Keynesian analysis, Robinson could not be called a Keynesian. In his review “Mrs. Robinson and the Accumulation of Capital” Lachmann dubbed her a “latter-day Ricardian” and thus classified her and her followers as counterrevolutionaries to the subjectivist revolution that Menger has initiated in reaction to Ricardo and the adherents of classical analysis.
The counterrevolutionary character of a growing body of current economic thought deeply disturbed Lachmann. Throughout the next decade he worked out a counterattack against the neo-Ricardians. A most insightful article in this vein first appeared in German (translated under the title “The Significance of the Austrian School in the History of Ideas”).
At this same time Lachmann was becoming increasingly disenchanted with the neo-Keynesian model builders, or “neoclassical formalists” as he called them. He questioned the value, either for understanding the economy or for formulating policy, of elegant models without a base in the microeconomic realities of the market. Once again he deplored the rejection of the subjective springs of economic phenomena for mathematical formulations and misleading equilibrium models. He singled out for criticism the work of the post-Keynesian theorists J. R. Hicks, Paul Samuelson, and Robert Solow (translated under the title “Model Constructions and the Market Economy”) in an article that originally appeared in German.
In Macro-economic Thinking and the Market Economy (London: Institute of Economic Affairs, 1973), Lachmann found fault with both the neo-Keynesians and the neo-Ricardians for ignoring the real issues in their disputations. He also sketched the subjectivist, or Austrian, answers to such important questions as the nature of techniques of construction to profit relationships in a market economy. In short, the controversy over “reswitching,” as it came to be known, is largely due, in Lachmann's estimation, to a confusion about the nature and source of profit. Profit is a result of adjustment to unexpected change, and therefore the magnitude of profit is constantly changing. Moreover unexpected change cannot be integrated within an equilibrium model of the economy. In equilibrium profit cannot exist.
During the 1950s and 1960s Lachmann continued to work on two lifelong interests, that is, the role of changing expectations in the economy and the theory of capital. His advanced concepts about expectations are formulated in “Professor Shackle on the Significance of Time.” Static equilibrium models are misleading because they ignore the importance of unanticipated change. Is there any reason to believe a tendency toward equilibrium really exists? Static equilibrium analysis and the models distilled from it assume that equilibrium can be attained automatically. To the contrary, in any real world market situation whether individual plans diverge or converge depends on the way expectations adjust. But inasmuch as expectations are conjectures about the future, it is presumptuous to graft expectations onto equilibrium models where the final position is predetermined by conditions stated at the outset.
Lachmann's concepts of expectations are both novel and intriguing. The future is unknowable but not unimaginable. Persons differ in their mental projections, since it is improbable that any large number of persons will ever anticipate the future exactly, expectations will always diverge. According to Lachmann (following G. L. S. Shackle), the forces for the divergence of plans are likely to be stronger than those for their convergence.
Fluctuations in economic life continuously alter the basic constellation of knowledge; and this fluidity is; after all, the essence of the economic problem and the reason why efficient central planning is impossible (see, for example, Hayek, “The Use of Knowledge in Society,” in Individualism and Economic Order, pp. 77–91). In his review of Shackle's Time in Economics (“Professor Shackle”), Lachmann pushed the logic of Hayek's insight to the conclusion that any attempt at economic prediction is futile: “The impossibility of prediction in economics follows from the fact that economic change is knowledge, and future knowledge cannot be gained before its time.” In a review of one of Shackle's later works, Kenneth Boulding called this stand on prediction and knowledge “Lachmann's Law” (“A Review of Epistemics and Economics by G. L. S. Shackle,” Journal of Economic Literature 11 [December 1973]: 1373–74). Thus after Mises and Hayek, Shackle was the economist whose thought had a tremendous impact on Lachmann's intellectual development.
As noted, the Lachmann-Shackle position that forces of divergence tend to outweigh forces of convergence makes a general market equilibrium unlikely. According to Lachmann, the strength of the forces of convergence depends almost entirely on the activities of entrepreneurs. If entrepreneurs take advantage of the price-cost discrepancies attending changing circumstances, the entrepreneurial function of using resources in search of profit (the process of innovation and imitation) will, as most Austrian economists agree, lead to a convergence of the plans of individuals in markets. However, because change is ever present and unpredictable, individuals have different expectations about the character and extent of change. It is this factor more than any other that precludes anything approaching a macroeconomic general equilibrium in the uncertain world of market activity.
Lachmann's policy positions are consistent with his basic approach to economic analysis. Although a determined opponent of interventionism in the market, his opposition is less philosophically founded than that of either Mises or Hayek. In many ways he is the perfect example of the traditional “classical liberal” economist. His defense of the market economy derives mostly from a deep concern for the historical development of Western civilization. All interference with the entrepreneurial process of adjustment and the market's consequent diffusion of knowledge weakens the forces of equilibrium and impedes rapid market clearing. Either piecemeal or planned market intervention inevitably creates dislocations that lead in turn to more extensive market interventions—a spiral that eventually cripples the market economy without providing a satisfactory substitute.
From the twelfth century onward Western civilization and the market economy developed side by side. During the nineteenth century the market economy experienced an accelerated development to the material advantage of the expanding populations of the Western world. During this century, and especially after World War I, both economic theory and economic policy have deteriorated to the point that the survival of the market economy is threatened. For the greater part of the twentieth century Western society has been sustained by the past accomplishments of the relatively unhampered market economy of the nineteenth century; however, such capital consumption cannot go on forever.
Interventionism in one form or another has become the stated policy of Western governments. Planners profess the ability to coordinate economic affairs better than the freely operating market process, which they often characterize as “chaotic” or “anarchistic”. In one form or another central governments cooperate with the private sector in programs to “rationalize” or “improve upon” the market system by cultivating “balanced growth” (“Cultivated Growth and the Market Economy”). However, intervention, no matter how well intentioned, leads to secondary economic dislocations that further hamper the market process and set the stage for more severe maladjustment.
Perhaps the most alluring and ultimately most pernicious of planned interventions are the expansionary, or “easy money,” policies of the central banks. It is monetary or credit expansion, causing a system-wide distortion of the price structure and the entrepreneurial process, that makes economic calculation difficult and sometimes impossible. Why do central banks inflate their currencies, and why do the Austrian economists see the consequences of this inflation to be so economically and socially disastrous?
Originally the money supply is increased with the object of artificially lowering market rates of interest in order to stimulate investment, production, and employment. However, along with the massive infusions of new money into the various banking networks is the ominous development of powerful and government-favored labor unions. Faced with the political-economic power of organized labor and the knowledge that monetary deflation would create labor unrest, governments resort to expansion of the money supply as a method of temporarily achieving full employment. In their privileged position, unions force a continued upward movement in money wages that can only be sustained by resorting to further increased in the money supply. Therefore the twin causes of the Western monetary malaise are monetary expansionism and powerful labor unions that prevent downward movements in wages and prices (“Causes and Consequences of Inflation in Our Time”).
To Lachmann the significance of inflation among the Western nations is not simply the continual rise in prices or the consequent redistribution of income from creditors to debtors. Equally important is that the artificial booms and consequent slumps caused by the infusion of money into the loan market make the market economy appear inherently unstable. This encourages the clamor for further intervention, such as planning for “investment stabilization” and the related call for “indicative planning.” With wages not permitted to fall because of the threat of union unrest and prices and wages moving upward at an accelerating pace, the planners opt for wage and price controls. At this point the market process cannot operate effectively, and if the wage and price controls are enforced, the market system comes to a halt. For these reasons government intervention in economic affairs should be minimal. The role of government should be as circumscribed as possible and conform to the classical liberal ideal of supporting the free market by strengthening the institutions of private property and voluntary business contract.
The roots of Lachmann's subjectivism date from his student days in the 1920s and his discovery of Menger's writings. However, while the subjectivist position in economics including the views that utility, cost, and market phenomena are rooted in the private plans of individuals was never dominant during the 1920s, it was considered a respectable position. By 1960 all had changed. Lachmann viewed with alarm the trend to ignore the Austrian, or subjective, contribution to the discipline. While to some observers Lachmann's subjectivism appeared increasingly uncompromising, his basic position was that, in Hayek's words, “every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism” (The Counter-Revolution of Science [New York: Free Press, 1955], p. 31). Consequently, as subjectivism lost favor in academic circles, Lachmann defended it with greater intensity. The form of Lachmann's defense was heavily influenced by the work of Alfred Schütz.
In 1935 Felix Kaufmann lectured at the London School on the recent writings of the Austrian philosopher and sociologist Alfred Schütz (A. Schütz, Der sinnhafte Aufbau der sozialen Welt [Vienna: Julius Springer, 1932; translated as The Phenomenology of the Social World [Evanston: Northwestern University Press, 1967]). In synthesizing the philosophy of Edmund Husserl and the sociology of Max Weber. Schütz presented a forceful antipositivist defense of the subjective foundations of the social sciences. While the Kaufmann lecture did not create much of a stir among the London School economists, Lachmann found it meaningful. Several years later he read an account of schütz's Der Aufbau that appeared in Economica (A. Stonier and K. Bode, “A New Approach to the Methodology of the Social Sciences”, Economica 4 [November 1937]: 406–24) but was not motivated to study Schütz in depth. Not until the midfifties when the subjectivist position was badly in need of defense did Lachmann begin a systematic analysis of Schütz's philosophy.
According to Lachmann, if the methods of the social sciences are to elucidate social phenomena, they must be based on the concept that the social world contains not only objective measurable facts but the “perceptions” of these facts by social actors, each of whom plans on the basis of his unique perceptions. If the social sciences are to mature, they must follow the course laid out by Mises, Hayek, and Schütz. Lachmann's work in this area is contained in “The Historical Significance” and his full-length study of Max Weber's thought, The Legacy of Max Weber.
In 1975 Ludwig Lachmann was named Visiting Professor of Economics at New York University and spends the academic year in New York City and the summer months at his home in Johannesburg, South Africa. He remains an active teacher and scholar, and a listing of his most recent publications appears at the end of this volume.
Austrian Economics in the Present Crisis of Economic Thought
In the present confused state of thinking on fundamental economic issues the time may have come to set forth a succinct outline of a position that we may with some justification denote as “Austrian.” This has to be done in a situation of considerable turmoil. While the Ricardian counterrevolution of our days has thus far failed to present any new insights that are either novel or compelling, the neoclassical forces called upon to resist it already seem to be in some disarray.1 Perhaps this is a temporary phenomenon due merely to the sheer dash and verve with which the attackers have conducted their forays; perhaps it betrays a sense of insecurity, reflecting an awareness of the weakness of their position. Elsewhere we learn, less than three decades after Keynes's death, of a crisis in Keynesian economics. And if as perspicacious a thinker as Professor G. L. S. Shackle chooses to give his most mature work, Epistemics and Economics, the subtitle A Critique of Economic Doctrines (Cambridge: Cambridge University Press, 1972), the implication that all is not well with more than one doctrine is noteworthy.
The main reason for an Austrian pronouncement is that otherwise a possibly interesting contribution to the discussion of some of the issues currently in dispute may go by default. But there are other reasons, with some of which we shall have to deal later on. One of them arises from the fact that, while a certain strand of Austrian thought has, over the last few decades, become fused with, and embedded in, what has come to be called the neoclassical synthesis, some Austrians have refused to regard this as a happy union. They and their heirs may feel that the case for a divorce is now strong.
This essay was prepared by the author especially for this volume and appears in print for the first time.
There is, however, also a case against such an Austrian pronouncement. It derives its strength from a distaste for what many will regard as a factious enterprise. The view is widely held that “schools of thought” belong to the adolescent stage of a discipline. We have heard it said that there is only good and bad economics, hence no place for Austrian economics. A mature discipline, we are told, continues to fuse what is best in the contributions of various schools and to discard the rest. Such a synthesis may not be easy to achieve, but we must do nothing to jeopardize it.
It seems to us, however, that the validity of such views depends on the epoch in which one is living. There are, in the history of economic thought, ages of convergence and ages of divergence.2 The period from about 1890 to 1914, the age of Fisher, Marshall, Pareto, and Wicksell, in which the neoclassical synthesis was born, was an age of convergence in which rivers flowing from many diverse sources merged into one broad stream. Ours, by contrast, is an age of divergence. We have already described the scene on which high-level debates in economic theory are pursued today as one of considerable turmoil. When factions are already in existence, who can be blamed for being factious? Where the air is full of the clamor of rivals, who can be reproached for raising a voice of dissent? In an age of convergence an enterprise such as ours may be frowned upon; in an age of divergence it can hardly be condemned.
The fact that Sir John Hicks gave his recent book Capital and Time the subtitle A Neo-Austrian Theory [Oxford: Clarendon Press, 1973] adds to the confusion reigning on our methodological scene. While it constitutes an obstacle, at the same time it provides us with an opportunity to exhibit certain aspects of Austrian thought by contrasting them with the well-articulated thought of a great contemporary. For in confronting this book the “Austrian” economist of our days is compelled to state that he is not a neo-Austrian in the Hicksian sense; and of course he has to explain why he is not before he can proceed to make his own positive contribution. But the very fact that he has to justify his refusal to follow Hicks enables him to make his reader gradually familiar (in a way that otherwise might not seem called for) with some Austrian ideas, at first by showing that they do not fit into the Hicksian mold, later on by displaying their positive uses in understanding a dynamic world. It thus becomes possible to examine the same object successively from various angles.
This is not the place to review sir John's remarkable book.3 We are not even called upon to do justice to it as an attempt to clarify some of our contemporary confusions. All we are concerned to show here is that a good deal of what is offered to us as neo-Austrian is at variance with what we must regard as fundamental Austrian tenets. It was not for nothing that Menger regarded Böhm-Bawerk's theory “as one of he greatest errors ever committed.”4 Böhm-Bawerk was, at least in his theory of capital and interest, a Ricardian, interested in capital only as a receptacle of the flow of interest, who asked the Ricardian question why and how the owners of “intermediate products” contrived to draw a permanent income from their wealth as if they were factor owner. He found a Ricardian answer to this question.
Hicks follows Böhm-Bawerk in stressing the time dimension of production, but also employs a kind of sequence analysis as providing causal chains to trace the gradual unfolding of the effects of technological innovation on income distribution and growth. We are shown how, with the lapse of time, these effects gradually show themselves at successive stages of production. Time is here both the dimension of production and the dimension in which the effects of change show themselves.
In order to accomplish this sequence analysis and formulate a theory of the “traverse” from one equilibrium path to another, Hicks has to make two assumptions, static expectations and the existence of only one good. The former means that the actors in his model always expect the future to be exactly like the present. The Austrian objection to this assumption rests not merely on its lack of realism, striking though this is. Can we really imagine employers who, though experiencing continually rising wage rates, nonetheless always expect their future wage costs to be the same as their present? Much worse is that this assumption effectively prevents what from the Austrian standpoint are some of the more important problems concomitant to change from ever coming into view.
Austrian economics reflects a “subjectivist” view of the world. The subjective nature of human preferences is its root. But in a world of change the subjectivism of expectations is perhaps even more important than the subjectivism of preferences. The assumption of “static expectations,” however, means not merely that expectations as autonomous forces causing economic change are ignored so that a mechanism of other forces may be exhibited in its “pure form” but also that the diversity of expectations, the pattern of inconsistent expectations held by different individuals at the same time, which we find in the real world, cannot even come into sight. Static expectations mean no less than that the minds of all actors at the same moment work in identical fashion. One of the achievements of the subjectivist revolution is blandly nullified.
Hick's other assumption, the one-commodity world, is no less open to objection from an Austrian point of view. But as criticism of it has also played a prominent part in the neo-Ricardian counterrevolution, at least at one stage, it will be more conveniently dealt with in our next section.
Since the label “neo-Austrian” has now been preempted by Hicks for his own brand of theory, we are unable to dub the point of view to be elucidated here “neo-Austrian.” We might perhaps call it neo-Mengerian, or Mises-type, or even palaeo-Austrian. Each of these would be an awkward label. We trust that if in what follows we simply call it Austrian without qualifying epithet the reader will understand what we mean by it.
Since Sraffa in 1960 gave the signal, the attack on the Walras-Paretian general equilibrium theory has steadily gained ground.5 From an Austrian point of view the strong antisubjectivist bias of this neo-Ricardian movement is naturally reason enough to oppose it. A style of economic thinking in which there is no place for human preferences, let alone time preferences, is hardly acceptable to the heirs of Menger. But some of the weapons the neo-Ricardians have used in their attack on the neoclassical citadel are of great intrinsic interest to the student of intellectual warfare. They might turn out to be useful for other purposes. It will be worth our while to have a close look at them and see what we can learn from them.
From a common source in Wicksell's work two broad streams of capital theory have emerged over the last fifty years. One is the distinctly Austrian stream we find manifested in Professor Hayek's work, in Prices and Production (London: George Routledge, 1931); in “The Maintenance of Capital” (Economica 2 [August 1935]: 141–276); and in The Pure Theory of Capital (London: Routledge & Kegan Paul, 1941). Here emphasis is on the importance of relative price movements and the impossibility of measuring investment without a criterion for the maintenance of a heterogeneous capital stock. The other stream found prominent expression in Professor Joan Robinson's well-known critique of neoclassical capital theory. Here the problems stressed by Hayek are ignored. The fact that in all these years there has been, with one exception noted below, virtually no contact between these two streams is of course just another reflection of the present crisis of economic thought.
In what follows we attempt to show that a keen pursuit of the implications of some of the more successful critical arguments used in the course of the neo-Ricardian counterrevolution will take us far afield, away from the mountain fastness of macroeconomics and into fields in which what happens depends on individual action and expectations, which of course need not be consistent; and that in the course of this pursuit one of the main sources of Keynesian inspiration becomes rather tarnished. Three examples will serve our purpose.
1. Ever since Professor Joan Robinson proclaimed “the generalization of the General Theory” as her aim, Cambridge economists fond of being described as “neo-Keynesians” have taken an interest in growth theory. In these endeavors the notion of investment, the famous Keynesian I = S, naturally plays a prominent part. How can its use be reconciled with the now-accepted fact that outside long-run equilibrium a measurable capital stock does not exist? The usual answer is that investment is a flow, not a stock, and thus exempt from such objections. But this answer applies only to gross investment, not to that part of it which concerns growth. Can we isolate this latter element without having to concern ourselves with the maintenance of the capital stock?
Keynes defined “the investment of the period” as “the addition to capital equipment as a result of the productive activities of the period.”6 But if we cannot measure this capital equipment, how do we know what constitutes an addition to it? To hold that in the short period capital is by definition constant and thus provides a firm floor for our adding activity would be to ignore the pre-Wicksellian innocence of the Marshallian definition. The awkward fact remains that the supposedly measurable macroeconomic magnitude I has to be measured by means of another magnitude based on subjective evaluation.
Keynes was well aware of the problem. He explicitly agreed with Professor Hayek “that the concepts of saving and investment suffer from a corresponding vagueness,”7 but added that this applies only to net saving and net investment since they depend on subjective evaluation. By contrast “The saving and the investment, which are relevant to the theory of employment, are clear of this defect, and are capable of objective definition.”8
In fact we soon learn that this is not so. For Keynes's own notion of investment, by contrast to the contaminated “net investment,” is defined as gross investment minus user cost, as A1−U. In the “Appendix on User Cost” Keynes admitted that “user cost partly depends on expectations as to the future level of wages” and that “it is the expected sacrifice of future benefit involved in present use which determines the amount of user cost.”9 Thus Keynesian investment, affected by user cost, is by no means “capable of objective definition.” User cost depends on expectations, which are as subjective as preferences. Investment is no more “objective” than the stock of capital.
2. From Ricardo to Professor Pasinetti the difference between a “classical corn economy” and a multicommodity world has often been used as a basis for critical arguments of all kinds. It ahs been a standard criticism of Böhm-Bawerk's theory that, in order to demonstrate the higher productivity of roundabout production, we need as a yardstick a price system invariant to those changes in interest and wages that are the necessary result of roundabout production. Furthermore, in a multicommodity world the subsistence fund must consist of wage goods in precisely that proportion in which wage earners wish to spend their incomes on them, otherwise there will be capital gains and losses. Pasinetti's main criticism of Irving Fisher's “rate of return over costs” has been that the price system of a multicommodity world entails a uniform rate of profit, and that to “explain” the rate of return on capital in terms of opportunities for profit inherent in such a price system is no explanation at all.
It seems to us, however, that the argument may be turned around and used to disclose, not just the inconsistency of certain conclusions within the framework of equilibrium theory, or even of a heuristic device such as Fisher's “rate of return over costs,” but also the weakness of the notion of a “price system” in a world of change. In a world in which prices depend on supply and demand in a multitude of markets, a constant price system is almost inconceivable. Relative prices change every day for one reason or another, for instance, changes in knowledge that may occur on both sides of the market. A Ricardian might say that these are daily fluctuations around an equilibrium level determine by “underlying forces” like technology and the wage level, but apart from changing technology, he can say that only if he regards demand as an ephemeral force. As soon as we regard demand as a “datum,” daily price changes reflect changed data. We conclude that a price system implying a uniform rate of profit and wage rate cannot exist. The forces tending to bring it about will always be weaker than the forces of change. For the explanation of phenomena observed in a market economy it is useless. The market is a continuous process, not a “given” state of affairs. Divergent rates of profit in a multicommodity world are both a result of change and a cause of further change.
3. In a one-commodity world the stock of capital is homogeneous and physically measurable. In a multicommodity world it loses this property and becomes heterogeneous. Here, as we saw in the case of Böhm-Bawerk's subsistence fund, there arises the problem of its composition or structure. Where many capital goods are durable and specific, the stock will never have its “equilibrium composition.” Some capital goods when worn out, will not be replaced by replicas. This fact of course presents an obstacle to the construction of any equilibrium theory of capital such as would fit into a general equilibrium model. It is hardly surprising that most neoclassical economists choose to ignore this inconvenient fact. Some have brought themselves to imagine that they have found a substitute for the missing theory of capital structure in a theory of intertemporal consumption—a capital theory without capital.
For the neo-Ricardians the problem at least seems to exist. In Pasinetti's writings we find occasional references to it. “Two techniques may well be as near as one likes on the scale of variation of the rate of profit and yet the physical capital goods they require may be completely different.”10 In his reply to Dr. Dougherty he explicitly describes this as “one of the important results of the reswitching-of-technique debate.”11 In his altercation with Professor solow he writes, “The two situations a and b that Solow compares differ not only by the single consumption good he has hypothesized but also by the whole structure of capital goods.“12
A capital structure is an ordered whole. How does it come into existence? What maintains it in the face of change, in particular, unexpected change? These are questions that now claim our attention. A capital structure is composed of the capital combinations of various firms, none of which is a simple miniature replica of the whole structure. What makes them fit into this structure? Wherever we might hope to find answers to these questions, it must be clear that they cannot be found within the realm of macroeconomics. Capital combinations, the elements of the capital structure, are formed by entrepreneurs. Under pressure of market forces entrepreneurs have to reshuffle capital combinations at intervals, just as they have to vary their input and output streams. Change in income distribution is just one such force. “Capital reswitching” in a world of heterogeneous capital is merely one instance of the reshuffling of existing capital combinations.
In the field of capital theory the crisis of economic thought has given rise to a situation full of irony. The neo-Ricardians have discovered a range of problems they are unable to tackle since this can only be done on a microlevel, a level to which their macroeconomic commitment does not permit them to descend. Their neoclassical opponents meanwhile, while irked by no such scruples, prefer to ignore these problems altogether and are turning to a capital theory without capital instead.
To substantiate Austrian dissent from neoclassical economics is no easy task. As we pointed out above, some Austrian strands of thought have merged into the main stream of what we may call the neoclassical synthesis. Some Austrian thinkers were quite content to see their school lose its identity within this broader union. Others felt less happy about it.
One reason, less superficial than might appear, why our task is difficult lies in the need to make the reader see the present neoclassical establishment and its main doctrines in a perspective that is not its own, one in which pupils in the best schools are not taught to view the economic world, not to mention the products of the textbook industry, and that must therefore be unfamiliar to the reader. By now most economists have learnt that the world seen in a Ricardian perspective is different from the world seen in, say, a Samuelsonian perspective. But other perspectives are just as possible. We may, for example, view both the perspectives mentioned as mere variants of a style of thought we might describe as late classical formalism. It is a characteristic of this mode of thought that for it the manifestations of spontaneous human action appear in the guise of formal entities, the continuous existence of which can only be assured by imposing constraints on spontaneity.
In order to sustain Austrian objections to neoclassical doctrines we must thus elucidate a “third perspective” rooted in subjectivism. But when we say that the central issue here stems from a different approach to the problem of knowledge and its relevance to economic action, many readers might refuse to follow us into what they might regard as a field of philosophy.
In these circumstances it will be best to start by indicating two areas which are not in dispute, despite what has sometimes been said in the past. Professor Jaffé, in reviewing the volume Carl Menger and the Austrian School of Economics (ed. J. R. Hicks and W. Weber [Oxford: Oxford University Press, 1973]), speaks of “the Austrians, who were not interested in the mathematical pin-point determination of equilibrium price à la Walras, but looked rather for the interval within which any price is advantageous to trading parties on both sides.”13 Suffice it to say that the introduction of the notion of the core in recent neoclassical writings has removed this point of dispute. Secondly, the difference has sometimes been traced to a preference for process analysis by the Austrians and for equilibrium analysis by the neoclassical economists, a difference between “genetic-causal” and “functional” analysis.14 But this difference is not essential in any way that concerns style of thought. A type of equilibrium theory that employs process analysis to show how various equilibria are attained is quite conceivable. Sir John Hick's “traverse” comes readily to mind. Forging chains of causation is not beyond the power to the neoclassical mind. We see no reason why the attempts now made in such quarters “to require of our equilibrium notion that it should reflect the sequential character of actual economics” might not succeed.15 If they do, the issue falls away.
The real issue lies much deeper. We catch a first glimpse of it when, with a critical mind and an air of innocence, we follow the usual introduction to general equilibrium theory. We are presented with three classes of “data,” tastes, resources, and knowledge, which are to serve as our “independent variables.” This is, surely, rather embarrassing, as knowledge “exists” in a way different from that in which rivers and typewriters do. How are we to determine that change in knowledge that would just offset a change in resources in such a way as to preserve an existing equilibrium situation? And what is the economic significance of tastes and resources nobody knows?
Closer reflection shows of course that what is meant here by knowledge as a “datum” is merely technical knowledge about the use of resources, while tastes and resources as such are known to every participant in the market. When they change, the fact is at once known throughout the market, and this does not constitute a separate change of datum. Such universal market knowledge by every participant is simply taken for granted. Neoclassical economics, then, operates with two kinds of knowledge; one appears as an independent variable and the other does not. In neoclassical writings, from presidential addresses to textbooks, this fact is never mentioned. By contrast, Austrian economics takes no form of knowledge for granted. The market appears to it as a continuous process, in the course of which the knowledge possessed by some participants become diffused to many, while new knowledge is acquired by some, and some earlier knowledge becomes obsolete. The reader will now understand why we said that the problem of knowledge is at the bottom of the dispute.
It goes without saying that it is possible to modify the rigor of the assumption about the universal market knowledge, and this has been done recently. The pattern of limited market knowledge then becomes a new “datum.” But such an assumption in no way affects the real weakness of the equilibrium model, which is that knowledge of whatever kind is here treated as an external datum and not as, at least partly, a product of the market process. Can market knowledge exist irrespective of what happens in the market? Some aspects of the problem are best elucidated by reference to two statements made by Professor Hahn in his recent inaugural lecture: “I shall want to say that an agent is learning if his theory is not independent of the date t. It will be a condition of the agent being in equilibrium that he is not learning.”16 It is difficult to know the range of implications here envisaged. Strictly speaking, it means that point-of-time equilibrium is the only equilibrium possible since it involves no learning. We may doubt, however, whether this is what was meant. For if so, how can such an equilibrium ever “reflect the sequential character of actual economies?” So we must assume that Professor Hahn envisages some time sequences in which nothing is learned by any participant and others in which something is learned. Needless to say, the former variety cannot exist. Time and knowledge belong together. As soon as we permit time to elapse, we must permit knowledge to change. The pattern of knowledge never stands still.
We are also told that “practical men and ill-trained theorists everywhere in the world do not understand what they are claiming to be the case when they claim a beneficent and coherent role for the invisible hand.”17 Here Hahn regrettably does not know that those he criticizes conceive of the market in terms very different from his own.
What Hahn means is that only in a market system with perfect intertemporal markets, including “contingent futures markets,” could a Pareto optimum be attained; in the real world in which there are only a few forward markets, and virtually none for industrial goods, no such optimum can be reached. “Ill-trained,” alias “Austrian,” economists are not entitled to claim Pareto optimality for the market economy of the real world.18
But the Austrians are making no such claim, and Hahn simply misunderstood their position. He tacitly assumes that everybody, like his well-trained disciples, identifies the market economy with a general equilibrium model. But to Austrians the market is a competitive process, not a given state of affairs. No general equilibrium model, however large the number of intertemporal markets it includes, can serve as a simile for the market process of reality, and the Pareto optimum is at best an irrelevant fiction. The markets of the real world, by contrast, while at no time constituting an ordered whole, invariably give rise to coordinating forces, reflecting and, over time, generating changes in the pattern of knowledge. In a market economy, as Professor Kirzner stated, “at any given time, an enormous amount of ignorance stands in the way of the complete coordination of the actions and decisions of the many market participants. Innumerable opportunities for mutually beneficial exchange ... are likely to exist unperceived.... The normative question raised by Hayek is how well the market succeeds in bringing together those uncoordinated bits of information scattered throughout the economy. Successful coordination of these bits of information cannot fail to produce coordinated activity—exchange—benefiting both parties.”19
In their defense of the market economy the “ill-trained” economists may have a strong or a weak case. It cannot be refuted by reference to a fictitious optimum irrelevant to it. Evidently the market processes of reality require closer study than they have thus far received. All Hahn has to offer his well-trained disciples is an argument insinuating to others a utopia that is very much his own. The formalistic mind, we may note, incapable of conceiving of a market otherwise than as a set of determinate relationships, is helpless when confronted with a set of forces the interaction of which yields no determinate outcome.
The Austrian objection does not apply to the use of the notion of equilibrium as such. It applies to its indiscriminate misuse at the three different levels of the individuals, the market, and the economic system. Equilibrium of the individual, household or firm, as an expression of consistent action, is indeed an indispensable tool of analysis. Equilibrium involving action planned by different minds involves altogether new problems. Equilibrium on a simple market, such as a Marshallian corn market, still has its uses. “Equilibrium of the industry” is already harder to handle. When we speak of “general equilibrium,” we are simply hypothesizing that among the forces of interaction between markets the equilibrating forces are of overwhelming power and will prevail over all obstacles. Also, they must be able to do their work quickly, before any changes in data can take place. General equilibrium is thus possible in a stationary world. Equilibrium in a world of change requires peculiar hypotheses.
In neoclassical writings we look in vain for arguments sustaining such strong hypotheses. For it is characteristic of the style of formalistic thought that a concept found useful in one context is often torn out of its natural habitat and indiscriminately transplanted to alien soil. Such are the uses of abstraction to careless thinkers.
The reader may feel that, instead of the promised outline of the Austrian position, he has been presented with a series of critical comments directed against non-Austrian views. He may demand to be told, in particular, what is to take the place of the general equilibrium model as the central paradigm of economic theory.
It was necessary, however, to prepare by extensive criticism the fundament on which to erect our structure. Our constructive task will be so much the easier. Our positive proposals simply follow the direction of our critical comments. As regards equilibrium in particular, all we need to do is let our thoughts roam freely along the lines indicated at the end of the previous section.
What would happen, we may now ask ourselves, if we were to reverse the order of significance assigned to equilibrating and disequilibrating forces respectively in neoclassical thought? If we were to assume that all equilibrating forces, so far from being of overwhelming strength, must sooner or later succumb to obstacles of various kinds before having reached their “destination”? In a world in which unexpected change is likely to overtake equilibrating forces, in which new knowledge is continually coming into existence as old knowledge becomes obsolete, this appears to us the more plausible hypothesis. This reversal of the order of significance attributed to the various forces of interaction cannot but affect the perspective in which we view the course of market processes.20
For neoclassical thought equilibrium is central; processes that may or may not lead to it are subsidiary to its main objective. For us, by contrast, market processes reflecting the interplay between equilibrating forces are the essence of the matter, while equilibrium itself, as Mises put it, is nothing but an auxiliary notion employed in its context and devoid of any sense when used outside of this context.”21 we refuse to believe that the equilibrating forces are always overwhelming strength.
Not all market action is consistent action. The actions of competitors are an obvious example. The notion of a “state of competition,” perfect or otherwise, in which they are made consistent, is not merely useless as a tool of analysis; it presents an obstacle to our understanding of competition as a process. In a market economy, at all times, as Professor Kirzner says, “an enormous amount of ignorance stands in the way of the complete coordination of the actions and decisions of the many market participants. Innumerable opportunities for mutually beneficial exchange ... are likely to exist unperceived.” Market processes, to be sure, will reduce such ignorance. But during the very same period in which old knowledge becomes more widely diffused, much of it becomes obsolete, and new ignorance emerges simultaneously with the new knowledge gained by some.
Economists have learnt that some technical progress is absorbed by means of “learning by doing.” But different men learn different lessons from doing the same work and embody what they have learned in differentiated products. The same applies to market knowledge. While the competitive market process leads to the erosion of profit margins, it also inspires some producers to seek safety in product differentiation. The market process is not a one-way street.
The image of economic action that emerges from our reflections is thus that of the market as a continuous process without beginning or end. Marshallian markets for individual goods may, for a time, find their respective equilibria. The economic system never does. This process is propelled by equilibrating forces of intermarket interaction which are, again and again, thwarted by changes in the pattern of the distribution of knowledge. These changes in turn result in part from the impact of exogenous forces, such as the progress of science and technology; in part from human reaction to market events; and also in part from the spontaneous action of the alert minds of participants inspired, but not compelled, by what they witness on the market scene around them.
[]For a somewhat blurred reflection of this state of affairs, see K. J. Arrow, “Limited Knowledge and Economic Analysis,” American Economic Review 64 (March 1974): 1–10; see also F. H. Hahn, “The Winter of Our Discontent,” Economica 40 (August 1973): 322–30. For as faithful a mirror image as the situation permits, we have to turn to John Hicks, Capital and Time (Oxford: Oxford University Press, 1973).
[]“The young economists of the 1920s were not spellbound, like those of earlier decades, by the great glow from a great focus of convergent thought where all the world's economists seemed to pour in their blending illuminations” (G. L. S. Shackle, The Years of High Theory [Cambridge: Cambridge University Press, 1967], p. 291).
[]L. M. Lachmann, “Sir John Hicks as a Neo-Austrian,” South African Journal of Economics 3 (September 1973): 195–207.
[]J. A. Schumpeter, History of Economic Analysis (Oxford: Oxford University Press, 1954), p. 847.
[]Piero Sraffa, Production of Commodities by Means of Commodities: Prelude to a Critique of Economic Theory (Cambridge: Cambridge University Press, 1960).
[]J. M. Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace & World, 1936), pp. 62–63.
[]Ibid., p. 60.
[]Ibid. Here, for once, the two streams of capital theory mentioned above were in contact. The encounter produced little but confusion.
[]Ibid., pp. 69–70; esp. 69n.
[]Luigi Pasinetti, “Switches of Technique and the ‘Rate of Return’ in Capital Theory,” Economic Journal 79 (September 1969): 523.
[]Luigi Pasinetti, “Reply to Mr. Dougherty,” Economic Journal 82 (December 1972): 1352.
[]Robert Solow, “On the Rate of Return: Reply to Pasinetti,” Economic Journal 80 (June 1970): 429.
[]William Jaffé, “Review of Carl Menger and the Austrian School of Economics,” Economic Journal 84 (June 1974): 401.
[]This distinction was drawn by Hans Mayer in “Der Erkenntniswert der funktionellen Preistheroien,” in Die Wirtschaftstheorie der Gegenwart, 4 vols. (Vienna, 1932), 2:148–50. The expression causal-genetic was introduced by Sombart (Werner Sombart, Die drei Nationalökonomien [Munich, 1930], p. 220).
[]F. H. Hahn, On the Notion of Equilibrium in Economics (Cambridge: Cambridge University Press, 1973), p. 16.
[]Ibid., p. 19.
[]Ibid., p. 14.
[]We find the same argument in K. J. Arrow's presidential address before the American Economic Association: “Even as a graduate student I was somewhat surprised at the emphasis on static allocative efficiency by market socialists, when the nonexistence of markets for future goods under capitalism seemed to me a much more obvious target” (Arrow, “Limited Knowledge,” pp. 5–6). In the absence of intertemporal markets men will pursue inconsistent plans, some of which must fail. So do the plans of all competitors. What the argument really shows is the incompatibility of intertemporal equilibrium with competition and not the vulnerability of “capitalism.”
[]Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), p. 217.
[]“It will be a kaleidic society, interspersing its moments or intervals of order, assurance and beauty with sudden disintegration and a cascade into a new pattern.... It invites the analyst to consider the society as consisting of a skein of potentiae, and to ask himself, not what will be its course, but what the course is capable of being in case of the ascendancy of this or that ambition entertained by this or that interest” (G. L. S. Shackle, Epistemics and Economics [Cambridge: Cambridge University Press, 1972], p. 76).
[]Ludwig von Mises, Human Action: A Treatise on Economics (New Haven: Yale University Press, 1949), p. 352.