Front Page Titles (by Subject) PART TWO: SETTING THE STAGE - Capital, Expectations, and the Market Process
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PART TWO: SETTING THE STAGE - 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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SETTING THE STAGE
The significance of the Austrian School of Economics in the History of Ideas
To speak of the spirit and its history in our age is a precarious undertaking. Even though one escapes the suspicion of having sat at the feet of a metaphysician such as Hegel, one still may face an indictment of “essentialism.” Fortunately, the authors of this Festschrift need harbor no such fears. Neither the celebrant of this anniversary nor the readers of this journal will be in any doubt as to what is meant by the spirit of the Austrian school in economic theory.
It is almost a century since Menger wrote the Grundsätze and founded the Austrian school.1 In this century there have been decades of triumph and decades of neglect. The favorable and unfavorable climate of the times has had much to do with the successes and failures of the school. At the end of the first century of its existence, we may expect a number of critical assessments of its ideas and their development. It is not my intention, however, to deal with problems of the history of ideas in the narrower sense.
In what follows I shall attempt to indicate the cognitive aim, intellectual trend, and typical methodology of the Austrian school in the light of some of its major achievements, and to contrast them with those of other economic schools. I maintain that there is characteristic and demonstrable “intellectual style” of the Austrian school and that this style is geared to the interpretation of cultural facts, as will have to be shown. This posture is of course in opposition to the currently dominant methodological monism of positivism, which proclaims that there is only one truly “scientific” mode of thought, namely, that of the modern natural sciences. I contrast, I shall attempt to show that the ideas and aims of the representatives of the Austrian school, perhaps unconsciously, were always directed not only toward the discovery of quantitative relationships among economic phenomena but also toward an understanding of the meaning of economic actions.
This essay, “Die geistesgeschichtliche Bedeutung der österreichischen Schule in der Volkswirtschaftslehre,” Zeitschrift für Nationalökonomie 26 (February 1966): 152–67, was translated by Robert F. Ambacher of Millersville State College and Walter E. Grinder.
It is curious that two thinkers, so different in descent, temperament, and intellectual interests as Schumpeter and Sombart, agreed in their judgment of the work of the Austrian school at least insofar as they saw in the teachings of the Viennese an imperfect preliminary to the general equilibrium theory of the Lausanne school. Schumpeter's position followed naturally from his view that Walras's accomplishment represented the very apex of the history of economic thought. He ascribed to the “defective technique” of the Viennese their failure to ascend to the true height of Walras's accomplishment after having discovered the ladder.2
Sombart's aim, on the other hand, was apparently to be able to deny any intellectual affiliation with the Austrians. For him, they belong to “taxonomic economics” (ordnende Nationalökonomie) but fare poorly compared with the Lausanners. “If there is to be any taxonomic economics, let it be Pareto's” appears to have been his verdict.3 I believe that both were mistaken because they misunderstood the cognitive aim and intellectual trend of the Austrian school.
Characteristic of the trend of thinking of the Austrian school is, in our view, Verstehen (understanding), introduced as a method into the theoretical social sciences. This statement in no way diminishes the significance of the concept of marginal utility, but only indicates that in the creation of this fundamental concept the Austrians had predecessors like Dupuit and Gossen, as well as contemporaries like Jevons and Walras, who, however—as we shall see—developed their own methodologies.
On the other hand, Verstehen as a method in the social sciences has, as is well known, a long and glorious history. Not only in the interpretation of texts, as in theology, jurisprudence, and philology, but also in the interpretation of the meaning of human actions, as in all history, this method has always found application. There is, however, a significant difference between understanding as historical method, as it found its systematic expression, for example, in Droysen's Historik, and understanding as a theoretical method, that is, as a method for the interpretation of typical courses of action with the aid of thought designs, for example, economic plans.4 The characteristic accomplishment of the Austrian school was, in our view, the gradual development of understanding as a method in the second sense. For them the thought design, the economic calculation or economic plan of the individual, always stands in the foreground of theoretical interest.
Before substantiating my thesis by contrasting the essential characteristics of Austrian thought with those of the classical and the Lausanne school, I must meet two obvious objections. It may seem that my interpretation of Austrian thinking cannot be reconciled with the methodological views of two thinkers like Menger and Mises.
One objection might be that in Menger's Untersuchungen, for decades considered the methodological catechism of the school, understanding as a method of the theoretical social sciences, and especially of economics, is never mentioned.5 On the contrary, Menger declared again and again that the task of the social sciences, as of the natural sciences, is to find “exact laws.” Sombart thus appears to be correct when he characterized the Unter-suchungen as the “most significant methodological work dealing with economics in the manner of the natural sciences.”6
We must, however, take into account the intellectual climate of the years in which Menger's work originated. In the first place, understanding as a method of theoretical culture study was scarcely known in 1883, the year in which both Dilthey's Einleitung in die Geisteswissenschaften [Introduction to the Social Sciences] and Menger's Untersuchungen were published. Secondly, with the publication of Menger's work the Methodenstreit began. Menger, in particular, attacked the attempts of Schmoller and his friends to impose historical understanding on the theoretical social sciences, for example, economics, as the only legitimate method. Hence, one could hardly expect much sympathy from Menger for variants of the same methodology still awaiting elucidation even if he had known them. But he did not.
Third, and probably most important, the real theoreticial work of the Austrian school had scarcely begun in 1883. Neither Wieser nor Böhm-Bawerk had appeared on the scene. Paradoxical as it may seem, the method defended by Menger in his Untersuchungen was neither his own nor the one followed by his disciples, but really that of the classical school. Mises correctly observed: “The transition from the classical to the modern system was not completed all at once, but gradually: it took considerable time until it became effective in all areas of economic thought, and a still longer time had to elapse before one became aware of the full significance of the completed change.”7 Hence I might say that what later on became the characteristic method of the school had scarcely made an impact in 1883.
Fourth, the day came when even Menger saw himself compelled to oppose the methods of the natural sciences in economics. In two letters to Walras, of June 1883 and February 1884, he insisted that we are dealing not only with quantitative relationships but also with the “essence” of economic phenomena. He also asked how with the aid of mathematics one could ascertain the essence, for example, of value, rent, or the entrepreneur's profit.8 However, since mathematics is essential to the modern natural sciences, Menger's attack was directed just as much against the latter as against the former. And if it is permissible to equate the “comprehension of essence” with the “interpretation of meaning,” we may conclude that Menger's intention in both letters was to defend the possibility of an economic theory designed to interpret meaning. It is of particular interest that both letters were written almost immediately after the completion of the Untersuchungen.
Another objection might be that Mises ascribed understanding as a method peculiar to the historical sciences, and that our formulation is incompatible with his distinction between Begreifen and Verstehen. The apparent contradiction, however, is purely verbal. Mises admitted explicitly: “In itself, it would be conceivable to define as understanding any procedure directed toward the comprehension of the meaning of things,” and that is precisely our standpoint. He continued, “As things are today, we must resign ourselves to contemporary language usage. We want therefore, within the procedure directed toward the comprehension of the meaning of things, a procedure of which the sciences of human conduct make use to separate ‘Begreifen’ and ‘Verstehen.’ ‘Begreifen’ seeks to comprehend the meaning of things by discursive thought; ‘Verstehen’ seeks the meaning through a total empathy with the total situation under consideration.“9
I do not believe that today's usage demands this distinction. It is nevertheless clear, I hope, that the method here ascribed to the Austrian school is the same as the one Mises labeled “Begreifen.” This method, which aims at discovering the meaning of things, apparently conflicts with most methods used in and suitable to the natural sciences.
I shall now investigate in detail the characteristics peculiar to Austrian thinking. Let us first contrast it with that of the classical school. I shall, however, disregard Adam smith, who is too firmly rooted in the eighteenth century for our problems to concern him. For to the mentality of his time natural law and the “natural economic order” were each “a piece of nature,” and conceptual distinctions such as we shall have to make were completely foreign to it.
With Ricardo and his disciples it was different. They consciously emulated natural science. The cognitive aim was the ordering of economic processes in terms of quantities. Such theory could be called successful insofar as it was able to determine quantitative relationships. Typical of the classical intellectual style are three characteristics.
First, the central problem: the distribution of income among the three factors of production: labor, land, and capital. This distribution is determined by two “laws,” which are regarded as empirical laws of nature (and they would be, if they really generally applied!), namely, the Malthusian law of population and the law of diminishing returns to land.
Secondly, the central concept: value. This is a concept denoting “substance,” which bears the typical traits of an older natural science. It is the measure of all economic things, as well as the fundamental norm of all exchange processes. But why exchange takes place at all is never discussed. In business the measure of all things is the monetary unit. The economist, knowing that the value of money fluctuates, distrusts this standard. Ricardo believed that he had found a measure free from this defect in the quantity of work necessary for the production of each good. Gradually, and almost without his noticing it, the measure became for him the substance of all economic processes, if not their cause. For us all that matters is that the classical “objective” theory of value is based on a concept denoting “substance.”
Third, economic man appears in classical theory only in his capacity as a factor of production. This means not merely that the consumer is not an economic subject, but that homo oeconomicus is always a producer. It means, moreover, that the only transactions of economic interest are those one performs in one's capacity as a factor of production: as a worker, as a landowner, or as a capitalist. Within these three classes, all members are regarded as equal. This assumption of homogeneity of the factors of production has odd consequences for the realism of classical theory.10 All capitalists, whether they invest wisely or unwisely, receive the average rate of profit on their invested capital. Malinvestments, capital losses, and bankruptcies do not exist. The assumed homogeneity of the factors of production makes it impossible to evaluate the success of any economic activity. Fundamentally, we cannot really speak of economic activity here. As in nature, people react to the current external conditions of their economic existence: they do not act.
It is only against this background of the classical thought that the specific accomplishment of the Austrian school becomes transparent. It can perhaps best be characterized in the following manner: Here, too, one strives to discover laws. But, no matter what Menger might originally have believed, the laws of catallactics are logical laws, vérités de raison. From the law of marginal utility there gradually developed an economic calculus, that is, a “logic of choice.” How this logic is related to reality, so that real processes can be interpreted with its help, is an important question and will be discussed later on.
The significance of the Austrian school in the history of ideas perhaps finds its most pregnant expression in the statement that here man as an actor stands at the center of economic events. Certainly, manifold quantitative economic relationships are also for the Austrian school in the first place the cognitive object of economic inquiry. But the determination of these quantitative relationships is not the ultimate objective. One does not stop there; for these relationships flow from acts of the mind that have to be “understood,” that is, their origin, their significance, and their effects must be explained within the framework of our “common experience” of human action.
Also important for understanding the Austrian school is that here, in contrast to the classical school, men are viewed as highly unequal. Each one has different needs and abilities. The quantities and prices of goods sold in the market depend on these individual needs and abilities. This fact is exactly what the subjective theory of value stresses. Each economic agent through his action imprints his individuality on economic events. Man as a consumer cannot be squeezed into any homogeneous class. The same may be said of man as a producer. The concept of opportunity costs disrupts the homogeneity of the cost factors and broadens the area of subjectivity, which now also embraces the theory of production.
Finally, in the work of the Viennese school the classical concept of value undergoes a fundamental change. Value is no longer a “substance” inherent in goods. The central concept of Viennese theory is evaluation, an act of the mind. The value of a good now consists in a relationship to an appraising mind. Owing to the heterogeneity of needs, it is highly improbable that the same good will be given the same appraisal by different economic agents.11 Out of the Ricardian concept of quasisubstance has emerged a concept of mental relationships.
My next task is to differentiate the specific characteristics of the Viennese school from those of the Lausanne school. It has been maintained that there are no fundamental differences between the two schools, that it is only a question of variations on the same theme, namely, of modern subjective value theory. I consider this view misleading and will attempt to show which fundamental differences do in fact exist here. Above all, this view ignores the fact that Austrian thinkers go far beyond the mere ordering of quantitative relationships, an activity much cultivated in Lausanne and elsewhere.
In the last eighty years, prominent Austrian thinkers in each generation have found it necessary to draw a dividing line between their mode of analysis and that of the school of Lausanne. I have already mentioned Menger's two letters to Walras. Almost three decades later Wieser himself was impelled to defend the “psychological” method adopted by him and his colleagues against the “mechanistic” method Schumpeter had borrowed from the Lausanners and his teacher Mach.12 Twenty years later, H. Mayer attacked the “cognitive value of functional price theories” and subjected it to a sharp and thorough criticism.13 And as late as 1948, Leo Illy, in a chapter in Das Gesetz des Grenznutzens [The Law of Marginal Utility],14 rightly criticized the defects of certain price theories that merely order price phenomena without explaining them. So the differences existed, and they still do. It is for us to determine those characteristics of the Austrian style of thought to which formalistic analysis cannot do justice.
Now it is not to be denied that Austrian theorists have not always adroitly defended their position. The “occasional blunders and unfortunate formulations in the application of their method of research,” which Hans Mayer justifiably criticized, have often impaired the effectiveness of their arguments.15 for example, Wieser always spoke of the Austrian as the “psychological” school, although he admitted that “perhaps our method would be exposed to fewer misunderstandings, if one had called it not the psychological but the psychical, although this name as well as well would still be open to misunderstanding. Our object is, simply, the consciousness of economic man with its wealth of general experience, i.e., that experience which every practical man possesses and which therefore, every theoretician as a practical man finds in himself, without the need first to acquire such experience by means of special scientific methods.”16 But Max Weber had already made clear, three years before Wieser, that the alleged “psychological” foundation of the Viennese theory was based on a misconception: “The rational theory of price formation not only has nothing to do with the concepts of experimental psychology, but has nothing to do with a psychology of any kind, which desires to be a ‘science’ going beyond everyday experience.... The theory of marginal utility and every other subjective value theory are not psychologically, but—if one desires a methodological term—‘pragmatically’ based, i.e., involve the use of the categories ‘ends’ and ‘means.’”17
In other respects, too, the methodological defense of the Austrian school was not always successful. To speak of “the cause of value” is obviously questionable. One lays oneself open to the objection that the economic system constitutes a general nexus of relationships within which “causes” can only be ordered as a class and, as such, have to be dealt with as “data”. The distinction between “genetic-causal” and “functional” price theories, which as we shall see, positively strikes at the heart of the matter, met with the same objection.18 The opponents maintained that, with a general interdependence of all quantities and prices, each individual quantity and price is, at the same time, the effect and cause of others. Against the distinction between “price formation theory” and “price change theory,” the latter valid only within the framework of comparative statics, the argument was advanced that in disequilibrium the same forces must influence price, whether or not equilibrium existed before. In the timeless statics of the Lausanne theory this argument is certainly valid, but otherwise it is not.
The difference between the Vienna and the Lausanne school is already reflected in the assumptions made by both. Among these, the role of time is of special significance. It is certainly not overstating the case if we say that the real disagreement concerns, in the first place, the significance attributed to the element of time. Lausanne theory is meaningful within the framework of timeless statics; the world of the Austrian school, on the other hand, requires time for its full meaning. This is not just a matter of the level of abstraction; it is much more than that.
Austrian theory needs the dimension of time, since all human action is only possible in time. The Lausanne theory of equilibrium not only does not require time; it requires time's exclusion. From the very beginning, Edgeworth and Walras clearly saw that any passage of time before the state of equilibrium is reached renders that state itself indeterminate, since all data-changing events happening on the path to a state of equilibrium help to determine that state. Lausanne theory requires, then, that all transactions undertaken on the path to equilibrium can be nullified, whether by “recontract” or by other means. This is the essence of timeless statics. For the Austrians, however, it is exactly these transactions, undertaken in the course of time, that are their real objects of interest, since conscious human action is bound to plans, and all plans require a time dimension.
I described how, in the course of the development of the Austrian theory, a theory of economic calculus gradually unfolded as a corollary of the law of marginal utility. Economic plans depend on the economic calculations of each agent. The interplay of economic plans accounts for the market phenomena. Now, there is certainly a general nexus of all market phenomena, and the Austrians by no means denied this fact. However, they took relatively little interest in the forces that operate in this connection, since these could operate only in a timeless world, that is, in a world without change. What appeared to them much more urgent was to take into account the continual need, in a constantly changing world, to adapt economic plans to these changes. For in such a world a general condition of equilibrium cannot be achieved. We thus see why economic plans occupy a central place in Austrian theory, while the general nexus of market phenomena is neglected. One takes one's orientation from reality.
It might be held, however, that Lausanne theory also takes account of the economic plans of individuals since they enter into its system as “data”. But the utility—and supply—functions in the work of Walras, and indifference curves in the work of Pareto, do not reflect real economic plans as we know them from our own experience. They must provide for every possible situation if the state of equilibrium is to be determinate. In fact they are comprehensive lists of alternative plans, comprehensive enough for unlimited application. Obviously, this requirement is quite beyond the capacity of the human mind. “No person will be in a position to indicate, truthfully and with mathematical accuracy, an infinite number of combinations of goods which would all be equally important to him. The expression ‘experiment’, used here by Pareto, is completely unsuitable: we have here simply the figment of an experiment.19
For the general theory of equilibrium, such functions are certainly as essential logical foundation. The difference between a taxonomic (ordnende) and a verstehende economics becomes quite apparent here. What is a logical necessity for the former must be considered as an absurdity by the latter. Here, the two schools part company for good.20
The methodology borrowed from the natural sciences may eschew concern with the alien—and dangerous!—theme of the construction of economic plans. However, it can do so only by assuming that all conceivable plans are already “given” from the start!
Pareto saw much more clearly than his predecessor Walras that genuine economic plans do not really fit into the model of the Lausanne school, and that to use them as “data” one must first divest them of their nature as mental acts. This is the truemeaning of the famous sentence: “L'individu peut disparaitre, pourvu qu'ilnous laisse cette photographie de ses goῦts.”21 Here plainly man as economic agent does not stand at the center of economic life. This statement of course makes sense only in a timeless stationary world in which these photographs would retain permanent validity. Everyday human acts shape the real world anew. Accordingly, all attempts to attach a time dimension to the timeless theory of equilibrium and thus to make it “dynamic” must fail.
It is probably unnecessary to discuss in detail a criticism once marshalled against the Austrian school regarding the so-called “circle of economic determination.” Viennese economists were charged with becoming entangled in circular reasoning since, on the one hand, market prices were derived from the valuations of the economic agents, and, on the other hand, the determination of these very valuations required prices already given.Illy showed that the reasoning in reality was not circular and that the criticism confused prices expected and prices actually paid.22 Economic agents must certainly orient themselves to prices they expect, but they by no means have to be the prices then formed in the market. In the system of equations of the Lausanne school, it is of course impossible to distinguish between expected and paid prices. This is again a necessary consequence of timeless statics.
We saw that the methodology of the Austrian school evolved gradually, for a long time without the members of the school being aware of it. It sometimes happened that the methodological pronouncements of some of its most prominent members lacked programmatic validity—often even for the time in which they were expressed. This was true, for example, of Menger's Untersuchungen. Moreover, Menger, concerned with establishing “exact laws,” never clearly distinguished between logical laws and empirical laws, between vérités de raison and vérités de fait.
As mentioned above, during its development marginal utility theory became a theory of economic calculus and of economic plans, and thereby a genuine “logic of choice.” But as late as 1911, Wieser referred to “common experience” as the ultimate basis of economic knowledge. It is to Mises that we owe the clear formulation of the logic of choice. However, as regards the actual relevance of this logic to human action, it will be seen that common experience is still indispensable to us.
In Hayeks's work are to be found penetrating discussions of the “scientistic” style of thought and its inadequacy for the problems of the social sciences,23 but also the first indication of problems of economic theory lying beyond the pure logic of choice.24 What matters here is, above all, the state of knowledge as a spring of human action and the process of its changes in time.
I now come to the main question of this section: how can a system of pure logic, like that of the logic of choice, provide factual knowledge? The answer follows form the essence of my thesis: the distinction between logic and factual knowledge is justified in the realm of nature, where no meaning is directly accessible to us, and in which care must thus constantly be taken to distinguish between our concepts and reality. In the realm of human action it is different. Here such a distinction seems unjustified. On the one hand we are unable to verify or falsify our schemes of thought as hypotheses by predicting concrete events. Scientific tests are not available to us since they require a complete description of that concrete “starting position” in which the test is to take place. Every human action, however, depends on the state of knowledge of the actors. A verification test therefore would require an exhaustive description of the state of knowledge of all actors, also according to the mode of distribution—an obvious impossibility. Otherwise, however, the starting position is not exactly defined, and no real test is possible.
In economics this means that every concrete transaction depends, among other things, on the expectations of the participants. To test an economic theory in concreto, we must, then, be able, at the point of time of theory formulation, to predict the expectations of economic agents at the (future) point of time of the verification test. It is easy to see why the representatives of a taxonomic economics are eager to keep the problem of expectations at arm's length as far as possible.
For “understanding” in economics, on the other hand, some methods are available that, though closed to the natural sciences, lend themselves for interpreting human actions. The historian inquires into the meaning and significance of concrete actions of individuals and groups. This whole method is inapplicable in the natural sciences. The history of science shows that research is confined to the ordering of quantitative relationships. In the theoretical cultural sciences, on the other hand, the significance of typical courses of action is interpreted with the aid of schemes of thought, such as the logic of choice. The approach is justified by the fact that all human action, at least insofar as it is of scientific interest, is oriented to plans. Plans are logical constructs immanent to the course of action. A plan serves the economic agent as a guideline; he orients himself to it. The social sciences can thus use plans as means of interpretation. Actions certainly are events in space and time and, as such, are observable. But observation alone cannot reveal meaning; for this, methods of interpretation are needed.
Why exactly is the logic of choice the scheme needed for interpreting economic actions? The logic of choice is a “logic of success”; its categories are means and ends. Why should we opt for precisely this method in interpreting economic transactions? Common experience gives us the answer: in economic life most people seek success. The striving for success as the meaning of economic action warrants the validity of the logic of choice.
Thus Mises was correct when he asserted that only logic, and not experience, can warrant the validity of economic theories— as opposed to Wieser, who in his critique of Schumpeter invoked common experience.25 And logic certainly is immanent in all human action. But this alone does not mean that the logic of success, which depends upon means and ends, is also the logic governing all action. Conceivably another kind of logic, one employing other categories, might be applicable here. In order to claim the validity of just this logic of success for economic life, we have to invoke common experience.
Finally we have to remember that, in a dynamic world there are economic problems that the logic of choice by itself cannot master. While it explains the designing of economic plans under given conditions, the revision of economic plans in the course of time, as well as the entire range of the problems of expectations, are outside the realm of logic. At best, we may say that in a stationary world economic plans will be adapted more and more to real conditions. It is exactly on this fact that the theory of general equilibrium of the Lausanne school rests.
I do not wish to conclude these observations without taking a brief look at the future tasks of “verstehende,” or “interpretative,” economics.
Our main aim, naturally, must be to preserve and defend in all directions the methodological independence of the theoretical social sciences in general, and of economics in particular. This certainly does not mean that methods may never be borrowed from other disciplines. The relevant question, however, always is whether these methods, however successful they may be outside the realm of economics, are able to serve our purposes, namely, the interpretation of human action.
If we keep this question in mind, we shall continue the work of Menger under the altered circumstances of our own time. In this we need only follow precedents already given in the work of the Austrian school. According to one of its most perceptive thinkers, E. Schams, we must always distinguish, in accepting mathematical methods, between “the mathematical form of the statement” (ansetzendes Denken) and the “material constants” to which it refers; only the uncritical acceptance of the latter into economic science is inadmissible.26
No doubt the task outlined here is not simple, especially in our time. In recent decades, especially in Anglo-Saxon countries, an unbelievable narrowing and impoverishment of the philosophical outlook has taken place. Today, innumerable economists everywhere, some in responsible positions, who have never learned of the existence of our problems, naively believe that the scientific method is the only legitimate one in all fields of knowledge.
How should we approach our task? First of all, we must continuously stress the inadequacy of the products of intellectual inquiry that ignores the meaning of actions. We must always be prepared to ask our opponents the following questions: Whence? By what means? To what end? When, for example, the designers of macroeconomic models present to us their creations, we may certainly admire their elegance: we may not, however, neglect to ask from which actions of the economic agents these models spring. We must also always ask what expectations guide these actions, and what would occur if these expectations were altered. When, moreover, such model builders attempt to include technical progress in their models, for example, in the form of a “technical progress function,” they must be shown that they are attempting to grasp meaningful action by an intellectual method to which meaning is alien, and that a significant discussion of these interesting problems is thereby made impossible. But we must not rest content with criticism of a method of inquiry that defies meaning; we must show the fruitfulness of the verstehende method in its various applications. There are, we may show, alternatives to equilibrium analysis. Certainly, in the analysis of a state of disequilibrium, we cannot dispense with an account of the equilibrating forces, but that does not mean that we must describe in its entirety a state of equilibrium, which is never really attained, decorated with formulas and equations. We can save ourselves that endeavor. All that is important is that every state of disequilibrium presents possibilities for profitable activity—be it income, capital grains, or even only the avoidance of losses. Each disequilibrium stimulates alert minds, but by no means all minds, to profitable action, and this action will reduce the chances for further profit. That is all that may be said. The cumbersome pedantry of the usual market models, with their alleged “precision,” is an obstacle rather than a help to understanding. What has happened to “perfect competition” should be enough of a warning.
Even outside the special field of economic theory, the need for the defense of the methods of inquiry specific to the cultural disciplines presents tasks that are as pressing as they are difficult. Here it is most important to put the methodological independence of the social sciences on a firm epistemological basis.
Since the Renaissance the theory of knowledge has taken its orientation almost exclusively from the methods of the natural sciences. For these sciences, which deal with apparently “meaningless” events, there is no alternative, in the absence of other criteria of comparison, but to attempt to make their theories and observable events agree in such a manner that predictions concerning these events may be made, and then “verified.” With human activity, however, this is impossible, since every action depends on the state of knowledge of the agent at the point in time of the action, which is not predictable at the point in time of the formulation of the theory. What, then, must the social scientist do to distinguish useful from useless theories? Which criteria of valid knowledge are at his disposal?
Since we lack successful prediction as a means of evidence, we must of course devote special care to the validity of our theoretical assumptions. The Austrian school has always done so, as, for example, we saw above in the criticism of the Lausanne theory. Also, in the theoretical social sciences a gap between scheme of thought and reality may have a different significance than in the natural sciences. For their task is essentially the comparative study of schemes of the agents, on the one hand, and typical courses of action, on the other. Here the significant and meaningful character of both can serve as tertium comparationis. In such comparative studies deviations from the planned schedule are often more interesting than a smooth course proceeding according to plan would have been. An economic plan as an observed fact does not lose its significance for us when it fails. On the contrary, we owe to such a plan our criterion of success, which alone allows us to speak of failure. A coherent plan of action that no one applies often allows us to draw interesting conclusions concerning the character of the situation, including the expectations entertained by the agents.
In these reflections I have taken the economic plan of an individual as the prototype of the scheme of thought lying at the base of action, mainly on account of its central significance for economic theory of Austrian character. Economic agents orient themselves to plans. There is no parallel for this in the study of the physical world. But to what facts do the planners orient themselves when making their plans? Partly to natural data, and partly to the actual or expected actions of other people. But there also are certain superindividual schemes of thought, namely, institutions, to which the schemes of thought of the first order, the plans, must be oriented, and which serve therefore, to some extent, the coordination of individual plans. They constitute, we may say, “interpersonal orientation tables,” schemes of thought of the second order. To them praxeology, for which until now the plan and its structure have understandably occupied the foreground of interest, will increasingly have to turn in time to come.
The Role of Expectations in Economics as a Social Science
In modern theory the introduction of expectations has opened new vistas to the economist and, at the same time, set him a new problem. It has made him realize that economic action concerned with the future, so far from being strictly determined by a set of objective “data,” is often decided upon in a penumbra of doubt and uncertainty, vague hopes and inarticulate fears, in which ultimate decision may well depend on mental alertness, ability to read the signs of a changing world, and readiness to face the unknown. But it has also compelled him to reflect on the causal explanation of expectations, to ask himself why they are what they are. This problem bristles with difficulties.
Given this fact and the natural proclivity of every science to become more limited in scope as it grows more conscious of its premises, it was perhaps inevitable that economists confronted with this problem should have attempted to dispose of it by relegating expectations to the category of “data” alongside with wants, resources, and the technical facts of production. This line was in fact taken by Lord Keynes,1 Dr. Morgenstern,2 Professor Myrdal,3 and Dr. Rosenstein-Rodan.4 But it is readily seen that expectations must feel ill at ease in this company. What entitles us to treat wants and resources as data and disinterest ourselves in their causal derivation is the simple fact that qua economists we have nothing to say about them. Why the geographical distribution of mineral resources is what it is, why the cinema-going public of the 1930s preferred moving pictures directed by René Clair to moving pictures directed by Ernst Lubitsch, are in themselves interesting questions, but the economist has no answer to them. Expectations, on the other hand, are on a somewhat different plane as they are, while wants and resources are not, largely the result of the experience of economic processes. It is therefore hardly surprising that the treatment of expectations as data, the explanation of which is not the task of the economist, should have given rise to strong protests. Outstanding among the critics are Dr. Lundberg and Professor Schumpeter.
Reprinted from Economica 10 (February 1943).
“It is sensible to link actions with expectations,” states Dr. Lundberg, “Only if the latter can be explained on the basis of past and present economic events. Total lack of correlation here would mean the complete liquidation of economics as a science. Not even an assumption of certain anticipations as given and an analysis of consequent plans and actions on the basis just mentioned would have the slightest interest.... In every process of economic reasoning we therefore have to make certain assumptions, often not specified, concerning the relations between expectations on the one hand and current or past prices, profits, etc., on the other.”5
“Expectations cannot be used as part of our ultimate data in the same way as taste for tobacco can,” writes Professor Schumpeter. “Unless we know why people expect what they expect, any argument is completely valueless which appeals to them as causae efficientes. Such appeals enter into the class of pseudo-explanations which already amused Molière.”6 “If we discontinue the practice of treating expectations as if they were ultimate data, and treat them as what they are—variables which it is our task to explain—properly linking them up with the business situations that give rise to them, we shall succeed in restricting expectations to those which we actually observe and not only reduce their influence to its proper proportions but also understand how the course of events moulds them and at certain times so turns them as to make them work toward equilibrium.”7
Unfortunately, however much we may agree with the point of view of these authors, it is not easy to carry out their proposals which are by no means unambiguous. In order to link up expectations “with the business situations that give rise to them” we must first of all define a “business situation.” If we define it in objective terms (as a combinatin of prices paid, quantities produced and sold, etc.) we soon find that the relationship between business situations and expectations is not uniquely determined as the same “business situation” may give rise to various kinds of expectation. A price rise, for instance, may lead to expectations either of a future fall, if the people in the market have some kind of “normal level” at the back of their minds, or of a future rise, if inflationary forces are suspected to be at work. If, on the other hand, we define “business situation” in subjective terms, viz. as the interpretation which the people give to the objective facts, there will be as many “business situations” as there are different interpretations of the same facts, and they will all exists alongside each other.
The absence of a uniform relationship between a set of observable events which might be described as a situation on the one hand, and expectations on the other hand, is thus seen to be the crux of the whole matter. Expectations, it is true, are largely a response to events experienced in the past, but the modus operandi of the response is not the same in all cases even of the same experience. This experience, before being transformed into expectations, has, so to speak, to pass through a “filter” in the human mind, and the undefinable character of this process makes the outcome of it unpredictable. We provisionally conclude that expectations are the result of a variety of factors only some of which are observable events, and only some of which are of an economic nature. It follows that they have to be regarded as economically indeterminate and cannot be treated as “variables which it is our task to explain.”
Under these circumstances, what can the economist do but construct various hypothetical types of expectations conceived as responses to various hypothetical situations, and then leave the process of selection to empirical verification in the light of economic history? Several such “ideal types” either of expectations, like Lord Keynes' “long-term” and “short-term” expectations, or of the holders of expectations, like Professor Schumpeter's “static producer” and “dynamic entrepreneur” or Professor Hicks's “sensitive” and “insensitive” traders, have already been evolved and served to elucidate important dynamic problems. This is a most promising field of research and much progress can be achieved along this line. It seems to us, however, that it is possible to carry the general theory of expectations a stage farther, and to the demonstration of this possibility the present paper is devoted.
The next step in the study of expectations, to be sure, has to consist in evolving hypothetical “ideal types” and testing them in the light of economic history. But it cannot be emphasized too strongly that if these efforts were to be confined to the study of relations between objective facts and expectations they would be quite useless. The Social World consists not of facts but of our interpretations of the facts. Nothing will be achieved in the way of an inductive study of expectations until people's expectational responses to the facts of a situation are made intelligible to us, until we are able to understand why the acting and expecting individuals interpreted a set of facts in the way they actually did. From this point of view we need not deplore unduly the indeterminateness of expectations, for it is intelligibility and not determinateness that social science should strive to achieve.
We have now reached a point at which it must be evident that we are facing a fundamental issue in the methodology of economics, and of social science in general. The intricacy of our problem is derived from the inadequacy of the traditional methods of analysis in a case of indeterminateness. Before we can pursue our study of expectations any further we shall have to reconsider some of the first principles of economic analysis.
All human action is directed towards purposes. Hence, As Professor Knight has repeatedly reminded us in recent years, all human activity is problem-solving. Man, before setting out on his course of action, has to make a plan embodying the means at his disposal and the obstacles he is likely to encounter, otherwise his action is not (rational) conduct but (non-rational) mere behaviour. Before starting on his way he tries to chart the path leading to the achievement of his purpose in the topography of his mind. If we say that we wish to “explain” an action, what we mean is not merely that we wish to know its purpose, but also that we wish to see the plan behind the action. Plan, a product of the mind, is both the common denominator of all human action and its mental pattern, and it is by reducing “action” to “plan” that we “understand” the actions of individuals. Plan is the tertium comparationis between our mind and the mind of the person who acts.
In economic action the problem to be solved is to devise a plan for the allocation of scarce resources to alternative wants in such a way as to maximize satisfaction. Equilibrium theory, which studies the problem and its implications, teaches us that, for each individual at least, the problem has a determinate solution. And since the elements of the plan are quantifiable, if not measurable, the problem and its solution can be illustrated more mathematico. However, that a problem has a determinate solution does not entail that those attempting its solution will actually succeed, otherwise there would be no failures in examinations or in business. A plan may fail, of course, for almost any number of reasons. For instance, it may have been faulty from the beginning because of lack of consistency between its various elements; or, while it was perfectly consistent, unexpected obstacles may have been encountered in the course of its execution of which it had failed to take account; or the planner may have misjudged the extent and efficiency of the resources at his disposal. It will be noted that in the second and third instance, but not in the first, failure is due to wrong expectation. Expectations therefore take a prominent place in the theory of economic action; but thus far such a theory does not exist.
It has to be admitted that hitherto the scope of economic theory has been unduly restricted to the formal characteristics of the economic problem and its implications. Equilibrium economics (what Professor Hayek has termed “The Pure Logic of Choice”) studies the full implications of a set of data, the “conditions of equilibrium”; it does not study the ways in which these logical implications are translated into human action, which is thus conceived as a quasi-automatic response to an external “stimulus.” But in the theory of economic action no such mechanistic preconception is admissible, a point which the introduction of expectations brings out with all necessary clarity. Unfortunately, the Pure Logic of Choice has filled the minds of economists to such an extent that the study of the actual means and ways by which men try to realize their aims has come to be sadly neglected.8 Economists, not unnaturally, prefer to do their field-work in a pleasant green valley where the population register is exhaustive and everybody known to live on either the right or the left side of an equation. Only on rare occasions—and scarcely ever of their own free will—do they embark on excursions into the rough uplands of the World of Change to chart the country and to record the folkways of its savage inhabitants; whence they return with grim tales of horror and frustruation. Traces of such folklore can be found in the touching Swedish saga of the unhappy partnership of Ex Ante (the plan) and Ex Post (the outcome of action).
Needless to say, if our attention is thus confined to the formal characteristics of the economic problem, if our approach remains “functional” rather than “causal-genetic,” we shall not only be unable to find explanations for failure to solve the problem, but also be in no way equipped to deal with characteristic instances of failure, like crises and misinvestment; hence, the peculiar helplessness of equilibrium theory in front of trade cycle problems. Whenever confronted with such problems, we shall almost inevitably be biased in favour of an explanation which runs in terms of initial inconsistency of, at least some, plans, for consistency is precisely one of those formal characteristics which we are best trained to investigate. A typical example of this is the explanation of industrial fluctuations which is currently in fashion. Such fluctuations are regarded solely as variations in the degree of utilization of the resources of Society, and underutilisation is explained by inconsistency between the plans of investment planners and of saver-consumers. We cannot therefore be surprised to learn that such theories have no real explanation for malinvestment and capital losses in investment goods industries, and that one of their favourite assumptions is that all such goods (tin, copper!) are made “to order!”
In the light of these considerations we are now able to view the indeterminateness of expectations in its proper perspective. In a world of imperfect foresight in which no plan can meet all contingencies all human activity is bound to be indeterminate; in this respect expectations are simply non a par with everything else. What may (and in the case of economic activity happens to) be determinate is the problem which this activity seeks to solve, but it does not follow that in this it will succeed; there is, after all, a difference between a problem tackled and a problem solved. Determinateness, we realize, is a possible property of problems; it is not a possible property of human action.
The reader will not, we hope, infer from all this that the Pure Logic of Choice with its equations and its indifference curves is altogether useless. On the contrary, it serves a most useful purpose by making economic activity intelligible to our problem-solving mind. For it is only by reducing the apparently chaotic World of Action to a mental pattern of relative simplicity that our problem-solving mind can comprehend it. All we have to remember is that to describe an action in terms of a problem is, of course, not to say that it will succeed in solving it.
After this long digression we may now return to our study of expectations. It is evident that if so often we fail to solve our problems, in a world of imperfect foresight the chief reason has to be sought in our being misguided by wrong expectations. More particularly will this be so in the economic field, in which the theoretical interest in expectations arose, not by accident, from the study of crises and depressions, the classical instances of failure to solve the problem of the optimum allocation of resources. That expectations are germane to failure is plain enough, but what precisely is the character of their relationship?
We have seen that we need not deplore the indeterminateness of expectations because this quality they share with all other forms of human activity. But, we said, it is the task of social science to make them intelligible. To make an action intelligible means to show not only its purpose, but also the general design of the plan behind it. What, then, are expectations? We saw that all human conduct (as distinct from mere behaviour) presupposes a plan. We now have to realize that, as a prerequisite to making a plan, we have to draw a mental picture of the situation in which we are going to act, and that the formation of expectations is incidental to the drawing of this picture. Such a picture of the situation will be drawn differently by different individuals confronted with the same observable events in accordance with psychic differences such as temperament, but the degree of variation between them does not entirely depend on psychic factors. In a stationary world in which the same observable events continually recur this degree of variation would be small although, owing to the psychic factors, it probably never would reach zero. But in a World in Motion it must be large, chiefly among other reasons because here every view of a situation necessarily implies a judgment on the character of the forces producing and governing motion. Two farmers confronted with the same observable event, a rise in apple prices, will yet take different views of the situation and react differently if one interprets it as a symptom of inflation and the other as indicating a shift in demand under the influence of vegetarianism.
The upshot of all this is, of course, the familiar proposition that observable events as such have no significance except with reference to a framework of interpretation which is logically prior to them. From this there follow two conclusions, a narrower one concerning expectations, and a broader one pertaining to the formulation of the economic problem in a dynamic World.
As to the first, our argument appears to shed some light on the nature of the “filter” which, as we learned, forms the link between observable events and expectations. We now know that, while it remains true that our expectations for the future are a response to our experience of the past, the mode of our response is largely governed by our interpretation of this experience. In a World of Change this interpretation is bound to reflect strongly what we believe to be the major forces operating in this World, causing and governing change. We now realize that ultimately it is the subjective nature of these beliefs which imparts indeterminateness to expectations as it is their mental nature which renders them capable of explanation.
Our second conclusion points to the desirability of a dynamic revision of the formulation of the economic problem. The problem is usually stated in terms of (objective) “resources” and (subjective) “wants.” In a stationary World these terms may have an unambiguous meaning, but in a dynamic World what is a resource depends on expectation, and so does what constitutes a want worth satisfying. In a properly dynamic formulation of the economic problem all elements have to be subjective, but there are two layers of subjectivism, rooted in different spheres of the mind, which must not be confused, viz. the subjectivism of want and the subjectivism of interpretation.
We have now reached a point at which we may pause and look around for an opportunity to test the efficacy of our newly forged analytical tools. Ultimately, of course, the only satisfactory test of any theoretical construction is the light it sheds on some segment of reality, it making an otherwise incomprehensible set of facts intelligible to us. Such a test will be applied in the concluding section, but prior to it we shall embark on another one of a somewhat different nature. In the light of the knowledge thus far gained we shall examine Professor Hicks's concept of “elasticity of expectations.” Considering the prominent place which this notion has come to occupy in the analytical apparatus of up-to-date economic theory, it should provide us with a suitable starting-point from which to measure whatever further progress it may be possible to make by the help of other devices. The purpose of our test is to see whether the lamp we have constructed is capable of throwing light on corners of the problem of expectations which the lighting apparatus hitherto in use had left dark.
In dealing with expectations Professor Hicks wisely refrains from seeking determinateness. He distinguishes between the influence of current prices on expectations and, on the other hand, all other influences the effects of which are labeled “autonomous changes,” Neglecting the latter he concentrates on the former type of influence. But seeing that “that influence may have various degrees of intensity, and work in various different ways”9 we realise that we need a criterion of classification, and it is for this rôle that the “elasticity of expectations” is cast.10 Its great merit is that by making it unnecessary to postulate a once-and-for-all uniform relationship between changes in current prices and expectations it enables us to deal with variable forms of this relationship. Its defect, we believe, is that, being a measure, it cannot tell us why this relation should take these variable forms any more than the most elaborate thermometer can tell us the causes of the fever from which the patient is suffering. However, for the greater part of his study of dynamic equilibrium Professor Hicks is content to make less than full use of the potentialities of his weapon and to assume the elasticity to be unity; he is in fact assuming a uniform relationship, and as long as he does this the defect mentioned does not cause much harm. But as soon as, in his discussion of wage rigidity, he abandons this restrictive assumption and allows for variations in this relationship, he apparently becomes conscious of the defect and feels compelled to give some kind of causal explanation of the forms which these variations may take. Unfortunately, however, the study of these variations is immediately restricted to those existing simultaneously between different groups of persons, after which it is not surprising that the causal explanation runs in terms of a spurious brand of “group psychology.” It is sought in the greater or smaller “sensitivity” with which different people react to identical present changes.11
It is not easy to attach any precise meaning to these terms. Does Professor Hicks seriously maintain that the same individual confronted with the same kind of change will invariably react in an identical—and incidentally, predictable—manner? Only such invariability of reaction would entitle us to use intensity of reaction as a criterion of classification. If, on the other hand, we allow for changes over time in the “sensitivity” of individuals, and thus for changes in the composition of the two groups, is it not precisely our task to explain these changes? Since there can be little doubt that in fact men's expectational reactions to change are subject to wide fluctuations, we have to find a principle informing us in accordance with what these reactions vary. There may be numerous reasons, but it would seem that they can all be reduced to the simple fact that men's reactions to identical observable events will vary if for any reason these come to have a different meaning to them. The conclusion suggests itself that whether a given price change—or, for that matter, any other observable event—will at different times give rise to identical expectations will largely depend on the way in which people interpret it. Interpreting an event means to fit it into a picture of the “situation,” a concept of a structure which serves as framework of reference. It follows that the “elasticity of expectations,” if it is not to lead us into having to accept absurdities like an invariant “sensitivity,” itself requires interpretation in the light of our argument.
By now the reader will probably have grown impatient to see our theory of economic action go into action. We said above that ultimately the only satisfactory test of a theoretical construction is its capability of throwing light on what otherwise must remain dark corners of reality. We now propose to test the method we advocate by showing its usefulness in elucidating a problem which has loomed large in recent controversies on the rate of interest; we shall thus be concerned with interest-expectations, not with price-expectations. But before testing it let us briefly summarise the position we defend.
All human action is directed towards purposes and therefore requires a plan. Plans are not made in vacuo, and the planner has therefore to draw a mental picture of the situation in which he will have to act, of the constellation of circumstances which he cannot, or at least thinks he cannot, change and which to him are “data.” We assert that the formation of expectations is incidental to, and derives its meaning from, this activity of the mind, and we therefore conclude that expectations have to be interpreted with reference to the situation as a whole as the expecting individual sees it.
The problem we shall discuss refers to the influence of expectations on the rate of interest. It is not our intention to take part in any of the numerous and fierce controversies which have of late raged on the theory of interest. On the contrary, we take as our starting-point a proposition which we believe to be entirely beyond controversy; that interest-expectations are one of the factors influencing the rate of interest. It is perhaps not unprofitable to insert here a brief sketch of the evolution of this idea in modern economic thought. It was introduced by Lord Keynes who used it as the main pillar to give shape and concreteness to his liquidity preference curve the negative slope of which could not otherwise be convincingly demonstrated.12 It was further elucidated by Mr. Durbin, who pointed out that “large stocks of securities, just as much as large stocks of commodities, constitute a continuous and serious threat to monetary equilibrium, and the existence of stocks of securities is inevitable in a way that that stocks of commodities are not,”13 for the larger stocks are relative to current output the wider the scope for speculative price fluctuations and the smaller the influence of long-run supply on market price. Mr. Harrod drew the important practical conclusion that in a capital market which has a very definite expectation about the future rate of interest “it seems improbable that banking policy, however inspired and well informed, could secure a sufficient fluctuation in long-term interest rates to ensure a steady advance,”14 as at rates lower than the expected the supply of securities would tend to become almost infinitely elastic. Professor Hicks does “not believe that we can count upon anything more than a small elasticity of interest-expectations.”15 “When the rate of interest (any rate of interest) rises or falls very far, there is a real presumption that it will come back to a ‘normal’ level. This consideration would seem to prevent interest-expectations from being very elastic.”16 But to the extent to which expectations are inelastic other influences on the current rate will grow correspondingly weaker. In Dr. Thomas Wilson, its latest exponent, the idea that the long-term rate of interest is largely fixed by “speculation” in the capital market has almost assumed the character of a major economic principle and been made the cornerstone of a trade cycle theory.17
We do not question the occurrence of inelastic interest expectations, but it is a corollary of our argument that we have to insist on an explanation of such occurrences. It is already a little surprising that while what in common parlance are described as “speculative markets” are mostly characterized by wide and frequent price fluctuations, “speculation” is here held responsible for price inflexibility. But so far this merely goes to show that “speculation” may be a misnomer for the phenomenon under discussion. More significant is that, almost under our hands, the proposition that expectations are one of the factors influencing the rate of interest has changed into the proposition that if expectations are inelastic none of the other factors will have a change to influence the result, because with a highly elastic supply of securities the other factors may influence the volume of sales but cannot affect price. This already suggests that unless the rate of interest is to be “left hanging by its own bootstraps” the other factors must somehow already be taken into account by the expectations. Furthermore, if the case of inelastic interest-expectations has such far-reaching consequences it clearly is our task to investigate what causes such expectations.
A little reflection will show that if in a market a strong increase in demand does not lead to any appreciable rise in price, not only must supply be extremely elastic, but where large stocks are the cause of this elasticity, holders of stocks must have a reason for selling out. They clearly will do it only if they have reasons to believe that the present strong demand is not only of an exceptional but of a transitory nature, and that for this very reason price will in the long run not be affected by it. If we apply this reasoning to the capital market we find that interest-expectations are most likely to be inelastic in a situation in which the capital market, that is to say, the majority of holders of securities, does not believe in the permanence of the forces exerting pressure on the market and hopes later on to be able to “re-stock” cheaply. It follows that if we find a case in which increased savings do not cause any appreciable fall in the rate of interest this indicates that the capital market has its suspicions—which may turn out to be entirely unjustified—about the permanent character of this sudden increase in the demand for securities. We are now able to understand the meaning of the “normal level” in the minds of people whose expectations are inelastic: this is a level determined by what are believed to be permanently operative forces. A market will exhibit inelastic expectations only if it believes that price is ultimately governed by long-run forces, and if it has a fairly definite conception of what these forces are. A capital market with inelastic interest-expectations is then a market which refuses to be impressed by present-day demand for securities which it believes to be short-lived. If therefore in a depression we find the long-term rate of interest remaining relatively inflexible this indicates that, rightly or wrongly, the capital market believes in the continued existence of investment opportunities yielding marginal profit at the former level, investment opportunities which the depression may have obscured but which it has not obliterated. For the same reason, in such a case, as Mr. Harrod predicted, an attempt to put the bond market under pressure by means of open-market operations is likely to prove a failure.
Finally, we always have to remember that whenever we observe large transactions taking place at little price change this indicated a case of conflicting expectations. It is scarcely necessary to remind the reader that we are here concerned solely with explaining a certain class of expectations, not with judging them in the light of ex post knowledge which the expecting individuals did not possess. It is indeed fairly obvious that in a dynamic economy with rapid technical progress and wide and frequent income fluctuations all expectations based on the prevalence of long-run trends must be of a somewhat problematical character, but to our present problem this is strictly irrelevant.
If inelastic expectations are really as frequent and important as some writers would have us believe, an interesting problem arises with regard to the interpretation of Wicksellian theory, more particularly in its Austrian version. According to this doctrine booms and slumps are engineered by banks lowering the “money rate of interest” below its “natural level,” or raising it above it. Whatever the precise meaning of these terms, we now know that if banks are to succeed in altering the long-term rate of interest, expectations have to be very elastic. Seen from this angle, the Wicksellian theory appears to be based on a very special assumption, viz. of a capital market without a very strong mind of its own, always ready to follow a lead on the spur of the moment, and easily led into mistaking an ephemeral phenomenon for a symptom of a change in the economic structure. Without fairly elastic expectations there can therefore be no crisis of the Austro-Wicksellian type. But again, before we can accept this theory we are entitled to hear an explanation why elastic expectations should be prevalent. Such a gullible capital market we should expect to find in an economy the structure of which is still highly fluid and in which long-run forces have not yet had time to take shape. We tentatively suggest that such a state of expectations may be typical of an economy in the early stages of industrialization, or of an economy undergoing “rejuvenation” owing to rapid technical progress.
In reality, of course, expectations of greatly varying degrees of elasticity are met with. It may be possible to reconcile apparently irreconcilable theories by reducing their differences to different assumptions about the prevailing type of expectation. But the story does not end here. In a World of Change no one type of expectation can be relied upon to provide stability. Neither a gullible capital market nor an obstinate one, nor, we may add, any intermediate variety is in itself a bulwark against crises of every kind. They each provide us with protection against some afflictions while leaving us unprotected against others. To investigate in what conditions what type of expectations is likely to have a stabilising or destabilising influence is no doubt one of the next tasks of dynamic theory. We submit that it cannot be successfully tackled unless expectations are made the subject of causal explanation.
Professor Shackle on the Economic Significance of Time
In the first of the De Vries Lectures, delivered in Amsterdam in 1957,1 Professor Shackle has further developed those ideas on the rôle of time in economic theory which students of his work know from his article on “The complex nature of Time as a concept in Economics.”2 These ideas are important for at least three reasons,
Reprinted from Metroeconomica 11 (April/August 1959).
In this paper we shall confine ourselves to a discussion of the problems listed under 2) and 3). No significance attaches to our neglect of issue 1). We shall simply take it for granted, that what Professor Shackle says about the logical structure and presuppositions of his own work is correct.
But all important work, such as the present, points beyond itself. It is in the implications of Professor Shackle's views for the progress of economic science that we are mainly interested.
This paper therefore falls into two parts. In the first, we shall examine Professor Shackle's views on the economic character of Time. In the second we shall consider some wider implications, for the methodology of Economics and the social sciences, of the inapplicability of certain concepts which the natural sciences can and do take for granted.
The natural starting point for both is our author's critique of the naturalistic time concept as applied to the phenomena of human action.
“In the classical dynamics of the physicist, time is merely and purely a mathematical variable. The essence of his scheme of thought is the fully abstract idea of function, the idea of some working rule or coded procedure which, applied to any particular and specified value or set of values of one or more independent variables, generates a value of a dependent variable. For the independent variable in a mental construction of this kind, time is a misnomer. Time as we seem to experience it has a character profoundly and radically different from that of a mere algebraic abstraction capable of being adequately represented by the symbol of a scalar quantity” (p. 23). How, then, do we experience time?
“In the experience of human individuals each of these moments is in a certain sense solitary. There is for us a moment-in-being, which is the locus of every actual sense-experience, every thought, feeling, decision and action” (p. 13).
“The moment-in-being rolls, as it were, along the calendar-axis, and thus ever transports us willy-nilly to fresh temporal viewpoints. This I shall call dynamic movement in time” (p. 15).
The human mind can, it is true, transcend the present moment in imagination and memory, but the moment-in-being remains nevertheless always self-contained and solitary.
“Any point of the calendar-axis within most of the supposed lifespan of the individual can by expectation or by memory be brought into relation with each successive station of the moment-in-being. But each such relation, in another sense, subsists wholly inside the moment-in-being. Expectation and memory do not provide a means of comparing the actuality of the moment-in-being at one of its stations with that a another, they do not enable two moments, distinct in location on the calendar-axis, to be in being together, for the nature of ‘the present,’ the essence of the moment-in-being, is an impregnable self-contained isolation” (p. 16).
It follows that it is impossible to compare human actions undertaken at different moments in time. For no two moments can be “in being” together, “the actuality of one denies and excludes the actuality of the other, there is no ‘common ground’ on which they can be brought face to face. The attempt to compare the individual's actual feelings at t0 with his actual feelings at t2 is for him impossible and does not make sense” (pp. 18–19).
In other words, in describing the phenomena of human action, time cannot be used as a co-ordinate because we lack an identifiable object which “passes through time.” Man with his “feelings,” preferences, and the content of his consciousness changes in unpredictable fashion. Our author holds that this implies the impossibility of any intertemporal or interpersonal dynamics. His dynamics “seeks to show the internal structure of a single moment,” it is “private and subjective.” It is valid for an individual at a point of time. Is he right in thus confining the scope of dynamic theory?
He is certainly right in questioning the usefulness of the naturalistic notion of time (as a continuum) for economic analysis. The natural sciences deal with changes in the properties of objects which are predictable because they are uniformly linked to changes in other variables, e.g. to motion in space, the passing of time, or forces emanating from other objects. But there is no way of telling in what way the preferences of a given individual will change over time, even when it is exposed to certain given conditions.
But if we were to take Professor Shackle's thesis literally, there could be no testing the success of plans, no plan revision, no comparison between ex ante and ex post. In fact planned action would make no sense whatever. Nor could there be a market in which the “private and subjective dynamics” of the individuals trading become socially objectified in the form of market prices and quantities of goods exchanged. Common experience tells us that these phenomena do exist. What, then, has gone wrong with our author's thesis?
It seems to us that while his thesis applies to human ends, of which we are unable to postulate any continuous existence in time, it does not apply to our knowledge of the adequacy of means to ends. But economic action is concerned with both, means and ends. The discontinuity of human ends, stressed by Professor Shackle, does not entail that there are no continuities at all in human action.
If no intertemporal comparison of the states of a man's knowledge were possible, most examinations would be pointless. Certainly in medicine and applied science all examinations involve intertemporal comparisons concerning knowledge of the adequacy of means to ends. We can, and occasionally do, learn from experience. Whatever may be discontinuous in us, the human mind is continuous. The acts of the mind of which our conscious life consists, follow each other ceaselessly. Bergson and Husserl have shown that the content of our consciousness is best regarded as a continuous stream of thought and experience.
No doubt Professor Shackle would not wish to deny all this. It would be ironic indeed if he, who set out to defend free will and the autonomy of the human mind, should in the end have to deny the continuity of mind. But on occasion he comes perilously close to holding such a position.
In our view he is going too far in one direction and not far enough in another. He is going too far when for discontinuity, which is a property merely of our ends, he wrongly claims the status of a universal category of human action.
But we can at least imagine a world in which the preferences of the individuals do not change for a time, and over longer periods change with almost imperceptible slowness. For such a world a dynamic theory would, even on Professor Shackle's showing, be possible. The continuity of ends would warrant it. But even in such a world Professor Shackle's general thesis about the creative power of the mind and our inability to predict its acts would still hold, because men would still be interpreting experiences, acquiring knowledge, planning and revising plans. We are able to imagine a world in which tastes do not change but unable to imagine one in which knowledge does not spread from some minds to others. Even continuity of ends does not entail an invariant means-end pattern; men would still be eager to make better use of the means at their disposal. Time and Knowledge belong together. The creative acts of the mind need not be reflected in changing preferences, but they cannot but be reflected in acts grasping experience and constituting objects of knowledge and plans of action. All such acts bear the stamp of the individuality of the actor.
Professor Shackle's strong emphasis on the subjective nature of economic action thus deserves every support, but our preferences and our interpretation of the world around us belong to different layers of experience. Our author fails to distinguish adequately between the subjectivism of utility and the subjectivism of interpretation.3
Intertemporal comparisons are thus possible except in cases where fundamental changes take place in an individual's system of preferences. But even the possibility of such intertemporal comparison does not of course mean that we can predict the future. While we may be able to say that a certain plan has so far succeeded we never can tell whether it will be further pursued. New ways of using the resources employed, or new and better ways of gaining the objective of the plan may in the meantime have been discovered, and may make it inadvisable to go on with the original plan, successful though it has been.
The model Professor Shackle set forth in Expectations in Economics, and for which he has now provided a methodological basis, is a Robinson Crusoe model. It is concerned with the equilibrium of the isolated individual and with the mental acts by which it is reached. It tells us nothing about market processes, nothing about the exchange and transmission of knowledge. But must we stop there? Is there no bridge from the solitary dynamics of Robinson Crusoe to a dynamic market theory?
The central problem of such a theory can be stated briefly. It concerns the distribution and transmission of knowledge in a market economy. Men make use of one another's resources and satisfy one another's wants. How, in a changing world, do they acquire the requisite knowledge about these changing wants and resources? There is no simple answer since today's knowledge may or may not have become obsolete by to-morrow. But common experience suggests that “keeping track” of these changes is possible and requires a continuous sequence of such acts of interpretation as we mentioned above. Different men will not be equally good at it.
Professor Shackle admits that besides his kind of dynamics, the private and subjective dynamics of the isolated individual, there may be others, e.g. the public and objective dynamics of the econometric model builders. “Between these two kinds of dynamics we can perhaps imagine a third kind, in which we should suppose an outside observer to be simultaneously informed by everyone of the individuals composing the whole economic system about the knowledge, thoughts, desires, expectations and decisions making up the content of each individual's mind in some one moment, a moment located at the same point of the calendar-axis for every individual” (pp. 25–26).
In the market, however, we have such an outside agency which, moreover, not merely registers decisions but also informs the individuals participating in it about them. How far a concrete market serves this function depends of course on a number of factors, such as its extent and degree of perfection. The markets for the services of the factors of production provide as a rule fairly good information about production plans.
Markets for products, on the other hand, provide it only where forward sales are possible. A perfect intertemporal market on which all producers sold their products before they were produced would provide complete information about all production plans. But of course, while a perfect forward market can provide information and bring production plans into consistency with each other and with the plans of consumers, it cannot predict the future. Here Professor Shackle is quite right in saying of his “outside observer,” “But even if he could do this, he would not be able, on our assumption that each individual is a decision-maker in the real sense, to go beyond this very first and immediate interplay of decisions and foresee the further evolution of the system. For he could not predict what would be the next decisions” (p. 26).
Thus, a dynamic market theory which shows how the expectations and plans of various individuals are brought into consistency with each other, is possible. It is possible to transcend the “private and subjective” dynamics of the individual and to reach the “socially objective” dynamics of the market, provided that our market is a forward market. Interpersonal and intertemporal dynamics belong together. The theory of equilibrium of the isolated individual is not necessarily the last word in dynamics.
We must now turn to the wider implications of Professor Shackle's ideas for the methodology of Economics and the social sciences in general. Our starting point is, again, his demonstration that the naturalistic concept of Time as a homogeneous continuum cannot be applied to an individual making his plans. We also have to consider the implications of his thesis that in economics prediction is impossible.
There can, of course, be no question of doubting the status of Economics as a science. Like other scientists, economists attempt to formulate systematic generalisations about observable phenomena. Like other scientists they frame hypotheses which are meant to reflect certain features of reality, and which stand or fall by this test.
If by “scientific method” we mean nothing more than this, no methodological problem arises. But it now appears that we must be on our guard against the uncritical adoption of certain auxiliary axioms and notions which may be useful to natural scientists but less so to us, like “time” as a continuum or “the closed system” within which alone determinism and prediction are possible.4
This means that economics needs a methodology sui generis, at least insofar as it has to deal with creative acts of the mind, with the setting of objectives and the interpretation of experience, which have no counterpart in nature. There can of course be no question of our setting forth here even an outline of such a methodology. But a few hints may be dropped and a few points made.
On the subject of prediction Professor Shackle's conclusions are quite definite and, in our view, cogent. “Complete prediction would require the predictor to know in complete detail at the moment of making his prediction, first, all ‘future’ advances of knowledge and inventions, and secondly, all ‘future’ decisions. To know in advance what an invention will consist of is evidently to make that invention in advance” (pp. 103–104).
“Predictability of the world's future history implies predictability of decisions, and this is either a contradiction in terms or an abolition of the concept of decision except in a perfectly empty sense” (p. 104). And “Predicted man is less than human, predicting man is more than human.”
But of what use, it may be asked, is economics if economists are unable to predict? The answer, we think, is that the systematic generalizations of the economists enable us to understand better certain predicaments of the past and present. The main social function of the economist is to provide the historian and the student of contemporary events with an arsenal of schemes of interpretation. Moreover, there is such a thing as “negative prediction.” It is often possible for the economist to predict that a certain policy will fail because of its inherent contradictions, e.g. a policy designed to increase deficit-financed investment and at the same time to stop an inflation. But in this case his prediction is based on a purely logical argument, not on any knowledge of specific circumstances, present or future. This possibility of making negative predictions is therefore quite consistent with Professor Shackle's conclusions.
Economists should, in our view, openly admit that they are unable to make positive predictions about the world. In this respect they are inferior to the natural scientists. But, on the other hand, in certain other respects the social sciences are actually superior, since they can, as the natural sciences cannot, give an intelligible account of the world with which they are dealing. We have to remember that the natural sciences, in the centuries of their evolution, have discarded a number of questions to which their methods can provide no answers, e.g. questions concerned with purpose and cause.
Why men have two legs and dogs have four, why the velocities of light and sound are what they are, why a certain flower emanates a certain smell, are questions with which modern natural sciences do not concern themselves. But why modern economies have evolved a certain type of money and credit system, or the institutions of the “Welfare State,” are relevant and meaningful questions to which answers can be provided.
The essence of the matter is that human action is planned, though of course few plans may ever succeed. It is always possible to compare the outcome with the plan, the ex post with the ex ante, the observable result with the, originally purely mental, cause. In fact it is impossible to give an intelligible account of human action in any other way. The natural sciences may have had good reasons to discard the concept of “cause” and to confine themselves to observable “uniformities of sequence.” There is no reason why the social sciences should follow them in this. Social causes have to be found in the creative acts of human minds. Economics explains that the reasons why certain prices are paid and quantities of goods produced, have to be sought in the choices made by consumers and decisions made by producers. Such causal genesis is a legitimate concern of the social sciences which has no counterpart in nature. It warrants the employment of genetic-causal schemes of interpretation which give rise to methodological problems sui generis.
A few words have now to be said about the relationship between knowledge and expectations. The impossibility of prediction in economics follows from the facts that economiç change is linked to change in knowledge, and future knowledge cannot be gained before its time. Knowledge is generated by spontaneous acts of the mind. We may ask what bearing this has on the theory of expectations. How are expectations formed? How is prognosis related to diagnosis? In answering these questions we shall permit ourselves to restate briefly what we said on another occasion.5
All prognosis which is more than mere guesswork must be linked to the diagnosis of an existing situation. The business man who forms an expectation is doing precisely what a scientist does when he formulates a working hypothesis. Both, business expectation and scientific hypothesis serve the same purpose; both reflect an attempt at cognition and orientation in an imperfectly known world, both embody imperfect knowledge to be tested and improved by later experience. The difference between them consists in that, unlike many scientists, the business man cannot repeat experiments in conditions he can control. Tests have to be made in a world which not merely changes, but whose change is not governed by any known law.
While this does not deprive these tests of all value, it does mean that in business even more than in science a good deal will depend on interpretation of experience, i.e. on creative acts of the mind, and that the knowledge yielded will be imperfect.
On the other hand, each expectation does not stand by itself but is the cumulative result of a series of former expectations which have been revised in the light of later experience, and these past revisions are the main source of whatever present knowledge we have. Our present expectation, to be revised later on as experience accrues, is not only the basis of any plan of action we may contemplate but also a source of more perfect future knowledge. The formation of expectations is thus a continuous process, an element of the larger process of the transmission of knowledge, the process by which men acquire knowledge about each other's needs and resources.
It follows that any experience made conveys knowledge to us only insofar as it fits, or fails to fit, into a pre-existent frame of knowledge. But the frame of knowledge in terms of which we interpret a new experience is always “private and subjective.” Knowledge always belongs to an individual mind. When we speak of the transmission of knowledge, we use this as a metaphorical expression for a process of interaction of minds. Knowledge spreads from mind to mind, it does not float from one individual to another as a piece of wood in a stream floats from one place to another. Its acquisition requires active participation in a social process. Following a different path, we have thus arrived at the same conclusion as Professor Shackle, viz., that expectations and the knowledge they reflect are always subjective. But this does not mean that the equilibrium of the isolated individual is necessarily the last word in dynamics.
Finally, we may view Professor Shackle's subjectivist dynamics in the perspective of the history of economic thought. In the history of our discipline objectivist and subjectivist tendencies have predominated at various periods, but the most remarkable progress of economics has been linked to the ascendancy of subjectivism.
The classical school, true to its 18th century origin, sought the ultimate determinants of economic life in certain “natural forces” like those reflected in the Malthusian law and the diminishing fertility of the soil, forces which were thought to shape the distribution of incomes and to set limits to economic progress. An “objective” theory of value with hours of (unskilled) labour as its measure crowned the classical edifice.
But about the middle of the last century subjectivism came into its own. As it was gradually realised that human ingenuity can overcome the obstacles presented by the classical forces, the human mind and its manifestations, choice and decision, came to occupy the centre of the economic stage. The “subjective revolution” of the 1870's presents only one aspect of this change, but it epitomises it well. It came to be realized that the value of a good does not reside in any measurable properties it might have, but constitutes a relationship between an appraising mind and the good.
The introduction of expectations into economics in this century, the realisation that what men will do in a given situation depends largely on their interpretation of it and on the direction of their imagination, was merely a further step along the same route. The problem of expectations, implicit in the work of Knight and Schumpeter, found explicit recognition by Keynes and the pupils of Wicksell in Sweden. Professor Shackle's Expectations in Economics readily finds its place within this tradition. Time in Economics, as we see it, is a more explicit statement of the methodological presuppositions of this approach.
One problem remains open. Can expectations be introduced into a general dynamic theory? The static equilibrium systems of Walras and Pareto, the greatest achievement of neo-classical economics, contain both, subjective and objective elements, tastes and quantities of resources. This is possible because of the timeless character of these systems. Once individuals have revealed their preferences, these become “data” like all others.
Individuals are free to choose, but having once chosen they are not free to change their minds: there literally is “no time” for that.
But expectations cannot be treated in this way if we want to make them elements of a dynamic system. As soon as we permit time to elapse we must permit knowledge to change, and knowledge cannot be regarded as a function of anything else. It is not the subjective nature of expectations, any more than that of individual preferences, which makes them such unsuitable elements of dynamic theories, it is the fact that time cannot pass without modifying knowledge which appears to destroy the possibility of treating expectations as data of a dynamic equilibrium system.
This conclusion does not affect the possibility of a theory of the forward market on which individuals reveal their expectations by engaging in forward transactions in the same way as individuals reveal their preferences by purchases and sales on an ordinary market.
The Science of Human Action
This is Professor Mises's magnum opus.1 It is a magnum opus in every sense of the word. Its majestic sweep embraces almost the whole field of economics and touches, at some point or other, on almost every social issue of our time. Not merely the formal-logical apparatus of economic theory, but the social structure of modern industrial society, its achievements, its weaknesses, and, most of all, its ideologies come under the relentless scrutiny of one who again and again confounds the smallminded within the precincts of our science and outside it. Perhaps his most outstanding merit is an intellectual courage which in these days of the cult of the “politically possible” has become all too rare. Throughout the 881 pages of the text the argument is presented with a pungency of style which rivals the clarity and vigour of his thought.
To render justice to a work of this nature on the few pages at our disposal is clearly impossible. All we can hope to do is to select a few topics for discussion.
When ten years ago Professor Knight reviewed the original German version2 of the book in this journal3 and found himself faced with the same dilemma, he selected one topic only for discussion, viz., the theory of capital. Quite possibly this is the best way of going about it. Undoubtedly the theory of capital occupies a prominent place in Professor Mises's doctrinal edifice. His theory of the trade cycle as well as his proof of the inadequacy of some recent “models” for a socialist market economy depend largely on his view of capital.
This article appeared in Economica 18 (November 1951):412–27.
Yet we shall not follow the method Professor Knight adopted ten years ago. Unable though we are to take the reader on an extensive tour of the palace and to show him every part of the building, it seems to us wrong to confine our inspection to the basement. The wide vistas to be gained from some of the windows on the upper floors are too enchanting for that.
Human Action is, of course, far more than a treatise on the methodology of the social sciences. But its centre of gravity certainly lies in its first seven chapters which are devoted to the discussion of method in the social sciences. We shall therefore have to deal at some length with the issues raised in these chapters.
In the study of human thought on any subject it is a fundamental principle that we cannot succeed in understanding what an author “really means” unless we understand the questions he is trying to answer. And an appraisal of Professor Mises's views on the methodology of the social sciences requires at least some knowledge of the history of the problems he is dealing with. In reading this book we must never forget that it is the work of Max Weber that is being carried on here.
Now, Max Weber's methodological writings had a dual purpose: to convince the historians who, at his time and in the German environment in which he grew up, were apt to claim a methodological monopoly for their “individualising” methods, that the social sciences offered just as much, if not more, scope for generalisation as the natural sciences; and that any historical “explanation” logically presupposes a generalised scheme of cause and effect. But at the same time he strove to uphold the methodological independence of the theoretical social sciences of the natural sciences by stressing the cardinal importance of means and ends as fundamental categories of human action.
This work has been carried on by others besides Professor Mises. There is Professor Hayek's famous essay on “Scientism and the Study of Society,” well known to readers of this journal.4 There is the work of Dr. Schütz who has applied Husserl's phenomenology to the logical analysis of the structure of human action.5 And there is, of course, Professor Robbins's Essay on the Nature and Significance of Economic Science (1932; 2nd ed. 1935), which firmly established the definition of our science in terms of scarce means and multiple ends.
It may be objected that this definition of the subject-matter of economics is too wide. At an election, for instance, each voter has one vote but more than one candidate to give it to; yet the problem is not usually regarded as an economic one.
Professor Mises's reply to such objections is that in our search for the causes of the market phenomena we observe, and the explanation of which is the primary task of economists, we have unwittingly strayed into the realm of Praxeology, the Science of Human Action. He therefore distinguishes between Praxeology, the Science of Human Action, and Catallactics, the science which deals with market phenomena (233). The theorems of the latter presuppose the categories of the former. In other words, what Professor Hayek has called “The Pure Logic of Choice” belongs to Praxeology rather than to Catallactics. In this way what we have come to regard as the main body of economics is seen to belong to two related but distinct fields. “Catallactics is the analysis of those actions which are conducted on the basis of monetary calculation. Market exchange and monetary calculation are inseparably linked together” (235).
Professor Mises claims a priori validity for the propositions of Praxeology. “Its scope is human action as such, irrespective of all environmental, accidental, and individual circumstances of the concrete acts. Its cognition is purely formal and general without reference to the material content and the particular features of the actual case.... Its statements and propositions are not derived from experience. They are, like those of logic and mathematics, a priori. They are not subject to verification or falsification on the ground of experience and facts. They are both logically and temporally antecedent to any comprehension of historical facts. They are a necessary requirement of any intellectual grasp of historical events” (32). At the same time “Praxeology conveys exact and precise knowledge of real things” (39).
These statements raise two fundamental questions: How can Praxeology at one and the same time be a priori true, and “convey knowledge of real things”? Secondly, even if no a priori validity is claimed for the propositions of Catallactics, is it true that all the fundamental economic theorems that would clearly fall into the field of Praxeology are, like logic and mathematics, a priori valid?
As regards our first question, we must remember that the “real things” about which we learn from Praxeology are human actions. They can be studied in two ways: we can study them, as it were, “from outside,” by observation and experience, like other phenomena of nature; or we can study them “from inside,” that is to say, we interpret them as the products of plans, as manifestations of a directing and controlling mind. Looked at in this way all human action has a logical structure. There is therefore such a thing as a Logic of Action closely linked to the logic of our thought. We act by virtue of the fact that we think before. “The real thing which is the subject matter of praxeology, human action, stems from the same source as human reasoning. Action and reason are congeneric and homogeneous; they may even be called two different aspects of the same thing. That reason has the power to make clear through pure ratiocination the essential features of action is a consequence of the fact that action is an offshoot of reason” (39).
Our second question raises a fundamental issue in epistemology. It is not merely a question of whether “means and ends” have the same epistemological status as, for instance, “time and space.” Behind it there lurks the even more fundamental question whether we can have any knowledge not ultimately derived from experience.
Fortunately this journal is not the proper place to raise such weighty issues in.Economica must not become a battleground for positivists and Neo-Kantians. It seems to us, however, that in this particular case it is possible to side with Professor Mises without taking sides on the wider issue. For we can, and in our opinion must, distinguish between different layers of experience. In economics we are concerned with the action of the adult house-holder and the business man. Even if we granted that our ability to distinguish between means and ends is the result of some kind of experience, it still remains true that this experience is not the experience gathered from spending one's income or running a business. Professor Mises is certainly right in holding that all such action already presupposes the distinction between means and ends.6 We may therefore say that, whatever the source of knowledge from which the distinction is ultimately derived, means and ends are indeed “logically and temporally antecedent” to the household and business plans which economists study. They may have their root in a layer of (juvenile?) experience, but it is a layer which precedes and underlies the layer with which we are concerned.
Having learnt that Professor Mises regards Praxeology as methodologically similar to logic and mathematics, we might expect him to welcome the use of mathematical methods in economics. In fact, however, this is not so. On the contrary, the section on “Logical Catallactics versus Mathematical Catallactics” in the chapter on Prices, one of the most interesting and perhaps the most characteristic of the book, turns out to be a devastating criticism, not of mathematical economics as such, but at least of the methods currently in use by mathematical economists. Two classes of mathematical economists are the chief target of Professor Mises's onslaught.
There are, firstly, the econometricians trying to make economics a “quantitative science.” But “there is no such thing as quantitative economics. All economic quantities we know about are data of economic history. No reasonable man can suppose that the relation between price and supply is in general, or in respect of certain commodities, constant. We know, on the contrary, that ... the reactions of the same people to the same external events vary, and that it is not possible to assign individuals to classes of men reacting in the same way” (348). Secondly, there is the equilibrium school which refuses to study the Market Process, the central object of economics. “They merely mark out an imaginary situation in which the market process would cease to operate. The mathematical economists disregard the whole theoretical elucidation of the market process and evasively amuse themselves with an auxiliary notion employed in its context and devoid of any sense when used outside of this context” (352).
The reason for this confusion has to be sought in the inability of many economists to grasp the difference between the essential character of the natural sciences and that of the sciences dealing with human action. This difference is brought out in a characteristically Misesque passage:
“In physics we are faced with changes occurring in various sense phenomena. We discover a regularity in the sequence of these changes and these observations lead us to the construction of a science of physics. We know nothing about the ultimate forces actuating these changes. They are for the searching mind ultimately given and defy any further analysis. What we know from observation is the regular concatenation of various observable entities and attributes. It is this mutual interdependence of data that the physicist describes in differential equations.
In praxeology the first fact we know is that men are purposively intent upon bringing about some changes. It is this fact that integrates the subject matter of praxeology and differentiates it from the subject matter of the natural sciences. We know the forces behind the changes, and this aprioristic knowledge leads us to a cognition of the praxeological processes. The physicist does not know what electricity ‘is.’ He knows only phenomena attributed to something called electricity. But the economist knows what actuates the market process. It is only thanks to this knowledge that he is in a position to distinguish market phenomena from other phenomena and to describe the market process” (352).
All this the mathematical economist ignores. In making equilibrium the central concept of his system “he merely describes an auxiliary makeshift employed by the logical economists as a limiting notion, the definition of a state of affairs in which there is no longer any action and the market process has come to a standstill.... A superficial analogy is spun out too long, that is all” (352).
In all this, to be sure, the word “causal-genetic” never occurs. Yet it is clear what Professor Mises is aiming at. The task of the economist is not merely, as in equilibrium theory, to examine the logical consistency of various modes of action, but to make human action intelligible, to let us understand the nature of the logical structures called ‘plans,’ to exhibit the successive modes of thought which give rise to successive modes of action. In other words, all true economics is not “functional” but “causal-genetic.”7
“Logical economics is essentially a theory of processes and changes.” And “the problems of process analysis, i.e., the only economic problems that matter, defy any mathematical approach.... The main deficiency of mathematical economics is not the fact that it ignores the temporal sequence, but that it ignores the market process. The mathematical method is at a loss to show how form a state of non-equilibrium those actions spring up which tend toward the establishment of equilibrium.... The differential equations of mechanics are supposed to describe precisely the motions concerned at any instant of the time travelled through. The economic equations have no reference whatever to conditions as they really are in each instant of the time interval between the state of non-equilibrium and that of equilibrium.... A very imperfect and superficial metaphor is not a substitute for the services rendered by logical economics” (353–4).
Two examples of the misinterpretation of economic phenomena resulting from the application of misleading mathematical metaphors are then given: Fisher's exchange equation, “the mathematical economist's futile and misleading attempt to deal with changes in the purchasing power of money”; and Schumpeter's rather unfortunate “dictum according to which consumers in evaluating consumers' goods ipso facto also evaluate the means of production which enter into the production of these goods.”8
We now have to face the central issue of Professor Mises's methodology. “Logical economics is essentially a theory of processes and changes.” But is there, can there be, a “Pure Logic of Choice”? In the field of human action we “explain” phenomena as the outcome of the pursuit of plans. Each plan is a logical structure in which means and ends are coordinated by a directing and controlling mind. But the plans of different individuals may be, and as a rule are, inconsistent with each other. Now, it is an undeniable fact that far too many economists are preoccupied with examining the consistency of plans without ever bothering to tell us how in reality men overcome inconsistencies brought to light by failure, how they set out to revise their plans in the light of their experience, favourable or unfavourable.
In other words, there is a tendency in the economic theory currently in fashion to treat knowledge as a datum without explaining how knowledge is transformed as a result of the market process. This tendency is to be deplored. But if the transformation of knowledge is an essential element in the market process, then the latter cannot belong to the province of logical economics, for the acquisition of knowledge is not a logical process. How does our author overcome this difficulty?
He has an answer of a kind, and we believe it, on the whole, to be a satisfactory answer. Unfortunately it is nowhere explicitly stated, and the elements of the answer have to be pieced together from passages and ideas scattered throughout the text of 881 pages. The explicit answer, on the other hand, which Professor Mises provides for us cannot be regarded as adequate.
According to our author the logical principle which coordinates the plans of different individuals is the division of labour. “The exchange relation is the fundamental social relation. Interpersonal exchange of goods and services weaves the bond which unites men into society. The societal formula is: do ut des” (195).
At first sight this suggestion does not appear very helpful. For the division of labour to serve as the fundamental principle of human interaction it would be necessary for everybody concerned from the beginning to know everybody else's needs, resources, and abilities. In a world of processes and changes this is clearly impossible. It would be possible only in that static world Professor Mises disdains. He thus appears to be confronted with this dilemma: his principle for the coordination of social action is immediately applicable only in equilibrium, while a “theory of processes and changes” would first have to explain how men gain that knowledge which enables them to adjust their action to the needs of others, and to make use of their abilities and resources.
Professor Mises's real answer to the dilemma lies in his conception of entrepreneurship and the function of entrepreneurial profits, a conception which is really dynamic and remarkably similar to Schumpeter's. Profits, those temporary margins between to today's cost of complementary factor services and tomorrow's product prices, are signposts of entrepreneurial success. In a symbolic form they convey knowledge, but the symbols have to be interpreted. In this ability men differ widely; its comparative rarity is the ultimate cause of human inequality. “If all entrepreneurs were to anticipate correctly the future state of the market, there would be neither profits nor losses.... An entrepreneur can make a profit only if he anticipates future conditions more correctly than other entrepreneurs” (291).
The market process, to be sure, conveys knowledge through profits realised. But it also promotes the rise of those better equipped than others to wrest economic meaning from the happenings of the market-place, the ups and downs of prices, the fluctuations in stocks, the doings of the politicians, and of those (they will always be few) who know how to learn from the mistakes of others. In other words, the market process is closely linked with what Pareto called “the circulation of élites,” perhaps the most important of all social processes. “One should not forget that on the market a process of selection is in continual operation. There prevails an unceasing tendency to weed out the less efficient entrepreneurs, that is, those who fail in their endeavours to anticipate correctly (580).... This specific anticipative understanding of the conditions of the uncertain future defies any rules and systematisation (582).... The resultant of these endeavours is not only the price structure but no less the social structure, the assignment of definite tasks to the various individuals. The market makes people rich or poor, determines who shall run the big plants and who shall scrub the floors, fixes how many people shall work in the copper mines and how many in the symphony orchestras” (308).
The essence of the matter is that the market process promotes the spreading of knowledge through the promotion of those capable of interpreting market data and of thus transforming them into market knowledge, and the elimination of those who cannot read the signs of the market.
We said already that the theory of capital occupies a prominent place in Professor Mises's doctrinal edifice. We must therefore look at it closely.
Broadly speaking, his theory of capital is more or less identical with that of Professor Hayek in the Pure Theory of Capital.9 Böhm-Bawerk's doctrine is not uncritically accepted. His wage-fund interpretation of the capital stock is rejected; so is the “backward-looking” concept of the period of production. “The length of time expended in the past for the production of capital goods available to-day does not count at all.... The ‘average period of production’ is an empty concept” (486). Moreover, Böhm-Bawerk's “demonstration of the universal validity of time preference is inadequate because it is based on psychological considerations. However, psychology can never demonstrate the validity of a praxeological theorem” (485). While in expounding his theory of the higher productivity of roundabout methods of production he “did not entirely avoid the productivity approach which he himself had so brilliantly refuted” (486).
The essence of Professor Mises's argument can perhaps best be expressed by contrasting it with, e.g., Professor Knight's theory of investment. For the latter a man who saves faces merely the choice between a present segment of a service flow and a permanent income stream. For Professor Mises the man faces a choice between a number of present goods and a large number of future goods all maturing at different points of time. But he has a scale of preference (“time preference”) which enables him to decide which combination of future goods he prefers to all others. Capital goods are thus future consumption goods in statu nascendi, and their valuation reflects the pattern of time preference between the various combinations of consumption goods of different degrees of futurity. The market rate of interest is the average rate of discount of future against present goods, the net result of these individual time preferences.
The question arises whether a form of economic organisation is possible in which there is a market for consumption goods, but no market for capital goods. Such a system has been advocated by the protagonists of the New Scientific Socialism. They would leave all investment decisions to a Central Planning Board, while output decisions about consumers' goods would be made by individual plant managers provided with “factor-price tables” and left with the general instruction to produce that output quantity for which market price equals marginal cost.
Professor Mises does not find it difficult to dispose of these schemes. He shows that they rest essentially on a misconception of the function of the entrepreneur in a market economy. “The cardinal fallacy implied in this and all kindred proposals is that they look at the economic problem from the perspective of the subaltern clerk whose intellectual horizon does not extend beyond subordinate tasks. They consider the structure of industrial production and the allocation of capital to the various branches and production aggregates as rigid, and do not take into account the necessity of altering this structure in order to adjust it to changes in conditions” (703). To be sure, the entrepreneur “invests,” and he produces and sells output. But this is not all. He has another function which we all know but about which little is, as a rule, heard from economists: the “regrouping of capital assets” by buying and selling them, the incessant reshuffling of the combinations of complementary capital goods with which he works and which in their complexity form the ever-changing basis of the capital structure.10 ,11
Almost forty years ago Professor Mises, through a brilliant interpretation of an idea of Wicksell, became the first exponent of what has come to be known as “The Austrian Theory of the Trade Cycle.” In its fully developed form this theory contends that what happens during a boom is not merely that “incomes, output, and employment” rise and approach the “point of full employment,” but that the capital structure becomes distorted. In some sectors of the economic system new capital goods are piled up, in others, owing to what Irving Fisher called “the money illusion,” existing capital goods are not even being maintained. Under the relentless pressure of credit expansion sooner or later some resources become scarce, and others thus come to lack those complementary factors in the expectation of whose availability they had been produced. It is plain that the heterogeneity of capital resources of which during the boom some become scarce, some abundant, is of the essence of the matter.
For 15 years this theory has been under a cloud. During most of that time the stage was held by underconsumption theories. To many economists it began to appear unthinkable that economic crises could be caused by anything but “lack of effective demand.” Keynesianism in all its forms ruled supreme.
But of late it has been possible to observe a gradual change of heart. Undoubtedly the high tide of Keynesianism is receding. In a mood of eclecticism an increasing number of economists appears to be ready to reconsider the evidence. In this new situation it is perhaps not too extravagant to hope for general, or nearly general, agreement that booms may collapse and depressions come to an end, for all sorts of reasons, that the economic systems of modern industrial societies are far too complex to offer much prospect of “stable progress,” and that a theoretical one-model show must needs fail to give an adequate picture of the range of analytical tools required to cope with these baffling complexities.
This changing mood finds a clear expression in Dr. Hicks's recent book on the trade cycle.12 Underconsumption crises are not impossible,13 but they are unlikely to be frequent. The most important cause of cyclical downturns Dr. Hicks sees in the existence of the “ceiling,” i.e., in the existence of physical obstacles to unlimited expansion of output. Of course, it is far from our mind to suggest that Professor Mises's theory is identical with Dr. Hicks's. Clearly it is not. But there are striking similarities, and the divergences are often more apparent than real. Of this we shall give three examples.
In the first place, Dr. Hicks relies heavily on the Acceleration Principle which Professor Mises scorns. But the essence of the boom is clearly, in both theories, and in open contrast to all underconsumptionist teaching, that entrepreneurs make investment plans the real resources for which do not exist. “The essence of the credit-expansion boom is not over-investment, but investment in wrong lines, i.e., malinvestment” (Mises, 556).
Secondly, Professor Mises, to whom capital resources are essentially heterogeneous, finds it easier to define the nature of malinvestment. “The whole entrepreneurial class is, as it were, in the position of a master-builder whose task is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder's fault was not over-investment, but an inappropriate employment of the means at his disposal” (Mises, p. 557).
Dr. Hicks, on the other hand, throughout the greater part of his book treats capital as homogeneous, and thus, at the critical point, lacks the sharpest-edged tool for making malinvestment explicit. But it is interesting to note that, when in Chapter X he embarks on a “further inspection of the ceiling,” his homogeneity assumption breaks down. He not merely contends that “resources needed for making investment goods are becoming scarcer than the resources needed for making consumption goods” (Hicks, 128). Four pages later we are actually told: “We could easily have made a further advance by splitting up these ceilings, and allowing a sectional ceiling for every product.” The important point is “that the accumulating real pressure will usually precipitate a downturn before the general shortage has become so acute as to induce a general inflation.” In other words, some resources will become scarce while others remain plentiful. This is precisely the situation the Austrian theory was designed to meet.
Thirdly, as regards the position on the morrow of the downturn, Dr. Hicks again relies on multiplier and accelerator, while Professor Mises, spurning such Keynesian devices, preaches the need for readjustment. But again the contrast is more apparent than real. For Dr. Hicks the downturn expresses the tendency of the system to return to the long-run equilibrium level (the danger being that this may be “passed by”). For Professor Mises “readjustment” means more or less the same thing. “The malinvestments of the boom have misplaced inconvertible factors of production in some lines at the expense of other lines in which they were more urgently needed. There is disproportion in the allocation of nonconvertible factors to the various branches of industry.” Now “one must provide the capital goods lacking in those branches which were unduly neglected in the boom. Wage rates must drop; people must restrict their consumption temporarily until the capital wasted by malinvestment is restored. Those who dislike the hardships of the readjustment period must abstain in time from credit expansion” (575–6).
As regards the depression, the main difference between the two authors consists in that Professor Mises is less afraid than Dr. Hicks of the effects of secondary deflation (Mises, 565–6). This is perhaps a matter for judgment from case to case rather than for theoretical generalisation.
In conclusion we may note that on the whole the Austrian theory has the broader scope, thanks largely to the fact that it is not tied to the homogeneity assumption. Dr. Hicks ignores existing capital goods and the problems of their versatility. We do not even learn whether his coefficients of production are fixed or variable. In the Austrian theory existing capital combinations can be reshuffled so as to release scarce resources. In fact, the constructive entrepreneurial task of the readjustment period consists largely in this, and not in indiscriminate investment. The core of the matter lies in this: the existence of unemployment and idle resources does not necessarily indicate “lack of effective demand”; it may indicate lack of complementary capital. When we reach his “ceiling” Dr. Hicks recognises this possibility; when we leave it its implications seem to fall into oblivion.
A few words have to be said about Professor Mises's altitude to the wider issues of our time. Among the members of the governing class of present-day Western society he is not a popular figure. Politicians and bureaucrats dislike him; the intellectuals who produce the ideologies to sustain their rule abhor him. The Fabians worship other idols.
Equalitarianism is the favourite myth of our century. No thinking person can fail to notice that as societies become more civilised, inequalities are bound to increase. This is simply a corollary of the division of labour. As this reaches ever higher degrees, individual contributions to the social product become more and more specific and thus less substitutable. For is it not an accepted maxim of economics that the division of labour enables everybody to give of his best, and that, as it is carried to higher degrees of complexity, this, individual and highly specific, “best” tends to become very much better than anybody else's “best” in the same line? As inequality can thus be shown to be an inevitable concomitant of civilisation, arguments about its desirability or undesirability are seen to be largely irrelevant. Therefore “the inequality of incomes and wealth is an inherent feature of the market economy” (836). No prejudice, however, was ever shaken by argument, and our contemporary mythologists are no more given no critical reflection on major tenets than were their medieval ancestors.
But Professor Mises not merely refuses to accept the contemporary myth. He can see through it! “In endorsing the principle of equality as a political postulate nobody wants to share his own income with those who have less. When the American wage earner refers to equality, he means that the dividends of the stockholders should be given to him. He does not suggest a curtailment of this own income for the benefit of those 95 percent of the earth's population whose income is lower than his” (836).
Nor is much comfort offered to those who would create “equality of opportunity” through education, by “making educational opportunities more equal.” The abilities by which men outdo each other in a complex society have little to do with education. Entrepreneurial ability is not to be acquired in lecture-rooms. Here Professor Mises makes an important point. “It is not generally realised that education can never be more than indoctrination with theories and ideas already developed. Education, whatever benefits it may confer, is transmission of traditional doctrines and valuations; it is by necessity conservative. It produces imitation and routine, not improvement and progress. Innovators and creative geniuses cannot be reared in schools. They are precisely the men who defy what the school has taught them” (311).14
The outlook for the praxeological sciences is not exactly bright. In our time they are bound to come into conflict with the dominant ideologies at almost every point. The high priests of “modern education” are unlikely to take kindly to any endeavour to substitute a scientific for a mythological view of the social function of education.
Yet, in the long run, society ignores the praxeological sciences at its peril. “The body of economic knowledge is an essential element in the structure of human civilisation; it is the foundation upon which modern industrialism and all the moral, intellectual, technological, and therapeutical achievements of the last centuries have been built. It rests with men whether they will make the proper use of the rich treasure with which this knowledge provides them or whether they will leave it unused. But if they fail to take the best advantage of it and disregard its teachings and warnings, they will not annual economics; they will stamp out society and the human race” (881).
It will be for History to judge.
Model Constructions and the Market Economy
For almost two centuries concepts of the market economy have had a significant place in the development of economic theory. The market, not just as the product of economic history, but as a focus of meaningful action—as the product of, and also as a means of orientation for, economic agents in a society with division of labor—constituted one of the most important themes of classical political economy. It was certainly no accident that in the Methodenstreit the partisans of the historical school accused their opponents, often unjustly, of “Manchesterism.” What they meant was that in classical theory the market and its institutions occupied such a predominant place, and this fact was to them an annoyance.
In recent decades, however, there has been a distinct change. Modern economic theory has become ever more abstract and occupied with the building of pseudo-Platonic models in imitation of the methods of the modern natural sciences. Within this framework, there is little room for a discussion of market processes or of the actions causing them. Even less attention is given to those mental acts from which these economic actions spring. Neoclassical formalism—as I shall designate the predominant trend in economic thinking that has gained such wide acceptance in recent decades—understandably does not find it a congenial task to explain economic phenomena in terms of underlying plans and actions.1 One abstracts from all these and, following the example of the natural sciences, substitutes the functional determination of magnitudes, within a closed system characterized by simultaneous equations, for causal explanation.2
This essay, “Marktwirtschaft und Modellkonstruktionen,” Ordo 17(1966):261–79, was translated from the German by Robert F. Ambacher of Millersville State College and Walter E. Grinder.
As a result of this development in economic theory, the vitality of our thinking about the market economy has been undermined. In this situation, the advocates of the market, faced with new problems, have to fashion their own analytical tools.
First of all, we must concentrate on the fundamental methodological problem facing us. The market is a focus of meaningful action. Market phenomena, quantities of goods and prices, result from the economic plans of market participants, such plans being based on the economic calculations of single individuals and enterprises. Economic plans, thus, are the components of meaningful action. To explain market phenomena therefore means to analyze these phenomena in terms of their meaningful components. If, however, as is done in modern economics, one views all economic phenomena, including market phenomena, as mere parts of a large complex of relationships, that is, the “economic system,” one is limited to the “exact” determination of those quantitative relationships that can be determined at all. This manipulation is possible, of course, only within a closed system and then only when all relationships are fully coherent. This also explains the current preoccupation with conditions of equilibrium. The need to refer all economic phenomena to a central point, the “economic system,” forces one to use such an approach.
Now the determination of economic quantities, as far as this is possible, is obviously a goal of any economic theory and thus of any market theory. But for a method of analysis that is also concerned with the interpretation of the meaning of action, this determination is only the first step. The real task is to explain how relations between quantities derive from mental acts.
The inadequacy of the models constructed by neoclassical formalism, which I shall deal with at length in the next section, stems, then, not from its high degree of abstraction as such, for all theory is abstract; nor from the fact that quantitative relations are determined, for all economic theory must achieve such determination; and most certainly not from the application of mathematics, for mathematics is a proved means of expressing quantitative relationships in all areas of knowledge. Rather, this inadequacy springs from the significance of the elements from which one must abstract: in macroeconomics one abstracts from the human actions and plans that underlie all economic phenomena, while in microeconomics these actions and plans appear all too often as an idealized distortion (“perfect competition”).
Under these conditions the defenders of the market economy are confronted with new tasks. Three of these appear to me to be of particular importance.
First, it must be demonstrated that the stylized images of the market in the neoclassical models have little relevance to actual market processes. When, for example, linear programming theory shows that all rational economic activity implies a price system with prices equal to costs and that all production involving time implies a rate of interest, the similarity of this price system to that of the market economy seems evident. But this similarity only seems evident, and market theory can gain nothing from it. For in this linear price system we are dealing with equilibrium prices that result from a calculus and not from market processes. No account is taken of the central problems of market economics: what occurs in a state of disequilibrium, whether and under what condition equilibrium can be reached at all, how long such a condition would last if once reached, and so on.
No one denies the usefulness of linear programming for solving practical planning problems. But it has nothing to contribute to an understanding of market processes. The reason is that no individual actor in the market actually possesses that total knowledge of the data that linear theory assumes. Market processes and the calculation of optimal allocations are entirely different things. The close proximity of equilibrium and linear theory, which characterizes the neoclassical thought of our time, shows upon close investigation the weakness of the former rather than the fruitfulness of the latter.
Secondly, we must come to terms with the view that the market economy can function only in a stationary state, since only then could orientation to existing market prices warrant the success of economic action. In reality, we are told, the entrepreneur must act on his expectations, which of necessity are uncertain. It is hard to see what could coordinate these expectations. The price system certainly could not do it; and the forward markets of the real world are too little developed and too few in number to offer a solution.3
Without going into these important questions more fully, the following comment is in order:
First, such reliance on forward markets exaggerates the importance of well-coordinated expectations. Even in a world of perfect forward markets the future remains uncertain, and even the best coordinated expectations do not guard against disappointments. Second, the absence of forward markets does not by itself imply an unsatisfied demand for the services of specialized risk takers. In general, the market economy generates the institutions it needs. The lack of an institution may be attributable to the fact that it is not needed.
Finally, the decisive question is whether the market can offer methods for the quick and effective liquidation of malinvestments, even though it cannot prevent thwarted expectations and the failure of plans. For the market economy the revision of plans has no less significance than their original conception.
The third task of market-oriented theory is, in my opinion, the creation of a useful concept of competition. This is a subject that E. H. Chamberlin, J. M. Clark, and a number of others have tackled in the last thirty years. Even those who view the solutions offered with some skepticism should not belittle the accomplishments of these authors; for they have thoroughly investigated actual market processes, an undertaking of no small merit in our age of formalism.
Most important is recognizing that the market is not a state of affairs but a chain of events. It is therefore not possible to view competition as a market condition whose form can be deduced from assumptions about typical schemes of action (market forms). These schemes of action themselves depend on market phenomena from which the actors in the market are continuously taking their orientation. I shall return to this matter in the third section.
IN CRITICISM OF ECONOMIC MODELS
I shall now subject the neoclassical models to a critical examination, above all with regard to the problem of “economic growth.” My reasons are that, on the one hand, theories of growth are really creations of the last twenty years, the neoclassical style of thought being particularly evident in this area, and, on the other hand, the unreal nature of the models often finds here its expression in striking ways.4
A characteristic common to most of these models is the search for, and the almost exclusive preoccupation with, so-called maximum growth paths. Since J. von Neumann's famous work,5 the major task of growth theory has been to show how, under given conditions, the factors of production must be employed in order to attain enduring optimal growth. We are dealing here with a kind of “dynamic welfare economics.” The solution of maximization problems, well known in microeconomics, is viewed here as the task of macroeconomics, although it is never revealed how each market participant gains the relevant partial knowledge he must have if total knowledge of all of market participants is to be equal to the total data possessed by the model builder. To conclude from the similarity of the formal characteristics of maximization problems that what is possible for an individual's personal economy is also possible for the economic system as a whole exactly characterizes the intellectual attitude of neoclassical formalism. At best, only the directors of a planned economy could possess such all-encompassing knowledge of the data—and even this is doubtful. All of this has nothing to do with the market economy.
Central to all activities of the market economy is the individual economic plan. It is one thing to show that all planned action is an attempt at problem solving. It is something quite different to examine “maximum growth paths,” beginning with the assumption that all participants' problems have been successfully solved. Some plans will always fail. What happens in such cases must be of great interest to us. In reality there are no optimal solutions for all participants—except in the minds of welfare economists. Dynamic equilibria, maximum growth paths, and similar concepts are notions of economists with little interest in what matters in the market economy. The logic of choice leads us to the equilibrium of the household and of the firm, and perhaps of the single market, insofar as the market situation is intelligible to its participants. Beyond this point, the logic of choice becomes distorted and loses its meaning.
Every planner and actor must always be aware of a series of viewpoints and changing conditions that are often quantitatively determined and graded and that may be regarded as functions. But that gives us no right to see functions everywhere, or even to limit our investigation to their existence. Concepts that may have significance in the sphere of the individual economy and of the single market often lose it if a “macro” connotation is attributed to them without close investigation of the facts. Working with aggregates whose origins remain unexamined and whose mode of composition is assumed to persist without explanation allows the constructors of economic models to withdraw from the task of tracing market phenomena to the meanings people attribute to their economic actions.
Growth theory has thus become a branch of applied mathematics, in which one is satisfied with the deduction of optimal solutions from given “data,” without having to be concerned with how many economic actors in the real world could possibly understand the meaning of these data. Methods borrowed from the natural sciences are applied without testing their applicability to the objects of the social sciences. The interpretation of complex relationships of meaning is replaced by a mechanical calculus. The market and its phenomena, however, are to be understood only as a focus of meaningful action.
However little the theory of the market economy, aspiring to interpret meaning, has to learn from economic models which lack such aspirations, it cannot afford to ignore it. The reason is simply that these maximum and optimum solutions—regardless of how unrealistic or how abstractly conceived—may be used as standards against which the real market economy can be measured and naturally found wanting. It is hardly an overstatement that most formalists seldom concern themselves with the phenomena of the real market economy except to prove, with great earnestness, that here the high ideal of “Pareto-optimality” has been missed. Unfortunately, we are not informed in what kind of society this could be achieved. The study of models is thus no idle occupation for an adherent to the market economy.
In particular my critique is directed against three features of these schemes: the unflinching use of equilibrium argument, the exclusively macroeconomic form of analysis, and the misunderstanding of the nature of technological progress.
In the individual economy the equilibrium concept obviously makes good sense, for here the actor tries to achieve such a state, even if it is never realized. This concept represents a real point of reference for mental acts. It also makes sense, in the single market, to speak of equilibrium between supply and demand. And where the actors respond very quickly, as, for example, in the stock market, such a condition is achieved every day. Only when we extend the concept to the entire complex of economic relationships do we encounter difficulty. Nevertheless, in a stationary world a general state of equilibrium is at least conceivable, and under certain circumstances it might even be achieved. But in a world of continuous unexpected change, this concept becomes highly questionable.
It is therefore remarkable that all modern growth theories are based on the same conceptual foundation, one that dates from Gustav Cassel's theory of a uniformly progressing economy, “steady state growth.”6 The creators of general equilibrium theory were aware that even in static analysis the conditions of equilibrium do not entail the achievement of a state commensurate with these conditions. They knew that the “road leading to equilibrium” conceals a number of problems.7 They even attempted to circumvent these difficulties through the postulates of “recontract” theory. More than thirty years ago, in a famous essay, Lord Kaldor referred to these problems.8 In recent economic models, however, they have been cast aside.9 This is noteworthy since obviously such problems are bound to cause even greater difficulties in a dynamic economy than in static analysis. Whether even a temporary state of equilibrium will be achieved obviously depends on the velocity of reaction of the various elements in the system; their respective magnitudes, in turn, depend on the expectations of economic agents. Yet formalism avoids confronting these difficult problems by postulating the continued existence of a growth equilibrium, the very origin of which is not explained. The problems of human action in a world of unexpected change are concealed behind a smoke screen of formulae and functions.
Much has already been said about the competition between macroeconomics and microeconomics.10 Here we shall come to grips with this problem in terms of market phenomena.
Obviously, a procedure that neglects to trace market phenomena to plans and fails to divide the complex relationships of these phenomena into their meaningful components is unsatisfactory. Furthermore, under what circumstances can the assumption be justified that changes in aggregates are independent of changes in their constituents? Assuming that the aggregates were composed of homogeneous elements, there would be no distinction between macroanalysis and microanalysis. Such an assumption, however, would obviously contradict reality. On the other hand, the assumption that aggregates follow “stochastic” laws rather than the causal laws of their elements would evidently signify the abdication of economic theory in its traditional sense. Finally, it might be contended that changes in the aggregates are accompanied by changes in the elements of precisely such a nature that regular and uniform growth of the aggregates results. In this case, the burden of proof rests on those who make such a claim.
The dilemma resulting from attempts to separate movements of aggregate quantities from the happenings in the individual markets may be illustrated by an example. The “production function” is a basic concept of modern macroeconomic theory.11 Of these production functions the “Cobb-Douglas-function” is perhaps the best known. How is it possible for such a function to be valid and remain in a world of constant change? It could be so if all firms had the same production functions, but that can hardly be the case (our example of homogeneity.) In a world of heterogeneous individual production functions, constancy of the total function is possible only if the “steady growth” of the whole is accompanied by proportional progress in each sector. Economic growth is in reality, however, almost always accompanied by considerable fluctuation in the relative magnitudes of the individual sectors. This example shows where the improper abstraction of micro processes has led the model builders.
All thought is limited by the forms and modes it employs. Formalism, in opting for the functional mode making possible precise quantitative determinations within a closed system of variables, forgoes the possibility of making meaningful statements about human action. What we call “technical progress,” however, encompasses a diverse complex of interrelationships consisting of many kinds of actions (such as of entrepreneurs and consumers). It is not surprising that formalism, which in its analysis of growth cannot but concern itself with technological progress, can master only those few aspects of the problem that can be compressed into the narrow ducts of its own mode of thought.12
Technological progress, viewed here ex post, is defined as an accomplished fact, as an increase in the productivity of the factors of production, uniform over time. The fact that ex ante it is by no means sure which technological changes will signify “progress” and which not, that this can only be established as the result of the interaction of numerous production and market processes, is simply disregarded. The fact that in a market economy many entrepreneurs continually experiment with new ideas, each in his own way and in another direction, and that final success or failure is determined only by the market lies beyond the model builder's imagination. At the same time, some of the difficulties encountered by them within their own mode of thought can be most instructive.
When technological progress occurs in “embodied form,” that is, when machines built recently are more efficient than those built previously, the capital stock loses the homogeneity upon which the concept of the production function rests. Naturally one then attempts to introduce a new time function that will restore homogeneity. It is hard to see, however, why real productivity changes should conform to this function. The unqualified homogeneity of capital, once questioned, cannot be easily reinstated. Similarly, Kenneth Arrow's concept of “learning by doing” opens to us even broader and more intriguing vistas.13
To the formalist this means, first of all, that technological progress is a function not only of time, but also of the volume of production. No detailed argument is needed to show, however, that no ordinary production index could serve us here as an independent variable. In any case, these occurrences call for a more penetrating interpretation than that compatible with the functional mode of thought.
It is well known that experience in the use of tools and implements will often promote skills that permit their more effective use in the future. Technological progress is thus a concomitant of production as such. Clearly, we are dealing here with mental acts that turn experience into a new awareness, and then into new applications. Certainly, many errors are made in the process. Inequality of men once more becomes apparent in their unequal ability to learn by experience, a process that requires a certain amount of mental alertness. There can be no question of quantitative precision here.
Formalism, again, avoids coming to grips with these difficult problems, inaccessible to its methods. It postulates a functional relationship between aggregate quantities that would, even in the best of cases, prove nothing. The actual conditions of this interesting type of progress lie in the individual abilities of various producers and their influence on others, and not in the quantitative properties of aggregate wholes.
SOME GUIDELINES FOR THE DEVELOPMENT OF A THEORY OF A MARKET ECONOMY
What then should be done to correct these deficiencies in economic models and broaden the conceptual basis of the market economy? To this question I can, within the framework of this essay, give no adequate answer. A few short hints to ideas that might serve as guidelines for a reconstruction of market economic theory, as it has now become necessary, will have to suffice. While a complete outline of market economic theory cannot be presented here, a few hints as to the style of our new edifice and the place of some of its parts in the whole design are in order. In doing so the major deficiencies of today's economic models should be avoided as far as possible.
These models all suffer from the same defect: an exaggerated significance is attributed to equilibrium concepts, and a consistency that does not exist is ascribed to the plans of individuals. To the contrary, room must be left for the unavoidable inconsistency of plans. We must be able to speak not only of unsuccessful plans and malinvestments, but also of the revision of such plans. Essentially, each new plan rests on a revision of an earlier plan.
Functionalism in neoclassical formalism requires a closed system of variables, in which the magnitudes of a number of dependent variables are determined by functional relationships. It is easy to see why such a mode of thought cannot do justice to the market economy, which by its very nature is an “open system.” In the systems of Léon Walras and Vilfredo Pareto, to choose the best known example, equilibrium prices and quantities of goods are determined by the magnitudes of the data. In actual markets, however, no one has such access to the complete constellation of data as would enable them to arrive at the equilibrium quantities and adjust his action to them. At best, one is familiar with the data directly concerning him. For the rest, he depends on conjectures, and for these, again, on inferences from available information. The market as a whole is fed by a broad stream of knowledge, which, although it flows constantly, provides each person with different information. The same information will be interpreted differently by an optimist and a pessimist. The same objective possibility will be used differently by an aggressive and by a restrained actor. In an uncertain world, in which economic agents are dependent on their expectations, a general coherence of plans is almost impossible. The objective existence of “data” that no one knows in their entirely is without significance.
The market economy is thus an “open” system, to which justice can hardly be done by the functionalist mode of thought. It requires, to the contrary, an “open” mode of thought that leaves room for the, at least temporarily, uncoordinated action of economic agents. Such a mode of thought of course does not permit “precisely” determined relations between quantities. It should help us to clarify, however, the manner in which human action is constantly oriented toward events; the interpretations of those events, which themselves change over time, the manner in which ideas are integrated and transformed over time into plans; and the manner in which all action flows from mental acts. In this sense, we may contrast the “genetic-causal” method with the functional one.14 I should like to illustrate this point with two examples.
During the market process the participants orient themselves by each other's actions. Since dissimilar expectations cannot all be accurate, plans based on different expectations cannot all be successful. The market determines success and failure and forces unsuccessful actors to revise their plans. In this way the market process becomes a process of selection of the currently successful. This selection is the necessary result of the original inconsistency of the plans. In a game there cannot be only winners.
Success or failure of a plan is expressed in a capital gain or loss; for every plan requires a capital combination in which the stock of fixed capital is of significance. The successful entrepreneur not only obtains a higher income. His stock of fixed capital will also rise in value, since through the success of his plan it now becomes the source of a quasi-rent income stream. The opposite is true for an unsuccessful plan. The unsuccessful entrepreneur even runs the risk, if he is in debt, of losing control of his capital combination. Even if this does not occur, a capital loss ordinarily restricts the sphere of operation of the entrepreneur.
We may thus regard the stock of fixed capital, which, despite limited economic versatility, forms the backbone of ever plan, as the vessel of the expectations for every plan. The market determines not only the distribution of income but also the distribution of wealth through changes in the value of capital goods.15 It is therefore highly misleading to maintain that the distribution of income in the market depends on the existing distribution of wealth. For the distribution of wealth changes constantly as a result of changes in the value of capital goods that accompany the success or failure of every plan.
The above throws some light on the function of the stock market in the market economy.16 Here, shares of different capital combinations, consisting essentially of fixed capital goods, are continually being evaluated. The stock exchange not only registers success and failure, but also expresses expectations about the prospects of plans already set in motion. The stock exchange may be viewed as the central forward market for future capital yields of indefinite horizon. Buyers and sellers on the exchange express their expectations about the chances of various plans, and thereby also evaluate the underlying capital combinations.
The function of the stock exchange is the same as that of any forward market, namely, to distill from many individual expectations a “market expectation,” finding its expression in the stock price, to which each interested person may orient himself. The equilibrium price of the stock market is determined, not by an “objective” body of information, but by the respective expectations of buyers and sellers. That this price changes from day to day indicates the sensitivity of the price-forming mechanism with regard to expectations, and not the impaired capability of the stock market to function; for the function of the stock exchange, as of any market, is not to guess the future but to reconcile, as much as possible, present actions that extend into an uncertain future.
As a second example I should like to use competition to illustrate the genetic-causal method. It is hardly necessary to show why the “perfect competition” of the textbooks is a thoroughly defective concept and can contribute nothing to our understanding of actual competition.17 Three points may be useful in the search for a better concepts of competition.
In the first place, as indicated previously, competition should be viewed as a chain of events rather than as a state of affairs.18 With competition as with the market as a whole, we are dealing with a process during the course of which the participants orient themselves to each other's actions. The most important point of orientation is here the size of the profits of competitors.
Second, we must discard the assumption, inherited from the classicists, that competitors all start from the “same position,” whereas monopoly involves “privilege.” On the contrary, the value of competition is precisely that buyers have a choice among unequal services. No one doubts that choice and decision are the most important attributes of the economic act. But what sense is there in a choice between equal services and identical goods? Here we see once again that the idea of “pure competition” springs from a mode of thought alien to meaning.
Third, two phases may be discerned in the process of competition, which constantly alternate. On the one hand, there is product differentiation, basically Schumpeter's “new combination,” and, on the other hand, there is the leveling competition of imitators of a successful innovation. Both phases are necessary and complementary elements of the competition process. Without innovation and product differentiation there would be nothing to imitate, and competition could not exist. Without constant competitive pressure from imitators of successful innovations, innovations would remain a permanent source of monopolistic or oligopolistic income.
For economic progress and the functioning of the market economy, the first phase is as necessary as the second. How could aircraft, cars, phonographs, and so on of fifty years ago have been developed to their present forms without constant product differentiation? All progress, especially progress through quality improvements, calls for continual experimentation in different directions. The market passes its final judgment on the technological knowledge gained in this fashion.
Of the second stage of the process, or “competition in the narrower sense,” little of a general nature may be said, other than that, here also, equilibrium concepts hinder rather than promote understanding.
Without price-cost differences no competition can exist in the sense of activity directed toward increasing one's share of the market. On the other hand, competition constantly diminishes these differences. For formalism this means that “ultimately” prices will everywhere be equal to costs. With regard to the actual market economy such a statement is meaningless; for reaching such a final stage simply means that the process of competition consisting of the two phases has come to a standstill. The continual emergence of new combinations with temporary profit possibilities in the first phase alone gives meaning to the leveling process of the second phase.
I have attempted to show why our thinking on the market economy has nothing to learn from contemporary economic theory, as long and insofar as it is dominated by formalism, and why its exponents will in the future have to go their own way. In the first section I briefly indicated those problems that seem especially important in the present situation. In the third section I attempted to outline a method that, in my opinion, promises to do justice to the actual tasks of market economy theory.
In evaluating the prospects of this undertaking, two points must be taken into account. On the one hand, formalism in its triumphal march through the contemporary world has met with resistance. On these islands of resistance we find schools of economic thought with roots in a tradition older than the one borrowed from the natural sciences, a tradition aimed at a meaningful understanding of human action. Although neoclassical formalism may justifiably invoke the analytic methods of its classical ancestors, nevertheless the subjective theory of value and the discovery of the significance of expectations have been achievements of the other tradition. This tradition survives even in this era of formalism. We should take it up again. Besides the work of Eucken and his disciples, there are above all the contributions of the praxeological school, of Mises, Hayek, and Röpke.19 Furthermore, there is rich material in the field of economic history that can be utilized in the development of market economic theory. I refer here to the essays in Capitalism and the Historians20 and the excellent work of Fritz Redlich.21 Finally, it is a historical fact that, even in regard to economic growth, the market form of economic organization has been the most successful. It is a sign of the times that the recipes for rapid growth being peddled everywhere stem from the kitchen of formalism, even though economic history, whose phenomena to be sure have to be interpreted, offers abundant evidence of the true causes of economic progress.
[]Grundsätze der Volkswirtschaftslehre [Foundations of Political Economy] (Vienna, 1871); 2d ed. By Karl Menger, Jr. (1923); translated as Principles of Economics (Glencoe, Ill., 1950).
[]2. J. A. Schumpeter, History of Economic Analysis (New York, 1954), p. 918. “They [the Austrians], too, found the ladder. Defective technique only prevented them from climbing to the top of it. But they did climb as high as their technique permitted. In other words: we must see in he Jevons-Menger utility theory an embryonic theory of general equilibrium or, at all events, a particular form of the unifying principle that is at the bottom of any general-equilibrium system. Though they did not make it fully articulate, mainly because they did not understand the meaning of a set of simultaneous equations, and though they saw in marginal utility the essence of their innovation instead of seeing in it a heuristically useful methodological device, they are nonetheless, just like Walras, among the founding fathers of modern theory.”
[]W. Sombar, Die drei Nationalökonomien (Munich, 1930), pp. 136–37. “The result of our investigations is clearly established.... We could observe that the majority carried out its work with unclear and incomplete concepts of the essence of the scientific method. Only the relationists or functionalists, i.e., the adherents of the ‘mathematical’ school, have thought the problems through and arrived at a clear and consistent method. Every friend of lucid thought must therefore feel some sympathy for these economists. They alone, also, have earned the respected title of ‘exact’ researchers, which so many other adherents of the scientific method in economics have most unjustly arrogated to themselves.” (The last sentence is, of course, a sideswipe at Menger.)
[]J. G. Droysen, “Historik,” in Vorlesungen über Enzyklopädie und Methodologie der Geschichte (Munich: Hrsg. Von Rudolf Hübner, 1937).
[]Carl Menger, Untersuchungen über die Methode der Sozialwissenschaften und der politischen Ökonomie insbesondere. [Inquiries into the Method of Social Sciences and Particularly Political Economy] (Leipzig, 1883); translated as Problems of Economics and Sociology (Urbana, Ill.1963).
[]W. Sombart, op. cit., p. 159.
[]Ludwig von Mises, Grundprobleme der Nationalökonomie (Jena, 1933), p. 67n; translated as Epistemological Problems of Economics (Princeton, 1960).
[]W. Jaffe, “Unpublished Papers and Letters of Léon Walras,” Journal of Political Economy, 1935, p. 200.
[]L. Mises, op. cit., p. 125.
[]Only for land is this not valid. Ricardo's rent theory rests on the heterogeneity of land.
[]H. Mayer, “Zur Frage der Rechenbarkeit des subjektiven wertes,” in Festschrift für Alfred Amonn (Bern, 1953), p. 76, n. 6. “The exact conception of the process by itself and the feel for language should have made it clear that to speak of subjective values as though they were a property of goods, is an elliptical and at bottom misleading way of expression: we are dealing with the process of evaluation, and this takes place not according to ‘larger’ or ‘smaller,’ but according to a higher or lower position within a hierarchy.”
[]F. v. Wieser, “Das wesen und der Hauptinhalt der theoretischen Nationalökonomie,” in Gesammelte Abhandlungen (Tübingen, 1929), pp. 10–34.
[]H. Mayer, “Der Erkenntniswert der Funktionellen preistheorien,” in Die Wirtschaftstheorie der Gegenwart, 2 vol. (Vienna, 1932) 2: 147–239.
[]L. Illy, Das Gesetz des Grenznutzens (Vienna, 1948).
[]H. Mayer, loc. Cit., p. 150.
[]F. v. Wieser, loc. cit., p. 16.
[]M. Weber, “Die Grenznutzlehre und das psychophysische Grundgesetz,” in Gesammelte Aufsätze zur Wissenschaftslehre, 2d ed., 1951, p.396.
[]H. Mayer, loc cir., p.148.
[]A. Mahr, “Indifferenzkurven und Grenznutzenniveau,” Zeitschrift für Nationalökonomie 14 (1954): 325 SS.
[]Pareto saw very well how absurd it is to ask a poor peasant woman how many diamonds she would buy at a given price if she were a millionairess, but the logic of his system forced such assumptions upon him. Cf. V. Pareto, Manuel d' Economie Politique, 2d ed. (Paris, 1927), p. 260.
[]V.Pareto, ibid., p.170.
[]Leo Illy, Das Gesetz des Grenznutzens(Vienna, 1948), ch.6, pp. 183–238
[]F. A. Hayek, “Scientism and the Study of Society,” Economica 9 (1942): 267; 10 (1943): 34 ff.; 11 (1944) 27 ff.
[]F. A. Hayek, “Economics and Knowledge,” in Individualism and Economic Order (London, 1949), pp. 33–56.
[]L. Mises, loc. Cit., pp. 21–22.
[]Cf. E. Schams, “Die zweite Nationalökonomie,” Archiv für Sozialwissenschaft 64 (1930): 453 ff.; and “Wirtschaftslogik,” Schmollers Jahrbuch 58 (1934): 513 ff.
[]At least for the “state of long-term expectation,” General Theory of Employment, Interest, and Money (New York: Harcourt, Brace & World, 1936), pp. 147–49.
[]“Vollkommene Voraussicht und wirtschaftliches Gleichgewicht,” Zeitschrift für Nationalökonomie 6 (September 1935):
[]Monetary Equilibrium (London: W. Hodge & Company, 1939).
[]“The Coordination of the General Theories of Money and Price,” Economica 3 (August, 1936): 257–80.
[]Erik Lundberg, Studies in the Theory of Economic Expansion (Stockholm and London: P. S. King & Son, 1937), p. 175.
[]J. A. Schumpeter, Business Cycles, 2 vols. (New York: McGraw Hill, 1939), 1:140.
[]Ibid., p. 55.
[]Fortunatley not without exception. While, for instance, equilibrium theory takes the shape of production functions for granted. Professor Schumpeter's theory of Innovation, which is really a theory of entrepreneurial action, explains how in the course of economic development one production function comes to supersede another.
[]J. R. Hicks, Value and Capital (Oxford: Clarendon Press, 1959), p. 205.
[]“I define the elasticity of a particular person's expectations of the price of commodity X as the ratio of the proportional rise in expected future prices of X to the proportional rise in its current price.” Ibid., p. 205.
[]“Some people's expectations do usually seem to be in fact fairly steady; they do not easily lose confidence in the maintenance of a steady level in the prices with which they are concerned; so that, when these prices vary, their natural interpretation of the situation is that the current price has become abnormally low, or abnormally high. But there are other people whose expectations are much more sensitive, who easily persuade themselves that any change in prices which they experience is a permanent change, or even that prices will go on changing in the same direction.” Ibid., p. 271.
[]General Theory, pp. 168–72.
[]E. F. M. Durbin, The Problem of Credit Policy (London: Chapman & Hall, 1935), p. 103.
[]R. F. Harrod, The Trade Cycle (Oxford: Clarendon Press, 1936), pp. 124–25.
[]J. R. Hicks, op. cit., p. 282.
[]Ibid., p. 262.
[]Th. Wilson, Fluctuations in Income and Employment (London: I. Pitman, 1948), Ch. II, pp. 16–26.
[]G. L. S. Shackle, Time in Economics (Amsterdam: North Holland Publishing Co., 1958).
[]In Economia Internazionale, vol. VII, no. 4.
[]See L. M. Lachmann, “The Role of Expectations in Economics as a Social Science,” Economica 10 (February 1943): 15.
[]Of course, what is a useful concept always depends on what concrete problem we have to deal with. Whenever we have to describe a succession of events in chronological order, whether in society or nature, time as a continuum is an indispensable notion. We cannot but admire the Walrasian system, though we may recall the difficulties Walras had in trying to show how equilibrium is reached in actual market processes.
[]Cf. L. M. Lachmann, Capital and Its Structure (London: London School of Economics, 1956), pp. 23–34.
[]Ludwig von Mises, Human Action: A Treatise on Economics (New Haven: Yale University Press, 1949), p. 421.
[]Ludwig von Mises, Nationalökonomie (Geneva: Editions Union, 1940).
[]“Professor Mises and the Theory of Capital,” Economica 8 (November 1941): 409–27.
[]In Economica, 9 (August 1942): 267–91; 10 (February 1943): 34–63; 11(February 1944): 27–39.
[]See A. Stonier and K. Bode, “A New Approach to the Methodology of the Social Sciences,” Economica 4 (November 1937): 406–24.
[]When he says: “There is no mode of action thinkable in which means and ends or costs and proceeds cannot be clearly distinguished and precisely separated” (40), we take him to mean: within the sphere of adult life, a particular household and business life. But what about games? Within each game the distinction can be drawn, but is this the “end” for which we play them?
[]The two concepts were originally used by Professor Mayer in “Der Erkenntniswert der funktionellen Preistheorien,” in Die Wirschaftstheorie der Gegenwart, vol. 2 (Vienna, 1932).
[]Capitalism, Socialism, and Democracy (New York: Harper & Row, 1950), p. 175. See also Professor Hayek's criticism in Individualism and Economic Order (London: Routledge & Kegan Paul, 1949), p. 90n.
[]London: Macmillan, 1941.
[]“The operations of the managers, their buying and selling, are only a small segment of the totality of market operations. The market of the capitalist society also performs all those operations which allocate the capital goods to the various branches of industry. The entrepreneurs and capitalists establish corporations, and other firms, enlarge or reduce their size, dissolve them or merge them with other enterprises; they buy and sell the shares and bonds of already existing and of new corporations” (703–4).
[]Cf. L. M. Lachmann, “Complementarity and Substitution in the Theory of Capital,”Economica 14 (May 1947): 108–19.
[]J. R. Hicks, A Contribution to the Theory of the Trade Cycle (Oxford: Oxford University Press, 1950).
[]For instance, the American situation in 1929 was, in our opinion, an underconsumption situation. In fact, most of the underconsumption theories of the last twenty years are simply “historical generalizations” of the memories of 1929–33.
[]As Professor Mises's detractors will probably dismiss this as “armchair philosophy,” we may note what one of the most discerning students of modern business organization has to say on this subject: “On the whole it looks very much as if the ‘integrated’ business education tends to make a man unfit to be an entrepreneur by paralyzing his intellectual muscles, just as the training in mere technical skills of the business school of yesterday tended to unfit a man by destroying his vision. The more emphasis there is on ‘administration.’ ‘organization,’ ‘policy,’ ‘analysis,’ etc., the more there is emphasis on the known ‘right’ way of doing things and on routines rather than on the new—in short on the accepted, the safe, the bureaucratic way rather than on the way of the risk taker and the innovator” (Peter F. Drucker “The Graduate Business School,” Fortune 42 [August 1950]: 94).
[]With a welcome lucidity, Paul A. Samuelson characterized the essence of the cognitive method of formalism: “Implicit in such analyses there are certain recognizable formal uniformities, which are indeed characteristic of all scientific method. It is proposed here to investigate these common features in the hope of demonstrating how it is possible to deduce general principles which can serve to unify large sectors of present day economic theory” (Foundations of Economic Analysis [Cambridge: Harvard University Press, 1947], p. 70).
[]“In every problem of economic theory certain variables (quantities, prices, etc.) are designated as unknowns, in whose determination we are interested. Their values emerge as a solution of a specific set of relationships imposed upon the unknowns by assumption or hypothesis. These functional relationships hold as of a given environment and milieu” (ibid., p. 7).
[]“To my knowledge no formal model of resource allocation through competitive markets has been developed which recognizes ignorance about all decision makers' future actions, preferences, or states of technological information as the main source of uncertainty confronting each individual decision maker, and which at the same time acknowledges the fact that forward markets on which anticipations and intentions could be tested and adjusted do not exist in sufficient variety and with a sufficient span of foresight to make presently developed theory regarding the efficiency of competitive markets applicable. If this judgment is correct, our economic knowledge has not yet been carried to the point where it sheds much light on the core problem of the economic organization of society: the problem of how to face and deal with uncertainty. In particular, the economic profession is not ready to speak with anything approaching scientific authority on the economic aspects of the issue of individual versus collective enterprise which divides mankind in our time. Meanwhile, the best safeguard against overestimation of the range of applicability of economic propositions is a careful spelling out of the premises on which they rest. Precision and rigor in the statement of premises and proofs can be expected to have a sobering effect on our beliefs about the reach of the propositions we have developed” (T. C. Koopmans, Three Essays on the State of Economic Science [New York: McGraw-Hill 1957], pp. 146–47).
[]A detailed survey of the state of growth theory at that time is offered by F. H. Hahn and R. C. O. Matthews, “The Theory of Growth: A Survey,” Economic Journal 74 (December 1964): 779–902.
[]J. von Neumann, Ergebnisse eines mathematischen Kolloquiums, ed. Karl Menger (Vienna, 1935–36).
[]Gustav Cassel, Theoretische Sozialökonomie (Leipzig, 1918), chap. 1, para. 6.
[]In what we might call a semiofficial pronouncement from the headquarters of neoclassical formalism, that, too, is freely admitted today: “Granted that an economy possesses a general equilibrium constellation of prices and outputs, if that constellation is not already in effect are there mechanisms in the economy that will bring it into being? ... Walras recognized this problem also, but was not able to give a satisfactory solution. In fact, the problem remains open to this day. We still do not have a satisfactory specification of the conditions under which the adjustment mechanism of an economy will guide it to its general equilibrium position” (Robert Dorfman, The Price System [Englewood Cliffs, N. J.: Prentice-Hall, 1964], pp. 107–8).
[]Lord Kaldor, “The Determinateness of Static Equilibrium,” in Essays on Value and Distribution (Glencoe, III., Free Press, 1960), originally in Review of Economic Studies 1 (February 1934): 122–36.
[]A notable exception is the incisive study by G. B. Richardson, Information and Investment (London: Oxford University Press, 1960), esp. chaps. 1 and 2.
[]See, for example, Fritz Machlup, Der Wettstreit zwischen Mikround Makro-theorien in der Nationalökonomie (Tübingen: J. C. B. Mohr, 1960).
[]“It is commonly called ‘neo-classical’ but the appropriateness of the description must surely be questioned. There is no ‘production function’ in Jevons or Marshall, Walras or Pareto, Menger or Böhm-Bawerk. There is in Wicksell, but he is careful to confine it to his model of ‘production without capital.’ J. B. Clark can hardly be regarded as a major neoclassical economist. The originators of the ‘production function’ theory of distribution (in the static sense, where I still think that it should be taken fairly seriously) were Wicksteed, Edgeworth, and Pigou” (John Hicks, Capital and Growth [Oxford: Clarendon Press, 1965], p. 293n).
[]On this see especially, F. H. Hahn and R. C. O. Matthews, “Theory of Growth,” pp. 825–52.
[]K.J. Arrow, “The Economic Implications of Learning by Doing,” Review of Economic Studies 29 (June 1962): 155–73.
[]The term “genetic-causal method of inquiry” originated with Sombart (Die drei National-ökonomien [Munich and Leipzig, 1930], p. 121) and was then taken over by Hans Mayer (“Der Erkenntniswert der funktionellen Preistheorien,” in Die Wirtschaftstheorie der Gegenwart [Vienna, 1932], 2:148–51).
[]See, for example L. M. Lachmann, “The Market Economy and the Distribution of Wealth,” in On Freedom and Free Enterprise: Essays in Honor of Ludwig von Mises, ed. Mary Sennholz (New York: D. Van Nostrand, 1956), pp. 175–87.
[]We trust our terminology will not cause a misunderstanding. Functionalism in modern sociology, whose terminology we use when we speak of the “function of the market” has, of course, nothing to do with the functionalism of formalistic economics.
[]F. A. Hayek: “The Meaning of Competition,” in idem, Individualism and Economic Order (London: Routledge & Kegan Paul, 1949).
[]“Competition is by its nature a dynamic process whose essential characteristics are assumed away by the assumptions underlying static analysis” (ibid., p. 94).
[]The word praxeology was first used in Mises's Nationalökonomie, Theorie des Handelns und Wirtschaftens (Geneva, 1940) (translated as Human Action [New Haven: Yale University Press, 1949]). We would like to take this opportunity to refer to the works of two American students of Mises: I. M. Kirzner, The Economic Point of View (New York: D. Van Nostrand, 1960); and M. N. Rothbard, Man, Economy, and State, 2 vols. (New York: D. Van Nostrand, 1962).
[]Capitalism and the Historians, ed. F. A. Hayek (Chicago: University of Chicago Press, 1954).
[]Fritz Redlich, Der Unternehmer (Göttingen, 1964).