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Wednesday, August 19, 2009

A Triple Whammy for Austrian Economics

They say that when economic times are good businesses can get away with sloppy practices. In the intellectual world, however, it seems that sloppy thinking prevails in desperate times and important distinctions get thrown out the window.

A good example of this appeared recently in a March 4 New York Times article titled “Ivory Tower Unswayed by Crashing Economy.” Reporter Patricia Cohen suggests that in spite of the apparent failure of the free market in housing and finance in 2008, supporters of the free market have been surprisingly slow to change their minds. “Free market theory, mathematical models and hostility to government regulation still reign in most economics departments at colleges and universities around the country,” the story said.

To begin with, this reveals a naive view of how intellectual paradigms shift in the academy. Does the reporter expect that professors would so quickly abandon long-cherished beliefs or that in a few short months they would be summarily replaced by professors with “better” ideas? (It may be too much to expect of someone evidently unfamiliar with university tenure to be familiar with the concepts of Thomas Kuhn.)

That aside, there were three other things that bothered me about this article because they reflect serious untruths that have been spreading into the larger public discussion in the wake of the Panic of 2008.

Blaming the Free Market: Orthogonal Mindsets

First is the all-too-common bromide that the free market is wholly or at least primarily responsible for the current economic mess. There is no need to attack this notion here, owing to the numerous articles that have already been published within the last year, including in The Freeman, thoroughly refuting this fallacy.

As I’ve debated the issue in various public forums over the past few months, I’ve realized that there are two widely held and mutually exclusive views on how the situation came about and therefore on the best way to fix the problem.

One is that to get the economy out of slump, it’s necessary to understand how and why we got to where we are. Identifying the causes of the widespread poor judgment that produced this mess requires that we look for changes in the “rules of the game” that gave investors the incentive to create it. Then, having understood that, we must change the incentive structure so as not only to revive the economy in a way consistent with sound economic principles but also to ensure that we don’t wind up back here ever again. (Since this has been addressed elsewhere, it is not my concern here.) Although consistent with several schools of thought, one might call this the “Austrian view.”

The other perspective sees markets as dominated by the irrational drives and psychological proclivities of private investors. It’s therefore a waste of valuable time during a crisis to search for the causes of perverse incentives because all incentives are in a sense perverse or at least potentially so.

One popular version of this blames the housing and financial bubbles of the recent past on an epidemic of “greed.” It argues that a psychological shift occurred under the apparently more market-friendly regimes of the 1980s and 1990s that intensified investor avarice and prompted irresponsible lending and borrowing. Since private investment is the source of the problem, the solution lies in massive government spending to stimulate confidence and restart the economy. (It is not my intent to critique this view here.) I will call this the “animal spirits” view, after John Maynard Keynes, who made the expression popular.

The interesting thing is that, because each side approaches the present situation from such divergent perspectives, neither really understands the other. The approaches aren’t “opposed” but “orthogonal”–the debate is really never joined, and each side simply doesn’t “get” the other.

“Free-Market Economics” = Mathematical Economics?

Second, and what I find just as disturbing and even more puzzling as an Austrian economist, is the way the reporter tacitly equates what she calls “free-market economics” with mathematical economics, and in particular the mathematical economics of equilibrium-obsessed neoclassical economics. This is something I’ve encountered a lot lately. It surprises me because, of course, the truth is in most ways just the opposite.

Standard economics bristles with mathematics. I routinely tell my undergraduates who express an interest in getting a Ph.D. in economics to double-major in mathematics, or at least take as many electives as they can in calculus, statistics and probability, and linear algebra. Austrian economics, which most people who have heard the term associate with “free-market economics,” does not reject mathematical methods when appropriate, such as doing economic history or illustrating economic principles of supply and demand. But mathematics is most applicable in describing situations in which all plans are coordinated and no discoveries are left to be made–that is, in an “equilibrium.”

Now economic regularities, such as prices, do emerge, and we can say some valuable things about the context–the rules of the game, if you will–in which we can expect them to do so and why. But the highly complex processes in which this happens are not usefully described as an equilibrium.

Real markets are, somewhat paradoxically, both orderly and unpredictable: orderly because entrepreneurial alertness to profit opportunities within a given market tends to reconcile inconsistencies among the plans of individual buyers and sellers; and unpredictable because there is no perfect guarantee that any profit opportunity will be discovered.

The bottom line is that Austrian economists in general are highly skeptical of attempts to mathematically model real markets, especially for the purposes of prediction. The high-powered mathematics used by financial analysts to evaluate complex derivatives and assets built on securitized mortgages, for example, are now seen as fundamentally flawed precisely because of the oversimplifications (relative to the reality to which they are applied) they had to incorporate to make them mathematically tractable. (The work of Nassim Nicholas Taleb brings this out.)

Lumping Austrian economics with other “free market” approaches (leaving aside the appropriateness of this term) that use these dubious mathematical techniques thus strikes me as bizarre.

Reasoning from a False Premise

Finally, because for Cohen free-market economics equals neoclassical mathematical economics, the only alternatives she mentions in the article naturally are those that are anti-market. That is, if free-market economics is mathematical economics and if mathematical economics failed, then we must abandon free-market theory. “There are a handful of departments that have welcomed alternative theorists, like the University of Massachusetts, Amherst; the University of Massachusetts, Boston; the University of Utah; and the University of Missouri, Kansas City (where the Heterodox Economics Newsletter is published),” Cohen states.

The prevailing heterodoxy at these departments places them in opposition to free markets.

Is there an economics that doesn’t proclaim the virtues of mathematical virtuosity? Does that economics appreciate the ability of the entrepreneurial-competitive process to generate social order and cooperation? Does that economics therefore search for the causes to the present situation, not in animal spirits, but in the rules of the game that gave rise to perverse incentives? Unfortunately, Cohen never asks these questions, but the answer is in the affirmative: Austrian economics.

Economists during an economic crisis are as popular as weathermen during a hurricane. And so, like many of my colleagues, I’ve been doing more speaking before public audiences in the past several months, trying my best to clarify the situation. I’ve found, however, that there’s much hostility not only to the idea of free markets, but also to economists in general, and even much skepticism about whether economics is a science.

Fighting the public conflation of Austrian economics with the mainstream whenever the opportunity arises is one thing Austrians can do to help turn the intellectual battle around. This is an instance in which methodological issues need to take center stage.

  • Sanford Ikeda is a Professor and the Coordinator of the Economics Program at Purchase College of the State University of New York and a Visiting Scholar and Research Associate at New York University. He is a member of the FEE Faculty Network.