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Thursday, March 31, 2011

Getting it Right or Knowing You Got it Wrong?

The Austrian edge.

There are many ways to explain the differences between standard approaches to economics and the approach of the Austrian school. In recent years much has been written, for example, about the Austrian theory of the business cycle and how it differs from Keynesianism in particular. In an earlier column I addressed a few aspects of these differences, but those are only some of the many issues that divide Austrians from the mainstream. Is there a broader difference that would help us understand all the more specific differences?

I think so. It is best seen in the way mainstream economics tends to define the fundamental question concerning the “optimal allocation of resources.” Economics tries to explain how resources might (or might not) get optimally allocated to their various possible uses. In a world of limited resources and unlimited wants, how do we ensure that resources are devoted to people’s most urgent wants?

Most standard economic models seek to demonstrate how, under certain conditions, resources will be allocated optimally by the free market. Those same models can also show that if the specified conditions do not hold, then resources will be less than optimally allocated. This generally referred to as “market failure” because free markets fail to achieve that optimal allocation. Many mainstream economists argue that government can step in and either change the conditions under which the market operates, or directly allocate resources itself, so that society reaches that optimal allocation pattern.

Notice that optimal allocation is the goal. In other words, what is valuable about markets is the degree to which they “get it right,” with the “it” being the resource allocation. Government intervention is deemed justified by people who believe that, in some cases, it can allocate resources better than markets can.

Fundamentally Different

For Austrians, the fundamental issue is not whether markets get it right. True, Austrians think markets are pretty good and governments quite bad in that respect. And even though Austrians might explain things differently from the mainstream, there are plenty of mainstream economists who would agree with those general conclusions. Note, though, that the question here is still about getting it right.

Where the Austrian view differs, I would argue, is in understanding that markets are also really good at helping people to know when resources are not optimally allocated and providing the signals and incentives needed to correct the mistakes. Being adept at getting things right at a given point is of course a good thing. But it is probably more valuable — given that we aren’t likely to get things perfectly right on a regular basis — to be able both to know when we are wrong and to have an incentive to do better.

Government Failure

This approach provides a way to see the problems government has in allocating resources even remotely well: It’s not just that government gets it wrong at various points but that political processes do not have the same error detection and correction abilities that markets have. Political actors are far less likely to know when they’ve erred and to have the right incentives to correct things. Government is not only less able to get it right; it’s also less able to know when it’s got it wrong.

A whole new light is now shed on the idea of “market failure.” In this more Austrian view, markets frequently “fail” by not allocating resources optimally at a given time. But calling this a “failure” ignores the Austrian point that what markets are particularly good at is telling us that resources are not optimally allocated and providing the knowledge and incentives necessary to correct the errors. From the Austrian perspective, “failure” should refer not to suboptimal allocation at a given time, but rather the inability to detect and correct error. If we understand that the crucial question is how well alternative processes do those things, we realize that supposed market “failures” are better seen as opportunities for market successes.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.