A Research Agenda for Austrian Economics (Elgar Research Agendas) 1800882254, 9781800882256

Citation preview

A Research Agenda for Austrian Economics

Elgar Research Agendas outline the future of research in a given area. Leading scholars are given the space to explore their subject in provocative ways, and map out the potential directions of travel. They are relevant but also visionary. Forward-looking and innovative, Elgar Research Agendas are an essential resource for PhD students, scholars and anybody who wants to be at the forefront of research. For a full list of Edward Elgar published titles, including the titles in this series, visit our website at www​.e​-elgar​.com​.

A Research Agenda for Austrian Economics Edited by

STEVEN HORWITZ

Distinguished Professor of Free Enterprise, Department of Economics, Ball State University, USA

LOUIS ROUANET

Assistant Professor, Department of Economics and Finance, University of Texas El Paso, USA

Elgar Research Agendas

Cheltenham, UK • Northampton, MA, USA

© Steven Horwitz and Louis Rouanet 2023

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2023937050 This book is available electronically in the Economics subject collection http://dx.doi.org/10.4337/9781800882263

ISBN 978 1 80088 225 6 (cased) ISBN 978 1 80088 226 3 (eBook)

EEP BoX

Contents

List of figuresvii List of contributorsix Introduction to A Research Agenda for Austrian Economicsxi Louis Rouanet 1

An Austrian perspective on militarism Abigail R. Hall

1

2

Monetary policy and business cycles: a post-crisis research agenda for Austrian economics Bryan P. Cutsinger

21

3

Austrian economics and mainstream entrepreneurship: retrospect and prospect David S. Lucas

45

4

Knowledge and incentive problems in regulatory studies: an Austrian perspective Diana W. Thomas and Michael D. Thomas

69

5

Reasonable disagreement: Austrian responses to behavioral economics Ennio E. Piano

89

6

EPE and the Viennese students of civilization Marta Podemska-Mikluch

113

7

Accounting and finance: capital and cost in economics Peter Lewin and Nicolas Cachanosky

129

8

An Austrian reassessment of the theory of “public goods”: what is left (and right)? Rosolino Candela and Vincent Geloso

145

v

vi

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Conclusion: Steve Horwitz (1964–2021): teacher, scholar, and public intellectual163 Peter J. Boettke Index169

Figures

2.1

Excess reserves of depository institutions, 1984–2020

28

2.2

Yields on long-term debt, 1984–2020

28

2.3

M1 and M2 money multipliers, 1984–2020

29

2.4

Share of cash assets to total bank assets, 1984–2020

30

2.5

Share of Federal Reserve to commercial bank assets, 2002–2020

31

2.6

Commercial bank deposits, loans and leases, and reserves, 1984–2020

32

2.7

Federal Reserve Assets, 2003–2020

35

2.8

Net revenues of the Federal Reserve system, 1984–202036

3.1

Articles citing Austrian journals over time

55

3.2

Articles citing Austrian journals by publication

55

6.1

Family tree of entangled political economy

115

vii

Contributors

Peter J. Boettke, George Mason University Nicolas Cachanosky, Metropolitan State University of Denver Rosolino Candela, George Mason University Bryan P. Cutsinger, San Angelo University Vincent Geloso, George Mason University Abigail R. Hall, University of Tampa Peter Lewin, University of Texas at Dallas David S. Lucas, Syracuse University Ennio E. Piano, Middle Tennessee State University Marta Podemska-Mikluch, Gustavus Adolphus College Diana W. Thomas, Creighton University Michael D. Thomas, Creighton University

ix

Introduction to A Research Agenda for Austrian Economics Louis Rouanet

Austrians prevailed academically more than most academics—including Austrians—know or care to admit. They convinced a large part of the economics profession, among other things, that utility was ordinal, that government ownership was ineffective,1 that economics could be applied to all human behavior,2 that macroeconomics should be price-theoretic,3 that macroeconomics should be based on dynamic as opposed to static theories,4 that socialism was unworkable, that institutions are crucial for explaining economic development, etc.5 Modern economics would look nothing like it does today without Menger’s intellectual heirs. And while it is true that many of the Austrians’ contributions were initially not well received, they resisted the test of time to such a large extent as to become fundamental and sometimes nearly uncontested. It is therefore expected that as some—but not all—“Austrian” insights and theories are adopted by scholars who do not identify as such, the meaning given to Austrian economics changes. This raises the question of whether there still is a distinguishable “Austrian school of economics,” or if, instead, it has won, meaning that its separate existence no longer fulfills a sufficient function for economic research (Williamson 2020). To a certain extent, references to the “Austrian school” are somewhat unfortunate as it never was a school and, although it originated in Austria, it was never exclusively Austrian. Instead, the “Austrian school” could be better described as the Austrian tradition; that is, as ways of thinking about the fundamentals of economic reasoning, passed down and developed through successive generations of members of that tradition. In that sense, Austrian economics is not a preconceived set of answers but rather a set of priors about how to think about human behavior. It is the economic way of thinking par excellence. xi

xii

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Austrians can, and in my opinion should, be the bulwark against repeated attacks on the economic approach to human behavior. These attacks, from behavioralism, sociology, narrow-minded empiricism or social science nihilists, give a renewed relevance to the Austrian tradition. One of the distinctive features of the Austrian tradition is that it places a lot of emphasis on providing solid epistemological foundations for economic science. Other traditions, for instance, the Marshallian tradition, do not.6 Mises’s (1949) goal in Human Action was to provide a solid basis for the logic of choice. Mises showed us the errors in the common tropes that utility maximization is a useful approximation or that rational behavior is a useful but obviously false assumption.7 In a sense, Mises defended with much greater fervor the economic approach to human behavior than Becker, Friedman, or Coase ever did. Indeed, Mises argued, the only way to interpret human behavior is to understand individuals as rational beings—as individuals intentionally trying their best to achieve their ends with the limited means they have. Without key concepts such as means, ends, preferences, cost, etc., human behavior is doomed to remain a mystery. For many economists, praxeology—i.e., the logic of choice—is something you should use if it produces better predictions as a theory. However, the point was never that praxeology is a theory, nor that it yields predictions, but only that applied theories of human behavior must be grounded in the logic of choice. The logic of choice by itself is tautological (people do the best they can, as can be attested by the fact that they do it). Only when we specify preferences and constraints can the logic of choice yield potential explanations—i.e. predictions. To do applied economics, we need to break out of the tautology, but we should not break the tautology.8 Armed with a superior understanding of the foundations of economics, Austrians have made important contributions to applied economics in recent years. To name just a few: one advance is the development of an economic theory of superstition squarely based on the serious interpretation of subjectivism (Leeson 2012a, Leeson & Suarez 2015). Another venue of research advanced by Austrians is the economics of self-governance (Stringham 2015, Leeson 2014a, Piano 2017). Austrians have also continued to contribute to macroeconomics.9 The recent development of cryptocurrencies has also spurred a new Austrian literature on decentralized moneys (Hendrickson et al. 2016, Hazlett & Luther 2020). From militarism (see Abby Hall’s chapter in this volume) to the family (Horwitz 2015) and sweatshops (Powell 2014), the applied Austrian literature has flourished.

INTRODUCTION

xiii

Economic history is another area of applied research where Austrians have had a fair amount of success.10 I hypothesize that the reasons for this success are: (1) the Austrians’ emphasis on theory; (2) the Austrians’ emphasis on good economic theories being about explaining the real world;11 (3) the Austrians’ emphasis on understanding agents in different historical contexts when trying to elucidate social phenomena. The massive fall in the cost of collecting and processing data has naturally led to a lower equilibrium consumption of theory by economists. In economic history, on the other hand, data is naturally scarcer and more incomplete and therefore requires greater investment in developing both workable theories and a solid understanding of the values and constraints individuals faced in different historical contexts. Despite the successes of those involved in the Austrian traditions, some dangers loom ahead. Of course, problems by themselves are no reason to be pessimistic if they are properly addressed. Yet addressed they must be. Scholars with different research agendas may identify different weaknesses in modern Austrian economics. I will take the vantage point of Austrian scholars who wish to do applied work. I will enumerate some pitfalls in the Austrian research agenda.

First. Meta-theorizing One danger for Austrians who want to do applied work is to spend an undue amount of time theorizing about how to best theorize. From this tendency comes the thoughtless dismissal of some theories as incompatible with Austrian methodology. Yet many of those theories, although not expressed in the preferred language of many Austrians, may nonetheless be useful. The propensity of some Austrians to engage in methodological warfare without any reference to how it enables us to explain empirical phenomena better is ironic when coming from scholars claiming to be methodological realists. The point of applied work is not to prove the superiority of the Austrian approach but to provide coherent explanations for regularities observed in the real world. Too often, when the primary goal of a paper is to convince the reader of the superiority of the Austrian approach, the empirics are poorly done. Only a few people care to know why Mises, Kirzner, or Hayek were in fact right and were great economists.12 Great applied work involves developing insights that other scholars will understand and find intellectually stimulating. Good applied work does not imply that the first thing that comes to a reader’s mind should be “Here is an Austrian take on X.”

xiv

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

The goal when doing applied work is not to be the “philosophical conscience of the economics profession” (Vaughn 1998, p. 167) but to cogently explain social phenomena. Catchphrases such as “spontaneous order,” “radical uncertainty,” “market processes,” “evolutionary procedures,” etc. certainly describe important theoretical insights, but they are no substitute for genuine economic reasoning. Showing and stating are two different things. For instance, stating that there are knowledge problems is not the same as showing under what constraints tacit knowledge comes to develop. The eagerness to prove the Austrians right is sometimes done at the expense of thorough reasoning.

Second. Misguided realism Another pitfall in the Austrian research agenda is the attempt to construct completely realistic theoretical accounts of individuals’ motives and meanings. Equally dangerous is the attempt of other self-styled Austrians to reject hypothesis testing altogether and pretend to rationally reconstruct history based on a priori—and perfectly realistic—economic theories.13 Let us here refer to Mises: The answer to the question whether or not definite theorems of praxeology apply to a definite problem of action depends on the establishment of the fact whether or not the special assumptions that characterize this theorem are of any value for the cognition of reality. To be sure, it does not depend on the answer to the question whether or not these assumptions correspond to the real state of affairs that the praxeologists want to investigate. The imaginary constructions that are the main—or, as some people would rather say, the only—mental tool of praxeology describe conditions that can never be present in the reality of action. Yet they are indispensable for conceiving what is going on in this reality. (Mises 2012, p. 37, emphases added)

Mises was clear, economic theories do not always apply—although the logic of choice always does—and their value does not depend on how realistic they are. Of course, models should comprise some fundamental features of reality, especially about both individual values and the constraints they face. Yet plenty is assumed away in all models. The logic of choice can never be tested empirically; the applicability of certain economic models can.14 A simple reading of Hayek’s Pure Theory of Capital or Rothbard’s Man, Economy and State reveals abundant uses of precisely unrealistic, but nonetheless useful, models.15 Maybe the most obvious example of this is the use of the “Hayekian triangle” where well-defined higher-order goods produce lower-order goods. In the real world, a good can simultaneously be a lower

INTRODUCTION

xv

and a higher order good. Hayekian triangles are unrealistic, and we need them to be unrealistic to study the roundaboutness of production in a tractable way. Too often, so-called “realistic” theories are no more than a classification of facts. There is no science of taxonomies. If the consequences of a theory imply the theory, just as the theory implies the consequences, then that theory isn’t one. Instead, it is just a reformulation of the empirical evidence.

Third. Not giving economic theory its due place Austrians sometimes make two contradictory statements that are difficult to reconcile. One is that preferences are only revealed in action—even agents may not know what their preferences really are before having to choose between alternatives. The second is that any properly applied economics requires knowing in great detail what people’s beliefs about means, ends, and the world are. Economics is the science of human action (Mises 1949). It is not a science of the meaning people give to their actions and certainly not the science of the meaning individuals give to the extended order surrounding them. It does not mean that individual subjective valuations have no place in economics. As Mises (1949, p. 27) argued, economics “cannot abandon reference to meaning and purpose.” In other words, economists have to pay attention to (1) what individuals’ objectives are, and (2) what alternative means they have identified as suitable to achieve their ends. Put differently, the applied economist needs to specify an objective function for the individuals in his model and the constraints these individuals perceive. This approach is not exclusive to Austrians but is used by all good economists. When economists specify a utility function, they specify valuations and beliefs about means and ends that they deem essential to explain some specific phenomenon. Setting a utility function and the relevant constraints is an exercise in understanding.16 But this is not enough. A utility function alone cannot yield explanations. Theory is needed. As Mises (1949, p. 66) puts it, “[Economics] adopts for the organized presentation of its results a form in which aprioristic theory and the interpretation of historical phenomena are intertwined.” It is because we seek an understanding of history that we need conception— formal economic theory. Without formalism, we are doomed to describe, not to explain.17 Analysis without formal theory leads to blindly transcribing events and human “meanings” by producing arbitrary taxonomies and without being

xvi

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

able to form any judgment about causes. Without formal theory, we are like headless chickens running around in search of facts to explain. It is impossible to develop a workable economic theory without some assumptions about preferences. Stable preferences would be one such assumption but not the only one. Workable theories require specifying value scales under alternative conditions.18 In the same way, asking individuals about their preferences can never be enough for the central planner to allocate resources, it can never be a sufficient foundation for formulating an explanation. When asking someone about his preferences, all we can hope to know is his marginal valuations of goods he currently consumes and his current beliefs about them—even accessing this is extremely uncertain. What we don’t know and need to make assumptions about is the value scale and beliefs that would prevail under different constraints! In plainer language, we always need to make assumptions about what the utility map looks like, even though we never have access to that knowledge empirically. Theory can help us sort the different, often contradictory, meanings we encounter in the available historical evidence. Imagine, for instance, that when reading reports of the secret police in 1795 Paris, we find that a fair number of them report that furious Parisians blame greedy merchants for the rapid rise in prices in November of that year. How much weight should the economist give to the Parisians’ assigned meaning of this market phenomenon? Not much because of economic theory. The greed explanation would not explain the timing of inflation, although it implies certain behaviors, such as reducing supplies to increase prices, which were not observed. In addition, even if we cannot find any data about these implied behaviors, we may know from theory that these behaviors are more or less likely to occur under certain conditions which are themselves observable. For instance, if we know, as we do, that industrial production in 1795 Paris occurred in thousands of small workshops, the overwhelming majority of which hired fewer than 50 people, we can reasonably infer that price competition must have been quite fierce. In this instance, the combination of facts and theory enables us to weed out the meaning some Parisians were giving to their environment.19 On the other hand, certain police reports pointed to the fear of demonetization of the Revolutionary paper money when describing the inflationary process. Here, theory would suggest that expected demonetization would reduce the value of paper money, and the beliefs about inflation are consistent with both theory and other pieces of evidence. Doing applied economics involves using the economic way of thinking to rule out relevant from irrelevant—and often contradictory—beliefs. Hayek was right to argue that the facts of social science

INTRODUCTION xvii

are what people believe and think. Yet facts don’t speak by themselves. We need formal theory to explain them.20 We often have no first-hand account of the agents’ meanings, values and beliefs. If we want to study the economic history of the Middle Ages, for instance, the few documents we have access to are not representative of the (mostly illiterate) population of that time. This does not mean that we can abstract from the preferences people had in that period. Yet what we cannot do, obviously, is ask them.21 Thankfully, we can often reasonably infer the values or beliefs of an individual from their observable actions.22 For instance, Crettez & Deloche (2018) use game theory to try to see if there are “valid reasons to confirm the possibility of a suicidal wish on the part of [Julius] Caesar.” Most of the time, applied theories of human behavior rely on reasonable guesses of individuals’ motives. But theory can also be useful to rule out certain motives in light of the existing historical evidence. In particular, the Austrian economist, having a solid grasp of the relationship and interconnections between means and ends, can analyze beliefs by looking at their impact on observable relationships and behaviors. Since choice between means involves the existence of substitution, we can analyze beliefs and non-pecuniary goods by forming theories about how a change in their demand would impact the price and quantity demanded of pecuniary goods. To paraphrase Pete Boettke, properly trained economists specialize in making sense of the senseless. I would add that this attitude is very different from the implicit attitude, all too common among some Austrians, according to which the only thing we know is that the world is a senseless chaos. Declaring that “the market is a process” or stating that agents face “radical uncertainty” is not, by itself, making any specific phenomenon intelligible.

Fourth. Behavioralism Some modern Austrians still accuse neoclassical economics of stubborn social hydraulics describing humans as hopeless automatons operating in a world of perfect information and perfect competition. Rejecting homo-oeconomicus, standard general equilibrium theorizing. etc., some Austrians have succumbed to the temptation of behavioralism.

xviii A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

I here will mostly refer to Ennio Piano’s excellent chapter in this volume, showing that behavioralism and Austrian economics are strange bedfellows. I will only add that the danger of behavioralism in Austrian economics, so well described by Ennio Piano, stems from a misreading of some themes in Austrian economics: for instance, the criticism of homo-oeconomicus and the use of equilibrium constructs. With respect to Mises’ (1949) criticism of homo-oeconomicus, it applies only to the view that economics deals only with behavior driven by “the intention of making the greatest possible material or monetary profit” (Mises 1949, p. 62). In other words, Mises was an economic imperialist long before Becker (1976). Mises’ criticism does not imply a criticism of modern mainstream economics or any endorsement of “bounded rationality.” The other misunderstanding is about the status of equilibrium constructs. Without equilibrium constructs, there is no way to make sense of individual choices. References to “disequilibrium” cannot yield explanations about human behavior because human behavior in disequilibrium is not constrained. Mises thought that much: The only method of dealing with the problem of action is to conceive that action ultimately aims at bringing about a state of affairs in which there is no longer any action, whether because all uneasiness has been removed or because any further removal of felt uneasiness is out of the question. Action thus tends toward a state of rest, absence of action. (Mises 1949, p. 245, emphasis added)

Some later Austrians rejected Mises’—correct—approach (O’Driscoll & Rizzo 1996). Not surprisingly, the proposed alternative approach yielded very little insights for applied work (Stein & Storr 2013). In disequilibrium we know nothing about how changes in constraints impact behavior. Hence, there are two approaches once we adopt the disequilibrium view: either we shrug and accept that we cannot provide any rigorous explanations of human behavior using economics, or we have to use other disciplines such as psychology to provide such explanations. In other words, the focus on disequilibrium leaves the door wide open to behavioralism and the subversion of economics.23 There are two competing views of the relationship between neoclassical economics and Austrian economics. The first sees Austrianism as completing neoclassicism. The other sees it as undercutting it. Sadly, those who deny that Austrian economics is a subset of neoclassical economics often end up either falling in the black hole of “anything goes” nihilism or rejecting economics altogether by embracing behavioralism.

INTRODUCTION

xix

Fifth. Adopting insulating strategies The fifth pitfall in an Austrian research agenda is the members of the Austrian tradition developing insulating strategies against developments originating both within and outside of the tradition. Any group generating some collective goods needs to prevent their value from being dissipated by its members’ opportunistic behavior. There can be several ways to prevent these behaviors, but one of them consists of raising the opportunity cost of leaving the group. One danger for Austrians is that raising the opportunity cost of leaving the group—for instance by deterring the acquisition of certain skills—may also make Austrian economics less attractive to the economics profession. Boettke (2019) points to the lack of horizontal relationships between Austrians and the rest of the economic profession. Yet, as he explains, those horizontal connections are necessary for an intellectual movement to gain broader acceptance. Here, Boettke (2019) rightfully emphasizes the importance of applied work in successfully building an Austrian research program. Yet Storr (2019) doubts Austrians can gain broader influence in the economics profession without abandoning Austrian economics. I would argue, on the other hand, that there is no way for Austrians to continue exerting an important and growing influence on the economics profession without reconnecting with their Austrian roots: the strict adherence to rational choice theorizing. I will posit that the main immunizing strategy used by Austrians is the inability to formulate arguments in ways that are intelligible to the broader profession. In particular, as explained by Beaulier & Subrick (2013), “the lack of Austrian articles in mainstream journals results from the lack of testable hypotheses in their arguments.” Describing a market as a spontaneous order, a historical case as showing the importance of entrepreneurship, or a particular event as being characterized by radical uncertainty, does not count as applied research. Notice that there is nothing in Mises or Hayek’s writings that prevents Austrians from formulating testable hypotheses. The great French economist Frédéric Bastiat once argued that “The worst thing that can happen to a good cause is, not to be skillfully attacked, but to be ineptly defended.” Doing work based on the foundations laid by the previous generations of Austrian economists is indeed a good cause. We, Austrians, cannot be complacent. The danger of falling in the pitfalls described above is that the absence of intellectual growth will disaffect young economists

xx

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

who would otherwise find it stimulating to work using the tools and insights bequeathed by earlier Austrian economists.

A Research Agenda for Austrian Economics: an overview When Steve Horwitz asked me to collaborate on this edited volume, we agreed that he would write the introduction while I would write the conclusion. Sadly, Steve left his friends and family too early after a long and courageous fight against cancer. Therefore, I had to write this introduction to the best of my ability. Steve would most likely have organized this introduction differently, and he should not be held responsible for any words written here. Above all, however, Steve believed that Austrian economics was alive and evolving. Being an Austrian does not (and shall I dare say should not) mean being a conformist among intellectual eccentrics. The contributors of this volume often have their own unique interpretation of what an Austrian research agenda should look like. Within the Austrian tradition more broadly, there are some who believe that Austrian economics is a subset of neoclassical economics, while others believe it is a radical alternative to the latter. There is no rigid dogma within the Austrian tradition. This is not a liability but an asset. It is a sign that Austrian economics is still very much alive. What are the questions Austrian scholars ask that others do not? The answer is: “too many!” There is no way to include all of the recent contributions made by Austrians in one volume. Instead, Steve and I agreed that we should invite younger Austrian scholars to have fresh and diverse perspectives on the future of the Austrian research agenda. The chapters in this volume, by the breadth of topics covered, testify to the applied turn Austrian economics took during recent decades. From monetary policy to militarism, from entrepreneurship to the theory and history of public goods, the contributors provide an overview of the Austrian-influenced research and the new directions it is taking. Hopefully, this volume honors Steve and provokes other scholars to engage and contribute to Austrian economics.

INTRODUCTION

xxi

Notes 1. Support for government ownership of businesses was almost unanimous among economists after the Second World War. This is no longer the case (Shleifer, 1998). Mises (1949) in 1949 was a lone voice arguing against state control. 2. See Mises (1949) and then Becker (1976). 3. See Hayek (1932) and Lucas (1995)—especially the opening quote. Hayek also anticipated by several decades advances in rational expectations theory. In an interview of Hayek by Armen Alchian, Hayek points that: “[My argument] began with becoming aware that all assumptions about prices are determined by what happened before are wrong, and that the function of prices is to tell people what they ought to do in the future.” Alchian responded by saying: “That’s the modern theory of rational expectations” (Hayek 1978). Boettke argues that relentless attacks by Austrians when Lucas was developing the rational expectations model was “the biggest mistake Austrians ever made” (Boettke 2009). 4. One macroeconomic tradition, to which the Austrians belong, maintains that we need to study the entire time horizon relevant for the question at hand. The other macroeconomic tradition—that of Keynes—deals only with how changes in present conditions change the present (McCandless et al. 1991). 5. Other areas where Austrian ideas either influenced or have been adopted by other researchers involve new monetarism—which develop formally Menger’s approach to money (Kiyotaki & Wright 1989, Nosal & Rocheteau 2011), and the creativity of the market process (Makowski & Ostroy 2001). 6. “For Marshall and the Marshallians, marginal utility plays a minor part in the main body of equilibrium theory. It is an embellishment to the theory of the market. If one wants to explain why the demand curve slopes downwards, well, the Law of Diminishing Marginal Utility may be invoked, if you like that sort of thing. It is a ritual to be repeated before the real performance commences!” (Robbins 1933, p. xvii). 7. “Human action is necessarily always rational.” Mises (1949, p. 18). 8. On this point, see Leeson (2020). 9. See for instance Cutsinger (2021), Luther & McElyea (2018), Hendrickson (2017), Lewin & Cachanosky (2020), Boettke et al. (2021). 10. See for instance the following few examples: Leeson (2011, 2012b, 2014b), Allen & Leeson (2015), Belzile et al. (2022), Candela & Geloso (2018), Piano (2021), Leeson & Piano (2021), Rouanet & Piano (2020, 2022), Cutsinger & Ingber (2019), Rouanet (2021, 2022), Cutsinger et al. (2020, 2022), Geloso & Rouanet (2021). 11. “[T]he end of science is to know reality. It is not mental gymnastics or a logical pastime. Therefore praxeology restricts its inquiries to the study of acting under those conditions and presuppositions which are given in reality” (Mises 1949, p. 65). 12. On this point, let me refer to David Lucas’ chapter in this volume. 13. One of the most foolish attempts to do this can be found in Hoppe (2015). 14. Here the attack by some Austrians on indifference curves analysis is among the most confused. Neither abstracting away from the discrete nature of economic units nor some of the more convoluted arguments about the impossibility of indifference are sufficient to give up this apparatus. McCulloch (1977) derive indifference curves purely from a means–ends framework with discrete units.

xxii A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

15. Mises (1949) also regularly uses simple fictitious models. For instance on page 747: “Let us assume that there are two countries only – Ruritania and Mauretania. In Ruritania the final wage rate is double what it is in Mauretania.” 16. Whether one likes verbal or mathematical language to set a utility function and the relevant constraints is a question of expediency, not one of principles. 17. Lachmann suggested that escaping from neoclassical formalism requires substituting intelligibility to causal explanation. Yet it very well seems that abandonment of the latter is the assassination of the former. Let’s also note that Lachmann’s view is a minority view among Austrians: “The sciences of human action by no means reject determinism. The objective of history is to bring out in full relief the factors that were operative in producing a definite event. History is entirely guided by the category of cause and effect” (Mises 1985, p. 93, emphasis added). 18. By value scale, one can think of the marginal rate of substitution along an indifference curve. That value scale changes as a change in the constraint changes real income. To assume a stable value scale is to assume that income does not change it and therefore one is making an assumption about preferences. 19. This example is derived from the applied research by Cutsinger et al. (2020). 20. “Understanding presupposes and implies the logical structure of the human mind with all the a priori categories” (Mises 2012, p. 44). Formal theory is not necessarily mathematical. 21. On this, Lemke & Kroencke’s (2020, p. 102) suggestion is completely off the mark. It is not true—and does not logically follow—that “[I]f it is true that beliefs about rules are the significant factor [...], we need access to the evidence on the variation in subjective beliefs about those rules. Given that those beliefs are invisible and unmeasurable with any known instrument, the only option left would seem to be to ask” (emphasis added). Notice that the authors would agree that the central planner cannot just ask about beliefs and preferences to access them and solve the problem of economic calculation. Somehow, however, the economist in doing applied work can access them by just asking. 22. “[Because] men renounce advantages which they could get from working more [...]. We infer from this fact that leisure is valued as a good” (Mises 1949, p. 65). 23. The confusion about the role of equilibrium is in large part a problem of semantics. For instance Mises’ (1949) “final state of rest” would probably be better described as a steady-state instead of as an equilibrium.

References Allen, D. W. & Leeson, P. T. (2015), ‘Institutionally constrained technology adoption: Resolving the longbow puzzle’, The Journal of Law and Economics 58(3), 683–715. Beaulier, S. A. & Subrick, J. R. (2013), ‘Understanding academic journal market failure: the case of Austrian economics’, Eastern Economic Journal 39(4), 444–463. Becker, G. S. (1976), The economic approach to human behavior, Vol. 803, University of Chicago Press. Belzile, G., Candela, R. A. & Geloso, V. (2022), ‘Regulatory capture and the dynamics of interventionism: the case of power utilities in Quebec and Ontario to 1944’, Public Choice pp. 1–27.

INTRODUCTION xxiii

Boettke, P. (2009), ‘Caplan and Boettke debate Austrian economics’. https://​www​ .youtube​.com/​watch​?v​=​WKJBss9p7Ts Boettke, P. J. (2019), What is still wrong with the Austrian school of economics? In Assessing Austrian Economics, Emerald Publishing Limited. Boettke, P. J., Salter, A. W. & Smith, D. J. (2021), Money and the rule of law: generality and predictability in monetary institutions, Cambridge University Press. Candela, R. A. & Geloso, V. J. (2018), ‘The lightship in economics’, Public Choice 176(3), 479–506. Crettez, B. & Deloche, R. (2018), ‘An analytic narrative of Caesar’s death: suicide or not? That is the question’, Rationality and Society 30(3), 332–349. Cutsinger, B. P. (2021), ‘Forced savings and political malinvestment: an application of Steve Horwitz’s microfoundations and macroeconomics’, The Review of Austrian Economics 34(2), 311–322. Cutsinger, B. P. & Ingber, J. S. (2019), ‘Seigniorage in the civil war south’, Explorations in Economic History 72, 74–92. Cutsinger, B., Ingber, J. & Rouanet, L. (2020), ‘Assignats or death: inflationary finance in revolutionary France’, Available at SSRN 3674658 . Cutsinger, B. P., Geloso, V. & Bédard, M. (2022), ‘The wild card: colonial paper money in French North America, 1685 to 1719’, European Review of Economic History 26(2), 185–207. Geloso, V. & Rouanet, L. (2021), ‘Can geography explain Quebec’s historical poverty?’ Available at SSRN 3950742. Hayek, F. (1978), ‘Friedrich von Hayek and Armen Alchian part I (u1008)’. https://​ www​.youtube​.com/​watch​?v​=​qNwceWargfs Hayek, F. A. (1932), Prices and production, George Routledge and Sons, Ltd, London. Hazlett, P. K. & Luther, W. J. (2020), ‘Is bitcoin money? And what that means’, The Quarterly Review of Economics and Finance 77, 144–149. Hendrickson, J. R. (2017), ‘Interest rates and investment coordination failures’, The Review of Austrian Economics 30(4), 493–515. Hendrickson, J. R., Hogan, T. L. & Luther, W. J. (2016), ‘The political economy of bitcoin’, Economic Inquiry 54(2), 925–939. Hoppe, H.-H. (2015), A short history of man: progress and decline, Ludwig von Mises Institute. Horwitz, S. (2015), Hayek’s modern family: classical liberalism and the evolution of social institutions, Springer. Kiyotaki, N. & Wright, R. (1989), ‘On money as a medium of exchange’, Journal of Political Economy 97(4), 927–954. Leeson, P. T. (2011), ‘Trial by battle’, Journal of Legal Analysis 3(1), 341–375. Leeson, P. T. (2012a), ‘An Austrian approach to law and economics, with special reference to superstition’, The Review of Austrian Economics 25(3), 185–198. Leeson, P. T. (2012b), ‘Ordeals’, The Journal of Law and Economics 55(3), 691–714. Leeson, P. T. (2014a), Anarchy unbound: why self-governance works better than you think, Cambridge University Press. Leeson, P. T. (2014b), ‘“God damn”: The law and economics of monastic malediction’, The Journal of Law, Economics, & Organization 30(1), 193–216. Leeson, P. T. (2020), ‘One rationality to rule them all’, Social Science Information 59(4), 563–568. Leeson, P. T. & Piano, E. E. (2021), ‘The golden age of mercenaries’, European Review of Economic History 25(3), 429–446.

xxiv A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Leeson, P. T. & Suarez, P. A. (2015), ‘Superstition and self-governance’. In New thinking in Austrian political economy, Emerald Group Publishing Limited. Lemke, J. & Kroencke, J. (2020), ‘Methodological confusions and the science wars in economics’, The Review of Austrian Economics 33(1), 87–106. Lewin, P. & Cachanosky, N. (2020), Capital and finance: theory and history, Routledge. Lucas, R. E. (1995), ‘Understanding business cycles’, Essential Readings in Economics, pp. 306–327. Luther, W. J. & McElyea, J. P. (2018), ‘Austrian macroeconomics in search of its uniqueness’, AIER Sound Money Project Working Paper (2018-05). Makowski, L. & Ostroy, J. M. (2001), ‘Perfect competition and the creativity of the market’, Journal of Economic Literature 39(2), 479–535. McCandless, G. T., Wallace, N. et al. (1991), Introduction to dynamic macroeconomic theory: an overlapping generations approach, Harvard University Press. McCulloch, J. H. (1977), ‘The Austrian theory of the marginal use and of ordinal marginal utility’, Zeitschrift für nationalökonomie 37(3), 249–280. Mises, L. v. (1949), Human action, Ludwig von Mises Institute. Mises, L. v. (1985), Theory and history, Ludwig von Mises Institute. Mises, L. v. (2012), The ultimate foundation of economic science, Liberty Fund. Nosal, E. & Rocheteau, G. (2011), Money, payments, and liquidity, MIT press. O’Driscoll, G. P. & Rizzo, M. (1996), The economics of time and ignorance, Psychology Press. Piano, E. E. (2017), ‘Free riders: the economics and organization of outlaw motorcycle gangs’, Public Choice 171(3), 283–301. Piano, E. E. (2021), ‘Specialization and the firm in renaissance Italian art’, Journal of Cultural Economics pp. 1–39. Powell, B. (2014), Out of poverty: sweatshops in the global economy, Cambridge University Press. Robbins, L. (1933), Introduction to: Common Sense of Political Economy. 2 vols. By Philip Wicksteed, London: Routledge and Kegan Paul. Rouanet, L. (2021), ‘The interest group origins of the Bank of France’, Public Choice 186(1), 119–140. Rouanet, L. (2022), ‘Foutu maximum the political economy of price controls and national defense in revolutionary France’, Available at SSRN 4066998. Rouanet, L. & Piano, E. E. (2020), ‘Filling the ranks: The remplacement militaire in postrevolutionary France’, European Review of Economic History 24(4), 696–715. Rouanet, L. & Piano, E. E. (2022), ‘Drafting the great army: the political economy of conscription in Napoleonic France’, The Journal of Economic History (forthcoming). Shleifer, A. (1998), ‘State versus private ownership’, Journal of Economic Perspectives 12(4), 133–150. Stein, S. & Storr, V. H. (2013), ‘The difficulty of applying the economics of time and ignorance’, The Review of Austrian Economics 26(1), 27–37. Storr, V. H. (2019), ‘On the status of Austrian economics’. In Assessing Austrian Economics, Vol. 24, Emerald Publishing Limited, pp. 81–87. Stringham, E. (2015), Private governance: creating order in economic and social life, Oxford University Press, USA. Vaughn, K. I. (1998), Austrian economics in America: the migration of a tradition, Cambridge University Press. Williamson, C. R. (2020), ‘Are we Austrian economists?’, The Review of Austrian Economics 33(4), 407–413.

1

An Austrian perspective on militarism

Abigail R. Hall

Introduction Militarism and heavy-handed interventionism are practical cornerstones of US foreign policy. Writing on what he terms the “new American militarism,” historian Andrew Bacevich (2005, p.  14) notes that “at the end of the Cold War, Americans said yes to military power. The skepticism about arms and armies that pervaded the American experiment from its founding, vanished. Political leaders, liberals and conservatives alike, became enamored with military might.” Discussions surrounding the issue of militarism have received substantial attention in recent years, particularly as it relates to the militarization of US domestic policing (see Diaz and Mountz 2020; Lowe 2020; Hall and Coyne 2013; and Coyne and Hall 2014b, 2018). But discussions of militarism are not new and not relegated to discussions of contemporary law enforcement agencies and tactics. This chapter aims to discuss the contributions of Austrian scholars to the discourse surrounding militarism and militarization and to offer ideas on where Austrian scholars may further contribute. The unique methodological perspective of those working within the Austrian tradition provides an opportunity for scholars to explore areas that would otherwise be neglected. The rest of this chapter proceeds as follows. In the next section, I outline the historical and contemporary literatures related to militarism and militarization. I then discuss how important figures within the Austrian tradition have contributed to our understanding of militarism. I provide an overview of some of the key themes from the Austrian school and illustrate how contemporary Austrian researchers have utilized these tools to enhance our understanding of militarism, militarization, and defense economics as a whole. Finally, I conclude with a discussion of areas particularly suitable for further inquiry.

1

2

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Existing literature Research on militarism is difficult to categorize neatly. This is due, in part, to the lack of a universal definition of the term itself. Van Tuyll (1994) offers three broad definitions of militarism. The first definition refers to the overall context of “militarization,” or how many resources a nation devotes to its military (e.g. military budgets). A second definition emphasizes how a given nation-state interacts with other nation-states within the context of military interventions, peace treaties, arms agreements, etc. Yet a third definition is more “cultural,” describing militarism as an adoption of, or adherence to military structures and operations, and veneration of the military. As Van Tuyll (1994, p.  519) notes, There are, of course, many variants and refinements of each of these [definitions]. Taken alone, none is entirely satisfactory. A high level of militarization might reflect only a response to a transient or temporary threat. Interventionist foreign policy can be the product of many things not related to militaristic attitudes.

When discussing issues of militarism or militarization, scholars often employ one or more of these definitions or alternative classifications. In their study of police militarization, for instance, Flores-Macías and Zarkin (2019, p. 6) define militarism and militarization along multiple dimensions, including weapons transfers, training, accountability, and organizational structure. Using these definitions, militarism is studied across multiple disciplines, though largely absent from contemporary economic analyses. A full review of the corpus of the contemporary literature on militarism is beyond the scope of this chapter. However, it is useful to emphasize some of the more common research veins and highlight how militarism is studied in these areas. Quantitative assessments of militarism rely almost exclusively on “militarization” and resource allocation as their operative definitions, as these items are more easily quantified. Scholars within this research vein utilize several measurements in their analyses, including funding, weapons transfers, troop deployments, military spending, etc. Although this definition necessarily narrows the scope of these analyses, the historical content of these studies is, perhaps surprisingly, wide. “[A]rms control advocates, pro-Soviet Marxists, and churches,” writes Van Tuyll (1994, p. 520), “defined militarism in terms of militarization.” Although examining the issue of militarization through radically different lenses, each of these groups utilized both this narrow definition and multiple quantitative approaches. Contemporary quantitative studies of

AN AUSTRIAN PERSPECTIVE ON MILITARISM

3

militarization are similarly broad in scope (see Acemoglu and Yared 2010; Delehanty et al. 2017; and Zafirovski 2020 for examples). Other analyses of militarism utilize alternative, broader definitions of the term. This allows for the examination of different types of questions but presents difficulties both in terms of data as well as determining appropriate research methodology. However, despite these challenges, these definitions are widely used in both historical and contemporary studies. The history and perpetuation of militarism have and continue to receive attention. The first widely recognized study of Western militarism is attributed to Vagts (1937). He distinguished between the “military way”—or the technical aspects of military operations, and “militarism”—the adoption of characteristics and attitudes that, while associated with the military, do not directly impact military capabilities. He argued that “unmilitaristic” societies were better equipped for actual military operations. Later treatments on the history of militarism cover both the United States and Europe and offer various explanations for the continued adoption of militarist attitudes in the West (see Donovan 1970; Ekrich 1956). More contemporary discussions of militarism have largely focused on the United States, its military engagements, and the factors contributing to the adoption of militarist attitudes. Within these works, scholars discuss several ideas and employ various frameworks from history, sociology, and political science. A common theme throughout this literature is the importance of foreign intervention, namely the Global War on Terror, in generating and perpetuating militarism both culturally and in matters of foreign policy (see Bacevich 2005; Boggs 2005; Coyne and Hall 2018, 2021; Gusterson and Besteman 2019; and Hossein-zadeh 2006). Other discussions of militarism are more narrowly focused. For instance, a growing body of literature examines the connections between militarism and economic development. This vein of research includes several of the aforementioned empirical treatments of militarization as well as examinations using the broader definitions of the term (see Acemoglu and Yared 2010; Dreze 2000; Irandoust 2018; Zafirovski 2020). Other researchers highlight the intersection of militarism and education (see Kershner and Harding 2019), militarism and professional sports (see Butterworth 2012; Lipsky 1981; and Wakefield 1997), and militarism and feminism (see Cockburn 2010; and Wibben 2018 for examples). The economic treatment of militarism, outside of statistical analyses related to militarization, is small and largely relegated to Marxist research. The discussion of militarism as a direct result of capitalism can be traced clearly

4

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

to the writings of well-known Marxists thinkers including Hobson (1902), Lenin (1908), and Liebknecht (1910). Lenin (1908), for example, wrote that militarism is the “vital expression” of capitalism. He argued that wars are the result of capitalist competition within the global context (i.e. imperialism). The militarization of labor became a key theme for many Marxist-Leninist thinkers during the Russian civil war. Trotsky developed the idea, and those responsible for Russia’s transition to communism viewed labor militarization as a necessary component of war communism. This “Red Militarism” remains a topic of interest and controversy in the literature, with questions regarding what motivated the Bolsheviks to implement such policies (see Albrecht 1980; Richman 1981; Daniels 2007 for examples).

Austrian contributions Key Austrian scholars and discussions of militarism Given that economic analyses of militarism are limited, it is unsurprising that “Austrian” treatments of the topic are also rare. Key Austrian scholars, such as F.A. Hayek, do not address militarization or militarism in any meaningful way. Others (e.g. Ludwig von Mises and James M. Buchanan) provide some discussion of militarism or war, but their treatments are far from comprehensive. Mises, Hayek, and Buchanan, however, all identify defense and security as a crucial function of government. While they did not thoroughly analyze militarism, some of their writings are relevant to review as they lay some important groundwork for future research. In Nation, State, and Economy, von Mises (1919) analyzes the consequences of war and considers the broader implications of World War I. He offers a defense of liberal (i.e. pacifist) nationalism and decries militaristic or imperialist nationalism. He argues that the former provides an avenue for continued peace while the latter only engenders perpetual conflict. Importantly for the Austrian research program as a whole, it is in this work where von Mises first offers an analysis of the perils of socialism as an economic system—an idea he would take up throughout the rest of his career (see von Mises 1920, 1922, 1940, and 1949 for examples). He details the nature of the “war economy” (1919, p. 115), its relationship to socialism as an economic system, and the implications of a socialist system for peace. He describes the differences between the war economy and socialism and the implications for citizen welfare. Mises concludes that while liberalism sustains peace and cooperation, socialism begets

AN AUSTRIAN PERSPECTIVE ON MILITARISM

5

the opposite—nationalism and war. (For a more detailed treatment of the insights of Nation, State, and Economy, see Coyne and Bradley 2019.) Two works from Buchanan figure in several contemporary Austrian discussions on militarism. The first is Buchanan’s (1949) conceptualization of conflicting theories of public finance. He explores what he calls the “organismic view,” in which public finance decisions are discussed as though a singular benevolent social welfare maximizer is making them. He contrasts this theory with the “individualistic view,” which focuses on how individual agents behave within various institutional contexts. While not related to militarism per se, contemporary Austrian scholars have used Buchanan’s work in this area to discuss these issues and highlight other inherent problems in how current literature models issues related to defense more generally (see Coyne 2015; Hall 2020). Elsewhere, Buchanan (1975, pp. 95–97) describes what he calls the “protective state.” This state, emerging at the constitutional level, is responsible for defending the rights of citizens from a variety of threats, both internal and external. This conceptualization of the state figures prominently in discussions of defense and militarism within the Austrian tradition as they confront the problems of the managerial-administrative state (see Coyne 2015; Coyne and Hall 2019). In his books, Rivalry In Central Planning: The Socialist Calculation Debate Revisited and National Economic Planning: What is Left, Don Lavoie (1985a, 1985b) takes up the issues of the socialist calculation debate of the 1920s and 1930s in which Mises and Hayek developed their critiques of comprehensive socialism. Absent a comparable mechanism to the price system, planners face critical “knowledge problems” that would prevent successful top-down planning (see von Mises 1920, 1922, 1940, 1949; and Hayek 1945). In Rivalry, Lavoie makes the case that the debate between the Austrians and the socialists was not settled and that market socialists had ultimately failed to answer the primary concerns of their Austrian critics. Those who attempted to answer Mises and Hayek failed to appreciate that state ownership of the means of production necessarily precludes the development of market prices, thereby rendering rational economic calculation impossible. In National Economic Planning, Lavoie extends this critique and introduces the concept of “noncomprehensive planning.” For Lavoie, non-comprehensive planning, in which the state controls parts of the economy while the remainder is left to operate freely, is similarly untenable. Relevant to the discussion of militarism, he concludes that “[t]he practice of planning is nothing but the militarization of the economy” (Lavoie 1985a, p. 230). In other words, planning within the piecemeal context of non-comprehensive planning requires the introduction of an apparatus similar to that of the military (see Coyne and Hall 2019).

6

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Contemporary Austrian contributions to defense and militarism Highlighting the contributions of the Austrian tradition on the topic of militarism necessitates an understanding not only of the aforementioned literature on the topic itself, but also of the broader field of defense economics. Defense economics emerged as a distinct economic subfield in the 1960s (for more comprehensive overviews of the field, see Hartley 2007a; and Coyne and Mathers 2011). Some of the earliest models examined issues such as alliances (see Olson and Zeckhauser 1966), arms races (see Richardson 1960; and Schelling 1966), military procurement (see Peck and Scherer 1962), and revolutions (see Tullock 1971). Relevant topics within the field have shifted and expanded over time. In addition to these early topics, the defense economics literature now hosts discussions related to arms proliferation and arms sales (see Levine et al. 1994; Sandler 2000; Hartley 2007b; Brauer and Dunne 2011; Coyne and Hall 2014b for examples), civil war (see Anderson and Tollison 1991; Collier and Hoeffler 2007; Garrison 2008), conscription (see Rouanet and Piano 2020, forthcoming), and terrorism (see Enders and Sandler 1995; Anderton and Carter 2005; Rubbelke 2004; Sandler and Arce 2007; Rosendorff and Sandler 2010). Other topics include analyses of the defense industrial base (see Dunne 1995; Neuman 2010; Dunne et al. 2007; and Duncan and Coyne 2013a, 2013b), coups (see Acemoglu et al. 2010; Singh 2014), and alternatives to war (see Cortright and Lopez 2011; Rosato 2011; and Zartman 2011), among many others. Austrian scholars within this field examine many of these issues, utilizing insights and themes that would be familiar to those within the Austrian tradition. In his analysis of the field of defense economics, for example, Coyne (2015) highlights several problems with the current literature, including the core theoretical assumptions regarding (1) the knowledge held by defense planners, (2) the level of analysis occurring at the nation-state as opposed to the individual actors within those states, and (3) the neutrality of intervention with respect to private economic activity and domestic political institutions. Coyne (2008), Coyne and Mathers (2011), Coyne and Hall (2019) and Hall (2020), draw extensively from the critiques developed by Mises and Hayek to discuss the inherent epistemological problems within the development and implementation of a variety of military interventions. They show how these knowledge constraints have led to a number of unintended consequences, from undermining defense policy abroad, to engendering significant institutional changes domestically. Coyne and Goodman (2020) argue that by focusing on defense as a public good provided by a nation state, orthodox economic models of defense neglect the importance of diverse institutions and individuals and, therefore, fall short in their analyses. In their analyses of the

AN AUSTRIAN PERSPECTIVE ON MILITARISM

7

defense industrial base, Duncan and Coyne (2013a, 2013b, 2015), illustrate how individual incentives facing individuals within and around the defense sector shaped the permanent war economy. Their analyses cuts firmly against standard models of defense in which those tasked with producing defense are assumed to generate the optimal quantity and quality of defense activities. Their work illustrates the importance of individual choice and explores the implications for reform. Drawing on insights from Kirzner (1973, 1997) and Lavoie (1986), Coyne et al. (2016) illustrate how the institutional structures of the defense sector incentivize unproductive entrepreneurship during both peacetime and times of war. Unlike market institutions in which individuals face an incentive to engage in welfare-enhancing (positive-sum) interactions, the institutional constructs of the defense sector generate alternative forms of entrepreneurship that may transfer or destroy wealth. The Austrian method offers unique insights into the phenomenon of militarization and militarism specifically. By employing a different methodology than what is typically utilized and by questioning the underlying assumptions of many models, Austrian scholars enhance our understanding of militarism along multiple margins. In particular, Austrian research has provided insights into understanding the process of militarization as it relates to resources and materiel being devoted to defense and defense-adjacent sectors. Using their unique methodological approach, Austrians have effectively brought economic insights into the “cultural” discussions of militarism. It is worth discussing some of the key themes from the Austrian literature more generally before turning to a more detailed analysis of specific contributions. The unit of analysis for Austrian discussions of militarization and militarism is profoundly different from other treatments. While other discussions of militarism focus on the nation-state or other aggregate units (e.g. “police”) and treat these aggregate units as a singular actor, Austrian scholars remain steadfastly committed to methodological individualism, arguing that only individuals face incentives and make choices. Groups or other larger organizations do not plan. Only the individuals within these groups do. Social phenomena, militarization and militarism included, must necessarily be examined within the context of individual purposive human action. Individuals undertake behaviors they perceive will make them better off. Individual choices and behavior may consistently be discussed within a means-ends framework whereby an individual will undertake an action he or she believes will move them to a preferred state. Unlike other treatments of various defense-related topics, Austrian treatments do not focus on the presence of some equilibrium where, with known and fixed prices, individuals or policymakers search out “optimal” outcomes. Instead, those within the Austrian school focus on how various institutional structures

8

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

influence individual behavior and the processes through which changes occur in market and nonmarket spaces. Austrian scholars also place an important emphasis on epistemological constraints. Just as Mises and Hayek argued that central planners lacked the knowledge to engage in rational economic calculation, Austrian research into defense economics more generally, and militarism more specifically, likewise illustrate that top-down planning, even in a piecemeal context, is subject to the same errors as comprehensive planning (see Coyne and Hall 2019; Hall 2020). Austrian discussions of militarization and militarism appreciate these constraints and highlight that outcomes are not predetermined, but emergent within ever-evolving complex and open-ended systems. These analyses reject outright the idea of a known singular welfare function that government agents, acting as some homogeneous unit, attempt to maximize. Instead, Austrian researchers within this arena appreciate that knowledge is dispersed, tacit, and discovered. Individuals within government and within markets act based on their own preferences and goals and respond to the incentives generated by the institutions in which they act. The concepts of intervention and neutrality are recurring themes in Austrian treatments of defense economics and militarism and militarization and within the Austrian school more generally (see Hayek 1935, 1966; von Mises 1940, 1977). Interventionism refers to the use of discretionary power by policymakers to replace the desires of private individuals with the desires and preferences of policymakers. Interventionism assumes that policymakers know how to allocate scarce resources, can alter any given intervention as conditions change, and know what outcome would have occurred absent the intervention so as to design and realize a more preferable outcome. Mises originally discussed these dynamics within the context of price controls and then further expanded his discussion (see von Mises 1940). He highlighted how, when faced with the failure of an intervention, policymakers can choose to: (1) admit failure and remove the intervention, or (2) engage in further interventions (e.g. regulations, subsidies, etc.). Mises and Hayek discussed the concept of neutrality with respect to money in their debates with Keynes on monetary policy in the 1930s. Essential to the Mises–Hayek critique is the idea that money is non-neutral and impacts real prices. As opposed to a change in the money supply resulting in an immediate and proportional change across the economy, they highlighted that monetary expansions do not occur instantaneously or in unison. Those receiving new money early in the expansion benefit at the expense of those who receive new money later. As a result, monetary interventions into the economy set off a chain reaction of unintended consequences, forming the basis of Austrian business cycle theory (see von Mises 1912, 1990).

AN AUSTRIAN PERSPECTIVE ON MILITARISM

9

For the study of defense and militarism, discussions of interventionism and the concept of neutrality are applied broadly to any number of government activities (e.g. surveillance, war, nation-building, etc.). In each of these cases, research from within the Austrian tradition highlights the dynamics of interventionism outlined above and how these interventions are non-neutral with respect to their implementation. Intervention in one part of a complex system can impact other parts of the system in unexpected and undesirable ways. For example, Coyne and Hall (2016, 2018) illustrate several cases where foreign intervention abroad generates a variety of long and variable unintended consequences domestically. Entrepreneurship plays a critical role in Austrian discussions of militarism as well. The neoclassical model views market “competition” as some steady state. In such a conceptualization of the market, there is no room for entrepreneurship or the entrepreneur. Within the Austrian tradition, however, competition is not some state of affairs but a process where entrepreneurs, alert to heretofore unforeseen opportunities, are able to earn a profit. The knowledge discovered as a part of this process works to move scarce resources toward a more efficient allocation (see Kirzner 1973, 1979, 1992, 1997, 2000). Within this broader discussion, the concept of “political entrepreneurship” is important. Political entrepreneurship is an extension of the theory of the market entrepreneur into the realm of politics. Just as entrepreneurs are alert to profit opportunities within the market context, political entrepreneurs are similarly alert to profit opportunities in the political arena (see Boettke and Coyne 2009; DiLorenzo 1988; Holcombe 2002; Podemska-Mikluch and Wagner 2010; and Wagner 1966). Perhaps the earliest “Austrian” studies on militarization and militarism specifically come from Higgs’ discussions of economic history and government growth (Higgs 1987, 2004, 2005, 2007). Higgs’ work most closely relates to the first definition of militarism. In explaining how government expands, he offers an account of how progressively more resources are channeled to the US military. The dynamics of interventionism and concepts of non-neutrality are readily apparent throughout his work on the topic. In Crisis and Leviathan, Higgs discusses the role of crises in expanding government and expanding the “warfare state.” The presence of crises—whether real or perceived—provides an opportunity for the government to engage in various interventions. This “ratchet effect” allows for marked increases in the scale and scope of government (Higgs 1987, pp.  57–76). As citizens become more permissive of government action in order to combat a supposed crisis, Higgs highlights that supposedly temporary interventions may very well become permanent.

10

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Moreover, as the dynamics of intervention laid out by Mises suggest, the expansions highlighted by Higgs have the effect of setting off a cascade of other interventions. As policymakers look to correct the unintended consequences of their original intrusions, they engage in further intervention. Higgs highlights this dynamic in Resurgence of the Warfare State. He examines how, following the crisis of the 9/11 terror attacks and the start of the war on terror, the US government undertook massive expansions in the areas of defense and national security, greatly expanding government reach and building upon previous interventions. Following Higgs, the vast majority of the Austrian literature on militarism and militarization comes from Coyne, Duncan, and Hall (see Coyne 2005, 2006, 2007, 2008, 2011, 2015; Coyne and Hall 2014a, 2014b, 2014c, 2016, 2018, 2021; Duncan and Coyne 2013a, 2013b, 2015; Hall 2020; Hall and Coyne 2013; Hall et al. forthcoming). These studies build upon the frameworks developed by Higgs and address multiple topics related to militarization and militarism. For instance, Duncan and Coyne (2013a, 2013b, 2015) contribute to the understanding of how additional resources come to be channeled toward the military. Through detailed examinations of relevant institutional structures, they disentangle the incentives actors face within and surrounding the defense-security sector. Through this work, they offer a novel explanation for the development, perpetuation, and expansion of a “permanent war economy” within the United States. Their emphasis on individual actors within these sectors provides powerful insights related to increases in government spending on the military and military-adjacent sectors. Related to this work on the permanent war economy more generally, Coyne et al. (2016) and Goodman (n.d.), utilize Austrian conceptualizations of entrepreneurship and entrepreneurial processes to explain the continued increase in spending on military-related activities and the expansion of these activities into other sectors. Coyne et al. (2016), for example, examines the functioning of the military contracting process during both peacetime and times of war. They argue that the network of government bureaus and private firms that comprise the military sector, in combination with military procurement processes, creates an environment that rewards unproductive entrepreneurship (i.e. zeroor negative sum) behaviors during times of peace as well as conflict. Goodman (n.d.) explores how American border security agencies have increased their use of military hardware and tactics and engaged in closer collaborations with US military and intelligence personnel. Building on Higgs’ work related to crises and the Austrian literature on entrepreneurship, Goodman argues that crises created profit opportunities for political entrepreneurs who then sought to expand the militarized components of border security. This militarization,

AN AUSTRIAN PERSPECTIVE ON MILITARISM

11

in turn, provided new opportunities for political entrepreneurs, further incentivizing increased militarization. Related to Goodman’s analysis of border militarization, Hall and Coyne (2013) and Coyne and Hall (2014a, 2016, 2018) offer an explanation for the militarization of US domestic police. Highlighting the role of the institutional structures surrounding policing, the military, and other government agencies, they illustrate how incentives effectively drive military hardware and other physical capital to police departments. Within these studies of police militarization, we see Austrian scholars address the third, “cultural” definition of militarism. Research on militarism within the Austrian tradition has offered critical insights into the mechanisms that have led to US domestic police, border patrol, and the broader public to adopt military tactics, attitudes, and embrace a more militaristic culture, in addition to military materiel. Each of these studies employs traditionally Austrian themes. These studies emphasize the importance of knowledge and limits of central planners, examine behavior within the context of purposive human action, and highlight the importance of institutional structures in generating incentives. Paramount in these studies is a focus on and appreciation for the dynamics of intervention and the consequences these interventions generate (see Hall and Coyne 2013; Coyne and Hall 2014a, 2016, 2018). The most detailed studies on militarism within the Austrian tradition to date come from Coyne and Hall (2018, 2021). Both of these items are worth discussing in some detail. In Tyranny Comes Home: The Domestic Fate of U.S. Militarism, Coyne and Hall (2018) highlight how preparation for and engagement in foreign intervention abroad provides a testing ground for the government to discover and hone tools of social control. These tools come to be used domestically through what they call the “boomerang effect” of foreign intervention. Individuals involved in foreign intervention, for example, face an incentive to acquire the skills, attitudes, etc., that will make them successful in the organizations carrying out various interventions (e.g. the military). Once their part in the intervention has concluded, these individuals reallocate this acquired human capital into organizations both within and out of the defense sector. Coyne and Hall argue that these individuals likewise integrate military organizational structures and the physical tools of war into these new endeavors. This has the effect of spreading militarism—both in terms of physical resources and culture—into various organizations. They apply this framework to several cases in the post-9/11 context, illustrating how military tools, tactics, and attitudes came to be integrated within police forces, prisons, and along the US border. Hall et al. (forthcoming) further this analysis and illustrate how this same dynamic process led to the progressive militarization of far-right extremist groups in the United States following the start of the war on terror.

12

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

They contend that increased deployments combined with changes to military recruitment standards as a part of the war on terror made it easier for extremists and extremist groups to integrate into the military and acquire military training. They discuss the implications related to the behavior of extremist groups and their consequences for counterterrorism policy. In Manufacturing Militarism: U.S. Government Propaganda in the War on Terror, Coyne and Hall (2021) further their analysis of militarism by developing a framework for understanding the importance of propaganda in democracies. They argue that democratic societies may be especially vulnerable to government propaganda because of various institutional structures. By presenting the public with purposely biased, false, or misleading information, government agents look to influence citizens’ opinions, attitudes, and behaviors so that they align with the interests of those within the government (i.e. the propagandist). This is particularly true, they propose, within the arena of “national security” due to a government monopoly on information and a culture of secrecy. They point out that propaganda limits the ability of individuals to engage in rational decision-making. Using cases following the war on terror, they illustrate how propaganda in the post-9/11 context has been used to garner support for US foreign policy (e.g., the war in Iraq) and to foster a broader culture of militarism within the general population.

Areas of future study Taken together, the aforementioned Austrian treatments of militarization and militarism offer unique insights into the different conceptualizations of militarism. The Austrian methodology allows for a deeper understanding of the processes through which organizations militarize as well as the processes through which individuals adopt more militaristic characteristics outside of physical capital. It is worth noting, however, that Austrian contributions to the discussion of militarism, and to the subfield of defense economics, are limited. The works referenced and discussed above represent a relatively comprehensive overview of Austrian contributions within these areas. However, this provides an opportunity for those who wish to make meaningful and original contributions to defense economics, Austrian economics, and the study of militarism. Austrian scholars within the field of defense economics have much to offer by continuing their analyses from a perspective of methodological individualism. In standard models of defense, a singular planner, what Coyne (2015) refers to as the “defense brain,” sets out to maximize some given social welfare func-

AN AUSTRIAN PERSPECTIVE ON MILITARISM

13

tion. Within the context of militarization and militarism, such a model would indicate that government agencies would “optimally” militarize, taking on the characteristics, organizational structures, and materiel of the military only to the point where such actions would maximize social welfare. Austrians are not only in a position to refute such a characterization of militarization and defense provision, but to also offer clear counterarguments. Austrians are also poised to bring further economic insights into the “cultural” discussions of militarism where other schools of economic thought may struggle. This is a direct result of the methodological tools Austrian scholars employ. Whereas other schools of economic thought rely primarily on statistical models in their analyses, Austrians employ a methodological pluralism that allows them to undertake studies that do not simply rely on econometric analysis. As a result, Austrian economists within this field may ask different types of research questions or approach the questions raised by other researchers in a different way. Coyne and Hall’s work on militarism is representative of this dynamic, employing economic frameworks to historical case studies, but their work is by no means exhaustive. To date, the Austrian literature on militarism and militarization examines these dynamics almost exclusively within the context of the United States. While Coyne and Hall (2018, 2021) argue that the dynamics they highlight and frameworks they develop are generalizable, their analysis and those of Higgs, Duncan, and Goodman all focus on issues related to the United States and US policies. The vast majority of these analyses relate to the United States in the post-9/11 period. This leaves ample room for those wishing to explore these issues and a clear avenue for research. For example, scholars interested in the “boomerang effect” of foreign intervention could analyze those dynamics within different periods within the United States. Alternatively, researchers could examine these effects within the context of other countries during different periods of history. Just as Mises and Hayek were well suited to critique Keynes and other proponents of top-down central planning, contemporary Austrians would likewise be well equipped to take up a key challenge issued by those writing in the Marxist tradition. From the Marxist perspective, militarism is the natural consequence of “capitalist imperialism.” No Austrian scholar has written to explicitly address and systematically dispel this conceptualization to this author’s knowledge. Röpke (1959) argued against such ideas: “The idea that the economic system which rests upon the regulating function of the market and the separation of political sovereignty from economic activity is that which compulsorily drives nations into war, must be completely rejected” (Röpke

14

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

1959, p. 88). He continues, arguing that it is not “the accused” (capitalism) that leads to imperialism and war but rather “the accuser” (socialism) that engenders conflict (Röpke 1959, p. 94). Coyne and Hall address these ideas in two places. Coyne and Hall (2014c) address the desirability and likely outcomes of imperialism from a robust political economy perspective. Using Adam Smith and John Stuart Mill’s arguments related to the British Empire to discuss contemporary discourse surrounding the United States, they examine the feasibility of empire when epistemological and incentive conditions deviate from their ideals. Coyne and Hall (2019) argue that, to the extent that capitalism necessitates the existence of a centralized state—even a minimal protective state (à la Buchanan)—cronyism will also exist. The question then becomes how much cronyism will emerge instead of if cronyism will emerge. They use the US military sector to illustrate how cronyism influences protective-state functions. They argue that, given the pervasiveness of the US military sector, cronyism is rampant even if the government is limited to its “protective” functions. Further explorations of these dynamics are needed, including more detailed discussions of the separability of imperialism and capitalism. Moreover, further explorations into Buchanan’s distinction between the protective and predatory states would be relevant. Hall and Coyne (2013) frame their initial discussions of police militarization around this distinction and how a protective state moves into the realm of a predatory state. Additional inquiries into this area, including more detailed discussions regarding the existence of protective states and how states become altered over time would be of interest. The aforementioned studies related to the militarization of police are also ripe for further inquiry. Although Austrian scholars have now approached the topic of domestic police militarization in the United States in several instances, further inquiry would be undeniably valuable. Once again, examining international cases through the Austrian lens could also provide important insights. Given militarization trends in Europe, Africa, and especially Latin America, analyzing how individuals interact within the institutional structures of these areas could provide meaningful explanations of global militarization trends. Questions related to imperialism and militarization could also be particularly valuable. The aforementioned paper by Flores-Macías and Zarkin (2019) discusses police militarization throughout Latin America. Other scholars have explored trends in police militarization in other parts of the globe. Examining if and how imperialism has influenced the adoption or rejection of militarized police would be a germane and timely topic—one that those comfortable with the Austrian method are primed to tackle. Thinking of these militarization trends within the United States and elsewhere, some Austrian scholars have noted mechanisms through which police and

AN AUSTRIAN PERSPECTIVE ON MILITARISM

15

other arms of government may be demilitarized. For example, Coyne and Hall (2018, pp. 176–187) point to the importance of ideology in providing a check against militarism. They argue that an ideological shift toward antimilitarism is imperative in turning the tide away from militarism. In essence, ideological changes are necessary for undoing the ratchet effect first outlined by Higgs (1987). Given the current sociopolitical climate surrounding police in the United States (e.g. the Black Lives Matter movement), explorations in this area would be particularly timely. Finally, Austrian scholars may further the discourse on militarization and militarism by additionally complicating the way the literature has defined “militarism” and militarization. The work of Lavoie (1985a) may prove a relevant starting point. As noted above, Lavoie argues that non-comprehensive planning, where the state controls some parts of the economy while leaving others to operate freely, is non-viable. He argues that “[t]he practice of planning is nothing but the militarization of the economy” (Lavoie 1985a, p. 230). Even within this piecemeal fashion, planning necessitates the use of discretionary government power to replace the desires of private individuals with those of policymakers. Interventionism of all types is a form of Lavoie’s non-comprehensive planning. These interventions assume that policymakers possess the knowledge to allocate resources in a way that is preferred to the market allocation, can adjust interventions in the face of new and evolving information, and that planners know what outcomes would have emerged absent intervention. This way of thinking, and application of Lavoie’s ideas are a clear connective thread throughout the Austrian literature on militarism. The idea is addressed directly by Coyne and Hall (2019). This conceptualization of non-comprehensive planning and militarization, however, provides yet another critical insight into this phenomenon, and offers a further arena in which Austrian scholars may make meaningful contributions.

Acknowledgments I would like to thank Chris Coyne and Nathan Goodman for their insights and workshop participants with the Institute for the Study of Political Economy at Ball State University. This chapter benefited greatly from their helpful comments and feedback. Any errors are my own.

16

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

References Acemoglu, Daron and Pierre Yared. 2010. “Growth in a Partially De-Globalized World: Political Limits to Globalization.” American Economic Review: Papers & Proceedings, 100: 83–88. Acemoglu, Daron, Davide Ticchi, and Andrea Vindigni. 2010. “A Theory of Military Dictatorships.” American Economic Journal: Macroeconomics, 2(1): 1–42. Albrecht, Ulrich. 1980. “Red Militarism.” Journal of Peace Research, 17(2): 135–149. Anderson, Gary M. and Robert D. Tollison. 1991. “Political Violence on Civil War Mortality Rates: The Electoral College as Battlefield.” Defence and Peace Economics, 2(3): 219–233. Anderton, Charles H. and John R. Carter. 2005. “On Rational Choice Theory and the Study of Terrorism.” Defence and Peace Economics, 16(4): 275–282. Bacevich, Andrew J. 2005. “The New American Militarism.” History News Network, April 20. Available online: https://​historynewsnetwork​.org/​article/​11497 Boettke, Peter J. and Christopher J. Coyne. 2009. “Context Matters: Institutions and Entrepreneurship.” Foundations and Trends in Entrepreneurship, 5(3): 135–209. Boggs, Carl. 2005. Imperial Delusions: American Militarism and Endless War. Maryland: Rowan and Littlefield International. Brauer, Jurgen and John Paul Dunne. 2011. “Arms Trade Offsets: What Do We Know?” In Christopher J. Coyne and Rachel L. Mathers (eds), The Handbook on the Political Economy of War. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 243–268. Buchanan, James M. 1949. “The Pure Theory of Government Finance: A Suggested Approach.” Journal of Political Economy, 57(6): 496–505. Buchanan, James. M. 1975. The Limits of Liberty: Between Anarchy and Leviathan. Chicago: Chicago University Press. Butterworth, Michael L. 2012. “Militarism and Memorializing at the Pro Football Hall of Fame.” Communication and Critical/Cultural Studies, 9(3): 241–258. Cockburn, Cynthia. 2010. “Gender Relations as Causal in Militarization and War: A Feminist Standpoint.” International Feminist Journal of Politics, 12(2): 139–157. Collier, Paul and Anke Hoeffler. 2007. “Civil War,” In Todd Sandler and Keith Hartley (eds), Handbook of Defense Economics, Volume 2. New York: Elsevier Science B.V., pp. 711–740. Cortright, David and George A. Lopez. 2011. “Sanctions as Alternatives to War.” In Christopher J. Coyne and Rachel L. Mathers (eds), The Handbook on the Political Economy of War. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Coyne, Christopher J. 2005. “The Institutional Prerequisites for Post-Conflict Reconstruction.” The Review of Austrian Economics, 18(3/4): 325–342. Coyne, Christopher J. 2006. “Reconstructing Weak and Failed States: Insights from Tocqueville.” Journal of Social, Political and Economic Studies, 31(2): 143–162. Coyne, Christopher J. 2007. “Deconstructing Reconstruction: The Overlooked Challenges of Military Occupation.” The Economics of Peace and Security Journal, 2(2): 76–82. Coyne, Christopher J. 2008. After War: The Political Economy of Exporting Democracy. California: Stanford University Press. Coyne, Christopher J. 2011. “The Political Economy of the Creeping Militarization of U.S. Foreign Policy.” Peace Economics, Peace Science and Public Policy, 17(1).

AN AUSTRIAN PERSPECTIVE ON MILITARISM

17

Coyne, Christopher J. 2015. “Lobotomizing the Defense Brain.” The Review of Austrian Economics, 28(4): 371–396. Coyne, Christopher J. and Abigail R. Hall. 2014a. “Perfecting Tyranny: Foreign Intervention as Experimentation in State Control.” The Independent Review: A Journal of Political Economy, 19(2): 165–189. Coyne, Christopher J. and Abigail R. Hall. 2014b. “The Case against a U.S.-Arms Monopoly.” Atlantic Economic Journal, 27(4): 181–190. Coyne, Christopher J. and Abigail R. Hall. 2014c. “The Empire Strikes Back: Adam Smith, John Stuart Mill, and the Robust Political Economy of Empire.” The Review of Austrian Economics, 27: 359–385. Coyne, Christopher J. and Abigail R. Hall. 2016. “Foreign Intervention, Police Militarization, and the Impact on Minority Groups.” Peace Review: A Journal of Social Justice, 28: 165–170. Coyne, Christopher J. and Abigail R. Hall. 2018. Tyranny Comes Home: The Domestic Fate of U.S. Militarism. California: Stanford University Press. Coyne, Christopher J. and Abigail R. Hall. 2019. “State-provided Defense as Noncomprehensive Planning.” The Journal of Private Enterprise Education, 34(1): 75–85. Coyne, Christopher J. and Abigail R. Hall. 2021. Manufacturing Militarism: U.S. Government Propaganda in the War on Terror. California: Stanford University Press. Coyne, Christopher J. and Anne R. Bradley. 2019. “Ludwig von Mises on War and the Economy.” The Review of Austrian Economics, 32: 215–228. Coyne, Christopher J., Courtney Michaluk, and Rachel Reese. 2016. “Unproductive Entrepreneurship in US Military Contracting.” The Journal of Entrepreneurship and Public Policy, 5(2): 221–239. Coyne, Christopher J. and Nathan P. Goodman. 2020. “Polycentric Defense.” The Independent Review: A Journal of Political Economy, 25(2): 279–292. Coyne, Christopher J. and Rachel L. Mathers. 2011. “Introduction.” In Christopher J. Coyne and Rachel L. Mathers (eds), The Handbook on the Political Economy of War. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 1–9. Daniels, Robert V. 2007. The Rise and Fall of Communism in Russia. New Haven: Yale University Press. Delehanty, Casey, Jack Mewhirter, Ryan Wlch, and Jason Wilks. 2017. “Militarization and Police Violence: The Case of the 1033 Program.” Research and Politics, April-June: 1–7. Diaz, Ileana I. and Alison Mountz. 2020. “Intensifying Fissures: Geopolitics, Nationalism, Militarism, and the US Response to the Novel Coronavirus.” Geopolitics, 25(5): 1037–1044. DiLorenzo, Thomas J. 1988. “Competition and Political Entrepreneurship: Austrian Insights into Public Choice Theory.” Review of Austrian Economics, 2(1): 59–71. Donovan, James A. 1970. Militarism, U.S.A. New York: Charles Scribner’s Sons. Dreze, Jean. 2000. “Militarism, Development, and Democracy.” Economic and Political Weekly, 35(14): 1171–1183. Duncan, Thomas K. and Christopher J. Coyne. 2013a. “The Origins of the Permanent War Economy.” The Independent Review: A Journal of Political Economy, 18(2): 219–240. Duncan, Thomas K. and Christopher J. Coyne. 2013b. “The Overlooked Costs of the Permanent War Economy: A Market Process Approach.” The Review of Austrian Economics, 26(4): 413–431.

18

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Duncan, Thomas K. and Christopher J. Coyne. 2015. “The Revolving Door and the Entrenchment of the Permanent War Economy.” Peace Economics, Peace Science, and Public Policy, 21(3): 391–413. Dunne, J. Paul. 1995. “The Defense Industrial Base.” In Keith Hartley and Todd Sandler (eds), Handbook of Defense Economics, Volume 1. New York: Elsevier Science B.V., pp. 399–430. Dunne, Paul, Maria del Carmen Garcia-Alonso, Paul Levine, and Ron Smith. 2007. “Determining the Defence Industrial Base.” Defence and Peace Economics, 18(3): 199–221. Ekrich, Arthur A. Junior. 1956. The Civilian and the Military. New York: Oxford University Press. Enders, Walter and Todd Sandler. 1995. “Terrorism: Theory and Applications.” In Keith Hartley and Todd Sandler (eds), Handbook of Defense Economics, Volume 1. New York: Elsevier Science B.V., pp. 213–250. Flores-Macías, Gustavo A. and Jessica Zarkin. 2019. “The Militarization of Law Enforcement: Evidence from Latin America.” Perspectives on Politics, 18(1): 1–20. Garrison, Steve R. 2008. “The Road to Civil War: An Interactive Theory of Internal Political Violence.” Defence and Peace Economics, 19(2): 127–151. Goodman, Nathan P. n.d. “Border Militarization as an Entrepreneurial Process.” https://​papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​=​4111704 Gusterson, Hugh and Catherine Besteman. 2019. “Cultures of Militarism.” Current Anthropology, 60(19): 3–14. Hall, Abigail R. 2020. “The Problems of Central Planning in Military Technology.” In Gary Chartier and Chad Van Schoelandt (eds), The Routledge Handbook of Anarchy and Anarchist Thought. New York: Routledge. Hall, Abigail R. and Christopher J. Coyne. 2013. “The Militarization of U.S. Domestic Policing.” The Independent Review: A Journal of Political Economy, 7(4): 485–504. Hall, Abigail R., Jerod T. Hassell, and Chivon H. Fitch. Forthcoming. “Militarized Extremism: The Radical Right and the War on Terror.” The Independent Review. Hartley, Keith. 2007a. “Defense and Economics: Achievement and Challenges.” Economics of Peace and Security Journal, 2(1): 45–50. Hartley, Keith. 2007b. “The Arms Industry, Procurement and Industrial Policies.” In Todd Sandler and Keith Hartley (eds), Handbook of Defense Economics, Volume 2. New York: Elsevier Science B.V., pp. 1139–1176. Hayek, F. A. 1935. Prices and Production. London: Routledge. Hayek, F. A. 1945. “The Use of Knowledge in Society.” The American Economic Review, 35(4): 519–530. Hayek, F. A. 1966. Monetary Theory and the Trade Cycle. New York: Augustus M. Kelley. Higgs, Robert. 1987. Crisis and Leviathan. New York: Oxford University Press. Higgs, Robert. 2004. Against Leviathan: Government Power and a Free Society. Oakland: Independent Institute. Higgs, Robert. 2005. Resurgence of the Warfare State: The Crisis Since 9/11. Oakland: Independent Institute. Higgs, Robert. 2007. Neither Liberty nor Safety: Fear, Ideology, and the Growth of Government. Oakland: Independent Institute. Hobson, John Atkinson. 1902 [2012]. Imperialism: A Study. London: Forgotten Books. Holcombe, Randall G. 2002. “Political Entrepreneurship and the Democratic Allocation of Economic Resources.” Review of Austrian Economics, 15(2/3): 143–159.

AN AUSTRIAN PERSPECTIVE ON MILITARISM

19

Hossein-zadeh, Ismael. 2006. The Political Economy of U.S. Militarism. New York: Palgrave Macmillan. Irandoust, Manuchehr. 2018. “Militarism and Globalization: Is There an Empirical Link?” Quality and Quantity, 52(3): 1349–1369. Kershner, Seth and Scott Harding. 2019. “Militarism Goes to School.” Critical Military Studies, 5(3): 191–194. Kirzner, Israel M. 1973. Competition and Entrepreneurship. Chicago: University of Chicago Press. Kirzner, Israel M. 1979. Perception, Opportunity, and Profit. Chicago: University of Chicago Press. Kirzner, Israel M. 1992. The Meaning of the Market Process. New York: Routledge. Kirzner, Israel M. 1997. “Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach.” Journal of Economic Literature, 35(1): 60–85. Kirzner, Israel M. 2000. The Driving Force of the Market. New York: Routledge. Lavoie, Don. 1985a [2016]. National Economic Planning: What is Left? Arlington: Mercatus Center. Lavoie, Don. 1985b. Rivalry in Central Planning: The Socialist Calculation Debate Reconsidered. Cambridge: Cambridge University Press. Lavoie, Don. 1986. “The Market as a Procedure for Discovery and Conveyance of Inarticulate Knowledge.” Comparative Economic Studies, 28(1): 1–19. Lenin, Vladmir I. 1908. “Bellicose Militarism and the Anti-Militarist Tactics of Social Democracy.” Proletary, 33. Levine, Paul, Somnath Sen, and Ron Smith. 1994. “A Model of the International Arms Market.” Defence and Peace Economics, 5(1): 1–18. Liebknecht, Karl. 1910 [2011]. Militarism and Anti-Militarism. New York: Black Rose Books. Lipsky, Richard. 1981. “How We Play the Game: Why Sports Dominate American Life.” Massachusetts: Beacon Press. Lowe Jr., Ricardo H. 2020. “Policing, Justice, and Black Communities.” Institute for Urban Policy Research & Analysis. Available online: https://​lbj​.utexas​.edu/​sites/​ default/​files/​UT​_IUPRA​_Policing​_Justice​_and​_Black​_Communities​_Part​-1​.pdf Mises, Ludwig von. 1912 [1953]. The Theory of Money and Credit. New Haven: Yale University Press. Mises, Ludwig von. 1919 [2006]. Nation, State, and Economy: Contributions to the Politics and History of Our Time. Indiana: Liberty Fund, Inc. Mises, Ludwig von. 1920 [2014]. “Economic Calculation in the Socialist Commonwealth.” Auburn: Ludwig von Mises Institute. Mises, Ludwig von. 1922. [1981]. Socialism: An Economic and Sociological Analysis. Indianapolis, IN: Liberty Fund, Inc. Mises, Ludwig von. 1940 [2011]. Interventionism: An Economic Analysis. Indianapolis: Liberty Fund, Inc. Mises, Ludwig von. 1949 [2007]. Human Action: A Treatise on Economics. Indianapolis: Liberty Fund, Inc. Mises, Ludwig von. 1977. A Critique of Foreign Intervention. New Rochelle: Arlington House. Mises, Ludwig von. 1990. “The Non-Neutrality of Money.” In Richard Ebeling (ed.), Money, Method, and the Market Process: Essays by Ludwig von Mises. Norwell: Kluwer Academic Publishers, pp. 69–77. Neuman, Stephanie G. 2010. “Power, Influence, and Hierarchy: Defense Industries in a Unipolar World.” Defence and Peace Economics, 21(1): 105–134.

20

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Olson, Mancur and Richard Zeckhauser. 1966. “An Economic Theory of Alliances.” Review of Economics and Statistics, 48(3): 266–279. Peck, Merton J. and Frederic M. Scherer. 1962. The Weapons Acquisition Process. Boston, MA: Harvard University Press. Podemska-Mikluch, Marta and Richard E. Wagner. 2010. “Entangled Political Economy and the Two Faces of Entrepreneurship.” Journal of Public Finance and Public Choice, 28(2/3): 99–114. Richardson, Lewis F. 1960. Arms and Insecurity: A Mathematical Study of the Causes and Origins of War. Pittsburgh, PA: Homewood. Richman, Sheldon. 1981. “War Communism to NEP: The Road to Serfdom.” The Journal of Libertarian Studies, 5(1): 89–97. Röpke, Wilhelm. 1959 [2007]. International Order and Economic Integration. Auburn: The Ludwig von Mises Institute. Rosato, Sebastian. 2011. “On the Democratic Peace.” In Christopher J. Coyne and Rachel L. Mathers (eds), The Handbook on the Political Economy of War. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Rosendorff, B. Peter and Todd Sandler. 2010. “Suicide Terrorism and the Backlash Effect.” Defence and Peace Economics, 21(5/6): 443–457. Rouanet, Louis and Ennio Piano. Forthcoming. “Drafting the Great Army: The Political Economy of Conscription in Napoleonic France.” Journal of Economic History. Rouanet, Louis and Ennio Piano. 2020. “Filling the Ranks: the Remplacement Militaire in Post-Revolutionary France.” European Review of Economic History, 24(4), 696–715. Rubbelke, Dirk T. G. 2004. “Differing Motivations for Terrorism.” Defence and Peace Economics, 16(1): 19–27. Sandler, Todd. 2000. “Arms Trade, Arms Control, and Security: Collective Action Issues.” Defence and Peace Economics, 11(3): 533–548. Sandler, Todd and Daniel G. Arce. 2007. “Terrorism: A Game-Theoretic Approach.” In Todd Sandler and Keith Hartley (eds), Handbook of Defense Economics, Volume 2. New York: Elsevier Science B.V., pp. 775–814. Schelling, Thomas C. 1966. Arms and Influence. New Haven, CT: Yale University Press. Singh, Naunihal. 2014. Seizing Power: The Strategic Logic of Military Coups. Baltimore: Johns Hopkins University Press. Tullock, Gordon. 1971. “The Paradox of Revolution.” Public Choice 11: 89–99. Vagts, Albert. 1937. A History of Militarism. New York: W.W. Norton and Company. Van Tuyll, Hubert P. 1994. “Militarism, the United States, and the Cold War.” Armed Forces and Society, 20(4): 519–530. Wagner, Richard E. 1966. “Pressure Groups and Political Entrepreneurs: A Review Article.” Papers in Non-Market Decision Making, 1: 161–170. Wakefield, Wanda Ellen. 1997. Playing to Win: Sports and the American Military, 1989–1945. New York: State University of New York Press. Wibben, Annick T. R. 2018. “Why We Need to Study (US) Militarism: A Critical Feminist Lens.” Militarism and Security: Dialogue, Possibilities, and Limits, 49(1-2): 136–148. Zafirovski, Milan. 2020. “Indicators of Militarism and Democracy in Comparative Context: How Militaristic Tendencies Influence Democratic Processes in OECD Countries 2010-2016.” Social Indicators Research: An International and Interdisciplinary Journal for Quality-of-Life-Measurement, 147(1): 159–202. Zartman, I. William. 2011. “International Negotiation and Conflict Prevention.” In Christopher J. Coyne and Rachel L. Mathers (eds), The Handbook on the Political Economy of War. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing.

2

Monetary policy and business cycles: a post-crisis research agenda for Austrian economics

Bryan P. Cutsinger

Introduction There has been a resurgence of interest in Austrian business cycle theory (ABCT) since the 2008 financial crisis. In many ways, this resurgence is unsurprising as the pattern observed before, during, and after the financial crisis aligned with the theory’s description of how overly expansive monetary policy could create an unsustainable credit-induced boom that ultimately results in a costly reallocation of capital. This resurgence has spawned an extensive literature that has extended the ABCT in several new directions.1 One area that remains to be studied in great detail is how the Federal Reserve’s post-crisis operating framework affects ABCT and the concept of malinvestment. The purpose of this chapter is to explore the link between this framework and the Austrian views of the business cycle. In response to the financial crisis, the Federal Reserve took unprecedented steps to stabilize the financial system, such as large-scale asset purchases that some feared would only start the boom–bust cycle over again. These concerns were not entirely without merit, however. As I explain in the following two sections, such purchases likely would have had the predicted effect before the financial crisis. But, amid the crisis, the Federal Reserve’s operating framework shifted to one where changes in the central bank’s balance sheet had less of an effect on the stance of monetary policy. This change was brought about by Fed officials’ decision to pay interest on excess reserves at a rate higher than comparable market rates. In consequence, banks opted to hold excess reserves rather than lend them, thereby attenuating the mechanism through which changes in the monetary base spill over into the market for loanable funds.

21

22

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

In this chapter, I argue that the Federal Reserve’s new operating framework should be incorporated into ABCT, and I provide a brief sketch of how to go about doing so in the third section. Such a revision is necessary since the payment of interest on reserves is a departure from the assumed institutional context within which the traditional theory was developed. Thus, a more general version of ABCT is needed to account for potential differences in the operating frameworks of alternative monetary institutions.2 My purpose in doing so is to illustrate that while this new framework short-circuits the traditional Austrian view of the transmission mechanism that begins the process of artificial credit expansion, the new operating system introduces another problem—namely, an increased role for monetary policymakers in the allocation of credit. Although this problem is different than the traditional Austrian view of malinvestment, it nonetheless involves a change in the capital structure that is guided less by market participants and more by political incentives. Finally, in the fourth and fifth sections, I discuss the political economy of the Federal Reserve’s post-crisis operating framework and the need for genuine monetary rules. I argue that paying interest on reserves benefits both political and monetary officials. One reason is that by paying interest on reserves, monetary and political officials can have more control over the allocation of credit and raise additional seigniorage revenue without risking higher inflation. In consequence, there will be less political pushback on policymakers by voters. For these reasons, the need for monetary rules has taken on new importance in the years since the financial crisis.

Monetary policy before and after the financial crisis In October 2008, Congress authorized the Federal Reserve to pay interest on reserves.3 How Federal Reserve officials used this authority fundamentally transformed the central bank’s operating framework in ways that have important implications for both monetary policy and ABCT (ABCT). Before discussing these implications, however, an overview of the Federal Reserve’s pre- and post-crisis operating frameworks, and a discussion of their differences illustrates the drastic differences between the two operating frameworks.4 Monetary policy before the crisis Before the financial crisis, the Fed varied the quantity of reserves in the banking system to achieve its target for the federal funds rate—the rate that banks charge one another to borrow reserves over short periods. Fed officials

MONETARY POLICY AND BUSINESS CYCLES

23

did not control this rate directly, however. Instead, the rate is determined by the supply and demand for reserves. The Fed can influence both sides of this market through open market operations or reserve requirements, for example, but it does not set the federal funds rate, the market for federal funds does. In the years leading up to the crisis, the primary tool Fed officials used to influence the federal funds rate was the supply of reserves. The ostensible objective of monetary policy is not to achieve a particular federal funds rate target, but to ensure that changes in the supply of demand for money do not result in cyclical unemployment or price-level uncertainty. However, there can be substantial lags between changes in the quantity of reserves and when these changes affect total spending (Friedman, 1960, p. 87). To deal with this issue, the Fed uses intermediate targets, such as the federal funds rate, which respond faster to changes in the monetary base than do the variables that are the ultimate objective of monetary policy. Assuming Fed officials have identified a reasonably stable relationship between the intermediate target and their broader objectives, then they could set the target in a manner consistent with achieving their long-run objective and adjust the quantity of reserves as necessary.5 If, for example, Fed officials believed that a lower federal funds rate target was necessary to prevent prices from falling and unemployment from increasing, the central bank would inject liquidity through an open market purchase, lowering the federal funds rate. Before the Fed began paying interest on excess reserves, banks had little incentive to hold reserves above those required by law, so they would transform the excess reserves into interest-earning assets. This process would continue until bank deposits increased sufficiently to transform the excess reserves into required reserves. Through this process, the money supply would increase, increasing total spending along with it, putting upward pressure on prices, and reducing unemployment. In this way, a reduction in the federal funds rate caused by an increase in the quantity of reserves would bring about changes in the variables with which the Fed officials were concerned.6 In sum, the pre-crisis framework involved adjusting the quantity of reserves to influence the federal funds rate in a direction consistent with achieving the Federal Reserve’s objectives of full employment and stable prices. In this framework, the quantity of reserves determined the stance of monetary policy; increases in the quantity of reserves would result in a larger money stock, more spending, and higher prices, all else equal.

24

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Monetary policy after the crisis After Congress authorized the Federal Reserve to begin paying interest on reserves in October 2008, Fed officials used this new authority to sterilize their emergency lending by setting the interest rate paid on reserves above the federal funds rate. In consequence, banks opted to hold the excess reserves created through emergency lending rather than lend them, thereby weakening the link between changes in the monetary base and the stance of monetary policy. This action transformed the monetary policy regime from one in which banks lent nearly all their excess reserves to one where banks opted to hold excess reserves (see Figure 2.1). In this new regime, interest on excess reserves became the Fed’s primary instrument for monetary policy since changes in the monetary base no longer had the same effect on total spending as they did in the old regime. Unlike the federal funds rate, the interest rate paid on reserves is an administered rate, i.e., a rate that monetary policymakers can set directly rather than target. The higher the rate paid on excess reserves relative to comparable market rates, the less incentive there is for banks to lend, all else equal. In contrast to the pre-crisis operating framework, an increase in the quantity of reserves does not necessarily alter the stance of monetary policy (Dutkowsky & VanHoose, 2018). Now, whether a change in the quantity of reserves leads to changes in total spending depends on the return that can be earned by holding reserves relative to what could be earned by lending them. The link between the equation of exchange and the money multiplier can illustrate the difference between the pre- and post-crisis frameworks. The equation of exchange is MV = PY, where M is the money stock, V velocity, P is the price level, and Y real output. The product of the monetary base, B, and the money multiplier, m, determines the money supply, i.e., M = mB.7 The money multiplier depends on three ratios: the currency-to-deposit ratio, c, which reflects the public’s demand to hold cash balances in the form of currency relative to deposits, the excess reserves-to-deposit ratio, er, which reflects the banking system’s demand for reserves above those required by law, and the required reserves to deposit ratio, rr, which is set by monetary policymakers.8 The relationship between the equation of exchange, the money supply, and the money multiplier can be expressed with some simple arithmetic.9 First, the money multiplier can be written as: 1 + c ​m  ​=  ​ _      ​  c + er + rr

​ (2.1) ​

MONETARY POLICY AND BUSINESS CYCLES

25

Next, substituting equation (2.1) into the money supply relationship, M = mB, yields: 1 + c ​M  ​=  ​ (​ _      ​  ​B ) c + er + rr

​ (2.2) ​

Finally, substituting equation (2.2) into the equation of exchange, MV = PY, yields: 1 + c ​[​ (​ _      ​  ​B]​V  ​=  PY ) c + er + rr

 ​(2.3) ​

Equation (2.3) is simply the equation of exchange with the money supply variable decomposed into its two constituent parts: the money multiplier and the monetary base. Before the financial crisis, the er term in equation (2.3) was typically zero, and the rr term rarely changed. Thus, if monetary policymakers wanted to increase or decrease total spending, they would do so by either increasing or decreasing the monetary base via open market operations. Under the current framework, however, paying interest on reserves is the Federal Reserve’s primary instrument of monetary policy, not the quantity of reserves.10 Monetary policymakers can vary total spending by setting the interest rate paid on reserves above or below the market rate on short-term securities without needing to adjust the quantity of reserves. For example, setting the rate paid on reserves below the market rate on short-term securities will increase the money multiplier by lowering the excess reserve ratio, and thereby increase total spending, holding velocity constant. Conversely, an increase in the monetary base could be fully offset by a sufficiently large increase in the interest rate paid on reserves such that increases in the quantity of reserves are held by banks as excess reserves rather than lent. In this case, changes in the monetary base would not affect total spending. In sum, the post-crisis framework involves adjusting the interest rate paid on excess reserves to influence banks’ willingness to lend excess reserves in a direction consistent with achieving the Federal Reserve’s mandate. Unlike the pre-crisis operating system, the quantity of reserves no longer determines the stance of monetary policy; increasing the quantity of reserves will only result in higher spending if the interest rate paid on reserves is sufficiently low to discourage banks from holding reserves rather than lending them.

26

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Implications for ABCT The Federal Reserve’s new operating framework of paying interest on excess reserves remains to be incorporated into ABCT. While doing so would require more than a book chapter, I will provide a few suggestions about how this task could be accomplished. Given the emphasis that ABCT places on how newly-created money enters the economy, integrating it with interest on excess reserves should be a high priority for those working in the Austrian tradition. Moreover, interest on excess reserves has important implications for how we think about the concept of malinvestment as it substantially increases the role of the central bank in the allocation of credit. Interest on reserves and ABCT ABCT describes the process by which increases in the supply of loanable funds brought about by injections of liquidity from a central bank can generate a boom–bust cycle (Mises, 1912, 1949; Hayek, 1933, 1935). Three analytical elements form the foundation of ABCT: (1) the market for loanable funds, which reflects both people’s time preferences and the productivity of investment; (2) the production possibilities frontier, which highlights the trade-off between present consumption and investment; and (3) the intertemporal structure of production, which illustrates the production of goods through time (Garrison, 2001, pp. 34–49). The key price that links these three elements is the interest rate, which adjusts in response to changes in the productivity of investment or people’s time preferences.11 Such changes need not cause a boom–bust cycle, provided the interest rate is free to adjust to changing economic conditions. Unlike other business-cycle theories that emphasize changes in the quantity of money, ABCT emphasizes how newly-created money enters the economy.12 Since central banks typically inject high-powered money into the economy through the banking system, these injections can temporarily increase the supply of loanable funds, causing a divergence between the natural rate and market rate of interest that destabilizes the intertemporal structure of production by misleading entrepreneurs into undertaking investment projects that will turn out to be unsustainable. Whether these injections bring about an unsustainable investment boom depends on whether they are consistent with providing an amount of liquidity that is necessary to maintain monetary equilibrium (Garrison, 1996; Horwitz, 2000; G. A. Selgin, 1991).13 A key assumption underlying the idea that liquidity injections can trigger a boom–bust cycle of the sort envisioned by the proponents of ABCT is that

MONETARY POLICY AND BUSINESS CYCLES

27

the banking system views excess reserves as a source of loanable funds. This assumption will typically hold so long as the return on loans and other financial assets exceeds the return on excess reserves. When this condition is met, liquidity injections will increase the supply of loanable funds as banks will seek to transform these reserves into interest-earning assets. Assuming there has been no change in the demand for reserves, these injections will push the market rate of interest below the natural rate. The lower rate signals to entrepreneurs that consumers now find future consumption more valuable than before the rate fell, making it seem as if long-term projects have now become more profitable. Entrepreneurs respond by undertaking investments today that will enable them to meet the future demand for consumption, and thus the intertemporal structure of production increases. Genuine savings have not changed, however, so during the boom phase of the business cycle, both consumption and investment increase beyond the production possibilities frontier. Eventually, however, it becomes apparent that there are not sufficient savings to complete these investments. When this realization occurs, the boom turns into a bust. In consequence, capital must be reallocated to ensure that the intertemporal structure of production aligns with consumers’ time preferences. If, however, excess reserves pay a sufficiently remunerative return, banks may opt to hold the excess reserves rather than transform them into interest-earning assets and, as Figure 2.1 illustrates, that’s exactly what banks have done since the Fed began paying interest on excess reserves in 2008.14 In this case, banks will not view excess reserves as a source of loanable funds, but rather as a type of investment.15 Under these conditions, liquidity injections no longer necessarily increase the supply of loanable funds, or the injections do not increase the supply of loanable funds by as much as before, and thus may have little-to-no effect on the natural rate of interest.16 As Figure 2.2 suggests, the massive amount of quantitative easing the Fed undertook after the financial crisis had no discernible effect on the decades-long decline in interest rates.17 In other words, paying interest on excess reserves has the potential to short-circuit the part of the monetary transmission mechanism critical to ABCT, or at least attenuate it. As I illustrated in the prior section, holding substantial quantities of excess reserves will reduce the money multiplier. In this case, changes in the monetary base will not have the same effect on broader measures of the money supply because banks are holding reserves instead of lending them. In addition, reserves will constitute a greater share of total bank assets than they would

28

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Note:  The vertical line indicates the month in which the Fed began paying interest on excess reserves. Source:  Federal Reserve Board Bank of St. Louis FRED Database.

Figure 2.1

Excess reserves of depository institutions, 1984–2020

Note:  The vertical line indicates the month in which the Fed began paying interest on excess reserves. Source:  Federal Reserve Board Bank of St. Louis FRED Database.

Figure 2.2

Yields on long-term debt, 1984–2020

MONETARY POLICY AND BUSINESS CYCLES

29

in a banking system that does not hold substantial quantities of excess reserves. As Figures 2.3 and 2.4 illustrate, the evidence from the US supports both of these conjectures.18 Both the M1 and M2 multipliers dropped precipitously while the share of cash assets to total bank assets reversed its decades-long trend decline when the Fed began paying interest on excess reserves in the fall of 2008.

Note:  The vertical line indicates the month in which the Fed began paying interest on excess reserves. Source:  Federal Reserve Board Bank of St. Louis FRED Database.

Figure 2.3

M1 and M2 money multipliers, 1984–2020

ABCT rests on a particular institutional assumption about how changes in reserves affect broader monetary aggregates, namely that banks will not opt to hold excess reserves, preferring instead to lend them. This assumption was appropriate for the Federal Reserve’s pre-crisis operating framework but inappropriate for the current framework. Incorporating this development into ABCT requires acknowledging that substantial increases in reserves—such as those that have occurred over the past decade—will not necessarily precipitate a boom–bust cycle. However, just because increases in reserves in the current framework need not result in malinvestment as traditionally conceived by those working in the Austrian tradition, does not mean that the current system is neutral with respect to its effects on the capital structure.

30

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Note:  The vertical line indicates the month in which the Fed began paying interest on excess reserves. Source:  Federal Reserve Board Bank of St. Louis FRED Database.

Figure 2.4

Share of cash assets to total bank assets, 1984–2020

Interest on reserves and malinvestment In the standard version of ABCT, artificial increases in the supply of loanable funds result in malinvestment—the unprofitable investment brought about by unnecessary liquidity injections (Holcombe, 2017). However, paying interest on excess reserves attenuates the link between changes in the monetary base and its effect on the supply of loanable funds. In consequence, traditional malinvestment is less likely to occur or may be eliminated. It may be tempting to conclude that paying interest on excess reserves is an improvement over traditional monetary policy tools since it has the potential to reduce the possibility of liquidity injections causing a boom–bust cycle, but in my view, such a conclusion would be in error. Under the pre-crisis framework, newly created reserves were allocated primarily by the banking system, as evidenced by banks’ typical unwillingness to hold excess reserves (see Figure 2.1). That is, newly created reserves were allocated primarily by market incentives, which meant that the economy’s scarce credit was largely channeled to where it was most valuable. In consequence, the Federal Reserve’s credit footprint was relatively small. The Fed’s limited credit footprint can be seen in Figure 2.5. In the years leading up to the financial crisis, the share of Federal Reserve assets to total commercial bank assets was

MONETARY POLICY AND BUSINESS CYCLES

31

declining. Indeed, just before the Fed began paying interest on reserves it was less than 10 percent.

Note:  The vertical line indicates the month in which the Fed began paying interest on excess reserves. Source:  Federal Reserve Board Bank of St. Louis FRED Database.

Figure 2.5

Share of Federal Reserve to commercial bank assets, 2002–2020

After 2008, this trend reversed dramatically. The share of Federal Reserve to commercial bank assets increased to nearly 30 percent in 2014, and despite decreasing somewhat, remained at nearly 25 percent in January 2020. As Figure 2.5 illustrates, the Fed’s credit footprint has increased substantially, meaning that political incentives are playing a much larger role in the allocation of scarce credit. The Fed has accomplished this feat by borrowing from the banking system by paying banks to hold excess reserves and using the resources so acquired to channel credit to the US Treasury and issuers of mortgage-backed securities. Figure 2.6 illustrates this change. Before 2008, banks typically intermediated nearly all the deposits they took into credit. Paying interest on excess reserves drove a wedge between deposits and credit. Rather than channel most deposits into economically productive uses, the banking system is now lending a substantial fraction of these deposits to the Federal Reserve, which is not responsible for making decisions on how those resources will be allocated. In short, the Federal Reserve has taken a much more active role in the allocation of credit than it did under the pre-crisis framework.19

32

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Note:  The vertical line indicates the month in which the Fed began paying interest on excess reserves. Source:  Federal Reserve Board Bank of St. Louis FRED Database.

Figure 2.6

Commercial bank deposits, loans and leases, and reserves, 1984–2020

Setting aside the political economy of the Federal Reserve allocating credit, the larger footprint is inevitable under the current framework. Adjusting the stance of monetary policy in response to changes in money demand can be accomplished by varying the interest rate paid on excess reserves or the quantity of reserves (or both). Lowering the rate paid on excess reserves in response to an increase in demand for money, for instance, would increase the money multiplier, but doing so would risk returning to the pre-crisis framework, risking substantial inflation given the size of the Fed’s balance sheet. As such, the safer route would be to increase the quantity of reserves, but given the relatively low value of the money multiplier, larger asset purchases will be necessary to accomplish the same amount of monetary expansion, thus increasing the size of the Federal Reserve’s credit footprint.20 Those working in the Austrian tradition rightly emphasize the importance of market institutions in allocating resources effectively (Hayek, 1945). Decision makers at institutions such as the Federal Reserve lack both the knowledge and the incentives to allocate credit to its highest valued uses because the knowledge and incentives generated by the market process are absent in the context of bureaucratic decision-making (Smith & Boettke, 2015; Salter & Smith, 2017). As such, the types of investments being undertaken under the current

MONETARY POLICY AND BUSINESS CYCLES

33

system may not be consistent with savers’ time preferences. Thus, while the current framework interrupts the transmission mechanism whereby liquidity injections can lead to malinvestment, it is not necessarily neutral with respect to the capital structure as a greater share of the economy’s credit is being allocated via political processes rather than market processes.21

The political economy of interest on reserves Another task for those working in the Austrian tradition is to examine the political economy of the Federal Reserve’s post-crisis operating framework. Again, while doing so would require much more than a book chapter, a few suggestions of how Austrian insights can be applied to this framework are in order. In my view, incorporating political-economy considerations into the analysis of monetary policy and business cycle theory, and how monetary rules can address these considerations, are areas where those working in the Austrian tradition can make important contributions. Before proceeding to these political economy considerations, it is important to note that there is a reasonable economic case for paying interest on reserves. Since central banks can produce reserves at zero marginal cost, the opportunity cost of holding reserves should also be zero. George Tolley (1957) and Milton Friedman (1960) proposed paying interest on required reserves as a way to achieve this optimality.22 The economic efficiency argument offered by Tolley and Friedman was the ostensible motivation behind Congress granting the Federal Reserve the authority to pay interest on reserves as part of the Financial Services Regulatory Relief Act of 2006 (G. A. Selgin, 2018; Ireland, 2019). Originally, the authority to pay interest on reserves was not supposed to go into effect until 2011. However, in 2008, Fed officials successfully lobbied Congress to move that date up to October 1 of that year. The Fed quickly used its newly acquired authority to engage in a series of credit market interventions that went well beyond the economic efficiency justification for paying interest on reserves, and in the process, ushered in a fundamentally different monetary policy regime—one where the Fed’s role in the allocation of credit was much larger. This episode is a clear illustration of the dynamics of interventionism (Ikeda, 2005; Mises, 1949, pp. 855–861). An arguably well-meaning and economically justifiable intervention intended to offset the effects of a prior intervention—minimum reserve requirements— took on a life of its own. In the subsections that follow, I discuss how interest

34

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

on reserves affected both bureaucratic and political incentives, and discuss the possibility of reform through the adoption of monetary rules. Bureaucratic incentives and interest on reserves Unlike other government agencies, the Federal Reserve funds itself via the interest income earned from its portfolio of assets. The larger the Federal Reserve’s portfolio, the greater its revenue will be, all else equal. The Federal Reserve’s unique funding mechanism creates an incentive for monetary policymakers to maximize the revenue the central bank can earn. Since there is not a residual claimant to the income produced by the central bank, Federal Reserve officials can use it to increase their salaries, benefits, working conditions, etc. The interplay of these two factors creates an inflationary bias (M. Toma, 1982).23 Under the pre-crisis framework, a larger asset portfolio meant risking higher inflation, which limited the size of the Federal Reserve’s balance sheet. However, by paying interest on excess reserves, Federal Reserve officials have managed to substantially mitigate this risk, which has unsurprisingly led to the Federal Reserve having a much larger asset portfolio than it did under the pre-crisis operating system, as illustrated by Figure 2.7. While the Federal Reserve’s income—as measured by its remittances to the Treasury—has increased substantially under the current framework, it remains an open question whether the Federal Reserve’s operating costs have increased as well (Cutsinger & Luther, 2022).24 How Federal Reserve officials went about implementing the new operating framework is also consistent with its peculiar bureaucratic features and the dynamics of intervention. The law authorizing the Federal Reserve to pay interest on reserves stipulated that the rate paid must be below comparable market rates. Federal Reserve officials circumvented this provision by claiming that the discount rate—the rate that banks pay to borrow directly from the Federal Reserve—counts as a comparable market rate. However, the discount rate is not a market rate, it’s an administered rate chosen by monetary policymakers.25 By interpreting the law in this way, Federal Reserve officials got around the legal constraint Congress placed on the central bank, and in so doing, adopted a framework that permitted the Federal Reserve to earn greater revenues that Fed officials can use to increase non-pecuniary benefits without generating as much inflation as they would under the pre-crisis framework.

MONETARY POLICY AND BUSINESS CYCLES

35

Note:  The vertical line indicates the month in which the Fed began paying interest on excess reserves. Source:  Federal Reserve Board Bank of St. Louis FRED Database.

Figure 2.7

Federal Reserve Assets, 2003–2020

Political incentives and interest on reserves Political officials also benefit from the current framework. Before the financial crisis, the risk of inflation limited the size of the Federal Reserve’s balance sheet. Under the current framework, this constraint has been severely attenuated. In consequence, there is now an incentive for Congress to use the Federal Reserve to fund off-budget projects without worrying about the risk of inflation, which may explain why there has been so little pushback by Congress on Federal Reserve officials’ dubious interpretation of the law authorizing the central bank to pay interest on reserves (Jordan & Luther, 2022; Plosser, 2020; G. Selgin, 2020). Another benefit the current framework provides for political officials is that it permits the Federal Reserve to raise greater amounts of seigniorage at lower rates of inflation. Federal Reserve officials use the interest income earned from its portfolio to cover the central bank’s costs, and then remit whatever revenue they do not spend to the US Treasury. Figure 2.8 illustrates how large of an effect paying interest on excess reserves has had on Federal Reserve’s remittances to the Treasury, and the share of those revenues in total tax receipts. Under the pre-crisis framework, generating this much seigniorage could only be raised via much higher inflation. The additional revenue that can be raised under the current framework can be used to fund projects without the need

36

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

to raise taxes. This concern is not merely hypothetical. In 2015, Congress instructed the Federal Reserve to turn over a part of its equity capital to the Treasury to help fund the so-called FAST Act.26

Notes:  Net revenues are reported in the Board of Governors of the Federal Reserve System, Annual Reports. Tax receipts are reported in the National Income and Product Accounts. Amounts have been converted into billions of 2012 dollars using the personal consumption expenditures implicit price deflator. The vertical line indicates the month in which the Fed began paying interest on excess reserves. Source:  Cutsinger & Luther (2022).

Figure 2.8

Net revenues of the Federal Reserve system, 1984–2020

Finally, the nature of the political incentives explains why neither Federal Reserve officials nor Congress are likely to opt for an allocatively-neutral portfolio (Rouanet & Hazlett, 2022). In principle, the issue of allocating credit could be avoided by holding assets that mimic those of the economy as a whole, but, after more than a decade under the current framework, the primary recipients of the credit allocated by the Federal Reserve have been the US Treasury and Federal Home Loan Banks. Given the nature of the political process, political officials are likely to direct credit in a manner that benefits the interests they represent.

MONETARY POLICY AND BUSINESS CYCLES

37

A renewed call for monetary rules The foregoing discussion points to the continued importance of considering alternative mechanisms for constraining the political and monetary authorities. The need to do so is more pressing under the current framework for two reasons. First, the feedback mechanism of higher inflation that would have previously limited the extent to which the monetary authorities could pursue inflationary policies has been severed. Second, the post-crisis framework has given political and Federal Reserve officials greater control over the allocation of credit, which threatens to reduce the efficiency of the financial system and harm long-term economic growth. The assumption underlying many discussions of monetary rules is that the political and monetary authorities act to promote the public interest. In this context, the purpose of a monetary rule is twofold. First, monetary rules can provide the monetary authorities with a credible commitment technology that can enable them to anchor the public’s inflation expectations (Barro & Gordon, 1983; Kydland & Prescott, 1977). Second, monetary rules can reduce the knowledge that monetary policymakers require to manage the money supply process (O’Driscoll, 2016; Salter & Smith, 2017). However, focusing on these two aspects of monetary rules without giving due consideration to political economy issues can lead to misleading conclusions about how best to implement a rules-based monetary regime. For example, some economists argue that while the long-term goal of monetary policy should be set by the political authorities, e.g., Congress, monetary policymakers should be free to select whatever means they deem best suited to achieving that goal, i.e., instrument independence (Fischer, 1995). Such a position is reasonable so long as one assumes monetary policymakers will act in a manner consistent with the public interest. Where one comes down on this question will ultimately depend on the public-choice model of political behavior that one accepts.27 In my view, a preponderance of the evidence about the behavior of monetary policymakers in practice should at least raise questions about the potential problems with instrument independence.28 How Federal Reserve officials interpreted the law authorizing the payment of interest on reserves, for example, should give advocates of the instrument independence view pause. To see why instrument independence can be a problem under the current framework, suppose Congress instructs the Federal Reserve to target the growth rate of nominal GDP but leaves Federal Reserve officials free to select

38

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

the means of doing so. In principle, there is no reason why the Federal Reserve could not target the growth rate of nominal GDP in the current operating framework. The only difference between doing so in the current system as compared with the pre-crisis system is that increasing the growth rate of nominal GDP now requires larger asset purchases, all else equal. Given the political incentives involved, these asset purchases are unlikely to be allocatively neutral. Thus, granting the monetary authorities instrument independence can still lead to undesirable outcomes, such as the misallocation of credit. The post-crisis experience points to the need to think beyond which monetary rules are superior in a purely technical sense, and instead incorporate political economy considerations into our analysis of monetary rules to gain a better understanding of how institutional alternatives will work in practice.29 In other words, we need to adopt a “monetary rules without romance” approach. Such an approach would take as its starting point that both political officials and monetary policymakers are self-interested.30

Conclusion In this chapter, I have endeavored to highlight those areas where I think those working in the Austrian tradition can contribute to ongoing discussions about monetary policy and business cycles. The first area that requires additional work is incorporating interest on reserves into ABCT. Under the current framework, banks no longer lend all their excess reserves, which limits the extent to which increases in the monetary base will spill over into the loanable funds market. Making this institutional feature explicit in Austrian models of the business cycle remains to be done. The next area where Austrian insights can be applied to current debates over monetary policy is the effect of the current framework on the allocation of credit, and how it will affect the efficiency of the financial system and long-term economic growth. In my view, the traditional type of malinvestment should not be the immediate concern of those working in the Austrian tradition as the new operating framework reduces the likelihood of an Austrian-style business cycle in the near future. Rather, the focus should be on the effects of the Federal Reserve’s increased role in financial intermediation and the sorts of investments the central bank is now financing.31

MONETARY POLICY AND BUSINESS CYCLES

39

Another area where those working in the Austrian tradition can contribute is to link the different types of investments the Federal Reserve is financing with public choice insights about political behavior. In my view, one limitation of the ABCT is that it treats the decision to expand the money supply as a sort of accident, rather than as the byproduct of political competition. For instance, how Federal Reserve officials interpreted the law authorizing the payment of interest on reserves and how they have used this authority is more consistent with traditional models of bureaucratic behavior than it is with the mainstream assumption of benevolence. These developments only serve to strengthen the case for monetary rules, especially in light of how Federal Reserve officials have used the central bank’s post-crisis operating framework to further allocate credit in response to the COVID-19 pandemic.32 There are two areas in this vein that I believe should receive the attention of scholars friendly to the Austrian tradition. The first is the comparative analysis of rules that could, in principle be capable of preventing or at least minimizing the harm caused by malinvestment. The second is the comparative analysis of rules that are more robust to a wider set of policymaker motivations. Here, the close relationship that the Austrian tradition has with Virginia Political Economy could be useful. In my view, the change in the Federal Reserve’s role in the fiscal process highlights the critical importance of coming up with rules that are robust to policymakers that may not be interested in promoting the public good. Perhaps, as Steve Horwitz (2011) has argued, no rule is necessary. Instead, more radical alternatives should be considered.

Acknowledgments I owe a debt of gratitude to Louis Rouanet for his helpful comments and criticisms of an earlier draft of this chapter. All remaining errors are my own.

Notes 1. 2. 3.

See Cachanosky & Salter (2017) for a review of the post-crisis literature. In this sense, the aim of this chapter is similar to other work, such as that by Young (2015) that seeks to incorporate additional features of the financial system that could affect the implications of ABCT in important ways. As I explain in the fourth section, Congress had already authorized the Fed to pay interest on reserves in 2006 as part of the Financial Services Regulatory Relief Act,

40

4. 5.

6.

7. 8. 9. 10. 11. 12.

13.

14.

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

but the interest on reserves provision was not originally set to take effect until 2011. At the Fed’s urging, Congress moved up the date the Fed could pay interest on reserves so that the Fed could prevent its emergency lending from affecting its federal funds rate target. See G. A. Selgin (2018) for an extensive analysis of the Federal Reserve post-crisis framework. The so-called Taylor Rule is an example of such an approach. The rule indicates the appropriate target of the federal funds rate given the real rate of interest, the gap between actual and the natural rates of output, and the gap between actual and desired inflation. See Taylor (1993) for additional details. This process worked in reverse as well. If, for example, prices were increasing too rapidly, Federal Reserve officials would target a higher federal funds rate by removing reserves from the banking system via open market sales. The money supply would shrink, total spending would decrease, and the speed with which prices were increasing would slow down as a result. The monetary base consists of two components: currency and reserves. Note the Federal Reserve no longer differentiates between required and excess reserves because monetary policymakers set the required reserve ratio to zero at the beginning of the COVID-19 pandemic. See McCallum (1989) for a simple exposition of the relationship between the money multiplier and the money supply. Indeed, proponents of the current framework point to the separation of money from monetary policy as one of the system’s primary benefits (Keister et al., 2008). See Garrison (2001) for a graphical exposition of the ABCT model. Lucas (1977, p.  23), for example, briefly contrasts the monetarist view of the business cycle with those of Haberler (1937) and Hayek (1933). In his view, changes in the relative prices of inputs and outputs brought about by variations in the supply and demand for money are the underlying cause of business cycles, whereas proponents of the Austrian view point to variations in the interest rate brought about by artificial increases in the supply of loanable funds as the source of business-cycle fluctuations. In principle, a central bank that maintained a constant state of monetary equilibrium via appropriate changes in the quantity of high-powered money would avoid business-cycle fluctuations of both the Austrian and monetarist varieties. So-called “real business cycles” would still occur, however. Since I aim to illustrate the implications of paying interest on reserves for ABCT, the remainder of my discussion will focus on those circumstances involving liquidity injections that are more than that necessary to maintain monetary equilibrium. Note that yields on alternative financial assets need not equal the interest paid on excess reserves to convince banks to hold the reserves rather than lend them. The interest paid on excess reserves is essentially a risk-free rate, and holding reserves does not require banks to incur the costs associated with making loans. Thus, holding reserves may offer a higher return than making loans even if the yield on the former is less than the latter. See Selgin (2018, pp. 73–79) for additional details on this point. See also Hogan (2021), who finds evidence that interest on excess reserves reduced bank lending. It is also worth noting that paying a negative rate of interest on excess reserves—as the European Central Bank did—could be contractionary. What matters is the difference between the rate the central bank pays and the relative market rate. Indeed, the behavior of nominal GDP in European countries during the Great Recession suggests that monetary policy was too tight

MONETARY POLICY AND BUSINESS CYCLES

15.

16.

17. 18.

19. 20. 21. 22. 23.

24. 25. 26.

27.

41

despite the European Central Bank paying negative rates of interest on excess reserves (Sumner, 2021, Ch. 19). Note, however, that whether banks regard excess reserves as a source of loanable funds or as a low-risk investment is particularly sensitive to the interest rate paid on excess reserves relative to market rates. If the rate paid on reserves is too low, then the monetary policy regime will shift to one wherein banks regard excess reserves as a source of loanable funds, which could then trigger a boom–bust cycle of the ABCT variety. See Dutkowsky & VanHoose (2017) for a discussion of this aspect of the Fed’s current operating system. If paying interest on reserves reduces the efficiency with which the financial system channels savings into investment, then doing so may reduce long-run economic growth. Lower growth would tend to reduce the demand for loanable funds, which would lower the natural rate of interest but would not generate an ABCT-style boom–bust cycle. Estimating the natural rate of interest is difficult to do, but these estimates are consistent with the long-run trend in the bond market. See Holston et al. (2017) for international estimates of the natural rate. Note that the time series of the money multiplier in Figure 2.3 reflects the average multiplier, not the marginal multiplier, which is likely much lower than the time series indicates. As such, the relationship between reserve creation and credit creation is probably much weaker than that indicated by the figure. More specifically, paying interest on reserves out of the interest income earned from the central bank’s asset portfolio transforms “the central bank into a zero-profit financial intermediary” (Champ et al., 2022, p. 231). In principle, the Federal Reserve’s asset portfolio could be structured in such a way as to avoid the problem of preferential credit allocation, but given the incentives that monetary policymakers face, such an outcome seems unlikely. I have made this point elsewhere as it applies to the Confederacy’s use of the financial system to fund the government’s activities during the US Civil War (Cutsinger, 2020). For criticism of the Tolley–Friedman optimality argument see Sargent & Wallace (1982). See Shughart & Tollison (1983) for empirical evidence in support of the bureaucratic hypothesis. See also: Timberlake (1985) and Toma & Toma (1985). To the best of my knowledge, Alchian & Kessel (1962) were the first to identify the effects that attenuated ownership will have on the cost function of a firm. Shughart & Tollison (1983) found a positive relationship between the Fed’s income and its total outlays. See G. A. Selgin (2018) for a detailed account of how Fed officials went about interpreting the law and how this interpretation contradicted earlier testimony by Fed officials in support of paying interest on reserves. More specifically, Congress capped the Federal Reserve’s equity capital, requiring the central bank to remit surplus over the legal maximum to the Treasury. Interestingly, capping the Federal Reserve’s equity capital increases the incentive for Fed officials to capture non-pecuniary benefits. Salter & Luther (2019) argue that the political process is unlikely to select monetary policymakers that act in accordance with the public interest. Moreover, it does appear that the political environment in which monetary authorities make decisions impinges on the policies they support (Salter & Smith, 2019).

42

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

28. See Abrams (2006) and Smith & Boettke (2015) for illustrations of how the executive branch influences monetary policy, Binder & Spindel (2017) and Hess & Shelton (2016) for illustrations of how the legislative branch influences monetary policy, and Blau (2017) and Blau et al. (2013) for illustrations of how political connectedness influences the Federal Reserve’s lender of last resort lending. 29. See Salter (2017) for a political economy analysis of various rules. 30. A note of caution is in order. I am not claiming that political officials and monetary policymakers are any more or less self-interested than their private-sector counterparts. Instead, I am arguing that our analysis of monetary rules should assume that political officials and monetary policymakers are no different than everyone else, i.e., they are self-interested. The assumption of behavioral symmetry across private and public spheres shifts the analytical focus away from policymakers’ motivations and refocuses it on the constraints generated by the institutional setting. See Boettke et al. (2021) for a book-length discussion of these issues. 31. Of course, that is not to say that traditional Austrian concerns are unfounded. If Federal Reserve officials lower the interest rate paid on reserves sufficiently, they may revive the traditional monetary transmission mechanism, which would have the potential to create the sort of credit boom with which those in the Austrian tradition are concerned. 32. See Cachanosky et al. (2021) for additional details.

References Abrams, B. A. (2006). How Richard Nixon pressured Arthur Burns: Evidence from the Nixon Tapes. The Journal of Economic Perspectives, 20(4), 177–188. Alchian, A. A., & Kessel, R. A. (1962). Competition, monopoly, and the pursuit of pecuniary gain. In Aspects of Labor Economics (1st ed., pp. 157–183). Princeton, New Jersey: Princeton University Press. Barro, R. J., & Gordon, D. B. (1983). A positive theory of monetary policy in a natural rate model. Journal of Political Economy, 91(4), 589–610. Binder, S. A., & Spindel, M. (2017). The Myth of Independence: How Congress Governs the Federal Reserve. Princeton, NJ: Princeton University Press. Blau, B. M. (2017). Lobbying, political connections and emergency lending by the Federal Reserve. Public Choice, 172(3-4), 333–358. Blau, B. M., Brough, T. J., & Thomas, D. W. (2013). Corporate lobbying, political connections, and the bailout of banks. Journal of Banking & Finance, 37(8), 3007–3017. Boettke, P. J., Salter, A. W., & Smith, D. J. (2021). Money and the Rule of Law. New York, NY: Cambridge University Press. Cachanosky, N., Cutsinger, B. P., Hogan, T. L., Luther, W. J., & Salter, A. W. (2021). The Federal Reserve’s response to the COVID-19 contraction: An initial appraisal. Southern Economic Journal, 87(4), 1152–1174. Cachanosky, N., & Salter, A. W. (2017). The view from Vienna: An analysis of the renewed interest in the Mises-Hayek theory of the business cycle. The Review of Austrian Economics, 30(2), 169–192. Champ, B., Freeman, S., & Haslag, J. H. (2022). Modeling Monetary Economies (5th ed.). Cambridge, MA: Cambridge University Press.

MONETARY POLICY AND BUSINESS CYCLES

43

Cutsinger, B. P. (2020). Forced savings and political malinvestment: An application of Steve Horwitz’s microfoundations and macroeconomics. The Review of Austrian Economics, 34, 311–322. Cutsinger, B. P., & Luther, W. J. (2022). Seigniorage payments and the Federal Reserve’s new operating regime. Economics Letters, 220, 110880. Dutkowsky, D. H., & VanHoose, D. D. (2017). Interest on reserves, regime shifts, and bank behavior. Journal of Economics and Business, 91, 1–15. Dutkowsky, D. H., & VanHoose, D. D. (2018). Interest on reserves and Federal Reserve unwinding. Journal of Economics and Business, 97, 28–38. Fischer, S. (1995). Central-Bank independence revisited. The American Economic Review, 85(2), 201–206. Friedman, M. (1960). A Program for Monetary Stability. New York, NY: Fordham University Press. Garrison, R. W. (1996). Central banking, free banking, and financial crises. The Review of Austrian Economics, 9(2), 109–127. Garrison, R. W. (2001). Time and Money: The Macroeconomics of Capital Structure. London; New York: Routledge. Haberler, G. (1937). Prosperity and Depression: A Theoretical Analysis of Cyclical Movements. Cambridge, MA: Harvard University Press. Hayek, F. A. (1933). Monetary theory and the trade cycle. In Prices and Production and Other Works: F.A. Hayek on Money, the Business Cycle, and the Gold Standard (pp. 1–130). Auburn, AL: Ludwig von Mises Institute. Hayek, F. A. (1935). Prices and production. In Prices and Production and Other Works: F.A. Hayek on Money, the Business Cycle, and the Gold Standard (pp. 189–330). Auburn, AL: Ludwig von Mises Institute. Hayek, F. A. (1945). The use of knowledge in society. The American Economic Review, 35(4), 519–530. Hess, G. D., & Shelton, C. A. (2016). Congress and the Federal Reserve. Journal of Money, Credit and Banking, 48(4), 603–633. doi: 10.1111/jmcb.12312 Hogan, T. L. (2021). Bank lending and interest on excess reserves: An empirical investigation. Journal of Macroeconomics, 69, 103333. Holcombe, R. G. (2017). Malinvestment. The Review of Austrian Economics, 30(2), 153–167. Holston, K., Laubach, T., & Williams, J. C. (2017). Measuring the natural rate of interest: International trends and determinants. Journal of International Economics, 108, S59–S75. Horwitz, S. (2000). Microfoundations and Macroeconomics: An Austrian Perspective. New York, NY: Routledge. Horwitz, S. (2011). Do we need a distinct monetary constitution? Journal of Economic Behavior & Organization, 80(2), 331–338. Ikeda, S. (2005). The dynamics of interventionism. Advances in Austrian Economics, 8, 21–58. Ireland, P. N. (2019). Interest on reserves: History and rationale, complications and risks. Cato Journal, 39(2), 327–337. Jordan, J. L., & Luther, W. J. (2022). Central bank independence and the Federal Reserve’s new operating regime. The Quarterly Review of Economics and Finance, 84, 510–515. Keister, T., Martin, A., & McAndrews, J. J. (2008). Divorcing money from monetary policy. Economic Policy Review – Federal Reserve Bank of New York, 14, 41–56. Kydland, F. E., & Prescott, E. C. (1977). Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy, 85(3), 473–491.

44

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Lucas, R. E. (1977). Understanding business cycles. Carnegie-Rochester Conference Series on Public Policy, 5, 7–29. McCallum, B. T. (1989). Monetary Economics: Theory and Policy. New York, NY: Macmillan Publishing Company. Mises, L. v. (1912). The Theory of Money and Credit. Indianapolis, IN: Liberty Fund, Inc. Mises, L. v. (1949). Human Action: A Treatise on Economics. Auburn, AL: Ludwig von Mises Institute. O’Driscoll, G. P. (2016). Monetary policy and the knowledge problem. Cato Journal, 36(2), 337–352. Plosser, C. I. (2020). Operating regimes and fed independence. Cato Journal, 40(2), 361–371. Rouanet, L., & Hazlett, P. (2022). The redistributive politics of monetary policy. Public Choice, 194 1–26. Salter, A. W. (2017). Some political economy of monetary rules. The Independent Review, 21(3), 443–464. Salter, A. W., & Luther, W. J. (2019). Adaptation and central banking. Public Choice, 180, 243–256. Salter, A. W., & Smith, D. J. (2017). What you don’t know can hurt you: Knowledge problems in monetary policy. Contemporary Economic Policy, 35(3), 505–517. Salter, A. W., & Smith, D. J. (2019). Political economists or political economists? The role of political environments in the formation of fed policy under Burns, Greenspan, and Bernanke. The Quarterly Review of Economics and Finance, 71, 1–13. Sargent, T. J., & Wallace, N. (1982). The real-bills doctrine versus the quantity theory: A reconsideration. Journal of Political Economy, 90(6), 1212–1236. Selgin, G. (2020). The Menace of Fiscal QE. Cato Institute. Selgin, G. A. (1991). Monetary equilibrium and the ‘productivity norm’ of price-level policy. In R. Ebeling (Ed.), Austrian Economics: Perspectives on the Past and Prospects for the Future (pp. 433–464). Hillsdale, MI: Hillsdale College Press. Selgin, G. A. (2018). Floored!: How a Misguided Fed Experiment Deepened and Prolonged the Great Recession. Cato Institute. Shughart, W. F., & Tollison, R. D. (1983). Preliminary evidence on the use of inputs by the Federal Reserve system. The American Economic Review, 73(3), 291–304. Smith, D. J., & Boettke, P. J. (2015). An episodic history of modern fed independence. Independent Review, 20(1), 99–120. doi: http://​www​.independent​.org/​publications/​ tir/​ Sumner, S. (2021). The Money Illusion: Market Monetarism, the Great Recession, and the Future of Monetary Policy. Chicago, IL: University of Chicago Press. Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195–214. Timberlake, R. H. (1985). Legislative construction of the Monetary Control Act of 1980. The American Economic Review, 75(2), 97–102. Tolley, G. S. (1957). Providing for growth of the money supply. Journal of Political Economy, 65(6), 465–485. Toma, E. F., & Toma, M. (1985). Research activities and budget allocations among Federal Reserve Banks. Public Choice, 45(2), 175–191. Toma, M. (1982). Inflationary bias of the Federal Reserve system. Journal of Monetary Economics, 10(2), 163–190. Young, A. T. (2015). Austrian business cycle theory: A modern appraisal. In P. J. Boettke & C. J. Coyne (Eds), The Oxford Handbook of Austrian Economics (pp. 186–212). New York, NY: Oxford University Press.

3

Austrian economics and mainstream entrepreneurship: retrospect and prospect

David S. Lucas

Introduction The purpose of this chapter is to analyze the role of Austrian economics in the field of “mainstream entrepreneurship.” Specifically, I use historical data, academic literature, and bibliometric analysis to present three key patterns. First, I provide a brief overview of the evolution of mainstream entrepreneurship. In this, I establish that the intellectual heritage of mainstream entrepreneurship is heavily influenced by economics—and specifically by the work of seminal Austrian economists. Second, despite a common heritage, I detail a pronounced intellectual divergence from ongoing Austrian scholarship. Mainstream entrepreneurship’s path evolved in parallel to, but distinct from, the path of Austrian economics scholarship following their concurrent emergence in the 1970s. I (speculatively) attribute this divergence to institutional factors in their respective academic contexts, leading to distinct research questions and analytical foci. Third, I propose that this divergence is diminishing. To that end, I present a bibliometric analysis revealing a small but growing cross-citation to Austrian field journal articles in top entrepreneurship and management journals. Having established this intellectual trajectory of common foundation, divergent evolution, and renewed synergy, I conclude with some general guidelines and potential pitfalls for Austrian scholars looking to contribute to mainstream entrepreneurship. While not without challenges, there are rich prospects for novel contributions to the entrepreneurship field that build on Austrian scholarship—both past and present.

45

46

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

A brief history of mainstream entrepreneurship What I am calling “mainstream entrepreneurship” essentially corresponds to what others label “the academic field of entrepreneurship research” (Aldrich, 2012). Mainstream entrepreneurship scholars typically study the emergence, growth, and performance of new and small businesses. Although not exclusively, the field is predominately housed within business schools and connected through business school-centric academic networks (e.g., the Academy of Management). In turn, the most directly adjacent areas of study are other business disciplines, such as management and strategy—although there are clear intellectual influences from across the social sciences. While a complete history of the field is beyond the scope of this article, a brief overview is instructive. First, a distinction must be made between the “field” of mainstream entrepreneurship and the “concept” of entrepreneurship. As a concept, the “entrepreneur” has been a part of economics for centuries; the term itself has been traced to Richard Cantillon and is riddled through the work of economists such as Menger and Knight. However, while some economists have persistently viewed economics as a science of the entrepreneurial market process (i.e., the Austrians), the same could not be said of the mainstream (Boettke, 1997). Throughout the 20th century, an increasing formalization around quantitative, equilibrium-centric models pushed the entrepreneurial element to the fringes of economics (Boettke et al., 2012). These trends belied the role of the alert entrepreneur—and with it, the rich implications of subjectively-evaluated, future-oriented, combinatory action by profit-seekers. The departure was so conspicuous that William Baumol lamented, “The theoretical firm is entrepreneurless – the Prince of Denmark has been expunged from the discussion of Hamlet” (Baumol, 1968, p. 68). It was, perhaps, this very expungement that led the outcast Prince to find a home in the business school. By this, I am referring to the rise of mainstream entrepreneurship: a distinct field of inquiry replete with its own scholars, departments, journals, and theories. Thus, despite the concept’s storied history, mainstream entrepreneurship can be traced to more recent roots in the 1970s (Landström et al., 2012). Parallel trends within academic halls and policy spheres gave rise to an increased attention to small business creation. On the academic side, a growing number of scholars were becoming increasingly interested in entrepreneurship and increasingly frustrated with its limited destiny in their respective disciplines. In turn, an interdisciplinary community of scholars began to emerge—a coales-

AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP

47

cence of disparate researchers united loosely by their interest in the emergence, growth, and performance of small and/or nascent businesses. Thus, the field’s inception involved a heavy phenomenological component, attracting diverse scholars from economics, psychology, sociology, business policy (strategy), and management. In 1974, an interest group was initiated in the Academy of Management (Landström & Lindhe, 2020). Interestingly, this timing also coincided with the Austrian school’s own “revival,” catalyzed by the famous South Royalton Conference and Hayek’s Nobel Prize that same year. In its formative years, the trajectory of mainstream entrepreneurship was marked by several other prominent events and publications by a growing group of academics seeking to carve out a distinct academic identity. These efforts were undoubtedly bolstered by entrepreneurship’s place in the political Zeitgeist. Most notably, David Birch’s (1979) work, The Job Generation Process, provided a comprehensive report attributing the majority of job creation activity to small businesses (cf. Decker et al., 2014). Many have suggested that this report was a key evidentiary resource for the rise of economic policies associated with Reagan in the US and Thatcher in the UK. Hence, policymaker and academic interest in entrepreneurship grew together, linked in part by the strong “small business” coalition. Soon, though, venture creation replaced job creation as the core focus in the field. Additional institutional and intellectual milestones followed in the next decades. The first Babson College Entrepreneurship Research Conference (a prominent field conference) was hosted in 1981. The first issue of Journal of Business Venturing was published in 1985. The Academy of Management interest group became a fully-fledged “Division” in 1986—solidifying its place in the halls of the business school (Landström & Lindhe, 2020). Against this backdrop of growing momentum, scholars began to carve out a distinct theoretical paradigm for mainstream entrepreneurship that has arguably persisted to this day. Perhaps most notable is the seminal Academy of Management Review piece by Shane and Venkataraman (2000), which drove a stake in the ground for mainstream entrepreneurship in the leading management theory outlet. Other concurrent works in top business journals (e.g., Shane, 2000) offered evidence that entrepreneurship was poised to ask unique questions and provide meaningful answers. In the next years, these efforts began to coalesce into a coherent theoretical foundation for studying entrepreneurial action (e.g., McMullen & Shepherd, 2006). Many new journals emerged that explicitly focused on entrepreneurship, innovation, and/or small business; a few vaulted quickly to highly respected positions within the aca-

48

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

demic research hierarchy, e.g., Entrepreneurship Theory and Practice (founded 2004) and Strategic Entrepreneurship Journal (2008). Today, the field has proliferated in terms of both research and teaching. The Academy of Management’s Entrepreneurship Division boasts over 3,200 members worldwide. There are many respected entrepreneurship field journals, and three have made it to what is likely the best-known business school journal list: the Financial Times Top-50 (“FT-50”). This is noteworthy since the FT-50 is referenced by many business schools in promotion and tenure decisions. In the classroom, undergraduate entrepreneurship programs have exploded. Many schools now have thriving incubators and business plan competitions for student ventures. Graduate programs are also on the rise; a number of top-tier business schools offer PhD programs specifically in entrepreneurship, including Indiana University, the University of Colorado, and Syracuse University, among others (Cooper, 2015). It is safe to say that the field of mainstream entrepreneurship has reached a stage if not of maturity, at least of prevalence and prominence within the business school context.

Austrian scholarship’s role in mainstream entrepreneurship The current state of the field Today, mainstream entrepreneurship boasts a vibrant and diverse set of topics, approaches, and perspectives. For instance, Journal of Business Venturing has field editors in Digital Issues, Economics, Finance, Innovation, International, Management, Marketing, Organization Theory, Psychology, Social/Sustainable/Development, Sociology, and Strategy. Many methodological approaches are leveraged, including quantitative (e.g., econometrics), qualitative (e.g., case studies, analytical narratives), and theoretical contributions of both formal (mathematical) and informal (narrative-style). This methodological potpourri reflects the intellectual diversity of the field—which, in turn, is a key reason why Austrian economics is poised to be well-received in the field’s future. Generally, the field’s focus is “the entrepreneurial process,” understood broadly as the process by which actors identify and exploit opportunities by combining resources to create and capture economic value. These actors are typically individuals, teams, or firms (though not always, e.g., Lumpkin & Bacq, 2019). In turn, the goal of entrepreneurship research tends toward explaining the emer-

AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP

49

gence, growth, and performance of new ventures based on individual-level, firm-level, and higher-level (e.g., institutional) factors. A complete summary of the many research streams in the field is well beyond this chapter’s scope. However, some of the key themes—and their Austrian influences—are worth mentioning. At the individual level, many key research questions fall under the umbrella of “individual cognition and choice.” This work often draws on psychology to explain the cognitive prerequisites to entrepreneurial action, looking at outcome variables related to the evaluation and exploitation of opportunities (e.g., by creating a business). While the emphasis on cognitive explanatory variables falls beyond the scope of traditional praxeological inquiry, Austrian ideas have nonetheless informed this research agenda. In particular, scholars have pointed to uncertainty, very much in the Austrian sense, as a foundational criterion for defining action as “entrepreneurial” (McMullen & Shepherd, 2006). The theoretical premise that individual entrepreneurs “recognize and exploit opportunities”—a decidedly Kirznerian notion—has led to a vibrant research agenda explaining the cognitive foundations of opportunity recognition (Grégoire et al., 2010; Grégoire & Shepherd, 2012). The Hayekian notion of distributed knowledge as a source of opportunity (Hayek, 1945) informs much of this work. Most entrepreneurship scholars will readily accept that prior, tacit, specialized knowledge informs the entrepreneur’s cognitive assessment (Shane, 2000), and they will increasingly seek to explain how such knowledge is leveraged to pursue profit under uncertainty. In turn, leading scholars of entrepreneurial action expressly grapple with Austrian insights in developing “cognitive” accounts thereof (McMullen, 2010; Packard, 2017; Packard & Burnham, 2021). Despite the field’s Kirznerian roots, some have challenged the opportunity-discovery-hegemony, arguing that Kirzner’s language and concepts have been misunderstood and/or misapplied in the above mainstream entrepreneurship literature. Interestingly, many of these critiques also rely on Austrian thinkers. For instance, Klein and Foss have leveraged Mises’ work to call for a focus on “judgment”, referring to the entrepreneur’s subjective assessment and the resulting resource allocation decisions (N. J. Foss et al., 2019; N. J. Foss & Klein, 2020). Others have sought to build an alternative account of entrepreneurial action based on insights from “radical subjectivist” Austrians such as Lachmann and Shackle (Chiles et al., 2007, 2010). Thus, individual-level entrepreneurship research is riddled with Austrian influences of multiple flavors.

50

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

When studying firm-level outcomes, entrepreneurship scholars generally look to explain the emergence, growth, and performance of new ventures. Here, questions of strategy come to the fore—in which Austrian ideas again have a welcome (but often implicit) role (Klein & Bylund, 2014). For instance, unlike in the field of economics’ homogenization of the capital stock, entrepreneurship scholarship tends to take the heterogeneity of firm resources and capabilities as the analytical starting point. Austrian ideas about capital heterogeneity have been, and continue to be, influential in this respect (K. Foss et al., 2007). Moving to a higher explanatory level, there is increasing interest in the “context” of entrepreneurship—e.g., the institutional factors that promote or deter entrepreneurial activity by individuals and firms. Here again, scholars have leveraged central Austrian ideas to articulate the role of functioning market institutions for entrepreneurship, e.g., to (1) provide useful knowledge through prices, (2) facilitate feedback through profit and losses, and (3) provide effective incentives through clear and defined property rights (McMullen et al., 2008; Minniti, 2008; Minniti & Lévesque, 2010). In this sense, the notion that “good” institutions promote entrepreneurial activity and “bad” institutions deter it has been studied and affirmed repeatedly—e.g., using the large-scale, international entrepreneurship data produced by the Global Entrepreneurship Monitor (GEM). Finally, there is a growing interest in what might broadly be called “social entrepreneurship,” understood as entrepreneurial action seeking to create economically sustainable ventures that also proactively address social challenges such as environmental degradation, unemployment, and homelessness. Austrian ideas seem to have had less of a role in this area (cf. Dean & McMullen, 2007); yet, this need not be the case going forward (Lucas, 2021). In sum, an informal review of the entrepreneurship literature readily reveals evidence of influence by leading Austrians such as Mises, Hayek, Kirzner, Lachmann, and Shackle. But while this affirms the “legacy” influence of Austrian thinkers, it does not reveal the ongoing relationship between the vibrant fields of modern Austrian economics and mainstream entrepreneurship. Common foundations, different trajectories? What, then, is the role of Austrian economics in the trajectory of entrepreneurship scholarship? A notable paper by Klein and Bylund (2014) utilizes citation data to analyze the influence of Israel Kirzner on management and entrepreneurship research. They find that several of the most influential

AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP

51

books and journal articles in mainstream entrepreneurship cite Kirzner’s seminal Competition and Entrepreneurship. They also view Kirzner’s work as the ostensible foundation for the “opportunity-discovery” view (Shane & Venkataraman, 2000). This dominant view defines entrepreneurship in relation to opportunities—a set of external conditions (e.g., a coalescence of unmet demand, undervalued resources, and favorable timing)—that alert entrepreneurs must discover and exploit in order to create and capture value. Thus, there is ample evidence that Austrian “ideas” have influenced entrepreneurship and management scholarship. Yet, there is also a general consensus that the two have evolved in quite different trajectories. While Klein and Bylund (2014) document a clear bibliometric trail for Kirzner within entrepreneurship, they argue that this trail has led mainstream entrepreneurship further afield of the core insights of the Austrian school. Similarly, Klein and Foss have repeatedly argued that the opportunity-discovery view has elicited a dubious interpretation and extension of Kirzner’s theory (e.g., N. J. Foss & Klein, 2020).1 Koppl and Minniti (2003, p. 218) also lament “misunderstandings… about the Austrian approach to entrepreneurship” as “particularly common” in entrepreneurship and the broader management field. Thus, while Austrian foundations were present during the field’s emergence, the sense shared by scholars at the intersection of these fields is that mainstream entrepreneurship has evolved largely independently of ongoing work in the Austrian tradition. Thus, what remains unclear is how the “modern” Austrian and mainstream entrepreneurship literatures intersect. Has ongoing work in Austrian economics beyond the foundational thinkers played a role in the intellectual trajectory of mainstream entrepreneurship?

Cross-citation analysis To answer this question, I analyze cross-citations to the leading Austrian field journals within the leading entrepreneurship and management journals. Cross-citation analysis is an established bibliometric technique for identifying interdisciplinary relationships in the social sciences (Osareh, 1996). This approach follows from the notion that citations—e.g., to specific articles or to a journal in another field—are indicative of intellectual influence. Scholars have leveraged citation analyses to identify fields within business research overall (Mingers & Leydesdorff, 2015) as well as the research terrain within entrepreneurship (Schildt et al., 2006). Based on this, citation analysis is an appropriate technique to assess the influence of Austrian scholarship in main-

52

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

stream entrepreneurship (Klein & Bylund, 2014). Since the question of interest pertains to the reach of Austrian work within entrepreneurship (not vice versa), I focus on references to Austrian journal articles in entrepreneurship and management publications. I collect cross-citation data from the relevant management and entrepreneurship field journals included on the FT-50. The included journals, along with their Impact Factors, are listed in Table 3.1. I also collect data for three prominent field journals in entrepreneurship that are not included in the FT-50: Entrepreneurship and Regional Development, Journal of Small Business Management, and Small Business Economics. Altogether, 15 journals are included in the analysis, six of which are entrepreneurship-specific field journals and two of which are entrepreneurship-adjacent field journals (Research Policy and Journal of International Business Studies). For the target Austrian outlets, I consider the five leading journals in this field: Advances in Austrian Economics (AAE), The Independent Review (TIR), Journal of Private Enterprise (JPrivE), Review of Austrian Economics (RAE), and Quarterly Journal of Austrian Economics (QJAE). While there are other journals devoted to Austrian and Austrian-adjacent scholarship, the selected journals arguably represent the “core” of the Austrian academic field in terms of topics and contributors. Citation analyses typically rely on either Thomson/Reuters Journal Citation Reports (JCR) or the Social Science Citation index (SSCI) to collect data. However, because some relevant Austrian journals are not indexed by these sources, I utilized Google Scholar. I searched within all articles in each entrepreneurship and management publication above (e.g., source: “Journal of Business Venturing”) for those that include the relevant Austrian journal title (e.g., exact search for “Review of Austrian Economics”). I then affirmed that at least one of the journal’s publications was included in the reference list. Data were collected in May 2021. This data collection effort yielded 207 unique articles that reference at least one Austrian publication across the 15 journals, for an average of 13.8 articles per journal. The most highly-cited Austrian outlet was RAE (N = 114), followed by AAE (42), and then a tie between JPrivE (36) and QJAE (36), followed by TIR (18). The majority of articles (N = 175, 84 percent) cited only one of the four Austrian outlets; a small number cited two (25, 12 percent) or three outlets (7, 3 percent). In addition, many of these articles also cite other “Austrian” literature—e.g., Kirzner’s Competition and Entrepreneurship or his Journal

AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP

Table 3.1

53

Journals included in the citation analysis

Journal

Field

Impact factora

FT-50b

Entrepreneurship Theory and Practice

Entrepreneurship

9.55

Yes

Journal of Business Venturing

Entrepreneurship

10.79

Yes

Strategic Entrepreneurship Journal

Entrepreneurship

5.41

Yes

Entrepreneurship and Regional Development

Entrepreneurship

4.58

No

Journal of Small Business Management

Entrepreneurship

4.55

No

Small Business Economics

Entrepreneurship

4.45

No

Academy of Management Journal

Management

11.89

Yes

Academy of Management Review

Management

14.17

Yes

Administrative Science Quarterly

Management

10.36

Yes

Management Science

Management

5.56

Yes

Organization Science

Management

5.61

Yes

Organization Studies

Management

5.24

Yes

Strategic Management Journal

Management

8.36

Yes

Journal of International Business Studies

c

Management

9.71

Yes

Research Policy

Managementc

7.35

Yes

Notes:  Five-year impact factor as of 2019; b FT-50 list as of May 2016; c Entrepreneurship-adjacent field journals in Management. a

of Economic Literature piece (Kirzner, 1997)—consistent with prior findings (Klein & Bylund, 2014). Figure 3.1 plots the number of Austrian-citing articles over time, starting with the first cross-citation identified in 1991. The figure reveals relatively limited cross-citation activity in the 1990s; this is consistent with the intellectual divergence of Austrian and entrepreneurship scholarship that I asserted above. However, the figure also shows a clear upward trend in Austrian-citing articles in top management and entrepreneurship journals in the 21st century. A particularly encouraging outcome is that the most recent complete year of data, 2020, yields the second-highest cross-citation result yet (N = 16). And

54

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

even though some 2021 issues were still forthcoming as of data collection, the running annual total is already the third-highest to date (15). This yields considerable cause for optimism about the growing reach of Austrian scholarship within mainstream entrepreneurship. Another instructive data point is 2008, which boasted the largest single-year count to date (17). Over half of these articles were produced in two special issues in the top entrepreneurship journals, Entrepreneurship Theory and Practice (ETP) (5) and Journal of Business Venturing (JBV) (4). Both special issues were co-edited by my colleague Maria Minniti, a leading scholar in both Austrian economics and mainstream entrepreneurship. Importantly, neither special issue was “Austrian” per se; the ETP special issue focused on public policy and entrepreneurship (Minniti, 2008), while the JBV special issue dealt with the economics of entrepreneurship (Minniti & Lévesque, 2008). Both resulted in multiple publications that build not only on the Austrian “legacy” but also on active research within Austrian economics. This is suggestive of the vital role that intellectual entrepreneurs such as Minniti play in building bridges between the two fields, while also highlighting research areas that Austrian scholars can build upon in the future. It is also worth noting that much of the recent increase is driven by entrepreneurship field journals that are not in the FT-50. Out of the 46 articles in 2019–2021, only 14 (30 percent) were found in FT-50 outlets: ETP (6), SMJ (4), JBV (2), AMR (1), and SEJ (1). The other 32 came from SBE (20), ERD (6), and JSBM (6). Thus, while the growth is certainly encouraging, there is still considerable room for Austrian scholarship to increase its influence in the most “impactful” journals. Figure 3.2 explores the results by publication and discipline. Entrepreneurship field journals yield consistently more cross-citation activity than general management journals; entrepreneurship journals round out the top five spots in the cross-citation data. SBE stands alone with the largest number of Austrian-citing articles (N = 53), followed by ETP (27) and JBV (24). Below these come field journals ERD (18) and JSBM (17). SEJ falls considerably behind (6; though note that SEJ is the newest of the three FT-50 entrepreneurship journals). Overall, it is encouraging that the entrepreneurship field journals are well-represented with respect to Austrian economics influence. The results from several of the top general management journals are also encouraging. In particular, Organization Science has published 12 articles with Austrian journal references. A notable instance is Chiles et al. (2007), who expressly offer a theory of entrepreneurship based on Lachmann (see also Chiles et al., 2010). The four Strategic Management Journal citations all came

AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP

Figure 3.1

Articles citing Austrian journals over time

Figure 3.2

Articles citing Austrian journals by publication

55

56

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

within the last two years. Together, these results signal a promising trajectory for Austrian economics in mainstream entrepreneurship and in management overall. Unpacking the results by Austrian contribution The bibliometric analysis reveals that there has been an increasing trend of cross-citation to Austrian scholarship in recent years. However, this does not necessarily speak to the nature of the intellectual overlap observed. To better understand this, I collected a second dataset: a bibliography of each Austrian article cited in the top three entrepreneurship field journals: ETP, JBV, and SEJ. With this, I tallied the total number of citations for each article in each journal; this differs from the above analysis, which reported the number of entrepreneurship articles with “at least one” citation to an Austrian journal. The present effort identifies all Austrian citations within a given entrepreneurship article and also considers Austrian contributions that multiple articles within the same outlet have cited. Thus, in addition to highlighting specific Austrian contributions, this exercise allows for a finer-grained analysis of intellectual influence. Table 3.2 reports the list of cited Austrian articles and the citing entrepreneurship outlets. Several results are worth noting. First, the top-cited articles (which tend to be older) are readily recognizable as important articulations of “Austrian” perspectives on key entrepreneurship issues. Kirzner (1999) is cited most; this is intuitive, given his influence. The next several articles also address central Austrian themes: opportunity discovery (Yu, 2001), institutions and entrepreneurship (Harper, 1998), and the entrepreneur’s role in economic growth (Holcombe, 1998). Each of these topics continues to generate ongoing, vibrant conversation in mainstream entrepreneurship, and Austrian ideas appear to have influenced scholarship therein. A second result is that many authors in this list could be classified as “mainstream entrepreneurship” scholars—e.g., Bylund, Elert, Foss, Klein, Harper, Henrekson, McMullen, Minniti, Sautet, Sobel, and Wennberg, to name a few. This overlap is further evidence of the important role that intellectual entrepreneurs—here, mainstream entrepreneurship scholars with training in (or a proclivity toward) Austrian economics—are playing in the growing success of Austrian ideas within mainstream entrepreneurship. A third result is that when citation counts are considered, ETP pulls away noticeably as the most-citing outlet. ETP’s 43 citations well outpace JBV (26 citations) and SEJ (11 citations) combined. This reveals additional variation in the “degree” of influence across the journals; specifically, it suggests that there are relatively more ETP articles that engage Austrian literature to a deeper extent.2

Year

1999

2001

1998

1998

2010

2010

1993

1999

2001

2002

2003

2003

Kirzner

Yu

Harper

Holcombe

McMullen

Foss & Klein

Monroy & Folger

Klein

Klein & Klein

Hayek

Berggren

Cowen

 

RAE

TIR

QJAE

QJAE

TIR

JPrivE

JPrivE

AAE

QJAE

AAE

RAE

RAE

Outlet

 

Entrepreneurship, Austrian economics, and the quarrel between philosophy and poetry

The benefits of economic freedom: a survey

Competition as a discovery procedure [reprint]

Do entrepreneurs make predictable mistakes? Evidence from corporate divestitures

Discovery and the Deepself

A typology of entrepreneurial paradigm

Alertness, action, and the antecedents of entrepreneurship

Perspective taking and the heterogeneity of the entrepreneurial imagination

Entrepreneurship and economic growth

Institutional conditions for entrepreneurship

Entrepreneurial alertness and discovery

Creativity and/or alertness: A reconsideration of the Schumpeterian entrepreneur

Title

 

Austrian articles cited in FT-50 entrepreneurship field journals

Author(s)

 

Table 3.2

1

2

 

 

1

1

3

 

2

2

2

4

ETP

 

 

1

 

1

1

 

3

2

3

4

4

JBV

1

 

1

2

 

 

 

 

 

 

 

1

SEJ

Citing journal

2

2

2

2

2

2

3

3

4

5

6

9

Total

  AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP 57

Year

2005

2014

1985

1988

1988

1989

1992

1996

1998

1999

1999

2001

Gwartney, Lawson & Clark

Klein & Bylund

Brady

Klatt

Solomon

Pasour

Herbener

Walstad & Kourilsky

Desrochers

Klein

Witt

Desrochers

 

Author(s)

 

TIR

RAE

QJAE

QJAE

JPrivE

RAE

RAE

JPrivE

JPrivE

JPrivE

RAE

TIR

Outlet

 

Eco-industrial parks: the case for private planning

Do entrepreneurs need firms? A contribution to a missing chapter in Austrian economics

Entrepreneurship and corporate governance

On the abuse of patents as economic indicators

The findings from a national survey of entrepreneurship and small business

The role of entrepreneurship in desocialization

The efficient-markets hypothesis and entrepreneurship

Small business management and entrepreneurial education in America: a national survey overview

A study of small business/entrepreneurial education in colleges and universities

Improving student attitudes toward careers in small business management

The place of Austrian economics in contemporary entrepreneurship research

Economic Freedom of the World, 2002

Title

 

1

 

 

1

 

1

1

1

1

1

2

1

ETP

 

 

 

 

1

 

 

 

 

 

 

1

JBV

 

1

1

 

 

 

 

 

 

 

 

 

SEJ

Citing journal

1

1

1

1

1

1

1

1

1

1

2

2

Total

 

58 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Year

2001

2002

2002

2002

2003

2003

2003

2003

2003

2003

2004

2005

Desrochers

Buchanan & Vanberg

Holcombe

Boettke

Boettke & Coyne

Witt

Minniti

Earl

Pejovich

Holcombe

Desrochers & Sautet

Ovaska, Sobel

 

Author(s)

 

JPrivE

RAE

RAE

RAE

AAE

AAE

AAE

AAE

RAE

RAE

RAE

RAE

Outlet

 

Entrepreneurship in post-socialist economies

Cluster-based economic strategy, facilitation policy and the market process

The origins of entrepreneurial opportunities

Understanding the transaction costs of transition: it’s the culture, stupid

The entrepreneur as a constructor of connections

Entrepreneurship studies: A stocktaking

Market opportunity and organizational grind: the two sides of entrepreneurship

Entrepreneurship and development: Cause or consequence?

Information and knowledge: Austrian economics in search of its uniqueness

Political entrepreneurship and the democratic allocation of economic resources

Constitutional implications of radical subjectivism

Geographical proximity and the transmission of tacit knowledge

Title

 

 

1

 

1

 

1

 

 

1

 

1

1

ETP

1

 

1

 

 

 

 

1

 

 

 

 

JBV

 

 

 

 

1

 

1

 

 

1

 

 

SEJ

Citing journal

1

1

1

1

1

1

1

1

1

1

1

1

Total

 

AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP 59

2006

2006

2006

2007

2009

2009

2010

2010

2013

2019

2021

Montanye

Thornton

Koppl

Sobel, Clark & Lee

Hicks

Salerno

Coyne, Sobel & Dove

Nell

Holcombe

Elert & Henrekson

Karlson, Sandstrom & Wennberg

 

2005

Kitzmann & Schiereck

Total

Year

 

Author(s)

 

 

RAE

RAE

TIR

RAE

RAE

QJAE

JPrivE

RAE

RAE

QJAE

TIR

RAE

Outlet

 

 

Bureaucrats or markets in innovation policy? A critique of the entrepreneurial state

The collaborative innovation bloc: A new mission for Austrian economics

Crony capitalism: By-product of big government

Competition as market progress: An Austrian rationale for agent-based modeling

The non-productive entrepreneurial process

Lionel Robbins: Neoclassical Maximizer or Proto-Praxeologist?

What business ethics can learn from entrepreneurship

Freedom, barriers to entry, entrepreneurship, and economic progress

Austrian economics at the cutting edge

Cantillon on the cause of the business cycles

Entrepreneurship

Entrepreneurial discovery and the Demmert/Klein experiment: Another attempt at creating the proper context

Title

 

43

 

1

 

1

1

1

1

1

 

1

1

1

ETP

26

 

 

1

 

 

 

 

 

1

 

 

 

JBV

11

1

 

 

 

 

 

 

 

 

 

 

 

SEJ

Citing journal

80

1

1

1

1

1

1

1

1

1

1

1

1

Total

 

60 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP

61

Austrian economics and the future of mainstream entrepreneurship Based on the above, the influence of Austrian economics in mainstream entrepreneurship could be described as initially strong, then weak, and now growing again. Both fields can trace roots back to leading Austrians such as Mises, Kirzner, and Hayek. Then, as the fields evolved in tandem in their respective academic contexts, they grew with relatively little overlap. Happily, though, there is now increasing overlap in the ongoing work happening in each area. Two natural questions arise with respect to this pattern. The first question pertains to the divergence: why did the two fields remain separate for so long despite their common roots and chronology? As someone trained in Austrian economics, I naturally look to the incentives generated by the respective institutional contexts. For the most part, Austrian scholars are trained in economics departments and spend their careers in economics departments—which are often (not always) situated departmentally alongside policy-oriented fields. These areas’ disciplines have a strong policy and/or “system” orientation—e.g., seeking to explain the economic performance of regions or countries. In turn, the Austrian economists’ success therein has largely been rooted in their unique articulation of the functioning of the entrepreneurial market process as a system. This emphasis on the macro implications of human action pervades virtually all of modern Austrian economics. Hence, even the “individual-level” focus on the entrepreneur within Austrian economics is typically focused on their coordinative role—i.e., of the entrepreneurial function in the economy. By contrast, entrepreneurship scholars are generally trained and work in business schools.3 Despite coming from a wide range of disciplines, the research focus is typically not the performance of the economy, but rather on the specific individual or venture. Business school scholars tend to uncover the determinants of success for the business. While broader societal implications are not dismissed, they tend to reside in the analytical “background” rather than the “foreground” (Wagner, 2010). For instance, whereas the Austrian economist sought to document how entrepreneurs’ reallocation of resources in a market-friendly institutional context tends to generate economic value—e.g., because the value-destroying decisions earn losses—the mainstream entrepreneurship scholar was more focused on explaining why a particular entrepreneurs’ decisions result in profit, while others yield losses. The analytical distinction is substantive enough that both sides are tempted to view one another’s contributions as superfluous to their own field. In sum, much of the

62

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

divergence between Austrian economics and entrepreneurship can be attributed to the kinds of research questions that are cultivated within the respective academic contexts that each field grew in. Given the above explanation, what then is behind the recent growth in overlap between the two fields? If incentives are leveraged to explain one pattern of behavior, a change in the pattern must correspond to a change in those incentives. Anecdotal evidence suggests that this is happening to some extent. For instance, business schools are facing increasing pressure to demonstrate societal implications and relevance beyond the provision of strategies to bolster corporations’ bottom lines. This is evident in an increasing number of calls for papers around “grand challenges” and “issues in society on management and organizations,” as well as the growth of inquiry around social entrepreneurship. As such, there is increasing attention in the top journals given to research questions addressing the societal implications of business (a theme that Austrian economists are well-suited to advance). On the other side, a more secular trend is the increasing breadth of Austrian scholarship and of the Austrian research community. As the field has grown rapidly, scholars trained in Austrian economics have increasingly branched beyond the economics discipline to grapple with issues more endemic to other disciplines such as public administration, political science, sociology, defense and peace studies, homelessness, criminal justice, and, yes—entrepreneurship. In fact, the Austrian and entrepreneurship communities have enjoyed a similarly imperialistic growth into areas such as public management and nonprofit studies (Lucas, 2018). In other words, the secular growth in research scope by both fields has brought them closer together. It is also worth noting that several entrepreneurial academics have sought to build research institutions that carve out space amenable to this intersection. The Institute for an Entrepreneurial Society at Syracuse University (where I am a Research Fellow) cultivates a research agenda around entrepreneurial solutions to major social challenges, drawing expressly on Austrian insights as well from its fellow intellectual travelers such as the Bloomington School and Public Choice. This is one example of a growing infrastructure of organizations, resources, and scholars at the intersection of Austrian economics and mainstream entrepreneurship. Finally, one omission from the above analysis is the reverse influence—i.e., of mainstream entrepreneurship on Austrian economics. There is at least one recent Special Issue (Bylund, 2020) wherein many mainstream entrepreneurship scholars offered interesting contributions to QJAE, providing another

AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP

63

fruitful source of cross-pollination for the future. If the two fields continue to increasingly overlap and intersect as predicted, we may expect to see more of this healthy discourse in journals from both fields—a desirable development for the competition of ideas in each area.

Final thoughts There are many recent efforts to expressly articulate research directions for Austrian economics to advance the study of entrepreneurship in some way or another (Burns & Fuller, 2020; Elert & Henrekson, 2019; N. J. Foss et al., 2019; Lucas, 2021; Lucas et al., 2018). Hence, what appears most lacking is not a research agenda per se but rather the effective execution of this agenda. Thus, rather than highlighting specific research questions, I instead conclude with a few interrelated (and seemingly common) “pitfalls” that Austrian scholars often face when seeking to engage with and publish in mainstream entrepreneurship journals (especially initially). It may be helpful to acknowledge that each of these emerges from a personal (ongoing!) learning experience. First, consider how the outcome you are trying to explain relates to published work in the field. Because Austrian scholars tend to think in terms of pattern predictions related to aggregate effects of the entrepreneurial process—e.g., highlighting equilibrating tendencies—they may be less inclined to ask questions about entrepreneur-level variation—e.g., what causes a given entrepreneur to succeed. As indicated above, entrepreneurship scholars tend to study the performance of the entrepreneur, explaining one entrepreneur’s decisions or outcomes compared with another entrepreneur’s decisions or outcomes. Some studies do look at higher-level outcomes, such as rates of entrepreneurial activity or job creation in a region or industry (Bennett, 2019; Lucas & Boudreaux, 2020), but these are less common. Whatever the level of analysis, consider whether your outcome of interest is also “of interest” to your target audience. Second, and relatedly, do not neglect extant literature in mainstream entrepreneurship. It is tempting to spend so much energy reviewing and regurgitating the seminal insights of the brilliant Austrians of yesteryear that ongoing research on the focal topic is overlooked or dismissed. As an aspiring grad student, I was repeatedly asked one simple question by the great Peter Leeson: “what is the puzzle you are trying to explain?” The implication is that there must be something yet unknown about the causes, mechanisms, or conditional effects associated with this outcome. To identify what is yet unknown, one

64

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

must be able to articulate what is known. This is difficult but essential work. Like other intellectual fields, literature review sections are one of the great barriers to entry in entrepreneurship, since they generally require a significant and irreversible intellectual investment to be executed well. Papers that fail to provide a thoughtful presentation of extant literature on the outcome of choice (in the mainstream entrepreneurship conversation) will face much greater hurdles than papers that do. Third, do not fear interdisciplinary collaboration and synthesis. While Austrian ideas will be readily entertained as legitimate theoretical lenses, they will not “replace” extant theories in the field ad hoc—theories which may originate in any number of social science traditions. Successful entrepreneurship contributions tend to “enrich,” “complicate,” or “extend” existing theories and relationships studied in the field. Indeed, many of the most promising future directions for Austrian work are at interdisciplinary intersections (Lucas, 2018, 2021; Lucas et al., 2022; McMullen, 2010; Packard, 2017). Despite an ebb-and-flow relationship over many decades, I conclude that the future is very bright for Austrian economics within mainstream entrepreneurship.

Notes 1. The debates around this view are not fringe concerns in the field; recent years have also seen a surge of “non-Austrian” contributions questioning the conceptual strength of the opportunity-discovery view (e.g., Davidsson, 2015; Ramoglou & Tsang, 2016). 2. As further evidence of scholarly overlap, a recent special issue co-edited by Bylund in Quarterly Journal of Austrian Economics yielded several publications by mainstream entrepreneurship scholars in the Austrian outlet. While the present study does not consider the reverse role of mainstream entrepreneurship within Austrian economics, that is also an interesting question. The gains from intellectual exchange are not unilateral! 3. Of course, there certainly are economics departments housed within business schools in some instances. Casual observation suggests that scholars in these departments tend to focus relatively more on firm- and manager-level outcomes, consistent with the incentive structure described.

AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP

65

References Aldrich, H. E. (2012). The emergence of entrepreneurship as an academic field: A personal essay on institutional entrepreneurship. Research Policy, 41(7), 1240–1248. Baumol, W. J. (1968). Entrepreneurship in economic theory. The American Economic Review, 58(2), 64–71. Bennett, D. L. (2019). Infrastructure investments and entrepreneurial dynamism in the US. Journal of Business Venturing, 34(5), 105907. Birch, D. L. (1979). The Job Generation Process. MIT Program on Neighborhood and Regional Change. Boettke, P. J. (1997). Where did economics go wrong? Modern economics as a flight from reality. Critical Review, 11(1), 11–64. Boettke, P. J., Fink, A., & Smith, D. J. (2012). The impact of Nobel Prize winners in economics: Mainline vs. mainstream. American Journal of Economics and Sociology, 71(5), 1219–1249. Burns, S., & Fuller, C. S. (2020). Institutions and entrepreneurship: Pushing the boundaries. Quarterly Journal of Austrian Economics, 23(3–4), 568–612. Bylund, P. L. (2020). Introduction to the entrepreneurship special issue. Quarterly Journal of Austrian Economics, 23(3–4), 255–264. Chiles, T. H., Bluedorn, A. C., & Gupta, V. K. (2007). Beyond creative destruction and entrepreneurial discovery: A radical Austrian approach to entrepreneurship. Organization Studies, 28(4), 467–493. Chiles, T. H., Tuggle, C. S., McMullen, J. S., Bierman, L., & Greening, D. W. (2010). Dynamic creation: Extending the radical Austrian approach to entrepreneurship. Organization Studies, 31(1), 7–46. Cooper, A. C. (2015). History of the academic study of entrepreneurship. In Wiley Encyclopedia of Management (Vol. 3, pp. 1–3). https://​doi​.org/​10​.1002/​ 9781118785317​.weom030048 Davidsson, P. (2015). Entrepreneurial opportunities and the entrepreneurship nexus: A re-conceptualization. Journal of Business Venturing, 30(5), 674–695. Dean, T. J., & McMullen, J. S. (2007). Toward a theory of sustainable entrepreneurship: Reducing environmental degradation through entrepreneurial action. Journal of Business Venturing, 22(1), 50–76. https://​doi​.org/​10​.1016/​j​.jbusvent​.2005​.09​.003 Decker, R., Haltiwanger, J., Jarmin, R., & Miranda, J. (2014). The role of entrepreneurship in US job creation and economic dynamism. Journal of Economic Perspectives, 28(3), 3–24. Elert, N., & Henrekson, M. (2019). The collaborative innovation bloc: A new mission for Austrian economics. The Review of Austrian Economics, 32(4), 295–320. Foss, K., Foss, N. J., Klein, P. G., & Klein, S. K. (2007). The entrepreneurial organization of heterogeneous capital. Journal of Management Studies, 44(7), 1165–1186. Foss, N. J., & Klein, P. G. (2020). Entrepreneurial opportunities: Who needs them? Academy of Management Perspectives, 34(3), 366–377. Foss, N. J., Klein, P. G., & Bjørnskov, C. (2019). The context of entrepreneurial judgment: Organizations, markets, and institutions. Journal of Management Studies, 56(6), 1197–1213. Grégoire, D. A., Barr, P. S., & Shepherd, D. A. (2010). Cognitive processes of opportunity recognition: The role of structural alignment. Organization Science, 21(2), 413–431.

66

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Grégoire, D. A., & Shepherd, D. A. (2012). Technology-market combinations and the identification of entrepreneurial opportunities: An investigation of the opportunity-individual nexus. Academy of Management Journal, 55(4), 753–785. Harper, D. (1998). Institutional conditions for entrepreneurship. Advances in Austrian Economics, 5(241–275). Hayek, F. A. (1945). The use of knowledge in society. The American Economic Review, 35(4), 519–530. Holcombe, R. G. (1998). Entrepreneurship and economic growth. The Quarterly Journal of Austrian Economics, 1(2), 45–62. Kirzner, I. M. (1997). Entrepreneurial discovery and the competitive market process: An Austrian approach. Journal of Economic Literature, 35(1), 60–85. Kirzner, I. M. (1999). Creativity and/or alertness: A reconsideration of the Schumpeterian entrepreneur. Review of Austrian Economics, 11(1–2), 5–17. Klein, P. G., & Bylund, P. L. (2014). The place of Austrian economics in contemporary entrepreneurship research. The Review of Austrian Economics, 27(3), 259–279. Koppl, R., & Minniti, M. (2003). Market processes and entrepreneurial studies. In Handbook of Entrepreneurship Research (pp. 81–102). Springer. Landström, H., Harirchi, G., & Åström, F. (2012). Entrepreneurship: Exploring the knowledge base. Research Policy, 41(7), 1154–1181. https://​doi​.org/​10​.1016/​j​.respol​ .2012​.03​.009 Landström, H., & Lindhe, J. (2020). History of Entrepreneurship—Entrepreneurship Division. Academy of Management. https://​ent​.aom​.org/​committees/​history​-of​ -entrepreneurship Lucas, D. S. (2018). Evidence-based policy as public entrepreneurship. Public Management Review, 20(11), 1602–1622. Lucas, D. S. (2021). Non-market competition as a discovery procedure. In Entrepreneurship and the Market Process (pp. 97–119). Springer. Lucas, D. S., & Boudreaux, C. J. (2020). National regulation, state-level policy, and local job creation in the United States: A multilevel perspective. Research Policy, 49(4), 103952. Lucas, D. S., Fuller, C. S., & Packard, M. D. (2022). Made to be broken? A theory of regulatory governance and rule-breaking entrepreneurial action. Journal of Business Venturing, 37(6), 106250. Lucas, D. S., Fuller, C. S., Piano, E. E., & Coyne, C. J. (2018). Visions of entrepreneurship policy. Journal of Entrepreneurship and Public Policy, 7(4), 336–356. Lumpkin, G. T., & Bacq, S. (2019). Civic wealth creation: A new view of stakeholder engagement and societal impact. Academy of Management Perspectives, 33(4), 383–404. McMullen, J. S. (2010). Perspective taking and the heterogeneity of the entrepreneurial imagination. In R. Koppl, S. Horwitz, & P. Desrochers (eds), Advances in Austrian Economics (Vol. 14, pp. 113–143). Emerald Group Publishing Limited. https://​doi​ .org/​10​.1108/​S1529​-​2134(2010)​0000014009 McMullen, J. S., Bagby, D. R., & Palich, L. E. (2008). Economic freedom and the motivation to engage in entrepreneurial action. Entrepreneurship Theory and Practice, 32(5), 875–895. https://​doi​.org/​10​.1111/​j​.1540​-6520​.2008​.00260​.x McMullen, J. S., & Shepherd, D. A. (2006). Entrepreneurial action and the role of uncertainty in the theory of the entrepreneur. Academy of Management Review, 31(1), 132–152.

AUSTRIAN ECONOMICS AND MAINSTREAM ENTREPRENEURSHIP

67

Mingers, J., & Leydesdorff, L. (2015). Identifying research fields within business and management: A journal cross-citation analysis. Journal of the Operational Research Society, 66(8), 1370–1384. Minniti, M. (2008). The role of government policy on entrepreneurial activity: Productive, unproductive, or destructive? Entrepreneurship Theory and Practice, 32(5), 779–790. Minniti, M., & Lévesque, M. (2008). Recent developments in the economics of entrepreneurship. Journal of Business Venturing, 23(6), 603–612. https://​doi​.org/​10​.1016/​ j​.jbusvent​.2008​.01​.001 Minniti, M., & Lévesque, M. (2010). Entrepreneurial types and economic growth. Journal of Business Venturing, 25(3), 305–314. Osareh, F. (1996). Bibliometrics, citation analysis and co-citation analysis: A review of literature I. Libri, 46(3), 149–158. Packard, M. D. (2017). Where did interpretivism go in the theory of entrepreneurship? Journal of Business Venturing, 32(5), 536–549. Packard, M. D., & Burnham, T. A. (2021). Do we understand each other? Toward a simulated empathy theory for entrepreneurship. Journal of Business Venturing, 36(1), 106076. Ramoglou, S., & Tsang, E. W. (2016). A realist perspective of entrepreneurship: Opportunities as propensities. Academy of Management Review, 41(3), 410–434. Schildt, H. A., Zahra, S. A., & Sillanpää, A. (2006). Scholarly communities in entrepreneurship research: A co–citation analysis. Entrepreneurship Theory and Practice, 30(3), 399–415. Shane, S. (2000). Prior knowledge and the discovery of entrepreneurial opportunities. Organization Science, 11(4), 448–469. Shane, S., & Venkataraman, S. (2000). The promise of entrepreneurship as a field of research. Academy of Management Review, 25(1), 217–226. Wagner, R. (2010). Mind, society, and human action: Time and knowledge in a theory of social-economy. Routledge. Yu, T. F.-L. (2001). Entrepreneurial alertness and discovery. The Review of Austrian Economics, 14(1), 47–63.

4

Knowledge and incentive problems in regulatory studies: an Austrian perspective

Diana W. Thomas and Michael D. Thomas

Introduction Regulatory studies is a branch of the Public Choice tradition responding to the market failure critique of Pigou (1920 [1938]). Public Choice responds to welfare economics with realistic claims about the limits of government intervention as a means of improving market outcomes. The original call by Public Choice economists for behavioral symmetry suggests political actors face many of the incentive problems of their market counterparts. Still, most policy proposals continue to be justified based on Pigouvian or other welfare economics arguments. In fact, despite significant empirical support, the incentive arguments from Public Choice are usually ignored when evaluating policy proposals. We argue here that welfare economics, and specifically Arthur Pigou’s argument regarding externalities, while he did not describe it this way, is fundamentally a critique of markets based on the ability of market institutions to fully account for all relevant information. This inability to account for all relevant information is ultimately the result of a lack of complete property rights. Among the varied responses to Pigou’s analysis, Ronald Coase’s (1960) paper on The Problem of Social Cost and Harold Demsetz’s (1969) paper Information and Efficiency: Another Viewpoint come closest to responding in kind to this argument about knowledge revelation, aggregation, and property rights. Yet the subsequent Public Choice response (Buchanan & Tullock 1962 [1999], Tullock 1967) and Stigler’s (1971) The Theory of Economic Regulation, rather than building on Coase, shifted the response to a critique of the behavioral assumptions underlying welfare economics. Both the Public Choice and Chicago traditions ultimately failed to address the comparative ability of markets as opposed to the political process to incorporate costs that 69

70

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

are external to the relevant market actors and regulators. As a result, while it was important, the public choice revolution is limited in its influence on how regulatory policy proposals are justified. A complete response to the welfare economics literature following Pigou (1920 [1938]) requires a direct response to the original welfare economics critique, explicitly addressing problems of the relative ability of market participants as opposed to regulators to access the relevant knowledge and information. We suggest that the economics of interventionism, which derives from Austrian economics, offers a more direct response to the original market failure arguments.1 It is only the combination of knowledge and incentive arguments that has the potential to effectively shift the focus of the conversation in economics from designing an efficient policy response to a higher level of comparative institutional analysis and constitutional constraints on politics along the lines articulated in Demsetz (1969). In addition, Austrian economic insights regarding knowledge and comparative institutions are essential for developing a response to the most recent variant of economic theory promoting the efficiency of regulation, the enforcement theory of regulation (Glaeser & Shleifer 2003). In what follows, we will review the history and development of economic analysis of regulation over the 20th century. More specifically, we will summarize the earliest theories promoting intervention as a solution to market failure problems and, most notably, the Pigouvian theory of externalities. We will summarize the Public Choice/Chicago response to these early theories justifying intervention and the most recent attempts to explain the rise of regulation despite these insights, which has come to be known as the enforcement theory of regulation. The third section three offers a description of the connection between Public Choice and Austrian Economics as well as a short overview of the existing Austrian theories of interventionism. Finally, we will discuss a potential Austro-Virginian response to the enforcement theory of regulation, highlighting the crucial fact that both arguments regarding knowledge and incentive problems are essential in understanding the shortcomings of this most recent attempt to justify intervention.

KNOWLEDGE AND INCENTIVE PROBLEMS IN REGULATORY STUDIES

71

The public interest theory of regulation The public interest theory of regulation following Pigou (1920 [1938]) was the dominant theory regarding regulation in economics until the 1970s. Pigou’s theory built on Marshall’s (1890 [1920]) observation about external economies, or the interdependency of firms and industries through common factor prices. Pigou held that when external effects were present, markets produced either beneficial or undesirable outcomes for third parties. Because the incentives of the buyer and seller did not incorporate these external costs and benefits, government was expected to either tax, subsidize, or regulate to induce market participants to account for existing external costs or internalize the external benefits and increase consumption. The premise that government action could improve market outcomes implied that regulation is initiated and monitored by benevolent and omniscient government actors whose primary objective is the resolution of market failure problems on behalf of the public.2 Along similar lines, natural monopolies could be regulated to induce an efficient level of production and lower prices to prevent the extraction of monopoly profits.3 In other areas of private interaction, government-determined safety standards and employment regulations could provide bright-line rules for existing power and information asymmetries in labor markets and beyond.4 The catalog of market failure problems resulting from these early efforts in welfare economics became the orthodox taxonomy of market failure problems taught in introductory economics courses: public goods, externalities, asymmetric information, and monopoly.5 These four categories conform neatly to a specific kind of government response deemed effective in each case. When a good is non-rival and non-excludable, i.e., public, government agents rely on general revenue to produce the good publicly and to bring output in line with what is considered an efficient level of production and consumption.6 The externality argument provides a justification to raise taxes or distribute subsidies to fine tune existing market outcomes. Asymmetric information problems can be countered with government assurance of quality and efficacy through regulation. Antitrust policy, which regulates producers or limits their scale (by disallowing mergers or forcefully breaking apart producers that have grown too large), offers an efficient response to monopoly-related market failures. Even simple conversations about these different types of market failure problems reveal some problems with the taxonomy. Public goods problems, which exist whenever non-payers cannot be precluded from consuming a good, are

72

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

not fundamentally distinct from positive externality problems where some share of the benefits from consumption accrue to bystanders. Both problems also result in underproduction relative to what policymakers consider economically efficient. Through the lens of intervention, underproduction is found everywhere.7 Similarly, asymmetric information problems are not problematic unless a producer has market power. The empirical record on such problems suggests that, as long as markets are relatively competitive, private solutions to asymmetric information problems, or “assurance,” abound (Klein 1998, 2001). Knowledge problems underlie all four of these market failure problems, which suggests a common analytical approach to their study. From an economic perspective, knowledge aggregation processes are extremely sensitive to how property rights are defined.8 The inability to exclude non-payers from consuming a good is everywhere and always a failure to clearly assign and protect property rights, which is why public goods (and common pool resource) problems disappear when individuals discover new ways of defining private property (Demsetz 1967). In the absence of clearly defined property rights, price signals can no longer communicate information about individual marginal benefit, and “public” goods are therefore under-produced. But this problem of accurately aggregating information about private valuations of a good does not disappear just because policymakers are in charge of producing that good. Almost identically, both positive and negative externality problems are fundamentally problems of incomplete property rights (Mises 1949 [2008], p. 650). In the absence of complete property rights, third parties are either harmed or benefited when a good is exchanged in a market.9 Because those external benefits and costs are not accounted for by the buyer and seller of the product, information about their valuation cannot enter the market exchange. As in the case of public goods, government intervention through taxation or subsidization confronts the same kind of knowledge problem, however, and therefore offers only an unsatisfactory fix. As a distinct category of a market failure, monopoly also distills down to a property rights problem. Rather than being rooted in the incompleteness of property rights, however, monopoly is usually the result of a problem regarding the divisibility and consequently the transferability of a property right. Natural monopolies and monopolies arising from network effects are both the result of the fact that it is technologically impossible to divide a resource (usually a network), which leaves the owner of the resource in the position of being the lowest-cost producer at increasing levels of output. Developments in telecommunications technology show clearly that once it becomes possible

KNOWLEDGE AND INCENTIVE PROBLEMS IN REGULATORY STUDIES

73

to divide up the resource, multiple producers can coexist and compete, eliminating the property rights problem that created the market failure in the first place. Finally, asymmetric information problems are also fundamentally related to incomplete property rights.10 Relevant information about a product or customer cannot be fully revealed, and technology to guarantee or assure the other party of the quality of the good or service does not exist such that the transfer rights of the owner of a resource become limited (in the sense that transfer is more costly than it would be under complete and symmetric information conditions). Property rights play an important role in each of these four classifications of market failures. A better understanding of how knowledge and aggregation problems are resolved in markets as opposed to politics, given incomplete property rights, offers a comparative institutional perspective, which welfare economists have eschewed by assuming market failure and policy success. If policy solutions do not accurately address the underlying problems, they merely substitute policy failure for market failure. In short, the orthodoxy which favored government intervention in markets never assessed the ability of the government to better define property rights and aggregate information than the markets they saw as failing, because market failure problems were categorized along margins that avoided this kind of analysis. Rather than asking whether the government could more effectively aggregate information about the valuation of different resources, or whether it had the technology to divide up a resource more efficiently or more clearly define rights to its use, welfare economists simply assumed that was possible. By starting from the assumption of generalized agreement on the ends (in the form of the social welfare function),11 this new consensus effectively assumed away any problems of aggregation or disagreement over ends resulting from incomplete or indivisible property rights.

Critiques of the public interest theory Coase’s problem of social cost and Demsetz on information and efficiency Ronald Coase’s (1960) The Problem of Social Cost relied heavily on the common law tradition of property rights to respond to some of these implicit assump-

74

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

tions underlying the Pigouvian perspective and to reintroduce a discussion of property rights to welfare economics. In his 1960 article, Coase offered an alternative to the Pigouvian framework and attempted to shift the conversation to concerns about property rights and their relationship to knowledge aggregation (Medema 2014). Coase asserted that market actors could identify and resolve problems relating to external effects when institutional circumstances allowed for well-defined property rights and low transaction costs (Stigler 1989).12 In more difficult circumstances, courts could help resolve conflict without requiring government intervention by simply assigning property rights, where possible, or issuing injunctions against certain types of market action when property rights could not be defined. Beyond simply resolving conflicts relating to external costs and benefits, however, courts also provided the function of developing precedent, which more clearly defined property rights in situations beyond the case at hand and thereby minimized the need for future legislative intervention in markets.13 Coase’s analysis had several implications that formed the basis of a more comprehensive critique of the market failure–government intervention orthodoxy. First, his focus on specific examples of external costs made it clear that identifying both scope and magnitude of external effects was more complex than Pigou or those who applied his analysis had ever acknowledged. External effects are reciprocal, and the information required to clearly identify the direction of the net effect on the involved parties is local and often subjective. The discovery of more exact magnitudes therefore requires direct negotiation by the affected parties and precludes an efficient solution through a third-party because the specific information is not directly accessible.14 Second, the reciprocal nature of externalities makes the identification of a preferred social state difficult and highlights the importance of recognizing welfare losses for compensation. Coase’s work generally, but his problem of social cost specifically, emphasized the bargaining and negotiations necessary to resolve problems in markets as well as the public space.15 Ultimately, externality problems are not problems at all when property rights are well defined, because the affected parties could negotiate around the externality until all relevant information was included in the transaction. Like Coase (1960), Demsetz (1969) offers a critique of Ken Arrow’s (1962) treatment of risk and uncertainty in his chapter titled The Rate and Direction of Inventive Activity: Economic and Social Factors. Demsetz’s argument fundamentally boils down to three specific critiques of Arrow’s approach, which he takes as representative of the approach to problems of efficient economic organization within the larger profession. Demsetz (1969, p.  1) argues that

KNOWLEDGE AND INCENTIVE PROBLEMS IN REGULATORY STUDIES

75

the approach to the analysis of economic organization taken by Arrow is fundamentally flawed because it “presents the relevant choice as between an ideal norm and an existing ‘imperfect’ institutional arrangement.” Demsetz uses the phrase nirvana approach to describe the shortcomings of this general approach to economic organization. More specifically, Demsetz suggests three logical fallacies are implicit in the approach that represented the orthodoxy in economics: (1) the grass is always greener fallacy, (2) the fallacy of the free lunch, and (3) the people could be different fallacy. According to Demsetz (1969, p.  3), Arrow commits the grass is always greener fallacy, when he asserts that a free enterprise economy will systematically invest too few resources in invention and research, and that because of this lack of investment, government investment in research and invention becomes necessary to achieve an optimal allocation of resources to the activity. Demsetz’s response to Arrow’s assertion is to point out that the governmental process that is substituted for the free enterprise system must be analyzed as to its outcome and workings to offer an accurate comparison to the free enterprise system that goes beyond merely asserting that the grass is always greener on the government-subsidized side of innovation and research. Demsetz similarly takes issue with Arrow’s approach to analyzing risk in the free enterprise system. Demsetz points out that the suggestion that a free enterprise system suffers from an incomplete adjustment for risk because of a lack of commodity options contracts commits what he calls the free lunch fallacy. It falsely assumes that commodity options are free, which would be required to accomplish a complete insurance against any risk on the part of individual market participants. While Demsetz (1969, p. 4) agrees that there are benefits to market participants from buying commodity options to insure against risks in production, he asserts there are also costs of such contracts, which if accounted for can explain what seems like incomplete adjustment to risk from Arrow’s perspective. Finally, Demsetz (1969, p.  7) takes issue with Arrow’s treatment of moral hazard. Arrow’s treatment of risk shifting through insurance compared with risk shifting in the ideal leads him to conclude that incomplete risk-shifting due to moral hazard is inefficient. In reality, moral hazard is just a cost of insurance that must be reckoned with given human agents. Specifically, Demsetz suggests that treating incomplete risk-shifting as inefficient relative to the ideal of complete risk shifting is committing “the people could be different” fallacy. It assumes some idealized version of humanity sans the tendency to shirk when no one is watching.

76

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Demsetz’s critique of welfare economics and Kenneth Arrow’s work does not explicitly address the idea that negotiations and exchange are required to reveal and aggregate the relevant information underlying exchange. His efforts to engage Arrow (and economics more generally) in a conversation about real as opposed to imagined people and scarcity as a relevant constraint on both government action and insurance markets, suggests, however, that Demsetz (1969) sought to offer a true comparative institutions perspective. Such a perspective would compare the processes for handling scarcity, risk, and real human agents implicit in the free enterprise economy with similar processes inherent in the political process. In fact, in his discussion of the grass is greener fallacy, Demsetz (1969, p. 2) states explicitly that “the forces that are substituted for free enterprise must be analyzed and the outcome of the workings of these forces must be compared to the market solution.” By emphasizing processes and reciprocal relationships in markets and beyond, Coase (1960) and Demsetz (1969) revealed an analytical perspective that had much in common with the focus on behavioral symmetry and politics as exchange that James Buchanan and Gordon Tullock advocated for as one of the foundational assumptions underlying public choice economics (Buchanan & Tullock 1962 [1999]; Buchanan 2000, p. 16).16 Public choice and Chicago: regulatory incentive problems Ronald Coase’s focus on property rights and negotiation around external costs and benefits highlights some important flaws in the Pigouvian approach to government intervention, which, as we outlined in the second section, assumed away any problems of aggregation or disagreement over ends. A similar focus on negotiations and information revelation is evident in Buchanan and Tullock’s (1962 [1999]) foundational work in Public Choice for which they stipulate the idea of politics-as-exchange as a core concept. Much of the Public Choice tradition since 1962 has, however, focused on incentive problems of political actors. The incentive critique of welfare economics and regulation weakens the assumption that government agents are benevolent maximizers of the public interest, but it has minimized the focus on the catallactic aspects of political negotiation, also present in market exchange. In the opening chapters of 1962’s The Calculus of Consent, Buchanan and Tullock explain that the analytical perspective of public choice centers on human action in different institutional contexts. Applying what Buchanan and Tullock call behavioral symmetry, public choice stipulates that human actors are motivated by the same goals no matter whether they operate in markets, politics, or any other institutional environment.

KNOWLEDGE AND INCENTIVE PROBLEMS IN REGULATORY STUDIES

77

Holding political actors to the same behavioral standards as market actors means that benevolence or omniscience cannot be assumed in one context but not the other. This perspective also informed Gordon Tullock’s essay on The Welfare Costs of Tariffs, Monopolies, and Theft (1967), which arguably became the cornerstone of regulatory studies. But while the article and subsequent literature on regulation emphasized behavioral symmetry, they lost the catallactic perspective of politics as exchange and, in the process, diminished the importance of complex property right negotiations. Building on Tullock, George Stigler’s influential article on the Theory of Economic Regulation published in 1971 suggested that regulation operated by rules susceptible to economic analysis, implicitly accepting the assumption of behavioral symmetry between market and political actors advanced by Buchanan and Tullock (1962 [1999]).17 These critiques of the Pigouvian public interest theory of regulation based on the incentives of the actors in the model, together with the increasingly prominent realization that little real-world regulation achieved the promise of fixing market failure and most interventions seemed to favor special interests instead, ultimately set the stage for a paradigm shift in the economic perspective on regulation. If positive economic profits were not within reach of market actors, political action offered an alternative source of rents, and regulation was a vehicle to deliver them.18 Behavioral asymmetry, benevolence, full rationality, and a focus on efficiency were replaced with an understanding of government intervention in markets that assumed politicians and political actors more generally were rationally self-interested maximizers of their own well-being, with substantive rationality, and partial information. While behavioral symmetry was assumed and became implicit, the focus on catallactic aspects of political processes virtually disappeared. Stigler’s Theory of Economic Regulation (1971) has since been the most widely accepted theory of regulation among economists. While the Theory of Economic Regulation was extremely successful in terms of shifting the theoretical focus in the academic analysis of regulation, it has had limited success in combating naïve versions of welfare economics, which, to this day, inform most policy proposals. Ultimately, this failure to inform pragmatic policy conversations is based on a comprehensive failure of the public choice critique (and ultimately also Stigler’s model) to engage welfare economics on its own terms. The shift away from Coase’s emphasis on property rights and information and the fact that much of the work in regulatory studies minimized the exchange aspects of real-world policymaking ultimately undermined the critique of orthodox welfare economics in practice. The study of regulation as informed by Stigler and Tullock, lost the most important insight

78

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

from comparative institutional analysis.19 Having failed to appreciate relevant insights on the dynamics of intervention (Mises 1940 [1998]; Böhm-Bawerk 1914 [2010]; Kirzner 1985; Ikeda 1996; Benson 2011), regulators design institutions as if they could control the incentive problems of market and political actors by ever-increasing interventions. Comparative institutional analysis based on incentive arguments only This failure to place comparative institutional analysis based on property rights and information aggregation and the catallactic approach at the center of public choice’s critique of welfare economics has had another long-lasting effect. The most recent variant of economic analysis of regulation, claiming that regulation is an efficient response to market failure, not despite but because of the incentive problems, places public choice scholars in the role of identifying systematic flaws in human behavior for which institutional solutions can be optimized. In an attempt to provide a comparative institutional perspective contrasting government regulation with market solutions (specifically courts), proponents of the enforcement theory of regulation focus on the severity of incentive problems in different institutional regimes. Andrei Shleifer and Ed Glaeser (Glaeser & Shleifer 2003; Shleifer 2005, 2010), argue that the pervasiveness of government regulation in otherwise wealthy nations is an efficient response to the subversion of justice by corporations. The rise of large corporate entities with enough power to systematically undermine market institutions, the courts, and government, has resulted in a situation where government regulation is a relatively more efficient response to such attempts at ex-post subversion, not despite but because of Public Choice concerns. Courts are crucial for the Coasean response to Pigouvian market failure theory because they enforce the contracts that allow private parties to resolve externality problems privately and because they “provide remedy for torts” (Shleifer 2010, p. 29). But when courts are subverted, regulation can be an efficient institutional alternative.20 Glaeser & Shleifer (2003) suggest specifically that the rise of regulation over the course of the 20th century was an efficient response to greater social losses from private expropriation, which resulted from a systematic subversion of the court system through private enterprises, which were increasing in relative size. According to Glaeser and Shleifer (2003), the enforcement theory of regulation is not in conflict with the economic theory of regulation. Rather, the enforcement theory accounts for the fact that all institutional environments are subject to subversion along the lines suggested by the economic theory of regulation, but that depending on the relative prevalence of different kinds of

KNOWLEDGE AND INCENTIVE PROBLEMS IN REGULATORY STUDIES

79

subversion and private as opposed to public expropriation, different institutional environments will be more efficient. By doubling down on the incentive argument and comparing different institutions as to their susceptibility to subversion, the enforcement theory of regulation builds on the Public Choice/Stigler orthodoxy in the analysis of regulation, which certainly lends credence to that theory. In doing so, Shleifer and his co-authors are also able to dismiss the role of catallactics, the importance of negotiation, and Coase’s insight regarding property rights and courts as giving “far too much leeway to courts, relying on them as unbiased, informed, and incorruptible promoters of social welfare” (Shleifer 2005, p. 441). In an almost ironic twist of fate, the only comprehensive comparative institutional theory of regulation to date uses arguments regarding behavioral symmetry from Public Choice to argue in favor of regulation, which represents a complete reversal of the conclusions most public choice scholars draw.21 We believe this is only possible because, like the public choice/Chicago critique of regulation, the enforcement theory fails to engage the public interest theory of regulation on the margin we have argued is the most relevant: its treatment of property rights and information/knowledge aggregation through exchange. We believe that because of these developments the only literature that still offers a broadly catallactic response based on property rights, incentives, and knowledge aggregation problems is the literature on interventionism from Austrian Economics, which we review in what follows.

Austrian studies of interventionism: doubling down on knowledge According to James Buchanan (2000, p. 16), the primary assumptions underlying the Public Choice tradition are rational choice, methodological individualism, and politics as exchange. All three either have their origin directly in the Austrian tradition or are traditionally interpreted in a way that is most closely associated with Austrian Economics. The last assumption of “politics as exchange” in particular connects public choice scholarship to the mainline tradition of economics following from Adam Smith’s propensity to “truck, barter, and exchange.”22 This approach stands in contrast to the more commonly taught definition of economics, which holds that economics is concerned with the efficient allocation of scarce resources to competing ends (Buchanan 2000, p. 16). The exchange-focused, classical economic understanding of the discipline was retained by Austrian

80

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

economists even after the mainstream of the discipline abandoned it in favor of the allocation paradigm in the mid-20th century.23 Throughout his work, James Buchanan explicitly uses the term catallactics, or the science of exchange, to describe his vision of economics, which originates with Richard Whately, but was extensively used and applied only by the Austrian economists.24 While this assumption is crucial for public choice scholarship more generally, it has, as we have argued above, remained largely irrelevant for the Public Choice/Chicago inspired theory of regulation according to Tullock (1967) and Stigler (1971), which instead focuses solely on the incentive problems of policymakers. The catallactic approach offers important insights regarding the potential merit of regulation as an alternative to private bargains, specifically with respect to knowledge aggregation and property rights, and is, therefore, essential for a comprehensive and accurate comparative institutional assessment of the relative merits and demerits of different institutional solutions to collective action problems. A response to welfare economics and the more recent enforcement theory of regulation must emphasize both knowledge and incentive problems if it is to be successful. If knowledge is dispersed, local, and often tacit (Hayek 1945), institutional solutions that disregard local information and instead impose top-down solutions to market failure problems are necessarily limited in their effectiveness. This insight, together with the argument regarding behavioral symmetry of the agents in the system from Public Choice, leaves the Public Interest Theory of Regulation and the Pigouvian perspective on intervention essentially dismantled, and the enforcement theory of Glaeser and Shleifer (2003) incomplete. Austrian skepticism about government intervention first developed at the end of the 19th century in response to the rise of the German Historical School in Prussia. This historical period predates the emergence of welfare economics and Pigouvian analysis in economics and is therefore not simply a response to the 20th-century literature. As a result of this broader context, the Austrian response is not motivated by the partial market failure problems that motivated Pigou and other, later, Welfare economists, but instead countered a more general critique of markets and capitalism. Austrian approaches to markets as the primary resource allocation mechanism respond to this broader critique, which may be the reason why Austrian concerns over knowledge and information problems have not been explicitly emphasized in the literature on regulation.25 Economists operating in the Austrian tradition engaged in the socialist calculation debate (notably Ludwig von Mises and F.A. Hayek) to emphasize incentive and knowledge problems. On the other side of the debate were Paretian economists, who understood the implications of market

KNOWLEDGE AND INCENTIVE PROBLEMS IN REGULATORY STUDIES

81

failure arguments to be more comprehensive and sought to organize the means of production to achieve a more just distribution of resources (among others Otto Neurath, Fred M. Taylor, Jacob Marschak, Oskar Lange, and Abba Lerner). The poverty revealed by the Industrial Revolution and the seeming efficiency of the war economy during the First World War motivated their arguments for a move toward central planning. These economists of the German Historical school argued for replacing the price mechanism with an alternative, a government-directed plan for allocating resources, which they envisioned to be more efficient than the private enterprise economy. Ludwig von Mises’ (1920 [1935]) response was framed around the idea that in the absence of exchange, prices would not emerge. Without prices, economic calculation is impossible, leading to the impossibility of reallocating goods and services rationally. Socialist economists responded that exchange and prices are not required in a system of Walrasian equations (Dickinson 1933). This response ultimately provoked F.A. Hayek’s work on prices and information, which occupied much of his career (1937, 1940, 1945, 1948, 1968 [2002]). Hayek’s argument, in a nutshell, was that no central planner could replicate the scale and scope of information conveyed through the price mechanism and that there was a distinct difference between the kind of knowledge experts could convey and communicate and the kind of knowledge of time and place individual action relied on. While experts may be able to replace the price mechanism for the communication of expert knowledge, it would be impossible to replace the decentralized price mechanism for the communication of local and tacit knowledge. Since the socialist calculation debate, Austrian economists have continued to elaborate on these insights regarding the inefficiency of interventionism. Israel Kirzner’s theory of entrepreneurship offers the important insight that a decentralized process of entrepreneurial discovery is required to allow the market process to function (1963 [2011], 1973, 1979). According to Kirzner, entrepreneurs discover opportunities for arbitrage across both time and space and, in doing so, are catalysts for the discovery of efficient prices and, ultimately, an efficient allocation of resources. Without this entrepreneurial function, prices would not adjust to new information and would not be as useful in transmitting information as envisioned by Hayek (1945). Kirzner (1985) discusses how intervention can adulterate the entrepreneurial process by either blocking or re-routing entrepreneurial efforts in less efficient or wholly superfluous directions.26 Comparative institutional analysis of regulatory institutions is incomplete unless it incorporates both an assessment of the ability of different institu-

82

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

tional structures to channel self-interest in the direction of socially productive as opposed to subversive activities, and an assessment of the ability of the institutional structure to aggregate dispersed information and coordinate individual desires. Such a more comprehensive comparative institutional perspective therefore requires an understanding of property rights institutions and knowledge. While Glaeser and Shleifer (2003) as well as other proponents of the enforcement theory of regulation may be right in their assessment that regulation is sometimes a more efficient response to rent-seeking or ex-post subversion activities by private actors, this sole focus on the incentive problems inherent in different institutional environments ignores the more essential problem of knowledge aggregation which welfare economics assumed away and which, for the purposes of the literature on regulation, has only been re-articulated by Coase whose critique was overshadowed by the Public Choice critique of market failure theory. In Thomas and Thomas (2018), we offer an example of how a sole focus on the incentives of the actors under different institutional regimes becomes problematic for policymaking. In the historical episode surrounding blood market regulation in the middle of the 20th century, we argue that interventions in whole blood markets served particular interests of hospitals. Nominally these interventions were offered to fix problems of higher rates of hepatitis transmission in paid blood, recruited from for-profit blood banks. Hospitals, we argue, used this opportunity to secure due care protection for unpaid blood to protect themselves from the high costs of legal liability for hepatitis transmission through blood transfusions. Regulation was focused on comparing the incentives of blood banks (paid), who often recruited blood from lower income individuals (the homeless, prisoners, alcoholics, and drug addicts) who needed the income, and hospitals (unpaid), who relied on volunteer donations which often came from higher income individuals with lower rates of hepatitis. This focus abstracted from a consideration of the effects of differing legal standards for the ability of market participants to resolve the underlying property-rights related issue regarding damages from the transfusion of contaminated blood. Different forms of product liability create different property rights regimes and have consequences for knowledge aggregation: due care protection instituted in 1974 by the FDA cleared the way for all unpaid blood to be protected from legal liability, whether it was contaminated with hepatitis or not, while paid blood carried strict product liability and with it financial responsibility for damages for the transmission of any disease. As a result, hospitals abandoned the use of blood from paid donors completely. This outcome, while it certainly reduced the rate of hepatitis transmission, did not create incentives for blood banks (whether paid or volunteer-based) to develop more accurate ways to establish whether blood was contaminated. Later experience with the blood

KNOWLEDGE AND INCENTIVE PROBLEMS IN REGULATORY STUDIES

83

supply, particularly HIV/AIDS, was compromised by weak feedback resulting from this decision. Rather than seeking a negotiated solution arbitrated under the auspices of the court, blood markets were resolved by fiat through intervention, which, because it only considered incentives and not knowledge and property rights arguments, institutionalized an inefficient regime. Crude efficiency is a poor replacement for catallactics.

Conclusion Put together, the Austrian and Public Choice critiques of regulation we discussed above, suggest that the enforcement theory of regulation, like its Pigouvian precursor, suffers from one fatal flaw: it overlooks the importance of symmetry as a methodological assumption. Welfare economics critiqued markets based on their ability to aggregate knowledge when property rights are incomplete or indivisible, but it assumed away such problems of aggregation for the political realm. The public choice revolution asserted the importance of behavioral symmetry. Yet its focus on incentive problems in markets and politics, while applied to study regulation, failed to convince policymakers that welfare economics was an insufficient justification for intervention. Because it (together with Stigler’s Theory of Economic Regulation) shifted the focus in the study of regulation away from the property rights problems Coase had put at the center of his retort to welfare economics, it also did not prevent the return of theoretical assertions regarding the efficiency of regulation in the form of the enforcement theory of regulation. If behavioral assumptions are symmetric and institutions are compared, courts, and with them private markets, may indeed be less efficient than regulation at constraining business. It is only in combination with the Austrian insights regarding dispersed information and knowledge aggregation that markets and courts come out ahead in a comparison of different institutions for the social control of business.

Notes 1.

Mises (1940 [1998]) offers a description of intervention implemented in a vacuum of knowledge, where flaws in regulation change incentives and create unexpected outcomes that in turn have to be corrected by further intervention. Mises suggests that regulation changes incentives in ways that subvert the goals of the regulator who, holding the original objective constant, has no choice but to intervene again. 2. The inarticulate assumption is usually that government observers have perfect knowledge of all relevant trade-offs, opportunity costs, and consequences of

84

3. 4. 5. 6. 7. 8. 9.

10. 11. 12. 13. 14. 15.

16.

17.

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

policy change. The knowledge problem alone is sufficient to make outcomes look less than benevolent. In a world of complexity, perfect knowledge does not hold. If experts are epistemically limited or if their knowledge is biased in any non-random way, then problems with the assumptions of omniscience matter. If there is any strategic use of regulation to further self-interest, benevolence cannot be assumed. (Thomas 2019). Ultimately this concept was abused to limit competition and maximize political rents. See, for example, Gray (1940, p. 11) The Passing of the Public Utility Concept, for an early treatment of how this approach came to be the standard. Glaeser and Shleifer (2003) treat progressive era reform as a necessary evolution in response to incentives. More recently, behavioral economics has added a fifth category of systematic market failure problems. This replaced Erik Lindahl’s principle of equalizing marginal benefits (see Buchanan 1949, p. 499). See Demsetz (1969) for an explanation of why costs of coordination in markets are not accounted for by policymakers. On this point, see Makowski and Ostroy (1995). My neighbor’s decision to play their radio loud in their own backyard costs me, but the problem of noise pollution can only be resolved by reference to community standards, local ordinance, or HOA guidelines to name a few. These methods of arbitration are themselves a process of comparing my neighbor’s right to enjoy their yard and my right to enjoy mine. Similar to what we are suggesting here, Barzel (1977) argues that information costs are the result of transactions costs. We refer specifically to the development of the Kaldor–Hicks potential compensation test (Kaldor 1939) as well as the welfare propositions of economics and the interpersonal comparisons of utility implicit in them (Hicks 1939). Relatedly, Piano and Rouanet (2020) argue that in the absence of transaction costs, the economic calculation problem would disappear. For a discussion of Coase’s contribution in the context of and contrast to Pigouvian welfare economics, see Samuels (1974, pp. 26–28, 31) and Shleifer (2005). Buchanan (1969 [1999]). Coase’s early work on the “Nature of the firm” (1937) similarly highlights the negotiations surrounding the formation of enterprise for joint production and the contractual foundations of the firm. Like his discussion of the problem of social cost, this work highlights the fact that transaction costs are the factor limiting the range of bargaining solutions to problems arising in exchange relationships in markets and beyond. While this shared focus on reciprocal relationships was never made explicit, at least not to our knowledge, it is not surprising that it became so crucial for public choice scholarship in its early days at the Thomas Jefferson Center at the University of Virginia, which housed both James Buchanan and Ronald Coase alongside several other early public choice scholars (Levy & Peart 2020). Tullock’s important insight in his 1967 article was that the true cost of monopoly, tariffs, and other government-protected rents was not limited to the deadweight losses created by these interventions, which Arnold Harberger (1954) had estimated to be relatively small (less than 0.1 percent of GDP for the efficiency losses from Monopoly), but instead extended to the resources expended in the pursuit of the redistributive gains offered by politics (monopoly rents, tariff protection,

KNOWLEDGE AND INCENTIVE PROBLEMS IN REGULATORY STUDIES

18. 19.

20.

21.

22. 23.

24. 25. 26.

85

etc.). The pursuit of these gains was later termed “rent-seeking” by Anne Krueger (1974) and it became the foundational insight required to understand George Stigler’s discussion of the demand for regulation in his 1971 paper. These economic rents could be discussed without coding them as entries on a balance sheet. In other words, Stigler’s insight that there was a demand for political gain was the next adjacent step in the argument after the clear articulation of the potential for redistributive gains and the expenditure of resources in their pursuit (by Tullock and Krueger). See Holcombe (2018). Much of James Buchanan’s independent work in Cost and Choice (1969 [1999]) and also on Constitutional Political Economy including the Calculus of Consent (Buchanan & Tullock 1962 [1999], Buchanan 1975, Buchanan & Wagner 1977, Buchanan & Brennan 1985) did elaborate on the assumption of politics as exchange and consequently offer this focus on property rights and knowledge. So, to be fair to Buchanan, it is mostly Gordon Tullock (1967) and following him Stigler (1971) who focused on incentive arguments to the exclusion of concerns about property rights and exchange. Along these lines, Djankov et al. (2003) develop a theory of comparative institutions which are distinct based on their relative location on a spectrum between complete private ordering and complete state ownership with various intermediate solutions. They argue that social losses can arise as a result of disorder due to private expropriation, which is most prevalent with completely private orderings, or as a result of dictatorship, which is most costly the greater the level of state ownership. Depending on the relative prevalence of social losses due to disorder or dictatorship, the ideal set of institutions will differ. In this framework, regulation becomes more efficient as the risk of social losses due to private expropriation increases. Becker (1985) argued that policy is the efficient result of competition between interest groups and Albrecht et al. (2022) similarly suggest that policy is asymptotically efficient and the result of bargains between interest groups that limits the inefficiency of the political process. Boettke et al. (2012). The Stockholm school of Knut Wicksell and Erik Lindahl offers an important branch of public economics that inspired some of Buchanan’s contributions. Paul Samuelson places Lindahl’s benefit theory squarely in his cross-hairs in his theory of public goods (Buchanan 1949). Mises (1949 [2008], p 66, p. 97). See Böhm-Bawerk (1914 [2010]) for an early contribution to the debate over the separability of the influence of power (economic and political) from fundamental economic laws in terms of their effect on economic outcomes. Benson (2011) citing Wagner (2010) takes this insight that intervention disrupts markets rather than stabilizing them one step further. Much in line with what we have argued here, he suggests that the Stigler–Tullock critique of the public interest theory of regulation fails to consider insights from Austrian economics regarding knowledge and entrepreneurship as well as from New Institutional Economics regarding property rights institutions. More specifically, Benson suggests that rather than fixing market failure problems and creating order, government intervention in markets will disrupt the existing spontaneous order and, by changing existing property rights arrangements, create opportunities for new, political and market profit opportunities. These new profit opportunities will in

86

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

turn generate a flurry of entrepreneurial activity directed at making adjustments to, circumventing, or evading the changed property rights regime. As a result, intervention, rather than bringing about a great level of order and stability, results in greater disorder and instability.

References Albrecht, B. C., Hendrickson, J. R., & Salter, A. W. (2022). Evolution, uncertainty, and the asymptotic efficiency of policy. Public Choice, 192(1-2): 169–188. Arrow, K. J. (1962). Economic welfare and the allocation of resources for invention, NBER Chapters. In The Rate and Direction of Inventive Activity: Economic and Social Factors, pp. 609-626, National Bureau of Economic Research, Inc. Barzel, Y. (1977). Some fallacies in the interpretation of information costs. The Journal of Law and Economics, 20(2): 291–307. Becker, G. S. (1985). Public policies, pressure groups, and dead weight costs. Journal of Public Economics, 28(3): 329–347. Benson, B. L. (2011). A neo-Mengerian examination of the regulatory process. Studies in Emergent Order, 4(2011), 193–208. Boettke, P. J., Fink, A., & Smith, D. J. (2012). The impact of Nobel Prize winners in economics: Mainline vs. mainstream. The American Journal of Economics and Sociology, 71(5), 1219–1249. Böhm-Bawerk, E. von (1914 [2010]). Control or Economic Law. Auburn, AL: Ludwig von Mises Institute. Buchanan, J. M. (1949). The pure theory of government finance: A suggested approach. Journal of Political Economy, 57(6), 496–505. Buchanan, J. M. (1969 [1999]). Cost and Choice. Indianapolis: Liberty Fund. Buchanan, J. M. (1975). The Limits of Liberty: Between Anarchy and Leviathan. Indianapolis: Liberty Fund. Buchanan, J. M. (2000). Politics as Public Choice. Indianapolis: Liberty Fund. Buchanan, J. M. & Brennan, G. (1985). The Reason of Rules: Constitutional Political Economy. Indianapolis: Liberty Fund. Buchanan, J. M. & Tullock, G. (1962 [1999]). The Calculus of Consent. Indianapolis: Liberty Fund. Buchanan, J. M. & Wagner, R. E. (1977). Democracy in Deficit: The Political Legacy of Lord Keynes. Indianapolis: Liberty Fund. Coase, R. H. (1937). The nature of the firm. Economica, 4(16) 386–405. Coase, R. H. (1960). The problem of social cost. The Journal of Law and Economics, 3, 1–44. Dickinson, H. D. (1933). Price formation in a socialist community. The Economic Journal, 43(70), 237–250. Demsetz, H. (1967). Towards a theory of property rights. The American Economic Review, 57(2), 347–359. Demsetz, H. (1969). Information and efficiency: Another viewpoint. The Journal of Law & Economics, 12(1), 1–22. Djankov, S., Glaeser, E., LaPorta, R., Lopez-de-Silanes, R. & Shleifer, A. (2003). The new comparative economics. Journal of Comparative Economics, 31, 595–619.

KNOWLEDGE AND INCENTIVE PROBLEMS IN REGULATORY STUDIES

87

Glaeser, E. L. & Shleifer, A. (2003). The rise of the regulatory state. Journal of Economic Literature, 41(2), 401–425. Gray, H. M. (1940). The passing of the public utility concept. Journal of Land & Public Utility Economics, 16(1), 8–20. Harberger, A. C. (1954). Monopoly and resource allocation. American Economic Review, 45, 77–87. Hayek, F.A. (1937). Economics and knowledge. Economica, 4, 33–54. Hayek, F.A. (1940). Socialist calculation: The competitive ‘solution.’ Economica, 7. Hayek, F.A. (1945). The use of knowledge in society. American Economic Review, 35(4), 519–530. Hayek, F. A. (1948). Individualism and Economic Order. Chicago: University of Chicago Press. Hayek, F. A. (1968 [2002]). Competition as a discovery procedure. The Quarterly Journal of Austrian Economics, 5(3), 9–23. Hicks, J.R. (1939). The foundations of welfare economics. The Economic Journal, 49(196), 696–712. Holcombe, R. G. (2018). Political Capitalism: How Political Influence is Made and Maintained. Cambridge: Cambridge University Press. Ikeda, S. (1996). Dynamics of the Mixed Economy. New York: Routledge. Kaldor, N. (1939). Welfare propositions of economics and interpersonal comparisons of utility. The Economic Journal, 49(195), 549–552. Kirzner, I. (1963 [2011]). Market Theory and the Price System. Indianapolis: Liberty Fund. Kirzner, I. (1973). Competition & Entrepreneurship. Chicago: University of Chicago Press. Kirzner, I. (1979). Perception, Opportunity, and Profit. Chicago: University of Chicago Press. Kirzner, I. (1985). Discovery and the Capitalist Process. Chicago: University of Chicago Press. Klein, D. B. (1998). Quality-and-safety assurance: How voluntary social processes remedy their own shortcomings. The Independent Review, 2(4), 537–555. Klein, D. B. (2001). The demand for and supply of assurance. Economic Affairs, 21(1), 4–11. Krueger, A. (1974). The political economy of the rent-seeking society. American Economics Review, 64(3), 291–303. Levy, D. M. & Peart, S. J. (2020). Towards an Economics of Natural Equals. Cambridge: Cambridge University Press. Makowski, L. & Ostroy, J. M. (1995). Appropriation and efficiency: A revision of the first theorem of welfare economics. The American Economic Review, 85(4): 808–827. Marshall, A. (1890 [1920]). Principles of Economics, 8th ed. London: Macmillan and Co. & Indianapolis: Liberty Fund. Medema, S. G. (2014). Juris prudence: Calabresi’s uneasy relationship with the Coase theorem. Law and Contemporary Problems, 77(2), 65–95. Mises, L. von. (1920 [1935]). Economic calculation in the socialist commonwealth. In F.A. Hayek, ed. Collectivist Economic Planning. Routledge. Mises, L. von. (1940 [1998]). Interventionism: An Economic Analysis. Indianapolis: Liberty Fund. Mises, L. von. (1949 [2008]). Human Action, The Scholar’s Edition. Auburn, AL: Ludwig von Mises Institute.

88

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Piano, E. E. & Rouanet, L. (2020). Economic calculation and the organization of markets. The Review of Austrian Economics, 33: 331–348. Pigou, A. C. (1920 [1938]). The Economics of Welfare, 4th ed. London: Macmillan and Co. Ltd. & Indianapolis: Liberty Fund, Inc. Samuels, W. J. (1974). The Coase theorem and the study of law and economics. Natural Resources Journal, 14(1): 1–33. Shleifer, A. (2005). Understanding regulation. European Financial Management, 11(4), 439–451. Shleifer, A. (2010). Efficient regulation. In D. P. Kessler (ed.), Regulation vs. Litigation: Perspectives from Economics and Law. Chicago: University of Chicago Press. Stigler, G. J. (1971). The theory of economic regulation. The Bell Journal of Economics and Management Science, 2(1), 3–21. Stigler, G. J. (1989). Two notes on the Coase theorem. The Yale Law Journal, 99(3): 631–633. Thomas, M. D. (2019). Reapplying behavioral symmetry: public choice and choice architecture. Public Choice, 180 (1+2): 11–25. Thomas, M. D. & Thomas, D.W. (2018). The rise of the regulatory state: Institutional entrepreneurship and the market for blood. The Independent Review, 22(4): 485–506. Tullock, G. (1967). The welfare costs of tariffs, monopolies, and theft. Economic Inquiry, 5(3): 224–232. Wagner, R. E. (2010). Mind, Society, and Human Action: Time and Knowledge in a Theory of Social Economy. London: Routledge.

5

Reasonable disagreement: Austrian responses to behavioral economics

Ennio E. Piano

Habit or impulse perpetually determines our selection between alternatives without any reflection on our part at the terms on which alternatives are offered us may change within wide limits without affecting us. […] But if they are altered beyond a certain point the habit will be broken or the unconscious impulse checked, and we shall enter a stage of conscious choice. (Wicksteed 2003 [1933], p. 29)

Introduction Before behavioral economics, there was good old plain economics. Economics emerged and developed as a very specific approach to the study of social (though, originally, mostly market) phenomena. According to this approach, social phenomena are the result of the interaction of individuals pursuing their own goals. Thus, at the heart of the new science was a theory of the factors that influence individuals’ pursuit (and manner of pursuit) of their goals, a theory of choice.1 Behavioral economists also see social phenomena as resulting from people making choices. They study the latter through the lenses of theoretical frameworks (theories of choice) of varying complexity and formalism. Cartwright (2018) offers a definition of behavioral economics in three parts: 1. Behavioral economics studies “economic behavior and its consequences” and as such can illuminate “whether people make good or bad choices” (p. 3). 2. Behavioral economics tests the applicability “[of] standard economic models on human beings,” and when these fail, it develops alternative theories “to better fit what we observe” (p. 3). 3. In developing these alternative theories, behavioral economics relies on insights from “psychology and other social sciences” (p. 4). 89

90

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

In other words, the scope of behavioral economics exactly coincides with that of the discipline but takes a skeptical perspective on the latter’s theoretical foundation, which it replaces with those of alternative social-scientific approaches. Among these, psychology is the most popular, so much so that two of the most important early contributors to behavioral economics—Amos Tversky and Daniel Kahneman—were psychologists. This chapter reviews recent work by economists in the Austrian tradition in response to the rising influence of behavioral economics in the profession. As the survey below makes clear, Austrian authors have taken a mostly negative attitude towards their behaviorist counterparts. Austrian scholars have taken issues with every aspect of the behavioral literature, from the approach of behavioral economists to theoretical matters to their empirical methods, from their interpretation of their own findings to their policy recommendations. The historical origins of both traditions may be responsible for this. Austrian economics’ approach to social science was developed in the last three decades of the 19th century and the first four decades of the 20th in direct opposition to that of a school of thought, the German Historical School, that rejected abstract theorizing and deductive logic and emphasized induction and the recording of empirical regularities instead. The behavioral tradition, on the other hand, emerged as a challenge to the mainstream economics of the 1970s and 1980s, the height of mathematical economics’ influence on the profession. Thus, its distinctive characteristic was the rejection of the neoclassical emphasis on abstraction. Instead, it adopted a more experimental approach to the study of human behavior aimed at the identification of behavioral regularities, especially ones that deviated from the assumption (and predictions) of neoclassical economics.2 Two caveats are in order. First, this chapter focuses entirely on the Austrians’ responses to the ‘new’ behavioral economics or what Dhami (2016, p. 45) has dubbed “radical behavioral economics” embodied by the work of economic psychologists Tversky, Kahneman, and Ariely, and their followers within economics.3 Thus, I will ignore the contribution of ‘old’ behavioral economists such as Herbert Simon and his followers and the literature on “bounded rationality.”4 Second, the survey centers on work in microeconomics and political economy and ignores contributions in macroeconomics and financial economics. The reader should not interpret this as meaning that behavioral economics has not made contributions in these fields as nothing could be further from the truth. As Thaler and Mullainthan have argued, financial economics has been the one field in the discipline where behavioral insights have made the greatest impact.5 Nor should readers take this neglect as evidence that Austrians have not engaged behavioral macroeconomics: possibly one of the

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES

91

most interesting contributions to Austrian macroeconomics falls squarely into that category (Koppl 2002).

Behavioral economics: a very, very brief introduction6 Inspired by psychology,7 behavioral economists depart in significant ways from the traditional theoretical foundations and methodology of mainstream economics. In matters of theory, the two most consequential deviations involve individual preferences (utility theory) and the information processing underlying human behavior. Consider the issue of preferences first. Two standard assumptions of traditional economics are that individual preferences over alternatives can be ranked and that this ranking is stable. The first assumption has a commonsensical appeal. If I were to expect to gain a greater reduction in my uneasiness from A than from B, and from B than from C, then keeping everything else constant, it seems reasonable to assume that I would also get more satisfaction from A than from C. This assumption also has the convenient property of making the economic theory of choice predictive.8 If one were to know someone’s ranking of several options and their exact circumstances (income, relative prices, etc.), one would be able to identify their option of choice. The second assumption is that this ranking is stable over time. This assumption is less intuitive as most people would probably admit having experienced a change in their preferences during their lifetime. However, the assumption has more pragmatic justifications. For instance, preference changes are hard to observe in most cases. Second, these changes may be endogenous to changes in prices.9 Thus, it is perfectly legitimate to relax this assumption when the preference change is both easy to observe and exogenous.10 Behavioral economists have come to reject both assumptions on empirical grounds. For instance, Kahneman and Tversky (1979) argue that experimental subjects behave in clear violation of these assumptions, especially in the context of choice under risk and uncertainty. Instead, their behavior is better captured by a theory of decision-making that incorporates loss aversion, reference dependence, and endowment effects. Consider the case of loss aversion. Standard expected utility theory assumes that if one were willing to pay $10 for a 10 percent chance of winning $100, the same person should also be willing to pay $10 to prevent a 10 percent probability of losing $100. Kahneman and Tversky’s (1979) findings suggest that people are more willing to pay to prevent a loss than get the chance of a win of the same value. Thus, one may

92

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

only pay $9 for a 10 percent chance of winning the $100 but $10 to prevent the loss of the same. This is in violation of the standard economic approach to preferences since A ($10) is preferred to B (the $9 one would be willing to pay to prevent a $100 loss), and B is preferred to C ($9.1), but C is not preferred to A (since one is not willing to pay above $9 for an expected win of $10) when it constitutes a win rather than a loss. Related to loss aversion is the notion of reference points. The basic idea is that human beings do not evaluate choices under uncertainty in terms of absolute values but rather relative to some baseline value such as their current level of income or the average price of a commodity. Reference dependence accounts for the fact that people get more satisfaction when they buy some commodities at a certain price if they know that the price is much lower than that by which the commodity generally sells than if they pay the same price but have no idea of how much of a deal it is. The endowment effect is a concept similar to reference dependence.11 It says that people will value the same asset more highly if they perceive it as part of their endowment. This leads to the prediction that people’s willingness to sell will exceed their willingness to buy, another violation of standard utility theory. In a famous experimental test of the endowment effect, Kahneman et al. (1990) gave a group of college students some coffee mugs bearing the insignia of their university while other college students were not. The same mugs could be bought easily at the local bookstore at a price that was public knowledge to all. The experimenters found that mug-owners had an average willingness to sell that much exceeded their colleagues’ willingness to pay. Since mugs were handed out at random, the difference could only be attributed to the fact that the former saw the mugs as part of their endowment and thus were experiencing an endowment effect. The second major departure behavioral economics makes from standard economics pertains to assumptions about the information processing abilities of economic agents. One of behavioral economists’ common criticisms of standard economics is that the latter sees human beings as “cold and calculating” (Cartwright 2018, p. i), impossibly smart, and incapable of committing mistakes. On the contrary, behavioralists see them not only as prone to error but systematically (and thus predictably)12 so. In support of their contrarian view, they point to experimental results suggesting that people are really bad at calculating probabilities. For example, Tversky and Kahneman (1983) found that a majority of experimental subjects suffered from a conjunctive effect. That is, they could not accurately calculate that the probability of two events happening in conjunction is necessarily less than the probability of either of

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES

93

them happening without the other. Specifically, when asked about a made-up character named Linda, whom the experimenters described as: 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Most subjects attributed a higher probability to Linda being a feminist bank teller than to her being a bank teller. In a previous experiment, Kahneman and Tversky (1972) found evidence of an even more glaring mistake in the calculation of basic probabilities. Specifically, when presented with the following scenario: There are two programs in a high school. Boys are a majority (65 percent) in program A and a minority (45 percent) in program B. There is an equal number of classes in each of the two programs. You enter a class at random, and observe that 55 percent of the students are boys. What is your best guess – does the class belong to program A or to program B?

A two-thirds majority of the subjects answered A, when B is the correct answer (Kahneman and Tversky (1972, p. 43). They attribute this failure to the participants’ “representative bias,” or the tendency to assign a higher probability to events that share some common characteristic with their generative process. In the case above, since, in program A, boys are the majority, subjects overestimate the probability of a majority boy class being part of the same program. Since the whole edifice of expected utility theory relies on the chooser’s present value calculations, these results have led behavioral economists to reject expected utility theory as a descriptive theory of human decision-making. In its place, behavioral economists have proposed a model of “mental accounting” according to which human behavior is not directly responsive to changes in prices. Rather, individuals come up with figures that are allocated to specific consumptive or productive activities. For instance, rather than adjusting downward the income share one allocates to the purchase of pastry following an increase in price, one simply stops buying pastry once the target share has been met. Similarly, rather than increasing the number of hours spent driving a taxi on a particularly busy and profitable day, the taxi driver stops working once she has met her pre-determined income target (Camerer et al. 1997). Armed with their alternative framework—prospect theory—behavioral economists have made several contributions to empirical social science. While many economists have questioned the overall value and validity of these

94

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

contributions,13 Dhami (2016, p.  29) argues that “no other decision theory in economics has been so successful in explaining such a wide range of phenomena.” For instance, behavioral economists have provided explanations for the higher returns on equity relative to bonds, people’s willingness to pay taxes, the prevalence of low-powered incentives in firms and bureaucracies, households’ tendency to gamble and insure at the same time, and many more.14 Finally, behavioral economists have contributed to the rise of the experimental methodology (mostly as developed by academic psychologists) in economics.15 Experiments are the preferred method by applied behavioral economists due to their “slow[ing] down [of] human behavior to a frame-by-frame narration of events, isolate individual forces, and examine those forces carefully and in more detail” (Ariely 2008, p. xxi).

Austrian economics and behavioral economics Foundations The Austrian tradition finds itself in a peculiar position vis-à-vis behavioral economics (Holcombe 2009; Whitman 2021). On the one hand, Austrians have traditionally shared the behavioralists’ dislike for mainstream economics’ formalism (Boettke et al. 2003), its embrace of unrealistic behavioral assumptions (Boettke and Candela 2017), its focus on equilibrium states (Kirzner 1997; Boettke 2002), and the adoption of de-facto objectivism in cost theory (Buchanan 1978; Vaughn 1980). On the other hand, Austrians take an axiomatic approach to the derivation of economic theory.16 Thus, many Austrians would reject the very notion that behavior can be meaningfully described as “irrational”:17 Austrian utility theory assumes only that people act to further their goals. Thus, all individual behavior is consistent with Austrian utility theory, and any findings of behavioral regularities—or irregularities—in behavioral and experimental economics remain consistent with a utility theory that posits only that people act to further their goals. (Holcombe 2009, p. 306)

While Austrian utility theory goes back to the 1870s, its modern foundations were first laid down by Mises (2007 [1949]). At the heart of the Austrian approach to economics lies an understanding of human behavior as purposeful. Austrians understand social phenomena as the result of the interaction of individuals pursuing their own goals. These goals the social scientist must take as given and are the purview of disciplines other than economics. In the pursuit of her objective, the agent is constrained by the limitations of the exter-

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES

95

nal world but also those of the human mind and body. Action aimed at reducing the plight of hunger is not any more rational than that aimed at fulfilling the desire for vengeance. Rationality only requires that the individual may conceivably choose among at least two courses of action in the pursuit of her goal or goals. To Mises, even behaviors that appear as unconscious or instinctual may, in fact, be understood as purposeful. Consider the act of blinking. Most of the time, humans blink unthinkingly. This would suggest that blinking is no action at all. However, humans have some control over blinking. If one had a goal that required her to reduce or even stop blinking for a prolonged period of time, she can and will do so.18 Thus, in Mises’ understanding of rationality, the only behavior that truly fails to meet this standard is that which the agent has no alternative but to perform. The involuntary contraction of a muscle, the injection of fresh oxygen into the bloodstream by our lungs, and so forth. Indeed, such features of the human condition are better understood as the context of action, as constraints on the purposeful behavior of individuals. Mises extended his logic to the world of mental states and beliefs:19 A peasant eager to get a rich crop may—according to the content of his ideas— choose various methods. He may perform some magical rites, he may embark upon a pilgrimage, he may offer a candle to the image of his patron saint, or he may employ more and better fertilizer. But whatever he does, it is always action, i.e., the employment of means for the attainment of ends. Magic is in a broader sense a variety of technology. Exorcism is a deliberate purposeful action based on a world view which most of our contemporaries condemn as superstitious and therefore as inappropriate. But the concept of action does not imply that the action is guided by a correct theory and a technology promising success and that it attains the end aimed at. It only implies that the performer of the action believes that the means applied will produce the desired effect. (Mises 2007, p. 37)

To the extent that one’s beliefs are not of one’s choosing, no matter how inconsistent they are with reality, they are neither rational nor irrational. They simply are. All that matters to the social scientist is that they inform one’s actions. Actions that, though influenced by wrongheaded beliefs, are aimed at the fulfillment of a goal and were selected among alternatives and are therefore rational by (Mises’) definition.20 Nor would Mises and his Austrian followers accept debates over the rationality of preferences as meaningful. Even when we find other people’s preferences puzzling (“why would anyone rather eat Chicago-style pizza over New York-style pizza?”), we are not puzzled by the effect that such preferences have on behavior, and we recognize that such a relationship is akin to the one that we ourselves experience. According to McChesney (2013, p.  50), behavioral

96

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

economists have the ability to positively contribute to traditional economics by doing what Mises saw as the role of psychology in informing applied economic analysis: identify the actual preferences and constraints (cognitive and physiological) faced by human actors. However, he sees them as mostly failing this task: “surprisingly, behavioral economics does not spend much time attempting to explain real-life motivations” (McChesney 2013, p. 50). Rather, “much behavioral work seems directed at illustrating phenomena perhaps of curiosity but unrelated to resolving any particular issue or making any salient predictions” (McChesney 2013, p. 55). Rizzo (2015, p. 381) criticizes the tendency of behavioralists to “equate irrationality of choice with the economist’s observed inconsistency or intransitivity in the agent’s pattern of choices.”21 The flaw with this attitude lies in the fact that the rationality of all behavior is contextual. Actions that seem irrational to an external observer may make perfect sense (i.e., appear rational) once the meaning attributed to them by the agent is revealed. To an Austrian, there is no such thing as the objectively optimal course of action, from which individuals may at times deviate. This is not to say that we cannot conceive of better or worse ways of addressing problems that face us. For instance, most people would acknowledge the superior effectiveness of contemporary medicine in treating infections than traditional forms of medicine. Yet, the fact that for most of human history people have failed to employ modern medical procedures does not render them irrational. It is simply the result of the limits of the medical knowledge available to them (Rizzo 2015, p. 283).22 Manne and Zywicki (2013) offer a complementary line of argument. Even if one were to concede that behavioral economics offers a better (i.e., descriptively more accurate) theory of human decision making, its usefulness would still be quite limited when extended to the study of environments that, like competitive markets, select for courses of action consistent with traditional economic rationality. To the extent that biases and behavioral imperfections lead to actions incompatible with survival in the marketplace, these actions are unlikely to “survive” the market test in the long run. For instance, firms that price their output wildly above (or below) their marginal cost, assuming they operate in comparative markets, whatever the mental processes leading their owners to make such a mistake, will necessarily go bankrupt in due time. In the end, the industry will be populated only by firms that do not systematically deviate ‘too much’ from the optimal pricing strategy (P=MC).23 The same principle applies to the case of generalized and systematic deviations from standard economic rationality by consumers and producers. Indeed, one person’s irrationality is another person’s profit opportunity (Manne and Zywicki 2013, p. 561). Unless one assumes that every agent in the economy is

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES

97

so irrational as not to be capable of perceiving such an opportunity,24 then the actual inefficiencies generated by irrational behavior will be smaller than the ones predicted by behavioral economists. McKenzie (2009) sees the failure of behavioral economists to recognize the power of entrepreneurship to combat the negative effects of behavioral biases as a key weakness: Behavioralists seldom consider how the prevalence of profitable opportunities embedded in the distribution of the irrational choices, as determined by subjects’ responses on surveys, can affect with time the relative value of, say, the sure-thing option and the prospect option. The division of the subjects’ choices between the two options is treated as a given with no implication for future choices, even if the subjects in the experiment knew that the vast majority of the subjects made wrong choices. Presumably, the minority of subjects who made the right choices are not deemed sufficiently rational, intelligent, or creative to take advantage of all the subjects who made the wrong choices. (McKenzie 2009, p. 242)

By ignoring entrepreneurship, behavioralists also ignore the potential for coordination and equilibration in a world of imperfect human beings. Boettke et al. (2013) attribute this failure to the fact that the field emerged as a challenge to a mainstream economics that had itself abandoned the study of the coordinating properties of markets: “Coordination was taken to be automatic, largely implicitly and for analytic reasons. The result was the banishment of error from economic theory” (Boettke et al. 2013, p. 91). By bringing human error back into economics, behavioral economists had the opportunity to redirect the attention of the profession towards the study of the market process. Instead, behavioralists concentrated all their energies towards proving that error is commonplace. Yet, by doing so, behavioral economists are contributing to the profession’s disregard for the study of how the degree of social order we do observe in real-world markets is achieved at all, given the existence of error and the need for learning and adjustment.25 Applied economics Rizzo and Whitman (2019, especially chapter 6) provide a critical discussion of the experimental methodology adopted by most empirical behavioral economists. They claim that a significant amount of evidence produced by the experimental literature in behavioral economics is the result of the behavioralists’ experimental design rather than the subjects’ irrationality. More specifically, they find that many of the empirical findings of such experiments suffer from some combination of the following: the behavior observed in the lab is highly context-specific and seldom has general applicability outside of it; the role of incentives within the lab is not accounted for, nor do experimental designers discuss how real-world incentives may change the behavior of the subjects;

98

A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

learning and adaptation are impossible due to the “one-off” nature of many experiments;26 the research design does not, perhaps intentionally, allow for “self-regulation and de-biasing” by the subjects (Rizzo and Whitman 2019, p.  191). On these bases, Rizzo (2015) and Rizzo and Whitman (2019) push against the interpretation of some of behavioral economics’ best-established empirical findings. Consider the case of the “framing effect,” or the argument that changing the framing of a choice between alternatives affects a subject’s choice even though the alternatives available remain objectively unaltered. Behavioralists believe that this fact is evidence against the rationality of human behavior since “[d]ifferent representations of the same choice problem should yield the same preference.”27 Scenarios that are described in different terms, whether or not their objective physical characteristics are left unchanged, are, in fact, different scenarios from the perspective of the chooser. Exposure to a different description may cause an individual to reassess her understanding of the alternatives available to them, which in turn may lead to a different choice. There is nothing irrational about this kind of behavior unless one takes a view of rationality that relies on the epistemological position that “facts speak for themselves, and interpretation is unnecessary” (Rizzo 2015, p. 385).28 Overall, behavioral biases, Rizzo and Whitman (2019, p. 18) conclude: [w]hen rationality is stripped of unnecessary and artificially confining restrictions or assumption, many (though not all) of the behavioral paternalists’ best arguments dissolve. Many alleged violations of rationality, on which they base their case for correction, are in fact violations of analytical assumptions that are not welfare-relevant. In short, much “irrational” behavior may be nothing of the sort.29

Law and economics Law and economics has been one field that has seen a significant amount of Austrian (or Austrian-inspired) pushback against the influence of behavioral economics. For instance, Zywicki (2018) has criticized the rise of behavioral law and economics on empirical and theoretical grounds: much of academia’s “settled science” approach to BLE [behavioral law and economics] is not grounded in any serious underlying theoretical or empirical support for the theory’s claims and hypotheses, but rather an agreed sense among its proponents of the validity of the claims that is unrelated to the underlying evidence that claims to support it. (Zywicki 2018, p. 440)

Leeson (2019) argues along similar lines to conclude that behavioral economics is generally unnecessary to make sense of existing legal regimes. Specifically, he pushes back against the suggestion that several features of American law cannot be understood without significant amendments to standard utility theory to

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES

99

incorporate merit goods and other-regarding preferences. Consider the two examples from Calabresi (2016): the regulation of the market for organs and the military draft. According to Calabresi, neither seems to make sense if one believes that their characteristics are the result of rational economic behavior. Instead, one must introduce fellow feelings in order to develop an explanation. On the contrary, Leeson (2019) shows that these cases are easily explained by the standard logic of concentrated benefits and dispersed costs of rent-seeking politics in a world of incomplete, costly information. Zywicki (2018) is particularly critical of the methodology of BLE, on the basis that it constitutes a departure from “the standard approach of identifying a testable hypothesis and then acquiring data to test it” (Zywicki 2018, p. 444). BLE scholars, he contends, first identify some well-established market practice that they see as having detrimental effects on consumers—effects that are often left unsupported by evidence—after which they pick one among the many supposed irrationalities and biases identified by behavioral economics and claim that it is responsible for the practice, and finally some policy must be introduced to address it (Zywicki 2018, p. 445). To make things (methodologically) worse, when confronted by evidence contrary to their theory, BLE scholars do not take it as evidence against their original argument but rather retroactively modify the theory to account for it. In doing so, they provide no evidence that the new interpretation is, in fact, the correct one, nor do they pay much attention to whether the revised theory is internally consistent (Zywicki 2018, p. 447).30 McChesney (2013) provides two further examples of policies enacted by the American federal government on behavioralist grounds: the so-called “Cooling-Off Rule” and the “Funeral Rule.” The former forces home-sellers to accept any return of commodities within three days after the sale. Apparently, this policy was motivated by the presumption that home-sellers were taking advantage of consumers’ irrationality (low-income ones’ in particular). Very little evidence was presented (or even collected) before the adoption of this policy. Only decades later did the Federal Trade Commission attempt to evaluate the validity of the behavioral arguments, only to find them severely wanting (McChesney 2013, p. 70). The “funeral rule,” which requires funeral service providers to abide by a variety of information disclosure practices, had a similar rationale. Consumers of funeral services find themselves in a sensitive, emotional state that impairs their ability to make fully rational economic decisions, opening the door for the opportunism of funeral service providers. As in the case of the cooling-off rule, little more than anecdotal evidence was presented in support of the new regulation. However, in this case, systematic evidence on consumer satisfaction and characteristics were available to the

100 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

FTC, which simply did not consider it possibly because it showed that consumers were indeed almost universally satisfied with their experience and that their consumption decisions were not the result of emotionally impaired mental processes (McChesney 2013, p. 73). Economic history and political economy From an Austrian perspective, the scant output of applications of the behavioral approach and method beyond the lab is a further source of skepticism. Austrians see the goal of theory as the development of causal explanations for historical social phenomena.31 Behavioral economists have produced very little work that explicitly employs their tools to make sense of the past.32 There are two prominent exceptions. One is the work of Shiller on financial crises (2008, 2015), which embraces concepts from behavioral finance, such as herding, to explain the growth (and eventual bust) of financial bubbles. He’s also taken the view that narratives (or storytelling) about the performance and direction of the macroeconomy shape the beliefs and thus actions of consumers and investors (Shiller 2020). The other exception is the recent work by Elster (2020) on the fall of the Ancien Regime in France. Here, Elster develops a framework that incorporates behavioral elements into a standard rational choice model. Perhaps the most important behavioral amendment he introduces is that of a feedback loop between desires (i.e., preferences) and beliefs (Elster 2020, p.  15). In the standard model, information affects beliefs that interact with desires to determine behavior. In Elster’s behavioral rendering, individuals have preferences over their own beliefs that, in turn, when new information is available, generate emotions which then interact with preferences to shape behavior. The complexity of the model is testament to the difficulty of embracing a behavioral approach to the study of social phenomena in the real world (and especially when these took place in the distant past). Emotions and beliefs are not easily observed (emotions even less so than beliefs), different emotions may emerge from the same stimuli, and the same emotion may lead to different patterns of behavior.33 Unsurprisingly, Elster’s treatment of pre-revolutionary France reads at once confusing and ad-hoc.34 Welfare economics One common criticism Austrian economists have made against behavioral economics is that the latter has economists who failed to reject neoclassical welfare economics as a normative benchmark and guiding principle for policy evaluation (Boettke et al. 2013; Rizzo 2015; Rizzo and Whitman 2019). For example, Holcombe (2009, p. 309) argues that if one accepts the behavioralists’ conclusion that their findings reject the theoretical foundations of

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES 101

neoclassical economics, then it is inconsistent for the same person to embrace normative implications derived from the same. At least one subset of Austrian economists, influenced by the work of Rothbard (1956), offers an alternative normative framework that sees the voluntariness of all parties involved in a transaction as the ultimate measure of its contribution to the welfare of society. By construction, such a framework leaves no room for “nudging” as a tool for welfare-increasing state-action.35 An alternative Austrian approach to welfare economics emphasizes the difficulties encountered in designing and implementing welfare-enhancing policies. This perspective builds on Hayek’s (1945) argument on the inarticulate nature of much of the knowledge markets generate and process in allocating (and reallocating) resources in society. This fact makes it impossible for governments to approximate the results of the market process via command and control. A similar logic applies to policies aimed at counteracting the consequences of alleged biases and behavioral anomalies—smoking, obesity, under-saving, herding in financial markets, and so forth. No matter how targeted the intervention, it will necessarily interact with existing policies, social norms, business strategies, and individual behavior in unpredictable ways (McKenzie 2009, p. 260). Any effective nudging process must overcome the knowledge problem at (at least) three critical junctures (Whitman 2021, pp.  10–11). First, scholars must identify an actual behavioral anomaly and the magnitude of its negative consequences on social welfare. Setting aside the problem of discerning actual anomalies, even if one were to be identified correctly, there remains the problem of estimating its social cost. There are certainly myriad systematic mistakes people make that are of little or no consequence to society. Moreover, “it is one thing to say people make mistakes; it is another to clearly and definitely identify which actions are, in fact, mistakes” (Rizzo and Whitman 2019, p. 17). The scholar must therefore discover which is which, and among these, the ones that more urgently need addressing. The knowledge required to make such a judgment is not readily available, and, in trying to obtain it, scholars face the same difficulties involved in traditional welfare economics, exposing them to the criticism of the latter (Hayek 1945; Buchanan 1959). The second “knowledge problem” nudgers face comes up in the development of the specific policy response to the behavioral anomaly of choice. For each of the available alternatives, one must show that it reduces the social cost of the anomaly, and it does so without itself generating costs that exceed its benefit. Among other things, this requires one to account for potential unintended consequences, which by definition cannot be envisioned, making it hard, if not impossible, to correctly estimate the policy’s full, long-term costs. If to this point one adds the behavioralist’s own argument that individuals are generally pretty bad at calculating expected utility gains and identifying courses of actions that generate

102 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

the greatest present discounted value,36 the problem facing the policy-designer is compounded. Finally, the nudge must be implemented and enforced by elected officials and professional bureaucrats who, at least in democracies, must ultimately respond to the general public. Given that politics lacks the kind of feedback mechanisms (property rights and prices) that are typical of markets,37 these actors lack the tools to calculate which policy to implement, what tools and how many resources to direct towards their implementation, and so forth. Moreover, the irrational beliefs and preferences of the general public are bound to influence this decision-making process if the public officials are to keep their seats.38 Finally, Cartwright and Hight (2020) provide a more philosophical criticism of behavioral public policy and nudging in particular. Specifically, they take issue with the popular argument in favor of such interventions that they result in making consumers better off according to their (i.e., the consumers’) own standards.39 This argument has the advantage of getting around the nudgers’ knowledge problem with identifying a social welfare function as well as the intervention that leads to its maximization. To meet this alternative criterion, “choice architects”—the individuals entrusted with designing the behavioral interventions—need ‘only’ to rely on what consumers themselves believe is the best outcome. But, as Cartwright and Hight (2020, p.  35) note, “exactly how such public-spirited individuals know that it is good to nudge is decidedly unclear, even if it has an intuitive pull.” They argue that if we are to know that such a standard is met by given intervention, we first need a clear definition of what the standard entails. Common grounds? Recently, Whitman (2021) has argued that Austrians and behavioralists have much to learn from each other. Yet, mutual learning between the two traditions has been scant. He suggests that this is due to their drastic divergence in matters of public policy, with the more libertarian Austrians seeing the behavioralists’ preferred “nudges” with skepticism. Nevertheless, he sees room for mutual learning in the interaction between the two camps. For instance, he suggests that experimental findings by behavioral economists may serve as a corrective to the Austrians’ reliance on introspection as a way to identify axioms for a universal theory of choice (Whitman 2021). At the same time, he encourages behavioralists to take the Austrian’s emphasis on subjectivism. In particular, behavioral economists often ignore the importance of the subjective character of one’s understanding of one’s circumstances. This is especially important when evaluating behavior that would at first appear to violate some objectively construed definition of rationality (Whitman 2021,

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES 103

p. 3). Recognizing that individuals must always interpret their circumstances through their subjective lenses would lead to a significant reconsideration of how behavioralists talk about the role of “framing” in human decision-making. Whitman further suggests that Austrians may be better off by leveraging the empirical findings of behavioral economics to reject the notion of a utility function as the object of individual constrained maximization altogether. Following Mises, many Austrians do not use utility functions in their work but often use the idea of a utility function for illustrative or pedagogical purposes. However, since neoclassical utility functions rely on the twin assumptions of preference transitivity and completeness, but Austrian utility theory does not require such assumptions (Holcombe 2009), such language is bound to lead to confusion. Instead, Whitman proposes the adoption of the phrase “utility improving” to describe human behavior (Whitman 2021, p. 6). Austrian economists and behavioralists are most likely to converge on the issue of beliefs. Both camps reject the neoclassical embrace of Bayesian updating and rational expectations. Behavioral economists do so on empirical grounds, having found much evidence contrary to both. Austrians do so on the grounds that beliefs are subjective, and there is no a priori reason to expect individuals to interpret new facts in the same fashion, nor that individuals starting with different belief systems in the first place will update in the same direction (Whitman 2021, p. 7). Boettke et al. (2013) suggest that behavioral economics may benefit from embracing a Hayekian approach to its subject. Hayek saw no problem in making room for error within economics and indeed saw the role of axiomatic economics (the “pure logic of choice” as he dubbed it [Caldwell 2016]) as relatively limited in scope (Hayek 1937). Admitting the existence of error and imperfections led Hayek to urge his fellow economists to focus on how order would ever be attained in such a world. His own answer was to look at the role of markets, social norms, and formal legal systems in generating the information necessary for enough error correction to prevent societal chaos and, at least in developed industrial economies, generate unprecedented levels of wealth. Sunstein (2023) takes up Boettke et al.’s (2013) challenge to develop a “Hayekian” behavioral economics. In doing so, Sunstein focuses on two elements of Hayek’s social philosophy. The first idea is that markets outperform central planning in generating, distributing, and processing information that is both decentralized and hard to articulate objectively.40 The second idea is that coercive infringements on personal freedom cannot be justified solely on

104 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

welfarist grounds. Sunstein argues that some of the interventions identified by behavioral economists are robust to both considerations. In particular, he supports government-mandated labels disclosing relevant (but overlooked, allegedly due to behavioral biases on the part of consumers)41 information. On the one hand, labels do not interfere with the price system. No economic activity is regulated by this intervention, nor are taxes levied that may hamper the informational content of prices. On the other hand, labels are not coercive. Consumers are not forced to buy or not buy anything, and they may even ignore the information contained in the labels altogether.42 However, Sunstein appears skeptical that such limited interventions or “educational nudges” would be enough to fully address the extent of irrational behavior and its negative consequences in society. In some scenarios, there may be very large gains available from the adoption of more coercive and/or price-distorting interventions. In such cases, Sunstein favors these interventions, although he doubts that they would get past “Hayek’s skepticism about coercion and top-down expertise” (Sunstein 2023, p. 185).

Conclusion: the unlikely convergence of BE and AE This chapter offers an overview of the response to the rise of behavioral economics by scholars working within the Austrian tradition. While no summary can do justice to the variety of opinions within the Austrian camp, one could fairly argue that they have been mostly negative. This fact may appear a bit surprising given the shared dislike they have for neoclassical economics as it developed in the decades following the Second World War. Both Austrians and behavioralists do not buy into the mathematical foundations of neoclassical economics, with their emphasis on the rationality of preferences, beliefs, and expectations. Both reject standard economics’ most popular methodology, the derivation of empirical predictions from clearly stated assumptions to be tested against large datasets. Both reject important aspects of standard neoclassical welfare economics. And so on. Yet, where Austrians and behavioralists disagree with neoclassical economists, they disagree with each other. Austrians reject neoclassical utility theory for its formalism and strict assumptions, as well as concepts such as indifference and revealed preferences (Mises 2007; Rothbard 1956). On the other hand, many behavioralists are perfectly happy to adopt axiomatic utility theory: they just draw utility functions differently. Behavioral economists’ preferred methodology is the experiment, while Austrians have fallen rather short of its embrace.43 Moreover, Austrian economists tend to agree with neoclassical economists

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES 105

that the testing of theoretical assumptions is not a useful scientific enterprise, and some would probably doubt that it can ever be done. Even when it comes to welfare economics, the behaviorists’ beef takes a rather different form than the Austrians’. The former buy entirely into the view that the rational choice model serves as a normative benchmark: Setting price so that marginal cost equals marginal revenue is the right answer to the problem of how to maximize profits. Whether firms do that is another matter. I try to teach my MBA students that they should avoid the winner’s curse and equate opportunity costs to out-of-pocket costs, but I also teach them that most people do not. (Thaler 2012, p. 197)

They merely disagree that such a benchmark can be met in the real world without external intervention (preferably by the government). Austrians reject neoclassical welfare economics altogether and are rather skeptical of government interventions of any kind. Ultimately, commonalities notwithstanding, the methodological, theoretical, and normative differences between the two fields are large. Probably too large to allow for much convergence beyond the self-interested adoption of this or that element of each other’s approach to employ in their criticism of neoclassical economists.

Notes 1.

To use Hayek’s terminology, we can say that economics is a science of spontaneous orderings built on a pure logic of choice, where the link between the two depends on the specific processes of the generation, distribution, and processing of knowledge by individuals. 2. Interestingly, behaviorists and historicists have employed similar lines of attack against neoclassical economics. Contemporary behavioralists (Cartwright 2018, p. i) often endorse Veblen’s ridicule of the neoclassical economics for its “hedonistic conception of man is that of a lightning calculator of pleasures and pains, who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift him about the area but leave him intact... He is an isolated, definitive human datum, in stable equilibrium except for the buffets of the impinging forces that displace him in one direction or another” (Veblen 1992 [1899]). 3. For a more comprehensive overview of the history of behavioral economics as well as a critical treatment of its theoretical foundations and major findings from an Austrian perspective, readers should consult Rizzo and Whitman (2019). 4. Such literature has had much greater success in influencing the work of mainstream economists. For instance, Nobelists Oliver Williamson, Vernon Smith, Elinor Ostrom, and Oliver Hart all employed the concept of bounded rationality à la Simon in their research.

106 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

5. 6.

7.

8.

9. 10.

11. 12. 13. 14. 15.

16. 17.

18.

See for instance Shleifer (2000) and Shiller (2008). This section does not constitute a comprehensive overview of the theoretical foundations and methodology of behavioral economics. Readers interested in such an overview may consult Kahneman (2011), Thaler (2012), and Cartwright (2018). For a more advanced treatment, see Dhami (2016). Although it had the greatest influence on the development of behavioral economics, psychology is not the only discipline to have provided fodder in the challenge to standard economics. In particular, sociology and anthropology have informed some behavioralists’ view of individual preferences and led them to modify the standard economic assumption of self-interest in favor of altruism. For instance, altruistic tendencies are generally assumed to explain the deviation from “optimal” strategic behavior in experimental settings such as cooperation in prisoners’ dilemma games. In his defense of economists’ use of rationality, McKenzie (2009, p. 6) argues that “rationality permits the conceptualization of precise and unique equilibriums which are a cornerstone of testable predictions primarily regarding the directional changes (but not their magnitudes) in market outcomes.” This led Stigler and Becker (1977) to develop a new framework to study consumption that allows one to study endogenous preference formation. One example is Allen and Brinig’s (1998) study of why women are the majority of divorce filers. They argue that human biology causes men and women to experience a preference change for sexual intercourse at different points of their life cycles. This, in turn, has a significant effect on their relative bargaining power within the household. See McKenzie (2009, 2018) for an argument for the adoption of evolutionary foundations to the choice of assumptions pertaining to preferences and preference variation. Anchoring is another behavioral departure from standard utility theory caused by reference effects. Shortly, exposure to some arbitrary value anchors individuals’ evaluations of a commodity to the same value (Furnham and Boo 2011). Ariely (2008). See Levitt and List (2007), McKenzie (2009), and Wright and Ginsburg (2012). For a review of the empirical literature applying prospect theory, see Dhami (2016, especially Chapters 3 and 4). However, as McChesney (2013) rightly points out, Vernon Smith was running experiments decades before Kahneman and Tversky. Due to the shared methodology, there is much overlap between experimental and behavioral economics. However, scholars in the two traditions tend to work on different sets of questions (Cartwright 2018). However, not all Austrians agree on the exact method of identifying the right axioms on which to base economic theory (Zanotti and Cachanosky 2015). In this, they follow Mises’s stance that “When applied to the ultimate ends of action, the terms rational and irrational are meaningless. The ultimate end of action is always the satisfaction of some desires of the acting man” (Mises 2007, p. 20). The skeptical reader may want to investigate the following scenario. Humans blink between 15 and 20 times every minute, on average. By how much would their blinking be reduced if they were taxed ten cents for every blink of their eyes? The fact that there are physiological limitations to our ability to reduce blinking is of no consequence to this argument. There is similarly a physiological limitation to

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES 107

19. 20. 21.

22.

23. 24. 25. 26. 27. 28.

29.

30.

31. 32.

33.

our ability to reduce our intake of calories, but we do not therefore jump to the conclusion that our decisions pertaining to food consumption are not purposeful. Mises would have probably found much of the discussion of the rationality of beliefs (or lack thereof) as nonsensical. See Leeson (2012, 2013, 2014) for a recent application of Mises’ approach to behavior inspired by superstitious beliefs. Rizzo and Whitman (2019, p. 206, emphasis in original) criticize another tendency they find typical of the literature: the conflation of other-regarding preferences with irrationality: “other regarding preferences are not biases for which we must investigate the effect of incentives. They are allowable preferences within the paradigm of inclusive rationality.” Effectiveness by itself does not make a course of action rational. Knowledge of such effectiveness must also be present. Moreover, even once the effectiveness of some course of action is recognized, it may still be unfeasible to adopt it due to its expensiveness. This argument was first formulated by Alchian (1950). But we know this cannot be true since at least some people (e.g., behavioral economists) have proven quite gifted in identifying irrationality in the market and estimating the negative consequences. Thus, behavioral economics has evolved into a subset of market failure theory in which behavioral anomalies are responsible for market inefficiencies (Boettke et al. 2013, p. 95). Noticeably, non-behavioral experimental economists do make room for both incentives and learning in their studies (Smith 2003). Tversky and Kahneman (1986, S253) as quoted by Rizzo (2015, p. 385). Rizzo also points out that human beings reasonably interpret different descriptions of the same scenario differently due to their knowledge of the ability of others to frame information strategically. Thus, the very choice of framing a scenario in a specific way would have informational content and thus alter the selection by the chooser (Rizzo 2015, p. 386). In order to position themselves as having a more sophisticated view of rationality than either behavioralists or neoclassical economists, some of the authors cited in this chapter have coined their own version of the term. Rizzo and Whitman’s (2019) term of choice is “inclusive rationality.” Boettke et al. (2013) adopt Vernon Smith’s (2003) “ecological rationality.” In the same article, the author provides several case studies to support his claims. One such case study focuses on emerging BLE scholarship on the biases that supposedly allow credit card companies to take advantage of consumers of financial services. Another case study centers on arguments made by BLE scholars in favor of regulating the use of cash payment discounts by commercial retailers. Where “historical” here should be understood broadly to include the immediate past as well as the distant one. See Mises (1985) for a discussion of this point. A google scholar search for “behavioral economic history” produces three results, only one of which is an article published in a peer review journal, and even this was published in 1966. (Link: https://​scholar​.google​.com/​scholar​?hl​=​en​&​as​_sdt​=​ 0​%2C43​&​q​=​%22behavioral+​economic+​history​%22​&​btnG​=​ (accessed on June 7, 2021). By Elster’s (2020, p. 19) own admission: I have been writing as if the relation between a cognitive antecedent and the triggering of an emotion, as well as the relation between the emotion and the subsequent action, are always

108 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS one-to-one. I believe that another person deliberately hurt me, I get angry, and I retaliate. While this pattern is frequently observed, the relations can also be one-many.



34.

35. 36. 37. 38. 39. 40.

This feature of Elster’s framework is particularly concerning since emotional states are not observable. If all sorts of behavior are consistent with the same emotional state, but emotional states are unknown, then what exactly does this theory explain? The social scientist’s explanations of choice will be (or, at least, will read) as necessarily ad hoc. This is not the only problem with Elster’s framework. Another major one is the use of rationality to mean “[the] pursuit of the long-term public good” (Elster 2020, p. 17). Thus, any behavior that would be understood as entirely rational by economists but that does not lead or even aim at “the long-term public good” is here treated as irrational by construction. In principle, mutually agreed upon nudges would be compatible with Rothbard’s approach. Not to talk of the problem of identifying the correct discount rate. Should policy designers employ subjectively weighted discounting or linear discounting? And if the former, whose subjective weights? Perhaps more accurately, one should say that these mechanisms exist in politics but are less pervasive than in markets (Wittman 1989). Or at least this is what a behavioral economist should expect (Caplan 2011). This approach has been dubbed “libertarian paternalism” by Thaler and Sunstein (2009). However, Sunstein seems to disagree with Hayek’s contention that markets are overall effective in directing economic agents to respond to changes in economic conditions: In view of modern behavioral findings about human error, it would be possible to object that the price system is not always so marvelous. Suppose, for example, that consumers show limited attention, unrealistic optimism, or present bias; if so, the price signal will miss something important, and the “system of telecommunications” will give the wrong messages. (Sunstein 2023, p. 3)

41. One peculiarity of this line of argument is that it often fails to address the failure of agents on the supply side to take action in the absence of government intervention, especially given the alleged large savings to consumers that would follow label adoption. 42. Note however that mandating labels is indeed coercive to suppliers. 43. Note however that many Austrians see Vernon Smith as one of them (Boettke 2012). See also Oprea and Powell (2010).

References Alchian, A. A. (1950). Uncertainty, evolution, and economic theory. Journal of Political Economy, 58(3), 211–221. Allen, D., & Brinig, M. (1998). Sex, property rights, and divorce. European Journal of Law and Economics, 5(3), 211–233. Ariely, D. (2008). Predictably irrational. New York, NY: Harper Books.

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES 109

Boettke, P. J. (2002). Information and knowledge: Austrian economics in search of its uniqueness. The Review of Austrian Economics, 15(4), 263–274. Boettke, P. J. (2012). Living economics. Oakland, CA: Independent Institute. Boettke, P., Caceres, W. Z., & Martin, A. (2013). Error is obvious, coordination is the puzzle. In Hayek and behavioral economics (pp. 90–110). Palgrave Macmillan, London. Boettke, P. J., & Candela, R. A. (2017). Rational choice as if the choosers were human. In Handbook of behavioural economics and smart decision-making. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Boettke, P. J., Coyne, C. J., & Leeson, P. T. (2003). Man as machine: The plight of 20th century economics. Annals of the Society for the History of Economic Thought, 43(43), 1-10. Buchanan, J. M. (1959). Positive economics, welfare economics, and political economy. The Journal of Law and Economics, 2, 124–138. Buchanan, J. M. (1978). Cost and choice: An inquiry in economic theory. University of Chicago Press. Calabresi, G. (2016). The future of law and economics: Essays in reform and recollection. Yale University Press. Caldwell, B. (2016). FA Hayek and the economic calculus. History of Political Economy, 48(1), 151–180. Camerer, C., Babcock, L., Loewenstein, G., & Thaler, R. (1997). Labor supply of New York City cabdrivers: One day at a time. The Quarterly Journal of Economics, 112(2), 407–441. Caplan, B. (2011). The myth of the rational voter: Why democracies choose bad policies – New Edition. Princeton University Press. Cartwright, A. C., & Hight, M. A. (2020). ‘Better off as judged by themselves’: A critical analysis of the conceptual foundations of nudging. Cambridge Journal of Economics, 44(1), 33–54. Cartwright, E. (2018). Behavioral economics. Routledge. Dhami, S. (2016). The foundations of behavioral economic analysis. Oxford University Press. Elster, J. (2020). France before 1789: The unraveling of an absolutist regime. Princeton University Press. Furnham, A., & Boo, H. C. (2011). A literature review of the anchoring effect. The Journal of Socio-economics, 40(1), 35–42. Hayek, F. A. (1937). Economics and knowledge. Economica, 4(13), 33–54. Hayek, F. A. (1945). The use of knowledge in society. The American Economic Review, 35(4), 519–530. Holcombe, R. G. (2009). The behavioral foundations of Austrian economics. The Review of Austrian Economics, 22(4), 301–314. Kahneman, D. (2011). Thinking, fast and slow. Macmillan. Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1990). Experimental tests of the endowment effect and the Coase theorem. Journal of Political Economy, 98(6), 1325–1348. Kahneman, D., & Tversky, A. (1972). Subjective probability: A judgment of representativeness. Cognitive Psychology, 3(3), 430–454. Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decisions under risk. Econometrica, 47, 263–292. Kirzner, I. M. (1997). Entrepreneurial discovery and the competitive market process: An Austrian approach. Journal of Economic Literature, 35(1), 60–85. Koppl, R. (2002). Big players and the economic theory of expectations. Springer.

110 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Leeson, P. T. (2012). Ordeals. The Journal of Law and Economics, 55(3), 691–714. Leeson, P. T. (2013). Vermin trials. The Journal of Law and Economics, 56(3), 811–836. Leeson, P. T. (2014). “God damn”: The law and economics of monastic malediction. The Journal of Law, Economics, & Organization, 30(1), 193–216. Leeson, P. T. (2019). Do we need behavioral economics to explain law? European Journal of Law and Economics, 48(1), 29–42. Levitt, S. D., & List, J. A. (2007). What do laboratory experiments measuring social preferences reveal about the real world? Journal of Economic Perspectives, 21(2), 153–174. Manne, G. A., & Zywicki, T. J. (2013). Uncertainty, evolution and behavioral economic theory. Journal of Law, Economics, and Policy, 10, 555–580. McChesney, F. S. (2013). Behavioral economics: Old wine in irrelevant new bottles? Supreme Court Economic Review, 21(1), 43–76. McKenzie, R. B. (2009). Predictably rational? In search of defenses for rational behavior in economics. Springer Science & Business Media. McKenzie, R. B. (2018). A Brain-Focused Foundation for Economic Science: A Proposed Reconciliation Between Neoclassical and Behavioral Economics. Springer. Mises, L. (1985). Theory and history. Ludwig von Mises Institute. Mises, L. (2007 [1949]). Human action: A treatise on economics. Liberty Fund. Oprea, R., & Powell, B. (2010). Why Austrians should quit worrying and learn to love the lab. Emerald Group Publishing. Rizzo, M. J. (2015). The problem of rationality: Austrian economics between classical behaviorism and behavioral economics. In P. J. Boettke, and C. J. Coyne (eds), The Oxford handbook of Austrian economics. Oxford University Press. Rizzo, M. J., & Whitman, G. (2019). Escaping paternalism: Rationality, behavioral economics, and public policy. Cambridge University Press. Rothbard, M. N. (1956). Towards a reconstruction of utility and welfare economics. In M. Senholz, (ed.), On freedom and free enterprise: Essays in honor of Ludwig von Mises. Van Nostrand. Shiller, R. J. (2008). The subprime solution: How today’s global financial crisis happened, and what to do about it. Princeton University Press. Shiller, R. J. (2015). Irrational exuberance: Revised and expanded third edition. Princeton University Press. Shiller, R. J. (2020). Narrative economics: How stories go viral and drive major economic events. Princeton University Press. Shleifer, A. (2000). Inefficient markets: An introduction to behavioural finance. Oxford: Oxford University Press. Smith, V. L. (2003). Constructivist and ecological rationality in economics. American Economic Review, 93(3), 465–508. Stigler, G. J., & Becker, G. S. (1977). De gustibus non est disputandum. The American Economic Review, 67(2), 76–90. Sunstein, C. R. (2023). Hayekian behavioral economics. Behavioural Public Policy, 7(1), 170–188. Thaler, R. H. (2012). The winner’s curse: Paradoxes and anomalies of economic life. Simon and Schuster. Thaler, R. H., & Mullainthan, S. (2008). Behavioral Economics. In Henderson, D. R. (ed.), The Concise Encyclopedia of Economics (pp. 34–38). Indianapolis: Liberty Fund. Thaler, R. H., & Sunstein, C. R. (2009). Nudge: Improving decisions about health, wealth, and happiness. Penguin.

REASONABLE DISAGREEMENT: AUSTRIAN RESPONSES 111

Tversky, A., & Kahneman, D. (1983). Extensional versus intuitive reasoning: The conjunction fallacy in probability judgment. Psychological Review, 90(4), 293–315. Tversky, A., & Kahneman, D. (1986). Rational choice and the framing of decisions. Journal of Business, 59(4), S251–S278. Vaughn, K. I. (1980). Does it matter that costs are subjective? Southern Economic Journal, 46(3), 702–715. Veblen, T. C. (1992 [1899]). The theory of the leisure class. Routledge. Whitman, G. (2021). Austrian behavioral economics. Journal of Institutional Economics, 1–18. Wicksteed, P. H. (2003 [1933]). The Commonsense of Political Economy: Volume One. UK: Routledge. Wittman, D. (1989). Why democracies produce efficient results. Journal of Political Economy, 97(6), 1395–1424. Wright, J. D., & Ginsburg, D. H. (2012). Behavioral law and economics: Its origins, fatal flaws, and implications for liberty. Northwestern University Law Review, 106, 1033. Zanotti, G. J., & Cachanosky, N. (2015). Implications of Machlup’s interpretation of Mises’s epistemology. Journal of the History of Economic Thought, 37(1), 111–138. Zywicki, T. J. (2018). The behavioral economics of behavioral law & economics. Review of Behavioral Economics, 5(3-4), 439–471.

6

EPE and the Viennese students of civilization

Marta Podemska-Mikluch

Introduction This chapter explores the relationship between entangled political economy (EPE) and the Viennese students of civilization. EPE is an analytical approach developed by Richard E. Wagner for the study of society, its emergence, evolution, and the coordinated patterns of relationships that form within it (Wagner, 2016). ‘Viennese students of civilization’ is a term proposed by Erwin Dekker (Dekker, 2016) to describe a group of scholars otherwise known as Austrian economists, among them Carl Menger, Friedrich von Wieser, Eugen von Böhm-Bawerk, Ludwig von Mises, Friedrich von Hayek, and Joseph Schumpeter. Dekker argues that the actual legacy of these intellectuals exceeds their more recognized contributions to the study of market processes (e.g. subjectivism, methodological individualism, uncertainty, entrepreneurship, etc.). While the Viennese view market activity as a crucial aspect of a liberal society, their primary focus was on civilization. This chapter focuses on three of the many themes that EPE and the Viennese study of civilization share in common. First, EPE and the Viennese are primarily interested in society—the generation and evolution of institutions that govern social interactions. EPE and the Viennese emphasize the bi-directional relationship between an individual and institutions: institutions emerge from social interactions, and, institutions provide an organizational structure within which social interactions take place. Markets are among the most noteworthy of these institutions because their civilizing and disciplining forces enable freedom and make modern society possible (Dekker, 2016, pp. 67–90). Second, EPE and the Viennese are concerned with the vulnerability of liberalism. The outlook of the Viennese was shaped by the decline and collapse of liberalism in Europe. Wagner seeks to understand the decline of liberalism in the United States.

113

114 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Both approaches suggest that civilizing processes, and cultivation of liberal values (e.g. the view that rights come with responsibilities), are necessary, though likely not sufficient, for the preservation of liberalism. Third, EPE and the Viennese share careful attention to methodology, the influence of analytical lenses on what is seen and understood, and the concern over the disciplinary separation that emerged within social science in the 20th century. The next section of this chapter gives a brief overview of entangled political economy. The following section explores the three main themes that the Viennese and EPE share in common. The fourth section discusses research directions enabled by their contributions. The fifth section concludes.

Entangled political economy EPE is an analytical approach developed by Richard E. Wagner (Smith et al., 2011; Wagner, 2009, 2016). The primary analytical interest of EPE is society, its emergence, evolution, and the “structured pattern of relationships” (Wagner, 2010, p. 1) that forms within it. Wagner conceptualizes society as a complex adaptive system, where the relatively orderly patterns of relationships emerge from interactions and mutual adjustments among individuals pursuing their diverse, often conflicting, plans. EPE builds on the Smith–Menger tradition of classical political economy and the Italian tradition of fiscal analysis (see Figure 6.1). While neoclassical economics is centered on choice and resource allocation, the Smith–Menger tradition is primarily interested in the institutions of human governance and the spontaneous order processes that generate them. Italian thinkers of the late 19th century sought to bring political activity within this emergent, explanatory approach. The combination of these two traditions lies at the foundation of Virginia political economy which emerged in the 1950s. Virginia political economy would form the basis for James M. Buchanan’s constitutional political economy (CPE) and, eventually, it would lead to Wagner’s EPE. However, EPE is not simply a continuation of Buchanan’s research program. While EPE and CPE share similar intellectual origins, and while they are deeply concerned with preservation of liberalism, their different methodologies lead them to different conclusions. Buchanan (1975) believes that liberalism could be protected through constitutional rules; that constitutions could avert tyranny. Wagner (2017, 2018) is skeptical about the power of constitutions to limit government predation. Rather, in Wagner’s analysis (1993, 2016), constitutional rules can be maintained only as long as there is a self-reinforcing balance of

EPE AND THE VIENNESE STUDENTS OF CIVILIZATION 115

private interests—a requirement of “concurrence among different participants with opposed interests” (Wagner, 2016, p. 220).

Figure 6.1

Family tree of entangled political economy

To study the emergence and evolution of social structures, EPE replaces equilibrium models of neoclassical economics with the tools of complexity economics. Equilibrium models remain the bread and butter of contemporary economists, part of the “holy trinity” of orthodoxy, along with rationality and selfishness (Colander et al., 2004; Koppl, 2006). While there is much insight that can be gained with the use of equilibrium models, they are not suitable for the study of generative interactions, emergence, or evolution (Arthur, 2021; Beinhocker, 2006; Koppl et al., 2015). For one, equilibrium models misclassify the economy as a closed system (Beinhocker, 2006, pp. 84–90)—assume a predictable end state, with all possible states of the model described in the assumptions. This means that there is no room for novelty to be generated from within the model, that there can be no endogenous innovation, no emergence or self-organization. To allow for emergence, one needs to work with open, creative systems. Two, equilibrium models are timeless—there is no meaningful passage of time within the model (O’Driscoll, Jr & Rizzo, 2015). Comparative statics can be used to compare two points in time but the process of transformation from one point to the other occurs outside of the model. Third, equilibrium models presume that that aggregate outcomes are consistent with individual behavior (Arthur, 2021); that all action stops at

116 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

equilibrium because there no longer are any incentives for individual action. Yet, real societies are turbulent (Wagner, 2012a). Fourth, there are no actual interactions within equilibrium models, rather, individuals interact indirectly, through prices (Beinhocker, 2006). Complexity research places the generative nature of individual interactions at the very core of its interest, seeking to understand the recursive loop between individual behavior and aggregate outcomes “[complexity research] studies how elements interacting in a system create overall patterns, and how these patterns, in turn, cause the elements to change or adapt in response” (Arthur, 2021, p.  136). Similarly, the study of the bi-directional relationship between interacting elements and the patterns they generate lies at the core of Wagner’s approach to society (Wagner, 2010). EPE’s main focus is on the study of how individual interactions generate structured patterns of relationships, and in turn, how these patterns alter the ends individuals choose to pursue. Interest in the emergence of the structured patterns of relationships marks a stark departure from neoclassical models. In the standard economic theory, there are microeconomic and macroeconomic phenomena. Macroeconomic phenomena are a product of aggregation of microeconomic phenomena, e.g. aggregate demand or gross domestic product. However, for scholars interested in emergence, the micro-macro dichotomy is unsatisfactory. Emergent phenomena, products of individual interactions, cannot be meaningfully described through aggregation of some feature of interacting individuals. Traffic is not a large car and society is not a large individual (Resnick, 1997; Wagner, 2010). So to allow for the analysis of emergent phenomena, EPE adopts the third level: meso (Dopfer et al., 2004). It is at the meso level that emergent phenomena become intelligible. While emergent phenomena might be detectable at the macro-level, it is the meso-level of analysis that provides insight into their origins, evolution, and influence, as Novak illustrates with respect to inequality (Novak, 2018). The influence of structured patterns of relationships on the content of human actions—the ends individuals choose to pursue—also marks a significant difference between EPE and mainstream economics. To speak of the influence of social structures on human action entails rejecting the assumptions of stable and given preferences. As Wagner notes, “Beyond some biological minimum, wants are not given but rather are continually being formed and changed through social interaction” (Wagner, 2016). Allowing for the ends people choose to pursue to be shaped by social interactions, gives insight into a variety of social dynamics. One example can be found in Wagner’s early publications, which examine the challenges to the formation of accurate perceptions of

EPE AND THE VIENNESE STUDENTS OF CIVILIZATION 117

the quality and price of government output. These challenges stem from the bundling of public services that comes from reductions in governmental overlapping (Wagner & Weber, 1975), and the growth in the complexity of fiscal revenue structures (Wagner, 1976b), and they are further magnified by public advertising (Wagner, 1976a). Reductions in governmental overlap and growth in the complexity of fiscal revenue structures are emergent phenomena that lead citizens to demand more public output than they otherwise would. They suggest a dynamic force within democracy that leads to the erosion of liberalism.

EPE and the Viennese students of civilization The Viennese study of civilization and EPE build on a long tradition that places spontaneous order processes at the forefront of analysis. Sometimes referred to as the Smith–Menger tradition, or as classical political economy, this line of analysis is primarily interested in the study of interactions and institutions—not in prices and allocation, as was the case for Léon Walras and the ensuing neoclassical tradition. The puzzle that classical political economists seek to understand is centered on “the institutions of human governance” (Schumpeter, 2003 [1943]; Wagner, 1966, 1976a; Wohlgemuth, 2005), and in particular, on the puzzle of how relatively orderly outcomes emerge from self-directed actions. As Carl Menger famously asked, “How can it be that institutions which serve the common welfare and are extremely significant for its development come into being without a common will directed toward establishing them?” (Menger, 1985 [1883], p. 146). Given this shared intellectual foundation, it is no surprise that there is much overlap between EPE and the Viennese. I here focus on three common themes. First, society, and not markets, are the primary analytical object and there is an emphasis on the bi-directional relationship between individuals and institutions. Second, there is a shared concern over vulnerability of liberalism. Three, both pay significant attention to the relationship between the students of society and the object of their study. Study of society Today, Austrian economics is understood primarily as a study of market processes that emphasizes subjectivism, methodological individualism, uncertainty, dispersed knowledge, and entrepreneurial discovery. Dekker (2016) contends that the focus on markets leaves out important elements of the

118 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Viennese legacy—the moral, cultural, and social dimensions of interaction. While institutional analysis is far more prominent in the scholarship of contemporary Austrian economists than in other streams of economics, the focus of “this ‘Austrian revival’ has been on the study of the economy, rather than the study of society or civilization” (Dekker, 2016, p. 16). In contrast, according to Dekker’s interpretation of the Viennese legacy, these scholars were primarily interested in civilization—“the norms and institutions which regulate human interactions” (Dekker, 2016, p. 8). In particular, the Viennese were interested in the dual influence of civilizing processes enabling freedom by restraining passions and taming instincts. This is not to say that Dekker, or the Viennese, were dismissive of markets. To the contrary, they believe that markets are a fundamental institution of a civilized society. Market forces, e.g. division of labor, fuel unprecedented creation of knowledge and allow individuals freedom to pursue diverse interests and aspirations. But what matters more to the Viennese is that civilization, including markets, enables freedom. Humans did not give up freedom to live in civilized society, it is the civilized society that enables freedom. Markets enable freedom by restraining passions and taming instincts—to succeed one needs to submit to market discipline: be trustworthy, responsible, conscientious, etc. “The disciplinary forces of the market, such as competition, instill certain values in individuals, it civilizes them” (Dekker, 2016, p. 190). The civilizing, or disciplining forces of the market, speak to the bi-directional relationship between individuals and institutions: markets emerge from social interactions and, at the same time, markets shape values individuals hold. By affecting which actions individuals undertake, institutions influence social practices and habits. In effect, certain values are cultivated while other values are eroded. As argued in the previous section, EPE is also interested in a study of society, it is an effort to understand the self-organizing forces within society, the processes that generate and erode liberal orders. In the effort to understand society, EPE seeks to countervail the analytical separation of economics from politics. Wagner (2016) argues that this separation occurred as some thinkers wanted to transition political economy out of moral philosophy into a more scientific study of material well-being, as exemplified by the work of Alfred Marshall. Economics then became a study of voluntary exchange. In this scheme of thought, political intervention is an exogenous event that modifies the economy from the outside.

EPE AND THE VIENNESE STUDENTS OF CIVILIZATION 119

In contrast, EPE rejects the notion of government—a monocentric organization—intervening into the economy from the outside, in a top-down fashion. Instead, EPE treats the state as a polycentric order, comprised of multiple entities that “are able in large measure to act independently of one another” (Wagner, 2016, p.  8). These political entities interact with market enterprises, forming a complex, entangled network of relationships. The network is entangled because “prudent political action cannot be determined independently of the interests of relevant economic actors, nor can prudent commercial action be determined independently of the interests of relevant political actors” (Wagner, 2016, p.  14). Regulations, changes in budgetary operations, and public policy are all an emergent product of these interactions. In orthodox formulations, the analytical questions regarding politics center on how the polity shapes the economy, or in the opposite direction, what policies are demanded by private voters, or interest groups. While neoclassical economics treats policy as an object of choice, from the perspective of entangled political economy, policy is an emergent phenomenon (Podemska-Mikluch, 2014, 2018). Similar to the Viennese, EPE also places an emphasis on the bi-directional relationship between an individual and institutions. In providing this organizational structure, institutions impose practices and habits, and in effect, shape and cultivate values. Wagner pays particular attention to how the cultivated values and habits differ between commercial and political practice, illustrating this difference with an example of a quota. Under a quota: “[…] no longer is everyone free to enter the competition for market share. Only those who receive a quota allotment can do so. Those in a position to award allotments hold positions of privileged status, as do those who receive allotments.” (Wagner, 2016, p. 214). Quota, and other similar policy measures, transform relationships of mutuality and equality into relationships based on status and hierarchy. While service, mutuality, and trust, are necessary components of success in markets, success in politics comes from the transformation of mutuality and equality into status and hierarchy that accompany the acquisition of power. Concern over vulnerability of liberalism Dekker’s (2016) reinterpretation of Austrian economists as Viennese Students of Civilization stems from the analysis of their intellectual contributions in the historical and geographic context. From the decline of the Habsburg Empire and its culture, through a rise of socialism, to emergence of fascism, the three generations of Viennese intellectuals saw their civilization decline and feared it might collapse. This sense was particularly strong during the interwar years, when “Viennese liberals felt that civilization they cherished was coming to

120 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

an end” (Dekker, 2016, p.  89). Their work was shaped by this experience, motivating them to understand what caused this shift away from liberalism, their role in this process, and whether the decline of their civilization was inevitable. Similarly, though focusing on the US, Wagner seeks to understand how “a regime founded on a constitution of liberty, where citizens pretty much can do as they choose so long as they respect the equivalent right of other people, can morph into a constitution of control, wherein political imperatives come to dominate large swaths of societal life” (Wagner, 2016, p. 8, emphasis in original). The Viennese saw the attack on their civilization as a reaction to the duality of civilizing dynamics that enable freedom through restraint. This restraint can be experienced as a burden, often described as the strain of civilization. Dekker defines it as “the responsibility individuals bear for their own choices, the acceptance of powerful social forces such as the force of competition, the necessary restraint of our instincts, and the submission to norms that we do not fully comprehend” (Dekker, 2016, p. 190). When the duality of civilizing forces is misunderstood or ignored, liberal institutions become vulnerable to attacks—the strain of civilization invites a revolt against liberal institutions. And if the restraining forces are weakened in effect, e.g. through limits on market competition, so are the freedoms that markets enable. For Wagner, the threat to liberalism is similarly inherent in democratic dynamics. Liberalism is eroded when relationships of mutuality and equality turn into relationships based on status and hierarchy. Consider occupational licensing requirements, usually proposed as a consumer protection measure, that operate by increasing entry barriers into a profession. There are alternatives to licensing that ensure quality, e.g. private certification, user ratings, consumer reports, etc. In general, consumers want quality assurance but have little interest in the different ways in which it can be delivered. Yet, it is these exact particularities that matter. Of the various measures through which quality can be ensured, only occupational licensing augments the power of political enterprises. Recognition of epistemic limits EPE and the Viennese pay careful attention to the relationship between social scientists and the object of their study. Following Menger, EPE and the Viennese understand society as an open system where knowledge is continuously generated. This continuous generation of knowledge means that

EPE AND THE VIENNESE STUDENTS OF CIVILIZATION 121

knowledge is dispersed and ever changing, and that no one has access to all knowledge in its entirety. This means that students of society are limited in what they can know: “These limits are threefold, he can never know all the relevant facts, he is unable to foresee the precise effects of various changes (or cures), and he is unable to change the outcomes of market processes much” (Dekker, 2016, p. 125). To further highlight the limitations of social scientists, Dekker (2016) distinguishes between knowledge about civilization and knowledge from civilization. Knowledge about civilization is what social scientists aspire to attain. Knowledge from civilization is the knowledge embedded in emergent institutional arrangements. Knowledge from civilization is frequently tacit. Yet, its significance becomes discernable in the attempts to replicate institutional complexity through planning and design. As Wagner (2016) argues, the liberal theory of a market economy came about as scholars sought to explain some general orderly patterns observed in the market. It was an outcome of astonishment that the generally coordinated, orderly patterns of activity emerge without anyone being in charge. In trying to render these orderly patterns of interactions intelligible, classical political economists adopted plausible reasoning. Similar to the position of the blind men from Hindustan, each of whom felt a piece of an elephant but none of whom knew the full picture, plausible reasoning seeks to develop plausible analyses based on knowledge that is inescapably limited and incomplete. (Wagner, 2016, p.25)

Just as the blind men of Hindustan could each only feel a part of the elephant, the social scientist can only study society from within, from their specific perspective. Since knowledge is dispersed and localized, and our experiences so diverse, these individual perspectives are bound to be different. Consequently, different thinkers can interpret events and processes very differently, with ensuing conversations reconciling these differences to some extent (Martin, 2021). While the blind men of Hindustan could eventually find out from a sighted person that they were touching an elephant, social scientists do not have such an option. The recognition of the limits in understanding of institutional complexity was essential in shaping the Viennese attitude towards their own role in relation to their civilization. Dekker argues that the Viennese shared with the mainstream economists the notion that economics was truly a dismal science because it emphasized the challenging aspects of life: “the unavoidable scarcity, the necessity of making (painful) choices, the fact that there are almost invariably trade-offs involved in our attempts to realize our goals” (Dekker, 2016, p. 190).

122 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

However, in Dekker’s assessment, the Viennese differ from mainstream economists in that they present these unavoidable challenges in a therapeutic manner, advocating an attitude of acceptance and gratefulness. This attitude might be most easily recognizable in Hayek’s admiration of the marvel that is the market process (Hayek, 1945). However, as Dekker also points out, the Viennese held similar admiration for other emergent institutions, e.g. law and language. Enthusiasm for change, and rational aspirations to improve society, are common among other social scientists. For one, the work of social scientists makes them particularly cognizant of social ills and injustices. Moreover, this enthusiasm is further reinforced by the expectations that citizens, politicians, and businessmen place on intellectuals. But for the Viennese, the enthusiasm for change meant a threat to their civilization. Rationalist aspirations for social betterment usually stems from ignorance of institutional complexity and the duality of civilizing forces. When the strain of civilization is only seen as a burden, and not a price to be paid for civilized life, liberal institutions come under attack. In response to the recognition of epistemic limits, earlier generations of Viennese adopted a passive attitude to civilizational processes. They gave into what they perceived as natural, or social forces, beyond their control. They saw their civilization in decline and felt there was nothing they could do about it. This passive attitude changed once Hayek and Popper begun to understand markets primarily as cultural phenomena, not as natural, or social forces. This altered understanding of markets meant that there was now a role for a social scientist to act as a custodian of civilization.

Direction for future research How can EPE and the Viennese shape the research agenda of Austrian economics? The agenda that these two programs suggest is not new, rather, it is a continuation of an old effort, one that is likely to always be necessary. Continue to expose the limits of social engineering Viennese intellectuals made significant contributions to our understanding of the limits and pitfalls of social engineering but fell short of eliminating it. What we see instead is a growing sophistication in the various attempts at managing and altering society. Despite the efforts of the Viennese to illuminate the

EPE AND THE VIENNESE STUDENTS OF CIVILIZATION 123

impossibility of social planning, the enthusiasm for it remains strong, fueling the development of new forms, e.g. behavioral policy, evidence-based policy, or market design. These recurring attempts at social planning might feel quite discouraging to the students of spontaneous order processes. But there is a silver lining. Social planning produces an unceasing need for exposure of the epistemic hazards embedded in the planners’ efforts. The recent work on the knowledge problems in behavioral policymaking (e.g. nudges), serves as an excellent example of what this type of contribution could look like (Rizzo & Whitman, 2019). In recent years, many economists embraced market design. There is now rich market design literature on electricity, marriage, kidneys, and the job market (Roth, 2008). This literature has translated into public policy changes, with some goods now allocated either through an auction or a matching mechanism. The Viennese, who saw markets as emergent phenomena that needed to evolve along with a culture necessary for their preservation, would likely doubt the success of market design schemes. So, if we accept the Viennese understanding of markets, then at the very least, we need to be able to explain the growth in popularity of market design and why these schemes appear to be more successful than the Viennese would anticipate. What explains the apparent success of market design? Another question for future research is to explore why market design was needed—why the particular markets did not emerge on their own. Market design is usually presented as a solution to market failure. But, more often than not, considered markets are either completely illegal or heavily restricted (e.g. the market for kidneys). If these restrictions were abolished, would market design mechanisms survive? And lastly, how is the influence of market design mechanisms shaped by existing social structures? Present-day Austrians are well-equipped to challenge any analysis that presumes an institutional tabula rasa. Comparative analysis of market design mechanisms could advance our understanding of how the density and nature of connections within a societal network affects policy adoption. Knowledge problems are also abundant in the evidence-based policy efforts. Evidence-based policy describes policy recommendations that are based on cutting edge research methods, such as randomized controlled trials (RCTs). Implications of this research depend on whether public policy is more usefully understood as an object of choice or as an emergent phenomenon. In contrast to the market design economists who conceive of their work as engineering (Roth, 2002), experimental economists think of their work as plumbing— seeking to fine-tune their designs by studying their performance (Duflo, 2017). Studies of RCTs-based policies suggest a disconnect between research findings and policy outcomes: scaled interventions typically display weaker impact

124 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

than what was expected from the experiment (Al-Ubaydli et al., 2017, 2019; Banerjee et al., 2017). Scholars believe that the solution lies in a better understanding of scalability (Al-Ubaydli et al., 2021). Having such understanding, researchers could more confidently draw a connection from experiments to scaled interventions. Of course, a better understanding of scalability is only helpful as long as policy is usefully understood as an intervention. If, as EPE suggests, policy is an emergent product of interactions, then RCTs would be more usefully understood as a tool of competition between political enterprises. An investigation into which function RCTs actually play might prove to be a valuable research avenue. Today, most economists see public policy as a path to societal betterment. This belief has wide-ranging consequences. First, it implicitly perpetuates the belief that societal well-being can be improved through coercion. Second, by fueling scholarly engagement, it legitimizes the political process of policy formation, despite having little influence over it. And third, it contributes to the crowding out of voluntary, bottom-up, solutions. Each of these three consequences is a threat to the classical liberal vision of society. For this reason, we need a more realistic understanding of public policy formation, and an explanatory theory of political processes. Entangled political economy offers a glimpse of hope for the restoration of public faith in the supremacy of voluntary solutions and mutually beneficial cooperation. Continue to deepen the understanding of self-governance One of the greatest contributions of the present-day Austrians is the advancement of our understanding of self-governance (Boettke, 2010; Leeson, 2014). These contributions describe institutions that are “the result of human action, but not the execution of any human design” (Ferguson, 1980 [1767]), including the emergence of social cooperation even in the most challenging circumstances, e.g. among pirates or in prisons (Leeson, 2009; Skarbek, 2014), and historical instances of private governance (Stringham, 2015). In their analysis of emergent institutions, scholars tend to focus on the emergence of institutions from cooperative behavior. Human action, as it appears in Ferguson’s quote, is usually understood to be voluntary action. In contrast, political action is usually analyzed as manifesting in the design of institutions, not in their emergence. EPE contradicts this common interpretation and instead suggests that political action also contributes to the emergence of institutions, along with voluntary action. One possible line of inquiry that can be built on this insight would focus on endogenizing policy formation— explaining public policy as an emergent phenomenon, not an object of choice

EPE AND THE VIENNESE STUDENTS OF CIVILIZATION 125

(Wagner, 2012b). To do so, scholars might choose to investigate entanglement in particular industries: public education, healthcare, and higher education. Numerous projects fit into this research stream and can be used as an inspiration for future work. For example, in his now seminal work on the municipalization of firefighting, McChesney (1986) vividly illustrates the creativity of political entrepreneurs in bringing firefighting into the realm of inalienable property and forced support. Candela and Geloso (2018) document how government provision of lighthouses crowded out private lightship services. Podemska-Mikluch (2018) explains that the broad adoption of contraceptive insurance mandates was driven by a rent-seeking effort oriented at increasing the demand for more profitable forms of contraception. In a similar vein, Rouanet explains that the creation of the Bank of France was a product of rent-seeking behavior by private actors (Rouanet, 2021). With social interactions shaping the ends people choose to pursue, leaders and entrepreneurs play an active role in the creation of desires and aspirations (Schumpeter, 2003 [1943]; Wagner, 1966, 1976a; Wohlgemuth, 2005). Novelty is injected into the system by political and market entrepreneurs, though there are significant differences in the types of novelty injected by them. Market entrepreneurs operate in the environments characterized by a tight connection between means and ends—consumers experience consequences of their choices directly. Such tight connection is often absent in politics, as a significant share of political activity comes in the form of credence goods—quality is not easily verified through experience. With consumers unable to directly evaluate their experience, how does competition between political enterprises unfold? The support political entrepreneurs gather is less a product of the trust in the promises they make, and more a product of the emotions they evoke in the process. This insight opens a path into the study of the differing role of narratives, e.g. advertising and ideology, in competition between private and public advertising, a direction sketched with particular clarity in Wagner (1976a).

Conclusions Based on recent Gallup polls, Millennials and Gen Z-ers are split equally in their affinity for capitalism and socialism, a change from the previous generations that favored capitalism more strongly. Millennials and Gen Z-ers appear to see market freedom as separate from all the other freedoms they enjoy and actively argue for government takeover of health care, environmental issues,

126 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

higher education, etc. Yes, the unprecedented freedom to direct personal growth, to live an unorthodox life is made possible by the market forces. Van life, tiny homes, minimalism and life off grid are now accessible to the masses thanks to the advances in technology that the division of labor enables. Thomas Jefferson was probably right to assert that eternal vigilance is the price we need to pay for liberty. If the benefits of a civilized life are not understood, there is really no room for a conversation about vigilance or personal responsibility. Austrian economists have an opportunity to build on the Viennese tradition and explain how liberal social arrangements emerge and how they crumble, and what is at stake when that happens. Dekker’s reinterpretation of the Viennese students illustrates that their legacy offers much more than the theory of market coordination or social evolution. It is, first and foremost, a study and defense of liberalism. The Viennese provided us with an understanding that individual freedom is made possible by the restraints liberal societies impose on individuals. These restraints make markets prone to attacks, and call for reform. EPE further deepens our understanding of the threats that democracy presents for liberalism. The present-day students of civilization can use the insights of EPE to illustrate how entanglement erodes liberal values by replacing mutuality and equality. In particular, they should feel particularly encouraged to expose the limits of social engineering and continue to deepen our understanding of self-organization.

References Al-Ubaydli, O., List, J. A., & Suskind, D. L. (2017). What can we learn from experiments? Understanding the threats to the scalability of experimental results. American Economic Review, 107(5), 282–286. https://​doi​.org/​10​.1257/​aer​.p20171115 Al-Ubaydli, O., List, J. A., & Suskind, D. (2019). The Science of Using Science: Towards an Understanding of the Threats to Scaling Experiments (Working Paper No. 25848; Working Paper Series). National Bureau of Economic Research. https://​doi​.org/​10​ .3386/​w25848 Al-Ubaydli, O., Lee, M. S., List, J. A., Mackevicius, C. L., & Suskind, D. (2021). How can experiments play a greater role in public policy? Twelve proposals from an economic model of scaling. Behavioural Public Policy, 5(1), 2–49. https://​doi​.org/​10​.1017/​bpp​ .2020​.17 Arthur, W. B. (2021). Foundations of complexity economics. Nature Reviews, 3. Banerjee, A., Banerji, R., Berry, J., Duflo, E., Kannan, H., Mukerji, S., Shotland, M., & Walton, M. (2017). From proof of concept to scalable policies: Challenges and solutions, with an application. Journal of Economic Perspectives, 31(4), 73–102. https://​ doi​.org/​10​.1257/​jep​.31​.4​.73 Beinhocker, E. D. (2006). The Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics. Harvard Business Press.

EPE AND THE VIENNESE STUDENTS OF CIVILIZATION 127

Boettke, P. J. (2010). Is the only form of ‘Reasonable Regulation’ self regulation?: Lessons from Lin Ostrom on regulating the commons and cultivating citizens. Public Choice, 143(3), 283–291. https://​doi​.org/​10​.1007/​s11127​-010​-9622​-9 Buchanan, J. M. (1975). The Limits of Liberty: Between Anarchy and Leviathan. University of Chicago Press. Candela, R. A., & Geloso, V. J. (2018). The lightship in economics. Public Choice, 176(3), 479–506. https://​doi​.org/​10​.1007/​s11127​-018​-0573​-x Colander, D., Holt, R., & Rosser, B. (2004). The changing face of mainstream economics. Review of Political Economy, 16(4), 485–499. https://​doi​.org/​10​.1080/​ 0953825042000256702 Dekker, E. (2016). The Viennese Students of Civilization: The Meaning and Context of Austrian Economics Reconsidered. Cambridge University Press. https://​doi​.org/​10​ .1017/​CBO9781316411162 Dopfer, K., Foster, J., & Potts, J. (2004). Micro-meso-macro. Journal of Evolutionary Economics, 14(3), 263–279. https://​doi​.org/​10​.1007/​s00191​-004​-0193​-0 Duflo, E. (2017). The economist as plumber. American Economic Review, 107(5), 1–26. https://​doi​.org/​10​.1257/​aer​.p20171153 Ferguson, A. (1980 [1767]). An Essay on the History of Civil Society. Transaction Publishers. Hayek, F. A. (1945). The use of knowledge in society. The American Economic Review, 35(4), 519–530. Koppl, R. (2006). Austrian economics at the cutting edge. The Review of Austrian Economics, 19(4), 231–241. https://​doi​.org/​10​.1007/​s11138​-006​-9246​-y Koppl, R., Kauffman, S., Felin, T., & Longo, G. (2015). Economics for a creative world. Journal of Institutional Economics, 11(1), 1–31. https://​doi​.org/​10​.1017/​ S1744137414000150 Leeson, P. T. (2009). The Invisible Hook: The Hidden Economics of Pirates. Princeton University Press. Leeson, P. T. (2014). Anarchy Unbound: Why Self-Governance Works Better Than You Think (1st ed.). Cambridge University Press. Martin, A. (2021). From taciturn to talkative political economy. In Studies in Public Choice (pp.  73–86). Springer. https://​ideas​.repec​.org/​h/​spr/​stpchp/​978​-3​-030​-56088​ -1​_6​.html McChesney, F. S. (1986). Government prohibitions on volunteer fire fighting in nineteenth-century America: A property rights perspective. The Journal of Legal Studies, 15(1), 69–92. Menger, C. (1985 [1883]). Investigations into the Method of the Social Sciences with Special Reference to Economics. (Reprint). New York University Press. Novak, M. (2018). Inequality: An Entangled Political Economy Perspective. Palgrave Macmillan. O’Driscoll, Jr, G. P., & Rizzo, M. J. (2015). Austrian Economics Re-examined: The Economics of Time and Ignorance. Routledge. Podemska-Mikluch, M. (2014). Public policy: Object of choice or emergent phenomena? Lessons from the Polish Medical Reimbursement Act. In S. Horwitz & R. Koppl (eds), Entangled Political Economy (Vol. 18, pp. 93–110). Emerald Group Publishing Limited. https://​doi​.org/​10​.1108/​S1529​-213420140000018005 Podemska-Mikluch, M. (2018). Contraception without romance: The entangled political economy of state and federal contraceptive insurance mandates. In R. E. Wagner (ed.), James M. Buchanan: A Theorist of Political Economy and Social Philosophy

128 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

(pp.  263–290). Springer International Publishing. https://​doi​.org/​10​.1007/​978​-3​-030​ -03080​-3​_13 Resnick, M. (1997). Turtles, Termites, and Traffic Jams: Explorations in Massively Parallel Microworlds. MIT Press. Rizzo, M. J., & Whitman, G. (2019). Escaping Paternalism: Rationality, Behavioral Economics, and Public Policy. Cambridge University Press. Roth, A. E. (2002). The economist as engineer: Game theory, experimentation, and computation as tools for design economics. Econometrica, 70(4), 1341–1378. https://​ doi​.org/​10​.1111/​1468​-0262​.00335 Roth, A. E. (2008). What have we learned from market design? Innovations: Technology, Governance, Globalization, 3(1), 119–147. Rouanet, L. (2021). The interest group origins of the Bank of France. Public Choice, 186(1), 119–140. https://​doi​.org/​10​.1007/​s11127​-019​-00765​-6 Schumpeter, J. A. (2003 [1943]). Capitalism, Socialism, and Democracy. Routledge. Skarbek, D. (2014). The Social Order of the Underworld: How Prison Gangs Govern the American Penal System (1st ed.). Oxford University Press. Smith, A., Wagner, R. E., & Yandle, B. (2011). A theory of entangled political economy, with application to TARP and NRA. Public Choice, 148(1–2), 45–66. Stringham, E. P. (2015). Private Governance: Creating Order in Economic and Social Life (1st ed.). Oxford University Press. Wagner, R. E. (1966). Pressure groups and political entrepreneurs: A review article. Papers on Non-market Decision Making, 1(1), 161–170. https://​doi​.org/​10​.1007/​ BF01718992 Wagner, R. E. (1976a). Advertising and the public economy: Some preliminary ruminations. In D. Tuerck (ed.), The Political Economy of Advertising (pp. 81–100). American Enterprise Institute. Wagner, R. E. (1976b). Revenue structure, fiscal illusion, and budgetary choice. Public Choice, 25(1), 45–61. https://​doi​.org/​10​.1007/​BF01726330 Wagner, R. E. (1993). Parchment, Guns, and Constitutional Order. Edward Elgar Publishing. Wagner, R. E. (2009). Property, state, and entangled political economy. In W. Schafer, A. Schneider, & T. Thomas (eds), Markets and Politics: Insights from a Political Economy Perspective (pp. 37–49). Metropolis. Wagner, R. E. (2010). Mind, Society, and Human Action: Time and Knowledge in a Theory of Social Economy. Routledge. Wagner, R. E. (2012a). Viennese kaleidics: Why it’s liberty more than policy that calms turbulence. The Review of Austrian Economics, 25(4), 283–297. Wagner, R. E. (2012b). Deficits, Debt, and Democracy: Wrestling with Tragedy on the Fiscal Commons. Edward Elgar Publishing. Wagner, R. E. (2016). Politics as a Peculiar Business: Public Choice in a System of Entangled Political Economy. Edward Elgar Publishing. Wagner, R. E. (2017). James M. Buchanan and Liberal Political Economy: A Rational Reconstruction. Lexington Books. Wagner, R. E. (2018). Buchanan’s liberal theory of political economy. In P. J. Boettke & S. Stein (eds), Buchanan’s Tensions: Reexamining the Political Economy and Philosophy of James M. Buchanan. Mercatus Center at George Mason University. Wagner, R. E., & Weber, W. E. (1975). Competition, monopoly, and the organization of government in metropolitan areas. The Journal of Law & Economics, 18(3), 661–684. Wohlgemuth, M. (2005). Schumpeterian political economy and Downsian public choice: Alternative economic theories of democracy. In A. Marciano & J.-M. Josselin (eds), Law and the State. A Political Economy Approach. (pp. 21–57). Edward Elgar Publishing.

7

Accounting and finance: capital and cost in economics

Peter Lewin and Nicolas Cachanosky

Introduction Early in its development, Austrian economics became renowned for its capital theory. Indeed, at the end of the nineteenth century, the label “Austrian School of Economics” evoked the work of Eugen von Böhm-Bawerk in his Capital and Interest, much more than the pioneering work of Carl Menger as one of the three “marginalists”. Of course, in the hands of Böhm-Bawerk and his contemporaries, Austrian economics was much more than exercises in the proper way to understand capital. Early Austrians perceived building a coherent capital theory as an indispensable first step toward building solid foundations for economics as a discipline. However, the important connection between ‘capital’ as a foundational concept and the rest of all of economics has been quite obscure to most economists, including many Austrian economists. That this should have been the case is unfortunate. In this chapter, we aim to make some progress toward rectifying it and, in doing so, point towards new paths in a contemporary research agenda on Austrian economics. We also argue that a renewed appreciation of capital theory’s importance is relevant to the connection between Austrian economics and mainstream (neoclassical) economics. Although this topic has been a central one throughout the post-1974 period of the Austrian revival, the nature of the perceived connection has varied. Starting from an examination of capital theory, we see this connection in terms of the relationship between economics and the contiguous disciplines of finance and accounting. In highlighting the roles of subjective value, time and disequilibrium, we contend that Austrian capital theory brings into sharp focus how economics, correctly understood, can be used alongside the practical disciplines of finance and accounting as a business management tool. The economic way of thinking is important for making good business decisions. 129

130 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

In the next section, we explain our conception of capital based on a common-sense financial approach. This way of thinking about capital clarifies the relationship between economics, finance, and accounting. Central to this are the different ways of thinking about “cost.” This is the subject of the third section. The fourth section considers the implications of a financial capital-based theory of the firm for business management, building on the growing literature of contributions to an “Austrian theory of the firm” (see, for example, Foss, Klein & McCaffrey, 2019). The fifth section briefly surveys some possible research agenda items emerging from our broader work, including potential contributions to business-cycle research, macroeconomics, and comparative institutional analysis. The sixth section concludes.

Capital as finance in an accounting framework: it is more than semantics We start with a view of capital extensively developed in our recent work1 and a definition of capital offered by Ludwig von Mises: Capital is the sum of the money-equivalent of all assets minus the sum of the money-equivalent of all liabilities as dedicated at a definite date to the conduct of the operations of a definite business unit. It does not matter in what these assets may consist, whether they are pieces of land, buildings, equipment, tools, goods of any kind and order, claims, receivables, cash, or whatever. (Mises, 1949 [1996], p. 262, emphasis added; see also Braun et al., 2016, and Braun, 2017)

This definition of capital might come as a surprise to anyone steeped in the history of Austrian capital theory as extensively developed by Böhm-Bawerk (1890), Strigl (1934), Hayek (1941 [2007]), and Lachmann (1956 [1978]). Mises is here seemingly departing from the preoccupation of Austrian capital theorists with the physical structure of production and its relation to time, and embracing a much more mundane everyday conception of capital that would appear to obscure or gloss over such fundamental concerns. At first sight it seems that in this passage Mises endorses an aggregate approach to capital, which is often criticized in the Austrian literature. Our recent work on capital aims to explain that this impression is wrong, that Mises did not depart from the fundamental insights of his fellow Austrians, but, rather, provided a perspective that enhanced the relevance of those insights. He did this in a way that has not been appreciated before. Seeing capital as finance provides the necessary connection between theory and practice that was until now missing, the absence of which made capital theory appear esoteric and irrelevant.

ACCOUNTING AND FINANCE: CAPITAL AND COST IN ECONOMICS 131

Mises’s definition appears to be about accounting, the balance of assets and liabilities. Taken literally, Mises is talking about the equity in a balance sheet (assets minus liabilities). He seems to be describing a normal balance sheet as of a particular point of time with no reference to the production structure of the business and seems almost to downplay the heterogeneity of productive resources. Yet Mises was preoccupied with money as a social institution that enables the calculation of profit and loss that guides decision making (Lewin, 1998). Understood in the context of Mises’s work, one realizes that he is taking as given the insights of Böhm-Bawerk and Hayek regarding the complexities that characterize capital theory and its development, including the various controversies associated with it, and is going beyond that to a discussion of how an Austrian view of capital informs the operations within an ongoing business concern. At the risk of over-simplifying, instead of looking at capital as inputs of a production function, Mises’s capital (as finance) is a key component of profit/loss calculation. He distinguishes capital from capital goods, which are inputs in the production process of goods and services. Rather than looking at just one input, or ignoring the differences between them, we think that a proper reading of Mises’s take on capital theory emphasizes these differences. Above all, Mises is clarifying that capital is about evaluation. To make business decisions the entrepreneur/manager/investor needs to evaluate the attractiveness (profitability) of various alternatives. In a monetary economy this is facilitated using money values. Only in a (well-functioning, financially stable) monetary economy is it possible to estimate the value of the diverse heterogeneous productive resources available to any business venture, and thus to the economy as a whole, in terms of a common metric. To be sure, there is nothing objectively fixed about the values thus estimated. They are based on the judgments of the decision-makers as to what can and will happen in various circumstances. Also, there is no implication that only money estimates are involved in any decision. Non-pecuniary elements (to which the decision-maker may well subjectively assign money values) might be important. But, without the ability to use money as a measuring rod, most modern-day business decisions would be impossible to execute. Money valuation is an essential aspect of the functioning of the capitalistic economy (see Cachanosky, 2017). Mises talks here about the money-equivalent of assets and liabilities. Capital is the value put upon a business concern or business project by whoever evaluates the existing assets and liabilities monetarily at a point in time. For Mises, capital is always capital-value. Such value would not exist in the absence of the productive resources we colloquially call capital-goods, though, as mentioned. Mises distinguishes capital sharply from capital-goods, and suggests the latter

132 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

would better be called productive resources (implying, perhaps unintendedly, that this includes also labor resources (human capital services)). He effectively conceives capital as a subjective cost–benefit exercise. In that respect, time in production is a crucial factor. The expected future costs and benefits incurred over the decision-making horizon determine the current values (the money-equivalents) of the assets and liabilities of the business. Cash flows over time are discounted by the decision-maker’s rate of time preference to arrive at current values. The link to the practice of managerial finance and accounting should be obvious.2 This Austrian view of capital is not connected to any kind of system equilibrium. Capital-value estimations occur in the open-ended universe of disequilibrium in which expectations regarding future economic developments will differ and conflict. Entrepreneurs with diverse economic visions will compete. Some will succeed, and many will fail. The capital-values recorded by the accountants or imagined by the decision-makers are subjective estimates reflecting their own preferences and expectations. It is a world where, unlike neoclassical economics, there is ample scope for entrepreneurship and subjectivity. An important implication of capital as finance is that it brings to the table the issue of subjectivity and, by implication, emphasizes the role of the entrepreneur. In a typical neoclassical problem, the producer maximizes profit by referring to a production function and with market values taken as given. Compare this to an Austrian approach. First, certainly, there are known production technologies, but what the entrepreneur must do is find production functions yet unknown. Second, market values are contrasted with the entrepreneur’s subjective expectations of future market prices. With the same information, different entrepreneurs arrive at different valuations. This is harder to see in a neoclassical profit maximization problem than in a typical discounted free-cash-flow (FCF) conception (explained below).3 The reason is that economists are trained to think of profits as an objective function to be maximized with a unique solution. However, it is more natural to recognize the subjective component when looking at an FCF. The discount rate is the investors’ subjective time preference, and future FCFs are subjectively expected prices. Thinking of capital and the production process in terms of finance rather than in the typical profit of the firm is more than a mere mathematical re-wording, it moves the focus away from objective maximization towards subjective valuation of productive assets. It also puts the economist in a framework closer to how business decisions are made in the real world.

ACCOUNTING AND FINANCE: CAPITAL AND COST IN ECONOMICS 133

Only in such a world does the economic way of thinking conform to the perspectives of the accountant and the financial manager. The static neoclassical model of perfect competition or economic growth, as captured by a production function, solves the problem of evaluation in the face of uncertainty by assuming it away. Thus, as informative as the static model may be as a logic of choice in a full-information system, it cannot tell the accountant anything that may help him understand what numbers may be useful to the real-world decision-maker. The very concept of “capital” and the closely related concept of “cost,” as understood in that static model, crucially depart from what is relevant to the decision-maker.

Capital: value, cost, and choice Consider Mises’s definition of capital again. In evaluating the money-equivalent of the assets and liabilities of a business, the decision-maker must estimate the future outlays and inflows of funds over the relevant horizon. These will differ depending on the uses to which productive resources at hand, or yet to be acquired, are put. In other words, part of evaluating the capital of a business consists of deciding the best use of the resources available, which involves comparing, as best one can, different possible scenarios. The cost of any such decision is appropriately conceived as the value of the best alternative use for the resources. This is the familiar “opportunity cost” idea embraced by almost all economists but adhered to consistently by only a few.4 The outlays anticipated by the decision-maker attributing an estimated capital-value to a chosen project do not constitute the true economic cost borne in pursuit of that project. Rather, the economic cost is the estimated capital value of the best alternative available but, in the event, not chosen. This way of viewing economic cost is a key distinguishing feature of the Austrian approach that differs from the neoclassical theory of the firm. In the latter we teach that “costs” are the outlays incurred by any chosen project (or the business as a whole). They are the objective results of choice, not the ongoing choice influencing considerations of a real business. The difference between the Austrian and the neoclassical conceptions is most apparent in the absence of system equilibrium. In static equilibrium, with complete shared information regarding all available alternatives, the marginal cost of producing one additional unit of output represents the minimum “cost” at which that unit will be produced because it is the value (money-equivalent) of the next best use of the resources necessary to produce that unit. For that choice the outlay involved corresponds to the opportunity cost. In a world of

134 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

disequilibrium, this is no longer generally true. In disequilibrium, perceptions of what is possible and the sacrifices involved in any chosen course of action differ among decision-makers. Competition is a discovery procedure in which entrepreneurs are the explorers, and profit (absent in static equilibrium) is the reward. At the start of the business, its observed capital value is the money put up for its establishment, but, in the entrepreneur’s mind, this value understates its real value given the business’s potential to create value. Economic value can be added over and above the alternative uses of the resources, which is the real measure of profit that motivates the decision-maker (Lewin & Cachanosky, 2021). Whereas, as Buchanan (1969 [1999]) explains, the neoclassical approach can be understood as an exercise in empirical hypothesis derivation, the LSE–Austrian approach must be understood as an exercise in explicating the necessary logic of choice that impels individual human action. Thus, capital and choice belong together in the same way as do cost and choice. Capital as value requires a valuer. Valuing and evaluating is associated with decision-making. Capital theory has sometimes failed to make this clear. Perhaps it would be better understood if the viewpoint of the would-be investor in any production project were kept front and center.5 Accounting data on cost and earnings do not deliver a complete understanding of the ingredients of the mental processes that inform the decisions that produced that data. In an important sense, accountants look back while economists look forward. Accountants report results (history), while economists analyze decisions using the economic way of thinking. Accounting data alone cannot inform an economic understanding of a business’s history. It has to be augmented by an analysis of the subjective estimates that motivated the decisions taken. A productive but difficult research opportunity exists in exploring the interaction between accounting data generation and economic decision-making.6 Some of the essential points discussed in the foregoing paragraphs can be illustrated as follows. We can characterize the essential elements contained in any investment decision. The capital values are the subjective imaginings of the relevant decision-maker (the manager, the entrepreneur). Following Irving Fisher (1906), we consider all productive resources to be capital assets, divided between human capital (labor) and physical capital. The firm can either rent or own physical capital assets and use their services, but it can only rent human capital and pay a wage to purchase its services. We designate i​  =  1, … , n​ as a set of heterogeneous outputs and ​j  =  1, … , m​heterogeneous inputs. Second, following Mises (and Menger) we insist that capital must refer to the value of the business venture (or production project) as a whole and not to the quantity

ACCOUNTING AND FINANCE: CAPITAL AND COST IN ECONOMICS 135

of any class of physical inputs (see Braun et al., 2016; Lewin & Cachanosky, 2019). Accordingly, the variable K, is to be understood as the capital-value of the firm – evaluated by whomever is the relevant decision-maker. Thus, we have: n

m

i​=1

j​=1

​   ​ ​  ​pi,t​  ​ ​oi,t​  ​ − ​∑ ​ ​  p ​ j,t​  ​ ​qj,t​  ​ ​πt​ ​  ​=  ∑

​ (7.1) ​

Where π ​ t​ ​is the net cash flow, for the current period. ​pi​ ​and p ​ j​ ​are, respectively, the price of outputs ​ (​oi​ ​) ​​and inputs ​ (​qj​ ​) ​​used at time t. Introducing the time dimension there are T total periods. At any point of time the capital-value of the firm or project is: T

​Kt​ ​  ​=  ∑ ​     ​  f​​ t​ ∙ ​π​ t​ t​=1

​ (7.2) ​

1 Where ​f​ t​  =  _ ​ ​ (1 + r  ) ​ ​  is the discount factor at time t, and the discount rate is r, ​ reflecting the time preference of the decision-maker.7 t

Note that the prices in equation (7.1) are either (expected) market prices or the entrepreneur’s estimate of the cost of using owned assets (the payment for their services to the firm, thus including user cost or depreciation).8 They are not equilibrium prices. And yet, the marginal conditions still apply, although in a very different way, as explained below. The logic of choice always involves the balancing of marginal benefits and costs, even when those values are not equilibrium values. To be sure, the theoretical constructs refer to financial accounting estimates and are subjective evaluations by the relevant decision-makers, not observable by outside analysts. They are no less real and describe what happens in the real world. Furthermore, these prices are not generally “costs” in the opportunity cost sense of the word discussed above. Instead, they are the necessary outlays required to produce, sell outputs and earn revenue. They are a consequence of the production plan, the production budget. Later, ex-post, they will become part of the accounting record of the production history. As such, they will be closer to or further from the prices as envisaged by the investor ex-ante, to the extent to which the accountant shares the investor’s appraisals. The enduring relevance of the marginal conditions can be explained as follows. In choosing a particular project, the entrepreneur will compare all investments that she considers available alternatives and choose the one with the highest capital value (which includes the non-pecuniary utility derived from it). If investment A is chosen, then ​KA​  ​ is considered to be the one with the highest

136 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

estimated capital value. It is the project that maximizes economic profits over time. The (opportunity) cost of the investment is the value of ​KB​  ​, which is the next highest value alternative. The decision elements involved in estimating​ K​B  ​ are the same as those involved in estimating ​KA​  ​​although, of course, the estimated values are different. ​KA​  ​and ​KB​  ​​ are two alternative ways of deploying the “same resources” (Thirlby, 1952, pp. 209–214).

Financial management: whose valuations should count? When talking about the decision-maker, we mentioned the production plan. When considering an individual or a single-person firm, there is no ambiguity associated with this. However, when, as is usually the case, the firm’s activities result from decisions made by a (large or small) number of individuals working together, the components of the production plan will depend on who has the responsibility for implementing which part of it. Thirlby (1952) offers the distinction between policy decisions and operating decisions. The latter takes the form of rules designed to have the actors conform as much as possible to the production plan as conceived by the responsible planner. The planner makes the policy decisions, decisions which embody his idiosyncratic evaluations. To effectively manage the firm to conform to the policymaker’s vision requires a judicious selection of resources to be provided to the rule-followers. Thirlby’s insights may be seen as quite prophetically anticipating the evolution of the business firm from a hierarchical structure to a more “democratic” one. Because of the growing complexity and specialization of knowledge within the firm, more “workers” need to have policymaking authority. Hayek’s knowledge problem (the problem of coordinating the contribution of people with specialized knowledge dispersed throughout the organization – including tacit knowledge and creative knowledge) comes to mind (analyzed by Jensen & Meckling, 1992, among many others). Thus, understanding capital valuation has important implications for general principal–agent situations. Incentives interact with information (interpreted into knowledge) to materialize in decisions that need to be coordinated within the firm. These are details of any production plan that cannot be specified and articulated to any significant degree and constitute an aspect of the pervasive uncertainty connected to any production plan. Coordinating management is an essential productive resource whose uncertain value is as crucial as any other input. As events unfold, the market serves as the ultimate adjudicator of

ACCOUNTING AND FINANCE: CAPITAL AND COST IN ECONOMICS 137

the estimated capital values. The economics textbook view of capital, cost, and the firm is a pale reflection of the richer perspective offered here.

Moving forward: research pathways So far, we have discussed some overall implications of thinking of capital as value as a different concept than capital goods for productive assets. A financial framework does not only explain how capital is valued. It also clarifies long-standing issues in capital theory, such as the elusive concept of the average period of production (APP) or the problem of reswitching (Cachanosky & Lewin, 2014; Lewin & Cachanosky, 2018, see 2020a, pp. 15–18, 101–103). In this section, we want to offer potential future research areas that extend the financial approach to capital theory. Before we proceed, however, we need to briefly expand on the financial framework introduced above. The framework Below we use four equations: the profit of the firm, the value of capital as the present value of future profits, the free-cash-flow (FCF), and the Economic Value Added (EVA).9 As before, ​π​represents economic profit. ROIC stands for return-on-invested capital, and W is the total amount of funds invested in the project. Time periods are denoted by t. n

m

i​=1

j​=1

​   ​ ​  ​pi,t​  ​ ​oi,t​  ​ − ​∑ ​ ​  p ​ j,t​  ​ ​qj,t​  ​ ​πt​ ​  ​=  ∑

​ (7.3) ​

T

​ t​ ​  ​=  ∑ ​     ​  f​​ t​ ∙ ​πt​ ​ K

​ (7.4) ​

t​=1

In this formulation, K is also the net present value of the FCF. The FCF notation is in turn equivalent to the EVA. ∞

FCF ​     ​  ​ _     ​ ​K  ​=  ∑ ( )t t​=1

 ​(7.5) ​

​  1 + r  ​​ ∞

​ (ROI ​C​ ​ − r) ​ W ​ ​  ​

∞

​EVA​ ​

t t−1 t ​   ​=  ​W0​ ​ + ​∑    ​  ​ ____________        ​  ​=  ​W0​ ​ + ​∑    ​  _ ​ (     ​ K ( )t )t

t​=1

​  1 + r  ​​

t​=1

​  1 + r  ​​

 ​(7.6) ​

There is an important relationship between these three seemingly different equations. As is well known in the field of finance, EVA is just a mathematical representation of the FCF (Koller et al., 1990, pp. 697–699). The second rela-

138 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

tionship is between the firm’s profit and the EVA representation of the FCF. To see this, we need to open ROIC into its components: ​ROIC  =  NOPAT / W​ (where NOPAT stands for net-operating-profits). As we show elsewhere (Lewin & Cachanosky, 2020a, Chapter 8 appendix), the connection between the equations (7.5) and (7.6) is that EVA is the financial name for economic profits: E ​ VA  =  π​. These are the similarities, what are the differences? The EVA representation has two advantages over its FCF equivalent. From a financial point of view, it distinguishes between outlays that are operational costs from outlays that are investments. The former will be inside the NOPAT, and the latter will produce a change in the value of W. This is relevant in business valuation because it is possible to have a negative FCF but a positive EVA (Lewin & Cachanosky, 2020a, Chapter 8; 2020b). From an economic point of view, the EVA representation is more economically friendly than the FCF representation. The EVA approach presents results in rates and connects to the familiar economic profit ​ (π) ​​. EVA (1) separates capital as value from capital goods and (2) is more general in the sense that inside the NOPAT we find the prices paid for any factor of production rather than only for wages, as is shown in the traditional neoclassical profit function (which confuses rental rates paid for the services of capital goods and interest).10 There is another advantage to using the EVA framework: duration can be interpreted as an average period of production, which is a finite and objective number.11 We can now move to discuss three broad areas of potential research: microeconomics, macroeconomics, and institutional economics.12 Microeconomics Because EVA and ​π​are intimately related, there is an obvious connection to the theory of the firm. Let us consider three examples. The first one is the inclusion of Cantillon effects in the EVA framework. This requires opening EVA to a second level of detail, the value drivers (Lewin & Cachanosky, 2020a, pp. 98–101). Value drivers capture where value is coming from in a firm. The “where” can be sliced in different ways. It can be different geographic areas of a corporation or different types of products offered by a large firm. The Austrian literature has historically emphasized the costs of Cantillon effects and the role of economic calculation. A financial approach reveals a specific method by which economic calculations are made and an analytical framework to precisely capture the impact of Cantillon effects. This framework can

ACCOUNTING AND FINANCE: CAPITAL AND COST IN ECONOMICS 139

inform how and where empirical work should look for evidence of the significance of relative price distortions. The second example connects economics with the fields of management and accounting. In the eyes of the entrepreneur, the same expense can be considered either as an operating cost or an investment, regardless of what accounting rules mandate. If the said expense is regarded as an operating cost, then the NOPAT falls, but if it is considered an investment, then NOPAT does not change; but W rises. To put it differently, the entrepreneurial alertness that Austrians emphasize is a subjective look applied not only to market conditions but also to the firm’s internal workings. A third example is to check if Kirzner’s alertness has a proper and consistent financial interpretation. If it is the case that Kirzner is onto something with his alertness concept, then it should be possible to frame this consistently in financial terms. This would be a connection to the field of finance and may also be a compelling way to approach Austrian and mainstream views on the theory of the firm and the role of the entrepreneur (see Cachanosky, 2017). Macroeconomics Our largest application of a financial approach to capital theory has been a financial interpretation of the Austrian business cycle theory (ABCT) (Cachanosky & Lewin, 2016a; Lewin & Cachanosky, 2020a, Chapter 10). In theoretical terms, this approach solves several issues. For instance, it offers clear microfoundations for the ABCT, not in terms of representative agents but in terms of relative prices, which are the present value of expected cash flows. As we insist in our work, movements in the discount rate produce the changes in relative prices needed for the ABCT to unfold. Using finance also shows that, in terms of intermediate and final prices, Cantillon effects are not needed to have an ABCT. What is needed is a movement of the discount rate, not a movement of relative final and intermediate prices. It also offers an ABCT that does not need to rely on the stages of production in the Hayekian triangle as represented in Garrison’s (2001 [2002]) model. As pedagogical as they can be, stages of production can also be quite problematic when used to decide how to carry on an empirical evaluation (see Cachanosky & Lewin, 2018). This area of research, however, lacks an empirical leg to assess how relevant ABCT effects are. In a limited empirical exercise, we find the empirical effects predicted by this financial framework (Cachanosky & Lewin, 2016b). Movements in the discount rate affect large firms’ (the financial “equivalent” to capital intensity) perception of profits and net investments to a larger degree

140 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

than small firms. However, this work is empirically limited with plenty of space for more contributions. The financial framework also provides a setting to add other effects to the ABCT easily. The first is the inclusion of exchange rates and extending ABCT to the international market.13 The ABCT implicitly assumes a gold standard regime with no exchange rates (all countries use the same base money: gold). In current times we have fiat moneys with a multiplicity of exchange rates. The canonical ABCT has one transmission channel, the discount rate. But, in current times, an expansionary monetary policy has the exchange rate as a second transmission channel. For instance, the exchange rate can be included in the inflow or outflow side of the NOPAT, depending on whether we are looking at an industry that trades final or intermediate goods.14 Another relevant extension of the ABCT is the inclusion of different risk premiums. This is easily done in the discount rate, where the discount rate ​ (r) ​​ equals the risk-free rate ​ ​(​rf​ ​) ​​plus a risk premium ​ ​(σ) ​​: ​r  =  ​rf​ ​ + σ​. This has been a pressing issue since the 2008 financial crisis, but little progress has been made.15 For instance, a certain regulation or easy bailouts can change σ​ ​ differently across different markets. Institutions The third area of research is institutional. Institutions influence the development and growth of an economy and affect investment through its effects on business valuations. If, for instance, good institutions result in higher total factor productivity, then NOPAT (and therefore the EVA) will increase, attracting more investment to this economy. For illustration purposes, one can use the Economic Freedom of the World (EFW) sub-indices to show how different institutional dimensions impact investment returns (see Lewin & Cachanosky, 2020a). Consider first EFW Area 1, the size of government. The larger the government, the higher the tax burden and public debt. Either through higher taxes or a higher interest rate, the EVA of the firms in this economy will be negatively affected. A similar application can be done with EFW 4, freedom to trade internationally. Tariffs and quotas affect tradable industries (as opposed to non-tradable industries). EFW 2, legal system and property rights, affects the risk premium of the economy. Institutional reforms can significantly impact an economy by reducing the risk premium in the discount rate. If, in hypothetical static equilibrium ​EVA  =  0​(because ​ROIC  =  r​), then an institutional reform moves the equilibrium point to a higher level of output,

ACCOUNTING AND FINANCE: CAPITAL AND COST IN ECONOMICS 141

attracting a flow of investments. EFW 3, sound money, relates to the inflation rate. We already mentioned that Cantillon effects can be easily included in this framework. Yet, there is another layer. The higher the inflation rate, the larger the uncertainty of the value of future cash flows. The volatility of the NOPAT increases (a standard measure of risk). The range of potential ex-post outcomes broadens. Finally, there is EFW 5, regulation. High regulatory costs reduce the NOPAT, and therefore the EVA, of the affected industries. Using the EFW sub-indices into the EVA financial framework illustrates how institutions can affect perceived profits.

Conclusions Capital theory can be problematic. On the one hand, it is considered a fundamental component of economic theory, particularly Austrian theory. On the other hand, it is perceived as an obscure area of research that leads to frustration, inapplicable insights, and no-exit roads. We see this in the work of figures as prominent as Böhm-Bawerk and Hayek. Yet, this does not have to be the case. Much is illuminated in capital theory once finance is applied. As shown in our work, basic financial theory is enough to make Austrian capital theory intelligible. While we emphasize research questions based on our work, we do not deny that other approaches can be highly productive. The overall message we want to get across is that studying capital theory is rewarding and useful. Even when a direct application does not take place, the analytical framework brings clarity and precision to the analysis.

Notes 1. 2.

For a summary see Lewin and Cachanosky (2019). Capital is a three-dimensional concept including value, time and quantity (incommensurate physical units). See Lewin and Cachanosky (2021). 3. The free-cash-flow is the operating cash flow minus capital expenditures. In other words, the cash that remains free to use after paying all operation costs (including taxes) and investment outlays. 4. Perhaps nothing captures the essential subjective nature of value better than the concept of opportunity cost. This realization operates to varying degrees in the literature. The idea likely originating with Wieser and Wicksteed and adopted by the Austrians, notably Mises, reached its most definitive form in the work of the

142 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

5. 6. 7.

8. 9. 10.

11.

12.

13. 14.

15.

LSE economists (including, Hayek, Coase, Buchanan, Thirlby and Wiseman) of the 1930s to the late 1960s. The best account of the dimensions and implications of opportunity cost are to be found in Buchanan (1969 [1999]), Buchanan and Thirlby (1973 [1981]) and Vaughn (1980). For Austrian economists teaching the theory of the firm this raises interesting questions. How should one teach an appreciation of these ideas given the dominance of the standard static equilibrium approach? See Lewin (2021). The matter is greatly complicated by the fact that businesses follow accounting rules and best practices for regulatory and tax purposes. Entrepreneurial alertness builds on the present value of subjective expected FCFs. It should be obvious that, insofar as investing the money for this project could alternatively be invested in some financial asset earning a particular rate of return, that rate of return will influence the discount rate applied by the investor to this project. The connection between market interest rates and appraised capital values of investments of various time dimensions will be apparent as will its relevance to the Austrian Business Cycle Theory. As we shall see, the value of these resources as part of an alternative project is part of the opportunity cost estimate that the investor must make, but does not enter here as part of the value of this project. On the EVA methodology see Ehrbar (1998), Koller et al. (1990), and Young and O’Byrne (2000). In neoclassical economics π ​   =  pq − rK − wL,​ where r refers confusingly to the “price” of capital and w the price of labor. In equilibrium, the rental rate on aggregate capital is equal to the interest rate. But, crucially, in the business world these are very different things. There are other implications of the EVA approach we mention in our work. This approach shows that what matters in terms of the sensitivity of the value of the firm is not the familiar K/L (capital intensity) (where K represents capital goods), but the modified duration of the expected cash-flow. See Lewin and Cachanosky (2020a, pp. 101–103). The mathematical and logical connection between equations (7.3) through (7.6) is provided in our extended work (for example Lewin and Cachanosky 2020a, 2021). The interested reader can consult that work, but that knowledge is not necessary to appreciate what follows. See Bilo (2018) and Cachanosky (2014a, 2014b, 2015). In a closed economy ​π  =  ​pi​ ​ o​ i​ ​ − ​pj​ ​ ​qj​ ​.​ Let e be the nominal exchange rate, then ​   =  ​pi​ ​ ​oi​ ​ − ​ep​j ​ ​qj​ ​.​This is for an exporter π ​   =  ​ep​i ​ ​oi​ ​ − ​pj​ ​ ​qj​ ​,​and for an importer π a simple example of how a nominal exchange rate can enter capital value, either in its FCF or EVA representation. For some early contributions see Young (2015).

References Bilo, S. (2018). The international business cycle as intertemporal coordination failure. The Review of Austrian Economics, 31(1), 27–49. https://​doi​.org/​10​.1007/​s11138​-016​ -0366​-8

ACCOUNTING AND FINANCE: CAPITAL AND COST IN ECONOMICS 143

Böhm-Bawerk, E. von. (1890). Capital and Interest (1890 ed.). Macmillan and Co. Ltd. Braun, E. (2017). The theory of capital as a theory of capitalism. Journal of Institutional Economics, 13(02), 305–325. https://​doi​.org/​10​.1017/​S1744137416000394 Braun, E., Lewin, P., & Cachanosky, N. (2016). Ludwig von Mises’s approach to capital as a bridge between Austrian and institutional economics. Journal of Institutional Economics, 12(04), 847–866. https://​doi​.org/​10​.1017/​S1744137416000102 Buchanan, J. M. (1969 [1999]). The Collected Works of James M. Buchanan. Volume 6. Cost and Choice (Vol. 6). Liberty Fund. Buchanan, J. M., & Thirlby, G. F. (1973 [1981]). LSE Essays on Cost. New York University Press. Cachanosky, N. (2014a). The effects of U.S. monetary policy on Colombia and Panama (2002–2007). The Quarterly Review of Economics and Finance, 54, 428–436. https://​ doi​.org/​10​.1016/​j​.qref​.2014​.03​.003 Cachanosky, N. (2014b). The Mises-Hayek business cycle theory, fiat currencies and open economies. The Review of Austrian Economics, 27(3), 281–299. https://​doi​.org/​ 10​.1007/​s11138​-012​-0188​-2 Cachanosky, N. (2015). U.S. Monetary policy’s impact on Latin America’s structure of production (1960-2010). Latin American Journal of Economics, 51(2), 95–116. https://​doi​.org/​10​.7764/​LAJE​.52​.1​.95 Cachanosky, N. (2017). Austrian economics, market process, and the EVA® framework. Journal of Business Valuation and Economic Loss Analysis, 12(s1). https://​doi​.org/​10​ .1515/​jbvela​-2016​-0014 Cachanosky, N., & Lewin, P. (2014). Roundaboutness is not a mysterious concept: a financial application to capital theory. Review of Political Economy, 26(4), 648–665. https://​doi​.org/​10​.1080/​09538259​.2014​.957475 Cachanosky, N., & Lewin, P. (2016a). Financial foundations of Austrian business cycle theory. Advances in Austrian Economics, 20, 15–44. https://​doi​.org/​10​.1108/​S1529​ -213420160000020002 Cachanosky, N., & Lewin, P. (2016b). An empirical application of the EVA® framework to business cycles. Review of Financial Economics, 30(September), 60–67. https://​doi​ .org/​10​.1016/​j​.rfe​.2016​.06​.006 Cachanosky, N., & Lewin, P. (2018). The role of capital structure in Austrian business cycle theory. Journal of Private Enterprise, 33(2). Ehrbar, A. (1998). EVA: The Real Key to Creating Wealth. Wiley Publishers. Fisher, I. (1906). The Nature of Capital and Income. Macmillan. Foss, N., Klein P., & McCaffrey, M. (2019). Austrian Perspectives on Entrepreneurship, Strategy, and Organization. Cambridge University Press. Garrison, R. W. (2001 [2002]). Time and Money. The Macroeconomics of Capital Structure. Routledge. Hayek, F. A. (1941 [2007]). The Pure Theory of Capital (L. H. White (ed.)). Chicago University Press. Jensen, M. C., & Meckling, W. H. (1992). Specific and general knowledge and organizational structure. In L. Werin and H. Wijkander (eds), Contract Economics. Oxford, UK: Blackwell Publishers. Reprinted in Journal of Applied Corporate Finance (Fall 1995) and M. C. Jensen, Foundations of Organizational Strategy. Harvard University Press, 1998). Koller, T., Goedhart, M., & Wessels, D. (1990). Valuation: Measuring and Managing the Value of Companies (2010 ed.). Wiley. Lachmann, L. M. (1956 [1978]). Capital and its Structure. Sheed Andrews and McMeel.

144 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Lewin, P. (1998). The firm, money, and economic calculation: Considering the institutional nexus of market production. American Journal of Economics and Sociology, 57(4), 499–512. https://​doi​.org/​10​.1111/​j​.1536​-7150​.1998​.tb03378​.x Lewin, P. (2021). How should an Austrian economist teach the theory of the firm? Do the equi-marginal conditions still apply? The Review of Austrian Economics. https://​ doi​.org/​10​.1007/​s11138​-020​-00540​-7 Lewin, P., & Cachanosky, N. (2018). The average period of production: The history and rehabilitation of an idea. Journal of the History of Economic Thought, 40(1), 81–98. https://​doi​.org/​10​.1017/​S105383721700013X Lewin, P., & Cachanosky, N. (2019). Austrian Capital Theory: A Modern Survey of the Essentials. Cambridge University Press. Lewin, P., & Cachanosky, N. (2020a). Capital and Finance: Theory and History. Routledge. Lewin, P., & Cachanosky, N. (2020b). Entrepreneurship in a theory of capital and finance—illustrating the use of subjective quantification. Managerial and Decision Economics, 41(5), 735–743. https://​doi​.org/​10​.1002/​mde​.3133 Lewin, P., & Cachanosky, N. (2021). Capital: Three dimensionally speaking. LIBERTAS: Segunda Epoca, 6(1), 1–11. Mises, L. von. (1949 [1996]). Human Action. Fox & Wilkes and The Foundation for Economic Education. Strigl, R. von. (1934). Capital and Production (M. R. Hoppe & H.-H. Hoppe (trans.); 2000 ed.). Ludwig von Mises Institute. Thirlby, G. F. (1952). The economist’s description of business behavior. Economica, 19(74), 148–167. Vaughn, K. I. (1980). Does it matter that costs are subjective? Southern Economic Journal 1, 46(3), 702–715. Young, A. T. (2015). Austrian business cycle theory: a modern appraisal. In P. J. Boettke & C. J. Coyne (eds), Oxford Handbook of Austrian Economics. Oxford University Press. Young, D. S., & O’Byrne, S. E. (2000). EVA and Value-Based Management. McGraw-Hill.

8

An Austrian reassessment of the theory of “public goods”: what is left (and right)?

Rosolino Candela and Vincent Geloso

Introduction According to Don Lavoie, economic theory serves as “a pair of spectacles through which we try to make sense of the world” (1985b, p. 8). Like a pair of spectacles, economy theory not only brings into focus the relevant questions that must be asked to address social phenomena but also guides us toward to the “right” answer to those questions. Since its modern formulation by economist Paul Samuelson (1954), the theory of public goods has been the most important economic justification for the state, which utilizes its monopoly on legitimized force to finance, produce and distribute public goods. While various examples have been utilized to illustrate the existence of public goods, including national defense, lighthouses, roads, and television broadcasting, their welfare implications all generate the same public-policy conclusion. That is, absent the existence of the state, public goods theory suggests that the market would fail to provide a Pareto-efficient amount of public goods. This chapter is motivated by the following questions. First, what are the implications of an Austrian reassessment of the theory of public goods? Second, what would be left to say that’s “right” about public goods? Although our motivation is primarily positive, its public policy implications are normative. Our point in drawing attention to this inquiry is neither to suggest that goods or services never exhibit the characteristics consistent with public goods nor to answer directly whether such goods ought to be provided by the state, per se. If anything, debates about such claims, we contend, put the normative cart before the analytic horse. Before we can even debate what “public goods” are and whether or not the state should or should not provide them, it would seem relevant to inquire how particular goods become “public”1 in the first place. The implicit assumptions in the theory of public goods being utilized

145

146 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

are that the theory is framed in terms of an outcome of its emergence and that it neglects to address the process by which so-called “public goods” emerge. By redirecting our focus on this cumulative process, our purpose in this chapter is to argue two essential points. First, the non-rivalrous aspect of public goods is a by-product of overcoming rivalry in the first place via the endogenous formation of excludability mechanisms. Second, an Austrian reframing of the theory of public goods completely transcends the inherent distinction between public and private goods, thus negating the most important economic justification for state intervention. The implication here is not to conclude that there is nothing left for mainstream economists to say about public goods theory. Rather, reframing the analysis through a market-process lens, it is to redirect mainstream economists to other questions that the model of perfectly competitive equilibrium, the normative benchmark of neoclassical welfare analysis, cannot address. This chapter proceeds as follows. The next section summarizes the traditional account of public goods theory and explains its implicit assumptions by revisiting the socialist calculation debate. In the third section, we suggest an alternative paradigm, one that filters public goods theory through a market-process framework. We also argue why any “public good,” from an analytical standpoint, is initially rivalrous in order to illustrate the process by which goods may become non-rivalrous and non-excludable. The fourth section provides historical examples of the emergence of so-called “public goods” to illustrate our theoretical point. Specifically, we examine two textbook examples of public goods allegedly depending on state provision: national defense and lighthouses. In doing so, we illustrate that the emergence of these “public goods” are themselves dependent on another public good: the emergence of the rule of law. Moreover, their provision was dependent on rivalry, from which excludability mechanisms endogenously formed.2 The fifth section summarizes implications for future research.

Is the market for public goods “imperfect”? Summary and reassessment According to Peter Boettke, economic calculation, or “the decision-making ability to allocate scarce capital resources among competing uses” (1998, p. 134), is the fundamental contribution to political economy. In his seminal article, “The Pure Theory of Public Expenditure,” from which the modern theory of public goods has developed, Paul Samuelson (1954) attributed the

AN AUSTRIAN REASSESSMENT OF THE THEORY OF “PUBLIC GOODS” 147

fundamental problem associated with the provision of public goods to the fact that “no decentralized pricing system can serve to determine optimally these levels of collective consumption” (Samuelson 1954, p. 388, emphasis in original). Thus, the absence of a price mechanism to economically calculate the optimal amount of public goods is also the fundamental problem according to public goods theory. For this reason, the Austrian account of the market process provides an excellent framework to reinterpret the theory of public goods and reassess its policy implications, thereby redirecting its analytic focus. Before providing an overview of public goods theory and its welfare implications, it is relevant to provide a brief overview of the socialist calculation debate for two reasons. First, from those debates, a unique and distinct Austrian account of the market process emerged and crystallized.3 Second, and more importantly for our purposes here, the implications of that debate have direct bearing not only on how a “decentralized pricing system” is interpreted by Samuelson and economists working within a neoclassical paradigm. It also has implications for how Austrians can reframe the theory of public goods and its welfare implications. Beginning with the publication of his 1920 article, “Economic Calculation in the Socialist Commonwealth,” Ludwig von Mises began a debate over the possibility of rational economic calculation under socialism (Mises 1975 [1920]). Against Otto Neurath and his Marxist counterparts, Mises argued economic calculation without private property and money was impossible. Because the exchange of private property rights over the means of production is the institutional prerequisite for the emergence of exchange ratios denominated in terms of money (i.e. money prices), the abolition of private property would eliminate pricing over the means of production. It would, in turn, result in the inability to calculate and assess the relative scarcity of the means of production in alternative consumer uses. The critical point we wish to raise here is that one raised by Don Lavoie in his seminal book reassessing the history of the socialist calculation debate, Rivalry and Central Planning (1985a). Lavoie argues that the responses made by the market socialists, Oskar Lange and Abba Lerner, to counter Mises’s critique, as well as those counter-responses made by F.A. Hayek to further explicate Mises’s argument, were lost in paradigmatic translation. Lavoie (1985a, p. 25, emphasis added) identified the heart of this misunderstanding in the following way: “the Marxists condemned rivalry, the Austrians asserted its necessity, and the neoclassical market socialists either assumed it away or failed to recognize the consequences of its introduction into their models.” According to Lavoie, economic rivalry refers to “the clash of human purposes” (1985a, p. 22). In their

148 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

model of market socialism, Lange (1936, 1937) and Lerner (1934, 1935, 1936, 1944) argued that central planners would direct managers of state-owned firms according to profit-maximizing rules to achieve market-clearing of goods and services. This implied, however, that central planners would respond passively to given parametric prices, like a Walrasian auctioneer, under conditions of general competitive equilibrium, which is a non-rivalrous situation. Reframed in terms consistent with our point here, Lange and Lerner implicitly assumed the existence of equilibrium prices, which exhibited the non-rivalrous and non-excludable features of a public good.4 Under conditions of perfect competition, in which rivalry is assumed away, the information embodied in prices reflects the full opportunity cost of resources and prices, simultaneously shared by all individuals, and are sufficient statistics to achieve a Pareto-efficient outcome. Lavoie’s identification of different paradigmatic notions of rivalry not only lies at the center of the socialist calculation debate but also has implications for an Austrian perspective on the theory of public goods. Like Lavoie, we will confine our focus to a subtly different notion of rivalry, which is distinct from how the term is understood under the neoclassical framework of perfect competition, which provides the normative benchmark from which the welfare implications of public goods theory is based. How does this overview of the socialist calculation debate pertain to the theory of public goods? According to conventional theory, a public good is one in which its consumption is both non-rivalrous and non-excludable. Non-rivalry here implies the ability of two or more individuals to consume a good or service simultaneously, or, put differently, at zero marginal cost. From an Austrian standpoint, there is no clash of human purposes in consuming a public good. When non-rivalrous goods are also not excludable, free-riding will occur among consumers, discouraging private actors from producing such a good. Due to free-riding, producers will not receive the full benefits of the costs incurred for the provision of public goods, the benefits of which are spilled over onto free-riders. As a result, private actors will be discouraged from producing an optimal amount of such a good or service. The welfare implication of public goods theory is that its provision by the market will be inefficient, resulting in a so-called market failure since there are mutually beneficial gains from trade that are not being fully exhausted. This market failure and the resulting inefficiency requires government intervention to be fixed. The point here is that because public goods theory and the model of market socialism are born out of the same neoclassical paradigm, they both arrive at

AN AUSTRIAN REASSESSMENT OF THE THEORY OF “PUBLIC GOODS” 149

the same welfare implications. Both justify their welfare conclusions in terms of an outcome of economic rivalry, which assumes away the process by which a state of affairs can become non-rivalrous. Lange and Lerner engaged in a Nirvana Fallacy (Demsetz 1969) by comparing imperfect markets with the ideal of central planning based on the conditions of perfect competition. Lange and Lerner assumed that central planners would already have the economic knowledge that emerges only at the end-state of an active process of economic rivalry between buyers and sellers of goods exchanging private property rights in goods and services. Analytically, this is no different from the way in which modern neoclassical economists understand the implications of public goods theory today. Like Lange and Lerner, who had assumed that parametric prices, understood as embodying the properties of a “public good,” modern neoclassical economists fail to consider that production of public goods is also a function of rivalry in the first place. As Aligica, Boettke, and Tarko (2019, p. 55) state: “what constitutes a public good is a consequence of how people have managed to deal with one another and with their conflicting preferences about each other’s behaviors: it is not something that is determined by the inherent nature of the good.” The public characteristics of a good are a consequence of coordinating the plans and goals of individuals in a manner that is consistent with ameliorating rivalry of purposes and plans, not an analytic starting point in which individuals’ goals and plans are already assumed not to conflict or rival one another. If modern neoclassical economists presume that imperfect deviations from the ideal of perfect competition will result in market failure, such as with the case of the provision of public goods, do imperfect markets imply an imperfect provision of public goods? Analytically, both modern neoclassicals and Austrians will answer yes, but this does not necessarily imply an economic justification of state provision. How can this be the case? As in the case of the socialist calculation debate, the answer can be found by evaluating the difference in economic paradigms from which Austrians and modern neoclassicals understand market processes (see Kuhn 1996 [1962]). In her book, The World in a Model, Mary Morgan provides an intellectual history of how economists have evolved in their construction of models as a device to think about how markets work. As she states, narratives about markets “are built into the identity of the model from the start” (Morgan 2012, p.  362, emphasis in original). Taking a lesson from the socialist calculation debate, a reframing of public goods theory as one that incorporates economic rivalry as a point of analytical departure will first require a reinterpretation of what we mean by the word “imperfect” in terms of markets and the provision of any good or service, whether public or private. The narrative that

150 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

is constructed and logically follows from the model of perfect competition is that observed deviations from perfect competition in the marketplace are indicative of imperfections, or “market failures,” such as with the provision of public goods. According to this narrative, government intervention is the deus ex machina that saves the market from its own “imperfections” through regulations, taxes, subsidies, and other public policy measures. However, the implicit meaning of the word “imperfect” that is baked into this narrative is that markets are flawed, non-ideal, or otherwise sub-optimal, and, therefore, need correction through government intervention. However, if we simply reinterpret our understanding of the word “imperfect,” not only will it reframe the narrative being told about the market process. It will also change the public policy implications that flow from this narrative pertaining to the provision of public goods. If we analyze the etymology of the word imperfect, breaking it down from its Latin origins, it does not mean that something, or some state of affairs, is flawed, suboptimal, or non-ideal. Instead, the meaning of “imperfect” is an act or process not thoroughly done, or incomplete. According to Merriam-Webster’s Dictionary, you will find a similar definition of the word imperfect: “constituting a verb tense used to designate a continuing state or an incomplete action” (emphasis added) (see Candela 2020b). The provision of public goods through the market process will always be imperfect. Yet this does not imply government intervention is necessarily justified once we consider that the process by which goods may become non-rivalrous and non-excludable must first begin, analytically speaking, with economic rivalry.

Rivalry and excludability: a market process perspective Since the publication of Samuelson’s seminal article on the theory of public goods, economists have critiqued not only the validity of public goods theory but also its applicability to particular circumstances of time and place (Minasian 1964; Buchanan 1965; Demsetz 1970; Coase 1974; Cowen 1985; Benson 1994; Aligica, Boettke, and Tarko 2019). Fundamentally, the problems associated with the market provision of public goods, according to proponents of market failure, are twofold: (1) a failure to define and enforce property rights over a positive externality associated with a public good; and (2) a failure to efficiently price a positive externality associated with a public good. Although these problems are intertwined and difficult to disentangle in real-world market processes, they are conceptually distinct stages of analysis for understanding the provision of public goods. Without the ability, first, to

AN AUSTRIAN REASSESSMENT OF THE THEORY OF “PUBLIC GOODS” 151

define and enforce property rights over the production of a good or service, producers will not be able to devise mechanisms to directly, or indirectly, price the consumption of a good. More importantly, however, if we can conceptually distinguish between these two aspects of public goods provision, then we can also illustrate three implications pertaining to the validity of public goods theory. First, there is no direct relationship between rivalry in consumption and rivalry in producing a good. It may be the case that, in consumption, a good is so abundant that rivalry does not exist, both in the Austrian and neoclassical understandings of the term. But it does not follow that rivalry in producing such a good does not exist. In fact, the prerequisite for non-rivalrous consumption of a good will be rivalrous competition in producing it. A good needs to be produced before it can become a “public good,” the characteristics of the latter emerging as an unintended by-product of economic rivalry, from which a tendency towards non-rivalry and non-excludability in consumption emerges. Second, and more importantly, before any good becomes “public,” it must first be a good, which implies it is rivalrous in consumption in the first place (see Menger 1981 [1871], pp. 94–106). As Hayek (1978 [1968], p. 181) states, “which goods are scarce goods, or which things are goods, and how scarce or valuable they are – these are precisely the things which competition has to discover.” Third, before goods can become non-rivalrous in consumption, not only must their production be rivalrous, but also the marginal benefits to their producers must exceed the marginal costs of production, and therefore be initially excludable to a producer or group of producers, even if this implies that some of the benefits are spilled over as externalities (see Hummel and Lavoie 1994, p. 360; see also Olson 1971 [1965], p. 33). We will apply these theoretical points in the next section, but for our immediate purposes here, we will illustrate how these implications are also illustrated in the context of the current COVID-19 pandemic. While this chapter is being written, governments worldwide have taken up the responsibility to combat the effects of COVID-19 under the justification that prevention of the pandemic is a public good. Most recently, on February 21, 2021, in a joint statement, UNESCO’s International Bioethics Committee (IBC) and the World Commission on the Ethics of Scientific Knowledge and Technology (COMEST) “have called for a change of course in current COVID-19 vaccination strategies, urging that vaccines be treated as a global public good to ensure they are made equitably available in all countries, and

152 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

not only to those who bid the highest for these vaccines.”5 Indeed, it may be the case that the outcome of widespread vaccination may be consistent with a public good in the form of herd immunity. But this argument conflates vaccination with vaccines. While the outcome of vaccination may be non-rivalrous and non-excludable, vaccines are both rivalrous and excludable. The fact that vaccines are rivalrous and excludable does not preclude the possibility that both the production and distribution of vaccines are possible through the market mechanism, even if this implies some spillover benefits are not fully reflected into their price.6 The fact that vaccines are regarded as a public good is, at best, an ex post justification of a policy that overlooks the very process by which such an outcome, namely vaccination, becomes a public good in the first place. This last point raises two potential objections, the first of which we will address here, and the second, following directly from the first, will be taken up in the next section. One may object that allowing for unfettered markets to produce and distribute vaccines will introduce a market failure associated with natural monopoly pricing. Harold Demsetz famously addressed this point in the context of utilities, arguing that a market structure defined by any natural monopoly does not preclude rivalrous competition to become the natural monopoly of a particular market, or “competition for the field” (Demsetz 1968; see also Chadwick 1859).7 Whether or not the good produced is rivalrous or non-rivalrous in consumption is independent of this rivalrous production process.8 The second objection (alluded to by Demsetz himself) is that the precondition for such “competition for the field” is the free entry of potential bidders to compete for contractual ownership over a natural monopoly, implying a justification of the state (albeit a passive one) in terms of implementing the rule of law. This, however, introduces a contradiction, since the state’s provision of a public good in the form of the rule of law implies its prior existence, the nature of its creation itself being a public goods problem as well! (Hummel and Lavoie 1994, p. 363). The issue is that in many instances, the government’s provision of public goods is itself a public good. This means that in the public sector as well, the provision of public goods may require bundling them with the provision of other goods (or rents) whose benefits are more easily appropriable.9 The analytic failure of this static, neoclassical rendition of public goods theory presents an intellectual profit opportunity for Austrians, whose analytical tools are equipped to address this apparent contradiction that resides only within the neoclassical paradigm, not in the real world characterized by institutional evolution under uncertainty.

AN AUSTRIAN REASSESSMENT OF THE THEORY OF “PUBLIC GOODS” 153

Public goods as outcomes of rivalry: lessons from history The provision of national defense According to Ludwig von Mises, human “society is an association of persons for cooperative action… All human civilization is founded on this fact” (2005 [1927], p. 1), yet “civilization itself is a process of all of us ‘free-riding’ on the achievements of others” (Rothbard 1981, p.  545). For individuals to realize the benefits of productive specialization and exchange under the division of labor, enforcement of private property rights is necessary against theft, fraud, and other violent transgressions. However, on this basis, economists have also concluded that enforcement of private property justifies government provision of one of the textbook examples of a public good: national defense. Following Hummel and Lavoie (1994, p.  362, emphasis added), we define national defense broadly to include not only protection of private property from private predation but also “the protection of people’s lives, property, and liberty from any state,” including the state within which an individual is residing. Defining national defense in this way implies that its provision is inextricably linked with the rule of law, the creation of which is itself a public good. This is evidenced by the fact that, historically, to the extent that states have exhibited the capacity to finance the provision of national defense and other “public goods” consistent with economic development, this has been an unintended consequence of having gradually accumulated constraints on predation (see Boettke and Candela 2020; Geloso and Salter 2020). Thus, although conceptually, economists have claimed that a state with the capacity to provide public goods is a necessary prerequisite for the enforcement of property rights and economic development, analytically and historically, the evolution of “state capacity” to provide national defense and economic development are by-products of a broader evolutionary process within which the rule of law also emerged. This raises a question: historically, how did the rule of law emerge? Based on historical evidence that explains the rise of Western Europe (Jones 1981; Rosenberg and Birdzell 1986) as a function of its political fragmentation and inter-jurisdictional competition, a number of economists working in the Austrian tradition have attempted to address this puzzle as to how an autocratic ruler, acting in his self-interest, could ever unintendedly unleash an evolutionary path towards the rule of law, liberal democracy, and economic development (Benson 1999; Candela 2020a; Cowen 1990; Salter and Hall 2015).10 Returning to our discussion in the second section, this question illustrates the link between the problem of economic calculation and the problem of providing public goods: both imply that institutional entrepreneurship is

154 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

required to reduce the transaction costs associated with establishing the institutional prerequisites to facilitate economic calculation. The underlying basis for this institutional evolution begins with modeling an authoritarian ruler as a political entrepreneur, one who is adjudicating a trade-off between their own personal security and personal wealth. In a world of zero transaction costs, a ruler unbound by any constraints could confiscate the entire value of their subjects’ wealth. This unrealistic scenario neglects two facts. First, predation leads to rent dissipation as the ruler must expend time and resources to capture such transfers of wealth and avert potential rebellion from his subjects. Second, such activity also stifles the conditions for economic calculation, productive specialization and exchange, and hence wealth creation, which is required for the acquisition of resources necessary for an autocrat’s defense from foreign aggression in the first place. Assuming an autocrat is a residual claimant, on the margin, he or she is willing to trade off some personal security by allowing his or her subjects to accumulate wealth through productive specialization and exchange. This implies, however, a credible commitment on the part of the ruler to enforce property rights, and not confiscate wealth. Assuming also the absence of third-party enforcement or any precedent to establish such a credible commitment, a secure ruler can establish this by providing the means through which to constrain himself via independent collective action from his subjects. This manifested itself in Western Europe in the Middle Ages in the formation of early parliaments, which were not democratic institutions as understood today. Rather, such forerunners to modern democratic institutions provided political elites with voting rights over revenues required for defense and other “public goods” in exchange for the enforcement of their property rights over their respective manors (see Congleton 2011; Salter 2015). Although such voting rights initially manifested themselves as political privileges exclusive to an aristocratic elite, a credible commitment to constraints on predation cannot be excluded from non-elites residing in a jurisdiction, manifesting itself as a public good, or a positive externality, from which non-elites may accumulate wealth. However, the very basis for such “free-riding” presented a political profit opportunity for monarchies to centralize their authority, namely by further extending political enfranchisement to the bourgeois with voting rights in parliaments, in exchange for tax revenue. Thus, the accumulation of wealth among the burghers, merchants, and other bourgeois became “internalized” by monarchs in Western Europe, and unintendedly generated the conditions consistent with the emergence not only of the state and “national defense,” but also the coevolution of liberal democracy and economic development.11 Rosenberg and Birdzell (1986, p. 101) make this point:

AN AUSTRIAN REASSESSMENT OF THE THEORY OF “PUBLIC GOODS” 155

“economic growth was a force for democratization and eventually produced a society unimaginable by the old landed elite and their political devices.” Our point here is neither to justify the emergence of the state, nor to claim that the state’s capacity to deliver public goods was historically necessary to deliver the conditions necessary for economic development. Rather, by reframing public goods theory through a market-process paradigm, what we are suggesting is that the emergence of the state, with the capacity to provide public goods, is itself a public goods problem, and the non-rivalrous and non-excludable nature of the outcome associated with its emergence cannot be understood without rivalry in production and consumption of goods and services. The historical emergence of the state and other public goods cannot be disentangled from each other, as they have been part of the same evolutionary process. This process applies no less to other textbook examples of public goods, including lighthouses, which also emerged in England and Wales with the growth of the modern nation-state. The provision of lighthouses Since at least the time of John Stuart Mill, economists have regarded lighthouses as being prone to market failures associated with their public good characteristics. The logic of such an argument is that lighthouses produce a light whose consumption is non-rivalrous and that producers cannot easily identify those who consume the light, which creates a window for opportunistic behavior in the form of free-riding. Paul Samuelson and William Nordhaus (2009, p. 37) state this point in the following way: lighthouse keepers cannot reach out to collect fees from ships; nor, if they could, would it serve an efficient social purpose for them to exact an economic penalty on ships that use their services. The light can be provided most efficiently free of charge, for it costs no more to warn 100 ships than to warn a single ship of the nearby rocks.

Whereas Samuelson and Nordhaus focused on the problem of non-excludability, Kenneth Arrow (1969, p. 47) argued that the greater problem associated with lighthouses is their non-rivalrous nature: “In my view, the standard lighthouse example is best analyzed as a problem of small numbers rather than of the difficulty of exclusion,” since exclusion is perfectly possible; the lighthouse need only shut off its light when a nonpaying ship is coming into range. But there would be only one buyer and one seller and no competitive forces to drive the two into a competitive equilibrium. If in addition the costs of bargaining are high, then it may be most efficient to offer the service free.

156 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

As such, lighthouses constitute a case of market failure – one often recounted in textbooks as there is a belief that lighthouses are the closest thing to a “pure” public good. In our own joint work regarding the private provision of lighthouses and lightships in England from 16th to 19th centuries, we have demonstrated how private financing and excludability mechanisms were crafted in order to overcome free-rider problems, and that the extent to which lighthouses have exemplified a public good is a function of government regulation crowding out private efforts to provide them (Candela and Geloso 2018, 2019, 2020). However, debating whether or not lighthouses (or lightships) exemplified a private good, a club good, or a public good is irrelevant for our purposes here (see also Coase 1974). This is because the production, financing, and consumption of any good or service will entail benefits that will become, to one extent or another, non-rivalrous or non-excludable, depending on the institutional context (see Cowen 1985). From this perspective, any good, to one extent or another, will exhibit public characteristics, but such public characteristics cannot be understood independent of rivalry in consumption and production. We illustrate this point with respect to lightships, also known as floating lighthouses. In 1731, two entrepreneurs, David Avery and Robert Hamblin, moored the world’s first modern lightship in the Thames River. The particular importance of the Nore lightship was that it was introduced precisely at a time when traffic at the Port of London was increasing rapidly. During the 18th century, merchant traffic entering the Port of London increased nearly fourfold, from 157,035 tons in 1702 to 620,845 tons by 1794. The lightship was strategically placed at the shallow mouth of the Nore bank, at the confluence of the Thames and Medway rivers, where lighthouses could not be constructed and the risk of shipwreck was highest. The willingness of entrepreneurs, such Avery and Hamblin, to supply a lightship, rather than constructing another navigational aid, such as a buoy or beacon, emerged only when the profitability of accommodating additional commercial ships rose. Therefore, the consumption of lighting services grew more rivalrous as commerce increased, as well the costs of shipwrecks. It was the rivalrousness of lighting services that incentivized Avery and Hamblin to advertise their product, price discriminate based on tonnage, and therefore craft an ingenious way to exclude non-payers. This included the use of subscription payments by which they were able to overcome free-riding. The fact that the lighthouse (and lightship) has been treated as a public good, and therefore as non-rivalrous and non-excludable, has directed economists’ attention away from the various ways in which lighting services were provided,

AN AUSTRIAN REASSESSMENT OF THE THEORY OF “PUBLIC GOODS” 157

and how excludability was an endogenous feature of such rivalrousness. Therefore, to the extent that lighthouse services have been regarded as being non-rivalrous and non-excludable, this is a description of an outcome associated with delivering lighthouse services. No doubt, some free-riding and non-excludability of benefits will exist after lighthouses are produced. But such public good characteristics are a by-product of entrepreneurs having devised innovative solutions to overcome excludability problems, which themselves originate from rivalry.

Summary and implications What is there left to say about public goods theory that is “right” about its application to the real world? We have argued that public goods theory, when filtered through an Austrian paradigm, provides no economic justification for the state. This conclusion neither implies that it is impossible for state action to implement technical solutions (i.e. applying a set of means to a given end), nor whether or not traditional state functions should discontinue for the purpose of fulfilling a particular end, per se. As Mises (1966 [1949], p. 15) argues, praxeology is a science of means, not of ends. Rather, to the extent that the economic justification of legitimizing the monopoly production of a particular good or service is predicated on the theory of public goods, this implies that, at best, public goods theory provides only an ad hoc justification for a government’s monopolization of the provision of a good or service that exhibits some degree of non-excludability or non-rivalry. We say “some” because a good that is truly non-excludable and non-rivalrous is policy irrelevant, since it is not a good in the economic sense of the term. For example, the provision of “clean air” or “breathable air” may be a policy issue, but the provision of air itself is not, revealing the contradictory nature of public goods theory. The very introduction of a value judgement, such as deeming air “clean” or “unclean,” implies economic rivalry, negating the relevance of the term “public good.” Another implication of our argument is that, if there is anything left to say about public goods, then only by abandoning the static, neoclassical rendition of the concept of public goods can we more directly focus on the “right” question for political economy: how have certain goods come to embody public characteristics that facilitate social cooperation under the division of labor as a product of human action, though not of human design?

158 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Notes 1. By “public,” we mean non-rivalrous and non-excludable in consumption, as used in the traditional definition of public goods. Although not our focus in this chapter, this does not rule out the fact that the provision of so-called “public goods,” such as national defense, can be used as an ex post justification to advance the private interests of those individuals in government, or special interest groups that benefit from the production of national defense, at the expense of the public interest, in which case they are “public bads” (see Coyne and Hall 2018; Holcombe 1997; Hummel and Lavoie 1994). Our focus, rather, is to understand, under what circumstances, it becomes possible to align the self-interest of individuals in such a manner that they unintendedly produce goods and services that exhibit characteristics that become “public goods.” 2. Besides national defense and lighthouses, there are innumerable other examples illustrative of the private provision of other goods and services often identified as public goods, in which private excludability mechanisms emerged from rivalry. These include, just to name a few, governance of property rights (Anderson and Hill 2004; Leeson 2014), law (Benson 1989), money (White 1984), stock exchanges (Stringham 2015), and private enforcement of intellectual property (see Plant 1974; Cheung 1982; and Cole 2001). 3. We use the word “distinct” here to mean that the modern Austrian paradigm and the modern neoclassical paradigm are not necessarily mutually exclusive of each other, in that they evolved from a common set of principles understood by early neoclassicals of the pre-Second World War era (see Lavoie 1985a). 4. This point is exemplified by the rendition of prices as made by Sanford Grossman and Joseph Stiglitz (1976, 1980) regarding the informational inefficiency of market prices. Given that equilibrium prices embody a state of affairs in which all profit opportunities are eliminated, private arbitrage opportunities are a concentrated cost, the benefits of which are spilled over onto free riders. Thus, they conclude, like other public goods, information will be underprovided by market prices. For a critique of the literature on information economics, see also Barzel (1977). 5. https://en.unesco.org/news/unesco-calls-covid-19-vaccines-be-considered-global-public-good#:~:text=UNESCO’s%20International%20Bioethics%20Com​mit​ tee%20(IBC,are%20made%20equitably%20available%20in 6. This also doesn’t account for the fact private actors will be incentivized to internalize the costs of potentially contracting an infectious disease, and thereby mitigating its spread, implying that the justification for government intervention due to presence of negative externalities is less prevalent than is often supposed. On this point in the context of COVID-19, see Leeson and Rouanet (2021). 7. Related to this point, F.A. Hayek (1973: 37) makes an important distinction between two types of order: exogenous order and endogenous order. The former refers to organizations, such as firms, which are deliberately and consciously directed, whereas the latter refers to spontaneous order, which is based on human action, but not deliberately designed. It may be the case that “competition in the field,” such as in the case of natural monopoly, may correspond to an exogenous order. However, this does not preclude the fact that such as exogenous order was itself dependent, and therefore a by-product of, a broader endogenous order – “competition for the field” – from which a single firm was discovered to be the most efficient producer as a result of rivalrous competition (see also Demsetz

AN AUSTRIAN REASSESSMENT OF THE THEORY OF “PUBLIC GOODS” 159

1973). I thank Steve Horwitz for highlighting these parallel insights between Hayek and Demsetz. 8. For example, the projection of a film in a movie theater is a common example of a non-rivalrous good. In a small town, one movie theater may have a natural monopoly in projecting films, but this doesn’t preclude buying and selling ownership rights over the movie theater itself. 9. On this point, see Rouanet (2022). 10. Economists who have not immediately identified with the Austrian tradition, but have approached this question from a market-process perspective, include Barzel (2000, 2002) as well as Kiser and Barzel (1991). 11. In the context of the US in the 19th century, Jayme Lemke (2016) also frames the creation of the rule of law as a public goods problem. As she states, “even if we assume the universal desirability of property rights reform, an unlikely proposition, legal reform is a public good. Identifying and implementing optimal laws is costly, and the non-rivalrous and non-excludable nature of reform is such that it is theoretically impossible for a private group to internalize benefits sufficient to motivate optimal provision of legal reform” (Lemke 2016: 292). She explains this evolutionary realization of the rule of law through the political enfranchisement of women, and the enforcement of their proper rights as spawned through interjurisdictional competition between political officials in territories seeking voters and the required population to be eligible for statehood. Thus, the rule of law became a public good only through rivalrous competition. One could argue that such an evolutionary process, both economically and politically, may be currently unfolding in China, as recounted by Coase and Wang (2012).

References Aligica, Paul Dragos, Peter J. Boettke, and Vlad Tarko. 2019. Public Governance and the Classical-Liberal Perspective: Political Economy Foundations. New York: Oxford University Press. Anderson, Terry L., and Peter J. Hill. 2004. The Not So Wild, Wild West: Property Rights on the Frontier. Stanford: Stanford University Press. Arrow, Kenneth J. 1969. “The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Nonmarket Allocation.” In Joint Economic Committee, U.S. Congress, the Analysis and Evaluation of Public Expenditures: the PPB System, Vol. 1 (pp. 47–66). Washington, DC: GPO. Barzel, Yoram. 1977. “Some Fallacies in the Interpretation of Information Costs.” Journal of Law and Economics 20(2): 291–307. Barzel, Yoram. 2000. “Property Rights and the Evolution of the State.” Economics of Governance 1(1): 25–51. Barzel, Yoram. 2002. A Theory of the State: Economic Rights, Legal Rights, and the Scope of the State. New York: Cambridge University Press. Benson, Bruce L. 1989. “The Spontaneous Evolution of Commercial Law.” Southern Economic Journal 55(3): 644–661. Benson, Bruce L. 1994. “Are Public Goods Really Common Pools? Considerations of the Evolution of Policing and Highways in England.” Economic Inquiry 32(2): 249–271.

160 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Benson, Bruce L. 1999. “An Economic Theory of the Evolution of Governance and the Emergence of the State.” The Review of Austrian Economics 12(2): 131–160. Boettke, Peter J. 1998. “Economic Calculation: The Austrian Contribution to Political Economy.” Advances in Austrian Economics 5: 131–158. Boettke, Peter J., and Rosolino A. Candela. 2020. “Productive Specialization, Peaceful Cooperation, and the Problem of the Predatory State: Lessons from Comparative Historical Political Economy.” Public Choice 182(3-4): 331–352. Buchanan, James M. 1965. “An Economic Theory of Clubs.” Economica 32(125): 1–14. Candela, Rosolino A. 2020a. “The Political Economy of Insecure Property Rights: Insights from the Kingdom of Sicily.” Journal of Institutional Economics 16(2): 233–249. Candela, Rosolino A. 2020b. “Are Markets Imperfect? Of Course, But That’s The Point!” The Library of Economics and Liberty, May 18. https://www.econlib.org/ are-markets-imperfect-of-course-but-thats-the-point/ Candela, Rosolino A., and Vincent J. Geloso. 2018. “The Lightship in Economics.” Public Choice 176(3/4): 479–506. Candela, Rosolino A., and Vincent J. Geloso. 2019. “Why Consider the Lighthouse a Public Good?” International Review of Law and Economics 60(2019): 105852. Candela, Rosolino A., and Vincent J. Geloso. 2020. “The Lighthouse Debate and the Dynamics of Interventionism.” The Review of Austrian Economics 33(3): 289–314. Chadwick, Edwin. 1859. “Results of Different Principles of Legislation and Administration in Europe; of Competition for the Field, as Compared with Competition within the Field, of Service.” Journal of the Statistical Society of London 22(3): 381–420. Cheung, Steven N.S. 1982. “Property Rights in Trade Secrets.” Economic Inquiry 20(1): 40–53. Coase, Ronald H. 1974. “The Lighthouse in Economics.” The Journal of Law & Economics 17(2): 357–376. Coase, Ronald H., and Ning Wang. 2012. How China Become Capitalist. New York: Palgrave Macmillan. Cole, Julio H. 2001. “Patents and Copyrights: Do the Benefits Exceed the Costs? Journal of Libertarian Studies 15(4): 79–105. Congleton, Roger D. 2011. Perfecting Parliament: Constitutional Reform, Liberalism, and the Rise of Western Democracy. New York: Cambridge University Press. Cowen, Tyler. 1985. “Public Goods Definitions and their Institutional Context.” Review of Social Economy 43(1): 53–63. Cowen, Tyler. 1990. “Economic Effects of a Conflict-Prone World Order.” Public Choice 64(2): 121–134. Coyne, Christopher J., and Abigail R. Hall. 2018. Tyranny Comes Home: The Domestic Fate of U.S. Militarism. Stanford: Stanford University Press. Demsetz, Harold. 1968. “Why Regulate Utilities?” The Journal of Law & Economics 11(1): 55–65. Demsetz, Harold. 1969. “Information and Efficiency: Another Viewpoint.” The Journal of Law & Economics 12(1): 1–22. Demsetz, Harold. 1970. “The Private Production of Public Goods.” The Journal of Law & Economics 13(2): 293–306. Demsetz, Harold. 1973. “Industry Structure, Market Rivalry, and Public Policy.” The Journal of Law & Economics 16(1): 1–9.

AN AUSTRIAN REASSESSMENT OF THE THEORY OF “PUBLIC GOODS” 161

Geloso, Vincent J., and Alexander W. Salter. 2020. “State Capacity and Economic Development: Causal Mechanism or Correlative Filter?” Journal of Economic Behavior & Organization 170: 372–385. Grossman, Sanford J., and Joseph E. Stiglitz. 1976. “Information and Competitive Price Systems.” The American Economic Review 66(2): 246–253. Grossman, Sanford J., and Joseph E. Stiglitz. 1980. “On the Impossibility of Informationally Efficient Markets.” The American Economic Review 70(3): 393–408. Hayek, F.A. 1973. Law, Legislation and Liberty, Volume 1: Rules and Order. Chicago: University of Chicago Press. Hayek, F.A. 1978 [1968]. “Competition as a Discovery Procedure.” In New Studies in Philosophy, Politics, Economics and the History of Ideas (pp. 179–190). London: Routledge & Kegan Paul. Holcombe, Randall G. 1997. “A Theory of the Theory of Public Goods.” The Review of Austrian Economics 10(1): 1–22. Hummel, Jeffrey Rogers, and Don Lavoie. 1994. “National Defense and the Public Goods Problem.” Journal des Economistes et des Etudes Humaines 5(2/3): 353–377. Jones, Eric. 1981. The European Miracle: Environments, Economies and Geopolitics in the History of Europe and Asia. New York: Cambridge University Press. Kiser, Edgar, and Yoram Barzel. 1991. “The Origins of Democracy in England.” Rationality and Society 3(4): 396–422. Kuhn, Thomas S. 1996 [1962]. The Structure of Scientific Revolutions, 3rd Ed. Chicago: University of Chicago Press. Lange, Oskar. 1936. “On the Economic Theory of Socialism: Part One.” Review of Economic Studies 4(1): 53–71. Lange, Oskar. 1937. “On the Economic Theory of Socialism: Part Two.” Review of Economic Studies 4(2): 123–142. Lavoie, Don. 1985a. Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered. New York: Cambridge University Press. Lavoie, Don. 1985b. National Economic Planning: What is Left? Cambridge: Ballinger Publishing Company. Leeson, Peter T. 2014. Anarchy Unbound: Why Self-Governance Works Better Than You Think. New York: Cambridge University Press. Leeson, Peter T., and Louis Rouanet. 2021. “Externality and COVID-19.” Southern Economic Journal 87(4): 1107–1118. Lemke, Jayme. 2016. “Interjurisdictional Competition and the Married Women’s Property Acts.” Public Choice 166(3): 291–313. Lerner, Abba P. 1934. “Economic Theory and Socialist Economy.” The Review of Economic Studies 2(1): 51–61. Lerner, Abba P. 1935. “Economic Theory and Socialist Economy: A Rejoinder.” The Review of Economic Studies 2(2): 152–154. Lerner, Abba P. 1936. “A Note on Socialist Economics.” The Review of Economic Studies 4(1): 72–76. Lerner, Abba P. 1944. The Economics of Control. New York: Macmillan. Menger, Carl. 1981 [1871]. Principles of Economics. New York: New York University Press. Minasian, Jora R. 1964. “Television Pricing and the Theory of Public Goods.” The Journal of Law & Economics 7: 71–80. Mises, Ludwig von. 1975 [1920]. “Economic Calculation in the Socialist Commonwealth.” In F.A. Hayek (Ed.), Collectivist Economic Planning (pp. 87–130). Clifton: Augustus M. Kelley.

162 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

Mises, Ludwig von. 2005 [1927]. Liberalism: The Classical Tradition. Indianapolis: Liberty Fund. Mises, Ludwig von. 1966 [1949]. Human Action: A Treatise on Economics, 3rd Ed. Chicago: Henry Regnery. Morgan, Mary S. 2012. The World in a Model: How Economists Work and Think. New York: Cambridge University Press. Olson, Mancur. 1971 [1965]. The Logic of Collective Action: Public Goods and the Theory of Groups. Cambridge: Harvard University Press. Plant, Sir Arnold. 1974. Selected Economic Essays and Addresses. London: Routledge & Kegan Paul. Rosenberg, Nathan, and L.E. Birdzell, Jr. 1986. How the West Grew Rich: The Economic Transformation of the Industrial World. New York: Basic Books. Rothbard, Murray N. 1981. “The Myth of Neutral Taxation.” Cato Journal 1(2): 519–564. Rouanet, Louis. 2022. “Foutu Maximum: The Political Economy of Price Controls and National Defense in Revolutionary France.” Explorations in Economic History, 101478. Salter, Alexander W. 2015. “Rights to the Realm: Reconsidering Western Political Development.” American Political Science Review 109(4): 725–734. Salter, Alexander, and Abigail R. Hall. 2015. “Calculating Bandits: Quasi-Corporate Governance and Institutional Selection in Autocracies.” Advances in Austrian Economics 19: 193–213. Samuelson, Paul A. 1954. “The Pure Theory of Public Expenditure.” Review of Economics and Statistics 36(4): 387–389. Samuelson, Paul A., and William D. Nordhaus. 2009. Economics, 19th Ed. New York: McGraw-Hill. Stringham, Edward Peter. 2015. Private Governance: Creating Order in Economic and Social Life. New York: Oxford University Press. White, Lawrence H. 1984. Free Banking in Britain: Theory, Experience, and Debate, 1800–1845. New York: Cambridge University Press.

Conclusion: Steve Horwitz (1964–2021): teacher, scholar, and public intellectual Peter J. Boettke

I first met Steve in the spring of 1985. Dave Prychtiko and I were already best friends when our professor Don Lavoie asked us to take a “hot recruit” to lunch and convince him to join the Center for the Study of Market Processes at George Mason University for his PhD studies. We gladly obliged, but we weren’t going to treat the new kid exactly the way Lavoie wanted us to – we were ourselves too cocky to do that. Instead, we decided to grill our potential new comrade as hard as we could. That conversation ranged from questions about Kirzner, Nozick, Rand, and the University of Michigan. Steve was a proud soon to be graduate of Michigan. The details of that first conversation are less important than the fact that it served as the basis of what became a 30+ year conversation of great joy and constant curiosity about all things economics, politics, philosophy, and life in general. The three of us became inseparable friends for the rest of our time at GMU. Dave and I graduated in 1988, Steve in 1989, and all three of us wrote our dissertations with Don Lavoie. In the process, we had the opportunity to study with Kenneth Boulding, to study with James Buchanan and watch him win a Nobel Prize, to study with Viktor Vanberg and wrestle with a draft copy of Hayek’s last book The Fatal Conceit, and to study with Michael Alexeev and discuss the last days of socialism in practice in East and Central Europe and the former Soviet Union. It was, indeed, a heady time to study and debate economic issues. And, in 1987, there was also a stock market “crash” which once more put the Austrian theory of the trade cycle into conversation. Heady days indeed. Steve was among my closest friends personally and professionally for all the years since. We shared a bond of youthful aspirations and ambitions, as 163

164 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

well as a long history of trials and tribulations, and finally professional and personal satisfaction. Steve was a happy warrior, he loved to win an argument with fellow economists, but he understood to win an argument you had to be part of a conversation. We lived by the motto – work in proportion to your aspirations. We had high aspirations as teachers and scholars, but we also were evidence-based enough that we knew when and how to check delusions. Steve, also, from the beginning had an itch to be a public intellectual in a way that neither Dave nor I ever really did. Not only did he have an itch, he had skills as I will discuss shortly. But most of all, I think one of the things that excited the three of us more than our fellow classmates was the desire to teach economics. We embraced our roles as teachers and we took great pride in the content of our courses as well as the evaluations we received. In 1987–88, my last year in graduate school, I was awarded for these efforts by being hired to a full time faculty position in the department of economics at GMU – in my assessment then (and now) the greatest faculty of economics in the world. I was appointed Assistant Professor, I had my own office, full salary and benefits, but it was a one-year appointment and came with a 4-4 teaching load. I was in heaven. The following year, Steve received that same appointment and with the same joy. The position was never filled again after that. As teachers, our primary motivation was to communicate the “economic way of thinking” as effectively and as persuasively as possible. We all used Paul Heyne’s book The Economic Way of Thinking, and supplemented it with various other works, such as the first chapter from Murray Rothbard’s Man, Economy and State. Steve was a master teacher at GMU, and then at Saint Lawrence University for the following 20 years. In his teaching career, Steve taught principles, comparative systems and of course money and macro. He also took great pride in his role in SLU’s freshman program and taught interdisciplinary courses, including a pivotal one on the modern family. What is perhaps not as well known is that, for many years, Steve also taught as a side gig for Mercatus at GMU, holding seminars for graduate students in our program, teaching them to learn to write and how to navigate the job search process. Steve took his task as a teacher seriously and constantly sought to perfect his craft, a theme I will return to when I discuss Steve as a public intellectual. In addition to excelling in the classroom, Steve was a consistent and persistent research scholar, publishing peer-reviewed journal articles, academic books, as well as more popular policy analysis and public intellectual contributions.

CONCLUSION 165

His main fields of study were money and macroeconomics, economic thought and methodology, and social theory. One can get a good sense of his contributions to these fields by listening to his appearances on podcasts such as MacroMusings and Economic Rock Star, or doing a search on YouTube for various lectures and public talks, and perhaps, most of all, his last extensive interview with Competitive Enterprise Institute on the occasion of him winning the Julian Simon Award in 2020. Steve’s first book, based on his dissertation, was Monetary Evolution, Free Banking and Economic Order, and it established him as the leading thinker in my generation of Austrian economists working on monetary theory and policy. He was a student of Don Lavoie, but he was also mentored by George Selgin. Steve would make his major contribution to the field with his Microfoundations and Macroeconomics, in which he developed his unique take on monetary disequilibrium theory. Besides the Simon Award, one of Steve’s fondest professional accomplishments was actually when he was asked to deliver the Frank P. Piskor Lecture at SLU in 1999. He worked hard on that presentation, and the essay he produced is a masterful demonstration of his skills as a historian of economic ideas: “‘Of Human Action but not Human Design’: Liberalism in the Tradition of the Scottish Enlightenment.” Steve wrote several such essays and, in fact, a book of his collected essays on the history of thought would be a most welcome addition. He obviously knew the Austrian tradition thoroughly – see his course on YouTube on Austrian Economics as well as the accompanying monograph Austrian Economics: An Introduction – but Steve also had a great knowledge of all the traditions that the Austrian school bumped into along its long evolutionary path, including Marxism, Keynesianism, Institutionalism, Old Monetarism, New Classical, etc. When Steve and I were students at GMU, Buchanan circulated a paper for all of us to read that he was going to publish in the New Palgrave Dictionary of Economics that was then in preparation, “Political Economy and Social Philosophy.” The intellectual world we occupied divided our field into three broad branches – technical economic science, political economy (which included law and economics as well as public choice and constitutional economics), and social philosophy (liberalism broadly, libertarianism more narrowly). Through the years since, Steve and I maintained seeing the world of our discipline in this way. My point is simply that social theory was not some passing interest for Steve, it was an intellectual preoccupation of his from the very beginning of his career. He was very proud of the argument he developed and executed in his book Hayek’s Modern Family.

166 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

The final area of Steve’s contributions I want to stress is his work as a public intellectual on TV, radio, blogs, podcasts and Facebook. He utilized Facebook to promote intellectual conversation far greater than any other contemporary academic I know. Steve might have pivoted to Twitter were it not for his illness, but he was relentless on Facebook. I want to stress something about this. Steve saw his public intellectual engagement as an extension of his role as a teacher. And again his role was to stimulate conversation, not to dictate that conversation. I think this is why so many cherished his Facebook persona, he was no doubt provocative and willing to discuss any idea from technical economics to high and low culture with regard to arts, cinema, TV and most of all music. But while provocative, Steve invited critical dialogue and engagement. This was already true in his interactions on blogs – both at Coordination Problem and later at Bleeding Heart Libertarianism. But his multiple postings per day on Facebook, often targeted at the younger generation of intellectually curious students, provide a demonstration of just how serious he took his role as a teacher in a free and self-governing democratic society. A key aspect here is Steve actually never privileged himself above the fray, but considered any and all arguments fair game for critical engagement and reflection. What mattered was the quality of argument – logic and evidence – and not who made the argument. I am sure his legions of fans appreciated that about him, and miss him dearly in their social media engagements. Steve Horwitz was an excellent economic thinker who was taken from us too soon due to cancer. We used to joke about the longevity of Austrian economists, those jokes today seem cruel to me, as Steve and his family were robbed of so many years and adventures. I miss my friend dearly. I am very excited to see this volume that he started come to completion. Steve cared deeply about how Austrian economics would carry on as an empirical research program capable of capturing the imaginations of the next generation. One of his first published papers in graduate school was a paper on the Panic of 1907 in the Southern Economic Journal. A detailed economic history paper, doing what might be called micro-history, which as students of Lavoie we all viewed as the primary empirical approach for Austrian economics. Steve identified Louis Rouanet as the best partner for him to work with during those final days as he fought cancer to help him finally get this volume planned and completed. Louis was certainly the right choice, as an accomplished scholar of Austrian economics, political economy and economic history himself. So I want to end with a word of thanks to Louis for completing this project and for the example of scholarship he is setting for his peer group and his students, and for the opportunity he gave me to remember my collaborator and dear friend – Steve Horwitz – on this occasion. Steve once said, at the end of the day he was

CONCLUSION 167

a teacher. And indeed, he was a teacher whose influence I hope will reverberate through the years.

Acknowledgements This chapter is based on remarks prepared for the Institute for the Study of Political Economy at the Ball State University conference “Building on the Intellectual Contributions of Steve Horwitz”, June 12–13, 2022. Thank you to Todd Nesbit for organizing the conference to honor Steve’s contributions and for the opportunity for me to speak in memory of my long-time friend and collaborator.

Index

ABCT see Austrian business cycle theory (ABCT) accounting accounting framework 130–33 accounting rules 139, 142 connecting economics with field of 139 context 129–30 data on cost and earnings 134 alertness concept 57, 139, 142 antitrust policy 71 applied economics xii–xiv, xv, xvi–xvii, xix, xx, xxii, 97–8 arbitrage opportunities 81, 158 asymmetric information 71–2, 73 Austrian business cycle theory (ABCT) context 21–2 and interest on reserves 26–30, 38, 40, 41 limitation of 39 macroeconomics 139–40 and malinvestment 30–33 Austrian economics as alive and evolving xx approach to social science 90 and behavioral economics 94–105 capital and cost in 129–41 connection with Public Choice 79 context xi–xiii cross-citation analysis 51–60 economics of interventionism deriving from 70 Horwitz’s contributions 165, 166–7 journals 52, 57–60, 64 and mainstream entrepreneurship 45, 48–51, 54, 56, 61–4 and militarism 4–12

reassessing public goods theory 145–57 research agenda EPE and Viennese shaping 122–6 overview xx pitfalls xiii–xx post-crisis 21–39 as study of market processes 117–18 Becker, G. S. xii, xviii, xxi, 85, 106 behavioral economics and Austrian economics 94–105, 107 context 89–91, 106 definition 89–90 introduction to 91–4, 106 and market failure problems 84 behavioralism xvii–xviii bibliometric analysis 45, 51–60 blinking 95, 106 blood markets 82–3 Boettke, P. J. xvii, xix, xxi, 9, 32, 42, 46, 59, 85, 94, 97, 100, 103, 107, 108, 124, 146, 149, 150, 153 Böhm-Bawerk, E. von 78, 85, 113, 129, 130, 131, 141 “bounded rationality” xviii, 90, 105 Buchanan, James M. 4, 5, 14, 59, 69, 76–7, 79–80, 84, 85, 94, 101, 114, 134, 142, 150, 165 bureaucratic incentives 34–5 Cantillon effects 138–9, 141 capital as finance in accounting framework 130–33 value, cost, and choice 133–6 169

170 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

capital theory 129, 130–31, 134, 137, 139, 141 catallactics 76–7, 78, 79, 80, 83 Chicago tradition 69–70, 76–9, 80 choice and capital 133–6 irrationality of 96 see also logic of choice; Public Choice; rational choice Coase, R. H. xii, 69, 73–4, 76, 77, 78, 79, 82, 83, 84, 142, 150, 156, 159 comparative institutional analysis 70, 78–9, 81–2 constitutional political economy (CPE) 85, 114–15 Coyne, C. J. 1, 3, 5, 6–7, 8, 9, 10–11, 12–13, 14, 15, 59, 60, 158 cross-citation analysis see bibliometric analysis defense contemporary Austrian contributions to 6–12 identified as crucial function of government 4 national, provision of 153–5, 158 “defense brain” 12–13 defense economics 1, 6, 8, 12–13 Dekker, E. 113, 117–18, 119–20, 121–2, 126 democracy 117, 120, 126, 153, 154 Demsetz, H. 69, 70, 72, 74–6, 84, 149, 150, 152, 158–9 disequilibrium xviii, 129, 132, 134, 165 ecological rationality 107 economic calculation xxii, 5, 8, 81, 84, 138–9, 146–7, 153–4 economic education 164, 166–7 economic history xiii, xvii, 9, 100, 107, 166 economic theory xv–xvii Economic Value Added (EVA) 137–41, 142 economics and law 98–100 efficiency 33, 70, 74–5, 77, 78–9, 81–3, 85, 155, 158 Elster, J. 100, 107–8 endogenous order 158

enforcement theory of regulation 70, 78–9, 80, 82, 83 entangled political economy (EPE) commonalities with Viennese students of civilization 113–14, 117–22 family tree 115 future research areas 122–5 nature of 113, 114–17 study conclusions 125–6 entrepreneurship and ABCT 26–7 and alertness concept 139, 142 behavioralists ignoring 97 and capital 131, 132, 134, 135 and defense sector 7 institutional 153–4 and interventionism 81 market 9, 125 as market process 113, 117 and new profit opportunities 85–6 political 9, 10–11, 125, 154 rivalry example 156–7 role in Austrian discussions of militarism 9, 10–11 unproductive 7, 10 see also mainstream entrepreneurship EPE see entangled political economy (EPE) epistemic limits, recognition of 120–22 excludability 150–52 exogenous order 158 externality argument 69, 70, 71–2 externality problems 72, 74, 78, 150–51, 158 Federal Reserve authorization to pay interest on reserves 22, 24, 39–40 bureaucratic incentives 33–4 context 21–2 credit footprint 30–32 decision-making at 32–3 excess reserves of depository institutions 28 incorporating interest on reserves into ABCT 26, 29 interpretation of law regarding interest on reserves 37, 39, 41

INDEX 171

M1 and M2 money multipliers 29 monetary policy before and after financial crisis 22–5, 27 and monetary rules 37–8, 39 net revenues 36 no longer differentiating between required and excess reserves 40 political economy of post-crisis operating framework 33–6, 37 political incentives 35–6 recommendations 38–9, 42 share of cash assets to total bank assets 30 share to commercial bank assets 31–2 yields on long-term debt 28 finance and alertness concept 139 behavioral 100 capital as, in accounting framework 130–33 context 129–30 making capital theory intelligible 141 public 5 financial framework 137–41 financial management 136–7 free lunch fallacy 75 free-riding 148, 153, 154, 155, 156–7 Friedman, M. xii, 23, 33, 41 Glaeser, E. L. 70, 78–9, 80, 82, 84 government intervention 69, 72, 73, 74, 76, 77, 80, 84, 85–6, 101, 104, 105, 108, 148, 150, 158 grass is always greener fallacy 75, 76 Hall, A. R. 1, 3, 5, 6, 8, 9, 10, 11, 12, 13, 14, 15, 153, 158 Hayek, F. A. von xiii, xvi–xvii, xix, xxi, 4, 5, 6, 8, 13, 26, 32, 40, 47, 49, 50, 57, 80, 81, 101, 103–4, 105, 108, 122, 130, 131, 136, 141, 142, 147, 151, 158–9, 163, 165 Hayekian triangle xiv–xv, 139 history of economic thought xiii, 165, 166

Horwitz, Steve xii, 26, 39 belief in Austrian economics xx tribute to 163–7 imperfect markets 149–50 incentive arguments 69, 70, 78–9, 85 incentive problems 69, 70, 76–8, 80, 82, 83 incentives in Austrian economics and mainstream entrepreneurship 61, 62 and blood banks 82–3 bureaucratic 34–5 and decision-making 32 in defense/security sector 7, 10, 11 individual 7, 8, 116 and information 136 market 30 political 22, 31, 34, 35–6, 38 prevalence of low-powered 94 and progressive era reform 83 provision of effective, through clear and defined property rights 50 in public interest theory of regulation 71, 77 regulation changing 83 inclusive rationality 107 information aggregate 72, 73, 78, 79, 82, 83 asymmetric 71–2, 73 and behavior 98, 100, 107 and capital 132, 133 Coase on 74, 77 Demsetz on 76 dispersed 82, 83 government monopoly on 12 Hayek on 81, 103 incentives interacting with 136 Kirzner on 81 local 80 and market prices 148, 158 and militarism 15 partial 77 relevant, accounting for and accessing 69–70 Sunstein on 103–4 information costs 84, 99

172 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

information processing 91, 92–3, 103, 105 institutions 140–41 insulating strategies xix–xx interest on reserves and ABCT 26–30, 38, 40, 41 and bureaucratic incentives 34–5 Federal Reserve’s authorization to pay 22, 24, 39–40 Federal Reserve’s interpretation of law regarding 37, 39, 41 as Federal Reserve’s primary instrument of monetary policy 25 and malinvestment 30–33 political economy of 33–6 and political incentives 35–6 intervention and behavioral public policy 101, 102, 104 concept 8–9 credit market 33 dynamics of 10, 11, 34, 78 effect on entrepreneurial process 81 foreign 2, 3, 9, 11, 13 justification for 70, 83, 146 Lavoie’s ideas on 15 military 2, 6, 11 monetary 8 neutrality of 6 political 118 scaled 123–4 state 146 and underproduction 72 in whole blood markets 82–3 see also government intervention interventionism 1, 8–9, 15, 33, 70, 79–83 Kahneman, D. 90, 91–2, 93, 106, 107 Kirzner, Israel M. xiii, 7, 9, 49, 50–51, 52–3, 56, 57, 78, 81, 94, 139 knowledge about and from civilization 121 and central planners 8, 11, 149 and competition 9 dispersed 8, 80, 117, 121, 136 of effectiveness 107 entrepreneurial 49 generation of 120 intervention in vacuum of 83

market forces fuelling creation of 118 and market institutions 32, 50 and militarism 15 and monetary rules 37 and prices 81 knowledge aggregation 74, 79, 80, 82, 83 knowledge constraints 6, 8 knowledge problems xiv, 5, 69–70, 72–3, 80, 83–4, 101–2, 123, 136 Lavoie, Don 5, 7, 15, 145, 147–8, 151, 152, 153, 158, 163, 165, 166 law and economics 98–100 Leeson, P. T. xii, xxi, 63, 98–9, 107, 124, 158 liberalism conditions necessary for 114 constitutional political economy’s approach to 114–15 democracy threatening 117, 120, 126 outlook of Viennese shaped by 113 shared concern over vulnerability of 119–20 as sustaining peace and cooperation 4–5 libertarian paternalism 108 lighthouses 125, 145, 155–7 lightships 125, 156–7 logic of choice xii, xiv, 103, 105, 133, 134, 135 loss aversion 91–2 macroeconomics 139–40 mainstream entrepreneurship Austrian scholarship’s role in 48–51 bibliometric analysis 51–60 brief history of 46–8 context 45 current state of field 48–50 foundations and trajectories 50–51 future of 61–3 recommendations 63–4 see also entrepreneurship malinvestment 22, 26, 29, 30–33, 38, 39 market design 123 market failure and imperfect markets 149, 150 lighthouses as prone to 155–6

INDEX 173

market design as solution to 123 monopoly-related 71, 72–3, 152 Pigouvian critique 69 and welfare implication of public goods theory 148 market failure–government intervention orthodoxy 74, 148 market failure problems 71–3, 78, 80, 84, 85, 123, 149, 150 market failure theory 78, 82, 107 market process Austrian economics as study of 117–18 and behavioral economists 97 and bureaucratic decision-making 32–3 catchphrase xiv contributions to study of 113 creativity of xxi emphasizing 76 entrepreneurial 46, 61, 81 governments and command and control 101 Hayek’s admiration of 122 and knowledge 121 perspective on rivalry and excludability 150–52 and public goods theory 146–7, 149, 150, 155, 159 McChesney, F. S. 95–6, 99–100, 125 Menger, C. xi, xxi, 46, 113, 114, 117, 120, 129, 134, 151 mental accounting model 93 meta-theorizing xiii–xiv methodological individualism 7, 12–13, 79, 113, 117 microeconomics 138–9 militarism contemporary Austrian contributions to 6–12 context 1 definitions 2 existing literature 2–4 future study areas 12–15 key Austrian scholars and discussions of 4–5 militarization Austrian discussions of 7–8, 15 Austrian literature on 10, 13 of border security 10–11

conceptualization 2–3 context 1 earliest Austrian studies of 9 of economy, and planning 5, 15 of far-right extremist groups 11–12 of government agencies 13 of labor 4 police 11, 14–15 process of 7, 12 trends 14–15 Mises, L. von xii, xiii, xiv, xv, xviii, xix, xxi, xxii, 4–5, 6, 8, 10, 13, 26, 33, 49, 50, 72, 78, 80–81, 83, 85, 94–6, 104, 106–7, 130–32, 133, 141 misguided realism xiv–xv monetary policy before financial crisis 22–3 following financial crisis 24–5 future research areas 38 impact of overly expansive 21 and interest on reserves 25, 30, 32, 33–4, 40–41 and monetary rules 37–8, 42 and neutrality 8 political environment 33–4, 41–2 transmission channels 140 monetary rules 22, 37–8, 39, 42 monopoly 12, 71, 72–3, 84–5, 145, 152, 157, 158, 159 moral hazard 75 national defense 153–5, 158 neoclassical economics xvii, xviii, xx, 90, 100–101, 104–5, 107, 114–15, 119, 129, 132, 142, 149 neutrality 6, 8–9 nirvana approach 75 Nirvana Fallacy 149 non-comprehensive planning 5, 15 non-rivalrous (or non-excludable) goods 71, 146, 148, 149, 150, 151, 152, 155, 156–7, 158–9 nudging 101–2, 104, 108, 123 people could be different fallacy 75, 76 Pigou, A. C. 69, 70, 71, 74, 80 Pigouvian perspectives/theories 69, 70, 74, 76, 77, 78, 80 Pigouvian welfare economics 69, 84

174 A RESEARCH AGENDA FOR AUSTRIAN ECONOMICS

political economy and abandonment of static concept of public goods 157 as discipline branch 165 economic calculation as fundamental contribution to 146–7 and economic history 100 imperialism from perspective of 14 of interest on reserves 33–6 need to consider issues of 37–8 see also entangled political economy (EPE) political entrepreneurship 9, 10–11 political incentives 22, 31, 34, 35–6, 38 political sovereignty 13 politics as exchange 76, 77, 79–80, 85 preferences xii, xv, xvi, xvii, xxii, 8, 116 in behavioral economics 91–2, 95–6, 99, 100, 102, 104, 106, 107, 149 time 26, 27, 33 processes ABCT 26 of artificial credit expansion, 22 civilizing 114, 118, 122 competition as 9 decision-making 102 of economic rivalry 149 entrepreneurial 10, 46, 48–9, 60, 61, 63, 81 evolutionary 153, 155, 159 Federal Reserve 23, 39, 40 of free-riding on achievement of others 153 governmental 75 interpretation of 121 knowledge aggregation 72 mental 96, 100, 134 of militarization 7, 12 military contracting 10 military procurement 10 money supply 37 nudging 101 political 33, 36, 41, 69–70, 76, 77, 85, 124 production 131, 132, 152 spontaneous order 114, 117, 123 of transformation 115 see also market process

profit opportunities 9, 10, 85–6, 96, 152, 154, 158 property rights 50, 69, 72–4, 76, 77, 78, 79, 80, 82–3, 85–6, 102, 140, 147, 149, 150–51, 153, 154, 158, 159 prospect theory 93–4, 106 psychology xviii, 49, 89–90, 91, 96, 106 public choice 37, 39, 70, 76, 77, 78, 79–80, 83, 84, 165 Public Choice tradition 62, 69, 70, 76–9, 80, 82, 83 public goods application of socialist calculation 148–9 context 145–6 development of modern theory 146–7 and imperfect market question 149–50 implications 158 as market failure problem 71–2 as outcomes of rivalry 153–7, 158 rivalry and excludability 150–51, 152 public interest theory of regulation 71–3 critiques 73–9, 85 dismantlement 80 rational aspirations 122 rational behavior xii, xxi, 94–9, 102, 104, 106–7, 108 rational choice xix, 79, 96, 97, 100, 105 rational decision-making 12 rational economic calculation 5, 8, 81, 147 rational expectations xxi, 103 rationality 77, 95–8, 99, 102, 106, 107, 108, 115 rationality of preferences 95–6, 104 regulation of funerals 99–100 government 78, 150, 156 and incentives 71, 76–8, 82, 85 of market for organs and military draft 99 and social losses 78, 85 see also enforcement theory of regulation; public interest theory of regulation regulatory incentive problems 76–8 regulatory studies 69, 77–8

INDEX 175

representative bias 93 research agenda cognition and entrepreneurs 49 EPE and Viennese shaping 122–6 overview xx pitfalls xiii–xx post-crisis 21–39 risk-shifting 75 rivalry 146, 147–50 market process perspective 150–52 public goods as outcomes of 153–7, 158 Rizzo, M. J. xviii, 96, 97–8, 100–101, 105, 107, 115, 123 Schumpeter, J. A. 113, 117, 125 self-governance xii, 124–5 Shleifer, A. 70, 78–9, 80, 82, 84 social cost 73–4, 84, 101 social losses 78, 85 socialism xi, 4–5, 14, 119, 125, 147–9, 163 socialist calculation debate 5, 80, 81, 147–9 society, study of 113, 117–19 spontaneous order xiv, xix, 85, 105, 114, 117, 123, 158 Stigler, George 69, 74, 77, 79, 80, 83, 85, 106 subjective value 129 subjectivism xii, 102, 113, 117 Sunstein, C. R. 103–4, 108 Thaler, R. 90, 105, 106, 108

time 129, 130–32, 135–6, 137–8, 141, 142 Tullock, Gordon 6, 69, 76–7, 80, 84–5 Tversky, A. 90, 91–2, 93, 106, 107 uncertainty xiv, xvii, xix, 23, 49, 91–2, 113, 117, 133, 136, 141, 152 utility theory 91 Austrian 94–5, 103 axiomatic 104 neoclassical 104 standard expected 91–2, 93, 98–9, 106 vaccinations 151–2 value 129, 131–2, 133–8, 139, 141, 142 Viennese students of civilization commonalities with EPE 113–14, 117–22 future research areas 122–5 nature of 113 study conclusions 125–6 Wagner, R. E. 9, 61, 85, 113, 114–17, 118–19, 120, 121, 125 welfare economics 69–70, 71, 74, 76, 77–8, 80, 82, 83, 84, 100, 101, 104–5 Whitman, G. 94, 97–8, 100–101, 102–3, 105, 107, 123 Zywicki, T. J. 96, 98, 99