Sunday, September 15, 2013

Austrian School Methodology

I want to thank Luke Westman from The Analytical Economist blog for devoting the time to have this friendly, serious, & meaningful discussion on the subject of how best to study economics from a methodological perspective. I will be presenting the case for the Austrian methodology while Luke will be presenting the methodology used by the Chicago School and others in the Neoclassical tradition.

While it is no surprise that the Chicago and Austrian Schools of Economics share many things in common with regards to a free market analysis and conclusions, I do think it is critically important to highlight the difference in methodology and how best to “do economics.”

Scientific Laws of Physical Sciences

It is no surprise a dichotomy exists between certain sciences. On the one side are the natural/physical sciences (Physics, Chemistry, Biology, etc.). On the other hand are the social sciences (Economics, Law, Anthropology, History, Sociology, etc.). The physical sciences study the natural world of matter (atoms, elements, compounds, etc.) and how different objects react to each other under certain conditions of motion or stimuli. This discipline aims to discover certain causal laws of nature. The substances under investigation in the natural world cannot choose how they react to stimuli, but through observation and understanding we can come to know these objects and categorize them by their properties and their behavior. As Rothbard states,

“Stones, molecules, planets cannot choose their courses; their behavior is strictly and mechanically determined for them.” (Rothbard, 2011, p. 3)

In the physical sciences, the scientific method is the technique used to derive knowledge, conclusions, and scientific laws using empirical hypothesis testing. This is the best approach to deriving so-called laws of nature since this realm is unintelligible.  To arrive at these casual laws of nature we employ the best means available to investigate this seemingly unintelligible world of phenomenon, a realm in which the subjects under investigation cannot communicate with us.

The procedure of the empirical scientific method goes something like this: 1) forming a hypothesis/conjecture, 2) gathering data relevant to hypothesis, 3) testing the data against the hypothesis and 4) stating a conclusion of whether the hypothesis failed or did not fail.

The presuppositions of the scientific method are important to our current discussion. The first presupposition is that events must be reproducible or repeatable. If we’re interested in examining the law of gravity, the events demonstrating this law should be reproducible by other independent scholars for confirmation/falsification. Second, the effects that are being hypothesized about are quantitatively definite. This is to say that a quantitative mathematical formulation/equation can be given to represent the hypothesis and demonstrate a precise quantitative aspect of the relationship. Third, effects are invariant across time and place operating universally. That is to say that in the realm of the physical sciences, the nature of things remains the same. The implication of the scientific method is that we can do scientific prediction given the universality of the hypothesis. For example, based on the law of gravity, we recognize its universality that two objects will behave the same regardless of whether they are dropped from the Eiffel Tower in the 19th Century or from the Sears Tower in Chicago tomorrow.

Scientific Laws of Human Action

In the social sciences, the realm of investigation deals with studying man. What is the proper way to study man? Can we import the same methodology as used in the physical sciences? What can we say about economics? And, should the methodology of economic science closer resemble Physics or that of Applied Logic?

Mises and others before him argued the study of man differed from the study of the physical sciences and thus required a distinctly different approach.

Mortal man does not know how the universe and all that it contains may appear to a superhuman intelligence. Perhaps such an exalted mind is in a position to elaborate a coherent and comprehensive monistic interpretation of all phenomena. Man--up to now, at least--has always gone lamentably amiss in his attempts to bridge the gulf that he sees yawning between mind and matter, between the rider and the horse, between the mason and the stone. It would be preposterous to view this failure as a sufficient demonstration of the soundness of a. dualistic philosophy. All that we can infer from it is that science-at least for the time being-must adopt a dualistic approach, less as a philosophical explanation than as a methodological device.

Methodological dualism refrains from any proposition concerning essences and metaphysical constructs. It merely takes into account the fact that we do not know how external events -- physical, chemical, and physiological -- affect human thoughts, ideas, and judgments of value. This ignorance splits the realm of knowledge into two separate fields, the realm of external events, commonly called nature, and the realm of human thought and action. (Mises, 1985, p. 1)

Mises argues there are two distinct realms of knowledge and this is fundamental to the way the scientist approaches his particular field of inquiry.

Rothbard also recognizes the dualist approach:

In the behavior of physical objects, science begins by empirical observation of constant relations, and then frames tentative hypotheses of explanatory laws, these hypotheses being always subject to testing and revision by referring their deduced consequents to controlled experiments, where all but the relevant, isolated factors are held constant. This is the “scientific method” of physics. But in the study of human action, as Mises shows, the reverse is true; here, we begin by knowing the causal laws: by knowing the fact of human consciousness, of free will, of motivated, purposeful action of human beings in using given means for the attainment of desired ends. (Rothbard, 2011, p. 26)

History of the Dualist Approach in Economics

Mises was not the first to recognize this methodological approach. He simply systematized that which other before him had always recognized and acknowledged. Other famous thinkers of political economy in the Classical tradition had long recognized this dualism. John Cairnes, Nassau Senor, J.B. Say, and most notably Lionel Robbins all held this dualist position. Lionel Robbins’ work, Essay on the Nature and Significance of Economic Science was held as the benchmark for economic methodology for nearly 30 years in the English speaking community which heavily cited Mises.

Rothbard traces how the dualist approach in the social sciences and especially economics was abandoned in favor of the “monist” methodology championed by Milton Friedman.

In the economics profession, of course, the practitioners down in the trenches only loosely reflect, or indeed have scarcely any interest in, the small number of methodological reflections in the upper stories of the ivory tower. But these seemingly remote philosophical musings do have an important long-run influence on the guiding theories and directions of the discipline. For approximately two decades, Lionel Robbins’s justly famous The Nature and Significance of Economic Science was the guiding methodological work of the profession, presenting a watered-down version of the praxeological method of Ludwig von Mises. Robbins had studied at Mises’s famous Privatseminar at Vienna, and his first edition (1932) stressed economics as a deductive discipline based on the logical implications of the universal facts of human action (for example, that human beings try to achieve goals by using necessarily scarce means). In Robbins’s more widely known second edition (1935), the Misesian influence was watered down a bit further, coupled with intimations no bigger than a man’s hand of the neo-classical formalism that would hit the profession about the time of World War II. After the war, the older economics was inundated by an emerging formalistic and mathematical neoclassical synthesis, of Walrasian equations covering microeconomics and Keynesian geometry taking care of macro.

Aiding and abetting the conquest of economics by the new neoclassical synthesis was the celebrated article by Milton Friedman in 1953, “The Methodology of Positive Economics,” which quickly swept the board, sending Robbins’s Nature and Significance unceremoniously into the dustbin of history. For three decades, secure and unchallenged, the Friedman article remained virtually the only written portrayal of official methodology for modern economics. (Rothbard, 2011, pp. 130-131)

Constancy & Human Action

An important distinction exists between the science of material bodies in the physical sciences and the science of human action involves the nature of the ends, goals, desires, tastes, preferences, and other factors. These factors constantly change the nature of things for each individual actor. Additionally, the means to achieve certain ends are never fixed, constant, or invariant.

One can assume constancy and an invariant nature of reality in the study of material bodies in the physical sciences to derive casual laws of nature. Mises points to this significant distinction in Human Action when he states:

Here we are faced with one of the main differences between physics and chemistry on the one hand and the sciences of human action on the other. In the realm of physical and chemical events there exist (or, at least, it is generally assumed that there exist) constant relations between magnitudes, and man is capable of discovering these constants with a reasonable degree of precision by means of laboratory experiments. No such constant relations exist in the field of human action outside of physical and chemical technology and therapeutics. For some time economists believed that they had discovered such a constant relation in the effects of changes in the quantity of money upon commodity prices. It was asserted that a rise or fall in the quantity of money in circulation must result in proportional changes of commodity prices. Modern economics has clearly and irrefutably exposed the fallaciousness of this statement. Those economists who want to substitute "quantitative economics" for what they call "qualitative economics" are utterly mistaken. There are, in the field of economics, no constant relations, and consequently no measurement is possible. If a statistician determines that a rise of 10 per cent in the supply of potatoes in Atlantis at a definite time was followed by a fall of 8 per cent in the price, he does not establish anything about what happened or may happen with a change in the supply of potatoes in another country or at another time. He has not "measured" the "elasticity of demand" of potatoes. He has established a unique and individual historical fact. No intelligent man can doubt that the behavior of men with regard to potatoes, and every other commodity is variable. Different individuals value the same things in a different way, and valuations change with the same individuals with changing conditions. (Mises, Human Action, 1996)

The aim of economic theory is to develop economic propositions which are necessarily true independent of experience, historical events, or statistical data. If we do conclude a distinction does exist between the nature of material bodies and nature of human action, it would only logically follow a different methodology would be required to engage in scientific study of man.

From the argument Mises raises above, we can foresee problems with the presuppositions of scientific method as it relates to applying it to human action given no constant relations or quantifiable measurement is possible. For a case study, let’s take the economic law of demand which says given a falling price of a homogenous good, an individual will buy the same or more of a said good. If we consider this an empirical proposition to be tested for some quantitatively definite magnitude of this effect, then it would seem the replication of events would be problematic. Every event at a different point in time or by a different person or by the same person at a different place under a different set of circumstances cannot be replicated. Nor can the effects of measured as a mathematical equation to be definite or precise. If today the price of a gallon of milk drops by 50%, an individual will the buy the same amount or more milk than they would at the previous price. However, it is impossible and fruitless to quantifiably model, predict, or know exactly how much more milk they will buy a represented by a mathematical equation. All that can be known as a reflective and qualitative fact of human action is that given such a price drop in milk, the same amount or more will be purchased all other things being equal.

Axiom of Action, Praxeology, & Economic Theory

Mises’ presupposition of methodological dualism rests on the action axiom. That is, human beings are conscious agents who make choices, adopt values, and “act” purposefully to attain certain goals, ends, or results. The action axiom is self-evident. Any attempt to refute this claim is contradictory based on the reality that such an attempt to do so would therefore be an action aimed at goal using a particular means to achieve an end.

The axiom of action is a simple yet profoundly important statement of reality. Mises stated it as such:

Human action is purposeful behavior. Or we may say: Action is will put into operation and transformed into an agency, is aiming at ends and goals, is the ego’s meaningful response to stimuli and to the conditions of its environment, is a person’s conscious adjustment to the state of the universe that determines his life. Such paraphrases may clarify the definition given and prevent possible misinterpretations. But the definition itself is adequate and does not need complement of commentary. (Mises, 1996, p. 11)

Mises defines this scientific realm of inquiry as Praxeology which can be better understood as the logic or science of human action. This realm can best be categorized as teleological.  That is, it is purpose-directed meaningful behavior as opposed to that of the physical sciences which is categorized causally.

Rothbard summarized the praxeological methodology and deductive method as follows:

Praxeology rests on the fundamental axiom that individual human beings act, that is, on the primordial fact that individuals engage in conscious actions toward chosen goals. This concept of action contrasts to purely reflexive, or knee-jerk, behavior, which is not directed toward goals. The praxeological method spins out by verbal deduction the logical implications of that primordial fact. In short, praxeological economics is the structure of logical implications of the fact that individuals act. This structure is built on the fundamental axiom of action, and has a few subsidiary axioms, such as that [sic] individuals vary and that human beings regard leisure as a valuable good. Any skeptic about deducing from such a simple base an entire system of economics, I refer to Mises’s Human Action. Furthermore, since praxeology begins with a true axiom, A, all the propositions that can be deduced from this axiom must also be true. For if A implies B, and A is true, then B must also be true. (Rothbard, 2011, p. 60)

Given the logical incontestability of the action axiom, an entire edifice of necessarily true economic statements can be implied or derived from it. The method employed to derive these ancillary conclusions is through logical deductive reasoning just as the same method employed in formal logic, mathematics, and geometry. These logical propositions inferred through this deductive method are held to be true so long as no logical mistakes, flaws, or errors occur in this process of reasoning. Therefore, these statements do not require confirmation or falsification via experience. The deductive process follows step by step using verbal logic since each statement is meaningful, important, and significant.

In order to formulate these logical propositions, Praxeologists uses imaginary constructs or thought experiments derived from action starting with simple constructs and adding layers of complexity along the way, which is also known as successive approximation. In the process of forming these deductions, the term “ceteris paribus” or “all things being equal” is used as a tool to hold certain variables as constant while one factor is changed.

Praxeology contains several categories or branches. Often, Praxeologists will use term “catallactics” interchangeably with the term “economics.” What is meant here is simply the branch or which deals specifically with interpersonal exchange. Other branches of Praxeology include the theory of isolated individual (Robinson Crusoe), theory of war, theory of law/ethics, theory of games, and others fields. (Rothbard, 2011, p. 117)

Status of Economics Propositions

The economic propositions as understood by Austrians in the praxeological tradition obviously differ in their epistemological status from those in the logical empiricist or the modern positivist camp. While I will not go into great detail about this debate, I would like to pay a little attention to it and make a few points.

As illustrated above, the implications derived from the logically incontestable axiom that humans act purposefully follows that these economic propositions are therefore necessarily true as opposed to being a non-necessary or contingent true. Some characterize these as a priori statements or a priori propositions. While there does exist a debate in certain circles on the perspective of how exactly these a priori propositions or laws of action are distinguished, all praxeologists share the common agreement that economics propositions are necessarily true.

Professor Barry Smith has written about this topic and frames the two a priori approaches as “impositionist” versus “reflective”. He writes:

All defenders of apriorism share the assumption that we are capable of acquiring knowledge of a special sort, called "a priori knowledge" via non-inductive means. They differ, however, in their accounts of where such knowledge comes from. Two broad families of apriorist views can be distinguished in this regard.

On the one hand are what might be called impositionist views, which hold that a priori knowledge is possible as a result of the fact that the content of such knowledge reflects merely certain forms or structures that have been imposed or inscribed upon the world by the knowing subject. Knowledge, on such views, is never directly of reality itself; rather, it reflects the "logical structures of the mind," and penetrates to reality only as formed, shaped or modeled by a mind or theory.

On the other hand are reflectionist views, which hold that we can have a priori knowledge of what exists, independently of all impositions or inscriptions of the mind, as a result of the fact that certain structures in the world enjoy some degree of intelligibility in their own right. The knowing subject and the objects of knowledge are for the reflectionist in some sense and to some degree pre-tuned to each other. And directly a priori knowledge of reality itself is therefore possible, at least at some level of generality, much along the lines in which we recognize the validity of a proof in logic or geometry. (Smith, 1990)

Rothbards also acknowledges the different epistemological perspectives.

There is considerable controversy over the empirical status of the praxeological axiom. Professor Mises, working within a Kantian philosophical framework, maintained that like the “laws of thought,” the axiom is a priori to human experience and hence apodictically certain. This analysis has given rise to the designation of praxeology as “extreme apriorism.” Most praxeologists, however, hold that the axiom is based squarely in empirical reality, which makes it no less certain than it is in Mises’s formulation. If the axiom is empirically true, then the logical consequences built upon it must be empirically true as well. But this is not the sort of empiricism welcomed by the positivists, for it is based on universal reflective or inner experience, as well as on external physical experience. Thus, the knowledge that human beings have goals and act purposively to attain them rests, not simply on observing that human beings exist, but also on the introspective knowledge of what it means to be human possessed by each man, who then assents to this knowledge. While this sort of empiricism rests on broad knowledge of human action, it is also prior to the complex historical events that economists attempt to explain. (Rothbard, 2011, pp. 33-34)

[…]

Whether we consider the Axiom "a priori" or "empirical" depends on our ultimate philosophical position. Professor Mises, in the neo-Kantian tradition, considers this axiom a law of thought and therefore a categorical truth a priori to all experience. My own epistemological position rests on Aristotle and St. Thomas rather than Kant, and hence I would interpret the proposition differently. I would consider the axiom a law of reality rather than a law of thought, and hence "empirical" rather than "a priori." But it should be obvious that this type of "empiricism" is so out of step with modern empiricism that I may just as well continue to call it a priori for present purposes. For (1) it is a law of reality that is not conceivably falsifiable, and yet is empirically meaningful and true; (2) it rests on universal inner experience, and not simply on external experience, that is, its evidence is reflective rather than physical; and (3) it is clearly a priori to complex historical events. (Rothbard, 2011, pp. 108-109)

Professor Jeffrey Herbener in his Austrian economics course produced by LibertyClassroom.com also agrees with Rothbard that economic laws of human action are “reflective facts” that we come to know through introspection of the reality or world around us through abstraction.

Falsifiable Propositions vs. Necessarily True Propositions

Building upon the last section regarding the status of economic propositions, let’s look at two groups of statements.

Group A - Propositions

  • Children prefer McDonalds over Burger King
  • Germans drink 5 times more beer than Frenchmen
  • Higher education leads to higher wage rates
  • Consumer spending before Christmas is higher than after Christmas

Group B – Propositions

  • Whenever the supply of a good increases by one additional unit, provided each unit is regarded as of equal serviceability by a person, the value attached to this unit must decrease. For this additional unit can only be employed as a means for the attainment of a goal that is considered less valuable than the least valued goal satisfied by a unit of such good if the supply were one unit shorter.
  • Whenever minimum wage laws are enforced that require wages to be higher than existing market wages, involuntary unemployment will result
  • Whenever the quantity of money is increased while the demand for money to be held as cash reserve on hand is unchanged, the purchasing power of money will fall
  • Of two producers, if A is more productive in the production of two types of goods than is B, they can still engage in a mutually beneficial division of labor. This is because overall physical productivity is higher if A specializes in producing one good which he can produce most efficiently, rather than both A and B producing both goods separately and autonomously.

Do these two groups of statements differ in anyway or are they of the same epistemological type or status? Austrians would reply to this query by saying unequivocally, YES – these two groups are different. All of the propositions in Group A are hypothetical statements which require confirmation or falsification in order to say whether the statements are true or false. All schools of thought, including Austrians hold the propositions in Group A can be categorized as a posteriori. Both Austrians and non-Austrians would both agree that these types of statements can never be true absolutely across time and space. Most importantly, Austrians would say that these statements would not necessarily have any predictive power of necessarily explaining future human action since the opposite or the negation of each of these statements could be the case.

What about the second group of statements, Group B? Austrians would classify these statements as true economic statements as opposed to hypothetical or contingent statements. However, all other schools of thought, including those in the Chicago school, would say that the propositions in Group B are also contingent or hypothetical and require confirmation or falsification.  Austrians would disagree and argue Group B does not require confirmation or falsification since these statements all can be known independent of historical investigation or experience. One does not need to test whether these propositions hold water in London, Paris, or Bangladesh to know their status. These are a priori propositions. Moreover, the negation of any of these statements (proposing the opposite) would be absurd.  This is a fundamental disagreement between the schools of thought. 

Thymology & Verstehen

The realm of knowledge which can be categorized teleological is obviously essential, useful, and of “utmost importance” as Hans Hoppe frequently states. While Praxeology encompasses the logic of human action and the consequences (cause & effect) inferred from the action axiom, there exists a separate branch of inquiry which is non-theoretical, but does utilize the application of praxeology & economic theory.

Mises coined this field of study, Thymology, which studies causes of human action of the past (economic history) and the future (forecasting & prediction). Mises defines Thymology as

a branch of history or, as Collingwood formulated it, it belongs in 'the sphere of history.' It deals with the mental activities of men that determine their actions. It deals with the mental processes that result in a definite kind of behavior, with the reactions of the mind to the conditions of the individual's environment. It deals with something invisible and intangible that cannot be perceived by the methods of the natural sciences. But the natural sciences must admit that this factor must be considered as real also from their point of view, as it is a link in a chain of events that result in changes in the sphere the description of which they consider as the specific field of their studies. (Mises, 1962, pp. 47-48)

Thymology employs its own method of investigation to explain and make sense of human events known as Verstehen, which is a “specific understanding.” Mises elaborates on what it means to employ, Verstehen, which was first introduced by Max Weber.

In analyzing and demolishing the claims of Comte's positivism, a group of philosophers and historians known as the s├╝dwestdeutsche Schule elaborated the category of understanding (Verstehen) that had already in a less explicit sense been familiar to older authors. This specific understanding of the sciences of human action aims at establishing the facts that men attach a definite meaning to the state of their environment, that they value this state and, motivated by these judgments of value, resort to definite means in order to preserve or to attain a definite state of affairs different from that which would prevail if they abstained from any purposeful reaction. Understanding deals with judgments of value, with the choice of ends and of the means resorted to for the attainment of these ends, and with the valuation of the outcome of actions performed. (Mises, 1962, p. 48)

Austrians are often accused of rejecting history or empirical data. However, this is simply not true and no Austrians are opposed to research of past events (or future events for that matter) or prescribing the likelihood of future events. Austrians simply posit no scientific laws of history exist nor can one scientifically predict future events with any definitive precision. Austrians acknowledge there does exist a difference between the realm of praxeology (theory) and the realm of applying or using theory, which Thymology encompasses.

Thymology & Economic History

First, let us examine the approach to doing economic history. In order to engage in the discipline of economic history or historical explanation, one must have an understanding of economic theory.. Without a grounding in sound theory (praxeology), how can one interpret the infinite amount of historical data recorded over the course of human events?

Rothbard connects the dots between economic history and praxeology.

Far from being opposed to history, the praxeologist, and not the supposed admirers of history, has profound respect for the irreducible and unique facts of human history. Furthermore, it is the praxeologist who acknowledges that individual human beings cannot legitimately be treated by the social scientist as if they were not men who have minds and act upon their values and expectations, but stones or molecules whose course can be scientifically tracked in alleged constants or quantitative laws. Moreover, as the crowning irony, it is the praxeologist who is truly empirical because he recognizes the unique and heterogeneous nature of historical facts; it is the self-proclaimed “empiricist” who grossly violates the facts of history by attempting to reduce them to quantitative laws. (Rothbard, 2011, p. 75)

[..]

What, then, is the proper relationship between economic theory and economic history or, more precisely, history in general? The historian’s function is to try to explain the unique historical facts that are his province; to do so adequately he must employ all the relevant theories from all the various disciplines that impinge on his problem. For historical facts are complex resultants of a myriad of causes stemming from different aspects of the human condition. Thus, the historian must be prepared to use not only praxeological economic theory but also insights from physics, psychology, technology, and military strategy along with an interpretive understanding of the motives and goals of individuals. He must employ these tools in understanding both the goals of the various actions of history and the consequences of such actions. Because understanding diverse individuals and their interactions is involved, as well as the historical context, the historian using the tools of natural and social science is in the last analysis an “artist,” and hence there is no guarantee or even likelihood that any two historians will judge a situation in precisely the same way. While they may agree on an array of factors to explain the genesis and consequences of an event, they are unlikely to agree on the precise weight to be given each causal factor. In employing various scientific theories, they have to make judgments of relevance on which theories applied in any given case; to refer to an example used earlier in this paper, a historian of Robinson Crusoe would hardly employ the theory of money in a historical explanation of his actions on a desert island. To the economic historian, economic law is neither confirmed nor tested by historical facts; instead, the law, where relevant, is applied to help explain the facts. (Rothbard, 2011, pp. 77-78)

Praxeologists are in the unique position to use theory to explain the cause and effect of past human events. Praxeologists armed with this a priori theory are naturally in a position to be good historians to know what data is relevant and what data is irrelevant.

Thymology & Economic Forecasting

Now that we’ve looked at the approach of examining human events of the past, how can Thymologists use economic theory and Verstehen to look forward to forecast the likelihood of future human events? Again, the knowledge derived from economic theory can be useful to assist Thymologists in looking forward, but it cannot ensure with exact certainty what will happen absolutely. The a priori knowledge of economic theory does provide us with a framework to foresee the trends or patterns by constraining the possible outcomes that might occur if certain conditions are met. But, this knowledge still provides an incomplete picture. Here we must turn to using Verstehen to determine the likelihood of particular event or set of events to occur, which is more an art than a science.

Lionel Robbins discussed the use of theory and predicting patterns.

Economic laws describe inevitable implications. If the data they postulate are given, then the consequences they predict necessarily follow. In this sense they are on the same footing as other scientific laws, and as little capable of "suspension". If, in a given situation, the facts are of a certain order, we are warranted in deducing with complete certainty that other facts which it enables us to describe are also present. To those who have grasped the implications of the propositions set forth in the last chapter the reason is not far to seek. If the "given situation" conforms to a certain pattern, certain other features must also be present, for their presence is "deducible" from the pattern originally postulated. The analytic method is simply a way of discovering the necessary consequences of complex collocations of facts—consequences whose counterpart in reality is not so immediately discernible as the counterpart of the original postulates. It is an instrument for "shaking out" all the implications of given suppositions. Granted the correspondence of its original assumptions and the facts, its conclusions are inevitable and inescapable. All this becomes particularly clear if we consider the procedure of diagrammatic analysis. Suppose, for example, we wish to exhibit the effects on price of the imposition of a small tax. We make certain suppositions as regards the elasticity of demand, certain suppositions as regards the cost functions, embody these in the usual diagram, and we can at once read off, as it were, the effects on the price. They are implied in the original suppositions. The diagram has simply made explicit the concealed implications. It is this inevitability of economic analysis which gives it its very considerable prognostic value. It has been emphasized sufficiently already that Economic Science knows no way of predicting out of the blue the configuration of the data at any particular point of time. It cannot predict changes of valuations. But, given the data in a particular situation, it can draw inevitable conclusions as to their implications. And if the data remain unchanged, these implications will certainly be realised. They must be, for they are implied in the presence of the original data. (Robbins, 1946, pp. 121-122)

Mises explains the role of prediction here.

Praxeological knowledge makes it possible to predict with apodictic certainty the outcome of various modes of action. But, of course, such prediction can never imply anything regarding quantitative matters. Quantitative problems are in the field of human action open to no other elucidation than that by understanding.

We can predict, as will be shown later, that--other things being equal--a fall in the demand for a will result in a drop in the price of a. But we cannot predict the extent of this drop. This question can be answered only by understanding.

The fundamental deficiency implied in every quantitative approach to economic problems consists in the neglect of the fact that there are no constant relations between what are called economic dimensions. There is neither constancy nor continuity in the valuations and in the formation of exchange ratios between various commodities. Every new datum brings about a reshuffling of the whole price structure. Understanding, by trying to grasp what is going on in the minds of the men concerned, can approach the problem of forecasting future conditions. We may call its methods unsatisfactory and the positivists may arrogantly scorn it. But such arbitrary judgments must not and cannot obscure the fact that understanding is the only appropriate method of dealing with the uncertainty of future conditions. (Mises, 1996, pp. 117-118)

Rothbard explains his thoughts on economic forecasting.

For the praxeologist, forecasting is a task very similar to the work of the historian. The latter attempts to “predict” the events of the past by explaining their antecedent causes; similarly, the forecaster attempts to predict the events of the future on the basis of present and past events already known. He uses all his nomothetic knowledge, economic, political, military, psychological, and technological; but at best his work is an art rather than an exact science. Thus, some forecasters will inevitably be better than others, and the superior forecasters will make the more successful entrepreneurs, speculators, generals, and bettors on elections or football games.

The economic forecaster, as Professor Jewkes pointed out, is only looking at part of a tangled and complex social whole. To return to our original example, when he attempts to forecast the price of butter he must take into consideration the qualitative economic law that price depends directly on demand and inversely on supply; it is then up to him, using knowledge and insight into general economic conditions as well as the specific economic, technological, political, and climatological conditions of the butter market, as well as the values people are likely to place on butter, to try to forecast the movements of the supply and demand of butter, and therefore its price, as accurately as possible. At best, he will have nothing like a perfect score, for he will run aground on the fact of free will altering values and choices, and the consequent impossibility of making exact predictions of the future. (Rothbard, 2011, p. 41)

An important point to mention is that while patterns are predictable through application of theory, the quantitative timing is never something that can be known with any degree of certainty. Again, it cannot be stressed enough that predicting human action is not a science but more akin to an art.

Austrian Business Cycle Theory & Thymology

An example of applying praxeology and economic theory to history and forecasting is the application of the Austrian Theory of the Business Cycle (ABCT), a theory which explains the cause and effect of economic booms and busts in the context of the macro economy. ABCT is probably the best example of economic theory used to explain both historical events pattern prediction of future events. Tom Woods’ book, Meltdown (2009), & Murray Rothbard’s book, America’s Great Depression (1963), are two excellent works of economic history which draw explicitly on the insight and explanatory power of the ABCT to assist their Verstehen and Thymological take on the cause and effect of the boom & bust in both eras of history.

Conversely, in an example using ABCT & Verstehen to forecast future events using pattern prediction, Peter Schiff, an entrepreneur and the President of Euro Pacific Capital, was and still is a frequent guest on the financial news media circuit. Schiff has written numerous books, articles, op-eds on the reason why he was able correctly predict much of the outcome of the 2008 financial collapse. A simple search on Google of the words “Peter Schiff was right” will illustrate what Schiff said during the run up to the financial collapse. Naturally, he did not get everything correct and has also written and spoken on the reason for this. It is important to emphasize here that prediction within the realm of Thymology is never going to provide a quantifiably measurable or definite prescription of what will unfold. Certain things can be known necessarily and absolutely based on our knowledge derived through praxeology, but the timing and magnitude of certain effects or outcomes will always be contingent or hypothetical knowledge.

Conclusion

I’ve attempted to represent the methodology of the Austrian tradition. I do not pretend to be an expert on all that I have written. However, I do think I’ve outlined the positive case for the dualist approach to the methodology of approaching the disparate fields of science. I welcome comments, feedback, and questions. Many eminent scholars have written at length on this subject and I do think methodology is extremely important to the study of economics and social sciences as well. While I recognize the Austrian methodology has been largely abandoned by the economics profession, I hope my examination highlights the benefits and the positive case for Austrian methodology in studying human action and applying the logic of human action to other fields of study within the social sciences.

 


References

Mises, L. v. (1962). The Ultimate Foundation of Economic Science. New Jersey: D. VAN NOSTRAND COMPANY, INC.

Mises, L. v. (1985). Theory and History: An Interpretation of Social and Economic Evolution. Auburn: Ludwig von Mises Institute.

Mises, L. v. (1996). Human Action. San Francisco: Fox & Wilkes.

Robbins, L. (1946). An Essay on the Nature and Significance of Economic Science. London: MacMillan & Company.

Rothbard, M. (2011). Economic Controversies. Auburn: Ludwig von Mises Institute.

Smith, B. (1990, Fall). The Question of Apriorism. Austrian Economics Newsletter, pp. 1-5.

Saturday, August 10, 2013

Richard Ebeling: Money Central Planning and the State

I stumbled upon a terrific in depth history on the debate about money, banking, and monetary policy written by Richard Ebeling and produced by FEE called Monetary Central Planning and the State.  It is a 40 part series with an A to Z look at the differing schools of thought on all things money and specific quotes from the various economists.

Amazing stuff, especially if one is a nerd (like me) who is much more interested in studying money than having a lot of it.

Friday, August 9, 2013

Deflation, Inflation, & Money II: A reply to Jacob Westman

9646432-inflation--decreasing-value-of-moneyJacob Westman, who blogs at the Analytic Economist, has replied to my initial blog post on the topic of deflation, money, monetary history, etc.  It’s an important topic and I’m happy to elaborate on my positions on this subject.

Here is one of the questions posed by Jacob:

Like I said before and explained in my previous post they disfavor cuts in the money supply.  One argument the Austrians utilize is to ALWAYS refer to the price decline due to added production in the late 19th century.  That is not what I am talking about when I am talking about investment.  I am talking about 2% decrease in the money supply each year.  Maybe I did not make that clear.

Apologies if I did not properly address the issue regarding money deflation specifically.  To restate Jacob’s primary question about deflation, it is this:

What would happen if there was a constant decrease in the money supply of 2% per year?  Or stated differently, what is the proper or optimal supply of money? 

Obviously, many neoclassical economists are partial to the Milton Friedman hypothesis that purport's to know the right amount of money an economy needs which he wrote about in The Optimum Quantity of Money

The Austrian school of thought has much to say about this subject and money in general.  An economic analysis about the effects of a stagnate or even falling money supply must occur by also within the context of the demand for money & expectations about the purchasing power of money in the future.  Fractional reserve banking is another important factor in contributing to the money supply.  These are the big hitters pertinent to the question about the supply of money.

In What Has Government Done to Our Money, Rothbard addresses the question of the proper supply of money should be in an economy.

Now we may ask: what is the supply of money in society and how is that supply used? In particular, we may raise the perennial question, how much money "do we need"? Must the money supply be regulated by some sort of "criterion," or can it be left alone to the free market?

First, the total stock, or supply, of money in society at any one time, is the total weight of the existing money-stuff. Let us assume, for the time being, that only one commodity is established on the free market as money. Let us further assume that gold is that commodity (although we could have taken silver, or even iron; it is up to the market, and not to us, to decide the best commodity to use as money). Since money is gold, the total supply of money is the total weight of gold existing in society. The shape of gold does not matter?except if the cost of changing shapes in certain ways is greater than in others (e.g., minting coins costing more than melting them). In that case, one of the shapes will be chosen by the market as the money-of-account, and the other shapes will have a premium or discount in accordance with their relative costs on the market.

Changes in the total gold stock will be governed by the same causes as changes in other goods. Increases will stem from greater production from mines; decreases from being used up in wear and tear, in industry, etc. Because the market will choose a durable commodity as money, and because money is not used up at the rate of other commodities--but is employed as a medium of exchange--the proportion of new annual production to its total stock will tend to be quite small. Changes in total gold stock, then, generally take place very slowly.

What "should" the supply of money be? All sorts of criteria have been put forward: that money should move in accordance with population, with the "volume of trade," with the "amounts of goods produced," so as to keep the "price level" constant, etc. Few indeed have suggested leaving the decision to the market. But money differs from other commodities in one essential fact. And grasping this difference furnishes a key to understanding monetary matters. When the supply of any other good increases, this increase confers a social benefit; it is a matter for general rejoicing. More consumer goods mean a higher standard of living for the public; more capital goods mean sustained and increased living standards in the future. The discovery of new, fertile land or natural resources also promises to add to living standards, present and future. But what about money? Does an addition to the money supply also benefit the public at large?

Consumer goods are used up by consumers; capital goods and natural resources are used up in the process of producing consumer goods. But money is not used up; its function is to act as a medium of exchanges--to enable goods and services to travel more expeditiously from one person to another. These exchanges 3%3 are all made in terms of money prices. Thus, if a television set exchanges for three gold ounces, we say that the "price" of the television set is three ounces. At any one time, all goods in the economy will exchange at certain gold--ratios or prices. As we have said, money, or gold, is the common denominator of all prices. But what of money itself? Does it have a "price"? Since a price is simply an exchange-ratio, it clearly does. But, in this case, the "price of money" is an array of the infinite number of exchange-ratios for all the various goods on the market.

Thus, suppose that a television set costs three gold ounces, an auto sixty ounces, a loaf of bread 1/100 of an ounce, and an hour of Mr. Jones' legal services one ounce. The "price of money" will then be an array of alternative exchanges. One ounce of gold will be "worth" either 1/3 of a television set, 1/60 of an auto, 100 loaves of bread, or one hour of Jones' legal service. And so on down the line. The price of money, then, is the "purchasing power" of the monetary unit--in this case, of the gold ounce. It tells what that ounce can purchase in exchange, just as the money-price of a television set tells how much money a television set can bring in exchange. What determines the price of money? The same forces that determine all prices on the market?that venerable but eternally true law: "supply and demand." We all know that if the supply of eggs increases, the price will tend to fall; if the buyers' demand for eggs increases, the price will tend to rise. The same is true for money. An increase in the supply of money will tend to lower its "price"; an increase in the demand for money will raise it. But what is the demand for money? In the case of eggs, we know what "demand" means; it is the amount of money consumers are willing to spend on eggs, plus eggs retained and not sold by suppliers. Similarly, in the case of money, "demand" means the various goods offered in exchange for money, plus the money retained in cash and not spent over a certain time period. In both cases, "supply" may refer to the total stock of the good on the market.

What happens, then, if the supply of gold increases, demand for money remaining the same? The "price of money" falls, i.e., the purchasing power of the money-unit will fall all along the line. An ounce of gold will now be worth less than 100 loaves of bread, 1/3 of a television set, etc. Conversely, if the supply of gold falls, the purchasing power of the gold-ounce rises.

What is the effect of a change in the money supply? Following the example of David Hume, one of the first economists, we may ask ourselves what would happen if, overnight, some good fairy slipped into pockets, purses, and bank vaults, and doubled our supply of money. In our example, she magically doubled our supply of gold. Would we be twice as rich? Obviously not. What makes us rich is an abundance of goods, and what limits that abundance is a scarcity of resources: namely land, labor and capital. Multiplying coin will not whisk these resources into being. We may feel twice as rich for the moment, but clearly all we are doing is diluting the money supply. As the public rushes out to spend its new-found wealth, prices will, very roughly, double--or at least rise until the demand is satisfied, and money no longer bids against itself for the existing goods.

Thus, we see that while an increase in the money supply, like an increase in the supply of any good, lowers its price, the change does not--unlike other goods--confer a social benefit. The public at large is not made richer. Whereas new consumer or capital goods add to standards of living, new money only raises prices--i.e., dilutes its own purchasing power. The reason for this puzzle is that money is only useful for its exchange value. Other goods have various "real" utilities, so than an increase in their supply satisfies more consumer wants. Money has only utility for prospective exchange; its utility lies in its exchange value, or "purchasing power." Our law--that an increase in money does not confer a social benefit--stems from its unique use as a medium of exchange.

An increase in the money supply, then, only dilutes the effectiveness of each gold ounce; on the other hand, a fall in the supply of money raises the power of each gold ounce to do its work. We come to the startling truth that it doesn't matter what the supply of money is. Any supply will do as well as any other supply. The free market will simply adjust by changing the purchasing power, or effectiveness of the gold-unit. There is no need to tamper with the market in order to alter the money supply that it determines.

At this point, the monetary planner might object: "All right, granting that it is pointless to increase the money supply, isn't gold mining a waste of resources? Shouldn't the government keep the money supply constant, and prohibit new mining?" This argument might be plausible to those who hold no principled objections to government meddling, thought it would not convince the determined advocate of liberty. But the objection overlooks an important point: that gold is not only money, but is also, inevitably, a commodity. An increased supply of gold may not confer any monetary benefit, but it does confer a non-monetary benefit--i.e., it does increase the supply of gold used in consumption (ornaments, dental work, and the like) and in production (industrial work). Gold mining, therefore, is not a social waste at all.

We conclude, therefore, that determining the supply of money, like all other goods, is best left to the free market. Aside from the general moral and economic advantages of freedom over coercion, no dictated quantity of money will do the work better, and the free market will set the production of gold in accordance with its relative ability to satisfy the needs of consumers, as compared with all other productive goods. [10]

[10] Gold mining is, of course, no more profitable than any other business; in the long-run, its rate of return will be equal to the net rate of return in any other industry.

Rothbard’s later devotes more time to study the proposition by many economists to stabilize the price level.

Some theorists charge that a free monetary system would be unwise, because it would not "stabilize the price level," i.e., the price of the money-unit. Money, they say, is supposed to be a fixed yardstick that never changes. Therefore, its value, or purchasing power, should be stabilized. Since the price of money would admittedly fluctuate on the free market, freedom must be overruled by government management to insure stability. Stability would provide justice, for example, to debtors and creditors, who will be sure of paying back dollars, or gold ounces, of the same purchasing power as they lent out.

Yet, if creditors and debtors want to hedge against future changes in purchasing power, they can do so easily on the free market. When they make their contracts, they can agree that repayment will be made in a sum of money adjusted by some agreed-upon index number of changes in the value of money. The stabilizers have long advocated such measures, but strangely enough, the very lenders and borrowers who are supposed to benefit most from stability, have rarely availed themselves of the opportunity. Must the government then force certain "benefits" on people who have already freely rejected them? Apparently, businessmen would rather take their chances, in this world of irremediable uncertainty, on their ability to anticipate the conditions of the market. After all, the price of money is no different from any other free prices on the market. They can change in response to changes in demand of individuals; why not the monetary price?

Artificial stabilization would, in fact, seriously distort and hamper the workings of the market. As we have indicated, people would be unavoidably frustrated in their desires to alter their real proportion of cash balances; there would be no opportunity to change cash balances in proportion to prices. Furthermore, improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of 383 free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.

Money, in short, is not a "fixed yardstick." It is a commodity serving as a medium for exchanges. Flexibility in its value in response to consumer demands is just as important and just as beneficial as any other free pricing on the market.

How the government would go about this is unimportant at this point. Basically, it would involve governmentally-managed changes in the money supply.

From Mystery of Banking: Chapter 5 - The Demand For Money:

An intangible, but highly important determinant of the demand for money, is the basic confidence that the public or market has in the money itself. Thus, an attempt by the Mongols to introduce paper money in Persia in the twelfth and thirteenth centuries flopped, because no one would accept it. The public had no confidence in the paper money, despite the awesomely coercive decrees that always marked Mongol rule. Hence, the public’s demand for the money was zero. It takes many years—in China it took two to three centuries—for the public to gain enough confidence in the money, so that its demand for the money will rise from near zero to a degree great enough to circulate throughout the kingdom.

Public confidence in the country’s money can be lost as well as gained. Thus, suppose that a money is King Henry’s paper, and King Henry has entered a war with another state which he seems about to lose. King Henry’s money is going to drop in public esteem and its demand can suddenly collapse.

It should be clear then, that the demand for paper money, in contrast to gold, is potentially highly volatile. Gold and silver are always in demand, regardless of clime, century, or government in power. But public confidence in, and hence demand for, paper money depends on the ultimate confidence—or lack thereof—of the public in the viability of the issuing government. Admittedly, however, this influence on the demand for money will only take effect in moments of severe crisis for the ruling regime. In the usual course of events, the public’s demand for the government’s money will likely be sustained.

[…]

Public expectation of future price levels is far and away the most important determinant of the demand for money.

But expectations do not arise out of thin air; generally, they are related to the immediate past record of the economy. If prices, for example, have been more or less stable for decades, it is very likely that the public will expect prices to continue on a similar path. There is no absolute necessity for this, of course; if conditions are changing swiftly, or are expected to change quickly, then people will take the changes into account.

If prices are generally expected to remain the same, then the demand for money, at least from the point of view of expectations, will remain constant, and the demand for money curve will remain in place. But suppose that, as was the case during the relatively free-market and hard-money nineteenth century, prices fell gradually from year to year. In that case, when people knew in their hearts that prices would be, say, 3 percent lower next year, the tendency would be to hold on to their money and to postpone purchase of the house or washing machine, or whatever, until next year, when prices would be lower. Because of these deflationary expectations, then, the demand for money will rise, since people will hold on to more of their money at any given price level, as they are expecting prices to fall shortly. This rise in the demand for money (shown in Figure 3.6) would cause prices to fall immediately. In a sense, the market, by expecting a fall in prices, discounts that fall, and makes it happen right away instead of later. Expectations speed up future price reactions.

On the other hand, suppose that people anticipate a large increase in the money supply and hence a large future increase in prices. Their deflationary expectations have now been replaced by inflationary expectations. People now know in their hearts that prices will rise substantially in the near future. As a result, they decide to buy now—to buy the car, the house, or the washing machine—instead of waiting for a year or two when they know full well that prices will be higher. In response to inflationary expectations, then, people will draw down their cash balances, and their demand for money curve will shift downward (shown in Figure 3.7). But as people act on their expectations of rising prices, their lowered demand for cash pushes up the prices now rather than later. The more people anticipate future price increases, the faster will those increases occur.
Deflationary price expectations, then, will lower prices, and inflationary expectations will raise them. It should also be clear that the greater the spread and the intensity of these expectations, the bigger the shift in the public’s demand for money, and the greater the effect in changing prices.


While important, however, the expectations component of the demand for money is speculative and reactive rather than an independent force. Generally, the public does not change its expectations suddenly or arbitrarily; they are usually based on the record of the immediate past. Generally, too, expectations are sluggish in revising themselves to adapt to new conditions; expectations, in short, tend to be conservative and dependent on the record of the recent past. The independent force is changes in the money supply; the demand for money reacts sluggishly and reactively to the money supply factor, which in turn is largely determined by government, that is, by forces and institutions outside the market economy

Guido Hulsmann’s essay, Optimum Monetary Policy (2003),  addresses monetary policy from a purely free market perspective where monopoly privilege to produce money does not exist.  That is, money production would occur just like any other good on the market.  Hulsmann argues that paper money is not a natural market good and even if we did have a lifting of legal tender laws, paper money would not be a viable options against other commodity based monies.

Although on a free market, any person could try to produce paper money, there are compelling reasons to assume that the production of money on a free market would in practice boil down to the mining and coining of precious metals, the physical characteristics of which make them more suitable as media of exchange than all other commodities. Theoretical analysis and historical experience both tell us that this will be the case. Paper money is unsuited to withstand the competition of the precious metals. The essential reason for its inferiority is that it does not attract a nonmonetary demand

Currency competition on a free market would thus be confined to the competition between precious metals. Here the relative scarcities of the various known metals play an important role in conjunction with certain technological constraints.
Suppose that the entire economy uses gold coins for its monetary exchanges, and that silver and copper are used only for ornamental purposes. Now suppose further that the economy grows and that as a consequence the purchasing power of gold constantly increases. There will come a point at which it is no longer convenient to produce and use gold coins that are sufficiently small to be used as payment in small transactions, such as paying for a cup of coffee or for a hair cut.

Hulsmann also addresses what would happen if the purchasing power of a given commodity (such as gold) became unusable for smaller transactions given that its purchasing power would consistently rise.  This is relevant to the question of a money deflationary environment where the money supply (where gold is money) may not grow much if at all in relation to the quantity of goods and services.

Another solution is to use a different metal, the purchasing power per weight unit of which makes it expedient to use coins made out of this metal for buying and selling those goods that can no longer be conveniently exchanged for gold. Let us therefore assume that some market participants start using silver coins in small transactions, and that other market participants imitate this successful behavior. As a consequence, our economy would use two monies—gold and silver—that freely circulate in parallel and overlapping networks. At least at the beginning, the gold network would probably be much larger, and silver coins would be used only in those less frequent cases in which neither gold tokens nor gold coins would be convenient.

If economic growth continues, the substitution process would replicate itself, both in the higher and in the lower echelon of money prices. Thus, at one point silver too might have such a high purchasing power that small transactions could no longer be made in silver coins. The market participants then might decide to use copper coins for these small transactions, thus layering a network of copper exchanges over the already existing networks of gold and silver exchanges. Meanwhile, gold coins could have such a high purchasing power that they might be unsuitable for most daily transactions. In this case, silver coins will replace them as the most widely circulating medium of exchange; the gold coins would be used only in transactions involving very expensive goods; and copper coins would be used predominantly in transactions involving goods of a very small value.

As long as a money can be easily divisible and prices are allowed to adjust, this is no problem with any amount of money or multiple monies circulating at once. 

Hulsmann continues to discuss that creating more money does not make an economy wealthier or reduce scarcity.  We desire real goods and not money per se.

Does printing more paper money reduce, by itself, the scarcity of resources? To raise the question is to answer it. Printing more paper tickets does not make us richer than we otherwise would be, because our welfare does not depend on the quantity of money we use, but on the quantities of real goods that can be purchased with this money. The simple fact is that printing money is not identical with producing goods that can be purchased with this money.  Additional money does not make the nation of money users better off than it would otherwise have been. If it were otherwise, we would long since have reached Nirvana. The incontestable fact is that printing more paper money is not the same thing as producing more of the nonmonetary goods that are offered in exchange for money. It follows that the production of money is in any case not a direct cause of those other goods.

Hulsmann’s essay provides a very comprehensive look a monetary policy from many angles.

The chief concern I suspect one would have regarding deflation has more to do with banking than the quantity of money.  Fractional reserve banking is really the culprit for causing serious problems in the economy and sowing the seeds of the business cycle.  During the 19th Century, we see inflationary booms and busts with banks expanding massive amounts of bank credit and loans than they had reserves to cover.

Let us know discuss the element of fractional reserve banking – where banks are only required to keep a fraction of reserves on hand of all deposits that can be redeemed at any point in time.  By deposits I’m including checking and saving account deposits.  Given the current day reserve requirement of 10% (that is banks only need to hold a reserve of 10% of all customer deposits), banks can lend out $9 dollars for every $10 it holds as reserves.  As more and more depositors put money into the banking system, the amount of money available to lend out increases and so on.  This is often known as the money multiplier. 

When the demand to hold money as cash balances falls, the money multiplier works in reverse and causes a massive downturn as we’ve seen countless times.  Banks are always susceptible to depositors pulling their money out and demanding redemption of their deposits in the form of currency.  If even a small amount of depositors pull their money out of the banks so as to hold some currency instead of deposits, the banks will be forced to reduce the amount of loanable they can lend out, which are considered assets by the banks. 

So, here we see the reason behind the logic for a the necessity of a Central Bank given a fractional reserve system that is always reliant on a constant money supply growth.  More could and should be said on FRB, but hopefully this will suffice for now.  For more information on this, I highly recommend Joe Salerno’s MIses University 2013 lecture on the Economics of Fractional Reserve Banking.

 

I usually do not quote large sections of books in a blog post, but the passages I’ve posted are extremely relevant to the issue at hand regarding the proper supply of money, the type of money unit being used, and the very idea of that one can know what a proper policy needs to be for controlling the supply of money.

As for the concern about a significant drop in the supply of money & credit (like what occurred in 1929), one needs to ask whether this event was precipitated by a period of significant increases in the supply of money and credit.  Also, one needs to understand and analyze what happened to interest rates during this time that lead up to the crash?  Were they being suppressed and kept artificially low despite a surge for loanable funds from banks?  If such a surge in demand for loanable funds (otherwise known as a increase in demand for money & credit), then interest rates should subsequently risen to reflect this reality. 

As I stated in my original blog post, Rothbard’s analysis of the 1920s stands as a significant response to the Friedman/Schwartz account of the 1920s.  As I posted in an update to my previous blog post:

I’d recommend special attention to Chapter 4 in Rothbard’s AGD where he discusses the inflationary boom despite stable prices or slightly falling prices in the economy.  Rothbard’s analysis properly points out that interest rates were stable despite great demand for loanable funds during the 1920s.  This appetite for loans should have caused interest rates to go up without Federal Reserve policy that pushed rates down through manipulation of the expansion of the money supply.  This is essential to the Austrian Theory of the Business Cycle, which I hold is a far superior explanation than other schools of economic thought, including Friedman’s “Plucking Model” or the Keynesian one.

Jacob takes issue with my characterization that a stable dollar is an oxymoron.  I stand firm in this claim and submit any money unit controlled by a government under a fiat-monetary system will suffer from this charge.

I assume the primary confusion rests on the definition of what we mean by a dollar.  One reason might be the term dollar has changed so many time over the last 200 years.  It’s as if the definition is meaningless.  This is the nature and essence of fiat-money in that the authority presiding over a given territory.  After all, fiat mean “let it be done.”  So, by definition, a fiat-dollar can mean whatever the governing body wants it to mean.

Now, if you are concerned about a money unit with stable purchasing power that stays constant over time and space, that is something worth investigating.  But, this has already been covered above in Rothbard’s chapter in What Has Government Done to Our Money.

On the issue of competing currencies and something Hayek recommended, I have a slightly different take on what the theory of competing currencies in that paper money would not last (as Hulsmann eluded) against other commodity based currencies.  Paper money (while we accept it now a days based on the fact it had purchasing power in the past and we hope it will have purchasing power in the future) is not a natural free market phenomenon.  There is a difference between fiduciary media or money substitutes and money proper.  If the legal tender laws were lifted, paper monies would virtually evaporate and dissolve.  So, I think Hayek’s analysis of a market chosen paper money is not realistic.  While I am encouraged by something like BitCoin as an alternative to modern fiat monetary system, I see problems with it being demanded as the most saleable good which is one of the core properties of money.

REFERENCES

Rothbard, Murray N. [1983] 2008. The Mystery of Banking. Auburn, AL.: Ludwig von Mises Institute

-- 1990. What Has Government Done to Our Money. Auburn, AL.: Ludwig von Mises Institute

-- [1963] 2000. America’s Great Depression. Auburn, AL.: Ludwig von Mises Institute

H├╝lsmann, J. Guido. 2003. “Optimal Monetary Policy” Quarterly Journal of Austrian Economics IV: 37-60

Salerno, Joseph T. “Economics of Fractional Reserve Banking.” Ludwig von Mises Institute, Mises University. Auburn, AL. 23 Jul. 2013.

Wednesday, July 24, 2013

Deflation, Inflation, & Money: A Reply to Jacob Westman

finance-deflationJacob Westman who blogs at The Analytic Economist wrote a critique of the exchange between Jeff Herbener and Tom Woods regarding deflation (shown below).

I have a lot to say on the subject of Deflation & Inflation as do other Austrian economists.  In actuality, it is one of my favorite subjects and something I’ve spent the better part of the last 4 years trying to better understand.  So, I thought it deserved a more fleshed out blog post instead a long-running post in the comment section.  This post is a continuation of the comments which can be found here and here while Jacob’s replies can be found here and here.

I fully recognize there is a difference between slowing money supply growth and a retraction/decrease in the money supply.  I think Jacob and I both need to be precise in our definitions and terms (i.e. phrases like “mild deflation”).  I'd maybe rephrase to say something like “mild price deflation” as opposed to “mild money supply growth” or “mild money inflation.” 

My argument is that most mainstream economists consider any form of deflation - either a falling aggregate price level (or price deflation) or a slow down/retraction in the money supply (money deflation) - as being bad.  Obviously, I disagree and say neither price deflation nor money deflation are bad per se.  However, many of the economists who frequent CNBC, Bloomberg, or even the Fed Board of Governors do in fact think price deflation (and money deflation) is in fact bad.  They all advocate a constant policy of price inflation and the deflationary boogey man is frequently right around the corner.  Bernanke himself has stated how we must take the advice of Friedman and always have his famous helicopter on standby should deflation rear its head.  I think the constant hysteria of deflation stems from the influence of Irving Fischer and his musing of the mythical deflationary spiral.

I think a good example of what an economy looks like with price deflation and a high economic growth is what we saw in late 19th century of the U.S.  As to a huge drop in the money supply, we see this happening after an inflationary boom whether in 1921, 1929, or in 2008.  What are we to think of an economy that experiences massive money/price deflation as experienced during a recession or depression?  Obviously, the effects of such an event are devastating to those individuals whose livelihoods are now turned upside down and must now pick up the pieces.  But, the Monetarists, Neoclassicals, and Keynesians all are united in the claim the Central Bank must do something and step in, right?  I would say no to this postulate and encourage readers to pick up any type of Austrian economics literature that explains the necessity of how the market economy must allow for prices to adjust and markets to clear.  More could be said of this, but let us return to deflation and inflation.

Friedman and many others Neoclassicals either forget or fail to understand what the monetary policy was during the 1920s.  During that time, the money supply was expanding at a very high rate year over year.  Yet, prices were relatively stable.  If the money supply had stayed relatively constant price should have fallen considering the rise in productivity.  Murray Rothbard provided this analysis in his great work America’s Great Depression 

Update: I’d recommend special attention to Chapter 4 in Rothbard’s AGD where he discusses the inflationary boom despite stable prices or slightly falling prices in the economy.  Rothbard’s analysis properly points out that interest rates were stable despite great demand for loanable funds during the 1920s.  This appetite for loans should have caused interest rates to go up without Federal Reserve policy that pushed rates down through manipulation of the expansion of the money supply.  This is essential to the Austrian Theory of the Business Cycle, which I hold is a far superior explanation than other schools of economic thought, including Friedman’s “Plucking Model” or the Keynesian one.

When there is high economic output, the price level should generally fall as the volume of goods increases at a faster rate than the supply of money.  Also, there is a non-neutrality of money in that the new money does not effect all prices at the same time or in the same way.  Rather, higher order goods (capital/producer goods) which are further away from the consumer are the most sensitive to inflationary policies and interest rates below the natural rate.  Fractional-reserve banking also complicates things, but that is a whole other blog post.

My point with gold and corn (and the other commodities I mentioned) is that all forms of money start out as goods used for direct exchange that have some type of use value and only become money when they can be valued as means for indirect exchange.  Whether money is beaver pelts/furs (Native Americans), cigarettes (used as money in many prison economies), or whatever that has been money in the past - there is a marginal utility for money like any other good.  There is a supply, demand, and price of money as Mises explained in his pioneering book, Theory of Money & Credit, which was the first to integrate and apply the laws of marginal utility to money.  Gold and Silver have value in their non-money properties where fiat-paper money does not - unless one values it as tinder for a fire, wallpaper, or maybe as a substitute for toilet paper.   I’ve written a lot about money and do not wish to repeat that which can be easily accessed on this blog.

To the point about the entrepreneur looking to put his $100M to its most valued use/end, I understand the statement just fine.  The premise of Jacob’s claim is that a constantly expanding money supply (assuming we're talking about a monetary system like what we have today) would be better than an economy with general price deflation (like the late 19th Century).  An entrepreneur role is to forecast or speculate what future prices of the outputs he/she wants to sell to perspective buyers.  The key to their success is that they aim to select the correct combination of inputs and sell them at a higher price than the cost of the inputs.  This will reward those entrepreneurs who are the best at constantly minimizing their costs and adjusting the combination of how much to spend on capital goods and how much to spend on labor.  Even if the money supply fails to grow at X%, this does not mean the entrepreneurs prices will fall in lock step with the money supply.

Deflation rewards savers and punishes debtors.  The purchasing power of money will increase in a deflationary environment and most likely encourage a strong pool for saving and investment where inflation does the opposite - encouraging debt and consumption.  Deflation rewards those who increase productivity as well as production at an ever falling price – especially in highly competitive industries.  Some of the wealthiest entrepreneurs of history made their money by consistently improving their output while also lowering the price of their goods.

Yes, under a gold/silver standard the money supply would obviously grow at whatever the rate it was profitable for mining companies to recover gold/silver.  I have no idea what the historical or future recovery rate is if gold/silver were money.  I’ve heard close to 2%, but the number is irrelevant since any quantity of money in the economy will suffice so long as prices are allowed to adjust. 

Here is probably the best question of the entire post:

Do you really think the argument of a stable dollar is bad?

I love this question because it begs the question: what is a dollar?  If the definition of a dollar is a fiat-money unit most commonly acknowledged as a piece of paper with green ink and dead presidents which I am required to use as the only form of legal tender for all debts public and private issued by Central Bank and decreed by government – then I’d respond by saying unequivocally yes this is bad.  Given this definition, a stable dollar is an oxymoron.  Now, if the definition of a dollar is a fixed weight of gold, fixed weight silver, or fixed weight of some other durable commodity with the correct money properties, then I’d respond by saying no there is nothing wrong with this type of stable dollar in the same sense a stable foot is to be 12 inches and a stable mile is to be defined as 5,280 feet.

I really wish Milton Friedman extended the virtue of being “Free to Choose” when it came down to advocating the freedom to choose what should be money.  What is wrong with competing currencies and the abolition of legal tender laws?

I’m quite aware of the hostility that exists towards Austrian economists and the various critiques which have been leveled towards the school of thought. However, I cannot seem to understand the lack of appreciation for the pioneering work done by Austrians on Money & Banking – especially for critics who espouse to be pro-free market. 

A constantly expanding supply of gold or silver accepted as money is not the same as a constantly expanding supply of fiat-money issued by a Central Bank.  I understand Friedman was trying to come up with a rule to emulate what the free market would do given some type of gold standard.  However, the key difference as I’ve stated before is the monetary unit itself.  For every gold/silver ounce that is mined, real wealth is brought into the economy that can be used for both direct & indirect exchange.  The mass production of pieces of paper with funny looking people on them yields no real wealth.  Paper money can be manufactured at virtually zero cost and only yields some type of marginal utility when backed by legal tender laws of coercion by a monopolist of ultimate decision making otherwise known as the State.  Fiduciary media masquerading as money proper is always going to be problematic.

To the point about inflation given a gold standard, it is entirely plausible for an inflationary boom to occur if a large deposit of gold is suddenly found.  This would cause the purchasing power of gold to fall and the goods priced in gold to rise as well near the area where the gold was recovered.  But, this also means that material wealth has been increased as I’ve said above in the sense gold can be used for other purposes than a medium of exchange.  This incident would further my position that we cannot know what the supply of money or the demand for money can or should be in a society given sound money always has two purposes.

Last is the claim that it’s a straw man to say Neoclassicals think it’s disaster for price deflation in computers or coffee.  I think Jacob conflates genuine product development by an entrepreneur who seeks to refine and improve the factors of production for a specific product or product-line with Schumpeter’s concept of “Creative Destruction.”  Innovation and productivity improvements are necessary for entrepreneurs in all industries and not just in silicon valley or technology goods.  Businesses naturally want to provide the highest value and best bang for the buck to their customers.  This would occur in a deflationary economy just as it does in an inflationary economy.  The key difference is as Woods/Herbener explain is that price deflation rewards the better entrepreneurs while price inflation rewards those well connected who have access to getting the new money first.

Individuals after all desire goods and services and not necessarily money per se but the future purchasing power of the goods/services they hope to exchange for their money.  A characteristic of a free market economy is a naturally falling price level and not an price inflationary one.

In closing, I’d like to recommend two great podcasts produced by Radio Free Market with Michael McKay on Inflation, Deflation, and Money.

Mr Douglas French on Hurray for Deflation

Dr. Jorg Guido Hulsmann on Natural Money vs Forced Money: Legal Tender Laws

Monday, June 10, 2013

Edward Snowden: hero or heretic?

My article on DefineLiberty.com

screen-shot-2013-06-10-at-12-57-59-pmGlenn Greenwald from the Guardian conducted an exclusive interview with Edward Snowden — the now admitted leaker and source of the highly controversial NSA surveillance programs disclosure.  The 29 year-old NSA Computer Technician contractor decided to come out to the world and had acknowledged he provided details to the Guardian and the Washington Post about what could be considered the most intrusive assault on the 4th Amendment at the hands of the most secretive arm of the State.  No one knows exactly how big the NSA is as far as employees, budget, or power.  However, it would not be a stretch to assert that the NSA easily dwarfs the CIA in its capabilities given the digital world we find ourselves.

If you caught any of the Sunday Morning Talk Shows, it would be safe to say most establishment polls and pundits are outraged at the leak and are quick to inject the politics of fear in their speculation of how damaging this leak is to “national security” and how “less safe” we will all be because of it.  Additionally, the establishment is quick to demand prosecution, imprisonment, and even possible execution of the now self-identified leaker.

What are we to think of Snowden?  Hero or criminal?  Patriot or Traitor?  Should we hang him for his deeds or honor his act as a courageous stand against the State and its depredation of our (so called) privacy and property rights?

While I personally have an opinion on the ethics of Snowden actions, let us consider a few things.  How do we view people from the past who, like Snowden, have taken a deliberate stance against the State?  How did we view them then and how do we view them now?

Click here to read more.

Thursday, March 28, 2013

Wenzel vs. Kinsella Debate on IP

The Robert Wenzel vs. Stephan Kinsella debate is set to air on Monday, April 1st (2013) on both gentlemen's podcasts (found here and here)..  This is sure to be an interesting April Fools Day.  But, who will be made out to be the fool: Wenzel or Kinsella?

To this question, my money is, sadly, on Robert Wenzel (whom I do follow and regard as a great liberty advocate).  Kinsella has reason, logic, and justice on his side and has responded at length about all of the possible objections and arguments for IP and he has continued to demolish them.

I have thought long and hard about the case for and against Intellectual Property (Copyright, Patents, and Trademarks).  As a software developer, I used to be in the pro-IP camp since much of my compensation comes from directly from my ability to turn ideas, patterns, and algorithms into lines of code that create software solutions.

But, the entire explosion of prosperity, products, and competition in the software industry as well as the legal battles between conglomerates like Apple, Google, Microsoft, Samsung, and other software/hardware makers has made me rethink everything about IP.

I've followed the whole Robert Wenzel versus Kinsella/Tucker debate for sometime (dating back to 2009).  I think the basic precursor to this entire debate revolves around 2 fundamental questions?

1) Why do we even need property rights?
2) What do we mean by the term property?

Hoppe (which both Kinsella and Tucker rely on as the basis of their argument against IP) wrote about the precondition for property in his classic "A Theory of Socialism and Capitalism" starting in Chapter 2.  Anyone who wants to debate IP must read Hoppe's brilliant discussion on property.  The basic point comes down to the fact that in a world of scarcity and rivalrous goods, a demarcation of ownership is needed to prevent conflict.

As Hoppe points out, in the Garden of Eden, property rights for goods would not be needed or even possible since everything would be super abundant and manifest itself in whatever manner imaginable.  However, everyone would still have a property right in their own person since everyone would not be able to occupy the same space (Hoppe explains this better than I can).

The fundamental fact is that ideas are non-rivalrous and there is no conflict since no one can exclusively "control" or "own" an idea, theorem, algorithm, etc.  Why?  Because there is no reason why two or more people (living completely independently who live on opposite ends of the globe) cannot come up with the same idea or mental construct at a given point in time.

Also, there is no way to really "homestead" an idea in the Lockean way and exclusively "own" or "control" it (for the reasons I've given above).  Now, one may "possess" an idea, but it is impossible to exclusively control it given that the basic law of  humanity is that we have the ability to reason given we all possess a supercomputer atop our shoulders.

Lastly, a primary issue to the IP debate concerns two concepts: stealing versus copying.  A comment by Ted Sonnier in an EPJ post back in January eloquently describes how ideas (even genuinely original ones) cannot be "stolen" as well as the difference between control/possession and ownership.  He gives a great example of how there is no such thing as theft when it comes to ideas.  Ideas can by copied and/or built upon but they cannot be stolen unless there is an act of battery where someone is brainwashed or hypnotized (which obviously is a form of injustice).  The IP advocates try to equate copying with stealing and pose this act as a form of violence when no such violence has taken place.