ADVANCES IN AUSTRIAN ECONOMICS VOLUME 11

EXPLORATIONS INAUSTRIAN ECONOMICS

EDITED BY

ROGER KOPPL

Fairleigh Dickinson University, Madison, USA

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ADVANCES IN

AUSTRIAN ECONOMICS

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LIST OF CONTRIBUTORS

University, Morgantown, WV, USA

Martin Gregor

Institute of Economic Studies, Charles

Peter J. Boettke

Department of Economics, George MasonUniversity, Fairfax, VA, USA

Christopher J. Coyne

Department of Economics, West Virginia

University, Prague, Czech Republic

Steven Horwitz

Department of Economics, St. LawrenceUniversity, Canton, NY, USA

Hansjorg Klausinger

Department of Economics, ViennaUniversity of Economics and BusinessAdministration, Vienna, Austria

Roger Koppl

Department of Economics and Finance,Fairleigh Dickinson University, Madison,NJ, USA

Peter T. Leeson

Department of Economics, George MasonUniversity, Fairfax, VA, USA

Peter Lewin

University of Texas at Dallas, School ofManagement, Richardson, TX, USA

Torsten Niechoj

Macroeconomic Policy Institute (IMK) inthe Hans Boeckler Foundation,Duesseldorf, Germany

Lawrence H. White

Department of Economics, University ofMissouri-St. Louis, St. Louis, MO, USA

Alfred G. Wirth

Wirth Institute for Austrian and CentralEuropean Studies, University of Alberta,Edmonton, Alberta, Canada

Anthony F. RotatoriFestus E. Obiakor

vii

ADVISORY BOARD

Don BellanteUniversity of South Florida, USA

Stephan BoehmUniversity of Graz, Austria

Peter J. BoettkeGeorge Mason University, USA

James BuchananGeorge Mason University, USA

Bruce CaldwellUniversity of North Carolina, USA

Jacques GarelloUniversite d’Aix-Marseille, France

Roger GarrisonAuburn University, USA

Jack HighGeorge Mason University, USA

Masazumi IkemotoSenshu University, Japan

Richard N. LangloisThe University of Connecticut, USA

Brian LoasbyUniversity of Stirling, Scotland, UK

ix

Ejan MackaayUniversity of Montreal, Canada

Uskali MakiUniversity of Helsinki, Finland

Ferdinando MeacciUniversita degli Studi di Padova,Italy

Warren SamuelsMichigan State University, USA

Barry SmithState University of New York,USA

Erich StreisslerUniversity of Vienna, Austria

Martti VihantoTurku University, Finland

Richard WagnerGeorge Mason University, USA

Lawrence H. WhiteUniversity of Missouri, USA

Ulrich WittMax Planck Institute,Germany

OPENING REMARKS

BY ALFRED WIRTH

Alfred G. Wirth

First, let me express my sincere welcome to all of you for what I expect willbe two days filled with the pleasures of exploration, learning, and respectfuldisagreement. I very much appreciate your attendance at what I hope willbecome a recurring event. Second, I would like to thank Franz Szabo, andall the others who have worked so hard to organize this symposium.

As you know – or will learn from Dr. Szabo – the Wirth Institute’sobjective is to study and disseminate important intellectual and culturalworks that originated in Austria and the other Central European nations thatwere part of the Habsburg Empire until 1918.

As a student of economics, I particularly wanted the Wirth Institute tosponsor this symposium. This was not easy to do, because the AustrianSchool is not represented in the University of Alberta’s EconomicsDepartment. Furthermore, music, art, psychoanalysis, architecture, but noteconomics – are what usually come to mind when people think of Austrian/Central European cultural contributions to our world.

The Austrian School of Economics differs from other schools in somesignificant ways. As is the case for most new schools, it began with the publi-cation of a seminal work. In this case, it was Carl Menger’s Grundsatze derVolkswirtschaftslehre, published in 1871. But other aspects are more unique:

1. No other school carries a nation’s name. National names are often off-putting and can also be misleading. Therefore it is important to remember

Explorations in Austrian Economics

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ALFRED G. WIRTH8

that this name was not chosen by the members of the school. The labelwas applied by its first critics, German economists. They considered theirhistoric approach to be appropriately rigorous and much more scientific.Given Prussian military and political successes over Austria by the 1870s,when Germans called something ‘‘Austrian’’, they meant that it wasslipshod or weak. So, originally the name ‘‘Austrian School’’ was apejorative.

2. Success, and especially general acceptance, often leads to being forgotten.Major parts of the Austrian approach, such as the theory of marginalutility, capital/interest, opportunity cost, monetary policy, business cycleanalysis, and value/price, were integrated into other systems of economicanalysis. Once these principles were well established, some felt that therewas little reason to carry on in the mold of the Austrian School.

3. Its intrinsic diversity sometimes makes Austrian economics difficult toidentify. And like any successful parent, it has given rise to manydiffering offspring, many with new labels.

4. The Austrian School is not as mathematical nor model-centric as ispopular today in most, if not all, economic faculties.

5. It encompasses many disciplines – economics, philosophy, and sociology.Thereby its development is in continuous disequilibrium, while cons-tantly searching for equilibrium.

The Austrian School played a significant role internationally well into the1930s, partly because a number of its major contributors taught in England.Friedrich von Hayek, while at the London School of Economics, became amajor disseminator of Austrian concepts to the English-speaking world,both directly and through some of his students like John Hicks and LudwigLachmann. Via Gottfried von Haberler, Hayek was one of the fathers of theUniversity of Chicago’s monetarism.

Ludwig von Mises also played a major role in the English-speaking world,especially after his arrival in the United States. So did Josef Schumpeter andPeter Drucker, both of them moving away from the core of the AustrianSchool, but not its tradition.

Yet, arguably because of the Austrian School’s opposition to the risingpopularity of Keynesian pump priming (Hayek’s pupil Nicholas Kaldorsubsequently moved over to Keynes), the School became largely forgotten inthe 1940s.

Austrian economics has enjoyed a resurgence since 1974, largely due totwo events: The Institute for Humane Studies conference held in Vermontthat summer, and the award of the Nobel Prize to Hayek that fall. Today,

Opening Remarks by Alfred Wirth 9

while work continues in many parts of Europe and even Asia, the USA(early on through Murray Rothbard and Israel Kirzner) is now the biggestacademic contributor to Austrian economics.

As a competitor outside today’s mainstream, the Austrian School’sinfluence may seem somewhat marginal sometimes, but its work is certainlynot second rate. And it remains a very important contributor to economicthought.

Throughout our symposium I suggest that we reflect on, and towards theend, try to address, some of the following questions:

1. What insights into human behavior, actual or normative, does your ownwork within the Austrian School offer?

2. What is the proper role of government: Active policymaking? Or just toset out the rules and then let the market work its wonders? What is thepractical impact of the Austrian School today in Eastern Europe, and inSoutheast Asia, where much of its philosophy has been adopted?

3. What is the appropriate role of the economist vis-a-vis the public or thegovernment?

4. What are the still unique and important insights to be offered by theAustrian School today?

5. How would we like the Austrian School to evolve:(a) Become better known and reach greater acceptance, with more

research in the Austrian style?(b) Have more influence on policy, as happened in years past?(c) Place more graduates into good faculties?(d) Address important questions in social sciences aside from economics?

We have a way of looking at the world that is diverse, prefers a liberal/libertarian approach, thinks that interference from above should beminimized, and believes that each human being’s imperfect search for hisown benefit, his personal equilibrium, will get the overall job done best.

Each of you has made the effort to be here. For Canadians this has beenespecially challenging because we inadvertently chose a major holidayweekend, our Thanksgiving. But together we can ensure that it will beworthwhile, and I thank you for coming.

THE RESEARCH PROGRAM

OF AUSTRIAN ECONOMICS$

Lawrence H. White

THE LINEAGE

Austrian economics today is a living research program, pursued by scholarsaround the globe, associated with an intellectual lineage that began inVienna with Carl Menger’s 1871 Grundsatze der Volkswirtschaftslehre(Principles of Economics).1 Menger’s ideas were soon advanced by hisfollowers Eugen von Bohm-Bawerk and Friedrich von Wieser. In themid-20th century Ludwig von Mises and Friedrich Hayek did the most toextend economic research along Mengerian lines. Some of the Mengerianinnovations (marginalism, opportunity cost) have been incorporated intomainstream neoclassical economics, and Mises and Hayek viewed their ownresearch program merely as modern economics.2 But as Israel Kirzner (1994,p. xii) has noted, those involved in ‘‘the contemporary post-Misesian revivalof Austrian Economics’’ now appreciate ‘‘the distinctiveness of the Austriantradition’’ stemming from Menger.3

Historians of economic thought often cite methodological commitmentsthat set Menger and his followers apart from other economists. A more

$Keynote address for conference on ‘‘The Austrian School of Economics’’ sponsored by the

Wirth Institute for Austrian and Central European Studies, University of Alberta, 8 October

2005.

Explorations in Austrian Economics

Advances in Austrian Economics, Volume 11, 11–24

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LAWRENCE H. WHITE12

fruitful way to distinguish Austrian economics is to note that it asks differentquestions.4 Its characteristic methods may then be seen as applications of thetools appropriate to its topics of inquiry, rather than as all that remainsavailable after rejecting standard methods.5 Austrian analysis properly usesverbal logic when it develops the theory of entrepreneurship or reconstructsthe evolution of an institution, because these topics resist the standardneoclassical method of mathematically solving for an optimum or a marketequilibrium. An economist who values the Austrian tradition should not feelrestricted to studying such topics as entrepreneurship by a pre-commitmentnot to use mathematics. Rather than its side constraints, its research goalsshould set Austrian economics apart: it pursues distinctive conjectures andrefutations.

I use the phrase ‘‘an economist who values the Austrian tradition’’ ratherthan simply ‘‘an Austrian economist,’’ because no economist should feelcompelled to tackle nothing but uniquely Austrian questions. StandardMarshallian supply-and-demand analysis is not specifically Austrian, but itis useful for addressing many interesting and important questions about theworld.

Let me briefly recap what Austrians have contributed to economics.Menger was a pioneer in tracing relative prices to subjective valuations.He pointed to consumer wants as the driving force behind the constellationof market prices and quantities. He distinguished ‘‘lower-order’’ consumergoods from ‘‘higher-order’’ productive inputs, and introduced the principlethat the prices of higher-order goods derive from their anticipatedcontributions to the production of valued consumer goods.

Menger (1985, p. 146) framed a key part of the Austrian economicsresearch program when he identified ‘‘a noteworthy, perhaps the mostnoteworthy, problem of the social sciences: How can it be that institutionswhich serve the common welfare and are extremely significant for itsdevelopment come into being without a common will directed towardestablishing them?’’ Today we may speak of research along these lines asthe search for ‘‘invisible hand’’ explanations, emphasizing its roots in AdamSmith. Smith understood that money (for instance) had emerged throughmarket forces rather than central design. But it was Menger rather thanSmith who offered the first satisfying explanation of how the institution ofmoney had arisen.

Smith had infelicitously said that people are ‘‘led by an invisible hand’’ topromote the wealth of the nation, not that the market operates almost as ifguided by an invisible hand. It should be ‘‘as if,’’ because there is no literalguiding hand or common will directing human action.6 And it should be

The Research Program of Austrian Economics 13

‘‘almost’’ because there are important cases when – as James M. Buchanan(1982) once put it – an order is defined only in the process of its emergence.When historical path-dependence matters, it is inaccurate to suggest that themarket outcome merely exhibits a unique equilibrium that was implicit inthe data.7

Building on Menger, Ludwig von Mises made the greatest contributionsto defining by example the research program of Austrian economics. Misesbrought microfoundations to the study of the value of money. He examinedthe effects of ‘‘free banking’’ (the competitive issue fiduciary media) on thequantity and purchasing power of money. Combining the insights of the19th-century Currency and Free Banking Schools with the interest theoriesof Bohm-Bawerk and Wicksell, he began to develop the monetary-malinvestment theory of the business cycle. He elaborated the monetaryapproach to the balance of payments. Mises analyzed monetary regimes –the gold standard, central banking – by taking a comparative institutionsapproach that incorporated the political incentives facing governments.And that’s all in his first book!

In his pathbreaking work on socialism, Mises began the work of spellingout the critical role of (genuine) markets in capital goods for economiccalculation. He pointed to entrepreneurship as the key to the marketprocess. He examined interventionism by asking whether its operationwould not bring about results contrary to the ostensible goals of itsproponents, and by sketching an ‘‘interventionist dynamic’’ that takes holdwhen proponents persist. In political economy, in the words of David Hart(1982), Mises sought to illuminate ‘‘the causal interrelationships betweenprivate property, the division of labor, free trade, and peace.’’

Friedrich Hayek extended two main areas of the Misesian researchprogram: the problem of economic calculation and the features of thebusiness cycle. In the area of calculation he emphasized the dispersion ofeconomically relevant knowledge in society and the attendant problemof coordinating the plans of people who act on local knowledge aboutresources and economical production techniques. He urged economiststo think about the price system as a coordinating device, and aboutcompetition as an irreplaceable procedure for discovering which businessplans are appropriate to the resources, technology, and plans of others ina society. In the area of business cycle research Hayek hypothesized thatthe seeds of the downturn are sewn when a distortion of the interest rateleads to unsustainable changes in the capitalistic structure of production.He pointed to inherent instabilities in the world monetary system created byspecifically national credit superstructures resting on national central banks.

LAWRENCE H. WHITE14

Late in his career, Hayek raised the question of the consequences of thedenationalization of money.

THE REVIVAL OF THE RESEARCH PROGRAM

For the first 15 years or so of the post-1974 revival, a large percentage of thepapers in ‘‘Austrian Economics’’ were exegetical exercises in the history ofeconomic thought, or methodological ruminations on how one ought to doeconomics.8 One of my own first publications (White, 1977) was a historicalexegesis of Austrian methodological ruminations, entitled ‘‘Methodologyof the Austrian School,’’ so I cannot plead innocence here. During thisperiod, graduate students in the Austrian economics programs at NYU andGeorge Mason were spending time and gray matter studying thehermeneutics of Hans-Georg Gadamer, although they had not yet readmuch of the economics of Menger or Mises. At a professional societysession I was asked to comment on a student paper on hermeneutics. I raisedthe obvious question of whether, for a student who has read Mises’ defenseof subjectivism, the marginal benefit of studying Gadamer’s defense ofsubjectivism exceeded the opportunity cost of studying actual Austrianeconomics.9

Too little of the ‘‘Austrian’’ work in this phase actually did economics,that is, used Austrian ideas to offer novel explanations of important featuresof the world. I say ‘‘too little’’ because the benefits from doctrine-historicaland methodological studies decline at the margin. Time spent on themcrowds out time spent making substantive contributions where Austriansare well equipped to contribute: to the study of capitalistic production,business cycles, monetary and banking institutions, the firm, monopoly andantitrust, entrepreneurship and market process, the legal system, socialism,and state intervention. Austrian economics will fail to capture the interestand respect of the economics profession if it is all meta-economic talk andno explanatory action, if it neglects to generate interesting explanatoryconjectures and refutations.10 I am not criticizing the work that was donein Austrian methodology or the history of economic thought, only theabsence of other more applied work. Some amount of backward-lookingand methodologically defensive work was no doubt indispensable to therevival of a consciously Austrian tradition.

Here I face a paradox. If I declare that I am against economists spendingmuch time prescribing to other economists how they should conduct their

The Research Program of Austrian Economics 15

research, I’m making a prescription to other economists myself. Let meinstead invoke the sage advice of Edgeworth (1891, p. 633):

As the producer of wealth will push his investment in the different agents of production

up to a certain limit which has been called ‘‘margin of profitableness’’; so, in the

manufacture of economic wisdom, each of us should expend his little fund of energy,

partly on the fixed capital of the deductive organon and partly on the materials of

historical experience. The margin of profitableness in the intellectual as in the external

world will differ with the personality of individuals. No general rule is available, except

that, like the cultivated Athenian, we should eschew the invidious disparagement of each

other’s pursuits.

Austrian economics provides a set of useful ideas for analyzing economicpatterns, for doing economic history. It provides a ‘‘set of tools.’’ The bestway to demonstrate that these tools are useful is to use them, not to talkabout their virtues in the Abstract. But of course we should do research forthe sake of better understanding the world, not for the sake of demonstratingthe greater virtue of one approach over others. The purpose of choosing themost effective potato masher is to mash potatoes most effectively, not tomake a case for that style of masher.

In the second half of the revival to date, from 1990 to the present, theabsolute volume and percentage of useful Austrian research, going beyondmethodology and history of thought, has fortunately increased. Austrianeconomics has become more applied. For example:

Peter Boettke (1993) on perestroika, Emily Chamlee-Wright (1997) onurban female entrepreneurship in Ghana, Roger Garrison (1994) onparallels between the business cycles of the 1920s and 1980s, Steve Horwitz(1990) on the Panic of 1907, Steve Horwitz and Peter Lewin (2001) onchanges in family structure, Sandy Ikeda (2004) on urban planning, Peter G.Klein and Sandra K. Klein (2001) on corporate divestitures, Israel Kirzner(1997, pp. 54–63) on advertising and antitrust, Roger Koppl and LelandYeager (1996) on ‘‘big players’’ in the Russian ruble market, RichardLanglois (1999) on the historical evolution of the factory system, MikeMontgomery (1995) on cyclical persistence in investment, Frederic Sautet(2000) on the entrepreneurial theory of the firm, George Selgin (2008) onthe history of private coinage, Stefan W. Schmitz (2002) on electronicmoney, Ed Stringham (2003) on the development of securities trading in17th-century Amsterdam and Esteban Thomsen (1992) on the informationalrole of prices.

What makes these works ‘‘Austrian’’ is their analytical grounding (at leastin part) in the theoretical tradition from Menger to Mises and Hayek.11

LAWRENCE H. WHITE16

What makes them valuable is their explanatory oomph. Defining Austrianeconomics as an analytical tradition makes it clear, I hope, that a pieceof economic research can be Austrian but unimportant or misapplied(the theory may not actually fit the case at hand) or even erroneous. Justas Mises (1981, p. 181) found flaws in Menger, we are free to find variousflaws in the arguments of Mises and Hayek. Conversely, a different pieceof economic research can be non-Austrian but extremely valuable. Usefuleconomics can be found outside the Austrian tradition.

Free banking research provides an example of research that is Austrian byits grounding in Mises. Subrick and Beaulier (2004, p. 7), however, write:

While the theoretical and empirical ‘‘free banking’’ contributions of Selgin and White

marked a significant contribution to monetary economics, its [sic] does not follow

directly from the Austrian tradition. [Footnote in the original: For example, Hayek did

not support free banking. See White (1999)]. Rather, their work has been adopted and

accepted by the Austrians. Additional work in monetary economics that flow fromMises

and Hayek has not materialized in great substance.

In fact, one of the points I made in White (1999) is that it is surprising thatHayek did not think free banking conducive to economic coordination,because Mises did. Furthermore, Hayek should have ‘‘supported’’ freebanking to be consistent with his own thought in other areas. Theproposition that free banking promotes economic coordination does ‘‘followdirectly from the Austrian tradition.’’

ECONOMIC POLICY

What defines whether a work is ‘‘Austrian in theory’’ is not whether itsupports laissez-faire conclusions. As a citizen I am not against laissez-faireconclusions, but as an economist I insist that such conclusions are neithernecessary nor sufficient for Austrianness. It is not sufficient because worksin the Chicago and Public Choice traditions, and other forms of neoclassicaleconomics, can be and are used to support laissez-faire conclusions. It is notnecessary because a useful Austrian work may support no policyconclusions, or even anti-laissez-faire conclusions.

Nobody can say that Austrian economics is entirely policy-neutral inpractice, because work in Austrian economics more often supports laissez-faire than does work in mainstream economics. Even Israel Kirzner (1992,p. 86), who scrupulously cautions against conflating wertfrei economicanalysis with policy advocacy, acknowledges that ‘‘the later Austrians

The Research Program of Austrian Economics 17

arrived at even more consistently laissez-faire positions’’ than the foundersof the school. Menger’s revolutionary view of how the market is driven byconsumer wants did not prevent him from endorsing positive degrees ofredistribution, paternalism, and state enterprise (Kirzner, 1992, pp. 94–96).But after Friedrich von Wieser (1927 [1914]), who advocated progressiveinterventionism bordering on Fabianism, and especially in the post-1974revival, the set of anti-laissez-faire policies promoted in Austrian works issmall (Boettke, 1995). Mises was more pro-laissez-faire than other Austriansof his and earlier generations, and it was above all Mises who has influencedthe post-1974 revival via his students in the United States (especiallyKirzner, Rothbard, and Sennholz, of whom Rothbard has been especiallyinfluential and especially libertarian).12

The reason for the laissez-faire connection is that Austrian theories(particularly the Mises-Hayek-Kirzner theory of the entrepreneurial marketprocess) explain how unrestricted markets tend to achieve coordination, andhow restrictions on markets hamper coordination.

So it is understandable to associate Austrian economics with laissez-fairepolicy conclusions, as, for example, Mark Skousen (2005) does in his recentbook Vienna and Chicago: Friends or Foes?13 But it is nonetheless potentiallymisleading to differentiate the Austrian School from the Chicago School,as Skousen does, not only by positive theory and methodology but also by agreater degree of ‘‘anti-statism’’ (e.g., greater skepticism of antitrust policy)and greater support for the gold standard.14 Those policy positions areneither necessary nor sufficient to identify an author as an Austrianeconomist. David Friedman is more anti-statist than Roger Koppl, butKoppl’s economics is more Austrian.15

Austrians have long debated whether Austrian economics is or can bewertfrei. One external observer, the Chicago economist Sherwin Rosen(1997, p. 143), complimented Austrians for not being wertfrei:

The analytical precision of neoclassical economics as a logical system in principle is

hermetically sealed from philosophical, ethical and moral issues, though of course in

practice it is not. Neoclassical welfare economics is greatly constrained by the necessity

of respecting known or given preferences and technologies. Austrians are not unwilling

to confront questions of what kinds of social institutions and rules of the game make for

a good society.

Do Austrians deserve the compliment? Yes and no. Yes, in the sense thatAustrian economics (but also public choice) does examine the effects ofinstitutions and ‘‘rules of the game’’ – for example, how stock markets andprivate property in capital goods enable economic calculation. No, in the

LAWRENCE H. WHITE18

sense that prescribing the features of ‘‘the good society’’ is outside the realmof Austrian economics as such. Austrian welfare analysis is every bit asconstrained as neoclassical analysis by ‘‘the necessity of respecting known orgiven preferences and technologies.’’ If these are your preferences (e.g., thatmisdirecting and thereby wasting investment is bad), then these are theappropriate policies (do not have the central bank expand the supply ofcredit so as to distort the interest rate temporarily). But yes again, in thesense that Mises, Hayek, and many of their followers, as individuals, haveoften been willing – more often than neoclassical economists – to replacetheir economist hats with political philosopher hats in order to writenormatively about constitutional political economy.16

Some readers simply miss the distinction between two disjoint sets:{an author’s work in Austrian economics} and {that same author’s work inpolitical philosophy or public policy}. Rosen (1997, p. 143) cites Hayek’sThe Constitution of Liberty as though it were just as much a work inAustrian economics as Hayek’s earlier economics articles ‘‘Economicsand Knowledge’’ and ‘‘The Use of Knowledge in Society.’’ Arnold Kling(2003), citing political commentary on the Mises Institute website, writes:‘‘The Austrian School thinks that you do not need a government toprovide national defense.’’ In case it needs to be said explicitly, letme say it explicitly: Austrian economics encompasses neither Hayek’sOld Whig constitutionalism nor Murray Rothbard’s anarcho-capitalism.Those are separate bodies of thought. It is in our interest as economiststo maintain the distinction between our economics and our politicalphilosophy, so that well-meaning observers who do not acceptparticular political views do not view our economic analysis (theoriesand their historical applications) as tainted. It is at least partly the faultof self-styled Austrians that the distinction has not been clear to readerslike Kling.

THE FORTUNES OF AUSTRIAN ECONOMICS

The Nobel Memorial Prize came to Hayek, not coincidentally, as Keynesianmacroeconomics was collapsing. Of course it was not Hayekian theory thatbrought down the Keynesian edifice, but Monetarist empiricism. There weretoo few working Austrian macroeconomists in 1974 to field a baseball team.The views that gained market share at Keynesian expense were Monetarismand then New Classical Macroeconomics (also known as RationalExpectations), which morphed into Real Business Cycle Theory. Austrian

The Research Program of Austrian Economics 19

economists received some nods in the process. Robert Lucas (1977) citedHayek on the research agenda of squaring business cycle theory with generalequilibrium theory. The first sentence of Finn Kydland and EdwardPrescott’s (1982) famous real business cycle paper cites Bohm-Bawerk’sobservation that production takes time. Some Austrian themes could beidentified in both new theories. Lucas shared with Mises and Hayek theproposition that monetary shocks initiate the cycle. But he explicitly rejectedon empirical grounds their view that temporary distortion of the interest ratepropagated the cycle. Kydland and Prescott rejected even the propositionthat monetary shocks initiate the cycle.

In retrospect, it seems a shame that no Austrians provided the journalswith empirical evidence in favor of the Austrian theory. If we recognize it asa shame, there is a lesson to be learned: it pays to keep on top of themainstream literature for openings where Austrian insights can beinterjected. My own best journal placement came from being alert topeculiar ideas in the work of Fischer Black and Eugene Fama (plus the goodluck that the AER sent my paper to Black to referee, and his responseconvinced the editor that his views were indeed very peculiar and worthcriticizing). I kick myself for not having been alert early on to theimportance of the Diamond-Dybvig model of bank runs.

In 1989, the Berlin Wall fell. Two years later the Soviet Union dissolved.The Austrian position in the debate over socialist calculation gainednew academic respect. Not only in comparative economics but also inindustrial organization, neoclassical economists gave new attention toHayek’s insights into the role markets play in coordinating activityin an economy of widely dispersed information. Wrote Rosen (1997,pp. 144–45):

In what was perhaps their finest hour, the Austrians, led by Mises and Hayek, argued

that [Lange’s] vision of market socialism was impossible, and that it was based on a

fundamentally misguided vision of markets and prices. The failure of planning and

central control and market reforms occurring all over the world today is one of the most

important economic events of our age. Isn’t it is odd that so few neoclassical economists

could use their theory to take much of a stand on such matters? But the logical basis of

neoclassical theory is not well-equipped for that task.

The non-Austrian libertarian Bryan Caplan (2004, p. 33), however, is lessimpressed: ‘‘[H]istorical evidence suggests that poor incentives – not lack ofeconomic calculation – were the main source of the economic defects of‘really existing socialism.’ ’’ Whether Caplan is right is a question nowcalling for applied research, not immunizing stratagems.

LAWRENCE H. WHITE20

WHY HAS NOT AUSTRIAN ECONOMICS RESEARCH

FARED BETTER PROFESSIONALLY?

Austrians have not published much in the top journals. Subrick andBeaulier (2004, p. 3 n. 1) find only five Austrian articles in the AER and JELsince 1984. Only two authors doing Austrian work appear in Tom Coupe’slist of the world’s top 1000 economists ranked by 1990–2000 publications intop journals.17 Why have the journals not been more receptive?

Peter Boettke (2005) has optimistically claimed that Hayek’s prize hada tremendously positive effect on the profession’s estimation of the scientificcharacter of Austrian economics:

Mises, unfortunately, after the Samuelsonian revolution was dismissed as a non-scientist

pretending to be a scientist. After Hayek won, at least the Austrians were considered as

part of the scientific community whereas before they were not.

Frederic Sautet (2005), however, pertinently asks (on a blog where he andBoettke are co-contributors) why Austrians are professionally marginalized(‘‘Why Aren’t Austrians at the Discussion Table?’’). He tentatively answersthat – contra Boettke – the mainstream still finds Austrian economicsunscientific due to its lack of mathematical logic and econometric testing.Given that the mainstream attitude is not going to change soon, Sautetrecommends that Austrians get on with doing empirical studies using ‘‘fieldwork research, statistical information,’’ and news accounts. It is not clearwhy he does not also recommend using mathematics and econometrics(non-naively, of course) where they can be judiciously used for what Sautetcalls ‘‘illustrating the logic of choice at work in the world.’’

The question of barriers to Austrian success in a mainstream-dominatedprofession is related to the question of whether Austrian economics iscomplementary or radically subversive of mainstream economics. I honestlythink that the most valuable explanatory parts of Austrian economics arecomplementary. The view that it is radically subversive, held by Austrians atthe Lachmann-Shackle end of the spectrum, seems to be pragmatically self-defeating in the sense that it hasn’t generated novel explanatory conjecturesand refutations.18 Strategically, marketing Austrian economics as radicallysubversive will not help Austrians get a ‘‘seat at the table.’’

NOTES

1. In English translation: Menger (1981).

The Research Program of Austrian Economics 21

2. Wrote Mises (1969, p. 41) about the success of Menger and his immediatefollowers: ‘‘But after some years all the essential ideas of the Austrian School wereby and large accepted as an integral part of economic theory. About the time ofMenger’s demise (1921), one no longer distinguished between an Austrian Schooland other economics.’’ He noted one exception: the ‘‘Austrian’’ label remainedattached to a distinctive theory of the business cycle.3. Steve Horwitz (2000, ch. 1) elaborates how Menger’s contributions have been

extended by Mises, Hayek, and Kirzner.4. Mario Rizzo (1996, p. xiv) has contrasted Austrians to neoclassicals as follows:

‘‘Austrians ask different kinds of questions and provide different kinds of answers.This is not to say that they may not sometimes ask the same or similar questions orthat their vocabulary might not be at least superficially similar to that of theneoclassical mainstream. It is to say, however, that Austrian economics is afundamentally different enterprise from neoclassical social physics.’’5. In 2005 the Wikipedia entry on ‘‘Austrian School’’ (http://en.wikipedia.org/

wiki/Austrian_School; accessed on 5 October 2005) unfortunately began: ‘‘TheAustrian School is a school of economic thought that rejects . . . ’’ It has since beenrevised to the prefereable ‘‘that advocates,’’ but still defines the school bymethodological commitments.6. The logo of the Association for Private Enterprise Education adds a paradox to

the infelicity of taking Smith’s metaphor literally: it pictures an ‘‘invisible hand’’holding the world.7. For a different perspective on the contrast between Menger and Smith, see

Daniel Klein (1997).8. For quantitative evidence based on counting articles in the Review of Austrian

Economics, see Subrick and Beaulier (2004), Table 1.9. Peter Boettke later told me that this became known as ‘‘the White critique’’ of

hermeneutics.10. I have made this argument before: White (1992, p. 258).11. For a summary of this tradition see Kirzner (1992, ch. 3).12. See Powell and Stringham (forthcoming).13. I must register my disagreement with Skousen’s statements (2005, p. 3) that

Austrian economics defends property as the basis of justice and defends the freemarket as a means of maximizing happiness. The former view conflates Austrianeconomics with libertarian legal theory. The latter would violate the Austrian tenetthat economic theory is about preferences and choices and not about hedonicexperiences (see White, 1995).14. A technical quibble: Skousen (2005, p. 8) writes that ‘‘the Austrians . . . maintain

that a given rate of monetary inflation is never sustainable, whatever the level.’’ If weassume a gold standard is in place, and is subject to supply and demand shocks, thesupposedly maintained position would be true. But nothing in Austrian monetarytheory says that a positive rate of monetary expansion is unsustainable under a fiatstandard. (Some Austrians may have suggested that any fiat standard must sooner orlater explode, but experience has cast doubt on that view by now). For example, themonetary base could grow at 2% per year for decade after decade.15. I use Roger Koppl as my example of an Austrian who is not an arch-

libertarian because he has so identified himself in public discussions.

LAWRENCE H. WHITE22

16. Israel Kirzner is a prominent Austrian who has seldom if ever been knownto don a political–philosopher hat.17. See Coupe’s lists at http://student.ulb.ac.be/Btcoupe/ranking.html18. I worry that viewing Austrian economics as ‘‘the economics of time and

ignorance’’ can devolve into viewing it as ‘‘the economics of questions about whichone can only make methodological statements’’.

REFERENCES

Boettke, P. (1993).Why perestroika failed: The politics and economics of socialist transformation.

New York: Routledge.

Boettke, P. (1995). Why are there no Austrian socialists? Ideology, science and the Austrian

school. Journal of the History of Economic Thought, 17(Spring), 35–56.

Boettke, P. (2005). ‘‘Re: RE: [mises] A Nobel for Kirzner,’’ Message 13724 posted to Mises

Yahoo! Group (14 Sept., 2005, 4:25 pm). Available at http://groups.yahoo.com/group/

mises/message/13724

Buchanan, J. M. (1982). Order defined in the process of its emergence. Literature of Liberty,

5(Winter), 5. Available at http://oll.libertyfund.org/Essays/Bibliographical/Barry0312/

ReadersForum.html#xx01

Caplan, B. (2004). Is socialism really ‘‘impossible’’? Critical Review, 16(1), 33–52.

Chamlee-Wright, E. (1997). The cultural foundations of economic development. London:

Routledge.

Edgeworth, F. Y. (1891). An introductory lecture on political economy. Economic Journal, 1,

625–634.

Garrison, R. W. (1994). The roaring twenties and the bullish eighties: The role of government in

boom and bust. Critical Review, 7, 259–276.

Hart, D. (1982). Ludwig von Mises, money, and the fall and rise of classical liberalism in the

20th century. Retitled editorial originally published in Literature of Liberty, 5 (Autumn

1982). Available at http://www.econlib.org/library/Essays/LtrLbrty/msEdBib1.html

Horwitz, S., & Lewin, P. (2001). Changes in the family – A market process approach to

divorce. Unpublished manuscript. Available at http://www.utdallas.edu/Bplewin/

marketprocessfamily.pdf

Horwitz, S. G. (1990). Competitive currencies, legal restrictions, and the origins of the fed:

Some evidence from the panic of 1907. Southern Economic Journal, 56, 639–649.

Horwitz, S. G. (2000). Microfoundations and macroeconomics: An Austrian perspective.

New York: Routledge.

Ikeda, S. (2004). Urban interventionism and local knowledge. Review of Austrian Economics,

17(June), 247–264.

Kirzner, I. M. (1992). The meaning of market process. London: Routledge.

Kirzner, I. M. (1994). Introduction. In: I. M. Kirzner (Ed.), Classics in Austrian economics

(Vol. 1). London: Pickering and Chatto.

Kirzner, I. M. (1997). How markets work: Disequilibrium, entrepreneurship and discovery.

IEA Hobart Paper no. 133. Institute of Economic Affairs, London.

Klein, D. B. (1997). Convention, social order, and the two coordinations. Constitutional

Political Economy, 8, 319–335.

The Research Program of Austrian Economics 23

Klein, P. G., & Klein, S. K. (2001). Do entrepreneurs make predictable mistakes? Evidence

from corporate divestitures. Quarterly Journal of Austrian Economics, 4, 3–25.

Kling, A. (2003). The sect of Austrian economics. Tech Central Station, 11/11/2003. Available

at http://www.techcentralstation.com/111103C.html

Koppl, R., & Yeager, L. (1996). Big players and herding in asset markets: The case of the

Russian ruble. Explorations in Economic History, 33, 367–383.

Kydland, F., & Prescott, E. C. (1982). Time to build and aggregate fluctuations. Econometrica,

50, 1345–1371.

Langlois, R. N. (1999). The coevolution of technology and organization in the transition to

the factory system. In: P. L. Robertson (Ed.), Authority and control in modern industry

(pp. 45–72). London: Routledge.

Lucas, R. (1977). Understanding business cycles. Carnegie-Rochester Conference Series on

Public Policy, 5, 7–29.

Menger, C. (1981). Principles of economics. (James Dingwall & Bert F. Hoselitz, Trans.).

New York: New York University Press.

Menger, C. (1985). Investigations into the method of the social sciences with special reference to

economics. (Francis J. Nock, Trans.). New York: New York University Press.

Montgomery, M. (1995). Capital complementarity, time-to-build, and the persistence of

investment starts. Journal of Macroeconomics, 17, 187–205.

Powell, B., & Stringham, E. Economics in Defense of Liberty: The Contribution of Murray

Rothbard. In: S. Horwitz (ed.), Biographical dictionary of Austrian economists.

Cheltenham, UK: Edward Elgar, forthcoming.

Rizzo, M. J. (1996). Foreward. In: P. Gerald, F. ODriscoll, Jr. & M. J. Rizzo (Eds),

The economics of time and ignorance (2nd ed.). New York: Routledge.

Rosen, S. (1997). Austrian and neoclassical economics: Any gains from trade? Journal of

Economic Perspectives, 11, 139–152.

Sautet, F. (2000). An entrepreneurial theory of the firm. London: Routledge.

Sautet, F. (2005). Why Aren’t Austrians at the Discussion Table. Posted to The Austrian

Economists blog (16 September 2005, 01:28 AM). Available at http://austrianeconomists.

typepad.com/weblog/2005/09/why_arent_austr.html

Schmitz, S. W. (2002). The institutional character of new electronic payments systems:

Redeemability and the unit of account. In: L. Michael & S. W. Schmitz (Eds), Carl Menger

and the evolution of payments systems: From barter to electronic money (pp. 159–183).

Cheltenham: Edward Elgar.

Selgin, G. (2008). Good money: Birmingham button makers, the royal mint, and the beginnings of

modern coinage, 1775–1821. Ann Arbor: University of Michigan Press.

Skousen, M. (2005). Vienna and Chicago: Friends or foes? Chicago: Regnery.

Stringham, E. (2003). The extralegal development of securities trading in seventeenth century

Amsterdam. Quarterly Review of Economics and Finance, 43, 321–344.

Subrick, J. R., & Beaulier, S. (2004). An appeal from new to old (and middle-aged)

Austrians. Unpublished manuscript. Available at http://www.scottbeaulier.com/

ANAPPEALFROMNEWTOOLD.doc

Thomsen, E. F. (1992). Prices and knowledge: A market-process perspective. London: Routledge.

von Mises, L. (1969). The historical setting of the Austrian school of economics. New Rochelle:

Arlington House.

von Mises, L. (1981). Epistemological problems of economics. New York: New York University

Press.

LAWRENCE H. WHITE24

von Wieser, F. (1927 [1914]). Social Economics. trans. A. F. Hinrichs. New York: Adelphi.

White, L. H. (1977). Methodology of the Austrian school. New York: Center for Libertarian

Studies.

White, L. H. (1992). Afterword: Appraising Austrian economics: Contentions and misdirec-

tions. In: B. J. Caldwell & S. Boehm (Eds), Austrian economics: Tensions and new

directions (pp. 257–268). Boston: Kluwer.

White, L. H. (1995). Is there an economics of interpersonal comparisons? Advances in Austrian

Economics, 2a, 135–151.

White, L. H. (1999). Why didn’t Hayek favor laissez-faire in banking? History of Political

Economy, 31, 753–769.

INTRODUCTION

Roger Koppl

The chapters collected in this volume were originally given at a memorable2005 conference in Edmonton, Canada. Our host was the Wirth Institute forAustrian and Central European Studies. The conference organizer,Professor Vivek H. Dehejia of Carleton University assembled an impressiveand amiable group of scholars, each of whom has a serious interest in theAustrian school of economics. The Wirth Institute took its current name inrecognition of the generous endowment of Dr. Manfred Wirth and his sonDr. Alfred Wirth. Their generosity to the institute reflects a commitment totheir Austrian heritage that extends beyond present-day Austria toencompass the broad cosmopolitan legacy of central Europe as a whole.Conference participants could not fail to notice the dedication of WirthInstitute staff including its Director, Dr. Franz A. J. Szabo, to the commoncultural legacy of central Europe.

The conference opened with a talk from Alfred Wirth, which revealedboth an unexpectedly deep immersion in the Austrian school of economicsand a capacity for brevity rarely seen in such patrons. Dr. Wirth noted thatthe Austrian school illustrates the fact that ‘‘Success, and especially generalacceptance, often leads to being forgotten.’’ Much of what was once uniqueto the Austrian school has become part of the cognitive DNA of work-a-dayeconomists. Given today’s sad neglect of the history of economic thought,these same economists often wonder quite sincerely what the fuss is aboutwhen it comes to the Austrian school. The conference confirmed theunstated premise of Dr. Wirth’s talk: There are more successes ahead forthe Austrian school; the riches of the Austrian school have not been

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ROGER KOPPL2

exhausted and further inquiry in the Austrian tradition will likely yieldmuch that is new and valuable to offer in trade with other intellectualtraditions.

Our keynote speaker was Lawrence H. White, the F. A. Hayek Professorof Economic History at the University of Missouri, St. Louis. No strangerto the history of economic thought, Professor White recounts some of thesuccesses Dr. Wirth referred to and chronicles the revival of the Austrianschool, which can be dated to about 1974. At first, work of ‘‘the post-1974revival’’ was heavy on methodology and exegesis, and light on economics.Beginning about 1990, however, the new Austrians started to shed thecocoon of methodology and exegesis and sat down to work on economicproblems. Professor White points to his own ‘‘methodological ruminations’’of this period in order to politely pretend that he, too, was wound up in thesame cocoon. In truth he was doing important work in money and bankingfrom the start. The rest of us caught up about 1990 and finally began toproduce ‘‘useful Austrian research, going beyond methodology and historyof thought.’’ (Larry does not mince words.) The talk ends with a discussionof ‘‘the fortunes of Austrian economics’’ and a plea that Austrians give upthe posture of ‘‘radical subversion’’ in favor of the view ‘‘that the mostvaluable explanatory parts of Austrian Economics are complementary.’’White seems to ask: ‘‘If you’re so smart, why aren’t you cited?’’

In the short time since White issued his challenge, we have seen the rise ofa group of talented young graduates of GMU’s doctoral program, includingEd Stringham, Ben Powell, Scott Beaulier, Bob Subrick, Peter Leeson, ChrisCoyne, Anthony Evans, and Dan D’Amico. They have amassed animpressive volume of publications, including many in non-Austrian journalssuch as Kyklos and Journal of Economic Behavior and Organization. Leesonand Coyne have ‘‘A hits’’ with articles in the Journal of Political Economy,Journal of Law and Economics, and Economic Journal. This same group ofauthors has succeeded in the popular media with appearances in (or on)CNN, the New York Times, The Economist, and the Boston Globe. More tothe point of the White challenge (‘‘If you’re so smart, why aren’t youcited?’’), this group has been cited frequently in the mainstream literature.

Mises and the economists of his ‘‘Circle’’ were cited frequently. They werealso deeply involved with the mass media of contemporary Austria, asHansjorg Klausinger chronicles. The episode he covers is important anddeserves greater attention. In the inter-war years, Mises and his colleagueswere trying to rescue Austrian civilization and fend off collectivist threats tocivil peace and the division of labor. They launched a coordinated campaignof newspaper articles, columns, letters, and so on meant to sway public

Introduction 3

opinion toward liberal policies and away from collectivism and nationalism.The liberalism of Mises’ group reflected a keen awareness of the disaster thatcollectivist ideologies threatened to create. Mises (1933, p. 202) warned atthe time that we will have ‘‘progress on the road the western civilization hastaken for thousands of years, or a rapid plunge into a chaos from whichthere is no way out, from which no new life as we know it will ever develop’’depending on whether the voice of the economist is heard. It was not heard.Klausinger notes that in this effort, ‘‘the liberal cause had to rely on shiftingcoalitions and fragile personal relations, which in the end turned out tooweak for sustaining the policies envisioned by the Austrian economists.’’

Austrian economists have not always appreciated the important eventsKlausinger describes. We have been more conscious of the methodologicalwritings of the period than of these popular writings. For Mises, Machlup,and the others, I think, both types of work were part of the same struggle tosave Austrian civilization. This point suggests and addendum to the Whitechallenge: If you must do methodology, be sure the points at issue matterfor what happens outside the moldering wall of your university’s perimeter.

White’s welcome challenge seems a fitting introduction to MartinGregor’s chapter comparing the efficacy of private and public institutionsat correcting erroneous believes. Adopting the epistemic perspectivecharacteristic of Austrian economics, Gregor takes on Wittman (1995),who argues that democratic markets are efficient. Gregor develops anevolutionary model that lets him compare the likely efficiency of collectiveand decentralized choice in converging on a language of commerce fortrading groups. With decentralized choice, agents with a low opportunitycost will more readily undertake the cost of learning a new language in orderto trade with persons having a different native tongue. In almost all cases,therefore, the system converges on the more easily learned language. Incollective choice, false perceptions of the electorate have a greater chance ofproducing the wrong collective choice. Gregor’s example reflects (con-sciously, I presume) the ‘‘language problem’’ of the Hapsburg empire(Schorske, 1981, p. 236).

Gregor’s chapter includes an astute critique of Bryan Caplan’s ‘‘rationalirrationality.’’ Caplan’s emphasis on the value of expertise may be at oddswith Hayek’s account of the production and distribution of knowledge insociety. This account owes much to Hayek’s role in the ‘‘calculation debate’’of the 1930s and 1940s. As the chapter of Boettke, Coyne, and Leesonexplains, the claim was that ‘‘without private property in the means ofproduction, rational economic calculation is not possible.’’ In The Road toSerfdom, they explain, Hayek drew out the social consequences of ignoring

ROGER KOPPL4

this epistemic limit. When governments try to substitute plan for marketthey must either mitigate the role of plan or turn tyrannical. ‘‘Hayek’sargument,’’ they say, ‘‘is that just as we should expect those with superiorskills in any industry to rise to the top, we should also expect those who havesuperior skills in exercising political power and coercion to advance withinthe political apparatus of planning.’’

I agree with the claim of Boettke, Coyne, and Leeson that Hayek’s classicbook and ‘‘his entire body of thought in the area of political economy, are asrelevant today as they were then.’’ To cite just one supporting example,much of the current literature on prediction markets, cascades, and othermanifestations of the wisdom (Surowiecki, 2004) and folly (Mackay, 1841)of crowds (Bikhchandani, Hirshleifer, & Welch, 1992 and Hanson, 1999)reflect Hayek’s insight from The Road to Serfdom that the ‘‘interaction ofindividuals, possessing different knowledge and different views, is whatconstitutes the life of thought’’ (Hayek, 1944, p. 165). Vela Velupillai’s(2007, p. 288) demonstration of ‘‘The Impossibility of an Effective Theoryof Policy in a Complex Economy’’ seems to have led him to an appreciationof Hayek’s ‘‘lifelong skepticism on the scope for policy in economies thatemerge and form spontaneous orders.’’

Velupillai is an important complexity theorist and several persons havenoted the links between Hayek’s theory of complexity and moderncomplexity theory (Rosser, 1999; Koppl, 2000; Caldwell, 2004; Markose,2005). Caldwell seems to infer that hermeneutics is ‘‘too literary inorientation’’ and ‘‘too extrascientific’’ to be a part of Hayek’s ‘‘scientificsubjectivism.’’ My chapter takes on this argument and a similar one fromViktor Vanberg. My argument depends crucially on distinguishing the‘‘classical hermeneutics’’ of Wilhelm Dilthey, Max Weber, and others fromthe ‘‘universal hermeneutics’’ that begins with Martin Heidegger. I believe itis a mistake to think that Hayek’s complexity theory or his theory of mind issomehow inconsistent with classical hermeneutics. In other words, peace,love, and understanding should prevail between scientific and humanisticsocial science. My chapter may run contrary to the spirit of White’s keynoteaddress because it is exegetical and methodological. I am even forced toadmit that is may all be a quibble over words. But if peace and love do notprevail between humanistic and scientific social science, then each style ofsocial science loses insights and wisdom peculiar to the other style. Pro-market economists should lament such lost gains from trade.

Torsten Niechoj provides an interesting opportunity for trade across adifferent border, namely that between supporters and opponents of tradeunions. Hayek was clearly in the latter group. He was concerned by his

Introduction 5

perception that many large labor unions in the democratic West hadexcessive power, including excessive political power. Niechoj thinks Hayekhas undervalued the positive functions of unions. He develops a brilliantinternal critique of Hayek’s posture toward unions that builds nicely onHayek’s work on the production and distribution of knowledge in society.For example, unions ‘‘collect the dispersed knowledge of individuals andtransform it into public knowledge, which can be used and discussed.’’Niechoj challenges Austrian economists by pointing deeply Hayekianarguments in unexpected directions.

Horwitz and Lewin also challenge Austrian economists by pointingHayek’s capital theory in unexpected directions. Horwitz gives us a closestudy of the analogies between Hayek’s theory of capital and his theory ofmind. Both are adaptive classifying systems in the sense of McQuade andButos (2005). Like the mind, the capital structure is a kind of map of theeconomy that embodies, and thus defines, ‘‘the contours of the possible.’’Like the mind, the capital structure is an ‘‘expectational model’’ because itembodies the forward-looking plans of entrepreneurs. Like the mind, finally,the capital structure is classificatory because the uses of the different bits andtheir inner relations undergo adaptive change in response to price changesand other changes in the economy.

The analogy has its limits, as Horwitz carefully points out. It is helpfuland informative, however, in part because it ‘‘might help us to deepen ourunderstanding of firms as sites of organized learning.’’ I might add thesuggestion that each firm has malleable and fixed aspects to its theory of theworld. The firm’s structure of human and non-human capital can changeover time, but its ‘‘core competency’’ may be fixed in invariable even whenthe outside world stops valuing that core competency. This fixed part of thefirm’s nature might be compared to the deepest and most invariable parts ofour mental apparatus, such as our psychology of vision. I cannot help seeingthe stick in the water as bent, even though I know it is not. Just as biologicalevolution endows us with a kind of Kantian a priori subject to change onlyin biological time, the founder of a firm may endow his organization with acore competency that cannot be altered even in the face of bankruptcy.

Peter Lewin also takes a capital-based perspective on the firm, one thatemphasizes the importance of disequilibrium, heterogeneity of resources,dispersed knowledge, and, vitally, a characteristically Austrian under-standing of rent that recognizes no essential difference between the ‘‘rent’’ ofland and the ‘‘rent’’ of a worker’s time. Armed with this Austrianunderstanding of rent, Lewin concludes that ‘‘heterogeneity of resourceswould have no strategic significance’’ in equilibrium and in the ubiquitous

ROGER KOPPL6

disequilibrium of markets, ‘‘rent is not an indication of inefficiency ormonopoly power.’’ Lewin’s analysis reveals the shallowness of pretending tofind objectionable monopoly rents in the value-creating strategic choices ofcreative entrepreneurs. All valuable assets yield a ‘‘rent,’’ properly under-stood. Those strategic choices could enhance such rents only if the systemwere in disequilibrium in the first place, so that those rent-enhancingdecisions serve the desirable end of increased coordination.

The contributions to this volume show that the Austrian tradition is richand full of surprises. They are heterogeneous and innovative, contentious,idiosyncratic, engaging. They suggest a bright future for the Austrianschool. For those of us lucky enough to have participated in the Wirthconference that October, they will also serve as a warm reminder of a placewhere ideas in a central European tradition are valued and explored.

REFERENCES

Bikhchandani, S., Hirshleifer, D., & Welch, I. (1992). A theory of fads, fashion, custom, and

cultural change as informational cascades. Journal of Political Economy, 100(5), 992–1026.

Caldwell, B. (2004). Hayek’s challenge. Chicago: University of Chicago Press.

Hanson, R. D. (1999). Decision markets. IEEE Intelligent Systems, 14(3), 16–19.

Hayek, F. A. (1944). The road to serfdom. Chicago: The University of Chicago Press.

Koppl, R. (2000). Teaching complexity: An Austrian approach. In: D. Colander (Ed.), The

complexity vision and the teaching of economics. Cheltenham: Edward Elgar.

Mackay, C. (1841). Extraordinary popular delusions and the madness of crowds. The second

edition (1852) can be downloaded from http://www.econlib.org/library/Mackay/

macExContents.html

Markose, S. M. (2005). Computability and evolutionary complexity: Markets as complex

adaptive systems (CAS). The Economic Journal, 115, F159–F192.

McQuade, T., & Butos, W. (2005). The sensory order and other adaptive classifying systems.

Journal of Bioeconomics, 7, 335–358.

Mises, L. v. ([1933b] 1976). Epistemological problems of economics. New York: New York

University Press.

Rosser, J. B. (1999). On the complexities of complex economic dynamics. Journal of Economic

Perspectives, 13(4), 169–192.

Schorske, C. E. (1981). Fin-de-Siecle Vienna: Politics and culture. New York: Vintage Books.

Surowiecki, J. (2004). The wisdom of crowds. New York: Random House.

Velupillai, V. (2007). The impossibility of an effective theory of policy in a complex economy.

In: M. Salzano & D. Colander (Eds), Complexity hints for economic policy. Milan:

Springer.

Wittman, D. (1995). The myth of democratic failure. Chicago: University of Chicago Press.

POLICY ADVICE BY AUSTRIAN

ECONOMISTS: THE CASE OF

AUSTRIA IN THE 1930S$

Hansjorg Klausinger

ABSTRACT

In Austria the 1930s constituted the final period of success and failure ofthe Austrian school, ending with its emigration to the United States. Thischapter focuses on this period, when the Austrian economy was hardest hitby the Great Depression, and it examines the ways and means by whichthe Austrian economists attempted to influence economic policy. Inparticular, from 1932 to 1934 in a concerted effort Austrian economistslike Ludwig Mises, Fritz Machlup, and especially Oskar Morgensterntried to ‘‘educate’’ the Austrian public and policy-makers in the benefits ofa liberal approach towards the crisis. This effort included the advocacy ofthe policies typically associated with the gold standard, that is, stablemoney, balanced budgets, the absence of exchange restrictions, and freetrade. In the actual situation the outcome of these endeavors was futile, ifnot harmful, insofar as indeed Austrian economic policy slowly convertedto the implied deflationary stance of monetary and fiscal policy. Yet,under the regime of the so-called corporate state the necessary

$Paper presented at the Austrian School Conference organized by the Wirth Institute for

Austrian and Central European Studies at the University of Alberta (Edmonton, Canada).

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HANSJORG KLAUSINGER26

complement of such policies, namely the flexibility of prices and thefurthering of competition, could not be accomplished. This eventualfailure of the liberal cause may be ascribed to the fact that it had to relyon shifting coalitions and fragile personal relations, which in the endturned out too weak for sustaining the policies envisioned by the Austrianeconomists.

1. INTRODUCTION

This chapter takes up a discussion ongoing in two largely unconnectedcommunities, that is, that of Austrian contemporary historians and thehistorians of Austrian economic thought, both contemplating the influenceof the Austrian school of economics on economic policy in the 1930s. Fromthese rather different points of view the policy recommendations of theAustrian economists have been considered, either as harmful and the causeof the Austrian economy’s failure to recover from the depression, or as thelast chance for rescue missed due to the incompetence of economic policy-makers.1 Here I will turn to a question preliminary to this debate, namely,on the ways and means by which the Austrian economists attempted toinfluence economic policy, and consequently on the extent of the success orfailure of this attempt.2

To begin with, we have to identify the Austrian economists underinvestigation and the sources used. At the beginning of the 1930s the hardcore of the liberal strand of the Austrian school consisted of Ludwig Mises,widely considered as the leader of the ‘‘Austroliberals,’’ and Fritz Machlup,Friedrich August Hayek, and Gottfried Haberler as members of the nextgeneration. Of these Hayek and Haberler have played only a minor rolebecause of their frequent absence from Austria. Furthermore, we add OskarMorgenstern to this list, who – although he emphasized his distance to theMises group and became increasingly critical of the theoretical tenets of theAustrian school – in the realm of economic policy almost completelyconcurred with the views of the Austroliberals.3 Thus the economists onwhom we will mainly focus in the following are Mises, Machlup, andMorgenstern.4

The claim to novelty of this chapter rests on its use of sources hithertolargely neglected in this type of studies. Thus, although the scientific con-tributions of the authors in question are given their due weight as a back-ground to the debate, the focus will be, on the one hand, on commentaries

Policy Advice by Austrian Economists 27

and columns published in daily newspapers dealing with topical issues ofeconomic policy,5 and on the other hand, on unpublished papers andcorrespondence. In the latter regard, the documents preserved in the OskarMorgenstern Papers, in particular Morgenstern’s diary from this period, areinvaluable, and much of the following will be based on them.6 Yet, one mustbe aware from the outset of the limitations and risks of the use of suchdocuments: Not only do such papers all too often convey their author’s rathersubjective interpretation of the facts, but the conclusions drawn may also bebiased by the arbitrary selection of the documents that survived – forexample, the relevant documents from Mises, Machlup, Hayek, and Haberlerare regrettably incomplete.

The structure of the chapter mirrors a twofold approach, theoretical andhistorical.7 In the following section we present the main problems faced byAustrian economic policy and the solutions and recipes recommended bythe economists. Then, in the next section, we pursue the economists’activities of policy advice through the 1930s, concentrating on a few crucialepisodes. Finally, in conclusion, a judgment is ventured on the extent of theeconomists’ impact on actual policy, and how this impact can be attributedto the individual economists that made up the group.

2. PROBLEMS, LESSONS, RECIPES: THE

ECONOMISTS’ ADVICE

In this section we shortly characterize the Austrian economists’ position ona list of topical issues especially relevant before the background of theAustrian experience in the 1930s.8

2.1. The Danger of Inflationism

In the aftermath of the experience with hyperinflation in 1922/1923 andbased on the Austrian theory of the business cycle – where inflation byfueling the boom is the true cause of crisis and depression – the Austriansconsidered inflation as the prime economic evil. Accordingly, theycondemned as misguided the policy of the Austrian National Bank in faceof the Creditanstalt crisis in 1931, that is, its coping with the crisis bysupplying funds in exchange for Creditanstalt bills, thus increasing its bills’portfolio and, simultaneously, loosing its exchange reserves due to acurrency crisis in the wake of the banking crisis. The Austrians persisted in

HANSJORG KLAUSINGER28

their warnings about inflation even when the public switched from bankingdeposits to currency and thereby more than compensated the increase inhigh-powered money – still they saw an overhang of money and a danger ofinflation due to the existence of hoarded banknotes. Consequently, theyrecommended the return to a fixed gold parity of the Schilling as the bestrecipe to prevent inflation or any other manipulation of the currency.9

2.2. Coping with Ailing Banks

The proper reaction to the Creditanstalt crisis, and later on to the crisis ofother ailing Austrian banks, would have been to put the protection of thecurrency above the protection of the banks. Thus, insolvent – possibly incontrast to just illiquid – banks should not be rescued by injections of credit,as in the end this will lead only to inflation and a crisis of the currency, as itdid in Austria in 1931. From an economic point of view the superiorsolution was therefore to let such banks go bankrupt and liquidate them, sothat monetary stability would not be endangered, as the sound firmsformerly under the control of the failed banks would survive anyway.10

2.3. The Nonsense of Exchange Controls

In October 1931 Austria had introduced exchange controls as an emergencymeasure to cope with the currency crisis and the precipitous loss of exchangereserves. As a consequence the volume of external trade shrank considerablyand the free market rate of the Schilling diverged from the official parity byup to a maximum 35 percent; in effect this worked like an additional duty onexports and a premium on imports. Small wonder that the Austrianeconomists turned their fiercest attacks on exchange controls and from thebeginning urgently demanded their unconditional abolition. In fact, as wewill see, the rejection of the regime of exchange controls was decisive inuniting these economists in their fight against an ill-guided economic policy.They argued consistently that exchange controls could not accomplish theirtask of defending the official parity – only monetary restriction could havedone so – but due to their harmful side effects crippled Austria’s foreigntrade. These negative effects were indeed aggravated when in the attempt tomake them work exchange controls were supplemented by ever more traderestrictions: tariffs, bans on imports, quotas, clearing arrangements, and areturn to bilateralism in general. Besides, the ensuing heavy regulation of

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foreign trade and foreign exchange was regarded as paving the way towardsa planned economy, and thus had to be combated also for the sake of savingthe liberal market economy (or what then had remained of it in Austria).11

2.4. The Mechanism of the Trade Balance

The economists’ approach towards the problem of the trade balance, andthus to Austria’s notorious trade deficit, was that fundamentally the state ofthe trade balance was the result (and not the cause) of the development ofthe other items in the balance of payments, in particular of the (desired)increase in foreign indebtedness. For example, they explained the Austriantrade deficit as the consequence of capital consumption due to policieshostile to profits and investment, which gave rise to the need for importingcapital. Accordingly, a trade deficit could by no means be remedied by theintroduction of trade restrictions – with the other items in the balance ofpayments fixed such restrictions just reduce exports to the same extent asthey do imports and thus affect the volume, but not the balance of trade.Therefore, protectionism was considered the wrong method because insteadof curing a trade deficit it harmed the domestic export sector and thuseconomic activity as a whole. Obviously, this view of the trade balance reliedon the swift working of the mechanism of external trade, that is, the effect ofchanges in exchange reserves on the real exchange rate and, thereby, on thetrade balance. Specifically, in the case of a fixed gold parity the burden ofadjustment will thus rest on the flexibility of domestic prices.12

2.5. The Goal of Free Trade

The Austrian economists were champions of free trade. Thus, they deploredall the obstacles to foreign trade introduced by so many countries as aprotectionist policy response to the problems of the Great Depression.Furthermore, faced with these protectionist regulations, they recommendedradical measures: to unilaterally eliminate tariffs and restrictions for foreignimports as the best recipe for the Austrian economy. Consequently, on aglobal level, the ultimate goal was the re-establishment of universal freetrade in contrast to the proliferation of preferential treaties, like thoseestablished in the Rome Protocols concluded between Austria, Italy, andHungary in 1934.13

HANSJORG KLAUSINGER30

2.6. Foreign Debts, Moratoria, and the Transfer Problem

Consistent with their confidence in the swift working of the mechanism ofinternational trade the Austrian economists considered the transfer problem(with regard to the repayment of foreign debts) solely as the problem ofraising the required sum of money, for example, through taxes. Thus,to them the failure to transfer signified more a lack of the willingness than ofthe ability to pay, and a transfer moratorium – like that announced inAustria in June 1932 – could not be justified along these lines. Just as inthe case of domestic debts the refusal to repay foreign debts constituteda serious threat to the rule of law as a crucial base for international tradeand finance in a liberal framework.14

2.7. The Chimera of Public Works

The rejection of the idea that public works could be used as a remedy fordepression was widespread among Austrian economists, and their argu-ments based on the quantity equation were quite simple. If not accompaniedby inflation, that is, by an increase in the quantity (or the velocity) of money,public works, or other attempts at pump priming will be ineffective in theaggregate, just redistributing employment between industries. And ifaccompanied by inflation, they will indeed be effective in creating a sortof prosperity, yet as with all sorts of inflation such a prosperity will be short-lived and in the end lead to a still more severe depression. Thus, no long-term benefits, but much harm, were to be expected from such projects.15

2.8. The Remedy of Wage Cuts

To the contrary, in a depression the ‘‘natural healing method’’ (Machlup,1933b, p. 781) to follow is wage cuts. By their effects on production coststhese will induce firms to employ more workers and by a suitableredistribution of purchasing power there will also be sufficient demand forthe goods additionally produced, thus the possibility of Keynes-like effectivedemand failures was firmly denied. Yet, in these days the existence andpower of trade unions, and regulations of the labor market like theprovision of unemployment benefits, were seen as interfering with thismethod. Therefore, to many Austrian economists the depression demon-strated the necessity, and afforded the opportunity, to reshape the

Policy Advice by Austrian Economists 31

institutional framework in order to bring it closer to the ideal of classicalliberalism.16

2.9. The Quest for Auflockerung

Regulations of many kinds did not only interfere with the functioning of thelabor market but with product markets, too. Greater flexibility of prices anda more competitive environment through lower barriers to entry fordomestic and – by a less protectionist trade policy – foreign firms werepropagated under the catching phrase of Auflockerung.17 The necessity ofsuch a kind of deregulation as the preferable alternative to devaluationderived from the discrepancy that had developed between the almost stabledomestic prices in Austria and the falling prices in the world markets.Furthermore, as a result of Austrian crisis policy – and of the anti-liberalspirit to which the regime of the corporate state (Standestaat) professed –the regulations of industry and agriculture were becoming ever more rigid,and thus the need for Auflockerung more pressing, in the course of the1930s.18

3. IMPLEMENTING THE AUSTRIAN RECIPES

In this section we discuss the practice of the Austrian economists’ policyadvice – first we give an overview on the diverse channels of influence usedand then pick out a few characteristic episodes to highlight if and how suchinfluence was actually exerted. Once more, it should be kept in mind thatdepending on the available sources the choice of examples is necessarilyselective.

3.1. Channels of Influence

The most visible (and as a source accessible) way in which the Austrianeconomists propagated their policy recommendations was the campaign inthe Neues Wiener Tagblatt, already referred to earlier.19 From 1931 to 1934two types of articles by Austrian economists, most of them publishedanonymously, appeared: on the one hand, commentaries on topics ofeconomic policy (Beitrage zur wirtschaftlichen Vernunft), and on the otherhand, short weekly columns which tried to educate the public in the basics

HANSJORG KLAUSINGER32

of Austrian economic thought (Zwei Minuten Volkswirtschaft). Whereasthese more than hundred columns were solely the work of Machlup, theapproximately 75 commentaries were authored by various writers, againwith Machlup the main contributor, followed by Morgenstern and others.The initiative to these journalistic writings was born at the end of 1931,when the economic situation appeared extremely chaotic and the authorsmost urgently felt the need for a turnaround in economic policy.Consequently, the aim of the campaign was to re-establish the adherenceto liberal ideas as a guideline for policy. Presumably, the campaign itselfgrew out of a kind of liberal network: Morgenstern, the newly appointeddirector of the Austrian Institute for Business Cycle Research, Machlup,Victor Gratz, the director of the Steyrermuhl Company, which published theTagblatt, and a close friend of Mises, and the Austrian industrialist JuliusMeinl appear to have participated in this initiative. In parallel within theChamber of Commerce Mises attempted – by and large successfully as longas he remained active in Austria – to unite the organized business interestsbehind this liberal program, as outlined in a series of papers, memoranda,and speeches.20 When the Tagblatt campaign petered out in 1933/1934, thiswas for a host of reasons, among them the emigration of most of the authors(except Morgenstern) and the hostility of the newly proclaimed corporatestate to lessons in liberalism made effective by the introduction ofcensorship. In any case, with few exceptions, after 1934 it had becomemore difficult to further the liberal cause openly in the press.

In the background of the campaign there existed some loose circles, whichnot only served as a place for discussion but also as a link between theeconomists and representatives from business and politics. One of thesecircles was that of the Meinl group. Meinl was well known for his support ofliberal economic policies, which he, jointly with the director of his company,Kurt Schechner, furthered in numerous pamphlets and articles.21 As pointedout by Machlup (1980, p. 135) often the contributions to the Tagblatt hadbeen discussed before in meetings initiated by Meinl, with Machlup,Morgenstern, Mises, and Gratz as regular participants. Even after the end ofthe Tagblatt campaign Meinl remained active for the liberal cause within thenarrower limits imposed by the corporate state, and in 1934 startedpublishing a monthly review, the Wirtschaftliche Rundschau, in the first yearwith Morgenstern as the editor and main contributor.

Another channel of influence consisted in the Austrian economists’personal contacts with those actually involved in policy-making, that is,politicians, officials from international organizations, Austrian businessleaders and representatives of the Chamber of Commerce. For example,

Policy Advice by Austrian Economists 33

from Morgenstern’s diary we see that beginning in 1931 he regularly metwith Viktor Kienbock, the president of the Austrian National Bank, Rostvan Tonningen, the representative of the Finance Committee of the Leagueof Nations (LoN), the LoN’s adviser to the National Bank Gijsbert Bruinsand his successor Maurice Frere, and with Adrian van Hengel, the generaldirector of the reconstructed Creditanstalt, to name but a few. Furthermore,Morgenstern built also the center (or so it appears from his own notes) ofanother circle, with participants mainly from Austrian industry. Within thiscircle, in 1932/1933, topical issues of economic policy became the subject ofa series of ‘‘conferences,’’ in which Morgenstern appropriately excelled inthe role of scientific expert.22

However, as we will find out, after 1934 for those economists that stilllived in Austria, most of them centered around Morgenstern and theInstitute, the way in which they were able to make their policy adviceeffective had changed: from the indirect influence through unofficial circlesand press campaigns to a more direct involvement in the bureaucracy ofeconomic policy-making.

3.2. The Economic Education of Viktor Kienbock, President of theAustrian National Bank

At the beginning of the time period considered Austrian economic policystood at the crossroads: on the one hand, from the Austrian economists’point of view it had committed a series of blunders by breaking most of therules of the liberal framework, on the other hand, the replacement ofRichard Reisch, the former president of the Austrian central bank, byKienbock,23 and a change of government at the same time,24 had opened upthe possibility to restore sound policies. Now in order to gauge the influenceof the economists’ policy advice we have to show inasmuch it was at oddswith the intentions of the newly appointed economic policy-makers.

At a first glance, it is obvious that in early 1932 both in the Tagblattcampaign and in personal contacts the radical recommendations ofMachlup and Morgenstern were in sharp opposition to the rather pragmatic(and slowly evolving) policies actually entertained. A few illustrations willsuffice: Morgenstern (M 3 February 1932) demanded an immediateabolition of exchange controls and criticized the idea of maintaining themprovisionally for an interim period, and Machlup (M 18 and 27 February1932) castigated Kienbock (and Weidenhoffer, the Austrian Minister ofFinance) for substituting appeals to ‘‘economic patriotism’’ for the effective

HANSJORG KLAUSINGER34

policy measures required, like for example, a restriction of the money supplyand a more austere fiscal policy. Already before, Morgenstern in privateconversation had attempted to dissuade Bruins from his toying with the ideaof a devaluation of the Schilling and his defense of exchange controls (see D26 January 1932), and apparently he succeeded in winning over Rost(against Bruins) for a more radical position on credit restriction and theloosening of exchange controls (see D 13 and 27 January 1932). In thisregard, he claimed ‘‘a great success’’ when the Finance Committee’s reportmirrored his and Rost’s position to a large extent, and he also tried to givethe report as much publicity as possible.25 However, Morgenstern (M 10April 1932) was severely critical of the Committee’s suggestion to sharpenthe effectiveness of exchange controls by supplementing them by bans onimports. With regard to Kienbock, in these times Morgenstern’s esteem forhim as an expert was quite low – although easily to be surpassed by hiscontempt for other representatives of Austrian economic policy. However,when it came to the introduction of a moratorium on foreign payments inJune 1932, it appears as if with respect to its technical implementationMorgenstern had lent and Kienbock had acted on behalf of his advice.26

Typically Machlup, who always had kept a much greater distance to thosein charge of policy-making, outright rejected the idea of a moratorium forreasons of principle.27 As a final example, when in 1932 problems of twomore ailing banks (the Wiener Bankverein and the NiederosterreichischeEscompte) became known, Morgenstern (jointly with for example, Misesand van Hengel) pleaded for letting them go bankrupt (D 31 October 1932).Yet, Kienbock (seconded by Rost) prevailed with his own favored solution,the founding of a trust company for rescuing these banks, financed by thecentral bank and the government.28

The debate on deflation versus devaluation as the conflicting options forAustria’s exchange rate policy provides another characteristic episode. Afterthe introduction of exchange controls and the depreciation of the Schillingin the free exchange markets (like Zurich), the choice was between deflation,that is, a restriction of the money supply, strong enough to enable a returnto the old gold parity after the abolishing of the controls, and a devaluationof the Schilling to a new lower parity. Up to mid-1932 the Austrianeconomists were unanimous in their preference for deflation: Morgenstern(M 3 February 1932), Hayek in a speech to the Industrieller Club (M 2March 1932), and similarly Mises in two speeches before the ViennaChamber of Commerce in March and July 1932 (Mises 2002, chapters 28and 29) adhered to this view. In this state of affairs statistical inquiries bythe Institute demonstrated that despite the official fixing of the Schilling

Policy Advice by Austrian Economists 35

parity a price gap had developed: Domestic prices had already adapted tothe actually lower value of the Schilling (or, conversely, to the higherSchilling price of gold in free markets) and stayed roughly constant incontrast to the falling prices in world markets.29 In face of this evidence andtaking into account the rigidity of the Austrian price structure, theeconomists reconsidered their position. Fixing the Schilling at a devaluedparity was then accepted, although with some moral indignation, as a mererecognition of the fact of previous and not as a signal of future inflation. Yetit was crucial in their view that the new parity could be crediblyestablished.30 Morgenstern (M 1 August 1932) specifically suggestedcombining devaluation with some credit restriction so that eventually thenew parity could be sustained above the one currently prevailing at freeexchange markets. In fact, this came close to the policy actually chosen bythe Austrian central bank:31 After a gradual easing of exchange controls theSchilling was fixed (formally in 1934) at a new rate approximately 20 percentbelow its former parity, where it remained henceforth.

It is this period of the easing of exchange controls and the eventual fixingof a new Schilling parity, when the conflicting views of Morgenstern andKienbock apparently began to accommodate. This was the more importantas concomitantly Kienbock became the person to dominate Austrianeconomic policy in general, not merely monetary policy.32 On the onehand, this rapprochement resulted from Kienbock unequivocally commit-ting himself to a hard currency policy and, as far as his political cloutpermitted, to fiscal austerity. On the other hand, Morgenstern moderatedhis critique, and the more he and the Institute became involved in thebusiness of policy advice the more he inclined to pragmatic views. As apoint in case we may note that still in 1932 he had judged the attempts tosecure a foreign loan as unnecessary and even harmful (Morgenstern M 10April 1932). Yet after the raising of the Lausanne loan in 1933, he praisedit (and the accompanying policies of the Austrian government) as a propermeans for securing monetary stability – that is, under the precondition thatthe loan was used solely for strengthening central bank reserves instead ofmisused for financing government expenditure (M 12 August 1933).33

Moreover, in this judgment he was not so much out of line with the othereconomists, even Mises had earlier on (2002, chapter 29 [25 July 1932])greeted the granting of the loan as providing the ‘‘breathing room’’ neededfor the implementation of reforms.34 In any case, now the opportunitiesbecame more frequent when Morgenstern found himself in completeagreement with Kienbock.35 Perhaps not quite incidentally, Morgenstern atabout the same time terminated his collaboration with the Tagblatt,

HANSJORG KLAUSINGER36

possibly reflecting the incongruity with his newly acquired role as policyadviser.

Significantly, at the same time the influence of Gottfried Kunwald,another important figure in Austrian economic policy, waned. Kunwald hadplayed an important role, in particular during the cabinets of the ChancellorIgnaz Seipel, whom he had advised in 1922/1923 on the stabilization of theSchilling after the Austrian hyperinflation. Yet, Kunwald had become anoutsider to the political establishment in the 1930s and he sharply criticizedKienbock’s policy for being deflationist putting forward in Kunwald (1934)his own theory of money and credit as an alternative to the liberalposition.36

3.3. Morgenstern and Industrial Interests: Pragmatism and Mischief

Morgenstern’s determination to occupy, also for the benefit of the Instituteand its finances, a vital role in economic policy advice is vividlydemonstrated by the burst of activities to which it gave rise, in particularin the period from 1932 to mid-1933. During this time he initiated a largenumber of meetings. The most broadly based was a series of ‘‘conferences’’for discussing the urgent problems of Austrian economic policy in general.The first such conference on 11 January 1932 was initiated by Rost (andMorgenstern), and hosted by the banker and economist Karl Schlesinger.37

Moreover, Morgenstern participated also in the meetings of the still moreliberal-minded Meinl group, organized by Meinl and later on by Schechner.These were then less frequented by the leaders of industry and politics, butmore so by liberal economists (e.g., Mises, Machlup, and Strigl) and officialsof the Chamber of Commerce. As a sort of spin-off Morgenstern and theMeinl group suggested establishing a committee, on the model of the British‘‘Royal Commissions,’’ at the Hauptverband der Industrie, an interest grouprepresenting Austrian industry.38 A meeting of this committee wasorganized by Anton Apold39 in May 1932, followed by four moreconferences, between November 1932 and April 1933, with an audienceslightly different from that of January 1932.40

The themes discussed at these meetings were wide-ranging and indeedencompassed all areas of economic policy. The issues directly impinging onmonetary policy, like exchange controls, devaluation and the like, havealready been dealt with earlier. Yet, in particular under the auspices of theindustrial interests the conferences focused on measures of how to cutproduction costs in order to restore the profitability and competitiveness of

Policy Advice by Austrian Economists 37

industry. The obvious candidates were taxes and social burdens on the onehand, and wages on the other hand. Yet, in these areas the room formaneuver was rather limited: As Morgenstern pointed out, most partici-pants’ (including Rost’s and Kienbock’s) view of the budget was much toooptimistic, and with regard to wage cuts he was doubtful of theireffectiveness – in sharp contrast to Mises and Machlup, who consideredthem the only viable way of overcoming the depression.41 Nevertheless heagreed that the problem faced by Austrian industry was first and foremost aproblem of excessive production costs.42 With regard to trade policy viewsand interests were divided: Whereas in this regard Morgenstern associatedhimself with the Meinl group’s (and the economists’) adherence to the ideaof free trade, Apold and others entertained more protectionist views, muchto Morgenstern’s disdain.43 Some influence of all these activities on actualpolicy-making can be ascertained from the documents. For example,Morgenstern and the industrialists apparently had some say in the specificregulation of the problem of private debts denominated in foreign currencyor covered by a gold clause. In fact, after in principle confirming the validityof the gold (and foreign currency) clauses the actual consequences weremitigated by a government decree (the Goldklauselverordnung).44 In anotherrespect it is also highly revealing that many participants in these conferencesshared the conviction that a parliamentary democracy is ill-suited toeffectively cope with the problem of crisis and must therefore be replaced bya more authoritarian regime – as indeed happened in Austria after March1933.45

One more project in which Morgenstern was involved must be dealtwith separately, that is, an industrial project of pump priming. In Austria, asin other countries, proposals for public works as a supposed remedyfor depression were pouring out relentlessly.46 In 1932/1933 some ofthose industrialists already active in the above-mentioned circles, withMorgenstern in the role of scientific adviser, began working on a pump-priming project, too. The committee that in the end was to propose thisproject was led by Hans Altmann, the director of Elin, an electrical industrycompany.47 The ‘‘pump primers’’ (or Ankurbler, as Morgenstern somewhatcondescendingly used to refer to them) met regularly from September 1932to January 1933, and as their plan matured it was also submitted tomembers of the government when a law on produktive Arbeitslosenfursorge(productive unemployment relief) was under consideration.48 Eventually, onFebruary 10, 1933 the plan (Industrieller Ankurbelungsplan) was presented tothe public in a press conference.49 The main proposition of the plan was awage subsidy for newly employed workers, in an amount double the

HANSJORG KLAUSINGER38

benefits paid to the unemployed. This value was justified by appealing to akind of multiplier effect insofar as primary employment in the investmentgoods industries would generate secondary employment (in a relation of 1:1)in the consumption goods industries.50 Additional conditions appended tothe granting of the subsidy were a minimum size of the project (of at least1,000 workers), the provision that new projects should not compete withexisting domestic plants, and that industries protected by import restrictionsbe excluded – conditions which were tailored to the interests of thecompanies represented by the plan’s proponents.51

Obviously, taking into account the economists’ prevalent disdain forpump priming, and in particular the rejection of the idea of secondaryemployment and the multiplier,52 Morgenstern’s role was rather awkward.In the discussion within the Altmann circle he had vehemently opposed theDeutsch plan (see D 24 September 1932), and on another occasion he noted,‘‘all people know that I consider the idea of the secondarily employed(nachgezogenen) consumption worker as unprovable’’ (D 26 December1932). Anyway, in spite of his doubts Morgenstern had good reasons, as wewill shortly notice, not to visibly distance himself from this project and thuswas forced to formulate diplomatically in public. Consequently, although amember of the committee of proponents his public support – in a discussionin the Industrieller Club (see D 12 February 1933) and in an anonymousarticle in the Tagblatt (M 12 February 1933) – was only lukewarm.Primarily, he defended the plan as being not inflationary because it wasneutral for the government budget – the saving in unemployment benefitsdue to the secondary effects just compensating for the expenditures onsubsidies – and not coupled with proposals for credit expansion. In contrast,Machlup, who had no reason for hiding his opinion, sharply criticized theplan (like any other instance of pump priming) in a column (M 19 February1932). Yet, in the end, the fate of the project was largely as Morgenstern hadexpected, after a meeting with Jakoncig: a ‘‘Pallawatsch’’ (D 19 January1933).53

Undoubtedly, in these days Morgenstern had acquired an imposingreputation in economic policy advice, and he was rumored as a candidatefor many important positions. Yet, besides his successful work within thediverse circles around Altmann, Apold, Meinl, Schechner, and many others,he also experienced harmful failures. An incident most interesting withrespect to the above-mentioned activities is the story how Morgenstern didnot become the General Secretary of the Hauptverband der Industrie, whichis enlightening insofar as this affair climaxed just in the same days when theindustrialists presented their pump-priming plan.

Policy Advice by Austrian Economists 39

Due to Morgenstern’s good connections with prominent captains ofindustry, in October 1932 Ludwig Urban, the president of the Hauptver-band, had offered him the post of an economic adviser, combined withthe directorship of a small scientific office, possibly alongside his work at theInstitute.54 During the process of deliberation within the Hauptverbandthe idea of a more thorough restructuring of the organization was born,such that Morgenstern should have replaced the present General Secretary,Gustav WeiX-Wellenstein, already in his seventies. As WeiX-Wellensteinbelonged to those who Mises (1978a, p. 83) considered his ‘‘dear goodfriends’’ and fellow combatants for the liberal cause, this idea contributed tomake Morgenstern’s always somewhat uneasy relationship with Mises evenmore delicate. In late 1932 some unexpected stumbling blocks delayed theappointment: First, the press caught word of the reorganization,55 whichapparently diminished the momentum of the reformers. Secondly, itcoincided with the presentation of the contentious pump-priming plan.And thirdly Morgenstern was asked to present himself to those memberswho did not yet know him56 by means of a lecture; when it eventually tookplace on February 22, 1933, apparently it was no great success.57 Since then,it appears, things began to go awry: Morgenstern had already been harmedby ongoing controversies within theHauptverband that involved both Urbanand Apold,58 then in February 1933 his ambitions became known to thepress creating once more some unwelcome turbulence,59 furthermoreSchechner – another of Morgenstern’s patrons – got embroiled in a taxfraud scandal, which drew blunt anti-Semitic attacks from right-wingnewspapers.60 Finally, after ever more delays, probably due to the resistanceby WeiX-Wellenstein and the acting Vice President, Robert Ehrhart,Morgenstern refused to wait any longer and declined the offer on March 3,1933. Possibly, the purpose of this action had been to force a response fromthe President, who had been absent in the crucial days, yet, the news ofMorgenstern’s rejection found its way from the Hauptverband to the pressthe same day, and thus it became final.61 To add insult to injury,Morgenstern above all became the target of an attack by the newspaperof the Austrian Nazis, which accused him of being a Jew, a Manchester-liberal, a disciple of Mises, and a protege of Schechner.62 As a result WeiX-Wellenstein remained in his post until October 1933, when he joined theboard of the Hauptverband until in 1934 it was dissolved and transformedinto the corporatist Bund der Industrie.

Morgenstern reacted to all this mischief by loosening his ties with theHauptverband and also with Apold, which however surfaced one more time,again in connection with one of Morgenstern’s failed projects. When in 1933

HANSJORG KLAUSINGER40

Morgenstern became involved in a plan to establish a private trust company(Treuhandgesellschaft) in Vienna63 for financing and restructuring bankruptfirms, it ran into heavy criticism from ‘‘patriotic’’ circles within the Austrianconservatives. These accused the Treuhand of forming a pretext for anattempt of the German Nazis to take over parts of the Austrian industry.64

In this regard, Morgenstern was not helped by his former close relationshipwith Apold, who in summer 1933 came under investigation for supportingthe illegal Austrian Nazis and in mid-1934 was temporarily arrested andforced to retire for his alleged involvement in the July putsch.65 Anyway, inconsequence the Treuhand project had to be abandoned. Still, in 1938 whenMorgenstern already in the United States contemplated the Austrian eventsafter the Anschluss, he wondered about having so many ‘‘personal enemies’’within the Hauptverband.66

In the end, these two failures illustrate how Morgenstern, in his rise toprominence in Austrian economic policy advice, had become entangled inthe net of opposing interest groups and competing political factions thatcharacterized Austrian politics. Significantly, he encountered resistancefrom otherwise sharply opposed camps: from the Mises group and thebureaucracy within the Hauptverband (because of their support for WeiX-Wellenstein); from Austrian conservatives, who suspected him of covertlyacting in favor of the German Nazis in the Treuhand affair; and finally fromthe Austrian Nazis, who conversely attacked Morgenstern for his allegedlyliberal credentials and his closeness to Mises. So in sum, these attacks mustnot be attributed to Morgenstern’s idiosyncratic temperament but reveal atypical feature of the constraints under which policy advice had to proceedin Austria these days.

3.4. Hard Currency Policy and Auflockerung: Success and Failure ofPolicy Advice

Leaving Morgenstern in 1933 and having a fresh look at him at the end of1934 – after a one-year-gap in his diary – we find that these two troublesomeaffairs had not interrupted his rise to an influential position in Austrianeconomic policy advice, but just redirected it – away from the representa-tives of Austrian industry and towards a closer cooperation with thecorporate state’s bureaucracy. Proof of this is the multiplicity of officialpositions that he filled in this period: He was part of the team thatnegotiated the treaty with the foreign creditors of the Creditanstalt; heeventually entered the Treuhandgesellschaft owned by the Austrian central

Policy Advice by Austrian Economists 41

bank; he became adviser to the bank and to the Ministry of Commerce,where he was concerned in particular with the regulation of railroads andfreight traffic; finally – within the mushrooming bureaucracy of thecorporate state – he played a major role in a newly formed price commissionassociated with the Institute and in the corresponding interministerialcommittee. These developments coincided with Morgenstern’s success inexpanding the tasks and securing the finances of the Institute.67 His rise wasalso facilitated by other prominent economists’ absence from Austria.Machlup had emigrated to the United States and had rejected an offer byMeinl to involve himself again in Austrian economic policy.68 Hayek alsoremained distant from Austrian politics although during the crucial phase tobe examined below he praised the axis consisting of Kienbock, Draxler, andvan Hengel for their competent financial policies.69 And even Mises, nowteaching in Geneva, was only occasionally present in Vienna, and moreoverwithin the corporate state the Chamber could no longer provide the channelof influence for his recommendations as it had done before.

These are the preconditions for the Austrian economists’ activities whenwe look at a last episode, namely the debate on devaluation andAuflockerung following the breakdown of the gold bloc. When in 1936 thegold bloc countries (France, Switzerland, and the Netherlands) eventuallywere forced into abandoning the gold parity, this left Austria in a dilemma.In order to maintain its competitiveness in international trade, it had to closethe gap between Austrian and world market prices, in particular the prices inthe former gold bloc countries. The available options were then either adevaluation of the Schilling or the attempt, similar to the Bruning campaignin Germany in the early 1930s, to bring down Austrian domestic prices. Inaccordance with its newly maintained hard currency policy the Austriangovernment and the National Bank chose not to devalue. Although in theshort run – due to exogenous events70 – this decision did not do much harmto the Austrian economy, combined with the inactivity in other respects tomost observers (past and present) this constituted the last missed chance fora recovery of the economy up to its pre-depression level of activity.

What was then the economists’ advice? Morgenstern’s concern with the‘‘price gap’’ had been an ever-resonating theme throughout the wholedecade. Thus, although he recommended against devaluation, he pointedout that such a hard currency strategy will only be feasible if accompaniedby a policy of Auflockerung in order to lower prices and ultimately close theprice gap. If such a policy could not be implemented, the second-best optionwould be to devalue. The arguments cited against devaluation were theburden of foreign denominated debt and political reasons, presumably the

HANSJORG KLAUSINGER42

necessity either to accept lower real wages or to accommodate nominalwages, where both strategies would aggravate an already difficult politicalsituation.71 These alternatives of Auflockerung and devaluation were clearlyspelled out in private communication and in a memorandum (Denkschrift)of November 1936 (Morgenstern, 1936a), parts of which were published (seeMorgenstern, 1936b). Crucial to all of Morgenstern’s advice in this regardwas his insistence on the urgency with which a policy of Auflockerung had tobe pursued. In contrast, Haberler, who observed these events from theoutside (in Geneva), openly favored devaluation in the form of pegging theSchilling to the devalued French franc. Already earlier he had recommendedsuch a policy for the case that France would leave the gold parity (Haberler,M 4 November 1933), and now he propagated it because he felt that theincome reductions required otherwise might turn out as untenable.Devaluation thus constituted an opportunity that should not easily bemissed, whereas to stick to the old parity would indeed be ‘‘heroic.’’72 Yet,when he presented his opinion in correspondence to Kienbock and Draxler,they reacted ungraciously.73 Finally, if we can trust Morgenstern’s notes,Mises played a curious role in this regard: He recommended a hard currencypolicy but allegedly (in October 1936) suggested to amend it with subsidiesto the most vulnerable industries,74 a policy not quite up to Mises’ liberalcredentials and which Morgenstern in his memo vehemently opposed.

As components of his favored strategy of Auflockerung Morgensternproposed the easing of trade restrictions, in particular abolishing the banson specific imports, and the facilitation of the entry of new firms intodomestic trades and industries, thereby furthering a more competitiveenvironment for Austrian production.75 Moreover, in the already highlyregulated Austrian economy there existed a multiplicity of measures fordirectly intervening into the formation of prices (and wages). Accordingly,with the decision not to devalue a new institutional framework for pricecontrol had been created with the Institute as an office of price observation,reporting to an interministerial committee, which in turn had to work outproposals for lowering prices.76

Now, at the outset Morgenstern was optimistic that this commissioncould be used as a vehicle for furthering the policies he favored. Yet, he soonhad the opportunity to experience the fate of Auflockerung in practicethrough his committee work. Already in the first sessions of the committeethe efforts to lower specific prices met firm resistance of the respectiveinterest groups, and especially so when prices of agricultural products (e.g.,sugar, milk) were concerned.77 Already the Denkschrift was written as adesperate attempt to speed up a process that Morgenstern deemed too slow

Policy Advice by Austrian Economists 43

and too indecisive to cope with the situation of the Austrian economy,which he described as a ‘‘morass’’ (D 21 October 1936). Yet, the oppositionagainst the lifting of import bans and forced price decreases subsisted. WhenMorgenstern attacked the persistence of import bans in an article(Morgenstern, 1937b), apparently with the backing of Kienbock,78 it drewharsh criticism from Austrian industry.79 Finally after a representative ofthe agrarian interests, Felix Feest, had been appointed to head the pricecommission, Morgenstern resigned – he ultimately had become convincedthat nothing useful would result from these activities.80 In the end, policy-makers had chosen to follow only one of the two component parts ofMorgenstern’s advice: they stuck to the parity of the Schilling with pricesand costs as rigid and high as before.

Morgenstern’s last words in this respect were those in a speech in January1938, held before a section of the Vaterlandische Front (Morgenstern, 1938),on the eve of his departure from Austria for a three-month visit to theUnited States and at a time when he had mostly withdrawn from policyadvice for the sake of his scientific career.81 On this occasion he warned thatAustria’s capability to survive (Lebensfahigkeit) did depend on thedirections chosen for economic policy, more so than on its endowmentwith natural resources. Consequently, Austria could only survive economic-ally if it did not drift any longer towards ‘‘autarky’’ and a ‘‘pseudo-plannedeconomy,’’ but instead integrated itself into the world economy by means offreer trade, opened up its industries to more competition, internal andexternal, and steered a course towards ‘‘rejuvenation.’’ Thus, this speechwas a last call for Auflockerung, and this time not mitigated in its wording byany propensity to compromise with the politics of the corporate state. Yet, itcame too late, not least because similar calls had been ignored for the yearsbefore.

4. THE ECONOMISTS’ INFLUENCE ON AUSTRIAN

POLICY IN THE 1930S: FACT OR FICTION?

The evidence reviewed above suggests some tentative conclusions. Thisinvestigation took 1931 as its point of departure, when in the name of‘‘emergency measures’’ Austrian economic policy discarded its adherence tothe liberal framework in many respects. The ensuing situation gave rise tothe combined effort of economists to fight this tendency and to restore aliberal economic order. And indeed, in the interim period 1932–1934,

HANSJORG KLAUSINGER44

characterized by economic crisis, the slow demise of the parliamentarysystem, and the restoration of monetary and financial stability, their impactwas considerable in ‘‘educating’’ politicians and representatives of interna-tional institutions in influential positions with regard to Austrian economicpolicy. (As may be concluded from Morgenstern’s experiences with theHauptverband the education of industrial interests eventually turned out stillmore difficult). This education resulted in firmly linking the conservativegovernments, in particular those of the Standestaat era, to a monetary andfiscal framework again dominated by the mentality of the gold standard,that is, the quest for sound money and a balanced budget. In any case, inthis regard a caveat is in order for it is difficult to judge, if the power exertedby the foreign creditors and the financial experts, for example, those of theLoN, had not led to a similar result, even without the interventions of theAustrian economists.

The economists’ success in the field of ‘‘macroeconomics’’ (allowing forthis anachronistic terminology) was, however, offset by their failure withregard to ‘‘microeconomic’’ issues, like the reduction of trade restrictions orthe deregulation of industry (and especially agriculture), where an anti-liberal spirit prevailed, in particular, under the reign of the corporate stateideology. This failure became the more glaring in the final phase of Austria’sexistence as an independent state. While the hard currency policy remainedalmost unchallenged, even in the face of the breakdown of the gold bloc andthe devaluation of its currencies, the attempt to implement a policy ofAuflockerung as its necessary complement came to naught. Here thearguments of the economists, although shared to some extent by members ofthe Austrian policy establishment, proved powerless when running counterto the combined interests of the ‘‘corporations’’ on which the corporateregime was based. Thus, Morgenstern’s resignation in 1937 symbolized thefinal defeat of liberalism in Austria even before the Anschluss and, in theend, the combination of success and failure, leading to contractionarymonetary and fiscal policies in the face of rigid prices, produced as anunintended consequence a sure recipe for depression.82

The episodes discussed also show to what an extent the Austrianeconomists in their pursuit of the goal of a liberal economic order wereforced to content themselves with ‘‘second-best’’ solutions. The necessity tocompromise was a common experience both for Mises and later on forMorgenstern in their role as policy advisers.83 The examples provided aboverange from the acceptance of devaluation to Morgenstern’s cooperationwith the pump primers, and eventually to his resignation when the finalcampaign for Auflockerung had failed. In particular, the position of the

Policy Advice by Austrian Economists 45

Austrian economists was aggravated by the fact that in interwar Austrialiberalism lacked a political base. Some refuge for liberal thought had beenoffered within the banking system (including the central bank), the Chamberof Commerce and a few circles of industrialists, but especially after thebreakdown of the Creditanstalt even this kind of support began toevaporate. The commitment of the Austrian state (in the form of theStandestaat) to the ideals of corporativism was of course detrimental, too.Thus eventually, best exemplified by the fate of Morgenstern, the liberalcause had to rely on shifting coalitions and fragile personal relations, whichin the end turned out too weak for sustaining the policies envisioned by theAustrian economists.

With regard to the individuals contributing to the successes and failures ofthe economists’ activities in policy advice, the available yet incompleteevidence supports the thesis that, although starting as a concerted action ofall the economists involved, Morgenstern became the central figure as timewent by. For example, there is scant evidence for Mises’ self-consciousstatement that it ‘‘was my achievement alone . . . that the inflation went nofurther’’ in 1932 (Mises, 1978a, p. 91); more generally this evidence shedsdoubts on a historiography of Austria in the 1930s largely based on theaccount in Mises’ Recollections. Furthermore, in the course of thisdevelopment Morgenstern’s role changed from an ‘‘outside observer’’ tothat of an ‘‘insider’’ within the bureaucratic structure of economic policy –in contrast to Machlup and, after 1934, also to Mises. One might thus findsome irony in the fact that it was Morgenstern, a stern critic of liberaleconomic theory in other respects, who became the last economist to holdout – and fail – in Austria in his fight for the liberal case.

NOTES

1. For examples of these two strands of literature see Stiefel (1988), Mattl (1984)and Senft (2002), and Ebeling (2001, 2002), Leube (2002), and Pallas (2005,Section 5.3), respectively. Both views take for granted that feasible alternatives to thepolicies actually followed have existed, a thesis famously disputed for Germany byBorchardt (1991); for Austria see Butschek (1984).2. In this regard, the following draws on, revises, and supplements an earlier paper

(Klausinger, 2007).3. For more biographical information see the entries in Hagemann and Krohn

(1999). For a characterization of the conflicting positions within Austrian economicsfrom Morgenstern’s point of view see Leonard (2004), on his sometimes strainedrelationship to the Mises group see also Klausinger (2006).

HANSJORG KLAUSINGER46

4. For sake of brevity we will refer to these authors as ‘‘the (Austrian)economists.’’ Obviously, this group of ‘‘economists’’ does not include those membersof the Austrian economics community associated with Austromarxism, universalism,or the tradition of the romantic or historical school.5. Most of these articles appeared anonymously in the Viennese daily newspaper

Neues Wiener Tagblatt between 1931 and 1934. A selection of these articles has beenreprinted in Machlup, Morgenstern, Haberler, and Hayek (2005); on the underlying‘‘campaign’’ see below, Section 3.6. In the text citations to articles reproduced in Machlup et al. (2005) are by an

‘‘M’’ followed by their date of publication – these are not included in the references;all other contributions to daily, weekly, and monthly papers are referred to as usual.Citations of the Oskar Morgenstern, Gottfried Haberler, and Fritz Machlup Papersare abbreviated by OMP, GHP, and FMP, respectively, followed by the number ofthe box. Morgenstern’s diary (in OMP 13) is cited by ‘‘D’’ and the date of the entry.If not indicated otherwise, translations from German sources are my own.7. On the Austrian economic history of the 1930s see also, in addition to the

references in note 1, Kernbauer (1991), Sandgruber (1995, pp. 382–402), and inparticular on the Creditanstalt crisis Schubert (1991).8. In this section references will be primarily to sources from the policy debate of

the 1930s. For an overview of the arguments typically used in Machlup’s columns seeKlausinger (2004).9. From the contemporary debate see, for example, Morgenstern (M 4 October

1931) for a general perspective; Machlup (M 27 February and 24 April 1932) on thedanger of hoarded notes; Machlup (M 4 September 1932 and 24 February 1933) onthe superiority of a gold currency; and Machlup (M 4 February 1934) on the priorityof a stable parity over a stable price level. On inflationism in general see Mises (1924,pp. 203–215, 1981, pp. 251–262).10. See, for example, Machlup (M 18 February and 22 May 1932), see also

Machlup (1933a).11. See for example, Machlup (M 8 and 9 October 1932), Morgenstern (M 7 May

1932); similarly Mises (2002, chapters 23 [18 February 1932] and 31 [19 October1932]).12. Machlup (M 15 May and 2 October 1932), Haberler (M 22 January and 12

April 1933), and Mises (2002, chapters 23 [8 February 1932] and 27 [30 May 1933]).For the persistence of the Austrian critique on the erroneous preoccupation with thetrade deficit see also Morgenstern (D 19 October 1935).13. See for example, Machlup (M 10 April 1932) and Morgenstern (M 13 May

1933) for the rejection of trade preferences and Machlup (M 23 October 1932) for theproposal of unilateral tariff reductions.14. See Machlup (M n.d. [May 1932?]), an article written for but not published by

the Tagblatt, and Morgenstern (M 22 May 1932).15. See, for example, Machlup (M 17 April 1932, 19 Feb, 4 March, and 7 May

1933) and Mises (1931, Section 4 [1978b, Section III.A]). On Morgenstern’s positionsee below.16. See, for example, Mises (1931) and Machlup (M 26 November 1933).17. The term Auflockerung – in its literal meaning: loosening (the ground) – was

well known from the German debate, where it had been used among others by

Policy Advice by Austrian Economists 47

Ropke and Lautenbach, who propagated it as a complement to (and not as theAustrians: as a substitute for) expansionist policy.18. For a general perspective see Mises (1931). For the later contributions by

Morgenstern and Strigl see below.19. For more details see Klausinger (2005). From the authors’ perspective see

Morgenstern (1937a) and Machlup (1980).20. See Ebeling (2002) and the papers reprinted in Mises (2002, 2003). Already in

1930 Mises had represented the Chamber in the Wirtschaftskonferenz on the causesof the depression, with participants from business, agriculture and labor; thepublished findings of this conference, where no consensus had been reached,mirrored Mises’ views to a large extent. See Grandner and Traxler (1984) andEbeling (2002, p. xxxi).21. See, for example, Meinl (1932) and Meinl and Schechner (1932).22. See more below.23. For biographical details see Kienbock (1995).24. When the Pan-Germans (Grossdeutschen), which propagated a policy of union

with the German Reich, had left the government in January 1932, this facilitated arapprochement towards France and Great Britain, and the LoN, paving the way fora ‘‘liberal solution’’ to the economic crisis.25. Later on Morgenstern (M 8 May 1932) also agreed with only minor exceptions

with Rost’s quarterly report to the LoN.26. Morgenstern’s article in the Tagblatt (M 22 May 1932) was based on an

expose written for Kienbock (D 22 May 1932), and in fact the fund in questionwas built along the lines proposed by Morgenstern. Nevertheless, after theencounter with Kienbock he still described him as ‘‘the greatest ignoramus’’ (D 26May 1932).27. See Machlup (M n.d. [May 1932?]).28. See Berger (2000, pp. 263–275) and Kienbock (1995, pp. 53–54).29. See Morgenstern (M 8 May 1932), where he refers to Anon. (1932), an article

in the monthly bulletin of the Institute, most probably authored by Morgensternhimself.30. See, for example, Strigl (M 29 May 1932) and Machlup (M n.d. [July 1932?]),

again Machlup’s commentary was not printed by the Tagblatt. Credibility should befurthered, for example, by upholding the validity of the gold clauses.31. Viktor Brauneis, the General Director of the Austrian National Bank, reacted

favorably to the views expressed in Morgenstern’s article (see Brauneis toMorgenstern, 5 August 1932, OMP 4).32. This was, for example, the judgment of Richard Schuller, a senior government

official, see Nautz (1990, pp. 173–174).33. Still Morgenstern probably shared the opposition to those clauses in the

Lausanne Protocol that reconfirmed the prohibition of the Anschluss to the GermanReich.34. This became the majority position of the Chamber of Commerce; however, a

minority (from Carynthia, Tyrol, and Salzburg) recommended to reject theLausanne loan (see Neues Wiener Tagblatt, 27 July 1932, pp. 9–10).35. For example, Morgenstern stated his broad agreement with Kienbock on the

loan and currency question (D 14 October 1933) and later on, even more

HANSJORG KLAUSINGER48

emphatically, exclaimed: ‘‘Now, he can be cited approvingly on so many things’’ (D13 November 1934; emphasis in the original).36. On Kunwald see Weissensteiner (2004) and, in contrast, the characterization

by Mises (1978a, pp. 80–82).37. Among the participants in the first conference were (besides Schlesinger)

Brauneis, Bruins, Rost, Gratz, and the bankers Victor Bloch, Emil Kux, andAlexander Weiner.38. Besides, there also existed the smaller and more exclusive Industrieller Club.

See Haas (1979, p. 110).39. Apold was general director of the Alpine Montan, an Austrian steel company

owned by the German Vereinigte Stahlwerke; see also below.40. These four conferences were hosted, respectively, by Alexander Hryntschak, a

member of parliament who represented the industrial interests within the rulingChristian Social Party, Apold, Schechner, and Alfred Gotzl, the director of theGarvenswerke, a machine company; regular participants included among others vanHengel, Kienbock, and Rost.41. See Morgenstern (D 25 November and 26 December 1932); see also Apold’s plea

for Auflockerung and cost cutting in a speech to the Industrieller Club (Apold, 1933).42. See Morgenstern (1933a).43. For example, Apold, representing a steel company also involved in coal

mining, favored the government’s policy of banning coal imports, whereas Meinl,much of whose business was based on the import of coffee, not only pleaded for freertrade in general, but also for a lowering of the duties on coffee in particular. SeeMorgenstern (D 3 November 1932) and on the coffee duties Schechner (1932).44. See Morgenstern (D 12, 15 and 19 March 1933).45. See Haas (1979, pp. 110–123). On Morgenstern’s position see Klausinger

(2006, Section 3).46. For example, the plan by Deutsch and Vertes (1932) and another by the

Chamber of Labour; see the critiques by Haberler (1932) and Machlup (M 4 March1933).47. The other members of the committee were Anton Apold and Eugen Herz (of

the Alpine Montan), Bruno Bauer (an architect), Ernst Geiringer (of Jute, Hanf &Textil, a textile company within the Creditanstalt group), Alfred Gotzl (of theGarvenswerke), and Martin Kink (of Porr, a construction firm).48. Morgenstern reports of meetings, with the Minister of Commerce, Guido

Jakoncig (D 9 December 1932), the Minister of Finance, Emanuel Weidenhoffer(D 18 December 1932), and the Minister for Social Affairs, Josef Resch (D 15February 1933), which all left him rather unimpressed.49. For a description of the plan see Neues Wiener Tagblatt (‘‘Industrieller

Arbeitsbeschaffungsplan,’’ 11 Feb 1933, 11–12); cf. also Weber-Felber (1990,pp. 229–230).50. In fact, this part of the plan was somewhat unclear so that in a first version the

subsidy proposed was not double but fourfold the unemployment benefits,apparently arguing that one primary investment worker would employ onesecondary investment worker, and both then employ two consumption workers.See the criticism in the Osterreichischer Volkswirt 25, 21 (‘‘Neuer Arbeitsbeschaf-fungsplan,’’ 18 February 1933, pp. 474–475).

Policy Advice by Austrian Economists 49

51. See Weber-Felber (1990, p. 229).52. See above, Section 2.53. Only insufficiently translated by ‘‘chaos.’’ On the public works initiatives of

the Austrian government in 1933 see Weber-Felber (1990, chapter 7).54. See D (30 October and 15 November 1932).55. See the remarks in the Neue Freie Presse (13, 14, and 16 December 1932); for

Morgenstern’s reaction see D (13 December 1932).56. To the ‘‘Provinzler’’ (people from the provinces, that is, the non-Viennese), as

Morgenstern referred to them (D 25 January 1933).57. See D (26 February 1933). The lecture was published in Die Industrie

(Morgenstern, 1933b), the weekly journal of the Hauptverband.58. This conflict was between, on the one hand, those (like Apold) who favored

decisive steps towards an authoritarian solution of the economic and politicalcrisis and simultaneously attacked the agrarian course of the acting governmentand, on the other hand, those (like Urban) who opted for a more detached position.As a consequence, in January 1933 Apold and the Alpine Montan had left theHauptverband. At the same time, the Hauptverband was also deeply dividedbetween advocates of protectionism and free trade and thus could not agree onan unequivocal position with regard to import restrictions. See Haas (1979,pp. 116–123).59. See Die Stunde (‘‘GroXe Personalveranderungen beim Hauptverband,’’

3 February 1933, p. 1, and ‘‘Sinnwidrigkeit der Einfuhrverbote,’’ 11 February1933, p. 2), where Morgenstern was associated with the free traders within theHauptverband. See on this D (7 and 27 February 1933).60. See, for example, articles in the Deutschosterreichische Tageszeitung (5 March

1933) and in Freiheit! (6 and 7 March 1933).61. See Die Stunde (‘‘Der Hauptverband der Industrie fur Hochschutzzoll,’’

5 March 1933, p. 2), which points out that Morgenstern’s liberal attitude got inconflict with the protectionist position of the majority within the Hauptverband.Morgenstern tells his version of the story in D (4 March 1933).62. See theDeutschosterreichische Tageszeitung (‘‘Die Kandidatur Dr. Morgensterns,’’

10 March 1933, p. 12). Already earlier as a reaction to similar rumors and to a request bythe Hauptverband, Morgenstern had asked his father for researching into the family’sgenealogy in order to prove his Aryan descent. See D (12 February 1933) and W.Morgenstern (1934).63. Not to be confused with the Treuhand company that had come into existence

by the merger of the Wiener Bankverein and the Niederosterreichische Escompte andwas partly owned by the Austrian National Bank.64. See the attacks (e.g., ‘‘Nationalsozialistische Industrieoffensive,’’ 3 September

1933, p. 1; ‘‘Zum Nazieinbruch in die Industrie’’ and ‘‘Wozu ein separatesKonjunkturforschungsinstitut?,’’ 10 September 1933, p. 2; ‘‘Der ‘gebesserte’Morgenstern,’’ 1 Oct 1933, p. 2) in Sturm uber Osterreich, the weekly journal ofthe Ostmarkische Sturmscharen, a para-military organisation close to the ChristianSocialists and headed by Kurt Schuschnigg, then Minister of Justice (seeMorgenstern D 3 September 1933 and passim). Significantly, in his attempts tostop these attacks Morgenstern turned to Kunwald for mediating between him andSchuschnigg (see D 12 and 30 September, and 2 October 1933).

HANSJORG KLAUSINGER50

65. Rost in his diary (12 Mar 1934) called Apold an ‘‘Austrian Nazi’’ (see Berger,2000, p. 529).66. Morgenstern to Haberler (28 April 1938, GHP 65).67. Morgenstern’s official positions are referred to in his diary in numerous places.

On the Institute’s finances see, for example, Craver (1986) and Fleck (2000).68. See the correspondence between Machlup and Meinl in January 1936

(FMP 53).69. See Hayek to Haberler (3 June 1936, GHP 67). During his term as Minister of

Finance 1935/1936 Ludwig Draxler pursued an uncompromising course of fiscalausterity.70. Such exogenous events were the stimulation of Austrian exports due to the

demand generated by re-armament and, in particular, due to trade with Italy, asAustria had not joined the LoN boycott after the Abessinyian war.71. Morgenstern (1936b, p. 169) also warned (somewhat obscurely) that a

devaluation would hurt Austria’s small Alpine farmers.72. See Haberler’s letters to Morgenstern (30 October, 20 November 1936, 9

January 1937 and n.d. [1937], OMP 5).73. See Haberler to Draxler (18 Dec 1936) and the replies by Kienbock (to

Haberler, 12 December 1936 and 9 February 1937, all in GHP 65).74. See Morgenstern (D 25 October 1936) and Morgenstern to Haberler (14

March 1937, GHP 65). Here, as in other places, the lack of documents makes itimpossible to crosscheck Morgenstern’s contentions.75. See Morgenstern (1936a); Strigl (1937a, 1937b, 1937c) also contributed to this

campaign.76. See Morgenstern (1936a, p. 4).77. See Morgenstern (D 31 October 1936).78. See Morgenstern to Haberler (14 March 1937, GHP 65)79. See Die Industrie 42, 28 (‘‘Die Einfuhrverbote,’’ 9 July 1937, p. 6).80. ‘‘Es wird nichts herauskommen.’’ (D 24 July 1937) On Feest and the price

commission see also Mattl (1984, pp. 145–146, 149).81. Morgenstern was ousted from the Institute after the Anschluss in March 1938

and did not return to Austria.82. In retrospect, Machlup (1980, p. 128) conceded that his policy advice in the

1930s had been shaped by his ‘‘inexperience with deflation and [the] downwardrigidity of wage rates.’’83. Cf. Mises (1978a, p. 75): ‘‘In science, compromises are treason to truth. In

politics compromises are unavoidable . . . ’’

ACKNOWLEDGMENT

I am grateful to the participants of the conference and to an anonymousreferee for their valuable comments. For the permission to quote from the

Policy Advice by Austrian Economists 51

Oskar Morgenstern Papers I thank the Rare Books, Manuscript, andSpecial Collections Library of Duke University (Durham, NC).

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THE CONTINUING RELEVANCE

OF F.A. HAYEK’S POLITICAL

ECONOMY

Peter J. Boettke, Christopher J. Coyne and

Peter T. Leeson

ABSTRACT

This chapter explores the political economy of F.A. Hayek with emphasison the continued relevance of his work for contemporary scholars. Wefocus on the theme of coordination throughout Hayek’s research program.This general theme can be traced from Hayek’s technical economics upthrough his later writings in political philosophy. After consideringHayek’s major works in political and legal theory, we conclude bydiscussing the contemporary implications of Hayek’s political economy.Specifically, we discuss eight areas where modern economists should payclose attention to the main lessons and themes in Hayek’s writings.

1. INTRODUCTION

Friedrich A. von Hayek was arguably the most important classical liberalpolitical economist of the 20th century. Although trained as a technicaleconomist, Hayek’s body of work extended well beyond the discipline of

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PETER J. BOETTKE ET AL.80

economics. Indeed, the most productive reading of Hayek’s body of work isas an interconnected research program of ‘‘political economy’’ that overlapsthe disciplines of economics, politics, and law (Boettke, 1999). As Gordon(1981, p. 471) notes, Hayek’s ‘‘writings on these matters [the relation ofeconomics to political philosophy] are unequalled in profundity, historicalscholarship, and current relevance.’’ Our goal in this chapter is to exploreHayek’s political economy with emphasis on the continued relevance of thiswork for contemporary scholars.

In order to pursue this line of inquiry we first provide a discussion of thefoundations of Hayek’s political economy. It is our contention that thegeneral theme of ‘‘coordination’’ can be traced from Hayek’s technicaleconomics up through his later writings in political philosophy (seeO’Driscoll, 1977). After exploring this foundation we discuss the historicalcontext and main theme of Hayek’s classic work, The Road to Serfdom.The Road to Serfdom is perhaps Hayek’s most well-known work. Inaddition to being a best seller in England and the United States, it hasbeen translated into nearly 20 languages. Unauthorized copies of the bookcirculated throughout Eastern Europe before the collapse of the BerlinWall. There can be little argument that Hayek’s ideas have been influentialthroughout the world. Indeed, according to Hayek (1944, p. xvii),the very reason he penned the book was ‘‘due to a peculiar and seriousfeature of the discussions of problems of future economic policy at thepresent time.’’

While The Road to Serfdom captures many critical elements of Hayek’spolitical economy, it cannot be considered a complete explication of hispolitical economy. Hayek’s later works, such as The Constitution of Liberty(1960), and his three-volume Law, Legislation and Liberty (1973, 1976, 1979)can be seen as developing and refining the arguments made in The Road toSerfdom. As such, after providing an overview of Hayek’s classic work, inSection 4 we discuss some of the critical insights in Hayek’s additionalwritings in political and legal theory.

We conclude the chapter by discussing the contemporary implications ofHayek’s political economy. We contend that Hayek’s political economy is asrelevant as ever and that modern economists should pay close attention tothe main lessons and themes in Hayek’s writings. The specific areas weconsider include:1

1. New institutional economics2. Institutional change3. Development economics

The Continuing Relevance of F.A. Hayek’s Political Economy 81

4. Understanding the scope of spontaneous orders5. Experimental economics6. The cognitive turn in economic science7. Understanding the costs of the growth of government8. The classical liberal agenda.

In order to demonstrate the continuing relevance of Hayek we discuss theimpact his work has had in each of these areas, as well as the implications ofthis for future research.

2. COORDINATION – THE FOUNDATION OF

HAYEK’S POLITICAL ECONOMY

At first blush, Hayek’s writings appear to be disjointed, as they span a widevariety of disciplines. For instance, Hayek contributed to technicaleconomics, political and legal theory, and psychology, among other areas.2

However, we argue that there are several clear themes that run throughoutthese inter-disciplinary works:

1. The role of subjective knowledge in individual decision-making.2. The ‘‘compositive method’’ in which institutions must be explained as the

result of ‘‘bottom-up,’’ individual action.3. A clear recognition that economic phenomena do not exist independent

of certain institutional, cultural, and legal structures.

Equally important is the fundamental question that Hayek was seeking toanswer throughout his body of research. Beginning with his 1928 essay,Hayek established the central problem of economics as one of coordination.Hayek was preoccupied with the same question that puzzled Adam Smithsome 150 years earlier: how does order emerge unintendedly from theactions of millions of economic actors? Carl Menger (1883 [1996], p. 124)captured the importance of this issue when he asked: ‘‘How can it be thatinstitutions which serve the common welfare and are extremely significantfor its development come into being without a common will directed towardestablishing them?’’ Menger went on to note that, ‘‘this is the question ofimportance for our science . . . ’’ (1883, p. 125).

Hayek’s earliest writings in economics were focused on tracing out theimplications of the coordination of economic activities through time. As hiswork matured, Hayek started to emphasize the institutions necessary forthis dovetailing of plans among different individuals. His early economic

PETER J. BOETTKE ET AL.82

writings on imputation, capital and interest theory, trade cycle theory, andmonetary theory all had a ‘‘coordinationist’’ theme.

Hayek’s focus on how individuals possessing dispersed knowledge of‘‘time and place’’ learn and coordinate their activities, as well as thespontaneous orders that result from these interactions, underlies his entireresearch program. According to Hayek (1937, pp. 50–51), the centralquestion of all social science is:

how the spontaneous interaction of a number of people, each possessing only bits of

knowledge, brings about a state of affairs in which prices correspond to costs, etc. and

which could be brought about by deliberate direction only by somebody who possessed

the combined knowledge of all those individuals.

For Hayek, economics is a science that studies coordination problems. Itexamines the dovetailing of plans by individual actors that must result sothat complex social orders can emerge. Moreover, incentives must bealigned between actors. Individuals must come to know not only the bestopportunities currently available for mutually beneficial exchange, butmust also continually discover new possibilities for mutual gain fromexchange with others. Indeed Hayek’s political economy stems directlyfrom the realization that the institutional setting affects individualbehavior and what is learned in an economic system. Keeping in mindthese fundamental themes is critical in order to fully grasp his politicaleconomy.

3. THE HISTORICAL CONTEXT OF THE ROADTO SERFDOM

To better understand The Road to Serfdom, it is important to understand thehistorical context in which the book was written. The first edition of thebook was published in Great Britain in March 1944. At the time, GreatBritain and the United States were engaged in a World War with NaziGermany. The Soviet Union was the main ally, while Nazi Germany was themajor enemy. Many in Great Britain and the United States viewed theSoviet Union as a model of an ideal socialist society, which would result inwidespread equality, and the removal of poverty. In stark contrast, NaziGermany was viewed as a brutal dictatorship that allowed capitalist elites tomaintain their entrenched positions.

The Continuing Relevance of F.A. Hayek’s Political Economy 83

Underlying the favorable view of the Soviet Union was a widespreadacceptance of the socialist ideology by both intellectuals and the public.Indeed, the socialist critique of the liberal economic order had effectivelyshaped the ideological and intellectual terms of the debate by the beginningof the 20th century. Most participants in the intellectual and political debateagreed that laissez-faire liberalism had failed to provide equality andhumane social conditions. Instead, progressive legislation was demanded inorder to correct for the failings of free competition. Sir William Harcourtcaptured this sentiment when he noted that ‘‘we are all Socialists now’’(quoted in Trevelyan, 1942, p. 510).

The Great Depression, which by popular interpretation of the timedemonstrated that not only was capitalism unjust but that it was alsounstable, contributed to the critique of laissez-faire liberalism. The collapseof the United States and United Kingdom economies shook an entiregeneration’s faith in the capitalist system. It was argued that if the capitalistsystem was to survive in the world of the 1930s, it had to be subject todemocratic political forces of control. Continual government interventionwas necessary to tame its operation and protect the populace fromunscrupulous business and irresponsible speculation. Rational planningcame to be viewed as not only a viable alternative to be debated, but also theonly alternative to chaos.

In The Road to Serfdom, Hayek’s aim was to demonstrate that NaziGermany was not a result of inconsistencies in the capitalist system. Rather,the Nazi movement was a result of socialist ideology of the pre-World War Iperiod that had been embraced by many intellectuals in both Great Britainand the United States. Hayek argued that this occurrence was not particularto Germany. Indeed, implementing socialist policies anywhere in the worldcould potentially lead to political tyranny.

It was Hayek’s goal to explain how socialist ideas change the demandson democratic institutions and how these institutions are then transformedinto tools of totalitarian rule. This transformation, Hayek argues, is due tothe fact that democratic institutions are unable to meet these changingdemands in a manner consistent with democratic principles. As Hayeksummarizes the argument: ‘‘Is there a greater tragedy imaginable than that,in our endeavor to consciously to shape our future in accordance with highideals, we should in fact unwittingly produce the very opposite of what wehaven been striving for?’’ (1944, p. 5). Keeping in mind both the historicalcontext in which Hayek wrote, as well as his main goals, we now turn toan overview of the main arguments in The Road to Serfdom.

PETER J. BOETTKE ET AL.84

4. THE ROAD TO SERFDOM: THE CENTRAL

ARGUMENTS

The Road to Serfdom is broken into 16 concise chapters that combine theory,intellectual history, and historical observation. The main focus of the bookwas to demonstrate the social consequences of ideas. Hayek envisions ideasas the motive force in history. Bad ideas are undesirable because they permitthe rule of privileged interests over the common interest. Ideas provide asocial infrastructure within which individuals pursue their own interests. Inorder to avoid political tyranny and economic servitude, these ideas mustconstrain the self-seeking behavior of individuals appropriately.

To understand the theoretical core of Hayek’s argument, one has to lookat the previous work of his teacher and mentor, Ludwig von Mises,regarding the feasibility of socialism as an economic system. In Socialism,Mises (1922 [1981]) argued that ‘‘rational’’ economic calculation wasimpossible under a socialist system. Economic calculation is ‘‘rational’’ ifdecision-makers can efficiently allocate scarce capital resources amongcompeting uses. Acting people must mentally process the alternativesavailable to them and to do so they must have some guide for comparinginputs and outputs. Mises’ contribution was to establish that this decision-making ability (i.e., rational economic calculation) is dependent on theinstitutional context of private property. Mises reasoned as follows:

1. Without private production in the means of production, there will be nomarket for the means of production.

2. Without a market for a means of production, there will be no moneyprices established for the means of production.

3. Without money prices, reflecting the relative scarcity of capital goods,economic decision-makers will be unable to rationally calculate thealternative uses of capital goods.

In short, without private property in the means of production, rationaleconomic calculation is not possible. Under institutional regimes thatattempt to abolish private ownership in the means of production, decision-makers will be in the dark with no guide as how to best allocate resources. Inthe world in which we live, economic decision-makers are confronted withmany possible projects and economic calculation provides a guide forselecting the best project from an economic standpoint. In the absence ofwell-defined property rights in the means of production, decision-makerswill have no guide for deciding which projects to pursue.

The Continuing Relevance of F.A. Hayek’s Political Economy 85

In his writings that preceded The Road to Serfdom, Hayek’s contributionto Mises’ argument was to elaborate the precise role that the price systemplayed in providing information required for complex plan coordination.The Mises–Hayek argument demonstrated that the socialist system couldnot replicate what the private property and price system provided. No onemind or group of minds could possibly possess the knowledge necessary tocoordinate a complex industrial economic system. In stark contrast, theprivate property and price system economizes on the information needed byeconomic actors to properly allocate resources.

Hayek proceeds in The Road to Serfdom under the assumption that thisMisesean–Hayekian theoretical argument has been established and acceptedin the technical economic literature. Hayek’s aim was not to establish thatsocialist planning could not achieve the efficiency that the capitalist systemcould. Rather, it was to demonstrate what would emerge from the failure ofsocialist planning to achieve its desired results. In other words, the Mises–Hayek technical economic calculation argument showed why socialismwould fail; in The Road to Serfdom, Hayek showed what would result fromthat failure.

In the intellectual history provided in the first three chapters, Hayek’sgoal was to demonstrate that despite the Mises–Hayek critique of socialism,the socialist criticism of competition had effectively undermined thelegitimacy of liberal institutions among the general public and especiallyamong the intellectual elite. Liberalism, Hayek argued, imparted a ‘‘healthysuspicion’’ of any argument that demanded restrictions on marketcompetition. With its critique of the competitive system, socialist theoryhad swept away the liberal constraints against special pleading and openedthe door for interest groups demanding protection from competition underthe flag of socialist planning (Hayek, 1944, p. 40).

Hayek not only highlighted the economic issues with socialism, but alsothe political difficulties of planning. Indeed, Hayek’s discussion of thedelegitimation of the need for constraints on democratic government andthe rule of law are one of the main arguments in The Road to Serfdom (1944,pp. 56–87). In order for planning to be implemented, government officialscannot be constrained by formal rules but must be entrusted withdiscretionary power. Additionally, planning requires widespread agreement,and democracy is only capable of producing a certain level of agreement.Hayek argued:

That planning creates a situation in which it is necessary for us to agree on a much larger

number of topics than we have been used to, and that in a planned system we cannot

PETER J. BOETTKE ET AL.86

confine collective action to the tasks on which we can agree but are forced to produce

agreement on everything in order that any action can be taken at all, is one of the

features which contributes more than most to determining the character of a planned

system. (1944, p. 62)

What is the result of the need for widespread agreement?

planning leads to dictatorship because dictatorship is the most effective instrument of

coercion and the enforcement of ideals and, as such, essential if central planning on a

large scale is to be possible. The clash between planning and democracy arises simply

from the fact that the latter is an obstacle to the suppression of freedom which the

direction of economic activity requires.

By its very nature, attempts at central planning will tend towarddictatorship because this is the only effective means of making the necessarydecisions required by central planning.

Yet another key point Hayek makes in The Road to Serfdom is the liberalproposition that economic freedom and political freedom are linked. Heargues that economic control does not control merely

a sector of human life which can be separated from the rest; it is the control of the means

for all ends. And whoever has sole control of the means must also determine which ends

are to be served, which values are to be rated higher and which lower – in short, what

men should believe and strive for. Central planning means that the economic problem is

to be solved by the community instead of by the individual; but this involves that it must

be the community, or rather its representatives, who must decide the relative importance

of the different needs. (1944, p. 92)

Economic choices cannot be separated from the other choices made byindividuals. As such, as planning increases, the freedoms and choicesavailable to individual members of the populace will decrease. When thegovernment decides what products are to be produced, there is little choiceleft to the individual citizen. The diverse preferences of the populace must behomogenized so that they conform to the central plan.

In addition to the highlighting the connection between economic andpolitical freedom, Hayek also pointed out the organizational logic impliedin the substitution of central decision-making for the private decisions ofthe citizenry in the marketplace. His analysis includes both an examinationof the incentives faced by representatives creating the central plan, and theevolutionary process engendered by these institutions for the selection ofleaders. Recall that Hayek assumed that the Mises–Hayek critique ofsocialism was widely accepted. Using this assumption as a startingpoint, he analyzed the organizational logic of central planning and what

The Continuing Relevance of F.A. Hayek’s Political Economy 87

societal/institutional transformation would occur in response to the failureof the socialist system to achieve its stated ends.

Hayek took as a given that due to the inability of central planners toengage in rational economic calculation, they would ultimately fail toachieve their desired purpose. When faced with this failure, one potentialoption would be for government officials to reverse course and adopt liberaleconomic policies. Hayek argued that in a context where liberalism had beenundermined by the socialist critique, government officials were unlikely toface sufficient incentives that would cause them to reverse course. As such,we should expect more interventions in the attempt to correct these pastfailures. This is the basis for the ‘‘slippery slope’’ argument whereby someinitial intervention leads to an increasing number of future interventions inthe attempt to remedy past failures.

Hayek’s analysis of organizational planning under socialism is evident inChapter 10, ‘‘Why the Worst Get on Top.’’ Hayek warns the reader thatsince the economic knowledge necessary to plan the economy rationally willnot be available to planners, these decision-makers will be forced to rely onthe forms of information that are readily available. In the context of centralplanning, this comes in the form of incentives to exercise political power.Hayek’s argument is that just as we should expect those with superior skillsin any industry to rise to the top, we should also expect those who havesuperior skills in exercising political power and coercion to advance withinthe political apparatus of planning.

In pointing this out, Hayek was challenging the claim that experiments inreal existing planning were tainted by ‘‘historical accident’’ and/or ‘‘bad’’people and therefore could not be used to illustrate the difficulties associatedwith central planning. Hayek’s counterargument was that it was not truethat if only ‘‘good’’ people controlled the planning bureau, then the resultswould be harmonious with liberal democratic values. As Hayek wrote:

There are strong reasons for believing that what to us appears the worst features of the

existing totalitarian systems are not accidental by-products but phenomena which

totalitarianism is certain sooner or later to produce. Just as the democratic statesman

who sets out to plan economic life will soon be confronted with the alternative of

assuming dictorial powers or abandoning his plans, so the totalitarian dictator would

soon have to choose between disregard of ordinary morals and failure. It is for this

reason that the unscrupulous and uninhibited are likely to be more successful in a society

tending toward totalitarianism. (1944, p. 135)

In this context, success requires a skill set including the talent for‘‘unscrupulous’’ and ‘‘uninhibited’’ moral behavior with respect tohumanity. Totalitarianism is neither a consequence of ‘‘corruption’’ not

PETER J. BOETTKE ET AL.88

‘‘historical accident,’’ but rather a logical consequence of the institutionalincentive of the attempt to centrally plan an economy.

Throughout The Road to Serfdom, Hayek tells the tragic story of theconsequences of central planning. It is not just that a band of thugs takescontrol of the coercive apparatus of the state and employs it to oppress themass of citizens for their own benefit. Instead, the arbitrary employment ofpower is a consequence, and not a cause, of the desire to plan the economyscientifically. In order ‘‘to achieve their end, collectivists must create power –power over men wielded by other men – of a magnitude never beforeknown, and . . . their success will depend on the extent to which they achievesuch power’’ (1944, p. 144).

Even liberal socialists, as opposed to collectivists, in their desire to planthe economy, must establish institutions of discretionary planning and grantauthority to the planners to exercise their political power in order toaccomplish the task entrusted to them. The complexity of the task implied inplanning an economic system would require that planners be granted almostunlimited discretion. As a result, we should expect that only those thatpossess superior talent in exercising discretionary power would survive.

5. HAYEK ON THE STATE, INDIVIDUAL, ECONOMIC

FREEDOM, AND THE LAW

Hayek’s interest in political and social theory, starting with The Road toSerfdom, continued in his later writings, specifically The Constitution ofLiberty (1960) and the three-volume Law, Legislation and Liberty (1973,1976, 1979). It is not Hayek’s purpose in The Road to Serfdom to explorewhat the role of the state should be, but rather to trace the consequences ofideas and specifically the adoption of socialist ideas and practices. In hislater writings, Hayek focused more directly on the role of the state in thecontext of individual and economic freedom, as well as the legal system. Inthis section we consider some of the main ideas in these later writings. Aswill become clear to the reader, much of Hayek’s analysis regarding the roleof the state, the legal system and political and economic freedom areoutgrowths of the arguments made in The Road to Serfdom and the themesfound in his earlier economic writings. According to Hayek (1976, p. 136),‘‘The possibility of men living together in peace and to their mutualadvantage without having to agree on common concrete aims and boundonly by abstract rules of conduct was perhaps the greatest discovery

The Continuing Relevance of F.A. Hayek’s Political Economy 89

mankind ever made.’’ Starting with The Road to Serfdom, Hayek’s writingsshould be read as an analysis of the moral and political significance of thisdiscovery as well an examination of the threats to its sustainability (Gordon,1981, p. 472).

As discussed at the outset, an emphasis on dispersed, local knowledge oftime and place, understanding how individuals coordinated their activitiesand the spontaneous orders emerging from these interactions are at thecenter of Hayek’s research program. In this regard, Hayek sought tounderstand how individuals can best learn and act on this dispersedknowledge. He concluded that a respect for private property, a well-functioning rule of law, and a stable monetary order were crucial forindividual experimentation, learning, and widespread coordination.

In the Constitution of Liberty, Hayek (1960 [1978], pp. 148–161) arguesthat these institutions provide a predictable environment within whichpeople can orient their behavior. As Hayek writes:

The significance for the individual of the knowledge that certain rules will be applied is

that, in consequence, the different objects and forms of action acquire for him new

properties. He knows of man-made cause-and-effect relations which he make use of for

whatever purpose he wishes. The effects of these man-made laws on his actions are of

precisely the same kind as of the laws of nature: his knowledge of either enables him to

foresee what will be the consequences of his actions, and it helps him to make plans with

confidence. (1960, p. 153)

Rules and laws are designed in the absence of perfect foresight. In otherwords, those developing rules and laws cannot know the particular casewhere they will be applicable. As such, general rules, which are predictableand known by all, allow unforeseeable situations to be dealt with in the mosteffective manner.

Hayek recognized the need for general rules that allowed individuals withdispersed knowledge to learn and, at the same time, limited the amount ofharm that could be done by any one individual. He realized that eachindividual is imperfect and as such we must develop the rules of the game sothat the best of all possible worlds will not be the enemy of the ‘‘good’’society. Hayek (1948, pp. 11–12) pointed this out, as well as the connectionof his research program with that of the Scottish Enlightenment program,when he wrote:

[T]he main point about which there can be little doubt is that [Adam] Smith’s chief

concern was not so much with what man might occasionally achieve when he was at his

best but that he should have as little opportunity as possible to do harm when he was at

his worst. It would scarcely be too much to claim that the main merit of the

individualism which he and his contemporaries advocated is that it is a system under

PETER J. BOETTKE ET AL.90

which bad men can do least harm. It is a social system which does not depend for its

functioning on our finding good men for running it, or on all men becoming better than

they now are, but which makes use of men in all their given variety and complexity,

sometimes good and sometimes bad, sometimes intelligent and more often stupid.

In this sense, Hayek’s political economy can be viewed as ‘‘robust’’ in thathis aim is to develop a system that will sustain and remain strong even in thepresence of imperfect individuals. Hume (1742 [1987], pp. 40–42) capturedthe issue of robustness when he noted:

Political writers have established it as a maxim, that, in contriving any system of

government, and fixing the several checks and controuls of the constitution, every man

ought to be supposed a knave, and to have no other end, in all his actions, than private

interest. By this interest we must govern him, and, by means of it, make him,

notwithstanding his insatiable avarice and ambition, co-operate to public good. Without

this, say they, we shall in vain boast of the advantages of any constitution, and shall find,

in the end, that we have no security for our liberties or possessions, except the good-will

of our rulers; that is, we shall have no security at all.

Hayek continued the development of this political economy project inLaw, Legislation and Liberty (1973, 1976, 1979). The main theme of thistrilogy is that rules must be general, non-arbitrary, and equally applied to allindividuals. This pure ‘‘Rule of Law,’’ as Hayek calls it, must serve as thebackdrop for imperfect agents. Given a predictable legal code, individualscan learn and adapt their behavior in order to coordinate their activitieswith those of others.

Consistent with the generality principle mentioned earlier, Hayek claimsthat in a free society only the general welfare can be pursued and not theparticular aims of any individual within society. According to Hayek, manycontemporary notions of social justice are focused on the particular case ofindividuals within the general order. But, in Hayek’s system, justice can onlybe maintained at the level of the general legal framework and rules of thegame. Specific actions designed to remedy certain instances of ‘‘injustice’’will fail to effectively remedy the situation and will undermine the generalsystem.

To understand Hayek’s argument, it must first be realized that politicaldecisions are never about particular distributions of resources. Instead,political decisions are decisions that affect the rules of the economic game.These rules create a set of expectations and a resulting pattern of exchange,production, and distribution. The ‘‘mirage of social justice,’’ is the beliefthat specific distributional outcomes can be picked independent of the veryprocess through which exchange and production takes place. The rules ofjust conduct serve to govern the means by which various purposes and

The Continuing Relevance of F.A. Hayek’s Political Economy 91

plans are pursued. As such, these rules serve to reconcile the actionspursued by disparate individuals within the general order governed bythese rules. In contrast, a command serves a particular purpose and as suchis in direct conflict with rules of just conduct. Put simply, discriminatorylaws undermine the rules of just conduct and the framework of a justsociety.

After describing and defending the ‘‘rule of law’’ in Volumes 1 and 2 ofLaw, Legislation and Liberty, Hayek (1979) makes the case for politicalconstraints in the third and final volume. Recognizing the role interestgroups play in democratic political systems, Hayek argued that the problemwith limited democracy is that it becomes ‘‘the playball of all separateinterests it has to satisfy to secure majority support’’ (1979, p. 99). As aresult, the government becomes unable to accomplish the tasks required forgood governance. Thus, constraints are necessary to avoid the devolutioninto arbitrary, unconstrained, interest-group government.

At this point, the reader can hopefully see the interconnectedness betweenHayek’s various strands of work. The underlying inquiry that drove all ofHayek’s research was: how do individuals learn to coordinate theireconomic activities with those of others under varying institutionalarrangements? In his earliest work, he focused on this question in thecontext of economic theory – capital structure, interest rates and monetarytheory, etc. Starting with The Road to Serfdom, his concern with these issuesbecame more focused on the implications of various political systems. Thisfocus on political, social, and legal theory continued throughout the rest ofhis career.

6. CONCLUSION – HAYEK’S RELEVANCE TODAY

F.A. Hayek’s political economic insights are as relevant today as when theywere first written. A number of areas in the contemporary economicslandscape reflect the continuing importance Hayek’s ideas. These areasinclude:

1. New institutional economics. New institutional economics (NIE) focuseson the study of institutions and the interplay between institutions andother organizational arrangements (Menard & Shirley, 2005, p. 1).Further, NIE assumes that actors have imperfect information and faceconstant uncertainty. The emphasis on institutions, as well as theabandonment of standard neoclassical assumptions of perfect information

PETER J. BOETTKE ET AL.92

and rationality can be found throughout Hayek’s work. In his review ofthe state of NIE, Oliver Williamson (2000) highlights Hayek as a criticalprecursor to NIE. As such, the NIE research program should be seen asbuilding on Hayek’s political economy.

2. Institutional change. Hayek’s influence is also evident in the effort tounderstand institutional quality and institutional change (Boettke, Coyne,Leeson, & Sautet, 2005). For example, Hayek’s influence can be seen inthe work of Olson (2000) and Djankov, Glaeser, La Porta, Lopez-de-Silanes, and Shleifer (2003) on institutional quality and the politics ofpredation. Hayek’s focus on the ‘‘bottom-up’’ emergence of institutionsversus the ‘‘top-down’’ imposition of institutions is relevant given ongoingefforts to ‘‘export’’ liberal institutions to countries where they do notcurrently exist (see, for instance, Coyne, 2007). In general, Hayek forcesus to realize that different institutional settings create different economic,social, and political outcomes. Understanding the various outcomes ofdifferent institutional settings is an empirical question.

In the realm of public policy, arguments about institutions andinstitutional capacity are more prevalent today than ever before. Theidea that we need simple rules for a complex world is no longerconsidered unthinkable and is much more common than the idea thatbecause of complexity we need detailed interventions.3 It is now aconventional wisdom that rules outperform discretion in the realm ofpublic policy. Policy analysis has moved to the level of the rules of thegame that create the institutional environment within which economicactivity takes place. This is most evident in the public policy discussionsurrounding development economics and the emphasis on creating aninstitutional environment that cultivates an entrepreneurial environmentwhere individuals are enabled to realize the mutual gains from trade.Cooperation is encouraged, and conflict minimized due to the institu-tional environment that is adopted in any given society (see, for instance,Ostrom, Gibson, Shivakumar, & Andersson, 2002).

3. Development economics. Many underdeveloped countries suffer from thevery problems Hayek was analyzing in his writings. In many of thesecountries corruption is rampant. Property is coercively redistributed ratherthan protected. A stable rule of law is absent as the legal system isunpredictable and constantly changing. Hayek’s political economy offersinsight into these outcomes. For example, Hayek’s work has proven to beextremely prescient and relevant for current debates in growth theory asillustrated by the work of Mahoney (2001) and Glaeser and Shleifer (2002).

The Continuing Relevance of F.A. Hayek’s Political Economy 93

The recognition of the importance of entrepreneurship to understandinggrowth continues to spur economists to find ways to incorporate the elusiveconcept of entrepreneurship into the understanding of the competitivemarket process (see Baumol, 2002). Some of this research is amenable tostandard empirical work, but there has also been a growing recognitionthat work that emphasizes institutions and economic change must eschewcross-country data analysis and engage in detailed micro-data analysis ofspecific context. This can be accomplished through an analytic narrativeapproach (see Bates, Greif, Levi, Rosenthal, & Weingast, 1998),ethnographic analysis of underground economies (e.g., de Soto, 1989), ormicro-data surveys (e.g., Frye, 2000). Empirical economics is goingthrough a transformation just as drastic as theoretical economics and itis doing this in line with Hayek’s focus on disaggregation and in a mannerthat is consistent with the subjectivist notion of developing a politicaleconomy of everyday life that respects the meaning that individualsconstruct and place on their activities and the activities of others.

4. Understanding the scope of spontaneous orders. A growing researchexplores the extent to which spontaneous orders can evolve and operatein the absence of the state (see, for instance, Leeson 2007a, 2007b, 2008;Benson, 1989; Anderson & Hill, 2004). An important aspect of Hayek’swork is the emergence of spontaneous orders that facilitate cooperationversus the need for the state to formally legislate rules to fostercooperation. The central question becomes the extent and robustness ofgovernance mechanisms, their ability to handle problems of socialdiversity, large populations, and capacity to handle violence.

5. Experimental economics. Vernon Smith (2005) has noted that his work inexperimental economics was originally inspired by Austrian economics,and specifically the work of Hayek. Indeed, Smith sees his research ascontributing to key questions asked by Hayek long ago: how doindividuals utilize human knowledge that is dispersed and can never bepossessed by a single individual? Under what conditions will individualspartake in mutually beneficial exchanges without any influence from acentral planner? Moreover, Smith emphasizes that laboratory experi-ments allow for the observance of the emergence of spontaneous ordersin the form of rules governing the market and market exchanges. In thisregard, the field of experimental economics should be seen as a directdescendent of Hayek’s political economy.

6. The cognitive turn in economic science. In the realm of economic science,Hayek’s influence can be seen in the cognitive direction of research

PETER J. BOETTKE ET AL.94

(see Koppl, 2006) that has been taken by Kuran (1995) and North (2004).Several scholars, including Gilad (1982) and Harper (1996, 1998) haveincorporated the psychological concept of ‘‘locus of control’’ into thetheory of entrepreneurship.4 Finally, the Hayekian view of cognition canbe seen in the works of complexity theorists including Holland (1992) andby Kauffman (1993).5 Hayek’s (1952) The Sensory Order will continueto play a role in the development of this sub-field (see Caldwell, 2004,pp. 270–279).

7. Understanding the costs of the growth of government. Even in developedcountries such as the United States, one observes a steady increase in thelevel of government intervention over time. Often, special interests areprotected through regulation, and protective measures such as tariffs.There have been frequent calls for nationalized healthcare despite the factthat the Medicare system is bankrupt. One also observes a call for moregovernment involvement in forced savings through interventions in theSocial Security system. Government spending has increased dramaticallyyear over year.

While the type of central planning employed in the Soviet Union is nolonger with us, governments around the world – in both developed andunderdeveloped nations – continually implement programs designed toincrease the scope of the state. As Hayek demonstrated, following such acourse of action runs counter to economic development as well aspolitical and individual freedom. Some scholars, such as Higgs (1987),have empirically explored how the onset of crisis leads to permanentgrowth in the size government. As Hayek noted in The Road to Serfdom,oftentimes efforts to utilize government to combat tyranny elsewhereactually result in the unintended consequence of movements towardtyranny at home.

8. The classical liberal agenda. In the realm of ideological commitment, anew generation of liberal scholars have emerged who have taken upHayek’s ideas and run farther with them than even Hayek dared toimagine. Kukathas (2003), for example, argues that the toleration ofreligious and ethnic minorities provided by liberal institutions must bepursued to its logical conclusion even in the world that we live in today.Also, recent work on decentralized governance and law by Benson (1990)has developed Hayek’s distinction between law and legislation in aconsistent manner. Finally, the work by scholars such as Weingast (1995)on market preserving federalism is another example where the argumentfor decentralized governance and fiscal federalism that Hayek made isinspiring new theoretical presentation and empirical investigation.

The Continuing Relevance of F.A. Hayek’s Political Economy 95

We have argued that F.A. Hayek’s political economy is as relevant todayas when it was first written. Modern scholars of political economy would dowell to go back to Hayek for untapped ideas and for a deeper understandingof the issues relevant to this area of study. Much of the current work inpolitical economy can be traced back to Hayek, even if his influence notexplicitly recognized by the authors (see, for instance, Acemoglu & Johnson,2005; Acemoglu, Robinson & Johnson, 2001; Glaeser & Shleifer, 2002).These writings also demonstrate how Hayek’s political economy cangenerate fruitful empirical analysis. Hayek’s writings consisted of manyempirical claims and these studies have contributed to the testing andanalysis of some of Hayek’s hypotheses. This growing empirical literaturedemonstrates the continued significance of Hayek’s political economy. It isour hope that modern scholars will recognize the lasting importance ofHayek’s research program.

NOTES

1. This is not an exhaustive list of all modern areas where Hayek’s work isrelevant. For example, Hayek’s work is also important in the areas of complexitytheory (see Rosser, 1999; Caldwell, 2004; Koppl, 2000, 2006) and public choice(see Boettke & Lopez, 2004) to name but two.2. For a discussion of the connections between Hayek’s political theory and his

work in economics, see Boettke (1999). Caldwell (2000, 2004, pp. 270–279) andHorwitz (2000) discuss the connections between Hayek’s economic theory and hiswork in cognitive psychology. Beaulier, Boettke, and Coyne (2004) discuss Hayek’slegal theory.3. For example, The 2004 Nobel Prize to Kydland and Prescott for, in part, their

work on rules versus discretion can be seen as consistent with this basic Hayekianpoint.4. Volume 7 of Advances in Austrian Economics addresses ‘‘Evolutionary

Psychology and Economic Theory.’’5. See also Butos and McQuade (2005). Butos (2003) explores Hayek’s cognitive

theory and the implications for the Austrian notion of rationality.

ACKNOWLEDGMENT

The authors would like to thank the Mercatus Center for their generoussupport of this research.

PETER J. BOETTKE ET AL.96

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MARKETS VS. POLITICS:

CORRECTING ERRONEOUS

BELIEFS DIFFERENTLY

Martin Gregor

ABSTRACT

In the fields of social choice, public choice, and political economics, thekey difference between private and political decision-making is whetherpreferences have to be aggregated to make a decision. A related, yetmuch less studied difference is whether also beliefs have to be aggregated.In this chapter, we argue that belief aggregation creates differentincentives for individual belief updates in private and political choice.We review contemporary theories of biased beliefs in politics: Bayesianmisperceptions, behavioral anomalies, and rational irrationality. Weexamine assumptions and consequences of all the approaches vis-a-visissues of common knowledge, stability, symmetry, and multiplicity ofstable states. As a route for further analysis, we construct an evolutionarymodel including a coordination failure. Differences in learning dynamicsmake the political play of this baseline game Pareto-inferior to theprivate play.

Explorations in Austrian Economics

Advances in Austrian Economics, Volume 11, 55–78

Copyright r 2008 by Emerald Group Publishing Limited

All rights of reproduction in any form reserved

ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11004-3

55

MARTIN GREGOR56

1. INTRODUCTION

In public choice and political economics, disagreement or conflict istraditionally attributed to heterogeneity of values, interests, or goals(Persson & Tabellini, 2000). By assuming conflicting objectives, one getsaround heterogeneity in beliefs on how the economy works, and politicalphenomena can be explained without any reference to errors of policy-makers or voters. Motivation for this abstraction is expressed relentlesslyin Wittman (1989, p. 1421): he rejects to explain government failures bysimply postulating ‘extreme voter stupidity.’ A typical example of thisapproach is incorporation of rational expectations into the political businesscycle, whereby Alesina and Roubini (1995) altogether eliminated myopia ofvoters.

Whether this modeling strategy is necessary and sufficient to address thekey issues of political economy nevertheless remains an open question.Specifically regarding political business cycles with rational expectations,Blankart and Koster (2006, p. 179) claim that they ‘remain in competitionwith the alternative and (at least sometimes) empirically better-performingmodels of public choice.’ More generally, in some contexts one finds itpuzzling that political economy models do not involve any error or mistake,and that players manage to converge on equilibria with largely sophisticatedbeliefs and strategies. To completely disregard that false descriptive beliefsexist and are corrected over the course of the play then restricts attentionto epiphenomena or leads to certain dubious implications. For instance,models of the Communist economy where apparatchiks possess with thesame knowledge on the role of price system as trained economists have(e.g., Shleifer & Vishny, 1992), appear implausible to anyone with moreprofound experience from the former Communist bloc.

An alternative viewpoint is that false descriptive beliefs persist andsignificantly affect policy outcomes, even in the long term. What is evenmore important, incentives to correct erroneous beliefs in markets maydiffer from incentives in politics. Traditionally, this problem is understoodunder the rubric of rational ignorance, where information gathering inpolitics is suboptimal due to uncompensated positive externalities ofinformed voting; however, latest advances show that this explanation isunsatisfactory, for voters can easily get reliable estimates at very low costs(Martinelli, 2006). Alternative explanations on the role of false beliefs inpolitics are proposed and examined.

Many prominent economists from different ages have elaborated on theidea that in politics people have erroneous beliefs, e.g., James Stuart Mill

Markets vs. Politics: Correcting Erroneous Beliefs Differently 57

(Mill, 1861/1972), Ludwig von Mises (Mises, 1979), and James Buchanan(Buchanan & Wagner, 1977). It is no coincidence that the role of falsedescriptive beliefs on economic policy is approached as a crucial issue inschools or traditions which attempt to derive general conclusions on the roleof the government intervention in the economy. Particularly illustratingis the difference between Chicago and Austrian schools of economics,discussed at length in Skousen (2005). Chicago economics leans to theexplanation that any market, even political one, sufficiently clears. This isspelled out in the idea of efficient democratic political markets, suggestedinitially in Stigler (1971) and reinvigorated in Wittman (1995). In the latterbook, labeled as an ‘amazing hit’ of Chicago school of political economy(Caplan, 2005a), Wittman argues that democratic political markets areefficient; voters are rational, compensations drive redistributive politics tothe centrist position, and adjustments between political supply and demandis instantaneous or take place without impediments. It is argued that thereis no significant difference between correction of beliefs and strategies inmarkets and in politics.

Austrian economists have a distinctly different approach. Firstly,Austrians argue that ideas, ideologies, or beliefs are important andexogenous determinants in the decision-making. According to Mises,‘[e]verything that happens in the social world in our time is the resultof ideas.’ (Mises, 1979, p. 108) Human action, by reflecting preferences,reflects also ideological and descriptive beliefs. Secondly, the market withpolitical ideas not necessarily features the best ideas available. Ideas areaggregate sets of descriptive beliefs which evolve and are tested; not only byempirical observation (benchmarking and comparing ex ante vs. ex postoutcomes), but also by manipulation, indoctrination, and via the media.Biases are sustainable for a very long time, which Austrians casually explainby referring to the history of political ideas. If there is convergence towardselimination of proponents of biases, it is very slow and hard to track; theCommunist empire with nowadays apparently mistaken ideology lastedover 70 years, and numerous proponents of the Communist ideology kepttheir support till the very end.

The perspective held by Austrians and others on the systematicallyerroneous beliefs has been recently resurrected because of advances in publicchoice and political economics. These recent developments reinvigoratedattempts to link classic Austrian insights to contemporary research onpolitical economy, like in Caplan and Stringham (2005). Three majormotivations for revived interest in political learning can be identified:evidence on maintaining (erroneous) political beliefs by laymen, models of

MARTIN GREGOR58

ideological or principled candidates replacing opportunistic candidates,and the lack of a comprehensive theory of reform resistance. A unifiedframework on market and political updates of false beliefs is nevertheless faraway from our reach.

This chapter proceeds as follows. In Section 2, we highlight recentevidence on systematic biases in policy-relevant beliefs and elaborate on theaforementioned motivation. The section also introduces the reader to coreissues related to modeling political learning. Next, we review recent theoriesof imperfect learning in politics: Bayesian misperceptions in Section 3,behavioral anomalies (especially confirmatory bias) in Section 4, andrational irrationality in Section 5. We examine assumptions and implica-tions of the approaches. Specifically, we analyze whether they explain ifincentives to correct beliefs in politics are weaker than incentives to improvebeliefs on markets. In Section 6, we construct an evolutionary model witha coordination failure. We prove that due to different belief updating, thecollective play of this baseline game is never Pareto-superior to the privateplay. In final Section 7, we conclude by arguing that original insights ofAustrians are useful part of this research, but have to be transformed intoformal models with adaptive learning and evolutionary dynamics.

2. PRELIMINARIES

2.1. Motivation

Anecdotic evidence from sciences and history reads that people not onlytend to repeat wrong decisions, but also keep false descriptive beliefsfor a long time. In terms of politics and specifically economic policy, a hostof studies recognized systematic differences of beliefs between laymen andexperts: voters underestimate the economic benefits of free trade, over-estimate the percentage of the budget spent on welfare, and misinterpretlow economic growth as absolute economic decline (Caplan, 2001b, 2002;National Survey of Public Knowledge of Welfare Reform and the FederalBudget, 1995; Survey of Americans and Economists on the Economy, 1996).Rubin (2003) identifies ‘folk economics’ as economics of wealth allocation,not production. Quoting surveys on popular beliefs, experimental econom-ics on exchange, monitoring, and shirking, and studies on how childrenlearn economics, Rubin finds that folk economics by and large disregardsphenomena of specialization, division of labor, capital investment, andeconomic growth.

Markets vs. Politics: Correcting Erroneous Beliefs Differently 59

Closely related is the literature on determinants of descriptive beliefs,especially ideological ones. In a trading experiment where subjects assessedto what extent price will reflect supply and demand, Austin and Cox (2007)illustrate that ideological differences influence descriptive beliefs abouteconomic institutions. Blinder and Krueger (2004) also find that economicknowledge is determined by ideology, not the use of information.They obtain evidence for idealism (or sociotropic motivation), namelywhen it comes to national economic policy, people are often more interestedin what they perceive to be the common good than what is in their narrowself-interest.

Public choice and political economics have undergone a relateddevelopment in the revival of interest in partisan (ideological or principled)candidates, replacing Down’s opportunistic candidates (Besley, 2006).Beliefs of politicians have a role, for which evidence can be drawn fromquasi-experiments with lack of policy convergence after a commonpopularity shock (Lee, Moretti, & Butler, 2004). Certainly, this complexissue is affected by the way the party system works, but the inability ofcandidates to commit to a policy concessions implies that they or theirorganizations indeed follow stable objectives, and possess with stable(and not necessarily identical) descriptive beliefs.

In addition, public choice and political economics are far from aconclusive theory of reforms of the public sector, sufficient to explainnumerous delays and deadlocks. For economists, it is notoriously difficult toexplain why there is such a striking difference between outcomes of currentpolitical markets and policy recommendations, if efficiency-enhancingmeasures can be complemented with compensatory mechanisms. Estab-lished political-economy explanations resort to very specific assumptions.Alesina and Drazen (1991) presume a non-intuitive tax system withinformation asymmetry resulting in the production of costly signals, andreceive a version of the war of attritions. Howitt and Windtrobe (1995)postulate that with a reform initiative, the policy issue fully discloses inpublic and the reform initiator risks a loss with some probability. Thus,unwillingness to accept a lottery prevents from submitting a reforminitiative. The model however requires passive media and passive voters,impossibility to bargain as well as a particular distribution of preferences.

On empirical side, the idea that reform resistance can be associated simplywith ignorance has been tested in Heinemann (2004). A working hypothesisis that there should be a negative function of the population’s levelof economic education. Unfortunately, since there is no internationallyconsistent data set on economic education, Heinemann uses variables

MARTIN GREGOR60

describing the general state of education such as school enrollment ratios,the availability of media information, and the development of the financialsector such as credit aggregates. He gets a significant effect of these variablesupon the reform realization, hence tentative evidence on the importance ofthe lack of knowledge in policy-making.

2.2. Modeling

Several frameworks capture the intuition that homo economicus maylearn differently than homo politicus. We investigate in details hypothesesof Bayesian learning from biased signals (misconceptions), behavioralanomalies, especially confirmatory bias or overconfidence, and meta-rational irrationality. Before proceeding to each theory, we recognize acouple of issues that any theory of learning, Bayesian or non-Bayesian, hasto address.

(a) Deviation from the best response. Does inability to derive a correct beliefnecessarily imply deviation from the best response strategy? If there is adeviation, the incorrect beliefs are not serving one’s own interests anddeserve to be called false consciousness (Boudreaux & Crampton, 2003).The problem is that strong evolutionary pressure will be exertedon corrections towards the best response, with associated updates inbeliefs; one has to explain why deviations towards the best response, forexample, via random experimentation, are impossible or costly.

(b) The best response with false beliefs. We may have a case when the beliefsare self-serving rationalizations of material interests (‘where you standdepends on where you sit’) and are upheld since an update toward amore correct belief could lead to a deviation from the best response.This explanation is plausible, but needs very detailed assumptions onthe underlying game where this ‘equilibrium with illusions’ occurs. Oneattempt is coordination failure in Section 6. Empirically, this poses aproblem for regressions that attempt to explain descriptive beliefs viaideology; the positive relationship between beliefs and ideology isspurious. Austin and Cox (2007) claim that their results are inconsistentwith the idea that ideology and belief are mere self-serving rationaliza-tions of interest. Yet, they also think that over shorter time periods,ideology is a relatively stable and exogenous determinant of descriptivebeliefs about the workings of the economy.

Markets vs. Politics: Correcting Erroneous Beliefs Differently 61

(c) Symmetry on the supply versus demand side. If people are prone to havefalse descriptive beliefs, the biases must be present both on the supplyand demand side of political markets. This is, among others, a problemfor confirmatory bias applied in the principal–agent framework. It alsoposes a challenge for self-selection of individuals with certain beliefs intopolitical supply.

(d) If information is acquired up to the point where the marginal costequals the marginal benefit (Stigler, 1971), there is no rationale toassume zero cost of information on the benefits and costs of acquiringthe information. Unless one purchases or seeks information on the basisof correct priors on the cost and benefits of the search, we have – for anyitem of practical information – an infinite number of benefit and costschedules: the cost of acquiring the practical information, the cost ofinformation on the cost of the information, and so on.

(e) Common knowledge. If possibility of an erroneous belief is commonknowledge, we need to know what gives credibility to statements;otherwise, massive cheap talk occurs. For example, if receivers believethat ideology partly reflects interests, then the question of what tobelieve depends less on the receiver’s ideology than it does on thereceiver’s perception of the difference between his or her own ideologyand that of the sender. If something is not common knowledge, we runinto the danger of arbitrary modeling. Recall also an important con-sequence of Bayesian learning, namely that people cannot ‘agree todisagree’: if all important aspects are common knowledge, exchange ofopinions and common priors must lead to agreement (Aumann, 1976).

(f) Multiple stable states. Technically speaking, it is not so difficult to createa model with coordination failure where a population converges toan inefficient stable state in pure strategies. A far more complicated isto get a situation where the population is mixed and stable, i.e., only apart of population holds false beliefs for endogenous, not exogenousreason. There must be either a very special dynamics or those with goodbeliefs must have some benefit from individuals having false beliefs andvice versa.

(g) Comparative statics. Does the model imply that if an error gets costlier,the size of error declines? This is in general a message of simpleheuristics approach (Gigenrenzer & Selten, 2001), expressive voting(Brennan & Hamlin, 1998) as well as rational irrationality (Caplan,2001a, 2001b). Cowen (2005) however claims that for pride goods, thisrelationship need not hold.

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3. BAYESIAN LEARNING

Even if individuals create rational expectations, Romer (2003) posits thatthe mean belief in a large population is biased whenever errors in individualbeliefs are correlated. This idea is modeled in a setup with two policies.Identical voters have priors on their relative advantage. At a known cost,they can get a signal on the relative advantage and can also observesignals of other voters. Each individual selects the number of her costlyobservations. The problem for inference is that the signal consists of truevalue and two types of errors – common and idiosyncratic. The commonpart is identical to all voters (hence is correlated), whereas the idiosyncraticpart is specific for each individual. This means that an individual observingsignals can eliminate the idiosyncratic part, but not the common part.

The shortcomings of this approach are as follows:

(a) Distribution of signals can be obtained only at a cost. This requirescareful interpretation of the cost of observing the distribution of signals.In politics, opinion polls (and summaries of expert judgments) arevirtually costless, hence even an individual who does not observe anysignal (e.g., does not watch TV) should be able to get the aggregateinformation. This echoes recent theories on the collective aggregation ofinformation, where the electorate with rational ignorance may haveasymptotically perfect knowledge (Martinelli, 2006).

(b) Common part of error. If the signal realizes with a political debate, ora political event, the common part of error can be explained byargumentation skills, spin, popularity, or attractiveness of one candidateover another. This is fully in spirit of probabilistic voting literature.However, such signals are not randomly drawn from distributionsindependent over time, but are persistent. Persistence obviouslyprecludes Bayesian elimination of the error unless mean of thedistribution of the common error is known.

(c) Discounting bias. If variance of the common error is low comparingwith variance of the idiosyncratic error, then people make almostunbiased estimates. Other than zero expected value is not a complicationeither: if individuals know that, for example, Candidate A is alwaysmuch nicer than Candidate B, they would discount attractiveness of hisor her talk. This is similar to Austen-Smith (1991) who claims that underasymmetric information on impact of transfers and tax incidence, votersinsure by buying less transfers and lower taxes; only those programsthat credibly signal their merit will win elections. Moreover, that the

Markets vs. Politics: Correcting Erroneous Beliefs Differently 63

improved information on common error is individually specific andcannot be transmitted contrasts with the probabilistic-voting literature(Persson & Tabellini, 2000), where a popularity shock realizes only once,and demand side cannot tackle it; its anticipated effect is mitigatedrather by the supply side, i.e., the competition of politicians.

(d) Individual decision on acquiring signal. The number of signals acquiredis independent on the values of the acquired data. Romer (2003)assumes individual-specific benefit and cost functions from acquiringinformation, solely motivated by civic engagement or expressivemotives. This goes against Stigler (1971), where acquiring informationdepends on the expected benefit of the correction. Although this canbe handled formally (distributions of both common and idiosyncraticparts are known, so an individual can compute expected improvementof obtaining a signal in the next period), the problem is that we mayget a very complicated dynamics of adjustments, depending on therealization of shocks in different periods.

(e) Application to private choice. Superiority of private over public choicecould be related to the fact that prior private consumption, one observesconsumption of the good by others. With exception of yardstickcompetition, that is in politics impossible. Unfortunately not much is tobe inferred from this difference, since the superiority is related toassumption that political choice involves a lower number of consump-tion decisions; by introducing sequential private choice, we create extraopportunities for obtaining true information, which makes comparisonof politics and markets worthless. What would happen for identicaltiming – when both the political and private choices were sequential – isambiguous; in Romer’s model, there would probably be no differences.In other words, this type of correlated error seems not to be helpfulin addressing the difference between market learning and politicallearning.

4. BEHAVIORAL ANOMALIES

4.1. Innate Biases

Evolutionary psychology suggests that the explanation of a large number ofbiases lies in the persistent traits of human psyche, and that systematicallywrong descriptive beliefs can be related to behavioral traits gained in the

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very past. Rubin (2003) refers to anthropological division of civilizationinto mobile and sedentary societies; the former being egalitarian, basedon hunter-gatherers, with little food storage, little division of labor, andoccupational specialization given only by age. As a result, ‘instinctiveeconomics’ (economics rooted in human instincts) disregards capitalinvestments and division of labor. This simple but ambitious explanationis very difficult to challenge since economic education that aims to deprivepeople of folk or instinctive economics is not very well measured, and alsobecause descriptive beliefs depend on the ideology, which is exogenous in theshort term, but arguably endogenous in the long term (Austin & Cox, 2007).

4.2. Status Quo and Loss Aversion

Heinemann (2004) argues that many psychological anomalies such as statusquo bias and loss aversion have a substantial explanatory potentialparticularly in the context of reform resistance. First, the status quo biasdescribes a situation where people have a preference for one optionamong many others only because the option happens to be the status quo.If a change occurs, this specific option immediately loses extra attraction.Loss aversion denotes the fact that the absolute change in utility associatedwith a loss is larger than the absolute change in utility associated with again. With loss aversion, the utility function is dependent on the referencepoint which tends to be the status quo. All these anomalies work againstreforms aiming to change the status quo.

The behavioral explanations nevertheless encounter severe problemsif taken literally on markets with behaviorally unbiased trading partners.The loss aversion combined with S-shaped utility curve would lead to theemergence of a special insurance, not observed in reality (Wittman, 1995).Even if valid, the anomalies are of little use for our purpose becausethey make no difference between private and collective choice. In addition,for any anomaly to exist, there is no need for biased descriptive beliefs;preferences are inconsistent with choice because of the psychologicallypredetermined structure of choice, not because of false beliefs.

4.3. Confirmatory Bias

Confirmatory bias can be understood by a phrase that ‘first impressionmatters,’ namely that one is overconfident about validity of an initially held

Markets vs. Politics: Correcting Erroneous Beliefs Differently 65

hypothesis. Experiments and psychologists confirm that the way peoplesearch for, process, and remember information is indeed guided by thepriors (Camerer, 1995). Rabin and Schrag (1999) were the first to model theconfirmatory bias as overconfidence in the currently held hypothesis.Specifically, an agent initially believes that each of two possible states ofthe world is equally likely. The agent then receives a series of independentand identically distributed signals that are correlated with the true state.When the agent gets a signal that is counter to the hypothesis hecurrently believes is more likely, there is a positive probability that he orshe misreads that signal as supporting his current hypothesis. Importantly,the agent is unaware that he is misreading evidence in this way and engagesin Bayesian updating that would be fully rational provided he were notmisreading evidence.

The problem with application of confirmatory bias in politics isarbitrariness of common knowledge. Rabin and Schrag (1999) in Section 5model principal–agent relationship when the principal is aware of agent’sbias. Thereby they introduce a fundamental asymmetry in knowledge,because the principal is aware of the bias, but the agent is not. However, atleast in citizen-candidate models, a politician must be behaviorally identicalto the voter, hence asymmetry is unfounded. If both are unaware of anybias, we can have a very rich structure of updates ending in a pseudo-Bayesian equilibrium based on incorrect updates. If both are aware, then itdepends on whether the bias is common knowledge – if so, then it isirrelevant for choice, since any agent can reconstruct her updates using theknowledge of the bias. Yet, if the bias is not common knowledge but issymmetric, then we again have a very specific problem of coordination onincorrect updates. In any case, either coordination is nearly by chance(nobody is aware of any bias), or coordination is an extremely deepinformational problem involving many levels of knowledge (what theindividual 1 thinks that the individual 2 thinks about what the individual 1thinks about the individual 2 etc.). Simply, the lack of common knowledgemakes the problem immensely complex. Indeed, even the authors honestlyadmit that ‘usefully incorporating confirmatory bias into economic analysiswill depend upon the extent to which people believe that others suffer fromconfirmatory bias’ (Rabin & Schrag, 1999, p. 71).

The most recent attempt to apply confirmatory bias into politics is Cowen(2005). He defines ‘self-deception’ as tendency to welcome confirmingevidence for a prior but throw out disconfirming evidence. The problem isthat he explains the phenomenon by two, mutually exclusive hypotheses.One is that ‘the quest for pride causes individuals to throw away

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information that reflects badly on their values and their affiliation’ (Cowen,2005, p. 439). Values or affiliations are therefore consumption goods (pridegoods), and one considers trade-off between pride and material consump-tion. Another explanation is evolutionarily psychological. Self-deception isa second-best heuristics for individuals who need to boost motivation,command the loyalty of others, avoid depression, and protect themselvesagainst a tendency towards distraction (Cowen, 2005, p. 440). Nevertheless,none is, in fact, confirmatory bias or overconfidence as defined in thebehavioral literature, e.g., Rabin and Schrag (1999).

At last, Cowen (2005) inclines to the pride-goods explanation of self-deception. The novelty is that any choice has both materially instrumentalcomponent and value (or emotional) component. This is exactly whatexpressive voting literature (Brennan & Hamlin, 1998) captures under‘instrumental voting’ (to affect what happens in the world) versus‘expressive voting’ (to make a statement on values). This approach impliesthat efficiency is affected only if the consumption of pride goods producesexternalities. Removal of self-deception is a classic collective actionproblem, identical information-gathering, and incentives for rationalignorance. In this respect, it adds nothing extra to the concept of rationalignorance.

5. RATIONAL IRRATIONALITY

One of the most systematic and the most ambitious attempts to rationalizebiased beliefs is ‘rational irrationality’ concept by Caplan (2000, 2001a,2001b, 2003), related to the cognitive dissonance by Akerlof and Dickens(1982). An individual faces a trade-off between the amounts of rationalityand irrationality consumed. Rationality brings benefits in terms ofidentifying the best instruments to achieve personal goals, while irrationalitydelivers emotional benefits. Each individual has rational expectations on thecosts and benefits of rationality, hence consumes a privately optimal amountof rationality.

Caplan (2001a, 2001b) argues that the opportunity costs of irrationalityin market exceed opportunity costs of irrationality in politics, which heconsiders to be the key difference between the markets and politics.To illustrate different equilibria amounts of rationality in politics andprivate life, Caplan (2003, p. 221) uses the way people interpret autarky:‘[T]he belief that protectionism is a wealth enhancing national policy makeslittle difference for the individual adherent, who still enjoys the benefits of

Markets vs. Politics: Correcting Erroneous Beliefs Differently 67

international trade. But holding that household self-sufficiency is the path toprosperity has large private costs.’

In other words, collective learning is less efficient than private learningdue to positive externalities involved in improving an erroneous belief.Private costs of irrational bias in politics are negligible, so people tend tobe biased, and politicians who win competition for the favor of voters withirrational biases tend to share those biases. This has interesting andprofound implications not only for politics, but also for academic socialcriticism and other fields (Boudreaux & Crampton, 2003).

One may further speculate about the difference between imperfectrationality and imperfect information. Caplan (2003, p. 222) notes:‘Intuitively, a person with ample free information might still choose toirrationally disregard it; conversely, a person with virtually no informationcould still take full advantage of the little that he does know.’ This suggeststhat the optimal level of rationality does not significantly change whenmedia, interest groups, and politicians bring virtually free information.If processing of information is too costly for a layman, additional items ofinformation remain out of scope of his or her interest.

The idea of rational irrationality can be addressed empirically, or rejectedin theory. For the issue of laboratory tests, see discourse between Caplan(2005a, 2005b) and Wittman (2005a, 2005b); in this text, we focusexclusively on the theoretical part, and identify several caveats:

(a) Costless thinking on meta-level. Caplan divides rationality into twolevels: meta-rationality, allocating rationality into activities, andrationality within the realm of each specific activity. As to the latter,we simply behave rationally only to extent chosen on the meta-level; wedispose with meta-rational expectations. If errors were due to lack ofthinking, we could conjecture that on meta-level, thinking is costless,but on lower levels, thinking is costly. This fundamental asymmetry isunfounded; why should one know the price of thinking, and not in theprice of information, and vice versa. No justification for this asymmetry,or for any dualism of meta-level and normal levels, has been offered.

(b) Anyway, suppose we dispose with an unbiased estimate of costs ofthinking. How could we arrive at the figure? It could be on the basis ofthe long-term experience. The psychic cost cannot be measured exactlybefore you start thinking, but can be approximated by the amount oftime spent by thinking. An individual might summarize previousexperiences into a vector of costs and a vector of benefits. A regressionof non-linear cost function on benefits might provide estimates of the

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benefit-cost parameters. If a rational individual had no reason to believethat the problem he is facing statistically significantly differs from theprevious problems, he or she would use the predicted estimates foroptimization. However, Caplan’s idea is not in the direction thatcognitive capacity is allocated, but that emotions are consumed.

(c) Experience as a capital good. The allocation of rationality could bedetermined by an individual whose thinking on meta-level is costly.However, in such a model we implicitly introduce a dynamic settingwithout considering other factors. Experience (the result of thinking)might be a stock variable (human capital), and enters the decision-making process along with pure thinking. For such decision-makingproduction, an individual gets an optimal amount of rationality whenshe optimizes evolution of capital over time, given the knowledge ofdepreciation rate, the expectation of dynamics of future problems, andthe possible changes to her thinking costs. Now the problem becomesgenuinely complex, and meta-rational expectation assumption loses partof its appeal. The chance that a boundedly rational individual selects anoptimal path of thinking investments turns to be very low.

(d) Compensations for learning. A very unclear yet important issue is howopportunities to learn are evaluated and compensated. Consider thefollowing problem exposed by Caplan (2003, p. 231): ‘Suppose freetrade provides $600 in benefits to each voter, but 60% are willing to payup to $2 for the irrational belief that free trade costs them $1000.A simple vote for free trade will clearly fail.’ Ordinary logrolling,according to Caplan, cannot utilize forgone gains to trade, becauseagents still retain their false beliefs. Even if the minority of 40% gave allnet benefits to the irrational majority (i.e. $400 each), members ofthe irrational majority would consider that to be a loss of $600($1000�400), and would vote for protectionism (status quo). Theobvious problem is that in such a case, voters are not rational on themeta-level. If they really had rational expectations, they would knowthat by investing $2 of $400 transfer into learning, they would realize netgain $398. Another possibility is that the minority is able to conditionthe transfer on learning, which is a much more plausible option that tocondition the transfer on vote with the secret ballot, as Caplan (2003)notes in footnote 11.

(e) Why false beliefs as empirical shortcuts come into being? Oneexplanation is via the cost of thinking. Strictly positive cost of thinkingand more generally costs of investments into human capital are obvious.Caplan’s intuition is however in the direction of pride goods mentioned

Markets vs. Politics: Correcting Erroneous Beliefs Differently 69

in subsection 4.3. ‘[Y]ou may be willing to forego some wealth in orderto retain cherished – though irrational – beliefs.’ (Caplan, 2003, p. 223)That invites an idea that changes in beliefs are avoided, because onepays special adjustment cost for leaving wrong beliefs and approximat-ing true beliefs. To explain where this cost comes from, and why it isconstant, needs very specific behavioral or evolutionarily psychologicalassumptions. Little is known on how these (probably emotional) costsaffect consumer behavior, and influence efficiency properties of marketand political allocations.

(f) Expertise and voters’ activity. In all areas where thinking costs matter,meta-rational individuals should behave as perfectly rational indivi-duals. First of all, they should respond to credible signals of rationalityor ability. If experts were able to produce credible (costly) signals ofincurring thinking costs (such as PhD in Economics), the meta-rationalindividuals would follow their advice, thereby economizing on thinkingcosts. But laymen do not follow experts views on many policy issues,which Caplan (2002) himself demonstrated in a survey comparing viewsof American economists and Americans on the economy.

(g) Meta-rational individuals would be able to perfectly deduce thatirrationality regarding specific issues is ruling the world. Anyconsequences related to the allocation of rationally would be known.For example, the meta-rational voters could not accuse political supplyof inefficiency, for they could easily conjecture that the main problemlies in the under-supply of reasonable political demand. These strangeconsequences lead us astray from the meta-rational individuals.

6. POLITICAL VS. INDIVIDUAL ADJUSTMENT

The attempts to theorize on error in political economy among Austrianeconomists have to date led to urgent claims to model learning anddynamics of the mixed economy at the micro- and macro-levels (Ikeda,2003). Evolutionary economics offers such a toolkit, comprising ingredientssuch as strategies, populations of players, well-specified interactions, andfitness functions. Evolutionary reasoning can be divided into two branches,stability and dynamic concepts. For stability, we seek for stable states whichcannot evolve, so mutants cannot outperform normal population. Suchstates frequently overlap with competitive equilibria in standard micro-economics and with plausible refinements of Nash equilibria in game theory.

MARTIN GREGOR70

For dynamic concepts, we have a colorful picture with differential equationsand simulations.

Although externalities and collective action in evolutionary frameworkoften produce interesting results, very little formal research has beenconducted with regard to evolution on political markets where collective-action problem and the possibility to impose own will upon the others areconstantly present. An interesting exception is Caveiro (2005) who appliesneural networks to the adaptation of voters to political business cycle.

This section attempts to contribute to this literature and show that it mayaddress modeling issues raised in Section 2.2. We introduce an evolutionarymodel of coordination of market exchanges in a heterogeneous population;the setup is a very straightforward application of elementary evolutionarygame theory. The model identifies one way why political (centralized)decision-making is more likely to produce a coordination failure thanindividual (decentralized) decision-making. Unlike rational irrationality andother previously discussed explanations, the model abstracts from differentmarginal benefits from learning in private and collective choice.

The thrust of the explanation lies exclusively in the different mechanicsof adjustment of strategies on markets and in politics. In markets,individuals can verify both their strategies and their beliefs. In politics,choice is imposed by the majority, and individuals only verify their beliefs.A population that could have converged to a superior equilibrium if marketsare let free may be forced to an inferior equilibrium by a majority will.Accordingly, remaining individuals verify their beliefs into pessimistic ones.At last, everyone, including dissenters, is satisfied with the inferiorequilibrium, since it perfectly corresponds to the pessimistic beliefs.We show that in this model, politics can work as a pessimistic ‘self-fulfillingprophecy,’ which markets cannot.

6.1. Core Assumptions

The setup assumes two groups normalized to a unit-size, A and B, differingin the mother tongues, a and b. In each of an infinite number of periods, arandomly selected pair iAA and jAB has an opportunity to trade, but thetrade occurs only if both i and j can use the same language; gains from tradeare 3 for each. Using the other language is costly, but let language a besimpler to master than b; the costs of using a translator are 1 for i and 2for j. These costs have to be expended in each and every period. As a result,trading in language a is Pareto-efficient, yielding in each period payoffs (3, 2),

Table 1. Payoff Matrix.

IAA/jAB Language a costly Language b costless

Language a costless 3, 2 0, 0

Language b costly 1, 2 1, 3

Markets vs. Politics: Correcting Erroneous Beliefs Differently 71

whereas trading in the more cumbersome language b is less efficient,yielding payoffs (1, 3). Such a game is an asymmetric modification of Battleof Sexes.

The use of a native or foreign language can be organized individually orpolitically. By political choice, we mean that the majority elects a citizen-candidate who decides on the mandatory business language. Thereby weassume that the politician can forbid members of her group to use the otherlanguage privately. The native language is costless, but risky (trade may nothappen), whereas the foreign language is risk-less, but costly. The twostrategies can also be interpreted as a nationalistic versus cosmopolitanstrategy. Payoffs in interactions between randomly drawn iAA and jAB arein Table 1.

Each individual has a private belief that the trade partner is able to use theother language, si or s j. In order to work with a polymorphic interpretationof the population, we assume only pure beliefs, si, s j A{a, b}. This hasexpositional advantages in terms of conveying the message of the model in avery simple, albeit simplified way.

Pure beliefs implies that the populations are represented by a realizationof two binomial distributions BA( � ) and BB( � ) over {a, b}, where we denotea � BA(a), 1� a ¼ BA(b), b�BB(b), and 1� b ¼ BB(a). Hence, aA[0, 1]denotes the share of group A that believes that members of group B arewilling to use a, and bA[0, 1] is the share of group B that believes thatmembers of group A are willing to use b. (In other than stable states, wealways add subscript t denoting period t). Below we will see that anyonewith belief si ¼ a or s j

¼ b plays only nationalistic strategy, so each variablealso represents the share of those who are nationalistic, namely are unwillingto pay the cost of using the other language.

6.2. Individual Adjustment

For individual decision-making, each individual selects the language on thebasis of her private belief, observes the payoffs and may update the belief, if

MARTIN GREGOR72

incorrect. Then, the random draw of trading pairs (i, j) is repeated. Sinceeach individual has a pure belief, we have only strict best responses, a or b(e.g., for player i, si ¼ a implies strategy a, and si ¼ b implies strategy b).Therefore, one can check whether the belief about the trading partner wascorrect, or not, simply by observing her payoffs and the correspondingstrategy profile.

By examination of Table 1, we can observe correct (equilibrium) beliefsin two strategy profiles (those with payoffs (3, 2) and (1, 3)) and incorrect(out-of-equilibrium) beliefs in two strategy profiles (those with payoffs (0, 0)and (1, 2)). What happens if the beliefs are incorrect? We have to specify therate of adjustment of an individual strategy. Here, it is plausible to assumethat the rate is linear in opportunity cost associated with the best response.In profile [a, b] with payoffs (0, 0), the opportunity costs are 1 – 0 ¼ 1 forplayer i and 2� 0 ¼ 2 for player j (See Table 1). We know that thisprofile occurs with probability atbt. In profile [b, a] with payoffs (1, 2),the opportunity costs are 3 – 1 ¼ 2 for player i and 3 – 2 ¼ 1 for player j.This profile occurs with probability (1 � at)(1 � bt). Assuming rate ofadjustment linear in opportunity cost with constant 0oPr1, we have twodifference equations

_a ¼ 2pð1� atÞð1� btÞ � patbt ¼ pð2� 2at � 2bt þ atbtÞ (1)

_b ¼ pð1� atÞð1� btÞ � 2patbt ¼ pð1� at � bt � atbtÞ (2)

Interpretation of p is straightforward: it is the share of people who, havingobserved an incorrect belief, make a correct adjustment. It is now useful toderive situations when shares a and b are constant; these are also depictedon Fig. 1

_a ¼ 0 : b ¼2� 2a

2� a(3)

_b ¼ 0 : b ¼1� a

1þ a(4)

The system converges to a stable state when _a ¼ _b ¼ 0. This is equivalentto a þ b þ ab ¼ 1 ¼ a þ b � ab/2, which holds as long as a ¼ 0 or b ¼ 0.By plugging into equation (3), we have two stable states, inefficient one,(a, b) ¼ (0, 1), and efficient one, (a, b) ¼ (1, 0). What is more interesting is toidentify the basin of attraction for each stable state. This appears difficult

at

bt

efficient

inefficient

0, 0

a = 0.

.b = 0

0, 1

1, 0

Fig. 1. Dynamics of Individual Adjustment.

Markets vs. Politics: Correcting Erroneous Beliefs Differently 73

analytically, yet we can use Fig. 1 with arrows indicating the signs ofattraction.

Although we have two evolutionarily stable states, the basin of attractionfor the inefficient one is a singleton. With exception of (a0, b0) ¼ (0, 1),there is no trajectory that would end up in the inefficient stable point,(a, b) ¼ (0, 1). In other words, the adjustment dynamics described inequations (1) and (2) drives any population to the efficient stable state, withonly one extreme exception, if all start using language b.

6.3. Political Adjustment

Suppose that two citizen candidates, each with a different belief, enterelections and manifest their beliefs. Voting is costless, and we concentrate onthe equilibrium with sincere voting, namely when each individual votes forthe language on the basis of her belief. This refinement is legitimate as longas individuals do not play weakly dominant strategies. Identity of thepoliticians depends on which type of private belief dominates in each groupin period t ¼ 0.

In period t ¼ 0, each of elected citizen candidates adopts a mandatorylanguage on the basis of his belief. Strategy set of each trader reduces toa singleton, and all trading pairs end up in an identical strategy profile.The profile is either an inefficient equilibrium, as in [b, b] with payoffs (1, 3),or an efficient equilibrium, as in [a, a] with payoffs (3, 2). In addition, there

Table 2. The Strategy Profile in Political Adjustment for t ¼ 0.

a0, b0 b0o1/2 b0Z1/2

a0Z1/2 a, a efficient a, b out of equation

a0o1/2 b, a out of equation b, b inefficient

MARTIN GREGOR74

are two out-of-equilibrium profiles, [a, b] with payoffs (0, 0) and [b, a] withpayoffs (1, 2). Table 2 summarizes.

Equilibrium. If the profile is equilibrium, none of politicians has anyincentive to change her belief. The citizens update beliefs like in individualchoice. The only difference is that in a purely individual adjustment, theyselected a strategy corresponding to their beliefs, and thereby verified bothbelief and strategy; here, the strategy is mandatory, so they only verify thebelief. Regardless of assumptions on the rate of adjustment, for a0Z1/2 andb0r1/2 (inefficient [b, b] profile), we have _a � 0 and _b � 0. For a0o1/2 andb0Z1/2 (efficient [a, a] profile), we have _a � 0 and _b � 0. Citizens’ beliefsconverge to the beliefs of the politicians, reflecting initial distribution(a0, b0); any initial disagreement or heterogeneity in beliefs disappearsthroughout the process of political learning.

Out of equilibrium. Here, we have to determine how the politicians changetheir beliefs (and accordingly the mandatory language). We have at leasttwo options, optimistic and realistic: (i) they are able to coordinate onefficient, risk-dominant equilibrium, or (ii) they adjust exactly like citizens.It also depends on the number of periods in-between consecutive elections.Regardless of these nuances, we will see that the main result, namely thatpolitical learning is less efficient than individual learning, preserves.

Start with profile [a, b] with payoff (0, 0), corresponding to a0Z1/2and b0Z1/2. In case (i), when politicians immediately coordinate on theefficient equilibrium [a, a], we have that all players j are forced to use a.This implies adjustment _a � 0 and _bo0. If elections come early, we mayhave at the time of elections bto1/2 (sufficient adjustment) or btZ1/2(insufficient adjustment). If adjustment is sufficient, a-politicians are electedand we have an efficient equilibrium. Otherwise, we have again [a, b] profile,but since btob0, repeated elections gradually push citizens’ beliefs to theefficient equilibrium.

In case (ii), when politicians adjust exactly like citizens, we have tospecify the rate of adjustment. This should reflect opportunity costs. Theopportunity cost for politician 1 is 1, and the opportunity cost for politician2 is 2. Both opportunity costs are exerted with probability one. Thedynamics is _a ¼ �pat and _b ¼ �2pbt. It is again irrelevant whether elections

Markets vs. Politics: Correcting Erroneous Beliefs Differently 75

arrive sooner or later because beliefs of repeatedly elected politicians willonly reflect gradual adjustments of citizen beliefs.

Adjustment for profile [b, a] is analogous. For risk-dominant politicians(case (i)), the economy operates under efficient [a, a] regime. For realisticpoliticians (case (ii)), politicians update by _a ¼ 2pat and _b ¼ pbt.Fig. 2 illustrates the dynamics. For any initial distribution of beliefs,

(a0, b0), it shows the point of convergence, i.e., of political stability.If politicians out of equilibrium can coordinate on the risk-dominantequilibrium (which is an optimistic assumption), then we have an inefficientstable state only for (a0, b0)AS0. If politicians adjust like citizens, then wehave an inefficient stable state for an even larger set, ða0; b0Þ 2 S0 [ S1 [ S2.S1 is formally defined as the set of all (a0, b0), for which there exists t,where atW1/2 and btr1/2. S2 is formally defined as the set of all (a0, b0), forwhich there exists t, where atr1/2 and btW1/2.

Notice that in the end, regardless of which state is achieved, bothpopulations are completely satisfied with their politicians because they shareidentical beliefs with the citizens and thereby promote language policies thatare equilibrium policies from the perspective of all citizens.

To conclude, Fig. 2 shows that in politics, initial majorities matter forlearning; if population B is initially strongly self-confident and population Ais weakly self-confident, a politically stable state induces trades in theinefficient language b. For markets, this occurs only in a degenerate case,(a0, b0) ¼ (0, 1); learning in markets drives nearly all populations to the

a0

b0

efficient

inefficient

0, 0

S1

S2S0

0, 1

1, 0

Fig. 2. Dynamics of Political Adjustment.

MARTIN GREGOR76

efficient stable state. By restricting individual experimentation in strategies,politics is significantly more likely to deliver an inefficient outcome.

7. CONCLUSION

Although the dominant interest of Austrian School of Economics inmarkets with well-defined and well-protected property rights sways maininterests away from political economy, many Austrian scholars dispose witha distinctive and common idea on how politics operates. One politicaleconomy insight frequently mentioned in Austrian writings is that voterssystematically keep false beliefs. We regard this hypothesis plausible, andreview contemporary literature so as to identify firm theoretical foundationsfor the hypothesis. In Sections 3–5, we analyzed three types of explanationsand pointed to their caveats: Bayesian misperceptions are unlikely to sustainover time, behavioral anomalies make no difference between private andpolitical choice, rational irrationality struggles with operational definitionof meta-rationality, and the implications of the consumption of pride goodsor emotions do not differ from implications of classic rational ignorance.

We have offered an evolutionary model as an alternative avenue. Theobjective of the model is to prove that politics may be more prone tocoordination failures; collective play of an identical baseline game leads to aPareto-inferior outcome than private play. The model addressed allmodeling issues analyzed in Section 2.2: (i) deviations toward best responsesare on the basis of opportunity costs, (ii) false beliefs play the crucial rolethroughout adjustment but disappear in stable states, (iii) citizen candidatesare behaviorally identical to voters, (iv) information on updated aggregatebeliefs is not available, so one tends to update private beliefs only on thebasis of private experience, and lastly (iv) comparative statics depends onlyon the initial distribution of population. This model shows that dispersedinsights by Austrian economists can be further extended if one engages informal modeling of simultaneous evolution of beliefs and strategies.

ACKNOWLEDGMENT

Roger Koppl and Mark Skousen deserve thanks for valuable comments to avery preliminary version of the paper. Support by the Ministry of Education(MSM0021620841) is gratefully acknowledged.

Markets vs. Politics: Correcting Erroneous Beliefs Differently 77

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SCIENTIFIC HERMENEUTICS:

A TALE OF TWO HAYEKS

Roger Koppl

ABSTRACT

Hayek favored both classical hermeneutics and science. His scientificreasoning shows the logical necessity of methodological dualism. BruceCaldwell and Viktor Vanberg oppose hermeneutics and methodologicaldualism in favor of science. Their arguments depend on inappropriateinterpretations of the doctrine of methodological dualism and animpoverished understanding of hermeneutics that fails to distinguish classicalhermeneutics from universal hermeneutics. Hayek showed that ‘‘scientific’’and ‘‘humanistic’’ approaches to social science can and should be compatibleand complementary. Opposing (classical) hermeneutics in favor of sciencemay cause a loss of knowledge by tending to deprive ‘‘scientific’’ socialscience of insights arising from more ‘‘humanistic’’ traditions.

Ex

Ad

Co

All

ISS

There is no method of reasoning more common, and yet none more blameable, than, in

philosophical disputes, to endeavour the refutation of any hypothesis, by a pretence of

its dangerous consequences to religion and morality. When any opinion leads to

absurdities, it is certainly false; but it is not certain that an opinion is false, because it is

of dangerous consequence. Such topics, therefore, ought entirely to be forborne; as

serving nothing to the discovery of truth, but only to make the person of an antagonist

odious.

David Hume

plorations in Austrian Economics

vances in Austrian Economics, Volume 11, 99–122

pyright r 2008 by Emerald Group Publishing Limited

rights of reproduction in any form reserved

N: 1529-2134/doi:10.1016/S1529-2134(08)11006-7

99

ROGER KOPPL100

HAYEK AS SCIENTIST AND HERMENEUT

Bruce Caldwell (2004) argues that F.A. Hayek abandoned methodologicaldualism in the wake of his discovery of complexity theory in 1952.Complexity saved Hayek from a slow slide into the dark waters ofhermeneutics. Caldwell thinks there are ‘‘dangers of association’’ withhermeneutics. Hayek is ‘‘scientific,’’ hermeneutics is not, and we had betterstick with science. Hayek’s methodology was not hermeneutics, according toCaldwell, it was ‘‘scientific subjectivism.’’ Viktor Vanberg (2004) makes asimilar argument. Hayek was not a methodological dualist, at least not after1952. Vanberg, too, sees Hayek as ‘‘scientific’’ in contrast with much of therest of the modern Austrian school including Ludwig von Mises, LudwigLachmann, and Don Lavoie. Vanberg speaks of Hayek’s ‘‘naturalisticsubjectivism.’’ For both Caldwell and Vanberg the main offense ofhermeneutics seems to be the doctrine of methodological dualism.

There is much that I agree with in the perspectives of both Caldwell andVanberg. In particular, I agree that Hayek’s subjectivism was both‘‘scientific’’ and ‘‘naturalistic.’’ But I believe it was also hermeneutic. Wemight as justly describe Hayek’s methodology as ‘‘scientific hermeneutics’’or as ‘‘naturalistic hermeneutics.’’ The source of my disagreement withCaldwell and Vanberg does not seem to be with their understandings ofHayek’s ‘‘scientific’’ or ‘‘naturalistic’’ subjectivism, but with their under-standings of what hermeneutics and methodological dualism are all about.

I will discuss the meaning of ‘‘hermeneutics’’ and methodological dualismonly later, but some brief comments now are in order. Hermeneutics‘‘attempts to understand human actions by interpreting them in more or lessthe way we interpret a written text, hermeneutics being the theory andmethod of such interpretations’’ (Koppl & Whitman, 2004, p. 295). WilhelmDilthey defined ‘‘hermeneutics’’ as ‘‘the methodology of the interpretation ofwritten records’’ (Dilthey, 1900, p. 249). Hans Albert (1985) distinguishes‘‘classical hermeneutics’’ from ‘‘universal hermeneutics.’’ Classical herme-neutics is more modest, claiming only that human actions can be understoodin much the same way we understand a poem or the instructions on a tube oftoothpaste: we attempt to understand the purpose of the act (whether writtenor otherwise) in terms of the internal perceptions and beliefs of the personwho performed it. Universal hermeneutics is an encompassing philosophyderiving in large part from the work of Martin Heidegger. It includesperplexing claims such as ‘‘the movement of human existence . . . issue[s] in arelentless inner tension between illumination and concealment’’ and‘‘interpretation is always on the way’’ (Gadamer, 1981, pp. 104 and 105).

Scientific Hermeneutics: A Tale of Two Hayeks 101

Caldwell and Vanberg fail to distinguish the two types of hermeneutics.Hayek was hermeneutic only in the more modest classical sense, which isperfectly consistent with modern science, including cognitive science andneuroscience.

Methodological dualism is a central doctrine of both classical anduniversal hermeneutics. It is the doctrine that the methods of the socialsciences differ from those of the natural sciences. The essential point here isthat matter does not talk (Machlup, 1978). A psychologist might interview asubject, but a botanist would not. The physicist does not need to know whatdust motes think they are doing as they bounce randomly in solution. Thenatural scientist studies phenomena that are interpreted only by observers.The social scientist studies phenomena that are being interpreted by hisobjects of inquiry. If I am going to study a race riot, I had better understandthe rioters’ theory of race. I might reject their theory altogether, but thetheory helps explain the riot. I must understand the theory and refer to it.The social scientist must understand the people he studies. To do his job, hemust ‘‘interpret’’ human meanings. This ‘‘method of interpretation’’ ispresent in the social sciences, but not in the natural sciences. (Later I willbriefly consider whether biology, especially ethology is an exception.)

The standard statement of methodological dualism does not tell us wherethe methods of the two branches of science are the same and where different.This point matters, I think. Citing Albert (1988), Vanberg (2004) stipulates ameaning for ‘‘methodological dualism’’ that makes it inconsistent withHayek’s naturalism. This stipulated meaning supports his thesis nicely, butmay not be the most appropriate one to apply.

The conflict between the hermeneutical and anti-hermeneutical Austriansis fueled in part by the existence of good textual evidence on both sides. Iwill look at some evidence that Hayek was a hermeneut before moving on tothe evidence that he was a scientist who took a stance incompatible withhermeneutics. After discussing the term ‘‘hermeneutics’’ I will argue my casethat Hayek was a scientific hermeneut. In the conclusion I discuss why thewhole business might matter.

HAYEK THE HERMENEUT

Hayek the hermeneut lives in some interpretations of The Counter-Revolution of Science (Hayek, 1952a). Caldwell reviews works, includingsome not discussed here, in which The Counter-Revolution is viewed ashermeneutical at least in part (2004, pp. 430–438). Theodore Burczak (1994)

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argues that there are ‘‘postmodern’’ and thus hermeneutic ‘‘moments’’ inHayek’s work and gives several examples from The Counter-Revolution.Caldwell describes G.B. Madison as an ‘‘influential early proponent’’ of theview that The Counter-Revolution ‘‘represents an ‘interpretive turn,’ ora turn toward hermeneutics’’ (2004, p. 430). He cites Madison (1989).In a somewhat more recent paper Madison (1994) says that Hayek asks‘‘genuinely hermeneutic questions.’’ He claims that Hayek ‘‘argued for analternative approach’’ to economics in The Counter-Revolution, ‘‘one whichtoday would be labelled interpretive or hermeneutical.’’

In his defense of ‘‘interpretive reasoning’’ in social science, Boettke makesseveral references to The Counter-Revolution (1990, pp. 40–41). Boettkeexplicitly links ‘‘interpretive reasoning’’ with ‘‘the continental philosophiesof hermeneutics and phenomenology’’ (1990, p. 35). He quotes Hayek fromThe Counter-Revolution saying that the social sciences start with ‘‘what menthink and mean to do’’ (Hayek, 1952a, p. 57 as cited in Boettke, 1990, p. 40).Boettke goes on to quote Hayek saying, ‘‘The data of the human sciences, infact, ‘are what the acting people think they are’ ’’ (Hayek, 1952a, p. 44 asquoted in Boettke, 1990, p. 40).

As we have seen with the quotes Boettke selected, there are good textualgrounds for interpreting The Counter-Revolution as hermeneutics. Hayekspeaks of ‘‘the peculiar object and methods of the social studies’’ (p. 41).He says famously, ‘‘it is probably no exaggeration to say that everyimportant advance in economic theory during the last hundred years was afurther step in the consistent application of subjectivism’’ (p. 53). He citesfavorably the famous phenomenologist Felix Kaufmann (p. 98, n. 51) and,of course Ludwig von Mises.

HAYEK THE SCIENTIST

Hayek’s other book from 1952, The Sensory Order, is clearly a fully‘‘scientific’’ effort. The general tone and argument may easily seem somehowinconsistent with hermeneutics. Beyond this rather vague consideration, isthe fact that Hayek (1952b, p. 122) presents a theory of mind in which all theelements creating mind operate in a ‘‘mechanistic’’ fashion. ‘‘The principlesby which the transmission of the individual impulses in the central nervoussystem is determined are of a kind which might well be described as‘mechanical.’ ’’ Hayek allows ‘‘the logical possibility’’ that we might ‘‘build amachine fully reproducing the action of the brain and capable of predictinghow the brain will act in different circumstances’’ (1952b, p. 189). In a

Scientific Hermeneutics: A Tale of Two Hayeks 103

lengthy discussion of ‘‘mechanical and purposive behavior’’ Hayek says‘‘machines could be produced . . . which show all the characteristics ofpurposive behavior’’ (1952b, p. 126). Indeed, ‘‘some, such as the predictorfor anti-aircraft guns, or the automatic pilots for aircraft, have actually beenproduced’’ (p. 126).

Caldwell (2004) thinks The Sensory Order is inconsistent with hermeneu-tics. Hayek never took the ‘‘interpretive turn,’’ Caldwell argues, because hewanted ‘‘a scientific rebuttal of scientism. Hermeneutics, with its origins inthe exegesis of sacred texts, was too literary in orientation, to extrascientific,to serve his purposes’’ (p. 437). The Sensory Order ‘‘would bring him[Hayek] closer to Popper but distance him from the hermeneutical critiqueof naturalism’’ (2004, p. 346).

Vanberg (2004) also uses The Sensory Order against claims for ahermeneutic social science. ‘‘By contrast to the versions of Austriansubjectivism discussed above,’’ says Vanberg, ‘‘F. A. Hayek advocates whatone may describe as ‘naturalistic subjectivism’’’ (p. 180). Hayek’s ‘‘empiricistsubjectivist research agenda’’ (p. 182) is an ‘‘alternative’’ (p. 180) to earlier‘‘versions of Austrian subjectivism,’’ (p. 180) including hermeneutics and theVerstehen tradition. The Sensory Order is ‘‘of particular interest in [that]context,’’ Vanberg argues (p. 183). Apparently, the point (in part at least) isthat Hayek eschews hermeneutics in favor of a ‘‘naturalistic, explanatoryaccount of mental phenomena’’ (p. 185).

If The Sensory Order is scientific while The Counter-Revolutionhermeneutic, and if science and hermeneutics are somehow at odds, thenit may cause perplexity to note that The Counter-Revolution is the only workof his own that Hayek cites in The Sensory Order.1 I discuss the relationshipbetween these two books in Koppl (2002, pp. 57–59). ‘‘Logically,’’ I say,‘‘The Sensory Order is volume 1; The Counter-Revolution of Science isvolume 2’’ (p. 57).

WHAT IS HERMENEUTICS?

Like more or less any other important term in the social sciences andhumanities, ‘‘hermeneutics’’ has been given many different meanings. Forthis essay I will stipulate a definition that I think is useful: Hermeneutics isthe theory and practice of interpreting human actions and their products. Thisdefinition is close to that of the Oxford English Dictionary. ‘‘The art orscience of interpretation, esp. of Scripture. Commonly distinguished fromexegesis or practical exposition.’’ Hermeneutics as used here emerged

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originally from the ‘‘art or science’’ of Scriptural interpretation. It nowapplies, however, more broadly. We may attempt to interpret any text orhuman action.2

The key to hermeneutics is Verstehen, which is simply the German wordfor ‘‘understanding.’’ As a technical term in the social sciences, the wordidentifies the human ability to grasp human meanings. This ability isremarkable because the data for any inference about human meanings neversingle out only one interpretation. For example, ‘‘Can you open thewindow?’’ may mean, ‘‘Please open the window,’’ or ‘‘Are you able to openthe window?’’ or something else, depending on context. While our guessesabout such things are fallible, we have a remarkable ability to hone in on theintended meaning.

Utterances are not the only meanings we can guess. Any purposefulhuman action has a meaning to the actor. It has a ‘‘meant meaning.’’Observers can guess the meaning. A certain gesture may be meant as athreat, as a greeting, or as a mock-threat. A given act may be a theft ora purchase depending on the intentions of the actors.

When we understand a human meaning, we interpret an act or utterance.The interpretation refers to the thoughts of others, which cannot beobserved. Only the external signs can be observed. The interpretation is aguess.

On the one hand, the evidence for any guess is always inadequate tologically isolate one interpretation. On the other hand, we consistently hitupon the right interpretation, or something close to it. Mistakes arecommon. But they are not as common as they should be given theinadequacy of the evidence supporting most interpretations.

Verstehen uses intuition. Etymologically, ‘‘intuition’’ means ‘‘looking in.’’It is direct perception or immediate apprehension. Intuition contrasts withdeliberation and logical reasoning. An intuition is not thought through; it isjust seen. When observing human action, we often ‘‘just see’’ the intendedmeaning. We use our intuition. Sometimes, we deliberate. We weighevidence and compare competing hypotheses. But even in these cases, we useour intuition. There is a gap between the evidence and our guess. Intuitioncloses the gap.

We cannot fully reveal the inferential processes that lie behind theintuitive understanding of others. To do so, one would have to identifythe physical signals that are interpreted as meaningful acts. If the signalswere not described in purely physical terms, some of the processes ofinference would remain hidden. Second, one would have to identify all theparticular inferential mechanisms applied to those signals. Either step is

Scientific Hermeneutics: A Tale of Two Hayeks 105

probably too much for current science. Hayek claimed that it is logicallyimpossible to eliminate reference to mental states in our descriptions ofhuman action (1952b, pp. 188–190). In any event, the method of Verstehenseems to be a practical necessity for us. This claim is the doctrine ofmethodological dualism.

The word ‘‘hermeneutics’’ is usually applied only to the more theoreticalside of things. First, as with Dilthey (1900, p. 249) and Schleiermacher(Forster, 2002), ‘‘hermeneutics’’ may refer to the theory of interpretation.For example, the notion of the ‘‘hermeneutic circle’’ is a theoretical claimabout how to interpret a text. We cannot understand the whole exceptby understanding the parts, but we understand the parts only in theirrelation to the whole (Dilthey, 1910, p. 127). We need to see the overallmeaning of Hume’s History of England if we are to understand his criticismof Cromwell, but it is only through knowing particulars such as hiscriticism of Cromwell that we understand the overall meaning of hisHistory. There is a ‘‘hermeneutic circle’’ whereby we pass from the whole tothe parts and from the parts to the whole until we feel satisfied in our overallinterpretation.

The term ‘‘hermeneutics’’ is also used, however, to refer to the manyinterpretations made by scholars in the different branches of human studies.Don Lavoie said hermeneutics ‘‘refers essentially to the way in which, in thesciences, the arts, history, and everyday life, we manage to come to anunderstanding of other people’s actions and words’’ (1994, p. 55). The word‘‘interpretation’’ is used to refer to individual cases in which one personunderstands another, or attempts to. But ‘‘hermeneutics,’’ may be usedwhen we refer to relatively broad classes of such cases, especially when theinterpreting persons are trained scholars and the persons being interpretedare not. A final note on the word ‘‘interpret.’’ In the context of a discussionof hermeneutics, the word refers not to any act of interpretation, but tothe attempt to understand human meanings. Copernicus gave us a new‘‘interpretation’’ of the movements of the planets, but it was not an‘‘interpretation’’ that drew out human meanings at work in thosemovements. Therefore, it was not an ‘‘interpretation’’ in the hermeneuticalsense.

HISTORICAL NOTES

One might trace the history of hermeneutics to ancient times, since there aremany ancient texts that discuss how to interpret texts. Plato’s ‘‘Euthyphro,’’

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for example, might be viewed as a lesson in the difficulties of interpretingany religious tradition. Abelard and Luther are two other reasonablebeginnings, since they were involved in controversies over the meaning ofthe Bible. A reasonably continuous hermeneutical tradition, however,probably does not precede the late 18th century. (This claim seems implicitin Forster, 2002). I will pick up the history of hermeneutics, however,with Friedrich Daniel Ernst Schleiermacher (1768–1834). Wilhelm Dilthey(1833–1911) built on Schleiermacher. The tradition that begins withSchleiermacher and Dilthey runs in a more or less continuous line throughWeber, Husserl, Schutz, Heidegger, and Gadamer. As far as I can tell, thehermeneutics tradition descends from Dilthey and not directly fromSchleiermacher. We might have begun with Dilthey, therefore. It wasSchleiermacher, however, who separated hermeneutics from scripturalinterpretation, and this act of separation may make him a more properstarting point.

According to Forster (2002), Schleiermacher made two original contribu-tions to hermeneutics. First, he made hermeneutics ‘‘universal’’ in the sensethat it applies to all subjects, times, and places and to both the spoken andwritten word. Second, he introduced the hermeneutic circle discussed earlier,apparently under the label ‘‘semantic holism’’ (Forster, 2002).

Dilthey, as we have seen, defined ‘‘hermeneutics’’ as ‘‘the methodologyof the interpretation of written records’’ (Dilthey, 1900, p. 249). Heemphasized the claim that understanding moves ‘‘from the external to theinternal’’ (1910, p. 69) and placed great weight on the notion of ‘‘meaning’’(p. 73). ‘‘Actions and their permanent, outward results constantly help us toreconstruct the mental content from which they arose’’ (p. 76).

Dilthey was an advocate of methodological dualism. Indeed, he seems tobe its originator, although I do not think he used the term. The usualstatement of the doctrine is that the methods of the social sciences differfrom the methods of the natural sciences. The statement may beanachronistic when applied to Dilthey, however, because he did not usethe term ‘‘social science’’ (as far as I know) and seemed to absorb all ofthe social sciences into history. Mises praises Dilthey highly, but notes thathe ‘‘failed entirely to recognize the unique epistemological character ofeconomics’’ (1957, p. 308). Decoded, Mises remark means that Dilthey didnot recognize the existence of theoretical laws of social science; he viewedall ‘‘the human studies’’ as history. For Mises, Dilthey’s ‘‘chief contribu-tion’’ was that the understanding of human meanings ‘‘was epistemolo-gically and methodologically different from the natural sciences’’ (1957,p. 312).3

Scientific Hermeneutics: A Tale of Two Hayeks 107

Dilthey distinguishes the causal relations articulated in natural sciencefrom the human meanings articulated in the human studies. If I see ascorched and broken tree I conclude that it was hit by lightning. I reasonfrom effect to cause. If I see a man throw his hands in front of his face andturn away, I conclude that he is afraid of something hitting him. I reasonfrom outward sign to inward meaning. It is not an inference from effect tocause because ‘‘the gesture and the terror are not two separate things but aunity’’ (p. 120). Cause and effect (the bolt and its aftermath) are twoseparate things, as Hume emphasized in his critique of induction (Hume,1748 [1910], pp. 346–350). Thus, for Dilthey, ‘‘Elementary understanding isnot an inference from an effect to a cause’’ (p. 119).

Dilthey distinguished the ‘‘human studies’’ from ‘‘the natural sciences’’(p. 79). Natural science produces results ‘‘which are esoteric,’’ that is, farfrom our common experience (p. 79). The human studies do not become‘‘detached’’ in this way from ‘‘our practical contact with the external world’’(p. 79). Dilthey says ‘‘the human studies . . . rest on experience, under-standing, and knowledge of life’’ (p. 80). They do not give us curved space,relativity of time, or action at a distance, all rather mysterious notions. Theygive us a world of human meanings such as love, fear, means, end, action,and plan, all of which are familiar and sensible precisely because they arehuman meanings.

The ‘‘system of interactions’’ of the human studies ‘‘is distinguished fromthe causal order of nature by the fact that, in accordance with the structureof mental life, it creates values and realizes purposes; and this, notoccasionally, not here and there’’ but always and everywhere (p. 129).

CLASSICAL HERMENEUTICS IS NOT UNIVERSAL

HERMENEUTICS

Universal hermeneutics is more radical than classical hermeneutics. The keyto universal hermeneutics is Heidegger’s ‘‘ontological turn’’ (Gadamer,1975, p. 434). ‘‘Heidegger’s hermeneutical phenomenology,’’ Gadamerexplains, ‘‘and the analysis of the historicalness of There-being had as theiraim a general renewal of the question of being and not a theory of thehuman sciences’’ (p. 229). Ontology can be difficult in any event. Itstreatment in universal hermeneutics is perplexing. Gadamer does not saythat our understanding of anything, whether a human meaning or not, ismediated by language. For him instead, that which is understood is

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language. ‘‘Being that can be understood is language’’ and ‘‘the nature ofwhat is understood’’ is ‘‘interprentation’’ (p. 432). Such a view might seemto leave out lots of extra-linguistic phenomena such as the warmth of theSun or the structure of the atom. But for Gadamer, ‘‘we may not only speakof a language of art, but also of a language of nature, in short, of anylanguage that things have’’ (p. 432). These supposed insights into languageand interpretation allow Gadamer to say, ‘‘the speculative nature oflanguage shows its universal ontological significance’’ (p. 432). It is in thissense that universal hermeneutics is universal.4

Don Lavoie reports that ‘‘the older hermeneutics tradition’’ of Dilthey,Max Weber, and others was confronted ‘‘with Edmund Husserl’sphenomenology, resulting in a transformation of both schools ofphilosophy’’ (1994, p. 54). The leading figures of the new ‘‘phenomen-ological hermeneutics’’ were ‘‘Alfred Schutz, Martin Heidegger, Hans-Georg Gadamer, and Paul Ricoeur’’ (1994, p. 54). Only the first twomembers of this list were not followers of Heidegger, which is to say thatSchutz is the odd man out. Phenomenological hermeneutics contains a partthat follows Heidegger and a part that does not. Though a phenomenol-ogist, Schutz was a classical hermeneut in Albert’s sense, whereas Gadamerand the others espouse universal hermeneutics.

Lavoie is explicit about the differences between Schutzian and ‘‘post-Heideggerian’’ (Lavoie, 1994, p. 59) hermeneutics. Following Heidegger(apparently), Lavoie rejects the idea of ‘‘an objective science of subjectivephenomena’’ (p. 59). The phrase alludes to Schutz’s claim that ‘‘All socialsciences are objective meaning-contexts of subjective meaning-contexts’’(Schutz, 1932, p. 241). Lavoie’s repudiation of ‘‘objectivism’’ is consistentwith Gadamer’s claim that the ‘‘illusions of reflective self-consciousness’’had been burst by Nietzsche’s ‘‘demand that we doubt more profoundly andfundamentally than Descartes,’’ so that ‘‘the purely theoretical validity ofscientific objectivity to which the sciences laid claim’’ was now in question(Gadamer, 1981, p. 100).

Nor is Lavoie satisfied with Schutz’s theory of meaning. For, ‘‘accordingto post-Heideggerian hermeneutics, meaning turns out to not really bestrictly about the recovery of original intentions at all’’ (Lavoie, 1994, p. 59).To the reader’s unspoken question of what, then, meaning is ‘‘about,’’Lavoie replies ‘‘Understanding is itself rendered as a dynamic process’’(p. 59). This remark is consistent with Gadamer’s claim that ‘‘Self-understanding is always on-the-way’’ (Gadamer, 1981, p. 103). The readermust not object that ‘‘understanding’’ and ‘‘self-understanding’’ aredifferent things, for we are dealing here with ‘‘a totally new concept of

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understanding and self-understanding’’ (p. 102), whereby ‘‘it becomesmore important to trace the interests guiding us with respect to a givensubject matter than simply to interpret the evident content of a statement’’(pp. 105–106). Thus, Lavoie is on solid post-Heideggerian ground when hesays, ‘‘understanding is not a merely reproductive, but rather a creativeproductive process’’ (Lavoie, 1994, p. 59).

Universal hermeneutics rejects ‘‘atomism,’’ which ‘‘locates the domain ofmeaning in isolated individual minds’’ (Lavoie, p. 57). Meaning is‘‘intersubjective’’ and ‘‘publicly available in all sorts of readable texts’’(p. 59). Lavoie attributes this view to Schutz. But Schutz never abandonedthe notion of subjective meanings. Schutz says quite clearly, ‘‘everyinterpretation of subjective meaning involves a reference to a particularperson’’ (1932, p. 135). I think Vanberg is fundamentally right to say,‘‘Lavoie sees the distinguishing characteristic of the hermeneutical approachthat he endorses in the fact that it is not about ‘seeing things from the agent’spoint of view’ . . . but is concerned with a kind of ‘meaning’ that is separablefrom the intentions of the acting person’’ (Vanberg, 2004, p. 162). As areferee has pointed out to me, meaning in Gadamer is emergent fromprocesses that involve human intentions and is not, in this sense,‘‘separable’’ from them. But this link to intentions is rather indirect anddoes not equal ‘‘seeing things from the agent’s point of view.’’

IS HERMENEUTICS ANTI-SCIENCE?

Caldwell and Vanberg are both concerned that hermeneutics might be anti-scientific. This fear is clearly inapplicable to classical hermeneutics. It doesnot apply to Schutz. The situation is cloudier with regard to universalhermeneutics. I take up each point in turn.

As far as I am aware, there is no serious question of whether classicalhermeneutics is anti-scientific. Certainly, the phenomenological hermeneu-tics of Schutz contains no ‘‘critique of science’’ of the sort worrisome tofigures such as Vanberg and Caldwell. Dilthey’s doctrine of methodologicaldualism entails no rebuke to natural science. I think it is true, as Misesargued, that Dilthey did not recognize the existence of an ahistorical,theoretical science of society. It was all history to him. But as the sameexample of Mises shows abundantly, there is no contradiction or particulardifficulty in retaining a hermeneutical view of ‘‘the human studies’’ whilerecognizing that they include disciplines that are ‘‘scientific’’ in the today’sAnglo-American sense.

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Similarly, there is no negative ‘‘critique of science’’ in Schutz. On thecontrary, Schutz recognized not only the value and legitimacy of naturalscience, but the value and legitimacy of social science as well. Schutz’s mostimportant work (Schutz, 1932) was largely a defense of an Austrian versionof economic theory against historicism (Prendergast, 1986; Koppl, 2002). Invarious works Schutz defends the scientific ‘‘attitude of the ‘disinterestedobserver’ ’’ who must ‘‘suspend his subjective point of view’’ (Schutz, 1945,pp. 247 and 248). The scientist seeks theories that are valid ‘‘at any place,and at any time, wherever and whenever certain conditions, from theassumption of which he starts, prevail’’ (p. 248). (This language closelyparallels language to be found in Mises’ work). Schutz’s defense of theobjectivity of science directly contradicts universal hermeneutics, for whichreason we saw Lavoie criticize him. Thus, it is hardly to be feared that aSchutzian hermeneutics is anti-scientific or ‘‘too extrascientific’’ (Caldwell,2004, p. 437) for the purposes of Hayek or Austrian economics.

It is more difficult to say whether the universal hermeneutics defended byLavoie and some other hermeneutic Austrians is anti-scientific. Post-Heideggerian philosophy in general includes some strongly anti-rationalistand anti-science elements as the Sokal hoax helped to reveal. But we cannotattribute such views to Austrian hermeneuts, who reject the fuzzy thinkingand collectivism present in some postmodern writings.

Lavoie and other Austrian defenders of universal hermeneutics tend tofollow Gadamer rather closely. Remarks in Gadamer’s work seemambiguous. Some remarks suggest that hermeneutics leaves science alone.Referring to Heidegger’s supposed insight that ‘‘scientific objectivity may beunderstood ontologically’’ (Gadamer, 1981, p. 162), Gadamer says, ‘‘Onlyfools could see in such an ontological derivation a diminishment of thesignificance or legitimacy of science’’ (1981, p. 162). Other remarks seem tooppose science in some degree. ‘‘Only by the de-mythologization of science(which controls what is proper to it but cannot know the one whom itserves) can the mastery of knowledge and ability become self-mastery’’(Gadamer, 1981, p. 150).

Gadamer’s critique of technology seems to reveal some resistance toscience (Gadamer, 1981, pp. 69–87). (Presumably, Gadamer derived thiscritique mostly from Heidegger’s critique of technology.) ‘‘Science,’’ we aretold, ‘‘is no longer the quintessence of knowledge and of what is worthknowing, but a way’’ (pp. 69–70). Science is responsible for ‘‘thecivilizational pattern of modernity’’ (p. 70). While such modernity mightseem to be a good thing, Gadamer is not happy. He broods darkly, ‘‘thescientific concept of mechanics has become an arm prolonged to monstrous

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proportions’’ (pp. 70–71). The technology science permits attacks our veryability to think. ‘‘It is inevitable, then, that the modern technology ofcommunication leads to a more powerful manipulation of our minds’’(p. 73). We feel ‘‘dependent and helpless in the face of’’ the ‘‘technicallymediated life forms’’ of modernity (p. 73). We descend into ‘‘society offunctionaries’’ who must adapt to circumstances, but whose creativecapacities are frustrated (pp. 72 and 73). These last comments seem to saywe are emasculated by technology. Is Gadamer asking us to choose betweenscience and virility?

I do not know whether Gadamer should be viewed as anti-science, and Ido not know whether we should attribute any anti-science attitudesGadamer might have to his Austrian followers. I am content if we recognizethe whole question is moot when it comes to the phenomenologicalhermeneutics of Alfred Schutz, which stay within the bounds of ‘‘classicalhermeneutics’’ as defined by Albert.

CALDWELL AND VANBERG ON

METHODOLOGICAL DUALISM

For both Caldwell and Vanberg, the biggest problem with hermeneutics ismethodological dualism. ‘‘A fundamental claim of the hermeneuticsapproach,’’ Caldwell says, ‘‘is that interpretation is unavoidable in thehuman sciences, specifically because their subject matter is different fromthat of the natural sciences’’ (Caldwell, 2004, pp. 434–435). Vanbergcriticizes the Austrian view, attributed to both Mises and Lavoie, that socialscience should ‘‘adopt a methodology fundamentally different from that ofthe natural sciences’’ (Vanberg, 2004, p. 164).

I believe Caldwell and Vanberg are both mistaken in their repudiation ofmethodological dualism. Their arguments are not quite the same. In bothcases, however, it seems to me that views they accept and, indeed, assert,contain the essential idea of methodological dualism. Caldwell is vagueabout the meaning of doctrine, perhaps because of his odd implicitassumption that there is, somehow, but one ‘‘split’’ or ‘‘divide’’ among thesciences to which one might adhere. Vanberg, by contrast, makes it veryclear just what he understands the doctrine to say. I do not believe, however,that his statement of the doctrine is the correct one, at least in the context ofAustrian economics. Let me take up each point in more detail.

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Caldwell

Caldwell, I have said, is never very clear about what methodological dualismis supposed to be. He is against it, but I cannot quite understand what it isthat he opposes. Indeed, it seems that the term ‘‘methodological dualism’’never appears in his 2004 book. (In addition to the index and my ownreading, I searched his book for the phrase through amazon.com). Caldwelldoes, however, refer repeatedly to the question of whether Hayek’s‘‘dividing line’’ (p. 255) between sciences separated the natural sciencesfrom the social sciences or studies of complex phenomena from studies ofsimple phenomena (p. 255). This odd notion of ‘‘the dividing line’’(my emphasis) crops up again on page 301. Hayek would ‘‘replace’’ theone distinction with the other (p. 305). Later, Caldwell claims the onedividing line was ‘‘viewed by Hayek as a more scientific way to make thedistinction’’ (p. 346 my emphasis). Somehow we must choose whether ‘‘the’’dividing line, ‘‘the’’ distinction, shall be ‘‘natural vs. social’’ or ‘‘simple vs.complex.’’ I cannot understand this idea and do not know why Caldwellwould make such an assumption.

Caldwell also says, ‘‘Hayek proclaimed that the natural science-socialscience split is less important than that between simple and complexphenomena’’ (Caldwell, 2004, p. 435). Caldwell does not tell us, however,where this supposed proclamation was made. With it, he says, Hayek was‘‘downplaying, perhaps even dismissing’’ hermeneutics. Those wishing to seeHayek as a hermeneut ‘‘must deal with this fact’’ (Caldwell, 2004, p. 435).Caldwell, however, has given no evidence of the fact (Hayek’s ‘‘proclama-tion’’) with which we are supposed to deal. [In spite of this strange andserious flaw in Caldwell’s 2004 book, it is probably the best overall treatmentof Hayek yet published, as I argued in my review of it Koppl (2006)].

Vanberg

Vanberg, happily, is clear as a bell. He defines the methodological dualism of‘‘Austrian subjectivism’’ by two claims. First, ‘‘because human action is basedon subjective intentions and expectations, understanding these intentions andexpectations rather than causal analysis is the appropriate method ofinquiry,’’ and second, ‘‘because human action is purposeful and goal-directed,it must be explained in teleological rather than in causal terms’’ (Vanberg,2004, p. 167). I think Vanberg’s definition of methodological dualism may beput this way: ‘‘Be interpretive, but don’t use the concepts of cause and effect.’’

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METHODOLOGICAL DUALISM IN DILTHEY

To address Vanberg’s view of methodological dualism, I will consider whatDilthey and Mises said about it. Mises’ view of the doctrine is the one thatreally matters, in the context of Austrian economics. Mises seems to be theone who imported the doctrine to Austrian economics and is celebrated forit by, I believe, all the hermeneutical Austrians, classical and universal. Itmay be worth considering Dilthey’s views, however. Dilthey seems to be theprogenitor of the doctrine and Mises praises him highly for it.

As we saw earlier, Dilthey sees three differences between the naturalscience and ‘‘the human studies.’’ First, natural science infers causes fromeffects, whereas the human studies infer inner meanings for outwardindications. Second, natural science produces concepts alien to commonsense, whereas the human studies do not. Finally, unlike the natural sciences,the human studies refer to values and purposes in their objects of inquiry.

Dilthey’s first point of distinction might seem subject to criticism.Causality is present in the natural and social sciences alike, one might argue.Such an argument, however, would use an anachronistic notion of causality.In today’s language we might say that John’s anger ‘‘caused’’ him to yell.We are not troubled by the objection that John’s yelling was a chosenaction. Saying the anger ‘‘caused’’ him to yell is saying that he yelled‘‘because’’ he was angry. The anger was a motive and explanatory factor.It does not mean that John had no choice about whether to yell. To Dilthey,however, causality meant a kind of ‘‘mechanistic’’ linkage that operatesindependently of human choices. If, therefore, we are appealing tointentions, desires, and beliefs in our explanation of something, we are notapplying ‘‘causal’’ reasoning in Dilthey’s sense.

Vanberg relies on precisely the sort present-day notion of causality I havebeen discussing. He says ‘‘cognitive factors such as intentions, desires, andbeliefs play a causal role in human action’’ (2004, p. 169). While I fully agreewith that statement, it would have seemed absurd and contradictory toDilthey, who relied on a notion of causality that excluded any reference to‘‘cognitive factors.’’ The difference between Vanberg and Dilthey on thispoint is the meaning of the word ‘‘cause.’’

Dilthey’s second point of distinction was that natural science producesconcepts alien to common sense, whereas the human studies do not. Diltheyseems to have adumbrated an insight later found in Hayek. In naturalscience we infer cause from effect. We see stars and imagine atoms. We inferatoms from the observable effects of their action. In the social sciences wework in the opposite direction. We see factories and imagine a time structure

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of production. We are directly familiar with the ‘‘atoms’’ of our analysis,people, and reason our way to larger social patterns from our understandingof people. Thus, in natural science the elements of the theoretical system arestrange things such as quarks and strings that produce familiar things suchas rocks and stars. In the social sciences, instead, the elements are familiarthings such as thoughts and emotions that produce strange things such asprice vectors and autocorrelated conditional heteroscedasticity in financialtime series. Hayek refers to the second kind of reasoning as ‘‘Menger’scompositive method’’ (Hayek, 1952a, pp. 61–76; Hayek, 1935, p. 11).

Finally, we noted, the human studies refer to values and purposes andnatural science does not. This point seems to be accepted by all (Caldwell,2004, p. 122; Vanberg, 2004, pp. 167–168). Dilthey says that we can‘‘understand’’ others because they are like us. ‘‘He understands historybecause he himself is a historical being’’ (Dilthey, 1910, p. 126). ‘‘Everyword, every sentence, every gesture or polite formula, every work of art andevery historical deed is intelligible because the people who expressthemselves through them and those who understand them have somethingin common’’ (Dilthey, 1910, p. 123).

Hayek makes the same point we have just seen Dilthey make. He citesEmpedocles’ ‘‘Knowledge is of like by like’’ and notes that he got the quotefrom Mises (Hayek, 1967, pp. 58 and 59; Mises, 1930 [1981], p. 134).5

It seems to me that biology, a natural science, refers to the values andpurposes of animals. We understand humans best and find it unproblematicto apply the categories of human mental life to other people. We understandother animals less fully, although we say the lion is ‘‘hunting’’ and the bird is‘‘building a nest’’ or ‘‘seeking prey.’’ Methodological dualists have generallycompared social science or ‘‘the human studies’’ to physics and chemistryand thus not faced the question of biology. I think we should recognize thatthe methodological differences between social science and natural scienceare matter of degree, while retaining the ancient label ‘‘methodologicaldualism.’’ The difference between day and night is a matter of degree, but westill have a ‘‘dualism’’ of night and day.

METHODOLOGICAL DUALISM IN MISES

Mises gives a complete statement of methodological dualism in Theory andHistory.

Methodological dualism refrains form any proposition concerning essences and

metaphysical constructs. It merely takes into account the fact that we do not know

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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 exterior events, commonly called nature, and the realm of

human thought and action (Mises, 1957, p. 1).

Methodological dualism as represented by Mises does not deny thatthe social sciences are sciences. It does not imply that empirical testingis impossible or forbidden. [Vanberg (2004) acknowledges this point onpage 161]. It does not even deny that cause and effect operate in the socialsphere, although our earlier remarks about anachronistic meanings ofcausality apply here as well. Mises says that natural science and socialscience are distinguished by ‘‘the categorical system resorted to in eachin interpreting phenomena and constructing theories’’ (1957, p. 240).The natural sciences ‘‘are entirely guided by the category of causality,’’whereas the social sciences refers to ‘‘purpose and of conscious aiming atends’’ (1957, p. 240). The social sciences are ‘‘teleological’’ (Mises, 1957,p. 240). Such ‘‘teleological’’ reasoning, however, is perfectly ‘‘causal’’ inthe sense most common today, which is the sense employed in Vanberg(2004, p. 169).

With Mises, methodological dualism is an argument against the sort ofreductionism that would replace references to mental phenomena withstatements using the language of physics, chemistry, and physiology. It is anargument against ‘‘positivism,’’ which Mises describes as ‘‘a materialisticmetaphysical doctrine’’ (1957, p. 241). In recent times, Mises argued in 1957,the two most important living variants of the hated positivist doctrinewere ‘‘panphysicalism’’ and ‘‘behaviorism.’’ Panphysicalism says, in Misesinterpretation, ‘‘What cannot be rendered in the language of physics ismetaphysical nonsense’’ (1957, p. 244). Behaviorism ‘‘is in some respectsdifferent’’ from panphysicalism. It is a similar doctrine, however, ‘‘in itshopeless attempt to deal with human action without reference toconsciousness and aiming at ends’’ (1957, p. 245). Both doctrines requiredelimination of all reference to cognitive factors.

Methodological dualism as defined by Mises aims at establishing preciselythe point that Vanberg claims is not at issue between methodological dualistand their critics. Vanberg says ‘‘Opponents of methodological dualism’’ donot deny the ‘‘cognitive factors’’ such as ‘‘intentions, desires, and beliefs playa causal role in human action.’’ They ‘‘can easily agree’’ that social science is‘‘teleological’’ in the sense that they must ‘‘account for the role of cognitivefactors.’’ Opponents of methodological dualism ‘‘will, however, insist thatcausation by such factors is still causation in the standard sense’’ (Vanberg,2004, p. 169).

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According to Vanberg, then, disputes over methodological dualism aresolely disputes about how we should use the word ‘‘causation.’’ This pointof view neglects the fact that the historical opposition to the doctrine ofmethodological dualism came from scholars who denied that Vanberg’s‘‘cognitive factors’’ should have any place at all in social science. The pointhe esteems beyond dispute was precisely the point being disputed whenMises articulated the doctrine and used it to defend the autonomy of thesocial sciences against the scientism of positivists such at Otto Neurath.Having defeated all opposition, the doctrine of methodological dualism isdeclared false and absurd!

HAYEK THE SCIENTIFIC HERMENEUT

I do not know if Hayek was a methodological dualist in Caldwell’s sense,because I do not know what meaning Caldwell gives to the term. I thinkHayek was not a methodological dualist in Vanberg’s sense, but Vanberggives us an inappropriate definition of it. In the sense of the termappropriate for any discussion of Austrian economics and economists,namely Mises’ sense of the term, Hayek was indeed a methodologicaldualist. As both Caldwell and Vanberg note, Hayek argued againstbehaviorism and positivism. He recognized and emphasized the ‘‘subjective’’nature of social phenomena.

Caldwell correctly notes that in The Sensory Order, Hayek ‘‘insisted that,as a practical matter, we will always have to refer to beliefs, desires, andintentions (what he [Hayek] calls mental terms) when we interpret humactions’’ (Caldwell, 2004, p. 437). Mises too defends methodological dualismas, in Caldwell’s words, ‘‘a practical matter.’’ It is for Mises a contingentfact that ‘‘up to now at least’’ we have been unable to ‘‘bridge thegulf . . . between mind and matter’’ (1957, p. 1). Thus, ‘‘at least for the timebeing,’’ Mises infers, we ‘‘must adopt a dualistic approach, less as aphilosophical explanation than as a methodological device’’ (Mises, 1957,p. 1). Is this not a defense of dualism ‘‘as a practical matter?’’

Some parallelism of language shows just how closely Hayek adhered, inThe Sensory Order, to Mises’ version of methodological dualism. In Theoryand History, Mises defends methodological dualism by noting that,‘‘Identical external events result sometimes in different human responses,and different external events produce sometimes the same human response.We don’t know why’’ (1957, p. 18). This same language appears also in TheSensory Order. ‘‘[P]sychology must start from stimuli defined in physical

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terms and proceed to show why and how the senses classify similar physicalstimuli sometimes as alike and sometimes as different, and why differentphysical stimuli will sometimes appear as similar and sometimes asdifferent’’ (1952a, pp. 7–8).

Hayek was a methodological dualist and a hermeneut, but not anti-science. He was a scientific hermeneut.

TWO DICHOTOMIES ARE BETTER THAN ONE

As we have seen, Caldwell imagines that Hayek will tolerate only onedichotomous classification of the sciences at a time. How ironic for a scholarwhose theory of mind emphasizes the role of multiple classifications!

The dichotomy between the social sciences and the natural sciencesclassifies the sciences according to whether ‘‘understanding’’ is an applicablemethod. In the social sciences we are engaging a pre-interpreted reality.In the words of Georg Simmel’s (1908 [1971], p. 7) Kantian analysis,‘‘the unity of society needs no observer.’’ Thus, we must ‘‘understand’’action in ways we do not ‘‘understand’’ the orbits of the planets.

The dichotomy between sciences studying complex phenomena andsciences studying simple phenomena relates to a different set of issues,namely prediction, explanation, and falsification. In ‘‘The Theory ofComplex Phenomena,’’ Hayek (1964 [1967], pp. 29–31) identifies severaldifferences between simple and complex phenomena. Statistics are of limitedvalue with complex phenomena, general ‘‘laws’’ of the sort found in physicsmay be absent (pp. 40–42), and we must often content ourselves with‘‘pattern prediction’’ rather than more precise predictions (pp. 27–29). Thesedifferences may exist even when the complex phenomena in question havenothing to do with interpretation of human meanings.

The distinction between complex and simple phenomena helps explain thedifference between the natural and the social sciences. It helps explainmethodological dualism. It is impossible to ‘‘reduce’’ mental phenomena tophysical phenomena in any sense other than explaining the principle; thisimpossibility is a consequence of the complexity of mental phenomena.Mental phenomena are complex in comparison to our apparatus forclassifying and ordering them, namely the human mind. We could attemptto describe human action ‘‘in purely physical terms,’’ says Hayek. ‘‘But if wetried to do so for the purposes of explaining human action, we wouldconfine ourselves to less than we know about the situation’’ (p. 43). Withouthermeneutics and interpretation we lose information about human action.

Table 1. The Table Gives Examples of Sciences Classified in Each ofFour Categories.

Complex Phenomena Simple Phenomena

Social science Economics, sociology, anthropology,

psychology

Demography, epidemiology

Natural science Biology, meteorology, parts of physics

and chemistry

Much of physics and

chemistry

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If we consider both dichotomies together, we have four types of science.Table 1 illustrates. In the Table 1, I have classed demography, epidemiology,and actuarial science as social sciences dealing with simple phenomena. Thisclassification is consistent with Hayek’s view that ‘‘Not all disciplines . . .concerned with the life of men in groups . . . raise problems which differin any important respect from those of the natural sciences’’ (1952a, p. 41).He gives epidemiology as an example.

Social sciences dealing with complex phenomena are what Hayek calls‘‘social sciences in the narrower sense of the term’’ (1952a, p. 41). Theyrequire the interpretation of human meanings. The doctrine of methodo-logical dualism distinguishes the methods appropriate to this group ofsciences from the methods of the natural sciences, which do not require theinterpretation of human meanings (Table 1).

WHY IT MATTERS

It seems that Caldwell and Vanberg wish to rescue Hayek from the darkwaters of hermeneutics and land him on the high ground of science. I thinkthey are right to see Hayek as a man of science. They diminish hisachievement, however, by attempting to distance Hayek from hermeneutics.Viennese positivism construed social science as ‘‘atoms all the way down.’’Post-Heidegger hermeneutics construes natural science as ‘‘interpretationall the way down.’’6 Either construal is false. One of Hayek’s greatachievements was to ‘‘bring atoms and interpretation together.’’ Hayek useda set of very carefully developed scientific arguments about complexity andneuroscience to show that logically necessary limits to our knowledge ofminds like our own require us to rely on classical hermeneutics. In his wordsfrom The Sensory Order, we must rely on ‘‘verstehende psychology’’ (1952b,p. 192). This great achievement is scarcely appreciated or understood today.

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With its scientific style and purpose, The Sensory Order hardly seems theplace for a defense of hermeneutics. But the book’s final chapter on‘‘philosophical consequences’’ contains a ringing endorsement of classicalhermeneutics. ‘‘In the study of human action,’’ Hayek says, ‘‘our startingpoint will always have to be the direct knowledge’’ of ‘‘mental events’’(p. 191). We ‘‘use our direct (‘introspective’) knowledge of mental events inorder to ‘understand,’ and in some measure even to predict, the results towhich mental processes will lead in certain conditions’’ (p. 192). By using theterms ‘‘understand’’ and ‘‘verstehende psychology’’ Hayek points directly tothe Dilthey tradition Albert calls ‘‘classical hermeneutics.’’

Hayek praised classical hermeneutics as late as 1973. In ‘‘The place ofMenger’s Grudsatze in the History of Economic Thought,’’ Hayek attributesto Menger the view that ‘‘in observing the actions of other persons we areassisted by a capacity of understanding the meaning of such actions in amanner in which we cannot understand physical events’’ (1978, p. 277).Observation for Menger, Hayek says, ‘‘implies Verstehen (‘understanding’)in the sense in which Max Weber later developed the concept’’ (p. 277). Byciting Weber, Hayek makes an explicit reference to classical hermeneutics.‘‘It seems to me,’’ Hayek continues, ‘‘that there is still much that could besaid in defense of the original position of Menger (and of the Austriansgenerally) on this issue’’ (p. 277). Hayek chooses to ‘‘pass over thisimportant point,’’ however, on the grounds that revealed-preference theoryhas shown ‘‘at least in principle’’ that we can dispense with ‘‘these‘psychological’ assumptions’’ for purposes of ‘‘micro-economic theory’’(p. 277). Hayek’s hedged concession to revealed-preference theory is noabandonment of hermeneutics. He went out of his way to introduce theword Verstehen favorably and link it to Weber, thus pointing explicitly tothe hermeneutics tradition. His concession is, as I have noted, hedged and itapplies only to pure theory. The significant point here is not the grudgingconcession, but the strong detour taken in order to specifically praise the‘‘underdstanding’’ tradition, not of the subject of his talk, Carl Menger, butof Max Weber, who came later and learned about Verstehen from others.

If my argument is about right, it may strengthen our appreciation ofAlfred Schutz. As far as I can tell, Hayek made few if any explicit referencesto Schutz’s work. Although it is an open question whether Schutz had anysignificant influence on Hayek, a negative conclusion would not besurprising. I have argued elsewhere, however, that Schutz and Hayek areboth Misesian methodologists (Koppl, 2002, pp. 25–70). Schutz and Hayekboth attempted to improve upon Mises’ methodology. Schutz took aphenomenological approach; Hayek took a naturalistic approach. Because

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Hayek’s naturalism explicitly leaves room for hermeneutics, it is a relativelystraightforward matter to integrate the two systems within the context ofMises work. I have attempted to demonstrate the value of such anintegration in my work in expectations (Koppl, 2002) and entrepreneurship(Koppl, 2002, pp. 96–106), which I have applied to problems in financialmarkets (Koppl, 2002, pp. 141–194).

It might be tempting to regard the main argument of this chapter as aquibble over words. I suppose it has been. But I think it matters even if it is a‘‘merely verbal dispute.’’ If I am right, then we must not see Hayek as ascientist who turned his back on the unscientific tradition of hermeneutics.We must see Hayek a scientist who brought the ‘‘understanding’’ traditionof classical hermeneutics under the umbrella of science. In so doing, Hayekhas made the rich heritage of the hermeneutics literature available to thescientific community. If we should, for ‘‘merely verbal’’ reasons, fail torecognize this achievement, we will needlessly cut ourselves off from animportant source of wisdom and understanding in the social sciences. Weare not so clever, however, that we can afford such a loss.

NOTES

1. In The Sensory Order, Hayek cites ‘‘Scientism and the Study of Society,’’ whichwas first published in Economica and later reprinted as ‘‘Part One’’ of Counter-Revolution. He notes both the original publication and the reprint. The evidence forHayek-as-hermeneut comes from Part I of Counter-Revolution.

2. The next six paragraphs come almost word-for-word from Appendix 1 ofKoppl (2002).3. Mises refers to Dilthey’s ‘‘psychology,’’ which is not obviously ‘‘the under-

standing of human meanings.’’ But from page 265 of Mises (1957) we learn that thepsychology in question is ‘‘the specific understanding of the historical disciplines,’’which is to say the understanding of human meanings.4. I thank an anonymous referee for emphasizing the importance of the

ontological turn.5. I thank Sudha Shenoy and Richard Ebeling for help with the Empedocles quote

which appears only in Greek in both Hayek and Mises. See the archives of theHayek-L list for March 2004, http://maelstrom.stjohns.edu/archives/hayek-l.html6. I thank my referee for the helpful phrases ‘‘atoms all the way down’’ and

‘‘interpretation all the way down.’’

ACKNOWLEDGMENT

I thank Steven Horwitz for managing the review of this chapter and I thankan anonymous referee for helpful comments.

Scientific Hermeneutics: A Tale of Two Hayeks 121

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Albert, H. (1988). Hermeneutics and economics – A criticism of hermeneutical thinking in the

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Boettke, P. (1990). Interpretive reasoning and the study of social life. Methodus, 2(2), 35–45.

Burczak, T. (1994). The postmodern moments of F.A. Hayek’s economics. Economics and

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Caldwell, B. (2004). Hayek’s challenge. Chicago: University of Chicago Press.

Dilthey, W. (1900 [1962]). The development of hermeneutics. In: H. P. Rickman (Ed.),

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Gadamer, H. (1975). Truth and method. New York: The Seabury Press.

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theory of Advances in Austrian Economics (Vol. 7). Amsterdam: Elsevier.

HAYEK VS. HAYEK: A DEFENCE

OF MODERATE TRADE UNION

ACTIVITY

Torsten Niechoj

ABSTRACT

According to Friedrich A. von Hayek, trade unions are the primaryproblem of our times. They coerce employers into raising the wages, andthey seek privileges in the political sphere. This harsh judgement is,however, not fully justified by Hayek’s own theory of action and order.In addition to some terminological difficulties, he undervalues hisinsights – developed and applied elsewhere – of competition as a discoveryprocess and of locally available knowledge when it comes to unions.Following this lead, further functions of trade unions apart from theirmonopoly face appear: trade unions channel information and developrules for conflict resolution; they are part of a process of preferenceformulation and opinion formation.

1. INTRODUCTION

It is not overly surprising that Friedrich August von Hayek as anunequivocal defender of individual freedom and spontaneous order dislikes

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trade unions. What is surprising is the verve with which Hayek holds thetrade unions responsible for nearly everything that goes wrong in economicsand politics. From the beginning of his writing to his late works thispervades all of his texts. In a speech addressed to the Mont Pelerin Society,in 1947 shortly after the end of World War II, he writes:

[I]f there is to be any hope of a return to a free economy, the question of how the powers

of trade unions can be appropriately delimited in law as well as in fact is one of the most

important of all the questions to which we must give our attention. (von Hayek, 1980a,

p. 117)

In his major work, the ‘‘Constitution of Liberty’’, Hayek goes a stepfurther in stating that:

[t]here can be no question [ . . . ] that the basic principles of the rule of law have nowhere

in recent times been so generally violated and with such serious consequences as in

the case of the labor unions. Policy with respect to them will therefore be the first major

problem that we shall consider. (von Hayek, 1960, p. 266)

According to Hayek nothing less than the market system itself is at stake:

While a functioning market and trade unions with coercive powers cannot co-exist, yet it

is only in the free system of the market that the unions can survive. Yet the unions

are destroying the free market through their legalised use of coercion. (von Hayek,

1980b, p. 55)

These are just a few examples of Hayek’s thinking with respect to tradeunions, but even these short statements contain far-reaching accusationsand far-reaching implications for economic policy and political theory.For Hayek trade unions are most influential and simultaneously extremelyharmful. In other words, diminishing the power of trade unions wouldincrease economic activity and reduce the waste of resources. Consequently,trade unions are crucial for economic policy.

Taking up this lead and investigating the role of trade unions in societyfrom Hayek’s point of view seems promising. Unions are actors playing ontwo levels – the economic as well as the political – and it is Hayek as anauthor in the Austrian tradition whose theory brings together both spheresof activity in one research framework. He always treated economics asa social science, not only focusing on exchange under given conditions butcombining the analysis of economic and political order.1 Starting froma spontaneous order of individuals, Hayek reconstructs the development oforder and the formation and behaviour of collective actors such as tradeunions. Then, the key question is: Why and to what extent become tradeunions a threat to economy and society?

Hayek vs. Hayek: A Defence of Moderate Trade Union Activity 125

The chapter is structured as follows: Initially Hayek’s distinction betweenspontaneous order and organisations is used to investigate the interactionof individual and collective action. Against this background, the role oftrade unions as monopolising economic actors and as rent-seeking politicalactors is analysed in Sections 3 and 4. It becomes apparent – summarised inSection 5 – that Hayek’s assessment of trade unions is not fully grounded inhis theory and that he undervalues his own insights – developed and appliedelsewhere – when it comes to unions. Based on these insights, the function ofcollective actors for knowledge formation and rule enforcement is described.

2. HAYEK ON ACTION AND ORDER

For Hayek order is a framework that coordinates the interaction of actorsby forming expectations on the actions of others. He differentiatestwo types of order: a constructed and hierarchical order coordinated byconcrete commands to achieve a common goal, called organisation, and aspontaneous order where all individuals achieve their goals under endogen-ously grown abstract rules (von Hayek, 1963; von Hayek, 1973, Chapter 2).An organisation is defined as an order which is created to fulfil the aim(or a set of aims) of its creator, who coordinates the people acting under thisorder on the basis of commands, not rules. Although a spontaneous ordercoordinates the individuals’ actions too, it leaves much more freedom formanoeuvre for the actors. An order of this type can adapt to changingsituations by individual actions without having to rely on one creator andleader, while still stabilising expectations because the abstract rulesguarantee that all actions are within a certain range of accepted behaviour(von Hayek, 1945, 1967); the rules transport implicit knowledge on whatcan and cannot be done and on the potential reactions and interactionsof others. While such an order is itself complex, it needs no complexcoordination centre but coordinates itself quasi-automatically (von Hayek,1973, pp. 36–52). The most prominent example of a spontaneous order –and the only one Hayek investigates in depth – is the catallaxy, or incommon terminology: a market economy which is ideally free of stateinterventionism (von Hayek, 1976, Chapter 10). In the catallaxy it isespecially the price system which signals information and leads to a mutualadjustment of the individuals’ plans through positive and not least ‘‘negativefeedback’’ (von Hayek, 1968, p. 10, my translation).

Between both types of order there is a complementary relationship.Besides individuals, organisations are also part of a spontaneous order.

TORSTEN NIECHOJ126

von Hayek (1973, p. 46) mentions families, firms, and associations which areall part of a spontaneous order but not themselves spontaneous in theirstructure; the government as well is a special kind of organisation.Therefore, we can conclude that spontaneous order is a superior solutionfor complex coordination problems, as in the case of a market economy, butnot a universal principle for all coordination situations, according to Hayek.Organisations, although restricted to low-complex situations, have a right toexist, too.

Despite their superiority in principle, in reality complex coordinationproblems, such as in an economy as a whole, are only more or lessspontaneously structured. Hayek – far from propagating a minimal state –recognises the necessity of the state to provide (some) public goods financedby taxes and to serve as a third party to enforce the rules of the order(von Hayek, 1960, pp. 257–260, 1979, Chapter 14). Moreover, jurisdiction isessential for the interpretation and enhancement of rules (von Hayek, 1973,Chapter 5). In some cases a spontaneous order is dependent on someorganisational elements, especially in as much as the state enters the picture.It has to be noted, however, that organisations, such as firms, trade unions,or other associations, do not play a role in rule building or enforcement forHayek. Collective action as intentional action concerning the rules of theorder is always bound to state action and not related to civil collective actors(von Hayek, 1960, pp. 142–147).

Additionally, the current existence of a spontaneous order does notnecessarily imply its future viability. The durability of an order cannot betaken for granted. A spontaneous order is not natural in the sense that itdevelops under any circumstances and maintains itself in spite of alladverseness. Interventionism caused by collective actors can disturb oreven destroy the order (von Hayek, 1976, p. 142f.). Individuals do nothave the power to endanger a spontaneous order, whereas groups do havethis power, and they may have reasons for interventionist activities.By combining the power of many individuals they gain a status of powerthat may be sufficient to enforce privileges or the redistribution of goods intheir favour (von Hayek, 1979, pp. 99–103).

Against this background, intentional collective action and collectiveactors themselves are suspected to inhibit the functioning of spontaneousorder; collective actors may harm or even destroy it. Why Hayek mistruststrade unions as expressed in the introductory quotations now becomesclearer. Trade unions as collective actors are suspected of using thecombined power of individuals to enforce the interests of a limited group.Acting at two levels – the economic and the political one – they influence

Hayek vs. Hayek: A Defence of Moderate Trade Union Activity 127

both the catallaxy (or more specific: the labour market) and the politicalprocess, thus dually hazarding the order. Nevertheless, there has to be morethan that to make the trade unions the most extreme example of harmfulcollective action. Acting at two levels and combining individual power isnothing especially inherent to trade unions; this is characteristic for nearlyall organisations. For Hayek the use of coercion by the unions is crucial toexplain the differentia specifica between organisations which are beneficial orneutral to the order, and those which are destructive. Collective action is alatent threat to spontaneous order, but not in general harmful.

3. TRADE UNIONS AS ECONOMIC ACTORS

As economic actors the trade unions organise the employees in order topromote their common interests. If trade unions acted solely as anassociation offering service and advice to their members and giving theirmembers a voice, and if they respected rules and the rights of others, theywould in Hayek’s view be a helpful part of the catallaxy. The problem withthe trade unions, according to Hayek, is their use of coercion to reach theiraims (von Hayek, 1960, pp. 267–284). Coercion as defined by von Hayek(1960, p. 133f.) means to force the enforcer’s will onto someone else bythreatening with harm:

Coercion occurs when one man’s action are made to serve another man’s will, not for his

own but for the other’s purpose. [ . . . ] Coercion implies both the threat of inflicting

harm and the intention thereby to bring about certain conduct.

This definition includes two essential elements: the intentionality ofsomeone to force and second, the threat of violence. Consequently, a marketexchange is not coercion because no one is intentionally influenced bysomeone else to trade or not to trade. If someone has little bargaining powerdue to low skills or unfortunate conditions, but no one is intentionallyforcing this person into a particular situation, it is not coercion (von Hayek,1960, p. 135f.). If someone is capable of restricting the scope of options ofsomeone else, he or she coerces, and there are different degrees of coerciondepending on the enforcer’s ability to limit the scope of options (von Hayek,1960, p. 136f.).

What does this mean when applied to the topic discussed here – thelabour market and the trade unions? Employees are not coerced by anemployer cutting wages in face of shrinking demand or lowered marketprices. It is not the will of the employer which creates a situation that allows

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someone to press someone else to work for a low wage, it is the currentsituation that makes low wages possible. Coercion is involved, however, iftrade unions enforce their members’ interests by picketing and by closedshop because the unions try intentionally to raise their bargaining power(von Hayek, 1960, p. 274f.; von Hayek, 1980b, pp. 51–53). Picketing isa means to force non-unionised employees to join or to behave in line withthe union’s actions, and closed shop aims at forcing them as well. If thetrade unions control a firm in this way, they can

exercise almost unlimited pressure on the employer and [ . . . ], particularly where a great

amount of capital has been invested in specialised equipment, such a union can

practically expropriate the owner and command nearly the whole return of his

enterprise. (von Hayek, 1960, p. 270)

By forcing other non-unionised employees to behave in line with theunion’s aims and by forcing them to withhold labour power, i.e., to strike,the trade unions control the labour supply by coercion and thus theprice of labour. Consequently, coercion leads to monopoly in the labourmarket and thereby to non-spontaneous price setting which diminishes theability of the order to discover or disseminate information (von Hayek,1980b, pp. 53–55).

This usage of coercion, however, is a tricky thing. Picketing does notnecessarily take on forms of violence or threatening with violence where theenforcement of someone’s will on others is obvious. In the past, both sides,employers and trade unions, used force, and picketing then took reallyviolent forms. Nowadays, however, picketing is normally a case of moralpersuasion. It is a metaphorical, but not real, ‘‘running the gauntlet’’. Theclosed shop is also not an illegal act of violence but a legalised supportof organising trade unions. This is even more true for the highly regulatedwage bargaining in continental Europe where there is a set of traditionallyemerged rules that intend to – and in reality do quite well – exclude violencefrom the conflict over wages and lead to a low strike intensity (Aidt &Tzannatos, 2002, pp. 115–118). In continental Europe there is no closedshop, and employees voluntarily join unions and participate in strikes.If for this reason we accept that – nowadays and for most industrialisedcountries – (the threat of) violence is not essential to picketing andclosed shop and thus cannot constitute the differentia specifica of the termcoercion, then the intentionality of person A to artificially create a situationwhich allows the enforcing of A’s will onto person B is the relevant elementof Hayek’s definition of coercion.

Hayek vs. Hayek: A Defence of Moderate Trade Union Activity 129

Unfortunately, difficulties still remain. In contrast to other Austrians, forexample, William H. Hutt (1975, 1988), for Hayek strikes are in principlepermissible and should not be declared illegal.2 Consequently, we have toconclude that the strike does not constitute a case of coercion. In the givenframework, this seems odd. In every strike there is an intentional moment toenforce a claim by an artificially created situation, the withdrawal of labourpower, i.e., the capacity to work. Therefore, the strike is in this senseanalogous to picketing and closed shop. Certainly, nearly all countriesrecognise a right to strike, but from a Hayekian point of view the existenceof the right to strike may be seen as an illegitimate outcome of the coerciveaction of trade unions in the political sphere (which will be discussed in thenext section more extensively). We could then conclude that a consequentdevelopment of the Hayekian point of view should include strike as a meansof coercion to solve the described difficulty of definition.

There is another case, however, that cannot be solved that easily: the caseof monopolies. Hayek mentions that when a monopolist offers an essentialservice, buyers are coerced to buy (von Hayek, 1960, p. 136f.): someonedying of thirst who is willing to give everything he or she has in a Swiss bankaccount in exchange for a glass of water is forced to agree to such a bargainmade by a trader owning the only spring in the desert. This case of amonopoly, however, does not fulfil the initial definition because no oneintended to create this situation and no one threatened to use violence. Here,Hayek introduces a completely new definition of coercion based alone onthe scope of options someone has which could in the Hayekian frameworkbetter be understood as a case of (extreme bad) conditions but not ascoercion because the element of intent is lacking.

Elsewhere, he states that if monopolies cannot, at that point of time, bereproduced by others they do not give rise to the existence of coercion (vonHayek, 1960, pp. 264–266). These monopolies are unavoidable, and there isno reason here to blame firms for constituting such a monopoly. In thissituation, however, elements of Hayek’s definition of coercion appear: Aperson or firm initiates a product innovation that constitutes a monopolyfor a while, or a process innovation whose cost-reducing effects are notcompletely reflected in lower prices. The intention is to make money thatothers are willing to pay because of the artificially created scarcity of theproduct in the case of the product innovation and a price – artificially kepthigh – in the case of the process innovation.

So, where is the difference to the labour market case? In both cases themonopolies – innovators and trade unions, respectively – receive a rent andrestrict others. The difference is that some rent activities are favourable for

TORSTEN NIECHOJ130

the economy – the temporary monopolies – but others are not – the tradeunion behaviour. The line between being favourable or not is, however, thin.Following transaction cost arguments in the tradition of Williamson (1985),collective agreements negotiated by the trade unions guarantee not onlyrents, i.e., higher nominal wages, but also save transaction costs, i.e., costsof negotiating and enforcing contracts, which otherwise arise for everysingle contract. Dynamic effects should also be included. Employers mayadapt to rising wages by introducing more machinery or differentproduction processes (Madsen & Damania, 2001). So, collective agreementsmay set incentives for more innovations. Acknowledging this, a differentia-tion between positive and negative functions for the economy is still possiblebut it introduces an element of normativeness, or to be more precise: anelement of external judgment which cannot be derived from the concept ofcoercion – understood as intentional rent seeking – itself.3

Having said that, it does not mean that all coercive actions, especiallytrade unions’ actions, are functional from the point of view of the order. Butit implies that trade unions cannot be blamed only because of the fact thatthey try to raise their bargaining power. To what extent trade unions’activities are functional or not, needs further investigation and cannot bederived from the existence of coercion, as defined by Hayek, alone.Furthermore, a prerequisite for (negative or positive) functionality is thatthe trade unions are actually able to monopolise. This hinges on theirbargaining power which is not fixed and depends on different factors: therelevance of skills the unions organise determines the effectiveness of theirthreat to withdraw labour power in a strike; the ability of trade unions toavoid free riding on the side of employees and to organise as manyemployees as possible raises their bargaining power and vice versa. Existingexit options of employers – due to high unemployment, substitution oflabour by capital, or the possibility to relocate production – raisesemployers’ bargaining power. The institutional and political context of aneconomy defines whether conflict regulation between employers andemployees will follow a cooperative or conflicting path. All these factorstogether determine how successful trade unions are in strengthening thenegotiation position of employees. In particular, in times of globalisedproduction and decreasing union density the power of trade unions tomonopolise seems to be limited.

The monopoly aspect of the trade unions, however, does not give acomplete picture of what unions do in the view of Hayek. Clearly, his mainfocus is on wage increases the unions cause if they succeed in establishing amonopoly position. Nevertheless, there is more in Hayek’s writings, but it is

Hayek vs. Hayek: A Defence of Moderate Trade Union Activity 131

more or less hidden. The role the unions play within the firm and for thediscovery of information is mentioned by Hayek, albeit not reallyelaborated. He only touches on the participation of unions in the creationof rules and of conditions of work as well as in a just structure ofremunerations and promotions within firms (von Hayek, 1960, p. 276f.).In Hirschman’s terminology, in addition to exit, when an employer(or employee) signals that the offer (or work) is no longer satisfying byquitting, there is voice, which signals dissatisfaction via linguistic commu-nication (Hirschman, 1970). Trade unions mediate between managementand employees, they are the voice of their members vis-a-vis management.Unions can signal potential and latent conflicts to the management and canhelp finding common solutions before such conflicts actually break out.Analogously, the management can communicate their problems to theunions. The trade unions also participate in the development of intra-firmrules which establish fairness norms – as an essential source of productiveworking conditions – and prevent conflicts. If the relationship betweenmanagement and trade unions is a successful one, the result is low strikeintensity and motivated employees.

That Hayek was not very interested in the role of trade unions withinfirms is probably due to the fact that his main focus was on spontaneousorder, not on organisations. Therefore, intra-firm relationships did notconcern him much. He treats firms as homogenous actors where conflictsshow up only in wage bargaining but have no further effect on the internalorganisation. Not all Austrians share this view. As Foss (1999) demon-strates, the firm also incorporates elements of a spontaneous order which isessential for the firm to use knowledge, to interpret the world, and to learnfrom mistakes. Nevertheless, a firm is different from a market: themanagement plans and decides in the end, but it also gives leeway for localdecisions and governs by rules as well as by concrete commands. Fossstresses that the members of the firm are people without perfect knowledge,notes the incomplete contracts in a firm, and concludes that a firm, althoughit is an organisation, is a complex body too, facing complex coordinationproblems and unintended consequences of their members’ actions.

What follows from this rearranged perspective on firms? A firm is anorganisation but not one where the will of a single person controlseverything the firm is doing directly and without resistance (Foss, 2002).Running a firm is not like programming a computer, it is a fragilecoordination of micro-actors that day after day constitutes itself newly asa collective actor, i.e., the firm (Coleman, 1990, chapter 16). The growingliterature on interest conflicts and coordination difficulties between

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management on the one hand and shareholders on the other, starting withthe seminal paper of Jensen and Meckling (1976), may serve as anillustration that this insight is spreading.

For the question under examination here, it is the relationship betweenmanagement and employees which has to be discussed in more detail. As anorganisation, a firm cannot rely on the market price system for its internalrelationships. Hierarchy, i.e., governance by commands, and intra-firm rulesmainly coordinate the work, based on the labour contract defining in whichway labour power can be used for the purposes of the firm. And here thefragility of this coordination has its source. Employees do not work in a firmin order to fulfil the aims of the firm (efficient use of resources, growth, andin the end profit). Their incentive to work is the wage plus good workingconditions. The management and the shareholders have their own, differentaims. The collective actor, the firm, is not held together by a common aimwhich is shared and promoted by all its members. James S. Coleman (1990,chapter 4) calls this a disjunctive control system, a collective actor wherea good is commonly produced and someone (or a body) governs andcommands the organisation, whereas, however, the interests of theproducers are diverse. This is different from a conjunctive control systemwhere the members of the collective actor follow the same vision andcooperate to make it real. In the case of the disjunctive control system firm,the employees’ control over their resources, over their labour power, istransferred to the management only because of a reciprocal transfer ofmoney: labour power usage for wage, which is regulated by the labourcontract. However these contracts cannot specify and concretise whatemployees should and should not do in advance; they are incompletecontracts. The management must have the possibility to change theproduction process, to reallocate the resources, and to deploy the labourpower adjusted to changing conditions. Consequently, a labour contractcodifies the exchange of the wage against the command over labour power,but not specified tasks describable in advance. This is a gateway for shirkingand disagreement on what is and is not covered by the contract. While someworking conditions, methods or tasks might not fall under the agreementfrom the employees’ perspective, they might do so for the management. As itis impossible to know exactly which ones these might be, because of theincompleteness of the contract, rules, and procedures for solving suchconflicts are needed. Here, besides financial incentives set by the employers(Akerlof, 1982), the task of the trade unions is to formulate the interestsof the employees vis-a-vis the management and to establish norms andprocedures which control shirking in the interest of the firm as well as in the

Hayek vs. Hayek: A Defence of Moderate Trade Union Activity 133

interest of the employees. Since the firm is not a spontaneous order, theserules cannot emerge spontaneously and information is not transported by aprice system substitute. An alternative way of creating and adapting rulesas well as institutionalised forms of signalling is necessary and is provided(not only, but to some extent) by trade unions.

Therefore, if we do not focus on the monopoly aspect of the unions only,but also on their rule-establishing and conflict solving capacities asmentioned by Hayek as well, it would be appropriate to take some blameoff the unions. But this is only half of the answer to the question of whatfunction trade unions do have in a Hayekian spontaneous order. They alsoact as political actors, which has to be included in the discussion. It is there,according to Hayek, that the unions try to reallocate resources and tochange the rules of the game.

4. TRADE UNIONS AS POLITICAL ACTORS

Hayek’s confidence in the success of the political process of a democracyvaries over time. In ‘‘Constitution of Liberty’’ he names the three mainadvantages of a democracy: it is a peaceful method of problem solving; asafeguard of individual liberty; and above all an opinion forming process.(von Hayek, 1960, pp. 107–109; see also Peacock, 2004). It is not a kind ofstatic efficiency or permanent superiority that Hayek appreciates in ademocracy. It is rather the steady increase in the quality of opinions that thepolitical process generates in the long run. In his later work, however, hestresses the elements within a democracy that lower its problem-solvingcapacity, endanger liberty, and interfere with the process of opinionformation. Here, organisations are the key. Collective actors try to changethe order, which until then had been successful and convenient foreverybody, in order to gain advantages for themselves.

While as a rough approximation it can legitimately be said that individual selfishness will

in most instances lead the individual to act in a manner conducive to the preservation of

the spontaneous order of society, the selfishness of a closed group, or the desire of its

members to become a closed group, will always be in opposition to the true common

interest of the members of a Great Society. (von Hayek, 1979, p. 90; cf. also von Hayek,

1976, pp. 137–139)

Intentionally or as an unintended side effect, collective actors impair theorder. Hayek gives the following rationale (von Hayek, 1979, pp. 143–145).It starts with rent-seeking behaviour of collective actors, not least of trade

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unions. Due to the combined power of a lot of individuals they are actorsthe government cannot ignore. Collective actors influence the government tochange the order and grant privileges to them. This situation is worsenedwhen the government tries to undo the negative consequences of theprivileges by more and more state interventions. Following von Mises(1929), Hayek forecasts cumulative interventionism and the destruction ofthe catallaxy by increasing inflation and price interventions (von Hayek,1980b, pp. 53–57).4 Therefore, we have to conclude that in principle – oridealiter – the political process in a democracy can produce collective goods(which are good), while nowadays – or realiter – it produces in most casesonly fights for rents and causes cumulative interventionism (which is bad).From this point of view, democracy is degenerated into ‘‘bargaining’’(von Hayek, 1979, p. 99) for rents.

Whether the political process leads to pure rent seeking only or toadvancement in opinion formation, the creation of desired public goods, orthe solving of conflicts depends – according to the citation given earlier – onthe existing influence of collective actors. The criterion for rent seekingseems to be for Hayek already and alone the participation of collectiveactors in the political process. But this would mean that media corporations,parties, firms, employers’ associations, trade unions, associations for theprotection of the environment or for human rights, and so on, are all andever rent seekers. If a business association threatens to relocate productionwhen there is no cut in firm taxes, is that rent seeking? If Greenpeace ishindering whalers doing their job, is that haggling for privileges? If groupstry to organise a boycott of Shell or McDonald’s, is that gaining advantagesfor a special group? All these actors clearly try to reach political aims, but itis not that clear if all of this is harmful.

Therefore, a closer look at what collective actors do is necessary. As chiefwitness, Hayek (1979, p. 90, footnote 12) refers to Mancur Olson’sarguments of the logic of collective action (Olson, 1971). The core of theargument is that collective actors – small or large does not matter – seekadvantages for an exclusive group only. Thus the principle of equaltreatment is violated. Olson in his 1982 book, however, differentiates morethan Hayek. Not all collective action is a seeking for exclusive rents, and notall interests are equally organisable. While small collective actors try to seekoutcomes mostly favourable only for themselves, comprehensive collectiveactors representing a broad range of people’s interests cannot help reachingresults that favour a broad range of people. But normally, large groupsface severe free-riding problems hindering them to organise as effective as

Hayek vs. Hayek: A Defence of Moderate Trade Union Activity 135

small groups. Olson’s arguments leads to the conclusion that some actors,normally small collectives, exploit comprehensive collectives, but not allcollective actors do exploit. Trade unions, by the way, are one of Olson’sexamples of comprehensive collective actors (Olson, 1982, pp. 47–53).

Nevertheless, the situation is not as bad as Olson predicts. Interests areorganisable to a different degree and are thereby represented differently inthe political process, but there are remedies to overcome organisationalproblems, also for interests that are difficult to organise: even a few actorscan start the production of a collective good, and when a critical mass isreached production grows and is stabilised; networks, trustees, or politicalentrepreneurs help to reach this critical mass; furthermore, the state can givesupport for organising interests (Oliver, Marwell, & Teixeira, 1985; Oliver &Marwell, 1988; Marwell, Oliver, & Prahl, 1988). Although this does notnecessarily lead to a well-balanced system of interests, it is a more balancedsystem than the works of Hayek and Olson suggest. A broad range ofinterests is represented, and rent-seeking actors have to face resistance byother organised interests.

But Hayek’s main point is still valid: is there not too much rent seeking inthe political process, which could be avoided? To answer this, we have toshed some light on the special attributes of the political process indemocracies. In a catallaxy, relations between the actors are characterisedby a situation in which goods can be individually owned and consumed.In the political sphere it is not possible for an individual to choose his or herown society. A political choice is always a collective choice whose effectsare not restricted to one person. Moreover, competition between parties isrestricted. Only a few parties compete and offer only bundles of goods wherenot all components might suit an individual. Doing politics in such a systemleads to the necessity of establishing coalitions and paying compensationsto get to a majority-based solution. It also implies that the outcomesnecessarily deviate from individual preferences due to bundling and choiceas collective choice. All of this can be described as rent seeking. However,this is due to the way a democratic political process works and cannot berevised comprehensively without turning a democracy into something whichis no longer a democracy, possibly something undemocratic.

Von Hayek (1979, pp. 133–152) – and in a similar way Buchanan andothers (Brennan & Buchanan, 1985; Buchanan & Congleton, 1998) – suggesta constitutional forum to reduce rent seeking. This forum still uses majorityvoting but aims at excluding all rent-seeking activities due to the obligationto decide on abstract rules only and not on concrete measures. Abstractness

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guarantees rules that do not privilege and do not discriminate againstanyone. In a way, it means having all members of the society in mind.

In contrast to an ideal catallaxy where we can imagine that the right rulesare in existence because the order emerged unintentionally and over a longerperiod of time through the daily actions and interactions of the peoplethemselves, a constitutional forum nowadays faces a different situation.Regardless of who is elected or appointed to formulate the rules in such aforum, the members have to find adequate rules for the existing order first.Or in other words: it is not known what the ‘‘true common interest’’(von Hayek, 1979, p. 90) is, besides the fact that it is rule-based. Thecriterion of abstractness alone does not help much. It can serve as atouchstone for non-discriminating treatment but it does not tell the forummembers the content of a rule. To find the right rules, the members needknowledge about what people want, they need knowledge whether therules serve these wants, and how they interact or interfere with each other;this knowledge is locally available but not automatically at hand in theforum. Furthermore, democracy is not only about the right rules. Everyrule has to be followed to establish a sustainable order. The pure existence ofa constitutional body does not guaranteed that everybody follows the rules,as people want to be convinced that these rules are the right rules, that theyare legitimate.

Why not use democracy to find that knowledge and legitimacy? ForHayek the catallaxy is a discovery process for knowledge; it might also workfor the political sphere (diZerega, 1989). A public debate is a necessaryprerequisite to discover the right rules and to generate legitimacy. It is thisdebate which formulates people’s preferences. In the debate the con-sequences of rules can be discussed. New ideas and new rules can bedeveloped in an open debate. Beliefs have to be justified and can be refuted.Last but not least, the debate is essential to convince people and therebyfind support for the rules. In doing this – developing ideas of rules, formingpreferences, justifying and disapproving beliefs, and building legitimacy – itproves that politics is not only the re-allocation of goods produced inthe economy, i.e., rent seeking, it is also not only the act of choosing asolution by majority voting. Democracy is a productive discovery processto determine urgent societal problems and to find out how to solvethem (Slembeck, 1997; Wohlgemuth, 2002a; Wohlgemuth, 2002b). Thisdiscovery process is obviously not a market-type process: it is voice-driven,not exit-driven.

Unfortunately, this democratic discovery process is vulnerable to rentseeking. Individuals have an incentive not to participate in debate and

Hayek vs. Hayek: A Defence of Moderate Trade Union Activity 137

discovery. They would have to invest a lot of time but would probably gainonly a minimal influence within the debate. One person – one vote – is alsothe principle in decisions. In this dilemmatic situation, collective actorsfunction as mediators. Parties, business organisations, trade unions and soon can fulfil five functions for the debate:

– First, they give preferences a voice that otherwise would not be expressedbecause of the free-riding problem. They collect information on people’swishes, formulate them and bring them to the public.

– Second, they combine resources to develop concepts and belief systems tointerpret the world for their members, which is necessary to decide whichrules are adequate.

– Third, they collect the dispersed knowledge of individuals and transformit into public knowledge, which can be used and discussed.

– Forth, they convince their clientele that the chosen rules are the right onesand should be followed.

– Fifth, they participate in the implementation, enforcement and actualisa-tion of rules.

Collective actors in the political process are therefore producers of thepolitical goods: preference discovery, information acquiring, rule proposing,and legitimacy creation. They are also interest groups, but as such they fightfor political aims, which is not necessarily the same as rent seeking.Switching exclusively to a constitutional body and restricting the activity ofcollective actors to zero, requires finding substitutes for the functionscollective actors hold.

Maybe this is not necessary, and maybe it is enough to sensitisethe political process towards what is needed for a successful establishmentof a catallaxy. This would also imply that economists and the economyhave to take into consideration that the political process has its ownlogic and that people’s preferences might be – not as a deficit but as anessential element – such as could lead to consequences not favourablefor a catallaxy. Even an ideally functioning political process, solelyproducing abstract rules, might not lead to a catallaxy-friendly set ofrules for the economy. If the majority prefers for example a stableenvironment, an equal ex post distribution, precautions to guard againstmisfortune, or if it favours risk-averseness, then the degree of competitionin the market will be diminished, consistent with people’s preferenceorder and will. From the point of view of a liberal democracy we have toaccept that.

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5. TWO RESULTS OR TOO TRADITIONAL RESULTS?

Hayek’s hypothesis that trade unions are the first major problem of ourtimes is not fully grounded even in his own assumptions. Trade unions havea monopolistic element in their role as economic actors but also havepositive functions for their members and the economy as a whole. The mainreason is that firms are organisations (and only partly spontaneous orders)in the form of disjunctive control systems where the relationship betweenemployer and employee is based on a mixture of a specific exchange incombination with command, and not on a common goal. Consequently,latent conflicts exist. In this situation, trade unions channel information anddevelop rules for conflict resolution. Hayek’s insights on rule emergence andinformation discovery, developed in the field of spontaneous order, can alsobe usefully applied to describing how firms work.

The same holds for the political sphere. Beside rent-seeking activities,trade unions and other collective actors can be conceived as being part of aprocess of preference formulation and opinion formation. By overcomingthe dilemma facing individuals – that they have only low incentives toengage themselves in the public debate – collective actors fill this gap andproduce knowledge and legitimacy necessary for well-grounded decisionson rules and their successful implementation. Hayek’s ideas of competitionas a discovery process and the importance of knowledge again offerfruitful insights for a theoretical reasoning of the democratic process as aspontaneous order. What has to be included is the role of collective actorssuch as mediators and discussants within this process.

It might appear that these results, which describe trade unions (orgenerally: collective actors) as helpful parts both of a democratic order andthe catallaxy, are too traditional, too much oriented towards a corporatistview of society. Especially for economists, trade unions might be quite anextreme example to demonstrate that collective actors can also supportspontaneous order. But if in the case of trade unions it could be reinforcedthat collective action is an essential part of the economic and political sphere,then this applies for less problematic collective actors all the more. If thepower of collective actors should still be curtailed because of their negativeeffects, substitutes would have to be found for their positive functions.

NOTES

1. See other Austrian authors dealing with economics in this broader sense – forexample, Schumpeter’s famous book on the economic and political perspectives of

Hayek vs. Hayek: A Defence of Moderate Trade Union Activity 139

capitalism (Schumpeter, 1942), or Mises’s book on interventionism (von Mises,1929).2. Hayek reserves some exceptions from this rule. ‘‘There are good reasons why in

certain employments it should be part of the terms of employment that the workershould renounce this right; i.e., such employments should involve long-termobligations on the part of the workers, and any concerted attempts to break suchcontracts should be illegal’’ (von Hayek, 1960, p. 269).3. Interestingly, the distinction between rent-seeking and profit-seeking activities in

a similar context, given by Buchanan (1980), leads to the same problem: the seekingactivity itself cannot offer the criterion whether this activity is desirable or not.4. This view was recently challenged by Wegner (1997) who demonstrates on a

Hayekian basis that the spontaneity of the order is not necessarily endangered bynon-spontaneous actions. Or in other words: competition is a very robust institution.Re- and devaluations of actors’ options are part of every day life, be they caused bystate action, by trade unions’ action, or by competitors’ actions. The actors canadapt to these changes and thereby prevent cumulative destruction.

ACKNOWLEDGMENT

I would like to thank the participants of the Edmonton conference ‘‘TheAustrian School of Economics’’, 7–8 October 2005, especially Roger Koppland John Prpic, for valuable comments. The chapter has also benefited fromcomments by Eckhard Hein, Christoph Sauer, Margit Schratzenstaller,and Jens Weiss on an earlier version and from helpful suggestions by ananonymous referee.

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ANALOGOUS MODELS OF

COMPLEXITY: THE AUSTRIAN

THEORY OF CAPITAL AND

HAYEK’S THEORY OF COGNITION

AS ADAPTIVE CLASSIFYING

SYSTEMS

Steven Horwitz

ABSTRACT

By the 1950s, F. A. Hayek’s contributions to a variety of disciplinesseemed to be more clearly center around the concept of spontaneousorder, or in more contemporary and more general language, ‘‘adaptiveclassifying systems.’’ In this chapter, I compare two such systems presentin Hayek’s thought: his contributions to the Austrian theory of capitaland his work on the theory of cognition. This comparison reveals anumber of very strong analogies between the two theories, which is notsurprising as Hayek himself acknowledged that his work on capitalinfluenced his thinking when he returned to theoretical psychology aftercompleting The Pure Theory of Capital. Specifically, I argue that bothcapital and the mind are adaptive classifying systems characterized by:multiple classification/specificity, the centrality of structure, and a

Explorations in Austrian Economics

Advances in Austrian Economics, Volume 11, 143–166

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All rights of reproduction in any form reserved

ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11008-0

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relational concept of order. The chapter concludes with some briefthoughts on the implications of the argument for the theory of the firmand for the place of methodological dualism in Hayek’s thinking moregenerally.

The last decade has seen a number of books looking at F. A. Hayek’scontributions to economics and social theory and attempting to draw bothconnections between them and large lessons from them. In the most recent,and best, of these books, Bruce Caldwell (2004) argues that one centralmoment in the development of Hayek’s thought is a shift in hismethodological perspective from one that emphasized the dualism of thesocial and natural sciences to one that explored the distinction between‘‘simple’’ phenomena and ‘‘complex’’ phenomena.1 Caldwell points to theperiod of the 1940s as the time when Hayek began to undergo this shift.Hayek’s decision to revisit theoretical psychology and publish The SensoryOrder (1952) brings together both this emphasis on complex phenomena andHayek’s attempts to provide a scientific underpinning for traditionalAustrian subjectivism.

At the most general level, Hayek was seeing this new framework of emer-gence, complexity, evolution, and spontaneous order in a variety of places.After quoting a passage from Hayek’s ‘‘Notes on the Evolution of Rules ofConduct’’ from 1967 that reflects Hayek’s move toward these otherexplanatory strategies, Caldwell (2004, p. 285) captures the breadth of thischange in Hayek’s thought:

Hayek included a note in the article containing the passage just cited that summarizes the

point well: ‘‘We shall occasionally use the pair of concepts ‘order and its elements’ and

‘groups and individuals’ interchangeably, although the former is of course the more

general term of which the relation between group and individual is a particular instance’’

(Hayek, 1967, p. 66, n. 1). This is just what one should expect from someone who was

identifying analogous explanations in a variety of fields.

To the extent that Hayek began to see, in the 1940s, a new framework forconceptualizing the relationship between the natural and social world, andto offer explanations for phenomena in each area, it is not surprising thatthere would be analogous explanatory strategies at work in diverse areas ofhis thought. McQuade and Butos (2005) argue that this shift in Hayek’sthought can best be understood as his having implicitly laid out in TheSensory Order the fundamentals of a class of phenomena that they christen‘‘adaptive classifying systems.’’ They offer an abstract discussion of how

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such systems operate and then offer several examples of such systems,focusing on the market and the scientific process.

However one chooses to characterize it, the question of what might haveprompted Hayek’s shift to these ideas remains an interesting one. A numberof hypotheses have been advanced, but what I wish to argue here is that onepossible source of Hayek’s thinking about complexity and adaptive systems,particularly as it appears in The Sensory Order and then later in a series ofessays in the 1960s, was his work on capital theory in the late 1930s thatculminated in 1941s The Pure Theory of Capital, along with the similarcontributions and extensions by Ludwig Lachmann in the 1940s and 1950s.It is striking how similar the Austrian theory of capital is to Hayek’s workon cognition. Many of the same underlying ideas of function, complemen-tarity, and structure are present in both. They are, I will argue, analogousmodels of complexity and capital can fruitfully be understood as an exampleof the ‘‘adaptive classifying systems’’ identified by McQuade and Butos.And there is, in fact, one piece of evidence in the secondary literature thatHayek saw a direct connection between the two areas, and it is certainlypossible that additional evidence exists in correspondence and other placesthat confirms that his work on capital got him thinking about ideas andapproaches that led to his later work on the mind and complexity moregenerally. After exploring both Austrian capital theory and Hayek’s theoryof mind, I discuss the ways in which capital is an instance of an adaptiveclassifying system and how capital and mind are analogous models ofcomplexity. I conclude with brief discussions of some theoretical andmethodological implications.

THE AUSTRIAN THEORY OF CAPITAL

Austrian capital theory begins where so much of Austrian economics begins,with Menger’s (1981 [1871]) Principles of Economics. Specifically, it isMenger who delineated the difference between goods of the ‘‘first order’’and goods of the ‘‘higher orders.’’ First-order goods are those devoted to thedirect satisfaction of consumer wants. Goods of the higher orders are thosethat contribute to the making of first-order goods. The piece of bread I eatfor breakfast is a first-order good, while the flour, eggs, milk, etc. that wentinto making it are second-order goods. The inputs that went into making theflour or the milk (e.g., the milking machines at the dairy where the milk wasproduced) are third-order goods, and so on. For Austrians, capital can beunderstood generally as any input that contributes to the production of a

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first-order good, either directly or indirectly. That is, capital is all of thegoods of higher orders.

Implicit in this definition is the idea that capital is ‘‘forward-looking.’’What makes something capital is not where it came from but what it isdoing in forwarding the production plans of its owner. Older definitions,such as Bohm-Bawerk’s, that referred to capital as ‘‘produced means ofproduction’’ or the like were focused on the origins of a good rather than itsfunction in determining whether or not it was capital. Even Hayek wassomewhat guilty of this as he defined capital as ‘‘the total stock of the non-permanent factors of production’’ (Hayek 1941, p. 9). As Lachmann (1956,p. 12) rightly responds, ‘‘we cannot adopt this definition as we cannot ignorethe uses to which permanent resources are put.’’ More generally, Lachmann(1956, p. 11, emphasis added) defines capital as ‘‘the stock of materialresources’’ and adds, in response to Bohm-Bawerk, that ‘‘the question whichmatters is not which resources are man-made but which are man-used.’’Lachmann focuses attention more sharply than Hayek on the uses to whichresources are put rather than their physical nature or origin.

But even Lachmann does not quite go far enough. Where his definitionfalls short is its focus on the ‘‘material’’ nature of capital resources. We cangeneralize Lachmann’s emphasis on capital being ‘‘man-used’’ by arguingthat capital resources need not be material. To see this, we can look atKirzner’s extension of Lachmann’s emphasis on ‘‘the plan’’ as central to histheory of capital. In addressing the question of how we are to understandhow capital gets used and what explains the ‘‘structure’’ that emergeseconomy-wide, Lachmann (1956, p. 8) argues that ‘‘Capital uses must ‘fitinto each other.’ Each capital good has a function which forms part of aplan.’’ Kirzner (1966) picks up on this idea by defining capital moregenerally as ‘‘unfinished plans.’’ Seen this way, capital is any input into aplan. If I wish to produce running shoes, all of the elements that must becombined to execute that plan are thus capital. Seen in the context of myoverall plan, each input and each intermediate good produced along the wayis an ‘‘unfinished plan.’’ Under this Kirznerian view, the materiality ofresources is not relevant to their capital status; any good that is part of theplan is capital. For example, human capital or things such as reputation andgoodwill should be counted as capital because they are aspects of theproduction plan need to create the final good in question. In their role in thecontext of that larger plan, they themselves are ‘‘unfinished plans.’’

Another way of viewing the question of what makes something capital isto see it as a matter of function. Capital is what capital does: contribute tothe plans of entrepreneurs. This observation’s importance is that the same

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good can be capital in one situation and not another. The identical hamsandwich would be a consumer good and not capital if I have prepared it athome for the purpose of direct consumption. However, if I had taken thatexact same sandwich and put it in a picnic basket and then sold it in mystore, it is now a capital good as it is an ‘‘unfinished’’ element of my plan tosell complete picnic lunches. What makes the sandwich capital or not is itsrelationship to other goods and services and the plans of actors. It is contextor, better yet, the place a good sits in the structure or network of productionthat determines its capital quality. The Austrian theory of capital denies thatone can look at a good or service, or even a non-material asset, standingalone and determine whether or it is capital. It is not the physical qualities ofthe good that make that determination but where it sits in the network ofplans of actors. This is why Lachmann (1956, p. 4) continually refers to thestructure of capital:

It will be our main task in this book to study the changes which this network of capital

relationships, within firms and between firms, undergoes as the result of unexpected

change. To this end we must regard the ‘stock of capital’ not as a homogenous aggregate

but as a structural pattern. The Theory of Capital is, in the last resort, the morphology

of the forms which this pattern assumes in a changing world.

This emphasis on relationships and unexpected change also highlights thedynamic nature of the theory.

Because being capital depends upon a good’s location within a plan, it ispossible, and quite likely, that the same good can serve as capital in morethan one imaginable plan. Any single good has what Lachmann (1956, p. 2)calls ‘‘multiple specificity,’’ which is the quality of being used for more thanone, but yet a still limited, number of purposes. What is central for theAustrian theory is that capital is not homogenous; capital goods are notperfect substitutes for one another. Any given good can only serve in alimited number of production plans, and it is not possible to create anygiven production plan out of any capital goods. Goods are not infinitelysubstitutable, and not all goods have the requisite complementaritynecessary to be part of any particular production plan. This emphasis onthe ‘‘heterogeneity’’ of capital distinguishes Austrian capital theory frommany of its predecessors, especially those, most obviously Knight’s‘‘Crusonia plant’’ or Solow’s ‘‘shmoo,’’ that viewed capital as ahomogenous fund of resources from which equally useful ‘‘ladles’’ couldbe applied to any production process.

Recognizing that capital is heterogenous in this way suggeststhe importance of the complementarity and substitutability of capital.

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When viewed as part of a production plan, the various capital inputsmust ‘‘fit together’’ in order for that plan to be executed. How well variouscapital inputs can be fit together in this fashion is their degree ofcomplementarity. What entrepreneurs do in constructing their plans is tointegrate complementary capital inputs. In the mind of the entrepreneur atthe moment the plan is put in motion, the various capital inputs are all ina complementary relationship to one another. Substitution, by contrast, is afeature of capital goods when we consider dynamic change. The plans ofentrepreneurs are always constructed in a world of uncertainty and may failto play out as intended. When plans fail to one degree or another,entrepreneurs may choose to reshuffle their capital inputs and formulate anew plan. At this point, the central question is the degree to which onecapital good can substitute for another in the plan. The substitutability ofcapital is what matters when change is necessary. The process ofentrepreneurship and monetary calculation is one of constant plan creation,execution, and revision, with the corresponding consideration of thecomplementarity and substitutability of the capital inputs into those plans.The result of this ongoing process is the production of a capital structurethat is an unintended consequence of the various decisions being made byentrepreneurs. Although each individual entrepreneur is consciously andintentionally fitting together complementary capital items into productionplans, the degree of integration and complementarity in the capital structureof the economy as a whole is an emergent outcome of the interplay betweenintra-plan complementarity and inter-plan substitution.

One final aspect of Austrian capital theory that should be noted is thatcapital is understood in a ‘‘forward-looking’’ manner. As noted earlier,capital is defined not by how it was produced but by how it contributes tothe production of future output in the plans of entrepreneurs. Capital’svalue is derived from the value of the output it helps to produce. In this way,capital is a good with a potential to contribute to the creation of furthervalue. That potential, like economic value in general, is due to theexpectations and perceptions of entrepreneurs about its contributions to theproduction process and nothing inherent in the good itself. When weconsider the importance of complementarity in the production process, italso becomes clear that the value-potential of any particular item of capitalis bound up with context in which it is placed at any point in time. Capital’svalue depends on its place in a production plan and the perceptions of itscontributions to the final good that plan will produce. Capital value is bothforward-looking and contextual.

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HAYEK’S THEORY OF MIND

Hayek’s theory of mind and cognition is largely laid out in his 1952 bookThe Sensory Order. The task he sets for himself in that book is to explainhow it can be that the world we understand to exist through the methods ofscience presents itself to us in the mind as a different sort of world. Forexample, we may know that what we see is but a jumble of waves, particlesand the like, but our minds somehow translate those raw physical inputsinto the orderly picture of the world we associate with mind andconsciousness. Hayek (1952, p. 7) wants ‘‘to know the kind of process bywhich a given physical situation is transformed into a certain phenomenalpicture.’’ Hayek frames his investigation in terms of the ‘‘physical’’ and‘‘mental’’ orders. He (p. 14) wants to understand the relationship betweenthe two and how mind renders the world orderly in a way that is differentfrom the order we know exists in the physical world:

There exists, therefore, no one-to-one correspondence between the kinds (or the physical

properties) of the different physical stimuli and the dimensions in which they can vary,

on the one hand, and the different kinds of sensory qualities which they produce and

their various dimensions on the other. The manner in which the different physical stimuli

can vary and the different physical dimensions in which they can be arranged have no

exact counterpart in the manner in which the sensory qualities caused by them will differ

from each other, or in the dimensions in which these sensory qualities can be arranged.

This is the central fact to which we have referred when we insisted that the two orders,

the physical order of the stimuli and the phenomenal or mental order of the sensory

qualities, are different.

Mind is ‘‘thus a particular order of a set of events taking place in someorganism and in some manner related to but not identical with, the physicalorder of events in the environment’’ (Hayek, 1952, p. 16).

More specifically, Hayek argues that mind is a ‘‘relational’’ order. Whatmakes any given situation ‘‘orderly’’ is not just that there is a certain set ofevents occuring together, but that there are ‘‘certain relations betweenthem’’ (Hayek, 1952, p. 47). It is in this sense that the whole (the order) isgreater than the sum of its parts. One has to understand the relationshipsamong the various elements in order to understand how their arrangementin particular ways can leads to an order that is something distinct from thesum of the elements. It is not just the presence of certain elementsthat generates an order, but how those elements are arranged. In the caseof the mind, it is certain relationships among physical stimuli thatproduce the orderliness in the world that we associate with consciousness.

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Furthermore, because we know that there are times when physicallydifferent stimuli present themselves identically to our senses and other timeswhen physically identical stimuli can appear different, we know that themental order depends on the context in which particular stimuli appear.There is no simple one-to-one correspondence between physical stimuliand the mental order. The role that a particular physical stimulus plays inproducing the mental order (what Hayek calls the sensory qualities of thatstimulus) will depend on the relational context in which it appears.

These relationships and the order they facilitate is made possible becausemind is, in the core of Hayek’s theory, a classification system. The mentalorder is the result of the mind classifying physical stimuli as they arrive.Hayek is careful to argue that the mind does not just take ‘‘pre-sorted’’stimuli and then ‘‘put’’ them in the right place. Rather, the mind is the wayin which stimuli are classified in the first place. The world presents itself tous as orderly because the mind ‘‘pre-classifies’’ stimuli based on networks ofneural connections that have been built up through our history ofinteraction with the external world. The complex part of this process isthat what is normally happening is a process of ‘‘multiple classification.’’The category to which particular inputs get assigned may differ dependingon the other inputs that accompany it. Hayek (1952, p. 50) explains anothersense of ‘‘multiple:’’

The classification may thus be ‘‘multiple’’ in more than one respect. Not only may each

individual event belong to more than one class, but it may also contribute to produce

different responses . . . if and only if it occurs in combination with certain other events.

An example of the first sort of multiple classification would be the factthat an orange can be classified as ‘‘round,’’ ‘‘orange,’’ and/or ‘‘fruit.’’ Theparticular response we have to an orange in front of us might well depend onwhat else it appears with. For example, on a tray with a strawberry and awatermelon, it would likely evoke ‘‘fruit,’’ but with a carrot and abasketball, it would evoke the color orange (Feser, 1999). Futhermore, it ispossible that it could generate a unique response if it occurs with a particularcombination of other objects. Individual events often have multiple ways inwhich they could be classified and the particular response they generate willoften depend upon the other events with which they present themselves.

As organisms learn through time, these connections and systems ofmultiple classification become progressively more sophisticated. Hayek(1952, p. 109ff ) uses the metaphors of ‘‘map’’ and ‘‘model’’ to explore theway in which the mental order is structured. The map and the modelgenerally reflect the more static and more dynamic aspects of cognition.

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The map refers to the relationship between the ‘‘network of connections’’among stimuli acting upon the organism and the ‘‘structure of externalevents which it can be said to reproduce’’ (Hayek, 1952, p. 109). These arethe established connections that have been built up in the mind over thelifetime of learning. They reflect the ‘‘lay of the land’’ in terms of the learnedassociations that the mind has made through time. They are neural andphysical phenomena. Hayek is careful to say that this is a ‘‘very imperfectmap, but also a map which is subject to continuous although very gradualchange’’ (p. 110). It is a record of past relationships. He continues:

The model, by contrast, refers to the pattern of impulses which is traced at any moment

within the given network of semi-permanent channels [and] may be regarded as a kind of

model of the particular environment in which the organism finds itself at the moment

and which will enable it to take account of that environment in all its movements.

(Hayek, 1952, pp. 114–15)

The map is a reflection of the past, but the model is what the organismuses to ‘‘represent’’ the present. The semi-permanent nature of the maprestricts the kinds of things that the organism can model at any point intime; we understand our present environment on the basis of the experienceswe have accumulated through time. However, the model is dynamic in thesense that it guides behavior in the particular context the organism findsitself. It reflects the set of current impulses that are taking place in the brain,as opposed to the channels for directing those impulses that are captured bythe ‘‘map.’’ How the behavior resulting from that set of current impulsesplays out in particular instances may feed back over time to gradually adjustthe map by restructuring the underlying physical relationships, but in theshort run, the model is bounded by the map. This dynamic feedback processis the ‘‘adaptive’’ part of the ‘‘adaptive classifying system’’ framework ofMcQuade and Butos.

More interestingly, Hayek (1952, p. 120) argues that the model ‘‘will thuscontinually tend to run ahead of the actual situation.’’ Because the modelframes the current situation in which the organism finds itself, based on thehistorical relationships embedded in the map, the model is essentially‘‘predictive’’ in that it can be used to anticipate the result of various actionsthe organism might take.2 The classification process that is the mind islargely one that classifies by function in the sense that it classifies by thelikely consequences that any set of stimuli will jointly produce. As a result,mental processes are very much processes of expectation:

The representation of the existing situation in fact cannot be separated from, and has no

significance apart from, the representation of the consequences to which it is likely to

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lead. Even on a pre-conscious level the organism must live as much in a world of

expectation as in a world of ‘‘fact,’’ and most responses to a given stimulus are probably

determined only via fairly complex processes of ‘‘trying out’’ on the model the effects to

be expected from alternative courses of action. The reaction to a stimulus thus frequently

implies an anticipation of the consequences to be expected from it. (Hayek, 1952, p. 121)

In summary, Hayek’s theory of mind suggests two important implicationsfor our analogy to capital. First, mind is a structure where the importance ofany element of that structure can only be understood in terms of itsrelationships to other elements of the structure, and where the said structurecan only emerge if the said elements have particular sorts of relationships.The mind is a network of such connections. Second, those more or less staticnetworks of neural relationships enable the organism to create a moredynamic model of its environment, where that model is constrained by thesemi-permanent network (what Hayek calls the map) but is essentiallyexpectational in that its representation of the current environment is theresult of having ‘‘tried out’’ various possible action-consequence combina-tions. Consciousness of the moment, for Hayek, is therefore a world ofexpectations not a world of ‘‘experienced facts.’’

This brief summary of Hayek’s theory cannot do it real justice. Thepurpose was to highlight those parts that seem most relevant to the analogyto capital theory.

IS CAPITAL AN ADAPTIVE CLASSIFYING SYSTEM?

McQuade and Butos (2005, pp. 338–340) identify three elements necessaryto be able to identify a phenomenon as an ‘‘adaptive classifying system.’’These elements are generalizations of features of Hayek’s description of themind found in The Sensory Order. After summarizing these, I will identifytheir analogues in the capital structure and then explore some furtheranalogies between mind and capital.

The first element McQuade and Butos identify is that the structured ofany adaptive classifying system ‘‘must implement an adaptive map.’’ Thegeneralized conception of the map is as a semi-permanent set of features thatprovide the system with ‘‘general integrity’’ and order as well as‘‘conforming it to the external environment.’’ At the same time, it mustalso be ‘‘adaptive’’ in the sense of having ‘‘reactive components’’ that acceptexternal stimuli and are connected to other components of the map suchthat the map can change as a result of this in-system activity: ‘‘The structure

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of the system is, therefore, mutable, and is conditioned by its experience’’(McQuade & Butos, 2005, p. 339).

Secondly, the activity defined by the map ‘‘must implement anexpectational model.’’ In abstract terms, the model must derive from theway in which ongoing stimuli affect the map and must also be ‘‘capable ofinducing responses on the environment consistent with the current map,responses which may, in some cases, anticipate events’’ (McQuade & Butos,2005, p. 339). The model is the ‘‘forward-looking’’ component of theadaptive classifying system in that the model, at any point in time, mightlead the system to react to current stimuli by anticipating further stimulibased on a past connection between the current stimuli and the anticipatedones. The model is the way in which the semi-permanent features of the mapenable the system to interact with the external world.

Finally, McQuade and Butos (2005) posit that ‘‘the reactive componentsof the system must be sufficiently interconnected to support the ability of thesystem as a whole to classify stimuli’’ (2005, p. 339). How any given externalstimulus changes the patterns of transmission across the system is both‘‘what is being classified and the results of the classification process’’ (p. 339).Changes in the external environment that impact the system at any point canonly be classified if the point of impact is ‘‘sufficiently interconnected’’ withthe rest of the system such that system-wide classificatory processes can beinvoked. Classification is a property of the system as a whole, thus the systemmust be sufficiently ‘‘tight’’ in order for external stimuli that impact it at anypoint to be classified effectively. They also note that the very interconnect-edness of the system ensures that if one part of the system is damaged, it willlead to the system relearning in ways that enable it to continue classifying but‘‘that work around the injury’’ (p. 340).

The capital structure, as described by Hayek and the Austrians, has thenecessary elements to be seen as an adaptive classifying system. The ‘‘map’’aspect of the capital structure can be seen as actual capital goods and thephysical production possibilities frontier they represent. In the easier case ofmachinery, this would be the physical, engineering capabilities of aparticular machine. For human capital, it would be the capabilitiesrepresented by the skills, experience, and knowledge of the person inquestion. For more abstract notions of capital, other notions of the ‘‘limitsof its capabilities’’ could be articulated. Clearly the array of ‘‘physicalpossibilities’’ of capital represent a kind of ‘‘semi-permanent’’ set of featuresthat both relate to the external environment of the capital structure andprovide it with general integrity. These possibilities represent the contours ofthe possible. They are also, however, mutable in response to changes from

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incoming stimuli. A historical inventory of the capital structure of theUS economy would illustrate the slow but steady changes that haveoccurred. Those changes result from the impact of external stimuli, in theform of market signals such as prices, profits, and losses, that feed back toenterpreneurs who then make decisions about what sorts of items willcomprise their own capital stock, and, through emergent processes, that ofthe economy as a whole. Again, the analogy to the map here is set of thingswe call capital as understood as a set of physical, biological, or mentalcapacities with objective limits. Changes in the physical stock of capitalrepresent changes in the ‘‘map.’’

The analogue to the model is the current array of uses to which thosecapital goods are being put, i.e., from among all the possible things the stockof capital could be producing, to what uses are capital goods being put at themoment? As noted above, the plans of entrepreneurs are ‘‘forward-loooking’’ in that the combinations of complementary capital that theyconstruct are based on their expectation that the particular combination willbe the most profitable from among those that are objectively possible basedon the capabilities of the capital items. The value of capital goods is derivedfrom expectations about the value of the output they will produce. In thisway, the capital stock at any point in time is an ‘‘expectational model’’ thatis based on ‘‘the effects of current stimuli on the map.’’ As market signalsimpinge on the current plans of entrepreneurs, they are led to reshuffle theircapital combinations in response to those ‘‘stimuli.’’ Like the generalizednotion of model outlined above, current stimuli may lead to anticipatoryreactions based on past connections between those stimuli and theanticipated ones. Owners of capital make use of historical and time-sliceinformation to assist in their adjustments. Routinized behavior has becomepart and parcel of recent work on the firm.3

McQuade and Butos (2005, p. 339) also note that the ‘‘overall patterninduced by a particular and concurrent stimuli is characteristic not only ofitself, but of what else is sensed by the system at the same time.’’ This is trueof the current uses to which capital is being put. If the owner of a capitalcombination is suffering losses, it will suggest the need for reshuffling thecombination. In deciding what new combination to make use of (and willthus determine the ‘‘overall pattern’’), the owner must pay attention notonly to the signals directly affecting his capital goods but those affectingothers as well (‘‘what is sensed by the system at the same time’’). Theeventual pattern of capital uses that emerges from this decision-makingprocess will reflect the owner having scanned the whole system for the effectsof other stimuli. Thus the pattern of capital uses at any moment is the result

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of the way in which specific stimuli (price changes) are related to othersimilar stimuli being sensed by the system at the same time. The model/pattern of capital uses at any one point in time is a consequence of decisionsthat are based on the ability of the capital stock as a whole to register andclassify the effects of stimuli at any point in the structure in a way that isusable system-wide. Entrepreneurial reshuffling, and the ‘‘substitutability’’of capital, represent the ‘‘activity within the system’’ that lead to a new set ofcapital combinations, which is the ‘‘model’’ of the adaptive classifyingsystem known as the capital structure.

It should be clear from this discussion that the third element ofan adaptive classifying system is present here as well. The ‘‘reactivecomponents’’ of the capital structure are tightly interconnected in ways thatallow ‘‘the system as a whole to classify stimuli.’’ The reactive componentsin the case of the capital structure are the owners of capital and theinterconnections among them are the price signals provided by the externalcontext of ‘‘the market.’’ Movements in prices induce reshuffling of thecurrent uses of capital in the short run (the model) and in the long runthose changes will affect the kinds of items that comprise the capital stock(the map). As noted in the previous paragraph, movements in price at anyone part of the capital structure will be transmitted system-wide, whichallows the system as a whole to classify those new stimuli, leading in turn to anew pattern of responses. The classification of these stimuli in the formof changes in the uses of capital (or the stock of capital in the long run)are indeed reflections of the ‘‘system’s knowledge of its environment’’(McQuade & Butos, 2005, p. 340). Finally, damage to one part of the capitalstructure will certainly reduce the system’s ability to classify and generatebetter response patterns to price inputs in the immediate run, but the signalsgenerated by the damage and the attempts to work around it in the short runwill lead to ‘‘relearning’’ and reconstruction of the map (i.e., the creation ofnew capital). For example, in the immediate aftermath of the capitaldestruction of Hurricane Katrina on the US Gulf Coast, existing capital wasrepurposed for new uses (i.e., adjustments in the model) and new, often lowerquality, capital was brought into being (i.e., adjustments in the map).4 As thecapital structure as a system operates in the external environment of themarket, the key interconnectedness within that structure are the prices ofcapital goods and the profit and loss signals they produce. The inter-connectedness of those signals ensure effective classification and reactivity.

The capital structure would therefore appear to qualify as an ‘‘adaptiveclassification system’’ by the criteria laid out by McQuade and Butos. It isimportant, if obvious, to note that their generalization of the argument of

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The Sensory Order offers no insight into whether Hayek himself saw theseconnections explicitly. However, the fact that the insights of The SensoryOrder can be generalized and then reapplied in ways consistent with Hayek’sthinking is certainly suggestive that he was ‘‘on to something.’’ In a latersection, I offer some textual evidence to support that he did indeed see theanalogies we have been exploring.

FURTHER ANALOGIES BETWEEN MIND

AND CAPITAL

Seeing capital as an instance of an adaptive classifying system as generalizedfrom Hayek’s theory of mind enables us to explore a few other analogiesbetween mind and capital.

Multiple Classification and Multiple Specificity

One such analogy is found in the concepts of ‘‘multiple classification’’ and‘‘multiple specificity.’’ In the same way that multiple specificity describes theability of any given piece of capital to be used to produce a variety (althoughless than an infinite variety) of outputs, Hayek’s description of the multipleclassification process of the mental order refers to the ways in which anygiven stimulus can lead to a variety of possible responses. In both cases, therelationship between the capital/stimulus and the output/response is not alinear one. That relationship depends on the other capital/stimuli that work/appear jointly with the good/stimulus in question. Hayek’s description ofthe ‘‘model’’ as ‘‘trying out’’ various possible responses and selecting the onethat is best can be seen as the mind sorting out how the particularcombination of stimuli it is processing are best understood. As with Feser’sorange example, the same stimulus can fall into various categories, andtrying to determine which categories which stimuli fit into and how best toclassify the particular combination of stimuli that appear at any given timeis the sort of multiple classification that Hayek is referring to.

In his discussion of capital mobility, Hayek (1941, p. 328) writes in a waythat suggests the parallel to the mind:

The problem of mobility becomes, however, still more complex by the fact that, in view of

the extremely intricate relationships of complementarity between different capital goods, it

is practically impossible to speak of the mobility of a particular capital good in isolation.

What effect any particular sort of change will have on its value will always depend not

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only on the alternative uses to which it can be turned, but also on the degree of mobility of

the other resources with which it might co-operate in its former and in its alternative uses.

Just as the value that capital goods will produce will depend upon therelationship between their alternative uses and those of the capital goodscomplementary to them, so does the way in which any sensory stimulus isclassified depend on the context of other stimuli it comes with. Similarly,Lachmann (1956, p. 58) writes of capital as ‘‘nodal points’’ in the move frominputs to outputs and points out that the same capital good can generatevery different flows of value in different situations.

The capital-theoretic ideas of complementarity and capital combinationsappear to translate fairly straight-forwardly to Hayek’s work on the mind.The vision of capital that emerges from the Austrian approach is one thatemphasizes the way in which heterogenous resources are combined intoproduction plans by entrepreneurs. These plans are integrated by the verycomplementarity of the elements envisioned by the entrepreneur, and theimportance of any one element of that plan depends upon its place withinthe entire structure. The very same input will take on a different importancein different contexts. The multiple specificity of inputs means that owners ofcapital often engage in multiple classification as they respond to marketsignals by considering alternative uses of specific capital and alternativecombinations of capital that might generate profits.

Structure

The most obvious way in which Hayek’s view of mind as the way in which anorganism orders the external world bears a resemblance to capital theory isits similarity to Lachmann’s insistence on viewing capital as a structure. Theopening chapter of his 1956 book is titled ‘‘The Order of Capital.’’ Early onin the argument, he rejects the notion of capital as either a flow of income oras a ‘‘stock’’ of material goods. Much as Hayek argues that minds ‘‘order’’the physical world for organisms, the order of capital is part of ‘‘the complexinteraction of economic forces from which the entrepreneur takes hisorientation’’ (Lachmann, 1956, p. 4). More specifically, as I noted at theoutset, Lachmann (p. 4) argues that the purpose of the book is to study thechanges which this network of capital relationships, within firms andbetween firms, undergoes as the result of unexpected change.

To this end we must regard the ‘‘stock of capital’’ not as a homogenous aggregate but as

a structural pattern. The Theory of Capital is, in the last resort, the morpohology of the

forms which this pattern assumes in a changing world.

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In the same way that Hayek’s definition of an ‘‘order’’ included not justthe presence of various elements, but that those elements have certainrelationships with each other, so does Lachmann’s use of ‘‘morphology’’ indescribing the order of capital suggest that it is not just the ‘‘counting’’ ofinputs that makes a capital structure, but that those inputs stand inparticular relationships to each other, i.e., they comprise a ‘‘structuralpattern.’’ Lachmann (1956, p. 59), in fact, defines structure precisely thisway: ‘‘A structure is a complex of relationships which exhibit a coherentpattern. The relationships exist between entities. It is probable that whenthese entities undergo change, so will the relationship between them:probable but not necessary.’’

Though he places less emphasis on it than Lachmann did later, this notionof capital as a structure is also present in Hayek’s The Pure Theory ofCapital. The second paragraph of the book claims that ‘‘the central aim ofthis study is to make a systematic survey of the interrelations between thedifferent parts of the material structure of the process of production, and theway it will adapt itself to changing conditions’’ (Hayek, 1941, p. 3). Heelaborates a few pages later (p. 6):

The problems that are raised by any attempt to analyze the dynamics of production are

mainly problems connected with the interrelationships between the different parts of the

elaborate structure of productive equipment which man has built to serve his

needs . . . The fact that this stock of capital is not an amorphous mass but possesses a

definite structure, that it is organised in a definite way, and that its composition of

essentially different items is much more important than its aggregate ‘‘quantity,’’ was

systematically disregarded . . . [S]uch hints [about the integration of capital] were not

followed up by a careful analysis of the way in which the different parts were made to fit

together.

Capital for Hayek, like his later theory of mind, was a matter ofexplaining a structure or an orderly pattern of events, where the individualevents stood in particular relationships to each other such that thecombination of events and their relationships produced the observedpattern. The recurrance of the words ‘‘structure,’’ ‘‘order,’’ ‘‘relationships,’’and ‘‘complexity’’ in Hayek’s work on both capital and on mind is highlysuggestive of some linkage between them.

Relational Orders

Deepening that suggestiveness is the idea that these are ‘‘relational orders.’’In the structures of both mind and capital, the importance of any of the

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elements of the order depends upon the relationship between that elementand the other elements. We have seen this in the case of the mental orderwhere the particular response from the organism will depend upon thewhole set of stimuli that impinge on it. Any given stimulus might producevery different results if it is accompanied by different other stimuli. Hayek’swhole discussion of multiple classification explores these issues. In thetheory of capital, this point is one of the most central Austriancontributions. Both Hayek and Lachmann stress the idea that capital mustbe understood as part of an entrepreneurial plan in which the comple-mentarity of those capital inputs is what defines that set of inputs as a‘‘plan.’’ In this way, the term ‘‘plan’’ serves the same purpose for theAustrian theory of capital as the word ‘‘order’’ does for Hayek’s theory ofmind: each captures the coherent and complementary interrelationships ofthe various elements of the capital structure and brain, respectively.

Within Austrian capital theory, there is almost no way to talk about theimportance of any single capital good without seeing it in the context of thecomplementary inputs that comprise the plan of which it is a part. Althoughwe can, analytically, attempt to talk about the marginal product of aparticular capital good, even the good’s marginal product will depend uponthe complementary contributions of the other inputs in the process.Lachmann (1956, p. 3, emphasis in original) argues that:

It is hard to imagine any capital resource which by itself, operated by human labor but

without the use of other capital resources, could turn out any output at all. For most

purposes capital goods have to be used jointly. Complementarity is of the essence of

capital use. But the heterogenous capital resources do not lend themselves to

combination in any arbitrary fashion. For any given number of them only certain

modes of complementarity are technically possible, and only a few of these are

economically significant.

Hayek (1941, pp. 328–329) makes a very similar argument about the‘‘mobility’’ of capital, where he notes that you cannot assess the value ormobility of a good based on its physical attributes such as its individualdurability, rather you have to understand ‘‘the position of the good in thewhole process.’’

DID HAYEK RECOGNIZE THE ANALOGY?

So far, I have avoided the question of whether this analogy is one thatHayek himself recognized. Though published after The Pure Theory ofCapital, the essential argument of The Sensory Order was laid out in a

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student paper of Hayek’s in 1920. So the question of whether Hayekrecognized the analogy is also bound up in the interesting question of whichset of ideas might have been the inspiration for the other, as it seems possibleit could go either or both ways. Although I have not had time to explore thearchives, there is only one mention of this relationship in Hayek’s publishedwork. In an essay he wrote on the occasion of the 25th anniversary of thepublication of The Sensory Order, he (Hayek, 1982, p. 291, emphasis added)notes the essentials of his theory of mind and what might have inspired theframework he brought to it:

Mind thus becomes to me a continuous stream of impulses, the significance of each

and every contribution of which is determined by the place in the pattern of channels

through which they flow within the pattern of all available channels – with newly

arriving afferent impulses, set up by external or internal stimuli, merely diverting

this flow into whatever direction the whole flow is disposed to move. Stimuli and

responses thus become merely input and output of an ongoing process in which the

state of the organism constantly changes from one set of dispositions to interpret and

respond to what is acting upon it and in it, to another set of such dispositions. In my

own mind – perhaps naturally, since not long before I wrote ‘The Sensory Order (1952),

I published the results of many years’ work on ‘‘The Pure Theory of Capital (1941) – I liked

to compare this flow of ‘‘representative’’ neural impulses, largely reflecting the structure of

the world in which the central nervous system lives, to a stock of capital being nourished by

inputs and giving a continuous stream of outputs – only fortunately, the stock of this capital

cannot be used up.

So this is some evidence that the mind-capital analogy is not coincidental,but very much a part of Hayek’s thinking.

IMPLICATIONS FOR THE THEORY OF THE FIRM

Does viewing the capital structure as an analogy to the mind and as aninstance of an adaptive classifying system have any payoff in terms ofunderstanding the social world? I will offer some brief and tentativethoughts on some implications it might have for the theory of the firm. Ingeneral terms, much of the literature in that area in the last few decades hasfocused on the firm as a site of organizational learning. In addition, severalimportant contributors to that line of thought have linked their work to theAustrian theory of capital.5 If the analogy explored in this chapter deepensour understanding of Austrian capital theory, it may well have someimplications for how we understand firms. I will suggest two possibilitiesbelow.

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Adaptive classifying systems are organized learning structures. Clearlythis is true of the mind, and it is true of the capital structure in the sense thatit responds to external stimuli in ways that cause it to adapt and better cometo ‘‘know’’ its environment as the capital structure is responsive to changesin human wants and the objective facts of the world. Thinking of the capitalstructure in this way might help us to deepen our understanding of firms assites of organized learning. First, it is worth asking whether firms areinstances of adaptive classifying systems. If that answer is yes, then we havea fruitful line of inquiry. But even if it is no, there may still be interestinganalogies between the ways in which the brain ‘‘learns’’ and the capitalstructure ‘‘learns’’ and firms ‘‘learn.’’ The focus on ‘‘routines’’ in the firmhas echoes of these other learning systems.

The second possibility is to see within the firm analogies to the ideasbehind the map and the model. Firms need both a map, in the sense of alonger-term, more permanent picture of its overall learning and a model, inthe sense of something that provides more immediate and ‘‘anticipatory’’kinds of feedback as to its relationship to its environment. One might see thebalance sheet and the budget as analogies to the map and model in this way.The balance sheet provides a more stock-oriented sense of the ‘‘semi-permanent’’ state of the firm. It represents the firm’s assets and liabilitiesand in that sense provides the contours of what is possible. The budget isanalogous to the ‘‘model’’ as it provides a way of ‘‘trying out’’ variousoptions for the use of capital and making a decision about which directionto pursue.6 It is ‘‘anticipatory’’ as it is based on the firm’s expectations aboutits actions over the next period of time. Budget models are also a key toolthrough with managers attempt to make decisions about the allocation ofcapital within the firm. Over the shorter run, changes to the budget registerinteractions with the external environment and those ‘‘stimuli’’ may wellaffect the balance sheet over time, in much the same way as the model-maprelationship in adaptive classifying systems. As the predictive accuracy ofthe budget model is born out by market responses, there will be feedback tothe firm’s balance sheet as it may need to recalculate the value of variousassets in light of these market results. If the budget model was accurate, thenthe balance sheet may need little reworking as current estimates of the valueof capital remain largely valid. However, if the market results differsignificantly from what was anticipated, then revaluation of the balancesheet and, by implication, capital, may be necessary.

These implications for the theory of the firm are, again, very speculative,but might well prove to be fruitful lines of inquiry.

STEVEN HORWITZ162

CONCLUSION: MIND, CAPITAL, AND

METHODOLOGICAL DUALISM

One crucial difference between the structure of capital and the structure ofthe mental order is that the former, at least to some degree, is the result ofhuman intentionality, while the latter, being the very source of humanintentionality, is not. Clearly, each individual entrepreneurial combinationof capital is the product of human design. The entrepreneur mustconsciously and intentionally create a plan for the use of resources thatintegrates complementary capital goods. This is what Lachmann (1956,p. 54) calls the ‘‘plan complementarity’’ of capital. It is both subjective (i.e.,the complementarity is in the eye of the entrepreneur) and the result ofintentional human action. He distinguishes this from ‘‘structural comple-mentarity,’’ which refers to the way in which the various plan-embeddedcapital goods fit together across the whole economy. Structural comple-mentary is not subjective in the same sense, and it is an emergentphenomenon. It is ‘‘objective,’’ or perhaps ‘‘inter-subjective,’’ in that it is afeature of the structure itself, not the subjectively perceived plan of theentrepreneur. Structural complementarity emerges because it is the task ofthe market to ensure that the whole variety of complementary capitalcombinations embedded in entrepreneurial plans are themselves integratedinto an overall capital structure that is highly complementary. Thatintegrated structure of complementarity comes about ‘‘indirectly’’ throughthe market rather than directly by the entrepreneur.

The mental order is, as noted above, more akin to structuralcomplementarity as it emerges in an unplanned way through the physicalprocesses of the brain. The brain, like the market, contains feedbackprocesses that indirectly turn individual events into a more or less integratedstructure. Much as the biological processes of the brain lead to the emergentphenomena of the mind and consciousness, so do the individual capital-using plans of entrepreneurs get translated via the market into the emergentphenomenon of a more or less integrated capital structure.7 What drives theanalogy between the mental and capital structures is the notion ofspontaneous order (and, as argued here, the idea that both are adaptiveclassifying systems). Both structures are complex, emergent phenomena.In the case of capital, the spontaneous order is a human one, emerging fromhuman action but not human design. With the mind, it is a spontaneousorder in nature, akin to the structuring of crystals that Polanyi (1958,p. 43ff) discusses. In both cases, however, there are feedback processes that

Analogous Models of Complexity 163

enable the interaction of individual elements to produce complexity that isof an order of magnitude greater than could be produced by any individualelement.

Recalling that capital is a social phenomenon while mind is, ultimately, anatural one returns us to Caldwell’s intepretation of Hayek’s ‘‘shift’’ fromthe dualist conception of the social and natural sciences to the continuum ofsimple and complex phenomena. It is worth noting, as Koppl (this volume)argues, that this shift need not imply a rejection of the methodologicaldualism that underlies the social/natural science distinction. One can,conceivably, make important distinctions between simple and complexphenomena and how to study them while still believing that natural andsocial phenomena, whether simple or complex, should be approached verydifferently. Rather than one distinction replacing the other, we might have a2� 2 matrix of different possibilities, with natural-social along one axis andsimple-complex along the other (Koppl, this volume).

The case at hand illustrates the need for these sorts of distinctions. Capitalis a social phenomenon and needs to be studied using the methodsappropriate to the study of human phenomena. The whole subjectivistapproach associated with Austrian economics is appropriate for such study.The mind, by contrast, being rooted in, but not reducible to, the physicalprocesses of the brain is, ultimately, a product of nature and should bestudied as such. The methods appropriate to the natural sciences are thoserequired to understand the emergence of the mind. Recognizing that bothcapital and mind are adaptive classifying systems only means that we musttreat them as complex phenomena; it, by itself, says nothing about where eachsits on the natural-social continuum.

Approaching capital and mind using different methodologies is appro-priate even though both are complex phenomena in Hayek’s sense of theterm. The fact that both are complex phenomena does suggest that we mightwish to bring similar analytical frameworks for studying both (e.g., viewingthem as adaptive classifying systems), but it does not replace or override thenatural/social distinction in guiding us how to proceed in doing the actualwork. Recognizing that human intentionality undergirds the emergence ofthe structure of capital implies the appropriateness of the use of subjectivistmethodologies that can start explanations with those intentions, while thephysical interactions that comprise the mental order of necessity eliminatereferences to human intentionality. So, as Koppl argues, rather thanreplacing the natural-social distinction, the simple-complex continuumoverlays it in important ways.

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The argument I have presented is largely, though not completely, anargument by ‘‘suggestion.’’ The analogy between Hayek’s theory of mindand the Austrian theory of capital is, I believe, a very strong one, especiallywhen both are viewed as examples of adaptive classifying systems. My claimhas been only that such an analogy exists and that it is fruitful enough toexplore in more detail. The suggestiveness of the mind-capital analogy fits inwith broader interpretations of Hayek’s work. The most fundamentalcharacteristic shared by the mental order and the capital structure is thatthey are complex phenomena in the way Hayek uses that phrase. It is notsurprising that these analogous modes of thought would be seen in Hayek’swork in the 1940s and 1950s, because, as Caldwell (2004) argues, he wasbeginning to distinguish between simple and complex phenomena ratherthan focusing on the natural/social distinction. And the one piece of textualevidence we have suggests that the parallels between mind and capital werenot accidental. However, the analogies between capital and mind end, as allanalogies must at some point, when we recognize that one is a socialphenomenon and one is a natural phenomenon and that, despite theirsimilarities, they would appear to call for differing methodologicalapproaches in attempting to study them. Thus, this specific analogy notonly allows us to see how Hayek’s shift in emphasis toward complexphenomena was put into motion, it also reminds us that such a shift doesnot obliterate the distinction between social scientific and natural scientificphenomena.

NOTES

1. As Koppl (this volume) argues, the switch to the simple/complex continuumneed not substitute for the natural/social science continuum, but might wellcomplement or supplement it. I shall return to these issues later in the chapter.2. Rather than ‘‘re-present’’ it might be more accurate to say that the model

‘‘pre-presents’’ the current environment.3. See Nelson and Winter (1982) for the origins of this work.4. Examples of the former include the ways in which existing buildings that had

little or no damage were used for new purposes and examples of the latter wouldinclude the construction of tents or other temporary structures to replace damagedbuildings.5. See the pioneering contributions of Penrose (1959) and Richardson (1972). On

the links to Austrian capital theory, see Lewin (1999), Sautet (2000), and Foss andIshikawa (2007).6. See Lewin (1998) for more on the firm, budgets, and the discovery process of

the market.

Analogous Models of Complexity 165

7. The philosopher John Searle (1998, p. 112ff ) makes a parallel argument about‘‘social meaning’’ as an emergent phenomenon. Like the complementarity seen in thecapital structure as a whole, the meanings that institutions or objects take on in asociety are not the results of anyone’s intention. They are emergent. Individuals canengage in acts of ‘‘intentionality’’ but social meaning is trans-individual.

ACKNOWLEDGEMENT

Earlier versions of this chapter were presented at the Southern EconomicAssociation in 2004 and in 2005 at ‘‘The Austrian School of Economics: AnInternational Conference’’ sponsored by the Wirth Institute for Austrianand Central European Studies. I thank participants at both conferences forcomments. I also deeply thank an anonymous referee for the extremelyhelpful suggestion of using ‘‘adaptive classifying systems’’ as an overarchingframework. Work on this chapter was also completed while I was a VisitingScholar at the Social Philosophy and Policy Center at Bowling Green StateUniversity.

REFERENCES

Caldwell, B. (2004). Hayek’s challenge. Chicago: University of Chicago Press.

Feser, E. (1999). Hayek’s solution to the mind-body problem (http://www.hayekcenter.org/

friedrichhayek/feserseminar.html).

Foss, N. J., & Ishikawa, I. (2007). Towards a dynamic resource-based view: Insights from

Austrian capital and entrepreneurship theory. Organization Studies, 28, 749–772.

Hayek, F. A. (1941). The pure theory of capital. Chicago: University of Chicago Press.

Hayek, F. A. (1952). The sensory order. Chicago: University of Chicago Press.

Hayek, F. A. (1967). Notes on the evolution of systems of rules of conduct. Reprinted in Studies in

Philosophy, Politics, and Economics. Chicago: University of Chicago Press.

Hayek, F. A. (1982). The sensory order after 25 years. In: B. W. Walter & S. P. David (Eds),

Cognition and thee symbolic processes (Vol. 2). Hillsdale, NJ: Lawrence Erlbaum

Associates.

Kirzner, I. (1966). An essay on capital. New York: Augustus M. Kelley.

Koppl, R. (Ed.). (this volume). Scientific hermeneutics: A tale of two hayeks. In: Advances in

Austrian Economics (Vol. 11). Bingley, UK: Emerald Group Publishing Limited.

Lachmann, L. M. (1956). Capital and its structure. Kansas City: Sheed Andrews and McMeel.

Lewin, P. (1998). The firm, money, and economic calculation: Considering the institutional

nexus of market production. American Journal of Economics and Sociology, 57(October),

499–512.

Lewin, P. (1999). Capital in disequilibrium. New York: Routledge.

McQuade, T., & Butos, W. (2005). The sensory order and other adaptive classifying systems.

Journal of Bioeconomics, 7, 335–358.

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Menger, C. (1981 [1871]). Principles of economics. New York: New York University Press.

Nelson, R., & Winter, S. (1982). An evolutionary theory of economic change. Cambridge, MA:

Belknap Press.

Penrose, E. (1959). The theory of the growth of the firm. Oxford: Oxford University Press.

Polanyi, M. (1958). Personal knowledge: Towards a post-critical philosophy. Chicago: University

of Chicago Press.

Richardson, G. B. (1972). The organization of industry. Economic Journal, 82, 883–896.

Sautet, F. (2000). An entrepreneurial theory of the firm. New York: Routledge.

Searle, J. R. (1998). Mind, language, and society. New York: Basic Books.

THE FIRM IN DISEQUILIBRIUM: A MARKET PROCESS VIEW OF FIRM ORGANIZATION AND STRATEGY

Peter Lewin

ABSTRACT

When understood as an inevitable inconsistency of individual plans, disequilibrium is not only a necessary condition for the existence, and hence understanding, of the market process as we know it, it is also the glue connecting three other ‘‘Austrian’’ themes. In equilibrium hetero­geneity of resources would have no strategic significance, specific and private knowledge would be much less problematic, and no profits net of contractual rent payments would be earned. In the real world of disequilibrium firm differences are not a mystery, rent is not an indication of inefficiency or monopoly power, and there is room to analyze, admire, reward, and consult about successful business strategy. Rent appropria­tion comes from ownership of valuable resources. And a successful strategy, one that earns enhanced rents, is one that acquires ownership of valuable and value-creating resources. Such a strategy is dependent for its success on superior vision (or luck), something which cannot exist in equilibrium.

Explorations in Austrian Economics Advances in Austrian Economics, Volume 11, 167–192 Copyright r 2008 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11009-2

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168 PETER LEWIN

INTRODUCTION

Economists are at long last emerging from the stage in which price competition was all they saw. In capitalist reality . . . it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization . . . competition which . . . strikes . . . existing firms . . . at their foundations and their very lives. This kind of competition is . . . much more effective than the other . . . and [is] . . . the powerful lever that in the long run expands output. (Schumpeter, 1962 [1942], p. 84)

The Firm from a Process Viewpoint

Recent work has focused attention on those aspects of the firm which might be helpful in seeking to understand how modern business organizations arise and function in the market process (see, e.g., the papers in Foss & Klein, 2001; Chiles, Bluedorn, & Gupta, 2007; Foss & Ishikawa, 2007; Foss, Foss, Klein, & Klein, 2005, 2006; Roberts & Eisenhardt, 2003). This chapter seeks to identify and further examine those aspects. An interesting, not widely noted, feature of these contributions is that they can all be seen to derive, directly or indirectly, from the Austrian theory of capital. Austrian capital theory, beginning with Carl Menger, through Eugene von Bo hm-Bawerk, Ludwig von Mises, Friedrich Hayek, Ludwig Lachmann, Murray Rothbard, and Israel Kirzner up to the present, presents us with a distinctive vision of the economic process, from which mainstream economics and other areas of research have, consciously and unconsciously, borrowed (Lewin, 1999). Furthermore, many current works on the theory of the firm, economic organization, and business strategy use ideas that bear a striking (no doubt mostly unconscious) similarity to ideas found in the evolved Austrian capital-theoretic approach. Placing this research in relation to its similarity and connection to Austrian capital theory, and market process theory more generally, may add an interesting perspective, one that will hopefully help to further research in this area.

I have divided these ‘‘Austrian’’ contributions into four related categories which I consider sequentially below, namely, disequilibrium, heterogeneity, knowledge, and rent.

� Disequilibrium is the key. It is an implication that emerges out of a consideration of Hayek’s and Lachmann’s work – closely related to capital theory (Chiles et al., 2007; Foss et al., 2006; Foss & Ishikawa, 2007).

169 The Firm in Disequilibrium

� The heterogeneity of resources, explicit in Austrian capital theory from Menger to Lachmann, is a theme repeated frequently in modern work on economic organization and strategic management. Heterogeneity is relevant only in disequilibrium.1

� Hayek’s insights into the nature of dispersed knowledge in society has proven crucial to the development of many approaches to economic organization. Dispersed knowledge is relevant only in disequilibrium. � Finally, the Austrians have a distinctive view of the concept of rent, aconcept much used (abused) in the theory of the firm and the strategic-management literature. It is related to the problem of appropriation of surplus value, which is an aspect also of value-imputation from Austrian capital theory (first considered in detail by Friederich Wieser). There is an important distinction between rent and profit (Lewin, 1999; Mathews, 2006a, 2006b). Profits are earned only in disequilibrium.

I conclude by attempting to gather the threads into a summary view drawn from these contributions.

We begin with a discussion of disequilibrium.

DISEQUILIBRIUM

The Meaning of Equilibrium

Following the work of F.A. Hayek (1937) equilibrium is here conceived as a situation in which individual knowledge and expectations, and the actions based on these, are compatible with the ‘‘data,’’ where the ‘‘data’’ for one individual include the actions of other individuals. Scratching the surface of any of the alternative definitions that could be offered indeed reveals that it is impossible to think of equilibrium in economics without bringing in the perceptions of individuals (Lewin, 1999, Chapter 2; Lewin, 1997a, 1997b). After all, we are dealing with human actions and these are determined by the perceptions of the actors. So, in the case of the supply and demand of a single well-defined market, the price will not be observed to change when all individuals are fulfilling their mutually related plans to buy and sell, and where such plans are not fulfilled we may expect these plans to be revised. This is widely recognized, though the formal technical treatments of modern economics are often apt to lose sight of it. There is no doubt, however, that Hayek’s insights have been accepted in principle and have been variously endorsed in the literature (Lewin, 1999, pp. 17–18).

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Nevertheless, current economic approaches consider equilibrium not so much as a state of affairs in the world, as an axiom of economic analysis. In using equilibrium in this way, economists are really using it as a synonym for ‘‘rational action,’’ or, more tautologically, for ‘‘purposeful action.’’ Individuals can be seen to be always in equilibrium if one construes the constraints, including the time constraints, widely enough to explain any action as a constrained maximization subject to those constraints. Any action can be explained by reference to the fact that the individual is ‘‘doing the best s/he can’’ given the time available, the knowledge s/he has, the physical and financial resources available, etc. This ‘‘Chicago-School approach’’ is not without its considerable payoffs in deriving many important insights (see Becker, 1992 for a survey). It gives short shrift, however, to an examination of the implications of the differences in knowledge and expectations across individuals that one arguably has to look to in explaining important and sustained differences in economic performance or organization across firms. Subjective values and expecta­tions turn out to be crucial for this. If everyone knew the ‘‘true’’ value of everything, if there were no room for differences in opinion, there would be no market process as we know it. The market process must be the result of this Hayekian disequilibrium; that is, the result of manifest, and inevitable, differences in the perceptions, hence valuations of economic resources. Out of these differences the trial and error process that we call competition emerges, in which the perceptions of most are falsified, at least in part. The question then arises; if we are in a state of perpetual disequilibrium, in which the market process is continually sorting out the more from the less accurate (prescient) perceptions, that is, if we are continually mistaken about things, how is successful action possible at all?

The Individual Plan and the Existence of Social Institutions

The answer (Lewin, 1997a, 1997b, 1999, Chapter 3), lies in unpacking the notion of the individual plan. Examination of the epistemology of the individual plan reveals that it must be based on three different kinds of knowledge (see Table 1) – (1) knowledge of the natural world (facts and ‘‘laws’’ of nature, the law of gravity), (2) knowledge of the social world (people stop at red lights), and (3) knowledge of specific facts and events (his mother is a film star, about which we can all agree; my product will be a best seller, about which we most certainly may not agree). Many (most?) social laws are known tacitly, knowledge about how others are going to act in

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Table 1. Action Depends on Different Type of Interrelated Knowledge.

Type of Knowledge Example Expectations Converge to Equilibrium?

Type 1 – Natural Things are expected to fall when dropped Yes laws

Type 2 – Social laws People stop at red lights Yes Type 3 – Specific His mother is a film star; My product will Often not

facts and events be a big seller

various circumstances. Each individual plan is informed by these three types of knowledge and contains some contingencies. However, the set of contingencies imaginable is strictly limited (bounded rationality) and, in this sense, all plans must be open-ended. The passage of time always brings with it some new knowledge, sometimes important, sometimes trivial, and the experience is never exactly as we imagined it would be in every detail (O’Driscoll & Rizzo, 1996). Plans are also multilayered. We plan at many different levels simultaneously. We plan our commute to and from work every day, we plan our weekly appointments, and we plan for our children’s college opportunities. Every individual has a complex and tacit structure of plans. Obviously some plans are more likely to succeed than others. We hardly stop to notice the success of the majority of our plans. We commute successfully every working day, manage to meet our weekly appointments, etc. We do notice when they are unsuccessful and we are late for work or forget an appointment. That is a situation of plan disappointment, a situation of disequilibrium in which the frustrated plan of one person implies the frustration of all those plans of others which depend on it. Clearly disequilibrium plays an important role in regulating our lives, in reorienting our actions, so that we do not forget the next appointment, or leave home a little earlier in order to make the train.

That most of our ‘‘routine’’ plans do not end in disappointment is due in no small measure to the existence of knowledge types 1 and 2, the latter implying social institutions, designed and spontaneously evolved, that provides a mechanism for coordinating plans. They do so by providing shared categories, like the way we keep time; by providing common rules of conduct, like the way we greet each other or decide who goes through a door first; and in multiple other ways, some only dimly perceived or not perceived at all. The market itself is an evolved social institution with evolved rules, norms, and customs governing individual behavior and so is the business firm. These social institutions rest on shared knowledge that

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condition actions so that people tend to behave much in the way we expect most of the time, thus ensuring that most of our plans are, indeed, coordinated.

We cope with the complexity and change in the world by converging on institutions. For example, once the arrival of a new range of products, made possible by the developments of a new technology, has been digested, new categories of classification tend to be developed, into which these products are grouped. The categories emerge spontaneously out of individual attempts to communicate the attributes of the new products. A good example is the product set associated with the personal computer. A whole range of products exist, whose inner workings remain a mystery to the vast majority of people, but whose purposes need to be explained by way of new categories of performance (the refresh rate on a monitor, the download speed of a wireless connection). Shorthands develop to provide an increasingly informed public with a way to tailor their expectations when choosing between products. They enhance predictability by enhancing the interpretability of information. Of course, these relatively predictable elements change with time and it is no accident that conscious innovation involving product differentiation is often referred to using the phrase ‘‘category killer.’’

Equilibrium within Evolutionary Change

About some things, some specific events, however, there is no predicting. These are the intricate specifics of each historical situation. Plans can never be coordinated in every detail. In that sense we are never in complete equilibrium. Nevertheless, in peaceful, lawful societies behavior is ordered. Hayek, in his later work, spoke less of equilibrium and more of order. The (extended) order of society is the result of the component orders which we call institutions. Many of them are ‘‘spontaneous orders.’’ They represent equilibria of a sort, in that they are states of convergence around which expectations are formed and conform. In this sense, we may say that the social process is composed of equilibrating and disequilibrating sub­processes. Economic growth, the arrival of new and better products and services and better methods of production is the result of unpredictable, disequilibrating processes. There is no overall tendency for expectations to cohere in these particular processes. They are ‘‘non-expectable’’ and thus non-convergent.

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The degree of predictability of any event is related to the extent to which it tends to exhibit repeatable, typical, or recognizable characteristics. Many routine events fall within the ‘‘very predictable’’ range, hence the emergence of ‘‘routines.’’ However, in the realm of the innovative activities of the firm in the market, many events fall very definitely outside of this range. New methods of production, new producer and consumer goods and services, new methods of organization, all embody and depend on new knowledge to a high degree and their emergence is intimately related to, and crucially dependent on, a divergence of expectations, which leads to a variety of implicit experiments. But, for this process to be coherent these experiments must play out within a framework of stable institutions, like the rule or law and property rights, that coordinate the expectations of most other things, so that, for example, peace is maintained and contracts are honored. They constitute the ‘‘rules of the game’’ as it were, even though the outcome of the game itself is intrinsically unpredictable, and must be for a dynamic society. Paradoxically, those societies that are in one sense most dynamically unstable (experience rapid and incessant change) are in another sense the most stable (exhibit stable laws and respected property rights, and customs and norms that condition human behavior in a predictable way). Those societies that experience constructive change are thus those societies best able to peacefully absorb change. This has obvious implications for the economics of transition (for example, North, 2005). Indeed, we may say, therefore, that predictability in one sphere is the

necessary ingredient for coping with its absence (novelty) in another sphere (Loasby, 1994). The amazingly wide range of ever emerging products and the persistent improvement in methods of production, are the results of a multitude of continual experimentations that would be completely out of place in a world of perpetual (Hayekian) equilibrium.2

HETEROGENEITY OF RESOURCES

The Productivity of Roundabout Methods of Production

Carl Menger, the founder of the Austrian School, pointed out that production depends crucially on time. There is a time structure to the pro­duction process as men take the fruits of nature and fashion them into products more useful to their purposes. The first order of goods are consumption goods, second and higher order goods are capital goods which are used to make other capital goods or (ultimately) consumption goods.

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Goods proceed from higher to lower order along a ‘‘supply chain’’ and emerge with time as consumption goods. This observation is hardly novel. Adam Smith, for example, very clearly identifies the need for an accumulation of resources to maintain the workers while the work was in progress (Smith, 1776 [1982], p. 343). Production takes time. Menger affirms that the ‘‘more’’ time it takes the more value will be added; but, this is not only because of natural growth, it is also, and more relevantly, because the more time is available, the more can be learned about how to do things more productively and the greater the division of labor that can be achieved. This is the germ of the idea spelled out in much more detail by Menger’s disciple Eugene von Bo hm-Bawerk in his three-volume work on Capital and Interest (1959) that the more ‘‘roundabout’’ production is, the more productive it is likely to be. Bo hm-Bawerk postulates that wisely chosen roundabout methods of production are more productive than ones of shorter duration.

This postulate is related to the intuitive idea that a higher level of savings leads to a higher level of sustainable consumption for the economy. A larger accumulated fund of savings for sustaining workers over a longer period of time allows for more productive, but more indirect (roundabout), production methods yielding a greater consumption value. So one needs to balance the gains in consumption value against the costs of ‘‘waiting’’ longer for that value, a balance that is captured in the interest rate, which balances impatience (or time preference) against the rewards for waiting. For any set of known productive techniques of equal value the shortest will be chosen; so if one is going to move to a technique which has a longer duration, one, necessarily, will require some compensation for the lengthening of the process unless waiting is irrelevant.

This idea became a hallmark of the Austrian theory of capital, the area of study for which the Austrian school is most renown. It is an idea that is quite intuitive and was expressed by Bo hm-Bawerk in different places in his voluminous work. In the process of capital accumulation, ‘‘lengthening’’ the production process could result in learning and thus an improvement in technology. Capital accumulation and technological change are kept conceptually separate in most modern economic theorizing, but this is a relatively recent development. Clearly Adam Smith saw them as inextricably connected as did Menger (Lewin, 2005). Bo hm-Bawerk considered the capital stock to be composed of heterogeneous items of varying specificity that fitted into a complex mosaic of production in a way not easily understood but clearly influenced by the fruits of the division of labor.

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Changing Technology and the Heterogeneity of Capital

Ludwig Lachmann is the modern Austrian scholar most well known for capital theory. He saw much to admire in Bo hm-Bawerk. He considered his proposition about the productivity of roundabout methods of production to contain an essential insight, one of enduring and underappreciated relevance. But he sought to cast it in a more accessible and defensible form. He considered the whole idea of trying to measure capital or its ‘‘length’’ to be misguided. Instead of thinking about the capital stock we should think about the capital structure. Like Hayek before him, he seems to have been much influenced by the Joseph Schumpeter’s views of the dynamic market process. Like Schumpeter, Lachmann envisages production as a process driven by the entrepreneur who forms new and continually changing capital combinations. Within these combinations the individual capital items (resources)3 stand in complementary relationship to one another. They are joint inputs into the achievement of a production plan in the broadest sense. When the plan fails, in part or in whole, the entrepreneur has to adapt by making substitutions. Thus substitutability and comple­mentarity are not so much attributes of capital resource inputs (as in neoclassical economics with its emphasis on equilibrium) as they are of states of the world. Complementarity is a feature of stability, substitution is a feature of change. Together they describe two aspects of the capital structure (broadly understood), its resilience and its flexibility (Lachmann, 1947, 1978 [1956]).

When substitutions have to be made, the entrepreneur must change the capital combination in a manner constrained by the physical (technical) and institutional constraints. Some resources will have only one use and will be rendered useless by the change. Their value will fall to zero. These, as explained, are completely specific resources. Most resources will have more than one use (they are characterized by multiple specificity). The more adaptable a resource the greater its value in alternative uses. A resource that has to be sold for scrap in the face of change has limited uses, while a resource that can be used in a variety of alternatives (an opera house can be turned into a movie theater) is more resilient.

Economic progress and capital accumulation take the form of an increasing complexity of the capital structure. This is a recasting of Bo hm-Bawerk’s essential truth. Production becomes more roundabout by becoming more complex – the capital structure comes to embody more elements with more complex interactions. In place of, or equivalent to, increasing roundaboutness, we have increasing complexity. Though there is

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no simple way to measure complexity one may plausibly argue that modern scholars will readily understand this assertion. It seems natural then to turn attention to the question of how modern organizations and societies at large develop and cope with increasing complexity in production.

Quantity and Structure

One might say that there exist two broad, and exclusive, approaches to capital theory. The first, tracing from Adam Smith, but more so from Carl Menger, may be thought of as a structural (or compositive) approach. The second, tracing from David Ricardo (1973 [1821]), having been incorporated into most modern economic approaches, may be thought of as a quantitative approach (Lewin, 2005). We have suggested that the former, a legacy of the Austrian tradition, is more relevant to an understanding of the modern business environment.

Consider the relationship between quantities and structures. A structure of things can be described by a list of items that stand in a certain orientation to one another. Complex structures are composed of many items with many possible interactions. A structure as opposed to a list (which could be unmanageably detailed and devoid of meaning) is distinguished by the fact that one can infer properties about the whole list from a description or observation of just a few component (or typical) parts together with an articulation of the principles of interaction. Quantities are formed by aggregating commensurable items. Structures can be aggregated (quantified) if the elements of the structure can be counted (valued) and if their orientation is constant, or, in other words, if substantial redundancy exists in the structure, so that similar principles of interaction are present in many different parts of the structure and these remain constant. Sometimes certain types of interaction are considered irrelevant and are ignored, while the focus is turned to interactions at other levels. If the latter are fixed while the former are irrelevant, aggregation may be facilitated. For example, if differences between firms (their internal structures as described by the interactions of their component parts) are considered to be irrelevant, while the interactions between firms is considered to be describable (hence quantifiable), as in the neoclassical case of perfect competition or monopoly for example, then aggregating firms (or their estimated values) may provide a meaningful conceptual result. However, if such interaction is not describable, when neoclassical perfect competition or monopoly is not a defensible or helpful description, and, by implication, the neglect of

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intra-firm interactions is not defensible, the result will have dubious meaning and relevance.

By recognizing the importance of structure as a phenomenon to be investigated in and of itself, economists could indeed broaden and enhance the value of their investigations. A rich and growing literature on economic organization illustrates the unlimited insights to be mined. A recent example considers the question of interactions at various levels within structures. If interaction patterns are such that they occur more at some levels than at others, we may make use of the phenomenon known as modularity to gain a better understanding of the structure – its behavior and development (see Garud, Kumaraswamy, & Langlois, 2003 for a general treatment). Modularity is a ubiquitous property of many types of structures like electronic systems, biological systems, social systems (like firm hierarchies) and, presumably, capital structures.

Modularity as a Roundabout Method of Production

Taking structure seriously leads to an investigation of principles involved in understanding and designing structures. This refers to both the structure of production itself and the structure of organization for production. Production is a set of activities or tasks that has to be organized (coordinated). It should not be surprising that specific organizational structures are related to the logic of specific production structures. Clearly organizations design production, but, in a less obvious but equally true sense, production designs organizations (Langlois, 2002). The nature of decision-making, information-sharing, design responsibility, etc. must accord with the logic of the structure of the production for the product being produced. The contrast between the vertically integrated production organizations of the 1920s and the largely decentralized organizations of the digital age has much to do with considerations of this nature. Modularity is a helpful concept in this context. Much depends on what capabilities are available already in the market and can be purchased (already modularized-providing external knowledge economies) and what has to be produced internally because new capabilities are called for. So the degree of vertical integration may change with circumstances as these considerations vary over time and space (Langlois & Robertson, 1995).

Modularity is implied by decomposability. A system is (wholly or partially, nearly) decomposable if the inner components of the subsystem interact exclusively (or almost exclusively) with each other and not at all

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(or very little) with components outside of the subsystem. In other words, interaction is encapsulated or modularized. In social systems interaction is a matter of coordination of actions. ‘‘The basic idea of coordination is simple; the effectiveness of one activity depends on what other and related activities are being performed and how . . . a central principle of organizational design is to divide the work among components in such a way as to minimize needs for coordination’’ (Simon & Augier, 2003, p. 40). Modularization is a way to do this. So, in the first instance, we may say that modularization is a way of dealing with complexity in the performing of production tasks by economizing on the need for communication, a way of economizing on information.

Clearly, this is an aspect of the division of labor. Productive resources are organized (internally or in the market) into modules that specialize in the performance of certain necessary tasks. But insofar as the module is self-contained, and can be replaced easily with a similar one without disrupting the entire production project, the knowledge required by those performing tasks in other modules need not include any knowledge about the workings of the one being substituted. Indeed each module needs knowledge pertinent only to its own set of specialized tasks, plus a minimum of knowledge necessary to allow it to connect to other modules in the structure. Each structure is thus describable as an architecture of (many or few) modules that interface according to a given standard. So the use of modularization is a way of economizing on knowledge by effecting a division of knowledge (Hayek, 1945), a theme we shall return to later. In terms of, and augmenting, Lachmann’s capital-theoretic framework, a module is a specialized combination of heterogeneous, complementary capital resources. A module is a synergistically specific component of the capital structure.

But modularity is more than this. Modularization provides the firm or the market with dynamic capabilities (Teece, Pisano, & Shuen, 1997). In the absence of change (equilibrium) modularization would not be necessary. The system architecture once in place need not be changed. Individual components can simply be replaced by identical substitutes when necessary. There is no vulnerability or need for redundancy. Stability is inherent in a static environment. In a dynamic system, however, one in which changes in technology are sought after and require continual upgrades to various parts of the system, modularity is crucial. This is perhaps the starkest shortcoming of a static neoclassical perspective on the firm. The modern firm is not simply an allocator of known resources possessing known capabilities in order to maximize shareholder value. In the modern economy the firm must actively plan for, and design its organization to accommodate and aggressively

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achieve continuing changes in production methods, organization, product design and quality, new products, etc. ‘‘The potential for technological change is enhanced when modules are independently upgradeable and can be designed to be so. [Also] modularity improves adaptability and reduces the risks of rapid obsolescence’’ (Garud & Kumaraswamy, 2003, p. 49). A prototypical example is the use of ‘‘object oriented programming’’ in software product design, where subcomponents of a program are designed as separate stand-alone ‘‘objects’’ that can be separately upgraded over time. This is both an example of, and a metaphor for, modularity more generally (Baetjer, 1998). But these benefits come at a price!

Designing a system upfront to be modular is more difficult and takes more resources than simply designing the system to achieve the immediate tasks at hand, ignoring the need for future adaptation and change. In this sense we may consider it a species of Bo hm-Bawerk’s more roundabout production and of Lachmann’s progressively more complex evolving capital structure.

Of course modularity is not always a result of conscious design. Modularity is also, perhaps even more so, a characteristic of spontaneously evolved systems like markets. And design and evolution interact insofar as more resilient designs tend to survive the competition of the marketplace where those that survive are often more complex and roundabout.

Firm Differences and the Economics of Organization are Related to Heterogeneity

Aggregation of the capital stock is a condition necessary for doing modern neoclassical growth economics, in order to account at an aggregate level for the contributions of the various categories of productive inputs to economic growth. But in order to arrive at such an aggregation one must forego investigation into the morphology of the capital structure. The neoclassical theory of the firm is thus not really a theory of the firm, but rather a theory of industry structure, in which there are no real firms. The inner workings of the firm are assumed away (as explained earlier). In fact, the neoclassical industry, and, indeed, the whole economy, can be described as a remarkably simply modular productive structure. Each firm is identical and produces a common homogeneous output, using combinations of individually homo­geneous resources (land labor and capital), employed in identical constant­returns-to-scale production functions. Each firm constitutes an identical, and redundant, production module. Any level of the economy, firm,

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industry, and economy, looks identical except for size. The ‘‘aggregate’’ production function is a mere ‘‘blow up’’ of the individual micro production functions. There is no room for the consideration of organizational structure – actions and decisions are subsumed away. Many strands of modern economic and strategic-management thought have sought to remedy this shortcoming in one way or another. Lachmann’s approach invites application to an examination of the firm as a living economic organization in the spirit of much of this work. Heterogeneity, and the complementarity and multiple specificity that it

implies, are relevant only in conditions of disequilibrium. In equilibrium where no unexpected changes occur the capital structure will be perfectly sustainable requiring no changes. In this way, heterogeneity and change are intimately related. In fact, only if ex ante values (as seen by someone in the market) turn out to be different from ex post values, will heterogeneity matter. ‘‘Matter’’ in this context relates to the question of strategic behavior, including organizational design, by decision-makers in the production process broadly understood. If the values of all resources always turn out as expected, their heterogeneity would have no strategic significance. No decision maker would be able to discover a way to combine known or newly created resources in a manner that conferred a competitive advantage to her or him. But in the absence of equilibrium, the heterogeneous nature of resources significantly reflects the fallible decisions of the past as well as the possibilities and constraints of the future. And that is why firms are different, and that is why there is room for strategic action.4 Heterogeneous resources give rise to differing expectations of their worth as conceived in various possible capital combinations. Those expectations that turn out to be correct give rise to profits. So, in a fundamental sense, it is the heterogeneity of expectations, that matters more than the heterogeneity of resources as such.

KNOWLEDGE

Knowledge is Tacit and Dispersed

Hayek published what is perhaps his most famous journal article in 1945 (Hayek, 1945). This much-cited article has elicited many interpretations and applications. It arose out of the Socialist-Calculation-Debate of the 1930s. Two key ideas relevant to the economics of organization are dispersed knowledge and tacit knowledge. Hayek asserts that the totality of

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knowledge used by a modern market economy is far beyond anything that could be perceived by a single human mind or even a central-planning­committee of minds. This is true because of the very nature of knowledge. Knowledge is necessarily widely dispersed across the individuals of the economy. There is a necessary division of knowledge that underlies the complex division of labor in the economy. The impossibility of centralizing knowledge is the result of more than the computational difficulties of centralizing decentralized information (data). Information requires inter­pretation to be useful as knowledge, and to accurately and usefully interpret information collected from local sources, out of context, is impossible. Individuals, pursuing their everyday specialties, make use of the special ‘‘knowledge of the particular circumstances of time and place,’’ knowledge acquired painstakingly, over extended time, often unconsciously. That is, much of this knowledge is tacit knowledge, knowledge of which we are not (or not completely) aware (Polanyi, 1974). Tacit knowledge is knowledge that we have about how to do things (like riding a bicycle) that is not knowledge we can articulate in any useful detail (you cannot provide the instructions about how to ride a bicycle to someone who wants to learn how). In addition, in the absence of a market, and therefore a market process, most of this knowledge, acquired in the pursuit of commercial goals, would simply not exist. Suppressing the market would suppress the generation of productive knowledge.

All kinds of centralized direction suffer to some extent from these problems. The centrally directed economy suffers the most, but regulation of all kinds must solve this Hayekian ‘‘knowledge problem.’’ And the business firm is no exception. Every firm faces a mini-knowledge problem (Minkler, 1993).

The Firm and the Knowledge Problem

There is a large and ever-growing literature on this problem of managing knowledge that is drawn, directly or indirectly, from Hayek’s insights. They are, in the first instance, concerned with appropriate incentive-alignment; trying to ensure that those who have control over resources have the incentive to use them in the interest of the resource owners (the firm). Making the most important (indispensable, specific) member of the team ‘‘the owner’’ (residual claimant) is one way of trying to do this (Klein, Alchian, & Crawford, 1978). Jensen and Meckling (1992) pay careful attention to decision-rights and the rights to alienate those decision-rights.

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As Richard Langlois explains, granting alienability is a form of modular­ization more extensive than the granting only of control ‘‘since the owner with alienability needs to engage in less explicit coordination with others to use the asset effectively under all circumstances . . . it is alienability that solves both the problem of knowledge decentralization and the problem of incentives: the asset may be placed under the control of the person whose knowledge best equips him or her to use it, and alienability disciplines the owner’s use of the asset by making its value (to which the owner has a residual claim) measurable on a market’’ (Langlois, 2002, p. 37). There is also a whole other level of the Hayekian knowledge problem

concerned not only with knowledge management, but also with knowledge development. Knowledge assets, in one form or another, are vital to the competitive performance of firms. And knowledge is an ever-changing phenomenon. Firms in the knowledge economy have to manage not only to use their knowledge and other resources correctly, they have also to manage in such a way as to encourage the continual profitable development of new knowledge. The problem extends beyond allocation to ‘‘discovery.’’ Hayek argued that competition should be seen as a ‘‘discovery process’’ (Hayek, 1978) and much of what firms do to remain competitive is to discover knowledge of how better to produce goods and how to produce better goods. There is an inextricable research element involved in production. The problem of organizational design must consider then how best to organize production not only to align incentives for appropriate resource usage but also for appropriate resource development and creation, that is, for learning (Nonaka & Takaeuchi, 1995). New knowledge obviously cannot be had before its time, its fruits cannot be predicted, so the revenues attributable to knowledge-creating assets must be extremely uncertain. There is ample room for different assessments and outcomes. In the event, valuable knowledge is unlikely to be distributed evenly across competitors, so resource heterogeneity is hardly a mystery or a rare event in this (disequilibrium) framework.

Having developed knowledge assets, firms need to consider how best to protect them from alienation by others, and how best to replicate them internally for purposes of growing (Liebeskind, 1996; Winter, 1995). Competitive advantage derives fundamentally from resource heterogeneity. As explained in the previous section, resource heterogeneity derives from the nature of knowledge and the expectations to which it gives rise (as distinct from physical heterogeneity). Firms do things differently and do different things because they have developed the knowledge (much of it tacit) to do it ‘‘their way.’’ Knowledge is not simply replicable across individuals and

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organizations. Much of it becomes embodied in routines that withstand the test of time and competition (Nelson & Winter, 1982). Further, there is inescapable causal ambiguity (Lippman & Rumelt, 1982). Even successful players may not fully understand the secrets of their success.

Inimitability of some resources is thus a twin-edged sword (Winter, 1995). On the one hand, it affords the resource-owner a measure of protection from competition by replication. Making resources inimitable is an insulating mechanism – whether by making them difficult to copy, or by obtaining an exclusive property right over them (patent, copyright). On the other hand, inimitability may inhibit the ability of the firm to grow by replicating its successful resources and resource combinations. The ideal for the firm, therefore, is to develop (or otherwise acquire) resources that it knows how to replicate, but are relatively difficult for others to do so. This not only protects the value of existing resources, but encourages the accumulation and discovery of new ones. The knowledge of how to replicate is, then, itself an inimitable resource.

The value of the firm is no more nor less than the value of the resources that comprise it. And the value of these resources at any time depends exclusively on their perceived ability to produce products that consumers value. This is the first proposition of (Austrian) capital theory. Strategies to enhance the value of the firm by enhancing the value of the resources it controls (by inhibiting their replicability, or enhancing the appeal of the products they produce) are important aspects of the strategy equation. To this, however, must be added considerations of how any enhanced resource-value may be appropriated and by whom. To this final topic we now turn our attention.

RENT AND APPROPRIATION

Rent through Austrian Eyes

Austrian capital theory begins with Carl Menger (1871), who emphasized that the value of productive resources (higher order goods) derive from their contributions to the value of the prospective outputs of consumer (first order) goods. This proposition (called Menger’s Law by Israel Kirzner) inverted the classical cost-of-production theory, most clearly developed by David Ricardo, according to which consumption goods are to be valued by the value of the resources used to produce them. Menger showed that cost derives from value and not the other way round. Menger’s Law provides us

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with the universal logic of present value, whereby the value of any asset (and hence the maximum price that the valuer will pay for it) is imputed from the value of the expected product attributed to its use in production, suitably discounted. Discounting is necessary because of time preference, the premium of present utility over future utility. Other things equal, a dollar now is worth more than a dollar sometime in the future – the premium being greater the further into the future we look. Bo hm-Bawerk (1959 [1921]) provided a path-breaking analysis of the nature of interest and time preference and their relation to the productivity of resources. He showed that the more productive an asset is perceived to be (in terms of value) the higher will be the price that people are willing to pay to buy it, or the higher the rental rate they will pay to rent it. Frank Fetter (1977) extended Bo hm­Bawerk’s insights and Murray Rothbard (1977) provided the definitive syntheses. This rental rate is to be understood as the price of the services of the asset. All productive assets earn rent, explicitly if rented or implicitly if employed by the owner. The wages of labor are the rents earned by human capital.

From the perspective of the economy as a whole, adopting, as it were, a ‘‘God’s eye’’ view, the value of resources, at any point in time, can be seen as the discounted total of the (estimated) income stream attributable to them. In other words, the value of any economic resource is logically the present value of any income stream that can be attributed to the use of that resource in production. That is the maximum price that anyone appraising that resource would be prepared to pay for it. We may leave aside the question of how it is possible to attribute to any resource an income flow. Clearly, as discussed earlier, insofar as resources must invariably be used in combination, it is no simple matter to impute to any single resource a value for its individual contribution – this is the ubiquitous imputation problem. And the estimation of the value of any production plan is in itself a speculative matter. The point is that anyone considering the purchase of any resource cannot avoid (perhaps implicitly) referring to the value that this resource is expected to add to economic production. Even if the resource is purchased for resale, ultimately its value must derive from some potential productive use.

Imagine for a moment, that no ambiguity or uncertainty whatsoever attaches to the production processes in the economy. All individuals possess the same hard knowledge of what resources can do and, therefore, what they are worth. In such a world, when a resource is rented its rental rate must reflect the value of the current addition it makes to the value of production (its value-marginal-product), or else the owner would be reluctant to rent it

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to the firm; and where the resource is not rented but is owned by the firm, the implicit ‘‘cost’’ of using the resource must reflect that same value. Thus there is no ‘‘surplus value’’ to be had, since all values are known and become incorporated into the (implicit and explicit) prices of resources. Nevertheless, in the sense advanced here, ‘‘rents’’ are earned by the factor owners.

‘‘Rents’’ refers here to the income streams attributable to the resource inputs in the productive process. Resources can generally be conceived of as a stock of potential productive services. Rents are the prices paid for these services. Rents are the prices of the flow of services emanating from the stock of resources (Penrose, 1995 [1959]; Dierickx & Cool, 1989). The price of the any resource stock is the discounted present value of the prices of the services it yields. In this framework rent is nothing more nor less than the rental price of the service of a productive input. As Murray Rothbard has explained:

We are using ‘‘rent’’ to mean the unit price of the services of any good. It is important to banish any preconceptions that apply the concept of rent to land only. Perhaps the best guide is to keep in mind the well-known practice of ‘‘renting out.’’ Rent, then, is the same as hire: is the sale and purchase of the unit service of any good. It therefore applies as well to prices of labor services (called ‘‘wages’’) as it does to land or any other factor. The rent concept applies to all goods, whether durable or nondurable. In the case of a completely nondurable good, which vanishes fully when first used, its ‘‘unit’’ of service is simply identical in size to the ‘‘whole’’ good itself. In regard to a durable good, of course, the rent concept is more interesting, since the price of the unit service is distinguishable from the price of the ‘‘good as a whole’’ . . . The price of the ‘‘whole good,’’ also known as the capital value of the good, is equal to the sum of the expected future rents discounted by . . . the rate of interest. (Rothbard, 1970 [1962], pp. 417–418)5

This conclusion is not changed at all when we drop our assumption of perfect and certain knowledge. In the real world where the future is irredeemably uncertain, the value of any productive resource will still reflect the discounted value of its expected future rental stream. Certainly, different people will have different estimates of these rental streams and, therefore, will appraise differently the value of the resources that yield them. The market process of production and exchange will work in such a way that resources tend to move to those who appraise them most highly. As mentioned earlier, a firm may employ resources in production by owning or renting them. If a firm decides to purchase a resource it must do so because, in its estimation, the additional value to it of the future incomes streams attributable to the use of that resource meet or exceed the price paid for it. Similarly a firm will not rent a resource unless, in its estimation, the value

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added to production, by combining that resource with others in the production process, meets or exceeds the rental rate asked. Once again this is not to deny or minimize the uncertainties or indeterminacies involved in the imputation problem. There may be significant bargaining problems associated with the inability to neatly apportion contributions to indivisible resources (Alchian & Demsetz, 1972) but none of this disturbs the conclusion that resource earnings are rents and that the value of these resources must derive from some way of estimating their contribution to production.

This framework suggests the following conclusions:

1. There is no categorical distinction between the earnings of some resources and others, they are all rents.

2. The value of any productive resource is the discounted value of the rent streams that can be attributed to it. There is no valid ‘‘cost of production’’ theory for the determination of value. All value derives from the value of final outputs to consumers. It follows then that there are no ‘‘unearned’’ rents in the sense of Ricardo or in the sense of any ‘‘monopoly rents.’’ All rents reflect the ‘‘value contributed’’ to the production process.

Recent Developments

The use of the concept ‘‘rent’’ (deriving from Ricardo) is confused and inconsistent in both the standard economic model of perfect competition and in the strategy literature, a confusion that arguably would be banished by use of the simpler Fetter-Rothbard approach (deriving from Menger and Bo hm-Bawerk). This has recently been realized (though not very explicitly) in three remarkable articles that address both strands of literature (economics and strategy) by Makowski and Ostroy (2001) and Lippman and Rumelt (2003a, 2003b, see also Lewin & Phelan, 2002 and Mathews, 2006b). The two articles by Lippman and Rumelt in particular evidence a notable, independent rediscovery of some perspectives outlined in this paper. All three articles aim at a conscious break with the past, with the standard model of perfect competition (generally referred to as neoclassical economics). Makowski and Ostroy provide an intriguing reformulation of ‘‘perfect competition’’ devoid of the usual heroic assumptions of full information, many buyers-sellers, no innovation or changes in technology,

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etc. and in so doing arrive at a vision of the world of competition as a rivalrous process in which profits are earned in disequilibrium. Competition is ‘‘perfect’’ when all possible value that can be created is created and is fully appropriated by someone. So, in the familiar case of a perfectly discriminating monopolist, no value-creating opportunity is left unexploited and ‘‘competition’’ is actually ‘‘perfect.’’ Paradoxically, but logically, all other perfectly competitive cases are variations of this theme in which full appropriation occurs. It follows that the price-taking condition of the standard model is not needed and bargaining, negotiation, and strategizing can occur.

Lippman and Rumelt’s two companion articles acknowledge the relevance of Makowski and Ostroy’s work, and of the Austrian tradition, to their own. But none of these three articles shows a clear perception of Hayek’s notion of equilibrium, and its relevance for the nature and role of knowledge in the market processes they describe, or of the Fetter-Rothbard theory of rent. Yet, especially in Lippman and Rumelt’s work, the similarity is striking. For example,

there is no residual part of revenue that is not attributable to a resource. The payments to resource are what we . . . define as simple rents – they are neither Ricardian, transfer, differential, quasi, nor economic rents. (2003a, p. 903)

Rent is a payment for the services of a factor of production (one pays for an apartment or a car). (2003a, p. 904)

Given a durable resource, the simple rent is the total payment received by the owner of that resource. The value of the resource is the discounted value of future simple rent payments. The economic [differential] rent is a portion of the simple rent payments and depends upon the analyst’s definition of ‘‘alternative use.’’ Given a specified alternative use, economic rent is the difference between the present simple rent payment and the simple rent payment that would be received in that alternative use. Such alternative payments are out-of-equilibrium conjectures based upon various assumptions about what might change (and what might not) to force the resource into its alternative use. (2003a, p. 917; cf. Lewin & Phelan, 2002)

The capitalized stream of payments for the services of a resource is its value, the total payments . . . for all resources in a firm is the value of the firm. The objective is to maximize its wealth by adjusting the ways in which it uses and combines resources and by its purchase and sale of resource. (2003a, p. 924)

Business management and strategy concerns the creation, evaluation, manipulation, administration, and deployment of unpriced specialized scarce resource combina­

tions . . . the strategy problem [is] one of discovering or estimating the value of various resource combinations. New wealth can be created by trade in resources as long as there

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are hitherto unexamined combinations. (2003b, p. 1069, abstract, it is not clear why attention is confined to unpriced resources)

These articles are not without blemish (some misconceptions and terminological quibbles exist – opportunities for further research and fruitful dialogue). They do, however, represent a remarkable move toward a dynamic Austrian-type vision. In that vision competition is an open-ended discovery process in which the earnings of profits (most plausibly under­stood to be a residual earned after the payment of all contractual payments-rents) are possible because the ex ante prices of resource turn out to be different from their ex post values. As Ludwig von Mises has lucidly expressed it,

What makes profit emerge is the fact that the entrepreneur who judges the future prices of the products more correctly than other people do buys some or all of the factors of production at prices which, seen from the point of view of the future state of the market, are too low. Thus the total costs of production – including the interest on the capital invested – lag behind the prices which the entrepreneur receives for the product. This difference is entrepreneurial profit. (Mises, (1980), p. 109; see also Sautet, 2000)

CONCLUSION

Of the four categories of contributions surveyed here two are integral parts of the attempts of the past few decades to remedy the limitations of the neoclassical theory of the firm, namely heterogeneity of resources and the nature of knowledge. These attempts are to be found in various literature strands including notably transactions-cost economics, the economics of organization, game theory, and strategic management and organization, especially in its RBV variety. Confusion and inconsistency concerning the concept of ‘‘rent’’ persists and, until the recent work of Lippman and Rumelt, the simpler, more plausible and more likely-to-be-consistent approach deriving from the Austrian tradition and definitively expressed by Fetter and Rothbard, was completely neglected, and is nowhere acknowledged outside of narrowly Austrian research.

It is in regard to the concept of equilibrium, however, that the Austrian vision stands to make its most valuable contribution (see Table 2). Hayek’s approach to equilibrium is almost never used explicitly and, even as theorists strive mightily to find a distance from the perfect-competition model, the allure of equilibrium theorizing remains untarnished. It seems to be an unspoken article of faith that disequilibrium theorizing is not possible, or is somehow undesirable. Yet, as argued in this chapter, when understood as

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Table 2. The Importance of Disequilibrium.

Heterogeneity Knowledge Rents

Disequilibrium Resource (capital-good) capabilities and values have to be estimated – entrepreneurial judgment is exercised in creating productive capital combinations

Equilibrium Has no operational relevance – resource (capital-good) values and capabilities, are known with certainty – no entrepreneurial judgment is necessary

Is dispersed and partially tacit, is never collectible, gives rise to disparate expectations

Is shared in common. Expectations converge – are identical

Are the earnings of resources (capital­goods) and have to be estimated and are often contracted; the residual after payment of rent is profit

Are the earnings of resources (capital­goods) and are known with certainty; there is no residual after payment to rent (no profit)

an inevitable inconsistency of individual plans, disequilibrium is not only a necessary condition for the existence, and hence understanding, of the market process as we know it, it is also the glue connecting the other three categories of consideration. In Hayekian equilibrium heterogeneity of resources would have no strategic significance, specific and private knowl­edge would be much less problematic, and no profits net of contractual rent payments would be earned. In the real world of disequilibrium firm differences are not a mystery, rent is not an indication of inefficiency or monopoly power, and there is room to analyze, admire, reward, and consult about successful business strategy. Rent appropriation comes from owner­ship of valuable resources. And a successful strategy, one that earns rents and profits, is one that acquires ownership of valuable and value-creating resources. Such a strategy is dependent for its success on superior vision (or luck), something which cannot exist in equilibrium.

NOTES

1. This chapter also contains a discussion of the role of modularity in facilitating successful action in disequilibrium and in particular a discussion of the relationship between structures and quantities (aggregates).

2. As a referee points out an implication of this is Hayek’s (1973) point that to satisfy some expectations it is vital that other expectations be disappointed.

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3. The notion of a capital good is interchangeable with the notion of an economic resource if we cast a wide enough net to include human capital. Then we may say that producers combine resources in order to use the services of those resources to produce some desired good or service. 4. To be sure, situations may exist where resource combinations promise to yield a

surplus of known value whose distribution among the resource owners is up for grabs and therefore invites ‘‘strategic’’ behavior. Since there is no disagreement as to the value of the surplus, the disagreement over the distribution may not (though it may) affect the employment of resources in specific combinations. There are no real ‘‘discoveries,’’ there is no innovation or entrepreneurial action. Whatever we mean by ‘‘strategic’’ then, we should like to analyze a world in which both types of disagreement (over the distribution and the size and nature of the surplus exist). I return to this later. 5. Also: ‘‘We have been using the term rent in our analysis to signify the hire price

of the services of goods. This price is paid for unit services, as distinguished from the prices of the whole factors yielding the service. Since all goods have unit services, all goods will earn rents, whether they be consumer’s goods or any type of producers’ goods. Future rents of durable goods tend to be capitalized and embodied in their capital value and therefore in the money presently needed to acquire them’’ (Rothbard, 1970 [1962], pp. 502–503).

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