Sunday, March 27, 2011

Paul Davidson's Foray into Austrian Economics

Austrians familiar with Paul Davidson's review of The Economics of Time and Ignorance consider this one of the low points in the development of Austrian economics. Austrians, in other words, do not like to talk about this review, largely because in their view it was "wholly unsympathetic." This is true; Paul Davidson pokes fun at the Austrians at almost every turn in his 15-page review. Here is a sample of Davidson's cruel sarcasm:

"If two schools share the identical axiomatic foundation -- as the Austrians and mainstream neoclassical econmists do -- then if they ask the same questions, they should reach the same answers, unless one school has made a mistake in logic and/or has introduced as hoc constraints on the operation of the system. No wonder, then, that after 230 pages O & R [O'Driscoll and Rizzo] declare that 'it should not be surprising if there were substantial overlap between Austrian or subjectivist economics and neoclassical orthodoxy.'"

But I would like to summarize briefly the main substantive points of Davidson's review, because I think it sheds considerable light on "Post-Austrian" economics. As can be seen from the passage I quoted above, the spirit of Davidson's critique can be found in his claim that "both the Austrian and mainstream neoclassical models share many of the same fundamental axioms." He does this by proving the absurdity of "pattern coordination" in a world of uncertainty, real time, and money. For Davidson, belief in the existence of equilibrium, or systematic movements toward equilibrium, requires the elimination of real time, monetary contracts, and incalculable uncertainty.

Next, Paul Davidson accuses Austrians of following the same three fundamental axioms of neoclassical economics: (1) money neutrality, (2) gross substitution, and (3) ergodicity ---- axioms which Keynes destroyed in his 1936 book.

(1) O'Driscoll and Rizzo (O&R) "accept the Austrian Carl Menger's definition of money which 'involve[s] commitments in the form of commodity inventories.' This definition reduces money to a commodity basis -- and hence it is based on the money neutrality axiom, where the conditions of individual plans for the demand and supply of real goods and services is independent of the nominal supply of money.

(2) "O&R's use of Hayek's definition of equilibrium in terms of the compatibility of individual plans, even when they modify it to represent 'pattern coordination', means that there must exist a vector of market prices which is consistent with market equilibrium. A sufficient condition for this to occur is if all excess demadn curves are downward sloping and hence well-behaved -- a condition that implies the gross substitution axiom, where every good (and service) is a gross substitute for every other good (or service)." (We know, however, that liquid assets and real producible [illiquid] assets are not gorss substitutes.)

(3) "Finally, since O&R assert that there is no reason to believe that entrepreneurs will be systematically in error, they are accepting the rational expectations hypothesis of neoclassical economics, which is based on the axiom of ergodicity."

That is the essence of Davidson's critique of Austrian economics. I think he makes some excellent points. In particular, I found his conflation of Austrian entrepreneurship theory and the rational expectations hypothesis exceedingly compelling. To believe that entrepreneurs will discover profitable opportunities on the basis of past errors does invoke the axiom of ergodicity. Also, Davidson's claim that pattern coordination works only in a world of gross substitution is also very good.

Austrians have a lot to learn from Post Keynesian economics, and this article is the best place to begin.

Paul Davidson "The Economics of Ignorance or Ignorance of Economics?" Critical Review, 3 (3-4), 1989, pp. 467-487.

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