The Beauty of Heterodoxy: Frank H. Knight

When the history of economics in the mid- to late 20th century comes to be written, one of the more puzzling questions will be the intellectual legacy of Frank Knight. The Chicago school has claimed him as one of their own --- indeed, in most cases, as the progenitor of the Chicago tradition --- but his work has done more to question my faith in markets than any other economist I have read. Frank Knight is certainly like no other. He has one of those fantastic, inimitable wits like Thorstein Veblen and Voltaire.

In several of his essays ("Ethics and the Economic Interpretation," in particular), Knight attacks markets on account of their inability to satisfy consumer wants. Now this is an assumption that undergirds the entire laissez-faire philosophy -- competition (rivalrous or perfect) drives the market to respond efficiently to consumer demands. But Knight objects to this by arguing that ends (desires and wants) cannot be taken as given because they are not the ultimate source of action. Individuals do not actually try to satisfy given wants. They are concerned instead with the discovery and pursuit of higher, more enlightened wants. This is a remarkable insight. The market relies for its defense on the principle of efficiency in want satisfaction. And Knight does not question this. He goes much further and questions the very nature of the wants themselves, and arrives at the conclusion that an individualistic competitive market order creates wants that have as their aim emulation and rivarly rather than personal satisfaction and the promotion of happiness. This applies to production as well, with businessmen engaged in a "game" where the goal is to dominate your opponent much like you would in a game of chess.

Another important theme in this book concerns the ethical character of economics. Knight argues that economics is more than a branch of mechanics. And although ethical judgments can never claim to possess the status of objectivity, there is a very real sense in which the actions and motives to which they give rise are influenced by "social ideals." From here, Knight also argues that these social ideals can be used to criticize the outcomes generated by a laissez-faire economic arragement, even if all available alternative economic systems fare no better. Ethical judgment is never "a purely relative matter", but is instead concerned with the question of "ideals."

Now, traditional debates surrounding the virtues of competing economic systems have focused on the way in which resources are most efficiently allocated in direction of the satisfaction of wants. But Knight undermines this literature by observing that "wants" are never simply given; they are constantly changing and are inherently dynamic in character. Here is Knight:

" The individual who is acting deliberately is not merely and perhaps not mainly trying to satisfy given desires; there is always really present and operative, though in the background of consciousness, the idea of and desire for a new want to be striven for when the present objective is out of the way. ... [A]ll intelligently conscious activity is directed forward, onward, upward, indefinitely."

Knight also questions the traditional conception of "happiness." Consider this passage: "A man who has nothing to worry about immediately busies himself in creating something, gets into some absorbing game, falls in love, prepares to conquer some enemy, or hunt lions or the North Pole or what not."

This is all perfectly consistent with my (quite radical) interpretation of Mises and equilibrium (see earlier post "Austrians on Equilibrium"). Knight is saying everything that was already in my mind. I will end with one final quote by Knight: "It is a stock and conclusive objection to utopias that men simply will not live in a world where everything runs smoothly and life is free from care." This is exactly what Mises was getting at. Men who live vegetative existences are not really men; men are insatiable, erring, and explorative creatures. To put them in equilibrium is to deny them their humanity.

Frank Knight as a Post-Austrian!

The Austrians on Equilibrium: Some Divergent Views

Pete Boettke has recently written an excellent blog post on the "epistemic turn" in Austrian economics. It was F. A. Hayek, according to Mr. Boettke, who introduced the idea of competitive entrepreneurial market discovery, and in so doing challenged standard economic theory's understanding of "knowledge." This is classic Boettke:

"The Austrian understanding of the market process explicitly rejects the mechanical interpretation of human behavior, and instead sees man as imperfect in perception, biased and often in error of judgment. Rather than a lightening calculator of pleasure and pain, man within the Austrian "model" is caught between alluring hopes and haunting fears. The importance of the "Epistemic Turn" is that it is precisely by taking this step that we switch the argumentative burden from behavioral assumptions to institutional coping devices for our ignorance."

Subsequent generations of Austrian scholars have followed this conception of knowledge, and have used it to great effect in developing a more refined model of competition and entrepreneurship. Market imperfection creates the possibility for entrepreneurial discovery, according to the Austrians. This is quite different from other theories of laissez-faire (Chicago/UCLA, for example) which argue that "whatever is is best" due to the existence of information and transaction costs. Austrians, on the other hand, emphasize sheer ignorance and market imperfection as a precondition for the emergence of market processes.

However, contra Mr. Boettke, I would instead interpret the "epistemic turn" as the moment when Austrian economics moved in two different directions. Mr. Boettke hints at this when he writes:

"The Behavioral critic would do well to read both Mises and Hayek on their rejection of "economic man". But they do retain a model of man as a purposeful being (admittedly Mises more so than Hayek, but I would argue both maintain a commitment to human action)."

In fact, the theory of Mises is quite different from that of Hayek. Mises spoke of human action, while Hayek spoke of market coordination. Now indeed these theories are complementary, and exhibit considerable overlap, but, in my opinion, the fundamental assumptions are profoundly different. Take equilibrium for example. According to Hayek, equilibrium can be understood only in connection to the mutual compatibility of individual plans (i.e. market coordination). For Mises, however, equilibrium signifies the destruction of the science of economics (i.e. human action). Conceiving of market activity as a competitive discovery procedure that gradually eliminates imperfection is tantamount to believing that the economy is perennially moving towards a system without institutions and purpose (see the paper by Boettke, Prychitko, and Horwitz 1986). For Hayek (and most other Austrians), the entrepreneur is responsible for correcting market imperfection. But for Mises, the entrepreneur, as understood by contemporary Austrians, is responsible for destroying human action. Economics must preserve purpose in human action. But equilibrium is the state without purposeful action. All men are vegetables in equilibrium. Therefore, economics, for Mises, is the science of non-equilibrium (and not the science of disequilibration or market equilibration).

Austrians have failed to identify this difference in outlook between the two leaders of the contemporary Austrian movement. Mises took economics down an entirely different path from the one created by Hayek. Austrians have continued to speak of market coordination as increasing plan coordination. But this is not Misesian economics. Austrians need to decide if they want to define Austrian economics as "Hayekian" or "Misesian."

Post-Austrian economics picks up and revives Mises' project, and conceives of economics as purposeful human action. Once this is understood, all references to equilibrium suddenly lose meaning. Equilibrium is the enemy of human action. Equilibrium should be used only to illustrate the importance of human action for economics. Arguing that competitive market proceeses are an imperfect representation of equilibrium destroys Mises' main project. Economics is the science of human action. This is what Post-Austrian economics is all about. Basically, the Hayekians (i.e. contemporary Austrians) are wrong.

So, to answer Mr. Boettke's question, viz.,:

"What do you think are the most effective ways we deal with the "constitutional limitations of man's knowledge and interests" and what are the best papers out there that attempt to address the limitations?"

I would say this is it. Mises was right on in his conception of economics as human action. Purposeful action is possible only in a world of uncertainty. With uncertainty removed, e.g., equilibrium, human action becomes impossible because choice is no longer necessary. This is how we should deal with the "constitutional limitations of man's knowledge and interests." And as for papers, I have one addressing this topic currently under review. Mr. Boettke has read it.

Libertarian Paternalism

I have decided to read Thaler and Sunstein's (T&S) recent book Nudge because I have been told that this is the direction in which big government liberalism will likely be moving.

The arguments are very subtle, and the implications powerful. Central to the argument is the idea of a "choice environment" --- i.e. the non-neutrality of the decision milieu (p. 3). Consumers make choices, but, according to T&S, there is no neutral way to frame the environment in which choices are made. Moreover, behavior is easily manipulated according to the way available choices are framed and advertised. Therefore, it is up to "choice architects" (libertarian paternalists) to try to make people "best off, all things considered." The standard libertarian position that decisions should be made so as to allow people to choose options they "would choose on their own" is misleading because this suggests that "choice environments" can be neutral. But available options must be framed (advertised) in some way, and the results will invariably have important consequences for how people behave. People are not rational maximizers. People suffer from biases, experience frequent self-control problems, and are subject to social influences. In short, people are Homer Simpsons, and not Mr. Spocks (p. 42).

That is the basic argument. And it is an interesting one. Now how should the true libertarian respond to this? Well, the libertarian might say that attempts to improve the "choice environment" will have adverse unintended consequences, and will lead to a dangerous slippery slope. But the analysis T&S are employing is very subtle. The central idea in the book is that all choices are non-neutral. We are never free to make our own choices. This is an implicit (yet very powerful) attack on libertarianism and laissez-faire. All choices must be framed and advertised in some way, and each proposal and option will affect behavior differently. This is a very powerful argument. Libertarianism collapses. How can we be in favor of freedom from government regulation and control if it is ontologically impossible to possess autonomy in our decision-making? There is no such thing as a "neutral" market.

Now an ancillary thesis to the argument of the non-neutrality of "choice environments" is the idea that private markets have recognized the existence of non-neutrality (and the concomitant manipulability of individual behavior) and have proceeded to exploit this to their own advantage. Private companies are acutely aware "of the power of social influences" and might try to make money by "enlisting conformity" (pp. 62, 64). T&S write:

"Frequently they [private companies] emphasize that 'most people prefer' their own product, or that 'growing numbers of people' are switching from another brand, which was yesterday's news, to their own, which represents the future. They try to nudge you by telling you what most people are now doing. ... The key point here is that for all their virtues, markets often give companies a strong incentive to cater to (and profit from) human frailties, rather than to try to eradicate them or to minimize their effects" (pp. 64-65, 72).

Can you think of a commercial on television that does not do this? Moreover, S&T anticipate objections to this analysis by arguing against the efficacy of market competition in writing that "[y]ou might think that firms could educate people not to buy [goods], and indeed they might. But why should firms do that? If you are buying something that you shouldn't, how do I make any money persuading you not to buy it?" (p. 79). The basic idea behind this book is that "social nudging" should try to offset (and possibly eliminate) the efforts of private companies in manipulating the the "humanness" of individual decision-making.

One final point I would like to make, and this applies to the field of "behavioral economics" generally. I think that something is being lost here in focusing almost exclusively on human psychology. The entire argument is based on research that has been done by psychologists, and not economists. We learn about "representativeness," various "self-control strategies," "spotlight effects," "priming," and many other things that seem to have no direct connection to economics. I think that we are missing something by diverting attention away from economic phenomena. Human behavior is best understood by trying to explain human plans in relation to incentives, scarcity, and opportunity cost. This book reads more like a treatise in psychology rather than in economics. Lachmann had it exactly right in his essay "Economics as a Social Science."

The Austrian Theory of Prices

Most Austrians consider Tomas Sowell's Knowledge and Decisions book an excellent statement of the Austrian (Hayekian) theory of prices and knowledge. In fact, Kirzner spoke of this book as "the most extensive and wide-ranging development of the implications of the Hayekian insights." In this book, Sowell described prices as "knowledge surrogates," because "nobody needs to know the whole story in order for the economy to convey the relevant information through prices and secure the same adjustments as if everyone had known." The Austrians have seized on this idea of prices as "knowledge surrogates" or summaries of information, and have used this to re-interpret the market process as a system that responds to conditions of disequilibrium by attempting to realize profit.

This recapitulation of the Austrian theory of prices will strike many readers as familiar and old-hat. But this theory was subtly, yet savagely, attacked by a great scholar who wrote a book in 1992 that tried to rescue the Austrian theory of the market process from this misleading interpretation of prices and knowledge. I am referring, of course, to Esteban Thomsen's Prices and Knowledge, a short book that accomplishes many great things. I will limit this post to Thomsen's critique of Sowell's account of the Austrian theory of the market process because I think it is important in view of how this interpretation has captured the minds of nearly every working Austrian.

The author is quite clear that it is wrong to interpret prices as summaries or "surrogates" of knowledge and information. He does this by distinguishing between the "discovery" of knowledge and its subsequent summarization. The Austrians, according to Mr. Thomsen, are making a mistake by eliding the discovery role in their emphasis on the role prices play in conserving information. The author makes this point clearly when he writes,

"Kirzner's emphasis is more on the discovery of knowledge than on its summarization or its transmission. ... The difference appears to stem from the dissimilar views held of ignorance and discovery, and from the difference between interpreting prices as only 'information-saving' devices and interpreting them as part of an entrepreneurial discovery procedure."

The author proceeds in the next chapter to a discussion of Herbert Simon's concept of bounded rationality. The author finds common ground between Herbert Simon's account of "satificing" and the Austrian theory of prices as "knowledge surrogates." In Simon's model, for example, prices work for individuals because they are a simplifying device in a complex world. Individuals, according to Simon, can infer market conditions from prices without having to know all the details of every event. But this is exactly what Austrians have been arguing! The author concludes by stressing the "discovery" role of prices, and not its "information-saving" role.

This is an important distinction because the author correctly points out that reliance on the "information-saving" role of prices defeats the purpose the market process. Thus Mr. Thomsen writes,

"This enables him [Simon] to imply that with the aid of computers man gets (even if only slightly) closer to (neoclassical) optimizing and that he may achieve objective rationality in 'simple problem situations,' in which case the neoclassical agent may be appropriate. In the market-process approach, on the other hand, facts, even if they were few and simple [and thus no longer need to be 'summarized'], have to be noticed, discovered, by alert, active agents."

I think this interpretation is very good. Austrians should be mindful of the implications of their analysis. By arguing that prices are "knowledge surrogates," other economists are likely to respond by arguing that advances in technology can aid the market in translating prices into "knowledge surrogates." In other words, if all prices do is "save" on the information individuals need to know in their decision-making, then the market should be arranged in a way that maximizes this "knowledge surrogate" function. However, this attention to prices as "knowledge surrogates," in Mr. Thomsen's view, ignores the more entrepreneurial role of "discovery."

Now if Austrians do not see this as a problem worth correcting, it is at least one that deserves further clarification. I also understand this to be one of the more important themes in Mr. Thomsen's book, so I would encourage every student to give this book a close and careful reading.

Obama and Public Choice Theory

Frederic Sautet has written an interesting post over at the Austrian blog. He seems to be suggesting that the people do not yet realize what they have done. Obama will not be able to deliver on his promise of change because politics, as Sautet writes,

"is all about promises made and promises broken, vote trading, bureaucracy capture, self-interest, ignorance, and perverse incentives. Politics is done by interest, not by principles."

In other words, the people do not yet understand Public Choice theory, according to Mr. Sautet.

I think Mr. Sautet is completely wrong. I can't stand reading these kinds of arguments, largely because nearly every Austrian thinks like this. Lachmann certainly would have never said something like this. It does not make sense to say that self-interested politicians can accomplish whatever they want; human behavior is not that simple (and knowledge is not that perfect!). Public Choice is so terribly naive. And we can prove this by making explicit Mr. Sautet's suggestion that the "public" does not yet realize that "politics without romance is impossible."

Let me give you an example in connection to Obama's victory. Implicit in the assertion that "politics without romance is impossible" is the assumption of public ignorance. The public does not understand the niceties of politics. This is all the more amazing upon observing how emotionally involved people become in something (presidential elections) while remaining so woefully ignorant of it --- and even ignorant of their own ignorance! Voters actually think that they are making the right choice; in most cases they are convinced of it. But the truth is that voters typically do not know what is going on. (They know the color of Mrs. Obama's dress, but are ignorant of the minute details of Mr. Obama's policy proposals.) And it is funny to hear commenators on the news repeatedly lament that other commentators are not sticking to the issues, issues that people want to hear! I would be willing to bet that if popular news outlets began discussing the "issues" in great detail, the people's interest in politics, and their participation in it, would quickly end.

But what makes Austrians think that this ignorance stops with voters? This ignorance cuts both ways. Politicians cannot know the effects of any political exchange (vote trading). Public Choice Theory relies on the principle of omniscience for its validity. And it is deeply disturbing to find that not only are Austrians not the most vigorous critics of this approach, but that they actually support it! Austrians are doing great injustice to Hayek and Mises in believing that politicians can accomplish whatever they want by acting in their own self-interest. The effects of any action in politics are terribly complicated, and its unintended consequences too numerous to assess and evaluate intelligently.

Here is the irony. Obama campaigned on the promise of Change and Hope. Austrians, as good Public Choice theorists, are for this reason afraid of an Obama presidency. But Obama does not actually know what he needs to do to bring about this Change. If Austrians abandoned Public Choice theory, they would be able to see this, and begin to worry more about the unintended consequences of positive action, and not about the effects of the "vote trading" that will result from Obama's empty promises.

What Laissez Faire Looks Like

I am convinced that the most powerful expositor of laissez-faire is Harold Demsetz. His writings are just so damn good. No economist, to my knowledge, has ever attempted to challenge his arguments. How could you? Here are some quotes from one of my favorite papers of his:

"The allegation is that even perfectly competetive markets fail to achieve efficiency. But, this reasoning generally fails to take account of the fact that the provision of a market (for the side effect) is itself a valuable and costly service."

"In asking the implications of the nonexistence of some markets, we seem to have fogotten the cost of providing market services or their government equivalent."

This is such a clever argument. Any situation can be justified by invoking the theory of transaction costs. In other words, what appears undesirable is really efficient once sufficient account is taken of the costliness of any proposed alternative for remedying it. How can you get around this? Demsetz gives several examples to illustrate his thesis:

1.) Free parking. "But while we have reduced the resources committed to constructing parking spaces, we have increased resources devoted to market exchange. We may end up by allocating more resources to the provision and control of parking than had we allowed free parking because of the resources needed to conduct transactions. By insisting that the commodity be priced, we may become less efficient than had we allowed persons to ration spaces on a first come, first serve basis."

2.) Use of nectar by bees. "A valuable and costly good, nectar, is provided free of charge because it would be too costly to take account of the indirect benefits to beekeepers."

3.) Public goods. "If the cost of policing the benefits derived from the use of these goods is low, there is an excellent reason for excluding those who do not pay from using these goods."

The logic in these arguments is really great. First of all, the argument acknowledges the existence of market imperfection. Markets are imperfect and usually do not work. But every activity involves a cost, even government regulation. Therefore, the reason why we haven't seen the elimination of costly and imperfect market arrangements is because every possible alternative (government regulation, for example) is more costly.

Carl J. Dahlman summarized this position beautifully: "If you do not like the smell of the air, seek comfort in the knowledge that it would cost you more than it is worth to you to do away with the stench, for, otherwise, would you not do it?"

Forget about the Austrians. This is real laissez-faire economics. This theory is much more sophisticated than Austrian libertarianism. In fact, Austrian economics was never intended to serve as a defense for the market. Menger, Bohm-Bawerk, and others in Austria were concerned mainly with methodological questions. It was only with Mises' arrival in New York that Austrian economics became identified as libertarian. Had Mises remained in Switzerland, it is likely that the American libertarian movement would have never encountered Mises and the Austrian tradition. Mises' decision to leave for the United States was a disaster for Austrian economics; it brought an end to the Mengerian tradition, and transformed Austrian economics into libertarian anarcho-capitalism.

The economics of Ronald Coase, Harold Demsetz, and Armen Alchian (on information cost and unemployment theory) is the real theory of laissez-faire, and I think this is the body of work that economists hostile to free market capitalism should be attacking. This, however, is not going to be an easy task. Harold Demsetz has easily one of the sharpest minds in the profession. But this is the guy to beat. No doubt about it.

Sources:

Armen Alchian "Information Costs, Pricing and Resource Unemployment" Economic Inquiry, 1969.

Carl J. Dahlman "The Problem of Externality" Journal of Law and Economics, 1979.

Harold Demsetz "The Exchange and Enforcement of Property Rights" Journal of Law and Economics, 1964.

Austrians and the State Theory of Money

So I have returned from the Grove City ASSC somewhat disappointed (I did not win any money). But I did manage to meet an Austrian student that impressed me a great deal: David Howden. He is pursuing a PhD under Huerta de Soto at Rey Juan Carlos University, and is very knowledgeable about Austrian economics. Post-Austrians should keep an eye on him and his work. Our discussions consisted mainly of bouncing ideas, interpretations, and obscure Austrian references off one another. I enjoyed it a great deal. He was also very knowledgeable about Post Keynesian economics, and criticized it for all of the right reasons! (rather than simply dismissing it).

His paper concerned the topic of money and the Austrian focus on the medium of exchange function. He attempted to "dynamize" this idea by using the Austrian time-preference theory to re-interpret money as principally a store of value function. (I liked this a great deal).

Anyway, this presentation prompted a question by me concerning the state theory of money (also known as Chartalism). This theory holds that money acquires value by virtue of government management of the currency. Austrians have objected to this by resorting to Menger's discovery of the evolutionary theory of money, arguing that money must first have a use-value before it can be used (and accepted) as a medium of exchange. Mises extended this argument by introducing his famous "regression theorem."

I am interested in this question of the connection between the functions of money and the state theory of money largely because Ludwig Lachmann, early in his career, wrote a paper addressing this issue entitled "uncertainty and liquidity preference," published in 1937. Lachmann, in proto-Chartalist fashion, argued that a lot of confusion has been generated on this question as a result of failing to distinguish between the functions of money and money's exclusive function (i.e. between what money does and what only money can do). Lachmann is basically taking a state theory of money approach by arguing that it is wrong to identify money as being either a medium of exchange or a store of value, because other commodities can and do assume these roles in varying degrees and under a variety of circumstances. What makes money unique is its "debt-discharging quality." Here is Lachmann:

"Now, money is the legal means of payment, i.e. its owner can use it for discharging debts. This is the only use in which it has no substitutes, for its very institutional character excludes that. ... It therefore seems legitimate to infer that ... it is principally because of its debt-discharging quality that money is demanded."

This is a direct refutation of the Austrian theory of money (i.e. a useful commodity). With this framework, we can safely say that all that need be said is that tree bark be assigned legal tender, and money would suddenly acquire value, irrespective of any previous role it would have served in exchange. The fact that it discharges debt (by virtue of legal tender) is sufficient in bringing value to tree bark.

What does all this mean? Should Post-Austrins look to the State Theory of Money instead of Menger in their analysis of money? Was Lachmann really a Proto-Chartalist? Can Austrians use Menger to refute the State Theory of Money approach? If not, what does this imply for the Austrian theory of money (on which so much of Austrian economics rests)?