“What Does Austrian Economics Predict?”

4 September 2007 at 2:42 am 22 comments

| Nicolai Foss |

At the professional development workshop on “The Austrian School of Economics: Applications to Organization, Strategy and Entrepreneurship,” arranged by my co-blogger for this year’s Academy of Management Meetings, the first question raised from the audience after the presentations was the one in the heading to this post. (Fabio at orgtheory.net has also made related, ehhh, provocations, which we will deal with later here at O&M).

It wasn’t entirely clear what the person who asked the question meant, the acoustics in the room were terrible (he had to repeat the question twice), and I am sure that complex issues like the symmetry thesis were popping up in the minds of my co-panelists, so there was some hesitation in the panel to address the question. (Afterwards I learned that unfortunately this was taken by some audience members as an implicit admission that AE isn’t predictive).

The question was unclear because it could mean any of this:

1) Does Austrian economics really predict anything?

2) Are Austrian predictions congruent with those of other economics approaches?

3) What is the novel fact — in the sense of Lakatos — predicted by Austrian economics, that is, what is the new Austrian explanation of a fact that, while known, had previously lacked any theoretical explanation?

4) What are the uniquely Austrian predictions?

5) Does Austrian economics only put forward “pattern predictions” (according to Hayek 1964 the only possible predictions in truly complex systems)?

6) Does Austrian economics only put forward “logical predictions“, that is, it is subject to ceteris paribus clauses (and therefore only has limited operational content)?

I responded, saying that Austrian economics, for example, predicted boom-bust cycles as a result of expansionary monetary policy, to which was replied (quite correctly) that other business cycle theories entertain the same prediction. It thus turned out that the person who asked the question really meant, What are the uniquely Austrian predictions?, and I responded in terms of the business cycle example by saying that the specific transmission mechanism could be seen as a uniquely Austrian prediction.

Peter changed the terms of the debate somewhat by arguing that explanation and prediction were two different things, and one shouldn’t condemn an approach for not being strong predictively, as long as it was strong explanatorily. Joe Mahoney added that in general processes approaches were likely to be stronger in the explanatory dimension than in the predictive dimension. Peter then asked for other questions.

However, it it worth pondering the issue of “what Austrian economics predicts.” If by “predict” we mean putting forward unique (i.e., not embodied in other economics approaches) conjectures concerning mechanisms in the economy, I think there are plenty of such predictions. Regardless of what one may think of the plausibility of the Austrian business cycle story, the specific mechanisms conjectured by the Austrians to be operative in boom-bust cycles are unique to the Austrian approach. The Misesian calculation argument, in all its complexity and mix of property rights and evolutionary arguments, also seem pretty unique to the Austrian approach. My co-blogger has a very nice paper, published ages ago, where he argues that the boundaries of firms are constrained by what are essentially Misesian calculation problems. With a frequent co-author I have sketched an argument to the effect that bringing Austrian ideas on the entrepreneurial market process inside firms provides identifies new transaction costs that help shape firm organization (e.g., here). Such stories are clearly testable. They embody distinct predictions. Other examples may be found in the modern Austrian literature.

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22 Comments Add your own

  • 1. Steve Phelan  |  4 September 2007 at 4:15 am

    There are the obvious “Austrian” predictions that:

    a) economic agents will have different opinions on the expected value of assets.

    b) central planners will not be able to effectively control an economy because of lack of local information

    c) Following Shane, that a single innovation (patent) will be used in different ways by economic agents with different experiences (or knowledge corridors to use Shane’s term)

    d) that the “true” value of an asset does not exist (nor does an equilibrium or ideal state) and that the economy may not even trend towards an equilbrium (if one follows Lachmann)

    e) that tinkering with the fed funds rate (and economic policy in general) may have unexpected consequences because it systematically alters expectations about future values

    f) that economic (strategic) plans will be constantly revised because of new information (i.e. that strategic plans will always be “wrong” to some degree)

    I guess these predictions are too obvious. If the questioner meant (and I think this is exactly what was meant), “Can you predict whether it will rain on Tuesday” then the answer would have to be no.

    I think one of the real challenges that this question raises is one of institutional design (in a Northian sense). Are there interventions that the government can make that assist economic agents in functioning more effectively to reallocate resources to higher valued uses? Or is intervention simply too dangerous and we should allow institutions to evolve over time no matter how long it takes?

    My own view is that parallel experimentation is a useful tool that enables multiple institutional designs to be rapidly tested and either discarded or with, in the case of the best practices, retained. Perhaps the multi-state nature of the US or EU is an example of this in practice and that the historically highly centralized government of China has contributed to its slow rate of economic development over the last thousand years.

    Thoughts?

  • 2. Nicolai Foss  |  4 September 2007 at 5:47 am

    Steve,
    I agree that your list captures Austrian predictions. However, the reason I didn’t list these kind of predictions is that many of them are not _unique_ to the Austrian approach. I don’t think the questioner had predicting rain in mind; I am pretty sure he had in mind what are the uniquely Austrian predictions. And if you look at your list, only point d) would seem to be unique to the Austrian tradition. Do you agree?

  • 3. Paul Jaminet  |  4 September 2007 at 8:32 am

    Austrian economics in the 20th century developed a fine critique of neoclassical economics, but it barely began to propose a way forward. One prediction which held up very well was the prediction that socialism would fail economically; Mises and Hayek were almost alone in this prediction in the 30s and 40s. But their analysis of why socialism would fail was somewhat rudimentary. Mises in particular didn’t seem willing to invest the effort to carry his economics beyond the “zero cost or infinite cost” modeling approach of much 20th century economics and thus confused people by saying that economic calculation under socialism was “impossible” – Hayek was better, but didn’t come up with a framework for carrying a research program forward. He was vindicated by events, but a more powerful theory might have hastened events more than he did.

    As a generalization, I think Austrians have been almost entirely right, but have said relatively little; mainstream economists have been often wrong but have said much. The second approach seems to lead to more successful academic careers. The ideal, of saying much and being entirely right, is still to be attained.

    I think that when the right path forward is found, the pioneers will have been influenced by the Austrian tradition, but I am not sure the content will be recognized as “Austrian.” But I must say I very much enjoy the attempts by the scholars here to carry the Austrian tradition forward.

  • 4. Steve Phelan  |  4 September 2007 at 2:07 pm

    Nicolai,

    I see where you are coming from. I think that the Austrian tradition is unique because it (uniquely) focuses on the idiosyncratic knowledge of each economic agent.

    I am no expert in different schools of economics – my core expertise is in agent-based models, complex adaptive systems, and computational economics – but, in my view, the Austrian tradition is almost unique in seeing the economy as a set of idiosyncratic agents (perhaps only evolutionary economics shares this view).

    Theory derived from bounded rationality does not tend to appreciate the path dependent (time-based) nature of knowledge, assuming that any economic agent can acquire the same information as any other agent if sufficient expenditure is made. So it is not simply the view that agents have subjective views but that those views are idiosyncratic. This has profound implications for points b) and c). This knowledge argument is also reminiscent of Dierickx and Cool’s asset stocks thesis.

    Researchers in complex adaptive systems are working on generalizations that can be derived from a group of interacting idiosyncratic agents – perhaps this is the way forward that Paul is talking about that owes a debt to Austrian ideas.

  • 5. Nils Stieglitz  |  4 September 2007 at 3:25 pm

    Hi Nicolai

    a rather striking example of a “pure” Austrian prediction would certainly be Hayek’s Ricardo effect. That is, under full employment, an increase in the demand of consumption goods decreases the demand for capital goods. There are others related to Austrian theory of business cycles (e.g. the Cantillon process and the non-neutrality of money). However, I think the real challenge is to develop new propositions for strategy & organization that are broadly informed by an Austrian perspective.

    The theory of the firm is a natural test bed to apply Austrian ideas, and I think scholars like you have made a lot of progress on that front. Furthermore, since you mentioned pattern predictions, research on industry life cycles might be interpreted along these lines. Essentially, the industry life cycle reflects different stages in the discovery and application of knowledge by both firms and customers. I think strategy might benefit from an approach rooted in the market process with dispersed knowledge.

    To be frank, I doubt that theories derived from bounded rationality do not appreciate the path-dependent nature of knowledge, as Steve Phelan claims. Levinthal & March (1981) and, of course, Levinthal (1997) clearly embrace the idiosyncratic and path-dependent process of knowledge accumulation.

  • 6. Steve Phelan  |  4 September 2007 at 3:36 pm

    Nils, nce observation on Levinthal and March.

    When I said “Theory derived from bounded rationality does not tend to appreciate the path dependent (time-based) nature of knowledge” I was thinking about economic theory, in particular, transaction cost economics. Perhaps I am also overgeneralizing there as well?

  • 7. Nicolai Foss  |  4 September 2007 at 3:47 pm

    Hi Nils, I agree entirely with your points on ABC (and your other points as well). That’s what I meant by this: “I responded in terms of the business cycle example by saying that the specific transmission mechanism could be seen as a uniquely Austrian prediction.” But one doesn’t say “Cantillon effects” etc. at the AoM (or perhaps even at O&M) ;-))

  • 8. Richard O. Hammer  |  4 September 2007 at 4:43 pm

    One possible explanation for the question “What does Austrian Economics predict?” would be that the questioner was being tactful. He may have heard (as I have heard, though I’m no pro) that Austrian economics does not attempt to predict things at all.

    The questioner may believe that a lack of predictions makes a study almost useless. But rather than expose this harsh criticism with a candid question such as “Of what value is Austrian economics if it does not predict anything?”, the questioner took a more tactful route and asked “What does Austrian Economics predict?” Or at least that would make sense to me.

  • 9. Nicolai Foss  |  4 September 2007 at 11:47 pm

    Richard, That is highly unlikely. The question was as provocative as it was ill-informed. As you will see from the post and the manyu comments a moment’s reflection reveals that Austrian economics predicts a lot.

  • 10. Nils Stieglitz  |  5 September 2007 at 4:06 am

    Steve, sorry for misreading you on bounded rationality. I think your point on TCE is spot on. TCE essentially assumes that all knowledge is common knowledge, heterogeneity only exists with respect to assets and incentives. A major weakness in my view.

  • 11. Nicolai Foss  |  5 September 2007 at 4:40 am

    Paul, To a certain extent I agree with what u are saying. However, I am not convinced that your characterization of Mises is correct. First, Mises and Hayek simply held very different views of the economic problem of socialism. Second, in some respects, Mises was “better” than Hayek; e.g., he was much more forthcoming about principal agent and property rights problems under socialism than Hayek was. (Peter Murrell has an old article (I believe from 1983) on this in History of Political Economy)).

  • 12. Nicolai Foss  |  5 September 2007 at 4:41 am

    Nils, I doubt that Prof. Williamson would agree with your characterization of TCE ;-) I think what you are talking about here is the GHM approach. After all, Williamson talks about “impacted information”, the ex post bargaining problems he talks about may very well involve asymmetric information/differential knowledge, and differential knowledge seems to be involved in notions of specific human capital.

  • 13. Nils Stieglitz  |  5 September 2007 at 1:33 pm

    Hi Nicolai, I am sure that Prof. Williamson disagrees (and you are right about impacted information). That being said, I would still argue that the (classic) TCE analysis implicitly clings to the common knowledge assumption. In deciding on vertical integration it does not matter who acquires whom; both parties put the assets to the same use, manage them equally efficient, earn the same rent. This is a weird prediction if one truly takes bounded rationality and the specialization of knowledge into account.

  • 14. Paul Jaminet  |  6 September 2007 at 1:09 pm

    Nicolai – No doubt I was unfair to Mises; I find Hayek’s writings more congenial and may therefore tend to deprecate Mises. I will look for the Murrell article.

    Let me rephrase and add to what I was trying to say: which is that the socialist calculation debate illustrates in miniature what I think will happen to Austrian approaches generally. Neoclassical economics was wedded to models that made transaction costs out to be always zero or infinity. Oskar Lange’s position in the calculation debate was essentially that the cost of transactions between the central planning board and the citizens could not be infinite, so it must be zero, and if it was zero then socialism would have to do as well or better than the market. The Austrian position was essentially that transaction costs between the central planning board and the citizens must be higher than under those between decision-makers in the market, and Hayek’s papers on the economy of information transmission through the price system, the economy of use of local knowledge specific to time and place under decentralized decision-making, etc., all were designed to illustrate specific transaction costs that were economized in market economies compared to socialist economies.

    However, Hayek did not build an analytical framework that could be extended by others. That project was initiated by Coase, who developed the transaction cost idea in direct response to the socialist calculation debate – especially the socialist response that the state under communism/socialism would just be a big firm, and economic calculation worked fine in firms. However, Coase was formalizing an idea that was already pregnant in Hayek. And people who have extended Coase’s idea do not consider themselves “Austrian.” Coase and others were inspired by Austrians, but did not necessarily build explicitly on them. I think that will continue to be true in the future.

    As for your questioner, it was a fair question I think, but one that could be turned equally well on others. What did Samuelson predict? Among other things, that the Soviet Union would surpass the United States in GDP. I would rather have the Austrian prediction portfolio, which if limited in number at least has been largely proven correct. A more important question may be: which tradition best facilitates progress. By that standard also, I think the Austrians will stand up well in the eyes of history, but there’s a good chance it will be Austrian-influenced original thinkers like Coase rather than more traditional Austrians who bring the discipline forward.

  • 15. twofish  |  7 September 2007 at 2:38 am

    One big prediction…..

    If the essential problem with socialist systems is calcuation, then a government owned system in which the institutions have been set up so that these calculations can be performed in a real market (and not an Oskar Lange pseudo-market) will work.

    That’s the system currently in place in China, and Chinese economic reform can be seen in the context of creating a real market to resolve the socialist calculation problem in the context of public ownership. A lot of this works because there aren’t vertical command and control systems, which means that actual decisions are taking place at a lower level.

    Also there is a fundamental tension between prediction and human freedom. If something is predictable than that means that you don’t have the freedom to change it, whereas if you to have the freedom to change something that renders it less predictable.

  • [...] China and the socialist calculation debate Filed under: austrian economics, china — twofish @ 7:39 am http://organizationsandmarkets.com/2007/09/04/what-does-austrian-economics-predict/  [...]

  • 17. Nicolai Foss  |  7 September 2007 at 2:45 am

    Nils, I agree with your reading: In TCE as conventionally stated it does not matter “who integrates who”. And as you quite rightly point out, this does not harmonize with bounded rationality. I think Brian Loasby made a similar critique in his review in Industrial and Corporate Change of Milgrom and Roberts (1992). But does this imply that we should ascribe common knowledge conditions to TCE. I think not. I would rather say that the theory may simply be incomplete in this particular dimension.

  • 18. twofish  |  7 September 2007 at 2:52 am

    The other prediction I think is that the natural size of firms are limited by information constraints, and that firms in areas were information is more uncertain and less predictable will be smaller.

    This comes from the question if “socialist calcuation works fine in firms” why wouldn’t it work fine in entire economies, and the answer is that the calculation problem in economies is much larger than in firms. This suggests that there is a “natural size” for a firm at which calculation becomes prohibitive. This is somewhat like the Coasian argument regarding transaction costs, but it is different since the focus is on information processing ability rather than on transaction costs.

    My view is that if you are talking about ‘transaction costs” you’ve already lost the argument, since talking about “transaction costs” implies that you have something that is quantifiable, and if you assume that “transaction costs” are knowable then I think you’ve undermined the socialist calcuation position that the problem is that you can’t calculate “costs.” Uncertainty is a quantity that exists independent of an economic framework.

    Also what exactly is a “firm.” The working definition that I have is that a “firm” is a bank account, which is where matters of corporate law come into play.

    One “sales and marketing” question is what do we define as “Austrian” and for that matter what do we define as “socialism.” I think of myself as Austrian even though I doubt Murray Rothbard would agree with most of my beliefs.

  • 19. Nicolai Foss  |  7 September 2007 at 2:54 am

    Twofish, U should check out my co-blogger’s paper in the Review of Austrian Economics 1996. It is related to what you are saying here.

  • 20. twofish  |  7 September 2007 at 3:02 am

    The other thing that I’m trying to construct is an Austrian theory of derivatives pricing. Current derivatives pricing models have their roots in neo-classical concepts of complete markets, and my sense here is that that they “got lucky” in getting a workable theory from economic principles that are wrong.

    I strongly suspect that there are mathematical connections between implied volatility, trade volume, forward curve prices, and implied volatility curve prices that can be derived from Austrian principles. The thing about derivative markets is that here you can use mathematics in a way that I think is acceptable to the Austrian framework.

    If you ask “what is the utility function of this derivative” that is talking about something that is abstract and unknowable. If you ask “what are people willing to pay me for this complex derivative” that brings in numbers and mathematics in a “non-bogus” way. The interesting thing about utility-function based models of derivative pricing is that they’ve published a whole bunch of papers, but none of that is useful in any real world situation, and I suspect that is because the economic theory behind these approaches is flawed.

    You can theoretically talk about the “utility function” of an indvidual, but it makes absolutely no sense to talk about the “utility function” of a market. Also, I strongly suspect, that even talking about the “utility function” of an individual will lend to some self-inconsistencies that can be illustrated with a derivatives market.

  • 21. Twofish  |  7 September 2007 at 3:18 am

    Some other lines of inquiry….

    Mainstream economics assumes that there is a well defined price. What if there isn’t? For example, right now talking about the market price of a sub-prime mortgage makes no sense. That goes with most economic objects. What is the price of a used car? What is the value of Exxon-Mobil? It *isn’t* a well defined quantity and I think treating it as if it is will lead to some sort of problem or contradiction. What that problem will be, I have no clue right now, but I think that Austrian economics says that there will be some major problem that no one has thought of yet is a testable prediction.

    Also related to calculation. The fact that people who deal with private equity talk human relationships and don’t use quantitative methods to allocate, I think can be explained in terms of Austrian concepts and are not amenable to mainstream economists. The observable fact that large companies are just plain bad at entrepreneurship I think is something that you can apply Austrian concepts toward that you just can’t with neo-classical approaches.

  • 22. John Fianna  |  27 August 2008 at 8:03 am

    I think the keyword here is “unique” Austrian predictions.

    a, b, and c have all been incorporated into the neoclassical framework (especially Hayekian uncertainty) and several of the information problems (stock/flow) associated with socialism have been solved by Stiglitz and Krugman and Coase back when they were economists.

    d) has not yet been incorporated into the neoclassical framework in a systematic way. although a lot of the Walrasian equilibrium work that contradicts has been revised thoroughly to account for it. so yeah, d) is definitely a unique and POTENTIALLY useful Austrian prediction.

    e) is not a unique prediction.

    f) is very similar to other points made on certainty and true but not unique.

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Nicolai J. Foss and Peter G. Klein, Organizing Entrepreneurial Judgment: A New Approach to the Firm (Cambridge University Press, 2012).
Peter G. Klein and Micheal E. Sykuta, eds., The Elgar Companion to Transaction Cost Economics (Edward Elgar, 2010).
Peter G. Klein, The Capitalist and the Entrepreneur: Essays on Organizations and Markets (Mises Institute, 2010).
Richard N. Langlois, The Dynamics of Industrial Capitalism: Schumpeter, Chandler, and the New Economy (Routledge, 2007).
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