Sunday, July 29, 2012

Economic Calculation Revisited

The use of words “economic calculation” are almost a mantra for vulgar internet advocates of Austrian economics. When criticisms are made of Austrian economic theory, the usual red herring response is some charge of having failed to understand “economic calculation.”

The last time I dealt with this issue it led to the following exchange:
Jonathan Finegold Catalán, Economic Miscalculation: A Reply, Economic Thought, 7 February, 2012.

Jonathan Finegold Catalán, Economic Miscalculation, Economic Thought, 6 February, 2012.

“Austrian Nonsense About Economic Calculation,” February 3, 2012.

“Economic Calculation Yet Again,” February 7, 2012.

“Economic Calculation, Part 3,” February 7, 2012.
The upshot of all this was Jonathan Finegold Catalán’s view of the Austrian business cycle theory (ABCT) as one theory within the broader Austrian theory of economic coordination and discoordination:
“To clear up any confusion amongst third party readers, what I call the “theory of intertemporal discoordination” is Austrian business cycle theory — I prefer my term, because I think it gets across what the theory is about much better than the conventional one. Furthermore, as I posited in my original post, the new term suggests that the theory is only one facet of many within the body of theory of economic coordination (and discoordination). More accurately, it describes an artificial tendency of discoordination between investment and societal time preference (the latter dictating the aggregate stock of savings at any given point in time).”
The ABCT is one of economic miscalculation and malinvestment. This overarching, broader Austrian theory of economic calculation is supposed to show how the market economy would work free from government distortions.

The fundamental part of this broad Austrian theory of economic coordination/discoordination is the role of prices in a market economy.

Supposedly government deficit spending, price controls, subsidies, income policies, and so on will impair economic calculation on the market by impairing prices, presumably in some disastrous destabilising way.

But it is not difficult to see how the Austrians have a view here that sees the market as ridiculously feeble. For example, does the existence of some minor government subsidies cause an Austrian trade cycle? Would they impair the ability of the private sector to engage in production of commodities with rising real output? Would they distort the market so badly that nobody could engage in “economic calculation”?

For example, the idea that the normal types of government spending cause some severe problems of “economic calculation” leading to market chaos is patent nonsense.

Whatever “distortion” government causes is no more or less severe than what the private sector itself imposes. For example, it is absurd to believe that the millions of agents offering goods and services get their prices right in terms of demand/supply dynamics. Many corporations and business are in fact price setters/administrators: they set their prices according to production costs and then a profit markup, then leave them unchanged for significant periods of time, even when demand changes, as even Ludwig Lachmann understood (Lachmann 1986). The prices are not fundamentally set by supply/demand dynamics at all: they are set by central planners in corporations. A market economy at any one moment has a vast number of “wrong” prices. But this does not mean that the market collapses: it still achieves investment, production and economic growth over long periods.

The alleged price “distortions,” either public or private, don’t destroy capitalist economies. They don’t prevent vast and successful private production of wealth and investment. In the case of price setting, the empirical literature suggests that it has benefits they outweigh costs: stability of profits and the prevention of disastrous price wars between businesses, for example.

And completely “unadulterated” prices in a free market would not necessarily be right prices in the sense imagined by neoclassical or Austrian economics at all. Many would be wrong, merely because producers/sellers aren’t perfect.

But the market system doesn’t require “right” prices in the standard economic sense of equilibrium prices to be successful and dynamic.

If we extend this analysis from price setting to profits, we can say that the existence of significant price setting in many markets by private businesses does not mean the economy is necessarily subject to some unsustainable and devastating “economic calculation” problems, because profits are, thereby, also made stable.

A consequence of price setting is a kind of profit “setting”: profits for the firm are made stable by price setting activities. Far from being a cause of intractable “economic calculation” problems, this profit stability is more likely a strong stabilising factor for modern businesses: for stable profits allow stable margins for internal financing of investment (Melmiès 2012).

The market system is far more robust than what Austrians think it is, with their feeble-minded obsession with price distortions.


UPDATE

I have added a quick update above on the role of profits in light of Jonathan Finegold Catalán’s reply to this post here:
Jonathan Finegold Catalán, “Irony; One Last Time,” Economic Thought, 29 July, 2012.

BIBLIOGRAPHY

Lachmann, L. M. 1986. The Market as an Economic Process. Basil Blackwell. Oxford.

Melmiès, J. 2012. “Price Rigidity,” in J. E. King, The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 452–456.

17 comments:

  1. So why doesn't the stickiness of wages and prices written into contracts cause economic chaos? For example, people and businesses regularly sign leases for various periods of time where they pay a regular amount of rent every month, even if the market rates for renting comparable properties change on a month-to-month basis.

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  2. While I am in agreement with what you are saying, I am struck by the part about price-setting. Do you consider the dismantling of airline price controls under the Jimmy Carter administration in the US to be a bad thing?

    The rationale for airline companies opposing the dismantling of price controls at the time was the same as what you suggest - the likelihood of price wars and a race to the bottom.

    Yet, surely the outcome was not worse for either the consumer or the airlines?

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    1. I suspect you will find many people who think the result of airline deregulation was a mixed bag.

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    2. Prateek-

      The US airline industry, while usually offering lower prices than the nationalized European lines, is something of a basket case. Airlines routinely declare bankruptcy. I think the argument can be made that, like commuter rail, air travel satisfies the conditions of a natural monopoly, and needs either regulation or public ownership.

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    3. Airlines in general seem to be a very fragile industry. Witness the many Austrian complaints regarding the 'zombie airlines' in Japan.

      http://online.wsj.com/article/SB10001424052748704559904576228082592256362.html

      It seems to me that airlines are fragile because they are exposed to volatile prices -- especially fuel prices -- and inconsistent market demand -- people cut holidays out of their budget in recessions rather than cutting food or rent, for example. My feeling is that we'll always have periodic government intervention in these markets. (Not to mention the fact that all the technology used in this sector comes from government subsidised military research...).

      On a personal note, I've found the 'budget' airlines -- which are generally held up as paragons of free market virtue -- to be rip-off artists and price gougers. I refuse to use them any more for the simple reason that, when hidden fees are included, they often add up to being the same price or even more expensive than the mainstream airlines. They also treat their staff like dirt, have poor customer service and play advertisements during the flights.

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  3. Austrians believe that in an unhampered market there would be a tendency for prices to move towards equilibrium levels. If all prices were at these equilibrium levels then the structure of the economy would be such that output would be optimized to meet the needs of the participants based based upon transactions freely engaged in between them. Whether such an outcome is desirable or not is obviously not an economic judgement.

    Austrians believe that the kind of interventions mentioned in the article will mean that prices will not tend towards their equilibrium levels as defined above. This will not cause capitalism to collapse - just to be sub-optimal. Resources will be used up enforcing these policies, and the structure of production will not produce the combination of goods that would be produced based people freely transacting with each other. Sometimes such interventionist polices (such as minimum wage and rent control) will have unintended side-effects, sometimes (such as tax to subsidize a govt bureaucracy) they will work as designed.

    You refer to ABCT. Austrians believe that a certain kind of interventionism - the artificial lowering of the interest rate below its natural level - can , if systematically carried out over many years , lead to a boom/bust cycle. This does not destroy capitalism - it just leads to it being sub-optimal in a way not intended by the policy-makers. Smart interventionists (such as post-keynsians ?) would probably avoid such policies.

    The argument in this post seems to be: Capitalism is robust so therefore its okay to mess with the price system for political ends. Even in a free market prices will always deviate from their equilibrium levels - therefore its okay if we cause them to deviate a bit more for these same political ends. I don't necessarily see anything wrong with this argument. If you want to live in a world of state-control and sub-optimal production because you think it creates a better society then nothing in Austrian economics would say that this is not a sustainable model.

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    1. "Austrians believe that in an unhampered market there would be a tendency for prices to move towards equilibrium levels."

      It is better to say some Austrians think this.

      But it is not an "Austrian" idea per se.

      The belief in a tendency to a price vector that will clear all markets (with wages clearing the labour market) is not an Austrian idea at all: it is Walrasian/neo-Walrasian neoclassical idea from general equilibrium theory.

      Some Austrians do not believe it, such as the radical subjectivists.

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    2. And, incidentally, anyone who says that this theory - the market clearing unique price vector - is an "Austrian" idea somehow not understood by critics of Austrianism is guilty of the sheer ignorance and intellectual incompetence.

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    3. To say something is an "Austrian" idea doesn't mean that it a UNIQUELY Austrian idea - merely that its a central idea in Austrianism.

      I take your point about the tendency to equilibrium not being held by all Austrians. A minority appear not to hold this view.

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    4. I am not even sure if this is a position strictly for the radical subjectivists. Catalán, for one, interprets Mises as one who didn't hold a 'tendency towards equilibrium' view. This claim actually sparked a little debate between him and Lord Keynes and I on Mises' position.

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    5. I have a lot of respect for Catalan but his arguments in that debate didn't persuade me that Mises did not believe in a tendency to equilibrium.

      Still to read Lachman but I am curious to understand how his idea actually fit into an Austrian framework at all given the discussions surrounding him that I have seen.

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    6. He is no doubt an Austrian, this really isn't debatable. In fact, as Vaughn points out in her book Austrian economics in Amerca: A Migration of a Tradition, he is probably the 'most Austrian' out of all the Austrians. Lachmann's vision was to think of the Austrian school as being the alternative of other economic school, and not necessarily a 'fill in the gaps' theory for neoclassical econ

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  4. Lord Keynes,

    I am really surprised that you did not mention Sraffa's work. You of all people should know he proved that income distribution determines prices, and not the other way around.

    Moreover, radical uncertainty about the future results in frequent mispricing of stocks, bonds, securities, etc.

    Pure markets, left on their own, also do not factor in negative and positive externalities, further disrupting these so-called "price signals."

    So, in a nutshell, there isn't anything really that sacrosanct about the prices in a totally laissez-faire society.

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  5. Supposedly government deficit spending, price controls, subsidies, income policies, and so on will impair economic calculation on the market by impairing prices, presumably in some disastrous destabilising way.

    But it is not difficult to see how the Austrians have a view here that sees the market as ridiculously feeble.

    Ah yes, when vulgar Keynesians see the destruction that is left in their wake, and their attention is directed to their own policies as the cause, the vulgar Keynesians do a bait and switch, and completely deny the context, and criticize Austrians for pointing out that central planning in money hampers economic coordination, because they are allegedly not as confident in the free market as the vulgar Keynesians?

    How can this be? If the vulgar Keynesians really were honest about how well they believed the market functions, even in the face of massive monetary manipulation, then there would be no need for vulgar Keynesian policies in the first place.

    But we're told a contradictory claim. We're told that the market process inevitably results in depressions and that only mommy and daddy government can fix it. Then, when economists point out to vulgar Keynesians that their policies are counter-productive, they turn around and DEFEND the market against the economists!

    This sophistry is on par with crank doctors who bash patients over the head, and then, when more intelligent doctors point out the counter-productive means of bashing patients over the head, the crank doctors then say "If you think the human body is that "feeble", then it's a good thing I am in charge, because it would be even worse without my management!"

    For example, does the existence of some minor government subsidies cause an Austrian trade cycle?

    Roddis and Catalan are right. You don't understand ABCT.

    For example, the idea that the normal types of government spending cause some severe problems of “economic calculation” leading to market chaos is patent nonsense.

    Government spending is not what causes the business cycle in ABCT, but it does hamper economic calculation of real consumer preferences. This is because government activity necessarily overrules market based consumer activity.

    Whatever “distortion” government causes is no more or less severe than what the private sector itself imposes.

    Well that's just rubbish. Violence backed state actions cannot possibly cause equally severe problems as peace-backed market actions.

    mojo.rhythm:

    Pure markets, left on their own, also do not factor in negative and positive externalities, further disrupting these so-called "price signals."

    State activity is cost externalization of costs par excellence. It trumps market externalities. For just consider. In order for the state to finance a court case, say, between Mr. Smith and Mr. Jones, they confiscate the property of millions of taxpayers. That is externalization of costs.

    There really isn't anything sacrosanct in state intervention. It's just thugs overruling others, good and bad.

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    1. "We're told that the market process inevitably results in depressions and that only mommy and daddy government can fix it. Then, when economists point out to vulgar Keynesians that their policies are counter-productive, they turn around and DEFEND the market against the economists!"

      There isn't any contradiction.

      To say that (1) the market has no tendency to full employment equilibrium is in no way incompatible with the assertion that (2) private price administration by corporations or government spending, subsidies etc results in pricing chaos or inability of the private sector to increase real output.

      "Violence backed state actions cannot possibly cause equally severe problems as peace-backed market actions."

      Ah, yes, the usual retreat to the sham of Rothbard's or Hoppe's ethics.

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    2. Jan said: There aren´t any "Austrian" economic school of any kind,since the first and second generation of Austrian economist.Both von Mises and Hayekian version are builded on a painful simplified distortion of Knut Wicksell´s cumulative process.The other parts they have picked up from Laussane school and Brittish currency school.When other great Austrian economists like for example Joseph Schumpeter made contributs he was of course just not considered a "Austrian"!It seems this crackpots have taken the Austrian Citisenship away people of Austria. The irony is when i talk with Austrian economist today,their hardly know much or is interested of this little side track of cranks.Since Austria indeed was one Metropolis in early 2000 century of new intectual ideas with real important ideas in all areas,this pale figures like von Mises et consortses just faded away.What is von Mises compared to such as Moritz Schlick,Sigmund Freud, Ernst Mach,Gustav Bergmann, Rudolf Carnap, Philipp Frank, Hans Hahn, Tscha Hung, Victor Kraft, Karl Menger, Richard von Mises, Marcel Natkin, Otto Neurath, Olga Hahn-Neurath, Theodor Radakovic,Herbert Feigl, Ludwig Wittgenstein and Kurt Gödel??I would say, nothing!!!

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  6. State activity is cost externalization of costs par excellence. It trumps market externalities. For just consider. In order for the state to finance a court case, say, between Mr. Smith and Mr. Jones, they confiscate the property of millions of taxpayers. That is externalization of costs.

    Two wrongs don't make a right. That's the kind of elementary logic you should have learned in kindergarten. I was criticizing markets and the oft repeated idea that only laissez-faire price signals are "correct." Attacking the state is just an obvious, hackneyed means to divert attention away from the issue at hand. Nice try, but no cigar.

    There really isn't anything sacrosanct in state intervention. It's just thugs overruling others, good and bad.

    Notice your bullshit black-and-white hyperbole there. Either the state must be sacrosanct or a force of pure evil. A damn lot of grey area exists between those two extremes, and that's where reality happens to be. Politics and society are messy and complicated; they always have been. Deal with it.

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