The Illusion That Makes the Math Look Nice

Perhaps the greatest contribution of socialism to economics was to cajole Austrian economists into understanding just how different their theoretical approach was from the main stream of economics. At first, Ludwig von Mises and F.A. Hayek thought they were on the leading edge of that main stream. But the two major debates that they engaged in in the first half of the 20th century — over business cycle theory and regarding calculation in the socialist society — both proved vexing. They should have won both debates. They had the better arguments. But in both cases the majority of economists sided against Mises and Hayek.

And in both cases it was, in a sense, over equilibrium theory.

Pete Boettke, interviewed on today’s EconTalk podcast by Russ Roberts about the contributions of Mises, makes this pretty clear. Three quarters into the program, both Boettke and Roberts attack the scientistic assumption that because an equilibrium can be defined, it can be established. For socialists, this might as well be a matter of hocus pocus. Mises and Hayek became interested in the processes that would allow many competing and co-operating traders to reach equilibria. Or, as Boettke and Roberts state it (this transcript does not indicate who’s speaking)

Hayek writes an essay called “The Meaning of Competition” and Mises starts developing and using the term the “market process” as opposed to equilibrium states of affairs. That analytical approach follows on the heels of what they learned in their debate over other economists over socialism, because what other economists were doing was going to the equilibrium end-states and saying: If the equilibrium end-state is defined as x, I can just say, under socialism, let’s assume x and then we’ve mimicked what it is that capitalism would deliver. And Mises and Hayek said no, we have to explain how x comes about, how it emerges from the exchange behavior of individuals. Because you can’t really take tastes and endowments as given — that’s an illusion that makes the math look nice but in real practice could never be implemented.

Earlier, Boettke had indicated that something similar was happening in the business cycle research area, where the Austrian view turns out to be far more nuanced than the simple quantity theory of money view:

In fact the quantity theory is one of the most important ideas because basically you are not going to make everyone better off by printing money. You are just going to make prices go up. So, there is a relationship between the quantity of money and prices in the economy. What Mises does is he defends the quantity theory, but he argues that we can’t have a mechanical interpretation of it. . . . Mises . . . argues that the quantity theory of money viewed mechanically underestimates the distortionary forces of inflation. It’s as if as soon as I double the money supply, prices are going to double instantly and there won’t be these consequences — the only costs of inflation are the menu costs: you have to change the numbers on restaurant menus. Mises wanted to show, and this was a great innovation on his part, was that injection effects — the way that prices adjust through the economy — they adjust through relative price changes, not a whole price level change. Eventually the math is going to work out that way: you double the money supply, eventually all prices are going to adjust. But in the short run there can appear to be a case where the effect on a nominal variable can have a real impact. You distort relative prices, distort your choices. That’s what sets up the business cycles.

In both monetary theory and regarding socialism, non-Austrian economists tend to misunderstand what equilibrium theory means. They misuse a tool of economics, and thereby misunderstand reality. Were I a Marxian, I would probably call this tool fetishism.

The whole conversation is interesting, and worth a listen. I certainly do not disagree with Boettke’s list of Mises’ major contributions, but I am slightly surprised that Boettke does not even mention Mises’ advancement of the ordinal conception of utility in The Theory of Money and Credit (and of course in Human Action). Mises insisted that utility was not measurable, and showed why elaborate cardinal conceptions of utility by economists such as Irving Fisher failed.

Not only was his work on this prior to the Slutsky/Allen/Hicks pushing of indifference curves over the regnant notion of cardinal (measurable) utility, it fits with the distinctive “Austrian distinctiveness.”

It served as Mises’ first major foray against the illusions of neoclassical economics. And it targeted, quite exactly, the neoclassical vice of over-emphasizing math and thereby misunderstanding what a mathematical theory’s actual value is, as a tool for understanding. Mainstream economists have demonstrated a preference, over and over again, to view economics as a kind of physics that gains its “scientific” character by elaborate mathematical reasoning. By leaping to mathematical conceptions, they tend for forget the things they are trying to explain, and get lost in a fantasy world of their own imagining.

Economists in the Austrian tradition, on the other hand, have emphasized the things themselves — not mere models of them — and developed principles and tools that explain what is actually going on in the real world.

Indeed, it may be helpful to think of Austrian economics as the science of economic reality and economic illusion — for in both the boom and bust cycle and in the attempts to establish a socialist society, human beings find themselves caught up in illusions. Austrian theory helps us sort out the fact from the fiction, the illusions embedded into central banking monetary systems and the very appeal of total government control of the economy. Austrians succeeded at these endeavors better than other schools in large part because they foreswear delusion as a tool for understanding.