Part 1: A Legacy outside the institution
Part 2: Currents in Austrian School; fundamentalism, scholarship, media, etc..
part 3: Financial economics: The Efficient Market Hypothesis
Part 4: Classsical economics and Market Socialism; Updating classical
Part 5: Hayek vs. Central Planning; Hayek Vs. Rational Expectations
Part 6: The Cycle and Rational Expectations; island Parables
Part 7: The Cycle as a Prisoner's Dilemma -- in "Anarcho Capitalism"?
Part 8: 2008 Crisis and Market Efficiency; Keynes vs. Chicago vs. Hayek vs. Warren Buffett
A Bird's-eye view of Keynes vs. Hayek in context of New Classical
Keynes believed that in a general economic downturn, there were incentive problems for both individuals and firms to act in a way that would get the economy back to full output. Let's let those reasons remain unspecified. The key Bird's-eye concept is that supply meets demand below the economy's full output potential. Keynes believed that by deficit spending and increasing the money supply (lowering interest rate), government could kick-start the engine and get the economy moving to full output. Perhaps like a chemical reaction that fizzles and needs a jolt of energy to move it along, the economy can be stuck at a false equilibrium. And if our macro data is good enough, we can fine-tune the machine -- keep that graph reading full output 24/7/365.
Sound good? An extreme example for the sake of clarity: Suppose that every time unemployment reached 6.756%, the model tells the central planners to lower interest rates by 2.356%, and this will move the economy back to full employment. The pattern is like this (pretend the dashed lines are 50% higher and reach the apex of the "V". It's supposed to be a flat line with randomly placed troughs):
--\/----\/\/---\/
The flat line is the economy at full employment. A downturn represented by "\". Rock bottom in this graph is 6.756% unemployment, because the Fed knows at this level to lower rates by 2.356%, which kick-starts the economy on the up slant until full output is reached at the solid line again. Life is good until the next downturn, and central command's market engineers watch closely until the needle falls to 6.756%.
Recall, or go back and read, part 3 about the Efficient Market Hypothesis. Remember this? /\/\/\/\/. If you're an analyst watching the price of a stock following a predictable pattern, you're going to buy at the troughs and sell at the peaks. But so are thousands of other analysts. The sum total of buying at the trough will bid up the price very quickly to where the "/" changes to something more like a "|", and you can begin to see how the information from the pattern will lead to market activity that destroys the pattern. If fact, the intuition tells us that there should never have been a pattern in the first place. Now consider the Keynesian world in this extreme example, do you think the Phds working for the largest financial and retail firms of our nation are going to say in a downturn, "Oh boy, unemployment is at 6.753%, only .003% left to go and we can have confidence in the economy again." No. They'll anticipate the Fed's intervention and adjust their plans before the Fed intervenes, thus, the "\" never reaches 6.756% because collective actions of firms begin the upturn early. The reasoning continues down the same path as the stock analysis scenario and we're left with the intuition that there should never have been a pattern in the first place, or rather, the central planners would never have had a model of the economy that allowed them to predict the effects of their intervention.
If you ever get a chance to watch Freakanomics, Steve Levitt of the University of Chicago subtly outlines the central dogma of Chicago in single minute. He drops an anecdote about potty training his 3-year-old daughter. She didn't want to go. He offers her a candy. It works. But then something unexpected happens, she begins going just a little, retrieving her candy, and then going a little more, and getting a second candy. Why go once for one candy when you can go 10 times and get 10 candies? Levitt is a Phd, his daughter is 3. His point: people are incredibly good at beating systems, or policies.
The credit officially goes to Robert Lucas (1972). His idea called Rational Expectations* is that if we have a model of the economy, people will use the model to adjust their expectations about the future, but since they are part of the model, the model changes. A swarm of bees might be a complex system like an economy, but what makes modeling an economy different than modeling a swarm of bees is that the individual bees do not change their behavior based on knowledge of the models we create. In my view, as an bonus, Rational Expectations cleanly undermines the intuitive step from "the economy is a system of equations," to "The economy is a system of equations an analyst can use to engineer the economy."
Moving on to the Austrian Business Cycle. Above, I assumed an economic downturn for Keynes to step into and fix. But why is there a downturn? If markets are adjusting and clearing, why should there ever be a time when the economy crashes? Why does the economy go through "booms" and then suddenly "bust"? Austrians believe that a system of markets should be coordinated enough that booms and busts never happen. The economy should just hum along at mediocrity. Without getting into the Austrian mechanisms yet -- next post -- they believe that economies do just hum along, but governments get involved with monetary policy to stimulate the economy, the stimulus works, but only in the sense that we're consuming our resources faster. We boom, but at some point, our stockpiles run dry and we go bust.
From the perspective of a person who has taken a basic macro class in school, it's trivial to see this model is much like the Keynesian model in an important sense, we can imagine a pattern: /\/\/\/\/\ (boom/bust-boom/bust; this is another oversimplification of course, to show the point). The Austrian version of Phds working for large financial and retail firms say, "Oh boy, the Fed is printing money again, good times! Let's expand! Let's ignore the fact that the last four times this happened we ended up in crisis. If we hold the fort down instead of expand, when the bust comes next spring, we can buy 20 companies before moving into the next boom. But it's better to go along for the crash." In both the Keynes and Hayek story, market participants will outsmart the government; in the case of Keynes, stimulus doesn't help, for Hayek, stimulus doesn't hurt. In a way, Keynes and Hayek are two peas in the same pod.
If we had to define "modern economics" by a clash between two economists, it wouldn't be between Keynes and Hayek or even Keynes and Friedman, but between Knut Wicksell of Sweden and Irving Fisher of America. A kernel of RE intuition traces back to their debates on money. Does infusing more money "do something" to the economy, or do people write it off as inflation? Keynes and Hayek have their influences in Wicksell, and the American libertarians were influenced by Fisher.
Paul Samuelson appreciated the RE criticism and reworked Keynesian theory. Although Friedman's own position is not explicitly defined by RE, much of that intuition is in his work. Friedman arrived at the point where deficit spending does nothing, and money expansion does almost nothing, but something. The end-game implications of RE is Real Business Cycle theory, which says neither fiscal nor monetary does anything. Interestingly, RBC and ABC prescribe the same policy of "do nothing" but the worlds are not alike. In ABC, "do nothing" stabilize the world and it goes on happy. In RBC, "do nothing" leaves the world getting kicked around by random shocks on occasion. Unlike Keynesian theory, the Austrians fully reject RE and maintain a unique position, as explained by economist Roger Garrison,
Garrison wrote:The Austrian treatment of expectations is guided by considerations about what kind of knowledge market participants can plausibly have. Hayek often makes use of the distinction between two kinds of knowledge. Theoretical knowledge, or knowledge of the structure of the economy, is contrasted with entrepreneurial knowledge, or the knowledge of the particular circumstances of time and place. Economists have some of the first kind of knowledge but not much of the second; market participants have some of the second kind of knowledge but not much of the first...
...It's worth pointing out that the Hayekian distinction between theoretical and entrepreneurial knowledge helps identify the limits of both rational planning and rational expectations. Trying to push beyond the limits reflects erroneous views about who can plausibly have what kind of knowledge: Advocates of rational planning believe that planners or their economists can have as much—if not more—of the second kind of knowledge as can market participants. Proponents of the more extreme versions of rational expectations assume that market participants have, or behave as if they have, as much of the first kind of knowledge as do economists.
http://www.auburn.edu/~garriro/a1interview.htm
The Austrian view is the middle ground. I'll take this as is, but I do wonder if this position reads an explicit view into Hayek that wasn't so fleshed out by him, since RE came years later. This distinction between the different kinds of knowledge market players have and economists have makes for an interesting view and perhaps is a good way to argue against market socialism, but I think it's an artificial distinction that isn't valid. And I think it is unnecessary as a guard against market socialism as post RE, markets naturally defy any models used to command them. Further, I think the Austrian rejection of RE allows central planning to sneak in the back door. If there are market participants who consistently outsmart the market in a significant way, they can become the central planners. Let the market decide who is silver and gold, and then elect the gold as the philosopher kings. I'll bet Lange would have liked this trial-and-error suggestion.
Finally, the "do nothing" bent of libertarians makes it easy to confuse Hayek or the Austrians as the rightful motif within mainstream migration away from Keynes, in particular, with Friedman's journey. But it's oil and water. If two people believe no ghosts are haunting a house, but one person believes it's because there are no ghosts and the other believes garlic is keeping the ghosts away, it's tough to say there is much in common here.
*Rational Expectations is the terminology in macro, Efficient Market is the terminology in financial econ.