Austrian Economics Re-Examined Austrian Economics Re-Examined: the economics of time and ignorance is an expanded version of the 1996 edition of The Economics of Time and Ignorance . This work is a classic statement of the role of subjectivism, radical uncertainty and change through real time in Austrian economics specifically, and in modern economics more generally. The new book contains the full text and Introduction of the earlier edition as well as the comprehensive, previously unpublished essay “What Is Austrian Economics?” and a new Introduction. The essay is a comprehensive overview of the central themes of the book from a somewhat different perspective than in the book itself. It supplements the analysis in the book. The new Introduction explains that the 2007–08 financial crisis and recent developments in behavioral economics have made the book more relevant than ever before. Austrian Economics Re-Examined develops and systematizes the funda- mental principles of the Austrian tradition and applies them to the analysis of rational expectations, business cycles, monetary theory, competition and monopoly, and capital theory. Gerald P. O’Driscoll, Jr. is Senior Fellow, Cato Institute, USA. Mario J. Rizzo is a Professor in the Department of Economics at New York University. He is also Director of the Program on the Foundations of the Market Economy and Co-director of the Classical Liberal Institute at the New York University School of Law, USA. Routledge Foundations of the Market Economy Series editors: Mario J. Rizzo New York University Lawrence H. White George Mason University A central theme in this series is the importance of understanding and assessing the market economy from a perspective broader than the static economics of perfect competition and Pareto optimality. Such a perspective sees markets as causal processes generated by the preferences, expectations and beliefs of economic agents. The creative acts of entrepreneurship that uncover new information about preferences, prices and technology are central to these processes with respect to their ability to promote the discovery and use of knowledge in society. The market economy consists of a set of institutions that facilitate voluntary cooperation and exchange among individuals. These institutions include the legal and ethical framework as well as more narrowly “economic” patterns of social interaction. Thus the law, legal institutions and cultural and ethical norms, as well as ordinary business practices and monetary phenomena, fall within the analytical domain of the economist. Previous books in this series: 1. The Meaning of Market Process Essays in the development of modern Austrian Economics Israel M. Kirzner 2. Prices and Knowledge A market-process perspective Esteban F. Thomas 3. Keynes’ General Theory of Interest A reconsideration Fiona C. Maclachlan 4. Laissez-Faire Banking Kevin Dowd 5. Expectations and the Meaning of Institutions Essays in economics by Ludwig Lachmann Edited by Don Lavoie 6. Perfect Competition and the Transformation of Economics Frank M. Machovec 7. Entrepreneurship and the Market Process An enquiry into the growth of knowledge David Harper 8. Economics of Time and Ignorance Gerald P. O’Driscoll, Jr. and Mario J. Rizzo 9. Dynamics of the Mixed Economy Toward a theory of interventionism Sanford Ikeda 10. Neoclassical Microeconomic Theory The founding Austrian version A. M. Endres 11. The Cultural Foundations of Economic Development Urban female entrepreneurship in Ghana Emily Chamlee-Wright 12. Risk and Business Cycles New and old Austrian perspectives Tyler Cowen 13. Capital in Disequilibrium The role of capital in a changing world Peter Lewin 14. The Driving Force of the Market Essays in Austrian economics Israel Kirzner 15. An Entrepreneurial Theory of the Firm Fré d é ric Sautet 16. Time and Money The macroeconomics of capital structure Roger Garrison 17. Microfoundations and Macroeconomics An Austrian perspective Steven Horwitz 18. Money and the Market Essays on free banking Kevin Dowd 19. Calculation and Coordination Essays on socialism and transitional political economy Peter J. Boettke 20. Keynes and Hayek The money economy G. R. Steele 21. The Constitution of Markets Essays in political economy Viktor J. Vanberg 22. Foundations of Entrepreneurship and Economic Development David A. Harper 23. Markets, Information and Communication Austrian perspectives on the Internet economy Edited by Jack Birner and Pierre Garrouste 24. The Constitution of Liberty in the Open Economy L ü der Gerken 25. Liberalism against Liberalism Javier Aranzadi 26. Money and Markets Essays in honor of Leland B. Yeager Edited by Roger Koppl 27. Entrepreneurship and Economic Progress Randall G. Holcombe 28. The Theory of Dynamic Efficiency Jes ú s Huerta de Soto 29. Mind, Society and Human Action Time and knowledge in a theory of social-economy Richard E. Wagner 30. Markets, Morals and Policy-Making A new defence of free-market economics Enrico Colombatto 31. Understanding the Culture of Markets Virgil Storr 32. Producing Prosperity An inquiry into the operation of the market process Randall G. Holcombe 33. Austrian Economics Re-Examined The economics of time and ignorance Gerald P. O’Driscoll, Jr. and Mario J. Rizzo Austrian Economics Re-Examined The economics of time and ignorance Gerald P. O’Driscoll , Jr. and Mario J. Rizzo First published 2015 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 711 Third Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2015 Gerald P. O’Driscoll, Jr. and Mario J. Rizzo The right of Gerald P. O’Driscoll, Jr. and Mario J. Rizzo to be identified as authors of this work has been asserted by them in accordance with the Copyright, Designs and Patent Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice : Product or corporate names may be trademarks or registered trademarks, and are used only for identifi cation and explanation without intent to infringe. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication data O’Driscoll, Gerald P. [Economics of time and ignorance] Austrian economics re-examined : the economics of time and ignorance / Mario Rizzo and Gerald P. O’Driscoll, Jr. pages cm. – (Routledge foundations of the market economy) Includes bibliographical references and index. 1. Austrian school of economists. 2. Time and economic reactions. 3. Uncertainty. I. Rizzo, Mario J. II. Title. HB98.O372 2014 330.15 ′ 7–dc23 2014016617 ISBN: 978-1-138-02300-0 (hbk) ISBN: 978-1-315-77673-6 (ebk) Typeset in Times New Roman by Out of House Publishing To the Memory of Ludwig M. Lachmann (1906–90) This page intentionally left blank Contents List of fi gures xi Preface xii PART I Introduction 2014: a changing world 1 A changing world 3 PART II What is Austrian economics? 17 What is Austrian economics? 19 PART III The economics of time and ignorance 47 Acknowledgments 49 Introduction: time and ignorance after ten years 51 1 An overview of subjectivist economics 68 SECTION I Framework 78 2 Static versus dynamic subjectivism 78 3 Knowledge and decisions 92 4 The dynamic conception of time 105 5 Uncertainty in equilibrium 119 x Contents SECTION II Applications 135 6 Competition and discovery 135 7 The political economy of competition and monopoly 162 8 A subjectivist theory of a capital-using economy 185 (Chapter 8 by Roger Garrison) 9 The microanalytics of money 207 10 Some unresolved problems 239 Bibliography 245 PART IV Austrian economics: recent work 261 Austrian economics: recent work 263 Mario J. Rizzo PART V Responses to criticism 281 Twenty-fi ve years after 283 Gerald P. O’Driscoll, Jr. Foundations of The Economics of Time and Ignorance 288 Mario J. Rizzo Index 297 Figures I.1 Velocity of M1 money stock 5 I.2 Gaussian vs. Cauchy distribution chart 6 III.1 Value theory: a utility scheme 100 III.2 Airline pricing 165 III.3 Firm behavior 167 III.4 Market pricing 173 III.5 Determination of interest rates 219 III.6 Interest rate dynamics 224 Preface We are extremely happy to see Austrian Economics Re-Examined in print. This is an expanded edition of The Economics of Time and Ignorance , published by Routledge in 1996. The new edition contains many important additional features. There is a substantially updated Introduction that explains why, in our view, the book is more relevant than ever before. Perhaps most importantly, we are including the previously unpublished essay “What Is Austrian Economics?” Although this article is more of a survey than is the book, it was the basis from which we wrote the book. There is also the full text of the New Palgrave Dictionary of Economics article “Austrian Economics: Recent Work,” first published in 2009. Finally, we are including our largely self-contained responses to criticism we received at a session of the Southern Economics Association on November 19, 2011, that was held in recognition of the twenty-fifth anniversary of the original Blackwell edition of the book. If readers want to see the full symposium, it is contained in The Review of Austrian Economics , 2013, vol. 26, issue 1. We are indebted to Professor David Harper of New York University for organizing this session. We have also decided to create a website with recommendations for fur- ther reading, photos and other material helpful for a further appreciation of the book. We are indebted to Professors Simon Bilo (Allegheny College) and Shruti Rajagopalan (Purchase College) for urging the construction of the website and for their invaluable help in gathering the relevant content. The site can be accessed at http://timeandignorance.com . We are also indebted to Anne Stubing of the C. V. Starr Center at New York University and various research funds generously made available by NYU for help in producing the manuscript for this book. We are also indebted to the H. B. Earhart Foundation for further financial support. Gerald P. O’Driscoll, Jr. Mario J. Rizzo March 2014 Part I Introduction 2014 A changing world This page intentionally left blank A changing world The world has changed tremendously since the first Blackwell edition of the book in 1985, and since the Routledge edition in 1996. There have been very important changes in the economy and in the discipline of economics. Paradoxically, these have made our book much more relevant than it was. The changes in the external world and in the economics profession have destroyed, or at least seriously weakened, many of the taboos that used to dominate economic thought. The passage of time and the growth of knowledge combined to bring about a new era. It used to be the case that questioning the static nature of competitive the- ory was not fashionable, but clearly economists are more concerned now about dynamic issues. How could they not when innovations are springing up everywhere around us? The universal applicability of rigid and narrow axiomatic rationality assumptions (preference completeness, transitivity, and independence of framing, etc.) is under severe pressure from behavioral eco- nomics. The questioning of these opens the door to a greater appreciation of the pragmatic nature of economic rationality and to the subjective interpret- ation of economic “data.” We are also now permitted to question the intra- personal stability of tastes. Economists are thus more willing to embrace the importance of change even at the level of the individual. The financial crisis of 2007–08 and the associated Great Recession were extremely important economic events that have had a still difficult-to-evaluate impact on economic thinking. The general revival of Keynesian thought dur- ing the financial panic and the Great Recession and its aftermath brought with it a renewed appreciation of the old Keynes-Hayek debate as it became obvious that Keynes and Hayek were the true antipodes on the fundamental macroeconomic issues. We were extremely interested in this in our book – as well as in those areas in which we believe Keynes had valuable things to say. The importance of Knightian and radical uncertainty has not gone unnoticed by economists in view of the financial crisis. We remember many neoclassical economists saying that the distinction between risk and uncer- tainty is not very important. Situations could be modeled, they said, as if they were merely risky, especially in light of subjective probability. However, insofar as the riskiness of new asset forms were judged by the “stable” data 4 Introduction 2014: a changing world of recent history the possibility of structural change was ignored to the det- riment of all. The rule of law (a topic long of concern to Hayek) became an issue of renewed importance in understanding the policy response to the financial crisis, the Great Recession and other problems. Increasingly critics worried about the violations of the rule of law in Federal Reserve policy, in TARP and in the auto bailout. 1 These developments naturally led to an accelerated appreciation of the importance of institutions. This was a development that had been gaining importance, perhaps ever since the work of Ronald Coase. But institutions become even more important – a matter of economic life or death – during rough patches. Institutions cannot be fully understood except in the context of local know- ledge, another Hayekian theme, as was seen in the still-limited recovery from Hurricane Katrina in New Orleans. 2 In a development-economics context, the neglected importance of local knowledge became a critical point in ana- lyzing what critics believe is the overall failure of World Bank policies. Thus, the shifting and dissolution of scientific taboos and the recognition of certain “Austrian issues” promoted by recent events, even when they are not recognized as Austrian, have given the ideas in the book new and height- ened relevance. We believe that our ideas provide, in many cases, an alterna- tive to the increasingly obvious poverty of standard approaches. The plan In this new introduction there will be two main parts. In the first we sketch the impact of recent economic history on (mainly) the macroeconomic and monetary ideas that we sought to promote in this book. In the second we describe recent developments in behavioral economics that strengthen the case for our general approach. I. The impact of economic crises The financial crisis began with the Panic of 2007, and continued into 2008 with multiple crisis events involving, among others, mortgage giants Fannie Mae and Freddie Mac; failed investment banks like Bear Stearns (bailed out) and Lehman Brothers (not bailed out); and many financial firms whose solvency was in doubt at some point (e.g., Citigroup and Morgan Stanley). 3 The Panic involved a great housing boom financed by innovative financial instruments. After the housing boom ended there was a crisis in housing finance involving actual or perceived insolvency of firms at the center of housing finance. The crisis occurred in the midst of a period known as the Great Moderation (Taylor, 2009, pp. 34–46). It was a period in which the growth rates of mon- etary aggregates moderated. Macroeconomic flow variables, like real GDP, A changing world 5 became less volatile. But it was also a period of a great expansion in the vel- ocity of the M1 monetary aggregate. The increase in velocity, or decrease in money demand, accompanied the rise of “shadow banking,” in which housing loans (and other bank lending) were securitized. Long-term debt, like home mortgages, was increasingly financed by short-term credit, even overnight funding as was so famously the case with Lehman Brothers. A credit pyramid was erected upon a narrow base of bank money. The possession of Treasury securities or other eligible collat- eral financed transactions in repo (overnight repurchase agreements) markets. Gorton succinctly described the process. Another important feature of repo is that the collateral can be rehypothe- cated. In other words, the collateral received by the depositor can be used – “spent” – in another transaction, i.e., it can be used to collateralize a transaction with another party. Intuitively, rehypothecation is tanta- mount to conducting transactions with the collateral received against the deposit. There is no data on the extent of rehypothecation. (Gorton, 2010 , p. 44) Traditional banking was increasingly being replaced by securities markets. Banks and thrift institutions continued to play a role in originating home mortgages (though origination was also done by mortgage companies). But they no longer held the mortgages, which were bundled with others and sold off as securities. Information about the underlying risk of each mortgage was Figure I.1 Velocity of M1 money stock Source: Federal Reserve Bank of St. Louis. 2014 research. stlouisfed.org. 1960 Q4 1970 Q4 1980 Q4 1990 Q4 2000 Q4 FRED Velocity of M l Money Stock 11 10 9 8 7 6 5 4 3 6 Introduction 2014: a changing world lost in the process. Yet securitization only grew. Investment banks supplanted commercial banks, and repo markets grew in importance relative to the federal funds market. During the crisis, the repo market dried up. But so, too, has the federal funds market. The Federal Reserve’s extraordinary monetary policy actions (quan- titative easing or QE) have made it, and not interbank lending, the source of liquidity in banking. Today the Federal Reserve is increasingly operating in repo markets. 4 The conventional modern analysis of risk was challenged by these develop- ments in financial markets. The challenge has been analyzed in two, ultimately complementary, ways. One line of analytical criticism of standard risk models we will describe as immanent. It questions the properties of the distribution of risk. Standard risk analysis models risk with a Gaussian distribution. That is typically described as a normal or bell curve. The events in the recent finan- cial crisis suggest “that financial returns are not Gaussian – or even remotely so” (Dowd et al ., 2011 , p. 14). The Cauchy distribution is one “fat-tail” distribution, and it is reproduced here along with a normal distribution. The Cauchy distribution implies that “extreme losses are much more likely than under the Gaussian” (Dowd et al ., 2011, p. 14). How much more likely? In August 2007, Goldman Sachs’ CFO David Viniar stated that “we were seeing things that were 25-standard deviation moves, several days in a row.” 5 Dowd et al . estimate that a single 25-standard Figure I.2 Gaussian vs. Cauchy distribution chart http://research.stlouisfed.org/fred2/series/M1V/ Source: © The Cato Institute 2011, from Policy Analysis , 681, p. 14. Used by permission. 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 - 8 6 -4 -2 0 x 2 4 6 8 G a u s s ia n C a u c h y A changing world 7 deviation event should occur only once every 10 (to the 137th power) years. They conclude that “to be plausible, risk models need to be based on alterna- tive distributions to the Gaussian” (Dowd et al ., 2011 , p. 14). Alternatively, one can view recent events as manifestations of Knightian uncertainty. Frank Knight argued there was (1) an absence of objective prob- abilities and (2) an inability to list, or determine beforehand, the complete set of possible outcomes. Risk managers extrapolated recent history to model the riskiness of new types of complex and bundled securities, especially mortgage- backed securities (MBS). In 2009, Edmund Phelps asked rhetorically, “why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention?” He went on: The answer, I believe, is that they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down. The banks’ chief executives, too, had little grasp of uncertainty. Some had the instinct to buy insurance but did not see the uncertainty of the insurer’s solvency. (Phelps, 2009 ) The Knightian critique is more fundamental, since it questions whether there are discoverable distributions of risk in all instances. Knight certainly recognized that many risks are calculable. Modern risk analysis collapses Knightian uncertainty into quantifiable risk, and then assumes a normal distribution of risk. In the wake of the fi nancial crisis, each of those steps must be questioned. When the housing boom went bust, economists of the Austrian school saw it as a textbook example of malinvestment ending in a crisis. The Austrian analysis built on that of classical political economy – as Mises, Hayek and others long emphasized (Mises 1966, p. 204). Some financial analysts, econo- mists and members of the public acknowledged the applicability of Austrian analysis. Many members of the economics profession busily defended theor- ies that neither predicted nor accounted for what had happened. The most surprising thing, however, was that the public policy response was to fall back on crude versions of Keynesian income-expenditure mod- els. Hoary myths of fiscal-expenditure multipliers greater than one were res- urrected, in some cases by advisers to President Obama whose own work undermined such beliefs. Of such beliefs, Milton Friedman observed more than 50 years ago that “they are part of economic mythology, not the demon- strated conclusions of economic analysis or quantitative studies” (Friedman, 2002, p. 84). In the ensuing 50 years, a large body of economic research – eco- nomic analysis and quantitative studies – debunked that mythology. Much