07 July 2014

What is Austrian Economics about?

"First they ignore you, then they laugh at you, then they fight you, then you win."

After Noath Smith's and Mike Munger's ridiculous attacks on Austrian economics can we can say that we have finally entered phase two? In case one is a neoclassical economist interested in moving to phase three, here's with what you have to deal with before anything else.

Take this quote from Knight and Johnson (2007) summarizing a basic point made by David Kreps in one of the most widely used microeconomics textbooks (emphasis added by me):
What economists offer is an analysis of the existence and qualities of equilibrium outcomes that does not explain how markets actually generate such nice equilibria. In other words this demonstration "doesn't provide... any sense of how markets operate. There is no model here of who sets prices, or what gets exchanged for what, when, and where" (Kreps 1990, 195-8). Instead, economists offer "a reduced form solution" that "describes what we imagine will be the outcome of some underlying and unmodeled process" (Kreps, 195, 187). Standard microeconomic analysis, in other words, offers little understanding of precisely how "market/exchange mechanisms" actually operate (Kreps, 195, 190). Thus the claim that economic agents will find their way to equilibrium in a decentralized process is a "rather heroic assertion" and, by implication, it "seems natural to think that we could increase (or decrease) our faith in the concept of Walrasian equilibrium if we had some sense of how markets really do operate." Progress on this task can be made "only if we are more specific about the institutional mechanisms involved" in mar ket interactions (Kreps, 187,190). 

In fact, Knight and Johnson and Kreps are somewhat uninformed. There are two major attempts to explain price adjustment. One is provided by Kenneth Arrow, and the other one by Israel Kirzner (his theory of entrepreneurship, which rests at the very foundation of Austrian economics). Here's a graph of their relative impact on the economic profession (numbers from Google Scholar):

Bottom line: (1) Austrian economics currently offers the most widely accepted model of how real markets actually operate. Austrian economics is alternatively referred to as "the theory of the market process" precisely because its main concern is with addressing Kreps' realism concern above, and deriving the consequences from it. (2) The importance of having such a realistic model is widely recognized by prominent authors like Kreps or Knight and Johnson. 

How about macroeconomics and the Austrian Business Cycle theory? After all, this is the focal point for scorn and ridicule. 
  1. First, it is absurd to identify Austrian economics solely with this theory, especially that prominent Austrians (e.g. Israel Kirzner or Richard Wagner) are actually critical of it for not being Austrian enough (ABCT is a highly aggregated theory with many idealized assumptions). (Here's an example.) And the idea that ABCT is supposed to be apriori correct and in no need of empirical testing is also absurd. The theory is hard to test because it requires disagregated data on the capital structure. Here's a list of empirical papers trying test it (e.g. by looking at the structure of the labor market).
  2. Second, I think that, properly understood, ABCT is an application to macroeconomics of the theory of entrepreneurship -- it is a theory of how entrepreneurial activity gets distorted. So, you cannot really criticize ABCT without getting into the deeper problem of explaining price adjustments. And to say it again: the neoclassical theory of price adjustment is not very well developed (Arrow's approach is interesting, and not necessarily contradictory to Kirzner's, but, in order to do the math, he is forced to make many highly unrealistic assumptions).
Addendum: For more details about various aspects of Austrian economics see my course at GMU.