In* recent decades we have witnessed several debates on the legacy of Friedrich von Hayek in the realm of monetary policy. His writings have been both endorsed and attacked by economists from opposing branches of Austrian economics.1 Part of the problem is that Hayek partially changed his mind throughout his life and gave different policy prescriptions in the 1970s than he did in 1930s.2 But even the interpretation of his major works on money, banking and business cycle from 1920s and 1930s poses some problems.

We would like to shed some light on the Hayekian analysis of different monetary institutions. Specifically, we want to clarify what the economic consequences of such institutions: fractional and one-hundred percent reserve banking; and various monetary policy norms of central banks.3 Special attention will be given to the differences between constructs of pure money and business cycle theories as opposed to policy prescriptions. The first section discusses the relation between fractional-reserve banking and the business cycle. It also deals with Hayek’s opinions on one hundred percent reserve banking. In the second section we debate the claim of Hayek endorsing the monetary policy of stabilizing the level of nominal spending. Several concluding remarks are offered in the last section.

Fractional and One-Hundred Percent Reserve Banking

In Hayek’s view the contemporary organization of the banking sector was responsible for the cyclical fluctuations of the economy. He devoted the whole chapter of the Monetary Theory and the Trade Cycle to show that the expansion of credit by fractional-reserve banks must necessarily lead to unsustainable boom even if there is no central bank.4

According to Hayek the magnitude of the bank’s credit expansion depends on its cash reserves. The crucial point is “that the ratio of reserves to deposits does not represent a constant magnitude, but, as experience shows, is itself variable.”5 If, for whatever reason, economic conditions improve and banks consider their cash reserve to be excessive, they will grant additional credit to their customers. “[F]or reasons of competition ... the bank that first feels the effect of an increased demand for credit cannot afford to reply by putting up its interest charges; for it would risk losing its best customers to other banks that had not yet experienced a similarly increased demand for credit.”6

This expansion of credit occurres without corresponding growth of savings. Other banks cannot distinguish between deposits created out of new savings and the ones created without it. They will join the credit expansion, as money from other banks will be deposited in their company, and lower their growing reserve ratio. The effect of the process is that the money rate of interest is for the time being lower than the natural rate.

Only so long as the volume of circulating media is increasing can the money rate of interest be kept below the equilibrium rate; once it has ceased to increase, the money rate must … rise again to its natural level and thus render unprofitable … those investments which were created with the aid of additional credit.7

Since fractional reserve banking is in Hayek’s view responsible for the business cycle, it’s hardly a surprise that he mentioned on several occasions the idea of one-hundred percent reserve banking. As early as 1925 he discussed the idea shortly in a review of Federal Reserve monetary policy after the crisis of 1920. Hayek wrote the following:

The older English theorists of the Currency School, who, as we already pointed out, understood the nature of cyclic fluctuations better than most of the economists who came after them, also hoped that cyclic swings could be prevented by their proposals for the regulation of note issues. … If the basic idea underlying the Peel’s Act were consistently implemented and a 100 per cent gold coverage were required for bank deposits as well as for bank notes, the problem of preventing depressions would be resolved in a drastic manner.8

A monetary system without business cycle seems like a desirable goal, but Hayek was not eager to advocate the idea of abolishment of fractional reserves. In Monetary Theory and the Trade Cycle Hayek stated clearly that in case of one hundred percent reserve banking:

[t]he stability of the economic system would be o9 btained at the price of curbing economic progress. The rate of interest would be constantly above the level maintained under the existing system. … The utilization of new inventions and the “realization of new combinations” would be made more difficult, and thus there would disappear a psychological incentive toward progress.

Hayek didn’t elaborate further on this point. It therefore seems unconvincing: why would capitalists earning a higher rate of interest on their capital be discouraged to innovate and invest? Shouldn’t a system where entrepreneurs make mistakes on a regular basis (malinvest during the business cycle) be more disruptive for innovators?10 Jesús Huerta de Soto thinks that “maybe it would be wiser to interpret the assertions Hayek made in 1929 (in Monetary Theory and the Trade Cycle) in the context of the lecture given before the Verein für Sozialpolitik. ... Hayek’s speech was subject to a rigorous examination by professors who were little inclined to accept conclusions they viewed as too original or revolutionary.”11

Hayek returned to the idea of one hundred percent reserve banking in 1937 in the series of lectures published as Monetary Nationalism and International Stability. In the fifth lecture he reviewed briefly “The Chicago Plan of Banking Reform.”12 This time Hayek’s objections to the abolishment of fractional reserve banking were completely different:

The most serious question which it raises, however, is whether by abolishing deposit banking as we know it we would effectively prevent the principle on which it rests from manifesting itself in other forms. … [T]he question is whether, when we prevent it from appearing in its traditional form, we will not just drive it into other and less easily controllable forms. … The [Peel’s Banking] Act of 1844 was designed to control what then seemed to be the only important substitute for gold as a widely used medium of exchange and yet failed completely in its intention because of the rapid growth of bank deposits. Is it not possible that if similar restrictions to those placed on bank notes were now placed on the expansion of bank deposits, new forms of money substitutes would rapidly spring up or existing ones would assume increasing importance?13

This analysis does not mention any economic deficiencies connected with the system of one hundred percent reserve banking. The obstacle is of a practical nature — whether we will be able to stop the creation of new money substitutes that will take the place of bank notes and deposits.14 We may conclude here that Hayek saw the merits of advocating for an end of fractional-reserve banking — a seed of the business cycle in the contemporary economy — but never fully endorsed the program of one hundred percent reserve banking, pointing to problems of both a theoretical and practical nature.

Central Bank’s Policy Prescriptions

The greatest controversies regarding Hayek’s stance on monetary theory arise from the central bank’s policy norms that Hayek allegedly proposed. Since we live (as Hayek did as well) in a world of central banks managing the fractional-reserve banking system, we may ask if there is something the monetary authorities can do to mitigate the business cycle.15 Recently Lawrence White stated:

Hayek’s business cycle theory led him to the conclusion that intertemporal price equilibrium is best maintained in a monetary economy by constancy of “the total money stream,” or in Fisherian terms, the money stock times its velocity of circulation, MV. Hayek was clear about his policy recommendations: the money stock M should vary to offset changes in the velocity of money V, but should be constant in the absence of changes in V.16

White’s bold statements led Marius Gustavson to propose a ‘Hayek Rule’ — understood as keeping MV constant — as a norm for Federal Reserve’s policy in the 21st century.17 Two questions arise:

(1) Did Hayek endorse such a policy?

(2) Does Hayek’s business cycle theory provide a justification for “Hayek Rule”?

To properly answer these questions it’s useful to consider the theoretical context of Hayek’s business cycle investigations. For Hayek the main puzzle was how to integrate the theory of business cycle into the general equilibrium theory.18 In other words: how it is possible that forces leading markets to clear fail to coordinate consumers’ preferences and producers’ decisions during the business cycle? Hayek’s view was that we should focus on the active role money plays in the economy. The introduction of money breaks the clear process of price formation in barter and makes it possible that “real” factors responsible for price formation will be for some time hindered by monetary factors.

Beginning in mid-1920s Hayek struggled to describe the active role money plays in price formation in a more detailed fashion.19 He came up with the idea of “neutral money” — a set of conditions needed for the money to be neutral toward prices. His first idea was that the supply of money must be constant in order to be neutral. In the 1930s he changed his mind and advocated the idea that money may be neutral when the effective money stream (MV) is constant.20 Does it follow that Hayek advocated the monetary policy of stabilizing MV? Not necessarily.

In the second edition of Hayek’s Prices and Production21 and in a paper from 1933 titled On ‘Neutral’ Money22 we find some clarifications as to the proper relation between the theoretical concept of neutral money and the prescribed monetary policy. In the latter Hayek wrote: “The concept of neutral money was designed to serve as an instrument for theoretical analysis, and should not in any way be set up as a norm for monetary policy, at least in the first instance.”23 Hayek stressed the monetary policy can have different goals than getting close to the state of neutral money. He also mentioned the stable MV is not the sufficient condition for money to be neutral.

It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, first, the total money stream remained constant, and second, all prices were completely flexible, and, third, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.24

Lack of perfect foresight regarding the future value of money and any degree of price stickiness make neutral money an impossibility. One could argue that even though we cannot reach perfection, it is still a good idea to pursue the ideal. But Hayek saw other problems with stabilizing the level of nominal expenditures. In Prices and Production he briefly discussed the problems with changing money velocity due to hoarding, dishoarding, changes in business organization etc.

For, in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy.25

For Hayek it was clear that pumping money in any place in the economy as a reaction for increased demand for money in another place would not suffice to get closer to money neutrality. The money would have to be given to exactly those persons whose demand has increased. Hayek understood well that giving more money to a single person will result in a series of small adjustments of incomes and spending habits of many individuals cooperating with the agent, who got the money in the first place.26 Increasing the quantity of money in places where the demand for money remained unchanged27 would entail another round of necessary adjustments of incomes and spending patterns without accommodating the original change in money velocity.

Apart from abstract arguments about problems with implementation of stable MV policy Hayek specifically argued against monetary policy measures to combat deflation during the Great Depression as late as 1932. In a preface to English translation of Monetary Theory and the Trade Cycle Hayek wrote:

[The existence of deflationary process] does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. … To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end.28

Not only did Hayek differentiate between theoretical concepts and policy norms, find practical problems in stabilizing MV and explicitly rejected fighting the recession with money creation, but he actually proposed another policy norm in the writings on money neutrality and constant flow of spending. In Prices and Production he mentions only that “Hence the only practical maxim for monetary policy to be derived from our considerations is probably the negative one that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that—save in an acute crisis—bankers need not be afraid to harm production by over-caution.”29 In On ‘Neutral’ Money Hayek dared to propose a more specific solution:

[I]t seems to me that the stabilization of some average of the prices of the original factors of production would probably provide the most practicable norm for a conscious regulation of the quantity of money.30

In light of these passages31 it seems that White’s statement about Hayek’s clear policy recommendation of stabilizing the level of nominal spending is unfounded — Hayek explicitly endorsed another rule and found problems with implementing targeted nominal spending rule.

There are big differences between stabilizing MV and stabilizing the prices of factors of production. Proponents of stabilizing MV claim that a shrinking nominal GDP is an indication that the central bank should increase the money supply (we need to remember that NGDP is only an approximation of the level of spending, since GDP excludes transactions of goods that are not final. If we want to measure the level of spending properly we should include all money transactions). A proponent of stabilizing MV could argue that even if money expenditures rose during the boom phase, it would be unwise to let it shrink to the pre-boom level. Therefore Quantitative Easing I in the USA would be justified since NGDP was falling between Q3 2008 and Q2 2009.32

A proponent of stabilizing the prices of the factors of production could argue that it’s unwise to maintain prices at the inflated boom level. Lower input prices would actually stimulate the demand by entrepreneurs to start investing again. Hence, if we look at the level of factors of production prices we see a different story. Let’s take for example Producer Price Index. At the end of the previous recession — in 2002 the index (1982=100) stood at around 100 points. At the bottom of recession in February 2009 it stood at around 160 points, so it would indicate that monetary policy was extremely accommodative.33

There is also another “Hayekian” problem connected with advocating QE: can the central bank actually gather and process all the information needed to fight the shrinking money expenditures in the same manner as private banks would do.34

Conclusions

Friedrich von Hayek rarely stated clearly his monetary policy proposals. He was mostly interested in the field of pure monetary theory (at least in the 1930s). It seems to us that his theories of money and business cycle can give good arguments for people advocating one hundred percent reserve banking. When it comes to monetary policy of the central bank Hayek briefly proposed the idea of stabilizing the prices of factors of production, but did not elaborate on why this should be the best policy.

Perhaps it is unfortunate Hayek used the framework of general equilibrium theory to investigate the problem of the business cycle.35 This might lead many to confuse the highly abstract and unrealistic conditions of general equilibrium with the desired state of monetary affairs, whereas occurrence of these conditions would actually mean that money is not needed in the economy at all.36 Only late in his life Hayek managed to incorporate his more dynamic view on economy regarding competition and entrepreneurial discoveries into the money and the area of business cycles. In Denationalization of Money37 he finally proposed the idea of opening the sphere of money and banking to the competition instead of leaving it to the plans of bureaucrats.

In a lecture from October 1977 Hayek stated:

The interesting fact is that what I have called the monopoly of government of issuing money has not only deprived us of good money but has also deprived us of the only process by which we can find out what would be good money. We do not even quite know what exact qualities we want because in the two thousand years in which we have used coins and other money, we have never been allowed to experiment with it, we have never been given a chance to find out what the best kind of money would be.38

This call for a competition in the field of money seems to me the best example of a truly Hayekian monetary policy.

References

Block Walter, Kenneth M. Garschina. 1996. “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process.” Review of Austrian Economics 9(1): 77–94.

Butos William N. 2012. “Monetary Orders and Institutions: A Hayekian Perspective.” Quarterly Journal of Austrian Economics 15(3): 259–76.

Gustavson Marius. 2010. “The Hayek Rule: A New Monetary Policy Framework for the 21st Century.” Reason Foundation Policy Study 389.

Hayek F. A. 2012. Business Cycles. Part II. In The Collected Works of F.A. Hayek, vol. 8, Hansjoerg Klausinger, ed. Chicago: University of Chicago.

——. Good Money. Part I: The New World, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 5, Indianapolis 2008.

——. Good Money. Part II: The Standard, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 6, Indianapolis 2008.

——. Intertemporal Price Equilibrium and Movements in the Value of Money. In idem, Good Money. Part I, pp. 186–27.

——. Monetary Policy in the United States after the Recovery from the Crisis of 1920. In idem, Good Money. Part I, pp. 71–152.

——. Monetary Nationalism and International Stability. In idem, Prices and Production and Other Works, pp. 331–422.

——. Monetary Theory and the Trade Cycle. In idem, Prices and Production and Other Works, pp. 1–130.

——. On ‘Neutral’ Money. In idem, Good Money. Part I, pp. 228–31.

——. Prices and Production. In idem, Prices and Production and Other Works, pp. 189–329.

——. 2008. Prices and Production and Other Works: F.A. Hayek on Money, the Business Cycle, and the Gold Standard, Joseph Salerno, ed. Auburn, Ala.: Mises Institute.

——. “The Paradox of Saving.” In idem, Prices and Production and Other Works, pp. 131–87.

——. The Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies. In idem, Good Money. Part II, pp. 128–229.

——. “Toward a Free Market Monetary System.” In Good Money. Part II, pp. 230–37.

Huerta de Soto, Jesús. 2006. Money, Bank Credit and Economic Cycles, translated by Melinda A. Stroup. Auburn, Ala.: Mises Institute.

Salerno Joseph T. “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (2012): 3–44.

——. “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6, no. 2 (1993), pp. 113–46.

Steele G. R., “Hayek’s Theory of Money and Cycles: Retrospective and Reappraisal,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 3–14.

White Lawrence H. 2008. “Did Hayek and Robbins Deepen the Great Depression?” Journal of Money, Credit and Banking 40(4): 751–68.

White Lawrence H. 1999. “Hayek’s Monetary Theory and Policy: A Critical Reconstruction.” Journal of Money, Credit and Banking 31(1): 109–20.

White Lawrence H. 1999. “Why Didn’t Hayek Favor Laissez Faire in Banking?” History of Political Economy 31(4): 753–69.

• *Mateusz Benedyk is a PhD Candidate at the Faculty of Social Sciences, University of Wrocław and the President of Ludwig von Mises Institute Poland. The author would like to thank Mateusz Machaj and David Howden for their helpful comments. I was a summer research fellow in 2012. This chapter was inspired by Professor Salerno’s many contributions in the field of history of the Austrian school of economics and his investigations regarding the monetary theory.
• 1For example Hayek was attacked for not seeing the merits of fractional reserve banking by Lawrence H. White, “Why Didn’t Hayek Favor Laissez Faire in Banking?” History of Political Economy 31, no. 4 (1999): 753–69; and for not blaming fractional reserve bankers for business cycles by Walter Block, Kenneth M.Garschina, “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process,” Review of Austrian Economics 9, no. 1 (1996): 77–94.
• 2For the discussion of Hayek’s writings in 1970s and 1980s see G. R. Steele, “Hayek’s Theory of Money and Cycles: Retrospective and Reappraisal,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 3–14. Here we will deal primarily with the earlier works of Hayek.
• 3This list does not pretend to exhaust all of the Hayek’s insights in the field of money. It includes only the problems that created numerous controversies and rivalrous interpretations in the literature. More comprehensive study should include e.g., effects of various international monetary systems and the differences between central and free banking or between token and commodity money.
• 4Friedrich A. Hayek, “Monetary Theory and the Trade Cycle,” In: idem, Prices and Production and Other Works, ed. Joseph Salerno, Auburn 2008, pp. 73–103.
• 5Ibid., p. 91.
• 6Ibid., p. 93.
• 7Ibid., p. 94.
• 8Friedrich A. Hayek, “Monetary Policy in the United States after the Recovery from the Crisis of 1920,” In: Idem, Good Money. Part I, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 5, Indianapolis 2008, p. 111, n. 37.
• 9Friedrich A. Hayek, Monetary Theory…, p. 103.
• 10On this point see: Joseph Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (2012): 22–23, 37–38.
• 11Jesús Huerta de Soto, Money, Bank Credit and Economic Cycles, translated by Melinda A. Stroup, Auburn 2006, pp. 470–71, n. 74.
• 12Friedrich A. Hayek, “Monetary Nationalism and International Stability,” In: Idem, Prices and Production and Other Works, pp. 410–13.
• 13Ibid., pp. 411–12.
• 14A description of these obstacles is a major part of Hayek’s discussion of the Chicago Plan. It’s therefore an overstatement to say that “in Monetary Nationalism and International Stability, [Hayek] changed his mind, proposed a constant money supply and advocated the demand for a 100-percent reserve requirement in banking” — Jesús Huerta de Soto, Money…, p. 470, n. 74.
• 15We have already discussed the possibility of central banks requiring banks to hold one hundred percent reserves on deposits, so we won’t mention the subject in this section.
• 16Lawrence H. White, “Did Hayek and Robbins Deepen the Great Depression?” Journal of Money, Credit and Banking 40, no. 4 (2008): 754–55, emphasis added.
• 17Marius Gustavson, The Hayek Rule: A New Monetary Policy Framework for the 21st Century, Reason Foundation Policy Study 389 (2010). Gustavson’s study includes references to White’s 2008 paper.
• 18In Hayek’s words: “By ‘equilibrium theory’ we here primarily understand the modern theory of the general interdependence of all economic quantities, which has been most perfectly expressed by the Lausanne School of theoretical economics.” — Friedrich A. Hayek, Monetary Theory…, p. 19, n. 15.
• 19Between 1925–1929 Hayek was preparing a book on the subject titled Geldtheoretische Untersuchungen, which he never completed. Two articles Hayek published at the time were excerpts from the book: Intertemporal Price Equilibrium and Movements in the Value of Money (originally appeared in German in 1928) published in Good Money. Part I; The Paradox of Saving (published in German in 1929) published inter alia in Prices and Production and Other Works. The English translation of the unfinished manuscript of the Geldtheoretische Untersuchungen has been recently published as Investigations into Monetary Theory, first chapter of: Friedrich A. Hayek, Business Cycles. Part II, ed. Hansjoerg Klausinger, The Collected Works of F.A. Hayek, vol. 8, Chicago 2012.
• 20This evolution of Hayek’s thought is well documented in another paper of Lawrence H. White, “Hayek’s Monetary Theory and Policy: A Critical Reconstruction,” Journal of Money, Credit and Banking 31, no. 1 (1999): 109–20.
• 21Friedrich A. Hayek, Prices and Production, [In:] Idem, Prices and Production and Other Works, pp. 301–04.
• 22Friedrich A. Hayek, On ‘Neutral’ Money, [In:] Idem, Good Money. Part I, pp. 228–31.
• 23Ibid., p. 228.
• 24Friedrich A. Hayek, Prices and Production, p. 304. Almost identical statement in: Friedrich A. Hayek, On ‘Neutral’ Money, p. 230.
• 25Friedrich A. Hayek, Prices and Production, p. 297.
• 26Example of such an analysis can be found in: Friedrich A. Hayek, Monetary Nationalism…, pp. 353–59.
• 27For example when central bank buys large quantities of securities in a Quantitative Easing program.
• 28Friedrich A. Hayek, Monetary Theory…, pp. 5, 6–7.
• 29Friedrich A. Hayek, Prices and Production, p. 298.
• 30Friedrich A. Hayek, On ‘Neutral’ Money, p. 231.
• 31Interestingly White quoted the same passage from “On ‘Neutral Money’” in Lawrence H. White, Hayek’s Monetary Theory…, p. 117.
• 32According to “The Economist”: “Hayek believed the central bank should aim to stabilise nominal incomes. On that basis Mr [Lawrence] White thinks the Fed was right to pursue the first round of quantitative easing, since nominal GDP was falling, but wrong to pursue a second round with activity recovering.”
• 33All the data is taken from Federal Reserve Bank of St. Louis.
• 34For the discussion see: William N. Butos, “Monetary Orders and Institutions: A Hayekian Perspective,” Quarterly Journal of Austrian Economics 15, no. 3 (2012): 259–76.
• 35For other problems associated with Hayek’s methodological choices see: Joseph Salerno, “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6, No. 2 (1993), pp. 113–46.
• 36Ludwig von Mises, Human Action. A Treatise on Economics, Auburn 1998, pp. 250–51.
• 37Friedrich A. Hayek, The Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies, [In:] Idem, Good Money. Part II, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 6, Indianapolis 2008, pp. 128–229.
• 38Friedrich A. Hayek, Toward a Free Market Monetary System, [In:] Idem, Good Money. Part II, p. 234.

Scholars* of the Austrian tradition are particularly known for their important work in the field of monetary economics. They analyze the dynamics of fiat money and its impact on the real economy. However, empirical attempts to support the theoretical claims are relatively rare. In this chapter, I sketch an empirical strategy to test whether a change in the monetary regime has significantly impacted the accumulation of public debt and government deficits in the United States. Government deficits appear to be significantly lower under the gold standard regime and significantly higher under a regime of fiat money after controlling for other explaining factors such as, for instance military expenses or interest charges.

This chapter is structured as follows. Section 2 gives an overview about the nature of money to understand the dynamics of fiat money. Section 3 outlines why the introduction of a fiat money regime potentially increases the accumulation of public debt. Section 4 outlines the econometric model to account for the effects of different monetary regimes on public debt. Furthermore, potential lines of research are provided to improve the explanatory power and robustness of the model. Section 5 concludes.

Monetary Mechanisms and Monetary Policy

As Mises repeatedly stresses, money is the fruit of indirect exchange (Mises 1980, p. 45). Thus, the emergence of money is spontaneous and becomes necessary as the division of labor increases and wants become more refined (Mises 1980, p. 5). Individuals only choose to have recourse to indirect exchange when the goods they can acquire are more marketable than those which they surrender.

As a result, the most marketable commodities will become common media of exchange and their position is strengthened as their relative marketability increases in comparison to other commodities (Mises 1980, p. 6). The main function of money according to Mises is its universal employment as a general medium of exchange (Mises 1980, p. 7).

Hülsmann (2008) introduces a further distinction between natural and forced monies. Natural money corresponds to money that arose through voluntary actions of individuals which circulates until it is displaced by an external pressure. Alterations to the former type of natural money are defined as forced money. In this case, money no longer complies with individual preferences, but is the result of a welfare reducing imposition. As a consequence, forced monies are per definitionem less socially beneficial than natural monies, as they only exist due to the violations of individual rights. Based on this distinction, it is possible to introduce a further division between credit money and paper money. As Hülsmann (2008) points out, the value of credit money (a claim to money in the future) is based on the trust that the respective sum of money is eventually refunded in the future.

Paper money or fiat money owes its existence to legal privileges. Hülsmann (2008) emphasizes that paper money has never spontaneously emerged as a result of the voluntary actions of individuals. Legal tender laws impose the use of a lower quality paper money at the expense of the natural money. The bad money, i.e., the overvalued paper money, drives the good money, i.e., the undervalued natural money out of the market as their legal equivalence is only due to imposed laws and do not reflect the economic reality. This process is known as Gresham’s law, named after Thomas Gresham (Hülsmann 2008, p. 127). Naturally, this leads to inflation of the overvalued money, “because this money is produced and held in greater quantities than would be the case in the absence of the price control” (Hülsmann 2008, p. 127). The natural limit in money production is distorted as the full consequences are not borne by the money producer. Legally established values are not altered and constraining competitive processes are suspended under legal tender laws. Moreover, Cantillon effects, named after the French economist Richard Cantillon1 enforce the enrichment of money producers under the regime of legal tender. As Hülsmann (2008, p. 44) points out, there can be no simultaneous increase of all prices as newly created money enters the market. The first users of the new money have the privilege to use it on goods priced according to the quantity of money that existed before the increase in the money supply. However, the newly acquired purchasing power does not remain unnoticed and spreads out through the economy. Prices eventually adjust upward due to the increased demand of the initial users. The last receivers have not benefited from the new money. To the contrary, they suffer a deteriorated quality of the money and higher price levels.

As Hülsmann (2008, p. 89) argues, debasement was traditionally the way to inflate the money supply. The nominal value of a coin was modified not reflecting the metal content any longer or the content of metal was reduced without an according change in the nominal value. However, debasement reached a whole new level with the emergence of fractional-reserve banking, i.e., the issuance of coins or bank notes which are not fully covered by the available reserves. This significantly reduced the cost of money production. According to Hülsmann (2008, p. 93), there are three main reasons that led to this phenomenon.

In the first place, the warehousing institutions, the original function of banks to the late 1700s, have been perverted. Second, credit banking has been perverted as banks use deposits for loans. Lastly, it was a natural response to the threat of government expropriation. As banks feared that their holdings would be eventually confiscated, they preferred to lend out the funds. However, as individuals eventually find out about the debased monies, it is necessary to guarantee a continual demand through legal tender laws. This privilege is the ultimate explanatory link for all other monetary advantages.

In addition to the outlined factors, the twentieth century witnessed the development of maturity mismatching in the banking sector (Bagus and Howden, 2009), i.e., borrow short and lend long. Nowadays, this is considered as one of the main functions of banks. For instance, Freixas and Rochet (2008) point out that “modern banks can be seen as transforming securities with short maturities, offered to depositors, into securities with long maturities, which borrowers desire.” Necessarily, this implies a certain “risk” for banks if the credits are not covered by corresponding savings of depositors. If depositors require their funds, banks can have recourse to derivatives (such as swaps or futures) or engage into interbank lending to limit this “liquidity risk.” However, this type of risk management is very costly. In a competitive environment where the success of a bank’s business is based on its ability to gain confidence of depositors, the constant mismatching of maturities must be relatively limited. Depositors are not likely to give their money to banks that accumulate negative working capital and struggle to refinance their debt.

To recapitulate, money evolved spontaneously in the market. Historically, gold and silver were chosen as the common medium of exchange for their practical purposes. For reasons of convenience, warehouses arose to store these metals and certificates were issued. As a consequence, certificates were traded in everyday business and rarely redeemed into gold. Unfortunately, this created a temptation to engage into fractional-reserve banking and to issue certificates in excess of the actual gold reserves. At some point, governments entered into the game and monopolized the minting of coins and established legal tenders laws. Under the classical gold standard from 1815–1914, a fractional gold standard was institutionalized and guaranteed by the respective states. As already outlined above, fractional-reserve banking diminishes the cost of money production and increases the profitability of banks. As a consequence, there is a tendency to threaten the financial stability of banks as the continual issuance of credits in excess of savings is eventually discovered by depositors and creditors. Bank runs and the liquidation of assets are naturally the cause as people lose confidence.

The drawbacks of this business model must be resolved by some external institution that guarantees the liquidity of banks. This is the role of central banks (Bagus 2012). Central banks are lenders of last resort for commercial banks. Banks can now refinance their debt through short-term credits and liquidity problems can be limited as the production of money is coordinated by the central bank. However, under the gold standard, even coordinated money expansion was limited by the fear of redemption in a crisis. By the 1970s the burden of the gold standard was removed and the doors were further opened for the lucrative business of money creation.

Monetary Policy Since the 1970s in the United States

The abolition of the gold standard on August 15, 1971, led to the establishment of a regime of paper monies for most of the national currencies. Before this date all national currencies were linked to the gold standard via the US dollar. As the US decided to go off gold altogether, the fractional-reserve gold certificates basically became paper money (Hülsmann 2008, p. 223). The new fiat money standard magnified moral hazard at a large scale. Fiat money allows producers of money to “create ex nihilo virtually any amount of money” (Hülsmann 2006, p. 10). The growth of the money supply increased significantly after the decision to go off the gold window. The M3 monetary aggregate grew by 12.42 percent in 1972 in the US, although the average growth rate was about 6.76 percent in the decade before.

Under the regime of William McChesney Martin from 1951 to 1970, monetary policy was relatively conservative. Growth rates of the CPI were below three percent during the early 1960s (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 23). As Martin points out in testimony to the Joint Economic Committee: “the Fed has a responsibility to use the powers it possesses over economic events to dampen excesses in economic activity by keeping the use of credit in line with resources available for production of goods and services.2 In 1964, Martin expressed his concerns about increasing inflation as federal spending increased a lot during the second half of the 1960s. Bremner (2004, p. 191) cites a quote by Martin which summarizes his worries: “I think we’re heading toward an inflationary mess that we won’t be able to pull ourselves out of.” Martin expressed in his last press conference that he had “feelings of failure for not having controlled inflation” (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). By 1970, Martin was replaced by Arthur F. Burns. He commenced a period of high inflation and very low real interest rates, a byproduct of loose money now simplified by the full fiat money standard. However, even before the suspension of payment by the Fed in 1971, the federal funds rate was already lowered from 8.02 percent during the first quarter in 1970 to 4.12 percent by the fourth quarter of the same year (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). What are the implications of low or even negative real interest rates? They reduce the incentives for people to save money and at the same time the cost of debt is significantly reduced. Even though federal funds rates were eventually raised during the following years, they never kept up with the running inflation rates and real interest would only be over 2 percent in the second quarter of 1976 (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). Thus, during his tenure until 1978, real interest rates were only above 2 percent for three quarters. The Per Jacobsson Lecture on “The Anguish of Central Banking” (Burns 1979) summarizes his views on monetary policy and central banking relatively well. Basically, the upward pressures on prices by interest groups are the real reason for the inflationary policy by the Fed. According to him, the Fed does not have enough power to effectively fight against inflation “as it is illusory to expect central banks to put an end to the inflation that now afflicts the industrial democracies” (Burns 1979, p. 21). After a short intermezzo by Miller whose tenure ended into an emergency sale of US gold and borrowings from the International Monetary Fund (IMF) (Dowd and Hutchinson 2010, p. 251), President Carter moved Miller to the Treasury department and appointed Paul Volcker as the chairman of the Fed.

As a consequence, the federal funds rates increased significantly from 2 percent to 12 percent (Dowd and Hutchinson 2010, p. 251) and real interest rates remained high during the 1980s. Just as Burns, he was also invited to give the Per Jacobsson Lecture, but concluded that inflation had been defeated under his regime. However, as the problem of inflation was apparently controlled, another chairman, Alan Greenspan was appointed. He supported the deregulation of the banking sector under Reagan (Dowd and Hutchinson 2010, p. 252). Greenspan emphasized that inflation must be kept low during his confirmation hearings (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 32), however it took only a few months until this plan was scrapped. Greenspan responded to the stock market crash of October 1987 by cutting interest rates and by declaring that the Fed is disposed to provide “liquidity” in such a case (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 32). Later, interest rates were kept low, even as inflation reached 6 percent during 1989–1990. The policy of low interest rates continued until 1994, where the Federal funds yield reached the lowest levels since the 1960s. As a reaction to this inflation scare, interest rates doubled, although Greenspan was reluctant to take this action initially.3 However, this led to big losses for many entities that were betting on low interest rates. Most notoriously California’s Orange County defaulted on its debt by speculating with derivatives on low interest rates (Dowd and Hutchinson 2010, p. 53).

By February 1995, Greenspan announced that his policy of increasing rates is over.4 Effectively, the money supply growth was 2.6 percent higher than nominal GDP during this tenure. The failure of Long-Term Capital Management in 1998 (Lowenstein 2001) illustrated perfectly the approach which was taken by the Fed by now. Not only was a bailout organized, but under Greenspan interest rates were subsequently cut three times to calm down financial markets. This low-interest policy basically allowed the financial sector to maintain more activity of unsustainable trading activities. Ultimately, this policy fueled the dotcom bubble during which stocks were even more overevaluated than during 1929 (Garrison and Callahan 2003). As a consequence, interest rate raises followed in the year 1999 and 2000 which eventually triggered the bust of the stock market. However, already by 2001, the federal funds rate was lowered again to fight the ongoing recession. Together with the occurrence of the 9/11 terrorist attacks and fiscal policy under the newly elected President Bush, interest rates attained the lowest level since 1961 by the year 2002. From 2002 to his retirement in January 2006, Greenspan kept interest low below 3 percent. This period also witnessed the housing bubble and the closely tied structured finance crisis. The burst of this bubble finally led to the current financial crisis. The following “non-moderate” recession is accompanied by nominal interest rates which are currently approaching zero, while real interest rates are simply negative. The development of the federal funds rate can be depicted as follows in figure 1.

To summarize, ever since the fight on inflation of the early 1980s under Volcker, interest rates have been declining. The most substantial reductions happened in the post-era of the dotcom bubble and as a response to the terrorist attacks of 2001. Likewise, federal funds rate have been lowered to an all-time low to fight the current recession. Monetary policy of the last thirty years substantially reduced the cost of debt and consequently eased the issuance of debt securities in the financial market.

Fiat Money and Public Debt

Fiat money and legal privileges reduce the natural barriers to the creation of credits. Debts are an easy way to increase the expenses of governments. Furthermore, debts are by far more popular than the alternative, i.e., taxes. However, governments are special debtors as they can have recourse to means of financial repression: “Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere” Reinhart, Kirkegaard, and Sbrancia (2011).

There are several measures that increase artificially the demand of sovereign bonds, however the main measure of financial repression is to keep nominal interest rates low through loose monetary policy. It reduces the interest expenses for governments and high inflation reduces the cost of debt at the expense of the creditors. Similarly, traditional investors are more likely to put their money into government bonds as savings accounts are not profitable enough. In the case of negative real interest rates, as witnessed 1945–1980 and since 2007 (Reinhart, Kirkegaard, and Sbrancia 2011), it even becomes a supplementary tax in addition to the redistributive consequences of inflation. Figure 2 shows the evolution of government debt during the phase of positive real interest rates and a sharp increase since 2007 when real interest rates were negative again.

Empirical Implications

Building upon the theoretical arguments of this paper, it is manifest to test whether public debt and government deficits have, ceteris paribus, significantly increased under a full fiat money standard.

Yoon (2012) shows, using a new recursive method for unit root testing, that the U.S. public debt–GDP ratio was explosive in nature during the sample period. This is an interesting result as a standard unit root test such as an augmented Dickey-Fuller test shows that this series contains an unit root and is therefore stationary (Bohn 2008). As a result, there is no concluding evidence about the properties of public debt in the United States during this period.

Figure 4 suggest that wars played a major role for the accumulation of debt. As Figure 3, Yoon (2012) points out “The War of Independence, Spanish–American War, the Civil War, World War I, and World War II — explain the high debt–GDP ratio in 1791 and the sharp increases in 1812–16, 1861–66, 1916–19, and 1941–46.” By way of contrast, the debt–GDP ratio has generally declined during peacetime periods, with the exception of the Great Depression/New Deal era (1929–39), the 1980s, and the post-1921 period.” Furthermore, the author interprets the exceptional period from the 1980s onwards as a result of the Cold War and the “post-2001 war on terror.”

There might be a potential endogeneity bias for the decision to adopt (or leave) the gold standard or a fiat money standard, which could likely lead to spurious results for our analysis. Basically, this would mean that some underlying factor accounted for both the choice of the monetary regime and the differences in the level of public debt. For example, war times and a suspended gold standard have been highly correlated in history for obvious reasons. However, as Bernanke (2004, p. 16) outlines, those decisions are highly influenced by internal and external political factors so that it is very unlikely to be an issue for our analysis.

Empirical Strategy

One potential empirical strategy has been outlined in Gabriel (2014). As outlined above, there is conflicting evidence about the stationarity of public debt. To overcome this problem, I analyze GDP deficits as the dependent variable for the sample period from 1800 to 2012 (Bohn 2008). In this paper, I use a VAR(2) model which controls for several factors such as military spending to capture the war periods or interest charges to capture the cost of debt.5 The model allows us to make interesting forecasts of how the dependent variable should have evolved during the period of the full fiat money standard (1971 to the present) after controlling for the outlined variables. Figure 4 summarizes the findings of Gabriel (2014).

The red line describes actual data on GDP deficits for the specified period. As described before, the VAR(2) model is applied to the dataset from 1800–1970 to generate a forecast of the how the values should have evolved based on the specified framework. This is the blue line. Finally, the green area corresponds to the confidence interval for the forecast of the VAR(2) model. This graph shows that actual deficits are in general higher (except for the year 2000) than they should be. Thus, the interpretation of this period by Yoon (2012) as a result of the Cold war is not supported by this analysis. The noteworthy GDP deficit figures must be explained otherwise. The theoretical arguments in this chapter make a case that the dynamics of fiat money are a plausible explanation for this observation.

Conclusion

Austrian scholars in monetary economics are not tired of pointing out the dynamics of fiat money and their impact on the economy. This chapter attempted to complement their theoretical arguments by providing a short historical overview of monetary policy in the United States. A preliminary empirical assessment provides evidence that the switch to the current monetary regime possibly explains higher GDP deficits after controlling for other factors such as military expenses or interest charges. A more detailed analysis on this issue is left for future research.

References

Bagus, Philipp. 2012. “Austrian business cycle theory: are 100 percent reserves sufficient to prevent a business cycle?” Procesos de mercado: revista europea de economia politica 9(1): 389–410.

Bagus, Philipp, and David Howden. 2009. “The Legitimacy of Loan Maturity Mismatching: A Risky, but not Fraudulent, Undertaking.” Journal of Business Ethics 90(3): 399–406.

Bernanke, Ben S. 2004. Essays on the Great Depression. Princeton, N.J.: Princeton University Press.

Bohn, H. 2008. The Sustainability of Fiscal Policy in the United States. Cambridge, Mass.: MIT Press.

Bremner, M. R. P. 2004. Chairman of the Fed: William McChesney Martin Jr., and the Creation of the Modern American Financial System. New Haven, Conn.: Yale University Press.

Burns, Arthur F. 1979. “The Anguish of Central Banking.” In The 1979 Per Jacobsson Lecture. Sava Centar. Complex, Belgrade, Yugoslavia, on September 30.

Dowd, Kevin, and Martin Hutchinson. 2010. Alchemists of Loss: How modern finance and government intervention crashed the financial system. New York: Wiley.

Fernandez-Villaverde, J. H., P. A. Guerran-Quintana, and J. Rubio-Ramirez. 2010. “Reading the Recent Monetary History of the U.S., 1959–2007.” Working Paper 15929, National Bureau of Economic Research.

Freixas, X., and J.-C. Rochet. 2008. Microeconomics of Banking. 2nd. ed. Cambridge, Mass.: MIT Press.

Gabriel, Amadeus. 2014. Public Debt and Fiat Money: An Empirical Assessment. Working Paper. Department of Finance and Economics, La Rochelle Business School.

Garrison, Roger, and Gene Callahan. 2003. “Does the Austrian Business Cycle Theory help explain the Dot-Com Boom and Bust?” Quarterly Journal of Austrian Economics 6: 67–98.

Hülsmann, Jörg Guido. 2006. “The political economy of moral hazard.” Politická ekonomie 2006(1): 35–47.

——. 2008. The Ethics of Money Production. Ala.: Mises Institute.

Lowenstein, R. 2001. When Genius Failed: The Rise and Fall of Long-Term Capital Management. Random House Trade Paperbacks.

Mises, Ludwig v. 1980. The Theory of Money and Credit. Indianapolis: Liberty Press.

Reinhart, C. M., J. F. Kirkegaard, and M. B. Sbrancia (2011): “Financial Repression Redux.” Finance & Development 48.

Reinhart, C. M., and K. Rogoff. 2011. This Time Is Different: Eight Centuries of Financial Folly. Princeton, N.J.: Princeton University Press.

Rothbard, Murray  N. 2010. What Has Government Done to Our Money? 3rd. ed. Ala.: Mises Institute.

Yoon, G. 2012. “War and peace: Explosive US public debt, 1791–2009.” Economics Letters 115(1): 1–3.

• *Amadeus Gabriel is assistant professor in the Department of Finance and Economics at the La Rochelle Business School, France. I was a summer fellow at the Ludwig von Mises Institute as an undergraduate student in 2006, and later as a graduate student in 2011.
• 1See Richard Cantillon, La nature du commerce en général (Paris: Institute national d’études démographiques, 1997).
• 2Martin’s testimony to the Joint Economic Committee, February 5, 1957. Cited by (Bremner 2004, p. 123).
• 3Board of Governors FOMC Transcripts, February 3–4, 1994, p. 55.
• 4Testimony to the House Banking Committee, February 22, 1995).
• 5Refer to Gabriel (2014) for the details of the model, where several tests, such as e.g., autocorrelation in error terms, to account for a potential downward bias are provided.

We* understand knowledge as an acquaintance with various facts and natures of objects in the real world. By studying and investigating aspects of our lives we get to “know” certain things and we classify these inquiries into disciplines. We can widen knowledge in total by different methods. In order to achieve progress in gained knowledge we use dissimilar frameworks to learn mathematics, physics, economics, social relations, characters of our friends, or languages. It is also important that we can learn some of these things through different methods, especially different methods for different people, or different methods for the same people over time. One term “knowledge” is being used to deliberate in general about all those disciplines, yet this should not cloud first and foremost feature of knowledge: its heterogeneity.

The Austrian school has been mostly successful in economic theorizing because it realistically emphasizes heterogeneous nature of the world. Whereas various neoclassical schools, or their siblings, tend to homogenize economic phenomena, the Austrians tend to do the opposite. The prime example of the case is theory of capital, which in the Austrian version is built on the notion that capital goods do not have a common physical denominator (which could theoretically express its aggregated “amount”). Starting from such basic observation the Austrians were able to build their own theory of socialism and theory of the business cycle. As Roger Garrison notes (1992, p. 171, emphasis added),

If capital goods were wholly non-specific, if the collection of them were fully homogeneous such that any one capital good is a perfect substitute for any other, then production processes could proceed as if time ran both ways. A half-finished performance hall could be completed — with no effects on cost or construction time—as a bowling alley; the production process that yields musical instruments could — with an eleventh-hour change of mind — yield bowling pins and bowling balls instead.

Under homogeneous circumstances the issue of proper allocations would never have to arise, since every process would already be fully integrated and properly coordinated. The problem of the trade cycle would be nonexistent, since any inconsistency in the various diverse stages of production would be absent. Similarly any socialist economy would not fail at the basic problem of equilibrating the capital goods market, because optimal allocations of them would have already been chosen.1

Other important Austrian contributions are also more or less related to the issue of heterogeneity. For this reason it could even be seen as a typical feature of the modern Austrian economist’s toolbox. Austrians are different, because Austrians heterogenize.

The same approach to heterogeneity applies for different types of “knowledge.” A typical model breakthrough comes from Hayek’s example of a breakaway from the neoclassical approach. Hayek’s famous contribution comes from the analysis on how knowledge is “used in society” (Hayek 1945). Yet even though this analysis of complexity of economic phenomena is fruitful and worth of deeper studying, it (along with others) created a lot of side debates about the “knowledge” problem under hypothetical socialist order. We will attempt to refrain from settling those debates here. Our goal is to follow Hayek’s footsteps and to try to distinguish several types of knowledge. The goal can allow us to settle the definitional importance of knowledge for Mises’s argument about the impossibility of the rational allocation of resources under socialism.

Here we offer our (arbitrary) classification of knowledge, which, though not very rigorous, helps to navigate through the usages of the term in the calculation debate. It is important to keep in mind that we don’t want to completely classify various types of knowledge, but to envision how it relates to the socialist puzzle.

Objective “Technological” Knowledge2

The word “objective” seems suitable, because the main feature lies in the interpersonal aspect of this knowledge, which can be simply transmitted from one person to another. It is knowledge which is coded in textbooks and countless publications.3 Due to its specific “objectivity” it can be communicated between the people with the use of alphabet, algebra and other symbols. Without those symbols there would be no abstract thinking, and consequently man would still live in caves (Cassirer 1944, pp. 46–47). Objectivity is here to be understood as the possibility to be (potentially) universally recognized by any intelligent being, no matter what place and time one lives in. Due to language and objectivity of those statements knowledge can be transmitted (sometimes through the painful process of learning) between all intelligent (and sufficiently capable) individuals.

Such knowledge can include statements from all developed sciences be they empirical or non-empirical; mathematics and logic, physics and chemistry, climatology and biology, economics and sociology, politics and history, etc. Even though all those disciplines differ and use radically dissimilar methods, they can be grouped into one big family of objective Science. There are multiple examples of that knowledge such as (geology) “earth is not flat,” (biology) “spiders eat flies,” (physics) “the speed of light is constant,” (mathematics) “In Euclidean geometry parallel lines do not intersect,” (climatology) “Earth is warmer than it was 40 years ago,” (economics) “minimum wage leads to higher unemployment,” (history) “Julius Cesar did not invent the caesar salad,” and so forth.

The important fact is that none of those statements has to do with distinct characteristics of the particular being who is proposing them. They are as general as possible and can be presented by a male teenager in Africa, a female doctor in Germany, or retired astronaut in the Moon. Also they are conditioned by the concept of Wertfreiheit. They are value-free. Their most important feature is correctness or incorrectness, no matter the values, opinions and views of the person proposing them. During the socialist calculation debate such knowledge was seen as easily obtainable and possessed by socialist bureaucrats.

Hayekian Knowledge

Human knowledge does not end with such universal and communicative observations. Not all the data can be effortlessly gathered in objectified and interpersonal form. Some information is hard or costly to transfer, so perhaps it seems sensible to use the name “transfer problem.” There exist two main reasons causing the transfer problem to arise. The first one is a subjective nature of individually “witnessed” data, which become a part of “tacit knowing.” Hayekian knowledge is perceived by an individual. At the same time it is being used by the individual even though she or he cannot formulate it explicitly and communicate it to another person. Tacit information is beyond textbooks and often beyond personal recognition of it (Polanyi 1966, p. xviii). Since personal boundaries are difficult to overcome such knowledge remains hidden behind individual barriers of the mind (Huerta de Soto 2010, pp. 27–28).

The second reason for the transfer problem is decentralized nature of Hayekian knowledge. At first it may seem that the reason is no different from the first one. Nevertheless the difference is important, because in the first case barriers have more to do with individual’s limits. In the second case scantiness of the data is an objective fact important for practical reasons. Because countless individuals are working with complex data, it is practically impossible for any isolated individual to gather their knowledge and unify it into one objective formula (even without admitting the “tacit” element of it). Hayek wrote extensively about its economic importance (see his illustrations in Hayek 1945, p. 522). He also made it an important part of the argument against market socialism model (Hayek 1940, pp. 192–93).

The examples of that knowledge could be “John knows unspoken local customs,” “Jack is the only one who knows how to talk to Mary,” “Martin knows how to start that machine,” etc.

Misesian Knowledge

An important question that arises with the title of the section is: why make a difference between “Hayekian” and “Misesian” knowledge? We are inclined to do so, because Mises emphasized the role of prices in the economy, whereas Hayek attempted to go further and focus on something underneath prices: production functions. For the former, prices per se were of interest. For the latter something more substantial had to be hidden behind those prices. Hence local conditions and knowledge about them was named by us as “Hayekian.” In the case of Mises, all aspects associated with calculation and prices will be seen by us as “Misesian” knowledge.

Therefore Misesian knowledge is strictly associated with monetary prices, and has three interrelated features in different time dimensions:

1. past prices and praxeological recapitalizations undertaken in the past,
2. current price offers,
3. “current allocation activities” (Salernian “social appraisement process”4 ).

Strictly speaking prices are ratios of exchange between sovereign owners in a realized transaction. In that sense they are phenomena of the past. Currently existing, though not yet realized, price offers are also often seen as “prices” of the present circumstances. Competing and cooperating owners of the factors of production establish a nexus of contracts that allows them to create the price structure. The phenomena of price activities arise in all instances of economic calculation — realized past prices , past actions undertaken to correct them, current price offers, and current actions based on calculation outcomes and expectations about future prices. Clearly, at every point in time part of the existing Misesian knowledge is objective and known, but part of it is always beyond human recognition, because it will be determined in the future: allocation activities undertaken after the acquaintance with price offers. That is why entrepreneurship consists of a combination of knowledge and ignorance.

Past prices can be observed and expressed in the form of statistics, therefore they belong also to our first category of knowledge (as we emphasized in the beginning we are not searching for fully non-overlapping definitions). Nevertheless past prices are only the beginnings of calculation, since they only reflect past choices conditioned by outdated anticipations (see Mises 1966, p. 330). The next constituents are price offers, which in the Misesian sense are not yet “prices.” They are offers formed today under current market conditions, which are different from the conditions under which past prices had been formed. Therefore in contrast to realized prices they convey some form of current information and views about the future. If someone theorizes about prices as information signals, currently available price offers perform this function (they are not strictly speaking prices as exchange ratios).5

Price offers and past prices close the category only of existing Misesian knowledge. Economic calculation involves economic activity under uncertainty, what results in changes of economic conditions and unexpected outcomes (with price changes). It is one thing to know past prices and current price offers, but it is another to act upon those prices. Past prices inform entrepreneurs about past events. Current price offers inform entrepreneurs about today’s conditions and expectations about the future. Potential, not realized, prices “transmit” correct and incorrect entrepreneurial anticipations about possible marginal valuations of resources they own. That is why they do not transmit strictly Hayekian “knowledge,” but can include entrepreneurial perspectives on Hayekian knowledge.

All knowledge associated with various past and present instances of monetary calculation is not sufficient for the market process to happen. The driving forces for it are allocation activities (part of yet non-realized Misesian knowledge of what would private entrepreneurs do). These are actions undertaken by entrepreneurs after recognition of current price offers (with considerations on past prices and recapitalizations). The central owner under socialism has precisely the following problem: he cannot know allocation activities based on current price offers.6 He is not in a position to recognize what private owners would do, and how they would exclude each other from the market process. He is able to gather data on past prices, or even price offers right before the complete nationalization of resources, but he cannot know which allocation activities would have been performed under private property. Even if he or she knew all the relevant Hayekian knowledge, it would not suffice to solve allocation problems under socialism, since all of the Misesian knowledge would have to be known. The activity of entrepreneurs is something which cannot be implicit in the informational parameters of any system of equations, or any prices based on past or current data (see Salerno 1994, p. 120).

Three distinctive examples of Misesian knowledge could be: (1) “Lemons sold for 3 dollars per kilogram yesterday,” (2) “This flat is for sale for a million dollars,” (3) “Martin decided to produce 30 uniquely designed cars and price them at $3 million per car.”

“Full” Economic Knowledge

Complete economic knowledge is not anything “real,” but it is one of the assumptions in the possible “mathematical” solution to the calculation problem (which was never consequently defended by anyone). It boils down to knowledge of all possible “production functions” available to human beings. Hayek had this type of knowledge in mind when he theorized about allocation problems after postulating many ifs; if we possess all relevant information, all preferences, all knowledge of available means, then the problem of allocation is “purely one of logic” (Hayek 1945, p. 519).

In the neoclassical analysis, production functions are very simple (they have to be) and easily subjected to mathematical formulation. They use only a few variables as factors of production. Their coefficients are given and their influence on production is established and well known. At the same time, since the equations are simple and use few variables, “marginal rates of substitutions” can be inferred from those equations. They can become sorts of shadow prices, which could in theory substitute real world monetary prices and entrepreneurial assessments.7 Those substitution levels can demonstrate, for example, “how much more is being produced when x amount of factor A is substituted for y amount of factor B?” Such contingent tradeoffs could be used for rational allocation.8

In reality such full economic “knowledge” cannot be achieved for two main reasons. Firstly, as Austrian economists have emphasized, production functions9 are complex and each one of them is extremely specific. Production functions consist of many factors of production, which cannot be constricted and grouped into such macroeconomic (or microeconomic) variables as “K” (capital goods) and “L” (labor), or additionally “H” (human capital) and “A” (technology, or “total factor productivity”). Real world production functions have many more variables and their coefficients are not stable numbers. Due to complexity of those functions, simultaneous equations of production functions cannot in fact be “solved” even in “theory.” Walrasian equations can surely be solved, because they are simple and have as many equations as unknowns with known coefficients (Walras 1954, p. 238).10 They appear to be mathematical tasks. By assuming such a trivial world of flat production functions, one is assuming away essential problems of complex economic reality.

The second reason for the lack of such “full” knowledge of the real world is uncertainty and human creativity. However precise the production functions are, they are never accurate, because people are never in a position to fully determine the future. They cannot “close” production functions and make them “complete,” because they would have to include all possibilities about the future.11 Assumptions about the knowledge of those functions implicitly embrace the notion that future is largely foreseen, and that man can anticipate what he or she will learn in the future. Human beings are not omniscient and the future is purely uncertain (in the Knightian sense). It cannot even be subjected to calculus of class probabilities, because in the course of economic events case probability prevails. By assuming away the uncertainty of the future, the fundamental problems of entrepreneurship are also assumed away. Change implies necessity for economic decision making (Mises 1966, p. 212).12 With full knowledge of the future, human beings do not face the problem of proper judgments, since all of them are optimal and efficient. Henceforth “full” economic knowledge (which would allow “shadow prices” instead of monetary prices) is impossible to be achieved, because production functions are too complex and because people can never have a complete list of “correct” functions (which would include information about future events).

The last few sentences seem too trivial and obvious to be mentioned, but there is an interesting consequence of them for the Hayekian concept of knowledge. The complete full economic knowledge is not split up and partitioned between the individuals, therefore it does not become “Hayekian knowledge” when decentralized. If we somehow summed up all the Hayekian knowledge we would still not achieve “full knowledge.” In referring to the hypothetical concept of full economic knowledge Mises writes “no single man can ever master all the possibilities of production, innumerable as they are,” and so the entrepreneurs are divided between their tasks in the environment of monetary calculation (Mises 1990, p. 17). Hayek has a footnote to that Mises’s passage when he refers to the “division of knowledge” (Hayek 1937, p. 50). Yet this is not what Mises had in mind, since clearly full economic knowledge, “all the possibilities of production, innumerable as they are,” cannot be either known or divided between individuals just as infinity cannot be divided into finite numbers. Mises’s point was that “full knowledge” can never be achieved, not that it is in some way divided between the people (compare with Horwitz 1998, p. 430).

As we see, full economic knowledge is unachievable because of the “complexity” and “indeterminacy” of what we sometimes call “production functions.” Indeterminacy problems were to be avoided only if man could turn into a sort of “Laplace’s demon” — entity capable of gaining knowledge about “everything,” meta-knowledge, which would allow the possessor of it to project reality in any way he or she wanted. Fortunately we deal in this article with humans, not gods; henceforth we can set such issues aside for philosophers and theologians. The theoretical economic system can never be “complete” in such sense.

Knowing, Guessing and the Market Process

Perfect Laplacian knowledge leads to perfect forecast. All-knowing man possessing features of the Laplacian “demon” could notice and understand the position of any molecule (even a social “molecule”) in the (social) universe. Such recognition would allow for the planning of every future step ahead and effectively adjust actions to any desirable and possible state of affairs. No mistakes would be committed and the equilibrated Utopian dream could be realized. Any step away from such perfect knowledge results in uncertainty. In order to cope with uncertainty people try to forecast future events.

Beyond the point of perfect knowledge the strict connection between knowledge and forecast breaks. At the extreme, perfect knowledge allows for perfect forecast.13 Once we move away from perfect knowledge we also move away from perfect foresight. Moreover, under the circumstances of uncertainty more knowledge does not always mean better forecasts. It may be truer for cases of natural sciences. The more we know about physics, or chemistry, the better we can forecast “behavior” of the matter. It is slightly different with knowledge of social sciences, where knowledge to some extent improves our understanding of the social world (not necessarily forecasting abilities). More Hayekian, or more current Misesian knowledge, does not necessarily lead to a better economic forecast.

Portions of social knowledge do not guarantee that foreseeing will be in a better shape. Entrepreneurs might be equipped with Hayekian knowledge, but this does not guarantee their success. They can gain a lot of Hayekian knowledge in the market, but still these gains will not automatically transform themselves into entrepreneurial successes. Even the elements of Misesian knowledge do not assure that. Entrepreneurs can acquaint themselves with past prices (realized exchanges) and price offers (currently existing ratios). Knowledge of those is not a formula for commercial accomplishments. When the entrepreneur starts to gather all the price data and gets to know current and previous price offers, it is still not enough to bring him good foresight. Moreover, it is almost nothing. The entrepreneur can gather all that knowledge, and still lose money.

Additionally, gains in knowledge per se do not reap entrepreneurial gains. The effective entrepreneur is not someone who knows “more” than others. There are many entrepreneurs who accomplish a lot even though they were less knowledgeable than their rivals. Especially in the light of the fact that many huge entrepreneurial successes work like in the romantic Schumpeterian story of the entrepreneurs, who break the existing social structures. Sources of triumphs for any entrepreneur do not lie in the typical knowledge build-up, but often in envisioning what is unseen and most likely cannot be seen. All those actions are subjected to revisions and to praxeological recapitalizations in the form of losses and profits, as well as changing asset ownership. Good choices are indicated by correct monetary imputation, and do not have to be correlated with gains in information, or any type of “knowledge” acquisition (Salerno 1990a, pp. 59–60; 1990, pp. 42–43).

Naturally, it does not follow that “knowledge” has nothing to do with forecasts and entrepreneurship. Nevertheless, the entrepreneurs are not spreading Hayekian “knowledge” in their calculations. First of all, in the case of the unfortunate word “transmission,” they are transmitting some things, but these are not Hayekian knowledge and not in the form of prices. Entrepreneurs are transmitting their judgments, and they do it mostly in the form of price offers conveying this information. Whether correct or incorrect, price offers given by sellers of goods and services inform us about how market conditions are currently perceived. The yet to be successful entrepreneur is the one who is capable of “spotting” false prices, a discrepancy between current price offers for factors of production and prices for consumer goods which will be created in the future. “Spotting” is a metaphor, since technically we can only “spot” what already exists. “False prices” do not exist yet. They shall only materialize once the future becomes present. Hence the reason why Kirznerian “profit opportunities” are blurred by clouds of uncertainty and they do not exist yet. Current price offers inform us how entrepreneurs envision today future market conditions. Precisely that kind of “information” is hidden behind prices, not information about proper ways of adjusting “production functions.”

In the neoclassical framework entrepreneurial choice is given by the intersection of the marginal revenue curve and marginal cost curve. The main oversimplification in such an apparatus comes from the coincidence of the two and presupposed incidental existence. In reality one can get to know marginal cost curves by searching for price offers (more or less). Nevertheless the marginal revenue curve does not exist; it cannot be spotted and properly acted upon. We cannot be alert to the marginal revenue curve because it is not there yet. Instead of one marginal revenue curve there is virtually unlimited number of potential non-realized marginal revenue curves. Each of them has case probability assigned to it, thus strictly speaking it has no numerical probability at all. Whoever is more successful in picking the “proper” curve, wins. The “proper” solution is offered with the future being realized. In order to foresee the demand, one does not need to “know more” than others. One needs to make a proper judgment (Hülsmann 1997, p. 35). The “selection” mechanism cannot be reduced to gains in any mentioned type of knowledge.

In other words, the market process is not driven by entrepreneurs who know more, but by entrepreneurs who deliberately select arbitrary types of information and act upon them. A real world forecast is based on those selections of information. Information is interpreted, understood and used.14 What types of information are available to various entrepreneurs? As we saw in the process of economic calculation there is lots of it: realized transactions, which inform us about habits; and recapitalizations, which inform us about the extent of past mistakes. On top of that there are current price offers, which inform us about competitive potential in the market e.g., in which field we can be outcompeted by others and in which fields can we rely on the division of labor. Finally, there are undertaken actions and reallocations by other owners. All this Misesian type of knowledge is generated by the market, based on praxis, and can be referred to as the social appraisement process.

Not only is the world and its information heterogeneous, but so too are individuals. Each entrepreneur is different and has his unique entrepreneurial vision, which can be expressed through the use of property. Entrepreneurs differ in their judgments and disagree on what is economical, and what is not (Lavoie 1985, p. 123). Whoever performs well enough in this task outcompetes his rivals in the market process.

Let us take the case of an entrepreneur producing machines with the use of steel. He can notice past prices for finished products (machines) and past prices of steel. They can inform him about past exchanges and demonstrate past market conditions. He can evaluate them and engage in Verstehen. Any information he gets by contemplation can be useful for current price considerations. Equally useful are “present prices,” price offers for steel. (The entrepreneur also tries to anticipate future prices of the machines). Steel prices inform the entrepreneur how steel is being valued by sellers and by his competitors, other entrepreneurs who alternatively employ steel (to produce something else or similar). Henceforth current prices (offers and transactions from the immediate past) at least inform the entrepreneur of how valuable alternative employments for various factors are, or how other market participants envision the markets of goods produced with steel (compare with Yeager 1994, pp. 95–96). This notification of how much factors are expected to be worth, is a relevant part of the market process and entrepreneurial division of labor.

Accurate anticipation of future prices based on individual understanding of selected information leads to profits. In everyday life we notice how new information changes the prices and actions of market participants. The person acquiring new knowledge cannot be sure that its spread should change prices in a particular way. In some cases we can be almost close to certainty what the effect should be. But it can never be “fully” known in advance. If new fields of oil are discovered, the anticipation is that the price of oil should go down. Nevertheless it need not to, and we can envision scenarios in which the opposite happens. Successful entrepreneur is the one who can “interpret the information” correctly, but only in the ex post sense. He acts very often against the tide and the rest of the market.

The crucial side of the competitive process is its legal aspect. The mechanism of entrepreneurial selection is based on property shifts, which result from monetary calculation. This works despite psychological motivations of the participants, or their “knowledge,” or their “ignorance.” It does not matter what entrepreneurs’ incentives are, or what kind of information they possess. They can know a lot, or little, they can be motivated in their actions by their personal skills, or act upon an ideological bias. Whatever they know, and whatever their incentives are, as economists we do know that those who satisfy consumers most survive in the market. We do not even have to assume that entrepreneurs are interested in “maximizing” profits (Alchian 1950, pp. 212–13).15 Their personal interests and motivations are not important. Profits are the link between consumer satisfaction and entrepreneurial decisions acknowledging them. That is why the market process “works” — because calculation has consequences for allocations.

In the economic analysis of socialism we can assume many things. If we assume that planners have “full knowledge,” then we “solve” the problem with an unrealistic assumption. In the real world planners can only gain other types of knowledge. They can possess all the necessary technological knowledge, and even the more specific Hayekian knowledge of time and place. We can even add that planners could possess scatters of Misesian knowledge: they could accurately know past prices and price offers right before the imposition of the socialist order. Yet even this knowledge does not solve the main socialist deficiency: the central owner does not know what are, or would be, the allocations of private owners. He cannot substitute them, or even hire them as bureaucrats, because tangible entrepreneurial skills are manifested in the realms of praxeological boundaries conditioned by asset ownership. When the central owner nationalizes the resources, all entrepreneurial skills are outlawed and simply lost.16 They cannot be recovered by any bureaucratic structure, because there is no real world competition set in the property regime.

Conclusions

As we have seen, in economics “knowledge” can have many different meanings. In assessing economic systems one has to be careful in making particular assumptions about “knowledge,” because any discussion may turn out to be blurred by definitional barriers. Depending on what we exactly mean by the term “knowledge” various conclusions about its possession or non-possession can be reached. It all comes down to what exactly we understand by this term.

References

Alchian, Armen A. 1950. “Uncertainty, Evolution, and Economic Theory.” Journal of Political Economy 58(3).

Barone, Enrico. 1935 [1908]. “The Ministry of Production in the Collectivist State.” In F.A. Hayek, ed., Collectivist Economy Planning. London: Routledge and Kegan Paul.

Cassirer, Ernst. 1944. An Essay on Man: An Introduction to a Philosophy of Human Culture. New Haven, Conn.: Yale University Press.

Garrison, Roger. W. 1992. “The Limits of Macroeconomics.” Cato Journal 12(1) (Spring/Summer).

Hayek, Friedrich August. 1937. “Economics and Knowledge.” In Individualism and Economic Order. Chicago: University of Chicago Press.

——. 1948 [1940]. “Socialist Calculation III: The Competitive Solution.” In Individualism and Economic Order. Chicago: University of Chicago Press.

——. 1945. “The Use of Knowledge in Society.” American Economic Review 35(4).

——. 1984. “Two Pages of Fiction.” In C. Nishiyama, K. R. Leube, ed. The Essence of Hayek. Stanford, Calif.: Hoover Institution Press.

Horwitz, Steven. 1998. “Monetary Calculation and Mises’s Critique of Planning.” History of Political Economy 30(3).

Huerta de Soto, Jesús. 2010. Socialism, Economic Calculation, and Entrepreneurship. Cheltenham, UK: Edward Elgar.

Hülsmann, Jörg Guido. 1997. “Knowledge, Judgment and the Use of Property.” Review of Austrian Economics 10(1).

Kirzner, Israel M. 1996. “Reflections on the Misesian Legacy in Economics.” Review of Austrian Economics 9(2).

Lavoie, Don. 1985. Rivalry and central planning. The socialist calculation debate reconsidered. Cambridge: Cambridge University Press.

Mises, Ludwig von. 1966. Human Action: A Treatise on Economics. Chicago: Contemporary Books.

——. 1990. Economic Calculation in the Socialist Commonwealth. Auburn, Ala.: Mises Institute.

Polanyi, Michael. 1966. The Tacit Dimension. Garden City, N.Y.: Doubleday.

Salerno, Joseph. 1990. “Ludwig von Mises as a Social Rationalist.” Review of Austrian Economics 4.

——. 1990a. “Postscript: Why a Socialism Economy is ‘Impossible’.” In Ludwig von Mises, Economic Calculation in the Socialist Commonwealth. 1990. Auburn, Ala.: Mises Institute.

——. 1994. “Reply to Leland B. Yeager on “Mises and Hayek on Calculation and Knowledge.” Review of Austrian Economics 7(2).

Stigler, George, and Gary S. Becker. 1977. “De Gustibus Non Est Disputandum.” The American Economic Review 67(2).

Walras, Léon. 1954. Elements of Pure Economics, or The Theory of Social Wealth. London: American Economic Association and the Royal Economic Society by Allen and Unwin.

Yeager, Leland B. 1994. “Mises and Hayek on Calculation and Knowledge.” Review of Austrian Economics 7(2).

• *Mateusz Machaj is assistant professor at the Institute of Economic Sciences at the University of Wroclaw, Wroclaw, Poland. I would like to thank to Professor Joseph Salerno for many years of his invaluable help. This article is an outcome achieved due to indispensable long-term academic guidance of Professor Salerno. My intellectual development would have not been possible without his personal support, and without the study of his masterful works on monetary theory and general economic theory.
• 1Mises notes (1966, pp. 206–07) that under perfect substitutability of capital goods would imply that “all means of production ... would be as if only one kind of means — one kind of economic goods of a higher order existed.” Therefore in a socialist economy one could calculate according to the usage of the one universal higher order good (e.g., kilograms of such good), and avoid the problem of valuation of heterogeneous factors of production (non-perfect substitutability of capital goods).
• 2Although other types below could also be seen as objectively existing.
• 3During the socialist calculation debate the term “technological” knowledge was used (see Mises 1966, p. 699).
• 4On the appraisement process see Salerno (1990, p. 42; 1994a, p. 120). It is of course debatable to call activities as “knowledge.” But, as we explain below, we will stretch a little bit and name them “knowledge,” because from a certain perspective this is what the central planners would need to “know” — the actions of private owners — in order to act efficiently.
• 5They also include current understandings of past trends in prices. The information on past prices visioned as valuable is being reflected in the current appraisal.
• 6At some point Hayek suggested this is not the main problem, because “price expectations and even the knowledge of current prices are only a very small section of the problem of knowledge” (Hayek 1937, p. 51). In the other paper he suggested otherwise. See Hayek (1984, pp. 57–58).
• 7Stigler and Becker (1977, p. 77) use the term “shadow price” to label a valuation for a good, which is not sold or purchased in the market. They use it for a different type of a discussion, but the idea to use the concept of “shadow price” is similar as in here. A “shadow price” is something which is to be inferred from subjective valuations and can substitute market pricing. Yeager uses “shadow price” in the analogous sense (Yeager 1994, p. 101).
• 8From the equations we can know how much of an additional amount of one factor of production is needed to replace decreased amount of the other factor if one wishes to maintain the level of output. These types of rate can be known only if production function is simple and known.
• 9Actually the word “function” is a doubtful name, but it is a topic for another discussion. There is not much typically “functional” about production processes.
• 10Walras later on (when he deals with progress) allows for adjustable coefficients, but still the system contains “as many equations as there are unknowns to be determined” (p. 384).
• 11This is why a neglected Barone stated that “it is frankly inconceivable that the economic determination of the technical coefficients can be made a priori” (Barone 1908, p. 287). Ironically he later became to be quoted for having “solved” the problem of economic calculation under socialism, even though he did not believe so and actually argued the opposite.
• 12As Hayek (1945, p. 94) notes “economic problems arise always and only in consequence of change.”
• 13“It may be added that knowledge, in the sense in which the term is here used, is identical with foresight only in the sense in which all knowledge is capacity to predict” (Hayek 1937, p. 51). It might be stated that we need calculation, because we can never possess enough knowledge.
• 14As Kirzner points “possessing all this information is not the same as having assimilated it” (Kirzner 1996, p. 150). In this sense “assimilation” process is always subjective (both for the entrepreneur and hypothetical central owner under socialism).
• 15Actually “maximization” is also an improper word, since it would imply we have a particular “function” to be maximized. In reality, entrepreneurs choose between various rates of profits and case probabilities associated with them.
• 16Mises (1990, p. 38) brilliantly emphasized this in his initial article: “Unfortunately ‘commercial-mindedness’ is not something external, which can be arbitrarily transferred. … The entrepreneur’s commercial attitude and activity arises from his position in the economic process and is lost with its disappearance.”

A* serious interest in the entrepreneur is often considered a defining characteristic of the Austrian school. This attention is evident in its prehistory, in the writings of Richard Cantillon, Jean-Baptiste Say, and others (Hébert 1985; Hébert and Link 1988), and also in Carl Menger’s foundational Principles of Economics (1871). Entrepreneurship plays a central role in the work of Ludwig von Mises as well, who often referred to it as the “driving force of the market.” However, despite the universal importance assigned to the entrepreneur among Austrian economists, there is still much discussion about what exactly entrepreneurs do, and their precise function in the market economy. The questions involved are often complex and cover a wide range of problems, such as the determination of profit and loss, the role of uncertainty and speculation in the market, and the equilibrating properties of arbitrage, to name only a few. As a result, the various theories of entrepreneurship that have appeared in the Austrian tradition, each of which has its own fundamental assumptions and goals, have been the source of disagreements about economic theory and policy.

One controversial problem that remains to be thoroughly examined is the relationship between entrepreneurial theory and public policy. The relevant questions are: does economic policy have a direct effect on entrepreneurial behavior, and if so, can the study of entrepreneurship inform economists regarding the welfare outcomes of intervention into the market process? Thus far, the conventional wisdom on this subject (and on entrepreneurship in general) has been largely informed by the writings of Israel Kirzner, which have proved quite influential among recent generations of Austrian economists. Kirzner argues that policy interventions remove the incentive provided by pure profits, thereby hampering entrepreneurs’ ability to discover beneficial opportunities in the market. This in turn implies that opportunities for mutually beneficial market exchange are passed over, and interference with entrepreneurial alertness therefore undermines the welfare-increasing properties of the market process, which normally encourages entrepreneurial alertness and discovery.

Given that Austrian economists are often critical of the various economic arguments in support of regulation, it should not come as a surprise that an entrepreneurial theory linking intervention to welfare losses would be readily accepted. However, I argue that the view of entrepreneurship advanced by Professor Kirzner faces serious difficulties when it tries to explain the effects of public policy on entrepreneurship. I suggest that more satisfactory answers to questions of policy can be found by considering intervention through the framework of entrepreneurial calculation and judgment. This approach was pioneered mainly by Ludwig von Mises, especially in his famous dispute over the feasibility of socialism. Mises’s work has in turn been expanded and elaborated by later economists, especially Joseph Salerno, whose contributions to our knowledge of the entrepreneur’s distinct role cannot be overstated (1990a, 1990b, 1993, 2008). The work of economists like Mises and Salerno clearly demonstrates that the calculation-judgment theory is applicable to a wide range of policy problems, and firmly establishes the dangers of economic intervention for the market process.

Entrepreneurial Incentives and Economic Policy

This section explores the relation between alertness theory and economic policy. The framework for Kirzner’s policy analysis is found in his theory of “entrepreneurial incentives,” developed primarily in his book Discovery and the Capitalist Process (1985).1 Entrepreneurial incentives are a way to explain the roots of alertness and their role in promoting opportunity discovery. This is necessary because for Kirzner discovery falls outside the conventional economic presentation of incentives, as I will now explain. A consistent theme in Kirzner’s writings is the contrast between what he calls “Robbinsian maximizing” and entrepreneurial alertness. Robbinsian maximizing is a textbook description of how individuals engage in the weighing of alternatives, perform cost-benefit analysis, and maximize utility.2 In other words, Robbinsian maximizing involves individuals perceiving and reacting to incentives in the usual economic sense. However, “ordinary” incentives cannot be used to explain entrepreneurs’ discovery of opportunities, Kirzner argues, because incentives must be known to an actor in order to be incorporated into standard utility calculus. But pure profit opportunities are unknown; they are waiting to be discovered, and therefore cannot consciously play into the cost-benefit analysis of individuals. Alertness to opportunities must therefore be explained by factors other than conventional economic incentives.

Kirzner calls these factors “entrepreneurial incentives.” Entrepreneurial incentives are contained in previously-unforeseen profit opportunities. Unlike ordinary incentives, pure profit opportunities attract the attention of entrepreneurs because it is in the entrepreneur’s interest to notice them (1985, pp. 28–29). Previously-unseen profit opportunities represent potential gains for entrepreneurs, who will be alert to them provided the opportunity is valuable enough. Entrepreneurial incentives are therefore another way of saying that opportunities cause their own discovery. Kirzner calls this conclusion a “paradox,” because it is unclear how such causation could occur:

How, one must surely ask, can an enhancement of the desirability of a particular course of action which by the very definition of this kind of incentive has not yet been noticed inspire its discovery? How can an unnoticed potential outcome, no matter how attractive, affect behavior? How can the attractiveness of an unknown opportunity that awaits one around the corner possibly inspire one to peer around that corner? (1985, pp. 108–09; emphasis in original)

Unfortunately, Kirzner does not resolve the paradox. Instead, he suggests that, although the foundations of alertness require serious investigation, the tendency of opportunities to cause their own discovery is a part of our basic factual knowledge of the economy (1985, p. 109).

Kirzner’s views on the foundations of alertness have already received critical attention (Hülsmann 1997; Foss and Klein 2010; Friedman and Evans 2011), and it has been argued that the opportunity paradox places the alertness theory on insufficient foundations (McCaffrey 2014). Because potential entrepreneurs are prevented by definition from knowing of the existence of an opportunity, and even of searching for it, the causal explanation of alertness must come from some other source, specifically the opportunity itself, and the “open-ended” environment it resides in. The problem pointed out by the critics is that it is logically unsatisfactory to think of unknown opportunities as causing alertness, or helping to “[switch] on the entrepreneurial antennae” (1985, p. 109). Opportunities are not acting agents, and without this key connection between opportunities and discovery, alertness theory runs into difficulty, almost anthropomorphizing opportunities in order to explain how they inspire discovery.

Consequently, this problem carries over to Kirzner’s analysis of economic policy as well, in that the alertness approach does not provide a framework for real-world analysis of the welfare effects of government intervention. Kirzner’s research in entrepreneurship is generally intended to demonstrate the equilibrating and welfare-enhancing properties of the market process, with policy considerations playing a secondary role. Nevertheless, thinking in terms of entrepreneurial incentives is supposed to shed new light on economic policy prescriptions too, explaining how hampering the market process produces inferior welfare outcomes, thus adding vital support to more conventional analysis.

Although economists have developed numerous ways to analyze public policy, many of these are framed in terms of the effects of regulation on ordinary incentives. Kirzner, however, argues that there is danger in thinking only in these terms, to the neglect of the welfare implications of entrepreneurial incentives (Kirzner 1984; 1985, pp. 132–33). This is because changes to entrepreneurial incentives affect the market process in a special way. Specifically, economic regulations hamper entrepreneurial alertness, and prevent the discovery of new opportunities, resulting in welfare losses. This assessment depends on the paradox of alertness discussed above.

Kirzner’s view of economic policy is a straightforward application of his incentive theory, and he describes the connection between regulation and entrepreneurial incentives as “intuitively obvious” (Kirzner 2009). Specifically, economic policy poses a threat to human welfare when it reduces or eliminates entrepreneurial incentives. When economic policy eliminates a profit opportunity or renders it less remunerative, it becomes less attractive to entrepreneurs. Because it is no longer in an entrepreneur’s interest to notice the opportunity, it tends not to be noticed. By reducing the rewards (in terms of pure profit) attached to alertness, regulation therefore decreases the likelihood that entrepreneurs will be successful discoverers:

[D]irect controls by government on prices, quantities, or qualities of output production or input employment may unintentionally block activities which have, as yet, not been specifically envisaged by anyone. Where these blocked activities turn out to be entrepreneurially profitable activities (perhaps as a result of unforeseen changes in data), the likelihood of their being discovered is then sharply diminished. Without necessarily intending it, the spontaneous discovery process of the free market has thus been, to some extent, stifled or distorted. (Kirzner 1982)

Intervention eliminates new and unknown opportunities, preventing entrepreneurs from being drawn to them, and ultimately preventing welfare-enhancing market coordination. How precisely does regulation affect alertness? The answer seems to be that,

To announce in advance to potential entrepreneurs that [for example] “lucky” profits will be taxed away is to convert open-ended situations into situations more and more approximating those of a given, closed character. The complete taxing away of pure entrepreneurial profit can, it is clear, succeed only in removing from potential entrepreneurs all incentive for paying attention to anything but the already known. (Kirzner 1985, p. 111, emphasis in original)3

Kirzner seems to be arguing that entrepreneurs possess a general knowledge of “where to look,” such that if this general field becomes less profitable, they will be less likely to notice specific opportunities in it. Yet if opportunities are discovered without ordinary incentives (such as those involved in search efforts), it is not clear how giving entrepreneurs general information would aid or hamper discovery. Would not information about where to look simply affect ordinary, known incentives? If expressed in these terms, the thrust of Kirzner’s argument would be unobjectionable. It would imply that when government announces a certain kind of production is no longer profitable, entrepreneurs acknowledge this change, alter their calculations accordingly, and shift their resources to more remunerative forms of production. Yet this view of entrepreneurship and regulation relies on the conventional approach to incentives: the open-ended-vs.-closed distinction is most plausible if entrepreneurs can act and search for opportunities, or, even better, exercise judgment about how to use resources. But if we try to apply the specific notion of entrepreneurial incentives to policy analysis, the causal problem of alertness appears again.

Consider an example. Suppose there are two industries, auto manufacturing and software engineering. In each of these industries entrepreneurs are earning the same returns, and as far as all potential entrepreneurs are concerned, both industries are equally attractive. Let us then suppose the government announces that a new tax will be levied on the profits of the auto industry, while the software industry will be left unhampered. According to Kirzner, opportunities in auto production have been eliminated, and potential entrepreneurs will now perceive the industry as closed, which in turn means relatively few profit opportunities will be discovered there. There are two ways to explain this result. First, entrepreneurs might acknowledge the new policy, ignore the auto industry, and focus their attention elsewhere. This would involve action and search, however, and is not consistent with Kirzner’s theory of alertness. The second possibility is that entrepreneurs do not act differently in response to the new tax policy, but instead the lack of profitability in auto manufacturing unconsciously steers them away from that industry and toward others. This seems more in keeping with Kirzner’s theory, but it returns us once again to the question of causation.

A potential entrepreneur’s knowledge of the tax could certainly influence his deliberate search efforts and decisions about production. But how could it influence the passive state Kirzner uses as a starting point? If a profitable opportunity cannot, by itself, cause its own discovery, how can we be sure that an unprofitable opportunity will have the opposite effect, and tend to remain unnoticed? If an entrepreneur does not know that an opportunity exists, how can a policy that decreases the profitability of that opportunity change the likelihood of his noticing it? In order to answer these questions, it seems we must incorporate other kinds of behavior, such as search or judgment.

I will not add to this criticism other than to point out that if entrepreneurial incentives cannot be integrated into a theory of unhampered markets, then the implications for restricted markets are ambiguous. If one believes there is no necessary tendency for entrepreneurs to notice opportunities (or even that opportunity discovery is not the best basis for a theory of entrepreneurship), then the above policy analysis loses its force; regulation might just as well hamper erroneous incentives or errors as prevent entrepreneurial success.4 Based on the above discussion, it should be clear that policy analysis poses a problem for alertness theory.

In addition to typical policy questions, the opportunity-causation problem also has implications for the debate over the feasibility of central planning, a system of organization Kirzner argues is subject to a lack of proper entrepreneurial incentives (1982). Using the entrepreneurial-incentives approach, however, the case against central planning might actually be weakened:

It is true in a trivial sense that entrepreneurs can be defined as those who are “alert to profit opportunities,” but we wonder why agents of the central planning board could not be equally alert. The real issue is not alertness, but the magical property that Kirzner attributes to those who are alert: the property of thereby finding what they are looking for (a profit opportunity) and knowing what to do about it. If mere alertness — activated by “the profit motive” … — were all it took to produce the requisite knowledge, one could incentivize central planners with the same motive or an even stronger one, such as the death penalty … (Evans and Friedman 2011)

There is then a difficulty in explaining how entrepreneurial alertness differs in market versus non-market (e.g., socialist) settings. If alertness is a universal phenomenon, as Kirzner believes, then it is unclear how or why government agencies do not also possess some degree of alertness — or why they could not be motivated to alertness. Once again, the necessary links between opportunity and alertness — and between decreased opportunity and non-alertness — are missing. Without them it does not seem possible to apply Kirzner’s alertness theory to economic policy, at least in the manner he suggests. The solution, I argue that we can solve this problem by relying on the concept of entrepreneurial calculation using money prices.

As mentioned above, Kirzner recognizes the problem involved in not explaining opportunity causation, yet still draws theoretical and policy conclusions as if the paradox had been resolved. It is difficult to escape the feeling that Kirzner accepts it as a matter of course that the market process produces beneficial welfare outcomes, and further, that this is the direct result of entrepreneurs tending to discover profitable opportunities. As he himself puts it, “there can be no doubt that such inspiration [i.e., entrepreneurial alertness] has been of enormous importance throughout recorded human history” (1985, p. 109). But this is a conclusion to be reached by careful reasoning, not a fundamental assumption. And until we clarify these assumptions and more clearly explain the foundations of entrepreneurial theory, economic policy is bound to remain a controversial subject. While this is far from an exhaustive discussion, I hope it is sufficient to demonstrate the need for careful scrutiny of the alertness hypothesis in economic policy, and moreover, to spark economists’ interest in alternative theories of entrepreneurship that more easily explain the effects of regulation on entrepreneurial behavior.

Entrepreneurial Calculation and Judgment

The problems of the alertness approach do not mean that entrepreneurial theory must give up any hope of policy relevance. However, they do require us to more carefully consider the basic elements of theory, and how they relate to real-world human behavior. To this end, I suggest that instead of a theory of entrepreneurial alertness, what is needed is a theory of entrepreneurial judgment. The judgment approach to entrepreneurship has a long history within the Austrian school, and can be traced back at least as far as Menger’s writings. Menger did not write extensively on the entrepreneur, but he did describe a number of different ways entrepreneurship can occur (1994, pp. 159–61). Two forms of entrepreneurship that are relevant for judgment are “the act of will by which goods of higher order … are assigned to a particular production process” and the “supervision of the particular production process” (Menger 1994, p. 160; emphases in original). Both of these aspects of entrepreneurship point to the idea of a capital-owning, decision-making entrepreneur (Salerno 2008).

The judgment approach flourished in the works of Menger’s disciples, especially in the writings of Böhm-Bawerk (McCaffrey and Salerno 2014), Frank Fetter (McCaffrey unpublished), and Ludwig von Mises. Of these economists, Mises’s writings have received the most attention, and are the subject of controversy. Yet a careful study of his writings shows that his work falls within the judgment tradition. This thread of Mises’s thought begins with early writings such as The Theory of Money and Credit (McCaffrey 2013), and continues on through his more systematic exposition of entrepreneurship in Human Action (Salerno 2008; Foss and Klein 2010). The judgment view was further elaborated by Murray Rothbard, who placed his own discussion in the midst of an extended treatment of production theory (2004, pp. 509–55).5 Among more recent generations of economists, the judgment theory has been developed by Joseph Salerno (2008) and has crystallized in such works as Foss and Klein (2012). This approach to entrepreneurship is therefore well-established within the Austrian school, and in fact represents a dominant trend in historical Austrian thinking on the subject.

The judgment approach views entrepreneurship as the function of residual decision making about the use of heterogeneous capital goods in production. In other words, the entrepreneur is the individual or group ultimately responsible for the direction of an enterprise, and this entails the ownership of capital and the direction of the factors of production. Because production takes time, arranging the structure of production implies that entrepreneurs make speculative judgments about the future state of the market. Eventually, consumer demand will reveal whether particular uses of capital were justified. If his initial judgments were correct, the entrepreneur earns profits, and if not, he incurs losses. The entrepreneur therefore bears the uncertainty of the future in exchange for the chance to reap profits. The key point, however, is that in order to do this entrepreneurs must exercise judgment about the allocation of resources.

However, when making decisions entrepreneurs first require some method of comparing the costs and benefits of each alternative use of scarce resources in order to determine which combinations of the factors will serve the most urgent needs of consumers. Entrepreneurs find this means of evaluation in monetary calculation. Calculation consists in entrepreneurs appraising the future prices of the factors of production through their “‘experience’ of past prices and … their ‘understanding’ of what transformations will take place in the present configuration of the qualitative economic data” (Salerno 1990a, p. 60). Once these mental estimates have been formed, entrepreneurs are in a position to gauge the relative merits of alternative arrangements of the factors. But their experience and understanding must be expressed in terms of a common denominator, namely money prices:

[A]s Mises points out, economic calculation involves arithmetic computation and … it is for this reason that economic calculation can only be calculation in terms of money prices. … As the only possible tool of calculable action, money prices do not merely permit people to utilize their individual “knowledge of particular circumstances of time and place” to enhance the efficiency with which goods are produced in society, prices render possible the very existence of social production processes. (Salerno 1990b)

Calculation therefore provides the “indispensable mental tool for choosing the optimum among the vast array of intricately-related production plans that are available for employing the factors of production within the framework of the social division of labor” (Salerno 1990a, p. 52). In other words, calculation provides, among other things, a basis for entrepreneurs’ judgment regarding the direction of the factors. More profoundly, calculation is actually the fundamental characteristic of a rational economic system, which is simply impossible in its absence, as in the case of socialist societies (Mises 1998 [1949]; Salerno 1990a; 1990b; 1993).

The distinct traits of calculation and judgment are all absent in the alertness view. This is a necessary result of Kirzner’s distinction between Robbinsian maximizing and entrepreneurial discovery, which excludes capital ownership, uncertainty bearing, and monetary losses from the start. Yet this exclusion is precisely why alertness theory stumbles when it confronts policy analysis. Because Kirzner cannot incorporate ordinary economic decision making into entrepreneurship, he instead explains it by appealing to variables outside the sphere of action, i.e., the existence of pure profit opportunities, which in turn leads to the problems discussed above. However, a capital-owning, uncertainty-bearing entrepreneur who earns monetary profits or losses can play an integral role in policy analysis.

The Policy Implications of Entrepreneurship

With the ideas of entrepreneurial calculation and judgment in mind, we can now make sense of the link between public policy and entrepreneurial theory. One distinct advantage of the calculation-judgment theory is that it is easily integrated into policy analysis; the causal connections between policy and entrepreneurship are not metaphorical or paradoxical, but can be analyzed using fairly straightforward economic tools. What is more, by showing how policy interventions interfere with the process of economic calculation and judgment, we can more clearly determine the welfare implications of such interference.

Ownership and Political Entrepreneurship

The application of judgment theory begins with the idea of ultimate or residual control over an enterprise. By determining where the locus of control and decision making lies, we can determine the scope and extent of entrepreneurial calculation, and also see how it might be hampered. More importantly, by discovering which individuals ultimately own and allocate resources, we can see how entrepreneurial behavior is different across institutional and policy contexts. The most obvious examples to contrast are entrepreneurial behavior in the market and in the political realm.

We have already said something about entrepreneurial calculation in the market. In sharp contrast is the element of “entrepreneurship” that occurs within government. Although decision making within government is often complex, it is clear that within any given state there is some form of ultimate authority over resource allocation. The exercise of this control may be termed “political entrepreneurship” (McCaffrey and Salerno 2011). Political entrepreneurship is distinct from market entrepreneurship in at least two important ways: first, it occurs outside the sphere of economic calculation, and second, it is financed through coercive redistribution as opposed to voluntary exchange.6 The non-voluntary nature of public finance means that no matter how decisions are made, they will conflict with the current preferences of the public at large, while the absence of calculation means decisions lack rational direction. Political entrepreneurship — i.e., government decisions about the allocation of resources—therefore diverts the stream of spending away from the path it would have taken in an unregulated market, and also distorts the structure of production (Rothbard 2004, pp. 1151–55, 1167–68; McCaffrey 2011). Political entrepreneurship cannot therefore produce the same welfare-enhancing effects as market entrepreneurship, and the absence of entrepreneurial calculation within government means that it never could.

Entrepreneurship and the Institutional Framework

The judgment approach also allows us to see how policy shifts the entrepreneurial function from one individual or group to another, and how this shift affects welfare outcomes. Changes in the entrepreneurial function are most relevant in a system of economic intervention. Under interventionism, ownership is systematically shared between government and private individuals, or in other words, there is a forcible separation of the ownership and control of the means of production. One way to describe this situation is “institutionalised uninvited co-ownership” (Hülsmann 2006; emphasis in original). For instance, when a government nationalizes an auto manufacturer or even the auto industry, entrepreneurs in these firms surrender their decision making ability, and the entrepreneurial function is shifted from the market to the political sphere. Even if entrepreneurs nominally retain ownership of the firm, they are little more than the managers of the enterprise — they can ultimately be replaced by the political entrepreneurs, who retain residual control. A system of government intervention, because it alters the pattern of ownership of the factors, also involves a systematic transfer of decision-making authority over them. Intervention therefore changes the pattern of entrepreneurship in society, by shifting the entrepreneurial function from some individuals to other more favored groups, be they rent-seeking firms or political entrepreneurs themselves.

“Institutionalized uninvited co-ownership,” is also closely tied to the incentive problem known as “moral hazard,” defined as, “the incentive of a person A to use more resources than he otherwise would have used, because he knows, or believes he knows, that someone else B will provide some or all of these resources” (Hülsmann 2006). When ownership and control are forcibly separated, a wide range of “perverse” incentives — such as moral hazard, adverse selection, and the tragedy of the commons — are brought into play. Under a system of free contracting, entrepreneurs (principals) must use judgment to arrange incentives within the firm, thereby mitigating moral hazard. However, when ownership is forcibly shared, the scope for calculation and judgment are reduced, prolonging or even institutionalizing incentive problems.

Moral hazard is not the only aspect of government intervention that can be viewed in an entrepreneurial light though. A closely related subject is the problem of “regime uncertainty.” This term was coined by Higgs (1997) as a way to explain the conditions which led to the long-term decline in private investment during the Great Depression. Higgs argues that entrepreneurs were reluctant to invest in a political environment hostile to their profit-seeking interests. In particular, widespread fear existed among businessmen that under the New Deal regime, industries would be nationalized, while taxes and other regulations would severely curtail profitability. What is more, the ideological stance of the Roosevelt administration was decidedly anti-business, creating an environment in which the viability of the fundamental institutions of the market economy was thrown into question. The uncertainty produced by the regime thus resulted in depressed investment and significantly delayed recovery.

Yet if the task of the entrepreneur is to allocate resources in the face of uncertainty, why would regime uncertainty pose a special problem? Regime uncertainty is relevant for judgment because it represents uncertainty about the institutional environment in which entrepreneurs make decisions; in a way, it tears the canvas on which entrepreneurs are trying to paint. One way to express this idea is to say that regime uncertainty occurs at a different institutional “level” than entrepreneurs are used to dealing with (Bylund and McCaffrey unpublished). That is, when regimes create fear about the security of the very system of private enterprise — in practice, the security of property rights and profits — they throw the “rules of the game” into question. Entrepreneurial judgment, on the other hand, usually takes place at the level of the “play of the game,” with certain institutional constraints taken for granted.

One result is that regime uncertainty undermines judgment by threatening its raison d’être. In a regime that is considered friendly to private enterprise, entrepreneurs constantly strive to earn profits and avoid losses. When regime uncertainty appears, however, entrepreneurs cannot be sure of the link between successful judgment and monetary rewards, and they therefore restrict their profit-seeking behavior (Bylund and McCaffrey unpublished). Reduced activity by entrepreneurs implies reduced effort to calculate in the economy, and ultimately, decreases in consumer satisfaction. There is then a reasonable chain of causation running from policy (actual or threatened), to entrepreneurs’ perceptions of monetary incentives, to a decline in entrepreneurial activity, and finally, to resulting welfare losses.7 Judgment therefore provides a substantive connection between regime uncertainty and welfare.

This is one way the conventional effects of regime uncertainty can be expressed in entrepreneurial terms. We can also imagine the reverse of regime uncertainty, when entrepreneurs believe returns will be guaranteed no matter the quality of their judgment. Of course, guarantees of profitability and security are not found in the market; they are, however, often made by government in its negotiations with rent-seeking firms. When guarantees are made, profit-seeking activities increase because entrepreneurs believe they will be protected (e.g., through grants of monopoly privilege or bailouts), whether their investments are wise or not. Entrepreneurs are more likely to engage in risky and unprofitable production when convinced they will not ultimately bear the uncertainty of their decisions. This again hints at moral hazard.

Conclusion

The theory of the entrepreneur is one of the most important components of economic science. But although it is vital for economists to understand the driving force of the market, it is equally important know how public policy hampers this force. The most obvious obstacle to economic progress is government intervention in the market economy, which inevitably involves interference with the decisions of the entrepreneur. Yet how we think of the entrepreneurial function matters greatly for our conclusions about exactly how economic policy changes the entrepreneurial process and the welfare outcomes of the market economy. If, following Kirzner, we view the entrepreneur as a resource-less and inactive agent awaiting the serendipitous discovery of profit opportunities, policy analysis becomes effectively impossible. Because the existence of profit opportunities does not explain a tendency toward entrepreneurial success, it likewise does not show how changes to the policy environment tend negatively to impact discovery and the welfare of market participants. The alertness theory does not then provide a substantial foundation on which to build a distinctly entrepreneurial approach to policy analysis.

However, once we take into account the vital roles of calculation and judgment, it is easy to see that economic policy distorts and changes entrepreneurs’ behavior. Judgment theory relies on the concrete notions of capital ownership, calculation in terms of money prices, and decision making about the use of the factors, all of which can be seen at work in the real world. Intervention shifts the pattern of ownership and therefore also falsifies the money prices entrepreneurs use to appraise the factors of production. Intervention also directly abrogates the judgment of entrepreneurs by diverting the structure of production from the course it would have taken in an unregulated market. The direction and scope of entrepreneurial decision making are thus altered, and consumer welfare is reduced. Moreover, public policy can drastically affect the business environment in which entrepreneurs act, threatening the fundamental institutions of the market economy on which entrepreneurs rely. This depresses entrepreneurial activity, resulting in a general loss of welfare.

Judgment, through its connections to economic calculation, provides a concrete reference point from which to analyze the effects of policy. Calculation is mass to judgment’s velocity, and together they form the driving force of the market. This view of the entrepreneur not only has a long history within the Austrian school, but has already been applied to numerous problems in theory and policy, and will no doubt serve as a useful tool for analyzing many more. It therefore represents a positive way forward for scholars in economics and public policy.

As a final thought, let me add that while the future is bright, so too is the past; in other words, it is vital to recognize that many of the most important advances in Austrian economics have emerged from careful reflection on the foundations laid by the giants of the tradition, whose insights must never be taken for granted. As our thinking on entrepreneurship moves forward, it too should be mindful of its roots in the Austrian school, and always take care to appreciate the contributions of previous generations. With that in mind, it is safe to say that as this tradition grows and thrives in the coming years, it will owe no small debt to Joseph Salerno.

References

Bylund, Per L, and Matthew McCaffrey. “Entrepreneurs and Regime Uncertainty: A New Institutional Approach.” Unpublished Manuscript.

Evans, Anthony J., and Jeffrey Friedman. 2011. “Search” vs. “Browse”: A Theory of Error Grounded in Radical (Not Rational) Ignorance.” Critical Review 23 (1–2): 73–104.

Foss, Nicolai J., and Peter G. Klein. 2012. Organizing Entrepreneurial Judgment: A New Approach to the Firm. Cambridge: Cambridge University Press.

——. 2010. “Alertness, Action, and the Antecedents of Entrepreneurship.” Journal of Private Enterprise 25(2): 145–64.

Hébert, Robert F. 1985. “Was Richard Cantillon an Austrian Economist?” Journal of Libertarian Studies 7(2): 269–79.

Hébert, Robert, and Albert Link. 1988. The Entrepreneur: Mainstream Views and Radical Critiques. 2nd ed. New York: Praeger.

Higgs, Robert. 1997. “Regime Uncertainty: Why the Great Depression Lasted So Long and WhyProsperity Resumed after the War.” The Independent Review 1(4): 561–90.

Hülsmann, Jörg Guido. 2006. “The Political Economy of Moral Hazard.” Politická ekonomie 1: 35–47.

——. 1997. “Knowledge, Judgment, and the Use of Property.” Review of Austrian Economics 10(1): 23–48.

Kirzner, Israel M. 2009. “The Alert and Creative Entrepreneur: A Clarification.” Small Business Economics 32(2): 145–52.

——. 1985. Discovery and the Capitalist Process. Chicago: University of Chicago Press.

——. 1984. “Incentives for Discovery.” Economic Affairs 4(2): 3–4.

——. 1982. “Competition, Regulation, and the Market Process: An “Austrian Perspective.” Cato Policy Analysis 18. Washington, DC: Cato Institute.

McCaffrey, Matthew. “Good Judgment, Good Luck: Frank Fetter on the Theory of Entrepreneurship.” Unpublished Manuscript.

——. 2014. “On the Theory of Entrepreneurial Incentives and Alertness.” Entrepreneurship Theory and Practice 38(4): 891–911.

——. 2013. “Conflicting Views of the Entrepreneur in Turn-of-the-Century Vienna.” History of Economics Review 58 (2): 27–43.

——. 2011. “On Government Investment and Consumption.” New Perspectives on Political Economy 7(2): 163–76.

McCaffrey, Matthew, and Joseph T. Salerno. 2014. “Böhm-Bawerk’s Approach to Entrepreneurship.” Journal of the History of Economic Thought 36(4): 435–54.

——. 2011. “A Theory of Political Entrepreneurship.” Modern Economy 2(4): 552–60.

Menger, Carl. 1994. Principles of Economics. Trans. James Dingwall and Bert F. Hoselitz. Grove City, PA: Libertarian Press.

Mises, Ludwig von. 1998 [1949]. Human Action. Scholar’s Edition. Auburn, Ala.: Mises Institute.

Rothbard, Murray N. 2004. Man, Economy, & State. Scholar’s Edition. Auburn, Ala.: Mises Institute.

——. 1987. “Breaking Out of the Walrasian Box: The Cases of Schumpeter and Hansen.” Review of Austrian Economics 1(1): 97–108.

——. 1985. “Professor Hébert on Entrepreneurship.” Journal of Libertarian Studies 7(2): 281–86.

Salerno, Joseph T. 2009. “Lionel Robbins: Neoclassical Maximizer or Proto-Praxeologist?” Quarterly Journal of Austrian Economics 12(4): 98–108.

——. 2008. “The Entrepreneur: Real and Imagined.” Quarterly Journal of Austrian Economics 11(3): 188–207.

——. 1993. “Mises and Hayek Dehomogenized.” Review of Austrian Economics 6(2): 113–46.

——. 1990a. “Postscript: Why a Socialist Economy is ‘Impossible’.” In Economic Calculation in the Socialist Commonwealth. Auburn, Ala.: Mises Institute.

——. 1990b. “Ludwig von Mises as Social Rationalist.” Review of Austrian Economics 4(1): 26–54.

• *Matthew McCaffrey is an assistant professor of enterprise at the University of Manchester, Manchester, United Kingdom. I was a summer research fellow from 2008–2013. Professor Salerno served on my master’s thesis committee in 2010, and we have since collaborated on several research projects. This essay was inspired by our work on the history and theory of entrepreneurship, for which Professor Salerno was an invaluable mentor.
• 1A thorough review of the theory of entrepreneurial incentives is beyond the scope of this paper, which deals only with its application to economic policy. For a more complete exposition, cf. McCaffrey (2014).
• 2It has been argued that Kirzner interprets Lionel Robbins too narrowly, mistakenly concluding that he is simply an early proponent of the conventional economic approach to utility maximization (Salerno 2009).
• 3The last sentence seems to imply that entrepreneurs can pay attention to the unknown. Unfortunately, Kirzner does not explain exactly what this might entail.
• 4Also, regulation need not simply inhibit the discovery of profitable opportunities: it might also produce new opportunities for rent-seeking or other forms of destructive entrepreneurship (Foss and Klein 2010).
• 5Rothbard also drew attention to the Austrian heritage in entrepreneurship and pointed out several confusions about this legacy (1985; 1987).
• 6Note that Kirzner’s entrepreneur does not possess resources in either a political or a market setting. Therefore, market entrepreneurship cannot easily be distinguished from political entrepreneurship based on this difference or on considerations of the entrepreneur’s methods of finance.
• 7Note that these links would be absent if entrepreneurs were unaware of the existence of monetary incentives.

Throughout* his career, Dr. Salerno has sought to expand the influence of Misesian scholarship, not only through his own research, but also classroom engagement, graduate student mentorship, and the education of the general public. His impressive body of work represents a true educator whose interest is fundamentally the advancement of human knowledge. It is in this spirit that this chapter seeks to provide an initial blueprint for the interdisciplinary expansion of Austrian principles to the political science realm, specifically the subfield of international relations theory. While international relations theory has strong shared origins in classical liberal approaches (Van de Haar 2009), recent theoretical evolution across the dominant paradigms has increased the potential for an expansion of Austrian ideas. Many theories within the subfield of international relations have begun to experience something of an “individualist shift” both methodologically and theoretically.1 For these reasons, if approached correctly, international relations research is a field ripe for future interdisciplinary engagement.

Notably, there does not exist an absence of political science research by Austrians, though these contributions remain beyond mainstream political science discourse. Perhaps the best examples are Murray Rothbard’s Power and Market and the concluding chapter of Man, Economy, and State which explicitly engage the effects of coercion, or politics, on human behavior.2 The foundation of the argument focuses primarily on the voluntary interactions of individuals in the absence of violence (economics), and yet concludes by engaging the reality that coercion (politics) is nearly always and everywhere present and “economic analysis must be extended to the nature and consequences of violent actions and interrelations in society” (Rothbard [1962] 2004, p. 875). In essence, the fields of economics and political science are highly complementary if not inherently intertwined. Unfortunately this early clear intersection of the two fields of inquiry did not occur more broadly, as political science, the younger of the two, developed from a combination of European legal and historical approaches (Carr 1939; Morgenthau 1948) and early American behavioralist research (Merriam 1924; Key 1934; Key 1966).3 However, unlike economics where certain biases may exist, Austrian ideas surrounding political organization, coercion, and the state are somewhat accepted. For example, James C. Scott’s The Art of Not Being Governed: An Anarchist History of Upland Southeast Asia and Charles Tilly’s “War Making and State Making as Organized Crime” share many commonalities with Rothbardian analysis of the state and are standard reading in undergraduate comparative politics courses.

This chapter proceeds by outlining the evolution of international relations theory over the past two decades with specific attention to the progression of theoretical development toward a greater focus on human action. While most research is heavily positivist in its construction, theoretical development over the course of the past two decades has led, steadily, away from the abstractions of traditional neorealist (Waltz 1979) and liberal institutionalist (Keohane and Martin 1995) paradigms that have dominated international relations research. New theoretical approaches that offer greater recognition to human agency, as well as new methodological challenges in qualitative research, provide an opportunity for Austrian engagement. Following a discussion of these theoretical approaches, I conclude with suggested strategies for continued expansion of Austrian ideas to the social sciences outside economics.

The Current State of the International Relations Literature

I first introduce through a simple illustration the relative position of the dominant international relations theoretical perspectives in the context of two fundamental criteria in Figure 1. The theories are organized according to their assumptions concerning the effect of anarchy on preferences, and thereby behaviors (y-axis), and the assumed level of analysis determining the type of actor under study (x-axis). Organizing each perspective by their nuanced conceptualizations on these two particular subjects provides an effective means of discussing their unique attributes within the context of their overarching similarities. (See Figure 1 on the following page.4 )

Notably, either abstraction presents potential problems for future Austrian interdisciplinary analysis. In particular, the level and corresponding relevant unit of analysis being anything beyond the individual is an inherently hostile assumption, as praxeological analysis recognizes accurately that only individuals are capable of action. For example, neorealists may assume for theoretical purposes that all states are rational unitary actors, but such an assumption is ineffective in generating common sense explanations of real world phenomena, given “there are no such things as ends of or actions by “groups,” “collectives,” or “states,” which do not take place as actions by various specific individuals (Rothbard [1962] 2004, p. 2). However, in the theoretical space that minimizes such abstractions, specifically the liberal and neoclassical realist conceptual spaces, the possibility for the development of an interdisciplinary Austrian discourse is quite plausible. Driving this evolution toward the individual over the past two decades of international relations research is in part the desire of applied research to understand real world outcomes, leading to what J. David Singer (1961) termed “vertical drift” wherein theories built on such abstractions as “state behavior” become applied to explaining foreign policy choices by individuals.

For much of international relations, anarchy defines contextual constraints, where expected behavior follows from the strength of the anarchy assumption (Powell 1994). Implied for many authors, particularly in the realist tradition, is that given anarchy and human depravity, conflict will ensue. Even neoliberal institutionalists acknowledge the anarchy assumption of neorealism, resigning themselves to searching for those conditions in which “cooperation under anarchy” is a possibility (Axelrod and Keohane 1985). If anarchy is as salient a political problem as neorealists suggest, then actors seek nothing more than power, as apart from coercive government their security is impossible to guarantee (hence Waltz’s characterization of the system as “self-help”). However, if anarchy is merely an environmental condition suggesting the absence of a single coercive entity, rather than being a constraint that determines behavior, then gains are not inherently zero-sum and cooperation is not only possible, but likely the dominant strategy within the anarchic context.5

On the right side of the horizontal axis are the predominantly system-focused explanations of international politics, depicting states as unitary actors. In this context, simplistically, the relationship of anarchy is perceived as either an aspect of the environment (English school) or the prime determinant of state preferences (Neorealism). On the left hand side of the graph reside those theories of international politics which focus on a sub-state unit of analysis, each providing an explanation of state behavior as a determinant of either group or individual action. The “Effect of Anarchy” in this context is parallel to the underlying discussion of the “state of nature” in much of political philosophy.6 Toward the top of the y-axis, anarchy has a powerful effect on human behavior, wherein man cares only for his self-preservation resulting in a Hobbesian existence that can only be described as “nasty, brutish, and short.” Alternatively, toward the bottom of the vertical axis, the state of nature, or anarchy, does not imply chaos. Intrinsic to anarchy in this Lockean conception is the principle of natural law endowed to the individual, wherein everyone is entitled to “life, liberty, and property.” In this context, human nature is not so negatively viewed, as individuals are capable of organizing themselves. Government, thereby, is either only necessary to protect person and property against those occasional individuals who seek to violate the principles of natural law, or alternatively is entirely unnecessary if individuals are capable of interaction absent a monopolizing coercive force (Rothbard 2002a). The vertical axis across both levels of analysis can also be described as the degree to which cooperation is possible in the absence of a centralized government in international politics.

Given the existing landscape of international relations theory, Moravcsik’s (1997) conception of liberalism, designated simply as “liberalism” in the illustration, provides the clearest potential avenue for the application of Austrian ideas. Recognizing the failures of systemic, state focused neorealism to account for domestic sources of state behavior (notably the collapse of the Soviet Union), Moravcsik (1997) presents a reframed variant of liberalism in international relations to fully account for the dynamics of policy formation. As both economists and political scientists are well aware, the term liberalism has been construed to mean a myriad of things, both within and beyond international relations research. Moravcsik’s articulation of a liberal theory of international relations is an attempt at salvaging liberalism’s “self-inflicted” condition. However, as the author makes clear, he is providing a “restatement” of liberal theory built squarely on classical liberal foundations.7 Liberalism as defined by Moravcsik thereby is explicitly a theory of preference formation, and it is in this particular conceptualization of liberalism that the most fruitful possibilities of interdisciplinary theorizing with Austrian researchers lies.

Moravcsik makes a series of core assumptions emphasizing preference formation and the evolution of interests within domestic society. First, the fundamental actor in international relations is the individual. Decisions are made by individuals acting in response to an environment to satisfy subjective goals determined by subjective sets of values. Already, we have dramatically complicated the study of international relations away from systemic theories. Second, and by extension, the state is a subset of individuals in society reacting to the preferences of individuals in the society at large. Actors in government, like actors in domestic society, have their own sets of values and preferences and exist in a particular institutional context, be it democratic or authoritarian. This environmental constraint shapes the availability and perceived values of the policy options available to state actors, but individuals remain the only entity capable of action. Finally, preferences across potential behaviors, and the resulting causal processes in policy choice, are constrained further by the international environment of interacting individual preferences and material capabilities (or opportunity to achieve some end).

Moravcsik (1997) essentially constructs a “bottom-up” view of international politics, tracing the source of state behaviors to the initial development of preferences by individuals within societies. What individuals within states want “is the primary determinant of what they do,” not the nature of the system as anarchic (Moravcsik 1997, p. 521), opening the door to understanding political phenomenon as they actually happen rather than under a predefined set of unrealistic abstractions. However, to employ liberalism to better understand outcomes we must have some means of logically deducing the source of preferences, of which Moravcsik lists three: ideational, commercial, and republican. The ideational components capture particular political, national, and socioeconomic cleavages and are manifest in normative explanations of the democratic peace (Dixon 1994), ethnicity based explanations of foreign policy behaviors (Davis and Moore 1997), and liberal economic preferences (Mousseau 2003). Commercial incentives are driven by motivations for some subjectively defined economic gain. These may take the form of trade and investment behaviors, but also may manifest themselves through preferences for resource access and even coercive seizure (e.g., Snyder 1991). Finally, republican sources of preferences are rooted in the political institution’s method of filtering the preferences articulated by the domestic populace. Likely the best examples are provided by the institutional democratic peace literature, but more specifically selectorate theory (Bueno de Mesquita et al. 1999). Indeed, selectorate theory, may provide the best illustration of the bottom-up preference formation process presented by liberalism while retaining a focus on individual action.

The implication of this articulation of liberal theory is a complete reformulation of how we conduct international relations research to refocus not on states, but upon the individual within society. Neorealism, restricted to the system level and states as actors, fails to independently account for state preferences, and so a focus on human action is the logical transition. However, a focus on individuals does not eliminate the systemic realm, in so far as the system is defined through the behaviors of other individuals engaging in their own series of actions within and between political systems.8 Furthermore, given the necessity of such a transition toward the individual and human action, there has been something of a convergence in international relations theory. For example, Jack Snyder’s (1991) work on empires, if one was ignorant of his self-identification as a “realist,” is indistinguishable from the theoretical processes outlined by Moravcsik. Specifically, Snyder discusses the logrolling interests of domestic actors, ideational preferences, and political institutional configurations all contributing to the propensity and rate at which empires historically over-expand — an outcome that is impossible to explain under any framework where states are rational unitary actors.

This international relations shift toward liberalism seems intuitively obvious, occurring quite broadly in mid-range topical analysis (see Oneal 2012): individuals have values for ends and employ means to achieve those ends. However, understanding, operationalizing, and incorporating the preferences of actors, determining their relative importance, and then interacting those aggregate preferences with state structures and the preferences of others individuals outside the state is a daunting task, and attempts to do so do not debunk clearly deduced theory as the burden of properly specifying such empirical analysis is exponentially greater than traditional state-level studies. However, with advancements in technology, the ability to conduct econometric tests of liberal ideas are more accessible and plausible, providing a means to mathematically sort out myriad coinciding human behaviors. In particular, the recent availability of multilevel modeling to political scientists is intuitively appropriate for testing liberal hypotheses, which employ indicators from across arenas of political interaction (e.g., actors both within and between states). Indeed, progress for the field entails “an increasing ability to explain and connect complex phenomenon” both theoretically and methodologically (Dryzek 1986, p. 301).

Liberalism in international relations theory is not the only path that has evolved to grant greater attentiveness toward the inherent basis of social science research in human action. Neoclassical realism possesses many of liberalism’s strengths while attempting to maintain many of classical realism’s fundamental Machiavellian assumptions. Like liberalism, neoclassical realism “explicitly incorporates both external and internal variables.” However, “the scope and ambition of a country’s foreign policy are driven first and foremost by its place in the system and specifically by its relative material power capabilities … the impact of such power capabilities on foreign policy is indirect and complex … translated through intervening variables at the unit level” (Rose 1998, p. 146). Though political preferences are influenced by the actor’s position in the power hierarchy relative to all other actors in the system, human action still is the fundamental phenomenon of interest. Indeed, there are close parallels evident in not only the analysis, but also the conclusions, of neoclassical realists and Austrians on the topic of war and empire. For example, both Snyder (1991) and Salerno (1995) engage in similar discussions of the relationship between inflation and imperial expansion, as well as highlighting it as a catalyst of further international conflict and long run unsustainability.9 Another possible example is that of Robert Higgs (1987) “ratchet effect” and the “phoenix factor” discussed by Organski and Kugler (1977). Distinctly, while liberalism is a theory of preferences from the bottom up, neoclassical realism is a theory of preferences from the bottom down. Though liberalism as discussed is perhaps more amenable to Austrian engagement, both approaches, however, attempt to integrate individual behaviors into a general theory of international relations, albeit with different emphases on the relative importance societal influences.

Perhaps neoclassical realism and liberalism constitute different roads leading to the same destination. Both take seriously the need to incorporate greater complexity into our theories to better account for political phenomenon. Encouraging for practitioners of international relations, and the potential for interdisciplinary engagement with the Austrian school, is the drifting of paradigms not further apart, but closer together. These two latest iterations of realism and liberalism are perhaps more theoretically compatible than ever before in the past, constituting, in Lakatosian terms, progress in the field. In conjunction with rising methodological interest in deductive theory development and qualitative analysis (see Goertz 2005), a fruitful cross discipline dialogue incorporating the Austrian school as a next necessary step to this theoretical evolution in international relations is now possible.

Strategies for Future Interdisciplinary Engagement

In order for such a debate to both occur and be fruitful, not only must the theoretical components be compatible and international relations researchers amenable to an Austrian turn, as I argue they now are, but the presentation of the ideas must be done in a thoughtful and effective manner. Just as in the presentation of any argument or position, the negative aspects of the method by which it is presented, or the individual doing the presenting, affect audience receptivity. For this reason, it is necessary for those engaging mainstream IR theory in advocacy of an Austrian perspective to be somewhat strategic, or at least minimally thoughtful, in the method and context of that interaction. While international relations as a field may be ready for interdisciplinary engagement, there are, in my opinion, three broad strategic impediments currently limiting the persuasiveness of the Austrian school to the social sciences (and the general public) that must first be addressed.

Strategy 1: Comprehension Before Engagement

One great pitfall to any interdisciplinary engagement is a failing to fully understand the core theories, methods, and even discipline specific jargon of the field you seek to engage.10 Comprehension is a necessary condition to effective engagement, and in its absence, attempts at an intellectual exchange may be dismissed or misunderstood, harming future discourse. As one example, there is a frequent and unfortunately persistent mischaracterization in Austrian circles of democratic peace theory, often inappropriately conflated with neoconservative foreign policy prescriptions. As but one example, a recent discussion by Hans Hoppe (2013) on the democratic peace grossly mischaracterizes the theory as including the claims “In order to create lasting peace, the entire world must be made democratic” and “war must be waged on those states to convert them to democracy and thus create lasting peace.” Such a claim about democratic peace is a complete invention, as there is not a single piece of democratic peace research in international relations that states either. Indeed, the original conceptualization of the democratic peace in modern political science empirical research was labelled the “libertarian peace” and focused on libertarian normative values (Rummel 1983). Such claims are completely absent in both the normative (Dixon 1994) and institutionalist (Bueno de Mesquita et al. 1999) explanations of the empirical finding, which has been described as “the closest thing we have to an empirical law in the study of international relations” (Levy 1989, p. 88). Indeed, the empirical record even suggests that newly created, unstable democracies are the most violent states in the system (see Mansfield and Snyder 2002). Dr. Hoppe appears to confuse the democratic peace, which originates as a deductive theory about domestic influence on the polity by Immanuel Kant ([1795] 1991, p. 113) and/or the rise of capitalist preferences by Joseph Schumpeter (1950; 1955), with neoconservative foreign policy recommendations (e.g., Kagan 2012) and the idealist policy prescriptions of Woodrow Wilson.11

While the criticism of such neoconservative policies that follows in Hoppe’s analysis is well crafted and would be predominantly shared by most democratic peace theorists, the failure to properly engage the enormous extant literature and demonstrate a basic knowledge of the theory as it currently exists in international relations fosters and supports divisions between the two social science fields rather than providing interesting political science insights from an Austrian perspective. Research in coercive hierarchical power relationships and the dissemination of democracy (Organski 1968; Rasler and Thompson 1994), the causal development of clear individual preferences within democratic (and non-democratic) institutional frameworks (Mousseau 2003; Peceny and Butler 2004; Gartzke 2007), and the relationship of foreign policy behaviors to institutional coercive strength (Rhamey 2012) all go ignored through this failing to engage international relations scholarship. Such a dialogue between these systemic and liberal approaches with Austrian scholarship has enormous potential for better understanding human action in the political context.12

Strategy 2: Engage and Incorporate Mathematics

If a priori science is a valuable approach, and we cannot knowingly observe the underlying motivations of actors, then generalizable and observable patterns of behavior should no doubt be present throughout a cadre of relevant historical events. While exploration of a single event may require a potentially dangerous divination of motivation in order to sensibly explain an historical episode, as well as any relevance to praxeological theories, econometric large-N analysis possesses the virtue of mathematically organizing possible relationships between events to uncover generally present correlations. A relationship between observable phenomena that are generalizably present in coincidence with an outcome of interest should correspond with any reasonably developed praxeologically deduced theorem, and certain types of statistical analysis may heavily complement Austrian research.13 While the idiosyncrasies of a single case may make for difficult historical illustration, laws of human behavior capable of explaining real world occurrences, in a Mengerian sense, should be observably evident in a statistically significant fashion across a relevant population in a properly specified model.14 While the failure to demonstrate expected empirical relationships that can be deduced from a praxeological approach does not, by definition, disprove the theory, it can serve the quite important purpose of highlighting deficiencies or logical fallacies within a deduced theorem. Theories are not apodictically true simply by labeling themselves a priorist, and a failing to observe generally present historical relationships that should coincide with the theory in a properly constructed econometric model is potentially an indication of a failing in the theory’s initial deductive logic. Furthermore, formal modeling, such as that often employed in applications of selectorate theory (see Bueno de Mesquita et al. 2008), can be a helpful means of organizing information regarding causal processes arrived at through clearly deduced theories.

Austrians often criticize econometric analysis as promulgating poorly developed or even illogical theories through the manipulation of algorithms to provide corroborating mathematical relationships. However, such a cautionary note surrounding statistical analysis is made by any serious approach to the social sciences, even in the most positivist corners, and an emphasis on theory prior to econometric testing is taught in every mainstream graduate research design course.15 This attack on econometrics, then, is something of a straw man caricature of econometric research as such inductive, hyper-positivist work is not the standard in mainstream social science. Instead, the hostility toward mathematics is more likely an indication of mathematical ignorance of underlying statistical algorithms, a confusion regarding statistical claims surrounding causality, or simply an attempt to promulgate a bad, illogical theory when confronted with a lack of, or even contradictory, empirical evidence. While properly developed social science theory is not dependent on empirical “proof,” an absence of such is typically a sound indication that something in the theory’s logic has gone awry. This is not to suggest that historical method of careful logical argumentation on a case by case basis is without merit (e.g., Rothbard 2002b). However, such qualitative approaches, while interesting, may not provide the most effective social science illustrations regarding generalizable theories. Econometric knowledge is neither the foundation nor the end goal of social science research, but if done well, it is an important tool in the arsenal of the social scientist and should be embraced.

Strategy 3: Focus on Academic Engagement

The ideas of the Austrian school have the potential to contribute greatly to the social sciences, but perceptions of those ideas, and thereby their dissemination, may be marred, however unfairly, by an unclear union between the intellectual development of theory building and libertarian political activism. As such, scholars should promote a clear distinction between Austrian research and political activism, not allowing scholarly work to be shrouded by irrelevant, and sometimes counterproductive or contradictory, agendas. This strategic concern is particularly applicable to interdisciplinary expansion to political science and international relations, fields already highly sensitive to the politicizing of social science research. In these fields, new research programs viewed as pandering to particular ideological perspectives or political groups, regardless of whether they are left, right, or libertarian, are likely to be quickly dismissed. For this reason, the community of Austrian scholars should promote a clear distinction between Austrian research and political activism.

In part due to the efforts of scholars such as Dr. Salerno, the Austrian school has grown in prominence and exposure by leaps and bounds in the academic community, both within economics and beyond. However, the growth of the Austrian school as a heterodox approach may also tend to attract elements that seek to exploit rising interest for personal profit, or those attracted to the community not necessarily by its ideas, but its distinctiveness from the existing status quo. Such groups may include racists, fear-mongers, or simply those advocating apophenic views contradictory to empirical reality. Clearly, as an intellectual enterprise that not only values the development of thoughtful theoretical and empirical research, but also one with a deep dedication to principles of human liberty, the scholarly community must act to quickly condemn any such groups that may attempt to associate themselves with the Austrian school for no other reason than its rising popularity. Organizations or individuals whose mission is contrary to that of advancing sound social scientific thought and human liberty central to the Austrian school should be immediately and quickly dismissed. Obviously most Austrian scholars are quick to condemn these types of groups or individuals, but a more active, vocal, and immediate stance is necessary within the scholarly community in opposition to such detrimental associations to prevent negative perceptions by broader academe and to preserve the school’s intellectual integrity. In addition to being clearly opposed to principles of human liberty and Austrian thought, such negative associations would also be highly detrimental to the advancement of interdisciplinary opportunities across the social sciences.

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• *J. Patrick Rhamey is assistant professor in the Department of International Studies and Political Science at Virginia Military Institute in Lexington, Virginia. I was a summer fellow in 2007 and 2008. During these experiences, under the advice and support of Dr. Salerno, I developed a passion for the field of international conflict. Furthermore, Dr. Salerno instilled in me the importance of thinking strategically regarding interdisciplinary theorizing and the importance of interdisciplinary work to the future of the social sciences.
• 1This trend originates in the renewed emphasis on domestic politics as a source of foreign policy behavior and extends to recent research examining the underlying causes of individual decision-making (Putnam 1988) and the relationship between the preferences of individual decision-makers and foreign policy selection (Bueno de Mesquita 1999).
• 2Indeed, the clarity of analysis from one volume to the other highlights the artificial and unnecessary division of the two works by the initial publisher.
• 3While some influence from economics is present in contemporary political science research, it is primarily of the positivist variant, to which there has been a significant backlash in the form of “post-positivist” theoreticians (e.g., Peterson 2004; Tickner 2005).
• 4Immediately the reader will notice the placement of constructivism. While I do not discuss constructivism at length in this chapter, constructivism is unique given its assumption of an endogenous relationship between levels of analysis. As examples, the key systemic features which frame state’s conceptions of world politics such as state sovereignty (Treaty of Westphalia) and anarchy are not universal truths, but social constructions by the states themselves (Wendt 1992, 1995). It is this endogenous relationship between society, state, and system the graphical portrayal is intended to illustrate.
• 5This distinction between anarchy as a defining characteristic that causes states to behave a certain way, as is the assumption by neorealists, versus anarchy as merely a systemic condition that describes the absence of a single coercive entity, as is the assumption by liberal researchers in international relations, has dramatic consequences for expectations of state behavior. Flowing from the neorealist assumption that anarchy causes behaviors are the assumptions that all states pursue self-help strategies, all gains are relative and mutually exclusive, and thereby this systemic condition leads inevitably to conflict. However, if anarchy is merely a descriptive characterization of the international system as the absence of government, which through liberal logic may be a systemic condition that expands possible behaviors rather than constrains as realists would claim, it cannot be assumed anarchy inherently leads to competition over relative gains and conflict. The “strength” of the anarchy assumption in international relations theory is thereby the degree to which the condition of anarchy forces states to behave in a specific manner.
• 6It is worth noting that the conceptions of “anarchy” in international relations theory are not entirely identical in classical realism and neorealism (or lower horizontal pairings) as the graph may suggest, as Morgenthau did not share Waltz’s view that the international system is inherently conflictual due to the effect of anarchy (see Morgenthau 1948, pp. 39–40). However, Morgenthau does share the Hobbesian view of human nature which is an abstraction based upon the Hobbesian view of the state of nature, or anarchy. Morgenthau’s conception of human nature, the basis for his description of statesmen and justification for the primacy of the state, exists as an extension of the idea of man’s nature under conditions of anarchy, even if he does not agree anarchy exists in the reality of international politics. Perhaps a more appropriate title for the y-axis would be “conception of human nature” ranging from good to bad. However, I expect in that case a footnote would be necessary explaining the nuances of the systemic level. The point here, however, is simple: philosophically the effects of anarchy on behaviors and human nature are directly related.
• 7Notably this restatement is not neoliberal institutionalism, which unfortunately dominated the term liberalism until very recently. In terms of assumptions, neoliberal institutionalism shares the entirety of the neorealist core (including the states as rational actors abstraction) while moderately relaxing the implications of anarchy on state preferences. Given this relation, Keohane’s (1993) statement that neoliberal institutionalism “borrows as much from realism as from liberalism” is disingenuous. Institutionalism borrows entirely from realism, while only moderately co-opting liberalism’s focus on the human progressivity (Zacher and Matthews 1995). To use the example of cooperation, it occurs despite systemic conditions of anarchy because actors determine that by doing so they can improve their condition (e.g., Axelrod and Keohane 1985). The core assumptions regarding states as rational unitary actors and the system organization as anarchic are identical. Neoliberal institutionalism appears to remain ambivalent to the historical emphasis of classical liberalism on the individual and the promotion of human freedom, leaving preferences as exogenously determined. I’ll refrain from delving further into the nuances of neoliberal institutionalism and neorealism, as the neo-neo debate has been thoroughly explored elsewhere (Jervis 2003; Baldwin 1993; Powell 1994).
• 8See the conceptual discussion of interactions in Bueno de Mesquita et al. (1999).
• 9Snyder’s Myths of Empire is both an excellent example of neoclassical realism and source of many parallels with existing Austrian perspectives, including coalition behavior in democracies leading to warlike behaviors, the pervasiveness of certain “myths” of external threat exploited by politicians to justify conflicts, and the inevitable destructive consequences of imperial overexpansion.
• 10Perhaps the best example is the term “institution” which possesses numerous definitions dependent upon the field and context within which it is used.
• 11Notably, Kagan and many neocons operate out of the field of history. There are no significant neoconservative international relations scholars, due both to the absence of any clear logic behind such an approach as well as a dearth of empirical evidence for such policies’ effectiveness. Wilsonian idealism, likewise, is generally absent in contemporary research, and the term exists in the present typically as a pejorative used by neorealists in describing liberal theorists (e.g., Mearsheimer 1995).
• 12For an introduction to the democratic peace in international relations, see Russett et al. (1995).
• 13Importantly, there is an intuitively plausible potential relationship between the praxeological approach and Bayesian empirical analysis that requires additional future attention by social scientists. Bayesian analysis recognizes the inherent uncertainty underlying observable events, obvious when observing real world phenomenon, as we cannot understand the complexity of motivations inherent in individual decision-making. However, rather than the explicitly inductive process of Bayesian updating, conceivably our priors may be updated instead by the deductive expression of a praxeologically based theory, permitting a more effective and appropriate large-N test. In other words, the logical posterior for an Austrian Bayesian model is the deductively generated theoretical information where probabilistic analysis is conditional on common sense claims.
• 14“Properly specified model” is simply one that accurately manages the nature of the data (e.g clustering, time series, hierarchical data structure) while also organizing the data to logically fit deduced theoretical priors. Generally, the problem in social sciences is not the models, but poor application and interpretation.
• 15Such criticisms are present in the most frequently used texts for such courses in political science and sociology doctoral programs, such as those by Shively (1974), King et al. (1994), Goertz (2005), and Ragin (2008).