The Free Market 31, no. 4 (April 2013)
The remarkable prosperity that people in capitalist economies enjoy at the beginning of the twenty-first century ranks at the very top of all achievements of human civilization. This prosperity is all the more remarkable when one realizes that the economic progress that has produced it dates back only a few hundred years. Prior to the Industrial Revolution, economic progress was so slow that people would not have been able to recognize it in their lifetimes, whereas today, such progress is so much a part of people’s lives that they take it for granted.
Economics as an area of inquiry has advanced along with the development of the economy, but in many ways the economy described by contemporary economic theory is not the same as the real-world economy that the theory should describe. Economic analysis, as it has developed through the twentieth century, is now heavily oriented toward understanding the properties economic equilibrium, and is not descriptive of the dynamic real-world economy that is characterized by economic progress.
The equilibrium approach views the economy as tending toward a stable equilibrium outcome, rather than describing a process of continuing economic progress that characterizes modern capitalism. The idea that people’s lives are improved more by economic progress than by moving toward that efficient equilibrium is foreign to the equilibrium approach. The entrepreneur–the central cause of economic progress–is ignored in the equilibrium approach to economic analysis. Instead, modern microeconomics depicts a competitive equilibrium as the benchmark for economic efficiency, and analyzes how economic policy can move an economy toward that equilibrium. This is done by correcting externalities, producing public goods, or controlling monopolies. For example, antitrust policy often attributes profits to monopoly rather than to innovation, penalizing innovative firms and slowing economic progress. In macroeconomics, stabilization policies work against progress by using monetary policy to interfere with price signals (mainly by manipulating interest rates) which are—as Austrian business cycle theory shows—destabilizing rather than stabilizing.
In macroeconomics, the goal is a full employment equilibrium with low inflation. But as in microeconomics, the idea of economic progress is largely absent. Even in more complex economic models, the focus is on income growth, and not on the entrepreneurial forces that generate economic progress. In the real world, however, prosperity is produced not by income growth, but by the introduction of new goods and services and new production processes. Income growth in itself cannot explain economic progress because there are limits to how much more food, or how many more horses, people will demand. Progress is able to occur when people are able to augment horse-drawn travel with automobiles, rail travel with aircraft, telegraphs with telephones, land lines with mobile phones, and wood-burning stoves with microwave ovens.
An entrepreneurial economy has a natural tendency to generate more entrepreneurship, partly because entrepreneurs provide examples to potential entrepreneurs, but mainly because entrepreneurial activity opens up new entrepreneurial opportunities. Obvious examples would be the opportunity to provide automotive services as a result of the innovation of the automobile, and the opportunity to provide digital content as a result of the microprocessor- led development of computing devices. Yet these developments which are central to economic progress are almost always omitted from the economic models economists use to describe the economy.
Much insight has come from the equilibrium models of the twentieth century, but too much economic research is devoted to understanding economic models which have little to do with real-world economic phenomena. The market-process approach of the Austrian School, on the other hand, offers a better method of analysis for understanding how the modern capitalist economy actually works.
My new book, Producing Prosperity, calls for a shift in the focus of economics. In the eighteenth century, the primary focus of economics was on how wealth is created, which is clearly shown in the title and the text of Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations. Since Smith’s day, the focus of economics drifted away from wealth creation toward other issues, and in the twentieth century, toward understanding the properties of economic equilibrium. Producing Prosperity argues that the focus of economic analysis should turn toward the big issue in eighteenth-century economics: Namely, producing prosperity.
To accurately represent real-world economic processes, economics should build on the work of Austrian School scholars who focus on factors such as entrepreneurship, wealth creation, and innovation which lead to an economy that is characterized by progress. This would make economic analysis much more consistent with the remarkable realworld progress and prosperity that characterizes the modern economy.
