Noahgreement on similarities between Austrians and New Classicals

by Ash Navabi

Originally posted on February 7, 2014

I’ve got a confession to make: my favourite economics blog name is Noah Smith’s “Noahpinion”. It’s a really great blog name.

With the niceties out of the way, let’s address Smith’s latest screed: “How the New Classicals drank the Austrians’ milkshake”. In it, Smith tries to make the case that the reason that the Austrian school is “dead” as a serious scholarship program isn’t because the Austrians have too many different ideas from the “New Classical” mainstream, but rather because all the best Austrian ideas have been incorporated into the New Classical tradition.

Smith does this using cutting edge blogging techniques: a list. First he lists three similarities between central Austrian and New Classical claims, and then lists two “big differences”. Let’s see what Smith gets right, and wrong, in his comparative analysis of Austrian and New Classical economics.

Smith Claim #1: “Rational Expectations” is a refinement of the Action Axiom

Smith starts out his characterization of the Austrian school by quoting Mises from Human Action, which is good. He goes on to describe Mises’ writing as “pre-WW2 European literary style”, which is somewhat funny, given that Human Action was written after the Second World War, and in the United States. But I get what he’s saying.

Let’s reproduce the Mises quote here:

Human action is purposeful behavior. Or we may say: Action is will put into operation and transformed into an agency, is aiming at ends and goals, is the ego’s meaningful response to stimuli and to the conditions of its environment, is a person’s conscious adjustment to the state of the universe that determines his life.

Now Smith contends that Mises’ observation that a person is aiming at ends and goals is “similar to modern economists’ notions of individual rationality”, and that the fact that a person uses “conscious adjustment” is just a fuzzier version of Rational Expectations theory. But this doesn’t hold up.

In Rational Expectations, a key assumption is that economic agents make the best use of the information they have, and so are never making the same mistake all the time. However, this clearly doesn’t jibe with Mises’ understanding of human actors (or more broadly, the human condition):

Economics does not deal with an imaginary homo oeconomicus as ineradicable fables reproach it with doing, but with homo agens as he really is, often weak, stupid, inconsiderate, and badly instructed.

Mises would thus never agree with modern theorists who think that humans are “rational” in the sense that they’re clever enough to logically consider and think through the mathematics and ramifications of every piece of information they have. No, to Mises, humans are not only capable of committing systemic errors, but indeed commit them often.

This, however, does not make them any less rational–because to Austrians, rationality merely means the cognitive ability to use means to attain ends. That people repeat the same thing over and over while expecting a different result is a sign of their sanity, not rationality.

Smith Claim #2: Praxeology is comparable to “Theory Ahead of Measurement”

Smith tries to show that when economist Robert Lucas made his famous critique of econometrics (his basic point was that when large scale statistical models are used to examine the effects of governmental policies, the aggregate variables are often made up of people and firms who will react to the same thing differently, making the aggregation meaningless), his call for stronger ties to “microfoundations“, plus Ed Prescott’s calls to have a theory before doing empirical research, the mainstream accepted the core tenet of praxeology–namely that history can’t prove or disprove theory.

As an aside, Smith seems to think that praxeology is a method of studying economics. This is not the case. Mises actually thought that economics was a branch of a larger science known as praxeology–the science (-ology) of human action (praxis), and that the method of praxeology is logical deductions. Economics, being a substratum of praxeology, therefore also must use logical deduction as its method. Empirical observations belong to the separate science of history, which has its own unique methods.

Back to the main point, Smith also is wrongheaded in his allegation that “Austrians who follow Mises tend to pooh-pooh empirical studies and assert the primacy of pure logic in predicting human behavior.” Austrians do no such thing. Austrians emphatically do not “assert the primacy of pure logic in predicting human behavior”, because Austrians reject predicting human behaviour altogether. For Austrians, the purpose of economics isn’t to predict, but to understand human action. This is a vital difference.

Back to Smith’s point on the similarities between his incomplete interpretation of praxeology with standard New Classical economics. While Smith admits that New Classical theory does not go as far as (his incorrect interpretation of) praxeology, they are still very similar, in that they both give high weighting to a priori theory over data.

But the problem here is that while the New Classicals may have reached vaguely similar conclusions about the primacy of theory over data, they came about them in a completely different way. Lucas says we must base econometrics models on other models that assume “full human rationality” and other nonsense, while the reason that Prescott calls for using theory ahead of measurement is because his business cycle theory happened to have very good predictions.

Again, the point of economics is understanding, not predicting, real world phenomena. And to do that, we have to start from solid foundations. When your foundations are ad hoc, any similarities with the real world are coincidental and fleeting.

Smith claim #3: New Classicals also are suspicious of government intervention

This is similar to the last point. The fact that Austrians and New Classicals, despite starting from different positions and using completely different methods of analysis, have come to share a few similar conclusions is purely coincidental. It means literally nothing. It analogous to comparing the answers of multiplying 4 by 2, and counting the heads of state at a G8 meeting. Yes, the answer to both is the same; but so what?

Smith claim #4: Austrians and New Classicals differ on the role of mathematical modeling

Smith is now onto the big differences between Austrians and New Classicals. And he’s off to a good start. Can’t find too much fault with this.

There are many problems with mathematical economics, but to Austrians, the biggest case against mathematical models is that they necessarily must assume that there are constants in human action. Austrians vehemently reject this notion from a theoretical standpoint. Individuals can and do completely change their behaviour on a whim, to say nothing of quantifying different behavioural traits and assigning strict relations to them. Austrians think it’s possible to develop a theory of economics without assuming people prefer and behave hyper consistently all the time.

Smith claim #5: Austrians think malinvestment causes the business cycle

Smith tries to differentiate Austrian and New Classicals by pointing out that they have different business cycle theories, which is true (but again, is entirely coincidental, because Austrians and New Classicals have completely different foundations and use completely different methods to develop their theories, and so any convergence or divergence is purely accidental). But Smith misunderstands Austrian business cycle theory (more evidence of Roddis’s Law?).

Smith says that to Austrians, “the business cycle is caused by malinvestment, which in turn attributed to excessively easy monetary policy.” This is imprecise. Admittedly this is a subtle point, but the business cycle is not caused by malinvestment.

The business cycle–that is, the recurring booms and busts in modern economies–is characterized by malinvestment (investment in the “wrong” goods, meaning investments that end up losing money because consumers don’t want them) and, Smith failed to add, overconsumption, known as the boom, which in turn leads to a credit crunch and economic crash. In other words, the business cycle is the boom and the bust. The boom does not cause the bust, but the bust is necessary after the boom. (Think of it this way: throwing something in the air does not cause it to fall down.) The boom-bust cycle starts from the large-scale expansion of fiduciary media–which in modern parlance is “excessively easy monetary policy”.

Smith goes to say that New Classicals “also feared overly easy monetary policy, but because they thought it would lead to inflation, not malinvestment. (Of course, Austrians feared inflation as well.)” But to Austrians, “overly easy monetary policy”, if that is to mean an increase in the money supply, is by definition inflation. And in fact, it is this inflation that results in malinvestment. Perhaps the key insight of the Austrian business cycle theory is its connection between inflation and economy-wide fluctuations.

Smith concludes: New Classicals drank the Austrians’ milkshake

Smith says that the New Classicals “captured and improved on the basic ideas of the Austrians in almost all of the ways that matter”. Smith asserts that the New Classical treatment of “rationality, distrust of empiricism, and distrust of government intervention are more moderate and nuanced than those of the Austrians”. Let’s re-examine these claims:

Austrians say: humans use means to attain ends, and make a ton of mistakes in the meantime and are often too dumb to realize it.
New Classicals say: humans know all the information they can be expected to know about things, and are as good at calculus and statistical analysis as any economist with a PhD.

Distrust of empiricism
Austrians say: you cannot derive theory from history (empiricism). The point of theory is to understand the real world.
New Classicals say: our theories already match pretty well with the data, so don’t bother doing more empirical tests on them. The point of theory is to predict the future.

Distrust of government
Austrians say: the government is made up of people just as dumb and clueless about the workings of the real world as the rest of us. They don’t have access to any secret information to make better economic decisions, and if you count bureaucracy and the fact that they do their business using the threat of violence, they very well might be a net negative on the economy.
New Classicals say: if you assume people know all the information they can be expected to know about things, and are as good at calculus and statistical analysis as any economist with a PhD, then maybe sometimes a government intervention isn’t always the best idea. Maybe. Sometimes.

Which of each of the above claims seems more “moderate and nuanced”?

Actually, only you, gentle reader, can answer that question.