Was Murray Rothbard a Good Economist?

Someone on Quora was wondering whether Murray Rothbard was a good economist. I obliged with an answer:

Yes. Murray Rothbard was a prolific thinker whose contributions to economics were numerous, original, and significant.

His magnum opus, Man, Economy, and State, was the first complete treatise on economics in a half century. The book was originally meant to be a textbook version of Mises’ Human Action, but Rothbard built on Mises’ work to create a more complete body of thought. He contributed his own theory of production and supply, while critiquing Mises’ theory of monopoly as a static conception that did not fit with his generally dynamic view of the economy. Rothbard argued persuasively for a return to the original definition of a monopoly as a government grant of exclusive privilege.

His work in economic history is excellent. His book, The Panic of 1819: Reactions and Policies is the definitive work on the titular panic. America’s Great Depression applied Mises’ theory of the business cycle to the Great Depression, showing how the Fed under Benjamin Strong pumped up an inflationary bubble in the 1920’s, which led to the 1929 crash. He also demonstrated that Herbert Hoover was not a laissez faire President but a big-state interventionist, in opposition to what was commonly (and wrongly) believed at the time.

An Austrian Perspective on the History of Economic Thought, Rothbard’s two-volume work on the history of thought, is by far the most exhaustive history of economic thought up to 1870 (he tragically died before he could write a third volume covering the developments after 1870). While most histories of economic thought focus on a few key figures, maybe Smith, Ricardo, John Stuart Mill, Marx, and Keynes, Rothbard covers everyone. If someone had a passing thought about economics before 1870, and it came down to us in print somehow, Rothbard probably discusses it. While most histories of economic thought will treat Adam Smith as the inventor of the discipline (maybe with a passing nod to the French Physiocrats), Rothbard spends over 500 pages discussing the economic thinkers who preceded Smith, beginning with Aristotle. It turns out that economics had a rich history before Smith, and some earlier thinkers (Turgot and Cantillon) even surpassed Smith in many respects. Even if you disagree with Rothbard on absolutely everything else, he deserves credit for being an outstanding historian of economic thought.

Against the Price Transparency Act

My latest article on Mises Canada takes on the Price Transparency Act, a piece of legislation that would allow the Competition Bureau to investigate alleged “price gouging” of Canadians. Here’s a bit of it:

The price transparency act aims to seek out firms that sell profitably in Canadian markets and shame them into charging lower prices for their outputs. I’ve seen complaints that, since the legislation doesn’t grant the Competition Bureau the power to set prices, the investigations will create costs for the government and for compliant firms without having any real impact on prices. Actually, that would be the best possible outcome. The legislation would be far more disastrous if it succeeded in its goal of putting downward pressure on prices. To do so would remove the incentive for entrepreneurs to efficiently employ their knowledge and insight in allocating resources. While bailouts famously socialize losses while privatizing gains, antitrust actions to reduce “gouging” effectively socialize gains while privatizing losses. We all know how privatized gains and socialized losses led investors to take excessive risks in the lead up to the financial crisis. If the antitrust authority steps in to force profitable firms to reduce prices, effectively socializing gains, then entrepreneurs will be excessively averse to risk taking. Entrepreneurs will not seek out opportunities for high profit if they anticipate that government officials will order them to reduce their prices if they succeed.

High profits are what motivate entrepreneurs to zealously pursue opportunities. Whether they achieve those profits or not, in pursuing them they bring their best knowledge and insight to bear on the problem of allocating scarce resources. High profits motivate entrepreneurs the same way a carrot can motivate a donkey. Mainstream economists are too worried about losing the occasional carrot to realize that taking away the carrot would seriously impair the donkey’s motivation to walk. Taking away the carrot would save a carrot, but it would forfeit something far more valuable. Similarly, while pushing down prices that far exceed marginal costs could reduce the deadweight loss in a particular time, place, and industry, doing so would hamper the entire entrepreneurial process.

Go read the whole thing.

Finance and the Austrian School with George Bragues

This episode of Economics Detective Radio features George Bragues, professor of business at the University of Guelph-Humber, discussing his work developing a distinctly Austrian theory of finance. While there have been forays into finance by Austrians such as Mark Skousen and Peter Boettke, Austrians have not yet fully developed a complete and distinctly Austrian theory of finance.

George names five pillars of modern finance theory: (1) The capital asset pricing model (CAPM), (2) the Black-Scholes option pricing model, (3) the efficient markets hypothesis (EMH), (4) behavioural finance, and (5) the Modigliani-Miller theorem.

CAPM is a model that derives the value of assets based on the risk-free rate and market risk, that is, risk that cannot be diversified away. The Austrian response to this model is that there is no such thing as a risk-free asset, as risk is inherent to human action. An Austrian alternative to CAPM would incorporate the Austrian theory of a natural interest rate derived from time preference.

Black-Scholes, a model for pricing options—opportunities to buy or sell at a given price at some point in the future—assumes that price movements are normally distributed. Nassim Taleb has been forceful in his critique of this assumption; in his book, The Black Swan, he argues that returns are subject to so-called Black Swan events. Statistically, this implies a fat lower tail in the distribution of returns. George holds that, given Austrians’ skepticism about mathematics, there is little hope for an Austrian option pricing model. However, pricing assets was never the role of theorists, but of entrepreneurs.

The efficient markets hypothesis, developed by Eugene Fama, holds that the market price reflects all available information. This view holds economic equilibrium to be a normal state of affairs. The Austrian view is that equilibrium is an abnormal state of affairs; the market is always tending towards equilibrium, but it rarely reaches equilibrium. Austrian theory holds that identifying misequilibriums and arbitraging them away is the role of entrepreneurs. Identifying such opportunities isn’t easy; it requires prudence, or what Mises called “understanding.” If you believe the EMH, then Warren Buffet is not an example of someone with great insight and prudence; rather, he is someone who has repeatedly won a stock-market lottery.

Behavioural finance, developed by Robert Schiller, is a theory that argues that, contra the EMH, market prices reflect psychological factors rather than the real underlying values of the assets being traded. Behavioural finance has identified so many biases that it is essentially irrefutable. For instance, the gambler’s fallacy and the clustering illusion, yield opposite predictions. If a stock price has risen repeatedly, the gambler’s fallacy would hold that it is “due” for a correction downwards, while the clustering illusion would hold that the trend must continue upwards. Behavioural economists could thus explain a movement in either direction according to their theory, making the theory untestable in principle. Austrian theory avoids such psychological theorizing. Austrians hold that you can derive sound theory from the axiom that humans act, that they use means to achieve ends. Austrians have no particular qualm with bringing psychological factors into the analysis of economic history, but they don’t see them as part of economic theory.

Modigliani-Miller is a theory of corporate finance that says that the way a firm is financed, with more debt or equity, is irrelevant to its value. M&M holds that the value of the firm is uniquely determined by its discounted stream of revenues. Austrians might contend, in contrast, that firms financed through debt are exposed to greater risk in the case that they make entrepreneurial errors.

George is working towards an “Austrian markets hypothesis,” which would hold that markets are constantly endeavoring to achieve equilibrium, but never actually succeeding. Austrians can bring a greater appreciation of understanding, prudence, practical experience, and local knowledge to finance theory. These ideas have been wrongly impugned by modern quantitative finance, which has elevated theoreticians above entrepreneurs.

Download this episode.

Is a Small Amount of Money More Valuable to a Low Income Person than to a High Income Person?

I answered this question over at Quora. Just about all the other answers were wrong, so I thought I’d set things straight.

No. Value is not a quantity. It cannot be compared across individuals, so we cannot say that $50 is more valuable to person A than to person B.

To understand value, you must understand action. To act is to select one thing and set aside another. Thus, an ability to evaluate one thing over another is a necessary prerequisite to action, one that all mentally functioning humans possess. Valuation is always a comparison between two alternatives. It is a comparison made in the mind of an acting human.

Because the high income person and the low income person are different individuals, their valuations cannot be compared. We could say something like, “the low income person values an hour of his time less than $50, while the high income person values an hour of his time more than $50.” But this does not mean the low income person values $50 more than the high income person does in any absolute sense, because an hour of time is not the same to different individuals.

Some people have said that the answer is yes because marginal utility decreases with quantity. This is a misinterpretation. It is true that people tend to value additional units of a stock of interchangeable consumer goods less with each additional unit. This is because a person will use the first unit of the good to satisfy his highest unmet need, the second unit to satisfy his second highest unmet need, the third unit to satisfy his third highest unmet need, and so on. Thus, marginal utility does decrease with quantity. But it only meaningfully decreases with respect to other goods! If I have five dumplings, I might value an additional dumpling more than a battery, but if I have six or more dumplings I might value the battery more than an additional dumpling.

While I value things less with each additional unit, we can’t take this to mean my valuation of my total wealth must decrease as I grow wealthier. Total wealth comprises everything, leaving nothing to compare it against, so valuation is meaningless.

Teaching Economics: Age of Empires and Central Planning

When I was young, I played a lot of Age of Empires. For those who are unfamiliar with the series, they are games where the player must direct a tiny civilization’s development. He begins with one building and only a few villagers. By right clicking on a villager, then left clicking on a tree, stone mine, gold mine, or animal, the player can direct the villager to gather wood, stone, gold, or meat. He can also direct villagers to make buildings. And with buildings, he can recruit more villagers or soldiers.

By directing every action of every person in his civilization, the player can eventually turn his tiny village into a sprawling city, clashing militarily with other players’ civilizations.

I think a game economy like that one could be a good teaching tool for young people. In the early stages of the game, centrally managing a few villagers works well. But as the civilization grows, the player’s attention becomes more stretched. It is common, in the game economy, for the player to discover a group of villagers clustered around a (now exhausted) mine or forest. The growing economy becomes ever more difficult to manage, and it becomes more difficult to coordinate the growing numbers of workers and soldiers.

In the game, the complexity cannot grow without limit. The computing limits of the day meant the game had to cap the population at about one hundred tiny people. Furthermore, the production processes allowed anything to be created from wood, food, gold, stone, and villager labour. In a real economy, these would expand into ever more complex and roundabout processes as the economy continued to grow.

Nonetheless, a game like Age of Empires is a good demonstration of how the difficulties of central planning compound as an economy grows in size and complexity. What remains is an explanation of the alternative: an economy where each of those villagers decides for himself whether he will chop wood, mine stone, mine gold, or hunt deer. Sadly, I don’t know of too many games that show how private property and prices can coordinate the actions of disparate individuals. There are plenty of business simulators, but these only show the activities of a single businessman, the player, and sometimes his competitors.

But maybe games aren’t the right place to look for examples of spontaneous order. The place to look for spontaneous order is the real world. Ask young people who have played Age of Empires (or similar games) what the difference is between the game economy and the real economy. They told each person in the game economy whether to be builders or miners or hunters; who in real life directs each person into an occupation? Nobody, at least under capitalism, performs this role. Each person decides for himself what job to apply for given the wage he thinks he can earn. Point to one of those clusters of workers around a long-since-exhausted resource. Ask the young people what the owner of that resource would pay to have people work there, even after it has been exhausted. Clearly he wouldn’t pay anything, so those workers would look for other jobs. Thus, if those workers had the free will to decide what to do for themselves, they would not be wasted waiting for the central planner (i.e. the player) to tell them what to do.

In my education, I was never told about the way people coordinate through prices until I saw someone draw supply and demand curves in an undergraduate classroom. But ultimately, these concepts are not too difficult for people to grasp at young ages. You don’t have to get into difficult, technical debates to show that prices reflect scarcity and people respond to prices, so people respond to scarcity through prices. Age of Empires demonstrates a world without prices, so it might be a good place to start.

Jane Jacobs as Spontaneous Order Theorist with Pierre Desrochers

On the Political Economy of Native Tribes

My latest Mises Canada post is all about Native tribes:

Ludwig von Mises wrote that, “[d]emocratic control is budgetary control. The government has but one source of revenue—taxes. … But if the government has other sources of income it can free itself from this control.”[1] This principle is particularly important for understanding the internal politics of Canadian Native tribes, whose governments are the recipients of large transfers from the Canadian federal government.

A recent scandal involving the Squamish Nation, a Vancouver-area tribe with a population of about 4,000, is a case in point. Two political officials of the band spent $1.5 million from an emergency fund for their personal ends. According to the investigation that eventually exposed them, “it was clear they handed out funds to develop political support from members.” [2] The scandal derives from the fact that funds earmarked for one purpose, emergencies, were used for a different purpose. But the interesting economic story would nonetheless hold if the funds had been used only for their intended purposes.

According to its most recent financial statements,[3] the Squamish Nation earned $11.3 million from Aboriginal Affairs and Northern Development Canada, i.e. the Canadian Federal Government, and only $8.4 million from taxation in 2014. As Mises suggests in the quote above, a government with alternative sources of income besides taxation can use this income to free itself from democratic control. Robbing Peter to pay Paul is a favourite activity of all governments, but when the robbery occurs through taxation, it is at least limited by Paul’s awareness that he is being robbed.

Go read the rest at Mises Canada.

Economics is a Philosophy of Tolerance

My latest Mises Canada article deals with the economist’s response to snobbery:

The world is full of snobs. There are music snobs who complain that most people prefer Lady Gaga to Stravinsky, film snobs who complain that most people prefer action movies to art films, and food snobs who complain that most people prefer pizza to fine sashimi. Whatever one’s area of interest, it is tempting to pass judgement on others’ preferences.

In learning economics, and in absorbing its lessons, one learns to be less of a snob. Economic analysis always begins by taking people’s preferences as given. The economist sees someone choosing pizza over sashimi and sees only a person acting towards the highest attainment of his ends. The economist trains himself to leave his personal biases and any inclination towards snobbery behind so that he can keep his analysis value free.

Even common terms like “responsible” and “irresponsible” are value-laden. Activities we recognize as responsible, such as saving for retirement, avoiding risks to life and limb, and living a healthy lifestyle are consistent with a specific set of preferences. Someone who values future experience highly against present experience (i.e. someone with a low rate of time preference) will favour all of these behaviours. Activities we recognize as irresponsible, such as profligate spending, risk-taking, and indulging in junk food, alcohol, or illicit drugs are consistent with a different set of preferences. Valuing present experience highly over future experience (i.e. having a high rate of time preference) makes all these activities more appealing. Economics permits us to understand these different preferences but it never permits us to judge one set of preferences to be superior to another.

Read the whole article at Mises Canada.

TruthCoin, Prediction Markets, and Anarchy with Zack Hess

About Those Monotonic Transformations…

Well, this is awkward. You told us that utility was strictly ordinal, that utility functions were unique up to a monotonic transformation. But whenever there’s a problem that requires them to be cardinal in some sense, you just revert right back to cardinality, don’t you? Remember how interpersonal comparisons of utility were supposed to be impossible? You made them anyways. You were never committed to the idea of ordinal utility. You just told us that to make us think we were safe. You lied to us.

In my newest post on Mises Canada, I critique expected utility theory on the grounds that it depends on cardinal utilities. Go read it and report back.

Garrett M. Petersen's blog about markets, institutions, and ideas.