Saturday, May 31, 2014

The Subjective Theory of Value

By Thomas Taylor

Satisfaction and Valuation

The explanation of all economic activity that takes place in the market economy ultimately rests on the subjective theory of value. The value of various consumer goods and services does not reside objectively and intrinsically in the things themselves, apart from the individual who is making an evaluation. His valuation is a subjective matter that even he cannot reduce to objective terms or measurement. Valuation consists in preferring a particular increment of a thing over increments of alternative things available; the outcome of valuation is the ranking of definite quantities of various goods and services with which the individual is concerned for purposes of decision and action. Theory resorts to the hypothetical concept of the scale of values in seeking to explain and understand the nature of human valuations. The ranking of alternative ends is determined by the person's expectations of satisfaction from each specific choice faced by him at any moment of decision. He will invariably select the alternative that he believes will yield him the greatest satisfaction.
The subjectiveness of valuation rests in the nature of satisfaction--satisfaction is subjective and not open to numerical measurement. The extent to which a thing gives satisfaction is always personal. People derive satisfaction from different goods and services; that is, all people are not alike in terms of the types of things that please them. Experience also demonstrates that a person's preferences vary from time to time. His ranking of alternative choices may undergo a reshuffling at any given moment. His scale of values may also be altered by deletions or additions.
To relate the matter of valuation to the individual person is not to suggest that each individual is concerned only with the satisfaction of his own appetites and needs. A person may find satisfaction or relief in helping another person. Satisfaction can be and often is derived from the attainment of altruistic as well as "selfish" motives. But the point remains that regardless of the form the satisfaction is to take, each choice arises from subjective valuation on the part of the particular person who is doing the choosing. The uneasiness that he seeks to remove is in his own mind, whether such uneasiness pertains to an immediate problem of his own or to a problem faced by someone else. His choice stems from the preference that he has for the removal of a particular uneasiness over another problem to which he could devote his attention.

The Principle of Marginal Utility

Valuation is always directed toward a definite quantity of a particular good or service. Choices and decisions are not concerned with the whole supply of a certain good or service. This marginal orientation was lacking in the classical economists' groping with the so-called paradox of value. They were unable to resolve the intriguing question of why diamonds had a higher price per unit than water when everyone knew that water was more useful and valuable than diamonds. Only through the principle of diminishing marginal utility could this conceptual dilemma be eliminated. Each additional unit of a particular good is devoted to a use that is less important and urgent than the use to which the preceding unit was applied.
To establish this principle one does not have to resort, as is sometimes done, to explanations of psychological or physiological satiety. The principle that a person will always apply a given unit of a good or service to the most pressing desire or need to which it relates is inherent in the concept of purposive action. Since each person prefers more satisfaction to less satisfaction, each succeeding unit obtained will be devoted to less and less important aims, given his scale of values at that time.
From the principle of diminishing marginal utility is derived an important law relating to the value of a unit of any good possessed in any particular quantity. The value of a unit of a given quantity of a particular good is determined by its usefulness in its least important use. To put the rule another way, the value of any unit of several units held of a given good is equal to the satisfaction that would be sacrificed if one unit were lost. Bohm-Bawerk illustrated the law by imagining a pioneer farmer who has reaped five sacks of grain from his harvest. [1] In planning carefully the use of this food supply, he first recognizes the essential need for a minimum amount of food to keep him alive until the following harvest. To this purpose he allots one sack of grain. A second sack will contribute to his enjoying full strength and complete health. A third sack will enable him to add some variety to his diet by using it for raising poultry. He decides to assign a fourth sack to the distillation of brandy; and finally, a fifth sack is to be devoted to the feeding of a group of parrots "whose antics give him pleasure."
The example depicts the operation of the principle of diminishing marginal utility. The farmer's plans for the sacks of grain proceed from the more important to the less important uses. The value of each sack of grain equals the satisfaction that the farmer expects to derive from being able to feed and enjoy his parrot friends. This is the satisfaction that he would surrender if he suffered the misfortune of losing one sack of grain. Since his sacks of grain are a homogeneous commodity, he does not have to go without any of the four more important uses because of his loss. He will simply select the least important use in determining which part of his original plan cannot be effected. The value of a unit is determined by its marginal utility or satisfaction.
The principle of diminishing marginal utility and its complementary law of value resolve the paradox of value as exemplified by the discrepancy between the price of diamonds and the price of water. The element of scarcity in controlling the extent to which a particular commodity can be used holds the key. The relative abundance of water as compared with the availability of diamonds means that increments of water can be devoted to less and less important uses than those to which the limited amount of diamonds can be put. No one is ever in the predicament of having to choose between all water and all diamonds; thus there is no meaningful paradox. Prices arise in connection with definite amounts of goods and not in connection with whole categories of various goods.
If the amount of a good with which one is concerned is enlarged to encompass several of the smaller "units," the value theory is no less applicable. In this case, the larger amount becomes the marginal unit, and its valuation equals the sum of the various satisfactions that the larger amount would yield if broken down into incremental usages. For example, if our farmer is faced with giving up in one stroke three sacks of grain, his valuation of this package is not equal to three times the valuation or satisfaction attached to the maintenance of his parrots. He is not in the situation of valuing just one sack of grain. He will sacrifice the three least important uses of his sacks of grain, thereby devoting his remaining two sacks to meeting his essential food needs. The value of a "unit" of three sacks of grain equals the total satisfaction expected to be obtained from raising poultry, distilling brandy, and feeding parrots. This is the marginal satisfaction pertaining to the marginal unit of three sacks.
The size of the unit used is not important for the operation of value theory. It can be seen that if one were in the impossible position of having to rank all water and all diamonds, one would rate the former first and the latter second, disproving the existence of any paradox of value. It also follows that if the supply of a particular good is so large that some units go unused, the marginal utility of the good is zero; in such case, no value would be attached to any particular unit. The good would not belong to the realm of economics and could be expediently termed a "free" good. This is the case with the ordinary air that we breathe (although problems with air pollution have created certain situations that involve costly, not free, clean air).

Value and Exchange

In a modern economy the purpose of production is to yield goods and services to be used by people other than the producers themselves. This is the essence of specialization and division of labor. In a developed society, production for exchange overshadows production for immediate use. As a result, units of goods and services take on exchange value in addition to the use value that they may have for the producer. And with the overwhelming emphasis on production for exchange, the exchange value of produced goods looms as the value that is of real significance and relevance for most producers, while the use value of goods is the meaningful value for consumers.
It may appear that the concept of exchange value introduces a departure from the subjective theory of value, yet this is not the case. A unit of a given good derives its exchange value from the subjective value that is identified with the amount of some other good that can be obtained in exchange for it. This is true whether the good is to be exchanged directly for some other consumable good or for a certain amount of money. People wish to obtain other goods, including money, because they place a subjective valuation on such acquisitions. The value of a good as a means of exchange is based on the greatest satisfaction that the owner expects can be derived by giving up the good in exchange for some other good. The subjective value of the most desirable good or service that can be obtained in exchange is the basis of the value imputed to the possessed good.
Thus any particular good takes on both a use value and an exchange value. Each of these values reflects the satisfaction that can be expected to come by way of employing the good; the good can be employed either for direct use or as a means of obtaining some other good through outright exchange with another person. The controlling valuation for decision and action is always the greater of the two alternative satisfactions. If the good's use value exceeds its exchange value, the good will be put to direct use or held for eventual direct use, and its exchange value will be forgone. On the other hand, if its exchange value exceeds its use value, the good will be utilized for exchange purposes or held for possible exchange at some time in the future.
It should be understood that exchange value here refers to the subjective valuation placed by the owner on the good as a means of exchange. The expression "exchange value" is used frequently in the sense of the money price that can be obtained for a given good through its sale. In the context of the subjectivity of value, however, this objective money value would be evaluated subjectively in the same way that a noncash good obtainable through exchange would be evaluated.

Uses of Money

In most modern economies, money is primarily fiat money, and its use value in the sense of being employed for consumption purposes is virtually zero. However, where specie is used, money can have a considerable use value. For example, gold and silver can be melted down for jewelry, decoration, and dental applications. Incidents of converting money into other useful products are not common in modern economies; money is valued almost invariably for its exchangeability. Its great service is that is obviates the requirement for a coincidence of product wants among the parties to an exchange, as is required in cases of direct barter. [2]
There are three ways that a specific quantity of money can be put to immediate use. It can be used for the expenditure necessary to acquire another good or service to be used for consumption purposes. It can be spent for another good or service that is to be used in the productive process of effecting or fabricating a new good. In such case, an investment expenditure is made that is designed to yield future consumption or investment benefits through subsequent disposal or consumption of the produced good. Even wholesalers and retailers who bring about no change to the physical good itself effect a new good by placing it at a more accessible and convenient location. They are thereby engaged in the productive process, and the money spent to acquire the goods stocked is expended for production as opposed to consumption purposes.
The third use is to add the money to one's cash balance to help pay for future exchange transactions. The fact that a person holds a certain amount of money at a given moment indicates that he values the money more than those things that he could obtain in exchange for it. Yet holding an amount of money at a given moment does not alter the fact that money is valued for its exchangeability. It merely shows that being prepared for later exchanges is valued more highly than making exchanges now. The satisfaction arising from an increased cash supply is often manifested in a feeling of greater security. This valuation springs from the belief that in the future one will be better able to meet his needs by spending his accumulated cash balance. That a money asset yields a service or satisfaction and thus is not sterile and unproductive--as has been widely held in the study of economics since the days of Aristotle--has been elucidated by Professor W.H. Hutt. [3]
The principle of diminishing marginal utility is no less applicable to money than to other commodities. Units of money are utilized in such a way that the most urgent goals or needs are met first. Because of the particularly easy divisibility of money, such allocations are made in more incremental steps than is the case with any other commodity. The marginal utility of money, then, equals the least highly valued use that the given unit serves. Just as in the case of the farmer's five sacks of grain, the satisfaction derived from a unit of money is the satisfaction that would be sacrificed if a unit were lost. The incidence of the loss will always be on the least important use that a unit was intended to serve. Yet this sacrifice is the most important use to which the marginal unit could be put. A person will thus allocate his money among consumption expenditures, production expenditures, and increases in his cash balance in terms of his scale of values or preferences.

Use and Exchange Value in the Market Economy

An important characteristic of the use of commodities, including money, in the productive process under a system of social cooperation is that the user is not concerned only with his own satisfactions or preferences. Since he is engaged in the generation of goods and services that are to be used by other people, the exchange value of the commodities depends on the relative preferences of the other people after the completion of the production process. The number of dollars that the producer anticipates will be the result of his productive efforts hinges ultimately on his perception of the values of other persons.
In a world of certainty, there would be no difficulty in arriving at a money appraisal for the group of employed goods and services. In the modern market economy, however, only in the few cases of guaranteed and contracted sales is the money outcome of certain productive efforts relatively certain. And even in those few cases the invested resources are usually of a scope exceeding what would be required to meet the contracted sales, indicating that the producer is banking on the occurrence of sales not yet contracted. The whole task of having to produce to suit the wants of other persons in the face of an uncertain future is the essence of entrepreneurship.
It can be seen that in the market economy, characterized by the production of goods and services for subsequent exchange by a common medium of exchange, both use and exchange values are a vital part of the economic process. For the ultimate users of goods and services, the consumers, the satisfaction arising from consumption is the source of value or utility. For producers, the goods and services devoted to production are meaningful only in terms of the money and its exchange value, which they expect to generate from the sale of their product. But the crucial point to remember in distinguishing between these two values is that the exchange value of any productive good tends to be connected with the use value that the consumers attach to its end product. The amount of money that consumers can be expected to allocate to various consumer goods and services is strongly influenced by their subjective preferences. It is this anticipated money inflow that provides the basis for arriving at an exchange value for goods and services devoted to production. An explanation of how the prices of productive resources tend to be derived from the prices of consumer goods will be offered in a later section.

The Pervasiveness of Subjective Valuation

Subjective valuation underlies all economic activity. Money is not a measure of value; quite the contrary, money is imputed a subjective value as a means of possessing other things. Any subjective valuation is immeasurable and is manifested only through specific choices and actions. Any particular choice is indicative of the decision maker's preference over all alternative courses of action considered during the time of decision. That this preference can be inferred from his actions does not mean that anything more than a preference is implied. As Rothbard has stated, "We deduce the existence of a specific value scale on the basis of the real act; we have no knowledge of that part of a value scale that is not revealed in real action." [4]
There is no way to measure quantitatively the satisfaction that the actor associates with his choice. Every choice requires rejection of the expected satisfaction from other possible choices; the highest ranked alternative forgone is the cost of any given decision. Benefits and costs are ultimately subjective. Every decision is predicated on the assumption that its benefits will exceed the advantages of the next best course of action; this is the background of every exchange. There is no such thing as an equal exchange. At the point of exchange, both buyer and seller consider themselves to be better off as a result of the exchange. In a system of extensive specialization and division of labor, most goods are produced for exchange. Specialized producers have little, if any, direct use for the goods they have produced; under the principle of diminishing marginal utility, the marginal utility of a unit of production is virtually zero as far as they are concerned. They place a higher valuation on the money that they can get for their goods. On the other hand, consumers or buyers value the goods obtained more highly than the money spent to acquire them. Exchanges can occur only when there are differences between the subjective valuations expressed by the parties of the exchanges.
The failure to consider this subjective orientation led to the unfortunate notion of the "economic man," which depicted every participant in the market economy as relentlessly seeking at every turn to maximize his monetary position. This idea is unrealistic because what people actually seek in every action is a maximum psychic or subjective profit.
There are numerous examples of people forgoing additional monetary wealth because they deem the "cost" to be greater than its worth. There are investors who resist monetarily rewarding investments in industries whose products they find objectionable. Marketers have recognized that consumers sometimes consider factors besides the purchasable good and its related price. The availability of parking, the courtesy of clerks, and "store personality" now receive attention in discussions of merchandising. Wealthy entrepreneurs who continue to involve themselves in profit making even in their old age are undoubtedly motivated in many cases by something besides money. People often consider factors in addition to wages in deciding on a career or particular job.
The point of these examples is to demonstrate that people are not "economic men" in the classical sense and that money is not the ultimate basis of valuation. Even when dealing with money matters, people do not calculate monetarily in utmost detail every step and decision. They maximize subjectively but not monetarily, because monetary calculation must be sacrificed when its requirements on time and energy are recognized. Bohm-Bawerk dealt with this point:
If anyone insisted on deliberating with maximum scrupulousness every one of the economic acts he undertakes every day, if he insisted on rendering a judgment of value throughout to the last detail concerning the most trifling good that he has to deal with by way of receipt or expenditure , by utilization or consumption, such a person would be too much occupied with reckoning and deliberating to call his life his own. The correct maxim and the one which would be observed in economic life is "Be no more accurate than it pays to be." In really important things, be really exact; in moderately important things be moderately exact; in the myriad trifles of everyday economic life, just make the roughest sort of valuation. [5]
It can be stated, however, that, other things being equal, people do strive to maximize their monetary position in choosing among alternative courses of action. A person will choose the alternative that promises to maximize his monetary position as long as he is indifferent to the nonmonetary factors pertaining to the alternatives. In a money economy it is through the common medium of exchange that people are able to acquire most of those goods that yield them satisfaction. By maximizing their monetary position, they are able to command more goods and services from the market than they could with less money. This should not be misconstrued as meaning that all individuals ultimately seek maximum monetary wealth. The fervent pleas of participants in fund-raising endeavors whose stated objectives are to help the crippled surely are not symptoms of greed. Money is the means by which many desired ends can be achieved.
A person will accept a less than maximum monetary position only when the satisfaction obtained from nonmonetary factors relating to another choice more than offsets the satisfaction associated with the money. The role of nonmonetary factors is likely to be greater with regard to the decisions of employment than with regard to those decisions relating to investment and consumption expenditures. Investors generally desire to maximize the financial return on their investment; consumers generally desire to acquire goods at the lowest possible prices.
Thus, despite the subjectivity of benefits and costs, the terms money revenues and money costs are meaningful references to the monetary inflows and outflows that arise in connection with productive activities. Regardless of the nonmonetary factors that are important to a given producer, his monetary position or outcome is also important to him insofar as he desires to continue to purchase certain goods and services. This means he must give more than cursory attention to money costs and money revenues.
However, it must be stressed once more that these money calculations are not in any way measurements of value in the subjective sense. Rothbard has stressed the need to use the term value with care: "It is important to keep distinct the subjective use of the term in the sense of valuation and preference, as against the 'objective' use in the sense of purchasing power or price on the market." [6]

Suggested Readings

Kirzner, Israel M. Market Theory and the Price System, pp. 45-62.
Menger, Carl. Principles of Economics (1871). Trans. Dingwall and B. Hoselitz. Glencoe, Ill.: Free Press, 1950, pp. 114-174.
Mises, Ludwig von. Human Action: A Treatise on Economics, pp. 92-98, 119-142.
[1] Eugen von Bohm-Bawerk, Capital and Interest, vol. 2, book 3 (South Holland: Libertarian Press, 1959), pp. 143-145.
2] In a later section the explanation of modern day inflation as the result of governmental debasement of money through credit expansion will be presented.
[3] See his essay, "The Yield from Money Held," in On Freedom and Free Enterprise, ed. Mary Sennholz (Princeton: Van Nostrand Co., Inc., 1956), pp. 196-216.
[4] Murray N. Rothbard, Man, Economy, and State (Princeton: Van Nostrand Co., Inc.), I, 224.
[5] Bohm-Bawerk, Capital and Interest, p. 202.
[6] Rothbard, Man, Economy and State, p. 271. Mises has chosen to make the distinction by using the term valuation with the subjective meaning and the term appraisement in the "objective," monetary sense. Cf. Human Action, pp. 331-33. The terms value and valuation have been employed in the subjective sense throughout this section.

The above originally appeared at

Wednesday, May 21, 2014

Marginal Revenue Product

Definition of 'Marginal Revenue Product - MRP'

The change in revenue that results from the addition of one extra unit when all other factors are kept equal. The marginal revenue product is used in marginal analysis to examine the effect of variable inputs, such as labor, and follows the law of diminishing marginal returns. As the number of units of a variable input increase, the revenue generated by each addition unit decreases at a certain point. It is calculated by taking the marginal product of labor and multiplying it by the marginal revenue of a firm.

The marginal revenue product is different than the marginal product in that it is not a measure of quantity but a measure of revenue. The MRP is often used to calculate the affect of adding employees, as companies want to add employees up to the point at which additional labor won't bring in enough revenue to cover costs.

(via Investopedia)

Janet L. Yellen At New York University's 2014 Commencement, New York, New York

Chair Janet L. Yellen
At New York University's 2014 Commencement, New York, New York
May 21, 2014
Commencement Remarks

Watch Live Leaving the Board

Thank you, President Sexton. On behalf of the honorees, let me express my thanks to NYU. And congratulations from all of us to you, the Class of 2014, and to your families, especially your parents. This is a special day to celebrate your achievements and to look forward to your lives ahead.

Your NYU education has not only provided you with a foundation of knowledge; it has also, I hope, instilled in you a love of knowledge and an enduring curiosity. Life will continue to be a journey of discovery if you tend the fires of curiosity that burn brightly in all of us.

Such curiosity led Eric Kandel, here at NYU, to his lifetime goal, to discover the chemical and cellular basis of human memory. A few years after his graduation, he was doing research on cats. But he had the idea of focusing on an animal with a simpler, more fundamental brain: the California sea slug. His colleagues all but ridiculed him for the idea. They "knew" that the study of the lowly sea slug was irrelevant for understanding human memory. Kandel's surgically-skilled collaborator deserted him. To get up to speed on sea slugs, he had to go abroad to study. But Kandel persisted and, in 2000, his curiosity won him the Nobel Prize. It was, as you must have guessed, for deciphering the chemistry of memory in humans, as revealed by his research on sea slugs. Kandel's life, I believe, demonstrates how a persistent curiosity can help us reach ambitious goals, even with great roadblocks in the way.

A second tool for lifelong intellectual growth is a willingness to listen carefully to others. These days, technology allows us access to a great breadth of perspectives, but it also allows us to limit what voices we hear to the narrow range we find most agreeable. Listening to others, especially those with whom we disagree, tests our own ideas and beliefs. It forces us to recognize, with humility, that we don't have a monopoly on the truth.

Yankee Stadium is a natural venue for another lesson: You won't succeed all the time. Even Ruth, Gehrig and DiMaggio failed most of time when they stepped to the plate. Finding the right path in life, more often than not, involves some missteps. My Federal Reserve colleagues and I experienced this as we struggled to address a financial and economic crisis that threatened the global economy. We brainstormed and designed a host of programs to unclog the plumbing of the financial system and to keep credit flowing. Not everything worked but we kept at it, and we remained focused on the task at hand. I learned the lesson during this period that one's response to the inevitable setbacks matters as much as the balance of victories and defeats.

There is an unfortunate myth that success is mainly determined by something called "ability." But research indicates that our best measures of these qualities are unreliable predictors of performance in academics or employment. Psychologist Angela Lee Duckworth says that what really matters is a quality she calls "grit"--an abiding commitment to work hard toward long-range goals and to persevere through the setbacks that come along the way.

One aspect of grit that I think is particularly important is the willingness to take a stand when circumstances demand it. Such circumstances may not be all that frequent, but in every life, there will be crucial moments when having the courage to stand up for what you believe will be immensely important.

My predecessor at the Fed, Chairman Ben Bernanke, demonstrated such courage, especially in his response to the threat of the financial crisis. To stabilize the financial system and restore economic growth, he took courageous actions that were unprecedented in ambition and scope. He faced relentless criticism, personal threats, and the certainty that history would judge him harshly if he was wrong. But he stood up for what he believed was right and necessary. Ben Bernanke's intelligence and knowledge served him well as Chairman. But his grit and willingness to take a stand were just as important. I hope you never are confronted by challenges this great, but you too will face moments in life when standing up for what you believe can make all the difference.

Having dwelt for a moment on failure and grit, let me turn to the deeper meaning that underpins grit and can carry us beyond failure. The hard work of building a life that makes a difference is much easier to sustain when you are passionate about what you pursue. When I first came to the Federal Reserve 37 years ago, I was struck by the passion of my colleagues for the mission of the Fed. And these many years later, each day at work, I see the importance of that passion to carrying out the Fed's duties effectively. If there is a job that you feel passionate about, do what you can to pursue that job; if there is a purpose about which you are passionate, dedicate yourself to that purpose.

Finally, I hope that you can find joy in the lives you choose. You are completing one important phase of your life today and embarking on an amazing new adventure. Serious decisions about life surely lie ahead, but take the time to savor the joys, large and small that come along the way. Share those joys with others, and share a laugh when you can.

In closing, thank you again, on behalf of myself and the other honorees. Thank you for the opportunity to speak to you today. Congratulations and good luck to the Class of 2014.

Janet L. Yellen Sppech At the National Small Business Week Event, U.S. Chamber of Commerce, Washington, D.C.

Chair Janet L. Yellen

At the National Small Business Week Event, U.S. Chamber of Commerce, Washington, D.C.

May 15, 2014

Small Businesses and the Recovery

Thank you, Administrator Contreras-Sweet, I am pleased to be at the U.S. Chamber, to have this opportunity to be part of Small Business Week, and to meet the outstanding entrepreneurs here this evening. I am also grateful to be able to share a few thoughts on the important role I believe small businesses have played and will continue to play in America's recovery from the financial crisis and the Great Recession. 

After the onset of the crisis, the Federal Reserve took extraordinary steps to stabilize the financial system and halt the plunge in economic activity. Since then, the Fed has continued to use its monetary policy tools to promote the recovery and make progress toward our mandated objectives of maximum employment and price stability. By putting downward pressure on interest rates, the Fed is trying to make financial conditions more accommodative--supporting asset values and lower borrowing costs for households and businesses and thus encouraging the spending that spurs job creation and a stronger recovery.

Crucial to this process, as I just mentioned, is job creation. The Federal Reserve tries to promote the conditions to foster job creation, but, overwhelmingly, it is businesses that create the jobs. About 85 percent of nonfarm employment is in the private sector, which traditionally is the source of a similarly large share of new jobs during economic expansions. So far during this expansion, public-sector employment has declined and the private sector has accounted for all of the net increase in employment, so businesses have been even more crucial to job creation than usual.

Small businesses, of course, are responsible for a large share of these new jobs. According to the latest data from the Labor Department, a little more than half of the net number of jobs created since employment began growing in 2010 has been generated by firms with fewer than 250 employees, and most of that amount was accounted for by firms with fewer than 50 employees.1 

One of the reasons I wanted so much to be here this evening was to be able to acknowledge these important contributions. America has come a long way since the dark days of the financial crisis, and small businesses deserve a considerable share of the credit for the investment and hiring that have brought that progress. Although we have come far, it is also true that we have further to go to achieve a healthy economy, and I am certain that small businesses will continue to play a critical role in reaching that objective.

I am honored to be addressing the owners of 53 small businesses whose excellence exemplifies the enormous contributions that millions of small businesses collectively make to our economy. You come from different places and have achieved success in a wide variety of ways, but you all share the entrepreneurial spirit that has always been central to our nation's prosperity. We at the Federal Reserve are keenly aware of your vital role, and we pledge to continue to do our part in promoting the recovery so that you can continue to help America grow and prosper.
Thank you.

1. See Bureau of Labor Statistics (2014), "Business Employment Dynamics: Third Quarter 2013," press release, April 29.

Tuesday, May 20, 2014

Cantillon Effects

By Mark Thornton

Cantillon effects are named for their discoverer, Richard Cantillon, who is widely credited as the first economic theorist, and in particular, was the first to show that changes in the money supply and credit have important impacts on the economy by changing relative prices. Cantillon showed that an increase in the supply of money would cause economic expansion, but that ultimately the process would be self-reversing as prices would rise and imports would increase, sending money back out of the economy. Cantillon further showed that monetary inflation does not affect all prices equally or at the same time, but in sequences that depend on the spending behavior of money holders all along the channels of monetary flows. These ideas have been adopted and extended by Knut Wicksell, Ludwig von Mises, and F.A. Hayek and more recently by McCulloch (1981) and Garrison (2001).

Cantillon effects are the real fundamental changes in resource allocation that result from changing relative prices between the time of the creation of new money and the full adjustment to the increase in supply. For Cantillon, an increase in commodity money, such as silver, would increase employment and prices. It would impose "forced savings" and lower real incomes on those whose income was not changed due to monetary inflation, possibly leading to unemployment or emigration. If the money supply increased due to a balance-of-payments surplus, then the additional money could cause an increase in manufacturing or expansion in whatever the new money holders chose to spend their money on.

Most importantly, changes in the supply of money can have effects on the interest rate and once again the effect will depend on how the money enters the economy. On the one hand, if it comes into the hands of traditional borrowers or lenders, such as developers, the rate of interest would initially fall. This is similar to the Austrian theory of the business cycle in that when banks expand the money supply and lower the interest rate below what it would have been, borrowers invest in longer-term capital projects. On the other hand, if the money came into the hands of consumers, the rate of interest might rise as suppliers attempt to meet the new demand for goods. In the Austrian view, changes in the interest rate change the relative price between longer-term capital projects and shorter-term capital projects. A lowering of the interest rate raises the prices of longer-term capital goods relative to shorter-term capital goods.

In response to the change in relative prices, more resources are allocated to long-term capital goods. Unlike other aspects of the self-adjusting market process, such as money, land, labor, and short-term or intermediate capital goods, these resources become suspended or fixed in long-term fixed capital goods. These resources become formulated in a highly specific capital good that may not be well suited to the alternative production processes of the postadjustment economy. As a result, all of the adjustment in these long-term fixed capital goods must come from a change in price and this will entail large losses and possible bankruptcies by the owners of these capital goods. To the extent that these types of adjustments are widespread, they pose a threat to capital markets and the banking system.

The above originally appeared at

Sunday, May 18, 2014

Pathological Altruism

Pathological Altruism--any behavior or personal tendency in which either the stated aim or the implied motivation is to promote the welfare of another or others. But, instead of overall beneficial outcomes, the "altruism" instead has irrational and substantial negative consequences to the other or even to the self. -- from Pathological Altruism, p4

Monday, May 5, 2014

Special Drawing Rights

Special Drawing Rights (SDR)--The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries' official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation that took effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs increased from SDR 21.4 billion to around SDR 204 billion (equivalent to about $316 billion, converted using the rate of March 12, 2014)

The SDR is a potential claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions. In addition to its role as a supplementary reserve asset, the SDR serves as the unit of account of the IMF and some other international organizations.

From the IMF.

Thursday, May 1, 2014

Biography of F. A. Hayek (1899-1992)

By Peter Klein
F. A. Hayek is undoubtedly the most eminent of the modern Austrian economists. Student of Friedrich von Wieser, protégé and colleague of Ludwig von Mises, and foremost representative of an outstanding generation of Austrian school theorists, Hayek was more successful than anyone else in spreading Austrian ideas throughout the English-speaking world. "When the definitive history of economic analysis during the 1930s comes to be written," said John Hicks in 1967, "a leading character in the drama (it was quite a drama) will be Professor Hayek. . . . It is hardly remembered that there was a time when the new theories of Hayek were the principal rival of the new theories of Keynes" (Hicks, 1967, p. 203). Unfortunately, Hayek's theory of the business cycle was eventually swept aside by the Keynesian revolution. Ultimately, however, this work was again recognized when Hayek received, along with the Swede Gunnar Myrdal, the 1974 Nobel Memorial Prize in Economic Science. Hayek was a prolific writer over nearly seven decades; hisCollected Works, currently being published by the University of Chicago Press and Routledge, are projected at nineteen volumes.

Life and Work

Hayek's life spanned the twentieth century, and he made his home in some of the great intellectual communities of the period.(2) Born Friedrich August von Hayek in 1899 to a distinguished family of Viennese intellectuals,(3) Hayek attended the University of Vienna, earning doctorates in 1921 and 1923. Hayek came to the University at age 19 just after World War I, when it was one of the three best places in the world to study economics (the others being Stockholm and Cambridge, England). Though he was enrolled as a law student, his primary interests were economics and psychology, the latter due to the influence of Mach's theory of perception on Wieser and Wieser's colleague Othmar Spann, and the former stemming from the reformist ideal of Fabian socialism so typical of Hayek's generation.
Like many students of economics then and since, Hayek chose the subject not for its own sake, but because he wanted to improve social conditions--the poverty of postwar Vienna serving as a daily reminder of such a need. Socialism seemed to provide a solution. Then in 1922 Mises published his Die Gemeinwirtschaft, later translated as Socialism. "To none of us young men who read the book when it appeared," Hayek recalled, "the world was ever the same again" (Hayek, 1956, p. 133). Socialism, an elaboration of Mises's pioneering article from two years before, argued that economic calculation requires a market for the means of production; without such a market there is no way to establish the values of those means and, consequently, no way to find their proper uses in production. Mises's devastating attack on central planning converted Hayek to laissez-faire, along with contemporaries like Wilhelm Röpke, Lionel Robbins, and Bertil Ohlin.
It was around this time that Hayek began attending Mises's famedPrivatseminar. Regular participants, who received no academic credit or other official recognition for their time, included Hayek, Gottfried Haberler, Fritz Machlup, Oskar Morgenstern, Paul Rosenstein-Rodan, Richard von Strigl, Karl Schlesinger, Felix Kaufmann, Alfred Schütz, Eric Voegelin, Karl Menger, Jr., and others not so famous. For several years the Privatseminar was the center of the economics community in Vienna, attracting such visitors as Robbins from London and Howard S. Ellis from Berkeley. Later, Hayek became the first of this group to leave Vienna; most of the others, along with Mises himself, were also gone by the start of World War II.
Mises had done earlier work on monetary and banking theory, successfully applying the Austrian marginal utility principle to the value of money and then sketching a theory of industrial fluctuations based on the doctrines of the British Currency School and the ideas of the Swedish economist Knut Wicksell. Hayek used this last as a starting point for his own research on fluctuations, explaining the origin of the business cycle in terms of bank credit expansion and its transmission in terms of capital malinvestments. His work in this area eventually earned him an invitation to lecture at the London School of Economics and Political Science and then to occupy its Tooke Chair in Economics and Statistics, which he accepted in 1931. There he found himself among a vibrant and exciting group: Robbins, J. R. Hicks, Arnold Plant, Dennis Robertson, T. E. Gregory, Abba Lerner, Kenneth Boulding, and George Shackle, to name only the most prominent. Hayek brought his (to them) unfamiliar views,(4) and gradually, the "Austrian" theory of the business cycle became known and accepted. At the L.S.E. Hayek lectured on Mises's business-cycle theory, which he was refining and which, until Keynes's General Theory came out in 1936, was rapidly gaining adherents in Britain and the U.S. and was becoming the preferred explanation of the Depression.
Hayek and Keynes had sparred in the early 1930s in the pages of theEconomic Journal, over Keynes's Treatise on Money. As one of Keynes's leading professional adversaries, Hayek was well situated to provide a full refutation of the General Theory. But he never did. Part of the explanation for this no doubt lies with Keynes's personal charm and legendary rhetorical skill, along with Hayek's general reluctance to engage in direct confrontation with his colleagues.(5) Hayek also considered Keynes an ally in the fight against wartime inflation and did not want to detract from that issue (Hayek, 1994, p. 91). Furthermore, as Hayek later explained, Keynes was constantly changing his theoretical framework, and Hayek saw no point in working out a detailed critique of the General Theory, if Keynes might change his mind again (Hayek, 1963, p. 60; Hayek, 1966, pp. 240-41). Hayek thought a better course would be to produce a fuller elaboration of Böhm-Bawerk's capital theory, and he began to devote his energies to this project. Unfortunately, The Pure Theory of Capital was not completed until 1941, and by then the Keynesian macro model had become firmly established.(6)
Within a very few years, however, the fortunes of the Austrian school suffered a dramatic reversal. First, the Austrian theory of capital, an integral part of the business-cycle theory, came under attack from the Italian-born Cambridge economist Piero Sraffa and the American Frank Knight, while the cycle theory itself was forgotten amid the enthusiasm for the General Theory. Second, beginning with Hayek's move to London and continuing until the early 1940s, the Austrian economists left Vienna, for personal and then for political reasons, so that a school ceased to exist there as such.(7) Mises left Vienna in 1934 for Geneva and then New York, where he continued to work in isolation; Hayek remained at the L.S.E. until 1950, when he joined the Committee on Social Thought at the University of Chicago. Other Austrians of Hayek's generation became prominent in the U.S.--Gottfried Haberler at Harvard, Fritz Machlup and Oskar Morgenstern at Princeton, Paul Rosenstein-Rodan at MIT--but their work no longer seemed to show distinct traces of the tradition founded by Carl Menger.
At Chicago Hayek again found himself among a dazzling group: the economics department, led by Knight, Milton Friedman, and later George Stigler, was one of the best anywhere, and Aaron Director at the law school soon set up the first law and economics program.(8) But economic theory, in particular its style of reasoning, was rapidly changing; Paul Samuelson's Foundations had appeared in 1947, establishing physics as the science for economics to imitate, and Friedman's 1953 essay on "positive economics" set a new standard for economic method. In addition, Hayek had ceased to work on economic theory, concentrating instead on psychology, philosophy, and politics, and Austrian economics entered a prolonged eclipse.(9) Important work in the Austrian tradition was done during this period by Rothbard (1956, 1962, 1963a, 1963b), Kirzner (1963, 1966, 1973), and Lachmann (1956), but at least publicly, the Austrian tradition lay mostly dormant.
When the 1974 Nobel Prize in economics went to Hayek, interest in the Austrian school was suddenly and unexpectedly revived. While this was not the first event of the so-called "Austrian revival," the memorable South Royalton conference having taken place earlier the same year, the rediscovery of Hayek by the economics profession was nonetheless a decisive event in the renaissance of Austrian economics.(10) Hayek's writings were taught to new generations, and Hayek himself appeared at the early Institute for Humane Studies conferences in the mid-1970s. He continued to write, producing The Fatal Conceit in 1988, at the age of 89. Hayek died in 1992 in Freiburg, Germany, where he had lived since leaving Chicago in 1961.

Contributions to Economics

Hayek's legacy in economics is complex. Among mainstream economists, he is mainly known for his popular The Road to Serfdom (1944) and for his work on knowledge in the 1930s and 1940s (Hayek, 1937, 1945). Specialists in business-cycle theory recognize his early work on industrial fluctuations, and modern information theorists often acknowledge Hayek's work on prices as signals, although his conclusions are typically disputed.(11) Hayek's work is also known in political philosophy (Hayek, 1960), legal theory (Hayek 1973-79), and psychology (Hayek, 1952). Within the Austrian school of economics, Hayek's influence, while undeniably immense, has very recently become the subject of some controversy. His emphasis on spontaneous order and his work on complex systems has been widely influential among many Austrians. Others have preferred to stress Hayek's work in technical economics, particularly on capital and the business cycle, citing a tension between some of Hayek's and Mises's views on the social order. (While Mises was a rationalist and a utilitarian, Hayek focused on the limits to reason, basing his defense of capitalism on its ability to use limited knowledge and learning by trial and error.)

Business-cycle theory.

Hayek's writings on capital, money, and the business cycle are widely regarded as his most important contributions to economics (Hicks, 1967; Machlup, 1976). Building on Mises's Theory of Money and Credit (1912), Hayek showed how fluctuations in economy-wide output and employment are related to the economy's capital structure. In Prices and Production (1931) he introduced the famous "Hayekian triangles" to illustrate the relationship between the value of capital goods and their place in the temporal sequence of production. Because production takes time, factors of production must be committed in the present for making final goods that will have value only in the future after they are sold. However, capital is heterogeneous. As capital goods are used in production, they are transformed from general-purpose materials and components to intermediate products specific to particular final goods. Consequently, these assets cannot be easily redeployed to alternative uses if demands for final goods change. The central macroeconomic problem in a modern capital-using economy is thus one ofintertemporal coordination: how can the allocation of resources between capital and consumer goods be aligned with consumers' preferences between present and future consumption? In The Pure Theory of Capital (1941), perhaps his most ambitious work, Hayek describes how the economy's structure of production depends on the characteristics of capital goods--durability, complementarity, substitutability, specificity, and so on. This structure can be described by the various "investment periods" of inputs, an extension of Böhm-Bawerk's notion of "roundaboutness," the degree to which production takes up resources over time.(12)
In Prices and Production (1931) and Monetary Theory and the Trade Cycle (1933a) Hayek showed how monetary injections, by lowering the rate of interest below what Mises (following Wicksell) called its "natural rate," distort the economy's intertemporal structure of production.(13) Most theories of the effects of money on prices and output (then and since) consider only the effects of the total money supply on the price level and aggregate output or investment. The Austrian theory, as developed by Mises and Hayek, focuses on the way money enters the economy ("injection effects") and how this affects relative prices and investment in particular sectors. In Hayek's framework, investments in some stages of production are "malinvestments" if they do not help to align the structure of production to consumers' intertemporal preferences. The reduction in interest rates caused by credit expansion directs resources toward capital-intensive processes and early stages of production (whose investment demands are more interest-rate elastic), thus "lengthening" the period of production. If interest rates had fallen because consumers had changed their preferences to favor future over present consumption, then the longer time structure of production would have been an appropriate, coordinating response. A fall in interest rates caused by credit expansion, however, would have been a "false signal," causing changes in the structure of production that do not accord with consumers' intertemporal preferences.(14) The boom generated by the increase in investment is artificial. Eventually, market participants come to realize that there are not enough savings to complete all the new projects; the boom becomes a bust as these malinvestments are discovered and liquidated.(15)Every artificial boom induced by credit e xpansion, then, is self-reversing. Recovery consists of liquidating the malinvestments induced by the lowering of interest rates below their natural levels, thus restoring the time structure of production so that it accords with consumers' intertemporal preferences.(16)

Knowledge, prices, and competition as a discovery procedure.

Hayek's writings on dispersed knowledge and spontaneous order are also widely known, but more controversial. In "Economics and Knowledge" (1937) and "The Use of Knowledge in Society" (1945) Hayek argued that the central economic problem facing society is not, as is commonly expressed in textbooks, the allocation of given resources among competing ends. "It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only those individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality" (Hayek, 1945, p. 78).
Much of the knowledge necessary for running the economic system, Hayek contended, is in the form not of "scientific" or technical knowledge--the conscious awareness of the rules governing natural and social phenomena--but of "" knowledge, the idiosyncratic, dispersed bits of understanding of "circumstances of time and place." This tacit knowledge is often not consciously known even to those who possess it and can never be communicated to a central authority. The market tends to use this tacit knowledge through a type of "discovery procedure" (Hayek, 1968a), by which this information is unknowingly transmitted throughout the economy as an unintended consequence of individuals' pursuing their own ends.(17) Indeed, Hayek's (1948b) distinction between the neoclassical notion of "competition," identified as a set of equilibrium conditions (number of market participants, characteristics of the product, and so on), and the older notion of competition as a rivalrous process, has been widely influential in Austrian economics (Kirzner, 1973; Machovec, 1995).
For Hayek, market competition generates a particular kind of order--an order that is the product "of human action but not human design" (a phrase Hayek borrowed from Adam Smith's mentor Adam Ferguson). This "spontaneous order" is a system that comes about through the independent actions of many individuals, and produces overall benefits unintended and mostly unforeseen by those whose actions bring it about. To distinguish between this kind of order and that of a deliberate, planned system, Hayek (1968b, pp. 72-76) used the Greek terms cosmos for a spontaneous order and taxis for a consciously planned one.(18) Examples of a cosmos include the market system as a whole, money, the common law, and even language. A taxis, by contrast, is a designed or constructed organization, like a firm or bureau; these are the "islands of conscious power in [the] ocean of unconscious cooperation like lumps of butter coagulating in a pail of buttermilk" (D. H. Robertson, quoted in Coase, 1937, p. 35).(19)
Most commentators view Hayek's work on knowledge, discovery, and competition as an outgrowth of his participation in the socialist calculation debate of the 1920s and 1930s. The socialists erred, in Hayek's view, in failing to see that the economy as a whole is necessarily a spontaneous order and can never be deliberately made over in the way that the operators of a planned order can exercise control over their organization. This is because planned orders can handle only problems of strictly limited complexity. Spontaneous orders, by contrast, tend to evolve through a process of natural selection, and therefore do not need to be designed or even understood by a single mind.(20)

Hayek and Austrian Economics

Clearly, the Austrian revival owes as much to Hayek as to anyone. But are Hayek's writings really "Austrian economics"--part of a separate, recognizable tradition--or should we regard them, instead, as an original, deeply personal, contribution?(21) Some observers charge that Hayek's later work, particularly after he began to turn away from technical economics, shows more influence of his friend Sir Karl Popper than of Carl Menger or Mises: one critic speaks of "Hayek I" and "Hayek II"; another writes on "Hayek's Transformation."(22)
It is true that Popper had a significant impact on Hayek's mature thought. Of greater interest is the precise nature of Hayek's relationship with Mises. Undoubtedly, no economist has had a greater impact on Hayek's thinking than Mises--not even Wieser, from whom Hayek learned his craft but who died in 1927 when Hayek was still a young man. In addition, Mises clearly considered Hayek the brightest of his generation.(23) Yet, as Hayek (1978a) noted, he was from the beginning always something less than a pure follower: "Although I do owe [Mises] a decisive stimulus at a crucial point of my intellectual development, and continuous inspiration through a decade, I have perhaps most profited from his teaching because I was not initially his student at the university, an innocent young man who took his word for gospel, but came to him as a trained economist, versed in a parallel branch of Austrian economics [the Wieser branch] from which he gradually, but never completely, won me over."
Much has been written on Hayek's and Mises's views on the socialist calculation debate. The issue is whether a socialist economy is "impossible," as Mises charged in 1920, or simply less efficient or more difficult to implement. Hayek (1992, p. 127) maintained later that Mises's "central thesis was not, as it is sometimes misleadingly put, that socialism is impossible, but that it cannot achieve an efficient utilization of resources." That interpretation is itself subject to dispute. Hayek is arguing here against the standard view on economic calculation, found for instance in Schumpeter (1942, pp. 172-186) or Bergson (1948). This view holds that Mises's original statement of the impossibility of economic calculation under socialism was refuted by Oskar Lange, Fred Taylor, and Abba Lerner, and that later modifications by Hayek and Robbins amounted to an admission that a socialist economy is possible in theory but difficult in practice because knowledge is decentralized and incentives are weak. Hayek's response in the cited text, that Mises's actual position has been exaggerated, receives support from the primary revisionist historian of the calculation debate, Don Lavoie, who states that the "central arguments advanced by Hayek and Robbins did not constitute a 'retreat' from Mises, but rather a clarification directing the challenge to the later versions of central planning . . . Although comments by both Hayek and Robbins about computational difficulties of the [later approaches] were responsible for misleading interpretations of their arguments, in fact their main contributions were fully consistent with Mises's challenge" (Lavoie, 1985, p. 20). Kirzner (1988) similarly contends that Mises's and Hayek's positions should be viewed together as an early attempt to elaborate the Austrian "entrepreneurial-discovery" view of the market process. Salerno (1990a) argues, by contrast, in favor of the traditional view--that Mises's original calculation problem is different from the discovery-process problem emphasized b y Lavoie and Kirzner.(24)
Furthermore, Hayek's later emphasis on group selection and spontaneous order is not shared by Mises, although there are elements of this line of thought in Menger. A clue to this difference is in Hayek's (1978a) statement that "Mises himself was still much more a child of the rationalist tradition of the Enlightenment and of continental, rather than of English, liberalism . . . than I am myself." This is a reference to the "two types of liberalism" to which Hayek frequently refers: the continental rationalist or utilitarian tradition, which emphasizes reason and man's ability to shape his surroundings, and the English common-law tradition, which stresses the limits to reason and the "spontaneous" forces of evolution.(25)
Recently, the relationship between Mises and Hayek has become a full-fledged "de-homogenization" debate. Salerno (1990a, 1990b, 1993, 1994) and Rothbard (1991, 1995) see Hayek's emphasis on knowledge and discovery as substantially different from Mises's emphasis on purposeful human action. Salerno (1993), for example, argues that there are two strands of modern Austrian economics, both descended from Menger. One, the Wieser-Hayek strand, focuses on dispersed knowledge and the price system as a device for communicating knowledge. Another, the Böhm-Bawerk-Mises strand, focuses on monetary calculation (or "appraisal," meaning anticipation of future prices) based on existing money prices. Kirzner (1995a, 1995b, 1996, 1997) and Yeager (1994, 1995) argue, by contrast, that the differences between Hayek and Mises are more matters of emphasis and language than substance.(26)
Regardless, there is widespread agreement that Hayek ranks among the greatest members of the Austrian school, and among the leading economists of the twentieth century. His work continues to be influential in business-cycle theory, comparative economic systems, political and social philosophy, legal theory, and even cognitive psychology. Hayek's writings are not always easy to follow--he describes himself as "puzzler" or "muddler" rather than a "master of his subject"--and this may have contributed to the variety of interpretations his work has aroused.(27) Partly for this reason, Hayek remains one of the most intriguing intellectual figures of our time.


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1. Peter G. Klein is assistant professor of economics at The University of Georgia and associate editor of The Collected Works of F. A. Hayek. He thanks, without implicating, Roger Garrison, Sandy Klein, Stephen Kresge, David Robinson, Joe Salerno, George Selgin, and Larry White for helpful comments on earlier drafts.
2. For a fuller biographical account see Hayek, 1994, and the introduction by Stephen Kresge.
3. Hayek's father was a physician and botanist. One grandfather, a statistician, was a friend of Eugen von Böhm-Bawerk; the philosopher Ludwig Wittgenstein was a second cousin.
4. Hicks (1967, p. 204) noted, in reference to Hayek's first (1931) English book, that "Prices and Production was in English, but it was not English economics."
5. In addition, Hayek (1963, p. 60) cited his own "tiredness from controversy"; he had already engaged the market socialists on economic calculation, Knight on capital theory, and Keynes on money.
6. For more on Hayek's failure to respond to the General Theory see Caldwell, 1995, esp. pp. 40-46. Hayek (1963, pp. 60-61; 1966, pp. 240-41) also believed that an effective refutation of Keynes would have to begin with a thorough critique of aggregate, or "macro" economics more generally. Caldwell (1988) suggests another reason: it was during this time that Hayek was losing faith in equilibrium theory and moving toward a "market process" view of economic activity, making it difficult for him to engage Keynes on the same terms in which they had debated earlier. McCormick (1992, pp. 99-134) and Blaug (1993, pp. 53-55) propose an entirely different reason: Hayek couldn't respond because the Austrian capital theory, on which the cycle theory was built, was simply wrong.
7. On the emigration of the Austrian economists see Craver, 1986.
8. However, at Chicago Hayek was considered something of an outsider; his post was with the Committee on Social Thought, not the economics department, and his salary was paid by a private foundation, the William Volker Fund (the same organization that paid Mises's salary as a visiting professor at New York University).
9. By this time, Hayek (1994, p. 126) said, "I had . . . become somewhat stale as an economist and felt much out of sympathy with the direction in which economics was developing. Though I had still regarded the work I had done during the 1940s on scientific method, the history of ideas, and political theory as temporary excursions into another field, I found it difficult to return to systematic teaching of economic theory and felt it rather as a release that I was not forced to do so by my teaching duties."
10. The proceedings of the South Royalton conference were published as The Foundations of Modern Austrian Economics (Dolan, 1976). A follow-up volume appeared two years later: New Directions in Austrian Economics (Spadaro, 1978). For perspectives on the Austrian revival see Rothbard, 1995, and Vaughn, 1996. Salerno (1996b) argues that the Austrian revival should be dated not from 1974, but from 1962-63, when Rothbard published Man, Economy, and State (1962), America's Great Depression(1963a), and What Has Government Done to Our Money? (1963b), the works that sparked the younger South Royalton participants' interest in Austrian economics.
11. Lucas (1977) cites Hayek as a leading exponent of pre-Keynesian business-cycle theory. Grossman and Stiglitz (1976) and Grossman (1980, 1989) argue that contrary to Hayek, market prices are not "sufficient statistics" for changes in tastes and technology. This literature tries to test the "informative content" of price signals, and contends that in general only perfectly competitive prices convey useful information. Farrell and Bolton (1990) claim that Hayek overstates the coordinating properties of decentralized market exchange. Hayek's 1945 paper is also frequently cited in the new institutional literature emphasizing process and adaptation, although coordination through markets is seen as only one type of desirable coordination. See, for example, Williamson, 1991.
12. Hayek ultimately rejected Böhm-Bawerk's "average period of production" as a useful concept, though he had used it earlier in Prices and Production (1931). See Hayek, 1994, p. 141, and White, 1996.
13. Hayek thought the more important case was when the market interest rate was kept constant despite a rise in the natural interest rate. In his writings, however, he focused on the expositionally easier case when credit expansion lowers the market interest rate below an unchanged natural rate.
14. For most of his career Hayek viewed a system of fractional-reserve banking as inherently unstable, endorsing a role (in principle) for government stabilization of the money supply. In later writings, beginning with The Constitution of Liberty (1960) and culminating in Denationalisation of Money(1976), he argued in favor of competition among private issuers of fiat money. See White, 1997.
15. Anticipating modern cycle theories, Hayek (1939) recognized that the behavior of the cycle depends on expectations about future price and interest-rate movements. As Garrison and Kirzner put it (1987, p. 612), for Hayek "prices are signals, not marching orders." But Hayek did not believe agents could know the real structure of the economy, to correctly distinguish movements in interest rates generated by changes in consumers' intertemporal preferences from those generated by changes in the money supply.
16. For general overviews of Hayek's macroeconomic views see O'Driscoll, 1977, and Garrison and Kirzner, 1987. For expositions and interpretations of the Austrian trade-cycle theory, particularly as it relates to modern cycle theories, see Garrison, 1978, 1984; Bellante and Garrison, 1988; Van Zijp, 1993; and Foss, 1994, pp. 39-55.
17. Hayek's use of an argument from ignorance as a defense of the market is unusual. Modern economists typically require assumptions of hyperrationality--complete and perfect information, rational expectations, perfect markets, and so on--to justify market allocations as "efficient." In the new microeconomics literature on information and incentives, theorists like Joseph Stiglitz have used deviations from these assumptions of perfection to reach a verdict of market failure and to provide a rationale for government intervention (see note 9 above). For Hayek, by contrast, the fact that agents are not hyperrational is an argument not against individual freedom, but against state planning and social control.
18. Earlier Hayek (1933b, p. 27) had used "organism" and "organization," borrowed from Mises, to distinguish the two; this is the distinction cited by Coase in his famous 1937 article, "The Nature of the Firm."
19. On the relationship between the socialist calculation debate and the theory of the firm see Klein, 1996.
20. For more on spontaneous order see Fehl, 1986. Vanberg (1994) argues that Hayek's notion of spontaneous order via group selection is incompatible with methodological individualism.
21. Wieser's have generally been considered a personal contribution, by Hayek himself and others. For a contrary view see Ekelund, 1986.
22. For Hayeks I and II see Hutchison, 1984, pp. 210-19; for the "transformation" see Caldwell, 1988. The secondary literature contains some debate about whether Hayek's 1937 article "Economics and Knowledge" represents a decisive break with Mises in favor of a Popperian "falsificationist" approach, one holding that empirical evidence can be used to falsify a theory (though not to "verify" it by induction). For the case that 1937 is a crucial turning point see Hutchison (1984, p. 215) and Caldwell (1988, p. 528); for the reverse see Gray (1984, pp. 16-21) and Garrison and Kirzner (1987, pp. 610). Hayek (1992, pp. 55-56; 1994, pp. 72-74) himself supported the former interpretation, maintaining that it was indeed Mises he had hoped to persuade in the 1937 article. If true, Hayek's attempt was remarkably subtle, for Mises apparently welcomed Hayek's argument, unaware that it was directed at him.
23. Margit von Mises (1984, p. 133) recalls of her husband's seminar in New York that he "met every new student hopeful that one of them might develop into a second Hayek."
24. Hayek's writings on socialist economic calculation are collected in Hayek, 1997. See Caldwell, 1997, for an overview.
25. For more on the complex and subtle Mises-Hayek relationship see Klein, 1992, pp. 7-13 and the references cited therein.
26. Kirzner (1995b, p. 1244), for example, writes that Mises's and Hayek's critiques of socialism "are simply different ways of expounding the same basic, Austrian, insight. . . . To fail to see the common economic understanding shared by Mises and Hayek, is to have been needlessly misled by superficial differences in exposition and emphasis. To compound this failure by perceiving a clash, among modern Austrians, of 'Hayekians' versus 'Misesians,' is to convert an interpretive failure into adogmengeschictliche nightmare." For more on the de-homogenization debate see Herbener, 1991, 1996; Salerno, 1994, 1996a; Hoppe, 1996; Boettke, 1997; and Yeager, 1995. Rothbard (1994, p. 559) identifies three "distinctive and often clashing paradigms within Austrian economics: Misesian praxeology; the Hayek-Kirzner emphasis on the market as transmission of knowledge and coordination of plans--rather than the Misesian emphasis on continuing coordination of prices; and the ultra-subjectivism of [Ludwig] Lachmann."
Interestingly, Hayek himself sought to de-homogenize his work from that of free-market thinkers with whom he disagreed methodologically. In an interview in the 1980s he described Milton Friedman as a "logical positivist," who "believe[s] economic phenomena can be explained as macrophenomena, that you can ascertain cause and effects from aggregates and averages. . . . [Friedman] is on most things, general market problems, sound. I want him on my side. You know, one of the things I often have publicly said is that one of the things I most regret is not having returned to a criticism of Keynes's treatise, but it is as much true of not having criticized Milton's [Essays inPositive Economics, which in a way is quite as dangerous a book." Quoted in Hayek, 1994, pp. 144-45.
27. On puzzlers and masters of their subjects see Hayek, 1975. Along with himself, Hayek named Wieser and Frank Knight as representative puzzlers, and Böhm-Bawerk, Joseph Schumpeter, and Jacob Viner as representative masters of their subjects. As Hayek (1975, p. 51) recalled, "I owed whatever worthwhile new ideas I ever had to not being able to remember what every competent specialist is supposed to have at his fingertips. Whenever I saw a new light on something it was as the result of a painful effort to reconstruct an argument which most competent economists would effortlessly and instantly reproduce."
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