Category Archives: Austrian School of Economics

A Brief Defense of Economic Models

Economic ModelingIn this write up my goal is to convince some Austrians that mathematical models aren’t as fallacious as they presume. Before I get into my arguments I must first make this point, and it is something that needs to be kept in mind as the readers works through this brief write up. Mathematics, insofar as it is utilized in economic theory, does not predict human action in a deterministic fashion, rather, it captures the laws of human action such that predictions can be made given the constraints of relevant conditions under examination within the theory.

To sum up the Austrian view of models, one could argue that they believe models use false assumptions and lead to fallacious results. On the Austrian view, models cannot capture human action. I am not bold enough to claim that mathematical models can perfectly capture human action, but I do think models are highly useful. Consider the standard model of supply and demand. It gives us proper results, is extremely intuitive, and it is a wonderful teaching tool. Austrians, on the other hand, believe that the assumed continuity of the supply and demand curves are false. As far as I can tell, this is their primary objection to using this model. According to them, because supply and demand are not continuous, it is much more unlikely to reach equilibrium. I would like to point out that adherents of this model do not assume that the supply and demand ever actually reach equilibrium, but rather, prices are always adjusting towards equilibrium. This is a part of this particular model’s usefulness.

But I digress.

Consider this quote out of one of the leading graduate school micro theory books:

“Imagine that you are trying to explain a particular phenomenon with one of two competing theories.  Neither fits the data perfectly, but the first does a somewhat better job according to the standard statistical measures. At the same time, the theory is built on some hypotheses about behavior by individuals that are entirely ad hoc, whereas the second is based on a model of behavior that appeals to your intuition about how people act in this sort of situation. I assert trying to decide which model does a better job of “explaining” is not simply a matter of looking at which fits better statistically. The second model should gain credence because of its greater validity, which brings to bear, in an informal sense, other data” (Kreps, A Course in Microeconomic Theory, pg 8)

Does this quote seem to fit the Austrian argument that Chicago school economists are stat chasers and do not care about the validity of assumptions? Quite the contrary, actually. It seems to me that Chicago School economists are concerned about human behavior/theory first, and stats second. I do not see why any economist should have a problem with this method of economics. As long as the economist will admit some of the draw backs his assumptions might have, why should we completely throw models out the window? Note that when models are introduced through scholarly journals the author will almost always point out some of its downfalls, but explain why it is still useful.

Another reason why I think models are important was touched on in my second paragraph. Models are helpful learning tools because they possess intuitive insights into real world phenomena. Consider supply and demand again. If I were to try and explain to someone why rent controls create housing shortages, it is to my explanatory advantage to draw supply and demand curves, and then show the different implications of keeping rent lower than the market clearing price. It is much easier for the layman to see the consequences as a picture, rather than sorting through all the material in their head. The same goes for the economic analysis of tariffs and the minimum wage. I have a hard time explaining why tariffs are bad even to a relatively knowledgeable audience, but as soon as I draw it out for them it clicks.

The last reason why I believe models are important is because even models that are falsified still help us gain knowledge. This is because learning what assumptions lead to the false conclusions now gives us insight into why these assumptions won’t work for future theories. As long as the economist is trying to encompass human behavior as much as possible, and it is fairly explanatory and predictive, why should anyone reject it? Models can have good explanatory power as to why things happen and to what will happen.

Finally, I would just like to point out that this is barely scratching the surface of how much thought goes into what makes a good economic model.  To simply reject these ideas based off of the use of models alone, is in my view, preposterous

 

– JW

 

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Austrians, Mathematics, and Economics

MathematicsThe purpose of this post is to address many of the statements/arguments made by Austrians (in the tradition of Mises) about math, or rather, their position on mathematical use in economics.

One statement I have been hearing lately is along these lines, “Austrians are not against all math, just SOME math” or, “Austrians are not against math, just mathematical predictions” etc etc. I find these claims to be rather telling of the person arguing on behalf of the Austrian position. These statements tell me right away they do not even know or understand the methodological position of their own school of thought. On their view, these 5 quotes need to be interpreted as only being against some math and/or mathematical predictions. Here are the relevant quotations:

“The only economic problems that matter, defy any mathematical approach” – Ludwig Von Mises

“Now, the mathematical economist does not contribute anything to the elucidation of the market process”  – Ludwig Von Mises

“The equations formulated by mathematical economics remain a useless piece of mental gymnastics and would remain so even if they were to express much more than they really do” – Ludwig Von Mises

(These next two are my favorite)

“The mathematical method must be rejected not only on the account of its bareness. It is an entirely vicious method, starting from false assumptions and leading to fallacious inferences. Its syllogisms are not only sterile: they divert the mind from the study of real problems and distort the relations between various phenomena” – Ludwig Von Mises

“Mathematics cannot and does not enter into measuring ideas or values that determine human action.  There are no constants in these. There is no equality in market transactions. Therefore, mathematics does not apply. The use of mathematics requires constants. Mathematics cannot be used in economic theory” – Percy L. Greaves.

All of these quotes can be found in various articles on mises.org.

I am truly baffled as to how someone claiming to be an adherent of the Austrian School could read these, or any Austrian literature, and conclude that Austrians are only against the use of some math. I have read a lot of Austrian literature, and I personally have never read anything that would support that claim. Of course, quotations cannot be “proof” of anything, but I do think they provide rather strong evidence in favor of my argument. Moreover, the Percy Greaves quotation is in response to the question, “is economics completely divorced from mathematics?” Clearly, from his response he thinks it is.

Another statement I hear from Austrians is that Neo-Classicals do not give them any mathematical propositions they should accept. This seems to be a rather silly statement, and in many ways, entirely meaningless. Austrians should accept all mathematical propositions that are true, from 1 + 1 = 2 to the propositions in set theory or algebraic topology etc.

John NashHowever, to get specific I would like to point out two mathematical fields that have vast applications in economics. First is game theory. Game theory is a branch of mathematics first developed by Emile Borel, and then popularized by the works of Von Neumann, Morgenstern, Nash etc. There is a plethora of economic questions game theory answers. One example of such a question is – how do oligopolies decide on how much to produce given the production of the other firms? Game theory provides the answer to this question.

Second, is functional analysis. In general, functional analysis is the study of infinite dimensional vector spaces. This field answers the question – how can a copper mining company extract Q tons of copper from a mine over T years and maximize its profit? To find this function is one thing, and to prove it is the maximum of all functions is another. I would like to ask an Austrian how to solve this problem without the use of mathematics? In my view, it simply cannot be done.

Mathematics is vitally important to the study of economics, and to denounce it the way influential Austrian scholars have is exactly why I am not an Austrian economist.

 

– JW

 

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Milton Friedman on Libertarianism and Humility

Milton Friedman on conservative/libertarian political and economic philosophy/methodology of The Chicago School vs. the methodology of Mises and Austrio-libertarians.

The most comprehensive rebuttal I’ve seen by Friedman on gradual vs non-gradual solutions to government overreach.

 

 

– Will Ricciardella

 

 

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Inflation vs. Deflation – A Monetarist Perspective

Inflation vs Deflation

Inflation or deflation, which is better?  The answer can vary depending on who you ask, and from which perspective this question is being considered. Consider the question from the perspective of a person working as an importer or exporter. If we have inflation, our dollar is weaker compared to other currencies, which leads to exporters selling more while importers will be buying less. From this perspective it is easy to see that each profession, whether a person is an importer or an exporter, will view inflation differently. The same can be said for deflation. In addition to the importer/exporter scenario, the same principle holds when considering this question from the position of a borrower vs. a lender.

Let me first point out that no economist would argue that mild deflation or inflation is troubling.

With that in mind, let’s consider some of the things Austrian economists say about deflation. They claim it is not something to be feared, and it is as silly to fear deflation as it is to think wars are good for the economy. In a video featuring Tom Woods and Jeff Herbener, they approach the discussion in a way that I find to be frustratingly uncharitable. Tom Woods begins by saying that there are various definitions of deflation. and when most economist are talking about deflation they are not referring to a drop in a money supply, but rather, a decrease in prices. Woods and Herbener go on to talk about the implications of falling prices (you can watch the video here). One of the implications they falsely represent is that people will delay making purchases indefinitely because of the falling prices. They laugh at the prospect of people waiting to buy coffee 10 days later because it will be five cents cheaper. I want to address some of these arguments because they are not handled properly.

First of all, when other economists talk about deflation as a negative for the economy, they are speaking in terms of deflationary policies being implemented by the Federal Reserve. They are not arguing that an increase in production that causes deflation is bad for the economy. What is meant by Federal Reserve deflationary policies is exactly what Tom Woods says most economists are not referring to, which is a decrease in the money supply. So right off the bat this video is misleading the viewer.

The next question you should be asking yourself is, why are deflationary policies unfavorable?  Consider a drastic decrease in the supply of money, say 20% (during the great depression the money supply dropped 33% over three years). The problem is not that prices will fall eventually, the problem is that inflation/deflation takes around 9-15 months before the economy will start to feel these effects. With this being considered, within the minimum of 9 months we would have only 80% of the the previous money supply while prices have yet to drop. This has various implications, but clearly with less money to go around there will be less investment by businesses, less consumption by the consumer, less lending by banks etc.  The economy will slow down because of this.

I also want to address the coffee argument because this is an egregious oversimplification of deflation.  First and foremost, no decent economist will ever tell you people will wait to buy coffee ten days because of falling prices, nor will they say that people will postpone buying a computer because the prices will fall. This is a straw man argument. What needs to be considered when thinking about the economic effects of deflation is whether a businessman wanting to invest $100 million into his company would wait a few months if prices are projected to fall? Any rational business man would consider waiting, because if they took out a $100 million loan and prices are falling by 2% each year for 30 years how much extra would they have to pay back? My investment will have to generate more profit than what I am paying back in interest to the bank, in addition to having to pay back the amount the dollar has deflated. This scenario doesn’t seem quite so laughable now does it? A business man thinking like an economist will not find it is laughable either.

Woods and Herbener do address this issue at around the 7 minute mark, but the manner in which they address it is improperly handled. In America we cannot simply switch money, which is Herbener’s solution to this problem. He claims that in times of mild deflation, historically, this did not happen, but I addressed this in argument in previous paragraphs.

What might the monetarist say?

In Milton Friedman’s view, he would want a slight increase in a targeted money supply. He usually argued somewhere between 3-5% with 3% being his best recommendation. This itself, according to Friedman, would keep inflation or deflation mild. This is what good economists argue on behalf of – a stable money supply leading to a stable economy. Friedman argued this because of the evidence Herbener points out.  During the times of great expansion there were small increases in the gold supply. Friedman wanted to emulate this with the Federal Reserve if our economy is to operate with a Federal Reserve.

The next time you hear an Austrian argue that it is silly to fear deflation you can argue that no economist fears mild deflation.

 

– JW

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Austrians and Game Theory

John Nash

My favorite area of economics and mathematics is Game Theory.  It is a fascinating subject with a wide variety of applications.  I am aware that Mises was not a fan of game theory, however, it is interesting to note that Oskar Morgenstern, an Austrian economist himself, co-founded modern game theory. Since this is the case, I was interested to see what current Austrian economists think of game theory, and needless to say there is a lack of understanding.

I searched on mises.org to find as many articles as I could, which lead me to the mises.org blog.  There were varying opinions of game theory on the blog, but the overwhelming understanding of game theory was completely mistaken.  One person mentioned how game theory is largely based off the prisoners dilemma, and therefore is a useless topic to study. This is very frustrating because game theory has roots all the way back to Emile Borel and other mathematicians, it’s most influential work was published in 1944, and the prisoner’s dilemma as we know it is credited to Luce and Raiffa in 1957! This, among other fallacious arguments, were very common in these blog discussions.

Okay, so people writing on the blogs misunderstand game theory, but the trained economists couldn’t be so drastically mistaken could they?  In an article entitled “The Games Economists Play” by Dr. Robert Murphy, he attacks the conclusions of game theory in a clearly misinformed fashion.  He analyzes the aforementioned prisoner’s dilemma, and uses it to claim that because of various problems within the dilemma, we should not accept game theory in general.

In the prisoners dilemma, two players are accused of committing crimes, one minor crime in which their guilt can be proven with out a confession, and a major crime for which they cannot be convicted unless at least one of them confesses. The confessor will go free, but the other will go to jail for 6 years.  If neither confess, they will both go to jail for only 1 year.  If they both confess they will go to jail for 5 years.  In this game without communication, the Nash Equilibrium is for each player to confess and hence go to jail for 5 years.  This, according to Dr. Murphy, is the downfall of game theory because each person could increase their non-jail time time by not confessing.

What Dr. Murphy does not seem to understand is that Nash Equilibrium does not tell you the outcome will be optimal, but rather, only the strategies that rational players will make.  The reason the prisoner’s dilemma is so famous is because it was the first example of an inefficient Nash Equilibrium (at least that I have found in my research)  Furthermore, he says,

“Even here, the game theorists orthodox analysis is not entirely appealing: real world players often do cooperate even in a one-shot prisoner’s dilemma”

This made me wonder if he is completely unaware of the study of games with communication or even the study of cooperative game theory?  In the situation described above, it is assumed that the prisoner’s cannot communicate and have zero way of knowing what the other will do.  Hence, it certainly becomes much more plausible to confess.  Also, if we analyze the game properly the outcome makes complete sense.  Since the criminals are not cooperating or communicating in any way, as soon as criminal A thinks criminal B will not confess, criminal A has all the incentive to confess.  His choice becomes, either go to prison for one year or zero years.  The same can be said for the other criminal.  Now one could argue that many criminals would rather go to jail than be a “rat”.  This is where I would like to point out that the focal point effect already deals with this objection.

Now, if we look at this game through a cooperative game theory lens, the outcome changes entirely.  Through this lens, we can consider any way in which the criminals will cooperate.  Consider the possibility that there is a contract signed before hand in which the criminals agree to not confess otherwise face a punishment worse than prison.  In this game, the person does not have any incentive to cheat because the time he spends free will be worse than time in prison due to the punishment.  Hence, the equilibrium now becomes both criminals not confessing.

Two more points to consider: first, Dr. Murphy mentions people using the prisoner’s dilemma to argue for government intervention.  Again, these people do not understand the fact that the criminals have no way to communicate or cooperate.  Hence, their argument is invalid.  Further, the fact that Dr. Murphy would actually use this claim to argue against game theory is intellectually dishonest.  He is misrepresenting something he should have studied while getting his PhD.  Any game theorist knows the prisoner dilemma can actually be used to argue for LESS government.

Finally, Dr. Murphy gives a formidable representation of “backward-substitution”.  Again, I am wondering if he is unaware of the vast literature on the subject of repeated games.  In 1982 Kreps, Milgrom, Roberts and Wilson constructed a way to show that “non-confession” strategy will be employed given an initial certain doubt and actions during the game.  The explanation gets very technical with a lot of game theoretical terms so I will not go into it here, but it is discussed in full detail in Game Theory: Analysis of Conflict by Roger B. Myerson in section 7.6.  Also, there are game theorists who study forward induction as well.

In conclusion, it is clear that Dr. Murphy builds up a straw man representation of game theory in order to knock it down. No where does he address any of the advancements of game theory in the last 20-30 years.  He does not address perfect equilibrium, proper equilibrium, sequential equilibrium, subgame perfect equilibrium, trembling hand perfect equilibrium, the focal point effect, repeated games, and the list could go on.  He does however, address Nash equilibrium and the prisoners dilemma, two aspects of game theory developed in the 1950’s.  Both of which have been greatly advanced.

 

– JW

 

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