Ordnungsökonomik

"Whether one is a conservative or a radical, a protectionist or a free trader, a cosmopolitan or a nationalist, a churchman or a heathen, it is useful to know the causes and consequences of economic phenomena."
George J. Stigler

The Unexpected Hanging

The man was sentenced on Saturday. “The hanging will take place at noon,” said the judge to the prisoner, “on one of the seven days of next week. But you will not know which day it is until you are so informed on the morning of the day of the hanging.”

The judge was known to be a man who always kept his word. The prisoner, accompanied by his lawyer, went back to his cell. As soon as the two men were alone the lawyer broke into a grin. “Don’t you see?” he exclaimed. “The judge’s sentence cannot possibly be carried out.”

"I don’t see," said the prisoner.

"Let me explain. They obviously can’t hang you next Saturday. Saturday is the last day of the week. On Friday afternoon you would still be alive and you would know with absolute certainty that the hanging would be on Saturday. You would know this before you were told so on Saturday morning. That would violate the judge’s decree.”

"True," said the prisoner.

"Saturday then is positively ruled out," continued the lawyer. "This leaves Friday as the last day they can hang you. But they can’t hang you on Friday because by Thursday afternoon only two days would remain: Friday and Saturday. Since Saturday is not a possible day, the hanging would have to be on Friday. Your knowledge of that fact would violate the judge’s decree again. So Friday is out. This leaves Thursday as the last possible day. But Thursday is out because if you’re alive Wednesday afternoon, you’ll know that Thursday is to be the day."

"I get it," said the prisoner, who was beginning to feel much better. "In exactly the same way I can rule out Wednesday, Tuesday and Monday. That leaves only tomorrow. But they can’t hang me tomorrow because I know it today!"

How dangerous are monopolies and oligopolies? How much can they reap in excessive profits? Several kinds of evidence suggest that monopolies and small-number oligopolies have limited power to earn much more than competitive rates of return on capital. A large number of studies have compared the rate of return on investment with the degree to which industries are concentrated (measured by share of the industry sales made by, say, the four largest firms). The relationship between profitability and concentration is almost invariably loose: less than 25 percent of the variation in profit rates across industries can be attributed to concentration.
A more specific illustration of the effect the number of rivals has on price can be found in Reuben Kessel’s study of the underwriting of state and local government bonds. Syndicates of investment bankers bid for the right to sell an issue of bonds by, say, the state of California. The successful bidder might bid 98.5 (or $985 for a $1,000 bond) and, in turn, seek to sell the issue to investors at 100 ($1,000 for a $1,000 bond). In this case the underwriter “spread” would be 1.5 (or $15 per $1,000 bond).
In a study of thousands of bond issues, after correcting for size and safety and other characteristics of each issue, Kessel found the pattern of underwriter spreads to be as shown in Table 2.
For twenty or more bidders—which is, effectively, perfect competition—the spread was ten dollars. Merely increasing the number of bidders from one to two was sufficient to halve the excess spread over what it would be at the ten-dollar competitive level. Thus, even a small number of rivals may bring prices down close to the competitive level. Kessel’s results, more than any other single study, convinced me that competition is a tough weed, not a delicate flower.

Reply to fatal-conceit on Austrian Economics

fatal-conceit

I don’t like the way reblogged questions are formatted so I’ll reply with a text post instead.

fatal-conceit:

I think most of your criticisms of methodology and rejection of mathematics apply almost exclusively to Rothbard. There are very real differences between Rothbard and almost everyone else in the Austrian school (except for his disciples). A Priorism as presented by Mises certainly does allow for empirical testing and evidence as I’ve argued in the past. See this paper by Peter Leeson and this essay by Steve Horwitz for more on that. If you reread Mises with those in mind, I think you’ll be surprised to find far more to agree with than you think.

That said, when you speak of the “solid philisophical wall,” you still will disagree with Mises when he says things like a priori truths providing “exact and precise knowledge of real things.” However, if I find that you will find little to disagree with in Hayek’s writings on method (see this paper by Bruce Cadwell for a good discussion of the relationship between Mises and Hayek on method, among other aspects of Hayek’s research project). And, certainly, just because you disagree with a few aspects of Mises’ epistemology (as I do), that doesn’t mean that you reject all of praxeology. A priori describes the philisophic status and method of praxeology, the word praxeology simply describes the sphere of study of human action. Praxeology does not mean the same thing as “a priori.”

Praxeology is a certain approach to studying human action, its defining feature being its a priori approach. If it simply meant “the study of human action” then all economists and psychologists would by definition be praxeologists, which they are not.

I remember hearing a story (which I can’t find a source for online, but it wouldn’t surprise me if it actually happened) that Hayek suggested to von Mises that he travel to the United States to collect data on business cycles, and that Mises advised against it because of his rejection of empirical testing.

Even though Hayek disagreed with certain aspects of Mises’ philosophy of economics, he still embraced the project of praxeology as described by Mises in Human Action (see his comments on that in Chapter Two of the Counterrevolution of Science). Either way, before you say you reject all of Austrian economics in part because of that, you are really just rejecting Rothbard, not the rich body of Austrian thought on method oustide of him.

Also, just because one disagrees with any methodological position of anybody—or even everybody—in the Austrian school does not mean that Austrian Economics should be rejected on the whole. Most scientists today probably disagree heavily with Isaac Newton’s heavily theologically-laden philosophy of science, yet nobody denies there’s something to be learned from Newtonian physics. There is a difference between one’s philosophy of economics and ones actual economics.

Yes, I agree. I appreciate some Austrian contributions to economics even though I would strip them of any a priori status. My favourite Chicago School economist is Frank Knight, and Knight was practically a methodological Austrian—so yes I don’t deny that someone can be a brilliant theorist even if their methodology is flawed.

As for you comments on the Calculation problem, I think you don’t really understand what that is actually about. It’s about more than just how much food to produce, it’s also about how to even produce it in the first place. How do you know whether to direct steel to the production of tractors for agriculture or towards industrial production? How do you know whether to direct water resources to purification for drinking, industrial production, or to crops? How do you know where to direct labor, into agricultural production or industrial production, without market-determined wages? How do you know  how to allocate any of the resources that are so heavily interconnected with the rest of the economy without price signals of relative scarcity? How do you have any improvement in technology and food production necessary for any degree of growth and continued division of labor without the entrepreneurial discovery process made possible by price systems and the profit motive?

I agree  on the issue of the dispersion of knowledge. This is why I think Hayek’s calculation problem is superior to Mises’ calculation problem, since the former brought out the key issue of the dispersion of knowledge. My point is that the importance of the ECP is overstated and other explanations for the failure of central planning are often ignored. As Bryan Caplan has pointed out, farmers in Russia before the revolution were largely subsistence farmers who didn’t perform economic calculation to begin with, so you can’t use the ECP to explain the famine.

Insofar as the central authority knows what to produce and how to produce it, the ECP is not a problem. The central authority could simply survey the quantities of raw resources available, decide what ratio of the various output should be produced, and using linear programming to work out how resources should be allocated. The amount of farmland required to produce X number of potatoes and the amount of chemical A used to produce product Y is largely a scientific question.

This is not to say that information problems do not exist, certainly they play an important role. But this only makes the centrally planned economy more stupid and inefficient, but hardly “impossible.” It’s obvious that incentive problems are what causes widespread shortages under command economies, not economic calculation.

Even ignoring how the food is made, the problem of calculation still persists. What of when one person needs more food to accomplish his heavy labor job or due to illness than another, what of the other various issues going into nutrition that determine a healthy diet, what of the subjective value judgements about the quality, quantity, and type of food that are impossible to meet in a centrally planned fashion? How do you determine how the various types of foodstuffs are distributed given the various needs of every individual in the market without prices?

All of these problems only mean the economy is inefficient, but it doesn’t make it “impossible” as Mises asserted.

It’s more than just “there were famines in the Soviet Union because they didn’t know how much food to produce,” that is a gross over-simplification of the calculation problem as stated by Mises, and even more-so the knowledge problem as developed by Hayek. You are not acknowledging the unseen, complex, interconnected components that go into production of goods in an economy, the epistemic problems facing one designing without dispersed knowledge, and the role the entrepreneurial discovery process plays in economic coordination.

When people’s conduct is a matter of routine, problems of coordination do not arise. It’s only when the economy is non-stationary that the need for entrepreneurial coordination arises, and given that many socialists actually do favour a stationary economy I think the critique is greatly overstated.

As for everything else, it sounds like you are acting as if Rothbard is all there is to Austrian economics. I agree that most of Rothbardian economics is simply atrocious and indefensible. I disagree with Rothbard on everything you cited in addition to his ridiculous moralistic rejection of fractional reserve banking, extreme over-application of Austrian Business Cycle Theory, refusal to understand monetarist theory (such as monetary equilibrium), and overall his dogmatic, anti-intellectual approach to economic theorizing in which he refuse to seperate his normative personal values from the positive science of economics (see Kirzner on that). He did make some decent contributions to the Austrian school, and he obviously did a lot of good in terms of making Austrian ideas known generally, but he offset that with very bad ideologically-driven theorizing and attempting to take ownership of the term “Austrian economics” so that anyone who ventured from the beaten path of his bad theories was ostracized. The result of Rothbard’s work has been reasonable people and economists like you, making all of Austrian economics out to be Rothbardian economics when it simply isn’t.

Unfortunately a large fraction of modern Austrians are Rothbardians. The Mises Institute is almost entirely Rothbardian. “and economists like you” — I’m not an economist or an economics student, I just read about economics.

However, there is so much more to the Austrian school than Rothbard. How much of the non-Rothbardian, more academic side of the Austrian school are you familiar with? Obviously, I imagine you know Hayek, but what of people like Fritz Machlup, Don Lavoie, Peter Boettke, Steven Horwitz, Larry White, Mario Rizzo, and Roger Garrison? I imagine if you read those economists seriously, you will not only find a ton of sound economics, but that they are immune from most of what you find so bitter in Rothbard. 

In sum, I think you reject Austrian economics based on ignorance, albeit completely understandable ignorance given the prevalence of Austrians on the internet, of what Austrian economics actually is about.

I reject Austrian economics for a variety of other reasons also. I don’t agree with the pure time preference theory, I don’t think ABCT pans out empirically, I think Böhm-Bawerk’s concept of a “period of production” is extremely vague (Hayek was unable to present a precise definition in his debate with Knight).

I also think Austrians have a very one-variable view of things. You ask them what determines the price of a thing and they’ll say marginal utility, when in fact marginal utility is an endogenous variable to the economic system, which is arrived at only by simultaneous determined of a bunch of other variables. It reminds me of a quote I recently posted from Frank Knight:

[Carl Menger] does offer the lame observation (taken seriously by some disciples) that the value of a good, determined by marginal utility (as we should say), sets the amount that may be expended in producing it — a far cry from recognition of the true relations of mutual determination between these variables.

(Knight, Introduction to Carl Menger’s Principles of Economics)

I find Austrians often downplay or completely ignore the role of cost in price determination, setting the “utility theory of value” in sharp contrast to any “cost of production theory of value.” I think Marshall’s concept of normal price equilibrium shows that the sharp distinction does not really exist.

Risk v. Credit

Paul Krugman argues that easy monetary policies had nothing to do with the financial crisis, and suggest that the key is Minsky’s emphasis on risk. John Aziz writes that Krugman is right regarding risk, but wrong regarding monetary policy. I think Krugman is ¼ right and Aziz ¾. The problem with the straightforward risk story is that there’s little to no evidence that investment banks were purposefully making more risky investments. In fact, mortgage backed securities were considered relatively safe, including by regulators (including the Basel packages, which in the United States were represented by the recourse rule) — indeed, the perception of low risk was one of the reasons so much investment made its way to the mortgage sector.

There have been a number of studies that suggest the risk hypothesis is not too relevant. I recommend Jeffrey Friedman’s and Wladimir Kraus’ Engineering the Financial Crisis. First, there is a short review of some of the early literature on CEO risk-taking during the boom, and the rest of the book deals with how capital requirements helped push investment to the mortgage sector. It’s an empirically oriented book, so you don’t have to worry about ideological assertions. Some articles that deal with risk-taking include Acrey, et. al., (2011) and Fahlenbrach and Stulz (2011). There are some pieces that argue in the opposite direction, too. But, strong evidence of the perception of risk prior to the crisis is how these assets were used as collateral in wholesale credit markets (see either Misunderstanding Financial Crises or Slapped by the Invisible Hand, both by Gary Gorton) — they were considered information insensitive.

The key take away isn’t that risk is irrelevant, it’s that risk isn’t obvious. Mortgage backed assets turned out to be incredibly risky ex post, but few people realized this ex ante. We can say that maybe society forgot about risk, but it’s probably more accurate to argue that people were genuinely deceived. This is what an asset bubble does. This is also why I disagree with Minsky’s financial instability hypothesis. The credit expansion facet is shared, but the mechanism is different. Whereas he posited that an increase in credit would come with a lowering of lending standards, I think there is a process inherit in credit expansion that distorts the perception of risk. The gist of this process is the distortion of profit, which is precisely why the assets that burst are the same as those which were previously considered (very) low risk and moderately profitable (individually).

I’ve been watching the Khan Academy linear algebra playlist and one thing doesn’t make sense to me. It says that ab = ab, but ab is a scalar and aᵀb is a 1x1 matrix. You can multiply any matrix by a scalar but multiplying an mxn matrix by a 1x1 matrix is undefined in most cases.