Steve Horwitz has a great post at the LSE blog that provides an introduction to and summary of the Austrian economic theory that’s relevant to macro policy questions, including the current Eurozone crisis. Most people know that Austrian economics provides a critique of the Keynesian policies emphasizing government stimulus spending, but what’s the underlying logic of the critique?
The key to their view is their understanding that economic resources, whether capital or labour, are not fungible. That is, capital goods and human beings have a multiple, though not infinite, number of ways they can contribute productively to the value creation process.
The productive structure of an economy is like a jigsaw puzzle where the pieces of capital and labour must fit together in particular combinations. Only specific pieces can be linked with others. However, unlike real jigsaw puzzles, we don’t have a picture of the pattern we are creating. Instead, we have prices, profits, and losses to inform us when pieces do or do not fit together appropriately. If those signals are working well, we will have success at fitting pieces together in ways that are orderly. The interesting thing about that orderly use of the jigsaw puzzle pieces is that we might not need to use all the pieces at any one time to generate a recognisable and desirable pattern.
Note two important points in that brief excerpt: (1) heterogeneity of labor and capital, and specific patterns of how they combine to produce value; (2) no teleology — there is no way of knowing what the actual possible outcomes are of those various combinations, and the economy is not a closed or deterministic system. Steve continues the metaphor to illustrate the flaw in the stimulus argument:
What advocates of stimulus are arguing is that we need spending, just any old spending, to jump start struggling economies. But this argument must assume that it does not matter which capital and which labour are brought out of idleness and into what sorts of activities. They must of necessity ignore the specificity of resources and their limited complementarity. It does us no good to try to force pieces together that don’t fit, as that’s what got us in trouble in the first place. And the point of doing a jigsaw puzzle of this sort is to get the pieces to fit in a way that forms an orderly pattern, not to simply use them all up.
This argument reminds me of the debate over the past few days between Bryan Caplan and Matt Yglesias over the relevance of Bastiat. Bryan kicked it off last week by saying that Bastiat is very good at exposing the bad logic underlying the naive reasons why people support interventionist ideas:
Take the minimum wage. Normal people like it because the government waves a magic wand and makes mean employers give helpless workers extra money, with zero blowback. So inane, yet so convincing to a psychologically normal human. An intellectually serious argument, in contrast, begins by conceding the theoretical possibility of a disemployment effect, then defends low estimates of labor demand elasticity. This is a huge improvement in intellectual substance, yet persuades only wonks.
This is the real root of Bastiat’s differential ideological appeal. Friends of the free market love him because Bastiat destroys the inane arguments that make the modern welfare state popular. Once you deprive the median voter of these inane arguments, friends of the modern welfare state have to resort to intellectually serious arguments to make their case. Alas, these arguments are utterly beyond the median voter’s comprehension. Most college students can’t even grasp them.
Matt responded, with the crux of his argument being that Bastiat assumes what he’s trying to argue:
Similarly, Bastiat’s alleged broken windows fallacy involves simply assuming that there’s no such thing as genuinely idle resources or an “output gap.” In that context, yes, it’s a vibrant intuitive depiction of crowding out. But this doesn’t counter any Keynesian or monetarist points about the viability of stimulus during a recession induced by nominal shocks, it involves assuming that no such recessions can occur even though they plainly do.
Here’s where I think Steve’s essay above helps illuminate why I think Matt is mistaken about Bastiat. In order for Keynesian stimulus arguments to hold, you have to assume (1) input heterogeneity and complementarity doesn’t matter and (2) that we know the desired outcomes and “right” combinations well enough to know what’s excess capacity and what’s not, as well as how to use that capacity correctly. A simpler version of that way of thinking is, at least in part, what Bastiat is trying to mock (to use Bryan’s word).
I interpret Bastiat’s model as being entirely consistent with what Steve said about the heterogeneity of labor and capital and the non-deterministic and non-teleological nature of open economic systems. Neither Bastiat in the broken windows fallacy nor Hayek in Austrian capital theory assume that there are known combinations and outcomes that external intervention can achieve, even in situations where it appears like there is underemployment/excess capacity. As Jonathan Pearce said at Samizdata about the debate between Bryan and Matt:
The point is that the issue of “idle resources” or an “output gap” only makes sense if you start from the position of assuming that there is an optimum amount of economic activity to be had, and that supposedly clever central bankers (try not to laugh please) know what this “gap” is and have the skills to fill it. Given the manifest failings of Keynesianism – and arguably also some of the cruder forms of monetarism – it seems those who want to push this approach are under an onus of proof.
Bastiat continues to be relevant to the extent that his arguments (and Smith’s, and other classical liberal economists, as Bryan notes) expose some of these essential assumptions that are really not borne out upon reflection. Yes, his examples may be dated and his arguments and examples are simplified, but isn’t simplification necessary for any kind of model of complex phenomena? If we are going to critique simplification, we have to critique all of analytical narrative and all of science while we’re at it. Simplification does not necessarily disqualify an argument; remember statistician George Box’s observation that “all models are wrong, but some are useful”. The useful ones make simplifying assumptions that abstract from less important details. This observation ties back around to the Austrian critique of Keynesian stimulus models, which rely on the assumptions that input heterogeneity and complementarity are unimportant and that desired macroeconomic outcomes are knowable.
Bastiat’s value-added: He elegantly exposes popular arguments’ absurdity, then reminds us that public policies are based on popularity, not truth.
My value-added: Building on Bastiat’s giant shoulders, I point out that most wonks used to be normal people. They initially embraced popular policies for absurd reasons. It is remarkable, then, that wonks continue to largely support the same policies as normal people.
This exchange has clarified my thinking about both Bastiat and critiques of Keynesian models and policies.
To return to Steve’s initial post, I have not done it justice in my excerpts. In particular, he elaborates on the political economy of how the limited knowledge of politicians about how best to do stimulus leads them to make government spending decisions through a lobbying-influenced political process more than they would if they did have better knowledge.