TIME AND MONEY
An Agenda For Macroeconomics
Adopting a means-ends framework for macroeconomic
theorizing is a way of emphasizing the critical time dimension--the time
that elapses between the employment of means and the achievement of ends.
In a modern, decentralized, capital-intensive economy, the original means
and the ultimate ends are linked by a myriad of decisions of intervening
entrepreneurs. As the market process moves forward, each entrepreneur is
guided by circumstances created by the past decisions of all entrepreneurs
and by expectations about the future decisions of consumers and of other
entrepreneurs. These are the decisions associated with what Ludwig Lachmann
(1986: 61) has called a network of plans. The concretization of these plans
gives rise to a capital structure, which we will call--to emphasize the
time dimension--the intertemporal structure of capital.
macroeconomics, then, concerns itself with two critical aspects of economic
reality: the intertemporal capital structure and entrepreneurial expectations.
Mainstream macroeconomics has long ignored the first-mentioned aspect but
has become keenly attentive--almost obsessively attentive--to the second.
On my interpretation, Lachmann's writings argue for a better balance of
attention and suggest that the mainstream's overemphasis of expectations
is directly related to its underemphasis of capital structure.
WHAT ABOUT EXPECTATIONS?
There is some dispute concerning the Austrian
school's attention to expectations as evidenced by conflicting perspectives
on the writings of Ludwig von Mises: "Mises always emphasized the role
of expectations" (Phelps, 1970b: 129); "Mises hardly ever mentions expectations"
(Lachmann, 1976: 58). Is it possible that these seemingly opposing pronouncements
are somehow both true? The "always" and even the "hardly ever" (Lachmann
didn't say "never") make us suspect that both involve overstatement. But
the validity of each derives from the different alternative treatments
of expectations to which Misesian economics is being compared. Phelps was
providing a contrast to the 1960s view of the tradeoff between inflation
and unemployment. The idea that this tradeoff is a stable one and that
it provides a menu of social choice for policy-makers requires a wholesale
neglect of expectations. Lachmann was providing a contrast to the 1930s
view of investment in an uncertain world. Equilibration, according to the
Swedish economists, involves a playoff between expected and realized values
of the level of investment; persistent disequilibrium, according to Keynes,
is attributable to the absence of any relevant and timely connection between
long-term expectations and underlying economic realities. In comparison
to Keynes and even the Swedes, Mises underemphasized expectations. This
was Lachmann's judgment.
a letter of August 1989, Lachmann posed to me a direct question about Mises's
and Hayek's neglect of expectations (a neglect he referred to in a subsequent
letter as "a simple matter of historical fact"). "Do you agree with me
that in the 1930s Hayek and Mises made a great mistake in neglecting expectations,
in failing to extend Austrian subjectivism from preferences to expectations?"
His particular phrasing of this question links it directly to his 1976
article, in which he traced the development of subjectivism "From Mises
to Shackle." Also, Lachmann's question was a leading question, followed
immediately with "What, in your view, are the most urgent tasks Austrians
must now address?" Lachmann himself had spent several decades grappling
with expectations. He recognized in an early article ( 1977) that
expectations in economic theorizing present us with a unique challenge.
They cannot be regarded as exogenous variables. We must be able to give
some account of "why they are what they are" (65). But neither can expectations
be regarded as endogenous variables. To do so would be to deny their inherent
subjectivist quality. This challenge always emphasized but never actually
met by Lachmann has been dubbed the "Lachmann problem" by Roger Koppl (1998:
response to Lachmann did not deal head-on with the Lachmann problem but
focused instead on Hayek and Keynes and derived from considerations of
strategy. Hayek was trying to counterbalance Keynes, whose theory featured
expectations but neglected capital structure. Without an adequate theory
of capital, expectations became the wild card in Keynes's arguments. Guided
by his "vision" of economic reality, a vision that was set in his mind
at and early age, he played this wild card selectively--ignoring expectations
when the theory fit his vision, relying heavily on expectations when he
had to make it fit. Hayek's countering strategy is made clear in his Pure
Theory of Capital (1941: 407ff.): "[Our] task has been to bring out
the importance of the real factors [as opposed to the psychological factors],
which in contemporary discussion are increasingly disregarded." But in
countering Keynes's "expectations without capital theory," Hayek produced--or
so it could be argued--a "capital theory without expectations." In response
to Lachmann's question about the most urgent tasks, I suggested that we
need to put capital theory (with expectations) back into macroeconomics
and that my inspiration for working in this direction was Lachmann's own
I saw then as inspiration I see now as legacy. Though exhibiting increasing
emphasis on the uncertain future and decreasing confidence that the market's
equilibrium tendencies will prevail, Lachmann's writings--from his 1943
"Role of Expectations" article, to his 1956 Capital and Its Structure
to his 1986 The Market as An Economic Process--were focused sharply
on both capital and expectations. During the three decades that separated
the two books, his own thinking grew ever closer to Shackle's. The macroeconomy
to him became the kaleidic society. The existence of equilibrating forces
was not in doubt. But neither was the existence of disequilibrating forces.
And there was no way to know which, in the end, would win out. Among Austrian
economists, Lachmann was virtually alone in his agnosticism about the ability
of the market economy to coordinate.
Lachmann's legacy is to bear fruit, today's Austrian macroeconomists will
have to allow their thinking to be guided by the question "What about capital?"
But as a preliminary task, they will have to respond effectively to the
question that has become the litmus test for modern macroeconomic theorizing:
"What about expectations?"
what about expectations in today's macroeconomics? In earlier decades,
this question could be asked out of concern about emphasis--too little
or too much? But more recently the question is posed impishly--with serious
doubts that any theory that does not feature so-called rational expectations
can survive a candid response. The question has gotten the attention in
recent years of defenders as well as critics of Austrian theory and particularly
of the Austrian theory of the business cycle. But as we have seen, the
challenge itself is not new to the Austrians. Hayek ( 1975) dealt
early on with "Price Expectations, Monetary Disturbances, and Malinvestments."
Lachmann ( 1977 and 1945) raised the issue anew--and with a hint
of impishness--arguing that the treatment (or neglect) of expectations
in Mises's account of business cycles constitutes the Achilles' heel of
the Austrian theory. Mises's glib response (1943), in which he acknowledged
an implicit assumption about expectations (their being fairly elastic),
suggested that he did not take Lachmann's critical assessment to be a particularly
hard-hitting one. More recently, however, critics within the Austrian school
(e.g., Butos, 1997) have charged that modern Austrian macroeconomists ignore
expectations or, at least, do not deal adequately with them.
defenders of the Austrian theory are often put on the spot to respond to
these critics in a way that (1) recognizes the treatment of expectations
as the sine qua non of business cycle theory it has come to be in
modern macroeconomics, (2) reconciles the Austrian view with the kernel
of truth in the rational expectations theory, and (3) absolves modern expositors
of Austrian business cycle theory for not giving expectations their due.
There is no direct answer, of course, that will satisfy the modern critic
who issues the challenge in the form of the rhetorical question: "What
about expectations?"--hence the impish tone with which it is posed.
my response to Lachmann in 1989 focused on the strategic considerations
made by Hayek in his battle with Keynes, my reply to the imps of the 1990s
hinges on the fact that Hayek lost the battle. Reflection reveals that
this question, or, more accurately, the context in which it is asked, is
wholly anachronistic. Modern treatments of expectations, which can be understood
only in the context of the macroeconomics that grew out of the Keynesian
revolution, cannot simply be grafted onto the Austrian theory, whose origins
predate Keynes and whose development entailed an explicit rejection of
Keynes's aggregation scheme. Accordingly, a brief history of macroeconomic
thought is prerequisite to a satisfactory answer to any question about
the role of expectations in the Austrian theory of the business cycle.
THE KEYNESIAN SPUR
It was in the 1930s that macroeconomics and,
with it, business cycle theory, broke away as a separate subdiscipline.
To describe the breakaway, some writers use terms such as "Keynesian detour"
or "Keynesian diversion," which suggest that the path of development was,
for a time, less direct than it might have been; my "Keynesian spur" (analogous
to a spur line of a railway) suggests development in the direction of a
dead end. As Keynesianism worked its way through the profession, macroeconomics
came to be defined not as a set of issues concerning the overall performance
of the economy but as a particular way of theorizing about the economy.
For purposes of gauging the economy's ability to employ resources, the
new macroeconomics focused on the aggregate demand for output relative
to the economy's potential output. For purposes of dealing with the issue
of stability and charting the dynamic properties of the economy (such as
those implied by the multiplier-accelerator process), the output of investment
goods was separated from the output of consumption goods: Investment is
the unstable component, and consumption is the stable component of aggregate
demand. The summary treatment of inputs was even more severe. Consistent
with the strong labor-market orientation, inputs were treated as if they
consisted exclusively of labor or could be reckoned in labor-equivalent
terms. The structure of capital was assumed fixed, the extent of its actual
utilization changing in virtual lockstep with changes in the employment
of labor. Income earned by workers was reckoned as the going wage rate
times the number of (skill-adjusted) worker hours, and changes in labor
income were taken to imply proportional changes in total income.
out of the macroeconomic picture was any notion that labor income may move
against other forms of income, as the classical economists had emphasized,
as well as the notion that changes in the structure of capital--more of
some kinds, less of other kinds--may figure importantly in the economy's
overall performance. These changes in relative magnitudes, by virtue of
their being relative changes, were no part of the new macroeconomics. In
fact, it was the masking of all the economic forces that assert themselves
within the designated aggregate magnitudes, particularly those that
are at work within the investment aggregate, that allowed macroeconomics
to make such a clean break from the pre-Keynesian modes of thought.
simplicity was achieved in part by the aggregation per se and in
part by the fact that the featured input aggregate was labor rather than
capital. All the thorny issues of capital--involving unavoidable ambiguities
in defining it, measuring it, and theorizing about it--were set aside as
the simpler issues of labor became the near-exclusive focus. The preeminence
of labor in this regard seemed almost self-justifying not only on the grounds
of its relative simplicity but also on the grounds that it is our concern
for workers, after all, and their periodically falling victim to economy-wide
bouts of unemployment that justify our study of macroeconomic phenomena.
Despite its being descriptively accurate, "labor-based macroeconomics"
is a term not in general use today but only because virtually all modern
macroeconomics is labor-based.
few noncontroversial propositions about spending on consumption goods as
it relates to aggregate income is enough to establish a clear dependence
of aggregate demand and hence aggregate income on investment spending,
which--absent capital theory--seems to be rooted in psychology rather than
in economics (Keynes, 1936: 161-63). It follows in short order that an
economy dominated by such a dependency and constricted by an assumed fixity
of the wage rate is inherently unstable. Movements in the investment aggregate,
up or down, give rise to magnified movements--in the same direction--of
income and consumption. Classical theory is reduced to the minimal role
of identifying the level of income that constitutes full employment, implying
that changes in the Keynesian aggregates are real changes for levels below
full employment and nominal changes for levels above.
comparison of the Keynesian analytics with those that predate the breakaway
of macroeconomics confirms that what counts in classical theorizing is
the interplay among landlords, workers, capitalists, and entrepreneurs.
Relative and sometimes opposing movements of the incomes associated with
these four categories gives the economy its stability. For Keynes, all
such relative movements were downplayed or ignored. It is as if an automotive
engineer, in his quest for analytical simplicity, had modeled a four-wheeled
vehicle as a wheelbarrow and then declared it inherently unstable. To impose
stability on the Keynesian wheelbarrow, some external entity would have
to have a firm grip on both handles. Those handles, of course, took the
form of fiscal policy and monetary policy. The mixed economy, whose market
forces are continually countered by policy activism, could achieve a level
of performance that a wholly private macroeconomy could never be able to
achieve on its own. If sufficiently enlightened about the inherent flaws
of capitalism, the fiscal and monetary authorities could keep the Keynesian
wheelbarrow between the hedgeposts of unemployment and inflation.
simple in the extreme, highly aggregative, labor-based macroeconomics was
ripe for development. Questions about each of the aggregates and their
relations to one another gave rise to virtually endless variations on a
theme. What about consumer behavior? Beyond the simple linear relationship
with current income, consumers may behave in accordance with the relative-income
hypothesis (Duesenberry), the life-cycle hypothesis (Modigliani), or the
permanent-income hypothesis (Friedman). What about the interest elasticity
of the demand for money and of the demand for investment funds? Different
assumptions, as might apply in the short run and the long run, allowed
for some reconciliation between Keynesian and Monetarist views. What about
wealth effects? What about investment lags? What about differential stickiness
between wages and prices?
"what-about" questions served to enrich the research agenda of macroeconomics
in all directions. The highly aggregative, labor-based macroeconomics survived
them all, even thrived on them, by providing answers that set the stage
for still more what-about questions. Even the critical question, "What
about the real-cash-balance effect?," whose answer initially separated
the Keynesians from the classicists, ultimately worked in favor of policy
activism. The Keynesians embraced the notion that the economy could settle
into an equilibrium characterized by persisting unemployment. Critics such
as Haberler, Pigou, and eventually Patinkin argued that falling wages and
prices would increase the real value of money holdings and that the spending
out of these real cash balances would restore the economy to full employment.
That is, even with all the other equilibrating forces buried deep in Keynes's
macroeconomic aggregates, there remained a single margin (between money
and output) on which to achieve a full-employment equilibrium. Real cash
balances became, in effect, a balancing act that allowed the market economy
to ride the Keynesian wheelbarrow as if it were a unicycle! Keynesians
could concede the theoretical point while making the classically oriented
critics look impractical if not downright foolish. If the critics willingly
accepted Keynes's aggregation scheme, they would have to accept the policy
implication of his theory as well. Considerations of practicality strongly
favor a policy activism that takes the macroeconomy to be a Keynesian wheelbarrow
rather than a policy of laissez-faire that presumes it to be a classical
one exception to the agenda-expanding queries was the question that eventually
came to be dreaded by practitioners of the new macroeconomics: What about
expectations? In the face of the Monetarist counterrevolution and particularly
the introduction of the expectations-augmented Phillips curve, it was no
longer acceptable to assume that workers expect stable prices even as their
real wage rate is being continually and dramatically eroded by inflation.
The notion of a stable downward-sloping Phillips curve was no longer possible
to maintain. Allowing workers to adjust their expectations of next year's
rate of inflation on the basis of last year's experience did not much improve
the theory's logical consistency or preserve its policy implications. The
short-run Phillips curve was not exploitable in any welfare-enhancing sense.
Even half-serious attempts to answer the question about expectations led
to a contraction rather than an expansion of the research program. Logically
consistent and rigorous answers led to a virtual implosion. If macroeconomists
could provide simple answers to the what-about questions, why couldn't
market participants? Some entrepreneurs and speculators could literally
figure out the same things that the macroeconomists had figured out. Others
could mimic these macro-savvy market participants, and still others could
eventually catch on if only by stumbling around in an economy where the
highest profits go to those most in the know. Any theory about systematic
macroeconomic relationships and certainly any policy recommendation would
have to be based on the assumption of rational expectations.
the rational-expectations theory had the effects of bringing long-run conclusions
into the short run (Maddock and Carter, 1982), denying the possibility
of using fiscal and monetary policy to stimulate or stabilize the economy
(Sargent and Wallace, 1975 and 1976), and--despite the fact that these
ideas were an outgrowth of Monetarism--questioning the importance of money
in theorizing about the macroeconomy (Long and Plosser, 1982). The sequential
attempts to deal with expectations became more and more directed towards
preserving the internal logic of macroeconomics at the expense of maintaining
a link between macroeconomic theory and macroeconomic reality. All too
soon, the very idea of business cycles was purged of any meaning that might
connect this term with actual historical events.
in the hands of the new classical economists, who tend to judge all other
macroeconomic theories in terms of their treatment of expectations, lost
the flavor but not the essence of its highly aggregative forerunners. The
1970s witnessed a search by macroeconomists for their microeconomic moorings.
That is, recognizing that macroeconomics had pulled anchor in the 1930s
and had been adrift for four decades, they sought to re-anchor it in the
fundamentals. The actual movement back to the fundamentals, however, affected
form more than substance. The macroeconomic aggregates were replaced by
representative agents. But the illusion of these agents forming expectations,
making choices and otherwise doing their own thing is just that, an illusion.
Kirman (1992: 119) refers to this mode of theorizing as "primitive [and]
the representative agent represents is the aggregate. Further, the things
that the agent is imagined to be doing leave little scope for theorizing
at either a microeconomic or a macroeconomic level. Phelps (1970a: 5),
who pioneered this search for microfoundations, clearly recognized the
nature of the new classical theorizing: "On the ice-covered terrain of
the Walrasian economy, the question of a connection between aggregate demand
and the employment level is a little treacherous." The terrain is featureless,
and the individuals, a.k.a. agents, are indistinguishable from the
representative agent. (One is reminded of the once-popular poster showing
ten thousand penguins dotting an ice-scape--with an anonymous penguin in
the back ranks belting out the title bar of I Gotta Be Me.) In typical
new classical models, the ice-scape is an especially bleak one, allowing
for the existence of only one commodity. And to rule out such considerations
as decisions about storing the commodity, leasing it, or capitalizing the
value of its services, the single commodity is itself conceived as a service
indistinguishable from the labor that renders it. This construction eliminates
the need to distinguish even between the input and the output. In order
to keep such an economy from degenerating into autarky, with each penguin
rendering the service to himself, we are to think in terms of some particular
service which, due to technological--or anatomical--considerations, one
penguin has to render to another. "Back-scratching services" is offered
as the paradigm case (Barro, 1981: 83).
their zeal to isolate the issue of expectations and elevate it to the status
they believe it deserves in macroeconomics, the new classical economists
have produced models whose sterility is matched by no other. Theorizing
centers on the question of whether or not a change in the demand for the
commodity is a real change or only a nominal change. The expectation that
a change will prove to be only a nominal one implies that no real supply-side
response is called for; the expectation that a change will prove to be
a real one implies the need for a corresponding reallocation of the representative
penguin's time--between scratching backs and consuming leisure.
order even to raise the issue of cyclical variation in output, new classical
macroeconomists, whose models are constructed to deal explicitly and rigorously
with expectations, must contrive some time element between (1) the observation
of a change in demand and (2) the realization of the true nature (nominal
or real) of the change. A construction introduced by Phelps (1970a: 6)
involves a multiplicity of islands, each with its own underlying economic
realities but all under the province of a single monetary authority. (Here,
we overlook the fact that the very existence of money on the new classical
ice-scape presents a puzzle in its own right.) In accordance with the fundamental
truth in the quantity theory of money, a monetary expansion has a lasting
influence only on nominal variables. Thus, in Phelps' construction, real
changes are local; nominal changes are global. The representative penguin
on a given island observes instantly each change in demand for the service
but discovers only later (on the basis of information from distant islands)
whether the change is nominal or real. The microeconomics of maximizing
behavior in the face of uncertainty allows us to conclude that even before
discovering the true nature of the change in demand, the penguins will
respond to the change as if it were at least partially real. Monetary manipulation,
then, can cause temporary changes in real magnitudes. This is the model
that underlies the new classical monetary misperception theory of the business
alternative development of new classicism, one that avoids the contrived
and theoretically troublesome notion of monetary misperception, simply
denies the existence of business cycles as conventionally conceived--or
as modeled with the aid of the distinction between local and global information.
According to real business cycle theory, what appear to be cyclical variations
in macroeconomic magnitudes are actually nothing more than market adjustments
to randomly occurring technology shocks to the economy--even if the shocks
themselves cannot always be independently identified. Changes in the money
supply have nothing to do with these adjustments (or are an effect rather
than a cause of them). Further, the adjustments take place at an optimum,
or profit-maximizing, pace (Nelson and Plosser, 1983 and Prescott, 1986).
Whereas conventional macroeconomics attempts to track the cyclical variation
of the economy's output around its trend-line growth path, real business
cycle theory denies that trend-line growth can be meaningfully defined.
It holds that actual variations in output reflect variations in the economy's
potential. According to this strand of new classicism (and despite its
being labeled real business cycle theory), movements in the macroeconomy's
input and output magnitudes are not actually cyclical in any economically
another alternative development closely tied to the idea of rational expectation
is one that recognizes the possibility of macroeconomic downturns but denies
any role to misperceptions. The variations in output can be attributed
to certain obstacles (costs) that prevent the instant adjustment of nominal
magnitudes. Technology shocks need not be the only source of change. Changes
in the money supply can affect the economy, too. There are no significant
information lags, but penguins cannot translate changes in demand instantaneously
into the appropriate changes in nominal magnitudes. Prices are sticky.
The stickiness, however, can be explained in terms of optimizing behavior
and rational expectations. So-called menu costs (the costs of actually
producing new menus, catalogs, and price tags) stand in the way of instantaneous
price adjustments. These are the ideas of new Keynesian theory (Ball et
al., 1988)--"Keynesian" because of price stickiness; "new" because the
stickiness is not indicative of irrational behavior. (We will argue in
Chapter 11 that new Keynesian ideas in the context of a complex decentralized
capital-intensive economy are worthy of attention.)
response to the question "What about expectations?" we get new classical
monetary misperception theory, real business cycle theory, and new Keynesian
theory. This is the state of modern macroeconomics. While each of these
theories include rigorous demonstrations that the assumptions about expectations
are consistent with the theory itself, none are accompanied with persuasive
reasons for believing that there is a connection between the theoretical
construct and the actual performance of the economy over a sequence of
booms and busts. Applicability has been sacrificed to rigor. The Keynesian
spur has led us to this dead end.
MEETING THE CHALLENGE TO THE AUSTRIAN THEORY
The very fact that the Austrian theory of the
business cycle is offered as a theory applicable to many actual episodes
of boom and bust--from the Great Depression to the Bush recession--seems
to raise the suspicions of modern critics. If the theory has maintained
its applicability, it obviously has not suffered the implosion that follows
from the attempt to deal adequately--rigorously--with expectations. The
critic imagines that he can stand flat-footed in front of an Austrian business
cycle theorist, ask "What about expectations?" and then step back to watch
the Austrian theory degenerate into some story about back-scratching penguins.
The questioner expects that the Austrian theorist will first grapple ineffectively
for an acceptable answer and then finally realize the true significance
of this implosion-inducing question.
modern Austrians (Butos and Koppl, 1993) have argued that dealing effectively
with expectations may be a matter of doing the right kind of cognitive
psychology. They suggest that Hayek's Sensory Order (1952), which
deals with sensory data in the context of the structure of the human mind,
may be relevant here. In this view, dealing with expectations consists
not of choosing among alternative hypotheses (static, adaptive, rational)
but of providing a theoretical account of the mental process through which
expectations are formed and then integrating this theory with the theory
of the business cycle. It is as if we must begin our story with photons
striking the retinas of the entrepreneurs and end it with the ticker tape
reporting the consequent capital gains and losses. This interdisciplinary
exercise may well have some payoffs. But surely it is doubtful that such
a merging of cognitive psychology and macroeconomics would provide answers
that would satisfy the critics for whom rational expectations have become
a bedrock assumption.
light of the evolution of modern macroeconomic thought (from its break
with the rest of economics and particularly with capital theory, to its
simplification on the basis of the now-conventional macroeconomic aggregates,
to its blossoming in the hands of practitioners exploring the many variations
on a theme, to its eventual implosion in the face of embarrassing questions
about expectations), the Austrians are ill-advised to take the question
about expectations at face value. "What about expectations?" proved to
be an embarrassing question for conventional macroeconomists; it need not
be an embarrassing one for Austrian economists, whose theory has not suffered
the same evolutionary fate. Further, the Austrians can hardly be expected
to resist embarrassing the modern business cycle theorists by simply turning
the impish question around and asking: "Expectations about what?" About
changes in the overall levels of prices and wages? About price and quantity
changes in a one-commodity world as perceived by a representative agent?
About real and nominal changes in the demand for back scratching? It should
go without saying that a satisfactory answer to the "Expectations about
what?" question is a strict prerequisite to a satisfactory answer to the
"What about expectations?" question. And for the Austrians, the prerequisite
question is to be answered in terms of the macroeconomics that predates
its breaking away from the fundamentals.
the Austrian view, the issues of macroeconomics are inextricably bound
up with the issues of microeconomics and particularly with capital theory.
The entrepreneurs, no one of whom is representative of the economy as a
whole, influence and are influenced by one another as they bid for resources
with which to carry out or possibly to modify their production plans. Conflicting
plans involving the provision of immediately consumable services, such
as Barro's back scratching, can be quickly reconciled as potential consumers
make decisions about whether to purchase this service or to consume leisure
and as they choose among the alternative providers of it. If an economy
could be usefully modeled as the market for a single service provided by
a representative supplier, there would not likely be any issues that would
give macroeconomics a distinct subject matter. Important macroeconomic
issues arise precisely to the extent that the economics of back scratching
is not the paradigm case, which is to say, to the extent that inputs
and outputs are not temporally coincident. If resources must be committed
well before the ultimate satisfaction of consumer demand, then capital
goods in some form must exist during the period that spans the initial
expectations of the entrepreneur and the final choices of consumers. These
capital goods can be conceived to include human capital as well as capital
in the more conventional sense and to include durable capital goods as
well as capital in the sense of goods in process.
is useful to think of the production process as being divided into stages
of production such that the output of one stage is sold as input to a subsequent
stage. Hayek ( 1967) employed a simple right triangle to depict the
capital-using economy--which gave him a leg up on Keynes, who paid no attention
to production time. This little piece of geometry will become a key element
of our capital-based macroeconomic model in Chapter 3. One leg of the triangle
represents consumer spending, the macroeconomic magnitude that had the
attention of both Keynes and Hayek; the other leg tracks the goods-in-process
as the individual plans of producers transform labor and other resources
into the goods that consumers buy. In Hayek's construction, human capital
and durable capital are ruled out for the sake of keeping the theory tractable
and developing a heuristic model, leaving us with the relatively simple
conception of capital as goods in process with a sequence of entrepreneurs
having command over these goods as they mature into consumable output.
Still, there is a nontrivial answer to the "Expectations about what?" question.
Complicating matters, however, is the fact that the sequence of stages
is far from linear: There are many feedback loops, multiple-purpose outputs,
and other instances of nonlinearities. Further, each stage may also involve
the use of durable--but depreciating--capital goods, relatively specific
and relatively nonspecific capital goods, and capital goods that are related
with various degrees of substitutability and complementarity to the capital
goods in other stages of production. These are the complications emphasized
by Lachmann in his
Capital and Its Structure.
is this context in which the Austrians can address the "Expectations about
what?" question. The proximate objects of entrepreneurial expectations
relevant to a particular stage of production include prices of inputs,
which are the outputs of earlier stages, and prices of outputs, which are
inputs for subsequent stages. The expected price differentials (between
inputs and outputs) have to be assessed in the light of current loan rates
and of alternative uses of existing capital goods. And judgments have to
be made about possible changes in credit conditions and in the market conditions
for the eventual consumer goods to which a particular stage of production
contributes. Price, wage, and interest-rate changes will have an effect
on entrepreneurs' decisions, and their decisions will have an effect on
prices, wages, and interest rates. This interdependency is what justifies
the general conception of the market as an economic process.
market process facilitates the translation of the underlying economic realities--resource
availabilities, technology, and consumer preferences (including intertemporal
preferences)--into production decisions guided by the expectations of the
entrepreneurs. The process plays itself out differently depending upon
whether the interest rate on which it is based is a faithful reflection
of consumers' time preferences or, owing to credit expansion by the central
bank, a distortion of those preferences. In the first case, the economy
experiences sustainable growth; in the second, it experiences boom and
bust. This, the essence of the Austrian theory of the business cycle (Mises
et al., 1996; Garrison, 1986a), will be presented graphically in
"assumptions" (a more appropriate term here might be "understandings")
about expectations are implicit in the Austrian theory: (1) the entrepreneurs
do not already know--and cannot behave as if they already know--the
underlying economic realities whose changing characteristics are conveyed
by changes in prices, wages, and interest rates, and (2) prices, wages,
and interest rates tend to facilitate the coordination of economic decisions
and to keep those decisions in line with the underlying economic realities.
Thinking broadly in terms of a market solution to the economic problem,
we see that a violation of the first assumption implies a denial of the
problem, while a violation of the second assumption implies a denial that
the market is a viable solution. Taken together, these two assumptions
do not allow us to categorize the Austrians' treatment of expectations
as static, adaptive, or rational, as these terms have come to be used.
But they do allow for a treatment of expectations that is consistent with
the view that there is an economic problem and that the market is,
at least potentially, a viable solution to that problem. And dealing with
expectations in the context of a market process does give us some basis
for a partial solution to the Lachmann problem identified early in this
chapter. Expectations can be regarded as endogenous in a special sort of
way when the market process has been set against itself by policies that
affect the intertemporal allocation of resources.
provides a standard by which the alternative treatments of expectations
can be compared. After all, the idea of rational expectations stemmed from
the recognition that the assumptions of static expectations and even of
adaptive expectations were often inconsistent with the theories in which
they were incorporated. Lucas (1987: 13) refers to the rational expectation
hypothesis as a consistency axiom for economics. As such, the adjective
"rational" refers neither to a characteristic of the market participant
whose expectations are said to be rational nor to a quality of the expectations
per se. It refers to only to the relationship between the assumption
about expectations and the theory in which it is incorporated. The new
classical assumption of rational expectations may well be consistent with
the monetary misperception theory as set out in a Barro-style back-scratching
model. But note that both the assumption and the model are inconsistent
with there being a significant economic problem for which the market might
provide a viable solution. Accordingly, a rational-expectations assumption
plucked from a new classical formulation and inserted into Austrian theory--or
into any other pre-Keynesian theory that affirms the existence of an economic
problem--would involve an inconsistency, and hence, by the standard
of consistency, would no longer be "rational." That is, it is not logically
consistent to claim (1) that there is a representative agent who already
has (or behaves as if he already has) the information about the underlying
economic realities independent of current prices, wage rates and interest
rates and (2) that it is prices, wage rates and interest rates that
convey this information.
distinction between local and global information together with the information
lag that attaches to global information allows for a telling point of comparison
of new classical and Austrian views. In the new classical construction,
this knowledge problem is contrived for the sake of modeling misperception.
The representative agent sees changes in money prices immediately but sees
evidence of changes in the money supply only belatedly. The agent does
not know immediately, then, whether the change in the money prices reflects
a real change or only a nominal change. In the Austrian theory, the treatment
of the knowledge problem rests upon a different distinction between two
kinds of knowledge--a distinction introduced by Hayek for the purpose of
calling attention to the nature of the economic problem broadly conceived.
Hayek (1945b) distinguishes between the knowledge of the particular circumstances
of time and place and knowledge of the structure of the economy. Roughly,
the distinction is one between market savvy and theoretical understanding.
It is not a contrivance for the purposes of modeling misperception but
rather an acknowledgment of the fundamental insight most commonly associated
with Adam Smith: The market economy works without the market participants
themselves having to understand just how it works.
strong version of rational expectations employed by new classicism exhibits
a certain symmetry with the notion of rational planning conceived by advocates
economic centralization. The notions of both rational expectations and
rational planning fail to give adequate recognition to Hayek's distinction
between the two kinds of knowledge. Both employ the term "rational" to
suggest, in effect, that reasonable assumptions about one kind of knowledge
can (rationally) be extended to the other kind. Central planning could
be an efficient means of allocating resources if the planners, who, we
will assume, have a good theoretical understanding of the calculus of optimization,
also had (or behaved as if they had) the knowledge that is actually dispersed
among a multitude of entrepreneurs and other market participants. Symmetrically,
monetary policy would have no systematic effect on markets if entrepreneurs
and other market participants, whose knowledge of the particular circumstances
of time and place are mobilized by those markets, also had (or behaved
as if they had) a theoretical understanding of macroeconomic relationships.
To recognize Hayek's distinction and its significance is simply to acknowledge
that central planning is, in fact, not efficient and that monetary policy
can, in fact, have systematic effects.
with expectations in the context of Hayek's distinction rather than in
the context of the contrived distinction between global and local knowledge
adds a dimension to Austrian economics that can be no part of new classicism.
While the global/local distinction is stipulated to separate two mutually
exclusive kinds of knowledge, the two kinds of knowledge identified by
Hayek exhibit an essential blending at the margin. Market participants
must have some understanding of how markets work, if only to know
that lowering a price is the appropriate response to a surplus and raising
a price is the appropriate response to a shortage. Suppliers of particular
products as well as traders in organized markets have a strong incentive
to understand much more about their respective markets--about current and
expected changes in market conditions and the implications for future prices.
They know enough to make John Muth's (1961) treatment of expectations as
applied to the hog market seem not only "rational" but eminently plausible.
Symmetrically, economists-cum-policy-makers must have some knowledge
about the particulars of the economy in order to apply their theories to
various existing circumstances. And to prescribe policies aimed at a particular
goal, such as a specific unemployment rate or inflation rate, they would
have to have a substantial amount of market information--about how changes
in actual market conditions affect, for instance, the demand for labor
and the demand for money.
the extent of the overlap is itself a matter of costs and benefits as experienced
differentially by policy-makers and by market participants. For policy-makers,
additions to their theoretical understanding are likely to be strongly
complementary to existing understandings and may even have synergistic
effects, while additional knowledge of the particular circumstances of
time and place would likely involve high costs and low benefits. A symmetrical
statement can be made about entrepreneurs with respect to costs and benefits
of increased market savvy as compared to increased theoretical understanding.
In general, specialists in one kind of knowledge experience sharply rising
costs of--and sharply declining benefits to--the other kind of knowledge.
Putting the matter in terms of costs and benefits suggests that the actual
and/or perceived costs and benefits can change. Undoubtedly, the extent
to which policy-makers and market participants make use of both
kinds of knowledge is dependent on the institutional setting and the policy
regime. A change in the direction of increased policy activism on the part
of the central bank, for instance, will increase the benefits to entrepreneurs
and other market participants of their understanding the short- and long-run
relationships linking money growth to interest rates, prices, and wages.
Stated negatively, entrepreneurs who experience a sequence of episodes
in which the central bank is implementing stabilization policy or attempting
to "grow the economy" may face a high cost of not understanding
how money-supply decisions affect the market process.
is an overlap between the two kinds of knowledge and the extent of the
overlap is itself a result of the market process. These aspects of Austrian
theory have no counterpart in new classical theory. Expectations will be
based on the knowledge of particular circumstances of time and place plus
the understanding that corresponds to the overlap. Expectations are not
rational in the strong sense of that term, but they do become more rational
with increased levels of policy activism and with cumulative experience
with the consequences of it. Equivalently stated, expectations are adaptive,
but they adapt not just to changes in some particular price, wage rate,
or interest rate, but also to the changing level of understanding that
corresponds to the overlap. Finally and significantly, further development
of the issue of expectations in the context of two kinds of knowledge and
the market as an economic process will involve an expansion rather than
an implosion of the Austrian research program.
WHAT ABOUT CAPITAL?
If we think in terms of market solutions to economic
problems, we must accord expectations a crucial role. But that role is
overplayed if it is assumed that expectations come ready made on the basis
of information that is actually revealed only as the market process unfolds;
it is underplayed if it is assumed that expectations are and forever remain
at odds with economic realities despite the unfolding of the market process.
Either assumption would detract from the equally crucial role played by
the market process itself, which alone can continuously inform expectations.
On reflection, we see that the near-obsessive focus on expectations in
modern labor-based macroeconomics owes much to the sterility of the theoretical
constructions. There is simply not much of anything else to focus upon.
about capital? Much of Austrian theory is aimed--either directly or indirectly--at
providing a satisfying answer to this question. And macroeconomists who
think in terms of entrepreneurial decisions in the context of a complex
intertemporal capital structure have at the same time written much "about"
expectations--even if that very word does not appear in their every sentence.
Ludwig Lachmann's attention to expectations was always explicit as was
his attention to capital and its structure. Accordingly, we can credit
him for setting an important agenda for macroeconomics. As the following
chapters are designed to show, capital-based macroeconomics with due attention
to entrepreneurial expectations and the market process can achieve a richness,
a relevance and a plausibility that are simply beyond the reach of the
modern labor-based macroeconomics and its assumption of rational expectations.