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Recorded at the Mises Institute in Auburn, Alabama, on 27 July 2023.

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Original Article: "Why Mises’s Theory of Economic Calculation Still Is Relevant Today"

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Original Article: "Socialism Isn't about Creating Economies. It Is about Amassing Political Power"

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Wendell Berry, a poet, novelist, and philosopher well known for his protests against mechanized agriculture and for his defense of the “land ethic,” is not a thinker one would immediately associate with Ludwig von Mises, and indeed, in economic theory the two are far apart. But there is nevertheless a passage in Mises’s Socialism that is central to Berry’s concerns.

The passage I have in mind is this:

When society’s existence is threatened, each individual must risk his best to avoid destruction. Even the prospect of perishing in the attempt can no longer deter him. For there is then no choice between either living on as one formerly lived or sacrificing oneself for one’s country, for society, or for one’s convictions. Rather, must the certainty of death, servitude, or insufferable poverty be set against the chance of returning victorious from the struggle. War carried on pro aris et focis [for hearth and home] demands no sacrifice from the individual. One does not engage in it merely to reap benefits for others, but to preserve one’s own existence.

Berry uses a similar idea to explain and defend the South’s standpoint in the Civil War, but he does not do so in the way one might expect. Far from extolling the virtues of antebellum slavery, he condemns it as a grievous sin. In this connection, he makes an interesting criticism of John C. Calhoun, who deemed manual labor beneath the dignity of gentlemen, fit only for slaves. Berry argues that it was in part the unwillingness of elements among the Southern planter elite to acknowledge the virtue of work that led them to turn away from the Jeffersonian position that slavery is a great evil. In this connection, Berry quotes John Quincy Adams, a great opponent of slavery whom he admires: “I told Calhoun I could not see things in the same light—It is in truth all perverted sentiment—mistaking labor for slavery, and dominion for Freedom” (Adams, quoted on p. 298).

If slavery was wrong, why, then, does Berry defend the South’s position in the Civil War? His answer is that the great bulk of those who fought for the South did so not to entrench slavery but rather to protect their land and homes from invasion: “But from the point of view of the Confederate soldiers, the great fact of the war, once it had begun, was that their country had been, and was going to be invaded. They shared with [Robert E.] Lee a settled determination to defend their homelands and their people” (p. 203).

In arguing in this way, Berry agrees with Murray Rothbard, another thinker not usually coupled with him. Like Berry, Rothbard argues that the Southerners were defending their lands from invasion:

In 1861, the Southern states, believing correctly that their cherished institutions were under grave threat and assault from the federal government, decided to exercise their natural, contractual, and constitutional right to withdraw, to “secede” from that Union. The separate Southern states then exercised their contractual right as sovereign republics to come together in another confederation, the Confederate States of America. If the American Revolutionary War was just, then it follows as the night the day that the Southern cause, the War for Southern Independence, was just, and for the same reason: casting off the “political bonds” that connected the two peoples. In neither case was this decision made for “light or transient causes.” And in both cases, the courageous seceders pledged to each other “their lives, their fortunes, and their sacred honor.”

If it is objected that without the war, the end of slavery might have been indefinitely postponed, Berry admits that he has no easy answer but that he does know that the violence of war exacts tremendous costs. He reminds us that the “crusade” mentality led to later disasters:

[The Civil War] remains popularly credited as the solution, entirely good, of our worst national problem. So successful were we at solving our own great problem that we have generously undertaken to solve international problems and the problems of other nations also by force of war and with the same assurance of our goodness in doing so. If we have a sort of notion of preventability, we are not long detained by it. We appear never to bother with the question of net good. We went to war in Iraq and Afghanistan as if such questions could not be asked, as if no useless war had ever been fought, and in a nationalist confusion of pride, fear, moral certainty, and (never dismissible) the allure of profits in the war industries. (p. 85)

In condemning the stern moralism of the Northern aggressors, Berry again finds himself at one with Rothbard.

The Civil War seems to me to have been, to an extent sufficiently noticeable, a conflict of patriotism, which is to say love for one’s actual country or the land under one’s feet, against nationalism, which is to say allegiance just short of worship to a political idea or ideal and to a government. The difference is well illustrated by the anthems of the two sides: the jaunty “Dixie,” which celebrates the “land where I was born,” versus “The Battle Hymn of the Republic,” a hymn sure enough of a sanctified nationalism, in which the misfortunate Jesus once again shows up in uniform. (p. 250)

In like fashion, Rothbard says:

The Northern war against slavery partook of fanatical millennialist fervor, of a cheerful willingness to uproot institutions, to commit mayhem and mass murder, to plunder and loot and destroy, all in the name of high moral principle and the birth of a perfect world. The Yankee fanatics were veritable [Isabel] Patersonian humanitarians with the guillotine: the Anabaptists, the Jacobins, the Bolsheviks of their era. This fanatical spirit of Northern aggression for an allegedly redeeming cause is summed up in the pseudo-Biblical and truly blasphemous verses of that quintessential Yankee Julia Ward Howe, in her so-called “Battle Hymn of the Republic.”

We have much to learn from Berry’s profound defense of the local and particular against militarism and fanaticism.

The prices of goods and services are either historical data describing past events or anticipations of probable future events. Information about a past price conveys the knowledge that one or several acts of interpersonal exchange were effected according to this ratio. It does not convey directly any knowledge about future prices. We may often assume that the market conditions which determined the formation of prices in the recent past will not change at all or at least not change considerably in the immediate future so that prices too will remain unchanged or change only slightly.

Such expectations are reasonable if the prices concerned were the result of the interaction of many people ready to buy or to sell provided the exchange ratios seemed propitious to them and if the market situation was not influenced by conditions which are considered as accidental, extraordinary, and not likely to return. However, the main task of economic calculation is not to deal with the problems of unchanging or only slightly changing market situations and prices, but to deal with change. The acting individual either anticipates changes which will occur without his own interference and wants to adjust his actions to this anticipated state of affairs; or he wants to embark upon a project which will change conditions even if no other factors produce a change. The prices of the past are for him merely starting points in his endeavors to anticipate future prices.

Historians and statisticians content themselves with prices of the past. Practical man looks at the prices of the future, be it only the immediate future of the next hour, day, or month. For him the prices of the past are merely a help in anticipating future prices. Not only in his preliminary calculation of the expected outcome of planned action, but no less in his attempts to establish the result of his past transactions, he is primarily concerned with future prices.

In balance sheets and in profit-and-loss statements the result of past action becomes visible as the difference between the money equivalent of funds owned (total assets minus total liabilities) at the beginning and at the end of the period reported, and as the difference between the money equivalent of costs incurred and gross proceeds earned. In such statements it is necessary to enter the estimated money equivalent of all assets and liabilities other than cash. These items should be appraised according to the prices at which they could probably be sold in the future or, as is especially the case with equipment for production processes, in reference to the prices to be expected in the sale of merchandise manufactured with their aid.

However, old business customs and the provisions of commercial law and of the tax laws have brought about a deviation from sound principles of accounting which aim merely at the best attainable degree of correctness. These customs and laws are not so much concerned with correctness in balance sheets and profit-and-loss statements as with the pursuit of other aims. Commercial legislation aims at a method of accounting which could indirectly protect creditors against loss. It tends more or less to an appraisal of assets below their estimated market value in order to make the net profit and the total funds owned appear smaller than they really are. Thus a safety margin is created which reduces the danger that, to the prejudice of creditors, too much might be withdrawn from the firm as alleged profit and that an already insolvent firm might go on until it had exhausted the means available for the satisfaction of its creditors.

Contrariwise tax laws often tend toward a method of computation which makes earnings appear higher than an unbiased method would. The idea is to raise effective tax rates without making this rise visible in the nominal tax-rate schedules. We must therefore distinguish between economic calculation as it is practiced by businessmen planning future transactions and those computations of business facts which serve other purposes. The determination of taxes due and economic calculation are two different things. If a law imposing a tax upon the keeping of domestic servants prescribes that one male servant should be counted as two female servants, nobody would interpret such a provision as anything other than a method for determining the amount of tax due. Likewise if an inheritance tax law prescribes that securities should be appraised at the stock market quotation on the day of the decedent's death, we are merely provided with a way of determining the amount of the tax.

The duly kept accounts in a system of correct bookkeeping are accurate as to dollars and cents. They display an impressive precision, and the numerical exactitude of their items seems to remove all doubts. In fact, the most important figures they contain are speculative anticipations of future market constellations. It is a mistake to compare the items of any commercial account to the items used in purely technological reckoning, e.g., in the design for the construction of a machine. The engineer—as far as he attends to the technological side of his job—applies only numerical relations established by the methods of the experimental natural sciences; the businessman cannot avoid numerical terms which are the outcome of his understanding of future human conduct.

The main thing in balance sheets and in profit-and-loss statements is the evaluation of assets and liabilities not embodied in cash. All such balances and statements are virtually interim balances and interim statements. They describe as well as possible the state of affairs at an arbitrarily chosen instant while life and action go on and do not stop. It is possible to wind up individual business units, but the whole system of social production never ceases. Nor are the assets and liabilities consisting in cash exempt from the indeterminacy inherent in all business accounting items. They depend on the future constellation of the market no less than any item of inventory or equipment. The numerical exactitude of business accounts and calculations must not prevent us from realizing the uncertainty and speculative character of their items and of all computations based on them.

Yet, these facts do not detract from the efficiency of economic calculation. Economic calculation is as efficient as it can be. No reform could add to its efficiency. It renders to acting man all the services which he can obtain from numerical computation. It is, of course, not a means of knowing future conditions with certainty, and it does not deprive action of its speculative character. But this can be considered a deficiency only by those who do not come to recognize the facts that life is not rigid, that all things are perpetually fluctuating, and that men have no certain knowledge about the future.

It is not the task of economic calculation to expand man's information about future conditions. Its task is to adjust his actions as well as possible to his present opinion concerning want-satisfaction in the future. For this purpose acting man needs a method of computation, and computation requires a common denominator to which all items entered are to be referable. The common denominator of economic calculation is money.

Economic calculation cannot comprehend things which are not sold and bought against money.

There are things which are not for sale and for whose acquisition sacrifices other than money and money's worth must be expended. He who wants to train himself for great achievements must employ many means, some of which may require expenditure of money. But the essential things to be devoted to such an endeavor are not purchasable. Honor, virtue, glory, and likewise vigor, health, and life itself play a role in action both as means and as ends, but they do not enter into economic calculation.

There are things which cannot at all be evaluated in money, and there are other things which can be appraised in money only with regard to a fraction of the value assigned to them. The appraisal of an old building must disregard its artistic and historical eminence as far as these qualities are not a source of proceeds in money or goods vendible. What touches a man's heart only and does not induce other people to make sacrifices for its attainment remains outside the pale of economic calculation.

However, all this does not in the least impair the usefulness of economic calculation. Those things which do not enter into the items of accountancy and calculation are either ends or goods of the first order. No calculation is required to acknowledge them fully and to make due allowance for them. All that acting man needs in order to make his choice is to contrast them with the total amount of costs their acquisition or preservation requires. Let us assume that a town council has to decide between two water supply projects. One of them implies the demolition of a historical landmark, while the other at the cost of an increase in money expenditure spares this landmark. The fact that the feelings which recommend the conservation of the monument cannot be estimated in a sum of money does not in any way impede the councilmen's decision. The values that are not reflected in any monetary exchange ratio are, on the contrary, by this very fact lifted into a particular position which makes the decision rather easier. No complaint is less justified than the lamentation that the computation methods of the market do not comprehend things not vendible. Moral and aesthetic values do not suffer any damage on account of this fact.

Money, money prices, market transactions, and economic calculation based upon them are the main targets of criticism. Loquacious sermonizers disparage Western civilization as a mean system of mongering and peddling. Complacency, self-righteousness, and hypocrisy exult in scorning the "dollar-philosophy" of our age. Neurotic reformers, mentally unbalanced literati, and ambitious demagogues take pleasure in indicting "rationality" and in preaching the gospel of the "irrational." In the eyes of these babblers money and calculation are the source of the most serious evils. However, the fact that men have developed a method of ascertaining as far as possible the expediency of their actions and of removing uneasiness in the most practical and economic way does not prevent anybody from arranging his conduct according to the principle he considers to be right. The "materialism" of the stock exchange and of business accountancy does not hinder anybody from living up to the standards of Thomas à Kempis or from dying for a noble cause. The fact that the masses prefer detective stories to poetry and that it therefore pays better to write the former than the latter, is not caused by the use of money and monetary accounting. It is not the fault of money that there are gangsters, thieves, murderers, prostitutes, corruptible officials, and judges. It is not true that honesty does not "pay." It pays for those who prefer fidelity to what they consider to be right to the advantages which they could derive from a different attitude.

Other critics of economic calculation fail to realize that it is a method available only to people acting in the economic system of the division of labor in a social order based upon private ownership of the means of production. It can only serve the considerations of individuals or groups of individuals operating in the institutional setting of this social order. It is consequently a calculation of private profits and not of "social welfare." This means that the prices of the market are the ultimate fact for economic calculation. It cannot be applied for considerations whose standard is not the demand of the consumers as manifested on the market but the hypothetical valuations of a dictatorial body managing all national or earthly affairs. He who seeks to judge actions from the point of view of a pretended "social value," i.e., from the point of view of the "whole society," and to criticize them by comparison with the events in an imaginary socialist system in which his own will is supreme, has no use for economic calculation. Economic calculation in terms of money prices is the calculation of entrepreneurs producing for the consumers of a market society. It is of no avail for other tasks.

He who wants to employ economic calculation must not look at affairs in the manner of a despotic mind. Prices can be used for calculation by the entrepreneurs, capitalists, landowners, and wage earners of a capitalist society. For matters beyond the pursuits of these categories it is inadequate. It is nonsensical to evaluate in money objects which are not negotiated on the market and to employ in calculations arbitrary items which do not refer to reality. The law determines the amount which ought to be paid as indemnification for having caused a man's death. But the statute enacted for the determination of the amends due does not mean that there is a price for human life. Where there is slavery, there are market prices of slaves. Where there is no slavery man, human life, and health are res extra commercium. In a society of free men the preservation of life and health are ends, not means. They do not enter into any process of accounting means.

It is possible to determine in terms of money prices the sum of the income or the wealth of a number of people. But it is nonsensical to reckon national income or national wealth. As soon as we embark upon considerations foreign to the reasoning of a man operating within the pale of a market society, we are no longer helped by monetary calculation methods. The attempts to determine in money the wealth of a nation or of the whole of mankind are as childish as the mystic efforts to solve the riddles of the universe by worrying about the dimensions of the pyramid of Cheops. If a business calculation values a supply of potatoes at $100, the idea is that it will be possible to sell it or to replace it against this sum. If a whole entrepreneurial unit is estimated $1,000,000, it means that one expects to sell it for this amount. But what is the meaning of the items in a statement of a nation's total wealth? What is the meaning of the computation's final result? What must be entered into it and what is to be left outside? Is it correct or not to enclose the "value" of the country's climate and the people's innate abilities and acquired skill? The businessman can convert his property into money, but a nation cannot.

The money equivalents as used in acting and in economic calculation are money prices, i.e., exchange ratios between money and other goods and services. The prices are not measured in money; they consist in money. Prices are either prices of the past or expected prices of the future. A price is necessarily a historical fact either of the past or of the future. There is nothing in prices which permits one to liken them to the measurement of physical and chemical phenomena.

Exchange ratios are subject to perpetual change because the conditions which produce them are perpetually changing. The value that an individual attaches both to money and to various goods and services is the outcome of a moment's choice. Every later instant may generate something new and bring about other considerations and valuations. Not that prices are fluctuating, but that they do not alter more quickly could fairly be deemed a problem requiring explanation.

Daily experience teaches people that the exchange ratios of the market are mutable. One would assume that their ideas about prices would take full account of this fact. Nevertheless all popular notions of production and consumption, marketing and prices are more or less contaminated by a vague and contradictory notion of price rigidity. The layman is prone to consider the preservation of yesterday's price structure both as normal and fair, and to condemn changes in the exchange ratios as a violation of the rules of nature and of justice.

It would be a mistake to explain these popular beliefs as a precipitate of old opinions conceived in earlier ages of more stable conditions of production and marketing. It is questionable whether or not prices were less changeable in those older days. On the contrary, it could rather be asserted that the merger of local markets into larger national markets, the final emergence of a world-embracing world market, and the evolution of commerce aiming at continuously supplying the consumers have made price changes less frequent and less sharp. In precapitalistic times there was more stability in technological methods of production, but there was much more irregularity in supplying the various local markets and in adjusting supply to their changing demands. But even if it were true that prices were somewhat more stable in a remote past, it would be of little avail for our age. The popular notions about money and money prices are not derived from ideas formed in the past. It would be wrong to interpret them as atavistic remnants. Under modern conditions every individual is daily faced with so many problems of buying and selling that we are right in assuming that his thinking about these matters is not simply a thoughtless reception of traditional ideas.

It is easy to understand why those whose short-run interests are hurt by a change in prices resent such changes, emphasize that the previous prices were not only fairer but also more normal, and maintain that price stability is in conformity with the laws of nature and of morality. But every change in prices furthers the short-run interests of other people. Those favored will certainly not be prompted by the urge to stress the fairness and normalcy of price rigidity.

Neither atavistic reminiscences nor the state of selfish group interests can explain the popularity of the idea of price stability. Its roots are to be seen in the fact that notions concerning social relations have been constructed according to the pattern of the natural sciences. The economists and sociologists who aimed at shaping the social sciences according to the pattern of physics or physiology only indulged in a way of thinking which popular fallacies had adopted long before.

Even the classical economists were slow to free themselves from this error. With them value was something objective, i.e., a phenomenon of the external world and a quality inherent in things and therefore measurable. They utterly failed to comprehend the purely human and voluntaristic character of value judgments. As far as we can see today, it was Samuel Bailey who first disclosed what is going on in preferring one thing to another.Cf. Samuel Bailey, A Critical Dissertation on the Nature, Measures and Causes of Values (London, 1825), no. 7 in Series of Reprints of Scarce Tracts in Economics and Political Science, London School of Economics (London, 1931). But his book was overlooked as were the writings of other precursors of the subjective theory of value.

It is not only a task of economic science to discard the errors concerning measurability in the field of action. It is no less a task of economic policy. For the failures of present-day economic policies are to some extent due to the lamentable confusion brought about by the idea that there is something fixed and therefore measurable in interhuman relations.

An outgrowth of all these errors is the idea of stabilization.

Shortcomings in the governments' handling of monetary matters and the disastrous consequences of policies aimed at lowering the rate of interest and at encouraging business activities through credit expansion gave birth to the ideas which finally generated the slogan "stabilization." One can explain its emergence and its popular appeal, one can understand it as the fruit of the last hundred and fifty years' history of currency and banking, one can, as it were, plead extenuating circumstances for the error involved. But no such sympathetic appreciation can render its fallacies any more tenable.

Stability, the establishment of which the program of stabilization aims at, is an empty and contradictory notion. The urge toward action, i.e., improvement of the conditions of life, is inborn in man. Man himself changes from moment to moment and his valuations, volitions, and acts change with him. In the realm of action there is nothing perpetual but change. There is no fixed point in this ceaseless fluctuation other than the eternal aprioristic categories of action. It is vain to sever valuation and action from man's unsteadiness and the changeability of his conduct and to argue as if there were in the universe eternal values independent of human value judgments and suitable to serve as a yardstick for the appraisal of real action.For the propensity of the mind to view rigidity and unchangeability as the essential thing and change and motion as the accidental, cf. Bergson, La Pensee et le mouvant, pp. 85 ff.

All methods suggested for a measurement of the changes in the monetary unit's purchasing power are more or less unwittingly founded on the illusory image of an eternal and immutable being who determines by the application of an immutable standard the quantity of satisfaction which a unit of money conveys to him. It is a poor justification of this ill-thought idea that what is wanted is merely to measure changes in the purchasing power of money. The crux of the stability notion lies precisely in this concept of purchasing power. The layman, laboring under the ideas of physics, once considered money as a yardstick of prices. He believed that fluctuations of exchange ratios occur only in the relations between the various commodities and services and not also in the relation between money and the "totality" of goods and services. Later, people reversed the argument. It was no longer money to which constancy of value was attributed, but the "totality" of things vendible and purchasable. People began to devise methods for working up complexes of commodity units to be contrasted to the monetary unit. Eagerness to find indexes for the measurement of purchasing power silenced all scruples. Both the doubtfulness and the incomparability of the price records employed and the arbitrary character of the procedures used for the computation of averages were disregarded.

Irving Fisher, the eminent economist, who was the champion of the American stabilization movement, contrasts with the dollar a basket containing all the goods the housewife buys on the market for the current provision of her household. In the proportion in which the amount of money required for the purchase of the content of this basket changes, the purchasing power of the dollar has changed. The goal assigned to the policy of stabilization is the preservation of the immutability of this money expenditure.Cf. Irving Fisher, The Monetary Illusion (New York, 1928), pp. 19–20. This would be all right if the housewife and her imaginary basket were constant elements, if the basket were always to contain the same goods and the same quantity of each and if the role which this assortment of goods plays in the family's life were not to change. But we are living in a world in which none of these conditions is realized.

First of all there is the fact that the quality of the commodities produced and consumed changes continuously. It is a mistake to identify wheat with wheat, not to speak of shoes, hats, and other manufactures. The great price differences in the synchronous sales of commodities which mundane speech and statistics arrange in the same class clearly evidence this truism. An idiomatic expression asserts that two peas are alike; but buyers and sellers distinguish various qualities and grades of peas. A comparison of prices paid at different places or at different dates for commodities which technology or statistics calls by the same name, is useless if it is not certain that their qualities—but for the place difference—are perfectly the same. Quality means in this connection: all those properties to which the buyers and would-be-buyers pay heed. The mere fact that the quality of all goods and services of the first order is subject to change explodes one of the fundamental assumptions of all index number methods. It is irrelevant that a limited amount of goods of the higher orders—especially metals and chemicals which can be uniquely determined by a formula—are liable to a precise description of their characteristic features. A measurement of purchasing power would have to rely upon the prices of the goods and services of the first order and, what is more, of all of them. To employ the prices of the producers' goods is not helpful because it could not avoid counting the various stages of the production of one and the same consumers' good several times and thus falsifying the result. A restriction to a group of selected goods would be quite arbitrary and therefore vicious.

But even apart from all these insurmountable obstacles the task would remain insoluble. For not only do the technological features of commodities change and new kinds of goods appear while many old ones disappear. Valuations change too, and they cause changes in demand and production. The assumptions of the measurement doctrine would require men whose wants and valuations are rigid. Only if people were to value the same things always in the same way could we consider price changes as expressive of changes in the power of money to buy things.

As it is impossible to establish the total amount of money spent at a given fraction of time for consumers' goods, statisticians must rely upon the prices paid for individual commodities. This raises two further problems for which there is no apodictic solution. It becomes necessary to attach to the various commodities coefficients of importance. It would be manifestly wrong to let the prices of various commodities enter into the computation without taking into account the different roles they play in the total system of the individuals' households. But the establishment of such proper weighting is again arbitrary. Secondly, it becomes necessary to compute averages out of the data collected and adjusted. But there exist different methods for the computation of averages. There are the arithmetic, the geometric, the harmonic averages, there is the quasi-average known as the median. Each of them leads to different results. None of them can be recognized as the unique way to attain a logically unassailable answer. The decision in favor of one of these methods of computation is arbitrary.

If all human conditions were unchangeable, if all people were always to repeat the same actions because their uneasiness and their ideas about its removal were constant, or if we were in a position to assume that changes in these factors occurring with some individuals or groups are always outweighed by opposite changes with other individuals or groups and therefore do not affect total demand and total supply, we would live in a world of stability. But the idea that in such a world money's purchasing power could change is contradictory. As will be shown later, changes in the purchasing power of money must necessarily affect the prices of different commodities and services at different times and to different extents; they must consequently bring about changes in demand and supply, in production and consumption.See below, pp. 411–13. The idea implied in the inappropriate term level of prices, as if—other things being equal—all prices could rise or drop evenly, is untenable. Other things cannot remain equal if the purchasing power of money changes.

In the field of praxeology and economics no sense can be given to the notion of measurement. In the hypothetical state of rigid conditions there are no changes to be measured. In the actual world of change there are no fixed points, dimensions, or relations which could serve as a standard. The monetary unit's purchasing power never changes evenly with regard to all things vendible and purchasable. The notions of stability and stabilization are empty if they do not refer to a state of rigidity and its preservation. However, this state of rigidity cannot even be thought out consistently to its ultimate logical consequences; still less can it be realized.See below, pp. 247–50. Where there is action, there is change. Action is a lever of change.

The pretentious solemnity which statisticians and statistical bureaus display in computing indexes of purchasing power and cost of living is out of place. These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred. In periods of slow alterations in the relation between the supply of and the demand for money they do not convey any information at all. In periods of inflation and consequently of sharp price changes they provide a rough image of events which every individual experiences in his daily life. A judicious housewife knows much more about price changes as far as they affect her own household than the statistical averages can tell. She has little use for computations disregarding changes both in quality and in the amount of goods which she is able or permitted to buy at the prices entering into the computation. If she "measures" the changes for her personal appreciation by taking the prices of only two or three commodities as a yardstick, she is no less "scientific" and no more arbitrary than the sophisticated mathematicians in choosing their methods for the manipulation of the data of the market.

In practical life nobody lets himself be fooled by index numbers. Nobody agrees with the fiction that they are to be considered as measurements. Where quantities are measured, all further doubts and disagreements concerning their dimensions cease. These questions are settled. Nobody ventures to argue with the meteorologists about their measurements of temperature, humidity, atmospheric pressure, and other meteorological data. But on the other hand nobody acquiesces in an index number if he does not expect a personal advantage from its acknowledgment by public opinion. The establishment of index numbers does not settle disputes; it merely shifts them into a field in which the clash of antagonistic opinions and interests is irreconcilable.

Human action originates change. As far as there is human action there is no stability, but ceaseless alteration. The historical process is a sequence of changes. It is beyond the power of man to stop it and to bring about an age of stability in which all history comes to a standstill. It is man's nature to strive after improvement, to beget new ideas, and to rearrange the conditions of his life according to these ideas.

The prices of the market are historical facts expressive of a state of affairs that prevailed at a definite instant of the irreversible historical process. In the praxeological orbit the concept of measurement does not make any sense. In the imaginary—and, of course, unrealizable—state of rigidity and stability there are no changes to be measured. In the actual world of permanent change there are no fixed points, objects, qualities, or relations with regard to which changes could be measured.

Economic calculation does not require monetary stability in the sense in which this term is used by the champions of the stabilization movement. The fact that rigidity in the monetary unit's purchasing power is unthinkable and unrealizable does not impair the methods of economic calculation. What economic calculation requires is a monetary system whose functioning is not sabotaged by government interference. The endeavors to expand the quantity of money in circulation either in order to increase the government's capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation. The first aim of monetary policy must be to prevent governments from embarking upon inflation and from creating conditions which encourage credit expansion on the part of banks. But this program is very different from the confused and self-contradictory program of stabilizing purchasing power.

For the sake of economic calculation all that is needed is to avoid great and abrupt fluctuations in the supply of money. Gold and, up to the middle of the nineteenth century, silver served very well all the purposes of economic calculation. Changes in the relation between the supply of and the demand for the precious metals and the resulting alterations in purchasing power went on so slowly that the entrepreneur's economic calculation could disregard them without going too far afield. Precision is unattainable in economic calculation quite apart from the shortcomings emanating from not paying due consideration to monetary changes.No practical calculation can ever be precise. The formula underlying the process of calculation may be exact; the calculation itself depends on the approximate establishment of quantities and is therefore necessarily inaccurate. Economics is, as has been shown above (p. 39), an exact science of real things. But as soon as price data are introduced into the chain of thought, exactitude is abandoned and economic history is submitted for economic theory. The planning businessman cannot help employing data concerning the unknown future; he deals with future prices and future costs of production. Accounting and bookkeeping in their endeavors to establish the result of past action are in the same position as far as they rely upon the estimation of fixed equipment, inventories, and receivables. In spite of all these uncertainties economic calculation can achieve its tasks. For these uncertainties do not stem from deficiencies of the system of calculation. They are inherent in the essence of acting that always deals with the uncertain future.

The idea of rendering purchasing power stable did not originate from endeavors to make economic calculation more correct. Its source is the wish to create a sphere withdrawn from the ceaseless flux of human affairs, a realm which the historical process does not affect. Endowments which were designed to provide in perpetuity for an ecclesiastic body, for a charitable institution, or for a family were long established in land or in disbursement of agricultural products in kind. Later annuities to be settled in money were added. Endowers and beneficiaries expected that an annuity determined in terms of a definite amount of precious metals would not be affected by changes in economic conditions. But these hopes were illusory. Later generations learned that the plans of their ancestors were not realized. Stimulated by this experience they began to investigate how the aims sought could be attained. Thus they embarked upon attempts to measure changes in purchasing power and to eliminate such changes.

The problem assumed much greater importance when governments initiated their policies of long-term irredeemable and perpetual loans. The state, this new deity of the dawning age of statolatry, this eternal and superhuman institution beyond the reach of earthly frailties, offered to the citizen an opportunity to put his wealth in safety and to enjoy a stable income secure against all vicissitudes. It opened a way to free the individual from the necessity of risking and acquiring his wealth and his income anew each day in the capitalist market. He who invested his funds in bonds issued by the government and its subdivisions was no longer subject to the inescapable laws of the market and to the sovereignty of the consumers. He was no longer under the necessity of investing his funds in such a way that they would best serve the wants and needs of the consumers. He was secure, he was safeguarded against the dangers of the competitive market in which losses are the penalty of inefficiency; the eternal state had taken him under its wing and guaranteed him the undisturbed enjoyment of his funds. Henceforth his income no longer stemmed from the process of supplying the wants of the consumers in the best possible way, but from the taxes levied by the state's apparatus of compulsion and coercion. He was no longer a servant of his fellow citizens, subject to their sovereignty; he was a partner of the government which ruled the people and exacted tribute from them. What the government paid as interest was less than the market offered. But this difference was far outweighed by the unquestionable solvency of the debtor, the state whose revenue did not depend on satisfying the public, but on insisting on the payment of taxes.

In spite of the unpleasant experiences with public debts in earlier days, people were ready to trust freely the modernized state of the nineteenth century. It was generally assumed that this new state would scrupulously meet its voluntarily contracted obligations. Capitalists and entrepreneurs were fully aware of the fact that in the market society there is no means of preserving acquired wealth other than by acquiring it anew each day in tough competition with everybody, with the already existing firms as well as with newcomers "operating on a shoe string." The entrepreneur, grown old and weary and no longer prepared to risk his hard-earned wealth by new attempts to meet the wants of consumers, and the heir of other people's profits, lazy and fully conscious of his own inefficiency, preferred investment in bonds of the public debt because they wanted to be free from the law of the market.

Now, the irredeemable perpetual public debt presupposes the stability of purchasing power. Although the state and its compulsion may be eternal, the interest paid on the public debt could be eternal only if based on a standard of unchanging value. In this form the investor who for security's sake shuns the market, entrepreneurship, and investment in free enterprise and prefers government bonds is faced again with the problem of the changeability of all human affairs. He discovers that in the frame of a market society there is no room left for wealth not dependent upon the market. His endeavors to find an inexhaustible source of income fail.

There are in this world no such things as stability and security and no human endeavors are powerful enough to bring them about. There is in the social system of the market society no other means of acquiring wealth and of preserving it than successful service to the consumers. The state is, of course, in a position to exact payments from its subjects and to borrow funds. However, even the most ruthless government in the long run is not able to defy the laws determining human life and action. If the government uses the sums borrowed for investment in those lines in which they best serve the wants of the consumers, and if it succeeds in these entrepreneurial activities in free and equal competition with all private entrepreneurs, it is in the same position as any other businessman; it can pay interest because it has made surpluses. But if the government invests funds unsuccessfully and no surplus results, or if it spends the money for current expenditure, the capital borrowed shrinks or disappears entirely, and no source is opened from which interest and principal could be paid. Then taxing the people is the only method available for complying with the articles of the credit contract. In asking taxes for such payments the government makes the citizens answerable for money squandered in the past. The taxes paid are not compensated by any present service rendered by the government's apparatus. The government pays interest on capital which has been consumed and no longer exists. The treasury is burdened with the unfortunate results of past policies.

A good case can be made out for short-term government debts under special conditions. Of course, the popular justification of war loans is nonsensical. All the materials needed for the conduct of a war must be provided by restriction of civilian consumption, by using up a part of the capital available and by working harder. The whole burden of warring falls upon the living generation. The coming generations are only affected to the extent to which, on account of the war expenditure, they will inherit less from those now living than they would have if no war had been fought. Financing a war through loans does not shift the burden to the sons and grandsons.Loans, in this context, mean funds borrowed from those who have money available for lending. We do not refer here to credit expansion of which the main vehicle in present-day America is borrowing from the commercial banks. It is merely a method of distributing the burden among the citizens. If the whole expenditure had to be provided by taxes, only those who have liquid funds could be approached. The rest of the people would not contribute adequately. Short-term loans can be instrumental in removing such inequalities, as they allow for a fair assessment on the owners of fixed capital.

The long-term public and semipublic credit is a foreign and disturbing element in the structure of a market society. Its establishment was a futile attempt to go beyond the limits of human action and to create an orbit of security and eternity removed from the transitoriness and instability of earthly affairs. What an arrogant presumption to borrow and to lend money for ever and ever, to make contracts for eternity, to stipulate for all times to come! In this respect it mattered little whether the loans were in a formal manner made irredeemable or not; intentionally and practically they were as a rule considered and dealt with as such. In the heyday of liberalism some Western nations really retired parts of their long-term debt by honest reimbursement. But for the most part new debts were only heaped upon old ones. The financial history of the last century shows a steady increase in the amount of public indebtedness. Nobody believes that the states will eternally drag the burden of these interest payments. It is obvious that sooner or later all these debts will be liquidated in some way or other, but certainly not by payment of interest and principal according to the terms of the contract. A host of sophisticated writers are already busy elaborating the moral palliation for the day of final settlement.The most popular of these doctrines is crystallized in the phrase: a public debt is no burden because we owe it to ourselves. If this were true, then the wholesale obliteration of the public debt would be an innocuous operation, a mere act of bookkeeping and accountancy. The fact is that the public debt embodies claims of people who have in the past entrusted funds to the government against all those who are daily producing new wealth. It burdens the producing strata for the benefit of another part of the people. It is possible to free the producers of new wealth from this burden by collecting the taxes required for the payments exclusively from the bondholders. But this means undisguised repudiation.

The fact that economic calculation in terms of money is unequal to the tasks which are assigned to it in these illusory schemes for establishment of an unrealizable realm of calm removed from the inescapable limitations of human action and providing eternal security cannot be called a deficiency. There are no such things as eternal, absolute, and unchanging values. The search for a standard of such values is vain. Economic calculation is not imperfect because it does not correspond to the confused ideas of people yearning for a stable income not dependent on the productive processes of men.

This article is excerpted from chapter 12 of Human Action.

The system of economic calculation in monetary terms is conditioned by certain social institutions. It can operate only in an institutional setting of the division of labor and private ownership of the means of production in which goods and services of all orders are bought and sold against a generally used medium of exchange, i.e., money.

Monetary calculation is the method of calculating employed by people acting within the frame of society based on private control of the means of production. It is a device of acting individuals; it is a mode of computation designed for ascertaining private wealth and income and private profits and losses of individuals acting on their own behalf within a free enterprise society.In partnerships and corporations it is always individuals who act, although not only one individual. All its results refer to the actions of individuals only. When statisticians summarize these results, the outcome shows the sum of the autonomous actions of a plurality of self-directing individuals, but not the effect of the action of a collective body, of a whole, or of a totality. Monetary calculation is entirely inapplicable and useless for any consideration which does not look at things from the point of view of individuals. It involves calculating the individuals' profits, not imaginary "social" values and "social" welfare.

Monetary calculation is the main vehicle of planning and acting in the social setting of a society of free enterprise directed and controlled by the market and its prices. It developed in this frame and was gradually perfected with the improvement of the market mechanism and with the expansion of the scope of things which are negotiated on markets against money. It was economic calculation that assigned to measurement, number, and reckoning the role they play in our quantitative and computing civilization. The measurements of physics and chemistry make sense for practical action only because there is economic calculation. It is monetary calculation that made arithmetic a tool in the struggle for a better life. It provides a mode of using the achievements of laboratory experiments for the most efficacious removal of uneasiness.

Monetary calculation reaches its full perfection in capital accounting. It establishes the money prices of the available means and confronts this total with the changes brought about by action and by the operation of other factors. This confrontation shows what changes occurred in the state of the acting men's affairs and the magnitude of those changes; it makes success and failure, profit and loss ascertainable. The system of free enterprise has been dubbed capitalism in order to deprecate and to smear it. However, this term can be considered very pertinent. It refers to the most characteristic feature of the system, its main eminence, viz., the role the notion of capital plays in its conduct.

There are people to whom monetary calculation is repulsive. They do not want to be roused from their daydreams by the voice of critical reason. Reality sickens them, they long for a realm of unlimited opportunity. They are disgusted by the meanness of a social order in which everything is nicely reckoned in dollars and pennies. They call their grumbling the noble deportment worthy of the friends of the spirit, of beauty, and virtue as opposed to the ignoble baseness and villainy of Babbittry. However, the cult of beauty and virtue, wisdom and the search for truth are not hindered by the rationality of the calculating and computing mind. It is only romantic reverie that cannot thrive in a milieu of sober criticism. The cool-headed reckoner is the stern chastiser of the ecstatic visionary.

Our civilization is inseparably linked with our methods of economic calculation. It would perish if we were to abandon this most precious intellectual tool of acting. Goethe was right in calling bookkeeping by double entry "one of the finest inventions of the human mind."Cf. Goethe, Wilhelm Meister's Apprenticeship, Bk. I, chap. x.

The evolution of capitalist economic calculation was the necessary condition for the establishment of a systematic and logically coherent science of human action. Praxeology and economics have a definite place in the evolution of human history and in the process of scientific research. They could only emerge when acting man had succeeded in creating methods of thinking that made it possible to calculate his actions. The science of human action was at the beginning merely a discipline dealing with those actions which can be tested by monetary calculation. It dealt exclusively with what we may call the orbit of economics in the narrower sense, that is, with those actions which within a market society are transacted by the intermediary of money. The first steps on the way to its elaboration were odd investigations concerning currency, moneylending, and the prices of various goods.

The knowledge conveyed by Gresham's Law, the first crude formulations of the quantity theory of money—such as those of Bodin and Davanzati—and the Law of Gregory King mark the first dawn of the cognition that regularity of phenomena and inevitable necessity prevail in the field of action. The first comprehensive system of economic theory, that brilliant achievement of the classical economists, was essentially a theory of calculated action. It drew implicitly the borderline between what is to be considered economic and what extra-economic along the line which separates action calculated in monetary terms from other action. Starting from this basis, the economists were bound to widen step by step the field of their studies until they finally developed a system dealing with all human choices, a general theory of action.

This article is excerpted from chapter 13 of Human Action.

Download the slides from this lecture at Mises.org/MU22_PPT_12.

Recorded at the Mises Institute in Auburn, Alabama, on 26 July 2022.

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One basic philosophic flaw in Polanyi is a common defect of modern intellectuals—a defect which has been rampant since Rousseau and the Romantic Movement: Worship of the Primitive. At one point, (in dealing with the Kaffirs), Polanyi actually uses the maudlin phrase "noble savage," but this idea permeates the book. (For an excellent discussion of Rousseau, primitivism, and the romantic movement, see Irving Babbitt, Rousseau and Romanticism.) Modern Rousseauism received a major impetus from the cultural anthropologists, such as Ruth Benedict, Margaret Mead, Franz Boas, and the like (many of whom were Communists, and the remainder highly left-wing), who went eagerly to visit the existing primitive tribes, and reported back about the gay, happy life of Tribe X which had no private property and no inhibitions imposed by monogamous marriage.

There are several things to be said about this worship of the primitive. First, it is absolutely illegitimate to do, as Polanyi does, and infer the history of pre-Western civilization from analysis of existing primitive tribes. Let us never forget that the existing primitive tribes are precisely the ones that didn’t progress—that remained in their primitive state. To infer from observing them that this is the way our ancestors behaved is nonsense—and apt to be the reverse of the truth, for our ancestors presumably behaved in ways which quickly advanced them beyond the primitive stage thousands of years ago. To scoff, therefore, at the idea that our ancestors among primitive tribes engaged in barter, then in monetary exchange, etc., on the basis of the magic and games indulged in by present-day primitives, is a blunder of the highest order.

Second, it is implicitly and even explicitly assumed that the way primitive tribes act is more "natural," is somehow more appropriate to man than the "artifices" of civilization. This is at the root of Rousseauism. The way ignorant, fear-ridden, quasi-animalistic savages act is somehow more natural, because presumably more "instinctual," than the ways of civilization. This is the root of Rousseau’s, and many other leftists', view that man is "naturally good," but is corrupted by his institutions. This basic idea is fundamentally and radically anti-human, because it denies the basic facts about human nature and the way human beings must necessarily operate. Animals are born with "instincts"; these instincts are, in essence, sense-determined responses. Animals do not possess a free will, rational consciousness; hence, they can only adapt, in sensory fashion, to their environment. Man, on the other hand, can alter his given environment by use of his reason and his free will.

Man is born a tabula rasa; he must learn and learn how to choose the ends that are proper for him, and the means which he must adopt to attain them. All this must be done by his reason.

Civilization is precisely the record by which man has used his reason, to discover the natural laws on which his environment rests, and to use these laws to alter his environment so as to suit and advance his needs and desires. Therefore, worship of the primitive is necessarily corollary to, and based upon, an attack on intellect. It is this deep-seated "anti-intellectualism" that leads these people to proclaim that civilization is "opposed to nature" and [that] the primitive tribes are closer to it. . . . And because man is supremely the "rational animal," as Aristotle put it, this worship of the primitive is a profoundly anti-human doctrine.

Anti-human, anti-rational doctrine, then, goes eagerly to illiterate, savage, fear-ridden primitives as people on whom we—the heirs of 2000 years of the finest products of civilization and the human race—are supposed to model ourselves. If an existing primitive tribe has no private property, or engages in indiscriminate promiscuity, this should be all the more reason for us to do the reverse.

The myth is then coined of the "happy savage," that [these] primitives are truly happy and content. This myth permeates the Polanyi volume. Let us shed the vestiges of romantic mythology and look at these savages as they are. They are, in the first place, complete slaves to their environment. When the fruit tree is in bloom, they can perhaps subsist by picking the fruit off the tree; but suppose there is a blight, one year, on fruit trees? What happens to this "happy-go-lucky" tribe? It dies, en masse. It is no wonder that the primitive tribes are all small in number.

Secondly, the primitive’s life is a life of almost constant terror. Terror of the world about him, which he does not and cannot understand, since he has not engaged in any sort of scientific, rational inquiry into its workings. We know what a thunderstorm is, and therefore do not fear it, and can take rational measures against lightning; the savage does not know, and therefore surmises that The God of the Thunder is displeased with him, and that therefore that god must be propitiated with votive offerings and sacrifices (sometimes human sacrifices). Since the savage has no concept of a world knit together by natural law (a concept which employs reason and science) he believes that the world is governed by a whole host of capricious spirits and demons, each of which can only be propitiated—with only partial "success"—by ritual, by magic, and by a priestcraft of witch doctors who specialize in this propitiation. So fearful is the savage that he can do nothing on his own, that his individuality is virtually completely undeveloped—because the individual savage makes almost no use of his reason and of his mind. Therefore, virtually everything the savage does is governed by immutable, utterly irrational, taboos or command: by custom.

And this is the fear-ridden, barely-human, creature whom we, people who have used our intellect to "conquer" nature, are being asked to emulate, whom Polanyi extols as being truly "social," and as being happily tree of the "inhuman" despotism of the free market.

Moreover, the life of the savage, as Hobbes put it, is "nasty, brutish, and short." His life expectancy is very short, and his life is ravaged by all manner of disease, disease which he can do nothing about except give food to witch doctors to utter incantations. The increasing conquest of disease has been made possible only by the advance of civilization: by the use of reason, by capitalism, and by the market.

Polanyi admires the tribal and other caste societies, because "nobody starves." Everyone might admittedly be on a subsistence level, he concedes, but no individual starves. Is it that great a comfort that everyone starves together? This is a grotesque statement. The primitive world—indeed all worlds before the Industrial Revolution—[is] constantly racked by famine and by plague. "Famine" was a continual occurrence before the Industrial Revolution; since the I.R. we have never heard of famine (the only recent famines have been in Communist China, and earlier, in Soviet Russia). Famine emerges from a lack of inter-local trade; when one locality’s food crop fails, since there is virtually no trade with other localities the bulk of the people starve. It is precisely the permeation of the free market throughout the world that has virtually ended this scourge of famine, by permitting trade between areas. It is this market that Polanyi castigates as the bringer of virtually all evils.

Polanyi admires all societies of caste and status: tribal, mercantilist, or whatnot. A caste society, he maintains, provides "security." Famines and plagues: are they "security"? No amount of restrictionism can provide that production from which any economic "security" must come; in fact, just the opposite, for all caste restrictions, all restrictions on the market, simply cripple and hinder production, and thus keep everyone at or near subsistence level. In fact, the Asiatic "extended family" system, has kept China, Indonesia, etc. in primitive poverty and misery for centuries. This "share and share alike" custom, which Polanyi undoubtedly admires, decrees that as soon as any individual makes a little more money, he must distribute it pro rata among a whole host of distant, as well as near, relatives. As a result of this "noble" system, there is no incentive for any individual Chinaman to earn more and produce more and hence, the Chinese did not (before Communism) do so and did not progress. In Java, the village commune system, definitely Polanyi-esque, means that a starving, massively overpopulated Java has been exploiting and tyrannizing over, the much more progressive and capitalistic islands of Indonesia (e.g. Sumatra).

The "security" of the caste system is the security of the prison-house. (By the way, anyone who wants "security" in a market economy can always commit a crime and go to jail, where Polanyi-esque security will be furnished to him.) This "security" means an all-pervasive hopelessness in a caste society. The son of a baker must always be a baker, even if his interests and abilities are completely elsewhere. No one can rise, no can shift his occupation or do anything differently from his ancestors. This is the annihilation of all that is most vital, most purposeful, most alive, in the life of any individual.

Another basic flaw in any caste society—and ignored by Polanyi—is the problem of population growth. The witch doctor, the custom of tribe, the chief or king, and Prof. Polanyi, can all decree that X and the son of X be a baker, Y and the son of Y be a farmer, etc., but what happens when population increases, as it almost inevitably tends to do? What does the younger son do? Polanyi sneers at Malthus but the Malthusian problem is always supremely evident in the caste society. What happens when the "natural checks" of famine and disease do not work sufficiently? This is why the caste-communal society of Sparta put their babies out to the woods for an "exposure test," not because the Spartans were inherently a cruel people, but because they were faced to what was, in the context of their social structure, an insoluble problem: what to do with their population increase. It was population growth, further, that was wrecking mercantilist Europe. Population growth was the reason for the rise of able-bodied beggars and thieves in 18th Century England. There was no work for them to do. It was the rise of capitalism, the advance of capital to provide them with jobs, the expansion of the market to producing cheap goods for the masses, that not only enormously increased the standard of living of the masses, but also provided jobs for these increasingly "excess" people.

Furthermore, Polanyi continues the old anti-capitalist canard that the Industrial Revolution was made possible by the enclosure movement, which supposedly drove sturdy yeomen off their lands, and into the cities. This is nonsense; not only did the enclosure movement enclose the "commons" and not people, and by the great increase in agricultural productivity provide the wherewithal in resources and income for the industrial revolution, but also the enclosures did not drive people off the land. The surplus population in the rural areas was a consequence of population growth; it was this increase in rural population that drove these desperate people into the cities to look for work.

Capitalism did not, therefore, tragically disrupt, as Polanyi would have it, the warm, loving, "social" relations of pre-capitalist era. Capitalism took the outcasts of society: the beggars, the highwaymen, the rural over-populated, the Irish immigrants, and gave them the jobs and wages which moved them from destitution to a far higher standard of living and of work. It is easy enough to wring one’s hands at the child labor in the new British factories; it is, apparently, even easier to forget what the child population of rural England was doing before the Industrial Revolution—and during the Revolution, in those numerous areas of England where the I.R. and the new capitalism had not yet penetrated: these children were dying like flies, and living in infinitely more miserable conditions. This is why we read nowadays, when it seems inexplicable to us, British and American writings of the period which praise the new factories for giving work to women and children! This praise was not due to their being inhuman monsters; it was due to the fact that, before such labor was available, and in those regions where such labor was not available, the women and children were living and suffering in infinitely worse conditions. Women, children, immigrants, after all, were not driven to the factories with whips; they went voluntarily and gladly, and that is the reason.

There are even broader aspects of the population problem which Polanyi ignores. For capitalism was responsible, in a sense, for the huge increase in population in the modern world. Capitalism’s upsurge in living standards has enabled capitalism to free the world from the Malthusian checks, from the grim evils of over-population, and has permitted a rapid multiplication of population at even higher living standards than before. So when Polanyi, in effect, asks us to scrap the market and return to a caste or communal or even tribal society, he is not only asking us to abandon the luxuries of civilization and return to the subsistence level of the primitive tribe; he is also asking for the liquidation and eradication of the vast bulk of the world’s population Because if a caste or tribal system will "work," even on the least subsistence level, it will work only for a small, tiny minority of the population; the rest of us will starve en masse. The fact noted above, of the small numbers of the primitive tribe, takes on, then, a new and more terrible significance.

(For a refutation of the enclosure myth and a recognition of the key being increase of population, see W.H.B. Court, A Concise Economic History of Britain (Cambridge University Press, 1954).)

In all of his complaining about laissez-faire and the free market, Polanyi somehow overlooks probably the single most important aspect of this system: freedom. In a free society, no one compels Polanyi or anyone else to join in the free market. If Polanyi or any other critic is so hostile to the alleged tyranny, "instability," etc. of the market, the free society leaves them free to get out. Anyone, at any time, can leave the market: can go off in the woods and live on berries in a cave, can buy his own farm and be completely self-sufficient, cut off from the rest of the world, or can vary his participation as much as he likes. Anyone who wants to can, in a free society, even join a voluntary commune, like Brook Farm, or an Israeli kibbutz, and lead as blissfully communistic a life as he or she wishes. Since everyone still has the option to do so, since anyone has the option to go oft to a desert island or join a commune, why is Polanyi bitter about the market??

In fact, the free society leaves everyone such options. Why, in that case, has the free market flourished when people have been left free, flourished until it brought about capitalist civilization? The reason is precisely that the vast bulk of the people, in the past and in the present ages, don’t agree with Polanyi: they vastly preferred the so-called instability, unhappiness, et. al. of the market to the supposedly happy subsistence-life of a communal savage. For, if they had not vastly preferred it, they would not have joined the market; they would have sacrificed monetary income for their tribal or self-sufficient farm life. Yet they did not. There is no better way of thoroughly refuting Polanyi’s weeping about the lost glories of "society" than to observe the numberless millions who have chosen the way of the market when they had the free choice.

In fact, it is precisely such left-wing intellectuals as Polanyi who are always weeping about the "Coca-Colaization" of the rest of the world, are bemoaning the supposedly lost glories of "folk culture" in the undeveloped countries. For, as soon as they get the chance, peoples all over the world, regardless of cultural tradition, abandon their supposedly beloved culture, in order to adopt Western ways, Western clothes, get a Western-type job or serve Western tourists, and earn Western money—and drink Coca-Cola and go to Hollywood movies, as well. It took only a few years, for example, for the people of Japan to abandon their thousand-year old traditional culture and folkways to turn eagerly to these supposedly decadent market-brought goods of the West. Why is that? Is it Western "imperialism"? Are American troops forcibly drugging everyone with Coca-Cola?

(For an inspiring and scholarly discussion of the enormous growth of a market and exchange economy, among illiterate natives of West Africa, I strongly recommend P.T. Bauer, West African Trade, Cambridge University Press, 1954).

Even in backward countries that are hostile to capitalism: such as India, Ghana, etc., these countries do not at all reject the fruits of Western civilization on behalf of their seemingly joyful tribal traditions. On the contrary, they want Western products and conveniences; it is just that they have not understood that capitalism is needed to obtain them.

Given a choice, then, almost everyone chooses the market economy and its advanced civilization, even, curiously enough, Prof. Polanyi himself, who most conspicuously did not rush off to some tribe or commune.

Why, then, do we consider the free market as "natural," as Polanyi sneeringly asks? The reason is that the free market is (1) what men have turned to when they have been allowed freedom of choice, and (2) what men should turn to if they are to enjoy the full stature of men, if they are to satisfy their wants, and mould nature to their purposes. For it is the market that brings us the standard of living of civilization.

In his book, Polanyi is continually assuring us that his beloved primitive natives do nothing at all for personal "gain"; only for magic, for what he calls "reciprocity," etc. What is so bad about gain, which Polanyi virtually assumes to be a malevolent word? The principle of the free market is voluntary exchange for mutual benefit. This mutual benefit constitutes gain. The free market is, in fact, that interpersonal relationship which does insure mutual benefit by all relating parties. Why does Polanyi find this so obnoxious? Why, at every point, does he seem to prefer only an inter-personal relation where only one party gains? For if only one party gains it follows that the other party loses; in short, it follows that for Polanyi, the ideal relationship between people is not mutual gain, but exploitation: the gain of one at the expense of another. Is this the "moral," "social" relationship for which we are supposed to abandon market-economy and civilization itself? Why is it that every socialist hates and condemns the exchange relationship—the supposedly "calculating," "inhuman," relationship where both parties gain? Do they consider it more moral for A to let himself be exploited by B, and for B to exploit A?? For make no mistake, when the socialist condemns A for not giving money to B without receiving anything, material or spiritual, in exchange, he is calling upon A to be a sacrificial animal for the benefit of an exploiting B.

In his discussion of his beloved primitive tribes, Prof. Polanyi says that they deal with each other, not on the basis of (Ugh!) mutual gain, but on the basis of "reciprocity" and "redistribution." The "principle of redistribution" is, of course, this same principle of exploitation. It is the "redistribution," coerced by the State or the tribe, from the producers to the parasitic class favored by the tribal or State chiefs. As for the "principle of reciprocity," Polanyi is certainly unclear about just what it entails. To some small extent, to the extent that the process is rational, this is simply exchange or barter, smuggled in by the conceptual back door. To the extent it is not rational, it is either play or sport—which hardly needs further comment, or it is ritual magic, which has been commented on above. It is apparently the latter part of "reciprocity" that Polanyi extols, for he is apparently enchanted by the "Kula trade," in which one island gives certain objects to another island, and will only receive similar (or the same?) stuff back years or decades later from some other island in the ring. What Polanyi especially likes about this is its lack of true mutual gain—or is it its obvious pointlessness? And, again, must we follow the path of a magic-ridden group of savages?

I mentioned that the free society would permit Polanyi or any who agree with him to abandon the market and find whatever other forms suit them. But one thing and one thing alone the free society would not permit Polanyi to do: to use coercion over the rest of us. It will let him join a commune, but it will not let him force you or me into his commune. This is the sole difference, and I therefore must conclude that this is Polanyi’s sole basic complaint against the free society and the free market: they do not permit him, or any of his friends, or anyone else, to use force to coerce someone else into doing what Polanyi or anyone else wants. It does not permit force and violence, it does not permit dictation, it does not permit theft, it does not permit exploitation. I must conclude that the type of world, which Polanyi would force us back into, is precisely the world of coercion, dictation, and exploitation. And all this in the name of "humanity"? Truly, Polanyi, like his fellow-thinkers, is the "humanitarian with the guillotine." (See Isabel Paterson’s profound work of political theory, The God of the Machine, Putnam’s, 1943).

The naked and open advocacy of force and exploitation would, of course, not get very far; and so Polanyi falls back on the fallacy of methodological holism, on treating "society" as a real entity in itself, apart from, and above, the existence or interests of the individual members. The market, Polanyi thunders, disrupted and sundered "society"; restrictions on the market [are] "society’s" indispensable method of "protecting itself." All very well, until we begin to inquire: who is "society"? Where is it? What are its identifiable attributes? Whenever someone begins to talk about "society" or "society’s" interest coming before "mere individuals and their interest," a good operative rule is: guard your pocketbook. And guard yourself! Because behind the facade of "society," there is always a group of power-hungry doctrinaires and exploiters, ready to take your money and to order your actions and your life. For, somehow, they "are" society!

The only intelligible way of defining society is as: the array of voluntary interpersonal relations. And preeminent amongst such voluntary interrelations is the free market! In short, the market, and the interrelations arising from the market, is society, or at least the bulk and the heart of it. In fact, contrary to Polanyi and other’s statements that sociability and fellowship comes before the market; the truth is virtually the reverse; for it is only because the market and its division of labor permits mutual gain among men, that they can afford to be sociable and friendly, and that amicable relations can ensue. For, in the jungle, in the tribal and caste societies, there is not mutual benefit but warfare for scarce resources!

Curiously, in his idyllic picture of tribal life, Polanyi never seems to mention pervasive inter-tribal warfare. Such warfare is almost necessary, because groups of people are fighting over scarce resources: water holes, hunting, etc. Tribalism, not capitalism, is the "rule of the jungle," for warfare and extermination of the "unfit" is the only way that some of the tribes can keep alive. It is the capitalist market economy, which increases resources by mutual benefit, that is able to bypass the rule of the jungle, and to rise above such animal-like existence to the status of advanced civilizations—and amicable relations among men.

The market, therefore, is preeminently social; and the rest of the social consists of other voluntary, friendly, non-market relations which also, however, are best conducted on the basis of a spiritual exchange and mutual gain. (Isn’t it better if A and B are both friendly to each other, than if A is friendly to B but not vice versa?) The market, then, far from being a disrupter of society, is society. What, then, would Polanyi use to replace the market? The only other relation aside from the voluntary, is the coercive; in short, Polanyi would replace the market by the "social" relation of force and violence, of aggression and exploitation. But this is not social; it is profoundly anti-social. The exploiter, who lives parasitically off the producer by violence, is anti-social; for he is not living according to the best nature of man: by producing and exchanging his produce for the produce of another. He is living by use of violence, one-sidedly and parasitically at the expense of the producer. This is a profoundly anti-social, and anti-human relationship. It disrupts the social market, and leads it—and with it—civilization and civilized living standards, to crumble into the dust.

Franz Oppenheimer, in his brilliant work, The State (Vanguard Press, 1922), put it very well: there are two possible roads to wealth, he wrote: one is by producing, by transforming matter with personal energy, and then exchanging this produce with the produce of another. This, he termed the "economic means." Another road is to wait until someone else has produced wealth, and then to seize it by force and violence. This he called the "political means." Which method is "social," and which is profoundly and disruptively anti-social, should be easy to see. Karl Polanyi, in claiming to save society from the market, is in the process of destroying society itself by destroying the market. Polanyi’s work is an apotheosis of the political means.

That this is what Polanyi will bring should also be evident from his discussion of free labor. For Polanyi, allowing labor to be a "commodity" was one of the worst sins of the free market; Polanyi therefore proposes to take labor out of the free market. But what is the only alternative to free labor? It is unfree labor, i.e. it is serfdom. The man who is not allowed to be a free laborer is a serf. In fact, in extolling the process (supposedly typical of the primitive tribe) of working without pay, Polanyi is precisely extolling the system of slavery. For what is unpaid, unfree labor, but slave labor?

Polanyi, like all socialists, is at pains to teach us that the coming of the new "society" without market is inevitable. Thus, for him, every restriction on the market in the recent century or so came as a "recognition" of social need, and not as a deliberate choice governed by certain ideas and interests. To preserve this myth, Polanyi angrily criticizes those, like Mises, who believe that certain definite socialistic and restrictionistic ideas and interests brought about these government interventions in the market. Polanyi sets up a straw man by calling this a "conspiracy" theory of history, which it is not at all. There need be no concerted conspiracy for two different statists or socialists to advocate statist measures in two different fields. (Of course, Polanyi also ignores very important actual conspiracies like the Fabians.) The result flows inevitably and "naturally" from the premises held by the two men. Not being willing to discuss the different and conflicting ideas at stake in the problems of socialism vs. the market, Polanyi tries to put the whole thing on the plane of social determinism and inevitability, so that human volition plays no role in the [process].

As a corollary, then, to his rejection of reason, Polanyi also rejects man’s free will. Instead, "society" acts, determines, protects, recognizes, etc. In this way are the real determinants of action in society: the ideas adopted and pursued by individuals, forgotten, and the spotlight, turned on so-called "social forces," "society," etc.

Like all determinists, Polanyi eventually involves himself in severe contradictions. For, when it comes to the adoption of the free market in the nineteenth century, [Polanyi claims] here was not something socially determined, but the reflection of tragically wrong ideas held by laissez-faire ideologues, who by "intervention" in the "natural" (tribal? caste?) processes of state regulation, etc. temporarily brought about a free market.

I could go on almost indefinitely in detailed criticism of Polanyi, but there is no point in prolonging this too much further. That by "society" Polanyi means force and the "political means" is indicated by his repeated warnings that "social reality" necessarily must involve force and violence. (But why not force limited to combating aggressive force, thus minimizing the role of force in society?) Polanyi, in caustically rejecting the ideal of free trade, doesn’t realize that he is thereby rejecting international peace, for a world of socialist nations will inevitably conflict with each other’s plans, and precipitate conflict of interest and wars.

Also revealing is this quotation: "Economic cooperation (in the free 19th Century free market) was limited to private institutions as rambling and ineffective as free trade, while actual collaboration between peoples, that is, between governments, could never even be envisaged." (Note the totalitarian identification of "people" and "government.") Polanyi sees that the commodity money of the old gold standard is indispensable to a true free-market economy, and therefore scornfully denounces it. Like most anti gold standard, pro-fiat paper men, he at the same time declares that money is more than a commodity (more than just a "veil"), and much less than a commodity (money is a "mere ticket"). Another contradiction; actually, money is, properly a commodity—period. Polanyi is also totally wrong when he says that business "needs" continual doses of inflation, to bolster purchasing-power, which a pure gold standard could not provide, and wrong too when he absurdly maintains that a Central Bank is not as deflationary, in a contraction, as a pure gold standard without such a central bank. A central bank is inherently more inflationary, but when the day of reckoning comes, and it must contract (under a gold standard) it contracts far more than would otherwise be necessary.

Further: Polanyi seems to think that he has scored a great coup on free market economists when he says that trade first developed in international and interregional channels, and not from first local and then international. So what? This is certainly not in any sense a refutation of free market economics. It is not surprising that, in a world of self-sufficient farms and manors, the earliest trade should be with far-distant places, which are the only places from which local farms can obtain certain produce. (E.g., Western Europe could only procure spices from the Near East.) This is, in fact, a manifestation of the gains of trade and division of labor, and the growth of the market, and not vice versa.

Finally, in the final chapter, Polanyi tries to assure us that his projected collectivist society would really preserve many of the "freedoms" that, he grudgingly admits, the market economy brought us. This chapter is almost a textbook presentation of utmost confusion about the concept of "freedom"; and of confusion between the vitally distinct concepts of "freedom" and of "power."

(On this crucial distinction, always blurred by collectivists, see F.A. Hayek, The Road to Serfdom.) Many "freedoms" would be kept, even maximized, (after all, isn’t a worker with more money more "free," and who cares about the money taken away from the luxurious rich, anyway?), and including such "freedom" as the "right to a job" without being discriminated against because of race, creed, or color. Not only does Polanyi vainly think, or assert, that we can have at least enough "freedoms" in his collectivist society; he also believes, equally vainly, that we can preserve industrialism and Western civilization. Both hopes are vain; in both cases, Polanyi thinks he can preserve the effect (freedom of speech, or industrial civilization), while destroying the cause (the free market, private property rights, etc.) In this way, he is thinking, not only as Nehru and Kwame Nkrumah think, he is thinking also in the same fashion as the savage whom he so exuberantly extols.

To sum up: I have read few books in my time that have been more vicious or more fallacious.

This critique was written as a private memo to the Volker Fund in June 1961. It has never been published.

My wife recognized that as a bit of economics jargon and accused me of trying to turn our son into an economist like me.

While it was said as a little joke between the two of us, the longer I teach and write, the more I seriously wish people actually thought in such marginal terms, because many of the times that we confuse ourselves and others are due to our failure to do so.

The marginal rate of substitution (MRS) is the term describing the rate at which a person would willingly give up one good or service in exchange for another, from his current situation (i.e., at the current margin of choice). Its focus is on the trade-offs, made necessary by scarcity, that individuals are willing to make between alternatives, a focus often absent in how we reason, which leads to serious misunderstandings and impaired choices.

The word "need" is a prime example of the failure to think in terms of marginal trade-offs.

Since many choices forced on us by scarcity are between different "needs," calling something a need diverts attention from the actual choices faced. For instance, a person's need for water to drink is irrelevant to virtually every choice they make about water. If the price of water rose from its current level, they would not cut back appreciably on water to drink. Instead, they would cut back on some of the many low-valued uses they put it to (and all of us frequently treat water as nearly valueless, because it is cheaply available, and we use it whenever the benefits of doing so exceed its very low price). That is, people's water needs will not be given up, so discussing water in terms of need adds confusion rather than insight. The same is true for innumerable other supposed needs.

The word "need" is also typically used to imply that someone ought to have something they don't. Therefore, "need" is used to imply that they should therefore be given the good (which is why "need" in political discourse really means "I want it but I do not want to pay for it"). But if you had sufficient resources at your disposal, you would buy something if you really needed it. Further, since to give you a good requires that someone else must have the resources taken from them, to talk in terms of need blinds people to the real choice: how much should A's supposed need force B to pay for A's benefit—when A will not.

The confusion generated by talking in terms of need is often compounded by using the word "we," as well, when things are to be provided to some from tax revenue raised from others. For example, people often argue for goods and services that "we" should provide. But the largest source of tax revenue is the income tax, which comes disproportionately from higher-income earners, while a large number pay zero income taxes (e.g., many students and retired people) or even negative income taxes (particularly those who receive EITC refunds).

As a result, when most people say "we" should pay for something, it really means "you, not I," making such arguments highly misleading, if not duplicitous. And when such spending will be financed not by current taxes but by deficits—which are just delayed taxes whose incidence is kept unknown until after the fact—the same argument applies. One cannot correctly analyze such programs or proposals without knowing who will actually be forced to pay how much, so we can recognize the real marginal trade-offs.

Misusing the word "need" is just one example of the problems caused by thinking in categorical language. For instance, someone might say that good A is more valuable than good B (e.g., food as a category is more important than sleep as a category). However, that is not true: the relative value of various goods in reality depends greatly on circumstances and preferences (e.g., as anyone who does not want to get up when their alarm goes off in the morning is aware, sleeping a few more minutes may often be more valuable to them than eating in the next few minutes). Basing decisions on such erroneous premises makes mistakes inevitable.

Failing to think at the appropriate margins of choice is a staple of politics, with adverse effects. For instance, politicians are always telling people what they are for. But that is typically not what citizens really want to know, since politicians are all "for" pretty much the same things (e.g., peace on earth, our "general welfare," Mom and apple pie, etc.).

Since politics consists of trade-offs, what we really want to know is the rate at which they would trade one thing they are for against other things they are also for, or the rate at which they would accept what they are against in order to get more of what they are for (i.e., at what price in other things that they are for will they "sell us out" on a particular issue). But what they are officially for or against gives us little insight into any of that.

Polls, after money the lifeblood of politics, also typically fail to ask the right marginal questions. One may ask, "Should we add another lane to the 101 freeway in the San Fernando Valley?" But the answer depends on what it is going to cost the person asked. Without knowing what costs respondents think they will pay when they answer, we have almost no idea what a yes or no response means. For that matter, even if the question specifies a cost of, say, $200 per year, we still can't be sure of what their answer means, because they may be answering based on the often very different costs they actually expect to bear, rather than the cost specified in the poll question.

The deceptive mirage of central planning is also a result of failing to think in marginal terms. Those who find the cure for everything in planning ignore the fact that market prices reveal people's MRS between goods, and without market processes to reveal that information, it is unknowable to planners. Central planning, which throws away the process by which relevant trade-offs are revealed, must throw away the wealth and mutual gain that acting on otherwise unknowable information makes possible, as both Mises and Hayek demonstrated.

Assertions of objective efficiency, and the regulatory impositions based on them, represent another failure to think at the margin. Preferences and circumstances differ, and anything that could alter the value of the expected marginal benefits or the marginal opportunity costs of a choice to a decisionmaker could change what people deem efficient. As a result, to regulate away allegedly inefficient options is either redundant (if an option is considered inefficient by everyone, no one will use the option anyway) or itself inherently inefficient (forcing people away from what they consider more beneficial choices).

For instance, where I live, air conditioners cannot be sold if they have less than a minimum level of thermal efficiency. But for someone cooling an infrequently used cabin, the added cost of the more energy-efficient air conditioner may easily be more than the value of the energy saved during use. And there are many other cases where supposedly technically inefficient choices are economically efficient (e.g., the fact that most of us choose to live in our current homes and drive our current cars, instead of "state of the art" new models).

Not only do objective efficiency claims mislead, but they also serve as cover for assertions that someone other than the owner of a good should be given the power to decide for them. Their reasoning is that since the owner isn't making the efficient choice (an oxymoron, from the owner's perspective) their judgment should "obviously" be substituted for that of owners—for their own good. But what they really mean is that effective ownership should be taken away from current owners and given for free to those who "know better," which is just a thinly disguised form of theft.

Failing to think at the margin makes some people blind to why trade is mutually beneficial. They think of market exchanges as involving equal values, so that no wealth is created by supposedly quid pro quo exchanges, rather than recognizing that exchanges take place only when all parties expect their marginal benefit to exceed their marginal cost (i.e., when they have different marginal rates of substitution between the goods or services involved). Failing to see the gains from trade, they also fail to see the harm imposed on society from restricting or penalizing it, a fallacy behind a host of very damaging restrictions on voluntary arrangements.

Marginal misunderstandings appear in all sorts of decisions, especially about public policy (especially because people have far worse incentives to think carefully when they are spending other people's money rather than their own).

For example, the current push to ensure that everyone has health insurance is supposedly motivated by the desire for everyone to have access to health care, but access to health care is a vastly different issue than health insurance (just as the absence of food insurance does not mean people will not eat). Food stamps are supported by people who don't trust recipients to spend assistance on food, yet by substituting for money that would have been spent on food, food stamps act just like money for most recipients, doing nothing toward the underlying rationale for their use.

And the list goes on.

One need not talk in terms of marginal rates of substitution to avoid confusion about issues such as these. However, thinking at the margin about the innumerable choices scarcity has faced us with is a valuable antidote against mistaken reasoning.

It is particularly important insurance against those who would "sell" some political panacea with misleading language and arguments. Given the vast sea of political rhetoric that uses just such misrepresentation and misdirection to win political power at the expense of individual rights (at an MRS that is appalling to lovers of liberty), it is an important part of the arsenal against the continuing expansion of the state. After all, only such careful thinking can force its proponents to defend their real positions to citizens, rather than baffling and befuddling, as they do now.

This article was originally published October 2007.

The best account of demonstrated preference is in Murray Rothbard’s essay “Towards a Reconstruction of Utility and Welfare Economics” (1956). Essentially, the doctrine is this. When you make a choice, it’s usually among a few options. The choice is an action, and the action demonstrates, or reveals, that the option, or preference, that you choose ranks higher than the competing options. As Rothbard puts it,

Human action is the use of means to arrive at preferred ends. Such action contrasts to the observed behavior of stones and planets, for it implies purpose on the part of the actor. Action implies choice among alternatives. Man has means, or resources, which he uses to arrive at various ends; these resources may be time, money, labor energy, land, capital goods, and so on. He uses these resources to attain his most preferred ends. From his action, we can deduce that he has acted so as to satisfy his most highly valued desires or preferences.

The concept of demonstrated preference is simply this: that actual choice reveals, or demonstrates, a man’s preferences; that is, that his preferences are deducible from what he has chosen in action. Thus, if a man chooses to spend an hour at a concert rather than a movie, we deduce that the former was preferred, or ranked higher on his value scale. Similarly, if a man spends five dollars on a shirt we deduce that he preferred purchasing the shirt to any other uses he could have found for the money. This concept of preference, rooted in real choices, forms the keystone of the logical structure of economic analysis, and particularly of utility and welfare analysis.

When we talk about “preferences” or “options” here, what is meant are the alternatives that an actor has in mind when he decides what to do. We aren’t assuming that these preferences remain constant over a substantial period of time, much less that the actor has “in his mind” a list of all possible actions he could take in all possible worlds and that this list also remains the same for a long period. Because we don’t assume these things, we also don’t assume “transitivity of preferences.” If you prefer A to B, B to C, and A to C, then your preferences are transitive; but if your preferences are A over B, B over C, and C over A, they are intransitive. Many people think that intransitive preferences are irrational, for reasons we won’t go into here.

In the Austrian view, this issue doesn’t arise, because we’re concerned only with someone’s choice at a particular time. If the actor now has to choose between A and B, we don’t assume that he considers how to choose in situations that involve other options, nor do we assume that his preference for A over B remains constant. As Rothbard puts it, “The prime error here is the assumption that the preference scale remains constant over time. There is no reason whatever for making any such assumption. All we can say is that an action, at a specific point of time, reveals part of a man’s preference scale at that time. There is no warrant for assuming that it remains constant from one point of time to another.”As Rothbard points out, there is a difference between constancy and consistency, and the former isn’t a requirement of reason.

[C]onstancy and consistency are two entirely different things. Consistency means that a person maintains a transitive order of rank on his preference scale (if A is preferred to B and B is preferred to C, then A is preferred to C). But the revealed preference procedure does not rest on this assumption so much as on an assumption of constancy —that an individual maintains the same value scale over time. While the former might be called irrational, there is certainly nothing irrational about someone’s value scales changing through time. Hence, no valid theory can be built on a constancy assumption.

One of the participants in the email exchange raised this objection:

It [demonstrated preference] at most reveals his higher preference, his preference between two alternatives he is free to choose between…. Consider a prude who is made unhappy by other people’s consumption of pornography. In the free market society he doesn’t have the option of forbidding it, even though his highest preference might be an otherwise free market plus a ban on pornography. If there were only two other people in the society he could offer to pay them to agree not to consume pornography, but in a society of millions transaction costs plus the public good problem—the ban is a public good from the standpoint of all the other prudes—make that impractical.

The mistake here is that demonstrated preference concerns only choices that face an actor at a time. It isn’t about how he ranks possible states of affairs. I’d “prefer,” in one sense of that word, a world in which everyone held the correct view (mine, of course) of how society should be organized, but that sense of preference isn’t relevant to Austrian economics.

Another comment about demonstrated preference didn’t aim to undermine it directly, but rather to show that the doctrine brought with it baggage Austrians wouldn’t welcome. Austrians are against logical positivism, but, the commenter said,

[t]here is actually something like logical positivism in Austrian economics. I mean the idea that one can’t make interpersonal utility comparisons, as well as the more fundamental idea that “preference” must mean “revealed preference”. This is very reminiscent of the positivistic idea that all meaningful statements must be testable by sensory observation. Good rationalists reject this assumption.

Maybe they do, but “demonstrated preference,” as Austrians use this concept, means that choice reveals the chooser’s highest preference. It isn’t a claim about the meaning of “preference.” 

This objection, one must say, doesn’t “demonstrate” much acquaintance with Austrian economics. It’s good to have it anyway. As W.V.O. Quine once said, “Every knock a boost.

The Whig theory of the history of science is very similar, of course, to the Whig theory of the history itself. The Whig theory of history of science was dominant until the 1960s. (It probably still is dominant in high school textbooks.) It essentially said that science, the growth of knowledge, is an onward-and-upward, step-by-step approach, from the year zero to now.

What are the implications of that? One implication is that you don't have to read a history of science unless you're an antiquarian. If you're a physicist in 1986, there's no point in reading some physicist from 1930; unless you're interested in the special conditions of what happened to him, you don't learn anything from it.

In other words, you never lose any knowledge. The theory is that, every step of the way, science patiently tests its assumptions and premises; it discards those that turn out to be unacceptable, false, and adds those that are acceptable. Everybody's always patiently testing their axioms, steadily advancing. Therefore, there's no loss of knowledge.

The current textbook then incorporates all the best of everything from the year zero to the present. This is the theory, at any rate. Here, the famous Kuhn doctrine I think comes in very neatly, the famous paradigm theory of Thomas Kuhn from The Structure of Scientific Revolutions. He effected a revolution in the history of science.

Kuhn has caught a lot of flak on his philosophy of science, which he claims he doesn't really have. I think he's not interesting as a philosopher; he is interesting as a historian and a sociologist of science, asking, How did science actually develop? And essentially what he says is that this linear, step-by-step stuff isn't the case. First of all, nobody ever tests their basic axioms, ever. That's of course obviously true. That's of course obviously true. Once an axiom (or a "paradigm," as he put it, a set of basic beliefs) is adopted, people just apply it. Now, various peripheral matters or "puzzles," he calls them, come up, but anybody who challenges the basic paradigm is considered not a scientist. Not that he's refuted, I think, just out of the dialogue: he's had it.

So this pegs on for a while until various anomalies pop up until the theory begins obviously to fail in explaining a lot of stuff, and then there's a crisis situation, as he calls it, where confusion and competing paradigms come up. If some new paradigm can solve these puzzles better, it then begins to take over and establishes a new paradigm, and they forget all the rest of the stuff.

Now, he is alleged to have said that no paradigm's any better than the other. I don't think that's true. But at any rate, the interesting thing, what happens here is that you lose knowledge. Even if this paradigm's better than that, often stuff gets lost along the way. One example is, of course, Greek fire. We didn't know until very recently what Greek fire was. We now know it's like flamethrowers, but we only found that out when we invented flamethrowers.

In 1900 nobody knew what Greek fire had been. Another example of course was the Stradivarius violin varnish, which nobody can duplicate, because you can't test everything, can't figure out the composition — secret formulas, in other words, which get lost.

These are obvious, blatant examples. A friend of mine in the history of science says there are certain laws of 18th-century optics that we've forgotten. We know less about certain areas of optics than they did in the 18th century. At any rate, when we get to the social sciences and philosophy, this is much more true.

By the way, another thing I should say is that the old guys never change, they don't shift to the new paradigms, usually. The old guys will stick to it until they die. The people who adopt the new paradigms are the younger people — graduate students, college students who are not intellectually locked into the old paradigm.

A famous example of that is Joseph Priestley, the late-18th-century libertarian and physicist, who discovered oxygen, and refused to believe it was really oxygen. He was so locked into the Phlogiston theory that he said it's only dephlogisticated air. He refused to acknowledge the implication of his own invention, his own discovery. Incredible. At any rate, this is very typical.

This is why, by the way, strategically, if you're an Austrian, you shouldn't spend time trying to convert Paul Samuelson or Milton Friedman. These guys are not going to be converted: they're locked into their paradigm. You convert people who are just coming up, new people, people who are on the fence. Graduate students, these are the people you can convert. Don't waste your time trying to convert Samuelson or Friedman or whoever the other paradigm people are.

So the war is for the souls of the people coming up, so to speak. Obviously, it's pretty clear that in social sciences, economics, philosophy, etc., there's even more of this, because there's less testable stuff, obviously. If this is true in science, physical science, which I think it is, it's all the more true in social science, and economics, where you can really lose knowledge very rapidly because you can replace a good paradigm by a lousy one.

It may be difficult to do it in physics, but it's certainly very easy to do in philosophy and economics and political thought. It's very easy for a new paradigm to get established for one reason or another that has nothing to do with its truth value. It could be fashion; it could be politics; it could be the king; it could be throwing all the old paradigm people into the Lubyanka, and whatever.

So reading history of economic thought (of philosophic thought even more so) is not just of interest for historians to see how a theory developed. It is of interest also to find out the truth, because somebody in 1850 might be better than somebody writing now — matter of fact, usually is — in economics, philosophy, and whatever.

So the whole history of thought then becomes, in the social sciences and philosophy, a much more exciting enterprise, it seems to me, than in physics. Again, the guiding philosophy in the history of thought and history of economics now, to get into that, the guiding doctrine has been Whig again, even though Whig theory seems to be obviously untrue.

In almost every textbook, a hallmark would be this: Any group, whoever they're talking about, any group has something positive to contribute to the building of economics. Whatever, even if they're totally contradictory — one group is obviously nutty — doesn't make a difference. They're not nutty; they're part of the "great dialogue." So any group then takes their place. Whoever you're talking about — the French, the Scholastics, the British classicists, the Austrians, the Keynesians, institutionalists, they're all great guys. They're all somehow contributing to a great edifice.

The historian of economic thought who says this is "noncontroversial," undogmatic, a nice guy, because he likes everybody. He's "tolerant."

The fact that he's got it wrong doesn't seem to make much difference.

It seems to me these histories are almost worthless. It's true that even a Whig approach can sum up what each group says, what each person says, but that's not really enough. It seems to me the historian should be critical, should find out, "Is this guy wrong?" or "To what extent is he wrong? Is he right? What's going on here?" Especially in economics or philosophy, where it's not just the cut-and-dried thing, where we now have the laser beam, and before we only had rubbing two sticks together.

By the way, probably the worst example of this sort of thing is the Leo Straussian doctrine in the history of liberal thought. Leo Strauss was a German refugee, came to the University of Chicago and set up what can only be called a cult group of Straussians, and all very self-consciously Straussian. "Follow the master in all things," etc.

Straussians take a few what they call "great thinkers" — I'm going to criticize that too, the concept of taking only great thinkers — they take a few great thinkers, more or less arbitrarily selected. How do they know they're great thinkers? Well, everybody says they're great. Machiavelli, Aristotle, Dewey, whatever. Hobbes.

Then they say, "Since this guy is a great figure, he must've been consistent. Why does he have to be consistent? Well, he's a great thinker? Who am I, a schnook professor, to challenge the greatness of this guy?" The assumption is this guy's a great thinker.

Most of these guys are very inconsistent. They contradict themselves on every page. Keynes did this all the time.

It looks as if he contradicted himself, say the Straussians, but he couldn't, because he's a great thinker and therefore consistent. So we have to look for the "deep inner consistency." The deep inner consistency amounts almost to astrology. It's numerology. Strauss will say if you take the fifth book of Machiavelli's Prince and compare it with the fifth book of the Laws, it's this number magic, you see, the five, you look for the deep things, really explain what he's saying. It's really bizarre.

Whiggism gone hog wild. And he desperately, actually, thinks everybody's great, and consistent as well as contributing to the edifice of thought.

So we have to realize, it seems to me, that it's just the opposite: many thinkers are great; other thinkers are lousy. Some developed truth; others sank into error. Therefore, analyzing economists, separating who these guys are, we have to ask, To what extent were they correct? To what extent were they bad? To what extent did they push economics in a wrong detour? Etc.

There is supposedly the vice of so-called presentism, where you attack everybody for not having read Human Action, and you attack Aquinas for not having read Human Action. It's called presentism. Very few people do that. I think it's a straw man. I don't know of anybody that really does that.

The real vice is the other way around. The real vice is to think everybody's great and everybody's true in some sense. To paraphrase one of my favorite quotes from Oscar Wilde, Miss Prism, in The Importance of Being Earnest, was asked whether her novel — she'd written a three-volume novel — whether it had a happy ending or not. She drew herself up and she said, "The good ended happily, and the bad unhappily. That is what Fiction means."

Of course, I would say with Lord Acton that the role of the historians is to praise the good and denounce the bad; that's the meaning of History. Acton says the muse of the historian is not Clio, the official Greek muse of history, but Rhadamanthus, the avenger of innocent blood.

Acton went on to say, "The historian must be a judge, and a hanging judge at that, to right the wrongs of history."

Excerpted from an edited transcript of "Ideology and Theories of History," the first in a series of six lectures, given in 1986, on the history of economic thought.

​For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Google Podcasts, Stitcher, Spotify, and via RSS.

Now Spitznagel is back with a new book that directly challenges our understanding of risk. Safe Haven asks, and answers, a fundamental question: Can mitigating risk actually add to the bottom line? Can safe havens be truly cost-effective, by adding to CAGR? Mises Institute Senior Fellow Robert Murphy, who consulted on the book, joins the show for a fascinating look at Spitznagel's penetrating and contrarian thesis. If you're interested in the intersection of investing and Austrian economics, don't miss this episode!

Mark Spitznagel's Safe Haven: Investing for Financial Storms on Amazon: Mises.org/SafeHaven

And, Spitznagel's 2013 book The Dao of Capital: Austrian Investing in a Distorted World on Amazon: Mises.org/Dao

Before Ludwig von Mises raised the calculation problem in his celebrated article in 1920,Mises's article, published in 1920 in German, "Die Wirtschaftsrechnung im sozialistischen Gemeinwesen," was only made available in English in 1935: Mises, "Economic Calculation in the Socialist Commonwealth," in F. A. Hayek, ed., Collectivist Economic Planning (London: Routledge and Sons, 1935), pp. 87–130. The article was republished as a monograph by the Mises Institute with a notable postscript by Professor Joseph T. Salerno (Ludwig von Mises, Economic Calculation in the Socialist Commonwealth [Auburn, Ala.: Ludwig von Mises Institute, 1990]). everyone, socialists and non-socialists alike, had long realized that socialism suffered from an incentive problem. If, for example, everyone under socialism were to receive an equal income, or, in another variant, everyone was supposed to produce "according to his ability" but receive "according to his needs," then, to sum it up in the famous question: Who, under socialism, will take out the garbage? That is, what will be the incentive to do the grubby jobs, and, furthermore, to do them well? Or, to put it another way, what would be the incentive to work hard and be productive at any job?

The traditional socialist answer held that the socialist society would transform human nature, would purge it of selfishness, and remold it to create a New Socialist Man. That new man would be devoid of any selfish, or indeed any self-determined, goals; his only wish would be to work as hard and as eagerly as possible to achieve the goals and obey the orders of the socialist State. Throughout the history of socialism, socialist ultras, such as the early Lenin and Bukharin under "War Communism," and later Mao Tse-tung and Che Guevara, have sought to replace material by so-called "moral" incentives. This notion was properly and wittily ridiculed by Alexander Gray as "the idea that the world may find its driving force in a Birthday Honours List (giving to the King, if necessary, 165 birthdays a year)."Alexander Gray, The Socialist Tradition (London: Longmans, Green, 1946),p. 90.  At any rate, the socialists soon found that voluntary methods could hardly yield them the New Socialist Man. But even the most determined and bloodthirsty methods could not avail to create this robotic New Socialist Man. And it is a testament to the spirit of freedom that cannot be extinguished in the human breast that the socialists continued to fail dismally, despite decades of systemic terror.

But the uniqueness and the crucial importance of Mises's challenge to socialism is that it was totally unrelated to the well-known incentive problem. Mises in effect said: All right, suppose that the socialists have been able to create a mighty army of citizens all eager to do the bidding of their masters, the socialist planners. What exactly would those planners tell this army to do? How would they know what products to order their eager slaves to produce, at what stage of production, how much of the product at each stage, what techniques or raw materials to use in that production and how much of each, and where specifically to locate all this production? How would they know their costs, or what process of production is or is not efficient?

Mises demonstrated that, in any economy more complex than the Crusoe or primitive family level, the socialist planning board would simply not know what to do, or how to answer any of these vital questions. Developing the momentous concept of calculation, Mises pointed out that the planning board could not answer these questions because socialism would lack the indispensable tool that private entrepreneurs use to appraise and calculate: the existence of a market in the means of production, a market that brings about money prices based on genuine profit-seeking exchanges by private owners of these means of production. Since the very essence of socialism is collective ownership of the means of production, the planning board would not be able to plan, or to make any sort of rational economic decisions. Its decisions would necessarily be completely arbitrary and chaotic, and therefore the existence of a socialist planned economy is literally "impossible" (to use a term long ridiculed by Mises's critics).

In the course of intense discussion throughout the 1920s and 1930s, the socialist economists were honest enough to take Mises's criticism seriously, and to throw in the towel on most traditional socialist programs: in particular, the original communist vision that workers, not needing such institutions as bourgeois money fetishism, would simply produce and place their products on some vast socialist heap, with everyone simply taking from that heap "according to his needs."

The socialist economists also abandoned the Marxian variant that everyone should be paid according to the labor time embodied into his product. In contrast, what came to be known as the Lange-Lerner solution (or, less commonly but more accurately, the Lange-Lerner-Taylor solution), acclaimed by virtually all economists, asserted that the socialist planning board could easily resolve the calculation problem by ordering its various managers to fix accounting prices. Then, according to the contribution of Professor Fred M. Taylor, the central planning board could find the proper prices in much the same way as the capitalist market: trial and error. Thus, given a stock of consumer goods, if the accounting prices are set too low, there will be a shortage, and the planners will raise prices until the shortage disappears and the market is cleared. If, on the other hand, prices are set too high, there will be a surplus on the shelves, and the planners will lower the price, until the markets are cleared. The solution is simplicity itself!Oskar Lange's well-known article was originally in two parts: "On the Economic Theory of Socialism," Review of Economic Studies 4 (October 1936): 53–71, and ibid. 5 (February 1937): 132–42; Fred M. Taylor's article was "The Guidance of Production in a Socialist State," American Economic Review 19 (March 1929); Taylor was reprinted and Lange revised and published in Oskar Lange and Fred M. Taylor, On the Economic Theory of Socialism, B. Lippincott, ed. (Minneapolis: University of Minnesota Press, 1938).

In the course of his two-part article and subsequent book, Lange concocted what could only be called the Mythology of the Socialist Calculation Debate, a mythology which, aided and abetted by Joseph Schumpeter, was accepted by virtually all economists of whatever ideological stripe. It was this mythology I found handed down as the Orthodox Line when I entered Columbia University's graduate school at the end of World War II — a line promulgated in lectures by no less an expert on the Soviet economy than Professor Abram Bergson, then at Columbia. In 1948, indeed, Professor Bergson was selected to hand down the Received Opinion on the subject by a committee of the American Economic Association, and Bergson interred the socialist calculation question with the Orthodox Line as its burial rite.Abram Bergson, "Socialist Economics," in H.S. Ellls, ed., A Survey of Contemporary Economics (Philadelphia: Blakiston, 1948), pp. 412–48.

The Lange-Bergson Orthodox Line went about as follows: Mises, in 1920, had done an inestimable service to socialism by raising the problem of economic calculation, a problem of which socialists had not generally been aware. Then Pareto and his Italian disciple Enrico Barone had shown that Mises's charge, that socialist calculation was impossible, was incorrect, since the requisite number of supply, demand, and price equations existed under socialism as under a capitalist system. At that point, F.A. Hayek and Lionel Robbins, abandoning Mises's extreme position, fell back on a second line of defense: that, while the calculation problem could be solved theoretically, in practice it would be too difficult. Thereby Hayek and Robbins fell back on a practical problem, or one of degree of efficiency rather than of a drastic difference in kind. But now, happily, the day has been saved for socialism, since Taylor-Lange-Lerner have shown that, by jettisoning utopian ideas of a money-less or price-less socialism, or of pricing according to a labor theory of value, the socialist planning board can solve these pesky equations simply by the good old capitalist method of trial and error.Lange was aided in this construction by being able to use Hayek's collection of articles on the subject, which had just been published the year before his first article, as a useful foil. Hayek's volume included the seminal article by Mises, other contributions by Pierson and Halm, two articles by Hayek himself, and the alleged refutation of Mises by Barone. See Hayek, Collectivist Economic Planning.

Bergson, attempting to be magisterial in his view of the debate, summed up Mises as contending that "without private ownership of, or (what comes to the same thing for Mises) a free market for the means of production, the rational evaluation of these goods for the purposes of calculating costs is ruled out…" Bergson correctly adds that to put Mises's point

somewhat more sharply than is customary, let us imagine a Board of Supermen, with unlimited logical faculties, with a complete scale of values for the different consumers goods', and present and future consumption, and detailed knowledge of production techniques. Even such a Board would be unable to evaluate rationally the means of production. In the absence of a free market for these goods, decisions on resource allocation in Mises' view necessarily would be on a haphazard basis.

Bergson sharply comments that this "argument is easily disposed of." Lange and Schumpeter both point out that, as Pareto and Barone had shown,

once tastes and techniques are given, the values of the means of production can be determined unambiguously by imputation without the intervention of a market process. The Board of Supermen could decide readily how to allocate resources so as to assure the optimum welfare. It would simply have to solve the equations of Pareto and Barone.Bergson, "Socialist Economics," p. 446.

So much for Mises. As for the Hayek-Robbins problem of practicality, Bergson adds, that can be settled by the Lange-Taylor trial-and-error method; any remaining problems are only a matter of degree of efficiency, and political choices. The Mises problem has been satisfactorily solved.

The breathtaking naiveté of the Orthodox Line should have been evident even in the 1940s. As Hayek later chided Schumpeter on the assumption of "imputation" outside the market, this formulation "presumably means … that the valuation of the factors of production is implied in, or follows necessarily from, the valuation of consumers' goods. But … implication is a logical relationship which can be meaningfully asserted only of propositions simultaneously present to one and the same mind."F.A. Hayek, "The Use of Knowledge in Society" (1945), in Hayek, Individualism and Economic Order (Chicago: University of Chicago Press, 1948),p. 90.

Economists were convinced of the Lange solution because they had already come under the sway of the Walrasian general equilibrium model; Schumpeter, for example, was an ardent Walrasian. In this model, the economy is always in static general equilibrium, a changeless world in which all "data"  — tastes or value scales, alternative technologies, and lists of resources — are known to everyone, and where costs are known and always equal to price. The Walrasian world is also one of "perfect" competition, where prices are given to all managers. Indeed, both Taylor and Lange make the point that the socialist planning board will be better able to calculate than capitalist markets, since the socialist planners can ensure "perfect competition," whereas the real world of capitalism is shot through with various sorts of "monopolies"! The socialist planners can act like the absurdly fictional Walrasian "auctioneer," bringing about equilibrium rapidly by trial and error.

Set aside the obvious absurdity of trusting a coercive governmental monopoly to act somehow as if it were in "perfect competition" with parts of itself. Another grievous flaw in the Lange model is thinking that general equilibrium, a world of certainty where there is no room for the driving force of entrepreneurship, can somehow be used to depict the real world. The actual world is one not of changeless "givens" but of incessant change and systemic uncertainty. Because of this uncertainty, the capitalist entrepreneur, who stakes assets and resources in attempting to achieve profits and avoid losses, becomes the crucial actor in the economic system, an actor who can in no way be portrayed by a world of general equilibrium. Furthermore, it is ludicrous, as Hayek pointed out, to think of general equilibrium as the only legitimate "theory," with all other areas or problems dismissed as mere matters of practicality and degree. No economic theory worth its salt can be worthwhile if it omits the role of the entrepreneur in an uncertain world. The Pareto-Barone-Lange, etc. "equations" is not simply excellent theory that faces problems in practice; for in order to be "good," a theory must be useful in explaining real life.The silliness of hailing Barone's essay as a refutation of Mises is highlighted by the fact that Barone's article was published in 1908, twelve years before Mises's article which it is supposed to have refuted. The date was well known to, and made no impression upon, Ludwig von Mises. Moreover, Barone and Pareto themselves had only scorn for any notion that their equations could aid socialist planning. See Trygve J. B. Hoff, Economic Calculation in the Socialist Society (1949; Indianapolis, Ind.: Liberty Press, 1981), pp. 222–23.

Another grave flaw in the Lange-Taylor trial-and-error approach is that it concentrates on consumer goods pricing. It is true that retailers, given the stock of a certain type of good, can clear the market by adjusting the prices of that good upward or downward. But, as Mises pointed out in his original 1920 article, consumers goods are not the real problem. Consumers, these "market socialists" are postulating, are free to express their values by using money they had earned on a range of consumers' goods. Even the labor market — at least in principleHere, as in other parts of his argument — as we shall see further below — Mises is leaning over backward to concede the market socialists their best case, and is not considering whether such free consumer or labor markets are really likely in a world where the state is the only seller, as well as the only purchaser, of labor.  — can be treated as a market with self-owning suppliers who are free to accept or reject bids for their labor and to move to different occupations. The real problem, as Mises has insisted from the beginning, is in all the intermediate markets for land and capital goods. Producers have to use land and capital resources to decide what the stocks of the various consumer goods should be. Here there are a huge number of markets where the State monopoly can only be both buyer and seller for each transaction, and these intra-monopoly, intra-state transactions permeate the most vital markets of an advanced economy — the complex lattice-work of the capital markets. And here is precisely where calculational chaos necessarily reigns, and there is no way for rationality to intrude on the immense number of decisions on the allocation of prices and factors of production in the structure of capital goods.

Moreover, Mises's brilliant and devastating rebuttal to his Lange-Lerner-"market socialism" critics has virtually never been considered-neither by the economics establishment nor by the post–World War II Hayekians. In both cases, the writers were eager to dispose of Mises as having safely made his pioneering contribution in 1920, but being superseded later, either by Lange-Lerner or by Hayek, as the case may be. In both cases, it was inconvenient to ponder that Mises continued to elaborate his position with a penetrating critique of his critics, or that Mises's "extreme" formulation may, after all, have been correct.Mises's later rebuttal is in his Human Action (New Haven: Yale University Press, 1949), pp. 694–711. For the establishment, the debate was supposed to be over by 1938. For an example of a Hayekian survey of the debate that does not bother to so much as mention Human Action, see Karen I. Vaughn, "Introduction," in Hoff, Economic Calculation, pp. ix-xxxvii. Indeed, in an earlier paper, Vaughn had sneered that "Mises' so-called final refutation in Human Action is mostly polemic and glosses over the real problems…." Vaughn, "Critical Discussion of the Four Papers," in Lawrence Moss, ed. The Economics of Ludwig von Mises (Kansas City: Sheed and Ward, 1976), p. 107. The Hayekian doctrine will be treated further below.    For a refreshing example of an outstanding Misesian contribution to the debate that does not neglect or deprecate Human Action but rather builds upon it, see Joseph T. Salerno, "Ludwig von Mises as Social Rationalist," Review of Austrian Economics 4 (1990): 36–48. Also see Salerno, "Why Socialist Economy is Impossible," a Postscript to Mises, Economic Calculation in the Socialist Commonwealth (Auburn, Ala.: Ludwig von Mises Institute, 1990).

Mises began his rebuttal in Human Action by discussing the "trial-and-error" method, and pointing out that this process only works in the capitalist market. There the entrepreneurs are strongly motivated to make greater profits and to avoid losses, and further, such a criterion does not apply to the capital goods or land market under socialism where all resources are controlled by one entity, the government.

Continuing his reply, Mises pressed on to a brilliant critique, not only of socialism, but of the entire Walrasian general equilibrium model. The major fallacy of the "market socialists," Mises pointed out, is that they look at the economic problem from the point of view of the manager of the individual firm, who seeks to make profits or avoid losses within a rigid framework of a given, external allocation of capital to each of the various branches of industry and indeed to the firm itself. In other words, the "market socialist" manager is akin, not to the real driving force of the capitalist market, the capitalist entrepreneur, but rather to the relatively economically insignificant manager of the corporate firm under capitalism. As Mises brilliantly puts it:

the cardinal fallacy implied in [market socialist] proposals is that they look at the economic problem from the perspective of the subaltern clerk whose intellectual horizon does not extend beyond subordinate tasks. They consider the structure of industrial production and the allocation of capital to the various branches and production aggregates as rigid, and do not take into account the necessity of altering this structure in order to adjust it to changes in conditions…. They fail to realize that the operations of the corporate officers consist merely in the loyal execution of the tasks entrusted to them by their bosses, the shareholders…. The operations of the managers, their buying and selling, are only a small segment of the totality of market operations. The market of the capitalist society also performs those operations which allocate the capital goods to the various branches of industry. The entrepreneurs and capitalists establish corporations and other firms, enlarge or reduce their size, dissolve them or merge them with other enterprises; they buy and sell the shares and bonds of already existing and of new corporations; they grant, withdraw, and recover credits; in short they perform all those acts the totality of which is called the capital and money market. It is these financial transactions of promoters and speculators that direct production into those channels in which it satisfies the most urgent wants of the consumers in the best possible way.Mises, Human Action, pp. 703–04.

Mises goes on to remind the reader that the corporate manager performs only a "managerial function," a subsidiary service that "can never become a substitute for the entrepreneurial function." Who are the capitalist-entrepreneurs? They are "the speculators, promoters, investors and moneylenders, [who] in determining the structure of the stock and commodity exchanges and of the money market, circumscribe the orbit within which definite tasks can be entrusted to the manager's discretion." The crucial question, Mises continues, is not managerial activities, but: "In which branches should production be increased or restricted, in which branches should the objective of production be altered, what new branches should be inaugurated?" In short, the crucial decisions in the capitalist economy are the allocation of capital to firms and industries. "With regard to these issues," Mises adds, "it is vain to cite the honest corporation manager and his well-tried efficiency. Those who confuse entrepreneurship and management close their eyes to the economic problem … The capitalist system is not a managerial system; it is an entrepreneurial system."

But here, Mises triumphantly concludes, no "market socialist" has ever suggested preserving or carrying over, much less understood the importance of, the specifically entrepreneurial functions of capitalism:

Nobody has ever suggested that the socialist commonwealth could invite the promoters and speculators to continue their speculations and then deliver their profits to the common chest. Those suggesting a quasi-market for the socialist system have never wanted to preserve the stock and commodity exchanges, the trading in futures, and the bankers and money-lenders as quasi-institutions.Ibid., pp. 704–05

Mises has been cited as stating, in Human Action, that it is absurd for the socialist planning board to tell their managers to "play market," to act as if they are owners of their firms in trying to maximize profits and avoid losses. But it is important to stress that Mises was focusing, not so much on the individual managers of socialist "firms," but on the speculators and investors who decide the crucial allocations of capital throughout the structure of industry. It is at least conceivable that one can order a manager to play market and act as if he were enjoying the profits and suffering losses; but it is clearly ludicrous to ask investors and capital speculators to act as if their fortunes were at stake. As Mises adds:

one cannot play speculation and investment. The speculators and investors expose their own wealth, their own destiny. This fact makes them responsible to the consumers, the ultimate bosses of the capitalist economy. If one relieves them of this responsibility, one deprives them of their very character.Ibid., p. 705.

One time, during Mises's seminar at New York University, I asked him whether, considering the broad spectrum of economies from a purely free market economy to pure totalitarianism, he could single out one criterion according to which he could say that an economy was essentially "socialist" or whether it was a market economy. Somewhat to my surprise, he replied readily: "Yes, the key is whether the economy has a stock market." That is, if the economy has a full-scale market in titles to land and capital goods. In short: Is the allocation of capital basically determined by government or by private owners? At the time, I did not fully understand the vital importance of Mises's answer, which I realized recently when poring over the great merits of the Misesian, as compared to the Hayekian, analysis of the socialist calculation problem.

For Mises, in short, the key to the capitalist market economy and its successful functioning is the entrepreneurial forecasting and decision-making of private owners and investors. The key is emphatically not the more minor decisions made by corporate managers within a framework already set by entrepreneurs and the capital markets. And it is obvious that Lange, Lerner, and the other market socialists merely envisioned the relatively lesser managerial decisions. These economists, who had never grasped the function of speculation or capital markets, therefore had no idea that they would need to be or could be replicated in a socialist system.The fact that some socialist bloc countries, such as Hungary, now permit a stock market, albeit small and truncated, and that other ex-communist countries are seriously considering introducing such capital markets, demonstrates the enormous importance of the de-socialization now under way in Eastern Europe.  And this is not surprising, since in the Walrasian general micro-equilibrium model, there is no capital structure, there is no role for capital, and capital theory has become totally submerged into "growth theory," that is, growth of a homogeneous "level," or blob, of aggregate macro-capital. The allocation of capital is considered external and given, and receives no consideration.

Joseph Schumpeter and Frank H. Knight are interesting examples of two eminent economists who were personally anti-socialist but were seduced by their Walrasian devotion to general equilibrium and their lack of a genuine capital theory into strongly endorsing the orthodox view that there is no economic calculation problem under socialism. In particular, in capital theory, both Schumpeter and Knight were disciples of J.B. Clark, who denied any role at all for time in the process of production. For Schumpeter, production takes no time because production and consumption are somehow always "synchronized." Time is erased from the picture, even to assuming away the existence of any accumulated stocks of capital goods, and therefore of any age structure of such goods. Since production is magically synchronized, there is then no necessity for land or labor to receive advances in payment from capitalists out of accumulated savings. Schumpeter achieves this feat by sundering capital completely from its embodiment in capital goods, and limiting the concept to a money fund used to purchase such goods.See Murray N. Rothbard, "Breaking Out of the Walrasian Box: The Cases of Schumpeter and Hansen," Review of Austrian Economics 1 (1987): 98–100, 107.

Frank Knight, the doyen of the Chicago School, was also an ardent believer in the Clarkian view that time preference has no influence on interest paid by producers, and that production is synchronized so that time plays no role in the production structure. Hence, Knight believed, along with modern orthodoxy, that capital is a homogeneous, self-perpetuating blob that has no lattice-like, time-oriented structure. Knight's fiercely anti–Böhm-Bawerkian, anti-Austrian views on capital and interest led him to a then-famous war of journal articles over capital theory during the 1930s, a war he won by default when Austrianism disappeared because of the Keynesian evolution.On Knight vs. Hayek, Machlup, and Boulding in the 1930s. see F. A. Hayek, "The Mythology of Capital," in W. Fellner and B. Haley, eds., Readings in the Theory of lncome Distribution (Philadelphia: Blakiston, 1946), pp. 355–83. For a Knightian attack on the Austrian discounted marginal productivity theory on behalf of what is now the orthodox undiscounted (by time-preference) marginal productivity theory, see Earl Rolph, "The Discounted Marginal Productivity Doctrine," ibid., pp. 278–93. For an Austrian rebuttal, see Murray N. Rothbard, Man, Economy, and State, vol. 1 (Los Angeles: Nash, 1970), pp. 431–33; and Walter Block, "The DMVP-MVP Controversy: A Note," Review of Austrian Economics 4 (1990): 199–207.

In his negative review of Mises's Socialism, Frank Knight, after hailing Lange's "excellent" 1936 article, brusquely dismisses the socialist calculation debate as "largely sound and fury." To Knight, it is simply "truistical" that the "technical basis of economic life" would continue as before under socialism, and that therefore "the managers of various technical units in production — farms, factories, railways, stores, etc. — would carry on in essentially the same way." Note, there is no reference whatever to the crucial capital market, or to the allocation of capital to various branches of production. If capital is an automatically renewing homogeneous blob, all one need worry about is growth in the amount of that blob. Hence, Knight concludes that "socialism is a political problem, to be discussed in terms of social and political psychology, and economic theory has relatively little to say about it."Frank H. Knight, "Review of Ludwig von Mises, Socialism," Journal of Political Economy 46 (April 1938): 267–68. In another review in the same issue of the journal, Knight claims that there would be a "capital market" under socialism, but it is clear that he is referring only to a market for loans, and not to a genuine market in equities throughout the production structure. Here again, Mises has a devastating critique of this sort of scheme in Human Action, pointing out that managers bidding for governmental planning board funds would not be bidding for or staking their own property, and hence they would "not be restrained by any financial dangers they themselves run in promising too high a rate of interest for the funds borrowed…. All the hazards of this insecurity fall only upon society, the exclusive owner of all resources available. If the director were without hesitation to allocate the funds available to those who bid most, he would simply … abdicate in favor of the least scrupulous visionaries and scoundrels." See Knight, "Two Economists on Socialism," Journal of Political Economy 46 (April 1938): 248; and Mises, Human Action, p. 705.

Certainly, that is true of Knight's orthodox-Chicagoite brand of economic theory!It is instructive to compare the naiveté and the brusque dismissal of the problem by Schumpeter and Knight with the penetrating Misesian critique of socialism by Professor Georg Halm:

Because capital is no longer owned by many private persons, but by the community, which itself disposes of it directly, a rate of interest can no longer be determined. A pricing process is always possible only when demand and supply meet in a market…. In the socialist economy … there can be no demand and no supply when the capital from the outset is in the possession of its intending user, in this case the socialistic central authority.

Now it might perhaps be suggested that, since the rate of interest cannot be determined automatically, it should be fixed by the central authority. But this likewise would be quite impossible. It is true that the central authority would know quite well how many capital goods of a given kind it possessed or could procure…; it would know the capacity of the existing plant in the various branches of production; but it would not know how scarce capital was. For the scarcity of means of production must always be related to the demand for them, whose fluctuations give rise to variations in the value of the good in question…

If it should be objected that a price for consumption-goods would be established, and that in consequence the intensity of the demand and so the value of the means of production would be determinate, this would be a further serious mistake…. The demand for means of production, labor and capital goods, is only indirect.

Halm goes on to add that if there were only one single factor of production in making consumers' goods, the socialist "market" might be able to determine its proper price. But this can not be true in the real world where several factors of production take part in the production of goods in various markets.

Halm then adds that the central authority, contrary to his above concession, would not even be able to find out how much capital it is employing. For capital goods are heterogeneous, and therefore how "can the total plant of one factory be compared with that of another? How can a comparison be made between the values of even only two capital-goods?" In short, while under capitalism such comparisons can be made by means of money prices set on the market for every good, in the socialist economy the absence of genuine money prices arising out of a market precludes any such value comparisons. Hence, there is also no way for a socialist system to rationally estimate the costs (which are dependent on prices in factor markets) of any process of productionGeorg Halm, "Further Considerations on the Possibility of Adequate Calculation in a Socialist Community," in Hayek, Collectivist Economic Planning, pp. 162–65. Also see ibid., pp. 13–200.

In his original 1920 article, Mises emphasized that "as soon as one gives up the conception of a freely established monetary price for goods of a higher order, rational production becomes completely impossible." Mises then states, prophetically:

One may anticipate the nature of the future socialist society. There will be hundreds and thousands of factories in operation. Very few of these will be producing wares ready for use; in the majority of cases what will be manufactured will be unfinished goods and production goods. All these concerns will be interrelated. Every good will go through a whole series of stages before it is ready for use. In the ceaseless toil and moil of this process, however, the administration will be without any means of testing their bearings. It will never be able to determine whether a given good has not been kept for a superfluous length of time in the necessary processes of production, or whether work and material have not been wasted in its completion. How will it be able to decide whether this or that method of production is the more profitable? At best it will only be able to compare the quality and quantity of the consumable end-product produced, but will in the rarest cases be in a position to compare the expenses entailed in production.

Mises points out that while the government may be able to know what ends it is trying to achieve, and what goods are most urgently needed, it will have no way of knowing the other crucial element required for rational economic calculation: valuation of the various means of production, which the capitalist market can achieve by the determination of money prices for all products and their factors.Mises, "Economic Calculation in the Socialist Commonwealth," pp. 106–08.

Mises concludes that, in the socialist economy "in place of the economy of the 'anarchic' method of production, recourse will be had to the senseless output of an absurd apparatus. The wheels will turn, but will run to no effect."Ibid., p. 106. This conclusion of 1920 is strikingly close to the quip common in the Poland of 1989, as reported by Professor Krzyztof Ostazewski of the University of Louisville: that the socialist planned economy is "a value-shredding machine run by an imbecile."

Moreover, in his later rebuttal to the champions of the Pareto-Barone equations, Mises points out that the crucial problem is not simply that the economy is not and can never be in the general equilibrium state described by these differential equations. In addition to other grave problems with the equilibrium model (e.g.: that the socialist planners do not now know their value scales in future equilibrium; that money and monetary exchange cannot fit into the model; that units of productive factors are neither perfectly divisible nor infinitesimal-and that marginal utilities ,of different people cannot be equated-on the market or anywhere else), the equations "do not provide any information about the human actions by means of which the hypothetical state of equilibrium" has been or can be reached. In short, the equations offer no information whatever on how to get from the existing disequilibrium state to the general equilibrium goal.

In particular, Mises points out, "even if, for the sake of argument, we assume that a miraculous inspiration has enabled the director without economic calculation to solve all problems concerning the most advantageous arrangement of all production activities and that the price image of the final goal he must aim at is present to his mind," there remain crucial problems on the path from here to there. For the socialist planner does not start from scratch and then build a capital goods structure most perfectly designed to meet his goals. He necessarily starts with a capital goods structure produced at many stages of the past and determined by past consumer values and past technological methods of production. There are different degrees of such past determinants built into the existing capital structure, and anyone starting today must use these resources as best he can to meet present and expected future goals. For these heterogeneous choices, no mathematical equations can be of the slightest use.Mises, Human Action, pp. 706–09: As Mises puts it: "socialists of all shades of opinion, repeat again and again that what makes the achievement of their ambitious plans realizable is the enormous wealth hitherto accumulated. But in the same breath, they disregard the fact that this wealth consists to a great extent in capital goods produced in the past and more or less antiquated from the point of view of our present valuations and technologica1 knowledge." Ibid. p. 710.

Finally, the unique root of Mises's position, and one that distinguishes him and his "socialist impossibility" thesis from Hayek and the Hayekians, has been neglected until the present day. And this neglect has persisted despite Mises's own explicit avowal in his memoirs of the root, and groundwork of his calculation thesis.In Mises's Notes and Recollections (Spring Mills, Penn.: Libertarian Press, 1978), p. 112. Also see the discussion in Murray N. Rothbard, Ludwig von Mises: Scholar, Creator, Hero (Auburn, Ala.: Ludwig von Mises Institute, 1988), pp. 35–38. For Mises was not, like Hayek and his followers, concentrating on the flaws in the general equilibrium model when he arrived at his position; nor was he led to his discussion solely by the triumph of the socialist revolution in the Soviet Union.

For Mises records that his position on socialist calculation emerged out of his first great work, The Theory of Money and Credit (1912). In the course of that notable integration of monetary theory and "micro" marginal utility theory, Mises was one of the very first to realize that subjective valuations of the consumers (and of laborers) on the market are purely ordinal, and are in no way measurable. But market prices are cardinal and measurable in terms of money, and market money prices bring goods into cardinal comparability and calculation (e.g., a $10 hat is "worth" five times as much as a $2 loaf of bread).On the market, then, consumers evaluate goods and services ordinally, whereas entrepreneurs appraise (estimate and forecast future prices) cardinally. On valuation and appraisement, see Mises, Human Action, pp. 327–330; Salerno, "Mises as Social Rationalist," pp. 39–49; and Salerno, "Socialist Economy is Impossible."  But Mises realized that this insight meant it was absurd to say (as Schumpeter would) that the market "imputes" the values of consumer goods back to the factors of production. Values are not directly "imputed"; the imputation process works only indirectly, by means of money prices on the market. Therefore socialism, necessarily devoid of a market in land and capital goods, must lack the ability to calculate and compare goods and services, and therefore any rational allocation of productive resources under socialism is indeed impossible.Mises says in his memoirs: "They [the socialists] failed to see the very first challenge: How can economic action that always consists of preferring and setting aside, that is, of making unequal valuations, be transformed into equal valuations, by the use of equations? Thus the advocates of socialism came up with the absurd recommendation of substituting equations of mathematical catallactics, depicting an image from which human action is eliminated, for the monetary calculation in the market economy." Mises, Notes and Recollections, p. 112.

For Mises, then, his work on socialist calculation was part and parcel of his expanded integration of direct and monetary exchange — of "micro" and "macro" — that he had begun but not yet completed in The Theory of Money and Credit.This integration was later completed by his business-cycle theory in the 1920s, and then in his monumental treatise Human Action.

The orthodox line of the 1930s and '40s was wrong in claiming that Hayek and his followers (such as Lionel Robbins) abandoned Mises's "theoretical" approach by bowing down to the Pareto-Barone equations, falling back on "practical" objections to socialist planning.Except for the unfortunate emphasis of Hayek and Robbins on the alleged socialist difficulty of computing or "counting" the equations. See below.  As we have already seen, Hayek scarcely ceded to mathematical equations of general equilibrium the monopoly of correct economic theory. But it is also true that Hayek and his followers fatally and radically changed the entire focus of their "Austrian" position, either by misconstruing Mises's argument or by consciously though silently shifting the crucial terms of the debate.

It is no accident, in short, that Hayek and the Hayekians dropped Mises's term "impossible" as embarrassingly extreme and imprecise. For Hayek, the major problem for the socialist planning board is its lack of knowledge. Without a market, the socialist planning board has no means of knowing the value-scales of the consumers, or the supply of resources or available technologies. The capitalist economy is, for Hayek, a valuable means of disseminating knowledge from one individual to another through the pricing "signals" of the free market. A static, general equilibrium economy would be able to overcome the Hayekian problem of dispersed knowledge, since eventually all data would come to be known by all, but the ever-changing, uncertain data of the real world prevents the socialist planning board from acquiring such knowledge. Hence, as is usual for Hayek, the argument for the free economy and against statism rests on an argument from ignorance.

But to Mises the central problem is not "knowledge." He explicitly points out that even if the socialist planners knew perfectly, and eagerly wished to satisfy, the value priorities of the consumers, and even if the planners enjoyed a perfect knowledge of all resources and all technologies, they still would not be able to calculate, for lack of a price system of the means of production. The problem is not knowledge, then, but calculability. As Professor Salerno points out, the knowledge conveyed by present-or immediate "past"-prices is consumer valuations, technologies, supplies, etc. of the immediate or recent past. But what acting man is interested in, in committing resources into production and sale, is future prices, and the present committing of resources is accomplished by the entrepreneur, whose function is to appraise — to anticipate — future prices, and to allocate resources accordingly. It is precisely this central and vital role of the appraising entrepreneur, driven by the quest for profits and the avoidance of losses, that cannot be fulfilled by the socialist planning board, for lack of a market in the means of production. Without such a market, there are no genuine money prices and therefore no means for the entrepreneur to calculate and appraise in cardinal monetary terms.

More philosophically, the entire Hayekian emphasis on "knowledge" is misplaced and misconceived. The purpose of human action is not to "know" but to employ means to satisfy goals. As Salerno perceptively summarizes Mises's position:

The price system is not — and praxeologically cannot be — a mechanism for economizing and communicating the knowledge relevant to production plans [the Hayekian position]. The realized prices of history are an accessory of appraisement, the mental operation in which the faculty of understanding is used to assess the quantitative structure of price relationships which corresponds to an anticipated constellation of economic data. Nor are anticipated future prices tools of knowledge; they are instruments of economic calculation. And economic calculation itself is not the means of acquiring knowledge, but the very prerequisite of rational action within the setting of the social division of labor. It provides individuals, whatever their endowment of knowledge, the indispensable tool for attaining a mental grasp and comparison of the means and ends of social action.Salerno, "Mises as Social Rationalist," p. 44.

In a recent article, Professor Israel Kirzner argues for the Hayekian position. For Hayek and for Kirzner, the market is a "discovery procedure," that is, an unfolding of knowledge. There is, in this view of the market and of the world, no genuine recognition of the entrepreneur, not as a "discoverer," but as a dynamic risk taker, risking losses if his appraisal and forecast go awry. Kirzner's commitment to the "discovery process" fits all too well with his own original concept of the entrepreneurial function as being that of "alertness," and of different entrepreneurs as being variously alert to the opportunities that they see and discover. But this outlook totally misconceives the role of the entrepreneur. The entrepreneur is not simply "alert"; he forecasts; he appraises; he meets and bears risk and uncertainty by questing for profits and risking losses. As Salerno points out, for all their talk of dynamism and uncertainty, the Hayek-Kirzner "entrepreneur" is curiously bloodless and passive, receiving and passively imbibing knowledge imparted to him by the market. The Hayek-Kirzner entrepreneur is far closer than they like to think to the Walrasian automaton — to the fictional "auctioneer" who avoids all real trades in the marketplace.Israel M. Kirzner, "The Economic Calculation Debate: Lessons for Austrians," Review of Austrian Economics 2 (1988): 1–18 [PDF]. Hayek coined the term "discovery procedure" in F. A. Hayek, "Competition as a Discovery Procedure," in New Studies in Philosophy, Politics, Economics and the History of Ideas (Chicago: University of Chicago Press, 1978), pp. 179–90. For a critique of Kirzner's concept of entrepreneurship, see Murray N. Rothbard, "Professor Hébert on Entrepreneurship," Journal of Libertarian Studies 7 (Fall 1985): 281–85 [PDF]. For Hayek's own contributions to the socialist calculation debate after Lange-Lerner, see F.A. Hayek, "Socialist Calculation 111: The Competitive 'Solution'" (1940), and "The Use of Knowledge in Society," (1945), in Individualism and Economic Order, pp. 181–208; 77–91.

Unfortunately, while lucidly expounding the Hayekian position, Kirzner obfuscates the history of the debate by claiming that the later Mises, along with Hayek, changed his position (or, at the least, "elaborated" it) from his original, "static" view of 1920. But on the contrary, as Salerno points out, the "later" Mises explicitly spurned uncertainty of the future as the key to the calculation problem. The key to the calculation question, stated Mises in Human Action, is not that "all human action points to the future and the future is always uncertain." No, socialism has

quite a different problem. Today we calculate from the point of view of our present knowledge and of our present anticipation of future conditions. We do not deal with the problem of whether or not the [socialist] director will be able to anticipate future conditions. What we have in mind is that the director cannot calculate from the point of view of his own present value judgments and his own present anticipation of future conditions, whatever they may be. If he invests today in the canning industry, it may happen that a change in consumers' tastes or in the hygienic opinions concerning the wholesomeness of canned food will one day turn his investment into a malinvestment. But how can he find out today how to build and equip a cannery most economically?

Some railroad lines constructed at the turn of the century would not have been built if the people had at that time anticipated the impending advance of motoring and aviation. But those who at the time built railroads knew which of the various possible alternatives for the realization of their plans they had to choose from the point of view of their appraisements and anticipations and of the market prices of their day in which the valuations of the consumers were reflected. It is precisely this insight that the director will lack. He will be like a sailor on the high seas unfamiliar with the methods of navigation…Mises, Human Action, p. 696. Also see Salerno, "Mises as social Rationalist," pp. 46–47ff.,Kirzner apparently believes that Mises's concentration on entrepreneurship in his Human Action discussion of socialism demonstrates that Mises had gone over to the Hayek position. Kirzner seems to overlook the vast difference between Mises's forecasting and appraisement view of entrepreneurship and his own "alertness" doctrine, which totally leaves out the possibility of entrepreneurial loss.

One of the unfortunate formulations of Hayek and the Hayekians in the 1930s, giving rise to the general misunderstanding that the only problems of socialist planning are "practical" not "theoretical," was their stress on the alleged difficulty of socialist planners in computing or solving all the demand and supply functions, all the "simultaneous differential equations" needed to plan prices and the allocation of resources. If socialistic planning is to rely on the Pareto-Barone equations, then how will all of them be known, especially in a world of necessarily changing data of values, resources, and technology?

Lionel Robbins began this equation-difficulty approach in his study of the 1929 depression, The Great Depression. Conceding, with Mises, that the planners could determine consumer preferences by allowing a market in consumer goods, Robbins correctly added that the socialist planners would also have to "know the relative efficiencies of the factors of production in producing all the possible alternatives." Robbins then unfortunately added:

On paper we can conceive this problem to be solved by a series of mathematical calculations. We can imagine tables to be drawn up expressing the consumers demands … And we can conceive technical information giving us the productivity … which could be produced by each of the various possible combinations of the factors of production. On such a basis a system of simultaneous equations could be constructed whose solution would show the equilibrium distribution of factors and the equilibrium production of commodities.

But in practice this solution is quite unworkable. It would necessitate the drawing up of millions of equations on the basis of millions of statistical tables based on many more millions of individual computations. By the time the equations were solved, the information on which they were based would have become obsolete and they would need to be calculated anew.Lionel Robbins, The Great Depression (New York: Macmillan, 1934).p. 151.

While Robbins's strictures about changes in data were and still are true enough, they helped divert the emphasis from Mises's even-if-static and full-knowledge calculation approach, to Hayek's emphasis on uncertainty and change. More important, they gave rise to the general myth that Robbins's strictures against socialism, unlike Mises's, were only "practical" in the sense of not being able to calculate all these simultaneous equations. Furthermore, in the concluding essay in his Collectivist Economic Planning, Hayek set forth all the reasons why the planners could not know essential data, one of which is that they would have to solve "hundreds of thousands" of unknowns. But

this means that, at each successive moment, every one of the decisions would have to be based on the solution of an equal number of simultaneous differential equations, a task which, with any of the means known at present, could not be carried out in a lifetime. And yet these decisions would … have to be made continuously…F.A. Hayek, The Present State of the Debate," in Hayek, Collectivist Economic Planning, p. 212.

It is fascinating to note the twists and turns in Oskar Lange's reaction to the equation-solving argument. In his 1936 article, which was long considered the last word on the subject, Lange ridiculed the very terms of the problem. Adopting his "quasi-market" socialist approach, and ignoring the crucial Misesian problem of the necessary absence of any market in land or capital, Lange simply stated that there is no need for planners to worry about these equations, since they would be "solved" by the socialist market:

Neither would the Central Planning Board have to solve hundreds of thousands … or millions … of equations. The only "equations" which would have to be "solved" would be those of the consumers and the managers of production plants. These are exactly the same "equations" which are solved in the present economic system and the persons who do the "solving" are the same also. Consumers … and managers … "solve" them by a method of trial and error… And only few of them have been graduated in higher mathematics. Professor Hayek and Professor Robbins themselves "solve" at least hundreds of equations daily, for instance, in buying a newspaper or in deciding to take a meal in a restaurant, and presumably they do not use determinants or Jacobians for that purpose.Oskar Lange, "On the Economic Theory of Socialism, Part One," p. 67. The Norwegian economist and defender of Mises's position, Trygve Hoff, commented that "Quite apart from the fact that the equations the central authority would have to solve are of quite a different nature to those of the private individual, the latter tend to solve themselves automatically, which Dr. Lange must admit the former do not." Hoff, Economic Calculation in the Socialist Society, pp. 221–22. This excellent book on the socialist calculation controversy was originally published in Norwegian in 1938. In contrast to Bergson's almost contemporaneous survey article, Hoff's English-language translation, published in 1949 in Britain but not in the United States, sank without a trace.

Thus, the orthodox neoclassical economic establishment had settled the calculation dispute with Lange-Lerner the acclaimed winner. Accordingly, when the end of World War II brought communism/socialism to his native Poland, Professor Oskar Lange left the plush confines of the University of Chicago to play a major role in bringing his theories to bear on the brave new world of socialist Poland. Lange became Polish ambassador to the United States, then Polish delegate to the United Nations Security Council, and finally chairman of the Polish Economic Council. And yet not once in this entire period or later, did Poland — or any other communist government, for that matter — attempt to put into practice anything remotely like Lange's fictive accounting-type, play-at-market socialism. Instead, they all put into effect the good old Stalinist command-economy model.

It did not take long for Oskar Lange to adjust to the persistence of the Stalinist Model. Indeed, it turns out that Lange, in post-war Poland, argued strongly for the historical necessity of the persistence of the Stalinist model as opposed to his own market socialism. Arguing against his own quasi-decentralized market-socialist solution, Lange, in 1958, revealed that "in Poland, we had some discussions whether such a period of highly centralized planning and management was historical necessity or a great political mistake. Personally, I hold the view that it was a historical necessity."

Why? Lange now claimed:

Shortly before his death in 1965, however, Oskar Lange, in his neglected last word on the socialist calculation debate, implicitly revealed that his socialist-market "solution" had been little more than a hoax, to be jettisoned quickly when he indeed saw a way for the planning board to solve all those hundreds of thousands or millions of simultaneous equations! Strangely gone was his gibe that everyone "solves equations" every day without having to do so formally. Instead, technology had now supposedly come to the rescue of the planning board! As Lange put it:

Were I to rewrite my essay ["On the Economic Theory of Socialism"] today my task would be much simpler. My answer to Hayek and Robbins would be: so what's the trouble? Let us put the simultaneous equations on an electronic computer and we shall obtain the solution in less than a second. The market process with its cumbersome tâtonnements appears old-fashioned. Indeed, it may be considered as a computing device of the pre-electronic age.Oskar Lange, "The Computer and the Market," in A. Nove and D. Nuti, eds. Socialist Economics (London: Penguin Books, 1972), pp. 401–02.

Indeed, Lange claims that the computer is superior to the market, because the computer can perform long-range planning far better, since it somehow already knows "future shadow prices" which markets cannot seem to obtain.

Lange's naive enthusiasm for the magical planning qualities of the computer in its early days can only be considered a grisly joke to the economists and the people in the socialist countries who have seen their economies go inexorably from bad to far worse despite the use of computers. Lange apparently never became familiar with the computer adage, GIGO ("garbage in, garbage out"). Nor could he have become familiar with the recent estimate of a top Soviet economist that, even assuming that the planning board and its computers could learn the correct data, it would take even the current generation of computers 30,000 years to process the information and allocate the resources.Yuri M. Maltsev, "Soviet Economic Reforms: An Inside Perspective," The Freeman (March 1990).

But there is a more important flaw in Lange's last article than his naiveté about the magical powers of the then-new technology of the computer. His eagerness to embrace a way of solving those equations he earlier had claimed didn't need conscious solving demonstrates that he had been disingenuous in claiming that his pseudomarket trial-and-error method would provide a facile way for the socialist society to solve the calculation problem.

Ever since 1917, or at least since Stalin's great leap forward into socialism in the early 1930s, the defenders of the possibility of socialism against Mises's strictures had one final, clinching, fallback argument. When all the arguments over general equilibrium or equations or entrepreneurship or Walrasian tâtonnenents or the command economy or pseudo-markets had been hashed over, the defenders of socialism could simply fall back on one point: Well, socialism exists, doesn't it? When all is said and done, it exists, and therefore it must be, for one reason or another, possible. Mises must clearly be wrong, even if the "practical" arguments of Hayek or Robbins, arguments of mere degrees of efficiency, need to be soberly considered. At the end of his celebrated survey essay on socialist economics Professor Abram Bergson put the point starkly:

there can hardly be any room for debate: of course, socialism can work. On this, Lange certainly is convincing. If this is the sole issue, however, one wonders whether at this stage such an elaborate theoretic demonstration is in order. After all, the Soviet planned economy has been operating for thirty years. Whatever else may be said of it, it has not broken down.Bergson, "Socialist Economics," p. 447.

In the first place, this triumphal conclusion now rings hollow, since the economies of the Soviet Union and the other socialist bloc countries have now manifestly broken down. And now it also turns out that the Soviet GNP and production figures that Bergson, the CIA, and other Sovietologists have been taking at face value for decades have been nothing but a pack of lies, designed to deceive not the United States, but the Soviet managers' own ruling elite. Even now, Western Sovietologists are reluctant to believe the Soviet economists who are finally trying to tell them the truth about these alleged and much revered data.

But apart from all that, this sort of seemingly decisive empiricist counter to the Misesian critique reveals the perils of using allegedly simple and brute "facts" to rebut theory in the sciences of human action. For why must we assume that the Soviet Union and the Eastern European countries ever really enjoyed full and complete socialism? There are many reasons to believe that, try as they might, the communist rulers were never able to impose total socialism and central planning. For one thing, it is now known that the entire Soviet economy and society has been shot through with a vast network of black markets and evasions of controls, fueled by a pervasive system of bribery known as blat to allow escape from those controls. Managers who could not meet their annual production quotas were approached by illegal entrepreneurs and labor teams to help them meet the quotas and get paid off the books. And black markets in foreign exchange have long been familiar to every tourist. Long before the Eastern European collapse of communism, these countries stopped trying to stamp out their black markets in hard currency, even though they were blatantly visible in the streets of Warsaw, Budapest, and Prague. Without uncontrolled black markets fueled by bribery, the communist economies may well have collapsed long ago.One source on this pervasive system in the Soviet Union is Konstantin M. Simis, USSR: The Corrupt Society (New York: Simon & Schuster, 1982). This historical point has also been bolstered by Michael Polanyi's "span of control" theory, which denies the possibility of effective central planning from a rather different viewpoint than Mises's.Michael Polanyi, The Logic of Liberty (Chicago: University of Chicago Press, 1951), pp. 111–37 and passim.

But the decisive rebuttal has, once again, been leveled by Mises in Human Action: the Soviet Union and Eastern European economies were not fully socialist because they were, after all, islands in a world capitalist market. The communist planners were therefore able, albeit clumsily and imperfectly, to use prices set by world markets as indispensable guidelines for the pricing and allocation of capital resources. As Mises pointed out:

People do not realize that these were not isolated social systems. They were operating in an environment in which the price system still worked. They could resort to economic calculation on the ground of the prices established abroad. Without the aid of these prices their actions would have been aimless and planless. Only because they were able to refer to these foreign prices were they able to calculate, to keep books, and to prepare their much talked about plans.Mises, Human Action, pp. 698–99.

Mises's insight was confirmed as early as the mid-1950s, when the British economist Peter Wiles visited Poland, where Oskar Lange was helping to plan Polish socialism. Wiles asked the Polish economists how they planned the economic system. As Wiles reported:

What actually happens is that "world prices", i.e. capitalist world prices, are used in all intra-[Soviet] bloc trade. They are translated into rubles … entered into bilateral clearing accounts.

Wiles then asked the Polish communist planners the crucial question. Since the Poles were, as good Marxist-Leninists, presumably committed to the triumph, as soon as possible, of world-wide socialism, Wiles asked: "What would you do if there were no capitalist world" from which you could obtain all those crucial prices? The Polish planners' rather cynical answer: "We'll cross that bridge when we come to it." Wiles added that "In the case of electricity the bridge is already under their feet: there has been great difficulty in pricing it since there is no world market."Peter J. D. Wiles, "Changing Economic Thought in Poland," Oxford Economic Papers 9 (June 1957): 202–03. Also see Murray N. Rothbard, "Ludwig von Mises and Economic Calculation Under Socialism," in Lawrence Moss, The Economics of Ludwig won Mises, pp. 67–77.

But fortunately for the world and for the Polish planners themselves, they were never truly forced to cross that bridge.

In his supposedly definitive article of 1936 vindicating economic calculation under socialism, Oskar Lange delivered a once-famous gibe at Ludwig von Mises. Lange began his essay by ironically hailing Mises's services to socialism: "Socialists have certainly good reason to be grateful to Professor Mises, the great advocatus diaboli of their cause. For it was his powerful challenge that forced the socialists to recognize the importance of an adequate system of economic accounting … the merit of having caused the socialists to approach this problem systematically belongs entirely to Professor Mises." Lange then went on to taunt Mises:

Both as an expression of recognition for the great service rendered by him and as a memento of the prime importance of sound economic accounting, a statue of Professor Mises ought to occupy an honorable place in the great hall of the Ministry of Socialization or of the Central Planning Board of the socialist state.

Lange went on to say that "I am afraid that Professor Mises would scarcely enjoy what seemed the only adequate way to repay the debt of recognition incurred by the socialists … " For one thing, Lange concluded, to complete Mises's discomfiture

a socialist teacher might invite his students in a class on dialectical materialism to go and look at the statue, in order to exemplify the Hegelian List der Vernuft [cunning of Reason] which made even the staunchest of bourgeois economists unwittingly serve the proletarian cause.Lange, "The Economic Theory of Socialism," p. 53.

Curiously enough, Lange, during his years as socialist planner in Poland, never got around to erecting the statue to Mises at the Ministry of Socialization in Warsaw. Perhaps socialist planning was not successful enough to accord Mises that honor — or perhaps there were not enough resources to build the statue. In any case, the opportunity has been lost. The countries of Eastern Europe now stand in the rubble wrought by what used to be called in the 1930s "the great socialist experiment." Emerging gloriously out of the rubble of the collapse of socialism are a myriad of Misesian economists, to whom socialism is little more than a grisly joke. Even as early as the 1960s it was a common quip among economists that, at international economic conferences, "the Western economists talk about the glories of planning while the Eastern economists talk about the virtues of the free market." Now Misesian economists are springing out of the ruins of socialism in Poland, Lithuania, Czechoslovakia, Hungary, Yugoslavia (especially Croatia and Slovenia) and the Soviet Union. Neither socialist planning nor Marxism-Leninism hold any charms for the economists of the once-socialist nations.

In all of these countries, the giant statues of Lenin are being unceremoniously toppled from the public squares. Whether or not the coming free societies of Eastern Europe choose to replace them with statues of Ludwig von Mises, as the prophet of their liberation, one thing seems certain: there will be no statues erected to Oskar Lange in Cracow or Warsaw. It is hard to see how even the cunning of Reason and the Hegelian dialectic can make Lange out to be a prophet or an important contributor to the laissez-faire Polish economy of the future. Perhaps the closet approach was a bitter quip pervading Eastern Europe during the revolutionary year of 1989: "Communism can be defined as the longest route from capitalism to capitalism.

Recorded at the Mises Institute in Auburn, Alabama, on 20 July 2021.

Desmond Ng (dng@tamu.edu) is associate professor of agribusiness and strategy management at Texas A&M University. The author would like to thank the special guest editor, Professor Bylund, and the two anonymous reviewers for their constructive comments and suggestions.

“No company, small or large, can win over the long run without energized employees who believe in the mission and understand how to achieve it.” – Jack Welch, General Electric

To succeed in an increasingly complex and changing market environment, ventures can no longer compete on the basis of their leader’s capabilities, knowledge, talents, and vision alone (e.g., Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering, Weitzel, and Muehlfeld 2019). Ideas to develop new products and services can come from anywhere, from loyal customers, blog spheres, supply chain partners, social media, and above all employees (Rigtering, Weitzel, and Muehlfeld 2019). For instance, 3M established a culture in which employees are encouraged to develop “home-grown” solutions to addressing their customers’ needs. These homegrown solutions transformed a small-scale mining venture into a leading material sciences company and have earned the company a spot on Fast Company’s Best Workplace for Innovators list (Rubinson 2009; FastCo Works 2019). Companies such as 3M underscore that in order to succeed entrepreneurs must be able to adapt to ideas that extend beyond their own (e.g., Lee, Lee, and Pennings 2001; Rigtering, Weitzel, and Muehlfeld, 2019; Sarasvathy 2001). Adaptation promotes an integration of different knowledge experiences that enables the venture to respond to changing market conditions and opportunities not previously considered (e.g., Hargadon and Sutton 1997; Sarasvathy 2001; Sullivan and Marvel 2011). Hence, although successful ventures are commonly attributed to an entrepreneur’s ideas, talents, and vision (e.g., Witt 1998, 1999), entrepreneurs today face increasing demands to adapt their ideas to the knowledge experiences of others (see Cowen and Parker 1997; Rigtering, Weitzel, and Muehlfeld 2019; Sarasvathy 2001).

Although the role of Austrian economics in contemporary entre­preneurship research remains a subject of much discussion and debate (Klein and Bylund 2014), Austrian economics is particularly suited to addressing the challenges faced by today’s entrepreneurs. According to the subjective tenets of Austrian economics, entre­preneurs operate in a sea of subjective experiences in which they adapt by mobilizing these knowledge experiences to address opportunities not currently met by the market. This adaption has been widely understood as the Hayekian knowledge problem: the problem of how to utilize knowledge experiences that are broadly distributed among the productive members of society. F. A. Hayek (1945) argued that the productive members of society, such as employees, have a knowledge of the “particular circumstances of time and place” (521). This knowledge involves an employee’s particular understandings of the special circumstances, challenges, and local conditions of their job. Hayek (1945) argued that a single mind, such as that of a centrally planner, cannot offer an adap­tation that can utilize this “knowledge of particular circumstance of time and place,” because this knowledge is highly localized to an employees’ experiences. He instead argued that employees are in the best position to utilize this knowledge because their understandings of the special circumstances of their job offered employees or “arbitrageurs” (522) opportunities to exploit local price differentials not known by others. This arbitrage function was later formalized by Israel M. Kirzner’s (1979, 2009, 2019) concept of the alert entrepreneur. Alertness involves discovering price arbitrage opportunities by bringing into use factors of productions at a price less than their valued uses. Specifically, as employees are key factors of a firm’s production, alertness solves the Hayekian knowledge problem, because the alert entrepreneur is incentivized to bring into use their employee’s knowledge to discover the price arbitrage opportunities of the market.

Although Kirzner (1979) has been credited with solving the Hayekian knowledge problem (Elert and Henrekson 2019; Foss and Klein 2016), the concept of alertness implicitly assumes that an employee’s knowledge can be centralized under an entrepreneur’s leadership. This leadership involves a position of authority in which the entrepreneur has the power to institute their vision over their employees (Shamir, House, and Arthur, 1993; Witt, 1998). In this position, however, an entrepreneur cannot readily identify their employees’ knowledge, because the entrepreneur’s authority is removed from their employees’ day-to-day experiences. This is consistent with Hayek (1945), who argued that employees are best suited to making decisions on how to allocate their time, resources, and efforts in dealing with their daily operational challenges because employees are most familiar with the circumstances facing them in carrying out their tasks. Hence, the challenge facing the entrepreneur is that their inability to centralize their employees’ knowledge introduces an internal Hayekian knowledge problem (see also Elert and Henrekson 2019; Foss 1997; Foss, Foss, and Klein 2007) of: how an entrepreneur in a position of authority can utilize the different knowledge experiences of their employees when employees are in the best position to know their valued contributions?

This study’s objective is to develop a concept of “Entrepre­neurial Empowerment” (EE) to address this internal Hayekian knowledge problem. Leadership research has widely recognized that employees are an important source of ideas and inspirations (Argyris 1998, Foss, Foss, and Klein 2007; Gagne and Edward 2005; Govindarajan and Srikanth 2013; Lee and Koh 2001; Lee, Willis, and Tian 2018; Rigtering, Weitzel, and Muehlfeld 2019). The task of the leader, then, is to empower employees to realize their skills and talents to achieve the organization’s mission and goals (Argyris 1998; Cowen and Parker 1997; Foss, Foss, and Klein 2007; Lee and Koh 2001; Lee, Willis, and Tian 2018). Drawing on this leadership premise, this article develops the concept of entrepreneurial empowerment (EE). EE involves a leadership task of organizing a firm’s internal decision-making process in which employees are delegated a decision-making authority that advances the entrepre­neur’s mission. Specifically, EE has structural and psychological dimensions that empower employees to utilize their knowledge of particular circumstances of time and place to solve the internal Hayekian knowledge problem. By solving this problem, EE offers opportunities for the entrepreneurial leader to adapt to and innovate using the knowledge experiences of their employees in ways that cannot be achieved through centralized direction. Propositions surrounding this EE concept are offered. One major contribution of the concept of EE is that the entrepreneurial leader offers an internal organization that empowers employees to solve an internal Hayekian knowledge problem and thus advances an entrepreneur’s mission or goals. As result, this study offers a theory of internal organization that opens up the “black box” of Austrian economics (Foss and Klein, 2012 70).

Before developing this study’s conceptual model, it is important to outline its definitions, assumptions, and units of analysis. According to leadership research, empowerment is defined by an “increased individual motivation at work through the delegation of authority to the lowest level in an organization where a competent decision can be made” (Seibert, Silver, and Randolph 2004, 332). As entrepreneurs often hold positions of leadership, an entrepre­neur’s leadership involves the power to delegate authority to the lower levels of their decision hierarchy (e.g., Cowen and Parker 1996; Foss, Foss, and Klein 2007; Shamir, House, and Arthur 1993; Witt 1998). In addition, this leadership also involves an ability to motivate and shape employees’ behavior and attitudes (Ashford and Sitkin 2019; Shamir, House, and Arthur 1993; Witt 1998), as well as empowering the psychological states or intrinsic motivations of their employees (Lee and Koh 2001; Lee, Willis, and Tian 2018). With these distinctions, entrepreneurial leadership is defined by structural and psychological dimensions that involve empowering employees through a delegation of authority to all levels of the decision hierarchy and an ability to appeal to employees’ intrinsic motivations. This definition assumes that employees’ empow­erment is “influenced or caused” by an entrepreneur’s leadership. This assumption is consistent with Lee and Koh (2001), in which empowerment is understood as the “behavior of a supervisor who empowers his/her subordinates” (685). With this assumption, the unit of analysis is focused on the structural and psychological rela­tionships that exist between the entrepreneurial leader and their employees (Lee and Koh 2001). Specifically, this study focuses on the leadership of senior members and not supervisory managers, because leadership studies find that hierarchically organized busi­nesses are subject to social learning processes in which a leader’s actions can have a “cascading effect” that impacts the lowest-level employees of their decision hierarchy (Liu, Liao, and Loi 2012; Shamir, House and Arthur 1993; Witt 1998).

Empowerment and Hayek’s Libertarian View of Markets

Although the concept of empowerment is commonly explained in terms of a leadership function (e.g., Lee and Koh 2001, Spreitzer 2008), empowerment also shares a similar political economic orientation to the libertarian tenets of F. A. Hayek (1945, 1952). As in Hayek (1945), empowerment is a political exercise that rejects the “politics in command” of centrally planned/socialist economies (Mohanty 1995, 1434). Empowerment involves granting freedom and equality by transferring power from an upper level agency, such as a central planner or authority, to people below (Mohanty 1995). This empowerment involves affirming an individual’s freedoms by strengthening their capacity for self-governance, autonomy and self-determination and is an important economic and political goal of Western societies (Mohanty 1995). Similarly, Hayek’s notion of “true libertarianism” is founded on a political economic philosophy that celebrates the benefits of individual choice and freedom. This libertarianism appeals to the collective powers of a decentralized decision-making process, as Hayek (1952) shows:

many of the greatest things man has achieved are not the result of consciously directed thought, and still less the product of deliberately coordinated effort of many individuals, but of a process in which the indi­vidual plays a part which he can never fully understand. They are greater than any individual precisely because they result from the combination of knowledge more extensive than single mind can master. (84)

Although empowerment shares a similar political-economic orientation to Hayek’s true libertarianism, their motivations for rejecting the powers of a central authority differ. Empowerment rejects the “politics in command,” because of the corruptive tendencies of government (Mohanty 1995). Hayek’s true libertar­ianism (1945) rejects central planning on grounds of its limited ability to process decentralized information (see also Klein 1996). Hayek (1945) argued that the allocation of societal resources requires centralizing dispersed knowledge experiences that cannot be fully known by a central authority. This dispersed knowledge is held by the “man on the spot,” consisting of workers or employees. Each employee has a knowledge of the particular “circumstances of time and place,” or more simply put, knowledge of the particulars. This knowledge consists of the particular work challenges and local work conditions faced by an employee. For instance, a real estate employee’s ability to develop their clientele is dependent on their unique understandings of the amenities in a neighborhood (i.e., quality of schools, relative affluence of homeowners, crime rates, general history of the neighborhood, etc.). The man on the spot/employee is better suited to utilizing this knowledge of the particulars than a centrally planned actor, because the man on the spot is most familiar with the unique circumstances of their job (Hayek 1945). As a result, Hayek (1945) argued that the chief economic problem is not concerned with how a central planner can allocate the scarce resources of society, but rather a knowledge problem “of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know” (520).

In sharing Hayek’s (1945) commitments to freedom and liberty, Kirzner’s (1979) concept of alertness offered a mechanism key to solving the Hayekian knowledge problem (Foss and Klein 2016). Alertness is defined as “an attitude of receptiveness to available, but hitherto overlooked, opportunities” (Yu 2001, 51). This recep­tiveness involves a psychological predisposition for discovering price arbitrage opportunities not seen by others (Kirzner 1979). Alertness involves discovering price arbitrage opportunities where the entrepreneur assembles their factors of production at a price that is less than the prices received from the sale of their products / services; however, it does not entail a deliberate search (Kirzner 1979, 2019; Yu 2001). Deliberate search involves a commitment of resources (Kirzner 2019) in which the “agents already know enough of the territory that they know what kind of information they want and where to acquire such information” (Yu 2001 51). Yet Tony Fu-Lai Yu (2001) argued that agents search because they are dissat­isfied with their current information. This dissatisfaction motivates a search for better knowledge involving the asymmetric knowledge experiences of the entrepreneur (Shane and Venkataraman 2001, Yu 2001). As employees’ knowledge of the particulars are distributed across an organization’s factors of production, an entrepreneur has an asymmetric knowledge that enables the entrepreneur to assemble these distributed experiences at a total price or cost that is less than their value uses (i.e., prices of the products or services received). Specifically, the task facing the alert entrepreneur is to draw on their asymmetric knowledge experiences in discovering those wage rates that will not only incentivize employees to utilize their knowledge of the particulars, but to also discover a wage rate that is less than the prices of their sold products or services. Hence, through this alert discovery of arbitrage opportunities, the entre­preneur engages in a nondeliberate search in which employees’ knowledge of the particulars is brought into use by the price system to solve the Hayekian knowledge problem.

Internal Hayekian Knowledge Problem

Yet in spite of Kirzner’s (1979) contributions to solving the Hayekian knowledge problem, the entrepreneur faces a distinct “internal Hayekian knowledge problem” (Elert and Henrekson 2019; Foss 1997). This internal Hayekian knowledge problem involves a use of knowledge in which employees’ knowledge of the particulars cannot be centralized under the direction of an entrepreneur’s authority (see also Cowen and Parker 1997; Elert and Henrekson 2019; Shane 2000). According to Hayek (1945), employees’ knowledge of the particulars cannot be centralized because this centralization requires aggregating an employee’s knowledge of the particulars in which differences in their local work conditions and special circumstances would be abstracted away. Due to the distributed nature of an employee’s knowledge of the particulars, this knowledge thereby cannot be conveyed to a central authority (Hayek 1945, 524). Since entrepreneurs are also tasked with allocating their firm’s factors of production (e.g., Klein 1996; Bylund 2016), this inability to centralize their employee’s knowledge of the particulars renders the entrepreneur unable to allocate their factors of production—employees—to their most valued uses. As result, unlike the traditional Hayekian knowledge problem, the internal Hayekian knowledge problem raises a distinct firm-level problem, because the challenges surrounding the centralization of a firm’s distributed knowledge impact a firm’s internal allocation of resources.

The internal Hayekian knowledge problem is closely tied to Ludwig von Mises’s economic calculation problem, and both can be used to elaborate on this firm-level distinction. According to Mises, a firm is tasked with an economic calculation problem of allocating a firm’s resources or factors of production that would satisfy the needs of its consumers (Foss and Klein 2010; Klein 1996). This allocation requires that the entrepreneur understand current factor prices as well as the anticipated prices of consumer goods sold (Foss and Klein 2010). An understanding of these current factor prices is critical, because in the absence of these factor prices, the entrepreneur cannot allocate their factor inputs into meeting the firm’s consumer needs (Klein 1996). Mises has used this economic calculation problem to challenge centrally planned governments, because the absence of property rights over factors of production limits a firm’s ability to discover the prices of their factor inputs (Klein 1996). In the absence of these factor prices, socialistic and, more generally speaking, centralized planned organizations, cannot offer an allocation of capital that solves the economic calculation problem (Bylund 2016; Klein 1996; Foss and Klein 2010). The internal Hayekian knowledge problem parallels the criticisms raised by Mises’s economic calculation problem. According to Hayek (1945), the distributed nature of an employee’s knowledge renders such knowledge unable to be aggregated into a price statistic (Hayek 1945). In the absence of these internal prices, an employee’s knowledge of particulars cannot be coordinated into discovering an allocation of resources that will meet the needs of the firm’s customers. As a result, like Mises, the internal Hayekian problem underscores that centrally planned organizations face limits in their ability to solve the economic calculation problem.

To address limits in a firm’s central authority, an entrepreneur’s judgment has been offered as a response to Mises’s economic calculation problem (Bylund 2016; Klein 1996). Judgment refers “to the process of businesspeople forming estimates of future events in situations in which the relevant probability distributions are them­selves unknown” (Foss, Foss, and Klein 2007, 1896). For instance, judgment can involve the formation of a business plan in which factor inputs are identified and coordinated with the purpose of earning future rents or profits (Foss, Foss, and Klein 2007). This judgment occurs by giving the entrepreneur ownership over the use of a firm’s factor inputs (Foss, Foss, and Klein 2007; Foss and Klein, 2010). According to Mises’s economic calculation problem, ownership over factor inputs creates an entrepreneurial incentive to reveal their prices such that factors of production can be allocated in ways that satisfy future needs or demand expectations (Klein 1996). This is because factor prices are influenced by the varied uses of an input, which gives owners of capital a strong incentive to reveal their factor input’s valued uses (see also Bylund 2016; Klein 1996). The challenge, however, is that these valued uses are known only by members who have an intimate or particular understanding of a factor’s varied uses (Hayek 1945). Hence, judgment suggests that owners of capital have a strong incentive to encourage their employees to utilize their knowledge of particulars to addressing their firm’s economic calculation problem (see also Klein and Foss 2010; Klein 1996). This is consistent with Per Bylund (2016), who noted, “the only basis for making decisions and attempting to identify room for improvement is entrepreneurial judgment: there are no market prices to guide the entrepreneur” (110). This judgment suggests that through ownership the entrepreneur exerts control over the firm’s internal allocation of resources that is distinct from those resource allocations determined by market prices (e.g., Foss, Foss, and Klein 2007).

Theory of the Firm: An Austrian Judgment Perspective

To understand this internal allocation, R. H. Coase’s theory of the firm is instructive to Austrian explanations of judgment (see also Bylund 2020; Klein and Foss 2010).In that, while Kirznerian (1979) and Hayekian (1945) explanations would argue that market prices would incentivize employees to utilize their knowledge of the particulars, Coase (1937) had long recognized that there is a trans­action cost in determining these relevant prices. Coase (1937) argued that if there are no transaction costs, an employee’s knowledge can be readily coordinated through a series of market-based exchanges. These contractual exchanges would do away with the need to transmit any knowledge to a central authority, and thus an organization—as defined by Coase (1937) an authority would cease to exist. The fact, however, remains that authority exchanges exist in all types of organizations, including entrepreneurial ones. The existence of these exchanges suggests that the price system is not a sufficient mechanism to incentivize the use of knowledge within an organization (see also Elert and Henrekson 2019; Shane 2000). This is particularly the case when considering an employee’s knowledge of the particulars, because such knowledge is tacitly known to the employee. With this tacitness, external prices cannot readily reveal the valued uses of an employee’s knowledge of particulars (see also Bylund 2016; Foss and Klein 2010), because there is a transaction cost in organizing this tacit knowledge through a market-based exchange. Thus, according to a Coasian explanation, a firm’s existence can be attributed to an entrepreneur’s judgment because judgment offers an alternative to market prices in allocating a firm’s internal resources (Bylund 2016, 2020).

For instance, Bylund (2020) draws on a Coasian argument to explain a firm’s existence. Bylund (2020) attributes a firm’s existence to the entrepreneur/manager’s ability to “actively directs factors of production instead of the price mechanism” (10). Through an entrepreneur/manager’s authority, external market exchanges are internalized in the firm, avoiding the transaction costs of the market (Bylund 2020). These transaction or marketing costs involve costs in determining factor prices and organizing factor inputs. Bylund (2020) argues that a firm exists when the entrepreneur/ manager directs an internal allocation of resources that avoids these marketing costs. Yet, due to limits in bounded rationality, an entrepreneur/manager’s internal allocation of resources is subject to diminishing returns. These diminishing returns limit an entre­preneur/manager’s ability to replicate the resource allocations of the market. Hence, Bylund (2020) argues that a firm’s existence depends on developing an internal allocation that not only avoids marketing costs (MktgCost) but also avoids the relative inefficiency of an entrepreneur/manager’s internal allocation (As) to a market efficient allocation (Ae).According to Bylund (2020), a firm’s existence is explained by a simple rear­rangement of his terms where Mktg Cost > Ae−As. By drawing on this marginal analysis, Bylund (2020)It should also be noted that Bylund’s (2020) work is based on an interpretation of Coase’s original insights. This work involves formulizing Coase’s theory and this formulization should not be conflated with Coase’s original or seminal contributions. An alternative to Coase’s theory is offered by Bylund (2016) also argues that the entrepreneur/manager can increase the size of their firm’s operation when their internal allo­cation of resources (As) exceeds the difference between the market efficient allocation (Ae) of resources and the market costs associated with this allocation (MktgCost).

Although Bylund (2020) does not directly examine the role of entrepreneurial judgements, an entrepreneur’s judgement is implicit in its explanations (see Bylund 2016). Since the entre­preneur/manager plays a “directive” role in the firm’s internal allocation of resources (Bylund 2020), an entrepreneur’s judgments surrounding the prices of factor inputs can offer an internal allo­cation of resources (As) that avoids Bylund’s (2020) marketing costs. For instance, since an entrepreneur’s judgment encourages employees to utilize their knowledge of the particulars (see also Foss, Foss, and Klein 2007), such knowledge offers an internal allocation of resources that is not readily known through external market prices. This judgment thereby offers an internal allocation (As) that avoids marketing costs and thus impacts a firm’s reason to exist. Furthermore, since an entrepreneur’s judgment is also subject to limits in bounded rationality, there are diminishing returns to an entrepreneur’s judgments. Such diminishing returns can reduce the efficiency of an entrepreneur’s internal allocation of resources (As) and thus impact the boundary conditions described in Bylund’s (2020) marginal analysis.

Entrepreneurial Judgment and a Firm’s Internal Organization

Although the concept of judgment offers important insights for explaining a firm’s existence and boundaries (e.g., Bylund 2016, 2020), Foss, Foss, and Klein’s (2007) theory of economic organi­zation argues that an entrepreneur’s judgment can also impact a firm’s internal organization. According to Foss, Foss, and Klein. (2007), judgment involves a leadership role in which a firm’s human and capital assets are organized under the direction and control of the entrepreneur. This internal organization involves judgments surrounding the design of a firm’s formal and informal communication structures and system of rewards that would secure the control and support of a firm’s employees (Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering, Weitzel, and Muehlfeld 2019). This internal organization has been historically described by an authoritarian decision-making structure in which the entrepre­neurial leader has direct control and influence over their employees’ behaviors (Bylund 2020; Coase 1937; Cowen and Parker 1997). Yet, due to the increasing complexity of markets, modern organizations face increasing pressures to organize this internal decision-making structure in ways that best respond to these external changes (Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering, Weitzel, and Muehlfeld 2019). This internal organization involves delegating a leader’s decision-making authority to all levels of the firm’s decision-making hierarchy (see also Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering et al 2019).

In response to this decentralization of decision tasks, Foss, Foss, and Klein (2007) argue that an entrepreneur’s leadership role involves organizing the firm’s decision-making authority such that employees are engaged in a “derived judgment” that acts on behalf of the entrepreneur’s original judgments (see also Cowen and Parker 1997; Rigtering, Weitzel, and Muehlfeld 2019; Witt, 1998, 1999). An entrepreneur’s original judgment, or simply judgment, refers to the “formation and execution of a business idea” (Foss, Foss, and Klein 2007, 1896), such as a firm’s mission or goals. A derived judgment involves “utiliz[ing] the knowledge best known to” the employee (Foss, Foss, and Klein 2007, 1894) in responding “to new circumstances or situations that may be unknown to the employer.” (Foss, Foss, and Klein 2007, 1894). These derived judgments draw on the employee’s knowledge to develop “productive” activities that advance an entrepreneur’s mission or judgment (Foss, Foss, and Klein 2007; see also Rigtering, Weitzel, and Muehlfeld 2019). Yet since this derived judgment is predicated on giving employees greater discretionary powers, employees can also draw on their knowledge to advance their personal goals (Foss, Foss, and Klein 2007). An employee’s derived judgment can thereby result in “unproductive” activities that undermine the entrepreneur’s mission or judgment (Foss, Foss, and Klein 2007). Hence, the challenge surrounding an entrepreneur’s judgment is in organizing a decision-making structure in which employees utilize their knowledge to serve the entrepreneur’s judgment and not their own (see also Cowen and Parker 1997; Witt, 1998).

For instance, Ulrich Witt’s (1998, 1999) concept of entrepreneurial leadership reflects this type of judgment. According to Witt (1998), entrepreneurial leadership involves a judgment surrounding an entrepreneur’s “imaginations” about the future prospects of a firm’s business concept or mission. Such imaginations or judgments are realized by inducing the support of the firm’s employees (Witt 1998). As in Foss, Foss, and Klein (2007), this support operates within a decentralized organizational setting. With this decentralization, there are limits on a leader’s bounded rationality that preclude the leader from directly controlling and influencing their employees’ behavior. Witt (1998) argues that this decentralization requires a leadership that appeals to the social and psychological aspects of a firm’s internal organization (Witt 1998). The social aspects of a firm’s internal organization involve instituting a social consensus among employees in order to realize an entrepreneur’s imaginations. In addition, while financial renumeration is important to inducing the support of employees, Witt (1998) argues that leadership must also appeal to an employee’s psychological motivations. This may involve relating an entrepreneur’s imaginations to an employee’s personal values. Hence, according to Witt (1998), judgments involve a leadership role of instituting a social and psychological decision-making process that seeks the support of employees. Such judgments are central to an entrepreneur’s leadership, because they allow the entrepreneurial leader to utilize their employees’ decen­tralized knowledge experiences in fulfilling the entrepreneur’s imaginations or judgments (see also Cowen and Parker, 1997).

Yet although the organization of a firm’s decentralized expe­riences is implicit to the internal Hayekian knowledge problem, an entrepreneur’s leadership role in empowering employees to address this knowledge problem remains largely undeveloped in theories of economic organization (Cowen and Parker 1997; Foss, Foss, and Klein 2007; Witt 1998). A concept of entrepreneurial empowerment (EE) is proposed. EE appeals to a judgment in which the decision task of the entrepreneurial leader is to institute “structural and psychological” forms of empowerment that encourage employees to draw on their knowledge of the particulars to realize an entrepre­neur’s mission or judgment. Specifically, since judgment involves an ownership stake, the entrepreneurial leader is defined as an individual who has an ownership stake in their business and/or holds a senior leadership position in the organization (i.e., CEO). With this ownership stake, the entrepreneurial leader has the incentive and decision-making power to institute structural and psychological forms of empowerment practices on their employees (see also Cowen and Parker 1997; Witt 1998).

With this characterization of the entrepreneurial leader, EE approaches the internal Hayek knowledge problem not by viewing the entrepreneur as a central planner, but as a collaborator who cultivates a greater sense of autonomy in their employees. In particular, although giving employees greater decision-making autonomy can offer a means to utilize their knowledge of the particulars (e.g., Foss, Foss, and Klein 2007), this decentralization is only a partial solution. As Hayek (1945) described,

We must solve it by some form of decentralization. But this answers only part of our problem. We need decentralization because only thus can we ensure that the knowledge of the particular circumstances of time and place will be promptly used. But the “man on the spot” cannot decide solely on the basis of his limited but intimate knowledge of the facts of his immediate surroundings. There still remains the problem of communicating to him such further information as he needs to fit his decisions into the whole pattern of changes of the larger economic system. (524–25; author’s emphasis)

In response to this form of decentralization (see also Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering, Weitzel, and Muehlfeld 2019), EE offers a structural and psychological source of empowerment that addresses the “communicative” and “man on the spot” requirements of Hayek’s decentralization. Structural empowerment consists of the communicative systems of a firm’s internal organization. This communication involves the provision of “opportunities, information and support” that empower employees to realize their latent skills and experiences (Spreitzer 2008, 55). Psychological empowerment involves an appeal to the “man on the spot’s” intrinsic motivations. These intrinsic moti­vations involve cultivating a psychological state “in which an individual wishes and feels able to shape his or her work role and context” (Spreitzer 1995, 1444).

The structural and psychological components of EE, it is argued, solve the internal Hayekian knowledge problem by empowering employees to utilize their knowledge of the particulars in addressing the unique or circumstantial challenges of their job tasks. Yet, as employee can utilize their knowledge for their own benefit (Foss, Foss, and Klein 2007), the solution to the internal Hayekian knowledge problem also requires that the entrepreneurial leader empower employees to utilize their knowledge of particulars in ways that realize an entrepreneur’s mission or judgment. In addition to examining the individual components of the EE concepts—structural empowerment and psychological empowerment—this study argues that an examination of their joint impact can empower employees to utilize their knowledge of the particulars to advance an entrepre­neur’s mission or judgment. In this fashion, the concept of EE offers a distinct firm-level solution to the internal Hayekian problem. To develop this argument, each of the structural and psychological components of the EE concept are first examined.

Structural Empowerment (SE)

Based on a social structural perspective, structural empowerment (SE) is defined by a “sharing power (i.e., formal authority or control over organizational resources (Conger and Kanungo 1988)) through the delegation of responsibility throughout the organi­zational chain of command” (Spreitzer 2008, 55). To institute this redistribution of authority, structural empowerment (SE) consists of practices that make efforts to develop in employees a greater: 1) autonomy to develop goals, a system of rewards, work procedures, and responsibilities in regard to employees’ assigned job tasks, 2) transparency of information where strategic goals and direction are communicated in ways relevant to their job performance, and 3) training practices that build their knowledge, skill, and ability to perform their assigned job tasks well (Spreitzer 2008).

The goal of the empowered entrepreneur is to develop SE practices that provide employees with the “opportunity, infor­mation, support, and resources” (Spreitzer 2008 55) to fully realize their latent skills and experiences in addressing the changing circumstances of their job (Spreitzer 2008). An entrepreneur can provide opportunities by developing resource forums and centers that promote the sharing of ideas among employees (Hargadon and Sutton 1997). For instance, in their study of the product design firm IDEO, Hargadon and Suttons (1997) pointed out that IDEO created a resource forum that pooled the design solutions used in previous projects. Engineers could draw on this pool to solve the current problems they faced in their job tasks. Entrepreneurs can also provide financial support to promote the development of new product ideas. Companies such as Google have provided millions in seed capital to help commercialize products developed by their project teams (Gagne and Deci 2013). Lastly, the entrepreneur can promote a sharing of information, for example through their organi­zation’s policies on risk taking. Jeff Bezos and Elon Musk recognize that their organizations’ success rests on a policy that failure is a necessary part of the innovation process. This policy of failure can promote greater risk taking in employees and thus promote a greater willingness to experiment with new ideas (Henao-Zapata and Peirὀ 2018).

By providing employees with such opportunities, information, and support, SE practices offer an important communicative structure that demonstrates an entrepreneur’s commitment to an employee’s autonomy (see also Argyris 1998). Leaders need to communicate to their employees that they have made a personal commitment to empowering them (see also Argyris 1998; Bendahan et al. 2015). Developing this commitment is important, because leaders can engage in empowerment practices with polit­ically correct motivations and not with a genuine commitment in promoting the autonomy of their employees (Argyris 1998). A communicative structure involving the provision of opportu­nities, information, and support signals a leader’s commitment to empowering their employees and thus assures employees that their leader’s empowerment efforts are genuine.

Exhibiting this genuine commitment, this communicative structure increases an employee’s willingness to exploit their knowledge of the particulars in that it reduces an employee’s fear that the use of their knowledge of the particulars will threaten the power and authority of the entrepreneur. For instance, studies find that leaders face difficulties giving up their positions of authority (Argyris 1998; Bendahan et al. 2015). This difficulty arises, because authority offers leaders the power to influence their subordinates in ways that advance a leader’s self-interest (Bendahan et al. 2015; Lubit 2002; Schyns and Schilling 2013). Hence, by providing employees the opportunities, information, and support to more fully utilize their knowledge, an entrepreneur not only demonstrates a clear commitment to relinquishing their control over their employees but also places trust in employees to utilize their knowledge of the particulars to advance their job task. This commitment as a result reduces the entrepreneur’s potential for retaliatory action and reduces an employee’s fear that utilizing their knowledge of particulars will threaten the entrepreneur’s authority (e.g. Bendahan et al. 2015; Lubit 2002; Schyns and Schilling 2013). This is consistent with empowerment studies that find that employees are hesitant to engage in greater decision-making autonomy because they fear the repercussions this may have for a leader’s authority (Spreitzer 1996). Therefore, in order to empower employees, their leaders must give their commitment to this, because in its absence employees do not want to be held accountable for decisions that are not supported by their leaders. SE offers a communicative structure that alleviates such concerns, because the provision of opportunities, information and support signals an entrepreneur’s commitment to empowering employees to make decisions.

Proposition 1: SE involving the provision of opportunities, infor­mation, and support positively influences an employee to utilize their knowledge of the particulars in their job tasks.

Psychological Empowerment (PE)

Unlike the communicative aspects of SE, PE appeals to an empow­erment that is experienced by the employees themselves (see also Spreitzer 2008). Psychological empowerment (PE) is defined as a “psychological state of a subordinate [i.e., employee] perceiving four dimensions of meaningfulness, competence self-determination and impact, which is affected by empowering behaviours of the supervisor [i.e., entrepreneur]” (Lee and Koh 2001, 686). Each of these psychological states is described as follows:

Meaning involves a fit between the needs of one’s work role and one’s beliefs, values and behaviours….Competence refers to self-efficacy specific to one’s work, or a belief in one’s capability to perform work activities with skill….Self-determination is a sense of choice in initiating and regulating one’s actions….It reflects a sense of autonomy or choice over the initiation and continuation of work behaviour and processes (e.g., making decisions about work methods, pace, and effort). Impact is the degree to which one can influence strategic, administrative, or operating outcomes at work. (Spreitzer 2008, 57)

Studies have found that meaning, competence, self-determi­nation, and impact increase an employer’s ability to achieve the objectives and challenges of their job (Lee and Koh 2001; Spreitzer 2008). For instance, an employee who finds meaning in their job develops greater motivation in fulfilling the requirements of their job (Henao-Zapata and Peirὀ 2018). Furthermore, competence or self-efficacy has been associated with improvements in an employee’s productivity (Henao-Zapata and Peirὀ 2018; Spreitzer 1996, 2008). Self-determination in which the employee takes on greater personal responsibilities in defining their job goals has been found to improve an employee’s goal achievement (Eva et al. 2019, Henao-Zapata and Peirὀ 2018; Spreitzer 1996, 2008). Lastly, impact has been found to increase an employee’s feelings of control over the workplace and promotes a greater commitment to pursuing organizational goals (Spreitzer 2008).

Since leadership is central to the empowerment of employees (Argyris 1998; Lee and 2001; Spreitzer 2008), the goal of the entre­preneur is to PE an employees’ sense of meaning, competence, self-determination, and impact in their jobs. This PE involves developing a vision that provides a sense of meaning and purpose to employees. For instance, Truett Cathy, the founder of the immensely successful Chick-fil-A restaurants, developed a vision based on Christian principles in which the glorification of God involved the provision of “second to none” service to his customers. This vision deeply resonated with the personal beliefs of his employees, and this greater sense of meaning and purpose has resulted in a commitment to service that is unrivalled in the food industry (Kruse 2015; Petrone 2014). An entrepreneur can promote self-determination by offering their employees the freedom to explore their personal talents and skills. Companies such as 3M and Google allow their employees to use up to 15 percent of their time to pursue projects of their own choice (Govindarajan and Srinivas 2013). Empowerment studies find that this self-determination can increase an employee’s sense of competence that they have the skills and experiences necessary to complete their jobs (Spreitzer 2008). Lastly, entrepreneurs who believe that their products and services have an impact on society can encourage their employees to develop job tasks in realizing such impacts. For instance, Toyota has made a commitment to producing cars that meet its environmental sustainability goals. To realize such goals, Toyota’s engineering specialists developed a solvent to clean the robots used in painting vehicle bumpers. The use of hazardous chemicals and water was significantly reduced as well as the number of defective bumpers.See https://www.toyota.com/usa/environment/.

By engaging in such forms of PE, entrepreneurs will not only develop a greater sense of meaning, competence, self-determination, and impact in their employees, but employees will also be more likely to utilize their knowledge of the particulars in ways not recognized by Hayek (1945). Hayek (1945) writes that “every individual has some advantage over all others in that he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active cooperation” (521–22). Austrians (Cowen and Parker 1997; Hayek 1945; Kirzner 1979, Foss, Foss, and Klein 2007) would argue that an extrinsic reward system would incentivize employees to engage in this active cooperation, to utilize their knowledge of the particulars. Yet various studies find that financial or extrinsic rewards (i.e., wage rates) can undermine an individual’s intrinsic motivation (Argyris 1998; Judge et al. 2010; Kuvaas et al. 2017; Ryan and Deci 2000). Judge et al. (2010, 158) explains

that extrinsic rewards are ultimately demotivating and dissatisfying to individuals. Because they have a negative effect on intrinsic interest in a task or job, extrinsic motivations tend to undermine perceived autonomy…. Moreover, goals for financial success have been argued to undermine well-being, because these goals represent a controlled orientation that interferes with the fulfillment of more enduring needs such as self-acceptance or affiliation.

Since PE involves an appeal to an employee’s intrinsic motivations, the use of financial, or extrinsic, rewards cannot psychologically motivate an employee to utilize their knowledge of the particulars. The reason is that financial rewards incentivize employees on the basis of achieving performance goals set by their supervisors and not on the basis of goals that advance their personal long-term growth (Judge et al. 2010). Stated differently, extrinsic, financial rewards only incentivize employees to take on initiatives when financial rewards are increased (Argyris 1998; Judge et al. 2010) and thus tend to undermine an individual’s autonomy to fulfill their high-order needs. In contrast to financial rewards, studies have shown that intrinsic motivations are positively related to greater levels of employee persistence and proactiveness (Judge et al. 2010; Kuvaas et al. 2017) and a greater ability to internalize the specific conditions of their work climate (Gagne and Deci 2005). These findings suggest that a PE employee will utilize their knowledge of the particulars in their job task because this knowledge offers them a greater sense of control in their work and the ability to proactively shape their tasks. This increased autonomy allows them to perform their jobs in ways that advance their personal goals and identities. Hence, PE increases an employee’s use of their knowledge of the particulars by empowering them to realize their higher-order or self-actualizing needs in ways that cannot be realized by the extrinsic financial rewards of Hayek (1945; see also Spreitzer 2008).

Proposition 2: a PE involving the development of a sense of meaning, competence, self-determination, and impact increases employees’ intrinsic motivation to utilize their knowledge of the particulars in their job tasks.

By utilizing an employee’s knowledge of the particulars, SE and PE not only offer a means to solve the internal Hayekian knowledge problem, but also offer opportunities to exploit the benefits of decentralization. Austrian economists recognize that decentral­ization introduces intrafirm learning opportunities that increase an organization’s ability to adapt to and innovate in changing market conditions (Elert and Henrekson 2019; Foss, Foss, and Klein 2007; Henao-Zapata and Peirὀ 2018; Rigtering, Weitzel, and Muehlfeld 2019). These benefits of decentralization stem from the greater autonomy given to an organization’s subunits to engage in local problem-solving behaviors (Cowen and Parker 1997; Kollman, Miller, and Page 2000; Richardson et al. 2002; Rigtering, Weitzel, and Muehlfeld 2019). For instance, by offering employees greater autonomy in their decision-making, employees can draw on their day to day operational experiences to adapt to the problems faced in their job tasks. Furthermore, this greater autonomy comes with a lower resistance to change and thus increases employees’ freedom to pursue new ideas and innovations (Henao-Zapata and Peirὀ 2018; Rigtering, Weitzel, and Muehlfeld 2019). Hence, as structural and psychological empowerment offer employees a greater decision autonomy, these different forms of empowerment enable employees to exploit the adaptive and innovative benefits of decentralization.

Yet since the task of the entrepreneurial leader is to empower employees in ways that realize the entrepreneur’s mission or judgment, the structural and psychological components of EE cannot individually accomplish this leadership task. This is because the structural and psychological components operate at different levels of analysis in which neither considers the influences of the other (Siebert, Silver, and Randolph 2004). Empowerment studies have argued that a joint consideration of these components is needed because a firm’s internal communication structure has been shown to influence an employee psychological motivations (Siebert, Silver, and Randolph 2004). In the context of entrepreneurial leadership, a leader who jointly leverages the structural and psychological components of the EE concept not only empowers their employees to exploit the adaptive and innovative benefits of decentralization but can also empower employees to utilize their knowledge of particulars to advance an entrepreneur’s judgment or mission.

Bounded Autonomy

To explain this aspect of entrepreneurial leadership, EE exploits the adaptive benefits of decentralization by leveraging the relationship between a firm’s “bounded autonomy” and an employee’s “self-de­termination” (Siebert, Silver, and Randolph 2004; Spreitzer 2008). Bounded autonomy refers to the structural empowerment aspects of EE and is defined by “organizational structures and practices that encourage autonomous action, including the development of a clear vision, and clarity regarding goals, work procedures, and areas of responsibility” (Seibert, Silver, and Randolph 2004, 333; see also Spreitzer 1996). In the Austrian economics literature, this bounded autonomy has been described as a “nested hierarchy” (Foss, Foss, and Klein 2007, 1897) or “polyarchy” (Cowen and Parker 1997, 59). Common to these descriptions is that the firm is organized around a number of decentralized/partly autonomous units, each of which is delegated a decision authority that operates within the context and constraints of a greater decision-making authority (Cowen and Parker 1997; Foss, Foss, and Klein 2007; Witt 1998).

Although a firm’s bounded autonomy is organized in a fashion similar to other studies or economic organization (Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering, Weitzel, and Muehlfeld 2019; Witt, 1998), this study adds that the depth / width of this bounded autonomy is influenced by limits in entrepreneurs’ judgment. Due to limits on bounded rationality, transaction cost explanations would argue that an entrepreneur’s judgment faces increasing costs in coordinating an increasing specialization of tasks within its decision hierarchy. The depth of an organization’s bounded autonomy is influenced by the extent to which these specialized tasks can be vertically integrated within the bounded autonomy (see also Bylund, 2016). With limits on an entrepreneur’s judgement, entrepreneurial leaders face increasing difficulties in understanding the specialized decisions made by lower or deeper members of its decision hierarchy because these employees’ tasks are highly specialized to the unique circumstances and challenges of their local work environment. As result, an entrepreneur’s efforts to institute a bounded autonomy are subject to diminishing returns that limit the depth of specialized activities that can be integrated into this bounded autonomy. Furthermore, limits in an entrepreneur’s judgment also impact the width or scope of activities in a firm’s bounded autonomy. The width or scope of a bounded autonomy consists of the diversity of specialized activities in a firm’s decision hierarchy. Bylund (2016) argues that this diversity of specialized activities can exhibit inter­dependencies or synergies that are difficult for the entrepreneur to know. The width of scope of these experimented activities is thus limited by an entrepreneur’s ability to discover the interdepen­dencies or synergies among them. Hence, as an entrepreneur’s EE is impacted by their judgment, an entrepreneur’s efforts to institute a bounded autonomy are subject to cognitive limitations that restrict the depth / width of this bounded autonomy.

By recognizing such limits in an entrepreneur’s structural empowerment efforts, a bounded autonomy is distinct from other decentralized forms of organization, such as Oliver E. Williamson’s (1975) M-form organizational structure. Williamson’s (1975) M-form organization emphasizes a highly diversified knowledge structure in which units are unrelated to the activities of others. With this autonomy, employees in each unit compete against others for corporate funds. While such competition offers a means to replicate the external market process, unit goals are prioritized over corporate goals (Cowen and Parker 1997). In contrast, the units in a bounded autonomy are guided and directed by the limits of an entrepreneur’s judgment. In order to conserve an entrepreneur’s bounded rationality, the entrepreneurial leader institutes a bounded autonomy in which the depth and width of unit activities are limited to those activities that are related to an entrepreneur’s mission or judgment. Hence, consistent with Cowen and Parker (1997), limits in an entrepreneur’s judgment result in a bounded autonomy in which the depth /width of a unit’s activities exhibit a coherence or relatedness that is absent from Williamson’s M-form structure.

Bounded Autonomy and Self-Determination

Under a bounded autonomy, employees engage in a self-deter­mination that exploits the adaptive benefits of decentralization in ways consistent with an entrepreneur’s mission or judgment. Specifically, bounded autonomy reduces the ambiguities surrounding the expectations and scope of an employee’s decision-making authority (Spreitzer 1996). This reduction of ambiguity is important, because “if people do not know the extent of their authority and what is expected of them, they will hesitate to act (i.e. lack of self-determination) and thus feel unable to make a difference (i.e. lack impact)” (Spreitzer 1996, 487). This reduction of ambiguity offers employees a clear delineation of their deci­sion-making authority, promoting a greater sense of self-deter­mination that avoids the resistance to change typically found in organizational bureaucracies (Spreitzer 1996) by giving employees greater authority to draw on their knowledge of the particulars to address the challenges and expectations of their jobs. Studies find that such self-determination can increase an employee’s resiliency in their decision-making and promote a greater resourcefulness to seek local resources and experiences (Henao-Zapata and Peirὀ 2018; Spreitzer 1996). This resiliency and resourcefulness suggest that employees will draw on their knowledge of the particulars to gain an intimate understanding of their local work conditions. This localized understanding in turn increases an employee’s ability to adapt to the changing circumstances of their job. Unlike the unproductive behaviours described by Foss et al. (2007), an employee’s self-determination is constrained by a firm’s bounded autonomy. That is, a bounded autonomy offers a clear delineation of an employee’s delegated decision-making authority in which their self-determination is limited to their local conditions.

For instance, the joint influences of bounded autonomy and self-determination can be explained in terms of Koch Industries’ “market-based management” strategy (Cowen and Parker 1996; see also Klein 1996). This management strategy involves communicating the corporate mission to each business unit and delegating a decision-making authority to each unit in support of this corporate mission. This delegated decision-making offers a type of “bounded autonomy” in which units are given discretion to determine unit-level missions that guide their employees to make daily decisions that support the corporate mission (Cowen and Parker 1997). With respect to the self-determinative aspects of psychological empowerment, Koch’s market-based management also involves adopting a matrix management structure in which employees report to the senior managers of different units. With this matrix management, employees are “ultimately accountable to the consumer of the firm’s products and to the firm’s mission rather than to some specific individual known as a “boss” (Cowen and Parker 1997, 50–51). While we cannot directly assess the psychological aspects of an employee’s self-determination, Koch’s matrix structure offers a means for employees to assert their self-determination in responding to the needs of the firm’s customers. Furthermore, Koch Industries also offers compensation that rewards employees for developing products and services that advance the firm’s mission. These resources provide opportunities that affirm an employee’s self-determination. As a result, by jointly leveraging the bounded autonomous and self-determinative aspects of EE, these empowerment practices enable employees to exploit the adaptive benefits of decentralization in ways that also advance the entrepreneur’s mission or judgment (see also Cowen and Parker 1997).

Proposition 3: entrepreneurial empowerment involving a SE practice of bounded autonomy positively influences an employee’s PE by developing a self-determination that adapts to an entrepre­neur’s mission or judgments.

Broad Sharing of Information and Competence

In addition, EE offers a structural and psychological empow­erment that exploits the decentralized benefits of innovation. Specifically, a SE policy involving a broad sharing of information can psychologically empower employees to institute new ideas in their job tasks by promoting a sense of competence. This broad sharing of information involves sharing an organization’s strategy to all members of its decision hierarchy (Spreitzer 1996). For instance, Kellogg’s CEO, Carlos Gutierrez, instituted a value-added strategy that differentiated Kellogg’s products from an increasingly competitive cereal market. Mr. Gutierrez was successful in imple­menting this value-added strategy, because he was able to relate this differentiation strategy to the specific job demands and goals of every employee in his organization (Boyle 2004). Empowerment studies find that this broad sharing of information increases an employee’s sense of meaning and purpose, because employees can see the “big picture” and gain a better understanding of how their job fits within their organization’s broader vision or mission (Siebert, Silver, and Randolph 2004; Spreitzer 1996). Furthermore, studies find that this greater sense of meaning and purpose can increase an employee’s feelings of competence (Gagne and Deci 2005; Siebert, Silver, and Randolph 2004; Spreitzer 1996). This competence is important to instituting new ideas and innovations, because it increases employees’ perception that their implemented ideas will succeed and will have a meaningful impact on their organization’s future goals (Gagne and Deci 2005; Henao-Zapata and Peirὀ 2018; Seibert et al. 2004).

As entrepreneurs are often admired for their vision, an EE involving a broad sharing of information psychologically empowers an employee’s competence to engage in innovations that realize this vision. Specifically, a broad sharing of an entrepreneur’s vision offers employees a greater context in which to understand how their knowledge of the particulars can help realize an entrepreneur’s vision. This communication is important, because an employee who fails to understand how their knowledge of the particulars fits within the entrepreneur’s vision can create coordination problems (Witt 1998). Each employee will seek to utilize their knowledge of the particulars without considering their impact on others. As a result, such autonomous decision-making introduces conflicts in implementing innovations that would realize an entrepreneur’s vision (see also Foss, Foss, and Klein 2007). In order to avoid such conflicts, employees must develop a shared understanding of the entrepreneur’s vision (Spreitzer 1996; Witt 1998). This shared under­standing is consistent with the communicative aspects of Hayek’s (1945) decentralization which posits that an employee’s knowledge of the particulars need to be understood within the context of a larger information system (see also Witt 1998). However, since Hayek (1945) relies on the price system to communicate the goals of this larger system, he does not consider those communication systems that appeal to an employee’s intrinsic motivations. EE addresses this shortcoming. An EE involving the broad sharing of an entrepreneur’s vision with all members of their organization (such as Gutierrez’s strategy at Kellogg’s), psychologically empowers an employee’s feeling of competence. This empowerment occurs, because a shared understanding aligns an employee’s knowledge of the particulars with their entrepreneur’s vision (Witt 1998) and thus increases an employee’s feelings of competence—that their knowledge of the particulars can have an impact in realizing the entrepreneur’s vision. This competence energizes an employee’s creativity to utilize their knowledge of particulars to develop new ideas in their jobs.

For instance, 3M started a new product that started with a complaint in their customer care division. The employee sought a solution by conducting his own research and then recontacted the customer to see if the solution was a suitable remedy (Rubinson 2009). This is consistent with studies’ finding that empowered employees tend to engage in greater creativity and innovation (Gagne and Deci 2005; Henao-Zapata and Peirὀ 2018; Kuvaas et al. 2017; Zhang and Bartol 2010). However, unlike these studies, which focus on the psychological aspects of empowerment, this study argues that a broad sharing of entrepreneur’s visions empowers employees competence to utilize their knowledge of the particulars to discover novel solutions that would realize an entrepreneur’s vision. This is consistent with J. P. C. Rigtering, G. U. Weitzel, and K. Muehlfeld (2019), who argue that lower-level managers and employees draw on their domain-specific knowledge to implement new business ideas. Hence, they argue, the task of corporate leaders is to “contex­tually frame” these lower-level innovative efforts to align with the corporate vision. This study argues that a SE practice of broad information sharing and its influence on an employee’s competence can contribute to a contextual framing in which the entrepreneur is able to exploit the decentralized benefits of innovation.

Proposition 4: entrepreneurial empowerment involving a SE practice of broad information sharing positively influences an employee’s PE by developing their competence to innovate in activities that advance an entrepreneur’s mission or judgment.

As entrepreneurs’ success is often attributed to their ability to identify unnoticed market opportunities, the discovery of opportu­nities within a firm’s internal organization remains largely under­examined in Austrian economics and mainstream entrepreneurship research (see Alvarez, Barney, and Anderson 2013). Yet leadership research has widely recognized that employees are central to an organization’s success and thus the task of a leader is to empower their employees to realize this success. This distinction was recognized earlier by Chester I. Barnard’s (1938) seminal work on leadership. He argued that the quintessential task of a leader is to communicate and empower a common purpose to their employees. A concept of entrepreneurial empowerment has been developed in which opportunities for employee empowerment are used to solve an internal Hayekian knowledge problem. In this solution to the internal Hayekian problem, the entrepreneur’s task as a leader is to structurally and psychological empower their employees in order to unleash their latent potential. EE’s structural and psycho­logical dimensions motivate employees to use their knowledge of the particulars to discover the adaptive and innovative benefits of decentralization. EE has three implications for Austrian economics and entrepreneurship research.

First, according to Austrian economic explanations, adaptation and innovation are largely explained in terms of market-level processes. As result, an organization’s adaptive and innovative processes remain generally understood as a “black box” (Kirzner 2019). EE offers a direction for Austrian economists to “open” up this black box in which a venture’s ability to adapt and innovate is attributed to the structural and psychological aspects of the EE concept. EE introduces an adaptive and innovative process that is endogenous to an employee’s knowledge of the particulars. This endogenous process underscores that although the success of a venture is widely attributed to its entrepreneur’s inspirational ideas, a venture’s success can also come from those involved in executing these ideas. This is because employees have the most familiar understandings of the challenges surrounding the implementation of their leader’s ideas. More broadly speaking, this knowledge of the particulars offers employees a unique position to adapt and innovate activities that reconcile the challenges of their job tasks with the ideas and goals of the entrepreneur. The utilization of this knowledge opens up the black box of Austrian entrepreneurship, in which an organization’s adaptation and innovation is explained by a decentralized process that cannot be centralized by an entrepre­neur’s leadership (see also Shane 2000).

More fundamentally, EE’s utilization of an employee’s knowledge of the particulars offers a decentralization that appeals to Mises’s open-ended view of entrepreneurship (Salerno 1993). By solving the internal Hayekian problem, EE offers an economic calculation in which the employee’s knowledge of the particulars is used in determining an allocation of internal resources that meets the needs of a firm’s consumers. Since consumer needs will continually evolve, EE’s solution to the internal Hayekian problem offers an economic calculation that evolves with the changing needs of the consumer. Consistent with Mises, EE will result in an economic calculation in which this changing allocation of internal resources may not converge toward an equilibrium outcome (see also Salerno 1993). EE thereby offers an alternative to alert explanations of the market process.

Second and relatedly, since the concept of EE has a distinctly proactive orientation, EE introduces a “deliberateness” not found in alert entrepreneurial explanations (Kirzner 2019). Unlike with Kirzner (2019), the structural and psychological dimensions of EE involve a search that requires a deliberate commitment of an entrepreneur’s time and efforts. Structural empowerment requires that the entrepreneur institute practices that provide employees the opportunity, information and support to realize their latent potential. As these policies involve redistributing the power in an organization’s hierarchy, supervisory members of this hierarchy are likely to resist such policies, because they undermine their position of power and influence (Argyris 1998; Bendahan et al. 2015). Hence, an entrepreneur who institutes such SE policies is likely to expend considerable time and effort in overcoming this resistance.A reviewer has noted that once an entrepreneur has instituted such structural and psychological forms of empowerment this resistance to change will not likely persist. That is, the ultimate goal of EE is to empower employees to act in accordance to an entrepreneur’s mission or judgment. Hence little resistance by employees will be expected once the individual and joint efforts of EE are instituted by the entrepreneur. With this commitment of effort, EE introduces a deliberateness that is particularly relevant to addressing recent debates surrounding an entrepreneur’s claims to the wealth creation process. For instance, a NY representative, Alexandria Ocasio-Cortez, argued that wealthy business owners did not deserve their wealth because they “sat on couches, while thousands were paid modern day slave wages.” EE argues that due to the commitment of resources required by the structural and psychological empowerment process, entrepreneurs have a direct claim to such wealth. Stated differently, EE argues for a Friedman system of ethics (see also Bylund 2019, Kirzner 2019) that justifies an entrepreneur’s wealth on the basis that they have contributed resources in empowering their factors of production (i.e., employees). Hence unlike Kirzner’s (2019) rejection of Friedman’s system of ethics, EE argues that entrepreneurs have a legitimate moral claim to the wealth creation process, because this wealth creation is based on an entrepreneur developing a deliberate relationship to their factors of productions (see also Bylund 2016).

Third and lastly, the concept of EE offers a type of judgment that is important to explaining a firm’s internal organization. EE appeals to a judgment that is not principally concerned with developing an internal allocation of resources that reduces the transactions cost of the market. Instead, EE appeals to a judgment in which the task of the entrepreneurial leader is to organize a firm’s internal decision-making structure in which employees utilize their knowledge of particulars to advance their entrepreneur’s judgment. In addition, entre­preneurs are often viewed as visionary leaders. But entrepreneurs have a leadership responsibility to not only articulate a compelling vision to their employees, but also to empower their employees to realize this vision. The concept of EE offers a type of judgement in realizing entrepreneurial visions. This judgment involves efforts to organize a firm’s internal communication structure and to provide appropriate psychological motivations that empower employees to realize their entrepreneur’s vision. The implication of this wealth creation process is that EE favors a more creative explanation of entrepreneurial opportunities (Alvarez and Busenitz 2001) in which opportunities are brought into existence by the empowerment efforts of the entrepreneur. EE, however, does not imply a rejection of the price arbitrage opportunities of alert entrepreneurship, because alert entrepreneurship and EE are concerned with solving different knowledge problems. EE emphasizes a distinctly firm-level approach to solving the internal Hayekian problem. This firm-level approach argues that an employee’s inherent potential cannot be fully realized by the external price system. In contrast, alertness emphasizes the discovery of price arbitrage opportunities at the market level and therefore relies on prices that cannot reveal an employee’s latent potential. An important direction for Austrian economics research is to examine both forms of entrepreneurship, because they address different aspects of the entrepreneurial discovery process.

Original Article: "Why Marx Never Figured Out How to Distribute Goods in a Socialist Society​".

This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.

Find Dr. Bylunds book at mises.org/Unrealized

And follow him on Twitter @PerBylund

Joanna Kruk (jkruk67@gmail.com) is a recent graduate of the Cracow University of Economics and Jagiellonian University.

The Austrian business cycle theory (ABCT) gained the interest and endorsement of non-Austrians as a valid theory shortly after the outbreak of the 2007/08 crisis. Then, major focus was placed on macrolevel aggregates such as the volume of loans, the threat of large scale bankruptcy or the supply of money. Little attention was paid to the analysis of corporate finance and the causes of companies’ erroneous decisions about initiating and carrying out unprofitable undertakings. One direct cause of the collapse was identified as cheap credit, which engenders a reallocation of resources between stages of production. That is inconsistent with the intertemporal preferences of consumers. In particular, lowering the interest rate below its natural level causes production to become more future-oriented. Artificially low interest rates are not only the cause of incurring new debts by companies, but are also the reason why less efficient companies enter the market. Due to the poor quality of their projects, these less efficient companies are more likely to mobilize necessary funds if funds are less limited, which is the result of expansionary monetary policy. Correspondingly, there are numerous entrepreneurs that will receive investment funds only when credit is “easy.” (Engelhardt, 2013) Moreover, erroneous decisions to engage more resources to projects which cannot be successfully completed are implemented, making the situation worse than it otherwise would be.

The aim of this paper is to analyze corporate finance from an ABCT perspective with a focus on the excessive risk-taking by companies. While the main literature about the business cycle focuses on the effects of certain policies on the aggregate and general shift of the economy to more risky positions, the motivation of financial decisions on a micro-level can shed new light on the foundations of the emergence of the business cycle. The vast difference between the profitability of an investment project relative to the interest rate change was previously discussed by Fuller (2013) using the net present value and the marginal efficiency of capital to show how interest rates affect the intertemporal allocation of capital and shift the resources to more roundabout projects. Enriching the analysis in risk assessment could lead to a further conclusion regarding the subject. One of the frequently used risk measures is duration, used in capital budgeting and precisely described by Blocher and Clyde (1979) and Johnson (2005).

In this paper, we plan to analyze previous work on the cycle effects on the microenvironment from the Austrian perspective, along with financial literature research on risk assessment, in order to try to capture the impact of interest rates changes based on financial decisions of firms with on numeric examples.

The Austrian business cycle theory was developed in the first half of the 20th century, mostly by Ludwig von Mises and Friedrich von Hayek. The main focus of the theory was placed on the intertemporal coordination and allocation of resources. In the market economy, the role of price signals was emphasized, as it is the major indicator of entrepreneurs’ success in fulfilling their clients’ demands. Special attention was paid to interest rates since the core of the ABCT is how artificially low-interest rates, which are falling below their natural level, influence the economic activity of agents.

As formulated by Rothbard (1978), the unhampered market interest rate is determined only by the “time-preferences” of the agents. People choose money right now over a promise made in the present to receive the same amount of money in the future, which means that their time preference is positive. Time preference also indicates the distribution of people’s income between savings and consumption. When the interest rate falls as the result of government intervention, rather than as a change in people’s preferences, an artificial boom starts. Agents are deceived into thinking that there is a greater amount of savings available for their investment projects, so they begin to engage more capital, particularly in lengthy and time-consuming undertakings, which previously were unprofitable due to the higher cost of financing them.

The main focus of Austrian economists is placed on emphasizing the disruption of intertemporal resources allocated between stages of production, resulting in malinvestments. At the later stage, these projects turn out to be impossible to complete since there are not enough resources to finish all undertakings initiated during the boom episode. This argument was originally formulated by Ludwig von Mises: “Projects which would not have been thought profitable if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found profitable and can be initiated.” (Mises 1912, 26)

In the microscale during the expansionary phase of the business cycle, firms will prefer to expand production. Since the interest rate is regarded not only as a cost factor but also as a factor of capitalization, decreasing the interest rate creates an incentive for investments in fixed capital by way of capitalization of future yields (Machlup 1935). This is the effect of the increased present value of future return, which is capitalized at the new, lowest interest rate. This reasoning applies to both lowering interest rates directly by the central bank and to credit expansion. In the second scenario, the newly available funds push down the interest rate and create the impression that there are more resources available for investment in lengthy projects. At the same time, the decreased interest rate is the reason people are less willing to keep their income as savings, thus the further discrepancy between real and natural interest rate is created (Engelhardt 2012).

The main reason for keeping interest rates low is to boost the economic activity of agents. As a direct consequence, on a corporate finance level, it causes an increase in debt to capital ratio but also has an effect on capital budgeting decisions as described by Cwik (2008). Firms tend to not only increase the volume on investments but also replace investment in working capital with investment in fixed capital, widening the distance between real-time preference and the one imposed by the nominal interest rates. After the boom ends, these projects are abandoned as they are no longer able to generate positive cash flows. Some of the fixed capital used in undertaking can be moved to other projects, which was described by Wood (1984) as the illusion of depression: when companies decide to quit unprofitable undertakings, thus causing a decline in economic activity, but releasing the necessary resources for more effective projects. The resources which cannot be engaged in another project due to their specifics are considered sunk costs.Mises (1949) used the distinction for convertible and partially or nonconvertible capital: “It is expedient to substitute the notion of the convertibility of capital goods for the misleading distinction between fixed and free or circulating capital. The convertibility of capital goods is the opportunity offered to adjust their utilization to a change in the data of production.”

Net Present Value is an indicator used in order to compare projects realized in different periods of time and with different lengths. It uses the discounted cash flow generated by the activity. The present value of delayed payoff can be found by multiplying the payoff by a certain discount factor, which is less than 1. If the value of the discount factor was greater it would mean that the dollar tomorrow is worth more than a dollar today, which denies positive time preference. Net present value is defined as follows:

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where:

CFt = a cash flow to be received in a period of time t,

r = discount rate.

Ludwig von Mises and Irving Fisher suggest using the present value approach to economic calculation since the price of an investment project is moving towards the present value of the project’s expected cash flows.Both values are equal in equilibrium or in the Evenly Rotating Economy. Present value approach was also advocated by Rothbard (1962, 62–63):

It is clear that the higher the rate of discount, the lower the present value of the future good will be, and the greater the likelihood of abstaining from the investment. On the other hand, the lower the rate of discount, the higher the present value of future goods will be on the actor’s value scale, and the greater the likelihood of its being greater than the value of present goods forgone, and hence of his making the investment.

The consequences of interest rate changes and their effect on the valuation of projects were examined by Fuller (2013) and can be presented graphically:

Figure 1. Net Present Value Profile

[[{"fid":"93413","view_mode":"image_no_caption","fields":{"alt":"figure 1","class":"media-element file-default media-wysiwyg-align-center","data-delta":"2","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"figure 1","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"2":{"alt":"figure 1","class":"media-element file-default media-wysiwyg-align-center","data-delta":"2","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"figure 1","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"figure 1","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"2"}}]]

Diagram from Fuller (2013).

There are three indications of the NPV profile shape: the NPV of the project increases as the interest rate falls, the chart is curved, so the NPV profile becomes flattened as the interest rate falls, meaning that the change in interest rates causes not proportional change in NPV and this dependence is explicit in long term investment projects in particular, since the longer stream of cash flows is discounted. Third, the NPV profile intersects the interest rate axis at the point where NPV is zero, indicating the positive NPV area on the right from the vertical axis (Fuller, 2013).

If the present value is used as an indicator of a project’s profitability, then the expected reinvestment rate should be used as a discount factor, since comparing two projects of a different outlays requires comparing in relative, rather than absolute terms. In that case, it is necessary to compare “present value per dollar of outlay” (Solomon, 1956). The valid comparison can be made not only with similar projects but also with two different courses of action, which can be brought to the same measure using NPV.

Wealth maximizing investors use NPV to rank their investment projects while competition in the market creates a tendency for the price of an investment project to equal the present value of expected cash flows. This is because investors will bid up the price when it is below the present value and bid it down when it is above, a simple arbitrage process. In the wooden and steel bridge example first described by Hansen (1953, 118) and later developed by Fuller (2013), there is presented the disproportionate effect of the change of the interest rate on the short-term and long-term projects. Since the lowering of interest rates favors longer projects, it is intuitive that these projects are usually associated with greater uncertainty, since they absorb resources for a longer period of time. The risk of the interest rate change may be one of the components that has an impact on how safe the particular investment is. For the purpose of expanding and quantifying this intuition, risk measures such as duration can be used.

One of the reasons for the 2007 crisis was aggressive profit targeting. As a result, agents tended to focus on the higher return from their investments, neglecting the difference in risk associated with their decisions. Since they were acting in the low rates environment, in the long term, more risky projects seemed more attractive as there was a possibility to achieve higher profits by engaging in these. That is the reason we cannot exclude risk from its role in the profitability of the investment projects, and this factor should be included in further analysis. It is not surprising that risk is positively correlated with higher potential profit. As a result of entrepreneurs being more likely to forecast consumers’ demand in the near future, they generate greater errors in forecasting longer periods. Therefore, on average, there is a higher probability of erroneously forecasting more distant cash flow than those forecasts of cash flows to be received in the relatively near future.

In the short run, if we examine the wealth generated by the project without adjusting the forecasted values for risk, the output of the economy appears better when it is associated with an incipient boom. Consequently, in the medium or long run, collapse starts when this risk taken by the entities materializes.Materialization of risk may be explained by an example: when a large number of companies engage in similar ventures, with a 70 percent probability of success each, it means that, on average, this will end up as a loss for about 30 percent of companies. In the beginning, the projects generate positive cash flows and investments pay off, but eventually at least part of the risky investments will not succeed and the bust phase of the business cycle begins. Generally, the lower the interest rate, the more profitable investments in more roundabout projects appear. At the same time, the risk grows. This implies shifting the economy to a more risky position with higher potential returns (Cowen, 1997).

To quantify this risk, the risk-adjusted NPV as a measure of profitability should be used. Since wealth maximizing investors are evaluating projects only using risk-free NPV they may underestimate the risk associated with their investment decisions. One of the risk measures for the purpose of adjusting NPV for risk can be the duration measure. It was discovered and developed by Frederic Macaulay (1938) for the purpose of measuring the average time an investor waits to retrieve his money from an investment. Hicks independently derived “average period,” an equivalent measure of elasticity, with respect to a discount ratio (Hicks 1939, 186). Although it has other applications, duration has been successfully used in problems regarding the reduction of basis risk, and even Macaulay himself was primarily focused on “the risk-proxying properties of his measure, despite the assigned name duration.” (Cox, Ingersoll, and Ross, 1979) Although it was originally designed for bonds, it was later developed to be used effectively in capital budgeting (Blocker and Stickney, 1979). The duration is represented as follows:

(2) [[{"fid":"93414","view_mode":"image_no_caption","fields":{"alt":"kruk02","class":"media-element file-default","data-delta":"3","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk02","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"3":{"alt":"kruk02","class":"media-element file-default","data-delta":"3","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk02","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"kruk02","class":"media-element file-image-no-caption","data-delta":"3"}}]]

where:

CFt = a cash flow to be received units of time from today, beginning with t=1 period from today,

r = an appropriate discount rate for determining the present value of the cash flow,

t = units of time.

The formula represents a weighted average of the stream payments, where the maturity of each payment is weighted by the proportion of the total value of an asset accounted for by the payment (Haugen 1990), so the duration, in a way, represents an average life of an asset.

For the purpose of capital budgeting, the duration can be measured as the duration of the net cash inflows and the duration of the net cash outflows (Durand 1974, 25). The properties of this measure, as Blocher and Stickney (1979) pointed out, are as follows:

When used in predicting bonds’ prices, duration assumes a linear relationship between price and changes in interest rates. In reality, however, prices rise more than proportionally as interest rates fall and decrease at an increasing rate as interest rates rise. As a result, the duration will underestimate the price increase, meaning that the risk can still be undervalued.

To illustrate the calculation of duration we will use the following example:

Table 1. Duration Calculation[[{"fid":"93415","view_mode":"image_no_caption","fields":{"alt":"table 1","class":"media-element file-default media-wysiwyg-align-center","data-delta":"4","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 1","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"4":{"alt":"table 1","class":"media-element file-default media-wysiwyg-align-center","data-delta":"4","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 1","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"table 1","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"4"}}]]

For this project, the duration is 1.74 and this is the number we receive by dividing the sum of the column (5) by the sum of the column (4).

Duration is also used as a measure of expected changes in market prices of bonds after a change in interest rates. The relation between duration (D), price (P) and interest rate (r) is described by the equation:

(3) [[{"fid":"93416","view_mode":"image_no_caption","fields":{"alt":"kruk03","class":"media-element file-default","data-delta":"5","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk03","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"5":{"alt":"kruk03","class":"media-element file-default","data-delta":"5","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk03","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"kruk03","class":"media-element file-image-no-caption","data-delta":"5"}}]]

Meaning, ceteris paribus, the greater the duration, the more sensitive will be a bond’s price to changes in the interest rate. The elasticity aspect of duration ensures its usefulness in capital budgeting decisions for the purpose of a measurement of a loss in the net present value of a project suffered from a change in required rates of return. In two comparable projects the shorter the duration, the less net present value of the project is vulnerable for interest rate changes (Blocher and Stickney, 1979) and the safer the investment, since the investors are waiting for the return, on average, for a shorter period of time. There is, however, a side effect of this approach: when investors expect the interest rate to fall, the investment in projects with a longer duration will experience a larger increase in their value than others, meaning that investors may shift to those projects if NPV valuation is not supported by further risk analysis. It may be perceived as the proper investment decision as long as the low interest rate environment is controlling. The problem is that longer investment projects are considered more attractive. But it is probable that the interest rate will increase during the project’s life. That will change profitability drastically.

Since duration reflects the average length of time consumed waiting for receipt of the cash flow generated by the project, it also demonstrates the liquidity of the project. It competes in that area with a conventional payback method,Payback period is the amount of time it takes to recover the cost of an investment. but duration surpasses payback period in that function since only duration can be incorporated in the analysis of NPV, and not as a supporting indicator alone.

Since, as explained in the above analysis, investors after lowering interest rates are switching their preferences to more capital-intensive, longer-term investments, at the same time, on average, they turn to projects with a longer duration. This means that during the phase of the boom of the business cycle economy shifts to a more risky position. Since the agents are targeting profit, there is a little attention paid to the risk exposure, measured by duration, of their projects.

Taking into the examination the example presented by Fuller (2013) of the two alternative projects, the further analysis of two investment projects will be carried out: a wooden bridge requiring a lower financial expense of 2,000 units and providing a constant cash flow of 1,000 in the next 3 years, and a steel bridge requiring the expense of 5,000 units and providing 0 units cash flow for the next 2 years, and a constant 1,000 units for the following 8 years, which is presented in the following table:

Table 2. Cash Flows Schedule[[{"fid":"93417","view_mode":"image_no_caption","fields":{"alt":"table 2","class":"media-element file-default media-wysiwyg-align-center","data-delta":"6","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 2","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"6":{"alt":"table 2","class":"media-element file-default media-wysiwyg-align-center","data-delta":"6","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 2","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"table 2","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"6"}}]]

The interest rate for which these projects generate the same net present value, meaning that they should be indifferent in the investors ranking, is approximately 5.48 percent. Discounted by this rate, the net present value of the projects is around 699.10 units. Calculating the duration for both provides more information about the expected returns. Since the duration for wooden bridge equals 1.96, and for the steel bridge it is 6.22, investors have to wait for returns from invested capital more than three times longer if they decide to invest in the steel bridge, which is associated with a higher risk for their income. But further assume that the investors demand a higher return and the interest rate increases from 5.48 percent to 7 percent. In this scenario, the net present value of the wooden bridge decreases only to 624.32 from 699.10, which is about an 11 percent decrease, while the steel bridge net present value decreases from 699.10 to just 215.56, which constitutes a 61 percent decrease, showing how sensitive projects with a large duration are to changes in interest rates.

This may explain why even a slight change in the interest rates may cause a dramatic change in the profitability of a project. Since in the present low rate environment, we expect that the average undertaken project has a longer duration, the expected vulnerability to the discount rate changes also increases.

Table 3. NPV and Duration Schedule[[{"fid":"93418","view_mode":"image_no_caption","fields":{"alt":"table 3","class":"media-element file-default media-wysiwyg-align-center","data-delta":"7","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 3","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"7":{"alt":"table 3","class":"media-element file-default media-wysiwyg-align-center","data-delta":"7","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 3","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"table 3","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"7"}}]]

To fully understand the duration’s significance in NPV analysis we present selected values in the table. The first conclusion is that the greater the interest rate, the smaller the duration is. It is the result of the NPV profile. When we increase the discount factor used for future cash flows, the more advanced payments are getting a lower share in the total NPV sum compared to prior payments. As a result, using the duration interpretation, we do not wait as long for future cash generated by the project as we do when using the same payment with a lower interest rate, due to the fact that later payments are given less significance. It also must be noted that the duration changes associated with interest rate changes are not substantial and are even small for the shorter projects.

The second conclusion which we can derive from the values in the table is that the greater the duration, the greater NPV loss from the increase of the interest rate. It is worth noting that this is only true for nominal values.

Figure 2. Duration Profile[[{"fid":"93419","view_mode":"image_no_caption","fields":{"alt":"figure 2","class":"media-element file-default media-wysiwyg-align-center","data-delta":"8","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"figure 2","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"8":{"alt":"figure 2","class":"media-element file-default media-wysiwyg-align-center","data-delta":"8","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"figure 2","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"figure 2","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"8"}}]]

In Figure 2, different duration values for different interest rates are presented. Although changes are not significant, it can be easily seen that the values for duration for the shorter project, the wooden bridge, are steady. Despite the fact that the NPV and the returns from investment are changing, the average waiting period for the investor to recover his money from the investment is not. In case of the longer, more deferred project, we see a steady drop in duration value as the interest rate increases. Although, as we mentioned, generally shorter projects are less risky, in this case the decline in duration is associated with decreasing share of later payments in overall value. That means that the greater weight is given to the less distant payments, which is decreasing the duration, but at the same time NPV values are decreasing on a larger scale.

If the interest rate is artificially reduced by a central bank, the duration gap between shorter-lived and longer projects increases. This causes a greater hazard for the second type of projects as their payment is not only subject to interest rate risk, which can be measured by duration, but is also subject to the uncertainty associated with changing economic conditions of business.

Longer-term projects are more information sensitive and are subject to profitability changes due to uncertainty. Even though this is unquantifiable, the entrepreneurs have to make a prediction about the forecasted cash flows generated by the company investment decisions. As described by Ludwig von Mises (1951, 27): “There is no certainty about the future state of the market and about the height of these earnings. They can only be determined by speculative anticipation on the part of the entrepreneur.”

The duration may prove useful to quantify at least some risks regarding the previously estimated profit not being realized. The duration may show that not every long term project is equally risky—e.g., risk may also depend on how flat the yield curve is for a particular project.The flat yield curve indicates that there is almost no difference between short-term and long-term rates for bonds and notes of similar quality.

Since the net present value is sensitive to interest rate changes, especially long-term projects should not be discounted with a nominal interest rate. Expanding the analysis for the illiquidity risk-adjusted interest rate could further develop the analysis. For projects in which annual cash flows constitute an annuity, the algorithm for the duration is reduced to:

(4) [[{"fid":"93420","view_mode":"image_no_caption","fields":{"alt":"kruk04","class":"media-element file-default","data-delta":"9","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk04","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"9":{"alt":"kruk04","class":"media-element file-default","data-delta":"9","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk04","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"kruk04","class":"media-element file-image-no-caption","data-delta":"9"}}]]

Where r is the value which equates the present value of the inflows to the price of the investment. For project analysis it can be the yield rate, the cost of capital rate, a risk-adjusted rate, or any rate that an investor may use as a required rate of return (Brown and Kulkarni 1993).

To perform the NPV analysis, the company can estimate the discount rate for each project using the Capital Asset Pricing Model (CAPM) method.CAPM defines the relationship between systematic risk and expected return for assets. While it is not the method consistent with the Austrian theory, it is still one of the most popular tools used by large companies on the market, which is the reason we cannot neglect its importance. Graham and Harvey (2001) surveyed 392 CFOs about the cost of capital, capital budgeting, and capital structure. The results indicate that “the CAPM is by far the most popular method of estimating the cost of equity capital: 73.5% of respondents always or almost always use the CAPM. The second and third most popular methods are average stock returns and a multibeta CAPM, respectively” (Graham and Harvey 2001). CAPM is also popular among academics. Research conducted by Welch (2008) revealed that about 75 percent of finance professors still advocate using the CAPM to estimate the cost of capital. Furthermore, there is evidence that while the CAPM deliberately fails to predict asset prices, it is more useful for the purpose of estimating the cost of capital (Da, Guo, Jagannathan 2012). Even if we do not fully acknowledge the prediction made using the CAPM model including the duration in the equation may reduce the entrepreneurial mistakes caused by the non-risk-adjusted version of it, which is the reason the model is included in the paper.

The model determines the required rate of return for an investment as the sum of the risk-free rate (Rf) and a premium, which is the product of beta and the difference between the market rate of return (Rm) and the risk-free rate:

(5) [[{"fid":"93421","view_mode":"image_no_caption","fields":{"alt":"kruk05","class":"media-element file-default","data-delta":"10","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk05","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"10":{"alt":"kruk05","class":"media-element file-default","data-delta":"10","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk05","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"kruk05","class":"media-element file-image-no-caption","data-delta":"10"}}]]

In order to obtain beta coefficients for investments, the method requires regressing the returns of the projects against the market returns, if available. In the case of the wooden and steel bridges, the most reasonable assumption is the beta coefficient for both projects moving in exactly same direction and having the same impact of changes on required return as a market,Beta belonging to the interval (0,1) means that the investment is reacting slower than the market, and beta greater than 1 means that every time the market rate changes the required rate of return changes more than the market rate. meaning that beta equals 1 and using the market return of 5 percent (for which the steel bridge is a more attractive investment using net present value as an indicator). The risk-free rate is usually described as the government bonds’ rate since they are currently considered the safest investment. We further make a conservative assumption that the risk-free rate is at 2 percent, meaning that 3 percent is the risk premium.The greater the risk premium, the greater impact duration will have on the risk-adjusted net present value. Since private investments usually have a few times higher return than the risk free rate, the 3 percent risk premium is a safe assumption.

We will now try to adjust the net present value of the wooden and steel bridges from the example using the following equation presented by Brown and Kulkarni (1993):

(6) [[{"fid":"93422","view_mode":"image_no_caption","fields":{"alt":"kruk06","class":"media-element file-default","data-delta":"11","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk06","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"11":{"alt":"kruk06","class":"media-element file-default","data-delta":"11","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk06","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"kruk06","class":"media-element file-image-no-caption","data-delta":"11"}}]]

where:

i = the rate of return adjusted for duration and timing of the cash flows

r = the required rate of return on a project,

D(i,n)= duration of a project with periodic cash flow over n years discounted at the rate appropriate for the duration of that project

D(r,n)= the duration of a project with equal periodic returns over the project life of n years discounted at the r rate

The equation derives from the standard CAPM equation with inclusion of liquidity adjustment coefficient (Di,n/Dr,n). A justification for including this ratio in the equation is that the “the ratio of duration of any project of n years life to the duration of a uniform series project of the same life, when multiplied by the risk factor should produce a close approximation to what the rate should be to correct for duration” (Brown and Kulkarni 1993). Since Dr,n is the function of only the project’s life and rate and it assumes equal periodic returns over the life of the project, it can be calculated using equation (4) using r just as in the CAPM model.

The values of i and Di,n remain to be calculated. We know that for a project with a higher earlier duration, the risk is decreased, so adjusting for the duration of the projects also decreases the discount rate. This is analogous to the case of the projects with lower earlier cash flows. Therefore we know that if the duration of the project is less than Dr,n, then i will be less than r, and i will be greater than r if the duration of the project is greater than Dr,n, as in this case. We find values of i and Di,n in the following way: first, we assume i = r and compute Di,n using (2). Then we find the difference between the left and right sides of (6). Therefore, we know whether our i lies in the interval [0, r] or [r, ∞]. Finally, we may use any method for finding roots, such as the bisection method, to find the value of i that makes both sides of (6) equal, again using (2) for finding Di,n.

For a steel bridge the proper discount rate i equals 5.65 percent with duration Di,n 6.21. Since the wooden bridge generates stable cash flows every year Di,n=Dr,n for this project, this means that the discount rate for this project is the same as the initially used 5 percent.

Table 4. NPV and Risk-Adjusted NPV Comparison[[{"fid":"93423","view_mode":"image_no_caption","fields":{"alt":"table 4","class":"media-element file-default media-wysiwyg-align-center","data-delta":"12","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 4","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"12":{"alt":"table 4","class":"media-element file-default media-wysiwyg-align-center","data-delta":"12","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 4","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"table 4","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"12"}}]]

Even though the steel bridge seemed the more attractive investment at the 5 percent discount rate and was higher in the NPV ranking, after adjusting the discount rate for the risk, the new risk-adjusted NPV changed the valuation, and in the effect the safer investment: the wooden bridge project is preferred.

Since the net present value is a frequently used indicator of the profitability of projects, when we consider its disadvantages—volatility resulting from even subtle interest rate changes—enhancing this measure for quantification of this risk can provide further information for investors. Since the duration of a project captures the impact of both uncertainty of future income and sensitivity for interest range changes in low rate environments, it can be used as a measure for interest risk changes and as a factor in determining the risk-adjusted NPV value. As presented in this paper, adjusting for risk can produce a different order of profitability of projects, enriching the analysis and preventing more risk-averse investors from taking excessive risk, which inextricably linked with longer investment projects.

It is worth noting that using such models for the purpose of making future predictions may constitute a part of the entrepreneur’s verstehen. In order to forecast future conditions of economic activity, entrepreneurs must use qualitative forecasts that are supported by his judgment. This was also the view emphasized by Rothbard (1997): “Misesian Man knows a lot; but he does not know everything and he must try to estimate the future, given various quantitative and qualitative estimates of change.” Duration is definitely among important parameters which have to be taken under consideration by entrepreneurs.

Previous research on corporate finance was focused on the liquidation phase and depression (Cwik 2008) or the focus was placed on the roundaboutness of projects (Cachanosky, Lewin 2014). A deeper understanding of financial foundations of the business cycle can increase knowledge of the effects of an easy monetary policy along with a better understanding of causal relations between companies’ decisions and any emerging crisis. While there is a common agreement about the wrong valuation of risk by companies throughout the business cycle, there is little evidence about the foundations of this factor underestimation. One of the reasons may be using measures that are not risk-adjusted and which may create an illusion of profitability in a current low rate environment.

This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.

Original Article: "Why the Economy Isn't Controlled by One Big Corporation".

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In all democratic countries, in the United States even more than elsewhere, a strong belief prevails that the influence of the intellectuals on politics is negligible. This is no doubt true of the power of intellectuals to make their peculiar opinions of the moment influence decisions, of the extent to which they can sway the popular vote on questions on which they differ from the current views of the masses. Yet over somewhat longer periods they have probably never exercised so great an influence as they do today in those countries. This power they wield by shaping public opinion.

In the light of recent history it is somewhat curious that this decisive power of the professional secondhand dealers in ideas should not yet be more generally recognized. The political development of the Western World during the last hundred years furnishes the clearest demonstration. Socialism has never and nowhere been at first a working-class movement. It is by no means an obvious remedy for the obvious evil which the interests of that class will necessarily demand. It is a construction of theorists, deriving from certain tendencies of abstract thought with which for a long time only the intellectuals were familiar; and it required long efforts by the intellectuals before the working classes could be persuaded to adopt it as their program.

In every country that has moved toward socialism, the phase of the development in which socialism becomes a determining influence on politics has been preceded for many years by a period during which socialist ideals governed the thinking of the more active intellectuals. In Germany this stage had been reached toward the end of the last century; in England and France, about the time of the first World War. To the casual observer it would seem as if the United States had reached this phase after World War II and that the attraction of a planned and directed economic system is now as strong among the American intellectuals as it ever was among their German or English fellows. Experience suggests that, once this phase has been reached, it is merely a question of time until the views now held by the intellectuals become the governing force of politics.

The character of the process by which the views of the intellectuals influence the politics of tomorrow is therefore of much more than academic interest. Whether we merely wish to foresee or attempt to influence the course of events, it is a factor of much greater importance than is generally understood. What to the contemporary observer appears as the battle of conflicting interests has indeed often been decided long before in a clash of ideas confined to narrow circles. Paradoxically enough, however, in general only the parties of the Left have done most to spread the belief that it was the numerical strength of the opposing material interests which decided political issues, whereas in practice these same parties have regularly and successfully acted as if they understood the key position of the intellectuals. Whether by design or driven by the force of circumstances, they have always directed their main effort toward gaining the support of this "elite," while the more conservative groups have acted, as regularly but unsuccessfully, on a more naïve view of mass democracy and have usually vainly tried directly to reach and to persuade the individual voter.

The term "intellectuals," however, does not at once convey a true picture of the large class to which we refer, and the fact that we have no better name by which to describe what we have called the secondhand dealers in ideas is not the least of the reasons why their power is not understood. Even persons who use the word "intellectual" mainly as a term of abuse are still inclined to withhold it from many who undoubtedly perform that characteristic function. This is neither that of the original thinker nor that of the scholar or expert in a particular field of thought. The typical intellectual need be neither: he need not possess special knowledge of anything in particular, nor need he even be particularly intelligent, to perform his role as intermediary in the spreading of ideas. What qualifies him for his job is the wide range of subjects on which he can readily talk and write, and a position or habits through which he becomes acquainted with new ideas sooner than those to whom he addresses himself.

Until one begins to list all the professions and activities which belong to the class, it is difficult to realize how numerous it is, how the scope for activities constantly increases in modern society, and how dependent on it we all have become. The class does not consist of only journalists, teachers, ministers, lecturers, publicists, radio commentators, writers of fiction, cartoonists, and artists all of whom may be masters of the technique of conveying ideas but are usually amateurs so far as the substance of what they convey is concerned. The class also includes many professional men and technicians, such as scientists and doctors, who through their habitual intercourse with the printed word become carriers of new ideas outside their own fields and who, because of their expert knowledge of their own subjects, are listened with respect on most others. There is little that the ordinary man of today learns about events or ideas except through the medium of this class; and outside our special fields of work we are in this respect almost all ordinary men, dependent for our information and instruction on those who make it their job to keep abreast of opinion. It is the intellectuals in this sense who decide what views and opinions are to reach us, which facts are important enough to be told to us, and in what form and from what angle they are to be presented. Whether we shall ever learn of the results of the work of the expert and the original thinker depends mainly on their decision.

The layman, perhaps, is not fully aware to what extent even the popular reputations of scientists and scholars are made by that class and are inevitably affected by its views on subjects which have little to do with the merits of the real achievements. And it is specially significant for our problem that every scholar can probably name several instances from his field of men who have undeservedly achieved a popular reputation as great scientists solely because they hold what the intellectuals regard as "progressive" political views; but I have yet to come across a single instance where such a scientific pseudo-reputation has been bestowed for political reason on a scholar of more conservative leanings. This creation of reputations by the intellectuals is particularly important in the fields where the results of expert studies are not used by other specialists but depend on the political decision of the public at large. There is indeed scarcely a better illustration of this than the attitude which professional economists have taken to the growth of such doctrines as socialism or protectionism. There was probably at no time a majority of economists, who were recognized as such by their peers, favorable to socialism (or, for that matter, to protection). In all probability it is even true to say that no other similar group of students contains so high a proportion of its members decidedly opposed to socialism (or protection). This is the more significant as in recent times it is as likely as not that it was an early interest in socialist schemes for reform which led a man to choose economics for his profession. Yet it is not the predominant views of the experts but the views of a minority, mostly of rather doubtful standing in their profession, which are taken up and spread by the intellectuals.

The all-pervasive influence of the intellectuals in contemporary society is still further strengthened by the growing importance of "organization." It is a common but probably mistaken belief that the increase of organization increases the influence of the expert or specialist. This may be true of the expert administrator and organizer, if there are such people, but hardly of the expert in any particular field of knowledge. It is rather the person whose general knowledge is supposed to qualify him to appreciate expert testimony, and to judge between the experts from different fields, whose power is enhanced. The point which is important for us, however, is that the scholar who becomes a university president, the scientist who takes charge of an institute or foundation, the scholar who becomes an editor or the active promoter of an organization serving a particular cause, all rapidly cease to be scholars or experts and become intellectuals, solely in the light of certain fashionable general ideas. The number of such institutions which breed intellectuals and increase their number and powers grows every day. Almost all the "experts" in the mere technique of getting knowledge over are, with respect to the subject matter which they handle, intellectuals and not experts.

In the sense in which we are using the term, the intellectuals are in fact a fairly new phenomenon of history. Though nobody will regret that education has ceased to be a privilege of the propertied classes, the fact that the propertied classes are no longer the best educated and the fact that the large number of people who owe their position solely to their general education do not possess that experience of the working of the economic system which the administration of property gives, are important for understanding the role of the intellectual. Professor Schumpeter, who has devoted an illuminating chapter of his Capitalism, Socialism, and Democracy to some aspects of our problem, has not unfairly stressed that it is the absence of direct responsibility for practical affairs and the consequent absence of firsthand knowledge of them which distinguishes the typical intellectual from other people who also wield the power of the spoken and written word. It would lead too far, however, to examine here further the development of this class and the curious claim which has recently been advanced by one of its theorists that it was the only one whose views were not decidedly influenced by its own economic interests. One of the important points that would have to be examined in such a discussion would be how far the growth of this class has been artificially stimulated by the law of copyright.

It is not surprising that the real scholar or expert and the practical man of affairs often feel contemptuous about the intellectual, are disinclined to recognize his power, and are resentful when they discover it. Individually they find the intellectuals mostly to be people who understand nothing in particular especially well and whose judgement on matters they themselves understand shows little sign of special wisdom. But it would be a fatal mistake to underestimate their power for this reason. Even though their knowledge may often be superficial and their intelligence limited, this does not alter the fact that it is their judgement which mainly determines the views on which society will act in the not too distant future. It is no exaggeration to say that, once the more active part of the intellectuals has been converted to a set of beliefs, the process by which these become generally accepted is almost automatic and irresistible. These intellectuals are the organs which modern society has developed for spreading knowledge and ideas, and it is their convictions and opinions which operate as the sieve through which all new conceptions must pass before they can reach the masses.

It is of the nature of the intellectual's job that he must use his own knowledge and convictions in performing his daily task. He occupies his position because he possesses, or has had to deal from day to day with, knowledge which his employer in general does not possess, and his activities can therefore be directed by others only to a limited extent. And just because the intellectuals are mostly intellectually honest, it is inevitable that they should follow their own conviction whenever they have discretion and that they should give a corresponding slant to everything that passes through their hands. Even where the direction of policy is in the hands of men of affairs of different views, the execution of policy will in general be in the hands of intellectuals, and it is frequently the decision on the detail which determines the net effect. We find this illustrated in almost all fields of contemporary society. Newspapers in "capitalist" ownership, universities presided over by "reactionary" governing bodies, broadcasting systems owned by conservative governments, have all been known to influence public opinion in the direction of socialism, because this was the conviction of the personnel. This has often happened not only in spite of, but perhaps even because of, the attempts of those at the top to control opinion and to impose principles of orthodoxy.

The effect of this filtering of ideas through the convictions of a class which is constitutionally disposed to certain views is by no means confined to the masses. Outside his special field the expert is generally no less dependent on this class and scarcely less influenced by their selection. The result of this is that today in most parts of the Western World even the most determined opponents of socialism derive from socialist sources their knowledge on most subjects on which they have no firsthand information. With many of the more general preconceptions of socialist thought, the connection of their more practical proposals is by no means at once obvious; in consequence, many men who believe themselves to believe themselves to be determined opponents of that system of thought become in fact effective spreaders of its ideas. Who does not know the practical man who in his own field denounces socialism as "pernicious rot" but, when he steps outside his subject, spouts socialism like any left journalist? In no other field has the predominant influence of the socialist intellectuals been felt more strongly during the last hundred years than in the contacts between different national civilizations. It would go far beyond the limits of this article to trace the causes and significance of the highly important fact that in the modern world the intellectuals provide almost the only approach to an international community. It is this which mainly accounts for the extraordinary spectacle that for generations the supposedly "capitalist" West has been lending its moral and material support almost exclusively to those ideological movements in countries father east which aimed at undermining Western civilization and that, at the same time, the information which the Western public has obtained about events in Central and Eastern Europe has almost inevitably been colored by a socialist bias. Many of the "educational" activities of the American forces of occupation of Germany have furnished clear and recent examples of this tendency.

A proper understanding of the reasons which tend to incline so many of the intellectuals toward socialism is thus most important. The first point here which those who do not share this bias ought to face frankly is that it is neither selfish interests nor evil intentions but mostly honest convictions and good intentions which determine the intellectual's views. In fact, it is necessary to recognize that on the whole the typical intellectual is today more likely to be a socialist the more he his guided by good will and intelligence, and that on the plane of purely intellectual argument he will generally be able to make out a better case than the majority of his opponents within his class. If we still think him wrong, we must recognize that it may be genuine error which leads the well-meaning and intelligent people who occupy those key positions in our society to spread views which to us appear a threat to our civilization.It was therefore not (as has been suggested by one reviewer of The Road to Serfdom, Professor J. Schumpeter), "politeness to a fault" but profound conviction of the importance of this which made me, in Professor Schumpeter's words, "hardly ever attribute to opponents anything beyond intellectual error." Nothing could be more important than to try to understand the sources of this error in order that we should be able to counter it. Yet those who are generally regarded as the representatives of the existing order and who believe that they comprehend the dangers of socialism are usually very far from such understanding. They tend to regard the socialist intellectuals as nothing more than a pernicious bunch of highbrow radicals without appreciating their influence and, by their whole attitude to them, tend to drive them even further into opposition to the existing order.

If we are to understand this peculiar bias of a large section of intellectuals, we must be clear about two points. The first is that they generally judge all particular issues exclusively in the light of certain general ideas; the second, that the characteristic errors of any age are frequently derived from some genuine new truths it has discovered, and they are erroneous applications of new generalizations which have proved their value in other fields. The conclusion to which we shall be led by a full consideration of these facts will be that the effective refutation of such errors will frequently require further intellectual advance, and often advance on points which are very abstract and may seem very remote from the practical issues.

It is perhaps the most characteristic feature of the intellectual that he judges new ideas not by their specific merits but by the readiness with which they fit into his general conceptions, into the picture of the world which he regards as modern or advanced. It is through their influence on him and on his choice of opinions on particular issues that the power of ideas for good and evil grows in proportion to their generality, abstractness, and even vagueness. As he knows little about the particular issues, his criterion must be consistency with his other views and suitability for combining into a coherent picture of the world. Yet this selection from the multitude of new ideas presenting themselves at every moment creates the characteristic climate of opinion, the dominant Weltanschauung of a period, which will be favorable to the reception of some opinions and unfavorable to others and which will make the intellectual readily accept one conclusion and reject another without a real understanding of the issues.

In some respects the intellectual is indeed closer to the philosopher than to any specialist, and the philosopher is in more than one sense a sort of prince among the intellectuals. Although his influence is farther removed from practical affairs and correspondingly slower and more difficult to trace than that of the ordinary intellectual, it is of the same kind and in the long run even more powerful than that of the latter. It is the same endeavor toward a synthesis, pursued more methodically, the same judgement of particular views in so far as they fit into a general system of thought rather than by their specific merits, the same striving after a consistent world view, which for both forms the main basis for accepting or rejecting ideas. For this reason the philosopher has probably a greater influence over the intellectuals than any other scholar or scientist and, more than anyone else, determines the manner in which the intellectuals exercise their censorship function. The popular influence of the scientific specialist begins to rival that of the philosopher only when he ceases to be a specialist and commences to philosophize about the progress of his subject and usually only after he has been taken up by the intellectuals for reasons which have little to do with his scientific eminence.

The "climate of opinion" of any period is thus essentially a set of very general preconceptions by which the intellectual judges the importance of new facts and opinions. These preconceptions are mainly applications to what seem to him the most significant aspects of scientific achievements, a transfer to other fields of what has particularly impressed him in the work of the specialists. One could give a long list of such intellectual fashions and catchwords which in the course of two or three generations have in turn dominated the thinking of the intellectuals. Whether it was the "historical approach" or the theory of evolution, nineteenth-century determinism and the belief in the predominant influence of environment as against heredity, the theory of relativity or the belief in the power of the unconscious—every one of these general conceptions has been made the touchstone by which innovations in different fields have been tested. It seems as if the less specific or precise (or the less understood) these ideas are, the wider may be their influence. Sometimes it is no more than a vague impression rarely put into words which thus wields a profound influence. Such beliefs as that deliberate control or conscious organization is also in social affairs always superior to the results of spontaneous processes which are not directed by a human mind, or that any order based on a plan laid down beforehand must be better than one formed by the balancing of opposing forces, have in this way profoundly affected political development.

Only apparently different is the role of the intellectuals where the development of more properly social ideas is concerned. Here their peculiar propensities manifest themselves in making shibboleths of abstractions, in rationalizing and carrying to extremes certain ambitions which spring from the normal intercourse of men. Since democracy is a good thing, the further the democratic principle can be carried, the better it appears to them. The most powerful of these general ideas which have shaped political development in recent times is of course the ideal of material equality. It is, characteristically, not one of the spontaneously grown moral convictions, first applied in the relations between particular individuals, but an intellectual construction originally conceived in the abstract and of doubtful meaning or application in particular instances. Nevertheless, it has operated strongly as a principle of selection among the alternative courses of social policy, exercising a persistent pressure toward an arrangement of social affairs which nobody clearly conceives. That a particular measure tends to bring about greater equality has come to be regarded as so strong a recommendation that little else will be considered. Since on each particular issue it is this one aspect on which those who guide opinion have a definite conviction, equality has determined social change even more strongly than its advocates intended.

Not only moral ideals act in this manner, however. Sometimes the attitudes of the intellectuals toward the problems of social order may be the consequence of advances in purely scientific knowledge, and it is in these instances that their erroneous views on particular issues may for a time seem to have all the prestige of the latest scientific achievements behind them. It is not in itself surprising that a genuine advance of knowledge should in this manner become on occasion a source of new error. If no false conclusions followed from new generalizations, they would be final truths which would never need revision. Although as a rule such a new generalization will merely share the false consequences which can be drawn from it with the views which were held before, and thus not lead to new error, it is quite likely that a new theory, just as its value is shown by the valid new conclusions to which it leads, will produce other new conclusions to which further advance will show to have been erroneous. But in such an instance a false belief will appear with all the prestige of the latest scientific knowledge supporting it. Although in the particular field to which this belief applies all the scientific evidence may be against it, it will nevertheless, before the tribunal of the intellectuals and in the light of the ideas which govern their thinking, be selected as the view which is best in accord with the spirit of the time. The specialists who will thus achieve public fame and wide influence will thus not be those who have gained recognition by their peers but will often be men whom the other experts regard as cranks, amateurs, or even frauds, but who in the eyes of the general public nevertheless become the best known exponents of their subject.

In particular, there can be little doubt that the manner in which during the last hundred years man has learned to organize the forces of nature has contributed a great deal toward the creation of the belief that a similar control of the forces of society would bring comparable improvements in human conditions. That, with the application of engineering techniques, the direction of all forms of human activity according to a single coherent plan should prove to be as successful in society as it has been in innumerable engineering tasks, is too plausible a conclusion not to seduce most of those who are elated by the achievement of the natural sciences. It must indeed be admitted both that it would require powerful arguments to counter the strong presumption in favor of such a conclusion and that these arguments have not yet been adequately stated. It is not sufficient to point out the defects of particular proposals based on this kind of reasoning. The argument will not lose its force until it has been conclusively shown why what has proved so eminently successful in producing advances in so many fields should have limits to its usefulness and become positively harmful if extended beyond these limits. This is a task which has not yet been satisfactorily performed and which will have to be achieved before this particular impulse toward socialism can be removed.

This, of course, is only one of many instances where further intellectual advance is needed if the harmful ideas at present current are to be refuted and where the course which we shall travel will ultimately be decided by the discussion of very abstract issues. It is not enough for the man of affairs to be sure, from his intimate knowledge of a particular field, that the theories of socialism which are derived from more general ideas will prove impracticable. He may be perfectly right, and yet his resistance will be overwhelmed and all the sorry consequences which he foresees will follow if his is not supported by an effective refutation of the idees meres. So long as the intellectual gets the better of the general argument, the most valid objections of the specific issue will be brushed aside.

This is not the whole story, however. The forces which influence recruitment to the ranks of the intellectuals operate in the same direction and help to explain why so many of the most able among them lean toward socialism. There are of course as many differences of opinion among intellectuals as among other groups of people; but it seems to be true that it is on the whole the more active, intelligent, and original men among the intellectuals who most frequently incline toward socialism, while its opponents are often of an inferior caliber. This is true particularly during the early stages of the infiltration of socialist ideas; later, although outside intellectual circles it may still be an act of courage to profess socialist convictions, the pressure of opinion among intellectuals will often be so strongly in favor of socialism that it requires more strength and independence for a man to resist it than to join in what his fellows regard as modern views. Nobody, for instance, who is familiar with large numbers of university faculties (and from this point of view the majority of university teachers probably have to be classed as intellectuals rather than as experts) can remain oblivious to the fact that the most brilliant and successful teachers are today more likely than not to be socialists, while those who hold more conservative political views are as frequently mediocrities. This is of course by itself an important factor leading the younger generation into the socialist camp.

The socialist will, of course, see in this merely a proof that the more intelligent person is today bound to become a socialist. But this is far from being the necessary or even the most likely explanation. The main reason for this state of affairs is probably that, for the exceptionally able man who accepts the present order of society, a multitude of other avenues to influence and power are open, while to the disaffected and dissatisfied an intellectual career is the most promising path to both influence and the power to contribute to the achievement of his ideals. Even more than that: the more conservatively inclined man of first class ability will in general choose intellectual work (and the sacrifice in material reward which this choice usually entails) only if he enjoys it for its own sake. He is in consequence more likely to become an expert scholar rather than an intellectual in the specific sense of the word; while to the more radically minded the intellectual pursuit is more often than not a means rather than an end, a path to exactly that kind of wide influence which the professional intellectual exercises. It is therefore probably the fact, not that the more intelligent people are generally socialists, but that a much higher proportion of socialists among the best minds devote themselves to those intellectual pursuits which in modern society give them a decisive influence on public opinion.Related to this is another familiar phenomenon: there is little reason to believe that really first class intellectual ability for original work is any rarer among Gentiles than among Jews. Yet there can be little doubt that men of Jewish stock almost everywhere constitute a disproportionately large number of the intellectuals in our sense, that is of the ranks of the professional interpreters of ideas. This may be their special gift and certainly is their main opportunity in countries where prejudice puts obstacles in their way in other fields. It is probably more because they constitute so large a proportion of the intellectuals than for any other reason that they seem to be so much more receptive of socialist ideas than people of different stocks.

The selection of the personnel of the intellectuals is also closely connected with the predominant interest which they show in general and abstract ideas. Speculations about the possible entire reconstruction of society give the intellectual a fare much more to his taste than the more practical and short-run considerations of those who aim at a piecemeal improvement of the existing order. In particular, socialist thought owes its appeal to the young largely to its visionary character; the very courage to indulge in Utopian thought is in this respect a source of strength to the socialists which traditional liberalism sadly lacks. This difference operates in favor of socialism, not only because speculation about general principles provides an opportunity for the play of the imagination of those who are unencumbered by much knowledge of the facts of present-day life, but also because it satisfies a legitimate desire for the understanding of the rational basis of any social order and gives scope for the exercise of that constructive urge for which liberalism, after it had won its great victories, left few outlets. The intellectual, by his whole disposition, is uninterested in technical details or practical difficulties. What appeal to him are the broad visions, the spacious comprehension of the social order as a whole which a planned system promises.

This fact that the tastes of the intellectual were better satisfied by the speculations of the socialists proved fatal to the influence of the liberal tradition. Once the basic demands of the liberal programs seemed satisfied, the liberal thinkers turned to problems of detail and tended to neglect the development of the general philosophy of liberalism, which in consequence ceased to be a live issue offering scope for general speculation. Thus for something over half a century it has been only the socialists who have offered anything like an explicit program of social development, a picture of the future society at which they were aiming, and a set of general principles to guide decisions on particular issues. Even though, if I am right, their ideals suffer from inherent contradictions, and any attempt to put them into practice must produce something utterly different from what they expect, this does not alter the fact that their program for change is the only one which has actually influenced the development of social institutions. It is because theirs has become the only explicit general philosophy of social policy held by a large group, the only system or theory which raises new problems and opens new horizons, that they have succeeded in inspiring the imagination of the intellectuals.

The actual developments of society during this period were determined, not by a battle of conflicting ideals, but by the contrast between an existing state of affairs and that one ideal of a possible future society which the socialists alone held up before the public. Very few of the other programs which offered themselves provided genuine alternatives. Most of them were mere compromises or half-way houses between the more extreme types of socialism and the existing order. All that was needed to make almost any socialist proposal appear reasonable to these "judicious" minds who were constitutionally convinced that the truth must always lie in the middle between the extremes, was for someone to advocate a sufficiently more extreme proposal. There seemed to exist only one direction in which we could move, and the only question seemed to be how fast and how far the movement should proceed.

The significance of the special appeal to the intellectuals which socialism derives from its speculative character will become clearer if we further contrast the position of the socialist theorist with that of his counterpart who is a liberal in the old sense of the word. This comparison will also lead us to whatever lesson we can draw from an adequate appreciation of the intellectual forces which are undermining the foundations of a free society.

Paradoxically enough, one of the main handicaps which deprives the liberal thinker of popular influence is closely connected with the fact that, until socialism has actually arrived, he has more opportunity of directly influencing decisions on current policy and that in consequence he is not only not tempted into that long-run speculation which is the strength of the socialists, but is actually discouraged from it because any effort of this kind is likely to reduce the immediate good he can do. Whatever power he has to influence practical decisions he owes to his standing with the representatives of the existing order, and this standing he would endanger if he devoted himself to the kind of speculation which would appeal to the intellectuals and which through them could influence developments over longer periods. In order to carry weight with the powers that be, he has to be "practical," "sensible," and "realistic." So long as he concerns himself with the immediate issues, he is rewarded with influence, material success, and popularity with those who up to a point share his general outlook. But these men have little respect for those speculations on general principles which shape the intellectual climate. Indeed, if he seriously indulges in such long-run speculation, he is apt to acquire the reputation of being "unsound" or even half a socialist, because he is unwilling to identify the existing order with the free system at which he aims.The most glaring recent example of such condemnation of a somewhat unorthodox liberal work as "socialist" has been provided by some comments on the late Henry Simons' Economic Policy for a Free Society (1948). One need not agree with the whole of this work and one may even regard some of the suggestions made in it as incompatible with a free society, and yet recognize it as one of the most important contributions made in recent times to our problem and as just the kind of work which is required to get discussion started on the fundamental issues. Even those who violently disagree with some of its suggestions should welcome it as a contribution which clearly and courageously raises the central problems of our time.

If, in spite of this, his efforts continue in the direction of general speculation, he soon discovers that it is unsafe to associate too closely with those who seem to share most of his convictions, and he is soon driven into isolation. Indeed there can be few more thankless tasks at present than the essential one of developing the philosophical foundation on which the further development of a free society must be based. Since the man who undertakes it must accept much of the framework of the existing order, he will appear to many of the more speculatively minded intellectuals merely as a timid apologist of things as they are; at the same time he will be dismissed by the men of affairs as an impractical theorist. He is not radical enough for those who know only the world where "with ease together dwell the thoughts" and much too radical for those who see only how "hard in space together clash the things." If he takes advantage of such support as he can get from the men of affairs, he will almost certainly discredit himself with those on whom he depends for the spreading of his ideas. At the same time he will need most carefully to avoid anything resembling extravagance or overstatement. While no socialist theorist has ever been known to discredit himself with his fellows even by the silliest of proposals, the old-fashioned liberal will damn himself by an impracticable suggestion. Yet for the intellectuals he will still not be speculative or adventurous enough, and the changes and improvements in the social structure he will have to offer will seem limited in comparison with what their less restrained imagination conceives.

At least in a society in which the main requisites of freedom have already been won and further improvements must concern points of comparative detail, the liberal program can have none of the glamor of a new invention. The appreciation of the improvements it has to offer requires more knowledge of the working of the existing society than the average intellectual possesses. The discussion of these improvements must proceed on a more practical level than that of the more revolutionary programs, thus giving a complexion which has little appeal for the intellectual and tending to bring in elements to whom he feels directly antagonistic. Those who are most familiar with the working of the present society are also usually interested in the preservation of particular features of that society which may not be defensible on general principles. Unlike the person who looks for an entirely new future order and who naturally turns for guidance to the theorist, the men who believe in the existing order also usually think that they understand it much better than any theorist and in consequence are likely to reject whatever is unfamiliar and theoretical.

The difficulty of finding genuine and disinterested support for a systematic policy for freedom is not new. In a passage of which the reception of a recent book of mine has often reminded me, Lord Acton long ago described how "at all times sincere friends of freedom have been rare, and its triumphs have been due to minorities, that have prevailed by associating themselves with auxiliaries whose objects differed from their own; and this association, which is always dangerous, has been sometimes disastrous, by giving to opponents just grounds of opposition…."Acton, The History of Freedom, I (1922). More recently, one of the most distinguished living American economists has complained in a similar vein that the main task of those who believe in the basic principles of the capitalist system must frequently be to defend this system against the capitalists—indeed the great liberal economists, from Adam Smith to the present, have always known this.

The most serious obstacle which separates the practical men who have the cause of freedom genuinely at heart from those forces which in the realm of ideas decide the course of development is their deep distrust of theoretical speculation and their tendency to orthodoxy; this, more than anything else, creates an almost impassable barrier between them and those intellectuals who are devoted to the same cause and whose assistance is indispensable if the cause is to prevail. Although this tendency is perhaps natural among men who defend a system because it has justified itself in practice, and to whom its intellectual justification seems immaterial, it is fatal to its survival because it deprives it of the support it most needs. Orthodoxy of any kind, any pretense that a system of ideas is final and must be unquestioningly accepted as a whole, is the one view which of necessity antagonizes all intellectuals, whatever their views on particular issues. Any system which judges men by the completeness of their conformity to a fixed set of opinions, by their "soundness" or the extent to which they can be relied upon to hold approved views on all points, deprives itself of a support without which no set of ideas can maintain its influence in modern society. The ability to criticize accepted views, to explore new vistas and to experience with new conceptions, provides the atmosphere without which the intellectual cannot breathe. A cause which offers no scope for these traits can have no support from him and is thereby doomed in any society which, like ours, rests on his services.

It may be that a free society as we have known it carries in itself the forces of its own destruction, that once freedom has been achieved it is taken for granted and ceases to be valued, and that the free growth of ideas which is the essence of a free society will bring about the destruction of the foundations on which it depends. There can be little doubt that in countries like the United States the ideal of freedom today has less real appeal for the young than it has in countries where they have learned what its loss means. On the other hand, there is every sign that in Germany and elsewhere, to the young men who have never known a free society, the task of constructing one can become as exciting and fascinating as any socialist scheme which has appeared during the last hundred years. It is an extraordinary fact, though one which many visitors have experienced, that in speaking to German students about the principles of a liberal society one finds a more responsive and even enthusiastic audience than one can hope to find in any of the Western democracies. In Britain also there is already appearing among the young a new interest in the principles of true liberalism which certainly did not exist a few years ago.

Does this mean that freedom is valued only when it is lost, that the world must everywhere go through a dark phase of socialist totalitarianism before the forces of freedom can gather strength anew? It may be so, but I hope it need not be. Yet, so long as the people who over longer periods determine public opinion continue to be attracted by the ideals of socialism, the trend will continue. If we are to avoid such a development, we must be able to offer a new liberal program which appeals to the imagination. We must make the building of a free society once more an intellectual adventure, a deed of courage. What we lack is a liberal Utopia, a program which seems neither a mere defense of things as they are nor a diluted kind of socialism, but a truly liberal radicalism which does not spare the susceptibilities of the mighty (including the trade unions), which is not too severely practical, and which does not confine itself to what appears today as politically possible. We need intellectual leaders who are willing to work for an ideal, however small may be the prospects of its early realization. They must be men who are willing to stick to principles and to fight for their full realization, however remote. The practical compromises they must leave to the politicians. Free trade and freedom of opportunity are ideals which still may arouse the imaginations of large numbers, but a mere "reasonable freedom of trade" or a mere "relaxation of controls" is neither intellectually respectable nor likely to inspire any enthusiasm.

The main lesson which the true liberal must learn from the success of the socialists is that it was their courage to be Utopian which gained them the support of the intellectuals and therefore an influence on public opinion which is daily making possible what only recently seemed utterly remote. Those who have concerned themselves exclusively with what seemed practicable in the existing state of opinion have constantly found that even this has rapidly become politically impossible as the result of changes in a public opinion which they have done nothing to guide. Unless we can make the philosophic foundations of a free society once more a living intellectual issue, and its implementation a task which challenges the ingenuity and imagination of our liveliest minds. But if we can regain that belief in the power of ideas which was the mark of liberalism at its best, the battle is not lost. The intellectual revival of liberalism is already underway in many parts of the world. Will it be in time?

Recorded at the Mises Institute in Auburn, Alabama, on 14 July 2020.

JEL Classification: P21

Márton Kónya (marton.konya@stud.uni-corvinus.hu) is a BA student of applied economics at the Corvinus University of Budapest.

I would like to thank everyone who aided me in writing this paper, especially Dr. Karl-Friedrich Israel of the University of Leipzig and my good friend Bálint Madlovics.

The People’s Republic of Walmart contains many ideas that are truly provocative to someone with Austrian views. In some everyday political circles, the book is cited as exposing how many neoclassical scholars’ objections to the high ideas of socialism are in fact unsubstantiated. It would seem that this book has become one of the fundamental “weapons” of today’s socialists. While reading it, the possible sources of its ideas became ever more apparent and its errors in economic theory showed themselves, which with a more careful study of Mises’s works would not have occurred.

The book’s argument, grossly simplified, is the following: socialist governments of the past failed to produce an efficient planned economy that could rival the market system, but this failure is almost entirely due to technological constraints that have since disappeared. Not only is a modern planned economy not impossible, but capitalism is partially operating it right before our very eyes. Megacorporations, such as Amazon and Walmart, are working at an economic capacity far greater than that of most of the former socialist countries. They are not only afloat, but can supply millions upon millions of consumers and arrange their production processes without having an inner market, which would need a price system based on private property to operate. These companies are the living evidence that the fears and objections of Austrian thinkers such as Ludwig von Mises and F. A. Hayek are wrong and that we have a system that can coordinate human efforts without a market.

This critique revives, in their accurate forms, the thoughts of Austrian school thinkers, mainly Ludwig von Mises, for he refuted the errors in the book long ago. Although this might be true for other arguments in the book as well, those elements which are not strictly connected to economic calculation will be avoided. Some of the book’s other fundamental ideas often appear in socialist works: for example, the exploitation theory of capital, the robber baron myth, the denial of the tragedy of the commons, the linking together of anarchism and the command economy, the idea that overproduction causes depressions, etc. These questions have been dealt with in countless books and essays. Instead, this essay’s purpose is to show that Mises and Hayek’s writings, if read correctly, already refute Phillips and Rozworski’s arguments and that Austrian economics provides more insight into the workings of large corporations than the book’s authors claim to.

This essay will first consider the book’s main terminological confusion, followed by a short restatement of the basic problem of economic planning. The second section applies these findings of the Austrian thinkers to the cases of large corporations. The final chapter briefly discusses the relation between planning as it occurs in a market economy, and in a collectivist economy.

The central error of the book is that it uses two fundamentally different terms synonymously, economic planning and planned economy, and views both as incompatible with the market. But one of them is not only compatible with market economies, but is one of their foundational tools: economic planning. In order to make a clearer distinction between the two phrases, they need to be defined first. Simply put, economic planning is the process by which the various participants in the economy make calculations about the economic steps they must take in the future. In contrast, a planned economy is an entirely centralized system in which the allocation of everything from raw materials to capital goods, to consumer goods is implemented by a central authority, without the market mechanism.

To a naïve reader the only difference may be the scale of the planning operation, but the distinction is much more fundamental. To briefly summarize and illustrate the problemThe illustration here used is heavily influenced by an example given in a YouTube video by the Learn Liberty channel (2015) called “What If There Were No Prices?” that Mises originally pointed out in Economic Calculation in the Socialist Commonwealth ([1920] 1990) and later elaborated in Socialism ([1922] 1981) and Human Action (1949), let us take a planned economy. There are no profit-oriented firms or capitalists, and all means of production (including labor) are under central control. Let us suppose that the board of directors is tasked with building a railroad connecting two cities between which there is a high mountain. Let us suppose further that somehow the board of directors knows that the routes going through and around the mountain would increase social welfare to the same degree, and that their goal is to use the society’s resources in the most economical way (meaning that they must only use up resources that are not needed by an enterprise that promises a higher increase in social welfare). In short, we have simplified the scenario so that the directors only have to wrestle with the problem of finding the lowest cost possible. For the sake of simplicity, let us say that only two means of production are necessary to build a railroad, engineering and steel, and let us establish that the route through the mountain requires a lot of engineering work but less steel, and that the route around it takes more steel and less engineering. The problem, then, is to determine whether the society needs steel or engineering more. How can this be discovered? The other uses of the two factors must be known.

Consider engineering. It is the foundation of modern industry. There are immeasurable known uses for it (and even more that are unknown!). What if, it might be asked, more tractors are made instead of the railroad, as they might be more beneficial? How can this be known? With more tractors, there could be a larger output of goods that require the use of tractors. But these are usually not final goods, but various crops in their raw forms, so it is not known how much these would increase the utility of people. We have to go further down the chain of production: it must be known how much the increased crop yield would benefit the industries that use them (such as livestock farms, canning factories, restaurants, mills, etc.). It needs to be realized that an increase in the quantity of tractors affects a huge number of processing industries that serve the consumer in a wide variety of ways. In the end, what the consumers think about these alternative uses of more tractors, manifested as final products, would need to be known. The citizens would presumably have to be asked for their preference between the railroad route and every existing and potential food and drink item whose production at some point involves a tractor. But in this case, the same process would have to occur with every existing and potential use of engineering as a means of production, not just tractors, since engineering can also has many other applications. (Of course, this assumes that collecting the data of people’s preferences is technically feasible, despite the known fact that there are various obstacles that prevent the acquisition of some basic information. It would be wrong to assume that a person expresses the same pattern of preferences under surveying conditions as he would when acting under real circumstances. He might answer carelessly, just to get the survey over with. It may even be in his interest to falsify a survey.)

The same exercise can be done with steel. Social welfare might be increased in millions of ways using steel, not just by laying down rails. For example, frying pans might be made out of it. But how important are frying pans? In order to know this, we would have to know how much every consumer (and potential consumer) of frying pans would value more pans. If, for example, the people have various kinds of frying pans, they might want the railway between the two cities more than an additional pan. But if they have nothing to cook scrambled eggs in but would happily go from city A to city B on foot, they would probably want the pans more. And we must consider not only consumer goods, but the staggering multitude of production goods made of steel (machinery, for example), not to mention those consumer goods that can be created with production goods made of steel.

Add technology to this problem, which, although in a free market society is a blessing, in this case appears to be a great problem. In Human Action, Mises writes: “It is permissible to say that the present state of technological knowledge makes it possible to produce almost anything out of almost everything” (p. 695). A couple of lines later he gives the example of tap water: in modern society, we gain drinkable water by cleaning local water deposits or by using expensive aqueducts to transport spring water to the cities. But with modern technology it is equally possible to produce drinkable water synthetically. Today, of course, people smile at such a suggestion, but only because they cannot even imagine a world without sensible economic planning. Water-supplying companies (mostly government owned in Europe) can choose these efficient means of “producing” and transporting clean water, because market prices make these solutions the most economical for them. Without such guidance, they would have no idea whether to build huge cleaning facilities or synthetic water “factories,” or which option deprives society of the most precious resources relative to the “value” of output. There would be real chaos of production.

It is easy to see that even in this elementary example, with just two nonhuman factors of production, the examination of all their possible involvement in production would require that we know (1) who the possible consumers are and (2) whether they would prefer that a new railroad route be built or some other use of the factors and their resulting consumer goods. Here the problem is not, as the authors of The People’s Republic of Walmart wish to present it, to have a sufficiently accurate method of linear programming that could process the available data and solve the optimization problems before the data becomes obsolete. Rather, the problem is that in order to make just one economic decision we need to know all the preferences of all the participants in economic life. Just in the case of steel and engineering, we can say that we have to know all the latest thoughts of every consumer about every existing and potential consumer good. Due to the intertwining of production processes, almost all factors of production affect almost every other factor of production (and we have not even mentioned human labor, which is part of every production process and must be economized as well, since it is also a scarce resource). As a result, just to assess the extent of a few costs, we would have to be aware of all the thoughts of all the economic participants.

And here it is not enough, contrary to the authors’ assertion, to find partial solutions.As the authors write: “That’s the trick: to find the best possible, even if partial, approximations. Amazon’s modelers work to bring intractably complex problems down to size, to build plans that neither stretch into infinite time, nor respond to all the possible random events that could happen at every step, but that simply work. This means coming as close as possible to the true answer of a planning question within a realistic time frame and with the use of available computing power. When it is impossible to use an ‘algorithm of algorithms’ to mechanically find the algorithm that best approximates the original problem, creativity then comes into play” (Phillips and Rozworski 2019, 34). As will be seen later, a planning unit in a market economy can resort to such simplifications, but in our example, which is a genuine planned economy, what can be simplified? There is nothing precise to approach. In the case of a railway project, wasting a bit of steel or wasting a bit of engineering skill might not seem drastic, but if the methods and inputs are chosen randomly, or just without precision, in every conceivable line of production, soon society will find itself with shortages of resources that can have catastrophic consequences.

The book is noticeably quiet about the failures of socialist attempts at solving this problem. We can read about Otto Neurath’s brave revolutionary deeds (Phillips and Rozworski 2019, 10), but his central “calculation in kind” idea, which has long been debunked, does not appear. Marx’s and Engels’s critiques of capitalism rage though the pages (ibid., 27), but the “labor theory of value” that they advocated is not discussed. In fact, all these previous failures point to the central distinction between economic planning and a planned economy: money prices.

If a railway company is in the hands of a private entrepreneur, he has every incentive to choose the method of construction with the lowest monetary costs, assuming the same utility to the consumers (the total income of the project in monetary terms), in order to achieve the highest degree of profit. However, this also serves society best. What does it mean that engineering is too expensive? It means that other participants in the market (for example, farmers) are willing to pay engineers more. The reason for this is most probably that the farmers’ consumers (producers of foodstuffs) are willing to pay them more for their goods (crops). These producers of lower-order goods, in turn, are willing to pay more, because their own customers are willing to pay more for their final goods (foodstuffs). In accordance with the marginalist theory of value elaborated by the founders of the Austrian school, such as Carl Menger ([1871] 2007, 114–65), a change in consumer demand (at whichever stage of production it may occur) creates a signal for producers at higher stages that tells them which needs are to be satisfied more and which less urgently. A rise in the price of engineering means that engineering is being used in production processes that are creating goods which the consumers urgently need, and thus only producers satisfying even more urgent needs may acquire it.

The price system, based on the maximization of profit and utility, seemingly coordinates economic participants without any planning. Looking at the big picture, this is certainly true. Yet planning as such not only does not disappear, but is only possible in a free market environment. The Austrian thinkers, such as Hayek (1945), were right in calling the price system a system of information sharing. The price system does nothing more than divide a kind of mental labor between several miniature “planned economies,” mental labor that could not be carried out by a single, publicly owned planned economy. Its tool for this task is money. Money provides the common denominator which the socialist thinkers were unable to invent. It is the tool which enables market participants to use accounting methods to compare the incomes and costs of their activities, and to plan their future steps accordingly (Mises 1949, 230). It is at this level that the important act of economic planning happens. Accounting is how corporations, governmental organizations, nonprofit organizations, the army, the police, the nationalized schools and hospitals, every level of human organization is able to solve its planning problems: via money prices established by the market process based on the private ownership of the means of production. This holds true, of course, only if the preconditions of the formation of a market price are satisfied. In the case of the armed forces, police, and other governmental monopolies, the consumers do not get to decide the price which they would be willing to pay for these services, and as a result prices of production factors employed in these branches (such as policemen’s and soldiers’ wages or the prices of various weaponry) can’t accurately reflect their value relative to other resources, leading to waste. (Later the reason such a monopoly (be it governmental or private) on factors of productions would impede the economic actor’s ability to determine their prices will be explored.) It is fair to say, therefore, that although governmental monopolies can calculate with money prices, their presence in the economy in fact obstructs the economic calculus (on a long-term basis, as opposed to private monopolies, whose errors in calculation are not compensated by taxation).

The authors fell into the same trap as earlier socialists. The difference is that while the authors discuss large firms, earlier thinkers spoke about governmental bodies, since earlier in history those organizations were the largest economic units without an inner market. Mises ([1922] 1981, 136), however, showed that government institutions’ ability to calculate is only due to the market surrounding them:

State and municipal enterprises calculate with those prices of the means of production and of consumption goods which are formed on the market. Therefore it would be precipitate to conclude from the fact that municipal and state enterprises exist, that socialist economic calculation is possible.

The same principle applies to the modern case: considering that large corporations, however great the volume of their activity, plan in terms of market prices, corporate planning on a huge scale is not sufficient evidence for the feasibility of a planned economy without market prices. It would still be “just groping about in the dark,” using Mises’s (1949) words.

Before it can reach the consumer (especially with today’s refined technology), a consumer good must go through several long stages of production. From the extraction of raw materials from nature through the various steps of manufacturing, time-consuming and complex processes are connected so that in the end some member of society may receive the final good or service. As has been shown above, the central management of the whole process would require complete knowledge—a supernatural if not impossible condition. But the reason for this is not the size of the economy or the greatness of cash flows occurring in it, nor the number of consumers. The constraint of a planned economy is not volume, but the complexity of alternatives.

Let Amazon and Walmart be as large as possible, even the sole monopolists of their industry on the entire globe. Still they could only coordinate their activities with market prices. True, their size would be gigantic, but this is not what makes economic calculation difficult. They are wide but thin slices of the entire system. And it is depth that really matters in calculation. Here it is worth mentioning the irony that the main activity of both Amazon and Walmart is the distribution of final goods. Mises (1981 [1922], 118) himself has pointed out in his works that the prices of (already available) consumption goods may be asserted even by a planned economy. Simply, the central planner should give money to the citizens and then hand out the final goods to the highest bidders. This is the farthest a socialist community (with available final goods) may go as far as gathering information is concerned, and only because the prices are expressed in terms of privately owned money and this process is still permitted by our definition of a collectivist society (producer goods still remain common property, but money is private property).Mises’s example goes as follows: “True, a socialistic society could see that 1000 litres of wine were better than 800 litres. It could decide whether or not 1000 litres of wine were to be preferred to 500 litres of oil. Such a decision would involve no calculation. The will of some man would decide. But the real business of economic administration, the adaptation of means to ends only begins when such a decision is taken. And only economic calculation makes this adaptation possible. Without such assistance, in the bewildering chaos of alternative materials and processes the human mind would be at a complete loss. Whenever we had to decide between different processes or different centres of production, we would be entirely at sea.” It is clear from what has been said above that the real problem only starts with the possible uses of the available production goods, and with finding production methods that are yet unknown. The latter point is illustrated by Ericson (1991, 21) when he writes about the Soviet Union’s tendency to only replicate the methods of production already used by capitalist firms and its inability pioneer such methods.As he wrote: “The [Soviet] system has been particularly effective when the central priorities involve catching up, for…the problems of what to do, when and how to do it, and whether it was properly done, are solved by reference to a working model, by exploiting what Gerschenkorn…called the ‘advantage of backwardness.’”

Knowing this, the book’s lengthy discussion about how complex and high-level technology is used by these corporations to find out the demand for different goods, seems only to be the knocking on an already open door. Moreover, the authors’ description precisely backfires: trading with final goods is just the ending move of the process of production, and this already requires a huge and costly computing system based on complex mathematics from these mammoth firms. Yet all this is only one function. We must not be deceived by the multitude of products these firms are selling, because Walmart and Amazon fundamentally produce only one good: they link the producers with the final consumers. Huge scale, little depth. And in order to carry out this function they must align their activity with market prices, much like every other corporation. Every step toward the complete ownership of the market would make their tasks exponentially more complex, since, as the example above showed, at every stage the number of different real and potential alternative uses of the factors multiplies until the point at which they would need complete knowledge. The need for calculation arises from the variety of alternative uses of the means of production. As long as this is solved by the market, Walmart can calculate how much income it has received from the suppliers who want to sell their goods at its stores (how high a need the members of society have expressed for the service rendered by Walmart), how much it had to spend on wages, capital goods, public utilities (how important the resources used up by its activity are to society), and how much profit these two leave (the difference between the valuation of its services and the resources used up). If all these were the property of Walmart, its efforts toward an efficient economic plan would also be in vain, since it would be unable to decide the most economical way of employing its production goods.

This problem is greatly elaborated in many relevant sections of Rothbard’s Man, Economy, and State ([1962] 1970, 547–48), especially those highlighted by Klein (1996) concerning the constraints economic calculation imposes upon the possible size of business units. Here Rothbard shows that firms require markets in order to efficiently calculate and plan their methods of production and operation. If a firm integrates stages of productions, it is required to conduct transfers within its divisional units without the market. If the managers want to know how profitable the operations of and transfers between the various units were, they have to use some kind of reference price in the accounts of the units. When a market of the transferred factor exists outside the firm, they can use its price as a “substitute price,” which helps them determine costs and thereby the most efficient methods of production. But if such a market does not exist, if, for example, the firm in question is the sole owner of the factors of production, then the managers have a very small chance of accurately determining the opportunity cost of the factors. This would result in gross misallocation of factors of productions, meaning not only losses on the firm’s accounts but also a wasteful, inefficient management of society’s resources. Rothbard argues that this problem forms an upper boundary on the size of the firm. The greater its share in the ownership of a factor of production, the less accurately it will be able to determine the factor’s opportunity cost, and the greater its losses will be on existing markets.In Rothbard’s words: “The force of this law multiplies as the area of the economy increases and as islands of noncalculable chaos swell to the proportions of masses and continents. As the area of incalculability increases, the degrees of irrationality, misallocation, loss, impoverishment, etc., become greater. Under one owner or one cartel for the whole productive system, there would be no possible areas of calculation at all, and therefore complete economic chaos would prevail.”

There is no doubt that this is true in the case of Amazon and Walmart. It may well be, as the authors have noted, that Walmart is able to utilize the huge volume of its capital equipment without an inner market. As they write, “[t]he different departments, stores, trucks and suppliers [of Walmart] do not compete against each other in a market; everything is coordinated” (Phillips and Rozworski 2019, 12). But if Walmart were the only owner of trucks in the world (or if it were somehow isolated in a such way as to be oblivious of the costs of transportation determined on the market), the only way of vaguely deciding the costs of trucking in order to plan the feasible amount of capital used for this purpose would be to approximate based on some other mode of transportation that does have a market price—and this would still lead to great inaccuracies. The fewer the reference points for this approximation are, the more inaccurate the calculation will be and the greater the amount of wasted resources will be.

As it is evident from the first sentences of their introduction, the authors more or less had to explain themselves in front of their fellow socialists. After all, writing a revering book about two corporate giants is quite a foreign thought in the circles to which the book is mainly addressed. To avoid confusion, after every admiration of planning comes an establishment of the fact that both Amazon and Walmart use planning for profit-induced reasons characteristic of capitalist corporations. We can read at length about how the firms, after buying the time and energy of the working class (Phillips and Rozworski 2019, 26–27), use them as they please, and that the workers are forced into this dictatorial system because they would starve to death without a salary. The working conditions, the authoritarian methods of force, the strict inner bureaucracy, the tools for the surveillance of workers are well detailed (Phillips and Rozworski 2019, 38). All this, of course, is attributed to the fact that despite being the living evidence of the possibility of planning, in a capitalistic environment all this efficiency benefits the capitalist class and oppresses the working class, which is forced into an autocratic system. They use the words of Noam Chomsky, who claims that firms, contrary to the “black box” concept of standard microeconomics and the cooperation models of business economics, are indeed “Islands of Tyranny.”

These are perhaps the most ironic parts of the book. The book’s main idea is that large corporations prove the viability of a planned economy, but its authors are forced to accuse these very examples of “planned economy” of using autocratic methods. And this, most ironically, they blame on the market economy surrounding these corporations. For those familiar with the ideas of Austrian economics it might be obvious that the case is just the other way around. It is easy to derive from what has been said above that the whole point of a market economy is to minimize the amount of planning necessary for an efficient economy. This is the “mental division of labor” of the market. It coordinates personal and organizational plans the central and complete coordination of which would take supernatural powers. However, the top-down organized hierarchal structure is an indispensable element of every planned economic process.

It seems expedient to mention here one of the most crucial chapters in The Road to Serfdom, “Planning and Democracy” (Hayek [1944] 2001, 59–74). In this chapter, Hayek clearly explains that in every planning process only one plan may exist and that it has to be one concrete aim. In such a process we are looking for a democratic element in vain. Every participant who opposes the plan constructed by the experts is sabotaging its realization. And if we want to plan the entire economy, there is no room for coexisting inner plans, either. There cannot be a separate steel industry plan, which contradicts the agricultural plan or the infrastructural plan. This leads to the centralizing nature of planning: in the end, only one plan can prevail. Under such conditions, it is impossible to create a consensus between people’s different motives, aims, and moral judgments. At most we can create an outcome which would not satisfy anyone. As Hayek explains:

That planning creates a situation in which it is necessary for us to agree on a much larger number of topics than we have been used to, and that in a planned system we cannot confine collective action to the tasks on which we can agree, but are forced to produce agreement on everything in order that any action can be taken at all, is one of the features which contribute more than most to determining the character of a planned system. (Hayek [1944] 2001, 65)

Speaking of “islands of tyranny,” the authors only listed those attributes of planning that are required for the realization of a certain goal. We know from business economics that the nonmarket inner world of a firm necessitates a high degree of harmony among its workers. If the experts at the top of the company have set a goal of opening a new plant, lessening administrative costs, installing a new technical system, changing some aspect of production, or anything else, every employee has to adjust his activity according to the company’s plan. Otherwise, they would sabotage the plan. In such a case, the leadership may choose to penalize lack of cooperation through the withdrawal of certain grants or privileges, by firing the employees or even starting lawsuits against them. But none of this originates from the profit motive of capitalism: it is inherent in planning as such. Profit only tells the managers how they can serve best the consumers as far as profit in a competitive industry represents the difference between the high valuation of the produced good and the low valuation of the factors of production used up. This profit system is not, however, what requires the centralized command structure, but firms have to employ undemocratic means precisely because they are the only effective way of carrying out a plan.

It would be mistaken to think that a completely planned economy would have not less but more democratic elements. The intertwining of production processes demands the cooperation of every part with every other:

A complex whole where all the parts must be most carefully adjusted to each other, cannot be achieved through a compromise between conflicting views. To draw up an economic plan in this fashion is even less possible than, for example, successfully to plan a military campaign by democratic procedure. As in strategy it would become inevitable to delegate the task to the experts….But the ends of an economic plan, or of any part of it, cannot be defined apart from the particular plan. It is the essence of the economic problem that the making of an economic plan involves the choice between conflicting or competing ends—different needs of different people. But which ends do so conflict, which will have to be sacrificed if we want to achieve certain others, in short, which are the alternatives between which we must choose, can only be known to those who know all the facts; and only they, the experts, are in a position to decide which of the different ends are to be given preference. It is inevitable that they should impose their scale of preferences on the community for which they plan. (Hayek 2001 [1944], 68)

It must not be denied that in the final sentences of the book, the authors themselves gave voice to the concern that the idea of a planned economy arouses in people:

It is not enough to say, ”Nationalize it!” We have to think hard about how to ensure that the already enormous amounts of information controlled by large, unaccountable corporate bureaucracies do not become the basis for new unaccountable bureaucracies (state-run or otherwise). As the two twins of undemocratic planning, Soviet Union and Walmart, show, planning on its own is no synonym for socialism. (Phillips and Rozworski 2019, 103)

However, all these concerns are naively set aside as the matter for some other book. After this paragraph, a remarkably humorous quotation (at least for an Austrian scholar) follows by Friedrich Engels, who expresses his deep contempt against all those who call every planned system “socialistic.” He says that if this were so, then “Metternich and Napoleon would be counted as the founding fathers of socialism,” and “the Royal Maritime Society and the nationalized Royal Porcelain Manufactures could all be called chief socialist institutions.” To the advocates of a free market economy, the elaboration of the irony surrounding these sentences is not necessary.

The economic calculation debate was perhaps the most important debate of the entire history of economic science. It has moved such brilliant minds that it is safe to say that the problem has been processed to such an extent that practically everything has already been said about it. Neurath, Böhm-Bawerk, Lange, Hayek, Lerner, Mises, and Dickinson have examined this area in such detail that the following generations only have to pull one of their works from the shelves in order to come across an answer for almost any question about it. In order to counter every collectivist supposition, it is enough to find out where in the twentieth-century debate we have to “look closer.”

To The People’s Republic of Walmart we can assign several such dates, but certainly to its early sections, since in them even the necessity of money prices is missing, which neosocialists (such as Oskar Lange and Abba P. Lerner) have already discovered. The ideas in Hayek’s The Road to Serfdom about economic planning, well-trodden ground, are also absent. But implicitly we can find the tendency characteristic to the economic calculation debate, namely that in every one of its stages the debate has approached step by step the triumph of the market economy. It is a history of constant concessions: first the collectivist idea of the common ownership of consumer goods had to be discarded, then the untenable ideas of the labor theory of value and the elimination of the market, and finally the entire idea of the public ownership of the means of production. It is a slow awakening from a deep slumber, in which during every doze we have to shake the dreamers awake. In the words of Ludwig von Mises:

The socialists cannot help admitting their crushing final defeat. They no longer claim that socialism is matchlessly superior to capitalism because it brushes away markets, market prices, and competition. On the contrary. They are now eager to justify socialism by pointing out that it is possible to preserve these institutions even under socialism. They are drafting outlines for a socialism in which there are prices and competition. (Mises 1949, 702)

Marius Kleinheyer (marius.kleinheyer@fvsag.com) is a research analyst at the Flossbach von Storch Research Institute in Köln, Germany and PhD candidate at the University Rey Juan Carlos, Madrid. Thomas Mayer (thomas.mayer@fvsag.com) is the founding director of the Flossbach von Storch Research Institute and honorary professor at the Universität Witten-Herdecke.

Prices fluctuate, and especially in financial markets, where they are heavily influenced by expectations of the future. Some economists have explained price fluctuations with the myopia of market participants. For instance, bid and ask prices are based on prices observed in the past, and when supply and demand do not match, prices are adjusted. Other economists have replaced myopia with perfect foresight in their models. According to them, all market participants always have all the necessary information to agree on a price equating supply to demand so that prices change only when they receive new information. However, actual price behavior is neither consistent with complete myopia nor perfect foresight among market participants. Sometimes, prices move as if market participants were myopic, sometimes as if they were forward looking. This has prompted another theory, according to which price fluctuations reflect market participants’ collective oscillation between rational and irrational behavior.

This paper argues that there is a better way to explain price fluctuations in financial markets. Market participants form their price expectations on the basis of information that they collect and interpret with their individual skills and knowledge of economic relations. They act in the market or communicate with others through narratives to improve their understanding of their factual information before acting. Thus, market prices are shaped by the subjective interpretation of emerging facts and shared narratives. The resulting price movements in return influence narratives and the subjective interpretation of facts.

First, the theories of adaptive and rational expectations and the concept of adaptive markets will be discussed. These theories will then be connected to the theory of subjective expectations and an extension to the latter suggested, the discovering markets hypothesis (DMH). Empirical evidence is presented to support this approach, and finally, its utility in making predictions.

Economist John Hicks took issue with the idea put forward by Léon Walras that transactions take place at prices where demand is equal to supply. Since traders generally could not know what would be supplied and demanded at certain prices, they could only guess. Hence, Hicks (1939) argued, transactions would generally occur at prices which did not equate supply and demand. Following Hicks, we could describe the market as a mechanism that matches expectations and prices, but not necessarily potential supply and demand.

John Maynard Keynes raised the question of how expectations about the future are formed. Where they could, people would rationally calculate subjective probabilities for different outcomes and choose the most likely. But they would also often fall back on whim, sentiment, or chance. The latter was especially the case in capital markets, where participants were driven by “animal spirits.” There, it was often necessary to forecast “what average opinion expects average opinion to be” (Keynes 1936). Keynes left the formalization of his macroeconomic expectations theory to his disciples, which often led to a mechanistic reduction of his arguments. An example of this is the theory of adaptive expectations.

In the adaptive expectations model an expected market price depends on the expected price of the previous period and an “error correction” term that is given as a fraction of the difference between the expected and the actual price in the previous period. This model is not only intuitively appealing but benefits also from the advantage that expected prices can be expressed as a weighted average of past prices. Given its user friendliness the adaptive expectations theory has been built into many macroeconomic models and has been used by many econometricians. However, even its most enthusiastic users have had to admit that it describes the formation of expectations in a very mechanical way that falls far short of Keynes’s more sophisticated view (see also Gertchev 2007).

In the early 1960s, the US economist John Muth contradicted the theory of adaptive expectations. He argued that the expectations of economic agents were nothing more than predictions, which could be made with the appropriate economic theory (Muth 1961). In the formation of rational expectations only the future counted, which would be fathomed with the help of economics. If people used all available information efficiently and knew how the economy really worked, then realized prices would differ from expected prices only as a result of random influences. And if the expected value of random influences were zero, market prices would over the longer run equilibrate supply and demand.

Muth’s theory, originally intended to explain price formation in specific markets, was incorporated into an economy-wide, dynamic general equilibrium model by Robert Lucas. According to Lucas, economic agents form their expectations of the future with full knowledge of all economic relations and using all available information. Based on these expectations they maximize their utility over their lifetime. With his work Lucas not only solved Hicks’s problem of imperfect information but also challenged established Keynesian macroeconomics. He argued that robust economic predictions could be made only with models founded in microeconomic theory because macroeconomic relations observed in the past were unstable over time.Lucas‘s challenge to Keynesian macroeconomics went down in the history of economics as the "Lucas Critique." Economic agents would change their behavior in response to economic policy. For instance, the famous relationship between unemployment and inflation proposed by the Phillips Curve would go up in smoke once people realized that the gains in purchasing power afforded by higher nominal wages were subsequently eroded by higher inflation.

Eugene Fama applied the concept of rational expectations to financial markets and hypothesized that financial prices contained all available information. At a minimum, it should not be possible to use past prices to predict future prices, and at best there would be no difference between market prices and fair prices of financial assets (Fama 1970). Thus, if markets are “weakly efficient,” future prices cannot be predicted on the basis of past prices. Already this rather restrained statement contradicts the theory of adaptive expectations, which assumes that past prices contain valuable information for future prices. Markets are “semi-strongly efficient” when prices reflect all publicly available information. In this case, forecasting on the basis of past price movements as well as by considering new publicly available information is impossible. Finally, Fama classifies markets as “strongly efficient” when prices not only reflect all relevant public information but also proprietary insider knowledge. In this case, market prices and fair values of assets would be identical.

Rational expectations theory and the efficient markets hypothesis (EMH) were not only very successful academically—Robert Lucas and Eugene Fama were both awarded Nobel Memorial Prizes for their work—but also highly influential in business and politics. EMH provided the theoretical foundation for “passive investing” through index funds. If no single fund manager could reliably beat the market, why pay fees for active portfolio management? Greater returns could surely be obtained by investing in the entire market at lower costs. And EMH also had a strong influence on government policies. If the market always knew best, why let government bureaucrats regulate it? “Light” regulation was in this case surely better than heavy-handed intervention.

However, Ricardo Campos Dias de Sousa and David Howden (2015), among others, have shown that EMH suffers from logical contradictions. If, as it stipulates, all market participants have all relevant information and interpret it in the same way, all would agree on a price and there would be no incentive to sell or buy. On the other hand, if only a sufficiently critical mass of market participants interpreted relevant information in the same way, transactions could take place, but the price allowing this transaction would be seen as efficient by one and inefficient by the other group. Thus, “efficient prices for one group requires inefficient prices in the eyes of the other” (Campos Dias de Sousa and Howden 2015, 396).

Rational expectations theory and EMH suffered their first practical setback in the early 2000s, when the “technology stock bubble” burst. Apparently market participants were not just cool-headed homines oeconomici but could get carried away by emotions. The experience gave a big boost to behavioral economics and finance. Until that point, behavioral economics had largely been an experimental science confined to the laboratories of a few universities—its key protagonists, Daniel Kahnemann and Amos Tversky, were Israeli psychologists. US economist Robert Shiller (2000) applied behavioral economics to finance, publishing a book in which he diagnosed the wild rally of technology stocks towards the end of the 1990s as a bubble just as it was peaking. Not least because of the excellent timing of the release of his book, a serious challenge to the EMH had emerged in science and financial business.

Rational expectations and EMH suffered another setback with the Great Financial Crisis of 2007–08. The systematic mispricing of risk, which became apparent when the credit bubble burst, was inconsistent with the idea that people would base their financial decisions on all available information and with a full knowledge of the true “economic model.” Obviously people in the credit markets had based their actions on inadequate information and a false economic model that indicated risk reduction through asset pooling when risks in fact accumulated as a growing number of people acted on this model.

Despite its obvious failure, EMH has remained the predominant theory of market behavior in academics and large parts of the business world simply because there has been no other theory in mainstream economics to displace it.The confusion in academics about how markets work became evident with the awarding of the 2013 Nobel Memorial Prize to both Eugene Fama and Robert Shiller. In 2017, however, the US financial economist Andrew Lo came up with another challenger to EMH. Conscious of the difficulty of dethroning a theory taught widely at universities and perhaps with the ambition to follow in the footsteps of Nobel Prize winners Fama and Shiller, he named his theory the adaptive market hypothesis (AMH) (Lo 2017).

Lo’s intention was not to scrap EMH entirely, but to restrict its validity to times of continuous market development. During those times people act rationally, based on a wide knowledge of facts and a good understanding of the valid economic model. But when markets are disrupted for whatever reason, people turn from rational analysis to instinctive behavior. They join others in either rushing into markets for fear of missing out or fleeing them for fear of losing their fortunes. Lo (2017, 188) summarizes his theory in five key principles:

Thus, during normal market conditions reward increases with risk. But at times of negative disruption people may shun risks irrespectively of the associated reward. The Capital Asset Pricing Model may work in normal times but fail in other market environments. Similarly, portfolio optimization according to Markowitz may work in good times but fail in bad times. When there is contagion among different markets, asset diversification may no longer reduce risk (Lo 2017, 282).

Lo’s AMH is an intriguing effort to overcome the contradiction between EMH and behavioral finance and connect them by making them state dependent. However, why should “rationally” acting professional investors suddenly turn “irrational” in market downturns, and why should “irrationally” acting retail investors suddenly turn “rational” in normal markets? And why do environments change from “normal” and continuous to “abnormal” and discontinuous? Perhaps we can get a better idea of how markets behave when we study more closely the way that market participants process information.Lo’s auxiliary assumption of shifting market environments to retain the EMH could be interpreted, in Lakatos’s (1976) words, as a “degenerative problem shift” in a descending research program (see below).

Like Hicks, Austrian economists in the tradition of Carl Menger and Eugen von Böhm-Bawerk acknowledged that people act with imperfect knowledge. However, these economists claimed that although prices realized in transactions may not equilibrate potentially available supply and demand they always cleared the market (in the sense that actual supply matches actual demand). The early Austrian economists introduced real-world outcomes as “points of rest” (Menger) or “momentary equilibria” (Böhm-Bawerk), where market exchanges are carried out without the adjustment of buyers´ and sellers´ preferences (Klein 2008, 172). Mises coined the term plain state of rest (PSR) as opposed to the imaginary construct of the final state of rest (FSR) (where all supply equals all demand). He explains: “When the stock market closes, the brokers have carried out all orders which could be executed at the market price. Only those potential sellers and buyers who consider the market prices too low or too high respectively have not sold or bought” (Mises 1949, 245). As an analytical tool, the FSR serves as a hypothetical scenario in which basic data of the market are frozen and market participants have perfect information and knowledge. In the FSR all feasible gains from trade are exhausted (Klein 2008, 173). But in reality the FSR never materializes, because market participants have imperfect knowledge that they continuously seek to improve. Thus, during the market process entrepreneurs shuffle and reshuffle resources and capital combinations in response to new knowledge to take advantage of profit opportunities and avoid losses (Salerno 2006). Hence, realized prices generally can be characterized as representing an “equilibrium with error” (Manish 2014). Since the errors of actors with superior knowledge are smaller than those of others, their profits from transactions are larger. As more profitable actors attract more capital at others’ expense, their influence on the exchange process increases. Thus, competition improves the functioning of markets and the economy at large.

Without perfect information and knowledge about the workings of the economy, prices are based on expectations, which are derived from the subjective interpretation of information (Manish 2017). Mises points out: “As action necessarily is directed toward influencing a future state of affairs, even if sometimes only the immediate future of the next instant, it is affected by every incorrectly anticipated change in the data occurring in the period of time between its beginning and the end of the period for which it aimed to provide” (Mises [1949] 1998, 253) From this it follows, according to Mises (1962), that “Every action is a speculation, i.e. guided by a definite opinion concerning the uncertain conditions of the future.” That is—in short—expectations. Thus, expectations “form a crucial component of every act” (Manish 2007, 209). The knowledge used to form expectations is somewhat different in each individual mind, because it reflects the individual’s experience and the specific and unique ability to collect and interpret information. The knowledge is often implicit. Actors may not be able to articulate it, and it certainly cannot be objectively measured. Mises coined the term thymology to describe a method that allows historians to “understand” a complex historical event (Mises [1985] 2007). In the same way that historians look into the past, market participants look into the future. This means that just as thymological experience serves as the basis for the historian´s interpretative understanding of past events (so far as they depend on social and not natural causes), it also conditions the actor's “specific understanding of future events” (Salerno 1995, 309).

After the Austrian revival in the 1970s, debates about expectations and the market process’s possible convergence towards equilibrium took on a central role. For Lachmann (1976), expectations are radically subjective and as such radically unpredictable. In consequence, he states: “Expectations must be regarded as autonomous, as autonomous as human preferences are” (Lachmann 1976, 130). This radicality has been criticized as nihilistic (Hülsmann 1997, 25). Of course, experience-based knowledge is fundamentally different from experimentally established facts of the natural sciences, but it is still real knowledge (Salerno 1995, 312). As Mises puts it: “To know the future reactions of other people is the first task of acting man.” (Mises [1985] 2007, 311). Kirzner (1973) argued that the alertness of entrepreneurs for profit opportunities leads to a general systematic tendency toward equilibration.

Thus, the market is in a state of continuous disequilibrium but moving toward an equilibrium. Although Mises sees a theoretical final state of equilibrium resulting from the exploitation of profit opportunities from disequilibria by capable entrepreneurs (see above), in reality continuously emerging new facts are changing this equilibrium so that it can never be attained.

In order to shed more light on the formation of expectations, subjective expectations theory will be extended by including two further observations: (i) The subjective reception of complex contents is communicated in narratives, and (ii) shared narratives shape prices and are shaped by them.

The Role of Narratives

Before they act, individuals communicate with each other to cross-check their subjective knowledge against the knowledge of others. Complex knowledge is difficult to communicate. When expressed in the form of narratives it is easier to “get across ideas” (Shiller 2017). Robert Shiller has launched a research program (dubbed ”narrative economics”) to study the influence of popular narratives on seminal events such as the depression of 1920–21 or the Great Depression of the 1930s (Shiller 2019). Among other things he has found that narratives can spread like epidemics and influence people’s behavior, which can feed back into the narratives. While Shiller traces the effects of “big” narratives on historical economic developments, the focus of this text is on the effect of “narrow” narratives on financial market prices. As market participants share narratives and act on them in the market, prices move. In turn, the movement of prices feeds back into the narratives. The legendary stock market trader Jesse Livermore (alias Larry Livingston) explains in the classic book Reminiscences of a Stock Operator: “Observation, experience, memory and mathematics—these are what the successful trader must depend on…He must bet always on probabilities—that is, try to anticipate them,” (Lefevre 1922, 416).

Battles of Narratives

Shiller explains the emergence and disappearance of narratives in terms of contagion and recuperation. This can be well applied to “big” narratives evolving and fading with time. The “small” narratives in financial markets, however, do not die of old age but are replaced by other “small” narratives. To understand how new narratives replace existing ones in financial markets, we recur to the theory of scientific revolutions developed by Thomas Kuhn (1970). He argues that scientific knowledge normally increases around a widely accepted paradigm. In normal times, the paradigm itself is not challenged but is fleshed out more by new insights. However, when a critical mass of new facts emerges that is inconsistent with the ruling paradigm a scientific revolution may occur. Previously widely shared and accepted beliefs are questioned and overturned. Uncertainty and confusion may reign until a new paradigm is found that better explains the new facts. After a turbulent period (“extraordinary science”), scientific work returns to its normal state of work (“ordinary science”).

Imre Lakatos (1976) speaks of research programs that have a paradigm at their core. According to him, however, the paradigm shift is not abrupt, but a tough struggle between the defenders of the old paradigm in the old research programs and the challengers who question it. When new facts put pressure on a paradigm, defenders find supporting auxiliary hypotheses to save it, but the original core of the paradigm is weakening. Lakatos calls this “degenerative problem shift.” The challengers, on the other hand, find new explanations for the facts and develop a theory with a higher explanatory value. This leads to a “progressive problem shift.” In contrast to Kuhn, who combines paradigm shifts with radical breaks, Lakatos sees continuous gains in knowledge through the problem shifts in research programs.

The insights of Kuhn and Lakatos into the creation of new scientific knowledge are valuable guides for understanding the effects of the emergence of new knowledge in the market. Participants acting on a new shared narrative influence market prices. For some time, there may be a battle of the ruling and the new narratives. The new narrative may change or bear new narratives during this battle. And eventually the argument will be settled, and a new narrative will rule until the process begins anew. It is possible that the battle of narratives is intense and the victory of the new one absolute, as Kuhn has described the revolutionary paradigm change in science, or that it is drawn out and the new narrative displaces the old one gradually, as Lakatos has argued.

Continuity and Discontinuity in Price Discovery

When knowledge improves incrementally narratives change only little and the process of price discovery proceeds gradually. Financial markets are then characterized by relatively small spreads between offer and demand prices (or “bid-ask spreads”) for securities and by moderate price volatility. This notwithstanding, market clearing prices are being found through a process of trial and error and may move around until all participants agree on the price that best reflects their shared narrative. A market “equilibrium with error” (or “plain state of rest” according to Mises [1949] 1998)At the “plain state of rest” markets are cleared, but not necessarily in an equilibrium free of all market participant error. This is the “final state of rest,” towards which the market is pushed by competition but which may never be reached in reality. has then been established, only we don’t see much of these movements.

One way to illustrate the search process for a market clearing price is the old-fashioned cobweb model shown in Figure 1. The suppliers want to supply quantity Q0 at price P0. However, the price they get when they offer Q0 is much lower than P0. Consequently, many cut their offer so that supply now falls below demand. Excess demand brings suppliers back into the market, but at the new price there is excess supply. They cut back again, only to face excess demand again. The process of trial and error continues until the market clearing price is found.

Figure 1. Finding the Market Clearing Price in a Cobweb[[{"fid":"90046","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"3":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Market Clearing Price","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"3"}}]]

In this graph, the market clearing price is found, because the supply curve is more elastic than the demand curve. In consequence, suppliers adjust their prices by large amounts in response to excess supply or demand. But what if suppliers react less and demanders more elastically to excess supply and demand than before? In this case, excess demand and supply grow with each step and a market clearing price cannot be found (Figure 2). This is, incidentally, also true when both sides react with the same elasticity.

Figure 2. Searching for the Market Clearing Price in Vain in a Cobweb[[{"fid":"90048","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"4":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Market Clearing Price","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"4"}}]]

Let’s now assume that the combination of a fairly inelastic demand with an elastic supply curve characterizes a market where the demanders represent the “wisdom of the crowd” in the eyes of suppliers. This is how people intending to sell securities probably would look at the market. They would adjust their intentions relatively strongly in response to the feedback they get from the market. This is how markets normally behave, when most people share similar knowledge about market circumstances. New knowledge emerges gradually, and prices converge to clear the market.

However, when new and disturbing knowledge drops like a bombshell into the market there will probably be determined (or even forced) sellers in the market and many demanders will be very unsure about what to make of this. In this case, the demanders overreact to sales by the suppliers, and the suppliers in turn underreact to the demand changes by the demanders. No new equilibrium can be found. Bid-ask spreads widen and price volatility increases, because suppliers and demanders are out of synch with each other. Only when the new knowledge has been absorbed and evaluated by everyone can the market return to its “normal” mode of operation.

Battles of Narratives and Fractal Geometry

Can we identify patterns in the emergence of gradual and revolutionary new narratives in the markets? Fractal geometry, developed by the mathematician Benoit Mandelbrot, may help (Mandelbrot and Hudson 2004). According to Mandelbrot smoothness and roughness alternate in nature and financial markets. There are long periods when little happens and short periods of high turbulence. To borrow from Kuhn, markets are calm when an accepted narrative is not seriously challenged, and they experience heavy turbulence when an accepted narrative is overturned by a radically new one. Or, to borrow from Lakatos, markets shift as new narratives gradually displace old ones. We call the evolution of prices in response to the spread of narratives the discovering markets hypothesis (DMH).

AMH and DMH Compared

Although Lo’s adaptive markets hypothesis and the DMH start with the same insight that markets may alternate between continuity and discontinuity, there are important differences. First, AMH takes the change in states as given while DMH explains it as the way in which knowledge emerges and spreads in the form of narratives. Second, AMH assumes schizophrenic minds in market participants and employs psychology to explain alternating behavior while DMH assumes psychologically stable market participants who act continuously and consistently—in a subjectively rational way. By focusing on the process of augmenting subjective knowledge in a battle of narratives, DMH provides a more consistent framework for analyzing and predicting market behavior.

Can we relate market price movements to the emergence of new facts and the spread of new narratives? In this section, DMH is applied to explain a few highly visible market movements, although this does not constitute a test of the theory in the spirit of Karl Popper, in which researchers aim to establish a numerically quantified causal relationship between exogenous and endogenous variables. In view of the complexity of the object of research, F. A. von Hayek’s (1974) “pattern recognition” method is employed. Hayek has argued that numerical predictions based on causal relationships between endogenous and exogenous variables are less reliable the more complex the system to which these variables belong is. The complexity of social systems in particular is such that the establishment of causal relationships between variables and their quantification are next to impossible. But this does not mean that falsifiable hypotheses cannot be created and that predictions are unable to be made (Hayek 1974).

Applying Hayek’s theory to the analysis of markets, it is possible to establish whether or not the DMH can explain the pattern of market price movements. What cannot be expected is to find a theory with which market outcomes can be predicted. Below a number of cases in which existing narratives were suddenly overturned by new ones (cases 1–2) is examined. This is followed by a study of two cases in which new narratives emerged after a battle of narratives (cases 3–4). A look at two cases in which the narrative shifted more gradually (cases 5–6) concludes the analysis.

Case 1: Diesel Shock

On September 22, 2015, the German car company Volkswagen AG (VW) published a profit warning acknowledging that Diesel engines had been manipulated so as to disguise the true level of NO2 exhaust. As Chart 1 shows, this attracted a lot of public attention and news coverage of Volkswagen surged (measured by the number of queries including the term “Volkswagen,” Chart 1).

Chart 1. News Concerning “Volkswagen,” 2014–19[[{"fid":"90043","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"5":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"5"}}]]

The share price plunged on the news and then moved along with other share prices represented by the DAX30 stock market index (Chart 2). The observed share price movement is consistent with one-off repricing in response to unexpected news as postulated by the efficient markets hypothesis. It is also consistent with a radical shift of the narrative about the profitability of Volkswagen. From the analysis of the share price development, it is not evident which theory gives a better explanation of the observed pattern.

Chart 2. VW Shares Compared to the DAX30 Equity Price Index, 2015–19 (100 = 01.06.2015)[[{"fid":"90050","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"7":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","style":"float: left;","class":"media-element file-image-no-caption","data-delta":"7"}}]]

However, things become clearer by looking at a corporate bond of the company. Until the release of the news the bond fluctuated around the bond price index iBOXX (Chart 3). In response to the release the price plunged in a way similar to the movement of the share price (though somewhat less) and volatility increased. Both markets seemed to follow the same narrative. Thereafter, however, the price of the bond recovered and returned to the level of the bond price index while volatility declined again. The narrative of a company in deep trouble was superseded by the narrative that the company would survive and creditors were fairly safe. If the market was “efficient,” the bond price should have reacted much more calmly than the stock price. But market participants needed to digest the news and differentiate the new narrative in the stock market from that in the bond market before prices in both markets settled.

Chart 3. Price of VW 4.625 Percent Perpetual Bond and iBOXX, 2015–19[[{"fid":"90051","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"8":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"8"}}]]

Likewise, the cost of insuring Volkswagen debt against default rose significantly (Chart 4) in September 2015, but it fluctuated at a lower level in the aftermath of the crisis outbreak.

Chart 4. Price of a Credit Default Swap for Volkswagen (in Basis Points), 2015–18[[{"fid":"90052","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"9":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"9"}}]]

Case 2: Brexit

On June 23, 2016, for many people unexpectedly, the British people voted in favor of the country’s exit from the European Union. Unsurprisingly, news coverage surged (Chart 5). The exchange rate of sterling against the US dollar took a dive and volatility surged (Chart 6). Following the nosedive, the exchange rate of sterling continued to weaken as it had done before the unexpected news. After some time, however, the initial shock faded and the exchange rate recovered part of the lost ground. Volatility also fell, suggesting that the initially high level of uncertainty gave way to a more stable pattern of views. The observed pattern is consistent with a weakening of the new Brexit narrative over time. As the debate about the terms of Brexit dragged on and the eventual outcome became ever more obscure, the exchange rate flattened. The confusion prevented any narrative from dominating the market.

Chart 5. News Concerning “Brexit,” 2014–19[[{"fid":"90053","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"10":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Brexit","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"10"}}]]

Chart 6. Price Quotation USD/GBP and Volatility, 2014–19[[{"fid":"90055","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit Prices Currency Pound Dollar","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"11":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit Prices Currency Pound Dollar","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Brexit Prices Currency Pound Dollar","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"11"}}]]

Case 3: Eurocrisis

Following Greece’s debt restructuring in early 2012 markets moved their focus to Italy. While the Greek debt crisis had posed only a limited threat to the survival of the euro an Italian debt crisis could spell its end. Hence, news reports mentioning a “euro crisis” increased (Chart 7). At the same time, Italian bond yields rose (Chart 8). On July 26, 2012, however, European Central Bank President Draghi said that the ECB would do “whatever it takes” to protect the euro. As a result, the Italian bond yields plunged. However, it took the rest of the year for the new narrative of the ECB’s survival guarantee to find its way fully into market prices. The pattern observed here is consistent with a new narrative (“whatever it takes”) replacing an old one (“euro crisis”) in the market.

Chart 7. News Concerning the “Euro Crisis,” 2004–18[[{"fid":"90057","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Euro Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"12":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Euro Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Euro Crisis","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"12"}}]]

Chart 8. Ten-Year Italian Government Bond Yields, 2004–13[[{"fid":"90059","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Italian Bonds","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"13":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Italian Bonds","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Italian Bonds","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"13"}}]]

Case 4: Subprime Crisis

In early 2007 defaults in a segment of the US mortgage market—called “subprime”—received public attention. Initially the events were described as problems caused by the mis-selling of mortgages to financially weak debtors and hence as a limited problem in a relatively small market segment (Chart 9). Money markets in the US and Europe were affected as banks lost trust in each other’s solvency, but the stock market remained calm (Chart 10). The narrative changed with the default of Lehman Brothers, causing news on the subject to surge again (Chart 9). Through the remainder of the year and into 2009 stock prices fell and volatility increased. However, by the end of the first quarter of 2009 the crisis narrative had weakened sufficiently to be superseded by a more positive one, first along the lines of “the worst is over” and then of the recovery beginning. The fear of missing out by sticking to the old narrative was a key motivation in the skeptics becoming optimistic.

Chart 9. News Concerning “Subprime,” 2005–18[[{"fid":"90061","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Subprime Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"14":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Subprime Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Subprime Crisis","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"14"}}]]

Chart 10. S&P 500 Price and Historical Volatility, 2006–09[[{"fid":"90062","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"15":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"SP500","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"15"}}]]

Case 5: Recession

Although during the Great Recession of 2007/08 money markets were already experiencing severe tensions as of mid-2007, recession fears in the US gained momentum only in August 2007 and peaked in December 2007 (as measured by the number of queries for the word “recession” on Google and Bloomberg, Chart 11). Fears subsided during the first half of 2008 but surged again in August 2008, peaking in October 2008, one month after the bankruptcy of Lehman Brothers. Recession fears eased again during the second quarter of 2009.

The absolute peak of Google recession queries in the observation period occurred just at the beginning of the recession in the US in the first quarter of 2008. The return to a more normal level of recession fears in mid-2009 coincided with the (later proclaimed) official end of recession in the US. At the beginning of 2008 the stock market (as measured by the S&P 500 price index) broke below its 2007 trading range but remained in this range until the end of August. Only after the news of the Lehman bankruptcy on September 15 did stock prices plunge. They reached a nadir in early March 2009, coinciding with the easing of recession fears (measured by the number of Google and Bloomberg queries).

Chart 11. News Concerning “Recession” and Year-on-Year Percent Change of S&P 500 (Inverted)[[{"fid":"90064","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500 Recession","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"18":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500 Recession","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"SP500 Recession","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"18"}}]]

Case 6: Austrian Economics

Conventional New Keynesian economists had not seen the financial crisis and recession coming. This created renewed interest in the explanation of credit and investment cycles in Austrian economics, an explanation which became a narrative of its own. Chart 12 shows queries for “Austrian economics” worldwide. Queries surged in October 2008, the month after Lehman Brothers’s bankruptcy. They jumped to an even higher level in January 2012, when fears rose that Italy would crash out of the European Monetary Union (EMU). As central banks flooded the banking sector with money and Mario Draghi, president of the ECB, effectively guaranteed the existence of the EMU by promising to do “whatever it takes” to preserve the euro, the narrative of “Austrian economics” lost some of its attraction. Past experience suggests that interest will increase again when the financial system comes under renewed pressure in the next economic downturn.

Chart 12. Queries for “Austrian Economics”[[{"fid":"90065","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Austrian Economics","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"17":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Austrian Economics","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Austrian Economics","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"17"}}]]

Having found the DMH to explain the pattern of market movements as a competition between different narratives, its use in making “pattern predictions” can now be discussed. Hayek uses the example of a ball game to illustrate what can and cannot be predicted: if we knew precisely the skills and fitness of the opposing teams in addition to the rules of the game, we should in principle be able to predict the outcome with a relatively high degree of certainty. However, the closer the teams come in skills and fitness, the greater will be the role of chance in determining the outcome (Hayek 1974).

The legendary German coach Sepp Herberger once said: “People go to soccer games because they don’t know how the game ends.” In reality, no one has precise information about the skills and fitness of the players at the time of the game, so that not only pure chance but also a lack of information will prevent a reliable anticipation of the outcome. Nevertheless, knowing the rules of the game helps observers focus their attention on what is important to the result. Moreover, as people observe the game they acquire more information about players’ ability and can improve their prediction of the outcome. It is obviously easier to correctly predict the result of a soccer match at halftime than at the beginning, but even then a lot of uncertainty remains.

All this implies that one should not expect to be able to predict market outcomes. But by understanding how markets move we can better focus on what is important to the outcome. Observation of the important drivers of market developments can then help us narrow down the possible range of outcomes. Specifically, the discovering markets hypothesis suggests that we focus on how new facts influence narratives, which shape prices and are themselves reshaped by them. By identifying narratives shared by a large number of people and by finding out whether they are ascending or descending, we may be able to assess the persistence of market price movements. In some cases, narratives that precede price movements may even be identifiable. This is illustrated in Figure 3.

Figure 3. Formation of Prices[[{"fid":"90068","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Price Formation","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"19":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Price Formation","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Price Formation","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"19"}}]]

Facts create subjective knowledge, which may induce financial market participants to act. More likely, however, they will exchange this knowledge with other participants with a view to identifying shared narratives, which have a more powerful influence on prices than individual action does.

Expectations of the future shape the movement of prices, which clear markets, although not necessarily at the point where potential supply is equal to potential demand. This paper followed the argument of Lachmann and Mises that market participants form their expectations on the basis of their ability to collect information and interpret it. In keeping with Shiller, it was observed that market participants tend to communicate their views about the future in the form of narratives and that they learn by listening to the narratives of others. Narratives compete, and winners emerge by knocking out or gradually wrestling down competitors. Winning narratives shape market prices until the facts confirm their victory or until they are discredited by the facts and replaced by new narratives. When we understand how market prices form we can predict the way they adjust to changing economic conditions.

Could artificial intelligence and machine learning replace human actors in financial markets? Those who believe in more mechanical models of expectations—assuming “rational,” “irrational,” or state-dependent “rational/irrational” behavior—may be inclined to say yes. However, if market participants indeed act subjectively rationally and interdependently based on proprietary knowledge accumulated through experience and incomplete information transmitted through narratives—as described in the discovering markets hypothesis—the hurdle to clear for artificial intelligence to beat human intelligence seems fairly high.

Can a socialist system really operate using the division of labor? Can mathematical equations lead us to equilibrium, the final and static price for any good or factor? Can the managerial state make the impossible possible? This is a rewarding discussion of socialism from Mises's brilliant and radical point of view.    

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Dr. Bylund and Jeff Deist consider Part Three of the book, "Economic Calculation," considering Mises's conception of value and the folly of attempting to define a "unit of value" in a highly subjective world. They discuss socialism and the elementary theory of value and prices; inputs and outputs in barter vs. under monetary exchange; prices as exchange ratios; why change is constant and price "stabilization" efforts fail; why mathematical calculation of money prices may rival the wheel as among the most important human inventions; and why Mises thought praxeology emerged when man started thinking about monetary calculation.

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Dr. Gordon and host Jeff Deist consider each of the book's first seven chapters, with topics including: Mises's categories of action and causality, a priori disciplines, polylogism, "felt uneasiness," value and preferences, praxeology as it relates to time and uncertainty, probability and its application to human action, and the nature of production. 

If you've wanted to read Human Action, this is your opportunity to hear it explained by great economists and scholars!

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Human Action: Mises.org/HumanAction

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As regards the views about probability of Ludwig von Mises, it is undeniably true that these display considerable nuance and that they can be considered as being of a sui generis variety. Even if Ludwig von Mises’s views on probability exhibit a closer conceptual affinity with Keynes’s philosophy of probability than with the frequency interpretation espoused by his brother Richard von Mises, an important difference between the views of Ludwig von Mises and those of John Maynard Keynes in this respect will nevertheless be acknowledged.

Interpretations of probability are commonly divided into (1) epistemological (or epistemic) and (2) objective. Epistemological interpretations of probability take probability to be concerned with the knowledge (or belief) of human beings. On this approach, any probability assignment describes a degree of knowledge, a degree of rational belief, a degree of belief, or something of this sort. The approaches of both Ludwig von Mises and John Maynard Keynes belong to this category. Objective interpretations of probability, by contrast, take probability to be a feature of the objective material world, which has nothing to do with human knowledge or belief. The theory of Richard von Mises belongs to this category.The logical, subjective and intersubjective interpretations are all epistemological. The frequency and propensity interpretations are objective. For a survey and discussion of the different interpretations, see Gillies (2000).

Despite the fact that Ludwig von Mises himself clearly embraced what must be considered an epistemic view regarding the interpretation of probability, the objectivist view has been propounded by several Austrian economists, especially among those belonging to the praxeological camp. These authors apparently take it for granted that Ludwig von Mises had simply adopted the philosophy of probability of his brother Richard von Mises. Thus in a characteristic passage of Man, Economy, and State M. N. Rothbard wrote:

The contrast between risk and uncertainty has been brilliantly analyzed by Ludwig von Mises. Mises has shown that they can be subsumed under the more general categories of “class probability” and “case probability.” “Class probability” is the only scientific use of the term “probability,” and is the only form of probability subject to numerical expression.Rothbard (2004, 553).

In the two footnotes accompanying this passage M. N. Rothbard refers both to Ludwig von Mises’s discussion in Human Action, and to Richard von Mises’s Probability, Statistics, and Truth, thus conflating the views of the two brothers.Rothbard’s interpretation is questionable for at least two reasons. First, Ludwig von Mises embraces an epistemic interpretation of his concept of numerical class probability whereas Richard von Mises’s interpretation of the concept of frequency probability is objective. Second, whereas for Richard von Mises there is indeed only one scientific use of the term probability, from the perspective of Ludwig von Mises both the concept of class probability and the concept of case probability are scientifically legitimate. See further. For other references by Prof. Rothbard to Richard von Mises’s theory, see in particular Rothbard (1997, 24n, 24-27, 122n, 229n).

Views like the ones expressed by M. N. Rothbard are often, if not always, accompanied, and rather consistently, by a rejection of quantitative methods for the conduct of applied research in economics. Again M. N. Rothbard tells the story of how he came to decide to leave the world of statistics in rather dramatic terms:

After taking all the undergraduate courses in statistics, I enrolled in a graduate course in mathematical statistics at Columbia with the eminent Harold Hotelling, one of the founders of modern mathematical economics. After listening to several lectures of Hotelling, I experienced an epiphany: the sudden realization that the entire “science” of statistical inference rests on one crucial assumption, and that that assumption is utterly groundless. I walked out of the Hotelling course, and out of the world of statistics, never to return.Rothbard (1995, 38).

According to Professor Rothbard the questionable assumption is the following:

In the science of statistics, the way we move from our known samples to the unknown population is to make one crucial assumption: that the samples will, in any and all cases, whether we are dealing with height or unemployment or who is going to vote for this or that candidate, be distributed around the population figure according to the so-called “normal curve.”Rothbard (1995, 38).

Statements like these have been both severely criticized and misunderstood. Thus David Ramsey Steele, in his review of Justin Raimondo’s An Enemy of the State: The Life of Murray N. Rothbard writes:

If the young Rothbard really had found something that refuted all statistical theory, this would be a momentous discovery, and a great consolation to tobacco producers. But, sixty years on, the edifice of statistics has not registered any tremors.

In the Rothbard-Raimondo account, statisticians accept the bell curve because of a single example, the distribution of hits around the bull’s eye on a target. In fact, statisticians don’t view the bell curve as sacrosanct. Since a great many phenomena are, as a matter of fact, so close to normally distributed that the assumption of normal distribution will yield correct predictions, normal distribution can be treated as an empirical generalization and a useful instrument.

Alternatively, normal distribution can be strictly derived by the Central Limit Theorem, which shows that where some variable is influenced by a large number of unrelated random variables, that variable will be normally distributed. This result holds subject to certain conditions, which are very widely, but not universally, encountered. Statisticians are open to the possibility of non-normal distributions where these conditions don’t apply. It doesn’t seem likely that Rothbard successfully debunked all of statistics around 1942.See Steele (2000). The Central Limit Theorem (in the classical sense) is the generic name of a class of theorems which give, in precise mathematical terms, conditions under which the distribution function of a suitably standardized sum of independent random variables is approximately normal. This theorem is one of the most remarkable results in all of mathematics. For an introduction to the Central Limit Theorem from a historical perspective, see also W. J. Adams (1974).

This interpretation of Rothbard’s position is certainly questionable. It doesn’t seem likely after all that Rothbard was intent upon questioning the mathematical validity of the Central Limit Theorem or of any other theorem of formal probability calculus. It may still remain true, however, that in contexts where random collectives do not exist (that is, contexts characterized by lack of independent repetitions), as will often be the case in economics, objective probabilities cannot be used. Given that Rothbard embraced an objective, frequency interpretation of numerical probability, his rejection of statistics is a defensible and logically consistent corollary. Moreover the rejection of the use of objective probabilities in economics is in agreement with the conclusions of some of the most recent research about these matters, and with general arguments for interpreting probabilities in economics as epistemological rather than objective.See Gillies (2000, 187 ff.). The main reason why objective probabilities cannot be validly introduced in economics is not too difficult to grasp and can be related to the impossibility of introducing a satisfactory notion of independent repetitions of conditions and of random and homogeneous samples. In a typical experimental situation in physics, a sequence of independent repetitions of the experiment is perfectly possible. The experiment can be performed in the same laboratory on different days, or in different laboratories on the same day etc., and these repetitions will typically be independent. The conditions necessary for the introduction of objective probabilities are satisfied. It might seem as if there exists a certain structural similarity between a typical situation in economics and the typical experimental situation in physics. The two cases nevertheless differ in important respects. Could we not conceivably use observations of the behavior and performance of economic systems as samples of independent repetitions of conditions similar to the ones present in the typical experiment in physics? The different samples could be taken from either (1) data related to the same economic system at different times, or (2) data related to different economic systems at a similar stage of development. One author who recently re-examined these questions aptly summarizes his answer to this question as follows: “In the first case, if the samples refer to ‘snapshots’ of the economy which are too close together in time, it is hard to maintain that the more recent performance is not influenced by that of the previous periods; thus the independence of the samples cannot be maintained. If the samples relate to historical periods far enough from each other to render the assumption of independence plausible, one is unlikely to get homogeneous samples; thus invalidating the ‘experiment’. In the second case the use of a sample of cross-section data would still not give independence as economic systems tend to be integrated in terms of trade and production, and particularly as the flow of information from one country is likely to affect the behavior of agents in others.” See Gillies (2000, 192). This view with respect to the interpretation of probability is thus apparently dictated by the fundamentally different nature of the phenomena under study in the realm of human action, when compared with physical phenomena. Acting individuals in a market economy are very different from, say, the molecules of a gas. Since an economic system is composed of acting individuals, who have thoughts and beliefs, an independent repetition of any situation becomes difficult if not impossible.

It is worth pointing out that for quite some time the objectivist view had also been rather influential in certain Marxist-Leninist circles. Whereas the objectivist view had indeed been dominant in statistical theory and practice throughout most of the previous century, it was in particular in certain Soviet writings that attempts had been made to provide the objectivist view with supposedly Marxist-Leninist philosophical underpinnings, and to dismiss the subjective characterization of probability as inevitably leading to subjective idealism.In this respect attention can be drawn to the influence of B. V. Gnedenko, author of the often revised and reprinted Theory of Probability containing an objective characterization of chance and at once the most complete statement of the Soviet Marxist understanding of probability. See also footnote 1 above and the discussion in Lad (1983).

The critical issue we want to examine here, however, is whether the precepts of praxeological methodology and epistemology indeed entail an exclusive commitment to the objectivist viewpoint. An examination of Ludwig von Mises’s viewpoint in this respect has not convinced us that this is actually the case.

In fact, and as mentioned briefly already, Ludwig von Mises’s views with respect to the interpretation of probability, are more akin to Keynes’s views than to the philosophy of probability of his brother Richard von Mises. In order to substantiate this view, we will compare Ludwig von Mises’s position concerning this matter with the positions both of John Maynard Keynes and of Richard von Mises. The two main approaches to the interpretation of probability theory which will be considered here are thus the frequency interpretation, as developed systematically by Richard von Mises, and the logical interpretation, as developed systematically by John Maynard Keynes.These correspond by and large—although not exactly—to Carnap’s two concepts of probability: probability as used in logic (degree of confirmation) on the one hand, and probability as used in statistical and physical science (relative frequency), on the other. See Carnap (1945). Keynes’s views on probability are contained in Keynes (2004 [1921]); for our analysis of Richard von Mises’s views we will use Richard von Mises (1981 [1957]) and (1964).

In the third and fourth sections hereafter I present a general characterization of the views on probability of these two authors. In section V I argue that the thesis that Ludwig von Mises embraced the objective frequency interpretation of probability of his brother Richard von Mises is disputable in view of a number of Ludwig von Mises’s own statements with respect to this subject matter.

In the sixth section I examine further whether and in what respects Ludwig von Mises’s views on probability indeed exhibit a conceptual affinity with John Maynard Keynes’s interpretation of probability. In the seventh section an important difference between the respective views about probability of Ludwig von Mises and of John Maynard Keynes is highlighted.

The principal goal of Richard von Mises was to make probability theory a science similar to other sciences. According to the frequency view probability theory is considered a science of the same order as, say, geometry or theoretical mechanics. He criticizes the view that probability can be derived from ignorance:

It has been asserted—and this is no overstatement—that whereas other sciences draw their conclusions from what we know, the science of probability derives its most important results from what we do not know.Richard von Mises (1981 [1957], 30).

Probability should be based on facts, not their absence. The frequency theory relates a probability directly to the real world via the observed objective facts (or the data), in particular repetitive events. As Richard von Mises wrote:

By means of the methods of abstraction and idealization (…) a system of basic concepts is created upon which a logical structure can then be erected. Owing to the original relation between the basic concepts and the observed primary phenomena, this theoretical structure permits us to draw conclusions concerning the world of reality.Richard von Mises (1981 [1957], v).

In the logical approach to be examined in the next section, probability theory is seen as a branch of logic, as an extension of deductive logic to the inductive case. In contrast to this view, the frequency approach sees probability theory as a mathematical science, such as mechanics, but dealing with a different range of observable phenomena. Probability should thus not be interpreted in an epistemological sense. It is not lack of knowledge (uncertainty) which provides the foundation of probability theory, but experience with large numbers of events.

A probability theory which does not introduce from the very beginning a connection between probability and relative frequency is not able to contribute anything to the study of reality.Richard von Mises (1981 [1957], 63).A key question raised by this view relates to how mathematical sciences relate to the empirical material with which they are concerned. Since Richard von Mises was an empiricist, the starting point for him was always some observable phenomenon such as an empirical collective. In fact, according to the random frequency definition it is possible to speak about probabilities only in reference to a properly defined collective. Probability has a real meaning only as probability in a given collective. The basis of Richard von Mises’s theory of probability is thus the concept of a collective. The rational concept of probability, as opposed to probability as used in everyday speech, acquires a precise meaning only if the collective to which it applies is defined exactly in every case. Essentially a collective consists of a sequence of observations which can be continued indefinitely. Each observation ends with the recording of a certain attribute. The relative frequency with which a specified attribute occurs in the sequence of observations has a limiting value, which remains unchanged if a partial sequence is formed from the original one by an arbitrary place selection.On the concept of collective, see also Mises (1964, 11–15). As explained further, a collective is a mass phenomenon or an unlimited sequence of observations fulfilling two conditions, the convergence condition and the randomness condition. According to Richard von Mises, many types of repeatable experiment generate collectives, or at any rate would do so if they could be continued indefinitely. The task of statistics is to identify which experiments have this collective-generating property and to elicit the associated probability distributions over their class of possible outcomes. The task of probability calculus in mathematical statistics consists in investigating whether a given system of statistical data forms a collective, or whether it can be reduced to collectives. Such a reduction provides a condensed, systematic description of the statistical data that may properly be considered an “explanation” of these data. See Richard von Mises (1981 [1957], 222).

To deal with such phenomena, we obtain by abstraction or idealization some mathematical concepts, such as, in this instance, the concept of mathematical collective. We next establish on the basis of observation some empirical laws which the phenomena under study obey. Then again by abstraction or idealization we obtain from these empirical laws the axioms of our mathematical theory. Once the mathematical theory has been set up in this way, we can deduce consequences from it by logic, and these provide predictions and explanations of further observable phenomena.

Applying this scheme to the case of probability theory, there are, according to Richard von Mises, two empirical laws which are observed to hold for empirical collectives. The first of these can be named the Law of Stability of Statistical Frequencies; it refers to the increasing stability of statistical frequencies and is designated by Richard von Mises as “the ‘primary phenomenon’ (Urphänomen) of the theory of probability.”Richard von Mises (1981 [1957], 14). In fact, the expression “Stability of Statistical Frequencies” is Keynes’; see Keynes (2004 [1921], 336).

As Mises explains:

It is essential for the theory of probability that experience has shown that in the game of dice, as in all the other mass phenomena which we have mentioned, the relative frequencies of certain attributes become more and more stable as the number of observations is increased.Richard von Mises (1981 [1957], 12).

The first law of empirical collectives was fairly well known before Richard von Mises. The second law, however, is original to him and it relates to a decisive feature of a collective. This feature of the empirical collective is its lack of order, that is, its randomness.

Richard von Mises’s ingenious idea is that we should relate randomness to the failure of gambling systems.

As he wrote:

The authors of such systems have all, sooner or later, had the sad experience of finding out that no system is able to improve their chances of winning in the long run, i.e., to affect the relative frequencies with which different colours or numbers appear in a sequence selected from the total sequence of the game.Richard von Mises (1981 [1957], 25).

In other words, not only do the relative frequencies stabilize around particular values, but these values remain the same if we choose, according to some rule, a subsequence of our original (finite) sequence. This second empirical law can be called the Law of Excluded Gambling Systems.

The next step in Richard von Mises’s programme is to obtain the axioms of the mathematical theory by abstraction (or idealization) from these empirical laws. The first axiom can be easily obtained from the Law of Stability of Statistical Frequencies:

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One of the main objections to this theory is that it is too narrow, for there are many important situations where we use probability but in which nothing like an empirical collective can be defined. In particular this definition is too narrow in the context of economics. This was the viewpoint of important economists such as Ludwig von Mises, John Maynard Keynes and John Hicks.

Nevertheless Richard von Mises considers this alleged disadvantage to be a strong point in favour of his theory. We can, according to Richard von Mises, start with the imprecise concepts of ordinary language but when we are constructing a scientific theory we must replace these by more precise concepts. Thus we can of course start with the vague ordinary language concept of probability, but for scientific purposes it must be made precise by a definition. This is done by the limiting frequency definition of probability. This definition excludes some ordinary language uses of probability for which a collective cannot be defined, but this is no bad thing. On the contrary, it is positively beneficial to exclude some vague uses of probability which are unsuitable for mathematical treatment. Summing up this line of argument, he writes:

‘The probability of winning a battle,’ for instance, has no place in our theory of probability, because we cannot think of a collective to which it belongs. The theory of probability cannot be applied to this problem any more than the physical concept of work can be applied to the calculation of the ‘work’ done by an actor in reciting his part in a play.See Richard von Mises (1981 [1957], 15). Regarding his positivist ideas Richard von Mises was much influenced by E. Mach whom he greatly admired. See Richard von Mises (ibid., 225) where he writes: “The point of view represented in this book corresponds essentially to Mach’s ideas.” See in this connection also Richard von Mises (1951, passim).

The limiting frequency definition of probability is supposed to be an operational definition of a theoretical concept (probability) in terms of an observable concept (frequency). It could be claimed, however, that it fails to provide a connection between observation and theory because of the use of limits in an infinite sequence. It is well known that two sequences can agree at the first n places for any finite n however large and yet converge to quite different limits. A similar objection relates to the question of whether the representation of a finite empirical collective by an infinite mathematical collective is legitimate.

Richard von Mises’s answer to this difficulty is that such representations of the finite by the infinite occur everywhere in mathematical physics, and that his aim is only to present probability theory in a fashion which is as rigorous as the rest of mathematical physics. In mechanics, for example, we have point particles to represent bodies with a size, infinitely thin lines to represent lines with a finite thickness, and so on. Richard von Mises argues that he is trying to present probability theory as a mathematical science like mechanics, but it is unreasonable to expect him to make it more rigorous than mechanics. As he wrote:

the results of a theory based on the notion of the infinite collective can be applied to finite sequences of observations in a way which is not logically definable, but is nevertheless sufficiently exact in practice. The relation of theory to observation is in this case essentially the same as in all other physical sciences.See Richard von Mises (1981 [1957], 85). The practical difficulty arises from the fact that a collective is defined for an infinite sequence. A collective is an idealization. Strictly speaking, no relative-frequency probability statement says anything about any finite event, group of events or series. In other words, any calculated frequency is perfectly consistent with any probability attribution from zero to one. Combined with the injunction that there is no such thing as a probability of a “singular” event, it would appear that any definitive empirical attribution of numerical probabilities is a chimera. A statement about the limit of a sequence of trials hypothetically continued to infinity contains by itself absolutely no information about any initial segment of that sequence. Any initial segment of a collective—and we are, of course, only ever capable of observing initial segments—can be replaced with any arbitrary sequence of the same length without affecting any of the limits in the collective. Richard von Mises acknowledges that “[i]t might thus appear that our theory could never be tested experimentally.” (ibid. 84) His probabilistic solution to this problem is a pragmatic one. The empirical validity of the theory does not depend on a logical solution, but is determined by a practical decision. This decision should be based on previous experience of successful applications of probability theory, where practical studies have shown that frequency limits are approached comparatively rapidly. Moreover the idealization of the collective is comparable with other wellknown idealizations in science, such as the determination of a specific weight (perfect measurement being impossible), the existence of a point in Euclidean space, or the concept of velocity.The velocity of an accelerating object at a moment in time is the ratio of the change in distance to the change in time, ds/dt. Supposing the motion is not uniform, as in the case of a freely falling body whose velocity increases as it falls, to obtain the velocity we calculate the “instantaneous rate of change” of the distance with respect to the time by taking the limit as follows:i.e., v = lim ds/dt.dt ⇒ 0It is impossible to verify that this limit exists. It does not follow, however, that the concept of velocity is nonoperational. This criticism would duplicate the criticism of probability as the limit of a sequence, but it would not be considered a serious objection, because the definition of velocity as a limit has proven itself to be applicable to many different instances of motion, in just the same way the frequency theory has been successfully applied to many instances. The relation of theory to observation in the latter case is essentially the same as in all other physical sciences. It is reminded here that Ludwig von Mises’s definition of class probability, which is discussed further, is finitist in the sense that it dispenses entirely with any reference to the concept of a limit. In that limited sense it can be considered that Ludwig von Mises’s definition of class probability constitutes an improvement upon the definition of a collective offered by Richard von Mises.

To complete Richard von Mises’s programme, it must be examined how the second mathematical axiom—the axiom of randomness—can be obtained from the empirical Law of Excluded Gambling Systems. It turns out that the formulation of the axiom of randomness does involve some rather considerable mathematical difficulties. Even if these were eventually overcome, the quite subtle mathematical developments which finally gave Richard von Mises’s theory a rigorous mathematical foundation, are of little relevance in the present context. The main idea is reminded here, however:

Randomness condition:

The fixed limits to which the relative frequencies of particular attributes within a collective tend are not affected by any place selection, that is, by choosing an infinite sub-sequence whose elements are a function of previous outcomes. That is, if we calculate the relative frequency of some attribute not in the original sequence, but in a partial set, selected according to some fixed rule, then we require that the relative frequency so calculated should tend to the same limit as it does in the original set. In this respect Richard von Mises made the following stipulation:

The only essential condition is that the question whether or not a certain member of the original sequence belongs to the selected partial sequence should be settled independently of the result of the corresponding observation, i.e., before anything is known about this result.See Richard von Mises (1981 [1957], 25). As indicated already, the fulfillment of the second condition, insensitivity to place selection, is also described by Richard von Mises as the Principle of the Impossibility of a (successful) Gambling System. (ibid.)

An important implication of Richard von Mises’s frequency theory is that, when dealing with unique events, statistical or stochastic methods will be essentially useless. Where collectives do not exist, probability theory and the calculations based on it will add nothing to our knowledge concerning the world of reality. Only where previous experience has established that events can be considered as belonging to a collective, can statistical methods play a role. The calculations of insurance companies for instance demonstrate that stochastic methods play a legitimate role in certain kinds of business decisions, namely when dealing with events belonging to a collective. The theory of probability starts with certain given frequencies and derives new ones by means of calculations carried out according to certain established rules. In other words, each probability calculation is based on the knowledge of certain relative frequencies in long sequences of observations, and its result is always the prediction of another relative frequency, which can be tested by a new sequence of observations. The task of the theory of probability is thus to derive new collectives and their distributions from given distributions in one or more initial collectives.The derivation of a new collective from the initial ones consists in the application of one or several of the four fundamental operations of selection, mixing, partition and combination. See Richard von Mises (1981 [1957], Second Lecture; 1964, 15–35).As regards the frequentist solution to the problem of inference given by Richard von Mises, it consists of a combination of the frequency concept of a collective with Bayes’s theorem, a result known as the ‘Second Law of Large Numbers’. (ibid. 125) Bayes’s formula shows a relationship between prior and posterior probability functions. If knowledge of the prior distribution does exist, there is no conceptual problem with the application of Bayes’s theorem. Often the prior probability function will not be known, however, and it is then an important part of probability theory to know what influence the prior probability function has in the calculation of the posterior distribution. In general the following will hold: no substantial inference can be drawn from a small number of observations if nothing is known a priori, that is, preliminary to the experiments, about the object of experimentation. If the prior distribution is not known, and the number of observations, say rolls of a die, is small, then the posterior distribution will not allow to draw any conclusions accurately. On the other hand, a large number of observations limits the importance of knowing the prior distribution. As long as the number of experiments is small, the influence of the initial distribution predominates; however, as the number of experiments increases, this influence decreases more and more.Often the prior distribution will not be known. The actor will then have to guess at a distribution, sample the population, and then revise his guess according to Bayes’s formula. This means that actions of an individual will also be guided by the accuracy of his or her guess.

Richard von Mises’s limiting frequency definition of probability was clearly intended to limit the scope of the mathematical theory of probability, and, in fact, of the scientific concept of probability.As he wrote: “Our probability theory has nothing to do with questions such as: ‘Is there a probability of Germany being at some time in the future involved in a war with Liberia?’” See Richard von Mises (1981 [1957], 9).We can only, he claims, introduce probabilities in a scientific sense—which here also means: in a mathematical or quantitative sense—where there is a large set of uniform events, and he urges us to observe his maxim: “First the collective—then the probability.”Richard von Mises (1981 [1957], 18).Richard von Mises thus advocated a monist view of probability, that is, he asserts that there is only one concept of probability that is of scientific importance, in contradistinction to his brother Ludwig von Mises who espoused a dualist view of probability.

Despite controversy it can be expected that the frequency theory of probability will remain significant for the conduct of natural science.For recent testimony of this fact, see e.g., Khrennikov (1999). This author argues that certain problems in the foundations of quantum mechanics—such as the Einstein-Podolsky-Rosen paradox—are connected with the foundations of probability theory and thus have a purely mathematical origin. In particular, the pathological (or nonclassical) behaviour of “quantum probabilities”—in particular Bell’s inequality—is a consequence of the formal use of Kolmogorov’s probability model. This author uses the ensemble and frequency interpretations as the two fundamental interpretations of probability and arrives at surprising results. Bell’s inequality cannot be used as an argument for non-locality or nonreality. Historically, and although it has been argued that the philosophical background of subjective probability strongly resembles that underlying quantum mechanics (see Galavotti 1995), it is frequentism that became the “received view” of probability and seems to have been tacitly assumed also by the upholders of the Copenhagen interpretation of quantum mechanics (although the attribution of probabilities to the single case was generally admitted). In this context attention has often been drawn to Heisenberg’s viewpoint according to which “(t)he probability function combines objective and subjective elements. It contains statements about possibilities or better tendencies (“potential” in Aristotelian philosophy), and these statements are completely objective, they do not depend on any observer; and it contains statements about our knowledge of the system, which of course are subjective in so far as they may be different for different observers. In ideal cases the subjective element in the probability function may be practically negligible as compared with the objective one. The physicists then speak of a ‘pure case.’” See Heisenberg (1958 [1990], 41), and also the discussion in Galavotti (1995).

The logical interpretation of probability considers probability as the degree of a partial entailment. Keynes’s Treatise is concerned with the general theory of arguments from premises leading to conclusions which are reasonable but not certain. Let e be the premises and h the conclusion of an argument. Keynes holds that the familiar relation ‘e implies h’ is the limiting case of a more general (probability) relation ‘e partially implies h.’ Keynes’s aim in the Treatise is to systematize statements involving such relations of partial implication. The logical theory uses the word “probability” primarily in relation to the truth of sentences, or propositions.

It aims at assigning truth values other than zero or one to propositions. In this process, that part of our knowledge which we obtain directly, supplies the premises of that part which we obtain indirectly or by argument. From these premises we seek to justify some degree of rational belief about all sorts of conclusions. We do this by perceiving certain logical relations between the premises and the conclusions. The kind of rational belief which we infer in this manner is termed probable (or in the limit certain), and the logical relations, by the perception of which it is obtained, we term relations of probability.See Keynes (2004 [1921], 111). Keynes mostly takes the empiricist line that knowledge acquired by direct acquaintance constitutes true and certain knowledge. Knowledge by argument, in contrast, proceeds through direct knowledge of relations of the form ‘e implies h’ or ‘e partially implies h.’

Comparisons are possible between two probabilities, only when they and certainty all lie on the same ordered series. Probabilities which are not of the same order cannot be compared. Only when numerical measurement of probabilities is possible, which is only occasionally possible and which is thus a matter for special enquiry in each case, algebraical operations such as addition and arithmetical multiplication, can be performed. The numbers zero and one figure as extreme cases. A probability of zero indicates impossibility, a probability equal to one indicates the truth of a proposition.

The idea of a logic of probability which should be the art of reasoning from inconclusive evidence was systematically developed by John Maynard Keynes although hints towards this approach had been expressed at least since Leibniz. Keynes regards probability theory, like economics, as a branch of logic. Although Richard von Mises calls Keynes “a persistent subjectivist,”Richard von Mises (1981 [1957], 94).Keynes makes it clear at the beginning of his book that his theory is, in an important sense, an objective one. For Keynes probability was degree of rational belief not simply degree of belief. The relevant passage is worth being quoted in its entirety:

The terms certain and probable describe the various degrees of rational belief about a proposition which different amounts of knowledge authorise us to entertain. All propositions are true or false, but the knowledge we have of them depends on our circumstances; and while it is often convenient to speak of propositions as certain or probable, this expresses strictly a relationship in which they stand to a corpus of knowledge, actual or hypothetical, and not a characteristic of the propositions in themselves. A proposition is capable at the same time of varying degrees of this relationship, depending upon the knowledge to which it is related, so that it is without significance to call a proposition probable unless we specify the knowledge to which we are relating it.

To this extent, therefore, probability may be called subjective. But in the sense important to logic, probability is not subjective. It is not, that is to say, subject to human caprice. A proposition is not probable because we think it so. When once the facts are given which determine our knowledge, what is probable or improbable in these circumstances has been fixed objectively, and is independent of our opinion. The Theory of Probability is logical, therefore, because it is concerned with the degree of belief which it is rational to entertain in given conditions, and not merely with the actual beliefs of particular individuals, which may or may not be rational.See Keynes (2004 [1921], 3–4). It is widely held that Keynes yielded to Ramsey’s (1988) critical arguments and that he abandoned the idea that rational beliefs are founded on logical relations of partial implication and accepted instead that they are closer to our perceptions and our memories than to formal logic. As Runde (1994) points out, Keynes’s theory of comparative probability emerges unscathed. On the one hand Ramsey’s theory embodies strong implicit presuppositions of its own and is in certain respects a considerably more idealistic construction than Keynes’s. On the other hand, Keynes’s emphasis is on incompleteness and on the fact that numerically definite probabilities can only be determined in situations which approximate games of chance.

It is important to acknowledge the point for point disagreement which exists between the theories of Richard von Mises and John Maynard Keynes.See also Gillies (1973, 14–15).For Richard von Mises probability is a branch of empirical science; for Keynes it is an extension of deductive logic. Von Mises defined probability as limiting frequency; Keynes as degree of rational belief. For von Mises the axioms of probability are obtained by abstraction from two empirical laws; for the other they are perceived by direct logical intuition. On one point there seems to be some agreement. Neither thinks that all probabilities have a numerical value, but the attitude of the two authors to this situation is very different. For Richard von Mises only probabilities defined within an empirical collective can be evaluated and only these probabilities have any scientific interest. The remaining uses of probability are examples of a crude prescientific concept towards which he takes a dismissive attitude. For Keynes on the other hand all probabilities are essentially on a par. They all obey the same formal rules and play the same role in our thinking. Certain special features of the situation allow us to assign numerical values in some cases, though not in general. Through the acknowledgement that frequency probability does not cover all we mean by probability, Keynes’s position is thus also closer to that of other economists such as Ludwig von Mises and John Hicks. Finally the position of statistics is different in the two accounts. For von Mises it is a study of how to apply probability theory in practice, similar to applied mechanics. For Keynes statistical inference is a special kind of inductive inference and statistics is a branch of the theory of induction.

The most striking differences between John Maynard Keynes and Richard von Mises are thus:

— according to Richard von Mises, the theory of probability belongs to the empirical sciences, based on limiting frequencies, while Keynes regards it as a branch of logic, based on degrees of rational belief; and

— Richard von Mises’s axioms are idealizations of empirical laws, Keynes’s axioms follow from the intuition of logic.

It is a quite remarkable fact that the practical significance of these differences in principles does not prevent the two authors from reaching nearly complete agreement on almost all of the mathematical theorems of probability, as well as on the potentially successful fields of application of statistics. Thus their complete disagreement on all the philosophical issues is accompanied by complete agreement on the mathematical side. Moreover an essentially similar conclusion can be drawn as regards the potential scope of successful application of numerical probability concepts.

Thus in Part V of the Treatise in the context of his discussion of statistical inference, Keynes has the great merit of noticing that the applicability of some of the essential parts of the classical doctrine assumes independence or irrelevance.As Keynes writes: “It is assumed, first, that a knowledge of what has occurred at some of the trials would not affect the probability of what may occur at any of the others; and it is assumed, secondly, that these probabilities are all equal à priori. It is assumed, that is to say, that the probability of the event’s occurrence at the nth trial is equal à priori to its probability at the nth trial, and, further, that it is unaffected by a knowledge of what may actually have occurred at the nth trial.” (2004 [1921], 344).As Karl Popper points out, the theory of independence or irrelevance is equivalent to the law of the excluded gambling system. See Popper (1983, 299).

Keynes also suggested renaming the law of large numbers the Law of Stability of Statistical Frequencies, which provides a clear summary of its meaning:

But the ‘Law of Great Numbers’ is not at all a good name for the principle which underlies Statistical Induction. The ‘Stability of Statistical Frequencies’ would be a much better name for it. The former suggests, as perhaps Poisson intended to suggest, but what is certainly false, that every class of event shows statistical regularity of occurrence if only one takes a sufficient number of instances of it. It also encourages the method of procedure, by which it is thought legitimate to take any observed degree of frequency or association, which is shown in a fairly numerous set of statistics, and to assume with insufficient investigation that, because the statistics are numerous, the observed degree of frequency is therefore stable. Observation shows that some statistical frequencies are, within narrower or wider limits, stable. But stable frequencies are not very common, and cannot be assumed lightly.Keynes (2004 [1921], 336).

According to the frequency view the successful application of probability theory, in particular for purposes of statistical inference, is conditioned by the fulfillment of a particular presupposition: in a particular domain of reality, one or more collectives exist as a matter of fact. This means that adequate applications of the laws of large numbers rest on a supposition of homogeneity with respect to the phenomena which are subjected to study.

Quite remarkably Keynes, when examining the validity and conditions of applicability of Bernoulli’s Theorem and its Inversion, arrives at similar conclusions.

As he wrote:

If we knew that our material world could be likened to a game of chance, we might expect to infer chances from frequencies, with the same sort of confidence as that with which we infer frequencies from chances.Keynes (2004 [1921], 384–85) Significantly, Keynes also wrote in connection with the application of Bernoulli’s formula: “In cases where the use of this formula is valid, important inferences can be drawn; and it will be shown that, when the conditions for objective chance are approximately satisfied, it is probable that the conditions for the application of Bernoulli’s formula will be approximately satisfied also.” (ibid. 290).

These reservations are similar to those expressed by several Austrian economists. For instance Ludwig von Mises clearly doubts whether the empirical Law of Stability of Statistical Frequencies is operative in social reality:

However, what the statistics of human actions really show is not regularity but irregularity. The number of crimes, suicides, and acts of forgetfulness (…) varies from year to year. These yearly changes are as a rule small, and over a period of years they often—but not always—show a definite trend toward either increase or decrease. These statistics are indicative of historical change, not of regularity in the sense which is attached to this term in the natural sciences.See Ludwig von Mises (1969 [1957], 84-5). See also (1978 [1962], 56) where Mises wrote: “There is no such thing as statistical laws.” According to this view, statistics is rather a sub-discipline, or an auxiliary discipline, of historiography.

In this section a certain amount of evidence is presented which is drawn from Ludwig von Mises’s writings and which is difficult to square with the thesis that Ludwig von Mises embraced what is basically the frequency interpretation of probability of his brother Richard von Mises.

It is remarkable that some of Ludwig von Mises’s most revealing statements about the nature and meaning of the concept of probability relate to a context which is alien to economic science proper. If there is one field of scientific enquiry where the nature and interpretation of the probability calculus have been the subject of much and reiterated debate, it is the domain of quantum mechanics and the philosophy of quantum mechanics. We have already noted at the end of section III that, controversy notwithstanding, the frequency interpretation remains highly significant for the conduct of natural science. Here we turn our attention more particularly to a comparison of Ludwig von Mises’s concept of class probability with Richard von Mises’s concept of frequency probability.

The writings of Ludwig von Mises contain many important insights with respect to the philosophy of the sciences and it is not quite surprising that he had an outspoken opinion about the matter. In Theory and History, in a section entitled Determinism and Statistics, he expressed his view with respect to quantum mechanics as follows:

Quantum mechanics deals with the fact that we do not know how an atom will behave in an individual instance. But we know what patterns of behavior can possibly occur and the proportion in which these patterns really occur. While the perfect form of a causal law is: A “produces” B, there is also a less perfect form: A “produces” C in n percent of all cases, D in m percent of all cases, and so on. Perhaps it will at a later day be possible to dissolve this A of the less perfect form into a number of disparate elements to each of which a definite “effect” will be assigned according to the perfect form. But whether this will happen or not is of no relevance for the problem of determinism. The imperfect law too is a causal law, although it discloses shortcomings in our knowledge. And because it is a display of a peculiar type both of knowledge and of ignorance, it opens a field for the employment of the calculus of probability.Ludwig von Mises (1969 [1957], 87–88).

Mises then provides the well-known definition of his concept of class probability:

We know, with regard to a definite problem, all about the behavior of the whole class of events, we know that A will produce definite effects in a know proportion; but all we know about the individual A’s is that they are members of the A class. The mathematical formulation of this mixture of knowledge and ignorance is: We know the probability of the various effects that can possibly be “produced” by an individual A.Ludwig von Mises (1969 [1957], 88).

Significantly Ludwig von Mises is also explicitly critical of the mainstream indeterminist interpretation of quantum mechanics since he pursues:

What the neo-indeterminist school of physics fails to see is that the proposition: A produces B in n percent of the cases and C in the rest of the cases is, epistemologically, not different from the proposition: A always produces B. The former proposition differs from the latter only in combining in its notion of A two elements, X and Y, which the perfect form of a causal law would have to distinguish. But no question of contingency is raised.Ludwig von Mises (1969 [1957], 88).

In Human Action Ludwig von Mises raised similar concerns when he wrote:

“The treatment accorded to the problem of causality in the last decades has been, due to a confusion brought about by some eminent physicists, rather unsatisfactory. (…)

There are changes whose causes are, at least for the present time, unknown to us. Sometimes we succeed in acquiring a partial knowledge so that we are able to say: in 70 per cent of all cases A results in B, in the remaining cases in C, or even in D, E, F, and so on. In order to substitute for this fragmentary information more precise information it would be necessary to break up A into its elements. As long as this is not achieved, we must acquiesce in a statistical law.Ludwig von Mises (1998, 22). In The Ultimate Foundation of Economic Science Ludwig von Mises also wrote: “There is always in science some ultimate given. For contemporary physics the behavior of the atoms appears as such an ultimate given. The physicists are today at a loss to reduce certain atomic processes to their causes. One does not detract from the marvelous achievements of physics by establishing the fact that this state of affairs is what is commonly called ignorance.” (1978 [1962], 23).

These passages are important and interesting because they clearly illustrate the fact that in the context of the well-known historical debate between physicists who believed that quantum mechanics is incomplete and who were tempted to assume that “God does not play dice,” on the one hand, and the physicists who, on the contrary, believed that the fundamental laws of nature are irreducibly probabilistic, on the other hand, Ludwig von Mises takes sides with the former.In particular quantum theory is irreducibly probabilistic. Unlike classical probabilities, quantum probabilities do not reflect our ignorance of the intricate details of some underlying physical reality. In particular Einstein disliked the element of chance implied by quantum theory. In a letter to Max Born, dated 4 December 1926, he wrote: “Quantum mechanics is very impressive. But an inner voice tells me that it is not yet the real thing. The theory produces a good deal but hardly brings us closer to the secret of the Old One. I am at all events convinced that He does not play dice.” Quoted in Baggott (2004, 34). Reference can in this context also be made to the confrontation between Einstein and Bohr over the interpretation of quantum theory, and to subsequent debates along similar lines, and which have often been portrayed in the past as a direct conflict between realism and positivism. For a good survey and discussion of these issues see also Baggott (2004). The issue for Einstein indeed seems to have been realism rather than determinism. Ludwig von Mises is apparently on the realist side. For a sophisticated analysis of Einstein’s views in this respect, see also Fine (1986); Einstein’s remark about the dice-playing God (“…ob der liebe Gott würfelt”) is also related in Bohr (1949, 218); see also Fine (1986, 29).Ludwig von Mises clearly associates the use of the probability calculus with partial knowledge, that is, with ignorance and the imperfections of our knowledge, and not with the existence of any contingency in re. Similarly Einstein believed, from the very beginning, that quantum theory lacked some key ingredients and that, in a very significant sense, it was “incomplete.” He compared it with the theory of light before the advent of light quanta. Quantum theory, he believed, was perhaps a “correct theory of statistical laws,” but it provided “an inadequate conception of individual elementary processes.”Einstein, Albert, letter to Sommerfeld, Arnold, dated 9 November 1927. Quoted in Fine, A. (1986, 29).

Thus Ludwig von Mises’s concept of class probability, in contradistinction to the frequency concept of his brother Richard von Mises, contains a reference to the deficiency of our knowledge, that is, to the idea that any probability assignment describes only a state of knowledge. A statement is probable if our knowledge concerning its content is deficient.Ludwig von Mises (1998, 107).According to this view the use of statistical laws signals partial knowledge and fragmentary information. There do not exist any statistical laws in an objective, physical sense.

As Popper reminds us too, the widely held view that whenever probability enters our considerations, this is due to our imperfect knowledge, is reminiscent of subjective interpretations of the probability calculus.Popper (1983, 295).The objective frequency interpretation does not have this connotation.

According to the mainstream view with respect to this matter, (nearly all) the probabilities appearing in theoretical quantum mechanics are indeed objective probabilities. That is to say, they inhere in the world and do not simply reflect the degrees of belief, or the degrees of knowledge, of an observer.See Hughes (1992, 218). The possible exceptions occur when a system is in a mixed state. Under the ignorance interpretation of a given mixture, a subjective probability is assigned to each of the pure states represented in it, and each of these in turn assigns objective probabilities to events. Not all mixtures can be given the ignorance interpretation, however. For a discussion of pure and mixed states, see also van Fraassen (1991, ch. 7). The interpretation of quantum states is a matter of much debate. For in-depth discussions of these and related matters, see in particular also Willem M. de Muynck (2002 passim).

These remarks are sufficient to establish the fact that Ludwig von Mises’s interpretation of numerical probability theory, and in particular his interpretation of the concept of class probability, is in a fundamental sense distinct from that of his brother Richard von Mises. Indeed, according to Richard von Mises, the point of view that statistical theories are merely temporary explanations, in contrast to the final deterministic ones which alone satisfy our desire for causality, is nothing but a prejudice which is bound to disappear with increased understanding.See Richard von Mises (1981 [1957], 223). As Richard von Mises writes: “The assumption that a statistical theory in macrophysics is compatible with a deterministic theory in microphysics is contrary to the conception of probability expressed in these lectures. Modern quantum mechanics or wave mechanics appears to be a purely statistical theory; its fundamental equations state relations between probability distributions.” (ibid. 223) The incompatibility with the views expressed by his brother Ludwig von Mises in this respect cannot be clearer. Therefore we do not share the view of an author who explains the absence of any reference in Ludwig von Mises’s Human Action to Richard von Mises’s frequency interpretation with reference to a supposed “estrangement” between the two brothers. See Hoppe (2006, 13). Clearly the two brothers disagreed on philosophical grounds.

The contrast between the views of Ludwig von​ Mises and of Richard von Mises in this respect can also be related to the fact that Ludwig von Mises’s worldview, in contradistinction to that of his brother Richard von Mises, apparently exhibited some leaning towards metaphysical determinism.See e.g., Ludwig von Mises (1978 [1962], 115). Turning back to quantum mechanics, it may be noted that the American-born physicist David Bohm has formulated in the 1950s an alternative interpretation of quantum mechanics that is fully deterministic (although non-local). The very idea of probability enters into this theory as some kind of an epistemic idea, just as it enters into classical statistical mechanics. Despite all the advantages of Bohm’s theory, an almost universal refusal even to consider it, and an almost universal allegiance to the standard formulation of quantum mechanics has persisted in physics throughout most of the past fifty years. For a summary introduction to Bohm’s approach, see David Z Albert (1994).

It is true that the contrast between Ludwig von Mises’s concept of class probability and Richard von Mises’s notion of a collective remains somewhat concealed and thus runs the risk of going unnoticed because of the fact that on a few occasions Ludwig von Mises uses terminology which is reminiscent of the idea of “frequency.”

In Human Action for instance Ludwig von Mises explicitly and unambiguously characterizes the notion of class probability as a variant of frequency probability.Ludwig von Mises (1998, 107).

Nevertheless this terminological issue cannot invalidate our thesis that, all things considered, Ludwig von Mises’s philosophy of probability exhibits a closer affinity with an epistemological view—such as Keynes’s logical theory—than with the frequency view of his brother Richard von Mises. The conclusion at which we have thus arrived is nuanced. On the one hand Ludwig von Mises clearly relates the idea of probability to the state of knowledge of the knowing subject. This is true both of class probability and of case probability. A statement is probable if our knowledge concerning its content is deficient. This view is shared by all adepts of an epistemological interpretation of the concept of probability, including John Maynard Keynes. Richard von Mises, to the contrary, very explicitly rejects the idea that the concept of probability refers to a state of partial or deficient knowledge. On the other hand, Ludwig von Mises clearly recognizes that the meaning of probability is different according to the field of knowledge in which it is used or according to the kind of phenomena to which it is applied. He thus embraces a dualist view in the philosophy of probability.Accordingly probability sometimes involves a reference to the notion of relative frequency, but relative frequency is not the general defining characteristic of the scientific concept of probability according to Ludwig von Mises.But in this respect his view is again clearly different from and opposed to that of his brother Richard von Mises who obviously embraces a monist theory of probability.

Moreover, from the perspective of the logical theory of probability too, the concept of probability sometimes refers to relative frequency. Contemporary adepts of the idea of probability theory as extended logic are confident that their approach can encompass frequentist methods, but merely as only one specialized application of probability theory.See Jaynes (2003, passim).

Apparently this was also Keynes’s view since he wrote that “the theory of this Treatise is the generalised theory, comprehending within it such applications of the idea of statistical truth-frequency as have validity.”Keynes (1921 [2004], 104).

In other words, on this view the problems that can be solved by frequentist probability theory form a subclass of those that are amenable to probability as logic; probability theory as logic, however, can also be applied consistently in many problems that do not fit into the frequentist preconceptions.

It would be premature to conclude that such concerns about the meaning of probability as are raised by Ludwig von Mises have now become obsolete and unambiguously belong to the history of the philosophy of probability. As one adept of the logical interpretation of probability explained recently:

Probabilities in present quantum theory express the incompleteness of human knowledge just as truly as did those in classical statistical mechanics; only its origin is different.

In classical statistical mechanics, probability distributions represented our ignorance of the true microscopic coordinates—ignorance that was avoidable in principle but unavoidable in practice, but which did not prevent us from predicting reproducible phenomena, just because those phenomena are independent of the microscopic details.

In current quantum theory, probabilities express our ignorance due to our failure to search for the real causes of physical phenomena; and, worse, our failure even to think seriously about the problem. This ignorance may be unavoidable in practice, but in our present state of knowledge we do not know whether it is unavoidable in principle; the ‘central dogma’ simply asserts this, and draws the conclusion that belief in causes, and searching for them, is philosophically naïve. If everybody accepted this and abided by it, no further advances in understanding of physical law would ever be made; indeed, no such advance has been made since the 1927 Solvay Congress in which this mentality became solidified into physics. But it seems to us that this attitude places a premium on stupidity; to lack the ingenuity to think of a rational physical explanation is to support the supernatural view.See Jaynes (2003, 328–29). In particular, this author’s views contrast sharply with those of Popper. With respect to the situation in physics, Popper, who argues for the compatibility of indeterminism with realism and objectivism, has gone so far as to blame the determinist interpretation of classical physics, or rather, what he characterizes as some unconscious determinist prejudice with respect to classical physics, for the subjective theory of probability and its consequence, the invasion of mysticism, irrationalism etc., into physics. See Popper (1982, passim).

Again a disagreement about the meaning of probability at the philosophical level need not preclude an approximate consensus regarding the legitimate scope of application of numerical probability theory. It is certainly doubtful whether the criterion of convergence and the conditions for the availability of a collective are ever satisfied in economic or econometric applications. Probabilities in economics are not the kind of physical entities that Richard von Mises seems to have had in mind in constructing his theory.

The empirical foundation for probability in this sense, that is to say for objective frequency probability, will typically be lacking. Richard von Mises himself seems to have suggested that the frequentist conception is not applicable to the moral sciences owing to the absence of events meeting the conditions of a collective. As he wrote:

The unlimited extension of the validity of the exact sciences was a characteristic feature of the exaggerated rationalism of the eighteenth century. We do not intend to commit the same mistake.See Richard von Mises (1981 [1957], 9).

On this point Ludwig von Mises and Richard von Mises seem to have agreed.

Attention has already been drawn to the fact that both Ludwig von Mises and John Maynard Keynes embrace an epistemological rather than an objective interpretation of probabilities. Both of these authors also point to certain limits of the applicability of numerical probability, and in particular of the laws of large numbers. These authors’ respective views on probability have another important characteristic in common, however. Both authors recognize and acknowledge the epistemological and scientific legitimacy of qualitative, nonmeasurable probabilities.

With respect to the question of whether a numerical measurement of probabilities is always possible, John Maynard Keynes was critical of the tendency to interpret probabilities as being, in general, numerically measurable. Thus he wrote:

The attention, out of proportion to their real importance, which has been paid, on account of the opportunities of mathematical manipulation which they afford, to the limited class of numerical probabilities, seems to be a part explanation of the belief, which it is the principal object of this chapter to prove erroneous, that all probabilities must belong to it.Keynes (2004 [1921], 37).

In similar vein Ludwig von Mises wrote:

The problem of probable inference is much bigger than those problems which constitute the field of the calculus of probability. Only preoccupation with the mathematical treatment could result in the prejudice that probability always means frequency.Ludwig von Mises (1998, 107).

Ludwig von Mises, who distinguishes between two kinds of probability—class probability, which by and large corresponds to frequency probability, and case probability—accorded the second meaning of probability important scientific status.

In Ludwig von Mises’s words:

Case probability means: We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing.Ludwig von Mises (1998, 110).

Here too, however, the idea of probability relates to the general idea of partial or imperfect knowledge; in this respect, and only in this respect, case probability is indeed similar to class probability:

Case probability has nothing in common with class probability but the incompleteness of our knowledge. In every other regard the two are entirely different.Ludwig von Mises (1998, 110).

Keynes, while he does not adopt the terms case and class probability, believes, like Ludwig von Mises, that frequency probability does not encompass all we mean by probability. Clearly the random frequency definition of probability is too narrow to encompass what we mean when we use the term probability. We do say of unique events that they are more or less probable. Many decisions that people make daily are based on probability statements that have no frequency interpretation.

In Chapter VIII of A Treatise on Probability, while discussing Venn’s elaboration of the frequency theory, he wrote:

It is the obvious, as well as the correct, criticism of such a theory, that the identification of probability with statistical frequency is a very grave departure from the established use of words; for it clearly excludes a great number of judgments which are generally believed to deal with probability.Keynes (2004 [1921], 95).

While the frequency theory of probability is concerned with a cardinally measurable degree of probability, case probability is not open to any kind of numerical evaluation according to Ludwig von Mises.Keynes (2004 [1921], 95).

According to this view, case probability focuses on individual events which as a rule are not part of a sequence, and case probability is not measurable in any but an ordinal sense; there is no cardinal measure of case probability.

What is commonly considered as a numerical evaluation of case probability, Mises argues, exhibits, when more closely scrutinized, a different character, viz. that of a metaphor.See Ludwig von Mises (1998, 114). Ludwig von Mises’s view regarding this matter is thus distinct from the view of Bayesians such as Howson and Urbach who argue that choices of personal fair betting quotients can provide a basis for making numerical assessments of uncertainty. See Howson and Urbach (2006, 51 ff.).When we proceed to a numerical evaluation of case probability, this amounts to an attempt to elucidate a complicated state of affairs by resorting to an analogy borrowed from the calculus of probability. As it happens, this mathematical discipline is more popular than the analysis of the epistemological nature of understanding. As has been pointed out already, a distinctive feature of Keynes’s view too is that not all probabilities are numerically measurable, and in many instances, they cannot even be ranked on an ordinal scale.In the Treatise Keynes illustrates this point with the famous example of the “beauty contest.” (2004 [1921], 25 ff.)Keynes explains how one of the candidates of the contest sued the organizers of the Daily Express for not having had a reasonable opportunity to compete. Readers of the newspaper determined one part of the nomination. The final decision depended on an expert, who had to sample the top fifty of the ladies chosen by the readers. The candidate complained in front of the Court of Justice, that she had not obtained an opportunity to make an appointment with this expert. Keynes argues that the chance of winning the contest could have been measured numerically, if only the response of the readers (who sent in their appraisals and thus provided an unambiguous ranking of the candidates) had mattered. The subjective taste of the single expert could not be evaluated in a similar way. Hence, a rational basis for evaluating the chances of the unfortunate lady was lacking. Keynes concludes:Whether or not such a thing is theoretically conceivable, no exercise of the practical judgment is possible, by which a numerical value can actually be given to the probability of every argument. So far from our being able to measure them, it is not even clear that we are always able to place them in an order of magnitude. Nor has any theoretical rule for their evaluation ever been suggested. (ibid. 27–28)

Keynes’s views on the applicability of large number statistics to singular propositions are in this respect somewhat similar to those espoused by Ludwig von Mises. Keynes was clear on why one might adopt case probability judgments even where large number statistics are available:

In some cases, moreover, where general statistics are available, the numerical probability which might be derived from them is inapplicable because of the presence of additional knowledge with regard to the particular case.See Keynes (2004 [1921], 29). In similar vein, Hoppe (2006), analyzing the meaning of Ludwig von Mises’s concept of case probability, points out that the method of Verstehen can be characterized as a method of place selection, or a method of individualization.

Acknowledging certain similarities between Ludwig von Mises’s and John Maynard Keynes’s respective positions in the philosophy of probability should not blind us to the fact that their respective views also exhibit some important differences. The most important of these relates to the fact that Ludwig von Mises advocates a pluralist, and in particular a dualist view of probability. According to a pluralist view of probability, there exist several different, though possibly interconnected, notions of probability which apply in different contexts, or with respect to different kinds of phenomena. Ludwig von Mises’s dualist position in the philosophy of probability is an aspect of his more general methodological dualism, which is based on a recognition of certain fundamental ontological, epistemological and methodological differences between the natural sciences on the one hand and the sciences of human action on the other, and between the natures of their respective subject matters. Moreover, in the particular case of Ludwig von Mises, his dualism in the philosophy of probability coincides with the distinction between measurable, numerical probability on the one hand and nonmeasurable, nonnumerical probability on the other, that is, with the distinction between class probability and case probability.It is not the case that according to Ludwig von Mises’s dualist (twoconcept) view with respect to probability, the different concepts of probability are conceived of as different interpretations of the same mathematical calculus, or as applications of the same mathematical calculus to different sets of phenomena, as is the case according to certain other dualist views of probability. The distinction between class probability and case probability is ultimately based upon the different kind of cognitive accessibility of human actors in contrast to noncommunicative entities. See Hoppe (2006).Ludwig von Mises’s view with respect to the meaning of probability may thus seem to occupy a truly unique place in the philosophy of probability. Another economist who adopted a nuanced viewpoint in this connection is John Hicks. This author wrote: “I have myself come to the view that the frequency theory, though it is thoroughly at home in many of the natural sciences, is not wide enough for economics.” (1979, 105) Hicks is contrasting two interpretations of probability—the frequency and the logical. The framework used here is wider since we distinguish objective theories of probability from epistemological theories.

Ludwig von Mises’s solution to the problem of defining the concept of probability remains, no less than Keynes’s, original and highly relevant. Where others have pleaded in favour of the introduction of operationalist procedures in the social sciences, as an alternative way of making the qualitative quantitative,See Gillies (2000, 200 ff.).Ludwig von Mises’s concept of case probability remains radically nonnumerical, geared to the needs of historical and entrepreneurial understanding.

While certain fundamental differences between the natural and the social sciences and the consequent need for a nuanced solution to the problem of finding an adequate definition of the concept of probability have been recognized by various authors and schools of thought, the solutions to this problem offered by both Ludwig von Mises and John Maynard Keyes remain both interesting from a theoretical perspective and useful from a more practical viewpoint.

We have been entitled to conclude that Ludwig von Mises’s views concerning the interpretation of the concept of probability, as they can be ascertained from certain passages of his writings, are in some respects more akin to the logical interpretation of probability as developed by John Maynard Keynes than to the frequency view as developed by his brother Richard von Mises. Summarizing, it can be acknowledged that this conclusion is supported by the fact that the views of Ludwig von Mises and of John Maynard Keynes about the interpretation of probability—that is, their philosophy of probability—have two important characteristics in common which are not shared by the probability theory of Richard von Mises.

First, both Ludwig von Mises and John Maynard Keynes adopt an epistemological (or epistemic) interpretation of probability, whereas Richard von Mises clearly embraces an objective theory of probability. The viewpoints of Ludwig von Mises and John Maynard Keynes, in so far as they amount to an argument for interpreting probabilities in economics as epistemological rather than objective, are thus in agreement with the conclusions of recent research. Second, both Ludwig von Mises and John Maynard Keynes, in their respective ways, acknowledge the existence and the epistemological and scientific legitimacy of nonmeasurable (or nonnumerical) probabilities, besides the usual measurable probabilities having a definite numerical value in the interval [0, 1]. Although Richard von Mises did acknowledge that there was an ordinary language or common sense notion of probability which was not covered by his frequency theory, he asserts that there is only one concept of probability that is of scientific importance. In other words, according to this view there is, in a scientific approach to the subject matter, no room for a purely qualitative notion of probability.

While some authors have gone so far as to question the adequacy of the orthodox frequency theory even for the physical sciences, there is a somewhat greater amount of consensus in favour of the conclusions (1) that in any case an objective interpretation of probability such as the orthodox frequency theory is not wide enough for economics, and (2) that in economics a qualitative nonnumerical concept of probability is both needed and scientifically legitimate. Both of the aforementioned characteristics have much relevance for the conduct of social science in general and of economics in particular.

An important difference between the views of Ludwig von Mises and those of John Maynard Keynes in this respect has nevertheless been acknowledged. Whereas Keynes advocated a monist view of probability and claimed that his interpretation of probability applies to all uses of the concept, Ludwig von Mises, in accordance with his methodological dualism, embraced a dualist view, recognizing more emphatically the existence of important differences between the natural sciences on the one hand and the social sciences, including economics, on the other. The particular solution offered by Ludwig von Mises thus remains highly distinctive and sophisticated, even if in comparison with the Keynesian approach, it has until present received somewhat less attention.Those contemporary Austrian economists who acknowledge the usefulness of modern data analysis methods for the conduct of applied research in economics can be confident that the now more and more widespread practice of interpreting probabilities as merely epistemological is in general agreement with Ludwig von Mises’s approach to probability. Moreover, it is neither clear nor obvious why a recognition of the usefulness of modern data analysis methods would have to amount to a denial of the essential importance of the method of understanding or Verstehen.

All human action, so far as it is rational, appears as the exchange of one condition for another. Men apply economic goods and personal time and labour in the direction which, under the given circumstances, promises the highest degree of satisfaction, and they forego the satisfaction of lesser needs so as to satisfy the more urgent needs. This is the essence of economic activity — the carrying out of acts of exchange.Schumpeter, Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie (Leipzig 1908), pp. 50, 80.,The following remarks reproduce parts of my essay "Die Wirtschaftsrechnung im sozialistischen Gemeinwesen," Archiv für Sozialwissenschaft 47 (1920): 86–121.

Every man who, in the course of economic activity, chooses between the satisfaction of two needs, only one of which can be satisfied, makes judgments of value. Such judgments concern firstly and directly the satisfactions themselves; it is only from these that they are reflected back upon goods. As a rule anyone in possession of his senses is able at once to evaluate goods which are ready for consumption. Under very simple conditions he should also have little difficulty in forming a judgment upon the relative significance to him of the factors of production. When, however, conditions are at all complicated, and the connection between things is harder to detect, we have to make more delicate computations if we are to evaluate such instruments. Isolated man can easily decide whether to extend his hunting or his cultivation. The processes of production he has to take into account are relatively short. The expenditure they demand and the product they afford can easily be perceived as a whole. But to choose whether we shall use a waterfall to produce electricity or extend coal-mining and better utilize the energy contained in coal, is quite another matter. Here the processes of production are so many and so long, the conditions necessary to the success of the undertaking so multitudinous, that we can never be content with vague ideas. To decide whether an undertaking is sound we must calculate carefully.

But computation demands units. And there can be no unit of the subjective use-value of commodities. Marginal utility provides no unit of value. The worth of two units of a given commodity is not twice as great as one — although it is necessarily greater or smaller than one. Judgments of value do not measure: they arrange, they grade.Cuhel, Zur Lehre yon den Bedürfnissen (Innsbruck, 1907), p. 198. If he relies only on subjective valuation, even isolated man cannot arrive at a decision based on more or less exact computations in cases where the solution is not immediately evident. To aid his calculations he must assume substitution relations between commodities. As a rule he will not be able to reduce all to a common unit. But he may succeed in reducing all elements in the computation to such commodities as he can evaluate immediately, that is to say, to goods ready for consumption and the disutility of labour and then he is able to base his decision upon this evidence. It is obvious that even this is possible only in very simple cases. For complicated and long processes of production it would be quite out of the question.

In an exchange economy, the objective exchange value of commodities becomes the unit of calculation. This involves a threefold advantage. In the first place we are able to take as the basis of calculation the valuation of all individuals participating in trade. The subjective valuation of one individual is not directly comparable with the subjective valuation of others. It only becomes so as an exchange value arising from the interplay of the subjective valuations of all who take part in buying and selling. Secondly, calculations of this sort provide a control upon the appropriate use of the means of production. They enable those who desire to calculate the cost of complicated processes of production to see at once whether they are working as economically as others. If, under prevailing market prices, they cannot carry through the process at a profit, it is a clear proof that others are better able to turn to good account the instrumental goods in question. Finally, calculations based upon exchange values enable us to reduce values to a common unit. And since the higgling of the market establishes substitution relations between commodities, any commodity desired can be chosen for this purpose. In a money economy, money is the commodity chosen.

Money calculations have their limits. Money is neither a yardstick of value nor of prices. Money does not measure value. Nor are prices measured in money: they are amounts of money. And, although those who describe money as a "standard of deferred payments" naively assume it to be so, as a commodity it is not stable in value. The relation between money and goods perpetually fluctuates not only on the "goods side," but on the "money side" also. As a rule, indeed, these fluctuations are not too violent. They do not too much impair the economic calculus, because under a state of continuous change of all economic conditions, this calculus takes in view only comparatively short periods, in which ‘sound money’ at least does not change its purchasing power to any very great extent.

The deficiencies of money calculations arise for the most part, not because they are made in terms of a general medium of exchange, money, but because they are based on exchange values rather than on subjective use-values. For this reason all elements of value which are not the subject of exchange elude such computations. If, for example, we are considering whether a hydraulic power-works would be profitable we cannot include in the computation the damage which will be done to the beauty of the waterfalls unless the fall in values due to a fall in tourist traffic is taken into account. Yet we must certainly take such considerations into account when deciding whether the undertaking shall be carried out.

Considerations such as these are often termed "non-economic." And we may permit the expression for disputes about terminology gain nothing. But not all such considerations should be called irrational. The beauty of a place or of a building, the health of the race, the honour of individuals or nations, even if (because they are not dealt with on the market) they do not enter into exchange relations, are just as much motives of rational action, provided people think them significant, as those normally called economic. That they cannot enter into money calculations arises from the very nature of these calculations. But this does not in the least lessen the value of money calculations in ordinary economic matters. For all such moral goods are goods of the first order. We can value them directly; and therefore have no difficulty in taking them into account, even though they lie outside the sphere of money computations. That they elude such computations does not make it any more difficult to bear them in mind. If we know precisely how much we have to pay for beauty, health, honour, pride, and the like, nothing need hinder us from giving them due consideration. Sensitive people may be pained to have to choose between the ideal and the material. But that is not the fault of a money economy. It is in the nature of things. For even where we can make judgments of value without money computations we cannot avoid this choice. Both isolated man and socialist communities would have to do likewise, and truly sensitive natures will never find it painful. Called upon to choose between bread and honour, they will never be at a loss how to act. If honour cannot be eaten, eating can at least be foregone for honour. Only such as fear the agony of choice because they secretly know that they could not forego the material, will regard the necessity of choice as a profanation.

Money computations are only significant for purposes of ecomonic calculation. Here they are used in order that the disposal of commodities may conform to the criterion of economy. And such calculations take account of commodities only in the proportions in which, under given conditions, they exchange for money. Every extension of the sphere of money calculation is misleading. It is misleading when in historical researches, it is employed as a measure of past commodity values. It is misleading when it is employed to evaluate the capital or national income of nations. It is misleading when it is employed to estimate the value of things which are not exchangeable as, for instance, when people attempt to estimate the loss due to emigration or war.Wieser, Über den Ursprung und die Hauptgesetze des wirtschaftlichen Werthes (Wien, 1884), p. 185 et leq. All these are dilettantisms — even when they are undertaken by the most competent economists.

But within these limits — and in practical life they are not overstepped — money calculation does all that we are entitled to ask of it. It provides a guide amid the bewildering throng of economic possibilities. It enables us to extend judgments of value which apply directly only to consumption goods — or at best to production goods of the lowest order — to all goods of higher orders. Without it, all production by lengthy and roundabout processes would be so many steps in the dark.

Two things are necessary if computations of value in terms of money are to take place. First, not only goods ready for consumption but also goods of higher orders must be exchangeable. If this were not so, a system of exchange relationships could not emerge. It is true that if an isolated man is "exchanging" labour and flour for bread within his own house, the considerations he has to take into account are not different from those which would govern his actions if he were to exchange bread for clothes on the market. And it is, therefore, quite correct to regard all economic activity, even the economic activity of isolated man, as exchange. But no single man, be he the greatest genius ever born, has an intellect capable of deciding the relative importance of each one of an infinite number of goods of higher orders. No individual could so discriminate between the infinite number of alternative methods of production that he could make direct judgments of their relative value without auxiliary calculations. In societies based on the division of labour, the distribution of property rights effects a kind of mental division of labour, without which neither economy nor systematic production would be possible.

In the second place, there must be a general medium of exchange, a money, in use. And this must serve as an intermediary in the exchange of production goods equally with the rest. If this were not so, it would be impossible to reduce all exchange relationships to a common denominator.

Only under very simple conditions is it possible to dispense with money calculations. In the narrow circle of a closed household, where the father is able to supervise everything, he may be able to evaluate alterations in methods of production without having recourse to money reckoning. For, in such circumstances, production is carried on with relatively little capital. Few roundabout methods of production are employed. As a rule production is concerned with consumption goods, or goods of higher orders not too far removed from consumption goods. Division of labour is still in its earliest stages. The labourer carries through the production of a commodity from beginning to end. In an advanced society all this is changed. It is impossible to argue from the experience of primitive societies that under modern conditions we can dispense with money.

In the simple conditions of a closed household, it is possible to survey the whole process of production from beginning to end. It is possible to judge whether one particular process gives more consumption goods than another. But, in the incomparably more complicated conditions of our own day, this is no longer possible. True, a socialistic society could see that 1000 litres of wine were better than 800 litres. It could decide whether or not 1000 litres of wine were to be preferred to 500 litres of oil. Such a decision would involve no calculation. The will of some man would decide. But the real business of economic administration, the adaptation of means to ends only begins when such a decision is taken. And only economic calculation makes this adaptation possible. Without such assistance, in the bewildering chaos of alternative materials and processes the human mind would be at a complete loss. Whenever we had to decide between different processes or different centres of production, we would be entirely at sea.Gottl-Ottlilienfeld, Wirtschaft und Technik, vol. 2 of Grundriss der Sozialökonomik (Tübingen 1914), p. 216.

To suppose that a socialist community could substitute calculations in kind for calculations in terms of money is an illusion. In a community that does not practice exchange, calculations in kind can never cover more than consumption goods. They break down completely where goods of higher order are concerned. Once society abandons free pricing of production goods rational production becomes impossible. Every step that leads away from private ownership of the means of production and the use of money is a step away from rational economic activity.

It was possible to overlook all this because such Socialism as we know at first hand exists only, one might say, in socialistic oases in what, for the rest, is a system based upon free exchange and the use of money. To this extent, indeed, we may agree with the otherwise untenable socialist contention — it is only employed for propagandist purposes — that nationalized and municipalized undertakings within an otherwise capitalist system are not Socialism. For the existence of a surrounding system of free pricing supports such concerns in their business affairs to such an extent that in them the essential peculiarity of economic activity under Socialism does not come to light. In State and municipal undertakings it is still possible to carry out technical improvements, because it is possible to observe the effects of similar improvements in similar private undertakings at home and abroad. In such concerns it is still possible to ascertain the advantages of reorganization because they are surrounded by a society which is still based upon private ownership in the means of production and the use of money. It is still possible for them to keep books and make calculations which for similar concerns in a purely socialist environment would be entirely out of the question.

Without calculation, economic activity is impossible. Since under Socialism economic calculation is impossible, under Socialism there can be no economic activity in our sense of the word. In small and insignificant things rational action might still persist. But, for the most part, it would no longer be possible to speak of rational production. In the absence of criteria of rationality, production could not be consciously economical.

For some time possibly the accumulated tradition of thousands of years of economic freedom would preserve the art of economic administration from complete disintegration. Men would preserve the old processes not because they were rational, but because they were sanctified by tradition. In the meantime, however, changing conditions would make them irrational. They would become uneconomical as the result of changes brought about by the general decline of economic thought. It is true that production would no longer be "anarchical." The command of a supreme authority would govern the business of supply. Instead of the economy of "anarchical" production the senseless order of an irrational machine would be supreme. The wheels would go round, but to no effect.

Let us try to imagine the position of a socialist community. There will be hundreds and thousands of establishments in which work is going on. A minority of these will produce goods ready for use. The majority will produce capital goods and semi-manufactures. All these establishments will be closely connected. Each commodity produced will pass through a whole series of such establishments before it is ready for consumption. Yet in the incessant press of all these processes the economic administration will have no real sense of direction. It will have no means of ascertaining whether a given piece of work is really necessary, whether labour and material are not being wasted in completing it. How would it discover which of two processes was the more satisfactory? At best, it could compare the quantity of ultimate products. But only rarely could it compare the expenditure incurred in their production. It would know exactly — or it would imagine it knew — what it wanted to produce. It ought therefore to set about obtaining the desired results with the smallest possible expenditure. But to do this it would have to be able to make calculations. And such calculations must be calculations of value. They could not be merely "technical," they could not be calculations of the objective use-value of goods and services. This is so obvious that it needs no further demonstration.

Under a system based upon private ownership in the means of production, the scale of values is the outcome of the actions of every independent member of society. Everyone plays a two-fold part in its establishment first as a consumer, secondly as producer. As consumer, he establishes the valuation of goods ready for consumption. As producer, he guides production-goods into those uses in which they yield the highest product. In this way all goods of higher orders also are graded in the way appropriate to them under the existing conditions of production and the demands of society. The interplay of these two processes ensures that the economic principle is observed in both consumption and production. And, in this way, arises the exactly graded system of prices which enables everyone to frame his demand on economic lines.

Under Socialism, all this must necessarily be lacking. The economic administration may indeed know exactly what commodities are needed most urgently. But this is only half the problem. The other half, the valuation of the means of production, it cannot solve. It can ascertain the value of the totality of such instruments. That is obviously equal to the value of the satisfactions they afford. If it calculates the loss that would be incurred by withdrawing them, it can also ascertain the value of single instruments of production. But it cannot assimilate them to a common price denominator, as can be done under a system of economic freedom and money prices.

It is not necessary that Socialism should dispense altogether with money. It is possible to conceive arrangements permitting the use of money for the exchange of consumers goods. But since the prices of the various factors of production (including labour) could not be expressed in money, money could play no part in economic calculations.Neurath too admitted this. (Durch die Kriegswirtschaft zur Naturalwirtschaft (München 1919), p. 216 et seq.) He asserts that every complete administrative economy (planned economy) is ultimately a natural economy (barter system). "To socialize therefore means to advance the natural economy." Neurath, however, did not recognize the insurmountable difficulties economic calculation would encounter in the socialist community.

Suppose, for instance, that the socialist commonwealth was contemplating a new railway line. Would a new railway line be a good thing? If so, which of many possible routes should it cover? Under a system of private ownership we could use money calculations to decide these questions. The new line would cheapen the transportation of certain articles, and, on this basis, we could estimate whether the reduction in transport charges would be great enough to counterweigh the expenditure which the building and running of the line would involve. Such a calculation could be made only in money. We could not do it by comparing various classes of expenditure and savings in kind. If it is out of the question to reduce to a common unit the quantities of various kinds of skilled and unskilled labour, iron, coal, building materials of different kinds, machinery and the other things which the building and upkeep of railways necessitate, then it is impossible to make them the subject of economic calculation. We can make systematic economic plans only when all the commodities which we have to take into account can be assimilated to money. True, money calculations are incomplete. True, they have profound deficiencies. But we have nothing better to put in their place. And under sound monetary conditions they suffice for practical purposes. If we abandon them, economic calculation becomes absolutely impossible.

This is not to say that the socialist community would be entirely at a loss. It would decide for or against the proposed undertaking and issue an edict. But, at best, such a decision would be based on vague valuations. It could not be based on exact calculations of value.

A stationary society could, indeed, dispense with these calculations. For there, economic operations merely repeat themselves. So that, if we assume that the socialist system of production were based upon the last state of the system of economic freedom which it superseded, and that no changes were to take place in the future, we could indeed conceive a rational and economic Socialism. But only in theory. A stationary economic system can never exist. Things are continually changing, and the stationary state, although necessary as an aid to speculation, is a theoretical assumption to which there is no counterpart in reality. And, quite apart from this, the maintenance of such a connection with the last state of the exchange economy would be out of the question, since the transition to Socialism with its equalization of incomes would necessarily transform the whole "set" of consumption and production. And then we have a socialist community which must cross the whole ocean of possible and imaginable economic permutations without the compass of economic calculation.

All economic change, therefore, would involve operations the value of which could neither be predicted beforehand nor ascertained after they had taken place. Everything would be a leap in the dark. Socialism is the renunciation of rational economy.

Aidan Walsh (aidan.walsh@ie.ey.com) is tax partner with EY, Dublin, Ireland. Malcolm Brady (malcolm.brady@dcu.ie) is associate professor at Dublin City University Business School.

“The enemies of liberty have always based their arguments on the contention that order in human affairs requires that some should give orders and others obey” (Hayek 1960, 159).

“We may only learn from the necessity of rules, wherever men have intercourse with each other” (Hume 1751, 38).

It is a universal feature of firms that they are hierarchical (Williamson 2009). Every firm, no matter how egalitarian, has a ‘boss’; even in Koch’s (2007, 130, 133) market-based management some individuals have more ‘decision-rights’ than others. It is a common view that firms are hierarchical in order to facilitate the flow of ‘orders’ and ‘commands’; hierarchy is equated to authority which inevitably is exercised through commands or orders (Schlicht 1998, 220).

The essential nature of command in conventional theories of the firm is clear from Coase’s seminal essay on the firm: “… the distinguishing mark of the firm is the supersession of the price mechanism…” (Coase 1988, 36, 38); he goes on to give a command as an example of such a supersession: an employee moving from department Y to department X “because he is ordered to do so” (Coase 1988, 35). This view of firms as command led hierarchies is strongly held because it is so intuitive.

The purpose of this article is to challenge this view that command is essential to the nature of the firm, to argue that we have misunderstood hierarchy and that rule-following, i.e. uncommanded, behaviour, may be a more important coordination mechanism for intra-firm activities than is generally recognised.

The article is divided into four parts. The first part looks at the emerging literature on hierarchy in naturally occurring spontaneous orders. The second part looks at the Austrian literature on the firm and the role of ‘command’ and ‘rule following’ in that literature and shows how understanding hierarchy as a natural feature of spontaneous orders resolves some difficulties in that literature. The third part looks at the conventional literature on the firm where rule-following has been a feature but where there is still recourse to command as being viewed as the primary coordination mechanism. The fourth section of the article argues that intra-firm coordination through rule-following extends the problem-solving power of the extended market order and allows different firms to create value in the larger market order in different ways. The paper concludes by suggesting that the role of rule-following within the firm has been under-appreciated and under-privileged.

One of the difficulties for Austrian theorists of the firm is a general belief that spontaneous rule-bound orders are not hierarchical (Pongracic 2009, 92). This is not necessarily correct.

It is now generally agreed that rules are the foundation of coordinated behavior in animals (Hayek 1967, 66; Miller 2010, 175; Quera, Beltran, and Dolado 2010). With no leaders or external factors, order can emerge naturally from independent agents following common rules, the classic example being Reynolds’s flocking ‘boids’ (Reynolds 1987; Miller 2010, 174). However, Reynold’s simple computer program, where ‘boids’ following simple rules (fly at the same velocity as nearby birds, stay close to nearby birds, but avoid collisions) resulted in flocking-like behavior, has in some ways led us astray. As has Hayek’s focus on spontaneous orders where unthinking objects, iron-filings etc., are the basis of spontaneous orders (Hayek 1973, 40, 43).

Recent research has shown that flocking and herding rules include taking cues from ‘leaders’ and decision-makers, such as more experienced homing pigeons (Flack et al. 2012). Leaders have been observed to emerge within flocks of pigeons: ‘we found that stable, hierarchical pattern of in-flight leadership does not build upon the stable hierarchical social dominance structure evident in the same birds. Instead, in the case of pigeon flocks, the emergence of leadership and dominance hierarchies are each affected by different factors. By ignoring social dominance when in flight, flocks of pigeons potentially make better navigational decisions because leadership can emerge from relevant attributes, such as local experience and route fidelity’ (Nagy et al. 2013). Even tiny stickleback fish exhibit differences in behavior which drives leadership which results in particular forms of emergent shoal behavior (Jolles et al. 2017).With an almost Austrian emphasis on the diversity of abilities, Jolles et al. write:In recent years it has become apparent that across a wide range of animal taxa, individuals commonly differ consistently from one another in their behaviour (‘animal personalities’), often with large fitness consequences and wide-ranging ecological and evolutionary implications. Such variations could provide a level of heterogeneity within animal groups that may drive collective behaviour. Indeed recent studies have started to provide support for that notion and have shown that consistent behavioural differences can influence leadership, social network structure, collective dynamics and group performance…. Relatively simple interaction rules play an important role in the emergence of collective behaviour…. (Jolles et al. 2017)

According to Biro, “every [homing] pigeon has their own opinion on how to get home” (Biro 2016). Every homing pigeon is obviously committed to getting home but they will be guided, to some degree, by more experienced pigeons, better navigators and, of course, staying in the flock has advantages that outweigh acceptable deviations from a preferred course home. But sometimes the leader is wrong and the other pigeons will ignore him or her (Watts et al. 2016). Further, the flock will not follow the same route home that the leader would follow if flying solo—showing that the leader is influenced by the flock (Pettit et al. 2015).

Hierarchy is also a natural feature of human spontaneous orders. In the market order, participants will be influenced by (or it could appear, “follow the commands” given by) other market participants like Warren Buffett. The anthropologist E.E. Evans-Pritchard described the Nuer in the Sudan in the 1930s; he noted that their society was extremely egalitarian but that forms of hierarchy also existed:

The ordered anarchy in which they live accords well with their character, for it is impossible to live among Nuer and conceive of rulers ruling over them.... Wealth makes no difference... Birth makes no difference... [But] The words of some elders count for more than the words of others... Leadership in a local community consists of an influential man deciding to do something and the people of other hamlets following suit at their convenience” (Evans-Pritchard 1940, 179–81).

Another example would be the common-law legal system, an example given by Hayek of a spontaneous order (Hayek 1973, 81, 86). Here, again, hierarchy naturally emerges, with judges making decisions at various levels until there was an ultimate arbiter at the apex of this hierarchy—a king, a group of bishops and now supreme courts.

It is therefore not inconsistent even with pure spontaneous orders for there to be a hierarchical element. This hierarchical element may also be a feature of the larger market order but in a much less visible way. We may not feel that Warren Buffett is our superior, but we may avidly read his annual letter to investors and follow his advice just the same; we may not have a ‘boss’ in our market based activities but we may be a slave of some market or trend influencer, the economics of Snapchat or Instagram may have made this much clearer to us all. This also makes clearer how entrepreneurs play a leadership role, in, in Kirzner’s phrase (p. 18), the “mutual learning” that is the essence of the market process.

Further, we embed ourselves in the rules of different rule-based orders all the time, as employees, as customers, as suppliers and owners. For example, we will behave quite differently in a fast-food restaurant than in a fancy expensive one; we would not dream of clearing our own table in a white-linen restaurant but would ‘automatically’ in a burger joint. This is not us accepting ‘commands’ from a hierarchy, we have not fleetingly become employees as we empty our tray, but evidence of our innate ability to switch from one set of rules to another usually without conscious effort. The maître d’ may tell us what wine goes with what dish but we do not follow his or her commands, we bow to his or her superior knowledge of fine dining.

This is not a command hierarchy; this is not a hierarchy with commands cascading down but individuals happy to be guided by the advice, decisions or actions of others, however, inarticulately barked out (Brady and Walsh 2008). This does not mean that individuals can not try to give a command, after all what is the point of humans being able to speak if we cannot shout instructions at each other? However, just because we can shout, does not necessarily mean that what we shout is an order or a command. As Mary Parker Follett put it: “I may say to an employee, ‘Do so and so,’ but I should say it only because we have both agreed, openly or tacitly, that that which I am ordering done is the best thing to be done. The order is then a symbol” (Follett 1941, 65)See Kline and Martin (1958) and Pongracic (2009, pp. 38, 39) for further examples. Kline and Martin (1958) is particularly interesting. Hayek quotes from it in The Constitution of Liberty (1960, 427, n. 10) but only in relation to the loss of knowledge in relation to command. He makes no reference to the article’s use of rules as the solution to the knowledge problem of authority. Indeed, it is not until the early 1960s that he publishes works specifically on rules and rule-following (outside of his prior interest in the rule of law) as decision and coordination mechanisms. The article may have been part, if uncited, of Hayek’s realization of rules and rule-following as the basis for the classification system articulated in The Sensory Order that was then recast in rule terms in his writings in the 1960s (Hayek 1967, 43ff; Caldwell 2004, 296, 306, 307). We can say the same of Coase’s seminal ‘order’ that an employee should move from Department X to Department Y: is that a command or merely an inarticulate expression of the rule, if there is not enough work in Department X at any particular point in time then go to Department Y?Once we see that hierarchy is not inconsistent with rule-following, our eyes are opened to the possibility that many ‘orders’ that cascade down that hierarchy may not be commands at all; many instructions that individuals consider to be commands may be merely the articulation of a rule. Simon’s (1991) example, “repair this hinge,” can be rearticulated as a rule, (“If a hinge is broken, repair it”) and a piece of information (“This hinge is broken”). Coase’s example of a command (Coase 1988, 35), an employee moving from department Y to department X “because he is ordered to do so,” can be reinterpreted as a rule: if Department Y is quiet then move to Department X (Schlicht 1998, 222). Therefore, when there is an articulation of a rule or a piece of information (“Repair that hinge!”) and the rule is followed, it can appear that this demonstrates the power of the command and of the commander. We recall that Hayek originally argued that very specific rules could end up being close (“shade gradually into”) to command (Hayek 1960, 114, 148; Vanberg 1994, 266, n. 14). However, while this might look like the position when a command is compared to an isolated application of a rule (repair that hinge!) that cannot be the case generally: even the most specific rule like “if a room is dark, turn on the light,” informs every situation where one is in a dark room and also allows for unexpected situations like there is no electricity and the light switch does not work and you could use your mobile phone as a light. This is completely different from a command: Turn on that light! This tells you nothing about any other room, any other light, or any other situation. You can disprove there is command in organizations by asking yourself if you told someone to move from Department Y to Department X and on some other day, when circumstances were similar, you saw the person in Department Y and they said they were only there because noone had told them to go to Department X. You would be annoyed. Why? If they failed to follow a clearly articulated rule you would be right to be annoyed; if they were waiting until someone told them what to do then you should congratulate them on their understanding of the theoretical basis of intra-firm coordination.

This insight, that hierarchy emerges naturally from rule-following within a group as individuals look to others with more experience, skills, more or better knowledge or information and better knowledge of the rules, has major implications for theories of the firm. Conventional theories of the firm are largely focused on this visible hierarchy and this has allowed them to starkly contrast the firm with the larger market order. Williamson in his Nobel Memorial Prize-winning speech made this point explicitly contrasting the hierarchical firm with “spontaneous adaptations” in the market (Williamson 2009). In conventional theories of the firm, individuals in authority do not, obviously, have coercive power—they cannot kill or imprison you if you do not follow orders. But they are thought to have power because leaders in organizations have control over the resources of the firm (Roberts 2004, 103). However, this argument is obviously circular and cannot explain how individuals lose power, how CEOs end up being sacked; in fact, Turner argues that causation is the exact opposite, individuals get control of resources because the group has conferred power on them (Turner 2005).

What we see when we look at our pigeons flying home is a powerful vindication of the early management theorist, Mary Parker Follett. Follett argued that there is no command within organization just individuals following the “law of the situation.” She wrote: “The leader gets an order followed first, because men do really want to do things in the right way and he can show them that way, and secondly, because he too is obeying” (Follett 1941, 276). This seems so counterintuitive when we look at leaders in organizations barking out orders. But when we look at our pigeons flying in a coordinate flock, we cannot hear any commands, we cannot see any gestures, no pigeon has control of resources or any property at all but we do see hierarchy and leadership. But if we have discounted hierarchy in natural spontaneous orders because the leadership is largely invisible, have we over-privileged hierarchy in firms where leadership seems so visible and where the ability to secure coordination through being able to give orders and commands seems so clear?

This focus on hierarchy and the logical flaws in coordination through command and orders has been central to a dispute within Austrian theorists of the firm. We will explore this next.

In this section, we look at Austrian, effectively Hayekian influenced, theories of the firm. Hayek’s starting point was to look at the difference between a command and a rule. A command “aims at a particular result or particular foreseen results, and together with the particular circumstances known to him who issues or receives the command will determine a particular action” (Hayek 1976, 14); a command, by definition, must not be in accordance with the rules, otherwise the ‘command’ is merely rule articulation. Coase’s example given above meets Hayek’s definition of command. Hayek contrasts a command with a rule. He suggests that a rule “merely states certain attributes which any such action ought to possess” (Hayek 1976, 14). For example: “If {condition/situation} A, do B” is a rule (Becker, 2004) as is “If A, B is forbidden.” The complexity of the rules is somewhat overlooked in the simplicity of each individual rule; if A do B but if A1 do B1 or if A2 then do B2 can often require quite subtle thinking as to discover the correct situation, the correct rule or priorities of rules and to articulate the rule or the consequent action (Hayek 1967, 57).

Hayek’s key insight into the knowledge problem of central planning (Hayek 1948, 33ff) was the starting point for much of his later work on how the market order solved this knowledge problem. As is well known, Hayek argued that rules and rule-following behavior provided for the solution; rules are used by individuals to make decisions despite their constitutional ignorance, and the larger market order is a spontaneous order created by individuals following common rules.

On the other hand, Hayek considered that organizations (taxis in Hayek’s phrasing), as opposed to markets (cosmos), were coordinated by commands, but that there was also a role for rule-following. However, Hayek said that these rules of organization were a particular type of rule—rules, allowing the organization member to use some element of their knowledge, for the performance of assigned tasks to fill in the gaps in commands (Hayek 1973, 49; Vanberg 1994, 114). Generally, Austrian students of the firm are now agreed that Hayek, who “had little interest in organizations” (Foss and Klein, 2013), made unnecessary distinctions (with the larger market order) when he argued that organizations had to have a concrete goalIn some cases at least it may be an example of the post hoc ergo propter hoc fallacy applied to the theory of the firm. Barnard, himself, gave an example of this in a letter of 6 January 1956 to Hayek:Based upon my experience and observation I had arrived at conclusions consistent with yours before I had read any of your work or had heard of Michael Polanyi whose analysis of the situation [in The Logic of Liberty], I think, is correct and very valuable, but it is not sufficient. It seems to me that one has to be able to explain the illusion of successful planning…. In this city [New York] and its environment, in which there are millions of telephones, it is possible with almost complete certainty to make anyone of millions of possible connections merely by dialling correctly. The extreme degree of coordination of electrical and mechanical details to make this possible is almost incredible and an enormous amount of engineering work has gone into it and there is a blue print for nearly inch of the property concerned. It certainly looks as if the system as a whole has been meticulously planned to be what it is [by the New York Telephone Company]. Yet, this is absolutely false, as a whole it never was and never could have been planned (Barnard, F.A. Hayek papers, 1956). (Vanberg 1994, 142) and where he argued that the rules were necessarily subordinate to the command in an organization—in fact the opposite may have to be true (Ioannidis 2003a).

Despite this, Austrian economists have sought to apply Hayek’s knowledge problem and its solution to internal coordination within the firm. And the more recent Austrian focus on entrepreneurship and uncertainty has given us real insight into the limitations in the knowledge of entrepreneurs and managers; there is a knowledge problem not just within the larger market order but also within firms. Ioannides writes: “….the promotion of the entrepreneur’s business conception requires the information absorption capacity, the creativity and the problem solving capability of firm members. All these capabilities presuppose that the individual member acts within a framework of sufficiently abstract rules … In other words, the firm cannot but, at the same time, must not operate on the basis of commands” (Ioannides 2003b). “Cognitive constraints prevent the entrepreneur, as much as anyone else, from imaging all possible moves that unfold in the future” (Witt 2007).

However, despite these commonalities in the Austrian literature on the firm, there are now two quite different lines of thought on the role of hierarchy in intra-firm coordination: one line, taking a realistic view of the internal workings of the firm, notes the universal existence of hierarchies within firms and argues that this must result for some role for ‘command’ within the firm (Foss and Klein, 2013); we can call this the ‘realism’ line of thought. The other line focuses on the knowledge problem in any kind of central direction and proposes market-process type solutions like rule-following; we can call this the ‘logical’ Austrian line of thinking on the firm (Langlois 1995).

The realism line argues that rule-following is an important coordination mechanism within the firm, but that this does not affect the essential role of authority, hierarchy (Sautet 2000, 98) and the ability to give ‘orders’ and ‘commands’: that managers can get things done by merely telling people to do it. This line in the literature argues that the role of rules fluctuates in line with the degree of uncertainty and the amount of knowledge of the employees that must be used—the paradigm example being a new entrepreneurial firm with knowledgeable employees and a boss with cognitive and knowledge limits (Ioannidis 2003a, Witt 2007).

But despite what should be a natural antipathy to ‘command’, the Austrian perspective on the firm constantly returns to the obvious existence of hierarchy and, as they take it, its inevitable consequent coordination mechanism: command. Foss and Klein argue that command is essential to firm purpose. While they note that “knowledge causes authority (as a centralized decision-making system) to fail in all its forms” (Grandori 2002) they also write that: “consistent (or heavy-handed) application of Hayek’s decentralized argument leads to an apparent absurdity: if decentralization always and everywhere improves the utilization of dispersed knowledge, it would be hard to find any rooms [sic] for firms, and certainly for contemporary mega-sized firms… Yet (large) firms exist” (Foss and Klein 2013). Pongracic makes the same point: “…it should be obvious that most successful firms engage in some form of command-and-control, hierarchical operations. It seems highly unlikely that all these multitudes of entrepreneurs have been doing it wrong all along!” (Pongracic, 2009, p. 43).

The overall result of this stream in the literature is that the business firm is a “hybrid Hayekian order” (Ioannidis 2003a)—partly coordinated by rules and partly by command (in Hayekian terminology, neither a ‘cosmos’ nor a ‘taxis’)—with the mechanism mix fluctuating from firm to firm. Unfortunately, and paradoxically, as Pongragic has noted (2009, 72ff), this point that firms do not or should not emulate the larger market order, has morphed into an Austrian emphasis on the importance of hierarchy, authority and command (Cowen and Parker 1997, 75).

The second line of thought, building up logically from Austrian insights into market processes, also looks to rule following but is more sceptical of the power or abilities of hierarchy. The most direct application of that thinking is to argue that markets should be brought within the firm to solve the inherent knowledge problem with intra-firm coordination (Cowen and Parker 1997, Koch 2007). But if the problem was that simple to solve, why would firms have emerged at all? And, sure enough, we find, within for example the Koch companies which apply this market-process approach, all kinds of rules, like formal “decision rights” (Koch 2007, 126), that do not exist in that way within the market order.

Langlois argues that firms cannot plan in the conventional sense but instead must emulate to some degree a spontaneous order (Langlois 1995). Langlois draws on business history to demonstrate that firms move, in some form of coordinated way, from business to business without, inevitably given cognitive constraints and uncertainty, having a clear idea what they are doing but still being able to do it. But Langlois’s solution of firms relying on abstract rules to navigate this uncertain future also resulted in Langlois being “sceptical of hierarchy.” More recently Bylund (2016) takes a similar market process approach and comes to an even stronger conclusion: “we commonly perceive the firm as a hierarchy and that we as employees ‘follow orders’ from higher-ups in the workplace. But this perception is unfounded…. There is no reason to perceive of the firm as a hierarchy. Indeed we find no basis for authority….” (Bylund 2016, 88, 95).

Emerging in the Austrian literature of the firm are two different approaches to the firm—the logical approach that relies on the market process and denies that an authority relationship can exist, or is even desirable, and a realism school that argues that hierarchies are an observable feature of firms and so must have some function.

However, it is possible to square this logical-realism circle. If we appreciate that hierarchy can be a feature of rule-following orders, in fact that hierarchy can emerge naturally within any group of sentient rule-following agents, then we can see how an Austrian focus on rules, rule-following, uncertainty and cognitive constraints can be consistent with hierarchy. Especially, when we appreciate Follett’s point that many articulated commands or orders may be merely rule articulation.

On the other hand there is no need for acute observers of the firm like Langlois, to be “sceptical” of authority or hierarchy. The power of a spontaneous order to deal with the Hayekian knowledge-problem is not diluted by a hierarchical element that, in fact, may be an emergent feature of all spontaneous orders created by sentient agents following common rules.

This insight in allowing us to integrate the different schools with the Austrian literature on the firm, by allowing for hierarchy to emerge naturally as a consequence of rule-following, also allows us to integrate the Austrian focus on rule-following with the more conventional literature on the firm as well.

Rules have become more central in general discussions about decision-making. In Risk, Uncertainty and Profit, Frank Knight noted that we all act in an environment of change and uncertainty: the problem of life is that we know so little and yet we manage to act. He argued that the manager in a business firm solves this problem through a process of ‘trained instinct’, ‘judgment’ or ‘intuition’ (Knight, 1921, pp. 211, 223); in other words he knew these decisions were made but had very little idea how they were made. Modern research in psychology and economics on how individuals make decisions has given us insights into the foundation of that ‘intuition’. We now know that individuals make judgments and decisions, not by elaborately generating and ranking options, but by following ‘heuristics’ i.e. rules. It is clear that this is also true for decisions made within business organizations. According to Kahneman, ‘[w]hatever else it produces, an organization is a factory that manufactures judgments and decisions’ (Kahneman, 2011, p. 418).

So we would expect the entrepreneur to attempt to coordinate through rule-following; articulated as such or not. An example of one entrepreneur using rules is when Henry Ford started the process of creating his “universal car;” he was trying to coordinate the activities of a number of individuals but without being able to articulate any concrete objective: “The plan which I then had in the back of my head but to which were then [1904] not sufficiently advanced to give expression....” (Ford and Crowther 1923, 56, 57). But even at that early stage Ford could articulate clear rules, from which the design of his car, he hoped but could not be sure, would emerge: “The universal car had to have these attributes: (1) Quality in material to give service in use; (2) Simplicity in operation—because the masses are not mechanics; (3) Power in sufficient quantity… (4) Absolute reliability….”

However, these insights into the power of rule-following have been missed because the emphasis on rule-following in the conventional literature on the firm had a different starting point and so a different focus. Max Weber in his writings about bureaucracy, and the rules that bureaucrats followed, wrote about the “regular,” “stable,” “methodical” characteristics of the modern bureaucracy (Weber 1968, 956). This early focus on rules in organizational studies has skewed the understanding of rules and rule-following in organizational theory and economic theories of the firm which have become focused on rules in routine situations (Becker 2004, Nelson and Winter 1982); ‘rules’ became synonymous with ‘rigidity.’

However, despite the “tendency for authors to slide between ‘rules’ and ‘routines’” (Loasby 2000), rules, more recent studies have shown, can also guide decisions in non-routine, novel or uncertain situations also (Gigerenzer and Gassmaier 2011, Gigerenzer 2007, Klein 1998, March 1997). Again, the conventional view has been inverted—it is following rules that provides for flexibility and following commands that is necessarily rigid. That rule-following allows for fast decision-making and that these quick decisions can be useful is a new development (Kahneman 2011). Eisenhardt and Sull (2001) make the point that rules are an appropriate coordination mechanism in “rapidly changing, ambiguous markets” where strategies are “constantly evolving.” Looking at actual company strategies, and without referring to any underlying theory or to management history, the authors had noticed the pervasiveness of rules in strategy formulation, articulation, and coordination.What is less well-known is recourse by the military to similar rules-based instruction. Arrow argued that (Arrow 1974, 68): ‘The purest exemplar of the value of authority is the military.... Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success’ (p. 69). And that putting in place rules for every eventuality is “highly costly.” This is a point repeated most recently by Foss and Klein (2012, 216).    Contrary to expectations, the military and other military-like organizations such as the fire services, police and coast guard, do not rely on command even in non-routine circumstances (Klein 1998); even though senior military figures have the ultimate coercive power to make their soldiers do exactly what they want, they do not use it. These are the orders that the great Prussian general Moltke made at the outset of Prussia’s war with Austria in 1866 to the commanders of Prussia’s First and Second Armies, who within weeks would crush the Austrian army between them:.... With regards to distance, road connections and railroad, the direction [i.e. not a specific location] of Gitschin has been designated for eventual junction of both armies.    By this it is not of course meant that the point must be reached under any and all circumstances, because that will depend entirely on the course of events ... [However] the convergence of all our armies for the main decision must always be kept in view (Moltke 1993, 245). Moltke’s orders can be easily expressed as rules: if there is a choice over direction, then choose the direction of Gitschin; if there is a choice between convergence and divergence with the other Army, then choose convergence; if there is a choice between direction and convergence, then choose convergence. (Note how there is no concrete goal.) The German army’s Field Service Regulations, dating back at least as far as 1887 (Samuels 2013) are almost Hayekian: “Every individual from the highest commander to the lowest private must always remember that inaction and neglect of opportunities will warrant more severe censure than an error of judgement in the action taken” (Halder et al. 1953, 7, 8; Creveld 1982). Articulated orders in this system were designed to give context and decision support premises to each individual soldier, so that when faced with the unexpected they knew what to do in a way that was coordinated with the rest of the soldiers in the army (Bungay 2011). This is the basis of current US Army military doctrine (United States Command and General Staff College 2014, 54). In developing his theories Hayek himself may have drawn on his own military experience: “his experience of the retreat [with the Austrian Army from the Piave River in Italy in 1918] first got Hayek thinking about spontaneous orders—the soldiers had no central direction, yet the retreat was more or less orderly” (Caldwell 2004, 135 n. 3; Leube 2003). This, of course, we now realize does not mean that the groups of men and boys were without leadership, there must have been individuals who had more local knowledge, better ability to find food etc. who would have emerged in the retreat.

If we take these insights into rule-following within the firm and apply them to existing theories of the firm we can see that many are writing about rule-following but, as with Knight, are struggling to articulate their insights in a clear way. Many existing theories are based on rules and rule-following behavior: routines (which are just rules to deal with regularly occurring situations) (Becker 2004, Nelson and Winter 1982), capabilities (the ability to make superior coordinated decisions, i.e., rule-following) (Loasby 1998), contractual relationships (that is, rule-bound relationships) with incentives for and monitoring of adherence to the rules (Alchian and Demsetz 1972), even hierarchies and authority (Williamson 2009, Coase 1988) (See Walker [2015] for a useful review).

But each theory has to introduce an artificial element that could be seen to fall away if a greater emphasis was given to rule-following. For example, if we look at Alchian and Demsetz’s paper, their logic, as Austrian writers on the firm have repeatedly pointed out, is impeccable: the employment relationship is just another market transaction, the employer has no more ability to ‘command’ the employee than the customer his or her grocer. However, to give their insight more realism, the authors introduced a centralized element:

… a special class of contracts…. Instead of multilateral contracts among all the joint inputs’ owners, a central common party to a set of bilateral contracts facilitates efficient organization of the joint inguts [sic] in team production.... We conclude with a highly conjectural but possibly significant interpretation… the firm can be considered a privately owned market….

They talk of the firm as a form of “specialised surrogate for a market” at the center of a nexus of contractual relationships with the firm as the central contractual hub. Rearticulating that description of the firm as a unique rule-bound order, with employees committing to following the rules, and agreeing to being sanctioned or excluded if they fail to follow them, eliminates the cumbersome, and completely artificial, requirement to have a complex system of ever-changing contractual relationships with a legal fiction as nexus. The requirement is now merely to follow different rules to the larger market order. This goes to the core of their analogy between the employee/employer relationship and the customer/grocer: as you wander around the grocery store looking for tins of tuna, you do not have, yet, any contractual relationship with your grocer—you have a market order in which you both will follow rules and within which you can predict each other’s behavior. Similarly, within a firm, the employees do not need a contractual relationship with each other or with a common artificial nexus. All they need are common rules and a mutual commitment to follow them. At the same time, the emergent feature of hierarchy within rule-following orders allows us to answer the most common criticism of Alchian and Demsetz’s article that there is a hierarchy within the firm but none in the larger market order. As we have pointed out rule-following within the larger market order and identical coordination mechanisms within the firm may result in more visible hierarchies in the latter than in the former but the mechanism is still the same.

Alghion and Tirole (1997) give a realistic view of the firm where decisions are delegated but they can only see this delegation as involving “a costly loss of control for” the superior. And they have no mechanism to explain how delegated decision can be coordinated; they very much imply they cannot and so only “relatively unimportant” decisions can be delegated. Again, a rule-following perspective from the Austrian literature would show how delegation exists within a hierarchy, both the hierarchy and the delegation are natural consequences of rule following, and how rule-following results in actions that can still be controlled and coordinated even in urgent and unforeseen circumstances.

Hayek’s work on rules was an early example of an increasing focus on rule following in human behavior and coordination. It has become clear that rules are central to all human activities. Dopfer writes that “Homo sapiens can thus be viewed more generally as a rule-making and rule-using animal” (Dopfer 2004). But rules and rule-following are especially important in institutional settings. Social institutions are “nothing more than agents rationally following rules of action, and being believed by other agents to do so” (Rowe 1989, 5). Other authors note the usefulness of rules in coordinating behavior generally (Heiner 1983) and specifically within firms (Grant 1996). However, in many ways the conventional literature on firms and management is merely catching up earlier theorists, like Follett, and practitioners, like Henry Ford.

A neglected subject, however, is the interaction of rules with ‘orders’ and ‘commands’ in an institutional setting. A command is, by definition (Hayek 1973, 97, 99; Vanberg 1994, 129; Polanyi 1951, 141; Hayek 1976, 20), outside of any rule-system. If we return to Coase’s example of a command: an employee is told to move from Department Y to Department X because “he is ordered to do so.” The employee must think: is this a command or a rule (Schlicht 1998, 232)? Do I go to Department X just this once or every time or times when the factual situation is similar (like there is no work to do in Department X)? Without such clarification, there is a risk that an employee mistakes a rule for a command or vice versa—i.e. repeatedly carrying out an action where the original instruction was actually a once-off command but the employee thought it was rule-articulation. This is not a source of error that is identified or discussed in the literature, or even much in real life. Why is that? Perhaps because rule following and its hierarchical consequences are more pervasive than we thought?

Chester Barnard noted an “authority paradox” within organizations: activity is coordinated within firms even though we do not do as we are told. In Barnard’s words, “It is surprising how much that in theory is authoritative, in the best of organizations lacks authority—or, in plain language, how generally orders are disobeyed” (1938, 161, 162). However, understanding rules as the coordination mechanism within the firm easily allows us to resolve this paradox, as Barnard did: ‘orders’ are not followed where they conflict with the rules (maybe the wrong rule was articulated or maybe circumstances have changed and a different rule should be applied now), and thus, despite orders being disobeyed there is no loss of coordination. In fact, coordination is sustained only because ‘orders’ are disobeyed and this is why, as Barnard pointed out, “…obvious disobedience [is] carefully disregarded” (p. 162).

This feature of corporate life, that things continue in their own way despite the frantic efforts of senior management, is often identified as ‘corporate culture’; Hayek defined ‘culture’ as “the rules of conduct which govern the structure and functioning” of groups of people (Hayek 1978, 156)—“the brain is an organ enabling us to absorb but not to design culture.” What is now clear to everyone is that every company has its own unique corporate culture; in Schlicht’s vivid phrase: “Anthropologists may travel from island to island and observe that each harbours people with a particular custom. It is not necessary to go that far away, however. In modern economics, each firm forms an island of custom in the ocean of the market” (Schlicht 1998, 207). And the number of potential islands appears to be almost infinite; Vanberg (1994, 78) points out: the “cultural rules … appear to be exceptionally variable and it is the variability of these rules that accounts for the diversity of social orders.” We can thus explain why there can be an infinite number of different ‘corporate cultures’ in the larger market order, but what is not so clear is: what problem is that solving and what value does a firm extract from having a different culture to every other firm?

In much of management literature this culture thwarts and frustrates the efforts of leaders and management; Roberts refers to it as an “inert” element (2004, 28). What is also clear is that this culture is not completely ‘created’ by the firm founder or leading entrepreneur; even in the smallest firms, of only two or three people, the founder can feel that “control… slips away” (Ruef 2010); as early as 1980 Apple was making decisions that Steve Wozniak, one of the founders, did not understand or “like one bit” (Wozniak and Smith 2006, 230). A firm is not a “designed order;” as Ruef has pointed out: “Entrepreneurs… are defined by their intention to form a social group” (Ruef 2010, 7). Any social group is beyond the ability of any one person to create or concretely manipulate (Hayek 1952, 71).

The firm retains coordination, despite ‘orders’ being disobeyed and despite control, even knowledge of the current rules, slipping away from the founders, because the rules of the order are being adhered to—or as it is put colloquially, “culture eats strategy for breakfast”! (Groysberg, Price, Lee, and Cheng 2018).

However, the purpose of this article is to argue that this culture is not a by-product or even an unfortunate complication of firm creation but instead may be regarded as the essence of the firm—the rule-bound order, the ‘culture’ in other words, is the firm and that those rules, that culture, is different from every other firm is both inevitable and potentially valuable. The basic premise of anthropology is that every culture sees the world in a different way; in the words of Engelke, anthropology is “a way of seeing things, a way of thinking. Culture is a way of making sense” (Engelke 2017, 31, 32). Within organizations, culture has been defined as having a coordination role: the “social or normative glue that holds an organization together” (Smircich 1983), and a decision-making role, as Casson has pointed out: “’Learning by doing’ is an important aspect of problem solving and so learning effects will give each culture a distinctive type of problem-solving expertise” (Casson 1995, 89). In other words, we have described rules following in terms of ‘If A, then B’ but the rules also tell you which ‘A’ to pay attention to in the infinite number of potential problems that might be solved.

Perhaps an example may help. Steve Wozniak designed the Apple I and the Apple II and was clear on this from the start that he wanted to build a cheap computer. He worked as an employee of HP when he designed those computers—yet he did not feel he was competing with HP’s personal computer “[i]t wasn’t like ours—it was aimed at scientists and engineers and it was really expensive…. How could HP [build a cheap computer]? It couldn’t” (Wozniak and Smith 2006, 175, 176). He founded Apple Computers in 1975 with Steve Jobs and Ron Wayne and but even Wozniak initially thought of his machine of hobbyists and not for “regular people in regular homes”—this came later (p. 197).

In late 1979 Steve Jobs was given access to the Xerox research center, PARC. During that tour, an engineer, Larry Tesler, gave him a demonstration of a ‘mouse’ and a graphical user interface. Malcolm Gladwell describes what happened: “Tesler recalled. “He was very excited. Then, when he began seeing the things I could do onscreen, he watched for about a minute and started jumping around the room, shouting, ‘Why aren’t you doing anything with this? This is the greatest thing. This is revolutionary!’” (Gladwell 2011). It is one of the most celebrated moments in modern business history and Xerox is widely derided for not having exploited this intellectual property and instead, effectively, giving it away to Apple. But, as Gladwell points out, Xerox and Apple saw the problem in different ways: “PARC was building a personal computer. Apple wanted to build a popular computer.”

What was obvious to Jobs and employees in Apple was not at all obvious to employees in Xerox or HP; as Yu points out rules facilitate decision-making by limiting our choices (Yu 2005, 9)—for Xerox or HP, building a consumer or popular product was not within its realm of choices. For an employee in Xerox, focused on business customers, a mouse was a way of making technicians more efficient; for Jobs and other individuals in Apple it was a way of making everyone a computer technician; the same A but for Apple—If A then B and for Xerox If A then C. Apple in 2018 reached a market value of over $1 trillion but Xerox still has a market capitalization of over $6 billion; with different rules Xerox might have a different market capitalization, but the service it currently provides in the larger market order would not be provided in the same way, if at all. Seen in this light, we can see how the larger market order expands its problem-solving abilities as different rule-bound orders are created within it and how these rule-bound orders create value for customers, employees and investors. The rule in the market order may be: If A then B; the rule in other orders may be: If A then C, D, E, etc. It may be that the market throws up numerous failed orders before we get to set of rules that provide: If A then Z; this then solves a problem in a way that customers really appreciate and will pay for.

In this article we have repeated the, now commonplace, assertion that rule-following behavior occurs within organizations in both routine and non-routine, even unforeseen, situations. More novel, we have shown that the existence of rules and rule-following behavior can co-exist with hierarchy; that hierarchy can emerge naturally in groups following common rules.This may also allow us to take a further step to resolving a controversy between Hayek and some of his critics. Both Rothbard (2009, 62) and Bruno Leoni (Leoni 1961, 99, 110; Hayek 1973, 168) criticized Hayek for his failure to distinguish between rules voluntarily committed to and rules imposed by a coercive authority. The conventional economic view has been to use the firm as an exemplar of the power of ‘command’—perhaps the exact opposite is the case? If this were correct, the apparent tremendously effective coordinating power of ‘command’ in the firm would be seen as something different and there would be a different focus on the power of voluntary coordination in the larger market order. Or as Mary Parker Follett wrote of her insights into the law of the situation: “This gives, does it not, a slightly different aspect to the whole of business administration through the entire plant?” (Follett 1941, 59) This may allow for a greater role for rule-following within the firm. However, nothing in this theory prevents firms from having a dual nature, being coordinated by command as well rule-following; a hierarchy, once in place, may achieve coordination using many different mechanisms—commands, goals, rules.

Beyond Hayek’s insight into the division of knowledge in the larger market order and, by implication, within firms, Austrian insights into the firm have been relatively limited. It is submitted that this is because Austrian theorists of the firm have, following Hayek’s lead, conflated hierarchy with coordination by ‘command.’ This has led some Austrian theorists to dismiss hierarchy and others to under-privilege rule-following. The purpose of this article has been to attempt to return Austrian theories of the firm to a realistic, hierarchical, but rule-based theory of the firm.

It may be that Hayek’s core insights into the tremendous power of spontaneous orders and rule-following may have more general application than he envisaged.Chester Barnard wrote to Mary Niles in a letter of 13 August 1956 after he had read her The Essence of Management:I note one omission that surprises me. I did not find any quotation from Michael Polanyi nor is his name listed in the index, nor his writings in the bibliography. I think that his book The Logic of Liberty is one of the most important contributions to the theory of organization and management that I know, particularly relating to the limitations of the span of control and the necessity for autonomous behaviour in most organizations. If you don’t know the book I can certainly recommend it most highly.’ (Barnard 1956) These late letters of Chester Barnard, to Hayek, Polanyi, de Jouvenal, etc., essentially restating firms as Polanyi-ish spontaneous orders are a hitherto un-investigated alternative to the Williamson explicit contrast between Barnardian hierarchical firms and Hayekian spontaneous orders (Williamson 2009). If so, Austrian insights into entrepreneurship, coordination and knowledge, have been under-appreciated in the conventional literature on the firm and management theory and practice.

Ludwig von Mises’s contributions to economics are widely known. For instance, his application of Carl Menger’s subjective theory of value to money (Mises [1912] 1953), his description of the necessary economic failure of any socialist regime (Mises [1920] 1963; [1922] 1951), and his reconstruction of economics as a theory of human action (Mises [1949] 1998) all stand as important contributions to the development of Austrian economics. But Mises was more than an economist; he was also a philosopher and sociologist. However, many of his insights to these fields of study are less well known. There is the work of Salerno (1990), which identifies reason, ideology, and the division of labor as the main vectors for social change in the Misesian interpretation of history. There is also the more recent comparison between the social rationalism of Mises and that of the French Idéologue Destutt de Tracy by Dorobăţ (2015), as well as a comparison between the social theories of Mises and of French sociologist Raymond Boudon by Fillieule (2014). Finally, we can find studies in which Mises’s work is compared to Max Weber’s work (Schütz 1967; Boettke and Storr 2002; Anderson 2004; Callahan 2007; Zafirovski 2010). However, there still lacks a more general analysis linking Mises’s epistemology with his answers to the particular questions sociologists have attempted to address. This general analysis will allow us to see the extent to which the study of Mises’s work can help sociologists understand the social world.

This article is therefore guided by two different but interconnected goals. In the first section of this paper, I want to explain how sociology can be understood in light of Mises’s general epistemological distinction between theory and history. Second, I want to present an outline of the general answers he provided to some of the most important questions that sociologists sought to address. From this, it will become possible to understand how a Misesian sociological investigation can be conducted.

Ludwig von Mises’s distinction between theory and history is perhaps one of his most general and useful epistemological insights. In short, theory constitutes the set of all praxeological categories (and a priori laws) framing our knowledge whereas history constitutes the description and analysis of particular or general empirical events or trends (Mises 1962, 44–6).

Theory and history are complementary. Indeed, Mises writes: “The fullness of reality can be mentally mastered only by a mind resorting both to the conception of praxeology and to the understanding of history” (Mises [1949] 1998, 642–43). Without theory, social scientists cannot meaningfully grasp and understand the empirical data of historyOn the necessity of conceiving empirical knowledge as being praxeologically framed, see Hoppe (1995, 69–70).; without history, they are condemned to know what limits their knowledge of the social world without ever using (applying) those limits to understand specific empirical events. In other words, theory (praxeology) provides boundaries to the set of possible interpretations about historical (empirical) reality. One cannot make sense of history if one does not know how to frame one’s interpretations.On the necessity of a “common ground” to determine the validity or possibility of a claim or interpretation and, in particular, on praxeology as such a common ground, see Hoppe (1989). As Mises (1962, 2) puts it: “For epistemology there is something that it must take as unchanging, viz., the logical and praxeological structure of the human mind.” Indeed, “knowledge is a tool of action. Its function is to advise man how to proceed in his endeavors to remove uneasiness.” And “the pure search for knowledge, not motivated by the desire to improve the external conditions of life, is also an action, i.e., an effort to attain a more desirable state of affairs.” (Mises 1962, 35). Praxeology therefore provides the conditions of possibility of the understanding of history: “Experience concerning human action,” Mises writes, “presupposes the category of human action and all that derives from it. If one does not refer to the system of the praxeological a priori, one must not and cannot talk of action” (Mises 1962, 42). Also, “Understanding presupposes and implies the logical structure of the human mind with all the a priori categories.” (Mises 1962, 48).

As Hoppe (1995, 20, 81) indicates, following Mises, it is because action is both a mental and an external process that one can acquire theoretical (a priori) knowledge about what frames historical (empirical) understanding.The same applies for predictions about future empirical events. See Hoppe (1995, 43-46, 81; 1997). Mises (1962, 42) indeed writes: “Both, a priori thinking and reasoning on the one hand and human action on the other, are the manifestations of the human mind. […] Reason and action are congeneric and homogeneous, two aspects of the same phenomenon.” Indeed, action is external behavior guided by thinking and reasoning; and the structure of action is discoverable through thinking about action. It thus frames its real—external—manifestations and, thereby, also frames thoughts about these external manifestations. Historical data provide a record of these empirical events whereas praxeological concepts provide the boundaries within which one can think about what caused these external manifestations. And the usefulness of these concepts depends on the extent to which they allow us to understand real actions. For instance, the praxeological law according to which every voluntary exchange is mutually beneficial is only useful to our knowledge if in history there was indeed (or we expect that there will be in the future) actors proceeding to what we know to be a voluntary exchange. There would be no need for a theory of exchange if we lived in a world where no exchange ever occurs. Theory must thus address, frame, and impose limits on the understanding of phenomena that occurred (or are likely to occur) in order to be useful (Mises 1962, 41).

With this in mind, it is possible to address the question of the epistemological status of sociology according to Mises.

1.1 Theory, History, and the Epistemological Status of Sociology

Other than the quite trivial claim that sociology is the study of society, there is no epistemological consensus on what sociology is and on how it should be studied. In particular, over the past few decades, the discipline has mostly become, to borrow the words of Anderson (2000, 77), a research program that “openly assumes an ideological tone palatable to only the most liberal of scholars or ignorant of laymen.” But Mises—although it is safe to assume that he would have been vigorously opposed to the epistemological status (or lack thereof) that is assigned to sociology by the current postmodern and neo-Marxist sociologists—died before he could have been aware that such research programs constituted any threat to the social sciences. However, he often discussed the sociology of many of the founders of the discipline such as that of Auguste Comte, Émile Durkheim, and, in much greater length, of Max Weber. In short, there are three meanings of the term “sociology” that were addressed by Mises: 1) sociology as praxeology, 2) holistic sociology (Comte, Durkheim), and 3) interpretive sociology (Weber). It is by analyzing what Mises had to say about each one of these meanings that we will be able to understand whether he considered sociology as a theoretical or a historical discipline.

Mises himself first termed “sociology” the theoretical science of human action. But he later deemed this to be a mistake, and changed the name of this science to “praxeology.” The reason for this was that the name sociology became widely used in a different sense than that used by Mises (Hülsmann 2007, 720). Sociology, Mises tells us—referring in particular to Weber’s work—is practiced as a discipline of descriptive or general history (Mises [1949] 1998, 30 n.1), not as the theoretical study of the logic of action. In his Memoirs, he wrote:

[…] I made the mistake of using the term “sociology” to designate the theory of human action. I should have used the term “praxeology.” That which one generally calls sociology today is not theoretical, but historical knowledge. Max Weber was quite right in describing what he saw to be sociology in terms of the humanities. He observed that this was the sociology that worked with the formation of ideal types. His error lay in assigning to it many praxeological elements and in seeing economics as a field serviced by the intellectual methods of understanding. My essay [“Sociology and History”] was primarily directed against Max Weber’s epistemology, about which I raised two objections: its failure to comprehend the epistemological characteristics of economics, and its distinction between rational actions and actions oriented otherwise. (Mises 2009, 106–07).

We will discuss in greater details the sociology of Weber later on. Suffice it to say here that the meaning of sociology as praxeology has been abandoned by Mises, and that, therefore, each time he refers to the term “sociology” in his earlier work (up to his 1929 essay “Sociology and History”), he refers to something quite distinct from what Weber (and many others) meant by the term.

The second meaning of the term that was addressed by Mises is the holistic sociologies of Comte and Durkheim. To say the least, he did not consider them to be very promising. The research program of Comte—the attempt to reproduce the methods of the natural sciences to the study of the social world (earlier called physique sociale), which then becomes an analysis of the necessary stages of human history (human “progress”) allowing us to predict the future evolution of society (Comte 1839, 450–70)—is characterized by Mises ([1957] 2007, 241) as “so shallow and impractical that no serious attempt was ever made to realize it.” That of Durkheim and the Durkheimians—a study of the social world that assigns to society the status of an acting entity which imposes its will on the individuals (Durkheim [1895] 1982)—is described as the unsatisfactory result of “arbitrary metaphysical effusions about the recondite meaning and end of the historical process [...]” (Mises [1957] 2007, 242) Sociology is then—in the senses given by Comte, Durkheim, and their followers—not a legitimate field of study, and we cannot, therefore, pass judgment about its epistemological status; it simply does not convey any useful knowledge other than by mere accident.

The third meaning of the term addressed by Mises—Weberian sociology—is worth discussing in more details. On the links between the Misesian epistemology and Weber’s work, scholars such as Zafirovski (2010)One can also find similar claims in Lachmann (1990). have argued that Mises’s praxeology is in fact identical or quasi-identical with what Weber termed sociology; it is merely “the Austrian school’s version of, alternative to, or different name for, sociology in Max Weber’s sense.” (Zafirovski 2010, 76) Although this can already be rejected based on the evidence provided earlier, we should nonetheless address the specific arguments that are supposed to support such a claim.

To provide evidence for this claim, Zafirovski first quotes Mises when he writes that “[sociology] promised to substitute true science for the rubbish and empty gossiping of the historians in developing an aposteriori science of ‘social laws’ to be derived from historical experience.” (Mises [1957] 2007, 308). Zafirovski (2010, 83) then adds that Mises thought of praxeology as being this “true science.” Combined with the fact that Mises elsewhere indicates a correspondence between general sociology and Weberian sociology, this is supposed to imply that the terms “praxeology” and  “Weberian sociology” are interchangeable. However, Zafirovski’s argument completely ignores what Mises wrote in the following paragraph of the same page, that is: “Their interpretations [that of the sociologists, including Weber] were in many regards unsatisfactory. They were deluded by many of the fundamental errors of historicism. All but Collingwood failed entirely to recognize the unique epistemological character of economics.” (Mises [1957] 2007, 308). In other words, their contributions to history notwithstanding, they failed to understand that history and sociology must be framed by praxeology (and, in particular, economics) in order to provide correct interpretations of empirical reality. The science of praxeology must thus be recognized as epistemologically distinct from history and Weberian sociology. This, in addition to Mises’s explicit rejection of Weberian sociology as theoretical in his Memoirs, is enough evidence to understand that the terms “praxeology” and “Weberian sociology” are not interchangeable.The confusion may lie in the previously mentioned fact that Mises used to term “sociology” what he then decided to call “praxeology” and on the other fact that Mises was appreciative of Weber’s work. This confusion is especially apparent throughout Zafirovski’s paper. After wrongly indicating that praxeology and Weberian sociology are identical or quasi-identical, he attempts to distinguish it from history in order to give to Weberian sociology the epistemological status of theory. To do so, he often cites Mises’s books Socialism and Epistemological Problems of Economics and the distinction between “sociology” and history that is presented in it (2010, 77, 82, 84–5). But this is an error of anachronism; the content of these books was written in the 1920s when Mises attempted to name “sociology” the general science of human action. As we have seen, Mises later distinguished sociology (including Weberian sociology) from this science. Weberian sociology is recognized as useful by Mises, but as a historical discipline and not as a theoretical one.

This terminological issue has implications about the way in which one is to understand the Misesian epistemology. For if the view of praxeology as sociology prevails, then one has to ignore or dilute Mises’s distinction between theory and history. Indeed, if Weberian sociology is identical to Misesian praxeology (or if there exists a mere difference in degree between them), there is no point in distinguishing between what would then be a quite trivial variation in method, i.e., between the analysis of history through the use of more general ideal types and through the use of less general ideal types.This is what Alfred Schütz (1967) attempted to do. Schütz’s conception of the ideal type is distinct from that of Weber in at least one major aspect. It takes into account the manner in which we choose the main characteristics to construct it. For Schütz, then, the “ideal types” of “pure economic theory” are constructed based on the universal invariants of human action (they have the highest possible degree of “anonymity”) and constitute, as such, necessary truths about action (244). In this sense, there should remain a distinction between the theorems of praxeology and the extra tools used in historical and sociological understanding. The problem is that by subsuming both under the concept of “ideal types” one can easily be confused as to whether there exists an epistemological distinction between the study of theory and that of history. Schütz himself, although agreeing with Mises on the universality of economic theory, seems to have failed to recognize its aprioristic and non-hypothetical character (Kurrild-Klitgaard 2001, 127–28), which therefore requires different tools of analysis than the a posteriori and hypothetical study of history. A similar—but even more problematic—confusion appears in Lavoie (1986), where it is argued that Mises did not really wish to “dichotomize” theory and history (194) since he thought both were complementary. This is a strange argument for 1) a dichotomy does not imply, as Block (1989, 219–20) correctly pointed out, an absence of complementarity, and 2) Mises was quite emphatic, as has already been shown, in claiming that such a dichotomy exists. The point of the Misesian distinction is precisely that the laws of action constitute necessary transhistorical knowledge about the social world whereas the additional tools of historical analysis are temporary, hypothetical (albeit often useful) constructions.

Indeed, praxeology provides us with a corpus of apodictic, non-hypothetical statements about human action and its logical consequences. True enough, this is often insufficient in order to study in depth an empirical event or trend. A historian or sociologist can then use additional tools or constructions to grasp the social world insofar as these tools do not lead him to reach any conclusion that enters in contradiction with praxeological laws (Mises [1949] 1998, 61). But it is clear that Weberian sociology and the study of history through the construction of temporary and hypothetical ideal types are fundamentally distinct from praxeology.

Now, keeping this in mind, there is no question that Mises was influenced by Weber. The question is: how? And the answer must be, in light of all the evidence, that Weber influenced Mises in his understanding of the proper methods for general historical studies. For, according to the Misesian framework, the Weberian method of sociological inquiry is indeed a useful and appropriate one in the study of history. It considers individuality and rationality as the central points of the understanding of social phenomena, as Mises (1962, 45–6) insisted it should. It tries to discover the commonalities and distinctions between various individuals or the reaction of individuals to various social contexts and organizes them into ideal types. In brief, it attempts to attribute a meaning to a historical event or trend. As such, from the point of view of Mises’s epistemology, ideal types constitute additional hypothetical tools for the understanding of history (Mises [1949] 1998, 60).

In light of all this, then, what is the epistemological status of sociology according to Mises? The methods of holistic sociology do not contribute to our knowledge; no epistemological status can thus be assigned to it. Weberian sociology, however, is acceptable when properly understood. This type of sociological research is a part of historical and thymologicalThymology refers to the study of the cognitive origins (or formation) of those elements that motivate action (values, beliefs, ideas, thoughts). See Mises ([1957] 2005, 271–72; 1962, 46–51). French sociologist Raymond Boudon (2003) refined Weber’s methods for the study of social phenomena by providing a typology for the rationality of beliefs and values (instrumental, axiological, and cognitive) which one can use in order to understand historical events or trends. This can be seen as an attempt to systematize the historical (thymological) study of values, ideas, and knowledge leading to action. studies aimed at providing an understanding of social phenomena. Thus, the epistemological status of sociology is that of general historical analysis such as what a properly understood Weberian sociology envisioned. As such, it must be based on ideal types, methodological individualism, and the actor’s rationality.

1.2. On Methodological Individualism and Rationality

The absence of methodological cohesion within the sociological profession is one of the key features characterizing the main debates in the discipline. Turner (2001, 3–4) has identified the problem as being a “micro-macro” problem, or an “agency-structure” problem. In short, the methodological debate is about whether social phenomena can be understood as the result of social forces constraining the individual (social structures determine the phenomena) or as the result of individual actions. If social structures are what determine the emergence of social phenomena, then methodological holism (social facts are considered real independent entities influencing one another) would be the correct method to understand the social world, whereas if we can only reconstruct social phenomena through individual actions, then methodological individualism would be the correct method to understand society.There exists a variety of solutions suggested to resolve the micro-macro problem. Turner and Boyns (2001, 354) identify eight solutions (ranging from what they call “microchauvinism” to “macrochauvinism,” and including many midway solutions). Turner’s own solution “involves recognizing that social reality does indeed unfold along micro, meso, and macro dimensions; that each of these levels reveals its own emergent properties; that these properties are driven by forces distinctive to each level; that theory is to be about the dynamics of the forces operating at each level; and that theoretical integration will always be about how the properties of one level load the values for the unique forces operating at other levels.” (Turner 2001, 6). But this heterogeneity in properties based on the level of analysis can only be considered as heuristically useful, depending on the question asked. It may be admitted that for the mere purpose of describing structural changes then it is sufficient to look at how two structures change together. But to explain it requires that we go deeper. One can describe how the state grows as a result of changes in the structure of central banking, but one certainly does not explain why the structure of central banking changed in the first place or why there would be a causal link simply by doing so. This would require an investigation of typical individual motivations and actions. And surely, if one can only explain macro phenomena by reducing them to (micro) individual actions and motivations, then the macro level is not, ultimately, a completely distinct realm of analysis. Tobe sure, how a structure (macro phenomenon) emerged is not always relevant to the question asked. Only in this sense is it permissible to argue that structures “constrain” the individual. But these structures, as Mises ([1922] 1951, 315; [1957] 2007, 326) argued—and Turner and Boyns (2001, 361) seem to agree—do not render deterministic explanations; and one must, therefore, still look at typical individual characteristics in order to understand how and why the structure impacted individual thoughts and actions leading to the social phenomena of interest. 

It is quite clear that, for Mises, every historical (and therefore sociological) analysis must use methodological individualism. Every action is individual action, and its meaning must be thought as individual meaning (Mises 1962, 43–4). This does not imply, of course, that the individual is by necessity “temporally prior” to the collectivity or to various social structures. There exists a multitude of different collectives (built around different goals) to which individuals adhere (Mises [1949] 1998, 42–3). But one must keep in mind that “A collective operates always through the intermediary of one or several individuals […]” (Ibid.) It is thus only metaphorically that one can attribute an action to a social group: “society itself is neither a substance, nor a power, nor an acting being.” (Mises 1962, 78). Such metaphors are often useful. But a scientific analysis may fall into error if it fails to realize that they are indeed mere metaphors.

Weber and Weberians such as sociologist Raymond Boudon understood this. For Boudon, the individual is the ultimate origin of social explanation (Boudon 2010, 16, 27). To both Mises and Boudon, it is only possible to understand a “macrosocial” phenomenon by considering it as the result of a multitude of particular actions and by assembling these particular actions “step by step, part by part.” (Mises [1949] 1998, 46). This is what Mises called “methodological singularism.” It is only by understanding smaller, singular, phenomena that we can understand larger, more complex ones. Likewise, Boudon argued that it is necessary to aggregate typical micro-sociological facts in order to make sense of macrosocial data (Boudon 1986, 16). The macro data can only be heuristically useful in the formulation of enigmas and of hypotheses of investigation (Boudon 1986, 313 n. 11). A cathedral, to adapt one of Mises’s examples, provides an enigma: why was it built?; how was it built?; etc. This “macro” datum requires an explanation; we wish to understand something about the processes that made this achievement possible. But, as Mises pointed out, understanding it requires that we reconstruct the actions of the various individuals involved in the project of building this cathedral (Mises [1949] 1998, 45). In the words of Mises: “In studying the actions of individuals, we learn also everything about the collectives and society. For the collective has no existence and reality but in the action of individuals. It comes into existence by ideas that move individuals to behave as members of a definite group and goes out of existence when the persuasive power of these ideas subsides. The only way to a cognition of collectives is the analysis of the conduct of its members.” (Mises 1962, 81).

Such an analysis presupposes that we understand acting men as rational men. They have reasons to think what they think and to do what they do. Every action, according to Mises, is necessarily rational in that it always follows a process of thought about the adequation of means towards the achievement of ends. Although Weber allowed, in his typology of social actions, for actions non-rationally oriented (Weber [1922] 1978, 24–5), Weberians such as Boudon have argued that an action can be thus classified only “residually,” that is, when it is impossible to understand an action in another way than by classifying it as a result of “impulses” (Boudon 1986, 294 n. 14). To Mises, these “actions” are, of course, mere behaviors. But since Boudon insists on the residual classification of such “actions,” there is usually no major contradiction between his and Mises’s methods of understanding.

If it is quite clear, then, that—according to the Misesian framework—Weberian sociology proceeds to analyze historical social phenomena in a satisfactory manner, it is not the case for sociologists that deny the validity of methodological individualism and rationalism. For instance, Durkheim’s method of using aggregated statistical data or legal codes in order to explain collective phenomena (explaining “social facts” by other, temporally prior or concomitant, “social facts”)—his methodological holism (see Durkheim [1895] 1982, 162)—presupposes action without properly taking it into account, and is therefore inadequate to provide any explanation at all. It is not “society” that imposes its “will” to the individuals, as Durkheim would have it, thereby allowing for a methodology that merely attempts to describe how an aggregate phenomenon Y followed another aggregate phenomenon X and that somehow pretends to have thus provided an explanation of Y. This method simply cannot provide any explanation of Y, for it is only a study of individual actions reconstructing phenomena X and Y that can help us elucidate questions such as: why was X followed by Y?; must X necessarily be always followed by Y?; and so forth.

Rationality and individuality, then, are at the center of Mises’s analysis of social evolution and devolution. Societies improve or decline based on the degree to which the individuals that compose them understand the benefits of increasing the division of labor.

Praxeology alone can teach us that increasing the division of labor is a process which allows for the maintenance and increase of material standards of living. But to claim that this process constitutes an improvement presupposes that we accept a few empirical assumptions. First, it must be accepted that individual actors generally seek to increase their material conditions of living (Mises [1949] 1998, 180). Indeed, if this were not the case, one could not talk of social progress when labor is further divided. Second, it must be accepted that these same actors tend to have a relatively low time preference, i.e., they do not seek to quickly, and for a short period of time, increase these standards of living at the cost of their long-run standards of living. For if this were not accepted, a society where there is just enough division of labor to have some wealth and where it is possible to fight and steal would still allow many individuals to improve their material wealth in the short-run while sacrificing the long-run process which allows material wealth to grow. Once these hypotheses are accepted, it is possible to better understand Mises’s analyses of how societies emerge, grow, and fall. The following section will contrast Mises’s social analyses to that of some of the major figures of early sociology and derive from them the distinct, praxeologically guided, sociology of Ludwig von Mises.

2.1. Division of Labor and the Emergence of Society

The question of the link between division of labor and the evolution of societies has been studied in depth by many sociologists. For instance, French sociologist Émile Durkheim argued that division of labor is the outcome—not the cause—of social development. Indeed, Durkheim criticized Herbert Spencer and the economists for their alleged failure to provide a rigorous explanation of the causes of division of labor. He accuses them of presenting a simplistic explanation, i.e., an explanation according to which isolated individuals suddenly recognize the productive advantage that it implies and that dividing labor will therefore make them happier (Durkheim [1893] 2013, 212).

His argument against this doctrine is, briefly put, that since division of labor has no known limit, if Spencer and the economists were right, then there would be also no known limit to happiness. But the science of psychology indicates that happiness is limited. Therefore, Spencer and the economists failed to explain why we still divide labor further (Durkheim [1893] 2013, 214–15). For Durkheim, the cause of the extension or intensification of the division of labor must thus lie outside of the individual. He finds it in the increases in the volume and density of the population (244). The increases in volume and density imply a larger market, which creates new needs, but also an increase in competition that forces the weaker members of society to specialize in order to survive (251–52). In other words, it is the “struggle to survive”It is unclear if Durkheim employed the terms “struggle to survive” in the usual sense of fighting for scarce resources or in the confused sense of competing for them (or if he subsumed both under the same category). There is, however, a clear distinction between fighting and competing in that the latter allows for the allocation of scarce resources to those who are inclined to provide consumer goods that are more highly valued, whereas the former seeks to deprive others of what they have. See Mises ([1922] 1951, 320–21; 1962, 88). that “forces” an expansion of the division of labor (248).This argument was supposed to contradict Spencer’s description of the extension of the division of labor. However, as noted by Perrin (1995, 793–94), Spencer did consider the influence of population pressures as one of the causes of the extension of the division of labor. For Durkheim, then, division of labor is a consequence of society rather than a cause (241).This theory is not completely shared by other sociologists. See for instance Georg Simmel ([1900] 1978, 175), who argues that social bonds and societies emerged from exchanges. It is imposed on the individual actors rather than chosen willingly as a means to prosper.

But these forces are not as “external” to the individual as Durkheim would like them to be. True enough, changes in man’s social environment can become problematic. An increase in scarcity (which can indeed be affected by population pressures) decreases the output per capita. This is the Malthusian law of population. But this in no way forces society to divide labor in the same sense that the law of gravitation forces earthly objects to fall when thrown.Durkheim indeed thought that his theory has the same status in the social world as the law of gravitation has in the natural world. See Durkheim ([1893] 2013, 330 n.1). Rather, as Mises ([1922] 1951, 293 n.1, 315–16) indicated, division of labor must first be recognized by individuals as a means to increase productivity for it to be extended in order to overcome or alleviate the effects of the struggle for existence that would otherwise prevail.

Far from being something which society imposes on the individual, the division of labor is something which he agrees to participate in because he recognizes it as a solution to a problem. This contradicts Durkheim’s classification of the division of labor as what he calls a “social fact,” and which he defines as “[…] manners of acting, thinking and feeling external to the individual, which are invested with a coercive power by virtue of which they exercise control over him.” (Durkheim [1895] 1982, 52). The increase of the division of labor, for Mises, is a deliberate means that men use in order to achieve their goals more efficiently (Salerno 1990, 28). It is also precisely because of the higher productivity of the division of labor that we can sustain growths in population density and volume, as Mises ([1922] 1951, 293 n.1) indicated, and that we can substitute cooperation for the war of all against all that characterizes the struggle to survive (Mises [1949] 1998, 159, 175, 663).

Therefore, according to Mises, although it is true that society pre-exists the individual and that man is not born in a cultural or social vacuum (Mises [1922] 1951, 315; [1949] 1998, 143, 164), it is incorrect to argue that society causes cooperation and the division of labor. On the contrary, it is cooperation that allows the creation of sophisticated social bonds such as friendship or love; it is the capacity of man to recognize the superiority of the division of labor as compared to autarky that creates a web of social links which we call civilized society (Mises [1949] 1998, 143–45). Indeed, Mises wrote: “Human society is an intellectual and spiritual phenomenon. It is the outcome of a purposeful utilization of a universal law determining cosmic becoming, viz., the higher productivity of the division of labor.” (145). And elsewhere: “Civilization is a product of leisure and the peace of mind that only the division of labor can make possible.” (Mises [1922] 1951, 305).

The sociological question of the causes of social evolution and devolution is therefore resolved by Mises. Although Durkheim is right in insisting on the fact that division of labor presupposes at least a primitive form of trust,On the loyalty that characterizes primitive tribes, and on how it is the outcome of ideas, see Mises (1962, 81). this is insufficient to demonstrate that social development is merely driven by pressures that are external to the individuals. Indeed, individuals are by no means forced to participate in the division of labor; they do so because they recognize that this is beneficial to the achievement of their various purposes.

It is the division of labor, then, which allows social scientists to distinguish society as the rational form of cooperation it has become from the mere impulses to associate such as what can be found in groups of animals (Mises [1922] 1951, 297). It is the variations in the extent and the intensity to which labor is divided that determine the evolution or devolution of society and which make it scientifically understandable (299–300; [1949] 1998, 160). Social evolution is therefore teleological (Mises [1922] 1951, 291; Salerno 1990), i.e., based on the rational thinking of individuals associating in order to overcome or alleviate natural or social problems—to “remove uneasiness,” as Mises would put it. It is not the necessary consequence of external sui generis social forces, as Durkheim and other sociologists have argued. Civilization, to Mises, is the purposeful result of an increase in the division of labor and the capital accumulation it allows, whereas social decline is the result of the reduction of the division of labor.

To understand social history, then, sociology must first identify whether and how the individuals are willing to extend the division of labor. It must describe how societies and civilization historically evolved or devolved by using this general criterion.

2.2. The Social Effects of Socialism and Capitalism

One of the effects of socialism, Mises ([1922] 1951, 458, 497) indicates, is to destroy the division of labor, and, therefore, civilization. The opposite is the case for capitalism. It is because the market economy is based on the division of labor that it is possible to “regard each other as comrades in a joint struggle for welfare, rather than as competitors in a struggle for existence.” (Mises [1922] 1951, 294–95) Thus, according to Mises, capitalism allows us to see our neighbor as a friend rather than a foe, for we do not see him as someone that will deprive us of scarce resources, but as someone with whom we can exchange and prosper. In other words, capitalism allowed for civilization to emerge because it presupposes a division of labor that bridges the potential divisions between men. As Mises pointed out, it is vain to try to preserve civilization without preserving capitalism because high culture and polite society rest on economic means that can only be obtained in a sufficient amount when the division of labor is unimpaired by state intervention (310). Thus, capitalism allows society to civilize itself whereas socialism dismantles it.

Indeed, for Mises, the erosion of civilization is inevitable under socialism. Dissenting opinions are to be prohibited, for only the central authority (not the consumers) has the power to decide what is allowed and what is not. With the socialist regime being in charge of the allocation of all scarce resources, it is impossible, for instance, for any scientist, artist or writer to seek funds in another way than to satisfy those who are in charge of this regime (Mises [1922] 1951, 188–89). Thus, socialism puts an end to some of the highest achievements of civilization—arts and sciences. In stark contrast, a capitalist society allows anyone to sell his artistic or scientific work to the public or to find a sponsor (189).

Indeed, Mises (194) writes, capitalism protects freedom. Not in the sense that it annihilates the costs of all actions of course, but rather in the sense that it allows individuals to be protected against arbitrary rules to a larger extent than any alternative system (192–94). One must not see freedom as the absence of rules, but rather as the absence of arbitrary rules. Indeed, some rules are unavoidable if one wishes to live in a society. If one desires to obtain the economic benefits of the division of labor and the social benefits of friendship, love, and cooperation, then one must adapt his actions in light of what the others desire.

But the rules imposed by the State are arbitrary. The State is not capable of meaningful economic calculation, and can therefore not adapt its action with the preferences of society. It is bound to make decisions and create rules that are merely based on the preferences of the ruling class (Mises [1922] 1951, 195). Indeed, economic calculation based on private property renders the cost of many actions more apparent than it would be otherwise (Mises [1949] 1998, 230); it allows for the estimation of how various actions will be profitable (Salerno 1990, 48). Hence capitalism, by making the satisfaction of consumers a condition of possibility for profit, makes it clear that there exists a bilateral dependency between the producer and the consumer: the producer depends on the consumer because he needs to sell goods in order to become a consumer himself and the consumer depends on the producer because he needs to obtain goods in order to maintain or improve his standards of living. The freedom to trade allows for this fact to be understood and for one to see one’s fellow men as allies in the achievement of his own goals. And this freedom, by favoring the increase of the division of labor, provides society with the means to evolve into civilization. 

We can now be more precise as to how sociology must describe the evolution of societies. It is by observing how socialistic or capitalistic a society is that one can understand its evolution. Because capitalism is the economic system allowing for an extension of the division of labor and because socialism destroys it, a sociologist can analyze social evolution by looking at whether and to what extent capitalism prevails in a given society.

2.3. On Class Conflicts

Mises wrote quite a lot on group or class conflicts. To be sure, his analysis of class conflicts is very different from the most famous one (and one of the most widely used in sociological analyses), i.e., that of Karl Marx. True, Marx’s analysis of class conflicts stems from the identification of an important question: Why is it that several groups within society seem to dislike or fight one another? But this is already giving too much credit to Marx. Indeed, class analysis was already used by many economists and social scientists before him. For instance, the non-socialist French industrialists—in particular Charles Dunoyer—had already delineated a framework for class analysis before (Leroux 2016, 86). It thus comes as no surprise that Mises’s own class analysis is much closer to that of Dunoyer and other French classical liberals than to that of Marx and the Marxists.This has been pointed out by Murray Rothbard in his 1978 preface to Mises’s The Clash of Group Interests. See Rothbard (2011, ix).

The question that both Marx and Mises attempted to answer is: why are there clashes between groups within society? The Marxist answer to this question is based on historical material conditions of production and class consciousness (Lukács [1923] 1971). It is because a dominated class is composed of individuals who realize the singularity of their own class with respect to its links to the material conditions of their time that irreconcilable interests become conflicts with the other—dominant—class. Under capitalism, the capital owners are the oppressors and have a common interest to keep and extend their “domination” over those who do not own the means of production. The laborers (proletarians) are the oppressed and, once they realize their oppression, have an interest in destroying the capitalist system which captures the plus-value of their labor (Marx and Engels [1848] 2012). According to the Marxists, there is only one way to arrive to a general state of peaceful interactions within society: one class (the proletarians) must violently take control of society as a whole and impose its own will on it.Mises (1990, 210–11) writes: “The Marxians promise us peace for the time after the final victory of the proletarians, precisely, in the words of Marx, after the working class will have passed ‘through long struggles, through a whole series of historical processes, wholly transforming both circumstances and men’.” Mises calls it the “peace of the graveyard,” as opposed to liberalism’s “peace of progress” (Mises [1922] 1951, 85).

But, as Mises pointed out many times, Marx’s class theory is, at best, unconvincing. One can indeed proceed to class distinctions based on the economic concepts of labor or capital in order to scientifically establish the distinctions between what it is to be a laborer and what it is to be a capital owner (Mises [1922] 1951, 331–32). But, first, the mere fact that such a distinction can be done for scientific purposes is no proof that the interests of the laborers are homogeneous or that the interests of the capital owners are homogeneous; and second, even if this were the case, it is still no proof that the interests of the laborer and that of the capital owner are necessarily opposed (in fact, quite the opposite is the truth: the so-called “oppressed” accepts, under capitalism, to exchange his labor time for an immediate income, see Mises [1922] 1951, 334–35).

Instead, argued Mises, class antagonism is the result of state privileges. One needs to explain why, given the heterogeneity in values and interests between various groups, they cannot coexist peacefully. For a variation in values and interests is not a sufficient condition to explain why one group pursues its own interests at the expense of another group. One must also look at the social context which constitutes the vector translating this original heterogeneity of group interests to the resulting situation of conflict. And this social context, for Mises, is the lack of respect for private property rights and for the market economy. In other words, it is because of the state’s redistributive or restrictive policies that diverging interests become class conflicts (Mises [1945] 2011, 10). Class conflicts, then, can only occur between two broadly conceived (and internally changing) classes: those who obtain privileges through the state, and those who must pay the price of these privileges; the productive class and the expropriating class (Hoppe 1990, 83–4).

Without State privileges, despite the multiplicity of individual or group interests, no group can advance its own interests at the expense of another (Mises [1945] 2011, 7). For Mises, a more general kind of “interests,” which he calls “long-run” or “rightly understood” interests, corresponds to this idea that specific interests can always, in the long-run, be realized more efficiently and without conflict in a market economy. Thus, Mises writes that the “rightly understood” interests are “harmonious” (16–7).As Leroux (2011, 136) noted, Mises’s formulation is very similar to that of Frédéric Bastiat. Not in the sense that all specific interests become exactly the same of course, but in the sense that their heterogeneity does not systematically lead to conflict and predation within society. In other words, the only way to achieve one’s most desired goals in a free market is to be able to first produce what the other members of society desire. It is in this sense that, although different, all interests are harmonious; everybody profits from the fact that everybody else achieves his goals. Systematic clashes cannot occur without state privileges: “Under free trade,” Mises tells us, “the manufacturers of shoes are simply competitors. They can be welded together into a group with solidarity of interests only when privileges supervenes, e.g., a tariff on shoes (privilegium favorabile) or a law discriminating against them for the benefit of some other people (privilegium odiosum).” (7).

Thus, in this perspective, we may understand social evolution or devolution by defining two broad classes: those who participate in and extend the process of division of labor (those who make a living by attempting to produce what is desired by consumers) and those who benefit from its destruction in the short-run (those who receive privileges from the state). The first class (the productive class or, using the French classical liberal terminology, the spoliés or the industrieux) is struggling in a fight against the second class (the spoliateurs).It becomes immediately clear what Marx’s mistake was; it was a misidentification of the “exploiters” and the “exploited” (Hoppe 1990, 83–5, 92 n.13). The whole history of mankind under statist conditions can indeed be understood by describing class conflicts between the productive class and the parasitic class. This is not the case with the arbitrary class distinctions of the Marxists. For a more detailed analysis of the similarities and differences between the Marxist and the Austrian theory of class conflicts, see Hoppe (1990). It is the task of history and sociology to identify the specific composition of these classes and to describe their interactions at any given time and place.

In order to assess the extent to which capitalism prevails (and, consequently, the extent to which division of labor and social evolution occur), a sociologist must then look at the specific group conflicts occurring in a society and their singularities. He must identify the composition of the productive class and of the parasitic class in order to understand the particular elements of socialism that prevent social evolution.

2.4. Ideology and the Role of Ideas

All of this leads to a final question: given that increasing the division of labor reduces class conflicts and leads to social evolution whereas the reduction of it leads to more class conflicts and social devolution, what factors determine the shift of societies towards one or the other? The most important factor, according to Mises, is the role of ideas and of ideology.

Vilfredo Pareto thought that what can convince a population to adopt certain ideas or ideologies are emotions or sentiments rather than reason (Valade 1990, 147). This is why, in his opinion, socialist ideas triumphed over classical liberal ideas. The former were defended by appealing to emotionally pleasing utopian promises whereas the latter were generally defended by mere arguments (Pareto 1902, 66–7). Some actions and ideas are therefore irrational. And this was the foundation of his sociology, i.e., the study of “non-logical” actions (Pareto 1917, 76; Valade 1990, 265).

In contrast, for Mises, there is no such thing as “non-logical actions.” Indeed, we have already seen that, according to him, every action must be conceived as rational to be understandable. There is no point in arguing against Pareto that emotions and sentiments play a role in shaping ideas. However, as Boudon for instance maintained, the manner in which passions are oriented is not intrinsic to them (Fillieule 2014, 102). Anger, for instance, can be used to appeal for either socialistic or capitalistic ideas. One must provide the public with justifications for why they should be angry at capitalism in order to convince them to support socialism. One must provide a plausible justification for attributing to capitalism an event or condition that makes people angry. Actions will be guided by accepted ideas.

Indeed, Mises ([1949] 1998, 177) argued that ideas and the process of thinking are presupposed by any action. The origin of these ideas is social, i.e., thought is always influenced by the social context of an individual. But this does not imply that society has any thoughts of its own that it imposes on the individuals (Mises 1990, 290–91). Only individuals can think. The individual must thus reconstruct, in his own mind, the ideas that he encounters in society into an ideology. For Mises ([1949] 1998, 178), an ideology includes elements of scientific ideas and elements of moral ideas. Praxeology has nothing to say about moral ideas, according to him. But from the moment we know or assume to know the ultimate ends of individuals, praxeology can judge the quality of the means that are thought to bring about the desired ends. Thus, any ideology aiming at human prosperity that is in any way antithetical to the division of labor will lead to failure (Mises [1949] 1998, 180–84). But describing how or why such ideology is accepted and how it is connected to a particular social change is a matter of history or thymology. And contextual rationality can be used as an additional tool to understand an ideology and the manner by which it spreads.This was noted by Fillieule (2014, 100–02).

For instance, Mises ([1922] 1951, 358) writes that the workers’ typical adherence to socialism can be understood by looking at what, given their social context, can lead them to accept the tenets of the socialist doctrine. Mises indicates:

The workman in the large or medium scale capitalist enterprise sees and knows nothing of the connections uniting the individual parts of the work to the economic system as a whole. His horizon as worker and producer does not extend beyond the process which is his task. He holds that he alone is a productive member of society, and thinks that everyone, engineer and overseer equally well as entrepreneur, who does not, like himself, stand at the machine or carry loads, is a parasite. Even the bank clerk believes that he alone is actively productive in banking, that he earns the profit of the undertaking, and that the manager who concludes transactions is a superfluity, easily replaceable without loss. Now from where he stands, the worker cannot see how things hang together. He might find out by means of hard thinking and the aid of books, never from the facts of his own working environment. Just as the average man can only conclude from the facts of daily experience that the earth stands still and the sun moves from east to west, so the worker, judging by his own experience can never arrive at a true knowledge of the nature and functioning of economic life. (Mises [1922] 1951, 358)

Given this fact, it becomes easier for the socialist ideologue to argue that it is the economic system of capitalism which makes the workers’ tasks underappreciated, and that substituting socialism for capitalism would bring them greater wealth and recognition. This helps shaping their own beliefs: “The masses incline towards Socialism, not because it really tends to their interests but because they believe that it does so.” (Mises [1922] 1951, 358) An ideology is propagated through the use of reasons provided to the public with the aid of which they can make sense of their own local situation and orient their passions (see Boudon 1986).

It is precisely because some actors are more prone to commit such errors that they support socialism; these actors truly believe that the market economy leads to an outcome which is ethically or economically undesirable, and this is the exact reason why they oppose it. It is without any doubt his belief that ideas are the driving force of action that led Mises to carefully address the mistakes of the socialist doctrine. For once the public is aware of them, it becomes difficult to implement it. True enough, resentment of those who succeed under capitalism can still be felt (see Mises [1956] 2008). But resentment does not constitute an argument. And once all arguments in favor of socialism are shown to be invalid, it becomes increasingly difficult to orient the public’s passions against capitalism: “Only ideas can overcome ideas and it is only the ideas of Capitalism and of Liberalism that can overcome Socialism. Only by a battle of ideas can a decision be reached.” (Mises [1922] 1951, 507)

To those like Pareto who believe that reason can never triumph over passions, Mises responds: “This pessimistic point of view is completely mistaken in its estimate of the influence which rational and quiet reflection can exercise on the masses. It also exaggerates enormously the importance of the part played by the masses, and consequently mass-psychological elements, in creating and forming the predominant ideas of an epoch.” (Mises [1922] 1951, 507–08) Since the masses are much less prone to think about ideas, they tend to accept the ideas of those who have the time and ability to do so (Ibid.). Educating the thinkers can then influence the ideas of the masses, which can then allow capitalism to triumph over socialism (510). But, it is true, the opposite can also occur.

It is ideas, then, as was also pointed out by Salerno (1990, 53), that are the driving forces of social change for Mises. And it is the task of history and sociology to study the variations in the spread of ideas and ideologies in order to understand social evolution or devolution (Mises 1990, 295, 297–98). Their task is to inquire about the reasons that made an idea consistent with the extension of the division of labor spread to the population sufficiently to bring social evolution (or that made an idea that is inconsistent with it spread to slow down or reverse this evolution).

Now let us sum up everything that has been said in the second section of this paper. Mises provided us with a general framework of understanding for sociological inquiries. In light of this, a sociologist must identify the reasons that made specific ideas prevail in society or in some of its parts. This can explain the specific composition of the productive class and the unproductive class of a society. This class composition then informs us on how, specifically, and to what extent, socialism or capitalism prevailed in a society. In turn, this explains how a society evolved or devolved, since capitalism leads to an increase in the division of labor whereas socialism leads to a decrease in it. We can thus, following Mises’s methodological singularism, reconstruct step by step the evolution or devolution of society while answering many singular sociological questions along the way. With all these insights, sociologists can usefully contribute to our understanding of social phenomena and social changes that occurred throughout history.

It has been shown in this paper that Ludwig von Mises, although primarily an economist, has addressed both the epistemological questions and many of the controversial topics of the discipline of sociology. In brief, sociology is a historical discipline. Its main task is to provide us with an understanding of actions and the results of actions that occurred in the past or are likely to occur in the future. It must in particular attempt to find the values and ideas that influenced the shift towards social evolution or devolution. It must also attempt to identify the reasons why these values and ideas prevailed.

To do so, praxeology is necessary but insufficient; sociology must use additional tools to analyze the social world. It must have specific criteria on which to base its judgements about social evolution or devolution, i.e., the extension or destruction of the process of division of labor. It must assume contextual rationality and use methodological individualism in order to identify whether and why different groups of individuals shared the values and ideas they had at the time and place they had them. It must find out if these values and ideas were consistent or antithetical to social evolution and connect them to historical trends. It requires the identification of classes of individuals based on whether their ideas, values, and actions were consistent or antithetical to social evolution. In brief, sociology must be a praxeologically oriented study of general history. In strike contrast to holistic sociology, a Misesian sociology (not unlike a properly understood Weberian or Boudonian sociology) is first interested in the individual and his rationality in order to understand larger complex social phenomena.

As such, and by considering “macrosocial” phenomena such as society or culture as the result of individual actions and interactions based on ideas (“microsocial” phenomena), Misesian sociology allows for a better understanding and explanation of social change than by considering macro phenomena as the ultimate bases of social explanations or by considering both macro phenomena and micro phenomena as analytically independent entities of equal importance in providing explanations. Contrary to contemporary metatheories such as that of George Ritzer (see Ritzer and Stepnisky 2018, 596–600), which often correctly assert that there exist interactions between the micro and the macro levels of explanation but fail to recognize the more fundamental character of action and thought in our understanding of social phenomena, Mises’s allows us to reconstruct macrosocial phenomena of interest from their ultimate origins in actions and ideas. Even when, from a strictly analytical perspective, an explanation seems to be only involving macrosocial phenomena, one can upon further investigation recognize that, ultimately, the proper explanation is rooted in actions and ideas. For instance, an increase in population can indeed explain why we divide labor more, as Durkheim argued, but this is only because individual actors recognize that dividing labor more is a means to avoid the decrease in standards of living it would otherwise bring. And the ultimate explanation for population increases must also be found in actions and ideas. Failing to recognize such microsocial origins to macrosocial phenomena can lead to the erroneous belief that individuals play only a very minor role (if any) in the formation of their own thoughts and actions, as Durkheim thought; the individual’s ideas and actions are then merely seen as the unavoidable result of deterministic social forces that are imposed on him. Although it is often heuristically useful to consider an aggregate social phenomenon as given in order to explain some other phenomena, one must always keep in mind while doing so that these social phenomena are ultimately rooted in actions and ideas.

These many insights of Mises can help sociologists (or economists interested in complementing their work with sociology) reconstruct the discipline of sociology on firmer grounds.

With the fall of the Berlin Wall, East Germans, who had lived under severe restrictions on travel and emigration, were able to freely travel to West Berlin, which continued a chain of events already begun earlier that year in which many anti-Soviet dissidents throughout Eastern Europe became emboldened and met with unprecedented success. Meanwhile, East Germans flooded into neighboring countries by the thousands, seeking refuge from Soviet-sponsored oppression in Austria and West Germany.

Throughout the mid-twentieth century, Eastern Europe was home to numerous anti-Soviet revolts and acts of civil disobedience. In Hungary in 1956, Prague in 1968, and especially in Poland throughout the 1970s and 1980s, resistance flared up, but was reliably crushed with Soviet-sponsored martial law and outright military intervention.

But in the summer of 1989, the Poles held an election that essentially overthrew the Soviet-approved regime in Poland. This, time, however, instead of sending tanks to crush the Polish agitators, the USSR did nothing.

By November of that year, dissidents had become emboldened by Soviet inaction. Hungary and Czechoslovakia haphazardly opened their borders, allowing East Germans to stream into Austria and on to West Germany. East Berliners began to demand free passage to the West. The “fall” of the wall, soon followed.

Americans today, and especially American conservatives, like to claim that the end of the Soviet bloc and the Soviet Union was America’s doing; that the Soviet oligarchs feared American military might, and simply decided to give up and vote themselves out of existence, as they did two years later. This tale makes for nice domestic propaganda in America, but the fact that regimes virtually never just “give up” without firing a shot when faced with a threatening foreign power makes it rather unlikely.

We are far more likely to find an answer if we ask ourselves not why the American state was so strong in the 1980s, but why the Soviet state was so weak. If the Soviets were more than capable of maintaining “order” in Eastern Europe during the 50s, 60s, and 70s, why was it unable or unwilling to do the same in the 1980s?

An inquiry along these lines quickly leads us to find that by the 1980s, the soviet economy, and most of the economies of Eastern Europe were economic basket cases. Housing was in disrepair. Vehicles and appliances were incredibly old-fashioned and unreliable. The standard of living was a fraction of what it was in the “West.” Basic items like soap and women’s pantyhose were often luxuries.

In other words, the centrally-planned economies of the Soviet bloc produced little actual wealth, and as the regimes siphoned off more and more of what little wealth was being produced, the people, as well as the regimes, became poorer and poorer.

This economic weakness meant not only that the legitimacy of the regime was imperiled, but that the Soviets no longer enjoyed a military “surplus” with which they could simply roll into every rebellious neighborhood and re-establish order.

In other words, the USSR was too poor to pay the political bills.

None of this would have surprised Ludwig von Mises. Decades before, Mises had shown that a socialist economy (by which he meant a centrally planned economy) could not possibly know what to produce, when to produce it, or for whom to produce. In explaining this, Mises proved that the Soviet Union, regardless of any victories it might have in remolding human nature, was economically impossible. Rothbard explains:

Before Ludwig von Mises raised the calculation problem in his celebrated article in 1920, everyone, socialists and non-socialists alike, had long realized that socialism suffered from an incentive problem. If, for example, everyone under socialism were to receive an equal income, or, in another variant, everyone was supposed to produce “according to his ability” but receive “according to his needs,” then, to sum it up in the famous question: Who, under socialism, will take out the garbage? That is, what will be the incentive to do the grubby jobs, and, furthermore, to do them well? ...

But the uniqueness and the crucial importance of Mises’s challenge to socialism is that it was totally unrelated to the well-known incentive problem. Mises in effect said: All right, suppose that the socialists have been able to create a mighty army of citizens all eager to do the bidding of their masters, the socialist planners. What exactly would those planners tell this army to do? How would they know what products to order their eager slaves to produce, at what stage of production, how much of the product at each stage, what techniques or raw materials to use in that production and how much of each, and where specifically to locate all this production? How would they know their costs, or what process of production is or is not efficient?

Mises demonstrated that, in any economy more complex than the Crusoe or primitive family level, the socialist planning board would simply not know what to do, or how to answer any of these vital questions. Developing the momentous concept of calculation, Mises pointed out that the planning board could not answer these questions because socialism would lack the indispensable tool that private entrepreneurs use to appraise and calculate: the existence of a market in the means of production, a market that brings about money prices based on genuine profit-seeking exchanges by private owners of these means of production. Since the very essence of socialism is collective ownership of the means of production, the planning board would not be able to plan, or to make any sort of rational economic decisions. Its decisions would necessarily be completely arbitrary and chaotic, and therefore the existence of a socialist planned economy is literally “impossible” (to use a term long ridiculed by Mises’s critics).

The Soviet central planners never had an answer to this critique. Indeed, their “answer” only came in 1991 when the USSR finally shut itself down. And even up to the end, American Keynesians never figured it out either, and Paul Samuelson still claiming in 1989 that a “socialist command economy can function and even thrive.”

In response to Mises’s claim of the impossibility of central planning, some then ask “well, if central planning was impossible, why did it last so long?”

The answer can be found in the fact that even in a centrally planned state, capital does not simply vanish overnight. The soviet planners were not starting with nothing. They had the accumulated capital of centuries of savings and investment by Russians, Ukrainians, Germans, Poles, and others under their control.

True, it was not possible for them to correctly plan or determine non-arbitrarily what goods should be produced. But they nevertheless had large amounts of capital at their disposal, and even if the centrally planned state produced zero wealth (which was not true since even the Soviet state produced some things people wanted), the state still had plenty of wealth to redistribute until it was all gone.

This is all the more true for regimes that are only partly centrally planned, as in the case of Venezuela, on which Nicolás Cachanosky observed:

[I]f one of the wealthiest and developed countries in the world were to adopt Cuban or North Korean institutions overnight ... [t]he wealth and capital does not vanish in 24 hours. The country would shift from capital accumulation to capital consumption and it might take years or even decades to drain the coffers of previously accumulated wealth. In the meantime, the government has the resources to ... enjoy the wealth, highways, electrical infrastructure, and communication networks that were the result of the more free-market institutional realities of the past.

Eventually, though, the “reserve fund,” as Mises called it, is used up:

An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.

In addition to this, the Soviets made money for the regime by selling oil (and other goods) in international markets, and high oil prices in the 1970s propped up the regime so well, that had it not been for Soviet oil sales, it’s quite possible the regime would have collapsed a decade earlier.

As the mainstream news outlets cover the anniversary of the Berlin Wall’s fall this year, they will surely spend much time discussing the role of various American politicians, and military programs, and international relations. It is quite possible that all of these things had an effect on the regimes of Eastern Europe that were non-trivial. Nonetheless, such analysis ignores the huge elephant in the room which is the inevitable failure of regimes that are built on central planning and wealth re-distribution. Without markets and prices, there can be no planning, and without planning, no wealth creation, and ultimately, no political durability. The rebels and demonstrators of Eastern Europe deserve immense credit for courageously standing up to the state. But in the end, those who were successful were helped immensely by good timing and bad economics.

religion    libertarianism    enlightenment

The Lou Church Memorial Lecture

It is broadly accepted that out of Enlightenment thinking came many of the “goods” of our society; goods economic, political, and social. Goods ranging from the material wealth and the technology we enjoy to classical liberalism and libertarianism. It is on the latter that I will focus.

An exhaustive discussion of the connection of Enlightenment thought to Classical liberalism and libertarianism is not necessary for this audience, so I will summarize: reason, the individual, equality, property rights, the separation of church and state, and science and politics freed from religious dogma. These pillars underlie the classical liberalism that many point to and exclaim: here, we finally found freedom! Instead, what if these have cost us our freedom?

What is Enlightenment? Immanuel Kant gave his answer:

Enlightenment is man’s release from his self-incurred immaturity. Immaturity is man’s inability to make use of his understanding without direction from another….” Have courage to use your own reason!” That is the motto of enlightenment. (Kant 1784)

There is Diderot’s Encyclopedia, considered “one of the greatest cultural and intellectual achievements of the Enlightenment;” (Champion 2012) a 20 million word man-made blueprint for the creation of a rational, improving and cultivated society.

Theology is kneeling, subordinate to reason. Diderot explained: “in countries enlightened by the light of reason and philosophy… the priest never forgets that he is man, subject and citizen.” (Champion 2012) Or as Steven Pinker proclaims: Enlightenment Now: The Case for Reason, Science, Humanism, and Progress. In other words, the case against tradition and religion—and by “religion,” read “Christianity.”

Yet who can deny the progress? It is easy to identify the many “goods” we attribute to Enlightenment thinking—the acceleration of trade and the drastic improvements in the economic standard of living. Political concepts such as classical liberalism are developed, and therefore—we believe—our freedoms.

Well, maybe. As Hans Hoppe (2018) offers, “According to the proponents of this theory,” of which he mentions Francis Fukuyama and Steven Pinker, “what makes the present age so great and qualifies it as the best of all times is the combination of two factors.” Hoppe offers first, the highest levels of technology and natural science in human history—to which he raises no objection; and second, the highest level of human freedom—which Hoppe considers “a historical myth.”

N. T. Wright offers: “Any movement that gave us… the guillotine as one of its first fruits and the Gulag as one of its finest cannot simply be affirmed as it stands.” (Wright 2008)

The “bads” of the Enlightenment are not so readily admitted by its proponents: communism, eugenics, racial purity, selective breeding, National Socialism, Fabianism, Progressivism, fascism, egalitarianism, modern democracy, freedom from all intermediating governance institutions, the ineffective separation of church and state, the American Revolution, the French Revolution.

Regarding the two revolutions: The America that came out of the Revolution is described by Ralph Raico as “…the model liberal nation, and, after England, the exemplar of liberalism to the world.” This “exemplar of liberalism” didn’t survive four-score-and-seven years, ending in 1861—and if you prefer to make a case for 1846 or even 1812, you will get no argument from me. Whatever one believes regarding liberalism, staying power certainly cannot be considered a meaningful characteristic.

But this example is much more successful than what came shortly thereafter: from his magnum opus, From Dawn to Decadence, Jacques Barzun offers (2000): “…the French Revolution of 1789 must be called the Liberal Revolution.” What does Barzun mean by “liberal”? He offers as an example a law passed two years after the outbreak: there are to be no interests other than the interests of the individual and the general interest of all; no intermediate interests are permitted.

An attack not only on tyrannical authority, but also on guilds, associations, universities, and especially Christianity—every intermediating institution that provided decentralization in governance and stood against the monopoly authority of a centralizing state; every intermediating institution that Robert Nisbet suggests offered the individual room and cover for his freedom.

Simon Schama (1989) offers that such an attack on intermediating institutions was welcomed by the elite; the people—powerless without these intermediating institutions or the king to turn to—saw it another way.

Not all Enlightenment thinkers wished for the guillotine or the gulag, as we certainly know; many sincerely held man’s liberty in their sights. John Gray (2018) offers that the asserted universal truth of the link between the Enlightenment and liberal values is tenuous; it was strongest in Enlightenment monotheists and weakest in those thinkers hostile to monotheism.

Yet a generic “monotheism” offered no sustainable foundation. Our liberties were born well before the Enlightenment in a specific cultural and religious tradition; those who lived in and developed this tradition would not refer to themselves blandly as “monotheists.”

Let’s look at this history. Barzun offers:

The truth is that during the 1,000 years before 1500 a new civilization grew from beginnings that were uncommonly difficult…. showing the world two renaissances before the one that has monopolized the name. …the Germanic invaders brought a type of custom law that some later thinkers have credited with the idea of individual freedom.…no rule was held valid if not approved by those it affected. …Anglo-Saxon law… defined crime literally as breaking the peace.

This era was born after the fall of Rome; Germanic tribes mixed with Christianity to create a culture that valued Christian ethics and German honor, resulting in what Fritz Kern describes as the old and good law; law of custom and good tradition. A man’s oath made his law. Any noble could veto the king if he could demonstrate his right in the old and good law. A law regime about as libertarian as has ever existed for an extended period in the west—and even the world.

Neither the Church nor the king held sovereignty. If anything held “sovereignty,” it was the law. Each of the Church and king competed with the other, in different yet overlapping circles; with one or the other taking a stronger or lessor role over the years. In the space between Church and king, freedom blossomed; in the space between Church and king, numerous meaningful intermediating governance institutions took root, giving the individual both the room and the means to exercise his freedom.

It was a time when the Church could reprimand the king despite having no army and no physically coercive means other than what the king provided. Libertarians speak approvingly about the use of shunning when dealing with non-aggressive trespasses. Well, try the eternal shunning of excommunication.

In Ecclesiastes we read of the meaninglessness of life when weighed against the eternity that God has placed in the hearts of men. In the Europe of the Middle Ages, the noble was concerned with his eternal life and God’s eternal kingdom and this concern shaped his behavior; no longer the case since the Enlightenment. The common motto for today’s enlightened “nobility” is “he who dies with the most toys wins.” This is reflected in our time: corruption, lust, and greed define the new nobility.

During much of the Middle Ages, there was a meaningful and functional separation of Church and king, each superior in its realm, neither with sovereign power or authority. Each offering an avenue for appeal if one felt his liberties were unfairly compromised by the other.

Today we have the subordination of church to state. One recalls the exchange between the Jewish priests and Pilate regarding Jesus’ fate. Pilate asked: “Shall I crucify your king?” and in reply, the priests shouted “We have no king but Caesar.” Sounds like a typical Sunday morning in America.

With the Enlightenment, the idea of leaning on tradition and custom was thrown out. The most important tradition to remove was Christianity. Not necessarily its ethics, just the supernatural history, the theology, and the church—as if the ethics could exist for long without God and an institution behind these. Barzun offers, “The Bible must be shown to be a set of fables invented by ignorant or designing people.”

What was a generally accepted belief in Christianity throughout the population began to dissolve in the eighteenth century. N.T. Wright (2018) points to the earthquake in Lisbon on All Saints Day in 1755 as a key event in this regard. A massive earthquake and calamity that completely shook Christianity; man’s reason could not accept that a good and wise God would allow such terrible tragedies.

Drop the ritual and prayers, ignore the priests and monks. “Wipe out the disgrace!” Voltaire said of the Roman Catholic Church. Voltaire—“the Enlightenment illuminated” according to Schama—did his part to make this so, through a series of four and five page pamphlets, consolidated into A Portable Philosophic Dictionary. Who needs 1700 years of scholarship and tradition to shape your philosophy when you can have a portable dictionary?

No more of this God of the Bible; Deism became the religion of “reasonable” men. God did create the universe, but the story of Genesis is a fable. God did set the rules — the laws of science; He has no reason to interfere thereafter. Jesus? Sure, He was a wise and good man; but out with the Virgin Birth and the Resurrection.

The road from Deism went through a revived Epicureanism and ended in Nietzsche’s infamous “God is dead,” to be found in “The Parable of the Madman,” published toward the end of the nineteenth century. After all, how big a leap is it from Deism’s “watchmaker” to Epicureanism’s gods that don’t care to “God is dead”?

“Where has God gone?” [Nietzsche’s madman] cried. “I shall tell you. We have killed him—you and I. We are his murderers. …Whither are we moving now? …Are we not perpetually falling? Backward, sideward, forward, in all directions? Is there any up or down left? Are we not straying as through an infinite nothing?” (Nietzsche [1974] 1882, 1887; 181–82)

The madman found that no one would listen; he lamented that he came too early. The Great War, the suicide of the west, was still a few years away.

What did Nietzsche see as replacing God and His moral law? Man-made ethics would be at the top of the pyramid; the enlightened elite were happy to comply. They would be the “superman,” establishing a “new ethos”: new standards of right and wrong, replacing Christian virtues.

Each of us using our own reason, making our own compass, creating our own definition of true north. One cannot even claim the “non-aggression principle” in such an environment. On what basis?

Well, we do have Hoppe and his argumentation ethics. But not so fast! From his radio broadcasts during World War Two, C.S. Lewis (1941) offers that two people properly argue on the basis of some standard. Frank van Dun (2018) offered a similar comment at last year’s Property and Freedom Society conference. To summarize: argumentation ethics is constantly appealing to the other person’s conscience—the things we already share; literally, common knowledge.

But the ideas of the Enlightenment—Liberty, Equality, the individual, patriotism, and Progress—are all abstract ideas, large buckets that can be filled with a wide variety of contents. We complain that these terms don’t have the meaning that we intend, or the meaning as originally intended—just as socialists complain the same thing.

Who is to say how and with what these buckets should be filled? Based on what foundation? Based on whose reason? Without a common conscience, who—or what—will arbitrate? Voltaire has said “commonsense is not so common.” Well, without sense that is common, on what basis do we live peacefully—in a state of conviviality, as van Dun puts it?

We can’t, and we have proved it. Barzun describes the Great War as “the blow that hurled the modern world on its course of self-destruction.” Yet this blow was struck in the west at the time we consider to be the most enlightened, peaceful and free. The decades before the outbreak of the war are known as La Belle Époque: “the beautiful era.”

It was an optimistic time, born after the end of the Franco-Prussian War in 1871. Regional peace, political stability, passport-free travel, material prosperity, technological and scientific innovations, literature and music. The height of what we might consider classical liberalism and freedom.

Certainly there was regional peace in Europe. But there was much violence between and among these same actors (and against the native populations) in the battle for colonies around the world. The art of violence was practiced and perfected; arms were developed in order to ensure victory. This art would soon be turned inward.

The Great War—perhaps alone among all substantial human conflicts—remains almost unexplainable. Why and how could such a thing have happened when and where it did—in this “beautiful era,” among the enlightened people? Aleksandr Solzhenitsyn (1983) offered an answer: “Men have forgotten God.” Nietzsche’s madman would agree.

In the Great War’s wake, western culture and society were transformed in speed and magnitude perhaps unknown in history: family life broken, careers ended, government allowance in the place of productive work, and a tide of egalitarianism; in other words, the perfect cultural soil for the expansion of monopoly state power.

War became total war, in large part driven by another gift of the Enlightenment, modern democracy. While Lincoln established the precedent fifty years earlier, it was finally in the Great War when war of all against all became generally accepted throughout and within Europe, an event for the nation and not merely the combatants—an “Advance to Barbarism,” as offered by F.J.P. Veale (1953). Poison gas, air raids over civilian populations, submarines destroying ships regardless of flag or purpose, the blockade of civilian food and supplies, even peace not leading to relief.

And church towers used as observation posts, leading to their destruction; painting a picture of the cost of the Enlightenment far better than my few-thousand words.

The war shattered the utopian visions of these students of Enlightenment, leading to the change from what we now call Classical Liberalism to its modern incarnation. Barzun describes this transition as the Great Switch; a switch from the idea that the best government is one that governs least to the best government is one that will give us liberty, good and hard. The “deplorables” are not capable of liberty; it must be forced upon them. At the time, the transition was barely noted, except by authors such as Chesterton and Belloc.

This new liberal now had nothing standing between him and the individual—all intermediating institutions, especially Christianity and the Church, had been stripped of any meaningful role. Each individual was standing naked, to be molded like clay by these progressive, enlightened, “reasonable” intellectuals. Legislation would solve every problem in life. Every need and want would be met, all bestowed via government largesse.

Barzun describes these naked individuals as impotent: the receivers of benefits, victims, lacking room to breathe, oppressed by his fellows and the state alike. This naked individual now had but one objective: the Unconditioned Life—emancipation from the realities of this world; nothing to stand in the way of every wish; expecting no rebuffs. Life with no conditions; anything goes, and you can’t stop me. My pleasure is my highest priority; the highest goal in life is to be happy.

Enlightened man, like his forefathers after the flood who attempted to build a tower to heaven in order to be like God, found—as Paul VanderKlay says—that when you try to bring heaven down to earth, you bring hell up with it. We need not even look to the “isms” of interwar Russia, Italy, or Germany for examples of this; it is sufficient to look to the social justice liberalism and grievance studies curriculum of America today.

Barzun concludes his magnum opus with a listing of the decadence found in the west over the last century; man’s liberation from all norms, traditions, and customs; nothing left to provide governance except the state—and a state happy to oblige.

What happened to the promise of the Enlightenment? We consider the individual and reason as born in the Enlightenment to be key foundations of liberty. As the meaning of these concepts has been divorced from God, these have actually brought on liberty’s downfall. Without God, the Enlightenment’s liberty is a house built on sand.

The individual was discovered not in the Enlightenment or even in the Renaissance. Anselm of Canterbury offered us the individual in the eleventh century, with roots to be found even centuries before. Anselm’s individual had a sense of self-awareness and personal identity; an individual with a moral responsibility; an individual requiring spirituality.

This was an individual who found his freedom within the cultural and religious context of the time, free to live according to and within this tradition. This individual found and was able to maintain his freedom via the many intermediating institutions of the time—most importantly the Church, which could stand against the king.

The Enlightenment’s guillotine killed all intermediating institutions, thus killing the freedom of this individual. We now have an individual freed from such troublesome burdens as truth, justice, and mercy; an individual freed from any moral responsibility; an individual standing naked and impotent in front of the state; an individual living free… in a gulag.

Meanwhile the state pushes further division—ever-more individualized individuals. The state encourages and subsidizes culture-destroying behavior, as absent governance provided by custom and tradition, governance will be provided by the state.

As the Enlightenment freed our reason from revelation and tradition, the result should be no surprise. Just because your reason has been freed doesn’t mean that the strongman’s reason will leave you alone or that your reason will convince him. As his reason is no longer bound by anything other than his reason, it will not be your reason that governs but his. To what higher authority can you appeal? There is no authority higher than man’s reason, and the strongman’s reason has bigger guns than does your reason.

Recognizing this “strongman’s reason,” John Gray (2018) offers:

What if the Enlightenment’s future is not in the liberal West, now almost ungovernable as a result of the culture wars in which it is mired, but Xi Jinping’s China, where an altogether tougher breed of rationalist is in charge? It is a prospect that Voltaire, Jeremy Bentham and other exponents of enlightened despotism would have heartily welcomed.

Maybe God knew what He was doing when he warned Adam off of the tree of the knowledge of good and evil, with death the consequence of man’s reason without God.

The Hoover Institution’s Peter Berkowitz offered a five-part challenge to Patrick Deneen’s recent book “Why Liberalism Failed.” While suggesting that Deneen has gone too far and attributed too much fault to the concepts of the Enlightenment, in part four he does recognize the detrimental features of contemporary society:

…the scorn for inherited wisdom, the demotion of duty in favor of personal preference, and the obsession with material goods and superficial amusements at the expense of citizenship, friendship, and love—promoted by the individualism and statism that arise from taking the principles of freedom and equality to an extreme. (Berkowitz 2018a)

Jordan Peterson asked regarding the postmodernists: What from the Enlightenment do you toss out the window before things get ugly? Jonathan Goodwin (2018) suggests that this is the wrong question if one’s objective is liberty. The question should be: what is required to be reintroduced that the Enlightenment destroyed?

In part five of his critique of Deneen’s book, Berkowitz aims at answering this question. To this end, he cites Edmund Burke. From Burke’s “Reflections on the Revolution in France,” written in 1790:

History consists, for the greater part, of the miseries brought upon the world by pride, ambition, avarice, revenge, lust, sedition, hypocrisy, ungoverned zeal, and all the train of disorderly appetites…. These vices are the causes of those storms. Religion, morals, laws, prerogatives, privileges, rights of men, are the pretexts. (Berkowitz 2018b)

It is worth noting: none of the vices identified by Burke violate the non-aggression principle—except maybe revenge, depending on how cold the dish is when served. Yet, perhaps, recognizing these vices as dangers to liberty—and incorporating this recognition into their work—is an appropriate task for libertarian thinkers of tomorrow. Continuing with Berkowitz:

[Burke] rebuked the French revolutionaries for supposing that “the rights of men” authorized the blanket repudiation of inherited faith, the established regime, and the country’s settled laws and their replacement with new modes of moral judgment and political order derived from pure reason.

Given the cost to liberty of this repudiation, perhaps libertarian thinkers might incorporate something of the inherited faith and tradition when considering liberty as the objective.

Further, Alexandr Solzhenitsyn, from his Harvard University commencement address in 1978. Having lived under a communist regime his whole life, he understood that a society without an objective legal scale is a terrible one, but a society with only an objective legal scale is as well. In such a society, man has been given freedom for good and evil—and such a society has no defense against the decadent abyss.

He suggests that for a thousand years man had freedom within a framework of his religious responsibility, but no such responsibility attaches today. Solzhenitsyn offers:

This means that the mistake must be at the root, at the very basis of human thinking in the past centuries. I refer to the prevailing Western view of the world which was first born during the Renaissance and found its political expression from the period of the Enlightenment. …the proclaimed and enforced autonomy of man from any higher force above him.

Nietzsche ([1998] 1889) offered the consequences of killing God in Twilight of the Idols: despite the wishes of many Enlightenment thinkers—the “English Flatheads” as he describes them—when one gives up the Christian faith one also loses the right to Christian morality.

What is this moral Christian “right” if not, at minimum, the non-aggression principle? This is what man has given up in the Enlightenment. We have traded Christian morality—and therefore our liberty—for the enlightened super-man’s reasonable right to decide what is moral.

Libertarians point to many Enlightenment thinkers and their theories and concepts that freed the individual and empowered reason; concepts that we believe offer the foundations for liberty. But we knew all of this before the so-called age of reason; we did not need the Enlightenment to become enlightened.

Hans Hoppe has made it acceptable, at least in these circles, for me to cite as foundational for liberty the Decalogue—certainly the portion of it that related to man’s relationship to man: honor your father and mother; do not murder, do not commit adultery, steal, or bear false witness; do not covet your neighbor’s wife or his possessions.

As Hoppe offers, “Some libertarians may argue that not all of these commandments have the same rank or status.” Quite true. In some cases, we see non-violent trespasses. The question for the libertarian as libertarian: does the violation rise to the point of requiring formal, physical punishment?

Jesus answered this question. We read in John chapter 8 of the Pharisees bringing to Jesus a woman caught in adultery—certainly not an offense that libertarians would view as rising to the level deserving of physical punishment. The law commanded stoning for such an offense. The Pharisees asked Jesus what should be done with this woman.

His reply: He that is without sin among you, let him cast the first stone. Yes, it was a sin; but it was not a violation worthy of physical punishment. One by one, the accusers left. Jesus then admonished the woman, “go, and sin no more.” Advice and counsel, not punishment, is the example Jesus gave us regarding what we would describe as non-violent trespasses.

Libertarians lament our inability to convert the masses. “Who can disagree with the logic and purity of the non-aggression principle?” we cry, while pouring ashes on our head. Maybe we should consider this lack of a common conscience; maybe we should consider that for us to move toward liberty, this cultural and religious tradition must be the foundation.

Goodwin recently asked: is libertarianism sufficient for liberty? Is our objective to purify libertarian theory, or is it to find liberty?

Maybe we should consider what it means to have lost the right to Christian morality when it comes to moving toward liberty. If our objective is liberty, maybe we should consider the necessity of regaining this lost right.

Paul offered the consequences of discarding the knowledge of God by the enlightened of his generation in Romans 1, beginning with verse 18 through to the end of the chapter. We read of God’s wrath against those who suppress the truth by their wickedness. From Paul:

…just as they did not think it worthwhile to retain the knowledge of God, so God gave them over to a depraved mind, so that they do what ought not to be done. …Although they know God’s righteous decree that those who do such things deserve death, they not only continue to do these very things but also approve of those who practice them.

Paul could be writing to our generation. From the seventh of his eight-part Gifford Lectures, Wright (2018) offers: “To be an image-bearer is more than just behavior; otherwise we put the knowledge of good and evil before the knowledge of God.”

By not keeping the knowledge of God before individual reason, good stands no chance against evil. As good loses to evil, we most certainly lose our liberty. This, ultimately, is the cost of the Enlightenment.

Goethe considered double-entry bookkeeping — the essence of accounting — to be "one of the finest inventions of the human mind." For without accounting, we lose the ability to calculate, and without the ability to calculate, modern civilization is impossible.

Accounting lets the entrepreneur know whether he earned a profit, utilizing scarce resources in order to produce something of greater value. Accounting also lets the entrepreneur know whether activities he performs are better outsourced, or, conversely, whether he should expand into new orders of production. In essence, accounting directs the entrepreneur toward activities that satisfy the wants of the consumer.Of course, accounting has changed as taxation creates financial incentives to beat the taxman by showing as little profit as possible, but that is another article.

Government accounting is a true oxymoron. We can determine the cost of government, but what about the value produced? What is the product? What is its value? What is the bottom line? Of course, these unanswered questions do not stop government from playing business, pretending to create value and profit for society.

Governmental entities operate under the cash basis of accounting, tracking cash in and cash out. To direct their activities, these entities create budgets that list revenue and expenditures. Accounting then is simply the recording of cash flows against the budget. In this world, the cheered concept of fiscal accountability is the process of reporting how close the entity's final revenue and expenditures matched its approved budget. And nothing more.

This is an important point to note: whenever government officials speak of fiscal accountability, they are only considering approved budget versus actual spending. They are not referring to worthiness of expenditures, only whether or not they spent revenue according to the budget, with no outright theft of money. Oh, sure, the officials will claim that fiscal accountability means that money was spent on productive activities since, as expected, it is assumed by the governmental entity that only productive activities were approved in the budget. Circular reasoning.

With cash accounting, the cost of infrastructure investments — roads, bridges, buildings, etc. — is reported in the year it occurs, though the capital assets continue to have value or usefulness for years. Reporting cash flow misses the complete financial picture of the government entity, leaving this question unanswered: is it in a better financial position than the year before?

To answer that question, the Government Accounting Standards Board issued its Statement 34 in 1999. Annual reports that satisfy this statement supposedly detail the financial health of governmental entities as if these entities were profit-oriented businesses. Reporting is now done on the accrual basis of accounting, and assets are depreciated over their lifetime. This change provides a bottom line: net assets. With a view of either increasing or decreasing assets over liabilities, we can now determine a profit or loss of sorts.

Under this logic, when a governmental entity has more net assets this year than the prior year, it is in a better financial state — it has achieved a profit. Government can now report to its constituents whether or not it was able to take scarce resources and turn them into something of greater value. Socialism, here we come.

But not so fast. Government assets are the product of theft, not the result of satisfying the wants of consumers. A governmental entity with increasing assets is simply stealing more from taxpayers year after year. Ironically, the same holds true for a governmental entity that has decreasing assets. In either situation, more is being thieved, with nothing of value being created.

The implication is that a governmental entity that increases its tax revenue faster than its expenditures is performing a service for its constituents; the entity is achieving a profit for the taxpayers. Conversely, a governmental entity in a deficit cycle is creating a loss for its taxpayers. So, the more a government confiscates, the better off the taxpayers. Does that make sense? Down is up, and up is down. Somewhere, somehow, we ventured down the rabbit hole.

It is as if we are to cheer a government that taxes and builds since increasing assets count as profit, not waste. The public school district that builds a $50 million high school is bettering its financial position. Whether or not the high school produces anything of value is of no consideration. In government accounting, the cost itself is a benefit.During the Cold War, both the US and Soviet governments calculated Soviet GDP to include tractors rusting on the plains of the Ukraine. That the tractors had no real value to the local farmer was not considered. With government, cost is always recorded as value. Of course, that is not how businesses serve the consumer, but, with government, we are through the looking glass.

The difference between government and business is the chain of taxation versus the dollar vote. The public school district taxes regardless of value produced. Once the bond issue passes the voters, the bill must be paid, to be enforced by the long, strong arm of government. On the other hand, the entrepreneur must face the consumer every day, product in hand, hoping to make a sale. The consumer can as easily bypass as enter his store, based on a whim if he so chooses. The taxpayer? Well, just try to hide.

If government is of the people, and I am one of the people, shouldn't I include changes in the net assets of my local school district in my financial portfolio? Since the local schools are my schools — or so the mantra goes — don't those changes have an impact on my finances? Shouldn't I record changes of district assets in my ledger?

Moreover, shouldn't I be able to sell my shares of the supposed public good and use the resulting proceeds for my benefit? Yes, I should. But, as I learned growing up in Allegheny County in southwestern Pennsylvania, the sign that reads, "Keep out, Property of Allegheny County," does not refer only to those who live outside the county; it means that even the taxpayers of Allegheny County have no right to that property.

The bottom line — increasing government net assets — is not my property; never was; never will be.

Original Article: Why the Government Can't Measure Income, Happiness, or Well-Being.

Mises's well-known calculation argument states this: If there is no private property in land and other production factors, then there can also be no market prices for them. Hence, economic calculation, i.e., the comparison, in light of current prices, of anticipated revenue, and expected cost expressed in terms of a common medium of exchange—money—(thus permitting cardinal accounting operations), is literally impossible. Therefore, socialism's fatal error is the absence of private property in land and production factors, and, by implication, the absence of economic calculation.

For Hayek, socialism's problem is not a lack of property but a lack of knowledge. His distinctly own thesis is altogether different from Mises's.See in particular the widely acclaimed 1945 article on "The Use of Knowledge in Society," reprinted in F. A. Hayek, Individualism and Economic Order (Chicago: University of Chicago Press, 1948). The Review of Austrian Economics Vol. 9, No. 1 (1996): 143-49 ISSN 0889-3047 For Hayek, the ultimate flaw of socialism is the fact that knowledge, in particular "the knowledge of the particular circumstances of time and place," exists only in a widely dispersed form as the personal possession of various individuals; hence, it is practically impossible to assemble and process all the actually existing knowledge within the mind of a single socialist central planner. Hayek's solution is not private property, but the decentralization of the use of knowledge.

Yet this is surely an absurd thesis. First, if the centralized use of knowledge is the problem, then it is difficult to explain why there are families, clubs, and firms, or why they do not face the very same problems as socialism. Families and firms also involve central planning. The family head and the owner of the firm also make plans which bind the use other people can make of their private knowledge, yet families and firms are not known to share the problems of socialism. For Mises, this observation poses no difficulty: under socialism private property is absent, whereas individual families and private firms are based on the very institution of private property. But for Hayek the smooth operation of families and firms is puzzling, because his idea of a fully decentralized society is one in which each person makes his own decisions based on his own unique knowledge of the circumstances, unconstrained by any central plan or supraindividual (social) norm (such as the institution of private property).

Second, if the desideratum is merely the decentralized use of knowledge in society, then it is difficult to explain why the problems of socialism are fundamentally different from those encountered by any other form of social organization. Every human organization, composed as it is of distinct individuals, constantly and unavoidably makes use of decentralized knowledge. In socialism, decentralized knowledge is utilized no less than in private firms or households. As in a firm, a central plan exists under socialism; and within the constraints of this plan, the socialist workers and the firm's employees utilize their own decentralized knowledge of circumstances of time and place to implement and execute the plan. For Mises, all of this is completely beside the point. But within Hayek's analytical framework, no difference between socialism and a private corporation exists. Hence, there can also be no more wrong with the former than with the latter.

Clearly, Hayek's thesis regarding the central problem of socialism is nonsensical. What categorically distinguishes socialism from firms and families is not the existence of centralized knowledge or the lack of the use of decentralized knowledge, but rather the absence of private property, and hence, of prices. In fact, in occasional references to Mises and his original calculation argument, Hayek at times appears to realize this, too. But his attempt to integrate his very own thesis with Mises's and thereby provide a new and higher theoretical synthesis fails.

The Hayekian synthesis consists of the following propositional conjunction: "Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people" and "the price system" can serve as "a mechanism for communicating information."Ibid., pp. 85-86. While the second part of this proposition strikes one as vaguely Misesian, it is anything but clear how it is logically related to the first, except through Hayek's elusive association of "prices" with "information" and "knowledge." However, this association is more of a semantic trick than rigorous argumentation. On the one hand, it is harmless to speak of prices as conveying information. They inform about past exchange ratios. But it is a non-sequitur to conclude that socialism's central problem is a lack of knowledge. This would only follow if prices actually were information. However, this is not the case. Prices convey knowledge, but they are the exchange ratios of various goods, which result from the voluntary interactions of distinct individuals based on the institution of private property. Without the institution of private property, the information conveyed by prices simply does not exist. Private property is the necessary condition—die Bedingung der Moglichkeit—of the knowledge communicated through prices. But then it is correct only to conclude, as Mises does, that it is the absence of the institution of private property which constitutes socialism's problem. To claim that the problem is a lack of knowledge, as Hayek does, is to confuse cause and effect, or premise and consequence.

On the other hand, Hayek's identification of "prices" and "knowledge" involves a deceptive equivocation. Not only does Hayek fail to distinguish between what one might call institutional knowledge-information that requires for its existence an institution (such as the knowledge of prices requires private property)—and raw or extra-institutional knowledge—like this is an oak tree, I like peanuts, or birds can fly. Moreover, Hayek also fails to notice that the knowledge of prices is not at all the same sort of knowledge whose existence he believes to be responsible for the "practical impossibility" of socialism and central planning. What makes central planning impossible, according to Hayek, is the fact that part of human knowledge exists only as essentially private information:

practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active cooperation.Ibid., p. 80.

While it is certainly true that such knowledge exists, and while it is also true that uniquely private knowledge can of course never be centralized (without information losses), it is just as certainly not true that the knowledge of prices falls into this category of uniquely private information. To be sure, prices are "prices paid at specific times and places," but this does not make them private information in the Hayekian sense. To the contrary, the information conveyed by prices is public information, because prices—qua objective exchange ratios—are real events. It may be difficult to know all of the prices paid at a specified date and location, just as it may be difficult to know every person's physical location at any given time. Yet it is hardly impossible to know either one, and with current computer technology it is probably easy. In any case, while I may never know everything that you know, and vice versa, it is no more problematic to assume that both of us can simultaneously possess the same price information than that we can both simultaneously know the same baseball results. Hence, the knowledge conveyed by prices actually can be centralized. But if price information is public information and thus can be centralized, then, according to Hayek's thesis that socialism's problem stems from the inefficiency of trying to centralize genuinely uncentralizable private knowledge, it would follow that the absence of prices, and hence of private property, has nothing to do with the plight of socialism. Otherwise, if one insists with Mises that the absence of private property and prices does have something to do with the plight of socialism. Hayek's contribution to the socialism debate must be thrown out as false, confusing, and irrelevant.

Hayek's misconception of the nature of socialism is symptomatic of a fundamental flaw in his thinking, pervading not only his economics but in particular also his political philosophy: his ultra-subjectivism. Hayek, as noted and quoted ad nauseam by his numerous followers, was convinced that "it is probably no exaggeration to say that every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism."The Counterrevolution of Science (New York: Free Press. 1955). p. 31 While this may well be true, it does not logically follow that every further advance toward subjectivism must also lead to an advance in economic theory. However, Hayek seems to have drawn this conclusion and has thus become a prime example illustrating its falsehood.

Mises, and in his steps even more clearly Murray N. Rothbard, conceives of economics as the science of human action. Action has two inseparable aspects: a subjective aspect (action is rational, intelligible action) and an objective aspect (acting is always acting with real things and physical stuff). Accordingly, Mises's and Rothbard's economics and political philosophy is never anything but robust, and their categories and theories invariably possess real, operational meaning: private property, division of labor based on private property, production, direct and indirect exchange, and also compulsory interference with private property and production and exchange such as taxation, counterfeiting, legislation, and regulation.

In distinct contrast, Hayek —and misled by him to different degrees also Israel Kirzner and Ludwig Lachmann— views economics as some sort of science of human knowledge. Accordingly, Hayek's categories and theories refer to purely subjective phenomena and are invariably elusive or even illusory. He is not concerned about acting with things, but about knowledge and ignorance, the division, dispersion, and diffusion of knowledge, alertness, discovery, learning, and the coordination and divergence of plans and expectations. The external—physical—world and real—material—events have almost completely disappeared from his view. Hayek's categories refer to mental states of affairs and relationships, completely detached from and compatible with any real physical state of affairs and events.

Most notable and disturbing is the ultra-subjectivist turn in Hayek's political philosophy. According to a long-standing tradition of political philosophy shared by Mises and Rothbard, freedom is defined as the freedom to privately own—and control—real property, and coercion is the initiation of physical damage—harm—upon the private property of others. In distinct contrast, Hayek defines freedom as "a state in which each can use his own knowledge and for his own purposes,"Law, Legislation, and Liberty, Vol. 1 (Chicago: University of Chicago Press, 1973), pp. 55-56. and coercion means "such control of the environment or circumstances of a person by another that, in order to avoid greater evil, he is forced to act not according to a coherent plan of his own but to serve the ends of another,"Constitution of Liberty (Chicago: University of Chicago Press, 19601, pp. 20-21. or alternatively, "coercion occurs when one man's actions are made to serve another man's will, not for his own but for the other's purpose"Ibid.,p. 133. (all emphases are mine). Clearly, Hayek's definition contains nothing regarding scarce goods and real tangible property, and his provides no physical criterion or indicator whatsoever for the existence or non-existence of either state of affairs. Rather, coercion and freedom refer to specific configurations of subjective wills, plans, thoughts, or expectations. As mental predicates, Hayek's definitions of freedom and coercion are compatible with every real, physical state of affairs. They possess no power to make any real distinctions.See also Hans-Hermann Hoppe, "Hayek on Government and Social Evolution," Review of Austrian Economics 7, no. 1 (1994): esp. 70f.

It is beyond the scope of this note to offer a detailed critique and refutation of Hayek's ultra-subjectivism. However, beside the fundamental question whether a science of knowledge as envisioned by Hayek is even possible, i.e., whether there can be any other science of knowledge apart from logic and epistemology on the one hand and the history of ideas on the other,For some serious doubts on this see Hans-Hermann Hoppe, Kritik der kausalwissenschaftlichen Sozialforschung (Opladen: Westdeutscher Verlag, 1983). two conclusions are painfully clear. Even if Hayek's science of knowledge is possible, it appears at best irrelevant because it is praxeologically—operationally—meaningless. At worst it is intellectually pernicious in promoting relativism.

As for the real world of acting with physical property, of production and exchange, of money and markets, profits and losses, capital accumulation and bankruptcies, there can be no lasting doubt about the existence of laws and the ceaseless operation of a tendency toward general equilibrium-action-coordination. Likewise, there can be no doubt about the existence of laws and the constant operation of dis-equilibrating tendencies within the world of actual taxation, counterfeiting, legislation, and regulation. Indeed, it would be extremely costly—prohibitive—to not recognize such laws and tendencies and to adopt relativistic views. In contrast, in surreptitiously shifting attention from the tangible world of action and property to the ethereal world of knowledge, ideas, plans and expectations, relativistic views become attractive (and cheap). There are no apparent regularities and tendencies in Hayek's knowledge world. In fact, it is difficult to even imagine what "law" and "equilibrium" could possibly mean in the context of purely subjective phenomena. Instead there exists seemingly nothing but constant kaleidoscopic change.

It is hardly surprising, then, that Hayek and his followers could proclaim such relativistic slogans as that we cannot do anything to improve our condition except rely on spontaneous evolution, that our future is completely unknowable, or that we cannot but participate in an endless and open-ended stream of conversation. As far as the realm of purely subjective phenomena is concerned, and as addressed to a purely spiritual—disembodied—being, this may well be good advice. Actually possessing physical—bodily—existence, however, why would anyone even care to know it? As applied to the world of bodily action and property, such advice is self-destructive nonsense.

Narrated by Jim Vann.

This view of capitalism has not been the least bit shaken by the steady rise in the average standard of living that has taken place in the capitalist countries since the beginning of the Industrial Revolution. The rise in the standard of living is not attributed to capitalism, but precisely to the infringements which have been made upon capitalism. People attribute economic progress to labor unions and social legislation, and to what they consider to be improved personal ethics on the part of employers.

By the same token, they tremble at the thought of unions not existing, of a society without minimum wage laws, maximum hours legislation, and child labor laws—at the thought of a society in which no legal obstacles stood in the way of employers pursuing their self-interest. In the absence of such legislation, people believe, wage rates would return to the minimum subsistence level; women and children would labor once more in the mines; and the hours of work would be as long and as hard as it is possible for human beings to bear—all for the benefit of the capitalists, precisely as Marx maintained.

It is obvious that the exploitation theory is one of the most powerful factors that have been operating to lead the world down The Road to Serfdom —as the title of Prof. Hayek's book so aptly describes the trend toward socialism.F. A. Hayek, The Road to Serfdom (Chicago: University of Chicago Press, 1944).  Indeed, the pernicious influence of the exploitation theory goes far beyond the direct and obvious support it gives to socialism. It has contributed to the triumph of socialism in more subtle ways, as well. It played a major, perhaps the decisive, role in the overthrow of British classical economics. The system of Smith and Ricardo was perceived as inescapably implying the essential tenets of the exploitation theory. The opponents of the exploitation theory, therefore, quite understandably felt obliged to discard such a perverse system. And discard it they did.

Along with "the labor theory of value" and the "iron law of wages," they discarded such further features of classical political economy as the wages fund doctrine and its corollary that savings and capital are the source of almost all spending in the economic system. Two generations later, the abandonment of the classical doctrines on saving made possible the acceptance of Keynesianism and the policy of inflation, deficits, and ever expanding government spending. In similarly paradoxical fashion, the abandonment of the classical doctrine that cost of production, rather than supply and demand, is the direct (if not the ultimate) determinant of the prices of most manufactured or processed goods led, with just about the same time lag, to the promulgation of the doctrines of "pure and perfect competition," "oligopoly," "monopolistic competition," and "administered prices," with their implicit call for a policy of radical antitrust or outright nationalizations to "curb the abuses of big business." Thus, along these two further paths, the influence of the exploitation theory has served to advance the cause of socialism. 

Indeed, so successful has the exploitation theory been in the discrediting of classical economics, that even to suggest that cost of production can be a direct determinant of price is to invite the censure both of being ignorant of all that economics has taught since 1870 and of being sympathetic to Marxism. Thus, it is important to point out in this connection that Böhm-Bawerk and Wieser were well aware of the fact that cost of production is often the direct determinant of price. They held merely that the determination of the prices that constitute the costs is based on supply and demand (a position very close to that of John Stuart Mill, incidentally) and thus on the operation of the principle of diminishing marginal utility.>Cf. Eugen von Böhm-Bawerk, Capital and Interest, Huncke and Sennholz translation, 3 volumes (South Holland Illinois: Libertarian Press, 1959), Vol. II, pp. 168-76, pp. 248-56; Vol. III, pp. 97-115; idem, "Wert, Kosten und Grenznutzen," Jahrbuch für Nationalökonomie und Statistik, Dritte Folge, Vol. III, 1892, p. 328 [this essay has subsequently been translated by the present author as "Value, Cost, and Marginal Utility," Quarterly Journal of Austrian Economics, vol. 5, n. 3; see also, idem, my "Notes on the Translation"]; Friedrich von Wieser. Ursprung und Hauptgesetze des Wirtschaftlichen Werthes, Vienna, 1884, pp. 146-160; idem, Natural Value, London and New York, 1893, p. 78, p. 181n, p.183; John Stuart Mill, Principles of Political Economy, Ashley Edition (reprint, Fairfield, New Jersey: Augustus M. Kelley, 1976), Bk. III, Chaps. III - VI. See also, Reisman, Capitalism, pp. 200-201, 206-209, 414-416. (Please note: page numbers in the online, pdf edition of Capitalism add 58 pages of front matter.) Most of the followers of Böhm-Bawerk and Wieser seem, unfortunately, to be more influenced by Jevons on this subject than by Böhm-Bawerk and Wieser.Jevons held that the only possible connection between cost of production and price was through the intermediary of variations in supply. Cf. W. S. Jevons, The Theory of Political Economy, Fourth Edition, (London: Macmillan and Co., 1924), p. 165.

My purpose here is to show how classical economics can easily cast off those aspects of it which in the past did contribute to the exploitation theory. And, more, to show how it can actually supply the basis for a fundamental and radical critique of the exploitation theory. If my effort is judged successful, then perhaps some interest can be reawakened in classical economics as an important source of knowledge, in particular in regard to the critique of Keynesianism and the currently dominant views on monopoly and competition. (The precise nature of these applications is a subject far too vast to be dealt with on this occasion. I have, however, attempted to explain it elsewhere.Chapters, 15 and 18 of my book Capitalism deal exhaustively with Keynesianism and its foundations, while Chapter 10 does likewise with the currently prevailing views on monopoly and competition; on this last, see also my "Platonic Competition," The Objectivist, August and September, 1968 (reprint, Laguna Hills, California: The Jefferson School of Philosophy, Economics, and Psychology).

There are three aspects of classical economics which contribute to the exploitation theory. The two best known are, of course, the labor theory of value and the iron law of wages. Somewhat less prominent, but no less important, is the conceptual framework within which the exploitation theory is advanced. This framework is the belief that wages are the original and primary form of income, from which profits and all other non-wage incomes emerge as a deduction with the coming of capitalism and businessmen and capitalists. The framework easily leads to the assertion of the wage earner's right to the whole produce or to its full value. It itself is based on the further belief that all income which is due to the performance of labor is wages and that all who work are wage earners. It is on the basis of these beliefs that Adam Smith opens his chapter on wages in The Wealth of Nations with the words: 

The produce of labour constitutes the natural recompense or wages of labour. In that original state of things, which precedes both the appropriation of land and the accumulation of stock, the whole produce of labour belongs to the labourer. He has neither landlord nor master to share with him.

And Smith continues, a little further on:

But this original state of things, in which the labourer enjoyed the whole produce of his own labour, could not last beyond the first introduction of the appropriation of land and the accumulation of stock. It was at an end, therefore, long before the most considerable improvements were made in the productive powers of labour, and it would be to no purpose to trace further what might have been its effects upon the recompense or wages of labour. 

As soon as land becomes private property, the landlord demands a share of almost all the produce which the labourer can either raise or collect from it. His rent makes the first deduction from the produce of the labour which is employed upon the land. 

It seldom happens that the person who tills the ground has the wherewithal to maintain himself till he reaps the harvest. His maintenance is generally advanced to him from the stock of a master, the farmer who employs him and who would have no interest to employ him, unless he was to share in the produce of his labour, or unless his stock was to be replaced to him with a profit. This profit makes a second deduction from the produce of the labour which is employed upon land. 

The produce of almost all other labour is liable to the like deduction of profit. In all arts and manufactures the greater part of the workmen stand in need of a master to advance them the materials of their work, and their wages and maintenance till it be completed. He shares in the produce of their labour, or in the value which it adds to the materials on which it is bestowed; and in this share consists his profit.Adam Smith, The Wealth of Nations, Cannan Edition, Bk. I, Chap. VIII.

In these passages, Smith clearly advances what I call the primacy of wages doctrine. That is, the doctrine that in a pre-capitalist economy—the "early and rude state of society"—in which workers simply produce and sell commodities and do not buy in order to sell, the incomes the workers receive are wages. Wages are the original income, according to Smith. All income in the pre-capitalist society is supposed to be wages, and no income is supposed to be profit, according to Smith, because workers are the only recipients of income. At the same time, of course, Smith advances the corollary doctrine that profit emerges only with the coming of capitalism and is a deduction from what is naturally and, by implication, rightfully wages.

These doctrines, as I say, constitute the conceptual framework of the exploitation theory. They are the starting point for Marx.

In a pre-capitalist economy, production, says Marx, is characterized by the sequence C-M-C. In this state of affairs, a worker produces a commodity C, sells it for money M, and then buys other commodities C. In this state of affairs, there is no exploitation, for there are no profits, no "surplus value"; all income is, presumably, wages. Surplus value, profit, emerges only with the development of capitalism, according to Marx. Here the sequence M-C-M' applies. Under this sequence, the capitalist expends a sum of money M in buying materials and machinery and in paying wages. A commodity C is produced, which is then sold for a larger sum of money, M', than was expended in producing it. The difference between the money the capitalist expends and the money he receives for the product is his profit or surplus value.Karl Marx, Das Kapital, Vol. I. Pt. II, Chap. IV.

Profits, then, according to both Smith and Marx, come into existence only with capitalism, and are a deduction from what naturally and rightfully belongs to the wage earners.

This is not yet the exploitation theory itself, only the conceptual framework of the exploitation theory. It is a framework broad enough to include Marx, the leading proponent of the exploitation theory, and Böhm-Bawerk, its leading critic.

Within this framework, Marx applies the labor theory of value and the iron law of wages, and arrives at the exploitation theory. Within this same framework, Böhm-Bawerk applies the discounting approach, and arrives at a critique of the exploitation theory.Ibid., passim; Böhm-Bawerk, Capital and Interest, op. cit., Vol. I, pp. 263-71; Vol. II, pp. 259-89, passim. Both men call upon their respective doctrines to explain what makes possible the alleged deduction of profits from wages and what determines the size of this deduction.

Böhm-Bawerk's explanation is that present goods are more valuable than future goods, and that the wage earner is justly treated in being given a smaller sum of present money than his future product will be worth. Marx's explanation is that the capitalist arbitrarily pays the wage earner a wage corresponding to the number of hours required to produce the wage earner's necessities and sells the wage earner's product at a price corresponding to the—larger—number of hours for which the wage earner works. 

Now, in my view, the fundamental place to challenge the exploitation theory is not over the labor theory of value or the iron law of wages, but here, over its conceptual framework—over the doctrines of the primacy of wages and the deduction of profits from wages. Furthermore, it is precisely classical economics itself which provides the means for making this challenge. For classical economics implies that it is false to claim that wages are the original form of income and that profits are a deduction from them. This becomes apparent, as soon as we define our terms along classical lines: 

"Profit" is the excess of receipts from the sale of products over the money costs of producing them—over, it must be repeated, the money costs of producing them. 

A "capitalist" is one who buys in order subsequently to sell for a profit.

"Wages" are money paid in exchange for the performance of labor—not for the products of labor, but for the performance of labor itself. 

On the basis of these definitions it follows that, if there are merely workers producing and selling their products, the money which they receive in the sale of their products is not wages. "Demand for commodities," to quote John Stuart Mill, "is not demand for labour."John Stuart Mill, Principles of Political Economy, op. cit., Bk. I, Chap. V, Sec. 9. In buying commodities, one does not pay wages, and in selling commodities, one does not receive wages. 

In the pre-capitalist economy, if such an economy ever in fact existed, all income recipients in the process of production are workers. But the incomes of those workers are not wages. They are, in fact, profits. Indeed, all income earned in producing products for sale in the pre-capitalist economy is profit or "surplus value"; no income earned in producing products for sale in such an economy is wages. For what the workers of a pre-capitalist economy receive are receipts from the sale of products. But they have no money costs of production to deduct from those sales receipts, for they have not acted as capitalists: They have not bought anything for the purpose of making possible their sales receipts, and therefore they have no money costs. The difference between receipts from the sale of products and zero money costs of production is the full magnitude of the sales receipts. 

Thus, in the pre-capitalist economy, only workers receive incomes and there is no money capital. But all the incomes which the workers receive are profits, and none are wages. In the sequence C-M-C, everything is "surplus value"—one-hundred percent of the sales receipts and an infinite percentage of the zero money capital. In the sequence M-C- M', a smaller proportion of the incomes is "surplus value"—in degree that M is large relative to M'. 

This same conclusion, that in the pre-capitalist economy all income is profit, and no income is wages, can be arrived at by way of Ricardo's badly misunderstood proposition that "profits rise as wages fall and fall as wages rise." The wages paid in production, according to Ricardo, are paid by capitalists, not by consumers. If, as in the pre-capitalist economy, there are no capitalists, then there are no wages paid in production, and if there are no wages paid in production, the full income earned must be profits. 

Smith and Marx are wrong. Wages are not the primary form of income in production. Profits are. In order for wages to exist in production, it is first necessary that there be capitalists. The emergence of capitalists does not bring into existence the phenomenon of profit. Profit exists prior to their emergence. The emergence of capitalists brings into existence the phenomena of wages and money costs of production. 

Accordingly, the profits which exist in a capitalist society are not a deduction from what was originally wages. On the contrary, the wages and the other money costs are a deduction from sales receipts—from what was originally all profit. The effect of capitalism is to create wages and to reduce profits relative to sales receipts. The more economically capitalistic the economy—the more the buying in order to sell relative to the sales receipts, the higher are wages and the lower are profits relative to sales receipts. 

Thus, capitalists do not impoverish wage earners, but make it possible for people to be wage earners. For they are responsible not for the phenomenon of profits, but for the phenomenon of wages. They are responsible for the very existence of wages in the production of products for sale. Without capitalists, the only way in which one could survive would be by means of producing and selling one's own products, namely, as a profit earner. But to produce and sell one's own products, one would have to own one's own land, and produce or have inherited one's own tools and materials. Relatively few people could survive in this way. The existence of capitalists makes it possible for people to live by selling their labor rather than attempting to sell the products of their labor. Thus, between wage earners and capitalists there is in fact the closest possible harmony of interests, for capitalists create wages and the ability of people to survive and prosper as wage earners. And if wage earners want a larger relative share for wages and a smaller relative share for profits, they should want a higher economic degree of capitalism—they should want more and bigger capitalists. 

Historical confirmation of the theory I am propounding can be found in Prof. Hayek's Introduction to Capitalism and the Historians. There we find such statements as: "The actual history of the connection between capitalism and the rise of the proletariat is almost the exact opposite of that which these theories of the expropriation of the masses suggest." And: "The proletariat which capitalism can be said to have 'created' was thus not a proportion of the population which would have existed without it and which it degraded to a lower level; it was an additional population which was enabled to grow up by the new opportunities for employment which capitalism provided."F. A. Hayek, editor, Capitalism and the Historians (Chicago: University of Chicago Press, 1954), pp. 15f.

The correct theory, as well as the actual history, is the exact opposite of the doctrine of the primacy of wages. 

In a pre-capitalist economy, the income of labor is profit, and profit is thus obviously a labor income. In a capitalist economy, too, there are many instances in which profits are obviously a labor income: all the cases in which businessmen perform labor in their own enterprises, whether in a managerial or manual capacity. Yet the practice of economics—in disregard of that of accounting and of business itself—has been to classify all such income as wages, and to reserve the term profit (most of which it has come to call interest) for describing income received by virtue of the ownership of capital. 

I shall argue that in a capitalist economy, no less than in a pre-capitalist economy, profit is still a labor income—an income attributable to the labor of businessmen and capitalists—and that this is so even though profits are for the most part earned as a rate of return on capital and tend to vary with the amount of capital invested. 

The variation of profits with the size of the capital invested is perfectly compatible with their being attributable to the labor of those who earn them, because in a capitalist economy the labor of profit earners tends to be predominantly of an intellectual nature—a work of thinking, planning, and decision making. At the same time, capital stands as the means by which businessmen and capitalists implement their plans—it is their means of buying the labor of helpers and of equipping those helpers and providing them with materials of work. Thus, the possession of capital serves to multiply the efficacy of the businessmen's and capitalists' labor, for the more of it they possess, the greater is the scale on which they can implement their ideas. For example, a businessman who thinks of a better way to produce something can apply that better way on ten times the scale if he owns ten factories than if he owns only one. The fact that in the one case the same labor on his part leads to ten times the profit as in the other case is perfectly consistent with the whole profit still being attributable to his labor. 

The compound variation of profits with the passage of time is also perfectly consistent with the fact that they are the product of the businessmen's and capitalists' labor. The relationship of profits to the passage of time derives from the fact that profits vary with the size of the capital invested per period of time. If one can earn profits in proportion to one's capital in any given period of time, then if investment for a longer period is to be competitive, one must earn the profits that one could have earned in the shorter period plus the profits one could have earned by the reinvestment of one's capital and its profits. 

It should be realized that wages, too, which no one disputes are attributable to the labor of the wage earners, vary with things other than the expenditure of labor by the wage earners—for example, with the state of technology and the supply of capital equipment and with competitive conditions in other industries. For an income to be attributable to labor, it is by no means necessary that the performance of labor be the only factor determining its size. In fact, by such a standard, virtually nothing could be attributed to human labor beyond what people could produce with their bare hands. Income is to be attributed to the performance of labor, despite its variation with the means employed and with other external circumstances, on the principle that it is man's labor which supplies the guiding and directing intelligence in production. It is only on this basis that a worker using a steam shovel, for example, is to be credited with digging the hole he digs, no less than a worker using his bare hands, for he guides and directs the steam shovel. 

Guiding and directing intelligence, not muscular exertion, is the essential characteristic of human labor. As von Mises says, "What produces the product are not toil and trouble in themselves, but the fact that the toiling is guided by reason."Cf. Ludwig von Mises, Human Action, Third Revised Edition (Chicago: Henry Regnery Company, 1966), p. 142. Guiding and directing intelligence in production is, of course, supplied by businessmen and capitalists on a higher level than by wage earners—a circumstance reinforcing the primary productive status of profits and profit earners over wages and wage earners. 

I would like to note that the attribution of profits to the labor of businessmen and capitalists is also perfectly consistent with their simultaneously reflecting the general state of time preference in the economic system. Time preference operates to determine the general rate of return on capital, which businessmen and capitalists then earn or not on the basis of their individual productive accomplishments.  Perhaps a useful analogy is the fact that consumer demand determines the general earnings of workers of a given degree of skill in comparison with those of workers of a different degree of skill. Yet, at the same time, each individual worker is responsible for his own earnings. This is merely a restatement of the principle that income is attributable to labor even though it varies with other factors as well. In the case of profit, one of those other factors, operating as a general determinant, is time preference. 

The precise nature of the work of businessmen and capitalists needs to be explained. In essence, it is to raise the productivity, and thus the real wages, of manual labor by means of creating, coordinating, and improving the efficiency of the division of labor. 

Businessmen and capitalists create division of labor in founding and organizing business firms and in providing capital. Business firms are the central units of the division of labor: they represent a division of labor externally, in the division of tasks between the different firms and industries, and internally, in the breakdown of tasks among different divisions, departments, and individual workers within the firms. The provision of capital is indispensable to the existence of the division of labor in its vertical aspect, that is, to a succession of workers each beginning his work where others leave off. In its absence, workers would have to wait to be paid by the ultimate consumers. In many cases, such as the production of durable equipment, the construction of buildings, and, still more, of factories producing durable equipment, including durable equipment for the further construction of such factories, this would entail a waiting time extending beyond the lifetimes of the workers, and even beyond the lifetimes of their children. The provision of capital, therefore, introduces a necessary division of payments, as it were, which permits producers to be paid within a reasonable period of time after performing their work. And the more capitalistic—the more capital intensive —the economic system, the larger is the proportion of the labor force which can be employed in the production of temporally more remote consumers' goods.Cf. Böhm-Bawerk, Capital and Interest, op. cit., Vol. I, pp. 263-71; Vol. II, pp. 105ff; Hayek, Prices and Production, revised edition, (London: Routledge & Kegan Paul, 1935; reprint, Fairfield, New Jersey: A. M. Kelley, 1967), passim.

Businessmen and capitalists coordinate the division of labor in seeking to avoid losses and to earn higher rates of return on their capital in preference to lower rates of return. For in so doing, they are led to try to avoid over-expanding any industry relative to other industries and, at the same time, to be sure that any industry that is insufficiently expanded relative to other industries is further expanded. This is a major aspect of the significance of the principle, so well developed by the classical economists, that there is a tendency toward a uniform rate of profit on capital invested in all branches of industry.Cf. Adam Smith, op. cit.,Bk. I, Chap. X, Pt. I; David Ricardo, Principles of Political Economy and Taxation, Third Edition, (London: 1821), Chap. IV. See also Reisman, Capitalism, pp. 172-180. In addition, the managerial activity of businessmen and capitalists represents a coordination of the internal division of labor in their firms. 

Finally, businessmen and capitalists continuously improve the efficiency of production as the result both of their competitive quest for exceptional rates of profit and their saving and investment for the purpose of accumulating personal fortunes. The only way to earn an exceptional rate of profit where the legal freedom of competition prevails is by being an innovator in the production of better products or equally good but less expensive products. The exceptional profits from any given innovation then disappear as competitors begin to adopt it and make it into the normal standard of an industry. This requires that one introduce repeated innovations as the condition of continuing to earn an exceptional rate of profit. In this way, the entire benefit of every innovation tends to be passed forward to the consumers in the form of better products and lower prices, with exceptional profits being entirely transitory in the case of each particular innovation and a permanent phenomenon only insofar as improvement is continuous.Successful anticipation of changes in consumer demand ahead of others is also an important way to make an exceptional rate of profit, and serves greatly to increase the benefits derived from economic progress. On this subject, see Capitalism, op. cit., p. 179.

The saving of businessmen and capitalists to accumulate personal fortunes operates to achieve economic progress by ensuring that a sufficiently high proportion of the economic system's ability to produce is devoted to the production of capital goods, with the result that each year's production can begin with the existence of more capital goods than were available the year before. Their saving and investment has this effect by virtue of raising the demand for capital goods relative to the demand for consumers' goods, and thus of making profitable the greater relative production of capital goods. (A further aspect of this saving and investment is that the demand for labor is raised relative to the demand for consumers' goods.) 

In the light of these facts about the nature of the productive contribution of businessmen and capitalists, it is possible to revise the classical doctrine of the labor theory of value in a way that helps to explain a steady rise in real wages and which nullifies the so-called iron law of wages. And that is simply this: In steadily raising the productivity of manual labor, the businessmen and capitalists are constantly reducing the quantity of labor required to produce virtually every good. The effect of this is steadily to reduce prices relative to wages, i.e., to raise real wages. 

It should be realized that the same result follows if we view both wages and prices as being determined by demand and supply in the classical sense— i.e., by the ratio of expenditure to quantity sold. Viewed in this light, a rise in the productivity of labor increases the supply of goods relative to the supply of labor and therefore reduces prices relative to wage rates. It should also be realized that this account of matters incorporates both the wages fund doctrine and Ricardo's doctrine of the distinction between "value and riches"— the former, in its implication of a distinct and given demand for labor; the latter, in its perception of the rise in real wages as proceeding not from a rise in money incomes but from a fall in prices, which is the natural consequence of a greater ability to produce.Ricardo, op. cit.,Chap. I, Sec. VII; Chap. XX. Thus, to admit that product prices are determined by the quantity of labor required to produce goods does not at all lead to the exploitation theory, provided one adds that businessmen and capitalists are responsible for the continuing reduction of that quantity and, therefore, for a continuing reduction in prices relative to wages. 

Of course, it must be made crystal clear, which the classical economists never succeeded in doing, that the quantity of labor as a determinant of prices is strictly confined to the category of reproducible products. Major categories of prices are in no way determined by it—above all, wage rates. Such prices are determined by supply and demand—by marginal utility, including the utility of marginal products. Nor are wages connected even indirectly with the "cost of production of labor." 

The growth of population in a division-of-labor, free-market society does not require the cultivation of progressively inferior soils under conditions of diminishing returns, until the point is reached where the productivity of labor on the "land last cultivated" yields only subsistence, as Ricardo often, but not always, maintained.Ibid., Chap. V. On the contrary, in such a society (a society which is capitalistic in the full sense of the term, i.e., incorporating economic freedom), population growth means that the division of labor can be carried further and that those branches of it which are concerned with the discovery of new knowledge and its application to production can be carried on on a larger scale. Thus the effect of rising population in such a society is actually to raise the productivity of labor and real wages. 

This conclusion, I believe, follows from Adam Smith's principle that "the division of labor is limited by the extent of the market."Smith, op. cit.,Bk. I, Chap. III. It also rests on the fact that private ownership of land and natural resources provides the incentive to steadily raise the productivity of the land, with the result that as time goes on the poorest farms and mines worked yield more than the best farms and mines previously worked, and the point from which returns diminish rises steadily higher. 

Once it is recognized that money wages are determined strictly by supply and demand, then it becomes clear that the wage earner's presumable willingness to work for a subsistence wage rather than die of starvation, and the capitalist's preference, other things equal, to pay lower wages rather than higher wages, are both irrelevant to the wage the worker must actually be paid. That wage is determined by the demand for and supply of labor. It can fall no lower than corresponds to the point of full employment. If it drops below that point, a labor shortage is created, which makes it to the self-interest of employers able and willing to pay a higher wage to bid wages up, so that they do not lose employees to other employers not able or willing to pay as much. 

Moreover, a fall in wages toward the full employment point does not represent the possibility of subsistence wages being achieved through the back door, as it were, because it is accompanied by a fall both in product prices and in the burden of supporting the unemployed. The fall in wages implies a fall in prices both on the principle of cost of production and on the principle of supply and demand, for the lower wages mean not only lower costs but also more employment, therefore, more production, and, therefore, a larger supply of goods coming to market. The fall in prices together with a reduction in the burden of supporting the unemployed almost certainly means a rise in real "take-home" wages. 

The rising productivity of labor and correspondingly falling product prices that the businessmen and capitalists achieve take place in this context of wage rates that are determined by the independent supply of and demand for labor. Thus, as product prices fall, wage rates do not fall, and, therefore, real wages rise. (If, the quantity of money and volume of spending in the economic system remaining the same, there is a growing supply of labor while the productivity of labor rises, money wage rates fall, but prices fall by more.) Of course, to the extent that the quantity of money increases while the productivity of labor rises, the demand for labor and products both increase. As a result, the rise in real wages may be accompanied by rising money wage rates and by constant or even rising product prices. But the relationship between wages and prices will reflect the change in the productivity of labor, for that reduces product prices relative to wages, while the increase in the quantity of money operates to affect both of them more or less equally. (Under a gold standard, there would be a modest rate of increase in the quantity of money, which would probably be accompanied by falling prices and rising money wages.)

So much for the "iron law of wages" in all its variations. 

Of course, even within the domain of reproducible products, quantity of labor is by no means the only determinant of price. As Ricardo himself explained in Sections IV-VI of his chapter on value, the period of time for which profits must compound on wages before the ultimate, final product is sold to consumers is a second major determinant of prices.Cf. Ricardo, op. cit.,Chap. I. (In my opinion, Ricardo's discussion of the time factor is in some respects more insightful even than Böhm-Bawerk's. Certainly, after reading those sections, there is every reason for believing that he would have been fully in accord with all of the essential points of Böhm-Bawerk's Karl Marx and the Close of His System.Eugen von Böhm-Bawerk, Karl Marx and the Close of His System, translated by Alice Macdonald (New York: The Macmillan Company, 1898; reprint, New York: Augustus M. Kelley, 1949). This essay is also reprinted under the title "Unresolved Contradiction in the Marxian Economic System" in Shorter Classics of Böhm-Bawerk (South Holland, Illinois: Libertarian Press, 1962). Indeed, many people may find remarkable Ricardo's statement to McCulloch: "I sometimes think that if I were to write the chapter on value again which is in my book, I should acknowledge that the relative value of commodities was regulated by two causes instead of by one, namely, by the relative quantity of labour necessary to produce the commodities in question, and by the rate of profit for the time that the capital remained dormant, and until the commodities were brought to market."Cf. The Works and Correspondence of David Ricardo, Piero Sraffa, Editor (Cambridge, England: The Syndics of the Cambridge University Press, 1952), Vol. VIII, p. 194.

In addition, wage rates themselves and prices of various materials determined by supply and demand are further factors entering into the determination of prices even in the domain where quantity of labor is relevant.John Stuart Mill comes very close to an accurate statement of all the relevant factors in his chapter on the ultimate analysis of cost of production. Cf. Mill, op. cit., Bk. III, Chap. IV. And, as previously indicated, of course, determination of price by cost is never an ultimate determination, for the prices that constitute the costs are themselves determined by supply and demand and reflect the utility of marginal products, as Böhm-Bawerk so brilliantly explained.Cf., above, note 2. And, to be sure, there are product prices which have no connection whatever to quantity of labor or cost of production in any form, but are determined exclusively by supply and demand, as Ricardo himself pointed out.Cf. Ricardo. op. cit.,Chap. I, Sec. I.

The fact that profits are an income attributable to the labor of businessmen and capitalists, and the further fact that their labor represents the provision of guiding and directing intelligence at the highest level in the productive process, suggests a radical reinterpretation of the doctrine of labor's right to the whole produce. Namely, that that right is satisfied when first the full product and then the full value of that product comes into the possession of businessmen and capitalists (which is exactly what occurs, of course, in the everyday operations of a market economy). For they, not the wage earners are the fundamental producers of products. 

By the standard of attributing results to those who conceive and execute their achievement at the highest level, one must attribute to businessmen and capitalists the entire gross product of their firms and the entire sales receipts for which that product is exchanged. Such, indeed, is the accepted standard in every field outside of economic activity. For example, one attributes the discovery of America to Columbus, the victory at Austerlitz to Napoleon, the foreign policy of the United States to its President (or at most a comparative handful of officials). These attributions are made despite the fact that Columbus could not have made his discovery without the aid of his crewmen, nor Napoleon have won his victory without the help of his soldiers, nor the foreign policy of the United States be carried out without the aid of the employees of the State Department. The help these people provide is perceived as the means by which those who supply the guiding and directing intelligence at the highest level accomplish their objectives. The intelligence, purpose, direction, and integration flow down from the top, and the imputation of the result flows up from the bottom. 

By this standard, the product of the old Ford Motor Company and the Standard Oil Company are to be attributed to Ford and Rockefeller. (In many cases, of course, the product must be attributed to a group of businessmen and capitalists, not just to a single outstanding figure.) In any event, labor's right to the full value of its produce is fully satisfied precisely when a Rockefeller or Ford, or their less known counterparts, are paid by their customers for their products. The product is theirs, not the employees'. The help the employees provide is fully remunerated when the producers pay them wages. 

This view of the nature of labor's right to the full produce leads to a very different view of the payment of incomes to capitalists whose role in production might be judged to be passive, such as, perhaps, most minor stockholders and the recipients of interest, land rent, and resource royalties. If the payment of such incomes did represent an exploitation of labor, it would not be an exploitation of the labor of wage earners. Such incomes are paid by businessmen—by the active capitalists; they are not a deduction from wages but from profits. If any exploitation were present here, it would be this group, not the wage earners, who were the exploited parties. What this would mean in practice is that individuals like Rockefeller and Ford were exploited by widows and orphans, for it is such individuals who make up a large part of the category of passive capitalists. 

In fact, however, the payment of such incomes is never an exploitation, because their payment is a source of gain to those who pay them. They are paid in order to acquire assets whose use is a source of profits over and above the payments which must be made. Furthermore, the recipients of such incomes need not be at all passive; they may very well earn their incomes by the performance of a considerable amount of intellectual labor. Anyone who has attempted to manage a portfolio of stocks and bonds or real estate should know that there is no limit to the amount of time and effort which such management can absorb in the form of searching out and evaluating investment possibilities, and that the job will be better done the more such time and effort one can give it. In the absence of government intervention in the form of the existence of national debts, loan guarantees, and deposit insurance, (not to mention "transfer payments"), the magnitude of truly unearned income in the economic system would be quite modest, for almost every other form of investment would require the exercise of some significant degree of skill and judgment. Those not able or willing to exercise such skill and judgment would either rapidly lose their funds or would have to be content with very low rates of return in compensation for safety of principal and, possibly, reflecting the deduction of management fees by trustees or other parties.

It should also be realized that in a laissez faire economy, without personal or corporate income taxes (a real exploitation of labor) and without legal restrictions on such business activities as insider trading and the award of stock options, the businessmen and active capitalists are in a position to own an ever increasing share of the capitals they employ. With their high incomes they can progressively buy out the ownership shares of the passive capitalists.

In this way, under capitalism, those workers—the businessmen and active capitalists—who do have a valid claim to the ownership of the industries in fact come to own them. Again and again, penniless newcomers appear on the scene and by virtue of their success secure a growing influence over the conduct of production and ultimately obtain the ownership of vast personal fortunes. An ironic consequence of Adam Smith's errors in this area, to be counted among all the other absurdities of socialism, is that the socialists want to give the ownership of the industries to the wrong workers! And to do so, they want to destroy the economic system which gives it to the right workers. They want to give it to the manual laborers, while capitalism gives it to those who supply the guiding and directing intelligence in production.

Not surprisingly, the socialists and their fellow travelers, the contemporary "liberals," denounce capitalism's giving ownership to the right workers. They denounce it when they denounce large salaries and stock options for key executives.

As a final irony it turns out not only that capitalism is not a system of the exploitation of labor, but that the actual system of the exploitation of labor is socialism. Socialism establishes the very kind of exploitation for the alleged existence of which people seek to overthrow capitalism. 

The socialist state holds a universal monopoly on employment and production. Its citizens are economically powerless in their capacity both as workers and as consumers. No economic factor compels the socialist state to take account of their wishes. From an economic point of view, the rulers of the socialist state need be concerned with the values of the citizens only insofar as it needs them to have the health and strength required to work. 

Moreover, the leading moral-political principle of the socialist state is that the citizen is not an end in himself, as he is acknowledged to be under capitalism, but is a means to the ends of "society." Since society does not inhabit any known mountain top, and cannot be communicated with in any direct way, its ends can be made known only through the rulers of the socialist state. Thus, the principle that the individual is the means to the ends of society necessarily means, in practice, that he is the means to the ends of society as divined, interpreted, and determined by the rulers of the socialist state. And what this means is that he is the means to the ends of the rulers. A more servile arrangement can hardly be imagined. 

Thus, the position of the individual under socialism is that he must spend his life in toil for the ends of the rulers, who have no reason voluntarily to supply him with anything more than minimum physical subsistence. They will provide more (assuming they have the ability to do so) only if it is necessary to prevent riots or revolution or as a means of providing special incentives for the achievement of their own values, such as, above all, the power and prestige of the regime. Thus, they will provide a relatively high standard of living for rocket scientists, secret police agents, and such intellectuals and athletes whose accomplishments help to reflect glory on the regime. The average citizen, however, is fortunate if they provide him with subsistence. He is fortunate, because, as Mises and Hayek have shown, the economic discoordination and chaos of socialism is so great that in the absence of an outside capitalist world to turn to for aid, socialism would lead to the destruction of the division of labor and hence to a reversion to the primitive economic conditions of feudalism. To borrow some of the clichés of Marxism and use them truthfully for once, socialism "cannot even maintain its slaves in their slavery"; left to its own devices, it causes the average worker "to sink deeper and deeper into poverty," until mass depopulation occurs.Cf. von Mises, Socialism (New Haven: 1951; reprint, Indianapolis: Liberty Classics, 1981), pp. 113–42, pp. 211–20, pp. 516–-21; Human Action, op. cit., pp. 698–715; Hayek, The Road to Serfdom, op. cit., pp. 48–50; idem, editor, Collectivist Economic Planning (London: George Routledge & Sons, 1935); Reisman, Capitalism, pp. 275-278, 288-290.

Despite the support which it historically gave to the exploitation theory, classical economics provides the basis for turning the exploitation theory upside down. On the basis of Ricardo's concept of profit and J. S. Mill's proposition that "demand for commodities is not demand for labour," it makes it possible to show how profits, not wages, must be regarded as the original and primary form of income, from which other incomes emerge as a deduction. And, further, not only how profits are a labor income (despite their variation with the size of the capital invested and the period of time for which it is invested), but how the labor of businessmen and capitalists has more fundamental responsibility for the production of products than the labor of wage earners, with the result that "labor's right to the whole produce" should mean the right of businessmen and capitalists to the sales receipts—a right which is honored every day, in the normal operations of a capitalist economy. In addition, the classical doctrines of supply and demand, the wage fund, the distinction between value and riches, and even the labor theory of value (appropriately modified along lines suggested by Ricardo and J. S. Mill and incorporating the advances in price theory made by Böhm-Bawerk) make possible an explanation of real wages based on the productivity of labor, which it is the economic function of businessmen and capitalists steadily to increase. Finally, it can be shown how socialism, with its universal state monopoly on employment and supply, is the economic system to which the exploitation theory actually applies.

* * * * *

This essay originally appeared in The Political Economy of Freedom Essays in Honor of F. A. Hayek, Edited by Kurt R. Leube and Albert H. Zlabinger (München and Wien: Philosophia Verlag, The International Carl Menger Library, 1985). In its original form, it is available as a pamphlet from The Jefferson School of Philosophy, Economics, and Psychology. Apart from a few changes in wording and the addition of a few paragraphs, the present version differs mainly in that endnote references have been updated to refer to works not in existence in 1985. This refers in particular to the author's book Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996), hereafter referred to simply as Capitalism, and his translation of Böhm-Bawerk's essay "Value, Cost, and Marginal Utility." The author wishes to note that Capitalism contains a far more comprehensive and detailed treatment of the subjects dealt with here (see in particular, Chapters 11 and 14).

ABSTRACT: In exalting the subjectivity of value, the marginalist revolution posed a fundamental problem for economic theory. Each person chooses how to allocate his means and thereby, economize his actions by rank ordering the value of alternatives. Being interpersonally incomparable, ordinal ranks cannot serve directly to economize means within a division of labor. Neoclassical economists solved this problem by foregoing an explanation of the division of labor grounded in the reality of human persons and instead, constructed formal, mathematical models. F.A. Hayek’s subjectivist response to the neoclassical project was to augment formal, mathematical models with select characteristics of human persons. In contrast, Ludwig von Mises grounded economic theory in the reality of human persons. He demonstrated how voluntary exchange of goods for and against money generate cardinal numbers from ordinal ranks. Actual money prices emerging from actual human choices constitute the necessary condition for economizing resources across the division of labor. Unlike subjective valuations, which cannot be compared interpersonally, and barter exchange ratios which are incommensurate, money prices can be compared. Economic calculations of net income and net worth, furthermore, are a phenomenon of the market economy alone. Mises’s approach not only solved the problem of economizing resources in a division of labor, but provides a robust framework for economic research.

Jeffrey Herbener (jmherbener@gcc.edu) is chair of the Department of Economics and Sociology at Grove City College.

Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.

It is probably no exaggeration to say that every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism (Hayek, 1955, p. 52).

F.A. Hayek (1955, pp. 52–53) appended the following footnote to his famous maxim concerning subjectivism quoted above:

This is a development which has probably been carried out most consistently by Ludwig von Mises, and I believe that most peculiarities of his view which at first strike many readers as strange and unacceptable trace to the fact that in the consistent development of the subjectivist approach he has for a long time moved ahead of his contemporaries. Probably all the characteristic features of his theories—from his theory of money (so much ahead of the time in 1912) to what he calls his a priorism—his views about mathematical economics in general and the measurement of economic phenomena in particular, and his criticism of planning all follow directly (although, perhaps, not all with the same necessity) from this central position. See particularly his Grundprobleme der Nationalökonomie (1933) and Human Action (1949).

One achievement of the Salerno camp in the second calculation debate was to demonstrate that Hayek, at least, leaves the wrong impression of the relationship between Mises’s work and his own. By referring to “the subjectivist approach,” Hayek seems to imply that his approach and that of Mises are fundamentally the same. Although Hayek admits to some differences in particulars, since Mises’s views, as he puts it, “all follow directly (although, perhaps, not all with the same necessity) from this central position.”

Mises, however, did not accept the subjectivist approach of Friedrich von Wieser, on which Hayek patterned his own framework, but instead worked within the causal-realist approach of Carl Menger and Eugen von Böhm-Bawerk.On Wieser’s approach, see Bostaph (2003). In discussing the two traditions in Austrian economics, Joseph Salerno (1999, p. 37) wrote:

It is important to note that even at this early stage, the Austrian school was deeply divided on a crucial issue of basic theory. On the one hand, Böhm-Bawerk fully absorbed Menger’s causal-realist approach to price theory and endeavored to develop it further and apply it to new areas. Wieser, on the other hand, seized narrowly on Menger’s “subjectivism” as embodied in the principle of marginal utility and, while usefully elaborating some of the implications of this principle, completely ignored the structure of reality-based price theory that Menger had labored to build upon it. Wieser’s purpose was to construct his own peculiar ideal of social welfare based on a state of general equilibrium that he called “natural value,” and to link it through the concept of marginal utility to foundations in human psychology.

With his acceptance of general equilibrium and emphasis on human psychology, Hayek belongs to the Wieserian wing of the Austrian school. Hayek attempted to graft onto the neoclassical general equilibrium conception his own insights into human learning, knowledge, and other “subjectivist” elements. In discussing the main contributions to modern price theory for an entry in The New Palgrave: A Dictionary of Economics in the early 1980s, which remained unpublished at the time, he wrote (Hayek, 1992, pp. 53–54):

Equally important is what may well be regarded as the final formulation of the marginal utility analysis by J.R. Hicks of the marginal utility analysis of value in the concept of the marginal rate of substitution, based on the indifference curve technique introduced by Irving Fisher and F. Y. Edgeworth. This conception of varying rates of substitution or equivalence, wholly independent of any conception of measurable utility, may well be regarded as the ultimate statement of more than half a century’s discussion in the tradition of the Austrian school….

Arguably, Hayek’s claim about Mises leading the advance of subjectivism may not be mistaken per se, however, Mises’s approach to grounding economic theory on a proper subjectivist foundation differed dramatically from that of Wieser and his followers.

In his magnum opus, Human Action, Mises subsumes subjectivist aspects of catallactics within the concept of economic calculation. The book is organized into seven parts containing 39 chapters. He devotes one entire part of the book, part 3, to economic calculation. It contains three chapters. In one of those chapters, Valuation without Calculation, we find Mises’s discussion of the subjectivity of value. He did not offer insights about how the advance of the concept of subjectivity can make the general equilibrium framework more suitable to economic theorizing. Instead Mises focused on two fundamental principles concerning the subjectivity of value.

First, he juxtaposed the ordinal ranking inherent in valuation with cardinal numbers in which the goods being ranked are measured. He did this to demonstrate a principle of economic calculation. He wrote (Mises, 1998, p. 201):

The immediate goal of acting is frequently the acquisition of countable and measurable supplies of tangible things. Then acting man has to choose between countable quantities; he prefers, for example, 15 r to 7 p; but if he had to choose between 15 r and 8 p, he might prefer 8 p…. This is tantamount to the statement that he prefers a to b and b to c…. It certainly does not render reckoning with cardinal numbers possible. It does not open a field for economic calculation and the mental operations based upon such calculation.

Second, he referenced the principle he (Mises, 1998, p. 699) would call in his critique of socialist schemes to provide a method of economic calculation, “the fundamental theorem of modern economics,” namely diminishing marginal utility. His purpose was, again, to make a fundamental point about economic calculation. Mises (1998, p. 206) wrote:

There is no method available to construct a unit of value. Let us remember that two units of a homogeneous supply are necessarily valued differently. The value attached to the nth unit is lower than that attached to the (n–1)th unit.

Mises (1998, p. 206) concluded this line of argument with the following words:

It is a fictitious assumption that an isolated self-sufficient individuals or the general manager of a socialist system, i.e., a system in which there is no market for the means of production, could calculate. There is no way which could lead one from the monetary computation of a market economy to any kind of computation in a nonmarket system.

In the subsection that closes out this section of the book, which Mises titled, “The Theory of Value and Socialism,” Mises (1998, p. 207) wrote the following about subjectivism:

The illusion that a rational order of economic management is possible in a society based on public ownership of the means of production owed its origin to the value theory of the classical economists and its tenacity to the failure of many modern economists to think through consistently to its ultimate conclusion the fundamental theorem of the subjectivist theory.

As noted above, Mises considered the “fundamental theorem of modern economics” diminishing marginal utility, which can be deduced from a person economizing with homogeneous units of a good. Although diminishing marginal utility is accepted by all modern economists, Mises was the first to perceive the implication of its reasoning for making economizing decisions about the use of resources in society and its application to this problem in socialism. Concerning the proposal of mathematical economists to solve the problem of economizing in socialism, Mises (1978, p. 112) wrote:

They failed to see the very first challenge: How can economic action that always consists of preferring and setting aside; that is, of making unequal valuations, be transformed into equal valuations, and the use of equations? Thus the socialist came up with the absurd recommendation of substituting equations of mathematical catallactics, depicting an image from which human action is eliminated for the monetary calculation in the market economy.Quoted in Salerno (1999, p. 58).

The deficiency in economic theory that needed correcting, according to Mises, was a fallacy economists held concerning economic calculation. Mises (1998, p. 202) wrote:

The elaboration of economic theory is heuristically dependent on the logical processes of reckoning to such an extent that the economists failed to realize the fundamental problem involved in the methods of economic calculation…. They misconstrued economic calculation. They took it for a category of all human action and ignored the fact that it is only a category inherent in acting under special conditions…. But they did not comprehend that money prices are the only vehicle of economic calculation. Thus most of their studies are of little use. Even the writings of the most eminent economists are vitiated to some extent by the fallacies implied in their ideas about economic calculation.

Contrary to Hayek, who thought that general equilibrium theory could be corrected by grafting subjectivist insights onto it, Mises perceived that the deficiency of the general equilibrium construct stemmed from its fallacious treatment of money. He identified two mistakes. First, the general equilibrium construct conceived of a market economy with only direct exchange and concomitantly asserted the neutrality of money. He wrote (Mises, 1998, pp. 203–204):

A serious blunder that owes its origin and its tenacity to a misinterpretation of this imaginary construction [a market with direct exchange] was the assumption that the medium of exchange is a neutral factor only…. This is, of course, what the fable of money’s neutrality implies. The whole theory of catallactics, it was held, can be elaborated under the assumption that there is direct trade only. If this is once achieved, the only thing to be added is the “simple” insertion of money terms into the complex of theorems concerning direct exchange. However, this final completion of the catallactic system was considered of minor importance only. It was not believe that it could alter anything essential in the structure of economic teachings. The main task of economics was the study of indirect exchange.

Only later economists realized that some of the most important and most intricate problems of catallactics are to be found in the field of indirect exchange and that an economic theory which does not pay full regard to them is lamentably defective.

Second, Mises noted a more momentous error drawn from the imaginary construct of a fictitious barter world, namely, that value is objective and can be measured by money.Mises (1998, pp. 697–699) repeats his indictment of the general-equilibrium framework in chapter 26 in which he criticizes mathematical economists for perpetuating the fallacy that economic calculation was possible in socialism. He wrote (Mises, 1998, p. 205):

Even Friedrich von Wieser and Irving Fisher took it for granted that there must be something like measurement of value and that economics must be able to indicate and to explain the method by which such measurement is effected. Most of the lesser economists simply maintained that money serves as “a measure of values.”

Mises’s corrective of the deficiencies of general equilibrium theory was based on his integration of money into subjective-value theory. He demonstrated (Mises, 1953) in 1912 how ordinal ranks are transformed into cardinal numbers suitable for economic calculation in a market economy. Buyers and sellers have preferences for a good they intend to exchange relative to money. They exchange to acquire the mutual benefit latent in the reverse ordering of their preferences. Competitive bidding by the buyers and competitive offering by the sellers results in a market-clearing price. As Rothbard (1991, p. 65) recounts it:

In the course of that notable integration of monetary theory and “micro” marginal utility theory, Mises was one of the very first to realize that subjective valuations of the consumer (and of laborers) on the market are purely ordinal, and are in no way measurable. But market prices are cardinal and measurable in terms of money, and market prices bring goods into cardinal comparability and calculation (e.g., a $10 hat is “worth” five times as much as a $2 loaf of bread).

Mises did not fully work out this integration and its implications until the German-language predecessor of his magnum opus, Human Action.See Rothbard (1991, p. 65) and Salerno (1999, p. 56). In that work, he demonstrated that the market economy is the only solution to transforming rank orders of value into cardinal numbers suitable for making economizing decisions in a division of labor. Only three alternatives to the market solution of monetary prices exist, according to Mises.

One is inter-personal value comparisons among the participants in the division of labor. Yet, modern economists all agree that inter-personal comparisons of value are impossible and therefore, this alternative is not entertained by modern economists as a solution to the economizing problem. A second alternative is imputation of value across the division of labor by a single person. Valuation, Mises argued, can be applied only to a self-sufficient economy, i.e., an economy in which a person is the producer of everything he consumes.As Mises (1998, p. 210) concedes, valuation is adequate to economizing resources within a family economy or that of a small tribe as well as a single person. In this case, a single mind can integrate the use of its resources across the entire array of producer goods with which it acts. It does this by imputing the value of lower-order goods to those of higher order. According to Mises, however, a single mind cannot decompose the value of the end achieved into the value of each factor’s contribution. He wrote (Mises, 1998, p. 332):

Valuation as it can be practiced by an isolated actor (Robinson Crusoe or a socialist board of production management) can never result in a determination of such a thing as quotas of value…. It is permissible to declare that, due allowance being made for time preference, the value attached to a product is equal to the value of the total complex of complementary factors of production. But it would be nonsensical to assert that the value attached to a product is equal to the “sum” of the values attached to the various complementary factors of production. One cannot add up values or valuations. One can add up prices expressed in terms of money, but not scales of preference…. The process of value imputation does not result in derivation of the value of the single productive agents from the value of their joint product. It does not bring about results which could serve as elements of economic calculation.

Mises insisted that in making economizing decisions about the use of resources in an extended division of labor, it is necessary to disentangle the contribution of each complementary factor of production used in producing each good. The necessity arises because factors of production are neither perfectly specific to each good nor perfectly non-specific among all goods. Absent either of those extreme conditions, economic calculation cannot be done by knowing only the value of goods of first order and the technical conditions of production of these goods. Which raises the third alternative: using the cardinal numbers of production possibilities as the basis for economic calculation. Although technical consideration allow the decomposition of the physical contribution to output made by each factor, these numbers have no connection to value of the ends attained. Mises wrote (1998, p. 208):

[The fact that] the various means allow for various uses, set man the tasks of allocating them to those employments in which they can render the best service. Here the computation in kind as applied by technology is of no avail. Technology operates with countable and measurable quantities of external things and effects; it knows causal relations between them, but it is foreign to their relevance for human wants and desires…. [Technology] ignores the economic problem: to employ the available means in such a way that no want more urgently felt should remain unsatisfied because the means suitable for its attainment were employed—wasted—for the attainment of a want less urgently felt.

In an extended division of labor, individual factors of production can be shifted from one line of production to another and configured in various combinations with other complementary factors of production in each production process. Therefore, to know whether or not a particular configuration of complementary factors of production will be more economizing for society than another configuration, prices of individual factors of production must exist. Mises (1998, pp. 209–210) wrote:

[The practical man] must know whether what he wants to achieve will be an improvement when compared with the present state of affairs and with the realizable projects which cannot be put into execution if the project he has in mind absorbs the available means. Such comparisons can only be made by the use of money prices…. Where there are no money prices, there are no such things as economic quantities. There are only various quantitative relations between various causes and effects in the external world. There is no means for man to find out what kind of action would best serve his endeavors to remove uneasiness as far as possible.

Mises concluded this line of inquiry by returning to the starting point in Robinson Crusoe, i.e., production in self-sufficiency instead of a division of labor. Crusoe could compare the value of output with the value of the complementary factors used because the possible combinations he can exploit are simple enough for him to impute value adequately for economizing.All of the combinations of factors of production can be valued by Crusoe through his own experience. Such cannot be done by a single person in a division of labor, especially the extended division of labor in a modern, capitalist economy. He wrote (Mises, 1998, p. 210):

There is no need to dwell upon the primitive conditions of the household economy of self-sufficient farmers. These people performed only very simple processes of production. For them no calculation was needed, as they could directly compare input and output. If they wanted shirts, they grew hemp, they spun, wove, and sewed. They could, without any calculation, easily make up their minds whether or not the toil and trouble expended were compensated by the product. But for civilized mankind a return to such a life is out of the question.

With his theory of economic calculation in hand, Mises critiqued the schemes of socialists to rationally allocate resources in chapter 26 in Human Action. Both the title of the chapter, “The Impossibility of Economics Calculation under Socialism,” and the summary list of schemes indicate Mises’s emphasis on economic calculation. He wrote (Mises, 1998, pp. 699–700):

The various schemes proposed can be classified in the following way:

1. Calculation in kind is to be substituted for calculation in terms of money....

2. Starting from the ideas of the labor theory of value the labor-hour is recommended as the unit of calculation….

3. The unit is to be a “quantity” of utility….

4. Calculation is to be made possible by the establishment of an artificial quasi-market….

5. Calculation is to be made with the aid of the differential equations of mathematical catallactics….

6. Calculation is to be made superfluous by resorting to the method of trial and error….

All of these socialist schemes, except number 6, are attempts to have economic calculation under socialism. And Mises’s critique of the socialist director using the method of trial and error to make economizing production and investment decisions relies on his views of economic calculation. He argued (Mises, 1998, p. 700) that economizing decisions fall into a category of trial and error in which “the only mark of the correct solution is that it has been reached by the application of a method considered appropriate for the solution of the problem.” His example is solving a multiplication problem. He wrote (Mises, 1998, p. 700):

One may try to guess the correct result by trial and error. But here the method of trial and error is no substitute for the arithmetical process. It would be quite futile if the arithmetical process did not provide a yardstick for discriminating what is incorrect from what is correct.

In the case of economizing decisions, the only way to discover if trial and error has succeeded is by a computation of profit and loss. Mises wrote (1998, p. 701):

The problem of socialist economic calculation is precisely this: that in the absence of market prices for the factors of production, a computation of profit and loss is not feasible.

We may assume that in the socialist commonwealth there is a market for consumers’ goods and that money prices for consumers’ goods are determined on this market…. But the characteristic mark of the socialist system is that the producers’ goods are controlled by one agency only in whose name the director acts, that they are neither bought nor sold, and that there are no prices for them. Thus there cannot be any question of comparing input and output by the methods of arithmetic.

Concerning the socialist scheme for a quasi-market, Mises noted that it represents the triumph of his approach to economics. He wrote (Mises, 1998, p. 702):

It is therefore nothing short of a full acknowledgement of the correctness and irrefutability of the economists’ analysis and devastating critique of the socialists’ plans that the intellectual leaders of socialism are now busy designing schemes for a socialist system in which the market, market prices for the factors of production, and catallactic competition are to be preserved. The overwhelmingly rapid triumph of the demonstration that no economic calculation is possible under a socialist system is without precedent in the history of human thought. The socialist cannot help but admitting their crushing final defeat.

Finally, Mises made it perfectly clear that the defeat of socialism owed nothing to the mathematical economics of general equilibrium. The problem of directing the use of resources in an economizing manner must start with existing conditions, which are not those of equilibrium but have been brought about by both successes and failures of the past. Even if the final equilibrium configuration of resource allocation is known, the economizing problem remains: how to move step-by-step from existing conditions to those of final equilibrium. For the solution to this problem, the mathematical expression of the state of final equilibrium is of no use. Mises wrote (1998, p. 709):

Even if, for the sake of argument, we assume that a miraculous inspiration has enabled the director without economic calculation to solve all problems concerning the most advantageous arrangement of all production activities and that the precise image of the final goal he must aim at is present to his mind, there remain essential problems which cannot be dealt with without economic calculation. For the director’s task is not to begin from the very bottom of civilization and to start economic history from scratch. The elements with the aid of which he must operate are not only natural resources untouched by previous utilization. There are also the capital goods produced in the past and not convertible or not perfectly convertible for new projects. It is precisely in these artifacts... that our wealth is embodied. Their structure, quality, quantity, and location is of primary importance in the choice of all further economic operations…. [The director] must try to take advantage of every piece of the already available capital goods in the best possible way.

Mises’s integration of money into the subjective theory of value did more than put monetary theory on solid ground. It set the entire body of economic theory on the causal-realist foundation laid by Carl Menger. Doing so required a reconstruction of price and production theory. Not merely grafting subjectivist elements onto general equilibrium theory, but rebuilding this theory from the bottom up. No better evidence of the soundness of this approach exists than Mises’s demonstration that central planners cannot allocate resources in an economizing manner in socialism for lack of economic calculation.

Since the second calculation debate made apparent Mises’s achievement in providing a truly general theory of economics, the causal-realist approach has been advancing on several fronts. To mention just a few: business cycle theory has been refined (Salerno, 2012); the theory of entrepreneurship and organizational theory has been developed (Klein, 2010); the theory of cost has been reconsidered (McCaffrey, 2018); the theory of interest has been further considered (Herbener, 2011); and Mises’s concept of entrepreneurial appraisement has been extended (Herbener and Rapp, 2016).

A central theme of all schools of economics is the notion that goods are scarce. The extent of human wants and needs is sufficiently great that the means man would apply to those ends are limited, requiring that he choose among alternative actions. The purpose of this article is to call attention to a facet of scarcity that stems from this fundamental notion and that is of relevance to economic decision making, the determination of what goals to pursue, and how to attain them. This facet is the ownership of these scarce goods. The fact of ownership means that there is an additional problem faced by those who would use such goods, beyond the fact that such goods are physically unable to satisfy all conceivable uses to which they could be put. This problem is how to convince the owner, who by the very meaning of ownership is entitled to complete control over those goods, to part with those goods (so that they may be applied to other uses).

Since some owners may be more willing to part with those goods than others, the notion of how scarce some good is for a particular use cannot be answered outside the context of ownership and the valuations of property owners, making scarcity in this sense subjective as well. The existence of and need for property is a consequence of scarcity, which is further affected by the very institution to which it gives rise. However, this “problem” in a sense supplies its own solution, as ownership implies the ability to exchange, and consequently, the emergence of exchange ratios in a common unit (that is, money prices) that permit economic calculation and thus the ability to coherently compare prospective courses of action.

This article will attempt to elaborate on this idea, and applications of this notion will be made to the problems of socialism, monopoly capitalism, and business cycle theory.

We live in a world characterized by scarcity. That is, the physical amount of the things man would use to satisfy his wants and needs are limited in relation to those wants and needs.Air, for example, is physically of finite supply, but no wants are currently left unmet on account of this. Thus, air cannot qualify as an economic good and in this sense is of “unlimited” supply.  It is for this reason that conflicts can arise over things: if goods were so plentiful that another’s use of them would not preclude my use of them, then no disagreements could arise over their use. It is because of the possibility of such conflicts that some means of conflict resolution is needed, and this is precisely why any theory of conflict resolution—ethics—is ultimately a theory of property rights (Rothbard 1998; Hoppe 1989, 1993). When scarce goods become owned, then conflict over their use is resolved (at least in principle). These goods then become property, and as the owner of property, I am entitled to exclude others from the use of the goods manifesting themselves as property. Of course, questions as to how property may be justifiably acquired must be resolved,See the preceding references. Kinsella (1996) provides an overview of other such recent work.  but once such questions are addressed, economic interactions between men become exchanges of property under a system delineating how such exchanges may legitimately take place.

Thus the concept of property stems from that of scarcity. This connection has long been recognized. Menger (1976, quoted in Salerno 1999) argues that

[A person’s] property is not ... an arbitrarily combined quantity of goods, but a direct reflection of his needs, an integrated whole, no essential part of which can be diminished or increased without affecting realization of the end it serves. (p. 84)

Salerno further notes that property is “a praxeological category that refers to a purposively created structure of goods that is adjusted through the operations of economizing to serve the structure of ends aimed at by an individual actor” (p. 84), the need for which (economizing) is entirely due to the fact of scarcity. Scarcity is a fundamental concept of economics and, more generally, of human action, as we confront scarcity with every action.

Unowned goods become property precisely because their use by one person means that others will be unable to use them. When a good is unowned (for example, in a state of nature), the question of acquiring it and making it one’s property is a question, as with all actions, of choosing one course of action over another. However, given a system of property rights that determines how goods may be justly acquired, interactions with others do not necessarily arise. That is, as an unowned good, no one else has any justifiable claim over it. Others may desire it or hope the prospective owner puts it to a certain use, but in attempting to obtain it, one needs, in principle, no more than one’s own labor. Cooperation with others is not necessary (though of course it may be preferable to acting alone).

The case is different regarding goods that are owned. Here, interactions with others necessarily arise when nonowners seek to put the good to an alternative uses. The owner, presumably, has a just claim over the use of that good, and he alone may decide how that good is put to use. Different property rights regimes may place greater or lesser constraints over the extent of his use, but ultimately the owner determines what will happen to this good. Of course, with a system of property rights there must not only be constraints on how property is acquired, but also on how it is exchanged. Still, what determines the terms on which exchanges of property take place are the desires of property owners on both sides of an exchange.

Because of the fundamental fact of scarcity, a good can be applied to multiple ends, any one of which precludes the others from being realized. In deciding whether to homestead an unowned good (that is, apply one’s labor to acquiring the good and so become the just owner), a person must judge whether that choice will best meet his ends. He must then make a further choice as to how the good should be obtained and used. Of course, he must understand the property rules for his society, so that his actions are justifiable, but in this case the only barriers due to scarcity that he faces are the facts that by homesteading the good, he cannot do something else, and that by using the good in one way he cannot use it in some other way.

He of course faces these same difficulties when deciding whether to acquire an owned good. However, now he faces an additional problem: namely, how to obtain access to property from which he is forbidden, absent the owner’s consent. The scarcity he now faces is distinct from the fundamental or general scarcity that characterizes our world. For under a private property regime, the owner alone decides how available an owned good will be for various purposes. This scarcity stemming from ownership holds across all property. For to obtain someone else’s property, I must engage in some kind of exchange with that owner, and this presumably will involve an exchange of property. If, say, owners of beer are demanding $20 a bottle for their product, then if I so desire beer that I will pay this price in money property, my money property likewise becomes scarce to me and I must be quite careful in how I apply it elsewhere. On the other hand, with money prices, I am at least able to coherently apprehend scarcity in this sense, as there exists numerical ratios that allow me to compare prospective actions to anticipated outcomes.

Thus we can see that goods can be considered scarce not only on the basis of the limits of their physical supply relative to wants, but also on the basis of the desires of the owners of those goods. The need for and existence of property stems from a fundamental fact of reality regarding objects as goods—namely, scarcity. However, once a good becomes property, there is a further aspect of scarcity that must be considered, and this aspect stems from ownership. Because of scarcity in the fundamental sense, one is forced to make choices. An action made in one endeavor is an action that cannot be made in another. A ton of steel used to make cars cannot be used to make railroad tracks.

Because of scarcity due to ownership, one is forced to take something else into consideration: how to persuade the owner of the good in question to part with it, and this is distinct from the notion of scarcity as reflecting a limited physical supply relative to wants (although, of course, it is ultimately dependent on this fact). Now, the question is not only whether to use steel to make cars versus railroad tracks, but how to obtain the necessary steel from the person who owns it. Depending on the relative ease with which this can be done (that is, how much other property must be given in exchange for this steel), one application might be chosen over the other, and it is possible that neither will be feasible. The owner may be so insistent on keeping his property that the only price (in terms of money property) that will change his mind is sufficiently high for an entrepreneur to judge that these goods cannot be profitably applied anywhere. Or, the owner might be sufficiently generous that an entrepreneur will judge a wide range of projects to be feasible. In either case, the good in question is scarce to the extent that the owner wants it scarce.

Property is a means for solving one problem: the fact that prospective means in the physical world are of insufficient supply to meet all our ends, so conflicts with others may arise as a result. Property rights in these means establish boundaries which exclude others from using these means, and so serve as a way of resolving conflicts over them. (Of course, any property rights system, including systems based on the violation of such rights, for example, the State, is only effective to the extent that people are willing to abide by it.) In solving one problem—namely, disagreement over (scarce) goods in a state of nature—property creates another problem: the fact that an owner must now be persuaded to part with his property if one desires to apply that good to some end. However, as a property rights system must provide some way of exchanging validly owned goods, the system permits a solution to this problem: specifically, economic calculation. The amount of property one must surrender to acquire some other property, deemed more important to satisfying one’s needs, can be determined in terms of money prices. One can calculate whether the anticipated proceeds from some course of action will exceed the costs required to presumably bring that action about.

So under a system of property rights, economic decision making must take scarcity into account, not only in the usual sense of choosing which wants are to be satisfied with a finite physical supply, but also in the sense that how available a good is depends also on the circumstances arising from that particular good being owned. When a good is owned (and on the free market, ownership implies not just control but the ability to exchange), the notion of a quantifiable amount of property needed to acquire that good comes into existence. This in turn leads to numerical exchange ratios (prices), which are the basis of economic calculation for comparing prospective gains and costs. Whether a particular good will be scarce or plentiful relative to a potential use then depends on how much property that good’s owner demands for it; the question of how to “best” produce something cannot be answered outside the framework of a property rights system for determining what factors are available (attainable) for its production. Indeed, the availability of factors in an economic sense plays a role in determining what should be produced in the first place.

Under a private property regime, there is a duality: On the one hand, consumers, as property owners, determine what is produced to the extent that producers whose products are unwanted by consumers will soon find themselves out of business. On the other hand, producers, as property owners, determine what is consumed to the extent that they decide to allocate their property to certain production processes. If the owner of some factor of production will not commit that factor to some line of production, those products will not be produced and, hence, not consumed. He may come to regret his decision, but that can only be revealed in the future, not now. The wishes of consumers and the “knowledge” of other entrepreneurs are irrelevant. As Rothbard (1993, p. 561–66) argues, the concept of “consumer sovereignty,” if used in any but the above sense, is false.

Attention here must be drawn to the aspect of scarcity that derives from the specific fact of ownership, as opposed to the more general condition that the physical supply of a good is insufficient to meet all wants regarding that good. To be sure, we live in a world where goods exist only in finite physical amounts, so that not all wants can be satisfied. However, a subset of this more general form of scarcity is the scarcity that depends on the subjective valuations and desires of property owners. Whether a good is scarce or plentiful from this standpoint depends on the wishes of the owner(s) of that good.Of course, if nobody else wants the good in question, then from the point of view of these others, the good is quite plentiful. However, to acquire an owned good requires the consent of the owner, and his desires will determine how scarce the good is for use by others. A few pounds of wheat, for example, may be more plentiful than a ton of wheat, if the owners in the former case are extremely generous with their property while the owners in the latter case are extremely covetous of theirs. It is this component of scarcity, and not only the general fact of physical scarcity relative to wants, which is relevant for economic decision making. Even to acquire an unowned good from a state of nature requires the concept of self-ownership, such that one can compare the amount of property one would receive by acquiring the good oneself or working in a different line of production. (This leaves aside issues of alienability in ones body compared with physical objects; see Kinsella 1999.)

Under a capitalist system, it is largely irrelevant who owns what.Provided, of course, that unowned goods may be homesteaded (that is, unowned goods can become property), and that one can expect such rights to be respected over time. More precisely, the functioning of a market does not depend on particular ownership, only on the fact of ownership. As a consumer of beer, it may matter quite a bit to me that the owners of factors that could produce beer are unwilling to devote their resources to such production, thus yielding less beer than (technically) possible. However, with unfettered private property rights (such that valid exchanges are unhindered), there will be no situations of surplus or shortage, where actors cannot adjust prices and where there are willing sellers and buyers, but no willing buyers and sellers, respectively. (Markets “clear,” in other words.A “common-sense” equilibrium, as opposed to the general disequilibrium case of unmet desires at any given time, see Gordon (1995).) It is only important that someone owns a factor of production. In that case, one may compare the anticipated revenues (in terms of money property) from an action with the costs (also in terms of money property) of bringing that action about. Once one has formed a judgment as to how much property consumers will give for some product, one can calculate how much property (in the same units) one can afford to give to acquire the means judged appropriate to produce that good. Regardless of whether a particular factor is owned by a miser or a freewheeling sort, exchange ratios result that permit the meaningful comparison of various actions on the market.

Factors of production are valuable because the output they produce is valuable. But because the outputs of production are subjectively valued, it is not possible to compare outputs with potential inputs on the basis of value. However, under a system of private property in the means of production, numerical exchange ratios (prices) exist which permit precisely this comparison (that is, economic calculation). Whether a factor owner is stingy or generous (so that the price of his factor is “high” or “low”) is irrelevant to the fact that economic calculation is the tool of entrepreneurs who must always first form a judgment about the future. Whatever “knowledge” may be “embedded” in the prices in those two different cases in no way changes the fact that, in either case, the factor in question can only be applied to production if an entrepreneur judges that it will be profitable, and if he can obtain property sufficient enough to acquire it (Hülsmann 1997). Indeed, the question of whether he can afford this factor determines the profitability of that factor in any given venture. The scarcity induced by ownership is always addressable by economic calculation.

The question of what goods to produce cannot be answered separately from the question of how scarce the factors needed to produce that good are. However, this scarcity is dependent on the ownership of those goods, and not simply on the fact that such resources exist in physically finite amounts. Thus one can never speak of value scales as such for the purposes of economic planning. One must always speak in terms of how much (anticipated) property consumers are willing to give in exchange for those goods, which, when combined with the amount of property (referred to a common unit) needed to obtain the means for producing those goods, enables one to decide what is to be produced for consumption.In fact, the price of any good depends both on the demand and supply of it, so one can never speak of prices for consumer goods without reference to prices for producer goods. For a discussion of price formation on the market, see Rothbard (1993, chaps. 2 and 3). Value scales of consumers are only part of the problem. If a particular factor owner will not surrender his property for less than what other entrepreneurs think it can yield in some line of production, then that factor will not be used in such a way, regardless of consumer wishes (or competing entrepreneurs’ knowledge thereof).Likewise, if factor owners are unable to ask for as much property as they would like to for their products (as is the case under, say, price controls), then they will not do so, and furthermore, prospective buyers of those factors will deem them more plentiful than they actually are. This is another example of the illusions fostered by the property rights violations of the State; see Hülsmann (1998).

The notion that the scarcity of a good depends on the ownership of that good is not entirely new. Indeed, an early economist of Austrian bent, Bastiat (1966b, chap. 1), spoke of the subjectivity of scarcity (and its flip side, abundance) when he noted that people have different attitudes toward scarcity depending on what side of a transaction they are on. In fact, property played a key role in his thought. Consider the following passage from Bastiat (1966a, p. 228):

What I now say, what I declare with conviction as an absolute certainty in my own mind, is this: Yes, there is constant interaction between private property and the communal domain. ... But the second assertion, amplified and exploited by the socialists, is even more dangerously erroneous; for this interaction does not cause any part of the communal domain to be appropriated into the domain of private property, but, on the contrary, constantly extends the former at the expense of the latter. Private property, inherently just and legitimate, because it always is proportional to services, tends to convert onerous utility into gratuitous utility. It is the spur that impels the human intellect to realize the latent potential of the forces of Nature. It attacks, to its own profit admittedly, the obstacles that stand in the way of gratuitous utility. And when the obstacle is surmounted to any degree, we find that it results in corresponding benefit to all. Then, tirelessly, property attacks new obstacles, and this process continues with never an interruption, steadily raising the standard of living, bringing the great family of man nearer and nearer the goals of community and equality.

There are probably a number of ways to interpret this passage, but its emphasis on the centrality of property in human society is clear. Bastiat clearly recognizes the role property plays as a means toward our ends. However, one can discern (at least, with a broad reading) elements of the role of economic calculation here. For by permitting exchange ratios (Bastiat elsewhere speaks of the necessity of exchange for determining value), individual ownership of property allows all others in society to appraise such property as means for meeting their ends, whereas such an appraisal would be impossible without property. The means available to man without economic calculation are of extremely limited scope; private property enabling such calculation broadens this scope enormously.

Among modern Austrians, it is Rothbard who comes closest to calling explicit attention to this concept in his discussion of monopoly prices (Rothbard 1993, chap. 10). Here, Rothbard notes that the notion of “restrictionist” production (a charge frequently leveled against entrepreneurs in support of antitrust policies) makes no sense on a free market, as the fact of scarcity means that one always restricts some production by the simple fact of pursuing one course of action over another. According to Rothbard,

In the real world of scarce resources in relation to possible ends, all production involves choice and the allocation of factors to serve the most highly valued ends. In short, the production of any product is necessarily always “restricted.” Such “restriction” follows simply from the universal scarcity of factors and the diminishing marginal utility of any one product. But then it is absurd to speak of “restriction” at all.

And in his discussion of the concept of “consumer sovereignty” (pp. 561–66), Rothbard notes the dual role all men play as both consumers and producers, and that the proper conception is one of self-sovereignty. The notion that producers serve consumers is true in the sense that producers must make things that consumers want, otherwise they will go out of business. However, it is false in a literal sense, and certainly unjustifiable in an ethical sense.

In the context of a different controversy of relevance, namely the socialist calculation debate, Rothbard (1991) quotes Professor Georg Halm:

It is true that the central authority would know quite well how many capital goods of a given kind it possessed or could procure....; it would know the capacity of the existing plant in the various branches of production; but it would not know how scarce capital was. For the scarcity of the means of production must always be related to the demand for them, whose fluctuations give rise to variations in the value of the good in question.

It can only be added to this insightful statement that “demand” must be understood to include reservation demand, the amount that sellers will withhold from the market (see Rothbard 1993, p. 118). But of course, something can only be withheld on an unhampered market if it is validly owned, so we see again the key role ownership plays in the decision making of all market participants, both of existing owners and prospective owners (that is, nonowners). The scarcity of a factor of production will depend not only on the demand for the products it can produce, but also on the judgments and valuations of the factor owner regarding its use.

The key point, the explication of which has been the objective of this here, is that restriction and sovereignty on the market stems from ownership, both in the sense of producers as owners of themselves, and as owners of the factors of production which they alone may decide how to best dispense with. In this case, scarcity of both consumer and producer goods is derived from the judgment of property owners. While scarcity is a fundamental fact of our existence, scarcity on that subset of existence, the market, is entirely dependent on ownership. If one wishes to attack a producer on the grounds that he makes his goods scarce, then one must do so on ethical grounds, for by granting him control over these goods, one grants the notion of their availability for production to be a question for him to decide. One cannot speak of consumer goods being scarce without reference to the scarcity of the goods needed to produce them, and this scarcity on the market must ultimately be considered in terms of the ownership of those factors.

We will use the term catallactic scarcity to refer to this notion of scarcity that derives from a good being owned, in distinction from the more general fact of scarcity, which we will term physical scarcity. Of course, physical scarcity is understood to have an economic component of its own, specifically the limitation of means relative to ends. However, we make the distinction to call attention to the ownership-dependent aspects of scarcity. By understanding catallactic scarcity as inseparable from ownership, we can turn attention to applying this concept to several current debates in Austrian economics.

The comparison of prospective gains with potential costs as a criterion of economic decision making has been referred to as economic calculation (Mises 1998, chap. 12). It was Mises who put forward the argument over seventy years ago that economic calculation is impossible under socialism, and that such an economic system is therefore not rational (Mises 1990; 1998, chap. 26). There has recently been a debate within the Austrian School over what, precisely, this argument means, with some researchers taking the position that the argument refers to the absence of private property, such that exchange ratios permitting computation of profit and loss are impossible (for example, Herbener 1991; Salerno 1993; Hoppe 1996); others interpret it as meaning that information conveyed by prices does not exist under socialism, such that opportunities for profit go unrevealed (for example, Kirzner 1996 and Horwitz 1998). These two camps may be called, respectively, “Misesian” and “Hayekian.”The neoclassicist position seems to be sympathetic to the Hayekian interpretation, see Yeager (1994). See also, among others, Hülsmann (1997) for a detailed analysis of these issues.

It is not the purpose here to enter into this debate. However, some support will be given for the Misesian framing of the argument by highlighting the centrality of privately owned property to economic decision making, and we will now turn to this topic.

Under socialism, of course, there is no private ownership of the means of production. Thus, the notion of scarcity in an economic sense has no meaning in such a system. A socialist planner may have complete knowledge of the physical amounts available to him, and all the ways to use them, but this is irrelevant for the purposes of economic planning. For this, he must have some knowledge of a factor’s catallactic scarcity, but this is entirely dependent on that factor being owned (so that exchange ratios may be formed). This “knowledge,” however, does not refer to some physico-chemical property of the good that could be “conveyed” to him through a price system. Rather, this knowledge refers to no more than being able to determine how much property he must give to acquire the good, which will then constrain what kind of consumer goods he can create with it. Under different patterns of ownership, this kind of catallactic scarcity will change, so there is in fact nothing objective the planner can know about. But when the factor is owned, prices for economic calculation can always be formed. Without any notion of catallactic scarcity of the means of production (which depends on ownership, not knowledgeProperty and knowledge are not the same thing, and unlike property, knowledge itself can never be scarce in any sense. That I have an idea in no way precludes someone else from having that idea, while ownership arising from scarcity does imply such exclusion (Kinsella 2001).), there can be no notion of what consumer goods are economically feasible.

What does not exist without private property (however incompletely attenuated) is a means for objectively comparing different courses of action, given a judgment about the future. At most, prices inform about how much property must be given now to acquire a particular factor of production. They tell nothing about how to use that factor or whether the future will prove some such use fruitful or not. Entrepreneurial judgment is required for this, and if some factor owner will not surrender his property for less than an entrepreneur thinks its products can be sold for, that factor will not be so used. It is ownership, not knowledge, that determines the status of the factor (Hülsmann 1997).

Thus, in a socialist economy, it is not enough to know (however completely) available physical amounts of resources and technologies for combining them along with consumer value scales. To speak of an action being economically “efficient” or rational requires being able to meaningfully compare inputs and outputs. One must be able to quantify what consumers will be willing to give in return for the outputs of production, and similarly relate the inputs of production to the same “standard.” However, it is clear that no such thing can be done in a socialist state, where there can be no ownership in the means of production, and so notions like catallactic scarcity (and resulting exchange ratios in terms of other property) are meaningless. It makes no sense to speak of how much property can be given in exchange for socialized factors of production, so it likewise makes no sense to speak of what products should be produced for consumption, as the ability to consume depends on the ability to produce. Knowing consumer preferences is of no use in solving this problem.

Socialism thus severs the duality between consumption and production, and this is its fatal flaw, not an absence of knowledge that could be conveyed by prices. (The equations of neoclassical economics explicitly make this dichotomy and consider only the physical scarcity of resources for production, and so are of no use for economic planning, even apart from knowledge problems and their static nature.All of these equations in their various guises essentially try to “maximize” utility subject to physical and technological constraints on available resources. Even granting that, with complete knowledge and perfect foresight, a planner could allocate resources for a given period based on these equations, the question of how much of his available resources he should hold in reserve for future consumption cannot be so addressed. At some point a planner must stop cannibalizing an existing capital structure and at the very least maintain that structure, so capital goods must be included in his value scale. However, it is nonsense to include indirectly valued means among his directly valued ends. Even means must be economized, but unlike ends, recourse to their utility is futile for doing so. They only have utility because of the (direct) utility of the ends they produce, but it is only the utility of ends that one may appraise, in terms of the wants they remove. Only monetary prices permit the appraisal of both means and ends. The choice of how to “model” available means in these equations is arbitrary at best, if not absurd (for example, modeling capital “growth” like some sort of natural phenomenon). Thus, as Salerno (1990, p. 56) noted, “[s]ocialism will have particularly devastating effects on the economy’s capital structure.”) To be sure, it has never been demonstrated how this transmission of knowledge through prices supposedly occurs, or exactly what information, “tacit” or otherwise, is contained in prices, but the point is that under a private property system, it is irrelevant whether someone “knows” of great, unmet demand toward which some factor of production can be applied. On the free market, such a factor is presumably owned, and unless that owner is willing to part with his property (which requires an exchange of other property), that factor cannot be applied to that production process, regardless of how much knowledge one possesses of alternative uses for it.

Also, one wonders where the importance of “decentralized” knowledge lies (see Hoppe 1996). For ownership is both centralized and decentralized: centralized in the fact that one and only one person controls access to some good (even when the good is jointly owned, different people own different shares), and decentralized in the fact that under a private property regime (either free or partly free), anyone can attempt to acquire the good by offering sufficient property in exchange. Indeed, at what stage does “economic knowledge” become decentralized? When, say, ownership of some physical supply is more or less evenly distributed? Why not when a single person owns 99 percent of a good? In either case, prospective actions can be coherently evaluated (“appraised”) via economic calculation. It is the existence of markets that permits economic calculation, not the decentralization of knowledge, economic or otherwise.

One may concede, however unlikely, that a socialist planning board may have complete knowledge of resources, technologies, and tastes, and may be able to assemble factors to produce some list of desired goods. However, this output has no economic meaning because there is no notion of exchanging one state of affairs for another, of sacrificing consumption to production and vice versa. One may contend that the central planning board could not “know” whether a particular allocation of resources is economically efficient, or whether they are meeting some needs at the expense of other, more urgent needs. However, these objections only make sense within the context of ownership of the goods and resources in question. However, it is pointless to exchange property for production purposes based on subjective valuations, and economic calculation with market prices (exchange ratios) permits the subjective valuations of consumer goods to be indirectly imputed to producer goods. But again, it is ownership and not knowledge that is central to this process, for only ownership enables the exchange ratios necessary for this comparison process to come into being.

What are economically wasteful inputs under one realization of private property rights may be profitable under another realization, depending on the desires of property owners, both from the point of view of producers as well as consumers. Correspondingly, a different set of outputs (consumer goods) will be economically rational or irrational, depending on these circumstances. Under such a system, it only makes sense to speak of less urgent needs being met if an entrepreneur obtains a loss on his venture. With different patterns of ownership, that venture may well prove profitable, in which case one would say he has met urgent needs. One cannot say, for example, that it is always economically wasteful to build a car with gold. It is only under current conditions (of ownership, valuations, etc.) that such an activity is wasteful. Under different conditions, it may well be profitable.

So, the problem with socialism is not that the central planning board will not know how to best meet given ends. It is that without the notion of privately owned means of production (and hence catallactic scarcity of those means), the notion of what ends are appropriate at all makes no sense. One may postulate a “market” for consumer goods in a socialist state, with “prices” for these goods. However, these prices have no relation whatsoever to their counterparts in a capitalist state, even if numerically they should happen to be the same. For the prices in a capitalist system imply an amount of property that can be given in exchange for that good. In a capitalist system, this (money) property encompasses consumer as well as producer goods. Obviously, whatever property can be obtained in a socialist economy must exclude producer goods, so the notion of “prices” as exchange ratios, even among consumer goods, is severely restricted if not meaningless. 

Of course, it may be objected that, even under socialism, catallactic scarcity also exists, as the central planning board does in fact own the means of production in the society under its control. However, this is better characterized as controlling these factors, as ownership suggests that one can divest oneself of property, and of course this cannot happen under socialism (if the system is to remain socialistic). A contrast may be made with the situation of monopolies under capitalism. Under capitalism, a person may be the sole owner of some particular factor or class of factors. In principle, however, one can always offer such a person property in exchange for these factors, so there is a notion of scarcity in the sense of what uses these factors can be profitably put to, relative to what must be used to first acquire them. Such a situation cannot, even in principle, occur under socialism. Indeed, we again see the duality of exchange that exists under a private property system. To own something means that someone else must surrender a certain amount of property in order to become the owner. How much property depends on the valuations of the prospective exchangers. Even a “monopolist” can in principle be persuaded to part with his goods, and an entrepreneur can at least attempt to calculate how much this will take. Such an endeavor may prove fruitless, but it is at least possible. (Likewise, if no one has any interest in or anticipates any profitable use of the monopolist’s goods, then the fact that he is sole possessor poses no problem for entrepreneurs.)

So even an extremely restrictive monopolist faces a categorically different situation than the director of the central planning board. The monopolist can in principle transfer ownership (for a price), while the director cannot. The extent to which the monopolist is willing to do so determines the scarcity (economic) of his factors, and thus what is feasible to produce for consumption. Whether the director would be generous or covetous is irrelevant; neither characteristic changes the fact that he cannot dispose of these goods, so attaching economic significance to them is impossible (or, better, meaningless), unlike under a private property system. Furthermore, from an economic perspective, the monopolist, as an owner, behaves no differently if he restricts use of his factors or applies them. In either case, his subjective valuations and judgment of how best to satisfy himself drives his actions. This aspect of economic behavior, either committing or withholding resources, is the dual part of every economic action under private property. For the director, it makes absolutely no sense to speak of him withholding resources. For what end? For the director, he must apply these resources, so the notion of catallactic scarcity which implies the need to conserve resources is absent. Again, the duality between production and consumption is severed under socialism.

Even if an entrepreneur should happen to come into ownership of all the means of production in some society, his position is quite different from that of the director of the central planning board under socialism. The monopolist can always assign economic significance to his property by entertaining bids from others, and of course he can accept those offers. In a capitalist society, money prices encompass both consumer and producer goods. For the central planner, it is absurd to think he can receive bids for the property under his control. He cannot exchange his property, so any attempts by him to “play” market are just that: meaningless games.More generally, as states may be considered territorial monopolists of judicial and protective services, one can make a distinction between privately owned governments, such as monarchies, which can engage in economic calculation, and publicly owned (“caretaker”) governments, such as democracies, which cannot. For more on this distinction, see Hoppe (1999).

Should the monopolist actually refuse all offers, he can still in principle accept them at any time. And in fact it is his stance that determines the notion of catallactic scarcity in his society. For assuming he came about his goods justly (that is, mixed his labor with unowned land or acquired, through voluntary exchange with others, property likewise created (Hoppe 1989, 1993; Rothbard 1998), then there can be nothing wrong in an ethical sense with him hoarding all of his goods. (Of course, socialism violates the “natural” property rights of others, and this alone would disqualify socialism as a justifiable system, but this is a separate issue.) Whether his hoarding, which would presumably lead to great suffering for others, is wrong in a moral sense is an entirely different matter.  In this case, the scarcity in society is quite extreme—one might say far “greater” than the mere fact of limited physical amounts.

The director of the central planning board is in no such position. The notion of him accepting or refusing an offer for his property (so that numerical exchange ratios for economic calculation could be formed) is absent under socialism. Any bid he could receive would be meaningless, for he cannot surrender any factor of production. Under capitalism, the bids made to factor owners, be they monopolists or not, permit the evaluation of prospective actions. That is, prospective gains can be meaningfully compared with costs because a common unit of comparison exists. No such common unit exists under socialism. Even a monopolist can coherently compare the gains from applying a factor to production himself or selling it to someone else. The socialist director cannot sell a factor. Single ownership of a good does not abolish markets for that good, so prices can still be formed. Coercive socialism, however, does abolish markets.

As a further, albeit brief, application of the concept of catallactic scarcity as determined by ownership, consider Austrian business cycle theory. The details of this theory need not be expanded upon here, and some familiarity will be assumed (for example, Rothbard 1983; Mises 1998, chap. 20). The main thrust of the theory is that economic downturns (“recessions”) are attributable to the fact that credit inflation distorts the structure of production, which depends on the time preferences of consumers (their willingness to forego current consumption in favor of future consumption). Thus, “artificially” low interest rates give rise to a (lengthened) structure of production inconsistent with the (unchanged) time preferences of consumers, necessitating at some point a restoration of the original structure (a boom-to-bust process).

Certain aspects of this theory have been criticized by Hülsmann (1998), in particular the notion that downturns are the consequence of credit inflation. (Hülsmann accepts the descriptive details of the nature, but not the cause, of the cycle as laid out by Austrian business cycle theory.) Among other points, he argues that inflation, like any other unanticipated change, can be correctly forecast by entrepreneurs, so there is no reason to presume that they will be so misled. (This is actually, in one form or another, a common critique of the theory.) Austrian business cycle theory in its usual form is at best, then, a contingent theory of economic downturns. Instead, he argues for an essentialist rendition of Austrian business cycle theory, wherein error is not a consequence of past conditions (no such consistent theory is possible), but rather is inherent in the system of banking that exists today throughout the Western world (that is, fractional reserve banking, the lending out of demand deposits in excess of reserves).

Some support will be given here for Hülsmann’s argument. First, it should be noted that, on a free market, it is consumer time preferences that determine the length of the structure of production. The more consumers are willing to save (that is, forego current consumption in favor of future consumption), the more far-removed or “roundabout” production processes can be relative to the finished product.See Rothbard (1993, chap. 8) for a more detailed discussion of this process. That is, the scarcity of capital goods in an economic sense is determined by ownership, namely the willingness of consumers to exchange their current property for future claims to property. This property can then become owned by entrepreneurs, who can assemble a structure of production as described above (that is, via judgments and economic calculation). Whether the consumers directly give their property to entrepreneurs or (more likely) use banks as an intermediary is irrelevant. The key point is that the availability of capital goods again depends on private property (ownership).

The situation is quite different under a system of fractional reserve banking. Here it is not property and the subjective valuations of its owners that determine scarcity (in the economic sense) and drive production processes. Rather, it is the ability of banks to create titles to property not backed up by actual property.See Hoppe et al. (1998) for more on this point, as well as the purely juridical nature of fractional reserve banking. That is, catallactic scarcity, which depends on the ownership of property, is not the determinant of production (and thus, ultimately, consumption). Instead, the catallactic scarcity of capital goods is inherently misrepresented under this system, as the bankers do not surrender their own property in exchange but rather create “false” property, claims to property divorced from existing property. It thus appears that more property is available for production than actually exists, and here is the nature of the crisis as laid out by Austrian business cycle theory—the mismatch between consumer time preferences and entrepreneurial judgments thereof.To use Hülsmann’s (1998) term, the illusion of more property is created by fractional reserve banking. More generally, as an inherently aggressive institution, the State relies on many other illusions to continue its existence, for example, the illusion that people can remain owners of themselves and their property while granting the State the ability to unilaterally tax, jail, etc.

Indeed, one may refer to this situation as a “political discovery process,” as distinct from a fallacious “price” discovery (Hülsmann 2000), since the availability of capital is not determined by the value judgments with property of individual owners, but by the ability of bankers to discover how much they can jointly issue titles to property in excess of actual, existing property. That is, the scarcity of capital is not determined by the subjective valuations of the owners of capital, whether they are generous or greedy with their property. Rather, the amount of capital is determined by the actions of others—in this case, other bankers. The more other bankers expand their lending beyond reserves, the greater latitude any other banker has for doing the same. This situation does not result when considering individual property owners, where the decision to make property available is entirely up to the individual owner. In fact, the entire concept of property at all is distorted under fractional reserve banking, for in this case what constitutes “property” is dependent on the will of the bankers to create something out of nothing. Under a true property regime, one cannot create something out of nothing, regardless of the intensity of one’s desires. This is not true under fractional reserve banking, where the only constraint on any individual bankers desires is the extent to which other banker’s are likewise willing to inflate.

Thus the notion of scarcity of capital goods (and the resultant production structure based thereon) is completely blurred under fractional reserve banking, and it is the nature of the system that is the ultimate source of the error (malinvestments) and that Austrian business cycle theory attempts to explain. To be sure, the concept of catallactic scarcity is not completely obliterated, as it is under full-blown socialism. It remains the case, though, that the scarcity of capital is falsely represented under fractional reserve banking.

To conclude and summarize, the notion of scarcity of a particular good for economic purposes must include reference to the ownership of that good, and not just the limited physical amount of that good relative to wants. It is scarcity in this economic sense (that is, the willingness of the owner of some good to exchange it for something else) that is of central importance to economic decision making (calculation, comparing anticipated revenues with prospective costs in a common denominator), both in deciding how to produce something, as well as what to produce. One cannot hope to reproduce the results of an unhampered market with systems that destroy the central characteristic of that market. Various forms of violent intervention in the market abolish this crucial notion of scarcity, either completely, as under socialism, or partially, as under fractional reserve banking, with results that are, at best, arbitrary from the point of view of consumers. In actuality, of course, the realized results have been utterly disastrous.

It is not a question of “knowing” how valuable ones actions can be, and learning of this through the price system. The point is that action within society is always action within a system of property rights, restricted or unrestricted to some degree. Given constraints on our actions as imposed by such a system, the question becomes, what must one do to attain one’s goals? In a system of property rights, one must exchange property for property, based on judgments of the future. Only under a system of property rights can one quantify and compare in a common unit gains relative to losses (comparison of procedures for producing subjectively valued goods being otherwise impossible), and only under a system of unfettered property rights is the duality between consumption and production preserved. That is, only then are there objective constraints on both what is produced and consumed. Social democracy and state capitalism as currently exist in the Western world blur this duality, while complete socialism demolishes it. 

Joseph T. Salerno (jsalerno@mises.org) is Academic Vice President of the Mises Institute.

I am indebted to David Gordon, Carmen Dorobăț, Matthew McCaffrey, and Mark Thornton for their very helpful comments and suggestions, which clarified and improved the argument of the paper. Responsibility for remaining errors or obscurities is mine alone.

Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.

Vlad Topan’s “Note on Rothbardian Decision-Making Rents” (2012) is a welcome and thoughtful addition to a neglected topic in the Austrian theory of entrepreneurship: what Murray Rothbard (2009) has dubbed the “decision-making” or “ownership” function of the capitalist-entrepreneur. This productive function had been recognized and discussed by Carl Menger, Eugen von Böhm-Bawerk, and Ludwig von Mises before Rothbard. Unfortunately, after the publication of Man, Economy, and State in 1962, the concept dropped out of the Austrian literature until the present author traced out the development of this concept in Austrian writings in his article, “The Entrepreneur: Real and Imagined” (Salerno, 2008).

The main thrust of Topan’s note is to deny Rothbard’s claim that there exists a specific form of income that is a return to the ultimate decision-making function of capitalist-entrepreneurs as property owners and is separate and distinct from their interest return as capital-investors and pure profit (or loss) return as entrepreneurial uncertainty bearers. In particular, Topan disputes Rothbard’s claim that the ownership function and its correlative income of decision-making rent has any place in the equilibrium conditions of the evenly rotating economy (ERE).

Despite the great degree of care and ingenuity that Topan puts into constructing his case, I believe that it rests on two fundamental errors.

First, Topan conflates Mises’s imaginary construct of the pure entrepreneur with what Mises (1998, p. 256) called the “entrepreneur-promoter” or simply “promoter.” The former, according to Mises (1998, pp. 253–254) is not a human actor but a single “definite function” that is embodied in “an imaginary figure” who is “propertyless” and whose only function is to bear risk. As such, for Mises the pure entrepreneur is a “methodological makeshift” designed to enable the economist to analytically isolate profit (and loss) from the interest earned on capital, both of which are inextricably bound together in the net income received by business owners and investors in the real world. In sharp contrast, Mises’s entrepreneur-promoter is a real actor who owns capital and puts it at risk by purchasing factors of production that he judges are undervalued relative to the prospective value of the future product they will yield. He is then obliged to efficiently combine these factors according to a technical plan in a time-consuming productive venture that he must oversee to completion. Indeed, Mises (pp. 254, 302) pointed out that it is not possible to think through the concept of a pure entrepreneur who owns no capital to a logical conclusion and he explicitly warned against the “error” of confusing the pure entrepreneur with the entrepreneur “in a living and operating market economy.”Rothbard (1997, p. 249) recognized and adamantly rejected Mises’s concept of the pure entrepreneur, “which treat[s] the entrepreneur as an entirely separate entity, and not just as the forecasting aspect of the activities of the capitalist or laborer.” In his own treatise, Rothbard (2009, p. 510) avoided the construct when analyzing the nature and causes of profit as a return to the function of uncertainty-bearing and spoke of “the active entrepreneurial element in the real world [that] is due to the presence of uncertainty.” Rothbard (2011, p. 285) also noted that Israel Kirzner’s conception of the pure entrepreneur, who owns no capital and earns profits essentially by arbitraging price differences, finds “a certain amount of textual justification in Mises.”

Topan (2012, pp. 76–77), however, ignores the distinction drawn by Mises between the two types of entrepreneur and, at the outset of his note, selects six quotations from Mises’s and Rothbard’s works which, because they are presented out of context, emphasize uncertainty-bearing while either completely ignoring or downplaying the role of ownership in the definition of the entrepreneur. In addition, at least four of these quotations refer specifically to the pure entrepreneur as Mises defined the term. Thus, for example, Mises (1998, p. 254) is quoted by Topan (p. 76) as follows: “The term entrepreneur as used by catallactic theory means: acting man exclusively seen from the aspect of the uncertainty inherent in every action.” But in the sentence immediately before the sentence quoted by Topan, Mises referred to this one-dimensional delineation of the function of the entrepreneur as being embodied in “an imaginary figure” that is a “methodological makeshift.” Moreover, in the very next paragraph following the one containing the quoted sentence, Mises (1998, p. 254) carefully demonstrated that this “imaginary construction of a pure entrepreneur” involves a logical contradiction, because he owns no property and, therefore, bears no risk!As Mises (1998, p. 254) described him,This [pure] entrepreneur does not own any capital. The capital required for his entrepreneurial activities is lent to him by the capitalists in the form of money loans.... Nevertheless, he remains propertyless for the amount of his assets is balanced by the amount of his liabilities. If he succeeds, the net profit is his, if he fails the loss must fall upon the capitalists, who have lent him the funds. Such an entrepreneur would, in fact be an employee of the capitalists who speculates on their account and takes a 100 per cent share in the net profits without being concerned about the losses.

The second quotation that Topan (76–77) draws from Mises (1998, p. 288) likewise refers to the pure entrepreneur and not the entrepreneur-promoter:

Like every acting man, the entrepreneur is always a speculator. He deals with uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur’s profits stem is his ability to anticipate better than other people the future demand of consumers.

In the paragraph immediately preceding the one in which this passage appears, Mises (1998, p. 288) made it clear that he was here focusing exclusively on entrepreneurial profit and loss and how changes in the data bring about differences between the selling prices of products on the one hand and the sum of the prices of their factor inputs on the other. At the same time, he explicitly abstracted from how such changes “affect the sellers of labor and those of original nature-given factors of production and of the capitalists as money-lenders.” In other words, Mises was once again describing the pure function of entrepreneurship and not the integral, flesh-and-blood entrepreneur. Likewise, in two of the three passages that Topan (p. 77) quotes from Rothbard, Rothbard is clearly referring to the function of “entrepeneurship” or what he calls the “active entrepreneurial element” and not to the real property-owning capitalist-entrepreneur.

Topan’s first error leads to and is compounded by a second error. Jumbling up two different concepts of the entrepreneur at the start of his note and overemphasizing the single function of uncertainty-bearing predisposes Topan to ignore the distinct decision-making function that is inextricably bound up with the choice of the organization and technical combination of heterogeneous capital goods and labor factors, particularly management. Thus Topan (p. 79) argues:

Specifically, by introducing this additional distinct function of ownership and its subsequent (supplementary) form of remuneration/income, [Rothbard] ends up separating—something considered as a shortcoming in Kirzner—ownership from entrepreneurship. If this is not so, and if it is still the ownership function that also receives the profit/loss residuum, then we have a function with two incomes, a situation which violates the “one function—one income” principle implied in the theory of distribution. Not to mention the emptying of the catallactic function of the entrepreneur, that would remain without an income share.

This assertion betrays Topan’s single-minded focus on the function of the disembodied pure entrepreneur to the exclusion of the real person of the capitalist-entrepreneur who embodies a number of conceptually distinct “catallactic functions.” For Rothbard and Mises the “one function—one income principle implied in the theory of distribution” is not violated by recognition of a decision-making rent that accrues to the entrepreneur qua property owner. Nor does Rothbard, a la Kirzner, “separate ownership from entrepreneurship” by identifying a separate property-owning function, as Topan (p. 79) claims. For all three functions of the capitalist-entrepreneur involve property. The capitalist function is advancing property in the form of wages and rents to the factors of production; the specifically entrepreneurial function is choosing the factors and allocating them to the production of property in definite forms that are anticipated to facilitate the achievement of ends chosen in light of forecasts of uncertain future market conditions; and the decision-making or ownership function involves supervising and organizing the various elements of productive property into a coherent structure of means, i.e. the firm, according to known techniques in order to achieve the chosen ends in the most efficient way possible.

Let us clarify the argument by analyzing the concrete data that must inform the analysis of the functions and corresponding incomes of the capitalist-entrepreneur. Indeed, by noting that some entrepreneurs earn profits while others suffer losses, Topan implicitly recognizes that it is a datum of everyday experience and of human history that people differ greatly in their capacities to anticipate and adjust their actions to changes in the world that affect their ends and means. Without inserting this subsidiary empirical postulate into the chain of praxeological reasoning, it would be impossible to account for the fact that some individuals are better entrepreneurs than others.As Mises (1998, p. 256) put it, economics must take into account “the promoter concept” because “it refers to a datum that is a general characteristic of human nature.... This is the fact that various individuals do not react to a change in conditions with the same quickness and in the same way.... There are in the market pacemakers and others who only imitate the procedures of their more agile fellow citizens.” Topan presumably would agree too that praxeology must recognize the obvious fact that people have different time preferences and therefore that they save and invest different proportions of their incomes, accumulate greater or less capital and receive unequal amounts of interest payments in the real world and in the ERE. Topan would also surely grant that economic theory must proceed on the empirical observation that individuals vary in their skills, aptitudes, energy, motivation, and productivity with respect to different types of labor and therefore receive unequal wage rates in the real world and that such wage inequalities would persist in the ERE.

Topan inexplicably seems to balk, however, at incorporating into economic theory the mundane observation that business owners differ markedly in their levels of technical knowledge, mental and physical energy, clarity of memory, strength of purpose, supervisory abilities, communications skills, aptitude for calculating and interpreting financial data, etc. But surely these differences affect the quality of the decisions capitalist-entrepreneurs make in choosing and combining the concrete elements of their property into an integrated structure of means in order to achieve their ends, even if they all correctly forecast the value of these ends. It is these qualities that cause people to differ in what Rothbard (2009, p. 602) calls “for want of a better term... the decision-making function or ownership function.” As this function is described in the long passage Topan (2012, pp. 78–79) quotes from Rothbard, it is clear that it has nothing to do with uncertainty per se. Rather it deals with the ultimate technical, supervisory, and organizational decisions that a capitalist-entrepreneur alone must make with respect to the disposition of his productive property. It may help to clarify this concept by describing it in the familiar context of everyday life before addressing it in a business environment.

Suppose that someone is throwing a large party with a certain theme and ambience that she anticipates would greatly please her guests. She has formed a creative overall vision of the prospective party—the future “product” or end—and is aware of the concrete means necessary to realize her vision. But to prepare for the party rationally and efficiently, the hostess must use her existing knowledge, skills, and abilities in many diverse areas: menu selection; food preparation, including both the knowledge of recipes and the skills to execute them; selection of wines and other beverages that complement the meal; location, layout, and decoration of the “space” for the party; the timing of the food and beverage service; the music that best comports with the guests’ diverse tastes and with the theme of the party; the optimum number, selection, and seating arrangement of guests; the suggested dress; the crafting of attractive and informative party invitations and so on. The hostess also must attend to mundane matters like the sufficiency of bathroom facilities and toilet items, the adequacy of parking, and the proper sequestering of her children and pets.

In addition the hostess must actively supervise and make continual decisions relating to the coordination of the overall “flow” of the party as it proceeds, whether or not she decides to “outsource” one or more tasks to a party planner, caterers, a professional DJ, or bartender. These hired “managers” do not spontaneously coordinate their actions with one another and with the hostess’s overarching plan for the party. Moreover, she requires the interviewing skills and psychological insight necessary to accurately assess the technical competencies and work ethic of the personnel she is considering, as well as the leadership skills to motivate those she hires to engage with her in realizing her vision for the party.

To take a simple example, the party would turn out very differently depending on whether the hostess: suffered from a chronic illness and needed to take a nap midway through the party; were prone to overindulging in alcoholic beverages; were easily flustered by mishaps; or were healthy, vital, resilient and remained alert to every aspect of the party.

The point is that given the same resources and using the same standard of success, parties hosted by different people with varying knowledge, skills, aptitudes, capacities for mental focus and physical stamina would vary in success, even if they all could foresee exactly how the party would turn out as a result of their decisions. In other words, the variations in success of different hostesses need not be due exclusively to uncertainty-bearing, that is, anticipating and visualizing guests’ reactions to the theme and ambience of party; they may just as well be caused by disparities in their “ultimate decision-making ability” as owners of property.

We may even extend our fanciful party example to the ERE. Individuals of given but different decision-making abilities would host parties at regular intervals, purely as social events and not for monetary gain. Each would throw the same parties over and over again and the regularity of their purchases of party supplies would not upset market supply and demand conditions.There is nothing preventing economists from extending the ERE to an analysis of household activities because it is a mental construct of their own making. As Mises (1998, p. 248) pointed out, the ERE is consistent with many different assumptions so long as they do not disturb supply and demand conditions. Thus, he wrote, “Only such change as do not affect the configuration of price-determining factors may be considered in its [the ERE’s] frame…. We are free to assume that infants are born, grow old, and finally die, provided that total population figures and the number of people in every age group remain constant.” Elsewhere Mises (2003, p. 16) remarked:A theory of action could conceivably be constructed on the assumption that men lacked the possibility of understanding one another by means of symbols, or on the assumption that men—immortal and eternally young—were indifferent in every respect to the passage of time and therefore did not consider it in their action. The axioms of the theory could conceivably be framed in such universal terms as to embrace these and all other possibilities…. We forgo these possibilities because conditions that do not correspond to those we encounter in our action interest us only in so far as thinking through their implications in imaginary constructions [e.g., the ERE] enables us to further our knowledge of action under given conditions. [Emphasis added.] They would all know the future perfectly but some would be renowned as great hosts or hostesses, others as relatively inferior ones. However, all those who host dinner parties would of course enjoy a surplus of satisfaction gained over satisfaction sacrificed in the foreclosure of other consumption opportunities to use the resources devoted to the party. As with spending on all consumption activities, the marginal utility of the end chosen would exceed that of the end foregone. Furthermore, these psychic “rents” to party hosts would persist in the ERE, although there would be no monetary or other objective expression of them and no method of comparing their magnitudes between different people.

What is true of owners of property in the service of extra-catallactic ends is also true of business owners. Now, given that the differences in decision-making abilities among individuals in household and business activities are a datum of human action—although these abilities admittedly may develop over time in the real world of change as a result of practice, experience, or formal instruction—we are free to assume that they exist and are frozen in the ERE. In business, the differential monetary rents to decision-making ability derive especially from owners’ organizational skills, technical knowledge and psychological insight although more mundane qualities such as health, physical energy, and aptitude for financial calculation may also affect such rents. Surely these personal qualities influence how successful the owner of the firm is in organizing and adapting the diverse yet complementary elements of his property to his entrepreneurial forecasts of future market conditions. Furthermore, the owner is unable to divest himself of the ultimate decision-making function even if he delegates most or all decisions about technology, organization and personnel to hired managers and technicians. This is not to deny, of course, that to the extent that the owner performs routine technical or straightforward managerial tasks that can be performed by hired labor, he is functioning as a pure laborer rather than as an owner making ultimate decisions about his property and is earning normal wages rather than special ownership rents.

In a neglected article published in 1935, M. M. Bober (1935) presented an enlightening discussion of the entrepreneur-owner’s crucial and undivestible function, while recognizing that it would continue under static conditions and earn a rent. Bober’s aim in the article was to connect the short-run and long-run analysis of the size of the firm and explain the U-shape of the long-run average cost curve by identifying the factor that remained fixed even in the long-run. This factor was the ultimate decision-maker or the “entrepreneur,” whom Bober (1935, pp. 81, 83) characterized as the “fixed factor at the apex of the whole structure” of the firm whose “personality and... power [becomes] diffused over a wide area” as the firm grows in size. Bober continued:

That some managerial operations can be delegated admits of no doubt; but there remains a solid substratum of activities that must emanate from one final source of authority and responsibility, and not only under dynamic conditions but under static conditions as well.... Officers and foremen die or resign, and new ones are to be selected; security issues mature, and the problem of financing reappears; short-term loans are recurrently made, and dealings with bankers are involved.... There is also the important problem of supervision, and the greater the differentiation and delegation of powers the more vital is the problem. Furthermore, it is difficult to assume that the bearer of final responsibility can afford to play hide and seek with static conditions, disappearing from the scene or relaxing in the tasks while static conditions prevail, and assuming the helm only when the industry is undergoing alterations.

Bober (1935, p. 83) also saw that entrepreneurs of “infra-marginal” firms earn differential rents depending on their abilities and these rents exceed the rent that “will suffice to attract into the industry the marginal entrepreneur.”Unfortunately, Bober (1935, pp. 83–84) was under the influence of the perfect competition doctrine. And, although he did recognize the distinction between static and dynamic conditions, he mixed up profit and decision rent. He also treated the latter as a cost to the firm just like differential rents to hirable factors, despite the fact that he seemed to discern that the ultimate decision-making function was unhirable.

Let me now turn to an analysis of Topan’s specific critique of Rothbard’s concept of decision-making rents. Citing several passages from Rothbard’s work, Topan (2012, p. 80) comments, “Rothbard seems to assimilate... the income of decision-making to a type of wage, and to view decision-making ability as some sort of labor.” But Topan (2012, pp. 80–81) notices a “tension” in Rothbard’s use of the concept. The tension arises, according to Topan, because on the one hand, decision-making is “logically antecedent” to labor but on the other it is a “special type of labor” requiring “some unique ability or talent.” But I suggest that this tension is merely semantic and not substantive. In suggesting a name for the function, Rothbard (2009, p. 610), as we saw, was not completely comfortable with the term “decision-making,” prefacing his suggestion with “for want of a better term,” and then offering “property-owning” as a possible alternative designation. Furthermore, in the passages that Topan (2012, pp. 82–83) cites as evidence to support his point, Rothbard repeatedly and clearly characterizes the decision-making function as “a certain kind of labor,” “an attribute of a labor factor” and the return to this factor as “wages of decision-making.” Viewed in context, there is no tension in Rothbard’s concept of the decision-making function. It is a unique kind of labor factor that is not separable from property ownership and therefore can never be hired.Topan (2012, p. 85) is therefore simply wrong in his claim that Rothbard rejects the idea that the decision-making function is “a special subcategory [of labor], special enough so that it deserves a separate and dedicated catallactic function, together with a form of income.” The passage in Rothbard (2009, p. 565) that Topan cites to support his claim clearly refers to the illicit distinction between the workers and the managers of the firm, both of whom are “hired by its owners.” (Emphasis added). In contrast to hirable labor, technically it has no market and, hence, no implicit wage, which is why Rothbard (2010, pp. 602–603) formally dubs its return a “rent” rather than a “wage.”Rothbard (2009, p. 559) draws the distinction between wage and rent as follows: “A wage is the term describing the payment for the unit service of a labor factor. A wage, therefore, is a special case of rent; it is labor’s ‘hire’.” (Emphases in the original.)

Topan raises an important point when he notes that, according to Rothbard’s analysis, the rent of any factor employed in production must be positive to induce its owner to participate in production. But what, asks Topan (2012, p. 84), is being rewarded by these positive rents when a firm’s owner qua entrepreneur suffers losses as a result of erroneous judgment of future market conditions? Does the decision per se generate a positive rent, even though it is an “uninspired decision” penalized by entrepreneurial losses? Topan answers in the negative and concludes that the Rothbardian concept of decision-making must imply “successful decision-making.”

As we saw above, however, for Rothbard, the owner’s “decision-making function” does not involve entrepreneurial decisions made under uncertainty. In fact, it is the application of a special type of labor, the oversight and stewardship of one’s productive property used by the owner or hired labor for a specific purpose. These decisions are not to be deemed successful or unsuccessful, but, like all “decisions” to expend labor of any kind, better or worse in terms of the physical quantity and quality of the product. In this sense, employing the same ingredients, recipe, cooking utensils, and kitchen appliances, my wife makes better “decisions” than I do in baking cookies. This outcome has nothing to do with uncertainty of the future but to existing differences between our baking skills. To extend the example to the market realm, a bakery owner deciding between employing me or my wife as a baker would need the technical expertise and insight to judge the present differential between our baking skills. If he hires my wife, his decision will generate higher owner’s rent than if he hires me.

Topan’s attempt to subsume the decision-making function and owner’s rent under entrepreneurship and profit may be criticized from another angle. Suppose that due to gross technical ineptitude the owner of specific means of production is unable to bring his product to the market. For example, the bakery owner above hires a baker whose cakes fail to rise and cookies turn out too hard to chew and the output is disposed of as waste. Surely in this case the failure is purely technical and there would be no question of earning a profit or loss because there is no product supplied on the market and entrepreneurial forecasting does not enter into the matter.I am indebted to David Gordon for this point.

Topan (2012, pp. 84–85) further argues that supposing that rents, like profits, can be positive or negative—as they would be if they were judged by the binary criterion of successful/unsuccessful—then the relationship between rents and profits would be unclear because both pertain to ownership. If decision-making alone pertains to ownership, Topan contends, then entrepreneurship as uncertainty bearing would be an empty concept. Alternatively, if the decision-making function is bound up with uncertainty-bearing, then, contrary to Rothbard’s view, nothing remains of the function in the ERE, from which uncertainty has been banished.

Topan’s arguments on these points betray a failure to fully grasp Rothbard’s rent theory. Rothbard (2009, pp. 559, 571–572, 694) maintains that only rents of factors actually used in production, whether marginal or supramarginal, must be positive. Submarginal factors like desert land, mines with the least accessible ore deposits, or potential laborers who suffer from severe mental or physical disabilities would earn zero rents in the ERE. Likewise, business owners who are inadequate as decision-making stewards of their productive property would incur such high production costs that their firm’s return in the ERE would fall short of the natural rate of interest. Such firms, of course, would not be in business in equilibrium. There would thus be submarginal decision-makers who are earning zero—never negative—rents in the ERE precisely because they are not operating firms.As Rothbard (2010, p. 603) points, out, even marginal firms operating in the ERE earn positive decision rents:[T]he marginal land earns some rent, even if ‘close to’ zero. Similarly, the marginal firm earns some rent of decision-making ability. We can never say quantitatively how much it will be, only that it will be less than the corresponding ‘decision rents’ of the supramarginal firms.

For Rothbard, then, decision-making rents in the ERE, like the rents of land and hirable labor factors, are completely independent of entrepreneurial profits under dynamic conditions. While Rothbard does not explicitly discuss the variation of pure profit and owner’s rent in the real world of uncertainty, Mises did so in some detail. Like Rothbard, Mises (1998, p. 288) maintained that the uncertainty-bearing and ownership functions are conceptually separate and distinct, warning, “One must not confuse entrepreneurial profit and loss with other factors affecting the entrepreneur’s proceeds.” He thus distinguished the “specific entrepreneurial function” which involves “determining the employment of the factors of production” from the entrepreneur’s personal “technological ability” including his “ability to hire adequate helpers.”

For Mises, therefore, “specific entrepreneurial profit or loss” is not influenced by the quality of the owner’s technological ability, which differs between owners and earns higher or lower “wage rates or quasi-wage rates.”Note that Mises, too, is reluctant to apply the unqualified term “wage-rates” to the entrepreneur’s undivestible technical function. For example, entrepreneurs of inferior technical ability in the bottling industry will experience more bottles bursting per given quantity filled in their plants than in more efficiently run plants. However, as Mises (1998, p. 189) pointed out, this reduces physical output and raises production costs, but “does not affect entrepreneurial profit and loss.” According to Mises, the owner’s knowledge of productive techniques is better or worse, but not uncertain. Thus Mises (1998, pp. 189–190) argued that if the risks of accidents are insurable, they

...do not introduce uncertainty into the conduct of the technological processes. If an entrepreneur neglects to deal with them duly, he gives proof of his technological insufficiency. The losses thus incurred are to be debited to bad techniques applied, not to his entrepreneurial function.... [T]he specific entrepreneurial profits and losses are not produced by the quantity of physical output.... What produces them is the extent to which the entrepreneur has succeeded or failed in anticipating the future—necessarily uncertain—state of the market.

In the real world, then, owners of going concerns always earn decision rents, which are part of the composite return to capitalist-entrepreneurs intermingled with profit and interest. Contrary to Topan, to recognize that pure profit and ownership rent together determine the success or failure of the firm under dynamic conditions is not to deny that they are functionally independent of one another. Mises (1998, pp. 289–290) is especially emphatic on this point:

The elimination of those entrepreneurs who fail to give their enterprises the adequate degree of technological efficiency or whose technological ignorance vitiates their cost calculation is effected on the market in the same way in which those deficient in the performance of the specific entrepreneurial functions are eliminated. It may happen that an entrepreneur is so successful in his specific entrepreneurial function that he can compensate losses caused by technological failure. It may also happen that an entrepreneur can counterbalance losses due to failure in his entrepreneurial function by the advantages derived from his technological superiority or from the differential rent yielded by the higher productivity of the factors of production he employs.... The technologically more efficient entrepreneur earns higher wage rates or quasi-wage rates than the less efficient in the same way that the more efficient worker earns more than the less efficient.

In sum, although owner’s rent of an operating firm is always positive, a firm may fail because either: the rents may be insufficient to offset entrepreneurial losses; or the inferiority of decision-making ability compared to that of other owner-entrepreneurs in the industry may result in a relatively high cost structure that wipes out any pure profit and drives the firm’s net return below the natural interest rate. We thus must reject Topan’s claim that Rothbard’s concept of decision making refers “to uncertainty bearing and overcoming.” His contention is based on confounding specifically entrepreneurial “decision making,” which refers to adjusting production to uncertain future market conditions, with “decision making” aimed at efficiently supervising and coordinating his existing property in light of his present production plan.

Topan (2012, p. 86) makes one final attempt to eradicate the owner’s decision-making as an independent category of economic theory by subsuming it under “entrepreneurial judgments,” which he asserts “must be as specific as possible.” By this he means that such judgments should be understood as “referring to particular circumstances of time, place and persons from the future.” But here Topan all but concedes the point. Owner’s decision making, in Rothbard’s and Mises’s view, refers to judgments of present labor skills, productive techniques, and organizational structures, as noted above.

Topan (2012, p. 87) recognizes that if the ownership function is completely eliminated from economic theory, as he advocates, then he must provide an alternative explanation for the ubiquitous phenomena of high-cost versus low-cost firms. He suggests but downplays the possibility of entrepreneurial errors because these would generate cost differences “of a rather ephemeral nature.” The “more lasting” inter-firm cost differences, he attributes to different preferences for non-pecuniary income among “skillful entrepreneurs” who may, for example, choose an inferior location for their enterprise because of its proximity to their home. But, here again, Topan is admitting owner’s rent into his analysis by the back door. For, unless the entrepreneur is purchasing the land for speculative purchases, his choice of the site is based on his technical knowledge of what constitutes a superior or inferior location for the production of a specific good to be sold on an uncertain future market. He would thus be trading off part of his decision rents rather than entrepreneurial profits for the psychic benefits of a short and pleasant commute to work.

In conclusion, I do not believe that Topan has succeeded in establishing his case that Rothbard’s concepts of the ownership function and its corresponding income of decision-making rent have no place in economic theory. On the contrary, these concepts are essential to comprehending the role of the capitalist-entrepreneur in real-world markets.

ABSTRACT: This article discusses the influence of the initiation of the Second Socialist Calculation Debate on my own subsequent research and contributions to that debate, and briefly summarizes that research presented in articles on arguments made by Plato, Karl Marx, Friedrich von Wieser, Friedrich Hayek, Lionel Robbins, Joseph Schumpeter, and Israel Kirzner. It also mentions some of the changes in Austrian economics understanding stimulated by the Second Socialist Calculation Debate, and suggests a direction for future research.

Sam Bostaph (bostaph@udallas.edu) is Emeritus Professor of Economics at the University of Dallas.

Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.

It is a pleasure to be here at this prestigious conference, and to be on this panel concerned with the most important economic issue of the past two centuries—that of economic calculation. After all, to economize is to calculate; it is to seek the lowest expected opportunity cost of the means to achieve the end for which one is economizing. That is why Mises argued that the socialist planned economy is in reality no economy. It cannot by definition calculate the expected opportunity costs of higher order goods in order to assess their relative scarcity, and thus enable a decision of how they are to be efficiently used in the production of lower order goods. It cannot do so because without private property in higher order goods, there cannot be market-determined prices for those goods to reveal their current relative scarcities and thus allow economic calculation.

Joe Salerno asked each of us to discuss our respective contributions to the second socialist calculation debate, how this most recent debate influenced our later research, and how we think Austrian economics has changed as a result of that debate.

My own interest in this topic stems from my interest in imagined, as well as attempted, historical utopias. As a scholar in the Austrian school tradition, I cannot help being in part a sociologist. Albion Small recognized this aspect of the Austrian school in his book Origins of Sociology (1924) where he devoted considerable space to a discussion of Carl Menger’s contribution to the discipline. Of course, I use the term “sociology” in the sense that Ludwig von Mises used it in his early scholarship. Later, Mises would substitute the term “praxeology” for “sociology” as the latter term came to mean a sort of philosophy of history, rather than a science of human action.

At one time, I intended to write a history of various theories of communism. In researching the topic, I came across a comment by Karl Marx in his inaugural article as editor of the Rheinische Zeitung. Marx identified Plato as an early communist theorist. “That can’t be true,” I thought. The research that falsified any such claim led to my 1994 contribution to David Reisman’s edited collection Economic Thought and Political Theory. Of course I argued against such a simple-minded assessment of Plato’s Republic and Laws. I also became aware of Friedrich von Wieser’s attempt at rationalizing a socialist utopia in his Natural Value during the preliminary research I did on communist theories.

At one time, I intended to write a history of various theories of communism. In researching the topic, I came across a comment by Karl Marx in his inaugural article as editor of the Rheinische Zeitung. Marx identified Plato as an early communist theorist. “That can’t be true,” I thought. The research that falsified any such claim led to my 1994 contribution to David Reisman’s edited collection Economic Thought and Political Theory. Of course I argued against such a simple-minded assessment of Plato’s Republic and Laws. I also became aware of Friedrich von Wieser’s attempt at rationalizing a socialist utopia in his Natural Value during the preliminary research I did on communist theories.

Meanwhile, Joe Salerno had attracted my interest back to Austrian school theory with his 1990 article “Ludwig von Mises as Social Rationalist.” There Joe began the process of dehomogenizing Mises and Hayek and initiated the second socialist calculation debate, which has occupied some of us Austrians for the past thirty years. When I read Joe’s 1993 contribution to that debate, it struck me that his reference to Hayek as strongly influenced by his teacher and mentor, Wieser, deserved a firm grounding. That caused me to go back and intensively read Wieser. The result was my summer 2003 QJAE article “Wieser on Economic Calculation under Socialism.” After having exhaustively studied Wieser’s published writings on the socialist planned society, I not only placed him in the general equilibrium tradition of Walras, but also explained the total emptiness of his theory of planning. I found his concept of a unit of “natural value” as the basic unit of economic calculation to be nothing but a faux “util” and thus a fantasy, and his explanation of “imputation” as the method of deriving the values of higher order goods from the “natural values” of first order goods to be spurious. The terms in his equations are ambiguous, and his conception of imputation appears to be an attempt at a mere static theory of distribution.

I concluded that Hayek’s attempt to use Wieser’s “simple economy” of socialism as an analytical device as late as 1941 in his Pure Theory of Capital, as well as a number of his other laudatory references to Wieser over the years, to be telling. Also, Hayek’s use of a general equilibrium context for most of his own theoretical work places him pretty firmly in the Walras/Wieser tradition. This may explain Hayek’s emphasis on knowledge problems in his critique of the planned socialist society, rather than on its inability to use economic calculation.

To my surprise and delight, my article won the 2005 Lawrence A. Fertig prize. For that I remain greatly thankful to the prize committee. I was stimulated to continue my research on Wieser and that had two results. While a visiting professor at the University of Economics in Prague, Czech Republic, in 2005 I had the honor of delivering the inaugural Wieser lecture. This later appeared as an article titled “Friedrich von Wieser’s Theory of Socialism: A Magnificent Failure” in the university’s journal Politicka Ekonomie. There I argued that the views that became the backbone of Wieser’s last book, The Law of Power (1926), actually lay behind many of his expressed criticisms of the market economy and his desire to rescue the theory of the planned economy.

Perhaps those previous two articles explain why I was later invited to contribute the Wieser chapter in a book collection on Austrian school economists. Unfortunately, after I had completed my 55-page contribution, publication apparently fell through and the book was never published. I hope to be able to harvest something from that manuscript at some point in the future.

At any rate, articles in the second calculation debate continued to stimulate my research and one result was a QJAE article arguing that Mises’s methodology was not an extension of that of Lionel Robbins. Rather, the influence actually ran the other way, although significant differences between the two approaches remain.

Another project that stemmed from arguments presented during the recent calculation debate was a result of references to Joseph Schumpeter as another of Wieser’s students. Schumpeter is known particularly for his theory of economic development and his concept of the entrepreneur as a force for “creative destruction.” I was intrigued to look for signs of Wieser’s influence on Schumpeter and I found them while reading through Schumpeter’s various publications. More importantly, I was astonished at the generally ad hoc nature, classical school roots, and Walrasian general equilibrium context of Schumpeter’s work. Schumpeter’s entrepreneurial theory stands in stark contrast to that of Mises, as well as to Israel Kirzner’s extension of Mises’s concept of functional entrepreneurship.

The result was my 2013 QJAE article unfavorably contrasting Schumpeter’s theory of entrepreneurship with that of Kirzner. The research on Kirzner’s theory had a further result. I decided to use it in a historical study of the steel magnate and entrepreneur, Andrew Carnegie. After obtaining a publisher, I read through the major biographies of Carnegie and discovered that none of them really explained why Carnegie was successful. They detailed his success, but only historically. Historical explanation needs more than bare facts, however obtained. It needs the application of theory to identify historical cause and effect relations. What was missing from what I read was the grasp of economic understanding that is only provided by Austrian school theory. So, I used an Austrian school context and Kirzner’s entrepreneurial theory as key elements of my economic biography of Carnegie.

Now that I am done with that project, I plan to return to writing my book on the early Austrian school trio of Menger, Böhm-Bawerk, and, of course, Wieser. So far, I only have about a couple of hundred pages and I am stuck on Böhm-Bawerk’s capital theory, but hope to dislodge myself. I particularly want to understand why Menger viewed Böhm-Bawerk’s capital theory as a big mistake.

How has Austrian economics changed as a result of the second economic calculation debate? Well, it certainly opened my eyes concerning the development of the Misesian paradigm, as compared to that of Hayek. And, it greatly increased our understanding of the theoretical failures of the various planned socialist society models. In addition, it has produced a refinement of our understanding of what Misesian economic calculation assumes as necessary for the market process to take place. Most particularly, it has highlighted the radical importance of private property rights, subjective aspects of ownership that affect relative scarcity, and accurate cost accounting.

Added to that is the additional understanding of the underwhelming arguments for what is now called “market socialism.” I find it ironical that when pressed to explain how market socialism could solve each of the successive problems identified with their successive models, advocates of market socialism step-by-step adopted features of the private property, free market model. And they have done this while still trying to keep an iron grip on their wish for an economy with no private property rights in higher order goods.

This started with the Lange/Taylor early attempts to adopt a surrogate perfect competition, general equilibrium model, with no private property in higher order goods. After this was exposed as a fantasy, then came Lange’s use of a Walrasian auction model of price determination. After that was knocked down, market socialism’s defenders proposed to turn firm managers into pretend entrepreneurs, without giving them the discretion over all of the firm’s physical and financial resources that exists in a private property regime. This infects the market socialist financial sector with a fatal weakness. The administrators have no financial skin in the game—kind of like the Board of Governors of our Federal Reserve System. And we all know the recent consequences of that morbid fact.Of course, there is a sense of “skin in the game” for administrators in a Stalinist system. See Simon Sebag Montefiori (2004), for detailed descriptions of the arrest, imprisonment, sentencing to forced labor, or execution of soviet administrators, as well as their families, who failed to achieve the goals set for their production units during the Stalin era of the USSR. This even extended down to the local level of agricultural production. In his Memoirs (1996, pp. 24–27), former General Secretary, then President of the USSR, Mikhail Gorbachev relates how his grandfathers were arrested, tortured, and accused of being Trotskyite counterrevolutionaries for their loss of grain, destruction of livestock, and repression of local Stakhanovites during the 1930s. One was exonerated and the other sent to a forced labor camp.

One is left with the question of why some perfectly intelligent people still lust for a society without private property rights in potentially productive resources. Is it simply the result of a personal lust for power? Or does it stem from the envy of those who are more materially successful in a free market context? I leave the question for future research. Particularly, I hope that young Austrian school economists will turn their interest to China. Under Xi Jinping, it looks like we have an emerging Stalinist regime. If so, it will function no better than its original, as the socialist calculation debate has taught us.

For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.

Karl-Friedrich Israel (KF_Israel@gmx.de) is lecturer at the Department of Law and Economics at the University of Angers, France.

Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.

This collection of essays edited by Dr. Matthew McCaffrey deals with one of the most fundamental fields of economic research: The Economic Theory of Costs. Indeed, it is so fundamental because of its close connection to all other central areas of research in theoretical economics, such as the theory of choice, value, price, capital, production, risk, uncertainty, and entrepreneurship. All of these are covered in some way in the book.

It spans over 263 pages and is separated into five parts, each containing two essays. Only the last part includes a third essay by the editor himself. Almost all of the eleven chapters are published for the first time in this collection and constitute pieces of original research. The one exception is chapter 4. It contains the first but ultimately discarded draft of Rothbard’s fifth chapter for Man, Economy, and State that was uncovered in the Rothbard archives at the Mises Institute a couple of years ago by Dr. Patrick Newman. He has re-edited and published it previously in this journal (Rothbard and Newman, 2015).In the volume it is also indicated that chapter 5 by Dr. Guido Hülsmann is a reprint of an earlier publication in the Quarterly Journal of Austrian Economics. This is incorrect. Hülsmann’s essay has only been published very recently as a GRANEM working paper (Hülsmann, 2017). The provided reference actually corresponds to the earlier publication of Rothbard’s draft chapter (fn. *, p. 144). The page numbers in the earlier reference to the first publication of the draft chapter given in the book are wrong (fn. *, p. 126). The reviewer earnestly promises that the rest of the review will be less pedantic. In fact, these are the only errors of this sort that have been spotted.

McCaffrey sets the stage with an introductory chapter, explaining that the contributions contained in the volume stand in the “causal-realist” tradition (McCaffrey 2018, p. 2), which is closely related to the distinctly Mengerian variant of the Marginalist Revolution and the research program that emerged out of it: Austrian economics. The purpose of the book is “to showcase a variety of research strands within the modern Mengerian tradition that relate in some way to the theory of cost” (p. 3). Menger and his intellectual heirs reconstructed economic theory on thoroughly subjectivist grounds, showing that costs in their various forms are derivatives of the subjective values of ends pursued or foregone. The subjective nature of costs is highlighted directly in the first part of the book entitled “Cost and Choice.” From there on the contributions proceed to different areas, applying the basic insights of the theory of costs to some relevant theoretical problems. We will go over them in the order maintained in the book, expanding on a number of selected issues that are of particular importance according to the undoubtedly subjective assessment of the reviewer.

In the first chapter of the book, Dr. Jonathan Newman clarifies some of the foundations of the notion of costs, which he ultimately always considers to be opportunity costs. In particular, he highlights their subjectivity and forward-looking nature: “The ordinality and subjectivity of preferences applies to both value and cost. Just as value is appraised in action ex ante, so are costs” (p. 12). An opportunity cost, in this >ex ante sense, is the subjective value of the next best perceived alternative course of action, all expected consequences taken into account.

Newman identifies two common but contradictory notions of opportunity costs in the standard literature. The first simply defines them as the subjective value attached to the next best choice alternative. According to the second they are objective physical production trade-offs. Both notions are typically presented side by side in modern standard textbooks. This might account, as Newman persuasively argues, for some of the confusion on the topic identified in the literature and by experimental research (Ferraro and Taylor, 2005).

Probably more interesting for readers of this journal, however, is Newman’s discussion of George Reisman’s stance on opportunity costs as well as the recent back-and-forth between Dr. Eduard Braun and Dr. David Howden on the topic (Howden, 2015, 2016b, 2016a; Braun, 2016a, 2016b). Howden criticized Braun in a review of his book Finance Behind the Veil of Money (Braun, 2014), for among other things abandoning the opportunity cost concept. This critique triggered the debate. Newman sides with Howden and reiterates and expands on his convincing arguments for why the notion of opportunity costs, understood as forward-looking subjective expectations of the value of alternative courses of action, is important and useful to analyze human choice. Howden also showed why the ex post evaluation of opportunities is indispensable to find out whether one could have done better than one actually did. Yet these points are not even disputed by Braun. Both Howden and Newman fail to appreciate the actual problem hinted at in Braun’s analysis, namely, the identification of profit in human action and, more specifically, the ex post identification of monetary profits.

Taking ex post opportunity costs as the relevant benchmark for identifying monetary profit leads to a very strange result: A profit could only be made if one had actually invested in the best (or shall we say most profitable) project out there. Imagine tech investor Pete who happens to have picked the project FB for his investment. FB turns out to be the best among all the projects. Pete strikes it rich and actually makes a monetary profit. The latter is determined by the difference between the generated monetary income from FB and the unrealized monetary income Pete could have earned by investing an equal amount of money in the next best alternative.

Now assume that instead it turned out that there was an even better project. Let us call it Twttr. It has generated, for some other investors, an even higher monetary return than FB. This means that Pete would have made a loss instead, as Reisman and Braun lament by providing a number of other examples of this kind. Under this notion of opportunity costs, only investments in Twttr would have generated a monetary profit. This led Braun to focus instead on costs understood as historically incurred monetary outlays for his analysis of financial markets and interest rates. In fact, Newman implicitly acknowledges that Braun has a point when he considerably narrows down the applicability of the opportunity cost concept by stating “that opportunity costs cannot be identified in hindsight and that opportunity costs may only be identified for one choice at a time” (p. 20). If that is so, then good for Braun that he got rid of it for his purposes.

Moreover, it is not quite correct to accuse Braun of denying the importance of alternative uses of resources and foregone opportunities altogether. They are precisely what determines the monetary outlays necessary to acquire the means of production for any given investment project. The higher the expected subjective value of the alternative ends, to the attainment of which those factors could have been dedicated instead, from the perspective of the relevant market participants, the higher will be their money prices, and hence the monetary outlays necessary for the realization of the project.This argument is made, for example, in chapter 10 of the book by Dr. Per Bylund. The investor thus has to compensate for the alternative ends forgone. Costs understood as monetary outlays are indeed, in this very important sense, opportunity costs.

In the second chapter of McCaffrey’s book, Dr. Joseph Salerno presents a very dense theoretical discussion of the “unitary valuation process” (p. 32) that gives rise to money prices paid for goods on the market. He tries to show why there is no such thing as an income effect as a result of price changes along the demand curve for a specific good in causal-realist price theory, and thus responds to a long-standing debate in neoclassical economics.

He argues first of all, following the causal-realist approach to price theory, that an individual’s demand curve for a certain good is a higher-order abstraction. It can be derived on the basis of an ordinal value scale, on which all relevant goods including money are ranked, as well as the existing stocks of these goods in possession of the individual at the given moment. Second, the ranking of money relative to other goods presupposes a given purchasing power—“or rather, a definitely anticipated purchasing power of money” (p. 36). In other words, the purchasing power of money has to be held constant in order to derive the demand curve at the given moment in the first place.

All that happens in response to changes in prices along the demand curve are then substitutions with other goods according to the value scale of the agent. There is no income effect, or as Salerno terms it, purchasing power effect>, because a given purchasing power is a prerequisite for the derivation of the demand curve. The income effect is then merely an “illusion” (p. 35) stemming from the misapplication of demand curves.

However, the reviewer is puzzled by the question of how a price change could be possible without also changing the purchasing power of money. If the purchasing power of money is to be understood as the array of goods that can be bought with a given amount of money, then surely a price change for some good necessarily changes the purchasing power of money. But if a constant purchasing power is presupposed for the derivation of a demand curve, must the very idea of a price change along a given demand curve then not be considered bogus? Rather, under these assumptions, an exogenous change in the supply curve of a good that causes “price changes along the demand curve” must also trigger an alteration of the demand curve itself, to the extent that the subjective value of money changes in light of changes of its purchasing power.

To the reviewer it seems wrong to assume that the purchasing of money as such needs to be held constant in order to construct the demand curve for a specific good. Rather, one has to hold constant the purchasing power of money with respect to other goods and of course the actor’s subjective value scale. In other words, the opportunity costs of spending money on the specific good for which the demand curve is derived need to be held constant. If that is done, there seems to be a way to reconcile a kind of “income effect” with causal-realist price theory. In the reviewer’s eyes, a better term would be “wealth effect.”This idea is further developed in Israel (2018).

Salerno goes on to show why his result does not contradict the possibility of a backward-bending labor supply curve. The latter is possible without an income effect, solely on the basis of the law of marginal utility and a given value scale on which leisure is ranked against money balances. Salerno thus counters a critique raised by Caplan (1999) against Rothbard’s denial of the income effect, while still assuming that the backward-bending supply of labor is possible.

The next two chapters are dedicated to production theory in the causal-realist tradition. Dr. Patrick Newman provides a review of Rothbard’s evolving thought on the topic in chapter 3, which is geared to Rothbard’s original draft chapter on production theory for Man, Economy, and State (Rothbard 2009), republished as chapter 4 in this volume. Rothbard ended up thoroughly revising his production theory and rejected this early version of the chapter. It therefore illustrates the evolution of Rothbard’s thought on the topic. Newman’s accompanying chapter is of great value for the student as well as the historian of economic thought as a brief comparative outline of different approaches to production theory.

Rothbard’s original draft chapter is much closer to the Marshallian partial equilibrium approach to production theory, although it already emphasized a number of weaknesses, such as the fact that one cannot develop a robust theory of investment from the perspective of an isolated firm. Rothbard’s final theory of production, however, adopts an Austrian general equilibrium approach as described by Newman. The latter is distinct from the Walrasian general equilibrium approach and essentially characterized by four features.

First, Rothbard rejects the conceptual distinction between competitive and monopoly prices for the analysis of a market economy as being arbitrary. The formal conditions that define a competitive situation are never met in the real world. As Rothbard pointed out even in his earlier draft chapter: “In this interpretation, every seller of an individualized commodity is a ‘monopolist’” (p. 85). Second, no firm can be a mere price taker. Every firm has some impact on the prices of its products and in that sense always acts under imperfect competition in neoclassical standard terminology.

Third, the standard isocost-isoquant derivation of factor demand curves is rejected as it obfuscates the causal link of price determination that runs from the money prices of the final product to the prices of the factors of production by backward imputation. In the causal-realist analysis, actual and expected output prices explicitly determine the capitalist-entrepreneur’s willingness to pay for factors of production according to their discounted marginal revenue product.

Lastly, the perspective taken in causal-realist production theory is not the one of a manager of some selected firm who in isolation—that is, at specified and constant factor costs—expands production until marginal revenue equals marginal costs. Instead, the vantage point of the capitalist-entrepreneur is taken, who can invest in a variety of different lines of production, which in a dynamic setting will have unequal rates of return. For any individual project it might therefore not be optimal to actually expand production to the point of optimality derived in the Marshallian partial equilibrium approach.

In chapter 5 of the book, entitled “The Myth of the Risk Premium,” Dr. Guido Hülsmann sets out to defend a rather bold theoretical claim. He argues that

the prevailing conception of risk as related to the gross rate of interest is ill-founded. It is wrong to conceive of the gross interest rate as the sum of separate components. A closer analysis reveals that the whole idea of a risk premium within the gross rate of interest is a myth and should be discarded from economic science. (p. 134)

His analysis of risk is based on the Misesian distinction between class and case probability as well as the principle of subjective value. The most fundamental claim in Hülsmann’s essay is that probability is not an ontic category, but an epistemic one—that is, probability and more specifically risk is nothing out there in the real world, but it instead refers to our imperfect state of knowledge about the latter. The real world and its transformation is simply what it is: “It is subject to the inexorable laws of cause and effect” (p. 136). These laws are not risky or probable as such, but there is risk involved as far as our knowledge and value judgments about them are concerned.

Case probability refers to the type of imperfect knowledge relevant in the sciences of human action. It refers to cases where actors know some causal relationships, but they know neither all of the related causal chains nor everything there is to know about the relationships that they are aware of, such as their relative importance as compared to other casual factors. Hülsmann explains that subjective value judgments function as a filter through which our partial knowledge becomes relevant for human action. To the extent that one subjectively conceives of a case-probable risk associated with some investment project—that is, a factor that would negatively change its outcome—one attempts to eliminate or diminish that risk as far as possible. At the same time, one tries to amplify the factors that positively influence the outcome. This is the task of entrepreneurship or, as Hülsmann calls it, “the production of success” (p. 138). To the extent that subjectively conceived case-probable risks cannot be eliminated, they have an impact on one’s ex ante subjective assessment of the future value of that investment, and on the assessment of the marginal value product of related factors, but it has no impact on the discounting of these values as such.

Hülsmann argues that the differences in observable gross interest rates can thus not be explained by a risk premium as part of the gross interest rate. Instead, they simply “result from different subjective appreciations of available investment opportunities” (p. 142). He concludes that

the risk component in the gross interest rate is a sort of optical illusion. Different prices for different assets result from the fact that buyers and sellers appreciate them subjectively. From a microeconomic perspective, the implied differences in yield might be called risk premia. And one might use such premia in computations with an internal interest rate, to distinguish more interesting ventures from less interesting ones. But this does not alter the fact that the idea of a risk premium is an intellectual short-cut. It does not correspond to any real object. (p. 144)

The following essay by Dr. Jeffrey Herbener presents the theory of cost as an “example of the mistreatment of time in economic analysis” (p. 147). He incorporates cost curves, which Rothbard thought would not add anything, into the causal-realist framework of the analysis of production decisions and factor pricing. Herbener uses them very effectively to illustrate two implications of the passage of time.

In a pedagogically useful reconstruction of the theory of factor pricing, he first contrasts the timeless neoclassical general equilibrium theory, in which prices of factors of production correspond to the factor’s marginal revenue product and are determined simultaneously with final output prices, with the Austrian analysis of price determination in the evenly rotating economy (ERE). The latter takes production time, or the time structure of production, into account. Hence, factor prices correspond to the discounted marginal revenue product (DMRP). Future output prices determine the capitalist-entrepreneur’s demand for factors of production and thus determine factor prices in the present. Since there is no uncertainty in the ERE, the capitalist-entrepreneur’s factor demand is always such that the money prices paid for the factors used in production correspond to the DMRP and are thus consistent with future output prices. Any change in consumer preferences alters the equilibrium state as output prices change and hence factor demand and factor prices adjust accordingly.

As Herbener points out: “In actual markets, this adjustment process is rarely, if ever, completed, because the underlying causal factors are continuously changing” (p. 160), and because there exists uncertainty of the future. Uncertainty is the second implication of the passage of time for the theory of costs. The passage of time implies change, and change implies uncertainty. According to Herbener, this had not yet been satisfactorily incorporated into the theory of cost in the causal-realist tradition (pp. 160, 165). Capitalist-entrepreneurs discount the MRP, but in the real world they can only anticipate the latter. Hence, factor prices in the present are determined by the factor’s anticipated discounted marginal value product (ADMRP).

It is in Herbener’s words the “spectrum of foresight possessed by the various entrepreneurs” (p. 166) that determine the “speed and accuracy” of the adjustment process toward the equilibrium state as well as the distribution of profits during that process. As he summarizes:

Those with superior foresight move earlier into what prove to be profitable lines of production and earn profits which will then be capitalized into the prices of assets more specific to that line of production as the less-astute entrepreneurs follow suit. Even when the adjustment process reaches its climax and no additional profit can be earned from a further expansion of production because cost structures have been pushed up by rising prices for the more-specific assets used, the entrepreneurs with superior foresight will have earned capital gains by buying the more-specific assets earlier in the process than less-astute entrepreneurs. (p. 166)

Chapter 7 of the collection contains a revision of the theory of monopsony, a concept that has been dismissed almost completely by both Mises and Rothbard. Dr. Xavier Méra argues that they and their followers “may have gone too far” (p. 170). Méra offers a brief overview of theories of monopsony, arguing that the new standard theory is essentially at a dead end in that it defines a monopsony in very much the same way as a monopoly is commonly defined, namely, in terms of a deviation from the pure and perfect competition model—that is, a situation in which supply and demand schedules from the perspective of the individual buyers and sellers, respectively, are less than perfectly elastic. Méra argues that this criterion “implies a nirvana fallacy,” since “such perfection is beyond anybody’s reach” (p. 174). Instead, in Rothbardian spirit, monopolies and monopsonies are to be regarded as the result of government intervention, whereby sellers or buyers are granted privileges over potential competitors. The consequences are to be analyzed in terms of more or less elastic supply and demand curves and how the interventions affect these elasticities.

Elaborating on one of his earlier publications on the topic (Méra, 2010), he argues that, when dealing with a producer, monopoly and monopsony are separable from each other only in so far as there could exist perfect competition on the other markets—that is, either the factor markets in case of a monopolist or the output markets in case of a monopsonist. Since perfect competition never exists, a producer is always both a monopolist and a monopsonist, or indeed neither of the two. A monopsony privilege on the factor markets always amounts to some form of monopoly privilege on the output market, albeit not in the absolute sense, and vice versa. Méra explains:

If it is often noticed that a monopoly is a monopsony or a monopsony is a monopoly, this is rarely considered a necessity. And it is true that, with an exclusive grant of monopoly privilege on the sale of a good, one may be its sole seller while still one among many buyers of its non-specific factors of production. However, even in this case competition is hampered on the factors’ markets since no competitor is allowed to hire them for the production of the monopolized good. With an exclusive grant of monopsony privilege, one may be the sole buyer of a factor of production while still one among many sellers of a good it helps to produce, provided this factor is not indispensable to its production. Yet even in this case competition is hampered in the product market, because competitors are not allowed to produce the product using this factor. (p. 178)

The important question is to what extent the granted privileges increase the price differential between factors of production and output in response to a restriction of output and factor demand, and thus to what extent they allow for monopoly-monopsony gains. Thus, Méra develops a “theory of monopoly price-gap” (p. 176).

In his discussion of non-specific factors (e.g., labor), Méra makes a very valuable theoretical contribution within the causal-realist framework. He shows that a monopolist-monopsonist could conceivably push money prices even for non-specific factors (e.g., wages) under certain conditions below the market-clearing rate. If the demand for the output that the monopolist-monopsonist sells is inelastic, then the buyers’ overall sum of money spent on that output will increase in response to a restriction of supply. This implies a reduction of money spent on other goods. The selling prices of those goods will fall along with the other producers’ demand for the non-specific factors of production. Hence, prices of the non-specific factors will, as a result, be pushed downward.

This, however, in and of itself, does not seem to be a sufficient condition for what Méra attempts to show. He neglects a potential offsetting effect. While nominal expenses of the buyers of the monopolist-monopsonist’s product on other goods will go down, nominal expenses of the monopolist-monopsonist on various other goods, in his or her capacity as consumer or investor, will go up as a result of the realized monopoly-monopsony gains. This will have exactly the reverse effect, increasing monetary revenues of other producers and hence their demand for the non-specific factors of production. It is not clear where the net effect lies.

Of course, this does not change the fact that Méra has nicely illuminated the mechanism by which prices for non-specific factors, such as wages, might be pushed below the market clearing level as a result of monopoly-monopsony power.

In the next essay, Dr. Mateusz Machaj deals with some Post-Keynesian criticisms of the neoclassical marginalist theory of product pricing and shows that the Austrian theory is mostly immune to those criticisms. Yet, he holds that “in some cases the Post-Keynesian contribution to price theory strengthens Austrian arguments about the market process, especially in those aspects where Post-Keynesians are anti-neoclassical” (p. 195).

Post-Keynesians tend to highlight the relative importance of quantity and inventory adjustments instead of price adjustments in response to changing conditions of demand. Prices tend to be more or less “sticky.” Moreover, they argue that output prices are rarely set in such a way that marginal revenue equals marginal cost. Machaj shows that Austrians have at least implicitly already addressed these considerations, which he argues could be interpreted as being “the result of a plain state of rest perspective” (p. 196). In contrast, neoclassical economists “seem to talk about the final state of rest,” which is another way of saying that they abstract from uncertainty, change and time as shown and discussed in Herbener’s essay in chapter 6 of the volume. The Post-Keynesian qualms stem from these unrealistic assumptions in the standard neoclassical theory, but “economic reasoning can rely on the realistic momentary equilibrium of the plain state of rest for analyzing the pricing process,” (p. 196) as Machaj argues.

In his discussion of the imputation process (pp. 198–200), Machaj gives the hypothetical example of shirt production. He supposes that blue and green shirts are produced and sold at the same price even though demand for blue shirts is much higher. Sellers have adjusted quantities instead of prices. He argues correctly that such a case would not prove the limitations of the marginalist approach, but his explanation strikes the reviewer as somewhat unsatisfactory. He writes:

According to Böhm-Bawerk, the law of costs is actually an idea about marginal utility in disguise. In the shirts example, for instance, it does not matter that demand (and marginal utility) for blue shirts is higher relative to green shirts. What matters are the marginal utilities of other goods and services that would have to be given up in order to reproduce blue shirts. And since green and blue shirts require basically the same sacrifice, virtually the same marginal utility would have to be lost. If we lose the last-produced blue shirt, we only have to give up the production of the last green shirt and switch green dye for blue (just as when we lose the most important blue shirt we only have to use the marginal shirt as the first). Therefore we have a perfect explanation of why the costs of both shirts are the same—in the end, their marginal utilities of reproduction are the same. (p. 199)

This does not really explain why their selling prices remain the same. In the plain state of rest analysis, they remain the same because of the price-elasticity of demand anticipated by the producers. If they anticipate that price-elasticity is high for whatever reason, they might not raise the price for blue shirts, and instead start to expand blue shirt production as far as this appears to be profitable—that is, simply to the point where marginal revenue equals marginal costs or demand is anticipated to be satisfied at the prevailing price. This in turn increases demand for blue dye and exerts upward pressure on its price. Whether or not “in the end, […] [the] marginal utilities of reproduction” of green and blue shirts are the same, depends on whether or not blue dye production can be expanded without significant increases in marginal costs.

In the end, the pricing of the factors of production depends on the prices of the final output. Indeed, Machaj puts this fundamental Böhm-Bawerkian insight very vividly:

From the perspective of an individual producer, it may seem that sellers practice cost-based pricing. Yet at the same time, this fact in no way validates the broad marginalist point that costs themselves result from other potential investment avenues that could be undertaken. Once we look at the economy as a whole, we see price-based costing despite the fact that firms attempt to engage in cost-based pricing. (p. 200)

The first chapter of the last part of the book is by Dr. Mihai-Vladimir Topan. It contains a discussion of the compatibility of Austrian economics and “transaction cost economics” as developed most notably by Ronald Coase and Oliver Williamson. Topan comes to the conclusion that transaction cost is a “chameleonic instrument which raises more questions than it solves” (p. 220). Consequently, incorporating transaction costs as a general abstract notion into Austrian economics would in his eyes not improve the theoretical analysis, neither in the areas of economics of property rights nor the theory of the firm, which he specifically investigates.

The most obvious problem with the notion of transaction costs is that it is not well-defined. Topan argues that it is based on a misleading dichotomy between production and exchange, or the firm and the market. Transaction costs are somehow related to the latter but not the former. Topan explains the problem:

Praxeologically, as Mises would say, any human action has the structure of an exchange—autistic exchange or interpersonal (direct or indirect) exchange—involving the giving up of a certain state of affairs in favor of another that is expected to be more satisfactory. […] Thus, the general category of costs, understood as opportunity costs of the actions undertaken by human agents, cannot theoretically be split into two categories—production costs and exchange (or transactions) costs. They are simply part of the same general category of cost with no substantive difference to set them apart. (pp. 209–210)

The vague notion of transaction costs has thus been applied to all kinds of questions in economics. There is what Topan calls a “transaction cost imperialism” (p. 217), in which attempts are made to explain not only firms, but markets themselves as well as all kinds of market phenomena, such as money, in terms of transaction costs. The notion ends up proving too much: “Coase suggests that the effects of transaction costs are ‘pervasive in the economy.’ The problem is that if transaction costs explain everything, they end up explaining nothing” (p. 218).

The next essay in McCaffrey’s volume does not deal with the elusive concept of transaction costs, but rather applies the more common notion of opportunity costs in order to show, in a first step, that value logically precedes costs> even if understood as outlays for production. Indeed, Dr. Per Bylund explains that it is the anticipated value of investment projects that leverages the costs in existing lines of production in an entrepreneurial economy. This is because the demand for factors of production increases when new lines and methods of production are explored. This is again an application of Böhm-Bawerk’s theory of factor pricing via imputation that was discussed and applied previously in the book.

The new element in Bylund’s chapter, with respect to the rest of the book, is his discussion of entrepreneurship and management as distinct economic functions. He draws certain implications from this distinction for the socialist calculation debate. His analysis seems to be targeted towards rebutting a recent contribution to the debate by Denis (2015). The latter has argued that one could have public ownership of, but decentralized decision making and control over, the means of production. This arrangement, which he terms “several control,” would provide market prices and thus allow for economic calculation.

Without having studied Denis’s contribution and judging solely from Bylund’s brief description, the reviewer suspects that such an arrangement of “several control” could strongly resemble what we observe in the real world today, for example, in Sweden or the US. After all, there is no full-blown private property, but rather a “fiat property” arrangement. There is decentralized “ownership” or control over the means of production and their revenue product only to the extent that a centralized state, or, if you like, a democratic collective, grants it.

Bylund argues that in Denis’s world there could be no entrepreneurship. There would merely be management. The validity of this claim depends, of course, on the definition of the terms. However, from Bylund’s outline, one gets only an intuition, and by no means a clear-cut answer as to where exactly the line is drawn. At one point, he states: “The entrepreneurial function is here one that provides value creation relative to other types of production that already exist in the market” (p. 230). The entrepreneur develops “new supply functions that disrupt the market and discover previously unknown demands […] [T]hey require new uncertainty-bearing and are consequently entrepreneurial” (p. 232). In contrast,

within the firm’s production process, the manager can improve its technical efficiency […] or the effectiveness of the already-established production process by reducing waste and lead times, and consequently increasing overall resource utilization. […] The product can also be refined in its functionality, features, and quality, particularly as the firm learns about its customers’ specific wants and can therefore better target those most highly valued. (p. 235)

What precisely distinguishes refinement of an existing good and the creation of new ones is not perfectly clear, but surely both, if successful, create value and thus economic growth. So does the reduction of waste.

At one point, the distinction is made more specific, when Bylund claims that entrepreneurship, that is, the “creation of a new supply function entails the withdrawal of capital from its existing use and the subsequent investment in the new endeavor, which requires ownership” (p. 232). If ownership is a necessary condition, then indeed in Denis’s world there can be no entrepreneurs by definition.

However, a lot seems to depend on how such an arrangement of “several control” is exactly exercised. As mentioned above, it could look more or less exactly like the US or Sweden today, where presumably there are at least some entrepreneurs. To what extent there will be interference with the free exchange of rights to control, exchange, and combine resources and factors of production in different endeavors is simply an extra layer of uncertainty. Successfully bearing this uncertainty requires entrepreneurial skill.

Now, one might not want to call that entrepreneurship, but this is a semantic issue and actually not the most important point of the essay. More importantly, Bylund argues that a pure management economy would be regressing or shrinking even if there are market prices. It is important to note that he does not directly criticize and reject Denis’s claim that one could have market prices under “several control.” Thus, Bylund seems to accept the idea that a pure management economy could have market prices.

It seems to the reviewer that a well-managed economy without entrepreneurial innovation, where market prices exist, would not necessarily be shrinking. It could expand and grow in at least three respects, namely, as mentioned above, by the reduction of waste, the refinement of existing goods, and through the accumulation of capital and the expansion of the physical output of known goods in existing lines of production. If the relative demand in terms of known goods changes, a well-managed economy would also be capable of redirecting factors of production from one existing line to another. The managers who are confronted with increases in demand could bid away factors of production from others.

There are, of course, undeniable problems if there truly is no innovation in the economy. Exhaustion of non-renewable resources might serve as an example. But this does not change the fact that Bylund’s conclusion that in a management-driven economy “value will not only not be created but will be actively destroyed” (p. 239) is exaggerated. The theoretical discussion does not suffice to support this claim.

The last essay is entitled “Economic Calculation and the Limits of Social Entrepreneurship.” It is written by the editor of the volume. McCaffrey links the Misesian theory of economic calculation to aspects of “social entrepreneurship.” In the introduction, social enterprises are defined as follows:

Social enterprises are business organizations that are not motivated by the desire to generate monetary profits for traditional shareholders. Instead, the profits of social enterprise are used to solve “social” problems, often by addressing the same kinds of needs as charitable organizations. Social enterprises are special, however, because they support their missions through successful commercial ventures rather than through donations. (p. 244)

Indeed, the weasel word “social” requires further explanation here. McCaffrey explains that “action is ‘social’ to the extent it fosters cooperation and thereby encourages specialization and the division of labor” (p. 245). It is thus ultimately “inaccurate to contrast social with non-social enterprises” (p. 246) in this broad sense of the word. Enterprises are always social, but may be so in different ways.

Moreover, using Fetter’s notion of psychic income, and the Misesian derivative of psychic profit, McCaffrey shows that it is likewise untenable to call any enterprise strictly “not-for-profit.” Social enterprises are bound up with a kind of profit motive too. If the “social cause” pursued by the enterprise involves giving money in some form or another to certain groups, it must generate monetary income if it attempts to be more than a mere charity organization, as McCaffrey points out (p. 249).

These considerations show that it is much more difficult to clearly distinguish the social and mundane types of entrepreneurship. There is no clear-cut theoretical distinction between them that makes their analysis in terms of economic calculation fundamentally different. This is the underlying point of McCaffrey’s essay. He nonetheless maintains that “[e]conomics provides wide-ranging theories of social interaction, value, calculation, profit, and pricing that can be used to rigorously define the domain of social entrepreneurship” (p. 259). However, the “social element” is ultimately simply one form of consumption, which has to be financed in some way.

McCaffrey discusses complementary social enterprises, which operate exactly like mundane enterprises, except that they donate their profits to some “social” cause and let their costumers know it. Yet, when it comes to integrated social enterprises, the pursuit of the “social” cause is tied up into the production process itself. In practice, this means that the entrepreneurs are willing to pay morefor some factors of production. They might hire homeless workers and pay them a salary above their discounted marginal revenue product (p. 257).

In so far as the pursuit of the “social” cause is valued by the customers, the entrepreneurs will attract additional revenue. It might turn out after all that the homeless workers are really not paid above their marginal revenue product as McCaffrey shows. If the pursuit of the “social” cause does not attract additional revenue from costumer spending, it must be financed out of other sources. These could be the “entrepreneur’s profits, the capital of the enterprise, the land of the enterprise, or the wages of other employees if they are willing to forego part of their potential earnings, as in the case of volunteers for a charitable cause” (p. 257).

McCaffrey thus shows in his article that enterprises in pursuit of a “social” cause are limited by profit and loss and hence by economic calculation, just like mundane enterprises. If they generate monetary profits, they can better promote the cause. If they incur losses, the continued existence of the enterprise and promotion of the cause becomes a matter of charity on the part of the entrepreneurs or other stakeholders. One way or the other, the subjective value creation, that is, the psychic income or want satisfaction, created by the enterprise has to be strong enough to attract finance of its expenses.

A realistic philosophical interpretation of history must abstain from any reference to the chimerical notion of a perfect state of human affairs. The only basis from which a realistic interpretation can start is the fact that man, like all other living beings, is driven by the impulse to preserve his own existence and to remove, as far as possible, any uneasiness he feels. It is from this point of view that the immense majority of people appraise the conditions under which they have to live. It would be erroneous to scorn their attitude as materialism in the ethical connotation of the term.

The pursuit of all those nobler aims that the moralists contrast with what they disparage as merely materialistic satisfactions presupposes a certain degree of material well-being.

The controversy about the monogenetic or polygenetic origin of Homo sapiens is of little importance for history. Even if we assume that all men are the descendants of one group of primates, which alone evolved into the human species, we have to take account of the fact that at a very early date dispersion over the surface of the earth broke up this original unity into more or less isolated parts. For thousands of years each of these parts lived its own life with little or no intercourse with other parts. It was finally the development of the modern methods of marketing and transportation that put an end to the isolation of various groups of men.

To maintain that the evolution of mankind from its original conditions to the present state followed a definite line is to distort historical fact. There was neither uniformity nor continuity in the succession of historical events. It is still less permissible to apply to historical changes the terms growth and decay, progress and retrogression, improvement and deterioration, if the historian or philosopher does not arbitrarily pretend to know what the end of human endeavor ought to be. There is no agreement among people on a standard by which the achievements of civilization can be said to be good or bad, better or worse.

Mankind is almost unanimous in its appraisal of the material accomplishments of modern capitalistic civilization. The immense majority considers the higher standard of living which this civilization secures to the average man highly desirable. It would be difficult to discover, outside of the small and continually shrinking group of consistent ascetics, people who do not wish for themselves and their families and friends the enjoyment of the material paraphernalia of Western capitalism.

If, from this point of view, people assert that "we" have progressed beyond the conditions of earlier ages, their judgment of value agrees with that of the majority. But if they assume that what they call progress is a necessary phenomenon and that there prevails in the course of events a law that makes progress in this sense go on forever, they are badly mistaken.

To disprove this doctrine of an inherent tendency toward progress that operates automatically, as it were, there is no need to refer to those older civilizations in which periods of material improvement were followed by periods of material decay or by periods of standstill. There is no reason whatever to assume that a law of historical evolution operates necessarily toward the improvement of material conditions or that trends which prevailed in the recent past will go on in the future too.

What is called economic progress is the effect of an accumulation of capital goods exceeding the increase in population. If this trend gives way to a standstill in the further accumulation of capital or to capital decumulation, there will no longer be progress in this sense of the term.

Everyone but the most bigoted socialists agrees that the unprecedented improvement in economic conditions that has occurred in the last two hundred years is an achievement of capitalism. It is, to say the least, premature to assume that the tendency toward progressive economic improvement will continue under a different economic organization of society.

The champions of socialism reject as ill-considered all that economics has advanced to show that a socialist system, being unable to establish any kind of economic calculation, would entirely disintegrate the system of production. Even if the socialists were right in their disregard for the economic analysis of socialism, this would not yet prove that the trend toward economic improvement will or could go on under a socialist regime.

As the transaction cost theory of the firm was taking shape in the 1970s, another important movement in economics was emerging: a revival of the “Austrian” tradition in economic theory associated with such economists as Ludwig von Mises and F. A. Hayek (1973; Dolan, 1976; Spadaro, 1978). As Oliver Williamson has pointed out, Austrian economics is among the diverse sources for transaction cost economics. In particular, Williamson frequently cites Hayek (e.g., Williamson, 1985, p. 8; 1991, p. 162), particularly Hayek’s emphasis on adaptation as a key problem of economic organisation (Hayek, 1945). Following Williamson’s lead, a reference to Hayek’s “The Use of Knowledge in Society” (Hayek, 1945) has become almost mandatory in discussions of economic organisation (e.g., Ricketts, 1987, p. 59; Milgrom and Roberts, 1992, p. 56; Douma and Schreuder 1991, p. 9). However, there are many other potential links between Austrian and transaction cost economics that have not been explored closely and exploited.

This article argues that characteristically Austrian ideas about property, entrepreneurship, economic calculation, tacit knowledge, and the temporal structure of capital have important implications for theories of economic organisation, transaction cost economics in particular. Austrian economists have not, however, devoted substantial attention to the theory of the firm, preferring to focus on business-cycle theory, welfare economics, political economy, comparative economic systems, and other areas. Until recently the theory of the firm was an almost completely neglected area in Austrian economics, but over the last decade, a small Austrian literature on the firm has emerged.Examples include Langlois (1992, 1995, 2002), Minkler (1993a, 1993b), Foss (1994, 1997, 1999, 2001), Klein (1996, 1999, 2008), Young, Smith, and Grimm (1996), Lewin (1998), Dulbecco and Garrouste (1999), Ionnanides (1999), Witt (1999), Yu (1999), Sautet (2000), Foss and Foss (2002a, 2000b), Lewin and Phelan (2000), Foss and Christensen (2001), Klein and Klein (2001), Foss and Klein (2002), Foss, Foss, Klein, and Klein (2002), Adelstein (2005), Ng (2005), Foss, Foss, and Klein (2007), Pongracic (2009), and Walsh (2009). While these works cover a wide variety of theoretical and applied topics, their authors share the view that Austrian insights have something to offer students of firm organisation.

The Austrian school was born with the publication of Viennese professor Carl Menger’s Grundsätze der Volkwirtschaftslehre (Menger, 1871) in 1871, making the Austrian school one of the three great “marginalist” traditions (along with the approaches of William Stanley Jevons and Léon Walras). Menger offered a unique account of the pricing process, the structure of capital, and the causes of economic fluctuations, along with an emphasis on explaining institutions, that differed

substantially from the Marshallian, Walrasian, and Keynesian approaches that came to dominate the economics profession. Like Jevons and Walras, Menger emphasised subjectively held consumer wants as the source of economic value (as opposed to the classical view that production costs determined value). Unlike the neoclassical approach, however, Menger’s approach to economics was causal and realistic, seeking to explain real-world prices and institutions in terms of the subjective values, plans, and actions of market participants.

The Austrian school rose to prominence in the late nineteenth and early twentieth centuries in Europe and the US under the influence of Menger, Eugen von Böhm-Bawerk, Frank A. Fetter, Herbert J. Davenport, Philip Wicksteed, Mises, Lionel Robbins, and Hayek, but fell into obscurity by the end of the 1930s. Important contributions to the Austrian tradition were added later by Mises (1949), Rothbard (1956, 1962, 1963a, 1963b), Kirzner (1966, 1973), and Lachmann (1956), but at least publicly, the Austrian tradition lay dormant. When the 1974 Nobel Prize in economics went to Hayek, interest in the Austrian school was suddenly and unexpectedly revived. Already that year an “Austrian revival” was underway, led by students and followers of Rothbard and Kirzner (Dolan, 1976; Vaughn 1994; Salerno, 2002). Since then, the modern Austrian school has become an important “heterodox” tradition within the milieu of contemporary economics, now featuring its own academic journals, professional societies, graduate programs, and sponsoring organisations.

Throughout its history, the Austrian school has developed many of its key ideas as alternatives to other, more dominant perspectives. Menger’s subjectivist, marginalist approach challenged the classical theory of value, and Menger later engaged the German Historical School in a lengthy debate on the proper scope and method of economics. Mises refined his views on monetary calculation during the socialist calculation debate, and Hayek developed and extended his and Mises’s theory of business cycles in the course of several encounters with Keynes. Similarly, the Austrian literature on the firm challenges important aspects of other, more popular perspectives on economic organisation, entrepreneurship, and strategic management.

While the Austrians until recently had little to say about the theory of the firm per se, problems of economic organisation and its institutional embodiment have always occupied centre stage within the Austrian tradition. This includes, most obviously, issues in comparative systems such as the socialist calculation debate (e.g., Mises 1920, 1936; Hayek, 1935, 1945; Lavoie 1985). Indeed, it is surprising that the Austrians had so many necessary ingredients for a theory of the firm and yet it was left to non-Austrian Ronald Coase to frame and analyse the problem of the existence, boundaries, and internal organisation of the firm.

Kinds of Orders

Perhaps the most pertinent overall distinctions to be made in a discussion of economic organisation are the ones between “pragmatic” and “organic” institutions (Menger 1883) or “planned” and “spontaneous orders” (Hayek 1973). While pragmatic institutions are the results of “socially teleological causes,” organic institutions are “the unintended result of innumerable efforts of economic subjects pursuing individual interests” (Menger, 1883, p. 158). Menger’s discussion aims primarily to explain the different ways institutions arise, not how they are preserved, or their principles of operation once established. Hayek’s (1973) distinction between planned and spontaneous orders supplements Menger’s discussion in this regard, because his distinction is based on the different organising rules these orders comprise. The rules supporting spontaneous order are abstract, purpose-independent, and general, while the rules (or commands) supporting a planned order are designed and specific in nature. Although Hayek tends to distinguish sharply not only between spontaneous and planned orders, but also between the relevant rules that direct them — nomos and thesis, respectively — precise distinctions are difficult to draw: spontaneous orders may be more or less general, planned orders may comprise elements of spontaneous orders, etc. Obviously, the overall distinction between planned and spontaneous orders closely parallels that between “markets and hierarchies” (Williamson, 1975), or “spontaneous” and “intentional governance” (Williamson, 1991).

The Socialist Calculation Debate

Of course, the interwar debate on the economic efficiency of socialism is a prime example of contrasting “spontaneous” and “intentional” modes of governance, albeit on an economy-wide level. However, the debate yielded numerous insights that have been important to later developments in the theory of economic organisation, including transaction cost economics, such as (1) the insight that welfare assessments of institutions and outcomes should not be based on a “Nirvana approach” (Demsetz, 1969); (2) the importance of change to economic organisation; (3) the understanding that an economic organisation should be sensitive to the knowledge and rationality that agents possess; and (4) an understanding of the principal-agent relationship and the importance of incentives more generally (see Foss, 1994). Thus, it is apparent already from Mises’s (1920) opening salvo in the debate that what really irritated the Austrians was their socialist opponents’ use of unrealistic and unattainable standards of comparison. Naturally, on such standards, capitalism would appear inefficient and wasteful. To the Austrians, socialists economists (including the proponents of market socialism) neglected the role of incentives (Mises 1936; Hayek 1940); made unrealistic assumptions about the amounts of knowledge that agents can possess (particularly the planning authorities); and formulated their reasoning within static models that obscured all significant economic problems. Mises, on the other hand, insisted that “the problem of economic calculation is of economic dynamics; it is no problem of economic statics” (1936, p. 121), and Hayek later added that “economic problems arise always and only in consequence of change” (1945, p. 82). In Salerno’s (1994, p. 121) words, Mises

makes it crystal clear that the static prices mathematically imputed from perfect knowledge of the economic data would not lead to a dynamically efficient allocation of resources. The latter can only be achieved by the entrepreneurially appraised prices that are generated by the historical market process.

One way to interpret this Austrian insight is that absent change there are no transaction and information costs; that is, in the absence of the knowledge and appraisement problems introduced by economic change there would be no costs of identifying contractual partners, drafting and executing contracts, monitoring production, constructing contractual safeguards, judging quality, and so on. In the absence of transaction costs the choice between price-mediated market transactions and firm hierarchies is indeterminate. This indicates a link between Austrian insights in the calculation debate and Coasian insights in economic organisation, though these links were not recognised either by the Austrians or by Coase, probably because they were focusing on different institutions: When Hayek (1945) praised “the marvel” of the price system, Coase had eight years earlier established that the reason firms existed was that the “telecommunications system” of prices did not perform costlessly. Indeed, some commentators have seen the analysis of Coase and that of Hayek as strongly opposed. Instead, however, it is only in the kind of dynamic economic reality visualised by the Austrians that Coase’s argument acquires its full force.

Incentives and Property Rights

One of the rapidly expanding areas in the theory of economic organisation is principal-agent theory. The Austrians made several arguments that in important ways anticipate this theory. They pointed to agency problems under socialism such as risk allocation (e.g., Hayek 1940). Under socialism, they noted, managers would be either inefficiently risk averse or risk loving, in the face of career concerns and the presence of an institution (the planning authorities) that could act as an insurance institution and take over the moral hazard of individual managers (Mises 1936, p. 122; Hayek 1940, p. 199). Moreover, the Austrians pointed out that socialist economic organisation would encourage rent seeking (Mises 1936, 1944, 1949).

A primary virtue of a market system organised on the basis of private ownership, as Mises saw it, is the strong mitigation of potential principal-agent problems:

In the capitalist economy, the operation of the market [does] not stop at the doors of a big business concern. . . . [It] permeate[s] all its departments and branches. . . . It joins together utmost centralisation of the whole concern with almost complete autonomy of the parts, it brings into agreement full responsibility of the central management with a high degree of interest and incentive of the subordinate managers (Mises 1944, p. 47).

Breaking the corporation into separate profit centres is the way that top management monitors subordinate managers. Anticipating Fama (1980), Mises (1944, pp. 42–47) points to career concerns as important forces mitigating manager shirking. To be sure, both principal-agent theory and the specific Austrian incentive

arguments in the calculation debate rest on more general property-rights reasoning. For example, it is fundamentally because agents usually do not have property rights to residual income streams from the productive activities they engage in that they may shirk their duties.

While Austrian thinking about the economic function of property rights begins with Menger (e.g., 1871, p. 97, 100), the most advanced Austrian thinking on the matter is represented by Mises’s work. For example, Mises (1936, p. 182) clearly explains that property rights are composite rights, and he argues that well-defined residual-income rights are crucial to the efficient working of the economy. A central reason why the “artificial market” of market socialists will not work is precisely because the transfer of goods between socialist managers is not equivalent to the transfer of goods in a capitalist economy: Under socialism it is not full property rights that are transferred; prices and incentives are accordingly perverse. Where Mises perhaps most explicitly anticipates modern developments, specifically work on the market for corporate control, is where he describes the critical role of capital markets for the efficient functioning of the economy. Securities markets facilitate the most important kind of economic calculation in a dynamic economy through “dissolving, extending, transforming, and limiting existing undertakings, and establishing new undertakings” (1936, p. 215).See also Klein (1999).

Capital Theory and Business Cycle Theory

Capital and business-cycle theory seem less-closely connected to the theory of economic organisation. However, they supply the last component in the set of concepts needed to make a coherent statement about economic organisation in general and the firm in particular. The relevant component is the intertemporal structure of production highlighted in Austrian capital and business-cycle theory (e.g., Hayek, 1931, 1941; Lachmann, 1956). To the Austrians, the economy’s production process represents a series of stages of production, each of which bears a temporal relationship to final consumption (Menger, 1871; Hayek, 1931, 1941; Lachmann, 1956). In other words, there are important complementarities among production processes. Moreover, credit expansion introduces maladjustments in the structure of production that have to be worked out over time (Hayek, 1931), which means that some resources or activities are specific to each other and to particular production processes (see also Lachmann, 1956). These relationships can only be understood fully in a framework that emphasises the time structure of production, like Austrian capital and business-cycle theory (ibid.); they are obscured in the usual production-function view of economic activity in which capital is homogeneous and production is timeless. Vertical integration is also much easier to portray and comprehend in a sequential framework than the atemporal framework of neoclassical microeconomics. As recent work in the theory of the firm has demonstrated, notions of complementarity and specificity are needed to tell a coherent story about the firm (Hart, 1995; Williamson, 1996).

There is some debate within the Austrian literature about the basic Coasian approach and its compatibility with the Austrian perspective. O’Driscoll and Rizzo (1985, p. 124), while acknowledg­ing Coase’s approach as an “excellent static conceptualization of the problem,” argue that a more evolutionary framework is needed to understand how firms respond to change. Some Austrian economists have suggested that the Coasian frame­work may be too narrow, too squarely in the general-equilibrium tradition to deal adequately with Aus­trian concerns (Boudreaux and Holcombe, 1989; Langlois, 1994). However, as Foss (1993) has pointed out, there are “two Coasian tradi­tions.” One tradition, the moral-hazard or agency-theoretic branch associated with Alchian and Demsetz (1972), studies the design of ex ante mechanisms to limit shirking when supervision is costly. Here the emphasis is on monitoring and incentives in an (exogenously deter­mined) agency relationship. The above criticisms may apply to this branch of the modern litera­ture, but they do not apply to the other tradition, the governance or asset-specifici­ty branch, especially in Williamson’s more heterodox formulation. William­son’s transac­tion cost frame­work incorpo­rates non-maxi­mising behaviour (bound­ed rationality); true, “structur­al” uncer­tain­ty or genuine surprise (com­plete con­tracts are held not to be feasible, meaning that all ex post contingen­cies cannot be contracted upon ex ante); and process or adapta­tion over time (trading rela­tion­ships develop over time, typically undergo­ing a “fundamental transfor­ma­tion” that changes the terms of trade). In short,

at least some modern theories of the firm do not at all presup­pose the “closed” economic universe — with all relevant inputs and outputs being given, human action conceptu­alized as maximization, etc. — that [some critics] claim are under­neath the contem­po­rary theory of the firm (Foss, 1993, p. 274).

Stated different­ly, one can adopt an essentially Coasian perspective without abandoning the Misesian view of the entrepre­neur as an uncertainty-bearing, innovating decision maker.Foss and Foss (2000) argue, more generally, that contractual and knowledge-based theories of the firm are fundamentally complements, not rivals. For more on the Misesian theory of the entrepreneur see Foss, Foss, Klein, and Klein (2007), Klein (2008), and Salerno (2008).

One approach to developing a uniquely “Austrian” approach to the firm is to start with the basic contractual approach, and the Coasian explananda of the firm’s existence, boundaries, and internal organisation, and add concepts of entrepreneurship, economic calculation, the time-structure of production, and other elements of the Austrian tradition. For example, the limits to firm size can be understood as a special case of the arguments offered by Mises (1920) and Hayek (1937, 1945) about the impossibility of rational economic planning under socialism (Klein, 1996). Kirzner (1992, p. 162) adopts this approach in interpreting the costs of internal organisation in terms of Hayek’s knowledge problem:

In a free market, any advantages that may be derived from “cen­tral planning” . . . are purchased at the price of an enhanced knowledge problem. We may expect firms to spontaneously expand to the point where additional advantages of “central” planning are just offset by the incremental knowledge difficulties that stem from dispersed information.

What, precisely, drives this knowledge problem? The mainstream literature on the firm focuses mostly on the costs of market exchange, and much less on the costs of governing internal ex­change. The new research has yet to produce a fully satisfactory explanation of the limits to firm size (William­son, 1985, chapter 6). Existing contractual explanations rely on problems of authority and responsibility (Arrow, 1974); incentive distortions caused by residual ownership rights (Grossman and Hart, 1986; Holmström and Tirole, 1989; Hart and Moore, 1990); and the costs of attempt­ing to repro­duce market gover­nance features within the firm (Wil­liamson, 1985, chapter 6). Rothbard (1962, pp. 544–50) offers an explanation for the firm’s vertical boundaries based on Mises’s claim that eco­nomic calculation under socialism is impossi­ble. Rothbard argues that the need for monetary calcula­tion in terms of actual prices not only explains the failures of central planning under socialism, but places an upper bound on firm size.

Rothbard’s account begins with the recognition that Mises’s position on socialist economic calculation, as noted above, is not about socialism per se, but the role of prices for capital goods. Entrepreneurs alloca­te resources based on their expectations about future prices, and the information contained in present prices. To make profits, they need information about all prices, not only the prices of consumer goods but the prices of factors of production. Without markets for capital goods, these goods can have no prices, and hence entre­preneurs cannot make judgments about the relative scarcities of these factors. In any environment, then — socialist or not — where a factor of produc­tion has no market price, a potential user of that factor will be unable to make rational decisions about its use. Stated this way, Mises’s claim is simply that efficient resource allocation in a market economy requires well-function­ing asset markets. To have such markets, factors of production must be privately owned.

Rothbard’s contribution is to generalise Mises’s analysis of this problem under socialism to the context of vertical integra­tion and the size of the organisation. Rothbard writes in Man, Economy, and State that up to a point, the size of the firm is determined by costs, as in the textbook model. However, “the ulti­mate limits are set on the relative size of the firm by the necessity for markets to exist in every factor, in order to make it possible for the firm to calculate its profits and losses” (Rothbard, 1962, p. 536). This argument hinges on the notion of “implicit costs.” The market value of opportunity costs for factor services — what Rothbard calls “esti­mates of implicit incomes” — can be determined only if there are external markets for those factors (pp. 542–44). For example, if an entrepreneur hires himself to manage the business, the opportunity cost of his labour must be included in the firm’s costs. Yet without an actual market for the entrepreneur’s mana­gerial services, he cannot know his opportunity cost; his balance sheets will therefore be less accurate than they would if he could measure his oppor­tunity cost.

The same problem affects a firm owning multiple stages of produc­tion. A large, integrat­ed firm is typically organised into semi-autonomous profit centres, each special­ising in a particular final or interme­diate product. The central management of the firm uses the implicit incomes of the business units, as reflected in statements of division­al profit and loss, to allocate physical and financial capital across the divisions. To compute divisional profits and losses, the firm needs an economically meaningful transfer price for all internally transferred goods and services. If there is an external market for the component, the firm can use that market price as the transfer price. Without a market price, however, the transfer price must be estimated, either on a cost-plus basis or by bargaining between the buying and selling divisions; such estimated transfer prices contain less informa­tion than actual market prices.

The use of internal­ly traded intermediate goods for which no external market refer­ence is available thus intro­duc­es distortions that reduce organisa­tional efficien­cy. This gives us the element missing from contemporary theories of economic organisa­tion, an upper bound: the firm is con­strained by the need for external markets for all internal­ly traded goods. In other words, no firm can become so large that it is both the unique producer and user of an intermedi­ate product; for then no market-based transfer prices will be available, and the firm will be unable to calculate divisional profit and loss and therefore unable to allocate resources correctly between divisions.Note that in general, Rothbard is making a claim only about the upper bound of the firm, not the incremental cost of expanding the firm’s activities (as long as external market references are available). As soon as the firm expands to the point where at least one external market has disappeared, however, the calculation problem exists. The difficulties become worse as more and more external markets disap­pear, as ‘islands of noncalculable chaos swell to the proportions of masses and continents. As the area of incalculability increases, the degrees of irrational­ity, misallocation, loss, impoverishment, etc., become greater’ (Rothbard, 1962, p. 548). Of course, internal organisation does avoid the holdup problem, which the firm would face if there were a unique outside supplier; conceivably, this benefit could outweigh the increase in “incalculability” (Rothbard, 1962, p. 548).

Like Kirzner (1992), Rothbard viewed his contribution as consistent with the basic Coasian framework. In a later elaboration of this argument (Rothbard, 1976, p. 76), he states that his own treatment of the limits of the firm:

serves to extend the notable analysis of Professor Coase on the market determi­nants of the size of the firm, or the relative extent of corpo­rate planning within the firm as against the use of exchange and the price mechanism. Coase pointed out that there are diminishing benefits and increasing costs to each of these two alter­natives, resulting, as he put it, in an “‘optimum’ amount of planning” in the free market system. Our thesis adds that the costs of internal corporate planning be­come prohibitive as soon as markets for capital goods begin to disappear, so that the free-market optimum will always stop well short not only of One Big Firm throughout the world market but also of any disappearance of specific markets and hence of economic calculation in that product or resource (Rothbard, 1976, p. 76).

“Central planning” within the firm, then, is possible only when the firm exists within a larger market setting. Ironically, the only reason the Soviet Union and the commu­nist nations of East­ern Europe could exist at all is that they never fully succeed­ed in establishing social­ism world­wide, so they could use world market prices to establish implicit prices for the goods they bought and sold internally (Rothbard, 1991, pp. 73–74).

The close relationship between the Misesian concept of entrepreneurship as action under uncertainty and the ownership and control of resources suggests a bridge between entrepreneurship and the mundane activities of establishing and maintaining a business enterprise. Foss and Klein (2005) and Foss, Foss, Klein, and Klein (2007) offer an entrepreneurial theory of the economic organisation that combines the Knight-Mises concept of entrepreneurship as “judgment” and the Austrian approach to capital heterogeneity. In Knight’s formulation, entrepreneurship represents judgment under “true” uncertainty that cannot be assessed in terms of its marginal product and which cannot, accordingly, be paid a wage (Knight 1921, p. 311). In other words, there is no market for the judgment that entrepreneurs rely on, and therefore exercising judgment requires the person with judgment to start a firm. As Mises (1949, p. 585) puts it,

the real entrepreneur is a speculator, a man eager to utilize his opinion about the future structure of the market for business operations promising profits. This specific anticipative understanding of the conditions of the uncertain future defies any rules and systematization.

Of course, judgmental decision makers can hire consultants, forecasters, technical experts, and so on. However, in doing so they are exercising their own entrepreneurial judgment. Judgment thus implies asset ownership, for judgmental decision-making is ultimately decision-making about the employment of resources. The entrepreneur’s role, then, is to arrange or organise the capital goods he owns. As Lachmann (1956, p. 16) puts it: “We are living in a world of unexpected change; hence capital combinations . . . will be ever changing, will be dissolved and reformed. In this activity, we find the real function of the entrepreneur.”

Austrian capital theory provides a unique foundation for an entrepreneurial theory of economic organisation . Neoclassical production theory, with its notion of capital as a permanent, homogeneous fund of value, rather than a discrete stock of heterogeneous capital goods, is of little help here. Transaction cost, resource-based, and property-rights approaches to the firm do incorporate notions of heterogeneous assets, but they tend to invoke the needed specificities in an ad hoc fashion to rationalise particular trading problems — for transaction cost economics, asset specificity; for capabilities theories, tacit knowledge; and so on. The Austrian approach, starting with Menger’s (1871) concepts of higher- and lower-order goods and extending through Böhm-Bawerk’s (1889) notion of roundaboutness, Lachmann’s (1956) theory of multiple specificities, and Kirzner’s (1966) formulation of capital structure in terms of subjective entrepreneurial plans, offers a solid foundation for a judgment-based theory of entrepreneurial action.

One way to operationalise the Austrian notion of heterogeneity is to incorporate Barzel’s (1997) idea that capital goods are distinguished by their attributes. Attributes are characteristics, functions, or possible uses of assets, as perceived by an entrepreneur. Assets are heterogeneous to the extent that they have different, and different levels of, valued attributes. Attributes may also vary over time, even for a particular asset. Given Knightian uncertainty, attributes do not exist objectively, but subjectively, the minds of profit-seeking entrepreneurs who put these assets to use in various lines of production. Consequently, attributes are manifested in production decisions and realised only ex post, after profits and losses materialise.

Entrepreneurs who seek to create or discover new attributes of capital assets will want ownership titles to the relevant assets, both for speculative reasons and for reasons of economising on transaction costs. These arguments provide room for entrepreneurship that goes beyond deploying a superior combination of capital assets with “given” attributes, acquiring the relevant assets, and deploying these to producing for a market: Entrepreneurship may also be a matter of experimenting with capital assets in an attempt to discover new valued attributes.

Such experimental activity may take place in the context of trying out new combinations through the acquisition of or merger with another firms, or in the form of trying out new combinations of assets already under the control of the entrepreneur. The entrepreneur’s success in experimenting with assets in this manner depends not only on his ability to anticipate future prices and market conditions, but also on internal and external transaction costs, the entrepreneur’s control over the relevant assets, how much of the expected return from experimental activity he can hope to appropriate, and so on. Moreover, these latter factors are key determinants of economic organisation in modern theories of the firm, which suggests that there may be fruitful complementarities between the theory of economic organisation and Austrian theories of capital heterogeneity and entrepreneurship.

Foss, Foss, Klein, and Klein (2007) show how this approach provides new insights into the emergence, boundaries, and internal organisation of the firm. Firms exist not only to economise on transaction costs, but also as a means for the exercise of entrepreneurial judgment, and as a low-cost mechanism for entrepreneurs to experiment with various combinations of heterogeneous capital goods. Changes in firm boundaries can likewise be understood as the result of processes of entrepreneurial experimentation. And internal organisation can be interpreted as the means by which the entrepreneur delegates particular decision rights to subordinates who exercise a form of “derived” judgment on his behalf (Foss, Foss, and Klein, 2007).

Witt (1998, 1999) offers another approach to combining an Austrian concept of entrepreneurship with the theory of the firm. Entrepreneurs require complementary factors of production, he argues, which are coordinated within the firm. For the firm to be successful, the entrepreneur must establish a tacit, shared framework of goals — what Casson (2000) calls a “mental model” of reality — which governs the relationships among members of the entrepreneur’s team. As Langlois (1998) points out, it is often easier (less costly) for individuals to commit to a specific individual, the leader, rather than an abstract set of complex rules governing the firm’s operations. The appropriate exercise of charismatic authority, then, facilitates coordination within organisations (Witt, 2003). This approach combines insights from economics, psychology, and sociology, and leans heavily on Max Weber. Leaders coordinate through effective communication, not only of explicit information, but also tacit knowledge — plans, rules visions, and the like. The successful entrepreneur excels at communicating such models.

Here, as in Coase (1937), the employment relationship is central to the theory of the firm. The entrepreneur’s primary task is to coordinate the human resources that make up the firm. Foss, Foss, Klein, and Klein (2007), by contrast, focus on alienable assets, as in Knight (1921). They define the firm as the entrepreneur plus the alienable resources the entrepreneur owns and thus controls. Each approach has strengths and weaknesses. The cognitive approach explains the dynamics among team members but not necessarily their contractual relationships. Must the charismatic leader necessarily own physical capital, or can he be an employee or independent contractor? Formulating a business plan, communicating a corporate culture, and the like are clearly important dimensions of business leadership. But are they attributes of the successful manager or the successful entrepreneur? Even if top-level managerial skill were the same as entrepreneurship, it is unclear why charismatic leadership should be regarded as more “entrepreneurial” than other, comparatively mundane managerial tasks such as structuring incentives, limiting opportunism, administering rewards, and so on. On the other hand, the judgment approach does not generalise easily from the one-person firm to the multi-person firm.

Transaction cost economics, while firmly rooted in the neoclassical economics tradition, has always drawn upon a broad range of sources in law, organisation theory, economic sociology, political science, history, as well as a diverse set of economists from behavioural, “old” institutional, and other “heterodox” traditions. The Austrian school, while providing some direct influence mainly through Hayek, has not had as much influence as one might imagine, given the Austrians’ rich heritage in the areas of property rights, knowledge, incentives, and institutions. This essay highlights some possible bridges between the Austrian and new institutional literatures and points to the emerging Austrian literature on the theory of the firm. We expect this to be a growth area in the years to come.

It has been contended that it would be possible for a socialist economy to solve the problem of economic calculation by applying the equations by the aid of which mathematical economics describes the conditions of economic equilibrium. This view made its first appearance in an article by Barone published in 1908An English translation is found in Hayek (1935); since then it has been advanced time and again and enjoys marked popularity at the present time.

Hayek has shown the practical difficulties which stand in the way of this attempt at solving the problem. The calculation would have to include all conceivable uses, and ways of combining all available goods. Moreover it is not sufficient here to bring together under a common denominator all the quantities of goods which appear to form a single class from a technological standpoint. Since the economic profitability of transporting goods from place to place must be reflected in the equations, and since the latter must also solve all problems of location, goods which are similar from a technological point of view, but which are not available for use at the same place must appear in the calculation as independent items. If Hayek (1935, pp. 207–14) estimates the order of magnitude of the number of necessary equations and calculations as hundreds of thousands, this is certainly far below the number which we are justified in assuming on the basis of this factor.certainly far below the number which we are justified in assuming on the basis of this factor.

It is at once clear that the collection of these data, and the setting up of the corresponding equations, is a task far beyond the powers of a socialist central administration composed of mere human beings. The practical impossibility of carrying out the proposals connected with this or any similar solution is certainly not disputed. In consequence, we might, if we were concerned solely with the problem of economic calculation in the socialist state and with the practicability of socialism, leave the matter here. The proposals are however of special interest from the point of view of economic theory. Their closer consideration leads to important propositions concerning the character of the equations of mathematical economics.

The only way we can analyze exchange transactions is by assuming that they are directed toward producing a state of affairs in which no further exchange takes place, either because a state of complete satisfaction has been reached, or because a situation has been reached which, though not completely satisfactory, could not in the given conditions be made more satisfactory by further transactions. In its use of the static equilibrium concept, economic analysis does not go so far as to construct a state of complete standstill in which no more trading takes place. It confines itself to the construction of a situation in which the process of exchange follows a uniform course. In the future the same transactions are supposed to be continually repeated, because the conditions which give rise to exchange, and the conditions under which it has to be effected, remain unchanged. In this equilibrium situation there is no inducement for the economic subjects to change the allocation of means of production, because there is no conceivable and possible way of using them which appears better suited to satisfy their wants.

The equations which describe the economic equilibrium give expression to this method of approach in mathematical language. They say no more and no less. They say: If an equilibrium situation is to be reached, it can only be a position such that it will no longer be possible to improve the satisfaction of wants: by making changes.

It is particularly characteristic of these equations in economics that they are necessarily inapplicable to all practical purposes and computations. The equations of mechanics may help us to foresee future events, because the physicist is able to find out approximately the empirically constant relationships between physical quantities. If we insert these constants in the equations we can work with them. We cannot with exactitude of course but nevertheless with sufficient accuracy for ]practical purposes solve given problems. With the equations of economics it is a different matter. For within the sphere of human trading activities we do not know any constant quantitative relationships. All quantities that we are able to ascertain have therefore no general significance but only an historical one (Mises 1933, pp. 113–15, 150ff).

Thus even if we know the present conditions, we are unable to say anything of a quantitative nature, on the basis of this knowledge, about the pattern of future values. This is the big mistake that has been made by all those who have wanted to substitute “quantitative” economics for “qualitative” economics. A quantitative treatment of economic problems can only be economic history: it can never be economic theory. And there is no economic history of the future. The equations which describe the state of economic equilibrium include consumers’ preferences. These are the preferences which will prevail at the moment when the equilibrium is established on the market. They are different from today’s preferences as we know them from the way in which they are expressed on today’s market. Today we know nothing about these future preferences and cannot predict what they will be. Thus, though we may know the present-day condition of the market and all the data determining the configuration of today’s market position, including consumers’ preferences as they are expressed in that market position, we still do not know the future preferences of consumers.

We may be justified in assuming that they change. This assumption does not help however. For the economic system is not in equilibrium today, and we want to know the consumers’ preferences for the point of time when it will be in equilibrium and when, in consequence, other conditions will prevail. The progressive approach of things towards an equilibrium situation which we have in mind, and which forms the subject of our inquiry, means the progressive transformation of the conditions determining the preferences and therefore also of the preferences themselves. The problem is not only that, in order to make use of the equations, we need to know the scale of preferences that will prevail at a future point of time and which are not known to us today. Even today’s preferences are only known to us in so far as they are reflected in the system of prices ruling on today’s market. That is to say we know roughly how great is the demand for a certain article by the price prevailing for it on the market today. But we know nothing of what the demand would be if another price prevailed. We do not even know the shape of the supply and demand curves; we only know the position of one point at which the two curves cut or, more precisely, have cut today. Experience tells us so much and no more. It can provide us with no information about the data which we require for solving our equations.

Finally there is still a third point which needs mention: The state of equilibrium which our equations describe is a purely imaginary state of equilibrium. It is merely a hypothetical, though indispensable, tool of analysis which has no counterpart in reality. Thus it is not only a future state which differs from the state of the moment that has just passed and with which we are acquainted: It is merely an imaginary theoretical construction which will never become reality. Hayek (1935, p. 211) has also pointed out that the possibility of using the equations describing the state of equilibrium for purposes of economic calculation presupposes a knowledge of the future scales of preferences of consumers. But here he has in mind only a complication of the practical task of applying the equations, and not a fundamental and insuperable obstacle to their use for any such process of calculation.

It makes no difference whether we conceive of the socialist state as a dictatorship of the central administration in which only the valuations of the dictator carry weight, or whether we conceive of it as a state which tries to imitate a democratic system in which the preferences of individual consumers of groups of consumers are supposed to determine the direction of economic activity. Even the dictator cannot know today what his relative preferences will be at a later date under changed circumstances: he is no more capable of knowing this than is an individual consumer.

The equations describe the hypothetical equilibrium position which the economic system would ultimately and finally reach if all causes liable to give rise to changes in preferences were to disappear from that system.

Economic calculation, which is essential to the economic system, does not, however, require that we should know this hypothetical situation which can certainly never be reached in the actual economic system. What is necessary for the direction of the economy is only the knowledge of the next step which is required to be taken in the economic system. It is necessary to find out which of all the conceivable changes can, in the given conditions, secure the fullest satisfaction of wants from the standpoint of the preferences of the consumers or of the dictator. For this purpose the equations which describe the final equilibrium position are quite inappropriate. They say absolutely nothing about the path which the economic system has to follow in order finally to reach the equilibrium. Some recognition of this fact is distinguishable in the criticism which is constantly brought against these equations that they are only “static” and not “dynamic.”

Socialists who are not amenable to reason have the habit of parrying the argumentation which sets forth the impossibility of economic calculation in the socialist state by pointing to an alleged deficiency in the economic calculation, in money terms, of the capitalist society. They will therefore not hesitate to bring the following objection against the foregoing exposition: All that the entrepreneurs in the capitalist exchange economy know are the relative valuations and prices of today. This does not however prevent them from taking their calculations and producing on the basis of these calculations. Why should it be any different for the economic dictator of the socialist state?

This kind of question merely reveals an entire lack of understanding of the problem under discussion.

The future is always uncertain for human beings. Consequently every transaction which is carried out for a future date is speculation. In this respect there is no difference between socialism and capitalism.

It will always be happening that new facts appear, which people have not foreseen, and which cause them to say after the event that they would have acted differently if they had known beforehand what was going to ensue. People cannot take account in their economic activities of things that are unknown to them. We cannot therefore blame the method of economic calculation of the capitalist system, operating on the basis of the money prices of the market, for the fact that the expectations of the economic subjects are occasionally disappointed subsequently by the occurrence of unforeseen events. In economic calculation regard is taken of the future configuration of conditions of supply and demand only insofar as people foresee them, or think they can foresee them, in the present. It is merely the expectations of the entrepreneur about the future which influence the market situation of today and contribute towards the formation of today’s prices: this applies particularly to the prices of means of production and of consumption goods which do not perish rapidly.

If we proceed to argue that, for the solution of his equations, the general manager of the socialist economic system would have to have data which are not and cannot be known to him, this does not mean to say that he will know less about the future and about future needs than does the entrepreneur in the capitalist economic system. The analysis of this problem belongs to another chapter of the treatment of the problems of the socialist economy, and has nothing to do with the question of economic calculation. We may assume for purposes of the argument that the dictator of the socialist economy knows just as much, or just as little, about the future as the capitalist entrepreneur. In any case even this dictator will desire a variety of things, and he will have to discover in which way the objects he aims at can be most effectively reached. Here “most effectively” means, of course, merely: as effectively as is possible from the standpoint of present-day knowledge. In making considerations of this kind the capitalist economy uses calculations in terms of money: it calculates on the basis of market prices, which also take account of the future insofar as it can be taken account of in the present. Now in order to solve his equations, the dictator would have to know the relative valuations which will correspond to the future equilibrium situation, i.e., to a situation which is different from the situation in the present and which can never be reached in the real world.

The monetary form of calculation operates by way of market prices in which the future also is reflected as it appears today to the parties on the market. The socialist director-general, however, needs, if he is to solve the equations, the knowledge of a hypothetical situation which is different from the reality with which he is acquainted and is a construction of our thinking which we know, without any doubt, will never become reality. It is no help to him in setting up his equations to know the conditions that are given today and the opinions that prevail today about the shape of things in the future. He would need to know how things would look if a hypothetical state were reached in which all data had become rigid, and no further change would be set in motion, because no change could afford any further increase in welfare.

Our conclusions are thus as follows: In the capitalistic economy it is possible to make calculations on the basis of our present-day knowledge. It may be that mistakes will occasionally be made because unexpected events interfere with our plans and expectations. In the socialist state however it would not even be possible to calculate on the basis of our present knowledge. Those who think that it would be possible to apply the equations of mathematical economics for making the calculations fail to see that included among the items of which these equations are composed are unknown preference scales belonging to a situation which is unreal and can never be realized in practice. The circumstance that they are unknown frustrates all attempts to use the equations for purposes of economic calculation.

Barone, Enrico. 1908. “The Ministry of Production in the Collectivist State.” Reprinted in Hayek (1935).

Hayek, F.A. 1935. Collectivist Economic Planning. London: Routledge and Kegan Paul.

Mises, Ludwig von. 1933. Grundprobleme der Nationalökonomie. Jena. Translated as Epistemological Problems of Economics.

George Reisman, trans. New York: New York University Press [1976]. Pareto, Vilfredo. 1927. Manuel d’économie politique. 2nd Ed. Paris

One of the most important sociological laws is the "Iron Law of Oligarchy": every field of human endeavor, every kind of organization, will always be led by a relatively small elite. This condition will hold sway everywhere, whether it be a business firm, a trade union, a government, a charitable organization, or a chess club. In every area, the persons most interested and able, those most adaptable to or suited for the activity, will constitute the leading elite. Time and again, utopian attempts to form institutions or societies exempt from the Iron Law have fallen prey to that law: whether it be utopian communities, the kibbutz in Israel, "participatory democracy" during the New Left era of the late 1960s, or the vast "laboratory experiment" (as it used to be called) that constituted the Soviet Union. What we should try to achieve is not the absurd and anti-natural goal of eradicating such elites, but, in Pareto's term, for the elites to "circulate." Do these elites circulate or do they become entrenched?

The free market economy provides an unparalleled example of a continuing healthy circulation of elites. In this dynamic economy, failure to keep up with competitors, failure to satisfy the demands of consumers in the best possible way, will topple elites quickly and establish new ones who do the job better. Ludwig von Mises wrote frequently of the inappropriateness of leftists referring to so-and-so as the "Steel King" or the "Automobile King"; for consumers frequently uncrown these alleged monarchs. Dethroning of financial monarchs on Wall Street is a frequent phenomenon. There are innumerable striking examples of big businesses failing to grasp the importance of a new product or new development, and of losing out to newer upstarts. I will refer to only two glaring cases experienced in my lifetime: the cry of leftists to "break up A&P" in the 1930s because of its alleged "monopoly" of the retail grocery business; and the failure of the old-time photography "monopolist" Eastman-Kodak to grasp the enormous significance, after World War II, of either instant photography or xerography, thereby leaving the field to newer, and more alert competitors.

By its nature, government is not subject to the profit-and-loss test, to the domination by the consumers, of the free market. Even voluntary non-profit organizations, while not seeking maximum profit, at least have to be efficient enough to avoid severe losses or bankruptcy. Furthermore, such voluntary organizations at least must satisfy the values and demands of their donors, if not the users of the good or service as in the profit-making market. But government is unique among organizations in attaining its revenue via the coercion of taxpayers. Hence, government suffers no worries about losses or bankruptcy; it need serve no one except itself. The only limit on government is the enormously wide one of people rising up to refuse to obey its orders (including taxes); short of such revolution, however, there is little to limit government or to check the entrenchment or burgeoning of its elite.The remarkable August Days in Moscow and elsewhere in the Soviet Union in 1991 was a glorious example of just such a limit to tyranny being reached.

Government, in short, is particularly subject to the well-known evils of an arrogant, hidebound, inefficient, red-tape-ridden, ever-expanding "bureaucracy." Socialists, even during the seeming heyday of the Soviet Union, were often worried about the problem of bureaucracy, and have tried vainly to detach government from its bureaucratic aspect. But Mises trenchantly pointed out in his classic Bureaucracy that all such hopes are in vain. Bureaucracy, with all its evident evils, goes hand-in-hand with government. A profit-making firm saves and invests its money, attempting to make profits and avoid losses; its use of funds is flexible, dependent on its profit-seeking decisions. But bureaucratic agencies have their allocated funds from the government budget. And strict, precise, quibbling, rule-keeping is vital so that each bureaucrat and sub-bureaucrat can demonstrate that he has used the funds in the manner designated by the legislature or Chief Executive, and has not put them into his own pocket or spent them in some other, non-authorized way.Ludwig von Mises, Bureaucracy (New Haven: Yale University Press, 1944).

Mises points out a crucial difference between bureaucratic and profit management. Business expenditures and products are gauged by the valuations of consumers, whose judgments "are congealed into an impersonal phenomenon, the market price." Moreover, consumer judgments are levied on the goods and services, not on the producers themselves. "The seller-buyer nexus as well as the employer-employee relation in profit-seeking business," Mises declares, "is a deal from which both parties derive an advantage." But in government, in bureaucratic organization, on the other hand, what the nation "gets for the expenditure, the service rendered, cannot be appraised in terms of money, however important and valuable this 'output' may be." Instead, Mises points out, "its appraisal depends on the discretion of the government" — that is, on arbitrary, personal decisions. Mises adds that "the nexus between superior and subordinate is personal. The subordinate depends on the superior's judgment of his personality, not of his work." In short, in government bureaucracy, there is no reality check.Ibid., p. 53.

As Mises analyzes the difference for a branch agency: In a government bureau,

It is not because of punctiliousness that the administrative regulations fix how much can be spent by each local office for cleaning the premises, for furniture repairs, and for lighting and heating. Within a business concern such things can be left without hesitation to the discretion of the responsible local manager. He will not spend more than is necessary because it is, as it were, his money; if he wastes the concern's money, he jeopardizes the branch's profit and thereby indirectly hurts his own interests. But it is another matter with the local chief of a government agency. In spending more money he can, very often at least, improve the result of his conduct of affairs. Thrift must be imposed on him by regimentation.Ibid., p. 46. To the extent that business has been subject to increasing taxes and controls in the twentieth century, of course, its management has become more bureaucratic. As Mises puts it, "no profit-seeking enterprise, no matter how large, is liable to become bureaucratic provided the hands of its management are not tied by government interference. The trend toward bureaucratic rigidity is not inherent in the evolution of business. It is an outcome of government meddling with business." Ibid., p. 12.

In a business firm on the market, the desires and goals of the managers are yoked to the profit-making goals of the owners. As Mises says, the manager of a branch must make sure that his branch contributes to the profit of the firm. But, shorn of the regiment of profit-and-loss, the desires and goals of the managers, limited only by the prescriptions and budget of the central legislature or planning board, necessarily take control. And that goal, guided only by the vague rubric of the "public interest," amounts to increasing the income and prestige of the manager. In a rule-bound bureaucracy, that income and status inevitably depend on how many sub-bureaucrats report to that manager. Hence, each agency and department of government engage in fierce turf wars, each attempting to add to its functions and the number of its employees, and to grab functions from other agencies. So that while the natural tendency of firms or institutions on the free market is to be as efficient as possible in serving the demands of consumers, the natural tendency of government bureaucracy is to grow, and grow, and grow, at the expense of the fleeced and benighted tax-payers.

If the watchword of the market economy is profit, the watchword of bureaucracy is growth. How are these respective objectives to be achieved? The way to attain profit in a market economy is to beat the competitors in the dynamic, ever-changing process of satisfying consumer demands in the best possible way: to create a self-service supermarket instead of the older grocery store (even a chain store), or to create a Polaroid or a Xerox process. In other words, to produce concrete goods or services that consumers will be willing to pay for. But to attain growth, the bureaucratic manager must convince the legislature or planning board that his service will, in some vague way, aid the "public interest" or the "general welfare." Since the taxpayer is forced to pay, there is not only no incentive or reason for the bureaucrat to be efficient; there is no way that a bureaucrat, even with the most eager will in the world, can find out what the consumers want and how to meet their demands. Users pay little or nothing for the service, and even if they do, investors are not allowed to experience profit or loss from investing in producing that service. Therefore, the consumers will simply have to allow the bureaucrats to bestow their services upon them, whether the consumers like it or not. In building and operating a dam, for example, the government is bound to be inefficient, to subsidize some citizens at the expense of others, to misallocate resources, and generally to be at sea without a rudder in supplying the service. Moreover, for some citizens, the dam may not be a service at all; in the jargon of economists, for some people, the dam may be a "bad" not a "good". Thus, for environmentalists who are philosophically opposed to dams, or to farmers and homeowners whose property may be confiscated and flooded by the Dam Authority, this "service" is clearly a negative one. What is to happen to their rights and properties? Thus, government action is not only bound to be inefficient, and coercive against taxpayers; it is also bound to be redistributive for some groups at the expense of others.

The major group the bureaucrats benefit is, of course, themselves. Their entire income is extracted at the expense of taxpayers. As John C. Calhoun pointed out in his brilliant Disquisition on Government, bureaucrats pay no taxes; their alleged tax payments are a mere accounting fiction. The existence of government bureaucracy, Calhoun pointed out, creates two great conflicting classes in society: the net taxpayers, and the net tax-consumers. The greater the scope of taxes and of government, then, the greater the inevitable class conflict created in society. For, as Calhoun states:

The necessary result, then, of the unequal fiscal action of the government is to divide the community into two great classes: one consisting of those who, in reality, pay the taxes and, of course, bear exclusively the burden of supporting the government; and the other, of those who are the recipients of their proceeds through disbursements, and who are, in fact, supported by the government; or, in fewer words, to divide it into tax payers and tax-consumers.

But the effect of this is to place them in antagonistic relations in reference to the fiscal action of the government and the entire course of policy therewith connected. For the greater the taxes and disbursements, the greater the gain of the one and the loss of the other, and vice versa; and consequently, the more the policy of the government is calculated to increase taxes and disbursements, the more it will be favored by the one and opposed by the other.

The effect, then, of every increase is to enrich and strengthen the one [the net tax-consumers], and to impoverish and weaken the other [the net tax-payers].John C. Calhoun, A Disquisition on Government (New York: The Liberal Arts Press, 1953), pp. 17-18. Also see Murray N. Rothbard, "The Myth of Neutral Taxation," Cato Journal, I (Fall 1981), pp. 555-58.

How, then can the bureaucrats achieve their overriding goal of adding to the number of their employees and therefore of their income? Only by persuading the legislature or the planning board, or the mass of public opinion as a whole, that their particular government agency is worthy of an increase in its budget. But how can it do that, since it cannot sell services on the market, and since, moreover, its activities are necessarily redistributive and injure instead of benefit many of the consumers? What it must do is to "engineer consent," that is, it must falsely persuade the public or the legislature that its activities are a shining benefit instead of a bane to the consumers and the taxpayers. To engineer consent, it must use or employ intellectuals, the opinion-molding class in society, to persuade the public or the legislature of its function as a source of universal blessing. And when those intellectuals, or propagandists, are employed by the agency itself, this adds insult to the injury inflicted upon the taxpayers: for the taxpayers are forced to pay for their own deliberate miseducation.

It is intriguing that left-liberals invariably castigate advertising on the market for being shrill, for being misleading, and for artificially "creating" consumer demand. And yet, advertising is the indispensable method by which vital information is conveyed to the consumer — about the nature and quality of the product, and about its price and where it is offered. Oddly enough, liberals never level their critiques on the one area where they do strongly apply: the propaganda, the public relations, the hokum, put out by government. The difference is that all market advertising is soon put to a direct test: does this radio or TV work? But with government, there is no such direct consumer test: there is no way in which the citizen or voter can figure out rapidly how a specific policy worked. Furthermore, in elections, the voter is not presented with a specific program to consider: he must choose between a package deal of a legislator or chief executive for X number of years, and he is stuck for that period of time. And since there is no direct policy test, we arrive at the commonly deplored failure of the modern democratic process to discuss issues or policy, but instead to concentrate on television demagogy.See Murray N. Rothbard, Man, Economy and State: A Treatise on Economic Principles (Auburn, AL: Ludwig von Mises Institute, 1993), II, 774–76, 843–47.

Bureaucracy is necessarily hierarchical, first because of the Iron Law of Oligarchy, and secondly because bureaucracy grows by adding more subordinate layers. Since, lacking a market, there is no genuine test of "merit" in government's service to consumers, in a rule-bound bureaucracy seniority is often blithely adopted as a proxy for merit. Increasing seniority, then, leads to promotion to higher ranks, while expanding budgets take the form of multiplying the levels of ranks under you, and expanding your income and power. Bureaucratic growth occurs, then, by multiplying levels of bureaucracy.

The theory of hierarchical government bureaucracy is that information is collected in the lowest ranks of the organization, and that at each successive higher rank, the manager culls the most important information from his subordinates, separates the wheat from the chaff, and passes the culled information higher up, so that, in the end, the President, for example, dealing with intelligence operations, receives a two-page memo distilling the most important information gathered and culled from hundreds of thousands of intelligence agents. The President, then, knows more than anyone else, say, about foreign affairs. One problem with this rosy model, as Professor Gordon Tullock points out in his illuminating book, The Politics of Bureaucracy,Gordon Tullock, The Politics of Bureaucracy (Washington, D.C.: Public Affairs Press, 1965), passim.  is that the model doesn't ask whether or not each bureaucrat has the incentive to pass the best distillate of truth on to his superiors. The problem is that bureaucratic favor, especially at the higher levels, depends on pleasing one's superiors, and pleasing them largely rests on telling the President and the higher bureaucrats what they want to hear. One of the great truths of human history is that one tends to shoot, or at least react badly, to the bearer of bad news. "Sire, your policy is working badly in Croatia," is not the sort of message that the President, say, wants to hear from his envoy, and, while the outcome in Croatia remains in doubt, the President and his aides want to continue to believe that their policy is doing well. Hence, the dissident is set down as a trouble-maker if not a subversive, and his career in the hierarchy is side-tracked, often permanently. In the meanwhile, the envoys or foreign service people who assure the President "things are going very well in Croatia," are hailed as perceptive fellows and their careers are advanced. And then, if years later, the dissident is proved correct, and the Croatian policy lies in shambles, is the president or any other ruler likely to turn in warm gratitude to the former dissident? Not hardly. Instead, he will still remember the dissident as a troublemaker, and he will not blame his aides, who, along with himself, have been proved wrong. For after all, didn't the great mainstream of experts make the same error? How common is sincere soul-searching and repentance for past errors among Presidents or other rulers?

Those bureaucrats who are shrewd analysts of human nature, then, and who understand the way rulers operate, will, if they see that the cherished policy of their President is in grave error, tend to keep their mouths shut, and let some other sucker be the messenger of bad news and get shot down.

Every human activity and institution will tend to reward those who are most able to adapt to the best route to success in that activity. Successful market entrepreneurs will be those who can best anticipate, and satisfy, consumer demands. Success in the bureaucracy on the contrary, will go to those who are most apt at (a) employing propaganda to persuade their superiors, the legislators, or the public about their great merits; and therefore (b) at understanding that the way to rise is to tell the President and the top bureaucrats what they want to hear. Hence, the higher the ranks of the bureaucracy, the more yes-men and time-servers there will tend to be. The President will often know less about what is going on than those in the lower ranks.

Hence, for example, the phenomenon of President Nixon, thinking he knew more than anyone else about the Vietnam War and yet actually knowing less than the astute reader of the New York Times. For the CIA and other intelligence warnings of what was going on, developed by many of the lower officers, were screened out by the higher-ups, for being contrary to the President's preferred line, i.e., that all was going well.This insight into the best success route in government underlies the celebrated Chapter 10, "Why the Worst Get on Top," in F. A. Hayek's The Road to Serfdom (Chicago: University of Chicago Press, 1944).

The standard explanation of why government grows is that, as time goes on, there is more work for government to do, and that therefore the public's "demand for government" rises. Far more accurate is the view that there is a case of an inverted Say's Law, where supply — or rather the suppliers of government "services," the bureaucracy — themselves constitute the "demand" for their own services, and that they engineer the consent of their superiors, or of the legislature, to provide the wherewithal in the form of increased taxation. Contrast the hilariously satirical, but all too perceptive account of "Parkinson's Law" of bureaucracy. Thus, Professor Parkinson asserted that, in a government bureaucracy, "there need be little or no relationship between the work to be done and the size of the staff to which it may be assigned."C. Northcote Parkinson, Parkinson's Law (Cambridge, MA: Houghton Mifflin, 1957), p. 2. The continuing rise in the total of government employees "would be much the same whether the volume of the work were to increase, diminish, or even disappear."Ibid., p. 4. Parkinson identifies two "axiomatic" underlying forces responsible for this growth: (1) "An official wants to multiply subordinates, not rivals"; and (2) "Officials make work for each other."

Parkinson begins his "model" with an official who feels himself overworked. The official could resign, but that is unthinkable; besides, he would lose his pension rights. To ask to divide his work in half with a new colleague on his own level is equally unthinkable; for his status would be cut, and he would bring in a dangerous rival for the job of his own boss when the latter retires. He could ask for one assistant under him; but that would be dangerous, because the new man might achieve something like equal status with himself. No, his preferred route is to ask for two assistants, who could then compete with each other for his favor; pretty soon, each of these new assistants will complain of overwork, and each one of these will get two assistants. The original bureaucrat now has the satisfaction of having six men under him, and he is now ready for a promotion and a substantial raise in pay.

But how about the work to be done? Won't the original quantity of work be divided into seven parts, and won't each man now be absurdly and manifestly idle and underworked? No — and here is one of Parkinson's scintillating insights into the theory of bureaucracy — for one aspect of Parkinson's Law is that "work expands so as to fill the time available for its completion." Or, as Parkinson also puts it: "The thing to be done swells in importance and complexity in direct ratio with the time to be spent."Parkinson's Law applies in daily life as well as to government bureaucracy."Thus, an elderly lady of leisure can spend the entire day in writing and dispatching a postcard to her niece … An hour will be spent in finding the post, another in hunting for spectacles, half an hour in a search for the address, an hour and a quarter in composition, and twenty minutes in deciding whether or not to take an umbrella when going to the mailbox in the next street. The total effort that would occupy a busy man for three minutes all told may in this fashion leave another person prostrate after a day of doubt, anxiety, and toil." Ibid., p. 2.  Here enters the second aspect of Parkinson's Law of Growth: that "officials make work for each other." For, says Parkinson, "these seven make so much work for each other that all are fully occupied," and the original man "is actually working harder than ever." Documents have to be sent to each man in turn, each has to comment on the document and send the comments to everyone else, they all have to confer on the document and the various amendments proposed, and the original man is now also wrapped up in problems of inter-personal relations between himself and his staff, and of each of his staff amongst the others. Finally, after a lengthy process of interaction, writes Parkinson, the original official produces the same reply to the document that he would have written if all his subordinates "had never been born." "Far more people," Parkinson concludes, "have taken far longer to produce the same result. No one has been idle. All have done their best."Ibid., p. 6.

Parkinson then illustrates his law with delightful examples from the British Royal Navy. From 1914 to 1928, the number of ships in the Navy fell by 68 percent; the number of officers and men fell by 32 percent. And yet, during the same period, the number of dockyard officials and clerks in the Navy increased by 40 percent, while, even more outrageously, the number of Admiralty officials increased by over 78 percent. The annual rate of increase in the number of Admiralty officials, with little variation, was 5.6 percent. Parkinson takes another example from the British Colonial Office, from 1935 to 1954. In that period, the area and population of colonial territories remained about the same from 1935 to 1939, fell during the war until 1943, rose again until 1947, and then steadily decreased as Britain shed its Empire. And yet, in each of these two decades, the Colonial Office bureaucracy rose steadily in number by about 5.9 percent per year, regardless of what was happening in the scope of the alleged work to be done. Considering then the rate of increase each year in the Admiralty, and averaging the rates of increase of Admiralty and colonial officials, which is not, after all, more outlandish than many other statistical procedures, Parkinson triumphantly concludes that the number of officials will increase by an average of 5.75 percent per year, "irrespective of any variation in the amount of work (if any) to be done."Ibid., p. 12.

A similar analysis was set forth earlier, in 1950, in a grievously neglected book by Connecticut attorney and farmer Thomas H. Barber, based on years of inquiry into government and on his observations of Washington bureaucracy during World War II. Barber writes that "there are two requisites for a bureaucrat's promotion, the first, the ability to get and hold votes, the second, the number of subordinates he is able to keep busy." Barber goes on:

… in the Federal Government the pay of a bureaucrat executive is proportioned by Civil Service law to the number of his subordinates. This leads to the rivalry in Washington as each bureaucratic chief tries to increase his "empire." Generally, in order to keep his subordinates busy the boss assumes an air of great importance and affects to be very hurried and under great pressure. He is very punctual at the office and insists that everyone else be. He then deliberately begins to multiply paperwork, calling for reports on any subject connected with his job. He issues enormously complicated orders and memoranda for the organization of his office, requiring that all papers be so routed round that almost every scrap has to be read by everyone in the office and discussed by a number of interlocking committees before it is acted upon. He requires that no paper be thrown away, but all shall be cross-indexed and filed. He has anybody who can be tagged, interviewed, a stenographic report made of the interview and typed (often he has them mimeographed), and circulated to be read and initialed. By these methods it is quite easy to take an amount of work that could be done easily and efficiently by three men and two stenographers, and blow it up so that it can keep from fifty to two hundred people extremely busy, and yet fall far behind in its execution. Thus the uncompleted work gives him an apparently sound excuse for more clerks, who increase his prestige and his pay.Thomas H. Barber, Where We Are At (New York: Charles Scribner's Sons,1950), p. 103.

Barber then goes on to relate a delightful example of bureaucracy in action that he had observed during World War II. He notes that there existed a department whose work, "supposing it was worth doing, which is doubtful," could have been done competently by about twenty people. It was run, as he puts it, "by a man with a bureaucratic soul." This man asked for written opinions from everyone on all sorts of subjects and had every one read and initial them:

He was always intensely busy himself, even at night; and he kept constantly increasing his department till he got it up to two hundred men and women. This made him very important. All the two hundred were so busy carrying out his regulations that they were in a constant sweat and confusion, had no time to think, and the essential work in support of the war effort — supposing it was essential — suffered dreadfully. He was rewarded and translated to a more important job.

His successor, Barber related, was a different kind of person; an old gentleman with little ambition and little regard for the taxpayer, but whose objective was to do the essential work, and keep himself and everyone else at the workplace contented. In contrast to the twelve hours a day spent in the office by his predecessor, this man spent only one-half an hour at work each morning. The rest of the day, he walked around the office, talking and joking with the employees, and played golf in the late afternoon. At the end of the first week, says Barber, "he fired about fifty of the two hundred people, apparently at random." As a result, "the work lessened considerably for the remaining ones." There was naturally a lot of discussion of this action, and "it was generally decided that he had fired the fifty he was sure he did not like." "Not a very scientific way of eliminating surplus help," adds Barber, "but it did lighten the work."

The following week, the new boss fired fifty more people, this time apparently dismissing those "he thought he did not like." In consequence, "the work for the remainder lightened enormously, though some of the essential work of those dismissed was apportioned around silently by those that remained." A few days later, another fifty people were dismissed, these being the people "he was not sure he did like." Barber notes: "With three-quarters of the force eliminated there was practically nothing left but the 'essential work', such as it was, to do." This work was done effectively in about half of each day by the fifty people remaining, "far more efficiently than it had been done by the original two hundred. The fifty did their stuff and devoted the time remaining — about half of it — to their own concerns."

Barber concludes that "the old gentleman, being now surrounded only by those he knew he liked, felt he had done enough." He was in the office about an hour a day, and then he evaporated. "The 'work' was far better done than it had been, people had time to think and were not in each other's way." Barber adds that the work probably could have been done by half again of those remaining, but that then the half would "have had to work about as hard as the original two hundred had worked and there would have been no benefit to anyone but the taxpayers."Ibid., pp. 103–04.

In addition to this keen treatment of bureaucracy, Thomas Barber was perhaps the first person to arrive at the essence of what is now called "public choice" analysis in the economics profession. Barber notes the "constant tendency for all governments to grow both in size and in authority." Why? Barber answers:

because the advantage of a big, powerful government, from the point of view of the bureaucrats, is personal, clear and ever-present to their eyes; and because the cost of it, not only in money but in freedom, which is lost by giving authority to officials, is vague and nebulous in the minds of the citizens whose attention is not focused on the government at all…. Therefore, since the bureaucrats know exactly what they want and are working for their own immediate interest, and since the other citizens do not realize what they are giving up, and, in fact, have not their attention on the matter at all, it is obvious which group will prevail.Ibid., p. 100.

What public choicer has put it better?

The great Italian sociologist Vilfredo Pareto stressed the importance for society of the "circulation of elites," that elites not become entrenched and solidified.Contrary to accepted myth, Pareto was neither a "fascist" nor any other sort of statist. Pareto was an ardent and brilliantly perceptive laissez-faire libertarian and even anarcho-capitalist who understandably became deeply pessimistic about the future of liberty at the turn of the twentieth century. After that, he retreated to his ivory tower, from which he wrote bitter and cynical works about the irrationality of human motivations. See in particular, Piero Bucolo, ed., The Other Pareto (London: Scholar Press, 1980); S. E. Finer, "Pareto and Pluto-Democracy: the Retreat to Galapagos," American Political Science Review 62 (1968), pp. 440-50; and Finer, "Introduction" in Vilfredo Pareto, Sociological Writings (ed., by S. Finer, London: Pall Mall Press, 1966).  In the market, elites circulate rapidly and smoothly, in accordance with the most efficient service to meet the desires of consumers. But what of government? In the sphere of government, there is no built-in process for the circulation of elites, and so the natural tendency for the burgeoning, entrenching and rigidifying of bureaucracy tends to prevail.

The Founding Fathers of the American republics — and it is important to stress that thirteen republican polities were founded in the several states years before the possibly misguided leap into the American Constitution — were very much alive to the problem of bureaucracy and of government power. Guided by a blend of libertarian and classical republican thought, they attempted, for the first time in human history, to construct deliberately a new political order in which government power would be decentralized, and be strictly confined to the task of keeping the peace, of insuring domestic tranquility. The program of at least the dominant libertarian-republican wing of the Founding Fathers consisted of ultra-minimal government: guarding the rights of private property, free markets, and free trade; freedom of speech, press, and religion; separation of government from money, banking, and the economy; allowing neither public debt nor public works; having no standing army but rather relying on popular militia in case of foreign invasion; keeping government revenue and expenditures so low as to be nearly invisible; and generally binding down governmental Power with chains of iron, and watching government like a hawk and with vigilance and deep suspicion, lest it resume its natural tendencies and extend Power beyond its strictest bounds.

Nowhere was this more clearly put than in Trenchard & Gordon's Cato's Letters, English newspaper articles of the 1720s which were reprinted, bound, and proved highly influential in America throughout the eighteenth century. Cato's Letters, which were powerful expressions of libertarian thought, put it this way:

Only the checks put upon magistrates [government officials] make nations free; and only the want of such checks make them slaves. They are free, where their magistrates are confined within certain bounds set them by the people … And they are slaves, where the magistrates choose their own rules … and therefore most nations in the world are undone, and those nations only who bridle their governors do not wear chains.David L. Jacobson, ed., The English Libertarian Heritage (Indianapolis, IN: Bobbs-Merrill, 1965), p. 256. In the controversial "Pocock Thesis," J. Pocock sets up an artificial and overblown clash between libertarian and "classical republican" thought, and uses Cato's Letters as his definitive reason why the Founding Fathers were influenced by classical republican rather than libertarian ideas. For the definitive demonstration that Cato's Letters were decidedly libertarian rather than Pocockian, see Ronald Hamowy, "Cato's Letters, John Locke and the Republican Paradigm," History of Political Thought, 11 (1990), pp. 273-94.

How did the libertarian republicans propose to accomplish this program and bind down government? There were two parts to this program. The first was to confine government, for the first time in history, by explicit written constitutions, consisting of severely limited grants of power to the government by the sovereign people, these grants to be strictly, narrowly, and harshly interpreted. Also within those constitutions were explicit bills of rights, warning that government may not transgress against the rights of person and property.

The second and equally essential part of the libertarian-republican program of confining government was to make sure that entrenched oligarchies and bureaucracies would not develop. First, the various powers of government would be separated, and each branch would act as a check upon the others. But more important was a second device, which has fallen even more grievously into neglect than the idea of strict construction, bills of rights of person and property, and division of powers. That device was compulsory rotation in office — the idea that in order to keep a bureaucracy and a power elite from becoming entrenched, the terms of office be strictly and severely limited.

Essentially, the Founding Fathers saw that government lacks the swift and smooth circulation of elites provided by the free market.

They saw that the rough analog within government, was giving the public the maximum opportunity to vote out the incumbents, and, in the grand phrase of nineteenth century politics, to "throw the rascals out!" Therefore, the program of what might be called the "classical liberals" of the late eighteenth century, in England as well as in the new American republics, was frequent (usually annual) elections, and strict limitations upon the terms of office.

It is noteworthy that the current, very popular term-limitation movement for legislators has been denounced for placing fetters on the scope of democratic choice. But that of course was precisely the idea of these libertarian republicans, who were just as aware of the tyranny of majorities as they were of the tyranny of elites, as noted in the case of bills of rights and other constitutional limitations imposed upon government."It is a mistaken notion in government, that the interest of the majority is only to be consulted, since . . . the greater number may sell the less, and divide their estates amongst themselves; and so, instead of a society, where all peaceable men are protected, become a conspiracy of the many against a minority. With as much equity may one man wantonly dispose of all, and violence may be sanctified by mere Power." English Libertarian Heritage, pp. 128-29.

Despite the unicameral legislature, the subordination of the executive, and the partial subordination of the judges, however, the Pennsylvania Constitution was scarcely a program for democratic despotism. In the first place, all local officials were to be elected by their communities, and not appointed by the state. Secondly, a comprehensive bill of rights was established in the state constitution to limit the government's power over the people. Third, in a fascinating provision unique to Pennsylvania, a council of censors was supposed to meet every seven years to review the actions of the state government in the preceding years and to see whether and where it had exceeded its constitutional powers, from which a new constitutional convention to correct these excesses might be chosen. And fourth, and enforcing severe term limitation, the assemblymen, elected annually, could not serve more than four out of any seven years.[20] On the Pennsylvania Constitution, see John P. Selsam, The Pennsylvania Constitution of 1776 (1936).

It is both curious and unfortunate that the term-limitation movement has so far been exclusively confined to state and federal legislatures, and has not moved on to include the executive and judicial branches of government. Before the Revolution, the judiciary had never been in the least independent in America. The colonial assemblies themselves exercised judicial functions, and in the seventeenth century the assemblies in Maryland, Virginia, and New England functioned as the supreme judicial arm in their respective colonies. By the eighteenth century, judges were appointed by the Crown and the royal governors, and therefore became an instrument of the British executive power. As part of their struggle for autonomy, the colonial assemblies began to advance the idea of life, or "on good behavior," terms for the higher provincial judiciary, as a means of obtaining some degree of independence for the judiciary from British executive control. The temptation, then, was simply to continue this practice after independence from Britain, even though there was now no British executive to struggle against. Even though the US Constitution established life, or good behavior, terms for the federal judiciary, state judges have generally been popularly elected to a multi-year term.

It is high time, however, for those interested in checking the growth of centralized national power in Washington, to re-examine the idea of fixed terms for the federal judiciary. A fixed term for Supreme Court justices would reduce the despotic power rapidly accumulating into the hands of the nine absolute and unchecked oligarchs who constitute the Supreme Court of the United States.

Not only would such term limits for judges subject the higher federal courts to some sort of check by the public. But, clearly, the hysteria and conflict now surrounding every Supreme Court nomination would be greatly reduced by the knowledge that the public would no longer be stuck with said oligarch for four decades; a fixed term, say of six or eight years, would mitigate the problem and greatly lower the stakes in each appointment.

But the sphere of government that is by far the most entrenched, by far the most insulated, and by far the most expansive, is the one we largely examine in this paper: the bureaucracy of the executive branch. If anger at the legislature has translated into the term-limitation movement, there has been no such channeling of anger into a movement to re-establish the equivalent of term-limitation for the executive branch: rotation-in-office. Such rotation in the executive branch of government is insured by carrying out as fully as possible the idea of "throwing the rascals out" at each change of elected administration. The system of radical change throughout an administration upon its defeat in an election was reversed and increasingly narrowed and marginalized after the adoption of civil service "reform" in the late nineteenth century, a "reform" which has been intensifying and expanding ever since. No system has been more savagely derided by right-thinkers and Establishment do-gooders than the system of rotation in office, pejoratively labeled "the spoils system." Opposition to civil service reform has almost invariably been denounced as merely the voice of corruption and of wicked political "machines." And yet, and despite the fact that the laissez-faire good-government men of the late nineteenth century were fanatically devoted to it, no measure of government has been more destructive of liberty and minimal government than civil service reform. For no measure has entrenched bureaucracy more deeply.

There are two intertwined aspects to this entrenchment, and to the expansion of government as a result of the civil service system. In the first place, the civil servant cannot be removed and replaced by someone else. He enjoys, short of drastic budget cuts and job abolition, lifetime tenure. That entrenches the bureaucracy, and blazes the path for the sort of dysfunctional system outlined by Parkinson, Tullock, and Barber. But there is another, neglected reason why civil service, and its continuing expansion, leads inexorably to the growth as well as the entrenchment of the bureaucracy. Let us say that, in a certain year, incoming Republicans (or Democrats) appoint 10,000 people to political jobs. (They can either attain these posts by kicking out Democrats or by adding new jobs.) Before civil service reform, the Democrats, after being elected in their turn, could happily kick out the 10,000 Republican rascals and replace them by deserving Democrats.

But suppose, during this putative Republican term, the Republicans, succumbing to a fit of public-spiritedness and devotion to civil service reform, now expand civil service protection to those 10,000 jobs. Hence, the happy result, which perhaps was not overlooked by the Republicans in their reforming zeal: 10,000 Republicans have now been locked into their jobs permanently, courtesy of civil service "reform." Four years later, when the Democrats return to office, they find that they cannot simply resume their good old ways, eject the rascally 10,000 and replace them by 10,000 good Democrats. To find jobs for these 10,000, they have to expand the bureaucracy by 10,000. Later, of course, seized in their turn by a fit of reforming zeal, they expand the civil service reform to these new jobs, thereby freezing 10,000 good Democrats into lifetime appointments. And so, in the sweet-sounding name of removing the bureaucracy from the sordid process of politics, both parties in effect collaborate into fastening both sets of rascals onto the taxpayers permanently. The process, of course, only works by expanding the total number of government jobs.

Or put it another way: regardless of how principled and ideological a political party may be, an essential point of party politics is to find jobs for the faithful of the winning party. If jobs cannot be found, the party system withers and dies, leaving only a self-perpetuating bureaucratic oligarchy behind. A system of minimal government can provide jobs for the winning party by throwing out the jobholders of the losing faction. But if civil service law freezes jobholders in place, the function of providing jobs for the winners can only occur by expanding the number of jobs: that is, at the expense of the taxpayers and of the productive, private sector. The "spoils system" allows all the costs to be imposed upon the losing party, and not at all on the body of the taxpayers. Surely a just and admirable system: who better to bear the costs of political defeat than the losing party?

I have only seen this analysis of the propulsive effect of civil service upon the growth of government in the charming little book noted above by Thomas H. Barber. Thus, Barber writes:

In former days all appointments to the bureaucracy were made by the political party in power. When that party was defeated, all the bureaucrats in office were immediately thrown out and their places were filled by faithful heelers of the victorious party. It was not a very noble system. It was not conducive to efficient governmental administration…. It did have certain virtues, however. It prevented anyone from becoming a bureaucrat for life and so losing completely the point of view of the man on the street. It also permitted the elected officials to reward their political workers by changing, instead of increasing, the bureaucracy.

After the advent of Civil Service reform, on the other hand, "once installed in the bureaucracy … the incumbent was there for life, or during good behavior." These laws meant that for the elected officials "to reward their political workers, they now had to devise new jobs for them instead of merely turning out the incumbents of the opposing party and filling their jobs. The result, of course, has been a great increase in the number of jobs, and thus in taxes…."Barber, Where We Are At, pp. 109-10.

Barber adds another highly important point: with the advent of Civil Service reform, the once temporary set of bureaucrats are now converted into a permanent and self-conscious class or caste, set aside from, and in fundamental opposition to, the mass of the citizenry. Until the coming of the Civil Service laws, Barber notes, the bureaucrats had "held their positions temporarily, until a change of party at election threw them back to earn what living they could … as ordinary citizens." Before reform, in short, the job holders "had not been a class — merely a group of people temporarily doing the same kind of work." But the Civil Service law "gave them a life tenure of their jobs — welded them into a class." When the class of bureaucrats began to get unpopular with the public, adds Barber, they "very quietly began organizing 'publicity bureaus', that is, propaganda bureaus, to 'educate the public' into believing in the divine wisdom and beneficence of the government (as represented by themselves) in managing everything and everybody." In other words, "the bureaucrats are given a strong incentive to organize and form a powerful bureaucratic lobby."Ibid., pp. 110-11.

Elections can only serve as a method of enforced circulation of bureaucratic elites if there exists more than one organized political party. Yet, so demoralized were the Anti-Federalists upon the adoption of the Constitution, and after their decision to accept a Bill of Rights in return for not insisting on a second constitutional convention, that the Federalists were allowed to assume power as a virtually unchallenged party. The Federalists therefore were allowed the scope to staff the nascent bureaucracy with their own conception of the Best and the Brightest — i.e., men of their own party, in contrast to the despised Anti-Federalists or the later Republicans.

Starry-eyed historians have contended that George Washington staffed the administrative bureaucracy with a genuinely non-political and non-partisan array of the Best and the Brightest. Carl Prince has shown, however, that, guided by his distinguished theoretician and organizer Alexander Hamilton, Washington deliberately developed a highly partisan, Federalist party-oriented federal civil service. In the first place, all Anti-Federalists were from the beginning deliberately excluded from office. Secondly, Prince concludes that "the civil service … formed a haven for [Federalist] party cadre (party managers at state and local levels), thus virtually professionalizing secondary leadership by individually linking status and pecuniary rewards to the success of the national party." The over two thousand federal office holders named by Washington and Adams in the 1790s constituted the activist middle-class base for the elite leadership of the Federalist party; "partly because of its connection with the first federal service, the new party in most states matured rapidly into a highly professional, tightly knit cluster at the state and local levels, closely aligned with and led by the national leadership at Philadelphia."Carl E. Prince, The Federalists and the Origins of the U.S. Civil Service(New York: New York University Press, 1977), pp. x-xi, 2.

Alexander Hamilton was perfectly suited to the role of building up an effective political machine in the civil service. His Treasury department contained three-quarters of the federal employees; and he was able to use that large base to penetrate other departments and to command the loyalty of the US attorneys and judges then employed in Jefferson's State Department.Ibid., pp. 6-10.  Even before the end of the Revolutionary War, Hamilton was thinking along similar lines. In arguing for the new idea of having the central government appoint the customs and revenue collectors within each state, instead of allowing the respective states to continue exercising such functions, Hamilton wrote that the reason for such a change would be "to create in the interior of each State, a mass of influence in favor of the Federal Government." In that way, a number of people in each state would be created who would be loyal supporters of the federal government and its increased power. As Hamilton assumed his powerful post at the start of the new Constitutional government, he received congenial advice from prominent Massachusetts merchant Stephen Higginson, one of the leaders of the ultra-High Federalist Essex Junto. Federal officeholders, warned Higginson, must be limited to dedicated Federalists. Toleration of non-Federalists in appointments would "increase the Evil" of opposition to Federalist views: such softness "encourages others to act the same part," and the "number of opposers is by this means generally increased."Ibid., pp. 7-8.

The partisan appointment policy under President John Adams was much the same, but much more blatant, and devoid of the insincere protestations of non-partisanship by the first president. As the premier historian of federal administration put it, under Adams "direct reference to party attitude … became more common and less concealed."Leonard D. White, The Federalists: A Study in Administrative History,1789-1801 (New York: Macmillan, 1948), p. 273.  Adams was far more concerned than Washington to direct personally the appointing process throughout his administration. During the second Washington administration, Washington and Hamilton had made sure to exclude members of the new Republican Party from office; and Adams not only continued this policy, but stepped up attempts to root out and summarily remove any Republicans from office. Thus, Adams, in justifying his removal of several Portsmouth, New Hampshire customs collectors from office, wrote the Customs Collector at Boston that the "daily language" of these federal officers was "so evincive of aversion, if not hostility, to the national Constitution and government, that I could not avoid making some changes." Adams concluded that "if the officers of government will not support it, who will?"Prince, The Federalists, pp. 11, 45-56.  On another occasion, bitter at criticisms by William Duane's radical Jeffersonian Philadelphia Aurora, Adams had his Secretary of State pass the word of his displeasure to the US Attorney for Pennsylvania William Rawle, for not cracking down on the Aurora for seditious libel. "If Mr. Rawle does not think this paper libelous," thundered the President, "he is not fit for his office; and if he does not prosecute it, he will not do his duty."Ibid., p. 11.

The federal civil service during the Federalist administrations consisted of four parts: two, the customs and internal revenue service, were in the Treasury Department, and constituted three-fourths of the total bureaucracy; the post office, inherited from the Confederation days, came under a postmaster-general, who reported directly to the President; and legal and judicial officers, including the Supreme Court, district judges, district attorney, marshals, and court clerks, came under the nominal jurisdiction of the State Department. Apart from the legal and judicial officers, which remained level in number at about 63, all the other wings of the bureaucracy grew rapidly during the Federalist era. Customs officials doubled from 478 in 1792 to 944 at the end of the Federalist period; internal revenue officials, called into existence by the new federal excise tax of 1791, expanded two-and-a-half fold from 219 in 1795 to 533; and the Post Office, which doubled its number of postmasters from 100 at the end of the Confederation period to 200 in 1791, more than quadrupled again to 824 in 1801. The entire bureaucracy increased two-and-a-half fold from the middle of the two Washington Administrations until the end of the Federalist reign.

John Adams as President not only maintained or accelerated the rate of growth of the bureaucracy, and politicized it even more blatantly; he also found ways to expand the politicized civil service into new areas. Thus, in the provisional army that Adams raised at the height of the undeclared war with France in 1798, Adams politicized the leadership by banning the appointment of Republicans from the upper ranks of the army. Also, Congress's enactment of a direct property tax in 1798, allowed Adams to appoint many good Federalists to the new openings at the lower reaches of the tax service. The Republicans charged that the Adams men had concluded that a direct tax "will make Roome for more officers; by this time all the yelpers was Nearly put into office with good Salaries."Ibid., p. 12. Also see Manning Dauer, The Adams Federalists (Baltimore:Johns Hopkins University Press, 1953), pp. 215-19.

The federal judiciary, unfortunately, enjoyed from the beginning the life tenure warned against by Thomas Barber, courtesy of the US Constitution. The Federalists had made sure, in Article III, Sect. 1, of the Constitution, that all the federal judges shall hold life tenure on good behavior. The federal judiciary, which then consisted of six Supreme Court justices and twenty-eight district court judges, was thoroughly politicized during the 1790's, the district courts even more than the Supreme Court.There were no separate appeals judges then, the circuit courts consisting of a blend of district judges and Supreme Court justices. Of the twenty-eight, fully three-quarters were partisans of ratification of the Constitution, and even the three doubters eventually supported ratification. Moreover, the bulk of the district judges were fierce Federalist partisans, campaigning for Federalist candidates, denouncing Republicans, and often going so far as making sure of partisan Federalist juries in important cases, such as trials of Republican editors for violation of the Alien and Sedition law. Thus, in one sedition case, Federalist District Court Judge John Lowell of Massachusetts took elaborate steps to make sure of obtaining "one panel of full blooded filtrated federalists, and from them the political verdict."Prince, The Federalists, p. 251.  Pennsylvania District Judge Richard Peters took upon himself a personal crusade, during the period of the Alien and Sedition laws from 1798-1800, to root out "Seditious scoundrels." There are "some Rascals," Peters wrote ultra-Federalist Secretary of State Timothy Pickering, "whom he wanted to handle if he could do it legally." One critic noted that it has "become a regular practice of the federal judges to make political discourses to the grand jurors throughout the United States."Ibid., pp. 242, 250. Overall, Professor Prince justly concludes that "both the first United States district and circuit courts were among the most thoroughly politicized federal judicial institutions in American history…. George Washington's 'independence' and 'integrity' and the obvious threat to constitutional liberties inherent in the situation notwithstanding."Ibid., pp. 252, 267.

The Republicans replaced the Federalists in what has justly been called "The Revolution of 1800." Unfortunately, Thomas Jefferson was not really the best man to lead that Revolution. A brilliant libertarian-republican theoretician before achieving power and after leaving it, Jefferson is a classic case of corruption of principle from being in power. The first Jefferson Administration, however, was certainly one of the finest libertarian moments in the history of the United States. Expenses were lowered, the army and navy were sharply reduced, the bureaucracy was cut, the public debt retired, and the federal excise tax, and the Alien and Sedition Acts, were repealed. In the second term, however, the course was reversed, as Jefferson began expanding government, and gearing up for economic war and eventually military conflict with England.

But even in his libertarian-oriented first term, the militant Republicans — the Jeffersonians — were bitterly disappointed. Jefferson was faced with a critical problem: what to do with the bureaucracy, with the politicized civil service that the Federalists had built up. If Jefferson had followed circulation-of-elites, rotation in office principles, he would have booted out the Federalists and installed good Republicans. But as early as his First Inaugural, Jefferson began to temporize, began to yearn for unity, the healing of wounds, and the rest of the homilies that politicians prattle when they get ready to scuttle the principles which had brought them to their current status. In his First Inaugural, Jefferson assured his listeners that "We are all Republicans; we are all Federalists." Jefferson decided on a middle-of-the road course: to wait until vacancies occur, through death or retirement, and to fill them only with Republicans until they constitute about half of the civil service; and only to remove egregiously anti-Republican officials. Jefferson was particularly angered at the "midnight appointments," that Adams had made at the very last minute before Jefferson took office. During his first two years in office, Jefferson removed the forty major midnight appointments, along with seventy other anti-Republicans in the presidential class of officials, amounting to about one-fourth of the major federal officeholders. But that was it: Jefferson removed virtually no one after 1803, and his successors removed very few bureaucrats as well. Madison dismissed only twenty-seven major officials in his eight years in the White House; and Monroe only twenty-seven in his two terms. And even though John Quincy Adams was strongly critical of President Monroe as being "universally indulgent, and scrupulously regardful of individual feelings," and therefore firing virtually no one, Adams himself removed the fewest of all: only twelve in his four years in office.

It's not that the Presidents lacked the legal power to remove office-holders. Indeed, they had the power to remove anyone at will. This power was established, albeit by narrow vote, in the first Congress, the fundamental administrative "Decision of 1789." The most extreme position in opposition was taken by Rep. William L. Smith of South Carolina (who would later change his mind.) Smith, absurdly, but foreshadowing modern labor union and civil service arguments, maintained that the office was "the property" of each bureaucrat, who could therefore only be removed by impeachment and trial for malpractice and improper behavior.David H. Rosenbloom, Federal Service and the Constitution: The Development of the Public Employment Relationship (Ithaca: Cornell University Press, 1971), pp. 26-33; White, The Federalists, pp. 20-25.

And so, from Jefferson through Adams, the civil service, while theoretically removable at will, by custom and the desire of the successive presidents, had become entrenched and rigidified bureaucracy. Characteristically, it took John Quincy Adams, still a federalist at heart though technically a Republican, to put this custom into stringent ideological terms. Any removal from office except "for cause," i.e., for malfeasance in office, might be politically expedient but it violated Adams's conception of the "public good." Even though it was not ensconced in the law, lifetime tenure on good behavior for the federal bureaucracy had become enshrined in custom for forty years, from 1789 to 1829.Leonard D. White, The Jeffersonians: A Study in Administrative History, 1801-1829 (New York: Macmillan, 1951), pp. 1-15, 347-55, 369-71, and especially pp. 379-81; Rosenbloom, Federal Service, pp. 38-44.

The most important defection of President Jefferson from militant Republican principle was his failure to challenge the entrenched Federalist judiciary. Not only did the judiciary enjoy life tenure under the Constitution; but, at the last minute, and shortly before they were forced to leave office, the lame duck Federalist Congress passed the Judiciary Act of 1801, which created six new circuit courts with sixteen quickly appointed Federalist judges; and expanded the jurisdiction of the circuit courts. Moreover, in one of his midnight appointments, President Adams appointed John Marshall of Virginia as Chief Justice of the Supreme Court, a Federalist Chief Justice who would plague libertarian Republicans with his decisions for over three decades.

The radical libertarian, or Old Republican, position was led by Virginians such as John Taylor of Caroline and John Randolph of Roanoke, by Benjamin Austin, leader of Boston's artisans, and by William Duane, editor of the Philadelphia Aurora. Many of the Virginia Old Republicans were friends and kinsmen of Jefferson, but they soon realized that their leader was really not one of them, really not prepared to carry forth the "Jeffersonian" Revolution. Steeped in Anti-Federalist hostility to strong central government and self-perpetuating bureaucracy, the Old Republican sought fundamental revolution. Virginia Old Republican William Branch Giles put their judicial program to President Jefferson with clarity and force:

What concerns us most is the situation of the Judiciary as now organized … the Revolution is incomplete, as long as that strong fortress is in possession of the enemy; and it is surely a most singular circumstance that the public sentiment should have forced itself into the Legislative and Executive Department, and that the Judiciary should not only not acknowledge its influence, but should pride itself in resisting its will, under the misapplied idea of "independence"…. No remedy is competent to redress the evil system, but an absolute repeal of the whole Judiciary and terminating the present offices and creating a new system, defining the common law doctrine and restraining to the proper Constitutional extent the jurisdiction of the Courts.Giles to Jefferson, June 1, 1801. Richard E. Ellis, The Jeffersonian Crisis: Courts and Politics in the Young Republic (New York: Oxford University Press, 1971), pp. 20-21.

In the fall of 1801, the veteran Old Republican, Edmund Pendleton, in his tract, The Danger Not Over, proposed constitutional amendments that were soon endorsed by the Virginia legislature. The anti-oligarchic and pro-rotation of office nature of these proposed amendments should be clear: the President was to be ineligible for more than one term; the term of Senators was to be reduced; and severe limits were placed on the public debt. As for the federal judiciary, appointments to the courts were to be made by the Congress with no role for the President, and the judges were to be removed at will by a joint vote of House and Senate.

The centrist Republicans, however, men like James Madison, Virginia's Wilson Cary Nicholas, Samuel H. Smith of Maryland, Robert R. Livingston of New York, and Alexander J. Dallas and Albert Gallatin of Pennsylvania, took a very different tack. All of them except Gallatin had favored the adoption of the Constitution, and all of them favored strong central government shorn of Federalist excesses; in short, they were content with the existing system provided that one of their own such as Jefferson was installed in Power. Since they believed that with Jefferson in office, the Revolution was now over, and there was no need for further radical or constitutional change, they favored the Jeffersonian policy of conciliating the Federalist party. At least when he was in power, Jefferson took his stand with the centrists of his party. Hence, his failure to bring about fundamental structural or administrative reform.

Indeed, with victory secured, the centrists now believed that their Old Republican colleagues, not the Federalists, were the main danger. To James Sullivan, Republican Governor of Massachusetts, the Old Republicans were "in opposition to all regular well established governments." They are possessed of a confidence stemming from "a frenzy," and "Having no idea of a solid rational government, they cannot be trusted with power…" Virginia Senator Wilson Cary Nicholas also denounced these Old Republicans whose libertarian "bias … is strongly against those who rule."Ibid., pp. 23-24. To Sullivan, the solution to this problem was "to destroy the lines of party distinctions" — a result that the centrists were finally to achieve in the one-party system during the Monroe and Adams administrations. But the lines of this conflict were blurred by the fact, as Professor Ellis points out, that Jefferson himself, even though a moderate in policy, was generally radically libertarian and Old Republican in rhetoric. Furthermore, unlike the centrists, he wanted to reconcile the Old Republicans rather than purge them from the party.Ibid., pp. 29-30.

On the judiciary, Jefferson, early in his administration, removed the aggressively Federalist prosecuting attorneys and the marshals who selected the juries and executed the courts' sentences. On the judges themselves, while Jefferson did not try to touch their life tenure, he did manage to repeal the Judiciary Act of 1801 the following year, and thereby to roll back the last minute tide of expansion of Federalist judges.

Jefferson's defection from the principles of rotation in office was the most important event in the entrenching of the combined old Federalist and new Republican bureaucracy. From Jefferson on, the Republican party remained in power, and from Monroe through Adams the United States lived under a one-party state, the Federalists having withered away. With no party competition, there was virtually no pressure for throwing the rascals out.

But in 1820 came what Professor Leonard White, a typical academic enthusiast for a life tenure civil service, called "the cloud on the horizon," the harbinger of the dread "spoils system" wrought by the Jacksonian movement. Secretary of Treasury in the Monroe Administration, William H. Crawford of Georgia, pushed through Congress the Tenure of Office Act, which Monroe came to regret signing, and which was bitterly denounced by all the champions of the entrenched bureaucracy, including Thomas Jefferson. Madison and following him Monroe actually denounced the law as "unconstitutional."

The Tenure of Office Act of May 1820 decreed that all presidential class officials, connected with the collection or disbursement of money, would henceforth serve, not indefinitely, but for fixed terms of four years, after which they would have to be reapproved by the US Senate after being renominated by the President. The covered officials included district attorneys, customs collectors, public land officials and registers, army and navy agents and paymasters. Not affected were postmasters, or any of the accounting and clerical employees. The Tenure of Office Act meant (a) that at least higher bureaucrats would be confronted with fixed terms, and (b) that the power to remove them would no longer be exclusively in the hands of the President, but that the US Senate could share in the removal process.

The Act came as a shock to the previously contented oligarchy. Jefferson wrote to Madison in horror, charging that the law "saps the constitutional and salutary functions of the President, and introduces a principle of intrigue and corruption … This places, every four years, all appointments under their [the Senate's] power … It will keep in constant excitement all the hungry cormorants for office, render them, as well as those in place, sycophants to their Senators, engage these in eternal intrigue to turn out one and put in another…" There is, of course, another way to look at this law than this frenetic diatribe: that such a system would introduce a bracing wind of competition and of public accountability into the stolid and complacent ranks of the ruling bureaucracy.White, The Jeffersonians, p. 388.

It may not be an accident that Secretary Crawford was the author of this bill. A Georgian who was close to the Old Republicans, Crawford, in 1824, was the Presidential candidate of that group as well as of Martin Van Buren, the brilliant political tactician who had been inspired by a weekend with Jefferson at Monticello in May 1824 to spend his life forming a new political party — later to be the Democratic Party — dedicated to taking back America for the old cause, for the libertarian Old Republican ideals of 1776 and 1798.On the importance of Van Buren's conversion experience at Monticello, see Robert V. Remini, Martin Van Buren and the Making of the Democratic Party (New York: Columbia University Press, 1959), pp. 59-63. On a similar conversion of Thomas Hart Benton of Missouri upon a visit to Monticello on Christmas Eve of the same year, see William N. Chambers, Old Bullion Benton: Senator from the New West: Thomas Hart Benton, 1782-1858 (Boston: Little, Brown, 1956). By the election of 1824, Crawford had fallen ill and had little chance for the presidency, but the Old Republican ideals, including that of bringing accountability and rotation of office to the bureaucracy, would go on to be championed by the Jacksonian movement and the Democratic Party forged by Van Buren and others devoted to the Old Republican ideal.

Under President John Quincy Adams, however, the Tenure of Office Act became a dead letter. Adams detested the law: "A more pernicious expedient could scarcely have been devised," and on principle renominated everyone upon his accession to office, and during his term. The Senate was persuaded to go along. So insistent was Adams on life tenure that, when his losing campaign for re-reelection was underway in 1828, he actually renominated James R. Pringle for collector of customs at Charleston, even though Pringle was frankly "devoted to the opposition." In his diary, Adams writes that "My system has been, and continues to be, to nominate for reappointment all officers for a term of years whose commissions expire, unless official or moral misconduct is charged and substantiated against them. This does not suit the Falstaff friends who 'follow for the reward'…."Ibid., p. 390.

The "spoils system," a derogatory term for rotation in administrative office,This famous phrase was included in a speech on the floor of the U.S. Senate in January 1832 by New York Jacksonian Democrat William Learned Marcy: "to the victors belong the spoils of the enemy". was brought to the United States by President Andrew Jackson. Jackson, an ardent Jeffersonian and Old Republican, was, like other Jacksonian leaders, dedicated to a new Democratic Party that would restore original Jeffersonian Republican principles of laissez-faire and ultra-minimal government. Jackson followed Jefferson in managing, for the second and presumably the last time in American history, to repay the national debt; and he and his dedicated successors, Van Buren and Polk, roughly succeeded in establishing hard money and separating the federal government from the banking system, as well as eliminating the protective tariff. Jackson, a wealthy cotton planter and merchant in Nashville, had been energized by corruption in the Monroe administration and by the bank credit collapse in the Panic of 1819.On the crucial influence of the Panic of 1819 in converting Andrew Jackson, and future Jacksonian leaders such as President James K. Polk and Thomas Hart ("Old Bullion") Benton, to a hard money, anti-inflationary-bank-credit position, see Murray N. Rothbard, The Panic of 1819: Reactions and Policies (New York: Columbia University Press, 1962), pp. 187-89. On the neglected pervasiveness of corruption in the Monroe Administration, and Jackson's response to it, see Robert V. Remini, Andrew Jackson and the Course of American Freedom, 1822-1832 (New York: Harper & Row, 1981), pp. 12-38. He had served in the House of Representatives and twice in the US Senate.

One of the aspects of government that desperately needed reform, according to Jackson, was the life-tenured bureaucracy. The spoils system had been operating in New York and in Pennsylvania for a number of years, and had been formally incorporated into the Tenure of Office Act. But now Jackson, head of a new incoming party hungry for office, became the first president to sound the trumpet call, and provide an ideological justification for rotation in office. He wanted to change the civil service, as well as to shrink it. In his First Annual Message, Jackson denounced the entrenched bureaucracy:

There are, perhaps, few men who can for any great length of time enjoy office and power without being more or less under the influence of feelings unfavorable to the faithful discharge of their public duties … [T]hey are apt to acquire a habit of looking with indifference upon the public interests and of tolerating conduct from which an unpracticed man would revolt. Office is considered a species of property, and government rather as a means of promoting individual interests than as an instrument created solely for the service of the people.

As a result, Jackson went on, government is diverted from "its legitimate end" and made into "an engine for the support of the few at the expense of the many." Jackson then proceeded to attack the idea of special privileged offices to the few, and endorsed an adherence to an extension of the Tenure of Office Act:In 1836, such an extension was applied to the postmasters, who then received a four-year term.

In a country where offices are created solely for the benefit of the people no one man has any more intrinsic right to official station than another. Offices were not established to give support to particular men at the public expense.

Jackson went on to hone in on the absurd and despotic theory that government officials acquire a property right in the office:

No individual wrong is, therefore, done by removal [from office], since neither appointment to nor continuance in office is a matter of right … The proposed limitation [four years] would destroy the idea of property now so generally connected with official station, and although individual distress may be sometimes produced, it would, by promoting that rotation which constitutes a leading principle in the republican creed, give healthful action to the system.James D. Richardson, ed., A Compilation of the Messages and Papers of the Presidents of the United States, 1789-1897 (Washington: Government Printing Office, 1896), II, 438-39; Ari Hoogenboom, ed., Spoilsmen and Reformers (New York: Rand, McNally, 1964), pp. 2-3; Paul P. Van Riper, History of the United States Civil Service (Evanston, IL: Row, Peterson, 1958), pp. 30-37; Leonard D. White, The Jacksonians: A Study in Administrative History (New York: Macmillan, 1954), pp. 317-21; Rosenbloom, Federal Service, pp. 47–50.

The Whig opposition, as the old, oligarchic, neo-Federalist as well as centrist Republicans now called themselves, lost no time in trying to block Jackson's reform, which threatened the longevity of their own people in office. Daniel Webster, a Federalist turned Whig, thundered that the government agencies, such as the armed forces, the Post Office, the Land Office, or the Customs-house, are "institutions of the country, established for the good of the people," and that therefore it threatened free institutions for these offices to be spoken of as but "the spoils of victory." Stronger in the courts and in the Senate than in the presidency, the Whigs continued to raise constitutional objections to the President's power of removal. But fortunately, the Supreme Court, in Ex parte Hennen (1839), its first case on the subject, ruled unequivocally that no government official, even in the federal judiciary below the Supreme Court, had a property right in his office, and that the President or any other statutory authority had the right to dismiss him at will.Hennen was later reinforced on the state level by Butler v. Pennsylvania (1850), which held that public employment was not a "contract" within the meaning of Article I, Sect. 10 of the Constitution, which prohibited any state from passing a law "impairing the obligation of contracts." Rosenbloom,Federal Service, pp. 52-53.

Faced with fierce resistance in the Senate, Jackson had to move cautiously, but he succeeded in the heaviest removal rate until that date: during his administration, he removed 252 out of 610 presidential class employees, or over forty-one percent. Including all the lesser federal employees, however, the removal rate was less than twenty percent.White, The Jacksonians, p. 308. On resistance in the Senate, see Van Riper, History, pp. 37-41. Van Buren, his successor and an ardent Jacksonian, had little reason to remove Jacksonian officials. In his last two years in office, he removed 364 postmasters, amounting to about three percent of 12,000, to tighten the officialdom a bit for the coming election campaign.

The true test of whether the spoils system would stay was what the Whigs would do when they ousted the Democrats from the Presidency in 1840. Would they stand by their allegedly fiercely held principles against rotation in office? Or would they succumb to the lure of kicking out the Democrats and replacing them by good Whigs? Fortunately, they abandoned their principles and succumbed to temptation, the Harrison and Tyler Administrations ousting fully fifty percent of the presidential class officials. When James K. Polk returned for the Democrats in 1844, he ousted thirty-seven percent of the presidential class employees, and also managed to appoint, during his four years, 13,500 out of the existing 16,000 postmasters, even though only 1,600 were removed from office while 10,000 filled vacancies caused by resignations. When Zachary Taylor came in for the second Whig administration, he settled the principle of rotation in office, ousting fifty-eight percent of the presidential class officeholders. Indeed, Taylor told his Secretary of the Treasury that "rotation in office, provided good men are appointed, is sound republican doctrine."White, The Jacksonians, pp. 309-13.

In the nineteenth century, especially after the emergence of the Democratic Party, the political parties in the United States were indispensable carriers of furiously clashing ideologies. Every American child or immigrant was socialized into a political party and its ideology, and as a result each American was fiercely loyal to his own party. In most states, elections were very close, and if one's party candidate dared to waffle in his ideological commitment, the party faithful punished him by staying away from the polls. In contrast to the current political scene, where parties have no particular ideology and command no particular loyalty, there were very few floating, independent voters.

By being carriers and instruments of a party ideology, the political parties in nineteenth century America were the vitally important means by which ideology could dominate the narrow clash of special interest groups and seekers after government subsidies and privilege. The disappearance of ideological parties, starting in 1896, brought about the weak and fuzzy party politics we are familiar with today.

It is clear that clashing ideological parties would be more willing to throw the rascals out, since they really believed that their opponents were rascals. The spoils system added the healthy incentive of occupying the offices for one's own party, so that party self-interest could be wedded to the pursuit of ideology. Both common party ideologies and the spoils system kept the political party system healthy and flourishing. What everyone now laments as the anemia and near-death of party organization and party loyalty was brought about by the twin blows of the demise of the spoils system and the disappearance of a fervently held party ideology.

Writing later, in the 1920s, historian Charles R. Lingley well expressed the importance of the spoils system and its linkage with ideology:

In the field of actual politics, parties are a necessity and organization is essential. It is the duty of the citizen, therefore, to support the party that stands for right policies and to adhere closely to its official organization. Loyalty should be rewarded by positions within the gift of the party; and disloyalty should be looked upon as politician treason.

Lingley adds that anyone who votes for other than party organization candidates and who "feels himself superior to the party" is "faithless to the great ideal." And he

is only a little less despicable than he who, having been elected to an office through the energy and devotion of the party workers, is then so ungrateful as to refuse to appoint the workers to positions within his gift. Positions constitute the cohesive force that holds the organization intact.Charles R. Lingley, Since the Civil War (New York: The Century Co., 1924), p. 118; quoted in Van Riper, History, p. 61.

In a thoughtful essay lamenting the demise of the spoils system as an important democratic check upon the growth and arrogance of bureaucracy, Professor Fred W. Riggs, an expert in Comparative Public Administration, first points to the untrammeled bureaucracy of Oriental Despotism, and of other examples where bureaucracy sped forward beyond any checks of competing political parties. He then goes on to point out that the much heralded "merit system" of promotion within a life-tenured bureaucracy, "cuts at the root of one of the strongest props of a nascent political party system, namely spoils." In the United States, "the spoils system played an important part in galvanizing the parties into action." While often seemingly more efficient in their tasks, Riggs points out, "the career bureaucracy can project greater political power on its own, resist more successfully the politician's attempts to assert effective control. What is lost in administrative efficiency through spoils may be gained in political development, especially if party patronage can also be used as a lever to gain control over administration." And even the edge in efficiency, notes Riggs, is often illusory:

Without firm political guidance, bureaucrats have weak incentives to provide good service, whatever their formal, pre-entry training and professional qualifications. They tend to use their effective control to safeguard their expedient bureaucratic interests — tenure, seniority rights, fringe benefits, toleration of poor performance, the right to violate official norms — rather than to advance the achievement of program goals.Fred W. Riggs, "Bureaucrats and Political Development: A Paradoxical View," in Joseph LaPalombara, ed., Bureaucracy and Political Development (Princeton: Princeton University Press, 1963), pp. 128-29.

When the Democrats returned to power in 1853, the Pierce Administration summarily removed approximately 89 percent of the Whig presidential class appointees. But the most massive employment of the spoils system came with the Lincoln Administration, when the Republican Party came to power for the first time. Of the 1,520 presidential class appointees existing in 1859, Lincoln removed no less than 1,457, or 96 percent. Employees who were in subordinate categories, who usually fared better during removals, this time suffered to the same degree. Even military appointments were now made on a largely partisan basis.Perhaps the most egregious of Lincoln's military appointments was that of General Grenville M. Dodge. Dodge, an Iowa political leader and railroad entrepreneur, came to the Republican convention in 1860 to help swing the wavering Iowa delegation to Lincoln. Dodge came at the behest of Lincoln's campaign manager Norman Judd, state chairman of the Illinois party and fellow railroad entrepreneur. In 1862, the Union Pacific Railroad received the first federal transcontinental railroad charter from the federal government, including massive land grant and monetary subsidies. One of the founders of the Union Pacific was Grenville Dodge, who was promptly made a general so that he could take parts of the Union Army and clear out Indians from the prospective path of the Union Pacific.General Dodge performed this feat under the direction of Acting Secretary and then Secretary of the Interior John Palmer Usher. An Indiana railroad attorney, Usher had been an entrepreneur, just before the Civil War, of the Leavenworth, Pawnee and Western Railroad in the Kansas Territory, and that railroad lobbied heavily and successfully to put Usher into a high post in the Interior Department. The Leavenworth Railroad soon became the Eastern Division of the Union Pacific Railroad. Philip H. Burch, Jr., Elites in American History, Vol. II: The Civil War to the New Deal (New York: Holmes & Meier, 1981), pp. 16, 23-24, 48, 54.Many of the directors of the new Union Pacific had been officers or directors of the connecting Chicago & Rock Island Railroad, of which Norman Judd had been general counsel.Before his election as President, furthermore, Abraham Lincoln had been a long-time attorney and lobbyist for the powerful Illinois Central Railroad, the leading U.S. railroad before the transcontinental. It is intriguing that his first appointed commander of the Union Army, George B. McClellan, before the Civil War had been chief engineer and vice-president of the Illinois Central, while McClellan's successor, the hapless General Ambrose Burnside, had been treasurer of the Illinois Central just before the war. Ibid., p. 55.

Professor Van Riper, generally an admirer of Abraham Lincoln, concedes:

From 1861 to 1865 the policy of [George] Washington, selection according to relative capacity and fitness [sic], was almost entirely forgotten … Lincoln left the bulk of the nominations for presidential as well as for subordinate offices to his political friends and advisors. The military forces as well as the civilian establishment were exploited freely, and political generals were notoriously numerous. With more offices at his disposal than any president up to that time, … Lincoln appears to have used — or permitted the use of — the appointing power at his command as deliberately as they could have been used for practical, and usually partisan, political purposes.Van Riper, History, p. 43. Also see Rosenbloom, Federal Service, p. 65.

Yet, curiously enough, the insufferable self-righteous group of civil service Reformers, many of whom would concentrate the rest of their lives on attacking spoils and calling for life tenure and open examinations on "merit" for the civil service, and who began their agitation at the end of the Lincoln reign, made no complaint whatever at President Lincoln's maximal use of the spoils system. Perhaps the reason was that the reformers, almost all Republicans themselves, benefited hugely from Mr. Lincoln's patronage.

Indeed, the men who would soon become leading reformers reveled in plush positions in the foreign service during the Lincoln Administration. Leading Boston Brahmin patrician, Charles Francis Adams, son of John Quincy, gained the devoted appointment of Minister to the Court of St. James in Great Britain.Unlike his father and grandfather, Adams was wealthy as well as being a leader of the Brahmin elite. For Adams married the daughter of one of Boston's wealthiest merchants, Peter Chardon Brooks. One son of Adams, John Quincy Adams II, married into the wealthy Crowninshield family, while another, Charles Francis Adams, Jr., was soon to become president of the Union Pacific Railroad. Ibid., p. 24. Boston Brahmin historian, John Lothrop Motely, was selected as minister to Austria. Novelist William Dean Howells became minister to Italy, a payoff for writing a puff campaign biography for Abraham Lincoln. New York's John Bigelow was Consul-General to France, while the man who was to become the leading spokesman for civil service reform, Boston-reared George William Curtis, editor of the influential Harper's Weekly, was offered but refused appointment as minister to Egypt. German immigrant Carl Schurz, a leading Republican in the German-American community in Missouri and throughout the Midwest, who helped win the election for Lincoln, was rewarded with the post of Minister to Spain. Restless at being far from the action, Schurz came back to the United States, where he became one of the many lackluster Union generals.Ari Hoogenboom, Outlawing the Spoils: A History of the Civil Service Reform Movement, 1865-1883 (Urbana, IL: University of Illinois Press, 1968), pp. 21 and passim. Hoogenboom's is the outstanding revisionist history of the civil service reform movement, culminating in the decisive Pendleton Act of 1883.

The civil service Reformers were a remarkably homogeneous group. Concentrated almost exclusively in the urban Northeast, including New York City and especially Boston, the Reformers virtually constituted an older, highly educated and articulate elite. From families of old patrician wealth, mercantile and financial rather than coming from new industries, these men despised what they saw as the crass materialism of the nouveau riche, as well as their lack of good breeding or education at Harvard or Yale. Not only were the Reformers merchants, attorneys, and educators, but they virtually constituted the most influential "media elite" of the day: editors, writers, and scholars. Even though many of them favored laissez-faire in trade and in monetary affairs, they were shaped by the cultural and religious values of their neo-Puritan Yankee culture. In religion, the Reformers were either mainstream post-millennial pietist Protestants, attempting to bring about the Kingdom of God on Earth, or, especially in Boston, Unitarians who secularized in moral terms the quest for the millennial Kingdom. During the 1850s, their moral and religious urge to get rid of slavery, either as frank abolitionists or merely by blocking slavery in the new western states and territories, led all of them into the Radical wing of the Republic Party. Underlying their religious thrust was a coercive Yankee temperament and moral doctrine that had brought the first public schools to the United States long before the rest of the country, in order to inculcate the region's children with the value of obedience to the State as well as in the Protestant religion. In keeping with their religious and moral concerns, their emphasis in civil service reform, from the beginning, was more on morality than efficiency.

For them, such structural changes as life-tenure and competitive open examinations were mere means to an end, their overall goal being to put "good men" into office. And, all too often, those "good men" were simply themselves and their kind.

The civil service reform movement began when Senator Charles Sumner (R., Mass), a Boston Brahmin and a leader of the Radical Republicans, introduced a bill for tenure and open examinations, to be administered by a federal civil service commission. Sumner's bill was introduced in April, 1864, as an expression of some of the Radicals' opposition to the renomination of Abraham Lincoln, whom they considered far too soft on slavery and on the South.During and after the Civil War, there were two clashing wings of the Radical faction of the Republican Party. One, headed by Sumner and dominant in New England, favored such laissez-faire economic policies as free trade and hard money. The other, headed by Pennsylvania ironmaster and Representative Thaddeus Stevens, Pennsylvania economist and ironmaster Henry C. Carey, and the Iron and Steel Institute, favored protective tariffs and inflationary greenbacks, to help steel exports and hinder imports, as well as to aid the heavily indebted large railroads. The Stevens wing was soon to become dominant in the Radicals and among the Republicans generally. The Sumner forces were later to become Liberal Republicans and to lose interest in Reconstruction. See Robert P. Sharkey, Money, Class and Party: An Economic Study of Civil War and Reconstruction (Baltimore: Johns Hopkins University Press, 1959). The bill was a warning shot across Lincoln's bow, but it got little public support, and Sumner himself did not strongly back the bill, and asked that it be tabled. Sumner had long fulminated against the spoils system, and repeated these charges when he introduced the bill, but, as chairman of the Senate Foreign Relations Committee, he did not hesitate to use his influence to win offices for his friends. Neither did George William Curtis, soon to become the leading champion of reform, scruple to urge his own friends upon Sumner.Hoogenboom, Outlawing the Spoils, pp. 10-12. Still, Sumner was surprised to find his "little bill on the civil service" draw more support than he had expected: several of the leading newspapers of Washington and New York; several leading academics; Lincoln's Minister to Denmark, Bradford R. Wood, of Albany; William E. Dodge, Jr. of the important metal importers, Phelps, Dodge & Co., who obtained the backing of the Union League Club of New York; and E. B. Ward, Detroit businessman and secretary of the National Manufacturers Association.One of the academic backers of the Sumner bill was the distinguished political theorist Francis Lieber, of Columbia College, who at the same time put in his bid to become one of the federal civil service commissioners. Hoogenboom, Outlawing the Spoils, p. 11.

Notwithstanding Sumner's abortive effort, the Radicals were basically happy with Lincoln's policies as well as his patronage, and so reform did not really take wing until after the assassination of Lincoln in April, 1865. Vice-President Andrew Johnson was a Union Democrat rather than a Republican, and his moderate policies on Reconstruction deeply angered the Radicals. In December, 1865, Representative Thomas Allen Jenckes (R., RI.), one of the leaders of the Rhode Island bar, made himself the leader of Congressional Reform by introducing a civil service reform bill. Jenckes, a wealthy patent attorney, was in correspondence with British civil service reformers, and he patterned his bill after their program: life tenure on good behavior, open competitive examinations, and a three-man civil service commission to administer the program.

Thomas Jenckes professed to have been converted to reform by his own experience during his Civil War public service, and by study of the English system. And yet, his alleged opposition to spoils did not prevent him from wielding a great deal of patronage while in Congress. It seems more likely that his newfound zeal for reform came from the advent of the hated Johnson Administration. Jenckes had been a zealous Radical, but a pro-Lincoln loyalist, and he was now trying to block Johnson from using his own patronage powers to oust the Lincoln Radicals. Indeed, Jenckes was to write one of the articles of President Johnson's impeachment, and narrowly missed being elected by the anti-Johnson Radicals as House manager of the impeachment trial.Hoogenboom, Outlawing the Spoils, p. 15. Jenckes was a wealthy patent attorney and manufacturer, whose Rubber Sole Shoe Company was based on his being a patent attorney for Goodyear Rubber, while his American Wood Paper Company used patents to monopolize the production of paper from wood pulp. Ibid., p. 14.

"For the civil service reformers, the overall goal being to put 'good men' into office. And, all too often, those 'good men' were simply themselves and their kind."

During 1866, however, Jenckes's bill only picked up the support of the new and increasingly influential weekly, The Nation, a New York periodical founded by young British journalist Edwin Lawrence Godkin, who had emigrated to the United States in 1856 and launched The Nation in 1865. Inspired by the British model, Godkin devoted the rest of his life to free trade, hard money, and civil service reform. But most of the soon-to-be reformers had little interest in reform at this point, joining the other Radicals in trying to wrest the patronage power away from the President and into the hands of the Radical-dominated Senate. Johnson attempted to remove the Radicals from executive office, dismissing over one-third of the presidential appointees, over the fierce resistance of the Senate. Finally, in March 1867, Congress passed the Tenure of Office Act over Johnson's veto, providing in unprecedented fashion that the President could not remove any officer — including Cabinet members — without Senate approval. Indeed, it was Johnson's insistence on firing the Radical Edwin M. Stanton as Secretary of War that brought the House to impeach Johnson, and for the Senate to acquit him in his impeachment trial by one vote in May, 1868.

Representative Jenckes resubmitted a reform bill in December 1866, but while it picked up the support of the New York Times, Republican, including future reformer, efforts became concentrated on the Senate battle over patronage with the President. On the floor of Congress, Jenckes denounced the spoils system, and held up the example of Prussian bureaucratic efficiency as recently displayed in the Austro-Prussian War. Opposition to reform was led by Vermont Republican Frederick E. Woodbridge, attorney and railroad builder, who declared that periodic changes of civil service officers are wholesome and democratic, and attacked the Jenckes bill as "antidemocratic." Political changes, Woodbridge declared, "are the great safety-value of the republican form of government … The health of the nation requires that the stable shall be occasionally cleared out."Hoogenboom, Spoilsmen and Reformers, p. 21.  The proposed Civil Service Commission, Woodbridge charged, would be "this great traveling menagerie, this inquisitorial court." In the vote in the House in early 1861, Radical leader Thaddeus Stevens successfully moved to table the Jenckes bill. The bill lost by a vote of 71 to 67; the Republicans voted 56 to 49 in favor of reform whereas the Democrats voted 22 to 11 against. The urban East was far more favorable to the Jenckes bill than the rural West, while within New England, the most urbanized states of Massachusetts, Connecticut, Rhode Island, and New Hampshire voted unanimously in favor, while the more rural Maine and Vermont voted totally against.Hoogenboom, Outlawing the Spoils, p. 31.

During 1867, however, increasing reformer disillusion with Johnson, coupled with the passage of the Tenure of Office Act, spurred greater interest in civil service reform. During the fall of 1866, Boston Brahmin Charles Eliot Norton launched a campaign to make his dear friend George W. Curtis US Senator from New York. When Roscoe Conkling was selected instead, it took the disappointed office-seeker only three weeks to take the plunge and come out for civil service reform — a cause that would occupy him the rest of his life. Reformers were particularly disgusted at President Johnson's having the effrontery to fire one of their own — John Lothrop Motley — as minister to Austria, for being hostile to the Johnson Administration. Charles Sumner, a close friend of Motley's, and Godkin of The Nation, were particularly disturbed that Motley would be replaced by Edgar Cowan of Pennsylvania, a man who was not only in favor of Johnson's policies, but who dared to defend the virtues of rotation in office. Taking the typical high moral stance of the civil service reformers, The Nation threw down the moral gauntlet to the Johnson Administration:

Mr. Lincoln … put into office the best set of foreign ministers we have had in many a day, and all our representatives at first-class courts for the last six years have been men who were in every sense of the word an honor to the country …

But, alas, continued The Nation, "they are now being removed one by one to make room for the broken-down adherents of 'the [Johnson] policy,' and if anything can be done to stop the process, stopped it should be."The Nation, IV, No. 82 (Jan. 24, 1867), pp. 61-62. Hoogenboom, Outlawing the Spoils, p. 37.

Reform agitation centered in the Joint Select Committee on Retrenchment in the House, created in July 1866 to curtail government spending. The old Jenckes bill of 1866-67 had been reported out of the Joint Select Committee. In the spring of 1867, the mysterious Julius Bing, an impoverished immigrant who was acquainted with Senator Sumner, received an appointment as clerk of the Joint Select Committee. During 1867-68, Bing worked tirelessly and on all cylinders to promote the cause of civil service reform. Bing wrote no less than twenty articles for the New York weekly Round Table from the fall of 1867 to the following spring boosting reform, as well as articles in the Chicago Tribune, Putnam's Magazine, and a prominent article in the nation's most influential monthly, the North American Review, in 1867. In addition, Bing distributed pamphlets to congressmen and editors, lobbied members of Congress, and was Representative Jenckes's right arm in advancing the cause.

In May 1868, Julius Bing prepared and wrote the Jenckes report of the Joint Select Committee on Retrenchment, a massive and comprehensive report which was for many years to serve as the bible of civil service reform. In addition to including reports on the Chinese, European and English civil service, the report contained replies of several hundred supervisory US officers to the committee's thirty-seven-point questionnaire. Unsurprisingly, ninety-seven percent of the replies favored reform, i.e., being frozen into life tenure.

Julius Bing's outlook was candidly expressed in his North American Review article for October, 1867. "In the early days of the Republic," Bing recalled wistfully, civil service officers as well as the Presidents and the Cabinet, were "generally selected from well-known families." With the advent of the spoils system, however, this aristocratic principle had fallen into disuse, but now, with the Jenckes bill, things would be very different. Andrew Johnson, Bing snarled, would not have passed a test by a civil service commission:

it would not have required a profound psychological knowledge to arrive at the conclusion, that a man may rise from the tailor shop to … the gubernatorial chair, and yet be morally and intellectually incapable of presiding … over the destinies of a great nation.

Bing's only objection to the Jenckes bill was that it did not go far enough, that it did not apply to the foreign service from top to bottom.Ibid., p. 41, and pp. 42-46. Also see Bing's frenetic attack on the "total depravity" and "total stupidity" of the existing spoils system, in an article in Putnam's Magazine, August 1868. Hoogenboom, Spoilsmen and Reformers,pp. 12-16.

Finally, after a year of frenzied activity, Bing left the center of the reform movement to become Crete's diplomatic agent in the United States.Hoogenboom, Outlawing the Spoils, p. 40n.

The reformers looked forward with great expectations to the coming Presidency of General US Grant in early 1869. An indisputable Radical, General Grant was a military man, previously uncontaminated by politics, and not beholden to political machines. Surely Grant, who was reputed to favor the Jenckes bill, would see the wisdom of appointing the Best and the Brightest to office? Charles Eliot Norton trumpeted that "'Honesty & Grant,' 'Good Faith & Grant,' must succeed," and Julius Bing wrote to Rep. Jenckes that Grant's imminent election makes "the prospects of our success … brighter now than … at any previous time."

Grant's installation did not dim the reformers' enthusiasm. Norton burbled that "Grant grows daily in my respect and confidence," and he worshipfully described Grant, as "so simple, so sensible, so strong and so magnanimous." The Nation exulted that "we have in Grant a man who will break up the present system."Hoogenboom, Outlawing the Spoils, pp. 48-49, 51.

A crucial aspect of the reformer enthusiasm for Grant was a conviction that they themselves, as clearly the best and brightest, would share in the boodle of the first Republican administration since Lincoln. Particularly active in scrambling for the spoils was none other than the leaders of the reformers, George William Curtis. Asked by his friend Norton to recommend him to Holland or Belgium, Curtis lobbied the new Secretary of State, Hamilton Fish, on Norton's behalf. Curtis also asked Senator Sumner to obtain the nomination of two friends as consuls in France, and he recommended to the patronage post of surveyor for the Albany Customhouse a friend, the poet Alfred Billings Street. In defense of Street, Curtis avowed that the man was not a drunkard, as alleged, but rather was a man "enlivened" by alcohol.

In the meanwhile, the reformers, even The Nation, made it clear that competitive examinations were not really an end in themselves, but a means toward the true goal: of filling government posts with the most qualified people. And they were sure who those particularly qualified might be: men very much like themselves.

The Grant Cabinet soon disillusioned the Reformers, however, though not enough to precipitate a break. It turned out that Grant's loose ties with political machines was a mixed blessing, for Grant insisted on selecting wealthy non-party types who had donated ("subscribed") money to his campaign. The reformers began to complain that the President was too independent of party, i.e., of themselves. The only satisfying Cabinet appointments by Grant were young ex-Governor Jacob D. Cox of Ohio as Secretary of Interior, and particularly the quintessential Boston Brahmin, Ebenezer Rockwood Hoar, as Attorney General.Hoar was Supreme Court Justice of Massachusetts, and a member of the Board of Overseers of Harvard College. Burch, Elites, pp. 35, 346. Also see Hoogenboom, Outlawing the Spoils, pp. 51-54.

The lesser appointments of the President soon confirmed the reformers' disenchantment. Apart from giving the coveted Minister of England post to the Boston Brahmin historian John Lothrop Motley, who had helped write Grant's campaign biography, Grant failed to acknowledge the Best and Brightest status for the reformers. The new Senator from Missouri, Carl Schurz, found to his consternation that the President had selected the postmaster for St. Louis without consulting him, capped by his telling Schurz that "I know Missouri a great deal better than you do." Charles Eliot Norton, finding himself out in the cold on a ministerial appointment, was no longer enchanted with President Grant by July of the president's inaugural year. By then, the reformers were no longer complaining that Grant was insufficiently political; quite the contrary. Norton wrote his friend, Curtis, of "Grant's surrender … to the politicians," who are about to "ruin the country." John Hay, a Boston Brahmin in the career foreign service, wrote angrily about "the herd of swine" whom Secretary of State Hamilton Fish "has commissioned." By late April, the gloomy reformer Henry Adams had washed his hands of the Grant administration:

My hopes of the new Administration have all been disappointed; it is far inferior to the last. My friends have almost all lost ground instead of gaining it as I hoped. My family is buried politically beyond recovery for years. I am becoming more and more isolated as far as allies go.

Adams wrote to his brother, Charles Francis Adams, Jr., lamenting their common political fate:

I can't get you an office. The only members of this Government that I have met are mere acquaintances, not friends, and I fancy no request of mine would be likely to call out a gush of sympathy.Hoogenboom, Outlawing the Spoils, pp. 62-63.

Not only were the Adamses, Curtis, Schurz and other reformers disgruntled by Grant's patronage policy, but so too were the media elite: the nation's editors who were peeved at not receiving lucrative appointments. No important editor or publisher was offered a post; and, by mid-April, only Charles A. Dana, editor of the New York Sun, was offered the picayune spot of appraiser for New York. All in all, it was easy for the reformers to see, with Julius Bing by mid-April, that Grant had acted "in apparent disregard of the principle of intrinsic fitness and qualification…"

If Grant was not to be relied upon, then the reformers must redouble their agitation for a professional civil service with life tenure. Henry Adams, who had not been particularly interested in reform before his disappointment, now plunged into the effort. By February, 1869, Adams had concluded that reform was fundamental, and by June he was writing what he described as a pro-civil service reform article "very bitter and abusive of the Administration." He expected that the article would get him in "hot water," but he felt that he had "nothing to lose." Disappointed in seeking office, the nation's editors stepped up their reform efforts. As Hoogenboom puts it, "Editors, always a vital part of the civil service reform movement, provided the driving force that eventually secured substantial legislation." But these were only the "respectable" editors: The Nation bitterly made it clear that the non-respectable press were not interested in reform since they were enough inside politics to get "their own hands and those of their friends into the public treasury."The Nation, #200 (April 29, 1869). Hoogenboom, Outlawing the Spoils,pp. 63-64.

Stung by their own disappointment, the reformers were incensed when President Grant removed previous officeholders wholesale, and when he made room in the bureaucracy for all the Republican Congressmen defeated in the November elections of 1868. By June, The Nation complained that "few people — few of his supporters certainly — were prepared for the 'clean sweep' which he made." The scandals, charged The Nation, "have been enormous, and have been deeply felt by the whole community."Ibid., p. 62.

In the meanwhile, agitation for the Jenckes Bill, which had escalated after Grant's election in the expectation that the new President would back reform, intensified further now that Grant had let the reformers down. Outgoing Secretary of the Treasury Hugh McCulloch called for the Jenckes bill, and the powerful Union League Club of New York unanimously called for reform. Moreover, in December 1868, the American Social Science Association, founded in Boston a few years earlier to oppose slavery, now added civil service reform to its agenda. German immigrant Henry H. Villard, secretary of the ASSA, and soon to be head of the Northern Pacific Railroad, brought Representative Jenckes in early January to Boston to meet with the society and its influential business and professional supporters. A large audience, including the Board of Trade, and several former mayors of Boston, unanimously signed a petition urging the Jenckes bill. The following week Villard held another meeting for Jenckes in New York, attended by 1,200 enthusiastic businessmen. From that base, Villard spread ASSA organizing for civil service reform to Washington and throughout the country. In June, Villard was able to establish a branch of the ASSA in Philadelphia, centering around the prominent anti-Catholic historian Henry Charles Lea, and fifty of the "best citizens of that city."Villard was the son-in-law of the fiery abolitionist leader, William Lloyd Garrison. One of the people whom Villard tapped to head up the Philadelphia branch of the ASSA was the veteran abolitionist James Miller McKim, a founder of The Nation, and the father-in-law of Villard's brother-in-law, Wendell Phillips Garrison.

In October 1869, George William Curtis took the lead of the reformers in addressing the annual meeting of the ASSA in New York, attacking the existing system and calling for the Jenckes bill. The Nation hailed the speech and claimed that the public owed a great debt to the ASSA for featuring the talk; it was also impressed by the fact that Curtis, one of the nation's most popular speakers on the lecture circuit, would stump the country for reform.

During the same month, Henry Adams published his "very bitter" article on "Civil Service Reform" in the North American Review. Taking the gloves off on Grant, he accused the president of carrying the spoils system to a new extreme. In particular, he pinpointed the politically powerful Civil War (North) veterans group, the Grand Army of the Republic, as aiding Grant in organizing a purge of administrative departments. Adams, however, was a fan neither of competitive examinations nor of the Jenckes bill; he wanted the President to impose civil service reform by executive fiat, and he wanted not so much competitive exams but permanence of the administrative oligarchy. Adams betrayed the reformers' overriding motives when he contrasted the alleged magnificence of Attorney-General Ebenezer Hoar with his fellow-Bostonian and Republican, the Radical Secretary of Treasury George S. Boutwell. Whereas Boutwell was a self-made man who rose to prominence, and "was the product of caucuses and party promotion" [Adams' sneer was almost visible], Hoar, coming from one of the top Brahmin families of Boston, was "by birth and by training a representative of the best New England school, indifferent to opposition whether in or out of his party." Adams added that

Judge Hoar belonged in fact to a class of men who had been gradually driven from politics, but whom it is the hope of reformers to restore. Mr. Boutwell [on the other hand] belonged to the class which has excluded its rival, but which has failed to fill with equal dignity the place it has usurped.Henry Brooks Adams, "Civil Service Reform," North America Review, CIX (October 1869), pp. 456-57. Excerpted in Hoogenboom, Spoilsmen and Reformers, pp. 25-26. Also see Hoogenboom, Outlawing the Spoils, p. 67. It was no wonder that Representative Jacob Benton of New Hampshire denounced the Jenckes bill as a "cunningly devised" scheme to oust the Administration's friends from office "unless they belong to the particular, select favorite class."

This was a contrast that The Nation immediately applauded.

In the meanwhile, the Radical Republicans, coming into power with the Grant Administration, were not about to have their priorities upset. In the first place, with their man in the White House, they rapidly repealed (or amended out of existence) the Tenure of Office Act, which they had passed two years later so that the Radical Senate could take power from Andrew Johnson. With one of their own as president, they rushed to restore the sole presidential power to remove federal appointees from office.

Similarly, with their man in power, the Radicals had now lost their previous enthusiasm for civil service reform. What was the point, now that General Grant, and not an enemy like Johnson, was president? Taking the lead against the Jenckes bill immediately after the 1868 election, for example, was leader Radical Senator John A. ("Black Jack") Logan of Illinois. When the hated Andrew Johnson was in power, Logan, in December 1867, had introduced a civil service reform bill. Now that Grant was president, however, it was a very different story. Logan now denounced reform as unconstitutional, aristocratic, monarchical, anti-republican, and undemocratic. On the contrary, he who does not support an administration should not work in it. As Logan put it, "he who does not unite in its view is not to be intrusted with its employment."

Logan pointed out the importance of rotation in office: "It is by having their agents constantly before them that their acts may be denounced or confirmed that the people maintain their supremacy and enforce their will. This, sir, is the theory and practice of our Government. Immediate responsibility we all incur, and speedy settlements we all must render." Logan concluded that "the right to become for a time a portion of the administrative force of the government is one of the recognized rights of the people of which it is proposed by this bill, utterly and forever, to deprive them."In Leonard D. White, The Republican Era: 1869-1901: A Study in Administrative History (New York: Macmillan, 1958), p. 292.

The Jenckes bill was also effectively attacked by Pennsylvania Democratic Representative George W. Woodward. Harking back to Jacksonian Democracy, Woodward instead called for the Jacksonian virtues of rotation in office, hard money, no excise taxes on industry, free trade, cutting the budget, and repaying the public debt. Rotation in office, Woodward assured, would far more readily assure morality in office than would civil service reform.Hoogenboom, Outlawing the Spoils, pp. 57-58.

The opposition of Logan and other Radicals doomed the Jenckes bill for the duration of the lame-duck 70th Congress; the reformers would try again in the 71st Congress, coming in with the new Grant administration in the spring of 1869. Prospects were dimmed, however, by the fact that the Democrats, doomed to extreme minority status during the Civil War, had made considerable gains in the congressional elections of 1868.

President Grant's first annual message to Congress in December 1869 disappointed the reformers still further, by omitting any call for civil service reform; The Nation extravagantly called this omission the "great scandal of General Grant's administration." The reformers were further embittered when their admired Judge Hoar, appointed by President Grant to the Supreme Court, was rejected by the Radical-dominated Senate, angry at Hoar's refusal to tolerate political appointees in the Justice Department.

Jenckes reintroduced his bill in the next Congress, in May 1870. This time, Jenckes threw a sop to the principle of rotation in office, but not to political rotation, by providing that his proposed Civil Service Commission could make civil servants subject to reexamination every four years. Most of the popular support was still confined to the northeast.

While the Jenckes bill languished in Congress, the year 1870 saw a number of body blows administered to the reformers by Grant Administration. Their two beloved leaders in the administration were both summarily fired; Ebenezer Hoar as Attorney General and John Lothrop Motley as minister to England. Both men joined Senator Charles Sumner in opposing President Grant's scheme for the United States to annex Santo Domingo, and Hoar in particular was detested by Massachusetts Radical Representative Ben Butler, a champion of the "spoils system" and enemy of reform. Furthermore, the other reformer in the Cabinet, Secretary of Interior Jacob Dolson Cox, was fired by the president, largely for imposing civil service tests and refusing to make political appointments in the Interior Department. Cox, too, ran afoul of the powerful Butler, as well as tangling with Radical Michigan Senator and wealthy Detroit merchant, Zachariah Chandler.In another blow to the reformers, one of their leaders, David Ames Wells, from a Massachusetts manufacturing family, was removed from his important post as Commissioner of Revenue by the simple device of allowing his position to lapse. Joseph Dorfman, The Economic Mind in American Civilization, Vol. III, 1865-1918 (New York: Viking, 1949), p. 11.

After his dismissal in October, Cox was urged to go public with the reasons by fellow Ohio reformer, Representative James A. Garfield, and the disclosure had the effect of demonstrating increasing disarray in Republican ranks. The ensuing elections of 1870 saw a Democratic gain of thirty seats in the House, as well as the carrying of critical states New York and Indiana. After the election, reform agitation continued, with Yale professors generating a New Haven meeting's "warm letter of sympathy" to Cox, denouncing the existing state of the civil service as "the root of much of our political corruption." Harvard quickly chimed in, a Republican "caucus" in Cambridge unanimously passing a pro-Cox resolution, and a group of young Harvard alumni talked of forming a civil service reform club.

During the election, however, reform lost its stoutest Congressional champion. Thomas A. Jenckes was defeated for reelection by an opponent backed by the powerful Republican Senator William Sprague, a wealthy textile manufacturer, railroad man, and real estate speculator. Having accused Sprague of all manner of corruption and then having lost the election, Jenckes went down howling fraud to the last, charging Sprague with having purchased the winning votes.

The 1870 election, indeed, saw the rise of a new faction within the national party, the Liberal Republicans, calling for free trade but devoted in particular to civil service reform. Carl Schurz bolted the Missouri Republican party, and managed to elect a Liberal Republican as governor. The Nation went to the length of calling for a new party devoted to civil service reform, lower tariffs, and, in particular, more representation in government of the "thoughtful, conscientious and intelligent" part of the population, "now excluded from all direct share in the government."

More prophetic was the call of the Bostonian American Free Trade League for an alliance of liberal or reform Republicans and Democrats, an idea seconded in the pro-reformer Chicago Tribune. Promptly after the election, the Free Trade League called a conference for a new alliance in New York. While Schurz, Cox and other Republican leaders refused to commit at this point on breaking with Grant, many leading pro-reform editors were in attendance, including Henry Adams of the North American Review, Horace White of the Chicago Tribune, and E.L. Godkin of The Nation. The conference endorsed both civil service reform and free trade, although Speaker of the House James G. Blaine was able to keep the reformers from calling for a new party by promising to make one of their own, James A. Garfield, chairman of the powerful House Ways and Means Committee. George Curtis also rejected the idea of a new party as insuring the victory of the hated Democrats.

The severe election losses, as well as increasing disaffection from the party by the reformers, caused a shift on the part of the Grant Administration. President Grant, in his annual December, 1870 message to Congress, actually called for civil service reform; the existing patronage system, he said, "does not secure the best men, and often not even fit men, for public place."

During the lame duck session of the 41st Congress, various reform bills, even though approved by President Grant, failed to pass, until congressional reform leaders put through a joint resolution, authorizing the President to appoint a civil service commission to prescribe rules for examining applications. And despite the fact that this resolution was trickily driven through both houses of Congress at the last minute in March as a rider to an appropriation bill, the reformers hailed its passage without commenting on the hasty and devious way that the process was handled.

The Grant Administration's tactic managed to split the reformers. Most reformers, indeed, followed Carl Schurz, Jacob Cox, and E.L. Godkin in forming a powerful Liberal Republican faction dedicated to taking over the Republic Party and denying Grant renomination in 1872. The Liberals challenged the dominant Radicals on every level. Whereas the Radicals were devoted to continuing the Reconstruction of the South, high protective tariffs, continuing greenback inflation, and preserving the spoils system, the Liberals favored conciliating the South and ending Reconstruction now that slavery had been abolished, free trade, and resumption of the gold standard — in short, the platform of the minority Sumner wing of the old Radical faction. But their greatest zeal was not so much for the old laissez-faire creed of the Jacksonian Democracy, but for the doctrine especially detested by that fading group: civil service reform. When Jacob Cox formed his Central Republican Association in Cleveland in early 1871, standing on the above program, Carl Schurz cheered him on, stating that this was the creed of his Missouri Liberal Republicans, and calling for similar organizations across the country.

Out of step with most of his colleagues, George W. Curtis was so delighted with the Grant call for reform and with the ensuing Congressional rider, that he hailed Grant and backed his renomination, a conversion toward Grand possibly influenced by Curtis's belief that the President planned to make him Minister to England. Instead, Curtis got another call from the President; responding to the Congressional rider and to charges of corruption in the New York Customhouse, President Grant surprised and delighted reformers in June by appointing a seven-man Civil Service Commission (CSC) , with none other than Curtis as its chairman. The New York Times, now a solid Administration organ since Horace Greeley's rival New York Tribune was becoming increasingly Liberal, heralded the appointment of the Curtis CSC as offering "practical proof that the President is actively enlisted for reform, and that he has the sense and courage to call to his aid men who are in earnest beyond suspicion."Hoogenboom, Outlawing the Spoils, p. 91.

Curtis succeeded, over the objections of many members of the Commission and over the reluctance of the President, in getting the CSC to promulgate, in mid-December, sweeping rules for all but a small handful of the top officials of the federal administration. He also got President Grant to promulgate the rules on January 1, 1872, to take effect in a mere two weeks. These draconian rules made the CSC the dictator of virtually the entire executive branch, with new entrants into each department coming in almost exclusively at the bottom, with jobholders to be selected by competitive open examination, and promotions from the ranks to be selected in the same way.

The CSC was supposed, however, to divide the civil service into grades, and clearly it was absurd to believe that it could accomplish this task in two weeks. On January 10, therefore, Grant suspended the new rules to give the CSC time to come up with a detailed classification into grades. It did so on March 12, 1872, dividing the entire administration into four classes, with all but the small fourth, or highest, class subject to the rules of examination, and their salaries determined by class. Grant quickly bowed to CSC wishes and promulgated the reform rules.

In a letter to the most reform-minded member of the CSC after Curtis, Chicago Tribune publisher Joseph Medill, President Grant came down squarely on the side of reform: "The great defect in the past custom is that executive patronage has come to be regarded as the property of the party in power."Hoogenboom, Outlawing the Spoils, p. 106.

The reformers, however, scarcely paused to celebrate their triumph. They had to battle against a hostile Congress, especially the Grantian Radicals for appropriations and to try to make the Grant rules permanent by statute; and they also arrogantly continued to press the president to extend the rules into the top category, even into those positions that had to be confirmed by the Senate.

In Congress, the Grantian Radicals struck hard. Senator Matthew Carpenter of Wisconsin denounced reform as unconstitutional, transferring the patronage from elected officials to a "board of schoolmasters." Carpenter also perceptively pointed out that not only were the new rules anti-republican, but that they favored the sons of the rich, who could afford a college education, and therefore do better at abstract written examinations than the practical fellow. Carpenter shrewdly identified the underlying class struggle involved in the agitation for and against reform:

So, sir, it comes to this at last, that … the dunce who had been crammed up to a diploma at Yale, and comes fresh from his cramming, will be preferred in all civil service appointments to the ablest, most successful, and most upright business man of the country, who either did not enjoy the benefit of early education, or from whose mind, long engrossed in practical pursuits, the details and niceties of academic knowledge have faded away as the headlands disappear when the mariner bids his native land good night.White, The Republican Era, pp. 293-94.

A battle ensued in Congress over appropriations for the CSC, which did not feel it could follow its true inclinations in an election year, and it grudgingly voted $25,000 in early May, a severe whittling down from the original proposal of $100,000, or even from the Senate's passage of $50,000. Again, biggest support for the bill was in the northeast, although this time the Grantian Radicals were even more opposed to the CSC than were the Democrats. Leading the anti-reform forces in the House, once again, was Massachusetts Representative Ben Butler, while James A. Garfield led the ranks of the reformers.For excerpts from a witty speech by Butler attacking reform, and the rider put through at the last minute by Senator Lyman Trumbull, a Liberal Republican from Illinois, see Hoogenboom, Spoilsmen and Reformers, pp. 26-28.

It was characteristic of the reformers that they repaid President Grant's conversion to their cause by giving him nothing but grief. The bulk of the reformers, determined to destroy the prospects of a second term for Grant, formed a new party, the Liberal Republicans. Meeting under the aegis of Senator Carl Schurz in Missouri in January, 1872, they called for a national convention to meet in Cincinnati on May 1. The idea was to pick a candidate whom the Democrats could also support, and thereby sweep a Democratic-Liberal Republican president into power. Particularly prominent in the new party were the nation's leading media intellectuals — the editors of the most important newspapers. These included Horace Greeley and publisher Whitelaw Reid of the New York Tribune, The Nation, the New York Evening Post, Horace White of the Chicago Tribune, Samuel Bowles of the Springfield Republican, Mural Halstead of the Cincinnati Commercial, and Henry Watterson of the Louisville Courier-Journal.

The reformers were anxious to nominate for president one of their very own, Charles Francis Adams, but in order to broaden their base, they were forced to accept delegates not really devoted to reform, who were often simply spoilsmen disgruntled that they had lost out in the battle for President Grant's favor. Such a man was Horace Greeley, who was nominated over Adams and others on the sixth ballot. Greeley's nomination left Schurz, the party's founder, and other reformers embittered. For the elderly Greeley was the opposite of the beau ideal of a civil service reformer: a Fourierite socialist and long-time protectionist, Greeley believed that the protective tariff, in contrast to "selfish" laissez-faire individualism, embodied the Christian principle of "universal love." Not only that: but Greeley was really a spoilsman who joined the Liberals because he had backed the wrong Republican faction in New York, from the point of view of the Grant Administration. Carl Schurz was dismayed, writing Greeley frankly that "the first fruit of the great reform, so hopefully begun, was a successful piece of political huckstering and that the whole movement had been captured by politicians of the old stamp." E.L. Godkin was even more upset, writing furiously to Schurz that Greeley was a "conceited, ignorant, half-cracked, obstinate old creature," and charged that Greeley's "election … would be a national calamity of the first magnitude … the triumph of quackery, charlatanry and recklessness."Hoogenboom, Outlawing the Spoils, p. 114. On Greeley's views, see Joseph Dorfman, The Economic Mind in American Civilization, 1606-1865, Vol. II (New York: Viking Press, 1946), pp. 669-71.

The civil service reformers were now split into four mutually quarreling factions. The main camp, headed by Schurz and Horace White, after gaining a commitment by Horace Greeley to civil service reform, swallowed their pride by the end of June and supported Greeley. The second, embittered faction, headed by Godkin and Charles Eliot Norton, went back to support President Grant as the lesser of the two evils. A small group of reformers in late June, detesting both Grant and Greeley, nominated W.S. Groesbeck of Ohio for President, but was not heard from again. And finally, the fourth faction, headed by Curtis, was with Grant from the beginning, remained with Grant, and denounced Greeley with relish. Interestingly, Curtis's letters reveal that his support of Grant was not so much on the civil service question as on his Radical view of reconstruction. Curtis denounced Greeley as too soft on the South, accusing Greeley of being a veritable Copperhead. In the meanwhile, the embattled Democrats, anxious for allies, made the great mistake of nominating Greeley themselves, thereby abandoning all their old principles of Jacksonian Democracy. New York Irish Catholic lawyer Charles O'Conner, a devoted libertarian and Jacksonian Democrat, ran for president on a third, Straight Democratic Party ticket in behalf of the Democracy.

In the 1872 election, Horace Greeley was trounced, losing every state, and he died shortly thereafter. The reformers continued to be split, with the Godkin-Norton faction particularly bitter at those who stuck with Greeley, accusing the latter of selfish and sordid political motives for backing Greeley. After the election, the Schurz-White forces, as true pragmatists, tried to reconcile the factions, but Godkin would have none of it, declaring that "there is at present a slight odor of ridicule hanging around everybody who had anything to do" with the Cincinnati convention. Ideas for a Civil Service Reform League or a daily newspaper in New York devoted to reform faded away.

Despite the disarray of the reformers, President Grant continued to be committed to reform, but he reaped only aggravation from George Curtis. In August 1873, Grant agreed to promulgate CSC rules tightening the old regulations, actually making all personal solicitation of appointments by congressmen and others illegal. But Grant wanted some flexibility in the rules for high positions in the administration. After much backing and filling, Grant insisted on naming his own person for the post of surveyor of the customs in New York, technically within the civil service rules but actually always a leading political position confirmable by the Senate. Curtis stubbornly resisted, however, and when illness prevented him from holding a hearing or examination to find someone to fill the post, the president went ahead in mid-March and appointed the prominent politician George H. Sharpe to the post, without notifying Curtis. In a pique Curtis promptly resigned as chairman of the CSC.

Curtis's successor as head of the CSC had impeccable reform credentials. Dorman B. Eaton was a reform intellectual and erudite attorney, born and raised in New England and resident in New York. In 1870, Eaton gave up his flourishing law practice, and spent the rest of his life fighting for municipal and civil service reform, publishing a scholarly history, Civil Service in Great Britain, in 1880. It is characteristic of Curtis that he was bitter about Eaton betraying the cause, whereas Eaton felt that Curtis was endangering the reform movement by his precipitous action. In any case, it was Eaton who presided over the tighter rules put forth in August.

But Curtis was not to be appeased; after six months of rest, he was back in the fall of 1873, on the attack in his Harper's Weekly, denouncing Grant as not sticking to the "spirit of the rules" by not extending them upward to the important posts of post-masters and collectors of revenue. There is evidence that some of Curtis's bitterness was caused by the thwarting of his ambition for rising in the Grant administration — perhaps his failure to be made Minister to England. For his part, Eaton was willing to conciliate Grant and give up reform rules for collectors and surveyors of ports. Although eventually the reformers would be forced to retreat to this more sensible stance, Godkin's Nation attacked Eaton's concession, in the process revealing the true ambitions of reform. It is easy for the President and department heads, the Nation wrote, to favor reform, "because it takes disagreeable work off their hands, while as to the more important offices, they are almost openly hostile to the spirit of the innovation, because it takes power away from them." It was the top positions that the reformers were mainly interested in conquering and securing, not the jobs of the lowly clerks.The Nation, Vol. XVIII (April 23, 1874), p. 260; cited in Hoogenboom, Outlawing the Spoils, p. 129.

The Radical Republican ranks in Congress were strengthened by the 1972 election, however, and they were ready for the reformers' blood. In addition, the reformers were increasingly distracted by the Panic of 1873, and by the Radicals' demand for monetary inflation to combat a panic that had been brought on by the Civil War and by post-Civil War inflationary expansion of bank credit. Since the reformers were generally hard-money opponents of inflation, the enmity of the Radicals was further redoubled. When President Grant, in his annual message of December 1873, suggested that Congress form a special committee to help the CSC devise enforceable rules, the House responded by naming a committee that featured the inflationist and spoils system champion Ben Butler and that failed to include reform leader James A. Garfield. After a fierce struggle over the existence of the CSC and over its funding, with Ben Butler leading the fight against both, Congress ended by leaving the CSC standing but depriving it of any appropriations.

In the Congressional elections of November 1874, the Democrats, spurred on by the damaging Panic of 1873, won a landslide majority of seventy votes in the House, capturing that body for the first time since the Civil War. The Republican majority in the Senate was reduced to a narrow one. Discouraged by the Democratic victories and by reformer complaints, President Grant finally threw in the towel. In his annual message of December 1874, he continued to endorse civil service reform, but stressed the absurdity of continuing the CSC and the regulations without Congressional funding or support. Grant threatened to abolish the competitive examination system if Congress failed to fund the CSC. Happy to kill the CSC through inaction, the lame duck 43rd Congress failed to appropriate funds, and Grant discontinued the competitive examinations in March 1875. The Civil Service Commission, and the first era of reform rules, 1871-1875, was ended. The reformer flirtation with Grant was over.

The abandonment by President Grant served to mobilize and unify the reformers. In February, 1875, Henry Adams called for a "consultation" of reformers, which was held in the form of a dinner honoring Schurz on his retirement from the Senate. The reformers resolved to unite and avoid the disastrous splits of '72, and they held a general meeting in New York in late April. The reformers concentrated their political fire that year in Ohio, where pro-reformer and hard-money advocate Rutherford B. Hayes managed to topple incumbent inflationist Democratic Governor William Allen. The campaigning for Hayes by Carl Schurz might have made a difference in the close race.

The reformers were also cheered when George W. Curtis was chosen chairman of the New York State Republican convention that year, and when the convention adopted a resolution against a third term for Grant. And in the Democratic party in New York, pro-reform Samuel Tilden was nominated — and later elected — for governor over Tammany opposition.

The reformers' political attention was now concentrated on the 1876 race. The reformers, now known as Independent Republicans, secretly cherished the pipe-dream of Charles Francis Adams, Sr. being nominated on both party tickets — which would have been the climax of their quiet belief in "democracy" guided by themselves. More realistically, they favored the popular Kentuckian Secretary of the Treasury Benjamin H. Bristow; at one point, Henry Adams contemplated buying the New York Evening Post as a Bristow organ with Schurz installed as editor. In April, the reformers held a large-scale New York conference at the Fifth Avenue Hotel, in which they made clear that they would avoid the separate party route of 1872, and maintain an Independent stance, waiting to see how the presidential nomination came out. The platform adopted by the conference was written by Schurz, stressing the twin issues of civil service reform and sound currency, meaning a return to the gold standard. The Nation exulted that the attendees at the conference were largely the "'moral element' … ministers, professors, and respectable persons who do not believe politics should be pursued as a trade."Hoogenboom, Outlawing the Spoils, p. 139.

Bristow failed to obtain the nomination at the June convention at Cincinnati, but the reformers were happy with the dark-horse choice, Governor Rutherford B. Hayes, who was committed to reform, to return to gold and to conciliating the South.A major reason for Bristow's being deprived of the nomination was the treachery of his campaign manager, Kentucky attorney John Marshall Harlan.At the crucial last minute, Harlan went over to the Hayes camp. Hayes rewarded Harlan by making him his first Supreme Court appointee, Harlan going on to become the first darling of left-liberals on the Supreme Court. Philip H. Burch,Jr., Elites in American History: The Civil War to the New Deal (New York:Holmes & Meier, 1981), p. 105. Hayes had been corresponding with the reformers since February, and after his nomination he wrote happily in his diary: "The best people, many of them heretofore dissatisfied with the Republican party, are especially hearty in my support. I must make it my constant effort to deserve this confidence."Hoogenboom, Outlawing the Spoils, pp. 140-41. And while the reformers were happy to back Hayes, they were also pleased when the Democrats nominated their most ardent reformer, New York's Governor Tilden. Either way, the reformers couldn't lose. In his official letter of acceptance of the nomination in July, Hayes, after consulting with Curtis and Schurz, called strongly for abolition of the spoils system and for a "thorough, radical and complete" reform of the civil service.

As President, Hayes, as we might expect, met with little but complaining from the reformers. During the campaign, the reformers grumbled that Hayes was "waving the bloody shirt" against the "rebels" in his campaign, that he was whipping up anti-Catholic sentiment, and that he was giving campaign posts to opponents of reform. The reformers then complained about Hayes's gaining the presidency from Tilden by evident fraud, and then rewarding the fraudulent election returns-counters from the South with patronage positions. And even though the reformers were delighted that Schurz was named Secretary of the Interior, that he imposed the examination system in his department, and that other reform work was done in the New York Customhouse, nothing, as usual, was enough to satisfy them. Why weren't all the other departments in the hands of the reformers? Also, they found that Hayes was taking the reformers' goal of life tenured appointments too seriously; what he was supposed to do was to kick out all the evil Grant people, replace them with good reformers, and then freeze the reformers into civil service by reform.

Thus, in June 1877, Horace White wrote in exasperation to Schurz:

At the beginning, there should have been some heavy & decisive blows at the old system — for instance, the removal of the Collectors at Boston, NY. & Phila. followed by appointments of friends of reform. Known to the country as such, & fostered by unequivocal instructions for all officers & their subordinates.Hoogenboom, Outlawing the Spoils, p. 153. As Professor Hoogenboom puts it, "A stable tenure of office was a means not an end in itself, and reformers never meant to apply it to undesirable civil servants as Hayes was doing." Ibid., p. 149.

Poor President Hayes! He just never really got it, although he should have gladdened their hearts by pulling federal troops out of the South and by returning to the gold standard in 1879.

Hayes tried to make up to the reformers by putting the major emphasis on a call for civil service reform in his annual message of late 1879; furthermore, he requested Dorman Eaton, who was still nominally head of the CSC though without office space or funds, to report on the British civil service system, and Eaton was happy to comply, with his paean to the recently-imposed merit and life tenure system in England, Civil Service in Great Britain (1880).

The reformers were puzzled about their stance in the 1880 election. When he was nominated, Hayes, in a burst of what the reformers felt was misguided reforming zeal, pledged to be only a one-term candidate. So Hayes, their favorite, took himself out of the race for 1880. The major Republican candidates in 1880 were General Grant, for a third-term, and House Speaker James G. Blaine of Maine. The reformers detested Grant and were unhappy with Blaine, and so they felt it a divine "deliverance" when the June Republican convention at Chicago, after deadlocking between the two leaders, picked pro-reform James A. Garfield as the compromise, anti-Grant candidate. And even though the reformers preferred Garfield to the Democrat choice, General Winfield S. Hancock, they continually complained that Garfield was a waffler, that he now refused to commit to reform, and that he was too close to James Blaine. The reformers grumbled particularly when Garfield chose as Vice President Chester A. Arthur of the hated New York machine of spoilsman Senator Roscoe Conkling.

The decisive step taken by the reformers during the 1880 campaign was not the election of Garfield, but the establishment of a permanent, single-issue civil service reform organization to agitate for reform. It began in the form of a suggestion in August by the Nation, and in a response by Frederick William Holls of New York calling for Independent Republicans to organize a society stressing "education and enlightenment … accomplished by agitation, political, social and even religious." Holls suggested that the new society employ the methods which they and their forerunners had used in the struggle for the abolition of slavery: in particular, to seize and stress the high ground of morality and moral principle. Holls urged that the new society put the argument especially on the basis of "abstract moral right". Favorable response in letters to the Nation inspired the reformers to organize such a society.

In particular, Dorman Eaton had set up a New York Civil Service Reform Association in May, 1877, but the lack of interest had caused the association to remain dormant after 1878. Now, Curtis revived the association, which reorganized in September and October, and named Curtis as its president, a post which he was to continue to hold until his death twelve years later. The association was to be single-issue and non-partisan. It was to specialize in lobbying, in a committee headed by Eaton, and in publishing and distributing publications, in an effort headed by Godkin. The New York association formed the model and the nucleus of other local associations, which sprang up like wildfire: by May 1881, affiliated associations had been established in Brooklyn, Boston, Cambridge, West Newton, Massachusetts, and in Cincinnati, Milwaukee, Philadelphia, Providence and San Francisco, and in the process of formation in Buffalo, New Orleans, Pittsfield and Worcester, Mass. Pamphlets were widely distributed, and in May, a monthly periodical, The Civil Service Record, started being published by the Boston and Cambridge associations.

Professor Hoogenboom's study of the forty-five active members of the New York Association's executive committee, from its inception in 1877 until 1883, reveals the following: most members were born within ten years of 1832, making them in their upper forties and lower fifties in 1880; half were attorneys, nine were editors, three professors and five clergymen contributed to the group's high moral tone, and the one-third businessmen were not industrialists but rather upper-middle rank merchants and bankers. Almost all were Protestant; over half were born in New England and the rest in New York. All were Anglophiles. Almost all were highly educated, many gaining advanced degrees. Nine attended Harvard College and seven Harvard Law School. The typical New York reform leader was entrenched in blue-blood society, and was a clubman — especially the Union League, Century, University, and Harvard clubs. Patterns were similar in the Brooklyn, Boston and San Francisco Associations.Hoogenboom, Outlawing the Spoils, p. 190-97.

Finally, on August 11, 1881, the New York Association called a general conference of local associations at Newport, to coordinate agitation and action for reform. Out of this conference came the umbrella national organization, the National Civil Service Reform League, with the executive committee of the New York group functioning as its provisional central committee.Hoogenboom, Outlawing the Spoils, p. 211.

In the lame duck Congress after Garfield's victory, the Democrats began to get increasingly interested in reform. Not only was the idea of reform being spread in the best circles, and becoming more influential among the media and in the electorate, but Democratic losses in the election of 1880 made many of them more enthusiastic about a non-partisan administration. In particular, Senator George Pendleton of Ohio, a recent convert, introduced a civil service reform bill in December. Fortunately for the reformers, the New York Civil Service Reform Association was in place, and when it squawked about technical errors, Pendleton was happy to substitute the bill written by the end of December by the legislative committee of the New York association, i.e., largely by Dorman Eaton.

President Garfield's few months in office proved a grave disappointment to the reformers. He appointed as his Secretary of State the reformers' enemy James G. Blaine, and the new Secretary of the Interior Samuel J. Kirkwood of Iowa promptly dismantled all of Carl Schurz's civil service reforms in that department. Not only that: Garfield's inaugural address, instead of backing the Pendleton bill, cleverly shifted gears by calling for the reform of limiting all officials to a fixed term of years. While to the superficial observer, this proposal seemed similar to the schemes of the reformers, it was precisely the opposite: compelling rotation in office across the board instead of establishing life tenure for high grades in examinations. In private correspondence, George Curtis saw the plan: Garfield, he pointed out, "knows better and therefore I can only interpret his heretical position to fix on terms of office by law, as an adroit measure to defeat the whole scheme without openly opposing it."Hoogenboom, Outlawing the Spoils, p. 203-04. Italics are Curtis's.

When Garfield was shot on July 2 by the crazed Charles J. Guiteau, James A. Garfield wounded and then dead proved far more of an asset to the reformers than Garfield alive. Guiteau talked himself into believing that he was responsible for Garfield's election, and demanded high office, either Minister to Austria or Consul to Paris. Guiteau has been depicted then and since as a "disappointed office-seeker," and the reformers redoubled their agitation, cynically and demagogically trying to exploit the tragedy — and heedless that the Pendleton Act would not have covered such a position in any case. The idea that murder by an office-seeker can only be combated by abolishing offices to be sought, is even sillier than the comparable argument that the way to eliminate assault or murder is to outlaw guns. From pulpit to press, the reformers pounded away on the spoils system as responsible for the shooting of Garfield, and it was in the wake of that shooting that the New York Civil Service Reform Association decided to go national. In September, the New York association nationally distributed a letter, drawn up by Curtis and signed by many eminent men, from industrialist Peter Cooper to ex-President Hayes, linking the "recent murderous attack" on Garfield with the alleged need for civil service reform.

When Garfield died of his wounds on September 19, the reformers stepped up their propaganda.Van Riper, History, pp. 88-91. Forgotten was President Garfield as a weak tool of James Blaine; he was now transformed into a fearless crusader for reform. Typical of Garfield-memorial publications was a poster that the New York association exhibited in every post office in the country. The poster pictured a monument to the murdered Garfield, surrounded by pro-reform quotations from Garfield from his days in Congress, while on the monument was an epitaph proclaiming Garfield "a martyr to the fierceness of factional politics and the victim of that accursed greed for spoils of office which was the bane of his brief conscious existence as President, and is the gravest peril that threatens the future of his country." Henry Adams, to his credit, was disgusted, writing to Godkin that:

The cynical impudence with which the reformers have tried to manufacture an ideal statesman out of the late shady politician beats anything in novel-writing. They are making popular capital. They lie and manoeuvre just like candidates for office. The independents and reformers are as bad as the late lamented, and for the same reason. It pays.Adams to Godkin, September 26, 1881. In Hoogenboom, Outlawing the Spoils, p. 212.

Contrary to the impression given by historians, Congress did not pass the Pendleton Act in direct response to the propaganda centered around the assassination. It is true that media agitation and the civil service associations had their effect, and the Independent bloc was beginning to have a formidable influence on both parties. More and more politicians paid lip-service to reform, and even its great opponent Ben Butler professed to be converted to the cause. But President Arthur, while waffling on the topic, happily proceeded to remove Garfield appointees, and while he (unsuccessfully) asked Congress to restore a $25,000 appropriation to the defunct Civil Service Commission, he also cleverly came out for a four-year limit on all tenure for the bureaucracy — the reverse of the reformers' demands.

The key to the ultimate reformer success and the passage of the Pendleton Act was the course of the 1882 elections. In August 1882, the National Civil Service Reform League held its second annual meeting at Newport. George Curtis vigorously denounced President Arthur for his appointments, and angered by Congress's derisive attitude toward reform, the League decided to become active in the congressional elections, questioning all candidates on specific civil service measures and then publishing their replies. Most state party conventions, as a result, put a pro-reform plank in their platforms, especially in the North and East. When the Maine Republican convention came out against reform, Independent Republicans organized an insurgent ticket demanding reform; as a result, Blaine felt forced to favor reform, at least to the extent of favoring the Arthur four-year plan.

When the New York State Republican convention nominated Secretary of the Treasury Charles J. Folger, a long-time member of the Arthur-Conkling "Stalwart" faction, for governor, the Democrats countered by nominating their leading reformer Grover Cleveland, and the Independent Republicans, headed by Curtis and the Rev. Henry Ward Beecher, advocated bolting the party to vote for Cleveland.

The 1882 elections were a terrible blow to the regular Republican forces. Grover Cleveland crushed the Republicans in New York by what was then the largest majority in New York history. The Democrats ousted the Republicans in Ohio, probably because the Republicans insisted on prohibiting liquor and thereby alienating the German Lutherans, who were not about to be deprived of their Sunday beer. But at least an ancillary cause was Arthur's appointment of Stalwart enemies of Garfield in the assassinated President's home state. Regular Republicans also lost by huge majorities in Pennsylvania, Indiana, Connecticut, and New Jersey, and even lost Massachusetts.

After the November elections, then, the heavily-Republican lame duck Congress, having been elected in 1880, faced the future knowing (a) that the successor, 1882 Congress, would be much more Democratic; and (b) that the prospect loomed for a Democratic President in 1884. The regular Republicans, at that point, suddenly heard the call of civil service reform. First, by converting to reform they might keep the Independent votes which they now saw as powerful and even decisive for 1884; and, second, by passing the Pendleton Act they could freeze existing Republicans into life tenure before they would be ousted by an incoming Democratic Administration. On the other hand, the Democrats dared not risk losing the Independent vote by voting against reform, even though it would mean that 10,000 federal office jobs would be locked away from deserving Democrats. The result: both parties made their calculations, and both shifted en masse to reform.

President Arthur made the same calculations. In his message in December, he called for prompt passage of the Pendleton bill. Virtually all Congressmen saw the light, and attempts to derail the measure with fixed-tenure in office bills got nowhere. Even Black Jack Logan claimed to have always been a staunch champion of reform. The only rock-ribbed opponent of reform remaining was the veteran Democratic Senator Joseph E. Brown of Georgia. Brown ridiculed the Democrats supporting a bill that would deprive them of the office they would receive in only two years' time. Brown insisted that parties fight for offices as well as principle. The only concession that Brown and the Democrats received was to allow entry into office at all grades of civil service, and not just at the lowest grade, as the Pendleton bill and the reformers had always wanted. The original bill would have meant that promotions could only take place from within the ranks of the bureaucracy, and that there could never be infusions from the outside directly into higher ranks. The bureaucracy would then have been far more of a hermetically sealed unit, a rigid, non-circulating, and hierarchical elite. Finally, the Senate voted, or declared, for the amended Pendleton bill by 45 to 12, Republican senators unanimously favoring the bill by 30 to 0, while the Democrats narrowly favored it by 15 to 12.Southern Democrats voted for the bill by 14 to 12, with Pendleton the only non-southern Democrat to vote in favor. Four Far Western Democrats abstained. The House followed swiftly. The voters and declarers supported the Pendleton bill by 162 to 48. All but a few Republicans voted in favor, while the Democrat opposition was centered in the South, the Old Northwest, and such states lacking reform associations as New Jersey. In the South, where the reform movement was nonexistent, only 14 Congressmen voted for the measures, 22 opposed, and 26 were absent. Generally, urban areas, where reform movements were strong, supported the bill far more than rural representatives.

Most congressmen, even those voting for the Pendleton bill, detested it. Senator Preston Plumb, Republican from Kansas, who ended up voting for the measure, protested that "we are not legislating on this subject in response to our own judgment … but in response to some sort of judgment which has been expressed outside." Indeed, every member of Congress received a letter from the National Civil Service Reform League urging passage of the Pendleton bill, and local associations intensively lobbied their representatives.

President Arthur signed the Pendleton Act of January 16, 1883, and appointed the last CSC chairman, Dorman Eaton, to be the head of the new three-man Civil Service Commission. Civil-service reform was now part of the statutes of the United States. The reformer triumph was not complete, however. The federal government bureaucracy amounted to an average of 140,000 in the 1880s; the Pendleton Act applied its system of examinations, grades and security of tenure to the "classified civil service," which then constituted about 10 percent of the total bureaucracy — largely clerks in Washington, D.C. and in large-city post offices and customhouses employing fifty or more persons. All the rest of the bureaucracy was left an "unclassified service" as before, and subject to patronage and removal. This remaining unclassified service could be brought under the Pendleton regulations if, when, and to the extent that the President saw fit. The only jobs exempt from this presidential authority under the statute were laborers, and those whose positions were so high as to be subject to confirmation on the advice and consent of the Senate.The reformers were not ready at that point for the reform rules to be applied to every post in the bureaucracy. Dorman Eaton himself, testifying before the Senate on the Pendleton bill in January 1881, declared that all-at-once application would "be too large altogether … We have got to create the machinery … you would be utterly overslaughed and broken down if you were to be required to carry it all at once." Van Riper, History, p. 105n.

President Arthur surprised and pleased the reformers by applying Pendleton rules strictly; but he disappointed them by not appointing leading reformers to the unclassified positions. In the election of 1884, most of the Independent Republicans deserted the hated Blaine to vote for the Democrat Grover Cleveland for president, earning the label "Mugwumps" from their reform colleague who stuck to the Republicans, young Theodore Roosevelt of New York. Since Cleveland carried New York State, a stronghold of the reformers, by a narrow margin, and this victory was decisive for his election, it is probable that Mugwump support was a key to his triumph.Another well-known critical factor in the New York vote was the denunciation by a leading Protestant minister, the Rev. Samuel Burchard, of the Democratic party as the party of "rum, Romanism, and rebellion" — the reference to rum alienating the German Lutheran swing voters.  In his annual message to Congress in the December after his election, President Cleveland pledged not only to execute the Pendleton Act faithfully, but also to apply its principles across the entire civil service. The reformers had seemingly reached Nirvana.

But the reform triumph did not turn out as expected. While Cleveland faithfully executed the Pendleton Act to the classified service, he purged all Republicans from the far larger unclassified service. Reformers were bitter, claiming that Cleveland had violated his pledge, and was not carrying out the spirit of reform. Curtis lamented that

Cleveland's course has left all of us Mugwumps in an apparently disagreeable position…. It has certainly discredited civil service reform and chilled those who were his most earnest supporters in 1884.[92] Hoogenboom, Outlawing the Spoils, p. 261.

In 1888, reformers were again split; some supported Cleveland grudgingly because of his low-tariff views; but others, including Henry C. Lea of Philadelphia, opposed Cleveland for "betraying the cause [civil service reform] on which he was elected." Cleveland was embittered by this opposition, denouncing Lea as a "base Calumniator" who "ought to be horsewhipped, with the rest of the dirty mendacious gang." Condemning the reformers after losing the election, Cleveland wrote to one of them:

the treatment I have received from the advocates of Civil Service Reform makes my blood boil…. I know what I have done and what I have suffered in this cause and with that I am satisfied as I retire from the struggle. I hope the next man will be better trusted by those who assume to be apostles of the Reform. The cause is worth much — very much; but the people who stand ready to attribute every mistake in the selection of officers to wanton violation of principle and assume to know more of the conditions, motives and intents that those charged with responsibility, are worth nothing.Cleveland to Silas W. Burt, December 6, 1888. Hoogenboom, Outlawing the Spoils, p. 262.

President Harrison, in turn, gave the reformers short shrift. Harrison made a clean sweep of Democrats in the unclassified service, and failed to reappoint leading reformers in high government positions. Harrison even went further than Cleveland in removing many officials before their fixed four-year terms were up. The reformers complained, by the end of 1890, that in two years of office, Harrison had violated his pledge by not extending the classified service by a single man. When Cleveland returned in 1892, a similar process occurred; Republicans were booted out of unclassified positions. Even one of their very own, Boston Brahmin Josiah Quincy, a founder of the National Civil Service Reform League, was appointed as Assistant Secretary of State; he then promptly fired within a few months one-third of the Republican consular officials and replaced them with Democrats.

Ironically, most of these presidents increased the classified service rapidly. But the reformers were not really delighted at this victory, since what each administration did was to toss out opponents, appoint good party people to unclassified posts, and then bring them to the classified service, thereby freezing them into tenure for life. With each alternating shift of party, the merit system was thereby extended, ratcheting the number of government officials upward, in order to find room for deserving party workers. As Professor Hoogenboom sums it up:

the federal classified service increased rapidly. The merit system advanced not because of further action by Congress, but because of executive action. Ironically, executive action stemmed more from a desire to place fellow party members permanently in the civil service than from a wish to reform. The process involved replacing all political enemies with political friends in a branch of the unclassified, or unreformed, service and then extending the rules to cover it. This process was hastened by the alternation of party control in the 1880s and 1890s, which led Presidents every four years to make additions to the classified list. The irony was compounded. The advance of the merit system stimulated rapacious spoils methods in the unclassified service, and the civil service reform movement itself languished.Hoogenboom, Outlawing the Spoils, pp. 260-61.

The reform movement was indeed languishing. Partly this decline was the result of the Pendleton Act victory; but partly, too, because the reformers were getting increasingly obsolete and losing political influence. Membership in the associations declined; the Brooklyn association, for example, lost over half of its members from 1882 to 1890, with the biggest fall off among the former heart of the association: the professionals — the lawyers, clergymen, and journalists. The number of associations also declined. In December, 1883, immediately after the Pendleton victory, there were 59 reform associations in existence; by 1892 however the number had sunk to 35. The San Francisco and New Orleans outposts disappeared, as did those in Louisville and Norfolk. By 1892, the shrinking reform movement was confined to its old Northeastern heartland.

In the 1896 election, William Jennings Bryan was openly anti-reform, and President McKinley, in May 1899, actually withdrew several thousand offices from the Pendleton rules, thereby bringing about "the first backward step in the history of the competitive merit system," and rolling back Cleveland's additions to the classified service. Indeed, the rules might have shrunk further, were it not for another presidential assassination, which catapulted the dedicated reformer Theodore Roosevelt into the presidency. When Roosevelt came into office, 46 percent of the federal bureaucracy was classified; when he left eight years later, he had frozen in Republicans by bringing 66 percent under the rules. The ratchet effect was alive and well, and was continued by successive presidents.

The aging reformers, dwindling in ranks and influence, turned on each other. As early as the first Cleveland Administration, Curtis, Silas Burt, and Godkin conspired successfully to persuade Cleveland to oust Dorman Eaton as CSC chairman. They disliked Eaton for his gradualism, but they urged Cleveland to oust Eaton as "impractical, indiscreet, and … dangerous."Hoogenboom, Outlawing the Spoils, p. 264.

The disheartened reformers, indeed, looked at the fruits of their victory and found it only ashes. These had been genteel Brahmins and educated elites, convinced of the inherent right of their sort to rule, and embittered at the rise to power of the uneducated, the non-elite, the brash, self-made, nouveau riche industrialist. They were also devoted to the ideals of free trade, hard money, laissez-faire, and retrenchment of government, but their chief focus had been a permanent rule by themselves and their cohort. But they lived to see the triumph of their "merit system" result not in the retrenchment of government, but in its acceleration, and not in the triumph of themselves, but of the brash politicians and corruptionists they despised. And in the Progressive era ushered in by Theodore Roosevelt, they were to find the ideals of "merit" and a technocratic elite employed in the service of every principle they detested: big government, protectionism, inflationary bank credit, and imperialism and foreign war.

And so the aging reformers looked on their world and back on their handiwork and found them futile and repellent. A few months before he died in 1892, George W. Curtis expressed his "scorn of the spurious Democracy which is always found in all American parties." Six years later, E. L. Godkin wrote to his old friend Charles Eliot Norton condemning "democracy": "I have pretty much given it up as a contribution to the world's moral progress…. I too tremble at the thought of having a large navy and the warmaking power, lodged in the hands of such puerile and thoughtless people — 100,000,000 strong. It is an awful prospect for the world, and I am glad to be so near the end of my career." The following year, Godkin wrote in the Nation seeing the fundamental problem as big centralized government:

The great obstacle in the way of reform is neither American nor English, it is simply human. All that we know, by past experience, of the attempts of man to provide himself with a government, makes it most unlikely that an effort, repeated every four years, on the part of one hundred millions of people, to elect a single officer as the chief of state, should succeed. It seemed reasonable enough when the Constitution was framed for 3,000,000 people, leading a simple agricultural life. All democracies of which the world has had any experience, have been small … Our desire to create a "world Power" out of the Federal machine is a fiasco, full of shame and disappointment.Edwin Lawrence Godkin, "Civil-Service Reform," The Nation, LXXI (September 27, 1900), pp. 256-57. Excerpted in Hoogenboom, Spoilsmen and Reformers, pp. 49-50.

In his 1962 Man Economy and State, Rothbard built on Mises’s work and further developed the complete deductive science of economics called Praxeology. Gordon highlights several of Rothbard’s contributions including the impossibility of a monopoly price occurring on the free market, the implications of the calculation problem on the size of the firm, and the impracticalities of fractional reserve banking. Rothbard’s exposition of the Great Depression and his work in History of Economic Thought are also discussed.

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Acting man transfers the valuation of ends he aims at to the means. Other things being equal, he assigns to the total amount of the various means the same value he attaches to the end which they are fit to bring about. For the moment we may disregard the time needed for production of the end and its influence upon the relation between the value of the ends and that of the means.

The gradation of the means is, like that of the ends, a process of preferring a to b. It is preferring and setting aside. It is manifestation of a judgment that a is more intensely desired than is b. It opens a field for application of ordinal numbers, but it is not open to application of cardinal numbers and arithmetical operations based on them. If somebody gives me the choice among three tickets entitling one to attend the operas Aïda, Falstaff, and Traviata and I take, if I can only take one of them, Aïda, and if I can take one more, Falstaff also, I have made a choice. That means: under given conditions I prefer Aïda and Falstaff to Traviata; if I could only choose one of them, I would prefer Aïda and renounce Falstaff. If I call the admission to Aïda a, that to Falstaff b and that to Traviata c, I can say: I prefer a to b and b to c.

The immediate goal of acting is frequently the acquisition of countable and measurable supplies of tangible things. Then acting man has to choose between countable quantities; he prefers, for example, 15 r to 7 p; but if he had to choose between 15 r and 8 p, he might prefer 8 p. We can express this state of affairs by declaring that he values 15 r less than 8 p, but higher than 7 p. This is tantamount to the statement that he prefers a to b and b to c. The substitution of 8 p for a, of 15 r for b and of 7 p for c changes neither the meaning of the statement nor the fact that it describes. It certainly does not render reckoning with cardinal numbers possible. It does not open a field for economic calculation and the mental operations based upon such calculation.

The elaboration of economic theory is heuristically dependent on the logical processes of reckoning to such an extent that the economists failed to realize the fundamental problem involved in the methods of economic calculation. They were prone to take economic calculation as a matter of course; they did not see that it is not an ultimate given, but a derivative requiring reduction to more elementary phenomena. They misconstrued economic calculation. They took it for a category of all human action and ignored the fact that it is only a category inherent in acting under special conditions. They were fully aware of the fact that interpersonal exchange, and consequently market exchange effected by the intermediary of a common medium of exchange — money, and therefore prices, are special features of a certain state of society's economic organization which did not exist in primitive civilizations and could possibly disappear in the further course of historical change.The German Historical School expressed this by asserting that private ownership of the means of production, market exchange, and money are "historical categories." But they did not comprehend that money prices are the only vehicle of economic calculation. Thus most of their studies are of little use. Even the writings of the most eminent economists are vitiated to some extent by the fallacies implied in their ideas about economic calculation.

The modern theory of value and prices shows how the choices of individuals, their preferring of some things and setting aside of other things, result, in the sphere of interpersonal exchange, in the emergence of market prices.Cf. especially Eugen von Böhm-Bawerk, Kapital and Kapitalzins, Pt. II, Bk. III These masterful expositions are unsatisfactory in some minor points and disfigured by unsuitable expressions. But they are essentially irrefutable. As far as they need to be amended, it must be done by a consistent elaboration of the fundamental thoughts of their authors rather than by a refutation of their reasoning.

In order to trace back the phenomena of the market to the universal category of preferring a to b, the elementary theory of value and prices is bound to use some imaginary constructions. The use of imaginary constructions to which nothing corresponds in reality is an indispensable tool of thinking. No other method would have contributed anything to the interpretation of reality. But one of the most important problems of science is to avoid the fallacies which ill-considered employment of such constructions can entail.

The elementary theory of value and prices employs, apart from other imaginary constructions to be dealt with later,See below, pp. 237-257. the construction of a market in which all transactions are performed in direct exchange. There is no money; goods and services are directly bartered against other goods and services. This imaginary construction is necessary. One must disregard the intermediary role played by money in order to realize that what is ultimately exchanged is always economic goods of the first order against other such goods. Money is nothing but a medium of interpersonal exchange. But one must carefully guard oneself against the delusions which this construction of a market with direct exchange can easily engender.

A serious blunder that owes its origin and its tenacity to a misinterpretation of this imaginary construction was the assumption that the medium of exchange is a neutral factor only. According to this opinion the only difference between direct and indirect exchange was that only in the latter was a medium of exchange used. The interpolation of money into the transaction, it was asserted, did not affect the main features of the business. One did not ignore the fact that, in the course of history, tremendous alterations in the purchasing power of money have occurred and that these fluctuations often convulsed the whole system of exchange. But it was believed that such events were exceptional facts caused by inappropriate policies. Only "bad" money can bring about such disarrangements. In addition people misunderstood the causes and effects of these disturbances. They tacitly assumed that changes in purchasing power occur with regard to all goods and services at the same time and to the same extent. This is, of course, what the fable of money's neutrality implies. The whole theory of catallactics, it was held, can be elaborated under the assumption that there is direct exchange only. If this is once achieved, the only thing to be added is the "simple" insertion of money terms into the complex of theorems concerning direct exchange. However, this final completion of the catallactic system was considered of minor importance only. It was not believed that it could alter anything essential in the structure of economic teachings. The main task of economics was study of direct exchange. What remained to be done besides this was at best only a scrutiny of the problems of "bad" money.

Complying with this opinion economists neglected to lay due stress upon the problems of indirect exchange. Their treatment of monetary problems was superficial; it was only loosely connected with the main body of their scrutiny of the market process. About the turn of the nineteenth and twentieth centuries, the problems of indirect exchange were by and large relegated to a subordinate place. There were treatises on catallactics which dealt only incidentally and cursorily with monetary matters, and there were books on currency and banking which did not even attempt to integrate their subject into the structure of a catallactic system. At the universities of the Anglo-Saxon countries there were separate chairs for economics and for currency and banking, and at most of the German universities monetary problems were almost entirely disregarded.Neglect of the problems of indirect exchange was certainly influenced by political prepossessions. People did not want to give up the thesis according to which economic depressions are an evil inherent in the capitalist mode of production and are in no way caused by attempts to lower the rate of interest by credit expansion. Fashionable teachers of economics deemed it "unscientific" to explain depressions as a phenomenon originating "only" out of events in the sphere of money and credit. There were even surveys of the history of business cycle theory which omitted any discussion of the monetary thesis. Cf., e.g., Eugen von Bergmann, Geschichte der nationalökonomischen Krisentheorien (Stuttgart, 1895). Only later economists realized that some of the most important and most intricate problems of catallactics are to be found in the field of indirect exchange and that an economic theory which does not pay full regard to them is lamentably defective. The coming into vogue of investigations concerning the relation between the "natural rate of interest" and the "money rate of interest," the ascendancy of the monetary theory of the trade cycle, and the entire demolition of the doctrine of the simultaneousness and evenness of the changes in the purchasing power of money were marks of the new tenor of economic thought. Of course, these new ideas were essentially a continuation of the work gloriously begun by David Hume, the British Currency School, John Stuart Mill and Cairnes.

Still more detrimental was a second error which emerged from the careless use of the imaginary construction of a market with direct exchange.

An inveterate fallacy asserted that things and services exchanged are of equal value. Value was considered as objective, as an intrinsic quality inherent in things and not merely as the expression of various people's eagerness to acquire them. People, it was assumed, first established the magnitude of value proper to goods and services by an act of measurement and then proceeded to barter them against quantities of goods and services of the same amount of value. This fallacy frustrated Aristotle's approach to economic problems and, for almost two thousand years, the reasoning of all those for whom Aristotle's opinions were authoritative. It seriously vitiated the marvelous achievements of the classical economists and rendered the writings of their epigones, especially those of Marx and the Marxian school, entirely futile. The basis of modern economics is the cognition that it is precisely the disparity in the value attached to the objects exchanged that results in their being exchanged. People buy and sell only because they appraise the things given up less than those received. Thus the notion of a measurement of value is vain. An act of exchange is neither preceded nor accompanied by any process which could be called a measuring of value. An individual may attach the same value to two things; but then no exchange can result. But if there is a diversity in valuation, all that can be asserted with regard to it is that one a is valued higher, that it is preferred to one b. Values and valuations are intensive quantities and not extensive quantities. They are not susceptible to mental grasp by the application of cardinal numbers.

However, the spurious idea that values are measurable and are really measured in the conduct of economic transactions was so deeply rooted that even eminent economists fell victim to the fallacy implied. Even Friedrich von Wieser and Irving Fisher took it for granted that there must be something like measurement of value and that economics must be able to indicate and to explain the method by which such measurement is effected.For a critical analysis and refutation of Fisher's argument, cf. Mises, The Theory of Money and Credit, trans. by H. E. Batson (London, 1934), pp. 42-44; for the same with regard to Wieser's argument, Mises, Nationalökonomie (Geneva, 1940), pp. 192-194. Most of the lesser economists simply maintained that money serves "as a measure of values."

Now, we must realize that valuing means to prefer a to b. There is — logically, epistemologically, psychologically, and praxeologically — only one pattern of preferring. It does not matter whether a lover prefers one girl to other girls, a man one friend to other people, an amateur one painting to other paintings, or a consumer a loaf of bread to a piece of candy. Preferring always means to love or to desire a more than b. Just as there is no standard and no measurement of sexual love, of friendship and sympathy, and of aesthetic enjoyment, so there is no measurement of the value of commodities. If a man exchanges two pounds of butter for a shirt, all that we can assert with regard to this transaction is that he — at the instant of the transaction and under the conditions which this instant offers to him — prefers one shirt to two pounds of butter. It is certain that every act of preferring is characterized by a definite psychic intensity of the feelings it implies. There are grades in the intensity of the desire to attain a definite goal and this intensity determines the psychic profit which the successful action brings to the acting individual. But psychic quantities can only be felt. They are entirely personal, and there is no semantic means to express their intensity and to convey information about them to other people.

There is no method available to construct a unit of value. Let us remember that two units of a homogeneous supply are necessarily valued differently. The value attached to the nth unit is lower than that attached to the (n-1)th unit.

In the market society there are money prices. Economic calculation is calculation in terms of money prices. The various quantities of goods and services enter into this calculation with the amount of money for which they are bought and sold on the market or for which they could prospectively be bought and sold. It is a fictitious assumption that an isolated self-sufficient individual or the general manager of a socialist system, i.e., a system in which there is no market for means of production, could calculate. There is no way which could lead one from the money computation of a market economy to any kind of computation in a nonmarket system.

The Theory of Value and Socialism

Socialists, Institutionalists and the Historical School have blamed economists for having employed the imaginary construction of an isolated individual's thinking and acting. This Robinson Crusoe pattern, it is asserted, is of no use for the study of the conditions of a market economy. The rebuke is somewhat justified. Imaginary constructions of an isolated individual and of a planned economy without market exchange become utilizable only through the implication of the fictitious assumption, self-contradictory in thought and contrary to reality, that economic calculation is possible also within a system without a market for the means of production.

It was certainly a serious blunder that economists did not become aware of this difference between the conditions of a market economy and a non-market economy. Yet the socialists had little reason for criticizing this fault. For it consisted precisely in the fact that the economists tacitly implied the assumption that a socialist order of society could also resort to economic calculation and that they thus asserted the possibility of the realization of the socialist plans.

The classical economists and their epigones could not, of course, recognize the problems involved. If it were true that the value of things is determined by the quantity of labor required for their production or reproduction, then there is no further problem of economic calculation. The supporters of the labor theory of value cannot be blamed for having misconstrued the problems of a socialist system. Their fateful failure was their untenable doctrine of value. That some of them were ready to consider the imaginary construction of a socialist economy as a useful and realizable pattern for a thorough reform of social organization did not contradict the essential content of their theoretical analysis. But it was different with subjective catallactics. It was unpardonable for the modern economists to have failed to recognize the problems involved.

Wieser was right when he once declared that many economists have unwittingly dealt with the value theory of communism and have on that account neglected to elaborate that of the present state of society.Cf. Friedrich von Wieser, Der natürliche Wert (Vienna, 1889),p. 60, n. 3. It is tragic that he himself did not avoid this failure.

The illusion that a rational order of economic management is possible in a society based on public ownership of the means of production owed its origin to the value theory of the classical economists and its tenacity to the failure of many modern economists to think through consistently to its ultimate conclusions the fundamental theorem of the subjectivist theory. Thus the socialist utopias were generated and preserved by the shortcomings of those schools of thought which the Marxians reject as "an ideological disguise of the selfish class interest of the exploiting bourgeoisie." In truth it was the errors of these schools that made the socialist ideas thrive. This fact clearly demonstrates the emptiness of the Marxian teachings concerning "ideologies" and its modern offshoot, the sociology of knowledge.

Acting man uses knowledge provided by the natural sciences for the elaboration of technology, the applied science of action possible in the field of external events. Technology shows what could be achieved if one wanted to achieve it, and how it could be achieved provided people were prepared to employ the means indicated. With the progress of the natural sciences, technology progressed too; many would prefer to say that the desire to improve technological methods prompted the progress of the natural sciences. The quantification of the natural sciences made technology quantitative. Modern technology is essentially the applied art of quantitative prediction of the outcome of possible action. One calculates with a reasonable degree of precision the outcome of planned actions, and one calculates in order to arrange an action in such a way that a definite result emerges.

However, the mere information conveyed by technology would suffice for the performance of calculation only if all means of production — both material and human — could be perfectly substituted for one another according to definite ratios, or if they all were absolutely specific. In the former case, all means of production would be fit, although according to different ratios, for the attainment of all ends whatever; things would be as if only one kind of means — one kind of economic good of a higher order existed. In the latter case each means could be employed for the attainment of one end only; one would attach to each group of complementary factors of production the value attached to the respective good of the first order. (Here again we disregard provisionally the modifications brought about by the time factor.) Neither of these two conditions is present in the universe in which man acts. The means can only be substituted for one another within narrow limits; they are more or less specific means for the attainment of various ends. But, on the other hand, most means are not absolutely specific; most of them are fit for various purposes.

The facts that there are different classes of means, that most of the means are better suited for the realization of some ends, less suited for the attainment of some other ends and absolutely useless for the production of a third group of ends, and that therefore the various means allow for various uses, set man the tasks of allocating them to those employments in which they can render the best service. Here computation in kind as applied by technology is of no avail. Technology operates with countable and measurable quantities of external things and effects; it knows causal relations between them, but it is foreign to their relevance to human wants and desires. Its field is that of objective use-value only. It judges all problems from the disinterested point of view of a neutral observer of physical, chemical, and biological events. For the notion of subjective use-value, for the specifically human angle, and for the dilemmas of acting man, there is no room in the teachings of technology. It ignores the economic problem: to employ the available means in such a way that no want more urgently felt should remain unsatisfied because the means suitable for its attainment were employed — wasted — for the attainment of a want less urgently felt.

For the solution of such problems technology and its methods of counting and measuring are unfit. Technology tells how a given end could be attained by the employment of various means which can be used together in various combinations, or how various available means could be employed for certain purposes. But it is at a loss to tell man which procedures he should choose out of the infinite variety of imaginable and possible modes of production. What acting man wants to know is how he must employ the available means for the best possible — the most economic — removal of felt uneasiness. But technology provides him with nothing more than statements about causal relations between external things. It tells, for example, 7 a + 3 b + 5 c + … xn are liable to bring about 8 P. But although it knows the value attached by acting man to the various goods of the first order, it cannot decide whether this precept or any other out of the infinite multitude of similarly constructed precepts best serves the attainment of the ends sought by acting man.

The art of engineering can establish how a bridge must be built in order to span a river at a given point and to carry definite loads. But it cannot answer the question whether or not the construction of such a bridge would withdraw material factors of production and labor from an employment in which they could satisfy needs more urgently felt. It cannot tell whether or not the bridge should be built at all, where it should be built, what capacity for bearing burdens it should have, and which of the many possibilities for its construction should be chosen. Technological computation can establish relations between various classes of means only to the extent that they can be substituted for one another in the attempts to attain a definite goal. But action is bound to discover relations among all means, however dissimilar they may be, without any regard to the question whether or not they can replace one another in performing the same services.

Technology and the considerations derived from it would be of little use for acting man if it were impossible to introduce into their schemes the money prices of goods and services. The projects and designs of engineers would be purely academic if they could not compare input and output on a common basis. The lofty theorist in the seclusion of his laboratory does not bother about such trifling things; what he is searching for is causal relations between various elements of the universe. But the practical man, eager to improve human conditions by removing uneasiness as far as possible, must know whether, under given conditions, what he is planning is the best method, or even a method, to make people less uneasy. He must know whether what he wants to achieve will be an improvement when compared with the present state of affairs and with the advantages to be expected from the execution of other technically realizable projects which cannot be put into execution if the project he has in mind absorbs the available means. Such comparisons can only be made by the use of money prices.

Thus money becomes the vehicle of economic calculation. This is not a separate function of money. Money is the universally used medium of exchange, nothing else. Only because money is the common medium of exchange, because most goods and services can be sold and bought on the market against money, and only as far as this is the case, can men use money prices in reckoning. The exchange ratios between money and the various goods and services as established on the market of the past and as expected to be established on the market of the future are the mental tools of economic planning. Where there are no money prices, there are no such things as economic quantities. There are only various quantitative relations between various causes and effects in the external world. There is no means for man to find out what kind of action would best serve his endeavors to remove uneasiness as far as possible.

There is no need to dwell upon the primitive conditions of the household economy of self-sufficient farmers. These people performed only very simple processes of production. For them no calculation was needed, as they could directly compare input and output. If they wanted shirts, they grew hemp, they spun, wove, and sewed. They could, without any calculation, easily make up their minds whether or not the toil and trouble expended were compensated by the product. But for civilized mankind a return to such a life is out of the question.

The quantitative treatment of economic problems must not be confused with the quantitative methods applied in dealing with the problems of the external universe of physical and chemical events. The distinctive mark of economic calculation is that it is neither based upon nor related to anything which could be characterized as measurement.

A process of measurement consists in the establishment of the numerical relation of an object with regard to another object, viz., the unit of the measurement. The ultimate source of measurement is that of spatial dimensions. With the aid of the unit defined in reference to extension one measures energy and potentiality, the power of a thing to bring about changes in other things and relations, and the passing of time. A pointer-reading is directly indicative of a spatial relation and only indirectly of other quantities. The assumption underlying measurement is the immutability of the unit. The unit of length is the rock upon which all measurement is based. It is assumed that man cannot help considering it immutable.

The last decades have witnessed a revolution in the traditional epistemological setting of physics, chemistry, and mathematics. We are on the eve of innovations whose scope cannot be foreseen. It may be that the coming generations of physicists will have to face problems in some way similar to those with which praxeology must deal. Perhaps they will be forced to drop the idea that there is something unaffected by cosmic changes which the observer can use as a standard of measurement. But however that may come, the logical structure of the measurement of earthly entities in the macroscopic or molar field of physics will not alter. Measurement in the orbit of microscopic physics too is made with meter scales, micrometers, spectrographs-ultimately with the gross sense organs of man, the observer and experimenter, who himself is molar.Cf. A. Eddington, The Philosophy of Physical Science, pp. 7-79, 168-169. It cannot free itself from Euclidian geometry and from the notion of an unchangeable standard.

There are monetary units and there are measurable physical units of various economic goods and of many — but not of all — services bought and sold. But the exchange ratios which we have to deal with are permanently fluctuating. There is nothing constant and invariable in them. They defy any attempt to measure them. They are not facts in the sense in which a physicist calls the establishment of the weight of a quantity of copper a fact. They are historical events, expressive of what happened once at a definite instant and under definite circumstances. The same numerical exchange ratio may appear again, but it is by no means certain whether this will really happen and, if it happens, the question is open whether this identical result was the outcome of preservation of the same circumstances or of a return to them rather than the outcome of the interplay of a very different constellation of price-determining factors. Numbers applied by acting man in economic calculation do not refer to quantities measured but to exchange ratios as they are expected — on the basis of understanding — to be realized on the markets of the future to which alone all acting is directed and which alone counts for acting man.

We are not dealing at this point of our investigation with the problem of a "quantitative science of economics," but with the analysis of the mental processes performed by acting man in applying quantitative distinctions when planning conduct. As action is always directed toward influencing a future state of affairs, economic calculation always deals with the future. As far as it takes past events and exchange ratios of the past into consideration, it does so only for the sake of an arrangement of future action.

The task which acting man wants to achieve by economic calculation is to establish the outcome of acting by contrasting input and output. Economic calculation is either an estimate of the expected outcome of future action or the establishment of the outcome of past action. But the latter does not serve merely historical and didactic aims. Its practical meaning is to show how much one is free to consume without impairing the future capacity to produce. It is with regard to this problem that the fundamental notions of economic calculation — capital and income, profit and loss, spending and saving, cost and yield — are developed. The practical employment of these notions and of all notions derived from them is inseparably linked with the operation of a market in which goods and services of all orders are exchanged against a universally used medium of exchange, viz., money. They would be merely academic, without any relevance for acting within a world with a different structure of action.

I cannot believe Mises was merely saying that if the socialist planners possessed in some remarkable way all the information normally conveyed by genuine market prices, they still would be stymied by inability to perform calculations in the narrow arith­metical sense, an inability that advances in supercomputers might conceivably overcome.Yeager, "Mises and Hayek," p. 94. Italics in the original.

Yeager then asserts that Joseph Salerno, Murray Rothbard, and I (SRH) claim that this is what Mises meant. If Yeager means by this assertion that we believe that this is Mises's entire calculation argument, then Salerno is correct in responding that, "it is wholly beside the point, because it rests on a gross misinterpretation of the meaning explicitly attached to the term 'calculation problem' by SRH."Joseph Salerno, "Reply to Leland B. Yeager on 'Mises and Hayek on Calculation and Knowledge,'" Review of Austrian Economics 7, no. 2 (1994): 112. In response to Yeager, Salerno says,

it does not follow that, for SRH, the calculation problem as Mises conceived it refers narrowly to the mathematical techniques employed for manipulating the given quantitative data; it refers, instead, to the origination and meaningfulness of the data them­selves. It is, in short, a problem of "appraisement" and not of "arithmetic."Ibid. Italics in the original.

From this beginning point, he proceeds to cogently rebut Yeager's claim by demonstrating that entrepreneurial appraisal is not subsumed under market information.

Yet Yeager seems to imply something else in his claim that by its nature goes untouched by Salerno's rebuttal. Yeager seems to imply that the arithmetic facet of Mises's calculation argument is trivial. This claim is not only false but is odd coming from a student of Mises's work; for Mises made several true and non­trivial arguments based solely on arithmetic or mathematics and statistics, more generally: the impossibility of interpersonal util­ity comparisons (lack of a unit of subjective value), the impossi­bility of economic calculation (inability of comparing heterogene­ous units of factors of production), the impossibility of mathe­matical equations in economic theorizing (lack of constants in human action), and the impossibility of statistical analysis in economic theory (lack of a probability density function for the data of human action).Mises discusses each of these points in Human Action: A Treatise on Econom­ics (Chicago: Henry Regnery, (1949] 1966). Acceptance of these merely arithmetic, mathematic, and statistical points destroys several major branches of orthodox economic theory: utility and welfare, social­ist, mathematical, macroeconomics, and econometrics. Together these constitute a significant portion of what passes for economic thought today.

While it is true that Mises's calculation argument is not merely arithmetic; it is also true that it is not merely appraise­ment. Mises argued that economic calculation is a problem of both arithmetic and appraisement.I am not asserting that Salerno fails to understand or appreciate the arithmetic facet of Mises's concept of calculation. He mentions it twice in his "Reply to Yeager," (pp. 112 and 120) and it is this point that Yeager himself notices in Salerno's work. My contention is only that proper recognition of this facet of Mises's argument also defeats the Yeager position. More precisely, Mises's calculation argument has two dimensions: the impossibility of central planners performing the arithmetic of profit and loss computa­tion in pure socialism which, in turn, makes it impossible for them to engage in entrepreneurial appraisals necessary to give meaning to profit and loss, and, thus, rationally allocate factors of production.By the phrase, "impossibility of performing the arithmetic of profit and loss computation," we do not have in mind what Yeager seems to accuse us of meaning. As Salerno says, "the Misesian demonstration of the logical impossibility of socialism is not predicated on the central planners' incapacity to perform tasks that can conceivably be carried out by individual human minds," including adding and subtracting. See Salerno, "Reply to Yeager," p. 112. The arithmetic problem of calculation is not the inability to add common units together, it is the absence of such units. No "advances in supercomputers" can overcome the impossibility of adding together apples and oranges. Although information enters into the latter, it cannot enter into the former.These two steps correspond to the two conditions Mises claimed were neces­sary for calculation to take place: voluntary exchange of all goods including factors of higher order and the use in these exchanges of money. The first is necessary to bring higher-order capital goods under the orbit of the entrepreneurial "intellec­tual division oflabor"; the second is necessary because without it, "It would not be possible to reduce all exchange-relationships to a common denominator." See Ludwig von Mises, Economic Calculation in the Socialist Commonwealth (Auburn, Ala.: Ludwig von Mises Institute, [1920] 1990), pp. 17-18.

The arithmetic facet of Mises's argument deals with the ex­istence, or lack thereof, of a format in which information can be put and appraisals can be made. A format is necessary because the "raw data" required to answer relevant economic questions posed by the operation of a social process of exchange and division of labor are denominated in incommensurate units. Unless these units can be converted into a common standard, they cannot be compared; unless they can be compared the economic questions cannot be answered. As Mises said of one socialist scheme of economic calculation, "Calculation in kind is to be substituted for calculation in terms of money. This method is worthless. One cannot add or subtract numbers of different kinds (heterogeneous quantities)."Ludwig von Mises, Human Action, p. 703. The impossibility of comparing the number of ap­ples to the number of oranges is an arithmetic problem; and a fundamental, not trivial, problem of arithmetic. Without its solu­tion, no arithmetic operations can be conducted at all.

The profit and loss calculation solves the arithmetic problem inherent in answering both economic questions posed by the operation of a social process of exchange and division of labor: what consumer goods should be produced and which combination of factors of production should be used to produce each consumer good. The arithmetic problem of the first question is the incommensurability of the subjective values of different individuals who participate in the social process of exchange and division of labor. There are two dimensions to the impossibility of making interpersonal comparisons of utility: no unit can be defined for preferences since they are subjective and even if units of subjec­tive value existed for each person, they would not be comparable from one person to another.As Mises said, "In an exchange economy the objective exchange value of commodities enters as the unit of economic calculation. This ... renders it possible to base the calculation upon the valuations of all participants in trade. The subjective use value of each is not immediately comparable as a purely subjective phenomenon with the subjective use value of other men. It only becomes so in exchange value, which arises out of the interplay of the subjective valuations of all who take part in exchange." Mises, Economic Calculation, p. 12.

The solution to the problem of the incommensurability of the subjective values of individuals and the answer to the question of what consumer goods should be produced to satisfy them lies in the possibility of market prices denominated in money. Con­sumers demonstrate their preferences for some goods relative to others by purchasing and refusing to purchase. Since all prefer­ences are demonstrated using the same standard, viz. money, the effects of action based on these preferences, viz. money prices, are commensurate, and, therefore, formatted for meaningful eco­nomic calculation.

Entrepreneurs then impute market value to each factor of production according to its marginal value product via their demand for the factors. Factors prices are then determined by the intensity of entrepreneurial demand relative to the opportunity cost placed on them by their owners. These prices make the different units of the factors commensurate and therefore, permit entrepreneurs to efficiently allocate factors across the production of consumer goods.lbid., p. 23.

As a student of Mises's work, Yeager is surely familiar with his account of the relationship between the subjective values of consumers and market prices as well as the impossibility of interpersonal utility comparisons. Even for those economists, few in number and among whom one should not expect to find Yeager, who disagree with the latter claim, it would seem strange for them to characterize the problem of interpersonal utility comparisons as anything but an arithmetic problem. You can only add or subtract items of like units. This fact is both arithmetic and non-trivial. An entire branch of economics (wel­fare economics) crashed to the ground on this point and another branch (utility economics) was completely revamped because of it.The old welfare economics and utility economics were based on the concept of cardinal utility which embodied two arithmetic mistakes: units of subjective value are possible and such units are interpersonally comparable. See Murray N. Rothbard, "Toward a Reconstruction of Utility and Welfare Economics," in On Freedom and Free Enterprise, Mary Sennholz, ed. (Princeton: Van Nostrand, 1956), pp. 224-62. The arithmetic dimension of Mises's calcula­tion argument is based on the same arithmetic truth that makes interpersonal utility comparisons impossible; and recog­nition of this fact helps clarify and strengthen instead of, "cari­cature and trivialize," Mises's argument as Yeager claims.Yeager, "Mises and Hayek," p. 94.

Mises understood that the question of what consumer goods should be produced can be answered by the central planners and therefore, is not a barrier to the establishment of a centrally-planned economy.Mises, Human Action, pp. 695-98. The planners can do this by simply substituting their preferences for the unknowable and incomparable preferences of consumers. They produce, or attempt to produce, the goods they themselves value. This solution, however, is arbitrary with refer­ence to the preferences of consumers. These, the central planners cannot know and even if they did they could not make the relevant comparisons to determine what subset of valuable goods should be produced to the exclusion of other goods consumers find valu­able. Central planners with perfect information of consumer preferences still could not calculate what to produce to satisfy such preferences because they are ordinal rankings and there­fore, cannot be compared. Even if central planners had perfect information of the subjective values of each individual denomi­nated in units, they could not perform economic calculation be­cause it is impossible to compare any items that are denominated in dissimilar units. Only if the central planners knew how to convert the subjective units of each individual into a common standard would they be able to perform this part of economic calculation.

The central arithmetic facet of Mises's calculation critique is the incommensurability of the different factors of production that could be combined in different ways to produce each consumer good. Hours of labor cannot be compared to acres of land nor can these units be compared to units of each capital good. As Mises, discussing his example of central planners contemplating build­ing a railroad, wrote in 1920, "Where one cannot express hours of labor, iron, coal, all kinds of building material, machines and other things necessary for the construction and upkeep of the railroad in a common unit it is not possible to make calculations at all. The drawing up of bills on an economic basis is only possible where all the goods concerned can be referred back to money."Mises, Economic Calculation, p. 25. Nearly thirty years later, he wrote,

The director wants to build a house. Now, there are many methods that can be resorted to.... Which method should the director choose? He cannot reduce to a common denominator the items of various materials and various kinds of labor to be expended. Therefore he cannot compare them.... In short, he cannot, in comparing costs to be expended and gains to be earned, resort to any arithmetical operation.Mises, Human Action, p. 698.

Concerning the pricing process of the market by which economic calculation solves the problem of incommensurability, Mises con­cluded that socialism cannot reduce the value of the means of production to "the uniform expression of a money price." In a market economy, "all prices can be referred back to a common expression in terms of money."Mises, Economic Calculation, pp. 23-24.

If there were no arithmetic facet of this "common expression in terms of money," (contrary to Mises's explicit statement that there is) then the problem of economic calculation would not exist since the planners could discover the value of each factor in each use by withdrawing it.

Mises summed up the problem of calculation in socialism by saying, "In the main, socialist production might only appear rationally realizable, if it provided an objectively recognizable unit of value, which would permit of economic calculation in an economy where neither money nor exchange were present."Ibid., p. 33. If this problem has no merely arithmetic facet, then why did socialists struggle to employ the labor theory of value to solve it? Mises finished the quote above by saying, "And only labor can conceivably be considered as such." But, why not perform economic calculation in all factors of production at once claiming each of them to have intrinsic value and thereby dispense with the search for a "socially necessary" amount of labor, i.e., a common unit of labor in which all factors can be rendered? The existence of cardinal units is not sufficient for economic calculation to be performed. One cannot add together factors denominated in incomparable cardinal units, nor compare the efficiencies stated in cardinal numbers, e.g., the aver­age product of labor with the average product of capital, of different factors of production. The task of economic calculation requires, in addition to cardinal units, a method by which the different units can be transformed into a common cardinal unit.These two issues, the existence of cardinal units and the existence of a common denominator into which the various cardinal units can be put, are analogous to the two dimensions of the impossibility of making interpersonal comparisons of utility discussed above. If it is not necessary to have a common objective unit in which all factors can be meaningfully compared, then a large part of the debate about the labor theory of value was so much spilled ink.

Yeager's contention about the arithmetic facet of Mises's ar­gument makes it neither erroneous nor trivial. To the contrary, it is both correct and devastating to naive socialists who believe that the economic problem of factor usage can be solved by central planners in the absence of profit and loss calculation based on monetary prices, i.e., in pure socialism, including those who think the problem could be solved by "advances in super-computers."

It is only to defeat those socialists who wish to enter the debate on economic theory that Mises moves to more complex dimensions of his calculation argument.Mises moves to some of these steps, in a different order than that presented here, when addressing a list of suggestions for socialist economic calculation in Human Action, pp. 703ff. To the assertion that socialism can overcome the incommensurability of different factors by having central planners set monetary prices for all goods and factors, Mises responds that the problem is calculation of objective value, not objective units per se. Such a procedure would not solve the allocation problem since it leads to a "solution" that is arbitrary even from the viewpoint of the central planners, let alone that of consumers. The problem of factor usage cannot be solved by having the central planners assign a monetary wage to be multi­plied by labor hours, and so on for each factor, so that the monetary costs of different combinations of factors capable of producing a given consumer good can be compared and the least cost method selected. Such cost calculations have no relationship to the preferences placed on the consumer goods and therefore, are useless for economic calculation. Only the market process can connect the value of factors to the value of consumer goods in a meaningful way.

Mises demonstrates this point by allowing that a socialist state could have a medium of exchange, limited in its scope to trading in some consumer goods. But, as he said,

where the means of production are state controlled ... because no production good will ever become the object of exchange, it will be impossible to determine its money value. Money could never fill in a socialist state the role it fills in a competitive society in determining the value of production goods. Calculation in terms of money will here be impossible.Mises, Economic Calculation, p. 6.

To the assertion that the central planners can overcome the arbitrary nature of prices set by their own decree by having the managers of state-operated production facilities act as if they were entrepreneurs engaged in trade, Mises argues that one cannot "play" market.Mises, Human Action, pp. 707-9. For entrepreneurial competition to per­form the function of factor evaluation, the possibility of bearing the opportunity costs of different factor allocations must be real. Only with private property can entrepreneurs and capitalists risk their own wealth in the process of social production and therefore be in a position to make accurate appraisals of factor values.Mises, Economic Calculation, p. 28.,One particular target Mises aimed at was the "market socialism" of Oskar Lange in his, "On the Economic Theory of Socialism," reprinted in On the Economic Theory of Socialism, vol. 2, Benjamin Lippincott, ed. (Minneapolis: University of Minnesota Press, 1938), pp. 57-129. Yeager, in using the debate between Mises and Lange as the text for criticizing the SRH view, reveals the source of his lack of appreciation for the arithmetic facet ofMises's calculation argument. See Yeager, "Mises and Hayek," pp. 103ff. Mises had no need to mention the arithmetic problem in response to Lange; market socialism overcomes that problem by employing money—the common denominator necessarily absent in a pure socialist system—and money prices. Mises was, thus, required to move to more complex dimensions of his calculation argument and criticize market socialism for its inability to perform entrepreneurial appraisals based on money prices which are not established in market exchanges of private property.     Because Rothbard fails to mention the arithmetic facet of calculation but does mention information in discussing the debate between Mises and Lange, Yeager attempts to construe Rothbard as once holding the Yeager position and then shifting to the SRH view. See Yeager, "Mises and Hayek," p. 106. But Rothbard had no more reason to mention the arithmetic facet of calculation in this context than did Mises. Moreover, neither Mises, nor Salerno, nor Rothbard, nor I claim that the central planners do not face an information problem. The SRH claim is that Mises's calculation argument has more to it than the information problem. Yeager's claim that it does not is not proven by noting that Mises and SRH recognize information as a problem. To argue that play acting could mimic the results of the market was to confuse the functions of management with those of entrepreneurship.

One cannot play speculation and investment. The speculators and investors expose their own wealth, their own destiny. This fact makes them responsible to the consumers.... If one relieves them of this responsibility one deprives them of their very character. They are no longer businessmen, but just the group of men to whom the director has handed over his main task, the supreme direction of the conduct of affairs. Then they—and not the nomi­nal director—become the true directors and have to face the same problem the nominal director could not solve: the problem of economic calculation.Ibid., p. 709. Italics in the original.

To the assertion that the central planners can overcome the "game-playing'' nature of market socialism by using the pre-ex­isting market set of prices, i.e., those prices existing in the capitalist system just prior to socialization, Mises argues that the transition from capitalism to socialism is too fundamental for the old prices to bridge the gap and that pricing must be "dynamic" since underlying economic phenomena are constantly changing. By destroying the differences in wealth in the existing market economy when expropriating private property, socialism discon­nects the prices that correspond to those inequalities with the different conditions now prevailing for which calculations must be made. Moreover, any changes in conditions that underlie the eco­nomic allocation off actors makes the existing set of prices obsolete, and all the more so the greater the extent of such changes.Mises, Economic Calculation, pp. 25-26.

Furthermore, as Salerno pointed out, Mises understood that answering the economic questions of what and how to produce requires entrepreneurs to correctly project appraisals of goods and factors into the future.Salerno, "Reply to Yeager," pp. 120-23. Since the data are continually changing, static modeling cannot be substituted for entrepre­neurs to perform economic calculation. Comparative statics serves no better since it cannot determine how human action moves the solution from one point to another.Mises, Human Action, pp. 710-11.

Moreover, general equilibrium is irrelevant to the actual problem that economic calculation must solve and that can be done so only by entrepreneurial activity. Neither the actual prices, both present and future, nor the preferences necessary for factor allocations to be made have any relationship to those of equilibrium. As Mises said, "what impels a man toward change and innovation is not the vision of equilibrium prices, but the anticipation of the height of the prices of a limited number of articles as they will prevail on the market on the date at which he plans to sell."Ibid., p. 711.

General equilibrium equations are formed by knowing the constants of those equations, under the assumption that no fur­ther change in the data is permissible. Without the assumption of no further changes, no constants exist and no equations can be formed. Yet, the economic system cannot achieve, or move toward, the equilibrium without changes from the existing set of data. The equations are, thus, useless for the task of allocating factors of production toward their general equilibrium uses. As Mises said, "What acting man needs to know is not the state of affairs under equilibrium, but information about the most appropriate method of transforming, by successive steps, [the total supply of produced factors allocated as they are today] into [the total supply of produced factors allocated as they need to be in equilib­rium]. With regard to this task the equations are useless."Ibid., pp. 712-13.

Even if the central planners had full knowledge of the state of general equilibrium and could see how to move production from original factors to the final equilibrium state, this would not suffice to circumvent the problem that only economic calculation can solve. The existing state of production does not correspond to any state of this perfect-knowledge production process. Existing capital goods embody past allocation errors relative to their perfect knowledge uses. Since these capital goods can neither be freely transferred into other uses nor transferred efficiently with­out taking account of their existing characteristics, central plan­ners with perfect knowledge would still need to resort to economic calculation to properly allocate them. Mises concludes his discus­sion of economic calculation at this step where no recourse is made to the arithmetic facet of the argument when viewed in its entirety.Ibid., pp. 713-14.

Instead of realizing the logical construction of Mises's argu­ment—beginning with its arithmetic facet and then in turn al­lowing, for the sake of argument, that the central planners can overcome progressively more difficult aspects of the calculation problem—Yeager implies that SRH assume that Mises was con­ceding that the central planners could solve these problems. Yeager says,

The necessary preparations for the vast central calculation, let alone the calculation itself, could not be accomplished; they are, to use Mises's word, "impossible." It seems perverse, then, to interpret Mises as nevertheless conceding the possibility of all those preparations and of balking only at the possibility of the calculation itself.Yeager, "Mises and Hayek," p. 101. Italics in the original. Also, see his other statements on Mises's concessions, pp. 97-98.

But Mises did not concede that a "preparation" or "information" problem could be solved by the central planners in the actual operation of socialism. He conceded the solution to these problems, for the sake of argument, for the very purpose of demonstrating that his calculation argument proved the impossibility of eco­nomic calculation, even if these problems were solved. The fact that he chose this method of argumentation is proof that his calculation argument has more to it than just the lack of infor­mation available to central planners.

In fact, Mises "concedes" much more than the solution to the "information" problem, in the final step of his argument. If Yeager has this perfect-information scenario in mind in his quote at the beginning of this article, then he misstates Mises's hypothetical conditions (under which there is no arithmetic facet of the argu­ment). Mises is not, here, assuming that the central planner has perfect information and therefore, can perform economic calcula­tion, as Yeager implies in his quote. Mises is assuming that the central planner has "miraculously" solved the problems of eco­nomic calculation—not just information but calculation it­self—and could therefore construct a perfect production structure over time, starting without any capital goods, to achieve some final equilibrium state. Even if the central planners had perfect information and the ability to calculate with that information, however, they still could not calculate how to effectively operate any actual existing economy they are attempting to control.

If Yeager means what he seems to say—that Mises could not have meant that a central planner with perfect information about preferences and factor conditions could not perform the arithmetic operations necessary to calculate—then he is wrong; for this is precisely the first step of Mises's argument demon­strating the impossibility of economic calculation in the socialist commonwealth.Mises explicitly made these assumptions in the development of his calcula­tion argument. In addition to the statements already quoted, see Mises, Human Action, p. 696.

On the importance of the arithmetic aspect of the economic calculation, Mises said,

every action can make use of ordinal numbers. For the application of cardinal numbers and for the arithmetical computation based on them special conditions are required. These conditions emerged in the historical evolution of the contractual society. Thus the way was opened for computation and calculation in the planning of future action and in establishing the effects achieved by past action. Cardinal numbers and their use in arithmetical operations are also eternal and immutable categories of the hu­man mind. But their applicability to premeditation and the re­cording of action depends on certain conditions which were not given in the early state of human affairs, which appeared only later, and which could possibly disappear again ...

Modern civilization is above all characterized by the fact that it has elaborated a method which makes the use of arithmetic possible in a broad field of activities. This is what people have in mind when attributing to it the—not very expedient and often misleading—epithet of rationality.Ibid., p. 199.

A Man of Principle: Essays in Honor of Hans F. SennholzJohn W. Robbins and Mark Spangler, eds.Grove City, Pennsylvania: Grove City College Press, 1992.

An important contributing factor to the resurgence of Aus­trian economics in the 1970s was the appearance of a handful of articles which drew the attention of the economics profession profession to the distinctiveness of the tradition of economic theorizing founded by Carl Menger.For example, Erich Streissler, "To What Extent Was the Austrian School Margi­nalist?," History of Political Economy 4 (Fall 1972): 426-41; William Jaffe, "Menger, Jevons and Walras De-Homogenized," Economic Inquiry 14 (December 1976): 511-24; and the articles in the Special Issue on Carl Menger and the Austrian School of Economics, Atlantic Economic Journal 6 (September 1978). Arguably the most influential of these articles was written by the eminent Walras scholar, William Jaffe, and entitled "Menger, Jevons and Walras Dehomogenized."Jaffe, "Menger, Jevons and Walras De-Homogenized." In this article, Jaffe argued persuasively that the three founders of margi­nalism, whose contributions up to that point had tended to be conflated due to an exclusive focus on their contemporaneous discoveries of the marginal principle, each initiated a separate and distinct tradition of economic method and analysis. Taken in conjunction with the 1974 award to F. A. Hayek of the Nobel Prize in Economics and the scholarly conferences on Austrian economics held annually between 1974 and 1976, this article and the others mentioned above broadened and reinforced recognition of and interest in contemporary Austrian economics as an alternative to the prevailing neoclassical paradigm.

But the Mengerian tradition was developed in very different directions by his brilliant followers, Eugen von Böhm-Bawerk and Friedrich von Wieser, and by their own students and followers. Without tracing out this doctrinal development in any detail, suffice it to say that today the term "Austrian economics" is used to designate two very different paradigms. One derives from Wieser and may be termed the "Hayekian" paradigm, because it represents an elabora­tion and systematization of the views held by F. A. Hayek, a student of Wieser's at the University of Vienna. Although it is yet to be generally recognized by Austrians, Wieser's influence on Hayek was considerable and is especially revealed in the latter's early work on imputation theory, which sought to vindicate the Wieserian (as against the Böhm-Bawerkian-Misesian) position that the imputation problem must be solved within the context of an exchangeless econ­omy subject to the control of a single will yet somehow able to calculate using (subjective) value as the "arithmetic form of utility."See, especially, F. A. Hayek, "Some Remarks on the Problem of Imputation," in idem Money, Capital, and Fluctuations: Early Essays, Roy McCloughry, ed. (Chicago: University of Chicago Press, 1984), pp. 33-54. That there is no possibility of economic calculation and rational or purposeful allocation of resources within an economy based on division of labor where one will alone acts is , of course, the essence of Mises's critique of socialism. Perceiving the unbridgeable gulf between his own and Wieser's position on the possibility of directly imputing values to higher-order goods in the absence of monetary exchange, Mises, in his Notes and Recollections ([Spring Mills, Ill.: Libertarian Press, 1978], p. 36), wrote that "[Wieser's] imputation theory is untenable. His ideas on value calculation justify the conclusion that he could not be called a member of the Austrian School, but rather was a member of the Lausanne School." Also, Hayek, explicitly following Wieser, conceives the main problem of capital theory to be to explain how it is that the non permanent resources constituting the capital stock can yield a permanent net (physical) return (F. A. Hayek, The Pure Theory of Capital [Chicago: University of Chicago Press, 1952], pp. 54-55). This Wieser-Hayek method of describing the quaesitum of capital theory loads the dice in favor of explaining the interest return on capital in terms of productivity (rather than time-preference) considerations and, at the same time, diverts attention from what Böhm-Bawerk brilliantly perceived to be the fundamental question that must be satisfactorily answered by a correct theory of interest and was so answered by Mises's pure time-preference theory: What is the cause of the difference in value between goods which differ only in their temporal availability? In theorizing on capital, moreover, Hayek (ibid., pp. 27, 156) makes significant use of the Wieserian device of a communist society subject to the control of an omniscient dictator, a device which reflects a paradigmatic lack of concern with problems of monetary appraise­ment and calculation. Finally, we have Hayek's revelation that his neutral-money doctrine represents a development, albeit "unconscious," of Wieser's remarks on the effects of "a one-sided supply of money" (Hayek, "On Neutral Money," in idem, Money, Capital, and Fluctuations, p. 160). The Hayekian paradigm stresses the fragmentation of knowledge and its dispersion among the multitude of individual consumers and producers as the primary problem of social and economic cooperation and views the market's price system as the means by which such dispersed knowledge is ferreted out and communicated to the rele­vant decision-makers in the production process.Thus, for example, Wieser's critique of central planning rests on a proto-Hayekian view of the market as the means for solving knowledge problems. Writes Wieser (Social Economics, A. Ford Hinrichs, trans. [New York: Augustus M. Kelley, 1967], pp. 396-97): "The one will and command which, in war and for legal unity, is essential and indispensable as the connecting tie of the common forces, detracts in economic joint action from the efficacy of the agency. In the economy, though it has become social, work is always to be performed fractionally .... Part-performances of this sort will be executed far more effectively by thousands and millions of human beings, seeing with thousands and millions of eyes, exerting as many wills: they will be balanced, one against the other, far more accurately than if all these actions, like some complex mechanism, had to be guided and directed by some superior control. A central prompter of this sort could never be informed of countless possibilities, to be met with in every individual case, as regards the utmost utility to be derived from given circumstances or the best steps to be taken for future advancement and progress." I am indebted to Peter Boettke, of New York University, or calling my attention to this passage.

The other paradigm is the "Misesian" paradigm, so called because Ludwig von Mises was the first to systematically expound it. This paradigm represents a development of Böhm-Bawerk's thought and focuses on monetary calculation using actual market prices as the necessary precondition for the rational allocation of resources within an economic system featuring specialization and division of labor.On the crucial significance of monetary calculation in the Misesian paradigm see Joseph T. Salerno, "Ludwig von Mises as Social Rationalist," Review of Austrian Economics 4 ( 1990): 36-41. Also see idem, "Two Traditions in Modern Monetary Theory: John Law and A. R. J. Turgot," Journal des Economistes et des Etudes Humaines 2 (June/September 1991): 368-70.

Unfortunately, the majority of those who currently regard them­selves as "Austrian economists" have failed to recognize the consid­erable differences between these two paradigms. And because Mises was the main influence on Hayek's early writings on business cycle theory and on socialist calculation, the most important manifesta­tion of this failure is the tendency to attribute to Mises positions originated by Hayek or independently developed by those working within the Hayekian paradigm. This tendency is reinforced by what may be called the ''Whig presumption," still inexplicably prevailing among many Austrians despite the publication of Thomas Kuhn's book three decades ago, that since Hayek "came after" Mises he must have incorporated in his own work all that was worthwhile in his predecessor's.This recrudescence of the "Whig presumption" among members and observers of the current Austrian school was recently brought to light in Murray N. Rothbard, The Present State of Austrian Economics, Working Paper from the Ludwig von Mises Institute, Auburn, Alabama (November 1992), pp. 4-5. The result is that attention has been deflected from the Misesian paradigm, and those seeking to deepen and extend it have found it increasingly difficult to gain recognition for their own efforts or to channel the interests and efforts of younger Austrian scholars into the same endeavor. There thus currently exists a press­ing need, especially for Misesians, to undertake the task of a coura­geous and thoroughgoing doctrinal dehomogenization of Hayek and Mises.

Evidence of this need is presented in some of the contributions to this Festschrift honoring Hans Sennholz-ironically, a student of Mises's whose writings on most topics fall squarely within the Mis­esian paradigm. While this volume contains many informative, in­structive, or inspiring papers by individuals who have been associ­ated with Dr. Sennholz in various capacities or who have been profoundly influenced by his prodigious and insightful writings on a broad range of politico-economic subjects, I am mainly interested in a handful of contributions from academic Austrian economists. Rather than offering a critical analysis of these papers, I will restrict myself to demonstrating that, in each case, the author imputes to Mises implicit or explicit support for or authorship of one or more positions originated by Hayek or rooted in a Hayekian view of the market's pricing process.

Let me begin with Israel M. Kirzner's contribution on "Human Action, Freedom and Economic Science" (pp. 241-49), which deals with the evolution of his own understanding of the Misesian concept of human action from the publication of his first book in 1960Israel M. Kirzner, The Economic Point of View: An Essay in the History of Economic Thought, 2nd ed. (1960; Kansas City: Sheed and Ward, 1976). to 1991, the year the essay under review was completed. In this essay, Kirzner explicitly repudiates the position he took in the concluding chapter of his 1960 book that the defining element of human action is "pur­posefulness" narrowly construed as expressed in economizing and choice and that the entire structure of Misesian economics, including its adumbration of the dynamic market process, can be logically deduced from insight into the "power of reason to guide purposeful behavior" (p. 244). Now, Kirzner informs us, he has come to realize that his earlier understanding of Mises's position is "inadequate," because it can only yield conclusions about "decisions made in given situations" and is thus incapable of analyzing "those systematic market proc­esses which are so central to Misesian economics" (p. 244).

While Kirzner still ascribes a central role to the concept of purposefulness in his reinterpretation of Mises, it is a concept purged of explicit reference to economizing and choice and completely rede­fined in terms of alertness and discovery. Thus for Kirzner, "the purposefulness of human action . . . is the essential key to the discovery by agents that they are in fact not in the 'given situations' which they had hitherto assumed to be relevant," and it is the "purposefulness which defines and identifies conscious human ac­tion" that motivates "alertness to the dynamic world in which we live" (pp. 245, 247). These essential attributes of purposefulness are summed up elsewhere by Kirzner in the statement that "purposive human action involves a posture of alertness toward the discovery of as yet unperceived opportunities and their exploitation."Israel M. Kirzner, Perception, Opportunity, and Profit: Studies in the Theory of Entrepreneurship (Chicago: University of Chicago Press, 1979), p. 109. To be sure, in proposing this definition, it is not Kirzner's intention to completely ignore the aspect of purposefulness that is expressed in human choice.Ibid., pp. 28, 30–31. However, he offers no argument establishing a logical link between these two aspects of purposefulness and merely asserts a predominating "propensity," inherent in human action, "to sniff out opportunities lurking around the corner," "to discover what is useful," to be alert to opportunities," "to notice what may be useful," etc. By this procedure, Kirzner hopes to provide a praxeological foundation for the empirical tendency of the market process toward equilibrium that is alleged by Hayek.Ibid., pp. 13–33. Thus Kirzner dismisses what he calls "any programmed pattern of allocative maximization" or "static decision making," i.e., choice, as a trivial expression of purposefulness that is unable to illuminate the equilibrating tendencies of the dynamic market process. In its stead he proposes "discovery," i.e., "man's entrepreneurial propensity to discover changes which can redound to his benefit," as the hallmark of purposive human action (p. 245).

It is important to reiterate at this point that Kirzner is not faulting Mises's conception of purposeful behavior but his own earlier failure to fully comprehend this conception, thereby imputing to Mises the origination of the discovery perspective which Kirzner has so elegantly elaborated in his later works. Thus when confronting the question of why Mises apparently endorsed Kirzner's earlier, mis­taken interpretation of his position by writing a laudatory Foreword to Kirzner's 1960 book, Kirzner responds that Mises did not "explic­itly articulate" the insights yielded by this perspective and therefore may well have believed that what was implicit in his own position was also implicit in Kirzner's "superficial exposition" of that position. Or, alternatively and even less plausibly, Kirzner speculates that Mises himself may not have been consciously aware of these momen­tous implications of his own thought (p. 249, n. 1).

I would like to suggest however that the simplest and most plausible explanation for Mises's uncensorious Foreword is the cor­rect one: Kirzner's concluding chapter gave a full and accurate expli­cation of what Mises knew to be his own "economic point of view," whose central element Mises himself repeatedly and explicitly char­acterized as purposive human action describable in terms of choice and the efficient allocation of scarce resources. Moreover, contrary to Kirzner's contention, Mises did indeed succeed in deducing from this restricted notion of purposeful behavior catallactic theorems relevant to the analysis of the dynamic market process. Preliminary to arguing this point, I will demonstrate that Kirzner's emphasis on discovery as the essence of purposiveness leaves him unable to logically account for the choice process and, ultimately, for the very existence of acting man.

For Mises, human action, whether isolated or involving monetary exchange, is always motivated by the eagerness of the actor to enhance his welfare and consists of choosing among alternative employments of resources whose necessarily future results are not known with certainty. Because the choice process logically implies uncertainty—choice and action would be obviously futile in a world where humans are predestined to endure a rigidly unchangeable sequence of future events known with perfect certainty—the prereq­uisite of any specific act of choice is the acquisition of knowledge, via direct experience or from other sources of information, about the events and prevailing circumstances of the recent past that may be relevant in formulating an "understanding" of the future conditions upon which the actions under consideration will impinge. For exam­ple, if the actor is choosing among alternative investments of re­sources for producing goods intended for sale on the market, then information about "current" prices, i.e., realized prices of the imme­diate past, in addition to qualitative knowledge concerning the most recent technical conditions of production and conditions underlying consumer demands, is an almost indispensable guide to forecasting future market conditions. It is only upon the basis of such knowledge and forecasts that the actor is able to appraise and estimate the future prices of the various products which enter into his calculations of monetary profit. These calculations permit his ranking of the alternative investments under consideration, which then enables him to purposefully and efficiently allocate his resources at the moment of choice.

Thus, for Mises, the moment of choice coincides with the emer­gence of a value scale that is the raison d'etre and consummation of the actor's previous "discovery" activities and that provides the framework for purposive behavior. Choice and action can only be con­ceived as occurring within such a "a given situation." Contrary to Kirzner's later interpretation of Mises, discovery cannot serve as the core of the central axiom in a praxeological system, precisely because there is no possibility of inferring from it the "given situation" prereq­uisite to the moment of choice. A being who is ever seeking to "discover changes that have occurred" in his situation can never act on those discoveries because he is incapable of creating the framework for choosing. In the newer Kirznerian interpretation, therefore, the Mis­esian homo agens has been transformed into homo quaerens, a per­petual and aimless seeker of new knowledge who is forever unable to turn it to account in improving his welfare; a shade who has become unstuck in (praxeological) time, having no existence in what Mises calls the "real present," that neverending sequence of "given situ­ations" which is created by purposive entrepreneurial evaluation of past experience and forecasting of the future and in which all action is initiated and all human life is lived.For Mises's conception of the "real present," see Human Action: A Treatise on Economics, 3rd ed. (Chicago: Henry Regnery, 1966), pp. 100-1. As Mises points out, "The present qua duration is the continuation of the conditions and opportunities given for action (ibid., p. 101). I have added the emphases in this quotation.

We have thus established that, according to Mises, "discovery" is logically implied in the very concept of choice and need not be posited as an independent facet of human purposiveness and, furthermore, that the propensity to discover new opportunities, when analyzed in isolation as the essential or predominant feature of purposiveness is incapable of generating any meaningful propositions about human action, not to mention the market process. Or, in other words, from the perspective of Misesian praxeology, entrepreneurial information gath­ering and forecasting are never autonomous and free-flowing activities directly expressing purposefulness, but are always rigidly governed by the exigencies of choosing under uncertainty. In my interpretation, therefore, it is a significant distortion of Mises's view to say with Kirzner that it is the discovery element in human action rather than "maximiz­ing rationality" that "drives the market" (p. 24 7); for Mises, it is the fact that the entrepreneur desires to efficiently allocate his resources in service of his goal of maximizing profit (and ultimately, utility) that drives both his quest for understanding of future market conditions and, when this quest culminates in the purposive choice of production processes, the dynamic market process.

But what of Kirzner's claim that a theorematic system derived from a concept of purposefulness lacking an independent discovery dimension is unable to elucidate "those dynamic processes through which the market absorbs and responds to exogenous changes" and which are central to Misesian economics (p. 245). In fact Misesian catallactics is exactly the spinning out of the implications of purpose­ful behavior engaged in by individuals who perceive the benefits of specialization and exchange described by the law of comparative advantage and whose productive activities are oriented by monetary calculation to satisfying anticipated consumer demands in the cheap­est possible way. For Mises one of the most important functions of the market process is to provide the meaningful numerical data, the money prices, that are used in such economic calculations. These computations of monetary profit enable each producer to discern and purposefully choose that pattern of uses for his resources that he expects to maximize his satisfaction from participation in the ex­change process. Because of the complexity of the technical interrela­tionships between the factors of production and the innumerable possibilities of their use and combination within a capital-using economy, without the ability to calculate, producers, no matter how much qualitative knowledge of the economic data they discovered or were endowed with, would never be able to use such knowledge in pursuit of their purposes and would abandon social cooperation under the division of labor as a means for enhancing their welfare.For recent discussions of Mises's contribution to the socialist calculation debate that characterize it as essentiaJly an argument about calculation and not knowledge, see Salerno, "Ludwig von Mises as Social Rationalist," pp. 41-49; idem, "Postscript: Why a Socialist Economy Is 'Impossible'," in Ludwig von Mises, Economic Calculation in the Socialist Commonwealth (Auburn, Ala.: Praxeology Press, 1990), pp. 51-71; Murray N. Rothbard, "The End of Socialism and the Calculation Debate Revisited," Review of Austrian Economics 5 (2) (1991): 51-76; and idem, "The Present State of Austrian Economics," pp. 19--22. It seems that Richard Ebeling now also interprets Mises's argu­ment along similar lines. See Richard M. Ebeling, "Introduction" in idem, The Global Failure of Socialism (Hillsdale, Mich.: Hillsdale College Press, 1992), pp. 6-8. Thus, severing choice from discovery, far from elucidating the nature and operation of the dynamic market process, yields the condition under which it ceases to operate.

Having linked up purposive individual behavior with the market process through the theory of monetary calculation, Mises then formulated his catallactic theory, based on Böhm-Bawerkian price theory and his own theory of the promoter-entrepreneur, to analyze the operation of this process. For purposes of arguing that Kirzner's view of the market process has much more in common with Hayek than Mises, allow me to briefly enumerate the most salient features of Mises's understanding of the dynamic market process as the outcome of calculable actions.

I focus first on the characteristics of the prices that are generated by the market process and serve as the data for economic calculation. These are realized prices; or, in other words, they are the actual outcome of the historical market process at each moment in time and are determined by the value scales of the marginal pairs in each market. They are, therefore, also market-clearing prices the estab­lishment of which coincides with a momentary situation, what Mises calls the "plain state of rest" (PSR),According to Mises (Human Action, p. 762), "The notion of the plain state of rest as developed by the elementary theory of prices is a faithful description of what comes to pass in the market at every instant. Any deviation of a market price from the height at which supply and demand are equal is-in the unhampered market­self-liquidating." For further discussion of the PSR, see ibid., pp. 244-45. Arthur Marget also clearly recognizes that all prices that actually emerge in the course of the historical market process are and must be market-clearing prices that create a temporary lull in the process. In Marget's words, "the prices which we must ulti­mately explain are the prices 'realized' at specific moments in clock time [and] the only demand and supply schedules which are directly relevant to the determination of these 'realized' prices are market demand and supply schedules prevailing at the moment the prices are 'realized' .... " (Arthur W. Marget, The Theory of Prices: A Re-examination of the Central Problem of Monetary Theory, 2 vols. [New York: Augustus M. Kelley, 1966], 2, p. 253). For an exposition of Marget's view of the pricing process and its relevance to monetary theory, see Joseph T. Salerno, "Ludwig von Mises's Monetary Theory in Light of Modern Monetary Thought," presented at the Austrian Scholars Conference, New York City, October 1992 (unpublished ms), pp. 46-50. in which no market participant, given his existing marginal-utility rankings of goods and money and knowledge of prevailing prices, can enhance his welfare by participating in further exchange. However, despite their charac­ter as market-clearing prices, these are also disequilibrium prices. Thus as a consequence of the unavoidable errors of entrepreneurial forecasting and price appraisement under uncertainty, most goods are sold at prices that do not conform to their monetary costs of production, thereby generating realized profits and losses for produc­ers. Nor does the law of one price for commodities and the associated but broader law of the absolute spatial equality of the purchasing power of money hold in the PSR, because market conditions are continually changing, while the information of each transactor about current conditions is necessarily incomplete and arbitrage processes do not operate instantaneously.For a Wicksteedian micro analysis of the market's tendency to rapidly establish and maintain interspatial equality in the purchasing power of money, see ibid., pp. 41-45.

Second, for Mises, the market process is open-ended and en­trepreneurial. It is open-ended because the continual exogenous changes in the economic data preclude it from ever reaching a state of long-run equilibrium or what Mises refers to as a "final state of rest" (FSR), in which all commodity prices and the purchasing power of money are perfectly arbitraged, speculative holding of commodity stocks is absent, and profits and losses have been completely eradi­cated.Mises's discussion of the nature and uses of the FSR concept can be found in Mises, Human Action, pp. 245-46. The FSR is an imaginary construct that enables the econo­mist to isolate and describe the entire sequence of adjustment, includ­ing the time-consuming reorientation of the production structure, which results from a given change in the economic data. In FSR analysis, the economist begins with an initial FSR, introduces an alteration in the data, i.e., in tastes, technology, money supply, etc., and then traces out the steps by which the market adjusts to a new FSR, all the while rigidly maintaining a ceteris paribus assumption. From this analysis it may be inferred that the reallocation of re­sources from less profitable to more profitable production processes coincides with an improvement in the satisfaction of consumer wants.

Or the economist may employ FSR analysis to demonstrate that, if at any point in time, all further changes in the economic data were to suddenly cease, the adjustment processes currently operating in response to past changes would eventually culminate in an FSR and, if no further changes intervened, in a state of eternally repetitive robotical activity or "evenly rotating economy" (ERE) in which uncertainty, entrepreneurship, and the demand for a medium of exchange are eliminated and the very conditions of choice and action abolished. This latter mode of employing the analysis is effec­tive in illustrating the point that at any instant in time all purposive behavior aimed at attaining a state of optimum satisfaction is tending toward establishing a state of nonaction. What prevents the emer­gence of such a state is the neverending flux in the means and ends of action. Thus, from the standpoint of Misesian catallactics, to declare that the market is "equilibrating" can never be taken to mean that the market process ever actually progresses toward a given long-run equilibrium in historical or calendar time. It can mean that the reallocations of productive resources undertaken by entrepre­neurs seeking to exploit anticipated profit opportunities—if and when such profits are realized—result in a relatively improved state of want satisfaction for consumers; or it can mean that the complex of autonomous yet coordinated choices and actions that constitute the market process, at any given moment in historical time, is aimed at establishing an optimum state of consumer satisfaction and would eventuate in such a state in the absence of further change in the data.

But despite its usefulness, FSR analysis was never intended by Mises to provide a grasp of the function of the entrepreneur or "promoter," whose activities drive the open-ended market process actually unfolding in time. For Mises, the promoter concept goes beyond the category of the pure entrepreneur derived from the action axiom, and its construction embodies cognition of a funda­mental datum of catallactic analysis: that some people are more adept than others at anticipating and adjusting to change.0n the "promoter" concept, see ibid., pp. 254-55, 303-11. As Mises (ibid., p. 585) points out, "What distinguishes the successful entrepreneur and promoter from other people is precisely the fact that he does not let himself be guided by what was and is [i.e., by realized prices], but arranges his affairs on the ground of his opinion about the future. He sees the past and present as other people do, but he judges the future in a different way ... . The impulse of his actions is that he appraises the factors of production and the future prices of the commodities which can be produced out of them in a different way from other people." Within the context of the Misesian market process, promoter-entrepreneurs are those who seek to profit by actively promoting adjustment to change. They are not content to passively adjust their catallactic activities to readily foreseeable changes or changes that have already occurred in their circumstances; rather, they regard change itself as an opportunity to meliorate their own conditions and aggressively attempt to anticipate and exploit it. The real market process is thus entrepreneurial in the sense that it is driven by an identifi­able, though ever-changing, class of individuals whose productive activities are guided by monetary calculations based upon purposeful and perpetual forecasting of an uncertain and changing future.It was William H. Hutt (The Keynesian Episode: A Reassessment [Indianapolis: LibertyPress, 1979], p. 165) who felicitously described entrepreneurial activity as "dominated by perpetual forecasting." As noted above, the prices used in such calculation are the appraised prices of the future, i.e., the prices anticipated to be realized at future moments of an open-ended market process that will never cease to be buffeted by changes in the economic data. It should be emphasized that these prices are not the same prices which emerge during the course of a ceteris paribus or "systematic" (as Kirzner terms it) market process smoothly progressing toward the FSR.

Third, and finally, Mises conceives the market process as coordi­native, "the essence of coordination of all elements of supply and demand."Ludwig von Mises, ''The Position of Money among Economic Goods," in Money, Method, and the Market Process: Essays in Honor of Ludwig von Mises, Richard M. Ebeling, ed. (Norwell, Mass.: Kluwer Academic Publishers, 1990), p. 65. This means that the structure of realized (disequilibrium) prices, which continually emerges in the course of the market process and whose elements are employed for monetary calculation, performs the indispensable function of clearing all markets and, in the process, coordinating the productive employments and combinations of all resources with one another and with the anticipated preferences of consumers. Such "price coordination," by insuring that scarce re­sources are secured by the entrepreneurs bidding the highest prices, also insures that at each instant Böhm-Bawerk's "Law of Costs" prevails, that is, that the constellation of resource prices that emerges on a market unhampered by legal restrictions always re­flects the circumstance that existing resources are devoted to their most valuable uses as determined by entrepreneurial appraisements of future output prices.On Böhm-Bawerk's law of costs as an early formulation of the concept of price coordination, see Salerno, "Two Traditions in Modern Monetary Theory," p. 369. Böhm­Bawerk's erroneous characterization of his law of costs as "a law which has only approximate validity and teems with exceptions" resulted from his failure to realize that this law does not depend on the assumption of perfect knowledge and foresight. The law of costs no more requires that entrepreneurs have perfect knowledge of future market conditions than the law of marginal utility requires that consumers are able to perfectly predict their future value scales. Both laws require for their full applicability only that agents, whether allocating resources to achieve final consumption goals or the business goal of pecuniary profit, evaluate and rank the anticipated outcomes of the alternative actions under consideration. For Böhm-Bawerk's statement of the law, see Eugen von Böhm-Bawerk, Capital and Interest, vol. 2, Positive Theory of Capital, George D. Huneke, trans. (Spring Mills, Penn.: Libertarian Press, 1959), pp. 248-56. Btihm-Baw­erk's error occurs on pp. 255-56. A more detailed presentation and defense of the law of costs can be found in idem, ''The Ultimate Standard of Value," in Shorter Classics of Eugen von Böhm-Bawerk (Spring Mills, Penn.: Libertarian Press, 1962), pp. 351-70. It should be noted that as a concept appli­cable to the real world of uncertainty and change, Misesian price coordination is consistent with the speculative withholding of labor and other resources from current production in anticipation of the later emergence or discovery of more valuable employments.On this point see, Joseph T. Salerno, "Commentary: The Concept of Coordination in Austrian Macroeconomics," in Richard M. Ebeling, ed., Austrian Economics: Perspec­tives on the Past and Prospects for the Future (Hillsdale, Mich.: Hillsdale College Press, 1991), pp. 330–40. While such speculative activities may modify the shape of the momentary supply and demand curves and the valuations of the marginal pairs in the affected markets, they do not in any way alter the coordinative quality of the market process.For an analysis of speculation which demonstrates that, whether successful or not, it does not impede the functioning of the coordinative market process, see Murray N. Rothbard, Man, Economy, and State: A Treatise on Economic Principles, 2 vols. (Los Angeles: Nash Publishing, 1970), 1, pp. 112-18.

From the Misesian perspective, price coordination is thus the very essence of the market and a necessary attribute of its real existence. As such it is an ex post concept. In the absence of price coordination, e.g., in a regime of all-around price controls, the alloca­tion of scarce resources within the social system of want satisfaction becomes purposeless and chaotic. The concept of equilibration, on the other hand, is an ex ante concept expressing recognition that entre­preneurs responding to the lure of expected monetary profits seek to anticipate and remove the continually emerging maladjustments between means and ends and that their success in doing so would culminate in a state of optimum satisfaction, i.e., nonaction. Equili­bration therefore presupposes price coordination in the same way that, in a nonsocial process of individual want satisfaction, purpose­ful allocation of resources presupposes the existence of a unitary value scale by means of which resources can be meaningfully evalu­ated and ranked.This understanding of equilibration as a strictly ex ante concept accords with the "purely logical concept of equilibration" superbly expounded and defended by George Selgin. See G. A. Selgin, "Praxeology and Understanding: An Analysis of the Contro­versy in Austrian Economics," Review of Austrian Economics 2 (1988): 33-43.

Let me now contrast this interpretation of Mises's view of the market process as deduced from the axiom of purposeful behavior with the Kirznerian interpretation that ascribes the axiomatic position in Mises's praxeological system to the proposition that individu­als have a propensity to discover changes that have already occurred in their given situations. In the latter interpretation, Mises does not view the market as an open-ended process, as a complex entwinement of mutually-influencing historical adjustment processes in various states of completion, a process which is constantly shifting direction in response to new changes in the data and never actually temporally approaches a state of final rest and nonaction. Rather, the Kirznerian interpretation emphasizes the market as a "systematic" process, one that really progresses toward equilibrium by effecting an increasing coordination of the plans of market participants. The ultimate goal of this process, the perfect coordination of individual plans, is an attribute of the final equilibrium state. But such "plan coordination" is worlds apart from the concept of price coordination adumbrated above. The latter concept, as I have argued, refers to a realized coordination of all the disparate and contingent individual buying and selling plans underlying the market demand and supply curves that actually exist at any given moment in a changing and uncertain world. Plan coordination, on the other hand, describes an imaginary situation in which automatons endlessly repeat a logically consistent pattern of actions, a situation that is akin to the perfect adaptation of the elements of a completely robotized factory to one another.

In fact, Kirzner's discovery perspective does not originate in Mises's concept of human action but in Hayek's conception of the market as a means for disseminating the knowledge which system­atically guides decentralized and initially ignorant decision-makers toward a full, ex ante coordination of their various production and consumption plans.Hayek (Pure Theory of Capital, p. 23) referred to this state of affairs as "a state of complete compatibility of ex ante plans." Adopting the preferred terminology of current Hayekians, I refer to it alternatively as "ex ante coordination of plans." But since ex ante plan coordination can only be achieved in long-run equilibrium—is a condition defining such equi­librium—as both Hayek and Kirzner recognize, Kirzner is forced to shift his analytical focus from the real-world, open-ended market process to a hypothetical market process which is generated by initial ignorance among market participants of the full range of exchange opportunities afforded by the prevailing and fixed con­figuration of the economic data and which must therefore eventually terminate in an FSR.

With the possibility of exogenous change and genuine uncertainty thus banished from its purview, Kirzner's analysis of the market process has no use for the concept of the dynamic promoter-entre­preneur who is perpetually forecasting and appraising the future in quest of anticipated profit opportunities. The market process is now characterized as driven toward its fixed and final goal of perfect-plan coordination by discoverer-entrepreneurs alert to "changes that have occurred in their very market situations," i.e., to contemporaneously emerging discrepancies between prices of the same good available at different locations or in different forms (virtual products, i.e., resources and actual products). In these quasi-static conditions, production loses its temporal dimension and may be conceived of as a matter of pure arbitrage, i.e., of simultaneously buying and selling the same good in spatially diffuse markets. It is only under these circumstances, where pro­ducers may be characterized as arbitrageurs, that the Hayekian proposition that information about prices of the immediate past substitutes for detailed qualitative knowledge of past and future market conditions in guiding the production process holds true. As producer-arbitrageurs act to exploit newly-discovered discrepancies between prevailing input and output prices, ignorance of mutually beneficial exchange opportunities among market participants meas­urably diminishes, the buying and selling plans of individuals are progressively coordinated (in the ex ante sense), and prices are sys­tematically driven toward their final equilibrium values.

Once we drop the assumption of an absence of exogenous change in analyzing the market process, Kirzner's characterizations of the entrepreneur as an alert discoverer of existing opportunities, of the market process as the means for plan coordination, and of realized prices as a surrogate for qualitative knowledge about the economic data all fall to the ground. And this we indeed must do in interpreting Mises, because he does not employ such an assumption for analyzing the function of the entrepreneur or deducing conclusions about the dynamic market process. As I pointed out above, for Mises, FSR analysis, which utilizes this assumption, is primarily useful for demonstrating that the consequences of a change in the economic data are not restricted to the initial adjustment of the market price but also involve longer-run adjustments in resource allocation and the production structure.

Hayek, on the other hand, even in his earliest writings on busi­ness-cycle theory, in which he was most heavily under Mises's influ­ence, envisaged the economy as actually departing from and rapidly returning toward a "static state" under impact of changes in the data. Thus, in Monetary Theory and the Trade Cycle, for instance, Hayek wrote that "For so long, at least, as disturbing monetary influences are not operating, we have to assume that the price which entrepre­neurs expect to result from a change in demand or from a change in the conditions of production will more or less coincide with the equilibrium price. For the entrepreneur ... will generally be in a position to estimate the price that will rule after the changes have taken place [i.e., in the new FSR]."F. A. Hayek, Monetary Theory and the Trade Cycle, N. Kaldor and H. M. Croome, trans. (New York: Augustus M. Kelley, 1966), p. 29.

While in later writings Hayek emphasized that the state of equilibrium and ex ante plan coordination is "an admittedly fictitious construction" never to be observed in the real world, he still insisted that the efficiency of the economic process is to be gauged by its observed proximity to such a state. Accordingly, in the Pure Theory of Capital, he argued that the "justification" of the concept of equi­librium "is not that it allows us to explain why real conditions should ever in any degree approximate towards a state of equilibrium, but that observation shows that they do to some extent so approximate, and that the functioning of the existing economic system will depend on the degree to which it approaches such a condition."Hayek, Pure Theory of Capital, pp. 27-28. Affirming the "tendency" of market prices to conform to their equilibrium levels, Hayek clearly indicates that he considers the historical market to usually operate in close proximity to the equilibrium state. Thus he defines "tendency" in the following terms: "A given phenomenon may tend to [approximate towards] a certain magnitude if in a great number of cases it may be expected to be fairly near that magnitude, even if there is no reason to expect that it will ever actually reach it, however long the time allowed for the adjustment."Ibid., p. 27, n. 2.

Indeed, as Hayek points out, in order for prices to fulfill their knowledge-disseminating and plan-coordinating functions, the econ­omy must subsist in a state of what I will call "proximal equilibrium," wherein realized prices are always fairly accurate indicators of future prices. Writes Hayek:

successful economic action [or the fulfillment of the expectations which prompted it] depends largely on the approximately correct predication of future prices. These predictions will be based on present prices and their trends .... Indeed the function of prices is precisely to communicate, as rapidly as possible, signals of changes of which the individual cannot know but to which his plans must be adjusted. This system works because on the whole current prices are fairly reliable indications of what future prices will probably be.F. A. Hayek, Denationalization of Money—The Argument Refined: An Analysis of the Theory and Practice of Concurrent Currencies, 2nd ed. (London: Institute of Economic Affairs, 1978), p. 82.

Kirzner evidently rejects the Hayekian concept of proximal equi­librium as a realistic description of the operation of the market economy, arguing that "the market is in a continual state of flux and is never in or near a state of equilibrium." He then goes on to argue that "the [endogenous] layer of change, consisting of systematic equili­brating tendencies (which never do manage to become fully completed before being disrupted by new exogenous change) is responsible for the degree of allocative efficiency and of growth potential that market economies display."Israel M. Kirzner, The Meaning of the Market Process: Essays in the Development of Modern Austrian Economics (New York: Routledge, 1992), pp. 38-39. But, if this is the case, Kirzner must logically conclude, which he does not, that market economies are not very efficient at all, because he has already argued that the market process never proceeds very far toward the ideally efficient state of perfect plan coordination.However, if Kirzner's standards for efficiency are relatively undemanding and are met by even small movements of the market process toward his ideal of perfect plan coordination, then this criticism loses its force. I am indebted to David Gordon for enlightening me on this point. This point aside, Kirzner's theory of the discov­erer-entrepreneur, whose activities systematically drive market prices toward their equilibrium configuration, can be viewed as an attempt to liberate Hayek's notion of catallactic efficiency as the ex ante coordination of decentralized plans from its dependence upon the vague and untenable assumption of proximal equilibrium as the normal state of the historical market economy. However, Kirzner's attempt itself implicitly invokes the ideas of quiescent calendar periods which separate successive exogenous shocks and during which equilibrating endogenous changes are given scope to work themselves out to some extent.

But there is no more basis in Mises's work for Kirzner's idea of real-time equilibration than there is for Hayekian proximal equilib­rium. As Mises emphasized, it is impossible to determine and meaningless to suggest that the real economy is closer to the FSR, and therefore manifests a superior coordination of plans and greater allocative efficiency, at one instant of time than it was at a previous instant. For Mises, each moment that passes introduces fresh exoge­nous changes into the system which impinge upon and reorient the ongoing market process toward a new FSR. As a result, very little can be established about the progress of any one of the host of individual adjustment processes that compose the market process. In fact the very idea of a single, compartmentalized adjustment process is no more than a useful analytical fiction which permits the economist to make sense of the overwhelmingly complex phenomena of the unitary market process. In Mises's words, "The various adjustment processes are in reality not isolated. Synchronously an indefinite number of them take their course, their paths intersect, and they mutually influence one another. To disentangle this intricate tissue and to observe the chain of actions and reactions set into motion by a definite change of the data is a difficult task for the historian's understanding and the results are mostly meager and questionable."Mises, Human Action, p. 653.

In the alternative interpretation of Mises's view of the market process that I have been expounding, the notion of allocative effi­ciency has nothing to do with the Hayekian criterion of plan coordi­nation. Rather, it derives from an analysis of principles of purposeful behavior. Thus, from the ex ante standpoint, the market economy is perfectly efficient, because entrepreneurial decisions based upon monetary calculation always result in the appraisement and alloca­tion of resources in strict accordance with anticipated consumer preferences, in the same manner in which the choices of an individual actor produce a pattern of resource use reflecting his value ranking of expected satisfactions. Thus the Böhm-Bawerkian law of costs, according to which the money price of each and every resource always corresponds to the lowest appraised of the employments for which its available quantity just suffices, i.e., its expected marginal revenue product, is the perfect catallactic equivalent of the law of marginal utility that governs autistic exchange. Far from being trivial, this concept of ex ante efficiency is indispensable for distinguishing the unhampered market economy from other conceivable methods of organizing social cooperation under a division of labor. Thus a com­pletely centrally-planned industrial economy is impossible of realiza­tion because, in the absence of actual exchange of productive factors and genuine factor prices, the planners are unable to "cost" and therefore purposefully or efficiently allocate the given resources under their control in accordance with even their own known scale of ends valuation.

The criterion of social welfare that is implicit in Misesian catallactics is therefore "Böhm-Bawerk efficiency," which empha­sizes the role of monetary calculation in enabling individuals to rationally evaluate and allocate the means at their disposal when pursuing their goals through social action, i.e., action that makes use of voluntary exchange and the social division of labor to realize its aims. Whereas Pareto efficiency and its Hayek-Kirzner plan coordination variant represent unrealizable standards—because based on perfect information and foresight—for evaluating the social outcomes of the choice process, Böhm-Bawerk efficiency invokes an ideal but attainable standard, i.e., the efficient ex ante allocation of resources by an individual choosing under uncer­tainty, and indicates the day-to-day coordinated functioning of the economy that results when the institutional preconditions of mone­tary calculation and, therefore, of rational social action are fulfilled. Judged by this criterion, the erroneous forecasts and malinvestments that sometimes characterize entrepreneurial choices are not proof against the efficiency of the real-world market; the market is efficient because it enables individuals to calculate and therefore to make meaningfully choices to reap the overwhelming benefits described by the law of comparative advantage and not because it yields absolute or approximate certitude about the outcomes of these choices (which is, in any event, also denied to autarkic choosers). In sum, the unhampered market is socially efficient because it provides the incentive for social action by establishing a tight producer-consumer nexus that gives full sway to consumer choice in determining the allocation of resources.Mises, of course, vigorously upheld "consumer sovereignty" as the operating principle of the unhampered market economy, while demonstrating the coordinative property of the market's price structure and its indispensability to economic calculation and rational social action. However, curiously, he never attempted to derive a formal criterion of social welfare from these elements. On the other hand, any coercive intervention into the market, which necessarily distorts or annuls its intricate calculational nexus coordinating consumer preferences and en­trepreneurial choices, ipso facto generates a less efficient allocation of resources, i.e., one that does not completely and exclusively reflect the anticipated preferences of the participants in the social division of labor, and lowers social welfare. We may thus conclude that every act of intervention unambiguously lowers social welfare.32Murray N. Rothbard (Toward a Reconstruction of Utility and Welfare Economics [Burlingame, Calif.: Center for Libertarian Studies, 1977]) has ably demonstrated on purely scientific grounds that government intervention always fails to increase social welfare. In advancing to our more radical conclusion, we are able to completely discount any gains, in terms of direct utility or exchangeable goods, that accrue to the interven­ers and their beneficiaries, while remaining safely within the bounds of strict Wertfrei­heit. The concept of Böhm-Bawerk efficiency is only concerned with the utility that derives from actions that take place completely within the social nexus, that is, the utility of "productive" consumers who earn income—and only to the extent that they earn this income—through voluntary exchange. Since it is the prospective or ex ante utility to be derived from acts of consumption that provides the rationale for individuals to participate in the social division of labor, it is their preferences and demands that must serve as the sole and ultimate standard of socially efficient resource use. Thus, for example, the redistribution of income to "nonproductive" consumers may be repre­sented as a net siphoning off of resources from society that reduces the utility of at least some of its members and weakens their incentives for social action. The market demands of the nonproductive recipients of these resources then can be treated as falsifying monetary calculation and fostering a socially inefficient reallocation of productive resources.

Regarding ex post efficiency, the market economy is once again on all fours with the autarkic economy, with entrepreneurial errors and inefficiencies in production the inevitable product of uncertainty and change. However the market economy does embody a process which operates to minimize such errors and efficiencies. This is what Mises calls the "selective process," which is continuously and actually oper­ating in calendar time via monetary profits and losses to weed out from the market the relatively unastute and inefficient entrepre­neurs while transferring the power to choose the best uses and technical combinations of productive resources to the more farsighted and technically proficient entrepreneurs.On the selective process, see Mises, Human Action, pp. 311-15.

In the Kirznerian interpretation there is no clear and meaningful distinction drawn between ex ante and ex post efficiency because the entrepreneur as homo quaerens never confronts the moment of choice, which would involve him in the purposeful allocation of resources or ''Robbinsian economizing." Nor, for the same reason, can the historical market process in this interpretation possess a means of systematically eliminating less successful entrepreneurs and shift­ing control over productive processes to the more successful. Never burdened with the necessity of choosing, discoverer-entrepreneurs need never place any resources at risk of loss in deciding to seize a profit opportunity. In criticizing the term "decision-making" which had come into vogue along with other technocratic jargon in the 1950s, Mises pointed out that the term is "designed to divert attention from the fact that what matters is not simply to make a choice but to make the best possible choice. This means: to proceed in such a way that no less urgently desired end should be satisfied if its satisfaction prevents the attainment of a more urgently desired end."Ludwig von Mises, The Ultimate Foundations of Economic Science: An Essay on Method, 2nd ed. (Kansas City: Sheed Andrews and McMeel, 1978), p. 69. Given the obvious importance that Mises attaches to purposeful choice in his praxeology and catallactics, it is difficult to fathom that he would have acquiesced in an interpretation of his view of the market process that assigns the central role to a nonchoosing entrepreneur.

Perhaps one of the more unfortunate consequences of the homog­enization of Mises's and Hayek's thought is manifested in the common tendency of current Austrian economists to formulate their entire research program in terms of a dictum uttered by Hayek, while uncritically attributing support for such a program to Mises. The dictum to which I refer is Hayek's oft-quoted remark that "it is probably no exaggeration to say that every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism."F. A. Hayek, The Counter-Revolution of Science: Studies on the Abuse of Reason, 2nd ed. (Indianapolis: Liberty Press, 1979), p. 52. For Mises, however, the goal of theoretical research in economics was not to simply "extend subjectivism," but to elucidate the crucial link between the subjective realm of individual purpose and valuation and the social pricing process that provides the objective data for economic calculation. According to Mises, such an endeavor must begin with "that brilliant achievement of the classical economists ... essentially a theory of calculated action" and then broaden it into a "a system dealing with all human choices, a general theory of action."Mises, Human Action, p. 231. Elsewhere Mises wrote that "supply and demand are only the links in a chain of phenomena, one end of which has ... visible manifestation in the market, while the other is anchored deep in the human mind."Ludwig von Mises, The Theory of Money and Credit, H. E. Batson, trans., 2nd ed. (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1971), p. 131. A further indication that Mises perceived the task of modern economics to be that of explicating the connection between individual purpose and the objective catallactic foundations of society is Mises's letter to Hayek in which he relates that he was initially undecided whether to entitle his magnum opus Human Action or Social Cooperation.

Richard M. Ebeling's contribution to the volume "Variations on the Demand for Money Theme: Ludwig von Mises and Some Twenti­eth-Century Views" (pp. 127-38) exemplifies this confusion of re­search programs. Ebeling gives a very good account of the essential differences between Mises's cash-balance approach to the demand for money, which derives from Carl Menger, and the Cambridge cash-bal­ance approach as formulated in the writings of A. C. Pigou and drawn from the "oral tradition" which had been initiated by Alfred Marshall. Ebeling then proceeds to analyze the neo-Keynesian and monetarist macroeconomic approaches from the perspective of the methodologi­cally individualistic Misesian approach, criticizing the propensity of both monetarists and Keynesians to argue in terms of the stability or instability of the aggregate demand for money. Unfortunately, in his critique, Ebeling throws out the demand-for-money baby with the stability bathwater, arguing that "from Mises's perspective, it is inappropriate to speak about the demand for money and its stability" and that "to speak of the community's 'aggregate demand for money' is not only methodologically unsound, but analytically incomplete" (pp. 135, 137).

Contrary to Ebeling's assertion, however, Mises did indeed hold that individual demands for cash balances could and should be aggregated into an overall market demand schedule for money. Thus, while he warned that investigation into the demand for money could not "begin with the demand for money of the community," he fully accepted the legitimacy of aggregating the individual demands into a social demand, declaring that "[t]he demand for money of the economic community is nothing but the sum of the demands for money of the individual economic agents composing it."Ibid., pp. 131-32. While such a seemingly innocuous aggregate of homogeneous quantities may very well violate some unwritten canon of the Hayekian "subjectivist" paradigm, Mises clearly recognized that without reference to the demand for and supply of money it would be impossible to carry out the core of his own research program: integrating value and monetary theory to permit the explanation of the unified structure of money prices whose existence is the sine qua non for economic calculation and the purposeful allocation of resources within the framework of an economy based upon the division of labor.

In support of his anti-aggregation interpretation, Ebeling ad­duces Mises's insights that: (1) the purchasing power of money is not a single price but an array of the alternative quantities of the various goods which the monetary unit commands in exchange and (2) changes in the supply of money never affect the elements of this purchasing­power array simultaneously and equiproportionally and therefore in­variably result in permanent redistributions of real income and wealth (p. 136). But, as Mises clearly recognized, these important insights establishing the nonneutrality of money are not relevant to the question of whether or not money-demand schedules may be properly aggregated across individuals; rather, they speak to the issue of the shape of the aggregate demand curve for money, leading to the conclusion that such curves can never be rectangularly hyperbolic.On this point, see Salerno, "Mises's Monetary Theory," pp. 19-33.

Although reluctance to employ the concept of a social demand for money cannot properly be attributed to Mises, it can be detected in Hayek's early works on business cycle theory. Thus, in Monetary Theory and the Trade Cycle, Hayek criticizes Menger and Mises for "including in the theory of the value of money all influences of money on prices."Hayek, Monetary Theory and the Trade Cycle, p. 117, n. In effect, Hayek is reproaching Mises in particular for attempting to provide an integrated analysis of variations in the supply of money in terms of both their systematic effects on relative prices and their effects on the height of overall prices, rather than just concentrating on the former type of analysis which Hayek con­siders the "far more important task" of monetary theory.Ibid. In Prices and Production, Hayek goes even further to encourage the realization by monetary theorists of "the superfluity of the concept of a general value of money, conceived as the reverse of some price level." He goes on to write that the type of monetary theory whose development he looks forward to "will be no longer a theory of the value of money in general, but a theory of the influence of money on the different ratios of exchange between goods of all kinds."F. A. Hayek, Prices and Production, 2nd ed. (New York: Augustus M. Kelley, 1967), p. 29. Lest it be thought that Hayek is here objecting only to the concept of a statistical price level, it should be noted that his critique of Menger and Mises was advanced despite his explicit recognition that their notion of the general value of money" ... has nothing to do with any measurable value, in the sense of some price level."Hayek, Monetary Theory and the Trade Cycle, p. 117, n. By challenging the very notion of the general purchasing power of money, Hayek, of course, is implying the uselessness of the concept of an aggregate demand for money.As Hayek ("On Neutral Money," p. 161) concludes: "... the theoretical concept of neutral money, which relates to the influence of money upon the price relationships [simultaneous and intertemporal] determined by real factors, cannot bear any relation at all to the concept of some 'price level' [even if this concept is introduced merely implicitly in the form of a 'demand for money' related to a definite price level]."

In contrast to the Wieser-Hayek position,As set forth in Hayek, "Some Remarks on the Problem of lmputation." however, Mises held that the social appraisement of productive factors via en­trepreneurial competition in resource markets, which is the very basis of economic calculation and purposive action, can only proceed in monetary terms.See Mises, Human Action, pp. 331-38, for an explanation of the distinction between imputation and appraisement as these processes relate to the valuing of higher-order goods and of the relevance of this distinction for economic calculation. Thus, in the course of estimating the expected marginal revenue products of the various inputs into his planned production processes and determining what prices to bid for them, the entrepreneur cannot help but estimate the absolute height of prices, i.e., the general purchasing power of money, because the exchange ratios between the various present goods and between present and future goods, i.e., Hayek's all-important "relative prices," are and must be embedded in the structure of money prices. Or, to put it another way, money's nonneutral effects on the economy oper­ate only through the medium of money prices.

These considerations tend to be lost sight of when focusing on Hayekian proximal equilibrium because, outside of an uncertain and changing world, there is no need for a monetary appraisement process to continually revolutionize and recreate the price structure; in proxi­mal equilibrium, money plays the role of a shadowy numeraire, and efficient action depends only on entrepreneurs knowing the currently prevailing configuration of relative prices, which serves as a good, if not perfect, indicator of their likely future configuration. For Hayek, it is only when the money spending stream expands or shrinks that it has a nonneutral impact on the economy by causing reversible changes in the ruling barter rates of exchange and jarring the economy temporarily out of its proximal equilibrium. For Mises, on the other hand, it is only the existence of a real and tangible medium of exchange, with a market and, hence, a driving force all its own, that permits the operation of market processes at all. From Mises's standpoint, then, it is not the inescapable fact of money's inconsis­tency with an imaginary state approximating equilibrium but mone­tary intervention misdirecting the dynamic appraisement process that falsifies entrepreneurial calculations, undermines efficient re­source allocation, and discoordinates the economy.

Sanford Ikeda's contribution, entitled "The Dynamics of Govern­ment Intervention: Theory and Implications" (pp. 201-12), is an interesting and original effort to formulate "a more systematic theory of what can be called the 'interventionist process"' that takes Mises's critique of interventionism as its point of departure (p. 202). What Ikeda seeks is to integrate the Misesian critique with public choice theory as a means of explaining the observed "ebb and flow of government growth," featuring prolonged periods of progressive de­regulation alternating with periods of increasing interventionism, with neither the deregulatory phase nor the interventionist phase ever culminating in complete laissez-faire or thoroughgoing social­ism, respectively (pp. 203-4).

In analyzing the "Misesian interventionist dynamic" which drives the process, however, Ikeda resorts to the Kirznerian discovery view of entrepreneurship, wherein the entrepreneur "serves a social func­tion by [unintentionally] solving the knowledge problem" (pp. 204-5). By discovering and arbitraging discrepancies between simultane­ously existing prices of the same or virtually the same goods, the entrepreneur repairs the gaps in knowledge of decentralized market participants and better coordinates their individual buying and sell­ing plans. As I argued above, however, this view is at odds with Mises's theory of entrepreneurship, which focuses on the entrepre­neur's function of calculating the most valuable uses of currently available inputs on the basis of anticipated output prices.

Ikeda also uses the Hayekian concept of "unintended conse­quences" to describe the outcome of single acts of intervention, and he characterizes the interventionist process as an "unintended proc­ess" (p. 205). From the Misesian perspective, however, the motivation for the various acts of intervention is precisely those immediate benefits that are intended by its proponents. And while Mises admits that there may be "unforeseen" long-run consequences of any inter­vention, he attributes them not to an inevitable and irremediable condition associated with the Hayekian "knowledge problem," but to antisocial and deliberately obscurantist ideologies that blind the masses to the conclusions of economic theory.

Moreover, Mises's analysis of the interventionist process does not preclude the possibility that the proponents of an intervention recog­nize and intend its generally unforeseen consequences. Thus unions support minimum wage laws precisely because these laws price low-skilled workers out of the labor market and increase the demand for skilled union workers, while bureaucrats manning municipal rent-control boards may welcome the growing apartment shortage resulting from rent control because it increases their power, prestige, and the value of the favors they can bestow. Indeed, it is precisely the goal of many radical environmentalists to cripple capital formation and productivity and to bring about a decline of real income and population via environmental regulations. The very crises which regularly recur as the interventionist process proceeds also may be desired by those who are ideologically committed to the extension of political control over the economy.

Finally, I contend that Ikeda is simply incorrect when he asserts that ''the reasoning underlying [Mises's] critiques of both socialism and interventionism [is] the same-the existence of the knowledge problem makes the consequences of government intervention nasty and unexpected" (p. 208). First, as Mises emphasizes time and again throughout his writings, "economic calculation," and not knowledge, is the "essential and unique problem of socialism."Ibid., p. 703. Thus, according to Mises, even if the central planning board was endowed with full and perfect knowledge of the relevant economic data, without re­course to monetary calculation using genuine market prices, it would not be able to determine the optimal among the infinitude of possible uses and technical combinations of the available factors of produc­tion.For a review  of Mises's argument on this point, see Salerno, "Postscript: Why a Socialist Economy Is Impossible," pp. 52-54. Second, as I have just pointed out, from the Misesian perspec­tive, the consequences of an intervention are not necessarily "unex­pected" to its active promoters and beneficiaries and need not con­tinue to be so to the masses it victimizes.

In his essay on "Mises on Free Banking and Fractional Reserves" (pp. 517-33), Lawrence H. White interprets Mises's advocacy of free banking based on fractional gold reserves as a program for economizing on the resource costs of supplying the medium of exchange while insuring that the issuance of fiduciary media is regulated in accord­ance with the desideratum of a neutral money, i.e., a money that does not impinge upon or distort the underlying real processes of the economy. It was Adam Smith, the acknowledged father of free bank­ing, who introduced into monetary theory the proposition that a pure specie money involved a waste of scarce resources, while it was Hayek who originated the concept of, if not the term, "neutral money." According to Hayek in his most mature writings, the "nearest prac­tical approximation" to such an admittedly "fictitious" ideal is a monetary system in which "increased demand for liquidity" is met by increases in the money supply aimed at maintaining stability of an index of raw materials prices that serve as a proxy for the average prices of the original factors of production, land and labor.Hayek, Denationalization of Money, pp. 84. Assuming no increase in the stocks of the original factors, the practical attain­ment of Hayek's monetary ideal would result in "constancy of the money stream,"Ibid., p. 77. 51. which, not coincidentally, also happens to be the desired goal of modern free bankers.For the free banking argument in favor of maintaining "monetary equilibrium," defined in Hayekian terms as a constant aggregate spending flow, see George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue (Totowa, N .J.: Rowman & Littlefield, 1988), pp. 52-69. I should note that nowhere in his essay does White invoke the Hayekian concept of"neutral money." In fact, in another essay, White expresses mild skepticism about whether a free banking system is fully compatible with any macroeconomic norm including Selginian monetary equilibrium, although he seems to count it as a merit of the system's operation that it comes relatively closer to obeying this norm in practice than the central banking alternative. See Lawrence H. White, "Commentary: Norms for Monetary Policy," in Ebeling, Austrian Economics, p. 477. Nonetheless, as I shall argue below in the text, the goal of"avoiding monetary demand shocks," which White imputes to Mises as a reason for supporting free banking and which White himself is obviously sympathetic to, is tantamount to stabilization of the money-spending stream.

In his paper, White characterizes Mises as the prototype of mod­ern free bankers, who opposed any ban on competing private banks issuing fiduciary media redeemable in gold on demand on the grounds that" ... such a ban (1) would make the economy more vulnerable to money demand shocks, and (2) would needlessly increase the cost of supplying the economy with media of exchange" (p. 528). As White notes, this interpretation of Mises's rationale for free banking clashes sharply with Murray Rothbard's argument that Mises favored free banking as a preferred means of suppressing the issuance of fiduciary media, because it circumvents the dangers associated with ceding virtual control over the banking system to government, a result that Mises believed might be entailed by an outright legal prohibition of fractional reserves.

In fact, White's interpretation of Mises's views on fractional re­serves and free banking is based on his unwarranted, if unintentional, homogenization of Mises with Smith on the question of the criteria of an ideal monetary system. White falls into error because he overlooks important passages in the very works of Mises that he cites, and because he ignores significant developments in Mises's theory of money that occurred between the publication of the first German edition of The Theory of Money and Credit in 1912 and the publication of Nationalökomie (the German language forerunner of Human Ac­tion) in 1940. In his 1940 work, Mises tells us, his "monetary theory achieve[d] completion" with the merger of "the theory of indirect exchange with that of direct exchange into a coherent system of human action.Mises, Notes and Recollections, p. 112. These developments resulted in an important modi­fication ofMises's earlier assessment of the relative benefits and costs of fiduciary media that is not acknowledged by White.

As White correctly points out (pp. 520-22), in The Theory of Money and Credit, Mises identifies three significant benefits of the issuance of fiduciary media. The first benefit involves the prevention of"convulsions" to economic activity that would have occurred in the absence of an expansion of the money supply caused by the creation of fiduciary media as a result of "an enormous extension of the demand for money" and the consequent increase in its purchasing power that was brought about by the historical extension of the money economy. The second benefit is the familiar Smithian one of reducing the "cost of the monetary apparatus." And the final benefit of fiduciary media is that their issuance sufficiently enhanced the profitability of the credit activities of the banking system early in its history to permit its survival and growth. The only disadvantage of fiduciary media that Mises recognized in this book, according to White, is a relatively minor one: the risk of default by the issuing bank due to mismanagement or bank runs. Thus White concludes that Mises "viewed fractional-reserve banking as a natural and de­sirable development in a free society" (p. 522).

But White's conclusion is mistaken, attributable to his failure to fully come to terms with one of Mises's most famous contributions to economic theory: his demonstration of the causal link between fidu­ciary media and the business cycle. White (pp. 524-25) evidently holds that according to Mises business cycles are generated by the overexpansion of fiduciary media by central banks unrestrained by competitive market forces. However, Mises's chapter on the business cycle, following directly upon the chapter enumerating the benefits of fiduciary media which White cites in support of his own interpre­tation,Mises's discussion of the advantages of fiduciary media occurs on pages 298-99 and 323, while his business cycle theory is presented on pages 339-66 (Mises, Theory of Money and Credit). makes it pellucidly clear that the necessary and sufficient cause of the cycle is the unsustainable divergence between the "loan" and "natural" rates of interest effected by the creation of fiduciary media. For Mises, then, cyclical discoordination of the economy is indeed a disadvantage to be counted against fiduciary media per se. Accordingly, it is only after fully discussing both the advantages and disadvantages of fiduciary media, that Mises, in a section comprising the concluding five pages of the book—which is not referred to by White—addresses the "basic questions of future currency policy."Ibid., p. 406. Here, Mises reprints the conclusion of the first German edition (the English edition is a translation of the second German edition publish­ed in 1924), in which he emphatically urged the suppression of all further creation of fiduciary media, if not the outright banning of fractional-reserve banking. Contrary to White's assertion, Mises was evidently convinced that the disadvantages of issuing fiduciary me­dia, now including their cycle-generating property, far outweighed their earlier enumerated advantages.

Concludes Mises:

[Fiduciary media] should logically be subjected to the same principles that have been established with regard to money proper; the same attempts should be made in their case as well to eliminate as far as possible human influence on the exchange ratio between money and other economic goods. The possibility of causing temporary fluctua­tions in the exchange ratios between goods of higher and of lower orders by the issue of fiduciary media, and the pernicious conse­quences connected with a divergence between the natural and money rates of interest, are circumstances leading to the same conclusion. Now it is obvious that the only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media. The basic conception of Peel's Act ought to be restated and more completely implemented than it was in the England of his time by including the issue of credit in the form of bank balances within the legislative prohibition.

It would be a mistake to assume that the modern organization of exchange is bound to continue to exist. It carries within itself the germ of its own destruction; the development of fiduciary media must necessarily lead to its breakdown. ... It will be a task for the future to erect safeguards against the inflationary misuse of the monetary system by the government and against the extension of the circula­tion of fiduciary media by the banks.Ibid., p. 407-09.

It is hardly to be concluded from the passage I have emphasized in the foregoing quotation that Mises looked with equanimity, let alone favor, upon the further creation of fiduciary media by banks, whether "free" or not.

White (p. 520) cites a part of a paragraph from a later, 1928 work of Mises's,The English translation is Ludwig von Mises, "Monetary Stabilization and Cyclical Policy," in idem, On the Manipulation of Money and Credit, Bettina Bien Greaves, trans. (Dobbs Ferry, N. Y.: Free Market Books, 1978), p. 145. in which Mises reiterates the point that a suppression of the issue of fiduciary media would have given rise to historical situations in which the emergence of an excess demand for money resulted in an increase in the purchasing power of money that was temporarily disadvantageous to the economy. However, White does not cite the last sentence of this same paragraph, which identifies an important benefit that would have followed from the prohibition of further emission of fiduciary media: "the economy surely would not then have experienced the stormy upswings followed by dramatic reversals of the upswings into crises and declines."Ibid.

Mises also makes it clear later in the same work that the benefits of fiduciary media fall far short of their costs in terms of cyclical discoordination of economic activity. He therefore calls for the imple­mentation of a revised Currency school program in the following terms:

The most important prerequisite of any cyclical policy, no matter how modest its goal may be, is to renounce every attempt to reduce the interest rate, by means of banking policy, below the rate which develops on the market. That means a return to the theory of the Currency school, which sought to suppress all future expansion of circulation credit and thus all further creation of fiduciary media.... [l]t means the introduction of a new program based on the old Currency school theory, but expanded in the light of the present state of knowledge to include fiduciary media issued in the form of bank deposits.Ibid., pp. 167–68.

Far from rejecting the Currency school program, as White would have us believe, it is clear Mises desired to reformulate it on a sounder theoretical basis in order to strengthen its practical application. Thus, contrary to White, Mises supported a free banking regime precisely because it would eventually result in "extreme restraint in the issue of fiduciary media." Free bankers would learn such restraint from their experiences of the crises and bank runs that would inevi­tably occur during the historical course of development of fiduciary media. Once such lessons were absorbed by the more astute banking entrepreneurs, policies of extreme caution and restraint would be enforced on the entire banking system as less responsible banks persisting in the further creation of fiduciary media would be imme­diately confronted by the twin threats of adverse interbank clearings and of loss of confidence by a once or twice chastened and now more sophisticated bank clientele.Ibid., pp. 138-40. At this point the program of the Cur­rency school would be fully and properly implemented, as further extension of "circulation credit" by the banks would be checked and any additional accumulation of bank assets would reflect an increase in commodity credit based on time deposits and equity investments of voluntarily saved funds.

Unlike our modern free bankers, Mises emphatically did not foresee the free banking system evolving toward a minuscule reserve ratio of gold to demand liabilities and the progressive transformation of gold into a practically demonetized interbank "clearing asset."Lawrence H. White and George A. Selgin, "The Evolution of a Free Banking System," in Lawrence H. White, Competition and Currency: Essays on Free Banking and Money (New York: New York University Press, 1989), p. 235. At least one prominent member of the modern free banking school, Richard H. Timberlake (Gold, Greenbacks, and the Constitution [Berryville, Va.: George Edward Durell Foundation, 1991]) has taken the leap and now forthrightly advocates free banking on a nonspecie standard, although White himself continues to firmly insist upon gold as the proper monetary standard for a free banking regime. For a critique ofTimberlake's plan, see Murray N. Rothbard, "Aurophobia: or, Free Banking on What Standard?" Review of Austrian Economics 6, no. 1 (1992): 97-108. For Mises, rather, evolution was all in the opposite direction, with initial entrepreneurial ignorance precipitating an early splurge in the creation of fiduciary media and the resulting cyclical fluctuations leading slowly back to a system of marginal 100 percent reserves while painfully renewing awareness among the public that bank notes and deposits are not money per se but merely claims to and substitutes for money, i.e., gold.

In his earlier writings, then, Mises did perceive there to be definite advantages associated with the issue of fiduciary media, but he was willing to forego such advantages for the greater advantage of maintaining the integrity of monetary calculation and preventing disruptions of the price-and-interest-rate coordination of the econ­omy. By the time he came to write Human Action, however, his views on entrepreneurship, monetary calculation, and money had evolved to the point where he was able to recognize that the benefits he had once attributed to the creation of fiduciary media were largely illu­sory. In particular, the later Mises abandoned his earlier belief that an increase in the purchasing power of money is somehow disadvan­tageous for the market economy.

Regarding a world in which there occurs a persistent "goods-in­duced" rise in the purchasing power of money resulting from secular growth in the supplies of commodities and services in conjunction with a rigidly fixed nominal money supply, Mises argued in Human Action that such a state of affairs would not disrupt the moment-to­moment price coordinating function of the market or upset the mone­tary calculations that lead entrepreneurs to efficiently allocate pro­ductive resources in service of anticipated consumer preferences.

As Mises wrote:

Entrepreneurs and investors ... do not heed the general movement of all prices. What matters for them is the existence of discrepancies between the prices of the complementary factors of production and the anticipated prices of the product. No businessman embarks upon a definite production project because he believes that the prices, i.e., the prices of all goods and services, will rise. He engages himself if he believes that he can profit from a difference between the prices of goods of various orders. In a world with a secular tendency toward falling prices, such opportunities for earning profits will appear in the same way in which they appear in a world with a secular trend toward rising prices ....

A secular tendency toward a rise in the monetary unit's purchasing power ... would certainly not influence substantially the course of economic affairs. It would not remove the urge of people to improve their material well being as far as possible by an appropriate ar­rangement of production. It would not deprive the economic system of the factors making for material improvement, namely, the striving of enterprising promoters after profit and the readiness of the public to buy those commodities which are apt to provide them the greatest satisfaction at the lowest costs.Mises, Human Action, pp. 469-70.

Nor does the later Mises share with Hayek and the free bankers a dread of "monetary demand shocks," i.e., a "money-induced" in­crease in the purchasing power of money caused by a shrinkage of the money-spending stream due to hoarding. In particular, Mises denies that an increase in the demand for money at the expense of spending on consumer goods while the money supply remains unchanged will impede the process of transforming the additional real savings thus generated into an accumulation of new capital goods. Monetary calculation, taking into account the relative decline in prices of lower-order and consumer products and of the nonspecific factors of production, will faithfully reflect the increase in the availability of capital goods, and the prospect of higher profits will induce entrepre­neurs to employ them in the expansion of their operations. As Mises concludes, "the main thing is that the capital goods resulting from additional savings are not destroyed by coincident monetary changes. . . . Whenever an individual devotes a sum of money to saving instead of spending it for consumption, the process of saving agrees perfectly with the process of capital accumulation and investment. It does not matter whether the individual saver does or does not increase his cash holding."Ibid., pp. 521-22. For the Misesian, then, the coordinative and calculative market process can and will respond with perfect (ex ante) efficiency to any combination of anticipated changes in the set of consumer preferences, including changes in "liquidity" preferences.For a demonstration of this, see Salerno, "Commentary: The Concept of Coordination in Austrian

This leaves us, finally, only with the advantage of fiduciary media in reducing the cost of supplying a medium of exchange. Although, as White notes, Mises was inclined to heavily weight this alleged advan­tage in his earlier writings, in Human Action, Mises does not allude to it; however, he does refer to "the expensiveness of gold production" as "the minor evil" when compared to the inflationary potential of paper fiat and credit money.Mises, Human Action, p. 422. In fact, when free banks invoke option clauses, post-dated notes, and other devices permitting the contractual suspension of specie payments, their notes and deposits are effectively transformed into a credit money, whose value is determined independently of the value of the original money commodity. For a discussion of Mises's neglected concept of credit money that touches upon this point, see Salerno, "Mises's Monetary Theory," pp. 8–11.

Of course, in Human Action, Mises still adhered to his previous view concerning the overwhelming disadvantage of the creation of fiduciary media associated with its potential for falsifying interest rates and monetary calculation, introducing inefficiency into the intertemporal allocation of resources, and precipitating the business cycle. This later assessment of the massive imbalance in favor of the disadvantages of fiduciary media may finally have led Mises to overcome his earlier fears of the expansion of political interference with banking that he foresaw as a possible ramification of the ultra­hardcore neo-Currency school program legally debarring all further additions to the outstanding circulation of fiduciary media, including demand deposits as well as notes. Thus, in his 1952 essay on "Mone­tary Reconstruction," which was included as Part Four in the second English edition of Theory of Money and Credit, Mises proposed just such a program as the basis for "the United States return to a sound currency."Mises, Theory of Money and Credit, pp. 448-52.

I conclude, then, that White's attempt to portray Mises's views on fractional reserves and free banking as prototypical of the modern free banking school, whose members draw their analytical orienta­tion from equilibrium-based Hayekian monetary theory, is unten­able. To the extent that Mises advocated the freedom of banks to issue fiduciary media, he did so only because his analysis led him to the conclusion that this policy would result in a money supply strictly regulated according to the Currency principle. Mises's de­sideratum was not a neutral money, or even a practical approxima­tion thereof, but to completely eliminate the distortive influences of fiduciary media on monetary calculation and the dynamic market process.

As I indicated at the outset, my purpose in writing this review essay has been specifically to illustrate and rebut the common ten­dency that I believe exists among fellow Austrian economists to conflate the views of Mises and Hayek. Rigid adherence to this purpose has caused the tone of the review to be decidedly negative. However, this should not be construed to mean that I disagree with all or even most of each of the essays under review. Had I reviewed these papers with a broader purpose in mind, the extent of the common ground between myself and the papers' authors, based on the "Mengerian overlap" between the Misesian and Hayekian para­digms, would have been quite evident. Moreover, I regard the contri­butions by Kirzner and White to this volume to be, each in its own respect, excellent summaries of these authors' pioneering efforts elsewhere to systematize and extend the Hayekian paradigm. In the case of Kirzner, it can be argued that his formidable body of work largely defines this paradigm as it currently stands. And the en­deavor by White and the modern free banking school to give this paradigm a contemporary macroeconomic expression rests on the Kirznerian conception of the market process. Ikeda's essay, his attri­butions to Mises notwithstanding, is a promising initial step in the direction of adumbrating a Hayekian theory of interventionism, and Ebeling's essay, for the most part, does capture the uniqueness and fruitfulness of the Misesian approach to the demand for money. Having said this, I still insist that the homogenization of the views of two brilliant but very different thinkers serves no purpose today but to significantly impede the quest for knowledge and truth among those working within the Mengerian tradition.

Professors Giuseppe Eusepi of Sapienza University of Rome in Italy and Richard E. Wagner of George Mason University have added another book to the already extensive list of literature on the political economy of public debt. The purpose of their book is to correct two major flaws in the existing literature. First, they argue that it is “pure illusion to treat a democratic regime as being indebted.” Second, they try to show that it is “pure mythology to treat so-called fiscal policy as the means by which governments manipulate public debt to promote systemic stability” (Eusepi and Wagner 2017, p. vii). Surely, both claims will strike the average reader as bold and by no means self-evident. They require analytical substantiation and clarification of terms. What exactly is illusory and mythical about the indebtedness of democratic regimes and their fiscal policy? Eusepi and Wagner’s analysis spans 164 pages separated into 6 chapters.

In the first chapter of the book, the authors provide a very brief overview and some fundamental criticisms of the conventional macroeconomic approach to fiscal policy and public debt. The legacy of Keynes’s General Theory in putting deficit spending at the forefront of fiscal policy measures to promote macroeconomic stability and full employment is well known and has been widely discussed among modern economists. Eusepi and Wagner argue that treating “political activity as a balance wheel to offset changes in private activity is overwhelmingly at work in contemporary political economy” (p. 7) and critically add “that the image of the balance wheel reflects the hold of myth and not the power of logic and observation.” According to the authors, underlying the balance wheel view is a “mythical” as opposed to a “realistic” type of theory, because it is merely “postulating” instead of actually “generating” the outcomes under consideration. In their view, the conventional “theory contains no explanation grounded in individual action that is able to generate the observed result.” In other words, it lacks microfoundations.

The authors themselves draw the connection to the famous microfoundations debate in modern macroeconomics. However, following Kirman (1992), they argue that representative agent analysis has not actually solved the problem, but only added another layer of “mythical” thinking. In this respect, one might say that Eusepi and Wagner are close to the “ultimate in microfoundationalists,” a label Hartley (1997, p. 107) used to describe Austrian economists in the Misesian tradition. Yet, the book is not a contribution to the latter, but rather to public choice theory.

The authors’ main point of contention seems to be that fiscal policy and public debt do not actually serve as a balance wheel, regardless of whether policy makers should try to use it as such. They do not engage in prescriptive policy analysis. Rather, they try to explain fiscal policy as an emergent phenomenon. They argue that a theoretical framework for the explanation of policy measures that we observe around us must take due account of the actual institutional environment within which the relevant actors make decisions, and needs to abstain from idealizing assumptions about their underlying motives. Eusepi and Wagner put themselves in the tradition of The Machiavellians (Burnham, 1943), including Niccolò Machiavelli himself, Gaetano Mosca, Roberto Michels and Vilfredo Pareto, who did not idealize politics, but treated it, arguably more realistically, as a struggle for power. In particular, they build upon the work of Antonio de Viti de Marco.

The authors do not intend to contribute to modern macroeconomics, but explicitly to the political economy of public debt. They hold that a “realistic line of analysis […] cannot rest content with positing relationships among aggregate variables, for to proceed in this fashion is to make it impossible to generate insight into the causal forces that are in play within a society” (Eusepi and Wagner, 2017, p. 32). Moreover, they explain that what they call “realistic” analysis is akin to Peter Boettke’s (2007) “mainline” in economic thought. The latter provides a broader and more encompassing perspective on social phenomena than conventional macroeconomics. It includes, for example, analyses of the relevant political regimes. In chapter 2, Eusepi and Wagner thus develop some preliminary thoughts on the differences between monarchical and democratic regimes as well as some implications for the analysis of public debt.

According to the authors, debt in monarchical regimes, where state activities are financed out of income from royal property, can analytically be treated just like debt in any individual case. Monarchs would certainly be more powerful than regular persons, but they remain individuals that manage their private property and take credit using their own property as collateral. The authors mention that the “macro literature contains many references to sovereign debt and the possibility of sovereign default” and claim that this “literature is reasonable for monarchical and dictatorial regimes, but it is not reasonable for democratic regimes” (p. 39). They argue that the “theory of choice is a useful framework for personal debt as well as for a monarch’s debts. It is not, however, generally useful for democratic debt because democratic debt emerges through some institutionally governed process of interaction” (p. 38).

While democratic debt may indeed emerge out of a somewhat more complex process, in which many individuals, negotiations and political bargains are involved, it strikes the reviewer as a rather odd claim to deny that the theory of choice is a useful framework for its analysis. After all, taking out a loan to finance public expenses, or increasing taxes as an alternative, is always a matter of choice on the part of government officials, regardless of the political system. It might be true that the theory of choice as such does not tell us very much about the subject matter, but that would also be the case when analyzing the indebtedness of monarchical regimes. A detailed analysis of the structural differences, that is, the institutional circumstances and incentives, under which representatives of democratic governments on the one hand and monarchs on the other make decisions, is required. Different arrangements of property rights are in fact a key issue. Put differently, monarchical debt also “emerges through some institutionally governed process of interaction,” although it is a very different one.

Eusepi and Wagner recognize the role of property rights and briefly discuss their relationship with taxes, the latter being the most important source of finance for democratic regimes. According to the authors, taxes represent an infringement upon private property rights or a transfer of property rights from private citizens to public officials, depending on what view of democracy is underlying the analysis. They move on, focusing mainly on the differences between the idealized version of democracy as self-governance, in which property rights are voluntarily transferred by consent, and its actual features in the real world, which include varying degrees of coercion. In reference to Schmitt (1996), they argue that power and subordination are relevant features of all political systems, but “democratic regimes generate mythologies that disguise that power by invoking an ideology of self-governance.” However, “power operates all the same.” (p. 40)

While this is a very important point, the authors overlook that the masquerade of power and despotism in democratic regimes is just an instance of a more general phenomenon that is not unique to democracies. Whoever is in power under whatever political system has an incentive to create and spread an ideological justification for their position in order to protect it. This is as true for democratically elected officials as it is for monarchs or dictators. Take North Korea and the personality cult around the Kim family as a timely example of a hereditary dictatorship.

In the third chapter of the book, the authors provide some further discussion of what characterizes the democratic process of political decision making. In particular, they suggest that an economy is better thought of as an “ecology” instead of an “engine.” The former view stipulates a system that comprises multiple economizing agents and allows for a realistic analysis of the subject matter, while the latter view pictures an economy as a machine constructed for a specific purpose. It is congenial to the mythical mode of analysis in modern macroeconomics. Chapter 3 picks up some of the thoughts from the beginning of the book and provides a transition towards the analysis of public debt under two types of democracy that follows. The subsequent chapter focuses on what de Viti de Marco (1936) called “cooperative” democracy, an idealized system that reflects the consent of the governed and represents an analytical benchmark. Chapter 5 covers public debt under “monopolistic” democracy, a more realistic form of democracy, which generates “gains for some people by imposing losses on other people” (Eusepi and Wagner, 2017, p. 85).

At the core of their argument lies the idea that public debt in democratic regimes does not follow the same principles as private debt under private law, namely, the principles of private property and freedom of contract, precisely because public debt generally emerges at the expense of some people, that is, against their will. The authors claim that “public debt falls within the rubric of public law and public ordering,” (p. 84) which operates differently, since it allows for coercive property transfers.

Chapter 4 starts with the benchmark case of public debt under the ideal of cooperative democracy. The conclusion should be straightforward, but is not drawn explicitly in the book. If state activities always reflect the consent of the people, there is no difference whatsoever between private law and private ordering on the one hand and public law and public ordering on the other. State activities would fall under the nexus of voluntary and mutually beneficial exchange relationships. In reality, however, the benchmark condition of consent is virtually never met. The authors still regard it as a useful point of analytical departure against which to compare real-world monopolistic democracies.

Eusepi and Wagner try to provide what they call a “canonical model of democratic debt” and explain that a

truly explanatory theory of democratic debt within the framework of a cooperative state must be able to explain the emergence of public debt from an initial situation where such debt did not exist. The model of the cooperative state requires that we explain how a set of people might choose to create public debt, just as it must explain how a set of people will agree to tax themselves. Otherwise, all one can do is start with the existence of debt or taxation and assert that this prior existence reflects the consent of the governed because the analyst presumes that consensus is an inviolable property of democracy. (pp. 85–86)

Now, interestingly, the authors are of the opinion that a meaningful notion of public debt is very difficult to conceive even within a cooperative state, or at least, that it is not plainly obvious how public debt could emerge under such a state. This is surprising. Indeed, the assumption of perfect consent is entirely heroic when it comes to actual nation states as they exist, but if we decide to start with that assumption for analytical purposes, it is not very challenging at all to explain the emergence of public debt, that is, a debt contract for which all citizens of the state collectively pledge to pay back a loan plus interest over some period of time.

All citizens might agree, given their time preferences, that it is preferable to finance some desirable government project not out of savings and their current incomes, but via a loan that they promise to repay out of future income. In order for the people truly to be indebted collectively, the creditor must come from outside. Otherwise, only a subgroup of the people would be indebted while the rest would not. Analytically, there would be no difference between this case and, for instance, a married couple taking out a loan together to purchase a house. Of course, it is not the husband who gives a loan to his wife, or vice versa, but there has to be an external creditor for the couple to be collectively indebted.

The word tax might not be very helpful when describing the sum of money voluntarily given to pay back the loan, but this is a semantic issue, not a substantive one. In fact, all taxes paid under a cooperative state would be voluntary payments made because the expected benefit of the government projects so financed exceeds the opportunity costs from the individual perspective of every person in the community. We would be entirely in the realm of private ordering based on the principles of private property and freedom of contract. This is the implication of the assumption of consent, but it goes without saying that it is not “an inviolable property of democracy” in the real world.

Eusepi and Wagner do not provide such a general and simple analysis. Instead, they give the example of a town that by consent of the inhabitants decides to build a dam. They invoke all kinds of complications in the form of disagreements among the citizens about how to finance the dam. Some might prefer to pay the tax directly out of current income or savings. Others might prefer to take out a loan. In such a scenario, the town would of course not collectively go into debt. Only some citizens would, collectively in subgroups or individually. Other citizens of the same state might even become their creditors. This would not be an instance of public debt as described above.

Eusepi and Wagner argue that when the town’s council decides to issue bonds to finance the dam, it would inevitably replace private ordering by public ordering (p. 88). However, the authors forget that under a cooperative system, it can do so only if every citizen gives consent. In such a case, we would remain within private ordering. What the authors convincingly convey, however, is that when we relax the assumption of cooperative democracy, which they implicitly do already in their discussion of the benchmark case, various problems with respect to public debt arise. These include that some inhabitants may be forced against their will to pay back a sum of money that government officials have borrowed to finance projects they themselves disapprove of. This precisely is the problem of political power.

The relevant question then is how can we approach the limiting case of cooperative democracy without coercion? Eusepi and Wagner make the important observation that as “a practical matter of democratic operation, the ideal of a cooperative democracy is surely limited to relatively small-scale democracies,” which is why they work with the example of a town “that contains a few thousand people at most, and where people can easily and nearly costlessly move somewhere else if they choose to do so” (p. 86).

The obvious conclusion seems to be that the right of opting out of public programs, including full-blown secession for sub-communities, must be granted in order to approach cooperative forms of governance. However, the authors do not dwell on this point. It is ironic that these rights exist, for example, in the monarchy of Liechtenstein.

Approaching the cooperative state is not primarily a question of public debt. Yet, it is reasonable to assume that genuine public debt would be extremely low, if it existed at all, under a cooperative state. Again, the tiny monarchy of Liechtenstein has practically no public debt outstanding. The authors conclude the fourth chapter by claiming that “de Viti’s ideal of a genuinely cooperative state is a limiting case that is difficult even to approach with respect to public debt, though it might be more easily approached without public debt” (p. 110). This might be true, but public debt ultimately does not seem to be a cause of non-cooperative or monopolistic governments. Quite to the contrary, it is, at least in its excessive form, one important effect of monopolistic governments. There are numerous problems involved in public debt, and it exists in such large quantities, because virtually all governments are monopolistic in de Viti de Marco’s terms.

Chapter 5 explicitly turns to the analysis of public debt under monopolistic democracies. In reference to Mosca (1939) and Pareto (1935), the authors hold that for “the most part, actual democratic systems operate in monopolistic fashion, meaning that they entail the dominance of a relatively small number of people over larger numbers” (Eusepi and Wagner 2017, p. 111). The authors explain that “people differ in their interests in and talents for acquiring political power. Possessing and wielding power will be more attractive to some people than to others. In this setting, political activity will become the province of subsets of people within any geographical territory.” Following Mosca, one might call this relatively small number of people the ruling class. For these people, public opinion and sentiment are the most important sources of power as explained, for example, in Wieser (1926) and de Jouvenel (1948). The characteristic feature of power, not only in monopolistic democracies, but in any political system, is that those who “hold positions of power can […] distribute costs and gains among the population over which they rule” (Eusepi and Wagner, 2017, p. 112).

According to the authors, debt contracts of monopolistic governments never reflect the will of all the people, but merely the will of some. Given that most actual states are monopolistic rather than cooperative it becomes clear what the authors could mean by calling public debt an “illusion.” It is illusory to take public debt for what the generated ideological tale of democracy as self-governance would have us believe. Public debt does not emerge out of consent, but is imposed upon the people by the ruling class that has successfully provided “ideological formulations that resonate with voter sentiments, such that people can support measures they would have opposed had they engaged truly in logical reasoning” (p. 130). This could include increased deficit spending.

More precisely, the burden of debt is imposed on a subgroup of the people. After all, there are also supporters of deficit spending among the electorate, and it is strictly speaking impossible to say, whether their support for public debt truly stems from a lack of logical reasoning as Eusepi and Wagner suggest. As a matter of fact, it might stem from perfectly logical reasoning. It is of course possible to personally benefit, directly or indirectly, from public debt. The authors do not consider this possibility. They realize that public debt virtually always “creates both voluntary and involuntary debtors” (p. 153), but even more importantly it creates voluntary creditors, who bring themselves in a position to benefit from the government’s power to tax. Others may benefit from public debt indirectly, when they become recipients of the additional government spending made possible by debt finance.

Under monopolistic democratic rule, public debt becomes a tool of power. Eusepi and Wagner correctly emphasize that it covers up a redistribution of wealth behind “illusory” slogans and “ideological images” such as “we owe it to ourselves” (p. 163). The authors point out that the bulk of public debt is in fact not even made explicit through the sale of bonds, but remains implicit in the form of other liabilities that the governments hold, for example, social security programs. They call this implicit public debt a “systemic form of collective lying” (pp. 138–141). They argue that it “is systemic and not personal lying because it is an emergent quality of a system of public ordering more than a quality of any politician, though it is also easy enough to find lying politicians, just as it is possible to point to lying business people for that matter.”

However, it seems rather odd to call lying a quality of a system. Here, the authors have forgotten, for a very brief moment, their ultra microfoundationalist inclinations. It is always individuals that lie, and if the system of public ordering encourages lies for personal benefit and the benefit of selected parties, it will attract opportunistic characters ready to tell them.

In the final chapter of their book, Eusepi and Wagner conclude that “there can be no such thing as public debt in a democracy because a democracy is not a sentient creature.” And furthermore, they claim that there “is no public that can pledge its wealth in exchange for credits from other people” (p. 163). Taken as such, these claims are exaggerated and slightly confusing. It is true that a democracy is not a sentient creature, of course, but neither is a monarchy. Democracies are composed of sentient creatures, if you like, and it is conceivable that they unanimously engage in a debt contract and pledge their wealth as collateral. It might be very unlikely to observe in any given community of a certain size, since such an arrangement would imply a socialization of personal default risk, but it is not impossible.

However, it is clear that much of the image of public debt, generated in ideological discourse is completely illusory. Professors Eusepi and Wagner have provided a fair number of arguments to substantiate this somewhat adjusted claim. The reviewer would hold that public debt is not an illusion of democratic political economy, but simply a very different creature from what it is made to be.

The particular occasion of this lecture, combined with the chief practical problem which economists have to face today, have made the choice of its topic almost inevitable. On the one hand the still recent establishment of the Nobel Memorial Prize in Economic Science marks a significant step in the process by which, in the opinion of the general public, economics has been conceded some of the dignity and prestige of the physical sciences. On the other hand, the economists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.

It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences — an attempt which in our field may lead to outright error. It is an approach which has come to be described as the "scientistic" attitude — an attitude which, as I defined it some thirty years ago,

is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed."Scientism and the Study of Society," Economica 9, no. 35 (August 1942); reprinted in The Counter-Revolution of Science (Glencoe, Ill.: 1952), p. 15.

I want today to begin by explaining how some of the gravest errors of recent economic policy are a direct consequence of this scientistic error.

The theory which has been guiding monetary and financial policy during the last thirty years, and which I contend is largely the product of such a mistaken conception of the proper scientific procedure, consists in the assertion that there exists a simple positive correlation between total employment and the size of the aggregate demand for goods and services; it leads to the belief that we can permanently assure full employment by maintaining total money expenditure at an appropriate level. Among the various theories advanced to account for extensive unemployment, this is probably the only one in support of which strong quantitative evidence can be adduced. I nevertheless regard it as fundamentally false, and to act upon it, as we now experience, as very harmful.

This brings me to the crucial issue. Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable. And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes.

It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world. This view, which is often quite naively accepted as required by scientific procedure, has some rather paradoxical consequences. We know, of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.

The correlation between aggregate demand and total employment, for instance, may only be approximate, but as it is the only one on which we have quantitative data, it is accepted as the only causal connection that counts. On this standard there may thus well exist better "scientific" evidence for a false theory, which will be accepted because it is more "scientific," than for a valid explanation, which is rejected because there is no sufficient quantitative evidence for it.

Let me illustrate this by a brief sketch of what I regard as the chief actual cause of extensive unemployment — an account which will also explain why such unemployment cannot be lastingly cured by the inflationary policies recommended by the now fashionable theory. This correct explanation appears to me to be the existence of discrepancies between the distribution of demand among the different goods and services and the allocation of labor and other resources among the production of those outputs. We possess a fairly good "qualitative" knowledge of the forces by which a correspondence between demand and supply in the different sectors of the economic system is brought about, of the conditions under which it will be achieved, and of the factors likely to prevent such an adjustment. The separate steps in the account of this process rely on facts of everyday experience, and few who take the trouble to follow the argument will question the validity of the factual assumptions, or the logical correctness of the conclusions drawn from them. We have indeed good reason to believe that unemployment indicates that the structure of relative prices and wages has been distorted (usually by monopolistic or governmental price fixing), and that to restore equality between the demand and the supply of labor in all sectors changes of relative prices and some transfers of labor will be necessary.

But when we are asked for quantitative evidence for the particular structure of prices and wages that would be required in order to assure a smooth continuous sale of the products and services offered, we must admit that we have no such information. We know, in other words, the general conditions in which what we call, somewhat misleadingly, an equilibrium will establish itself; but we never know what the particular prices or wages are which would exist if the market were to bring about such an equilibrium. We can merely say what the conditions are in which we can expect the market to establish prices and wages at which demand will equal supply. But we can never produce statistical information which would show how much the prevailing prices and wages deviate from those which would secure a continuous sale of the current supply of labor. Though this account of the causes of unemployment is an empirical theory — in the sense that it might be proved false, e.g., if, with a constant money supply, a general increase of wages did not lead to unemployment — it is certainly not the kind of theory which we could use to obtain specific numerical predictions concerning the rates of wages, or the distribution of labor, to be expected.

Why should we, however, in economics, have to plead ignorance of the sort of facts on which, in the case of a physical theory, a scientist would certainly be expected to give precise information? It is probably not surprising that those impressed by the example of the physical sciences should find this position very unsatisfactory and should insist on the standards of proof which they find there. The reason for this state of affairs is the fact, to which I have already briefly referred, that the social sciences, like much of biology but unlike most fields of the physical sciences, have to deal with structures of essential complexity, i.e., with structures whose characteristic properties can be exhibited only by models made up of relatively large numbers of variables. Competition, for instance, is a process which will produce certain results only if it proceeds among a fairly large number of acting persons.

In some fields, particularly where problems of a similar kind arise in the physical sciences, the difficulties can be overcome by using, instead of specific information about the individual elements, data about the relative frequency, or the probability, of the occurrence of the various distinctive properties of the elements. But this is true only where we have to deal with what has been called by Dr. Warren Weaver (formerly of the Rockefeller Foundation), with a distinction which ought to be much more widely understood, "phenomena of unorganized complexity," in contrast to those "phenomena of organized complexity" with which we have to deal in the social sciences.Warren Weaver, "A Quarter Century in the Natural Sciences," The Rockefeller Foundation Annual Report 1958, chapter I, "Science and Complexity." Organized complexity here means that the character of the structures showing it depends not only on the properties of the individual elements of which they are composed, and the relative frequency with which they occur, but also on the manner in which the individual elements are connected with each other. In the explanation of the working of such structures we can for this reason not replace the information about the individual elements by statistical information, but require full information about each element if from our theory we are to derive specific predictions about individual events. Without such specific information about the individual elements we shall be confined to what on another occasion I have called mere pattern predictions — predictions of some of the general attributes of the structures that will form themselves, but not containing specific statements about the individual elements of which the structures will be made up.See my essay "The Theory of Complex Phenomena" in The Critical Approach to Science and Philosophy: Essays in Honor of K.R. Popper, ed. M. Bunge (New York, 1964), and reprinted (with additions) in my Studies in Philosophy, Politics and Economics (London and Chicago, 1967).

This is particularly true of our theories accounting for the determination of the systems of relative prices and wages that will form themselves on a well-functioning market. Into the determination of these prices and wages there will enter the effects of particular information possessed by every one of the participants in the market process — a sum of facts which in their totality cannot be known to the scientific observer, or to any other single brain. It is indeed the source of the superiority of the market order, and the reason why, when it is not suppressed by the powers of government, it regularly displaces other types of order, that in the resulting allocation of resources more of the knowledge of particular facts will be utilized which exists only dispersed among uncounted persons, than any one person can possess. But because we, the observing scientists, can thus never know all the determinants of such an order, and in consequence also cannot know at which particular structure of prices and wages demand would everywhere equal supply, we also cannot measure the deviations from that order; nor can we statistically test our theory that it is the deviations from that "equilibrium" system of prices and wages which make it impossible to sell some of the products and services at the prices at which they are offered.

Before I continue with my immediate concern, the effects of all this on the employment policies currently pursued, allow me to define more specifically the inherent limitations of our numerical knowledge which are so often overlooked. I want to do this to avoid giving the impression that I generally reject the mathematical method in economics. I regard it in fact as the great advantage of the mathematical technique that it allows us to describe, by means of algebraic equations, the general character of a pattern even where we are ignorant of the numerical values which will determine its particular manifestation. We could scarcely have achieved that comprehensive picture of the mutual interdependencies of the different events in a market without this algebraic technique. It has led to the illusion, however, that we can use this technique for the determination and prediction of the numerical values of those magnitudes; and this has led to a vain search for quantitative or numerical constants. This happened in spite of the fact that the modern founders of mathematical economics had no such illusions. It is true that their systems of equations describing the pattern of a market equilibrium are so framed that if we were able to fill in all the blanks of the abstract formulae, i.e., if we knew all the parameters of these equations, we could calculate the prices and quantities of all commodities and services sold. But, as Vilfredo Pareto, one of the founders of this theory, clearly stated, its purpose cannot be "to arrive at a numerical calculation of prices," because, as he said, it would be "absurd" to assume that we could ascertain all the data.V. Pareto, Manuel d'économie politique, 2nd. ed. (Paris, 1927), pp. 223–24. Indeed, the chief point was already seen by those remarkable anticipators of modern economics, the Spanish schoolmen of the 16th century, who emphasized that what they called pretium mathematicum, the mathematical price, depended on so many particular circumstances that it could never be known to man but was known only to God.See, e.g., Luis Molina, De iustitia et iure (Cologne, 1596–1600), tom. II, disp. 347, no. 3, and particularly Johannes de Lugo, Disputationum de iustitia et iure tomus secundus (Lyon, 1642), disp. 26, sect. 4, no. 40. I sometimes wish that our mathematical economists would take this to heart. I must confess that I still doubt whether their search for measurable magnitudes has made significant contributions to our theoreticalunderstanding of economic phenomena — as distinct from their value as a description of particular situations. Nor am I prepared to accept the excuse that this branch of research is still very young: Sir William Petty, the founder of econometrics, was after all a somewhat senior colleague of Sir Isaac Newton in the Royal Society!

There may be few instances in which the superstition that only measurable magnitudes can be important has done positive harm in the economic field: but the present inflation and employment problems are a very serious one. Its effect has been that what is probably the true cause of extensive unemployment has been disregarded by the scientistically minded majority of economists, because its operation could not be confirmed by directly observable relations between measurable magnitudes, and that an almost exclusive concentration on quantitatively measurable surface phenomena has produced a policy which has made matters worse.

It has, of course, to be readily admitted that the kind of theory which I regard as the true explanation of unemployment is a theory of somewhat limited content because it allows us to make only very general predictions of the kind of events which we must expect in a given situation. But the effects on policy of the more ambitious constructions have not been very fortunate and I confess that I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretense of exact knowledge that is likely to be false. The credit which the apparent conformity with recognized scientific standards can gain for seemingly simple but false theories may, as the present instance shows, have grave consequences.

In fact, in the case discussed, the very measures which the dominant "macroeconomic" theory has recommended as a remedy for unemployment — namely, the increase of aggregate demand — have become a cause of a very extensive misallocation of resources which is likely to make later large-scale unemployment inevitable. The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labor and other resources into which can last only so long as the increase of the quantity of money continues at the same rate — or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganization of all economic activity. The fact is that by a mistaken theoretical view we have been led into a precarious position in which we cannot prevent substantial unemployment from reappearing; not because, as this view is sometimes misrepresented, this unemployment is deliberately brought about as a means to combat inflation, but because it is now bound to occur as a deeply regrettable but inescapable consequence of the mistaken policies of the past as soon as inflation ceases to accelerate.

I must, however, now leave these problems of immediate practical importance which I have introduced chiefly as an illustration of the momentous consequences that may follow from errors concerning abstract problems of the philosophy of science. There is as much reason to be apprehensive about the long-run dangers created in a much wider field by the uncritical acceptance of assertions which have the appearance of being scientific as there is with regard to the problems I have just discussed. What I mainly wanted to bring out by the topical illustration is that certainly in my field, but I believe also generally in the sciences of man, what looks superficially like the most scientific procedure is often the most unscientific, and, beyond this, that in these fields there are definite limits to what we can expect science to achieve. This means that to entrust to science — or to deliberate control according to scientific principles — more than scientific method can achieve may have deplorable effects. The progress of the natural sciences in modern times has of course so much exceeded all expectations that any suggestion that there may be some limits to it is bound to arouse suspicion. Especially all those will resist such an insight who have hoped that our increasing power of prediction and control, generally regarded as the characteristic result of scientific advance, applied to the processes of society, would soon enable us to mould society entirely to our liking. It is indeed true that, in contrast to the exhilaration which the discoveries of the physical sciences tend to produce, the insights which we gain from the study of society more often have a dampening effect on our aspirations; and it is perhaps not surprising that the more impetuous younger members of our profession are not always prepared to accept this. Yet the confidence in the unlimited power of science is only too often based on a false belief that the scientific method consists in the application of a ready-made technique, or in imitating the form rather than the substance of scientific procedure, as if one needed only to follow some cooking recipes to solve all social problems. It sometimes almost seems as if the techniques of science were more easily learned than the thinking that shows us what the problems are and how to approach them.

The conflict between what in its present mood the public expects science to achieve in satisfaction of popular hopes and what is really in its power is a serious matter because, even if the true scientists should all recognize the limitations of what they can do in the field of human affairs, so long as the public expects more there will always be some who will pretend, and perhaps honestly believe, that they can do more to meet popular demands than is really in their power. It is often difficult enough for the expert, and certainly in many instances impossible for the layman, to distinguish between legitimate and illegitimate claims advanced in the name of science. The enormous publicity recently given by the media to a report pronouncing in the name of science on The Limits to Growth, and the silence of the same media about the devastating criticism this report has received from the competent experts,See The Limits to Growth: A Report of the Club of Rome's Project on the Predicament of Mankind (New York, 1972); for a systematic examination of this by a competent economist, cf. Wilfred Beckerman, In Defence of Economic Growth (London, 1974), and, for a list of earlier criticisms by experts, Gottfried Haberler, Economic Growth and Stability (Los Angeles, 1974), who rightly calls their effect "devastating." must make one feel somewhat apprehensive about the use to which the prestige of science can be put. But it is by no means only in the field of economics that far-reaching claims are made on behalf of a more scientific direction of all human activities and the desirability of replacing spontaneous processes by "conscious human control." If I am not mistaken, psychology, psychiatry, and some branches of sociology, not to speak about the so-called philosophy of history, are even more affected by what I have called the scientistic prejudice, and by specious claims of what science can achieve.I have given some illustrations of these tendencies in other fields in my inaugural lecture as Visiting Professor at the University of Salzburg, Die Irrtümer des Konstruktivismus und die Grundlagen legitimer Kritik gesellschaftlicher Gebilde (Munich, 1970), now reissued for the Walter Eucken Institute, at Freiburg i.Brg. by J.C.B. Mohr (Tübingen, 1975).

If we are to safeguard the reputation of science, and to prevent the arrogation of knowledge based on a superficial similarity of procedure with that of the physical sciences, much effort will have to be directed toward debunking such arrogations, some of which have by now become the vested interests of established university departments. We cannot be grateful enough to such modern philosophers of science as Sir Karl Popper for giving us a test by which we can distinguish between what we may accept as scientific and what not — a test which I am sure some doctrines now widely accepted as scientific would not pass. There are some special problems, however, in connection with those essentially complex phenomena of which social structures are so important an instance, which make me wish to restate in conclusion in more general terms the reasons why in these fields not only are there only absolute obstacles to the prediction of specific events, but why to act as if we possessed scientific knowledge enabling us to transcend them may itself become a serious obstacle to the advance of the human intellect.

The chief point we must remember is that the great and rapid advance of the physical sciences took place in fields where it proved that explanation and prediction could be based on laws which accounted for the observed phenomena as functions of comparatively few variables — either particular facts or relative frequencies of events. This may even be the ultimate reason why we single out these realms as "physical" in contrast to those more highly organized structures which I have here called essentially complex phenomena. There is no reason why the position must be the same in the latter as in the former fields. The difficulties which we encounter in the latter are not, as one might at first suspect, difficulties about formulating theories for the explanation of the observed events — although they cause also special difficulties about testing proposed explanations and therefore about eliminating bad theories. They are due to the chief problem which arises when we apply our theories to any particular situation in the real world.

A theory of essentially complex phenomena must refer to a large number of particular facts; and to derive a prediction from it, or to test it, we have to ascertain all these particular facts. Once we succeeded in this there should be no particular difficulty about deriving testable predictions — with the help of modern computers it should be easy enough to insert these data into the appropriate blanks of the theoretical formulae and to derive a prediction. The real difficulty, to the solution of which science has little to contribute, and which is sometimes indeed insoluble, consists in the ascertainment of the particular facts.

A simple example will show the nature of this difficulty. Consider some ball game played by a few people of approximately equal skill. If we knew a few particular facts in addition to our general knowledge of the ability of the individual players, such as their state of attention, their perceptions and the state of their hearts, lungs, muscles, etc. at each moment of the game, we could probably predict the outcome. Indeed, if we were familiar both with the game and the teams we should probably have a fairly shrewd idea on what the outcome will depend. But we shall of course not be able to ascertain those facts and in consequence the result of the game will be outside the range of the scientifically predictable, however well we may know what effects particular events would have on the result of the game. This does not mean that we can make no predictions at all about the course of such a game. If we know the rules of the different games we shall, in watching one, very soon know which game is being played and what kinds of actions we can expect and what kind not. But our capacity to predict will be confined to such general characteristics of the events to be expected and not include the capacity of predicting particular individual events.

This corresponds to what I have called earlier the mere pattern predictions to which we are increasingly confined as we penetrate from the realm in which relatively simple laws prevail into the range of phenomena where organized complexity rules. As we advance, we find more and more frequently that we can in fact ascertain only some but not all the particular circumstances which determine the outcome of a given process; and in consequence we are able to predict only some but not all the properties of the result we have to expect. Often all that we shall be able to predict will be some abstract characteristic of the pattern that will appear — relations between kinds of elements about which individually we know very little. Yet, as I am anxious to repeat, we will still achieve predictions which can be falsified and which therefore are of empirical significance.

Of course, compared with the precise predictions we have learned to expect in the physical sciences, this sort of mere pattern predictions is a second best with which one does not like to have to be content. Yet the danger of which I want to warn is precisely the belief that in order to have a claim to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm. In the physical sciences there may be little objection to trying to do the impossible; one might even feel that one ought not to discourage the overconfident because their experiments may after all produce some new insights. But in the social field, the erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority. Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous-ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims. We are only beginning to understand on how subtle a communication system the functioning of an advanced industrial society is based — a communications system which we call the market and which turns out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed.

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants. There is danger in the exuberant feeling of ever-growing power which the advance of the physical sciences has engendered and which tempts man to try, "dizzy with success," to use a characteristic phrase of early communism, to subject not only our natural but also our human environment to the control of a human will. The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men's fatal striving to control society — a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

The Nobel Foundation 1974. Reproduced with permission.

Mises’s exposition of economic science differed decisively from all modern authors in that it drew a sharp line between praxeology and psychology. This has remained a defining feature of the works of his disciples.

Mises did not contest that the psychological background of a person, his worldview, knowledge, conscious motivations, subconscious urges, and so on have an immediate impact on his behavior. Neither did he ignore the important psychological problems that his friend F.A. Hayek began to stress in those years, in particular, that of knowledge acquisition. Mises’s point was that there were also laws of human behavior that exist in complete independence of these psychological dispositions.

For example, in chapter 4, Mises discusses ends and means, scales of values, and scales of needs. He does not deal with the question of how or why people select ends and means, or how or why they have certain values and certain needs. He argues that in every human action we do use means to attain ends, and that needs and values can be rankedMurray Rothbard later argued that as a consequence of the mere fact that people rank their choice alternatives, it follows that demand curves must slope downward to the right. See Murray N. Rothbard, Man, Economy, and State, 3rd ed. (Auburn, Ala.: Ludwig von Mises Institute, 1993), chap. 2. Mises made no such inference. He was skeptical about the use of graphical methods in exact analysis (he did accept them as pedagogical devices). In chapter 15 (“The Market”) he points out that consumers are sovereign because their buying decisions steer the market.Mises, Human Action, p. 270. This is obviously true, irrespective of what consumers buy or the reason why they make these purchases. Therefore he does not deal with these questions. In chapter 16 (“Prices”) Mises states that the number of market participants determines how narrow the margins are within which prices are determined. Yet this implies that the number of market participants has no influence on how prices are formed. Irrespective of the number of market participants, market prices are always determined by the decisions of marginal buyers and sellers.Ibid., p. 324. Thus, all prices can be explained as a result of the mere fact that market participants prefer one good A to another good B.Ibid., pp. 328f.

Praxeology is the science of these laws. It examines the ramifications of the mere fact that a man makes this or that choice. Considering the relationship between a choice and its consequences, praxeology examines the suitability of different means to attain particular ends. In praxeological analysis, the ends are “given,” not in the sense that human beings cannot choose them or that the choice of the right end is not problematic, but in the sense that the choice of ends is outside the scope of this particular science.Mises would later discuss the irrelevance of homooeconomicus for modern economics in Human Action, pp. 62ff. He concluded that "theorems concerning commodity prices, wage rates, and interest rates refer to all these phenomena without any regard to the motives causing people to buy or to sell or to abstain from buying or selling" (p. 64).

With respect to the knowledge of market participants, Mises emphasized the fact that the individual market participants are not equally well informed. Yet even if they all had the same information they would appraise this information differently.Ibid., p. 325.

As to equilibrium, he stated again and again that the market never reaches such a state, that it is a mere mental construct the only function of which is to analyze profits and losses. That is, the equilibrium construct is needed to explain a particular component of price spreads. It is not required to explain prices (wages, interest, commodity prices) as such.Ibid., pp. 245ff.

Consequently, in Mises’s view, equilibrium is not the right benchmark for the evaluation of the market. To critics of economic science who complain that the market never produces a perfect balance between different goods and services, Mises replies in two steps.Ibid., p. 647, for example. First, he points out that this fact of imbalance does not refute economic doctrine because economic science explains any state of affairs as it results from the fact that consumers make certain valuations. Second, he observes that the relevant benchmark for the market is government intervention. And because government officials are not supermen, one cannot make the a priori assumption that entrusting them with the maintenance of the market will bring improvement. As the analysis of government interventionism shows, the very opposite is the case.

Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)

ABSTRACT: As the first application of the praxeological discipline of “Cratics” (Taghizadegan and Otto, 2015), a theory of the supply and demand of bads is developed. On this foundation, a violence cycle theory will be introduced in analogy to the praxeological business cycle theory (according to Ludwig von Mises). Central to this approach are the subjective perceptions of threats and possible bluffs regarding the backing of those threats. Such a violence cycle theory can explain the stability of structures of violence and reveal new interpretations of the “long peace” hypothesis.

Those actions and things which render a marginal utility to men can be described as goods. In analogy, those actions and things which cause to expect a “marginal disutility” can be described as bads. Catallactics, i.e., the economics of direct and indirect exchange, can describe the process of the interaction of men who mutually promise and transfer goods to each other. In this case, concrete exchange relations are documented in the form of prices, reflecting subjective preferences and promises. The supplier of a good communicates the following promise:

I promise to give the good A to a person who offers me, at least, X in return.

A potential counterparty, however, communicates:

I promise to give, at most, X to a person who offers me the good A.

The exchange, i.e. the contracting, follows as the implementation of the given promises.

Similarly, coercive interactions as described by the discipline of cratics (cf. Taghizadegan and Otto, 2015), contain promises as an essential element. In analogy to catallactics, we can distinguish suppliers and counterparties regarding bads. The supplier of a bad pursues a marginal utility on his part by making the counterparty act in a certain way through promising a bad in case of that counterparty’s refusal. Critical herein is the specific and subjective expectation of the ensuing damage, the marginal disutility, rather than some objectively quantifiable harm. In particular, the expected disutility depends on the counterparty’s situation. The promise, i.e. the threat, to kick a paraplegic’s leg might lead to a smaller expectation of disutility than is the case with a non-paraplegic person.

A threat can be considered as an “offer” of a bad. It is an offer only in an extended sense, since it can be rejected by the counterparty—but not without incurring costs. The actual interaction, however, runs contrary to a catallactic process: In catallactics, the offering party endeavors to contract in order to obtain a certain good in exchange for another good. In cratics, contracting implies the unilateral transfer of the good in order to avoid the bad. Non-contracting on the part of the counterparty implies to keep the good and to “test” the validity of the threat to execute the bad. The “supplier” of the bad makes the following promise:

I promise to not execute the bad B on those who, at least, provide me with good G in return.

The “consumer” of a bad is a party that acknowledges the validity of the threat and therefore gives in to it. Thus, the term “bad” might be somewhat counterintuitive, however, it helps to establish the mirror-inverted analogy to catallactics. The consumer of a good ascribes a higher marginal utility to this good than to the asked exchange good and therefore wishes to transact. The “consumer” of a bad expects a higher marginal disutility from the bad than from giving up the demanded good. Herein, the “consumer” confirms the (validity of the) bad and encourages the “supplier” of the bad to provide more thereof, much like a catallactic consumer encourages a supplier to offer more of the same good. In effect, the “consumer” of the bad communicates the following promise:

I promise to give G if the bad B is not done to me.

Goods are offered in the hope of meeting demand—meaning, a willingness to pay more than the costs, i.e. the marginal disutility from employing the factors of production. Bads are offered based on the expectation that, for the “consumer,” the willingness to evade the bad is inferior to the marginal utility of the good. The willingness to evade therein denotes the amount of utility or value that the counterparty is willing to risk in order to evade the respective bad. Namely, the “consumer” risks that his costs to evade the bad exceed the costs of the bad itself. In effect, a high willingness to pay implies a large demand for goods, or a large willingness to contract, whereas high willingness to evade implies low demand for bads, or a low willingness to contract. In catallactics, the willingness to evade is irrelevant, since evasion costs are typically zero. In cratics, the willingness to pay—i.e., the readiness to contract—amounts to a willingness to obey, to give in to threats.

In analogy to the turnover of goods, the turnover of bads can be illustrated with analytical functions. Such supply and demand functions, to be sure, do not reflect reality in an exact manner, but rather serve to illustrate certain mechanisms: the higher the willingness to pay for a certain good, the more suppliers can expect turnover and will therefore join the market. In the case of bads, the tendency is the same: The higher the willingness to pay (willingness to obey), the more bads will be offered, whereas the higher the willingness to evade, the less bads remain as effective threats on the “market.”

Needless to say that this analogy must not be misunderstood. The “market” for bads is no market at all. At this point another analogous term would be necessary. The term “market” is derived from the Latin word mercatus, which in turn stems from merx: a product or good. Bads in Latin would be malae merces, so that one could form the concept of a malmarket, but that would probably be too much of a play of words. Let us stay with the Greek language: catallactic for a market order, cratic for a coercive order, whereby the study of the first is called catallactics while the study of the second is denoted as cratics. This contrast resembles Franz Oppenheimer’s (1924) juxtaposition of the political and the economic means—the former would be cratic, the latter would be catallactic.

Back to the dynamics of the willingness to evade, where we can observe two extreme cases: A zero willingness to evade would mean to give up all values without resistance. There would be a maximum of bads, but a minimum of actual violence. As soon as “buyers” with a zero willingness to evade are discovered by “producers” of bads, the former—reluctantly—nurture the production of bads, which may entirely drive out the production of goods.

Let us clarify that example conceptually: “Production” of bads means the intention, preparation and propagation of harm to other people to the benefit of the “producer” at the lowest cost possible. In this case, a threatening appearance could constitute a “factor of production.” When a bully runs into a classmate who has no willingness to evade, an angry look alone could be enough to be recognized as the offer of a bad, whereupon the transfer of snacks may follow without resistance, amounting to the immediate contracting in this coercive exchange. This would typically lead to a marginal rise of the production of bads, both because the producer of bads will be encouraged to further employ his “production factor,” and because successors may appear who recognize how easy it is to obtain other people’s goods. If, in a given “market,” all the “buyers of the bads,” i.e., those who give away the demanded goods, exhibited zero willingness to evade, the production of goods would not be profitable anymore, because even the smallest bads would lead to their uncompensated transfer. Such a society would break apart very quickly, because all those “buyers” would run out of resources. A short period of absolute non-violence—during which violence was not necessary to break the will of the “buyers”—would yield to a period of violence among the producers of bads.

In contrast, a maximum willingness to evade would require the highest degree of violence for coercive exchange. Every threat would immediately be checked for its “backing.” The “demand” for bads would be reduced to a minimum because the potential “buyers” preferred to risk the bad. A maximum willingness to evade may have two reasons: A maximum distrust in threats, and/or an absolute firmness with regard to one’s principles, whereby one would risk everything in order to avoid giving up one’s principles and values. In catallactics, analogous reasons would explain a minimum willingness to pay for offered goods: A maximum distrust in promises on the market, and/or an absolute firmness with regard to one’s principles, which do not allow for a gain in utility through exchange (hostility against trade, defeatism etc.).

A cratic “buyer” expects that the cost of the evasion is higher than the demanded payment (buying into the threat). A catallactic buyer expects that the gain in utility through the offered goods is higher than the loss in utility through the demanded payment. The cratic “price” amounts to the demanded payment (loss of utility) to evade the threatened bads. The higher the demanded price and the higher the willingness to evade, the less the “demand.”

In the field of catallactics, interventions in prices and quantities are known that have a cratic character by themselves. Namely, they are efforts to replace particular exchange relations of goods by means of the threat of bads. Every imperative or prohibition represents a cratic exchange: An “offer” (the threat) of bads is linked to an action or non-action preferred by the coercive party. At first sight, again, the analogy between omissions (caused by prohibitions) and services (preferred actions as goods) might seem overstretched. However, the objective character of the action to be performed or refrained from is a technical, not an economic question. An economic judgment of actions according to their technical content would violate the value neutrality principle, and amount to an arrogation of knowledge, respectively. In contrast, in the disciplines of medicine and religion, to name only two striking examples, action cannot easily be distinguished from non-action. In addition, catallactic offers can aim at a non-action, such as an offer of money to a street musician in exchange to stopping the performance.

Following these introductory remarks, let us now proceed to the core of this work, the analogy to business cycle theory. Namely, broadly speaking, the cratic character of offers or threats is not always obvious. Bluffs (or deceptions) might have the same effect as price and quantity interventions. A particularly important field of such deceptive interventions is described by the business cycle theory according to the Austrian school of economics (see Mises, 1912). It describes the periodical emergence of an economic boom, followed by a bust. The reason for this typical pattern is a credit expansion beyond the level of real savings, which is revealed in suppressed interest rates. Such interest rates would be untenable and, in particular, would cause illiquidity, were they not enabled by cratic interventions (compulsory wealth transfers, privileges such as those arising from central banking, contract breaches without consequences, etc.).

This distortion of interest rates is, on the one hand, a price intervention, and, on the other hand, a deception. The lowered interest rate has a similar effect as a maximum price coercively set at a level below the market price. In this case, demand is higher than supply. The interest rate is the price for savings; the demand for savings—thus indebtedness—rises; the supply of real savings—the propensity to save—decreases. This would cause a supply gap, if the created circulatory credit had not filled that gap. But since the circulatory credit is based on the assumption that bank deposits will not be withdrawn, it is a deception regarding the true extent of available savings. During phases of credit expansion arising from artificially low interest rates (a “maximum rate of interest fixed below the market rate”), consumption and investment are booming at the same time. The overestimated savings and thus resources considered as disposable are unbacked promises. The insufficient backing within the financial system will be uncovered through a bank run, a run on illiquid banks, which without bailouts would have to default on their depositors. In the economy, an insufficient backing of promises with resources will be visible through unexpected price increases, which cause the illiquidity of entrepreneurs who are now unable to finish their projects.

An analogous, systematic discrepancy between promise and backing—namely, between threat and capability to execute—exists in the field of cratics. An actor can, very easily, issue threats that exceed what he himself is capable and willing to execute. In the same way, entrepreneurs can make incorrect estimations about their own liquidity. Whenever such miscalculations accumulate, cycle patterns appear. In his “General Theory of Error Cycles,” Jörg-Guido Hülsmann describes such accumulations of errors as illusions of legitimacy (Hülsmann, 1998). When, in the above schoolyard example, at some point in time it becomes common practice to hand over one’s snacks to the bully, the need to “back” his threat disappears. One day he could lose his physical ability to supply the bads—punching disobedient schoolmates. As long as this ability is not checked, the bully can still collect the goods—until the day when a person again takes a risk and the illusion of the powerful bully bursts.

This pattern of deceptions and bursting illusions resembles the business cycle. The illusion starts a phase of apparent stability that actually appears to be particularly peaceful and free from violence: the threat boom. The issuer of threats is peaceful at this stage—he might even thank the classmates for handing over their snacks and return half of them. At this stage, the contracting of bads is high. Let us remember: The contracting of bads does not imply a preference for such bads (they are, after all, bad). However, it does imply the willingness to engage in cratic exchange, which consists of the delivery of goods or the execution or omission of actions in exchange for the non-execution of the threat. After the revelation of the incapacity to execute the threats, the stage of apparent voluntariness is followed by an explosive correction: The willingness to contract falls extremely rapidly. Even if the bully seeks rapid execution, he now detects that his power is “illiquid”: it does not suffice to meet the suddenly accumulating challenges. While, during the boom, the physical overpowering of an individual was sufficient, now the physical overpowering of larger groups becomes necessary. The threat boom ends with a correction of the level of coercion, in which the power of the aggressor competes directly with the resistance of the victims. Now the schoolyard exhibits a high level of violence. Actually, it is a period of the reduction of (implicit) violence in which unsustainable cratic relations finally yield to catallactic relations. Clueless teachers might intervene to stop the violence, by sanctioning the challenging pupils. Thereby, the correction might be postponed, creating the impression that the bully stood up against the challenges to the backing of his threats. In the worst case, the teachers intervene for the purpose of a superficial reduction of violence by artificially legitimizing the bully’s claim: “The wiser head gives in!” Through this, another threat boom could follow, where the bully could increase his demands even more—after all, the wiser head has to give in! Apparent peacefulness would increase again, up to the point where someone decides to challenge the bully again.

Coercive rule as a systematic implementation of cratic exchange is possible either through a physical superiority of the rulers or through the illusion of superiority, as De la Boëtie observed a long time ago:

He who thus domineers over you has only two eyes, only two hands, only one body, no more than is possessed by the least man among the infinite numbers dwelling in your cities; he has indeed nothing more than the power that you confer upon him to destroy you. (La Boëtie, 1550)

The paradox of prolonged apparent peacefulness of coercive rule can thus be explained through the violence cycle theory presented here. That puts the observation in its true light—that open violence may have decreased throughout the last centuries. One of the most detailed expositions of this development is Steven Pinker’s (2011). He reasoned that in the course of history the “better angels” within human nature have prevailed against the “inner demons”—leading to modern man being more civilized. The presented empirical evidence seems conclusive: The violence among individuals as well as between states (wars) seems to have decreased.

Two of the many reasons that Pinker proposes for this development are of direct concern to the field of cratics: On the one hand, he argues, the growth of Leviathan—the centralized state monopoly on the use of force—has displaced the violence between smaller units, while on the other hand, commercialization has made people more peaceful. The latter argument finds confirmation in the fact that catallactic transactions are able to replace cratic transactions: After all, for each bilateral action he envisions, man can choose whether to employ the cratic or the catallactic mode. The former argument finds, at best, partial confirmation. Phases of cratic legitimacy may indeed have a pacifying effect. This idea goes back to Thomas Hobbes and can be confirmed by praxeological analysis—but with serious reservations that lead to conclusions which differ completely from those drawn by Hobbes and Pinker.

Indeed, the violence cycle has a paradoxical effect which complicates its quantitative assessment—just like the business cycle. The possible “evaluation of the backing” of promises of violence can lead to violent corrections after peaceful periods, a cratic recession, during which the violence is bid up dramatically. This explains the conclusion of Hobbes that such “evaluations of the backing” should be completely avoided, which can only succeed through the subjects’ complete renunciation to challenge the government. Otherwise a civil war would be imminent:

For those men that are so remissly governed that they dare take up arms to defend or introduce an opinion are still at war; and their condition, not peace, but only a cessation of arms for fear of one another; and they live, as it were, in the procincts of battle continually. It belonged therefore to him that hath the sovereign power to be judge, or constitute all judges of opinions and doctrines, as a thing necessary to peace; thereby to prevent discord and civil war.” (Hobbes, 1651, chapter XVIII)

The fallacy lies in considering the high potential of violence during the cratic recession as the natural state—just like the fear of the high “clean-up costs” of economic recessions, which usually show a steep rise in unemployment and insolvencies. In fact, however, the recession is a corrective process, revealing the discrepancies between economic actions and economic realities which had accumulated during the artificial boom. Hobbes sees fear of violence as the only chance for pacification and dismisses catallactic alternatives, the possibility for people to reach complementary or inverse goals by peaceful means without harming each other. This leads to an interventionist perspective on politics, seeking a monopoly of fear, analogous to economic policy claiming the monopoly of trust for the state, as the supposed guardian of money and contracts. Hobbes’ concept of man is, accordingly, biased:

Of all passions, that which inclineth men least to break the laws is fear. Nay, excepting some generous natures, it is the only thing (when there is appearance of profit or pleasure by breaking the laws) that makes men keep them. (Hobbes, 1651, chapter XXVII)

If fear were really the main reason for rule-consistent behavior, the costs of violence would be uneconomically high for Leviathan: The sanctions for breaches of law would have to be backed to a degree where the related costs would reach the level of income from cratic action. In the short term, it may be possible to compensate for a lower likelihood of revelation of violence with more draconian penalties. But in this way the legitimacy further decreases and thereby also the subjects’ “willingness to contract” (willingness to obey). These dynamics are missed by Hobbes, as well as the observation that in times of long and far-reaching peace obtained through a highly stable coercive setup (i.e, a high level of implicit fear and obedience), the probability of a “black swan” of massive violent corrections—or, more generally, reactions—is growing: in particular, our violence cycle theory suggests a correlation between the intensity of violent reactions and the lengths and intensities of the respective preceding coercive periods, that is of those periods within a certain culture or society that are characterized by a stable coercive setup. Following Nassim Taleb, the distribution of the intensity of violent outbursts indicates a fat tail (Taleb, 2012); accordingly, we assume a fat-tail distribution regarding the length (and intensity) of preceding coercive periods. Hence, we also agree with Taleb’s criticism of Pinker, particularly regarding the evaluation of our present-day situation. On a side note, to be sure, Taleb’s analysis does not distinguish between the internal and external type of a violent outburst (civil war versus interstate war). Indeed, we argue that a violent reaction does not necessarily have to affect the coercing party or institution, as would typically be the case in a civil war. Rather, we hold that interstate wars have consistently been employed by coercing institutions as a means to divert internal backlashes.

With threat boom and threat bust as the two elements of a cycle, the total enacted violence across such a cycle—or in economically more precise terms: the total volume of contracted and enacted bads—may be considerably higher than it would be without the cycle, or with a less pronounced one. Analogously, the growth in prosperity over the entire economic cycle is lower than it would be without boom-and-bust sequences. This is so both because the boom constitutes a distortion in which goods are misallocated—meaning, allocated not in accordance with the preferences and plans of the people—and because the bust, while it might correct this distortion, typically produces highly damaging side effects in the process, which would not have been “required” with a less pronounced or non-existing cycle.

However, this perspective does not only apply for archaic or low-level regimes of fear but also for modern regimes of legitimacy. Indeed, Hobbes praised fear, which he correctly recognized as a stabilizing element of cratic structures, as a corollary of freedom:

Fear and liberty are consistent: as when a man throweth his goods into the sea for fear the ship should sink, he doth it nevertheless very willingly, and may refuse to do it if he will; it is therefore the action of one that was free: so a man sometimes pays his debt, only for fear of imprisonment, which, because nobody hindered him from. (Hobbes, 1651, chapter XXI)

Similaly, legitimacy is used as a synonym for freedom in modern cratic systems, for example under the terms “rule of law” and “democracy.” However, whereas in catallactics unbacked promises can be corrected sooner and on a smaller scale, because the self-interest of the people serves as a corrective, cratic promises can expand to a higher degree. The potential “black swan” consists in a sudden implosion of legitimacy. In effect, the legitimization of cratic exchange reduces its costs below the otherwise necessary level and leads to the preponderance of the political (cratic) means over the economic (catallactic) means. The resulting preponderance of supply and contracting of bads leads to an allocation of means which, on average, corresponds less to the preferences and plans of the people than would be the case without such legitimization and the resulting violence cycle.

There is a similar problem in case of interstate violence. Peaceful coexistence is not only stabilized by mutual threat potential, but also by perceived legitimacy of predominance, respectively transfer of sovereignty. Praxeological analysis, however, shows that these seemingly stable arrangements are more fragile than is generally perceived, because these arrangements themselves sow the seeds of “corrective catastrophes.”

The problem of “black swans” in case of the threat potential through weapons of mass destruction is a matter of common knowledge. Nassim Taleb probably had precisely this in mind when criticizing Pinker:

Ancestral man had no nuclear weapons, so it is downright foolish to assume the statistics of conflicts in the 14th century can apply to the 21st. A mean person with a stick is categorically different from a mean person with a nuclear weapon, so the emphasis should be on the weapon and not exclusively on the psychological make-up of the person. (Taleb, 2012)

Let us translate this into the language of cratics: Frequent evaluations of the backings of geopolitical arrangements through small scale skirmishes may at first exhibit a higher rate of violence, while in the long term they could harbor a lower potential of violence than a peace order (or the order of a cold war), the backing of which can only be evaluated through the use of nuclear weapons. We have survived the 20th century without mutual destruction, but to deduce therefrom the superiority of a peace order based on massive threat potential would be a statistical fallacy, as Taleb observed. The fallacy of the “survivor bias” fits in every sense of the word: The world has frequently been on the brink of catastrophe. We have survived; that is why we can praise modernity as the best of all worlds, which, as Pinker empirically claims, may show less violence and war than earlier epochs. If that lottery had turned out differently, there would be hardly anyone left to sing such praises. A mere 100 years ago, a similar analysis would also have praised an apparent age of peace:

Panelists in 1912 could have produced compelling evidence documenting the decline of great power war. The previous century had been the most peaceful on record, continuing the decline in great power war over the previous three centuries. There had been zero great power wars for nearly four decades, a 50% decline over the last two centuries, and zero general wars involving all of the great powers for 97 years. This was the longest period of great power peace in the last four centuries of the modern European system.” (Levy and Thompson, 2013, p. 412)

As well, in the case of interpersonal violence, a low level of violence can have causes other than the development of so-called angelic behavior—unless one praises obedience as an angelic virtue and condemns human freedom as a satanic temptation. Cratic structures which enforce obedience through physical superiority, rather than through habit and legitimization, correspond to the phenomenon of stationary bandits, which Mancur Olsen (1993) analyzed economically. Olson concludes that the monopolization of the use of violence should minimize such violence. The stationary bandit replaces non-stationary bandits and contents himself with less, though continuous, prey. Our analysis, however, indicates that this compensation is not certain: The same rationality leads to a lower and thus cheaper backing of threats for a stationary bandit. On the one hand, this enables, ceteris paribus, a higher level of exploitation. On the other hand, since criminals (who also operate cratically) are the first ones who evaluate the backing of threats, a lower degree of backing by the “primary, stationary bandit” may imply that the quality of his “service” (security) relates very poorly to his cost level (appropriation of goods). In extreme cases, the population may be harassed to an insupportable degree through unbacked threats, while at the same time left completely and utterly at the mercy of criminals who operate with backed threats. In such a setup, peacefulness may purely result from defenselessness. The officials seem to get along with forms and stamps; weapons are hardly used. But behind this facade of peacefulness grows a black swan of cognitive dissonance that is expressed at first through declining trust and increasing resentment. It is difficult to predict the behavior of people who have been peaceful only due to apathy and blindness, when they suddenly fear for their survival. Explosions of violence at the end of such a cycle cannot be excluded. In effect, this is the risk of pacification through fear or legitimization of cratic threats. Ultimately, a level of violence at which threats are challenged and thus evaluated more often might be higher in the short term, but should be lower in the long term—even in the case where, during a long threat boom, people get accustomed to “angelic peacefulness.”

The threat boom is not only characterized by the fact that one day a correction is due, which can lead to an explosion of violence (revolutions, civil wars, uprisings), but also by the fact that it leads to a systematic overestimation regarding how well the existing order corresponds to the preferences of the people. It is similar to an economic boom: The order books and supermarkets are full, the companies are flourishing, but the markets are distorted—less and less of what the people intrinsically demand is produced while, rather, value destruction takes place. Scarce and therefore valuable resources are transformed into less valuable things. Similarly, during a threat boom, behind a facade of legitimacy, hidden exploitation takes place. Of course, “value” and “exploitation” are normative concepts. Expressed in a value neutral way, it boils down to a situation in which actions are legitimized as valuable and just, and are thus encouraged, which, after revelation of the consequences, are regarded as destructive and exploitive in hindsight. The problem lies precisely in this encouragement, thus in the dynamics: A hidden tension between aspirations and reality is growing.

The violence cycle theory facilitates a critical analysis of the succession of periods of war and peace. Furthermore, it allows a new interpretation of the prevailing civilization and reduction of inter-personal violence in large parts of the world throughout modernity. Cratic analysis also nourishes the debate about an ethical justification of state violence with new insights, e.g., through a critical examination of the possibilities and conditions for a minimization of violence.

The violence cycle theory is more than a mere analogy to the business cycle theory. The business cycle is not a necessary result of monetary expansion, as Hülsmann has shown. Monetary expansion is usually linked to a cycle of erroneous trust by entrepreneurs in the institutional framework and distorted market signals. Hülsmann argues:

The mere fact that the quantity of money changes does not prevent the entrepreneurs from judging correctly what influence it will exercise on market prices. (Hülsmann, 1998, p. 4)

He concludes that the business cycle theory is “not generally and apodictically valid.” Thus, a more general theory is needed, even to explain the business cycle in the first place—the business cycle is not an explicans, but an explicandum, on which the cratic cycle theory may shed additional light. Trust in unbacked promises, misled by coercion, may play a larger role than previously thought. Of course, trust is a subjective category and does not allow for deterministic or quantitative predictions. Misguided booms, based on unbacked promises or threats, are not necessarily corrected; if gullibility increases at the same pace, they may go on forever. If they are corrected, they tend to collapse; disillusionment is self-reinforcing.

Hopefully, these introductory considerations help to show the potential of further application of “cratics,” i.e., the praxeology of coercion and violence, in the fields of ethics, political science and history.

ABSTRACT: Although commonly misconstrued as a statement concerning the “correctness” of prices, the Efficient Market Hypothesis (EMH) is a statement about their informational content. The aftermath of the recent recession has brought renewed skepticism to EMH, even leading some to redefine it as the “inefficient” market hypothesis. We demonstrate that such a course of action is misguided, as it changes the nature of the input (i.e., the market) but not the truth value of the statement (i.e., whether markets are efficient). We outline further several logical fallacies of the Hypothesis which negate its usefulness. We conclude by showing that the EMH was never a hypothesis and as such is best considered a conjecture. As a conjecture, it is increasingly difficult to reconcile with market behavior in both theory and practice.

Phishing for Phools: The Economics of Manipulation and Deception, by Nobel Laureates George A. Akerlof and Robert J. Shiller, presents the thesis that we are overly confident in unregulated markets and that entrepreneurs accrue profit by preying on hapless consumers, exploiting “our weakness in knowing what we really want” through the market’s tendency “to spawn manipulation and deception.” Mavens of manipulation themselves, Akerlof and Shiller claim many, if not most people — especially the poor — are irrationally exuberant and are induced into buying things they really do not want. How do they know what the consumer really wants, one might ask? The answer is that anything the authors would not do themselves is ipso facto not in the best interest of the consumer. In fact, it is something that “no one could possibly want.”

Their opening chapter is an exercise in convoluted methodology. In it, Akerlof and Shiller obliterate any distinction between adroit entrepreneurship/marketing and deception/fraud. The most fundamental problem, however, is that Akerlof and Shiller think that what people really want is what is (objectively) good for them. They refuse to recognize that even if consumers were aware of the costs of eating Cinnabon — their bête noire in the opening chapter — and consuming a high calorie meal devoid of nutrients, they still might choose to eat Cinnabon. In their paternalist fervor, they cannot fathom that some people, in some places, at some times, might be willing to make such a trade off.

Rejecting Mises’s economic tautology that business owners stay afloat by satisfying consumer preferences through voluntary exchange, they believe that, instead, business owners compete for who can best deceive their customers. They call Cinnabon’s efforts to attract customers by making their product more desirable and available in convenient locations “phishing.”

Is the alternative, then, to mandate that businesses instead locate their stores in inconvenient locations, where they are less likely to sell their products to increase market efficiency? No answer is forthcoming. Also never answered by the duo is, if advertising is so effective at deceiving consumers, why do firms not spend nearly all of their budgets on advertising? Wildly exaggerating the problem they present, Akerlof and Shiller even think that the cumulative effect of “phishing” that companies like Cinnabon do through luring people in with the aroma of their cinnamon rolls may be as significant as the financial crash of 2008.

They also maintain that the incompetence of the average person prevents them from wisely investing their funds. What they do not show is that a disinterested bureaucrat spending someone else’s money has an incentive to invest carefully, which they simply assume. No matter that an individual has knowledge of his time, place, and preferences that a bureaucrat cannot have, regardless of whether or not consumers make systematic cognitive errors. What they call informational asymmetries, i.e., the different levels of knowledge among consumers and producers, should properly be called the division of labor and knowledge in society, which underpins all markets and gives us a basis to make exchanges in the first place. It is for the very reason, namely that producers of goods know more about the goods they produce, that we purchase from them. Hence, in criticizing information asymmetry in markets, they are criticizing all exchange. Akerlof and Shiller habitually succumb to this Nirvana fallacy, holding up the utopian ideal of perfect information as their (unreachable) model, and then when markets fail to reach this ideal, assume that this justifies government intervention, never giving us a reason why these systemic cognitive biases and information asymmetries can be avoided by bureaucrats more than they can by the average consumer.

Fundamentally, they mistake the beauty of the market and its convenience with manipulation. When they see a wide variety of products to choose from within arm’s reach, such as in a supermarket, they view it as a scheme to induce consumerist depravity and indulgence, rather than as a wonder to behold. They critique overpaying for health plans at the same time they critique obesity. We also see them succumbing to extraordinarily misleading explanations of history. For instance, in chapter six, they repeated the canard that Upton Sinclair’s The Jungle exposed the meatpacking industry’s unsanitary practices, when in fact his book was a complete fabrication, making no mention of this.

In general, Akerlof and Shiller appear oblivious to the roles consumer reporting institutions, competition, reputation, repeated dealings, and quality assurance play in doing just what they claim markets fail to do. If they desired to write a complete, and balanced look at the phenomenon they studied, rather than forward their agenda — what is in reality a jobs program for economists — they had ample material with which to work. The “heroes” of the story, instead, are primarily government regulators, and others who “step back from the profit incentive.” The profit incentive, for them, is essentially a one-way trip down Deceit Drive toward Manipulation Station. This single chapter focuses on the ways these problems are overcome, but they present nothing but impotency regarding the ability of businesses to do anything other than manipulate and deceive. The market, apparently, cannot provide solutions to or protect against this predatory behavior they attribute to these businesses, evidence to the contrary notwithstanding. We are left with the impression that these phishing problems are real, devastating, pervasive, and unresolved, as well as the impression that the solution is government regulation and bureaucratic administration. Nothing could be further from the truth.

In every instance, Akerlof and Shiller showcase their own “irrational exuberance” and monomania for decrying consumer choices, rather than market failures arising from information asymmetries. What else can we conclude from the foregoing but that there are informational asymmetries abounding about the true value of the information in Phishing for Phools — and that it is, objectively, something that “No One Could Possibly Want” to buy? If there is anything that could shake one’s faith in unregulated markets, it’s that anyone could be duped by Phishing for Phools.

Still, you can usually spot free market conclusions lurking in the background of Austrian work, and this raises important questions about how policy implications influence the development of theory. For example, is it possible that the need to justify free market policies distorts Austrian research? This is the argument made in a new collection of essays edited by Guinevere Nell, titled Austrian Theory & Economic Organization: Reaching Beyond Free Market Boundaries.

Nell claims that contemporary Austrian economists focus on doing research that they know will arrive at “mandatory free market conclusions.” Thus, according to Nell, their work is more about ideology than methodology, and any research questioning free market orthodoxy is shunned and dismissed.

According to Nell, the Austrian status quo must give way to a more unbiased “post-Austrian” approach to economics, especially in organization theory (the focus of this collection). Of course, not all of this book’s contributors share her views. However, most of the chapters are consistent with her goal of developing Austrian ideas without concern for making them fit free market conclusions.

In practice, this boils down to making several claims Austrians are likely to find controversial. There are variations on the core themes, but the basic ideas are as follows:

I’m not convinced the book succeeds in defending any of these propositions. Before explaining this assessment, however, I’d like to emphasize that this is only a short summary of some issues I noticed while reading the book. For a fuller discussion of its merits and failings, my full-length review (with additional references) is here.

To begin, the book’s core premise strikes me as flawed, because it’s not obvious to me that the eponymous free market boundaries exist, and if they do, how Austrian research has suffered from them. Now, I don’t object to posing questions about this kind of bias, because complacency and prejudice are real and constant threats to academic research. However, I do think it’s reasonable to expect that any claims of bias be supported with specific evidence, and furthermore, that critics be able to clearly explain, in detail, how bias hinders the development of current research.

Unfortunately, contributors to this volume offer precious few examples of free market bias undermining research, and when examples do appear, they’re usually mistaken. For instance, one author claims Mises and Rothbard were unable to discuss utility and welfare economics, while another suggests that cooperatives and other horizontal forms of organization can’t be explained by an Austrian approach. A basic literature review shows these claims are unfounded.

This brings me to another major theme of the collection: alternative forms of economic organization. Several chapters criticize traditional corporations, and propose replacing them with cooperatives and other “democratic” organizations. I actually agree these are topics worth exploring, as it’s clear that in a free society the role of the corporate form would be, at the very least, greatly reduced. If the authors limited themselves to discussing such problems, I would have few objections. Unfortunately, some of them try to push further by arguing that alternative forms of organization represent solutions to free market problems that Austrian economists can’t or won’t acknowledge.

In particular, several chapters seem to suggest that Austrian economics consists of little else but singing the praises of traditional, hierarchical, profit-maximizing business. I find this claim simply baffling, and unsurprisingly, the authors don’t support it with serious evidence. Even worse, most chapters ignore the most valuable Austrian contribution to organization theory: Mises’s writing on economic calculation. Mises not only provided the definitive critique of central planning; his work is also vital for showing whether any form of production — from market anarchy to totalitarian socialism — will work in practice. These forms include cooperatives, social enterprises, and many others.

Sadly, errors of omission and commission are scattered throughout the book. Unsupported assertions and missing evidence are common, as is blaming the market for public policy failures. There are even tired allusions to Hayek and the Grand Neoliberal Conspiracy™. Such comments make it clear that the chapters most critical of Austrian economics are actually the ones least familiar with it.

Happily, several chapters — in my view, the most successful ones — actually support the views Nell criticizes. These essays are presented as a kind of benchmark against which to measure the more controversial chapters, but they do a good job of showing why there isn’t much reason to fear that Austrian economics is hopelessly biased by free market ideology.

For instance, Randall Holcombe’s chapter offers a nice overview of the concept of spontaneous order, and explains why top-down methods to improve these orders are doomed to failure. Likewise, Per Bylund provides a searching essay on the necessity of hierarchy in market firms. Last, Ed Stringham and Caleb Miles review historical and anthropological evidence on the origin of states. They show convincingly that, contrary to popular belief, states did not emerge as the result of a social contract, but through a combination of force and persuasion.

Yet, each of these papers cuts against the general motivation of the book as well as its most ambitious contributions; if anything, they highlight the value and necessity of the Austrian tradition, and the persistent relevance of economists like Mises.

Some of the essays have never before appeared in print, and only surfaced with the discovery of Mises's personal papers, which had landed in Moscow after World War II. This volume is beautifully produced and printed, with outstanding editorial work by Richard Ebeling. A special bonus is a Soviet-sponsored attack on Mises, appearing in a Soviet journal, and published here for the first time.

We were told that workers must be organized into unions. They must have job protection. Their safety must be guaranteed by legislation. There must be a minimum wage. People under the age of 15 must never engage in remunerative work, for that would be exploitation. And workers need retirement income. If unemployment rises, nothing short of full scale central planning is required!

So on it goes, except for one inconvenient fact: the age of intervention accomplished precisely the opposite of its stated goals for workers. The unemployment of the 20th century was government created. And today, workers are taxed, regulated, and regimented to their own detriment.

Here is the uncompromising case against the entire interventionist regime erected on behalf of workers. No one does a better job in showing how the state has harmed the very group that it claimed to be backing.

Sennholz refutes dozens of theoretical fallacies and exposes the bad policies that flow from them. His focus on current trends like "mandated benefits" explains how they have so drastically increased labor costs. He also deals with the feminist arguments against the free market, and makes a strong case for the benefits of the underground economy. A principled and readable work that unfies theoretical rigor and a passion for liberty.

Author Edwin G. Dolan is a leading environmental economist and academic. This 40th anniversary edition includes the full original text along with a new introduction and extensive commentaries on each chapter by the author. The commentaries explore aspects of environmental issues that have changed over time, for example, the arrival on centre stage of climate change, something that merited only a few words in the 1971 edition. They also discuss things that have not changed: for example, the tendency of government to play the role of villain at least as often as that of hero when it comes to protecting environmental values. As the author repeatedly emphasizes, it is as important today as in the past to apply the TANSTAAFL principle: the polluter must pay.

The most reliable barometer of economic honesty is to be found in prices. Honest prices, neither manipulated nor controlled, provide both investors and consumers with reliable economic signals. They are the foundation for a successful economy.

A corrupt economic system does not want honest prices, honest information, or honest results. The truth may be unprofitable for powerful government leaders, private interests allied with them, or economic “experts” whose careers have been devoted to price manipulations and controls.

The US Federal Reserve and other central banks have created a system of “liar loans” and false prices. Other parts of government have contributed as well. In effect, the regulators on whom we depend have become dis-regulators.

Can it really be this simple, that economic prosperity and job growth depend on allowing economic prices to tell the truth, free from the self-dealing and self-interested theories of powerful special interests?

Yes.

Although Lewis takes us inside the complexities of the national economy and the Federal Reserve, his lively and transparently clear writing style makes it easy for anyone to follow him.

In honor of the twenty-fourth anniversary of the collapse of the Soviet Union, we have a special guest on the latest episode of Mises Weekends, Dr. Yuri Maltsev. A Mises Senior Fellow and a Soviet economist during the Gorbachev era, Maltsev shares his thoughts on the West’s enduring love affair with socialism. He and Jeff also discuss its political consequences in regard to Obama, Trump, and the Bernie Sanders phenomenon. This is an interview you won’t want to miss.

And in case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:

Data has always been used, but what’s new for our time is the very low (or even zero) marginal cost for collecting and analyzing huge amounts of data. The concept of “Big Data” is taking over and is predicted to be “the future” of business.

There’s a problem here, and it is the over-reliance on the Law of Large Numbers in social forecasting. Statistical probabilities for events may mathematically converge to the mean, but is it applicable in the real world? The answer is most definitely yes in the natural sciences. Repeated controlled experiments will weed out erroneous explanations or causes to phenomena, at least assuming we’re good enough at separating and controlling those causes.

What about the social sciences? In this age of scientism, as Hayek called it, we’re told “Big Data” will completely transform production, logistics, and sales. The reason for this is that vendors can better target customers and even foresee what they might want next. Amazon.com does this on their web site in crude form, where they make suggestions based on your purchase history and what others with similar purchase histories have searched for. Sometimes it works, and sometimes it doesn’t.

There is some regularity to our interests and behavior. All of us are, after all, human beings — and we’re formed in certain cultures. So one American with interests x, y, and z may have other interests similar to another American who also has an interest in x, y, and z.

But similarity is not the same thing as prediction. Amazon.com’s suggestions or the highly annoying ads following you around web sites are useful methods for sellers because they can somewhat accurately identify what not to offer. Exclusion of very low-probability interests increases the probability for suggesting something that the person behind the eyeballs focusing on the computer screen may be interested in.

To use as prediction, however, exclusion of almost-zero probability events is far from sufficient. Indeed, prediction requires that we are able to accurately exclude all but one or a couple highly probable outcomes. And we have to be able to rely on that these predictions turn out to be true. Otherwise we’re just playing games, and so we’re making guesses. Sure, they’re educated guesses (because we’ve excluded the impossible and almost-impossible), but they’re still games and guesses.

Speaking of guesses, Microsoft’s Bing search engine, which powers the Windows digital assistant Cortana among other things, has produced a prediction engine with the purpose of predicting sports and other results. They rely on very advanced algorithms and huge amounts of collected data.

Amazingly, they did very well initially and predicted the outcomes of the World Cup perfectly. So maybe we can use Big Data to get a glimpse of the future?

No, not so. The Bing teams are learning a lesson only Austrians and, more specifically, Misesian praxeologists, seem to be alone in grasping: that there are no constants in human action, and therefore that predictions of social phenomena are impossible. Pattern predictions, as Hayek called them, may not be impossible, but predictions of exact magnitudes are. For instance, we can rely on economic law (such as “demand curves slope downward”) to estimate an outcome such as “the price will be lower than it otherwise would have been,” but we can’t say exactly what that price will be.

When it comes to sports, reality shows and other competitions between individuals or teams, the story is exactly the same. The team with a better track record doesn’t always win. Why? They have objectively performed better than the other team, perhaps exclusively so, but this doesn’t say anything about the future. We’re not here referring to the philosophical doubt as in “will the sun shine tomorrow?” (maybe something changes completely the sun’s ability to shine during the night).

In the social sciences we’re dealing with complex phenomena. Action and, especially, its outcome is the result of a complex system of social interaction, psychology, and much more. Are the players in both teams as motivated and focused as they were before? Did anything in their personal lives affect their mindsets or psyches? How do the players within their teams and players in other teams react on each other before and during the game? A team with a poor track record can upset a team with an objectively better track record; this happens all the time. Sometimes for the sole reason that the better team underestimates the worse team, or because the underdog feels no pressure to perform and therefore plays less defensively.

Bing’s prediction engine struggles with this, just as we would predict. As Windows Central reported recently, the prediction engine had its “worst week yet” picking only four of fourteen winners in the NFL. Overall, its track record was approximately two-thirds right and one-third wrong (95–53). It’s definitely better than tossing a coin, but pretty far from actually predicting the results.

In other words, if you’re placing bets you may want to use the Bing prediction engine. That is, unless you have the type of tacit, implicit understanding of what’s going on that the engine is missing. Maybe you can beat it, or maybe not. In either case, you cannot count on coming out a victor each and every time.

The reason for this is that the outcome simply cannot be predicted perfectly — or even close to it. Even the players themselves cannot predict who’ll win a game, but they may have inside information about whether their own team seems motivated and focused. It is not a perfect method, however, and it certainly cannot be scientific.

Even with Big Data there’s no predicting of social events — there’s only guessing. Yes, guessing with access to huge amounts of data is easier, at least if the data is reliable and relevant. But a good guess is not the same thing as a prediction; it is still a guess, and it can be wrong. Winning every time requires luck.

This week at mises.org, we explored how deeply indebted governments blame the ones who lend them money, while government prosecutors blame entrepreneurs, businesses, and “white collar crime” for other problems in the economy. And surges in drug prices, we’re told, have nothing to do with government control of the drug market.

Lackluster new jobs data and continued surges in home price inflation confirm that the distortions of the Fed-induced boom continue to add up.

But even with all the bad news, the miracles of the market place point toward a brighter future. This week on Mises Weekends, Rod Martin, a co-founder of PayPal and world renown philosopher-capitalist, joins Jeff for a wide-ranging interview covering such topics as the refugee situation in Europe, unrest in the Middle East, and why some cultures are more prosperous than others. Martin contrasts the difficulties world governments have in confronting global macro-crises with the hope and resilience of technological innovation and entrepreneurship.

Indeed, Ludwig von Mises would have easily understood how market innovations outpace government innovations, since Mises, whose birthday we celebrated this week, pioneered our understanding of how government intervention cannot achieve the goals it tries to achieve. Be sure to see this never-before-published essay by Bettina Bien Greaves, and this newly-discovered recording of a Mises lecture from 1962.

In case you missed any of this week’s Mises Daily and Mises Wire articles, take a second look: