Chapter 11 of 15 · The Capitalist and the Entrepreneur: Essays on Organizations and Markets by Peter G. Klein
8. Commentary
CHAPTER8
Commentary
A Government Did Invent the Internet, But the Market Made it Glorious†
Libertarians often cite the Internet as a case in point that liberty is the mother of innovation. Opponents quickly counter that the Internet was a government program, proving once again that markets must be guided by the steady hand of the state. In one sense, the critics are correct, though not in ways they understand.
The Internet indeed began as a typical government program, the ARPANET, designed to share mainframe computing power and to establish a secure military communications network. Of course, the designers could not have foreseen what the (commercial) Internet has become. Still, this reality has important implications for how the Internet works—and explains why there are so many roadblocks in the continued development of online technologies. It is only thanks to market participants that the Internet became something other than a typical government program, characterized by inefficiency, overcapitalization, and irrelevance.
In fact, the role of the government in the creation of the Internet is often understated. The Internet owes its very existence to the state and to state funding. The story begins with ARPA, created in 1957 in response to the Soviets’ launch of Sputnik, and established to research the efficient use of computers for civilian and military applications.
During the 1960s, the RAND Corporation had begun to think about how to design a military communications network that would be invulnerable to a nuclear attack. Paul Baran, a RAND researcher whose work was financed by the Air Force, produced a classified report in 1964 proposing a radical solution to this communication problem. Baran envisioned a decentralized network of different types of “host” computers, without any central switchboard, designed to operate even if parts of it were destroyed. The network would consist of several “nodes,” each equal in authority, each capable of sending and receiving pieces of data.
Each data fragment could thus travel one of several routes to its destination, such that no one part of the network would be completely dependent on the existence of another part. An experimental network of this type, funded by ARPA and thus known as ARPANET, was established at four universities in 1969. Researchers at any one of the four nodes could share information, and could operate any one of the other machines remotely, over the new network. (Actually, former ARPA head Charles Herzfeld says that distributing computing power over a network, rather than creating a secure military command-and-control system, was the ARPANET’s original goal, though this is a minority view.)
By 1972, the number of host computers connected to the ARPANET had increased to 37. Because it was so easy to send and retrieve data, within a few years the ARPANET became less a network for shared computing than what has been called “a high-speed, federally subsidized, electronic post office.” The main traffic on the ARPANET did not consist of longdistance computing, but news and personal messages.
As parts of the ARPANET were declassified, commercial networks began to be connected to it. Any type of computer using a particular communications standard, or “protocol,” was capable of sending and receiving information across the network. The design of these protocols was contracted out to private universities such as Stanford and the University of London, and was financed by a variety of federal agencies. The major thoroughfares or “trunk lines” continued to be financed by the Department of Defense. By the early 1980s, private use of the ARPA communications protocol—what is now called “TCP/IP”—far exceeded military use. In 1984 the National Science Foundation assumed the responsibility of building and maintaining the trunk lines or “backbones.” (ARPANET formally expired in 1989; by that time hardly anybody noticed). The NSF’s Office of Advanced Computing financed the Internet’s infrastructure from 1984 until 1994, when the backbones were privatized.
In short, both the design and implementation of the Internet have relied almost exclusively on government dollars. The fact that its designers envisioned a packet-switching network has serious implications for how the Internet actually works. For example, packet switching is a great technology for file transfers, email, and web browsing but not necessarily the best for real-time applications like video and audio feeds, and, to a lesser extent, server-based applications.
Furthermore, without any mechanism for pricing individual packets, the network is overused, like any public good. Every packet is assigned an equal priority. A packet containing a surgeon’s diagnosis of an emergency medical procedure has exactly the same chance of getting through as a packet containing part of a pop star’s latest single or an online gamer’s instruction to smite his foe. Because the sender’s marginal cost of each transmission is effectively zero, the network is overused, and often congested. Like any essentially unowned resource, an open-ended packet-switching network suffers from what Garrett Hardin famously called the “Tragedy of the Commons.”
In no sense can we say that packet-switching is the “right” technology. One of my favorite quotes on this subject comes from Michael Hauben and Ronda Hauben’s Netizens: On the History and Impact of Usenet and the Internet (1995):
The current global computer network has been developed by scientists and researchers and users who were free of market forces. Because of the government oversight and subsidy of network development, these network pioneers were not under the time pressures or bottom-line restraints that dominate commercial ventures. Therefore, they could contribute the time and labor needed to make sure the problems were solved. And most were doing so to contribute to the networking community.
In other words, the designers of the Internet were “free” from the constraint that whatever they produced had to satisfy consumer wants.
We must be very careful not to describe the Internet as a “private” technology, a spontaneous order, or a shining example of capitalistic ingenuity. It is none of these. Of course, almost all of the Internet’s current applications—unforeseen by its original designers—have been developed in the private sector. (Unfortunately, the original web and the web browser are not among them, having been designed by the state-funded European Laboratory for Particle Physics (CERN) and the University of Illinois’s NCSA.) And today’s Internet would be impossible without the heroic efforts at Xerox PARC and Apple to develop a useable graphical user interface (GUI), a lightweight and durable mouse, and the Ethernet protocol. Still, none of these would have been viable without the huge investment of public dollars that brought the network into existence in the first place.
Now, it is easy to admire the technology of the Internet. I marvel at it every day. But technological value is not the same as economic value. That can only be determined by the free choice of consumers to buy or not to buy. The ARPANET may well have been technologically superior to any commercial networks that existed at the time, just as Betamax may have been technologically superior to VHS, the MacOS to MS-DOS, and Dvorak to QWERTY. (Actually Dvorak wasn’t.) But the products and features valued by engineers are not always the same as those valued by consumers. Markets select for economic superiority, not technological superiority (even in the presence of nefarious “network effects,” as shown convincingly by Liebowitz and Margolis, 1990, 1995, 1999).
Libertarian Internet enthusiasts tend to forget the fallacy of the broken window. We see the Internet. We see its uses. We see the benefits it brings. We surf the web and check our email and download our music. But we will never see the technologies that weren’t developed because the resources that would have been used to develop them were confiscated by the Defense Department and given to Stanford engineers. Likewise, I may admire the majesty and grandeur of an Egyptian pyramid, a TVA dam, or a Saturn V rocket, but it doesn’t follow that I think they should have been created, let alone at taxpayer expense.
What kind of global computer network would the market have selected? We can only guess. Maybe it would be more like the commercial online networks such as Comcast or MSN, or the private bulletin boards of the 1980s. Most likely, it would use some kind of pricing schedule, where different charges would be assessed for different types of transmissions. Unfortunately, the whole idea of pricing the Internet as a scarce resource—though we usually don’t notice this, bandwidth is scarce given current technology—is ignored in most proposals to legislate network neutrality, a form of “network socialism” that can only stymie the Internet’s continued growth and development. The net neutrality debate takes place in the shadow of government intervention. So too the debate over the division of the spectrum for wireless transmission. Any resource the government controls will be allocated based on political priorities.
Let us conclude: yes, the government was the founder of the Internet. As a result, we are left with a panoply of lingering inefficiencies, misallocations, abuses, and political favoritism. In other words, government involvement accounts for the Internet’s continuing problems, while the market should get the credit for its glories.
B Networks, Social Production, and Private Property†
Yochai Benkler’s The Wealth of Networks is a comprehensive, informative, and challenging meditation on the rise of the “networked information economy” and its implications for society, politics, and culture. Benkler is a leading authority on the law, economics, and politics of networks, innovation, intellectual property, and the Internet, and he puts his wide knowledge and deep understanding to good use. He argues that the digital revolution is more revolutionary than has been recognized, even by its most passionate defenders. The new information and communications technologies do not simply make the old ways of doing things more efficient, but also support fundamentally new ways of doing things. In particular, the past few years have seen the rise of social production, a radically decentralized, distributed mode of interaction that Benkler calls “commons-based peer production.”
Peer production involves the creation and dissemination of “user-generated content,” including Wikipedia and open-source software, such as Linux, that allow users to generate their own entries and modify those created by others. Commons-based peer production is characterized by weak property rights, an emphasis on intrinsic rather than extrinsic (monetary) rewards, and the exploitation of dispersed, tacit knowledge. (Some readers will immediately think of Hayek’s concept of the market as generator and transmitter of knowledge, though Hayek does not figure prominently in the book.)
The Wealth of Networks is divided into three main parts. The first deals with the economics of the networked information economy. This is well-trod ground, having been explored in detail in Shapiro and Varian (1998), Liebowitz and Margolis (1999), and other works, but Benkler’s treatment is nevertheless insightful, intelligent, and engaging. The characteristics of information as an economic good—high fixed costs and low marginal costs; the ability to be consumed without exhaustion; the difficulty of excluding “free-riders”— support the widespread use of commons-based peer production.
Benkler proposes social production as an alternative to the traditional organizational modes of market and hierarchy, in Oliver Williamson’s terminology. Indeed, open-source production differs in important ways from spot-market interaction and production within the private firm. But here, as elsewhere, Benkler tends to overstate the novelty of social production. Firms, for example, have long employed internal markets; delegated decision rights throughout the organization; formed themselves into networks, clusters, and alliances; and otherwise taken advantage of openness and collaboration. Many different organizational forms proliferate within the matrix of private-property rights. Peer production is not new; rather, the relevant question concerns the magnitude of the changes.
Here, the book suffers from a problem common to others in this genre. Benkler provides a wealth of anecdotes to illustrate the new economy’s revolutionary nature, but little information on magnitudes. How new? How large? How much? Cooperative, social production itself is hardly novel, as any reader of “I, Pencil” (Read, 1958) can attest. Before the web page, there was the pamphlet; before the Internet, the telegraph; before the Yahoo directory, the phone book; before the personal computer, electric service, the refrigerator, the washing machine, the telephone, and the VCR. In short, such breathlessly touted phenomena as network effects, the rapid diffusion of technological innovation, and highly valued intangible assets are not novel. (Tom Standage’s [1998] history of the telegraph and its revolutionary impact, The Victorian Internet, is well worth reading in this regard.)
Part two, “The Political Economy of Property and Commons,” is the book’s most original, provocative, and—for me—frustrating section. Benkler sees social production as a powerful force for individual liberty. People used to be passive recipients of news, information, norms, and culture; now they are active creators. Each participant in an open-source project, each creator of user-generated content on Wikipedia or YouTube, “has decided to take advantage of some combination of technical, organizational, and social conditions within which we have come to live, and to become an active creator in his or her world, rather than merely to accept what was already there. The belief that it is possible to make something valuable happen in the world, and the practice of actually acting on that belief, represent a qualitative improvement in the condition of individual freedom” (Benkler, 2006, p. 137).
What Benkler means by “freedom” and “liberty,” however, is not the classical liberal notion of the absence of state coercion, but the modern liberal view of “autonomy,” individuals’ ability to achieve their goals without restraints, voluntary or otherwise. This understanding of liberty, which originates with Kant and Rousseau, is central to Benkler’s political economy. Autonomy means that “individuals are less susceptible to manipulation by a legally defined class of others—the owners of communications infrastructure and media” (Benkler, 2006, p. 9)—hence Benkler’s sympathy for the commons, an institutional framework in which property rights are held not by individuals, but by a collective. It does not matter for Benkler whether the collective is a private club, such as the participants of an open-source project or the subscribers to a particular information service or the state. What matters is how the commons facilitates “freedom of action” in comparison to how a system of private-property rights affords freedom.
Benkler strongly opposes privatizing the information commons by allowing owners to exercise property rights. He chides Cisco Systems, for example, for designing and deploying “smart routers” that allow broadband service providers to control the flows of packets through their systems (for example, giving priority to some forms of content over others). This action is akin to erecting toll gates on the Information Superhighway. To ensure open access to the networked economy, Benkler (2006, p. 21) favors a public ownership network infrastructure, loose enforcement of intellectual property rights, subsidized R&D, and “strategic regulatory interventions to negate monopoly control over essential resources in the digital environment.”
This approach has some problems. First, although information itself cannot be “owned,” the tangible media in which information is embedded and transmitted are scarce economic goods. Information may yearn to be “free,” but cables, switches, routers, disk drives, microprocessors, and the like yearn to be owned. Such innovations do not spring from nowhere; they are the creations of profit-seeking entrepreneurs that consumers or other entrepreneurs purchase to use as they see fit. Of course, private property can be nationalized. Federal, state, and local governments can own broadband lines as they own streets and highways, or they can treat network infrastructure as a regulated public utility. If these resources are to be treated as public goods, then what about computers, iPods, and cell phones? Are these gateways to the Information Superhighway also part of the digital commons? If individuals can own cell phones, can they sign contracts with service providers to deliver whatever content is mutually agreed upon? Content providers and consumers are free to terminate their agreements if they are unhappy. In this sense, a private property regime allows as much “autonomy,” in the libertarian sense, as a commons-based system. Moreover, if one takes into account the problems of collective ownership, about which Benkler is largely silent, the case for the commons becomes even more problematic.
Second, Benkler appears to adopt the Frankfurt school view of consumers as passive recipients of culture, easily manipulated by powerful corporate interests. “From the perspective of liberal political theory, the kind of open-participatory, transparent folk culture that is emerging in the networked environment is normatively more attractive than was the industrial cultural production system typified by Hollywood and the recording industry” (Benkler, 2006, p. 277). However, as Cowen (1998), Cantor (2001), and others have argued convincingly, commercial culture—which properly includes Elizabethan theater, classical music, and the Victorian novel, as well as television, movies, and popular music—has always been participatory in the broad sense Benkler describes. Far from being passive consumers of culture, individuals have played an active role in shaping the plays, books, songs, and shows made available to them simply by deciding to buy or not to buy, to patronize or not to patronize, to support or reject particular producers and particular products. The main difference today is that technological change—the advent of digital technology, cheap infrastructure, and the like—has lowered the costs of entry (production costs, distribution costs, and so forth), giving consumers additional options besides voice and exit. Is this difference one of degree or kind?
Moreover, in any model of social and cultural production, opinion makers play an important role. Even today, on political blogs and other forms of user-generated content, the range of acceptable opinion among the dominant sites, the ones at the left-hand side of Anderson’s (2006) “long tail,” is hardly broader than what one finds in the New York Times or the Wall Street Journal. Yes, a great deal of user-generated content exists, but most of it is ignored and is unlikely to have any lasting influence. An elite group of gatekeepers, Hayek’s “second-hand dealers in ideas,” continues to exercise an important influence on social, political, and cultural trends. In this sense, Benkler seems influenced, ironically, by the perfectly competitive general equilibrium model of neoclassical economics, with its assumption that all agents possess complete, perfect information. He worries: private ownership of digital resources “gives some people the power to control the options perceived by, or the preferences of, others, [which] is... a law that harms autonomy” (Benkler, 2006, p. 149). In a world of subjective knowledge and beliefs and of dispersed, tacit knowledge, how can everyone have the same perceived options? Elsewhere he dismisses the effectiveness of competition as a means of enabling “autonomy” under private ownership because of transaction costs. In other words, competition must be “perfect” to be effective. But he undertakes little comparative institutional analysis. What are the transaction costs associated with commons-based peer production?
The book concludes with a section on public policy, summarizing Benkler’s (2006, p. 25) concerns about privatizing the digital commons—what he calls a “second enclosure movement”—and outlining a positive role for the state, whose most important job, he argues, is to maintain openness, or “neutrality,” within the economy’s digital infrastructure. Here, as elsewhere, I find the treatment of government failure much too glib. Information itself is not scarce, but, as noted earlier, is embodied in tangible resources that are subject to the usual economic laws of supply and demand. Public ownership implies that a host of agency, information, and calculation problems need to be treated in an appropriately comparative manner, and Benkler does not do so. Despite these difficulties, The Wealth of Networks is a useful guide to the networked information economy and an eloquent statement of the left-liberal conception of the Internet’s “institutional ecology.” Benkler clearly believes that social production is more than a fad and has potentially revolutionary implications. I remain unconvinced, but I feel better informed about the relevant issues after reading Benkler’s book.
C Why Intellectuals Still Support Socialism†
Intellectuals, particularly academic intellectuals, tend to favor socialism and interventionism. How was the American university transformed from a center of higher learning to an outpost for socialist-inspired culture and politics? As recently as the early 1950s, the typical American university professor held social and political views quite similar to those of the general population. Today—well, you’ve all heard the jokes that circulated after the collapse of central planning in Eastern Europe and the former USSR, how the only place in the world where Marxists were still thriving was the Harvard political science department.
More generally, US higher education is now dominated by the students who were radicalized in the 1960s and who have now risen to positions of influence within colleges and universities. One needs only to observe the aggressive pursuit of “diversity” in admissions and hiring, the abandonment of the traditional curriculum in favor of highly politicized “studies” based on group identity, the mandatory workshops on sensitivity training, and so on. A 1989 study for the Carnegie Foundation for the Advancement of Teaching used the categories “liberal” and “conservative.” It found that 70 percent of the professors in the major liberal arts colleges and research universities considered themselves liberal or moderately liberal, with less than 20 percent identifying themselves as conservative or moderately conservative (cited in Lee, 1994). (Of course, the term “liberal” here means left-liberal or socialist, not classical liberal.)
Cardiff and Klein (2005) examined academics’ political affiliations using voter-registration records for tenure-track faculty at 11 California universities. They find an average Democrat:Republican ratio of 5:1, ranging from 9:1 at Berkeley to 1:1 at Pepperdine. The humanities average 10:1, while business schools are at only 1.3:1. (Needless to say, even at the heartless, dog-eat-dog, sycophant-of-the-bourgeoisie business schools the ratio doesn’t dip below 1:1.) While today’s Republicans are hardly anti-socialist—particularly on foreign policy—these figures are consistent with a widespread perception that university faculties are increasingly unrepresentative of the communities they supposedly serve.
Now here’s a surprise: even in economics, 63 percent of the faculty in the Carnegie study identified themselves as liberal, compared with 72 percent in anthropology, political science, and sociology, 76 percent in ethnic studies, history, and philosophy, and 88 percent in public affairs. The Cardiff and Klein study finds an average D:R ratio in economics departments of 2.8:1—lower than the sociologists’ 44:1, to be sure, but higher than that of biological and chemical engineering, electrical engineering, computer science, management, marketing, accounting, and finance. A survey of American Economic Association members, examined by Klein and Stern (2006), finds that most economists support safety regulations, gun control, redistribution, public schooling, and antidiscrimination laws. Another survey, reported in the Southern Economic Journal, reveals that “71 percent of American economists believe the distribution of income in the US should be more equal, and 81 percent feel that the redistribution of income is a legitimate role for government. Support for these positions is even stronger among economists with academic affiliations, and stronger still among economists with elite academic affiliations” (Lee, 1994, p. 21).
Why do so many university professors—and intellectuals more generally—favor socialism and interventionism? F. A. Hayek offered a partial explanation in his 1949 essay “The Intellectuals and Socialism.” Hayek asked why “the more active, intelligent and original men among [American] intellectuals... most frequently incline toward socialism.” His answer is based on the opportunities available to people of varying talents.
Academics tend to be highly intelligent people. Given their leftward leanings, one might be tempted to infer from this that more intelligent people tend to favor socialism. However, this conclusion suffers from what empirical researchers call “sample selection bias.” Intelligent people hold a variety of views. Some are lovers of liberty, defenders of property, and supporters of the “natural order”—i.e., defenders of the market. Others are reformers, wanting to remake the world according to their own visions of the ideal society. Hayek argues that exceptionally intelligent people who favor the market tend to find opportunities for professional and financial success outside the Academy (i.e., in the business or professional world). Those who are highly intelligent but ill-disposed toward the market are more likely to choose an academic career. For this reason, the universities come to be filled with those intellectuals who were favorably disposed toward socialism from the beginning.
This also leads to the phenomenon that academics don’t know much about how markets work, since they have so little experience with them, living as they do in their subsidized ivory towers and protected by academic tenure. As Joseph Schumpeter explained in Capitalism, Socialism, and Democracy (1942, p. 17), it is “the absence of direct responsibility for practical affairs” that distinguishes the academic intellectual from others “who wield the power of the spoken and the written word.” This absence of direct responsibility leads to a corresponding absence of first-hand knowledge of practical affairs. The critical attitude of the intellectual arises, says Schumpeter, “no less from the intellectual’s situation as an onlooker—in most cases also as an outsider—than from the fact that his main chance of asserting himself lies in his actual or potential nuisance value.”
Hayek’s account is incomplete, however, because it doesn’t explain why academics have become more and more interventionist throughout the twentieth century. As mentioned above, during the first half of the twentieth century university faculty members tended to hold political views similar to those held by the general population. What caused the change?
To answer, we must realize first that academics receive many direct benefits from the welfare state, and that these benefits have increased over time. Excluding student financial aid, public universities receive about 50 percent of their funding from federal and state governments, dwarfing the 18 percent they receive from tuition and fees. Even “private” universities like Stanford or Harvard receive around 20 percent of their budgets from federal grants and contracts (US Department of Education, 1996). Including student financial aid, the figure is almost 50 percent. According to the US Department of Education, about a third of all students at public, 4-year colleges and universities, and half the students at private colleges and universities, receive financial aid from the federal government.
In this sense, the most dramatic example of “corporate welfare” in the US is the GI Bill, which subsidized the academic sector, bloating it far beyond the level the market would have provided. The GI Bill, signed by President Roosevelt in 1944 to send returning soldiers to colleges and universities, cost taxpayers $14.5 billion between 1944 and 1956 (Skocpol, 1996). The latest (2008) version of the GI Bill is expected to cost $52 billion over the next ten years.
To see why this government aid is so important to the higher education establishment, we need only stop to consider for a moment what academics would do in a purely free society. The fact is that most academics simply aren’t that important. In a free society, there would be far fewer of them than there are today. Their public visibility would no doubt be quite low. Most would be poorly paid. Though some would be engaged in scholarly research, the vast majority would be teachers. Their job would be to pass the collective wisdom of the ages along to the next generation. In all likelihood, there would also be far fewer students. Some students would attend traditional colleges and universities, but many more students would attend technical and vocational schools, where their instructors would be men and women with practical knowledge.
Today, many professors at major research universities do little teaching. Their primary activity is research, though much of that is questionable as real scholarship. One needs only to browse through the latest specialty journals to see what passes for scholarly research in most disciplines. In the humanities and social sciences, it is likely to be postmodern gobbledygook; in the professional schools, vocationally oriented technical reports. Much of this research is funded in the United States by government agencies, such as the National Science Foundation, National Institutes of Health, the National Endowment for the Humanities, the USDA, and others. The large universities have tens of thousands of students, themselves supported by government-subsidized loans and grants.
Beyond university life, academics also compete for prestigious posts within government agencies. Consider economics. The US federal government employs at least 3,000 economists—about 15% of all members of the American Economic Association. The Federal Reserve System itself employs several hundred. There are also advisory posts, affiliations with important government agencies, memberships of federally appointed commissions, and other career-enhancing activities. These benefits are not simply financial. They are also psychological. As Lee (1994, p. 22) puts it:
Like every other group, academics like to exert influence and feel important. Few scholars in the social sciences and humanities are content just to observe, describe, and explain society; most want to improve society and are naive enough to believe that they could do so if only they had sufficient influence. The existence of a huge government offers academics the real possibility of living out their reformist fantasies.1
It’s clear, then, that for academics, there are many benefits to living in a highly interventionist society. It should be no wonder, then, that academics tend to support those interventions. Economists, in particular, play active roles as government advisers, creating and sustaining the welfare state that now surrounds us. Naturally, when government funds their research, economists in applied fields such as agricultural economics and monetary economics are unlikely to call for serious regulatory reform in their specialty areas.
Murray Rothbard devotes an interesting chapter of Man, Economy, and State, to the traditional role of the economist in public life. Rothbard notes that the functions of the economist on the free market differ strongly from those of the economist on the hampered market. “What can the economist do on the purely free market?” Rothbard asks. “He can explain the workings of the market economy (a vital task, especially since the untutored person tends to regard the market economy as sheer chaos), but he can do little else.”
Furthermore, economists are not traditionally popular as policy advisors. Economics teaches that resources are limited, that choices made imply opportunities forgone, that our actions can have unintended consequences. This is typically not what government officials want to hear. When they propose an import tariff to help domestic manufacturers, we economists explain that this protection will come only at the expense of domestic consumers. When they suggest a minimum-wage law to raise the incomes of low-wage workers, we show that such a law hurts the very people it purports to help by forcing them out of work. Over the last several decades, however, the role of the economist has expanded dramatically. Partly for the reasons we discussed earlier, the welfare state has partly coopted the profession of economics. Just as a higher murder rate increases the demand for criminologists, so the growth of the welfare/regulatory state increases the demand for policy analysts, antitrust consultants, tax and regulatory experts, and various forecasters.
To some degree, the increasing professionalization of the economics business must share the blame for this change. The economists’ premier professional society, the American Economic Association, was itself created as an explicitly “progressive” organization. Its founder, the religious and social reformer Richard T Ely, planned an association, he reported to a colleague, of “economists who repudiate laissez-faire as a scientific doctrine” (Coats, 1960, p. 556). The other founding members, all of whom had been trained in Germany under Gustav Schmoller and other members of the younger German Historical School—the so-called Socialists of the Chair—were similarly possessed with reformist zeal. The constitution of the AEA still contains references to the “positive role of the church, the state and science in the solution of social problems by the development of legislative policy” (Coats, 1960, p. 558). Fortunately, the AEA subsequently distanced itself from the aims of its founders, although its annual distinguished lecture is still called the “Richard T Ely lecture.”2
If asked to select a single event that most encouraged the transformation of the average economist from a critic of intervention to a defender of the welfare state, I would name the Second World War. To be sure, it was the Progressive Era that saw the permanent introduction of the income tax and the establishment of the Federal Reserve System. And it was during the Great Depression that Washington, D.C., first began to employ a substantial number of economists to join such central planning organizations as the National Resources Planning Board. Still, even in those years, the average economist favored free trade, low taxes, and sound money.
World War II, however, was a watershed event for the profession. For the first time, professional economists joined the ranks of government planning bureaus en masse. One job was to control prices, as with the Office of Price Administration, led by Leon Henderson and later John Kenneth Galbraith. This group included prominent free-market economists such as Herbert Stein and George Stigler. Another role was to study military procurement (what later became known as “operations research”) with Columbia University’s Statistical Research Group (including Stigler, Milton Friedman, Harold Hotelling, Abraham Wald, Leonard Savage), or with the Army’s Statistical Control Group, which was led by Tex Thornton, later president of Litton Industries, and his “Whiz Kids.” The most famous Whiz Kid was Robert McNamara, Thornton’s leading protégé, who later applied the same techniques to the management of the Vietnam War.3
Moreover, before World War II the primary language of economics, in the English-speaking world, was English. Since then, however, economic theory has come to be expressed in obscure mathematical jargon, while economic history has become a branch of applied statistics. It is common to attribute this change to the publication of Paul Samuelson’s mathematical treatise (Samuelson, 1947), and to the development of computers. These are no doubt important. However, it is likely the taste for central planning that economists—even nominally free-market economists—got during World War II that forever changed the direction of the discipline.
What about other public figures, what Hayek called “second-hand dealers in ideas”—the journalists, book editors, high-school teachers, and other members of the “opinion-molding” class? First, intelligent and articulate liberals (in the classical sense) tend to go into business and the professions (Hayek’s selection-bias argument). Second, many journalists trade integrity for access; few are brave enough to challenge the state, because they crave information, interviews, and time with state officials.
What does the future hold? It is impossible to say for sure, but there are encouraging signs. The main reason is technology. The web has challenged the state university and state media cartels as never before. You don’t need a PhD to write for Wikipedia. What does the rise of the new media, new means of sharing information, new ways of establishing authority and credibility, imply for universities as credential factories? Moreover, as universities become more vocationally oriented, they will find it hard to compete with specialized, technology-intensive institutions such as DeVry University and the University of Phoenix, the fastest-growing US universities.
The current crises in higher education and the media are probably good things, in the long run, if they force a rethinking of educational and intellectual goals and objectives, and take power away from the establishment institutions. Then, and only then, we may see a rebirth of genuine scholarship, communication, and education.
D Management Theory and the Business Cycle† (with Nicolai J. Foss)
Is management theory to blame for the current crisis in the world economy? Some commentators think that business schools’ focus on shareholder wealth maximization, performance-based pay, and the virtue of self-interest have led banks, corporations, and governments astray. Hefty bonuses promoted excessive risk-taking, and the free-market philosophy taught in business schools removed the final ethical checks and balances on such behavior. “It is the type of thinking,” worry Raymond Fisman and Rakesh Khurana (2008), “that is now bringing capitalism to its knees.”
The populist crackdown on executive pay is linked to such thinking. The late Sumantra Ghoshal of the London Business School, widely hailed as one of the world’s foremost management gurus, was a forceful critic of performance pay and its allegedly destructive consequences. More generally, Ghoshal thought that management theory was “bad for practice” financially, ethically, and politically Ghoshal and Moran (1996); Ghoshal (2005).
We think, however, that management theory has much to offer policymakers, practitioners, and analysts seeking to understand the current crisis. Take, for example, the notion of heterogeneity. The idea that resources, firms, and industries are different from each other—that capital and labor are specialized for particular projects and activities, that people are distinct—is ubiquitous in the theory and practice of management. What strategists call competitive advantage arises from heterogeneity, from doing something differently from the competition. Human-resource managers deal with an increasingly diverse workforce and people with highly specialized talents. Firms that expand internationally learn the lessons of market, cultural, and institutional heterogeneity. As a consequence, management scholars think of firms as bundles of heterogeneous resources or assets. Assets can be specific to certain firms. Assets may be “co-specialized” with other assets, such that they generate value only in certain combinations. And as any accountant knows, assets have different (economic) life expectancies. Such unique and specialized assets can also be intangible, such as worker-specific knowledge or firm-specific capabilities.
To the uninitiated this may sound trite. But look at economics. Here homogeneity, not heterogeneity, rules the roost. Economic models of industries and economies typically start with “representative firms,” implying that all firms in an industry are alike. This may be a handy starting point if one is interested in the industry per se rather than in individual firms, but can be seriously misleading if one is interested in the relative performance of firms or industries.
And, here, macroeconomists are the worst transgressors. Their models of an entire economy treat factors of production as homogeneous within categories. Thus, “labor” means homogeneous labor inputs. “Capital” has the same interpretation. Nobel Laureate Robert Solow adopted the notion of “shmoo” from the comic Lil’ Abner—shmoos are identical creatures shaped like bowling pins with legs—to capture this kind of homogeneity. This style of reasoning originated with Ricardo, who found it a useful simplification. And it can be. But sometimes economists’ assumption of homogeneity leads them into trouble, as is the case with the current crisis.
The macroeconomic problem, we are told, is that “banks” made unwise investments, and now aren’t “lending” enough. “Businesses” and “consumers” can’t get “loans.” “Firms” have too many “bad assets” on their books. The key question, though, is which ones? Which banks aren’t lending to which customers? Which firms have made poor investments? A loan isn’t a loan isn’t a loan. The relevant question, in analyzing the credit mess, is which loans aren’t being made, to whom, and why? The critical issues are the composition of lending, not the amount. Total lending, total liquidity, average equity prices, and the like obscure the key questions about how resources are being allocated across sectors, firms, and individuals, whether bad investments are being liquidated, and so on. Such aggregate notions homogenize—and in doing so, suppress critical information about relative prices. The main function of capital markets, after all, is not to moderate the total amount of financial capital, but to allocate capital across activities.
The US stimulus package and similar proposals around the world are likewise stymied by their crude, Keynesian-style reliance on macroeconomic aggregates. According to the common wisdom, the bank crisis led to a collapse of effective aggregate demand, and only massive increases in government expenditure (and government debt) can kick-start the economy. Expenditures—on what? It doesn’t matter: just spend. The only criterion is whether the projects are “shovel-ready.”
But a shovel isn’t a shovel isn’t a shovel. As Hayek—Keynes’s most important intellectual opponent—argued in the 1930s and 1940s, the economy’s capital structure is a complex and delicate structure, one that cannot be mashed and pushed like putty. Resources cannot be shifted costlessly from one activity to another, particularly in a modern economy in which much of those resources are embodied in industry-specific, firm-specific, and worker-specific capabilities. Even idle resources can be misallocated—what Hayek and Mises called “malinvestment”—if invested in activities that don’t produce the goods and services the economy needs.
Every manager knows that directing specialized resources to the wrong projects is a bad bet, even if it leads to a slight boost in short-term earnings. In the same way, the path to economic recovery is to allow markets to channel specialized resources to their highest-valued uses, not to dump taxpayer funds on whatever firms and industries happen to be ready for them—or politically connected. In an important sense, banks’ failure to distinguish among heterogeneous borrowers got us into this mess. A mistaken focus on homogeneity, in pursuit of a quick fix, will only bring more of the same.
E Menger the Revolutionary†
“There never lived at the same time,” wrote Ludwig von Mises (1949, p. 869), “more than a score of men whose work contributed anything essential to economics.” One of those men was Carl Menger (1840–1921), Professor of Political Economy at the University of Vienna and founder of the Austrian school of economics. Menger’s path-breaking Grundsätze der Volkswirtschaftslehre [Principles of Economics], published in 1871, not only introduced the concept of marginal analysis, it presented a radically new approach to economic analysis, one that still forms the core of the Austrian theory of value and price.
Unlike his contemporaries William Stanley Jevons and Léon Walras, who independently developed concepts of marginal utility during the 1870s, Menger favored an approach that was deductive, teleological, and, in a fundamental sense, humanistic. While Menger shared his contemporaries’ preference for abstract reasoning, he was primarily interested in explaining the real-world actions of real people, not in creating artificial, stylized representations of reality. Economics, for Menger, is the study of purposeful human choice, the relationship between means and ends. “All things are subject to the law of cause and effect,” he begins his treatise. “This great principle knows no exception” (Menger, 1871, p. 51). Jevons and Walras rejected cause and effect in favor of simultaneous determination, the idea that complex systems can be modeled as systems of simultaneous equations in which no variable can be said to “cause” another. This has become the standard approach in contemporary economics, accepted by nearly all economists but the followers of Menger.
Menger sought to explain prices as the outcome of the purposeful, voluntary interactions of buyers and sellers, each guided by their own, subjective evaluations of the usefulness of various goods and services in satisfying their objectives (what we now call marginal utility, a term later coined by Friedrich von Wieser). Trade is thus the result of people’s deliberate attempts to improve their well-being, not an innate “propensity to truck, barter, and exchange,” as suggested by Adam Smith (1776, I, p. 24). The exact quantities of goods exchanged—their prices, in other words—are determined by the values individuals attach to marginal units of these goods. With a single buyer and seller, goods are exchanged as long as participants can agree on an exchange ratio that leaves each better off than he was before.
In a market with many buyers and sellers, the price reflects the valuations of the buyer least willing to buy and the seller least willing to sell, what Böhm-Bawerk would call the “marginal pairs.” With each voluntary exchange, then, the gains from trade are momentarily exhausted, regardless of the exact structure of the market. Menger’s highly general explanation of price formation continues to form the core of Austrian microeconomics.
Menger’s analysis has been labeled “causal-realistic,” partly to emphasize the distinction between Menger’s approach and that of the neoclassical economists (see chapter 7 for a detailed discussion of Menger’s economic theory). Besides its focus on causal relations, Menger’s analysis is realistic in the sense that he sought not to develop formal models of hypothetical economic relationships, but to explain the actual prices paid every day in real markets. The classical economists had explained that prices are the result of supply and demand, but they lacked a satisfactory theory of valuation to explain buyers’ willingness to pay for goods and services. Rejecting value subjectivism, the classical economists tended to treat demand as relatively unimportant and concentrated on hypothetical “long-run” conditions, in which “objective” characteristics of goods—most importantly, their costs of production—would determine their prices. The classical economists also tended to group factors of production into broad categories—land, labor, and capital—leaving them unable to explain the prices of discrete, heterogeneous units of these factors. Menger realized that the actual prices paid for goods and services reflect not some objective, “intrinsic” characteristics, but rather the uses to which discrete units of goods and services can be put as perceived, subjectively, by individual buyers and sellers.
The Principles was written as an introductory volume in a proposed multi-volume work. As noted in chapter 7 above, however, no later volumes were written. Menger did not in the Principles develop explicitly the concept of opportunity cost, he did not extend his analysis to explain the prices of the factors of production, and he did not develop a theory of monetary calculation. Those advances would come later from his students and disciples Böhm-Bawerk, Wieser, J. B. Clark, Wicksteed, Fetter, Davenport, Mises, and Hayek. Many of the most important ideas are implicit in Menger’s analysis, however. For example, his distinction among goods of lower and higher “orders,” referring to their place in the temporal sequence of production, forms the heart of Austrian capital theory, one of its most distinctive and important elements. Indeed, Menger emphasizes the passage of time throughout his analysis, an emphasis that has not yet made its way into mainstream economic theorizing.
While most contemporary economics treatises are turgid and dull, Menger’s book is remarkably easy to read, even today. His prose is lucid, his analysis is logical and systematic, his examples clear and informative. The Principles remains an excellent introduction to economic reasoning and, for the specialist, the classic statement of the core principles of the Austrian school.
As Hayek (1976, p. 12) writes, the significance of the Austrian school is “entirely due to the foundations laid by this one man.” However, while Menger is universally recognized as the Austrian school’s founder, his causal-realistic approach to price formation is not always appreciated, even within contemporary Austrian economics. As we saw in chapter 7, Vaughn (1994) finds Menger’s price theory unoriginal, identifying as the distinctive “Austrian” contribution in Menger his brief references to institutions, evolution, and the like. My view is different: Menger’s main contribution to the Austrian tradition is his price theory, his “mundane” economics, which is distinct from that of the neoclassical tradition and which is the fundamental building block of Austrian economic analysis.
Another remarkable feature of Menger’s contribution is that it appeared in German, while the then-dominant approach in the Germanspeaking world was that of the “younger” German historical school, which eschewed theoretical analysis altogether in favor of inductive, ideologically driven, historical case studies. The most accomplished theoretical economists, the British classicals such as J. S. Mill, were largely unknown to German-speaking writers. As Hayek (1976, p. 13) notes, “[i]n England the progress of economic theory only stagnated. In Germany a second generation of historical economists grew up who had not only never become really acquainted with the one well-developed system of theory that existed, but had also learnt to regard theoretical speculations of any sort as useless if not positively harmful.” Menger’s approach—haughtily dismissed by the leader of the German historical school, Gustav Schmoller, as merely “Austrian,” the origin of that label—led to a renaissance of theoretical economics in Europe and, later, in the US.
In short, the core concepts of contemporary Austrian economics—human action, means and ends, subjective value, marginal analysis, methodological individualism, the time structure of production, and so on—along with the Austrian theory of value and price, which forms the heart of Austrian analysis, all flow from Menger’s pathbreaking work. As Salerno (1999a, p. 71) has written, “Austrian economics always was and will forever remain Mengerian economics.”
F Hayek the Innovator†
F. A. Hayek is undoubtedly the most eminent of the modern Austrian economists. Student of Friedrich von Wieser, protégé and colleague of Mises, and foremost representative of an outstanding generation of Austrian school theorists, Hayek was more successful than anyone else in spreading Austrian ideas throughout the English-speaking world. “When the definitive history of economic analysis during the 1930s comes to be written,” said John Hicks in 1967, “a leading character in the drama (it was quite a drama) will be Professor Hayek.... [I]t is hardly remembered that there was a time when the new theories of Hayek were the principal rival of the new theories of Keynes” (Hicks, 1967, p. 203). Unfortunately, Hayek’s theory of the business cycle was eventually swept aside by the Keynesian revolution. Ultimately, however, this work was again recognized when Hayek received, along with the Swede Gunnar Myrdal, the 1974 Nobel Memorial Prize in Economic Science. Hayek was a prolific writer over nearly seven decades; his Collected Works, currently being published by the University of Chicago Press and Routledge, are projected at nineteen volumes.
Life and work
Hayek’s life spanned the twentieth century, and he made his home in some of the great intellectual communities of the period.4 Born Friedrich August von Hayek in 1899 to a distinguished family of Viennese intellectuals,5 Hayek attended the University of Vienna, earning doctorates in 1921 and 1923. Hayek came to the University at age 19 just after World War I, when it was one of the three best places in the world to study economics (the others being Stockholm and Cambridge, England). Though he was enrolled as a law student, his primary interests were economics and psychology, the latter due to the influence of Mach’s theory of perception on Wieser and Wieser’s colleague Othmar Spann, and the former stemming from the reformist ideal of Fabian socialism so typical of Hayek’s generation.
Like many students of economics then and since, Hayek chose the subject not for its own sake, but because he wanted to improve social conditions—the poverty of postwar Vienna serving as a daily reminder of such a need. Socialism seemed to provide a solution. Then in 1922 Mises published his Die Gemeinwirtschaft, later translated as Socialism. “To none of us young men who read the book when it appeared,” Hayek recalled, “the world was ever the same again” (Hayek, 1956, p. 133). Socialism, an elaboration of Mises’s pioneering article from two years before, argued that economic calculation requires a market for the means of production; without such a market there is no way to establish the values of those means and, consequently, no way to find their proper uses in production. Mises’s devastating attack on central planning converted Hayek to laissez-faire, along with contemporaries like Wilhelm Röpke, Lionel Robbins, and Bertil Ohlin. It was around this time that Hayek began attending Mises’s famed Privatseminar. Regular participants, who received no academic credit or other official recognition for their time, included Hayek, Gottfried Haberler, Fritz Machlup, Oskar Morgenstern, Paul Rosenstein-Rodan, Richard von Strigl, Karl Schlesinger, Felix Kaufmann, Alfred Schütz, Eric Voegelin, Karl Menger, Jr., and others not so famous. For several years the Privatseminar was the center of the economics community in Vienna, attracting such visitors as Robbins from London and Howard S. Ellis from Berkeley. Later, Hayek became the first of this group to leave Vienna; most of the others, along with Mises himself, were also gone by the start of World War II.
Mises had done earlier work on monetary and banking theory, successfully applying the Austrian marginal utility principle to the value of money and then sketching a theory of industrial fluctuations based on the doctrines of the British Currency School and the ideas of the Swedish economist Knut Wicksell. Hayek used this last as a starting point for his own research on fluctuations, explaining the origin of the business cycle in terms of bank credit expansion and its transmission in terms of capital malinvestments. His work in this area eventually earned him an invitation to lecture at the London School of Economics and Political Science and then to occupy its Tooke Chair in Economics and Statistics, which he accepted in 1931. There he found himself among a vibrant and exciting group: Robbins, J. R. Hicks, Arnold Plant, Dennis Robertson, T. E. Gregory, Abba Lerner, Kenneth Boulding, and George Shackle, to name only the most prominent. Hayek brought his (to them) unfamiliar views,6 and gradually, the “Austrian” theory of the business cycle became known and accepted. At the LSE Hayek lectured on Mises’s business-cycle theory, which he was refining and which, until Keynes’s General Theory came out in 1936, was rapidly gaining adherents in Britain and the US and was becoming the preferred explanation of the Depression. Hayek and Keynes had sparred in the early 1930s in the pages of the Economic Journal over Keynes’s Treatise on Money. As one of Keynes’s leading professional adversaries, Hayek was well situated to provide a full refutation of the General Theory. But he never did. Part of the explanation for this no doubt lies with Keynes’s personal charm and legendary rhetorical skill, along with Hayek’s general reluctance to engage in direct confrontation with his colleagues.7 Hayek also considered Keynes an ally in the fight against wartime inflation and did not want to detract from that issue (Hayek, 1994, p. 91). Furthermore, as Hayek later explained, Keynes was constantly changing his theoretical framework, and Hayek saw no point in working out a detailed critique of the General Theory, if Keynes might change his mind again (Hayek, 1963b, p. 60; Hayek, 1966, pp. 240–41). Hayek thought a better course would be to produce a fuller elaboration of Böhm-Bawerk’s capital theory, and he began to devote his energies to this project. Unfortunately, The Pure Theory of Capital was not completed until 1941, and by then the Keynesian macro model had become firmly established.8
Within a very few years, however, the fortunes of the Austrian school suffered a dramatic reversal. First, the Austrian theory of capital, an integral part of the business-cycle theory, came under attack from the Italianborn Cambridge economist Piero Sraffa and the American Frank Knight, while the cycle theory itself was forgotten amid the enthusiasm for the General Theory. Second, beginning with Hayek’s move to London and continuing until the early 1940s, the Austrian economists left Vienna for personal and then for political reasons, so that a school ceased to exist there as such.9 Mises left Vienna in 1934 for Geneva and then New York, where he continued to work in isolation; Hayek remained at the LSE until 1950, when he joined the Committee on Social Thought at the University of Chicago. Other Austrians of Hayek’s generation became prominent in the US—Gottfried Haberler at Harvard, Fritz Machlup and Oskar Morgenstern at Princeton, Paul Rosenstein-Rodan at MIT—but their work no longer seemed to show distinct traces of the tradition founded by Menger.
At Chicago, Hayek again found himself among a dazzling group: the economics department, led by Knight, Milton Friedman, and later George Stigler, was one of the best anywhere, and Aaron Director at the law school soon set up the first law and economics program.10 But economic theory, in particular its style of reasoning, was rapidly changing; Paul Samuelson’s Foundations had appeared in 1947, establishing physics as the science for economics to imitate, and Friedman’s 1953 essay on “positive economics” set a new standard for economic method. In addition, Hayek had ceased to work on economic theory, concentrating instead on psychology, philosophy, and politics, and Austrian economics entered a prolonged eclipse.11 Important work in the Austrian tradition was done during this period by Rothbard (1956, 1962, 1963a, b), Kirzner (1963, 1966, 1973), and Lachmann (1956), but at least publicly, the Austrian tradition lay mostly dormant.
When the 1974 Nobel Prize in economics went to Hayek, interest in the Austrian school was suddenly and unexpectedly revived. While this was not the first event of the so-called “Austrian revival,” the memorable South Royalton conference having taken place earlier the same year, the rediscovery of Hayek by the economics profession was nonetheless a decisive event in the renaissance of Austrian economics.12 Hayek’s writings were taught to new generations, and Hayek himself appeared at the early Institute for Humane Studies conferences in the mid-1970s. He continued to write, producing The Fatal Conceit in 1988, at the age of 89. Hayek died in 1992 in Freiburg, Germany, where he had lived since leaving Chicago in 1961.
Contributions to economics
Hayek’s legacy in economics is complex. Among mainstream economists, he is mainly known for his popular The Road to Serfdom (1944) and for his work on knowledge in the 1930s and 1940s (Hayek, 1937, 1945). Specialists in business-cycle theory recognize his early work on industrial fluctuations, and modern information theorists often acknowledge Hayek’s work on prices as signals, although his conclusions are typically disputed.13 Hayek’s work is also known in political philosophy (Hayek, 1960), legal theory (Hayek, 1973–79), and psychology (Hayek, 1952b). Within the Austrian school of economics, Hayek’s influence, while undeniably immense, has very recently become the subject of some controversy. His emphasis on spontaneous order and his work on complex systems have been widely influential among many Austrians. Others have preferred to stress Hayek’s work in technical economics, particularly on capital and the business cycle, citing a tension between some of Hayek’s and Mises’s views on the social order. (While Mises was a rationalist and a utilitarian, Hayek focused on the limits to reason, basing his defense of capitalism on its ability to use limited knowledge and learning by trial and error.)
BUSINESS-CYCLE THEORY. Hayek’s writings on capital, money, and the business cycle are widely regarded as his most important contributions to economics (Hicks, 1967; Machlup, 1976b). Building on Mises’s Theory of Money and Credit (1912), Hayek showed how fluctuations in economy-wide output and employment are related to the economy’s capital structure. In Prices and Production (1931) he introduced the famous “Hayekian triangles” to illustrate the relationship between the value of capital goods and their place in the temporal sequence of production. Because production takes time, factors of production must be committed in the present for making final goods that will have value only in the future after they are sold. However, capital is heterogeneous. As capital goods are used in production, they are transformed from general-purpose materials and components to intermediate products specific to particular final goods. Consequently, these assets cannot be easily redeployed to alternative uses if demands for final goods change. The central macroeconomic problem in a modern capital-using economy is thus one of intertemporal coordination: how can the allocation of resources between capital and consumer goods be aligned with consumers’ preferences between present and future consumption? In The Pure Theory of Capital (1941), perhaps his most ambitious work, Hayek describes how the economy’s structure of production depends on the characteristics of capital goods—durability, complementarity, sub-stitutability, specificity, and so on. This structure can be described by the various “investment periods” of inputs, an extension of Böhm-Bawerk’s notion of “roundaboutness,” the degree to which production takes up resources over time.14
In Prices and Production (1931) and Monetary Theory and the Trade Cycle (1933b) Hayek showed how monetary injections, by lowering the rate of interest below what Mises (following Wicksell) called its “natural rate,” distort the economy’s intertemporal structure of production.15 Most theories of the effects of money on prices and output (then and since) consider only the effects of the total money supply on the price level and aggregate output or investment. The Austrian theory, as developed by Mises and Hayek, focuses on the way money enters the economy (“injection effects”) and how this affects relative prices and investment in particular sectors. In Hayek’s framework, investments in some stages of production are “malinvestments” if they do not help to align the structure of production to consumers’ intertemporal preferences. The reduction in interest rates caused by credit expansion directs resources toward capital-intensive processes and early stages of production (whose investment demands are more interest-rate elastic), thus “lengthening” the period of production. If interest rates had fallen because consumers had changed their preferences to favor future over present consumption, then the longer time structure of production would have been an appropriate, coordinating response. A fall in interest rates caused by credit expansion, however, would have been a “false signal,” causing changes in the structure of production that do not accord with consumers’ intertemporal preferences.16 The boom generated by the increase in investment is artificial. Eventually, market participants come to realize that there are not enough savings to complete all the new projects; the boom becomes a bust as these malinvestments are discovered and liquidated.17 Every artificial boom induced by credit expansion, then, is self-reversing. Recovery consists of liquidating the malinvestments induced by the lowering of interest rates below their natural levels, thus restoring the time structure of production so that it accords with consumers’ intertemporal preferences.18
KNOWLEDGE, PRICES, AND COMPETITION AS A DISCOVERY PROCEDURE. Hayek’s writings on dispersed knowledge and spontaneous order are also widely known, but more controversial. In “Economics and Knowledge” (1937) and “The Use of Knowledge in Society” (1945) Hayek argued that the central economic problem facing society is not, as is commonly expressed in textbooks, the allocation of given resources among competing ends. “It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only those individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality” (Hayek, 1945, p. 78).
Much of the knowledge necessary for running the economic system, Hayek contended, is in the form not of “scientific” or technical knowledge—the conscious awareness of the rules governing natural and social phenomena—but of “tacit” knowledge, the idiosyncratic, dispersed bits of understanding of “circumstances of time and place.” This tacit knowledge is often not consciously known even to those who possess it and can never be communicated to a central authority. The market tends to use this tacit knowledge through a type of “discovery procedure” (Hayek, 1968b), by which this information is unknowingly transmitted throughout the economy as an unintended consequence of individuals’ pursuing their own ends.19 Indeed, Hayek’s (1948) distinction between the neoclassical notion of “competition,” identified as a set of equilibrium conditions (number of market participants, characteristics of the product, and so on), and the older notion of competition as a rivalrous process, has been widely influential in Austrian economics (Kirzner, 1973; Machovec, 1995).
For Hayek, market competition generates a particular kind of order— an order that is the product “of human action but not human design” (a phrase Hayek borrowed from Adam Smith’s mentor Adam Ferguson). This “spontaneous order” is a system that comes about through the independent actions of many individuals, and produces overall benefits unintended and mostly unforeseen by those whose actions bring it about. To distinguish between this kind of order and that of a deliberate, planned system, Hayek (1968c) used the Greek terms cosmos for a spontaneous order and taxis for a consciously planned one.20 Examples of a cosmos include the market system as a whole, money, the common law, and even language. A taxis, by contrast, is a designed or constructed organization, like a firm or bureau; these are the “islands of conscious power in [the] ocean of unconscious cooperation like lumps of butter coagulating in a pail of buttermilk” (D.H. Robertson, quoted in Coase, 1937, p. 35).21
Most commentators view Hayek’s work on knowledge, discovery, and competition as an outgrowth of his participation in the socialist calculation debate of the 1920s and 1930s. The socialists erred, in Hayek’s view, in failing to see that the economy as a whole is necessarily a spontaneous order and can never be deliberately made over in the way that the operators of a planned order can exercise control over their organization. This is because planned orders can handle only problems of strictly limited complexity. Spontaneous orders, by contrast, tend to evolve through a process of natural selection, and therefore do not need to be designed or even understood by a single mind.22
Hayek and Austrian economics
Clearly, the Austrian revival owes as much to Hayek as to anyone. But are Hayek’s writings really “Austrian economics”—part of a separate, recognizable tradition—or should we regard them, instead, as an original, deeply personal, contribution?23 Some observers charge that Hayek’s later work, particularly after he began to turn away from technical economics, shows more influence of his friend Sir Karl Popper than of Carl Menger or Mises: one critic speaks of “Hayek I” and “Hayek II”; another writes on “Hayek’s Transformation.”24
It is true that Popper had a significant impact on Hayek’s mature thought. Of greater interest is the precise nature of Hayek’s relationship with Mises. Undoubtedly, no economist has had a greater impact on Hayek’s thinking than Mises—not even Wieser, from whom Hayek learned his craft but who died in 1927 when Hayek was still a young man. In addition, Mises clearly considered Hayek the brightest of his generation.25 Yet, as Hayek (1978) noted, he was from the beginning always something less than a pure follower: “Although I do owe [Mises] a decisive stimulus at a crucial point of my intellectual development, and continuous inspiration through a decade, I have perhaps most profited from his teaching because I was not initially his student at the university, an innocent young man who took his word for gospel, but came to him as a trained economist, versed in a parallel branch of Austrian economics [the Wieser branch] from which he gradually, but never completely, won me over.”
Much has been written on Hayek’s and Mises’s views on the socialist calculation debate. The issue is whether a socialist economy is “impossible,” as Mises charged in 1920, or simply less efficient or more difficult to implement. Hayek (1992, p. 127) maintained later that Mises’s “central thesis was not, as it is sometimes misleadingly put, that socialism is impossible, but that it cannot achieve an efficient utilization of resources.” That interpretation is itself subject to dispute. Hayek is arguing here against the standard view on economic calculation, found for instance in Schumpeter (1942, pp. 172–186) or Bergson (1948). This view holds that Mises’s original statement of the impossibility of economic calculation under socialism was refuted by Oskar Lange, Fred Taylor, and Abba Lerner, and that later modifications by Hayek and Robbins amounted to an admission that a socialist economy is possible in theory but difficult in practice because knowledge is decentralized and incentives are weak. Hayek’s response in the cited text, that Mises’s actual position has been exaggerated, receives support from the primary revisionist historian of the calculation debate, Don Lavoie, who states that the “central arguments advanced by Hayek and Robbins did not constitute a ‘retreat’ from Mises, but rather a clarification directing the challenge to the later versions of central planning.... Although comments by both Hayek and Robbins about computational difficulties of the [later approaches] were responsible for misleading interpretations of their arguments, in fact their main contributions were fully consistent with Mises’s challenge” (Lavoie, 1985, p. 20). Kirzner (1988a) similarly contends that Mises’s and Hayek’s positions should be viewed together as an early attempt to elaborate the Austrian “entrepreneurial-discovery” view of the market process. Salerno (1990a) argues, by contrast, in favor of the traditional view—that Mises’s original calculation problem is different from the discovery-process problem emphasized by Lavoie and Kirzner.26
Furthermore, Hayek’s later emphasis on group selection and spontaneous order is not shared by Mises, although there are elements of this line of thought in Menger. A clue to this difference is in Hayek’s (1978) statement that “Mises himself was still much more a child of the rationalist tradition of the Enlightenment and of continental, rather than of English, liberalism... than I am myself.” This is a reference to the “two types of liberalism” to which Hayek frequently refers: the continental rationalist or utilitarian tradition, which emphasizes reason and man’s ability to shape his surroundings, and the English common-law tradition, which stresses the limits to reason and the “spontaneous” forces of evolution.27
Recently, the relationship between Mises and Hayek has become a full-fledged “de-homogenization” debate. Salerno (1990 a, b, 1993, 1994a) and Rothbard (1991, 1995) see Hayek’s emphasis on knowledge and discovery as substantially different from Mises’s emphasis on purposeful human action. Salerno (1993), for example, argues that there are two strands of modern Austrian economics, both descended from Menger. One, the Wieser–Hayek strand, focuses on dispersed knowledge and the price system as a device for communicating knowledge. Another, the Böhm-Bawerk–Mises strand, focuses on monetary calculation (or “appraisal,” meaning anticipation of future prices) based on existing money prices. Kirzner (1994, 1995, 1996, 1997) and Yeager (1994, 1995) argue, by contrast, that the differences between Hayek and Mises are more matters of emphasis and language than substance.28
Regardless, there is widespread agreement that Hayek ranks among the greatest members of the Austrian school, and among the leading economists of the twentieth century. His work continues to be influential in business-cycle theory, comparative economic systems, political and social philosophy, legal theory, and even cognitive psychology. Hayek’s writings are not always easy to follow—he describes himself as “puzzler” or “muddler” rather than a “master of his subject”—and this may have contributed to the variety of interpretations his work has aroused.29 Partly for this reason, Hayek remains one of the most intriguing intellectual figures of our time.
G Williamson and the Austrians†
Oliver Williamson’s 2009 Nobel Prize, shared with Elinor Ostrom, is great news for Austrians. Williamson’s pathbreaking analysis of how alternative organizational forms—markets, hierarchies, and hybrids, as he calls them—emerge, perform, and adapt, has defined the modern field of organizational economics. Williamson is no Austrian, but he is sympathetic to Austrian themes (particularly the Hayekian understanding of tacit knowledge and market competition), his concept of “asset specificity” enhances and extends the Austrian theory of capital, and his theory of firm boundaries has almost single-handedly displaced the benchmark model of perfect competition from important parts of industrial organization and antitrust economics. He is also a pragmatic, careful, and practical economist who is concerned, first and foremost, with real-world economic phenomena, choosing clarity and relevance over formal mathematical elegance. For these and many other reasons, his work deserves careful study by Austrians.
Opening the black box
In economics textbooks, the “firm” is a production function or production possibilities set, a “black box” that transforms inputs into outputs. Given the existing state of technology, the prices of inputs, and a demand schedule, the firm maximizes money profits subject to the constraint that its production plans must be technologically feasible. The firm is modeled as a single actor, facing a series of uncomplicated decisions: what level of output to produce, how much of each factor to hire, and the like. These “decisions,” of course, are not really decisions at all; they are trivial mathematical calculations, implicit in the underlying data. In short: the firm is a set of cost curves, and the “theory of the firm” is a calculus problem.
Williamson attacks this conception of the firm, what he calls the “firm-as-production-function” view. Building on Coase’s (1937) transactioncost or “contractual” approach, Williamson argues that the firm is best regarded as a “governance structure,” a means of organizing a set of contractual relations among individual agents. The firm, then, consists of an entrepreneur-owner, the tangible assets he owns, and a set of employment relationships—a realistic and thoroughly Austrian view. Williamson emphasizes “asset specificity”—the degree to which resources are specialized to particular trading partners—as the key determinant of the firm’s boundaries, defined as the set of transactions that are internal to the firm (or, put differently, the set of assets owned by the entrepreneur). More generally, he holds that entrepreneurs will tend to choose the form of organization—a loose network of small firms, trading in the open market; a franchise network, alliance, or joint-venture; or a large, vertically integrated firm—that best fits the circumstances.
Some Austrians have argued, following Alchian and Demsetz (1972), that Coase and Williamson wrongly claim that firms are not part of the market, that entrepreneurs substitute coercion for voluntary consent, and that corporate hierarchies are somehow inconsistent with the free market (e.g., Ellig and Gable, 1993; Minkler, 1993a; Langlois, 1994a; Mathews, 1998). I think this is a misreading of Coase and of Williamson. It is true that Coase speaks of firms “superseding” the market and entrepreneurs “suppressing” the price mechanism, while Williamson says firms emerge to overcome “market failure.” But they do not mean that the firm is outside the market in some general sense, that the market system as a whole is inefficient relative to government planning, or anything of the sort. Moreover, Williamson does not use the term “market failure” in the usual left-interventionist sense, but means simply that real-world markets are not “perfect” as in the perfectly competitive general-equilibrium model, which explains why firms exist. Indeed, Williamson’s work on vertical integration can be read as a celebration of the market. Not only are firms part of the market, broadly conceived, but the variety of organizational forms we observe in markets—including large, vertically integrated enterprises—is a testament to the creativity of entrepreneurs in figuring out the best way to organize production.
What about Williamson’s claim that markets, hierarchies, and hybrids are alternative forms of governance? Does he mean that firms and hybrid organizations are not part of the market? No. Coase and Williamson are talking about a completely different issue, namely the distinction between types of contracts or business relationships within the larger market context. The issue is simply whether the employment relationship is different from, say, a spot-market trade or a procurement arrangement with an independent supplier. Alchian and Demsetz (1972) famously argued that there is no essential difference between the two—both are voluntary contractual relationships, there is no “coercion” involved, no power, etc. Coase (1937), Williamson, Herbert Simon (1951), Grossman and Hart (1986), my own work, and most of the modern literature on the firm argues that there are important, qualitative differences. Coase and Simon emphasize “fiat,” by which they mean simply that employment contracts are, within limits, open-ended. The employer does not negotiate with the employee about performing task A, B, or C on a given day; he simply instructs him to do it. Of course, the employment contract itself is negotiated on the labor market, just as any contract is negotiated. But, once signed, it is qualitatively different from a contract that says “independent contractor X will perform task A on day 1.” An employment relationship is characterized by what Simon (1951) called the “zone of authority.” Williamson emphasizes the legal distinction, namely that disputes between employers and employees are settled differently from disputes between firms, between firms and customers, between firms and independent suppliers or distributors, etc. Grossman and Hart, and my own work with Nicolai Foss, emphasize the distinction between asset owners and non-owners. If I hire you to work with my machine, I hold residual control and income rights to the use of the machine that you do not have, and thus your ability to use the machine as you see fit is limited. If you own your own machine, and I hire you to produce services with that machine, then you (in this case, an independent contractor) hold these residual income and control rights, and this affects many aspects of our relationship.
While Coase, Simon, Hart, and other organizational economists do not draw explicitly on the Austrians, this distinction can also be interpreted in terms of Menger’s distinction between orders and organizations, or Hayek’s cosmos and taxis. Coase and Williamson are simply saying that the firm is a taxis, the market a cosmos. This does not deny that there are “unplanned” or “spontaneous” aspects of the internal organization of firms, or that there is purpose, reason, the use of monetary calculation, etc., in the market.
Asset specificity and Austrian capital theory
As we have seen in prior chapters, the black-box approach to the firm that dominated neoclassical economics omits the critical organizational details of production. Production is treated as a one-stage process, in which factors are instantly converted into final goods, rather than a complex, multistage process unfolding through time and employing rounds of intermediate goods. Capital is treated as a homogeneous factor of production. Williamson, by contrast, emphasizes that resources are heterogeneous, often specialized, and frequently costly to redeploy. What he calls asset specificity refers to “durable investments that are undertaken in support of particular transactions, the opportunity cost of which investments are much lower in best alternative uses or by alternative users should the original transaction be prematurely terminated” (Williamson, 1985, p. 55). This could describe a variety of relationship-specific investments, including both specialized physical and human capital, along with intangibles such as R&D and firm-specific knowledge or capabilities. Like Klein, et al. (1978), Williamson emphasizes the “holdup” problem that can follow such investments, and the role of contractual safeguards in securing the returns (what Klein, et al. call “quasi-rents”) to those assets.
Austrian capital theory focuses on a different type of specificity, namely the extent to which resources are specialized to particular places in the time-structure of production. Menger famously characterized goods in terms of “orders”: goods of lowest order are those consumed directly. Tools and machines used to produce those consumption goods are of a higher order, and the capital goods used to produce the tools and machines are of an even higher order. Building on his theory that the value of all goods is determined by their ability to satisfy consumer wants (i.e. their marginal utility), Menger showed that the value of the higher-order goods is given or ‘imputed’ by the value of the lower-order goods they produce. Moreover, because certain capital goods are themselves produced by other, higher-order capital goods, it follows that capital goods are not identical, at least by the time they are employed in the production process. The claim is not that there is no substitution among capital goods, but that the degree of substitution is limited; as Lachmann (1956) put it, capital goods are characterized by “multiple specificity.” Some substitution is possible, but only at a cost.
Mises and Hayek used this concept of specificity to develop their theory of the business cycle. Williamson’s asset specificity focuses on specialization not to a particular production process, but to a particular set of trading partners. His aim is to explain the business relationship between these partners (arms-length transaction, formal contract, vertical integration, etc.). The Austrians, in other words, focus on assets that are specific to particular uses, while Williamson focuses on assets that are specific to particular users. But there are obvious parallels, and opportunities for gains from trade. Austrian business-cycle theory can be enhanced by considering how vertical integration and long-term supply relations can mitigate, or exacerbate, the effects of credit expansion on the economy’s structure of production. Likewise, transaction cost economics can benefit from considering not only the time-structure of production, but also Kirzner’s (1966) refinement that defines capital assets in terms of subjective, individual production plans, plans that are formulated and continually revised by profit-seeking entrepreneurs (and Edith Penrose’s, 1959, concept of the firm’s “subjective opportunity set”).
Vertical integration, strategizing, and economizing
The general thrust of Williamson’s teaching on vertical integration is not that markets somehow “fail,” but that they succeed, in rich, complex, and often unpredictable ways. A basic conclusion of transaction cost economics is that vertical mergers, even when there are no obvious technological synergies, may enhance efficiency by reducing governance costs. Hence Williamson (1985, p. 19) takes issue with what he calls the “inhospitality tradition” in antitrust—namely, that firms engaged in non standard business practices like vertical integration, customer and territorial restrictions, tie ins, franchising, and so on, must be seeking monopoly gains. Indeed, antitrust authorities have become more lenient in evaluating such practices, evaluating them on a case-by-case basis rather than imposing per se restrictions on particular forms of conduct. While this change may reflect sensitivity to Chicago School claims that vertical integration and restraints need not reduce competition, rather than to claims that such arrangements provide contractual safeguards (Joskow, 1991, pp. 79–80), the Chicago position on vertical restraints relies largely (though not explicitly) on transaction-cost reasoning (Meese, 1997). In this sense, Williamson’s work can be construed as a frontal attack on the perfectly competitive model, particularly when used as a benchmark case for antitrust and regulatory policy.
Likewise, Williamson argues that for managers, “economizing” is the best form of “strategizing.” The literature on business strategy, following Porter (1980), has tended to emphasize “market-power” as the source of firm-level competitive advantage. Building directly on the old structure-conduct–performance model of industrial organization, Porter and his followers argued that firms should seek to limit rivalry by enacting entry barriers, forming coalitions, limiting the bargaining power of buyers and suppliers, etc. Williamson challenges this strategic positioning approach in an influential 1991 article, “Strategizing, Economizing, and Economic Organization,” Williamson (1991d) where he claims that managers should focus on increasing economic efficiency, by choosing appropriate governance structures, rather than increasing their market power. Here again, moves by firms to integrate, cooperate with upstream and downstream partners, form alliances, and such are not only profitable for the firms, but for consumers as well. Deviations from perfect competition are, in this sense, part of the market process of allocating resources to their highest-valued uses, all to the benefit (as Mises emphasized) of the consumer.
Coda
On a personal level, Williamson is friendly and sympathetic to Austrians and to Austrian concerns. He encourages students to read the Austrians (particularly Hayek, whom he cites often). Williamson chaired my PhD dissertation committee, and one of my first published papers, “Economic Calculation and the Limits of Organization,” was originally presented in Williamson’s Institutional Analysis Workshop at Berkeley. Williamson did not buy my argument about the distinction between calculation and incentive problems—he maintained (and continues to maintain) that agency costs, not Mises’s calculation argument, explain the failure of central planning—but his reactions helped me shape my argument and refined my understanding of the core Misesian and Hayekian literatures. (Also, the great Sovietologist Alec Nove, visiting Berkeley that semester, happened to be in the audience that day, and gave me a number of references and counter-arguments.) Williamson, knowing my interest in the Austrians, once suggested that I write a dissertation on the Ordo School, the influence of Hayek on Eucken and Röpke, and the role of ideas in shaping economic policy. He cautioned me that writing on such a topic would not be an advantage on the job market, but urged me to follow my passions, not to follow the crowd. I ended up writing on more prosaic topics but never forgot that advice, and have passed it along to my own students.
The Capitalist and the Entrepreneur: Essays on Organizations and Markets
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