Anatomy of Economic Advice I.

As is the case with virtually all branches of human knowledge, economic knowledge and understanding are valued not only (or even primarily) for their own sake, but for their usefulness in practical terms. The enormous sums expended each year on economic research and economic education certainly would not be forthcoming if it were not expected that such research and education could help promote wise policies leading to prosperity and economic well-being.

Indeed, there can be no doubt that those advocating free-market policies (in The Freeman or elsewhere) do so firmly convinced that such advocacy grows naturally out of economic understanding. I certainly share this conviction. Yet the path leading from valid economic understanding to sound economic policy advice is not straightforward. To proceed from an “is” statement to an “ought” statement is, in all contexts, fraught notoriously with philosophical hazards. In the context of economics these dangers are compounded further by the subtleties that complicate the sources of economic understanding itself.

Our attempt to clarify the basis in economic science for valid and useful economic advice will proceed as follows. In the present article we elaborate on the apparent paradox involved in offering “scientific” advice (that is, advice supported or even entailed by science) in the economic arena. In the second article we shall examine the philosophical foundations of economic science itself (with a special interest in its potential in regard to economic policymaking). In the concluding article we will try to draw together our various insights and to formulate our conclusions in regard to the scientific validity of economic advice.

The “Science” and the “Art” of Political Economy: A Nineteenth-Century Dilemma

The founding fathers of economics, including, most prominently, Adam Smith, generally saw their discipline as constituting what came to be called an “art”—that is, a body of advice on how to achieve a well-defined objective—the enhancement of national wealth. Although the title of Adam Smith’s classic was An Inquiry into the Nature and Causes of the Wealth of Nations (suggesting it to be a disinterested scientific inquiry, concerned neither to promote increased national wealth nor to prevent it), Smith himself has usually been seen to have conceived his subject as an art (setting forth ways to increase national wealth). But thoughtful economists of that period had serious misgivings about such an approach.

Some of the classical economists following Smith indeed wrestled with the relation between a science of political economy and an art of political economy. One such economist was Richard Whately, who was not only an economist of note but also an Anglican archbishop. He felt the need to defend himself in regard to his interest in the science of wealth (an interest his critics apparently thought of as unbecoming a clergyman). Whately pointed out (in a 1831 lecture at Oxford) that the conclusions of political economy can be deployed in policies designed to reduce wealth (if wealth be seen as morally suspect)—just as they can be used to formulate policies for increasing wealth!

At one stage in his academic career Nassau Senior, one of the most prominent early nineteenth-century political economists, flatly denied the very possibility of such an art. Although Senior later retreated from this categorical position, he was never completely reconciled to the idea of political economy as an art. In his 1860 presidential address to The Section of Economic Science and Statistics (of the British Association), almost a quarter century after his denial of the possibility of an art of political economy, Senior insisted that the political economist is concerned only with the production or distribution of wealth—regardless of whether “wealth be a good or an evil.” He clearly believed that, qua economist, the economist has no business offering advice. “Whenever he gives a precept, whenever he advises his reader to do anything, or to abstain from doing anything, he wanders from science into art. . . .”

As the nineteenth century wore on, Senior’s qualms came to be ignored. Particularly on the Continent, economists paid scant heed to Senior’s admonitions. The German Historical School (which dominated continental economics during the closing decades of the century) made no attempt whatever to separate their substantive economics from advocacy on behalf of specific social programs. For them it was precisely this advocacy that gave economics its importance as a branch of knowledge. Joseph Schumpeter cited the testimony of a student in a class taught by a prominent leader of the School, to the effect that the mood in the classroom resembled that of an election rally.

It was the great sociologist Max Weber who recognized the danger to the reputation of economics as an objective science that was posed by such a politicized attitude. He maintained that the scientific character of any social science requires that it be meticulously impartial as between different judgments of value. This ran counter to the dominant perspective in German economics. At a meeting of German-language social scientists held in 1907, Weber’s position was the subject of bitter disagreement. Weber insisted that scientists who disagree sharply on moral priorities should, despite this, be able, at least in principle, to agree on the positive propositions of their discipline. We shall return very soon to comment further on this Weberian doctrine of wertfreiheit (freedom from value judgments).

The Twentieth Century: The Economics of Welfare

By the end of the nineteenth century, mainstream economic theorists no longer saw their discipline as concerned with material wealth. Instead they focused on the subjective sense of well-being that human beings hope to derive from their wealth and from their economic activities. This led them (particularly in England) to see economics as primarily concerned with “welfare.” Very soon they were speaking of the “Economics of Welfare” (the new title of A. C. Pigou’s 1920 book, itself the second edition of a 1912 book titled Wealth and Welfare). To think of economics as the science able to promote economic welfare seemed an innocuous small step.

Thus for much of the first half of the twentieth century it was taken almost for granted that the economist is the expert who formulates policies to be implemented in order to promote aggregate economic welfare. It seemed to be obvious that economists had the professional duty of advocating policies they believed would, scientifically, enhance social well-being. And even economists squeamish about the philosophical coherency of any notion of aggregate well-being were able to devise more carefully formulated versions of welfare economics by reference to “Pareto optimality” or similar sophisticated constructions.

It was during this period that economists began to find ample employment opportunities in government. As the tide of public opinion turned (during the second quarter of the century) decisively in favor of massive government intervention in the market economy, economists increasingly saw their discipline as capable of generating very definite policies for enlightened governments to follow. Economists were placing their science (particularly the branch that made up “welfare economics”) at the service of political parties. Inevitably this tended to raise those same gnawing questions concerning the objectivity and impartiality of that science which had so troubled Max Weber. More and more, it seemed, any political program, any proposal for economic legislation, could find economists prepared to present a “scientific” case in its support.

Mises and Wertfreiheit

Ludwig von Mises, the towering Austrian School economist of the twentieth century, was an ardent champion of Weber’s wertfreiheit principle for all social sciences, and particularly for economics. He believed that the objectivity of the science requires nothing less than its complete detachment from the personal preferences and value judgments of its practitioners. Implicit in Weber’s wertfreiheit principle is the conviction that it is, at least in principle, possible for the economist to pursue his science in detachment from his own personal judgments of value. In fact, however, some twentieth-century philosophers have challenged (and do still challenge) this, maintaining that it is an illusion to believe that one can suppress one’s value judgments while engaging in one’s science. Inevitably, they argue, one’s science reflects one’s moral presuppositions. Mises may have agreed that to maintain such detachment may be difficult—but he would have emphatically rejected claims that it is impossible. It is the scientist’s obligation to the reputation and integrity of his science, Mises would have insisted, that he insulate his scientific work from any hint of “contamination” arising from personal predilections. The medical researcher exploring the links between cigarette smoking and cancer must pursue his laboratory testing and his statistical analysis without that research being affected in any way by his own preference for smoking or his own fears concerning the disease. So too must the economist’s analysis of markets, of regulation, and their consequences be utterly independent of his own moral opinions concerning liberty, the inequality of incomes, or whatever.

Mises’s position offers a fascinating illustration of the ambiguities and complexities involved in the wertfreiheit principle. Gunnar Myrdal was a prominent twentieth-century Swedish social scientist. (His positions on economic policy were so utterly at odds with those of Mises, that when, in 1974, Myrdal and F. A. Hayek were joint recipients of the Nobel Prize in economics, it was widely understood that these choices represented a kind of ideological balancing act, with Hayek’s approving views on free markets being counterbalanced by Myrdal’s advocacy of comprehensive government control of the economy.)

In 1930 Myrdal published a German-language book that examined the history of economics and concluded that most of the leading economists during that history had injected political presuppositions and ideals into what they presented as scientific investigations. This book was translated into English in 1955. Fritz Machlup (himself an eminent Austrian-trained twentieth-century economist who had been a pupil of Ludwig von Mises and who treated Mises at a personal level with exemplary loyalty) wrote a review of this published translation. Machlup drew attention to Myrdal’s declaration that (unlike the other schools of economic thought) the Austrian School of economics was not guilty of injecting political ideals into their scientific work. Machlup found this approving judgment surprising. “How did the anti-interventionist writings of the Austrian von Mises escape Myrdal’s attention?” he asked. Apparently Machlup was not able to reconcile Mises’s stated insistence on wertfreiheit and detachment from ideological precommitments with Mises’s eloquent writings in favor of laissez faire and the free-market economy.

In fact a reader of Mises’s work cannot fail to sense a paradox surrounding the passion with which Mises wrote his economics. By the time we reach the third part of this series, we shall hopefully have resolved this paradox. Here we shall merely identify it and relate it to the broader challenge of extracting useful advice from wertfrei economic science.

Ludwig von Mises and the Importance of Economics

Mises was, as we have seen, convinced that economics must be pursued dispassionately—as a wertfrei discipline—but he wrote with white-hot passion about the dangers that face mankind should it ignore the truths which academic science reveals. He concluded his magnum opus, Human Action, with the following searing sentences: “The body of economic knowledge is an essential element in the structure of human civilization; it is the foundation upon which modern industrialism and all the moral, intellectual and therapeutic achievements of the last centuries have been built. It rests with men whether they will make proper use of the rich treasure with which this knowledge provides them or whether they will leave it unused. But if they fail to take the best advantage of it and disregard its teachings and warnings, they will not annul economics; they will stamp out society and the human race.”

It is this passionate conviction on the utter importance of the teachings of economic science that accounts for the attention which Mises paid to the philosophical status of those teachings. Mises believed that the enemies of the free society can maintain their advocacy of central planning and massive government intervention in (or replacement of) the market economy only by ignoring or denigrating economic science. He saw all the attempts to question the validity of the foundational propositions of economics as driven by the ulterior motive of discrediting laissez-faire economic policy. Because Mises believed that only laissez-faire policies can sustain modern civilization, he felt driven to clarify and defend the philosophical foundations of what he called “modern economics.” (For Mises, modern economics was the body of economic teachings rooted in the classical economics of Adam Smith and his followers, as refined and reformulated by the so-called neoclassical economists, including especially the founder of the Austrian School, Carl Menger and his followers, among whom was Mises’s own teacher, the eminent Eugen von Böhm-Bawerk).

Mises’s clarifications of the foundations of neoclassical economic theory included, in particular, his defense of economics from the Marxist charge that conventional economists are merely the lackeys of Wall Street, advocating free markets only in order to serve their capitalist paymasters. Mises saw clearly that, unless economists purged their science of any taint of personal bias (that is, as expressing personal judgments of value), their teachings would be vulnerable to such dismissal. Precisely because he saw free markets as the essential prerequisite for civilized, prosperous society, and because he believed that disinterested economic analysis definitively supported this view, Mises was terrified by the possibility that economic science was to be dismissed as nothing but capitalist propaganda. Fritz Machlup saw Mises’s advocacy of laissez faire (his “anti-interventionist” writings) as an example of precisely that departure from impartiality in the pursuit of economic science, for which Myrdal had indicted so many economists (but for which had declared the Austrian School, in general, as having been not guilty). We shall return, in the third essay in this mini-series, to examine the validity of Machlup’s charge.

Most economists of the postwar period did not pay much attention to these concerns. It is true that Milton Friedman, one of the leading scholars of the eminent Chicago School, advocated (in an influential 1953 essay) what he called “positive economics” (in which economic propositions could be established that might command the assent of scholars regardless of their personal predilections). But this came to be viewed primarily as an exercise in methodology, presenting the case for treating economics as a strictly empirical (as opposed to a logical) discipline (rather than as a case for wertfreiheit).

From time to time more serious attention was devoted to the wertfreiheit issue. Thus a leading historian of thought, Terence W. Hutchison (who was, as it happens, a scholar in the methodology of economics who had bitterly criticized Mises’s own methodological writings), wrote a book on the subject. But few other economists gave much thought to the dangers to their impartiality (or to their perceived impartiality) that may lurk in their policy pronouncements. And some economists otherwise deeply influenced by the Austrian School, and Mises in particular, expressed strong reservations against the wertfreiheit doctrine. Thus Murray Rothbard, a leading disciple of Mises, argued for the explicit articulation of the ethical principles on the part of the economic scientist offering policy advice.

Recently a noted exponent of free-market economic policymaking, Daniel B. Klein, called on economists to deploy their science to modify the political-economic choices of the public. Klein contended that economists who themselves value the free society have a moral obligation to help mold public opinion toward an appreciation for liberty. Economists are in a unique position to do this because they enjoy a respected professional reputation. Instead of spending their time talking to each other in the language of abstract mathematical models, economists ought to be engaging in “public discourse,” talking to Everyman about issues of practical public policy. Klein surveys a swath of literature in which economists, both advanced scholars and frustrated graduate students, bemoan the irrelevance of the academic work being done by the economics profession. He finds the profession locked into a mindset in which it is in the rational professional interest of the individual economist to avoid addressing Everyman on realistic issues, focusing instead on the abstract models upon which professional repute and rewards (perversely) depend. In urging the economist to tell Everyman what is good for him, Klein is clearly urging the economist to see his professional responsibility as extending beyond the strictly positive. The economist must not only—or even primarily—concern himself with the understanding and prediction of chains of economic cause and effect; he must also deploy that understanding to advise (and even to exhort) the man in the street as to what are his best (and worst!) courses of action.

Castigated Economists

In urging the economist to tell the public what economic science sees as good for them, Klein was explicitly rebelling against the position taken by George J. Stigler, the Nobel-laureate Chicago School economist. In 1982 Stigler published a book in which he castigated economists (from Adam Smith to Stigler’s own time) for doing precisely what Klein wished them to do (that is, to tell the public what is good for them). Stigler strongly protested against economists being “preachers” (treating the public as mistaken, perverse children whose behavior can be improved if they are properly instructed through appropriate moral suasion).

For Stigler the economist should refrain from “preaching” not because of any concerns that such preaching violates their scientific objectivity and moral neutrality. Rather Stigler denounced such preaching because to preach economic policy is to believe—quite mistakenly, in Stigler’s opinion—that the economist knows what is economically good for the public better than the public itself knows. Stigler carries the assumption of perfect knowledge (which has notoriously characterized many of the models constructed by economic theorists in order to account for real-world facts) to a consistent, but extreme, degree. He assumes, in effect, that all that economics might be able to teach is already known to the public and to its political agents. The economist may think the outcome to be expected from a given policy to be undesirable, but if the public adopts that policy this proves that the public in fact desires that very outcome. The economist who denounces that policy as “wrong” is simply revealing that he has a set of objectives different from those that are in fact being pursued by the public.

Certainly the history of economics reveals little unanimity among economists concerning the possibility and the usefulness of the wertfreiheit principle. The prestige associated with the teachings of economic science, and the importance that educated public opinion attaches to them, have waxed and waned during that history. The views of economists themselves as to whether or not they have an obligation to enlighten the public on economic policy have varied widely. It is against this rather confusing background that we shall try to clarify the legitimacy of (“scientific”) advice to the public by economists.

From “Is” to “Ought”

In the second of this series we shall review the foundations of the strictly positive lessons taught by economic science. That is, we shall briefly set forth the nature of the economic reasoning that establishes the existence of chains of cause and effect in the economic sphere. In this regard we shall follow the Austrian tradition in economic reasoning, particularly as developed in the relevant writings of the twentieth-century leaders of that tradition, Mises and F. A. Hayek. What will emerge from this examination is insight into the powerful market tendency to systematically translate consumers’ rankings of needs, and physical resource constraints, into corresponding patterns of resource allocation. This systematic translation, we shall see, follows from the purposefulness of human action, the entrepreneurial propensity of human beings to discover what is of interest to them, and from the information-communicating capabilities of the market price system. This will lead us directly to the third and final part of this series.

In that third article we shall examine what implications this Austrian perspective holds for the possibility of offering impartial advice on public-policy issues, such that the advice does not reflect any personal or ideological preferences of the economist offering it. Only if this possibility exists can the doctrine of wertfreiheit be upheld consistently by the policy adviser; only if this possibility exists can the objectivity and impartiality of the advising economists be preserved; only if this possibility exists can we hope to uphold the scientific repute of economics. Our conclusions in regard to these questions will enable us to clarify some of the paradoxes we have encountered in the present article. They will provide us, in particular, with an understanding of how the teachings of free-market economists need not compromise their objectivity and impartiality, and may, nonetheless, be presented with passionate conviction and dedicated advocacy.

II.

How can positive science (consisting entirely of “is” statements) be translated into “ought” statements within the framework of economic understanding? In the first part of this series we drew attention to some of the paradoxes surrounding economic advice. In particular we drew puzzled attention to the passionate advocacy by Ludwig von Mises of free-market arrangements—the same Ludwig von Mises who insisted on an attitude of purest, disinterested wertfreiheit (“value-freedom”) on the part of all social scientists. In the present article, as a step toward clarifying these paradoxes and puzzles, we discuss the nature of the strictly positive central propositions of economics. We shall find that a careful appreciation for the manner in which economic science accounts for the existence of chains of economic cause and effect can help us see how knowledge of these chains can sustain very definite ways of providing advice and guidance to economic policymakers. Statements describing chains of cause and effect are “is” statements. But, as we shall see, these statements can, in a carefully defined sense, generate the “ought” statements of which economic advice consists.

Cause and Effect in Economic Affairs

Economic science was established as a branch of knowledge in the eighteenth century, when the classical economists recognized that there exist systematic chains of cause and effect in economic phenomena (just as they exist in regard to physical phenomena). Although subsequent progress in economic theorizing radically altered the way in which economics understands economic cause and effect, it was the classical economists who, by establishing the idea of systematic chains of cause and effect, established the scientific discipline of economics.

The very perception of a scientific discipline of economics (or “political economy,” as it was called by the classical economists of the late eighteenth and early nineteenth centuries) carries revolutionary implications for public policy. As Mises emphasized again and again, the discovery of regularities in economic phenomena means that statesmen concerned with public policy can no longer treat the economy as putty that they are free to mold into whatever shape they believe best for society. Every political act, every legislative constraint over economic activity, and every public subsidy must now be recognized as entailing specific consequences. Before instituting any tariff, before granting any right of monopoly, before printing any money, before imposing any kind of price control, those responsible for state policy must ask themselves whether they have fully taken into account all the consequences that are likely to follow from these actions. There are, the classical economists had shown, “laws” of economics that must be respected and taken into account if economic disaster is to be avoided.

But how can such “laws” possibly exist? Surely an intuitive impossibility blocks any conceivable “laws” from existing. It is one thing to observe and understand regularities and causal or functional relationships in physical phenomena. But to expect such regularities and relationships in economic phenomena (which represent the outcome of the independently made decisions and actions of millions of freely choosing individual agents) seems to be glaringly counterintuitive. There seems to be no way of ensuring that freely choosing agents “obey” the regularities that a science might declare to be determinative.

This intuitive difficulty is the fundamental reason why both economic theorists and philosophers have, during the past two centuries, puzzled and argued over the very possibility of an economic science, and over its epistemological character. The present series of papers (and this one in particular) are informed by the insights and philosophical framework identified with the Austrian School of Economics, and especially with the thought of its leading twentieth-century representatives, Mises and F. A. Hayek.

In this framework the focus of attention is on the purposefulness of human beings, and on the way in which the expectations and knowledge of these human beings are systematically modified by economic experience. Changing economic experience alters the terms on which individual agents in fact find themselves able to choose; that experience also teaches agents where they had over-optimistically or over-pessimistically misjudged the terms on which others were prepared to trade with them; that experience also alerts individual agents to opportunities for the future that had hitherto not existed or that have until now not been noticed. Economic theory is able, in this analytical framework, to provide understanding of how exogenous changes in resource availabilities, technical knowledge, and consumer preferences may systematically change market phenomena, and thus determine the course of production and the patterns of resource allocation. To illustrate this approach to economic reasoning, let us take perhaps the most basic of the “regularities” in the market economy, the “law” of supply and demand.

The “Law” of Supply and Demand

This basic understanding of the behavior of market prices identifies the nature and the direction of the forces operating in the market for each product and for each resource. This understanding sees the market for any given item, be it a product for human consumption (such as milk or the services of an opera singer), or a resource (such as farmland for growing crops or the services of an engineering instructor for the training of engineers), as being continually modified by market experience in systematic fashion. At any given time “too much” or “too little” of the given item may be offered for sale (or sought to be bought). (“Too much” being offered for sale means that, at current prices, more of an item is being offered for sale than is being bought. “Too little” being offered for sale means that, at current prices, more of the item is being sought to be bought than sellers wish to sell.) The “law” of supply and demand focuses attention on the existence of spontaneous market forces tending to “correct” these imbalances.

Where “too much” has been offered for sale, falling prices (for the relevant item) tend to encourage some (“marginal”) sellers to cut back on its production and to encourage potential buyers to seek additional quantities for purchase. Where “too little” has been offered for sale, rising prices for the relevant item tend to encourage potential sellers to increase production (and thus the quantities they will offer for sale) and to discourage some (“marginal”) buyers from continuing to buy. Were this process of adjustment in a given market to be permitted to continue indefinitely (that is, were the costs and techniques of production for the relevant item, on the one hand, and the preferences of the consumers, on the other, to remain indefinitely unchanged while market adjustments continued), the market for that item might be imagined to attain “equilibrium.” Market equilibrium corresponds to the imaginary state of affairs in which neither “too much” nor “too little” of an item is being offered for sale. In such an imagined state of equilibrium there would be no scope for market forces to be set into motion. Prices and quantities offered for sale and sought to be bought are, in such an imagined state of equilibrium, such that no tendencies are set in motion for any of them to change.

Contrary to what many students of economics have been taught to believe, the “law” of supply and demand does not (when it is properly understood) declare that each market is at or near equilibrium at each moment. Nor does it declare (the less-objectionable form of the above) that markets tend rapidly to achieve equilibrium. Rather the “law” declares that, to the extent that a market, at any given moment, is not at equilibrium, this will itself set into motion forces predominantly pushing the market in the direction of equilibrium.

However, it should be understood and emphasized, the continual changes in the relevant exogenous variables (for example, the costs of production, the availability of resources, and the patterns of consumer preferences) will almost inevitably ensure that the equilibrium position for a market at any given moment is different from what that position was at any earlier moment. So the market forces unleashed by the disequilibrium conditions at one moment will almost certainly not ensure the attainment of equilibrium at any subsequent moment.

Nonetheless, it is reasonable to point out, the more gross imbalances present in the market at any given moment will, according to the “law” of supply and demand, tend to be corrected. An “oversupply” places pressure on prices to fall, discouraging marginal sellers from some production and encouraging additional purchases, and thus tending to eliminate the imbalance. A “shortage” operates in the reverse, but equally benign, direction. Let us examine why the elimination of these “imbalances” can legitimately be described as “benign.” In the final article of this series, this will help us to understand the sense in which economic theory can, in scientifically objective fashion, promote sound economic-policy advice.

Market Imbalance—Why Is It Regrettable?

Let us consider the case of “overproduction” in a particular market (a market seen as isolated and insulated from other markets). Due to miscalculation or other error, the decisions of producers in this market have overestimated the eagerness of buyers to buy. The amounts offered for sale, and the prices expected and asked by potential sellers, are not matched by the decisions of potential buyers (and thus by the prices at which potential buyers expect to be able to buy, and at which they are willing to buy). This imbalance corresponds to decisions that have turned out to have been disappointing, and to decisions that turn out to have been regrettable. Some potential sellers (who might otherwise have offered to sell for lower prices, but who mistakenly held out for higher prices) are disappointed in that their plans to sell at higher prices cannot be successfully carried out. Those sellers may also regret their refusal to offer to sell at lower prices, or they may regret their decisions to produce in the first place. The failure of the decisions of some of the potential sellers to dovetail with corresponding decisions of potential buyers reveals the “error” of all of those decisions and is the source of both disappointment and regret.

A different, more accurate pattern of decisions, by both potential buyers and potential sellers, might have permitted them to achieve more successful fulfillment of plans than has in fact occurred. When a pair of market participants might have engaged in voluntary exchange to mutual advantage (for example, at a lower price), their failure to have done so (due to “error”) seems, at least at first glance, to have been unambiguously unfortunate—for everybody. Nobody, it seems at first glance, has gained anything by the fact that potential steps to mutual advantage were not taken.

So, if we are correct in this judgment, the market process, which according to our “law” of supply and demand initiates continual market tendencies toward the correction of such imbalances, would appear to be benign. It tends to discover and to correct “erroneous” market decisions—that is, decisions which operate to frustrate the exploitation of potentially mutually gainful exchanges.

Although we have been careful to express this approving judgment (for the outcome of the “law” of supply and demand) strictly in tentative terms, we shall find that it in fact holds more robustly than we have suggested. As we shall see in the final article of this series, it tends to hold even when we drop the special assumptions made in this section. There is a definite sense in which the “positive” theory of supply and demand leads ineluctably to an understanding of its socially benign character (that is, of its “normative” implications). We have in fact glimpsed here the basis for scientifically based economic advice. But the present article has not yet completed its exposition of the “positive” operation of the “law” of supply and demand. Before proceeding further we must explore more carefully exactly how this “law” achieves its magic—its tendency to correct market imbalance. We shall find that the “normative” discussion of this section can help us understand the “positive” operation of the competitive market process.

How the Market Works

As we have seen, market imbalance reflects and expresses decisions that have been made in error. Market participants have been disappointingly left with unsold goods. Had they known this previously, they might have produced fewer units of these goods; they might even have gone into entirely different lines of production; or they might have been happy to have sold for lower prices (the only reason for their having failed to do so being their erroneous conviction that they could obtain higher prices).

Notice that this understanding of market imbalance refers, in effect, to two distinct kinds of error. One kind of error made by participants in the market we have considered is that mutually gainful exchange opportunities have simply not been taken advantage of. (Thus when market prices have been “too high,” generating offers to sell that have been rejected, this is likely to mean that mutually gainful sales could, in principle, have occurred at lower prices.) A second kind of error has meant that some market participants have been led to believe (quite erroneously) that (nonexistent) opportunities for mutually gainful exchange really did exist. The first of these two kinds of error is thus to fail to recognize existing opportunities. The second kind of error is to “see” opportunities which in fact do not exist. One might describe the first kind of error as one of undue pessimism (failure to see opportunities really staring one in the face); the second kind of error might be described as one of undue and unjustified over-optimism. This insight can help us understand the process of market adjustment, the operation of the “law” of supply and demand.

Let us consider the errors of over-optimism. Whenever such an error occurs, it is discovered (and thus presumably corrected) almost inevitably. One’s market experience reveals where one has been over-optimistic; the opportunities that one had over-optimistically expected to encounter simply do not happen. Such chastening experience tends, almost inevitably, to rein in over-optimistic market anticipations. Such experience “teaches” where and how more realistic expectations are in order. Where over-optimistic would-be sellers had, for example, refused to sell for lower prices (confidently, but erroneously, expecting to sell at higher prices), their disappointing experience in the market tends to teach them to lower their asking prices.

But the other kind of error (that expressing undue pessimism) does not seem capable of “automatic” correction in any similar way. An opportunity (for mutually beneficial exchange) that was not seen today by the relevant parties (and therefore not taken advantage of) may not be seen tomorrow either (even if it still exists tomorrow). Let us take an example. If different prices for “the same” item have been prevailing in different parts of “the same” market, this is a scenario in which potentially mutually advantageous trading opportunities have existed, but have been missed. After all, in any market in which buyers have been buying at higher prices while some sellers have been selling at lower prices, we have a situation where these buyers and these sellers could obviously have benefited by trading with each other at some price lower than those higher prices at which the buyers have been buying, but higher than those lower prices at which the sellers have been selling. Clearly these market participants were simply unaware of what was going on elsewhere in this same market. But there seems no obvious manner in which such unawareness might be spontaneously replaced by superior market information. There seems no obvious way through which the market might tend to replace widely divergent market prices with less divergent prices.

It is here that the spontaneous market process depends on entrepreneurial alertness for one of the most fundamental (and widely recognized) tendencies in free, competitive markets: that prices for the same item do move toward a single price throughout the market.

Entrepreneurial Alertness

One of the less obvious, but nonetheless most powerful elements acting in markets is entrepreneurial alertness—the propensity of human beings to notice that which it is in their interest to notice. Sooner or later buyers paying unnecessarily high prices do tend to discover where they can obtain comparable goods at significantly lower prices. Sellers selling for unnecessarily low prices do tend to discover where they can find buyers willing to pay higher prices. Moreover, sooner or later entrepreneurs will discover that they can grasp pure profit simply by buying at the lower prices and selling at the higher prices. We do feel convinced that widely diverging prices in the same market for a given product or resource will give way in this fashion to competitive forces tending to push these diverging prices toward each other. Errors of undue pessimism do tend to be corrected in this way—as a result of entrepreneurial alertness.

So the “law” of supply and demand explains chains of economic causation along each of two distinct dimensions. First, as we have seen earlier, it operates toward the correction of market imbalances for given items. Second, it operates to correct such imbalances at the same time as it corrects the phenomenon of divergent prices for each such item. The forces of supply and demand operate to correct “wrong” decisions that are unduly optimistic, at the same time as it operates to correct “wrong” decisions that are over-pessimistic.

The Broad Scope of Our Analysis

Our discussion thus far has been extremely simple both in its assumptions and its substance. We have talked of the market for a “given item” while assuming this market to be isolated and insulated from all other markets. When one broadens one’s analytical perspective to include the markets for innumerable products and resources that may be bought and sold, and to include not only simple buying and selling decisions but also decisions on what to produce and how to produce, it might appear that we are now in a world of mind-boggling complexity, for which our simple analysis has little relevance. But this is not the case. The insights of the previous sections do have immediate relevance even for the most complicated of interlocking markets.

Consider, for example, a market in which a particular item C is produced by combining input A with input B, in accordance with some production recipe. Imagine that such production is highly profitable. The combined costs of inputs A and B are, at a given level of output, significantly lower than the revenue obtainable from selling C in the consumer-goods market. This scenario may seem fairly complicated (in comparison with the scenarios discussed earlier). But we should notice that this scenario is one in which buyers are paying higher prices than necessary, and sellers are selling at lower prices than necessary—exactly as in the single-item market discussed in the preceding section. Thus those selling A and B at prices summing to less than the price being paid for C could, in principle, have produced C and sold it for the higher price (since only A and B are needed to produce C). The profitability of this line of production results from a (disguised) divergence of prices “for the same item” in the same market (that is, it results from the circumstances that everything needed to produce C can be bought for less than the market price for C). Thus this profitability can be expected (unless we postulate monopolistic control of access to resources A and B) to tend to attract competitive entrepreneurial attention. This will tend to eliminate the profitability of this line of production (by pushing the price of C and the sum of the prices of A and B closer together).

Although this is not the place to do so, similar analysis can demonstrate the broad relevance of our earlier discussion of the “law” of supply and demand to key aspects, at the very least, of complex market scenarios.

Cause and Effect in Economic Affairs

Our discussion has illustrated the way in which simple economic theory accounts for the existence of definite and systematic chains of cause and effect in economic affairs. There do exist definite ways in which economic decisions made in any one period tend to take systematic account of the other decisions being made in the same markets. In this way decisions do mold each other in systematic fashion. And we have seen how the manner in which such “molding” tends to occur appears, at least at first glance, to deserve being called “benign.” This simple analysis will help us understand, in principle, how economic theory can lead toward making judgments on the “goodness” of specific policy initiatives through an understanding of the likely consequences of such initiatives.

We are now ready to tackle, in the final article in this series, the question posed at the beginning of the first article: Can positive economic understanding be translated into scientifically objective and valid economic advice?

III.

In the first section we explored some of the ambiguities and difficulties that surround the very idea of “economic advice” based on economic science. In the second article we set forth some of the basic foundations of economic science (with special reference to what the science can teach us about what we called the “benign” character of the spontaneous market process). We are now ready to draw together the various strands of our discussions and to set forth the scientific legitimacy of economic advice based on an accurate understanding of the nature and significance of the free-market process.

As was developed in the preceding article, economic science has explicated the nature of the forces that govern the market process. What we saw was that the market process is made up of powerful tendencies set into motion by “erroneous” market decisions. Such “erroneous” (that is, uncoordinated) market decisions are responsible for “imbalances,” in which over-optimistic expectations are frustrated and disappointed, while over-pessimistic expectations are translated into overlooked opportunities for mutually beneficial exchanges. The market process consists partly of forces that tend to modify over-optimism, replacing erroneously hopeful decisions by more realistic market bids and offers (and more realistic production plans); and it consists, in addition, of “entrepreneurial” tendencies toward the discovery of hitherto overlooked opportunities. At any given time these coordinative tendencies are operating to eliminate the earlier errors—at the same time as “exogenous” changes in consumer preferences, resource availabilities, and technological possibilities are altering the very framework against which “error” is to be defined.

To the extent that production decisions are geared, not to the satisfaction of current consumer needs, but to the satisfaction of future needs, our above capsule description of the market process must be deepened. We must recognize that a production decision may be “over-optimistic” not only in overestimating the urgency of consumer demand for today’s fresh milk, but also in overestimating the future demand for a particular style of automobile. Such a production decision may be “over-pessimistic” not only in failing to realize that today’s market will express an unsatisfied demand for cheese products (which might have been even more profitable than the production of fresh milk), but also in failing to realize that (perhaps as a result of advances in medical research), in five years’ time the demand for fresh fish (and thus the profitability of now producing fishing trawlers) may increase substantially.

To recognize all this does not require us to change our basic understanding of the nature of the forces that make up the market process. It merely requires us to recognize that these forces operate along channels that permit us to apply our elementary understanding of the “law” of supply and demand to levels of intertemporal complexity not noticed previously. Ultimately, however, the intertemporal coordinating forces unleashed by the “law” of supply and demand operate in ways fundamentally similar to the operation of this “law” in the simplest of markets. Market decisions are continually modified to take more realistic account of future possibilities; entrepreneurs are continually alert to the possibilities of discovering hitherto unnoticed gainful opportunities (whether these opportunities are short-run or long-run in their nature).

Is the Market Process Really Benign?

Our discussion in the preceding section (and in parts of the preceding article) may suggest that each step of the market process is, at least in its tendency, socially beneficial. After all, this process tends to correct the erroneous expectations that individuals may have. It tends to discourage individuals whose over-optimism might otherwise inspire them to undertake projects doomed to failure. And it tends to inspire individuals to discover hitherto overlooked ways in which they can be useful to each other. To the extent that we would hope that such opportunities would be discovered, the market process, it would seem, is “benign” in its tendency. But what about the possibility that the successful achievement of mutually beneficial exchange between parties A and B is seen by party C as an undesirable development? (Economists term such situations “externalities.”) We may consider several different scenarios.

a) Suppose, as a result of newly discovered trade possibilities between A and B, C (who had previously enjoyed B’s spending as a customer in his store) now finds his income reduced. Of course he is dismayed by the newly discovered mutually gainful exchange opportunity between A and B. (C would be similarly dismayed if, as one who used to buy from A at a low price, he now finds himself forced to match the higher price that B is now paying A in their newly discovered mutually gainful exchange.) While C certainly feels himself to have been “hurt” by the discovery, does this compromise our earlier judgment that the latter discovery is socially beneficial? The basis for our earlier judgment was the implicit assumption that the trade between A and B benefits them both (which is certainly the case) without affecting anyone else negatively (which is not the case in our present scenario).

Without entering into any deep philosophical issues revolving around comparisons between the “harm” suffered by C and the gains enjoyed by A and B, let us carefully notice that C has not really been harmed at all. What has happened is merely that C, who had enjoyed income received by selling to B as a result of B’s earlier ignorance, is now no longer able to do so. (Or, in our alternative case, C, who had enjoyed being able to buy cheaply from A, as a result of A’s earlier ignorance, is now no longer able to do so.) C has not been harmed in the sense of having lost any of his physical assets. Nor, as we shall see, has he been harmed in the sense of having lost some of the established true value of his assets; his “harm” consists strictly in his having now to live with a more realistic assessment (by himself and others) of what his physical assets are worth, and have really been worth, to others. Up until now he has, as is presently apparent, been extracting an unrealistically and unjustifiably higher value from others, in exchange for what was really a lower-value asset.

But what if the exchange between A and B does indeed physically harm C; suppose that what A sells to B is his service as a musician and that this music played by A is so loud and so repulsive to C that the latter feels as if physically assailed.

Let us consider this scenario. A sells live music to B; C’s life is totally disrupted by what he considers atrocious noise. Surely we cannot describe the discovery by A and B of this opportunity for mutually gainful exchange as constituting an unambiguously socially benign development. Surely the gain to A and to B has to be offset, at least in part, by the harm caused to C. Let us distinguish two cases: (i) one in which the law recognizes C’s right not to be disturbed by other people’s music and (ii) one in which the law does not restrain individuals from disturbing others with their noise. In case (i), C’s right not to be disturbed will certainly have to be taken into account by A and B. They will, if they wish to trade with each other, have to pay C to persuade him to permit them to do so.

If C accepts such a payment, we would have a three-way trading arrangement in which everyone (at least in his own estimation) has been made better off. B gets to hear music at a total cost that he apparently believes to be worthwhile; A plays his music for a net price (after paying C) that he finds worth his while; C, while he must now sacrifice his peace and quiet (to which he is legally entitled), finds that the payment he receives from A and/or B is more than sufficient to make it worthwhile to do so. Everyone (to whom the trade between A and B is of relevant interest) has gained from trade.

In case (ii), in which the law does not recognize any right not to be disturbed by the noise of next-door music-lovers, C’s pain will be legitimately ignored by A and B (unless of course they choose to act altruistically to consider C’s suffering). But C has a way of making sure that his pain is taken into account by A and by B; he can offer them money to sign a contract undertaking not to play music during agreed-on periods. If they accept his money, C will consider himself to have gained (since he has purchased peace and quiet, to which he had not previously been legally entitled). If they do not agree to such a contract, C will indeed suffer from the music; but it is the legal system that is the source of this pain. The market process merely translates the legally recognized rights of A and B into corresponding realities. In both case (i) and case (ii) the market process benignly tends to reveal all relevant opportunities for mutually beneficial gain—within the given framework of legally recognized (and enforced) individual rights. We may approve or disapprove the morality of the legal system of rights, but given that system, whatever it may be, the market process benignly tends to inspire mutual discovery; it tends to bring about coordination among the decisions of all those who are considered relevant by society’s adopted system of law.

Has Economics Proven the Market Process to Be Morally Good?

We have seen that elementary economic reasoning shows that the market process tends to promote the discovery of hitherto overlooked possibilities for mutually beneficial exchanges. We have therefore described the process as “benign” in its tendency. Does this mean that the market process is morally “good”? Have we shown that, since the market process is economically good, we have scientifically demonstrated that public policies which promote the market process are morally good policies, while those which hinder the process are morally bad? Have we used science-based “is” statements to generate morally compelling “ought” statements? Careful examination of our reasoning will show that we have not demonstrated any necessary moral goodness in the market process—but that we have nonetheless succeeded in securing a valid basis for economic policy, properly understood.

What we have called the “benign” results that tend to flow from the spontaneous market process are benign in a very special, limited, sense. It seems a pity that Jones, who prefers a (which he does not have) to b (which he does), is somehow (let us say as a result of unnecessary ignorance—unnecessary in the sense that it could be eliminated with virtually zero cost) held back from trading with Smith, who prefers b (which he does not have) to a (which he does). A market process that tends to reveal to both Jones and Smith a way in which they can mutually benefit each other (without harming anyone else) seems to be an obviously “socially” beneficial process. But the beneficial character of this process is strictly relative to Jones’s and Smith’s given preferences. If these preferences are, in a moral sense, praiseworthy, the process that promotes their fulfillment can be seen as morally praiseworthy too. But suppose that the a which Jones prefers is a cholesterol-laden dessert that is likely to trigger a heart attack; suppose further that the b which Smith prefers is a hectic ride on a wildly unsafe motorcycle on a busy highway. Surely many observers would think the world a morally better place without the implied exchange. But—and this is the important point—the economist who applauds the market process is doing so not as a moralist; he is doing so strictly within the “instrumentalist” framework of his profession. He is pointing out that, from a purely economic point of view (that is, in terms of given preferences and given resources), free exchange is “beneficial” in its tendency, for all relevant parties.

An educational psychologist who has been consulted on the best color that might be chosen for the walls of a classroom may recommend a bright color that will stimulate alertness and learning. But before pronouncing this color to be morally superior to other possible classroom-wall colors, we would want to be sure that the classroom is to be used for morally good teaching purposes. If the classroom is to be the arena in which students are indoctrinated into hateful ideologies, we would probably consider a color which slows down the learning process to be morally superior to the alertness-inducing color. “Goodness” is strictly relative to the professional focus of the expert. For the educational psychologist this focus is the promotion of alertness to new information—regardless of the moral status of that information. For the economist the professional focus is the fulfillment of mutually beneficial opportunities for exchange, based on given preferences and resources—regardless of the moral status of those preferences.

But if this is properly understood, it does not appear to be wrong to label a coordinative economic policy to be “good economic policy,” since it does promote mutual discovery among the Smiths and the Joneses. The economist who argues that one economic policy is economically better than another policy is doing so strictly within his professional framework.

What We Have Not Claimed

There are other claims that are not implied by our claim on behalf of the economic goodness of the market process. To show this does not, however, call for philosophical or moral insight; it simply requires rigorous economic reasoning.

For example, take the idea that free markets maximize national wealth. Now the great economists who were the founding fathers of the discipline—the “classical economists”—did indeed define their science as the “science of wealth.” It is well known that the (short) title of Adam Smith’s classic work is The Wealth of Nations. As we noted in the first article, Smith, followed by the other classical economists, took it for granted that the objective of good economic policy is to increase national wealth. Yet the very meaning of the term “aggregate national wealth” (especially if confined as it was in classical economics to material wealth) begins to crumble away, as a scientifically useful term, as soon as it is subjected to analysis.

Two bushels of wheat may certainly appear as more wealth than one bushel. But are they also more wealth than, say, a package of one bushel of wheat and one sack of potatoes? And even when we consider only wheat, are we sure that two bushels owned by a single wealthy person constitutes more wealth than one bushel that has been somehow distributed among several desperately poor large families? Simply drawing attention to the valuation problems of adding up apples and oranges, or to the complications introduced by the insights of subjectivist (and especially, Austrian) economics, explains why economists at the end of the nineteenth century sought to replace the criterion of aggregate national wealth by less-physical concepts. One such concept, which came to be associated particularly with the work of British economist A. C. Pigou, was that of the aggregate national “economic welfare.” What good economic policy seeks to maximize, according to this approach, is the aggregate economic well-being of the members of society.

But the idea of treating individual economic welfare as something that might in principle be added together with someone else’s individual economic welfare is one which could hardly be sustained. In particular Austrian economics, which had pioneered the subjectivist understanding of consumer utility, could never accept any such aggregate notion. Moreover, attempts to replace direct notions of aggregate welfare by less-direct formulations (that is, those implied in the notions of aggregate efficiency in the allocation by society of its economic resources) are easily seen to be doomed to failure.

Thus, it turns out, economic policy advice cannot meaningfully claim to be based on the idea that a particular policy should be described as economically “good” because it tends to promote aggregate wealth, or aggregate economic welfare, or a more efficient allocation of a society’s economic resources. We seem to be forced back to the more modest (but yet enormously important!) claims examined earlier—that certain economic policies may be shown to promote mutual discovery by potential market participants (and may therefore be considered to be “economically good” policies). Sometimes, as we have indicated, this is expressed by pointing out that such policies promote “coordination” among the decisions made in a society. They tend to alert relevant market participants about the possibilities available to them, tending thus to ensure that potentially beneficial opportunities for innovative production, and mutually gainful exchange, do not go unnoticed and unexploited. Implicit in the work of Ludwig von Mises, however, are insights into several additional criteria for judging economic policies to be good or bad.

Ludwig von Mises and the Goodness (or Badness) of Economic Policies

Mises never did fully explain the basis on which he felt able to pronounce an economic policy to be good or bad. He never (as far as I am aware) explicitly discussed the “coordination” criterion for good economic policy to which we have repeatedly referred. But there are grounds for believing our position in this article to be consistent with Mises’s philosophical and economic perspectives. In his explicit discussions Mises seems to have grounded his judgments (on the goodness or badness of economic policies) on one or more of three separate foundations:

Self-Frustrating Economic Policies: A policy that can be shown by economic science to bring about results that are emphatically not desired by the policymakers themselves is bad policy. A classic Misesian example of this was the policy of urban residential rent control. Whatever the merits might be of the results hoped for from a policy of rent control, it must be pronounced a bad policy. Economic analysis shows that it tends to generate housing shortages—which were not (one hopes!) the objective of the legislators.

Unsustainable Policies: A policy that can be shown to be inherently impossible to be successfully carried out is an obviously flawed policy. For Mises a policy of monetary inflation (to fuel a boom in the initiation of long-term capital-using ventures) is a bad policy because economics shows how extremely unlikely it is that any such sustainable boom will result. Such a boom can be sustained only through long-run consumer sacrifices, which the consumers are not in fact prepared to make. Such policies amount to attempts to run simultaneously in two opposite directions. Economics can show that a particular policy cannot expect to be successfully completed. Such a policy may be described as bad policy.

Violations of Consumer Sovereignty: Mises (like most economists) apparently supposed that most people believe it to be a “good thing” for members of society to fulfill their preferences. He therefore shared the conviction of most economists that a policy which structures a society’s allocation of resources in patterns clearly at odds with the dynamics of consumer preferences is an economically “bad” policy. A policy that creates a pattern of excise taxes tending to nudge consumer purchases away from goods and services the consumers prefer, toward goods and services legislators believe to be “better” for consumers—is a policy that Mises believed to be “bad,” because it violates consumer sovereignty.

Science and Passion

We noted in the first article in this series that writers have been puzzled by the passion with which Mises denounced what he believed to be bad economic policies. Fritz Machlup, an eminent economist and devoted student of Mises, was one of these writers. Mises’s passion seems, at first glance, difficult to reconcile with his own insistence on the absolute necessity for scientific wertfreiheit—detached objectivity—in social science. When Mises denounced socialism as a disastrous economic system—one that tends to impoverish society, to bring misery on its members, and to threaten the very survival of Western civilization—he waxed passionate. He was firmly convinced that economic science shows all this to be true. (In particular he was convinced that economics demonstrates how the most benevolent of would-be national planners would not be able to plan [that is, to coordinate individual activities] at all! Thus a policy of socialism—that is, a system in which an integrated, single, national plan is sought to replace the “anarchy” of innumerable individual plans in a free-market society—is one that is simply impossible to carry out [just as would be a policy aiming to run in two opposite directions at the same time].)

But by now it should be clear that there is no inconsistency in Mises’s positions. Because Mises believed—on objective, scientific grounds—that socialism is a sure recipe for misery and worse, he believed it to be his moral duty to communicate his belief to society with whatever passion might be able to command attention and inspire political relief. Machlup may have seen this as a violation of wertfreiheit. Mises would have vehemently disagreed. His passion was—like the passion of someone earnestly preaching the health dangers of tobacco smoking—based on cold, objective science.

As we saw in the first article, the eminent economist George Stigler believed that any “preaching” by any economist for any particular economic policy is, on grounds of consumer sovereignty, out of order. Stigler believed that the public already knows full well what the likely results of any economic policy are likely to be. If the economist is preaching against a policy voluntarily adopted by the public through its political channels, he is simply attempting to promote what he believes to be better for society over what society believes to be better.

But economic science surely has, again and again, revealed how particular policies result in outcomes not foreseen by policymakers, or by those who elected or appointed them. Economics shows how imperfect knowledge may be responsible for enormously valuable (and completely overlooked) opportunities remaining unexploited. It is no violation of consumer sovereignty to demonstrate where such ignorance has been (or is likely to be) responsible for disastrous results. In fact, to demonstrate this is to promote consumer sovereignty. As long as the philosophical and moral detachment of economic science is well understood, this science can be used, in a wertfrei manner, to inform the public of what it does not yet know. Where the results of such ignorance are likely to be serious, the economist (in his capacity now of a citizen fully alive to society’s suffering) may consider it his moral obligation to bring the results of his objective scientific researches to the attention of the public. Such moral obligation may indeed be expressed with Misesian white-hot passion—but this is, in principle, in no way inconsistent with the cold objectivity with which those researches were conducted.