Thinking Carefully About Macroeconomics; S. Horwitz

THEFREEMAN IDEASON LIBERTY Thinking Carefully About Macroeconomics by Steven Horwitz M ost people who believe in a free soci ety have some knowledge of econom ics. After all, the case for economic freedom is usually the most difficultone to argue, and if one is going to defend the idea of freedom , one must be prepared to discuss economic issues. However, this strategy can some times face two differing problems. The first is that economics is not a ho mogeneous entity-there are different schools of thought with different approaches to the subject matter and different policy conclusions that emerge from these ap proaches. Knowing some economics isn't enough. One must be careful about what it is one knows and what economics others might know. This point by itself suggests those who wish to make the case for the market need to be as aware as they can be about developments in economic theory and policy.

Even beyond the issue of policy, a second complication comes into play. There are a number of different theoretical arguments for the free market. It would be easy to simply dismiss these differences as irrele vant, since all seem to wind up with the same conclusion.However, some of those argu ments may be better than others, and some may be more convincing to particular audi ences. Here, too, it pays for defenders of the Dr. Horwitz is Eggleston Associate Professor of Economics at St. Lawrence University in Can ton, New York. market to be as informed as possible about these differences and the various arguments each group presents. What I would like to do in this essay is to layout the Austrian school's approach to some fundamental issues in macroeconom ics, and, in so doing, address both of the issues noted above: how does this approach differ from more interventionist schools of thought, and how does it differ from other market-oriented approaches?

Macroeconomicsand Microeconomics One of the issues that spans both of these questions is the relationship between mac roeconomics and microeconomics. Prior to John Maynard Keynes in the 1930s, there was not really a distinct system of analysis known as "macroeconomics" which was concerned with establishing direct causal relationships among aggregates such as in flation, unemployment, and gross domestic product (GDP). Keynes was interested in determining the "level of output as a whole," and he argued that economists beforehimhadignoredthiscrucialquestion. A great deal of Keynesian economics from the 1930sto the 1960swas solely concerned with these macroeconomic aggregates, never asking what the relationship between them and the choices made by individual persons and firms in the economy might be. 781 782 THE FREEMAN • DECEMBER 1995 An important accomplishment of eco nomics in the 1960s was to begin to ask precisely this kind of· question. Milton Friedman's work, in particular, sought to explain inflation and unemployment more in terms of the choices made by individuals who were smart enough not to be fooled consistently by government policy. Later developments of those themes have ex tended the assumption of individual ratio nality to the point where individuals in many recent models cannot ever be fooled by systematic government policies. The work of the so-called New Classical economists, such as recent Nobel Prize winner Robert Lucas, was important in reminding econo mists that people do not behave the same way no matter what policies governments adopt. If governments inflate, for example, individuals will have an incentive to recog nize that inflation and take steps to neutral ize its effects on themselves and their fam ilies or firms.

As important as these contributions are, they remained the victim of one central flaw. They were couched in terms of more and more abstract models that assumed that observed macroeconomic outcomes had to be the result of perfect utility-and profit maximizing behavior by individuals and firms. The central assumption was that the ~ economy was in equilibrium and that ob served macroeconomic outcomes had to be compatible with microeconomic equilib rium. The problem with this strategy is that first, the conditions necessary for equilib rium to hold never exist in the real world, and second, it suggests that major macro economic difficulties (such as 25 percent unemployment during the Great Depres sion) are just the result of optimal decisions by individuals. Although it concluded from this analysis that government policies will be unable to improve on market outcomes, this strategy does shift the analyst's focus away from the role that government inter vention might play in causing those out comes.

Of course the Keynesians did not sit still for these developments. They recognized and accepted many of the counterarguments made by Friedman and the New Classicals. However, the general strategy of the so called New Keynesians was to point out that various informational limitations and rigid ities inherent in real-world markets prevent markets from achieving the equilibria that the New Classical models were built upon. As a result, argued the New Keynesians, government intervention might improve upon the free market by virtue of govern ment's supposedly superior information and ability to take advantage of those rigidities , and push the economy closer to that equi librium. So New Keynesians share many of the same underlying assumptions as the New Classicals, they simply believe that in some (if not many) cases markets alone are unable to reach the equilibrium that the New Classicals believe they can.

An Alternative Perspective on Macroeconomics It might surprise people who know a little bit about Austrian economics to read an essay about why macroeconomics matters. Austrians are presumed to .reject the whole concept of macroeconomics as being incon sistent with the individualism that has long defined their approach. To the extent that macroeconomics is understood as only be ing about the direct relationships among economic aggregates, then it would be wise to reject such an approach. However, all economists are still interested in explaining phenomena such as unemployment, infla tion, and economic growth and their effects, so we do need some way of analyzing those issues. As noted earlier, a sound approach to macroeconomics would insist that such explanations (and the effects of changes in aggregates) have to be understood in terms of the microeconomic choices made by individuals and firms.

One alternative way to explore these issues is to reject the equilibrium orientation of the major mainstream schools of thought and see what difference that might make in the analysis. Specifically, where these schools see market prices as equilibrium signals to perfectly rational actors (they THINKING CAREFULLY ABOUT MACROECONOMICS 783 simply differ on how well prices perform this function), we might, by contrast, see market prices as disequilibrium signals that guide imperfectly informed individuals about what to do and how well they do it. For example, if you assume markets are always in equilibrium, then any given price is fully reflective of all of the knowledge and pref erences of market actors. If so, then what ever results is optimal. This is how an equilibrium-oriented macroeconomics can shrug its shoulders at 25 percent unemploy ment. It's an equilibrium outcome, hence it is optimal.

If, however, we argue that equilibrium never actually exists, then the existing prices of goods and services in the market are not perfect reflections of people's pref erences and correct knowledge, but rather indicate the imperfect information con veyed by individuals making choices in a complex economy. Prices then have multi ple roles in the market. First, prices help to inform market actors about what choices they might make next. Suppose I make tshirts. In deciding how to make my prod uct I would want to know the prices of my various options for raw materials and labor in order to decide how much labor, what kind of shirt material, and what kind of dye or screening process I might use. Prices help to inform these decisions. Second, after having made my choices about inputs, I sell (or can't sell) my tshirts at some price in the market. After the fact, the difference be tween the price I receive for my output and the combined prices of my inputs (including time), tells me whether what I have already done was the right thing to do.

These roles of prices are perhaps obvious. But when one assumes equilibrium, only the first role is emphasized and even then prices are assumed to be the right prices from the start. If one starts by assuming markets are always in disequilibrium, .a third role for prices emerges. Our first two roles assumed that we already knew that we wanted to make t-shirtsand that therefore we had some perception that a market for such . tshirts existed. But what makes such real izations occur? As Israel Kirzner's work has long emphasized, this recognition of previ ously unseen opportunities is known as entrepreneurship and it is essential to the discovery process of the market. This third role of prices is to alert us to such oppor tunities that would otherwise be missed. I might currently produce tshirts, but in look ing at various input prices and by imagining what price I might get if I began to produce shorts with cartoon characters or sports logos on them, I might be .led to see an opportunity I would not have without prices. The disequilibrium prices of the market are central to alerting people to entrepreneurial opportunities.

InBation How does all of this relate to macroeco nomics? What an alternative approach to macro might look for are the ways in which government policies, which are designed to affect broad aggregates like the price level or rate of unemployment, affect these indi vidual disequilibritIm prices and undermine their ability to lead to market coordination. Take inflation, for example. Mainstream discussions of inflation generally emphasize the problems created by variations in the aggregate price level. Inflation is bad be cause it is hard to, for example, write contracts if the parties cannot be sure of what the overall level of prices will be in the future. Alternately, inflation is bad because it means that sellers have to remark their prices more frequently, and these ongoing changes in prices require the use of re sources that would otherwise go toward production directly. Although both of these are indeed problems caused by inflation, they seem relatively minor when compared with what a view that takes the market process seriously suggests.

Rather than worry about the overall level of prices, economists could instead look at the way in which inflation affects the individual prices in an economy. As excess supplies of money work their way through the market, they cause differential effects on prices. Some go up by a lot, some only by a little. These price effects divorce prices 784 THE FREEMAN • DECEMBER 1995 from the underlying preferences of produc ers and consumers and in so doing under mine all three informational roles ofprices discussed above. When the informational role of prices is damaged, economic coor dination is more difficult and economic growth suffers as a result. 1 The real effects of a macroeconomic disturbance like infla tion are the ways in which it undermines the microeconomic coordination process by disrupting price signals. If the analyst begins by assuming this coordination has already occurred, as do equilibrium models, then these effects of macroeconomic distur bances will be overlooked.

These price effects cause further effects throughout the economy. Of special interest is the way changes in the prices of consumer goods lead to distortions in input markets and the capital structure as they respond to the constantly changing signalscomingfrom consumer goods. The changes in capital equipment orjob training that result as firms react to the temporary effects of inflation are generally not completely reversible and thus involve economic waste. Once again, this perspective illuminates an aspect of macroeconomics not captured by main stream approaches, including those, like Friedman's, which are sympathetic to eco nomic freedom. In addition, this approach differsfrom the New Keynesians because of this stress on the role of prices in stimulating entrepre neurial discoveries. The New Keynesian argument that governments can overcome information problems in markets is almost always put in terms of the information necessary for reaching equilibrium. Even if governments were capable of doing so (a dubious assumption at best), it still ignores the discovery role of prices. As market process economists have long stressed, achieving equilibrium is not the standard by which tojudge a capitalist economy. Rather, the comparison is between what really existing market competition can achieve in comparison to really-existing (not what get drawn up on a blackboard or computer) government intervention that suppresses the market.

Macroeconomics does indeed matter and it is important to understand both the main stream and non-mainstream approaches to the subject. The differences between these approaches are important for how we un derstand macroeconomic phenomena, how we assess their costs, and what we might do to reduce those costs. Austrian-type argu ments are notjust one more weapon one can pick up along with those of other econo mists. They reflect a distinct perspective on political economy which needs to be under stood both on its own terms and in compar ison to other such perspectives. It is impor tant for those who value freedom to be reasonably aware of these differences and their implications. D 1. I have discussed these issues in much more depth in my, "The Political Economy ofInflation: Public and Private Choic es," Durell Journal of Money and Banking, 3 (4), November 1991;and also "Inflation" in Peter J. Boettke, ed., The Edward Elgar Companion to Austrian Economics (Aldershot, UK: Edward Elgar), 1994.