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The Actuary The magazine of the Institute & Faculty of Actuaries
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Economics: A battle of minds

In a fascinating interview, ‘Capital Gains’ (The Actuary, November 2009), economist Roger Bootle says: “There’s potential for a lot of cross-fertilisation [between actuaries and economists”, if only the economists would climb down from their ivory tower and confront the structure of real world problems...”

The conflict between abstract theorising and practicality in economics has a long history. Today, the ‘ivory tower’ mentality manifests itself in two schools of thought, both highly influential in recent times. One is the ‘Chicago’ or ‘neo-classical School’ (Milton Friedman and others), which relies heavily on mathematical models, often far from realistic. The other is the ‘Austrian School’ (Ludwig von Mises, Friedrich von Hayek and others), which eschews such models but bases its arguments on a priori assumptions about human behaviour, rather than on observation of how real-life economies actually function. Both schools exalt the free market.

Against these stands a tradition of more pragmatic economics, which has been sidelined since the 1970s.

In the beginning
Modern economics began with David Hume and Adam Smith in Scotland, and their contemporaries François Quesnay, physician to the French court, and Anne- Robert-Jacques Turgot, friend of Smith and, briefly, Louis XVI’s finance minister. This was ‘classical’ economics, based on self-regulating markets: the right of individuals to enter into contracts without regulation by governments, guilds or unions; the belief that economic behaviour follows universal laws like those of physics, and is driven purely by the self-interested actions of individuals; and the iron law of wages, which states that the natural level of labourers’ wages is a basic subsistence level.

The German Historical School
In reaction against the grim social consequences of industrial development under classical principles, the ‘German Historical School’ of economics appeared in the mid-19th century. Its members believed that economics should be based not on theoretical assumptions but on the study of history: how economies have behaved in practice. History, as they saw it, showed that economic behaviour depends on national characteristics, traditions and levels of development; it does not follow universal laws. Here we see foreshadowed our recent controversies over the World Bank and the IMF, often accused of imposing identical strategies on widely differing societies, regardless of local cultures and conditions.

Thus Wilhelm Roscher (1817–1894) called for an holistic approach: “The life of a nation forms an entity whose diverse phenomena are intimately connected with each other. To scientifically understand one aspect thereof, one must understand them all... the language, the religion, the art, the science, the law and the state, as well as the economy.”1

The Historicists objected to the heavy emphasis in classical economics on the pursuit of self-interest. Thus Karl Knies (1821–1898) regretted that “private egotism, self-interest, plays such a significant role in the theory of national economics” and observed that “self-interest... serves, so to speak, the public interest in its weakness Annebut is dangerous in its strength”2. Surely a message for our times!

The clear leader of the Historical School was Gustav Schmoller (1838–1919), for many years a professor in Berlin and a dominant influence on German economic thought and practice. In 1879 he founded the Verein für Sozialpolitik, a think-tank that advised Bismarck’s government and inspired the famous state pension scheme of 1889. Far from accepting the iron law of wages, Schmoller and his colleagues were concerned to improve workers’ conditions: “It is progress when the lower classes demand meat, good clothes, agreeable lodgings, their share in intellectual culture”3.

Schmoller favoured a strong public sector, however, warning that “the public economy should not absorb the private, or vice versa. The pans of the scales must remain in balance...”4. Public-sector activities should include child and adult education, assistance for the poor, hospitals and health insurance, railways, “even banks and mortgage banks”5. The Historicists sought a well-regulated mixed economy to provide well-being and security for its citizens, thus neutralising the attractions of communism. Their strategies helped to lay the foundations of the German industrial economy, which remains to this day among the strongest in Europe.

Schmoller denounced classical economic theory in striking words, which fit our recent financial theories as precisely as if they were fresh off the press: “The more its theory departed from observation and from the needs of real life... the less valuable were the productions of the classical school. It finished, as a class weapon delivered by Mammon itself into the hands of the capitalists, as a clever toy for clever people in ivory towers, ignorant of the world”6.

In Bibliothèque Nationale de France in Paris, it is not only Schmoller’s text that seems fresh off the press, but even the volume that contains it. A beautiful edition dated 1900, on open access, it appears scarcely to have been opened. Admittedly, I refer to the original German edition; the French version shows signs of use. No English translation exists. Thus have the Historicists been neglected.

The Austrian School
Economists in Vienna were horrified at this challenge to classical economics. The Austrian School, beginning in the 1870s with Carl Menger (1840–1921), reacted sharply against German ideas, opening a long and bitter controversy. Menger is best known as the founder of the theory of marginal utility and pricing, which I have described elsewhere (The Actuary, February 2008). He argued that untrammelled competition between suppliers must be right, since it encourages maximum production and consumption.

Later, Ludwig von Mises (1881–1973), a follower of Menger, became the dominant Austrian voice. He insisted that “economics... is a display of abstract reasoning”7 and that “the economist does not learn directly from history”8. His abstract reasoning starts from assumptions about human behaviour, such as “human action is necessarily always rational”9, “action can only be imputed to a discontented being”10 and “labour is a means, not an end in itself”11.

It follows that one only works (acts) if one is in need of money, and thus discontented. Hence there must be no unemployment or sickness benefits. For if one can claim benefits while not working, one will be content without working and so will not work. “Compulsory sickness insurance... tends to encourage disease by weakening or completely destroying the will to be well and able to work.”12

Compare this with Schmoller’s recognition of the human need for work: “Man cannot do nothing but eat and make love; he needs other things to occupy his time and his soul...13 all moral strength has its roots in work”14.

Mises adopted the curious assumption that “labour is the most scarce of all the primary means of production”15 and therefore that “on the labour market of a market society there are buyers for every supply of labour offered”16. Other means of production (energy, natural resources, capital) are always more abundant than labour. Accordingly, we can always eliminate unemployment by pumping up growth until all available labour is employed.

Mises’ pupil Friedrich von Hayek (1899– 1992), Margaret Thatcher’s favourite guru, held that individual freedom means being constrained only by impersonal forces, “the absence of restraint and constraint”17 by the will of others. Thus, a free society would ‘run on auto-pilot’, controlled by the impersonal forces of the untrammelled market and an inflexible system of laws (no specific regulation of market activities and no judicial discretion). Hayek’s ideal polity was “a society which does not depend for its functioning on our finding good people for running it”18.

In his philosophy, planning by any central authority is objectionable, both because it infringes our freedom and because planners cannot know as much as the market knows. The market is a ‘game’ in which “there is no point in calling the result just or unjust”19; claims that free markets lead to injustice are void, for “social justice is an empty phrase with no determinable meaning”20.

Trade unions are harmful because they restrict members’ freedom, and useless because they cannot raise wages above market levels without causing unemployment. Altruistic conduct in the public interest implies some vision of what is good for the community; this falls under the same condemnation as central planning. We are urged to “gain from not treating one another as neighbours”21.

However, Hayek was not totally opposed to the welfare state. He was prepared to tolerate “some provision for those threatened by the extremes of indigence or starvation, be it only in the interest of those who require protection against acts of desperation on the part of the needy”22.

The triumph of neoclassicism
The Austrian philosophy, developed from the late 19th century onwards, remained largely out of favour until the late 20th century. The more practical Historicists, and their successors, remained influential on the Continent, backing the ‘Rhenish model’ of capitalism; in Britain and America, the pragmatic strategies of Keynes and the ‘New Dealers’ dominated much of the last century. Why did harsh and unrealistic Austrianism and its near relative, neoclassicism, conquer the world in its last quarter?

When mixed economies ran into trouble, with overbearing unions and excessive inflation, the neoclassical and Austrian economists convinced policymakers that their faulty economies could not be repaired and must be replaced by a ‘new’ (but actually remodelled classical) design. Freer markets rhymed with the rising tide of individualism after 1968. The fall of communism seemed to prove the uselessness of state direction. Mises proclaimed that “laisser-faire eliminates the causes of international conflict”23, blaming German economics for the cataclysmic nature of both World Wars. The rich yearned for lower taxes. Ronald Reagan, ‘turning the bull loose’, seemed to offer the seductive promise of a freer, richer and happier future.

That dream has turned sour. Our societies are disfigured by extravagant affluence at the top, sordid misery at the bottom and increasingly precarious, stressful, unsatisfying working lives in the middle. Menger’s maximum consumption is ecologically intolerable. Our financial institutions have become bloated and perilously unstable. Our economic behaviour has become increasingly egotistic and uncivilised. It is time to demolish the ivory towers and return to more practical and humane economic philosophies.

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1 Wilhelm Roscher, Die Grundlagen der NationalÖkonomie (1854), book I, chap. 2
2 Karl Knies, Die Politische Ökonomie (1853), book I, part 2, pages 147 and 157
3 Gustav Schmoller, Grundriss der allgemeinen Volkswirtschaft (1900), vol. I, #12
4 Ibid., #112
5 Ibid., #112
6 Ibid., #40
7 Ludwig von Mises, Human Action (Hodge, London 1949), chap. 38
8 Mises, The Ultimate Foundation of Economic Science (Van Nostrand, Princeton, 1962), chap. 5
9 Mises, Human Action, chap. 1, #4
10 Ibid., chap. 2, #11
11 Ibid., chap. 7, #3
12 Mises, Socialism [Die Gemeinwirtschaft, 1922”, trans. J Kahane (Yale University Press, New Haven, 1951), part V, chap. 2, #3
13 Schmoller, Grundriss, vol. I, #11
14 Ibid., #20
15 Mises, Human Action, chap. 7, #3
16 Ibid.
17 Friedrich von Hayek, The Constitution of Liberty (Routledge & Kegan Paul, London, 1960) chap. 1
18 Hayek, Individualism and Economic Order (Routledge & Kegan Paul, London, 1948), p. 11
19 Hayek, The Mirage of Social Justice (vol. II of Law, Legislation and Liberty) (Routledge & Kegan Paul, London, 1976), chap. 10
20 Ibid., chap. 11
21 Hayek, The Fatal Conceit (Routledge, London, 1988), chap. 1
22 Hayek, The Constitution of Liberty, chap. 19
23 Mises, Human Action, chap. 34, #1. Mises asserts here that “what has transformed limited warfare between royal armies into total war... is... the substitution of the welfare state for the laisser-faire state”. _______________________________________________________________

Angus Sibley, a retired actuary and former member of the London Stock Exchange, now lives in Paris. He writes regularly on www.equilibrium-economicum.net