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The Actuary The magazine of the Institute & Faculty of Actuaries

Economics: Neoclassicists vs Austrian school

My article, ‘A Battle of Minds’ (The Actuary, March 2010 www.TheActuary.com/873406), focused on Austrian economics, but also attacked the neoclassical economics of Milton Friedman and the Chicago School. In ‘Opposing opinions’ (The Actuary, August 2010 www.TheActuary.com/874890), Terry Arthur claims that these two schools are now miles apart, yet they have many basic features in common — their belief that democracy and unhampered markets are inseparable; their certainty that markets know best and are self-correcting; their rejection of attempts by the state to mitigate inequalities; and their disapproval of state ownership and enterprise.

One can scarcely deny that this cluster of ideas did indeed ‘conquer the world’ in the late twentieth century. Whether it came mainly from Vienna or from Chicago is a moot point — the two schools influenced and reinforced each other. According to Alan Greenspan, “The long tentacles... of the Austrian school reached far into the future from when most of them practiced and have had a profound and, in my judgment, irreversible effect on how most mainstream economists think in this country”(1).

Friedrich Hayek’s ideas underpinned the chaotic liberalisation of the Russian economy under Boris Yeltsin, whose prime minister Yegor Gaïdar recalled that “I read Milton Friedman’s book with interest, and also Hayek. They were very authoritative for me”(2), while his economic strategist Anatoly Chubaïs “remembered nights spent in a St Petersburg library reading Hayek as the happiest of his life”(3). These leaders’ shock therapy led to economic mayhem; thereafter, the authoritarian regime of Vladimir Putin was seen by most Russians as a welcome relief.

One basic difference between the two schools is that neoclassicism is dominated by the theory, pioneered by Léon Walras in the late nineteenth century, of general equilibrium. This means that the various activities in the economy interact in such a way that they form, or tend towards, an integrated system in which everything is in equilibrium with everything else. The theory implies that it is possible to construct models of the economy as a whole, or of distinct parts of it, and that these models can predict the behaviour of the whole or parts. Such modelling techniques form the basis of, among other things, financial economics. But clearly too many models failed to predict the misbehaviour of complex marketable instruments, or the disaster to which that contributed.

Austrian economics, by contrast, denies that economic behaviour, even of large groups of economic agents, can be predicted mathematically. Therefore, Austrian economists avoid the use of mathematical models. But both groups believe in ‘universal laws’ of economics. Mises, for example, claimed that the German Historicists were not economists at all, since they denied the existence of universally valid economic laws: “Understanding [of diverse cultures” does not permit the modern historian to state that an economic law was not valid in ancient Rome or in the empire of the Incas”(4). The Historical School began with Wilhelm Roscher in the early 1840s, predating Kaiser Wilhelm I’s Second Reich (1871).

According to Arthur, Austrians had little political influence even in the Margaret Thatcher era, and have none today. This seems unlikely, given Thatcher’s admiration of Hayek and the continuing prominence in America of politicians who still want to leave markets to their own devices, despite all the evidence that poorly regulated markets have disgraced themselves. Visit www.mises.org, the site of the Ludwig von Mises Institute in Auburn, Alabama, to see the huge efforts still being made to promote Austrian ideas. Congressman Paul Ryan, author of the recent controversial US budget proposals, lists Hayek’s The Road to Serfdom among his favourite books.

Like other free-marketeers, Arthur claims that post-war West Germany achieved its fine record of recovery, stability and growth under conditions ‘close to laissez-faire’. Certainly the Ordoliberal economists Walter Eucken and Wilhelm RÖpke, leaders in the creation of the Soziale Marktwirtschaft, were founding members of the Mont Pèlerin Society, along with Austrians Hayek and Mises as well as Chicagoans Friedman, George Stigler, Frank Knight and Aaron Director. Yet Eucken and RÖpke were hardly mainstream Austrians. “Both... believed in the merits of the market, but they did not believe that it could function automatically without the help of the government. In this sense, government was not seen as an enemy but as a friend of the market, and the libertarian economics of today would not have been acceptable to Ordoliberals.”(5)

West Germany, the ‘Rhenish model’, was always a mixed economy with considerable public ownership and control. Actuaries familiar with German insurance will recall that, until 1994, the Bundesaufsichtsamt für das Versicherungswesen (federal supervisory office) had to give prior approval of contract terms and premium and valuation bases for both life and general policies, imposing minimum standards. This procedure suppressed competition between insurers. Many banks were public sector entities such as the Landesbanken, with restrictions on the scope of their operations; keen competition between banks was discouraged on the grounds that “... the principles of competition... must take second place to the confidence of depositors in their banks”(6). Large, stable bank shareholdings in private sector companies meant that a free market in corporate control was essentially absent.

As Arthur observes, the historical economist Werner Sombart wrote that “... facts are like beads: they require a string [of theory” to hold them together”(7). Quite so, but it generally makes better sense to infer a theory from facts, than to assume a priori a theory and then expect facts to fit it. Only theories well grounded in observed facts make sound bases for deduction. Does Mises’ assumption that “... human behaviour is necessarily always rational” (8) pass this test?

Arthur objects to my thesis that Austrian economics is harsh, inhumane and unjust. Its harshness would seem to be a matter of widely shared experience, which might, however, be written off as mere subjective opinion. What can be quantified are the prevalent increases in inequality, unemployment and destitution — these are matters which induce a real sense of injustice. Austrians and other libertarians reply, with Arthur, that “... the study of economics... has no moral dimension”. In other words, “... important though justice is, most economists deny that it has any bearing on economic transactions”(9).
In the neoclassical and Austrian worlds, this charge sticks. Lionel Robbins wrote that “... it does not seem possible to associate economics with ethics”(10); Friedman claimed that “... there is a fundamental conflict between the ideal of ‘fair shares’ and the ideal of personal liberty”(11); Hayek insisted that, in a free market, “the question of whether the resulting distribution of incomes is just or unjust has no meaning”(12).

There is something very odd about this. Economics, like law and religion, is concerned with human behaviour and with the interactions of people in society. A jurist who held that the law should not concern itself with justice would be justly ridiculed. A priest who preached that religion had nothing to say about justice would get the same treatment. Yet we tolerate the bizarre notion that justice need not concern economists. The Indian economist Amartya Sen, professor at Harvard, Nobel prizewinner and former master of Trinity College, Cambridge, complains of the “...self-consciously ‘non-ethical’ character of modern economics”(13).

This unconcern with justice underpins the very bedrock of laissez-faire — the doctrine of unlimited freedom of contract. It is held that any human being has an inalienable right to contract with any other, provided only that the terms of the contract are mutually agreed. There lies the libertarians’ excuse for rejecting regulation by governments, or by unions, or by trade associations. But this theory overlooks the obvious fact that the parties to economic contracts are often of very unequal strength; therefore, such contracts are often inequitable.

The Austrian attitude to charity is another logical consequence of ethics-free economics. Austrians cannot or will not see that poverty that reflects persistent exorbitant inequalities constitutes an injustice, not simply a personal misfortune calling for a helping hand from charity.

Austrians like to claim that they are the best, or even the only, predictors of boom and bust. Yet a fascinating survey(14), ironically titled ‘No-one saw this coming’, identifies twelve serious forecasters, including Wynne Godley, Fred Harrison and Nouriel Roubini, who predicted the latest disaster. Two of the twelve are clearly Austrians. And it is surely inadmissible to claim, as Austrians do, that central banks ‘cause’ the booms that precede busts. The house of subprime cards was built by the stupidity and greed of bankers and their customers, of bond investors, and of rating agencies with their faulty models. To put the primary blame on central banks is like saying that policemen ‘caused’ a fire by not being quick enough to arrest the arsonists.

Austrians take this line because a key part of their ideology is the belief that the public sector is always wrong — “... big government is incorrigible”. So they have no interest in the vital, but difficult and unending, task of creating and maintaining a well-functioning, beneficent state. They want instead to minimise the state and entrust most of its duties to untrammelled markets. But markets are not substitutes for politics. And, with too much power and too little supervision, free markets can themselves become tyrants.


1 Alan Greenspan, testimony to the House Financial Services Committee, 25 July 2000
2 Yegor Gaïdar in an interview on PBS ‘Commanding Heights’, 10 May 2000
3 Andrew Cowley, Moscow correspondent of The Economist (London), letter to the International Herald Tribune, 10 February 1995
4 Ludwig von Mises, Human Action (Hodge, London, 1949), chap. 2, #10
5 Naoshi Yamawaki, Walter Eucken and Wilhelm RÖpke in The German Historical School, ed. Yuichi Shionoya (Routledge, London, 2001), page 198
6 Magali Demotes-Mainard, L’Economie de la République Fédérale Allemande (La Découverte, Paris, 1989), page 88
7 Werner Sombart, Economic Theory and Economic History (1929), #3; see Journal of Institutional Economics, vol. 2, no. 1 (Cambridge University Press, 2006)
8 Mises, Human Action, chap. 1, #4
9 M R Griffiths (Tillinghast Towers Perrin) and J R Lewis (fellow of Merton College, Oxford), Ethical Economics (Macmillan, 1997), chap. 2
10 Lionel Robbins, An Essay on the Nature and Significance of Economic Science (Macmillan, London, 1932), chap. 6
11 Milton and Rose Friedman, Free to Choose (Harcourt Bruce Jovanovitch, San Diego, 1980), chap. 5
12 Friedrich von Hayek, The Mirage of Social Justice (Routledge & Kegan Paul, London, 1976), chap. 10
13 Amartya Sen, On Ethics and Economics (Blackwell, Oxford, 1987), preface
14 Dirk J Bezemer (University of Groningen), ‘No-one saw this coming’, see http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf


Angus Sibley is a retired actuary and former member of the London Stock Exchange