How to Refute the Core of Austrian/Neoclassical Economics in Four Easy Points

Lord Keynes August 6, 2017 Socialdem. 21st Century

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Summary:
Both Austrian and Neoclassical economics stem from the Marginalist revolution of the 1870s. Although there are important differences between both schools, they have enough in common that is flawed to make them both subject to this critique:(1) both Austrian and Neoclassical theory ultimately hold that free markets have a tendency towards general equilibrium, and hence economic coordination by means of a flexible wage and price system, and a (supposed) coordinating loanable funds market that equates savings and investment. This is an empirically false view of market economies: it is essentially the product of Marginalists from the 1870s onwards who had physics envy and wanted to model a market economy like a self-equilibrating physical system.(2) the core Neoclassical and Austrian model in

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Both Austrian and Neoclassical economics stem from the Marginalist revolution of the 1870s. Although there are important differences between both schools, they have enough in common that is flawed to make them both subject to this critique:

(1) both Austrian and Neoclassical theory ultimately hold that free markets have a tendency towards general equilibrium, and hence economic coordination by means of a flexible wage and price system, and a (supposed) coordinating loanable funds market that equates savings and investment. This is an empirically false view of market economies: it is essentially the product of Marginalists from the 1870s onwards who had physics envy and wanted to model a market economy like a self-equilibrating physical system.
(2) the core Neoclassical and Austrian model in (1) is false because:
(i) market systems are complex human systems subject to degrees of non-calculable probability and future uncertainty, so that market economies would not converge to general equilibrium states even if wages and prices were perfectly flexible. This makes human decision-making highly different to the fundamental model proposed by Neoclassical economics (even with their modern ad hoc models that invoke asymmetric information and bounded rationality), and, even if Austrians supposedly accept subjective expectations in decision making, they fail spectacularly to apply it properly in their economic theory. At the heart of this failure of both Neoclassical and Austrian theory is the mistaken ergodic axiom.
Investment is essentially driven by expectations which are highly subjective and even irrational, and come in waves of general optimism and pessimism;
(ii) the loanable funds model is a terrible model of aggregate investment (partly because the mythical natural rate of interest can’t be defined outside one commodity worlds) but very importantly because of (i) (which is the point that kills both Austrian economics and Neoclassical loanable funds models).
(iii) the price and wage system is highly inflexible, and even if it were flexible all sorts of factors prevent convergence to equilibrium states anyway (e.g., the reality of a non-ergodic future, subjective expectations, debt deflation, failure of the Pigou effect);
(3) the quantity theory of money is virtually useless, because of the following reasons:
(i) the modern money supply is endogenous because broad money creation is credit-driven (that is, created by private banks and its quantity is determined by the private demand for it), and, furthermore, a truly independent money supply function does not actually exist in an endogenous money world, since credit money comes into existence because it has been demanded, and so the broad money supply is not independent of money demand, but can be demand-led;
(ii) money can never be neutral, neither in the short run nor in the long run.
(iii) the direction of causation is generally from credit demand (via business loans to finance labour and other factor inputs) to money supply increases, contrary to the direction of causation as assumed in the quantity theory, and
(iv) changes in the general price level are a highly complex result of many factors, and not some simple function of money supply.
(4) the (non-Keynesian) Neoclassicals and Austrians have an obsessive-compulsive fixation with the supply-side, but this cripples their economic theory. In our capital-rich Western economies historically (and once we re-implement some kind of industrial policy now), what mostly constrains our prosperity is the demand-side, not the supply-side.

Of course, you have to say an incredible amount in addition to this to refute all the other manifold errors of Austrian theory and Neoclassical economics (see also here, here, and here), but these points above are in essence devastating to their core ideas.

Finally, George L. S. Shackle summed up the essence of Keynes’ theory as follows:

[sc. Keynes’s] ... theory of involuntary unemployment is perfectly simple and can be expressed in a paragraph, or in a sentence. If you express it in a sentence, you simply say that enterprise is the launching of resources upon a project whose outcome you do not, and cannot, know. The business of enterprise involves investment, the investing of large amounts of resources--huge sums of money--in things whose outcome you cannot be certain of, which could perfectly well turn into a disaster or a brilliant success.
The people who do this kind of investing are essentially gamblers and they can lose their nerve. And if they decide to withdraw from trade, they sweep their chips up from the table. If they decide it’s too risky, if their nerve gives out and they can’t bring themselves to go on investing, they cease to give employment and that is the explanation.
When business is at all unsettled--when there’s any sign at all of depression--or when there’s been a lot of investment and people have run out of ideas, or when their goods are not selling quite as fast as they have been, they no longer know what the marginal value product of an extra man is—it’s non-existent. How can you say that a certain number of men have a certain marginal productivity when you can’t know what the per unit value of the goods they would produce if you employed them would sell for?”
“An Interview with G.L.S. Shackle,” The Austrian Economics Newsletter, Spring 1983.

This is actually a splendid summing up of what Keynes’s theory is about, and why both Austrian and Neoclassical economics are nonsense.

Links
“King on Post Keynesian Approaches to Microfoundations,” April 1, 2013.

“The Essence of Keynesianism is Investment,” December 8, 2012.

“Money Has Direct Utility,” October 25, 2012.

“World GDP versus Total Value of Financial Asset Market Exchanges,” February 21, 2013.

“Capitalism has Two Fundamental Sectors,” February 22, 2013.

“Steve Keen, Debunking Economics, Chapter 6: Wages,” February 12, 2014.

“Steve Keen, Debunking Economics, Chapter 5: Theory of the Firm,” February 13, 2014.

“Kaldor on Economics without Equilibrium,” March 9, 2013.

“Kaldor on the Irrelevance of Equilibrium Economics,” May 15, 2013.

“The Marginalist Pricing Controversy Revisited,” April 12, 2014.

“Where Gardiner Means went Wrong,” May 11, 2014.