Kingston University Becoming an Economist Lecture 03: The Austrians

Though they shared many of the same concepts as the mainstream–supply and demand analysis, and the belief that “value” was subjective rather than objective–they diverged on many others, especially on how much knowledge could be had about the economy.

Neoclassicals began with attempting to analyse the economy as if it were in equilibrium, because their analytic tools at the time could not handle a disequilibrium position. Over time, for reasons explained in the last lecture in this series, they became wedded to the proposition that the economy itself was in equilibrium, or would always return to it rapidly after any “exogenous shock”. As part of explaining how this would happen, they invented the concept of “rational expectations”, which assumed that a “rational person” had a model of the economy in his head that let him accurately predict the future of the economy.

Austrians regaled at this assumption, instead arguing that real people have limited knowledge even of the present, and the Neoclassical assumption that they could predict the future was not a “simplifying assumption”, but a dangerous fantasy (Keynes was in complete agreement with his Austrian rival Hayek on this point, and the rejection of this fantasy by some of Keynes’s followers led to the formation of the Post Keynesian school, which I discuss in the next lecture).

Austrians instead argued that people have very limited knowledge of the present, and that the great advantage of the market was that it assembled this limited individual knowledge into something meaningful in the aggregate. But this also meant that the economy would never be in perfect equilibrium, and entrepreneurs could then profit by exploiting the difference between where the market currently was, and what would actually be its equilibrium.

Schumpeter is not regarded as an Austrian economist by today’s school of Austrian economics, but I regard his analysis and vision as very compatible with theirs, and giving a great explanation of how innovation occurs in a capitalist economy. I therefore devote much of the lecture to discussing his explanation of how transformational change occurs, thanks to entrepreneurs disturbing what he calls “the circular flow” of the equilibrium model developed by the Neoclassicals.