Reprinted from Mises.org
How did you come to know Austrian economics?
I discovered Austrian economics by accident, and learned more about it gradually over many years. In the late 1960s, when I was just beginning my career as a professor of economics at the University of Washington, I stumbled across Hayek’s 1945 article “The Use of Knowledge in Society.” I liked it very much, used it in my teaching, and cited it in my writing, even though at first I did not truly understand how its argument differed significantly from basic neoclassical microeconomics and the “economics of information” I had previously absorbed from the writings of George Stigler and other Chicagoans.
Not long afterward, having acquired an appreciation of Hayek’s work, I read The Constitution of Liberty, which impressed me greatly by the scope and depth of its scholarship. By that time, owing to graduate education at Johns Hopkins, I had already come to understand the beneficial working of the price system, but I had not yet broken free of neoclassical welfare economics, with its various blackboard models of “market failure.”
Hayek led me to Mises, whose treatise Human Action I read in the late 1970s. This book had a profound effect on my thinking as an economist. Hayek, at least as I then understood him, had not challenged my positivist conception of the scientific underpinnings of economics. Mises, however, shook these foundations of my thinking, and I pondered Mises’s epistemological formulations for years before I really understood them. The idea that anything can be simultaneously (a) apodictically certain a priori and (b) empirically meaningful and true was difficult for me to assimilate intellectually, though eventually I succeeded in doing so.
From Mises’s Human Action, I went on to read not only much more by him and Hayek, but also many works by other Austrians, including Rothbard (who influenced my thinking about politics and history more than he influenced my thinking about economics), Kirzner, and Garrison.
And why did you feel attracted to Austrian economics? What are the main distinctive features that you value the most of the Austrian School relative to other more conventional approaches?
I immediately appreciated the realism of Austrian economics, which contrasts starkly with the often wildly unrealistic assumptions of neoclassical economic theory and the sheer silliness of many of its models and their implications. With a foundation in the action axiom and the implications logically derived from that axiom and well-founded auxiliary propositions, Austrian economics provides a solid “logic of choice” that does not hinge on econometric findings or other sorts of “empirical testing.” This logic of choice may then be applied in the interpretation of complex actions and interrelations in the empirical world.
Most of all, an understanding of Austrian economics reveals that mainstream economics is the exact opposite of what it claims to be: it is not science, but scientism. Relying on crude imitation of 19th-century physics, it implicitly or explicitly assumes that human actions can be understood in the same way that natural scientists understand the motions and interactions of material particles, chemical substances, and electrical currents. Unfortunately for mainstream economics, human beings — unlike particles, chemicals, and currents — have purposes, which they choose and may change, as well as a capacity for creativity in their choice or invention of means for the attainment of their chosen ends. Only a science that recognizes the essential nature of human beings, and how they differ from material particles and electrical currents, can achieve an understanding of human action. Neoclassical economics hides its epistemological nakedness beneath a massive cloak of symbolical representations and mathematical manipulations in formal models. Once one comes to understand what is being done, and presupposed, in this nursery of playful idiots savants, one comes to see that hardly any of it will bear critical scrutiny.
Has your economic thought evolved and changed significantly throughout your academic career?
When I received my PhD in 1968, I was a completely conventional neoclassical economist; nothing in my education to that point had sought to make me anything else. However, I was already skeptical of the high degree of mathematical formalism and conceptual artificiality in economic theory — one of the reasons I was drawn to specialize in economic history, which is necessarily much closer to the ground — so I was predisposed to look at conventional models and methods skeptically, and I did so to an increasing degree as I proceeded with my own work as an economist.
As time passed, my views changed substantially, but never very quickly except in the immediate aftermath of my reading of Mises’s Human Action, which posed a major challenge to many of the views I held at the time. Nevertheless, I did not instantly abandon neoclassical economics and become a full-fledged Austrian economist; that transition took many years, and perhaps I have still not completed it.
In addition, as I learned more about econometrics — not only in theory, but also in actual practice — I became very skeptical of how mainstream economists use this set of statistical techniques. For one thing, few of them pay any attention to the quality of the data they employ; most simply plug in data drawn from standard sources, usually government-generated databases. Hence, the result of their econometric exercises, regardless of their method’s seeming sophistication, is frequently GIGO: garbage in, garbage out. In addition, I learned that econometrics rests to a great extent on false assumptions about the underlying sampling by which the data have been obtained. Usually in economics, no genuine random sampling at all has taken place. The analyst simply plugs in historical data — the only data that do, or can, exist on the subject at hand — and treats those data as if they were the results of a random sampling procedure. For this reason, virtually the entire ceremony associated with so-called tests of statistical significance is misplaced and does not mean what it is taken to mean. My old friend Deirdre McCloskey has been tutoring the mainstream profession for decades about this matter, but professional practice in this regard continues much as it has for decades.
Of course, the preceding misgivings that I developed about mainstream economics were only heightened by my continuing self-education in Austrian economics. The upshot has been that over the years, I have done less and less econometrics, and more and more conceptual and analytical interpretation and criticism of established beliefs and practices. To say that I no longer fit in well in the mainstream profession would be a great understatement, although I have been pleased that some of my old friends and colleagues in the mainstream have stuck with me and paid attention to my work. The PhD students I trained at Washington have been completely loyal, and lifelong friends, as well, which brings me tremendous satisfaction. None of them, however, has become an Austrian.
If I am not wrong, you had Douglass North as a professor at the university: what were the main lessons you drew from him?
I did not have North as a professor, but he and I were colleagues at the University of Washington from 1968 to 1983, when both of us left that university to take other positions. One reason I took the job in Seattle in 1968, however, was because North was already there, and I relished the idea of learning from him and perhaps receiving some mentoring, as well. Over the years, he helped me in many important ways, for which I shall always be grateful, and we remain friends today. (Doug wrote the foreword to Government and the American Economy, the Festschrift in my honor published by the University of Chicago Press in 2007.)
North’s influence on me had more to do with stimulating my interest in certain subjects than with teaching me specific methods of analysis or historical conclusions. In the 1970s, Doug was regarded as perhaps the leading expert in “government and the economy” among the economic historians, and after working with him for a decade or so, I became interested in that area, too. Of course, his interest in institutions and in the creation of what became known later as the “new institutional economics” also influenced me greatly, although the theoretical core of this research program came more from other colleagues at Washington, Yoram Barzel and Steven N.S. Cheung, as well as from economists at other institutions, such as Ronald Coase at Chicago and Armen Alchian at UCLA.
Should Austrians pay much attention to North’s and other New Institutionalists’ (e.g., Coase, Williamson) work?
Yes, they should. Whether one is a neoclassical economist or an Austrian economist, there is much of value in this new field. In reality, all social behavior is shaped by the institutional environment in which the actors are situated. For a long time, neoclassical economics was essentially “institution-free,” and as a result, mainstream economists made major errors in interpreting a variety of institutions (e.g., firms, government agencies) and developments (e.g., the conduct and results of central planning in the USSR, China, and other communist countries). Of course, certain aspects of the new institutional economics cannot be accepted by Austrians because they clash with basic Austrian methods and understandings. Nevertheless, anyone who seeks to understand the empirical reality of complex institutions and events can gain something of value from the best work in the new institutional economics.
Some of the PhD students I trained — Robert McGuire, Lee Alston, John Wallis, Yuzo Murayama, Price Fishback, and Charlotte Twight — have done outstanding research that combines public choice, economic history, and the new institutional economics in creative and revealing ways. They have greatly surpassed their teacher, and I am immensely proud of their accomplishments.
My own work in this area has included a number of studies of farm tenancy and related contracts for the use of farm land and labor; race relations in the US South; anti-Japanese land laws in the Pacific coast states; fishery regulation in Washington and Alaska; soft price controls during the Carter administration; the military-industrial-congressional complex; US international trade and finance sanctions; FDA regulation of drugs and medical devices; and “externality” management in the Northwest metal mining industry; among other things. My work in these areas has had some influence among mainstream economists and economic historians, but remains largely unknown to (or ignored by) Austrians.
One of your most important theses in your work is the idea of the “ratchet effect.” You developed a theoretical framework for understanding the growth of government in Crisis and Leviathan and applied it to several historical episodes. Could you tell us what the “ratchet effect” means and why it is important for understanding the history of government in the 20th century and current events too?
In my work, the ratchet effect describes the characteristic way in which government under modern ideological conditions grows during a perceived national emergency. The government’s size, scope, and power grow abruptly as the government acts to “do something” to allay the threat. Then, as the threat is eliminated or diminished, the government shrinks, but not all the way to the level it would have reached if the crisis had not occurred. Hence, each crisis shifts the government’s growth trajectory to a higher level of size, scope, and power.
In my formulation, the reasons for the ratchet are several: one is political and legal inertia; another is institutional persistence brought about by those who operate or benefit from crisis-spawned government agencies or authority; and still another — perhaps the most important — is institutional change associated with the public’s becoming accustomed to the exercise of new government powers and with the government’s concurrent efforts to justify its exercise of these powers. Other economists and historians had described a ratchet effect, but most of them confined it to fiscal growth, and none of them developed its ideological aspect in the same detail that I have. The ideological change engendered by seemingly successful passage through a major crisis then predisposes the government to create and the public to accept even greater growth of government when the next crisis occurs.
Another area in which you have made important contributions is the Great Depression, in your book Depression, War, and Cold War. There are several interesting debates about this particular episode. One of them is why it came about, why the crash and the Great Contraction until 1933. Do you agree with the Friedman and Schwartz thesis, according to which the GD was mainly due to a mismanagement of the monetary policy — in particular, because the Fed’s policy was too contractionary and let the money supply shrink by a huge amount? Should the Fed have acted to avoid this so-called secondary contraction?
I disagree with Friedman and Schwartz in that I believe that Fed actions during the 1920s caused widespread malinvestment in longer-lived capital projects, such as real-estate developments, residential housing, and large office buildings, and thereby guaranteed that some kind of serious restructuring would have to be made eventually, perhaps in the form of a widespread bust, with its related bankruptcies. Friedman and Schwartz think that the Fed performed well during the 1920s and made its big mistakes only after the economy began to decline in 1929.
I do agree, however, that once the economy began to contract rapidly, the Fed should have done more to prevent the nearly 10,000 commercial bank failures that occurred between 1929 and 1934. These failures created secondary effects that exacerbated the overall economic decline not only via increased illiquidity and falling asset values, but also via shattered business confidence and heightened consumer pessimism that encouraged an increased demand for cash balances. This increase meant that even though the Fed increased the monetary base, the money multipliers declined so much that the money stock (M2) fell by about a third in less than four years. The resulting deflation was too rapid to be easily or quickly accommodated, and hence many needless bankruptcies and other difficulties occurred that might have been avoided.
I do not blame the Fed exclusively for the Great Contraction, however, as Friedman and Schwartz come close to doing. The government’s response to the crisis — propping up wage rates, increasing tariffs, bailing out privileged banks and insurance companies, and many other actions — along with the Fed’s timidity in dealing with the contraction, created a veritable “perfect storm” smashing the private economy and its price system. The authorities did almost everything wrong from 1929 to 1933; small wonder that they turned a decline into a disaster.
Another debate is why the Great Depression lasted so long. You talk about this in your work, and you elaborated an explanation for this in “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War.”
“Regime uncertainty” is the name I give to widespread fears that the nature of the economic order will be changed. This has to do mainly with fear that private-property rights will be altered for the worse by higher taxes, more costly regulation, more hostile treatment by government functionaries of all kinds, and perhaps outright confiscation of private property. When investors feel regime uncertainty, they are reluctant to make long-term investments, because they fear that they will be unable to receive the income those investments will generate and may even lose the capital itself. Between 1935 and 1940, many US investors feared that the market-oriented US economy was being transformed into fascism, socialism, or some other system dominated by the government.
Long-term investment remained depressed throughout the 1930s, and overall investment did not regain the levels of the latter 1920s until after the war ended. At that time, Roosevelt was dead, the New Deal was in retreat, and the most zealous New Dealers no longer had the ear of the president — Harry Truman, who was a less menacing New Dealer by far than Franklin Roosevelt had been.
There’s one more controversial issue among scholars on the Great Depression that you have dealt with: When did the US economy really get out of it? The conventional view is that the Second World War — because of its expansionary effects due to massive public spending — made it. But you have a different explanation in “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s.”
By any normal measure except the rate of unemployment (which was very low during the war because approximately 20 percent of the prewar labor force was put into the armed forces and approximately 20 percent was employed in producing munitions and related goods), the economy was not prosperous during the war. Many goods were not produced at all; many ordinary goods were rationed; almost all civilian goods were subject to price controls, and therefore many were chronically in short supply. Yes, people were earning what seemed to be high money wages, but they could not exchange these earnings for the consumer goods they preferred, and therefore they saved at extraordinarily high rates (20–25 percent of personal income). Genuine prosperity did not resume until the war ended. The year 1946 had the greatest rate of growth of private output ever experienced in the United States — probably more than 30 percent, if it could be measured accurately.
Could you tell us one or two of the most remarkable anecdotes or reactions your work (on the ratchet effect or on the revisionist history of the Great Depression) has had on your mainstream academic colleagues?
These parts of my work have been well received by Austrians and even by many mainstream economic historians. My work on the growth of government is often cited by public-choice analysts, political scientists, historians, and other scholars.
My work on the Great Depression has been ignored almost entirely, however, by mainstream macroeconomists, no doubt because of their belief that “if you have no formal model, you have nothing.” They also seem, for the most part, incapable of understanding that the standard macro data series on real output and the price level during World War II are devoid of meaning (even of the small amount of meaning they may possess under normal conditions).
Someone called my attention recently to an NBER working paper by Robert J. Gordon and Robert Krenn on the end of the Great Depression. These authors actually devote several paragraphs to taking note of my argument that World War II did not end the Depression (although they do not list any of my publications among their references), concluding that my argument is completely wrong. However, given the nature of their comments on my work — partly attacking a straw man of their own creation and partly dismissing my argument on the basis of data I have shown to be meaningless — I suspect that they have not actually read my book Depression, War, and Cold War (the 2009 paperback edition of which seems to be the reference they have in mind in their comments).
In a paper published in February 2010 by the European Commission’s Directorate General for Economic and Financial Affairs, however, macroeconomist Paul van den Noord respectfully cites my argument about regime uncertainty in the latter half of the 1930s as a noteworthy contribution to a defensible interpretation of the macroeconomic events of that period.