December 15, 2017

Austrian idiocy ― the case of Hayek

Comment on David Glasner on ‘Hayek’s Rapid Rise to Stardom’*

Blog-Reference and Blog-Reference on Dec 25

At some point in history, economics left science for good and became part of the entertainment industry. Perhaps this was in 1931 when Hayek became the star of the London School of Economics.

The economic problem then was the Great Depression. Economists were expected to come forward with diagnosis and therapy. This expectation, indeed, was delusional because economists had no idea how the monetary economy works. Hayek was one of them.#1

In order to fully appreciate the proto-scientific state of Austrianism one needs the axiomatically correct theory. Because economics is a failed science it has to be reconstructed from scratch.

As the new analytical starting point, the pure production-consumption economy is defined with this set of macroeconomic axioms: (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

Under the conditions of market-clearing X=O and budget-balancing C=Yw in each period, the price is given by P=W/R (1), i.e. the market-clearing price is equal to unit wage costs. This is the most elementary form of the macroeconomic Law of Supply and Demand. For the graphical representation see Figure 1.#2

The price is determined by the wage rate, which takes the role of the nominal numéraire, and the productivity. The quantity of money is NOT among the price determinants. This puts the commonplace Quantity Theory forever to rest. The Quantity Theory, to recall, was one leg Hayek stood on.

From (1) follows that if the productivity increases over time the market-clearing price falls. So, in order to avoid deflation, the wage rate has to rise with the same rate as productivity. The problem is that, when deflation and depression come together, the wage rate tends to fall, thus worsening the situation.

The critical insight at this point is that the market economy does NOT stabilize itself neither does it return to some acceptable equilibrium ― just the contrary. The price mechanism DESTABILIZES the economy. Needless to emphasize that Hayek and the other supply-demand-equilibrium storytellers never arrived at this insight. Hayek’s narrative of the market system as a superior information processor stands forever as a monument of utter scientific incompetence.

Monetary profit for the economy as a whole is defined as Qm≡C−Yw and monetary saving as Sm≡Yw−C. It always holds Qm≡−Sm, in other words, the business sector’s surplus = profit (deficit = loss) equals the household sector’s deficit = dissaving (surplus = saving). This is the most elementary form of the macroeconomic Profit Law. Under the condition of budget-balancing total monetary profit is zero.

The Profit Law makes it immediately clear that saving is NEVER equal to investment.#3 There is NO such thing, as Hayek argued, as an “equilibrium relationship between savings and investment, investments being financed entirely by voluntary savings, …”.

What is needed in a monetary economy is two things (i) a central bank which creates money on its balance sheet in the form of deposits, and (ii), a legal system which declares the central bank’s deposits as legal tender.

Deposit money is needed by the business sector to pay the workers who receive the wage income Yw per period. The need is only temporary because the business sector gets the money back if the workers fully spend their income, i.e. if C=Yw.

Overdrafts are needed by the household sector for consumption expenditures if the households want to spend before they get their income. This time sequence is no problem for the central bank because the temporary overdrafts vanish with wage payments.

For the case of a balanced budget C=Yw, the idealized transaction sequence of deposits/overdrafts of the household sector at the central bank over the course of one period is shown in Figure 2.#4

The household sector’s deposits/overdrafts are zero at the beginning and end of the period. The business sector’s transaction pattern is the exact mirror image. Money, that is, deposits at the central bank, is continually created and destroyed during the period under consideration. There is NO such thing as a fixed quantity of money. The central bank plays an accommodative role and simply supports the AUTONOMOUS market transactions between the household and the business sector.

From this follows the average stock of transaction money as M=κYw, with κ determined by the transaction pattern. In other words, the average stock of money M is determined by the autonomous transactions of the household and business sector and created out of nothing by the central bank. There is NO such thing as a monetary policy.

The transaction equation reads M=κYw=κPX=κPRL in the case of budget balancing and market clearing and this yields the commonplace correlation between the average stock of money M and price P for a given employment level L, except for the fact that M is the DEPENDENT variable. If employment is doubled the average stock of transaction money M doubles. If the average wage rate rises with productivity the price remains constant, no matter how much the economy and the average stock of transaction money expands. Money is absolutely neutral in the elementary case of the production-consumption economy.

So much for the basics of the production-consumption economy and the basics of economics. With the investment economy, things get a bit more complex.#5 The takeaway though remains the same: in order to get out of deflation and depression, the wage rate must rise faster than productivity. This does NOT happen spontaneously. The market system is NOT self-adjusting. Hayek’s fundamental premise is provably false. Because of this, the whole analytical superstructure of Austrianism is false.

Hayekian policy prescriptions lack sound scientific foundations and have only one effect: they worsen the situation. Hayek will be remembered as one of the imbeciles about which Napoleon spoke: “Late in life … he claimed that he had always believed that if an empire were made of granite the ideas of economists if listened to, would suffice to reduce it to dust.” (Viner)

Egmont Kakarot-Handtke

#1 For details see cross-references Failed/Fake scientists
#2 Wikimedia AXEC31 Elementary production-consumption economy
#3 For details see cross-references Refutation of I=S
#4 Wikimedia AXEC98 Idealized transaction pattern, household sector, balanced budget
#5 Full employment through the price mechanism