Noah Smith has acknowledged the failings of mainstream macroeconomics, but he says that none of the “outside ideas” offer a better replacement. He failed to mention the Austrian school, but we can still show how the Austrian tradition parries his criticisms with ease.
1. Quantitative Models Totally Miss the Nature of Human Action
Smith dismisses all outside approaches that do not produce quantitative forecasts, even though the best, newest, and high-powered quantitative macroeconomic models have failed recently.
The quantitative approach, however, totally misses the nature of human action, the fundamental starting point for economics. All economics boils down to individuals making choices, the outcome of which is dependent on individuals’ preferences.
Unfortunately, you can’t even do basic math with people’s preferences for two reasons: preferences are subjective, and preferences are ordinal. You can’t measure or compare something you can’t observe, and you can’t do math with ordinal figures. Adding 2nd place to 3rd place doesn’t get you 5th place or 1st place. It gets you nowhere, which is exactly where mainstream macro is today.
2. The Micro/Macro Separation is Baseless
Smith dedicated his article to problems with macro theories, but Austrians understand that there is no meaningful distinction between micro- and macroeconomics. The only difference is one of scale and focus, but the fundamentals of economics are the same no matter if you are looking at individual consumers and firms, or the effects of credit expansion and inflation.
Mainstream economists find their way into smaller and smaller categories. Now, there is “health economics” and “development economics” and “energy economics.” There is also a major divide between those who do macro and everybody else, to the point that neither side really understands what the other is doing.
But how could we expect individuals to act differently if we are just changing our perspective? Macroeconomic relationships are just the sum of many microeconomic happenings. Price inflation (usually considered a macro topic) happens because many individuals (micro-level) bid up the prices of various goods and services because their nominal incomes increase with an increase in the money supply.
Micro and macro are not separate sciences. They aren’t even two sides of the same coin. They are the same science, because all causal relations in economics are at the individual (micro) level.
3. Economic Laws Aren’t Just Empirical Regularities
Smith also said that many heterodox theories “have some serious flaws that make it very difficult to test them empirically.” This is meat on the table for anybody who has read Mises.
Economic laws are derived from the logic of action. It is undeniable and irrefutable that we will use additional units of some good toward the satisfaction of a lower ranked end (diminishing marginal utility). Subsequent claims are equally rock-solid, as long as each step in the chain is logically sound.
The cause-and-effect claims in economics are more than regularities, and they can’t even be tested. This is because the true effect of any cause requires the observation of the counterfactual — the alternative course of events that would have happened without the cause.
4. Austrian Economics is not a Collection of “Vague Ideas”
Even though empirical testing is out of the question, economics is not reduced to a collection of “vague ideas,” as Smith put it.
Economics is based on both causal relationships and realistic relationships, which is why some rightfully refer to the Austrian brand as “causal-realist economics.” We do not conjure up some homo economicus who behaves in some predictable way or consider human behavior as a formula with a stochastic component. We consider real humans as they really act.
Since economics deals with cause-and-effect, it is inherently structured, both logically and pedagogically. Diminishing marginal utility gives way to the law of demand. Opportunity costs and tradeoffs give way to comparative advantage, which gives way to the law of association and the benefits of the division of labor. These ideas are systematic and intricately connected. Economics, properly understood, is not just a collection of vague ideas.
5. Austrian Economists Did Predict the Housing Bubble Catastrophe … and the Great Depression
The funny thing is that the economists who don’t hang their hat on empirical validation, prediction, and quantitative models are the ones who consistently get it right when it comes to business cycles and other macroeconomic phenomena.
You can search this website, mises.org, for articles published way back to the early 2000s, when a housing bubble wasn’t on anybody’s radar. Detractors like to say, “Even a broken clock is right twice a day …,” but these authors were pointing out specific causes of a specifically housing-centered boom and the specific consequences that would occur because of the Fed’s and the federal government’s policies.
For example, see Sean Corrigan’s December 3, 2002 interview:
But both Freddie and Fannie are doing everything possible to encourage more debt. They have online mortgage applications. You can even get an online appraisal of your house.
There is a subterranean literature on the fringes of the mainstream press about how the appraisal process in home loans has been corrupted in this boom. The appraiser is paid if the loan goes through. Therefore, the potential borrower or purchaser or even the vendor can prod the appraiser to give a higher evaluation, just to get the deal done. Even with the inflation in prices that we’ve seen, it’ worse than it looks because the house values aren’t there in the first place.
Given the government’s encouragement of lax lending practices, home prices could crash, bankruptcies would increase, and financial companies, including the government-sponsored mortgage companies, might require another taxpayer bailout.
Of course the Peter Schiff was Right video is a classic, too.
I’ve said it before: mainstream economics is fraying at both ends. At one end, heterodox and Austrian economists keep pulling on loose strands: pointing out the inconsistencies, failures, and absurdities of their unrealistic models. At the other end, top mainstream economists and mouthpieces are doing the same, but with a touch of deflection and embarrassment.