A Few Thoughts on Austrian Economics

trying out a new approach to doing posts on here

Because I have written a lot on Keynes, people often ask what I think of Austrian Economics. My understanding is that people ask this question because they are posed as necessarily rival schools of thought by so august a source as the “Epic Rap Battles of History”. There have also historically been a lot of attempts by American right wingers to pose this tradition as an internally self-consistent alternative approach to either “mainstream” or “Keynesian” economics.

But Hayek vs. Keynes is a boring framing because of how much more Keynes can be used for, and how little of Hayek is worth absorbing. Since it is cheap heat, and slop that has been run a million times over, and we don’t want to publicly reward that kind of thing, I am going to be putting the discussion of “The Use of Information In Society” below the paywall.

When interest rates were low, and demand was slack, there was essentially no reason to read Austrian economics. The only stuff that’s useful in there, to my eyes, is the questions about the relevance of the level of interest rates to the optimal “roundaboutness” of production in a capital-using economy. So when interest rates are structurally low, and with little prospect for moving, there’s not really a good reason to engage, so I didn’t.

Now that rates are moving around again in a five year window, let’s go through the good parts of Austrian econ, and then, if you really want to hear it, we can go through the bad parts.

The Good: Worrying About The Roundaboutness of Production

Contrary to what you might expect, there actually are places where Austrian Theory is worth remembering, and it is on a narrow technical question that is essentially downstream of Marx. In Capital II, we hear a lot about the circulation of commodities and money. One idea is that one way capitalist firms can do better on their M-C-M’ (money -> commodities -> more money) responsibilities is by shortening the length of time moving from one step to the next takes.

This might mean figuring out ways to speed up production, to improve marketing, to expand market access (sell faster by selling to a wider audience), or, crucially, to shrink the number of discrete steps involved in production. There’s even a special name for when this stuff gets too out of wack — a “circulation crisis”.

Now, there are a lot of ways to do each of those things to speed up the pace of circulation. You can put the speedup on line workers, and make them work faster at their existing tasks. You can create “ideological state apparatuses” and “mass media” and use it to increase the public’s desire to buy specific things, or even just encourage their somatic impulse to buy stuff in general. You can “Do Imperialism” in the broadly Marxian sense of colonizing other places in order to open them up as markets for your domestic production. You can shrink the number of steps that a good passes through on its journey from being raw materials to being finished goods, whether through technical innovation, or vertical consolidation, or any other approach to the reduction of the “roundaboutness” of production. 

It is this last one that we are going to talk about, because it is the one interesting piece of Austrian economics, to my mind.

Production can be very roundabout, the more the division of labor increases, in terms of the proliferation of firms and dispersion across geographies. People get really upset when they hear about how far this process can go. Remember that diagram of a cup of pears taking three or four transatlantic journeys before being sold? This is one of the most intuitively understandable of Austrian frustrations about low interest rates: the lower the cost of credit (so, the lower the rate of interest), the lower the financial penalty for “excessively roundabout techniques of production”. If you don’t pay interest on your holding costs for the value of inventory, then in theory there is less rush to move product or tighten up the “roundaboutness” of production than if interest rates were higher. 

At worst, the goal in this situation becomes maximization of profit through minimization of production cost through dispersal of supply chain, which means every player chases down and chooses only contracts with the precisely lowest cost producer. As we have seen over the pandemic, doing this for years and years leads to fragile supply chains which have been excessively optimized to one specific state of the world, and which break down rather than adapt when hit with shocks.

Instead of developing vertically integrated techniques in-house, this regime would push more firms towards more brittle but concentrated supply chains. This “excessive roundaboutness” leads to a production system with a lot of potential breakage points, because it will have longer sequences of connected actions to provide the same product, whether in geographical or firm-boundary space.

This notion is well-formalized in the “Hayekian Triangles” that Roger Garrison explains so well. The idea is that, essentially, for a constant interest rate, the more steps in production, the higher the final cost of production for a given final good. Different kinds of goods have different minimal network complexity (and so their triangles are different sizes), but for each good, there is also a range of choices available to each firm as to how many steps more than this necessary minimum should be undertaken. Specialization is good until it is excessive, and overspecialization is bad until it becomes necessary.

On the logic of the Austrian idea here, one of the goals of monetary policy is to act as a forcing mechanism for production networks to target some optimal degree of roundaboutness. Too low, and the system is presumed to provide insufficient incentive towards concentration and “cutting out the middleman”. Too high, and the range of goods that it is financially viable to produce is unduly constrained by the interest rate’s impact on the network of production. Granted, all this is in the most ideal-typical of terms, and the actual impact of this is undoubtedly completely swamped by the other impacts of raising or lowering interest rates, but there is a cute little logic to this account of this system.

But even without this logic, the triangles are an interesting conceptual tool for theory, because they make it easier to talk about how different classes of goods really do have different minimal roundaboutnesses. This is important for thinking about things like all the corner cutting forced on engineers by MBAs, the example of Boeing comes to mind.

But it’s also important for thinking through what has to happen for decarbonization. We want to ramp up the level of production of end goods, which means ramping up the production of everything earlier on in the process of their production. Ramping up the level of output of things on the far right side of the triangle, when the triangles are large, will require some significant time-coordination in terms of standing up upstream and downstream capacity simultaneously. Without this, regardless of interest rates, the baton cannot be smoothly passed between production steps without hitting bottlenecks.

The IRA very explicitly is trying to address this issue, but because people broadly lack the theory background to see that in it, they don’t “get it”.

There are folks out there who do “get” this theory stuff though – especially Hyun Song Shin building on the work of Pol Antras building on the work of Hyun Song Shin. In 2023, Antras published a working paper outlining an “Austrian” model of the impact of the changed rates environment on the “optimal roundaboutness of supply chains” thru the channel of the compounding cost of trade credit. This was broadly based on the work that Shin has done to develop formal representations of models of the dynamics of global value chains relevant to the work of the BIS. 

As foreign exchange and interest rates are both involved in the global transmission of this balance-sheet side impulse, the actual implementation of the model can get messy quick. Despite this, the dynamics are relatively intuitive, and have interesting implications:

I won’t gloss the papers – you should read them – but they leave two points worth noting for policy. First, incremental increases in interest rates within these models seem to broadly swim in the same direction as the promotion of near-/on- shoring, because of the dynamics implied in the HS Shin paper. Coupled with subsidies to firms in targeted sectors to pay these added costs, there is a certain logic to the use of rates to intervene in industrial organization (tho, as mentioned, this effect liable to be swamped by the comovement of other factors/forces with interest rates).

Second, the way that the Fed took interest rates from 0% to 5% is emphatically not the way to use higher interest rates to achieve this goal, which would seem to require a smoothly telegraphed hike trajectory at a speed that businesses can productively react to by rearranging their supply chain topology. What yanking rates straight up and holding them there will do is generally reinforce uncertainty about changes in upstream costs and broadly leave firms to take a defensive rather than exploratory or experimental posture, with respect to their supply chains.

In conclusion: the parts of Austrian theory that you have heard of are bad, and the useful parts are rarely talked about because they are sort of abstruse and too close to Marx for the tastes of the theory’s boosters. Despite this, it’s worth thinking seriously about these other parts, especially as industrial policy looks increasingly towards understanding and reinforcing specific supply chains. It can be hard to understand things without a clear theory.

Now that you have had your vegetables, if you have paid for a ticket, there is red meat below the paywall.

The Bad: Markets as Computational Institutions