AUSTRIAN ECONOMISTS PREDICTED THE FINANCIAL CRISIS?: CRITIQUE OF THE AUSTRIAN BUSINESS CYCLE THEORY (Part III)

3. The Fed did it?: critique of “exogenous” explanation of the crisis

The other central point of the argumentation that is made from the Austrian Business Cycle Theory in order to sustain that the State caused the crisis refers to the preponderant role of the Federal Reserve (Fed) in the generation of the “credit bubble”. In this manner, the problem is not the free market, deregulation or the dynamics of private banks but rather the distorting action of “central agent”.

Taking into account the important caveat that the Federal Reserve is, in institutional terms, a private organization and not a government organization (as is often believed), one can answer the Austrian's argument in two ways.

First, by demonstrating that the causal process involved is not as simple or straightforward as the Austrians claim. There have been periods of significantly low interest rates in which asset bubbles or substantial recessions have not occurred. Interest rates are merely another cost of companies among many others. In fact, the Federal Reserve began to raise interest rates in a period as early as 2005 but even so the bubble doesn’t burst. Likewise, the economist Nouriel Roubini, internationally promoted as who predicted the crisis, had said in his lecture September 2006 at the International Monetary Fund, that an “imminent” crisis would occur in early 2007 (13). However, the economy seemed to be working perfectly even until early 2008 and the bubble did not burst until September. Therefore, the correlation between economic activity and interest rate is not as simple or straightforward as to try to make a reliable prediction based only on it. (14)

Second, by attending to the distinction between the monetary aggregates and their respective dynamics. Austrian economists tend to illustrate his argument by referring to a Central Bank which manipulates “the” money supply. However, it is widely accepted (from orthodox neoclassicals to the heterodox post-Keynesians) that there is an important distinction between the types of monetary aggregates. The aggregate M0 is a narrow measure of money supply and M3 is the broadest. While M0 is strictly controlled by the Federal Reserve, M3 basically depends on the specific action of individual banks. Thus, if one wants to find evidence that “the Fed did it”, such as the Austrians argue, must be verified that the dynamics of M0 is much more correlated with the crisis than the dynamics of M3.

Is there such evidence? In his article “Debunking Macroeconomics”, heterodox economist Steve Keen gives relevant econometric information in this regard (15). Specifically, he establishes, for the period 1990-2012, the correlation between changes in M0 and M3 and the dynamics of real economy (taking the level of unemployment inversely). In what follows, the graphs presented by Keen:

Graph 1

Graph 2

As shown in Graph 1 the correlation between M0 and economic activity is weak and has the wrong sign, whereas the correlation between M3 and economic activity is strong and has the correct sign. Therefore, according to this, you can consistently say that the dynamics of the crisis is more due to the action of individual banks rather the action of Central Bank (the Fed).

But you could still argue that the initial action of the Fed is what has distorted the dynamics of banks. However, this reply should be dismissed because “the correlation between changes in M0 and changes in M3 is (…) strongly of the wrong sign for the pre-crisis period from 1990-2008 (-0.55), and only barely positive for the post-crisis period (+0.14)”. (16)

Therefore, there is no solid basis for considering the current crisis as a merely “exogenous” phenomenon regarding the market caused by the arbitrary intervention of a central agent (Fed) in a financial system which would work perfectly without such intervention. You cannot ignore the context of “moral hazard” generated by private banks, the “toxic assets”, the role of “rating agencies” (with the implied corruption) and the specific influence of private agents in the process of deregulation. All this, then, must lead us to an “endogenous” explanation of the crisis.

References:

14) It must be said, however, that the Roubini’s theory, an heterodox and multidisciplinary economist, incorporated many more items than the mere Austrian Business Cycle Theory and therefore is much more plausible.

15) Steve Keen, “Debunking Macroeconomics”, Economic Analysis & Policy, vol. 41, nº 3, December 2011.

16) Steve Keen, Ibídem, p. 160.

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AUSTRIAN ECONOMISTS PREDICTED THE FINANCIAL CRISIS?: CRITIQUE OF THE AUSTRIAN BUSINESS CYCLE THEORY (Part II)

2. Hayek - Sraffa debate and the fallacy of the “natural rate of interest”

The debate between Friedrich von Hayek, perhaps the most prominent representative of the Austrian School in the twentieth century, and Piero Sraffa, Italian economist who founded the Neo-Ricardian school, on the problem of uniqueness and consistency of the notion of “natural price” was curiously result (and somehow the continuation) of an earlier discussion between another two great economists: John Maynard Keynes and Lionel Robbins.

In the early thirties the intellectual environment of the University of Cambridge (England) was largely dominated by Lord Keynes who, by then, had already published his Treatise on Money and was working in The General Theory of Employment, Interest and Money. The professor Robbins, renowned liberal economist of the time, disagreed with the ideas of Keynes. However, he had failed to build until that moment a conclusive rebuttal of them.

It is precisely in this context that Hayek was invited to Cambridge. Joan Robinson, considered as the most important disciple of Keynes, describes the event as follows: “While the controversy about public works was developing, Professor Robbins sent to Vienna for a member of the Austrian school to provide a counter attraction to Keynes. I very well remember Hayek’s visit to Cambridge on his way to the London School. He expounded his theory and covered a black board with his triangles. The whole argument, as we could see later, consisted in confusing the current rate of investment with the total stock of capital goods, but we could not make it out at the time”. (2)

Thereby Hayek’s involvement in the Keynes-Robbins debate began to tip the balance to the side of Robbins. Keynes would had to overcome such criticism to continue successfully the project of the General Theory, but had little success in response: like other English economists, he had difficulty understanding and replying to Hayek given the little knowledge we had about the conceptual structure of the Austrian approach. And that's where Sraffa, with more knowledge of the Austrian tradition and invited by Keynes in 1927, enters in the debate.

The controversy between Hayek and Sraffa focuses, as has been said, on the issue of “natural price” which, of course, is central and relevant to the Austrian Business Cycle Theory since this theory postulates that crises are caused by Central Banks that artificially determine an interest rate below the level of the “natural rate of interest”. In 1932, Sraffa published in the Economic Journal the article “Dr. Hayek on Money and Capital” (3) and the same year Hayek responds with “Money and Capital: A reply” (4). Subsequently Sraffa replies with “Money and Capital: A rejoinder”. (5)

Sraffa’s critique is basically an internal critique, i.e., he analyzes the logical consistency and coherence of the Hayek’s argument. By doing this analysis Sraffa realize that there are serious logical gaps in Hayek’s theory and therefore is canceled all the explanatory value of the notion of "natural price" and also of the notion of “natural rate of interest”.

Specifically, the strongest Sraffa’s attack is to the uniqueness of the “natural price”. Starting from Hayek’s assumption about that money is merely a medium of exchange and by introducing the notion of “own rate of interest” for each good, Sraffa demonstrates the non-uniqueness of the alleged “natural price”. He writes: “If money did not exist, and loans were made in terms of all sorts of commodities, there would be a single rate which satisfies the conditions of equilibrium, but there might be at any one moment as many ‘natural’ rates of interest as there are commodities, though they would not be ‘equilibrium’ rates. The ‘arbitrary’ action of the banks is by no means a necessary condition for the divergence; if loans were made in wheat and farmers (or for that matter the weather) ‘arbitrarily changed’ the quantity of wheat produced, the actual rate of interest on loans in terms of wheat would diverge from the rate on other commodities and there would be no single equilibrium rate”. (6)

Thereby, considering the dynamics of the market, if there is only one disequilibrium between supply and demand of goods, the natural rate of interest on such goods will diverge with respect to the natural rate of other goods. Therefore, there is no uniqueness of the “natural price”.

In his reply Hayek, having had to admit the existence of multiple “natural rate of interest”, however says that they all are “equilibrium rates” (7). Sraffa is conclusive in showing the theoretical and practical difficulties of such a response: “Dr. Hayek now acknowledges the multiplicity of the ‘natural’ rates, but he has nothing more to say on this specific point than they ‘all would be equilibrium rates’. The only meaning (if it be a meaning) I can attach to this is that his maxim of policy now requires that the money rate should be equal to all these divergent natural rates”. (8)

Hayek’s attempts to revive the debate were sterile. Sraffa’s critique was too strong and the Austrian economists had to bear it for decades. In fact, it was not until 1994 that the prominent Austrian economist Ludwig Lachmann, defender of radical subjectivism, gave a relevant answer to the Sraffa's critique pointing out the ability of “entrepreneurial action” to eliminate the disequilibrium (9).

However, in an important paper in 2010 entitled “Multiple Interest Rates and Austrian Business Cycle Theory”, the Austrian economist Robert Murphy recognizes the inadequacy of the Lachmann’s solution: “Lachmann’s demonstration -that once we pick a numéraire, entrepreneurship will tend to ensure that the rate of return must be equal no matter the commodity in which we invest- does not establish what Lachmann thinks it does. The rate of return (in intertemporal equilibrium) on all commodities must indeed be equal once we define a numéraire, but there is no reason to suppose that those rates will be equal regardless of the numéraire. As such, there is still no way to examine a barter economy, even one in intertemporal equilibrium, and point to “the” real rate of interest”.  (10)

It is clear that there is no such thing as a “natural rate of interest” and therefore actually Austrian economists lack an objective parameter on which to base their argument that the crisis is caused because the Central Bank establishes a rate of interest “below” of “the” natural rate of interest. In fact, that leads us to the epistemological issue of falsifiability: given a lack of objective parameters, there is no way to determine if the theory corresponds to reality or not. One can understand the Austrians’ critique of the mathematization of Economics because this is not the ideal way to understand “complex phenomena” (11) but their rejection of the Statistic itself in the study of specific cases turns the theory in unfalsifiable and, therefore, puts into question its scientific character. (12)

To be continued

References:

2) Joan Robinson, “The Second Crisis of Economic Theory”, The American Economic Review, vol. 62, Issue ½, 1972, p. 2

3) Piero Sraffa, “Dr. Hayek on Money and Capital”, Economic Journal, vol. 42, 1932, pp. 42-53.

4) Friedrich von Hayek, “Money and Capital: A reply”, Economic journal, vol. 42, 1932, pp. 237-249.

5) Piero Sraffa, “Money and Capital: A rejoinder”, Economic Journal, vol. 42, 1932, pp. 249-251.

6) Piero Sraffa, “Dr. Hayek on Money and Capital”, Economic Journal, vol. 42, 1932, p. 52.

7) Friedrich von Hayek, “Money and Capital: A reply”, Economic journal, vol. 42, 1932, p. 245

8) Piero Sraffa, “Money and Capital: A rejoinder”, Economic Journal, vol. 42, 1932, p. 251.

9) Cf. Ludwig Lachmann, Expectations and the Meaning of Institutions: Essays in Economics, Routledge Press, London, 1994, p. 154.

10) Robert Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory”, consultingbyrpm.com, 2010, p. 14.

11) Cf. Friedrich von Hayek, “Theory of Complex Phenomena”, Studies in Philosophy, Politics and Economics, University of Chicago Press, Chicago, 1967, p. 22-42.

12) See: Karl R. Popper, La Lógica de la Investigación Científica, Tecnos Press, Madrid, 1980.

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AUSTRIAN ECONOMISTS PREDICTED THE FINANCIAL CRISIS?: CRITIQUE OF THE AUSTRIAN BUSINESS CYCLE THEORY (Part I)

1. Austrian Business Cycle Theory and the financial crisis

The global financial crisis is, without doubt, the most important economic event of our time. Its depth, extent and duration have led many people to put into question the free market and capitalism. This, of course, has resulted in a very heated debate about its causes (and possible solutions). On one side are those who call for more regulations, institutional improvement and implementation of Keynesian policies and, on the other side, those who argue that the current crisis is the fault of governments and Central Banks because they, and not the market, created the “financial bubble” that eventually had to burst. In the view of this group, the crisis is not sample of the failure of neoliberal capitalism but rather of the interventionist paradigm, the unregulated free market is still the perfect way to organize the economy and if there are problems is not because the market doesn’t work but because the State has not allowed it work. Among those who advocate this position are obviously the Austrian economists. In fact, this view is at present strongly promoted by prominent Austrians such as Ron Paul and Peter Schiff, who claims to have predicted the crisis.

The theoretical basis of these economists to support their position is on the Austrian Business Cycle Theory. According to this theory, originally proposed by Ludwig von Mises and Friedrich von Hayek, crises are the result of “distorting action” generated by the State to intervene in the market. So, as the coordination capacity of the market is destroyed, is necessary a painful process of “adjustment” to restore the “spontaneous order” and, consequently, the crisis comes.

This is in a very general and abstract level. However, the most interesting formulation of the Austrian Business Cycle Theory is about the crises caused by “credit bubbles”. Here the “spontaneous order” is the correspondence between actual savings and investments of private agents. In this context, the State, through the Central Bank intervenes in the market to “stimulate” the economy by relaxing credit conditions. To do this is applied a monetary policy that determines a rate of interest below the “natural rate of interest”, that is, the one that would be configured under conditions of absolute free market. In this new “artificial economy”, consumers have access to more loans and entrepreneurs make more investments with respect to what would occur merely on the basis of actual savings and then the bubble begins to emerge. At some point, as already said, this bubble has to burst and the economy will have to “adjust” itself, and the crisis occurs. All this does not happen through the fault of free market but rather through the fault of the State intervention.

Like most economists, Austrians developed their analysis of the mechanism of causation of the crisis taking as main reference the U.S. economy. Specifically, they argue that the financial crisis was caused in 2001 when, precisely in the context of economic depression and loss of confidence after the attack on the Twin Towers, the U.S. Federal Reserve, to “stimulate” the economy, reduced the interest rates from 6.5% to 1.75% and then to a minimum of 1% in 2003. Also in June 2002 the U.S. government announced would guarantee to the companies Fannie Mae and Freddie Mac to help create liquidity in a secondary market for mortgages so that the vast majority of families can access the “American dream” of own home. This, argue the Austrians, was what created the credit bubble which would trigger the financial crisis in 2008.

This is the Austrian view of the crisis. The liberal Spanish economist Jesus Huerta de Soto, the most famous representative of the Austrian School in Spanish-speaking countries, puts it this way: “Economic depression is not a crisis caused by the market economy. This is something we have to remove of our mind definitively. The crisis is not a crisis of the market, it is a crisis of state intervention, state intervention which produced the current banking system and credit expansion, which has deceived entrepreneurs, which has distorted the production structure (...). Therefore, in a free market economy does not have to exist economic depressions”. (1)

The implicit assertion that “the market is always and necessarily perfect, and the State always and necessarily is at fault” is too radical and deserves to be examined. And this is the subject of this article: make a critical analysis of the Austrian Business Cycle Theory in the context of the current financial crisis.

To be continued...

References:

1) Jesús Huerta de Soto, “Una interpretación liberal de la crisis económica”, Estudios de Economía Política, Unión Editorial Press, Madrid, 2004, p. 157.

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ECONOMY AGAINST HAPPINESS: THE GREAT PARADOX (Part 4)

The issue of “relational goods”

In fifth place is argued that as our income increases, or precisely because we strive to have more and more things, the consumption of so-called “relational goods” is reduced. Indeed, in an effort to make us richer,  our friends and the time we dedicate to our family are reduced. A perfect example of this we can find it in Mr. Burns, sinister personage of the famous series “The Simpsons”, immensely rich and miserable who has no family, no friends, only his assistant, Mr. Smithers, whom is often undervalued and ignored by him.

But the problem is that it is not only our ambition but also the inevitable development of technology what condemns us to this situation since every step toward technological progress transforms our dependence on other human beings in dependence on machines. “The devaluation of the human world grows in direct proportion to the increase in value of the world of things”, said Marx concisely (1).

Technology begins to offer us substitutes for human relationships: children do not need parents to raise and educate them as they have to television, computer, internet and video games; families no longer need to come together to share a nice meal because the microwave oven allows everyone to warm your own food and eat separately, the person who wants to have children does not need to meet and fall in love with a special someone, or build a nice family and get married, simply he may resort to artificial insemination or a “surrogate mother”.

But the most tragic thing is that we have realized too late that the love and human warmth so necessary for happiness, are not products that can be manufactured by a company or created by technology and it is very difficult to find the return path.

The problem of moral and spiritual degradation

Finally, and even more serious from a transcendent point of view, economic progress (in the way in which we live it) by their very dynamic tends to undermine the moral and spiritual conditions in which man can achieve his happiness. For how could a system based on boundless ambition, envy, selfishness, emulation and competition create a society of “good and happy men”? How could a “progress” which systematically encourage and justified as “rational” all these vices be the solution to the problems of man and be the way to a happiness necessarily linked to conditions of peace, love, solidarity and virtue? To pretend such thing would be like to believe that the best way to expel demons is to invoke Beelzebub, who is the prince of demons.

In this point is likely that someone thinks that I am demonizing economic progress. But that is not what I want to do. It makes no sense to oppose the economic development in itself because it can also become a powerful tool to deliver man from his material and moral poverty. But we must resist the current model of economic progress as being carried out today mainly in Western countries as it requires countless human sacrifices to the “god” of Development. It is time to understand that progress by itself, the mere economic efficiency, never bring peace and prosperity to man but rather can only do so if this progress is oriented. And this orientation must come from within us through a deep ethical and social consciousness.

So maybe we should not pay much attention to what Keynes had said about that, to reach the desired welfare, “we must pretend to ourselves and to everyone that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer still. For only they can lead us out of the tunnel of economic necessity into daylight” (2). Rather we should seek a more human economic progress, based on qualitative things rather than quantitative things, and pay attention to messages as this one by John Paul II when he said: “It is not wrong to want to live better; what is wrong is a style of life which is presumed to be better when it is directed towards ‘having’ rather than ‘being’, and which wants to have more, not in order to be more but in order to spend life in enjoyment as an end in itself. It is therefore necessary to create lifestyles in which the quest for truth, beauty, goodness and communion with others for the sake of common growth are the factors which determine consumer choices, savings and investments”. (3)

References:

1) Karl Marx, Economic and Philosophical Manuscripts, Madrid, 1970, p. 105.

2) Quoted by E.F. Schumacher, Small is Beautiful, Orbis Press, Barcelona, ​​1983, p. 24.

3) John Paul II, Centesimus Annus, 1991, nº 36.


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ECONOMICS FOR HERETICS: DEBUNKING THE MYTHS OF ORTHODOX ECONOMICS Excerpt from Chapter 5 – “The Myth of Competitive Markets”

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Redemption failed: The “false messiah” of the successive approximations

Let us turn now to the issue of unrealism of the model of perfect competition. What orthodox economists say about this lack of realism? Simple: they minimize it by saying that all scientific models are in some measure unrealistic. However, as already mentioned, the model of perfect competition is not a simplification of reality but rather is openly at odds with reality . But orthodox economists have an answer yet. They say: “This model is only the basis and principle of our research program. After, starting from this we will develop other models of imperfect competition more realistic, with market power, product differentiation, barriers to entry and uncertainty. The student only needs to be patient. Little by little as he progresses in his courses, will go looking models more and more realistic”. Here we have, therefore, the grand means of redemption that has neoclassical theory to its unrealism: the method of “successive approximations”.

The first thing we must say about this is that it is a big scam. In effect, during the first years of study is said to economics students that they will study models more and more realistic, but later, already explained the models of imperfect competition (monopoly, oligopoly and monopolistic competition), economic theory courses become much more unrealistic and abstract. Anyone can check this by reviewing any advanced economics textbook. For this reason, Martin Shubik, in his famous article “Curmudgeon's Guide to Microeconomics”, says: “There are very few textbooks that indicate to the students that there are several forms institutionally different in that a company can operate. Insofar more elemental is the textbook, it is more probable that contains information on various forms of organization. However, as soon as our study becomes advanced, we do not bother to differentiate between General Motors and a small candy store. There are several institutional forms the basic text by Samuelson, but not in its Foundations” (1).

But even setting that aside, we must say that the proposal of successive approximations to reality starting from unrealistic models is a terribly misguided strategy because, in doing so, ends up turning to the reality in a sort of “special case” of theory!

And not only that. The method of successive approximations, while it may be appropriate for systems in which the parties are not intrinsically interrelated, it is never for complex or holistic system, in which the elements are intrinsically interrelated and display emergent properties. Well, this is exactly what happens with the market structures. In them the information, risk, uncertainty, technology and the relative power of the participants should never be considered as exogenous elements that may be introduced into the system after keeping intact the basics of the above structure because when the system has a holistic structure emerging properties as soon as a new element is added, the system is fully reconfigured.

It is precisely due to this that the orthodox theory can never build realistic models even through his method of successive approximations. By keeping the same structure always deterministic, the neoclassical economics can never build “open models”, can only move from a closed system to another slightly larger closed system. The mathematical formulation, although allows us to play to the theoric ping-pong and formulate fun exercises, sterilizes any attempt to holistic analysis, which is what really should to the market structures. So Shubik, referring to the model of duopoly (competition between two firms with market power), notes that: “Personally, I like the theory of duopoly. I like it more that the crossword puzzles. However, if I forget the distance that separates highly simplified models that I study and real markets of our society, would cause a lot of damage to myself and to my students” (2).

Finally, regarding the method of successive approximations should also be pointed that in the process of building new models (supposedly more realistic) frequently are maintained many of the false previous assumptions and what is worse, are added new false assumptions in order to secure the deterministic-mathematical “closing”  of the new system. Thereby falsehood is placed over falsehood and promise to eliminate false assumptions is never fulfilled. Therefore, the method of successive approximations, or successive closings, maybe it should be called "method of successive falsehoods". But what is sure is that it is a "false messiah" because it does not "redeems" to the orthodox theory of its lack of realism. And neither redeems to young students of economics who wish to understand well the reality and end up getting scammed by their teachers (who in turn were scammed when they were students).

References:

1. Martin Shubik, “Curmudgeon's Guide to Microeconomics”, Journal of Economic Literature, vol. VIII, nº 2, june 1970, pp. 405-434.

2. Martin Shubik, “Curmudgeon's Guide to Microeconomics”, pp. 405-434.


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ECONOMY AGAINST HAPPINESS: THE GREAT PARADOX (Part 3)

The phenomenon of the expansion of needs

It’s also sustained the argument of the “expansion of the needs” according to which in the measure that the levels of income and consumption of the people increase also increase their needs so that, paradoxically, the gap of dissatisfaction or of unsatisfied needs tends to grow up instead of diminishing.

In fact, the Greek philosopher Platon had observed this more of two thousand years ago and for it he said that “poverty is not caused by the decrease of wealth, but rather for the multiplication of desires”. So, one can be miser in between opulence, a poor man in luxury; because while the poor person’s hunger can be been satisfied with by bread, the rich person’s hunger is insatiable and, what is worse, grows up as more it tries to satiate it. The rich person that seeks to be happy consuming everyday more and more goods tends for it to create for himself more needs and, therefore, to feel more dissatisfaction. In order to illustrate this with an analogy we could say that he is like a thirsty man that seeks to calm his thirst drinking salt water or that he is like a hamster that tries to get ahead of the wheel that he himself is triggering with his own forces.

But it is important to have in mind that the above not only is valid for the individuals but also for the groups and nations because, as to the famous North American economist John Kenneth Galbraith explained in his book The Affluent Society (1958), “in the measure that a society become more opulent, needs keep on being created more and more all by the same process that satisfies them” (1). In this sense, the market has passed from be a mechanism for the satisfaction of the needs to become in a producer of needs.

Only economists (specially neoclassics) ignore this uncontrovertible reality because they are afraid to verify the falseness of their religion when looks refuted the sacred dogma of the consumer’s sovereignty. But it is enough with to observe how the market of cellular phones has evolved to come to realize how the reality has refuted this theorem completely. Initially cellular phones were acquired by important executives of large firms with needs of communication. A short time after they became cheaper and began to offer services like hour, alarm, text messages and notebook, all relatively reasonable. Next they began to offer services of enjoyment such like radio, games, player of images, camera of photos, video player, internet, bluetooth, touch screens and so on. Thus, the innovation began to sophisticate themselves more and more create us many “superfluous needs” as to know the luck in the horoscope daily, to have personalized pornography, to receive advices of how to kiss, to have sex, to be infidel and a lot of things more.

Thus, the cell went from being a mere object of use to become a powerful weapon to exploit the "needs" of individuals by subjecting them to a terrible dependence on fashion and technology and making them live in a constant state of anxiety and tension as they no longer consume to be satisfied but rather to escape from dissatisfaction. It seems that rather than the production of companies serve consumer needs are the needs of consumers those that serve the production of companies, as if they were wagons of a frenetic train moved from side to side by fashion, technological change and the desire for profits.

References:

1. John Kenneth Galbraith, The Affluent Society, Ariel Press, Barcelona, 1984, p. 204.


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ECONOMICS FOR HERETICS: DEBUNKING THE MYTHS OF ORTHODOX ECONOMICS Excerpt from Chapter 4 – “The myth of profit maximization”

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Maximize profits or minimize losses?: the problem of risk

The problem of uncertainty we have just analyzed inevitably leads us to consider another important business decision problem: the problem of risk. This essentially means that entrepreneurs, by always acting under conditions of uncertainty, are constantly faced with the possibility that their actions do not achieve the expected results. In other words, their decisions always involve risk.

The consequences of this for the orthodox model of business rationality are truly destructive because, in conditions of risk, the rationality of businessman will consist more on ensuring a minimum level of profits or minimize losses than in maximize profits. And this for three reasons:

First, by the direct relationship between benefit and risk. Entrepreneur are well aware that if they want more benefits will have to take greater risks. Therefore, seek maximum profits would imply also assume the greatest risks. But because practically no one wants to do that we will have that entrepreneur do not necessarily be governed by the maximum possible but rather will accept a net income in accordance with the conditions (think in the cases of economic crisis). There is no reason, therefore, to believe that the entrepreneur has to act in a position of maximum, that is only a theoretical possibility.

Second, due to the stability that businesses require to plan. In effect, every company needs to maintain a minimum level of income to carry out their plans. Otherwise, if you search always maximum profit, the company may end up having a level of profit too fluctuating and therefore, it will be extremely difficult to make long-term plans due to financial uncertainty. So not only must take into consideration the profit but also the stability and security. That's why Japanese economist Shigeto Tsuru, after reviewing several cases of real companies, refers that: “It became clear that the determinant essential criterion of the behavior of the company was rather that of stabilize the benefit for a period of time long enough. Even more recently, it has been suggested an amendment in the sense that the goal of the companies should target to “maintain position of stability for a long period”. In other words, it means that in the description of the behavior of the company, the term maximization of security is more accurate than the term maximization of profit” (1).

Third, because the managers are more punished for incurring losses than rewarded for make profit. Effectively, given the context of separation between management and ownership, managers are more interested in avoiding losses than in achieve the maximum profit. Why? Because while managers and executives do not receive the benefits that may result from assume higher risks (shareholders take these), they may be dismissed if incur significant losses. Therefore, they will seek carry out their work efficiently obtaining for shareholders an acceptable profit level, but not necessarily will seek the maximum profit because this could also endanger their own job security.

Thus, if, as often happens, the maximization of profits increases the risk of losses, the manager will not accept the bet for basic considerations of interest. And more even if it is a large company with market power. It's no wonder that Paul Samuelson himself accepts that “as the company gets to have significant size and to have some control of prices, it can afford to loosen up a bit in its maximizer activity” (2). Or that the orthodox economist Carl Kaysen says: “While in the very competitive market the company has no choice but to seek maximum benefits, because the alternative to it is a insufficient benefit to ensure the survival, in the less competitive market the company can choose between seeking maximum profits or conform with a profit “aceptable” and pursue other goals” (3).

References:

1) Shigeto Tsuru, “¿Ha cambiado el capitalismo?”, in: ¿A dónde va el capitalismo?”, Oikos Press, Barcelona, 1967, p. 47

2) Paul Samuelson, Economics, McGraw-Hill, New York, 1976, p. 508.

3) Carl Kaysen, “The Corporation: How much power? What scope?”, in: The Corporation in Modern Society, Edward S. Mason ed., Harvard University Press, Cambridge, 1959, p. 90.


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