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  • A Model of Austrian Economics

    Hendrik Hagedorn

  • I would like to thank Prof. Hans Hermann Lechner, Prof. Ulrich van Suntum, Dr. Stefan Kooths,

    Dr. Pascal Seppecher, the Ludwig-von-Mises Institute, and my entire family. This work would

    not have been possible without their guidance and support. Moreover, I thank Adam Lederer

    and Alexander Malt for proofreading the manuscript and Hella Steinke for improving its layout.

    Berlin, April 9, 2014

    Hendrik Hagedorn

  • Contents

    1. Introduction 1

    2. The setup of the model 5

    2.1. A monetary market economy . . . . . . . . . . . . . . . . . . . . . . . . . 52.2. Physical capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82.3. The financial system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

    2.3.1. Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112.3.2. Firm creation, equity requirements, bankruptcy . . . . . . . . . . . 14

    2.4. Time periods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162.5. National accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

    3. Household behavior 21

    3.1. Purchases and money demand . . . . . . . . . . . . . . . . . . . . . . . . . 213.2. Pre-income preferences and appraisement . . . . . . . . . . . . . . . . . . 24

    4. Firm behavior 27

    4.1. Schedules for production and offers . . . . . . . . . . . . . . . . . . . . . . 274.2. The sales strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284.3. Liquidity management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314.4. Production management . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344.5. The investment rationale . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

    4.5.1. Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354.5.2. Fixed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

    5. Bank behavior 39

    5.1. Liquidity management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395.2. Commercial banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

    6. The functioning of the model 43

    6.1. Competition and steady states . . . . . . . . . . . . . . . . . . . . . . . . 436.2. The systemic view . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456.3. Preference changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

    7. Results 53

    7.1. General results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 547.2. A change in relative preferences . . . . . . . . . . . . . . . . . . . . . . . . 557.3. Changes in time preferences . . . . . . . . . . . . . . . . . . . . . . . . . . 60

  • Contents

    8. Considerations about interest rates 65

    9. Further aspects 69

    9.1. The character of this model . . . . . . . . . . . . . . . . . . . . . . . . . . 699.2. Uncertainty and spontaneous order . . . . . . . . . . . . . . . . . . . . . . 729.3. On preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

    A. List of Symbols 79

    Bibliography 83

    vi

  • 1. Introduction

    Although Austrian economics has many fervent followers, its relative popularity withinthe science of economics is limited. Neoclassical economics, with its DSGE modeling,1

    is far more visible to not just the general public but also amongst those educatingfuture economists. This single focus has not gone without debate and the discussion wasrenewed after the most recent financial crisis (Hicks, 1981; Solow, 2008; Caballero, 2010).Without doubt, limiting economic research to only one methodological standard preventsthe scientific community from incorporating the insights of those fields of economics thathave developed independent of this standard (Caballero, 2010). Therefore, some of themain themes that were elaborated by Austrian scholars, such as the theory of capital,the theory of entrepreneurship, and the theory of the money-driven business cycle, havenot or only to a small extent be accommodated by neoclassical economics.What inhibits mainstream economists from adopting these theories is, on the one hand,

    the absence of a general modeling approach for Austrian economics and, on the otherhand, that the neoclassical approach is fundamentally unsuited to capture these insights.As demonstrated by Mirowski (1989), the concept of general equilibrium is not at all anatural approach to economic thinking. Rather is the equilibrium approach an attemptto transcribe the metaphors of 19th century physics to economic phenomena. However,in order to obtain such a transcription it is necessary to make compromises betweenmathematical tractability and economic realism. And hence the equilibrium perspectiveeasily becomes distorted. Thelaw of one price is a case in point: it provides equilibriummodels with the symmetry that is necessary to emulate a conservation principle of thephysical sciences, but it is foreign to all economic processes. In fact, it is price dispersionand not price unity which allows markets to develop their coordinating function (Gintis,2007).

    On a similar note, the compliance with the general equilibrium framework led economiststo make widespread use of the rational expectations framework, whose flaws have longbeen exposed (e.g. Davidson, 1983). Again, the symmetry between future states of theworld and the expectation thereof does not represent economic insight, but is only postu-lated out of mathematical necessity. The dilemma of modern macroeconomics can thusbe framed as follows: The need for mathematically tractable models has led to a generalacceptance of premises that are highly unrealistic at best and have often provoked aserious deal of confusion.This work provides a possible solution to this dilemma. It does so by developing a

    model that synthesizes elements of post-Keynesian economics and complexity economics

    1DSGE is an abbreviation for dynamic stochastic general equilibrium. DSGE models are also usedin new-Keynesian economics, but the term neoclassical is here used as to comprise both strands ofliterature.

  • 1. Introduction

    with the central tenets of Austrian economics thereby portraying Austrian economicsin a formal and coherent way. The model that is thus established is just as generalas a DSGE model, but it is by all means more realistic and it treats macroeconomicsfrom an entirely different perspective. At the same time, the proposed model providesa mathematically rigid framework under which the propositions of the Austrian schoolcan be scrutinized.The centerpiece of the Austrian school is the study of the formal implications of

    human action, a discipline that Austrians call praxeology (Mises, [1949] 2008, pp.1).Economics, according to this research paradigm, is only a subdiscipline of praxeology.This methodological perspective has many consequences. First, in Austrian economics,valuation not only originates from the human mind alone and is therefore subjective, butalso are valuations only expressed through action. On the other hand, the things thathuman beings value are inherently heterogeneous. Thus, in essence, Austrian economicsdescribes the world on the basis of a dynamic theory of subjective value and a theory ofheterogeneous capital. Second, in Austrian economics all economic agents are treated astrue economic actors and not as mere reactors to their environment, as is characteristicfor the neoclassical school. The Austrian perspective thus implies that all economicanalysis is based on the principle of cause and effect, which, as a corollary, implies thepassage of time. Austrian economics therefore depicts the economy as a process, asopposed to the static interdependency of neoclassical economics.Furthermore, what distinguishes Austrian economics from other schools of thought

    is its purely theoretic and essentialist character. Since only the formal implications ofthe fact that human beings act are described, Austrian economics is not concerned withthe specific choices made by individuals or with the circumstances under which suchchoices arise. According to the Austrian understanding such inquiry belongs to differentfields of science, namely psychology and history. Austrian economics confines itself tostatements that are true for all actions made by human beings. These statements aretrue a priori like the statements of mathematics and logic and they are not subject toverification or falsification on the ground of experience and facts (Mises, [1949] 2008,pp.32). For instance, the law of diminishing marginal utility is logically implied in theconcept of action (Mises, [1949] 2008, pp.119). Almost nothing in Austrian economicsis assumed. Only basic premises like, e.g., capital being heterogeneous are taken as self-evidently true and are thus taken for granted (Rothbard, 1957). Hence, this approachassumes almost universal validity. The mechanisms underlying the proposed model arefirmly rooted in this causal-realist and non-positivistic world view. This serves as themodels epistemological foundation. Also, Austrian economics is here understood in thisnarrow sense. Much of what runs under the heading of Austrian economics today is notdirectly implied by the logic of action, but rather by a logic of choice and equilibrium-likeconcepts (Gloria-Palermo, 1999). However, the idea of this model is to emphasize theessentialist character of the Austrian approach and to describe economic insights basedon processes that are driven by human action alone.The concrete modeling approach taken in the following is agent-based and accounting-

    based. That is, all economic activity in the model results from the decentralized actions

    2

  • of agents. These agents ex

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