Keynesian economics has witnessed a remarkable resurgence since the crisis of 2008.

The inability of mainstream economics to predict or explain the crisis led many economists to become skeptical of its core macroeconomic tenets. Several have turned the clock back to the ideas of Keynes to make sense of the housing bubble and the ensuing recession.

One such explanation inspired by the General Theory emphasizes the endemic uncertainty of the future and its implications for market stability. Championed by Paul Davidson1 and popularized by Robert Skidelsky,2 this line of thought blames the crisis and recession on the fickle expectations and “animal spirits” that guide investment in a market economy.3

Per this thesis, in an uncertain world, entrepreneurs and investors suffer from mood swings. Optimism regarding the future abruptly gives way to pessimism. Fluctuations in economic activity are the result of these variations in outlook.

With its focus on uncertainty, this line of thought bears a striking resemblance to Austrian ideas. Moreover, its rejection of mathematical probability as a foundation for expectations is echoed by several prominent Austrian economists.

Nevertheless, while Keynesians conclude that the uncertainty of the future renders a market economy inherently unstable, Austrians embrace uncertainty without losing faith in the order generated by a market economy. What lies at the root of this puzzle?

Keynes on Expectations, Uncertainty, and Market Stability

Think of Mary, a plastic bottle manufacturer drawing up plans to open a new factory. Given the durability of the investment, her decision is based on a set of long-term expectations. How does Mary arrive at these estimations of future prices?

In a neo-classical world, she does so by absorbing as much information as possible regarding past prices. Using this information, she calculates the numerical probabilities associated with various prices and forms her expectations based on these probability distributions.

In such a world, expectations share a deterministic relationship with the past. The numerical probabilities associated with future prices are inferred mechanistically from those associated with past prices. Thus, Mary’s expectations of the future are objective in nature. Anybody else in her place would have come to identical conclusions regarding the future with the information at hand.

Keynes sharply disagreed with this approach. Long-term expectations, he argued, are formed in a fog of uncertainty. This renders mathematical probability useless as a basis for forming one’s expectations. Since the future may differ significantly from the past, information about past prices provides “no scientific basis on which to form any calculable probability whatever” regarding the likelihood of future prices.4

Entrepreneurs and investors cannot mechanically extrapolate probability judgments regarding the future from an analysis of information regarding the past. As a result, their expectations are subjective in nature. Mary’s expectations now bear a personal stamp.

These subjective expectations share no connection to the past. The inability to use probability to form expectations renders the future unknowable to entrepreneurs and investors. Unable to turn to the past to assess the likelihood of future events, they find themselves confronted by a radical uncertainty.

In such a world, Mary’s decision to build a new factory is not the “outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” Instead, it is governed by her “animal spirits;” by a sense of “spontaneous optimism” that results in an “urge to action rather than inaction.”

Nevertheless, even in a radically uncertain world, investments must be guided by some expectations regarding the future. Instead of grounding them in an analysis of the past, Mary bases her expectations on an assessment of what others believe regarding the future.

Lurking behind her animal spirits are expectations formed as the result of an attempt on her part to “conform with the behavior of the majority or the average.” A similar striving on the part of everyone else gives rise to a “conventional judgment” regarding the future, shared by the overwhelming majority of entrepreneurs and investors.

Based on the flimsy foundations of the psychology of opinion and with no moorings in experience, this conventional judgment is subject to sudden and violent change. Like a school of fish, investors and entrepreneurs swim this way and that, always taking their cues on what to do from others, without recourse to any solid foundations in which to ground their expectations.

Buoyed by an optimistic conventional judgment, investors, with positive animal spirits pumping through their veins, rush to produce more capital goods, lifting the fortunes of workers with them. Soon the judgment turns and pessimism sets in. Investors no longer have the urge to act. They become quiescent, and unemployment increases.

Thus, for Keynes the endemic uncertainty that surrounds the future gives rise to an inherently unstable market economy. Fluctuations in output and employment are endogenous to the market and are ultimately to be traced to the shifting sands that underlie the prevailing conventional judgment regarding the future.

The path to greater market stability requires heavy government intervention. It is the job of the state to counter the waxing and waning of animal spirits and help stabilize the level of investment, output and employment.

Uncertainty and Subjective Expectations in the Austrian Framework

Prominent Austrian economists such as Mises,5 Lachmann,6​ and Rothbard7​ agree with Keynes’s rejection of a mechanistic relationship between past and future prices.

This rejection is the result of a consistent application of the subjective theory of value. The prices of the past result from the individual valuations that prevail in a specific set of circumstances. Two individuals, however, can form different valuations in the same circumstances. Moreover, the same individual may react differently to identical conditions at two different points in time.

It follows that the reemergence of a similar set of conditions in the future need not result in the reappearance of the same set of prices as in the past. Thus, there is no simple, deterministic relationship between the past and the future. Instead, the future is inherently uncertain.

This has implications for the formation of expectations. Entrepreneurs cannot study past prices, calculate the numerical probability associated with them and then simply extrapolate these numbers into the future. As a result, mathematical probability is not a suitable foundation on which to base expectations. However, this does not imply that we know nothing about the future. The past can still serve as a guide to action.

Entrepreneurs can still estimate the likelihood of future events. They do so by trying to understand the motivations underlying the valuations of market participants in specific situations in the past. They must peer beneath the veil of past prices and must analyze why market participants acted the way they did under the given conditions.

This analysis of unique, heterogeneous situations as they arose in the past, and not the numerical probabilities associated with past prices, provides the raw material to appraise the valuations and prices that will prevail in the future in a different set of conditions. Thus, in the Austrian framework, expectations do not rest on utilizing numerical probability but on interpreting and understanding the past.

This, as in the case of Keynes, lends them a subjective flavor. Nevertheless, the subjective expectations of entrepreneurs do not coalesce into a homogenous and ever-shifting conventional judgment regarding the future. Instead, these expectations are heterogeneous. Two entrepreneurs may come to different conclusions regarding why individuals behaved the way they did in the past. Moreover, their grounding in the past gives them a basis in reality. Thus, they are not whimsical and subject to random fluctuations.

Subjective Expectations, Profit and Loss, and Market Order in the Austrian Framework

The expectations of entrepreneurs, while subjective, exhibit a discernible pattern. The ability to appraise the future is not distributed evenly across market participants. Instead, in a market economy there are leaders, or those who are better able to formulate a judgment of the future based on the past, and there are others who are less proficient at doing so.

The profit and loss system ensures that the better appraisers are rewarded for their more successful judgments and accumulate capital. Those who are less successful at this endeavor are, meanwhile, gradually stripped of their capital. Thus, they lose influence in shaping the course of the market.

This process of entrepreneurial selection allows for the coordination of the decisions of producers and consumers. It ensures that, at any given moment in time, the best appraisers of the future are in control of making the key production decisions in the economy. Thus, in the Austrian framework, uncertainty and subjective expectations are compatible with market order and stability.

The key to ensuring this is a price system that results from the voluntary decisions of market participants to engage in mutually beneficial exchange. The prices that emerge on the various factor markets must reflect the appraisements of the participating entrepreneurs. Any interference with such a system of prices can interfere with this process of coordination and the order generated by the market.

An artificial reduction of the interest rate that results from an expansion of the money supply is an example of such an intervention. The increase in liquidity interferes with the process of entrepreneurial selection. In fact, it turns this system on its head.

Profits no longer reward those entrepreneurs who allocate scarce resources to the highest ranked ends of the consumers. Instead, they reward those who, misled by the artificially low interest rate, embark on production projects that are unsustainable. Those entrepreneurs who correctly perceive the underlying unsustainability now lose control of the capital at their disposal and gradually lose the ability to influence the course of affairs.

Thus, it is monetary expansion and an artificially low interest rate and not the endemic uncertainty of the future that generates booms and busts and market instability. In a free market, thanks to the profit-loss system, resources are allocated primarily by those who are best at grappling with uncertainty. In a world of artificially cheap credit, however, the very same system rewards those entrepreneurs who engage in the consumption of capital and the malinvestment of scarce resources.


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