3. Man, Economy, and State:Rothbard’s Treatise on Economic Theory

MAN, ECONOMY, AND STATE:
ROTHBARD’S TREATISEON ECONOMIC THEORY

Rothbard soon attracted the attention of the William Volker Fund, at that time the leading group that gave financial aid to classical-liberal scholars. It commissioned Rothbard to write a textbook, suitable for college students, which would explain Human Action in simple language. He wrote a sample chapter on money and credit that won Mises’s approval. As Rothbard’s work proceeded, the project turned into something much larger. The result, the two-volume Man, Economy, and State, was a major treatise, published in 1962, and, one of the most important twentieth-century contributions to Austrian economics.

Mises recognized the book’s importance. Reviewing it in The New Individualist Review, Mises called it “an epochal contribution to the general science of human action, praxeology, and its practically most important and up-to-now best elaborated part, economics.”¹⁵ Mises, as any student of his work knows, was a formidable critic; for him to say this about a book is genuinely remarkable.

Rothbard was entirely in accord with Mises’s endeavor to deduce the whole of economics from the axiom of action, combined with a few subsidiary postulates. In much more detail than Mises had done, he carried out the deduction; and in the process, he contributed major theoretical innovations to praxeology.

His view of praxeology differed in a subtle but substantial way from that of Mises. Rothbard thought that we directly grasp necessities in the empirical world. Not only do we see that human beings act: we at the same time understand that this is a necessary feature of human nature. This is an Aristotelian and Scholastic view, in contrast with Mises’s Kantian position; when stating that “all human beings act by virtue of their existence and their nature as human beings”, Rothbard cites in support Book I of Aristotle’s Nicomachean Ethics.¹⁶ Mises contended that human beings have to think according to certain categories. If so, we can know certain propositions, like the action axiom, to be true a priori; we know these propositions in the sense that we cannot think in a way that contradicts them. This allows a gap between the world as it appears to us and the world as it is in itself. No such gap exists in Rothbard’s view.

He rejected the standard neoclassical use of mathematical proof in economics, a point that was not lost on Mises, who commented:

In a few brilliant lines, he [Rothbard] demolishes the main device of mathematical economists, viz., the fallacious idea of substituting the concepts of mutual determination and equilibrium for the allegedly outdated concept of cause and effect.¹⁷

The work was remarkable for its rigor and creativity. One of the most important of the book’s innovations involved a famous argument of Mises. Rothbard maintained that Mises’s socialist calculation argument was not, in essence, an argument about socialism at all. Rather, the fundamental point of the argument was that in the absence of the market, economic calculation could not take place. Thus, a single firm, even if privately owned, that controlled an entire economy would likewise be unable to calculate:

Our analysis serves to expand the famous discussion of the possibility of economic calculation under socialism, launched by Professor Ludwig von Mises over 40 years ago. Mises, who has had the last as well as the first word in the debate, has demonstrated irrefutably that a socialist economic system cannot calculate, since it lacks a market, and hence lacks prices for producers’ and especially for capital goods. Now we see that, paradoxically, the reason why a socialist economy cannot calculate is not specifically because it is socialist! Socialism is that system in which the state forcibly seizes control of all the means of production in the economy. The reason for the impossibility of calculation under socialism is that one agent owns or directs the use of all the resources in the economy. It should be clear that it does not make any difference whether that one agent is the State or one private individual or private cartel. Whichever occurs, there is no possibility of calculation anywhere in the production structure, since production processes would be only internal and without markets. There could be no calculation, and therefore complete economic irrationality and chaos would prevail, whether the single owner is the State or private persons.¹⁸

Rothbard here brilliantly combined Mises’s argument with a central contention of Ronald Coase’s “The Nature of the Firm.”¹⁹ Coase considered individual firms, faced with the decision whether to extend production internally or buy products on the market. He said that in “a competitive system there is an ‘optimum’ amount of planning.”²⁰ Rothbard saw that Mises and Coase were making a similar point. As Rothbard notes,

For every capital good, there must be a definite market in which firms buy and sell that good. It is obvious that this economic law sets a definite maximum to the relative size of any particular firm on the free market..... Because of this law, there can never be One Big Cartel over the whole economy or mergers until One Big Firm owns all the productive assets in the economy.²¹

No tendency toward monopoly existed on the free market. Here Rothbard followed Mises and other free market economists; but he went beyond them. In another innovation, he claimed that the entire concept of monopoly price did not apply to the free market. No means exists to distinguish a so-called monopoly price, charged by a single firm in an industry, from a competitive price.

[T]here has been a great deficiency in the economic literature on this whole issue: a failure to realize the illusion in the entire concept of monopoly price ... that there is assumed to be a “competitive price,” to which a higher “monopoly price”—an outcome of restrictive action—is contrasted. Yet, if we analyze the matter closely, it becomes evident that ... there is no way of distinguishing, even conceptually, any given price as a “monopoly price.” The alleged “competitive price” can be identified neither by the producer himself nor by the disinterested observer.²²

Rothbard’s argument for this radical conclusion was straightforward:

Neither does the elasticity of the demand curve establish any criterion. Even if all the difficulties of discovering and identifying the demand curve were waived ... we have seen that the price, if accurately estimated, will always be set by the sellers so that the range above the market price will be elastic. How is anyone, including the producer himself, to know whether or not this market price is competitive or monopoly?²³

He shows no mercy to the monopolistic competition theories of Joan Robinson and Edward Chamberlin:

The monopolistic-competition theorist contrasts this ideal firm [i.e., one without influence on price] with those firms that have some influence on the determination of price and are therefore in some degree “monopolistic.” Yet it is obvious that the demand curve to a firm cannot be perfectly elastic throughout.²⁴

Capital theory is central to Austrian economics, and Rothbard attaches especial importance to his unification of Frank Fetter’s “brilliant and neglected theory of rent”²⁵ with the pure time preference theory of interest and the Austrian theory of the structure of production. It is hardly surprising that he was keen to show the advantages of the Austrian view against competing doctrines, and he gives a penetrating criticism of the main alternative position. According to Frank Knight, capital is a perpetual fund; this contrasts with the Austrian view, pioneered by Eugen von Böhm-Bawerk, that stresses the stages of production over time. Rothbard assails this theory in the form given to it by one of Knight’s disciples, Earl Rolph.

Let Rolph picture a production system, atomized or integrated as the case may be, with no one making the advances of present goods (money capital) that he denies exist. And as the laborers and landowners work on the intermediate products for years without pay, until the finished product is ready for the consumer, let Rolph exhort them not to worry, since they have been implicitly paid simultaneously as they worked. For this is the logical implication of the Knight-Rolph position.²⁶

Rothbard offers a fundamental and far reaching criticism of Keynesian economics. He begins his assault on Keynes by pointing out that at the basis of the entire Keynesian system is a false assumption. Keynes maintained that total spending could fall short of what is needed to maintain full employment. But how can this be? If workers are unemployed, will they not bid down wages? How then can there be continued unemployment on the free market?

Keynes assumed that wages could not fall. “The Keynesian ‘underemployment equilibrium’ occurs only if money wage rates are rigid downward, i.e., if the supply curve of labor below ‘full employment’ is infinitely elastic.”²⁷

By an increase in government spending, while money wages remain constant, real wages drop. Keynes’s much vaunted innovation consists of an elaborate attempt to trick workers. They look only to their money wages; somehow, they will fail to notice that they face a wage cut.

Rothbard finds the Keynesian prescription totally inadequate:

Unions, however, have learned about purchasing-power problems and the distinction between money and real rates; indeed, it hardly requires much reasoning ability to grasp this distinction. Ironically, Keynes’ advocacy of inflation based on the “money illusion” rested on the historical experience ... that, during an inflation, selling prices rise faster than wage rates. Yet an economy in which unions impose minimum wage rates is precisely an economy in which unions will be alive to any losses in their real, as well as their money, wages.²⁸

To end unemployment, then, wages must fall. But the Keynesians are not yet defeated: they “fall back on one last string in their bow.”²⁹ They argue that even if wages do fall, unemployment can persist. The speculative demand to hold cash will block investment: businessmen, anticipating a drop in prices, will hoard their money.

Rothbard’s analysis of this idea is one of his foremost innovations. In his criticism, he anticipated the work on rational expectations for which Robert Lucas later won the Nobel Prize.³⁰Rothbard maintains that Keynes wrongly thinks that the speculative demand to hold money determines the rate of interest. Instead, the demand to hold money is a speculative response:

One grave and fundamental Keynesian error is to persist in regarding the interest rate as a contract rate on loans, instead of the price spreads between stages of production. The former, as we have seen, is only the reflection of the latter. A strong expectation of a rapid rise in interest rate means a strong expectation of an increase in the price spreads, or rate of net return. A fall in prices means that entrepreneurs expect that factor prices will fall further in the near future than their selling prices ... all we are confronted with is a situation in which entrepreneurs, expecting that factor prices will soon fall, cease investing and wait for this happy event so that their return will be greater. This is not “liquidity preference,” but speculation on price changes.³¹

At this point, Rothbard advances the crucial point that anticipates Lucas. He argues that such speculation is not a source of instability. To the contrary, the “expectation of falling factor prices speeds up the movement toward equilibrium and hence toward the pure interest relation as determined by time preference.”³²

But what if the demand to hold money increases to an unlimited extent? What if entrepreneurs do not invest at all? Rothbard again counters with a “rational expectations” point:

The Keynesian worry is that people will hoard instead of buying bonds for fear of a fall on the price of securities ... this would mean ... not investing because of expectation of imminent increases in the natural interest rate. Rather than act as a blockade, however, this expectation speeds the ensuing adjustment. Furthermore, the demand for money could not be infinite since people must always continue consuming, whatever their expectations.³³

In sum, the Keynesian view of liquidity preference is fundamentally inadequate:

Keynesians, however, attribute liquidity preference, not to general uncertainty, but to the specific uncertainty of future bond prices. Surely this is a highly superficial and limiting view.³⁴

Rothbard’s point about the role of expectations in speeding adjustment of the interest rate applies more widely than to the Keynesian problem of hoarding. The effect is present for all anticipated price changes. He writes:

[T]he natural interest rate on the market has contained a purchasing-power component, which corrects for real rates, positively in money terms during a general expansion, and negatively during a general contraction. The loan rate will be simply a reflection of what has been happening in the natural rate. So far, the discussion is similar to [Irving] Fisher’s, except that these are the results of actual, not anticipated changes.... We have seen that rather than take a monetary loss ... entrepreneurs will hold back their purchases of factors until factor prices fall immediately to their future low level. But this process of anticipatory price movement does not occur only in the extreme case of a prospective “negative” return. It happens whenever a price change is anticipated.... If all changes were anticipated by everyone, there would be no room for a purchasing-power component [of the rate of interest] to develop.³⁵

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¹⁵Ludwig von Mises, The New Individualist Review (Autumn, 1962): 41.

¹⁶Man, Economy, and State with Power and Market, p. 2.

¹⁷Mises, New Individualist Review, p. 40.

¹⁸Man, Economy, and State with Power and Market, pp. 614–15.

¹⁹Ronald Coase, “The Nature of the Firm,” Economica n.s. 386 (1937).

²⁰Quoted in Man, Economy, and State with Power and Market, p. 613.

²¹Ibid., p. 613; emphasis in the original.

²²Ibid., pp. 687–88; emphasis in the original.

²³Ibid., p. 689; emphasis in the original.

²⁴Ibid., p. 721; emphasis in the original.

²⁵Ibid., p. xcv.

²⁶Ibid., p. 507.

²⁷Ibid., p. 780.

²⁸Ibid., p. 784.

²⁹Ibid., p. 785.

³⁰I am grateful to Professor Bryan Caplan for calling this to my attention.

³¹Man, Economy, and State with Power and Market, pp. 789–90; emphasis in the original.

³²Ibid., p. 790.

³³Ibid., p. 791.

³⁴Ibid.; emphasis in the original.

³⁵Ibid., p. 796.