Tom Woods had a podcast out recently in which he gave the Austrian explanation of the effect of maximum hours legislation:
Let’s take maximum hours legislation because that seems harmless enough. We don’t want people working too long so we will have maximum hours legislation. Who could possibly be against that? Well, I want to think through the logic of this here. Think about you yourself today. Think about you and the number of hours that you work. Now, you, no matter how much you work . . . could be working more. . . you could get a second job, a third job, you could work an extra two hours a week as a tutor, whatever. . .
Why aren’t you doing it? Because you value the leisure. Because you’ve gotten to a point and society and the economy have gotten to a point where we are physically productive enough that we can produce enough goods that you would be physically satisfied, after, say a 40 or 50 hour week. . .
What if we said a 40 hour week was inhuman, it’s just too much? . . . And we impose on you, a limit. We have a law saying, you can’t work more than 30 hours a week.
Woods goes on to say that because you’ve already balanced your preference for work vs. leisure, the law clearly makes you worse off. If you now are forced to work 30 hours, sure, you’ll have more time for leisure, but you won’t be able to get as much money and buy as many goods as you did before. And you’ve already shown (through your allocation of time before the enactment of the law) that you value the extra income you receive over extra time for leisure.
The problem with this argument is that there are all sorts of situations in which someone might value their work/leisure balance after the law higher than their balance before it. For example, it is entirely possible that you did not limit yourself to working 30 hours prior to the law because in those circumstances, you could not find any 30 hour jobs in your local area and would have to commute between two jobs (which you highly dislike). Or perhaps the 30 hour jobs you could find didn’t pay enough. After the law is enacted, though, you might actually be happier with your new configuration because the situation has now changed. Since every employer is now forced to hire each employee for a maximum of 30 hours/week, the number of job opportunities goes up and you’re able to stick with your old job or find a new single job that pays well in your area.
It’s important to clarify what this means for Austrian economics. Woods’s argument makes complete sense within the Austrian framework. It is true that if we keep everything constant, a person’s action shows he prefers that action over his alternatives. However, when applying this argument to reality and making policy prescriptions, we have to take care not to go too far and make our claims too strong. Preferences or (in this case) situations might change over time, and therefore the actual effect may differ from the one Austrians have theoretically.
The number of other examples where this can happen is probably very large. I do not think Austrians can make policy prescriptions without adding certain empirical claims as well. However, what’s particularly pernicious about my example is that the situational effect is present within the law. It would be more accurate to say the law benefits you than to say the law would have harmed you, if not for the situational change – because the situational change is itself one of the law’s effects!
Check out this post if you are unfamiliar with tax shifting. It will help in understanding the following.
Rothbard states “Shifting occurs if the immediate taxpayer is able to raise his selling price to cover the tax, thus “shifting” the tax to the buyer, or if he is able to lower the buying price of something he buys, thus “shifting” the tax to some other seller.” (p. 1156)
As he goes on to point out in the case of the general sales tax, however, both a producer’s selling prices go up and buying prices go down. So I thought these clearly could not be the key criteria.
He states “It is true that a tax can be shifted forward, in a sense, if the tax causes the supply of the good to decrease, and therefore the price to rise on the market. This can hardly be called shifting per se, however, for shifting implies that the tax is passed on with little or no trouble to the producer. If some producers must go out of business in order for the tax to be “shifted,” it is hardly shifting in the proper sense but should be placed in the category of other effects of taxation.” (p. 1156-1157)
My issue with Rothbard was, however, that I felt this argument could be flipped on him; Rothbard believed that a sales tax could be shifted backward.
I could say “It is true that a tax can be shifted backward, in a sense, if the tax causes the demand for the factors of the production of the good to decrease, and therefore the price of the factors to fall on the market. Production in this way is hampered, causing supply to decrease and marginal firms to go out of business. This can hardly be called shifting per se, however, for shifting implies that the tax is passed on with little or no trouble to the producer. If some producers must go out of business in order for the tax to be “shifted,” it is hardly shifting in the proper sense but should be placed in the category of other effects of taxation.”
This is because, even in Rothbard’s proposed correct version of events where a tax is shifted backward, supply decreases, meaning marginal firms go out of business.
If the above seems a little confusing to you, try this one instead:
In Murphy’s Study Guide to Man, Economy, and State with Power and Market, he states:
“Tax incidence refers to the actual long-run burden of taxation, which may differ from the immediate target. No tax can be shifted forward. (If retailers had this power, why wait for the tax?)”
That’s basically what I was trying to do, although my response to Rothbard’s is more detailed.
After discussing this with Dr. Herbener, he pointed out that the two cases are not symmetric in the relevant sense. What matters is not whether firms eventually go out of business, but whether firms immediately go out of business as a result of shifting the tax. It’s true that firms eventually go out of business in both scenarios, but in the forward shifting scenario, firms go out of business immediately (as supply decreases – this is the proposed mechanism for tax shifting for this scenario, firms immediately go out of business) while in the backward shifting scenario, firms go out of business eventually (the tax shift occurs earlier, the proposed mechanism being firms paying lower incomes to their facts, which they do not directly go out of business from, but eventually go out of business from because of the “other effects”).
Why is this important? Because the immediate effect is what matters for whether we call it tax shifting or not. If firms go out of business as an immediate effect of shifting the tax, this cannot be properly seen as shifting a tax. However, in every scenario where taxes are added to a free market, there will be “other effects”, or as I have been saying, eventual effects, where people are harmed, including firms. So firms being eventually hurt does not invalidate backward shifting as an example of tax shifting.
In conclusion, yes: a tax can be shifted backward and this is perfectly consistent with Rothbard’s argument against forward shifting.
A response to ABCT from the typical person is a “well duh, of course if banks create money out of thin air, creating more claims on their supplies then they actually have, people will realize their insolvency and there’ll eventually be a bank run.”
Or “of course interest rates are a price just like any other price and coordinate market activity, and if you essentially place a price control on interest rates there’ll be unintended consequences.”
ABCT is common sense applied to economics. The reason that business cycles occur is not that complicated.
I’ve gone through most of my life in auto-drive mode. I didn’t think much in terms of “is this really worth it?” or “is there something more fundamentally necessary that I should be allocating my time toward?” We all have to allocate our time, a scarce resource, to particular ends that we choose. And sure, we do this on a daily basis; e.g. do I really want to do this assignment or should I go and play pingpong instead? But up till college, I had never really considered these type of questions on a more fundamental level. “Is my time worth doing this at all? Could it be a complete waste in the end?”
I consider myself lucky. When I fell ill two years ago, I found some answers that I may have not found otherwise. Two things really pop out to me. The first is Austrian economics, a deductive method of economics that teaches us a lot about the world, even if only with its simplistic truths. For example, ex ante, two individuals that exchange different goods voluntarily both gain. This is fairly indisputable, and knowing such obvious truths allows us to build a base of knowledge with which we can expand on top of. Most people don’t spend much time scrutinizing their base. They simply take it for granted (and once again, go into autodrive mode).
The second is pai-da/la-jin. Because I was ill with a disease contemporary, mainstream doctors could not cure, I was in a sense, forced to try something I may not have tried otherwise. Now I’ve found something that can help with almost all deficiencies in human health, and once again, it is simplistic. In fact, it’s something you could teach someone in a minute.
Unfortunately (? or maybe fortunately), what I’ve realized is that the base probably extends even further below. And so I have to keep scrutinizing it. While auto-drive is useful for many activities, there are points where we have to sit back and think: examine our lives and asks ourselves questions we have been avoiding. We may not always come up with precise answers. In fact, precise answers are usually the exception.
Why do we avoid these simple questions? As mentioned before, sometimes we are constantly doing activities and the thought never reaches us. But sometimes we are also scared of the answer. “Well, I don’t want to realize the last 10 years of my life was a waste so I’m just going to avoid thinking about this.” No! Don’t fall into this trap. Experiences are rarely useless. I only say rarely because I am uncomfortable using the absolute “never.” You can almost always find ways that experiences have benefited you. The only reason you think it’s useless is because the experience is useless with your original purpose in mind. For example, if I learned to be a mainstream economist, and then found Austrian economics 20 years into my career and thought its simplistic truths actually had more explaining power than mainstream models, I might initially feel as if my investment into mainstream economics was a waste. The original purpose was to explain certain occurrences in the world, e.g. exchange, prices. etc, and basically all of my learning for that purpose is now a waste. But this set of skills and experiences can be used in other ways. You could use your knowledge of mainstream economics to argue against it for what you now believe is true. You could use your hard work and the ability you developed in writing and teaching to now spread Austrian ideas. There are many other possibilities, but this is for you to think up for your particular situations.
One of the prime features of the free market is that you only have to know that the price does change, but not necessarily the reasons for it.
Money prices are the medium through which the communication of necessary information is made to coordinate effectively the actions of individual planners. As Hayek has pointed out, each particular decision maker does not need to know all the facts pertaining to the changes in resource usage. What is relevant to each is “how much more or less urgently wanted are the alternative things he produces or uses.”  The economic question is always a question of the relative importance of specific things available for the satisfaction of human wants. Each planner does not usually need to know why the relative importance of the things that he uses or produces has changed. What he does need is some indication of the extent to which its relative importance has been altered.
The coordinating function performed by the price system can be illustrated by assuming a sudden shortage of some resource. Those people who will eventually solve the problem of the shortage do not need to understand its cause. The price of a unit of the resource will be driven upward as those who employ it in the most important usages, i.e., use it for the generation of products promising the highest return, outbid those producers who plan to use it in less remunerative products. The shortage has meant that the marginal uses of the resources that could be supplied before the advent of the shortage cannot be provided for as long as the shortage persists. The higher price successfully causes the curtailment of the employment of the resource in its marginal uses. (Thomas C. Taylor, An Introduction to Austrian Economics, 35-36)
…the marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction….I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do. (F.A. Hayek, “The Use of Knowledge in Society,” p. 87)
When that occurs with credit expansion (the reason) changing the interest rate (the price change), knowledge of the reason would allow an entrepreneur to make proper investments. The fact that he does not know how much of the lowering in the interest rate is due to credit expansion and how much is due to real increased savings is the reason the business cycle must take place. An invaluable market signal tampered with by government intervention loses its prime quality as a signal.
We have just seen that there are two factors that tend to hold down the rate of interest below the level sufficient to allow for the related elements emerging on the market: (1) The implementation of the price premium lags behind the changes in purchasing power stemming from the inflation; and (2) the additional supply of money thrown onto the market has a dampening effect on the interest rate. Concerning the latter point, it must be realized that entrepreneur-producers are unable to differentiate between additional funds that have been artificially created and additional funds emanating from real savings. (Taylor, 93) [my emphasis]
To blame the entrepeneur for not being able to understand the signal misses the point and misunderstands the esteem Austrians hold entrepreneurs with.
Tom Woods sums up this type of thinking very eloquently:
“If the free market is so great, why can’t it operate without the free market?”
“It’s dangerous to look ignorant, but I suppose I will.
What is: praxeology???”
It’s the deductive method of Austrian economics. It starts with the premise that persons act, that actions are purposeful, they involve the use of a means to attain a end and are motivated by that end. It goes on to deduce conclusions from this premise through the use of logic: if a premise is true, and valid logic is applied, then the conclusion must also be true. Logical chains can be formed by using the old conclusion as a new premise and then again using valid logic. Austrians have used this method to explain marginal utility, the law of demand, how the business cycle occurs, and much more.
If you’re looking for an introduction to the type of reasoning used by Austrian economists, you can look at An Introduction to Economic Reasoning by David Gordon or look at praxgirl‘s videos on YouTube. If you’re interested in reading about Austrian economics in depth, you can look at Man, Economy, and State by Rothbard.
A guest also posts a link to a youtube video lecture I would highly recommend: Is Austrian Economics ‘Unscientific’? Here, Dr. Jeffrey Herbener compares and contrasts Austrian economics with the natural sciences, statistics, and morality. He also explains the methodology in an easily understandable way.
J.B. Say was a 19th century French economist whose work was mostly ignored by mainstream economists other than for one minor aspect of his economic theory that came to be known as “Say’s Law.”
Say’s Law states that the demand for a good is made up of the production of other goods. This can be clearly demonstrated by an imaginary barter economy. Suppose there are only two goods, fish and potatoes. If an individual wants to buy a fish, he must exchange a potato for the fish. He could not buy the fish without first producing the potato. Thus, the production of the potato is what constitutes the demand for the fish. And vice versa. The production of the fish is what constitutes the demand for the potato. Now, if the individual who wanted the fish did not produce a potato to use in exchange first, there would be no economic demand. All he would have is desire. But desire is only one part of demand, the other being the ability to actually buy the product. And this ability only comes with production.
In a large economy, the production of a larger amount of goods will make up the demand for the fish. And in a money economy, money only being a medium of exchange, producers will exchange their products for money and then exchange money for the fish. The only difference is that there is an intermediate step.
Why has an economic law so simplistic attracted so much attention? Rothbard explains:
Say’s law is simple and almost truistic and self-evident, and it is hard to escape the conviction that it has stirred up a series of storms only because of its obvious political implications and consequences. Essentially Say’s law is a stern and proper response to the various economic ignoramuses as well as self-seekers who, in every economic recession or crisis, begin to complain loudly about the terrible problem of general ‘overproduction’ or, in the common language of Say’s day, a ‘general glut’ of goods on the market. ‘Overproduction’ means production in excess of consumption: that is, production is too great in general compared to consumption, and hence products cannot be sold in the market. If production is too large in relation to consumption, then obviously this is a problem of what is now called ‘market failure’, a failure which must be compensated by the intervention of government. Intervention would have to take one or both of the following forms: reduce production, or artificially stimulate consumption.
This underconsumptionist theory is what Keynesians believe causes the business cycle. But as Rothbard explained, the underconsumptionist belief far predated John Maynard Keynes.
If Say’s Law is true, there cannot be a general overproduction (the flip side of underconsumption) of goods on the free market. However, there can be overproduction in one area and underproduction in another, a misallocation of goods. This insight will help us understand what really causes business cycles, which will be explained in a future post.