A bilingual interdisciplinary journal 1
New Perspectives on
Political Economy
A bilingual interdisciplinary journal
Vol. 9, No. 1–2, 2013
New Perspectives on Political Economy2
A bilingual interdisciplinary journal 3
New Perspectives on Political Economy
A bilingual interdisciplinary journal / Vol. 9, No. 1–2, 2013
New Perspectives on Political Economy is a peer-reviewed semi-annual bilingual interdisciplinary
journal, published since 2005 in Prague. The journal aims at contributing to scholarship
at the intersection of political science, political philosophy, political economy and
law. The main objective of the journal is to enhance our understanding of private property-,
market- and individual liberty-based perspectives in the respected sciences. We also belive
that only via exchange among social scientists from different fields and cross-disciplinary
research can we critically analyze and fully understand forces that drive policy-making and
be able to spell out policy implications and consequences. The journal welcomes submissions
of unpublished research papers, book reviews, and educational notes.
Published by CEVRO Institute Academic Press
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New Perspectives on Political Economy
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ISSN 1801-0938 (on-line)
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New Perspectives on Political Economy4
Editor-in-Chief:
Josef šíma, President, CEVRO Institute, Prague
Advisory Editor:
Ladislav Mrklas, CEVRO Institute, Prague
Associate Editors:
Pavel Pšeja (political science), Masaryk University, Brno
Michal Kořán (international relations), Institute of International Relations, Prague
Alena Zemplinerová (political economy), Institute of Economics, Academy of Science,
Prague
Roman Cardal (political philosophy), CEVRO Institute, Prague
Jakub Kříž (law), CEVRO Institute, Prague
Book Review Editors:
Jan Jireš CEVRO Institute, Prague
Language Editor:
Shelly Gussis
Editorial Board:
Terry Anderson, Hoover Institution, Stanford University
Peter Boettke, George Mason University
Hardy Bouillon, Trier University
Enrico Colombatto, University of Turin
Christie Davies, University of Reading
Frank van Dun, Ghent University, Faculty of Law
Richard Ebeling, Northwood University
Richard Epstein, New York University School of Law
Robert Higgs, The Independet Review
Jesus Huerta de Soto, Universidad Rey Juan Carlos
Jorg Guido, Hulsmann Université Anger
Zdeněk Kühn, Charles University, Faculty of Law
Miroslav Novák, CEVRO Institute
Svetozar Pejovich, Texas A&M University
David Schmidtz, University of Arizona
Gerald Steele, Lancaster University
A bilingual interdisciplinary journal 5
Aggregates and Methodological
Individualism: A Relational Approach
Alexander William Salter1
Abstract
Methodological individualism, coupled with radical subjectivity, leads naturally to skepticism
regarding the objective theoretical value of economic aggregates. I restate the role of
aggregates in the methodological individualist paradigm, focusing on the Austrian tradition,
in a way consistent with Hodgson’s (2007) critique and emphasize belief and meaning
as the relevant channel through which these aggregates operate. Viewing aggregates this
way leads to a relational approach which is consistent with formulations made by scholars
working within in the methodological individualist paradigm and answers Hodgson’s call
for recognition of the importance of interactive relations between individuals.
Keywords
Aggregates, belief, meaning, methodological individualism, subjectivism
1	 Department of Economics, George Mason University, Fairfax, VA, USA; email: asalter2@gmu.edu.
	 I thank the Mercatus Center at George Mason University for its support, Will Luther, Virgil Storr, Peter Leeson,
and Solomon Stein for valuable feedback on earlier drafts, and an anonymous referee for helpful comments
and suggested revisions. Any remaining errors are my own
New Perspectives on Political Economy6
“The economist is not primarily concerned…with any physical properties of the world as
such, but rather the meaningful constructions of social actors.” –Peter J. Boettke (1990,
37)
1. Introduction
Economists who adhere to methodological individualism, especially those of the Austrian
school, are typically skeptical of methods in the social sciences which attempt to mimic
the natural sciences. A popular manifestation of this skepticism is a critique of economic
aggregates, such as the price level or national income, as theoretical constructs able to
generate useful information without the necessary context of individual action. As a result,
some believe that methodological individualism is too limited a paradigm for the conduct
of rigorous social analysis (e.g. Bunge 2000). This position is inaccurate. It is true that
methodological individualists, Austrian economists in particular, have critiqued the kind
of aggregate-level theorizing exhibited by mainstream macroeconomics. However, a closer
reading of eminent Austrian economists such as Mises or Hayek, not to mention modern
Austrian methodologists, show that methodological individualism, along with the corollary
of radical subjectivity, implies the beliefs of individuals and the meanings they attach to
various social constructs are central to social analysis. To the extent that economic aggregates
are social constructs, in the sense of their recording and study by professionals and
the cognizance which is taken of them by individual economic actors, they certainly fit this
description and thus cannot be dismissed. While this extension may seem trivial, Hodgon’s
(2007) recent critique of methodological individualism warrants an explicit statement of
this postulate. Hodgson invokes a “folk theorem” which requires that “all satisfactory and
successful explanations of social phenomena (including in economics) involve interactive
relations between individuals” (217). The implication is that the methodology advocated by
Mises, Hayek, Schumpeter, and others in the Austrian school neglects interactional aspects.
My response focuses on the role of economic aggregates which, whatever the particulars
of their compilation, are the result of a multitude of interacting individuals. I meet Hodgson’s
challenge by highlighting the individual mind as the relevant channel through which
aggregates operate and impact economic outcomes. This also has the benefit of addressing
once again the popular claim that social analysis founded on methodological individualism
is unscientific because it disdains quantitative analysis. Specifically I argue there is a distinction
between aggregation as a way of theorizing and aggregation as a way of thinking; thus
there is also a distinction between what I call the usefulness and meaningfulness of these
statistics. I provide a cogent definition of these two measures and argue that the latter, as
determined by the individual economic agent, must be taken into account.
This paper is not meant to invalidate previous formulations of methodological individualism
but to fill a gap in the recognition of its versatility. I believe there is a fundamental
distinction between aggregation as a way of doing economics and aggregation as a way of
A bilingual interdisciplinary journal 7
understanding economics, with the latter occurring in the minds of individual economic
actors. In response to the question, “Is methodological individualism inconsistent with
aggregation?” I answer, “Not if the individual is the one doing the aggregating.”2
As I will
show, this distinction is reconcilable with previous authors’ formulations.
Because the term has been interpreted so widely, I first must make clear which definition
of methodological individualism I will work with. I hold with the Austrian tradition by defining
methodological individualism quite plainly: It is the recognition that only individuals
choose, and therefore the social sciences’ fundamental unit of study ought to be the indi-
vidual.3
Some interpretations of methodological individualism insist it is flawed because it
fails to consider environmental and interactional explanations for individual action.4
Again
referring to Hodgson’s critique, he asserts that “explanations in terms of individuals alone
have never, as yet, been achieved” (2007: 211). However, this seems to be directed at the
old neoclassical modeling tradition of agent omniscience and institutional irrelevance, best
described as methodological atomism, rather than the Austrian conception (Zwirn 2007).
Although Austrian economics emphasizes methodological individualism, it does so in the
context of radical subjectivity and the market process (Boettke 1994). It does not assume
flawless individuals and context-void action. Lange-von Kulessa (1997) recognizes Hayek’s
individualism is devoid of such reductionism and emphasizes an evolutionary theory and
social context. Boettke (2002) highlights the Austrians’ unique theories of information and
knowledge, which have as their root the richer conception of methodological individualism.
Boettke and Storr (2002) recognize the importance to social analysis of individual embeddedness
in society, polity, and the economy. Evans (2010) argues against Hodgson (2007)
and recognizes that institutional considerations are perfectly reconcilable with the Austrian
conception of methodological individualism. These authors’ works, some of which predate
Hodgson (2007), satisfy Hodgson’s folk theorem on other margins.5
For my purposes they
serve as a defense of methodological individualism upon which I can build my argument of
relational aggregates.
Aside from rebutting straw man arguments and defining the position more explicitly,
modern developments in the Austrian literature relating to methodological individualism
and aggregation have been focused on showing how new historical evidence and theoretical
developments are consistent with methodological individualism and radical subjectivity
(Keeler 2001; Bismans and Mougeot 2009; Lewis 2008; Aligica and Evans 2009), as well
2	 This approach is in no way a concession to behaviorism. For a general refutation of behaviorism see Mises
(2007). In addition, Hudik (2011) argues that economics is not a science of behavior in the psychological
sense.
3	 This does not deny the existence or relevance of social groups; it merely requires the explanation of the groups’
actions to be expressed in terms of its constituent members’ decision calculus. See Wagner (2010) for a social
theory that treats society as a whole as a real entity yet holds that methodological individualism is the proper
avenue of inquiry.
4	 See also Clark (2003).
5	 Other authors recently have sought not to refute but to expand upon methodological individualism by incorporating
insights from cognitive science (Nooteboom 2007) and the methodology of critical realism (Lewis
2005). Also Crespo (2002) accepts the basic formulation of methodological individualism but offers an Aristotelian
interpretation of Austrian ideas similar to Rothbard’s (1976).
New Perspectives on Political Economy8
as their macro-level implications of dynamism and emergence (Axtell 2007; Seagren 2011),
and continuing the battle against mainstream welfare and equilibrium analysis (Higgs 1994;
Folmer, Heijman, and Leen 2002; Holcombe 1999; 2008). As such, they are only tangentially
related to theoretical issues of methodological individualism and aggregation. It is this
gap in the literature I hope to address.
I proceed as follows: In Section 2 I briefly summarize the Austrian literature relevant
to my contention that economic aggregates can be reconciled with methodological indi-
vidualism.6
I draw special attention to the meanings-belief channel of individual actors. In
Section 3 I explicitly formulate the distinction between usefulness and meaningfulness as
motivated by the difference between aggregation as method and aggregation as understanding
and illustrate this difference by working through an example and employing a thought
experiment. I also provide some evidence that this approach is perfectly reconcilable with
the methodology of Mises, Hayek, and later-day methodological individualists. In Section 4
I offer some implications of this insight. In Section 5 I conclude.
2. Historical Development7
Mises
Mises continues in the tradition of Carl Menger and Eugen von Böhm-Bawerk by affirming
the validity of methodological individualism. In Human Action Mises puts forth praxeology,
“the general theory of human action,” as the supercategory to the more specific science of
economics (2008, 3). Mises plainly spells out the link between praxeology and methodological
individualism: “Praxeology deals with the actions of individual men. It is only in the
further course of its inquiries that cognition of human cooperation is attained and social
action is treated as a special case of the more universal category of human action as such”
(41). In refuting analyses of social phenomena which treat the group rather than the individual
as the appropriate unit of study, Mises writes, “[A]ll actions are performed by individuals.
A collective operates always through the intermediary of one or several individuals
whose actions are related to the collective as the secondary source” (42).
Mises’s views on methodological individualism lead to his suspicion of quantitative
methods in economics (1962, 62-63). Mises’s skepticism of statistical measurement for
6	 See Boettke, Horwitz, and Prychitko (1986) for an extended discussion of historical evidence as empirical
illustration in a similar context.
7	 This section’s treatment is by no means exhaustive. For an overview of subjectivity and methodological individualism,
and the Austrian conception of economic science in general, see Evans (2010), Coyne (2010),
Storr (2010), and Stringham (2010); for a more comprehensive exploration of Austrian methodology, see
White (1984).
A bilingual interdisciplinary journal 9
theoretical purposes frequently manifests itself as skepticism of particular economic aggregates.
For example, Mises is hostile to the development and use of instruments which purport
to measure the price level: “The idea implied in the inappropriate term level of prices,
as if –other things being equal –all prices could rise or drop evenly, is untenable. Other
things cannot remain equal if the purchasing power of money changes” (2008, 223). Mises
insists any discussion of the price of money be limited to its purchasing power of various
and specific goods and services (339). As a result, we can safely interpret the various occasions
on which Mises employs terminology such as “the volume of credit” or “the supply of
money” as abstractions for the sake of pedagogical expediency rather than a concession to
the validity of measurement or aggregation (568–583).
Hayek
While Hayek is just as dedicated to methodological individualism as Mises, he emphasizes a
different aspect of the epistemic issues of economic science. For Hayek, the social sciences
classify rather than explain human action (1943, 7–8), and, as such, any attempt to analyze
the phenomena of the social sciences using the methods of the natural sciences is to reduce
the whole to the parts, thus overlooking that as emergent phenomena, wholes comprise
different analytical categories than the parts which comprise them.8
In The Counter-Revolution of Science, Hayek further solidifies his objections to applying
the methodology of the physical and natural sciences to economics. His argument is largely
similar to that employed in “The Use of Knowledge in Society” with added emphasis on the
localized knowledge of individual agents as the distinction between objective (i.e. scientific)
and subjective (i.e. of time and place) knowledge and reaffirming this distinction as the
justification for methodological individualism and decentralized analysis (1979, 49–59; 88-
89). Specifically, Hayek criticizes the paradigm of scientism, saying
It [the misapplication of methods] is probably responsible for the worst aberrations and
absurdities produced by scientism in the social sciences. It not only leads frequently to the
selection for the study of the most irrelevant aspects of the phenomena because they happen
to be measureable, but also to ‘measurements’ and assignments of numerical values
which are absolutely meaningless (89–90).
Further support for methodological individualism comes from Hayek’s assertion that
the use of statistics “deliberately and systematically disregards the relationships between
the individual elements” (108). He continues by saying, “Statistics may supply us with very
interesting and important information about what is the raw material from which we have
to reproduce these structures [the structures with which the social sciences are concerned],
but it can tell us nothing about these structures themselves” (110). In his particular criticism
of the concept of national income, we see Hayek at his most Misesian: “there is no
8	 Elsewhere Hayek (1945, 523–524) emphasizes that to overlook micro-level issues by relying on statistical
aggregates gives a false sense of stability because doing so ignores this informational difference.
New Perspectives on Political Economy10
reason to expect that these measurements will ever reveal anything to us which is of significance
beyond the particular place and time [Mises’s ‘historical constellation’] at which they
have been made” (110).
It is important to note the framing role Hayek gives to statistics and aggregates in the
very next sentence: “That they cannot produce generalizations does, of course, not mean
that they may not be useful, even very useful; they will often provide us with the data to
which our theoretical generalizations must be applied to be of any practical use” (110).
Here Hayek seems to be dancing around the distinction between usefulness and meaningfulness,
but he never makes this distinction explicit. Without claiming whether he recognized
the distinction, we can clearly see Hayek’s defense of methodological individualism
both reaffirms and complements Mises’s.
Later Treatments
Several more recent treatments of methodological dualism (Kirzner 1976), measurement
(Lachmann 1976; Rizzo 1978), and the logical status of the action axiom (Rothbard 1976)
touch on the issue of aggregation as theory vs. aggregation as understanding. Despite the
differences in approach in this later literature, we see a clear pattern emerge: a reaffirmation
of the individual as the appropriate unit of study coupled with a rejection of statistical techniques
and aggregation because they are inconsistent with this methodological primary.
However, there are two works that stand out as foundational to the argument presented
in this paper. In outlining the methodology of the Austrian school, Lachmann highlights a
chief characteristic as “a distrust of all those formalizations of economic experience that
do not have an identifiable source in the mind of an economic actor. Such distrust naturally
engenders skepticism about macroeconomic aggregates” (1978a, 2). The sentence on
skepticism of aggregates seems a natural progression from the views of Mises and Hayek,
but the previous sentence contains an interesting implication. Distrust of formalizations
that do not find themselves in an individual’s means-ends framework suggests that, if a
formalization did “have an identifiable source in the mind of an economic actor,” it would
be permissible as an explanation of how the individual’s state of mind manifested in action.
Lachmann’s work on expectations (e.g. 1978b, Ch. 2) suggest this interpretation is feasible.
Aggregates as understanding can be grounded on the link between interpreted experience
and the means-ends framework in question.
The second is Wagner’s (2012) work on the relationship between micro- and macroentities.
Wagner (433) suggests that approaches that view macro-entities as scaled-up versions
of micro-entities, i.e. that proceed as if “macro is micro addressed in a loud voice,”
are fundamentally misguided. Macro-entities instead should be thought of as emergent phenomena,
unintended consequences of interaction amongst micro phenomena that exist at a
separate level of complexity. However, Wagner does recognize that macro phenomena can
“supervene” on micro-level actors (434), thus providing a theoretical foundation by which
A bilingual interdisciplinary journal 11
individual actors (micro-entities) can take cognizance of aggregates (emergent macro-entities)
without embracing a reductionist approach by conflating the levels of complexity
involved.9
Ultimately, Lachmann and Wagner provide a methodological and theoretical inroad
respectively for the argument to be developed. This argument is firmly grounded in the
Austrian “main line” from Mises and Hayek onward. It is with these points in mind that
we proceed to unpack the distinction between aggregation as method and aggregation as
understanding.
3. The Distinction between Useful and Meaningful
Formulation
As we have seen, the Austrian focus on methodological individualism naturally leads to
skepticism of the ability of statistical aggregates to reveal anything more than a historical
instantiation of particular economic phenomena; as such, the proper use of these statistics
is in the hands of economic historians, not theorists attempting to explain human action.
Vedder (1997) correctly notes that aggregate statistics can be selectively interpreted to
support many different theories, and often different theories cite the same statistics as
evidence. As such, methodological individualists are rightly wary of aggregation as method
–as a way of doing economics, namely economic theory. Even recent attempts to provide
empirical evidence for the Mises-Hayek theory of the business cycle (Keeler 2001; Bismans
and Mougeot 2009) agree with Boettke (1994) by claiming their results are illustrative of
rather than proof of the theory: “Historical interpretation illustrates the power of the theoretical
framework adopted” (Boettke 1994, 5; quoted in Bismans and Mougeot 2009, 242).
For this reason modern authors influenced by the Austrian school have used and argued
in favor of qualitative research methods, such as interviews and comparative ethnographies
(Chamlee-Wright 2010a, 2010b; Storr 2010). These research methods have produced fruitful
results because they take methodological individualism seriously, going straight to the
individual actors to discover what they think and feel –the data of the social sciences.
However, every economic aggregate, regardless of how it is computed, is a fundamentally
relational measure. An aggregate, by definition, supposes a multitude of interacting
individuals. What information in particular it captures, and whether that information is
9	 As will be discussed shortly, there are parallels between this point an Hayek’s arguments in chapter 4 of The
Counter-Revolution of Science.
New Perspectives on Political Economy12
appropriate for the analysis of economic phenomena a priori, is not the issue here.10
If individuals
take cognizance of economic aggregates –if they become both part of their beliefs
and something to which they ascribe meaning, and if individuals then act upon those beliefs
–then it must be the case that these aggregates impact economic outcomes in a way consistent
with methodological individualism and do so in an inherently relational manner, thus
comporting with Hodgson’s folk theorem.
Is it plausible that individuals start thinking in terms of statistical aggregates? We live in
a world where the synthesis of neoclassical microeconomics and Keynesian macroeconomics
is the dominant economic paradigm. Data on output, national savings, unemployment,
and hundreds of other aggregates are available to anyone with access to the internet. Many
of these figures also appear daily in the pages of the popular and financial press. Considering
the ease with which individual economic actors can access this kind of information,
and considering the use of these statistics is given an intellectual sanction by mainstream
economic thought (and some heterodox schools such as Post-Keynesianism), it is entirely
reasonable to suppose that these aggregates enter the mind of the individual and influence
his or her decision process. Once we’ve moved from the theorizing of academic economists
to the thoughts, beliefs, and actions of the individual, we move from aggregation as method
to aggregation as understanding, the latter being a purely subjective phenomenon entirely
contained within the mind of the actor.11,12
Here we are confronted with the chief motivation for this paper: past Austrian economists
have focused on showing that statistical aggregates are of limited theoretical use, but
this does not imply these aggregates are not meaningful to the individual qua actor. To define
these terms explicitly, an aggregate is useful if it increases our knowledge of economic
phenomena without concealing the microfoundations, namely the purposeful actions of
individuals, which give rise to these aggregates. An aggregate is meaningful if, regardless
of whether it is useful in any objective sense, an individual actor takes cognizance of it and
incorporates it into her decision rule with regards to various actions. Useful corresponds to
aggregation as method; meaningful corresponds to aggregation as understanding. The definition
of “meaningful” carries with it the requirement that a methodological individualist
must consider the impact any and all aggregates which individuals view as meaningful have
on that individual’s economic calculus; as such, any explanation of human action founded
10	 Thus this claim does not invalidate, or even attempt to oppose, Hayek’s arguments on the misleading nature of
statistics in the social sciences. It simply recognizes that without multitudes of acting individuals, there would
be no “data” with which to construct a statistical aggregate.
11	 “Understanding” is somewhat of a loaded word. I do not have in mind Mises’s verstehen. (See chapter 14 of
Theory and History and chapter 2 of Human Action; also Selgin 1990.) When I use the word “understanding”
I intend it to be synonymous with “taking cognizance of.”
12	 The objection that individuals would not think in these terms if academic economists did not first provide
the theoretical framework is irrelevant (and also quite possibly mistaken; see the price index example below).
Chicken-or-the-egg speculation does not change the fact that this information is readily available, nor is it able
to invalidate its transition from inputs into a testable hypothesis (according to the mainstream) to the methodological
individualist’s data once it becomes the content of an individual’s thoughts.
A bilingual interdisciplinary journal 13
on methodological individualism is incomplete if it does not recognize and incorporate this
distinction.13,14
As a refinement of the useful/meaningful distinction, consider Hayek’s (1979, 62–63,
emphasis in original) treatment of “ideas which are constitutive” of the phenomenon in
question and ideas formed by individuals “about these phenomena and which are not the
cause of, but theories about,” the phenomena in question. In this case, we are not concerned
with why an individual has incorporated an aggregate into his means-ends framework, only
with the fact that he has and the implications arising therefrom. To use an example that I
will elaborate on later in the paper, if an individual incorporates the price level (CPI, GDP
deflator, etc.) into his decision calculus, it does not mean that an individual’s perception of
the price level is essentially constitutive of the price level qua aggregate. It does mean that
the beliefs formed by the individual about the price level are decision-relevant. Thus the
meaning that an individual imparts on a statistical aggregate falls on the “theories about”
side of Hayek’s thought categories.
At first glance it seems there must be a fundamental asymmetry in the distinction –an individual
would not consider an aggregate meaningful if he first did not judge it to be useful.
This claim overlooks the possibility of strategic interaction amongst individuals: I may not
believe Aggregate X is of any use, but if I think everyone else in my community does, it may
benefit me to act as if Aggregate X actually does convey useful knowledge. If I am the only
such member of the N-sized community, then there are N-1 actors for whom Aggregate X
is both useful and meaningful, and myself for whom it is only meaningful. The fraction of
the community which plays <not useful, meaningful> versus <useful, meaningful> depends
on the belief distribution of that community.15
In the following subsections I work through an example and employ a thought experiment,
a method supported on both epistemological and methodological grounds (Moss
1997; Aligica and Evans 2009), which I believe will help illustrate the distinction.
Example: The Aggregate Supply-Aggregate Demand Framework
Aggregation allows for the construction of tractable economic models and provides a
ready source of data which can then be used to test the relevance of these models. The
costs of aggregation include a lack of precision and the likelihood of losing sight of the
micro-level causal chains related to individual choice. Methodological individualists in the
Austrian tradition insist the benefits derived from aggregation as method are largely illusory
while the costs are very real.
13	 I believe the useful/meaningful distinction is helpful in categorizing the different uses of economic aggregates
for the purposes of this paper. I do not intend these terms to take on this definition forever after; as such, they
may be considered as ‘thought organizers’ in the context of this specific argument.
14	 The discussion going forward is focused exclusively on aggregation. Although I have tangentially made reference
to criticisms of econometrics and empirical methods in economics more broadly, what follows only
applies to them to the extent they utilize aggregate statistics. For example, empirical macroeconomics frequently
uses econometric modeling techniques. That technique is not relevant to this paper by itself, but the
data inputs –aggregates such as national income, unemployment, etc. –are relevant.
15	 It is less obvious whether the converse (an individual considering an aggregate useful but not meaningful) is
viable.
New Perspectives on Political Economy14
As an example, consider the standard aggregate supply-aggregate demand (ASAD)
framework, characterized by the equilibrium condition Y = C + I + G + (X–M). Students in
introductory macroeconomics classes are painfully familiar with the Keynesian cross and
the resulting equilibrium: the variables comprising aggregate demand, the right side of the
equation, are given as functions of output Y and finding the solution is a matter of quick
substitution. Methodological individualists in the Austrian tradition are quick to point out
that this simple accounting identity does not and cannot convey the complexities and entanglements
of individual elements which lead to the diverse quantity of goods and services
an economy produces.16
Mario Rizzo sums up the objection:
What is aggregate supply? There are no producers of goods-in-general. There are just producers
of specific goods aimed at specific customers. (Of course, some guy can run around
adding this up in terms of market prices or whatever.)  There are no demanders-in-general.
There are just demanders of specific goods to be purchased from specific producers.17
Moreover, there is no reference to individual actors, except in the background concession
that their actions generated the aggregates which are now being used to solve the
problem. As such, the problem as formulated is unrelated to the environment in which the
individual is imbedded and the choices which she faces –a troubling feature for a model
which purports to describe phenomena generated by individual actors. Thus methodological
individualists frequently conclude the marginal cost of adopting this framework, which
include the obfuscation of individual resource consumption and opportunity cost, exceed
the marginal benefits of traction, leading to a rejection of the paradigm.
This analysis of the costs and benefits of a particular framework, however, are founded
on usefulness considerations. What we must also consider is meaningfulness –individual
actors may still use this information in formulating decisions and choosing courses of action.
If an individual thinks in terms of the ASAD paradigm, then aggregation as method
has become aggregation as understanding. If an individual uses data on national output (or,
what is more likely, an individual component such as consumption expenditure) in making
decisions about asset allocation or savings rates, then both requirements –interpersonal
relation and consistency with methodological individualism, coupled with radical subjectivity
–are satisfied.18,19
16	 For a complexity/spontaneous order conception of macroeconomics, see Wagner (2012).
17	 Mario Rizzo, “Macroeconomics from a Pre-Keynesian Perspective.” http://thinkmarkets.wordpress.
com/2010/10/21/macroeconomics-from-a-pre-keynesian-perspective/ October 21, 2010.
18	 There is also the possibility that, even if the agent believes certain aggregates are meaningful, he will not
behave in a way consistent with any existing theoretical model. In this case an Austrian-influenced theorist has
fertile ground to work with.
19	 It should be noted that individuals or a group of individuals holding flawed economic beliefs, in the sense that
those beliefs are meaningful to the individuals but not objectively useful, does not necessarily imply permanently
suboptimal economic outcomes. Consider a community of agents with Keynesian priors, but without
a centralized apparatus with which to implement either fiscal or monetary countercyclical policy, such as a
small and isolated town in the Midwestern United States. A fraction of agents expect their neighbors’ time
preference to decrease, resulting in higher savings, leading to a negative aggregate demand shock sometime
in the future. They “know” that it would be optimal for them to all increase their expenditure to combat the
decrease in demand, but lacking a coordination/enforcement mechanism, they each make the individually
A bilingual interdisciplinary journal 15
Thought Experiment: Price Indices
Price indices, such as the CPI or PPI, are another example where applying the useful-meaningful
distinction yields different insights than considering usefulness alone. Price indices
have been criticized for the same reason as other aggregates: in compiling the statistic, we
necessarily lose sight of some of the underlying microeconomic forces. In this case, methodological
individualists worry about focusing on a generalized price level rather than the
relative prices between specific goods and services, especially when the creation of a price
index tends to obscure relative price changes. This is true for both real (demand-driven)
changes and Cantillon effects. As such, many methodological individualists conclude that
price indices do not pass the usefulness test (remember Mises’s admonishment from Section
2!). However, we must consider the meaningfulness of price indices as well. In short,
we must ask, “Are individuals likely to take this aggregate into account when making economic
decisions?” The answer is, “Almost certainly.”
Individuals care about the purchasing power of their money. As such, any measure of the
purchasing power of money –the inverse of the “price level” –is likely to be both meaningful
and useful to them. They can use this information to negotiate cost-of-living increases
so their real wages are not eroded by inflation. It is also important for helping an individual
decide his or her cash balances. Since two phenomena associated with trade cycles are the
wedge between a worker’s real wage and his marginal revenue product and an excess demand
for money, in this case taking meaningfulness seriously can shed light on the raison
d’être of macroeconomic theory.
The robustness of the importance of meaning can be seen through an application in
which the aggregate in question arises endogenously, itself the result of purposeful human
action in the sphere of catallaxy, apart from the realm of pure economic theory. A short
thought experiment will be useful in further solidifying this point. Imagine a world without
any kind of a price index. Individuals come into contact with the prices of goods and services
they purchase regularly and currently this is their only means of discerning the purchasing
power of their money. In this world, agents are likely to expend real resources on search
–browsing through catalogues, window shopping, gathering information from friends and
rational decision to cut expenditure and increase their money balances. If the fraction of agents behaving thus
is “large enough”, the resulting decline in economic activity becomes a self-fulfilling prophecy. Other members
of the community, facing hardship, also cut expenditure and increase their money balances. Without countercyclical
policy, the prices of goods and services in the community falls until the agents perceive the real value
of the savings of their neighbors has increased to the point where they expect their neighbors to begin resuming
normal economic activity; as a result, they begin to adjust their activity as well, decreasing their money
balances as they begin to purchase their old mix of goods and services once more. From the community’s perspective,
the shortfall in aggregate demand has corrected itself and life is rosy once more, following a path very
similar to that outlined by Rothbard (2000). In fact, the correction process proceeds much along the same way
it would have had the agents understood Say’s Principle and monetary equilibrium theory, two models much
more consistent with methodological individualism. This is of course a highly stylized example and by no
means definitive; the impact of beliefs on economic outcomes is a separate research project entirely. However,
this example shows it is not trivial that a widely-held nonuseful belief necessarily spells economic doom.
New Perspectives on Political Economy16
family, etc. –in order to get at least some estimate of their money’s ability to command
goods and services. One day a clever statistician begins an extensive study of the prices of
many goods and services, creating the world’s first price index and making the information
publicly available. This new information presents an opportunity to the economy’s
agents: it offers them the possibility to economize on search costs by referring to the new
price index when they want information regarding the purchasing power of their money. Of
course each individual must make a decision regarding how appropriate this information is
for their purchasing patterns and how noisy this new estimate is relative to their old search
habits. Nevertheless, at the margin, we should expect some agents (namely those with the
highest time opportunity cost) to rely on the new index and use the resources previously
spent on search to satisfy more urgently-felt wants.20
Thus the new price index, although it is
obviously imperfect, induces individuals to change their behavior because the information
it conveys is meaningful to them. Again we see both relational and methodological consistencies:
the relational in one individual’s reaction to the purposeful action of another and
the methodological in the channel (the individual’s beliefs) through which the price index
impacts economic outcomes.
Consistency with Previous Formulations
As I indicated in the introduction, this approach to aggregates is perfectly reconcilable with
methodological individualism. The importance of meaning and its centrality to social analysis
was perhaps best stated by Boettke: “Social life is comprised of the meaningful constructions
of the various actors that dwell within it” (1990, 37, emphasis in original). Nobody
can deny that economic aggregates, in the sense that they are consciously compiled and
analyzed, are social constructions. The degree to which they are meaningful is the degree to
which individuals use this information in attempting to pursue their ends. “This subjectivist
perspective is the very basis…of any claim of objectivity that we as social theorists can have”
(37). Thus radical subjectivity in the context of methodological individualism is requisite
in the sense that any meaning which individuals attach to their actions must be taken as
datum. This reasoning also has close ties to the interpretive dimensions of social science
(Lavoie 2011) and, since a difference in meaning can lead to a difference in the operationalization
of belief, to questions amongst scientists as to which theoretical apparatus ought
to be employed (Caldwell 1982).
Indeed, a closer reading of Mises and Hayek shows they laid the epistemological foundation
for the investigation of meaning and its implications for economic analysis.21
For
20	 The usual assumptions apply: search is a normal good, and for some agents, the income effect dominates the
substitution effect.
21	 The following, again, are brief but representative examples. I keep the analysis short because this particular
point, using similar evidence, was made by Boettke (1990), which the interested reader should consult for a
more thorough treatment.
A bilingual interdisciplinary journal 17
example, Mises obviously recognizes this point in his discussion of economic calculation
in Human Action. Economic calculation is concerned with “the analysis of the mental processes
performed by acting man in applying quantitative distinctions when planning conduct”
(2008, 211). Hayek’s oft-neglected work on sensory orders (1976) also entails such
an interpretive framework. Most importantly, Hayek recognized that “in the social sciences
things are what people think they are” (1943, 1). In light of these views, my argument seems
obvious. After all, if individuals find certain economic aggregates meaningful, then it is silly
to suggest these aggregates ought to be purged from scholarly analysis. Hopefully, by explicitly
stating the link between aggregation and meaning, further critiques of methodological
individualism on these grounds will be recognized as a flawed interpretation.22
4. Implications
The main implication of distinguishing between aggregation as method and aggregation as
understanding, and hence recognizing the difference between usefulness and meaningfulness,
is no different from that which methodological individualism has already prescribed:
if one desires a good foundation for the social sciences, look to the individual. In this case
it merely extends that tenet to aggregate statistics. Taking meaningfulness seriously means
letting the individual tell us which aggregates are relevant.
Theoretically, this means nothing more than expanding the realm of permissible “if,
then” statements. Specifically, rather than saying “If Aggregate X increases, then…” these
statements take the form “If these specific individuals think Aggregate X is important, and
Aggregate X changes, then…” These kinds of statements are compatible with methodological
individualism and even strict apriorism. In the case where a priori theory leads us to a
case of conflicting magnitudes, it is perfectly valid to use conditionals to illustrate potential
22	 It may be argued that my formulation, built upon the arguments supporting the importance of individual
belief and meaning, “proves too much.” After all, why limit the extension of meaning to economic aggregates?
What if individuals believed occurrences or objects completely unrelated to economics in any objective sense
had an impact on economic outcomes, a la Jevons (1878)? Methodological individualists would, of course,
have to take these flawed beliefs into account. However, the self-enforcing cycle of beliefs and outcomes could
then lead to the conclusion that these extra-economic occurrences impact economic outcomes, and the line
between economics and psychology seemingly becomes increasingly blurred. However, as recent work on the
economics of unusual beliefs shows (Leeson 2010, 2011), beliefs endogenous to the social system can have
both an economic explanation and an economic impact. When the objection is applied to aggregates specifically,
the answer is even simpler: economic phenomena occur independently of the study of economics.
Whether one believes a specific aggregate carries important information (i.e. is useful in the definition I proposed)
or so inherently flawed as to convey nothing intelligible, it is still generated by the actions of economic
actors. This generality holds with regards to aggregates in general, and thus I do not need to defend any particular
economic aggregate, which is beyond the scope of this paper. The act of measuring it is the beginning of
the process by which it transitions from debatable usefulness to definite meaningfulness, but we can be assured
we do not have to worry about ending the story with an answer outside the domain of economic science.
New Perspectives on Political Economy18
outcomes. So long as these aggregates only play a role because they influence the action of
the individual, we remain on sound theoretical ground.23
Empirically, this means going directly to the individuals and discovering which aggregates
they use in their capacity as economic agents. We currently see market evidence
showing that individuals do take cognizance of aggregate statistics: organizations such as
the American Institute for Economic Research (AIER)24
and Conference Board25
publish
reports which try to anticipate overall trends in business activity comprising leading, coincident,
and lagging indicators. While not as technically complex as some econometric models
designed for the same purpose, this approach still utilizes correlation amongst aggregates
to give their readers an edge in the marketplace. These reports are available for an annual
subscription fee. If individuals are willing to pay for the information, it’s almost certain
they find it meaningful! Even the Mises Institute26
makes available aggregate market data
(presumably for historical illustration rather than inputs into a theoretical model) on current
prices, stock market behavior, measures of the money supply, and other macro-level
statistics. To the extent that these aggregates enter the minds of individuals and influence
their decisions, they become data with which the social sciences, especially economics, are
concerned.
Interestingly, mainstream economics has started investigating how agents’ beliefs can
impact the economy, especially in the context of optimal policy design. This literature incorporates
the social planner’s uncertainty as to which model correctly specifies agents’
beliefs. These methods have been applied to the study of growth (Brock et al. 2003; Doppelhofer
et al. 2004) and finance (Avramov 2002), but the work most relevant to my thesis
explores individuals’ expectations and monetary policy (Levin and Williams 2003; Brock
et al. 2007; Cogley et. al 2011). The authors consider various models of individual expectations
(forward-looking, backward-looking, or some hybrid) and weight them according to
some rule as a way of determining optimal monetary policy when the planner knows the
types of agents in the economy but not their particular characteristics. These models best
exemplify taking individuals’ thoughts and actions seriously since they explicitly recognize
that the same individuals acting on the same information can generate substantially different
economic outcomes depending on how that information enters into their beliefs. By following
these authors’ strategic approach, if not their theoretical methods, methodological
individualists can gain a better understanding of the impact agents’ thoughts can have on
economic outcomes by recognizing that some of those thoughts, and hence their actions,
are influenced by statistical aggregates.
23	 Consistent with methodological individualism, this is the sole channel by which a change in an aggregate can
result in an individual altering his behavior. For example, if the price level rises, and the individual believes the
price level (or rather, its inverse) is a meaningful measure of his money’s purchasing power, he will change his
behavior at the margin. If he believes the (inverse of the) price level is meaningless, the individual’s purchasing
power will increase only in the strict definitional sense, and he will not change his behavior at the margin.
24	 “Understanding AIER’s Business-Cycle Research Methodology.” http://www.aier.org/research/business-cycle
25	 “Global Business Cycle Indicators.” http://www.conference-board.org/data/bci.cfm
26	 “Markets and Data.”http://mises.org/markets.asp
A bilingual interdisciplinary journal 19
5. Conclusion
Economists in the Austrian tradition have long affirmed that, with methodological individualism
as an inviolate primary, quantitative methods which utilize statistical aggregates
are not a proper foundation upon which to build economic theory. In doing so they build
a chain of logic which shows that the methods of positivism and empiricism are incompatible
with methodological individualism, which is the proper frame of reference with which
to analyze social phenomena. The conclusion they reach most frequently is that statistical
aggregates of the kind which can be found in the ASAD paradigm or in formulations of
various price indices are not useful –that is, they do not convey valid economic knowledge
(or the costs of that knowledge exceed the benefits) and so they should be disregarded.
However, usefulness is only part of the equation. It is the part of the equation resulting
from aggregation as method. Once we consider the role these aggregates play not in theory,
but in the minds of the individual actors, we have transitioned to aggregation as understanding.
In this case, we must consider meaningfulness as well. As I have argued, meaningfulness
–what the information contained in statistical aggregates means to the individual economic
actors and how they incorporate this information into their decision calculus –is the
channel through which economic aggregates operate. It is fundamentally relational and still
consistent with a proper conception of methodological individualism. I have also argued
this insight, at a general level, has already been made by previous authors in the tradition
of methodological individualism. It thus applies to the specific instantiation of economic
aggregates. This postulate is not controversial. After all, failing to take the distinction into
account would result in a contradiction: it would entail an affirmation of the contents of
the individual’s mind as the proper data of the social sciences, but then would likely disregard
some of the factors which influence that individual’s decision-making process. As
such, economists who are also methodological individualists recognize the importance of
discovering how individuals use these aggregates since is the beliefs of the individuals and
the meaning they attach to those beliefs which is important.
I am not encouraging a methodological transformation to match that of neoclassical
or New Keynesian economics; nor am I suggesting the flaws in mainstream economic beliefs
and methods ought not be critiqued (Boettke et al. 2011). All I am suggesting is that,
since beliefs and meanings of individuals are supreme to those working in the tradition
of methodological individualism, aggregates can play a role in the thoughts of economic
agents without being a theoretical primary. Extending the implications of belief and meaning
to this aspect of the methodological individualist tradition constitutes progress towards
a proper recognition of the requirements and implications of the paradigm.
In this paper I have offered two highly stylized examples of how an individual might behave
when certain aggregates are meaningful to her but likely nonmeaningful to an economist.
I believe from these I have adequately shown that information which economists view
as nonuseful can be both useful and meaningful to an individual actor, as well as some
possible consequences which result from this divergence of beliefs. These examples were
New Perspectives on Political Economy20
meant to illustrate the difference between aggregation as method and aggregation as understanding
by emphasizing the importance of meaningfulness rather than make any claim as
to how these specific beliefs impact real economic outcomes. Ultimately it is an empirical
question whether an individual thinks Aggregate X is meaningful, and disagreements over
the particular cases I presented here do not refute the underlying argument: the meaningfulness
consideration reconciles economic aggregates with individual beliefs in a way which is
consistent with and highlights the versatility of methodological individualism.
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New Perspectives on Political Economy24
Nonrivalness, Subjectivity and Capital –
An Overview of the Austrian Theory of
Club Goods
Jakub Bożydar Wiśniewski27
Abstract
According to neoclassical economic theory, club goods would be underproduced by the
market in the absence of a monopoly of force capable of coercing every able member of society
to contribute to their provision. By applying both the methodological tools developed
by the Austrian School of Economics and the tools used to investigate the institutional
robustness of various systems of political economy, I shall argue, first, that the neoclassical
characteristics of club goods are based on a number of false assumptions or unacceptable
oversimplifications, and second, that even if they were correct as stated, they would not
establish the desirability of the existence of a monopoly of force due to the existence of a
more efficient, purely market-based alternative. Then I shall apply the results of my argument
to the issue of the provision of law and defense, which appears to lend itself particularly
well to being a promising case study in this context.
Keywords
Club goods, Capital, Austrian School
27	 Department of Politics at Queen Mary, University of London, UK; email: jakub@cantab.net
A bilingual interdisciplinary journal 25
1. Introduction
Perhaps the most common argument describing a putatively beneficial function performed
by a monopoly of force refers to its alleged ability to supply society with certain crucial, otherwise
unattainable classes of goods. There are many names to designate such goods and
many ways to categorize them, but for my purposes I shall regard them as falling into two
relatively broad classes – club and common goods, which together constitute the category
of public goods.
Various theorists writing on the subject in question identify the said goods according to
various characteristics – Malkin and Wildavsky (1991) provide an illuminating insight into
the degree to which there is no final agreement on the matter. While in general the literature
on public goods is “terminologically over-endowed” (Hummel 1990, p. 90), which engenders
a great deal of semantic confusion, I believe that it is fair to say that since the publication
of Samuelson’s classic articles on the subject (Samuelson 1954, 1955), one strand of
terminological convention has come to dominate the picture. According to this convention,
club goods are defined as possessing the characteristic of joint (or non-rival) consumption
(Buchanan 1965, Olson 1971, Berglas 1976, McNutt 1999), while common goods are defined
as possessing the characteristic of non-excludability (or the existence of related externalities)
(Musgrave and Musgrave 1980, Kim and Walker 1984, Ostrom 1990).
The former means that the consumption of a unit of a given good by a particular person
does not in any way diminish the ability of others to consume that same unit, while the latter
means that a given good produces spillover effects, which enable non-payers (most notably
the so-called “free riders”) to benefit from the good without in any way contributing to
its production. Some standard examples of the former type of goods – i.e., pure club goods
(nonrival but excludable) – would be TV signals and computer software. Some examples
of the latter type – i.e., pure common goods (rival but non-excludable) – would be air and
fish in the ocean. Finally, some paradigmatic examples of the goods combining the above
features, oftentimes called pure public (Leach 2003, pp. 171–86) or collective (Demsetz
1970) goods include lighthouses and national defense.
It is often claimed that these two characteristics give rise to the corresponding two types
of market failure – in the case of club goods some people are excluded from consumption
even though they would not generate any additional costs for the producer, while in the case
of common goods the social gains, including the gains of free riders, outweigh the private
gains of the producer, which undermines the incentive to produce in the first place. Thus,
a monopoly of force is expected to intervene and coerce every able member of society to
contribute financially in order to secure a sufficient supply of the goods in question. Absent
such a monopoly, the argument goes, the results are bound to be sub-optimal. This line of
argumentation, first developed in the late 1950s (Bator 1958), came to dominate the “market
failure” literature of the succeeding decades (Baumol 1961, p. 268; Arrow 1969, Head
1972, Stiglitz 1989) and continues to be an integral element of economics textbooks (see,
e.g., Willis 2002, pp. 161–3; Arnold 2004, pp. 720–3; Ayers and Collinge 2004, pp. 555–9),
New Perspectives on Political Economy26
as well as a focal point of the literature devoted to the so-called “global economic problems”
(Sandler 1997, Sandmo 2000).
By applying both the methodological tools developed by the Austrian School of Economics
and the tools used to investigate the institutional robustness of various systems of
political economy (Boettke and Leeson 2004, Leeson and Subrick 2006), I shall argue, first,
that the above characteristics of club goods are based on a number of false assumptions or
unacceptable oversimplifications, and second, that even if they were correct as stated, they
would not establish the desirability of the existence of a monopoly of force due to the fact
that the alleged club goods can be produced more efficiency in a purely market-based system.
After developing a general critique and reconstruction of each part of the neoclassical
theory of club goods, I shall apply its results to the issue of the provision of law and defense,
which I think lends itself particularly well to being a promising case study in this context,
since it is often seen as a paradigmatic example of a pure public good (Head and Shoup
1969, p. 567; Bush and Mayer 1974, p. 410; Buchanan and Flowers 1975, p. 27; Samuelson
and Temin 1976, p. 159; Cowen 1992) or even a typical club good, which prompted some
of those authors who believe that a sufficient amount of non-rival goods can be provided
by voluntary means to analogize a monopoly of force to a private club or firm (Buchanan
1965, 1975; Blankart 1994, p. 273; Mueller 1996, p. 81, 301).
Unfortunately, due to space constraints, I will not be able to develop a similar critique
of the standard theory of common goods in this paper. This shall be dealt with on another
occasion. Let me just signal here that I believe there are at least as many good and strong
arguments to be made in that area as there are in what I will concentrate on in the following
section.
Having made the above introductory remarks, let us now consider some aspects of the
theory under consideration in more detail.
2. Non-rivalness, subjectivity and capital – the theory
Let us start from an attempt at a reductio ad absurdum: if a viewer in a movie theatre behaves
appropriately (i.e., does not talk, eat loudly, etc.), he might be reasonably thought of
as not imposing any costs on other viewers, or, in other words, as not in any way diminishing
the value of their consumption. Hence, if only half of the tickets for a movie have been
sold, the outcome is sub-optimal as long as the remaining empty seats are not filled with
additional viewers admitted free of charge. In view of the above, movie theatres should be
treated as club goods and thus either nationalized or at least subsidized or heavily regulated
by a monopoly of force in order to ensure that no zero-cost consumers are excluded from
their use (Hoppe 1989a, pp. 41–2).
It seems plausible to expect that the overwhelming majority of club goods theorists
would reject such a conclusion. Since this reaction appears intuitively right, there must be
something wrong with the underlying theory. I believe that there are several things wrong
A bilingual interdisciplinary journal 27
with it, and I think that the Austrian appreciation of the elements of value subjectivity and
intertemporal coordination in economic processes highlights them particularly well.
As noted by James Buchanan in his summary of the theory of costs, “cost is subjective,
it exists in the mind of the decision-maker and nowhere else. (…) [It] cannot be measured
by someone other than the decision-maker because there is no way that subjective experience
can be directly observed” (Buchanan 1969, p. 43). It might seem that no monetary
(or perhaps “tangible”) costs are involved in letting non-payers into the theatre to fill up
the hall, but this is actually a misperception, since an external observer is in no position to
pass such judgments.
In reality, various individual costs are presumably present in the considered situation.
First of all, there might be psychological costs for the viewers associated with decreased
comfort brought about by the unexpected letting of additional people into the hall (here
we have to remember that the perception of crowding is also subjective). Secondly, there
might be costs associated with the perception of being cheated by being treated on a par
with non-paying free riders. These latter costs are initially purely psychological and borne
out exclusively by the paying viewers, but if one takes into account the passage of time
(Lachmann 1986, Kirzner 1992), one should discover that as outraged customers begin to
ostracize the theatre and actively discourage their acquaintances from using it, what used
to be subjective in the sense of being immaterial and financially impalpable turns into very
objective, tangible monetary losses for the theatre owner.
The general inference to be drawn from the above considerations is that non-rival consumption
can perhaps be seen as a useful analytical construct, but not as a tool for policy
guidance. This is because whether a given good is non-rival can be established only by
means of the intellectual division of labour performed by the totality of consumers engaged
in voluntary transactions. In other words, the existence of non-rivalness can be borne out by
the market process, but neither any of its individual participants nor any outside observer
can be (or indeed needs to be) aware of whether the transacted goods have this characteristic
or not.
However, it is possible to imagine a variety of club goods theorists who would be quite
happy to embrace wholesale behaviourism or physicalism and rely on such doctrines as the
basis for insisting that there remains a fundamental difference between the goods whose
consumption is physically (and therefore objectively) rivalrous and the goods whose putative
rivalness can be inferred only by accepting what they take to be dubious psychologicalsubjectivist
assumptions. Furthermore, let us suppose that such theorists would be willing
to bite the bullet and accept the aforementioned reductio ad absurdum by agreeing that
movie theatres should indeed by subjected to the control of a monopoly of force. Such
indeed would be a consistent decision to be drawn from the conclusion that consumption
of movies is physically non-rivalrous.
But having bitten the bullet, they now have to answer the following two crucial questions:
how much of the ostensible club good should be produced and how to keep its production
within the limits imposed by sound cost accounting? Being maximally sympathetic to an
imaginary group of planners willing to grapple with the above problems, and thus granting
New Perspectives on Political Economy28
the institutional framework they have to erect in order to implement their ideas maximal
robustness, I am assuming they are fully aware that even though movies themselves are
physically non-rival, the same cannot be said about the goods constituting the underlying
capital structure. After all, the theatre building has to be maintained continually, the
screening equipment has to be conserved and eventually replaced, the management has to
compile and update the movie repertoire, etc. It is thus crucial not to confuse the short-term
costs of letting an extra person into the hall with the long-term costs of maintenance and
management of the relevant capital assets (Brownstein 1980, pp. 101–2).
Now, let us recall that the goal of our planners is to ensure efficient allocation of resources,
by which they mean not excluding any zero-cost consumer from enjoying physically nonrival
goods. However, since there are other essential costs lurking in the background, some
means of covering them have to obtained if production is to be sustained.
The first method that can be resorted to in this context is the quasi-market procedure propounded
by Taylor and Lange (Taylor 1929, Lange 1936), based on the attempt to mimic a
perfectly competitive market environment, with the monopoly of force assuming the role of
a Walrasian auctioneer, who alters the price of a given good in response to consumer reactions.
Initially the price is set arbitrarily, but with the subsequent appearance of surpluses
or shortages it is adjusted accordingly, downwards or upwards, until the equilibrium price
is determined, supply meets demands and efficient allocation is obtained. Furthermore,
this price is then supposed to be imputable to the goods constituting the underlying capital
structure, which allows for establishing their monetary value and subjecting them to financial
profit-and-loss calculation.
Carrying this procedure out effectively might involve a host of separate problems, associated,
e.g., with potentially insufficient incentives of the theatre managers (who, unlike
private entrepreneurs, cannot benefit from the mobilizing power of the profit motive) or
with covering the costs of integrating this particular managerial cell with the broader, vertical
structure of the monopolist regulator. However, in the spirit of our methodology, let us
assume that the planners can somehow solve these issues effortlessly.
But even given this, there remain significant difficulties with the approach under consideration.
Let us start analyzing them by quoting Hayek, who objects to the claim that
“the valuation of the factors of production is implied in, or follows necessarily from, the
valuation of consumers’ goods” by noting that “implication is a logical relationship which
can be meaningfully asserted only of propositions simultaneously present to one and the
same mind” (Hayek 1948, p. 90). Since in the situation in question none of the consumers
(moviegoers) is in a position to challenge the coercive monopolist by becoming a theatre
owner or a shareholder, no competitive appraisal of the relevant capital goods can take
place, and thus no intersubjectively meaningful cardinal value (price) can be attached to
them (Herbener 1996, Reynolds 1998). The appraisal in question can occur only if every
individual, having evaluated a certain final good in his consumer’s role (and confronted
his evaluation with that of the totality of other consumers), can then proceed to become
a producer or an entrepreneur and engage in competitive bidding against the rest of the
producers and entrepreneurs for the ownership of the capital goods used in production
A bilingual interdisciplinary journal 29
of the aforementioned final good (Mises 1990; 1996, ch. 16). But as long as there exists a
“functional” gulf between the monopolist of force, who is the sole owner of a given stock of
capital goods, and the consumers who are forcibly prevented from assuming any other role
in a given area of economy, the production of any supposed club good is bound not to be
efficient, but wasteful and unsustainable in the long run.
Equally importantly, it is necessary to realize that the putative equilibrium price of a final
good, determined under conditions of initial ignorance with regard to the monetary value
of the relevant factors of production, need not be optimal. In fact, it is very likely to lead to
irremediable inefficiency. The entrepreneurial task of, say, the owner of a lemon orchard, is
not to sell the entire supply of lemons at such a price that no customer is left empty-handed,
but to sell enough lemons at a price sufficiently high to (at least) cover all the expenses
associated with maintaining the orchard. In other words, he needs to know the monetary
value of his capital assets in advance of determining the price of the final goods he wishes
to sell, and only by utilizing his knowledge of the difference between the two can he sustain
his enterprise, let alone make it profitable.
However, in the absence of signals associated with “counter-demands” for a given factor
of production expressed by other entrepreneurs, based on their anticipations of the future
market value of alternative final goods that could be produced with the use of the factor in
question, its economic worth necessarily remains unknown, leaving no chance for establishing
whether it is used efficiently (Böhm-Bawerk 1894/5). In other words, in the absence of
competitive intellectual division of labor capable of establishing a uniform, monetary scale
of exchange values expressible in cardinal terms, to which all goods and services can be
reduced and which allows for determining the extent to which any given entrepreneur acts
in line with consumer sovereignty, the notions of profit and loss, surplus and shortage, and
revenue and cost (understood not as an objective physical cost, but as a social opportunity
cost) are bound to be logically meaningless (Machaj 2007), and thus entrepreneurially
useless. The crucial observation to be made in this context is that the market process of
competitive appraisal operates simultaneously at two mutually informative levels – that of
final consumption goods and that of factors of production of various orders – and it cannot
run smoothly with only one of these levels intact. If one relies on only one of them with the
hope that the other is somehow “implied” in the former, then his actions will be necessarily
(and fatally) uninformed.
Thus, we can see that the Taylor-Lange quasi-market procedure is crucially defective and
that even the aforementioned narrower, “physical” variety of non-rivalness of certain consumption
goods is subordinate to the ineradicable rivalness of the underlying capital goods.
In other words, the said procedure does not offer the monopoly of force any promising way
of managing effectively the production of what it considers to be club goods.28
28	 Interestingly, and quite tellingly, the Austrian rebuttals to the Taylor-Lange quasi-market solution to the problem
of economic calculation under socialism were not addressed in any systematic manner by the sympathizers
of the latter. Instead, the neoclassical mainstream largely accepted the alleged viability of the solution in
question, thereby declaring market socialists the winners of the original calculation debate (see, e.g., Arrow
1974, p. 5; Lavoie 1985). In addition, the post-Soviet collapse treatments of the topic of market socialism by
New Perspectives on Political Economy30
Another method that a monopoly of force might resort to would be to dispense with
trying to appraise the productive assets in its possession by using the dubious imputation
strategy and instead impose a tax on society in order to finance the capital structure needed
to produce the supposed club goods. This solution, however, seems even less promising
than the previous one, since, unlike the latter, it does not even maintain the connection between
the price of final goods and consumer demand demonstrated in concrete, voluntary
actions. In other words, the compulsory payment that it proposes – being detached from
the market price system – is likely to be completely arbitrary. And even if the payment in
question were to be based on the prices prevailing among the private providers of any given
club good, its imposition is bound to generate inefficiencies by distorting valuation information
in other areas of the market, since a tax levied on other goods and/or their producers’
income “will lead to inefficiently small rates of production of these (…) goods” (Demsetz
1964, p. 21).
Could such a trade-off be worthwhile? It appears difficult to conclude that it could, since
it implies that society could be better off with a smaller amount of “private” goods (for
which demand is voluntarily displayed) and with a larger amount of “public” (club) goods
(for which there is no voluntary demand, and which are therefore funded coercively). Such
a conclusion runs afoul of the principle of demonstrated preference (Rothbard 1956, Herbener
1997), which says that every free market transaction is a positive-sum game, where all
involved parties demonstrate by their uncoerced actions that they prefer the post-transaction
state to the pre-transaction state. Given the subjectivist approach to economics, it is thus
hard to claim that the existence of monopolistically and coercively produced club goods
is preferable on efficiency grounds to their nonexistence coupled with the corresponding
existence of a higher amount of competitively and voluntarily produced “private” goods. In
sum, the tax-based strategy seems to be as untenable (if not more so) as the Taylor-Lange
method.
Finally, since capital assets used in the production of club goods are not open to purchase
by individual entrepreneurs, none of them can utilize his personal, “tacit” knowledge
of the specific circumstances of time and place (Hayek 1945) in order to cater to the needs,
tastes and preferences of any given group of consumers with maximum efficiency. In the
case of cinemas this would involve, for instance, diversification and constant updating of
the movie repertoires.
Of course, a monopoly of force might try to engage in similar activities in an efficient
manner by, for example, decentralizing its decision-making structure and encouraging local
cinema managers to utilize their tacit knowledge as far as possible. However, if such
managers are to remain managers of publicly owned capital goods rather than their private
proprietors, they cannot become completely independent in their decisions – the vertical
structure of the public sector requires that the relevant, time- and place-specific information
the neoclassicists (e.g., Roemer 1994 and Stiglitz 1994), while mentioning and acknowledging the significance
of some aspects of the abovementioned Austrian rebuttals, nevertheless contain assertions and conclusions
that betray a continued lack of understanding of their general import, let alone their finer details (Hill 1997,
Wohlgemuth 1997).
A bilingual interdisciplinary journal 31
be gathered at the bottom and then either sent to the higher authorities for approval of the
action plan that involves their utilization or at least periodically reported to those authorities.
In both cases such a vertical relationship creates significant transaction costs, perhaps
most notably time costs – in the best-case scenario the local managers are thereby slowed
down in their decision-making processes, whereas in the worst-case scenario their efforts
are rendered completely futile, since the information they collect may routinely become
obsolete and useless before the authorities manage to put a stamp of approval on the business
plan that draws on them.
Moreover, since in such cases the authorities can access the relevant information only in
the form of indirect description rather than in the form of first-hand experience of specific
circumstances of time and place, they are usually in no position to assess the accuracy of
the local managers’ reports and thus the usefulness of any given set of data to the success
of the action plan under consideration. If, however, we were to assume that the remedy to
this problem would be to give the managers full discretionary powers over the creation and
execution of their plans, they would cease to be employees of the public monopoly and
become private entrepreneurs instead (Rothbard 1991, pp. 57–60).
Having made the above theoretical points, let us now see how they apply to the operation
of the sector which, as I indicated earlier, is typically seen as particularly suited for being
controlled by a monopoly of force, namely, law and defense.
3. Non-rivalness, subjectivity and capital – the application
There is no quick and easy answer to the question of whether law and defense constitute
club goods, since they cannot be treated as any sort of homogeneous lump – instead, they
come in various forms and categories (Hoppe 1989a, p. 35). What follows is that the relevant
economic characteristics of some of them can be more readily identified than those
of the others. I shall analyze what I take to be examples of goods belonging to both ends of
this spectrum.
The issue seems relatively straightforward in this regard when it comes to a generic service
that might be called “the availability of competent people” – in this case, e.g., policemen
and judges. One more policeman or one more judge present in region A means one less
policeman or one less judge present in region B. One more representative of either of these
professions occupied at any given time by person A means one less of such professionals
capable of servicing person B at the same moment. Thus, the availability of services offered
by people working in these sectors is fully rivalrous. This is because rather than being some
monolithic wholes, the sectors in question consist of “specific resources committed in certain
definite and concrete ways” (Rothbard 2004, p. 1032). Consequently, it is incorrect to
claim that without ceding their management to a monopoly of force any zero-cost consumers
will be inefficiently excluded from their use, since there are no such consumers.
New Perspectives on Political Economy32
The situation could seem to be somewhat different with respect to what might be termed
“mid-range” protective services – for instance, the presence of surveillance cameras in a
given area. It appears that no additional costs are generated by the fact that a camera observes
an extra person. At the same time, the ex ante benefit of deterring criminals and the
ex post benefit of their easier identification and apprehension seem to remain intact. Does
that mean that surveillance cameras constitute an example of a club good?
My answer is negative – I contend that the above impression of non-rivalness is illusory
for two main reasons. Firstly, the above brief remarks disregard the influence of the dimension
of time and the corresponding phenomenon of crowding. As certain areas become
more frequented due to their reputation for being safe, the human traffic in them gets much
denser and thus more difficult to monitor effectively. And while it seems reasonable to
conclude that such a change is likely to make certain sorts of crimes (e.g., shop robbery,
car theft) less frequent, it might facilitate undertaking other kinds of criminal activity (e.g.,
assault, pick pocketing). In any event, it is not implausible to argue that increases in human
traffic in area A should lead to an increase in the number of cameras in the same region –
and hence to an increase in the relevant costs – which highlights the rivalrous character of
the amenity in question.
Secondly, and perhaps more importantly, even prior to the occurrence of crowding, surveillance
can perhaps be treated as temporarily non-rival, but the capital structure needed
for its operation cannot. This is a general point that I already gestured towards in the previous
section, and I think of it as universally applicable in the field under consideration. If we
look at the right type of cost – that is, not the cost of letting an extra person enjoy any given
amenity, but the cost of creating that amenity in the first place – we have to conclude that
every good whose building materials are not available in superabundance is in an important
sense rivalrous.
It is particularly worthwhile to notice that the above observation applies also to what
might be termed “long-range” protective assets – e.g., anti-ballistic missiles and nuclear
weapons (thought of as deterrents) – as well as to their legal counterparts,29
such as the
institutions responsible for promoting and reinforcing the concept of the rule of law (Hayek
1960, 1973). Admittedly, in this context it is impossible to envisage the phenomenon of
crowding to have any relevant effect on the degree to which the above elements can successfully
perform their intended functions. And yet, neither their creation can be accomplished
nor their operation can be maintained costlessly. Moreover, if these goals are not only to
be achieved, but also to be achieved effectively, then it is crucial not only to realize that the
procedures that have to be undertaken to this end are costly, but also to determine which of
them (and there is an endless number to choose from) is least costly or at least inexpensive
enough to be sustainable.
To be successful in this task, one needs to have a meaningful price system to rely on,
a price system reflecting the relative scarcities of goods and the social demand for them.
Such a system, however, as mentioned in the previous section, can emerge only in a freely
29	 Counterparts in terms of the range at which they operate rather than the mode in which they operate.
A bilingual interdisciplinary journal 33
competitive environment of private property rights and the voluntary exchange of property
titles. Competition should be seen in this context as the process whereby subjective appraisals
are turned into intersubjective exchange ratios, or, in other words, as the process
whereby prices are rationalized. Thus, it is perfectly legitimate to view competition as, to
echo Hayek’s (2002) words, a “discovery procedure”, a process as rivalrous as it is cooperative,
in which “each and every type of productive service is objectively appraised in monetary
terms according to its ultimate contribution to the production of consumer goods”
(Salerno 1990a, p. 36).
As should have already become clear from the above remarks, the management of production
by a monopoly of force is antithetical to the existence of any meaningful price
system, since it is also antithetical to the existence of free competition. This applies to every
area of service, including law and defense. What should perhaps be mentioned in this connection
is that trying to wed these two modes of production by allowing a competitive private
sector to arrive at market prices and then instructing the public officials to copy them
for the purpose of developing efficient public policy is problematic as well, since covering
the costs of the eventual implementation of that policy would require taxing the market
participants, which would necessarily degrade valuation information in the taxed industries
and thus distort the price mechanism.
Lastly, it should be noted that even if it were granted for the sake of argument that law
and defense are non-rival, it would not follow that they could be assumed to be universally
regarded as goods. This, in turn, implies that their coercively funded, monopolistic production
could actually be regarded by certain individuals as a “bad”. There exist anarchists who
oppose every form of initiatory violence and thus regard levying forced contributions as
an unacceptable encroachment on legitimate property rights (Rothbard 1981). There exist
pacifists who consider the existence of vast military arsenals, even if ostensibly accumulated
for defensive purposes only, as necessarily increasing the risk of armed conflict.30
There exist
those who see the monopolistic production of the putative club goods as creating worse
free-rider problems than their decentralized, private production does (de Jasay 1989). None
of these groups can be declared to benefit from judicial or protective dirigisme. To claim
otherwise is to disregard the teachings of subjectivist economics and subscribe to an unfounded
psychological assumption that an individual’s costs and benefits can be measured
by or shifted to a third party. Alternatively, it might indicate contravening the principle of
Wertfreiheit (Rothbard 1973b, Block 1975) and asserting that individuals can be coerced
for their own good, which moves the asserter from the realm of positive political economy
into the realm of normative ethics.
30	 Some of the public goods theorists seem to understand this point clearly. See, for instance, the following quotation:
“In the case of a pure public good, voluntarism may be absent, since the good may harm some recipients
(e.g., defense to a pacifist, fluoridation to someone who opposes its use)” (Cornes and Sandler 1986,
p. 159). However, this supposed understanding does not stop them from maintaining that something that is
harmful for some people may nonetheless be regarded as a “pure public good”, a conclusion I find logically
incoherent insofar as the existence of “pure public goods” is supposed to be beneficial to payers and non-payers
alike, and these two categories exhaust the set of potential recipients, thus logically implying that, in the
context at hand, the set of harmed recipients is empty.
New Perspectives on Political Economy34
4. Conclusion
In conclusion, law and defense do not differ from other scarce goods in terms of rivalness.
Moreover, they are similar to all other scarce goods in that if their production is detached
from the market price system, their relative worth vis-à-vis other goods, as well as their most
cost-efficient production method, cannot be determined. Finally, the subjective nature of
benefits and losses makes it impossible to presume that to the extent that consumption of
these goods can be considered as temporarily non-rival, being able to so consume them is
unanimously accepted as advantageous.
Now, it is an entirely different question whether in the cases where the market price
system reveals the above information to the producers of protective and judicial services,
they are able to generate sufficient revenue to cover all the necessary expenses, or whether
free-rider problems are bound to make their enterprises unsustainable in the long run. My
own opinion is that there exist excellent grounds for asserting that the market system, unlike
a monopoly of force, can deal with free-riders swiftly and effectively, but, as I indicated
earlier, due to space constraints, I have to leave further elaboration of that contention for
another occasion.
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New Perspectives on Political Economy38
“People, Your Government Has Returned
to You!” The Czech Constitution of 1992
as Return to Constitutional Tradition31
Gwendoline Tuma32
and Nikolai G. Wenzel33
Abstract
Unlike many of its Eastern European neighbors, the Czech Republic originates from a
healthy constitutional tradition. Upon the creation of Czechoslovakia and through the
modern day, the Czech Republic has had four constitutions, with major amendments to
the documents of the Communist era. Three constitutions, from 1920, 1948, and 1960,
served as guidelines for the creation of the 1992 constitution. Because the Czech Republic
had not foreseen the Velvet Divorce from Slovakia, government officials found themselves
in a rush to create a constitution for the new Czech state. The new document responded to
the many injustices of the Communist era and adopted most of the precedents set in the
1920 constitution. The Czech Republic’s democratic and constitutional past sets it apart
from other Eastern European countries, especially in terms of contemporary political and
economic liberty.
Keywords
Constitutional Culture; Constitutional Adoption; Post-Soviet Constitutionalism; Czech Re-
public
31	 „Václav Havel, President of Czechoslovakia, in his 1990 New Year‘s Address. Havel was adapting words
from the seventeenth-century Czech scholar Comenius originally quoted by Tomáš Masaryk in his inaugural
address as first President of Czechoslovakia, in 1918“ (Ash 1999, epigram).
32	 Hillsdale College, Hillsdale, Michigan, USA
33	 Florida Gulf Coast University, Fort Myers, Florida, USA; email: nwenzel@fgcu.edu
A bilingual interdisciplinary journal 39
1 Introduction
The Czech Republic boasts a strong constitutional and democratic history, despite totalitarian
occupation under the Third Reich and the Soviet Union. The leaders who advocated
for Czechoslovak independence during World War I were impressed with the democratic
values of the West and envisioned an ethical, humanist, and democratic political system for
Czechoslovakia. Under their authority, Czechoslovakia shined among its Eastern European
neighbors as a successful constitutional nation. Although socialism (of both the Nationaland
Soviet varieties) undermined the established democratic principles, the Czech leadership
returned to the principles of the interwar period after the fall of communism. For
this reason, the Czech Republic’s rankings from various indices of political and economic
freedom surpass those of most of its Eastern (and even Western) European neighbors.
A democratic tradition as well as a Western-minded culture aided the Czech Republic in
transitioning from a communist political system to a stable democracy. Section two offers
theoretical background on constitutional culture – the set of thoughts, feelings and attitudes
about constitutional constraints that ultimately determines whether a given constitution
will stick. Section three examines Czech constitutional history, with a particular emphasis
on the constitutional culture underlying the formal constitution. Section four focuses on the
1992 Czech constitution as the culmination of almost a century of constitutional efforts.
The final section concludes, with a brief comparative discussion.
2. Constitutional Culture
Instead of the more typical analysis of constitution as contract,34
we understand constitutions
primarily as coordination devices for mutually beneficial exchange (Hardin 1999; see
also Hayek 1960 and 1079 [1973, 1976, 1979]). Successful coordination around a constitution
requires a willingness to be bound35
with informal norms as the ultimate guardian of
constitutionalism. Because constitutions are mere parchment, informal mechanisms become
the ultimate preserver of constitutional order. Whereas contracts rely on a combination
of internal constraints and external enforcement mechanisms, a constitution is the
formal enforcement mechanism of last resort: there can be no outside appeal to any other
formal institution beyond the constitution itself. Hardin (1988) explains that “without support
from relevant people, perhaps often in the grudging form of those unable to co-ordinate
in refusing support...rules would not be worth the paper on which they are recorded.”
34	 See, e.g. Buchanan (1990 and 2000 [1975]) or Brennan and Buchanan (1985). For commentary and critique,
see Hardin (1988), Gordon (1976) or Voigt (1997).
35	 See Elster 2000, or, again, Hardin 1999.
New Perspectives on Political Economy40
This informal constraint can be defined as constitutional culture. Existing attempts at
defining constitutional culture offer a useful start.36
But existing approaches all limit the
concept of constitutional culture to situations where the country accepts constitutional constraints.
Defining constitutional culture as a culture that accepts constitutional constraints
is simply too limiting, as it does not explain constitutional failure.
Constitutional culture includes the implicit and explicit, stated and unstated, conscious
and subconscious, thoughts, feelings, beliefs, and norms the predominant group in a country
holds about the nature, scope and function of constitutional constraints. It reflects the
most basic beliefs and attitudes about constitutional organization, not just the constitutional
text itself, “but the entire network of attitudes, norms, behaviors and expectations among
elites and publics that surround and support the written instrument” (Burnham 1982, 82).
For definitional and methodological details, see Wenzel 2007 and 2010a.
Constitutional culture gains particular importance when we look at constitutional sticki-
ness.37
To stick, a constitution must match the underlying constitutional culture. If it does
not, the informal will reject the formal. Rejection can occur for a variety of reasons, ranging
from the cultural to the philosophical. For example, a constitutional culture might reject
constitutionalism entirely – perhaps because of opportunism or fatalism, or perhaps
because constitutionalism is seen as an unfair thwarting of the popular will. Likewise, a
constitutional culture might reject a specific constitution.
A constitution will fail if it is perceived as a foreign graft onto a constitutional culture
that formally rejects it. If constitutional culture and the formal constitutional system are
radically mismatched, the culture will reject the foreign transplant completely. Thus the
Philippines rejected its post-World War Two constitution (see Wenzel 2010b) and thus
Argentina rejected its 1853 constitution (see Wenzel 2010c).
3. Czech Constitutional History: Culture and Parchment
1. Czechoslovakia, 1918–1938: Independent, Constitutional, Democratic
The Czechoslovak state was established at the end of World War I upon consultation
with US President Woodrow Wilson in 1918. Tomáš Masaryk, known as the „President-Liberator,“
and his pupil, Edvard Beneš, envisioned a nation in which the Czechs and Slovaks
joined in a political union with Western political foundations. While every other Eastern
European nation in the interwar period fell into various forms of authoritarian government
(see Fisher 2006, 26, or Ash 1999, 126), Czechoslovakia built a parliamentary democracy
that sustained it until 1938. Táborský (2007[1945], 154) ascribes this success not to the
constitutional parchment, but to the underlying constitutional culture, „to factors which
36	 See, e.g. Ferejohn et al. (2001, especially 10 and 14); Mazzone 2005; Friedman 1975, Kahn 1999 or Levinson
1988; see also Merriam 1931.
37	 On institutional stickiness generally, see Boettke et al. 2008
A bilingual interdisciplinary journal 41
have not… much to do with the written rules of the Constitution, and which in some cases
have even developed in opposition to them.“
Czechoslovakia‘s democratic tradition originated within the Austro-Hungarian Empire.
Even greater was the Czechoslovak people‘s love of freedom, which strengthened after
three hundred years of Austro-German domination (Táborský 2007[1945], 155). The
Czechoslovaks were characterized as a people jealous, and thus protective, of their rights.
Their sensitivity to their promised rights and justice made them determined to build a nation
that protected rights and embodied justice. The Czechoslovaks were also a strongly
nationalistic people. In 1860, they founded the organization Sokol, which attracted people
who loved their nation and wished to achieve independence from the Austro-Hungarians.
The Czechoslovak Sokol not only offered recreational opportunities, it also encouraged forums
to discuss political philosophy, such as democratic thinking and unity. Sokol encouraged
Czech nationalism and boasted the membership of Masaryk and Beneš.
Furthermore, the Czechoslovaks represented various different cultures. This diversity
resonated within the new nation in which a respect for the rights of minorities was upheld.
The minorities‘ privileges „were greater than the privileges accorded to national minorities
in [almost] any other state“ (Táborský 2007[1945], 12). The 1920 Constitution reflected
this philosophy.
Czechoslovakia maintained a reputation as one of the most constitutional and democratic
nations in Europe, but also as „the most Western of all the so-called Eastern European
countries“ (Ash 1999, 130). Led by Masaryk, „both a philosopher and a politician with a
consequent democratic orientation“ (Berglund and Dellenbrant 1994, 143), Czechoslovakia
embraced Western political theory, ethics, and humanism. Masaryk (1938, 12) argued
that good politics should be ethical and humanitarian:
Democracy means the abolition of degrading misery; in a republic, in a democracy,
it must not be possible for individuals or ranks to exploit their co-citizens. Not organization,
and not a privilege, not aristocratic coercion, but mutual service. Democracy
needs leaders, not masters.
Masaryk‘s dedication to these values helped drive the Czechoslovak movement to adopt
Western values and a constitution. Masaryk and Beneš strove to create a solid constitutional
foundation for a lasting Czechoslovak state, in spite of political pressure from neighboring
countries. Each drew from his experience abroad–in France, Great Britain, Russia,
and the United States–to develop a constitution that embodied Masaryk‘s humanism and
attachment to democracy.
The Constitution of 1920 followed the example of democracies in Great Britain, France,
and the United States. It was founded on the theory of natural rights and the doctrine of
the separation of powers. The Constitution’s principles of republicanism, democracy, and
parliamentarism followed France’s precedent, as explained by Táborský (2007[1945], 129):
“The Constitution is perhaps nearest to that French individualistic republican liberalism
New Perspectives on Political Economy42
so admired by the Czechoslovak Constituent Assembly, and which was looked upon at the
time as the most developed system of republican parliamentary democracy.”
Masaryk and Beneš believed that a parliamentary democracy would fit the Czechoslovak
culture best, considering that its democratic traditions stemmed from European roots.
Economically, the Czechoslovaks pursued Western capitalism (it helped, of course,
that „Bohemia…was the most prosperous part of the Austro-Hungarian empire“ (Howard
1993, 3). The 1920 Constitution emphasized the importance of private property, more
so than any other right.38
Parliament had the power to limit property in only very few
cases, leaving “no doubt that the whole Czechoslovak economic order is based upon private
capital and private enterprise. Here again we can trace the influence of western European
liberalism” (Táborský, 2007[1945], 130). Moreover, economic and social rights were only
hinted at in the new constitution. Safeguarding these would have introduced unending political
and philosophical disputes (ibid): “Faithful to their western models and having other
urgent problems on their minds, the framers of the Constitution did not attempt to cut
through the tangle of complex economic and social questions but left them for the deliberations
of future legislators.39
In practice, the system became more presidential, and centralization overtook local autonomy.
This trend may be attributed to the leadership that was envisioned for the nation.
Because Masaryk and Beneš invested themselves into the Czechoslovak nation, decisions
and leadership were centralized on their expertise and their understanding of Western political
systems allowed them to lead the Czechoslovak nation for almost 20 years.
Additionally, the U.S. provided an example for the Czechoslovak nation within the legal
and electoral system. The Czechoslovaks borrowed judicial review, becoming the first country
in continental Europe to adopt that practice (Calda 1999, 3). The document also drew
from the U.S. Constitution to practice popular sovereignty and republican representation;
according to the Czechoslovak constitution, „Czechoslovakia was a democratic republic in
which the supreme power belonged to the people“ (Berglund and Dellenbrant 1994, 144).
This was especially important given the legacy of Austro-Hungarian tutelage. Because the
creation of Czechoslovakia merged many different cultures together, such as the Germans,
Bohemians, Moravians, Slovaks, and Hungarians, it became necessary to keep a multiethnic
character in mind. Czechs and Slovaks made up only two-thirds of the Czechoslovak
population (Bergenon 1978), and special attention was paid to the protection of individual
rights, including the rights of minorities. Masaryk hoped that such protection would prevent
future disenfranchisement of minorities. In spite of the divisions, Masaryk (1934, 78)
still wanted to unify the nation:
There is no Slovak nation…the Czechs and Slovaks are brothers. Only cultural level
separates them – the Czechs are more developed than the Slovaks, for the Magyars
38	 Others have pointed to the Civil Code that the Czechoslovak Republic inherited from the Austro-Hungarian
Empire – rather than the 1920 Constitution as an intermediary – as the source of respect for property rights.
We thank an anonymous referee for emphasizing this.
39	 For details on negative v. positive rights, see e.g. Rand 1966
A bilingual interdisciplinary journal 43
[Hungarians] held them in systematic unawareness. We are founding Slovak schools.
We much await the results; in one generation there will be no difference between the
two branches of our national family.
Czechoslovak politics differed in its treatment of minorities. As stated earlier, minorities
were viewed as equals under the 1920 Constitution; the state made an effort to integrate
them, not only politically, but also culturally. The Germans, for example, “were not only
permitted to organize their own parties but were also, after 1926, always included in governing
coalitions as junior partners” (Leff 1997, 29–30). Maintaining political equality in this
way set a precedent for future democratization, even though the Communist Party “scornfully
dismissed [it] as ‘bourgeois-democratic’”(ibid). Since the founders of the Czechoslovak
constitution emphasized the necessity of a unified and equal state, they outlined the
structure as unitary, instead of federal, in the 1920 Constitution. As can be seen through
organizations such as Sokol, the Czechoslovak Provisional Assembly protected nationalism
since it played an important role in the creation of the Czechoslovak state. The presentation
to the Provisional Assembly argued:
There is not the slightest basis for federalism in our past history. Dicey says that the
precondition for federalism is where there are nations who want to be joined without
unity. And this is something we do not have…Therefore, there is no incentive, nor the
least basis, for some kind of federal structure…to be created. (Sidor 1943, 104)
In developing a unitary state, the Czechoslovaks integrated the diverse backgrounds of
the populations making up the new Czechoslovakia. This success reinforced free institutions,
a feature unique to Eastern European nations in the interwar period. Most found
themselves under authoritarian rule (whether from within or from Nazi Germany or Soviet
Russia) that did not end until the fall of communism in 1989. Czechoslovakia’s free institutions
were ultimately destroyed only by outright foreign invasion.
3. 1938 –1989: From Nazi Occupation to Soviet Communism
Although Czechoslovakia thrived politically throughout the interwar period, Masaryk’s Republic
was seriously challenged by outside political forces: the pressure from the territorial
demands of the Third Reich and the subsequent Munich Treaty destabilized the Czechoslovak
Republic. In 1938, the Nazis “created a Protectorate of Bohemia and Moravia where
Czech institutions were formally preserved–but with all the power in the hands of the ‘protectors’
( Berglund and Dellenbrant 1994, 146),
The Red Army “liberation” of 1945 did not immediately seek to start a revolution and
change the democratic system that preceded the occupation of the Third Reich. Instead, the
Soviets were careful to start by restoring the old constitutional system. In the first years, the
New Perspectives on Political Economy44
Communist Party took care to hide its motivations and keep its influence from becoming
transparent. In April 1945, the Czechoslovak cabinet created the Košice Program, within
which the many parties of the National Front worked out the republic’s new constitution.
Because the Program was part of the Soviet agenda, the communists took care to treat the
Czechoslovak parties as “equal in rights and responsibilities” (Berglund and Dellenbrant
1994, 147). In exchange for equal rights, parties were required to pledge allegiance to the
Košice Program. That Program aimed to reform social and economic institutions, culminating
in the nationalization of various industries.
May 9th
, 1948 was deliberately chosen as the inception of the new constitution, because
it was the anniversary of the Czechoslovak “liberation” from Nazi Germany by the Red
Army. The new constitution was based off of the Soviet Constitution of 1936, but it was not
a verbatim copy. The communists argued that the new constitution must reflect the local
state of development, as well as “the people” in a people’s republic. The constitution “did
not entirely abolish the old fundamental laws but incorporated many of their features, especially
the provisions with regard to legislative, executive, and judicial power and the political
rights of citizens” (Skilling 1952, 201). It also created a new national economic system and
defined the “social and economic rights” of citizens.
The communists ensured that their ascent to power was supported by the Czechoslovak
citizens. Their agenda was initially moderate, reminding citizens that their interests were at
the forefront of new policy and that their political precedents would be valued. Nevertheless,
the new constitution “declared legally invalid the Constitution of 1920, as well as all
constitutional and other acts inconsistent with the new Constitution or with the principles
of the people’s democratic order” (ibid). Thus were the Masarykian political values of democracy
eradicated.
The Constitution of 1948 was explicit in listing the freedoms ensured to the Czechoslovak
citizens. Acknowledging political rights first, the constitution included uncommon
freedoms, such as the freedom of conscience. Although the constitution granted “personal
freedom,” it did not detail what that entailed. Furthermore, the communist drafters implemented
a very elaborate version of “social rights,” which “include[d] the right to work, to
just payment, to leisure and to the protection of health…right to education and equal rights
for women” (Skilling 1952, 206). Using the Soviet constitution and doctrine as a guideline,
the drafters sought to develop a more socialist political and economic system. The new
constitution also imitated the Soviet document in providing “an extensive statement of
duties—the duty to work, to defend the state, to uphold the constitution and the laws, to
preserve public property, and to discharge all public functions” (Novotný 1960). These duties
contrasted with the Constitution of 1920, in which the sole required duty was that of
military service. In stating these duties, the new constitution subtly but firmly shifted the
status of Czechoslovaks from citizens into servants of the state.
By taking a furtive approach to establishing socialism, the Communist Party ensured
its own success. July 11, 1960 marked the day the new constitution was ceremoniously and
unanimously approved. Czechoslovakia celebrated that day, becoming the first Soviet satellite
to document the triumph of socialism with a new constitution. As the preamble of the
A bilingual interdisciplinary journal 45
1960 constitution states, “Socialism has conquered in our land…The people’s democracy
as a path to socialism has fully proved itself; it has led us to the victory of socialism.”40
The
Communists referred to the new constitution as a document that cleanses “our state of
various ‘birthmarks’ of the past, comprehensible in a transitional period [such as] liberal,
pseudo-democratic principles of the division of power” (Skilling 1962, 145). Since it was
important to ensure a smooth transition from democracy to communism, the communists
felt obliged to pay lip service to the procedures of the 1920 constitution. These precedents,
these “’birthmarks of the past,” were now replaced by a more current and relevant constitu-
tion.
Although there was great fanfare in the adoption of the 1960 Constitution, it introduced
very little real reform. Czechoslovakia was now officially a socialist state, yet it retained
the same political structure from 1920, most specifically the one-man presidency, whereas
most other East European communist states and the Soviet Union adopted a State Council.
Communist President Antonín Novotný justified the one-man presidency, saying that it had
„become in the eyes of the working people a characteristic feature of the Czechoslovak
state“ (Novotný 1960). Even though the communists hoped to reorder the political and economic
system to resemble the system of the Soviet Union, they still took care to implement
their doctrine around existing Czechoslovak culture and traditions. This approach ensured
relative success in completing a smooth transition to communism.
While respecting traditions (if only for the sake of a smooth transition and political
stability), the Communist Party still wished to instate reforms that would fix the problems
of the „liberal, pseudo-democratic principles.“ The 1948 Constitution still permitted individual
private property; in the 1960 version, this „was omitted, although small private enterprises
not employing the labour of others were permitted (art. 9) and ‚personal ownership
of consumers‘ goods‘ was guaranteed (art. 10)“ (Skilling 1952, 161).
The 1960s were a period during which President Dubček, who succeeded Novotný following
his resignation, attempted to create “Socialism with a human face.” These reforms
developed into the Prague Spring, a period that highlighted the immense discontent with
Novotný’s regime and the stagnant economy, the celebration of freedom of expression, and
the articulation of Slovak national ambitions.
The Soviet Union and its satellite states heavily criticized the renegade Czechoslovakia.
In August, Warsaw Pact forces invaded the country, returning strict Communist occupation
for the next 20 years. The Prague Spring’s failure motivated reformers to attempt to
preserve some of the reform efforts. These achievements translated into the 1968 Act on
the Czechoslovak Federation, which also assuaged Slovak fears of Czech domination in the
National Assembly. Two national governments were established, the unicameral National
Assembly was replaced with a bicameral Federal Assembly, and dual citizenship was created.
The Act, however, “failed to resolve the real issue… the federal structure set up by the
1968 amendment was never tested in practice, because the bicameral Federal Assembly
was reduced to a rubber-stamping organ” (Mathernová 1993, 476). Just two months later,
40	 „Ústava Československé socialistické republiky,“ 1960 <http://www.psp.cz/docs/texts/constitution_1960.
html>
New Perspectives on Political Economy46
the Federal Assembly adopted more constitutional laws that effectively undermined the
previous amendment. Václav Havel referred to 1968 as the time when history stopped and
the country was put to sleep for 20 years – and the Act of Federation was, naturally, an
important (if unintended) precursor to the Velvet Divorce of 1992.
4. From the Fall of Communism to the Velvet Divorce: the
Constitution of 1992
Czechoslovak communism fell with Soviet communism (see Ash 1999) in 1989, but tensions
quickly emerged. Slovakia was ready to terminate the union shortly after the Velvet
Revolution of 1989, and the Slovak National Council unveiled a separate and completed
constitution in September 1992. The Czech Republic, on the other hand, had remained
hopeful for unity throughout the summits, believing that it could find a constitution that
would fit both the Czechs and the Slovaks. By October 1992, that effort proved to be in
vain. The Czechs now had three months in which to create a constitution that would carry
them through reconstruction and the dismantling of communist institutions. January 1,
1993 marked the beginning of separate Czech and Slovak Republics and the dissolution of
Czechoslovakia.
Insider reports show that “the easiest agreement in the end was to follow the1920 Constitution”
(Stein 1997, 57). The document was also a stalwart of Czechoslovakia’s lost democracy:
“This made good sense and for the Czechs it fit well with the aspirations of the Czech
Republic to step into the shoes of the democratic, internationally respected, pre-World-War
II Czechoslovakia” (ibid, 68). As Howard (1993, 5), summarizes, “Czechoslovakia…cherished
the legacy of a vibrant, functioning democracy in the years between the world wars.”41
In addition to following the 1920 Constitution’s precedent, the Czech Republic adopted the
1991 Charter of Fundamental Rights and Basic Freedoms. The Charter was initially drafted
to apply to the entire Czechoslovak nation; after its dissolution, Slovakia integrated the
basic provisions of the Charter in its constitution. The Czech Republic, however, took the
Charter a step further, preserving the document in its entirety and declaring “the Charter
of Fundamental Rights and Freedoms as a part of the constitutional order of the Czech
Republic.”42
The Charter displayed the strong reaction to the 50-year occupation of the
Czechoslovak nation and can be compared to the United States Bill of Rights.
The 1920 Constitution provided a strong precedent and stable foundation for a country
that had just emerged from a half century of communism. Much of the 1960 constitution
41	 Alas, if Czechoslovakia as a whole cherished this legacy, there were differences between the Czech lands and
Slovakia. The former moved immediately to constitutional democracy, while „Slovakia had to pass through the
dark valley of Vladimir Meciar‘s semi-authoritarian regime before having its own belated ‚revolution of catching
up‘ in 1998“ (Ash 1999, 167); see also Fisher‘s (2006, 126) blunt assessment that the Meciar government
evinced a „lack of respect for democracy.“
42	 Charter of Fundamental Rights and Freedoms, Ústavní Soud České Republiky, http://www.usoud.cz/view/
czech_charter, accessed 9/30/2012
A bilingual interdisciplinary journal 47
was abrogated; out of 106 Articles, only 17 remained (Calda 1999, 7). The framers and legal
advisors worked swiftly, passing a Czech constitution on December 16, 1992.
The Czech constitution’s framers returned their country to a sovereignty reserved for the
citizens. Returning to these principles proved to be an advantage to the Czech state. Within
months of reinstating a democratic constitution, the Czech Republic became the first postcommunist
nation to show economic and political stability.
The 1920 Constitution carried proportional representation and the role of a single presidency
within the parliamentary system into the 1992 constitution. The presidency evolved
into a stronger position, “in large part attributable to the strong position of Prime Minister
Klaus during the drafting of the Constitution” (Stein 1997, 62). The first Czech president,
Václav Havel, was tasked with “‘breath[ing] life into his office‘ by capitalizing on the precedent
of the monarchical presidency of T.G. Masaryk and on his own broad popularity”
(Stein 1997, 63). Generally, the 1989 revolution appealed specifically to the memory of
Masaryk (Ash 1999, 84) and the 1920 constitutional framework.
The 1992 constitution also introduced new democratic provisions in order to create a
balanced representative government. The new electoral law imitated that of the United
States, in which one third of the Senators must be elected every two years. Furthermore, the
Czech constitution offered different systems of representation: the Assembly of Deputies
reflected proportional representation, while the Senate used the first-past-the-post system.
5. Conclusions: The Czech Republic in Comparative Context
To be sure, this is not fundamentally a comparative paper on Eastern European constitu-
tionalism.43
However, it is helpful to frame the Czech Republic in regional context – and
various regional rankings corroborate our story of Czech exceptionalism. Excluding the
Baltic States which were outright incorporated into the Soviet Union, we can focus on five
other post-communist Central and Eastern European countries: Slovakia, Poland and Hungary,
Romania and Bulgaria.
First, the Czech Republic has the highest score possible (along with all but Romania
and Bulgaria) in political rights and civil liberties (in the “Freedom in the World 2011”
survey44
). Refining this analysis, we turn to the Economist Intelligence Unit’s Democracy
Index 201045
, which assesses democracy based on civil liberties, stability, corruption, and
other related factors. The Czech Republic ranks 16th out of 167 in the world – slightly
above the United States and surpassing the democracy rankings of many Western European
43	 For such work, see, e.g. Howard 1993, Schwartz 2000, or Priban 2004; see Mathernova (2003) on Czech
constitutionalism, 1989–1992; on the 1989 revolutions, see Ash 1999; for superb comparative work on postcommunist
Slovakia and Croatia, see Fisher 2006 ; on more general comparative constitutionalism, see Billias
1990, Blaustein 1992, Friedrich 1967 or Bellamy 1996; for an excellent regional overview (with an emphasis
on economic ideas), see Aligica and Evans 2009.
44	 www.freedomhouse.org, accessed 6/8/11
45	 Democracy_Index_2010_web[1].pdf, accessed 6/8/11
New Perspectives on Political Economy48
nations, such as the United Kingdom and France. Regionally, the Czech Republic is the
only “full democracy”; its fellow post-communist countries are all “flawed” democracies,
ranging from Slovakia’s ranking of 38th, through a cluster in the 40s, and Romania at 56th
.
Adding to our constitutional story, the most relevant variable in the democracy ranking
is that of political culture (which is, of course, intimately tied to constitutional culture)46
.
Not surprisingly, the Czech Republic ranks highest, with a score of 8.13/10; it is followed
by Slovakia, Poland and Hungary in the 7-point range, and Romania and Bulgaria in the
6-point range. It is no coincidence that the “Programmatic Principles” of the revolutionary
Civic Forum, as drafted by future Prime Minster Vaclav Klaus, featured “rule of law with
an independent judiciary” and “free elections” as the first two points on its platform (Ash
1999, 103–104).
Moving from political manifestation to underlying cultural explanation, Mathernová
(2003, 61) explains that the “Czechs, originally Protestant and now largely secular with
some Catholic population, cherish the democratic ideals of a civil society, liberalism, and
individual rights. In contrast, one of the dominant factors in the Slovak society is a traditional,
socially conservative form of Catholicism.” One anecdote seems to capture the
Czech attitude. After the Velvet Divorce of 1992, the Czech Republic adopted enthusiastic,
forward-looking symbols; Slovakia, by contrast, adopted backward-looking symbols of past
oppression and lingering grief (Fisher 2006, 81). Not surprisingly, the Czech Republic leapt
forward into free-market democracy, while Slovakia endured six years of Mečiar hiccups.47
Second, moving from political to economic liberty, the Czech Republic ranks the highest
in the 2011 Index of Economic Freedom,48
at 28th
in the world, and the only post-communist
country in the region to be ranked “mostly free” (all the others are ranked as “moderately
free”). It is followed by Slovakia at 37th
and Hungary at 51st
, with the others in the 60s. This
is not surprising, given the link between sound constitutional environments and economic
freedom.49
Beyond theory, one can turn to history. The French classical-liberal political
economist Frédéric Bastiat had been translated into Czech as early as 1923, and free-market
economists Milton Friedman, George Stigler and James M. Buchanan had followed
through the 1960s and 1970s (Aligica and Evans 2009, 146); Ash (1999, 87) adds that
free-market economists Milton Friedman and F.A. Hayek influenced the Czech transition
from communism. Aligica and Evans (2009, 146) cite the Czech Republic as a post-1989
“market-fundamentalism” example; the first Prime Minister, Václav Klaus, was a devoted
friend of free markets. Economic freedom and responsibility appear to be deeply ingrained
in Czech culture, as evinced by one very telling anecdote: Ash (1999, 107) reports that the
anti-communist strikes of 1989 were mostly symbolic (if effective), as workers made up lost
time during evenings and weekends!
46	 See Wenzel 2007 or Wenzel 2010a.
47	 This ties in with the general literature on the “political economy of forgiveness,” which indicates that countries
that move forward, rather than dwelling resentfully on the past, tend to do better, as explained, e.g., by Boettke
and Coyne 2007.
48	 http://www.heritage.org/index/ranking.
49	 See, e.g., Scully 1992 and, more generally, the New Development Economics literature, e.g. Boettke et al.
2003.
A bilingual interdisciplinary journal 49
Third, the theoretical link between economic freedom and economic performance is
well established, as evinced by the Index of Economic Freedom cited above. It comes as
no surprise, then, that the Czech Republic should rank first among its neighbors, at a
GDP/ capita of roughly $25,000/year.50
The Czech Republic is followed closely by Slovakia
(at roughly $22,000), then Poland and Hungary in the high teens, and Romania and Bulgaria
in the low teens.
In the short span of 20 years, the Czech Republic has demonstrated a successful democratic
system that surpasses many of the very countries after which the Czech political
system was modeled. The Czech Republic struggled through different political systems, beginning
with the Austro-Hungarian Empire, the interwar period of Czechoslovakia, the tyrannical
dirigisme of Nazi and Soviet Socialism, and finally, a democratic and free country
since 1989. Ultimately, however, the ethics, humanism, and freedom of the West triumphed
as the new Czech Republic readopted the 1920 Constitution, as developed by Tomáš Masaryk
and Edvard Beneš, to escape damaging socialist traditions. In contrast with the other
former Soviet satellites, the Czech Republic had a developed democratic and constitutional
tradition, and a culture that was sympathetic to Western political philosophy. Consequently,
the Czech Republic managed to preserve its democratic culture of constitutionally limited
government throughout a half century of socialism.
50	 Depending on whether one uses IMF, World Bank or CIA Factbook figures
New Perspectives on Political Economy50
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Berglund, S. and J. Dellenbrant (1994), The New Democracies in Eastern Europe (Cambridge:
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Blaustein, A. (1992), Constitutions of the World, Fred B. Rothman & Co.
Boettke, P. and C. Coyne (2007), “Political Economy of Forgiveness,” Society, Volume 44,
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Boettke, P., C. Coyne and P. Leeson, “Institutional Stickiness and the New Development
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A bilingual interdisciplinary journal 53
BOOK REVIEW
The New Lombard Street: How the Fed Became the Dealer of Last
Resort by Perry Mehrling, 2010. Princeton and Oxford: Princeton
University Press, 174 p
Much of this slender book centers on the tensions of the two opposing views of money in
the economy. The view of economics peers through the veil of money to see how capital
investments in the past determine present prospects. The view of finance focuses on the
present valuation of future projects. Both views largely take money as a given, and ignore its
different forms and the institutions that allocate it. Perry Mehrling, a professor of economics
at Columbia University, focuses on where the two views meet: in the present. Common
at the Fed’s conception, the “money view” has returned and allows us to bridge the gap
where finance and economics meet.
The money view harks back to the American economist Harold Moulton who focused,
like many other economists, on the role of commercial banking in capital formation. By
relying on the “shiftability” (salability) of long-term securities rather than self-liquidating
short-term loans, American banks of Moulton’s time were able to participate in financing
long-term investments. Moulton’s shiftability view was once accepted doctrine until a nasty
Depression and a World War intervened. Modern policymakers focus on the rate of interest
in an attempt to create a perfectly liquid system. While Moulton’s policy would balance the
elasticity of credit with the discipline of the investors, the modern view attempts to keep the
bank rate of interest aligned with Wicksell’s natural rate.
In laying the groundwork for an updated lender of last resort, Mehrling is careful to
illustrate the institutional changes that have occurred in central banking since Bagehot’s
time. Dollars have replaced pounds and gold as settlement standards. Repurchase agreements
(repos) have replaced bills of exchange as financing requirements have shifted from
buying real goods to holding financial assets. Bagehot’s central bank used the traditional
discount rate to manage the system, while today the Fed focuses on overnight lending, and
does so only indirectly by using the Treasury repo market to control the supply and demand
of underlying deposits to be borrowed or lent in the federal funds market. This gives rise
to the largest difference between Bagehot’s time and the modern system – “under modern
conditions, the Fed is always lending freely” (p. 27). The only constraint is that the Fed only
lends to its primary dealers, only against Treasury securities as collateral, and only at the
Treasury repo rate that corresponds to its federal funds rate.
It is in this distinction that the Fed has moved from being a lender of last resort to a dealer
of last resort during the recent crisis. The Fed’s recent policies are Bagehotian in every
sense, except that the penalty rate on its loans fell to almost zero. Even this is a response to
New Perspectives on Political Economy54
an institutional curiosity of the changing world over the past 150 years. The Fed, unlike the
nineteenth-century Bank of England, faces no reserve constraint in its gold holdings.
The triumph of the shiftability view can be traced to the 1935 Bank Act, whereby the
Fed opened itself to any “sound” collateral instead of limiting itself to self-liquidating paper.
Private dealers were originally to provide shiftability, secure in knowing that the discount
window was available if they got into trouble. By 1937 the Fed had committed itself to
maintaining “orderly conditions in the money market” (p. 48) generally, and consequently,
assigned itself the role of security dealer.
The historical account is flawless and quite readable, and it is only where Mehrling ventures
to present and future policy changes that ambiguities arise. If the Fed is to become the
dealer of last resort it must do so only to support healthy bank lending and not to promote
imbalances or bubbles. In an earlier discussion (pp. 12–17), Merhling discusses the opposing
views on bubbles – a Hawtreyan bubble is inherently unstable and should be reined in; a
Schumpeterian bubble represents dynamic growth and should be encouraged. What stance
the central bank takes will depend on identifying what type of bubble is at hand, and Mehrling
finds interest rate policy alone unable to contain the resulting collapse that occurs.
Yet, in advocating the Fed shift to concern itself with the elasticity of credit and not focus
on the interest rate exclusively, one gets the opinion that Mehrling ventures too far into the
across the money view, and leaves the economics behind. The result is that he focuses fully
on the financial aspects of the bust. Serving as dealer of last resort may support asset prices
and maintain an appearance of liquidity, but the bust will also have real misallocations of
capital in the economy. These will not be evaded by maintaining liquidity; indeed, these
misallocations may be exacerbated if overpriced assets are not able to fall in value to signal
their ex post success or failure as investments.
In committing to act as dealer of last resort, the Fed is accepting that it can recognize
a disorderly market from an orderly one and intervene to rectify things. Yet, as Mehrling
recognizes, “how is the Fed supposed to know when the market is ‘disorderly’, and how is
it supposed to know what kind of intervention is needed?” (p. 48). Such interventions can
occur only with some idea that asset prices are disequilibrated, though as recent events well
show, there is considerable disagreement as to what constitutes a correct asset price.
The book has several tangential digressions, both good and bad. That the Great Depression
demonstrated the “failure of the decentralized market system” (p. 60–61), oversimplifies
and overstates the case. The influence of Jacob Marschak, Harry Markowitz and
James Tobin in integrating money into a general equilibrium analysis is well-done, and the
influence of John Gurley and Edward Shaw in modernizing and stressing the institutional
framework that the money market functions within fuses the academic and applied monetary
policy worlds together seamlessly (p. 63–65). The creation of financial products as unintended
consequences of untimely regulations is timely at this juncture of ever-increasing
levels of regulation, e.g., swaps as a response to post-War capital controls (p. 72), credit default
swaps as a response to central banks not being interested in fostering market liquidity
for private debt (p. 83–84), or Regulation Q’s interest rate ceiling fostering money market
mutual funds (p. 89).
A bilingual interdisciplinary journal 55
Channeling Hyman Minsky, one underlying theme in Mehrling’s analysis is that capital
markets are inherently unstable. Due to this continual instability, the Fed must stand ready
to allocate liquidity to the dealer network to avoid illiquidity cum insolvency crises. Mehrling
doesn’t give the reader much substantiating evidence for the inherent instability of
credit, instead relying on vague references to Minsky’s work. As a result his attitude towards
the Fed’s more recent interventions and expanded balance sheet is much more optimistic
than this reviewer’s. The Fed has recently allocated an additional $2 trillion to the dealer
network; Mehrling never mentions the mechanics of reversing these transactions when the
time arises. Perhaps that is because he believes the time will never arise – after all, credit
is, according to him, inherently unstable. Maybe so, though I doubt it, and such a claim
requires more justification than Mehrling provides to believe this “inherent instability” hy-
pothesis.
Likewise, Mehrling never answers why taxpayers should be on the hook for bank losses
should continued bailouts arise. He downplays the role of capital in safeguarding solvency,
and instead relies on the dealer of last resort to take its place. It might be true that Fed
allocated liquidity can replace capital to stabilize the banking system, though it seems too
much like a free lunch for this reviewer. Shareholders have a role in the financial system as
well – they aren’t passive investors, but allocate funds according to expected profits and,
perhaps especially as of late, losses.
Like so many historical exposes, The New Lombard Street’s termination leaves the reader
thinking “the more things change, the more they stay the same.” The Fed’s recent shift to
shifting its assets to provide market liquidity is not so different from how the Fed operated
at its inception, and that the intervening years have been the unorthodox ones. In advocating
the Fed embrace its renewed role as dealer of last resort, Mehrling makes the case that
there is historical precedent available, as well as a healthy dose of academic debate over the
past century to support it. Yet in this final policy recommendation, one can’t help but have
some hesitation. A great deal of recent attention has been placed on the moral hazard of the
Fed serving as lender of last resort for the banking system. Do we really want to promote
the moral hazard of the Fed acting as dealer of last resort through the repo market?
David Howden
Chair of the Department of Business and Economics, St. Louis University – Madrid Campus,
Madrid, Spain,
dhowden@slu.edu
New Perspectives on Political Economy56
list of articles
Alexander William Salter: Aggregates and Methodological Individualism:
A Relational Approach....................................................................................6
Jakub Bożydar Wiśniewski: Nonrivalness, Subjectivity and Capital – An
Overview of the Austrian Theory of Club Goods.........................................36
Gwendoline Tuma and Nikolai G. Wenzel: “People, Your Government
Has Returned to You!” The Czech Constitution of 1992 as Return to
Constitutional Tradition ..................................................................................59
BOOK REVIEW
David Howden: The New Lombard Street: How the Fed Became the Dealer
of Last Resort by Perry Mehrling, 2010. Princeton and Oxford: Princeton
University Press, 174 p.....................................................................................82
www.cevroinstitut.cz