THE KALEIDIC WORLD OF LUDWIG LACHMANN

Review Article: The Market as an Economic Process
by Ludwig M. Lachmann.
New York: Basil Blackwell, 1986, pp. xii, 173.

Ludwig M. Lachmann has been writing about markets for half a century. Having received his formal education in Germany by the early 1930s, Lachmann went to England where, along with fellow student G. L. S. Shackle, he studied under Friedrich A. Hayek. After writing and lecturing for some years in London, he settled in at the University of Witwatersrand in Johannesburg, South Africa for several decades of continued scholarship.
        Until the mid 1970s Lachmann was known to Americans only through his writings, and his influence on American economics was not great. But in 1974 he was one of three lecturers featured at a conference on Austrian economics held in South Royalton, Vermont and sponsored by the Institute for Humane Studies. Beginning in 1975 and largely as a result of the South Royalton lectures, Professor Lachmann has taught each spring semester at New York University, returning to Johannesburg for the remainder of the year.⁽¹⁾
        The Market as an Economic Process, itself the result of a process that began several years ago, serves as the major focus of this review. A second volume, Subjectivism, Intelligibility, and Economic Understanding: Essays in Honor of Ludwig M. Lachmann on his Eightieth Birthday (New York: New York University Press, 1986), plays a minor role. Because of the diversity of the twenty three papers that make up this birthday offering, no comprehensive account can be undertaken. But two of those papers, one by the reviewer, will aid in linking the arguments in Lachmann's own book to an important issue that has captured the attention of Lachmann and his readers for the last several years: the presence—or absence—in the market process of a tendency toward equilibrium. But before dealing with this or any other substantive issue, let me focus attention on Lachmann's vision (as Joseph Schumpeter used the term) of the market economy.

Clockworks and Kaleidoscopes
Readers familiar with Lachmann's writings will not be surprised or puzzled by his frequent allusions to the kaleidoscope. Readers not so familiar may wonder about the recurring prepositional phrase "in a kaleidic world." An understated passage in Chapter 3 links Lachmann's own usage of this imagery with G. L. S. Shackle's. The society in which we live, according to both Shackle and Lachmann, is a "kaleidic society, interspersing its moments or intervals of order, assurance and beauty with sudden disintegration and a cascade into a new pattern"⁽²⁾ (p. 48). The underlying vision of the market economy adopted by Shackle and Lachmann is captured by this comparison of the market process to the dynamics of a kaleidoscope.
        Many proponents of the Austrian school forswear using the language of Newtonian mechanics, sometimes brashly condemning altogether the use of metaphors in constructing economic theories. While recognizing that pendulums and kaleidoscopes each have their own internal logic, Lachmann systematically rejects Newtonian mechanics in favor of Shackelian kaleidics as the more relevant metaphor. He makes his preference clear in one of his chapter titles: "The Market is not a Clockwork."
        Neither, as I will argue below, is it a kaleidoscope. But the kaleidoscope does serve as a convenient peg on which to hang Lachmannian ideas: radical subjectivism, emphasis on process, the role of asset markets, and the Keynesian connection, to name a few. Throughout Lachmann's discussions of methodology, knowledge, capital and money, and his comparison of equilibrium and disequilibrium approaches to economic theorizing, the reader will want to keep one eye on the pendulum while peering into the kaleidoscope with the other. The contrast between these two models of the economy, the reader will discover, is a true reflection of the contrast between Lachmannian economics and the orthodoxy.
        The kaleidoscope's intricate pattern of colored glass represents the pattern of prices that are determined by buyers and sellers in commodity markets and by bulls and bears in asset markets. The pattern has order and beauty, but not longevity; no given pattern can last for long. The passage of time is necessarily marked by the discovery of new information in the form of fulfilled or disappointed expectations of investors. This is the nature, according to Lachmann, of the market process. Such discoveries can change bulls into bears or bears into bulls. The resultant shuffling about of capital assets jars the kaleidoscope. A new pattern of prices emerges, but the particulars of the new pattern could not have been predicted solely from the former pattern or from the sum total of knowledge that underlay it.
        The inevitable discovery of new information as the market process unfolds has no analogue in Newtonian mechanics. Future positions of a pendulum can be calculated from its present position, its mass, and the forces acting upon it. The position at which the pendulum finally comes to rest is not the result of a process—as Lachmann uses the term. That is, the final equilibrium position is independent of the magnitude and direction of the particular movements that delivered the pendulum to that position.

Radical Subjectivism
Lachmann is a thoroughgoing subjectivist. Though influenced at an early age by the writings of Carl Menger, he takes his methodological cue directly from Hayek, who wrote more than forty years ago what was to become one of the most frequently quoted statements of Austrian methodology. "It is probably no exaggeration to say that every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism." Lachmann quotes this statement from Hayek's Counter-Revolution of Science not just once, but twice (pp. 23 and 144). Menger established the subjectivity of value. Ludwig von Mises employed the subjective marginal utility theory to account for the value of money. Shackle and Lachmann have emphasized the subjectivity of knowledge and expectations.⁽³⁾ And in his concluding chapter, Lachmann makes a plea (pp. 142 and 147) for still a further "thrust toward subjectivism."
        Students of Menger's marginalism should be the first to recognize that there can be too much of a good thing. While we need not call Hayek's assessment into question, we may legitimately wonder how far we can push subjectivism without losing sight of the essential objective aspects of economic reality. Lachmann's critics who are disturbed with the nihilistic overtones of Radical Subjectivism have argued, in effect, that Lachmann has pushed too far.⁽⁴⁾ Consider, for instance, subjectivism in monetary theory, an issue that Lachmann addresses in his Chapter 5 by chronicling what he sees as a "thrust towards subjectivism" over the last three-quarters of a century. The reader may suspect that Lachmann has taken Hayek too literally. Do we really want to measure progress in economics by the extent to which the subjectivist elements are readily detectable?
        Beginning his account with the publication of Irving Fisher's Purchasing Power of Money, Lachmann identifies the major steps, as he sees them, away from functionalism and towards subjectivism. The success of Fisher's book is attributed to his combining a truism (the equation of exchange: MV = PT) with an empirical generalization (the near constancy of V, the velocity of money). From these elements follow the proposition that PT, the number of transactions multiplied by the average price of the goods transacted, is proportional to M, the quantity of money in circulation.
        Lachmann leaves out of account Mises' Theory of Money and Credit because it was not published in English. He identifies the next step in the subjectivization of monetary theory as a 1917 article by A. C. Pigou in which both sides of the equation of exchange are divided by V. The reciprocal of the velocity of money is rechristened k in what was to become known as the "Cambridge equation." The Cambridge k focused attention on the amount of money that people choose to hold as a proportion of their incomes rather than on the rate at which money circulates through the economy. Most historians of monetary thought believe that the difference between the Fisher equation and the Pigou equation, especially when judged in the light of the textual material that accompanied each, is one of form rather than substance. The formal difference was put in proper perspective by a quip attributed to D. H. Robertson: "k is money sitting; V is money on the wing." But Lachmann sees significance in the reformulation: "The introduction of k connotes the infusion of a dose of subjectivism into a set of relationships which did not seem to offer much scope for acts of human minds" (p. 91).
        Credit for the next advancement goes to John Maynard Keynes, who insisted upon dividing the total demand for money into several separate demands each identified with some specific purpose. The use of the word purpose in this context is enough to win kudos from Lachmann (p. 92). The question of whether one of the alleged purposes, the so-called speculative demand for money, makes sense, and the question of whether it makes sense to treat different reasons for demanding money as separate and additive demands for money, are downplayed. We should not complain too loudly, the reader is led to believe, if the road to a radical subjectivist monetary theory contain some rocky stretches.
        While John R. Hicks is cited for having given explicit and articulate expression to monetary subjectivism (p. 94), the highwater mark in Keynesian subjectivism came in Keynes' 1937 article in which he attempted to explain what his 1936 book, The General Theory, actually meant. Keynes explains, in effect, that the demand for money in the present derives from the uncertainty of our knowledge about the future. And the kind of uncertainty that Keynes is referring to is the kind that Lachmann calls radical uncertainty and associates with radical subjectivism. According to Keynes, as quoted by Lachmann, "We simply do not know" (p. 99).
        But as Lachmann recognizes, the Keynesian refrain, "we simply do not know," is frequently invoked when not knowing serves some polemical purpose (pp. 98 and 100). Keynes' views on private spending and public spending are illustrative. We cannot leave investment decisions to businessmen in the private sector because they do not know enough about the future to make their "parting with liquidity" worthwhile. By contrast, when government spending on public works is under consideration, the debilitating uncertainty goes into remission. And the question of whether the spending is worthwhile somehow becomes irrelevant. More tellingly, Keynes has great confidence in his own "knowledge" that total output in the economy will rise to a certain multiple of the initial government spending.
        Finally, and with some uneasiness, Lachmann extends subjectivist honors to Milton Friedman for his reformulation of the quantity theory. Friedman shifted the focus of analysis from the supply of money to the demand for money; he included an "almost embarrassing variety of expectations" (p. 102) in his demand-for-money equation; and he (easily) outdid Keynes by consistently accounting for the effects of the expectational variables. Lachmann concludes his discussion of Friedman's "thrust towards subjectivism" in puzzlement. "For reasons not for us to fathom Professor Friedman chose to don the mantle of a subjectivist. For reasons more readily understood he decided to borrow one from the Keynesian wardrobe. Embarrassing as it is, we cannot fail to notice how ill the garment fits him" (p. 104).
        The reader may suspect that Lachmann's dogged attention to subjectivist elements in monetary theory has led him to an untenable view of Friedman's Monetarism. Friedman included expectational variables in his demand-for-money function only to show that when these expectations are proxied by actual values from the past and incorporated into an appropriate lag structure, the demand for money in the present is almost wholly accounted for. That is, the Monetarists have sought to show that the demand for money is a stable function of a relatively small number of current and past variables. Further, the reason that Monetarists focus on demand and its stability properties is precisely to establish the importance of supply: If demand is stable, then changes in the price level—or in the rate of inflation—are to be wholly attributed to changes in the money supply. The empirical demonstrations that "inflation is always and everywhere a monetary phenomenon," which are based on money-supply and price-level data from many countries over many decades, reflect little in the way of Keynesian or Lachmannian subjectivism.
        Curiously, the Austrian monetary theorists are all but left out of account in Lachmann's chapter on money. And except for a single hint (p. 105), there is no mention of a central bank or recognition that bank policy may seriously impair the private sector's ability to make monetary calculations and to equilibrate the supply and demand for money. Lachmann simply reaffirms that the Austrian treatment of expectations in the context of capital theory and the business cycle has never had much plausibility to him. He references his 1943 article in which he challenged Mises on the basis of what would now be called a rational-expectations argument. The reader might justifiably wonder if Lachmann hasn't taken a cue from Keynes and selectively ignored the knowledge problem when doing so squared with his own vision of the market economy. Investors, evidently, have no problem in anticipating the policy moves of the central bank and offsetting the effects of those policies by appropriately altering their own investment decisions. It is interesting to note that a radical subjectivist anticipated by several decades the extremes of modern formalism that now characterize the New Classicism.

The Question of Equilibrating Tendencies
Developments in economic science from Adam Smith's invisible hand to Friedrich Hayek's spontaneous order have provided increased assurance that market forces are equilibrating forces and therefore that there is a distinct tendency in market economies toward the coordination of the individual plans of market participants. But Lachmann calls into question all such claims that a tendency toward equilibrium exists (pp. 14ff. and passim). Because of the subjectivity of the knowledge which is acquired as the market process unfolds, and of expectations, which are based upon but are not uniquely determined by this changing knowledge, no tendency toward equilibrium can be established.
        The issue of the existence or the effectiveness of equilibrating tendencies in a market economy is complicated by the multiplicity of meanings of the term "equilibrium." Can we count on markets to create and maintain some degree of intertemporal coordination among the economic activities of a multitude of market participants? This is the question that concerns Lachmann. Two particular conceptions of equilibrium relevant to this question must be distinguished: partial equilibrium and general equilibrium. Under normal circumstances, approximate equality between the amount of a particular good supplied and the amount demanded is maintained by appropriate pricing responses to incipient surpluses and shortages. This Marshallian notion of partial equilibrium, described by Lachmann as the result of "intra-market processes" (p. 6), is not in serious dispute.
        But the question of a tendency toward a general equilibrium is a different matter. The issue is not whether the economy is actually in an equilibrium or whether it will eventually achieve such a state. There are no economists who believe that general equilibrium is actually realized—except for the New Classicists, who are willing to redefine equilibrium such that it squares with any imaginable state of affairs. Lachmann is concerned, in effect, that Marshall's partial equilibrium may not legitimately be extended, or generalized, to apply to the market economy as a whole. The interconnectedness of markets coupled with other considerations warns against such an extension. Market forces spill over from one market to another; intertemporal market forces are weak or nonexistent; each market participant must form his own expectations in a cloud of radical uncertainty. Lachmann finds it "hard to see why, in a world in which thousands of markets are connected by links however tenuous, inter-market processes should be thought necessarily to converge on positions of equilibrium" (p. 9). This agnosticism, which permeates much of Lachmann's writings, reinforces his preference for Shackelian kaleidics over Newtonian mechanics. In a kaleidic world, one pattern of prices gives way to another, but there can be no claim that a given pattern is any closer to a general equilibrium, or represents any higher degree of coordination, than the one that preceded it.
        Most market-oriented economists, whether Austrian or Neo-Classical, are willing to rely on the system of profits and losses to produce a tendency toward equilibrium. Entrepreneurs who can see most clearly through the cloud of uncertainty earn profits, which, in turn, increase their command over productive resources; entrepreneurs who see least clearly make losses, which decrease their command over productive resources. These aspects of the market process are the basis of my own contribution to Lachmann's birthday volume. As hinted in my title, "From Lachmann to Lucas: On Institutions, Expectations, and Equilibrium tendencies," I positioned Lachmann the radical subjectivist and (Robert) Lucas the New Classicist at polar extremes on a spectrum of views. I dubbed Lachmann's position "Equilibrium Never," and Lucas' position "Equilibrium Always," and then I opted for the middle-ground, somewhere between clockwork and kaleidoscope: the market exhibits "Equilibrating Tendencies." Drawing on Mises and Hayek, I argued that entrepreneurship coupled with profits and losses conferred by the market would anchor market activities to the "underlying economic realities."
        In subsequent correspondence, Lachmann indicated, in effect, that he was not persuaded to move any distance from his polar position. He further indicated that there can be no such thing, in his view, as "underlying economic realities" that form a basis for coordination—not, at least, in our world, a world of ceaseless change. (I could almost see him shaking his kaleidoscope at me as he spoke.) But rather than to carry on the debate in private correspondence, he referred me to another contribution to the birthday volume, one by Jan Kregel, a Post Keynesian who sought to put "underlying economic realities" in their place. And as it turns out, Kregel's essay, "Conceptions of Equilibrium: The Logic of Choice and the Logic of Production," is worthy of some attention.
        Kregel discusses several conceptions of equilibrium whose differences hinge on the different roles played by subjective factors and objective factors. But because of the nature of his subjective/objective distinction, his arguments invite misinterpretation. So-called objective factors, for instance, include not only technology but also input costs and relative rates of return. Those who have learned their value theory from Menger and Mises will find Kregel's distinction puzzling. It may be helpful, then, to recast his argument using the more conventional, and more modern, Neo-Classical terminology.
        Essential to standard Neo-Classical theory is the notion that each firm in the economy maximizes its own profits within a set of given constraints. For the economy taken as a whole, the given constraints include consumer tastes and preferences, the distribution of wealth, resource availabilities, and technology. These are the factors that I referred to above as the "underlying economic realities." In Kregel's terminology an equilibrium in which these factors form the binding constraints is logically implicit in the constraints themselves. Such an equilibrium is said to be based exclusively on objective data.
        This objectively defined equilibrium abstracts from any problems or frictions in the market process that supposedly performs the equilibration. But according to Kregel and Lachmann, subjective expectations, which are inherent in the market process, rob the objective data of all their significance. In fact, the very existence of the objective data is called into question. Consumer demands are governed in part by consumer incomes, which are determined by the decisions of entrepreneurs, which, in turn, are based upon expectations about consumer demands. The reasoning may be circular, but it captures a critical circularity that characterizes the market process. If the expectations of entrepreneurs turn out to be the binding constraint, the objective data have no opportunity to reveal themselves, and any equilibrium actually achieved is one based exclusively on the subjective data.
        The emphasis on the role of expectations to the virtual exclusion of the more fundamental constraints is what gives Kregel's Post Keynesianism and Lachmann's Radical Subjectivism their kaleidic nature. Expectations can and do change in ways that we have no way of predicting or even fully explaining. We can only watch the resulting changes in the pattern of prices and wonder why others associate those patterns with an "underlying economic reality." A partial explanation of such changes, however, comes in the form of a path-dependency effect, the sine qua non of Lachmann's market process. 

The Significance of the Path-Dependency Effect
The dynamic properties of Lachmann's world depend in large part upon the dominance of a certain path-dependency effect. This effect gets brief mention in the first chapter (pp. 4-5) and underlies much of Lachmann's theorizing. In the broadest terms, if the specifics of a general equilibrium position depend upon the particular sequence in which the market process eats away at disequilibrium, a path-dependency effect is said to exist. If the path-dependency effect is sufficiently large, it may be misleading if not meaningless to speak of an equilibrating tendency. Each step in the market process significantly changes the equilibirum toward which the process is supposedly tending thus guaranteeing that the next step will be in some other direction.
        In modern Neo-Classical theory, path-dependency effects usually take the form of income or wealth effects. Trading at disequilibrium prices can shift wealth from one market participant to another. While the very same trading helps to bring prices to their equilibrium levels, the equilibrium itself is determined by the preferences of each market participant weighted by his ability to influence market outcomes, that is, by his wealth. To avoid analytical messiness Leon Walras, the father of modern general equilibrium theory, assumed that there is no trading at false (i.e. disequilibrium) prices.
        In Lachmann's analysis, the path dependency takes the form of changing knowledge rather than changing wealth. Expectations are necessarily divergent: it takes both bulls and bears to clear the asset markets. Even if we conceive of the market process as tending toward some equilibrium, we must recognize that as the process begins to unfold, asset holders will acquire additional informations, which will cause their expectations to change. In turn, the changing expectations will have an effect, possibly a drastic effect, on the equilibrium to which the market process is tending. Discoordination, as implied by the conflicting views of bulls and bears, does not give way to coordination but only to some alternate pattern of discoordination. The Lachmannian bull (as well as the bear), we are led to believe, is a bull in a china shop.

Austrianism and Keynesianism in Perspective
"It is a fact," according to Lachmann, "that the neoclassical orthodoxy has, to this day, failed to grasp the consequences of the volatility of asset markets" (p. 42). Attention to path-dependency effects in the form of highly volatile asset markets gives Lachmann's analysis a distinct and overt Keynesian flavor. In Keynes' vision of the market process the marginal efficiency of capital, which reflects profit expectations, shifts about with waves of optimism and pessimism. Businessmen are moved by "animal spirits," to use Keynes' own colorful language, to undertake investment projects. When riled by the spirits, investors create a prosperous economy; when the spirits are on the wane, the demand for capital assets falls, possibly triggering an economic collapse.
        Keynes goes so far as to lament the emergence of organized capital markets. Without such markets, changing expectations about the profitability of different capital combinations, whether brought about by the waxing and waning of the animal spirits or the acquisition of new information, could not disturb an otherwise orderly market process. Keynes own grasp of the consequences of the volatility of asset markets becomes clear when he ponders possible remedies. "The spectacle of modern investment markets has sometimes moved me toward the conclusion that to make the purchase of an investment indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils."⁽⁵⁾
        While Lachmann abstains from offering such a Draconian prescription, his diagnosis of the problem is much the same as Keynes'. The invisible hand of Adam Smith works tolerably well in a exchange economy. With such a steady hand on the kaleidoscope, the particular pattern of glass and prices is more interesting than the fact that the kaleidoscope might be bumped. But with the emergence of organized capital markets, the invisible hand becomes palsied. In Keynesian terms, speculation dominates enterprise; in Lachmannian terms, the shaking of the kaleidoscope renders any particular pattern of glass and of prices irrelevant.
        Grasping what Lachmann is saying is easier than understanding why he is saying it. It is coming to be recognized, especially in Austrian circles, that Keynes' view of the market process derives from the fact that Keynes had no theory of capital. Intertemporal market forces that work to coordinate savings with investment and to tailor the economy's production activities to match intertemporal consumption preferences are not at work in the General Theory. The conclusion that market economies are inherently unstable follows trivially.
        But the Austrians do have a theory of capital. In his Capital and Interest, Eugen von Böhm Bawerk identified the critical intertemporal relationships within the economy's structure of production; Hayek in his Pure Theory of Capital identified the corresponding relative-price relationships and showed how the market process could achieve intertemporal coordination. Lachmann's own Capital and Its Structure gave us a healthy appreciation for the difficulties involved in market directed intertemporal coordination, but it did not reduce our confidence in the market's performance—especially when compared to the performance of possible alternative institutions.
        It is true that neither Keynes nor Lachmann can see these market mechanisms by peering through a kaleidoscope. But for the Austrians, this just means that the scope of analysis is too narrow. If movements in asset prices are not understandable within the context of a single period, we should broaden the analysis to include a sequence of periods. Only by taking into account the intertemporal relationships within the multi-period capital structure can we make such price movements intelligible. We need not claim that the market process in a highly industrialized market economy is smooth and trouble free. The kaleidoscope does on occasion get bumped. But based on our reading of Mises and Hayek, we can suggest that the bumping is done not by bulls and bears but by the central bank—a factor that Lachmann now chooses to downplay.
        Lachmann's readers have long valued his early contribution to the theory of capital. His Capital and Its Structure, published over thirty years ago, provided a satisfying account of the heterogeneity of the economy's capital stock and of the network of interrelationships that, taken together, govern the market value of each of the elements that make up the capital structure. While his readers may wonder why this thoroughly Austrian vision of the market economy did not serve as the point of departure for his Market as an Economic Process, they will appreciate this most recent book's demonstration—however inadvertent—of the importance of a well developed capital theory in theorizing about the market process. 

Roger W. Garrison is Assistant Professor of Economics at Auburn University, Auburn, AL 36849. He would like to thank Roger Koppl, Sven Thommesen, and Leland Yeager for their helpful comments on an earlier draft of this article.

1. Lachmann's South Royalton lectures, along with the lectures of Israel M. Kirzner and Murray N. Rothbard, are published in Edwin G. Dolan, ed., The Foundations of Modern Austrian Economics (Kansas City: Sheed and Ward, Inc., 1976). For a more complete biographical treatment of Lachmann's long and scholarly career, see Walter E. Grinder's introduction, "In Pursuit of a Subjectivist Paradigm," in Ludwig M. Lachmann, Capital, Expectations, and the Market Process (Kansas City: Sheed, Andrews, and McMeel, Inc., 1977), pp 3-24.

2. Lachmann took the quoted passage from G. L. S. Shackle, Epis temics and Economics (Cambridge: Cambridge Universtiy Press, 1972), p. 76. This imagery also underlies Shackle's Keynesian Kaleidics (Edinburgh: Edinburgh University Press, 1974).

3. See Ludwig M. Lachmann, "From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society," Journal of Economic Literature, vol. 14, no. 2 (March 1976), pp. 54-62.

4. See Leland B. Yeager, "Why Subjectivism?," The Review of Austrian Economics, vol. 1, 1987, pp. 5-31.

5. John Maynard Keynes, The General Theory of Employment, Interest and Money (London: Macmillan, 1936), p. 160.