What I learned about Austrian Economics
Economics might seem like a settled science to anyone who follows the news, or perhaps takes an interest in government budget announcements. Economic policy appears to consist of tinkering with a machine comprised of distinct parts such as monetary and fiscal policy, tariffs, cash rates, and taxation. It is generally understood to be a mature and scientific discipline, the eventual result of iterations and adaptions to historical events and challenges like the Great Depression and 2008 credit crisis.
But the complex discipline now known as economics (and at one point ‘political economy’) is based on theories and assumptions not universally agreed upon by economists. One school of alternative economic thought is Austrian economics, which sits among other ‘heterodox’ ideas such as post-Keynesianism and Marxism1.
To better understand the key ideas and merits of Austrian economics, I turned to a An Introduction to Austrian Economics by Thomas C. Taylor.
Background
Carl Menger, an Austrian economist, is considered to be the founder of the Austrian school. His most-cited work is Principles of Economics, published in 1871. Menger was a key figure in the ‘marginal revolution’2, which occurred around the time that economics emerged as a distinct academic discipline (and which contributed to this process). Menger disputed the ideas of the German ‘historical school’ and their empirical approach to economics. Other key prominent figures and advocates for the school include Eugen von Böhm-Bawerk, Ludwig von Mises, Friedrich von Hayek, Henry Hazlitt, and Murray Rothbard.
Austrian economic ideas have been influential in shaping modern economic theory, in particular marginal utility, opportunity cost, and the criticism of socialism (which, in the absence of market prices, is thought to lack a basis of economic calculation to allocate scarce resources efficiently). It embraces individualism and bases its analysis on a capitalistic market economy. Its differences to other economic schools of thought include its reliance on theory rather than empiricism, and a rejection of the type mathematical analysis and modelling typical of the discipline as taught today.
It retains a strong following and online presence, particularly among libertarians, classical liberals, and others who oppose government intervention in the economy.
Key concepts and ideas
The subjective theory of value
The Austrians believe that economic value is subjective and a matter of individual preference, and that economic goods do not have intrinsic or objective value in an economy based on market exchanges. Money prices, which move up and down because of variations in consumer preferences and supply, do not reflect the value of a good or service.
“There is no such thing as an equal exchange. At the point of exchange, both buyer and seller consider themselves to be better off as a result of the exchange.” (Taylor, 1980, p. 49)
The notion of “better off” is subjective and based on expectations of satisfaction derived from goods obtained through exchange. Such exchanges only occur when there are differences in the subjective valuations of goods by two parties; people want and prefer different things at different times.
In a related argument, the Austrians criticise the theoretical concept of ‘economic man’3 for not considering subjective value (and, by extension, the human nature of economic decisions).
“The failure to consider the subjective orientation led to the unfortunate notion of the ‘economic man’, which depicted every participant in the economy as relentlessly seeking at every turn to maximise his monetary position. This idea is unrealistic because what people actually seek in every action is a maximum psychic or subjective profit.” (Taylor, 1980, p. 49)
While they believe the idea is not realistic because it fails to consider individual preferences and non-monetary factors, it is true that in the absence of such mitigating factors people seek to maximise their financial or economic gain. Some of these factors might include community, common beliefs and culture, or close personal relationships; in a society where these are lacking, it seems clear that people will seek to exploit each other for economic gain where possible, being constrained only by law or, perhaps, custom. As Charles Dickens, in his novel Hard Times, characterised the prevailing school of economic thought:
“…his only reasonable transaction in that commodity would have been to buy it for as little as he could possibly give, and sell it for as much as he could possibly get; it having been clearly ascertained by philosophers that in this is comprised the whole duty of man—not a part of man’s duty, but the whole.” (Dickens, Hard Times)
The Principle of Marginal Utility
The Principle of Marginal Utility is important in understanding subjective value and prices. A common example used to demonstrate the principle is the difference in market prices of water (of which there is an abundant supply) and diamonds (of which there is a limited supply). It is clear that water is more valuable than diamonds, but the market value of water is lower than diamonds. Why is this? This perplexing question is sometimes referred to as the ‘paradox of value’, having been posed by Adam Smith in his Wealth of Nations (and others beside him):
“Nothing is more useful than water: but it will purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it.” (Smith, 1776)
The Austrian response is, firstly, that the valuation by each individual person is made based upon a definite quantity of goods (not all goods). And once they have enough of a particular good - water, for example - each additional unit of that good is less valuable to them. Goods are prioritised by people based on their most urgent needs, and once those needs are satisfied, acquiring further units becomes less important; if I have enough water for my most pressing needs, additional units beyond this will be devoted to more ‘marginal’, or less important uses. So, because of the abundance of water supply, additional units of water (put to less and less important uses) can be less valuable to an individual than a quantity of diamonds (when the diamonds are put to some more immediately valuable use).
A second example from Böhm-Bawerk involves a farmer who owns five bags of grain. He employs the each bag in order from the most important to least important uses. The fifth bag of grain is surplus to his needs and is put to a more marginal use. The value of each sack (or unit) of grain is equal to the satisfaction given up by its loss; in the case of the last bag of grain, its value is relatively low.
The principle of marginal utility can be observed through market prices in supply and demand theory. On the demand side, a consumer is willing to pay more for initial units of a good (when demand is highest) than subsequent quantities of a good. This is described as the ‘diminishing marginal utility’ of goods – each good is less and less useful beyond the need which motivated their purchase. The idea is illustrated in a demand curve, which slopes down to the right; this shows that demand decreases as quantity increases (shown by a decrease in price).
Time preference and interest
People generally prefer goods now rather than in the future; this tendency is called ‘time preference’. It follows that future monetary values should be discounted to their present values (using a ‘discount’ rate) because people want to know what something is worth to them in the present. Goods to be received x periods into the future are worth less than they would be if they were received today.
The Austrians believe that interest can be explained entirely by decisions based on individual time-preferences; part of their broader theory of the business cycle. For example, in the absence of government artificially increasing credit and the money supply, an increase in genuine savings available for investment reflects the choices of individual consumers to save, or postpone purchases of consumer goods. Where the government artificially increases the money supply, it can cause the rate of interest to fall below its ‘natural’ rate4. This artificial rate decrease makes borrowing cheaper and might send a false signal to producers that they should invest in goods that require longer production cycles. Producers might then allocate their resources inefficiently even though consumers actually prefer to spend now5. A resulting lack of coordination between resources and consumer preferences can ultimately lead to economic downturn or even recession.
This idea of time preference is also referred to as the ‘time value of money’ in finance theory and is recognised in the following equations:
Present value = FV / [ 1 + (r / n)] (n x t) 6
Future value = PV x [ 1 + (r / n)] (n x t)
In many large businesses, ‘discounted cash flow analysis’ (DCF) is performed using a ‘weighted average cost of capital’ (WACC) as the ‘discount’ or ‘hurdle’ rate.
A related concept is opportunity cost, which is the value of an alternative opportunity foregone in an investment or resource-allocation decision. For example, I might invest money now and earn compounding interest. If I chose not to invest it, I would forego the interest income.
Human action
Mises wrote that: “The market process is entirely the result of human actions. Every market phenomenon can be traced back to definite choices of the members of the market society.”
Economic theory after Adam Smith and other intellectuals of the ‘classical era’ evolved towards a more ‘scientific’ approach, and it was expected that fundamental rules and laws could be discovered as the basis for the discipline, similar to those of physics. The Austrian school argues that individual decisions are the basis of economic activity (which, as mentioned earlier, are not entirely ‘rational’ from the perspective of maximising financial gain; non-financial things also matter to us). It is thought that individual decisions can be deduced, or predicted, in response to certain economic phenomena in a law-like way (such as resource scarcity and supply and demand)7.
Qualitative orientation: a rejection of the mathematical approach
Empiricism and quantitative analysis are prioritised in the dominant ‘neoclassical’ ideas, perhaps best demonstrated by the importance placed upon ‘econometrics’, a discipline which will be familiar to any economics undergraduate. Econometrics is a mathematical form of analysis, which uses statistics to understand relationships between economic variables and provide rigour to economic theory.
Neoclassical economics relies heavily on abstract concepts and modelling, while the Austrian school believe that economics is a human phenomenon, consisting of individual decisions and behaviours that arise organically in a capitalistic market economy. For them, ‘human action’ is at the core of economics, and these actions cannot be reduced to, or understood properly by, mathematical modelling alone. Taylor describes the “bewildering artificiality of econometrics”, “unrealistic textbook models”, and “sad record of predictions by ‘professional economists’” as evidence of neoclassical flaws.
The economic calculation and the necessity of market prices
“Economic calculation is the fundamental issue in the comprehension of all problems called economic” (Mises in Taylor, 1980, p. 34)
A critical issue in economics is the efficient allocation of resources and the information needed for individual producers and consumers to coordinate and make decisions that help to achieve this goal. How do we best satisfy needs and wants with scarce resources? In a complex market economy, individuals require signals to make resource allocation decisions and coordinate actions; the primary signal is market prices. People possess only imperfect and partial knowledge with which to make decisions, and as such there must be a coordinating factor to help them. Prices ensure that resources are allocated to their most important uses (and away from ‘marginal’ uses).
Market prices for individual consumer goods move towards a point where demand and supply are equal: a state of ‘equilibrium’. Prices above or below equilibrium will influence supplier or consumer choices: if prices are too high, demand decreases and so does quantity supplied; if quantity supplied is too low, prices are bid up to encourage greater supply. This process is taken as evidence that the price system is necessary to coordinate the decisions of market participants.
In a related argument, Mises argued that socialism cannot work because it lacks a basis for economic calculation; that is, market prices. Resource allocation decisions would be inefficient under such a planned system.
Capital and income
Mises defined capital as the value of net assets (all asset minus all liabilities) used in a “definite business unit”. Net assets may be tangible (such as plant and equipment) and intangible (such as cash or receivables). When net assets for a business are increased during the course of its activities, income is created; this income, or excess value created, is the amount that can be consumed without reducing capital: capital can be consumed (reduced), maintained, or accumulated. If only the income is utilised, capital is maintained; if less than the income amount is utilised, capital is accumulated; if an amount of capital greater than income is utilised, capital is consumed/reduced.
This is equivalent to saying, in accounting terms, that the change in retained earnings (one part of a business’s owner’s equity), is the profit or loss for the business operations. This profit or loss is vital to planning future operations (that is, where and how to direct its resources). The famous ‘accounting equation’ is:
Assets – liabilities = Owners Equity (A - L = OE)
Inflation and the Business Trade Cycle
The Austrians believe that inflation (a general rise in prices) is caused by an expansion of the money supply by government, and that such policies reduce consumer purchasing power:
“The printing of additional Federal Reserve notes and the creation of new demand deposits in connection with the monetisation of federal debt along with fractional reserve banking and member bank borrowing (discounting) from Federal Reserve banks constitute the basic mechanisms of inflation of the money supply. These are all forms of credit expansion…” (Taylor, 1980, p. 91)
There is necessarily a lag between the expansion of credit by a government and banking system and an increase in interest rates (the addition of a “price premium”) to compensate savers for increased prices. Continued increases in the money supply keep interest rates artificially lower than those adequate to cover the “discount, entrepreneurial, and inflation elements” (or the ‘natural rate’). This effect on interest rates distorts the signal used by entrepreneurs to allocate resources to either capital of consumer goods; it is not possible to tell whether the additional funds are from real savings or artificially created.
As described earlier, this can cause a misallocation of resources and the production of capital goods (longer production cycle) rather than consumer goods (shorter production cycle). One consequence is a short-lived credit expansion or ‘boom’. The correction to this misallocation is a recession or depression. The longer a credit expansion lasts, the worse the effect: “the boom must stop once the credit expansion is terminated”.
This process is one example of how government intervention can disrupt normal market processes. The problem of inflation lies not just in reducing the value of money and purchasing power, but also in distorting the market process and creating cyclical swings or recessions.
Entrepreneurs and profit
The role of entrepreneurs is to “capitalise on opportunities to invest…” at a profit. Profits are an indication that resources have been directed towards valuable uses (ones that best suit the wishes of consumers). Entrepreneurs search for situations where resources are misallocated and, because of this, play a vital role in a market economy: profits and losses result in corrective actions to resource misallocation.
“It is the ceaseless search on the part of entrepreneurs for profitable opportunities that leads to the allocation of scarce resources to their most desirable productive usages.” (Taylor, 1980)
Profit is not, as is stated in traditional theories, the reward for taking risk, nor the natural income for capital (the income for labour is wages while income for land is rent). Profits for producers arise where producers are able to correctly anticipate consumer prices that are higher than the productive factors they employed; it is a process of arbitrage, where producers successfully manage uncertainty around factors such as consumer demand (and the subjective valuations consumers place upon goods). Taylor writes that profits arise only from successful risk-taking, not merely as compensation for taking risks.
What did I learn about Austrian economics?
Austrian ideas operate under the assumption of a modern, capitalistic market economic based upon the division and specialisation of labour.
The school is strongly tied to ideas of individual freedom and choice and opposes collectivist ideas such as socialism (and government intervention in the economy generally). Henry Hazlitt warned against the ‘unintended consequences’ of government policies in his well-known book Economics in One Lesson.
Today, Austrian economics sits outside of the mainstream, with key elements such as its theory of the business cycle and rejection of mathematical modelling and empiricism going against the academic consensus. It is perhaps unavoidable, in a society which increasingly resembles an economic model itself 8, that the rejection of mathematical modelling and empiricism is unwelcome. The ideas are certainly worth exploring to get a more complete picture of economic theory.
Want to learn more about economics with like-minded people?
Join Men’s School to access group discussions, a private chat group, forums, learning programme, and courses.
References
Taylor, Thomas C., 1980, An Introduction to Austrian Economics, Cato Institute.
1 Other lesser-known approaches include distributism and localism.
2 The principle of marginal utility is a theory relating to the value of goods and services with respect to their lesser or ‘marginal’ uses. It is discussed in this essay in the section ‘The Principle of Marginal Utility’.
3 The term homo economicus (‘economic man’) describes the rationality of man in relation to his economic decisions. If human beings are a certain way, it was and is thought, then laws might be discovered as the basis of a system that produces greater wealth and prosperity for all. Perfect rationality would require people always to act in ways that maximise ‘utility’, or benefit, when faced with economic decisions such as the purchase of a good or service. From our article The Human Nature of Economics
4 The rate that reflects the genuine time preferences of consumers and that helps coordinate savings and investment.
5 In terms of the calculation involved, the higher the rate of interest, the more monetary values are discounted (reduced) in present value terms, which means that the benefit from goods completed further into the future are worth less now; this incentivises producers to make consumer goods (with a shorter production cycle than capital goods) rather than capital goods (which take longer to make).
6 PV = present value; FV = future value; r = interest rate; t = time (years); n = Number of compounding periods per year
7 It is perhaps trivial today to observe that people will generally respond in predictable ways to, what amount to, coercive measures and policies undertaken by ever-more centralised authorities in highly-controlled and partly-planned economies.
8 With government control of variables such as interest rates, taxation, and credit creation/increase in the money supply that influence or, really, determine consumer choices in order to create desired outcomes (such as increased demand, reduced unemployment, or lower inflation).
Comments