Austrian School

The Austrian School of Economics derives its name from its Austrian founders and early supporters, including Carl Menger, Eugen von Böhm-Bawerk and Ludwig von Mises. Other significant economists include Henry Hazlitt, Murray Rothbard and Nobel Laureate Friedrich Hayek. Current research is represented by, among many others, scholars from the Ludwig von Mises Institute.

This school emphasizes the spontaneous organizing power of the price mechanism and holds that the complexity of subjective human choices makes mathematical modeling of the evolving market extremely difficult (or impossible). Its proponents tend to advocate a laissez faire approach to the economy and the strict enforcement of voluntary contractual agreements between economic agents, but otherwise hold that the smallest imposition of coercive force (especially government-imposed force) on commercial transactions is the most effective way to secure long-run economic stability and wellbeing.

In particular, they argue for an extremely limited role for government and the smallest possible amount of government intervention in the economy, especially in the area of money production (advocating instead a commodity money system and free banking - a system not dominated or controlled by government or a central bank).

History

While the Austrian School of Economics has connections as far as 15th century, it began with notable 19th century economists of Austrian origin. Austrian economists can now come from anywhere in the world, and the term describes a particular school of economic thought rather than the nationality of its practitioners.

Pre-Austrian Economists

With noted contributions of earlier thinkers, like Nicole Oresme, the Austrian school traces its roots to the followers of St. Thomas Aquinas, writing and teaching at the University of Salamanca in Spain.

These Late Scholastics established the first modern economic theories and argued, in current terms, for free trade and property rights. Over the course of several generations, they discovered and explained the laws of supply and demand, the cause of inflation, the operation of foreign exchange rates, and the subjective nature of economic value. They were advocates of property rights and the freedom to contract and trade. "Austrians share the scholastic belief that there is no such thing as an economic science dealing with autonomous variables. Economic problems are aspects of larger social phenomena; and it is most expedient to deal with them as such, rather than to analyze them in some twisted separation."

The first general treatise on economics, Essay on the Nature of Commerce, was written in 1730 by Richard Cantillon, a man schooled in the scholastic tradition. Born in Ireland, he emigrated to France. He saw economics as an independent area of investigation, and explained the formation of prices using the "thought experiment." He understood the market as an entrepreneurial process, and held to an Austrian theory of money creation: that it enters the economy in a step-by-step fashion, disrupting prices along the way.

Cantillon was followed by Anne Robert Jacques Turgot, the pro-market French aristocrat and finance minister under the ancien regime, one of the Physiocrats. His economic writings were few but profound. His paper "Value and Money" spelled out the origins of money, and the nature of economic choice: that it reflects the subjective rankings of an individual's preferences. Turgot solved the famous diamond-water paradox that baffled later classical economists, articulated the law of diminishing returns, and criticized usury laws (a sticking point with the Late Scholastics). He favored a classical liberal approach to economic policy, recommending a repeal of all special privileges granted to government-connected industries.

Turgot was the intellectual father of a long line of great French economists of the eighteenth and nineteenth century, most prominently Jean-Baptiste Say and Claude-Frederic Bastiat. Say was the first economist to think deeply about economic method. He realized that economics is not about the amassing of data, but rather about the verbal elucidation of universal facts (for example, wants are unlimited, means are scarce) and their logical implications.

Say discovered the productivity theory of resource pricing, the role of capital in the division of labor, and "Say's Law": there can never be sustained "overproduction" or "underconsumption" on the free market if prices are allowed to adjust. He was a defender of laissez-faire and the industrial revolution, as was Bastiat. As a free-market journalist, Bastiat also argued that nonmaterial services are subject to the same economic laws as material goods. In one of his many economic allegories, Bastiat spelled out the "broken-window fallacy" later popularized by Henry Hazlitt.

Despite the theoretical sophistication of this developing pre-Austrian tradition, the British school of the late eighteenth and early nineteenth centuries won the day, mostly for political reasons. This British tradition (based on the objective-cost and labor-productivity theory of value) ultimately led to the rise of the Marxist doctrine of capitalist exploitation.

The First Austrians

The dominant British tradition received its first serious challenge in many years when Carl Menger's Principles of Economics (text) was published in 1871. Menger, the founder of the Austrian School proper, resurrected the Scholastic-French approach to economics, and put it on firmer ground.

Together with the contemporaneous writings of Leon Walras and Stanley Jevons, Menger spelled out the subjective basis of economic value, and fully explained, for the first time, the theory of marginal utility (the greater the number of units of a good that an individual possesses, the less he will value any given unit). In addition, Menger showed how money originates in a free market when the most marketable commodity is desired, not for consumption, but for use in trading for other goods.

Menger's book was a pillar of the "marginalist revolution" in the history of economic science. When Mises said it "made an economist" out of him, he was not only referring to Menger's theory of money and prices, but also his approach to the discipline itself. Like his predecessors in the tradition, Menger was a classical liberal and methodological individualist, viewing economics as the science of individual choice. His Investigations, which came out twelve years later, battled the German Historical School, which rejected theory and saw economics as the accumulation of data in service of the state. They took great exception to his defense of "theory" and gave the work of Menger and his followers the derogatory name "Austrian school" because of their faculty positions at the University of Vienna. The term stuck.

As professor of economics at the University of Vienna, and then tutor to the young but ill-fated Crown Prince Rudolf of the House of Habsburg, Menger restored economics as the science of human action based on deductive logic, and prepared the way for later theorists to counter the influence of socialist thought. Indeed, his student Friederich von Wieser strongly influenced Friedrich von Hayek's later writings. Menger's work remains an excellent introduction to the economic way of thinking.

Menger's admirer and follower at the University of Innsbruck, Eugen von Böhm-Bawerk, took Menger's exposition, reformulated it, and applied it to a host of new problems involving value, price, capital, and interest. His History and Critique of Interest Theories (pdf), appearing in 1884, is a sweeping account of fallacies in the history of thought and a firm defense of the idea that the interest rate is not an artificial construct but an inherent part of the market. It reflects the universal fact of "time preference," the tendency of people to prefer satisfaction of wants sooner rather than later (a theory later expanded and defended by Frank Fetter).

Böhm-Bawerk's Positive Theory of Capital (pdf) demonstrated that the normal rate of business profit is the interest rate. Capitalists save money, pay laborers, and wait until the final product is sold to receive profit. In addition, he demonstrated that capital is not homogeneous but an intricate and diverse structure that has a time dimension. A growing economy is not just a consequence of increased capital investment, but also of longer and longer processes of production.

Böhm-Bawerk engaged in a prolonged battle with the Marxists over the exploitation theory of capital, and refuted the socialist doctrine of capital and wages long before the communists came to power in Russia. Böhm-Bawerk also conducted a seminar that would later become the model for Mises's own Vienna seminar.

Böhm-Bawerk favored policies that deferred to the ever-present reality of economic law. He regarded interventionism as an attack on market economic forces that cannot succeed in the long run. In the last years of the Habsburg monarchy, he three times served as finance minister, fighting for balanced budgets, sound money and the gold standard, free trade, and the repeal of export subsidies and other monopoly privileges.

Mises and Hayek

It was Böhm-Bawerk's research and writing that solidified the status of the Austrian School as a unified way of looking at economic problems, and set the stage for the School to make huge inroads in the English-speaking world. But one area where Böhm-Bawerk had not elaborated on the analysis of Menger was money, the institutional intersection of the "micro" and "macro" approach. The young Ludwig von Mises, economic advisor to the Austrian Chamber of Commerce, took on the challenge.

The result of Mises's research was The Theory of Money and Credit (text), published in 1912. He spelled out how the theory of marginal utility applies to money, and laid out his "regression theorem," showing that money not only originates in the market, but must always do so. Drawing on the British Currency School, Knut Wicksell's theory of interest rates, and Böhm-Bawerk's theory of the structure of production, Mises presented the broad outline of the Austrian theory of the business cycle. A year later, Mises was appointed to the faculty of the University of Vienna, and Böhm-Bawerk's seminar spent a full two semesters debating Mises's book.

Mises's career was interrupted for four years by World War I. He spent three of those years as an artillery officer, and one as a staff officer in economic intelligence. 1919, at war's end, he published Nation, State, and Economy (text), arguing on behalf of the economic and cultural freedoms of minorities in the now-shattered empire, and spelling out a theory of the economics of war. Meanwhile, Mises's monetary theory received attention in the U.S. through the work of Benjamin M. Anderson, Jr., an economist at Chase National Bank. (Mises's book was panned by John Maynard Keynes, who later admitted he could not read German.^{[citation needed]})

In the political chaos after the war, the main theoretician of the now-socialist Austrian government was Marxist Otto Bauer. Knowing Bauer from the Böhm-Bawerk seminar, Mises explained economics to him night after night, eventually convincing him to back away from Bolshevik-style policies.^{[citation needed]} The Austrian socialists never forgave Mises for this, waging war against him in academic politics and successfully preventing him from getting a paid professorship at the university.

Undeterred, Mises turned to the problem of socialism itself, writing a blockbuster essay in 1921, which he turned into the book Socialism (text) over the next two years. Socialism permits no private property or exchange in capital goods, and thus no way for resources to find their most highly valued use. Socialism, Mises predicted, would result in utter chaos and the end of civilization.

Mises challenged the socialists to explain, in economic terms, precisely how their system would work, a task which the socialists had hitherto avoided. The debate between the Austrians and the socialists continued for the next decade and beyond, and, until the collapse of world socialism in 1989, academics had long thought that the debate was resolved in favor of the socialists.

Meanwhile, Mises's arguments on behalf of the free market attracted a group of converts from the socialist cause, including Hayek, Wilhelm Roepke , and Lionel Robbins. Mises began holding a private seminar in his offices at the Chamber of Commerce that was attended by Fritz Machlup, Oskar Morgenstern, Gottfried von Haberler, Alfred Schutz, Richard von Strigl, Eric Voegelin, Paul Rosenstein-Rodan, and many other intellectuals from all over Europe.

Also during the 1920s and 30s, Mises was battling on two other academic fronts. He delivered the decisive blow to the German Historical School with a series of essays in defense of the deductive method in economics, which he would later call praxeology or the logic of action. He also founded the Austrian Institute for Business Cycle Research, and put his student Hayek in charge of it.

During these years, Hayek and Mises authored many studies on the business cycle, warned of the danger of credit expansion, and predicted the coming currency crisis. This work was cited by the Nobel Memorial Prize committee in 1974 when Hayek received the award for economics. Working in England and America, Hayek later became a prime opponent of Keynesian economics with books on exchange rates, capital theory, and monetary reform. His popular book Road to Serfdom helped revive the classical liberal movement in America after the New Deal and World War II. And his series Law, Legislation, and Liberty (online) elaborated on the Late Scholastic approach to law, and applied it to criticize egalitarianism and nostrums like social justice.

Outside of Austria

In the late 1930s, after suffering from the worldwide depression, Austria was threatened by a Nazi takeover. Hayek had already left for London in 1931 at Mises's urging, and in 1934, Mises himself moved to Geneva to teach and write at the International Institute for Graduate Studies, later emigrating to the United States. Knowing Mises as the sworn enemy of national socialism, the Nazis confiscated Mises's papers from his apartment and hid them for the duration of the war. Ironically, it was Mises's ideas, filtered through the work of Roepke and the statesmanship of Ludwig Erhard, that led to Germany's postwar economic reforms and rebuilt the country. Then, in 1992, Austrian archivists discovered Mises's stolen Vienna papers in a reopened archive in Moscow.

While in Geneva, Mises's wrote his masterwork, Nationalokonomie (pdf), and, after coming to the United States, revised and expanded it into Human Action (text), which appeared in 1949. His student Murray N. Rothbard called it "Mises's greatest achievement and one of the finest products of the human mind in our century. It is economics made whole." It remains the economic treatise that defines the School. Even so, it was not well received in the economics profession, which had already made a decisive turn towards Keynesianism.

Though Mises never held the paid academic post he deserved, he gathered students around him at New York University, just as he had in Vienna. Even before Mises emigrated, journalist Henry Hazlitt had become his most prominent champion, reviewing his books in the New York Times and Newsweek, and popularizing his ideas in such classics as Economics in One Lesson (pdf). Yet Hazlitt made his own contributions to the Austrian School. He wrote a line-by-line critique (pdf) of Keynes's General Theory (text), defended the writings of Say, and restored him to a central place in Austrian macroeconomic theory. Hazlitt followed Mises's example of uncompromising adherence to principle, and as a result was pushed out of four high-profile positions in the journalistic world.

Mises's New York seminar continued until two years before his death in 1973. During those years, Rothbard was his student. Indeed, Rothbard's Man, Economy, and State (text) was patterned after Human Action, and in some areas--monopoly theory, utility and welfare, and the theory of the state--tightened and strengthened Mises's own views. Rothbard's approach to the Austrian School followed directly in the line of Late Scholastic thought by applying economic science within a framework of a natural-rights theory of property. What resulted was a full-fledged defense of a capitalistic and stateless social order, based on property and freedom of association and contract.

Rothbard followed his economic treatise with an investigation of the Great Depression, which applied Austrian Business Cycle Theory to show that the stock market crash and economic downturn was attributable to a prior bank credit expansion. Then in a series of studies on government policy, he established the theoretical framework for examining the effects of all types of intervention in the market.

In his later years, Mises saw the beginnings of the revival of the Austrian School that dates from the appearance of Man, Economy, and State and continues to this day. It was Rothbard who firmly established the Austrian School and classical liberal doctrine in the U.S., especially with Conceived in Liberty (volumes I, II, III, IV), his four-volume history of colonial America and the secession from Britain. The reunion of natural-rights theory and the Austrian School came in his philosophical work, The Ethics of Liberty (text), all while he was writing a series of scholarly economic pieces gathered in the two-volume Logic of Action, published in Edward Elgar's Economists of the Century series.

The founding of the Ludwig von Mises Institute in 1982, with the aid of Margit von Mises as well as Hayek and Hazlitt, provided a range of new opportunities for both Rothbard and the Austrian School. Through a steady stream of academic conferences, instructional seminars, books, monographs, newsletters, studies, and even films, they carried the Austrian School forward into the post-socialist age.

The fascinating history of this great body of thought, through all its ebbs and flows, is the story of how great minds can advance science and oppose evil with creativity and courage. Now the Austrian School enters a new millennium as the intellectual standard bearer for the free society. That it does so is thanks to the heroic and brilliant minds that make up the family history of the School, and to those who are carrying that legacy forward.

Economics and Philosophy

Main article: Economics

Austrian School economists advocate strict adherence to methodological individualism – analyzing human action from the perspective of individual agents. Proponents of this method, praxeology, argue that the only means of arriving at a valid economic theory is to derive it logically from basic principles of human action. Proponents of this method hold that it allows for the discovery of fundamental economic laws valid for all human action. Alongside praxeology, the school has traditionally advocated an interpretive approach to history to address specific historical events.

Methodology

This article uses content from the Wikipedia article on Austrian School under the terms of the CC-by-SA 3.0 license.

Austrian economists reject empirical statistical methods, natural experiments and constructed experiments as tools applicable to economics, saying that while it is appropriate in the natural sciences where factors can be isolated in laboratory conditions, the actions of human beings are too complex for this "numerical" treatment as passive non-adaptive subjects. Instead one should isolate the logical processes of human action. Von Mises called this discipline "praxeology" – a term he adapted from Alfred Espinas (but which had been in use by others).

The Austrian praxeological method is based on the heavy use of logical deduction from what they assert to be undeniable, self-evident axioms or irrefutable facts about human existence. The primary axiom from which Austrian economists deduce further certain conclusions is the action axiom, which holds that humans take conscious action toward chosen goals. Austrian economists focus on goal-directed action and say that it is undeniable because in order to deny action, one would have to employ action in the act of denial.

Methodology is the one area where Austrian economists differ most significantly from other schools of economic thought. Mainstream schools such as the neoclassical economists, the Chicago school of economics, the Keynesians and New Keynesians, adopt "empirical" mathematical and statistical methods, and focus on induction to construct and test theories—while Austrian economists reject this approach in favor of deduction and logically deduced inferences. According to Austrian economists, deduction is preferred, since if performed correctly, it leads to certain conclusions and inferences that must be true if the underlying assumptions are accurate. However Austrian economist Robert Murphy has stated that those using Austrian theories can still err in their interpretations of history, even if based on a theory formulated by deduction. Caplan makes a similar point about quantitative significance, explaining that a theory, such as one which logically relates minimum wage and unemployment, tells nothing of the approximate quantity of change in unemployment one can expect upon minimum wage increases.

Austrian economists hold that induction does not assure certainty like deduction, as real world economic data are inherently ambiguous and subject to a multitude of influences which cannot be separated or quantified, one cause or correlation from another. Austrians therefore claim that mainstream economics has no way of verifying cause and effect in real work economic events, since economic data which can be correlated to multiple potential chains of causation. Mainstream economists counter that conclusions that can be reached by pure logical deduction are limited and weak.

Critics of the Austrian school contend that by rejecting mathematics and econometrics, it has failed to contribute significantly to modern economics. Additionally, they contend that its methods currently consist of post-hoc analysis and do not generate testable implications; therefore, they fail the test of falsifiability as prescribed by the scientific method. Austrian economists counter that testability in economics is virtually impossible since it relies on human actors who cannot be placed in a lab setting without altering their would-be actions.

Criticism of mainstream practices

Austrians hold their methodology to be superior to empiricism which mainstream economists strive to uphold. German economist, banker and Keynesian critic, L. Albert Hahn, noted the following in October 1952:

It is seldom realized that belief in the possibility of "scientific" business forecasts, and the forecasting mania of our time, are comparatively new phenomena. Until about 1930 serious economists were not so bold — or so naive — as to pretend to be able to calculate the coming of booms and depressions in advance. It would not have fitted into their general view on the working of a free economy. They considered the economic future as basically dependent on unpredictable price-cost relationships and on the equally unpredictable psychological reactions of entrepreneurs. Predictions of future business conditions would have seemed to them mere charlatanry, just as predictions, say, regarding the resolutions of Congress two years from now... The basic error of the whole approach lies in the fact that the causative link between objective data and the decision of the members of the community are treated as mechanical. But men are still men and not automatons... Insufficiently educated in the history of economic thought, they [Anglo-American economists] do not realize that Keynesianism — down to the most technical details, like the concept of the foreign exchange multiplier — is mercantilism or, more precisely, John Lawism pure and simple... Reading, quoting, praising, and promoting each other, and only each other, will not liberate these economists from their voluntary isolationism. They will remain in their dream world. They will continue to predict the unpredictable.

Mainstream economists reject the Austrian assertion that prediction in economics is inherently impossible. On the Austrian critiques of mainstream economics, economist Bryan Caplan has asserted that, "Mises and Rothbard reject the foundations of modern neoclassical economics too quickly, and their substitutes are inadequate."

In their rejection of mainstream practices, Austrians have long argued that mainstream economic models have a very poor record of prediction, citing the Global Financial Crisis as an example. However, on the other hand some Austrian adherents have themslves been labeled as "Chicken Littles" for continually making predictions of "catastrophic" financial crises.

Academic and political background

Austrian school theorists, like Ludwig von Mises, insist that praxeology must be value-free—that the method does not answer the question "should this policy be implemented?", but rather "if this policy is implemented, will it have the effects you intend"? However, Austrian economists often make policy recommendations that call for the elimination of government regulations and their policy prescriptions often overlap with libertarian or anarcho-capitalist solutions. These recommendations are similar to, but further reaching than the minarchist ideas of Chicago School economists, and frequently address issues that other schools ignore, such as monetary reform. Both schools advocate strict protection of private property, and support for individualism in general, and are often cited by libertarian, classical or laissez-faire liberal, fiscal conservative, and Objectivist groups for support.

Austrian economists view entrepreneurship as the driving force in economic development, see private property as essential to the efficient use of resources, and usually (if not always) see government interference in market processes as counterproductive. In this, their views do not differ far from those of the Chicago school.

As with neoclassical economists, Austrian economists reject classical cost of production theories, most famously the labor theory of value. Instead they explain value by reference to the subjective preferences of individuals. This psychological aspect to Menger's economics has been attributed to the school's birth in turn of the century Vienna. Supply and demand are explained by aggregating over the decisions of individuals, following the precepts of methodological individualism, which asserts that only individuals and not collectives make decisions, and marginalist arguments, which compare the costs and benefits for incremental changes.

Contemporary neo-Austrian economists claim to adopt economic subjectivism more consistently than any other school of economics and reject many neoclassical formalisms. For example, while neoclassical economics formalizes the economy as an equilibrium system with supply and demand in balance, Austrian economists emphasize its dynamic, perpetually dis-equilibrated nature.

The opportunity cost doctrine was first explicitly formulated by the Austrian economist Friedrich von Wieser in the late 19th century. In its original and purist sense, opportunity cost doctrine argues that the only cost relevant to the price of a product is the cost involved in choosing it over other competing, and mutually exclusive, options, and its technical coefficients of production. In the 1930s Gottfried Haberler applied the doctrine to the problems of foreign trade, confident that much of the work done in classical economics to incorporate the much broader array of costs in price analysis could be abandoned.

This focus on opportunity cost alone means that their interpretation of the time value of a good has a strict relationship: since goods will be as restricted by scarcity at a later point in time as they are now, the strict relationship between investment and time must also hold. A factory making goods next year is worth much less than the goods it is making next year are worth. This means that the business cycle is driven by mis-coordination between sectors of the same economy, caused by money not carrying incentive information correct about present choices, rather than within a single economy where money causes people to make bad decisions about how to spend their time.

Contributions

Some general contributions of Austrian economists:

• A theory of distribution in which factor prices result from the imputation of prices of consumer goods to goods of "higher order", that is goods used in the production of consumer goods (goods of the first order).
• A fundamental rejection of mathematical methods in economics, seeing the function of economics as investigating the essences rather than the specific quantities of economic phenomena. This was seen as an evolutionary, or "genetic-causal", approach against the alleged "unreality" and internal stresses inherent in the "static" approach of equilibrium and perfect competition, which are the foundations of mainstream Neoclassical economics (see also praxeology). This methodology is also driven by the belief that econometrics is inherently misleading in that it creates a fallacious "precision" in economics where there is none.
• Eugen von Böhm-Bawerk's critique of Marx, which centered on the untenability of the labor theory of value in the light of the transformation problem. There was also the connected argument that capitalists do not exploit workers; they accommodate workers by providing them with income well in advance of the revenue from the output they helped to produce.
• Eugen von Böhm-Bawerk's capital theory, which equates capital intensity with the degree of roundaboutness of production processes.
• Eugen von Böhm-Bawerk's demonstration that the law of marginal utility, as formulated by Menger necessarily implies the classical law of costs and hence the vast majority of the conclusions of the British classical economists. This discovery was later fully developed and its implications traced by a student of von Mises, George Reisman, in his book, Capitalism.
• An emphasis on opportunity cost and reservation demand in defining value, and a refusal to consider supply as an otherwise independent cause of value. (The British economist Philip Wicksteed adopted this perspective.)
• The Mises-Hayek business cycle theory, which is asserted as explaining depression as a reaction to an intertemporal production structure fostered by monetary policy setting interest rates inconsistent with individual time preferences.
• Hayek's concept of intertemporal equilibrium. (John Hicks took over this theory in his discussion of temporary equilibrium in Value and Capital, a book very influential on the development of neoclassical economics after World War II.)
• Mises and Hayek's view of prices as permitting agents to make use of dispersed tacit knowledge.
• The time preference theory of interest, which explains interest rates through intertemporal choice - the different time preferences of the borrower or lender - rather than as a price paid for a factor of production.
• The economic calculation debate between Austrian and Marxist economists, with the Austrians claiming that Marxism is flawed because prices could not be set to recognize opportunity costs of factors of production, and so socialism could not make rational decisions.
• Friedrich Hayek was one of the few economists who gave warning of a major economic crisis before the great crash of 1929. In February 1929, Hayek warned that a coming financial crisis was an unavoidable consequence of reckless monetary expansion.
• Stressing uncertainty in the making of economic decisions, rather than relying on "Homo economicus" or the rational man who was fully informed of all circumstances impinging on his decisions. The fact that perfect knowledge never exists, means that all economic activity implies risk.
• Seeing the entrepreneurs' role as collecting and evaluating information and acting on risks.
• An emphasis on the forward-looking nature of choice, seeing time as the root of uncertainty within economics (see also time preference).

Notable theories

Economic calculation problem

Main article: Economic calculation problem

The economic calculation problem is a criticism of socialist economics. It was first proposed by Ludwig von Mises in 1920 and later expounded by Friedrich Hayek. The problem referred to is that of how to distribute resources rationally in an economy. The capitalist solution is the price mechanism; Mises and Hayek argued that this is the only viable solution, as the price mechanism co-ordinates supply and investment decisions most efficiently. Without the information efficiently and effectively provided by market prices, socialism lacks a method to efficiently allocate resources over an extended period of time in any market where the price mechanism is effective (an example where the price mechanism may not work is in the relatively confined area of public and common goods). Those who agree with this criticism argue it is a refutation of socialism and that it shows that a socialist planned economy could never work in the long term for the vast bulk of the economy and has very limited potential application. The debate raged in the 1920s and 1930s, and that specific period of the debate has come to be known by historians of economic thought as The Socialist Calculation Debate. Ludwig von Mises argued in a famous 1920 article "Economic Calculation in the Socialist Commonwealth" that the pricing systems in socialist economies were necessarily deficient because if government owned the means of production, then no prices could be obtained for capital goods as they were merely internal transfers of goods in a socialist system and not "objects of exchange," unlike final goods. Therefore, they were unpriced and hence the system would be necessarily inefficient since the central planners would not know how to allocate the available resources efficiently. This led him to declare "…that rational economic activity is impossible in a socialist commonwealth." Mises's declaration has been criticized as overstating the strength of his case, in describing socialism as impossible, rather than having to contend with a source of inefficiency. A recent paper on this question has criticized the Austrian view from the viewpoint of computational complexity, arguing that if finding a true economic equilibrium is not just hard but impossible for a central planner, then the impossibility applies equally well to a market system, since a system of dispersed calculators (i.e. a market) has no advantage over one large central calculator in overcoming complexity.

Inflation

The Austrian School has consistently argued that a "traditionalist" approach to inflation yields the most accurate understanding of the causes (and the cure) for inflation. Austrian economists maintain that inflation is by definition always and everywhere simply an increase in the money supply (i.e. units of currency or means of exchange), which in turn leads to a higher nominal price level for assets (such as housing) and other goods and services in demand, as the real value of each monetary unit is eroded, loses purchasing power and thus buys fewer goods and services.

Given that all major economies currently have a central bank supporting the private banking system, money can be supplied into these economies by way of bank-created credit (or debt). Austrian economists believe that this bank-created credit growth (which forms the bulk of the money supply) sets off and creates volatile business cycles (see Austrian Business Cycle Theory) and maintain that this "wave-like" or "boomerang" effect on economic activity is one of the most damaging effects of monetary inflation.

According to the Austrian Business Cycle Theory, the central bank's policy of attempting to control the market economy is ineffective and creates volatile credit cycles or business cycles, and, as a necessary by-product, inflation (especially in asset markets). By the central bank artificially "stimulating" the economy with artificially low interest rates (thereby permitting excessive increases in the money supply), the government-sponsored central bank itself allows debasement of the means of exchange (inflation), often focused in asset or capital markets, resulting in "false signals" going out to the market place, in turn resulting in clusters of malinvestments, and the artificial lowering of the returns on savings, which eventually causes the malinvestments to be liquidated as they inevitably show their underlying unprofitability and unsustainability.

Austrian School economists therefore regard the state-sponsored central bank as the main cause of inflation, because they regard the bank as the institution charged with the creation of new money. When newly created currency reserves are injected into the fractional-reserve banking system, private financial institutions generally choose to further expand the level of bank credit, which multiplies the inflationary effect many times over.

The Austrian School also views the "contemporary" definition of inflation as inherently misleading in that it draws attention only to the effect of inflation (rising prices) and does not address the "true" phenomenon of inflation, which they believe simply involves an increase in the money supply (or the debasement of the means of exchange). They argue that this semantic difference is important in defining inflation and finding a cure for inflation. Austrian School economists maintain the most effective cure is the strict maintenance of a stable money supply. Ludwig von Mises, the seminal scholar of the Austrian School, asserts that:

Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. . . . As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.

Following their definition, Austrian economists measure the inflation by calculating the growth of what they call 'the true money supply', i.e. how many new units of money that are available for immediate use in exchange, that have been created over time.

This interpretation of inflation implies that, within a centralized banking system, inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply.. Mises includes bank credit as a significant contributor to inflation; the value of bank credit generated by private financial institutions and held within checking accounts greatly exceeds the value of physical paper bills and metallic coins issued by the Federal government (see Figure 1). In addition to state-induced monetary expansion via printing of paper money, the Austrian School also maintains that the effects of increasing the money supply are exacerbated by the credit expansion performed by private financial institutions practising fractional-reserve banking system, legally permitted in most economic and financial systems in the world.

Austrian School economists claim that the state uses monetary inflation as one of the three means by which it can fund its activities, the other two being taxing and borrowing. Therefore, Austrians often seek to identify reasons why the state resorts to allowing the creation new money (whether fiat paper or electronic money) and what the new money is used for. Various forms of military spending are often cited as reasons for resorting to inflation and borrowing, as this can be a short term way of acquiring marketable resources and is often favored by desperate, indebted governments. In other cases, the central bank may try avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions or depressions by artificially trying to "stimulate" the economy through money supply growth and further borrowing via artificially low interest rates.

Accordingly, many Austrian School economists support the abolition of the central banks and the fractional-reserve banking system, and advocate instead a return to money based on the gold standard, or less frequently, free banking. Money could only be created by finding and putting into circulation more gold under a gold standard.

Advocates argued that the Gold Standard would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth ("inflation") would never spiral out of control. Ludwig von Mises asserted that civil liberties would be better protected:

It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and for bills of rights was a reaction against arbitrary rule and the nonobservance of old customs by kings.

Business cycles

Main article: Austrian Business Cycle Theory

According to Austrian School economist Joseph Salerno, what most distinctly sets the Austrian school apart from neoclassical economics is the Austrian Business Cycle Theory:

The Austrian theory embodies all the distinctive Austrian traits: the theory of heterogeneous capital, the structure of production, the passage of time, sequential analysis of monetary interventionism, the market origins and function of the interest rate, and more. And it tells a compelling story about an area of history neoclassicals think of as their turf. The model of applying this theory remains Rothbard's America's Great Depression.

Austrian School economists focus on the credit cycle as the primary cause of most business cycles. Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.

According to the Austrian School business cycle theory, the business cycle unfolds in the following way:

Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "credit-fuelled boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable.

Austrian School economists argue that a correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when credit creation cannot be sustained. They claim that the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back toward more efficient uses.

Economist Steve H. Hanke identifies the financial crisis of 2007–2010 as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by Austrian school economic theory. Some analysts such as Jerry Tempelman have also argued that the predictive and explanatory power of ABCT in relation to the recent Global Financial Crisis has reaffirmed its status and, perhaps, cast into question the utility of mainstream theories and critiques.

Criticism of the Austrian School

Critics argue that modern Austrian economics generally lacks scientific rigor, which forms the basis of the most prominent criticism of the school. Austrian theories are not formulated in formal mathematical form, but by using mainly verbal logic and what proponents claim are self-evident axioms. Mainstream economists believe that this makes Austrian theories too imprecisely defined to be clearly used to explain or predict real world events. Economist Bryan Caplan noted that, "what prevents Austrian economists from getting more publications in mainstream journals is that their papers rarely use mathematics or econometrics."

A related criticism is applied to Austrian School leaders; these leaders have advocated a rejection of the application of empiricism to economics, which involves directly using historical data and hypothesizes correlations in the development of theories. Mises wrote of his economic methodology that "its statements and propositions are not derived from experience... They are not subject to verification or falsification on the ground of experience and facts." Murray Rothbard was also an adherent of Mises's methodology, and though Rothbard assigned a quasi-empirical description to it, he comments that "it should be obvious that this type of 'empiricism' is so out of step with modern empiricism that I may just as well continue to call it a priori for present purposes". Additionally, the prominent Austrian economist, F. A. Hayek, stated his belief that social science theories can "never be verified or falsified by reference to facts."

There are also criticisms of specific Austrian theories. For example, Nobel laureate Milton Friedman, after examining the history of business cycles in the US, concluded that "The Hayek-Mises explanation of the business cycle is contradicted by the evidence. It is, I believe, false." In addition to Milton Friedman's criticism, noted liberal neo-Keynesian economist Paul Krugman has criticized the theory.

Economist Jeffrey Sachs has pointed out that when comparing developed free-market economies, those that have high rates of taxation and high social welfare spending perform better on most measures of economic performance compared to countries with low rates of taxation and low social outlays. He asserts that poverty rates are lower, median income is higher, the budget has larger surpluses, and the trade balance is stronger (although unemployment tends to be higher). He concludes that Friedrich Hayek was wrong when he said that high taxation would be a threat to freedom; but rather, a generous social-welfare state leads to fairness, economic equality, international competitiveness, and strong vibrant democracies. In response to Sachs' article, William Easterly states that Hayek, writing in 1944, correctly recognized the dangers of large-scale state economic planning. He also questions the validity of comparing poverty levels in the Nordic countries and the United States, when the former have been moving away from social planning toward a more market-based economy, and the latter has historically taken in impoverished immigrants. Easterly also argues that laissez-faire countries were the leaders of "the ongoing global industrial revolution" which is responsible for abolishing much of the world's poverty.

Seminal works

• Principles of Economics (1871) by Carl Menger
• Capital and Interest (1884–1921) by Eugen von Böhm-Bawerk
• Human Action (1940–1949) by Ludwig von Mises
• Economics in One Lesson (1946) by Henry Hazlitt
• Individualism and Economic Order (1948) by Friedrich Hayek
• Man, Economy, and State (1962) by Murray N. Rothbard
• Competition and Entrepreneurship (1973) by Israel M. Kirzner
• Capitalism: A Treatise on Economics (1996) by George Reisman
• The Economics of Ignorance and Coordination, Subjectivism and the Austrian School of Economics (2004) by Thierry Aimar.

External links

• What is Austrian Economics? from the Mises Institute
• Austrian School on Wikipedia
• Austrian School of Economics from The Concise Encyclopedia of Economics
• The Austrian School from the History of Economic Thought page
• A Primer on Austrian Economics by Jonathan M. Finegold Catalan, June 2010