Austrian Economics A Primer Dr Eamonn Butler Dr Eamonn Butler is director of the Adam Smith Institute. He has degrees in economics, philosophy and psychology from the University of St Andrews. He worked for the US House of Representatives, and taught philosophy in Hillsdale College, Michigan, before returning to the UK to help establish the Adam Smith Institute in the late 1970s. He is author of books on the economists Milton Friedman, F. A. Hayek and Ludwig von Mises, and of primers on von Mises and Adam Smith for the Institute of Economic Affairs. He contributes frequently to print and broadcast media, and his recent popular books The Best Book on the Market, The Rotten State of Britain and The Alternative Manifesto have attracted considerable attention. The Adam Smith Institute has an open access policy. 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ISBN: 1–902737–69–5 Some rights reserved Printed in England Contents 1 The Austrian School’s history and approach 5 2 Key principles of Austrian Economics 11 3 Why economists don’t know what they’re doing 19 4 The importance of values 24 5 Prices, costs and profit 31 6 Co-ordination through markets 38 7 Competition and entrepreneurship 47 8 Time, production, capital and interest 55 9 The business cycle 62 10 The trouble with money 70 11 The flaws of socialism 80 12 Liberalism 87 13 Criticism of the Austrian approach 96 14 Contemporary Austrian thinking 104 15 Relevance of the Austrian School today 111 Biographical sketches 119 1 The Austrian School’s history and approach • The Austrian School is an approach to economics that originated in Vienna in the 1870s. It is highly critical of modern mainstream economics. • Austrians (as they are called – though today they are found everywhere) hold that all economic events stem from the values and choices of the particular individuals involved and their circumstances at the time. • Austrians argue that mainstream economists are therefore wrong to look for statistical linkages between economic phenomena. • Austrians say that their individual- and values-based approach provides a better explanation of economic events such as boom and bust. The Austrian School of Economics is not some teaching institution in Vienna, nor is it even about the economy of Austria. Rather, the term refers to a particular approach to economics, and to the economists around the world who subscribe to it. How economists should work Nevertheless, the Austrian School did have its origins at the University of Vienna, with the publication of the book Principles of Economics by Carl Menger. The book criticized the economic ideas that then prevailed in the German-speaking world – the so-called Historical School, led by Wilhelm Roscher. They took the view that economics was like history, dealing with unique events that would never be repeated in exactly the same way. It was therefore impossible to establish general laws of economics – linkages that would apply regardless of place or time, like the laws of physics – as England’s Classical School economists supposed. Menger thought that economists could indeed come up with principles that would hold true in every place and time; but that the English economists were wrong in looking for linkages among the statistics of trade and commerce. Statistics, he believed, simply smother what is actually going on. And what is going on in economics is that millions of individuals are constantly making choices. Those choices are the basis of economic phenomena such as demand, supply, price, and markets. They must be the basis of economic science too. Economics must start at the level of individuals – an approach known as methodological individualism – and seek to understand how they choose. Menger also argued that the actual choices that individuals make depend on the particular values and preferences they have for different things. But these are matters of personal feeling and emotion, something to which the economist cannot get direct access. A physical scientist can measure weight or volume, but economists cannot measure people’s values, any more than 6 | Adam Smith Institute they can measure someone’s grief, or joy, or love. Inevitably, economics is not about objective, natural phenomena, but subjective, human ones. As if this was not enough, Menger also developed (alongside William Stanley Jevons and Leon Walras, though they worked independently) a revolution in economic thought called marginal utility analysis. It remains a key building block of mainstream economics today. The idea is that when people make choices and trades, they strive to acquire whatever that will satisfy their most urgent needs first. After that, they attend to their less and less urgent (or more and more ‘marginal’) needs. Likewise, if they must give something up, they first surrender whatever gives them least satisfaction, before giving up things they value more. People choose, in other words, on the basis of the marginal utility which different things provide them. This principle enables us to understand a great deal about how people make economic bargains, and about how markets work. The first waves Menger’s approach sparked a huge dispute on what social sciences like economics were actually all about, known as the Methodenstreit or debate on method. In the course of it, Menger and his followers at the University of Vienna, Eugen von Böhm-Bawerk and Friedrich von Wieser, were dubbed the “Austrian School”. Böhm-Bawerk developed Menger’s subjectivist approach by applying it to the area of interest and capital. He showed that interest rates reflect a particular preference of human beings, namely time preference. We prefer to have things now than in the future, and we are prepared to borrow at interest to get them. When Austrian Economics | 7 we lend something for a while, we demand to be paid interest. And from this Böhm-Bawerk derived much of the theory of investment, production, and how capital is used. Wieser, for his part, took the same approach into the analysis of costs. He showed that costs are not an objective measure but, once again, stem from the subjective values and preferences of those involved. Production involves giving up some things now to produce others later, and it is a matter of individual judgement, not hard measurement, whether those choices are considered worthwhile. Wieser stressed the role of entrepreneurs in testing out such judgements, based on their expert understanding of markets. Menger, Böhm-Bawerk and Wieser constitute the ‘first wave’ of the Austrian School. The ‘second wave’ was led by Ludwig von Mises and Friedrich Hayek, who collaborated in the 1930s to explain business cycles – the periodic booms and busts that seem a permanent fixture of the commercial world. They argued that the cycles originate from an injection of bank credit. Cheaper borrowing prompts entrepreneurs to invest more in production, and consumers to buy more in the shops. But once the credit stimulus has worn off, reality reasserts itself. Entrepreneurs find they are producing too much of the wrong things, business slumps, and over-ambitious investments have to be written off. With the threat of Nazism growing, Hayek and Mises left Austria in the 1930s. Mises went to America, and focused on the pure science of choice and action, sharpening Menger’s original principles and working out their implications. Hayek went first to Britain, then also to America, and concentrated on the crucial role of information in how people make choices and how markets actually work. 8 | Adam Smith Institute Contemporary Austrians The ‘third wave’ Austrian School economists have come mostly from America, in Universities such as New York, Auburn, and George Mason. But they reflect a wider range of intellectual traditions, and while many would not hesitate to call themselves ‘Austrians’, others would admit only to having been influenced, to a greater or lesser degree, by the Austrian School approach. Among the prominent Austrians must be listed Murray Rothbard, who pinned the blame for business cycles squarely on central banks, and developed a rigorous libertarian critique of the state; Israel Kirzner, who traced the critical importance of entrepreneurship in driving economic progress; and Lawrence White, who showed how banking works better without government controls and regulations. But many other prominent economists, including several winners of the Nobel Prize in Economic Science, accept some of the Austrian School’s ideas and acknowledge their debt to it. Hayek himself won a Nobel Prize, in 1975, for his 1930s work on the business cycle, and this raised some worldwide interest in Austrian ideas. Nevertheless, Austrian economists remain very much the minority, outside and opposing the mainstream, textbook view. Partly this is because their approach is subtle and complex and not easy to explain to students. Or because they reject much of what passes for economic ‘science’ and so are seen as ‘unscientific’ by the mainstream. Or because they are regarded as a sect, unwilling to engage with criticism. Whatever the reason, the fact remains that the Austrian School approach has much to teach us about how people make choices Austrian Economics | 9 – or ‘economize’ as the experts would say. And that is plainly the very heart of economics. Hence the need for Austrian ideas to be presented simply, in ways that are more widely accessible – even at the risk of some oversimplification and distortion. 10 | Adam Smith Institute