Austrian school of economics

The Austrian School is a heterodox school of economic thought that emphasizes the spontaneous organizing power of the price mechanism. Its name derives from the identity of its founders and early supporters, who were citizens of the old Austrian Habsburg Empire, including Carl Menger, Eugen von Böhm-Bawerk, Ludwig von Mises, and Nobel laureate Friedrich Hayek. Currently, adherents of the Austrian School can come from any part of the world, but they are often referred to simply as Austrian economists and their work as Austrian economics.

The Austrian School was influential in the late 19th and early 20th century. Austrian contributions to mainstream economic thought include involvement in the development of the neoclassical theory of value and the subjective theory of value on which it is based, as well as contributions to the "economic calculation debate" which concerns the allocative properties of a centrally planned economy versus a decentralized free market economy. From the middle of the 20th century onwards, it has been considered outside the mainstream, with notable criticisms related to the School leveled by economists such as Bryan Caplan, Jeffrey Sachs, and Nobel laureates Paul Samuelson, Milton Friedman, and Paul Krugman. Followers of the Austrian School are now most frequently associated with libertarian political perspectives that emanate from such bodies as the Ludwig von Mises Institute and George Mason University in the southern US.

Austrian School principles advocate strict adherence to methodological individualism – analyzing human action exclusively from the perspective of an individual agent. Austrian economists also argue that mathematical models and statistics are an unreliable means of analyzing and testing economic theory, and advocate deriving economic theory logically from basic principles of human action, a method called praxeology. Additionally, whereas experimental research and natural experiments are often used in mainstream economics, Austrian economists contend 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. Mainstream economists are generally critical of methodologies used by modern Austrian economists; in particular, a primary Austrian School method of deriving theories has been criticized by mainstream economists as a priori "non-empirical" analysis and differing from the practices of scientific theorizing, as widely conducted in economics.

Austrian School economists generally hold that the complexity of human behavior makes mathematical modeling of an evolving market extremely difficult (or undecidable) and advocate a laissez faire approach to the economy. They advocate the strict enforcement of voluntary contractual agreements between economic agents, and hold that commercial transactions should be subject to the smallest possible imposition of coercive forces. 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).

History and mainstream opinion

Classical economics focused on the labour theory of value, which holds that the value of a commodity is equal to the amount of labour required to produce it. In the late 19th century, however, attention was focused on the concepts of “marginal” cost and value. The Austrian School was one of three founding currents of the marginalist revolution of the 1870s, with its major contribution being the introduction of the subjectivist approach in economics. Carl Menger's 1871 book, Principles of Economics was the catalyst for this development; while marginalism was generally influential, there was also a more specific school that grew up around Menger, which came to be known as the “Psychological School,” “Vienna School,” or “Austrian School.” Thorstein Veblen introduced the term neoclassical economics in his Preconceptions of Economic Science (1900) to distinguish marginalists in the objective cost tradition of Alfred Marshall from those in the subjective valuation tradition of the Austrian School.

Austrian economics is closely associated with the historical insights on the spontaneous order provided by Aristotle, Lao Tzu, Juan de Mariana and others as they discussed utility theory, trade, private property, the nature of government, and the role of currency in society. The Austrian School, especially through the works of Friedrich Hayek, was influential in the revival of laissez-faire thought in the 20th century.

Origins and etymology

The school originated in Vienna, in the Austrian Empire. However, later adherents of the school such as Murray Rothbard have derived the roots of the thought of the Austrian School from the Spanish Scholastics teaching at the University of Salamanca of the 15th century and the French Physiocrats of the 18th century. The School owes its name to members of the German Historical School of economics, who argued against the Austrians during the Methodenstreit ("methodology struggle"), in which the Austrians defended the reliance that classical economists placed upon deductive logic. Their Prussian opponents derisively named them the "Austrian School" to emphasize a departure from mainstream German thought and to suggest a provincial, Aristotelian approach.

Specifically, in 1883 Menger published Investigations into the Method of the Social Sciences with Special Reference to Economics (Untersuchungen über die Methode der Socialwissenschaften und der politischen Oekonomie insbesondere), which attacked the methods of the Historical school. Gustav von Schmoller, a leader of the Historical school, responded with an unfavorable review, coining the term "Austrian school".

The name "Psychological School" derived from the effort to found marginalism upon prior considerations, largely psychological – compare behavioral economics. The school was no longer centered in Austria after Hitler came to power, and is now based almost entirely in the United States.

First wave

Carl Menger was closely followed by Eugen von Böhm-Bawerk and Friedrich von Wieser, in what is known as the "first wave" of the School. Austrian economists developed a sense of themselves as a school distinct from neoclassical economics during the economic calculation debate with socialist economists. Ludwig von Mises and his student Friedrich A. Hayek represented the Austrian position in contending that without monetary prices and private property, meaningful economic calculation is impossible.

The Austrian economist Böhm-Bawerk wrote extensive critiques of Marx in the 1880s and 1890s, as was part of the Austrian economists' participation in the late 19th Century Methodenstreit, during which they attacked the Hegelian doctrines of the Historical School.

Inter-war period

Austrian economics after 1920 can be broken into two general trends. One, exemplified by Friedrich A. Hayek, while distrusting many neoclassical concepts (like most of the corpus of Keynesian macroeconomics), generally accepts a large part of the neoclassical methodology; the other, exemplified by Ludwig von Mises, seeks a different formalism for economics, considering the neoclassical methodology to be irredeemably flawed. According to Austrian school economists, the main area of contention between the mainstream and the Austrian school is on their view of the market system as a process, not only to be studied using equilibrium models, but to be viewed as an incessant process that only tends toward a constantly changing equilibrium. This difference is the root of the Austrian business cycle theory, the economic calculation debate, and their different views of monopoly and competition.

A second area of contention between neoclassical theory and the Austrian school is over the possibility of consumers being indifferent between choices – neoclassical theory says it is possible, whereas Mises rejected it as being “impossible to observe in practice.” Additionally, Mises and his students argued, building on Czech economist František Čuhel (1862–1914), that utility functions are ordinal, and not cardinal; that is, the Austrians contend that one can only rank preferences and cannot measure their intensity. The Austrian School rejects any neoclassical results that are based on cardinal utility and criticizes mainstream economics for accepting cardinality, despite the fact that neoclassical economists have shown that their work holds for ordinal preferences.

Finally there are a host of questions about uncertainty and the utility of "conventional" financial models raised by Mises and other Austrians, who argue for a fundamentally different means of risk assessment in economics compared to that used by the mainstream. Mises and others argued that numerically accurate "probabilities" could never be assigned to "singular" cases. The utility and accuracy of financial modeling is an on-going source of debate, even within the Austrian School. These questions are directly linked to the dynamic market process approach to economic theory, where it is argued by Mises and others that the unique confluence of events in each moment of time in real markets makes the assignment of "objective" probabilities unrealistic, as these events are intrinsically unique and not capable of numerical probabilistic modeling. Mises and others argued that the application of probabilistic uncertainty would require the ability to exactly replicate objectively similar events to obtain an accurate understanding of the range of probabilistic outcomes of any event, and this is not possible in real markets, where past market events intimately affect the present and the future.

Later reputation

Austrian economics was ill-thought of by most economists after World War II because it rejected mathematical and statistical methods in the area of economics. Its reputation rose somewhat in the late 20th century with the work of Israel Kirzner and Ludwig Lachmann, as well as a renewed interest in Hayek after he won the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel (a.k.a. the Nobel Prize in Economics). Following Hayek, one of Ludwig von Mises's students, Murray Rothbard, became prominent in both Austrian applied theory and Libertarian philosophical thought. However, it remains a distinctly minority position, even in such areas as capital value.

Currently, universities with a significant Austrian presence are George Mason University, Loyola University New Orleans, and Auburn University in the United States and Universidad Francisco Marroquín in Guatemala. The library of Universidad Francisco Marroquín is named after Ludwig von Mises, and the university also provides seminars and lectures through a program named for Austrian School proponent Henry Hazlitt. Austrian economic ideas are also promoted heavily by bodies such as the Mises Institute and the Foundation for Economic Education. In May 2010, Antal E. Fekete declared his intention to establish a New School of Austrian Economics in Budapest, based on the Real bills doctrine, but the status of this "New Austrian School" remains uncertain.

Influence

According to Austrian school economist Peter J. Boettke, during its history the position of the Austrian School within the economics profession has changed several times from the center to the fringe of the mainstream. By the mid-1930s, the mainstream had more or less absorbed what were seen as the important contributions of the Austrians, and it is currently a distinctly minority position.

The former U.S. Federal Reserve Chairman, Alan Greenspan, speaking of the originators of the School, said in 2000, "the Austrian school have reached far into the future from when most of them practiced and have had a profound and, in my judgment, probably an irreversible effect on how most mainstream economists think in this country."

Nobel Laureate James M. Buchanan is sometimes considered to be a member of the Austrian School and he stated that, "I certainly have a great deal of affinity with Austrian economics and I have no objections to being called an Austrian. Hayek and Mises might consider me an Austrian but, surely some of the others would not." Republican U.S. congressman Ron Paul is a firm believer in Austrian school economics and has authored six books on the subject. Paul's former economic adviser, Peter Schiff, is an adherent of the Austrian school. Jim Rogers, investor and financial commentator, also considers himself of the Austrian School of economics. Prominent Chinese economist Zhang Weiyin, who is known in China for his advocacy of free market reforms, supports some Austrian theories such as the Austrian theory of the business cycle.

Methodology

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 the scientific principles which mainstream economists strive to uphold. 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 argued that mainstream economics has an unsatisfactory record of prediction, citing the Global Financial Crisis as an example. However, there were warnings from the mainstream about an economic bubble in the housing market discussed in The Economist magazine and by prominent economists; economists associated with mainstream economic schools, such as Robert Shiller and Nobel laureate, Joseph Stiglitz, have received international recognition for warning of the impending crisis. Another mainstream economist who has become popular due to warnings is Nouriel Roubini. Heterodox economists not of the Austrian school who warned of an impending crisis include Dean Baker, Wynne Godley, Michael Hudson and Steve Keen.

Also of note in relation to contested "accurate predictions" between Austrians and the mainstream are the false predictions from Austrian School adherents which failed in their timing or description of the financial crises, as with Ludwig von Mises's failed prediction regarding a collapse of the British pound or with Peter Schiff who predicted that the U.S. dollar would weaken significantly, whereas the opposite occurred. Some Austrian adherents have been labeled as "permabears" or "Chicken Littles" for continually making predictions of "catastrophic" financial crises, whilst making little allowance for spans of stable economic growth. For example in 2002, months before a multi-year advance in the US stock market, Austrian advocate Peter Schiff claimed that the US was at the early stage of an economic crisis and has frequently predicted an imminent U.S. dollar "crash" (which has yet to materialize). These claims have prompted Schiff to be labeled a "permabear" and to draw comparisons of his pronouncements with "stopped clocks" (which are right twice a day but useless nevertheless).

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.

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:

Figure 1. Components of the US money supply as measured in modern economics. Included are the printed dollar bills, as well as other bank notes in circulation and the quantity of bank deposits subject to check. The currency printed by the Federal government (through the Federal Reserve) and the checkable deposits are colored in green and white at the bottom of the graphs. The M2 money measure, colored in the lighter shade of gray, is generally dominated by funds held in private institutions, far exceeding the value of the currency printed by the Federal government.

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.

At the beginning of his career Alan Greenspan, former chairman of the Federal Reserve, was also a strong advocate of the Gold Standard as a protector of economic liberty:

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the 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.

The Austrian theory of the business cycle varies significantly from mainstream theories. Economists such as Gordon Tullock, Bryan Caplan, and Nobel laureates Milton Friedman and Paul Krugman have said that they regard the theory as incorrect.

In contrast to most mainstream theories on business cycles, 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.

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.

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.

Criticism of the Austrian School

Critics have concluded 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 methods which involve directly using empirical data in the development of (falsifiable) theories; application of empirical data is fundamental to the scientific method. In particular, Austrian School leader, Ludwig von Mises, has been described as the mid-20th century's "archetypal 'unscientific' economist." 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." Such rejections of empirical evidence in economics by Austrian School leaders have led to the school being dismissed within the mainstream.

Another general criticism of the School is that although it claims to highlight shortcomings in traditional methodology, it fails to provide viable alternatives for making positive contributions to economic theory. In his critique of Austrian economics, Caplan stated that Austrian economists have often misunderstood modern economics, causing them to overstate their differences with it. He argued that several of the most important Austrian claims are false or overstated. For example, Austrian economists object to the use of cardinal utility in microeconomic theory; however, microeconomic theorists go to great pains to show that their results hold for all monotonic transformations of utility, and so are true for purely ordinal preferences. Caplan has also criticized the school for rejecting on principle the use of mathematics or econometrics.

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, Nobel laureate and neo-Keynesian economist Paul Krugman argued that Austrian business cycle theory implies that consumption would increase during downturns, and cannot explain the empirical observation that spending in all sectors of the economy fall during a recession.

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.

See also

• List of Austrian intellectual traditions
• Newtonian time in economics, a debate concerning whether Newtonian time is an appropriate concept to use in economics
• Quarterly Journal of Austrian Economics, one of the most prominent organs of the Austrian School in academia

References

• Stephen Littlechild, ed. (1990). Austrian economics, 3 v. Edward Elgar. Description and scroll to chapter preview links for v. 1.
• Justin Ptak, 2001. Action, Coordination, and Exchange, Institute for Business Cycle Research.

External links

• Austrian school of economics at Curlie
• Austrian Economics Concise encyclopedia of economics on Econlib
• The Austrian School from the History of Economic Thought website.
• Mises.org, official website of the Ludwig von Mises Institute, containing a large selection of online books, video/audio, journal archives, and research on Austrian economics
• Introduction to Austrian Economics, an online lecture series from the Foundation for Economic Education