Austrian school of economics

The Austrian School of economics is a heterodox school of economic thought that advocates methodological individualism in interpreting economic developments and emphasizes the spontaneous organizing power of the price mechanism. Austrian economists 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 they term '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. Austrian School economists generally advocate a laissez faire approach to the economy and are most frequently associated with libertarianism.

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 of economic thought. Its reputation rose somewhat in the late 20th century.

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 a market extremely difficult (or undecidable).

Etymology

The Austrian School derives its name 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. In 1883, Menger published Investigations into the Method of the Social Sciences with Special Reference to Economics, 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". 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".

History

Origins

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. French classical economists Jean-Baptiste Say and Frédéric Bastiat considered that value was subjective. In the late 19th century, attention then 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.

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.

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.

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.

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 in the late-20th century with the work of Israel Kirzner and Ludwig Lachmann, and renewed interest in Hayek after he won the Nobel Memorial Prize in Economic Sciences. However, it remains a minority position.

Hayek's work was influential in the revival of laissez-faire thought in the 20th century. Following Hayek, one of Ludwig von Mises's students, Murray Rothbard, became prominent in both Austrian applied theory and Libertarian philosophical thought.

Methodology

Methodology is where Austrian economists differ most significantly from other schools of economic thought. Mainstream schools such as Keynesians and Monetarists adopt empirical, mathematical, and statistical methods, and focus on induction to construct and test theories. 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. They claim one should instead isolate the logical processes of human action. Mises called this discipline "praxeology." 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.

According to Austrian economists, deduction is preferred to induction in interpreting economic developments, since if performed correctly, it leads to certain conclusions and inferences that must be true if the underlying assumptions are accurate. 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.

Theories

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. 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.

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. Economist Steve H. Hanke identifies the 2007-2010 Global Financial Crises 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 Global Financial Crisis has reaffirmed its status and, perhaps, cast into question the utility of mainstream theories and critiques.

Capital

Austrian economist Eugen von Böhm-Bawerk created a theory of capital as a response to Marx's theories on capital. Böhm-Bawerk's theory centered on the untenability of the labor theory of value in the light of the transformation problem. He also argued 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. Böhm-Bawerk's theory equates capital intensity with the degree of roundaboutness of production processes. Böhm-Bawerk also argued that the law of marginal utility necessarily implies the classical law of costs.

Economic calculation problem

Main article: Economic calculation problem

The economic calculation problem is a criticism of socialist economics. It was first proposed by Max Weber in 1920. This led to Ludwig von Mises discussing Weber's idea with his student Friedrich Hayek, who expanded upon it to such an extent that it became a key reason cited for the awarding of his Nobel prize. 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 the computational complexity of economic equilibrium notes 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. While a true equilibrium may be impossible under both free markets and central planning, Austrians maintain that free markets are generally more efficient than central planning, since it is highly unlikely that a few economic planners would have a computational advantage over a distributed network of free market information.

Inflation

Ludwig von Mises asserted that inflation only results when the supply of money outpaces demand for money:

In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur.

While the Free Banking branch of Austrian economics maintains the above definition, the Rothbardian branch argues 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 nominal price level that is higher than it would have been without the inflation, 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) is the blue line at the bottom, and the checkable deposits is the green line in the middle. The M2 money measure, in red, 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 usually the result of 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, advocating that the market should choose what is used as money. Some Austrians and supporters of the Austrian School also favor a return to a 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.

Opportunity cost

Main article: Opportunity cost

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.

Praxeology

Main article: Praxeology

Praxeology is the study of human action. Praxeology rejects the empirical methods of the natural sciences, because the observation of how humans act in simple situations cannot predict how they will act in complex situations. Ludwig von Mises developed his own system of praxeology which is adhered to by many Austrian economists. Mises' praxeology is 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. 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. 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."

Differences with neoclassical economics

The Austrian school and neoclassical economics are similar in many respects. According to Austrian school economists, the main area of contention between neoclassical economics 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. 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 supposedly 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 mainstream economics. 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.

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, and it is currently a distinctly minority position. By the mid-1930s, the mainstream had more or less absorbed what were seen as the important contributions of the Austrians. 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."

Two modern schools of thought are seen as being either Austrian economics, or as the direct philosophical heir of Austrian economic philosophy. These are the Free Banking school and the Rothbardian movement. Although they have competing views of monetary policy, they share a fundamental view of most economic philosophy. Free Banking advocates see themselves as coming directly from Hayek's later progress, especially his work The Denationalization of Money, while the Rothbardians follow the views of Murray Rothbard and Mises.

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. 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.

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. Austrian economic ideas are also promoted by bodies such as the Mises Institute and the Foundation for Economic Education.

Criticisms

Critics argue that Austrian economics generally lacks scientific rigor, rejects the scientific method, and rejects the use of empirical data. Thomas Mayer has said the Austrian School has advocated a rejection of scientific methods which involve directly using empirical data in the development of (falsifiable) theories; application of empirical data is fundamental to the scientific method. Murray Rothbard has argued that the scientific method of the natural sciences is not applicable to the social sciences, and has rejected any attempt of using mathematics in the study of economics calling it "scientism". Rothbard has argued that the use of the wrong methodology is what is truly unscientific. Economic historian Bruce Caldwell has described Ludwig von Mises as the mid-20th century's "archetypal 'unscientific' economist." Austrians argue that empirical data in and of itself cannot explain anything, which in turn implies that empirical data cannot falsify a theory. Paul A. Samuelson has said such rejections of empirical evidence in economics has led to the Austrian School being dismissed within mainstream economics.

Economist Bryan Caplan has noted that, "what prevents Austrian economists from getting more publications in mainstream journals is that their papers rarely use mathematics or econometrics." Austrian theories are not formulated in formal mathematical form, instead they use mainly verbal arguments based on, 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. More generally, Paul Krugman has noted that the Austrians' failure to use models has left them unaware of holes in their own thinking.

Bryan Caplan has argued that Austrian economists have often misunderstood modern economics, causing them to overstate their differences with it. For example, many 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 strictly monotonic transformations of utility, and so are true for purely ordinal preferences. The result is that conclusions about utility preferences hold no matter what values are assigned to them. 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.

Economist Jeffrey Sachs observes that among developed countries, those with 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 concludes that Friedrich Hayek was wrong to argue that high levels of government spending harms an economy, and "a generous social-welfare state is not a road to serfdom but rather to fairness, economic equality and international competitiveness." Austrian school economist Sudha Shenoy countered by claiming that countries with large public sectors have grown more slowly.

Krugman has been critical of the Austrian business cycle theory, which he dubs the "hangover theory". Austrians believe that many booms and busts are caused by the misallocation of resources from consumption to investment; entrepreneurs invest funds in sectors inconsistent with consumers' buying preferences, causing booms and leading to excess capacity. Busts occur when resources reallocated back into consumption sectors. Krugman argues that this theory does not explain unemployment. Since total spending is equal to total income, the reallocation of resources during recessions would increase employment in consumption sections. In addition, the initial booms also cause resource reallocation, which implies an increase in unemployment under the Austrians' theory of the business cycle. Krugman also points out that recessions impact productive workers as well, and notes that spending declines in almost all sectors of an economy during recessions. In response, Austrian economist David Gordon has argued that prices on consumption goods may go up as a result of the investment bust, which could mean that the amount spent on consumption could increase even though the quantity of goods consumed has not.

Jeffery Hummel points out Hayek's solution in Prices and Production to Krugman's argument, but then argues that it is unsatisfactory. Hayek argues that the decrease in spending in investment sectors creates unemployment, because a decline in investment spending causes some laborers to return to the consumption sector where demand is increasing. The result is that there is an insufficient amount of laborers left to complete industrial projects, which causes them to be laid-off. Hayek continues by arguing that there are too many industrial workers laid-off to be accepted into the consumption sectors of the economy, because consumption projects can be completed more quickly. Hummel dismisses this argument on two fronts. He notes that this explanation makes peculiar assumptions about demand curves for labor.

In addition, Hummel argues that the Austrian explanation of the business cycle fails on empirical grounds. In particular, he points out that investment spending has decreased but has remained positive in all recessions where there are data, except for the Great Depression. This casts doubt on the notion that recessions are caused by a reallocation of resources from industrial production to consumption, since the Austrian business cycle theory implies that net investment should be below zero during recessions. In 1969, 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." He analyzed the issue using newer data in 1993, and again reached the same conclusions. In 2001, Austrian economist James P. Keeler stated that the hypotheses of the theory are consistent with empirical evidence.

Mainstream economists argue that the Austrians' theory of the business cycle requires bankers and investors to exhibit a kind of irrationality, because their theory requires bankers to be regularly fooled into making unprofitable investments by temporarily low interest rates. In response, Austrian economists Carilli and Dempster have argued that a banker or firm loses market share if it does not borrow or loan at a magnitude consistent with current interest rates, regardless of whether rates are below their natural levels. Thus businesses are forced to operate as though rates were set appropriately, because the consequence of a single entity deviating would be a loss of business.

According to economic historians, economies have experienced less severe boom-bust cycles after World War II, because governments have addressed the problem of economic recessions. This has especially been true after central banks were granted independence in the 1980s, and started using monetary policy to stabilize the business cycle, an event known as The Great Moderation. Critics have also argued that, as the Austrian business cycle theory points to the actions of fractional-reserve banks and central banks to explain the business cycles, it fails to explain the severity of business cycles before the establishment of the Federal Reserve in 1913. For example, the Panic of 1873 initiated the Long Depression in the United States and much of Europe. There were also severe market crashes in the United States of magnitude comparable to the 1929 crash in 1869, 1884, 1896, 1901, and 1907, though there was no central bank or national monetary policy in the US during these crises. In fact, the movement to establish central banking in the United States was in part a response to the business cycle, particularly the Panic of 1907. Austrian School historian Thomas Woods argues that the crashes were caused by various privately-owned banks with state charters that issued paper money, supposedly convertible to gold, in amounts greatly exceeding their gold reserves.

Seminal works

Treatises

• 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
• 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

Divulgation books

• Economics in One Lesson (1946) by Henry Hazlitt
• Capitalism: A Treatise on Economics (1996) by George Reisman

See also

• List of Austrian School economists
• List of Austrian intellectual traditions
• Perspectives on capitalism
• Quarterly Journal of Austrian Economics
• Fear the Boom and Bust

References

• Harald Hagemann, Tamotsu Nishizawa, and Yukihiro Ikeda, eds. Austrian Economics in Transition: From Carl Menger to Friedrich Hayek (Palgrave Macmillan; 2010) 339 pages
• Stephen Littlechild, ed. (1990). Austrian economics, 3 v. Edward Elgar. Description and scroll to chapter preview links for v. 1.

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.
• Introduction to Austrian Economics, an online lecture series from the Foundation for Economic Education
• A Primer on Austrian Economics by Jonathan M. Finegold Catalan, June 2010