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The Austrian Tradition

Mises Daily: Monday, November 16, 1998 by

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"We have progressively abandoned the freedom in economic affairs without which personal and political freedom has never existed in the past." (F.A. Hayek, The Road to Serfdom).

Economic thinking today is divided into many schools of thought, such as the following : the Keynesians, the Post- Keynesians, the Rational Expectations School, the Monetarists, the Public Choice School, the Game Theorists, the Supply Siders and so on. Also part of this mix, but in many ways removed from and above it, is the Austrian School. It is not a field within economics, but an alternative way of looking at the entire science.

Austrians place an emphasis upon the purposefulness and intentionality of all human endeavours. For them, social science is grounded in methodological individualism and methodological subjectivism. Whereas other schools rely primarily on idealized mathematical models of the economy and suggest ways the government can make the world conform, Austrian theory is more realistic and thus more practical.

Austrians view economics not in terms of static equilibria, but rather as processes constantly in flux, processes which turn above all on changes in the perception, expectations and subjective evaluations of economic agents. The members of the Austrian School have accordingly devoted much effort to the analysis of the role of knowledge and error and of processes of reason and appraisal in economic life.They see entrepreneurship as a critical force in economic development, private property as essential to the efficient use of resources, and government intervention in the market process as always and everywhere destructive.

The School has become increasingly influential in recent decades—especially in North America—above all in virtue of its emphasis on the unsurveyable complexity of economic phenomena and on the consequent unfeasibility of economic planning. Its influence in the UK, the Netherlands, Germany (e.g. the post -war economic program of Ludwig Erhard in the Federal Republic ), in parts of Eastern Europe and in Latin America is considerable.

In the academic world, this increasing influence has been due to the backlash against mathematical modeling and econometrics, the resurgence of verbal logic as a methodological tool, and the search for a theoretically stable tradition in contrast to the irrelevance and sterility of much of macroeconomic theorizing. In terms of policy, the Austrian School looks more and more attractive, given continuing business cycle mysteries, the collapse of socialism, the costs and failure of the welfare state and public frustration with big government.

Before a brief examination is undertaken of Austrian thinking and methodology, a more general point can be made. All Irish people who are middle aged or younger have grown up in an era of big government. They have been taught to believe that it is impossible to be a compassionate caring person without supporting the idea of very major government interventions in many aspects of life. While they accept that market forces have some uses in promoting economic efficiency, they nevertheless believe that entrepreneurship is connected with greed and that the government has to intervene in countless ways to prevent "market failure" and that it has a moral duty to redistribute resources on a massive scale to ensure "social justice." Incidentally, these views are most strongly advocated by academics and other opinion makers who are themselves either directly or indirectly employees of the state.

There are, however, many phenomena in our own time that may cause people to reassess this view. The first has been the demise of communism in Eastern Europe and the Soviet Union. It is simply intellectually dishonest to argue that the collapse of planning on a large scale has no implications for planning on a small scale. Most peoples' confidence in big government everywhere has diminished as a result of these and other events. What has been striking about the Austrian analysis of "planning" is that more than three generations ago they predicted the demise of Marxism and that their critiques of socialism in all its forms are every bit as devastating as those of an Alexander Zinoviev or an Igor Shafarevitch.

As early as The Road to Serfdom, Hayek was well aware that the dangers posing a threat to democratic regimes consisted in failing to set unbreachable limits on legislative activity, and in preferring to rely on unmodifiable rules.

"At the root of the dissolution of the boundary between democracy and tyranny," writes Raimondo Cubeddu, "lay the huge popularity of the belief that economic planning would allow a more efficient use and fairer distribution of resources. This in its turn gave rise to the ethical need for state intervention through legislation directed towards the fulfilment of social goals that would be binding on the members of society. In fact, however, substantive justice of this kind involves discrimination among people, so that any policy aiming at a substantive idea of distributive justice leads to destruction of the rule of law and hence to totalitarian political organization."

The Austrian Method

Austrians are especially interested in problems of method in economics and hold that the solutions to such problems constitute the primary task for the promotion of liberty. They wish to reestablish the status of economics as a pure science, a science that has more in common with a discipline like applied logic than, for instance, with the empirical natural sciences. It is this assessment of economics as a pure science, a science whose propositions can be given a rigorous logical justification, which distinguishes Austrians from all other current economic schools.

All the others conceive of economics as an empirical science, as a science like physics, which develops hypotheses that require continual empirical testing. Positivism and science are supposed to go together, but that view—for the Austrians—is simply mistaken. People think that positivism lends prestige to economics because it requires rigorous methods and training. But the truth is that economics and the social sciences are far more difficult. The process of thought by which true conclusions are reached is hard. It requires a level of abstraction which, quite possibly, many people are unable to sustain.

Mathematical economists mainly need formal rigor, that is, the ability to shift logically from one statement to the other, but they do not need conceptual rigor, which is the ability to understand fully the meaning of the words they are using. Austrians seek to attain both forms of rigor.

We may also say that Austrians have held for long that subjectivism, as a substantive doctrine and as a method, lies at the heart of their contribution. The theory of subjective value as pioneered by Menger, Böhm-Bawerk and Wieser was the first lesson the Austrians taught the economics profession. The subjectivism of value soon expanded into a more general approach with regard to understanding in which the economic actor's problem situation is defined as he perceives it to be.

Austrian economics today—and it has changed much in the last two decades—is often seen as "the economics of time and ignorance" after the landmark text of that title by Gerald O'Driscoll and Mario Rizzo in the mid-nineteen eighties. The reference to "time and ignorance" is of course derived from Keynes's "dark forces of time and ignorance." That does not mean, however, that Austrian economics has become the economics of John Maynard Keynes. (That would truly be ironic). The expression is important because it highlights the basic problems with which real time confronts individual actors. To say that Austrian economics is the economics of time and ignorance is to say that it is the economics of coping with the problems posed by real time and radical ignorance.

Although individuals are not paralyzed by these problems, they do not automatically or completely overcome them. The behavior generated by this predicament in which human beings find themselves is a source of market phenomena and institutions. It is also the source of prudential limits to these institutions. Human beings are prisoners of time. In the Austrian view, this prison acts not only as a constraint (i.e. the allocational aspects of time ) but also as a formulator of experience, thus generating and limiting our knowledge.

Austrians have now become among the most creative, innovative and least doctrinaire of economists. While the neoclassical mainstream continues to spin its wheels, Austrians (meaning the broad subjectivist and market-process school of thought) are asking and answering deep questions at the frontier of social-scientific knowledge. They understand that the application of the mechanistic model of nineteenth -century physics may well have reached the limits of its useful contribution. They are not afraid to challenge many widely, but passively held beliefs among economists (such as the "income effect": which holds that people produce less when they have an increase in income). They know that the twentieth century is almost at an end and that not all of its intellectual developments have been beneficial.

The History of the Austrian School

The proto-Austrian tradition dates from the fifteenth century Spanish Scholastics who first presented an individualist and subjective understanding of prices and wages. But the formal founding of the school dates from the 1871 publication of Carl Menger's 'Grundsaetze der Volkswirtschaftslehre' (Principles of Economics) which changed economists understanding of the valuing, economising and pricing of resources, overturning both the Classical and Marxian concepts of marginal utility. Menger (who lived from 1840 to 1921) also generated a new theory of money as a market institution and grounded economics in deductive laws discoverable by the methods of the social sciences.

Menger's position was explicitly Aristotelian and was much influenced by Brentano's ideas. He sought to dig down to the fundamentals of economic reality in just the way that Brentano sought to dig down to the fundamentals of psychological reality. The working out of many of the implications of this position is outside the scope of this essay, but at least one or two points can be made in this connection.

The theory of value, for Menger, was to be built up on subjective foundations, that is to say exclusively on the basis of the corresponding mental acts and states of human subjects. Thus value for Menger - in stark contrast to Marx - was to be accounted for exclusively in terms of the satisfaction of human needs and wants. Economic value, in particular, was seen as being derivitive of the valuing acts of ultimate consumers and Menger's thinking could be said to be an attempt to defend the possibility of an economics that would be at one and the same time both theoretical and subjectivist.

Menger held that there were no "social wholes" or "social organisms." This clearly implied a doctrine of ontological individualism. This went hand in-hand with a concomitant methodological individualism, according to which the economist was encouraged to build up his theories from the analysis of the individual acts of individual subjects whose processes of thought and action were seen to be similar to his own. Taken together, the two doctrines implied that all talk of nations, classes, firms etc was to be treated by the social theorist as in principle eliminable shorthand for talk of individuals.

Economics is thus methodologically individualist when its laws are seen as being made true in their entirety by patterns of mental acts and actions of individual subjects, so that all economic phenomena are capable of being understood by the theorist as the result or outcomes of combinations and interactions of the thoughts and actions of individuals.

Eugen von Böhm-Bawerk (1851 to 1914) was the next important figure in the Austrian School. He showed that interest rates, when not manipulated by a central bank, are determined by the time horizons of the public, and that the rate of return on investment tends to equal the rate of time preference.

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

Böhm-Bawerk engaged in a prolonged battle with the Marxists over the exploitation theory of capital and refuted the socialist doctrine of capital and wages long before the communists came to power in Russia.

He favored policies that deferred to the ever-present reality of economic law. He regarded interventionism as an attack on market economic forces that cannot succeed in the long run.

Böhm-Bawerk's greatest student was Ludwig von Mises (1881-1973). His contributions to the Austrian School spanned six decades and touched upon almost every aspect of economic science. For a substantial minority of people he was the most brilliant economist of the twentieth century. Mises' first major project was the development of a new theory of money. The Theory of Money and Credit, published in 1912, elaborated on Menger, showing not only that money had its origin in the market, but that there was no other way that it could have come about.

Mises also argued that money and banking should be left to the market and that government intervention can only cause harm. In that book, which remains a standard work today, Mises also sowed the seeds of his business cycle theory. He argued that when the central bank artificially lowers interest rates, it causes distortions in the capital-goods sector of the structure of production. When malinvestment occurs, an economic downturn is necessary to wash out bad investments.

Along with his student F. A. Hayek, Mises established the Austrian Institute for Business Cycle Research in Vienna and he and Hayek showed that the Central Bank is the source of the business cycle. Their work eventually proved to be most effective in combating Keynesian experiments in fine-tuning the economy through fiscal policies and central banking.

The Case Against Keynesianism

Austrians view Keynesianism as an untidy jumble of theorems that arise from the abuse of mathematical concepts by applying them to a science that is not mathematical in the development of its basic theorems. No one can doubt - they would add - that economists are capable of erecting impressive mathematical models upon conceptually confused foundations.

In the Austrian view, Professor W.H. Hutt in his book The Keynesian Episode: A Reassessment has written on all of this with the most insight, as in the following:

"It has become obvious that Keynesianism, especially when it is combined with the policy of the welfare state, is destructive of labor incentives to productivity ; and other disasterous sociological results of the Keynesian experiment are being perceived,I think, by an ever-widening circle."

"Keynes offered an economic theory so profound as to be inscrutible to all but the initiated—and thus an exclusive cult was born... All too many people in all spheres—the academic sphere not excluded—are apt to accept obscurity for profundity."

Hutt added:

"Already in 1936, although I had been bewildered by it, I had seen clearly and predicted that The General Theory would have a quite unparalleled influence by reason of what I judged to be its demerits as a contribution to thought. Its policy implications appeared to have been chosen for their political attractiveness, its misrepresentations of the classical economists seemed certain to have a powerful appeal (because the techniques of the dismal science had at all times been accepted reluctantly...)"

It is worth recalling also that Keynes was no great friend of market capitalism, in fact it would be correct to call him a socialist—as Professor Hans-Hermann Hoppe does—not of the egalitarian-proletarian variety, as espoused by the Bolsheviks, but rather that of the national socialist variety. For instance, in the preface to the German edition of his General Theory (which appeared in late 1936) Keynes wrote : "The theory of aggregate production that is the goal of the following book can be much more easily applied to the conditions of a totalitarian state than the theory of the production and distribution of a given output turned out under conditions of free competition and of a considerable degree of laissez- faire."

The Horror of Marxism

The Austrian School is the historical bete noire of the Marxian School. Long before any other school came around to understanding the deep flaws in the Marxian approach, the Austrians had devoted an enormous amount of intellectual power to exposing its fallacies and dangers. Carl Menger refuted the labour theory of value, his student Eugen von Böhm-Bawerk demolished Marx's views of capital, F.A. Hayek showed the incompatibility between socialism and political freedom and Ludwig von Mises attacked the core of socialist economic theory.

It was Mises's criticism which has proven to be the most prescient. In his essay of 1920 "Economic Calculation in the Socialist Commonwealth," he argued that the socialist economy cannot properly be called an "economy" at all, since the system provides no means for rationally allocating resources. It abolishes private property in capital goods, thereby eliminating the markets which produce prices with which to calculate profit and loss. The absence of rational economic calculation and the institutional structures that undergird it, prevents any realistic assessment of the proper uses and opportunity costs and resource allocation options. "As soon as one gives up the conception of a freely established monetary price for goods of a higher order," Mises wrote, "rational economic production becomes completely impossible." The central planners of an industrial economy will find themselves in a perpetual state of confusion and ignorance, "groping in the dark."

The decades-long effort to eliminate markets in the former Soviet Union, for instance, resulted in the destruction of the work ethic, the mass misallocation of resources through centralized investment, the demolition of the base for private capital accumulation, the distortion of the means of economic calculation and the employment of technology so obsolete that the capital value of industrial enterprises was zero or negative.

On Interventionism

Austrians take the view that government intervention within a market order ultimately creates the same problems as did socialism, only in a more moderate form. To the extent that the interventions infringe upon the free market formation of prices and direction of production, to that extent, market forces—that is entrepreneurial attempts to satisfy consumer demands in the most efficient manner—are thwarted.

In addition, as each government intervention distorts and disrupts the competitive market price structure, the government must continually face the problem of either extending its controls and regulations in an attempt to compensate for the imbalances its previous interventions had caused or repeal the existing interventions and allow a return to a competitive market arrangement. Thus, in the Austrian view, an interventionist, "mixed economy" is inherently unstable ; logically it requires either an extension of the interventions until all- round planning is established via a continuing piecemeal process or the interventionist state must disengage until a free market order once again predominates.

General Propositions

Austrians hold that so far as the question of market failures is concerned that the burden of proof is still with the government to demonstrate that it can perform the task more efficiently than the market. Austrians would refocus the energy that goes into finding market failures into understanding more about government failures. They believe that economic regulation is always destructive of prosperity because it misallocates resources and is extremely injurious to small businesses and entrepreneurship. They oppose all forms of government intervention in the labor market: they hold that where employers are not able to hire, fire and promote based on their own criteria of merit, misallocations occur within the firm and more generally in the market for labor.

They also oppose all forms of redistributionism because in their view it takes from property owners and producers and gives, by definition, to non-owners and non-producers. This diminishes the value of the property that has been redistributed. Far from increasing total welfare, redistributionism diminishes it. By making property and value less secure, income transfers lessen the benefits of ownership and production and thus lower the incentives to both.

They oppose the institution of central banking: in their view it creates incentives towards inflationary monetary policies.

The Austrian School's Virtues

In summary, one could say that Austrian economics has at least six major virtues:

The first is its realism. Austrians analyze market capitalism as it is, not as it might be. Unlike neoclassicals, they make room for such real world phenomena as Tony O'Reilly, the prominent Irish-born businessman. The Austrian vision of market competition as an endless dynamic process in which powerful companies struggle for commercial supremacy accords perfectly with the everyday experience of business people and workers. This red- blooded characterization of capitalism is in sharp contrast to the insipid general equilibrium model, so beloved by mainstream theorists.

The second virtue of Austrian economics is its emphasis on the dispersal of knowledge. Hayek made this point with great clarity in some famous papers in the late nineteen-thirties and nineteen forties. As he argued, the sum total of knowledge available in an economy 'never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. It follows that nobody—and that obviously includes the governments—is able to take a God's eye view of economic and social life.

Politicians should be humble and cautious when they attempt to make decisions on behalf of the community as a whole, because they rarely, if ever, possess enough knowledge to make the right decisions. The fact that this humility is so rarely evident only shows that Hayek's arguments are still not widely understood. Once Hayek's argument is grasped, there is no alternative but to adopt an Austrian view of markets: to see competition as a process by which knowledge is discovered and efficiently shifted around an economy. Knowledge is what you get as a result of the competitive process, not something you can assume from the outset. This argument is perhaps the most powerful available against all forms of government intervention.

The third virtue of Austrian economics is the Misesian theory of entrepreneurship. It is, after all, rather curious that mainstream economics has so little to say about the motive force of capitalism. At least the communist Chinese know better : in Jiaotung Business School at the University of Shanghai, for instance,the MBA Program now offers a course in entrepreneurship. Ludwig von Mises held that entrepreneurship is utterly fundamental to all economic activity - indeed to all human action, which he defined as purposeful attempts to remove feelings of uneasiness. This is because all human action occurs in conditions of radical uncertainty. We have to act, yet we cannot know the consequences of our actions. As Mises emphasized, we are thus all entrepreneurs or speculators.

The fourth important virtue of the Austrian School is breadth of vision and philosophical sophistication. Austrians are not mere technicians. Besides economics,they tend to be well versed in related disciplines such as political science, law, philosophy and history. It is impossible to miss this feature in the work of Menger, Mises and Hayek and more recently in the work of Rothbard, Kirzner, Salin and Hoppe.

The fifth virtue of Austrian economics is the clarity of its policy prescriptions. Austrians do not equivocate.

The sixth and final virtue is the Austrian School's historical credibility. Austrians saw the flaws of socialism, for instance, sooner than anyone else. By contrast, neo-Keynesian technocrats were still defending socialist planning in the mid-nineteen eighties, sixty years after the publication of Mises's book Socialism.

In this year just after the fiftieth anniversary of the founding of the Mont Pelerin Society, a society dedicated to libertarian ideals, the fortunes of the Austrian School are again in the ascendant. Austrians, however, are never complacent or intellectually lax. They hold dear the following lines of Ludwig von Mises:

"Everyone carries a part of society on his shoulders ; no one is relieved of his share of responsibility for others. And no one can find a safe way out for himself if society is sweeping towards destruction. Therefore everyone, in his own interest, must thrust himself vigorously into the intellectual battle."

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Edmund Shanahan, BA MA BSc MSc is a Dublin-based financial economist. His research interests include technology transfer and the Chinese market ; business cycle theories ; and genetic algorithms in finance. This article originally appeared in Reflections: A Publication of the Edmund Burke Institute (Summer 1998) (11 Herbert Street; Dublin 2) and is reprinted with permission.