Why Austrian Economics Matters

In its twelve decades, the Austrian School has experienced different levels of prominence. It was central to the price theory debates before the turn of the century, to monetary economics in the first decade of the century, and to the controversy over socialism’s feasibility and the source of the business cycle in the 1920s and 1930s. The school fell into the background from the 1940s to the mid-1970s, and was usually mentioned only in history of economic thought texts.

The proto-Austrian tradition dates from the 15th-century Spanish Scholastics, who first presented an individualist and subjectivist understanding of prices and wages. But the formal founding of the school dates from the 1871 publication of Carl Menger’s Principles of Economics, which changed economists’ understanding of the valuing, economizing, and pricing of resources, overturning both the Classical and the Marxian view in the “marginal revolution.”

Menger 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 book, said Ludwig von Mises, made an economist of him, and it is still of great value.

Eugen von Böhm-Bawerk 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. He also dealt a deadly blow to Marx’s theory of capital and exploitation, and was a key defender of theoretical economics at a time when historicists of every stripe were trying to destroy it.

Böhm-Bawerk’s greatest student was Ludwig von Mises, whose 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 it could have come about. Mises also argued that money and banking ought to 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 malinvestments occur, 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 the central bank.

The Mises-Hayek theory was dominant in Europe until Keynes won the day by arguing that the market itself is responsible for the business cycle. It didn’t hurt that Keynes’s theory advocating more spending, inflation, and deficits was already being practiced by governments around the world.