A Primer on Austrian Economics - By Jonathan M. Finegold Catalan

<blockquote>'There are some basic questions that most "beginners" ask when first delving into Austrian theory. What is Austrian economics? Who are these Austrian economists? Why is Austrian economics relevant in today's world? These are all questions worthy of a response, and this is what the present essay sets out to do. The present essay also serves as a bibliography of sorts, as one can further investigate into the topics proposed by following the sources suggested in the footnotes throughout.

...

One of the most important Austrian positions is the belief in the non-neutrality of money. The mainstream believes in the long-run neutrality, or superneutrality, of money. This belief maintains that changes in the money supply only cause proportional and permanent changes to prices, while leaving the "real economy" — investment, production, and employment — unchanged.<a href="[mises.org];[18]</a> While money may change the underlying economy in the short-run, it is believed that nevertheless these will adjust proportionally to changes in the money supply over the medium term or long run.<a href="[mises.org];[19]</a> It is exactly this belief in the superneutrality of money that led to the development of the mechanistic quantity theory of money, or MV=PT.<a href="[mises.org];[20]</a>

Austrians expressly reject the notion of the superneutrality of money. The Austrian rejection bases itself on the idea that the purchasing power of money is decided only upon the moment of an exchange. In other words, the price of a good relative to a medium of exchange is decided during individual exchanges, depending on the amount of money following that particular good during that particular period of time. Therefore, a change in the supply of money will not affect all prices proportionally; rather it influences only certain prices, depending on what the new money is spent on.<a href="[mises.org];[21]</a>

...

Believing in the non-neutrality of money is an important step towards understanding the Austrian business-cycle theory. The Austrian theory of the trade cycle is perhaps their most well-known contribution to economics, at least for the mainstream. This is especially true when considering that the principal reason for the rise in popularity of Austrian economics after the recession of 2007 was their explanation of the causes of the recession — and their predictions of the recession prior to the crash.

Important to understanding the underlying premises behind the theory of the trade cycle is the recognition of the relationship between the supply of money and the rate of interest. This relationship is explicitly rejected by John Maynard Keynes. Keynes suggests that the main contributing factor behind the rate of interest is society's so-called liquidity preference, or the preference of the consumer to hold money in liquid form or surrender it to an investor by saving it in nonliquid forms (such as a time deposit).<a href="[mises.org];[22]</a>

Unlike Keynes, Mises recognized the demand for money as time neutral. Keynes conflated the concepts of money and capital, not realizing that to hold money (or to hold a medium of exchange) did not translate into a reduction in the supply of capital on the market. As opposed to Keynes, Mises believed that a decrease in the supply of money-chasing loanable capital would simply manifest itself in the structure of production as a change in the prices of capital goods.<a href="[mises.org];[23]</a>

The rate of interest on a good, or what Mises called the originary interest, is that established by the ratio of the value of future goods discounted against the value of present goods.<a href="[mises.org];[24]</a> As explained by Jesús Huerta de Soto, "the term 'interest rate' [denotes] the market price of present goods in relation to future goods."<a href="[mises.org];[25]</a>

Money relates to the rate of interest in the sense that as a medium of exchange money can be used to acquire a certain amount of goods. Instead of bartering actual capital on the market, money allows for a complex series of exchanges to take place, without one individual having to directly satisfy another by offering the other the exact good in demand. As such, the lending and borrowing of money follows the same praxeological laws as other goods. Like any other goods on the market, as price decreases demand increases. As the supply of money on the market increases the cost of borrowing, or the rate of interest, decreases and the quantity demanded of loanable funds increases. This tends to catalyze investment.

...

While business-cycle theory is perhaps what the Austrians are currently most well known for, there is a myriad of other concepts the Austrians introduced or expanded upon. One such insight is that of the socialist calculation problem.

There is no objection amongst economists that given the existence of scarcity, the market is in need of a rationing device. Most economists, except those in extreme favor of centralized rationing, will also agree with the notion that price is the best rationing device of the market.<a href="[mises.org];[28]</a> While price hardly acts as a measure of value, due to the fact that no object has an objective value,<a href="[mises.org];[29]</a> it nevertheless serves as a useful tool to coordinate production by serving as a conveyor of information between different market agents and a method by which an individual can decide whether or not a particular action is economical.<a href="[mises.org];[30]</a>

In a socialistic economy, where prices are absent, this coordination would simply not exist. There would be no host of individual agents communicating through the price mechanism and allocating resources by means of subjective ratiocination. As a result, all meaningful economic activity would come to a halt. Complex programs would be impossible to complete economically, since without a price mechanism there would be no way for a central planner to distribute resources according to their most economical use. Thus, socialist economies are bound to fail.<a href="[mises.org];[31]</a>

These key Austrian positions have been explained in an effort to offer the reader an introduction. Understanding the basics of Austrian methodology, monetary and capital theory, and finally Mises's calculation problem, the reader can now fully plunge into a wider and deeper body of Austrian theory.'</blockquote>


A Primer on Austrian Economics

By Jonathan M. Finegold Catalan
June 04, 2010
Source

The jurisdiction of economics extends far beyond the study of production and consumption of goods and services. The science of economics consists of the study of human action, interaction, and cooperation. Even if you accept the mainstream division of micro- and macroeconomics, at the most basic levels economics deals with how market agents make decisions and how these decisions affect interactions between individuals. Even the broadest of market trends, usually condemned to the realm of "macroeconomics," boils down to interactions between individual market agents.<a href="[mises.org];[1]</a>

How individuals interact in tandem, forming the economic system as studied in modern macroeconomics, is simply fascinating. Even the most complex economies, such as today's global market, are made up of individual human actors, each seemingly unaware of the others' intentions and goals. Economics is the science that studies these individual agents of the market and how they coordinate through the price mechanism to create, not just what the mainstream considers "the market," but society as a whole, all without the necessity of a central planner or authority. The fact that human civilization is the product of billions of individuals, each acting to accomplish certain self-serving ends, is truly mind blowing.

What economists call "political economy," or modern economics, did not come into being until the mid-18th century.<a href="[mises.org];[2]</a> Since then the study of economics has not been one of linear progress; neither has it been free of controversy. Even before the birth of political economy, the study of economics was done by competing schools of thought; for example, the French mercantilists and the French liberals.<a href="[mises.org];[3]</a> Following the Smithian movement and despite the development of Marxism in the mid-19th century, economics was largely unified by the marginal revolution.<a href="[mises.org];[4]</a> However, the marginal revolution was followed by the birth of several distinct schools of economic thought. Some of the most well-known include the Neoclassical, Austrian, and Keynesian Schools, which interestingly all enjoy the same foundations in the marginal revolution.<a href="[mises.org];[5]</a>

Of the three above-mentioned major intellectual movements, the Austrian School is probably the smallest and least known. Despite this, it has become one of the fastest growing schools of thought in the past decade. And its ranks have swollen since the financial crisis of 2007.<a href="[mises.org];[6]</a> This growth is impressive enough as to prompt responses to the Austrian School from intellectual opponents who are usually ambivalent.<a href="[mises.org];[7]</a> All of this should be evidence enough that the Austrian School merits a closer look.

There are some basic questions that most "beginners" ask when first delving into Austrian theory. What is Austrian economics? Who are these Austrian economists? Why is Austrian economics relevant in today's world? These are all questions worthy of a response, and this is what the present essay sets out to do. The present essay also serves as a bibliography of sorts, as one can further investigate into the topics proposed by following the sources suggested in the footnotes throughout.

What is Austrian Economics?

The Austrian School of thought has offered economic science a wide variety of unique insights. It is unrealistic to provide a detailed account of all Austrian theory within the limits of an introduction. Nevertheless, there are some key theories that the Austrians have become known for, providing a solid foundation for further investigation into Austrian economics.

The unique keystone to Austrian theory is the concept of praxeology. Praxeology is the science of human action, under which the broader subject of political economy is categorized.<a href="[mises.org];[8]</a> The employed methodology of praxeology is known as a priorism,<a href="[mises.org];[9]</a> which is based on the ideas
<blockquote> a. that the fundamental axioms and premises of economics are absolutely true;
b. that the theorems and conclusions deduced by the laws of logic from these postulates are therefore absolutely true.<a href="[mises.org];[10]</a></blockquote>

Praxeology recognizes the fundamental axiom that is human action.<a href="[mises.org];[11]</a> Human action is purposeful and aims at completing ends through deliberately chosen means. Human action differentiates itself from instinctual reaction, such as a human's reaction to biological stimuli, in the sense that the latter is subconscious while human action is entirely conscious.<a href="[mises.org];[12]</a> Apart from the axiom of human action there are also several subsidiary axioms, including the facts that man values leisure over work and individuals vary — no one individual is the same as another.<a href="[mises.org];[13]</a>

From the axiom of human action, praxeology seeks to develop theory through logical deduction. Modeled, the axiom of human action is represented by A; if A implies B, and A is accepted as true, then B must also be true. That B must be true if implied by A is independent of experience (or a priori), proven through logic.<a href="[mises.org];[14]</a> As such, Mises denies the usefulness of historical experience in the study of economics, given that through praxeology any theories developed would be apodictic. It follows that praxeology makes empirical validation or falsification not only superfluous but, as Mises holds, almost useless.<a href="[mises.org];[15]</a>

Praxeology and a priori reasoning lead to the important concept of time preference. This is the notion that, ceteris paribus, individuals prefer present satisfaction to future satisfaction, under the condition that the utility of future satisfaction is the same or less, ordinally speaking.<a href="[mises.org];[16]</a> As such, humans choose certain time-consuming actions because they expect the end to have greater utility than any other end closer in time.<a href="[mises.org];[17]</a> In the broader sense, the idea of time preference becomes clearer once it is understood that capital accumulation, or savings, comes about as a result of changes in time preference. Individuals save as a means of garnering greater satisfaction at some point in the future.

While praxeology could be the subject of an entire book — and a complete understanding of praxeological science as developed to date would certainly be useful — for the purposes of a primer only the basic idea of what praxeology consists of is necessary. Praxeology is the science of rational human action, and its a priori methodology makes Austrian theory valid independent of experience. It follows that the following major Austrian insights are products of reason and not empiricism.

Non-neutrality of Money

One of the most important Austrian positions is the belief in the non-neutrality of money. The mainstream believes in the long-run neutrality, or superneutrality, of money. This belief maintains that changes in the money supply only cause proportional and permanent changes to prices, while leaving the "real economy" — investment, production, and employment — unchanged.<a href="[mises.org];[18]</a> While money may change the underlying economy in the short-run, it is believed that nevertheless these will adjust proportionally to changes in the money supply over the medium term or long run.<a href="[mises.org];[19]</a> It is exactly this belief in the superneutrality of money that led to the development of the mechanistic quantity theory of money, or MV=PT.<a href="[mises.org];[20]</a>

Austrians expressly reject the notion of the superneutrality of money. The Austrian rejection bases itself on the idea that the purchasing power of money is decided only upon the moment of an exchange. In other words, the price of a good relative to a medium of exchange is decided during individual exchanges, depending on the amount of money following that particular good during that particular period of time. Therefore, a change in the supply of money will not affect all prices proportionally; rather it influences only certain prices, depending on what the new money is spent on.<a href="[mises.org];[21]</a>

Austrian Business-Cycle Theory

Believing in the non-neutrality of money is an important step towards understanding the Austrian business-cycle theory. The Austrian theory of the trade cycle is perhaps their most well-known contribution to economics, at least for the mainstream. This is especially true when considering that the principal reason for the rise in popularity of Austrian economics after the recession of 2007 was their explanation of the causes of the recession — and their predictions of the recession prior to the crash.

Important to understanding the underlying premises behind the theory of the trade cycle is the recognition of the relationship between the supply of money and the rate of interest. This relationship is explicitly rejected by John Maynard Keynes. Keynes suggests that the main contributing factor behind the rate of interest is society's so-called liquidity preference, or the preference of the consumer to hold money in liquid form or surrender it to an investor by saving it in nonliquid forms (such as a time deposit).<a href="[mises.org];[22]</a>

Unlike Keynes, Mises recognized the demand for money as time neutral. Keynes conflated the concepts of money and capital, not realizing that to hold money (or to hold a medium of exchange) did not translate into a reduction in the supply of capital on the market. As opposed to Keynes, Mises believed that a decrease in the supply of money-chasing loanable capital would simply manifest itself in the structure of production as a change in the prices of capital goods.<a href="[mises.org];[23]</a>

The rate of interest on a good, or what Mises called the originary interest, is that established by the ratio of the value of future goods discounted against the value of present goods.<a href="[mises.org];[24]</a> As explained by Jesús Huerta de Soto, "the term 'interest rate' [denotes] the market price of present goods in relation to future goods."<a href="[mises.org];[25]</a>

Money relates to the rate of interest in the sense that as a medium of exchange money can be used to acquire a certain amount of goods. Instead of bartering actual capital on the market, money allows for a complex series of exchanges to take place, without one individual having to directly satisfy another by offering the other the exact good in demand. As such, the lending and borrowing of money follows the same praxeological laws as other goods. Like any other goods on the market, as price decreases demand increases. As the supply of money on the market increases the cost of borrowing, or the rate of interest, decreases and the quantity demanded of loanable funds increases. This tends to catalyze investment.

Austrians distinguish between a rise in the supply of loanable funds as a result of an increase in savings and the rise resulting from an increase in the supply of money. The latter is what leads to the business cycle. Providing a complete understanding of the Austrian business-cycle theory would require a deeper foray into Austrian capital theory, which unfortunately is something outside the scope of the present essay. Regardless, using what has been established thus far, the business-cycle theory can be explained as one that predicts discoordination in the market resulting from an artificial decrease in the cost to borrow money. This decrease in the rate of interest is artificial in the sense that it came as a result, not of an increase in loanable funds through an increase in savings, but an increase in loanable funds through an increase in the supply of money.<a href="[mises.org];[26]</a>

Given that a decrease in the market rate of interest will lead to an increase in the quantity demanded of loanable funds, this leads to an increase in investment. Investment leads to the lengthening of the structure of production in the hope of producing future goods.

Discoordination is caused by the fact that, given that the supply of money was increased artificially, consumers have not generally sacrificed present consumption for future consumption. Thus, existing capital is divided between continued production of consumer goods, for present consumption, and capital goods, which will be used to finance projects dedicated towards satisfying future consumption. This discoordination leads to widespread malinvestment, and when this discoordination is revealed it leads to an inevitable bust. Thus, Austrians hold that business cycles are caused by intertemporal discoordination, caused by artificial increases in the supply of loanable funds without an equal fall in present consumption.<a href="[mises.org];[27]</a>

Socialist Calculation Problem

While business-cycle theory is perhaps what the Austrians are currently most well known for, there is a myriad of other concepts the Austrians introduced or expanded upon. One such insight is that of the socialist calculation problem.

There is no objection amongst economists that given the existence of scarcity, the market is in need of a rationing device. Most economists, except those in extreme favor of centralized rationing, will also agree with the notion that price is the best rationing device of the market.<a href="[mises.org];[28]</a> While price hardly acts as a measure of value, due to the fact that no object has an objective value,<a href="[mises.org];[29]</a> it nevertheless serves as a useful tool to coordinate production by serving as a conveyor of information between different market agents and a method by which an individual can decide whether or not a particular action is economical.<a href="[mises.org];[30]</a>

In a socialistic economy, where prices are absent, this coordination would simply not exist. There would be no host of individual agents communicating through the price mechanism and allocating resources by means of subjective ratiocination. As a result, all meaningful economic activity would come to a halt. Complex programs would be impossible to complete economically, since without a price mechanism there would be no way for a central planner to distribute resources according to their most economical use. Thus, socialist economies are bound to fail.<a href="[mises.org];[31]</a>

These key Austrian positions have been explained in an effort to offer the reader an introduction. Understanding the basics of Austrian methodology, monetary and capital theory, and finally Mises's calculation problem, the reader can now fully plunge into a wider and deeper body of Austrian theory.

A Brief History of the Austrian School

Adam Smith is generally considered the father of political economy, and between Smith and the marginal revolution it is traditionally believed that there was a linear progression in the science of economics.<a href="[mises.org];[32]</a> Schumpeter's History of Economic Analysis suggested otherwise, and since then there has been a wealth of revisionism looking to correct economists' view on the Smithian movement. From an Austrian perspective, Smith did much to damage economic theory. Not only was much of Smithian theory erroneous — including his monetary and value theories — but also The Wealth of Nations effectively blotted out a rich tradition of economics prior to the Scottish enlightenment, including the School of Salamanca and the French liberals.<a href="[mises.org];[33]</a> It was left to the marginalists of the late 19th century to "rediscover" much of the pre-Smithian tradition.<a href="[mises.org];[34]</a>

The marginalist revolution was spearheaded by William Stanley Jevons, Léon Walras, and Carl Menger through the concept of marginal utility. It was Carl Menger who founded the Austrian School, expounding his ideas in two major economic works: Principles of Economics and Investigations into the Method of the Social Sciences with Special Reference to Economics. While Carl Menger laid the foundations for Austrian theory, his greatest influence was his support of an individualistic approach to economics, or what is called methodological individualism. This would ultimately lead to Mises's development of praxeology. In fact, Mises alludes to the importance of Menger's methodology by describing what was called the Methodenstreit (dispute on method) between Menger and Gustav Schmoller of the German Historical School (and others). While Menger's methodology did not recognize economic logic as all derived from the same axiom, one can certainly find the roots of the schism between a priori reasoning and empiricism in Menger.<a href="[mises.org];[35]</a>

enger influenced two important economists. These were brothers-in-law Eugen von Böhm-Bawerk and Friedrich von Wieser. Böhm-Bawerk considerably developed Austrian capital theory, expounded over two important volumes — Capital and Interest and [urll=http://mises.org/resources/3326/The-Positive-Theory-of-Capital]The Positive Theory of Capital[/url]. Perhaps his greatest contributions to capital theory were his concepts of time-preference and roundaboutness. Böhm-Bawerk also wrote a devastating criticism of Marxism and Marxian economics, Karl Marx and the Close of his System. Friedrich von Wieser made great strides in the socialist-calculation debate and would also become widely known for his development of the concept of opportunity cost.<a href="[mises.org];[36]</a>

Ludwig von Mises did not become immediately acquainted with Menger's economics. Mises read Menger's Principles only after Menger had retired from the University of Vienna. Jörg Guido Hülsmann believes that Mises became fully aware of Menger after being exposed to Friedrich Wieser, who gave a series of lectures at the university and attempted to expand on Menger's theories on money. Both Menger's book and Wieser's lectures impacted Mises's later writings on money, in many ways providing the basis of Mises's beliefs. While Menger did not immediately persuade Mises to embrace liberalism, it did cause a fundamental shift in the way Mises critically viewed the legitimacy of government intervention. It was this critical approach to theory that slowly converted Mises into the great liberal economist of Human Action, written over forty years after his first encounter with Menger and the Austrian School.<a href="[mises.org];[37]</a>

While Human Action can be considered the peak of Mises's intellectual career, it was not long after reading Menger that Mises published his first major theoretical work. This was The Theory of Money and Credit, published in 1912. It was this book that propelled Mises to forefront of the study of economics, although Mises's success was interrupted by the eruption of the Great War in 1914. Also rather unfortunate was the fact that The Theory of Money and Credit was not translated into English until the 1930s. Ultimately, Mises's views on money were drowned out by the views of figures such as Fisher and Marshall. Regardless, after the Great War Mises continued theorizing and developed Austrian methodology (what he would refer to as praxeology), he elucidated the socialist calculation problem, and prepared his great treatise, Human Action. The wide scope of Mises's contributions to Austrian theory, and the depths to which he pursued these topics, makes him the most important Austrian economist — and, to an Austrian, the most important economist of the 20th century.

Apart from directly contributing to the renaissance of Austrian thought, Mises also influenced many other economists, including Friedrich Hayek. Hayek contributed greatly by popularizing Austrian theory. During his stint at the London School of Economics, Hayek enjoyed widespread support of his beliefs, including from Lionel Robbins. Hayek was also awarded the Nobel Memorial Prize in Economic Sciences, a major stimulant in the resurgence of the Austrian School during the last two decades of the 20th century.

Hayek also contributed greatly to the Austrian theoretical corpus. This includes his work on the Austrian business-cycle theory,<a href="[mises.org];[38]</a> for which he would be awarded the Nobel Memorial Prize, and his writings that further developed capital theory.<a href="[mises.org];[39]</a> Hayek also revisited the calculation problem and was a renowned political scientist. Today, he is probably most well-known for <i><a href="[mises.org] to Serfdom</a></i>, where he warned that all "middle of the road" policies would eventually lead to socialism and tyranny.

After Hayek came a host of new Austrians. Many of them were not Austrians of the same ilk as Mises, but were nevertheless greatly influenced by Austrian methodology and theory. The post-Hayek generation of economists includes Israel Kirzner and Murray Rothbard, the latter of which heavily influenced the Austrian School by merging the school's classical-liberal ethical foundations with anarchism. Although the Austrian School had already become much more than a school of economics, Rothbard fully broadened the scope to cover ethics and political science. The state of modern "Austrianism" owes much to Rothbard, even if many Austrians disagree with Rothbard's conclusions.<a href="[mises.org];[40]</a>

Today, the Austrian School has grown to include an even larger body of professional economists, and a previously inconceivable body of followers and students. There is no doubt that great strides will be made in theory, throughout the multitude of fields that now completely fall within the scope of the school.

Relevance

Apart from the school's valuable insight in academics, how is the Austrian School relevant to current events? What makes Austrian theory important to the common man?

The answer to these questions can be deduced praxeologically, beginning with the axiom of human action. If we accept society as merely a web of purposeful interactions between individuals, then we begin to realize the potential distortions caused by exogenous factors — namely government through regulation. As a value-free science, praxeology cannot tell you whether or not government intervention is good or bad but it can tell you the consequences of exogenous distortion of human action. "Austrian" ethics, on the other hand, do serve the purpose of deciding between "good" and "bad," but in the purest sense the Austrian School can at least enlighten the layman by suggesting what effects certain economic policies will have.

This idea that government distorts, for better or for worse, is important. In a world where government is an irrefutable reality, and where intellectually the concept of anarchism has not been accepted by the mainstream, Austrian economics becomes very relevant in the sense of aiding individuals to judge the value of certain government programs. With an ongoing financial crisis and an impending greater crash, there is no better time to become aware of the consequences of interventionism.

It was the aim of the present essay to skim the surface of Austrian theory, in the hope that those interested will further explore Austrian thought. The message is not necessarily that one should uncompromisingly accept the views of the Austrian School, only that these insights are valuable and can add to whatever knowledge is already held by any given individual.

Nevertheless, the rigor of the Austrian method makes its methodology incomparable to that of any other school, which certainly makes the case for Austrian theory that much stronger.