What is “Austrian Economics?”

While the phrase “Austrian Economics” has become remarkably more well-known since the turn of the millennium, most people are still perplexed when they hear it.  What exactly does it refer to?  The first thing to clarify is that Austrian Economics has nothing to do with the economic policy of the country of Austria.  As one economist in the “Austrian tradition” has remarked, the economic policy of Vienna might be interesting, but that is not what we are referring to.

Austrian economics refers to a certain “school of thought” in regards to economic theory that has its roots in the economic theorists who came out of Austria in the late 19th and early 20th centuries.  Hence the name.  There are many schools of economic thought: there are classical economists, neoclassical economists, Marxists, Keynesians, Chicago School economists (which morphed into the modern day Monetarists), and various other subcategories and branches.  There is also some overlap. The point is that Austrian Economics is a specific school of thought that offers an alternative view compared to the many other approaches.

The first economic thinker in the “Austrian tradition” was Carl Menger. He was a key figure in what is now called the “Marginalist Revolution.”  This refers to the breakthrough idea that value –economic value– is not intrinsic in the economic good itself, but rather, is a subjective judgement by each individual in society.  The individual values something to the extent that the good and satisfy his goals.  If one is very hungry, a sandwich has more value than the money paid (say, $5) for the sandwich.  But the sandwich is not always more valuable to the person than the $5.  Sometimes the individual may be full; and thus, when presented with the opportunity to trade his $5 for the sandwich, he finds more value in holding on to the $5.  Value then depends on the judgement of each person, given his specific context and moment in time.  This idea of “subjectivism” in value is the foundation of economic exchanges.

The second generation of Austrian economists included Menger’s students Eugen von Böhm-Bawerk, who contributed greatly to an “Austrian view” of an economy’s capital structure, and Friedrich von Wieser.  Interestingly, these two proteges of Menger were brothers-in-law and marked an important split in the Austrian tradition due to an important difference regarding price theory.  This split has trickled down to the differences between the third generation Austrians (such as between Ludwig von Mises [following the Bohm-Bawerk tradition] and F.A. Hayek [following the Wieser tradition]) and continues on in the modern Austrian School (such as the distinctions in approach of the Mises Institute in Alabama [who might prefer Mises and Rothbard over Hayek generally] and George Mason University [who might generally prefer Hayek over Mises/Rothbard]).  The fourth generation Austrians included Mises’ most important expositor and disciple Murray Rothbard who carried on the Misesian tradition and even strengthened it with clarifications such as regarding monopoly theory.

Perhaps the most important Austrian economist in the history of the school of thought is Ludwig von Mises– who single handedly carried on the Austrian framework through its dark years during the age of the fascism, communism, and central planning of the Word War II Years. A Jew, Mises narrowly escaped the German rush into Austrian and ended up in the United States where he continued to write and teach until his death in the 1970s.  Mises’ two most important contributions to economics included the “Austrian Business Cycle Theory” as well as his insights regarding the impossibility of economic calculation under a socialist order.

Austrian economics is set apart from other schools primarily in its approach to economic science, which of course has implications in the realm of conclusions of the effect of various economic “programs” and efforts taken up by governments trying to improve economic conditions around the world.  It is important to note that the Austrian School is not a set of ideas about the best course of action to be taken by governments, as if economics was merely about policy proposals.  Rather, the Austrian School analyzes economics through the lens of the individual human actor, who is a decision maker and profit seeker in every one of his actions in the real world.  It is through this lens –and not mathematical models and presumptions about “equilibrium levels”– that makes Austrian economics so unique, and yet so attractive.  It might seem obvious that to embark on a study of economics one needs to consider the actions and decision making of individual human beings rather than starting with “empirical data,” but unfortunately, this is the aspect of Austrian economics that is most criticized.

Austrian economics centers it approach to economic science by way of “praxeology,” which was the term employed by Mises to describe “the study of human action.” Economic laws stem deductively from the simple fact that human beings engage in action purposely and in order to employ means to attain whatever ends they desire. From this come economic ideas including marginal utility, the division of labor, mutually beneficial economic exchange, and the inclusion of things like money and interest rates in an economy.

Austrian economics is not about what is right and wrong for the government to do; it is not a political theory.  It does not say that some action by the government is morally wrong, nor does it suggest that the government’s role is to do X instead of Y. It is not normative (it does not seek to advance policy prescriptions).  Rather, Austrian economics is descriptive in nature, explaining what would happen if governments did X and what would happen if government did Y.  Whether the government should do X or Y or neither depends on a different field of social science altogether (such as political theory).  For instance, Austrian economists might point out that (other things being equal) a government price ceiling below the true market level (that is, a law that sets a limit on how much a business can charge for a good) would result in a shortage of that good.  But the Austrian does not go on to say “therefore, it is wrong for the governments to set price ceilings.” That would be the role of the political theorist.

Austrian economics is especially relevant in our current context of market volatility due to its pathbreaking “Austrian Business Cycle Theory” (ABCT) as formulated by Mises and later built upon by his student FA Hayek.  The ABCT teaches basically that it is the expansion of the supply of credit in the economy by the banks, encouraged and exacerbated by the establishment of a Central Bank with cartelizes the banking industry, that is the root of our economic problems. This fresh supply of new credit, literally created out of thin air, artificially lowers the rate of interest.  Interest rates are a very important and healthy part of any productive economy, as it is basically the price of credit; a price that is set by the time preference of both the savers/lenders as well as the borrowers.  When the rate of interest reflects the time preference of borrowers and savers, all is well.  But when the rate of interest is pushed below its natural/market rate, borrowers suddenly are more attracted to this cheap money.  They will thus borrow and engage in long-term projects that they otherwise would not have been able to afford at a higher rate of interest.  However, the savings in the economy are not ready to take on this increased borrowing and thus, the sudden increase in business borrowing for the sake of investment, cannot sustain itself.  There are not enough savings in the economy to be able to purchase the goods that are created by the sudden increase in production activity.

Business’ will eventually discover that they either cannot afford to complete their projects, or, if they do, there are not enough people who can actually purchase the completed projects.  Hence why, in the housing bust in 2008 for instance, there were so many uncompleted real estate projects on one hand, but also completed projects that nobody could actually afford (China’s ghost cities come to mind).  These investments are revealed to have been a misallocation of scarce resources and the investments turn out to be unprofitable. A bust follows as the bad debt is liquidated and the economy seeks to readjust back to its pre-boom levels.  For more, see Murray Rothbard’s monograph on economic depression.

Does Austrian Economics Help with Investing?