Austrian Economics

What is it about the Austrian School of Economics that attracts adherents even more than 100 years after the school’s founding by Carl Menger in 1871? Many think the answer lies in the libertarianism that is so closely associated with this analysis of economic issues. No doubt in the case of many teachers and scholars, the libertarian conclusions reached by many Austrian economists go a long way toward explaining their interest in the subject. However, if one is primarily concerned with the conclusions drawn by libertarianism, which, after all, is primarily a political theory, it does not follow that one must adhere to the Austrian School’s teachings on economics. Milton Friedman, probably the most notable of all libertarian economists, was methodologically and analytically at odds with the Austrian School, although he shared the normative conclusions of many Austrians. Friedman’s long-​time colleague, George Stigler, shared Friedman’s views, as does Friedman’s son, David. Indeed, non-​Austrian libertarians within the economics profession have proven themselves much more successful in advocating the necessity of reducing the role of government in the economy. Austrian economists, however, insist that one must take issue with economic orthodoxy to arrive at a proper understanding of how markets really work, thus supplying a firm support to the underlying economic argument for freedom. Nor indeed does Austrianism necessarily imply a defense of an unrestrained market economy. Many of its most prominent spokesmen supported some, and in certain instances substantial, government intrusion in the economy. For example, Friedrich von Wieser, under whom Hayek studied in Vienna, advocated a fairly extensive welfare state. In the main, however, Austrian economists have embraced a free and unfettered market only minimally constrained by government.

Austrian analysis of economic phenomena rests on the methodological foundation comprising (a) methodological individualism, (b) methodological subjectivism, (c) methodological dualism, (d) an analytical focus on processes of adjustment to changing conditions, and (e) the study of spontaneous order by use of the composite method. These methodological foundations were forged in the context of the intellectual development of economic thought and, in particular, in response to two opposing intellectual forces—the Ricardianism of the late-​classical economics and the historicism that defined the German School and the American Institutionalists. The Ricardians argued that economic outcomes are the product solely of long-​run technological possibilities. Thus, they purged the human element from economic explanation. Historicism, in contrast, denies that universal economic explanations, valid at all times and in all places, are possible but argues that economic explanations hinge on the details of historical circumstance and culture. The Austrian School, beginning with the work of Carl Menger and continuing to this day, argues that a universal science of economics is possible and that man is the alpha and omega of economic life. In the Austrian conception of economic science, the individual is not an abstract being disembodied from his social environment. Instead, scholars working in the Austrian tradition understand man as embedded in social relations. Like the historicists, Austrians are critical of an economic science that models human actors as isolated automatons, yet they are sympathetic to other neoclassical economists who argue against those critics who insist that universal explanation on the basis of marginal utility analysis is possible. All economic outcomes, the Austrians insist, are filtered through the human mind. Our imagination gives rise to desires, which lead to actions and, in turn, economic outcomes. Human action can indeed be systematically studied and not merely described. But it must be underscored that human action in reality takes place in a world of uncertainty. Action is directed at an unknown future and logically must be; if the future were known, there could be no way in which human action could affect the outcome. As Mises puts it: “The uncertainty of the future is already implied in the very notion of action. That man acts and that the future is uncertain are by no means two independent matters. They are only two different modes of establishing one thing.”

The market process emerges out of the interaction of human actors. We can conceive of the market process in a way best explicated by Israel Kirzner in his book The Meaning of Market Process. There are two sets of variables in economic life, Kirzner argues. There are the underlying variables of tastes, technology, and endowment of natural resources, and there are the induced variables of prices, profit, and loss. In competitive equilibrium, the induced variables of the market correspond perfectly to the underlying variables, such that all resources are utilized in such a way that the highest value is achieved and the least costly technologies are employed. When the market is in competitive equilibrium, it simultaneously realizes production efficiency, exchange efficiency, and product-​mix efficiency. In short, given the conditions of the world, one could not better arrange these variables even were an omnipotent being to do so.

Critics of economics emphasize the highly specific conditions required for this simultaneous achievement of efficiency. These critics tend to deny that there is any relationship among the underlying variables of tastes, technology, and resource endowment, on the one hand, and the induced variables of monetary prices, profit, and loss, on the other hand. Without postulating an intimate relationship between the underlying and the induced variables, it is argued, the efficiency properties of the market cannot be sustained. The Austrians have mediated this debate between the perfect and imperfect markets by maintaining that, although induced variables do not perfectly map the underlying variables, nevertheless they are closely related. Economics is not a science about exact points, but instead a science of tendency and direction. A lagged relationship exists between the two sets of variables. To the extent that the induced variables of the market do not reflect the underlying variables, there will exist opportunities for pure profit for those who move in the direction of narrowing the gaps between the two. Ironically, if all actors knew of these opportunities, then no profit would be realized because profit opportunities that are known to all will be realized by none. Austrianism postulates that no knowledge is perfectly known to all. Instead, knowledge is divided among market participants and must be communicated through the activities of economic agents and through the institutions of the market system. In the absence of any change in the underlying variables, the induced variables of the market will move in the direction of dovetailing with them. However, because tastes and technology are constantly changing as circumstances change, a perfect correspondence of economic variables and plans is impossible. Nevertheless, economic analysis is able to inform us on how any state of affairs outside of perfect correspondence will provide incentives and information for actors to move in the direction that would result in such perfection were it not for intervening changes in the underlying variables.

This emphasis on the mechanics that encourage adaptation to changing conditions requires not only a different way to do economic science, but also a different set of economic arguments that point to the benefits of markets. In the canonical general equilibrium model, for example, the plans of economic agents are prereconciled, such that the market is said to clear. This approach highlights the interconnectedness of all economic activities and represents one of the great intellectual achievements in the field of economics of the 19th and early 20th centuries. Yet the equilibrium approach tends to preclude from analysis the very activities that enable markets to emerge and work effectively to coordinate the plans of economic actors. The most obvious activity that must be eliminated in equilibrium analysis is the entrepreneurial discovery of pure economic profits because economic profits, by definition, are zero when all aspects of the economy are in equilibrium.

One of the implications of eliminating the entrepreneur as a central character in economic analysis is that competition is given a different meaning, as Frank Machovec has pointed out in his book Perfect Competition and the Transformation of Economics (1995). The economist’s notion of competition differs from its common usage. In ordinary parlance, competition is a term used to connote an activity. Thus, to compete is used when we wish to refer to two teams vying to win a game. However, when an economist uses the term, it is more than likely used as a noun to describe a state of affairs. The contrast between these two meanings of the term is no more evident than it was in the antitrust case brought by the Justice Department against Microsoft. It is hardly the case that only Austrian economists have supported Microsoft against an overzealous government. Indeed, perhaps the most able critics of the government’s case are Stanley Leibowitz and Stephen Margolis, whose book, Winners, Losers & Microsoft, argued the case in terms of equilibrium economics. However, a significant aspect of their analysis turns not on equilibrium economics, but on human imagination and entrepreneurial activity.

One of the primary reasons that the Austrians are so sensitive to these issues in ways that other economists are not is because of the debates these economists were embroiled from the 1930s to the 1950s. The Austrian economists, in particular Mises and Hayek, led the intellectual opposition to the new models of market socialism and Keynesian demand management. The Austrians were perceived by most economists and the general public to have lost both debates. However, both the market socialists and Keynesian models failed utterly as guides to enhance prosperity, as Mises and Hayek warned. The reason that both models failed to achieve the level of economic prosperity promised was because of what these approaches—market socialism and Keynesian demand management—had assumed away. In both instances, the models were predicated on the assumptions that they sought to prove. Government officials were assumed to be both benevolent and to possess omniscience, which allowed the government to be employed as a corrective to perceived failures. It is almost certainly because of this intellectual history that Austrian writers have tended to focus their applied economics on issues of socialism and macroeconomics.

Macro models suffered the same problems as did models of market socialism and were plagued by unwarranted assumptions and excessive aggregation. Classic works in Austrian macroeconomics by Mises and Hayek were largely written before the Keynesian hegemony in economics, which lasted from the 1940s to the mid-​1970s. A younger generation of Austrian economists, however, was inspired by these classics, the work on monetary theory, and the business cycle by Murray Rothbard, which sought to develop further the insights first offered by Mises and Hayek. They have pioneered work in the area of free banking and challenged the idea that unregulated banking would be chaotic. More recent work has challenged the theoretical coherence of the contending macroeconomic models and argued that, rather than a labor-​based approach, macroeconomics should restructure its analysis to be capital-​based. The most significant shortcoming of standard macroeconomics in all its varieties is the slight attention that is paid to capital theory. Roger Garrison has dubbed this labor-​based macro, as opposed to the more Austrian style capital-​based macro. The main issue here is not simply a focus on capital markets, but the way the capital markets are conceived. Austrian economists view capital not as a stream of financial resources, but as a structure of capital goods that must be coordinated in the process of production through time. Capital goods are heterogeneous and have multiple specific uses, and Austrians have traced in detail the important role of capital goods and capital accounting in a modern economy.

With respect to my original question regarding what continues to make Austrian economics a worthwhile approach to the study of the production and distribution of goods and services, several economists have attempted to answer this question by way of the biography of a set of ideas and by developing these ideas in the hope that they will transform economic scholarship. This approach springs from an honest commitment to the belief that the Austrian school provides us with a better opportunity to gain truth in economic understanding. It is an approach to economics that is grounded in the choices of human beings. It shies away from heroic assumptions, and it does not begin every analysis by postulating an asymmetry between private and public actors. Instead, the same foibles and weaknesses that might be attributed to people in the private sector are equally assumed in describing those in the public sector. The difference in the conclusions of the comparative analysis between private and public actors is a function of the institutional environment within which choices are made. In the absence of an institutional environment of secure private-​property rights, freedom of price negotiation, accurate profit and loss accounting, and nondiscretionary politics, the promise of material progress and social cooperation will go unrealized.

The Austrian School of Economics provides a set of utilitarian arguments in support of a classical liberal order that are indispensable for those who place a high value on human liberty. However, it is important to stress that these arguments are a consequence of the analysis that Austrians undertake and not presumptions that they hold before the analysis. Austrian economics is not synonymous with libertarianism. Rather, it is a scientific body of thought that, when combined with some ethical precepts, leads to a strong argument for a libertarian society.

Further Readings

Boettke, Peter. Coordination and Calculation: Essays on Socialism and Transitional Political Economy. New York: Routledge, 2001.

———, ed. Socialism and the Market: The Socialist Calculation Debate Revisited. 9 vols. New York: Routledge, 2000.

Hayek, F. A. Individualism and Economic Order. Chicago: University of Chicago Press, 1948.

Horwitz, S. Microfoundations and Macroeconomics. New York: Routledge, 2000.

Kirzner, I. Competition and Entrepreneurship. Chicago: University of Chicago Press, 1973.

Lachmann, L. Capital and Its Structure. Kansas City, MO: Sheed Andrews McMeel, 1977 [1956].

Lewin, P. Capital in Disequilibrium. New York: Routledge, 1999.

O’Driscoll, G., and M. Rizzo. The Economics of Time and Ignorance. 2nd ed. New York: Routledge, 1995.

Rothbard, Murray. America’s Great Depression. Princeton, NJ: Van Nostrand Press, 1963.

Selgin, G. The Theory of Free Banking. Totowa, NJ: Rowman & Littlefield, 1988.