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Understanding “Austrian” Economics

“Austrian” economics owes its name to the historical fact that it was founded and first elaborated by three Austrians: Carl Menger (1840–1921), Friedrich von Wieser (1851–1926), and Eugen von Böhm-Bawerk (1851–1914). The latter two built on Menger, though Böhm-Bawerk, in particular, made important additional contributions.

Menger’s great work, translated into English (but not until 79 years later!) under the title of Principles of Economics, was published in 1871. In the same year, by coincidence, W. Stanley Jevons in England published his Theory of Political Economy. Both authors independently developed the concept now known as “marginal utility.” (Menger never used the term. Jevons called it “final degree of utility.” It was Wieser who first employed the German term Grenznutzen, which translates as “marginal utility.”)

But as few American or British economists read German in the original, it was years before the real extent of the revolution begun by Menger was realized outside of German-speaking countries. For it was Menger, by recognizing most fully the implications of the marginal-utility concept, who opened up new paths and, so to speak, turned the old classical economics upside-down.

Menger insists throughout his work that value is essentially subjective, and that therefore economics must be in the main a subjective science. Goods have no inherent value in themselves. They are valued because they help to satisfy some human want or need. A given quantity or unit of a certain good will satisfy a man’s most intense desire or need. He may also want a second, third, or fourth increment. But after each unit is consumed or employed, his desire or heed for a further unit of that good may be less intense, and may finally become completely satisfied.

It follows that each increment of that good at his disposal will have a reduced value to him. But as no unit of the total available quantity of that good can have a greater value in exchange than any other (of the same quality), it follows further that no other unit will be worth more in the market than the “final” unit of the supply. Thus in a given community the exchange value of a given increment of each good will be determined by the relation between its total available quantity and the intensity of the human need or want that it fills.

So far this may seem like little more than a refinement on the old classical doctrine that value and price are determined by supply and demand. It seems merely to state that doctrine in subjective rather than objective terms. But then Menger comes to point out some of its implications. The values of goods are mutually interdependent. Bread is valued because it meets a direct consumption need. Flour is valued because it is needed to bake bread. Wheat is valued because it is needed to produce flour. Plows, seed, land, and labor are valued because they are necessary to produce wheat, and so on.

Values are also interdependent because, for example, if one raw material necessary in combination for the production of a final product is missing, that lack reduces the usefulness and value of the other raw materials needed.

Goods wanted and ready for direct use or consumption are called by Menger “goods of the first order.” Raw materials and other factors necessary to produce these are called “goods of the second order.” Materials, machinery, labor, and other factors needed in turn to produce these goods of the second order are called goods of the third order, and so on. These goods of the second, third, and other “higher” orders are valued because of the consumption goods that they produce.

Thus while the classical Ricardian doctrine held that the “normal” value of consumption goods was determined by their “cost of production,” the Austrian doctrine holds that the “cost of production” itself is ultimately determined by the value of consumption goods.

These two doctrines can be partly reconciled in the statement that though what a good has cost to produce cannot directly determine its value, what it will cost to produce determines how much of it will continue to be made. It is the limit that cost of production puts on the total quantity of a good produced that determines its marginal value and therefore its market price. Thus there is a constant tendency for marginal cost of production and market price to equal each other, though not because the first directly determines the second.

Something should be said also about the sharp distinction between the Ricardian and the Austrian concept of “cost.” The Ricardian (and the modern businessman) thinks of cost as a money outlay. But the Austrian economist has a much wider concept, what economists now call “opportunity” costs, or “foregone opportunity” costs. Such costs exist, of course, not only in business but in all our decisions and actions in life. The cost of learning French in any given period is to forego learning German, or to learn less mathematics, or to give up some tennis or bridge, and so on.

Menger emphasizes the importance of time and the role of uncertainty in the whole productive process. He also points out that no single good, no matter how abundant, can maintain life and welfare, but that these depend on the production of combinations of goods of different kinds in the proper proportions. And he points out, finally, that the process of production cannot be expected to go on at an adequate rate unless there is adequate protection of property.

The economic value of goods, to repeat, depends on their respective quantities in relation to the human needs they meet. It does not necessarily depend on the amount of labor expended in their production. To quote from Menger’s Principles of Economics,

If there were a society where all goods were available in amounts exceeding the requirements for them, there would be no economic goods nor any “wealth.”… Hence we have the queer contradiction that a continuous increase of the objects of wealth would have, as a necessary final consequence, a diminution of wealth. (p. 109–10)

(In other words, Menger pointed out more than a century ago a basic fallacy in the now-fashionable national-income statistics.)

The value of goods arises from their relationship to our needs, and is not inherent in the goods themselves. (p. 120)

Objectification of the value of goods, which is entirely subjective in nature, has nevertheless contributed very greatly to confusion about the basic principles of our science. (p. 121)

The importance that goods have for us and which we call value is merely imputed. (p. 139)

There is no necessary and direct connection between the value of a good and whether, or in what quantities, labor and other goods of higher order were applied to its production…. Whether a diamond was found accidentally or was obtained from a diamond pit with the employment of a thousand days of labor is completely irrelevant for its value. (p. 146)

Menger goes on to discuss further how higher goods, including capital goods, get their value:

It is evident that the value of goods of higher order is always and without exception determined by the prospective value of the goods of lower order in whose production they serve. (p. 150)

He outlines a theory of interest, but he leaves it vague. On page 156 of Principles of Economics he tells us, “We have reached one of the most important truths of our science, the ‘productivity of capital.'”

But he emphasizes that this productivity occurs only through the passage of time, and that therefore the market value of presently existing and available goods is at a “discount” compared with the expected value of equivalent goods in the future.

A Time-Preference Theory

This suggests that Menger leaned more toward a “time preference” than a “productivity” theory of interest, though the distinction between these theories was not sharpened and made explicit until the publication of Böhm-Bawerk’s Capital and Interest in 1884 and his Positive Theory of Capital in 1888. Böhm-Bawerk laid great emphasis on the superior productivity of “roundabout” processes of production, and therefore (after a brilliant demolition of productivity theories of interest) ended by himself offering a theory of interest that combined productivity and time preference. Nearly all “Austrians” today, however, following the lead of Frank A. Fetter and later of Ludwig von Mises, support a pure time-preference theory.

To return to Menger: His Principles of Economics next presents a “theory of exchange.” In this he points out that men do not buy from or sell to or exchange with each other merely because of a “propensity of men to truck and barter,” as implied by Adam Smith, but because each man seeks to maximize his satisfactions by exchanging what he values less for what he values more. In this way the satisfaction of all is increased. Exchange is thus an integral part of the whole process of production. What is being produced is value. Menger’s whole theory of price, to repeat, is developed on the basis of “the subjective character of value.”

The final chapter of Menger’s Principles is on “The Theory of Money.” This does not explicitly discuss such subjects as interest rates or inflation, but deals solely with fundamentals, especially the origin and evolution of money: “Money is not the product of an agreement on the part of economizing men nor the product of legislative acts. No one invented it” (p. 262). It developed out of barter. Because it so seldom happened that A and B each had and was willing to offer exactly what the other wanted, triangular and indirect barter began to take place. Men first offered their specialized goods for more “marketable” goods more widely wanted, in the hope that they could exchange these, in turn, for the particular goods that they themselves wanted. As a result these more “saleable” goods became still more saleable because of this extra demand. The most saleable of all finally became “money.” Historically, all kinds of goods have served as money, though it later came down to coins of precise weights of copper, silver, or gold.

Money is not a “measure of value,” though it is legitimate to call it a measure of price. It is the only commodity in which all others can be evaluated without roundabout procedures. It is the most appropriate form in which people can save and store part of their wealth. The right of coinage has generally been left to governments, even though “they have so often and so greatly misused their power” (p. 283).

I may have seemed to devote a disproportionate amount of space to Menger, but the special contributions of Austrian economics can be most clearly realized, it seems to me, if we begin by dwelling in some detail on those of its originator.

Menger’s first important successor as an “Austrian” economist was Friedrich von Wieser, who, beginning in 1884, published several books elaborating, rounding out, and refining Menger’s theory of value, clarifying especially problems of cost, “imputation,” and distribution.

The next great successor was Eugen von Böhm-Bawerk, whose trailblazing contributions in Capital and Interest, in 1884, and the Positive Theory of Capital, in 1888, have already been referred to. In addition, Böhm-Bawerk wrote a brilliant demolition of Marx’s Das Kapital in 1896, in a comparatively short work first translated into English under the title Karl Marx and the Close of His System. In this essay Böhm-Bawerk exposed particularly the fallacies in Marx’s labor theory of value and his “exploitation” theories, which the latter had derived as a supposed corollary from errors of Ricardo. It should be emphasized that it was the analysis of Austrian economics that made Böhm’s refutation of Marx so conclusive. No refutation based on the assumptions of the old classical economics could have been as devastating.

After the passing of its three founders—Menger, Wieser, and Böhm-Bawerk—Austrian economics fell for a long time into eclipse. It was not so much refuted as neglected. English-speaking economists began devoting themselves to such matters as mathematical treatment of problems of “general equilibrium.” The Austrian view was revived mainly by one man, an Austrian by birth as well as an “Austrian” by conviction—Ludwig von Mises (1881–1973). He made his influence felt both by his written works and by his oral teachings. Among his early distinguished students and followers were Gottfried Haberler, Fritz Machlup, Oskar Morgenstern, Lionel (now Lord) Robbins, and, most influential of all, F.A. Hayek (b. 1899).

Ludwig von Mises was prolific, but his principal contributions were made in three masterpieces. These were The Theory of Money and Credit, first published in German in 1912; Socialism: An Economic and Sociological Analysis, also first published in German in 1922; and Human Action, which grew out of a first German version appearing in 1940, but was not published in Mises’s own rewritten English version until 1949.

Mises on Human Action

Though there is now a gratifying number of able young American economists writing in the Austrian tradition, Human Action still stands as the most complete, powerful, and unified presentation of Austrian economics in any single volume. Mises always generously acknowledged his indebtedness to his predecessors. He recalled in a short autobiography (Notes and Recollections, 1978) that around Christmas 1903 he read Menger’s Principles of Economics for the first time. “It was the reading of this book,” he wrote, “that made an ‘economist’ of me.”

It would carry me to too great length to itemize and explain all the contributions to economics that Mises made, and I will content myself with mentioning only two. He was the first to prove that it was impossible for socialism to undertake “economic calculation,” and he made one of the most important contributions of any economist toward solving the problem of “the trade cycle.”

Because Mises so uncompromisingly rejected government interventionism in all its forms, he acquired the reputation of a “laissez-faire extremist” during most of his lifetime, and was scandalously neglected by the majority of academic economists. But because Hayek elaborated his own ideas in a more conciliatory form, his writings attracted more attention from the academic world, and he leapt into prominence in 1931 with his own contribution to the theory of the trade cycle, Prices and Production, along lines similar to Mises’s. The result is entitled to be called the “Mises-Hayek” theory.

Hayek is also a prolific writer, but though he has written volumes on money, on the trade cycle, on inflation, and on The Pure Theory of Capital (1941), he has never attempted a comprehensive book on economic principles. Of late years he has turned his attention mainly to the realms of politics, ethics, and law, and has written profound and widely discussed treatises on The Constitution of Liberty (1960) and a three-volume work, Law, Legislation and Liberty, completed in 1979. He has been more widely influential in his own lifetime than was Mises, and was awarded the Nobel Prize in Economics in 1974.

Today’s zealous group of younger “Austrian” economists, though all acknowledging their great debt to Mises, do not treat his Human Action as the final word on the subject but are exploring a whole range of economic problems with a new vigor. Murray Rothbard (b. 1926), a student of Mises’s, produced a two-volume treatise, Man, Economy, and State (1962), along Misesian lines, with notable clarity of exposition, and making important contributions of his own, pointing out the fallacies, for example, in the prevailing theories of “monopoly price.”

Israel M. Kirzner (b. 1930), professor of economics at New York University, another former Mises student, although he has not undertaken a comprehensive book of “principles,” has explored individual problems in five separate volumes: The Economic Point of View (1960), Market Theory and the Price System (1963), An Essay on Capital (1966), Competition and Entrepreneurship (1973), and Perception, Opportunity, and Profit (1979). His work is distinguished by great scholarship, systematic thoroughness, and precision of statement. He has brought further illumination to every problem he has dealt with.

Finally, no reference to individual writers would be adequate that did not include Professor Ludwig M. Lachmann (b. 1906). Though he is one of the most original and profound among living Austrian economists, his work has not yet nearly achieved the recognition it merits. Among his principal books are Capital and Its Structure (1956; republished in 1978), The Legacy of Max Weber (1971) and Capital, Expectations, and the Market Process (1977).

His writings are notable for their emphasis on the role of expectations and for their thoroughgoing application of a “radical subjectivism.”

Restrictions of space permit me merely to list the names of half a dozen of the now-increasing group of important “Austrian” economists: S.C. Littlechild, Gerald P. O’Driscoll, Jr., Mario J. Rizzo, Hans Sennholz, Sudha R. Shenoy, and Lawrence H. White. But so arbitrarily short a list must omit a number of names unjustly.

The “Austrian” economists, more consistently than those of any other school, have criticized nearly all forms of government intervention in the market—especially inflation, price controls, and schemes for redistribution of wealth or incomes because they recognize that these always lead to erosions of incentives, to distortions of production, to shortages, to demoralization, and to similar consequences deplored even by the originators of the schemes. But personal value judgments of government policy are of course not an essential part of Austrian theory.

The present vigorous Austrian School is not content merely to keep reexpounding the principles developed by Menger and Mises, but is addressing itself constantly to new problems, or a more thorough probing of old ones. This is dramatically evident in a recent volume, New Directions in Austrian Economics (1978), edited by Louis M. Spadaro, with contributions from 11 writers. Professor Spadaro himself, in his concluding essay, outlines some of the still-unresolved problems that Austrians ought to explore. In some sense, however, practically all 11 contributions do the same thing.

I have heard it said (by an economist of another school) that there is no such thing as Austrian economics; there is only good economics or bad. But in the same way we could say that there is no such thing as Ricardian economics, Marxist economics, Keynesian economics, and so on. This sort of statement, though true in one sense, is false in another. It is fallacious in implying that if anything is classified in accordance with one characteristic, it cannot be classified in accordance with any other. It is like saying that there are no such persons as Americans or Japanese; there are only men and women. Those who call themselves “Austrian” economists give themselves this label because of its historical origins; but they happen also to believe that its fundamental theses are true, and offer more promise than any other for further progress in economic science.

Perhaps something should be said about the chief differences today between Austrian economics and what we may call “orthodox” or “mainstream” economics. The difficulty here is that “mainstream” economics itself would be hard to define. Economists are still divided into a number of recognizable “schools”: neoclassicists, Keynesians, the Chicago School, the Lausanne School, and so on. The limits of space forbid me to go into the distinguishing doctrines of each of these schools. But one outstanding difference of the Austrians from all of these lies in their method of reasoning. The Austrians emphasize methodological individualism. That is, they not only begin by emphasizing human actions, preferences, and decisions, but individual actions, preferences, and initiatives. Mainstream economists are concerned with “macroeconomics,” with averages and aggregates; and those of the Lausanne School, trying to reduce economics to an “exact” science, and therefore seeking to quantify everything, are obsessed with complicated mathematical equations that try to stipulate the conditions of “general equilibrium.”

Now “general equilibrium” is defined by these economists (when it ever is) in highly abstract and obscure phrases; but for laymen it might be defined as a condition in which all the tens of thousands or millions of commodities and services are being turned out in the exact quantities and proportions in which they are relatively wanted by producers or consumers, so that there are no “shortages” or “surpluses.” All prices reflect costs, and there is no more profit in making one commodity than any other. (In fact, there is no “pure” profit at all.) These economists admit that at any moment this condition does not exist, but they contend that there is a constant long-run tendency toward equilibrium, because when there is an unusual profit in turning out some one product, producers will turn out more of it, and when there is a loss in turning out some other product, producers will make less of it, or transfer to making something else.

Now the concept of equilibrium (or much better, the Mises concept of an “evenly rotating economy”) can have great usefulness as a tool of thought. We are often better able to analyze the problems of change if we begin with the fictitious assumption of a state of affairs in which certain changes are hypothetically eliminated. But this is a purely imaginary construction, a useful fiction. It should never be confused with reality.

While a true “equilibrium” between the marginal cost of production and the market price of any one commodity is a condition that is seldom reached, even momentarily, a “general equilibrium” in the relative production, supply price, and demand price of all commodities and services is a condition that is never reached, even for an instant of time.

The concept itself is extremely nebulous. Neoclassical economists seem obsessed today with setting up complicated algebraic equations stipulating the conditions of equilibrium or functional relations under “perfect competition” and the like, but it is difficult to specify precisely what their x’s and y’s stand for. They cannot refer to physical quantities, because you cannot add apples to horses, or a ton of gold watches to a ton of sand. One might add or compare quantities times prices, but what would be the meaning of the total, or any of the parts that make it up? The price, even of one commodity, differs from hour to hour, place to place, and transaction to transaction. The value of the currency itself fluctuates and constantly changes its exchange ratio with commodities. If we simply add or compare “values,” then we must recognize that values are purely subjective. They are impossible to measure or to total because they differ with each individual.

If we pass over these fundamental difficulties, where do we arrive? Even if we assume that there may be a persistent long-run tendency toward general equilibrium, we must admit that there is also a persistent short-run and long-run tendency toward the persistence of disequilibrium.

This is not only because there is a tendency of entrepreneurs, in increasing or reducing production in response to market and profit signals, to overshoot the mark, but because individual entrepreneurs, so far from making merely automatic responses, are constantly gaining new knowledge, alert to new opportunities, changing methods and reducing production costs, improving products, innovating—turning out entirely new products or inventions. And consumers too are constantly learning, changing tastes, and demanding new products to meet new wants. So Austrian economists seldom speak of market equilibrium, but of the market process.

My own suspicion is that the enormous attention now being devoted to stipulating the mathematical conditions of “general equilibrium” is a pursuit of a will-o’-the-wisp, of questionable help in solving any real economic problem.

But space forbids me to go into too many detailed contrasts. Let me sum up briefly the main Austrian theses once again, this time not in my own words or in Menger’s, but in those of two prominent living “Austrians.”

“Beginning in the 1870’s in Vienna, Austria,” writes Professor Kirzner, “the school was distinguished by its emphasis on the subjective elements in economic analysis, on the significance of time in production processes, and on the role of error and uncertainty in economic phenomena.” (His italics.)

The summarization by Professor Lachmann is remarkably similar:

The first, and most prominent, feature in Austrian economics is a radical subjectivism, today no longer confined to human preferences but extended to expectations…. Secondly, Austrian economics displays an acute awareness of the many facets of time that are involved in the complex network of interindividual relations…. In the subjective revolution of the 1870’s the first step in the direction of subjectivism was taken when it was realized that value, so far from being inherent in goods, constitutes a relationship between an appraising mind and the object of its appraisal. (New Directions in Austrian Economics, pp. 1–3)

All the rest of Austrian economics follows from these basic insights. Let me conclude with my own opinion that any economic analysis that fails to embody such insights cannot be entirely sound.

Recommended Reading

Those who have no previous acquaintance with Austrian economics, and would like a short and simple text written along Austrian lines, might begin with Essentials of Economics by Faustino Ballvé (126 pages; Irvington-on-Hudson, N.Y.: Foundation for Economic Education). A more advanced, and quite recent, introduction (1979) specifically explaining the Austrian point of view, is The Fallacy of the Mixed Economy by Stephen C. Littlechild (85 pages; San Francisco, Calif.: Cato Institute).

Surprisingly, the original Principles of Economics, first published in 1871 by Carl Menger, the founder of Austrian economics (328 pages), still makes an excellent, very readable, and not-too-technical introduction to the school’s basic principles.

Of course, the authoritative and most complete work on modern Austrian theory is Human Action, by Ludwig von Mises. Some may find this difficult reading. A very clear two-volume work written 13 years after Human Action by a student of Mises is Murray N. Rothbard’s Man, Economy, and State.

For the reader interested in the latest developments in Austrian economics I can highly recommend two books: One is The Foundations of Modern Austrian Economics, edited by Edwin G. Dolan, which contains contributions by half a dozen writers (1976). The other is New Directions in Austrian Economics, edited by Louis M. Spadaro with contributions by 11 writers (1978).

Most of these foregoing books have already been mentioned in the text. The reader may also profitably consult others mentioned there, especially the volumes by Kirzner and Lachmann.