The Austrian School of Economics originated with the 1871 publication of Carl Menger’s Principles of Economics, which emphasized the theory of marginal utility. Two other economists at the University of Vienna, Eugen von Böhm-Bawerk and Friedrich von Wieser, continued and expanded on Menger’s work. The Austrian School was named as such to distinguish it from the German Historical School. Current-day economists working in this tradition are located in many different countries, but their work is referred to as Austrian economics.
The Austrian School made several significant contributions to what is now considered “mainstream” economics, such as the subjective theory of value and marginalism in price theory. Most significantly, Austrian economists developed the “economic calculation problem” which is a criticism of central economic planning. Ludwig von Mises and Friedrich A. Hayek continued the Austrian tradition in the 1920s, 1930s, and 1940s with their works on the business cycle and on the impossibility of economic calculation under socialism. Austrian analysis fell out of favor with economists during the 1950s and 1960s, but the awarding of the Nobel Prize in economics to Hayek in 1974, coupled with the spread of Mises’s ideas by his students and followers, led to a revival of the Austrian school.
The major cornerstones of Austrian economics are methodological individualism, methodological subjectivism, and an emphasis on processes rather than on end states.
- Methodological Individualism: The actions of individuals, not of groups or collectives, are the focus of study for Austrian economists. Economics, to an Austrian economist, is the study of purposeful human action in its broadest sense. Since only individuals act, the focus of study for the Austrian economist is always on the individual.
- Methodological Subjectivism: An individual’s actions and choices are based upon a unique value scale known only to that individual. It is this subjective valuation of goods that creates economic value.
- Processes versus End States: An individual’s action takes place through time, along with the actions of other individuals, so the exact outcome of a vast number of plans being executed at the same time can never be predicted. A person decides on a desired end, chooses a means to attain that end, and then acts to attain it. Because all individuals act under the condition of uncertainty—especially uncertainty regarding the plans and actions of other individuals—people sometimes do not achieve their desired ends. The actions of one person may interfere with the actions of another. The actual consequences of any action can be known only after the action has taken place. This does not mean that people do not take into account others’ plans, but the exact outcome of a vast number of plans being executed at the same time can never be predicted.
It is important to note that Austrian economic theory conflicts with the theory of rational expectations. Austrian economists agree with adherents of rational expectations that individuals make decisions based on their rational outlook, available information, and past experiences. Ludwig von Mises wrote, “Human action is necessarily always rational” (Mises 1949, 18). But Austrians economists do not believe that the rational expectations theory can be consistently utilized. For instance, they believe malinvestment, or badly allocated investments by entrepreneurs, occurs when interest rates are kept artificially low by a central bank. Rational expectations theory would contradict this view and argue that entrepreneurs are so rational that they would not get fooled by lower interest rates, and consequently would not make malinvestments. Austrians’ objection to rational expectations stems from their belief that people’s intentions do not necessarily result in coordinating actions. While individuals are rational in their thinking, their aggregated actions do not necessarily result in rational actions. Roger Garrison noted the implications of the Austrians’ objection: “There are ultimate limits on the individual’s ability to transform expectations into actions. Put bluntly, you can’t spend expectations” (Garrison 1989, 9).
Another important concept the Austrians utilize is of “time preference,” which is used to illustrate the choice of consuming now or in the future (and saving now). Time preference is what determines the market’s interest rate. If people have a higher time preference, they will spend more now and save less. People who have lower time preferences will save more and spend less now so they can consume more in the future. Also important is “money demand,” or a person’s cash balance, which is the funds people are willing to hold (and not spend or put into a savings account, which would then be used as investment). The less secure a person is about their future, the higher their cash balance. The more secure a person is about their future, the lower their cash balance.
Austrian Business Cycle Theory
Austrian economists believe business cycles are the consequence of excessive growth in bank credit due to an artificially low interest rate, which results in a volatile imbalance between saving and investment. Low interest rates tend to stimulate borrowing from the banking system. This leads to an increase in capital spending funded by newly issued bank credit. A credit-sourced boom results in widespread malinvestment. Malinvestment occurs when firms make investments choices that are faulty due to an artificially low interest rate. Then, a correction or “credit crunch” occurs when the credit creation has run its course. Then the money supply contracts, causing resources to be reallocated back towards their former uses. Ultimately, business cycles are caused by distortions in the availability of credit. The Austrian Business Cycle Theory is shown using the Production Possibilities Frontier, the Loanable-Funds Market, and the Hayekian Triangle.
The Production Possibilities Frontier
Austrian economists use the Production Possibilities Frontier (PPF) to show the trade-off between consumption and investment. Consumption and investment represent alternative uses of the economy’s resources. This is in contrast to Keynesian models that treat consumption and investment as additive components. Investment in this model represents gross investment, including replacement capital. Replacement capital is the portion of gross investment that replaces old capital, so it does not contribute to the economy’s expansion. The difference between gross investment and replacement capital is the significant portion responsible for fueling the economy’s growth.
The economy grows over time, shown on the PPF via the curve shifting outwards, (see Figure 1). The actual rate of expansion of the PPF depends upon many factors. For instance, with economic expansions, capital depreciation increases, too. Increasing incomes are generally accompanied by further increases in saving and investment, since the marginal propensity to consume decreases as incomes rise. Changes in technology can impact the rate of expansion of the PPF, which is discussed within the Loanable-Funds model.
A change in saving preferences provokes a movement along the initial PPF and affects the rate at which the PPF expands outward. The point moves clockwise along the PPF to represent an increase in investment, (see Figure 2). For example, when people become thriftier, or more future oriented, they reduce their current consumption and save instead. With the increased saving (and investment), the economy grows at a faster rate. The rate at which the economy grows is higher with this increased investment, shown by the bigger gaps between each time period, shown by the larger space between lines on the graph.
Figure 2. PPF expansion with increased savings
Note the difference that an initial increase in saving makes in the pattern of consumption and investment. Without an initial increase in saving, consumption and investment increase modestly from period to period. With an initial increase in saving, investment increases at the expense of consumption, after which both consumption and investment increase dramatically from period to period. Starting with the fourth period, the initial saving pays off as a higher level of consumption than would otherwise have been possible. When you compare this to the original PPF, you’ll see that even though people originally had to reduce their consumption to provide the funds for the increase in capital, consumption has risen at such an increased rate that it is now higher than in the original example, (See Figure 3).
Figure 3. Comparison of original PPF and increased savings PPF
In the Loanable-Funds Model (LF), the y-axis indicates interest rates and the x-axis indicates savings, which in the Austrian view is equivalent to investment. The model of loanable funds is a straightforward application of supply and demand, with the interest rate serving as the price. Demand reflects businesses’ willingness to borrow and undertake investment projects. Supply reflects people’s willingness to save and consume in the future.
It is within this model that Austrian economists explain how an autonomous increase in investment (for example via improved technology resulting in a reduction of production costs) impacts the business cycle. An increase is investment opportunities or an increase in the expected return on investment would simply shift borrower’s demand curves upwards, showing they would be willing to pay a higher interest rate in order to invest. This has the same impact as an increase in savings (the example used to demonstrate this model), since it would ultimately raise interest rates, which would then induce more savings. Austrian economists have discussed the importance of changes in technology altering entrepreneurs’ business decisions, and how Joseph Schumpeter’s creative destruction impacts the economy. Friedrich A. Hayek discussed technical invention in his book Money, Capital & Fluctuations:
…Advances in our technical knowledge which by their nature are spontaneous and not foreseeable in detail. Clearly, there is no doubt that every time such an immediately useful invention has been made, a large proportion of the plants previously built and of the expenses previously incurred appear inappropriate in the light of this new level of knowledge…Yet, so long as we do not know any method of determining in advance who at any time possess the most appropriate knowledge…we shall have to restrict ourselves to asking what will be the socially most desirable and advantageous reaction towards the new situation once the new invention has become known and been tested. (Hayek 1984, 165)
Figure 4. Loanable-Funds Model responds to an increase in saving
If people become more future-oriented (have a lower time preference), they will reduce their consumption and save more, causing the interest rate to fall. This increase in savings sends a signal to the business community through the resulting lower interest rate, and encourages businesses to undertake more investment projects, (see Figure 4). The LF and PPF models tell mutually reinforcing stories. The LF shows how interest rates affect saving and investment. The PPF shows the trade-off between consumption and investment. Thus, a change in interest rates or a change in time preference shifts the equilibrium point along the PPF curve.
In this model, more investment is undertaken as consumption falls. Movements along the PPF necessarily entail opposing movements of consumption and investment, which contradicts Keynesian theory. According to Keynes, any reduction in consumer spending would result in excess inventories, which in turn would cause production cutbacks, worker layoffs, and a spiraling downward of income and expenditures. The economy would go into recession, and the business community would commit itself to less, not more, investment. This is Keynes’s “Paradox of Thrift.”
If retail inventories were a “representative” investment, then Keynes would be right. Here, the derived-demand effect dominates. Reduced consumer spending means reduced inventory replacement. In general, late-stage investments move with consumer spending. However, the interest-rate effect dominates in long-term, or early-stage, investments. A lower interest rate can stimulate industrial construction, for instance, or product development. To keep track of changes in the general pattern of investment activity, Austrian economists consider the structure of production and stage-specific labor markets.
Stages of Production
Every business goes through various stages of production. For example, an oil company would explore for oil, extract it, refine it, distribute it, and then retail it. These stages are arranged graphically from left to right in the Hayekian Triangle, (see Figure 5). The output of the final stage, on the furthest right, is consumable output. Early stage investment activity is exemplified by product development while inventory management exemplifies late stage investment activity.
Figure 5. The Hayekian Triangle
For simplicity, the initial capital structure is shown as having five stages, hence the triangle divided into five parts. With growth, the number of stages will increase. All of the five stages are operating at any given time, but resources can be tracked through the structure of production over time. The Hayekian Triangle is a simple model of the economy’s “intertemporal structure of production.” In a growing economy, the triangle increases in size along with the outward expansion of the production possibilities frontier, (see Figure 6).
Figure 6. The Hayekian Triangle expands with the PPF
When people choose to save more, it sends two seemingly conflicting signals to the market. First, decreased consumption dampens the demand for the investment goods that are in close temporal proximity with consumable output, which is called the derived demand effect. This means that businesses will invest less in the later stages of production. Second, a reduced interest rate stimulates the demand for investment goods that are temporally remote from consumable output. This is the time-discount or interest-rate effect. This means that businesses choose to invest more in the earlier stages of production.
The derived demand and time-discount effects have their separate and complementary effects on the capital structure. The derived demand effect dampens investment activities in the late stages of production, which reduces the height of the Hayekian Triangle. The time-discount effect stimulates investment activities in the early stages of production, increasing the base of the Hayekian Triangle, potentially creating additional stages of production. So an increase in savings results in a reallocation of resources among the stages of production. The Hayekian Triangle becomes longer in width and shorter in height, (see Figure 7).
Figure 7. Hayekian Triangle and PPF in response to an increase in savings
We can connect the Hayekian Triangle with the PPF. Increased saving has an effect on both the magnitude of the investment aggregate and the temporal pattern of capital creation. Increased saving shifts the point in PPF along the curve towards investment. The Hayekian Triangle shows that capital creation in the late stages, such as retail inventories, is decreased while capital creation in the early stages, such as product development, is increased. The structure of production is given more of a future-orientation, which is consistent with the saving that made the restructuring possible. That is, people are saving now in order to increase their future spending power.
Figure 8. Hayekian Triangle and PPF in response to an increase in savings, over time
With increased saving, the economy will grow more rapidly, (see Figure 8). In the short run, the economy’s consumption is seen to fall as it is adapting to a higher growth rate, after which consumption rises more rapidly than before and eventually surpasses the old projected growth path. Thus, saving implies the giving up of some consumption in the near future in order to enjoy more consumption in the intermediate future.
Stage-Specific Labor Markets
While most macroeconomic theories deal with the labor market and the wage rate, capital-based macroeconomics allows for stage-specific labor markets. With a change in the interest rate, stage-specific wage rates change in a pattern rather than change uniformly. Although a labor market for each stage could be depicted, the pattern of changes (the wage-rate gradient, as Hayek called it) is revealed by distinguishing between early-stage and late-stage labor markets, (see Figure 9).
Figure 9. Stage-Specific Labor Markets
An increase in saving has differential effects on the demand for labor in the early and late stages. In the late stages, the derived-demand effect (labor demand moves with consumption) dominates the interest-rate effect. In the early stages, the interest-rate effect (favorable credit conditions) dominates the derived-demand effect. This means that in the late stage labor market, wages will fall and the employment level will fall in response to a decrease in consumption. In the early stage labor market, wages will rise and the employment level will increase in response to the increase in investment, (see Figure 10). The differential shifting of labor demands gives rise to a “wage-rate gradient.”
Figure 10. Early and Late-Stage Labor Markets responses to an increase in savings
Increases in the money supply enter the economy through credit markets. The central bank literally lends money into existence. The new money masquerades as saving. This shifts the supply of loanable funds curve rightward – but without there being any increase in actual saving. With an artificially lowered interest rate, people will respond by saving less and consuming more. Thus, actual saving will move down along the un-shifted supply curve. The result is not a new sustainable equilibrium but rather a disequilibrium that, for a time, is masked by the infusion of loanable funds.
Figure 11. Loanable-Funds Model with credit expansion
Pumping new money through credit markets drives a wedge between saving and investment. Investors move down along their demand curves, taking advantage of the lower interest rate. Savers move down along their un-shifted supply curve in response to the weakened incentive to save. The discrepancy between saving and investment is papered over with newly created money, which itself represents no investable resources.
Favorable credit conditions spur on investment activity, which suggests a clockwise movement along the PPF in the direction of investment. But income-earners are actually saving less and consuming more, which suggests a counterclockwise movement along the PPF in the direction of consumption. The wedge between saving and investment translates into a tug-of-war between consumers and investors. Noting the investment dimension of the clockwise movement and the consumption dimension of the counterclockwise movement, we see that credit expansion pushes the economy toward a point that lies beyond the PPF.
Figure 12. The LF and PPF respond to an expansion of credit
The low interest rate, consistent with a future orientation, stimulates investment activities in the early stages of production. But without sufficient resources being freed up elsewhere, many of these investment projects will never be completed. In fact, increased consumer demand draws some resources toward the late stages, further reducing the prospects for completing a new capital structure.
Figure 13. The LF, PPF, and Hayekian Triangle respond to an expansion of credit
The dynamics of boom and bust entail both overinvestment and malinvestment, an unsustainable lengthening of the Hayekian Triangle. These distortions are compounded by overconsumption. The tug-of-war that pits consumers against investors pushes the economy beyond the PPF. The low interest rate favors investment, and increasingly binding resource constraints keep the economy from reaching the extra-PPF point. The temporally conflicted structure of production (dueling triangles) eventually turns boom into bust, and the economy goes into recession—and possibly into deep depression.
Figure 14. The LF, PPF, and Hayekian Triangle respond to an expansion of credit, showing an economic downturn.
Padding the supply of loanable funds with new money drives a wedge between saving and investment. Papering over the difference between saving and investment gives play to the tug-of-war between consumers and investors. Pitting early-stages against late-stages distorts the Hayekian triangle in both directions, the temporal discoordination eventually turning boom into bust. In conclusion, the Austrian Business Cycle Theory shows that an increase in savings supports genuine growth of the economy, while credit expansion triggers boom and bust (Garrison 2013).
Austrian economists support the idea that a free market would be best for economic growth and stability, because a central bank’s manipulation of interest rates is what causes the business cycle. Government intervention in is widely discouraged among Austrian economists. Ludwig von Mises said, “The first job of an economist is to tell governments what they cannot do.” They also support minimal taxation and the assurance of property rights. They view private property in the means of productions as a necessary condition for rational economic calculation. They are opposed to price controls and any regulations that inhibit enterprise. Austrian economist Henry Hazlitt said, “the larger the percentage of the national income taken by taxes, the greater the deterrent to private production and employment”(Hazlitt 1979, 39). Austrian economists generally oppose both monetary and fiscal policy, and prefer to allow the economy to function without intervention. Almost all government functions would be better executed and less costly if undertaken by private business. The exception is government functions that are necessary at the national level, such as national defense.
Austrian economists are especially critical of monetary policy and the Federal Reserve. They strongly support the idea of abolishing the Federal Reserve, and letting the economy function independently from government. Austrian economist Roger Garrison wrote,
It is implausible that the Federal Reserve’s policymakers who could not tell whether we were in a bubble until it burst could nonetheless determine the optimal policy for avoiding busts and then, once the busts come, for nursing the economy back to health. Given the policymakers’ incentives, a central bank acts to extend an ongoing boom and then, when it eventually ends in a bust, to initiate another one. And if the market were allowed to nurse the economy back to macroeconomic health, a central bank even of the most beneficent sort could only hope to do no harm. The hope of achieving long-run sustainable growth can only rest on the prospects for centralizing the business of banking. (Garrison 2012, 436)
Not all Austrian economists believe there is no role for government in economic planning, however. For example, some believe that if the government wanted to raise the minimum wage, it could do so by increasing the marginal labor productivity through implementing policies that encourage profits, investment in technology development, education, and skill training; not by setting a minimum wage as a law using government fiat. Austrian economists say the government should implement more efficient and effective policies that actually increase production and stimulate economic expansion. This would better address the problems of low wages and unemployment because it would increase the demand for labor. Therefore, the government should focus on how to increase the rate of productivity rather than on increasing the employment rate or individuals’ wage earnings. They assert minimum but efficient intervention will result in the greatest economic growth.
Criticisms of Austrian Economics
Austrian economists are known to be comparatively more philosophical than mathematical. The Austrian School’s rejection of data and statistics is the most common and biggest criticism against them. The critics say that since Austrian economists are innumerate, they cannot quantify the cause to an effect. This means that it is not possible to distinguish the significance of different causes in a theory. For example, there may be more than one cause to a theory, and among those causes, one may have a lesser or greater impact on the effect. In this case, it is impossible for them to differentiate or rank the significance of different causes. Thus, the critics say, the Austrian economists rely on their “biased” philosophy and assumptions, rather than on statistical measurements. Many economists consider Austrian economic theories, which are inconsistent with empirical evidence, to be incorrect. Monetarist Milton Friedman said,
I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You will only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and in the United States, they did harm. (Friedman 1999)
Austrian economists believe that “economics is not about the amassing of data, but rather about the verbal elucidation of universal facts and their logical implications” (Mises Institute 2014). In response to criticism over their rejection of econometrics, Austrian economist Murray Rothbard calls statistical tests for economic theory a “grave mistake that plagues economic studies.” He claimed statistics meant little and definitely did not determine the validity of economic theory because it only records past events and cannot describe “unrealized events” (Rothbard 1963, 81). In light of their rejection of the mathematics used by mainstream economists, economist Bryan Caplan, argues that Austrian economics is not economics at all, but rather a “philosophy, methodology, and history of thought.” When the mathematical models used by other schools of thought do not work to explain or predict economic events, it is worth examining the Austrian perspective, which offers an alternative explanation.
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Ludwig von Mises Institute:
Tax Foundation Tax Policy Blog
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