In the late 19th and early 20th century, Vienna had a much higher significance than today. It was the capital of a multi-ethnic empire that comprised the present-day states of Austria, Hungary, the Czech Republic, Slovakia, Slovenia, Croatia, Bosnia-Herzegovina and parts of Italy, Poland, Romania, Serbia, Montenegro and Ukraine. Many great thinkers, scientists and artists lived in the city on the Danube. Some of them made important contributions to modern economics.
The Austrian School of Economics was founded by Carl Menger (1840–1921), who in 1879 became the first professor for political economics at the University of Vienna. His main work was a new theory of prices and values. Equally important was Eugen von Böhm-Bawerk (1851–1914), who served as a minister for the Austrian Empire and taught at several Austrian universities, including the University of Vienna. Böhm-Bawerk became so well-known for his theory on capital and interest that the Austrian 100 Schilling bank note sported his portrait until the Schilling was abandoned for the euro in 2002.
Mises and Hayek
The most influential thinker of the Austrian school was undoubtedly Böhm-Bawerk’s disciple Ludwig von Mises (1881–1973). He was born in Lemberg (or Lviv), which today belongs to Ukraine. Mises refined Menger’s monetary theory and developed a new theory of business cycles. Unlike his predecessors, he never became a professor at the University of Vienna. This was partly because he was Jewish, as Anti-Semitism befouled Vienna at that time. But even more important was his strong commitment to a free market economy, which contradicted the socialist zeitgeist of the 1920s and 30s.
So he organized a private seminar on economics instead, which was frequented by a number of scholars who later became well-known economists. The most prominent one was Friedrich August von Hayek (1899–1992), who became Mises’ partner in the Austrian Institute for the Research of Business Cycles in 1927. When the National Socialists took power in Austria in 1938, Mises escaped, first to Geneva, then in 1940 to the USA. Hayek had already immigrated to England in 1931 to teach at the London School of Economics. In 1950 he subsequently moved to the USA to join the Chicago School of Economics.
As a result of their movements to the US, the Austrian School has become much more popular in the US than in its home country, where it is virtually extinct. Some other important “Austrians” who never lived in Austria are Murray N. Rothbard (1926–1995) and Israel Kirzner (born 1930), both from the USA, and Jesús Huerta de Soto (born 1956) from Spain.
Renaissance of the Austrian School
The early 20th century was dominated by national and international Socialism, and the Austrian School was nearly forgotten. After World War II it regained some ground when Friedrich August von Hayek published his popular book, The Road to Serfdom.
Mises and Hayek also co-founded the Mont Pelerin Society, which influenced many politicians, among them the German Minister of Economics, Ludwig Erhard. Erhard’s courageous free market policy was based upon the insights of the Austrian School. Against heavy resistance from all German parties he abolished all post-war price and wage controls and unleashed the power of the free market. This lead to the so-called “Wirtschaftswunder” (“German Economic Miracle”) of the 1950s.
The economic policies of Margaret Thatcher and Ronald Reagan were also partly inspired by Hayek, although they did not roll back the state as much as he would have preferred. The US politician and “Austrian” Ron Paul, who ran as a presidential candidate for the Republican Party in 2008 and 2012, triggered another major popularity boost for the Austrian School. Although his candidacy was not successful, he attracted a huge base of followers – especially among young people – and inspired them to learn more about Austrian Economics.
Economy and Libertarianism
There are many private institutes and think tanks conserving and promoting the teachings of the Austrian School. The most prominent one is the Ludwig von Mises Institute in Auburn, Alabama. Mises Institutes can now be found in many countries all over the world.
Classical Liberalism, which in the US is better known as Libertarianism (because “liberal” for some strange reason has become a synonym for “left wing”) is deeply connected to the Austrian School. It is important to realize that the Austrian School is not a political ideology, but rather a set of methods to analyze and understand the economy.
However, having apprehended the insights of the Austrian School on prices, values, interest, money and business cycle, it is nearly impossible not to favor a free market economy with no government intervention. Even Ludwig von Mises and Friedrich August von Hayek were socialists before they discovered the works of Menger and Böhm-Bawerk!
Human Action
The individual and its actions are at the center of Austrian Economics. Austrians frown upon the habit of economic schools to squeeze human action into abstract mathematical models. Austrians always start at the needs and desires of real people, and do not accept the concept of a “homo economics,” whose behavior is simplified to fit into the artificial models of economists.
In contrast, mainstream economists work with abstract terms and formulas, mimicking the precision of natural sciences. But economic processes are much more complex than scientific experiments in a laboratory, which can be repeated at will. In contrast, the economy is influenced by many factors, which work together differently in every situation.
The Austrian School therefore instead focuses on understanding the actions of human beings. It is no coincidence that Ludwig von Mises’ magnum opus is called Human Action. In its early days, the Austrian School was sometimes referred to as the “Psychological School,” because of its human-centered approach. Mises rejected this name, as he did not care about the psychological motives of human behavior, but only about its practical consequences for the economy. He preferred to call his approach Praxeology: the science of human action.
Where Do Prices Come From?
A good starting point to understanding Austrian economic thinking is to look at its explanation of how prices arise in a free market. While earlier economists argued the price of a product is mainly derived from the costs of its production, Carl Menger and his successors claim that prices are solely defined by the subjective value that a user assigns to a product in a specific situation. For this, he coined the term “marginal utility.” The marginal utility of a product is the additional benefit you get from consuming an additional unit. This can differ significantly depending on the situation, even for the same good.
Someone who is nearly dying of thirst in the desert would be willing to pay more money for a bottle of water than he would at his hometown supermarket. For him, the value of this life-saving bottle of water is much higher than the 100 dollars a greedy seller would charge.
His willingness to pay will be significantly lower for a second bottle, because its marginal utility is much lower after his thirst has been quenched. The seller, on the other hand, will value the 100 dollars higher than the bottle of water – if he disposes of enough water not to die of thirst himself. Otherwise he would not sell his last bottle for any amount of money.
Value is Subjective
We see that the buyer and the seller do not assign the same value to a product. Quite the contrary: a transaction will only take place if for the buyer the product has a higher value than the money he pays for it, while the seller appreciates the money more. Therefore, a “fair price” or an “intrinsic value” of a product does not exist. Prices always arise from individual decisions in specific situations. If a central authority fixes prices, distortions and unwanted aftereffects will inevitably follow.
The Function of Prices
The Austrian School believes prices are extremely important to the proper functioning of an economy. Prices send signals to which buyers and sellers adapt their behaviors. When resources become scarce in a free economy, prices rise and buyers will use less of this resource by replacing it with another, less scarce one.
They do this without having to know anything about the supply, delivery volume or production costs of that resource; they simply want to save money. Entrepreneurs may then find it pays to tap new resources which were previously economically unviable. Alternatively, entrepreneurs may invent new products that work without using the expensive resource but offer the same benefits. The ecosystem will automatically adapt to the scarcity of that resource, and often this adaption process will lead to innovation and progress.
This natural adjustment cannot happen in a planned economy, where prices do not arise from supply and demand, but are instead fixed by a central institution. Therefore, central planning inevitably leads to a waste of resources and a lack of innovation. A central institution would have to inform all participants of a production process when a resource becomes scarce. But it is mathematically impossible to dispose of all necessary data, let alone to compute them and draw the right conclusions. And how should the central authority convince people to change their behavior? By appealing to their reason and insight? Most likely they will resort to use force.
Market Economy and Socialism
In a free market economy, resources are channeled to where they can be used in the best way via the simple but striking signaling effect of prices. Only a price-driven process of competition in which inferior products are constantly ousted by better ones can lead to an efficient usage of scarce resources – which is what economy is all about.
Ludwig von Mises already proved why Socialism could never work and would lead to impoverishment in the 1920s. At the time, he faced a chorus of outrage, as Socialism was popular and had not yet been discredited.
But history has proven Mises right, as one could easily see by comparing the economies of Socialist East Germany and North Korea with their free market counterparts in West Germany and South Korea. Both countries began under the same conditions and shared the same culture, work ethics and natural resources. But whether socialist or free market policies were applied made a huge difference. Currently, Venezuela proves that even the country with the largest oil reserves on earth can be run down through socialist policies.
The Austrian Interest Theory
Interest is another topic the Austrian School has thoroughly examined. The Austrians claim that people value the money at their immediate disposal higher than money for which they need to wait, e.g. when they have lent it to someone else. Carl Menger has coined the term time preference for this phenomenon, which became the basis of Eugen von Böhm-Bawerk’s theory of interest.
When you lend money to someone else, you might to do this for a close friend or family member without a markup on the return. However, in most other cases you would charge an interest that compensates you for not being able to immediately spend the money yourself. It is also a compensation for the risk that the loan may not be repaid.
Some religions and even some economic schools reject interest and consider it immoral. In contrast, the Austrian School sees it as fair and justified, as long as it results from a voluntary agreement between lender and borrower. Due to time preference, no loans would be given if there were no interest. Indeed even in Islamic banking, which officially bans interest, there are many incentives for a lender. He would receive presents or a profit share, which have similar effects as an interest.
Interest becomes problematic when it is artificially set by a central institution. Austrian economists disapprove of the central bank’s power to fix interest rates. It is an intervention in the economy that is as harmful as a central planning authority fixing prices. The free market’s advantages in determining the prices for consumer goods should also be used to set the price for money, which is the interest. In a free market, the interest rate would depend on people’s willingness to save. If there are many people who save and want to lend money, the interest rate will be low. If the supply of loans is lower, as people are less willing to save and lend, the interest rate will be higher.
Mises’ Theory of Business Cycles
In the current monetary system, this natural balance of interest rates is malfunctioning. Loans are not given by people who have gained a surplus and want to invest it, but by banks that have the privilege to create money out of thin air. The interest rate is defined by a central bank, so it does not have any connection to the saving rate and the “natural” interest rate that a free market would produce. This results in misleading incentives for investors.
Due to artificially low interest rates, they invest their money into projects that under normal circumstances would not be economically viable. Cheap money can cause a short-termed economic boom, but it is only a straw fire. In the long run, uneconomic investments will fail and the boom will turn into a recession.
Ludwig von Mises’ theory of business cycles does not only deliver a logical proof of this, he also correctly predicted the economic crisis of 1929. According to his theory, the boom of the “Roaring Twenties” was caused by cheap loans issued through the US Federal Reserve System, which was founded in 1913. When investors discovered that this boom did not correspond to real value being created, it collapsed.
Also the financial crisis of 2007–2008, which hit many “economic experts” by surprise, was correctly predicted by Austrian economists. The combination of the Federal Reserve’s low interest rate policy with the political demand to grant loans to people who do not have the conditions to afford them resulted in the burst of the real estate bubble. Many complicated financial products that were “secured” only by subprime credit became worthless.
From an Austrian perspective, only money that is saved by abstaining from short-term consumption can lead to a sustainable buildup of capital. The current monetary system, which is based on debt and loans created from thin air, does not deserve the name “capitalism,” as it does not lead to an accumulation of capital and has nothing to do with a free market economy.
Austrian economists reject a monetary system that is based on a state monopoly. They observe many harmful effects that are the results of governments and central banks acting. The Austrian School has logically proven why a central authority should not fix prices. However, a central institution fixes the price for the most important good of an economy, which is money. That’s why the libertarian author Roland Baader calls our current system “money Socialism.”
Gold Standard or Competition?
Inside the Austrian School there are different opinions on which is the best alternative to a state monopoly on money. Ludwig von Mises was in favor of a currency backed entirely by gold, which would theoretically prevent government manipulation. Friedrich August von Hayek believed that governments would never allow such a strict gold standard; he therefore favored a free competition of currencies.
In his book The Denationalization of Money he suggested that state-issued money should compete with money issued by private companies. In such a free monetary system, he predicted, better currencies would prevail.
Read more about the flaws of our current monetary system in this Steemit post.
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