The Austrian school in plain words, from Carl Menger to Friedrich Hayek

Water is cheap and diamonds are expensive. Water keeps you alive and diamonds do nothing of the kind. For a century before 1871, economists had trouble explaining that, and the puzzle even had a name, the paradox of value. Then a professor in Vienna solved it with an idea so simple that it is a little embarrassing it took so long: the value of a thing depends on what one more unit is worth to the person who is deciding, at the moment he decides.

That idea is the seed of the Austrian school of economics. A school of economic thought gets a bad reputation when its followers talk in jargon, so I will try to do the opposite. What follows is the Austrian school in plain words: where it came from, what it claims, what its best critics say and what a conservative can fairly keep from it.

The terms, defined

Three ideas run through the whole tradition, and I want you to hold them in your mind as I go.

1. Value is subjective. A good has no value in itself. It has value to a person, for a purpose, at a time. A bucket of water is worth little in a rainy town and a great deal in a desert.
2. Prices carry knowledge. A market price is not just a number. It is a signal that compresses the plans, needs and information of millions of people into something one person can act on.
3. Money and credit shape the structure of production, and cheap credit distorts it. This is the heart of the Austrian theory of the business cycle, and it is the most controversial piece. I will give it a section of its own.

Everything else in the tradition grows from those three.

Carl Menger, 1871

The founder is Carl Menger (1840 to 1921), an Austrian economist who taught at the University of Vienna. In 1871 he published Principles of Economics (Grundsätze der Volkswirtschaftslehre in German). The same decade saw two other economists, William Stanley Jevons in England and Léon Walras in Switzerland, reach similar conclusions about marginal utility. Historians call this convergence the marginal revolution.

What did Menger say? Before him, the dominant tradition, running through Adam Smith, David Ricardo and later Karl Marx, tended to explain value by the cost of production, or by the labor put into a good. Menger turned it around. Value does not come from what went into the thing. It comes from what the thing can do for someone, and the amount of satisfaction depends on the quantity he already has. The first glass of water to a thirsty man is worth a great deal. The tenth is worth almost nothing. That is the idea of marginal utility, and it dissolves the water and diamonds puzzle: it is the value of the next unit that sets the price, not the value of the whole category.

The consequence is large. If value is subjective, then it is no use asking whether a trade is "fair" by some objective measure of labor. Both sides of a voluntary exchange expect to gain, or they would not make it. I buy your bread for a dollar because I value the bread more than the dollar, and you sell it because you value the dollar more than the bread. Both of us go home better off. That is why voluntary trade is a positive-sum activity, and that is the moral center of the case for free markets. The Marxist notion that a worker's labor creates value that a capitalist steals runs straight into Menger's point.

Menger also fought a famous methodological fight in the 1880s with the German Historical School, led by Gustav Schmoller, over whether economics should be a deductive science of general principles or a collection of historical case studies. Menger argued for theory. The quarrel, known in German as the Methodenstreit, shaped the Austrian habit of reasoning from first principles.

Eugen von Böhm-Bawerk: time and capital

Menger's student Eugen von Böhm-Bawerk (1851 to 1914) carried the tradition into the theory of capital and interest. He served as Austria's finance minister more than once, and he is remembered for a three-volume work, Capital and Interest, and for his arguments with Marx.

His central ideas were these. People prefer present goods to future goods, other things equal. That preference, called time preference, is why interest exists: a lender is paid to give up the use of money now. And production takes time. Making a tool that makes a better tool that makes bread is a longer, more "roundabout" process than picking berries by hand, and the longer process is more productive. But it requires someone to wait, which means someone must save. Savings, in this view, are not just idle money. They are the supply of time that lets an economy build longer, more productive structures of capital.

Böhm-Bawerk's insistence that capital is a structure with a time dimension becomes important when we reach the business cycle, because the Austrian explanation of booms and busts depends on it.

Ludwig von Mises: calculation, action and money

The next great name is Ludwig von Mises (1881 to 1973). Three contributions stand out.

The theory of money and credit. In The Theory of Money and Credit (1912), Mises applied marginal utility to money and began to sketch a theory of how expansions of credit could disturb the economy.

The calculation argument. In 1920 he published an essay arguing that a socialist economy cannot calculate. Without private ownership of the means of production there are no market prices for them, and without prices, planners cannot know whether a given use of steel or labor is efficient or wasteful. I take that argument up in Mises Showed in 1920 That Socialism Cannot Calculate a Single Price, and it is one of the strongest pieces of economic reasoning in the whole tradition.

Praxeology. His major systematic book, Human Action, appeared in English in 1949. In it Mises set out a science of human action, which he called praxeology, built on the axiom that people act purposefully. From that premise, he argued, economists can deduce general laws without needing to test them against statistics, in the way a mathematician deduces theorems. This methodological claim is also where the school draws its sharpest criticism, as I will explain.

Mises left Austria in 1934 for Geneva and in 1940 came to the United States, where he taught at New York University and trained a generation of students who carried the tradition forward in this country.

Friedrich Hayek: knowledge, order and the cycle

Friedrich Hayek (1899 to 1992) was Mises's most famous student, and he did more than anyone to bring the Austrian approach to a wide audience. He moved to London in 1931 to teach at the London School of Economics, and later taught at the University of Chicago and elsewhere.

His contributions include:

• The knowledge problem. In "The Use of Knowledge in Society" (1945) he argued that the information needed to run an economy is dispersed among millions of people, and that prices are the means by which it is coordinated. That is why central planning fails. (A version of the argument appears in Solyndra to Amtrak, why government picks losers when it picks winners.)
• Spontaneous order. Many of the most important human institutions, language, law and markets, are the result of human action but not of human design. See Nobody Designed the English Language, and Hayek Called That Spontaneous Order.
• The business cycle. In Prices and Production (1931), based on lectures at the LSE, he presented the Austrian theory of the cycle in a form that drew attention in the early 1930s.
• Political philosophy. The Road to Serfdom (1944) argued that economic planning tends toward the loss of political freedom, and The Constitution of Liberty (1960) set out a theory of law and liberty.

In 1974 Hayek shared the Nobel Memorial Prize in Economic Sciences with the Swedish economist Gunnar Myrdal, the committee citing his work on money and economic fluctuations and his analysis of the interdependence of economic, social and institutional phenomena. It was a remarkable honor for a man whose ideas had been out of fashion for decades. (He also wrote an essay that conservatives should read honestly, explaining why he did not want the label; see Hayek Wrote Why I Am Not a Conservative, and He Had a Point Worth Facing.)

The Austrian theory of the business cycle

Now for the claim the school is best known for, and the one the rest of the economics profession argues about most.

Here is the argument, in steps.

1. In a healthy economy, interest rates coordinate saving and investment. If people save more, rates fall, which tells businesses that more resources will be available in the future and encourages longer-term projects.
2. A central bank can push market interest rates below the level that voluntary saving would produce, by creating credit. The rate signal now says: "People have saved more, so it is time to build long-term capital projects." But nobody has actually saved more.
3. Businesses respond to the false signal. They start long-term projects, such as housing, factories and speculative ventures, that the real pool of saved resources cannot finish. This is the malinvestment of the Austrian theory: investment misdirected by a distorted price.
4. The boom feels wonderful. Employment is up, asset prices climb, everyone is optimistic.
5. Eventually the resources run short. Some projects cannot be completed, costs rise, credit tightens, and the structure of production must be reorganized. That reorganization is the bust. The bust is not the disease. It is the painful correction of the errors made during the boom.
6. The policy conclusion follows: the way to avoid the bust is to avoid the artificial boom, which means not creating credit at below-natural rates. Once the bust has arrived, propping the structure up with more cheap credit only postpones and worsens the reckoning.

Notice how this lines up with conservative skepticism about the Federal Reserve, as discussed in Gold standard, Friedman's rule or today's Fed, three answers compared. And the Austrian account of the Great Depression and of the housing boom of the 2000s has real appeal to people who think central banks cause as many problems as they solve. The case for linking the 2008 collapse to easy credit and government-promoted lending is made in The 2008 housing crash began with Washington's push for easy mortgages.

The criticisms, stated fairly

A post that only praised the school would be a pamphlet. Here are the serious objections, in the form its critics would give them.

Method. Mises held that the basic propositions of economics are known to be true by reflection on the nature of action, and that they cannot be refuted by data. Critics, including most mainstream economists, answer that a theory that cannot be tested cannot be distinguished from a theory that is wrong. Science, on this view, requires that theories risk contradiction by evidence. Milton Friedman's methodological essays pressed this point, and it is the most common reason economists give for setting the Austrian tradition aside.

The Depression. Friedman and Anna Schwartz, in their 1963 A Monetary History of the United States, argued that the Great Depression was made catastrophic by a collapse in the money supply that the Federal Reserve failed to prevent. That is nearly the opposite of the Austrian prescription, which treats contraction as a necessary correction. Many economists consider the Friedman and Schwartz account more persuasive than the claim that the Depression was the inevitable result of earlier credit expansion. (For the Chicago view, see Austrian, Chicago and Keynesian economics compared on one table.)

Hayek and Keynes. In the 1930s Hayek and John Maynard Keynes sparred in print, and most observers judged that Keynes's side won the policy argument of the day. Hayek criticized Keynes's earlier Treatise on Money in 1931 but did not write a full review of the General Theory, an omission scholars have long discussed. Critics take this as a sign that the Austrian cycle theory was not equipped to explain a deep slump with idle capacity and mass unemployment.

The mechanism. Even sympathetic economists ask how firms and banks could be fooled by a rate signal in a world of sophisticated, forward-looking lenders. If everyone knows the central bank is pushing rates down, why do they respond as though the signal reflected real saving? Rational-expectations economists made versions of this objection.

Policy. If the Austrian prescription, to let busts run their course, had been followed in 2008 or in the early 1930s, the human cost could have been enormous, and critics argue that no democracy would accept it.

What should a fair reader make of these? I would say the following. The methodological objection has force against the strongest claims, though not against the practice of using logic and history together. The Depression objection is serious, and the Friedman and Schwartz account has better evidence behind it. But the Austrian warning that credit expansion can misdirect investment is not a fringe idea. It echoes in the work of mainstream economists who study asset bubbles and "financial cycles." Economists argue about how much weight to give it, not whether it has a place.

What conservatives should keep

So what do we take from the Austrians? I would keep four things.

1. Subjective value and voluntary exchange. The moral and economic case for markets rests on the fact that both parties to a free trade expect to gain. That is the answer to every theory that treats profit as theft.
2. The knowledge problem. Prices carry information that no planner can gather, which is a standing warning against centralized control of the economy.
3. Humility about the central bank. Whether or not you accept the whole cycle theory, the Austrian point that artificially low interest rates have consequences deserves a place in every debate about monetary policy.
4. The habit of looking for the unseen. Every policy has costs that do not appear in the first round, and the Austrian instinct to trace them is a healthy one.

I would not keep the claim that economic theory needs no empirical testing, and I would not accept that the school has a complete account of every slump. A conservative can honor the tradition without treating it as scripture.

Why it matters to a family

This is not only a story about professors. When a central bank holds interest rates low, a family may find that a house or a car is cheaper to finance, and savers find that their money earns little. When rates rise sharply, the families that borrowed at low rates feel it. The business cycle is, in the end, what happens to your job, your savings and your mortgage. Knowing the theories behind the policy arguments helps you ask better questions of the people who set them. To read what the Fed's own mandate requires, begin with The Fed's dual mandate and the 1977 law that gave it two masters.

The case in brief

1. Carl Menger's 1871 Principles of Economics established that value is subjective and set by the margin, which is the foundation of the case that voluntary trade benefits both sides.
2. Böhm-Bawerk added the theory of time preference and capital, Mises the calculation argument and Human Action (1949), and Hayek the knowledge problem and a Nobel Prize in 1974.
3. The Austrian business-cycle theory holds that credit expansion below the natural rate causes malinvestment, a boom and then a corrective bust.
4. Critics fairly object to the school's methods, to its account of the Depression, which Friedman and Schwartz in 1963 explained differently, and to the mechanism by which firms are fooled.
5. Conservatives should keep the subjective theory of value, the knowledge problem and the skepticism about easy credit, and leave the claim that theory needs no testing.

What you can do: read the Federal Reserve's own page on its statutory goals, then write your members of Congress asking whether the Fed's mandate should be narrowed to price stability alone.