The Austrian School of Economics traces its origins back to the 1870s with its founder, Karl Menger. Two of Menger's outstanding students, Eugene Böhm-Bawerk and Friedrich von Wieser, in turn, had their own notable students in Ludwig von Mises and F.A. Hayek, respectively. These figures form the intellectual lineage of the school.
The fundamental starting point for Austrian economics is the study of purposeful human action. This means that economic inquiry begins by observing how individuals weigh alternatives and make decisions upon which they act.
While economics is not concerned with the psychology behind these choices, it focuses on the actions that are chosen. Such actions are termed demonstrated preference or revealed preference.
The central insight derived from this is that everything that occurs in an economy is driven by real human beings demonstrating their preferences through these purposeful actions. This perspective describes the economy as causal realist, meaning the only agents making anything happen are people.
A core tenet of Austrian economics is that value is inherently subjective and remains so at all times. My preference for tea might differ from your preference for coffee, and preference for something like coffee can change over time. Austrians contend that prices in the real economy are invariably based on these subjective preferences, which are inherently unmeasurable. They argue that other economists, despite acknowledging subjective value, often overlook this when modelling prices by implicitly assuming that production costs determine prices. Austrians firmly insist that production costs do not determine prices; only subjective preferences do.
Because we cannot know people's subjective preferences and valuations, Austrians reject the notion that economics can be a hard science like physics. They argue that predicting human behaviour is impossible because human beings are not like stones, which react predictably to conditions. Moreover, one can never achieve constant variables in the real world. Consequently, Austrians reject the use of mathematical modelling in economics.
A final crucial characteristic of Austrian economics is their consistent recognition of the role of time. Since humans must act within a world bounded by time, time is a constant feature of our economic affairs, often overlooked by other schools. This temporal aspect is vital when considering topics such as pricing, inflation, and the role of the entrepreneur.
The Austrian School has made several significant contributions to economic theory:
- Marginal Utility: Advanced by Karl Menger, this concept concerns the subjective theory of value. It highlights how the value or utility gained from consuming successive units of a good diminishes. For instance, the value of a glass of water to someone dying of thirst in a desert is immense, but the value of a subsequent glass after having just drunk a pint is considerably less. Marginal utility explains why even a highly useful item like water can ultimately be valued less than a luxury item like a diamond.
- Opportunity Cost: Introduced by Friedrich von Wieser, this is the straightforward concept of the loss of other alternatives when one alternative is chosen. We face these choices constantly. Choosing to study hard for an exam means forgoing the enjoyment of seeing a movie with friends; the movie is the opportunity cost of studying. Conversely, seeing the movie means incurring the cost of potentially a lower grade.
- Time Preference: Eugene Böhm-Bawerk introduced the idea that people generally prefer to have goods or money sooner rather than later. Offered a choice between £100 today or £100 in a month, most would choose £100 today. This preference for present consumption over future consumption is known as time preference.
- Business Cycle Theory: One of the most famous theories from the Austrian school argues that most modern economic boom-bust cycles are caused by expansionary credit. Ludwig von Mises first outlined this theory in 1912.
- Economic Calculation Problem: Ludwig von Mises argued that in the absence of a market economy, socialist systems would be unable to effectively allocate resources because they lack market prices to act as signals of what people want. Mises first put forward this argument in 1922 and, it is argued, was proven correct by the collapse of most socialist governments in the late 20th century.
- Knowledge Problem: F.A. Hayek extended the economic calculation problem to encompass virtually all decisions made by central planning units. Hayek argued that the knowledge required for effective economic decision-making is dispersed among countless individuals on the ground, and no single person can possibly acquire enough data to make even a semi-informed decision. Thomas Sowells book _Knowledge and Decisions_ provides an accessible exploration of this issue.
The Two Schools of Austrian Thought
Today, the Austrian School has broadly split into two branches, roughly following the ideas of F.A. Hayek and those of Ludwig von Mises and his American protégé Murray Rothbard.
The followers of Hayek tend to analyse real-world institutions and policies, focusing on the misallocation of resources and avoidable disasters resulting from interventionism, while promoting the efficiency of the market mechanism, which provides accountability and feedback loops. Hayekians are notably found at George Mason University and the Mercatus Center.
The followers of Mises and Rothbard, conversely, advocate more radical laissez-faire positions and are more strongly opposed to the state. The Rothbardians are strongly associated with the Ludwig von Mises Institute and champion positions such as opposition to central banking, fiat currency (favouring commodity money like gold), and fractional reserve banking.
Across the Austrian school, opinions on the appropriate size of the state vary. Views range from minarchists and contractionists, who favour a limited government or night-watchman state, to full anarcho-capitalists, who believe all societal functions would be better handled by private enterprise.
The Austrian School stands in contrast to The Chicago School of Economics.
While the Austrian School starts with human action, the Chicago School focuses on the allocation of scarce resources with alternative uses. This focus on resources leads the Chicago School to view economics as a hard science, relying heavily on data and mathematical models, in contrast to the Austrian rejection of economics as a hard science and their emphasis on a priori reasoning from first principles. They also differ on price theory; Austrians maintain a strictly subjective view, whereas the Chicago School incorporates the neoclassical perspective that production costs are a factor in determining prices.
In macroeconomics, Austrians reject the distinction between micro and macro, explaining recessions primarily through their business cycle theory and credit expansion. The Chicago School, like Keynesians, considers the economy as a whole using aggregate statistics but focuses government intervention on controlling the money supply rather than aggregate demand.
Despite these differences, the Austrian School shares significant similarities with the Chicago School. Both schools are strong proponents of the free market and are generally opposed to government interventions and regulations. They are both utterly opposed to socialism. Both broadly accept Hayek's insights regarding the knowledge problem, which enables them to extend their analysis beyond traditional economic topics like trade and money to aspects of everyday life.
In substantive areas of disagreement, such as monetary policy or pricing, the Austrian view is often seen as more consistently and rigorously argued. However, in real-world debates, the Chicago School has often been more successful because it relies on data and statistics to support its arguments. There is considerable persuasive power in being backed by statistics.