Austrian Economics: An Introduction

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Introduction

The Austrian School of economics has received renewed attention in the past few decades as its free-market policy conclusions and association with libertarianism have played a growing role in academic and public debate. This attention became even greater during the housing crisis and the Great Recession, as Austrian ideas were frequently invoked to explain that boom-and-bust cycle. In addition, Ron Paul’s campaigns for president in 2008 and 2012 made some of the school’s ideas part of the popular political discourse. During the past decade, more young people have been studying the Austrian School as part of their formal college educations, because more economists with PhDs have been trained in that tradition and are themselves teaching at colleges and universities and contributing as public intellectuals to various media outlets.

The increasing public presence of the ideas of the Austrian School might suggest that this approach to economics is something new. However, the truth is otherwise. The Austrian School dates back to the revolution in economic thinking of the 1870s that created the modern approach to economics. At the turn of the 20th century, and for the next few decades, the Austrian School was one of the dominant schools of thought in economics. Its influence was diminished in the 1930s by two developments. First, the Keynesian revolution in macroeconomics that emerged out of the Great Depression pushed Austrian ideas aside. Around the same time, microeconomics was becoming increasingly expressed in formal mathematical terms, with economic problems being seen as special types of engineering problems. Both of these changes in the way economics was done were at odds with the Austrian approach. As a result, the Austrian School all but disappeared from around World War II until the early 1970s.

A second confluence of events, this time in the early 1970s, produced the conditions that led to a revival in the school’s intellectual activity and reputation. The combination of high unemployment and high inflation in the early 1970s was not supposed to be possible according to the (broadly) Keynesian economic models in vogue at the time. The failure of mainstream macroeconomics to explain what was happening opened the door to alternative approaches. Two events in 1974, specifically, helped bring the Austrians back into the conversation. First was the awarding of the Nobel Prize in Economics to Friedrich August Hayek for his work on monetary theory and macroeconomics, as well as for his contributions to understanding the informational properties of the price system. All of this work was in the Austrian tradition. Also that year, the Harvard philosopher Robert Nozick published his National Book Award–winning Anarchy, State, and Utopia, a defense of libertarian political philosophy informed by ideas from the Austrian School.¹ Hayek’s Nobel and Nozick’s book put discussions of Austrian economics back on the agenda of scholars in a variety of disciplines, in addition to informing public debate.

These events, along with the publication of Israel Kirzner’s Competition and Entrepreneurship the year before, marked the beginning of a revival of the Austrian School that has continued since, accelerating in the past decade thanks to the inability of the economics discipline to predict and explain the Great Recession.² Since the 1970s, the Austrian School has slowly elbowed its way into conversations in the mainstream of economics and is now informing policy analysis and public debate in ways it has not before. Although no reliable data exist, it is almost certain that there have never been more professional economists working in the Austrian tradition than there are today.

The Austrian School’s roots are in the Marginal Revolution in economics that took place in the 1870s. That revolution fundamentally changed the way economists understood the concept of value, which had major consequences for the subject matter and methods of the discipline. Before the 1870s, the value of a good or service was most often explained with reference to the cost of producing it, especially the labor involved in doing so. The labor theory of value was, in one form or another, accepted by almost all major economic thinkers, from Adam Smith to Karl Marx. The theory has a number of obvious problems, including how to reduce different qualities of labor to a single measure and how to explain the value of things that are discovered serendipitously. Early economists worked hard to try to explain their way around these puzzles, much like Ptolemy resorted to inelegant mathematical contrivances to make his geocentric model of the solar system predictively accurate. The ad hoc nature of those explanations created the opportunity for a new systematic explanation of value, which arrived in the form of the Marginal Revolution, the economic equivalent of the Copernican Revolution in astronomy.

In the early 1870s, three thinkers changed the way economics was done by making clear that the value of a good or service was the result of the subjective perceptions of the usefulness to the consumer of the specific amount required for the use at hand (what is known as the marginal amount). Goods did not have intrinsic value, nor were their values determined by the amount of labor or other inputs that had gone into producing them. Instead, goods had value because people thought they were useful, and the specific amount of value they had depended on the particular quantity that was needed to satisfy the user’s specific want.

Two of those three revolutionaries, William Stanley Jevons in England and Léon Walras in Switzerland, employed a mathematical approach, applying the concept of marginality to model their new conception of utility in terms of simple calculus. By contrast, the third of the three revolutionaries laid out a different understanding of this way of seeing value, stressing more than the other two the subjectivity of economic value and that the margin of choice was determined by the minds of those making choices rather than being an abstract mathematical concept. That third revolutionary was Carl Menger, a professor at the University of Vienna, and the approach to economics he laid out in his Principles of Economics in 1871 became the foundation of what was later termed the Austrian School. In addition to his emphasis on the subjective nature of value, at the center of Menger’s economics was human knowledge and the way in which its limits mean that we must constantly deal with uncertainty. For Menger, economics was the study of how humans possessing limited knowledge and facing an uncertain future attempted to improve their well-being by figuring out what they wanted and how best to get it. Menger’s vision of economics was very much a human-centered one: man, with his needs and his command of the means to satisfy them, is himself the point at which human economic life both begins and ends.³ This conception of economics remains at the core of the modern Austrian School.

Menger’s other great contribution was to expand and extend the invisible hand concept of Adam Smith. Both in his Principles of Economics and in his later book Investigations into the Methods of the Social Sciences (1883), Menger offered explanations of social phenomena that began with the choices of individuals and showed how the outcome of those choices was often a result that none of the individuals had planned or intended. In his Principles, he explained the emergence of money using this sort of strategy, and in the Investigations, he generalized that strategy and asked what is sometimes called the Mengerian question:

How can it be that institutions which serve the common welfare and are extremely significant for its development come into being without a common will directed toward establishing them?⁴

This explanatory strategy, later termed spontaneous order theory, is also at the heart of modern Austrian economics. Understanding how social phenomena are the unintended outcomes of human choice filtered through various social institutions is the analytical technique Austrians use to do economics and social science. Spontaneous order explanations rest on the concepts of subjectivism and limited knowledge noted earlier. It is precisely because our knowledge is partial and local that we rely on social institutions, rather than the intelligent design and control of experts, to coordinate our behavior. This claim has broad implications for issues in political economy as well as for the nature of economics as a discipline.

In what follows, I will explore the ideas of the Austrian School of economics, with an emphasis on how its analysis differs from the standard textbook presentation of economics. My approach will be broadly historical, in that I will discuss specific ideas in roughly the historical order in which they became a focus of the school’s attention. I will also not dwell on particular thinkers or books, but instead proceed topically and make note of important contributors as they are relevant to the ideas under consideration. Compared to the mainstream economics of today, the Austrian emphasis on subjectivism, uncertainty, and the importance of knowledge, as well as the school’s conception of the market as a spontaneously ordered process of discovery, offers a different and more realistic explanation of economic phenomena, from the most basic to the most complex. As economics has become more abstract and more dependent on unrealistic assumptions about what humans know and how they choose, an approach that addresses those issues will find a receptive audience, as the revival of