The Austrian School of Economics

The Austrian school of economics (Austrian economics) is a distinct tradition within economic theory that adheres more stringently to value as being subjective and theory as a matter of logic than does mainstream economics. Generally recognized as “free market economics,” the school is a positive theory tradition that uses a precise and rigorous methodology, and that has and continues to make important contributions to our understanding of markets and economics.

The tradition has its origin in the publication of University of Vienna professor Carl Menger’s treatise Grundsätze der Volkswirtschaftslehre (Principles of Economics) in 1871. Menger’s work was one of three texts published in the 1870s that shaped modern economics by introducing marginal analysis. “Marginalism” is the recognition that people value and make decisions regarding goods and services in specific units. In other words, that one’s valuation of a good is the value of the next unit not all units – we do not value and act on water in general but the next gallon, glass, or bottle.

Although all modern approaches to the study of economics are marginalist, Austrian economics stands out. Modern mainstream economics relies heavily on formal and mathematical modeling, often using unrealistic assumptions, but Austrian economics continues and builds on the tradition of economic reasoning that previously defined the discipline.

Austrian economics was one of several main traditions in economics well into the first half of the 20th century and made many significant contributions to the science. In the grand debates that shaped economic thinking and theory, “Austrians” were either the instigators or important contributors. The school’s importance and influence declined with World War II as economics increasingly shifted from explaining how markets work to providing policy recommendations and making precise predictions using formalized models. Austrian economics again rose to prominence in public debate, albeit not in academic economic research, beginning in the 1970s with F.A. Hayek receiving the 1974 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel and again in the 2000s with the failings of mainstream macroeconomics to explain the causes and provide solutions to the Great Recession.

“All things are subject to the law of cause and effect,” begins Menger’s treatise. All observable economic and social phenomena have specific but not necessarily independent causes. Some are designed and intended, such as production of some good or starting of a company. Others are undesigned and unintended. Proper economics must deal with and explain both types. It must also explain how they interrelate and interact to bring about the complex mass of transactions that we refer to as simply “the economy.” Austrians therefore focus on understanding the mechanisms, processes, and drivers that are intrinsic to economic affairs.

All processes and mechanisms in the economy emerge from people’s actions. Human action, Ludwig von Mises reminds us, is “purposeful behavior.” It is intended to attain some end by causing a specific change to the world. This end is valued by the individual who pursues “purposeful behavior” and is thus subjective. This does not mean that an action’s outcome is immeasurable or relative, only that it is valued in some way by the person pursuing it. When we act to earn a profit, we can measure the profit in terms of dollars and cents or as a ratio to the investment. How and why that profit is valued by the person is a matter of the satisfaction the person feels, not of objective measurement.

The observation that value is subjective is fundamental for economic understanding. For example, what we typically refer to as goods are real things, but this does not mean every real thing is a good. Something is an economic good by virtue of its anticipated usefulness in bringing us personal value; because it is not abundantly available, we must economize. The reason we engage in production and exchange is that we expect those actions to generate to us, directly or indirectly, the means to some personal satisfaction. All actions, whether or not they take place in a market setting, are motivated by some value subjectively understood.

Value subjectivity is core to the Austrian understanding of the economy as it is to most economists today. Indeed, as Hayek put it in The Counter-Revolution of Science, “…it is probably no exaggeration to say that every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism.” Where Austrians differ from mainstream economics is that they consistently apply value subjectivism and that they recognize that the processes of a person’s mind that makes them value certain things and not others do not matter for how an economy works. It is sufficient to recognize that we value.

Austrians study the real economy and its processes. What goes on in a person’s mind matters only to the economy if and when the individual chooses to act to buy, sell or produce. It is therefore enough to understand action to study how the economy works; we do not need to look into people’s minds.

Austrian economics holds that theory precedes and informs rather than is generated from empirical observations. We cannot observe causality so to understand economic processes and mechanisms, we must first have an understanding for what it means to act. Most economic concepts are based on our understanding of their meaning, not observation using our senses.

For example, we can observe a great number of people showing up every morning to enter a building to then late in the afternoon exit. But we cannot observe that this building is an office building that houses several separate business firms in which these people have certain roles as employees for which they earn wages. We also cannot observe that these companies have owners, that they are part of different industries, that they offer products under different brands that differ in their meaning to consumers, etc. In other words, we need prior understanding to even identify the relevant concepts, no less to study the specifics of this building’s use, these companies, and these persons’ roles. Theory thus precedes and informs empirical observation, not the other way around.

Because of their strict adherence to logical reasoning, Austrians are often accused of not only prioritizing theory development but also rejecting empirical analysis. This is untrue. Even in a strict interpretation of Austrian school method, such as Mises’s praxeology (the logic of action, from which economic theory is derived), much economic analysis is left for empirical analysis. However, theory defines and determines the economic mechanisms that are studied using data. Theory is in other words used to make sense of and analyze the data. Thus, to study what happened in the Great Depression, we apply economic theory to shed light on and guide our analysis of the specific circumstances (that is, data).

Core to Austrians’ understanding of the market economy is economic calculation. While originally conceptualized by Mises in his argument that a socialist economy is impossible, we cannot understand economics, and certainly not markets, without this mechanism.

The economic problem above all is how consumers’ wants, which are varied and change over time, can be satisfied to the greatest degree possible using the scarce resources available to us. Not only is this a matter of discovering what consumers value subjectively (personally and for themselves), but in what ways their wants can be properly satisfied – and when. New goods must be imagined, and investments made toward their realization before it can be known that those goods will satisfy wants and to what degree they may do so. In other words, investments must be made before – and sometimes long before – it can be known that the products will sell.

The issue is further complicated by the fact that consumers themselves rarely know what they want or how to satisfy those wants. A producer cannot simply ask their future customers what they want. As was the case with many if not all important innovations, the innovator struggled to realize the innovation and was not recognized as a genius until after the fact. The economic problem is not whether and to what extent one should continue producing what was already produced, but to figure out what should be produced to meet future consumer wants.

Markets solve this grand puzzle. How? By facilitating economic calculation. Entrepreneurs imagine and innovate goods that they believe will provide consumers with value. Faced with the risk of losing their personal investment if the plans do not pan out, but motivated by the potential for earning profits, they make what they consider to be appropriate investments. Without the threat of loss, they might overinvest. Without the lure of profit, they will underinvest.

The specific implementation of their production undertaking is guided (and limited) by how much they think consumers will be willing to pay for the final good when it is offered for sale. So they estimate the value to consumers and therefore their willingness to pay. This potential revenue is the maximum that any entrepreneur is willing to pay when acquiring production factors (primarily labor and capital goods) in the market. Production choices – which materials to use, which processes to implement, what quantities to produce and how soon, etc. – are therefore based on the entrepreneur’s profit calculus: how much the anticipated selling price may exceed the production cost. This also guides which productions should be undertaken. What matters is the return on investment – the relative profitability of a venture. If it is not profitable enough, which means the entrepreneur has not created enough value given the cost of inputs, then the idea will rarely be pursued. The resources are better used elsewhere.

For this calculation to be possible, there must be market prices of production factors so that entrepreneurs can estimate the cost of production. Mises’s insight was that the factor prices that every individual entrepreneur pays are determined by entrepreneurs collectively through implicit market bidding. This bidding works as follows. All entrepreneurs’ willingness to pay for factors – their reservation prices – is limited by and based on the anticipated market value of the goods they set out to produce. As entrepreneurs compete with each other for those factors, those factors that are most useful and expected to create most value will be most sought after and will therefore be traded at the highest prices. Consequently, entrepreneurs’ competitive bidding constitutes to Mises a “division of intellectual labor” that estimates the social value of all production factors, represented by their prices. Productions are then undertaken by individual entrepreneurs based on these value assessments (prices) and as a result market production generates the best possible (but not perfect) outcome in terms of expected consumer valuation.

Mises’s argument against socialism was that this process is only possible where factors can be owned privately and, therefore, entrepreneurs’ losses hurt them personally. Where this is not the case, such as socialism where all means of production are commonly owned, there is no division of intellectual labor as bids are not made for personal gain and losses are not borne by the bidder. Therefore socialist economies cannot economize with respect to consumer value; they are neither efficient nor value-creative. They cannot even be properly thought of as economies, since they do not economize: they are unable to figure out how to produce the greatest value possible, on consumers’ terms, using the scarce resources available.

In market economies, in contrast, the consumer is sovereign in determining the value of what is produced – after the goods have already been produced. The want satisfaction that consumers can attain from what entrepreneurs offer is limited only by the collective innovativeness and ingenuity of entrepreneurs (both in terms of consumption goods and the development of new capital goods and production techniques).

When competing in the unhampered market, entrepreneurs earn profits by serving consumers. They compete by producing as much value as possible. The result is a dynamic and increasingly value-creative market process driven by entrepreneurship; imperfect but unbeatable at generating prosperity.

Markets are not perfect. This is often used as rationale for interventionism: the use of non-economic measures, typically via government, to seek to improve on market production, value distribution, etc. For example, government regulation or provision of goods is a common conclusion of the mainstream economics analysis of so-called market failures (the market’s inability to produce theoretically maximizing outcomes). Austrians are generally more hesitant to make this type of argument, but this is not, as some critics claim, for ideological reasons.

From the perspective of Austrian economics there are no means by which we can assess the maximizing or “perfect” outcome of a market as an unfolding entrepreneurial process (which is how Austrians see it). What may be theoretically possible is also not a relevant benchmark for assessing reality – the unreal (and perhaps even unattainable) is not a shortcoming of reality. After all, that we can theoretically travel from A to B soaring through the air in a straight line, because we cannot fly but must rely on other means, is not a “travel failure.” Soaring through the air without an airplane may be a more efficient way to travel, but it is neither realistic nor relevant.

In reality, the conditions, circumstances, and consumer valuations are in constant flux. This means the market process can be assessed only by means of procedure – not in terms of outcome. The question is not whether what is is perfect but whether there are better real alternatives. The Austrian school analysis of the economy is in a fundamental sense a comparative institutional analysis: different rules and frameworks facilitate different outcomes as they affect not nature but effect of universal economic mechanisms and processes. Considering the economic calculation argument, it is immensely difficult to improve on the entrepreneurial market process without replacing consumers’ valuations with the interventionist’s and inadvertently causing other problems.

A telling example of how interventions in the market causes imbalances and problems is the Austrian theory of the business cycle (often referred to as Austrian business cycle theory, or ABCT). The theory traces the effects on the market from the expansion of credit.

Entrepreneurs pursue productions that are intended to best satisfy consumers’ wants using the means at hand. This process determines money prices of factors as well as of consumers’ goods. To be spent on goods, an actor must first earn the money. Simply put, someone’s demand is constituted by their supply: the value provided largely corresponds to the purchasing power gained in return (whether in the form of wages, interest, rent, profits, or a combination). Market prices that are determined by open entrepreneurial bidding provide the goods’ relative value contributions given the existing money in circulation.

The creation of new credit, through for example loans made by banks creating new money, upsets the natural balance of the market and undermines the prices that have already been determined. The new money offered as loans tends to lower interest rates that therefore make more entrepreneurial projects profitable. More importantly, there is now more purchasing power than there are goods at the already determined prices. Thus, those who first get their hands on the new money (the debtors) increase their purchasing power without it being earned through production – it is new and therefore changes the circumstances in the economy. By getting this new purchasing power, they can bid higher to purchase goods than before and, likely, higher than those who only have “old,” earned money.

This causes an artificial boom in those industries first and most heavily affected by the new money and resources are invested there. This is not a result of expected higher consumer value (wants satisfaction) but because of new purchasing power. Because it is based not on consumer wants relative the means available to satisfy them but on manipulated signals, this is an artificial boom. It is fundamentally unsustainable because it is not based on actual consumer value. It is the seed to the inevitable crash and correction as new prices are determined by entrepreneurs bidding for resources given the new (greater) money supply.

Whether by the government, the central bank, or private banks, the manipulation of market mechanisms and processes causes imbalances in the market that are not without downside. The expansion of credit creates winners (bankers, early debtors) and losers (those who have to pay higher prices before their incomes have adjusted) in the present and near future. But the imbalance is itself unsustainable and will need correction. The bust, recession, or depression is to Austrians an effect of creating the artificial, unsustainable boom. It is the costly process of the market economy finding its way back to its “natural” order of producing for consumers.

The Austrian School of economics, despite being a modern (marginalist) school of economics, is distinct from mainstream economics in many ways. The first difference that students of economics encounter is the relative absence of mathematical models and the reliance instead on “verbal theory.” This is often in our scientistic age interpreted as a lack of precision, but Austrians see it the other way: economics, as the other social sciences, is predominantly a study of society and, therefore, based on concepts that matter for people individually or collectively.

As noted above, ownership, employment, contract, business firms etc. are not observable and cannot be measured or controlled in the same way that what is studied in the natural sciences can. The use of mathematics is therefore in the social sciences a translation from the verbal explanations and descriptions that are primary. Lots of detail and meaning is lost in translation. Further, the use of mathematics requires the assumption not only that social phenomena can be measured and separated, but also that there are constant relationships between them. This is at best a tenuous assumption.

Austrian economics sees the economy as a process: it is organic and unfolds over time, directed by people’s personal valuations and limited by their imaginations, and always in disequilibrium. This view is very different from mainstream economics’ models to explain and predict the market, which typically are based on the simplifying assumption that the economy is a static system in equilibrium.

Finally, despite being theory heavy, the Austrian school understanding of the market process has a firm basis in realism. Menger recognized his approach to economics as “causal realist”: the purpose of economics is not to cook up highly formalized models of alternative worlds, but to explain the world we live in by means of causal mechanisms and processes. Proper economic theory uncovers the processes that we would have a hard time observing. It provides the tools and framework for a deeper understanding of the economy.