The Austrian School, also known as the “Vienna School” or the “Psychological School”, is a heterodox school of economics that advocates adherence to strict methodological individualism. Proponents of the Austrian School hold that the only valid economic theory is logically derived from basic principles of human action. Alongside the formal approach to theory, often called praxeology, the school has traditionally advocated an interpretive approach to history. Proponents of praxeological method hold that it allows for the discovery of economic laws valid for all human action, while the interpretive approach addresses specific historical events. On the other hand, critics of the Austrian school contend that its methods consists of post-hoc analysis and do not generate testable implications, and so fails falsifiability.
Austrian economics is currently closely associated with the advocacy of laissez-faire views. Earlier Austrian economists were more skeptical compared to later economists such as Ludwig von Mises and Karel Engliš, with Eugen von Böhm-Bawerk saying that he feared unbridled competition would lead to “anarchism in production and consumption”. However, the Austrian School, especially through the works of Friedrich Hayek, was influential in the revival of laissez-faire thought in the 1980s.
The school originated in Vienna. However, later adherents of the school like Murray Rothbard and others have derived the roots of the thought of the Austrian School from the Spanish Scholastics teaching at the University of Salamanca of the 15th century and the French Physiocrats of the 18th century. It owes its name to members of the German Historical School of economics, who argued against the Austrians during the Methodenstreit, in which the Austrians defended the reliance that classical economists placed upon deductive logic. Their Prussian opponents derisively named them the “Austrian School” to emphasize a departure from mainstream German thought and to suggest a provincial, Aristotelian approach. (The name “Psychological School” derived from the effort to found marginalism upon prior considerations, largely psychological.) The school was no longer centered in Austria after Hitler came to power, and is now based almost entirely in the United States.
Menger was closely followed by Eugen von Böhm-Bawerk and Friedrich von Wieser. Austrian economists developed a sense of themselves as a school distinct from neoclassical economics during the economic calculation debate, with Ludwig von Mises and Friedrich von Hayek representing the Austrian position, where they contended that without monetary prices and private property, meaningful economic calculation is impossible.
The Austrian economists were amongst the first to clash directly with Marxism, since both dealt with such subjects as money, capital, business cycles, and economic processes. This was part of the Austrian economists' participation in the late 19th Century Methodenstreit, during which they attacked the Hegelian doctrines of the Historical School. The Austrian economist Böhm-Bawerk wrote extensive critiques of Marx in the 1880s and 1890s.
Austrian economics after 1920 can be broken into two general trends. One, exemplified by Friedrich A. Hayek, while distrusting most neoclassical concepts (like the entire corpus of macroeconomics), generally accepts a large part of the neoclassical methodology; the other, exemplified by Ludwig von Mises, seeks a different formalism for economics. The main area of contention between the mainstream and the Austrian school is on their view of the market system as a process, not only to be studied using equilibrium models, but to be viewed as an incessant process that only tends toward a constantly changing equilibrium, this difference is the root of the Austrian business cycle theory, the economic calculation debate, and their different views of monopoly and competition. The second primary area of contention between neoclassical theory and the Austrian school is over the possibility of consumer indifference neoclassical theory says it is possible, whereas Mises rejected it as being “impossible to observe in practice.” This is a more philosophical problem, than one directly relevant to the understanding of the operation of the market. The third major dispute arose when Mises and his students argued, building on Czech economist Franz Cuhel, that utility functions are ordinal, and not cardinal; that is, the Austrians contend that one can only rank preferences and cannot measure their intensity, in direct opposition to the neoclassical view at the time. Finally there are a host of questions about uncertainty raised by Mises and other Austrians, who argue for a different means of risk assessment. These questions are directly linked to the market process approach to economic theory, since the world of probabilistic uncertainty is the equilibrium world. Only immersed in a world of genuine uncertainty the market process theory is relevant.
Austrian economics was ill-thought of by most economists after World War II because it rejected observational methods. Its reputation rose somewhat in the late 20th century with the work of Israel Kirzner and Ludwig Lachmann, as well as a renewed interest in Hayek after he won the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. However, it remains a distinctly minority position, even in such areas as capital value. Currently, the only major US university with a significant Austrian presence is George Mason University. Austrian economic ideas are promoted mainly by non-academic bodies such as the Mises Institute.
According to the Austrian economist Peter J. Boettke, during its history the position of the Austrian school within economics profession has changed several times from the center to the fringe, and currently its position lies between mainstream and heterodox economics. While often controversial, the Austrian School has been historically influential due to its emphasis on the creative phase (i.e. the time element) of economic productivity and its questioning of the basis of the behavioral theory underlying neoclassical economics.
The influence that Austrian school ideas have had on Keynesian macroeconomics is often overlooked. Keynes himself acknowledged being exposed to the Misesian notion that “nominal” values could have “real” effects. A further source of this influence is the period of time when the London School of Economics brought in Hayek and other “continental” economists. While their students, though initially receptive, ultimately were drawn to the new Keynesian doctrines, many of the Hayekian concepts, particularly those relating time to the value of capital and its importance, would find their way into the work of Keynesians, especially by way of John Hicks (who, while distancing himself from Keynesianism, nonetheless made the most influential attempt to formalize it).
The former U.S. Federal Reserve Chairman, Alan Greenspan, speaking of the originators of the School, said in 2000, “the Austrian school have reached far into the future from when most of them practiced and have had a profound and, in my judgment, probably an irreversible effect on how most mainstream economists think in this country.” Greenspan also said that he had attended a seminar hosted by Ludwig von Mises.
In more recent politics, Ron Paul, a Republican U.S. Representative who was running for the 2008 American Presidency, is a strong believer in Austrian school economics. He has authored six books on the subject, and displays pictures of classical liberal economists Friedrich Hayek, Murray Rothbard, and Ludwig von Mises (as well as of Grover Cleveland) on his office wall.
Austrian School theorists, like Ludwig von Mises, insist that praxeology must be value-free. That the method does not answer the question "should this policy be implemented?", but rather "if this policy is implemented, will it have the effects you intend?" However, Austrian economists often make policy recommendations that call for the elimination of government institutions - anarcho-capitalist solutions. These recommendations are similar to, but further reaching than the minarchist ideas of Chicago School economists. Both schools advocate strict protection of private property, and support for individualism in general, and are often cited by conservatives, laissez-faire liberal, libertarian, and Objectivist groups for support.
The Austrian method is based on the heavy use of logical deduction from self-evident axioms, undeniable facts about human existence. The primary axiom from which Austrians deduce further certain conclusions is the action axiom which holds that humans take conscious action toward chosen goals. The axiom actually affirms many other axioms such as existence, identity, consciousness, and free-will. Austrians recognize this but focus on action and say that it is undeniable because in order to deny action, one would have to employ action in the act of denial.
This is the one area where Austrians differs most significantly from other schools of economic thought. Mainstream schools such as the neoclassical economists, the Chicago school, the Keynesians and New Keynesians, adopt mathematical and statistical methods, and focus on induction and empirical observation to construct and test theories; while Austrians reject this approach in favor of deduction and logically deduced inferences. Austrians stress deduction because deduction, if performed correctly, leads to certain conclusions and inferences that must be true. Though Austrians do not discount induction, they hold that it does not assure certainty like deduction. Mainstream economists do not argue with this assertion, but believe the conclusions that can be reached by pure logical deduction are limited and weak.
Austrians view entrepreneurship as the driving force in economic development, see private property as essential to the efficient use of resources, and usually (if not always) see government interference in market processes as counterproductive. In this, their views do not far differ from those of the Chicago school.
As with neoclassical economists, Austrians reject classical cost of production theories, most famously the labor theory of value. Instead they explain value by reference to the subjective preferences of individuals. This psychological aspect to Menger's economics has been attributed to the school's birth in turn of the century Vienna. Supply and demand are explained by aggregating over the decisions of individuals, following the precepts of methodological individualism, which asserts that only individuals and not collectives make decisions, and marginalist arguments, which compare the costs and benefits for incremental changes.
Contemporary neo-Austrian economists claim to adopt economic subjectivism more consistently than any other school of economics and reject many neoclassical formalisms. For example, while neoclassical economics formalizes the economy as an equilibrium system with supply and demand in balance, Austrian economists emphasize its dynamic, perpetually dis-equilibrated nature.
The core of the Austrian framework can be summarized as taking a subjectivist approach to marginal economics, and a focus on the idea that logical consistency of a theory is more important than any interpretation of empirical observations. Austrians focus completely on the opportunity cost of goods, as opposed to balancing downside or disutility costs. It is an Austrian assertion that everyone is better off in a mutually voluntary exchange, or they would not have carried it out.. Mainstream economists point out that this is not necessarily true if there are external costs.
This focus on opportunity cost alone means that their interpretation of the time value of a good has a strict relationship: since goods will be as restricted by scarcity at a later point in time as they are now, the strict relationship between investment and time must also hold. A factory making goods next year is worth as much less as the goods it is making next year are worth. This means that the business cycle is driven by miscoordination between sectors of the same economy, caused by money not carrying incentive information correct about present choices, rather than within a single economy where money causes people to make bad decisions about how to spend their time.
Given that all major economies currently have a central bank supporting the private banking system, almost all new money is supplied into the economy by way of bank-created credit (or debt). Austrian economists believe that this bank-created credit growth (which forms the bulk of the money supply) sets off and creates volatile business cycles (see Austrian Business Cycle Theory) and maintain that this "wave-like" or "boomerang" effect on economic activity is one of the most damaging effects of monetary inflation.
According to the Austrian Business Cycle Theory, it is the central bank's policy of ineffectually attempting to control the complex multi-faceted ever-evolving market economy that creates volatile credit cycles or business cycles. By the central bank artificially "stimulating" the economy with artificially low interest rates (thereby creating excessive increases in the money supply), the bank itself induces inflation (often focused in asset or commodity markets) and speculative investment, resulting in "false signals" going out to the market place, in turn resulting in clusters of malinvestments, and the artificial lowering of the returns on savings, which eventually causes the malinvestments to be liquidated as they inevitably show their underlying unprofitability and unsustainability.
Austrian economists therefore regard the state-sponsored central bank as the main cause of inflation, because it is the institution charged with the creation of new currency units, referred to as bank credit. When newly created bank credit is injected into the fractional-reserve banking system, the credit expands, thus enhancing the inflationary effect.
The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation. Ludwig von Mises, the seminal scholar of the Austrian School, asserts that:
Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. . . . As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation (Emphasis added).
Following their definition, Austrian economists measure the inflation by calculating the growth of what they call 'the true money supply', i.e. how many new units of money that are available for immediate use in exchange, that have been created over time.
This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply. In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.
Austrians claim that the state uses inflation as one of the three means by which it can fund its activities, the other two being taxing and borrowing. Therefore, they often seek to identify the reasons for why the state needs to create new money and what the new money is used for. Various forms of military spending is often cited as a reason for resorting to inflation and borrowing, as this can be a short term way of acquiring marketable resources and is often favored by desperate, indebted governments. In other cases, the central bank may try avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions or depressions by artificially trying to "stimulate" the economy through "encouraging" money supply growth and further borrowing via artificially low interest rates.
Accordingly, many Austrian economists support the abolition of the central banks and the fractional-reserve banking system, and advocate instead a return to sound money such as a 100 percent gold standard, or, less frequently, free banking. Money could only be created by finding and putting into circulation more gold under a gold standard. This would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth (and inflation) would never spiral out of control.. Dr. Alan Greenspan asserts that economic liberty and Ludwig von Mises asserts that civil liberties would be protected.
In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.
This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.
It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and for bills of rights was a reaction against arbitrary rule and the nonobservance of old customs by kings.
The Austrian theory embodies all the distinctive Austrian traits: the theory of heterogeneous capital, the structure of production, the passage of time, sequential analysis of monetary interventionism, the market origins and function of the interest rate, and more. And it tells a compelling story about an area of history neoclassicals think of as their turf. The model of applying this theory remains Rothbard's America's Great Depression.
Austrian economists focus on the amplifying, "wave-like" effects of the credit cycle as the primary cause of most business cycles. Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.
According to the Austrian business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "monetary boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable.
Austrian economists argue that a correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when credit creation cannot be sustained. They claim that the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back towards more efficient uses.
The economic calculation problem is a criticism of socialist economics. It was first proposed by Ludwig von Mises in 1920 and later expounded by Friedrich Hayek. The problem referred to is that of how to distribute resources rationally in an economy. The capitalist solution is the price mechanism; Mises and Hayek argued that this is the only possible solution, and without the information provided by market prices socialism lacks a method to rationally allocate resources. Those who agree with this criticism argue it is a refutation of socialism and that it shows that a socialist planned economy could never work. The debate raged in the 1920s and 1930s, and that specific period of the debate has come to be known by economic historians as the The Socialist Calculation Debate. Ludwig von Mises argued in a famous 1920 article "Economic Calculation in the Socialist Commonwealth" that the pricing systems in socialist economies were necessarily deficient because if government owned the means of production, then no prices could be obtained for capital goods as they were merely internal transfers of goods in a socialist system and not "objects of exchange," unlike final goods. Therefore, they were unpriced and hence the system would be necessarily inefficient since the central planners would not know how to allocate the available resources efficiently. This led him to declare "...that rational economic activity is impossible in a socialist commonwealth.".
Another general criticism of the School is that although it claims to highlight shortcomings in traditional methodology, it fails to provide viable alternatives for making positive contributions to economic theory. This criticism is generally accepted, in the sense that the theories of Austrian economics are qualitative in nature and do not yield testable predictions. As an example, some Austrians propose that the net possibility of gain is a more accurate measure of the cost of an action than opportunity cost (subjectivism). However, it is ultimately difficult to measure the possibilities and risk involved.
In his critique of Austrian economics, the libertarian economist Bryan Caplan stated that Austrian economists have often misunderstood modern economics, causing them to overstate their differences with it. He argued that several of the most important Austrian claims are false or overstated. For example, Austrian economists object to the use of cardinal utility in microeconomic theory; however, microeconomic theorists go to great pains to show that their results hold for all monotonic transformations of utility, and so are true for purely ordinal preferences. He has also criticized the school for rejecting on principle the use of mathematics or econometrics. In response, Austrians argue that neoclassical economists are innumerate and do not understand the mathematics they rely on. Austrians also claim that econometrics is fundamentally based on mathematically and logically invalid summation and averaging of demonstrably non-additive personal utility functions, and therefore is subjective.
There are also criticisms of specific Austrian theories. For example, neo-Keynesian economist Paul Krugman argued that Austrian business cycle theory implies that consumption would increase during downturns, and cannot explain the empirical observation that spending in all sectors of the economy fall during a recession. Nobel Laureate Milton Friedman, after examining the history of business cycles in the US, concluded that "The Hayek-Mises explanation of the business cycle is contradicted by the evidence. It is, I believe, false."
Economist Jeffrey Sachs pointed out that when comparing developed free-market economies, those that have high rates of taxation and high social welfare spending perform better on most measures of economic performance compared to countries with low rates of taxation and low social outlays. Poverty rates are lower, median income is higher, the budget has larger surpluses, and the trade balance is stronger. (Unemployment however, tends to be higher in those countries.) He concludes that Austrian economist Friedrich von Hayek was wrong when he said that high taxation would be a threat to freedom; but rather, a generous social-welfare state leads to fairness, economic equality, international competitiveness, and strong vibrant democracies. In response to Sachs' article, William Easterly noted that Hayek, writing in 1944, correctly recognized the dangers of large-scale state economic planning. He also questions the validity of comparing poverty levels in the Nordic countries and the United States, when the former have been moving away from social planning towards a more market-based economy, and the latter has historically taken in impoverished immigrants. Easterly also argues that laissez-faire countries were the leaders of "the ongoing global industrial revolution" which is responsible for abolishing much of the world's poverty.