What is Austrian Economics?
Austrian Economics is a school of economic thought developed in the late 19th and early 20th century by prominent Austrian economists including Carl Menger, Eugen Böhm von Bawerk*, Ludwig von Mises, and Friederich Hayek. It has been expanded by many other thinkers over the years since then, and while it is often marginalized by adherents to more mainstream ideologies, I believe it is the best avenue of thought for a sound understanding of economics.
It is distinct from other schools of economic thought in its general rejection of macroeconomic theories, instead focusing on human action. This has led to significant insights, including subjective value, opportunity costs, time preference, the effects of inflation, description of the economic calculation problem, and the Austrian Business Cycle Theory.
Taken to its logical conclusion, Austrian economic theory explains in clear terms how economic intervention is invariably detrimental to the economy and imposes unnecessary burdens upon the general populace. Whether this suggests a preference for a minimal night watchman state or outright rejection of governmental control is hotly debated. This author is biased toward the latter. In any case, intervention always misinforms or reduces the scope of human action to respond to changes in the economy.
Subjective Value
This is one of the key concepts easily explained to the layman but apparently mystifying to the mainstream economist. Value is not an intrinsic property of any good or service. There is no definitive value for anything, and prices are merely an average estimation of value. Voluntary exchanges only occur because the parties involved in the exchange each value what they receive more than they value what they give up.
As an illustration, a baker may sell a loaf of bread for $5 to a customer. This is not because the loaf of bread is worth exactly the same as a $5 bill, but because the maker values $5 more than he values the bread, and the customer values the bread more than the $5. This is not a zero-sum game. Both parties profit according to their subjective values.
Another illustration would be your own music preferences. Suppose someone offers you a CD from a popular singer you dislike. Let's further suppose the sticker price is $15. You value keeping your $15 more than you value receiving bad music, so no exchange occurs. Someone else may see the offer and be excited to find that same CD at $3 less than elsewhere, and be extremely satisfied.**
Price controls restrict the opportunity to find mutually-beneficial exchanges. Either the prices are set too high, resulting in a shortage of buyers for goods due to a low number of buyers willing to make exchanges at that value level; or they are set too low, resulting in a shortage of goods to meet demand as too many people rush to make exchanges at that value level.
Opportunity Costs
When one course of action or one use of resources is chosen, the alternative courses or uses are necessarily discarded. These foregone alternatives are part of the cost of the opportunity chosen. While this concept is understood in many schools of economic thought, it originated in the Austrian school.
When certain choices are forbidden by political coercion, these opportunity costs are imposed arbitrarily rather than chosen rationally. This is one of the burdens a command economy or regulatory state imposes on the productive citizenry.
Time Preference and Interest
All else being equal, goods now are preferred over the promise of future goods. Would I prefer $5 now, or $5 in the future? Immediate satisfaction of wants is preferable to delayed gratification. Now is a sure thing, while the future is uncertain. Interest rates thus put a price on time preference and account for risk. If I borrow money and agree to repay with interest, I am stating a time preference for immediate spending over the eventual repayment cost. If I save money in an investment system, I am stating a preference to save over time in exchange for receiving a greater sum in the future.
Of course, time preference and savings can extend beyond monetary matters, but it is the easiest illustration tool. Another example might be the farmer who saves a portion of his crop for seed the next year instead of selling it or consuming it. The next crop is the anticipated interest in exchange for the delayed gratification and longer time preference.
This avenue of thought directly opposes the Keynesian "Paradox of Thrift," which ignores the benefits of savings in favor of immediate circulation of currency.
Inflation
Inflation is commonly understood as an increase in prices over time, but this is the effect rather than the cause. In order to understand inflation, one must look beyond prices and instead consider the money supply. Murray Rothbard explained this concept quite well when he said,
Money is different from all other commodities: other things being equal, more shoes, or more discoveries of oil or copper benefit society, since they help alleviate natural scarcity. But once a commodity is established as a money on the market, no more money at all is needed. Since the only use of money is for exchange and reckoning, more dollars or pounds or marks in circulation cannot confer a social benefit: they will simply dilute the exchange value of every existing dollar or pound or mark. So it is a great boon that gold or silver are scarce and are costly to increase in supply. But if government manages to establish paper tickets or bank credit as money, as equivalent to gold grams or ounces, then the government, as dominant money-supplier, becomes free to create money costlessly and at will. As a result, this 'inflation' of the money supply destroys the value of the dollar or pound, drives up prices, cripples economic calculation, and hobbles and seriously damages the workings of the market economy.
Inflation occurs when new money is injected into the economy, and the price increases are just a natural adjustment in response to this devaluation of the currency. This does not mean that all prices will rise at the same rate though, and the nature of the inflationary policies will affect how the price increases manifest. I would suggest that the current historic high stock market prices may be evidence of monetary inflation being pumped into the financial industry rather than evidence of real economic strength.
The Economic Calculation Problem
Market prices are a form of information. They inform consumers of supply, and producers of demand. This signal mechanism organically informs everyone in the productive economy of the ebb and flow of the market and allows rational economic calculation by consumers and producers alike in all sectors of the economy. However, the more an industry is artificially regulated, burdened by price controls, or outright centrally planned by the government, the less it can respond to market signals and the worse it will perform.
This absence if information on the part of consumers and producers alike guarantees gluts and shortages, compounding the waste and abuse inherent in monopolies and cartels. In fact, it is the economic calculation problem among other things that explains why the fear of monopolies in a free market is an unrealistic paranoia.
The Austrian Business Cycle Theory
So how can these concepts be used to explain something concrete? How can Austrian Economics help us examine historical data or current events? The ABCT uses these concepts to explain the cycle of economic boom and crashes.
The economy is always in a state of flux, moving toward an equilibrium but always adapting to changing conditions. Central banking interest rate manipulation and inflationary monetary policies insert false information for market actors. In an effort to make the economy look good, interest rates are artificially lowered, indicating to the economy that there is more saved wealth than really exists. After all, interest rates are a price on time preference, and real savings of surplus wealth in the economy lowers the cost of borrowing while suggesting future market demand. This demonstrates the economic calculation problem, where a centrally planned monopoly cannot operate through real market signals, and instead plays with whatever numbers they think look best on paper.
This indicates to businesses that major construction work, expansions, and other capital goods are sound investments. The "malinvestment" creates a boom and the appearance of prosperity, especially in the financial, real estate, construction, and related supporting industries. Such goods are subjectively valued higher due to this misinformed speculation, and the opportunity costs of such expenditures are mistakenly believed to be worthwhile.
This malinvestment is obviously built on false information when examined after the fact. There is no stored wealth to pay back those investments. Businesses have overextended their finances beyond market demand. When this is discovered, a "bust" or "credit crunch" occurs. These malinvestments must be liquidated in order to restore market stability. The central banks attempt to further lower interest rates over time to forestall this "depression" or "recession" under the belief that the bust is the problem, failing to realize that they are adding to the imbalance and just increasing the destruction the eventual correction must bring. Like a game of Jenga, they balance more and more weight on an ever-eroded foundation.
What Does this Mean to Us?
Students of Austrian economics don't play a role in setting government policy, and their votes carry little weight in elections, but they can observe the machinations of government in order to mitigate their personal exposure to malinvestments.
Historically, many Austrian economists have been quick to predict disaster, but never forget the resilience and adaptability of the market even when heavily manipulated by central planners. The manipulation of credit does not always exhibit the same symptoms. Perhaps the housing crisis will re-emerge. Perhaps the stock market will crash. Perhaps businesses will contract again. perhaps student loans will be the tipping point. But then again, perhaps the economy will continue to plod along for many years despite these bubbles.
We can't live in perpetual fear, but we can take steps. Cryptocurrencies, precious metals, durable goods, stored food, new skills, and capital investments made with a long-term plan are all potential ways to insulate yourself from eventual disaster without abandoning all opportunity. And there is always opportunity in the market regardless of governmental policy. Just remember that better understanding means more protection for yourself and your family as you navigate the chaos.
This is just an overview of some basic concepts, and there is certainly more to cover. I can't claim to be an expert in the field, just an interested amateur. Please comment below if you would like to discuss these ideas. Consider the following links as well.
The Mises Institute
Human Action, by Ludwig von Mises
Man, Economy, and State, by Murray Rothbard
The Contra Krugman podcast
*No, I can't pronounce his name properly.
**How long before this illustration is completely obsolete? I value a few megabytes of empty hard disk space over a Justin Bieber MP3? This does at least illustrate opportunity costs. That hard drive space can hold either Bieber noise or good music.
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I thank you for this lesson, it has helped.
Nicely done: Smart and well written. I wish our society would put more focus on understanding economics as a science, and less time jumping to emotional conclusions that lead to counterproductive public policies.
It's von Bay work (looks funny like that!) Good article...I'm a big defender of the Austrian school- it's pretty much based on Smith. Hayek is my hero (one of) I did an article on him not long ago.
Great info! It actually flickered some light of definition in my non economic bio-mainframe unit! Thx.
That's the beauty of Austrian theory. It makes sense. It has technical terms, of course, and analysis of many factors is always necessary in any economic question, but it's understandable on an instinctual level once the core ideas are grasped.
Communism looked great on paper also, it still does to some people - disgustingly. I don't discount the Austrian theory, in which, the fundamental principles follow the opinions of those who built this country -- but I am skeptical to see how this period of systemic crony capitalism will end. Either with socialism or actual free enterprise, seems to be an arms race in promoting the two.
Austrian economics is hardly favorable towards crony capitalism. Perhaps I should work on a "part 2."
Communism is an economic system that says, "People should behave in manner X we approve." Keynesianism, Georgism, the Chicago school, etc. also offer prescriptive solutions. Austrian economics begins first by examining how and why humans act, and prefers to describe rather than prescribe.