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Austrian School

The Austrian School of economics is a school of economic thought which advocates a methodological individualist approach to economics called praxeology, the theory that money is non-neutral, the theory that interest rates and profits are determined by the interaction of diminishing marginal utility with diminishing marginal productivity of time and time preferences, the theory that the capital structure of economies consists of heterogeneous goods that have multispecific uses which must be aligned (see Austrian business cycle theory), and emphasizes the organizing power of the price mechanism (see economic calculation debate).[1]

Austrian views are heterodox and mainstream economists are generally critical of its methodology.[2][3][4][5] Austrian economists are in turn critical of mainstream economic methodology. Whereas mainstream economists generally use economic models and statistical methods to model economic behavior, Austrian School economists argue that they are a flawed, unreliable, and insufficient means of analyzing economic behavior and evaluating economic theories. Instead, they advocate deriving economic theory logically from basic principles of human action, a study called praxeology. Furthermore, whereas experimental research and natural experiments are often used in mainstream economics, Austrians generally hold that testability in economics and precise mathematical modeling of an economic market are virtually impossible. They argue that modeling a market relies on human actors who cannot be placed in a lab setting without altering their would-be actions. Supporters of using models of market behavior to analyze and test economic theory argue that economists have developed numerous experiments that elicit useful information about individual preferences.[6][7]

Some theories developed by early Austrian economists have been absorbed by mainstream economics. Austrian theories have also significantly influenced theories in mainstream economic thought, including the subjective theory of value, marginalism, and the economic calculation debate.[8] From the middle of the 20th century onwards, the Austrian school has been considered outside the mainstream of economic thought. Its reputation rose in the mid-1970s, after Austrian economist Friedrich Hayek shared the 1974 Nobel Prize in Economics.[9] According to Austrian economist Peter J. Boettke, the position of the Austrian School within the economics profession has changed several times from mainstream to heterodox, and is now a distinctly minority position.[3]

Austrians are generally advocates of laissez-faire policies.[10] Some Austrians oppose fractional reserve banking, viewing it as a fraudulent contract.[11][12][13]

Contents


Methodology

Ludwig von Mises

Methodology is where Austrians differ most significantly from other schools of economic thought. Mainstream schools, such as Keynesians and Monetarists, adopt empirical, mathematical, and statistical methods, and focus on induction to construct and test theories. Austrians reject empirical statistical methods, natural experiments, and constructed experiments as tools applicable to economics, arguing that while it is appropriate in the natural sciences where factors can be isolated in laboratory conditions, the actions of humans are too complex for such a treatment because humans are not passive and non-adaptive subjects. Austrian economist Jeffrey Herbener has argued that "there are no statistical characteristics to human behavior. It is purposeful rather than random, and changeable rather than constant".[14] Austrians argue one should instead isolate the logical processes of human action. Mises called this discipline "praxeology."[15] The Austrian praxeological method is based on the heavy use of logical deduction from what they argue to be undeniable, self-evident axioms or irrefutable facts about human existence.[16]

According to Austrians, deduction is preferred to induction in interpreting economic developments, since if performed correctly, it leads to certain conclusions and inferences that must be true if the underlying assumptions are accurate. Austrians hold that induction does not assure certainty like deduction, as real world economic data are inherently ambiguous and subject to a multitude of influences which cannot be separated or quantified, one cause or correlation from another. Austrians therefore argue that empirical statistical methods, natural experiments, and constructed experiments have no way of verifying cause and effect in real world economic events, since economic data can be correlated to multiple potential chains of causation.[17]

Mainstream economists generally argue that conclusions reached by pure logical deduction are limited and weak.[18] Economists Bryan Caplan and Paul A. Samuelson have argued that this methodology has led to the Austrian School being generally dismissed within mainstream economics.[19]

The Austrian view of the market system differs from that of neoclassical economics. Austrians reject the possibility of consumers being indifferent between choices neoclassical theory says it is possible, whereas Mises rejected it as being impossible to observe in practice. Mises argued that utility functions are ordinal, and not cardinal. Therefore, one can only rank preferences and cannot measure their intensity. Austrians reject any conclusions based on cardinal utility and criticize mainstream economics for generally accepting cardinality, despite neoclassical economists commonly stating that their work holds only for ordinal preferences.[20] Mises argued that numerically accurate "probabilities" could never be assigned to singular cases because the unique confluence of events in each moment of time in real markets makes the assignment of "objective" probabilities unrealistic, as these events are intrinsically unique and not capable of numerical probabilistic modeling. Mises argued that the application of probabilistic uncertainty would require the ability to exactly replicate objectively similar events to obtain an accurate understanding of the range of probabilistic outcomes of any event, and this is not possible in real markets, where past market events intimately affect the present and the future.[21]

Austrian economist Steven Horwitz argues that Austrian methodology is consistent with macroeconomics and that Austrian macroeconomics can be expressed in terms of microeconomic foundations.[22] Austrian economist Roger Garrison argues that Austrian macroeconomic theory can be correctly expressed in terms of diagrammatic models.[23]

Theories

Business cycles

Background

The Austrian theory of the business cycle (or "ABCT") varies significantly from mainstream theories and is generally rejected by mainstream economists. In contrast to most mainstream theories on business cycles, Austrians focus on the credit cycle as the primary cause of most business cycles. Economists such as Gordon Tullock,[24] Bryan Caplan,[25] Milton Friedman,[26][27] and Paul Krugman[28] have said that they regard the theory as incorrect. The theory was created by Hayek, by integrating B hm-Bawerk's theory of capital and interest with Mises's arguments concerning how an expansion of the money supply or government manipulation of interest rates contributed to malinvestment.

Empirical research by economists regarding the accuracy of the Austrian business cycle theory has generated disparate conclusions, though most research within mainstream economics regarding the theory concludes that the theory is inconsistent with empirical evidence. In 1969, Milton Friedman argued that the theory is not consistent with empirical evidence.[29] He analyzed the issue using newer data in 1993, and reached the same conclusion.[30] In 2001, Austrian economist James P. Keeler argued that the theory is consistent with empirical evidence.[31] In 2006, Austrian economist Robert Mulligan argued that the theory is consistent with empirical evidence.[32]

According to most economic historians, economies have experienced less severe boom-bust cycles after World War II, because governments have addressed the problem of economic recessions.[33][34][35][36] They argue that this has especially been true since the 1980s because central banks were granted more independence and started using monetary policy to stabilize the business cycle, an event known as The Great Moderation.[37]

According to Austrian economist Murray Rothbard, the Austrian business cycle theory attempts to answer the following questions about things which Austrians believe appear over the course of a business cycle:[38]

  • Why is there a sudden general cluster of business errors?
  • Why do capital goods industries and asset market prices fluctuate more widely than do the consumer goods industries and consumer prices?
  • Why is there a general increase in the quantity of money in the economy during every boom, and why is there generally, though not universally, a fall in the money supply during the depression (or a sharp contraction in the growth of credit in a recession)?

Assertions

According to the theory, a boom-bust cycle of malinvestment is generated by excessive and unsustainable credit expansion to businesses and individual borrowers by the banks.[39] This credit creation makes it appear as if the supply of "saved funds" ready for investment has increased, for the effect is the same: the supply of funds for investment purposes increases, and the interest rate is lowered.[40] Borrowers, in short, are misled by the bank inflation into believing that the supply of saved funds (the pool of "deferred" funds ready to be invested) is greater than it really is. When the pool of "saved funds" increases, entrepreneurs invest in "longer process of production," i.e., the capital structure is lengthened, especially in the "higher orders", most remote from the consumer. Borrowers take their newly acquired funds and bid up the prices of capital and other producers' goods, which, in the theory, stimulates a shift of investment from consumer goods to capital goods industries. Austrians further contend that such a shift is unsustainable and must reverse itself in due course. They conclude that the longer the unsustainable shift in capital goods industries continues, the more violent and disruptive the necessary re-adjustment process. While agreeing with economist Tyler Cowen, Bryan Caplan has stated that he also denies "that the artificially stimulated investments have any tendency to become malinvestments."[41]

The preference by entrepreneurs for longer term investments can be shown graphically by using any discounted cash flow model. Lower interest rates increase the relative value of cash flows that come in the future. When modeling an investment opportunity, if interest rates are artificially low, entrepreneurs are led to believe the income they will receive in the future is sufficient to cover their near term investment costs. Therefore, investments that would not make sense with a 10% cost of funds become feasible with a prevailing interest rate of 5%.

The proportion of consumption to saving or investment is determined by people's time preferences, which is the degree to which they prefer present to future satisfactions. Thus, the pure interest rate is determined by the time preferences of the individuals in society, and the final market rates of interest reflect the pure interest rate plus or minus the entrepreneurial risk and purchasing power components.[42]

Many entrepreneurs can make the same mistake at the same time (i.e. many believe investment funds are really available for long term projects when in fact the pool of available funds has come from credit creation - not real savings out of the existing money supply) because the debasement of the means of exchange is universal, . As they are all competing for the same pool of capital and market share, some entrepreneurs begin to borrow simply to avoid being "overrun" by other entrepreneurs who may take advantage of the lower interest rates to invest in more up-to-date capital infrastructure. A tendency towards over-investment and speculative borrowing in this "artificial" low interest rate environment is therefore almost inevitable.[39]

This new money then percolates downward from the business borrowers to the factors of production: to the landowners and capital owners who sold assets to the newly indebted entrepreneurs, and then to the other factors of production in wages, rent, and interest. Austrians conclude that, since time preferences have not changed, people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. In other words, depositors will tend to remove cash from the banking system and spend it (not save it), banks will then ask their borrowers for payment and interest rates and credit conditions will deteriorate.[39]

Austrians argue that capital goods industries will find that their investments have been in error; that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production will have turned out to be wasteful, and the malinvestment must be liquidated. In other words, the particular types of investments made during the monetary boom were inappropriate and "wrong" from the perspective of the long-term financial sustainability of the market because the price signals stimulating the investment were distorted by fractional reserve banking's recursive lending "ballooning" the pricing structure in various capital markets. This concept is dependent on notion of the "heterogeneity of capital", where Austrians emphasize that the mere macroeconomic "total" of investment does not adequately capture whether this investment is genuinely sustainable or productive, due to the inability of the raw numbers to reveal the particular investment activities being undertaken and the inherent inability of the numbers to reveal whether these particular investment activities were appropriate and economically sustainable given people's real preferences.[43]

Austrians argue that a boom taking place under these circumstances is actually a period of wasteful malinvestment, a "false boom" where the particular kinds of investments undertaken during the period of fiat money expansion are revealed to lead nowhere but to insolvency and unsustainability. It is the time when errors are made, when speculative borrowing has driven up prices for assets and capital to unsustainable levels, due to low interest rates "artificially" increasing the money supply and triggering an unsustainable injection of fiat money "funds" available for investment into the system, thereby tampering with the complex pricing mechanism of the free market. "Real" savings would have required higher interest rates to encourage depositors to save their money in term deposits to invest in longer term projects under a stable money supply. According to Mises's work, the artificial stimulus caused by bank-created credit causes a generalized speculative investment bubble, not justified by the long-term structure of the market.[39]

Mises further argues that a "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates.[43][44] Mises conjectured that the "recession" or "depression" is actually the process by which the economy adjusts to the wastes and errors of the monetary boom, and reestablishes efficient service of sustainable consumer desires.[43][44]

Austrians argue that continually expanding bank credit can keep the borrowers one step ahead of consumer retribution (with the help of successively lower interest rates from the central bank). In the theory, this postpones the "day of reckoning" and defers the collapse of unsustainably inflated asset prices.[43][45] It can also be temporarily put off by exogenous events such as the "cheap" or free acquisition of marketable resources by market participants and the banks funding the borrowing (such as the acquisition of land from local governments, or in extreme cases, the acquisition of foreign land through the waging of war).[46]

Austrians argue that the monetary boom ends when bank credit expansion finally stops - when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates. They further argue that the longer the "false" monetary boom goes on, the bigger and more speculative the borrowing, the more wasteful the errors committed and the longer and more severe will be the necessary bankruptcies, foreclosures, and depression readjustment.[43]

It is important to point out that Austrians do not argue that fiscal restraint or "austerity" will bring about economic growth.[47] Rather, they argue that all attempts by central governments to prop up asset prices, bail out insolvent banks, or "stimulate" the economy with deficit spending will only make the misallocations and malinvestments worse, prolonging the depression and adjustment necessary to return to stable growth.[47] Austrians argue the policy error rests in the government's (and central bank's) weakness or negligence in allowing the "false" credit-fueled boom to begin in the first place, not in having it end with fiscal and monetary "austerity". According to Ludwig von Mises:[43]

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

The role of central banks

Austrians generally argue that inherently damaging and ineffective central bank policies, including unsustainable expansion of bank credit through fractional reserve banking, 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.[48] Under fiat monetary systems, a central bank creates new money when it lends to member banks, and this money is multiplied many times over through the money creation process of the private banks. This new bank-created money enters the loan market and provides a lower rate of interest than that which would prevail if the money supply were stable.[39][40] However, Murray Rothbard paid particular attention to the role of central banks in creating an environment of loose credit prior to the onset of the Great Depression, and the subsequent ineffectiveness of central bank policies, which simply delayed necessary price adjustments and prolonged market dysfunction.[47] Rothbard begins with the premise that in a market with no centralized monetary authority, there would be no simultaneous cluster of malinvestments or entrepreneurial errors, since astute entrepreneurs would not all make errors at the same time and would quickly take advantage of any temporary, isolated mispricing. In addition, in an open, non-centralized (uninsured) capital market, astute bankers would shy away from speculative lending and uninsured depositors would carefully monitor the balance sheets of risky financial institutions, tempering any speculative excesses that arose sporadically in the finance markets. In Rothbard's view, the cycle of generalized malinvestment is greatly exacerbated by centralized monetary intervention in the money markets by the central bank. Such propositions from Rothbard prompted criticism from Bryan Caplan, who questions "Why does Rothbard think businessmen are so incompetent at forecasting government policy? He credits them with entrepreneurial foresight about all market-generated conditions, but curiously finds them unable to forecast government policy, or even to avoid falling prey to simple accounting illusions generated by inflation and deflation... Particularly in interventionist economies, it would seem that natural selection would weed out businesspeople with such a gigantic blind spot."[41]

Rothbard argues that an over-encouragement to borrow and lend is initiated by the mispricing of credit via the central bank's centralized control over interest rates and its need to protect banks from periodic bank runs (which Austrians believe then causes interest rates to be set too low for too long when compared to the rates that would prevail in a genuine non-central bank dominated free market).[39][44]

Capital and interest

Eugen B hm von Bawerk

The Austrian theory of capital and interest was created by B hm-Bawerk. He created the theory as a response to Marx's theories on capital. B hm-Bawerk's theory centered on the untenability of the labor theory of value in the light of the transformation problem. He also argued that capitalists do not exploit workers; they accommodate workers by providing them with income well in advance of the revenue from the output they helped to produce. B hm-Bawerk's theory equates capital intensity with the degree of roundaboutness of production processes. B hm-Bawerk also argued that the law of marginal utility necessarily implies the classical law of costs. He created a theory of interest and of profit in equilibrium based upon the interaction of diminishing marginal utility with diminishing marginal productivity of time and time preferences.[49]

Austrians therefore reject the notion that interest rates are determined by liquidity preference. In his book America's Great Depression, Rothbard argued that interest rates are instead determined by time preference. Says Rothbard, "Increased hoarding can either come from funds formerly consumed, from funds formerly invested, or from a mixture of both that leaves the old consumption-investment proportion unchanged. Unless time preferences change, the last alternative will be the one adopted. Thus, the rate of interest depends solely on time preference, and not at all on "liquidity preference." In fact, if the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to fall because time preferences have fallen."[50]

Economic calculation problem

Friedrich Hayek The economic calculation problem is a criticism of socialist economics. It was first proposed by Max Weber in 1920. This led to Ludwig von Mises discussing Weber's idea with his student Friedrich Hayek, who expanded upon it to such an extent that it became a key reason cited for the awarding of his Nobel prize.[51][52] 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 viable solution, as the price mechanism co-ordinates supply and investment decisions most efficiently. Without the information efficiently and effectively provided by market prices, socialism lacks a method to efficiently allocate resources over an extended period of time in any market where the price mechanism is effective (an example where the price mechanism may not work is in the relatively confined area of public and common goods). 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 in the long term for the vast bulk of the economy and has very limited potential application. The debate raged in the 1920s and 1930s, and that specific period of the debate has come to be known by historians of economic thought as The Socialist Calculation Debate.[53]

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.[53] This led him to declare " that rational economic activity is impossible in a socialist commonwealth."[54] Mises's declaration has been criticized as overstating the strength of his case, in describing socialism as impossible, rather than having to contend with a source of inefficiency.[5][55]

Inflation

Murray Rothbard

Ludwig von Mises argues that inflation only results when the supply of money outpaces demand for money:

In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur.[56]

Given that all major economies currently have a central bank supporting the private banking system, money can be supplied into these economies by way of bank-created credit (or debt).[57] Austrians therefore regard the state-sponsored central bank as the main cause of inflation, because they regard the bank as the institution charged with the creation of new money.[58] When newly created currency reserves are injected into the fractional-reserve banking system, private financial institutions generally choose to further expand the level of bank credit, which multiplies the inflationary effect many times over.[59]

The Austrian School also views the "contemporary" definition of inflation as inherently misleading in that it draws attention only to the effect of inflation (rising prices) and does not address the "true" phenomenon of inflation, which they believe simply involves an increase in the money supply (or the debasement of the means of exchange). They argue that this semantic difference is important in defining inflation and finding a cure for inflation. Austrians maintain the most effective cure is the strict maintenance of a stable money supply.[60] Ludwig von Mises, the seminal scholar of the Austrian School, argues 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.[61]

Following their definition, Austrians measure inflation by calculating the growth of what they call "the true money supply", i.e. how many new units of money which are available for immediate use in exchange have been created over a specified period of time.[62][63][64]

This interpretation of inflation implies that, within a centralized banking system, inflation is usually the result of action taken by the central government or its central bank,[65] which permits or allows an increase in the money supply.[66] Mises includes bank credit as a significant contributor to inflation; the value of bank credit generated by private financial institutions and held within checking accounts greatly exceeds the value of physical paper bills and metallic coins issued by the Federal government (see Figure 1). In addition to state-induced monetary expansion via printing of paper money, Austrians also maintain that the effects of increasing the money supply are exacerbated by the credit expansion performed by private financial institutions practising fractional-reserve banking system, legally permitted in most economic and financial systems in the world.[67]

Austrians hold that states use monetary inflation as one of the three means by which it can fund its activities, the other two being taxing and borrowing.[68] Therefore, Austrians often seek to identify reasons why the state resorts to allowing the creation new money (whether fiat paper or electronic money) and what the new money is used for. Various forms of spending are often cited as reasons 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.[69] In other cases, the central bank may try avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions by artificially trying to "stimulate" the economy through money supply growth and further borrowing via artificially low interest rates.[70]

Accordingly, many Austrians support the abolition of the central banks and the fractional-reserve banking system, advocating either a gold standard or that the market should choose what is used as money.[71][72]

At the beginning of his career Alan Greenspan, former chairman of the Federal Reserve, was also a strong advocate of the gold standard as a protector of economic liberty:

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.[73]

Advocates argued that the gold standard would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth ("inflation") would never spiral out of control.[74][75] Ludwig von Mises argues that civil liberties would be better protected:

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.[76]

Opportunity cost

Friedrich von Wieser

The opportunity cost doctrine was first explicitly formulated by the Austrian economist Friedrich von Wieser in the late 19th century.[77] Opportunity cost is the cost of any activity measured in terms of the value of the next best alternative foregone (that is not chosen). It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices.[78] The opportunity cost is also the cost of the foregone products after making a choice. Opportunity cost is a key concept in economics, and has been described as expressing "the basic relationship between scarcity and choice".[79] The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[80] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output foregone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs.

Etymology

The Austrian School derives its name from the identity of its founders and early supporters, who were citizens of Austria-Hungary, including Carl Menger, Eugen von B hm-Bawerk, Ludwig von Mises, and Friedrich Hayek.[81] In 1883, Menger published Investigations into the Method of the Social Sciences with Special Reference to Economics, which attacked the methods of the Historical school. Gustav von Schmoller, a leader of the Historical school, responded with an unfavorable review, coining the term "Austrian School" in an attempt to characterize the school as provincial.[82] The label remained and was adopted by the adherents themselves. Currently, adherents of the Austrian School can come from any part of the world, but they are often referred to as "Austrian economists" or "Austrians" and their work as "Austrian economics".

History

Precursors

Jean-Baptiste Say

Classical economics focused on the labor theory of value, which holds that the value of a commodity is equal to the amount of labour required to produce it. French classical economists Jean-Baptiste Say and Fr d ric Bastiat argued that value is subjective. In the late 19th century, attention then focused on the concepts of marginal cost and value. The subjectivist and marginalist approaches are generally considered to be precursors to the Austrian School. Austrian economist Murray Rothbard has argued that the roots of the Austrian School came from the teachings of the School of Salamanca in the 15th century and Physiocrats in the 18th century.[83]

Carl Menger's 1871 book, Principles of Economics, is generally considered the founding of the Austrian School. The book was one of the first modern treatises to advance the theory of marginal utility. The Austrian School was one of three founding currents of the marginalist revolution of the 1870s, with its major contribution being the introduction of the subjectivist approach in economics.[84] While marginalism was generally influential, there was also a more specific school that began to coalesce around Menger's work, which came to be known as the Psychological School, Vienna School, or Austrian School. [85] Thorstein Veblen introduced the term neoclassical economics in his Preconceptions of Economic Science (1900) to distinguish marginalists in the objective cost tradition of Alfred Marshall from those in the subjective valuation tradition of the Austrian School.[86][87]

First Wave

Carl Menger The school originated in Vienna, in the Austrian Empire. However, later adherents of the school such as > The School owes its name to members of the German Historical School of economics, who argued against the Austrians during the Methodenstreit ("methodology struggle"), in which the Austrians defended the reliance that classical economists placed upon deductive logic.

Carl Menger contributions to economic theory was closely followed by that of B hm-Bawerk and Friedrich von Wieser. These three economists became what is known as the "first wave" of the Austrian School. Austrians developed a sense of themselves as a school distinct from neoclassical economics during the economic calculation debate with socialist economists. Ludwig von Mises and his student Friedrich Hayek represented the Austrian position in contending that without monetary prices and private property, meaningful economic calculation is virtually impossible.[88] B hm-Bawerk wrote extensive critiques of Karl Marx in the 1880s and 1890s, as was part of the Austrians' participation in the late 19th Century Methodenstreit, during which they attacked the Hegelian doctrines of the Historical School.

Twentieth century

Israel Kirzner

By the mid-1930s, much of mainstream economics had absorbed what were seen as the important contributions of the Austrians.[3] After World War II, Austrian economics was ill-thought of by most economists because it rejected mathematical and statistical methods in the study of economics.[89]

Austrian economics after 1940 can be divided into two schools of economic thought. One, exemplified by Ludwig von Mises, regards neoclassical methodology to be irredeemably flawed; the other, exemplified by Friedrich Hayek, accepts a large part of neoclassical methodology.[5][90]

A controversial issue regarding Austrian economics is whether or not F.A. Hayek opposed the Fed's deflationary policy during the 1930s. Lawrence White argues that the business cycle theory of Hayek and Lionel Robbins did not prescribe a monetary policy which would permit a severe contraction of the money supply. Nevertheless, during the deflationary period of the early 1930s, Hayek and Robbins did not advise policy makers to pursue a monetary policy aimed at preventing a sharp decrease in the money supply. White says concerning their inaction:

"Hayek thought, based on ad hoc ( political ) reasoning and contrary to his own theoretical norm, that a brief deflation might have a salutary effect on recovery by restoring flexibility to wages. . . .Both later regretted their mistake in not promptly recognizing the need to prevent the damage done by the contraction of money and nominal income."[91]

In the 1970s, Hayek criticized the Fed's sudden contraction of money early in the Depression and its failure to offer banks liquidity:

"I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression."[92]

The reputation of the Austrian School rose in the late-20th century due in part to the work of Israel Kirzner and Ludwig Lachmann, and renewed interest in the work of Hayek after he won the Nobel Memorial Prize in Economic Sciences.[9] Hayek's work was influential in the revival of laissez-faire thought in the 20th century.[10][93] Following Hayek, one of Mises's students, Murray Rothbard, became prominent in Austrian theory, particularly praxeology.[94]

Twenty-first century

Several Austrian economists have made contributions to Austrian economics in the twenty-first century, including Anthony Carilli,[95] Gregory Dempster,[95] Roger Garrison,[96] Steven Horwitz,[22] and Robert Murphy.[97] Garrison and Horwitz have contributed to Austrian macroeconomics. Carlilli, Dempster, Garrison, and Murphy have contributed to the Austrian business cycle theory.

Influence

Many theories developed by "first wave" Austrian economists have been absorbed by mainstream economics. These include Carl Menger's theories on marginal utility, Friedrich von Wieser's theories on opportunity cost, and Eugen von B hm-Bawerk's theories on time preference, as well as Menger and B hm-Bawerk's criticisms of Marxian economics.

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."[98] Nobel Laureate James M. Buchanan has stated that he would not object to being identified as an Austrian economist.[99][100][101] Republican U.S. congressman Ron Paul is a firm believer in Austrian School economics and has authored six books on the subject.[102][103] Paul's former economic adviser, Peter Schiff,[104] is an adherent of the Austrian School.[105] Jim Rogers, investor and financial commentator, also considers himself of the Austrian School of economics.[106] Chinese economist Zhang Weiyin, who is known in China for his advocacy of free market reforms, supports some Austrian theories such as the Austrian theory of the business cycle.[107] Currently, universities with a significant Austrian presence are George Mason University, Loyola University New Orleans, and Auburn University in the United States and Universidad Francisco Marroqu n in Guatemala. Austrian economic ideas are also promoted by bodies such as the Mises Institute and the Foundation for Economic Education.

Criticisms

General criticisms

Some economists have argued that Austrians are often averse to the use of mathematics and statistics in economics.[108]

Economist Bryan Caplan argues that Austrians have often misunderstood modern economics, causing them to overstate their differences with it. For example, many Austrians 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 strictly monotonic transformations of utility, and so are true for purely ordinal preferences.[109][110] The result is that conclusions about utility preferences hold no matter what values are assigned to them. Austrian economist J rg Guido H lsmann responded by arguing that Caplan's criticism is inconsistent.[111]

Paul Krugman has stated that because Austrians do not use "explicit models" they are unaware of holes in their own thinking.[112]

Economist Benjamin Klein has criticized the economic methodological work of Austrian economist Israel M. Kirzner. While praising Kirzner for highlighting shortcomings in traditional methodology, Klein argued that Kirzner did not provide a viable alternative for economic methodology.[113]

Methodology

Mainstream economists generally argue that Austrian economics lacks scientific rigor, rejects the scientific method, and rejects the use of empirical data.[5][108][114] Some economists describe Austrian methodology as being a priori or non-empirical.[5][19][108][115]

Thomas Mayer has argued that Austrians have advocated a rejection of scientific methods which involve directly using empirical data in the development of falsifiable theories.[114][115]

Mark Blaug has criticized over-reliance on methodological individualism, arguing it would rule out all macroeconomic propositions that cannot be reduced to microeconomic ones, and hence reject almost the whole of received macroeconomics.[116]

Business cycle theory

According to most mainstream economists, the Austrian business cycle theory is incorrect.[33]

Some mainstream economists argue that the Austrian business cycle theory requires bankers and investors to exhibit a kind of irrationality, because their theory requires bankers to be regularly fooled into making unprofitable investments by temporarily low interest rates.[5][24][117] In response, historian Thomas Woods argues that few bankers and investors are familiar enough with the Austrian business cycle theory to consistently make sound investment decisions. Austrian economists Anthony Carilli and Gregory Dempster argue that a banker or firm loses market share if it does not borrow or loan at a magnitude consistent with current interest rates, regardless of whether rates are below their natural levels. Thus businesses are forced to operate as though rates were set appropriately, because the consequence of a single entity deviating would be a loss of business.[95] Austrian economist Robert Murphy argues that it is difficult for bankers and investors to make sound business choices because they cannot know what the interest rate would be if it were set by the market.[97] Austrian economist Sean Rosenthal argues that widespread knowledge of the Austrian business cycle theory increases the amount of malinvestment during periods of artificially low interest rates.[118]

Economist Paul Krugman has argued that the theory cannot explain changes in unemployment over the business cycle. Austrian business cycle theory postulates that business cycles are caused by the misallocation of resources from consumption to investment during "booms", and out of investment during "busts". Krugman argues that because total spending is equal to total income in an economy, the theory implies that the reallocation of resources during "busts" would increase employment in consumption industries, whereas in reality, spending declines in all sectors of an economy during recessions. He also argues that according to the theory the initial "booms" would also cause resource reallocation, which implies an increase in unemployment during booms as well.[28] In response, Austrian economist David Gordon argues that Krugman's argument is dependent on a misrepresentation of the theory. He furthermore argues that prices on consumption goods may go up as a result of the investment bust, which could mean that the amount spent on consumption could increase even though the quantity of goods consumed has not.[119] Many Austrians also argue that capital allocated to investment goods cannot be quickly augmented to create consumption goods.[120]

Economist Jeffery Hummel is critical of Hayek's explanation of labor asymmetry in booms and busts. He argues that Hayek makes peculiar assumptions about demand curves for labor in his explanation of how a decrease in investment spending creates unemployment. He also argues that the labor asymmetry can be explained in terms of a change in real wages, but this explanation fails to explain the business cycle in terms of resource allocation.[121]

Hummel also argues that the Austrian explanation of the business cycle fails on empirical grounds. In particular, he notes that investment spending remained positive in all recessions where there are data, except for the Great Depression. He argues that this casts doubt on the notion that recessions are caused by a reallocation of resources from industrial production to consumption, since he argues that the Austrian business cycle theory implies that net investment should be below zero during recessions.[121] In response, Austrian economist Walter Block argues that the misallocation during booms does not preclude the possibility of demand increasing overall.[122]

Critics have also argued that, as the Austrian business cycle theory points to the actions of fractional-reserve banks and central banks to explain the business cycles, it fails to explain the severity of business cycles before the establishment of the Federal Reserve in 1913.[33] Supporters of the Austrian business cycle theory respond that the theory applies to the expansion of the money supply, not necessarily an expansion done by a central bank.[123] Historian Thomas Woods argues that the crashes were caused by various privately-owned banks with state charters that issued paper money, supposedly convertible to gold, in amounts greatly exceeding their gold reserves.[124]

In 1969, economist Milton Friedman, after examining the history of business cycles in the U.S., concluded that "The Hayek-Mises explanation of the business cycle is contradicted by the evidence. It is, I believe, false."[26] He analyzed the issue using newer data in 1993, and again reached the same conclusion.[27] Austrian economist Jesus Huerta de Soto argued that Friedman's conclusions are based on misleading data (such as GDP).[123] Austrian economist Roger Garrison argued that Friedman misinterpreted economic aggregates and how they related to the business cycles he reviewed.[125]

Government spending

Jeffrey Sachs argues that among developed countries, those with 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. He concludes that Friedrich Hayek was wrong to argue that high levels of government spending harms an economy, and "a generous social-welfare state is not a road to serfdom but rather to fairness, economic equality and international competitiveness."[126] Austrian economist Sudha Shenoy responded by arguing that countries with large public sectors have grown more slowly.[127]

Principal works

  • Capital and Interest by Eugen von B hm-Bawerk
  • Individualism and Economic Order by Friedrich Hayek
  • Principles of Economics by Carl Menger
  • Human Action by Ludwig von Mises
  • Man, Economy, and State by Murray N. Rothbard

See also

  • List of Austrian School economists
  • List of Austrian intellectual traditions
  • Perspectives on capitalism
  • Quarterly Journal of Austrian Economics

Footnotes

References

External links

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