Austrian School

The Austrian School of economics is a heterodox school of economic thought.[1][2] It advocates methodological individualism in interpreting economic developments (see praxeology), propounds the theory that money is non-neutral, and emphasizes the organizing power of the price mechanism (see economic calculation debate).[3] Austrian economists are generally advocates of laissez faire policies.[4]

Whereas mainstream economists generally use mathematical models[5] and statistical methods[6] to model and test economic behavior, Austrian economists argue that mathematical models and statistics are an unreliable means of analyzing and testing economic theory. Instead, they advocate deriving economic theory logically from basic principles of human action, a study called praxeology. Additionally, whereas experimental research and natural experiments are often used in mainstream economics, Austrian economists generally hold that testability in economics and mathematical modeling of a market are virtually impossible. They claim 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.

Austrian contributions to mainstream economic thought include involvement in the development of marginalism and the subjective theory of value on which it is based, as well as contributions to the economic calculation debate.[7] 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 a Nobel Prize in Economics in 1974.[8]

Mainstream economists are generally critical of methodologies used by modern Austrian economists.[9] In particular, the Austrian method of deriving theories has been criticized by mainstream economists as being a priori or non-empirical.[9][10][11][12] Many authors have noted that Austrian economists often seem averse to the use of mathematics and statistics.[11]

Contents

Etymology

The Austrian School derives its name from the identity of its founders and early supporters, who were citizens of the old Austrian Habsburg Empire, including Carl Menger, Eugen von Böhm-Bawerk, Ludwig von Mises, and Friedrich Hayek.[13] 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".[14] Currently, adherents of the Austrian School can come from any part of the world, but they are often referred to simply as "Austrian economists" and their work as "Austrian economics".

History

Origins

Classical economics focused on the labour 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 Frédéric Bastiat considered that value was subjective. In the late 19th century, attention then focused on the concepts of “marginal” cost and value. 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.[15][page needed] Carl Menger's 1871 book, Principles of Economics, was the catalyst for this development; while marginalism was generally influential, there was also a more specific school that grew up around Menger, which came to be known as the “Psychological School,” “Vienna School,” or “Austrian School.”[16] 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.[17][18][not specific enough to verify]

The school originated in Vienna, in the Austrian Empire. However, later adherents of the school such as Murray Rothbard 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.[19] 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. Their Prussian opponents derisively named them the "Austrian School" to emphasize a departure from mainstream German thought and to suggest a provincial, Aristotelian approach.

First wave

Carl Menger was closely followed by Eugen von Böhm-Bawerk and Friedrich von Wieser, in what is known as the "first wave" of the School. Austrian economists 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 impossible.[20] The Austrian economist Böhm-Bawerk wrote extensive critiques of Marx in the 1880s and 1890s, as was part of the Austrian economists' participation in the late 19th Century Methodenstreit, during which they attacked the Hegelian doctrines of the Historical School.

Austrian economics after 1920 can be broken into two general trends. One, exemplified by Friedrich Hayek, while distrusting many neoclassical concepts (like most of the corpus of Keynesian macroeconomics), generally accepts a large part of the neoclassical methodology; the other, exemplified by Ludwig von Mises, seeks a different formalism for economics, considering the neoclassical methodology to be irredeemably flawed.[21]

Post-WWII

By the mid-1930s, the mainstream had more or less absorbed what were seen as the important contributions of the Austrians.[2] After World War II, Austrian economics was ill-thought of by most economists because it rejected mathematical and statistical methods in the area of economics.[22]

Its reputation rose somewhat in the late-20th century with the work of Israel Kirzner and Ludwig Lachmann, and renewed interest in Hayek after he won the Nobel Memorial Prize in Economic Sciences.[8] Hayek's work was influential in the revival of laissez-faire thought in the 20th century.[4][23] Following Hayek, one of Ludwig von Mises's students, Murray Rothbard, became prominent in both Austrian applied theory and libertarian philosophical thought.[24]

Current influence

According to Austrian school economist Peter J. Boettke, the position of the Austrian School within the economics profession has changed several times from the center to the fringe of the mainstream. Currently, it remains a distinctly minority position.[2]

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."[25] Nobel Laureate James M. Buchanan is sometimes considered to be a member of the Austrian School[26][27] and he stated that, "I certainly have a great deal of affinity with Austrian economics and I have no objections to being called an Austrian. Hayek and Mises might consider me an Austrian but, surely some of the others would not."[28] Republican U.S. congressman Ron Paul is a firm believer in Austrian school economics and has authored six books on the subject.[29][30] Paul's former economic adviser, Peter Schiff,[31] is an adherent of the Austrian school.[32] Jim Rogers, investor and financial commentator, also considers himself of the Austrian School of economics.[33] 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.[34] 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 Marroquín in Guatemala. Austrian economic ideas are also promoted by bodies such as the Mises Institute and the Foundation for Economic Education.

Two modern schools of thought are seen as being either Austrian economics, or as the direct philosophical heir of Austrian economics. These are the Free Banking and anarcho-capitalist movements. Although they have competing views of monetary policy, they share a fundamental view of most economic philosophy. Free Banking advocates tend to see themselves as coming directly from Hayek's later progress, especially his work The Denationalization of Money, while the anarcho-capitalists tend to follow the views of Rothbard and Mises.[citation needed]

Methodology

Methodology is where Austrian economists 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. Austrian economists reject empirical statistical methods, natural experiments, and constructed experiments as tools applicable to economics, saying 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. As Austrian economist Jeffrey Herbener has noted "there are no statistical characteristics to human behavior. It is purposeful rather than random, and changeable rather than constant".[35] Austrian economists claim one should instead isolate the logical processes of human action. Mises called this discipline "praxeology."[36] The Austrian praxeological method is based on the heavy use of logical deduction from what they assert to be undeniable, self-evident axioms or irrefutable facts about human existence.[37]

According to Austrian economists, 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. Austrian economists 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. Austrian economists therefore claim that mainstream economics has no way of verifying cause and effect in real world economic events, since economic data can be correlated to multiple potential chains of causation.[38] Mainstream economists counter that conclusions that can be reached by pure logical deduction are limited and weak.[39] Economists Bryan Caplan and Paul A. Samuelson have noted that such rejections of empirical evidence in economics has led to the Austrian School being dismissed within mainstream economics.[12]

Differences with neoclassical economics

The Austrian school and neoclassical economics are similar in many respects. According to Austrian economists, the main area of contention between neoclassical economics 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. A second area of contention between neoclassical theory and the Austrian school is over 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.” Additionally, Mises and his students argued, building on Czech economist František Čuhel,[40] that utility functions are ordinal, and not cardinal; that is, the Austrians contend that one can only rank preferences and cannot measure their intensity. The Austrian School rejects any neoclassical results that are based on cardinal utility and criticizes mainstream economics for supposedly accepting cardinality,[41] despite the fact that neoclassical economists have shown that their work holds for ordinal preferences.[42][43][44]

There are a host of questions about uncertainty and the utility of "conventional" financial models raised by Mises and other Austrians, who argue for a fundamentally different means of risk assessment in economics compared to that used by mainstream economics. Mises and others argued that numerically accurate "probabilities" could never be assigned to "singular" cases. The utility and accuracy of financial modeling is an on-going source of debate, even within the Austrian School.[45] These questions are directly linked to the dynamic market process approach to economic theory, where it is argued by Mises and others that 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 and others 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.[citation needed]

According to Austrian economist Joseph Salerno, what most distinctly sets the Austrian school apart from neoclassical economics is the Austrian Business Cycle Theory:[46]

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.

Theories

Business cycles

The Austrian theory of the business cycle varies significantly from mainstream theories. Economists such as Gordon Tullock,[47] Bryan Caplan,[48] and Nobel laureates Milton Friedman[49][50] and Paul Krugman[51] have said that they regard the theory as incorrect.

In contrast to most mainstream theories on business cycles, Austrian economists focus on 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.[52]

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 "credit-fuelled 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 toward more efficient uses.

Friedrich Hayek was one of the few economists who gave warning of a major economic crisis before the great crash of 1929.[53][54] In February 1929, Hayek warned that a coming financial crisis was an unavoidable consequence of reckless monetary expansion.[55] Economist Steve H. Hanke identifies the 2007-2010 Global Financial Crises as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by the Austrian business cycle theory.[56] Some analysts such as Jerry Tempelman have also argued that the predictive and explanatory power of ABCT in relation to the Global Financial Crisis has reaffirmed its status and perhaps cast into question the utility of mainstream theories and critiques.[57]

Capital

Austrian economist Eugen von Böhm-Bawerk created a theory of capital as a response to Marx's theories on capital. Böhm-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. Böhm-Bawerk's theory equates capital intensity with the degree of roundaboutness of production processes. Böhm-Bawerk also argued that the law of marginal utility necessarily implies the classical law of costs.

Economic calculation problem

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.[58][59] 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.[60]

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.[60] This led him to declare "…that rational economic activity is impossible in a socialist commonwealth."[61] 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.[9][62]

A recent paper on the computational complexity of economic equilibrium notes that if finding a true economic equilibrium is not just hard but impossible for a central planner, then the impossibility applies equally well to a market system, since a system of dispersed calculators (i.e. a market) has no advantage over one large central calculator in overcoming complexity.[63] While a true equilibrium may be impossible under both free markets and central planning, Austrians maintain that free markets are generally more efficient than central planning, since it is highly unlikely that a few economic planners would have a computational advantage over a distributed network of free market information.

Inflation

Ludwig von Mises asserted 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.[64]

While supporters of Free Banking maintain the above definition, Murray Rothbard argued that inflation is by definition always and everywhere simply an increase in the money supply (i.e. units of currency or means of exchange), which in turn leads to a nominal price level that is higher than it would have been without the inflation, for assets (such as housing) and other goods and services in demand, as the real value of each monetary unit is eroded, loses purchasing power and thus buys fewer goods and services.

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).[65] Austrian economists 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.[66][unreliable source?] 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.[67]

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. Austrian economists maintain the most effective cure is the strict maintenance of a stable money supply.[68] 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.[69]

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.[70][71][72]

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,[73] which permits or allows an increase in the money supply.[74] 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, Austrian economists 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.[75]

Austrian economists claim that the state uses monetary inflation as one of the three means by which it can fund its activities, the other two being taxing and borrowing.[76] Therefore, Austrian economists 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.[77] 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.[78]

Accordingly, many Austrian economists 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.[79][80]

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.[81]

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.[82][83] Ludwig von Mises asserted 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.[84]

Opportunity cost

The opportunity cost doctrine was first explicitly formulated by the Austrian economist Friedrich von Wieser in the late 19th century.[85] In its original and purist sense, opportunity cost doctrine argues that the only cost relevant to the price of a product is the opportunity cost involved in choosing it over other competing, and mutually exclusive, options, and its technical coefficients of production.

Praxeology

Praxeology is the study of human action. Praxeology rejects the empirical methods of the natural sciences, because the observation of how humans act in simple situations cannot predict how they will act in complex situations. Ludwig von Mises developed his own system of praxeology which is adhered to by many Austrian economists. Mises' praxeology is a fundamental rejection of mathematical methods in economics, seeing the function of economics as investigating the essences rather than the specific quantities of economic phenomena. This was seen as an evolutionary, or "genetic-causal", approach against the alleged "unreality" and internal stresses inherent in the "static" approach of equilibrium and perfect competition, which are the foundations of mainstream Neoclassical economics. This methodology is also driven by the belief that econometrics is inherently misleading in that it creates a fallacious "precision" in economics where there is none. Mises wrote of his economic methodology that "its statements and propositions are not derived from experience... They are not subject to verification or falsification on the ground of experience and facts."[86]

Criticisms

General criticisms

Economist Bryan Caplan argues that Austrian economists have often misunderstood modern economics, causing them to overstate their differences with it. For example, many 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 strictly monotonic transformations of utility, and so are true for purely ordinal preferences.[43][44] The result is that conclusions about utility preferences hold no matter what values are assigned to them.

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.[87]

Methodology

Critics argue that Austrian economics generally lacks scientific rigor, rejects the scientific method, and rejects the use of empirical data.[9][11][88] Thomas Mayer[10] has argued that Austrian economists have advocated a rejection of scientific methods which involve directly using empirical data in the development of (falsifiable) theories; application of empirical data is fundamental to the scientific method.[88] Austrians argue that empirical data in and of itself cannot explain anything, which in turn implies that empirical data cannot falsify a theory.[89]

Austrian economists reject empirical statistical methods, natural experiments and constructed experiments as tools applicable to economics, saying 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. As Austrian economist Jeffrey Herbener has noted "there are no statistical characteristics to human behavior. It is purposeful rather than random, and changeable rather than constant".[90] Austrian economists claim one should instead isolate the logical processes of human action. Mises called this discipline "praxeology."[91] The Austrian praxeological method is based on the heavy use of logical deduction from what they assert to be undeniable, self-evident axioms or irrefutable facts about human existence.[92]

Austrian theories are not presented in mathematical form;[93] proponents rely mainly on verbal arguments based on what are claimed to be self-evident axioms. Murray Rothbard has argued that the scientific method of the natural sciences is not applicable to the social sciences, and has rejected any attempt at using mathematics in the study of economics, calling it a form of "scientism". Rothbard has argued that the use of the wrong methodology is what is truly unscientific.[94] Mainstream economists believe that this makes Austrian theories too imprecisely defined to explain or predict real world events. Paul Krugman has stated that because Austrians do not use "explicit models" they are unaware of holes in their own thinking.[95]

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.[96] Paul Krugman has stated that because Austrians do not use "explicit models" they are often unaware of holes in their own thinking.[95]

Business cycle theory

According to most mainstream economists, the Austrian business cycle theory is incorrect.[97]

Most 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.[9][47][98] In response, Austrian economists Anthony Carilli and Gregory Dempster have argued 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.[99]

Paul Krugman dubs the theory the "hangover theory", and has written that it 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.[51] Krugman also argues that Austrian economists often explain the boom in terms of changes in demand, but then fail to accept the implications of that position during the bust.[95]

Austrian economist David Gordon has argued 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.[100]

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.[101] 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. In response, Austrian economist Walter Block argues that the misallocation during booms is only relative, and that there is an absolute increase in demand.[102] In addition, Hummel argues that the Austrian explanation of the business cycle fails on empirical grounds. In particular, he points out 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 the Austrian business cycle theory implies that net investment should be below zero during recessions.[101]

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.[97][103][104][105] This has especially been true after central banks were granted independence in the 1980s, and started using monetary policy to stabilize the business cycle, an event known as The Great Moderation. 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.[97] 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. 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.[106]

In 1969, 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."[49] He analyzed the issue using newer data in 1993, and again reached the same conclusions.[50] In 2001, Austrian economist James P. Keeler stated that the hypotheses of the theory are consistent with empirical evidence.[107]

Laissez faire

Jeffrey Sachs observes 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."[108] Austrian economist Sudha Shenoy countered by claiming that countries with large public sectors have grown more slowly.[109]

Seminal works

Methodological works

  • Investigations into the Method of the Social Sciences with Special Reference to Economics (1883) by Carl Menger
  • Epistemological Problems of Economics (1933) by Ludwig von Mises
  • Ultimate Foundations of Economic Science (1962) by Ludwig von Mises
  • Studies in Philosophy, Politics and Economics (1967) by Friedrich Hayek
  • New Studies in Philosophy, Politics, Economics and the History of Ideas (1978) by Friedrich Hayek

Reference works

See also

Footnotes

  1. ^ Boettke, Peter. "Is Austrian Economics Heterodox Economics?". The Austrian Economists. http://austrianeconomists.typepad.com/weblog/2008/05/is-austrian-eco.html. Retrieved 2009-02-13. 
  2. ^ a b c Boettke, Peter J.; Peter T. Leeson (2003). "28A: The Austrian School of Economics 1950-2000". In Warren Samuels, Jeff E. Biddle, and John B. Davis. A Companion to the History of Economic Thought. Blackwell Publishing. pp. 446–452. ISBN 978-0-631-22573-7. http://books.google.com/?id=3H8gBQv5MysC&pg=PA445&dq=austrian+school+heterodox+economics. 
  3. ^ Austrian School of Economics: The Concise Encyclopedia of Economics | Library of Economics and Liberty
  4. ^ a b Raico, Ralph (2011). "Austrian Economics and Classical Liberalism". mises.org. Mises Institute. http://mises.org/etexts/austrianliberalism.asp. Retrieved 27 July 2011. "despite the particular policy views of its founders ..., Austrianism was perceived as the economics of the free market" 
  5. ^ Morgan, Mary S. (2008). "Models". The New Palgrave Dictionary of Economics. http://www.dictionaryofeconomics.com/article?id=pde2008_M000391. Retrieved 22 November 2011. 
  6. ^ Hoover, Kevin D. (2008). "Causality in economics and econometrics". The New Palgrave Dictionary of Economics. http://www.dictionaryofeconomics.com/article?id=pde2008_C000569. Retrieved 22 November 2011. 
  7. ^ Birner, Jack; van Zijp, Rudy (January 25, 1994). Hayek, Co-ordination and Evolution: His Legacy in Philosophy, Politics, Economics and the History of Ideas. London, New York: Routledge. p. 94. ISBN 978-0415093972. 
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References

  • Harald Hagemann, Tamotsu Nishizawa, and Yukihiro Ikeda, eds. Austrian Economics in Transition: From Carl Menger to Friedrich Hayek (Palgrave Macmillan; 2010) 339 pages
  • Stephen Littlechild, ed. (1990). Austrian economics, 3 v. Edward Elgar. Description and scroll to chapter preview links for v. 1.

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