Six lessons from the Austrian School of Economics

Readers, please note the following scroll appears in the direct speech tone since it is a republication of the original piece.

Last week, Renato Moicano, a professional martial artist who competes in the Ultimate Fighting Championship (UFC), made a rather unusual announcement after a fight. He said:

“I love private property, and let me tell you something, if you care about your […] country, read Ludwig von Mises and the six lessons of the Austrian Economic School […]!”

I first thought this was an AI deepfake, some nerdy economics student’s idea of a “hilarious” joke. But one of my younger colleagues, who knows more about these things than I do, assures me that it’s real.

If so – good! I agree with Mr Moicano, and today, I’ll talk a little bit about the school of economic thought he mentions: the Austrian School of Economics.

The Austrian School emerged in Vienna in the 1870s. The name was given to them by their adversaries from the German Historical School, who meant it pejoratively, because for them, “Austrian” meant “provincial”. But there was nothing provincial about them, and in their prime, they had a profound impact on economics.

I am not sure what the “six lessons” that Mr Moicano refers to are (it may have been a reference to a book by the Mises Institute, which is composed of six lectures), but I will highlight six important contributions that this school made.

1. Subjectivism trumps the Labour Theory of Value

In Economics, the most important insights are often those that seem completely obvious once somebody has spelt them out, but that are not obvious at all until somebody does so. Two insights of the first generation of the Austrian School fall into this category: Subjectivism and Marginalism.

Subjectivism refers to the idea that goods and services have no intrinsic or objective value. They are as valuable as we think they are. Their value is something that we see in them, something that exists in our minds, not a property of the goods themselves.

Seems obvious, right? Why does this need saying at all?

Because until that point, economists subscribed to the Labour Theory of Value, the idea that the value of a good is determined by the number of labour hours contained in it. If that were the case, “value” would be a property of a good itself, almost like a physical, measurable property, like its weight, its height, or in the case of food, its calorie content. The Labour Theory of Value is, nowadays, mostly associated with Marxist economics, but it was not specifically Marxist. The classical economists believed it too, even if they did not draw the same conclusions from it as Marx.

But they were all wrong. As Carl Menger, the founding father of the Austrian School, explained in Grundsätze der Volkswirthschaftslehre [=Principles of Economics] in 1871:

“The value of goods arises from their relationship to our needs, and is not inherent in the goods themselves. With changes in this relationship, value arises and disappears. […] Value is […] nothing inherent in goods, no property of them, nor an independent thing existing by itself. It is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Hence value does not exist outside the consciousness of men.”

Quite so. My cousin is not an economist, but he discovered the Mengerian principle of Subjectivism when he sold his old comic book collection, after finding out that they were going for ridiculous amounts on eBay. This was not because the number of labour hours contained in them had gone up since the 1990s, when he had bought them for a fraction of their current price. It is not that the comic illustrators had come round to his house in order to add some more drawings. It is because a subculture of comic book collectors had developed, who see something in those comics that nobody saw in them previously.

2. Marginalism

Subjective or otherwise, it is not the total value of a good that matters, in economic terms. It is the marginal value. Most goods and services are characterised by what economists call “diminishing marginal utility”. Each unit we consume gives us less pleasure than the previous units. Again, this sounds obvious. Of course the sixth pint of beer is no longer as enjoyable as the first one. Of course a second burger is less enjoyable than the first one.

But, again, it was not obvious at all until the “Marginal Revolution” of the 1870s, driven by three economists who had discovered the principle at around the same time, independently of each other. One of them was the aforementioned Carl Menger. Until then, economists had grappled with what was later called the “Diamond-Water-Paradox”. Isn’t it strange, they said, that we value diamonds so highly, and water so little? A diamond has no practical value whatsoever, but without water, we could not survive for longer than three days.

But there is nothing “paradoxical” about this. The mistake they made was to focus on the total value of water, rather than the marginal value: the value of the last unit we consume, under typical circumstances.

Of course, if you are lost in the desert, you would happily trade a bag of diamonds or gold for a bottle of water. But here’s the thing: most of the time, we’re not lost in the desert. Most of the time, we have enough water, and an additional unit would make little further difference to our wellbeing. Diamonds, on the other hand, are so rare that the law of diminishing marginal utility has barely had a chance to manifest itself yet.

This would, of course, be different if somebody invented a 3D printer that can mass-manufacture diamonds, and flooded the market with them.

3. Profits are a reward for risk-taking, and patience

One of Menger’s students was Eugen von Böhm-Bawerk, who became the leading figure of the second generation of the Austrian School. He became the anti-Marx, in a sense. Marxists believe that profits are inherently exploitative. They are stolen from the workers. That is because Marxists see a capitalist as akin to a feudal landlord.

The feudal landlord does not produce anything. They do not produce land: the land is already there. They do not improve the land either. They just sit in their castles, and collect rent from the peasants.

However, the role of a company owner in a capitalist economy is not remotely comparable to that. Profits, as von Böhm-Bawerk explained, are a reward for risk-taking, and patience.

To this day, Marxists like to point out that when a company makes large profits, the situation of its workers does not automatically improve. And they are right. It doesn’t. What they overlook is that, when a company does badly, the situation of its workers does not automatically get worse either. The company owners cannot say “Sorry, business has been slow this month, so we’ll only pay you half your salaries.” If you are a wage-earner, you are entitled to the full amount specified in your employment contract, and if business has been slow – that’s the company’s problem, not yours. It’s like an insurance contract, under which you are insulated from the ups and downs of the company. You always get the same amount of money, no matter what. You are not liable for the company’s losses. But by the same token, you are not entitled to any extra profits either. It has to cut both ways.

Why would anyone want to take that risk, if there wasn’t a prospect of earning substantial profits if things go well?

In addition: if you sign an employment contract, you are entitled to a salary from the very first month, whereas it can take years for a new company, or a new product line you’re working on, to make a profit. Again, why would anyone want to defer consumption in that way, unless there was a prospect that their patience will pay off in the future?

Thus, as Böhm-Bawerk showed, there is nothing “exploitative” about employment relations between workers and capitalists in a market economy. Yes, some capitalists make large profits. So what? In order to do so, they have to take big risks, and make long-term commitments.

4. No rational economic calculation under socialism

When we say that X is worth three times, or five times, or ten times as much as Y, what do we mean by that? We mean that that is the ratio at which people generally trade X for Y. If X and/or Y are not tradable, we cannot say anything about their relative value. In order to do that, we need to observe people trading them. For that to happen, we need private property rights in X and Y, and people need to be able to trade them freely. No market exchange – no market exchange ratios. No markets – no market prices.

On this basis, Ludwig von Mises, the leading figure of the third generation of the Austrian School, started what later became known as the Socialist Calculation Debate.

Von Mises believed, rather too optimistically, that even under socialism, there could still be at least secondary markets for consumer goods. But what there could not be is markets for inputs, and capital goods. These are allocated by a state planning bureaucracy. They would not be tradable, and they would not have prices.

Without prices, though, there could be no economic calculation, in the conventional sense. There could be no profit-and-loss accounts. Without economic calculation, the state planners and the managers of state-owned enterprises would have no idea whether they are doing the right thing.

This turned the Marxist argument on its head. Marxists have always portrayed capitalism as chaotic, crisis-prone and unstable – Friedrich Engels had talked about “anarchy in production” – while claiming that a socialist economy would be rationally planned. Ludwig von Mises said that the precise opposite is true. It is precisely the “planned” economy of socialism which would be unplanned and chaotic. In Die Wirschaftsrechnung im sozialistischen Gemeinwesen [=Economic Calculation in the Socialist Commonwealth], von Mises said:

“[W]e have the spectacle of a socialist economic order floundering in the ocean of possible and conceivable economic combinations without the compass of economic calculation. Thus in the socialist commonwealth every economic change becomes an undertaking whose success can be neither appraised in advance nor later retrospectively determined. There is only groping in the dark. Socialism is the abolition of rational economy.”

Granted: the fact that planned economies later really did fail does not, in itself, prove von Mises right. They may not have failed for precisely that reason. But a lack of economically relevant knowledge among planners was certainly a persistent theme in Eastern Bloc economies.

5. Knowledge is tacit, and dispersed

What is so special about market prices, though? Why should socialist planners not equally be able to assign the correct values to goods and services? Perhaps not in the days of the Soviet Union, but why not nowadays, with all the data processing powers we have?

This is where Friedrich August von Hayek, Ludwig von Mises’s most prominent student – and future Godfather of the Institute of Economic Affairs – comes in, for the second round of the Socialist Calculation Debate. To boil down his argument:

Everyone possesses some economically relevant knowledge, usually specific to our own circumstances, time, and place. If nothing else, at least we all know our own needs and preferences better than anyone else.

This kind of knowledge is often “tacit”: we possess it, but we would struggle to articulate it.

In a market economy, we do not need to articulate it. We just need to act upon it. Our actions influence market prices, and in that way, our knowledge enters the market process, and is communicated to other economic actors, while their knowledge is communicated to us. We react to it, and act upon it, almost automatically and subconsciously. No central planner, and no democratic mechanism, could possibly replace that process. One might add that this is not a matter of data processing power, so modern computers, the internet, “Big Data” and AI do not change that argument.

6. Low interest rates cause boom-and-bust cycles

Mises and Hayek also developed a theory of the business cycle, which works, very roughly, as follows.

Imagine two otherwise identical societies, which only differ in one respect: in one of them, people are patient and forward-looking, in the other one, people seek instant gratification.

This would lead to very different economic structures. The patient society would have a high savings rate. In that economy, it would be possible to have sectors with long production timelines, which take a long time to mature. These would not be viable in the impatient society.

Now what happens if the central bank of the impatient society manipulates interest rates downwards? This would create the impression that this society has become more patient, and that long-term investment projects that were previously unviable have become viable now.

But this would be an illusion, and if investors are tricked into starting those long-term investment projects, they will sooner or later find out that they are built on sand. An illusory investment boom is followed by a bust.

Unlike Keynesians, Austrians do not believe that governments can do much to fight a recession. The malinvestment has already taken place, and needs to be liquidated. The economy has to go through a painful adjustment process.

Conclusion

In the second half of the 20th century, the Austrian School fell out of favour. This was partly a matter of methodology. Mainstream economics became a highly mathematical science, imitating physics, an approach which the Austrian School rejects. It did not help that Austrian economists – certainly von Mises – tend to be very purist and uncompromising, which made it difficult to apply their policy recommendations in a world which had moved very far away from laissez-faire liberalism. But the insights from their golden age are timeless, and you can still find interesting thinkers in the Austrian tradition today.

So, in conclusion, I can only repeat Renato Moicano’s advice. Read some Austrian Economics!

 Reading recommendations:

• Jesus Huerta de Soto (2010): “The Austrian School: Market Order and Entrepreneurial Creativity”
• Eamonn Butler (2010): “Ludwig von Mises – A Primer”
• Christopher Coyne and Peter Boettke (2020): “The Essential Austrian Economics“
• Kristian Niemietz (2023): “The Socialist Calculation Debate – Then and Now”

The piece originally appeared on the IEA blog and due permission has been obtained from IEA to republish the piece on Bastiat Scrolls