When a presidential candidate declares, as Ron Paul has, “We’re all Austrians now,”  it’s inevitable that his critics would try to discredit him—whether they understand what he’s talking about or not. That’s what Matthew Yglesias does in his Slate piece “What Is ‘Austrian Economics’?”

I recommend the piece because it’s highly informative—about what Austrian economics is not.

We’re off to a rocky start with this: “The Austrian school originally referred to a set of classical liberal thinkers with diverse interests who came out of the Austro-Hungarian Empire.”

The earliest Austrian economists did not make their mark by advocating free markets and other classical-liberal ideas. They did so by proffering a revolutionary positive (not normative) theoretical approach to understanding how markets work, focusing on value, price, and capital, theory. What Wikipedia says is consistent with my understanding of the matter: “When Carl Menger, Eugen von Böhm-Bawerk, and [Friedrich von] Wieser began their careers in science, they were not focused on economic policy issues, much less in the rejection of intervention promoted by classical liberalism. Their common vocation was to develop an economic theory on a firm basis.”

Economics vs. Politics

Yglesias thus conflates Austrian economic theory with libertarian political theory. In fairness, he is not alone in committing this error. Many libertarians do the same, which is unfortunate. Austrian economic theory describes how purposive action by fallible human beings unintentionally generates a grand, complex, and orderly market process. An additional ethical step is required to pronounce the market process good. Economic theory per se cannot recommend but only explain markets. This is what Ludwig von Mises meant when he insisted that Austrian economics is value-free. Anyone of any persuasion ought to be able to acknowledge that economic logic indicates that imposing a price ceiling on milk will, other things equal, create a shortage of milk. But that in itself is not an argument against the policy. Mises assumed the policymaker would have thought that result bad, but the economist qua economist cannot declare it such. As Israel Kirzner likes to say, the economist’s job in the policy realm is merely to point out that you cannot catch a northbound train from the southbound platform.

Yglesias writes: “Austrians reject the idea that there is anything at all the government can do to stabilize macroeconomic fluctuations.” It’s odd to say this without also pointing out that Austrians believe that government causes the instability of inflationary booms, recessions, and depressions. In light of that point, the suggestion that government is capable of stabilizing the economy may be seen in its proper light.

That said, Yglesias’s statement is not quite right. Some prominent Austrian macroeconomists think that in a second-best world, the central bank (which of course wouldn’t exist in a first-best world) should counteract a sudden and substantial monetary contraction. In other words, deflation is not necessarily a cure for inflation. Mises made the point metaphorically in 1938: “If a man has been hurt by being run over by an automobile, it is no remedy to let the car go back over him in the [opposite] direction.” (See Steven Horwitz’s “Deflation: The Good, the Bad, and the Ugly.” )

Distorts Markets

“In the view of the Austrians,” Yglesias goes on, “practically every economic policy pursued by the federal government and Federal Reserve is a mistake that distorts markets. Rather than curing recessions, claim Austrians, stimulative policies cause them by producing unsustainable bubbles.” Well, yeah, and it’s amply demonstrated by George Selgin, William D. Lastrapes, and Lawrence H. White in“Has the Fed Been a Failure?” (See my summary, “‘F’ as in Fed.” ) As they put it:

Drawing on a wide range of recent empirical research, we find the following: (1) The Fed’s full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed’s establishment. (2) While the Fed’s performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I. (3) Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.

Yglesias understands that the Austrian theory of the business cycle has something to do with artificially low interest rates breeding malinvestment, but he thinks it can’t be right because “it’s hard to understand why business people would be so easily duped in this way. If Ron Paul and Ludwig von Mises know that cheap money can’t last forever, why don’t private investors? Why wouldn’t firms avoid making the supposedly dumb investments?”

Gerald P. O’Driscoll and Mario Rizzo addressed this long ago in The Economics of Time and Ignorance:

[T]here are profits to be made from exploiting temporary situations. . . . Though entrepreneurs understand [the macro-aspects of a cycle] they cannot predict the exact features of the next cyclical expansion and contraction. . . . They lack the ability to make micro-predictions, even though they can predict the general sequence of events that will occur. These entrepreneurs have no reason to foreswear the temporary profits to be garnered in an inflationary episode. . . . From an individual perspective, then, an entrepreneur fully informed of the Austrian theory of economic cycles will face essentially the same uncertain world he always faced. Not theoretical or abstract knowledge, but knowledge of the circumstances of time and place is the source of profits.

Spending Shifts

Puzzlingly, Yglesias also thinks he can refute the Austrian theory by noting that “[s]pending patterns shift all the time without sparking a recession.” To which, Peter Klein replies, “Of course, Yglesias’s breezy summary of the theory skips over the time structure of production, the difference between consumption and investment, the role of interest rates in securing intertemporal coordination, the problem of expectations, and the other basic elements of the theory, which ten minutes of Wikipedia browsing could have explained.”

Yglesias reveals his unfamiliarity with the Austrian literature when he writes, “Many of the original Austrians found their business cycle ideas discredited by the Great Depression, in which the bust was clearly not self-correcting.” Considering that Herbert Hoover’s and Franklin Roosevelt’s New Dealimpeded the market’s correction process, one wonders how the 1930s could possibly have discredited the Austrian theory of the origin of recessions.

Finally, Yglesias contends that “the Austrian school . . . preaches despair and demands no action at all.”

Balderdash. Since it explains that busts are central-bank-caused and hence avoidable through market-based money and banking, its implicit message is one of hope and optimism. And as for demanding no action, on the contrary, it puts forth a long list of actions for those who want stable economic growth—all of them designed to dismantle the interventionist state.

Sheldon Richman is editor of The Freeman, where this article originally appeared.

Source: Reason.

Written by Murray N. Rothbard.

The Austrian theory of money virtually begins and ends with Ludwig von Mises’s monumentalTheory of Money and Credit, published in 1912.[1] Mises’s fundamental accomplishment was to take the theory of marginal utility, built up by Austrian economists and other marginalists as the explanation for consumer demand and market price, and apply it to the demand for and the value, or the price, of money. No longer did the theory of money need to be separated from the general economic theory of individual action and utility, of supply, demand, and price; no longer did monetary theory have to suffer isolation in a context of “velocities of circulation,” “price levels,” and “equations of exchange.”

In applying the analysis of supply and demand to money, Mises used the Wicksteedian concept: supply is the total stock of a commodity at any given time; and demand is the total market demand to gain and hold cash balances, built up out of the marginal-utility rankings of units of money on the value scales of individuals on the market. The Wicksteedian concept is particularly appropriate to money for several reasons: first, because the supply of money is either extremely durable in relation to current production, as under the gold standard, or is determined exogenously to the market by government authority; and, second and most important, because money, uniquely among commodities desired and demanded on the market, is acquired not to be consumed, but to be held for later exchange. Demand-to-hold thereby becomes the appropriate concept for analyzing the uniquely broad monetary function of being held as stock for later sale. Mises was also able to explain the demand for cash balances as the resultant of marginal utilities on value scales that are strictly ordinal for each individual. In the course of his analysis Mises built on the insight of his fellow Austrian Franz Cuhel to develop a marginal utility that was strictly ordinal, lexicographic, and purged of all traces of the error of assuming the measurability of utilities.

The relative utilities of money units as against other goods determine each person’s demand for cash balances, that is, how much of his income or wealth he will keep in cash balances as against how much he will spend. Applying the law of diminishing (ordinal) marginal utility of money and bearing in mind that money’s “use” is to be held for future exchange, Mises arrived implicitly at a falling demand curve for money in relation to the purchasing power of the currency unit. The purchasing power of the money unit, which Mises also termed the “objective exchange-value” of money, was then determined, as in the usual supply-and-demand analysis, by the intersection of the money stock and the demand for cash balance schedule. We can see this visually by putting the purchasing power of the money unit on the y-axis and the quantity of money on the x-axis of the conventional two-dimensional diagram corresponding to the price of any good and its quantity. Mises wrapped up the analysis by pointing out that the total supply of money at any given time is no more or less than the sum of the individual cash balances at that time. No money in a society remains unowned by someone and is therefore outside some individual’s cash balances.

CONTINUED at the Ludwig von Mises Institute.