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 Tho Bishop.

An Introduction Into The Free Market Divide: Austrian and Chicagoan:

The economic climate of the present has pushed Americans to bolster their understanding of the “dismal science”. Those on the right tend to turn to one of three men: Milton Friedman, F.A. Hayek and Ludwig von Mises. The three have many similarities: they were all highly respected intellectuals, prolific writers, all rejected the label of “conservative” in favor of classical liberal or libertarian, and were champions of free trade and free markets. If looking for arguments against government intervention into the economy, one would do well to quote from one or all of the three titans. This being said, there are some stark differences between them. Before I address those, perhaps it would be best to introduce these men.

Mises and Hayek and the Austrians:

Ludwig von Mises (1881-1973) attended the University of Vienna.  During this time, Mises learned and befriended the prominent Austrian economists Carl Menger and Eugen von Böhm-Bawerk. Mises would go on to surpass his mentors as the greatest mind of the Austrian School. An economist as well as a social philosopher, Mises demonstrated that socialism was economically disastrous, that mankind would best flourish in a free lassiez-faire economy and that government interventionist measures were counter productive. In 1929 Mises was offered a lucrative position with the Austrian Kreditanstalt bank. He turned it down. When asked by his wife why, he replied: “A great crash is coming, and I don’t want my name in any way connected with it.”

Mises economic philosophy would force him to flee to America from threat of Nazi imprisonment. Mises position on lassiez-faire and the gold standard would increasingly alienate him from academia both in Austria and, as he would learn upon arrival, America. The man, who as chief economic advisor to the Austrian government in the 20’s was able to successful combat inflation, found himself unable to find a University willing to pay him to teach. Mises would end up at NYU, his salary paid by the pro-free market Volker Fund. In America Mises would inspire a new generation of Austrian Economists (most notably Murray Rothbard) and, as such, the majority of Austrian Scholarship has come from this country.

Before fleeing Austria, however, Mises would change the life of a one collegiate socialist named Friedrich August von Hayek (1899-1992). A student of law, political science, psychology and philosophy along with economics, F.A. Hayek began attending a scholarly group hosted by Mises after he read his treatise Socialism before joining the London School of Economics. Armed with an understand of Austrian Economics, Hayek would become a rival of British economist John Maynard Keynes, among the most prominent advocates of government economic intervention in the world.

It was in Britain that Hayek wrote the book he is most remembered for today, the Road to Serfdom. Though initially intended specifically for a British audience, the book became tremendously successful in the United States, in part due to a consolidated version published by the Readers Digest. Hayek would follow Mises to America and wind up at the University of Chicago, his salary also provided by the Volker Fund. Relied upon by Old Right opponents of FDR’s New Deal, Hayek would go on to become the best known Austrian Economist in the world, culminating in his receiving the Nobel Prize in Economics in 1974. Hayek would spend most of his career after Serfdom writing on Social and Political Philosophy. Margaret Thatcher, it is said, slammed down Hayek’s book the Constitution of Liberty proclaiming, “This is what we believe!”

Though Mises was Hayek’s mentor and both came from Austria, the two have differences between them. Though both believed economic liberalism was the natural state of man, Mises’s passion for lassiez-faire was guided by his individualist morality; Hayek, on the other hand, more viewed lassiez-faire for it’s benefits to society. Some have noted that The Road to Serfdom is less an advocate of lassiez-faire economics and more a condemnation of economic planning. In fact Hayek would reject a “pure” hands off role of government, advocating a modest degree of labor laws. Such views would lead Ayn Rand, an admirer of Mises, to become a harsh critic.

In spite of their differences, Mises and Hayek worked together on developing many of the key tenants to Austrian Economics. Most notably is the Austrian Business Cycle, which contends that periods of “boom” and “bust” that seemed to hamper a capitalist economy were not the result of natural market failures but government monetary policy. The logic goes that moves by the Federal Reserve to encourage investment (be it by artificially lowering interest rates or increasing the money supply) served to promote malinvestment. A key tenant to Austrian Economics is an understanding of Time Preference – which understands individuals decide whether to consumer wealth now or in the future. In a complex market economy it was a natural interest rate that most effectively guided development in either consumption or investment areas of the economy. The more savings (demonstrating a later time preference), the more money goes into banks, the more money banks have to lend. Interest rates drop which leads to an emphasis on long-term projects (housing construction, plant construction, development of capital.) Alternatively, more consumption (an immediate time preference), the less money flowing into banks, the higher the interest rate and money is developed on producing goods rather than expanding capital. The Great Depression, as written by Rothbard in his book on the event, was caused by inflationary policy of the new Federal Reserve.

Friedman and the Chicago School:

Hayek would start a classical liberal intellectual group, the Mont Pelerin Society. Though, like Hayek, the group was formed around a philosophy of liberalism, the group’s tolerance for a role of government in certain aspects of the economy infuriated Mises and his followers. One member would recalled: “The story I remember best happened at the initial Mont Pelerin meeting when he got up and said, ‘You’re all a bunch of socialists.’ We were discussing the distribution of income, and whether you should have progressive income taxes. Some of the people there were expressing the view that there could be a justification for it.“ That man was Milton Friedman (1912-2006.)

Though Hayek is often described as an Austrian Economist, he also has roots in its largest free market rival, the Chicago School of Economics popularized by Friedman. Friedman began his economic career as a Keynesian, though came to reject the approach during the 50’s as he began his own original economic analysis. Friedman would come to reject interventionalist fiscal policy and became perhaps the most respected libertarian scholar. Friedman championed deregulation of industry, repeal of prohibition and ending conscription (he achieved this as a consultant for Nixon and believed this to be his greatest accomplishment). Friedman later in his career focused on school choice and voucher programs. His greatest regret became his work on income tax withholding, which he developed in the 40’s.

Perhaps more than anything, though, Friedman became renown for Monetarism. Monetarism is a macroeconomic philosophy that emphasizes the role of the money supply on domestic output and price. The role of a central bank for a monetarist (though Friedman opposed it in theory) is to manage the money supply. Freidman advocated increasing the money supply during times of economic stagnation and decreasing it during times of economic growth – the goal being to maintain equilibrium between the supply and demand of money. Friedman viewed the Great Depression as a failure of the Federal Reserve in not providing enough liquidity to banks.

This view differs dramatically from the Austrians. Where the Austrians believed that the government should only concern itself with stabilizing the money supply (by maintaining a gold standard), the Chicago School works from a similar foundation as Keynes in it’s view of the business cycle. Where Austrians see the market economy as naturally occuring and the science of economic a priori (independent of experience, stemming from reasoned deduction), in nature Chicagoans view economics as a man-made positive science (one requiring testing to be proven true or false). Capitalism, to the Chicago School, is not the natural state of man, but merely the most efficient means to create wealth. Where the Chicago School relies upon Keynesian notions of calculable “perfect competition” and a calculable “equilibrium”, Austrians dismissed these hypothetical notions entirely, preferring to focus on real individual human action and the consequences of artificial manipulation of natural markets.

The Practical Difference:

All of the above is fine and dandy, but what does it really mean? If one has not deduced as such from the above, Alan Greenspan’s Federal Reserve policy was monetarist. Facing the recession brought on by the dot-com bubble bursting, Greenspan sought to spur economic growth by lowering interest rates and promoting industries like the housing market. This increased the investment sector of the economy. The problem is that consumption remained the same. Consumers time preference hadn’t changed, only their access to inflated currency did. Money was going into projects with no demand to support them. Though this was coupled with Federal policy encouraging home ownership, placing individuals in homes that could not afford them, it was the actions of the Federal Reserve that caused the economic meltdown, not the failure of Fannie and Freddie.