Austrian economics in plain English
I came to Austrian economics through reading about money: where it comes from, why it loses value, and why interest rates matter so much. I'm not an economist. But the Austrian school changed how I think about prices and investment, and I've found it useful in my own work. This is my attempt to explain it simply, including the parts its critics disagree with.
Where the name comes from
It's called the Austrian school because it started in Vienna. Carl Menger published Principles of Economics in 1871, and that's usually taken as the starting point. Ludwig von Mises built on it in the early 1900s, with The Theory of Money and Credit in 1912. His student Friedrich Hayek became the best-known name, and shared the Nobel prize in economics in 1974.1
Most of them ended up leaving Austria in the 1930s. Mises went to Geneva and then New York. Hayek went to the London School of Economics, which is where he had his famous arguments with Keynes.
Idea one: value is personal
The starting point is that things don't have a fixed value built into them. A bottle of water is worth very little to someone standing next to a tap and a great deal to someone lost in a desert. Same water. Different value.
Menger's point was that value comes from the person and the situation. That sounds obvious, but it has a big consequence. You can't calculate what something is "really" worth from the cost of making it. People's choices are the only real evidence of value you have.
Idea two: prices carry information
This is Hayek's big idea, and the one I find most convincing. In his 1945 essay The Use of Knowledge in Society, he argued that the knowledge an economy runs on isn't sitting in one place. It's spread across millions of people: the farmer who knows his field, the shopkeeper who knows her customers, the engineer who knows a cheaper material.2
Prices pull all that together. His example was tin. If tin suddenly becomes scarce, the price goes up. Everyone who uses tin starts using a bit less or finding substitutes, without knowing or caring why. Nobody had to plan it.
That's the core of the Austrian case against central planning. No planner, however clever, can gather all that scattered knowledge. The price system does it for free.
Idea three: booms and busts
This is the most controversial part. Austrians see the interest rate as the price of time. It reflects how much people prefer having money now over having it later. If people save more, rates should fall, and that tells businesses there are real resources available for long-term projects.
The problem, in the Austrian view, comes when a central bank pushes rates lower than savers would. Businesses read the cheap money as a signal that savings are plentiful. They start long, expensive projects: new factories, property developments, big expansions. For a while it looks like a boom.
But the savings were never really there. Eventually costs rise, the money runs short and many of those projects can't be finished. That's the bust. To an Austrian, the bust isn't the disease. It's the painful correction of mistakes made during the boom.
Why it interests me
My day job is about long-term decisions on buildings. Do you spend money now on a heat pump or new glazing to avoid a bigger cost in ten years? That's exactly the trade-off between now and later that interest rates are supposed to price.
When money is cheap, long payback projects look great on a spreadsheet. When rates go up, the same project can suddenly look like a bad idea. The Austrian lens helps me see that the building hasn't changed, only the price of time.
Where the critics push back
It's only fair to say that most economists don't accept the Austrian school as a whole. The main criticisms are worth knowing:
- Method. Mises in particular argued economics should be worked out by logic from first principles, not tested against statistics. Most economists see that as a serious weakness. Bryan Caplan's essay Why I Am Not an Austrian Economist sets out this case clearly.3
- The business cycle theory. Critics say it doesn't fit the evidence for many recessions, and struggles to explain why busts often hit all industries at once, not just the long-term projects.
- The policy advice. Letting a bust "run its course" can mean years of unemployment and real hardship. Paul Krugman's 1998 article The Hangover Theory is a well-known attack on this idea.4
I take those points seriously. Where I've landed, for now, is that you don't have to sign up to all of it. The ideas about value and about prices as information are worth knowing whatever you decide about the rest.
Where to start
Read Hayek's essay. It's short, free online, and you can get through it in under an hour. Then read Caplan's critique. Between the two you'll have a fair picture.
References
- The Nobel Prize, The Sveriges Riksbank Prize in Economic Sciences 1974.
- F. A. Hayek, "The Use of Knowledge in Society", American Economic Review, 1945. Free at Econlib.
- Bryan Caplan, "Why I Am Not an Austrian Economist", George Mason University.
- Paul Krugman, "The Hangover Theory", Slate, December 1998.