Lesson 5


Austrian Economics

Austrian Economics

VIDEO: Masters Of Money │ Episode 2 │ Friedrich Hayek Documentary

Austrian Economics

The Austrian School originated from the economist Carl Menger in the late 19th century. Back then there was a fierce scientific debate about the laws of economical actions. The question was whether they derive from timeless principles, that was Menger’s position, or ever shifting historical conditions, as supposed by his opponents. Is there a predetermined set of rules being valid for all actions and therefore all economic actions?

In Menger’s view the object of economic theory is not society but the individual human being as an autonomous subject of his actions. An action is defined as a voluntary and conscious decision about the ends a person wants to seek and the means he or she wants to apply to reach them. And this can already be seen as the most important and simplest example of an invariant law of human action discovered by economic theory: No matter how much the historical circumstances may change, people make decisions about their goals and how to achieve them. And they want to arrive at their ends rather earlier than later. That’s called the a priori law of time preference, which forces people to be economical according to their individual knowledge of what is economical for them.

The individualistic attitude of the Austrian School is owed to the evident fact that only individuals can act, societies, since they have no personal freedom and consciousness for themselves, cannot. Therefore the explanation of economical phenomena has to start with actions of individuals. If human action didn’t have reliable principles that cannot change over time, it would be impossible for economists to explain empirical phenomena like the failure of socialism or business cycles and to advise entrepreneurs, consumers, or economic policy on a solid basis.

Most of the advice Austrians give to policy is negative: According to Ludwig von Mises, another famous Austrian economist of the 20th century, economic policy should be reduced to guaranteeing property rights through a functional jurisdiction, because property is a prerequisite for the exchange of property on the free market. His scholar Murray Rothbard went even further on the libertarian road and stipulated a free market for jurisdiction, too. In this anarcho-capitalistic view as a consequence of the individualistic position of the Austrian School any form of centralized government has become obsolete considering the indisputable self-governance of the individual person.

But still Rothbard believed in property rights to be a natural moral law of human actions. Starting from the methodological standpoint of individualism, however, there is no scientific way to justify this assumption of human action being morally restricted by a natural law. That’s why some Austrians today try to deduce property rights from human action itself rather than from a natural law. They say that every individual has to make the decision whether he or she wants to act cooperatively with others or not. In this decision the person is absolutely free and not morally bounded by a natural law. If the person decides to act cooperatively, because of the obvious advantages cooperation has over fight, property rights can be derived as a logical consequence of this individualistic decision. If I want to cooperate with somebody else, I presuppose that I respect his means (e.g. his body) of cooperation. Therefore I concede that these means are his rightful property.

Subjective Theory of Value

Another way to describe the concept of action would be utility maximization. That’s the principle of all human actions according to Menger. Everybody is trying to lead his life in the best possible way. But what is a good life? What is good? Instead of giving an answer to this rather philosophical question the Austrian School simply says that this is for the individual to decide. In line with that the value of something can never be found in the thing itself, but in the value judgment of the person. Let’s take ice cream as an example. Ice cream is scarce and useful as a mean to Alice’s end, because she likes ice cream and wants to have some now. Therefore Alice will ascribe some grade of value to it and be ready to exchange it for something with less value in her judgment, let’s say a one dollar note. However, by accepting the trade and selling her some ice cream for a dollar Bob, the ice cream shop owner, shows that he’s valuing the dollar note higher than the ice cream. For Alice the ice cream is worth less than a dollar, whereas for Bob it is worth more. The value judgments of the two are diverse. Otherwise the trade would not happen because Alice and Bob wouldn’t make any profit through the exchange. So how can you tell objectively how much value something really has in the economy? There is no way to determine that. The economy consists of acts of voluntary exchange carried out by individuals. Exchange only happens when the trading partners value one and the same thing differently in relation to another thing. Therefore the assertion of objective values contradicts the whole concept of economics as science of voluntary exchange.

Within a broader economy, of course, there are developed market prices for goods and services. The market price again is not a sign of an alleged objective value but a mere result of many subjective value judgments both on the demand and supply side. It can fluctuate when the individual preferences, the subjective decisions of the individuals on the market, change. Even relatively sticky prices on bigger markets are not non-subjective. Let’s look at our ice cream example again. If Bob knows that he can sell his ice cream for a dollar and ten cents to Charlie, he won’t give it away to Alice for one dollar any more. So Alice has to decide if she values one dollar and ten cents higher or Bob’s ice cream. If now Freddy comes along and offers the same quality of ice cream as Bob for ninety cents, Alice and Charlie would buy at his place and Bob would have to decide whether he values ninety cents higher than his ice cream or not. If so, he will reduce his price accordingly to be back in business.

The subjective value theory of the Austrians is opposed to Marx’ labor theory of value. For Marx the value of a thing derives from the work necessary to produce it. At first sight this theory seems to be more just. Unfortunately it has two unsolvable problems: How to measure the value of the invested work and how to explain that nobody wants to purchase an artfully shaped cake of poo no matter how many hours of work went into it?

Economic Calculation Problem

The methodological subjectivism of the Austrians based on the timeless laws of human action enables them to disprove socialism. Socialism wants to distribute wealth in a fair way. Let’s skip the philosophical discussion about what is fair for a moment and get straight to the problem of wealth creation. Wealth is created through production and voluntary exchange. After the trade of produced goods both parties feel richer subjectively. And subjectivism is the only way to measure wealth. Therefore the fairest distribution of goods can only be a distribution based on voluntary exchange on the free market.

Socialism however wants allocate resources in a different way through central planning. The means of production of consumer goods, also called capital goods, are taken away from private owners to be administered by the leading representatives of the socialistic state. Now these leaders have to decide what to produce and how. Since value is subjective the best production would be a production adjusted to the demand of the individuals. But how can an entrepreneur know what goods people demand and whether he can produce them in an economical way so that he can make a profit, too?

On the free market it would be the market price of goods that provides the necessary information. Whenever capital goods and consumer goods are traded freely between individuals against money as the general medium of exchange and measuring stick of value entrepreneurs can calculate how much it would cost them to produce a certain good with certain capital goods and how much value they would get for the exchange of the good from the customer. If the difference between the market price and the costs is positive, they can make a profit and start producing. Now a win-win-situation for producers and consumers occurs that makes the economy as a whole richer. In socialism, however, capital goods are expropriated and under the control of the state. Since they live outside of the free market pricing mechanism capital goods have no market price based on real supply and demand that could reflect the actual costs and profit chances of a production applying them. Therefore the production in socialism is economically blind. It cannot differentiate clearly between profitable and loss-making production processes. Without a market price for capital goods there is no reliable relation between consumer satisfaction and economic activity. Consumer utility and incentives for production cannot match. No win-win-situations can be discovered. As a result scarce resources get wasted in the production of goods not really demanded by the people and the economy as a whole necessarily gets poorer. A fair distribution of wealth is impossible to achieve under socialistic conditions, because without market prices for capital goods there is no way to measure the value or wealth creation of production.

In socialism there is no entrepreneur working economically for his personal profit and thereby serving the economy as a whole. Instead bureaucrats have to decide what people demand and how to produce it. But how can a few people at the center of the administration know what the individuals in the local communities all over the country really demand? Friedrich August von Hayek, a scholar of Mises, called central planning a “pretense of knowledge”, because value is subjective and nobody, no central institution can know what anybody else wants. Every person has his or her own plan. The only way to coordinate the individual plans of the many in a non-coercive manner is the self-coordination of the economical subjects via the price system of a free market. Free market prices are a decentralized communication network that fits our needs the best, because as autonomous subjects we are by nature decentralized.

Austrian Business Cycle Theory

Each and every branch of industry has its own up- and downswings. In times of the personal computer, for example, the production of type writers has become unprofitable. These structural changes due to technological innovation are a healthy development and make people richer. The business cycle however is a completely different phenomenon. It relates to up- and downswings in the economy as a whole. Why do entrepreneurs cross-border unrelated kinds of industrial branches, especially after a period of prosperity, all of a sudden cumulatively make mistakes? That’s all the more astonishing if you consider that these entrepreneurs have been going through an evolutionary process in which only the best businesses survive. They are renowned experts in their markets and still collectively make wrong decisions. Why? And why do these up- and downswings repeat in a cyclical manner?

The answer Austrians give is quite complex. We have to go through it step by step. The basic prerequisite to understand the occurrence of the business cycle is knowledge of the economic effects of saving. Imagine yourself stranded on the coast of a lonely island with a relatively bleak landscape but quite some deer running around. You have two options to feed yourself: either culling fruits the whole day long for the rest of your life or saving some of them here and there until you have enough fruit to take some days off and have time to build a bow and arrows for deer hunting. A deer, hunted in a few hours, is food for a couple of days. So less consumption and saving makes you richer when you invest reasonably. The same is true for the economy as a whole. Saving is a prerequisite for the production of capital goods. Capital goods like bows and arrows make the production of consumer goods – in this case the production of food – more effective. To save means to renounce consumption in the presence to be more productive and have more to consume in the future. The saved consumption goods can get applied in more elaborate and sophisticated production processes, if these processes promise to have a bigger production output.

Within a developed monetary economy with many individuals the meaning of saving money is to trade the possibility to acquire goods in the presence against the possibility to purchase in the future. Therefore Austrians look at the economy basically as a time market in which present goods are exchanged for future goods. Savers offer the present good money, producers demand money to exchange it against capital goods needed in their production processes. Supply and demand of money result in the interest rate as the market price of money.

When people start to save more money than they used to the following happens: Demand for consumption goods goes down. Together with that prices and profit chances in this sector decrease, while they are still constant in the sector of capital goods. That’s a signal for entrepreneurs to invest more in the production of capital goods instead of consumption goods. At lower interest rates complex time- and capital-consuming production processes become more profitable and attract investors and entrepreneurs. With nominal wages staying constant due to work contracts and prices of consumption goods going down the real wages – measured in consumption goods – go up. Workers can now buy more consumption goods with their earnings. That means for entrepreneurs that substituting human labor with machines becomes more attractive. From this we can see that saving has an effect on the economy: more investment in capital goods and extension of the production process. The consequence is an increase in the productivity of the whole economy. After a period of time this makes everybody in the economy richer.

Now the riddle of the business cycle and the cumulative entrepreneurial mistakes can be solved. At the beginning stands inflation of the money supply through banks. Within our monetary system commercial banks can increase the money supply because of the legality of fractional reserve banking. Whenever banks grant a loan they create check book money out of thin air. The loan does not equal a prior saving. Therefore the money supply in the economy goes up when banks create money based on credit. The effect of the money expansion through credit is at first very similar to the effect of saving. Banks push the interest rate artificially below the former market price to sell their loans. Entrepreneurs take this as a signal to invest in future goods and extend their production structure. They act as if the volume of savings had increased and abstention from consumption had happened. But the consumption behavior of the individuals has not changed. They still consume in the same unreduced manner. Initially that leads to a strong upswing in the economy.

As time goes by a countermovement of the market takes place. Several steps are to consider. First of all prices of capital goods go up due to a higher demand from entrepreneurs. But with unbraked consumption there are not more consumption goods available as resources for the extended production processes. This would have been the case with real savings instead of an artificial decrease of the interest rate through fractional reserve banking. Without more resources from the consumption sector free to be allocated in the capital sector the increase in the costs of production is stronger than expected from entrepreneurs.

In a next step prices for consumption goods go up. Why? Well, demand didn’t decline and in addition to that the rising production drained resources from the supply side of the consumption goods market. Raw materials and labor power, now allocated in the formerly more profitable production of capital goods, are no longer available for the production of consumption goods. With supply going down and constant demand prices rise. Last but not least the artificial lowering of the interest rate discourages saving and reinforces consumption driving the price of consumption goods up even more.

The unexpected increase in the price of consumption goods leads us to the next step of the countermovement of the market: profit chances in the consumption sector grow. The costs for capital goods go up faster than their selling price. With consumption goods it’s just the opposite. As a result entrepreneurs start to liquidate their involvements in the capital goods sector and invest in the now more lucrative consumption sector. That tendency gets boosted by the constant nominal wages. Now machines are a more expensive investment for entrepreneurs than human labor which further increases the profitability of the consumption goods sector.

Now interest rates go up. Banks expect higher prices of goods and are afraid of a negative real rate of interest. Entrepreneurs need more credits to finish their projects due to the unexpected high costs of capital goods. The competition among debtors for new credits makes them willing to pay higher interest rates. They lose more and more equity capital which in turn increases the risk premium in the interest rate of their credits. Finally the credits become too expensive and entrepreneurs have to liquidate their businesses. The crash has arrived. These developments could, of course, be counteracted by another expansion of the money supply. But that would only lead to a higher height of fall in the end.

Without real savings that go hand in hand with the renunciation of consumption the means of production will finally be too expensive. The consequence of the business cycle of boom and bust is a huge loss of capital. Wrongly invested resources cannot easily be reintegrated into the consumption goods sector. Due to their increased specificity some of them cannot be used again and lose most of their value.

Free Banking

Advocates of Free Banking mostly come from the Austrian School. In their vision the banking market should be a free market without any regulation by the government or, at least, should not be regulated differently than other markets. They criticize any form of restrictions as well as privileges for entrepreneurs in the banking sector.

The most prominent example for a privilege granted to banks are legal tender laws. Through these laws the government can force everybody to accept the product of a central bank as a medium of exchange. Even if it is allowed that trading partners agree on a legally binding usage of other forms of money, the government grants its central bank a huge privilege by collecting taxes exclusively in central bank money. Since everybody has to pay taxes, this creates an artificial demand for central bank money. Free Banking proponents sharply reject that. Some are anarcho-capitalists and think that taxes cannot be justified at all. The others call for freedom of choice in respect to the medium of tax payments. But all of them want to abolish legal tender laws. In their opinion everybody should have the freedom to issue any kind of money – even completely unbacked bank notes. As long as nobody is forced to use any of these currencies a free market competition is expected to lead to the establishment of the best form of money as the generally accepted medium of exchange, unit of account and store of value.

Historically we had gold and silver as money established on the free market and standardized through coinage mostly by governments. The invention of the bank note and checkbook accounts as tokens redeemable for precious metal made trading a lot easier. But it also seduced the banks to run a fractional reserve scheme. The free market would be capable of finding solutions to control and supervise banks in a way that only full reserve banks can stay in business. But governments as debtors profit from the additional money supply and lower interest rates made possible by fractional reserve banking. Therefore they often misused their power and protected cheating banks by dispensing them from the duty of redeeming notes against bullion. In a free banking environment this violation of depositors’ property rights would no longer be possible.

Opponents of Free Banking invoke the risk of bank runs. But without fractional reserve lending banks would always be liquid. Who would deposit his money for retirement in a bank that overtly works with a fractional reserve when he can use full reserve banks instead? On a free market that problem would be obsolete. Even then fractional reserve banks could give an economic incentive to depositors by promising them interest on their money. But everybody would know that there is a certain risk involved. If the bank doesn’t invest the depositors’ money profitably, it can be lost forever. But if in a banking crisis like in 2008 governments intervene and guarantee that all deposits are safe, they help an unsuccessful fractional reserve scheme to survive and cause even more moral hazard. In a system where the government resp. tax payer intervenes whenever banks make bad investments with the depositors’ money, banks have a strong economic incentive to run bigger risks than usually, because they get the profits but don’t have to pay for the losses. Governments give guarantees to prevent a collapse of the economy. The problem is, however, that by these measures the collapse is only postponed and not prevented at all. The Austrian Business Cycle Theory claims that the longer an unsustainable economic system based on fractional reserve lending is kept alive the more resources get wasted and the higher the fall will be in the end for the younger generations.

 

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