Introduction to the Austrian School of Economics Cameron M. Weber PhD Student in Economics and Historical Studies New School for Social Research cameroneconomics.com

Introduction to the Austrian School of Economics

Cameron M. Weber

PhD Student in Economics and Historical Studies

New School for Social Research

cameroneconomics.com


• Unlike most economics the Austrian School does not separate micro- and macroeconomics

• Economic calculation is made by an individual at a given time and place with limited knowledge and based on subjective preferences

• Society is organized by this ‘market process’ of individual, entrepreneurial, decision-making


• The market process means that individual entrepreneurs (all people) discover ways they can add value to society and to themselves by producing economic goods which will be demanded by others through free-exchange in the market

• Individual economic calculation improves over time through trial-and-error and increased knowledge of ourselves and of the societies in which we live


• A person has the decision to consume now, indicating high time-preference, or to consume later, indicating low time-preference

• When individuals save money (lower time-preference) or borrow money (higher time-preference) we are exchanging time-preferences in the financial markets and each of us benefit (gain utility) through this free-exchange

• Time-preference is subjective to an individual and dependent on each unique time and place of economic calculation


Historical Examples

When human society first formed we were hunter-gatherer tribes we very high time preference. We lived day-to-day and did not have a societal division of time-preferences.

There was as of yet any economic calculation in early human societies as no one was planning for the future.

Introduction to the Austrian School of Economics Historical Examples

The capital structure in society is represented in the “Hayekian Triangle”, formulated by Hayek (1931) and built-upon by Garrison (2001).


• As society began to develop into primitive agriculture specialization of labor began to occur and different people began to do different things based on their subjective time-preferences and economic calculations

• Some people made primitive farm tools, others raised animals, others planted and harvested crops, others stored and distributed the agriculture products


• Society developed from one without capital investment into one with differing investments based on how far removed from consumption the investments took in time

• The longer the “pay-back” for a person’s investment the lower is that person’s time-preference, they could wait longer for remuneration by expecting a higher profit for waiting

Introduction to Austrian School of Economics Historical Examples


The development of varying time-preference based investments in the means of production depends on the expected cooperation of society, which is factored into the economic calculation

With sound societal institutions longer, more efficient, investments processes can take place and economic growth can occur


• We can see from our primitive example some important aspects of economics. It takes four years to make a tool versus the 2 years it takes to raise animals. Therefore the tool-maker is taking on more risk. There is risk that the iron-based tool-making process may not work, or that the farmer who has contracted to buy the tool may have a crop failure and be unable to pay or that the animals that the herder tends with grain from the farmer may have a disease and thus the farmer might not get paid and in turn the tool-maker might not get paid.


• This primitive example shows how all economic calculation in a society is causal and inter-related

• Each person along the stages of production leading to consumption depends on cooperation with their trading partners along the causal chain


• Societal development at large in turn depends on the ability to price contracts based on the time and place of economic calculation, and the degree of expected societal enforcement of these contracts

• The more a society is able to freely-contract and price-in longer term risk, the lower time-preferences become, and the more that longer-term more efficient production process are developed

• This in turn leads to increasing standards of living


• The development of institutions in society which help to create these longer-term more efficient means of production is known as ‘economic development’

• Without trust and cooperation, and without freely-moving market prices signals, the ability to make subjective economic calculation is limited


• As societies develop through today what is known as ‘capitalism’, they become increasingly complex and interdependent

• It is impossible for any one person or any group of persons to know the multi-dimensional, multi-causal relationships, entrepreneurial decision-making and contracting which occurs in modern societies


• Carl Menger (1871) in the founding work of Austrian School economics described the economic calculation each person makes as ‘imputation’. We all know subjectively what brings us value (utility) and we base our decisions on fulfilling these utility needs, both backward and forward in time. This is ‘imputation’.


• The market provides us price signals, prices which adjust up and down the causal chain depending on the dynamic utility-satisfying economic calculations of others

• Hayek describes the importance of the price signal to the welfare-maximizing self-organization of society in “The Use of Knowledge in Society” (1945)


• Without market price adjustment capital investment is made in stages of production and for goods and services that society does not value

• It is price-adjustment based on individual time and place which organizes an otherwise very complex society

• When these prices signals fail due to institutional constraints, so can societal organization, leading to crisis



In modern industrial capitalism in a global economy there are hundreds of millions of firms and entrepreneurs investing hundreds of billions of dollars and hiring billions of workers. Each of these investment, trade and hiring decision require economic calculation.

In such a geographically-disbursed and decentralized economy the importance of the self-organizing price mechanism should not be minimized.

An Austrian School Explanation for the Financial Crisis

• If we divide our capital structure into the sources and uses of money (loanable funds) available for real estate investment in the economy we can isolate the “housing” stage of production

• Because housing was heavily subsidized by tax and regulatory policy (mortgage interest tax write-offs and Ginnie Mae and Freddie Mac guarantees of mortgage-backed securities) the price signals were maladjusted to the economic actors in society


• Housing prices (the cost of housing finance) seemed cheaper than they really should have been according to society’s time-preferences for housing, so the too-low price signal created an over-investment in housing (a “bubble”) relative to the other stages of the real estate capital structure



• When the Federal Reserve Bank increased interest rates in 2006 this sent a price signal raising the cost of real estate capital, helping to “pop” the unsustainable housing bubble

• Because the over-investment in housing was not able to correct itself through liquidation of the mortgage-backed securities due to the bailouts of the financial institutions holding these securities, price adjustment has not taken place, causing crisis

Austrian School Capital Theory and the “Natural Rate” of Interest

• The price of money (loanable funds) used for investment is the interest rate

• The interest rate is what matches the time-preferences of borrowers (investors) with the time-preferences of lenders (savers)

• Absent price-distortions, where the Supply and Demand of loanable funds meet the needs of borrowers and lenders we find the “natural rate” of interest


In our example the natural rate of interest (i *) matching the time-preferences of savers and borrowers is 5% and per year contracted amount ($ *) is $250 billion.


• Now let’s assume that instead of the price signal for the interest-rate being set in the market, e.g., at a “natural rate”, the interest rate is manipulated by a central monetary authority or central bank


• If the central bank sets an interest rate price for loanable funds that is too low, and makes funds available to the banks to cover the shortage so that a lower rate would not prevent savers from saving instead of consuming, then investors have a price signal that will encourage them to invest in longer-term (lower time-preference preference) stages of production than they would under a natural rate



• The artificial-low interest rate encourages investment in stages of production which would not occur under a market-determined natural rate of interest, economic calculation has been distorted because the price signal (interest rate on money) has been distorted


• Entrepreneurs (people) build things or start to build things, and hire people away from other, later, stages of production due to these new, lower, price signals (a lower rate of interest means a lower investment hurdle and therefore longer-term more risky projects now seem feasible under a central bank-manipulated lower interest rate).


• When the artificially-low interest rate is discovered by market actors, inflation fears start to set-in so the central bank is forced to raise the interest rate to prevent inflation

• At this point those investments made under the artificially-low interest rates are no longer feasible so economic actors abandon the over-investment begun under the artificially-low interest rate


• Because it is not possible to instantaneously give-up one investment for another this causes unemployment and wastes resources in half-finished projects

• The end result of centrally-planned monetary policy is needless unemployment and capital tied-up in unfeasible projects which could otherwise better be applied elsewhere

• Bailouts just exacerbate the problem because oftentimes only bankruptcy can free-up resources and allow renewed entrepreneurial discovery


The Law of Supply and Demand

• In many economic models it is assumed that “one-price” clears the markets and creates an equilibrium where price adjusts to meet Supply and Demand

Introduction to Austrian School of Economics

Example of the Non-Austrian Theory of “One-Price” in Supply and Demand

Austrian School Supply and Demand

• This “one price” theory can be juxtaposed with the Austrian School theory that because of the human impossibility of perfect information, and the local and decentralized nature of economic calculation, there is not “one price” which clears the market, but rather Hayek’s notion of a “pattern of outcomes”

• The market tends towards equilibrium but is in constant flux due to entrepreneurial discovery, therefore, a “one price” equilibrium does not exist

Austrian School Supply and Demand


Summary:

The Austrian School of Economics provides an alternative to mainstream economic thinking and is based on individual entrepreneurial economic calculation at a given time and place given uncertainty

The “market process” provides a logical tool to explain the development and organization of society based on human action and time-preference and shows the importance of market-based price signals to provide for society’s welfare


References:

Eugen Bohm-Bawerk (1888), The Positive Theory of Capital

F.A. Hayek (1931), Prices and Production

F.A. Hayek (1945), “The Use of Knowledge in Society”

Roger Garrison (2001), Time and Money: The Macroeconomics of Capital Structure

Carl Menger (1871), Principles of Economics

Documents

Introduction to the Austrian School of Economics Cameron M. Weber PhD Student in Economics and Historical Studies New School for Social Research cameroneconomics.com