Economics for Real People

An Introduction to the
Austrian School

2nd Edition

An Introduction to the
Austrian School

2nd Edition

Gene Callahan

Copyright 2002, 2004 by Gene Callahan All rights reserved. Written permission must be secured from the publisher to use or reproduce any part of this book, except for brief quotations in critical reviews or articles.

Published by the Ludwig von Mises Institute, 518 West Magnolia Avenue, Auburn, Alabama 36832-4528.

ISBN: 0-945466-41-2

ACKNOWLEDGMENTS

Dedicated to Professor Israel Kirzner, on the occasion of his retirement from economics.

My deepest gratitude to my wife, Elen, for her support and forbearance during the many hours it took to complete this book.

Special thanks to Lew Rockwell, president of the Ludwig von Mises Institute, for conceiving of this project, and having enough faith in me to put it in my hands.

Thanks to Jonathan Erickson of Dr. Dobb’s Journal for permission to use my Dr. Dobb’s online op-eds, “Just What Is Superior Technology?” as the basis for Chapter 16, and “Those Damned Bugs!” as the basis for part of Chapter 14.

Thanks to Michael Novak of the American Enterprise Institute for permission to use his phrase, “social justice, rightly understood,” as the title for Part 4 of the book.

Thanks to Professor Mario Rizzo for kindly inviting me to attend the NYU Colloquium on Market Institutions and Economic Processes.

Thanks to Robert Murphy of Hillsdale College for his frequent collaboration, including on two parts of this book, and for many fruitful discussions.

Thanks to the many commentators on the book (and sections of it as they appeared in article form), whose efforts improved this book tremendously and drove me to greater precision and clarity of expression. These include Walter Block (Loyola

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E C O N O M I C S F O R R E A L P E O P L E

University), Peter Boettke (George Mason University), Sam Bostaph (University of Dallas), Colin Colenso (Shanghai, China), Harry David (New Haven, Conn.), Brian Doherty (Reason), Richard Ebeling (Hillsdale College), Roger Garrison (Auburn University), Jeffrey Herbener (Grove City College), Sanford Ikeda (SUNY Purchase), Stephan Kinsella (Houston, Texas), Peter Lewin (University of Texas at Dallas), Stan Liebowitz (University of Texas at Dallas), Jeanne Locklair (Laboratory Institute of Merchandising), Marcel Popescu (Romania), Joseph Salerno (Pace University), Jeff Scott (Wells Fargo), Glen Tenney (Great Basin College), Jeff Tucker (Mises Institute), Christopher Westley (Jacksonville State University), Rich Wilcke (University of Louisville), Marco de Wit (University of Turku), James Yohe (University of West Florida), Sean Callahan (my brother), and my parents, Eugene and Patricia Callahan.

Any errors that remain are, of course, entirely mine. Thanks to Pete Kavall, for teaching me what science is, and to Chogyam Trungpu and Tarthang Tulku, for continuing inspiration.

CONTENTS

The harm done . . . was that they removed economics from reality. The task of economics, as many [successors] of the classical economists practiced it, was to deal not with events as they really happened, but only with forces that contributed in some not clearly defined manner to the emergence of what really happened. Economics did not actually aim at explaining the formation of market prices, but at the description of something that together with other factors played a certain, not clearly described role in this process. Virtually it did not deal with real living beings, but with a phantom, “economic man,” a creature essentially different from real man.

—Ludwig von Mises

The Ultimate Foundation of Economic Science

Introduction
Stayin’ Alive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

PART I: THE SCIENCE OF HUMAN ACTION

CHAPTER 1

What’s Going On?

On the nature of economics . . . . . . . . . . . . . . . . . . . . . . . . 17

CHAPTER 2

Alone Again, Unnaturally

On the economic circumstances of the isolated individual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

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CHAPTER 3

As Time Goes By

On the factor of time in human action . . . . . . . . . . . . . . . 47

PART II: THE MARKET PROCESS

CHAPTER 4

Let’s Stay Together

On direct exchange and the social order . . . . . . . . . . . . . . 59

CHAPTER 5

Money Changes Everything

On indirect exchange and economic calculation . . . . . . . . 81

CHAPTER 6

A Place Where Nothing Ever Happens

On the employment of imaginary constructs in economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

CHAPTER 7

Butcher, Baker, Candlestick Maker

On economic roles and the theory of distribution . . . . . . 101

CHAPTER 8

Make a New Plan, Stan

On the place of capital in the economy . . . . . . . . . . . . . . 121

CHAPTER 9

What Goes Up, Must Come Down

On the effect of f l uctuations in the money supply . . . . . 137

C O N T E N T S

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PART III: INTERFERENCE WITH THE MARKET

CHAPTER 10

A World Become One

On the difficulties of the socialist commonwealth . . . . . . 157

CHAPTER 11

The Third Way

On government interference in the market process . . . . . 177

CHAPTER 12

Fiddling with Prices While the Market Burns

On price f l oors and price ceilings and other interferences with market prices . . . . . . . . . . . . . . . . . . . 189

CHAPTER 13

Times Are Hard

On the causes of the business cycle . . . . . . . . . . . . . . . . . 209

CHAPTER 14

Unsafe at Any Speed

On improving the market through regulation . . . . . . . . . 237

CHAPTER 15

One Man Gathers What Another Man Spills

On externalities, positive and negative . . . . . . . . . . . . . . 249

CHAPTER 16

Stuck on You

On the theory of path dependence . . . . . . . . . . . . . . . . . . 259

CHAPTER 17

See the Pyramids Along the Nile

On government efforts to promote industry . . . . . . . . . . . 271

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PART IV: SOCIAL JUSTICE, RIGHTLY UNDERSTOOD

CHAPTER 18

Where Do We Go from Here?

On the political economy of the Austrian School . . . . . . . . . 291

APPENDICES

APPENDIX A

A Brief History of the Austrian School . . . . . . . . . . . . . . 307

APPENDIX B

Praxeological Economics and Mathematical Economics . . 321
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343

About the Author . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352

I N T R O D U C T I O N

Stayin’ Alive

WHY READ THIS BOOK?

ERHAPS, AT SOME point, you have heard about the Austrian School of economics and are curious as to what it is. Or you may be discouraged by the economics

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you have encountered in textbooks and newspapers, and are searching for a more realistic view of economic life. The dominant school of economics, often referred to as the Neoclassi- cal School, seems to describe people behaving in ways that are hard to relate to the human activity we see around us every day. The textbook humans seem robotic, rigidly obeying a set of equations that “maximizes their utility” based on a set of parameters. The equations themselves are said to “cause” supply and demand to meet at an equilibrium price— one that sets the quantity demanded equal to the quantity supplied. What place do humans have in such a system of equations? It seems difficult to relate those mathematical constructs to the world in which we live. How is the idea of man as a utility equation solver relevant to an Islamic revolution, to Mother Teresa, to Jimi Hendrix, or to your own decision to take a vacation that you “really can’t afford,” but really need?

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Yet, you feel that economics ought to be relevant to real life. Doesn’t it deal with jobs, money, taxes, prices, and industry: stuff of everyday existence? Why should the subject seem so obscure?
The Austrian School of economics is an alternative to the mainstream approach. It places economics on a sound, human basis. It avoids the traps that plague most of modern economics: the assumption of selfishness as the basic human motivation, a narrow definition of rational behavior, and the overuse of unrealistic models. This book is an attempt to introduce you to the main ideas of the school.

The Austrian School is so-named because most of its early members hailed from—you’ve probably guessed by now— Austria. The Nazi occupation of that country, however, scattered the practitioners. Today we can find prominent Austrian School economists all over the world. I will use “Austrian economist” to mean a member of the Austrian School, whether or not the person in question ever lived in Austria.

My focus will not be on the history of the school, although
I have included an appendix with a brief overview of that history. Nor is my goal to convince professional economists of other schools to “convert.” It is instead intended to be the proverbial “guide for the intelligent layman.” While I have always tried to be precise, I have tried to avoid entering into the fine details of esoteric debates from the economics profession, which would only create a schizophrenic book.

Because of the nature of this book, it cannot explore Austrian economics in the same depth as do systematic treatises such as Murray Rothbard’s Man, Economy, and State or Ludwig von Mises’s Human Action. If this book succeeds in interesting you in this subject, it will have done its job; I urge you to then pick up one of these masterworks on the topic. (There is also a bibliography at the end of the book recommending further reading.)

I N T R O D U C T I O N

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But there are advantages to the approach taken by this book. First of all, Rothbard’s and Mises’s tomes are huge: you don’t really want to be hauling a book like that to the beach, now, do you? Second, most people are not attempting to become professional economists. You probably have a very limited amount of time and effort you are willing to put into the subject, at least until you sense of how it might benefit you to know more. Last, neither of those great works has anything about the hit TV show Survivo r¹in it, nor does either of them so much as mention the actress Helena Bonham-Carter. I guarantee that this book will be free of both of those flaws.

Speaking of Survivor (see, you didn’t even have to wait long before I took care of the first problem!), I’m going to ask you to imagine a slightly different conclusion to the series. In the original television show, the winner—the fellow who “survived” the longest—was a guy named Rich. In our alternate universe Rich is still the winner, but, as the film crew packs up, they decide that they are fed up with his antics. Instead of transporting him home, they quietly slip off of the island while Rich is getting in a last session of nude sunbathing.

Rich arises to find that he is alone. He is now facing the most elementary human problem, how to survive, in the most

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For those who don' t follow what' s on TV, or who might be reading this book twenty years after its publication: Survivor was a show where a number of contestants were placed, by a TV network, on a desert island. Then they were presented with a series of “survival” challenges. A voting process eliminated contestants until only the winner was left. This turned out to be a fellow named Rich. The particular details of the show are unimportant to this book, as Rich is merely used as an example of an isolated individual and the economic problems he faces. (Hey, using Robinson Crusoe has become a cliché, so I had to think of something else.)

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basic of settings. What can economics say about his situation? Is our science rooted in man’s nature, or is it just a creation of certain social arrangements that we can change at will? If someone isn’t concerned with becoming as wealthy as possible, or rejects consumerism, is economics still relevant to them? These are some of the questions that this book will attempt to answer.

We will come back to Rich in Chapter 2, but first, we will examine the question of what, exactly, economics is.

PART I
HE SCIENCE OF HUMAN ACTION

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C H A P T E R

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What’s Going On?

O N

T H E

N A T U R E

O F

E C O N O M I C S

[Economics] is universally valid and absolutely and plainly human.

—LUDWIG VON MISES, H UMAN A CTION

WHAT ARE WE STUDYING?

HEN WE FIRST approach a science we want to know, “What does it study?” Another way of approaching the same issue is to ask, “What basic assumptions

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does it bring to its examination of the world?” As a first step in tackling a new subject, you usually try to gain an idea of what it is all about. Before buying a book on biology, you determine that you will be reading about living organisms. At the beginning of a chemistry course, you learn that you can expect to study the ways in which matter combines in different forms.

Many people feel that they are generally familiar with economics. However, if you ask around, you will find that people have difficulty in defining the subject. “It’s the study of money,” some might tell you. “It has to do with business, profit and loss, and so forth,” someone else asserts. “No, it’s about how society chooses to distribute wealth,” another person argues. “Wrong! It’s the search for mathematical patterns that describe the movement of prices,” a fourth insists. Professor Israel Kirzner points out, in The Economic Point of

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View, that even among professional economists, there are “a series of formulations of the economic point of view that are astounding in their variety.”

The primary reason for this confusion is that economics is one of the youngest sciences known to man. Certainly there has been a proliferation of new branches of existing sciences in the several centuries since economics came to be recognized as a distinct subject. But molecular biology, for example, is a division of biology, not a brand-new science.

Economics, however, is different. The existence of a distinct science of economics can be traced back to the discovery that there is a predictable regularity to the interaction of people in society, and that this regularity emerged without being planned by anyone.

The inkling of such regularity, standing apart from both the mechanical regularity of the physical universe and the conscious plans of any specific individual, was the first emergence of the idea of spontaneous order into the Western scientific consciousness. Before the emergence of economics as a science, it was simply assumed that if we found order in things, then those things must have been put in order by someone—God in the case of physical laws, and specific humans in the case of man-made objects and institutions.

Earlier political philosophers proposed various schemes for organizing human society. If the plan did not work out, the plan’s creator generally assumed that the rulers or the citizens had not been virtuous enough to execute his plan. It didn’t occur to him that his plan contradicted universal rules of human action and could not succeed no matter how virtuous the participants were.

The increase in human freedom that began in Europe during the Middle Ages and culminated in the Industrial Revolution

W H A T ’ S G O I N G O N ?

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exposed a tremendous gap in the existing scheme of knowledge. Increasingly, Western European society was not being explicitly ordered by the command of a ruler. One by one, restrictions on production were falling. No longer was the entry into trades strictly controlled by a guild. Yet somehow there seemed to be about the right number of carpenters, blacksmiths, masons, and so on. No longer was a royal license necessary to enter into some line of manufacturing. And yet, although anyone could open a brewery, the world was not flooded with beer. Once again, the amount made seemed just about right. Even without anyone creating a master plan for a city’s imports, the mix of goods that showed up at the city gates seemed roughly correct. In the nineteenth century, French economist Frédéric Bastiat remarked on the wonder of that phenomenon by exclaiming, “Paris gets fed!” Economics did not create that regularity, nor is it faced with the task of proving that it exists—we see it in front of us every day. Economics, rather, must explain how it comes about.

Many scholars contributed to the dawning realization that economics was a new way of looking at society. The origins of economic science stretch back earlier than is frequently thought, certainly back to at least the fifteenth century, when work done by the Late Scholastics at the University of Salamanca in Spain later prompted Joseph Schumpeter to dub them the first economists.

Adam Smith may not have been the first economist, as he is sometimes called. But more than any other social philosopher he popularized the notion that human beings, left free to pursue their own goals, would give rise to a social order that none of them had consciously planned. As Smith famously put it in The Wealth of Nations, free man acts as if “led by an invisible hand to promote an end which was no part of his intention.”

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The Austrian economist Ludwig von Mises said in his mag- num opus, Human Action, that this discovery left people filled with

stupefaction that there is another aspect from which human action might be viewed than that of good and bad, of fair and unfair, of just and unjust. In the course of social events there prevails a regularity of phenomena to which man must adjust his actions if he wishes to succeed.

Mises described the initial difficulties in determining the nature of economics:

In the new science everything seemed to be problematic. It was a stranger in the traditional system of knowledge; people were perplexed and did not know how to classify it and to assign it its proper place. But on the other hand they were convinced that the inclusion of economics in the catalogue of knowledge did not require a rearrangement or expansion of the total scheme. They considered their catalogue system complete. If economics did not fit into it, the fault could only rest with the unsatisfactory treatment that the economists applied to their problems. (Human Action)

For many, the feeling of stupefaction was soon replaced by one of frustration. They had ideas for reforming society, and now they discovered that the emerging science of economics stood in their way. Economics advised these reformers that some plans for social organization would fail regardless of how well they were carried out, because the plans violated basic laws of human interaction.

Stopped in their tracks by the achievements of the early economists, some of these reformers, such as Karl Marx,

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attempted to invalidate the entire subject. Economists, Marx contended, were simply describing society as they found it under the domination of the capitalists. There are no economic truths that apply to all men in all times and places; most specifically, the laws formulated by the classical school, by writers such as Smith, Thomas Malthus, and David Ricardo, will not apply to those living in the future socialist utopia. In fact, said the Marxists, these thinkers were merely apologists for the exploitation of the masses by the wealthy few. The classical economists were, to phrase it in the style of the Chinese Marxists, running dog lackeys of the imperialist warmonger pigs.

The extent to which Marx and like-minded thinkers succeeded in their goal of undermining the foundations of economics reflected the fragility of those foundations. The classical economists had discovered many economic truths, but they were plagued by certain inconsistencies in their own theories, such as their inability to construct a coherent theory of value. (We will address this specific difficulty in more detail later.)

It was Mises, building on the work of earlier Austrian economists such as Carl Menger, who finally reconstructed economics “upon the solid foundation of a general theory of human action.”

For some purposes it might be important to differentiate between the general science of human action, which Mises called praxeology, and economics as the branch of that science that deals with exchange. However, since the term praxeology has not gained widespread use, and a sharp delineation of economics from the rest of praxeology is unimportant in an introductory book, I will use economics as the name for the entire science of human action. Mises himself often uses it in this manner: “Economics . . . is the theory of all human action, the general science of the immutable categories

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of action and of their operation under all thinkable special conditions under which man acts” (Human Action).

What does Mises mean by “human action”? Let him tell us:

Human action is purposeful behavior. Or we may say: Action is will put into operation and transformed into an agency, is aiming at ends and goals, is the ego’s meaningful response to stimuli and to the conditions of its environment, is a person’s conscious adjustment to the state of the universe that determines his life. (Human Action)

In a similar vein, the British philosopher Michael Oakeshott described human action as the attempt to replace what is with what ought to be, in the eyes of the person acting.

The wellspring of human action is dissatisfaction, or, if you want to see the glass as half full, the idea that life might be better than it is at present. “What is” is judged to be deficient in some way. If we are completely satisfied with the way things are at this moment, we have no motivation to act—any action could only make matters worse! But as soon as we perceive something in our world that we judge to be less than satisfactory, the possibility of acting in order to remedy this situation arises.