The of

The Austrian School of Economics was founded in 1871 with the publication of Carl

Menger’s Principles of Economics. Menger, one of the three co-developers of the marginalist revolution in economic analysis, dedicated his book to his German colleague William

Roscher. The German Historical School dominated economic thinking in German language countries and Roscher was the leading figure. Menger’s book argued that economic analysis was universally applicable and that the appropriate unit of analysis was man and his choices.

These choices are determined by individual subjective preferences and the margin on which decisions are made. The logic of choice was the essential building block to the development of universally valid economic theory.

The Historical School, on the other hand, had argued that economic science was incapable of generating universal principles and that scientific research should be instead focused on detailed historical examination. The English classical economists were in error to believe that they had found economic laws that transcended time and national boundaries.

Menger’s Principles of Economics restated the classical political economy project of universal laws by way of marginal analysis. Roscher’s students, especially Gustav Schmoller, took great exception to Menger’s defense of “theory” and labeled the work of Menger, and his followers Eugen Bohm-Bawerk and Friedrich Wieser, the ‘Austrian School’ because of their faculty positions at the University of Vienna. As with most labels in economics, the Austrian

School was a derogatory term that stuck even though the geographic identity of the school of thought was inaccurate.

1 Since the 1930s, no economists from the University of Vienna or any other Austrian university have become a leading figure in the so-called Austrian School of Economics.1 In the 1930s and 1940s, the Austrian School moved to Britain and the and scholars associated with this approach to economic science were located primarily at the

London School of Economics (1931-1950), New York University (1944-), Auburn

University (1983-), and (1981-). Moreover, many of the ideas of the leading mid-20th century Austrian economists, such as Ludwig Mises and F. A. Hayek, can find their intellectual roots in classical figures like Adam Smith and David Hume or early

20th century figures like Knut Wicksell, as well as Menger, Bohm-Bawerk and Wieser. This diverse mix of intellectual traditions in economic science is even more obvious for contemporary Austrian school economists who have been influenced by modern figures in economics like Armen Alchian, James Buchanan, Ronald Coase, Harold Demsetz, Axel

Leijonhufvud, Douglass North, Mancur Olson, Vernon Smith, , Leland

Yeager and Oliver Williamson as well as and . While one could argue that a unique Austrian school of economics operates within the economic profession today, one could sensibly argue that the label “Austrian” no longer possesses any substantive meaning.

Discussions of the Austrian School usually take one of two forms: a discussion of the leading individuals (Menger, Bohm-Bawerk, Wieser, Schumpeter, Mises, Hayek,

Machlup, Kirzner, and Rothbard) or the unique methodological position of Austrian economics (methodological individualism vs. methodological holism; subjectivism versus objective theories of values, costs and expectations; apriorism versus positivism, etc.). In

1 Though Eric Streissler at the University of Vienna has made several contributions to the history of the economic thought of the Austrian School, and Stephan Boehm of the University of Graaz has made significant contributions to the history of thought and methodology of the Austrian school.

2 this essay I would like to minimize the discussion of individuals and methodology and instead present a list of the main propositions about economics, and the workings of an economy, that Austrians have argued over the years. My hope in doing this is that the reader will see the insights of the Austrians and why the modern reader can benefit from revisiting the old texts and the debates of the late 19th to middle 20th century.

I will divide my list into three sections: propositions about the science of economics, propositions about microeconomics, and propositions about . I will limit my list to ten propositions that I consider the most important and well-established positions within the Austrian camp.

I. The Science of Economics

Proposition 1: Only Individuals Choose

Man, with his purposes and plans, is the beginning of all economic analysis. Only individuals make choice, collective entities do not choose. There are no economic phenomena unconnected to the choices of individuals. The primary task of economic analysis is to render intelligible economic phenomena in terms of individual purposes and plans, while the secondary task of economic analysis is to trace out the unintended consequences of individual choices.

Proposition 2: The study of the market order is fundamentally about exchange behavior and the institutions within which exchanges take place

The price system and the market economy are best understood as a , and thus the science which studies the market order falls under the domain of . These terms derive from the original Greek meanings of the word -- Katallaxy – exchange, and bringing a

3 stranger into friendship through exchange. Contrary to the widely held view that the study of the market order focuses on the allocation of scarce resources amongst competing ends, catallactics focuses our analytical attention on the exchange relationships that emerge on the market, the bargaining that characterize the exchange process, and the institutions within which the human activity of exchange takes place.

Proposition 3: The ‘facts’ of the social sciences are what people believe and think

Unlike the physical sciences, the human sciences begin with the purposes and plans of individuals. Where the purging of purposes and plans in the physical sciences led to advances by overcoming the problem of ‘anthropomorphism’, in the human sciences the elimination of purposes and plans results in the purging of the subject matter of the sciences of , and lead to a lack of progress through ‘mechanomorphism’. In the human sciences the “facts” of the world are what the actors think and believe.

The meaning that individuals place on things, practices, places and people determines how they will orient themselves in making decisions. The goal of the sciences of human action is intelligibility, not prediction. The human sciences can achieve this goal because we are what we study, or because we possess knowledge from within, whereas the natural sciences cannot pursue a goal of intelligibility because they rely on knowledge from without. We can understand purposes and plans of other human actors because we ourselves are human actors, but we cannot assign purposes and plans to planetary movement.

The classic thought experiment Austrians have invoked to convey this essential difference between the sciences of human action and the physical sciences is a Martian observing the ‘data’ at Grand Central Station in New York. Our Martian could observe that when the little hand on the clock points to 8 there is a bustle of movement as bodies leave

4 these boxes, and he can observe that when the little hand hits 5 there is a bustle of movement as bodies reenter the boxes and leave. Our Martian may even develop a prediction about the little hand and the movement of bodies and boxes. But unless our

Martian comes to understand the purposes and plans (the commuting to and from work) his

‘scientific’ understanding of the data from Grand Central Station would be limited. The sciences of human action are different than the natural sciences and we impoverish the human sciences when we try to force fit them into a philosophical/scientific mold in which they do not belong.

II. Microeconomics

Proposition 4: Utility and Costs are Subjective

All economic phenomena are filtered through the human mind. Objective realities of the world matter, but as far as in the realms of value and price they only matter in relation to individual perception of them. Since the 1870s economists have agreed that value is subjective, but following Marshall many argued that the cost side of the equation is determined by objective conditions. As Marshall insisted, both blades of a scissor cut a piece of paper just as subjective value and objective costs determine price. But Marshall failed to appreciate that costs are also subjective being determined by the alternative demands for scarce resources. Both blades of the scissors do indeed cut the paper, but the scissors of economic analysis (supply and demand) are made up of the subjective valuations of individuals.

Scarcity is a condition of human existence that follows from the logic that we cannot do two things at once. In deciding courses of action one must choose --- pursue one path and set aside an alternative path. The focus on alternative in choices lead to one of the

5 defining concepts of the economic way of thinking --- opportunity costs. The costs of any action are the alternatives foregone in making that choice. Since the forgone alternative is never realized, at the time of decision we weight the expected benefits of an activity against the expected benefits of the alternative activity. The forgone expected benefits represent the costs to the decision maker at the moment of decision.

Proposition 5: The price system economizes on the information that economic actors have to process in making their own decisions

Prices summarize the terms of exchange on the market. In summarizing the terms of exchange, prices translate the subjective trade-offs of market participants into objective data that others can utilize in assessing their own subjective trade-offs. The price system signals to market participants the relevant information so they may act in manner that enables individuals to realize the mutual gains from exchange. In Hayek’s famous example of a tin factory, actors do not need to know whether there has been an increase in demand for tin, or a decrease in supply, all they need to know is that the price of tin has increased and thus they will economize on its use. Market prices not only guide actors in making their own decisions in the current period, but if allowed to operate freely they accommodate changing conditions quickly and communicate that information to actors in a timely and efficient manner so that they can coordinate their plans to realize the gains from exchange through time.

Proposition 6: Private property in the means of production is a necessary condition for rational economic calculation

Many economists and social thinkers had long recognized that private ownership provided more powerful incentives for husbanding scarce resources than collective ownership. But

6 those sympathetic to socialism thought that the change in human nature brought forth by a change in the material conditions of society would transcend these incentive problems.

Ludwig von Mises demonstrated that even if this assumption were granted, socialism would run afoul because of the inability of economic planners to rationally calculate the alternative use of resources. Without private ownership in the means of production, Mises reasoned, there would be no market for the means of production. Without a market for the means of production, there would be no money prices for the means of production. And, without money prices reflecting the relative scarcities of the means of production, economic planners would be unable to rationally calculate the alternative use of the means of production. In other words, without recourse to the knowledge provided by market prices and profit and loss accounting, economic planners could not calculate whether it was more economical to allocate scarce resources to project A or project B. Technological information is not enough to satisfy the demands of economic calculation. For example, it would be technologically feasible to use platinum to build railroad tracks. The objective properties of platinum might even suggest certain advantages in this use --- it is smoother than steel for example. But it is expensive. We know this because of market prices, but without prices we may be inclined to pursue technologically feasible projects without regard to their economic efficiency.

Mises showed that the linchpin to socialism was in fact the great strength of the market economy. The market system – with prices and profit and loss accounting – continually steers resources in the direction of their most valued uses. The market penalizes wasteful use of resources by losses that tug on the financial resources of those who incur them. Economic calculation is part of the tug and pull of the dynamic market economy that utilizes resources effectively, continually reshuffles resources in response to changing

7 conditions, and provides the lure of profit for those alert to new and better ways of satisfying demands of others.

Proposition 7: The competitive market is a process of entrepreneurial discovery

Competition is economics is often defined as a state of affairs --- infinite number of buyers and sellers, perfect knowledge, price taking, zero transaction costs, and thus zero economic profits. But the term competition invokes an activity --- to compete against someone, two runners in a race, two buyers attempting to outbid each other, two sellers vying for the loyalty of a consumer. Competition as a noun tends to eliminate the need for the entrepreneur as the focus is on a state of affairs in which the entrepreneur would have no role. Competition as a verb, on the other hand, focuses attention on the entrepreneur because it is this agent of change who prods and pulls markets in this direction or that.

The entrepreneur is alert to unrecognized opportunities for mutual gain. By recognizing that previously unrecognized gains from exchange, the entrepreneur earns a profit. The mutual learning from the discovery of gains from exchange (either through closing a price gap as in the case of arbitrage, or improving the process of production, or providing a new product as a result of innovation) moves the market system to a more efficient allocation of resources. Entrepreneurial discovery ensures that not only does a free market system tend toward the most efficient utilization of resources, but also that the lure of profit will continually prod entrepreneurs to seek the innovations to increase our productive capacity. Today’s imperfections represent tomorrow’s profit for the entrepreneur who recognizes the opportunity and pursues a course of action that enables him to capture

8 the gains from eradicating the previous error.2 The price system and the market economy are learning devices that guide individuals to discover mutual gains and how to utilize scarce resources efficiently.

III. Macroeconomics

Proposition 8: Money is Non-neutral

The most basic definition of money is the commonly accepted medium of exchange. The purpose of money is to facilitate exchange, and in an advanced economy it is ½ of all exchanges. If the monetary unit is distorted through government policy it distorts the exchanges in the economy. The goal of monetary policy is to minimize these distortions.

This task is quite difficult. Any increase in the money supply not offset by an increase in money demand will lead to an increase in prices, but prices do not adjust instantaneously and costlessly throughout the economy. Price adjustments occur through a series of relative price adjustments, not in one-shot general price level adjustments, and each of these relative price adjustments exerts their influence on the pattern of exchange and production. Money by its nature cannot be neutral.

The importance of recognizing this proposition is nowhere as evident as in the discussions of the costs of inflation. The quantity theory of money argued correctly against the monetary cranks of the past that printing money is not the solution to poverty. In the strict interpretation of the quantity theory, if the government doubles the money supply, prices will double and thus printing money will not eliminate poverty. But while the quantity theory of money represented an important advance in economic thinking, a mechanical interpretation of the quantity theory underestimated the costs of inflationary policy. If prices

2 Entrepreneurship can be characterized by three distinct moments: serendipity (discovery), search (conscious deliberation), and seizing the opportunity for profit.

9 simply doubled when the government doubled the money supply, then economic actors would anticipate this price adjustment by closely following money supply figures and would adjust their behavior accordingly. They would not, in other words, suffer from monetary illusion. The cost of inflation would be minimal.

But inflation is socially destructive on several levels. First, even anticipated inflation breaches a basic trust between the government and its citizens. Government is attempting to confiscate the wealth of citizens in the form of inflation. Second, unanticipated inflation is redistributive as debtors gain at the expense of creditors. Third, since inflation cannot be perfectly anticipated by economic actors it distorts the pattern of exchange and production due to its injection effect. New money is injected into the system at particular points, and those who receive the new money first before prices have adjusted experience increase purchasing power and thus are able to pull resources in their direction. Those who receive the new money last experience a decrease in their purchasing power because prices have already started to adjust upward.

Money is the link through which all transactions flow through in a modern economy.

Monetary distortions thus impact all those transactions, and thus in the short run the classical dichotomy is violated as a nominal variable has a real effect on the pattern of exchange and production. The goal of monetary policy, therefore, should be to strive to minimize these monetary distortions precisely because money is non-neutral.3

Proposition 9: The capital structure consists of heterogeneous goods that have multi-specific uses that must be aligned.

3 Finding solutions to this elusive goal has generated some of the most innovative work among Austrian economists and led to the development in the 1970s and 1980s of the literature on free-banking by F. A. Hayek, Lawrence White, , Kevin Dowd, Kurt Schuler and .

10 Right now individuals are designing cars that consumer will not purchase for a decade. How do they know how to allocate resources to meet that goal? Production is always for an uncertain future demand and the production process requires different stages of investment from the most remote (mining iron ore) to the most immediate (the car dealership) to consumption. The value of the most remote stages of production is derived from the value that consumers place on the product being produced.

The prices for producer goods are determined as alternatives demands are expressed in competition for these scarce resources. The production plan must align various goods into a capital structure that produces the final goods in the most efficient manner. Capital goods are heterogeneous and multi-specific. If capital goods were homogenous, they could be used in producing whatever final products consumers desired. If mistakes were made, the resources would be reallocated quickly and with minimal cost toward producing the more desired final product. But this is not the situation faced in complex economy. Capital goods can be used to produce some products, but not others. The intricate alignment of capital to produce various consumer goods is governed by price signals and the careful economic calculations of investors. If the price system is distorted, investors will be led into error in their alignment of capital goods. Once the error is revealed, economic actors will reshuffle their investments, but resources will be lost.4

Proposition 10: Social Institutions often are the result of human action, but not of human design

Many of our most important institutions and practices are the result not of direct design, but the by-product of our striving to achieve another goal. When a student in the mid-West in

4 Propositions 8 and 9 form the core of the Austrian Theory of the Business Cycle which explains how credit expansion by the government generates a malinvestment in the capital structure during the boom period that must be corrected in the bust phase. is the leading expositor of this theory in contemporary economics.

11 January is confronted with the task of getting to class quickly and to avoid the cold, he may cut across the quad rather than walk the long way around. Cutting across the quad in the snow leaves footprints, and as other students follow the lead and cut across they make the path bigger. Their goal is merely to get to class in a timely manner and avoid the cold weather, but in the process they have created a path in the snow that actually makes the task of getting to class quickly easier for the students who come later. The path in the snow story is but a trivial example of a “product of human action, but not of human design”.

The market economy and its price system are examples of a similar process. Nobody intends to create the complex array of exchanges and price signals that constitute a market economy. Their intention is simply to improve their own lot in life. But their behavior results in the market system that enables them and millions of others to pursue their intention of improving their lot in life easier. Money, law, language, science, etc. are all social phenomena that can trace their origins not to human design, but as a by-product of individuals striving to achieve their own betterment and in the process producing an outcome that benefits the public.5

***********

If these ten propositions are accepted, the implications for economic science and public policy are rather radical. Economic theory would be grounded in verbal logic and empirical

5 Not all spontaneous orders are beneficial and thus this proposition should not be read as an example of a Panglosian fallacy. Whether or not individual’s pursuing their own self-interest will generate public benefits is a function of the institutional conditions within which they pursue their interests. Both the of market efficiency, and the tragedy of the commons are results individuals striving to pursue their individual interests, but in one social setting this generates social benefits whereas in the other we generate a less desirable social outcome. New Institutional economics has refocused professional attention on how sensitive social outcomes are to the institutional setting within which individuals interact. It is important, however, for the modern reader to realize that classical political economists and the early neoclassical economists all recognized the basic point of New Institutional economists and that it was only the mid-20th century fascination with formal proofs of general competitive equilibrium, on the one hand, and the Keynesian preoccupation with aggregate variables, on the other, that tended to cloud the institutional pre-conditions required for social cooperation among diverse actors to emerge.

12 work focused historical narratives. With regard to public policy, severe doubt would be raised over the ability of government officials to intervene optimally within the economic system, let alone rationally manage the economy.

The doctors creed is first do no harm, and this may in fact be the creed that economists must adopt as well. The market economy develops out of the natural inclination of individuals to better their situation and in so doing seek to discover the mutually beneficial exchanges that will accomplish that goal. Adam Smith first systematized this message in his The Wealth of Nations and in the 20th century economists of the Austrian

School of Economics were the most uncompromising proponents of this message not because of a prior ideological commitment but because of the logic of their argument.

Peter J. Boettke

George Mason University

Acknowledgements

I would like to thank the editor, and Scott Beaulier, Christopher Coyne, , and Edward Stringham for comments on an earlier draft. The usual caveat applies.

Suggest Readings

A. General Readings Boettke, P. ed., The Elgar Companion to Austrian Economics. Edward Elgar Publishing, 1994.

Dolan, E., ed. The Foundations of Modern Austrian Economics. Sheed, Andrews, McMeel, 1976.

B. Classic Readings Bohm-Bawerk, E. , 3 volumes. Libertarian Press, 1883 [1956].

Hayek, F. A. Individualism and Economic Order. Press, 1948.

Kirzner, I. Competition and Entrepreneurship. University of Chicago Press, 1973.

Menger, C. Principles of Economics. New York University Press, 1871 [1976].

13 Mises, L. Human Action: A Treatise on Economics. Yale University Press, 1949.

O’Driscoll, G. and Mario Rizzo. The Economics of Time and Ignorance. Basil Blackwell, 1985.

Rothbard, M. Man, Economy and State, 2 volume. Van Nostrand Press, 1962.

Vaughn, K. Austrian Economics in America. Cambridge University Press, 1994.

C. Essays on the History of the Austrian School of Economics Boettke, P. and Peter Leeson. “The Austrian School of Economics: 1950-2000,” in Jeff Biddle and Warren Samuels, eds., The Blackwell Companion to the History of Economic Thought. Blackwell Publishers, 2003.

Hayek, F. A. “Economic Thought VI: The Austrian School,” International Encyclopedia of the Social Sciences. Macmillan, 1968.

Machlup, F. “Austrian Economicls,” Encyclopedia of Economics. McGraw-Hill, 1982.

Biography Peter J. Boettke is the Deputy Director of the James M. Buchanan Center for Political Economy, Senior Fellow at the , and Professor of Economics at George Mason University. Prior to joining the faculty at George Mason University in 1998, Boettke taught at New York University and was a National Fellow at the Hoover Institution on War, Revolution and Peace, Stanford University. He is the author of The Political Economy of Soviet Socialism: The Formative Years, 1918-1921, Why Perestroika Failed: The Politics and Economics of Socialist Transformation, and Calculation and Coordination: Essays on Socialism and Transitional Political Economy. He is the co-author with Paul Heyne and of the popular text-book, The Economic Way of Thinking. He was a founding editor of the journal Advances in Austrian Economics and is the current editor of The Review of Austrian Economics.

14