Austrian School: What it is, How it Works

What Is the Austrian School?

The Austrian school is an economic school of thought that originated in Vienna during the late 19th century with the works of Carl Menger, an economist who lived from 1840–1921. It is also known as the "Vienna school," "psychological school," or "causal realist economics."

Understanding Austrian School

The Austrian school is set apart by its belief that the workings of the broad economy are the sum of smaller individual decisions and actions; unlike the Chicago school and other theories that look to surmise the future from historical abstracts, often using broad statistical aggregates. Economists who follow and develop the ideas of the Austrian school today hail from around the world, and there is no particular attachment of these ideas to the country of Austria beyond the historical origin of their creators.

The Austrian school traces its roots to 19th century Austria and the works of Carl Menger. Menger, along with British economist William Stanely Jevons and French economist Leon Walras, ushered in the Marginalist Revolution in economics, which emphasized that economic decision making is performed over specific quantities of goods, the units of which provide some additional benefit (or cost) and that economic analysis should focus on these additional units and their associated costs and benefits.

Menger’s contribution to the theory of marginal utility focused on the subjective use-value of economic goods and the hierarchical or ordinal nature of how people assign value to different goods. Menger also developed a market-based theory of the function and origin of money as a medium of exchange to facilitate trade.

Following Menger, Eugen von Bohm-Bawerk furthered Austrian economic theory by emphasizing the element of time in economic activity—that all economic activity occurs over specific periods of time. Bohm-Bawerk’s writing developed theories of production, capital, and interest. He developed these theories in part to support his wide-ranging critiques of Marxist economic theories. 

Bohm-Bawerk’s student, Ludwig von Mises, would later go on to combine the economic theories of Menger and Bohm-Bawerk with the ideas of Swedish economist Knut Wicksell on money, credit, and interest rates to create Austrian Business Cycle Theory (ABCT). Mises is also known for his role, along with colleague Friedrich von Hayek, in disputing the possibility of rational economic planning by socialist governments.

Hayek’s work in Austrian economics emphasized the role of information in the economy and the use of prices as a means to communicate information and coordinate economic activity. Hayek applied these insights to both the advancement of Mises' theory of business cycles and the debate over the economic calculation under central planning. Hayek was awarded the Nobel Prize in 1974 for his work in monetary and business cycle theory.

Despite its contributions, the Austrian School was largely eclipsed by Keynesian and neoclassical economics theories in both academia and government economic policy during the mid-20th century. However, by the end of the 20th and into the early 21st centuries, Austrian economics began to see a revival of interest with a handful of academic research institutes currently active in the U.S. and other countries.

The Austrian school has also received favorable attention from a few politicians and prominent financiers for the apparent confirmation of Austrian ideas by historical trends. Notably, the Austrian school of economics is cited for having predicted the eventual collapse of the Soviet Union and the abandonment of communism in other countries, and for its explanatory power regarding recurring economic cycles and recessions in the economy.

Mainstream economists have been critical of the modern-day Austrian school since the 1950s and consider its rejection of mathematical modeling, econometrics, and macroeconomic analysis to be outside mainstream economic theory, or heterodox. 

Themes in Austrian Economics

The following are some unique themes that help to define and differentiate the Austrian school.

Causal Realism

Austrian economics describes the economy as a vast and complex network of cause-and-effect relationships driven by purposeful human action and interaction, which occur in real-time and space and involve specific, real economic goods in discrete quantities as the objects of action. Austrian economics does not approach the economy as a mathematically solvable problem of optimization or a collection of statistical aggregates that can be reliably modeled econometrically. Austrian theory applies verbal logic, introspection, and deduction to derive useful insights regarding individual and social behavior that can be applied to real-world phenomena.

Time and Uncertainty

For the Austrian school, the element of time is ever-present in economics. All economic activity occurs in and through time, and it's oriented toward an inherently uncertain future. Supply and demand are not static curves that intersect at stable points of equilibrium; supplying and demanding quantities of goods are actions that buyers and sellers engage in and the act of exchange coordinates the actions of producers and consumers. Money is valued for its future exchange value, and interest rates reflect the price of time in terms of money. Entrepreneurs bear the risk and uncertainty as they combine economic resources in productive processes over time in the hope of an expected future return.

Information and Coordination

In Austrian economics, prices are viewed as signals that encapsulate the competing values of various users of economic goods, the expectations of future preferences for economic goods, and the relative scarcity of economic resources. These price signals then influence the real actions of entrepreneurs, investors, and consumers to coordinate planned production and consumption across individuals, time, and space. This price system provides the rational means to economically calculate what goods should be produced, where and when they should be produced, and how they should be distributed, and attempts to override or replace it through central economic planning will disrupt the economy. 

Entrepreneurship

Entrepreneurs play a pivotal role in the Austrian view of the economy. The entrepreneur is the active agent in the economy who uses the information available from prices and interest rates to coordinate economic plans, exercises judgment of expected future prices and conditions to choose among alternative economic plans, and bears the risk of an uncertain future by taking ultimate responsibility for the success or failure of the chosen plan. The Austrian view of the entrepreneur encompasses not just innovators and inventors, but business owners and investors of all sorts as well.

Austrian Business Cycle Theory 

Austrian Business Cycle Theory (ABCT) synthesizes insights from the Austrian school’s capital theory; money, credit, and interest; and price theory to explain the recurrent cycles of boom and bust that characterize modern economies and motivate the field of macroeconomics. ABCT is one of the most widely familiar, but widely misunderstood, aspects of the Austrian school.

According to ABCT, because the productive structure of the economy consists of multistep processes that occur over variable amounts of time and require the use of different complementary capital and labor inputs at different points in time, the success or failure of the economy depends critically on coordinating the availability of the right kinds of resources in the right amounts at the right time. A key tool in this coordinating process is the interest rate because, in Austrian theory, interest rates reflect the price of time. 

A market interest rate coordinates among the many, varied preferences of consumers for consumption goods at various points in time with the multiplicity of plans of entrepreneurs to engage in production processes that yield consumption goods in the future. When a monetary authority like a central bank alters market interest rates (by artificially lowering them through expansionary monetary policy), it breaks this key link between the future plans of producers and consumers.

This sparks an initial boom in the economy as producers launch investment projects and consumers increase their current consumption based on false expectations of future demand and supply for various goods at various points in time. However, the new boom-time investments are doomed to failure because they are not in line with consumers’ plans for future consumption, labor in various jobs, and savings, or with the productive plans of other entrepreneurs to produce the required complementary capital goods in the future. Because of this, the resources that the new investment plans will require at future dates will not be available. 

As this comes to light over time through rising prices and shortages of productive inputs, the new investments are revealed to be unprofitable, a rash of business failures occurs, and a recession ensues. During the recession, the unproductive investments are liquidated as the economy readjusts to bring production and consumption plans back into balance.

For the Austrians, the recession is an admittedly painful healing process made necessary by the discoordination of the boom. The length, depth, and scope of the recession can depend on the size of the initial expansionary policy and on any (ultimately futile) attempts to ease the recession in ways that prop up unproductive investments or prevent labor, capital, and financial markets from adjusting.