The Correct Model for the Economy: An Austrian View

Thinking Things Over              November 27, 2011

Volume I, Number 19:  The Correct Model for the Economy: An Austrian View (Part 3 of 3)  

By John L. Chapman, Ph.D.                                                                                                                         Washington, D.C.

In this third and final installment of our three-part trilogy on the importance of seeing the world clearly in order to solve the vexing challenges of a depressed economy, we offer a brief summary of the main tenets of the Austrian school of economics.  Two weeks ago we critiqued the problems that can arise from the neoclassical paradigm in economic theory – this is the theoretical framework for “mainstream economics” prevalent since Alfred Marshall developed it after 1870.  The Keynesian framework grew out of Marshall (directly so, as Keynes was a student of Marshall’s at Cambridge), and last week we illustrated how theorizing via Keynesian analysis can miss critical truths about a real world affected by an infinite number of variables.  Today we correct the errors inherent in the limiting vantage of both Keynes and Marshall.

Why should any investor or interested observer care about arcane details of the methodology behind economic theory and model-building?  Again, we reiterate that core theory always informs ultimate real world policy.  And in a world where U.S. unemployment is north of 9% for nearly three years; where up to 27 million Americans who want full-time work cannot find it; where real incomes are 10% lower than they were 4 years ago; where the value of the dollar has harmed consumers by dropping for the better part of the young century; and where a prospective economic collapse due to a crushing debt burden, monetary instability, and unsustainable fiscal habits becomes more likely by the day, it is imperative to impel economists and policy analysts toward clear thinking.

Summary of the Main Themes in Keynes and Marshall

In short, as discussed in the prior two essays, we object to the following building blocks of modern economic theorizing, and the major policy implications that follow:

  • The economy consists of infinite buyers and sellers who have no market power. Economic profits therefore should be zero since an infinite number of sellers compete them away.  Any evidence of outsized corporate profits may therefore be anti-consumer, and evidence that the market is failing; government should intervene to protect consumers.
  • Taxation is assumed away by Marshall so as to focus on industrial dynamics of supply and demand; taxes can be thought of in an add-on way as a result, and do not affect economic behavior to any great degree (this is a pervasive but very unfortunate undercurrent in all Keynesian thinking, as discussed below).
  • Economic activity generates “perfect information” in terms of known prices and quantities, and forces of supply and demand move to equilibrate any discrepancies in market conditions.  The intermediating role of money, entrepreneurial discovery and risk-bearing, production through time into an uncertain future, and other market institutions are assumed away or disregarded as unimportant.  Keynes did address risk and uncertainty but, unable to completely divorce himself from Marshall, regarded them as unimportant if mitigated by all-knowing government planners (which he implicitly thought possible, starting with himself in such a role). And again, any shortcomings due to seeming market imperfections over a lack of relevant knowledge are automatically assumed to be able to be remediated via government intervention.
  • Capital was, analytically, seen to be perfectly homogenous in the models of both Marshall and Keynes.  As such, it was effectively relegated to superfluity and an ‘easy add-on’ where needed.
  • The Keynesian corollary to the above is that spending drives the economy, and spending is a cause of economic growth.

Every one of these points is erroneous, yet these precepts guide real world policy development at this very moment, in Washington and around the globe.  The following corrects the errors and offers a better way to think about economic phenomena.

The Austrian School of Economics

The Austrian school is so named for its origin at the University of Vienna, and effectively dates to 1871 with Carl Menger’s publication of his principles book (Grundsätze der Volkswirtschaftslehre) .  Today there are economists who espouse the Austrian paradigm all over the globe, though its main locus of research and publishing activity is the United States.  The main tenets of Austrian theorizing, while accepting and using many of the same analytical tools of supply-and-demand as the mainstream, stand in stark contrast to those of Keynes and his neoclassical adherents in several respects.  We now highlight these briefly to illustrate how better policy can ensue from a better framework.

Methodology.  The Austrians begin by insisting that economics is an a priori field of inquiry, and non-quantitative in terms of forward policy prescription.  That is to say, the main truths of economic analysis can be deduced through rational thought, rather than needing to be induced from empirical observation.  This is so because economics deals with human action, at its essence: humans act purposively, and because we ourselves are human, we can apprehend reality and interpret actions of others via rational thought. (An example of this is to say that if the price of apples rises, fewer will be demanded.  This is a statement that is axiomatically true, and can be deduced from the mere fact or axiom of human action; that is to say, that human beings act to improve their condition in life.  No “empirical studies” need be undertaken to determine this fact; we know its truth in an a priori way.).

To say this differently, reality in economics cannot be comprehended via statistical studies or controlled empirical research the way physics or chemistry can; nothing can be quantitatively analyzed in the social sciences where, unlike the physical sciences, purposive human beings are involved and “cannot be held constant”.  Related to this, the Austrians place prime importance on valuation being subjective, and as such, it, too, cannot be quantified.  We can only say, for example, that a person prefers an apple to an orange (viz., in an ordinal sense); we cannot say how much more, even if relative money prices are involved.  This is because relative preferences, being subjective, can change two minutes from now for no seeming reason, and indeed this can cause changes in the trend of pricing.

(It is important to remember that for Marx explicitly, and for Keynes implicitly or at least upon occasion, valuation was thought of in objective terms. If value is objectified, government intervention becomes much easier to justify for policy-makers: this is so because they then claim to know with precision the value of any initiative they are pursuing, and can assert it is over and above any program costs).

These core methodological cornerstones imply very different proclivities with respect to activist public policy, and they permeate the entire body of analytics in the respective Austrian and Keynesian policy camps beyond this high plane of theorizing. For Austrians, their apriorism precludes them from using as a guide to policy what they consider to be merely interesting statistical history on economic phenomena of the past, that may bear no relation to the future.  Keynesians, meanwhile, often justify policy pursuits based on some pseudo-ironclad findings from past data that, they allege, explain the future.  For example, conventional analysis has always held that the Federal Reserve was too tight with the money supply in the early 1930s, exacerbating the crisis at the time.  Ben Bernanke justified outsized levels of base money creation in recent years on this historical observation, in spite of the obvious potential for future monetary instability as a result.

Further, an economic model in which subjective valuation is held in mind is superior to any objective-value thinking, and better as policy guide, too.  For example, to take the famous paradox from classical economics, why are diamonds, a luxury, more highly valued than water, which is critical for the sustenance of human life?  This is due of course to relative scarcities and subjective preferences at the margin, rather than any (objective) cost-of-production differences between the two.  But given this fact, the more interesting observation is that in the desert, the reverse valuation may hold: the wealthiest man in the world, marooned and parched by thirst to the point of near-death due to dehydration, may well trade his fortune for water.  Given this, the Austrian economist is far more likely to abstain from government intervention that would impede the subjective valuations inherent in market-based pricing from supply-and-demand interaction.  This in turn implies that the harmful and destabilizing effects of government intervention will then be avoided entirely.

The market as a process of discovery.  The heart of Austrian analysis, while utilizing the concepts of supply and demand in exactly the same way as mainstream Keynesian economists, rejects the static analytics of Marshallian “equilibrium”.  The Austrians insist that a market is a process far more so than a physical place — a process in which buyers and sellers of infinite millions of commodities find each other, and interact to trade with each other for mutual gain.  This too has important policy implications.  First, there is no objective reality behind market prices beyond — or apart from — their subjectively-determined origin, following a process of buyer/seller interaction.  Indeed markets involve a pattern of interchanges borne of ever-increasing knowledge of economic conditions regarding consumer preferences, intensity of demand, supply availability, the application of technology and how it affects things, and innumerable other factors that affect supply, demand, and ever shifting market prices.

This looks, to a typical Keynesian, like a disorderly and unruly process.  and because it is “chaotic”, government intervention can often be justified via clever arguments in favor of “planning to avoid redundancies”, and to “better make use of scarce resources and information not privy to market participants.”  Here again, the reality of how markets work as a process, to coordinate the plans and actions of literally billions of economic agents, and how their actions are peacefully dovetailed via the pricing mechanism, leaves the Austrian analyst both awe-struck and very wary of any attempt at justifying intervention which, by definition, impedes this natural process.  For the process itself is knowledge-generating, and in turn quickly makes this knowledge actionable and useful for all market participants toward the end of universal human betterment.  As F.A. Hayek pointed out in his seminal 1945 essay “The Use of Knowledge in Society“, Americans need not know why the price of automobiles increases suddenly, in case there is a shortage of tin due to, say, a shutdown of iron ore mines in Africa.  But the transmission of the effects of the newly-created shortage occurs almost instantaneously downstream, throughout the whole chain of value-added production and distribution, in the final form of higher consumer prices.  This induces the consumer to change his behavior in ways that are beneficial to society: he economizes on automobile use in the face of higher prices for autos.  And in turn, the same beneficent behavioral effects occur for all allied producers, distributors, and even competitors involved in this market.

This process, seemingly chaotic and certainly decentralized and impersonal, could not have been the product of any intended human design: it is far too complex.  But it IS the result of purposive human action.  And it DOES end in socially optimal outcomes, in terms of conserving scarce resources, reserving them to their highest valued uses, and inducing the desired behavioral changes on the part of producers and consumers.  Where prices rise, for example, new production to serve unmet desires at lower prices is the sure consequence.  Here again, the Austrian economist rejects interference in this knowledge discovery process, being reticent to induce cross-currents in the market that would by definition be at odds with consumer preferences as expressed in prices, or the optimal deployment of resources.

Emphasis on the institutions of the market, developed via purposive human action.  As a result of this evolutionary process of discovery that leads to best use of resources – that is to say, those which maximize the creation of real economic value and wealth, and optimize scarce assets – Austrians also greatly respect market-based institutions that have developed via trial-and-error.  The two most crucial of these, after language itself, are those of money and entrepreneurship.  

i. Money.  Money is fundamental to society and the advancement of civilization.  As a medium of exchange, money permits specialization and the division of labor as far and wide as the money-unit is used.  As Adam Smith famously said, “The division of labor is limited [only] by the extent of the market.”  That is to say, in a primitive society based on barter, for trade to occur, there must be a “double coincidence of wants.”  The cobbler, if he wants bread, must find a baker who wants shoes, at that exact moment.  Money permits indirect exchange, as the baker will accept the medium of exchange from the cobbler in lieu of shoes he does not need; the existence of money, therefore, permits production for a mass, anonymous market.    That is to say, money permits specialization and production for this mass market rather than for specific traders where the double coincidence of wants exists. 

Money, in short, radically intensifies the division of labor, and dramatically thereby improves the productivity of labor – or, the creation of real wealth.  To manipulate its value for political purposes thus upsets the trade and exchange mechanisms that money serves; indeed, the Austrians alone have a unified theory of the trade cycle and its booms and busts.  Austrian analysis is unique in blaming the boom-and-bust cycle in the modern world of a monetary exchange economy entirely on the credit creating processes of modern central banks, which falsify interest rates and thence the structure of production in an economy.  This is because the falsification of interest rates distorts relative prices of both current goods as well as those of future goods, and the terms of trade between them, too.  Indeed the manipulation of money and credit in an economy causes monetary instability, that in turn generates the business cycle and its recessions. 

Austrians are therefore loath to interfere in the monetary order generated by free markets at all; this is in stark contrast to Keynesians, who, it must be remembered, have no causal theory of recessions, and consider monetary manipulation a core policy tool.  Keynes merely had said that recessions were caused by the changing whims and unpredictable “animal spirits” of investors, but he never explained what causes their changing animal spirits.  

ii. Entrepreneurship.  Entrepreneurship is the other great institutional development of a market economy, generated by human action, but in no way can it emanate from human design.  Indeed, entrepreneurship is the driving force of a market economy: it involves the process of risk-taking by economic agents in the face of an uncertain future that is unknowable, but not unimaginable.  Any government intervention in markets, indeed any regulation at all, involves a curtailment of entrepreneurial pursuits.  Austrians have a deep literature in entrepreneurship and its crucial importance to economic growth and wealth creation; Keynes himself however panned entrepreneurs and their categorical function in markets.  Instead, he felt that government planners could better plan and allocate resources in complex economies.   The Keynesians thus show a serious lack of discernment in how knowledge is created that the planners can then utilize; they further mis-apprehend the importance of incentives in generating the actions that lead to wealth creation. Solyndra-type resource deployment, or better yet, Fannie Mae and Freddie Mac, are what ensue from Keynesian policies that seek to over-ride the forward-looking judgment of entrepreneurs.     

The importance of capital.  As mentioned, Keynes virtually ignored capital, following Marshall’s misunderstanding of its role, and to this day, Keynes’ disciples assume its triviality while not comprehending its heterogeneous nature or true economic role and impact. 

For Austrians, capital – the real wealth (machines, tools, human skills) that produces income for consumption — is a crucial building block for the development of wealth and human progress.  It can only ensue from prior saving, and thus Austrians give pre-eminence to the capital formation process.  Further, capital is understood to be highly heterogeneous, and thus formed to be part of a complex and interconnected whole.  Interfering with either that process or the prices of capital assets thus upsets the coordination of the lattice-work of interconnected prices and asset deployments, and is thus seen to be a cause of malinvestment – errors that are only corrected via a retrenchment process that idles resources (including of the human variety).  There can be no greater example of this misdirection of capital thanks to false (that is, artificially low) interest rates than the housing crisis and subsequent recession with whose after-effects we are still grappling.  Austrian economists were warning of the build-up in housing and its likely ending badly for years before the onset of the crisis; Keynesians applauded the spending right up to the collapse of Fannie Mae and Freddie Mac.  


Developing a model or framework of the economy from the fundamental axiom of purposive human action by individuals, as the Austrians do, has several implications.  First, action is necessary because the future is uncertain; if everything were known and foreordained, there would be no reason to act to change things.  This uncertainty therefore cannot be “assumed away” or made light of; it is an important material fact in the real world that itself has several implications.  Fundamentally, it affirms the importance of seeing the market as a dynamic process in which buyers and sellers come together in mutual discovery: via competing bids and offers, prices are formed which direct resources to their highest and best uses.  These prices in turn act as signals that convey information to all market participants about the demands of consumers as well as relative scarcities; this new and ever-updated knowledge is then useful to economic agents as they pursue continually-evolving plans to better their station in life, by producing for profit or buying at the best possible terms.

The market process is propelled by ubiquitous acts of entrepreneurship that involve risk-taking in the face of the uncertain future.  Entrepreneurs expend scarce capital wealth to pursue initiatives in pursuit of profit; to the degree profits accrue, their estimates of future conditions are seen, ex post, to have worked out and been correct.  Losses conversely are a signal that their vision was incorrect, the risk did not pay off, and resources need to be moved to better uses.  And a well-functioning monetary unit is therefore necessary to calculate these profits and losses and materially aid in the direction of scarce resources to their best uses.  The money unit also, of course, greatly facilitates trade and exchange, thus encouraging the specialization and division of labor that have been so responsible for the material advance of civilization in the last 300 years.  That money therefore needs to be dependably-valued is also obvious.

Money also serves as a store of value and thus aids in saving and the accumulation of capital, a crucial feature of modern economies and critical to economic growth and human progress.  Austrians therefore tend to favor a regime of laissez-faire; the institutions of entrepreneurship and money both serve to promote the smooth functioning of the market process, and capital is the prime motive force behind the general level of productivity that inheres in that process.  To manipulate the value of money is to distort its utility; to regulate the build-up or use of capital and/or to place strictures around acts of entrepreneurship are the same things, in essence.  All impose costs on market transactors and in the case of the manipulation of money and credit, boom-bust cycles and harsh recessions are the sure result.  Bad theory begets bad policy, and Austrians are therefore far more reticent than Keynesians to interfere in what they see as the natural harmony of the competitive market process.

The foregoing represents the essential features of the Austrian paradigm, and it is obvious that this view of markets as a dynamic, kaleidoscopically-changing process captures reality far more than Keynesian or neoclassical models.  The Austrians take note of the importance of time and uncertainty in the unfolding advance of human progress through the dynamics of the competitive market process; the Keynesians ignore these or assume them away.  The crucial role played by money and entrepreneurship, as well as the nature of capital and how it is accumulated, is at the front and center of Austrian analysis; these are all given short review and low priority in the Keynesian world.

This more realistic worldview leads to better policymaking as a result.  Whereas, for example, the Keynesians consider spending to be of prime importance to generating growth — because for them it is the embodiment of aggregate demand — Austrians understand that spending is an effect of a growing economy, NOT a cause of growth.  For Austrians, our present torpor is the result of massive destruction of capital wealth through errant monetary and regulatory policies.  It is a lack of capital, not a lack of spending, that is our core problem now.  As a result, nothing is more important to Austrians than a re-ignition of saving and capital accumulation — manifested in a real rise in equity and bond markets — to heal and grow this economy.  By contrast President Obama, advised by Keynesian acolytes, has spent the better part of three years attacking and even vilifying savings.  Again, bad theory, alas, yields bad policy. 

Similarly, Keynesian policies, emanating from a Keynesian model which under-appreciates the role, economic effects, and practical impact of taxation on growth will always lead to proposals for higher rates of taxation to support a growing government sector.  But Austrians understand that taxation creates a wedge that inhibits the highest and best use of resources in support of production and output growth, both by harming incentives and distorting price signals and economizing behavior (which can shift from producing more output to avoiding taxes).  Society is ultimately poorer as a result of confiscatory levels of taxation that seem to become axiomatic as modern welfare states advance.

Over the decades, the Keynesian “mindset” that at its core implies higher taxes, bigger government, more regulation, and a greater degree of central planning won over the economics profession.  This was so not least because of Keynes’ popularity with government officials who saw in him an intellectual justification for what they wanted to do anyway.  But the ghost of Keynes haunts our world, because the policies he espoused can be shown to have led directly to the present global disaster we are still trying to move beyond — four years after its onset, and a decade into a slow-growth era for the United States.  If over time Austrian ideas can make their way into the public realm, and indeed re-enter the public debate, investors can know a sustained recovery will be in the offing.  For there is no better antidote to darkness than light itself.     

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com.

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