Last week, Renato Moicano, a professional martial artist who competes in the Ultimate Fighting Championship (UFC), made a rather unusual announcement after a fight:
‘I love private property, and let me tell you something, if you care about your […] country, read Ludwig von Mises and the six lessons of the Austrian Economic School […]!’
Wise words! The Austrian School of Economics, which emerged in Vienna in the 1870s, was one of the world’s leading schools of economic thought in the late 19th and early 20th centuries, and while they have since somewhat fallen out of favour, we still have a lot to learn from them today. I am not quite sure what Mr Moicano means by ‘the six lessons’ (there is some speculation that he was referring to the book ‘Economic Policy: Thoughts for Today and Tomorrow’ published by the Mises Institute, which is composed of six lectures), but either way: in this article, I will single out six important insights that we owe to the Austrian School.
Value is subjective
The value of a good is not a property of the good itself. It is something that we, the consumers, see in it. As Carl Menger, the founding father of the Austrian School, explained, value exists in our minds, not in the physical world.
Like a lot of important insights, this seems extremely obvious – trivial, even – once somebody has spelt it out. But it is not obvious at all until somebody does so. For a long time, economists believed in the so-called ‘Labour Theory of Value’, the idea that the value of a good is determined by the number of working hours needed to make it. That would make ‘value’ an objective, physical property of a good, like its weight, its volume, or in the case of food, its calorie content.
But value is clearly nothing of the sort. We can see this from the fact that things go up and down in value as consumer preferences change, even as the number of labour hours contained in them remains constant.
Value is determined at the margin
The first pint of beer in the evening is a delight. The second one is still very nice, but it does not quite replicate the magic of the first one. Each subsequent pint is a bit less enjoyable than the previous one. Economists call this ‘diminishing marginal utility’.
Again, this seems obvious once somebody spells it out, but it was not at all obvious at all until the ‘Marginal Revolution’ of the late 19th century, which the Austrian School was part of. Economists used to struggle with what was later called the ‘diamond-water paradox’: isn’t it strange that we value diamonds so highly, and water so little, given that diamonds have no practical use whatsoever, while we cannot survive for longer than three days without water?
But there is nothing paradoxical about this at all once we think in terms of marginal rather than absolute value. If we are lost in the desert, we would, of course, pay any price for a bottle of water. However, most of the time, we are not lost in the desert. Most of the time, we have enough water. And an additional unit of it would not make us much better off.
If somebody invented a 3D printer that can ‘print’ diamonds, the marginal value of diamonds would also drop. But with the limited number of diamonds currently in circulation, it never even gets to that stage.
Profits are not exploitative
Marxists see capitalists as parasitic exploiters. They see them as the equivalent of a feudal landowner, who does not produce anything: they just own the land, and collect rents.
Eugen von Böhm-Bawerk, the leading figure of the second generation of the Austrian School, explained that the role of the capitalist in a market economy is nothing like that. Profits are a legitimate reward for risk-taking, and patience.
If you are a salaried employee, you are, to a large extent, insulated from the ups and downs of the company you work for. When the company goes through a rough patch, that is not your problem: you are still entitled to the same salary. You are also paid from the very first month, although it can take many years until a new company, or a new product line, generates any profit.
But the flipside of this is that when a company eventually does generate large profits, you are not automatically entitled to a share of those. Employment contracts are like an insurance contract between risk-takers and risk-averse people. There is nothing ‘exploitative’ about that.
No economic calculation without market prices
When we say that Good X is worth three times, or five times, or ten times as much as Good Y, what do we mean by that?
We mean that that is the ratio at which people generally trade X for Y. When X and Y are not tradable, we cannot know what that ratio is. Without market exchange, there can be no market exchange ratios. Without markets, there can be no market prices.
Ludwig von Mises, the leading figure of the third generation of the Austrian School, pointed out that therefore, there can be no market prices in a socialist economy. Or more precisely: Mises assumed that even in a socialist economy, there could still be a (secondary) market for consumer goods. What there could not be is a market for capital goods, and input factors, e.g. raw materials, land, labour, machinery, and so on.
Why does this matter? Because without prices, there can be no rational economic calculation. Marxists had always argued that capitalism was chaotic: ‘anarchy in production’, as Friedrich Engels called it. A socialist economy would be a more rational economy. Mises turned this logic on its head. He said that the so-called ‘planned’ economy of socialism would, in reality, be chaotic and unplanned. Because in the absence of price signals, the planners would not know what to do. This kick-started what later became known as the Socialist Calculation Debate.
Knowledge is tacit, and dispersed
Everyone possesses some economically relevant knowledge, usually specific to our own circumstances, time, and place. If nothing else, at least we all know our own needs and preferences better than anyone else.
This kind of knowledge is often ‘tacit’: we possess it, but we would struggle to articulate it.
In a market economy, we do not need to express it. We just need to act upon it. Our actions influence market prices, and in that way, our knowledge is communicated to other economic actors. No central planner could possibly replace that process – not even today, with all the computer power we now have.
These important clarifications were added in the second round of the Socialist Calculation Debate by the man who would become Ludwig von Mises’s most prominent student, and the future Godfather of the Institute of Economic Affairs: Friedrich August von Hayek.
Low interest rates cause boom-and-bust cycles
Mises and Hayek also developed a theory of the business cycle, which works, very roughly, as follows.
Imagine two otherwise identical societies, which only differ in one respect: in one of them, people are patient and forward-looking, in the other one, people seek instant gratification.
This would lead to very different economic structures. The patient society would have a high savings rate. In that economy, it would be possible to have sectors with long production timelines, which take a long time to mature. These would not be viable in the impatient society.
Now what happens if the central bank of the impatient society manipulates interest rates downwards? This would create the impression that this society has become more patient, and that long-term investment projects that were previously unviable have become viable now.
But this would be an illusion, and if investors are tricked into starting those long-term investment projects, they will sooner or later find out that they are built on sand. An illusory investment boom is followed by a bust.
Unlike Keynesians, Austrians do not believe that governments can do much to fight a recession. The malinvestment has already taken place, and needs to be liquidated. The economy has to go through a painful adjustment process.
Conclusion
In the second half of the 20th century, the Austrian School fell out of favour. This was partly a matter of methodology. Mainstream economics became a highly mathematical science, imitating physics, an approach which the Austrian School rejects. It did not help that Austrian economists tend to be very purist and uncompromising, which made it difficult to apply their policy recommendations in a world which had moved very far away from laissez-faire liberalism.
But the insights from their golden age are timeless, and you can still find interesting thinkers in the Austrian tradition today. Renato Moicano is right. Read some Austrian economics!
Click here to subscribe to our daily briefing – the best pieces from CapX and across the web.
CapX depends on the generosity of its readers. If you value what we do, please consider making a donation.
