The Booms and Busts of Austrian Economics

December 27th, 2012

This week and next I am traveling to Austria. Following from this trip, I am writing this two-part blog series on Austrian economics, its successes, failures, and application to current dilemmas in economic theory and policy.

In the past few years the world—and the United States in particular—has witnessed a resurgence of the term “Austrian economics.” Many of those who use it, including Ron Paul who declared we are “all Austrians now” after his third place finish in Iowa, are referring to a narrow segment of the body of thought. That segment might be better termed “libertarianism.” Other bloggers and thinkers have already written extensively about the relative merits and failures of Paul’s interpretation of Austrian economics and I’ll leave continued discourse on that subject to them. What I’m more interested in—and what I’ll explore with this two-part blog series while I travel the birthplace of this economic school of thought—is the academic discussion and resurgence of Austrian economics that has followed from the financial crisis and the European debt crisis.

First some history.

The Austrian school of economics got its name from its German opponents. The founder of the school of thought is Venetian professor and economist Carl Menger. In 1871 Menger published his Principals of Economics, which not only lays the groundwork for Austrian economics, but also advanced the theory of marginal utility. Proving that economists have been snarky since the 19th century, Menger dedicated his book to his German rival William Roscher. Roscher and his students, summarily rejecting Menger’s work, derogatorily labeled him and his colleagues “Austrian school” because their positions at the University of Vienna.

In some ways Menger got the last laugh, although not for his contributions to Austrian economics, but rather for his theory of marginality. It would be difficult to overstate the importance of Menger’s achievement here. Marginal utility is not only an accepted part of current mainstream economics—it plays a crucial role in economists’ understanding of consumers’ decision-making and the setting of market prices. It also lays the foundation for his school of thought.

Ironically, there are few other Austrian economists who are notable contributors to the so-called Austrian school of economics. Most 20th century Austrian economists were, in fact, Americans and Britons. The one notable exception is Friedrich August Hayek, who was born, raised, and studied in Vienna. Hayek made important contributions to the Austrian understanding of business cycles—which are swings in economic activity between booms and busts—and their interlacing with capital and monetary theory.

Hayek—and Austrian economists generally—held that recessions (busts in the business cycles) occur as a result of changes in the money supply. To keep it simple, Hayek argued that increases in the amount of money supply would drive down interest rates, creating “malinvestment” or poor allocation of investment by firms facing low interest rates. At the same time, the artificially high level of investment creates economic growth (a boom) and economic bubbles. The logical conclusion is that these bubbles will burst, creating a bust in the cycle.

The reason Austrian economics has received more academic attention in recent years is that (this overtly simplistic version of) it does a good job of both explaining and predicting the financial crisis of 2007-8. In fact, our banking system and monetary policy did expand the money supply, creating credit booms and investment bubbles. Inevitably these bubbles burst. Indeed, this is what we saw, e.g., in the U.S. housing bubble predicated by reckless lending practices by U.S. banks that followed from cheap and easy credit. As a result, as the Economist pointed out in the wake of the crisis that a great number of economists who “would not describe themselves as Austrian have reached conclusions that chime with Hayek.” For example, we might now all agree that long booms will result in excessive risk-taking and “Ponzi finance.”

Ironically, though the Austrians enjoy a boom in their theories as they are able to explain the sources of our crisis, their proposed solutions are a bust. In fact, the evidence, politics, and most mainstream economists have summarily rejected its prescriptions for our ills. That’s the topic I’ll explain next week.

Written by Ann Hollingshead

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