In Defense of Austrian School Economics

It is incredibly frustrating to see pundits of all stripes critique “free market” economics while ignoring the only school of economic thought that actually espouses free markets.  In fact, the neoclassicists and Chicago school are anything but believers in free markets, but espouse various forms of statist economics. By contrast the principles of the Austrian school, named for the origin of its founders in the 19^th century, are about a true market economy.

The key element that differentiates the usual suspects (Chicago school and neoclassical school) shredded by critics of free market economics, and the Austrian school (conveniently avoided by those same critics) is the requirement there be a free market in money and not a fiat currency regime.  In concrete terms, the Austrian school places the majority of blame for our present woes on the operations of the Federal Reserve and our government mandated (non free market) fiat currency.

Milton Friedman of the Chicago school was the closest to a true free market economist, but his monetary theories were so abjectly wrong that he too cannot qualify, though even Austrian economists owe him a debt of gratitude for his ability to champion the market economy and win so many sound bite battles on TV and radio interviews.  Dr. Friedman believed that a monetary system should be run by a computer which would expand the money supply at about a 3% annual rate.  This made him an inflationist whose ideas must ultimately end in disaster.  Please see my posts on innumeracy for additional discussion relating to this point.

Dr. Friedman misrepresented the gold standard as well.  He likened it to fixing the price of gold, then stating that price fixing never works.  The misrepresentation occurs because a gold standard does not fix the price of gold.  In a true gold standard there is an identity of gold and the paper currency in your wallet.  Gold is not equal to money it IS money.  Under a true gold standard, it is only when someone turns gold into the treasury that currency issued.   When the Federal Reserve was established we abandoned the true gold standard in favor of what I call the Cheating Standard.  The central bank issued currency not backed by gold.  Eventually we had to admit the truth that the fed had created many times the amount of money that we had in gold to back it at only $35 per ounce and closed the gold window in 1971 (essentially a default on our obligations).

Austrian economists emphasize the gold standard not because of any special magic associated with gold, but because that was the standard chosen by the market over thousands of years and many trillions of market (uncoerced) transactions.  Nothing is more important to a functioning market economy than a fully functioning free market for our money, the one thing that touches all of us every day.

Another key difference between the Austrian school and other so-called free market theories is there is no assumption of either rational man or money maximizing man.  For Austrian theory, value, like beauty, is in the eye of the beholder.  It is a fundamental mistake of all other market oriented economic theories that assumes a priori knowledge of people’s values or that there is some special or intrinsic value in things when creating their spurious models.  In fact, relative values are only revealed through market transactions and market prices.

The most basic way to illustrate the point is that raspberry ice cream and coffee ice cream cost almost exactly the same amount to make.  I will pay dearly for a top quality coffee ice cream but would not consume raspberry ice cream even if you paid me!  This may sound trivial, but the same principle applies all along the spectrum of such values and choices for all products and services.  In the real world of the Austrian school values are rarely, if ever, chosen rationally and the same would therefore apply to our choices as revealed by our market transactions.

Nor can it be said that man always rationally seeks to maximize his monetary gain.  It is not at all unusual for people to make apparently irrational choices against their personal financial interests.  Austrian theory, unlike virtually every other school of economic thought, explicitly recognizes this phenomenon.

Austrian theory does not posit perfect information among any participant let alone among all participants as do classical and neoclassical schools.  Just the opposite, the Austrian view is that knowledge and information is asymmetrical and local.  This is a key reason behind von Mises prediction that Soviet socialism would collapse without a fight.

One key element in Austrian theory is to use irrefutable assumptions to arrive at logically required conclusions.  For example, the theory of how manipulation of interest rates by the monetary authorities cause the boom and bust cycle has at its root the fact that no unsubsidized business enterprise can indefinitely run at a loss.  Also, in a true market economy, interest rates fall only when there is an added abundance of available savings.  Therefore, certain projects can be undertaken only at lower interest rates when savings are relatively high.  When the government artificially lowers interest rates, false information is transmitted to borrowers and lenders regarding the true availability of savings, which results in harsh losses when the truth comes to light much later after the project is completed.

Another difference is the Austrian school eschews modeling and indexing.  You cannot model (quantify) human behavior.  Indexing is equally futile.  It is crude at best.  For an example I refer you to Shadow Government Statistics (shadowstats.com) for a thorough discussion of the shenanigans going on with the Consumer Price Index.

Modern economic theories use complicated models, algorithms and inappropriate mathematical equations to mask the fact that their conclusions are foreordained by their unsupported assumptions.  This is the economics version of GIGO.  We see this every day in nearly always inaccurate forecasts churned out on Wall Street and in Washington.  Worse, when accurate forecasting is needed most the models fail miserably – when we pivot from growth to contraction.  This was most acute in the failure of economists of virtually all explicitly statist as well as faux free market schools to see our current “Great Recession” even when anyone with some common sense and a little observation would have figured it out.

Most of the readers of this post would have seen the crash coming by refraining from watching the news and reading the Wall Street Journal, and instead focusing on what was right before your eyes.  Example were the tsunami of TV advertisements for zero down mortgage loans and later 125% loan to value mortgage lines of credit.

The foregoing represents just a small sample of the important differences between the faux free market schools and the true market economic orientation of the Austrian school.  All of what you have read here is an anathema to the economics profession.  If Austrian school ideas were widely adopted tens of thousands of professional and academic economists would be summarily fired, and the few that remained would earn a small fraction of their current income.

Economists (including the Chicago boys) generally believe they are the anointed, given special knowledge on how the economy works and that they could make things so much better if only they were given the power.  Few if any have the slightest clue about how a business enterprise works.  Nearly all cannot fathom why, for example, a lowly plumbing or electrical contractor can deserve many times what the economist earns.  The Austrian school exhibits no such envy.

The historical record repeatedly validates Austrian theory.  Examples include the stagflation of the 1970’s, the collapse of Soviet socialism and the economic mess we experience today.  Yet, critics of free market economics studiously avoid attacking Austrian theory.  Apparently, power and prestige wins out over the facts.

For more easy to understand analysis and illustrations by an Austrian school economist I highly recommend MELTDOWN by Thomas Woods.

Read the original story at SedonaCyberLink