The Austrian School of Economics has been widely identified with classical-liberal and free-market ideas. This is especially the case in the writings of Ludwig von Mises (1881–1973) and Friedrich A. Hayek (1899–1992). But the free-market, liberal orientation of many members of the Austrian School goes back to its founding in 1871 with the publication of Carl Menger’s (1840–1921) Principles of Economics in 1871. This was most clearly seen when he served in 1876 as tutor in political economy to the Habsburg heir-apparent Crown Prince Rudolf (1858–1889), in a series of lectures in which he educated the young prince in the logic and workings of a competitive market economy and the dangers from socialism and paternalist interventionism. Alas, the Prince Rudolf took his own life in a moment of great despair over his personal circumstances in 1889. (The lectures only appeared in English in 1995 under the title Carl Menger’s Lectures to Crown Prince Rudolf of Austria.)
Menger developed a subjective theory of (marginal) value to explain the process by which prices emerge in the market for both finished goods and the factors of production and how competition tends to bring about a balancing or coordination of supply and demand. He also devoted a chapter to showing how money emerges out of the “spontaneous” interactions of multitudes of transactors over time and is not the creation of the government.
In his second book, Investigations into the Methods of the Social Sciences (1883), besides defending the analytical importance of economic theory in place of merely descriptive history, Menger restated his theory of the evolution of money in the wider context of showing how many, if not most, social institutions — language, custom, tradition, law, notions of rights — are also the product of spontaneous evolutionary processes of far greater long-run significance than government legislation, regulation, and decrees.
Eugen von Böhm-Bawerk and Friedrich von Wieser
The liberal orientation of the Austrian School continued with one of its first intellectual followers, Eugen von Böhm-Bawerk (1851–1914), who became an internationally renowned economist as the developer of the “Austrian” theory of Capital and Interest (revised ed., 1914). He also served three times as finance minister of the old Austro-Hungarian Empire. Particularly during his four-year term in that office between 1900 and 1904, he limited government spending, reduced the national debt, opposed wasteful infrastructure projects, and supported liberal free-trade policies.
He also criticized the proto-Keynesian ideas of his time, including the notion that government spending can create lasting prosperity separately from market-based savings and investment. His last written work, published shortly after his death in 1914, was Control or Economic Law, in which Böhm-Bawerk demonstrated that price controls, including minimum wage laws, cannot repeal the market laws of supply and demand and can only result in imbalances and distortions between the two sides of the market that in the long-run make the conditions of workers worse, not better.
Menger’s other early intellectual follower, Friedrich von Wieser (1851–1926), became famous for the development of the subjectivist theory of cost. Cost is not the quantity of labor that goes into the manufacture of a good; rather, it is the value to the individual decision-maker of the foregone alternative uses of the scarce means available to him for another purpose considered of greater value or importance by that individual. Wieser understood very well the prerequisites and workings of the market economy and especially highlighted Menger’s theme that the institutions of society are primarily the outcome of free “spontaneous” social evolution and development, not the product of political or legislative designs and commands.
But he was more in sympathy with some of the “social” liberal ideas of the late nineteenth and early twentieth centuries on policy issues such as income redistribution. For instance, in his major treatise Social Economics (1914), he argued that the theory of diminishing marginal utility could be used to demonstrate that the last unit of money in the possession of a rich man would have a far lower value to him than such a dollar would add to the wellbeing of a financially poor person if transferred to him by either charity or government through progressive taxation. He was also more tolerant of some tariff restrictions on behalf of domestic sectors of the national economy.
Wieser’s analysis of political elites, social processes, and institutional evolution appeared in The Law of Power (1926); he has often been accused of a bias in favor of political elites, arguing that society is always the product of “the few” guiding and directing “the many.”
One of the early “Austrian”-oriented textbooks in the German-language was written by Eugen von Phillippovich (1858–1917), Foundations of Political Economy (1893). Phillippovich had studied with Menger at the University of Vienna and became a professor there in 1893. He clearly and thoroughly explained the “individualist” principles and premises underlying any real understanding of the logic and universal validity of core economic concepts and their playing out in the marketplace. But he, too, like Wieser, was open to a variety of government interventions in the name of social justice and the attempt to ameliorate the economic conditions of the “working class” and the poor, and he also spoke of a “national interest” that at times had to preempt the narrower interests of the individual.
Ludwig von Mises and the “Austrian” liberal tradition
It is in the period just before and during the two decades after the First World War that the Austrian School became far more clearly and distinctly associated with free-market and classical-liberal policies. With little doubt, it originated with and was most consistently developed by Ludwig von Mises. As a student at the University of Vienna, Mises was at first heavily influenced by the interventionist ideas of his time. But in his Memoirs (1940), Mises said that it was reading Menger’s Principles over the Christmas holiday in 1903 that “made me an economist.” He later participated in a university seminar run by Böhm-Bawerk, and this also greatly impacted Mises’s thinking on economics in general.
In addition, as a graduate student, he wrote a series of economic history monographs on the emancipation of the peasantry in the Galicia region of Austria-Hungary in the late eighteenth century and then on the introduction of government-built and subsidized public housing in Vienna in the late nineteenth century. He concluded that all real improvements in the working and living conditions of the poor and less well-off had been due to the freeing of markets from government control and the initiative of private enterprise. Political interference, he said, had been the great barrier to human betterment. His reading of the early Austrian economists and his historical research made him a proponent of free-market classical liberalism when he was in his mid-twenties.
His other major area of study in the years before the First World War had been on the nature of money and the monetary and banking systems. These culminated in The Theory of Money and Credit (1912). In it, Mises laid out what became known as the Austrian theory of money and the business cycle. The booms and busts of the business cycle, with accompanying inflations and depressions, are not inherent in the market system but are ultimately due to various forms of government control and manipulations of money, credit, and interest rates in the banking system.
His theoretical and policy conclusions were refined in the second edition of The Theory of Money and Credit (1924) and in Monetary Stabilization and Cyclical Policy (1928). Mises concluded that the only way to prevent or minimize the likelihood of the reoccurrence of the business cycle was the separation of government from the monetary and banking systems. The medium of exchange should be determined by the free choices of participants in the marketplace, and central banking should be replaced with free, private competitive banking. He reiterated and improved this argument in his discussion of money, banking, and the business cycle in his magnum opus, Human Action: A Treatise on Economics (1949; revised ed., 1966).
But what won Mises international recognition and, indeed, controversy for the rest of his life, was his critique of socialist central planning. In the immediate aftermath of the First World War, and in the wake of the communist revolution in Russia in 1917, a growing socialist movement in many European countries was presumed to be leading to “the end of capitalism.” In its place would come government ownership and control of the means of production, with central planners determining what would be produced, how, where, when, and for whom. Most previous critics of socialism had focused on the danger of a terrible tyranny once government controlled the entire economy, determining and dictating the life of everyone in the society, from which there would be no escape since there no longer would be a private sector offering some haven from the all-powerful grasp of the state.
Mises’s critique of socialist central planning
Mises asked a simple but fundamentally profound question, first in his article, “Economic Calculation in the Socialist Commonwealth” (1920), and then in Socialism: An Economic and Sociological Analysis (1922, revised eds. 1932, 1951). How would the socialist planners know how to rationally and efficiently utilize the scarce resources of the society for the betterment of “the people” than the market system that socialism had now replaced? With the nationalization of all the means of production by the state, there would be nothing to (legally) buy and sell. With nothing to buy and sell, there would be no ability or incentives for people to make bids and offers for the purchase and hire of land, labor, resources, or capital, especially since there would no longer be private entrepreneurs making appraisements as to how best to apply them in manufacturing goods wanted and paid for by consumers.
Without bids and offers there would be no agreed-upon terms of exchange, and without agreed-upon terms of exchange, there would be no market prices to inform all participants in the economy what goods were wanted by consumers and what might be the most highly valued and best uses of those scarce resources in producing those desired consumer items. Hence, there would be no means or method
for rational economic calculation. Competitive, market-generated prices give direction and orientation to all that goes on in the market system of division of labor, said Mises.
Abolish private property in the means of production, eliminate the market system of exchange with the motivations of pursuing profits and avoiding losses, and end a market-based medium of exchange through which the value of everything may be commonly expressed for ease of economic calculation, and the central planners will have institutionally created a system of what Mises later called Planned Chaos (1947).
Mises’s conclusion, therefore, was that institutionally, if a society of both freedom and prosperity is desired, there is no substitute for a functioning competitive free-market economy. A comprehensive system of socialist central planning would only lead to economic disaster and human material hardship. The history of all systems of socialist central planning, from the Soviet Union to Mao’s China, to Cuba, North Korea, and all the others, have confirmed what Mises argued starting in the early 1920s. But was there no middle ground between laissez-faire and the total command economy? Could there not be a “mixed” or interventionist economy?
Mises’s critique of the interventionist state
Ludwig von Mises concluded his analysis of alternative economic systems with his next two books, Liberalism (1927) and Critique of Interventionism (1929). Liberalism is a highly readable, clear, and articulate case for the free society based on individual liberty, free markets and free trade, and a government primarily limited to the securing of people’s life, liberty, and honestly acquired property. In addition, he criticized imperialism, colonialism, and authoritarianism in general, concluding that only the power of ideas can secure a free and prosperous society; liberty can never be won through political intrigue or manipulative propaganda.
But what about a “middle way?” Government intervention and regulation did not fully do away with the institutions and functioning of a market economy, but it imposed controls, prohibitions, and restrictions the cumulative effect of which was to undermine the efficient operation of the market, ultimately threatening the ability of the market to effectively function at all. Production restrictions, commands, prohibitions, and controls, all ended up narrowing or preventing the ability of private enterprisers to fully make their own decisions on how best to (peacefully and honestly) apply and utilize the scarce means of production under their ownership and control in the service of consumer demand, from which they hoped to earn profits and avoid losses.
The most disruptive form of government intervention, Mises argued, were all types of price controls. His critique of socialist planning had made it clear that market-based prices have a vital function: to inform entrepreneurs what is wanted by the consumers and what are the appraised value of resources on the supply-side of the market in terms of their worth and cost in alternative lines of production. Market prices also serve, at the same time, to bring the two sides of the market into coordinated balance through competitive bids and offers by demanders and suppliers. Mises insisted that when government attempts to impose either minimum or maximum price controls on various goods and services in the market, it soon brings about wasteful surpluses when prices are fixed above market-determined prices and frustrating shortages when prices are fixed below market-determined prices.
The dilemma, Mises reasoned, is that when the government fixes, say, the price of milk below what was or would be the market price, the supply of milk falls short of all that consumers would desire to purchase at the controlled price. The only way retail milk suppliers could afford to continue to buy the same or a larger quantity of milk from the milk wholesalers is for the government to extend the price controls to the wholesale level. But now, at this below-market wholesale price, the wholesalers cannot afford to continue to buy the same amount of milk from the dairy farmers. So then the government would have to extend the price controls to the dairy farmers. But, once again, the below-market price fixed for the sale of milk from the farmers would reduce the farmers ability to afford to purchase the same amount of feed and other supplies without which they cannot continue to raise and care for the same number of dairy cows. So, once more, the controls must be extended to the suppliers of inputs to the dairy farmers. But now, the same problem arises for the suppliers of daily farm inputs. The result, concluded Mises, was that step-by-step, the price controls would have to be extended throughout the entire economy due to the interconnectedness of all markets and prices.
At the end of the day, if the government refused to give up its attempt to artificially fix the prices for various goods, the controls finally would have to encompass the entire economy. But then, since prices could no longer guide market-based decisions in determining what, how, where, and for whom to produce, the government would have to come in and dictate these decisions. Hence, through the introduction and extension of price controls, the government would have imposed (even if not intentionally) a form of centralized planning over the entire society.
The conclusion that Mises reached, therefore, was that socialism was an inherently dysfunctional economic system, and the interventionist economy was fundamentally unstable and distortion-creating through price controls and production regulations. Hence, there is no logical and institutional alternative to a free and competitive market economy in which government’s role is to secure and protect the individual’s right to his life, liberty, and honestly acquired property, and under which all human interactions in the social system of division of labor are based on voluntary agreement and mutual consent.
Mises’s influence on a new generation of Austrian economists
Through his books and articles, his teaching at the University of Vienna as an unsalaried lecturer (a privatdozent), his work as a senior economic analyst for and public figure of the Vienna Chamber of Commerce, Crafts and Industry, and his organizing of a private seminar of selected Viennese scholars and authors covering several fields and disciplines that would meet regularly at his Chamber offices, Ludwig von Mises succeeded in influencing a generation of younger “Austrian” economists in the 1920s and 1930s. Many of them later became internationally renowned.
They included Gottfried Haberler (1900–1995), who wrote The Theory of International Trade (1933), Prosperity and Depression (1936), Economic Growth and Stability (1974), and Judging Economic Policy (1997); Fritz Machlup (1902–1983), whose works included The Stock Market, Credit, and Capital Formation (1931; revised ed., 1940), A Guidebook Through Economic Crisis Policy (1934), The Political Economy of Monopoly (1952), The Economics of Sellers’ Competition (1952), and “Liberalism and the Choice of Freedoms” (1969); Oskar Morgenstern (1902–1977), who wrote Economic Forecasting (1928), The Limits of Economic Policy (1934), The Theory of Games and Economic Behavior (1944, coauthored with John von Neumann), and On the Accuracy of Economic Observations (1966); and, in Great Britain, Lionel Robbins (1898–1984), who oversaw the economics program at the London School of Economics and transformed the LSE into what one German economist called in the early 1930s (with a high degree of exaggeration), “a suburb of Vienna.” Even when not all of them fully accepted Mises’s integrated and consistent analysis and defense of the liberal, free-market society and its laissez-faire implications, virtually all of them were greatly influenced by his ideas in fundamentally free-market-oriented policy directions.
Friedrich A. Hayek on business cycles and Keynesian economics
No doubt, however, the younger Austrian economist most influenced by Mises in these years, the one who took up and developed many of Mises’s ideas and gave them further international exposure and recognition, was Friedrich A. Hayek. Hayek returned from his service in the Austrian Army during the First World War and earned a doctoral degree in jurisprudence at the University of Vienna in 1921, followed by a second doctorate in political science from the university in 1923. At that time, economics was taught as part of the law faculty, and it is in that way that Hayek was trained to be an economist, at first greatly influenced by Friedrich von Wieser, who replaced Carl Menger at the University of Vienna when Menger retired in 1903.
In need of a job upon graduation from the university, Hayek found one in a government office being run by Mises as part of sorting out the postwar financial arrangements among the successor states to the old Austro-Hungarian Empire. In later years, Hayek more than once said that for the next decade there was no other person who so molded his thinking on economic and social matters as did Ludwig von Mises. This was reinforced by Mises helping to arrange the financing and the legal documents for the establishment of the Austrian Institute for Business Cycle Research in 1927, with a young, twenty-seven-year-old Hayek as the institute’s first director. Hayek soon gained the institute growing respectability in Austria and Europe in general through the monthly economic bulletins written almost completely by him, the joint work he arranged between the institute and the economic section of the League of Nations in Geneva, Switzerland, and his own scholarly and policy writings.
But what redirected his professional career for the rest of his life was an invitation to deliver a series of lectures at the London School of Economics in January 1931, which led to a visiting and then permanent professorship at the LSE, where he remained until 1949, when he accepted an appointment at the University of Chicago, which he held until 1962. His lectures were published later in 1931 as Prices and Production (2nd revised ed., 1935), followed by the English translation and publication of his 1929 book, Monetary Theory and the Trade Cycle, in 1933.
In these two works, Hayek presented his version of the Austrian theory of money and the business cycle, arguing that it was the monetary policies of the Federal Reserve during the 1920s that created the distortions and imbalances between savings and investment that made the economic downturn of 1929 and the resulting depression inescapable. He also explained that the severity and duration of the depression of the 1930s was not a “failure of capitalism” but the product of the unprecedented degree of government interventions that prevented markets from a normal and reasonably short-lived rebalancing and readjustment back to a market-based “full employment.”
This put Hayek on a collision course with British economist John Maynard Keynes (1883–1946). Hayek wrote a devastating lengthy review essay of Keynes’s A Treatise on Money (1930), in which he drew attention to numerous logical errors, factual misinterpretations, and economic fallacies and confusions, especially with Keynes’s misplaced focus on economic aggregates and averages instead of understanding the microeconomic interconnections between prices and time-consuming production processes that are at the heart of economic coordination and the potential for discoordination and depressions. Keynes implicitly admitted defeat and went back to Cambridge University to lick his wounds and work on a new book, The General Theory of Employment, Interest, and Money (1936), which became the starting point for Keynesian economic theory and “activist” monetary and fiscal policy. In later years, Hayek said he greatly regretted not returning to the battle and critically reviewing this work of Keynes as well.
Hayek’s political and economic critique of socialist central planning
With the severity of the Great Depression, many academic and intellectual eyes turned to the Soviet Union, where Stalin had instituted full socialist “five-year” central planning in 1928 as an alternative to a “failed” capitalism in the Western world. Little attention was given to the government-imposed famine to coerce the peasants into government collective farms, or the mass murder of those accused of trying to “wreck” the central plan when failures and shortfalls occurred in meeting planning targets, or the millions arrested and sent to prison camps in Siberia and Soviet Central Asia to help fulfill the planning goals through forced labor.
The case was made for forms of central planning in the Western democracies, only without the “rough edges” of Soviet-style dictatorship and brutality. Hayek’s most famous response was in The Road to Serfdom (1944), in which he calmly and cogently argued that regardless of the good intentions and democratic sentiments of socialists in countries like Great Britain, the very institutional nature of a centrally planned economy was to narrow individual freedom and choice to the confines of the goals and targets set by the central planners. Personal freedom, civil liberties, and economic choices would have to be radically reduced if “the Plan” was to be achieved. This would also seriously threaten the rule of law and the democratic processes of the country. Socialist planning, if fully implemented, ran the risk of returning society to a system of government-controlled serfs, tied down to what the government commanded them to do and how to live.
In addition to the political analysis of the consequences of socialist planning, Hayek built on Mises’s earlier critique of socialism to argue in a series of articles that central planning was inherently unworkable, independent of its threats to human liberty. These writings may be found in his collection of essays, Individualism and Economic Order (1948), the most important of which are “Economics and Knowledge” (1937), “Socialist Planning: The Competitive Solution” (1940), “The Use of Knowledge in Society” (1945), and “The Meaning of Competition” (1946).
Matching the division of labor is a division of knowledge of many layered sorts that only the individual members of society possess, know, understand, and have the ability and incentives to try to effectively use, guided by the profit motive and the price signals of a competitive market order. Through prices, all participants in the market communicate with each other in a convenient and shorthand form about what goods and services they may desire for reasons only they know in their respective corners of society, along with competing private enterprisers deciding on what they may think resources and types of capital and labor are worth when used in alternative lines of production. Prices integrate, coordinate, and disseminate more information in a simple, economizing form than any single or group of central planners could every successfully know or understand, regardless of how wise and well intentioned they may be.
Without all the individuals in all the corners of the world having the liberty to use their knowledge, judgements, and abilities as they see fit, and coordinated through the now global network of market prices that incapsulate everything that everyone knows, wants, and may be willing to do, society (meaning all of us) cannot benefit from all that others know that we do not for the greatest betterment of ourselves and everyone else. Markets and prices must be free to bring about the human improvement that only a free society makes possible.
The spontaneous order and the later generations of Austrian economists
In his later works, The Constitution of Liberty (1960) and his three-volume Law, Legislation, and Liberty (1973–1979), Hayek extended his analysis of man and mind to an understanding of the general social and political importance of the liberal market society. Following in Menger’s footsteps, Hayek emphasized that our complex human order has not been the result or outcome of human design but is the outgrowth of the spontaneous development of human interactions inside and outside of the marketplace over multitudes of generations. The preservation of and the improvements in a free and “great society” require a clear system of rule of law that restricts infringements on people’s peaceful freedom of action, with a limited government that secures liberty rather than violating it.
All that later “Austrian” economists, such as Israel M. Kirzner (b. 1930) or Murray N. Rothbard (1926–1995) have contributed to the body of Austrian economic theory and policy analysis, to name only two of the most prominent and important contributors in the post–World War II period in the United States, have built on the writings of those earlier members of the Austrian School, especially Mises and Hayek. And they, in turn, have inspired new generations of younger “Austrians” who continue the tradition, including its policy implications for a liberal market order. At the heart of many of the new contributions by these intellectual heirs of Menger, Mises, and Hayek are precisely the importance and wonder of a social, cultural, and economic order without imposed political design, one that is threatened by all governmental encroachments on the free interactions of humanity’s billions. Only the establishment of a truly (classical) liberal society, based on the many insights of the “Austrian” analysis of the dynamics of the market process, can ensure continuing improvements in the conditions of humankind.
This article was originally published in the November 2023 issue of Future of Freedom.