Transcript Slide 1

Introduction to the Austrian School of
Economics
Cameron M. Weber
PhD Student in Economics and
Historical Studies
New School for Social Research
cameroneconomics.com
Introduction to the Austrian School
of Economics
• Unlike most economics the Austrian School
does not separate micro- and macroeconomics
• Economic calculation is made by an individual
at a given time and place with limited
knowledge and based on subjective
preferences
• Society is organized by this ‘market process’
of individual, entrepreneurial, decision-making
Introduction to the Austrian School
of Economics
• The market process means that individual
entrepreneurs (all people) discover ways they can
add value to society and to themselves by
producing economic goods which will be
demanded by others through free-exchange in the
market
• Individual economic calculation improves over
time through trial-and-error and increased
knowledge of ourselves and of the societies in
which we live
Introduction to the Austrian School
of Economics
• A person has the decision to consume now,
indicating high time-preference, or to consume
later, indicating low time-preference
• When individuals save money (lower timepreference) or borrow money (higher timepreference) we are exchanging time-preferences
in the financial markets and each of us benefit
(gain utility) through this free-exchange
• Time-preference is subjective to an individual and
dependent on each unique time and place of
economic calculation
Introduction to the Austrian School of
Economics
Historical Examples
When human society first formed we were
hunter-gatherer tribes we very high time
preference. We lived day-to-day and did not
have a societal division of time-preferences.
There was as of yet any economic calculation in
early human societies as no one was planning
for the future.
Introduction to the Austrian School of Economics
Historical Examples
Hunter-Gatherer Tribes Consumption is the same as production
Consumption
Production
The capital structure in society is represented in the “Hayekian Triangle”,
formulated by Hayek (1931) and built-upon by Garrison (2001).
Introduction to the Austrian School of Economics
Historical Examples
• As society began to develop into primitive
agriculture specialization of labor began to
occur and different people began to do
different things based on their subjective timepreferences and economic calculations
• Some people made primitive farm tools, others
raised animals, others planted and harvested
crops, others stored and distributed the
agriculture products
Introduction to the Austrian School of Economics
Historical Examples
• Society developed from one without capital
investment into one with differing investments
based on how far removed from consumption
the investments took in time
• The longer the “pay-back” for a person’s
investment the lower is that person’s timepreference, they could wait longer for
remuneration by expecting a higher profit for
waiting
Introduction to Austrian School of Economics
Historical Examples
Primitive Agriculture Societies Stages of Production begin to develop
1 year
2 years
4 years
Consumption
farming
animal
husbandry
time
Production
toolmaking
Introduction to the Austrian School
of Economics
The development of varying time-preference
based investments in the means of production
depends on the expected cooperation of
society, which is factored into the economic
calculation
With sound societal institutions longer, more
efficient, investments processes can take place
and economic growth can occur
Introduction to the Austrian School of Economics
Historical Examples
• We can see from our primitive example some
important aspects of economics. It takes four
years to make a tool versus the 2 years it takes to
raise animals. Therefore the tool-maker is taking
on more risk. There is risk that the iron-based
tool-making process may not work, or that the
farmer who has contracted to buy the tool may
have a crop failure and be unable to pay or that
the animals that the herder tends with grain from
the farmer may have a disease and thus the farmer
might not get paid and in turn the tool-maker
might not get paid.
Introduction to the Austrian School
of Economics
• This primitive example shows how all
economic calculation in a society is causal and
inter-related
• Each person along the stages of production
leading to consumption depends on
cooperation with their trading partners along
the causal chain
Introduction to the Austrian School
of Economics
• Societal development at large in turn depends on
the ability to price contracts based on the time and
place of economic calculation, and the degree of
expected societal enforcement of these contracts
• The more a society is able to freely-contract and
price-in longer term risk, the lower timepreferences become, and the more that longerterm more efficient production process are
developed
• This in turn leads to increasing standards of living
Introduction to the Austrian School
of Economics
• The development of institutions in society
which help to create these longer-term more
efficient means of production is known as
‘economic development’
• Without trust and cooperation, and without
freely-moving market prices signals, the ability
to make subjective economic calculation is
limited
Introduction to the Austrian School
of Economics
• As societies develop through today what is
known as ‘capitalism’, they become
increasingly complex and interdependent
• It is impossible for any one person or any
group of persons to know the multidimensional, multi-causal relationships,
entrepreneurial decision-making and
contracting which occurs in modern societies
Introduction to the Austrian School
of Economics
• Carl Menger (1871) in the founding work of
Austrian School economics described the
economic calculation each person makes as
‘imputation’. We all know subjectively what
brings us value (utility) and we base our
decisions on fulfilling these utility needs, both
backward and forward in time. This is
‘imputation’.
Introduction to the Austrian School
of Economics
• The market provides us price signals, prices
which adjust up and down the causal chain
depending on the dynamic utility-satisfying
economic calculations of others
• Hayek describes the importance of the price
signal to the welfare-maximizing selforganization of society in “The Use of
Knowledge in Society” (1945)
Introduction to the Austrian School
of Economics
• Without market price adjustment capital
investment is made in stages of production and
for goods and services that society does not value
• It is price-adjustment based on individual time
and place which organizes an otherwise very
complex society
• When these prices signals fail due to institutional
constraints, so can societal organization, leading
to crisis
Introduction to the Austrian School of
Economics
Capitalist Societies Highly complex inter-related Stages of Production
Distribution
Light
Manufacturing
Retail
Wholesale
Heavy
Manufact.
Chemical
Processing
Machine tool
Production
Steel
Smelting
Mill
Works
Iron
Smelting
Consumption
Mining
Research and
Development
time
Production
Introduction to the Austrian School
of Economics
In modern industrial capitalism in a global
economy there are hundreds of millions of
firms and entrepreneurs investing hundreds of
billions of dollars and hiring billions of
workers. Each of these investment, trade and
hiring decision require economic calculation.
In such a geographically-disbursed and
decentralized economy the importance of the
self-organizing price mechanism should not be
minimized.
An Austrian School Explanation for
the Financial Crisis
• If we divide our capital structure into the sources
and uses of money (loanable funds) available for
real estate investment in the economy we can
isolate the “housing” stage of production
• Because housing was heavily subsidized by tax
and regulatory policy (mortgage interest tax
write-offs and Ginnie Mae and Freddie Mac
guarantees of mortgage-backed securities) the
price signals were maladjusted to the economic
actors in society
An Austrian School Explanation for
the Financial Crisis
• Housing prices (the cost of housing finance)
seemed cheaper than they really should have
been according to society’s time-preferences
for housing, so the too-low price signal created
an over-investment in housing (a “bubble”)
relative to the other stages of the real estate
capital structure
An Austrian School Explanation for the
Financial Crisis
Sources and Uses of Loanable Funds for Real Estate The Housing "Bubble"
Retail
Establishments
Transportation
Infrastructure
ManufacturingFactories
Real Estate
Sources of
Loanable
Funds
Housing
Real Estate
Commercial
Real Estate
time
Uses of Loanable Funds
An Austrian School Explanation for the
Financial Crisis
• When the Federal Reserve Bank increased interest
rates in 2006 this sent a price signal raising the
cost of real estate capital, helping to “pop” the
unsustainable housing bubble
• Because the over-investment in housing was not
able to correct itself through liquidation of the
mortgage-backed securities due to the bailouts of
the financial institutions holding these securities,
price adjustment has not taken place, causing
crisis
Austrian School Capital Theory and the
“Natural Rate” of Interest
• The price of money (loanable funds) used for
investment is the interest rate
• The interest rate is what matches the timepreferences of borrowers (investors) with the
time-preferences of lenders (savers)
• Absent price-distortions, where the Supply and
Demand of loanable funds meet the needs of
borrowers and lenders we find the “natural rate”
of interest
Austrian School Capital Theory and the “Natural
Rate” of Interest
Loanable Funds Market
Price
(Interest Rate)
Supply
(Savers)
i*
Demand
(Borrowers,
for Investment)
$*
Quantity ($$'s of
Loan Agreements)
In our example the natural rate of interest (i *) matching the timepreferences of savers and borrowers is 5% and per year contracted
amount ($ *) is $250 billion.
Austrian School Capital Theory and
the “Natural Rate” of Interest
• Now let’s assume that instead of the price
signal for the interest-rate being set in the
market, e.g., at a “natural rate”, the interest
rate is manipulated by a central monetary
authority or central bank
Austrian School Capital Theory and the “Natural
Rate” of Interest
• If the central bank sets an interest rate price for
loanable funds that is too low, and makes
funds available to the banks to cover the
shortage so that a lower rate would not prevent
savers from saving instead of consuming, then
investors have a price signal that will
encourage them to invest in longer-term (lower
time-preference preference) stages of
production than they would under a natural
rate
Austrian School Capital Theory and the “Natural
Rate” of Interest
Artificially-Low Interest Rate and Over-Investment
Consumption
capital structure under a natural
rate of interest
over-investment
due to artificiallylow interest rate
Production (investment in means of production)
Austrian School Capital Theory and
the “Natural Rate” of Interest
• The artificial-low interest rate encourages
investment in stages of production which
would not occur under a market-determined
natural rate of interest, economic calculation
has been distorted because the price signal
(interest rate on money) has been distorted
Austrian School Capital Theory and
the “Natural Rate” of Interest
• Entrepreneurs (people) build things or start to
build things, and hire people away from other,
later, stages of production due to these new,
lower, price signals (a lower rate of interest
means a lower investment hurdle and therefore
longer-term more risky projects now seem
feasible under a central bank-manipulated
lower interest rate).
Austrian School Capital Theory and the “Natural
Rate” of Interest
• When the artificially-low interest rate is
discovered by market actors, inflation fears
start to set-in so the central bank is forced to
raise the interest rate to prevent inflation
• At this point those investments made under the
artificially-low interest rates are no longer
feasible so economic actors abandon the overinvestment begun under the artificially-low
interest rate
Austrian School Capital Theory and the “Natural
Rate” of Interest
• Because it is not possible to instantaneously giveup one investment for another this causes
unemployment and wastes resources in halffinished projects
• The end result of centrally-planned monetary
policy is needless unemployment and capital tiedup in unfeasible projects which could otherwise
better be applied elsewhere
• Bailouts just exacerbate the problem because
oftentimes only bankruptcy can free-up resources
and allow renewed entrepreneurial discovery
Introduction to the Austrian School
of Economics
The Law of Supply and Demand
• In many economic models it is assumed that
“one-price” clears the markets and creates an
equilibrium where price adjusts to meet Supply
and Demand
Introduction to Austrian School of Economics
Example of the Non-Austrian Theory of “One-Price” in Supply
and Demand
Market for a Pound of Coffee
Price
Supply
$10
Demand
100 pounds
Quantity
Austrian School Supply and Demand
• This “one price” theory can be juxtaposed with
the Austrian School theory that because of the
human impossibility of perfect information, and
the local and decentralized nature of economic
calculation, there is not “one price” which clears
the market, but rather Hayek’s notion of a
“pattern of outcomes”
• The market tends towards equilibrium but is in
constant flux due to entrepreneurial discovery,
therefore, a “one price” equilibrium does not exist
Austrian School Supply and Demand
Market for a Pound of Coffee
Price
Range of
prices at
any one
time
$10
Supply
. . . . .
.. . . ... . .
. . . . . ... .. . .
. . . . . .
. .. . .
..
. .
....
.
Hayek's "pattern
of outcomes"
Demand
100 pounds
Quantity
Range of quantity sold at any one time
Introduction to the Austrian School of
Economics
Summary:
The Austrian School of Economics provides an
alternative to mainstream economic thinking and is
based on individual entrepreneurial economic
calculation at a given time and place given
uncertainty
The “market process” provides a logical tool to explain
the development and organization of society based on
human action and time-preference and shows the
importance of market-based price signals to provide
for society’s welfare
Introduction to the Austrian School
of Economics
References:
Eugen Bohm-Bawerk (1888), The Positive Theory of
Capital
F.A. Hayek (1931), Prices and Production
F.A. Hayek (1945), “The Use of Knowledge in Society”
Roger Garrison (2001), Time and Money: The
Macroeconomics of Capital Structure
Carl Menger (1871), Principles of Economics