Modern economics was born in the early 1870s when the British economist Stanley Jevons, the French economist Léon Walras, and the Austrian economist Carl Menger independently solved the paradox of value. How is it that diamonds, a dispensable luxury have a higher price than water, an indispensable necessity? The solution was the recognition that the price of a good is determined by the relationship between the desire people have for it and the amount of it that is available for people to have. In short, the degree of a good’s scarcity determines its price.
Menger laid a foundation for economics on the action of persons (instead of groups) and a method suitable for a science of human action (instead of methods of the natural sciences). Students across Europe were drawn to Vienna to study under Menger not only for his pioneering approach but also for his attractive personal qualities as a teacher and mentor.
A thriving community of scholars arose in the wake of Menger’s achievements. Like in every lively academic discipline, members of the Austrian school had vigorous debates among themselves and with scholars of other schools of thought.
The contemporary Austrian school is still a living and active academic community. Austrian economics continue working to build upon the edifice of economic theory grounded on the foundation Menger laid 150 years ago with the same goal of advancing our understanding of the social world. Although the Austrian approach of Menger has some affinity with the neoclassical approach of Jevon and Walras, the advantage of its distinctiveness has proven itself in its power to explain human events. The following three examples illustrate the point.
Capital and Interest and Marx’s Exploitation Theory of Wages
The foremost student of Menger during his tenure at the University of Vienna was Eugen von Böhm-Bawerk. By the end of the 19th century, Böhm-Bawerk was counted as one of the top economists in the world. His devastating refutation of the labor theory of value stands today among economists as definitive. Based on the labor theory of value, Marx claimed that capitalists expropriated surplus value from what was rightfully due to labor’s productivity. Having refuted the labor theory of value, Böhm-Bawerk advanced an alternative explanation for the return received by capitalist. He demonstrated that this return was earned by capitalists for advancing income to workers during the production process before revenue was received from the sale of output. Böhm-Bawerk’s explanation of the return to capitalists was a part-and-parcel of his understanding of the broader field of capital and interest. His views have been the genesis of both neoclassical and Austrian theories of capital and interest advanced from his day to the present.
The Great Depression and Great Recession
Ludwig von Mises was among the most gifted students of Böhm-Bawerk during his tenure as a professor at the University of Vienna. In 1912, Mises published his book, "The Theory of Money and Credit," in which he sketched out his business cycle theory. During the 1920s, he and F.A. Hayek worked together to elaborate the theory more fully. Austrian business cycle theory demonstrates that periods of credit expansion fueled by monetary inflation result in misdirecting investment into building up the capital capacity of an economy in a manner that proves to be unsustainable. Economic booms, such as the roaring 20s before the Great Depression or the housing boom of the 2000s before the Great Recession, inevitably collapse as resources become further and further misaligned with people’s preferences for having consumer goods produced sooner instead of later. The bust that follows the boom reallocates capital and labor into sustainable patterns as determined by people’s preferences. In 1974, Hayek was awarded the Nobel Memorial Prize in Economics, in part, for his contributions to Austrian business cycle theory.
Central Planning and Political Direction of Resources
In 1920, Mises advanced one of the most provocative economic arguments in the twentieth century. In his book, "Socialism," he demonstrated that central planning of a modern, industrial economy was impossible and by implication that socialism is not an economy at all. Decisions about the use of resources in a genuine economy must be economizing for participants. The market economy achieves this condition by giving legal protection to private property and voluntary exchange. Social interaction among participants in the market results in money prices for all traded goods and factors of production. Entrepreneurs who decide what and how to produce goods can organize production within their enterprises by economic calculation of monetary profits and losses accruing to various lines of production. In socialism, the state owns all means of production. There can be no trade in resources and, therefore, no resource prices. Deprived of economic calculation, central planners cannot make decisions about the use of their resources that economizes them in attaining what they want produced.
Mises’s argument ignited an extended debate with economists of other schools of thought who were attempting to circumvent his claim. A summary of his rebuttals can be found in his 1949 book, "Human Action."
Having demonstrated the primacy of private property to the operation of a genuine economy, Mises, Hayek, Murray Rothbard, and other Austrian economists extended the argument to political direction of resources within an otherwise market economy. Because the decisions of political officials are not fully bound by economic calculation, political direction of resource use always involves a deficiency in economizing. The broader the scope of political decision making over the use of resources, the greater the degree of inefficiency. The inefficiency from not being fully bound by economic calculation is distinct from that generated by corruption or deficiency of personal qualities that may be associated with political officials.
The application of these insights can be seen in the history of the economies in the last 30 years. As private property rights have been strengthened in various countries around the world, freer economies have raised standards of living dramatically. According to the World Bank, from 1990 to 2019 the number of people living in extreme poverty has fallen from two billion to less than 700 million.
In conclusion, economists working in the tradition begun by Carl Menger 150 years ago have continually made significant contributions to the understanding of the working of economies. They have enlightened economists with a rich theorical insights and politicians with robust policy analyses. Each generation has contributed to the debate over issues of its day. The current generation is focusing on issues of its day such as the role of entrepreneurship, the economics of war, causes and consequences of economic development, the impact of fiscal and monetary policy, and private versus state governance.