Part 2: The Fundamentals of Austrian School Economics

The Days Inn is very basic for a motel. They didn't even have an alarm clock! I guess they figured it was too easy to steal. The continental breakfast was lousy, so I'm glad the Mises Institute is going to be feeding everyone before the first session each morning.

There are no concurrent sessions for the first two days of seminar classes; everybody goes to the same lectures. They focus in on the fundamentals of Austrian School Economics...

The first lecture topic was "the Marginalist Revolution" given by Joseph Salerno. The Marginalist Revolution refers to the year 1870, when the subjective theory of value and the law of marginal utility were developed by the first of the Austrian economists, Carl Menger. He solved the classical economic problem of value that had puzzled even the great Adam Smith. Menger looked upon the market and noticed that diamonds had an extremely high price, especially compared to bread. But why is this? Bread is an essential of human life, and diamonds are a luxury good. David Ricardo and Adam Smith could not solve this problem because they believed value was intrinsic to goods, hence this strange working of the market was called a "paradox of value." They attempted to explain it by saying the cost of producing a diamond was much more than the cost of producing a loaf of bread. What they didn't realize is that in the end the consumer determines the prices on goods by their continual choosing of whether to buy or not buy. Thus, the value of goods is subjective to human wants and desire. This is the phenomena of supply and demand. Quoting Menger: "Man is the beginning and the end of any economy." and "Our science is the theory of a human being's ability to deal with his wants. All things are subject to the law of cause and effect."

Jeffrey Herbener then lectured on value, utility, and price. The lecture focused on two fundamental ideas in economics: valuation and appraisement. In the course of the lecture, the price system was also discussed as the bridge between the two. The problem for valuation in society is a tricky issue, how do conflicting value systems work themselves out in the social order? Because means are scarce, we have to compare the value of one thing to another. But value is subjective! It exists in our mind, nothing objective can be said about it. You can't perform arithmetic operations with it, value has to be considered in rank order rather than quantitatively. When we engage in choosing, it's always a comparison of value, motivated by a value difference. These differences are behind personal actions and exchange. Every action has a value (what we mean to obtain) and a cost (what we will forego). Every action aims at a profit. In human action we economize, we try to attain higher valued ends with lower valued means. In a social order, we must make value comparisons and trade with our fellow human beings in order to attain our ends. As a result, prices develop in order to signal people as to what their preferences are.

Hans-Hermann Hoppe lectured next on praxeology, or the logic of action. Almost all mainstream economists nowadays believe their field is an empirical discipline akin to physics or chemistry where propositions must be continually supported by experiments. Austrians of course do not, and yet they were considered "in the mainstream" up until 1950. Modern positivism (also known as methodological empiricism) displaced the old school in universities all around the world. Positivism was a philosophical outlook that was the most influential view in philosophy for a number of years, although it is going out of favor nowadays. Karl Popper was one of positivisms most prominent proponents.

Popper said there are two types of scientific propositions. First are empirical propositions, which can say something about the real world but must be falsifiable by experience. That is, it must be possible to encounter contrary examples to the proposition. However, there is nothing that we can know about reality with certainty. Everything must be falsifiable by a counter-example. The second are analytical statements, which are true by definition, such as that a bachelor means unmarried man. These don't say anything about real world, they are just definitions. There are also normative propositions, which say nothing scientific but can describe tastes (I like this, I don't like this). You should see immediately how troublesome this philosophy can be, but then you probably will also notice that this philosophy falls on its head.

What is the philosophical status of the distinction "all statements are either empirical or analytical"? According to the theory, it has to be empirical or analytical. If it is empirical, then we have made the hypothesis that all statements are either empirical or analytical. We can just as easily claim the opposite. There is no reason to believe it at all even upon "testing," whatever that would entail. If the statement is analytical, then so what? You just defined it… If you are willing to throw out the existence of truth, then none of this argument matters in the first place. But if you expect anything at all to be true, you can't accept positivism. Much more about this can be said, but I think you get the idea. Go read Mises…

Guido Hulsmann from France lectured on the division of labor in society. This could also be called the "Economics of Production" lecture. He started with the general law that human action takes place in a physical context constrained by the laws of nature. As far as production is concerned, there are two laws of nature that are particularly important. First, production takes place in time. Humans act in order to improve their condition, and this is done in time. The second law is the Law of Diminishing Returns, that by increasing the quantity of a factor used to produce a good you get less in return. Since we are limited in time, we sacrifice the production of one good for the production of another good. There are two techniques for increase of productivity. First is the saving of capital. By saving excess production, we can then engage in other new productive efforts. Results in a shift upward of the productivity curve (called the Product Possibility Frontier). The second is the division of labor. Specialization allows people to make more of one thing rather than produce everything. One person has the ability to produce more of good A than good B, and the other person is vice versa because their opportunity costs are different. This is the economic motivation for forming a society. Two completely equal people have no motivation to join forces, so the has an interesting implication for our idea of equality. In fact, inequality is actually a driving force for trade to occur. Economic analysis enables us to understand the mechanisms of production and how to improve our conditions, and also explains the formation of societies.

How can I possibly describe George Reisman's lecture on money and banking? It was absolutely amazing. This man must surely be one of the most brilliant people I have ever known. Reisman is a professor emeritus at Pepperdine University and studied with both Ludwig von Mises and Ayn Rand. In his lecture, he wanted to develop the basis for a theory of monetary society. He started with a question: what is money? Money is simply a generally accepted medium of exchange. People are willing and eager to accept it in return for goods and services and then exchange it again. However money comes into existence, its existence is enormously beneficial. A division of labor society is characterized by individuals producing a small number of things to trade to be consumed by others. The volume of knowledge employed in production has radically increased since the industrial revolution. It represents the body of knowledge from all specializations. We all benefit from individuals producing in kind with their specialized knowledge. A division of labor society would not be possible without money! Otherwise, you would have to trade good for good in ways you couldn't possibly attain - money makes this all irrelevant. How could those who produce capital goods trade for such smaller goods such as a loaf of bread? In the absence of money, the only way to get life's necessities is to be a farmer or to produce the stuff that farmer's frequently need. Because of money, it is not necessary to produce all the goods your suppliers want in return for your farming goods. Money can be exchanged for anything, because everybody wants it in a monetary society. Money broadens the way the division of labor works. Money provides the basis of economic calculation for profit and loss through the cost system. Closely related to this is the ability to compare different methods of production and choosing the most efficient method of production. In essence, money makes possible the modern material society.

Why should gold be used as money? First, gold has been used for centuries. It also has many technological uses because of its excellent physical properties. It can be shaped to be beautiful and then given as gifts to those one loves. However, even though gold has high value because of its uses, many of those uses can be supplied by many other more abundant metal. Gold became a standard because people believed it was a store of value.

This leads us to a discussion about the "quantity theory of money." This is the proposition that the quantity of money that exists is the major determinant of the amount of money that is spent. Any system of redeemable paper money (or any sort of fiat money) must come into existence on the back of a commodity money such as gold. But an essential difference between gold and paper money is the ability to obtain it. Gold is difficult to get - it requires much more effort than simply making paper and slapping some ink on it. Paper could only stay as currency if it were redeemable for gold. Irredeemable paper would become worthless as people could produce it at will. Inflation would then result, and a hard money would again become the standard. But now in the US, you can't redeem paper money for gold from a bank at all - as I recall it's even illegal. Gold money makes the government financially dependent on the citizens, fiat money makes the government financially independent of the citizens. With gold, every time the government needs money it must turn to the citizens. On fiat money, they just print it if the citizens won't give! Thus, even cutting taxes at the whims of citizens makes not one bit of difference if the government prints more paper money whenever they need it - this is inflation and is effectively an unseen tax! Whoever introduces the money into the system enjoys the first gain by buying the goods and services they want with money they did not earn. This is effectively wealth redistribution. The increase in the quantity of money enriches some at the expense of many. Period.


The next lecture was on capital and interest, presented by Robert Murphy of Hillsdale College. Capital and interest is probably the most difficult part of economic theory, according to Murphy. Friedrich Hayek, after writing one volume of a theory of capital and interest, decided to quit and then wrote a treatise on the human nervous system. On a more personal note, Murphy noted that before he got into deep capital and interest theory, he had a full head of hair.

The first thing to note is the distinction between capital and capital goods. Capital is the sum of money you could obtain if you sold all the capital equipment dedicated to a particular enterprise. Capital goods, though, are the actual devices used in making goods. For example, in a Laundromat the capital goods are washers and dryers, the capital is the amount of money you would have if you sold all the capital goods. This distinction is so important that Murphy said he considered planning the lecture so that he would leave right after this statement. We would then understand something that half of all economists couldn't figure out and proceed from there for the rest of our lives. But he figured he would get fired if he did that.

Murphy then described the work of Eugen Bohm-Bawerk, whose primary contribution to Austrian economics was his capital and interest theory. Bohm-Bawerk heavily criticized the naïve productivity theory and explained the theory of originary interest - if you invest money not as a direct loan but to buy factors of production, you earn money in the future. Bohm-Bawerk also examined what is known as the "Structure of Production." This can be easily explained - consider consumer goods, the stuff you buy in a store. First order goods would be the goods that the store uses to sell you the item - shelves, packaging, location, advertising. Second order goods would be the goods that bring the first order items to the seller - trucks, construction services, managements, etc. This "order of goods" from n-th order to first order over time describes the production of a consumer good.

Roger Garrison's lecture on Capital-based Macroeconomics is difficult to describe here because of the frequent graphs he used to explain the workings of the structure of production. The elements of Capital-based Macroeconomics are the "production possibilities frontier" that represents how a market balances the production of consumer and capital goods, the loanable funds market, the structure of production, and stage-specific labor markets.

In the production possibilities frontier (or PPF), investments means the shifting of production efforts towards more capital goods. The economy grows over time when new capital goods are produced. Suppose people become more thrifty, more future oriented. They reach their current consumption and save instead. We would find that the growth rate of the economy increases. Without an initial increase in saving consumption and investment increase modestly form period to period. With an initial increase in saving investment increases at the expense of consumption, after which both consumption and investment increased dramatically from period to period.

Savings also constitutes the supply of loanable funds. The demand for loanable funds reflects the business community's willingness to borrow and undertake investment projects. If people become more future oriented they increase their savings causing the interest rate to fall and thereby encouraging the business community to undertake more investment projects. With a given technology, saving is a prerequisite to genuine (sustainable) economic growth.

We have already talked about the "Structure of Production," so I'll skip to stage-specific labor markets and credit expansion. Most macroeconomists deal with "the labor market" and "the wage rate," but Capital-based Macroeconomics allows for stage-specific labor markets and wage rates. By "stages" Garrison means the various areas inside the structure of production. The result of this line of reasoning is clear; an increase in saving affects the demand for labor in the early and late stages of market production, and hence affects each of those stage wage rates differently.

After setting the stage of the macroeconomy, Garrison focused on explaining the effects of credit expansion by a central bank. Increases in the money supply must enter the economy through credit markets. The central bank literally "lends money into existence" through fractional reserve banking practices. The new money masquerades as saving. That is, the supply of loanable funds shifts - but without there being any increase in saving. Responding to a lower interest rate, people actually save less and consume more. The result is not a new sustainable equilibrium but rather a disequilibrium, that, for a time, is masked by the infusion of loanable funds. Pumping new money through credit markets drives a wedge between saving and investment. Investors move down along their demand curves, taking advantage of lower borrowing costs. Savers move down along their unshifted saving curves in response to weakened incentive to save. The discrepancy between saving and investment is papered over with newly created money, which itself represents no investable resources. Favorable credit conditions spur on investment activity. But income earners are actually saving less (and hence consuming more). The wedge translates into a tug-of-war between consumers and investors ultimately resulting in an artificial boom and eventual bust of the economy, probably sending the economy into recession or depression.

By the way, Roger Garrison is an electrical engineering graduate from the University of Missouri-Rolla. I knew he was cool.