Appendix A: A Brief History of the Austrian School

THE AUSTRIAN SCHOOL of economics can trace its roots back to at least the fifteenth century, when the followers of St. Thomas Aquinas, writing and teaching at the University of Salamanca in Spain, sought to explain how individual human action created social order.

These Late Scholastics observed the existence of economic laws. Over the course of several generations, they discovered and explained the laws of supply and demand, the cause of inflation, the operation of foreign exchange rates, and the subjective nature of economic value. Those discoveries are among the reasons that Joseph Schumpeter called them the first real economists.

The Late Scholastics were advocates of property rights and the freedom to contract and trade. They lauded the contribution of business to society, while opposing most taxes, price controls, and regulations that inhibited enterprise. As moral theologians, they urged governments to obey ethical strictures against theft and murder.

Richard Cantillon, who had been schooled in the scholastic tradition, wrote the first general treatise on economics, Essay on the Nature of Commerce, in 1730. Born in Ireland, he later immigrated to France. He saw economics as an independent subject and explained the formation of prices using the method of thought experiments. He understood the market as an entrepreneurial process. The Austrian School would later adopt his theory that money enters the economy in a step-by-step fashion, disrupting relative prices along the way.

The next notable “Austrian ancestor” after Cantillon was Anne Robert Jacques Turgot, the French aristocrat who for a few years was finance minister of France. His economic writing was limited but profound. His paper “Value and Money” discussed the origins of money and the reflection in economic choice of an individual’s subjective preference rankings. Turgot offered a solution to the famous diamond-water paradox that baffled later classical economists, articulated the law of diminishing returns, and criticized usury laws. He favored a classical-liberal approach to economic policy, recommending a repeal of all special privileges granted to government-connected industries. Turgot had noticed the importance of the “particular circumstances of time and place” two centuries before Hayek:

There is no need to prove that each individual is the only competent judge of the most advantageous use of his lands and his labour. He alone has the particular knowledge without which the most enlightened man could only argue blindly. He learns by repeated trials, by his successes, by his losses, and he acquires a feeling for it which is more ingenious than the theoretical knowledge of the indifferent observer because it is stimulated by want (Turgot as quoted in Murray Rothbard’s Economic Thought Before Adam Smith)

Turgot was the intellectual father of a long line of great French economists of the eighteenth and nineteenth centuries, most prominently Jean-Baptiste Say and Claude-Frédéric Bastiat.

Say was the first economist to think deeply about economic method. He held that economics is not about the amassing of data, but rather about the elucidation of universal components of the human condition—for example, the fact that wants are unlimited but means to aid in their satisfaction are scarce—and the tracing of the logical implications of these principles. Say discovered the productivity theory of resource pricing and the role of capital in the division of labor. He formulated the famous Say’s Law: there can never be sustained overproduction or underconsumption if the market process is not hampered by artificial restrictions.

Bastiat, an influential economic journalist, argued that nonmaterial services are subject to the same economic laws as material goods. In one of his many economic allegories, Bastiat spelled out the “broken-window fallacy” later employed to great effect by Henry Hazlitt. He held that there is a general distinction between bad economists and good economists: Bad economists look only at “what is seen,” for instance, the fact that there is work for a repairman when a window is broken. Good economists look beyond this to “what is not seen,” noticing that the person paying for the window repair would have spent that money on something more useful to him, if he hadn’t been forced to repair the window. Human action only operates over time, and the gap between initiating an action and the final discernible ripple of effect from that action is often significant. If we desire to rearrange social relations, it won’t do to simply consider the immediate effect of the reform; we must trace its influence out over time.

Despite the theoretical sophistication of this developing pre-Austrian tradition, the British school of the late eighteenth and early nineteenth centuries came to dominate economics. The British tradition (based on objective-cost and labor-productivity theories of value) ultimately led to the rise of the Marxist doctrine of capitalist exploitation.

The dominant British tradition received its first serious challenge in many years when Carl Menger’s Principles of Economics was published in 1871. Menger, the founder of the Austrian School, resurrected the Scholastic-French approach to economics, grounding the science on the subjective valuations of individuals, rather than any objective properties of goods or labor.

Together with the contemporaneous writings of Léon Walras and William Stanley Jevons, Menger explained, for the first time, the theory of marginal utility. In addition, Menger showed how money originates in a free market when the most marketable commodity is desired, not for consumption, but for use in trading for other goods.

Menger’s book was a pillar of the “marginalist revolution” in economics. When Mises said it “made an economist” out of him, he was not only referring to Menger’s theory of money and prices, but also his approach to the discipline itself. Like his predecessors in this tradition, Menger was a methodological individualist, viewing economics as the science of individual choice. His Investigations into the Method of the Social Sciences came out twelve years after Principles. It battled the German Historical School, which had rejected theorizing and held that the proper scope of economics was the accumulation of historical data about the economy. To varying degrees, every Austrian since Menger has seen himself as Menger’s student.

Menger was professor of economics at the University of Vienna and tutor to Crown Prince Rudolf of the House of Habs-burg. Unfortunately for the Austro-Hungarian Empire, Prince Rudolph committed suicide in 1889, before he had an opportunity to implement any of Menger’s advice on liberalizing the empire’s economy.

One of Menger’s most prominent followers was Friedrich von Wieser, who later held the chair at the University of Vienna that had been occupied by Menger. Wieser’s greatest contribution to economics was the theory of opportunity cost. He also coined the term “marginal utility” (Grenznutzen), and, as a teacher, was the first major economic influence on the thought of F.A. Hayek.

In Britain, Philip Wicksteed, an economist whose name is closely linked with the Austrian School, made the concept of opportunity cost central to his work, Common Sense of Political Economy. He also rejected the notion of economics as the study of wealth, and explored the process by which markets move toward equilibrium. Later, Ludwig von Mises would draw inspiration from Wicksteed’s insistence “on the universal application of the conclusions which flow from our understanding of human purposefulness and rationality in the making of decisions” (Israel Kirzner, “Philip Wicksteed: The British Austrian,” in 15 Great Austrian Economists).

Menger’s follower Eugen von Böhm-Bawerk took Menger’s theories and applied them to capital and interest. His History and Critique of Interest Theories, which appeared in 1884, is a sweeping account of fallacies in the history of thought on interest. It defends the idea that the interest is not an artificially imposed construct but is an inherent part of human action. Interest is a product of the fact that time preference runs in only one direction—that, all other things being equal, we always prefer our satisfactions sooner rather than later. Frank Fetter, Ludwig von Mises, Murray Rothbard, and Israel Kirzner later expanded upon his theory.

Böhm-Bawerk’s Positive Theory of Capital demonstrated that the normal rate of business profit is the interest rate. Capitalists save money, pay laborers, and wait until the final product is sold, collecting interest for the time period involved. He also held that capital is not homogeneous but is an intricate and diverse structure with a time dimension. A growing economy is not just a consequence of increased capital investment, but also of more roundabout processes of production.

Böhm-Bawerk engaged in a prolonged battle with the Marxists over the exploitation theory of capital, and refuted the socialist doctrine of capital and wages long before the communists came to power in Russia. Böhm-Bawerk also conducted a seminar that would later become the model for that of Mises.

Böhm-Bawerk, in the last years of the Habsburg monarchy, served three times as finance minister. In that role he advocated a balanced budget, the gold standard, free trade, and the repeal of export subsidies and other monopoly privileges.

It was his research and writing that solidified the status of the Austrian School as a unified way of looking at economic problems, and set the stage for the school to make converts in the English-speaking world. One economist who took up the Austrian banner was Frank Fetter, an American.

Fetter’s Principles of Economics (1904) was the best systematization of Austrian thought prior to the work of Mises in the 1940s. Fetter developed the pure time preference theory of interest, achieving a unified theory of value for capital, rent, wages, and consumer goods, leaving only money outside its scope. He taught economics at Cornell, Indiana University, Stanford, and Princeton.

The final topic in classical economics for subjective value theory to reformulate was money, the institutional intersection of the microeconomic and macroeconomic approach. A young Mises, economic advisor to the Austrian Chamber of Commerce, took on the challenge.

The result of Mises’s research was The Theory of Money and Credit, published in 1912. In that work, he demonstrated that the theory of marginal utility applies to money. He laid out his regression theorem, an elaboration of Menger’s theory of the origin of money, showing that money not only originates in the market, but that it could not have done so in any other way. Drawing on the British Currency School, Swedish economist Knut Wicksell’s theory of interest rates, and Böhm-Bawerk’s theory of the structure of capital, Mises presented the outline of the Austrian theory of the business cycle. A year later, Mises was appointed to the faculty of the University of Vienna. Böhm-Bawerk’s seminar spent a full two semesters debating Mises’s book.

Mises’s monetary theory received attention in the United States through the work of Benjamin M. Anderson, Jr., an economist employed at various times by Columbia, Harvard, Chase National Bank, UCLA, and Cornell. His major works included The Value of Money, a critique of Irving Fisher’s quantity theory of money, and Economics and the Public Welfare, a study of the U.S. economy from World War I through the end of World War II.

World War I interrupted Mises’s career for four years. He spent three of those years as an artillery officer, and one as a staff officer in economic intelligence. At the war’s end, he published Nation, State, and Economy, arguing on behalf of the economic and cultural freedoms of minorities in the now-shattered empire, and theorizing on the economics of war.

In the political chaos after the war, the main theoretician of the socialist Austrian government was a Marxist, Otto Bauer. Mises knew Bauer from the Böhm-Bawerk seminar. Mises engaged in an ongoing effort to convince Bauer of the wisdom of laissez-faire, eventually persuading him to back away from Bolshevik-style policies.

Mises next undertook an in-depth analysis of socialism. After writing a breakthrough paper in 1920 on the problem of calculation under socialism, he completed his second great book, Socialism, in 1922. A worldwide socialist commonwealth, Mises demonstrated, would result in utter chaos and a return to barbarism. Mises challenged the socialists to explain, in economic terms, precisely how their system would work—a task that the socialists had avoided up to that point. (Marx had contended that it was “unscientific” to ask such questions.) The debate between the Austrians—chiefly Mises and Hayek—and the socialists continued in a series of papers published during the ‘20s and ‘30s. Israel Kirzner holds that it was during this debate that Mises and Hayek came to understand how different their “Austrian” approach was from the emerging neoclassical mainstream.

Mises’s arguments for free markets attracted a group of converts from the socialist cause, including Hayek, Wilhelm Röpke, and Lionel Robbins. Mises began holding a private seminar in his offices at the Chamber of Commerce, that was attended by Fritz Machlup, Oskar Morgenstern, Gottfried von Haberler, Alfred Schutz, Richard von Strigl, Eric Voegelin, Paul Rosenstein-Rodan, and many other intellectuals from across the European continent. Several of these scholars later held positions at leading universities in the United States: Machlup taught at Johns Hopkins, NYU, and then Princeton, Rosenstein-Rodan at MIT, Haberler at Harvard, and Morgenstern at Princeton. Morgenstern, working with mathematician/physicist/computer scientist John von Neumann, did pioneering work in the area of game theory.

During the 1920s and ‘30s, Mises was working on two other academic fronts. He argued against the German Historical School with a series of essays in defense of the deductive method in economics, which he would later call praxeology. He also founded the Austrian Institute for Business Cycle Research, putting Hayek in charge of it.

During these years, Hayek and Mises authored several studies on the business cycle, warned of the danger of credit expansion, and predicted the coming economic crisis. The Nobel Prize committee cited Hayek’s work during this period when he received the award for economics in 1974. Hayek was one of the most prominent opponents of Keynesian economics in his works on exchange rates, capital theory, and monetary reform. His popular book The Road to Serfdom helped revive the classical-liberal movement in America in the 1940s. His three-volume work Law, Legislation, and Liberty elaborated on the Late Scholastic approach to law, and applied it to criticize egalitarianism.

In the early 1930s Austria was threatened by a Nazi takeover. Hayek had already left for London in 1931, at Mises’s urging. In 1934, Mises moved to Geneva to teach and write at the International Institute for Graduate Studies. Following the Anschluss, knowing that Mises was an enemy of National Socialism, the Nazis confiscated Mises’s papers from his apartment in Vienna and hid them for the duration of the war. After the fall of the Soviet Union, the papers were unearthed in a formerly secret archive and brought to the attention of scholars by Richard Ebeling of Hillsdale College. Ironically, Mises’s ideas, through the work of Wilhelm Röpke and the statesmanship of Ludwig Erhard, had a profound influence on the postwar economic reforms that led to the “German miracle.”

Meanwhile, in London, Hayek taught and researched at the London School of Economics. Among his students was a young post-graduate named Ludwig Lachmann. Hayek also profoundly influenced English economist Lionel Robbins, whose synthesis of Alfred Marshall’s ideas with those of the Austrians helped to create the neoclassical mainstream that has dominated economics since that time.

Robbins incorporated certain Austrian insights, especially the notion of economics as the science of employing scarce means to achieve subjectively desired ends, into Marshall’s economics. The Austrian-Marshallian synthesis focused on the properties of equilibrium markets, which were taken to be a good approximation of the real world. However, at the same time, Austrian economist Hans Mayer was critiquing price theories that simply assumed equilibrium, foreshadowing Hayek’s work on knowledge and prices. Austrians moved away from Robbins’s formulation of economics. They began to emphasize the freedom and unpredictability of human action. Unlike Robbins’s picture of a given set of fully understood means and ends, from which choices are plucked on the basis of maximizing a utility function, Austrians gradually realized that both our means and our ends only come to be understood through the market process itself. They came to view general equilibrium as a model of an unreal and unobtainable world.

In Geneva, Mises wrote his systematic work, Nationalökonomie (published in 1940). With war seeming to threaten even Switzerland, Mises left for the United States. Once settled in the U.S., he wrote Bureaucracy, Omnipotent Government, and translated, revised, and expanded Nationalökonomie, resulting in the publication of Human Action in 1949. His student Murray N. Rothbard called it: “Mises’s greatest achievement and one of the finest products of the human mind in our century. It is economics made whole.” The work remains, in my mind, the preeminent work of the Austrian School. However, it was not well received in the economics profession, where neoclassical and Keynesian theories dominated.

Even before Mises immigrated to the U.S., American journalist Henry Hazlitt had become his most prominent champion. Hazlitt reviewed Mises’s books in the New York Times and Newsweek, and popularized Austrian ideas in such classics as Economics in One Lesson. Hazlitt also made original contributions to Austrian School thought, writing a detailed critique of Keynes’s General Theory, entitled The Failure of the “New Economics.” Hazlitt defended the work of Say, restoring him to a central place in Austrian macroeconomic theory.

In 1946, Leonard E. Read founded the Foundation for Economic Education (FEE) in Irvington-on-Hudson, New York The Foundation worked to promote free-market economics, with a heavy Austrian and Misesian influence, during times when they were especially unpopular.

Mises eventually landed at New York University. There, he gathered students around him, just as he had in Vienna. Among those attending his seminar at Washington Square (and two other locations in Manhattan) were Rothbard, Israel Kirzner, Leland Yeager, Ralph Raico, Percy Greaves, Bettina Bien Greaves, William Peterson, George Koether, Lawrence Moss, George Reisman, Paul Cantor, and Hans Sennholz. Mises’s New York seminar continued until two years before his death in 1973.

Murray Rothbard’s treatise Man, Economy, and State (1962) was patterned after Human Action, but in some areas—monopoly theory, utility and welfare, and the theory of the state—expanded on or diverged from Mises’s views. Rothbard’s approach to the Austrian School picked up on Late Scholastic thought by applying economic science within a framework of a natural-rights theory of property. What resulted was a rationalist defense of a free-market, stateless social order, based on property and freedom of association and contract. Rothbard was also at work applying Austrian economics to historical periods such as the Great Depression and the colonial period of American history.

Rothbard gained new exposure for the Austrian School with his work For a New Liberty. A union of natural-rights theory and the economics of the Austrian School was forwarded in The Ethics of Liberty. Those books and several others were completed while Rothbard was producing many scholarly economic pieces, gathered in the two-volume Logic of Action, published in Edward Elgar’s “Economists of the Century” series.

Meanwhile, Israel Kirzner extended Mises’s analysis on another front. Focusing on Mises’s concept of entrepreneurship as a component of all action, Kirzner developed his theory of the entrepreneur in a number of works, including Competition and Entrepreneurship, The Meaning of the Market Process, and The Driving Force of the Market. Kirzner’s first book, The Economic Point of View, was a comparative work on economic methodology, highlighting the advantages of Mises’s praxeological approach. In An Essay on Capital, Kirzner performed a similar exercise on the varieties of capital theory. He continued the Austrian presence at New York University, teaching there from 1957 until the spring of 2001. Extending the tradition of Böhm-Bawerk and Mises, he gathered a weekly Austrian discussion group and tutored a new generation of Austrian scholars.

Ludwig Lachmann took Misesian thought in yet a third direction. While his work in the 1950s and 1960s flowed directly from Mises’s ideas, Lachmann increasingly concerned himself with the effect of radical uncertainty on economic order. Deeply influenced by the work of British economist G.L.S. Shackle, Lachmann’s work emphasized the subjective nature of expectations.

The awarding of the Nobel Prize to Hayek in 1974, and a conference on Austrian economics in South Royalton, Vermont, that same year, marked a decided upsurge of interest in the Austrian School. The founding of the Ludwig von Mises Institute in 1982, with the aid of Mises’s widow, Margit von Mises, marked a further milestone in the resurgence of Austrian economics. Another organization for promoting Austrian thought, the Society for the Development of Austrian Economics, was officially founded in 1996.

Scholarly centers for the Austrian School are thriving in Paris, Rome, Madrid, Bucharest, Beijing, Tokyo, Prague, and Latin America. The writings of the masters appear in every major language and new translations appear just about every month. Austrian ideas have gained currency in other fields, including history, philosophy, and law. And they are increasingly popular in the mainstream financial press and brokerage houses.

Today, 130 years after its founding, the Austrian School has more adherents and a more active literature than at any previous time in its history. Dissatisfaction with the artificial, “economic man” of mainstream economics is widespread, making the future of the Austrian School look even brighter than its present.