Understanding "Austrian" Economics; H. Hazlitt

((Austrian" economics owes its name to the historic fact that it was founded and first elaborated by three Austrians-Carl Menger (1840 1921), Friedrich von Wieser (1851 1926), and Eugen von Bohm Bawerk (1851-1914). The latter two built upon Menger, though Bohm Bawerk, in particular, made impor tant additional contributions. Menger's great work, translated into English (but not until seventy nine years later!) under the title of Principles of Economics, was pub lished in 1871. In the same year, by coincidence, W. Stanley Jevons in England published his Theory ofPo litical Economy. Both authors inde pendently developed the concept now known as ((marginal utility." (Men ger never used the term. J evons called it ((final degree of utility." It was Wieser who first employed the German term Grenznutzen, which ~ranslates as ((marginal utility.") Henry Hazlitt Understanding "Austrian "

Economics But as few American or British economists read German in the orig inal, it was years before the real ex tent of the revolution begun by Menger was realized outside of Ger man-speaking countries. For it was Menger, by recognizing most fully the implications of the marginal utility concept, who opened up new paths and, so to speak, turned the old classical economics upside-down. Goods have no inherent value in themselves. They are valued be cause they help to s.tisfy some hu man want or need. Menger insists throughout his work that value is essentially sub jective, and that therefore economics must be in the main a subjective sci ence. Goods have no inherent value in themselves. They are valued be cause they help to satisfy some hu67 68 THE FREEMAN February man want or need. A given quantity or unit of a certain good will satisfy a man's most intense desire or need. He may also want a second, third, or fourth increment. But after each unit consumed or employed, his desire or heed for a further unit of that good may be less intense, and may finally become completely satisfied.

It follows that each increment of that good at his disposal will have a reduced value to him. But as no unit of the total available quantity of that good can have a greater value in exchange than any other (of the same quality), it follows further that no other unit will be worth more in the market than the ufinal" unit of the supply. Thus in a given commu nity the exchange value of a given increment of each good will be de termined by the relation between its total available quantity and the in tensity of the human need or want that it fills. So far this may seem like little more than a refinement on the old classical doctrine that value and price are determined by supply and demand. It seems merely to state that doctrine in subjective rather than objective terms. But then Men ger comes to point out some of its implications. The values of goods are mutually interdependent. Bread is valued because it meets a direct consumption need. Flour· is valued because it is needed to bake bread.

Wheat is valued because it is needed Henry Hazlitt, a frequent contributor to The Freeman, has a long and dis tinguished career as an economist, journalist,editor, and literarycritic. Best known of his numerous books is Eco nomics in One Lesson, originally pub lished in 1946 and since translated into eight languageswith sales of more than 700,000 copies. The recently re vised edition is once more available in inexpensive paperback. This introduction to the basic con cepts and principles of the so-called Austrian school of economics was commissioned by and appears here through the courtesy of Silver and Gold Report, Newtown, Connecticut. to produce flour. Plows, seed, land and labor are valued because they are necessary to produce wheat, and soon. Values are also interdependent because, for example, if one raw ma terial necessary in combination for the production of a final product is missing, that lack reduces the use fulness and value of the other raw materials needed.

Goods wanted and ready for direct use or consumption are called by Menger ugoods of the first order." Raw materials and other factors necessary to produce these are called cCgoods of the second order." Materi als, machinery, labor and other fac tors needed in turn to produce these 1981 UNDERSTANDING "AUSTRIAN" ECONOMICS 69 goods of the second order are called goods of the third order, and so on. These goods of the second, third, and other ((higher" orders are valued be cause of the consumption goods that they produce. The Austrian doctrine holds that the "cost of production" itself is ultimately determined by the value of consumptiongoods. Thus while the classical Ricar dian doctrine held that the ((normal" value of consumption goods was de termined by their ~~cost of produc tion," the Austrian doctrine holds that the ~~cost of production" itself is ultimately determined by the value of consumption goods.

These two doctrines can be partly reconciled in the statement that though what a good has cost to produce cannot directly determine its value, what it will cost to produce determines how much of it will con tinue to be made. It is the limit that cost of production puts upon the to tal quantity of a good produced that determines its marginal value and therefore its market price. Thus there is a constant tendency for marginal cost of production and market price to equal each other, though not be cause the first directly determines the second. Something should be said also about the sharp distinction between the Ricardian and the Austrian con cept of ~~cost." The Ricardian (and the modern businessman) thinks of cost as a money outlay. But the Aus trian economist has a much wider concept, what economists now call ~~opportunity" costs, or ~~foregone op portunity" costs. Such costs exist, of course, not only in business but in all our decisions and actions in life.

The cost of learning French in any given period is to forego learning German, or to learn less mathemat ics, or to give up some tennis or bridge, and so on. Menger emphasizes the impor tance of time and the role of uncer tainty in the whole productive pro cess. He also points out that no single good, no matter how abundant, can maintain life and welfare, but that these depend upon the production of combinations of goods of different kinds in the proper proportions. And he points out, finally, that the pro cess of production cannot be ex pected to go on at an adequate rate unless there is adequate protection of property. The economic value of goods, to repeat, depends upon their respec tive quantities in relation to the hu man needs they meet. It does not necessarily depend upon the amount of labor expended in their produc tion. To quote from Menger's Prin ciples ofEconomics: ~~If there were a society where all goods were avail able in amounts exceeding the re70 THE FREEMAN February quiremen:ts for them, there would be no economic goods nor any (wealth' (p. 109).... Hence we have the queer contradiction that a continuous in crease of the objects of wealth would have, as a necessary final conse quence, a diminution of wealth (p.

110)". (In other words, Menger pointed out more than a century ago a basic fallacy in the now-fashionable na tional income statistics.) ((The value of goods arises from their relationship to our needs, and is not inherent in the goods them selves (p. 120).... Objectification of the value of goods, which is entirely subjective in nature, has neverthe less contributed very greatly to con fusion about the basic principles of our science (p. 121).... The impor tance that goods have for us and which we call value is merely im puted (p. 139). ~(There is no necessary and direct connection between the value of a good and whether, or in what quan tities, labor and other goodsof higher order were applied to its produc tion. . . . Whether a diamond was found accidentally or was obtained from a diamond pit with the em ployment of a thousand days of la bor is completely irrelevant for its value (p. 146)."

Menger goes on to discuss further how higher goods, including capital goods, get their value: ((It is evident that the value of goods of higher order is always and without exception determined by the prospective value of the goods of lower order in whose production they serve (p. 150)." He outlines a theory of interest, but he leaves it vague. On page 156 of Principles of Economics he tells us: ~(We have reached one of the most important truths of our sci ence, the (productivity of capital.'" But he emphasizes that this produc tivity occurs only through the pas sage of time, and that therefore the market value of presently existing and available goods is at a ((dis count" compared with the expected value of equivalent goods in the fu ture. A TimePreference Theory This suggests that Menger leaned more toward a ((timepreference" than a ((productivity" theory of interest, though the distinction between these theories was not sharpened and made explicit until the publication of Bohm-Bawerk's Capital and Inter est in 1884 and his Positive Theory of Capital in 1888. Bohm-Bawerk laid great emphasis upon the supe rior productivity of ((roundabout"

processes of production, and there fore (after a brilliant demolition of productivity theories of interest) ended by himself offering a theory of interest that combined productiv ity and time preference. Nearly all UAustrians" today, however, follow ing the lead of Frank A. Fetter and 1981 UNDERSTANDING "AUSTRIAN" ECONOMICS 71 later of Ludwig von Mises, support a pure timepreference theory. To return to Menger: His Princi ples of Economics next presents a Htheory of exchange." In this he points out that men do not buy from or sell to or exchange with each other merely because of a ((propensity of men to truck and barter," as implied by Adam Smith, but because each man seeks to maximize his satisfac tions by exchanging what he values less for what he values more. In this way the satisfaction of all is in creased. Exchange is thus an inte gral part of the whole process of pro duction. What· is being produced is value. Menger's whole theory of price, to repeat, is developed on the basis of ((the subjective character of value."

The final chapter of Menger's Principles is on ((The Theory of Money." This does not explicitly dis cuss such subjects· as interest rates or inflation, but deals solely with fundamentals, especially the origin and evolution of money. ((Money is not the product of an agreement on the part of economizing men nor the product of legislative acts. Noone invented it (p. 262)." It developed out of barter. Because it so seldom happened that A and·· B each had and was willing to offer exactly what the other wanted, triangular and in direct barter began to take place. Men first offered their specialized goods for more ((marketable" goods more widely wanted, in the hope that they could exchange these, in turn, for the particular goods that they themselves wanted. As a result these more ((saleable" goods became still more saleable because of this extra demand ..The most saleable of all finally became ((money." Histor ically, all kinds of goods have served as money, though it later came down to coins of precise weights of copper, silver, or gold.

Money is not a ((measure of value," though it is legitimate to call it a measure of price. It is the only com modity in which all others can be evaluated without roundabout pro cedures. It is the most appropriate form in which people can save and store part of their wealth. The right of coinage has generally been left to governments, even though Hthey have so often and· so greatly mis used their power (p. 283)." I may have seemed to devote a disproportionate amount of space to Menger, but the special contribu- . tions of Austrian economics can be most clearly realized, it seems to me, if we begin by dwelling in some detail on those of its originator. Menger's first important succes sor as an ((Austrian" economist was Friedrich von Wieser, who, begin ning in 1884, published several books elaborating, rounding out, and re fining Menger's theory of value, clarifying especially problems of cost, ((imputation," and distribution.

72 THE FREEMAN February It was the analysis of Austrian eco nomics that made Bohm's refuta tion of Marx so conclusive. No ref utation based on the assumptions of the old classical economics could have been as devastating. The next great successor was Eu gen von Bohm-Bawerk, whose trail blazing contributions in Capital and Interest, in 1884, and the Positive Theory of Capital, in 1888, have al ready been referred to. In addition, Bohm-Bawerk wrote a brilliant demolition of Marx's Das Kapital in 1896, in a comparatively short work first translated into English under the title Karl Marx and the Close of His System. In this essay Bohm Bawerk exposed particularly the fallacies in Marx's labor theory of value and his ((exploitation" theo ries, which the latter had derived as a supposed corollary from errors of Ricardo. It should be emphasized that it was the analysis of Austrian eco nomics that made Bohm's refutation of Marx so conclusive. No refutation based on the assumptions of the old classical economics could have been as devastating.

After the passing of its three founders-Menger, Wieser, and Bohm-Bawerk-Austrian econom ics fell for a long time into eclipse. It was not so much refuted as ne glected. English-speaking econo mists began devoting themselves to such matters as mathematical treatment of problems of ((general equilibrium." The Austrian view was revived mainly by one man, an Aus trian by birth as well as an ((Aus trian" by conviction-Ludwig von Mises (1881-1973). He made his in fluence felt both by his written works and by his oral teachings. Among his early distinguished students and followers were Gottfried Haberler, Fritz Machlup, Oskar Morgenstern, Lionel (now Lord) Robbins, and, most influential of all, F. A. Hayek (b. 1899). Ludwig von Mises was prolific, but his principal contributions were made in three masterpieces. These were The Theory of Money and Credit, first published in German in 1912, Socialism: An Economic and Sociological Analysis, also first pub lished in German in 1922, and Hu man Action, which grew out of a first German version appearing in 1940, but was not published in Mises' own rewritten English version until 1949.

Mises on Human Action Though there is now a gratifying number of able young American economists writing in the Austrian tradition, Human Action still stands as the most complete, powerful, and unified presentation of Austrian economics in any single volume. Mises always generously acknowl edged his indebtedness to his pred1981 UNDERSTANDING uAUSTRIAN" ECONOMICS 73 ecessors. He recalled in a short au tobiography (Notes and Recollections, 1978) that around Christmas, 1903 he read Menger's Principles of Eco nomics for the first time. ((It was the reading of this book," he wrote, ((that made an (economist' of me." It would carry me to too great length to itemize and explain all the contributions to economicsthat Mises made, and I will content myself with mentioning only two. He was the first to prove that it was impossible for socialism to undertake ((eco nomic calculation"; and he made one of the most important contributions of any economist toward solving the problem of ((the trade cycle."

Because Mises so uncompromis ingly rejected government interven tionism in all its forms, he acquired the reputation of a ((laissez-faire ex tremist" during most of his lifetime, and was scandalously neglected by the majority of academic econo mists. But because Hayek elabo rated his own ideas in a more concil iatory form, his writings attracted more attention from the academic world, and he leapt into prominence in 1931 with his own contribution to the theory of the trade cycle, Prices and Production, along lines similar to Mises'. The result is entitled to be called the uMises-Hayek" theory. Hayek is also a prolific writer, but though he has written volumes on money, on the trade cycle, on infla tion, and on The Pure Theory of Capital (1941), he has never at tempted a comprehensive book on economic principles. Of late years he has turned his attention mainly to the realms of politics, ethics, and law, and has written profound and widely-discussed treatises on The Constitution of Liberty (1960) and a three-volume work on Law, Legis lation and Liberty, completed in 1979. He has been more widely in fluential in his own lifetime than was Mises, and was awarded the Nobel Prize in Economics in 1974.

Today's zealous group of younger "Austrian" economists are explor ing a whole range of economic problems with a new vigor. Today's zealous group of younger ((Austrian" economists, though all acknowledging their great debt to Mises, do not treat his Human Ac tion as the final word on the subject, but are exploring a whole range of economic problems with a new vigor. Murray Rothbard (b. 1926), a stu dent of Mises, produced a two-vol ume treatise, Man, Economy, and State (1962), along Misesian lines, with notable clarity of exposition, and making important contribu tions of his own, pointing out the fallacies, for example, in the pre vailing theories of ((monopolyprice." Israel M. Kirzner (b. 1930), pro fessor of economics at New York 74 THE FREEMAN February University, another former Mises student, although he has not under taken a comprehensive book of ((principles," has explored individ ual problems in five separate vol umes: The Economic Point of View (1960), Market Theory and the Price System (1963), An Essay on Capital (1966), Competition and Entrepre neurship (1973), and Perception, Opportunity, and Profit (1979). His work is distinguished by great scholarship, systematic thorough ness, and precision of statement. He has brought further illumination to every problem he has dealt with.

Finally, no reference to individ ual writers would be adequate that did not include Professor Ludwig M. Lachmann (b. 1906). Though he is one of the most original and pro found among living Austrian econ omists, his work has not yet nearly achieved the recognition it merits. Among his principal books are Cap ital and Its Structure (1956; repub lished in· 1978), The Legacy of Max Weber (1971) and Capital, Expecta tions, and the Market Process (1977). His writings are notable for their emphasis on the role of expectations and for their thoroughgoing appli cation of a ((radical subjectivism." Restrictions of space permit me merely to list the names of half a dozen of the now increasing group of important ((Austrian" economists: S. C. Littlechild, Gerald P. O'Driscoll, Jr., Mario J. Rizzo, Hans Sennholz, Sudha R. Shenoy, and Lawrence H. White. But so arbitrarily short a list must omit a number of names un justly.

The "Austrian" economists, more consistentlythan those of any other school, have criticized nearly all forms of government intervention in the market-especially Inflation. The ((Austrian" economists, more consistently than those of any other school, have· criticized nearly all forms of government intervention in the market-especially inflation, price controls, and schemes for· re distribution of wealth or incomes because they recognize that these always lead to erosions of incen tives, to distortions of production, to shortages, to demoralization, and to similar consequences deplored even by the originators of the schemes. But personal value judgments of government policy are of course not an essential part of Austrian theory. The present vigorous Austrian School is not content merely to·keep re-expounding the principles devel oped by Menger and Mises, but is addressing itself constantly to new problems, or a more thorough prob ing of old ones. This is dramatically evident in a recent volume, New Di rections in A ustrian Economics (1978), edited by Louis M. Spadaro, with contributions from eleven wri1981 UNDERSTANDING "AUSTRIAN" ECONOMICS 75 ters. Professor Spadaro himself, in his concluding essay, outlines some of the still unresolved problems that Austrians ought to explore. In some sense, however, practically all eleven contributions do the same thing.

I have heard it said (by an econo mist of another school) that there is no such thing as Austrian econo mics; there is only good economics or bad. But in the same way we could say that there is no such thing as Ricardian economics, Marxist economics, Keynesian economics, and so on. This sort of statement, though true in one sense, is false in another. It is fallacious in implying that if anything is classified in ac cordance with one characteristic, it cannot be classified in accordance with any other. It is like saying that there are no such persons as Ameri cans or Japanese; there are only men and women. Those who call them selves ((Austrian" economists give themselves this label because of its historic origins; but they happen also to believe that its fundamental theses are true, and offer more promise than any other for further progress in economic science. Perhaps something should be said about the chief differences today be tween Austrian economics and what we may call Uorthodox" or ((main_ stream" economics. The difficulty here is that ((mainstream" econom ics itself would be hard to define.

Economists are still divided into a number of recognizable ((schools" neoclassicists, Keynesians, the Chi cago school, the Lausanne school, and so on. The limits of space forbid me to go into the distinguishing doc trines of each of these schools. But one outstanding difference of the Austrians from all of these lies in their method of reasoning. The Aus trians emphasize methodological in dividualism. That is, they not only begin by emphasizing human ac tions, preferences, and decisions, but individual actions, preferences, and initiatives. Mainstream economists are concerned with ((macroeconom ics," with averages and aggregates; and those of the Lausanne school, trying to reduce economics to an ((exact" science, and therefore seek ing to quantify everything, are ob sessed with complicated mathemat ical equations that try to stipulate the conditions of ((general equili brium."

Equilibriuma UsefulConcept, Though Nevera Reality Now ((general equilibrium" is de fined by these economists (when it ever is) in highly abstract and ob scure phrases; but for laymen it might be defined as a condition in which all the tens of thousands or millions of commodities and ser vices are being turned out in the ex act quantities and proportions in which they are relatively wanted by producers or consumers, so that there 76 THE FREEMAN February are no ((shortages" or ((surpluses." All prices reflect costs, and there is no more profit in making one com modity than any other. (In fact, there is no ((pure" profit at all.) These economists admit that at any mo ment this condition does not exist, but they contend that there is a con stant longrun tendency toward equilibrium, because when there is an unusual profit in turning out some one product, producers will turn out more of it, and when there is a loss in turning out some other product, producers will make less of it, or transfer to making something else.

Now the concept of equilibrium (or much better, the Mises concept of an ((evenlyrotating economy") can have great usefulness as a tool of thought. We are often better able to analyze the problems of change if we begin with the fictitious assump tion of a state of affairs in which cer tain changes are hypothetically eliminated. But this is a purely imaginary construction, a useful fic tion. It should never be confused with reality. While a true ((equilibrium" be tween the marginal cost of produc tion and the market price of anyone commodity is a condition that is sel dom reached, even momentarily, a ((general equilibrium" in the rela tive production, supply price and de mand price of all commodities and services is a condition that is never reached, even for an instant of time. Neoclassical economists seem ob sessed today with setting up com plicated algebraic equations, but it is difficult to specify precisely what their x's and y's stand for.

The concept itself is extremely nebulous. Neoclassical economists seem obsessed today with setting up complicated algebraic equations stipulating the conditions of equi librium or functional relations un der ((perfect competition" and the like, but it is difficult to specify pre cisely what their x's and y's stand for. They cannot refer to physical quantities, because you cannot add apples to horses, or a ton of gold watches to a ton of sand. One might add or compare quantities times prices, but what would be the mean ing of the total, or any of the parts that make it up? The price, even of one commodity, differs from hour to hour, place to place, and transaction to transaction. The value of the cur rency itself fluctuates and con stantly changes its exchange ratio with commodities. If we simply add or compare ((values," then we must recognize that values are purely subjective. They are impossible to measure or to total because they dif fer with each individual.

If we pass over these fundamental difficulties, where do we arrive? Even if we assume that there may be a persistent longrun tendency toward 1981 UNDERSTANDING "AUSTRIAN" ECONOMICS 77 general equilibrium, we must admit that there is also a persistent short run and longrun tendency toward the persistence of disequilibrium. This is not only because there is a tendency of entrepreneurs, in in creasing or reducing production in response to market and profit sig nals, to overshoot the mark, but be cause individual entrepreneurs, so far from making merely automatic responses, are constantly gaining new knowledge, alert to new oppor tunities, changing methods and re ducing production costs, improving products, innovating-turning out entirely new products or inventions. And consumers too are constantly learning, changing tastes, and de manding new products to meet new wants. So Austrian economists sel dom speak of market equilibrium, but of the market process.

My own suspicion is that the enor mous attention now being devoted to stipulating the mathematical conditions of ~~general equilibrium" is a pursuit of a will-o'-the-wisp, of questionable help in solving any real economic problem. But space forbids me to go into too many detailed contrasts. Let me sum up briefly the main Austrian theses once again, this time not in my own words or in Menger's, but in those of two prominent living ~~Austrians." ~~Beginning in the 1870's in Vi enna, Austria," writes Professor Kirzner, ~~the school was distinguished by its emphasis on the sub jective elements in economic analy sis, on the significance of time in production processes, and on the role of error and uncertainty in economic phenomena." (His italics.) The summarization by Professor Lachmann is remarkably similar: ttThe first, and most prominent, fea ture in Austrian economics is a rad ical subjectivism, today no longer confined to human preferences but extended to expectations. . . . Sec ondly, Austrian economics displays an acute awareness of the many fac ets of time that are involved in the complex network of interindividual relations .... In the subjective rev olution of the 1870's the first step in the direction of subjectivism was taken when it was realized that value, so far from being inherent in goods, constitutes a relationship be tween an appraising mind and the object of its appraisal." (New Direc tions in Austrian Economics, pp.

1-3.) All the rest of Austrian economics follows from these basic insights. Let me conclude with my own opin ion that any economic analysis that fails to embody such insights cannot be entirely sound. RECOMMENDED READING Those who have no previous ac quaintance with Austrian econom ics, and would like a short and sim78 THE FREEMAN pIe text written along Austrian lines, might begin with Essentials of Eco nomics by Faustino Ballve (126 pages; Irvington-on-Hudson, N.Y.: Foundation for Economic Educa tion). A more advanced, and quite recent introduction (1979) specifi cally explaining the Austrian point of view, is The Fallacy of the Mixed Economy, by Stephen C. Littlechild (85 pages; San Francisco, Calif.: Cato Institute). Surprisingly, the original Princi ples of Economics, first published in 1871 by Carl Menger, the founder of Austrian economics (328 pages), still makes an excellent, very readable, and not too technical introduction to the school's basic principles.

Of course, the authoritative and most complete work on modern Aus trian Theory is Human Action, by Ludwig von Mises (907 pages, first published in 1949, third revised edi tion published in 1966 by Henry Regnery Company, Chicago). Some may find this difficult reading. A very clear two-volume work written thirteen years after Human Action by a student of Mises is Murray N. Rothbard's Man, Economy, and State (Mission, Kan.: Sheed, Andrews and McMeel, 1962, 987 pages). For the reader interested in the latest developments in Austrian economics I can highly recommend two books: One is The Foundations of Modern Austrian Economics, ed ited by Edwin G. Dolan, which con tains contributions by half a dozen writers (1976, 238 pages, Kansas City: Sheed & Ward, Inc.) The other is New Directions in Austrian Eco nomics, edited by Louis M. Spadaro (1978), 239 pages, with contribu tions by eleven writers. (Kansas City: Sheed, Andrews and McMeel, in co operation with the Institute of Hu mane Studies at Menlo Park, Calif., and with Cato Institute.) Most of these foregoing books have already been mentioned in the text.

The reader may also profitably con sult others mentioned there, espe cially the volumes by Kirzner and Lachmann. , Reprints of this article are available from: The Foundation for Economic Education, Inc. Irvington-on-Hudson, New York 10533 3 copies for $1.00 10 copies or more, 20 cents each IT is a sad fact that most Americans have become poorer during the 1970s. They can no longer afford the amenities and luxuries to which they had grown accustomed. Many con sumer goods are getting smaller or cheaper in quality although their prices continue to soar. We are urged to ~~conserve" and make do with less. Our new economic motto is ~~more conservation," which is a euphemis tic. term for ~~more· poverty." Other industrial countries in Europe are experiencing similar difficulties. Their economies are stagnating or lingering in recession. Inflation is raging and unemployment is rising. To most Americans the deteriora tion of living conditions is all the more incredible as their inborn op timism is calling for an ever brighDr. Sennholz heads the Department of Economics at Grove City College In Pennsylvania and Is a noted writer and lecturer on monetary and economic af· fairs. His latest book, Age of Inflation, describes our dilemma and offers recommendations for restoring a sound monetary system.