This is the opening lecture to the Mises University, delivered August 3, 2003
What is Austrian Economics? A few years ago, at the University of Paris, I gave a course with the title “Introduction to Austrian Economics.” It turned out that some of the students who signed up for the course believed it was meant to deal with business conditions in the country that lies between Germany, Switzerland, Italy, Hungary, Slovakia, and the Czech Republic. They were very surprised by the content of my lectures. To be fair, it must be said that one of them stayed on throughout the course. One lady was glad to discover that Austria had brought forth a school of economic thought that up to the present day enjoys a living tradition in the entire world.
Austrian Economics is a body of ideas, and we are here this week to study these ideas. That in itself is already an exciting and instructive activity. After all, the history of ideas is a fascinating subject. However, I take it that most of you have not come to Auburn because you are merely interested in ideas as such. You are interested in ideas that are true—ideas that properly reflect the workings of the real world to which they refer. You are interested in gaining an adequate understanding of the world of social relationships, and in sharpening your judgement in political matters.
If this is what you desire, you have come to the right place. The faculty of our summer university is not a group of bookish scholars that share an antiquarian interest in the history of ideas. Rather, they are intellectuals who not only believe that ideas make a difference in society and politics, but who are firmly convinced that ideas alone reign supreme when it comes to political decision-making; and that, therefore, it is of crucial importance for the welfare of our families, regions, nations, and all of mankind that the best available knowledge be applied in matters political.
The reason for the existence of the Mises Institute is that the works of its name patron, Ludwig von Mises, are the best available foundation for an adequate understanding of the issues involved in political decision making. In a word, the very point of Austrian Economics, as embodied in the works of Mises, is that it is the foremost political science of our day. It is far more systematic, rigorous, and penetrating than anything else in the field.
This is also the conviction of the faculty assembled here to instruct you during the coming week. This does not mean that we agree among ourselves on each single issue, and neither does it mean that we agree with Mises on all issues. Science is after all very much a work in progress. It does not provide ultimate answers such as revealed religion. It is only a special way, even though a very powerful way, to find guidance for our actions.
In a word, the works of Mises are not something like holy writ for our faculty, and neither should they be for you. But they are a precious starting point for further explorations and critical corrections, and a rich fountain of inspiration.
Who Was Mises
Ludwig von Mises was born in 1881 in Lemberg, a provincial capital of what was at the time the second-largest country of Europe: Austria-Hungary. His father was a railroad engineer in Lemberg who had married a lady from a bourgeois family in Vienna, the capital of the country. Both parents were Jews and Mises too received the standard religious education. Let me mention in this context that, although he later became agnostic, he never lost his respect for religious life. In many of his writings and correspondence he also stressed that there was no contradiction whatever between libertarian political views and faith.
When Ludwig was still a small boy, the family moved to Vienna, where his father had obtained employment in the railroad ministry. At the age of eleven, Ludwig entered some sort of an early-age college, where during the next eight years he received a humanistic education. The main subjects taught were Latin (eight hours per week) and Greek (six hours).
Young Ludwig had at that point already developed a vigorous interest in history and politics. He devoured a great number of books on various periods of the history of his country, and it was in these years that he developed the spirit of criticism that is so essential for scientific work and which served him well during the rest of his life. The interest he displayed for the history of his own country, and more specifically for contemporary history, foreshadowed much of his later intellectual development. He was not interested in history merely for its own sake. The point was to learn from the past the lessons necessary to guide action here and now.
When Mises finished school at the age of nineteen, therefore, he signed up as a student at the department of law and government science at the University of Vienna, which in those days was one of the top universities in the entire world. He joined the seminar of Carl Grünberg, an economic historian who studied the evolution of peasant life in Eastern Europe. Grünberg had him write a dissertation on the conditions leading to the liberation of peasants in Galicia, the province in which Mises was born. It was his first academic work and so impressive in the eyes of his professors that it was immediately published as a monograph by the university press.
Mises continued to study the economic condition of the working classes, and under the guidance of Grünberg he learned to understand history as resulting from the interplay of special interests. This bode him well for the rest of his life. In his later works on economic theory, Mises accorded due attention to “the clash of group interests,” as he called it, something that distinguished him from many other theorists.
Thus Mises started off as an economic historian, and he very probably would have become a great champion of the so-called Historical School of Economics, which dominated in those days the social-science departments in Germany and Austria. But then something unexpected happened that turned him away from fact gathering, as it was practised by the Historical School, and toward the study of economic theory. Around Christmas of 1903, Mises had his first exposure to Austrian Economics when he read Carl Menger’s Principles of Economics.
He later said that it was this reading that turned him into an economist. For the rest of his life, Mises would say that books are the best university. This one book certainly made a huge difference in his life.
Menger convinced Mises that historical research, important though it was, did not cover all layers of social reality. There was an entire universe of things that played a crucial role in human conduct, but which could not be grasped by empirical field studies or archival work. Scarcity, value, intentions, choice, error, and uncertainty were such things. They could only be grasped through an intellectual process of reflection or meditation, and knowledge about these things was not “history,” but “theory.”
After reading Menger, Mises turned back to the great classic works of economic science, to Hume, Smith, Say, and Ricardo. And he came to see that theory was not merely necessary for a full understanding of human behavior, but also that theory alone provided a firm guidance in all practical matters, in particular, in political decisionmaking.
The Historical School could not offer such guidance. One of its critics, writing in Mises’s day, said that the method of this school verged on the absurd. “They go into workers’ apartments, measure the surface, and then claim that they are too small.” (Ludwig Pohle) But by which standards were the apartments too small? And even if one came to agree that the living conditions of workers were not very good by some absolute standard, it was not at all clear which political consequences this entailed. For the crucial question was whether government interventions could improve these conditions at all. Historical enquiry could not answer this question, theory could.
Hence, Mises became a theoretician—in fact, the foremost economic theoretician of the 20th century—not for the sake of intellectual pleasure derived from playing with constructions of his own making. He had no talent to be some sort of an early game theorist or general-equilibrium model builder. He became a theoretician because Menger had shown that theory could describe a part of reality that was not covered by any other type of knowledge. In short, it was Mises’s quest for greater realism and his interest in practical questions that led him to study and develop pure theory in the way Carl Menger had done it before him.
When Mises became interested in Menger’s work, Menger himself had already retired from the University of Vienna. He had left the field to his two most important disciples, both of whom taught at this University from 1905 onwards. Their names were Eugen von Böhm-Bawerk and Friedrich von Wieser.
Wieser’s work was inspired at least as much by the Englishmen Jevons as it was based on Menger’s Principles. Like Jevons, indeed, much like present-day theoreticians, Wieser made in his theories ample use of fictions. The central element of his economic thought was the concept of “natural value.” This type of value had nothing to do with the wealth of any concrete acting person, and it was objective in the sense that it was the same for all persons.
Yet although his analysis of value was much less realistic than Menger’s, Wieser felt no inhibitions to derive sweeping political conclusions from his constructions. The fact that real-life economies were necessarily different from economies in which natural value reigned, did in his eyes not count against his theory; it counted against the real world. He saw in his brainchild of natural value an economic ideal and recommended that economic policy should make sure that all factors of production be treated according to their natural values. According to Wieser, this might be achieved in a perfect communist state. But it might also be achieved through heavy government intervention in the market economy.
In his early years, Mises was very sympathetic to Wieser’s policy stance, but he was not at all impressed with his lack of realism. Rather than attending any one of Wieser’s classes, Mises attended the classes of the man who seemed to represent most faithfully the Mengerian legacy, and who was also in Carl Menger’s own judgement his most important follower.
Starting in the fall of 1905, Eugen von Böhm-Bawerk conducted a graduate seminar at the University of Vienna. He had just retired from his position as a Minister of Finance and dedicated the last years of his life (he died in 1914) to research and writing, and also to some debating in the Austrian House of Lords. Mises graduated in early 1906, but he continued to attend Böhm-Bawerk’s seminar until the very end. It was here that he received his final polish as an economics student and, most importantly, it was here that he formed his ideas about what a professor should be like.
At the same time, Mises did the research on his first great theoretical treatise in the Mengerian spirit, the Theory of Money and Credit. Let me mention in passing that Mises could work on the project only in the evening and night hours. He never found a full paid university position in Vienna, and therefore had to earn a living with other activities. In 1909, he accepted a job at the local chamber of commerce and remained an employee until he left Vienna in 1934, when he finally did obtain a university chair—in Geneva, Switzerland.
After some five years of hard work in his spare-time, then, Mises published his treatise on money in 1912. Some sixteen other books would follow in the coming years and decades. But the money book belonged to the four truly great books that he had written and which every student of Austrian Economics should read. The other three great books have the titles Socialism (first published in 1922), Human Action (1940/1949), and Theory and History (1956).
Money
In the Theory of Money and Credit, Mises demonstrated that Carl Menger’s value theory could also be applied to the case of money. Menger himself, as well as Böhm-Bawerk, had left money out of their considerations. Following the classical economists—Hume, Smith, Say, Ricardo, Mill—they had assumed that, ultimately, money does not have an impact on the wealth of nations; real factors alone determine productivity and incomes.
Critics of the Austrian School had argued that this neglect was a rather serious shortcoming. Money was in fact quite unlike all the other goods when it came to the relationship between value and price. In the case of other goods, the price resulted from the interaction of the subjective values of different individuals. Value was the cause of price. But in the case of money, there was no such one-sided causal determination. The value of money certainly had some impact on the formation of money prices, but money prices were themselves causes of the value of money. A unit of money with a higher purchasing power was after all more valuable, ceteris paribus, than a unit with a lower purchasing power. But if this was true, there seemed to be an inescapable circle: the value of money determined money prices, and these prices in turn determined the value of money—some sort of a chicken-egg problem.
The first Austrian to take up the challenge was Friedrich von Wieser, but unfortunately he again came up with a theoretical construct based by and large on fiction. The challenge had remained unanswered.
It was in this situation that Mises stepped in and provided a truly Mengerian “realist” solution. He showed that the use of money was determined by marginal value, just as the use of any other good. The key to his demonstration was the regression theorem. Mises argued that the circle in the explanation of money prices was only apparent. It was not the case that marginal value determined the formation of money prices, and that these very same money prices in some sort of a feedback process determined the values from which they had sprung. Rather there was a time component in the chain of causation. Market participants relied in their present value judgements on the money prices of the past, not on the money prices that in the present resulted from those present value judgements.
But what about those past money prices? How did they come into existence? Through the same process. They resulted from value judgements that relied on money prices existing even further back in time. The same explanation could be applied to all money prices existing in times past. Each time one had to go back to somewhat older prices.
But was this not an infinite regression—and thus a nonexplanation? Mises argued this was not the case. If one went back far enough, one would reach the point at which money emerged from some pre-existing commodity that had not been used in indirect exchange. At this point, money prices would result from values that were based on the nonmonetary uses of these commodities.
Mises’s regression theorem has remained one of the core elements of Austrian price theory, and more recently it has found an important new application in the field of currency competition. Indeed, the regression theorem tells us that it is impossible to launch a new paper money in the way one would launch any other new product on the market. Nobody would have any idea about the purchasing power of such a new paper money, precisely because it is new, and thus the market participants could not evaluate it.
Mises made other important contributions in his Theory of Money and Credit. He delivered a thorough analysis of the redistribution effects that go hand in hand with changes in the money supply. Additional quantities of money reach certain individuals first and allow them to bid up prices and thus to buy commodities that would otherwise have been bought by other market participants. It follows that money is never neutral. It has a profound impact on the allocation of resources through time and space.
But the single best-known contribution of the Theory of Money and Credit is probably its business-cycle theory, which Mises called the circulation-credit theory of the business cycle and which is today usually called the Austrian theory of the business cycle. Mises argued that the business cycle results from fractional-reserve banking. Under a fractional-reserve banking system, bankers can create money substitutes ex nihilo and give these substitutes to their customers in the form of fiduciary credit or circulation credit.
When this happens, the new supply of fiduciary credit reduces interest rates below the equilibrium level. This in turn distorts entrepreneurial calculations. At the lower interest rate, more investment projects appear to be profitable than would otherwise have been the case. But this impression is fallacious because the quantities of real resources have not increased. It is not possible to complete any additional investments projects. If entrepreneurs, deluded by the increased availability of fiduciary credit, launch new investment projects, they squander resources and set the economy on a crash course. It is physically impossible to complete all the projects that have been started, because there are just not enough real resources. Sooner or later a decision must be made where to put the available resources; all other projects must be abandoned. This is what happens in the bust phase of the business cycle.
Let me draw your attention to the implications of this theory for the interpretation of the boom phase and the so-called bust phase of the business cycle. In the popular mind, the boom is a period of growth—certainly an exuberant growth, but growth nevertheless. And the bust is a period of stagnation and destruction.
By contrast, in the light of Mises’s business cycle theory, one understands that the apparent improvement of things in the boom is just that—an illusion. What really happens is that scarce resources are wasted and society as a whole is therefore objectively impoverished. The illusion springs from the fact that the wasting goes hand in hand with a simultaneous redistribution process (remember: money is not neutral). Some members of society do improve their lot during the boom, and because public attention is on these happy fates, the general impoverishment goes unnoticed.
Similarly, the bust or—as it is sometimes called—the crisis is not, as in the popular perception, the beginning of all trouble. Rather, it is the beginning of a new sanity. The outbreak of the crisis occurs at the very moment when entrepreneurial fantasies meet the hard rock of economic reality, and finally cease. Entrepreneurs now abandon projects that cannot be continued with the available resources, and they watch out for new projects that are better adapted to present conditions. There is some stagnation in a crisis, but from the point of view of the Austrian business cycle theory, stagnation is certainly better than a continued boom, because after all it does not waste resources.
Socialism
The next major contribution that needs to be mentioned is Mises’s critique of socialism.
The first champions of socialism had depicted their ideal society as some sort of a small self-contained egalitarian community. Then the classical economists pointed out that living in autarky is not very productive. The socialist projects would therefore tend to be islands of misery in a capitalist world; and it was very unlikely that many people would be attracted by such prospects.
The socialist intellectuals could not help but accept this critique, but now they came up with a new idea. They claimed that central planning, the characteristic feature of socialism, was more productive than the anarchy of the market. It made no sense to establish socialism in little islands. What was needed was worldwide central planning, or at any rate central planning on as large a scale as possible. This was the state of the debate at the end of World War I, when Mises set out to critically examine the socialist tenets.
In one of the greatest economics articles ever written, Mises once and for all destroyed the claim that central planning would make production in society more efficient than the division of labor in a market economy. The article had the title “Die Wirtschaftsrechnung im sozialistischen Gemeinwesen.”
What is a rational allocation of resources? The allocation of a resource unit is rational when this unit is used in a project that is more important than any other project in which it could also have been employed. Hence, the rationality or nonrationality of a resource use is to be decided on the basis of a comparison between alternative uses of that resource.
Now Mises raised the crucial question: What is the standard of comparison? In terms of which criterion can or should we compare investment alternatives? Mises pointed out that a market economy could use the profitability criterion. For all investments, entrepreneurs can estimate the selling proceeds as well as the cost expenditure in terms of money prices. And then they can compare the ratios that spring from these estimates.
Let us notice that entrepreneurs are of course not somehow compelled to only look on profitability when they make their decisions. The point is that they can look at the profitability criterion, and that in the light of this criterion all investment alternatives in a market economy are indeed comparable.
Now what about a socialist economy? Mises argued that monetary calculation is here out of the question. For money prices can only come into existence in market exchanges, and market exchanges presuppose the existence of at least two owners. But in socialism there is only one owner of all means of production—the very definition of socialism—and thus there are no prices for factors of production. It follows that it is impossible, in a socialist regime, to calculate a profit rate for any investment project and to compare the profitability of different alternative investments.
The central planning agency of a socialist society is therefore deprived of the very means of economic rationalism. It is confronted by a huge array of heterogeneous resources, but it cannot compare the conceivable alternative uses of these resources in terms of a common unit. For example, one cannot tell whether 1,000,000 gallons of milk are somehow more (or less) than the 1,000 cows that produce this milk, just as it is impossible to say whether a castle park is more (or less) than the 100 gardeners that brought it in shape. All these things are heterogeneous and cannot therefore be compared quantitatively—the problem of adding up apples and oranges. For the same reason it is also impossible to tell whether using the cows to produce the milk is more efficient than using the gardeners to bring the garden in shape.
Only if all of these things are exchanged against money can we make such quantitative comparisons, namely, by comparing their money prices. It follows that while capitalism is a truly rational economic system, socialism is like a huge ship without a compass. Far from overcoming the alleged “anarchy of production,” socialism actually produces more chaos than would have existed without the imposition of central planning. Socialism, as Mises would say, is planned chaos.
Epistemology
You might think that, with his business cycle theory and his critique of socialism, Mises had stirred up more than enough trouble for a lifetime. But I can only encourage all of you to read his books, in particular the four great books, very carefully. Each of them is a rich mine of insights and arguments. Tonight we cannot do more than go through some of the highlights.
Let me therefore move on to another one of these highlights: Mises’s clarification of the epistemology of economics. Mises stated that economic science is a particular branch of a more general science—praxeology, the science of human action. The laws of this science are valid a priori, that is, they cannot possibly be refuted or verified by any facts that we gather through our senses. They can only be verified or refuted by discursive reasoning, which in turn is based on our reflective knowledge of what human action is.
Let me give you just one example. Consider first the most basic phenomenon that lies at the heart of all modern economic theories: human choice. There is absolutely no doubt that human beings can make choices and do make choices, and that, if it were not so, it would be pointless to engage in economic science at all (and several other disciplines such as ethics and law would of course be pointless as well). No school of economics disputes this fact, neither the monetarists, nor the supply-siders, nor the Walrasians, nor the game theorists, nor the Keynesians (old, new, post, and whatever sort of Keynesianism we will get yet).
Now ask yourselves how we come to know about the existence of choice. Do we actually observe choices with our eyes? Do we hear choices? Do we smell them? Clearly, this is not the case. But this means that the most basic phenomenon of economic science is known to us, not by facts we gather through our senses, but through an act of reflection on our own actions. And the knowledge that we gain this way does therefore not depend on information we gather from our senses, and thus it cannot be refuted or verified by any such information. It can only be verified or refuted by a more exact reflection on the structural features of our actions.
This is why Mises is right in his claim that economic science is valid a priori. And all other economists, who believe that economics is empirical in the very same sense in which for example the natural sciences are empirical are wrong.
Most mainstream economists have never given any serious thought to the epistemology of their science. They just repeat the slogans of a few academic high priests, who endlessly profess the litany of positivism, the doctrine according to which all scientific knowledge comes from observed facts or other sense-based methods of fact gathering. These words might sound harsh to some of you, but it is no exaggeration to say that positivism, despite all beneficial effects it might have had at some point in the past, has today become a quasi-religious creed. We can be sure that Auguste Comte, the founding father of positivism, now marvels in his grave, because that is exactly what he had in mind: replacing Christianity with his brainchild.
This bad new religion does not make good weather for the Austrians. Today mainstream economists disdain Mises and his followers for shunning empirical work and engaging in the armchair gymnastics of a priori theorizing. Many mainstream economists cannot pronounce the words “a priori theorizing” without grinding their teeth.
Milton Friedman once characterised a priori theorizing as a deadly undertaking. If two Austrians disagree, according to Friedman, there is only one solution left for them: they have to shoot it out.
Now I can assure you that in the ten years or so during which I have had the opportunity to observe the Austrians at a fairly close distance, it never ever came to a shooting, all the while we constantly disagreed with Mises, Rothbard, and amongst ourselves. The Mises Institute is located in Alabama, a state blessed with very liberal gun laws. There is no problem whatever to go to one of our nice local gun shops, buy a decent weapon, and so prepared go to the Mises Summer University or to the Austrian Scholar’s Conference to apply Friedman’s precept. But nobody has ever done this.
I therefore think it is high time now that Friedman finally accepts the historical record as an empirical refutation of his hypothesis. But I doubt he will.
When two Austrians disagree, they do not shoot it out; rather, each of them tries to come up with a better argument next time, but usually the disagreements remain. Things are not at all different in mainstream economics. It is a grave error to believe that empirical field studies provide something like a final verdict on a contested question. The empirical record shows that disagreements between positivists remain in the face of even the most impressive findings.
If anything, therefore, Friedman’s horror scenario applies with equal right to the positivist camp. If two positivists disagree and refuse to accept each other’s empirical studies as the final word, there remains only one solution: the trigger. But of course this is as nonsensical as it is in the case of disagreements between Austrians. Science is a process; it is never something like a final state of rest. Disagreements are not only unavoidable; they are also necessary and even beneficial to spur scientific progress.
So much for Friedman’s errors. But even many Austrian fellow travelers feel uncomfortable about Mises’s views on what economics is all about. They encourage students of Austrian Economics to leave the ivory tower and apply the theory in empirical work.
This recommendation also rests on a serious misunderstanding. Carl Menger, Ludwig von Mises, Murray Rothbard, Hans Hoppe, and many other excellent Austrians engage in a priori theorizing not because they shun empirical work, but precisely because a priori theorizing is the only way to adequately describe certain features of the real world, without which it would be impossible to fully understand human behavior and to give a scientific underpinning to political decision-making.
If anything, we need not less exercises in pure theory, but much more of it. It is true that not everybody is born to be a theorist and that applied historical case studies have a great pedagogical value. But the future of our science, and thus the future of our civilization will depend on the number of young intellectuals willing to learn pure theory in the realist tradition of Menger and Mises, and to develop this tradition to the best of their abilities.
Realism
This brings us to a final issue. As I just said, it is important that we develop praxeology in the realist tradition of Menger and Mises. Austrians should not become more like the mainstream, based on the false hope that thereby our ideas will become more palatable to academics. Turning Austrian economics into just another branch of the mainstream will at best flatter the little egos of the protagonists. Austrians should become and be all that they can be as the bearers of realist economic theory. But they can do this only if they are willing to immerse themselves in the tradition of Austrian realism.
This tradition is most vividly present in the works of the main line of Austrian theorists: Menger, Böhm-Bawerk, Mises, Rothbard, and today in the works of Hans-Hermann Hoppe and the other senior fellows of the Mises Institute, as well as in the works of a few others, such as Jesús Huerta de Soto, Pascal Salin, and George Reisman. It is less present in the works of Friedrich von Wieser, Friedrich von Hayek, and those who, following in their footsteps, place too much emphasis on the use of fictitious constructions, for example, on the equilibrium construct and on processes of equilibration.
The quest for greater realism in the social sciences—this is the core mission of Misesian scholarship in our times. At its heart this is a quest for the full truth, and even though we cannot expect to ever gain a full picture of anything here on earth, we will try to get as close as we can in the coming week. If Misesians remain faithful to their mission, it will not fail to yield a rich harvest. For not only the truth, but the mere honest quest for realism has a great power of attraction.
It has brought the Austrians important converts from the mainstream. For example, at the beginning of the twentieth century, Ludwig von Mises himself defected from the mainstream of his time—the Historical School. In the 1970s, Hans-Hermann Hoppe, who is among us tonight, defected from the mainstream philosophy of the Frankfurt School; and in the 1980s, Jeffrey Herbener, also here tonight, defected from neoclassical economics.
Today the Austrian School is a vibrant and growing movement of economists, historians, philosophers, and other social scientists united in their love for the search of truth and in their courage to say the truth even if it does not fit the political or academic fashions of our day. There is no better place and no better occasion to become acquainted with this movement than the Summer University here at the Mises Institute, and I hope you will make good use of it.
