If you carry the popular impression that data-hungry economists are always busy with complex formulas and not with outside-the-box thinking, then you should take a look at the Austrian school. Just like monks living in their monastery, the economists of this school strive to solve complex issues—economic ones—by conducting "thought experiments." The Austrian school believes it is possible to discover the truth simply by thinking aloud. Interestingly, this group does have unique insights into some of the most important economic issues of our times. Read on to find out how the Austrian school of economics has evolved and where it stands in the world of economic thought.

An Overview of the Austrian School

What we know today as the Austrian school of economics was not made in a day. This school has gone through years of evolution in which the wisdom of one generation was passed on to the next. Though the school has progressed and incorporated knowledge from outside sources, the core principles remain the same.

Carl Menger, an Austrian economist who wrote Principles of Economics in 1871, is considered by many to be the founder of the Austrian school. The title of Menger's book suggests nothing extraordinary, but its contents became one of the pillars of the marginalism revolution. Menger explained in his book that the economic values of goods and services are subjective in nature, so what is valuable to you may not be valuable to your neighbor. Menger further explained with an increase in the number of goods, their subjective value for an individual diminishes. This valuable insight lies behind the concept of what is called diminishing marginal utility.

Later on, Ludwig von Mises, another great thinker of the Austrian school, applied the theory of marginal utility to money in his book Theory of Money and Credit (1912). The theory of diminishing marginal utility of money may in fact help us in finding an answer to one of the most basic questions of economics: How much money is too much? Here also, the answer would be subjective. One more extra dollar in the hands of a billionaire would hardly make any difference, although the same dollar would be invaluable in the hands of a pauper. (For related reading, see: How can marginal utility explain the 'diamond/water' paradox?)

Other than Carl Menger and Ludwig von Mises, the Austrian school also includes other big names like Eugen von Bohm-Bawerk, Friedrich Hayek and many others. Today's Austrian school is not confined to Vienna; its influence spreads across the world.

Over the years, the basic principles of the Austrian school have given rise to valuable insights into numerous economic issues like the laws of supply and demand, the cause of inflation, theory of money creation and operation of foreign exchange rates. On each of the issues, the views of Austrian school tend to differ from other schools of economics.

Some of the main ideas of the Austrian school and their differences with other schools of economics are examined below:

Methodology of Thinking on Your Own

The Austrian school uses logic of a priori thinking—something a person can think on his/her own without relying on the outside world—to discover economic laws of universal application, whereas other mainstream schools of economics, like the neoclassical school, the new Keynesians and others, make use of data and mathematical models to prove their point objectively. In this respect, the Austrian school can be more specifically contrasted with the German historical school that rejects universal application of any economic theorem.

Price Determination

The Austrian school holds that prices are determined by subjective factors like an individual's preference to buy or not to buy a particular good, whereas the classical school of economics holds that objective costs of production determine the price and the neoclassical school holds that prices are determined by the equilibrium of demand and supply.

Austrian school rejects both the classical and neoclassical views by saying costs of production are also determined by subjective factors based on value of alternative uses of scarce resources, and the equilibrium of demand and supply is also determined by subjective individual preferences. (For related reading, see: Macroeconomics: Schools of Thought.)

Capital Goods

A central Austrian insight is capital goods aren't homogeneous. In other words, hammers and nails and lumber and bricks and machines are all different and can't be substituted for one another perfectly. This seems obvious, but it has real implications in aggregated economic models. Capital is heterogeneous.

The Keynesian treatment of capital ignores this. Output is an important mathematical function in both micro and macro formulas, but it is derived by multiplying labor and capital. Thus, in a Keynesian model, producing $10,000 in nails is exactly the same as producing a $10,000 tractor. The Austrian school argues that creating the wrong capital goods leads to real economic waste and requires (sometimes painful) re-adjustments.

Interest Rates

The Austrian school rejects the classical view of capital, which says interest rates are determined by supply and demand of capital. Austrian school holds that interest rates are determined by subjective decision of individuals to spend money now or in the future. In other words, interest rates are determined by the time preference of borrowers and lenders. For example, an increase in the rate of saving suggests that consumers are putting off present consumption and that more resources (and money) will be available in the future.

The Effect of Inflation

The Austrian school believes any increase in money supply not supported by an increase in the production of goods and services leads to an increase in prices, but the prices of all goods do not increase simultaneously. Prices of some goods may increase faster than others, leading to greater disparity in the relative prices of goods. For example, Peter the plumber may discover that he is earning the same dollars for his work, yet he has to pay more to Paul the baker, when buying the same loaf of bread. The changes in relative prices would make Paul rich at the cost of Peter. But why does it happen like that? If the prices of all goods and services were to increase simultaneously, it would have hardly mattered. But the prices of those goods through which the money is injected into the system adjust before other prices. For example, if the government is injecting money by purchasing corn, the prices of corn would increase before other goods, leaving behind a trail of price distortion. (For related reading, see: How Inflation Affects Your Cost of Living.)

Business Cycles

The Austrian school holds that business cycles are caused by distortion in interest rates due to the government's attempt to control money. Misallocation of capital takes place if the interest rates are kept artificially low or high by the intervention of the government. Ultimately, the economy goes through recession

Why does there have to be a recession? The labor and investment employed toward inappropriate industries (such as construction and remodeling during the financial crisis of 2008) need to be redeployed towards actually economically feasible ends. This short-term business adjustment causes real investment to drop and unemployment to rise.

The government or central bank might attempt to circumvent the recession by lowering interest rates or propping up failed industry. Austrian theorists believe that this would only cause further malinvestment and make the recession that much worse when it actually strikes.

Market Creation

The Austrian school views the market mechanism as a process and not an outcome of design. People create markets with their intention to better their lives, not by any conscious decision. So, if you leave a bunch of amateurs on a deserted island, sooner or later their interactions would lead to the creation of a market mechanism.

The Bottom Line

The economic theory of the Austrian school is grounded in verbal logic, which provides a relief from the technical mumbo jumbo of mainstream economics. There are considerable differences with other schools, but by providing unique insights into some of the most complex economic issues, the Austrian school has earned a permanent place in the complex world of economic theory.

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