Austrian Economics and the Financial Crisis

The following has been adapted from a slideshow presentation given at a symposium on Marginal Revolutionaries: The Mainstream Economics Crisis and Heterodox Approaches  held at the Canadian Economics Association annual meeting in Calgary, Alberta on Friday, June 8, 2012.

Good morning.

Opening remarks

I want to begin my presentation by thanking Marc-André Pigeon for his leadership in putting together this organized symposium.  The two previous speakers and the article in the Economist motivating this session reveal the sharp differences about the nature of the current problematic situation and prescriptions aimed at resolving it.  I am grateful for the opportunity provide my interpretation of the Austrian perspective.


The purpose of my presentation is twofold.

First, I want to explain what Austrian Economics is.

My perception is that most people are innocently uninformed or unaware of the Austrian School of Economics.  Whenever you get exposed to anything new, you don’t really appreciate what you are getting exposed to without some context.  It’s like travelling to a foreign country for the first time.  If you really want to understand what you are experiencing, you better know a little about its history.  Likewise, to fully grasp the central ideas of the Austrian approach, one needs to understand its development.  In so doing, it becomes clear that Austrian Economics is partly within and partly beyond the mainstream.

My second objective involves a diagnosis of the financial crisis using an Austrian approach.  With the benefit of hindsight, it is apparent that conventional neo-classical methods did a poor job helping to predict the crisis and subsequently guiding what ought to be done.  The ongoing deteriorating situation provides compelling evidence of the soundness of the Austrian approach.

Austrian School Family Tree

It may come as a surprise that Austrian Economics is likely the oldest continuous school of economic thought.  While Carl Menger is generally considered the founder of the Austrian School, its roots originate in the fifteenth century, when followers of St. Thomas Aquinas at the University of Salamanca in Spain sought to explain the full range of human action and social organization.

Late Scholastics

Writings of the Late Scholastics, such as Covarrubias, explained price, value, the function of money, saving, entrepreneurship, inflation, and the subjective nature of value.  The Late Scholastics were advocates of private resource ownership and the freedom to contract and trade.  They opposed taxes, price controls, and regulations inhibiting enterprise.  As moral theologians, they urged authorities to obey ethical strictures against theft.

The first general treatise on economics, Essay on the Nature of Commerce, was written in 1730 by Richard Cantillon who was schooled in the Spanish scholastic tradition.  He recognized economics as an independent area of investigation, understood the market as an entrepreneurial process, and held to what became an Austrian concept of money creation: that it is introduced in a step-by-step fashion, disrupting prices to varying degrees over space and time.


Cantillon was followed by Jacques Turgot.  In his 1769 paper “Value and Money”, Turgot traced the origins of money and untangled the nature of economic choice:  that it reflects the subjective, ordinal rankings of individual preferences.  As a classical liberal, he recommended the repeal of all special privileges granted to government connected industries.

Say and Bastiat

Turgot was the intellectual forbearer of several notable French economists of the eighteenth and nineteenth century, most prominently Jean-Baptiste Say and Frederic Bastiat.

Say realized that economics is not about amassing data, but the exposition of universal facts (such unlimited wants, scarce means, and the concept what Austrian Economist Friedrich von Wieser later coined — “opportunity cost”), and their implications.  Say discovered the marginal productivity theory of resource pricing, the role of capital in the division of labor, and how there can never be sustained “overproduction” or “underconsumption” on the unhampered market.

The main theme of Bastiat’s writings was how unhampered markets were a necessary precondition for peaceful interpersonal exchange and the creation of wealth.  To this end, Bastiat advocated that government activities be restricted to protecting the lives, liberties, and property of citizens against theft or aggression.  His writings constitute an intellectual bridge between the ideas pre-Austrian economists and those of Carl Menger.


Despite the sophistication of the pre-Austrian tradition, the British-Classical school based on the objective-cost and labor-productivity theory of value, emerged as the first modern school of economic thought.  The British-Classical School received its first serious challenge when Carl Menger’s Principles of Economics appeared in 1871 which brilliantly resurrected and solidified the Scholastic-French approach to economic science.

Together with the contemporaneous writings of Leon Walras and Stanley Jevons, Menger clarified and reinforced the subjective basis of value, and fully explained, for the first time, the theory of marginal utility.  Menger also showed how money originates in a free market when the most marketable commodity is desired, not for consumption, but as a means in exchange.  Like his predecessors whom I have cited, Menger was a methodological individualist, viewing economics as the science of human action based on deductive logic.


Eugen von Boehm-Bawerk took Menger’s exposition and applied in a host of settings.    Boehm-Bawerk made clear the rate of interest is not an artificial construct, but an inherent part of all market processes.  It reflects the universal fact of subjective time preference, the tendency of individuals to prefer the satisfaction of wants sooner than later.  He also showed that “capital” is neither a homogeneous nor an objective entity, but an intricate and diverse structure that is subjective with a time dimension.  Boehm-Bawerk cemented the status of the Austrian School as a unified way of looking at economic problems and set the stage for inroads in the English-speaking world.


Ludwig von Mises took up the challenge of integrating Knut Wicksell’s theory of interest rates, and Boehm-Bawerk’s theory of the structure of production.  Thus began the career of one of the greatest economists and social philosophers of the twentieth century.  Ironically, most contemporary students of economics know nothing about him.

Mises published many books and articles in his long and productive life, each of them making important contributions to the theory and application of economic science.  But there stand out among them four towering masterpieces.  The first, which established Mises in the front rank of economists, was his 1912 book The Theory of Money and Credit.  In it, Mises innovatively integrated the theory of money and the theory of relative prices, and outlined a consistent and compelling theory of the business cycle.  His second great work was Socialism in 1922, which provided the definitive, comprehensive critique of socialism and demonstrated the impossibility of economic calculation in a socialist commonwealth. The third was his 1949 treatise Human Action, which set forth an entire structure of economics based on the analysis of acting man.  Mises’s final great methodological work Theory and History appeared in 1957.  In it, he explained the basis of his approach to economics and provided devastating critiques of fallacious alternatives such as historicism and scientism.   Even though his economic analysis itself was “value-free” — in the sense of being irrelevant to values held by economists — Mises concluded that the only viable economic policy for humanity was unrestricted laissez-faire, of free markets and the unhampered exercise of the right of private property, with government strictly limited to the defense of person and property against aggression.

Hayek and Hazlitt

Mises’s arguments attracted a group of converts from socialism, including Freidrich Hayek, Wilhelm Roepke, and Lionel Robbins.  Hayek and Mises authored many studies on the business cycle and the consequences of credit expansion which are essential to understand the present day financial crisis.

Working in England and America, Hayek was a prime opponent of Keynesian economics.  His popular 1944 book Road to Serfdom helped revive the classical liberal movement in America.  His paper  “Use of Knowledge in Society”, which appeared in the AER the following year, provided a complete and devastating critique of market socialism based on the division of knowledge, the sum of which no person or group of experts is capable of acquiring.  Informed decision-making entails allowing individuals to act on the information of “time and place” that only they themselves have, while providing a system of communication – prices —  that motivates and informs how best to do it.

Journalist Henry Hazlitt was Mises’s most prominent supporter in the United States.  Hazlitt reviewed Mises’s books in the New York Times and in Newsweek, he popularized Mises’s ideas in such classics as Economics in One Lesson, and he wrote a brilliant line-by-line critique of Keynes’s General Theory.


Murray Rothbard’s Man, Economy, and State (1963) was patterned after Mises’s Human Action.  His  approach followed directly in the line of Late Scholastic thought by applying economic science within a framework of a natural-rights theory of property.  What resulted was a complete and thorough defense of a capitalistic and stateless social order, based on private property and freedom of association and contract.  He also developed a theoretical framework for examining the effects of all types of interventionism.

Rothbard followed his economic treatise with an investigation of the Great Depression, which applied Austrian business cycle theory to show the economic downturn was attributable to prior bank credit expansion.  The reunion of natural-rights theory and Austrian economics was the objective of his philosophical work, The Ethics of Liberty, published in 1982.  These seminal works serve as the crucial link between the Mises-Hayek generation and those now working to expand the tradition.


Many theories developed by early Austrian economists have been absorbed by the mainstream including the subjective theory of value, marginalism, and the failures of central planning.  Partly as a result of the financial crisis, Austrians are now in a more prominent position within the discipline than at any point since the 1930s.

Distinctive Features

A summary of the key features of the Austrian approach include: Rationality, Equilibrium, Equilibration and Method.


The distinctive and crucial feature is the concept of purposeful action.  Every human action is an attempt to move from a less desired state to a more desired state.  The purpose of an act is the end; the desire to achieve this end is the motive.  Learning and action take place in real time.

This notion of rationality is in sharp contrast to the maximization of an objective function subject to a set of identified constraints, the mechanical starting point of mainstream micro.


A second attribute is the conceptualization of equilibrium.  For Austrians, equilibrium is a hypothetical construct.  Mises characterized it as steady state or an “evenly rotating economy”.  It is useful only for thought experiments.  Market processes are constantly affected by the disturbing elements of nature and new human actions.  In other words, the ever changing constellation of economic phenomena as individuals perceive them, gives rise to chronic disequilibrium.


The process of entrepreneurial discovery with learning is central to the Austrian perspective.   All human activity takes place in time. Uncertainty of the future holds genuine surprises for individuals stemming from two sources: [1] the unpredictability of human acts of choice, and [2] incomplete knowledge about natural phenomena.  The prevailing disequilibrium gives rise to potentially profitable opportunities for alert entrepreneurs, producers and consumers.  Competition among individuals over scarce resources is a process toward equilibrium; it is not an outcome, a market structure or a steady state.


Mainstream economists are generally dismissive of Austrian methods.  Whereas mainstream economists generally use statistical methods to model economic behavior, Austrians argue this approach is misplaced, unreliable, and insufficient to analyze economic behavior and to evaluate economic theories.

Austrians subscribe to the notion of dualism:  the realm of knowledge has two separate fields.  The first is the realm of external events, called nature.  The second is the realm of human thought and action.  While statistical methods, natural experiments, and constructed experiments are appropriate in the natural sciences where factors can be isolated in laboratory conditions, the actions of humans are too complex for such a treatment because humans are not passive and non-adaptive subjects.

Method – A priorism

Austrian economics is rooted in a priorism.  This means foundational propositions are ascribed validity prior to experience.  For instance, a fundamental axiom of economics absolutely independent of experience is that all human action is aimed at substituting a more satisfactory state of affairs in place of a less satisfactory one.  This irrefutable premise is the basis of subsequent unified, logically deduced theorems and conclusions, through which Austrian economists interpret the world about them.

Method— Realism

Austrians criticize the mainstream for the unrealistic character of their modelling assumptions.  In his enormously influential 1953 article “The Methodology of Positive Economics”—a work which Friedrich Hayek once described as being “as dangerous” as Keynes’s General Theory—Milton Friedman defended the use of unrealistic models against Austrian-style criticisms.  Freidman asserted that any good explanatory theory must be abstract, and abstractions by their very nature are unrealistic.

The Austrian response to Friedman is that features typically omitted by the mainstream are the very ones crucial to understanding how markets function, and so cannot be “irrelevant for the phenomena to be explained.” 


Finally, an often overlooked fact about human action is that it can be undertaken only by individual “actors.”  Only individuals have ends and can act to attain them. There are no such things as ends of or actions by “groups,” “collectives,” or “States,” which do not take place as actions by various specific individuals. “Societies” or “groups” have no independent existence aside from the actions of their individual members.  And the actions of each individual are guided by a subjective evaluation concerning economic goods which are person, place, time and circumstance specific.


Austrians view economics as a tool for understanding how people both cooperate and compete in the process of meeting needs, allocating resources, and discovering ways to peaceful prosperity.  Austrians view entrepreneurship as being indispensible for economic development, private property as essential for an efficient use of resources, and government interventionism as always and everywhere destructive.  This background is important to understand the Austrian diagnosis and prescription for the ongoing financial crisis.

Problematic situation

It is generally accepted the financial crisis was caused by egregiously low interest rates, large inflows of money and easy credit conditions.  In North America, Europe, and South East Asia, central banks and national governments are currently engaged in an impossible exercise — trying to re-inflate the artificially created boom through near zero interest rates and deficit spending.   In other words, the response to the crisis is more of the same which created the problem in the first place.  This is like an oncologist treating a cancer patient by encouraging cancer cells to metastasize.  While the counterproductive effect of the oncologist’s cancer treatment is clear, most individuals — including many economists — do not recognize the similarly counterproductive effects caused by government conjured cures to the financial crisis.


The Austrian thesis is that the present use of fiscal and monetary policies by central authorities, particularly in the United States but also in Canada and elsewhere, to control and stabilize macroeconomic variables are not only self defeating, but likely will lead to conditions which are even less desirable than our present state of affairs.  By means of the Austrian Business Cycle Theory I will first explain why this is so and then conclude by identifying some monetary implications.


The theory unfolds in the following way:  Interest rates fixed below what they would have been in an unhampered market stimulate borrowing from the banking system.  The expansion of credit causes an expansion of the money supply through the money creation process in a fractional reserve banking system.  This leads to an unsustainable credit-sourced boom during which capital is mal-invested in longer-term production processes for which there is insufficient real capital for profitable completion.  Artificially stimulated borrowing seeks out ever diminishing investment opportunities, with higher prices and higher real interest rates eventually bringing the artificially initiated boom to an end, but not before real capital, real vendible goods, have been directed to lines of production that will never turn a profit.  Mounting losses propel a costly shift of resources toward other uses, beginning a process of re-establishing the structure of production that reflects the true preferences of consumers.

In a nutshell, the induced boom is the origin of the problem while the bust is the inevitable solution.

Fear the boom and the bust

Two years ago, producer John Papola and George Mason University Professor Russ Roberts cleverly communicated the essence of the Austrian Business Cycle Theory in the widely popular YouTube video titled Fear the Boom and the Bust.  The video is notable because almost 80 years of philosophical and economic debates were distilled into five minutes of pithy verse.  It has more than 3.6 million views on YouTube – incredible for something explaining macroeconomic concepts.  It is worth a look if you haven’t seen it.  And I also recommend the sequel which focuses on the housing crash.

Contribution of Mises and Hayek

The theory of mal-investment was conceived by Austrian economists Ludwig von Mises and Friedrich Hayek in the first half of the 20th century.  Despite it falling into near oblivion after the Keynesian revolution in macroeconomics, Mises and Hayek provided the most sound, compelling and timeless explanation of how an artificially reduced rate of interest leads producers to invest in the wrong kinds of capital, in particular the longest-lived capital goods, such as land and buildings, as opposed to inventories, equipment, and software with a relatively short life.  Thus, when central banks maintained low rates of interest, like those between 2002 and 2005, this led individuals to overvalue longer-term capital projects and to shift their investment spending in that direction — producing booms in building construction like houses, factories or barns, among other things.  This shift would make economic sense if the interest rate had fallen in a free market, thereby signaling that people wish to defer more consumption by saving more of their current income.

Cluster of Error

But if people have not changed their preferences in this way, and they continue to prefer present consumption as much as they did before, then businesses will make mistakes choosing investment projects, which are, in effect, attempts to anticipate future demands that will never come to pass.  These general clusters of business error are a direct product of interventionism with respect to the rate of interest.  When these projects ultimately begin to fail, the boom that the artificially lowered interest rates set in motion will collapse into a bust, with attendant bankruptcies and unemployed labor, as unsustainable projects are liquidated and resources are shifted — painfully in many cases — to more viable uses.

Restructuring can be delayed, but not avoided.

Bankruptcies and unemployment necessarily attend a substantial realignment of capital resources to re-establish the structure of production congruent with the true preferences of consumers.  This restructuring cannot be avoided but it can be postponed — at an ever accumulating cost –- and there is ample evidence this is currently transpiring.  Central governments in Europe, North America and Japan are using deficit spending to make up for reduced private investment and consumption spending, to restore business to profitability, and re-employ workers with little or no restructuring of capital resources.  The requisite financing comes from future taxpayers, an expansion of the money supply, or both.  Prices will rise and wealth will be redistributed.

Bottom line

The bottom line is that no means are available to avoid the collapse of a boom brought about by credit or monetary expansion.  The alternative is only whether the crisis should come sooner, as the result of abandoning further credit or monetary expansion, or later, as a collapse of the fiat currency.  The longer the restructuring of capital resources is postponed by central authorities, the more costly is the correction.  The end result seems fixed; the only question that remains is what happens between now and then.   To paraphrase an overused cliché: “we cannot kick the can down the road indefinitely”.


From the perspective of an individual, it is possible live beyond one’s means, but for only a limited period of time.  Likewise, it is obvious that a debt problem cannot be resolved by borrowing more.  The same limitations which apply to each of us individually apply to groups of individuals.  Unless entitlements (welfare, health care and public pensions) are substantially reformed and other forms of spending curtailed, central governments in particularly in Europe and North America appear on the way to defaulting on their debts.

In the case of default, there are two possible monetary scenarios: (1) monetary deflation due to a decrease in the money supply, in the case that no government intervention takes place; and (2) monetary inflation of the money supply in the case that it does.

If one or more governments defaulted, large-scale investors in government debt would have massive loan and capital losses.  The result of these losses would be banks going out of business, calling in outstanding loans, or both, thereby reversing the money multiplier process and causing a decline in the money supply.  The falling money supply — deflation — would make the currency more, not less, valuable relative to the existing stock of goods and services.

The second alternative appears more likely by historically verifiable policies — low interest rates, an expansion of credit and an expansion of the supply of money, through the money creation process in a fractional reserve banking system.

Consider the situation in the United States.

1. Since 2008, the Fed has more than tripled the base money supply (inflation) and reduced interest rates to zero.

2. $1.5 trillion in newly created money is being retained by commercial banks in reserve. This money is not circulating through the economy, hence the effects of the inflation are negligible.  But it is evidently required to keep the banks in business or at least to prevent them from having to sell assets few want at present prices.  In short, all this money is needed to sustain a mirage of solvency of the financial system and an illusion of ‘recovery’.

3. When commercial lending activities expand the effects of inflation will appear and the central bank will raise interest rates.

4. Eventually, the effects of inflation — high commodity prices, and interest rates — will trigger a bust.  To the extent the current restructuring of capital resources from the financial crisis is impeded or distorted, the more costly will be this impending correction

 Mises summarized the alternatives succinctly:

Either banks continue the credit expansion and thus cause constantly mounting price increase and an ever-growing orgy of speculation, which, is in all other case of unlimited inflation, end in a collapse of the money and credit system.

Or the banks stop before this point is reached, voluntarily renounce further credit expansion which brings about the liquidation of malinvested resources.

A depression follows in both instances.

Thank you.

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2 Responses to “Austrian Economics and the Financial Crisis”

  1. iakovos1000 says:

    The Causes of the Economic Crisis for non Economists- The Austrian Approach

  2. andrew cullen says:

    very laudable summary !

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