The Austrian economists: why we would bring them back from the sidelines

Amongst the many schools of economic thought, the Austrian school lies outside the economic mainstream. However, it has perhaps surprisingly punched above its weight in terms of its influence over the political and economic thought of the 20th century. Some of the most prominent and influential economists were from this particular school, such Friedrich Hayek.  Hayek in particular had a large influence on the thinking of some of the great leaders of recent history such as Ronald Reagan and Margaret Thatcher.

Known for their “laissez-faire-ness” and strong individualist and libertarian undertones, the Austrian’s ultimately advocate a much broader philosophy that reaches beyond just economics. It is perhaps this point that has given them an even wider reach and audience.

The more technical economic theories of the Austrian school of thought receive little mention in a contemporary economics education. This might be because of their rejecting of econometric and macroeconomic methods, and any economics student would be aware that such mathematically underpinned fields form the basis of a conventional education in economics. Usually, the Austrians’ theories and ideas only ever receive mention in economic history classes.

Yet far from belonging to the history books, the Austrian school present some interesting analytical tools and methodologies and can provide some interesting insights into the economic morass that plagues us today.

For example, consider the following diagram:


This is a depiction of the Austrian capital theory, probably the most recognizable of the theoretical contributions of the Austrian’s. The trademark of this theory is that it incorporates “time” into its analysis and the changes in the composition of production in response to changes in interest rates.  Essentially, the crux of this theory is: by artificially lowering the interest rate, producers will be inclined to take advantage of lower interest rates to make capital investments for the later stages of production (plant and equipment, a.k.a. fixed assets). Then, as this production is directed towards more roundabout methods of production (capital deepening), the relative production of consumer goods declines and existing demand will eventually bid up their prices. This eventual increase in the price of final (consumer) goods will then mean a reverting of production and resources back to more intermediate goods (capital shallowing).

Basically, the Austrians postulate that when the interest rate is lowered to a level below its natural rate by a central bank, there will be structural misalignments of production in that while the lowered interest rates will stimulates demand for consumer goods, it diverts factors away from the higher stages of production.

It is here that the Austrians contrast sharply to the Keynesians in explaining the economic boom-and-bust story. While the latter will blame stocks of unused capital seen during economic downturns as evidence of a lack of consumer demand (aggregate demand), the Austrians say that it is because demand for final goods relative to the amount of capital investment in the later stages of production has been “too urgent” (Hayek 1935).

How well does all this theory help us in understanding events today?

In answering this, I found an interesting chart in The Economist recently:


As this chart illustrates, Gross fixed capital formation investment as a percentage of GDP in these nations is decreasing. Alas, these same nations/regions have central banks buying bonds and “printing” money in a concerted effort to drive down long-term interest rates to zero.

This trend is consistent the Austrians’ notion that cheap money will result in capital shallowing and decreased fixed capital formation. Yet the above diagram shows decreased gross fixed capital formation post-GFC, an economic environment still mired with pessimism and uncertainty – it hardly seems that this cheap money is fueling red-hot consumption at the moment.

But we shouldn’t write off the Austrian’s just yet. It should be noted that prior to the GFC, interest rates in these countries, particularly the US, were too low and were largely responsible for helping inflate the housing bubble. Moreover, perhaps what we are witnessing now is a post-bust “secondary deflation” period, a term which means that businesses are still getting over the fact that their previous prosperity was unsound and are thus still pretty gloomy about things. Austrian economist, Friedrich Hayek back in 1931, propounded this idea.

But as there has historically been little empirical evidence of many of the Austrians’ theories, it has usually all been taken with a grain of salt.

Yet, rather than sidelining the Austrian’s as “anarcho-libertarian radicals” (as they often are), we should at least recognize that they can give us a different and original perspective of the economic events and trends that are happening right before our eyes. Maybe it’s time to be more inclusive of them in mainstream economic discussion.

Image: ‘Friedrich August von Hayek’ by Levan Ramishvili, Licence at public domain mark

1 thought on “The Austrian economists: why we would bring them back from the sidelines”

  1. Interesting article.
    I agree we need to bring Austrian economics into mainstream econoomics education. Every ecpnomic theory is a fable. As an economist, we need to be exposed to all the different stories.
    I understand why Austrians would suggest that using models is useless as they can never be accurate enough, yet Economists believe in them too much. I also understand the mainstream view of having a model otherwise it is hard to see faults in logic in a clear way.

    It is too easy to get impressed by the mathematics and think this represents reality. And anything better is better than nothing? Not necessarily as pointed out by Daniel Kahneman.

    Basically, I reckon we need to stop this culture of expecting economists to make forecasts. We don’t ask Biologists for that kind of rigour. Economics is a social science, not a physical science.

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