Introduction To Economics

This article aims to provide a general introduction to Austrian economics. We will focus the majority of our attention on the epistemological foundations of the science. We will also look at some specific key ideas that will allow you actually start performing real world analysis.

Unfortunately, I simply can not cover every topic of interest. The references provided at the end of the article are all excellent places for further reading. This article is adapted from two primary sources - Human Action by Ludwig von Mises and Economic Science and the Austrian Method by Hans-Hermann Hoppe. I consider these two texts the most essential further reading. Beyond there, I make reference to several other works covered in the references.

History of Austrian Economics

Austrian economics is relatively new. Let's take a tour of where it came from.

In the late 1700s Malthuse publishes his famous work on the Malthuse trap. This work is still of influence today. This is the idea of populations growing exponentially but resources only growing linearly. Unfortunately, this idea continues to plague us now. For instance, The Population Bomb published in 1968 predicting global famine. None of the predictions within that book came to pass. Unfortunately, people of that generation internalised the ideas.

However, the the theory was soon smashed by reality. Adam Smith noticed that in some places it was possible to escape this trap. He noticed that free enterprise, good institutions and human ingenuity bring about conditions of plenty. He noticed this by observing some of the most prosperous countries of the time - England and the Netherlands. Deirdre McCloskey notes that starting around the late 1700s both England and the Netherlands are able to escape the Mathusian trap.

There was another man writing about the same time, David Ricardo (1772-1823). Ricardo was particularly involved in the idea of free trade. From the late medieval period up until Ricardo's time the prevailing idea was Mercantilism. This is the idea that international trade is about running trade surpluses and accumulating bullion. Ricardo argued that there was more to trade than this - by trading away bullion countries could import goods they would not otherwise have access to. Combine this with the law of marginal utility and it is easy to see that allowing such importations goes a long way to increasing wealth.

A little later on Frederic Bastiat (1801-1850) lays an important foundation in method. His critical work That Which is Seen, and That Which is Not Seen encourages consideration of alternatives. Alternatives and margins are a key and critical concept in economics. Bastiat uses the analogy of the broken window - the fallacious argument that smashing windows is good for an economy because it drives people to buy from the glass maker. Of course, what is not considered is that which is not seen - the shoes, books, toys, engines and other investments not made. Indeed, we can also consider the margins. There's some shopkeeper who is so marginal that a broken window is the final straw, putting him out of business. This leads to fewer jobs, and fewer places to trade goods.

Up until now these economists mentioned are somewhat aligned with the Austrian school but they have some serious distinction with the Austrians. To them, economics has remained an empirical science. That changes in 1871.

Carl Menger (1840-1921) publishes Principles of Economics. This is the first work in the Austrian canon. This book emphasised the importance of the law of marginal utility. Thus, it solved the diamond-water paradox which had been puzzling economists of the time. (The diamond-water paradox is the paradox that diamonds are far more valuable than water despite water being "more important" than diamonds). Menger had extensive disputes with the historical school of economics. The historical school proposes the opposite view to the Austrians that economics is discovered through collating historical facts. Carl Menger also formalised the origins of money in one of his later works, which we will study in some detail.

Eugene von Böhm-Bawerk (1851-1914) also contributes to the early school. Böhm-Bawerk contributed to capital theory, and he also started to unravel the mysteries of the phenomena of interest. Böhm-Bawerk also was the first to understand the mechanism of capitalism and the phenomena of "roundaboutness" in production. He was also famous for starting the tradition of Austrians critiquing Marxist and socialist works.

Ludwig von Mises then publishes the crowning jewel of Austrian Economics - Human Action. This expansive work covers almost every subject imaginable in economics. It restates the important theory from earlier economists and expands upon them in significant ways. Mises also forwards the idea of praxeology, thus completing the epistemological foundations of Austrian Economics.

At this point there is a split. Mises influences the next great Austrian Economist, the American Murray Rothbard. Rothbard brought Austrian economics to the forefront of American politics, and influenced helped influence policy decisions. His The Mystery of Banking in 1983 was particularly influential. Rothbard's contribution was the formulation of Rothbardian ethics. It is beyond the scope of this work. You can find a brief introduction to Rothbardian ethics in the final chapters of The Economics and Ethics of Private Property by Hans-Hermann Hoppe.

Rothbard's pupil, Hans-Hermann Hoppe, is the current key thinker of Austrian Economics. Hoppe focused on elaborating the epistemological framework laid by Mises, and made explicit links with Kantian philosophy. He also contributed many social, political and historical analysis through the lense of Austrian economics.

On the other side of the split from Mises is Hayek. Hayek was very influential in British politics. Margaret Thatcher was famously influenced by his book The Road To Serfdom. Like Rothbard in America, Hayek's influenced softened the socialist tendencies of Britain and helped bring about the tremendous economic modernisation and prosperity that ended the stagnation Britain had been experiencing. This essay will not cover Hayekian thought, and stay within the thought of the Mises branch of Austrian economics.

Today, Austrian economics remains popular and well studied. Thankfully, it is extremely accessible due to the efforts of the Mises Institute, who have made almost every book, lecture, article and essay written by the key Austrian thinkers available for free download on their website, mises.org. I thank them for this, as without this wonderful resource writing this article would not be possible.

What is Economics?

Economics, as understood by the Austrian school, is a science. Austrians often form close alliances with some Classical Economists, such as the Chicago School Economists but these are tactical. Even when policy goals align, Austrian economics has an altogether different view of economics as science.

The most striking innovation of Austrian Economics is to view Economics as a logical science rather than an empirical science. This started with thinkers like Menger and Böhm Bawerk. For instance, as mentioned in the historical overview, while people like Adam Smith and David Ricardo are the precursor to the school, their methodology was empirical or historical in nature.

It might be helpful here to look briefly at the role and nature of science. What is the role of the scientist? A scientist has precisely one goal - an accurate description of natural law. Anything beyond this goal is not science. If a "scientist" gives a policy suggestion, he does so not as a scientist but as someone else.

The role of the historian is to interpret record. The historian is not a recorder - that is mere journalism - the historian collates relevant facts and forms a narrative. It is through theory that an appropriate framework for historical analysis can be formed.

Logical sciences differ from natural sciences. In natural science some kind of hypothesis is formed, and experimentation helps falsify the hypothesis so a more refined hypothesis can be formed. Through trial and error more and more correct hypothesis are formed. Logical sciences like the study of formal logic itself and also mathematics do not require any experience to validate their findings. Research in these fields is done through thought experiment. As we will discuss at length soon, economics (and more precisely, praxeology) falls into the category of a logical science.

As Mises says in Human Action

Its statements and propositions are not derived from experience. They are, like those of logic and mathematics, a priori. They are not subject to verification or falsification on the ground of experience and facts. They are both logically and temporally antecedent to any comprehension of historical facts. They are a necessary requirement of any intellectual grasp of historical events. Without them we should not be able to see in the course of events anything else than kaleidoscopic change and chaotic muddle.

Before diving further into the specifics, what are the motivations and goals of Austrian Economics? What does it hope to achieve? Its aims are humble in nature. The only aim is a description of reality - exactly the same as the goals of physics. Austrian Economics is 100% value free - there is no value analysis given in any of its statements. This is important, and many people struggle to make value free analysis.

An economists must remain value free at all times. His purpose is only to state facts about reality. As such, he can not pass moral judgement on any given policy. When an economist passes moral judgement on policies, he is acting not as the economist. (A suitable analogy is a nurse who also happens to be a mother. When she cares for other people's children she does so as "nurse". When she cares for her own child she does so as "mother").

As such, when an Austrian Economist describes policies as "good" or "bad" they do so only in a teleological sense. That is, from the perspective and stated goals of the person who proposes the policies, can it actually achieve their goals? Certainly they expect the policies to achieve their goals but whether the goals will be realised is another question. The role of the economist is to advise on this matter alone in policy.

Again in summary

Economics as Science

The purpose of this section will be to outline the core Austrian position which I have already alluded to - that economics is not an empirical science but rather a logical science.

Let us begin with the empiricist view. To the empiricist, there are only two kinds of statements - hypothetical statements and analytic statements.

To the empiricist, hypothetical statements are observational statements, for instance "the cat is on the mat" or "the grass is green". Such statements are subject to infinite testing and always remain hypothetical. For instance, if I mix chemical A and chemical B and observe an explosion, can I say that mixing chemical A and chemical B caused the explosion? I can only say that I observed such an explosion. I can also continue to invent an endless chain of reasons as to why various other factors C, D, E and so on are relevant. Perhaps I need to wear a green hat for the explosion to occur. Perhaps I need to have the lab door open. Perhaps I need to...

The other kind of statement available in the empirical view of epistemology is the analytic statement. These are true by definition, but don't tell us anything about the real world. They are simply descriptions of how we use terms - hot air, scribbles on a page, conventions. This would be us pointing at things "this is green", "that is a chair" and so on.

The core of the Austrian viewpoint is that this empirical approach is incorrect. Let us start by refuting it then finding a suitable replacement.

So, it is fair to ask then, what is the type of the proposition that all propositions are hypothetical or analytic? First assume it is analytic. In this instance, I have no reason to believe the empiricists at all by their own claims, since analytic statements are mere convention, they don't say anything about anything. On the other hand, the solution could be that this is an empirical statement. For the empiricist, this is actually even worse. This turns the epistemology into nothing more than mere historical fact, something like "all henceforth studied statements are either analytic or hypothetical". This also has the impact of turning it into something totally meaningless and arbitrary, since, how did one come to the conclusion that all statements are either analytic or hypothetical if this is only an empirical claim? Or in other words, from what original definition did you begin to categorise statements as you scrutinised them?

Another issue of empiricism in the sciences is the existence of causality. In order to move from "I did A and observed B" to "A caused B" one must assume some kind of causality in the universe. For the empiricist, this presents a problem - how do they know causes exist? What experiment will allow them to identify the existence of causality? Furthermore, what is the category of statements about causalities existence? Analytical or hypothetical?

What the empiricist can not admit is that there is another kind of statement possible. We will need a quick detour into Kantian philosophy to understand. In the Critique of Pure Reason Kant makes a refutation to Hume on this exact point. He devises two different dimensions on which statements can be categorised. The first is whether the statements are analytic or synthetic

So in other words the analytic-synthetic distinction deals with whether the statement contains new knowledge beyond just the definitions contained within the statement.

Then there is the a priroi and a posteriori distinction

Thus we have four possible types of statements, as given by the table below

Synthetic Analytic
a priori Synthetic a priori Analytic a priori
a posteriori Synthetic a posteriori Analytic a posteriori

Let's take a deeper look at these combinations

Analytic a posteriori statements can be ignored. It doesn't make sense to say that there's a class of propositions where the predicate is contained within the subject yet requires empirical observation to prove. You should take a moment to convince yourself this is true.

Analytic a priori statements are self evident and do not rely on any kind of empirical experiment because the predicate is contained within the subject. This kind of statement is not controversial - all logical statements are of this type. If you define "triangle" as "three sided shape" then all three sided shapes must be triangles.

Synthetic a posteriori statements are also not controversial - typical empirical statements are of this type. They provide new knowledge about reality but require empirical testing. Typically, you observe things in your life and make statements about that, for instance, "my keys are in the bowl" or "grass is green" or "the bridge can support a car" and so on.

Now the characteristic mark of Kantian philosophy is the existence of synthetic a priori statements i.e. statements that can be known without experience but pure logic alone is not sufficient to prove them to be true. How is this possible? Kant describes these statements as following from "self evident truths". The phrase "self evident" has been unfortunately misconstrued to mean a kind of "psychological self evidence". People will say e.g. "well it isn't obvious to me, so how do we know it's true". Rather, "self evident" in this context means that no argument can be presented against these statements without tacitly admitting to their truth.

An example is more enlightening here. An important axiom in Austrian Economics is the concept of "human action" - the idea that humans are actors, who seek to achieve ends given scarce means. Suppose you thought this axiom was silly and you wanted to argue against it. In the course of this abortive refutation you would be a human acting to seek an end given scarce means. In other words, the very act of your attempted refutation would prove the axiom!

To give some more examples of synthetic a priori statements in situ let's consider the empiricist approach to "1+1=2". To the empiricist, this must be either hypothetical or analytic. Let's suppose it's an analytic statement first. If this were true then this can never tell us anything about reality, since it would be nothing but a convention. But how could it possibly not tell us something about reality? Physical laws clearly follow definite mathematical descriptions. (I have asked many empiricists to come sky diving with me while they wear a parachute designed off the assumption that 1+1 is not 2 and so far all have refused). Note that what we are getting at here is not the symbolic representation (which clearly is a convention) but the concepts behind the symbolic representation.

On the other hand, suppose it is empirical. What experiment could we design to test that this is the case? Perhaps you could go pick up a stone, and then pick up another stone and bring them together to see two stones. However, this experiment totally fails. It fails because in order to perform the experiment you first had to lean on the definition of "1" to pick up a stone, and then lean on the definition of "2" as "1+1=2" in order to identify that you had two stones! In other words, your attempt to empirically test such a statement proved beyond doubt that it is not empirical. Such is the power of a priori synthetic statements.

I strongly advise you take some time to convince yourself of the existence and use of synthetic a priori statements now. If you are not comfortable with the idea that we can find out things about the real world without making any observations of the real world then the rest of this essay will make no sense. This is by far the largest tripping point for most people - especially that economics deals with humans, and they expect to see some kind of psychology. While economics does deal with humans, psychology is useless at answering any economic questions!

How would an Austrian Economist engage in research? The research itself is done through reason alone - in other words, a series of thought experiments. We use these imaginary constructs to engage in research. This allows us to probe around an issue. We will look at a variety of these constructs across this article.

When engaging in these thought experiments, there is no need to have them mirror the "real world". We are very happy and comfortable to engage in thought experiments which we know could not exist in the real world. These experiments can still teach very valuable things about the real world. Not only that, but if we stick to the assumptions made within the thought experiment then we will necessarily have correct conclusions within the thought experiment.

However, if we attempt to bring such a deliberately non-real thought experiment into the real world it necessarily fails. How can we determine which thought experiments are relevant to the real world? I have not seen anyone else explain it quite like this before, so we are breaking new ground here. The way in which we differentiate our "correct" thought experiments which can only exist in our minds from those which can exist in the "real world" is via the synthetic a priori statement. These kinds of statements act as a kind of metaphorical bridge from the land of thought experiment to the land of the "real world".

Praxeology and Psychology

Human action is purposeful behaviour. We could refine this by adding additional information for clarity. However, given the standard definitions of these terms this proposition stands alone. Praxeology is the study of human behaviour. This is the bedrock of economics.

Humans need not only engage in purposeful behaviour. The patellar reflex, or movements or utterances while sleeping can not be considered purposeful behaviour - they are unconscious behaviour.

A common confusion is to mistake praxeology for psychology. One might imagine that since we are concerned with the action of humans we need to study humans empirically. This is not so. In praxeology we are dealing with action qua action - in other words, we are analysing the action of agents who need to aim at some goal in an uncertain future with the desire to substitute a less desirable state of affairs for a more desirable state of affairs given scarce means. Whether humans "in the real world" actually meet these criteria is of little concern to praxeology. As Mises explains in Human Action

The field of our science is human action, not the psychological events which result in an action. It is precisely this which distinguishes the general theory of human action, praxeology, from psychology. The theme of psychology is the internal events that result or can result in a definite action. The theme of praxeology is action as such. This also settles the relation of praxeology to the psychoanalytical concept of the subconscious. Psychoanalysis too is psychology and does not investigate action but the forces and factors that impel a man toward a definite action. The psychoanalytical subconscious is a psychological and not a praxeological category. Whether an action stems from clear deliberation, or from forgotten memories and suppressed desires which from submerged regions, as it were, direct the will, does not influence the nature of the action. The murderer whom a subconscious urge (the Id) drives toward his crime and the neurotic whose aberrant behavior seems to be simply meaningless to an untrained observer both act; they like anybody else are aiming at certain ends. It is the merit of psychoanalysis that it has demonstrated that even the behavior of neurotics and psychopaths is meaningful, that they too act and aim at ends, although we who consider ourselves normal and sane call the reasoning determining their choice of ends nonsensical and the means they choose for the attainment of these ends contrary to purpose.

(It should be noted that Mises was writing around the same time as Freud and Jung were popular)

In other words from the perspective of praxeology the fact that humans have desires is the ultimate given. The theory does not aim at explaining why such desires arise. The reasons for this are plain to see - ultimately it is concerned with desires in general and not a particular set of desires. As such, we can make conclusions about desires in general without considering specific desires. Even if psychology were to determine that all human desires stemmed from some subconscious coping of repressed childhood trauma and was totally deterministic it would not have any impact on praxeology whatsoever. Mises explains in Human Action

Yet rationalism, praxeology, and economics do not deal with the ultimate springs and goals of action, but with the means applied for the attainment of an end sought. However unfathomable the depths may be from which an impulse or instinct emerges, the means which man chooses for its satisfaction are determined by a rational consideration of expense and success.

You are encouraged to take a moment to convince yourself of this.

It is for this reason that we can say that all human action is rational. "Rational" in this context means action aimed at some goal. Since we defined human action as purposeful behaviour, this is a simple tautology. As Mises explains in Human Action

Human action is necessarily always rational. The term “rational action” is therefore pleonastic and must be rejected as such. When applied to the ultimate ends of action, the terms rational and irrational are inappropriate and meaningless. The ultimate end of action is always the satisfaction of some desires of the acting man.

The source of confusion on the point of rationality of action comes from a failure to remain value free. It might be tempting to label some human action as irrational because the "goal is silly" or the "action is not efficient" or any other rebuttable. This, however, introduces the personal values of the thinker into the mix - inherently an anti-scientific a view. Maintaining a truly value free approach to economics is intellectually and humanly challenging. We humans are constantly impulsed to introduce our personal emotional baggage into sciences of human action. Such is why most economics is so poorly done.

Strictly speaking humans always act to remove uneasiness. A person imagines situations which suit them better. Thus, their actions are to substitute more satisfactory states of affairs for less satisfactory states of affairs. They must also expect that this action will actually result in a better state of affairs. In other words for human action to make sense as a concept "in the real world" man must be able to

Again, you are encouraged to spend a moment to convince yourself this is true. First, imagine a world in which each was false and realise that it invalidates the possibility of goal-orientated behaviour. Then, attempt to argue that each one is not true "in the real world", which will produce a synthetic a priroi argument that they are true.

Value

The first and most important economic concept is value. Austrian Economics correctly identifies value as subjective. The Marxists incorrectly assume value is some objective measure of labour spent on some product. This is obviously incorrect as people are willing to pay more for faster produced goods.

The Austrians instead see value as totally subjective. I may value oranges more than apples, and you apples more than oranges. Notice how if we swap, we both become richer. You jettison your less valuable oranges for more valuable apples, and I jettison my lower value apples for higher value oranges. There is no contradiction here - value is in the eye of the beholder.

We say that value can only be measured by ordinal numbers. In other words, there is no objective measure of value or a unit of value. You may be tempted to think money is the measure of value but this is incorrect, which we will see in various places across this essay. We can only rank values of an individual.

Marginal Utility

Let us look at the first economic law of the day! This is the law of marginal utility. The law of marginal utility is extremely easy to understand - trivial, really. However, it gives us the ability to get hands on (in our minds!) experience with the Austrian method.

The law of marginal utility states this: given a single unit of a homogeneous good, an actor will always utilise that good for their currently most urgent need.

What does this mean? First, "homogeneous good" means that if I have, say, three of these goods I do not value them differently. If I have three oranges, but one is fresh and the other is just about to go off I may not necessarily value them the exact same, since the fresher orange has more longevity.

The current most urgent need is tautologically linked to that which the actor employs the good for. Again, suppose I gain one orange when I before had none. Should I eat this orange then we now know exactly what at that moment was my most urgen need.

A critical point to note here, which is a working example of the previous section on praxeology vs psychology is that in praxeology we make no attempt at all to determine beforehand

In other words, there's nothing within the theory of praxeology which could allow you to estimate which actions some person would take if they received their first orange. Equally, there is nothing within the theory which allows for an explanation of why that was the most urgent need. Some people will eat the orange, some will juice the orange and some will throw the orange away. There are clearly psychological differences between the people but that is beyond the scope of praxeology.

Another point to make here is that from day to day the most urgent need is always changing. Some days I might juice the orange, some days I might eat the orange, some days I might give it away as a gift. There is not one universal most urgent need. There is not even a most urgent need for one person. There is only the thing which happened to be the most urgent need at the moment the decision was made. Flux is a core aspect of Austrian Economics. I may gain new knowledge. For instance, I might eat the orange and find out I hate it. So, the next day I might try something new. In this way I have changed.

Time and Time Preference

A core axiom of Austrian Economics is that time exists and it passes. Things which have happened are in the past, and things yet to happen are unknown as they have not happened yet. There is uncertainty on the future. These are self evident and do not require justification.

Time preference is how willing someone is to delay consumption now for future potential greater consumption. Lower time preference indicates more willingness to delay consumption. Higher time preference indicates the tendency to consume now.

We can only discuss relatively higher and lower measurements in economics. We say that we can only use ordinal numbers not cardinal numbers. There is no unit of measurement that can be assigned to measure time preference. This is a common theme in Austrian Economics.

It is common to speak of raising and lowering time preference. Let's say John buys a coffee from a coffee shop every day. Should his time preference raise then perhaps he buys the fancier coffee - spending and consuming more now. Should his time preference lower then perhaps he stops buying coffee altogether, and saves the money.

A relative lowering of time preference is essential for economic development. At the dawn of man time preference was significantly higher than it is today, on average. What was produced by any rudimentary means (hunting by hand, gathering by hand) was consumed quickly. Little time was saved and invested into production methods.

Investing time and/or resources into production methods raises economic efficiency. For instance, a manufacturing firm might choose between lavish bonuses or upgrading all production machines on the shop floor. The bonuses would be nice right now, but upgraded machines mean greater capacity at lower costs, and could lead to even greater bonuses next time.

In order to engage in any kind of investment to improve economic efficiency, we must relatively lower our time preference. Even something as simple as purchasing stocks or putting money in a high-yield savings account requires us to have a relatively lower time preference than if we did not do those things. In both these cases we are forgoing now the benefits of spending and consuming with that money in favour of saving it, with expected future returns.

As such, a relative lowering of time preference in the past was an event (or series of events) which gives us the modern, comfortable life we have now.

There are limits to the lowering of time preference. Humans have to do some things right now to sustain our own existence. For instance, it might be tempting to forego eating altogether and save that money for some greater future consumption but I would perish before I could ever see that pay off!

Imagine Robinson Crusoe alone on an island. He gathers fish to survive. Let's say he does this with his hands. With a relative lowering of his time preference, he could sacrifice some time to construct a fishing spear. While constructing the fishing spear, he is not directly engaged in actually catching fish or in other leisure activity which satisfies his immediate wants. This is why we talk about a "sacrifice". However, Crusoe expects that after constructing the spear he can catch greater numbers of fish in less time. This improves his overall quality of life.

However, it would be a mistake for Crusoe to lower his time preference so far that he aims at constructing an oil powered fishing trawler! Of course, the potential efficiency in catching fish in a trawler vs a fishing spear is almost infinite! But, Crusoe would likely die of starvation before this project is ever seen through.

On the other hand, imagine some angels who have no immediate wants to fulfill and they enjoy engaging in economic activity for fun. In this instance, they have such a low time preference they always choose to delay gratification. They never produce a final consumer good, as they have nothing to consume. They instead only ever produce production goods - that is, goods at making production more efficient. They would quickly become incredibly "rich" but never have anything to show for it!

Why do Austrians engage in these seemingly weird and random examples? Why talk about angels? The reason is that when we introduce a topic, it's good to build a kind of intuition for it. In this case, we know that time preference can raise or lower - so what happens if it raises or lowers all the way? What does it look like at the extremes, and how does that compare to the average case? This tells us a lot about the concept. It also helps us know if it is consistent. (In physics first thing you do when deriving some equation is imagine the results if any of the values go to infinity, negative infinity, zero and other edge cases relevant. This tells you a lot about the equation. For instance, if I come up with an equation which tells me the height an object will go into the air when I throw it given its mass, and the height is not zero with infinite mass I would be very suspicious!).

Profits

Profits need not be monetary in nature. In fact, all profits are psychic in nature.

I start by stressing that profits are not necessarily monetary in nature. Modern business has somewhat perverted the word so that profits are only something that businesses make on spreadsheets from selling goods.

Instead, all human action aims at being profitable. When you go to the gym you are profiting. When you eat you are profiting. When you go to bed you are profiting. When a friend comes over for tea you both profit.

What does it mean for profits to be "psychic"? Acting man has wants. His wants are always aimed at removing uneasiness. Man wants to remove as much uneasiness as possible. What are these uneasinesses? That depends on his values. The Buddhist monk removes the most uneasiness when he is poor and starving. The mogul removes the most uneasiness when his balance sheets show huge monetary profits. And so on - it varies wildly from person to person.

Nevertheless, whenever we take an action that at the moment we decide to take it, we perceive will contribute to reducing uneasiness, as defined by our values, we profit. Every single voluntary trade that can ever take place is profitable to both parties. If even one of the parties perceived the trade as being unprofitable, then it will not occur.

This is where it is important to remember that profits are only a psychic phenomena not a monetary phenomena. Sometimes in business they will discuss certain ventures as being unprofitable. This is because after the fact, when looking back into the past, and analysing money exchanges, they find they have made a monetary loss. However, note that the business venture only went forward because at the moment it was decided to engage in it, it was perceived as profitable.

Why do Austrians use this unusual psychic definition of profit rather than the business understanding of an accounting profit? There are two reasons.

First, time passes linearly. We do not know if a business venture will be monetarily profitable a year from now because it has not happened yet. Things that have not happened yet are unknown to us. However, Austrians are trying to look at why people now are making the decisions they do. They are speculating about future potential monetary profits. If there were no speculation involved then no business venture could ever be monetarily unprofitable. That is manifestly not the case. (You may have some regrets in life. Why did you do those things at the time, if you were to regret them? It is because at the moment you did them, they had not yet happened, and so you did not know you would come to regret them. The concept of "the future hasn't happened yet and we have to speculate about it" is very important to Austrians.)

Second, because we want to explain all human action not just business action. Many economic theories fall flat because they think economics is limited only to the world of business - once a person comes home from work then economics "stops" to these people. The Austrians astutely observe that the precise same phenomena that gives rise to whether a business goes forward with some venture is the precise same phenomena that is how you will decide where to holiday, or whether to wear makeup, or what time to go to bed and on and on. Man is an economic animal insofar as he simply can not escape making economic decisions. Your decision to read this article is an economic decision. (Do not try and be coy and not perform economic decisions because that, too, is an economic decision!)

Supply, Demand and Equilibria

Let's look at a simple problem. What determines prices?

A naive approach might conclude that prices are the result of previous prices plus a profit margin. So, if you're selling eggs in the supermarket you might take the bulk price of eggs, the bulk price of cardboard, work out the per unit cost, add some margin for profit and that's the final selling price. However, this isn't quite accurate.

Let's start with a simpler scenario. Imagine an auction. At this auction we are selling a special pair of ruby slippers. Let's suppose this item is absolutely unique - there is exactly one pair of the ruby slippers. We can call this the supply - the supply of ruby slippers is one in this case. At the auction the ruby slippers have a lot of buyers. Everyone wants the ruby slippers, and not only that, people are willing to pay big money for them. We call this the demand. The demand is rising, and the supply is fixed - what happens? There is now a tendency for the price to rise.

Sometimes this tendency is discussed as a force - analogous to a force in physics. However, keep in mind this force is metaphorical. There is no real force, only the individual decisions of individual people.

How does low supply and high demand cause the price to rise? Let's say at the auction there are five participants: Bob, Jill, Alice, Harvey and Crusoe. Bob has no interest in the ruby slippers and no matter how low the price is, he does not want to buy them. Bob can now be disregarded from the analysis. Jill is willing to pay £500 for the slippers, Alice willing to pay £600, Harvey is willing to pay £700 and Crusoe is in such desperate need for the slippers he is willing to go up to £1500.

Note that these are not the prices the attendees want to pay - everyone would like to buy everything for £0. However, we must keep in mind all transactions are voluntary - the attendees will only buy the slippers at a price they think the slippers are worth. If the auctioneer tries to sell the slippers at £2000 he will not be able to part with them. Consider, though, that the auctioneer (let's call him Joe) is also a member of this analysis - he is a person too. Joe would like to sell the slippers for £∞. However, he knows he can't do that. The task, then, is to find a price somewhere between £0 and £∞ where both parties are willing to pay. Joe is trying to maximise this price, and the attendees are trying to minimise this price.

Betting starts at £100. Jill bumps it to £200. Alice outdoes her at £300. Harvey sees the threat: £400. Jill tries £500 - her maximum. Alice pushes to £600. Jill now leaves the analysis as she will no longer bid. Harvey bids £700. Alice also leaves the analysis. Crusoe, after biding his time, now bids £800 and takes home the ruby slippers. (Part of the game of the auction is not bidding too early - Crusoe could have instantly bid £1500 but by waiting and playing the game right he got a steal at £800).

If in the auction nobody was willing to go over £500 then the slippers would not have sold exceeding this price. Equally, had there been multiple pairs of slippers the price could have been lower. Let's also remember Bastiat - we see the sale of the slippers because the current owner is willing to part with them. What we don't see is the emerald ring he wasn't willing to part with, for any price. We also don't see dirt at the auction, as nobody is willing to bid on it.

Returning to the supermarket, how does this impact the price of eggs? First, it's important to take into account all the goods not being sold. Each of these was also an economic decision to not sell them, as they would be unprofitable. If the unit price plus margin was above the price any consumer would be willing to pay for it then eggs are simply not sold. Secondly, it's important to remember competition. In the ruby slipper auction, there's only one pair of these slippers in existence. This isn't so with eggs - there are other egg farmers who can supply the same good. Not only that, but eggs compete with other products, for instance cheese and meat. This pushes prices down, to ensure that eggs still sell with respect to these alternatives.

It is these factors of highly interconnected decisions by individuals within a market economy which send information back through the supply chain. If the price is too high such that units simply are not selling then either production ceases or contracts are renegotiated so as to ensure profits can be made. If prices are too low such that the seller thinks that they can make a bit more money on eggs the price might rise. However, if you, the chicken farmer, see the price of eggs rising in the store without your egg sales to stores rising, you might consider taking your eggs to a different seller!

Another thing to consider is changes in prices are market signals. A rising price is a massive signal to capitalists and entrepreneurs that the good is becoming more and more popular. Rapidly rising biscuit prices due to increasing demand is a huge signal to manufacturers to produce more biscuits, and even new biscuit makers enter the market. A falling price is a red flag to stop investment in that sector. Furthermore, if prices are falling then the marginal firms, that is those that are only just making a profit, will likely go bust.

That leads us onto the final concept of equilibrium is a conceptual state where supply exactly meets demand and there are no further changes in prices. Such a state can never be truly achieved since market conditions are always changing: consumer tastes, environmental conditions and so forth. However, the market is always working towards equilibrium, whatever equilibrium the market is currently told to approach that day.

Roundabout Methods of Production

Böhm-Bawerk in his Capital and Interest discusses the concept of roundabout methods of production.

This is the idea that longer production chains can actually be more efficient, that is, they can result in greater output per unit input. Let's look at an example. You go back in time to medieval England and explain to a peasant how you buy corn.

"Well, we want to buy corn in a supermarket for about one minute's worth of time, so to do that we need to transport it to the supermarket so we need to put fuel in the truck, so to do that we need to refine crude oil into petrol in bulk, so to do that we need crude oil, so to get that we build giant floating platforms in the middle of the ocean, and to know where we should put those giant platforms we need to know where the oil is, so we do some subsurface imaging, and to do that we first need to have a boat drive over the water and blast compressed air so that microphones can detect it, but the raw data is useless so we need experts to run calculations on the data to produce the image, but that's very computationally expensive so we need huge computing clusters to make it viable so we need bulk production of transistors, so in order to do this we find a very specific type of sand and then it needs to go into a very..."

The peasant interrupts you "why don't you just plant some corn in the ground? Then you can just pick it a few months later."

Of course, on the surface, it seems ridiculous - you're explaining corn, why would you ever discuss GPU production in Taiwan? And yet, we know that it is actually more efficient this way! A tin of corn probably costs around 50p - this is a fraction of a typical hourly wage. Equal to literally seconds of work by a modern worker. In the past, corn was relatively more expensive. For the medieval peasant every step in the production of corn is more direct - you till the soil, plant the corn, wait and harvest. However, this is actually a significantly less efficient method - the time investment produces way less corn than by using a variety of machines and modern techniques.

In order to have more roundabout methods of production you need to have a lowering time preference. Time and capital invested in some production method, like better subsurface imaging, so we can find oil cheaper, so we can fuel the truck, is time and capital not directed to corn production now. In the long run, the benefits of oil powered machinery in agriculture are almost infinite but it does mean sacrifices in the short term.

Interest

Interest is a phenomena of time preference.

Interest is a very simply phenomena to understand. Present goods are of higher value than future goods. That is the whole phenomena. Think of the edge cases to convince yourself this is true: if you were offered next-day delivery cheaper than a one-month delivery, the cheaper next-day delivery would be vastly more popular. On the other hand, next-day delivery is typically more expensive, but those with lower time preference who are prepared to wait can get better deals.

Another example of this is land. An owner of land receives a continuous stream of revenue - nature causes plants and animals to grow, to bear fruit and meat. This is new wealth being created from virtually nothing. If future goods were not discount with respect to current goods then land could never be profitable - a potential buyer of land would have to pay the up-front monetary value of not only the land directly but also all potential future revenues.

Another example is if someone offered you money. If you're offered £10 now and £100 in a month you might need to think about it. Now, different people have different time preferences - some might take the £10 and some the £100. That spread is showing you something about interest in the economy.

What this means, is those of higher time preference can offload assets now for cash to those with lower time preference who can manage them far into the future.

Recall the section on roundabout methods of production now. At some point in those production methods, a less efficient method does need to be used so that we can actually produce the final good. Ultimately, our actions are driven by final consumer goods. This shows that scarcity is important to interest - if scarcity was not present then there would be no need for us to ever take less efficient technological routes. The primary scarcity that drives this is time itself.

The actual rate of interest itself is a psychological phenomena. There is no praxeological way to determine how much a person, or group of people, will value present goods over future goods. Some societies might exist where in general people place very very great value on present goods (relatively high time preference). Equally some societies might exist which place much less value on present goods (relatively lower time preference). Determining which will come to be present is beyond the scope of praxeology - this is for the realm of history, psychology, sociology and so on.

If this section on interest has confused you a little due to it not being what you expect, that's okay. The term interest, as used now, refers to some specific rate set by the Bank of England (or your local central bank, Federal Reserve for the Americans). This is however, a market distortion. This is beyond the scope of the article to discuss, but I will make a few brief points. First, such a situation where a single authority can dictate a rate of interest is not possible in the unhampered market. It is only through centralised violence can the state create such a situation. Second, we call this a market distortion since the real rate of interest is constantly changing. By fixing rates at some value you distort the market - real interest might be higher or lower than this value and mislead about the profitability of an enterprise. This is what creates malinvestments.

If you are more interested in banking distortions, I suggest the further reading of The Economics and Ethics of Private Property by Hans-Hermann Hoppe and The Mystery of Banking by Murray Rothbard.

Money and its Origins

The work which influenced the Austrian view on money and its origins was "The Origins of Money" by Carl Menger.

To explain the origins of money, let's first consider a very simple economic situation. We have an island with two people only on it: Crusoe and Friday. Now Crusoe happens to be a skilled fisher, and has many many fish. Friday just so happens to be a skilled tree climber and has many many bananas. Crusoe has more fish than he wants to eat, and he would like some bananas. Friday has more bananas than we wants to eat, and he would like some fish. Crusoe and Friday agree some exchange rate of bananas to fish and swap. They trade. This is called "direct exchange".

It's worth pausing for a moment here because many people make a mistake with even this simple a trade. While this might look "even" both parties actually profit from this exchange. Remember that profit is not a monetry but a psychic phenomena. In this example, both parties get rid of something they have lower value of and both parties gain something they have a higher value of. You might be confused that how can Crusoe have a lower value of some fish compared with other fish? The answer is marginal utility! Crusoe doesn't want to eat nothing but fish (imagine fish for breakfast, lunch, dinner AND snacks!). His "first" fish is valueable to him - he does want to eat some fish. But what about the 10th fish? Or the 15th fish? These fish are worth less to him - this is called the "law of diminishing marginal utility". He can spare a fish or two to gain some bananas when he previously had none. The same applies to Friday.

After this trade both Crusoe and Friday have made a profit. If they both did not expect to make a profit at the moment of the trade, the trade would not happen. Remember that profits are psychic only so sometimes people seem to make trades that do not seem profitable to you but they always necessarily are perceived as profitable to the parties involved.

We call this happy scenario where Crusoe and Friday can directly swap two commodities (because they both want the other commodity) the "double coincidence of wants". However, let's now change the scenario. In this new scenario Crusoe does not want bananas at all. No banana carries any value whatsoever to Crusoe. He will never make a trade for a banana. This presents both Crusoe and Friday with a problem. Crusoe can no longer offload his spare fish. Friday can no longer offload his spare bananas, and, he can not get the fish he so desperately wants.

Now, if Crusoe and Friday are the only two people on this island and also they never introduce new commodities into the market, then this is the sad state of affairs they are stuck in forever!

But, let's introduce some new people. Let's say Alice comes along, and she is a baker. She has lots and lots of bread. We also say that Bob comes along and he is a prolific beekeeper and has lots and lots of honey. We now have four commodities in the market - fish, bananas, bread and honey. This presents an opportunity for Friday. Friday wants fish very badly, but he has nothing to offer Crusoe. However, maybe Friday can get from Alice and Bob something to give Crusoe.

Let's say that Crusoe wants bread. Alice has bread. Let's say that Friday recognises this and wants to trade some bananas for bread (so that he can trade with Crusoe). Unfortunately for Friday, once again, his day is spoiled by Alice simply not wanting bananas. However, he finds out that Alice does want honey. So, he goes to Bob and to his relief Bob is willing to trade bananas for honey. Friday can then take this honey to Alice, and trade for bread. And finally, he can take this break to Crusoe and trade for fish. Everyone in this example at every stage made a psychic profit (the only kind of profit!).

We call this kind of exchange an indirect exchange. In fact, we have already explained the origins of money! You see, Friday had no interest in bread or honey as commodities - he simply was using them as money to obtain fish. Money does not need to be necessarily something like gold nor does it need to be something to do with banks or governments. All indirect exchanges use money whatever that money happens to be. In this example, to Friday, both the bread and honey were money. However, to someone else the bread and honey were consumer goods (if they ate them).

What happened? Essentially Friday had to go on a kind of RPG fetch quest. These are only fun in RPGs (and even then, not really). Now this situation wasn't too bad since there was only a few steps between Friday's bananas and Crusoe's fish. But imagine if there were 20 or 30 commodities Friday had to swap! We also didn't take into account how far apart these different merchants are on this island. Maybe Friday has to walk miles and miles a day just to get these fish. This is all terribly inconvenient.

Another flaw is that Friday had to use bread and honey as money. This is also kind of inconvenient. Bread and honey are poor choices for money. Bread goes stale. It loses its value by time simply passing. Not only that but bread is pretty low value compared with fish (generally speaking). So you usually need quite a lot of bread just to get a fish.

(Just out of curiosity on that last point I went online and looked at prices of bread and fish in my local supermarket. As it turns out, you can buy 800g of bread for 75p right now. A 520g whole sea bream costs £7. In other words, to get a fish at these exchange prices Friday would need to lug around 7.5kg of bread. Because I'm like this I also looked up the dimensions of bread, and typical bread sold in UK supermarkets at that price is about 10 x 10 x 40 cm which means he would need to carry about 37.333 litres of bread! Very inconvenient!!!)

So, now that we have established why money arises, we want to ask why does money usually end up arising as something like gold, or silver or gems or other precious things? Well, there are actually a number of answers to that.

First, these materials do not lose value with the passage of time. For instance, fish will rot and bread goes stale but gold just sits there forever, unchanging. This means that they are very useful for storing value. Let's say you have a bunch of stuff to sell but you don't really want to buy anything right now. That means that you could save gold for another day to buy later on.

Second, they're relatively valuable. As we saw in the bread example, a single loaf of bread is not very valuable so you need to transport a lot of it to be able to trade for other things. Precious metals do not have this limitation and a small amount of them can purchase a large amount of commodity goods.

(At the time of writing, the price of gold was £1528.96 per troy ounce. A troy ounce is 31.1035g. In other words, Friday would not need to carry 7.5kg of bread for his fish but only the very very low amount of 0.1424g of gold.)

Third, gold is very divisible and rejoinable. For instance, you can quickly cut gold into smaller quantities or smelt it into larger quantities. With fish this isn't quite so possible as once you've cut a fish in half you can't rejoin it. Something like a car would not be a very good as a unit of money, since dividing a car into parts destroys the value of the car.

The other property is saleability. Now, this is a little more complex to understand so I will explain this in more detail.

Consider a market where wheat has emerged as a pretty standard commodity. Let's also say that this economy has a standard coin - a Lira. Let's suppose that a starving man who owns some astronomical equipment goes to the market, hoping to sell his astronomical equipment and buy some wheat. Let's say that the market rate of the astronomical equipment is 10 Lira. Let's also say that wheat is 1 Lira per kilogramme. Consider the rate of sale of 10kg of wheat vs astronomical equipment - even though they are the same price, the wheat has a higher turnover rate. It sells faster. Someone with astronomical equipment may have to wait some time to find the appropriate buyer. So, even though 10kg of wheat and astronomical equipment have the same price on the market, the wheat is more valuable if you have a higher time preference.

Hopefully, our starving man with a high time preference (since if he does not eat he will die) can meet a man with relatively lower time preference. To this man he can sell his astronomical equipment. However, this buyer is very unlikely to be actually interested in the astronomical equipment itself but instead potential monetary profit. Therefore, the merchant might offer 8 Lira for the astronomical equipment. Let's suppose the seller accepts. In this case both men have psychic profits - the seller has 8 Lira which he can use to instantly buy some wheat and fulfil his most urgent wants. The buyer, who has a low time preference, can now wait with his astronomical equipment until he finds a buyer willing to purchase it for 10 Lira, the going rate. In this way he can make a monetary profit. This is the relationship between money and time preference.

Inflation

"Inflation" is an economic term that has changed meaning in the last century or so. As Mises says

There is nowadays a very reprehensible, even dangerous, semantic confusion that makes it extremely difficult for the non-expert to grasp the true state of affairs. Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term "inflation" to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. It follows that nobody cares about inflation in the traditional sense of the term. As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.

Thus, it is now quite apt to differentiate between "monetary inflation" and "price inflation". Monetary inflation is the increase of bank notes in circulation and quantity of bank deposits ready to cheque (and, these days, electronic money ready to be spent!). Price inflation is the across-the-board increase in prices which comes as a necessary consequence of monetary inflation.

When discussing monetary inflation we must be careful about the banking system in use. In the past, it was the case that monetary inflation took place through literal printing of new banknotes. Almost everyone is aware of images of children playing with huge stacks of cash in the Weimar Republic.

Monetary inflation can also occur naturally. For instance, if the currency is backed by gold, a sudden discovery of new gold veins can introduce new currency without government interference. Some real world examples of this was the Spanish discovery of the New World. The Spanish brought back so much gold and silver it created shock inflationary events all across Europe. Another very famous example (which has become popular on the internet) is the pilgrimage of Mansa Musa. He spent so much on his journey that the economy around Cairo experienced inflationary events.

In the modern day, governments often use central bank interest rates to induce monetary inflation. Contrary to popular belief, the Bank of England is not the only bank which can produce new currency in the UK. In fact, any commercial bank can.

When interest rates are low, it encourages borrowing. Businesses can get good deals on loans. Buyers can purchase houses more easily due to cheaper mortgages. This is often called "easy money" - the commercial banks are creating new money. I previously wrote an article on the 2008 financial crash which covers some of this which you can read here.

Conversely, as interest rates rise fewer and fewer people can afford loans and mortgages. Borrowing slows. House purchasing slows also. Debtors are also encouraged to pay back loans faster than they may otherwise have done so. This depends on the loan contract - many mortgages have a variable interest rate which changes with the Bank of England's interest rate. The consequences of this might be individuals priced out of a home they thought they could afford. Bank creation of new currency is slowing, meanwhile, loans are being recuperated which has the opposite effect of money creation - it is removed. This is why in recent times the Bank of England has been raising interest rates - as a response to high inflation.

It's important to pause here and recognise the margins again. Economically interesting events only happen at the margins. If interest rates rise, it is obvious that home buying will not stop. Sometimes this criticism is made by those that do not understand the margins. There are some people who can afford a mortgage all the way up to a 15% interest rate - they are not impacted by a rise from 1% to 2%. However, there are also those who can only afford a mortgage when the interest rate is 1.5% or below. For them, a rise from 1% to 2% does mean being priced out of the market. Praxeologically, there is no way to determine a priori what distribution of people can afford which interest rates. This is an accidental historical fact.

Inflation is when prices for all goods rise across the board. How is it possible for this to happen? In some sense, it isn't what we expect.

Suppose for instance there's a major coffee craze. Let's also say that coffee production is at capacity - the demand is going up but the supply is not. The price of coffee rises dramatically. Let's say it even shoots up to £100 a jar. What happens? Will everyone continue to pay this? No. Some people will be put off the coffee craze by the new price and will switch to alternative goods, like tea. This will cause the demand for coffee to drop and the demand for tea to rise (let's also say that tea production is at capacity). Thus, the price for tea is rising, but now the price of coffee is falling. Classical Economists call this "positive cross price elasticity".

So, how could coffee and tea at once increase in price?

It's important to remember money is also a good. As such, money itself has a supply, and a demand. Let's suppose the supply of money goes up. What happens when the supply of a good increases? Its price goes down. But now, how do we even think about this? You've likely been thinking about prices rising and falling in terms of money value. But now, the money itself is changing value? How do we grapple with this?

It's important here to pause and think about what a price is, really. It's also important to take a review of what money is. We remind ourselves that money is a tool invented to help with the double coincidence of wants. Another way to think about this is that money encodes for the exchange ratios of goods. So, if in an economy 1 fish exchanges for 2 loaves of bread and 1 fish is exchanged for 1 coin we expect to exchange that coin for 2 loaves of bread, also. There is nothing economically magical or special about money - it is simply another commodity.

So, the supply of money rises - what happens to the price of money? It goes down. Money is more available. What does that mean for the exchange ratio of goods to money? Try thinking about it the other way around - rather than thinking of measuring the value of a fish in terms of money, think about measuring the value of money in terms of a fish. If you are considering whether to hand over your fish for coins, and the supply of coins is going up, you might want to ask for more coins.

So, what's the mechanism? Let's suppose some person is the lucky recipient of additional, new money. They now have increased disposable income, which they can spend. They buy goods they otherwise could not have bought. This stimulates demand, which causes prices to rise. It's that simple. Assuming no new money is added into the economy, eventually the varying supplies and demands will cause all prices to settle at new, higher levels. The exact same analysis can be performed in reverse with a decreasing supply of money.

Notice how the person who benefited from the increased supply of money was the person who was able to act first. That person was able to buy at the old, uninflated prices. Every person after that is subject to a worse and worse deal due to having to buy at the new, inflated prices with their old, uninflated supply of money.

Inflation rewards high time preference. What does that mean? Let's go back to our understanding of time preference. Lower time preference is that which brings about savings, investment, invention and and overall improvement in the efficiency of an economy. Since we are discouraging people from engaging in this lower time preference behaviour, what are we encouraging? We're encouraging consumerism. The consequence of this is invariable a higher GDP due to money velocity, but a retarded economic development. What is the consequence of that? It means that in time two things are true. First, that people are in the long run not as well off as they could have otherwise been due to the processes of natural economic efficiency development being stunted. Second, it means that spending will occur that otherwise would not have. For instance, business ventures may be started based on a false market signal of this extra cash. This business may not necessarily be able to survive. Thus, the business will go bankrupt. Since this happens at a higher rate than the uninflated economy (of course, even in the uninflated economy some businesses will go bust) we call this a bubble.

The bubble must necessarily eventually "pop". This is what we call the necessary period of readjustment. There are a few ways in which this necessary period of readjustment can occur. There is the financial crash which is a rapid deflationary period. Alternatively, there is the "crack up boom", or more blandly, the "flight into real goods". This is where the inflated currency is widely recognised as worthless and it is sold of immediately in favour of any real good that might hold its value.

Why must this happen? Why can we not just print money forever? The reason is because of uncertainty about the future. Due to this, there is a demand for cash - that is, money reserves. However, as inflationary practices continue to reduce the value of money, the value of cash reserves also decrease. $1000 in a bank account today becomes worth less and less each day that passes. Eventually, the crack up boom destroys the money system itself. So long as the future remains in doubt, the possibility of eternal inflation remains elusive.

Roles within Business

Within a business, there are three roles

  1. The capitalist or entrepreneur - these people have put capital towards the business venture

  2. The manager - these people organise resources or time

  3. The worker - these people do the work

An important thing to note about these roles is that one person can express more than one role at a time. For instance, in knowledge work fields many managers also do work. An example might be tech leads in programming fields - they manage the time and resources of the team but they also do some programming themselves. Self-employed people are by definition all three.

Some mistakes made by Marxism or Syndicalism is to place special emphasis on the worker.

Marxism operates as though only the worker creates value and is being exploited by the capitalist. In fact, the capitalist's role is to identify modes of production that are efficient (i.e. can deliver value). The capitalist then pays the worker (i.e. a voluntary transaction) for their labour. Identifying what consumers want and delivering those products to market in an efficient manner is no small task - the purpose of the market is to reward the capitalists who do this well (i.e. profit) so they can continue to open new business with this new capital and continue to deliver value to consumers. On the other hand, the market also punishes (i.e. losses) the capitalists who do not do a good job of this so they can not open new businesses again and continue to produce inefficiently.

Syndicalists place exploitation emphasis on the manager of factories. This is also badly misplaced. They fail to realise that managers themselves usually have no capital investment in the business and are merely employees of the capitalist. Yet, they serve a vital role in organising the time and resources of the workers. Not everyone is particularly good at this, for a start. Secondly, even if the syndicalist plans came to fruition and the factories were owned only by those who directly worked inside them they would come to a cross roads. They could choose to not have managers and accept lower efficiency production. If they were only factory in the world who did this they could expect to be vastly out competed by superior factories. If the whole world engaged in this syndicalist plan then everyone would need to accept lower standards of living than they otherwise would have owing to reduced economic output. Or, they can appoint one of the workers who has the skills to engage in managerial work as a manager, which defeats the purpose of the syndicalist plans to begin with.

In history and other fields it is rare to use these terms "capitalist", "entrepreneur", "manager" and "worker" in the same sense as these words are used in Praxeology. For instance, the owners of small time mom-and-pop shops are entrepreneurs, managers and workers. Very rarely will historians refer to a borderline poverty shoe shiner as an entrepreneur; however, that's what he is, economically.

Catallactics

Catallactics is a very challenging subject.

Catallactics deals with market phenomena. While up to this point we have considered economics in general, here we consider the special case of economics wherein there is a unhampered market economy with money. Let's look at some characteristics of such an economy. Remember that everything we have established so far continues to be true.

Economic Calculation

The tool of the market economy is economic calculation. Economic calculation is a technology - it has not always been available to humans. First, it requires money. However, the invention of money does not necessarily coincide with the invention of economic calculation. It necessarily occurs at a later date. Economic calculation is the process by which a firm can determine if it has been profitable or unprofitable. It goes further, and allows the firm to understand what aspects of the business have been profitable or unprofitable. Through this process, business decisions to remove unprofitable departments and bolster profitable departments can be made.

Mises notes that when he was writing Human Action that precise economic calculation had still not yet been universally adopted. Even today precise economic calculation is not practiced by every business. For instance, many agricultural firms do not consider depreciating value of land due to soil erosion and overuse - causing them to report profits higher than in reality. Many technology firms make a similar mistake with respect to decreasing value of computers over time.

Economic calculation also now allows us to understand precisely why inflationary policy can do such harm - businesses recieve incorrect information about the state of the economy. Inflation causes businesses to assess higher profits than they really had by considering profits at the old, uninflated rate of currency. Thus, expansionist malinvestments are made. As such, once market adjustments have been made, these malinvestments will find themselves unable to continue operation. Hence why inflationary policy leads to boom and bust cycles. In other words, inflationary policy distorts the signals provided from economic calculation.

The Evenly Rotating Economy

Action aims at a state of rest. In other words, action always aims at arriving at a state where there is no more uneasiness to remove (or, at least, it is not possible to remove any more uneasiness). This is not exactly a totally imaginary construction - when the stock market closes for the day, there will be some traders who made no buys or sells because the prices were not of interest to them. However, such state of affairs is only temporary and limited in scope. A global, eternal state of rest as such is impossible - we approach the limits of our biology. If someone becomes uneasy about the prospects of dying they obtain food. Once the food is consumed, it can not be consumed again. So more must be purchases. So work must be done to obtain it. And so on.

A slightly different variation on this theme is that prices will also eventually reach a "final price". It must be stressed that "in the real world" no such final price can actually be achieved. The reason why this doesn't happen "in the real world" is that human desires change and new technology is invented before the price finalises.

Think about a Big Mac. The Big Mac starts at some price. Let's say the price is too low - every day the store is totally sold out of Big Macs. They raise the price until they still sell out, but now they make greater profits. Let's say they eek above this price - now they don't quite sell all the units and the profit goes down (this is a special case - in general it is not necessarily the case that maximum profit happens at every unit being sold exactly). So they lower the price and reside at their maximum profits. In reality, such a state of affairs is unlikely to happen. Consumers tastes will change - a new fitness magazine comes out talking about how bad Big Macs are for your waistline and the demand drops. Cattle farmers in Argentina work out some kind of new land management system and are able to sell beef 5% cheaper than other producers causing supply chains to change. A war breaks out cutting off the supply of cooking oil. And so on, and so forth.

However, we can make an imaginary construct in which prices - all prices - are allowed to reach these final prices. All prices. We call this the evenly rotating economy (for reasons that will become clear soon). We know going into this that it's just not possible but we do it anyway - what can we learn?

The first thing we learn is that there can not be any kind of innovation. Previously we used the example of new land practices in the cattle farmers of Argentina that reduced the price of beef. Of course, this is directly prohibited in the evenly rotating economy due to this causing a price change. But I also want to reflect momentarily on the price change of the Big Mac. Well, perhaps now with access to cheaper beef new burger firms offering alternative products to the Big Mac open. This creates more competition so the Big Mac price needs to drop to continue to sell product. Or perhaps on the other hand the news of cheaper beef drives a beef craze and suddenly the desire to eat beef goes way up - the Big Mac price can actually rise. There's no way for us to know this from pure thought experiment alone. However, I also want to point out something a little more subtle here. Imagine if both of these things happen at the same time. So, the competition opens driving the price of the Big Mac down but at the same time there's a beef craze driving the price of beef up. Imagine for a moment these price driving forces are exactly even. This would mean that the actual price itself does not change - but this is still prohibited in the evenly rotating economy. In other words, the evenly rotating economy thought experiment does not just prohibit prices changing but forces that could cause prices to change. In summary then, through the construct of the evenly rotating economy, we learn that innovation, technology and changing consumer preferences are the cause of changing prices.

The second thing we learn from the evenly rotating economy is about money. First, consider what cash is. By this I mean held cash - money placed aside for savings. It might not even have a particular purpose in mind as such. It is common practice for people to have some cash reserves specifically for the purpose of uncertainty. For instance, an emergency fund if the economy goes bad or if the roof leaks or emergency repairs. In a sense, this saver hopes none of these things actually happens as such, however, uncertainty means such cash reserves are necessary. However, the evenly rotating economy must by definition explode uncertainty as a concept - in this way no cash reserves are ever held.

The third thing is that the evenly rotating economy explodes human action. There is no concept of human action within the evenly rotating economy. Automatic reaction is substituted for conscious striving. Given that there is now no longer any uncertainty, there is simply nothing to be said about values for removing uneasiness. Every person mechanically knows precisely that which eliminates uncertainty the best.

There are also other minor things which come as a consequence of the evenly rotating economy. For instance, the stock market simply can not exist! Prices of stocks would never change! The stock market is in other words the monetisation of uncertainty.

The Stationary Economy

The stationary economy is a slightly different construct to the evenly rotating economy. However, in this economy we do not prohibit prices from changing but instead enforce that the income and wealth of every individual remains constant. Prices may change, uncertainty may exist, populations may rise and fall, innovations come and go, whole sectors of industry can appear and go bust, so long as each person maintains a precisely identical level of wealth.

This stationary economy implies the existence of two other kinds of economies - the progressing (expanding) and the retrogressing (shrinking) economy. In the stationary economy the sum of all profits and losses in the economy is zero. In the progressing economy the sum of all profits and losses in the economy is positive. In the retrogressing economy the sum of all profits and losses is negative.

We can know a lot about an economy and a society by whether it is a progressing or retrogressing economy. A progressing economy means conditions are improving for the citizens, and vice versa. It is prudent to attempt to find methods which lead to the progressing economy.

Criticisms

Not Everyone Has the Same Goals

One criticism that is levied against Austrian Economics is that it can not be true since there are some people who do not wish to act in the world. For instance, Buddhists sometimes have the goal of simply not acting. Even more, their philosophy is that acting is evil and suffering, and must be avoided at all costs. Praxeology is entierly neutral with respect to these ideas. Even if tomorrow every person decided to adopt these ideas it would in no way invalidate Austrian Economics. In fact, we can Praxeologically and Catallatically analyse this kind of behaviour (for instance, we can see that social progress, in the sense of new economic development would cease and that the market would lose all data necessary for economic calculation, of which none would be happening anyway). The strength of Austrian Economics is that it does not depend upon everyone acting in the same way in the same situation. Equally, Austrian Economics does not wish these people would act economically - again, it is 100% value free and neutral. As Mises explains in Human Action

Some philosophies advise man to seek as the ultimate end of conduct the complete renunciation of any action. They look upon life as an absolute evil full of pain, suffering, and anguish, and apodictically deny that any purposeful human effort can render it tolerable. Happiness can be attained only by complete extinction of consciousness, volition, and life. The only way toward bliss and salvation is to become perfectly passive, indifferent, and inert like the plants. The sovereign good is the abandonment of thinking and acting.

Such is the essence of the teachings of various Indian philosophies, especially of Buddhism, and of Schopenhauer. Praxeology does not comment upon them. It is neutral with regard to all judgments of value and the choice of ultimate ends. Its task is not to approve or to disapprove, but only to establish facts.

Maintaining a strict value free analysis is intellectually exhausting and is usually the largest hurdle to an understanding of Economics. I hope this essay has provided ample examples to you of how to engage in a value free analysis.

Not Everyone Knows Austrian Economics so it can't be real

This criticism is that not everyone knows Austrian Economics, so, for instance, firms do not "know" how to set prices according to Austrian principles. For instance, firms are not typically working out which price is equellibria or which price maximises profit based on various factors discussed so far.

This criticism fails to appropriately take account of catallactics. When we say things like "firms choose prices that maximise profitability" this is a kind of teleological narrative. Firms may set prices in any number of ways - they could get a random number generator, they could take lottery numbers, they could ask a psychic from the horoscope section of the newspaper. It doesn't actually matter. The point is that firms who set incorrect prices will find themselves at a loss and will lose to the competition of firms that set prices more appropriately.

This is actually somewhat analagous to evolution. We often say things like "animals evolve to be more suitable to their environment" but if you looked at any one animal it doesn't do any evolving! In fact, its methods for survival seem to have nothing to do with evolution. However, within its offspring some mutations occur and the mutations which help the animal survive and the mutations that hinder the animal die out.

It's again important to remember that in Austrian Economics we look at not just that which is seen but that which is not seen. For instance, we don't just consider firms that exist and what they do, but also firms that don't exist and specifically firms that went bust, and how they went bust.

Excess Capacity

A criticism raised against Austrian Price theory specifically by post-Keynsian thought is that firms these days have large amounts of excess capacity. When demand goes up, rather than increase prices, they are simply able to produce more goods at a rapid rate with virtually no spin-up time. For instance, there could be some factory producing some item and normally it operates at 50% capacity, and can scale up to 100% capacity within a single day. Thus, demand is going up but prices are not going up.

This is a very abortive attempt at a criticism. The fundamental confusion here probably (I would guess) comes from that many Classical Economics texts say something like "when demand goes up, prices go up". However, you will note that throughout this essay I've been very careful to never actually use this phrase. I either say, "all other variables held equal, when demand goes up, price goes up" or I use the even more generalised form "an increase in demand brings about a tendency for prices to rise".

Specifically, in this case, the post-Keynsians fail to realise that the supply is also increasing freely with demand. Thus, real prices need not necessarily rise when demand increases. This is only true, though, when some other tendency for prices to fall or remain the same, is stronger.

I think a good analogy for this is gravity. When you see a leaf blowing in the wind you wouldn't run to your physics professor and proclaim "see, gravity is not real for this leaf is not falling". Simply, there is another (stronger) force causing the leaf to fly. The force of gravity is still acting exactly the same.

Why do we use simplified "toy problems" rather than these real life cases? The answer is - we don't. If you dig around Austrian Economics papers you will find the Praxeology and Catallatics of excess capacity in firms. The reason why you (personally) maybe only see examples where one economic force is present is that you likely have only seen more introductory texts. Why do introductory texts focus on "toy problems" rather than "real life" examples? The same reason that introductory physics textbooks contain problems of gravity with only one force and no air resistance! It's important to develop the intuition of how the economics works in these isolated cases before it can be considered in the more generic cases.

Not Everyone is Logical

The most common criticism of Austrian Economics by far is in the axiom that human action is logical. The criticisms of this come in many forms, but usually essentially say that people are not logical. They could be examples of people doing "stupid things", or perhaps they could be something like "well, not everyone has taken logic classes". I once saw a well-meaning but confused person ask for guidance on formal logic from mathematics. His reasoning was that the "economy we made assumes everyone is logical" but since we've never been taught it "no wonder it's a mess!".

This criticism is only a misunderstanding in nature. When Austrian thinkers say everyone is "logical" they do not mean that people never make mistakes, or always think carefully about decisions or that they are using some kind of mathematical logic theory in their day to day lives. Instead, when Austrians use the term "logical" in this specific context, they are referring to the fact that people necessarily act with reference to their own personally, at that moment, value judgements.

In other words, if you give me an orange and I hate oranges and throw it in the bin, I am acting logical. In that moment, I see no potential use of the orange so I simply discard it. If the next day you give me an orange and overnight I suddenly realise I love oranges and eat it immediately, I am still acting logical since I now have use for the orange aligned with my values.

It is not possible, in this sense, to not act logically. You might think "well, what if I don't act in accord with my value judgements" but this simply is not possible. The relationship between action and value judgements is tautological in nature. In other words, your actions tell us immediately your value judgements.

Something Happened but the Economy Doesn't Reflect it

A very common criticism of Austrian Economics is that something happened but it isn't reflected in the economy. For instance, the demand for beef might go up without the supply going up and supermarket shelves go empty rather than prices going up. This criticism always comes from a failure to understand catallactics.

When Austrians quote simple models of economies, they are usually idealised models. The most common idealised economy is that of the evenly rotating economy that we studied earlier. But equally, other less idealised (but still somewhat idealised) economies are possible. For instance, often economies are treated as though shops operate like the stock market with a new price every instant of the day. Austrians know that this is not how the real world works - this is taken into account elsewhere. Those models are to analyse very specific attributes.

The existence of catallactics totally explodes this. The reason why shops don't operate like the stock market with a new price every instant is due to various factors taken into consideration in catallactics. For instance, some really basic ones are that shop workers would have to go change price tags, or perhaps stores have contracts with suppliers that last for months where they can not change the price. All of this is "propagation delay" and it in no way invalidates Austrian Economics. This is already taken into account!

What's the Point in All This?

"How is this useful?". The most common criticism used when someone is losing an argument about Austrian Economics but can't emotionally accept that their list of ideas about how to save the world can not actually work. Used as a distraction. "Sure you can have all these theories, but I need to do stuff in the real world".

A good scientist is never motivated by utility but instead only by a single-minded desire to, as accurately as possible, describe physical reality and natural laws. To ask what the use is in Austrian Economics is the same as to ask what the use is in discovering the wave-particle duality in physics. It does not matter if it happens to be useful or not - it simply is reality and it is our job to describe that.

That being said, the use of Austrian Economics is quite apparent. First, it provides us with an excellent epistemological framework for economic science, and allows us at a glance to know which questions can be answered strictly scientifically and which fall under the realm of business and speculation. This prevents us from wasting time trying to scientifically answer questions like "which colour for my logo will help me sell to consumers best?".

The second is it helps us avoid common pitfalls in policy. Improper government policy can be very detrimental to the prosperity of a naion. When you aim at certain ends, it is important that the action taken is actually capable of achieving these ends. Austrian economics is a good reality checking tool - "I want to raise the average standards of living by printing money? Oh I best be prepared for an inflationary bubble" and so on. Sadly, few listen and mistakes are often repeated.

Conclusions

Austrian Economics is inconvenient. Grandiose identification of politicians is evaporated because of it. The elite class, the lackeys of the political system, must shun it.

Nevertheless, there it is. So far, the only systematic study of economics that first engaged in a through analysis of the epistemological foundations of the subject matter. All other theories come from non-scientific sources. They arise from the perspective of trying to fix some social ill. As such, they quickly become mislead.

It is through this unwavering dedication to scientific ends that Austrian Economics has become the only economic theory to accurately describe reality. And it did that without any empirical observations. Quite the achievement.

I hope this essay has served as a suitable place to begin an understanding of economics. The references contain many interesting books for further study.

References

Hoppe, H.H. (1995) Economic Science and the Austrian Method. Ludwig von Mises Institute.

Menger, C. (1892) On the Origins of Money. The Economic Journal.

Bastiat, F. (1850) That Which is Seen and That Which is Not Seen.

Hoppe, H.H. (1993) The Economics and Ethics of Private Property. Ludwig von Mises Institute.

von Mises, L. (1949) Human Action. Ludwig von Mises Institute.

Rothbard, M. (1983) The Mystery of Banking. Richardson & Snyder.

Kant, E. (1781) The Critique of Pure Reason

von Mises, L. (1990) Economic Freedom and Interventionism: An Anthology of Articles and Essays. Liberty Fund Inc.