What Is “Austrian Economics” and Why Is Ron Paul Obsessed With It?

Commentary about business and finance.
Jan. 6 2012 4:16 PM

What Is “Austrian Economics”?

And why is Ron Paul obsessed with it?

Ron Paul
Ron Paul

Photograph by Justin Sullivan

As he declared quasi-victory in Iowa following a third-place finish, Ron Paul puzzled cable news watchers across the country by proudly proclaiming, “We are all Austrians now.” The average Republican presidential candidate would sooner officiate a gay marriage than praise Europe, yet here was Paul pledging allegiance to Vienna. What did he mean? Why would we all be Austrians?

Paul’s statement was crystal clear to those familiar with the internecine controversies of the libertarian movement. He was referring to so-called “Austrian economics,” an idiosyncratic passion of his and a set of beliefs that put him at odds with the vast majority of well-known economists of all ideological inclinations.

For starters, it’s important to note that the term has something of a double meaning. The Austrian school originally referred to a set of classical liberal thinkers with diverse interests who came out of the Austro-Hungarian Empire. Many of these thinkers are obscure today, but the most distinguished member of the group, Friedrich Hayek, is anything but. By the same token, an appreciation for Hayek’s work by no means makes you an “Austrian.” Hayek, who died in 1992, won the Nobel Prize, and mainstream economists thoroughly embraced his important work explicating the role of the price system in conveying information. His ideas undergird everything from carbon taxes to wireless spectrum auctions and thoroughly permeate policy throughout the Western world.

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But “Austrians” in Paul’s sense refers to something narrower, specifically the thought of Ludwig Von Mises and his student Murray Rothbard. It is a form of capitalism that is even more libertarian and anarchic than that espoused by many libertarians. Rothbard‘s followers, most prominently longtime Paul associate and founder of the Mises Institute Lew Rockwell, have been waging a decades-long war against the Koch brothers and the more mainstream form of libertarianism the Kochs represent.

“Austrian economics,” in this sense, goes beyond standard-issue free market thinking in a number of ways. Most notably, it seeks to build a strong ethical case for strict libertarianism without admitting that this would lead to any practical problems whatsoever. Therefore, along with rejecting the legitimacy of any intervention to protect the poor or regulate anything (a position much more extreme than even the Hayek of Road to Serfdom), Austrians reject the idea that there is anything at all the government can do to stabilize macroeconomic fluctuations. This, to be clear, is different from the mainstream Republican view that the stimulus bill enacted by Congress in 2009 and signed into law by President Obama was wasteful or ineffective. Austrians also believe that cutting taxes to boost economic activity doesn’t work either. And they disagree with Milton Friedman that appropriate monetary stimulus by the Federal Reserve could have prevented the Great Depression. Indeed, they disagree with even the least controversial of all stabilization measures, the ordinary tweaking of short-term interest rates that all modern central banks use to try to prevent either inflation or deflation. In the view of the Austrians, practically every economic policy pursued by the federal government and Federal Reserve is a mistake that distorts markets. Rather than curing recessions, claim Austrians, stimulative policies cause them by producing unsustainable bubbles.

The way this works, according to the Austrians, is that artificially low interest rates spur “malinvestment” in unworkable enterprises that inevitably crash when the stimulus is withdrawn. This is an emotionally appealing idea, positing that the suffering of a bust is a kind of cosmic payback for the boom. But it doesn’t make much logical sense. For one thing, as George Mason University economist Bryan Caplan, who’s ideologically sympathetic to the Austrians, points out, it’s hard to understand why businesspeople would be so easily duped in this way. If Ron Paul and Ludwig von Mises know that cheap money can’t last forever, why don’t private investors? Why wouldn’t firms avoid making the supposedly dumb investments? Ironically, the Austrians have replicated an error from the crudest forms of postwar Keynesianism—the failure to consider the role of expectations feedback in macroeconomic policy.

More broadly, the Austrian story of investment booms and busts doesn’t actually explain recessions and unemployment. Spending patterns shift all the time without sparking a recession. People stop buying BlackBerrys and they buy iPhones instead. Or people stop buying boot-cut jeans and buy skinny jeans instead. Across sectors, maybe people go see fewer movies and with the money they save they eat out at nicer restaurants. A business that curtails its investment spending should have extra money to pay out as dividends. Or if they want to horde the cash, it sits in a bank for someone else to lend out.

It may seem “obvious” that the decline in housing activity caused the current recession, in line with the Austrian view, but in fact fixed residential investment turned negative in 2006. It stayed negative for more than a year before the recession began, and then continued negative for a couple more quarters before it turned severe. People spent less on home-building and renovation and more on other things. If investment spending in general declines, you would expect spending on consumer goods to rise to offset it. In practice, this doesn’t always happen and you get a recession. It’s this anomalous collapse in overall spending that needs explaining, and describing some of the past spending as “malinvestment” doesn’t help you understand it.

The interesting question is what to do about it. Many of the original Austrians found their business cycle ideas discredited by the Great Depression, in which the bust was clearly not self-correcting and country after country stimulated real output by abandoning the gold standard and engaging in deficit spending. Then for a long time after World War II, policy elites more or less agreed on a combination of “automatic” fiscal stabilizers (the deficit naturally goes up during recessions as tax revenues fall and social service outlays rise) and interest rate cuts. And it worked, so nobody much cared about Austrian economics outside of crank circles. But when short-term rates hit zero and the Fed couldn’t push them any lower despite high unemployment, political consensus broke down.

Ever since, we’ve been fighting about fiscal stimulus and quantitative easing, and unusual economic theories have been coming to the fore. Some of them offer useful suggestions about possible fixes. Unfortunately, however, it’s the Austrian school, which preaches despair and demands no action at all, that has the most effective political champion and the most dedicated followers. If I’m wrong, and the economy doesn’t recover in 2012, then these faddish views may gain more steam and perhaps we really all will be Austrians someday soon. But let’s hope not. The developed countries that have done best in the recession—places like Israel and Sweden—are the ones that have pursued the least “Austrian” courses of action, while the European Central Bank’s insistence on pursuing a somewhat Austrian-style course in Spain and Italy is creating a deepening crisis.

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