Review of Steven Horwitz, Austrian Economics: An Introduction

The Austrian tradition in economics–the tradition in economics that follows the revolutionary contributions of Carl Menger–is strewn with enormous, hernia-inducing tomes. You can find a lot of them in PDF online thanks to organizations like the Ludwig von Mises Institute and Liberty Fund, but you’ll probably want to think twice before printing them out. The PDF of the scholar’s edition of Ludwig von Mises’s magnum opus, Human Action? 950 pages. Murray Rothbard’s Man, Economy, and State with Power and Market? 1,506 pages. Eugen von Bohm-Bawerk’s Capital and Interest? That’s much shorter, at least, but it’s still 538 pages. Even the shorter volumes, like Friedrich Hayek’s Individualism and Economic Order, tend to be pretty dense.

I was relieved, therefore, to see the latest contribution to the Cato Institute’s series of short introductions–Steven Horwitz’s Austrian Economics: An Introduction–is 167 small pages (only 127 of them which are the text of the book). It’s a worthy complement to the other volumes in Cato’s series and a very good introduction to the theory, method, and history of the Austrian school. I wish the book and the accompanying lecture series had been available in summer 2003, when I taught my very first course as the instructor of record (a course called “Explorations in Austrian Economics”). My job would have been a lot easier.

Economics teachers know all too well the difficulty of conveying complicated, abstract concepts and ideas in simple language. They will benefit from perusing Austrian Economics as Horwitz offers clear and simple definitions and analogies that will help teachers help their students understand what we mean when we say “monetary calculation” (“tallying up of past and prospective profit and loss”) and “profit and loss” (“like the pleasure and pain signals sent by our nerve endings”). He notes that “A loan represents the movement of wealth through time, from the future to the present for the borrower and from the present to the future for the lender.” The book is loaded with good answers to “How can I explain this so my students will understand?” that a lot of instructors will find useful.

Horwitz explains what in Austrian economics has been incorporated into the mainstream and what remains largely ignored. Menger was, along with Leon Walras and William Stanley Jevons, one of the first to identify value as a function of the best thing one could do with the next unit–the marginal unit. The value of an ounce of water, therefore, was determined not by the fact that “water is life,” to borrow from a yard sign you’ve probably seen recently, or even the amount of labor that went into producing it. Rather, the value of that ounce of water is the most important thing you would do if you had it or the most important thing you would have to give up if you didn’t have it.

He contrasts the modeling assumptions of the neoclassical competitive framework with the intellectual approach of the Austrians, who view coordination by imperfect people with incomplete information as the problem to be explained. He goes through several steps in the development of the theory and finishes with Israel Kirzner’s emphasis on the entrepreneur as someone who identifies ignorance and brings the structure of production into harmony with the previously misunderstood actual preferences and production policies underlying the pattern of social cooperation at a given point in time. The entrepreneur’s judgment is rewarded with a profit–or punished with a loss in the event that their realignment doesn’t actually match production possibilities and consumers’ preferences.

Horwitz explains an old saw that circulates in Austrian circles: there are macroeconomic questions but only microeconomic answers. He stresses the importance of market-determined prices both in the Austrians’ critique of plans for socialist central planning and in their analysis of business cycles. In the first case, market prices are necessary for the calculation of profits and losses, which are necessary if we are going to know whether we are wasting resources or using them wisely. In the second case, an oversupply of money relative to the amount people wish to hold at the current price level leads to higher prices–and especially to a distortion in the structure of relative prices (the price of one good in terms of another). If banks wish to expand their loan portfolios, they will have to do so by offering more loanable funds at lower interest rates. 

If this represents an increase in real savings, then there is no problem. If, however, this is driven by an increase in the amount of money in the economy, then the price of present goods in terms of future goods–the interest rate–gets distorted and starts telling lies about what people actually want where and when. As Horwitz stresses, the Austrian theory of the business cycle emphasizes specificity and limited convertibility in the capital structure. By this, he means that there may be a lot of ways to skin a cat, but not every tool is appropriate for cat-skinning. Chef’s knives? Probably. Feather dusters? Probably not. A distorted interest rate leads people to consume too much while, at the same time, inducing investors to invest in overly long production processes.

Here’s an example. We would need wood in order to replace the floors in our hundred-year-old house. You also need wood to build new houses (investment in the long-term stages of production). If you enjoy a cozy evening around the fireplace, you need wood for this, as well. As Horwitz notes, one of the problems with the Austrian analysis is that it doesn’t give policymakers and those Adam Smith might call the Men (and Women) of System anything to do apart from “Keep your hands to yourself because you’ll probably just make things worse.” It’s not a message that inspires or flatters the aspiring reformer.

The distortion in the interest rate sends everyone a misleading signal about how much wood there actually is. Builders borrow money to procure wood for new construction. People like me (might) borrow money or draw down our savings to redo our floors. As saving is less attractive at the lower interest rate, people might choose to consume more by buying firewood for those chilly winter evenings. The problem is that there is not enough wood and not enough of the complementary factors of production to satisfy everyone without prices changing unexpectedly. The changing prices will reveal that someone’s monetary calculation–their “tallying up of past and prospective profit and loss”–will be wrong. 

As this is a review, I have to spend some time picking out some of the book’s imperfections. It doesn’t provide a grand unification theory of everything, and I was a little surprised that Horwitz included so much discussion of the Austrian economists when in the podcast he explicitly said he tried to minimize this. I was probably primed to be extra alert to this by an episode of the Cato Daily Podcast with Horwitz as he discussed the book. It also would have been very useful to get a more comprehensive exploration of applied Austrian insights that have been superior to those in the mainstream and other heterodox approaches (to his credit, though, Horwitz explores how Austrian insights have informed the work of the Public Choice school and the “Bloomington School” of 2009 Nobel laureate Elinor Ostrom and her husband Vincent). Finally, he discussed Roger Garrison’s ingenious graphical explanation of the Austrian Business Cycle Theory (pp. 114ff). It would have been very nice to see the graphs included in the book. Of course, he sails into the choppy waters of fractional reserve banking, which he defends–this, most likely, is not going to convince people who think anything but deposits backed by 100% gold reserves are fraudulent.

At its heart, Austrian economics emphasizes social processes and rules, not so much the people who are acting within the system. It’s a way of thinking about the world that doesn’t privilege social reformers and grand visionaries. Rather, it leads to the conclusion that patterns of intelligible social order arise from the complex interplay of people’s unintelligible individual actions in response to a few relatively simple rules about property rights and exchange. Austrian Economics: An Introduction is a very useful and accessible summary of what we know about this simple but powerful paradigm. Teachers and students alike would benefit from consulting it.

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