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Concepts: The Austrian School

Gunnar Jaerv
Gunnar Jaerv 2 December 2020

The Austrian school of economics gave us concepts like opportunity cost, and called for a currency immune to inflation and central bank control.

The Austrian school is an individualist school of economics that holds that we don’t need to understand large groups, macroeconomics or historical factors in economics. Macroeconomics, to the Austrian school, is just microeconomics in large numbers.

Microeconomics of the individual

The school originated in Austria, as the name suggests, in Vienna in the late 19th and early 20th centuries. We owe several important economic ideas to the Austrian school, some so important that it’s now surprising that anyone ever had to think them up — subjective theory of value, for instance, suggesting that the same goods can have different value to different people, seems very obvious to us now; but we owe it to the Austrian school.

Similarly, the Austrian school gave us the first economists to formulate opportunity cost. The school also produced Nobel winner Friedrich Hayek, but is nevertheless viewed as outside the mainstream of economic thought.

We also owe a less well-supported belief that major economies don’t need to be regulated. To the Austrian school, economic regulation — including central bank control over a currency — is not only useless but actively harmful.

Marginal utility and time preference

The Austrian school was the first economic school to focus on small transactions at the personal level and on the reasons behind those transactions. That meant that ideas from the Austrian school were borrowed and merged with the mainstream of economic thought even while the Austrian school itself was regarded as an outlier.

These ideas included marginal utility and time preference.

To understand the idea of marginal utility we first need to grasp the economic concept of utility. In economics, utility is the benefit or gain that comes with a good or service. You may be familiar with the ancient marketer’s maxim: don’t sell the steak, sell the sizzle. In a sense, utility is like this: I’m buying a dinner with friends, not so many grams of meat. I’m buying travel in comfort and style, not a car.

Marginal utility is the difference in utility as consumption increases. The increase in usefulness that I get by buying two cars rather than one is marginal utility.

Naturally enough, the difference in utility between one additional car when I already own one, and one additional car added to my fleet of thirty, is called diminishing marginal utility; the increase in utility per unit consumed decreases as consumption rises, at least in theory.

Time preference is related, because it affects marginal utility. Time preference is the relation between the value of getting something now, and getting it later. In the case of print newspapers, yesterday’s newspaper is yesterday’s news. A bar of gold is different: you might prefer to acquire it as soon as possible, but it won’t grow or shrink in size or value (probably, within certain bounds) in a week or a year, compared to today.

Time preference goes beyond this, though, to examine the relative value to the individual of goods acquired now and in the future. For instance, would you prefer to receive $1,000 in gold bullion now, $10,000 at the weekend, or $1,000,000 in forty years? The difference between the amounts is significant. Your time preference here is determined by all sorts of factors — your current financial status, your expectations (you may expect to be a multimillionaire in forty years anyway, in which case it hardly matters) and even your age; few ninety-year-olds would take the $1 million, but most twenty-five-year-olds might.

Most things in an economy aren’t bars of gold or copies of yesterday’s newspaper, though. If I can buy a stock or bond today whose value has risen every day for the last week, it’s worth more to me the sooner I buy it, because the difference between the price I pay and its maximal market value will be greater. If I can buy cheaply an investment which matures in twenty years to a handsome profit, the margin may be worth the wait.

For most people, there’s an inbuilt time preference in the sense that we have finite lives; for businesses, the tension is between the value of acting now rather than later, and the likely increase in available capital and markets later rather than now.

The major contribution of the Austrian school was to build microeconomic principles like these, further explored in behavioral economics, into the mainstream of economic thought.

The Austrian school and digital assets

Many commentators regard the increasing popularity of digital assets as being linked to the thoughts of the Austrian school, looking to the individualism of the group and to Hayek’s comments that inflation is inevitably harmful — even the moderate inflation viewed as inevitable by most mainstream economists. To Hayek, this is really a form of harm wished on the economy by central banks trying to spend their way out of trouble. As they do so, they devalue the currency the economy relies on; to Hayek this is like a person trying to fill up a hot air balloon by breathing into it, in that the volume expands but the value falls.

Naturally, this is impossible for BTC and other digital assets with hard supply restrictions: the total number of Bitcoins that will ever be mined is known in advance and because of the nature of the blockchain underlying BTC, it will forever be impossible to raise this number. Bitcoin can’t be quantitatively eased, fractionally banked, or spent into being by any agency. It can only be mined. In that sense it represents a finite resource whose value is determined by the market — exactly what economists of the Austrian school thought money should be.

This makes it sound as if Austrian school economists and digital assets enthusiasts should be natural friends; in fact, the affection mostly flows only one way. The first generation of Bitcoin geeks were very keen on the individualist economics proposed by the Austrian school.

However, at one current home of Austrian school economics, the Mises Institute, Nikolay Gertchev writes that while “[p]rima facie, bitcoins [sic] possess all the qualities required from a money (a generally-used medium of exchange)”, they face a barrier to widespread adoption: “in order to become a viable alternative to existing monies, bitcoins must generate a sufficiently large demand so that their usage becomes generalized. Without the certainty that they can be transacted for any other good in the economy, a demand to hold them as money could not develop. It is with respect to their capacity to become and remain commonly used that bitcoins suffer from a relative disadvantage”.

Note that Gertchev doesn’t say BTC isn’t valuable, only that it’s unlikely to elbow out greenbacks any time soon. Note also that some Austrian school economists are very pro-digital assets, such as Jeffrey Tucker, whose LibertyME website features reports from the Libertarian Party Convention and books by Hayek and Henry David Thoreau.

It also features several of Tucker’s own books, including Bit by Bit, in which he argues that “bitcoin [sic] is routinely analyzed and explained in terms of its properties as an alternative to national currencies, as if there were no more than that at stake”. In Tucker’s view, there’s more to it: “Once you understand the driving ethos — voluntarism, creativity, networks, individual initiative — you can see the outlines of a new social structure emerging within our time, an order that defies a century of top-down planning and nation-state restrictionism.”

The Austrian school’s interactions with digital assets are as heterogeneous as the school itself, and prophesize everything from a bubble to a new beginning. It’s likely the schools’ contributions to mainstream economic theory that offer most to those who would understand the underpinnings of the new digital economy.

Disclaimer:

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