Ewald Nowotny: The Austrian school of economics and Austrian
economic policy
Text of the Zilk Lecture by Prof Dr Ewald Nowotny, Governor of the Central Bank of the
Republic of Austria, at the Hebrew University of Jerusalem, Jerusalem, 31 May 2015.
* * *
This paper has been prepared with the help of Dr. Paul Ramskogler.
Accompanying slides can be found on the Central Bank of the Republic of Austria's website.
The tensions of a ceasing empire - the founder generations
Unlike the natural sciences economics is not progressing incrementally. As in any social
science economic schools of thought rather reflect the character of the societies in which
they are created. Therefore the Austrian school of economics cannot be understood without
having a thorough comprehension of the institutional environment in which it was created.
The beginning of the school and its core determinants lay in the Austria of the second half of
the 19th century. This period served as the formative environment for the founders of the
Austrian school of economics: Carl Menger, Eugen von Böhm-Bawerk and Friedrich Wieser.
It was a period that was characterised by a massive underlying tension. On the one side
there was a state that progressively lost legitimacy yet continued to claim a massive grasp on
the life of his subordinates. On the other side there was an increasingly professional elite that
witnessed the accumulating dysfunctionalities of the empire yet owed its entire reputation to
it. The internal conflicts arising out of this contradiction turned out to be a huge inspiration for
the intellectuals of the time. Of course these internal conflicts also were decisive in the
making of the Austrian school of economics. Let me therefore explore these two major
influences in more detail.
The first two generations of the Austrian school of economics lived their early life during the
first decades of the second half of the 19th century. They thus formed what might be called
the first post-1848 generation. As a result, the first important political development they
experienced was the immediate reactionary backlash against the bourgeois revolution of
1848. Metternich - the powerful former chancellor who had returned from his temporary exile
taken in 1848 - continued to strongly influence Austrian politics until his death in 1860.
However, also after Metternich's death, the empire continued to rigorously regulate daily life,
most ostentatiously through censorship.
The events of 1848 also had brought Franz Josef I to power, who continued to govern the
country until 1916. His rule was most strikingly characterized by an obsession with a strict
Spanish-type court ceremonial that appeared vastly anachronistic even to his
contemporaries. More relevant in daily life, however, was that one's social status was
strongly determined by the personal ties that one could establish with court members and
representatives. Carl Menger, for instance, was a teacher of the unfortunate Crown Prince
Rudolf for two years.
The importance of the court created an environment in which protectionism and
interventionism were endemic and affected all parts of public life. Mundane aspects of daily
life such as verdicts, the granting of trade licenses or at times even the playing schedule of
theatres were subject to interventions. The huge bureaucracy offered a more than fertile
ground for protectionism. In other words: The empire was omnipresent, omnipotent and
determined career paths. What is more, the interventionism and protectionism made the
activities of the empire quite often very arbitrary.
This might not have been as fatal for the empire as it turned out to be, had it still been able to
deliver successes. However, the Austro-Hungarian Empire - as it became to be called after
1867 - lost a succession of wars and, as a direct consequence, provinces like Lombardy or
Venetia. As a further consequence of these defeats it lost much of its importance in the
German-speaking world to the rising young Prussia and after the Austro-Prussian war in
1866 it finally was expelled from the German confederation - an event substantially reducing
its significance in international politics. Simultaneously, the intellectual evolution of the 19th
century and the growing importance of the middle classes brought an alternative concept of
the sovereign into play. The concept of the emperor as sovereign that was the basis of the
rule of Franz Josef I was increasingly contrasted with a view that put the nation as the
sovereign. The empire thus was increasingly challenged by the concept of the nation state.
This development was wide-spread in the 19th century and not a phenomenon that was
limited to Austria. However in the multi-ethnic society the Austro-Hungarian Empire that
hosted so many nations under its common roof it turned out to be particularly devastating.
The rising tensions amongst the "peoples of Austria" led to an escalating dysfunctionality of
the parliamentary process that had been introduced only reluctantly anyhow. Eventually the
ageing Franz Josef I found himself forced to rule by emergency decrees for almost a decade
around the fin de siècle (1897-1906). On top of this ever more obvious systemic political
crisis there was a systemic economic crisis. Austria had been a late starter in the industrial
revolution as post-feudalistic elements and repressive commercial policies had inhibited
faster capital accumulation and the rise of a confident bourgeoisie at an earlier stage. The
belated industrialization now culminated in the so-called Gründerkrach of 1873. The result of
this major banking crisis was an ensuing period of economic stagnation and deflation that
Austrian economists like Joseph Schumpeter later came to refer to as great depression. The
deep irritation triggered by the experience of Austria's first major economic crisis further
fuelled the rise of alternative concepts to capitalism. In this regard, socialist ideas were most
prevalent at the fin de siècle - note that Karl Marx was a contemporary of the first
generations of the Austrian school of economics. An omnipotent, often arbitrary and, on top
of this, increasingly dysfunctional state thus triggered a deep and systemic crisis of
confidence. This was the first part of the intellectual framework that should govern early
Austrian economic thinking.
However, there was a deep insoluble ambivalence to this crisis of confidence for the first
proponents of Austrian economics. It should not be forgotten that the main pillar of the
empire was its bureaucracy. A major basis for the formation of this bureaucracy was the
educational system, which, as early as in 1850, had been subject to fundamental reforms.
These reforms did not only extend the curriculum from six to eight years but shifted the
emphasis of education from religion and obedience to an education in preparation of
academic research duties. It was a school system that - at least compared to its predecessor
- rather encouraged than suppressed critique and opposition. It cannot be overestimated
how much this added to the vastly fruitful intellectual soil of fin de siècle Vienna. However, at
the same time the school system created a very elitist breed, with graduates of certain
schools often forming lifelong ties. It is no coincidence that the most important proponents of
the second generation of Austrian economists - Friedrich Wieser and Eugen von
BöhmBawerk - for many years had been class mates in the well-known Viennese
Schottengymnasium. This educational system formed the basis for a highly trained
bureaucracy, with a bourgeois class consciousness and a strong, technocratic work ethos.
Menger, Wieser and Böhm-Bawerk were members of these bureaucratic cadres not only as
academics but also through occasional employment within ministries such as the finance
ministry or even - as in the case of Böhm-Bawerk - as ministers. The crux was that they
derived their status and reputation from being representatives of a regime whose
dysfunctionalities and anachronisms lay blatantly open to everyone who was willing to see.
The second part of the Austrian intellectual framework thus was the extremely ambivalent
association with the elite of a crumbling regime.
The massive tension that arose out of these two - in principle irreconcilable - factors created
an extremely fertile ground for the intellectuals of those days. Two different reactions
prevailed: obsession with the individual and therapeutic nihilism. Already during the
Biedermeier of the Metternich period the rising class-consciousness and social presence of
the middle classes had been channelled into the epidemic cultivation of domestic
aestheticism amid a repressive and contractionary state. The fin de siècle somewhat echoed
this escapism - now in a more public form. The arts turned toward an unprecedented
aestheticism as represented for instance in the works of Makart, Klimt and Schiele or in the
music of Johann Strauss. It is not by sheer coincidence that Maurice Ravel later should refer
to the waltz as a "fantastic whirl of destiny". Amongst more analytical minds this obsession
with one's destiny amid an omnipresent and arbitrary state turned into a twist toward
inwardness and an occupation with the individual. Think for instance of the hugely influential
Sigmund Freud and his psychoanalysis. Another very telling example is the work of Arthur
Schnitzler - not by chance one of the first masters of the inner monologue - and his
explorations of the depths of the human mind.
However, at the extreme edge this individualistic twist was taken ad absurdum. This more
extreme approach amongst intellectuals was the so-called therapeutic nihilism. Originally this
term had been coined in the medical science at the beginning of the 19th century to describe
an approach that gave the diagnosis absolute primacy - even if at the cost of dissection -
over the therapy. At the turn of the century this attitude was widely adopted amongst
philosophers (e.g. Weininger, Wittgenstein), social scientists and other intellectuals (Kraus).
With these intellectuals therapeutic nihilism turned into a more generalized view that
"diseases" of society or language could not be healed or corrected in any sensible way and
efforts to do so would be in vain.
It is fair to say that the Austrian school of economics within its own development covered the
distance between these two intellectual extremes. In the end, both the obsession with the
individual and therapeutic nihilism found shelter under the theoretical roof of Austrian
economic analysis. At the beginning, however, the focus on the individual was the prevalent
force in the making of Austrian economics. Carl Menger introduced methodological
individualism and methodological subjectivism into the analysis and thereby became one of
the fathers of the so called marginalist revolution in economics. From that point on, efforts to
base a theory of value on any objective criterion - like for instance labor as in the Marxist
labor theory of value - were outside the realm of mainstream economics. The concept of
marginal utility - first labelled as such by Friedrich Wieser - quickly became the main theory
of value used around the world. However, these innovations today are widely accepted
elements of mainstream economic analysis and if it were only for these innovations we would
find no necessity to discuss a separate Austrian school of economics.
Yet, there were already important concepts in the early Austrian economic discourse that
would later put this school outside the emerging mainstream debate. Already Menger
stressed the importance of uncertainty, which, according to him, increases along with the
accumulating stock of a society's knowledge. The concept of time and path dependency
became central to the Austrian theory of capital as put forth by Böhm-Bawerk. The relative
importance of these aspects continued to increase steadily within Austrian economic
thinking. Further, in defining freedom and one's own responsibility as the basis of the general
development of a state Carl Menger already sketched what became the leitmotif of the
Austrian school of economics. However, contrary to more recent definitions that would define
freedom as the free availability of opportunities, the definition of the Austrian school of
economics always remained a negative one that exclusively defined freedom as the absence
of constraints. This should become decisive for the spin that later Austrian economists took
toward analytical nihilism.
Collapse and exile - the later generations
Despite all the dysfunctionalities and anomalies a core property of the Austro-Hungarian
Empire was the remarkable stability of its society. In the institutional sphere things only
changed at glacial speed. The great stagnationist phase at the end of the century further
helped to accentuate this political stagnation in the economic and social sphere. Against this
background, the shock that was triggered by World War I and the dissolution of the
AustroHungarian Empire was even larger. As anachronistic as the empire may have been it had
been omnipresent and had hardly changed. Now, the man who had governed the empire for
more than sixty years was gone and with him not only the empire's grandeur but also its
existence was a thing of the past. The intellectuals of Vienna had been used to seeing
themselves as the elite of the capital of an empire with fifty million inhabitants. Suddenly they
were situated at the fringe of a six-million people carcass. Long-standing truths were invalid
and the structure of the society fundamentally changed. An illustrative example is the
abolishment of the gentry and its nomenclature. Austrian economists of the third and fourth
generation like Mises continued to use the noble version of their names until the end of their
days but this nomenclature already had been abolished in 1919 thereby eliminating the "von"
in the names of Hayek and Mises. More decisive for the Austrian school of economics
however was that the socialist challenges of capitalism now had become a very serious and
a very real threat. Russia had become a communist country and the financial wealth of many
Austrians was lost during the period of hyperinflation of 1920-1922, which fuelled the further
erosion of trust into capitalism. The endemic rivalry between bourgeois and socialist
politicians in Austrian politics had turned into a subcutaneous civil war now that real power
was at stake. Occasionally this conflict turned into open confrontations that eventually were
to culminate in a brief civil war.
Finally, the world economic crisis added to the ongoing conflicts. The Austrian economists
strongly pushed for a clear laissez faire approach entailing balanced budgets, the absence of
exchange restrictions and free trade. They later were to receive much of the blame for the
above-average severity of the crisis in Austria for their role in the design of economic policies
during the crisis. Nonetheless with the beginning of Austro-Fascism in 1933 the most
important students of the founders of the Austrian school of economics - Joseph
Schumpeter, Ludwig Mises and August Hayek - already had left Austria for universities
abroad. From now on the Austrian school of economics and the economic development in
Austria would be increasingly separated.
It will hardly come as a surprise that the turbulent times of the inter-war period were strongly
reflected in the mind-set of the third and fourth generations of Austrian economists. While the
first two generations had contented themselves with the analysis of a largely static economy
this now radically changed. Austrian economists pioneered the analysis of the business cycle
in the inter-war years. Innovation and the role of entrepreneurship became a central theme in
the works of Joseph Schumpeter. Mises too insisted on the importance of entrepreneurs
amid an uncertain environment. However, while the occupation with a critique of Marxist
ideas already had been endemic among the first generations it turned into an obsession
starting with Mises. Mises spent a considerable part of his career with the effort to prove the
theoretical inconsistency of the concept of a planned economy and objected to public
interventions into the economy.
Mises contrasted with the more reflected Schumpeter. However, with their successor Hayek,
the Austrian school had completed its transformation toward the libertarian fringe in which it
is situated today. Hayek developed the economic concept of knowledge that already had
been present in Menger's thought into a full-blown attack against any public interventions. In
the evolutionary concept of an economy that Hayek had in mind no public authority would
ever be able to outperform the allocative efficiency of markets due to its incomplete
knowledge. The Austrian theory of the business cycle in his hands turned into a theory that
regarded credit creation by public authorities as the main source of economic fluctuations.
Completely ignoring that problems of this kind might also arise in the private sector, Hayek
thus fervently argued for an absolute minimum state. He also was one of the most prominent
Austrian economists that actively tried to influence the economic policies during the world
economic crisis. As early as in 1930 Hayek's prime policy recommendation to fight the crisis
- published in his book "Prices and Production" - was to refrain from any interventions and
wait for markets to stabilise themselves. This was a recommendation whose devastating
effect only becomes clear when it is contrasted with the beneficial effects of the successful
New Deal in the USA that did exactly the opposite. The more mature Hayek's career became
the more focus he put on propagating these libertarian ideas in the policy arena which
ultimately led him to found the Mont Pelerin society in 1947.
Recalling the two extreme positions taken by the intellectuals of fin de siècle Vienna -
individualism and therapeutic nihilism - it thus is fair to say that the Austrian school of
economics had made a long journey from the more individualistic positions of Menger to
eventually reach the climax of therapeutic nihilism with Hayek. Austrian economists like
Wieser had been deeply concerned with problems arising out of inequality and the law of
declining marginal utility in the hands of Böhm-Bawerk turned into an intellectual tool for
promoting progressive taxation. Hayek - a Fabian socialist in his youth - with a zeal often
found among converts now gave the Austrian school of economics its final extremist spin.
This extremism somehow helps to understand why later representatives of Austrian
economics - as for instance represented by Fritz Machlup or Israel Kirzner - never came
close to reaching the academic impact of its founders. Somewhat mimicking Hayek's career
path from now on the most important influence of the Austrian school of economics was in
the political sphere. The influence of the political agenda of the later generations on political
circles around the world, and especially in the United States, should not be underestimated,
though. However, as far as the economic policy of the name-giving country - Austria - is
concerned the influence of the Austrian school of economics remained very limited after
World War II. To some extent this was one of the major reasons for the remarkable success
of the Austrian post-war economy.
Austrian economic policies - a lesson in non-Austrian economics
The period after the horrors of World War II and the Holocaust marked the ultimate
radicalization of the Austrian school of economics. However, this time also brought a
structural shift in Austrian economic policies. The emigrating generations of Austrian
economists had left a country that was characterized by a destructive and violent conflict
between conservatives and socialists and was headed for disaster. However, the terrors of
World War II and the necessities of the ensuing occupation and reconstruction fundamentally
altered these dynamics. In lieu of the hostility and distrust, the new style of Austrian politics
was one of cooperation and compromise. This helped to pave the way for the revitalization of
the Austrian economy.
The most important manifestation of this development was the cooperation of the social
partners. It started in an effort to stabilize price growth in the economy of scarcity of the
immediate post-war years. While these efforts only turned out to be successful at the
beginning they planted the seeds of the neo-corporatist approach to economic policy that
was to form the backbone of Austrian post-war economic policy. The basis of this approach
was a high degree of voluntary cooperation between many of the key players of the social
partnership such as chambers representing employer and employee interests and trade
unions. The cooperation was built around a simple but effective settlement of the concurring
claims whose incompatibility had caused so many troubles in the inter-war years. Institutions
representing employee interests acceded to moderate their wage claims in exchange for a
steady and high degree of investment and the moderation of social hardship by a generous
social state. Bi- and tripartite bodies became the rule and had strong influence on the
legislative procedure thus decisively shaping the design of post-war Austria. At the same
time the high level of coordination of collective bargaining made it easier to internalize
positive externalities. This helped to build Austria's much acclaimed system of vocational
training that was to become a basis for Austria's remarkable productivity growth in the
postwar years.
Most importantly, the atmosphere of mutual trust significantly reduced uncertainty and
thereby supported the high rates of investment that were so crucial for rebuilding Austria.
This was decisively supported by the substantial international help that Austria received in
the years after the war. First of all - but not exclusively - the funds granted under the
Marshall Plan Fund helped Austria to finance its initially persistent current account deficit.
This made it possible to start the reindustrialization of the devastated industry. Nationalized
industries took the key role in this process and the social partnership was crucial, with social
partners being represented on the boards of the nationalized industry. At the beginning, the
output of these industries grew much faster than that of the private industries. What is more,
they were at the cutting edge of innovation and leading in the export sector.
Eventually this system of moderate wage policies and a high share of nationalized industries
fused into what came to be labelled as Austro-Keynesianism. An additional ingredient of
Austro-Keynesianism was a strong anticyclical focus of the fiscal system combined with the
effort to make the tax system more redistributive. Another key ingredient was the currency
policy. The Austrian central bank pursued a hard currency policy and steadily reduced
fluctuations in the exchange rate vis-à-vis the German mark. The major motivation was
mistrust against the instrument of currency depreciations, which, in other countries,
repeatedly had proven as a merely temporary means of relief. Indeed the central bank's hard
currency policy put the Austrian export industry on projectable foundations and helped to
contain the uncertainty that had been vastly increased by the breakdown of the world
currency order under the system of Bretton Woods. These initially quite painful policies - in a
period before the introduction of central bank independence - could only be pursued thanks
to the backing and support of the social partners.
This was especially important as with a growing distance to the era of reconstruction the
heavy industry increasingly gave way to the production of consumer goods; a development
that was further fuelled by the take-off of globalisation and the associated shifts of production
abroad. This process implied a decrease in the relative importance of the nationalized
industries. On top of this structural change, the nationalized industries were increasingly
aching from a structural set-up that was sorely in need of reform. The fact that they
increasingly had to obey to the necessities of regional policies often came at the expense of
economic efficiency. Thus, in retrospect, the adjustments imposed on Austria's economy by
the hard currency policy turned out to be a blessing for Austria. The private sector industry
was forced to adjust its international competitiveness at a very early stage. This helped the
private sector to step in and replace the importance of the nationalized industries as the latter
went through a fundamental crisis. This structural change made Austria's economy fit to
sustain the periods of harsh consolidation that later came in preparation for the accession to
the EU. What is even more important: The increased price competiveness of the Austrian
economy made the integration into the European economy far easier. The regained
profitability of the Austrian industry also supported the successful expansion into Eastern
Europe after the fall of the iron curtain that significantly added to Austria's economic growth
of the last decades. Ultimately, the combination of a competitive industry with a skilled
workforce and a low degree of labor disputes has also helped Austria to emerge from the
recent crisis in a relatively strong condition.
Certainly, any approach to economic policy comes with its specific downsides. The approach
taken in Austria is no exception to this rule. To some extend the current state of the Austrian
economy echoes the famous bon mot of the Austria's former chancellor Bruno Kreisky who
stated that: "a few additional billions of debt cause me fewer sleepless nights than a few
additional hundred thousands of people being unemployed" The nationalized industry and
the active fiscal policy and large social state have left a large debt burden. This cannot be
disputed, yet Austria's national debt is still at a manageable level. The strong role of the
social partners led to some idiosyncrasies, and limiting room for manoeuvre not only reduces
uncertainty but also reduces some innovative capacity. The educational system - despite its
successes in the past - requires a structural overhaul to adapt skill-formation and knowledge
dispersion to the requirements of a modern computerized society. Finally, the financial sector
is on its way to undertake some structural adjustments. However, compared with its peers,
Austria has performed very well, producing decent growth, a skilled population and very low
unemployment rates at the cost of some problems that still are quite manageable. At the
bottom line, the non-Austrian economic policy of Austria has been very successful.
To sum up: The Austrian school of economics developed an approach based on
methodological individualism and a subjective theory of value. It put knowledge in the centre
of the analysis and deduced that increasing knowledge would lead to increasing uncertainty.
As a result - according to Austrian economists only the free interplay of market forces and
entrepreneurship can reveal the underlying knowledge by an undisturbed determination of
prices and profits. A minimum state and strict non-interventionism thus would be the policy
ideal.
Economic policy in Austria indeed has tackled key aspects raised by the Austrian school of
economics such as uncertainty, the dispersion of knowledge and entrepreneurship. It is a
strange irony however that the success of Austrian economic policy was brought about by
tackling these problems with policy tools that ran completely counter those recommended by
the Austrian school of economics. Uncertainty was handled by stabilizing expectations
through corporatist institutions and by a generous social state. Knowledge dispersion was
promoted by centralized collective bargaining institutions. While the Austrian school of
economics thus regarded uncertainty as the main argument why entrepreneurship
outperforms any public intervention, in post-war Austria it was only through public
interventions that uncertainty was brought to sufficiently low levels and entrepreneurship
could unfold. Thus, where the Austrian school of economics was obsessed with fighting
constraints to ensure freedom, economic policymakers in Austria tried to ensure freedom by
equalizing opportunities. Indeed, it was actions contrary to the libertarian recommendations
by late proponents of Austrian economics that made Austria economically successful.
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