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Tuesday, July 13, 2010

Vienna and Chicago: Friends or Foes? A Tale of Two Schools of Free-Market Economics

An Analysis of the Two Leading Free-Market Voices

In the post-World War II era, two of the leading voices for a return to a competitive free-market economy have been the Austrian and Chicago schools of economics. Both schools have influenced many people about how markets work and how government affects economic affairs.

To many, the Austrian and Chicago economists seem to be saying the same thing: markets are an efficient way of using scarce resources to best serve consumers; individuals know their own interests and circumstances better than government regulators and planners; political controls tend to distort supply and demand and the price system through which markets are kept in balance. In addition, members of both schools of thought have long warned that inflation and its negative consequences stem from government monetary mismanagement.

As a result, on the surface there seems not to be much difference between the two schools. Yet anyone fairly familiar with the Austrian and Chicago approaches knows that in fact they not only look at the world through significantly different conceptual lenses, they often are extremely critical of each other.

In his recent book, Vienna and Chicago: Friends or Foes?, Mark Skousen tries to explain the history of the Austrian and Chicago approaches, and critically evaluate their strengths and weaknesses. Skousen explains the beginnings of the Austrian school in the last decades of the nineteenth century, during which Carl Menger, Eugen von Böhm-Bawerk, and Friedrich von Wieser developed the theory of marginal utility and opportunity cost; formulated a theory of capital, investment, and interest; and undermined the foundations of Marxian economics. He then traces the contributions of such leading twentieth-century Austrians as Ludwig von Mises and F. A. Hayek in the areas of monetary and business-cycle theory, their insightful criticisms on socialist central planning, and their conception of the market as a dynamic competitive process.

The Chicago school developed later, in the 1920s and 1930s, out of the writings of Frank Knight, Jacob Viner, and Henry Simons, who were early critics of some aspects of Keynesian economics and of government planning. But the Chicago school only really flowered in the postwar era out of the contributions of Milton Friedman and George Stigler, who challenged, respectively, some of the rationales for macroeconomic and regulatory management of market activities.

For the remainder of the book, Skousen contrasts the two schools on a variety of topics, including methodology; inflation, business cycles and the monetary system; and government regulation and intervention. Somewhat irritatingly, Skousen concludes each section by declaring which school “wins the debate,” using the language of tennis: “advantage” Vienna or Chicago. While seeming to be a cute way to evaluate the two schools, it comes across as rather sophomoric. Also, it often seems that Skousen’s decision reflects his judgment about which school has been more influential among economists or in the policy arena. But the correctness of an idea is not measured, per se, by the number of its adherents. Alchemy and astrology have had wide followings, after all.

The core of the differences between the Austrian and Chicago schools is the question of how one tries to understand the world, including the market. Imagine that two objects are observed moving toward each other at a certain velocity. What can we predict about what will happen? Well, we can attempt to estimate their respective speeds and calculate when they are likely to collide, given the measured space between them.

There is nothing wrong with doing this. But if the two objects happen to be human beings, limiting the “facts” or “evidence” to these quantitative dimensions will leave out crucial features of the situation. For example, do these individuals view each other as friend or foe? The answer to that question alone will greatly influence what we predict as the likely sequence of events as they come closer to each other. (If foe, one of them might suddenly stop dead in his tracks and run in the oppose direction from fear.)

To analyze this situation requires the social scientist or economist to look beneath the quantitative surface to try to determine how the actors define the situation, including the meanings they see in their own actions and those of others with whom they may interact. A voluntary exchange and a coerced transfer may look the same to an observer. But they are certainly not the same when understood from the perspectives of the actors.

Unlike the Chicago-school economists, the Austrians have always insisted on emphasizing this “subjectivist” approach. This is partly due to the Chicagoans’ continuing belief (a subjective state of mind, for sure!) that “science” should be defined narrowly as the quantitatively measurable and predictable.

Skousen tries to reduce and ridicule the Austrian view by making it into a caricature of an “a priori deductive” approach that is both incorrect and unjust to the actual arguments that Austrians like Mises developed in great detail. Nor does Skousen do justice to the fact that Austrians, too, believe in “applied” economics, historical studies, and factual evidence. They just do “empirical” work differently from the Chicago economists—the Austrian approach tries not to forget that it is the course of human events that is being investigated.

He therefore too easily gives “advantage” to the Chicago school when comparing their contributions, for instance, in the area of government regulation. The Austrians focus on the entrepreneurial element of innovation and market coordination; they think of competition as a creative discovery procedure; and they view markets as processes of change and adjustment through time. To appreciate the power of the unregulated market, none of these aspects of the real “empirical” world can simply be reduced to econometric coefficients of correlation without losing essential qualities of the subject. It would be like trying to study man by looking only at the skeleton and ignoring the flesh, blood, muscles, nerve endings, and most especially, the mind that guides what the body does.

Skousen finds the most important Austrian contributions in the areas of money, inflation, the business cycle, and monetary institutions. This should not be surprising since these are the areas in which he has written the most over the years from an Austrian-oriented perspective. Friedman’s monetary contributions have basically followed in the Keynesian footsteps. While rejecting most of Keynes’s assumptions about the power of fiscal policy for stimulating the economy, Friedman accepted his “aggregate” approach of looking almost purely at money’s impact on prices, wages, and output in general.

The Austrians, on the other hand, have always focused on the more insidious effects of monetary expansion on relative prices and wages, and on demand, effects that can give a wrong twist to the entire economy.

Unfortunately, while an easy read and even entertaining in places, Vienna and Chicago fails to give the reader a fully balanced understanding of the Austrians or a sufficiently critical appreciation of the limits of the Chicago school.

  • Richard M. Ebeling is BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel in Charleston, South Carolina. He was president of the Foundation for Economic Education (FEE) from 2003 to 2008.

  • Mark Skousen is a Presidential Fellow at Chapman University, editor of Forecasts & Strategies, and author of over 25 books. He is the former president of FEE and now produces FreedomFest, billed as the world's largest gathering of free minds. Based on his work “The Structure of Production” (NYU Press, 1990), the federal government now publishes a broader, more accurate measure of the economy, Gross Output (GO), every quarter along with GDP.