Belief: Economic phenomena are the result of actions by the individual.
Policy recommendation: Reduce government intervention and decrease the influence of the central bank.
This school of thought originated in Vienna with the ‘first wave’ of Austrian economists including Carl Menger. In the 1970s, the Austrian school attracted renewed attention and was further developed by Friedrich von Hayek.
The Austrian school is based on the concept of methodological individualism, that is, the view that aggregate social phenomena results from the actions of individuals. Basically, Austrian economists believe that groups cannot act except through the actions of individuals. This is in stark contrast to mainstream macro schools of thought which focus on aggregate variables and societal groups.
Subsequently, when explaining macro behaviour, Austrians take a micro based approach. However, unlike mainstream microeconomics, Austrians argue that we can never know whether individuals seek an approach based on maximising behaviour. Instead, Austrian economists highlight the process by which agents acquire information and form expectations in order to reach their own subjective ‘best solution’. They therefore emphasise the idea of methodological subjectivism: when explaining group economic phenomena, we must look back to the judgments and choices made by the individual on the basis of the knowledge and expectations they possess regarding external developments and the perceived consequences of their own intended actions.
Because of their focus on subjectivism, the Austrian school generally rejects the use of mathematics and econometrics because, as they argue, these cannot capture the complex and idiosyncratic decision making of the individual.
Austrians don’t totally reject all of mainstream economics though, and vice versa. In fact, much of mainstream economics has grown out of Austrian concepts including marginalism, opportunity cost, time preference and the economic calculation problem. The Austrian school was actually one of the three founding members of the 1870s Marginalist Revolution.
Mises and Hayek developed an Austrian theory of the business cycle which points to banks issuing credit as the source of booms and busts. Mises and Hayek argued that when banks extend credit at artificially low interest rates, firms invest in ’roundabout’ production processes, leading to malinvestment or a misallocation of resources. Firms over-invest in capital-intensive production processes which, in turn, causes a diversion of investment from consumer goods industries to capital goods industries and sets the economy on to the path of a recession.
Due to its heterodox approach, the Austrian school has come under fire from various angles. Paul Krugman contends that Austrians are unaware of holes in their own analysis because they do not use explicit models. The Austrian school has also been criticised for its reliance on methodological individualism as this would rule out any macro propositions that are not built on micro foundations.