I’ve been talking about what I see to be a great error that began in the 1870s, which was the reduction of all of “political economy” — this basically means: the philosophy of government economic policy — into questions of Price, Interest and Money. This “error” that I am talking about is, essentially, the “Austrian school of economics.”
Now, don’t get me wrong: I actually like the Austrians. I think that they were right about a lot of things, within their little sandbox of Prices, Interest and Money. And, I think that the investigation and elucidation of related concepts that they undertook was a positive forward development.
However, in the process, they scrubbed “economics” of everything that didn’t fit within this quantifiable box. One of the early activities of the “Austrian School” was against the German Historical School, which believed that economics could not be separated from history and society — very much the opposite of a program to reduce economics to something like a physical science subject to laws that could be represented in the “dynamic stochastic general equilibrium models” that began with Leon Walras. Here is Wikipedia on the topic:
Dynamic stochastic general equilibrium modeling (abbreviated DSGE or sometimes SDGE or DGE) is a branch of applied general equilibrium theory that is influential in contemporary macroeconomics. The DSGE methodology attempts to explain aggregate economic phenomena, such as economic growth, business cycles, and the effects of monetary and fiscal policy, on the basis of macroeconomic models derived from microeconomic principles.
The Historical School contended that economists could develop new and better social laws from the collection and study of statistics and historical materials, and distrusted theories not derived from historical experience. Thus, the German Historical School focused on specific dynamic institutions as the largest variable in changes in political economy. The Historical School were themselves reacting against materialist determinism, the idea that human action could, and would (once science advanced enough), be explained as physical and chemical reactions.
The Austrian School, beginning with the work of Carl Menger in the 1860s, argued against this (in Grundsätze der Volkswirtschaftslehre, English title: Principles of Economics), that economics was the work of philosophical logic and could only ever be about developing rules from first principles — seeing human motives and social interaction as far too complex to be amenable to statistical analysis — and purporting to deduce universally valid precepts from human actions.
Menger and the German Historical School
The first move was when Carl Menger attacked Schmoller and the German Historical School, in his 1883 book Investigations into the Method of the Social Sciences with Special Reference to Economics (Untersuchungen über die Methode der Socialwissenschaften und der politischen Ökonomie insbesondere). Menger thought the best method of studying economics was through reason and finding general theories which applied to broad areas. Menger, as did the Austrians and other neo-classical economists, concentrated upon the subjective, atomistic nature of economics. He emphasized the subjective factors. He said the grounds for economics were built upon self-interest, evaluation on the margin, and incomplete knowledge. He said aggregative, collective ideas could not have adequate foundation unless they rested upon individual components.
The direct attack on the German Historical School lead Schmoller to respond quickly with an unfavourable and quite hostile review of Menger’s book. Menger accepted the challenge and replied in a passionate pamphlet, written in the form of letters to a friend, in which he (according to Hayek) “ruthlessly demolished Schmoller’s position”. The encounter between the masters was soon imitated by their disciples. A degree of hostility not often equaled in scientific controversy developed.
The term “Austrian school of economics” came into existence as a result of the Methodenstreit, when Schmoller used it in an unfavourable review of one of Menger’s later books, intending to convey an impression of backwardness and obscurantism of Habsburg Austria compared to the more modern Prussians. A serious consequence of the hostile debate was that Schmoller went so far as to declare publicly that members of the “abstract” school were unfit to fill a teaching position in a German university, and his influence was quite sufficient to make this equivalent to a complete exclusion of all adherents to Menger’s doctrines from academic positions in Germany. The result was that even thirty years after the close of the controversy Germany was still less affected by the new ideas now spreading elsewhere, than any other academically important country in the world.
Here is a “primer on Austrian Economics” from Mises.org:
What is Austrian Economics?
The Austrian School of thought has offered economic science a wide variety of unique insights. It is unrealistic to provide a detailed account of all Austrian theory within the limits of an introduction. Nevertheless, there are some key theories that the Austrians have become known for, providing a solid foundation for further investigation into Austrian economics.
The unique keystone to Austrian theory is the concept of praxeology. Praxeology is the science of human action, under which the broader subject of political economy is categorized. The employed methodology of praxeology is known as a priorism, which is based on the ideas that the fundamental axioms and premises of economics are absolutely true; that the theorems and conclusions deduced by the laws of logic from these postulates are therefore absolutely true. Praxeology recognizes the fundamental axiom that is human action. Human action is purposeful and aims at completing ends through deliberately chosen means. Human action differentiates itself from instinctual reaction, such as a human’s reaction to biological stimuli, in the sense that the latter is subconscious while human action is entirely conscious. Apart from the axiom of human action there are also several subsidiary axioms, including the facts that man values leisure over work and individuals vary — no one individual is the same as another.
Economics is the science that studies these individual agents of the market and how they coordinate through the price mechanism to create, not just what the mainstream considers ‘the market,’ but society as a whole, all without the necessity of a central planner or authority.” From the axiom of human action, praxeology seeks to develop theory through logical deduction. Modeled, the axiom of human action is represented by A; if A implies B, and A is accepted as true, then B must also be true. That B must be true if implied by A is independent of experience (or a priori), proven through logic. As such, Mises denies the usefulness of historical experience in the study of economics, given that through praxeology any theories developed would be apodictic. It follows that praxeology makes empirical validation or falsification not only superfluous but, as Mises holds, almost useless.
I think we can agree that this is an extreme degree of scientism — that economic cause and effect can be deduced, without reference to history, from initial principles. It is a little like building up molecules from atoms. What about the Protestant work ethic? What about education? What about regulation? What about taxes? What about family, or morality — and underlying that, things such as religion — as it affects such things as business or family?
Alfred Marshall, the author of Principles of Economics (1890) which served as a standard university text through the 1920s, had this to say about economics:
The advantage which economics has over other branches of social science appears then to arise from the fact that its special field of work gives rather larger opportunities for exact methods than any other branch. It concerns itself chiefly with those desires, aspirations and other affections of human nature, the outward manifestations of which appear as incentives to action in such a form that the force or quantity of the incentives can be estimated and measured with some approach to accuracy; and which therefore are in some degree amenable to treatment by scientific machinery. An opening is made for the methods and the tests of science as soon as the force of a person’s motives—not the motives themselves—can be approximately measured by the sum of money, which he will just give up in order to secure a desired satisfaction; or again by the sum which is just required to induce him to undergo a certain fatigue.
We can see the intense desire to move towards a “scientific” approach, expressed in quantitative form, which can then be manipulated with mathematical models. Everything that doesn’t fit within this agenda threatends to reduce economics to the sad state of “the other branches of social science,” such as history. To claim that some unquantifiable element (such as taxes or regulation) is important would effectively invalidate the mathematical model — the model doesn’t incorporate something important, and thus its conclusions are suspect. Actually, this is indeed the case. I don’t think all the mathematical modeling since Walras or Menger has really added up to much. It just invites confusion. Mises didn’t bother with it.
Most of academic economics today — at least “macroeconomics” — still fits within this model of dynamic stochastic general equilibrum equations. A lot of economists are outside this box, working on issues like upward social mobility among Latin American immigrants, or the effectiveness of state welfare policy, or whether Dodd-Frank should be reformed. Real things in the real world. But, on the “macro” level, we still have this spurious ahistorical scientism.
Now, it is entirely possible that the German Historical School was coming to all kinds of conclusions that were rather unfortunate. It sounds like they had a strong tendency towards socialism and state planning. Certainly, there is a lot of “historical economics” that suffers from a lack of theoretical understanding, the kind of understanding that informed the work of Mises and others — a sort of newspaper headline economics. For example, you could say that the difficulties of the 1970s were due to the Arab oil embargo and a general decline in public morality, which was actually a common response in the 1970s (exemplified by Jimmy Carter). So, I would say that economics is best informed by theoretical understanding, but that this theoretical understanding must embrace things that are not really quantifiable, tax policy in particular but also extending to a great many other things.
For the most part, we don’t have to repudiate the findings of the Austrians. The “supply side revolution” of the 1970s, which I say finally got beyond the Prices, Interest, Money box on a macro level, doesn’t really brush that aside so much as adds to it. That’s why we see Historicism make a reappearance, with case studies of Japan and Germany in the 1950s and 1960s, the JFK tax cut of 1964, the Mellon tax cuts, and so forth. The idea that “praxaeology makes empirical validation or falsification superflous” becomes totally laughable. (Actually, it was always laughable.)