This essay will examine mainstream and Austrian schools of thought in economics, drawing on both theoretical and empirical evidence in assessing each view. Their respective differences and similarities in methodology, epistemology, and ontology will be evaluated to understand their theoretical perspectives and explain the conclusions they draw from premises. Furthermore, each view’s explanation and policy prescriptions in the context of the financial crisis will be explored as a means of understanding the translation of theory into application, a critical component of economics.
The term ‘mainstream’ in the realm of economics is well defined. Sociological definitions are typically used to explain the term; Kuhn’s concept of a paradigm defines the mainstream view in terms of an assembly of views and perspectives that dominate popular discourse within a domain that are prone to shifts in the long term (Kuhn, 1962). In this spirit, the economic views that are most widely taught in academic institutions, published in prestigious journals, and sought out for consultory advice are the ones considered mainstream (Dequech, 2007). Based on these definitions, it can be ascertained which views predominate.
Many see the current mainstream being predominated by neoclassical economics accompanied by an increasing level of integration with psychological, complexity theory, and evolutionary perspectives (Colander, 2000, Davis, 2007). For the purposes of this essay emphasis will be placed on the neoclassical underpinning of the current mainstream. The neoclassical view emphasises the use of mathematical rigour in its approach, accompanied by assumptions relating to consumer rationality and the existence of equilibria in markets. These assumptions are considered by many to be unrealistic due to their abstract nature and lack of realism, but this is often rebuked with the argument that their use of mathematics creates an objective and positive view of the world whilst offering a basis for the falsification of ideas (Friedman, 1953). Further to the fostering of positivism, a belief in the omniscience of markets is a salient characteristic of the mainstream view, naturally creating an argument against the use of government interventions as a means of ‘correcting’ market outcomes. This becomes a point of contention when discussing the perspective in the context of the so-called financial crisis, as will be done further on in the essay.
The Austrian perspective differs in a fundamental way from the mainstream as it is a less paradigmatic set of beliefs, values, and approaches. Whilst typically rejected from the mainstream for their lack of mathematical rigour and formalism, there is evidence that they do belong to the mainstream. A figurehead of the Austrian movement, Friedrich Von Hayek, shared the 1974 Nobel Prize in economics for his work on the theory of money and economic fluctuations: according to Dequech’s definition of mainstream this would qualify elements of Austrian thinking as mainstream. Despite this, going forward the Austrian perspective will be considered as distinct from mainstream thought.
With a different understanding of the nature and characteristics of the world than the mainstream, this naturally creates a departure from the hegemonic view when it comes to issues of methodology and epistemology. Preferring the view that the world is a complex and unstable system, there is justified scepticism as to the utility of mathematical reasoning (Selgin, 1988). This deprives the Austrian perspective of the basis on which a system of falsification can occur, potentially stripping the school of scientific credibility. Considering this scepticism of mathematical formality, concepts like catallaxy make intuitive sense, with a greater emphasis on the study of social structure and individual interaction as opposed to the establishment of universal economic laws in markets (Hayek, 1982). The other beliefs of the perspective run in a similar vein, with the philosophical foundations of economics considered a greater necessity when attempting meaningful analysis. Considering these salient characteristics of Austrian and mainstream economics, attention will not turn to a comparison of the similarities and differences between the two.
The criteria that will be used to compare each perspective will be methodology, epistemology, and ontology. Dow (2012) uses these criteria when assessing the use of plurality in economics, and their use can be extrapolated into comparisons between different schools of thought: their relevance to the Austrian approach in terms of philosophical foundations and the mainstream approach in terms of mathematics and positivism make the criteria a natural fit. Firstly, the differences and similarities in methodology will be examined.
Economic methodology involves the investigation of economics as a science, and questions relating to the ways in which economic analysis should be undertaken (Boumans and Davis, 2010 p.2). Each view favours fundamentally different methodologies, with the contrast of opposition and advocation of science in economics being a key point of each school’s philosophy.
The respective methodologies of the Austrian and mainstream perspectives are similar in the way that empirical reasoning is used in their approach. The axioms derived from Austrian reasoning are said to be grounded in empirical truth (Rothbard, 1976 p.8), drawing on historical, sociological, and institutional considerations when attempting to understand an economic issue. Similarly, the mainstream implements empirical reasoning through its assimilation of data in creating models in answer to economic questions (Christiano et al., 2018), particularly in the case of dynamic stochastic equilibrium DSGE models. Christiano et al. (2018) further note that institutional factors impact the construction of such models, which will be evaluated later in the context of the financial crisis. These approaches are what allow each perspective to lay claim to validity and cogency in the conclusions and corollaries derived from the premises they assert. This can create the dispute of how information be determined to be false of true, and this epistemological consideration will be considered later in this essay. Despite this concept of empirical reasoning the two schools still have some dichotomy in their methodological approach, embodied in the approach preceding the application of evidence in support of their arguments.
A significant difference in the methodology of the mainstream and Austrian perspectives is their respective uses of aposteriorism and apriorism. This relates to the use of inductive and deductive thinking, each of which impact the arguments and conclusions each school make. Von Mises, a figurehead of the Austrian movement, was a key proponent in the logical foundations of economics and argued for the use of inductive thinking as a means of considering economic problems relating to consumer behaviour and government intervention (White, 1984). This contrasts with the opinion of mainstream and neoclassical economics: Paul Samuelson was said to have disdained apriorism and argued in favour of deductive logic (Wong, 1973). This encouraged a more mathematically rigorous approach, invigorating the possible delusions of early neoclassicals that economics was as much a science capable of answering universal questions as natural sciences. The main difference in these approaches is about the conclusions taken from the general or specific, and their respective applications to the specific or general. This facilitates an epistemological comparison, as the approach used in determining economic laws must necessarily influence the expression and form of these laws.
The word ‘epistemology’ is derived from the Greek words ‘episteme’ and ‘logos’, meaning literally ‘knowledge and reason’ (Steup et al., 2020). Theories of knowledge and reason are central to economic thought, as they influence the viability of abstract models and the role of mathematics and philosophy in deriving economic principles. Understanding how each view validates their findings is key in developing a holistic comparison of each school.
Both perspectives believe that economic knowledge can and should take on an abstract form. This may be in the form of mathematical models in the case of neoclassicals or deeply philosophical models in the case of Austrians. White (1984, p. 7) notes that the Austrian economists Bohm- Bawerk and Menger were interested in the expression of economics in a theoretical and abstract way, as opposed to a practical way. Axioms can be considered ‘true’ if they are logically sound. This is similar to the mainstream view: 1976 Nobel Prize Winner Milton Friedman’s Essays on Positive Economics aimed primarily to justify the use of abstract models and assumptions. This was done through encouraging an ex-post evaluation of models: the assumptions of the model do not matter if the outcome is predicted with accuracy (Friedman, 1953). The application of deductive methodology in establishing universal economic truths on the part of the Austrians and the perceived positive nature of mathematics on the part of mainstream economists results in a similar view of knowledge: one that allows real phenomena to be explained in theoretical terms. Whilst there is a shared belief in abstract modelling, it is the reasons behind that modelling that there is some divergence in perspective.
The mainstream and Austrian perspectives on epistemology diverge somewhat when considering the conditions required for an assertion to be proven to be true; their respective use of mathematics and philosophy are what distinguish them in this domain. The Popperian concept of falsifiability is central to science, and the mainstream is seen to rely on this as a way of establishing credibility in their models with the use of positive economics (Batemarco, 1985). Austrian economists dismiss this idea of ‘falsifiability’, instead point towards the incontestability of an ‘action axiom’ upon which praxeological operations are conducted (Selgin, 1988 p. 21); the fact that all humans act in the pursuit of utility maximisation is not necessarily falsifiable, but ostensibly true. Whilst this difference would appear to be methodological, it can be argued as an epistemological problem; methodology concerns the approach used in discovering knowledge, whilst epistemology is primarily about determining whether this knowledge is ‘true’. In this way, each perspective rejects the other’s means of validating arguments, stemming from the reasoning used in obtained the proprietary information. If the methodology is wrong, then the knowledge gained from it must necessarily be invalid.
Ontology is primarily concerned with the nature of the world around us (Hofweber, 2021). In the context of economics, understanding the nature and reality of economic issues is of critical importance. Different ontological beliefs have implications for the axioms asserted by any school of thought; exploring these contrasts helps to explain the foundation for approach and investigation in economics. The Austrian and mainstream perspective view the role of markets in a similar way, primarily that economies and society are driven by market processes. Further to this, a general agreement of the disutility brought to markets from government intervention creates a view of the world that objects to any friction preventing ‘natural’ economic forces from acting. Fama’s Efficient Market Hypothesis postulates that markets are consumers of information that generate efficient outcome based on such information (Fama, 1973). The government, by design, cannot have access to the same volume of information and as such interventions detract from the gains in efficiency derived from the market (Malkiel, 2003). Austrians agree with the notion of ineffective and detrimental government intervention, with the argument that altering market signals distorts preferences communication, which will inevitably result in a suboptimal allocation of resources with unforeseen future consequences. Both perspectives understand the world through the ubiquitous role of markets and believe that the mechanisms involved are one of if not the most important determinant of economic phenomena events and non-events. They differ, however, in their wider view of the world and its fundamental qualities; this has stark implications for analysis and the pursuit of axiomatic truth.
A key difference in the ontological thinking of the mainstream and the Austrian is that they regard the world as stable and predictable and complex and unpredictable, respectively. The mainstream view regards the world as a stable environment, most importantly, for the purposes of argument and the establishment of axioms that can be mathematically proven. The use of regression analyses requires the ability to hold variables constant as a means of understanding the relationship between two specific variables. That mainstream economists rely on this modelling for approaching economic problems offers an insight into their view of the world; applying values determined in a sterile analytical environment reflect, accurately, the real world. Austrians, understandably, dispute this view. The myriad interactions that determine the direction of the market undermine the possibility of stability: The school sees the market process as a product of transactions between microcosmic agents, a concept known as catallaxy that stresses the importance of social structure in the context of markets (Hayek, 1982). These ontological views punctuate the differences between perspectives in methodology and epistemology; Schumpeter noted that analysis is necessarily preceded by a vision of the world. These ontological views are markedly important in the context of the financial crisis, in both explanation and policy prescription.
When it comes to discussions of the mainstream view of economics and the global financial crisis it is arguably more useful to look at how the perspective failed to predict the crisis, rather than understand any ex-post argument for why it happened. In this sense, it is of central importance to understand the role of general equilibrium business cycle modelling in the mainstream. Formulated by Kydland and Prescott (1990), the use of data in the models (Ohanian, 2010) are characteristic of the methodological approach of the neoclassicals and may be fallacious when relying on them for predictability. The use of historical information in models and their use in policy decisions has been criticised extensively, often using the Lucas Critique. Lucas (1976) stresses the naivety in economic prediction in relation to policy, especially when dealing with aggregated data sets. Like the problem of Lucretius, it is clear these models were simply incapable of handling the immense complexity that would eventually unravel over the course of the crisis. It is also worth considering the policy prescriptions of the mainstream, as the post-crisis response by central banks was marked by a departure from the typical policy prescriptions of the neoclassical view.
In 2009 the American Recovery and Reinvestment Act was signed by President Obama as a means of stimulating the economy; estimates put the stimulus at a cost of around $831 billion (CBO, 2012). Furthermore, there were repeated bailouts of banks in the UK, US, and across the world, costing taxpayers billions (these policies were unorthodox, but not necessarily heterodox). This willingness to stimulate the economy in previously unforeseen ways, like asset purchase programmes, is evidence in support of Colander’s (2000) argument that mainstream economics is headed in the direction of increasing diversity. The neoclassicals would actively discourage this policy response, with the assertion of government intervention being an inherently inefficient thing: the occurrence of market correction, in this case the crisis, is an opportunity to ensure the survival of the fittest. Given the role of central banks and governments in the decision and execution of these policies, it stands in Dequech’s (2007) definition of mainstream that advocation of these policies is no longer on the margins of macroeconomic thinking.
Austrian explanations of the crisis are of a fundamentally different nature to the mainstream, given their lack of reliance on mathematical formulation in understanding economic phenomena. Furthermore, this explanation helps to explain the Austrian view of government intervention in markets. The Austrian view is primarily concerned with the role of interest rates and credit in economic systems, and the role they play in encouraging or disincentivising behaviours of saving and borrowing (Sechrest, 2006). Interest rates are considered a signal to economic agents: low rates encourage investment and dissaving, whilst high rates incentivise lending and saving. However, artificially low rates create investment that could end up exceeding future demand, resulting in unutilised spare capacity, and the consequent restructuring of businesses that results in dire economic conditions.
Above is an illustration of US interest rates in the period 2003 to 2010 (FRED, 2022). As seen in the graph, interest rates were held artificially low until Q2 2004, when rates increased to just above 5% in 2007. This fits with Austrian reasoning, with low rates causing an overinvestment into the real estate market and disastrous consequences. What is perhaps even more radical than their explanation of the crisis is their policy prescriptions in the fallout of it.
The Austrian policy recommendation stresses the virtues of laissez-faire market management. Rothbard (1972) advocated the allowed collapse of the banking system, as the system of fractional reserve banking was ‘bankrupt’ and in need of systemic change. He argued allowing the banks to collapse would prevent the overextension of credit that he considered the principal reason behind the collapse, drawing on Minskyian theories of credit cycles (Minsky, 1977). A systemic reset would also have set a precedent that disincentivised the reliance of banks on bailouts: bailing the banks out for behaving irresponsibly is a quintessential example of moral hazard, and a characteristic of an unsustainable system. This prescription was unlikely to materialise, given the integration of the financial sector in societal life and its lobbying power in Washington.
Mainstream and Austrian perspectives on economics share some similar characteristics, but also diverge in important ways when discussing certain topics. Their shared view of the role of markets, belief in the value of abstract expression, and commitment to the use of empiricism show that they are not so dissimilar as is perhaps suggested. Their most salient departures from the thinking of one another comes in the reasoning used to derive axiomatic truth, which is grounded in their respective views of the world; a dichotomy between stable and unpredictable. This explains their respective belief in and disdain of mathematisation, and the scepticism of one another’s conclusions, even when drawn from similar premises. These differing views manifest themselves particularly in the context of the financial crisis, with contrasting opinion on cyclical economic phenomena and their policy prescriptions for dealing with such phenomena. Understanding these theoretical and applied differences is of central importance when comparing the two perspectives.
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