The Austrian Way – Part 3

An Introduction to Austrian Economics

Part 3 – by Aaron Koenig

Read: Part 4 | Part 2 | Part 1

The Function of Prices

Best price tage
Best price tag

The Austrian School believes prices are extremely important to the proper functioning of an economy. Prices send signals to which buyers and sellers adapt their behaviors. When resources become scarce in a free economy, prices rise and buyers will use less of this resource by replacing it with another, less scarce one. They do this without having to know anything about the supply, delivery volume or production costs of that resource; they simply want to save money. Entrepreneurs may then find it pays to tap new resources which were previously economically unviable. Alternatively, entrepreneurs may invent new products that work without using the expensive resource but offer the same benefits. The ecosystem will automatically adapt to the scarcity of that resource, and often this adaption process will lead to innovation and progress.

This natural adjustment cannot happen in a planned economy, where prices do not arise from supply and demand but are instead fixed by a central institution. Therefore, central planning inevitably leads to a waste of resources and a lack of innovation. A central institution would have to inform all participants of a production process when a resource becomes scarce. But it is mathematically impossible to dispose of all necessary data, let alone to compute them and draw the right conclusions. And how should the central authority convince people to change their behavior? By appealing to their reason and insight? Most likely they will resort to use force.

Market Economy and Socialism

Vegetables with price tags
Vegetables with price tags

In a free-market economy, resources are channeled to where they can be used in the best way via the simple but striking signaling effect of prices. Only a price-driven process of competition in which inferior products are constantly ousted by better ones can lead to an efficient usage of scarce resources – which is what economy is all about. 

Ludwig von Mises already proved why Socialism could never work and would lead to impoverishment in the 1920s. At the time, he faced a chorus of outrage, as Socialism was popular and had not yet been discredited. But history has proven Mises right, as one could easily see by comparing the economies of Socialist East Germany and North Korea with their free market counterparts in West Germany and South Korea. Both countries began under the same conditions and shared the same culture, work ethics and natural resources. But whether socialist or free market policies were applied made a huge difference. Currently, Venezuela proves that even the country with the largest oil reserves on earth can be run down through socialist policies.

The Austrian Interest Theory

Pulling Interest rates
Pulling Interest rates

Interest is another topic the Austrian School has thoroughly examined. The Austrians claim that people value the money at their immediate disposal higher than money for which they need to wait, e.g. when they have lent it to someone else. Carl Menger has coined the term time preference for this phenomenon, which became the basis of Eugen von Böhm-Bawerk’s theory of interest. 

When you lend money to someone else, you might to do this for a close friend or family member without a markup on the return. However, in most other cases you would charge an interest that compensates you for not being able to immediately spend the money yourself. It is also a compensation for the risk that the loan may not be repaid.

Some religions and even some economic schools reject interest and consider it immoral. In contrast, the Austrian School sees it as fair and justified, as long as it results from a voluntary agreement between lender and borrower. Due to time preference, no loans would be given if there were no interest. Indeed even in Islamic banking, which officially bans interest, there are many incentives for a lender. He would receive presents or a profit share, which have similar effects as an interest.

Interest becomes problematic when it is artificially set by a central institution. Austrian economists disapprove of the central bank’s power to fix interest rates. It is an intervention in the economy that is as harmful as a central planning authority fixing prices. The free market’s advantages in determining the prices for consumer goods should also be used to set the price for money, which is the interest. In a free market, the interest rate would depend on people’s willingness to save. If there are many people who save and want to lend money, the interest rate will be low. If the supply of loans is lower, as people are less willing to save and lend, the interest rate will be higher.

To be continued

If you like this article, you will be glad to read, “The History of Money” by Census Open Finance

Aaron Koenig's book cover page
Aaron Koenig’s book cover page

This is an excerpt of Aaron’s book A Beginner’s Guide to Bitcoin and Austrian Economics

Aaron Koenig is a contributor to the Census Blog. He is an entrepreneur, consultant, writer and film producer, specialized in Bitcoin and Blockchain technology. Aaron is the author of the books A Beginner’s Guide to Bitcoin and Austrian Economics, Cryptocoins – Investing in Digital Currencies and The Decentral Revolution

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