Carl Menger
5.4.1. The birth of the Austrian School and the Methodenstreit
The label ‘Austrian School’ was used for the first time, with a clearly derogatory meaning, by opponents of Menger’s ideas, especially the members of the German Historical School.
The philosophical life of Austria in those times was still dominated by Aristotelian realism, a way of thinking which certainly must have appeared old-fashioned to people who had read Kant and Hegel. Nevertheless, it was precisely this Aristotelian background that allowed Menger to develop a theoretical perspective which the exasperated inductivism of his German contemporaries could not but reject en bloc. In fact, we owe to Aristotle the idea that there are qualities and facts, such as action and human nature, which can be understood on an a priori ground, and that it is possible to formulate ‘laws’ without any need to confirm them inductively. It was precisely by devoting himself to the search for the ‘laws of the economy’ that Menger set up, in opposition to Schmoller’s German Historical School, the theoretical system of the Austrian School.Of the three champions of the marginalist revolution, Menger was undoubtedly the most sophisticated and original, particularly on the subject of methodology. While for Jervons and Walras the main purpose of economic theory was the solution of the allocative problem, for Menger it was the study of the nature of human needs, taking into account the temporal dimension of decisions. In his correspondence with Walras, Menger explained why he considered mathematics not a useful instrument for the economist. From a methodological point of view he distinguished understanding from knowledge. The first aims to find out the reasons why things happen, the second to offer a mental representation of them. To understand economic phenomena it is necessary to go back to the motivational system of agents; to know them the axiomatic method suffices.
In his Grundsatze Menger endeavoured to reconstruct the foundations of economic science, intended as a pure theoretical discipline, so as to offer an alternative explanation of value and prices to that proposed by the classical school. If the classical economists considered value to be essentially governed by past costs, Menger considered it to be an expression of the judgement of the consumer in regard to the goods suitable to satisfy his needs. On the other hand, Menger’s book and the way of doing economic science which prevailed in the German universities at that time were poles apart. Most of the German economists also criticized classical political economy, but the principal target of their criticism was method rather than content: the historical and not the theoretical approach should be followed in economics, and should be applied only to the description, classification, and collection of observed phenomena.
In the period in which Menger published the Principles, the ‘Old’ German Historical School, that of Roscher, Knies, and Hildebrand, was giving way to the ‘Young’ German Historical School, led by Gustav Schmoller. Menger thus had to fight on two rather different fronts: on the theoretical front, against the classical theoretical system, and on the methodological front, against the German Historical School. This is all-important in understanding Menger’s complex scientific personality and, in particular, making sense of his concern for methodological matters—a concern not found either in Jevons or in Walras.
The results of Menger’s battle on the second front are well known. The German economists virtually ignored the Principles. For about a decade after its publication, Menger remained an isolated thinker. It was not until the 1880s, with the enthusiastic work of Bohm-Bawerk and von Wieser, that a new school formed.
Gustav Schmoller was the most important economist of imperial Germany and a leader of the ‘chair socialists’. As the leader of the Young Historical School, Schmoller was a tenacious opponent of the axiomatic- deductive approach of the classical and neoclassical schools.
His research programme, which Schumpeter has defined as the ‘Schmollerprogramm', overtly proposed to follow the line of that German tradition which, with the Cameralists and subsequently with List and the members of the Old Historical School, had already tried to create the presuppositions for an alternative theoretical approach to economics—alternative both to classical and to neoclassical economics. The principal accusation levelled against all of them was that they did not take into account, in their theoretical formulations, any knowledge of historical facts and material. Schmoller, instead, was a supporter of an interdisciplinary approach which aimed at blending the psychological, sociological, and philosophical aspects of the economic problems. By means of detailed historical research on the formation of the social classes and on the history of the Strasbourg weavers’ guilds, Schmoller tried to show how political economy had to be liberated from ‘false abstractions’ and anchored to solid empirical foundations. In particular, he wished to focus both on the general effects produced by the process of capitalist accumulation on social classes and relationships and on the effects of laissez-faire principles and policies on less wealthy people.Schmoller’s work, however, turned out to be rather lacking on the analytical ground; above all, it failed to reach its author’s main objective: the formulation of a new way of doing economic theory. Schmoller’s influence on the development of economic science in Germany was somewhat harmful, especially because it helped to isolate the German economists from the rest of the world for more than half a century. In fact, economists with different cultural orientations were not allowed to work in any of the German universities. This meant that the works of the new marginalist school were received by the German academic circles with almost complete silence.
This rejection of classical and marginalist theory had an immediate effect at the political level, where all approaches differing from economic historicism were silenced as ‘Manchestertum', that is to say, as orientations favourable both to the absolute liberty of economic initiative and to the progressive reduction of the role of the State.
Schmoller was a fervent supporter of enlightened and despotic sovereigns, especially the Prussian kings, whom he considered to be the only people able to defeat particularism and unify the national economy. Social reforms and distributive justice were central elements in his theoretical work. In all respects, Schmoller could be considered as a conservative in the specific Prussian sense of the term: he rejected Marxism and liberalism, but also the anti-reformist and reactionary positions, and went as far as proposing a strategic alliance between the monarchy and the working classes.
Menger’s reaction to the German Historical School was harsh. The dispute between German and Austrian economists reached its climax in 1883 with the publication of Menger’s Untersuchungen Uber die Methode der Sozialwissenschaften und der politischen Oekonomie insbesondere, which officially opened the bitter Methodenstreit (struggle over method) and brought the new-born Austrian School to the attention of the international scientific community. There were two principal arguments with which the Viennese economist defended himself from Schmoller’s attacks. The first was that ‘pure science’ is always wertfrei, value-free. Economics, if it wishes to be science, must keep itself free of value judgements: ‘The so-called ‘‘ethical orientation’’ of political economy is thus a vague postulate devoid of any deeper meaning in respect both to the theoretical and to the practical problems of the latter, a confusion in thought’ (p. 237). Here Menger anticipated by a few decades the famous argument of the neutrality of economic science which was later to be ‘codified’ in the 1932 Essay by Robbins.
The second argument is that economics can only scientifically deal with the behaviour of individual agents, whether they are consumers or firms. It is not possible to speak, in a scientific way, of economic aggregates. There would be no space in economic science for macroeconomics and concepts such as national interests or collective wealth.
To move from the idea that individual desires are the only criteria of good and bad to the argument that social welfare is promoted and encouraged by policies aiming at maximizing the total amount of pleasure would lead to serious logical and practical difficulties. Menger, unlike Bentham, correctly perceived the technical difficulties of the reformist policies based on utilitarian principles: ‘the greatest welfare for the greatest number’ is not compatible with methodological individualism, that is, with the view that all propositions about the behaviour of the collective agents must be reducible to propositions about the behaviour of their individual components. In this sense, methodological individualism is opposed to holism or methodological organicism (at that time championed by the Historical School), according to which the properties of a system are not reducible to the properties of its elements. Not only the members of the Historical School but also the classical economists and Marx, according to this point of view, were supporters of methodological holism: they believed that it is impossible to understand the operation of the economic system on the grounds of a theory of the behaviour of the single agents.5.4.2. The centrality of the theory of marginal utility in Menger
To understand the terms of Menger’s theoretical battle on the other front, i.e. the critique of classical economics, the intricacies of the theory of marginal utility must be explored. Menger never dealt with questions regarding the nature and measurement of (cardinal) utility. For him the principle of decreasing marginal utility was simply a fact of evidence. His main theoretical problem was: under which conditions can the principle of marginal utility be considered as the foundation of the whole of economics? The answer for Menger must be: under the condition that this principle can be extended from the limited field of exchange to the more complex problems of production and distribution.
In other words, it is not enough to explain how it is possible, beginning from a given quantity of consumer goods, distributed among individuals in a known way, that a set of exchanges is established which maximizes the utility of the subjects and determines the equilibrium prices. In order that the principle of marginal utility can form the basis of a general theory, it is necessary to extend its application to the phenomena of production and distribution. And this is where the difficulties arise.In fact, while demand can be directly linked to its subjective determinant, which is utility, supply poses special problems. Supply is regulated by the costs that must be sustained to produce the various goods; but it seems that costs cannot be reduced to utility. The only way to preserve the symmetry between supply and demand would be to link costs to a certain homogeneous entity which is comparable to utility. Menger’s specific contribution to economics is on this problem, and this is what distinguished him both from Jevons and from Walras.
With his theories of imputation and opportunity cost, Menger resolved costs into utility. His starting point was a classification of goods according to their distance from final consumption: the ‘higher-order goods’, or the ‘factors of production’, derive their utility from the goods of the ‘first order’ (consumer goods) they contribute to produce. This indirect utility can be imputed to each productive factor by taking into account the marginal contribution it makes to the production process. In this way the actual cost sustained to produce a certain good becomes an opportunity cost, namely, the cost represented by the sacrifice of utility of those other goods that could have been obtained from the resources actually used to produce the good in question. The production costs are evaluated no longer in absolute but in relative terms, i.e. in terms of sacrificed alternatives.
In conclusion, the principle of marginal utility was extended by Menger to cover the cost phenomenon and therefore the conditions of supply; so, supply and demand appear to be two aspects of the same problem and can both be explained in terms of utility. But this is not all. Since what is a cost for the firm is an income for the owners of the productive factors, the same principle is capable of explaining both the cost phenomena and the formation and distribution of income. Wages, profits, and rents depend, ultimately, on the demand and the prices of the consumer goods and are therefore determined by utility. In this way the distribution of income ceases to be a separate chapter in economic theory, as it was in the classical approach, and just becomes a section, a part devoid of autonomy, of the chapter dealing with the theory of prices.
While the other versions of marginalism needed about two decades to establish that the theory of value based on marginal utility leads directly to the marginal-productivity theory of distribution, Menger reached this conclusion immediately. In particular, we owe to him the first expression of a proposition which was later to assume a central role in the debate on the neoclassical theory of distribution: if each factor receives the value of its productive contribution, the value of the total production will be perfectly ‘exhausted’ in the remuneration of the factors, and there will be no surplus that somebody can appropriate without having produced it. This was to be known later as the ‘theorem of product exhaustion’. We will discuss it in the next chapter.
One final observation may be useful in understanding the basic difference between the neoclassical and classical theoretical system. Smith considered market exchange as a direct consequence of man’s natural propensity to ‘exchange one thing for another’, and therefore an expression of freedom. Menger, on the other hand, held that exchanges pertain to the order of means. Since economic transactions are costly, individuals will enter into exchange relationships only after they have made calculations and found that the advantages outweigh the disadvantages.