In 1867, the Habsburg Empire was reconstituted, after a defeat against Prussia the year before which meant that Austria gave up her role as leader of the German states. The defeat was a blessing in disguise because now the Habsburgs could turn their attention to necessary internal reforms. They accepted the division of their Empire into two parts, the old domains in Austria and elsewhere in the North and West, often called Cisleithania because the river of Leitha divided them from the rest, and the Kingdom of Hungary, sometimes called Transleithania, which became an independent state under the Habsburgs. In the next half a century the dual monarchy, forming a large free-trade area, enjoyed peace and prosperity and Vienna became one of the greatest cultural centres of Europe, with the second capital, Budapest, also flourishing. One of the most prominent representatives of Austrian science in this golden age was the economist Carl Menger who died exactly one hundred years ago, on 26 February 1921.
Menger revolutionised economics with his marginal analysis. Despite his profound insights, Adam Smith, the father of modern economics, had wrongly believed that the value of goods was determined by their costs of production: If it cost twice the labour to kill a beaver than a dear, then one beaver would exchange for two deer. But there were obvious problems with the labour theory of value. If it was ten times more difficult to catch a rare edible frog than a deer, it did not follow that the frog was ten times more valuable. An old wine was usually more valuable than a new one, whereas new bread was more valuable than old. Mozart and Salieri may have spent equal time on their compositions, but those of Mozart were much more valuable.
What Menger did to explain value was as simple as it was brilliant. He broke a good into units. For a thirsty man, the first cup of water is delicious, but as the number of cups he consumes increases, the value of each of them goes down, to the point when an additional cup does not provide more satisfaction than something else on offer. This is the point where the ‘marginal utility’ of water (as it was later called) will be equal to the price offered for the cup of water in the marketplace, or for something else with the same capacity to satisfy a human need. The marginal utility of a good is the utility of an additional unit, which usually decreases with increased consumption, until demand meets supply at a mutually acceptable price.
This was a Copernican Revolution in economics: Just as it had been discovered that the Earth and other planets revolve around the sun, instead of the sun revolving around the Earth, it was now realised that goods derived their value from the subjective evaluation of consumers at the margin. Man was in the centre, not human products. It was the substitute value, or opportunity cost, of a good which was important, not its production cost. A madman might spend days in constructing a sand castle, but it would be valueless without any buyers.
With his subjective theory of value, Menger was able to refute two political ideas popular in late nineteenth century, Georgism and Marxism. Henry George taught that land was a special good because it had not been produced and was irreproducible. It existed more or less in fixed amount which meant that increased demand for it would simply raise the profit of landowners without them making any effort themselves: this was the notorious ‘unearned increment’ of land. Karl Marx taught that labour was a special good because without it nothing could be produced. Indeed it was labour that created all value, he believed. The capitalists however, Marx added, deprived the labour force of the true value of their contribution by exploiting their own superior bargaining position, forcing their employees to work long hours and seizing the ‘surplus value’ thus created.
Menger showed that these theories of exploitation under capitalism were built on outdated theories of value. Both land and labour were goods which were valued and hence priced in the market according to their marginal utility, not according to their cost of production. There was nothing special about these goods, as goods. What mattered was the value of these goods in the eyes of their consumers.
Menger also pointed out a deficiency in Adam Smith’s conception of the economic process. For Smith, market exchanges took place in space, almost instantly. On their desert island, Robinson Crusoe and Man Friday could exchange pieces of fish and fruit to their mutual benefit on the same day. The Poles sold corn to the Portuguese in exchange for wine in the same month. Menger pointed out, however, that one of the characteristics of a developed market order was that transactions took place not only in space but also in time. People plan and prepare for future exchanges, not least by investing in capital goods which they then use to produce consumer goods. This introduces ignorance and uncertainty as crucial features of the market process, categories that two of Menger’s most distinguished disciples, Ludwig von Mises and Friedrich von Hayek, were trenchantly to analyse. Mises pointed out that would-be socialist planners could not in the absence of market prices for capital goods make relevant calculations and estimates about the future. Hayek explained how the market process was first and foremost a process of acquiring, utilising and transmitting the dispersed knowledge necessary to coordinate human behaviour peacefully and productively.
Although Menger thus made a real and lasting contribution to the science of economics, ranking as one of the greatest economists of all time, his story is sadly also about what was not to be. As Austria’s most distinguished economist, he was appointed tutor to the Austrian-Hungarian Crown Prince, Rudolf, and accompanied him on his travels around Europe (somewhat like Adam Smith accompanied his student, the Duke of Buccleauch, on his travels). Menger’s lectures to the Crown Prince have recently been rediscovered, and they are a lucid and even uncompromising exposition of the case for a free economy, based on private property, free trade, and limited government. But Crown Prince Rudolf was tragically to commit suicide, for reasons that are still not entirely clear, and the reforms begun in 1867 did not continue and fully extend to the many nationalities under Habsburg rule other than the Hungarians. Moreover, when the assassination of the next Crown Prince, Franz Ferdinand, was organised by the Serbian secret service the dual monarchy was not allowed to punish the Serbians accordingly. The United Kingdom foolishly decided to enter a war that the French and the Russians wanted to wage in defence of Serbia against Germany and Austria-Hungary, with disastrous consequences, not least after the United States also needlessly and foolishly decided to enter. It almost meant the end of Western civilisation.
When Menger died in 1921, the old Habsburg Empire lay in ruins. It had certainly not been perfect but what replaced it was much worse, as an unlikely source, Czech writer Milan Kundera, later commented: ‘The Austrian empire had the great opportunity of making Central Europe into a strong, unified state. But the Austrians, alas, were divided between an arrogant Pan-German nationalism and their own Central European mission. They did not succeed in building a federation of equal nations, and their failure has been the misfortune of the whole of Europe. Dissatisfied, the other nations of Central Europe blew apart their empire in 1918, without realizing that, in spite of its inadequacies, it was irreplaceable. After the First World War, Central Europe was therefore transformed into a region of small, weak states, whose vulnerability ensured first Hitler’s conquest and ultimately Stalin’s triumph.’ Menger could not take solace in the later revival of Austrian economics and in the rebirth of what I would call conservative liberalism under Thatcher and Reagan in the last quarter of the twentieth century.
But the most important lesson to be learned from Menger and the Austrian example is: maintain private property, free trade, and limited government, and solve the problem of nationalities by as much devolution as possible. Let the European Union not repeat the mistakes of the Danubian Monarchy. Build a European federation of equal nations, and only present yourself as a strong unified state to the outside (for example to the Russians or the Chinese). Switzerland can act as a strong state outwardly, even if inwardly she is divided up into many semi-autonomous political units.