Invisible Hand or Iron Fist

The Gist: How the ideas of free market capitalism triumphed over Marx and might still over Keynes.

A review of Vienna & Chicago by Mark Skousen.


If you desire limited government, there are a couple of things you need to get right first. 

Acme Time Machine

Figure 1. Time travel and/or a well-regulated militia ready to tar and feather select politicians.


The first prerequisite of limited government is the law, and in particular, a governing constitution. Why is kind of obvious: if you actually enforce the rules that say the government can only do a finite number of things, you’re already there. The trick is setting up institutions that will see that project through. The second is the most important, least familiar topic in American politics: sound money. Here, the relationship to limited government might not be immediately clear – but so long as government can unilaterally determine the value of its debts (i.e. the value of the dollar), it has a lot of flexibility around its supposed limits.


Figure 2. Pro tip from governments and little kids when they discover they’re losing a game: next time you arrange a mortgage with a bank, surreptitiously add a clause to the contract that indicates that all payments are to be made in your very own currency. Whatever the interest rate, print off whatever denomination of your own portrait you’d like!


We have a long ways to go on restoring the original meaning of the Constitution, but we’ve at least spent decades trying to build a farm team of potential jurists with the right mindset while winning over the public to the need for them. Nominees to the Supreme Court attract mass attention and intense scrutiny to match their importance. Nominees to the Federal Reserve, on the other hand, barely get a notice beyond the financial pages of dying newspapers. Can you name any currently serving governors, beyond the chairman? That kind of quiet would be fine if we were getting what we wanted but, until we do, money is too serious a matter to be left to the central bankers.

But what is a “conservative” view of money and what should we want? At a very high level, conservatives have tended to be skeptical of both inflation and intervention, which in the last few centuries typically means limiting the discretion (or existence) of central bankers. Because unrestrained central banks empower further already powerful interests – the government and banking industry – conservatives have always fought an uphill battle. (Not to mention that bankers often support much of the rest of a conservative financial agenda, so they’re thought to be friends). But conservatives have also faced a significant challenge in that they’ve never been able to agree on exactly how to limit central bank discretion. In 1962, a collection of essays was released by a number of prominent free market oriented economists, including future Nobel prize winners, called In Search of a Monetary Constitution – and their smart proposals were all over the map, often contradicting each other. 

I want to dig into the potential solutions to this problem in another email, but to really understand them, you have to be familiar with two schools of economic thought associated with the right, how they came into being, and why and where they disagree with each other. What follows is primarily a review of Mark Skousen’s Vienna & Chicago: Friends or Foes?, describing the histories of the Austrian and Chicago schools of economics. 

For several centuries, there was a general “mercantilist” understanding that there was only so much gold and silver and worthwhile objects in the world and so national economic policy was about trying to get and keep as much of that value as possible. Loath to give away precious metals to potential rivals, royals aggressively taxed and restricted international trade, instead preferring to pursue self-reliance, initially to the microscopic point of individual agricultural manors, eventually at a national level that spurred global colonialism. At one time or another, there were substantial debates about the morality of lending at any interest rate (even the morality of freely-set prices) or about the value of private versus public property. Royals were often keen to deal with convenient, cooperative, taxable economic actors like guilds or monopolies. Mercantilism’s virtue was that it embraced savings (but only because they didn’t want any gold to leave the country). Economics was understood to have very clear winners and losers, especially internationally, and every state naturally wanted to be a winner.


Figure 3. Among the most famous mercantilist economists is Smeagol, known for putting the precious in precious metals.


1776 saw the popularization of a different model. The year may not point to what you think. Though America was founded by free trade radicals, what started to alter government officials’ perception of how much they should intervene was a book: the Wealth of Nations by the Scottish philosopher Adam Smith. Smith famously argued that the path to national (and personal) riches did not come through careful management by government officials but instead from allowing people to be free to pursue their own interests through which they might be guided, as if by an invisible hand, to efficient ends for society at large. “It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” Smith advocated for low and simplified taxes, open business competition free of subsidy, “free trade, limited government, balanced budgets, the gold standard, and laissez faire; in short, maximum economic freedom.” Smith’s views would generally be adopted by the British government, spurring the industrial revolution and massive wealth creation (as well as imitation around the world). Remarkably, there even emerged a powerful political lobby for the freest market possible that only began to fray as Britain faced trouble paying for its new promises of welfare.

But tangential to Smith’s variety of good points, he also advanced a theory that the value of anything came from the labor that went into it. You yourself only have so many hours in a day to do your own job, to raise cattle and butcher and prepare it to eat, to grow cotton and fashion it into clothing, etc. With wealth, however, you could pay for others to do this for you – i.e. their labor. “The real price of everything, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it,” Smith claimed. 

Within a few decades, free market economics faced its most serious theoretical challenge: Communism. Earlier than you might think, in fact: the infamous Manifesto was published in 1848. Karl Marx built his critique of capitalism on the foundation of this labor theory of value – clearly the rich were exploiting the poor! People were contributing their labor without capturing all of the profit! Marx seized on a flaw in Smith’s analysis and came to radically different conclusions as a result: “While Adam Smith views the commercial world as harmonious, progressive, and socially stabilizing, Karl Marx sees capitalism as brutally exploitative, alienating, poverty-stricken, and crisis-prone.” There was no invisible hand of the free market – just an iron fist wielded by greedy capitalists. In essence, Marx insisted, laborers were slaves. Proclaiming that he had discovered scientific laws of economics, Marx promised a better system – if only workers of the world would unite and seize control of the means of production. Then a workers’ paradise might emerge, where resources might be extracted and distributed “from each according to his ability, to each according to his need.” This perspective proved more popular than was beneficial for those who would live under it.

The Austrian School of economics emerged to defend capitalism in its first great crisis of credibility. Carl Menger, an economist literally from Austria, argued that the whole labor theory of value is wrong. Products and services are not valued on the basis of how much work is put into them – they’re valued differently and subjectively by every consumer. In particular, if you’re hungry, that first bowl of ice cream looks delicious and you will readily pay handsomely for it. But the 11th bowl of ice cream may require the exact same amount of labor to produce but you may be willing to pay NOT to eat it. Or as Menger himself noted, if people stopped smoking tobacco, the tobacco would lose value in the marketplace even though the amount of labor that went in didn’t change at all. “He noted that farm land used to grow tobacco doesn’t fall to zero, but is valued according to its next best, or marginal, use, such as growing wheat or raising cattle.”  This “marginal revolution” pioneered concepts like marginal utility and opportunity cost.


Figure 4. If you’ve ever been puzzled by your grandmother devoting substantial resources and countless hours to collecting obscure knick knacks or by your grandson devoting substantial resources and countless hours to following an offensive musical genre easily confused with totally random very loud noises, then you’ve discovered the subjective theory of value. 


But the Austrians didn’t stop at correcting Smith’s error. They proceeded to demolish the whole Marxist framework. Another literally Austrian economist, Eugen von Bohm-Bawerk, argued that the Marxist theory of exploitation ignored the plain fact that capitalists were efficiently contributing capital to projects that would otherwise not exist. In particular, a capitalist was willing to forgo the use of his money in the short term to pay a construction crew to build a factory and workers to manufacture products in the hopes that he’d eventually get paid back (and hopefully more), thus bearing a risk that the presently-compensated workers do not. In the Marxist model, should workers forgo wages, possibly for years as initial costs are paid off, until and unless the profits come in? To ensure that every worker captures the full value of his labor according to Marx, how should any profits be split between the workers who built the factory, the workers who supplied the raw materials, the workers who manufactured the end product, all the other workers who somehow contributed to the outcome? True slave labor would emerge in self-titled Marxist economies where workers did not have much choice about how to deploy their efforts; by contrast, in a free market, workers could offer their labor to the highest bidder, before their work even produces profit to pay for it. Free to contract, both worker and employer benefit – otherwise, they wouldn’t make the deal. Skousen argues that this “critique of Marx’s exploitation theory is considered so devastating that Marxian economics never really took hold of the economics profession as it did in other fields. He demonstrated that entrepreneur/capitalists deserve the fruits of their labor because they take greater risks than workers fulfilling a vital creative use in the market system.”

As if that was not thorough enough, another literally Austrian economist, Ludwig Mises, took on the reality of centrally planned economies as they came into existence. Marx never got a hold of the national means of production himself, but he inspired others who did. Setting aside their tendencies toward mass murder, their practical application of Marxist ideas involved a small number of central planners replacing the spontaneous agreements of consumers and capitalists as deciders of how to distribute resources. Mises pointed out that, in a complex national economy, this was not only extremely difficult but actually impossible to do well -“without prices and competitive bidding, a centrally planned totalitarian state could not operate an efficient, progressive economy.” Real, unsubsidized, unregulated prices instantly demonstrate to everyone the economic value of a product or service. As F.A. Hayek expanded on how this works in a capitalist system, 

Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose—and it is very significant that it does not matter—which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. 

In contrast, a central planner must decide how much resources to devote to mining tin and how to disperse the tin across the entire economy – but how would they know how valuable tin is to users without knowing what they’d pay for it? Or, as Mises simply asked: how does a central planner know whether to build a bridge? If it should be built, where along the river? With what materials? How does he weigh the opportunity cost of countless alternatives? How will he be held accountable for the decision? The far better solution was to empower capitalists to put their capital at risk when prices signalled that a profit could be made. Or, to paraphrase Winston Churchill, socialists criticize profits but the absence of profits is far worse. 

All of these arguments helped restore laissez-faire to a position of preeminence in the late 19th and early 20th centuries, at least among economists, and certainly versus Communism. In practice, British and American politicians were more or less pursuing the right path, but were also pursuing fresh socialist schemes, central banks, tariffs, antitrust, and any number of economic interventions that Austrians found anathema.

But in addition to savaging Marx and salvaging Smith, the Austrians were promulgating new ideas about economics, including a theory of the business cycle, wherein the drunken hazes of booms are followed by the correctional hangovers of busts. In the Austrian view, the booms were fueled by over-aggressive bankers (later, central bankers) who lent out too much money at rates that fooled consumers into overspending and capitalists into malinvestments. When money is cheap to acquire, everyone is tempted by (marginal!) buys that wouldn’t normally make sense. Busts were the inevitable outcome where people realized their mistakes.


Figure 5. When money is cheap (and you’re drunk), suddenly the numbers on that real estate deal upgrading alligator-infested swampland start to look real promising.


Throughout the roaring 1920s, Mises and Hayek were predicting that a big crash was coming – a fairly easy prediction, given the theory, and why Austrians are known for predicting 8 of the last 2 recessions. When the crash did come in 1929, Austrians were suddenly the belles of the ball – everyone wanted to know what the economists who called the crisis recommended what to do next. But the response of the Austrians did not satisfy their listeners: Don’t just do something, stand there! The Austrians insisted that the bust would work out the problems of the boom – and if the bust was especially severe, it was because the boom was especially irresponsible. Austrians warned that government intervention would actually make the economy less stable because you would be sending the wrong signals, again, to capitalists about the desirability and safety of possible investments. Instead, the harsh medicine of the Austrians was to let the pain happen: every unemployed person would be willing to work for less and less over time and capitalists would eventually look at the bargain offered by labor and rebuild the economy on a firmer foundation. Relatedly, all in accordance with supply and demand, any product already produced would eventually drop in price to become consumed. Creative destruction would replace old, inefficient firms with new, spry ones.

This was not what government officials wanted to hear. “In the United States, industrial output fell by 30 percent and nearly a third of the commercial banks failed. The unemployment rate soared to 25 percent. Stocks lost nearly 90 percent of their value. Europe and the rest of the world faced a similar fate.” Capitalism faced its second major crisis of credibility. Unable to withstand the pain, many governments turned to John Maynard Keynes to try to “fix” rather than fully replace capitalism. “Keynes’s principal thesis is that financial capitalism is inherently unstable and therefore inescapably flawed” – a free market economy could not always guarantee full employment, for example. Keynes offered the flattering and enabling solution that brilliant government officials only needed to tinker with the economy – at its most basic, in rough times, government should borrow against the future and stimulate by spreading money around (perhaps the money would be used frequently, thus you’d be getting a multiplier of the effect!) When the crisis was past, when prosperity returned, governments could raise taxes and reduce spending, paying off the debt. (Except somehow otherwise dedicated Keynesians mostly forget about cutting spending in the good times).


Figure 6. The motto of the Austrian Gym is “No pain, no gain”. No trainers, of course: you just hit the machines and build those muscles. Result: Arnold Schwarzenegger. The motto of the Keynesian Gym is “No judgment.” There are no trainers, either, just “Buddies” assigned to encourage you between opulent snacks at the in-house ice cream bar whenever you’re tired. Result: Chris Farley.


But that wasn’t all. Austrians insisted that people needed to be free to save their money because saving itself represented a valuable signal as to whether profit opportunities were worthwhile. Keynes instead called this the paradox of thrift: saving might be nice for an individual but, according to Keynes, was bad for the economy at large because money was on the sidelines during a crisis. Furthermore, Keynes charged, the wealthy were disproportionate savers and so must be induced through progressive taxation and estate taxes and whatever other penalties can be politically applied to get them to go out and spend. As a result of Keynes winning this argument, America has built nearly a century of policy on the very successful attempt to get our citizens to consume – never mind the Austrian insights about saving for the right opportunity or “that an increase in consumer spending is the effect, not the cause, of prosperity”; never mind the general benefits of saving for a rainy day; never mind practically no one puts their money under their mattress, so money in a bank means loans to others are cheaper.

conjunction junction

Figure 7. Consumption function, what’s your injunction? 


Austrians dismissed Keynes as a passing fad – and were stunned that not only governments but that the economics profession embraced his theories wholly and at length. Though the pioneering earlier work of Austrian economists on marginal utility, opportunity cost, price signals, and other concepts were integrated into mainstream economics, Austrians’ continued belief in the true freedom of markets amidst and after the Great Depression invited – pun intended – marginalization. The Austrians made occasional headway in popular books – in very likely the last time that a political movement attempted to win power by distributing a book, Britain’s Conservative Party sent out thousands of copies of F.A. Hayek’s Road to Serfdom in a fruitless attempt to persuade voters to return to the free market – but they were otherwise on the outs for decades as Keynes reigned supreme.

But in the years after World War II, some questions about Keynesian economics started to come from scholars at the University of Chicago. Whereas the Austrians had tried to engage Keynes on the abstract level of theory, Milton Friedman started to run the numbers on Keynesian formulas, predictions, and theories and discovered… they didn’t actually work. The supposed multiplier of government spending during a recession may not even add. Whether the government taxes or sells debt, it has to take money from somewhere else. Friedman and Chicago School colleagues further unraveled data that demonstrated that consumers did not act like Keynes predicted, specifically that they could not be so easily induced to spend their own money with a temporary prod from the government. “Friedman, a scholar intimately familiar with the Keynesian language, apparatus and policy implications, used Keynes’s own language and apparatus to prove him wrong on every count.”

Furthermore, whereas Keynes had made government fiscal policy (how much the government spends) the center of his attention, Friedman came to realize that far more important, perhaps the only important thing, was actually monetary policy (how much the dollar is worth). Friedman revived an old theory originating with, of all people, the astronomer Copernicus: money acted according to the same principles of supply and demand as any other product, thus the value of the dollar can be influenced by how many dollars are in circulation. Friedman concluded that the Federal Reserve is generally quite bad at managing their work, partially because they don’t actively manage the money supply but instead try to manage the interest rate at which money is lent, too often excessively favorably to the government; partially because supposedly nimble discretion involves lags between a problem like unemployment arising, central bankers discovering and interpreting the problem through statistic collection, and central bankers finally conjuring and applying unpredictable, bespoke, and heavy-handed responses.


Figure 8. Both embracing truth attacked as heresy, Friedman fared better than Copernicus’ other disciple Galileo. But then, the Fed doesn’t yet have the power of house arrest. Wait for the next crisis, though.


Initially, in the prosperous 1950s and 1960s, Friedman’s work consisted of an extremely well-researched historical argument, especially famous for recasting the reasons for the Great Depression (the severity of which he blamed on the central bank bungling the money supply). But soon the argument became very real. After Keynes’ death, the next generation of his followers had come to believe that there was a fundamental relationship between inflation and employment – and that the trick of the bureaucrats was to have full employment with manageable inflation. But in the 1970s, something impossible seemed to occur: high inflation and unemployment happened simultaneously! Keynesians grasped for solutions (wage and price controls?) but lost serious credibility as “stag-flation” continued unabated. Chicago’s thoroughly backed research revived the credibility of laissez-faire economics. Eventually, the Fed (and the British equivalent), having exhausted Keynesian suggestions, under the threat of the Austrian recommendation to return to the gold standard, managed the money supply for long enough to bring inflation under control. But, significantly, Chicago did not fully win the debate: whereas Milton Friedman ideally wanted the Fed replaced with a computer that would automatically grow the money supply by a small amount, he otherwise suggested that the Fed be constrained by rules they must follow. Though Chicago remains deeply influential to the Fed (which did not start publishing estimates of the money supply until Friedman estimated and published them himself), it operates under no especially binding rules.

Great lakes

Figure 9. Because the University of Chicago is proximate to the Great Lakes and its Keynesian rivals tended to be based at universities near the coasts, the debate was amusingly referred to as a battle between “freshwater” economists and “saltwater” economists. In case you didn’t realize, drinking saltwater is hazardous to your health (and wealth).


While Friedman was a giant of the Chicago school and the primary debunker of the Keynesian challenge to laissez-faire, the Chicago School also diligently and numerically advanced the principles of free market economics across a wide range of disciplines, prompting them to win a cornucopia of Nobel Prizes for work on transaction costs, regulatory capture, law and economics, public choice, the efficiency of the stock market and more. Chicago’s work may not yet have cut government, but it has certainly made lots of government programs less credible. As Friedman argued, “One of the great mistakes is to judge policies and programs by their intentions rather than their results.” To describe their role in the battle of ideas, George Will once quipped, “The cold war is over and the University of Chicago has won.” 

Today, our economic battles are often impenetrable debates between math nerds in the Chicago School or Keynesian persuasion, the latter freshly ascendant after the 2008 financial crisis shook faith in the capital system (never mind the massive government involvement in housing). Keynes can never quite be killed off because he is Santa Claus to politicians (except that he rewards the especially naughty ones). But the Austrian way of thinking never went away – the Austrians are not merely Chicago’s predecessors. The two schools have important, notable disagreements that we shall explore in our next correspondence.

vienna chicago

Figure 10. Click here to acquire Mark Skousen’s Vienna & Chicago, a good overview and introduction to its subject matter. If you have not already, check out the entertaining and insightful rap battles between Marx and Mises, Keynes and Hayek.

Free to choose

Figure 11. Click here to acquire Milton Friedman’s Free To Choose (also a miniseries well-worth watching), a powerful introduction to Chicago by its most famous member. Click here to acquire Howard Baetjer’s Free Our Markets, a modern introduction to the Austrian way of thinking.

Red plenty

Figure 12. Click here to acquire Francis Spufford’s Red Plenty, a revealing exploration of Soviet central planners trying their best to work without prices. (Spoiler: It doesn’t work.)

Thanks for reading!  If you enjoyed this review, please sign up for my email in the box below and forward it to a friend: know anyone interested in economics or history? How about someone who wants limited government? Or do you know anyone who ever uses money to pay for things?

I read over 100 non-fiction books a year (history, business, self-management) and share a review (and terrible cartoons) every couple weeks with my friends. Really, it’s all about how to be a better American and how America can be better. Look forward to having you on board!

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