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[This article is excerpted from Mises: Last Knight of Liberalism]

Carl Menger was born in 1840 in the Galician town of Neu-Sandez (today located in Poland). His father was a lawyer from a family of army officers and civil servants; his mother came from a rich Bohemian merchant family that had moved to Galicia. His full name was Carl Menger Edler von Wolfesgrün, but he and his brothers—the influential politician Max and the socialist legal scholar Anton—did not use their title of nobility.

Menger was a fascinating and energetic personality. Intellectually vigorous into his old age, he was a true polymath in his youth. He had studied law and government science first in Prague and then in Vienna. One of his teachers at the University of Vienna was Peter Mischler, a champion of marginalvalue theory, but apparently Menger was not then interested in economics or an academic career. He preferred non-academic writing and in 1863 worked as a journalist for the Lemberger Zeitung. Around 1864, he began preparing for a doctorate in law and government science and passed the first exam in March 1865. Even at this point his new academic commitment was overshadowed by his literary pursuits. When he passed the last of his four doctoral exams, in March 1867, he was in the process of writing several comedies.

His literary interest was more than academic. Menger founded the journal Wiener Tagblatt, which first appeared on November 26, 1865. In an early issue, he began publishing an anonymous novel with the scandalous title Der ewige Jude in Wien (The Eternal Jew in Vienna). In March 1866, he joined the economics staff of another Vienna journal, the Wiener Zeitung. This paper was

a pure government organ, controlled by the Council of Ministers and in particular by the President’s Office of the Ministry of the Interior. The editorial staff was selected by the government, official articles were written in the ministries, and edited and submitted by the Council of Ministers.

Thus Menger became a government employee in a fast-track position that offered prospects to reach the highest strata within the Austrian civil service.

A government position carried great prestige and was highly coveted by the young elites. Competition was fierce even for lesser positions. To succeed one needed Protektion—the friendly ear of someone sufficiently high in the government’s pecking order to influence the nomination. In Menger’s case, the initial Protektion might have come through his brother Max, but Carl quickly learned to stand on his own.

One of his tasks as an officer of the Wiener Zeitung was to write market surveys. As he later told his disciple, Friedrich von Wieser, this was his practical introduction to price theory. He was struck by the discrepancy between the actual pricing process as explained by traders and the standard textbook explanations he had learned at the university. Upon closer inspection, he came to believe that prices ultimately depended on the value judgments of consumers. It was with this thesis that he eventually earned his Habilitation (the traditional central-European university professor’s credential) in government science. In 1871 he published his work under the title Grundsätze der Volkswirtschaftslehre (Principles of Economics).

In his book Menger presented a theoretical study of fundamental economic phenomena such as economic goods, value, exchange, prices, commodities, and money. He explained the properties of these phenomena and the laws to which they are subject at all times and places. This is of course what good economics textbooks always did and still do. What made Menger’s book special is the method he used in his explanations. He tried to trace the causes of the properties and laws under scrutiny back to the simplest facts.

His purpose was to demonstrate that the properties and laws of economic phenomena result from these empirically ascertainable “elements of the human economy” such as individual human needs, individual human knowledge, ownership and acquisition of individual quantities of goods, time, and individual error. Menger’s great achievement in Principles consisted in identifying these elements for analysis and explaining how they cause more-complex market phenomena such as prices. He called this the “empirical method,” emphasizing that it was the same method that worked so well in the natural sciences.

To the present reader, this label might be confusing, since it is not at all the experimental method of the modern empirical sciences. Menger did not use abstract models to posit falsifiable hypotheses that are then tested by experience. Instead, Menger’s was an analytical method that began with the smallest empirical phenomena and proceeded logically from there. This put Menger in a position to consider market exchanges and prices as macro-phenomena and to explain how they are caused by atomistic, but empirically ascertainable “elements of the human economy” situated in an economic microcosm of individual needs and the marginal quantities owned and acquired. In Menger’s words, prices were “by no means the most fundamental feature of the economic phenomenon of exchange,” but “only incidental manifestations of these activities, symptoms of an economic equilibrium between the economies of individuals.”

As later works and correspondence revealed, Menger was fully aware that his most important innovation was the consistent application of the new “empirical method,” which he also called the “exact method,” the “analytical-synthetic” or the “analytical-compositive” method. In a February 1884 letter to Léon Walras, criticizing Walras’s claim that there was a mathematical method of economic research, Menger wrote:

It is rather necessary that we go back to the most simple elements of the mostly very complex phenomena that are here in question—that we thus determine in an analytical manner the ultimate factors that constitute the phenomena, the prices, and that we then accord to these elements the importance that corresponds to their nature, and that, in keeping with this importance, we try to establish the laws according to which the complex phenomena of human interaction result from simple phenomena.

Only in this manner was it possible accurately to describe the essence of economic phenomena, and not just the contingent quantitative relationships in which they might stand with other phenomena at certain times and places. Referring to the disagreements between his theory of prices and the price theory of his French correspondent, Menger argued that real-life experience was the only legitimate way to decide the points under contention. The merit of a theory

always depends on the extent to which it succeeds in determining the true factors (those that correspond to real life) constituting the economic phenomena and the laws according to which the complex phenomena of political economy result from the simple elements.

Menger continues:

A researcher who arrives by the way of analysis at such elements that do not correspond to reality or who, without any true analysis, takes his departure from arbitrary axioms—which is only too often the case with the so-called rational method—falls necessarily into error, even if he makes superior use of mathematics.

Menger's Departure from Classical Economics

The empirical foundation of Menger’s approach contrasted sharply with the Anglo-Saxon approach of that time, which was inspired by David Ricardo’s Principles and relied on fictitious postulates and on such arbitrarily constructed aggregates as price level, capitalists, landowners, and laborers. But Menner’s approach also contrasted with the dominant fashions on the Continent and in particular in Germany, where economists—in the manner of historians—treated observed complex phenomena such as market prices as the starting point for their analysis rather than trying to explain them as resulting from more fundamental factors.

In one stroke, Principles of Economics departed from both paradigms. Menger had found the delicate balance needed to develop economic theory that remained in touch with the real world. The comprehensive architecture of his book also showed that the principle of marginal value, which had played only an obscure role in earlier theories, is of fundamental and all-pervasive importance in economic science.

The core of Menger’s book is the chapter on value, which consumes a quarter of its pages. While financial analysts of Menger’s experience stressed subjective factors in price formation—the personal judgment of consumers, entrepreneurs, traders on the stock exchange, etc.—academic economists relegated these subjective factors to a secondary position beneath supposedly objective factors independent of human perceptions. The British classical economists (Adam Smith and David Ricardo, most notably) had created a thoroughly objectivist price theory that sought to explain the natural or long-run prices of all goods by reference only to the costs of production, particularly the cost of labor. According to this labor theory of value, subjective factors can cause actual market prices to deviate from “correct” prices, but only temporarily and never by enough to outweigh the impact of the objective costs of labor. The value of a product was therefore ultimately one of its inherent qualities, just like weight or volume. It was “in” the good rather than an accidental feature that stemmed “from outside.”

The writings of Smith and Ricardo were overwhelmingly successful in the Anglo-Saxon countries, and had made great inroads on the European continent. The French Revolution had shifted the center of economic research and learning from the Continent to Britain. The Napoleonic era was particularly effective in suppressing the classical-liberal movement on the Continent. Public attention naturally shifted to Adam Smith, the patron saint of the still-vigorous British branch of the movement. Smith became the main authority on economic theory, displacing Quesnay, reducing Turgot to a footnote, and condemning Condillac to oblivion.

But his popularity as the intellectual leader of political liberalism did not help Smith in Germany. German economists were far less receptive to the Smithian message than were their peers in the West. German economists tended to be government employees and abhorred unbecoming political affiliations. Wilhelm Roscher, a great historian of economic thought and one of the leading German economists of the nineteenth century, famously observed that it was:

a national peculiarity of the Germans ... to deviate from the rule of free trade, which has been imported from England and France, through numerous exceptions made for government interventionism.

The German professors read Adam Smith, even read him attentively, but only to dismiss his views as lacking solid foundations. And while they did recognize Smith as an authority in the field, wrongheaded or not, they dismissed Ricardo almost out of hand. Smith’s errors were debatable, but in Ricardo they found no scientific merit whatsoever. This preference for Smith over Ricardo grew stronger over the next century and culminated in the works of the very influential Younger Historical School, which rejected economic “theory” altogether.

In his Principles, Ricardo had invented what today would be called macroeconomics, stressing the relationships between various aggregates such as price levels, average wages, average profits, but also between social aggregates such as laborers, capitalists, and landowners. On the basis of his insights about the relationships between such aggregate variables, he made the case for a far-reaching laissez-faire program. This approach did not meet with enthusiasm among German social scientists. Ever since the French revolutionary army had invaded Germany under the bloody banner of abstract human rights, Germans tended to be suspicious of sweeping political programs derived from theory without basis in observed reality. Under the trauma of the French Revolution, nineteenth-century German historians, jurists, and government scientists tended to stress the particular conditions of concrete human communities, rather than focus on features of an unobservable humanity en masse.

Smith did have an extremely able advocate in Jean-Baptiste Say, who was indefatigable in his efforts to promote British classical economics. Say’s Traité d’économie politique is a masterpiece in its own right, in many ways more sophisticated than the books of Smith and Ricardo. Say gave an axiomatic exposition of Smithian (and possibly even Ricardian) economic science, enhancing enormously the prestige of the Scotsman’s unsystematic Wealth of Nations. He refined the British economists’ focus on whole classes or aggregates of goods, subdividing economic science into a macroeconomic trilogy: production, distribution, and consumption of consumers’ goods in general. Most important, he gave classical economics an appealing epistemological justification, showing it to be rooted in common experience. This empirically oriented methodology made much more sense to Continental scholars and convinced them that there was a scientific case to be made for Ricardian economics and the political program it seemed to entail.

Say was the central figure in the promotion of British economics on the European continent, but he clearly owed a far greater intellectual debt to the scientific tradition of his own country. By the mid-nineteenth century, thanks to the efforts of Say, British economics had become the academic orthodoxy of Europe and America. It was against the background of this orthodoxy that Menger worked on a restatement of the explanation of the pricing process.

Menger's Subjective Theory of Value

In developing his theory of value and prices, Menger relied on the remnants of an ancient price theory from the late-Scholastic School of Salamanca, which in the sixteenth and early seventeenth centuries had stressed precisely those subjective features of the pricing process that were conspicuously absent from the British classical school. But the Spanish late-scholastics never produced a treatise on economics, and their discoveries about the nature of value and prices were scattered across thousands of pages.

The subjectivist theory of value survived only in this diffused form with one important exception: Etienne de Condillac’s great treatise, Commerce and Government. Published in the same year as Smith’s Wealth of Nations (1776), Condillac’s treatment gave the first full axiomatic presentation of political economy on the basis of the subjectivist theory of value. But the impact of his work was minimal because French economists rejected it. Condillac was already a famous philosopher when he published the book, and did not deem it necessary to follow the conventions of the disciples of Quesnay; rather, he presented his thoughts in an independent and original manner—an offense, it turns out, serious enough to prevent the translation of his work into English for more than two hundred years.

Still, Commerce and Government was one of the main sources of inspiration for Menger (who of course read French, among other languages) when he elaborated his economic value theory. Menger pointed out that value can only come into existence once human beings realize that economic goods exist and that each of them has a personal—or, as Menger would say “subjective”—importance.

Most importantly, value always concerns the concrete units of a good, that is, the “marginal” units under consideration, like one cup of water, four loaves of bread, three diamonds, two glasses of milk, etc. It never concerns the total available stock of these goods, except when decisions are actually made about the total stock. This insight is the key to solving an apparent paradox of the subjectivist theory of value, which had prevented a wider acceptance of the theory. If the price of a good really depends on the subjective importance of the good, then how is it that water, which is essential to human survival, commands a far lower price than diamonds, which are much less important than water? This apparent paradox played in favor of the labor theory of value, virtually the only alternative to the subjectivist approach. Whatever the problems of the labor theory of value, it did not contradict reality as strikingly as its subjectivist competitor.

Menger showed that the paradox is only apparent: it vanishes as soon as we stop asking about the value of entire classes of goods, which are economically irrelevant because they are not subject to human decision-making. If we ask instead about the laws that rule the evaluation of individual units of a good, the answer becomes clear. Water is so abundant that it not only serves to satisfy the most important—and thus most highly valued—human need for water, but also far less important needs for water, such as decorative fountains; it is the value of the least important but still satisfied need that determines the economic value of every unit of water, which therefore commands a low market price. By contrast, diamonds are so rare that the available supply can only satisfy the most important needs for them, and as a consequence they are very expensive.

Menger also showed that the value of factors of production is always derived from the value of consumer goods and not the other way around. Contrary to the assertion of cost-of-production theorists, a bottle of wine is not valuable because it has been produced with valuable land and valuable labor; the land and the labor invested in winemaking are valuable in the first place because consumers value the bottle of wine.

Finally, Menger argued that the micro-phenomenon of value exists independent of any social system of the division of labor. Thus he starts analyzing the macro-phenomena of exchange, prices, and money only after his chapter on value.

In the light of Menger’s analysis, the market economy appeared as one great organism geared toward the satisfaction of consumer needs. Not only the market prices, but also the institutions of the market such as money are part and parcel of a rational order that can exist and operate without needing the assistance of political authorities.

In a way, Menger delivered a complement to Condillac’s thesis that human needs are the great regulator of all human institutions. Condillac had made his case from an economic and, most famously, from an epistemological point of view, arguing that perceptions are determined by needs. He lacked the important element of marginalism, however, and it was on this that Menger built a complete and thorough revision of economic science.