Using Austrian Business Cycle Theory to Invest in the Current Depression

I know I've talked about Austrian business cycle quite a bit in my blog posts, but I wanted to make a post that provides a clearer introduction to it and its logic. So here goes.

Austrian economics and Austrian business cycle theory have regained a bit of popularity of late, given the recent turmoil in the financial markets. Understanding Austrian business cycle theory can help us understand where things are headed, so that we can invest accordingly.

What it is: Austrian business cycle theory basically posits that bubbles and busts result primarily from an overexpansion of credit. Credit is too cheap and too easy. Entrepreneurs are trained in finding market opportunities and inefficiencies in the market; and thus, the Austrian business cycle posits, entrepreneurs as a whole can only be collectively mislead for a sustained period if credit is excessively expanded. This will cause entrepreneurs to excessively invest in capital-intensive projects, like building houses.

The result: The result of this excessive expansion is that the market will eventually try to deflate and purge the misguided investments out of the market. This will result in deflation.

What government policy should be: According to Austrian business cycle theory, deflation is good, and government policy should be to embrace it -- not avoid it. Deflation will encourage "hoarding of cash," which is perhaps more accurately referred to as savings. These savings will then form the basis for the economy to heal itself and become strong again.

What happens if government intervenes: If government intervenes to prevent deflation, one of two things will happen: deflation will be prolonged and deepened, as we see in Japan; alternatively, if government goes into greater debt while its tax base diminishes, it runs the risk of being unable to find borrowers, at which point faith in the currency is lost and a run on the currency begins -- meaning everyone looks to sell the currency, causing its value to fall and prices to rise, as we saw in Argentina in 2001 and 2002.

Which brings us to where we are today.

So the key question: how much deflation? To answer that question, consider the chart below:

Note the uptrend that begins in 1995; this is the beginning of the tech bubble, which was brought about by excessive credit expansion under Greenspan's Fed. The market tried to deflate -- this was the "dot com apocalypse" from 2001-2003 -- but the Fed lowered rates again, preventing a full deflation, and instead pushing the bubble into the housing market. A full deflation would then push S&P back to the 1995 level of around 400. Alternatively, a run on the US dollar may cause the nominal price of stocks to rise, but it will fall respective to other currencies. A way to gauge whether the stock market is truly rising in value or if it is just a nominal gain resulting from currency weakness is to compare percentage gains in stocks to gains in gold. If stocks are rising faster than gold, it could be a sign of real growth.

According to Austrian business cycle theory, if money supply was not excesively expanded but was kept at appropriate levels, there would be no real bubbles or busts. This may make the stock market less fun. Conversely, it would lead to greater focus on profitability rather than financial ratios, and a corresponding focus on dividends rather than valuations.

Discuss This On InformedTrades

Milton Friedman, John Keynes, and Other Foes of Sound Money

Given that debates on how to fix the financial crisis have become the conversation du jour, now seems like an appropriate time to re-visit various monetary theories to see what works. So here goes:

Keynesian. John Maynard Keynes is the father of contemporary macroeconomics. I would consider this to be a rather negative claim, given that Keynesian policies are at the heart of our current crisis. According to Keynes, deficit spending is not a problem, and the government should use it when necessary to stimulate the economy. Traditional Keynesian economists are not concerned with price inflation, because they argue that prices will not rise above aggregate demand (i.e. prices will not rise above what people are willing to pay for them). Stagflation is precisely the term for the scenario in which prices begin to rise beyond aggregate demand; witness Zimbabwe, and to a lesser extent, the United States in the late '70s and in 2007.

Regrettably, we still see Keynesian solutions being offered to Keynesian problems. US President-elect Barack Obama has stated that deficit spending should not be feared, and needs to be embraced in the short-term to boost the economy.

Friedmanites. Milton Friedman is not too different from Keynes; the only real difference the most significant difference is that Friedman advocates legislative bodies like Congress regulate the money supply via an agreed upon formula, rather than an independent central bank unbound by formulas. The assumption implicit in this school of economics, though, is that a proper formula can be devised, and that a political body can manage it appropriately without the threat of overwhelming corruption.

Supply-siders. Led by Arthur Laffer and Charles Kadlec, supply-siders argue for watching commodity prices, and then tinkering with the money supply to keep commodity prices stable. In a way, this is similar to the policies championed by Paul Volcker, Federal Reserve chairman during the late '70s. Gold prices were rising dramatically, and Volcker raised interest rates to effectively contract the money supply, strengthen the US dollar, and bring gold prices back down.

Austrians. The Austrian school of economics calls for commodity-backed money. This means that government's job is simply to ensure that each currency certificate can be redeemed for a specific commodity -- typically a precious metal like gold or silver -- and that it is government's role to define the terms of convertibility. The money supply is thus determined by the availability of a commodity. Should the market need to expand the money supply, demand for commodity production will grow. Thus the money supply is regulated by market forces.

What Type of Monetary Policy Can We Expect -- And How to Trade It

I am a strong proponent of the Austrian school of economics, and believe it will result in the most sound monetary system, upon which free market capitalism can best survive and flourish. Though the Fed is pushing interest rates to zero, should the US dollar give back the gains it made in 2008 and should the US government have difficulty finding buyers of its debt at such low rates in a globally weak economy, the result may be the need to raise interest rates sharply, thus bringing about a return to supply-side ideas and Volcker's policies in the '70s (we talked about this previously in our article on bond prices). This would be a bearish argument for gold -- just as we saw gold fall in price after Volcker's Fed raised rates.

Ultimately, though, I think Keynesianism is still the dominant ideology. The ideal result of this would be prolonged deflation, as seen in Japan, though as I've stated before, my larger concern is that this will result in sharp currency devaluation, as seen in Argentina.

Trade accordingly!