Not for nothing is economics known as the dismal science. Having failed to foresee the global bubbles in credit, banking and housing, mainstream economists have compounded the problem by advocating entirely the wrong solutions. Like generals fighting the last war, most economists (and leftists who think they understand economics) continue to bang the drum of Keynesian stimulus, evidently un-able or unwilling to understand that countries, like their citizens, cannot borrow their way out of debt. Cue the world’s largest ever sovereign-debt crisis.
But not every economist got it lament-ably wrong. A number of financial thinkers anticipated both the bubble and the crash. Though few of them actually hail from Austria these days, they are known in financial circles as the Austrian school. Institutional investor Kevin Duffy is representative of this small group that foresaw problems ahead for the credit markets. Note, for example, the title of his 2005 essay, Panic Now and Beat the Rush.
The original (and authentic) Austrians were Ludwig von Mises and Friedrich von Hayek. Mises single-handedly demolished the case for socialism in ‘an economic and sociological analysis’ published as long ago as 1922; Hayek, whose The Road to Serfdom of 1944 did a similar job, influenced the free-market philosophies of both Margaret Thatcher and Ronald Reagan. As Mises and Hayek both explained, socialism can never work because sooner or later governments run out of our money.
At the risk of oversimplification, Austrians have three core beliefs: in the rights of the individual and the primacy of a free market; in small government as opposed to over-mighty bureaucracy; and in sound money as opposed to easy credit and essentially fraudulent money production courtesy of central banks. The Austrians hate central banks, in fact, and for good reason. The Austrian respect for sound money would prohibit any government agency from creating money out of thin air, the sort of state-sanctioned inflationism in which the US and UK economies have recently been drowning. US presidential candidate Ron Paul, perhaps the only Austrian in the race for the White House, makes no secret of his disdain for the Federal Reserve, the US central bank, as the title of his book End the Fed (2009) pithily indicates. The Fed is not even a branch of government, but a private banking cabal — which might explain why Wall Street has been such a beneficiary of Fed policy even as Main Street goes under.
Not many people know this, but traditional economics was born out of physics envy. Frenchman Léon Walras, who was rejected, twice, from the prestigious École Polytechnique due to poor mathematical skills and afterwards failed both as an engineer and as a novelist, finally decided to devote himself in 1858 to the then new school of economic science. At the time, physicists were getting all the glory. Walras concluded that if equations and calculus could capture the motion of planets and atoms, they could do the same for financial interactions. Unfortunately for the rest of us, Walras was an idiot. The economy cannot be reduced to a bunch of equations, because the economy is us. Or as P.J. O’Rourke put it, economics is an entire scientific discipline of not knowing what you’re talking about.
But the Austrian school is different. Mises’ seminal economic thesis, first published in 1949, was titled Human Action. Austrians understand that the economy is not driven by a super-rational Homo economicus but by human beings with all their faults and frailties. Where most economists are dogmatic, Austrians are pragmatic. Austrians venerate the entrepreneur, but acknowledge that he is prone to mistakes (or ‘malinvestments’) — especially when the price of money, in the form of interest rates, is directed by central banks as opposed to the free market. In Austrian theory, a boom triggered by easy money and too much credit is followed by an inevitable bust.
This is where Keynesians and Austrians diverge spectacularly. The followers of Keynes would throw money at the bust, just as our own authorities have done, even when those governments are grotesquely overdrawn. Austrians, on the other hand, would simply stand back and let a free market sort out the winners from the losers. Austrians would contend that monetary stimulus merely perpetuates the recession rather than alleviating it.
The problem with the Austrian school is that whenever the faecal matter meets the oscillating ventilation device, as is now the case throughout the economies of the west, Austrians do not simply scurry off in the direction of political expediency. Mises himself was no slouch when it came to stating hard truths: ‘The credit expansion boom is built on the sands of banknotes and deposits. It must collapse. If the credit expansion is not stopped in time, the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system founders. Continuous inflation (credit expansion) must finally end in the crack-up boom and the complete breakdown of the currency system.’
Complete breakdown of the currency system sounds about right. The mood music of the markets ever since the financial crisis began in 2007 has been a one-note chorus of cans being kicked further down roads. Whether in the context of US, eurozone or UK sovereign indebtedness, reality must at some point be faced. Mises darkly warned that there is no escape from the final collapse of a boom brought about by the issuance of too much debt. ‘The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved.’
But the Austrian school is not entirely a counsel of despair. It is still likely to believe in making some allocations to productive capital in the form of high-class equities. And just as Austrian economists were the first to identify the credit bubble, they were also among the first to seek shelter in the form of gold — a currency that comes from the marketplace, and not from politicians.
Tim Price is director of investment at PFP Wealth Management.