This post is from Stephan Haller.
Phil was so kind to allow me to write more on economic issues. I try to make the economic theory relevant to Rule#1 investing. The first issue I wanna talk about is Austrian Economics vs. Keynesian Economics.
Lord John Maynard Keynes (1883-1946) was the most influential economist of the 20th Century. Modern representatives of Keynesian Economics are Paul Krugman, Alan Greenspan, Ben Bernanke and a lot of others. His book “The General Theory of Employment, Interest and Money“ was for decades the most influential book on macroeconomics.
The most important issue in Keynesian Economics is fiscal policy. Confronted with the problems of the Great Depression, Keynes saw the under-consumption and sticky wages during a recession as the biggest obstacle on the road out of a depression back to economic growth. In his view, there are several problems which make a recession worse and can lead to a depression:
In order to solve the problems causing a recession and to prevent the economy from falling into a depression, Keynes advises that government fight the recession by lowering interest rates (reducing interest rates to the point where full employment is achieved), lower taxes and provide deficit spending.
“Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better....If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.“ (Quoted from: “The General Theory of Employment, Interest and Money“, Page 128,129)
This sounds weird but a former Federal Reserve Chairman had a similar idea to solve the housing crisis: The government should buy and destroy the surplus houses.
Let’s stop here and ask some important questions:
What makes a society grow wealthier? More goods and services or more money and higher asset prices? Are we really better off if we destroy already existing houses, so that the prices of the remaining houses rise? Is cash for clunkers really such a good idea?
Keynes argues that it is a good idea because he
believed there is a multiplier effect. If
the government spends 10 million dollars on the construction of a bridge, construction
businesses get paid and with the money they pay their workers and buy new
machines. This enables the businesses that build the machines to hire more
workers. The new hired workers spend their money on housing and cars. This is the multiplier effect. In Keynes opinion the economic output added
to the GDP will be quite a lot greater than 10 million dollars invested in the
bridge because of this effect.
Once, in the judgment of the central bank enough stimulus has been applied, according to Keynes, the central bank should then counter inflationary influences by reducing spending, paying back the debt and raising interest rates.
These economic theories have been applied liberally by the US Federal Reserve for the last 80 years with the result that the dollar has lost 95% of its buying power, we have a huge national debt, we seem to go from one asset bubble to the next and today we have high unemployment although interest rates are near zero percent.
To sum up, Keynesian theory says the following:
Keynesian theory is criticized by the Austrian School of Economics, in particular by Mises, Hayek and Rothbard.
Austrian Business Cycle Theory
The ABCT describes why we have continuous booms and busts in the economy. The ABCT was developed by Ludwig van Mises in 1912 in his book “Theory of Money and Credit“ and further elaborated by Murray N. Rothbard and Friedrich August von Hayek, who received a Nobel Prize for economic science in 1974 amongst many other “Austrians” who are still alive such as Hans-Hermann Hoppe, Joerg Guido Huelsmann, Thorsten Polleit, Phillip Bagus, Joseph T. Salerno and Jesús Huerta de Soto.
ABCT disagrees with Keynesian theory. According to ABCT when governments attempt to steer the economy it leads to asset bubbles, devaluation of the currency and boom/bust cycles. When a central bank lowers interest rates, the commercial banks are able to expand the money supply significantly. Lower interest rates artificially stimulate economic activity. In this artificial environment new projects are undertaken that in a normal economy wouldn’t have been profitable. New economic activity increases demand for labor. With the increased demand for labor, wages rise and hence prices increase. This creates a boom. The housing boom is an example of this effect. Because of rising prices and wages, domestic goods lose their competitiveness with the products of foreign nations. This results in a trade deficit.
Another problem is that the economy adapts very fast to the new rate of inflation. Like a heroin addict who needs higher and higher doses to get high, in order to stimulate more growth you need a higher rate of inflation every year. When people soon become aware that there is no reason to expect an end to increasing inflation and increasing prices, they get rid of their fiat money by buying hard goods. This creates real goods inflation and results in rising commodity prices and a decrease in the exchange rate for domestic money.
ABCT says that to prevent a collapse of the currency, the central banks need to step on the brakes by raising interest rates. When the central banks did this in the early 80’s, the 30 Year Treasury Bond yielded about 16%. When interest rates are artificially low, numerous people exercise poor judgment and create mal-investments. Those investments that once appeared profitable due to artificially low interest rates eventually cease to be profitable. Companies cut down their operations or close down. Workers get laid off. Prices collapse. Depression ensues.
ABCT argues that the longer the period of credit expansion lasts and the longer the central banks stick to their policy of low interest rates, the worse the impending crash becomes.
So what should the government do to solve our current problems according to the Austrians?
According to ABCT the government must immediately stop re-flating the economy. This will bring the inflationary boom to an end. The economy can readjust, liquidate mal-investments and reestablish truly desired proportions between investment and consumption. This will be a painful process because prices and wages need to fall and unemployment will rise for some time. But if this painful cure is allowed to take place, it won’t last long and the economy will grow again. If government and the central banks stay out of the game, the growth will be more sound and future recessions will be much shorter and less severe.
How would this business cycle look in an Austrian world?
In a truly free market economy without a central bank and with a 100% gold standard, there is no way for banks to expand credit and lower interest rates without a simultaneous rise in deposits.
Imagine yourself standing at a roulette table in Las Vegas. How much would you risk? All your savings? Your house? Your kids’ college savings fund? Probably not.
Now imagine the same situation with Bernanke and Geithner standing behind you, whispering: “No fear! We back you up. We will cover your losses and bail you out because we can print all the money we want.”
You would take on much more risk.
This is what the commercial banks are supposed to do with the central bank standing behind them.
Without central banks and government interventions the interest rates (the price for money) will adapt to supply and demand. If the savings rate is high (the demand for money is low) interest rates will fall. Entrepreneurs will borrow money in order to invest because the low interest rates give them the signal that money is available.
In this ABCT world we would have slower but healthier growth, fewer and smaller recessions and no inflation (price deflation is more likely because of technological progress).
ABCT argues that our economic problems are not the fault of capitalism and free markets, but the consequence of continuous inflating of the money supply, artificially low interest rates and government market interventions.
In the next lesson I will try to find out what this all means to us as Rule#1 investors and how we can profit from all these economic booms and busts created by the government and the central banks.
-- Stephan Haller
PHIL’S COMMENTS: Thank you, Stephan. In your next post, would you address this question? ABCT says government intervention should create inflation. However, Bernanke argues that he is reflating the economy, pouring billions into a hole created by the trillions of dollars of asset losses in the real estate melt-down and that without doing so, the economy would have gone into a depression. He points to a lack of significant inflation as proof that he hasn’t gone too far. Is he right in this case?