As interest in the Austrian School continues to expand in our day, people are going to increasingly consider the practical relevance of this highly philosophical school of economic thought. After all, for better or for worse, we live in the “practical age.” People are less interested in theory and more interested in “whether it works.” While this can have some destructive ramifications, especially in the world of economics (consider that today’s central bankers are flying by the seat of their pants, with no theory, just trying to repair the machine, so to speak), the question remains: do the tenants of the Austrian School of economics have anything to say about personal investments?
The four authors of this newly translated (from the German) book —Rahim Taghizadegan, Ronald Stoferle, Mark Valek, and Heinz Blasnik— answer in the affirmative. In nine chapters plus an introduction and conclusion, they proceed to give a backdrop of the Austrian School, discuss the proper approach for thinking about the current economic paradigms, and offer their own interpretation of the various investment vehicles.
As the authors point out in Chapter 1, the Austrian School is named such because this approach to thinking came out of the academic setting in Vienna during the latter half of the 19th century.
Namely, it was Professor Carl Menger who, according to the book, brought to the table of economic science four unique pillars: subjectivism, marginalism, individualism, and realism. For someone not familiar with economic theory, we should quickly clarify what these mean in the context of economics:
- Subjectivism: the value of a good or service depends on how the individual thinks that good or service will satisfy his personal goals.
- Marginalism: the important idea that humans make economic valuations “on the margin,” that is, they value units of a good or service, not the good or service in general. For example, when at the store, the consumer isn’t deciding between all the money in the world verses all the eggs in the world; rather, he is deciding between several dollars and a set number of eggs (usually a dozen).
- Methodological Individualism: the idea that only humans act and make decisions. “Societies” or “communities” themselves are not separate entities with their own value scales and ability to act.
- Causal-Realism: the idea that economics is about real life human actions, and theories should not be built upon statistical models. Economics is a science which sought cause-and-effect explanations for real life phenomenons such as prices and interest rates and so on. This, of course, flies in the face of the modern paradigm of economics which is wholly dependent on mathematical models and statistical correlations.
Chapter 2 gives an overview of the difference between the productive gains of Western civilization in the 18th and 19th century on one hand, and the “illusions of prosperity” that have eaten away at those gains during the 20th century (which of course prepares them to offer their concerns over the start of the 21st). Civilizations and economies grow, as the authors point out, by adding to the capital stock of an economy; that is, by deferring immediate consumption and investing in longer term productive efforts. It is the growth of capital that allows economies to expand and for “prosperity to quickly extend to the masses.” And this was the miracle of the 19th century. And yet, here we are, less than 200 years later, facing the consequences of destroying the capital stock and engaging in immediate consumption. This, as the authors will later explain, comes about chiefly as a result of morally and economically destructive banking practices. Today we face the illusions of prosperity: high national and personal debts, easy credit and suppressed interest rates, consumer goods that came about in a context that a true free market would have never allowed. This cannot last forever. So then, how should one protect his wealth?
The first answer to this question, as the authors answer in Chapter 3, is to step back and not get caught up in gospel of the modern prophets of prosperity. The future is uncertain, unknowable, and yet there are those who make their living forecasting the greatness of the economy, the future prices of certain stocks, companies, and sectors. Those who can stand up and sell a certain stock or industry, or who claim they can predict the timing of a trade, or who know where statistical aggregates will be one year from now, are a dime a dozen. And yet, “A study of 6,500 forecasts by ‘economic experts’ shows that they were on average congruent with reality in 48% of the cases. This means: it is safer to flip a coin than to follow the forecasts of an economic expert” (page 65). But the authors also observe that those who view the economy through an “Austrian” lens foresaw the dot com and housing busts, while the central bank’s economists, including Greenspan and Bernanke, expressed confidence in the economy leading right up to their respective crashes. Indeed, it was Austrian economist Ludwig von Mises who in the 1920’s explained why the monetary expansion at the time would eventually lead to disaster. This, compared to the Keynesian and Chicago (such as, famously, Irving Fisher) Schools who considered the boom of the 1920’s as a permanent reality.
Being an economist is not about knowing how to get rich or how to make lots of money. In this way, Austrians explicitly deny to man the knowledge of future prices and the ability to “know” exactly where to put one’s money in order to make a future profit. They criticize prophets of prosperity on TV, who claim to have the solution to making one’s future financial situation sure. Because of this, Austrians recognize that their economic outlook is not a formula to stock picking or short term speculation. The Austrian does not know what tomorrow’s consumer will value anymore than any businessman. For this is not the role of an economist. Rather, it is the role of the entrepreneur to anticipate consumer needs; and entrepreneurs are made up of Austrians and non-Austrians alike. Austrian economics is not a success formula.
Chapter 4 is important for those who have never considered the question “What is Money?” While seemingly highly theoretical and irrelevant to one’s stock portfolio, it is by starting here that one is provided with the foundation to know what, exactly, has gone wrong with the modern economy. This is because, as Austrian theory has shown, the chief economic problems in our day stem from a corruption of money and banking by government control. Money is not capital. It is a claim on capital. It is a medium of exchange that comes about as a result of the need for indirect exchange. Money represents the ability to either consume immediately or to invest in capital goods so that more consumption can take place in the future. It is the falsification of the supply of money in the economy (by various means, depending on the context), that can increase the claims on real world resources and thereby encourage consumption and also destruction of the capital stock. In this chapter, the authors explain what money is, where it came from, and the transition from a market based money to a government (or government-endorsed central bank) provided money. The chapter concludes with an analysis of measuring the money supply, which is vital to an Austrian approach to investing.
Chapter 5 is a very important chapter, as it gives a distinctly Austrian approach to the old and tired debate of inflation versus deflation that has even seeped into Austrian circles themselves. In my estimation, this book presents the situation in a highly convincing way. First, the authors rightly point out that inflation and deflation should be used to express the expansion or contraction of the money supply respectively. Second, the authors criticize the tendency to see the future as either “deflationary” or “inflationary,” preferring instead to characterize the situation as a pendulum that results from the necessary volatility of a collapsing credit system. As the authors present it, rather than seeing “the system” as either inflationary or deflationary, they see two opposing forces in the current trends of financial policy, monetary policy, and commercial bank practices. Whereas the central bank is acting inflationary by expanding its balance sheet and creating new money, the commercial banks are deleveraging and keeping more excess reserves at the Fed. The Fed pursues ZIRP and Quantitative Easing, while the commercial banks are hesitant to lend and there is a high demand to hold onto money. Part of this is fear of a second round of bad loans, and part of this is the various changes in regulatory policy. Thus, the prudent investor must be wary of both of the trends, rather than going all in over “hyperinflation” fears.
Chapter 6 gives an overview of the Austrian Business Cycle Theory (ABCT), which is the Misesian-Hayekian theory of how an expansion of the money supply (primarily in the form of fiduciary media— new loans that are not backed up by the monetary base) leads to low interest rates, which in turn encourages investments into long term projects that otherwise would not have taken place. These projects, being dependent on the easy credit, are not sustainable and the economy must sometime in the future correct back to its pre-boom levels. This painful process is part of the healthy liquidation required to “start over” and rebuild. Unfortunately, in our time, central bankers all around the world are seeking to “heal” the economy by the very means which destroyed it in the first place.
Chapter 7 gives an extended overview of the possible scenarios: another artificial boom (characterized by high and unsustainable “growth” and price increases), stagnation (characterized by low growth and price increases), or recession (characterized by low growth and falling prices), which, again while painful, is a necessary precondition for a return to the normal and healthy market (characterized by higher growth rates and falling prices). Unfortunately, the final scenario is the least likely as central banks are increasing in their power and desire to control the economy. Therefore, a recession is likely to be met with more inflation, rather than with a healthy “hands off” approach.” Coupled with these trends are the possibility of an increase in global centralization efforts and the internationalization of currency and banking. Already the IMF’s “Special Drawing Rights” (a basket of four currencies) are playing a bigger and bigger role in the global economy. What would happen in the case of another global recession? One other trend that needs to be considered is increased financial repression/compulsory levies. Again, it is already being discussed that involuntary “investment” should be required by 401ks in sovereign debt. And the rise of the “MyRA,” which only invests in US government debt is one more sign of this trend.
Chapter 8 is really where an Austrian approach to investing is laid out for the reader. The first step to investing is to understand where investing fits in the context of one’s greater personal plan. Investing should not be a get rich quick scheme. People must begin to understand the morals of saving, the role that profit and debt play in one’s life, and why investing should never be a false front for “gambling.” No person should be putting their money in the markets until their financial houses are in order. This is especially difficult in the era of tax deferred accounts such as IRAs and 401ks, but at least one should recognize the ideal: being debt free and having immediate access liquid reserves for emergencies. Holding physical cash and/or gold/silver is part of the vital “hoarding” aspect of one’s financial plan. It is only after being debt free (ideal) and having a healthy hoard level (the authors recommend one year’s worth of expenses), that one should begin investing.
The investing section is the heart of the book, but space limits my ability to get into detail. Thus, future articles will reflect on the lessons included. The most important line in this section is this: Investing is always an entrepreneurial activity! Investing is always about looking for a discrepancy between value and price, as the authors explain, putting them square in the “Value Investing” tradition of Benjamin Graham. Investing is not about making a quick buck, it is about acquiring ownership of future cash flows.
Finally, in chapter 9, the authors give an overview of how to put together a portfolio in light of our current economic scenario and the various possible trends. They give an overview of the four main categories, the sectors, and the major aspects of one’s financial picture. Future reflections on this section will allow me to get more detailed here.
In the end, the book was a welcome contribution to the practical side of Austrian theory. I am personally hesitant about claims to “practically apply” Austrian economics, because that is not the purpose of economic theory as such. But the authors of this book do well in not using Austrian economics as a blueprint for “knowing” what to invest in, but rather as a way to interpret the reality of banking and governmental trends and the effect that these trends might have on real world resources and capital availability. Central banks and governments have an ingrained ability to confuse the natural way of the market. One must always take that into account; one must always keep in mind that these institutions are active, they participate in the economy and one must balance the consequences of monetary policy with the old adage “don’t fight the Fed.”
I am excited to blog through this volume in the future. But let it be known: it was a fantastic read and much needed volume for our time.