John Dizard: Vindication of Austrian economists and their theories

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Now that most people are back from their summer break, it is time to set the investment theme, or themes, for the autumn.

There is the spectre of an American war with Iran but that won’t happen for a while.

The investment theme of the autumn will instead be the vindication of the Austrian economists and their theories about the nature of the business cycle.

At this point, even most well-informed financial people will say “What? Austrian what?” After giving the matter a little thought, though, it will turn out that many will find they have been Austrians all along, though they didn’t realise it.

There are many aspects to, and conflicts within, the Austrian school of economics, much of which is based on the work of Ludwig Van Mises and Frederick Hayek in the middle part of the past century.

While based on earlier theorists, the Austrians – not all of whom were Austrian – were reacting to the whole range of state-directed macroeconomics, from communism and fascism to social democracy and Keynesianism. They believed that state planning not only got the economics wrong but led to political and intellectual servitude.

The aspect of Austrian economics that will be central to investment decision-making this autumn is the role of central banking in generating unsustainable investment booms and subsequent busts.

The biggest world investment boom in history, which we have been going through for the past decade, is becoming a bust, most notably in the US housing market.

If the founding Austrians had Marxists and Keynesians as their opposition theorists, the present-day Austrians have Alan Greenspan and Ben Bernanke and their enablers in the US political system.

While the profit motive is central to the Austrian economic model, what really motivates the practitioners is the prospect of being able to say “I told you so”, which is much more satisfying than merely getting rich.

What they have been telling the so-far uninterested public is that the Federal Reserve has been keeping interest rates below the “natural rate”, or what an unconstrained set
of lenders would be able to charge borrowers, given what the borrowers could earn on the new capital.

The Fed, with the encouragement and support of the political class, kept rates low so as continually to postpone financial busts over the past decade and a half.

This has led to over-investment, from the technology bubble to the housing bubble, with one bubble obligingly taking over from the previous bubble. Now there are no bubbles left to blow.

The term the “Austrians” use for this sort of policy mistake is “intertemporal misallocation”. That means that the only way growth has been maintained as high as it has as long as it has is by borrowing it from the future, so to speak. Well, the future is now.

Bernard Connolly, the global strategist for Banque AIG, has been making the case that we face intertemporal misallocation for years but, unlike other Austrians, he takes no pleasure in the prospect of being proved right. He says: “The time has come – too late – for the Fed to recognise that intertemporal misallocation has been at the root
of all US economic problems. The difficult question is whether acting
on that recognition would in fact be better late than never.”

What central bankers do, apart from fly around to a lot of meetings, is raise or lower interest rates. The Fed now faces the growing recognition that official interest rates are both too high and too low. Rates are too high to maintain a trend rate of growth and to avoid the effect on the larger economy of a housing bust. They are too low to ensure price stability.

This is reflected in the minutes of the last Fed meeting, as well as in the range of financial analyses I get from market people.

People such as Bridgewater Associates and Morgan Stanley correctly point out that growth is continuing, shortages and order delays are increasing, and inflation remains a problem.

The interest rate futures market participants, consumer economists such as Susan Sterne, and others say, also correctly, that policy rates have to be cut, and soon.

Mr Bernanke is famously a student of the Great Depression, and an advocate of rapid intervention in such circumstances to throw cheap loans
at people so they will do something, anything. The problem is that as short-term cycles pass, the cheap money has to get cheaper and cheaper as the over-investment piles up.

The Austrian analysis is probably the best one on hand to analyse the present bind of investors and central bankers. It does not, however, give you a cookbook approach to making lots of money fast with no risk, the noble goal of this column. For example, while Austrians are natural goldbugs, I think the price of gold will be lower over the next nine months than it is now.

If you do believe – or come to believe – in intertemporal misallocation, you will decide that continued tactical flexibility is important to making or preserving your money. As long as policymakers are torn between conflicting imperatives, you should anticipate their next, politically driven, move.

Right now, Mr Connolly of Banque AIG thinks that means buying US Tips inflation-indexed bonds, since long-term real rates will have to come down again, over time. Both of us are also bullish on the longer term prospects for gold.

john.dizard@hotmail.com

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