Wednesday, April 2, 2008

Austrian Economics, Recessions, and the Dollar

If you are investing in cash itself, rather than assets or commodities, you are betting that price of the goods and services money can buy will decline in the future. The Austrian School of Economics explains this well.

The Austrian School is an economic theory that arose in Austria around the time of the Weimar Republic. Its best known writer is Ludwig von Mises, most known for his general work on economics, Human Action (1949). It is worth a read if your investments are mainly in dollars, or want a contrarian viewpoint for weathering the upcoming recession. With the rise of the Nazi’s, most Austrian-school economists moved to America, and its hub is now situated in Atlanta, Georgia. Generally, its focus is pro-free market and anti-regulation of any sort. Mises argued that any and all government regulation of the economy benefits one group of citizens at the expense of another, and so is unfair except for necessary government services. Whether necessary or not, it introduces economic inefficiencies into the system, through tax burdens. This is a point I plan to return to over the course of this blog.

The theory is useful for explaining credit bubbles, which have been recurrent in history since at least the beginning of central banking. (Consequently, Austrian economics is highly critical of central banking, advocating for a gold standard instead.) Reading histories on the subject e.g. Extraordinary Popular Delusions and the Madness of Crowds (1841) by Charles Mackay, they all repeat similar patterns.

Here is how it works: during times of easy credit, investors will borrow cheap money (at artificially low interest rates) to invest in higher-paying asset-based investments. Thus asset prices will rise due to demand. Then people borrow more money to buy assets expecting profits through capital gains. In short order, speculation gets carried away, to the point where the speculative cost of assets is far, far higher than its value in generating dividends. Recent examples have been the Internet bubble and the housing bubble.

According to Austrian Economics, there are only two ways to resolve the recession that follows a credit bubble: deflation, or hyperinflation. There is no middle ground-- there is no “muddle through” with moderate inflation, which just delays the price correction that must follow. Deflation of asset prices will occur if the market is left alone. The only way to stop deflation would be to “hyperinflate,” which means printing currency to pay off bad debt and keep asset prices high. History has examples of both deflationary recessions (i.e. The Great Depression, or Japan 1990’s-current) and hyperinflationary recessions (i.e. Weimar Republic, or Zimbabwe).

Since printing money is easy enough, it is the decision of our politicians and regulators which route to take. If they do nothing, deflation will occur. Hyperinflation will occur by printing the amount of money necessary to offset the impending deflationary event. This makes investing in the dollar rather exciting during the collapse of a credit bubble. With deflation, the value of the dollar will increase and cash becomes a good investment. With hyperinflation, the value of cash goes to nothing and it is a horrible investment. Making the right guess as to which way our regulators will choose to go will be critical to making the right investment.

If you invest in the dollar, you are absolutely betting this recession will be deflationary, and not hyperinflationary, and not even inflationary “muddle through.”

No comments: