Find Investment Opportunities Using the Austrian Business Cycle Theory

I know I've talked about the Austrian business cycle quite a bit in my blog posts, but I wanted to make a post that provides a clearer introduction to it and its logic. So here goes.

Austrian economics and Austrian business cycle theory have regained a bit of popularity of late, given the recent turmoil in the financial markets. Understanding Austrian business cycle theory can help us understand where things are headed, so that we can invest accordingly.

What it is: Austrian business cycle theory basically posits that bubbles and busts result primarily from an overexpansion of credit. Credit is too cheap and too easy. Entrepreneurs are trained in finding market opportunities and inefficiencies in the market; and thus, the Austrian business cycle posits, entrepreneurs as a whole can only be collectively misled for a sustained period if credit is excessively expanded. This will cause entrepreneurs to excessively invest in capital-intensive projects, like building houses.

The result: The result of this excessive expansion is that the market will eventually try to deflate and purge the misguided investments out of the market. This will result in deflation.

What government policy should be: According to Austrian business cycle theory, deflation is good, and government policy should embrace it -- not avoid it. Deflation will encourage "hoarding of cash," which is perhaps more accurately referred to as savings. These savings will then form the basis for the economy to heal itself and become strong again.

What happens if government intervenes: If government intervenes to prevent deflation, one of two things will happen: deflation will be prolonged and deepened, as we see in Japan; alternatively, if government goes into greater debt while its tax base diminishes, it runs the risk of being unable to find borrowers, at which point faith in the currency is lost and a run on the currency begins -- meaning everyone looks to sell the currency, causing its value to fall and prices to rise, as we saw in Argentina in 2001 and 2002.

Which brings us to where we are today.

So the key question: how much deflation? To answer that question, consider the chart below:

Note the uptrend that begins in 1995; this is the beginning of the tech bubble, which was brought about by excessive credit expansion under Greenspan's Fed. The market tried to deflate -- this was the "dot com apocalypse" from 2001-2003 -- but the Fed lowered rates again, preventing a full deflation, and instead pushing the bubble into the housing market. A full deflation would then push S&P back to the 1995 level of around 400. Alternatively, a run on the US dollar may cause the nominal price of stocks to rise, but it will fall respective to other currencies. A way to gauge whether the stock market is truly rising in value or if it is just a nominal gain resulting from currency weakness is to compare percentage gains in stocks to gains in gold. If stocks are rising faster than gold, it could be a sign of real growth.

According to Austrian business cycle theory, if money supply was not excessively expanded but was kept at appropriate levels, there would be no real bubbles or busts. This may make the stock market less fun. Conversely, it would lead to greater focus on profitability rather than financial ratios, and a corresponding focus on dividends rather than valuations.

Comments

[Wayne Found...:]

Excellent article Simit. So all this, combined with current government actions, would indicate we are once again ignoring Austrian economic theory and, perhaps foolishly, intervening to prevent deflation by printing money like mad and injecting it into the system. The question now is, will this remedy boost stocks again like it did for the dotcom/tech and housing/commodity bubbles? Or have the feds gone back to the well once to much? As interest rates approach zero in the US and Europe, perhaps the interest rate cut vaccine is finally no longer effective? How would we know until after time passes? And, if another bubble is in the offing, what will it be this time? As we look back at the chart, it was dot/com tech, then housing/commodities... what's left? Where can the money run to? My guess would be consumer staples--General Mills, Dean Foods, Johnson & Johnson, Proctor & Gamble, Walmart, etc. Where will the working folks spend their money when Obama implements his program? And will there be any working folks left to make any of this matter?

2008 Dec 04 08:25 AM

[Augustus:]

The possible suggested investment opportunity is ????? It would be great to have some suggestions so that the implications of the scenario could be illustrated.

2008 Dec 04 11:24 AM

[doubleguns:]

The bubble forming now is US treasuries. They have such small returns now since the cost went so high. The price will come down and returns will go up but the dollar will be weaker so you loose every way.

The investment to move to would be gold.

Just my humble opinion. Got gold!

2008 Dec 04 04:33 PM

[upgrayed:]

So we're going to either have deflation or inflation according to the Austrian blah blah blah theory. That's great. Thanks.

2008 Dec 04 11:18 PM

[sbenard:]

If the currency is devalued, then gold and other physical assets would be primary beneficiaries. All hard assets would benefit. That would include -- hard to believe right now -- real also, perhaps. However, with credit difficult to come by, real estate would require monstrous amounts of cash, so remain in a deflationary cycle. Excessive credit makes high ticket assets easier to acquire, but also tends to exacerbate the inflationary aspect of that to-easy credit. I'm banking on commodities -- again -- sometime next year. Perhaps we have begun to see the resurgence of some commodities in the last few days. Corn, soybeans, wheat, and other food commodities skyrocketed today, for example. Gold has also held up remarkably well over the past few months.

2008 Dec 12 05:05 PM