In a couple of articles, we'll investigate the tenets of Austrian economics, more especially those of Peter Schiff, as he prominently represents that school of economic thought.
Austrian economics, although a rather diverse group, holds as one of its strongest beliefs that the government can't do anything to stabilize the economy, which is a considerably more radical view than that of monetarists like Milton Friedman.
Peter Schiff gained fame by calling the 2008 financial crisis (we'll look into that as well in a later article), so a lot of investors are taking clues from him to make macro bets.
We think investors should think twice in doing that, as we will argue that the foundations, as well as the track record of Schiff's Austrian economics leaves much to be desired.
We'll start with discussing monetary policy, what Schiff doesn't favor (Fed's QE) and what he favors (a return to gold).
Peter Schiff argues that appointing Janet Yellen as Bernanke's successor at the Fed would spell disaster, basically because she's most likely to continue the Fed stimulus, which Schiff argues will lead to a currency war, a dollar and bond market collapse, as well as hyperinflation.
These things have yet to materialize, which is somewhat problematical because Yellen is likely to continue policies that have been ongoing for quite some time, but who knows, perhaps they will. With respect to inflation (let alone 'hyperinflation'), his prediction is somewhat curious:
The disappearance of inflation over the past 20 years, however, has barely dented the pervasive belief that inflation remains one of the greatest threats to economic stability. These convictions persist in spite of all evidence to the contrary: Inflation is nowhere visible. [The Atlantic]
Perhaps this is why Schiff seems to have backtracked from his (2008) hyperinflation prediction to some extent already. That is a bit painful, as it's him arguing that official inflation statistics are, well:
official inflation numbers are "a total fraud," Schiff said
There is simply no evidence for that. For instance, the online prices captured by the Billion Price Project at MIT (see here for more on that) is only marginally higher than the official CPI. If reality clashes with your theory, you should investigate the assumptions of your theory, not explain reality away. We fear this isn't the only thing that's wrong with Schiff's theory.
He calls the US economic recovery "phony" and totally dependent on Fed policy, that is, the QE stimulus and zero interest rates. Bernanke is the worst Fed president ever and we already know what he thinks of Yellen. We're not sure what the difference between a "phony" and a real recovery is, or whether he would even prefer a "phony" recovery over a "real" recession.
Actually, we do know. He seems to prefer the "real" recession, this is the "cleansing" of the system that Austrian economist like Mr. Schiff favor. The government and the Fed should simply stop stimulating after which the economy will cleanse itself (from unproductive investments financed by cheap money during the boom time).
The fact is, the government has long stopped stimulating and public austerity is actually subtracting substantially from economic growth (see graph below), but the Fed hasn't stopped stimulating.
We think that under the conditions in which banks and the private sector are deleveraging and interest rates have hit zero, fiscal policy is more powerful than monetary policy, so we would argue for exactly the reverse policy mix.
Now, we have already argued in another article that the evidence shows that the effect of QE on bond yields is rather small. So the thesis that the whole recovery, phony or otherwise, depends on it, well we await some evidence from Schiff (or anybody else).
But the effects on global liquidity are likely to be larger, and credit creation in emerging countries seems to be firm still. So we can expect markets to take a hit when the Fed reverses policy, but how much of that will filter through to the real economy remains to be seen.
We also think it's fair to say that emerging markets are running on more than just Fed QE alone, even if reversing monetary course by the Fed will have a substantial impact in emerging countries (we saw what expectations of that did to emerging markets earlier in the year).
What Schiff proposes as a monetary solution instead is for the Fed to stop the stimulus and for the US to return to the gold standard as soon as possible. How would that work out? Well, that's not unlike the euro area, where monetary union unleashes the same deflationary forces as the gold standard did in the 1930s, and the ECB is less keen on stimulus.
(click to enlarge)
It turns out the US isn't doing so badly, compared to most other developed countries that went through a similar economic crisis.
While it's a little too soon to declare victory, but Abeconomics, the effort to get Japan out of a two decades long deflationary slump, seems to be working, and one should take note that Abeconomics doubles down on Fed and fiscal policy stimulus, exactly the opposite of what Schiff prescribes.
We also know, of course, that the countries which emerged sooner from the 1930s depression where the ones that left the gold standard sooner, a stimulative measure the Austrians generally abhor and call 'currency debasement.'
Further, recessions were more frequent and extreme (and here) under the gold standard and prices actually fell often during the gold standard era. The latter is noteworthy. Schiff is allergic to inflation, but actively welcomes deflation.
The total value of gold ever mined since the beginning of time is $4.3 trillion whilst the global economy is $60 trillion, Hard Assets Investors asked Schiff whether he is suggesting that we should cut the global economy by $56 trillion, Schiff responds:
Mike, prices adjust downward to reflect the supply of gold; that's fine, and we want prices to fall.
What falling prices, let alone one of that magnitude, would do to the real value of outstanding debt, we'll leave to your imagination. Indeed, even in the absence of actually falling prices, Italian, Spanish, Portuguese, and Greek debt dynamics are already significantly worsened by the so called 'denominator effect,' that is, ever increasing as a percentage of a stagnant nominal GDP.
One might also note that even severely deflationary policies, like the one let loose on Greece, haven't been able to get prices into negative territory in any decisive manner. We also note that a gold standard prevent asset bubbles:
Quite why gold bugs think that the Gold Standard prevents asset bubbles and excess debt is beyond me. The 1920s saw US debt levels surge to around 300pc to 350pc of GDP. It is very similar to what occurred in our own Noughties up to 2008. [Evans-Pritchard]
And, of course, gold isn't exactly a stable anchor for prices..