Inflation, Easy Money And The Austrian School Of Economics

by: Shareholders Unite

Here is a thought experiment. What would happen if someone who is an adherent of a rather obscure economic school called Austrian economics would make economic policy or rule the Fed? This is less of a hypothetical question than might seem at first hand. There is, in fact, an Austrian school candidate (Ron Paul) who's got support of quite a number of big names in finance.

Austrians would do a couple of things if they would have control over policy making. They would wind down all expansionary monetary policy and bailouts (as it happens, they would ultimately abolish the Fed altogether, but we won't go into that here). They would also reintroduce the gold standard. The timing of these policies matters a great deal, so let's first take the best case scenario, and assume they would introduce these policies when the economy is healthy (that is, not today).

What the Austrians want is to cleanse the system, no matter the consequences. Easy money is the source of all evil. Easy money produces bubbles, which then need more easy money to salvage the situation when the bubble implodes, and that leads to hyperinflation. That, in a nutshell, is the Austrian analysis.

So they want to do away with the easy money, and one way is to reintroduce the gold standard. Now, don't get us wrong, we agree to some extent that easy money has been a factor in creating past asset bubbles, so we partly agree with the Austrians here. However, their solution is like throwing out the proverbial baby with the bathwater.

As we know from the 1920s, reintroducing the gold standard isn't a guarantee against asset bubbles from materializing. What's more, we have two preoccupations:

  1. There were easier ways to prevent bubbles from arising
  2. Once a bubble burst, the cost of easy money are low and the returns high, exactly the opposite of what the Austrians believe.

Preventing bubbles

While many people worry themselves into a stupor about public debt, the rise in private debt has gone largely unnoticed, or at least it doesn't provoke anywhere near the same alarm. Yet it was private debt that was behind the housing bubble. Not only in the US, but in many other countries (Ireland, Spain, Denmark, The Netherlands, the UK, etc.).

There are a couple of simple regulations that could have prevented the run-up in private debt, and thereby prevent bubbles from forming. For instance:

  • Higher bank capital ratios
  • Maxima on leverage
  • Better regulation of financial markets, derivatives markets in particular, markets in which purposely complex products were created purposely to mislead investors and traded on near unregulated markets
  • Down-payments on mortgages, maxima on mortgages related to income, and better regulation of the mortgage markets (preventing stuff like robo-signing and enabling people to take mortgages that clearly couldn't enforce them with the bank not worried as these mortgages were quickly packages into inscrutable securities and shifted off the balance)
  • Don't allow banks to trade for their own account, and/or limit their personal profit from it (bonuses)
  • Don't allow banks or any other financial institution to be "too big to fail," thereby creating a huge moral hazard problem.

In short, there is simple regulation available that could have prevented the run-up of asset bubbles, but since the Austrians have a religious belief in free markets that seems inversely related with an understanding how they actually function in the real world. If anything, they want to deregulate financial markets again.

Austrians are also insufficiently aware that policy can do good. Central banks have stopped economies from overheating many times in the past.

The seem to have complete disregard from the fact that markets are inherently unstable and can be trapped in an under-employment equilibrium, or that market restoring mechanisms can, at times, be overwhelmed by self-reinforcing feedback loops (the paradox of thrift, in which people try to save more, but if everybody tries to do that we're ending up with less savings as reduced spending lowers income. Or Fisher's debt-deflationary cycle in which deflation increases the real value of debt, leading to less spending, more forced asset sales and even more deflation, etc.).

Easy does it

But our main gripe with the Austrians comes from the mayhem that introducing their policy prescriptions would introduce under today's circumstances. Easy money is what kept the 2008 financial crisis from developing into something much worse. Few people realize that by most relevant statistics, the decline after Lehman was as worse, or worse compared to the crash in 1929. If you have doubts, see the figures below:

Guess what caused the arrest? Could the unprecedented Fed interventions have something to do with that. After all, that was the main differentiator this time around. Yes, it was terribly unjust, yes it bailed out people who caused all the trouble. Yes it reinforces moral hazard. But there was simply no alternative.


And their main worry about all this easy money is that hyperinflation will take off at any time. It is rather comical, day-in, day-out the Austrian blog ZeroHedge parades another financial specialist warning that accelerating inflation is just around the corner. They have been doing that since 2008. In the meantime, the monetary base of the Fed has tripled at least, without causing even a minimal uptick in inflation.

One would think that by now, they should start to doubt their own analysis at least a little, but no, instead attacking:

patently false economic models spread by hacks whose only credibility is being endorsed by the same system that created these models over the past century

After having been wrong about inflation (let alone hyperinflation) for years, one would assume a certain moderation would set in (they even make that bizarre claim about central banks underpinning a large part of the world economy again).

However, not an inch of reflection on their own Austrian models here (we really invite you to read the article in its entirety, as the level of arrogance and lack of self-reflection is quite breathtaking).

And there is a simple explanation why there isn't any threat of inflation taking off, despite the tripling in the monetary base. After the 9 trillion (40%) housing implosion, households are repairing their balance sheets, preferring to pay off debt, rather than assume new debt, despite record low interest rates.

So there is simply little demand for credit, which is the main way how money gets into the economy in the first place. We're in a liquidity trap, banks store their reserves as deposits at the Fed, rather than lend it out. Hence little danger of inflation taking off.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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