For the Austrian school of economics - hallmarked by the views of Von Mises, Hayek, etcetera - it's been six long years of winter. Ever since 2009, alarmist expectations of runaway inflation and all-around disaster have not (yet) come to pass. Perhaps the biggest red herring was that famous chart, which all Austrian enthusiasts recall, of the Federal Reserve balance sheet shooting up into the stratosphere. With all that insane credit creation, how could rampant inflation not have been the follow-on result? With so much blatantly manipulative control wielded by the Federal Reserve (and central bankers everywhere), how could the world not reap what it sowed?
In understanding what could happen to the global economy (how all of this could end), it is perhaps useful to first be aware of just where the Austrian school went wrong (in the popular sense that is… not at all automatically assuming that every Austrian practitioner made the following catalog of economic errors). In general terms, here are some things the popularized version of Austrian economics badly botched:
The false notion that Federal Reserve QE (Quantitative Easing) was the same as "printing money."
This error was especially obnoxious because it was so widespread, and so wrong. It is important to remember that words mean things, and that a bad definition can be worse than no definition at all. Thus to say the Fed was "printing money," when that is not what was happening, is to sow confusion. There exists a major difference between 1) a "helicopter drop" of cash, which didn't happen, and 2) asset swaps which add liquidity to bank reserves, which are more or less what did. There was in fact a very powerful QE effect… but not in a money printing sense, as if consumers had received extra money in their mailbox. Instead, the impact of QE came through artificially lowered interest rates and expanded willingness of banks to lend to blue chip corporations, which in turn fueled financial engineering, reaching for yield, and a paper asset boom.
The false notion that all inflation is the same.
This was not said out loud, but largely implied. The vision of a big spike on the Federal Reserve balance sheet led to images of runaway inflation, in turn invoking memories of the 1970s and prices running haywire. But that is not how inflation works. You can have many different types of inflation, and you can actually have inflation in one pocket of the economy, yet deflation in another pocket, at the exact same time. The past six years indeed saw meaningful inflation of a certain type: Most all of it went into paper assets and liquidity-sensitive stores of wealth. This is a real and legitimate form of inflation, but clearly very different from what so many were expecting…
The false notion that America has a lousy balance sheet.
Yet another widespread belief was (and is) that the United States is debt-addled, burdened with a truly lousy balance sheet. But this view makes little sense in light of America's trove of valuable property and cash-flow-producing assets running into the uber-trillions… not to mention a host of intangibles that underscore all the reasons why the USA remains a global superpower. It surely makes no sense to assume a company is doomed because it has borrowed "a large sum of money" without also being aware what that company's cash flow position is, and how it is positioned vis a vis competitors. The same logic applies to countries. In assuming, say, that the US bond market would disintegrate, nobody bothered to assess how much elbow room the USA might have to leverage an asset base that was not actually that leveraged to start with.
A Calvinist view of debt as sin requiring retribution.
There is a broad view that debt is evil and accumulating it is sinful. The degree to which this view drives a culture can have big impact on worldviews and policies (for ex. note Germany). But this view is distorted from a pure economic sense. It isn't always clear that borrowing is bad. Such depends on how the money is spent, and the strength of the asset base borrowed against. A knee-jerk reaction to debt (in the general sense of things) led to assumption that sinners would be punished. But this view was too simplistic, and also overlooked saintly aspects of the USA's position. If debt accumulation is a form of moral cost, then what about the build-up of surplus on the positive side of the ledger born from American innovation, corporate dynamism, entrepreneurial agility and so on? The sinner versus saint view, in all the ways it is unhelpful, also tends to overweight the sin side and downplay the offsets.
A time frame mismatch in light of extended macro cycles.
Another clear mistake was assuming that, just because the powers that be (global central banks) had built up huge amounts of debt, the fallout would have to be imminent. But why? We know that, in terms of macro cycles, six years is not necessarily enough time to even complete a single spin of the merry-go-round. If global financial crisis rolls along every five to seven years, as it has seemed to for a good while now… then why would this aspect of the cycle be any different?
Hyping precious metals while missing wage suppression.
The focus on gold and silver as antidote to central bank folly was out of logical synch with the environment. As already noted there are different types of inflation. Paper asset inflation will tend to favor yield-producing assets and real estate, not precious metals. Meanwhile it is hard to assume inflation will show up in the traditional ways when wages are stagnant or flat! Historic US inflation had wages rising, driven by unions with pricing power, coupled with other reasons for the price of goods and services to keep getting bid up. These past six years however, wages were suppressed as corporate USA rebuilt its profitability - a benign inflation combination.
One final trap that Austrians fell into, especially in regard to that expanded Fed balance sheet, was forgetting to balance the visible creation of public credit against the less visible destruction of private credit. In the aftermath of 2008, many trillions worth of private sector credit simply vaporized. The credit creation efforts of the Federal Reserve may have been like air-dropping a mattress into a volcano by comparison.
With all the above said, it is not at all clear that the Austrian school is discredited. If anything, the logical core of Austrian economics seems more useful and on point than ever… as long as one does not fall into one of the many hidden pitfalls or traps (a few of which are mentioned above). Consider:
- The "full cycle" of market conditions is not yet complete
- Short-term benefits with delayed consequences are typical
- One doesn't know the full cost of the bill until one has paid
- China is the grand offender of Austrian economic thought
- We are now seeing China's chickens come home to roost…
One of the most important concepts in Austrian economics is the misallocation of capital. When free market signals are badly distorted, governments and businesses make lower quality investments, or even flat-out terrible ones. These illogical investments lead to lowered productivity and waste build-up throughout the economy. Eventually this build-up of "muda," the Japanese word for waste and wastefulness, leads to a forced reckoning, in the exact same fashion that, if a business is run poorly for many years while living off credit lines, the costs of those decisions are eventually born out.
Another key Austrian concept is "Katastrophenhausse" or "crack-up boom." In a crack-up boom, an orgiastic frenzy of spending and gross capital misallocation, driven by liquidity and greed and optimism turned to euphoria, leads to a sort of "party for the ages" before it turns to disaster as citizens realize that their money, upon threat of becoming worthless (in this case literally "worth less"), should be quickly spent or otherwise turned into something other than cash.
One could say China is now confirming the Austrian thesis.
This is a curveball, because so many "doomers" expected the Austrian comeuppance to take place for the United States. But as we have pointed out repeatedly in these pages, the fiscal position of the USA is actually far better than many are willing to admit when "positive side of the balance sheet" factors are taken into account… and in the same vein China's position is actually much, much worse than it appears. For instance, much is made of the fact China has three or four trillion worth of foreign reserves: But nobody really digests the fact that an estimated trillion-plus was just now spent on foolhardy efforts to stabilize China's equity market, with debt and derivative exposures in the many trillions beyond that amount. China's fiscal accounts are closer to Enron than to the rock of Gibraltar, despite what many believe!
For multiple decades China has appeared to defy the laws of both gravity and complexity, avoiding economic recession and political crisis through top down management. There are two ways to interpret this: Either the mandarins in Beijing have found loopholes allowing them to bypass the realities of free market economics, or they have been saving up the costs for one hell of an aggregated bill when crisis hits. The second view is hallmarked by problems building up below the surface, and this seems the case. So where does the Austrian view apply? Consider Von Mises' prophecy:
There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
When Mother Nature finally demands payment, the Austrian school argues, she can get it via one of two ways: Through a painful adjustment in the credit-pumped economy, or an even more painful adjustment to the currency. It is often the case that the currency is sacrificed to save the economy: This is known as "default by another name," in which debt burdens are reduced by paying with deeply devalued paper.
But here is another thing: The global economy is deeply connected now… so the actions of one player have heavy impact on another. We can think of "the currency system involved" as being represented by all countries, with various levels of strength and weakness therein. And so, when China makes extreme choices, the ripple of impact is felt across the globe… and the weakest players tend to feel it first. In fact there is a general "pecking order" of consequences based on economic strength. The stronger a country is on a standalone basis, economically speaking, the better it can weather big policy moves by, say, China or the United States. The weaker that same country, the more that movements from the "big dogs" will impact its fate, often for the worse. This is broadly why, if China continues to flail on the path to economic meltdown, it is emerging markets who will feel it most. The "destruction of the currency system involved," as noted by Von Mises, then applies to multiple currency systems, even as various emerging markets engage in "currency war" to help boost export sales, while reducing the repayment cost of expensive dollar-denominated debt. This is the channel by which capital misallocation (which many EM governments are heavily guilty of) develops knock-on potential for currency crisis, as China exports deflation (via devaluation and lowered prices) to its neighbors.
This, in turn, could fuel some serious "risk-off" drama, as anyone who remembers the late 1990s Asian currency cirsis may recall. The flipside of "survival of the fittest" is turbulence for the weakest.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.