Introducing the Austrian School of Economics

By Filipe R. Costa 

There is a great deal of confusion about the current disconnect between corporate profits and stratospheric stock markets and the state of the real economy. Mainstream economics has failed to explain what is probably coming, but for Austrian economists the path is clear. We’re heading towards a recession.

In case you’ve missed it, recent economic policy has been guided by the principle of more monetary intervention and more fiscal intervention as the means of smoothing business cycles and avoiding harsh periods of contraction. Keynesian thinking has been behind all this, best exemplified by the actions of Bernanke, Yellen and Abe. Even faced with a Keynesian liquidity trap, as I wrote last week, which shows their policies just aren’t working, these people still press ahead regardless. After 20 years of failure, the Bank of Japan still believes in more of the same! 

The failure of the Keynesians to grasp the nature of boom and bust over the last few decades has given rise to a resurgence in the Austrian school of economics. According to the Austrians busts in the economic cycle occur as a result of periods of poor capital allocation thanks to artificially low credit and an unsustainable increase in the money supply.

Dismissed by Krugman as the “Hangover Theory”, the Austrian school of Mises and Hayek provides a more powerful means of explaining the current predicament we all find ourselves in.

For the Austrians the trouble starts when a central bank, for example the Federal Reserve, changes the optimal allocation of capital by lowering rates and injecting money into the economy. Thanks to the free availability of too much “easy” money, poor investment decisions are made and this creates unsustainable asset inflation until a crash occurs. This then gives way to a period of readjustment as the economy recovers from the preceding malinvestment. Deleveraging follows and deflation occurs.

If this all sounds familiar it is because this is exactly what happened. Think back over the last ten years since the Dotcom Crash.  

So where are we now?

In a recent article about corporate profit growth, The Economist revealed that corporate profits are at a 50 year high as a percentage of GDP. This might sound very positive but the reality is that profits are no longer growing, thanks to their cyclical nature. This suggests we are at or are approaching a top in the market:

Where profits look like they are at a top, earnings per share ratios (EPS) still are growing. This should be a cause for concern. If profits aren’t growing, then what could be driving EPS higher?

The Austrians have an explanation.

Artificially low interest rates heavily incentivise corporations to refinance debt and borrow money. With persistent economic uncertainty this does little to increase output. Instead companies are buying back shares and paying higher dividends. This is what is driving EPS growth and the lack of serious investment reduces depreciation charges, which also helps corporate bottom lines.

There is no doubt that the Federal Reserve’s policies are directing capital allocation into stock markets. The statistics suggest this is at the expense of serious investment geared towards increasing economic output and generating real wealth. Executives appear gripped by a frenzy to repurchase more and more of their stock, artificially helping to drive share prices higher. Given how bonus payments are structured around stock performance, their motivation for doing this is obvious. The rest of the market is understandably excited at the short term prospects of more gains.

However, the Austrians have a warning for us. Under such conditions of capital misallocation caused by excessive and cheap credit, prices will rise until the inevitable crash. The Federal Reserve has staked a hell of a lot betting against the Austrians. Let’s see who is right.