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There's No Escaping Austrian Economics

Fed Bubble is Popping

Written by Geoffrey Pike
Posted August 28, 2015

The stock market is on a roller coaster ride — mostly down at this point. Analysts are wondering the cause and also asking whether this is a short-term correction or if there is more to worry about.

There is no shortage of explanations. Some are saying this is a correction in anticipation of the Fed raising its key interest rate. Some are blaming the problems on China, saying it is spilling over to global markets. Some believe this is just a healthy correction within the bull market of U.S. stocks.

When it comes down to it, there isn’t one specific explanation that tells us everything. For example, why did stocks start this major downturn just in the last couple of weeks, while Chinese markets have been tumbling already for a couple of months?

With that said, we do need to step back and look the broader picture of what is going on. For this, I am going to turn to Austrian economics.

As I've mentioned in the past, Austrian school economics is free market economics, named as such because the founders came from Austria (it has nothing to do with Austria's economy).

For Austrian school economists, there is a big emphasis on monetary policy. Since money makes up at least half of most transactions in a civilized economy, it plays a huge role in an economy.

It is no coincidence that countries or regions with a somewhat reliable currency tend to be more prosperous than those without. Of course, property rights and the law play a huge role as well. But if a society has a currency that is forced on it and the currency is highly unstable, it will generally translate into low living standards for the population.

When you have a currency that is constantly inflated to a great degree, it distorts the entire economy. It discourages saving and encourages debt. It makes it difficult for entrepreneurs to make calculations, and pricing is almost impossible.

Even historically strong currencies, such as the U.S. dollar, are not immune to all of the ill effects of bad monetary policy. This brings us to the business cycle.

The Austrian Business Cycle Theory

The Austrian school has a relatively simple theory, and it is becoming more accepted even in some mainstream circles.

To sum it up, when the central bank (in this case, the Fed) creates money out of thin air and keeps interest rates artificially low, it causes distortions in the economy.

This leads to an unsustainable boom.

The degree of distortions in the economy will generally be proportional to the degree of the Fed’s loose monetary policy.

When we talk about a business cycle, it is important to realize that a boom does not have to be artificial. If you have real savings and investment in an economy that leads to greater production and technology, you will get real prosperity that increases living standards.

But when a boom is fueled by an artificial stimulus of loose money, the boom is not sustainable. Perhaps people are spending more and feel wealthier, but it is an illusion — it cannot keep going on.

A middle-class family can spend its entire savings on a luxurious vacation and live like royalty for a couple of weeks. But reality will eventually hit when they run out of money. They will be forced to return to their previous lifestyle (or worse).

The problem in an unsustainable boom is that most people don’t realize it is an illusion. And it also makes it hard for entrepreneurs to calculate true demand for goods and services.

If the central bank keeps inflating the money supply at a greater and greater rate, then this may keep the illusory boom going for a while longer. If the central bank never stops, you eventually get hyperinflation and currency collapse, which is worse than any kind of a recession.

But typically what will happen is that the central bank will not keep increasing the rate of inflation. And without the continual injection of greater amounts of money, all of the misallocated resources from the boom get exposed. People quickly realize it is unsustainable when the money dries up.

This generally leads to a recession. Areas that were built up based on the central bank stimulus will all of a sudden collapse. In other words, the bubbles will burst.

When we have an artificial boom, there is no way to know for sure where the bubble will form. It can happen in real estate, commodities, bonds, stocks, collectibles, or any number of things.

When a central bank or government significantly increases the money supply that results in bubble activity, then the damage is already done at that point. It is just a question of when the bust will come and how bad it will be. The longer the central bank tries to prop it up, the worse it ends up in the end.

Are U.S. Stocks in an Artificial Boom?

So the big question is whether the U.S. economy — and U.S. stocks in particular — are in an artificial boom. Is the boom in stocks over the last six years fueled by real growth and prosperity, or is it a result of a loose monetary policy?

The answer is almost never 100% one way or the other. There is no doubt that our living standards improve in some aspects, even during economic downturns. The economic downturn in 2008 did not do too much to slow down the technological revolution we are in.

On the monetary policy side, the Fed has increased the adjusted monetary base by a multiple of five since 2008. It went from somewhere in the neighborhood of $800 billion to $4 trillion.

While this has been unprecedented for the U.S., we have also had the unique situation of seeing most of the newly created money go into excess reserves. In other words, the banks have not been lending out most of this new money, which means it does not multiply through the system via fractional reserve lending. This has helped keep consumer prices down, but there is still a misallocation of resources.

We should not be fooled by relatively mild price inflation. The easy money has flowed into stocks. There has been more asset price inflation than consumer price inflation. This is actually similar to what happened in the late 1920s, culminating in the major downturn in stocks. Most people were not too concerned about a stock bubble because consumer price inflation was mild.

It is hard to avoid the fact that the Fed had an extremely loose monetary policy from 2008 to October 2014, when the last round of so-called quantitative easing ended. When you consider that there is a lag effect in the economy, it is now almost 10 months since the money creation stopped by the Fed.

Are the previously misallocated resources now getting exposed as the flow of new money dries up?

Where Do Stocks Go From Here?

The Austrian Business Cycle Theory tells us that the easy money policies of the Fed since 2008 created something of a false boom. The Fed never allowed the correction to fully take place in 2008/2009 and instead distorted things even more.

The problem with using Austrian economics is that it can’t predict the timing of anything or exactly how it is going to unfold. It tells us that there are misallocated resources that need to be corrected and that our current conditions are unsustainable.

It is quite possible that stocks go back up from here. But I would be extremely cautious about this. This is a time for wealth preservation. You don’t have to sell all of your stocks, but it is a great time to reduce your holdings and hedge your bets. You need to own gold, cash, and even government bonds, as interest rates could go even lower from here if investors are seeking safety.

As a side note, China has the same thing going on, but to a much greater degree. China’s stock market is collapsing, even with all of the government attempts to stop it. And don’t forget the country has the largest real estate bubble in world history, with empty cities.

With the recent downturn in U.S. stocks, I have started to see suggestions that the Fed needs to start up another round of quantitative easing, which is nothing more that digital money printing.

If that happens, then perhaps they can keep the boom going for a while longer, but even that is doubtful. If the Fed turns to the digital printing presses again, we will have to consider increasing our allocation in commodities, especially gold and silver.

For now, don’t assume this stock market correction is temporary. The Fed built it up with all of its easy money, and now it is taking it away.

Until next time,

Geoffrey Pike for Wealth Daily

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